Month: January 2018

An Update: Real Estate Professionals and Passive Losses

Dreaded Passive Losses

An Update: Real Estate Professionals and Passive LossesA passive loss from a real estate activity occurs when your rental property’s expenses exceeds its income. The undesirable consequence of passive losses is that a taxpayer is only allowed to claim a certain amount of losses on their tax return each year.

When income is below $100,000, a taxpayer can deduct up to $25,000 of passive losses. As income increases above $100,000, the $25,000 passive loss limitation decreases or “phases out.” The phase out is $0.50 for every $1 increase in income. Once income increases above $150,000, taxpayers are completely phased out of deducting passive losses.

Rentals are passive, unless they aren’t

The general rule is that all rental activities are, by definition, passive. However, the Internal Revenue Code created an exception for certain professionals in the real estate business.

Who is a real estate professional?

As discussed in a previous post, for income tax purposes, the real estate professional designation means you spend a certain amount of time in real estate activities.

According to the IRS, real estate professionals are individuals who meet both of these conditions:

1) More than 50% of their personal services during the tax year are performed in real property trades or businesses in which they materially participate and

2) they spend more than 750 hours of service during the year in real property trades or businesses in which they materially participate.

Any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operations, management, leasing, or brokerage trade or business qualifies as real property trade or business.

Can I qualify as a real estate professional?

I get these questions quite often from taxpayers:  Do I qualify as a real estate professional?  If not, how can I qualify?

There have been many cases that appear in front of the Tax Court where a taxpayer argues they qualify as a real estate professional and the IRS has disallowed treatment and subjects the taxpayer to the passive activity loss rules of Code Sec. 469.

A recent case held that a mortgage broker was not a real estate professional (Hickam, T.C. Summ. 2017-66). The taxpayer was a broker of real estate mortgages and loans secured by a real estate. Although the taxpayer held a real estate license, he did not develop, redevelop, construct, reconstruct, operate, or rent real estate in his mortgage brokerage operation.

The taxpayer argued that his mortgage brokerage services and loan origination services should be included for purposes of satisfying the real estate professional test. The Court held that the taxpayer’s mortgage brokerage services and loan origination services did not constitute real property trades or businesses under Code Sec. 469(c)(7)(c).

We’ve got your back

If you invest in real estate, it can be difficult to keep track of tax laws and how they impact you. At KRS CPAs, we stay on top of all the laws – especially the changes under the new tax reform – and can help you avoid tax problems. Contact me at [email protected] or 201.655.7411 for a complimentary initial consultation.

2017 Tax Legislation: What Individual Taxpayers Need to Know

2017 Tax Legislation: What Individual Taxpayers Need to KnowThe new Tax Cuts and Jobs Act amends the Internal Revenue Code (IRC) to reduce tax rates and modify policies, credits, and deductions for individuals and businesses. It is the most sweeping update to the U.S. tax code in more than 30 years, and from what we’re seeing, it impacts everyone’s tax situation a bit differently.

What works for one individual or family may not work for another, although their circumstances may appear to be similar on the surface.

Here are some of the key features of the tax reform legislation that you need to know about as an individual tax payer. (I’ll cover the impact on businesses in a separate post.)

Individual Tax Rates

There are still seven tax brackets, however the rates have dropped in all except the lowest bracket. The new maximum tax rate was reduced from 39.6% to 37%, which applies for those earning over $500,000 annually, if single, or $600,000 if married.

Here is a comparison of the old and new tax rates:

Comparison of new and old tax rates

While these changes are likely good for everyone, I do have some clients who are married, filing jointly and when I recalculated their taxes under the new law, the results were not what we expected. The husband and wife both work, and it turns out they’re only going to save $200 in taxes! So that’s why it’s important to work with your accountant and look at your situation individually.

Alternative Minimum Tax

The alternative minimum tax (AMT) is a supplemental income tax imposed by the United States federal government. AMT is a separate tax calculation that is run after the regular tax calculations are done. The taxpayer pays the higher of the two taxes. Although this was supposed to be a tax to ensure that everyone, including the wealthy, pay some tax, in the past it did hit many middle income wage earners.

Under the new law:

  • The amount exempt from AMT increases from $86,200 to $109,400, if married, and from $55,400 to $70,300 if single.
  • The phase-out of the exemption amount begins at $1,000,000 – instead of $164,100 – if married, and $500,000 – instead of $123,100 – if single.

So we expect we will be seeing fewer middle income wage earners subject to AMT.

Deductions, exemptions, and capital gains

The standard deductions have nearly doubled to $24,000 (married) and $12,000 (single), however there is no longer any personal exemptions allowed at any income level.

Individual deductions for state and local taxes (SALT) for income, sales, and property are limited in aggregate to $10,000 for married and single filers and $5,000 for married, filing separately. What this means in a high real estate tax state like New Jersey, where you’re probably paying more than $10,000 a year in real estate taxes, you’re going to be taking a hit starting in 2018.

Most miscellaneous itemized deductions – for example, tax preparation and investment expenses – that had been subject to the 2% of adjusted gross income (AGI) floor will no longer be allowed.

As far as capital gains, there were no changes to the tax rate. The maximum rate on long-term gains and qualified dividend income (before 3.8% net investment income tax) remains at 20%.

As the reform bill was being negotiated, there had been talk of doing away with the medical expense deduction completely, which would have hurt the elderly. Instead, they reduced the floor to 7.5% of AGI for tax years 2017 and 2018.

Fortunately, there were no changes to how securities are treated. You can continue to specify which stocks you’re selling, which means if have a lot of the same stock, you can pick your highest basis so that you have the lowest amount of capital gain.

The child tax credit increases from $1,000 per qualified child to $2,000, with $1,400 being refundable. Phase-out of the credit begins at $110,000 (single) and $400,000 (married).

You will no longer be penalized if you don’t have health insurance. Starting in 2019, the new legislation eliminates the Affordable Care Act’s individual mandate.

Mortgage interest and real estate

Before the tax law changed, you could deduct mortgage interest on mortgages up to $1 million, if you’re married, and $500,000 if you’re single. Interest on a Home Equity Line of Credit (HELOC) could be deducted up to $100,000. Under the new law, individuals are allowed an itemized deduction for interest on a principal residence and second residence up to a combined $750,000. Mortgages obtained before 12/16/17 are grandfathered and new purchase money mortgages may be grandfathered if the purchase contract is dated before 12/16/17.

Refinancing of grandfathered mortgages is grandfathered, but not beyond the original mortgage’s term and amount, with some exceptions for balloon mortgages. Interest on HELOCs is no longer deductible.

The rules for capital gain exclusion for a primary residence remain unchanged, which is good for the real estate market. When you sell your primary residence, you get to exclude $500,000 of gain. As the taxpayer, you must own and use the home as your primary residence for two out of the previous five years. This exemption can only be used once every two years.

You will still be able to do a like-kind exchange on real estate, but no longer on personal property. This type of exchange allows for the disposal of an asset and the acquisition of another replacement asset without generating a current tax liability from the gain on the sale of the first asset.

College savings plans, estates and gifts

If you have a Section 529 plan, you can now pay up to $10,000 a year per student for high school education. This had always been limited to college, but now if you are paying public, private or religious high school tuition, you can use some of your 529 here.

Under the new tax law, the estate, gift and generation skipping transfer (GST) tax exemptions are doubled to $11.2 million per US domiciliary.  These exemptions sunset after 2025 and revert back to the law in effect for 2017 with inflation adjustments. There’s a possibility for “clawback” at death if the law is not changed.

Pass-through and charitable deductions

If you own a business that is set up as a partnership, S-corporation, or sole proprietorship, income was passed through to your individual tax returns, where it was taxed as ordinary income. There is now a new 20% deduction for qualified business income from a partnership, S-corp, or sole proprietorship. There are some income limitations to this deduction, so be sure you consult your tax advisor on this one.

We still have deductions for charitable contributions. Under the new law, a contribution made to public charities is deductible, as long as it doesn’t exceed 60% of the taxpayer’s AGI – this is up from 50% of AGI.

We’ve got your back

At KRS, we’ve been tracking tax reform legislation closely and are ready to assist you in your tax planning and preparation now that it is finally signed into law. Don’t lose sleep wondering what impact the new law will have on you and your family. Contact me at 201.655.7411 or [email protected].

 

Excluding Gain on the Sale of a Principal Residence

Excluding Gain on the Sale of a Principal ResidenceOne of the most valuable assets a taxpayer will ever sell is their personal residence. Under IRC Section 121 of current tax law, a taxpayer can exclude up to $250,000 ($500,000 if married, filing jointly) of gain realized on the sale or exchange of a principal residence.

Any loss on a principal residence is deemed a personal loss and non-deductible.

What is a principal residence?

The determination whether a property is used as a taxpayer’s principal residence depends on a variety of factors. Some of these factors include:

  • Principal place of abode for the taxpayer’s family members
  • Address on the taxpayer’s driver’s license, automobile registration, and voter registration
  • Mailing address for bills and correspondence
  • Location of taxpayer’s banks
  • Location of religious organizations and recreational clubs with which the taxpayer is affiliated
  • Location of the taxpayer’s doctors
  • Taxpayer’s place of employment

If a taxpayer uses more than one property as a residence, the property that checks the most boxes will likely be assessed as the primary residence. If a taxpayer alternates between two properties, the property used the majority of time during that year will be considered the principal residence for purposes of the IRC Section 121 exclusion. A houseboat, trailer, or apartment a taxpayer is entitled to occupy in a cooperative housing corporation (co-op) may also qualify as a principal residence.

How is gain or loss computed?

Gain (or loss) is computed based upon the selling price less expenses of the sale and the taxpayer’s adjusted basis in the residence. Adjusted basis is original cost plus the cost of improvements (not repairs) made to the residence and reduced by any depreciation claimed on the property.

Gain exclusion requirements

Taxpayer’s must meet three tests for the full gain exclusion to apply:

  1. Ownership – the taxpayer must have owned the residence for at least two years during the five years ending on the date of the sale or exchange. Tip – The measuring period is the actual time between sales, not taxable years.
  2. Use – the taxpayer must have occupied the residence as a principal residence for periods adding up to at least two years within the five-year period ending on the date of sale or exchange.
  3. One Sale in Two Years – the exclusion under Section 121 does not apply to any sale of a principal residence if, during the two-year period ending on the date of sale, the taxpayer sold their principal residence in which gain was excluded under section 121.

Example: A taxpayer sold a principal residence on March 1, 2016 and excluded the gain under Section 121. The taxpayer would not be eligible to claim the exclusion under Section 121 until April 2, 2018.

It is important to note The Tax Cuts and Jobs Act proposed increasing the length of ownership and use from two out of five years to five out of eight years. This was removed from the final version of the bill.

Property used partially as business and partially as principal residence

The IRS takes the position that the Section 121 exclusion is not available for any portion of the residence used for business purposes during the qualifying use period. Thus, if a portion of the property was used as a principal residence and a portion separate from the dwelling unit was used for non-residential purposes, only the gain allocable to the residential portion is excludable. However, no allocation is required if both the residential and nonresidential portions are within the same dwelling unit (commonly seen in home offices). It is important to note gain attributable to depreciation claimed after May 6, 1997 is not eligible for exclusion.

Example – Home office impact on gain exclusion

Jeff, an accountant, purchases a house in 2014. The house is a single unit, but Jeff has one room that is used exclusively for the accountant practice until the property is sold in 2017. Jeff claims depreciation of $3,000 attributable to the portion used as a home office. Upon the sale in 2017, Jeff realized a gain of $75,000.

Since Jeff’s home office is part of the dwelling, no allocation is required. However, Jeff must recognize $3,000 of the gain as unrecaptured Section 1250 gain (currently taxed at 25%), the depreciation claimed for the business portion of his home. The remaining $72,000 is excludable under the Section 121 exclusion.

Selling your principal residence? Get the advice you need for smart tax decisions

For more about how the sale of your principal residence can affect your tax situation, please contact me at [email protected] or (201) 655-7411.