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Real estate is a powerful wealth building tool that brings with it some awesome tax advantages. As an investor in real estate, you require a professional tax firm who can advise you through the tax implications of your transactions, so you can adequately analyze them and make decisions. Further, if you raise private capital from multiple investors, you need someone who is an expert in partnerships (and LLCs taxed as partnerships).
Leasehold Improvement Property
Improvements made to a building or other real property subject to a lease are depreciable. Under MACRS (the Modified Accelerated Cost Recovery System), the term of the lease is irrelevant. MACRS improvements to the interior of nonresidential real property can be depreciated over 15 years if placed in service before January 1, 2014, provided the building was at least three years old. Without this rule, the improvement could be treated as 39-year MACRS property. Bonus depreciation may be taken on leasehold improvement property.
Ordinarily, the lessor takes depreciation; the lessee can deduct rental payments. The owner of property may decide to engage in a sale-leaseback transaction, where the owner sells real or personal property to a buyer, who leases it back to the seller. If the transaction is bona fide, the seller-lessee can free up capital in the property, and can deduct rental payments to the buyer-lessor. This may provide a larger deduction than depreciation and interest. The lessor can also depreciate the property. However, a sale-leaseback may be recharacterized as a financing device, if the seller retains the economic risks of ownership; this may diminish the seller’s tax benefits. The IRS and the courts have identified several factors to consider when characterizing the transaction.
The tax treatment of amounts paid to cancel a lease may vary. A lessor that pays to cancel a lease for its own use generally has to amortize the payment over the unexpired term of the lease. However, a lessor that cancels a lease so it can sell the property adds the payments to the property’s basis. A lessee that pays to cancel a lease so that it can make improvements or put up a new building must amortize the payments over the life of the new building or improvements.
If the lessor provides an option to buy, payments under the lease made after the option is exercised are treated as purchase price installments. If the lease is treated as a disguised sale, the payments are also treated as purchase price installments, not rent. The characterization depends on objective economic factors and whether the lessor retained sufficient indicia of ownership.
Sales and Exchanges; Like-Kind Exchanges
Gain or loss on the disposition of real property is capital gain or loss, unless the property is held primarily for sale to customers or is depreciable property used in a trade or business. As described below, depreciable property is subject to recapture on its disposition. If real property is sold to a related party, any gain is ordinary income, and any loss is disallowed.
If the taxpayer exchanges like-kind property, no gain or loss is recognized, except for items such as depreciation recapture. Taxpayers may engage in a deferred exchange involving three parties, to accomplish a like-kind exchange. Real property can be like-kind. Unlike personal property, parcels of real property may qualify as like-kind even if they differ as to grade or quality.
Gain from the sale of property usually is treated as capital gain, and taxed at a lower rate than ordinary income. However, on the sale of Code Sec. 1245 property or Code Sec. 1250 property, the seller must recapture depreciation taken on the property as ordinary income. For Code Sec. 1245 property, all depreciation taken on the property has to be recaptured. For Code Sec. 1250 property, the excess of accelerated depreciation over straight-line depreciation must be recaptured as ordinary income.
Code Sec. 1245 property generally is tangible personal property, but it also includes certain real property whose basis was reduced by specified deductions (such as the five-year amortization rule for pollution control facilities). Code Sec. 1250 property is depreciable real property that is not Code Sec. 1245 property. It includes intangible property, such as a leasehold, and buildings and their structural components.
Real Estate Professionals
Real property that is held primarily for sale to customers in the ordinary course of business is not a capital asset. Any gain or loss on its disposition is ordinary. The seller is identified as a dealer. However, if the property is acquired and held principally for investment, any gain is capital. The determination of whether property is held primarily for sale depends on the facts of the case; the courts have identified a number of factors for making this determination.
Under Code Sec. 1231, property must be property used in the trade or business for taxpayers to apply. Code Sec. 1231, which treats gains as capital and losses as ordinary for gains and losses resulting from the sale or exchange of the property. Rental real estate can be a trade or business if the owner rents properties and is substantially involved on a regular basis with renting, servicing tenants, and maintaining the properties. However, a taxpayer with a single rental property may have a harder time demonstrating that the rental is a trade or business.
REITs and REMICs
Taxpayers may invest in real estate, mortgages and similar assets through a corporation that is treated as a real estate investment trust (REIT). Income that is earned by a REIT and distributed to its shareholders is taxed only to the shareholders, and not at the REIT level. REITS must satisfy a number of requirements as to structure, income source, assets and distributions.
Taxpayers may also invest in pools of mortgages (mortgage-backed securities) through a real estate mortgage investment conduit (REMIC). Like REITs, REMICs are subject to a number of requirements. A REMIC is not a taxable entity, whereas a taxable mortgage pool may be treated as a corporation.
There are two special tax credits that can involve real estate: the low-income housing tax credit (LIHTC), and the New Markets Tax Credit (NMTC). The LIHTC is claimed over a 10-year period as a percentage of the qualified basis of a qualified low-income building. While the purchase of an existing building generally does not qualify for the credit, rehabilitation expenses may qualify. A qualified building is rental real estate that provides a portion of its units at lower rents to low-income renters
For the NMTC, an investor is entitled to a credit, which could reach as high as 39 percent over seven years, for an equity investment in a community development entity that makes qualified investments in a low-income community. A qualified investment can be made in a business or in real estate. Currently, most investments are made in real estate.
Another tax benefit involving real estate is the deduction for conservation easement. The owner of the property must donate a real property interest to charity for conservation purposes, such as the preservation of open space or wildlife habitat. A restriction on the use of real property, such as a restrictive covenant that preserves a façade, may also qualify.
We have highlighted only some of the many federal tax laws that impact real estate businesses. Every business is unique and has particular tax considerations. Please contact our office so that we can set a time to discuss your business in more detail.
DEDUCTIBLE MORTGAGE INTEREST
The Tax Cuts and Jobs Act (Tax Cuts Act) has placed new restrictions on the home mortgage interest deduction, one of the most important tax breaks available for homeowners today. Because the potential for tax savings is so great, it may be useful to review the rules. As you'll see, they are quite complex and full of pitfalls as well as opportunities.
Home acquisition. Like the vast majority of Americans, you generally can fully deduct the interest paid on a loan if the proceeds are used to buy or build a residence (a main home and one vacation home). This type of financing is called acquisition debt; it can't exceed an aggregate of $1 million for all interest to be deductible, and must be secured by your home.
Under the Tax Cuts Act, a taxpayer may treat no more than $750,000 as acquisition debt ($375,000 in the case of married taxpayers filing separately) for tax years 2018 through 2025. The reduced amounts for acquisition debt do not apply to any debt incurred on or before December 15, 2017. Therefore, a taxpayer who purchased their home on or before December 15, 2017, may continue to deduct interest paid on the first $1 million of debt ($500,000 for a married taxpayer filing a separate return). The acquisition debt incurred on or before December 15, 2017, reduces the $750,000/$375,000 limit to any acquisition debt incurred after December 15, 2017.
Points. In general, any points you pay to the lender in the year you get a mortgage loan to buy your main residence are fully deductible. In order for points to be deductible, they must be paid from funds separate from loan principal at the time of closing. Points paid to refinance a mortgage on a principal residence are generally not deductible in the year paid and must be prorated over the period of the new loan. However, if the borrower uses part of the refinanced mortgage proceeds to improve his or her principal residence, the points attributable to the improvement are deductible in the year paid.
Home equity loans. The Tax Cuts Act suspends the deduction for interest on home equity debt. Therefore, for tax years beginning after December 31, 2017, a taxpayer may not claim a deduction for interest on home equity debt. However, home equity loan interest is still deductible in certain circumstances. For example, interest on a home equity loan used to build an addition to an existing home would be deductible if certain requirements are met. The suspension ends for tax years beginning after December 31, 2025.
Refinance. It may be beneficial to refinance acquisition debt for a lower rate of interest (or more favorable terms overall). The ($1million/$500,000) higher dollar limit continues to apply to any debt incurred after December 15, 2017, if it used to refinance existing acquisition debt as long as the refinancing does not exceed the amount of the refinanced debt. Therefore, the maximum dollar amount that may be treated as acquisition debt on the taxpayer’s principal residence will not decrease by reason of a refinancing. The exception for refinancing existing acquisition will not apply after:
the expiration of the term of the original debt; or
the earlier of the expiration of the first refinancing of the debt or 30 years after the date of the first refinancing
VACATION HOME - 15-DAY RULE
Rental of Vacation Home or Residence
If you rent out your vacation home or primary residence for part of the year, whether or not that income is taxable can depend on how many days the property is rented out. In the same sense, deducting certain expenses in relation to this rental income also depends on how many days the property is rented out.
When is the rental income not part of gross income on the tax return? When are expenses related to the rental not deductible?
Minimum Rental Use
If you rent the property for fewer than 15 days during the year, you are not allowed deductions directly attributable to such rental, but that's because of a bigger benefit: no rental income is includible in gross income. Deductions allowed without regard to whether or not the home is used for business or the production of income (e.g., mortgage interest, property taxes, or a casualty loss) may still be taken.
So for this special rule, if you use a dwelling unit as a residence and rent it for fewer than 15 days. In this case, don't report any of the rental income and don't deduct any expenses as rental expenses.
For example, if you decide to rent out your personal residence on Airbnb for only 14 days out of the whole year, you do not have to report this rental income as part of your gross income on your tax return and any rental expenses incurred cannot be used as deductions.
What if I rent out my property for 15 or more days?
If you rent out your property for 15 or more days in the year, then the rental income received is part of your gross income on your tax return.
If you rent the property for 15 or more days during the tax year and it is used by the taxpayer for personal purposes for the greater of (a) more than 14 days or (b) more than 10% of the number of days during the year for which the home is rented, the rental deductions are limited. Under this limitation, the amount of the rental activity deductions may not exceed the amount by which the gross income derived from such activity exceeds the deductions otherwise allowable for the property, such as interest and taxes.
If you use the dwelling unit for both rental and personal purposes, you generally must divide your total expenses between the rental use and the personal use based on the number of days used for each purpose. You won't be able to deduct your rental expense in excess of the gross rental income limitation (your gross rental income less the rental portion of mortgage interest, real estate taxes, and casualty losses, and rental expenses like realtors' fees and advertising costs).
Home Office Deduction
Individuals who use part of their personal residences for business may be able to deduct expenses for the business use of their home. This is known as the home office deduction. The tax-saving opportunities available to you will depend not only on the type of work you do at home but where in the home you perform it.
What Does Not Qualify as a Home Office?
You won't get any home-office-type deductions unless you regularly and exclusively use a room or specific area in your home or apartment for business.
If you're an employee who regularly comes home from the office with a loaded briefcase, catching up on paperwork at home won't do you any tax good. Employees qualify for home-office deductions only if they work at home for the convenience of their employer. So there are no deductions if you decide on your own to do office work during evenings and weekends, or work a couple of days a week at home because you'll get more done. And even if your employer requires you to work at home, you don't get any extra deductions unless you also get by the home-office hurdles.
What Qualifies as a Home Office?
Your home office must be a specific part of your home that is solely used as your office or to conduct business activities. So, for example, you don't get deductions if you work out of a room that your family also uses as a den. In addition, generally, the office must either be the principal place of your business, or a place where you meet or deal with clients or customers.
If you're a professional such as a doctor, dentist, or consultant who regularly meets with clients or patients in the home, you probably qualify for home-office deductions, but you may benefit from help on how best to allocate "shared" personal/business expenses.
In a nutshell, home office expenses may be deductible if part of the home is used regularly and exclusively as (1) a principal place of business for any trade or business of the taxpayer or (2) as a place of business which is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his trade or business. In the case of employees, their use of their home must be for the convenience of their employer.
Exclusive use means just that. To qualify under the exclusive use test, a taxpayer must use a specific part of his or her home only for his or her business. A taxpayer does not meet the requirements of the exclusive use test if he or she uses the part of the home both for business and for personal purposes.
What Types of Expenses Qualify for Home Office Deduction?
You may be able to deduct part of your home's normal operating expenses for items such as utilities and insurance, you may be able to claim write-offs for depreciation or lease payments, depending on whether you own or rent, and you may even get some extra business car deductions.
Taxpayers who qualify to deduct expenses for the business use of their home must divide the expenses of operating their home between personal and business use. Among the type of expenses that may be taken into account are the costs of insurance, utilities, repairs, and depreciation. Taxpayers who own their homes and qualify to deduct expenses for its business use may be able to claim a depreciation deduction.
How Is This Deduction Calculated?
Generally, deductions for a home office are based on the percentage of the taxpayer’s home devoted to business use. If an individual uses one or two rooms or merely part of a room, the taxpayer must calculate the percentage of the home devoted to the business. For example, if the taxpayer’s home is 1,200 feet and she uses one room (which is 240 square feet) for business activities, the business percentage use of the home is 20 percent (240 square feet divided by 1,200 square feet).
Taxpayers claiming the home office deduction file Form 8829, Expenses for Business Use of Your Home, with their individual income tax returns. According to the IRS, 3.4 million taxpayers claimed the home office deduction in 2010
Simplified Option of Calculating
The simplified option allows a taxpayer to calculate the amount of allowable deductible expenses for business use of a home for the tax year by multiplying the allowable square footage by the prescribed rate. The allowable square footage is the portion of the home used in a qualified business use of the home, but not to exceed 300 feet. The prescribed rate is $5.00. Effectively, the simplified option provides a maximum deduction of $1,500 (300 square feet multiplied by $5.00).
Should I Use the Simplified Option to Calculate Instead?
The simplified option is optional. Some taxpayers may find it valuable because of its intended ease of use but it is not a “one-size-fits-all” substitute to the regular rules.
As you can see, working at home may be anything but simple from a tax standpoint. We'll be happy to supply complete details on how the rules work in your situation, and how to make the most of them. If you need any help, don't hesitate to call. We can help you weigh the advantages of a home office deduction against the potential for subsequent increased taxes. You should also call us if you've been taking a home office deduction and you're now thinking of selling your combined home/office. With some advance tax planning, you may be able to minimize taxes on the transaction.
SALE OF PRIMARY RESIDENCE
Generally, taxpayers may exclude up to $250,000 ($500,000 for married couples filing a joint return) of gain from gross income on the sale or exchange of their principal residence. Below is some information you may find useful in determining possible exclusions when you sell your home.
This exclusion applies if the taxpayer has owned and used the property as a principal residence for periods aggregating two years or more during the five years immediately preceding the sale or exchange of the residence.
The exclusion applies to only one sale of a principal residence in any two-year period. The two-year ownership and use periods do not have to be concurrent for the exclusion to apply.
What is the "Two-Year Ownership and Use Periods" Requirements?
A taxpayer is treated as owning and using the property as his or her principal residence during any period that a deceased spouse owned and used the property as a principal residence before death if:
That spouse is deceased on the date the property is sold, and
The taxpayer has not remarried at the time of the sale of the house.
In Cases of Divorce
If a taxpayer obtains property from a spouse or former spouse in certain divorce transactions, the period that the taxpayer owns the property for purposes of the two-year rule includes the period that the spouse or former spouse owned the property.
What if the Requirements Are Not Met?
If the ownership and use requirements are not met, or if more than one principal residence is sold within a two-year period, a reduced exclusion may be available if the sale or exchange of the residence is due to a change in the taxpayer’s place of employment, health, or unforeseen circumstances.
When Does the Exclusion Not Apply?
The exclusion does not apply to certain sales of a principal residence acquired in a like-kind exchange. It generally is available only to individuals but, under certain circumstances, a bankruptcy estate or grantor trust may use the exclusion. The gain from the sale of a partial interest in a principal residence also may be excluded. Generally, the exclusion is available only for the portion of the property that is used as a principal residence. The exclusion does not apply to gain allocable to any portion of the property that is not used as a principal residence if that portion of the property is separate from the dwelling unit. No allocation is required, however, if both the residential and non-residential portions of the property are within the same dwelling unit. However, in this case, the amount of the exclusion does not apply with respect to any depreciation adjustments taken for periods after May 6, 1997.
What Happens if the Exclusion Does Not Apply?
When the exclusion does not apply, any gain realized on the sale of the residence is capital gain income, which is taxed at reduced rates. Any loss realized on the sale of the residence is not deductible
If you would like more information regarding the primary home sale exclusion and want to discuss your individual situation, feel free to contact the office.
A well-known, but sometimes overlooked, way to alter investment holdings without paying tax at the time of the transaction is through the use of "like-kind" exchanges. If you think you will be engaging in activity that constitutes a like-kind exchange, here is some information that might apply to your situation and be beneficial for tax planning.
What is a Like-Kind Exchange?
In a like-kind exchange, investment property is traded for other investment property. The person transferring one piece of property receives different property but keeps the same basis as that for the old property. That way, the gain is deferred while other tax attributes are preserved.
What Are the Tax Benefits of a Like-Kind Exchange?
Like-kind exchanges generally result in a postponement of gain recognition for business and investment property owners. The tax savings from participating in a like-kind exchange can be substantial.
A like-kind exchange provides a wonderful alternative to selling the property outright. The sale of the property may cause you to recognize a gain on the sale, requiring you to pay taxes on this gain. A like-kind exchange, on the other hand, allows you to avoid gain recognition through the exchange of qualifying like-kind properties. The gain on the exchange of like-kind property is effectively deferred until you sell or otherwise dispose of the property you purchase in the exchange
Why Does the IRS Allow This Tax-Deferred Transaction?
The IRS allows this tax-deferred transaction because it recognizes that because your economic position remains the same (i.e., you have merely exchanged one property for another), you should not have to incur taxable gains. You will, however, have to recognize gain on any cash or unlike property that you receive in the exchange.
What Qualifies for Like-Kind Exchanges?
Only qualifying property may receive like-kind treatment. To qualify, both the property you give up and the property you receive must be held by you for investment or for productive use in your trade or business. Buildings, rental houses, land, trucks, and machinery are examples of property that may qualify.
Moreover, cars, light-duty trucks, and cross-over vehicles have been determined by the IRS to qualify as like-kind business property that can be exchanged tax-free under the like-kind exchange rules. The vehicles are like-kind even if they are in different classes under the depreciation rules.
To illustrate how these exchanges can work, consider the following example:
Fred owns an interest in an office building. He bought it years ago for $10,000, but today it's worth at least $100,000. Fred has decided to move to Florida and convert his office building interest into an ownership share in a Florida apartment building. Allison wants to buy Fred's office building interest, and for tax reasons, she wants to own the building interest by December 31. Fred wants to avoid the high tax he would have to pay after a cash sale.
A solution is a deferred like-kind exchange. Fred transfers his building interest to Allison on December 31. Allison agrees to locate and buy a Florida apartment building interest of equal value suitable to Fred. (Fred can even insist that Allison put the purchase price in escrow, so long as Fred has no independent right to the cash). After Allison finds and buys the Florida property, she transfers it to Fred, and the like-kind exchange is completed. Provided the 45/180 day rules along with other requirements are satisfied, Fred receives the Florida property tax-free, with the same basis and holding period he had in the office building.
Like-Kind Exchanges Provide a Valuable Tax Planning Opportunity if:
You wish to avoid recognizing taxable gain on the sale of property that you will replace with like-kind property;
You wish to diversify your real estate portfolio without tax consequence by acquiring different types of properties with the exchange proceeds;
You wish to participate in a very useful estate planning technique (continued like-kind exchanges allow you to permanently avoid recognition of gain); or
You would generate an alternative minimum tax liability upon recognition of a large capital gain in a situation where the gain would not otherwise be taxed. (The like-kind exchange shelters other income from the alternative minimum tax).
As you can see, a like-kind exchange can be an excellent tool that can be used to achieve investment goals. Even in situations where it is impractical to arrange a completely tax-free transaction, like-kind exchanges may still reduce the immediate tax consequences of altering your investment holdings. Any transaction must be carefully structured.
If you would like more information on like-kind exchanges, or if you feel that you may benefit from a like-kind exchange, please contact our office at your convenience so that we may discuss this in greater detail.
REAL ESTATE PROFESSIONAL VS. PASSIVE ACTIVITY LOSSES
Passive Activity Losses
The so-called "passive activity loss rules" have developed into a complicated set of guidelines since their inception in the mid-1980s. However, if you keep in mind the general principles that drive loss limitations in this area, you will have a good foundation for selecting investment strategies that take full advantage of, rather than solely react to, the current tax rules.
Generally, losses from passive activities may not be deducted from other types of income (for example, wages, interest, or dividends). To the extent that the total deductions from passive activities exceed the total income from these activities for the tax year, the excess (the passive activity loss) is not allowed as a deduction for that year. A disallowed loss is suspended and carried forward as a deduction from any passive activity in the next succeeding tax year. Any unused suspended losses are allowed in full when the taxpayer disposes of his entire interest in the activity in a fully taxable transaction.
Special rules apply to rental real estate activities in which a taxpayer actively participates. Losses and credits that are attributable to limited partnership interests are generally treated as arising from a passive activity. However, losses from working interests in oil and gas property are not subject to the limitation.
A passive activity is one that involves the conduct of any trade or business in which the taxpayer does not materially participate. Any rental activity is a passive activity whether or not the taxpayer materially participates. However, there are special rules for real estate rental activities and real estate professionals.
Generally, to be considered as materially participating in an activity during a tax year an individual must satisfy any one of the following tests:
1. He participates more than 500 hours
2. His participation constitutes substantially all of the participation in the activity
3. He participates for more than 100 hours and this participation is not less than the participation of any other individual
4. The activity is a "significant participation activity" and his participation in all such activities exceeds 500 hours; 5. He materially participated in the activity for any five years of the 10 years that preceded the year in question; 6. The activity is a "personal service activity" and he materially participated in the activity for any three years preceding the tax year in question; or
7. He satisfies a facts and circumstances test that requires him to show that he participated on a regular, continuous, and substantial basis.
A significant participation activity is one in which the taxpayer participates more than 100 hours during the tax year but does not materially participate under any of the other six tests set forth above.
A personal service activity involves the performance of personal service in (1) the fields of health, engineering, architecture, accounting, actuarial services, the performing arts, or consulting, or (2) any other trade or business in which capital is not a material income-producing factor.
Portfolio income is not treated as income from a passive activity; it must be accounted for separately, and passive losses and credits generally may not be applied against it. The term "portfolio income" includes interest, dividends, annuities and royalties, as well as gain or loss from the disposition of income-producing or investment property that is not derived in the ordinary course of a trade or business.
How Losses Are Deducted
Generally, a loss arising from a passive activity is deductible against the net income of another passive activity. Losses that are not deductible for a particular tax year because there is insufficient passive activity income to offset them (suspended losses) are carried forward indefinitely and are allowed as deductions against passive income in subsequent years. Unused suspended losses are allowed in full upon a fully taxable disposition of the taxpayer's entire interest in the activity.
Please do not hesitate to contact us if you have any questions about how the passive activity loss limitations apply to any particular investment activity in which you may be involved now, or in the future.
VACATION HOME - 15 DAY RULE
SALE OF PRIMARY RESIDENCE EXCLUSION
REAL ESTATE PROFESSIONAL VS. PASSIVE ACTIVITY LOSSES