Month: August 2016

How to Defer Taxes on Capital Gains

Here’s how receiving installment payments can help you defer taxes on capital gains.

What Is an Installment Sale?

An installment sale is an agreement under which at least one payment is received after the end of the tax year in which the sale occurs. When a real estate investor sells a property on the installment basis, a down payment is usually received at closing with the balance of the purchase price paid in installments in subsequent years. As the seller, you are not required to report an installment sale using this method. However, installment sale reporting allows you to spread the tax liability over all the years in which the buyer makes installment payments.

installment sales tax benefits in real estateUnder the installment method, each year the portion of the gain received via installment payments is included in the seller’s income. Fundamentally, interest should be charged on an installment sale. If the interest charged is less than the applicable federal rate (“AFR”) or no interest is charged, the seller is considered to have received “imputed” taxable interest equal to the AFR.

Each payment received in an installment sale consists of three components:

  1. Interest income
  2. Return of basis
  3. Gain on the sale

Not All Sales Qualify as Installment Sales

Certain sales do not qualify as installment sales, including:

  • Sale of inventory items
  • Sales made by dealers in the type of property being sold (see my blog, Investor vs. Dealer)
  • Sale of stocks or other investment securities
  • Sales that result in a loss

Combining Installment Sales with Like Kind Exchanges

Like Kind Exchanges (§1031 exchanges) are often combined with seller financing of the relinquished (sold) property. This creates an opportunity for an installment sale transaction in which a promissory note, issued by the buyer for the benefit of the seller, represents a portion of the purchase price.

For example, if the relinquished property value is $1 million, the taxpayer (via a qualified intermediary) might receive $500,000 in cash and a $500,000 promissory note from the seller. The taxpayer/seller would ideally use the $500,000 proceeds in a tax-deferred exchange, while also benefiting from installment sale reporting on the remaining $500,000 note.

An installment sale is an option for taxpayers to spread a tax liability over time and collect interest income. However, it can carry risk for the seller. If the buyer is unable to make timely payments, the seller would be responsible for the costs of foreclosure and repossession.

Your tax professional can help you determine the tax effects of any installment sales arrangements you may have. As always contact me at [email protected] if you have any questions.

Ten Tips for Choosing a Reliable Payment Processor

Choosing a credit card processor can be confusing. Here’s what you need to know to get it right.

Since businesses usually cannot withdraw funds directly from a customer’s bank or credit card account they rely on payment processors as the middleman. These payment processors connect you to merchant accounts such as Visa or American Express.

Tips for choosing a credit card processorThere are many ways to obtain payment processors. For example, they can be found through banks, online providers and companies such as PayPal. They all have different rates. Some may require contracts or mandatory leasing of their equipment (credit card machine), so it is very important that you choose one that will work best for your company’s needs.

Finding the right credit card processor is important and there are many points you should consider. For example, mobile businesses must consider the ability to accept credit card payments from anywhere. For these businesses, a mobile credit card processor would be best. Also consider integration with your accounting system and CRM software to ensure efficient processing and recording.

Selecting Your Payment Processor

With the help of Christopher Mammaro, CEO/President of Integrity Card Systems, we have listed 10 tips to consider when selecting your payment processor:

  1. Don’t be sold/fooled – Make sure you are not being set up with equipment you do not need. Quite often representatives will indicate that you need new equipment that is proprietary in nature and only works with their processing system. If you do need such equipment, are you paying for it? Often merchants will offer a “FREE” terminal when in fact you are actually paying for it through unexpected monthly or annual fees, or costly termination fees.
  2. Bigger does not always mean better – Just because a bank is larger does not mean that it will provide better service. Inquire if your bank uses a third-party provider and be sure to get comfortable with them. As a third party, they may not know anything about your business.
  3. Availability – Make sure the processor you choose can be reached in a timely manner. Inquire about their customer service and response times. Common complaints are in the area of support as many do not have local representation and you will not have a dedicated service representative.
  4. Trust –Referrals from people you trust or respect are more likely to place you in front of a good payment processor.
  5. Rates – Understand your current pricing structure and what type of pricing structure the processor suggests for you. Here are some examples: flat rate, tiered, interchange plus, and surcharge.
  6. Education – The processor should listen to the needs of your business and, afterwards, present a few solutions. Make sure their processing solutions are PCI (payment card industry data security standard) compliant and utilize current technology.
  7. Beware the contract – Avoid a long-term contract. If there is a contract, find out the term and if there is the penalty for leaving before the end. You are looking for a client relationship, not a hostage situation.
  8. Reputation – Do your homework. Make sure the company is reputable. Look for ratings and referrals.
  9. Sales rep vs sales partner – A sales rep may have a quota to fulfill and will be very accommodating during the sales process only to never be seen or heard from again. Make sure the person you deal with has a vested interest in your satisfaction.
  10. Bait and switch – Have a frank discussion about fees. Inquire as to any extra fees there are and how often they are charged. Request this information in writing. You do not want to be sold on a monthly savings only to be charged another “non-disclosed” fee.

Accepting credit/debit cards can increase sales, help you better compete with your competitors, have quicker access to funds, and avoid the cost and time of collections. Choosing a payment processor is perhaps the most difficult task in any businesses decision to accept credit cards. Mammaro’s advice is to take your time, comparison shop and search for the one that best suits your needs and business operations. Credit card processing companies are competitively priced, yet each may have a unique set of fees and contracts; it’s important to understand those nuances so you find the processor that’s a good match for your business needs.

At KRS CPAs, we work with businesses to provide the bridge from operations to financial reporting. Our accountants and bookkeepers understand the sales and collection process and assist our clients in evaluating merchant services and integrating these services with their accounting systems. If you need help, contact me at 201.655.7411 or [email protected].

Beware of Phantom Income

Real Expenses vs. Phantom Expenses

As a real estate investor, it is essential to know the difference between a real expense and a phantom expense. An investor might think a $1,000 roof repair is a good thing since he or she can deduct it as an expense. What if you never had to make that repair in the first place? You would have $1,000 of taxable income in your pocket. Being taxed isn’t automatically a bad thing, since that means you are making money on the property.

real estate and phantom incomeWhat is a Phantom Expense?

Depreciation is the perfect example of a phantom expense since it allows an owner of real estate to recover the value of the building against rental income. The IRS allows a deduction for the decrease in value of your property over time, irrespective of the fact that most properties never really wear out. Simply put, depreciation allows you to write off the buildings and improvements over a prescribed period of time, providing a “phantom expense” that is used to offset rental income.

Residential real estate and improvements are depreciated over a 27.5 year period. Commercial real estate and improvements are depreciated over 39 years.

Debt Amortization

In addition to a depreciation deduction, the Internal Revenue Code allows for the interest portion of a mortgage payment to be deducted for income tax purposes. The principal portion of a mortgage payment is treated as taxable income or “phantom income“.

During the initial years of a typical mortgage loan, the principal reduction (debt amortization) is normally offset by depreciation deductions and interest expense, decreasing taxable income. In the later years of a typical loan amortization, principal reduction will exceed interest expense and depreciation, thereby increasing taxable income and generating a seemingly disproportionate tax liability (the dreaded phantom income).

Disposition of a Property

A taxpayer may incur phantom income upon disposition of a property. Phantom income is triggered when taxable income exceeds sales proceeds upon the disposition of real estate. Usually, this results from prior deductions based on indebtedness. You may have deducted losses and/or received cash distributions in prior years that were greater than your actual investment made in the property. If you are planning to dispose of a property and believe you are in this situation, there are strategies to minimize the tax impact including IRC 1031 exchanges, which are discussed in my blog Understanding IRC Code Section 1031 and why you should care.

Real estate investors who want to maximize their after tax cash flow need to be cognizant of phantom income and compare their cash flow to taxable income. This analysis should be undertaken regularly as it may impact their investment returns. If you have questions about phantom income and your real estate, contact me at [email protected] or 201.655.7411.

Treasury Proposes New Tax Regulations to Limit Discounts in Intra-Family Wealth Transfers

Proposed Regs Would Impact Family Limited Partnerships

A popular tax saving technique used by wealthy taxpayers involves transferring assets such as real estate or securities to a family limited partnership, followed by a gift of partnership interests to family members. For estate and gift tax purposes, the value of partnership interest transfers are discounted, that is the transfers are reported for less than the value of the underlying partnership assets.

Discounts are permitted because partnership interests transferred are minority interests and also subject to significant restrictions, such as restrictions on transferability of the partnership interest.   Although the Internal Revenue Service has contested these discounts, Federal Courts have consistently allowed discounts in the 30% to 35% range for cases with the correct fact pattern.

intra-family wealth transfersLast week, the Treasury issued proposed regulations which, if adopted, would severely limit taxpayers’ ability to discount for intra-family wealth transfers. As they would affect family limited partnerships, the proposed regulations would require that in family controlled entities, many of the restrictions giving rise to discounts would be disregarded, effectively eliminating such discounts.  If discounts are eliminated, property transfers would be at fair market value of the underlying property, potentially resulting in increased federal estate and gift taxes.

Now Is the Time to Transfer Wealth to Family Members

The proposed regulations are subject to a 90-day public comment period, and will not go into effect until the comments are considered and then 30 days after the regulations are finalized. If you have a federally taxable estate and are considering wealth transfers, now is the time to do it.  Although there is uncertainty whether the proposed regulations will be adopted, and if they are adopted what the final version will say, the window may be closing on an opportunity for intra-family wealth transfers at a greatly reduced transfer tax cost.

If your estate is close to being taxable, act quickly and contact your tax advisors.  Once this window is closed, it may never open again.

Prince Died Without a Will – Why Estate Taxes Get Complicated

What happens to the estate when someone dies without a will?

Usually when a famous person dies, news of their death travels fast, far and wide. Living relatives and those claiming to be relatives will come forward staking their claim on estate assets.

Signing Last Will and TestamentIf you die without a will or trust, you have died “intestate” and state law will determine how your assets are distributed. State law will provide a hierarchy of beneficiaries to which an intestate estate will be distributed. The state intestate succession law will only apply to those assets that would have passed through your will, known as “probate” assets, which you owned at the time of your death.

For example, some accounts you own may have named designated beneficiaries, such as an IRA or life insurance policy. Such assets will be distributed to the named beneficiaries. Also, joint assets and “paid on death” accounts will also pass to the joint or paid on death holder even if there is no will.

If you die without a will in New Jersey, determining who gets what depends upon factors such as: do you have a living spouse, children, parents or other close relatives. It can get complicated with blended families, children from multiple marriages, half and whole siblings and their decedents. Click here to see the NJ intestate succession law. In NJ, if you die without a will and do not have any close family your property will “escheat” to the state coffers.

Dying without a will is costly

Unless your estate is insubstantial, if you die without a will the Surrogate Court will appoint an estate administrator. It is the administrator’s responsibility to secure your assets, pay any debts and taxes as well as search for any heirs. Administrators will be paid by the estate for their services.

Prince’s estate could be worth in excess of $150 million and most likely will earn millions over years to come. At the time of his death, he was known to have a sister and half-siblings. His parents were deceased and he had two ex-wives. Rumors surfaced that he may indeed have a child born out of wedlock and at least one individual claimed he was Prince’s son. Under Minnesota inheritance law all siblings are treated equally. Without a will and clear instructions as to how Prince wanted his assets to be distributed, most likely there will be a will contest over the estate.  Litigation is expensive. The attorneys are sure to benefit along with the State and Federal governments due to the lack of estate planning and tax minimization strategy he could have had in place.

Who should have a will?

If you want your assets to be distributed in a manner of your choosing, you will need a will or a living trust. Your will appoints an “executor” who you choose to be in charge of securing your assets, filing and paying any taxes, and distributing your assets as you have instructed. Of great importance, a will makes it easier for your loved ones to work it all out.

If you have minor children your will can provide for the guardianship of those children. A will can also provide an opportunity for estate planning, potentially reducing estate or inheritance taxes. You may believe your estate is not large enough to require a will. That may not be so true in a state like New Jersey that taxes estates in excess of $675,000 in addition to collecting an inheritance tax on certain family member beneficiaries. The process of preparing a will can also provide an opportunity to review designated beneficiaries on any retirement accounts and life insurance policies, and to determine if you have adequate life insurance coverage.

At KRS, we work with individuals in developing tax minimizing strategies for current taxes as well as estate tax planning, estate administration and estate tax compliance. Visit our website to download our executor’s checklist for more information regarding the estate administration process.

Rental Income: There’s More to It than Just Collecting Rent Checks

 

Payment for the occupancy of real estate is includable in the landlord’s gross income as rents. Generally, rents are reportable by the landlord in the year received or accrued, depending upon whether the landlord uses the cash or accrual method of accounting. What constitutes rent is not always obvious and depends on factors that include the lease and relevant facts and circumstances.

HiResTypes of Rents

  • Amounts paid to cancel a lease – It is fairly common for a landlord to receive payments in consideration for allowing a tenant to terminate their lease before the expiration date. This payment is included in the landlord’s rental income in the year of receipt.
  • Advance rent – Generally, advance rent is immediately taxable to the landlord. The regulations specify that advance rentals must be included in income for the year of receipt regardless of the period covered or the method of accounting employed by the taxpayer.
  • Security deposit – A security deposit that is refundable at the end of the rental period is excluded from income. If a landlord requires a security deposit to be used to pay the last month’s rent under a lease, it is included in gross income in the year of receipt.
  • Expenses paid by a tenant – If a tenant pays expenses on behalf of the landlord, those payments are considered rental income by the landlord.  The tenant is entitled to deduct those expenses.

Improvements by Tenants

If a tenant makes an improvement to the landlord’s property that is a substitute for rent, the value of the improvement is taxable to the landlord as rental income.

Permanent improvements by a tenant usually enhance the value of the landlord’s property. The mere enhancement in value of the property does not, by itself, constitute rental income to the landlord. Court cases have held that a tenant’s payments for improvement costs will not be treated as deductible payments in lieu of rent unless it is demonstrated that both the landlord and tenant intended the payments to be in lieu of rent. If a landlord agrees to receive reduced rents in exchange for a tenant’s improvements, the cost of the improvement is plainly rent.

Net Leases

Under certain lease arrangements, also known as net leases, the tenant or lessee must pay specified expenses of the lessor. For tax purposes, these payments are treated as additional rental income by the lessor and additional rent expense by the lessee. Assuming the landlord would have been entitled to a business deduction if it was paid directly, the landlord is entitled to a business deduction for the amount paid by the lessee.

From experience, most lessors (landlords) recognize income only for the actual rent paid, and the lessees (tenants) generally deduct the net leases expenses paid as expenses other than rent.

Before entering into a lease, it is important for a landlord to consider the provisions included in the lease and their impact on taxable rental income.

Your tax professional can help you determine the tax effects of any rental arrangements you may have. As always contact me at [email protected] if you have any questions.

Family Limited Partnership May Result in Significant Estate Tax Reduction

 

When Natale Giustina died in 2005, he owned a 41% limited partner interest in a partnership named Giustina Land & Timber Co. Limited Partnership. The partnership owned 47,939 acres of timberland and had 12 to 15 employees.  It earned profits from growing trees, cutting them down, and selling the logs.  The partnership had continuously operated this business since its formation in 1980.

Keyboard with hot key for estate planningAll limited partners in Giustina Land were members of the same family, or trusts for the benefit of members of the family. The partnership agreement provided that a limited partner interest could be transferred only to another limited partner or to a trust for the benefit of another limited partner unless the transfer was approved by the two general partners.

Although this case has a long history, the final decision determined the value based entirely on the partnership’s value as a going concern, which is the present value of the cash flows the partnership would receive if it were to continue operations. To put it another way, the value was determined based on the cash that a partner would receive from company operations rather than would might be received if the partnership assets were sold and the proceeds distributed to the partners.

For twenty-five years, general partners Larry Giustina and James Giustina ran the partnership as an operating business.  The court was convinced that these two men would refuse to permit someone who was not interested in having the partnership continue its business to become a limited partner.  Therefore, the only cash flow available to limited partners is the cash flow from operations. In determining the value of the partnership, the court applied a 14% capitalization rate to $6,333,600 projected normalized pre-tax cash flows to arrive at a value of $45,240,000.  This value is over $105 million less than the value of the partnership assets.

Why the taxpayer prevailed

Valuation cases, especially those involving family partnerships, are very fact specific. The taxpayer prevailed in this case because the business had operated continuously for twenty-five years, and there was no indication that it would not continue to operate.  The asset value was not considered the valuation because the only way that a limited partner could receive the asset value was on the dissolution of the partnership, which the court concluded was unlikely.

The taxpayer’s position in this case was strengthened by the fact that the partnership had been operating a business for twenty-five years. There is no requirement that a partnership operate for this length of time, however, a partnership formed shortly before death or asset transfer may be more susceptible to successful IRS challenge.  Also, to be respected by the IRS, a family partnership must have a business purpose.  Tax reduction does not qualify as a business purpose.

With proper planning, a family limited partnership may be an effective option to reduce estate and gift taxes. However, there are many technical requirements.  If you are interested in establishing a family limited partnership, you should consult a tax professional.