REAL ESTATE: INCOME TAX MATTERS
Surprises are for birthdays. Not for tax time ® It’s all in the planning. What a tax projection can reveal. THE MOST FREQUENT MISTAKES WE FIND: – Reinvested dividends – Deduction for Medicare premiums for the selfemployed – Child care credit – Estate tax on income in respect of a decedent – State tax paid last spring
REAL ESTATE CLASSIFICATIONS
– Investor (most typical) (Limitation on deduction of rental losses)
– Dealer / Trader (usually the least desirable if profitable) – Real Estate Professional (best of all worlds)
REAL ESTATE TAX OVERVIEW For federal tax purposes a real estate professional can deduct net losses from rental real estate activities in which he materially participates and use the losses to offset income from other sources. (CA does not conform.) For all other taxpayers, rental real estate is automatically passive, and the net loss that can be deducted from a rental real estate activity in which the taxpayer materially participates is limited to a maximum of $25,000, depending on the taxpayerâ€™s modified adjusted gross income.
REAL ESTATE TAX OVERVIEW Starting in 2013, individuals with modified adjusted gross income over $200,000 ($250,000 for taxpayers who are married filing joint) will be subject to a 3.8% Net Investment Income Tax on the lesser of their net investment income or the excess of modified adjusted gross income over the $200,000 (or $250,000) threshold. For most taxpayers net income from rental real estate is included in the “net investment income” to which the 3.8% additional tax applies because income from rental real estate is considered to be “passive” under IRC Sec. 469. For a real estate professional, however, income from a rental real estate activity in which the taxpayer materially participates is not “passive” under Sec. 469 and is not subject to the 3.8% additional tax.
Real Estate Professionals (REP) The BASIC REQUIREMENT for ALL REAL ESTATE PROFESSIONALS is the following: • •
MORE THAN HALF of the personal services performed in trades or businesses (“work”), must be performed in real estate trades or businesses Spend at least 750 HOURS during each taxable year in performing personal services in real estate trades or businesses IN WHICH YOU MATERIALLY PARTICIPATE
MATERIAL PARTICIPATION means that your participation is regular, continuous, and substantial – generally, 500 HOURS OR MORE TIME THAN ANYONE ELSE SPENDS, including onsite employees
Taxpayers, including real estate professionals, generally elect to AGGREGATE MULTIPLE REAL ESTATE ACTIVITIES in order to meet the MATERIAL PARTICIPATION REQUIREMENT with respect to each activity in which the taxpayer participates
Real Estate Professional (REP) Benefits: (THE BEST OF ALL WORLDS) • Can offset losses against income (unlimited) • Can do 1031 exchanges • L/T Gains are taxed at LTCG rates • Doesn’t pay the 3.8% Medicare tax
REAL ESTATE CLASSIFICATIONS In general, an individual who is not a real estate professional cannot deduct a net loss from rental real estate or use a loss from rental real estate to offset other kinds of income. Exception to the general rule: â€˘ A taxpayer who is not a real estate professional, but who materially participates in a rental real estate activity, may deduct a net loss from the activity of up to $25,000, if he has modified adjusted gross income of $100,000 or less. The $25,000 loss allowance is phased out for modified adjusted gross income between $100,000 and $150,000. Special rules apply to taxpayers who are married filing separately.
Section 1031 Exchanges â€“ Must follow the rules â€“ Consider doing a reverse exchange or a partial reverse.
COST SEGREGATION The closest thing to an IRS sponsored free lunch for long term holders.
PORTFOLIO INTEREST EXEMPTION •
IRC Sections 871 (h) and 881 (c)
FOR FOREIGN INVESTORS • No withholdings or reporting of any kind on qualified portfolio interest loans. •
I.R.C. §871(a)(1) (nonresident alien individual) (CCH) (1986) as amended (the Code) and I.R.C. §881(a)(1) (foreign corporation); see also I.R.C. §§1441(a) and 1441(b) which similarly impose a withholding requirement on the payor and its agent(s). §§871(h) (nonresident alien individuals) and 881(c) (foreign corporations).
Key Elements of a portfolio loan • Cannot be offered to a US person • Cannot be transferred or transferrable to a US person • No contingency provisions for interest • Interest rate can be floating but must be objectively determined • Adequate equity to be provided
Key Elements of a portfolio loan
• Not available to a 10% or more equity holder (with attribution) • Not valid for bank loans • Loans to be registered and not in bearer form • The loan instrument cannot be assigned (must be redeemed and reissued)
Examples of Prohibited Contingent Interest:
• Linked to gross receipts • Linked to net cash flow • Linked to profits or change in value Permissible Example : Linked to LIBOR or Prime Bank Interest
• Accrual of unpaid interest • Allows for delinquent unpaid interest to be deferred • In the current lending climate a high coupon can be justified • The loan is unsecured and thinly capitalized
(Continued) Tax Issues Pertaining to Real Estate
1. Medicare Contribution Tax • Imposed as part of 2010 health care reform. • Effective 1/1/2013 • Imposes new 3.8% surtax on the lesser of: – An individual’s “net investment income” or excess of modified adjusted gross income over a threshold amount ($200,000 or $250,000 for joint filers) – An estate or trust’s undistributed net investment income or the excess of the adjusted gross income over the dollar amount at which the highest tax bracket in IRC Section 1(e) begins to apply (currently $11,350).
• Why 3.8%? This equals current 2.9% “hospital insurance” tax + new 0.9% surtax starting 1/1/2013.
Medicare Contribution Tax, cont’d
• Exemptions apply for: – Amounts subject to self-employment tax (because already contains 2.9% + 0.9% components); – Nonresident aliens; – Distributions from qualified plans; – Certain types of trusts (charitable, religious, etc.)
• 3.8% surtax N/A for corporations. • Special look-through rules apply to partnerships and S-corporations.
Medicare Contribution Tax, cont’d
• “Net Investment Income” means the excess of: – (A) the sum of: • Gross income from interest, dividends, annuities, royalties, and rents, other than income derived in the ordinary course of a trade or business; • Gross income from (i) trading in financial instruments or (ii) passive trade or business activities; and • Net gain attributable to the disposition of property (other than property held in a trade or business), over
– (B) the deductions allowed that are properly allocable to such gross income or net gain.
Tax Rate Matrix Maximum Rates
2. Condemnations Under IRC Section 1033
• Section 1001 requires gain recognition from the sale or other disposition of property • Section 1033 provides an exception to Section 1001, allowing gain from certain “involuntary conversions” of property to be deferred or recognized, at the taxpayer’s election, where qualifying replacement property is acquired • “Involuntary conversion” – results from the property’s destruction (in whole or in part), theft, seizure, requisition or condemnation or sale made under threat or imminence of requisition or condemnation
Purpose of Section 1033 • The purpose of Section 1033 is to allow the TP to replace property without realization of gain “where he is compelled to give up such property because of circumstances beyond his control.” S.H. Kress and Co. v. Comm’r, 40 T.C. 142 (1963). • “The involuntary conversion provisions allow recognition of gain to be postponed on the theory that the taxpayer was compelled to dispose of property and had no economic choice in the matter.” Rev. Rul. 80-175, 1980-2 C.B. 230. • These themes run throughout the cases and rulings discussed herein.
Key elements for tax deferral 1. Gain from compulsory or involuntary conversion of property into money (e.g., through receipt of insurance proceeds, a condemnation award or upon qualifying sales). 2. Taxpayer makes election for 1033 deferral. 3. Taxpayer purchases qualified replacement property within applicable time period (generally, 2 years after the close of the first taxable year in which any gain is realized or 3 years for business or investment real property in case of a condemnation). Note that tracing is not required.
What is an involuntary conversion? • Theft • Destruction – Equated to a “casualty” under Section 165(c)(3) – Unlike casualty, destruction need not be sudden – pollution, contamination and deterioration qualify – Destruction must be beyond taxpayer’s control – arson does not qualify
What is an involuntary conversion? • Seizure • Requisition or Condemnation – Fifth Amendment requires payment of just compensation (i.e., a “taking”) – Many different types of property rights covered • Fee Interest • Easements • Rights of way – May include regulation against otherwise lawful use of property in order to effect public purpose
What is an involuntary conversion? • To qualify, takings by government must relate to and serve a public benefit • But, in contrast, exercises of the government’s power to regulate and maintain its citizens’ health, well-being and safety (“police powers”) do not require compensation and are not Section 1033 conversions – Even though taxpayer is deprived of use of property taken – Examples: SEC orders; forced sales or exchanges under state corporate statutes; antitrust orders; loan foreclosures; court ordered partition
Examples of Condemnation • Grant of perpetual air rights over property adjacent to an air base. Rev. Rul. 54-575, 19542 C.B. 145. • Involuntary grant of flowage easement to the government in connection with a flood control project. Rev. Rul. 72-433. • Sale of resort to federal government after enactment of anti-motorboat legislation that severely, adversely affected TP’s resort business amounted to a taking. Rev. Rul. 82147, 1982-2 C.B. 190.
Condemnation – Severance Damages
• Rev. Rul. 83-49, 1983-1 C.B. 191. TP’s farmland was condemned in part for an interstate highway. TP received $175x as compensation for the condemned part, and $135x for reduction in value of the retained part. The $135x is called “severance damages.” The severance damages first reduced the TP’s basis in the retained land, and the excess was eligible for § 1033 treatment. • To obtain the benefits of severance damage treatment, the condemnation award should specifically allocate part of the award to such damages. • Absent earmarking, the entire award may be deemed consideration for the condemned tract only, meaning the basis of the retained tract is not available to offset a portion of the realized gain.
Condemnation – Economic Unit • If two or more parcels of property constitute an “economic unit” and depend on each other for profitability, and one parcel is condemned, the TP generally may sell the retained parcel and treat the sales proceeds under Section 1033. See Masser v. Comm’r, 30 T.C. 741 (1958); Rev. Rul. 59-361, 1959-2 C.B. 183. • Requirements: (1) substantial economic relationship between the condemned property and the other property sold by the TP, (2) the unavailability of suitable nearby property of a like kind to that converted, and (3) the proceeds of the voluntary sale must be expended in acquiring property of a like kind.
Threat or Imminence of Condemnation • Must be informed by a reliable source that entity with authority to condemn has decided to acquire the property • Have reasonable grounds to believe that condemnation will be carried out • Authority need not have the requisite funds • Document the threat before sale agreement is reached • “Reverse” option -- taxpayer can acquire replacement property after threat but before disposition of condemned property
Threat or Imminence - Examples •
TP sold property to city after passage of ordinance authorizing eminent domain proceedings. Passage of the ordinance satisfied requirement that there be a threat of condemnation. Rev. Rul. 89-2, 1989-1 C.B. 259.
TP sold gravel to state after highway engineer (employed by the state) made credible threats of condemnation if TP didn’t sell. It was reasonable for TP to infer that engineer spoke with sufficient authority to make it likely that his threats could and would be carried out. Thus, sales were held to be made under threat or imminence of condemnation. Maixner v. Comm’r, 33 T.C. 191 (1959).
TP owned property in urban renewal area and was given 3 choices by the city agency: (1) improve the property in compliance with urban renewal plan, (2) sell the property to a 3P or the agency, or (3) let the property be condemned. TP sold to a 3P, and Section 1033 applied. S&B Realty Co. v. Comm’r, 54 T.C. 863 (1970).
U.S. v. Wickersham, 29 F.3d 191: criminal prosecution where taxpayer conspired with governmental authority so sell taxpayer’s grain elevator at inflated price. Key fact was that taxpayer asked to document threat in writing after the sale occurred.
Acquisition and Basis • Qualifying replacement property must be acquired by “purchase” – “Purchase” may include construction • Basis: – Conversion into money: cost of qualifying replacement property less gain not recognized – Corporate stock acquisitions: basis of stock and corporation’s basis in its property both reduced • Same taxpayer must acquire replacement property
Qualifying Replacement Property • Section 1033 applies to ALL types of “property” • Section 1033(a): All involuntary conversions – similar or related in service or use (SRSU) standard applies – Not defined in Code or Regs; but see Maloof v. CIR, 65 T.C. 263 (1975) – replacement property should return taxpayer as closely as possible to its original position – Replacement property physically similar to converted property – Taxpayer’s relationship to the replacement property is substantially the same as relationship to converted property – Also controlling interest in corporation owning SRSU property – but how much SRSU property is sufficient?
Qualifying Replacement Property • Section 1033(g): Business or investment real property that is seized, requisitioned or condemned (or threat thereof) – “Like-kind” standard of Section 1031 applies (broader and more flexible than SRSU) – SRSU corporate stock purchase alternative does not work with like-kind standard – Extends replacement period to 3 years.
Special Issues • Building replacement property on Taxpayer-owned land may not work – See Rev. Rul. 67-255 and similar rulings – Same rulings prohibit building on own land in context of reverse exchanges under Rev. Proc. 2000-37 and Rev. Proc. 2004-51 – What is the rationale for this position?
Special Issues • Related Party Rules – Generally, replacement property cannot be acquired from a “related person.” – However, acquisition from a related person is allowed if the related party “acquired” the replacement property from an unrelated person during the 2-year or 3-year replacement period, as applicable. – Does “acquired” include new construction?
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