Tag: commercial real estate

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.

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.

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.

Understanding IRS Rules for Self-Rentals

Owner or renter – or both? 

Tax effects of self rentalsSelf-rental is an arrangement in which a business and property that it rents are both owned by the same person(s). It is common for a taxpayer to own an operating business and also own the accompanying real estate. That person has to materially participate in the operating company for the self rental rules to apply. If the operating company is an entity that the owner(s) actively participate in on a day-to-day basis, in most cases the owner(s) would be considered to materially participate in that activity.

Additional details on material participation can be found in Internal Revenue Service  Publication 925.

The passive activity loss rules

As discussed in my blog post, Passive Loss Limitations in Rental Real Estate, the IRS Code generally prohibits taxpayers from deducting passive activity losses against other income, including salaries, interest, dividends, and income from nonpassive activities. Generally, a passive activity loss can only be used to offset other passive income.

The IRS considers most business activities to be nonpassive if a taxpayer materially participates in the business.  One of the exceptions to this rule is rental real estate. Rental real estate activities are generally considered passive regardless of level of participation.

Trapped losses

Passive losses can only offset other passive income. Assuming a taxpayer incurs a loss on the rental of property to a business in which he or she materially participates, absent any other passive income during the year, the loss will not be deductible. However, the loss is carried forward to future tax years to offset income from the activity.

If there are unused passive losses from the activity when the property is sold, such suspended losses from that activity are recognized in the year of disposition.

How self-rental rules can apply

What does it all mean? Here’s an example to help you understand how the rules apply:

A taxpayer owns a warehouse which is rented by his distribution company that he materially participates in as owner and president. During the year the rental warehouse incurs a loss of $50,000, while the distribution company has $50,000 of income.

Does the $50,000 of losses incurred by the warehouse offset the $50,000 of profits from the distribution company?

No. Because the property was essentially rented to himself (i.e., to a business in which he materially participated), the self-rental rules apply. In the case of a self-rental, income is treated as nonpassive and loss is treated as passive. The self-rental rule characterizes the $50,000 of rental loss as passive which cannot offset the nonpassive income from the distribution company.

If you are currently involved in a self-rental or are considering this transaction, there are methods whereby you can avoid or reduce the disadvantageous tax effect of the self-rental rule. Contact me at 201.655.7411 or [email protected] and I can help you understand which methods are most advantageous to you.

Investor vs. Dealer

Purchasing real estate assets? This post explains what you need to know about the important distinction between real estate investor and dealer for tax purposes.

A real estate developer is taxed differently than a real estate investor. Real estate investors purchase real estate with the intention of holding properties and gaining financial return. Typically, real estate dealers acquire and sell real estate as part of their everyday business.

career or new opportunity concept, business backgroundA real estate professional who is involved in buying real estate with the intention of selling for a profit in a short time frame, or flipping is usually considered a dealer. Contractors and builders who build houses and commercial structures, and subsequently sell the finished property to customers are also considered dealers.

A question that arises often is whether a real estate developer who purchases properties (sometimes raw land or an outdated property) and makes improvements should be considered an investor or a dealer. Real estate developers are usually treated as dealers by the IRS because they are in the business of buying and selling real estate. However, if the developers work on individual and sporadic long-term projects, they may be able to take a position they should be taxed as investors.

Why does it matter to real estate professionals?

When a real estate investor sells property that has been owned for more than one year, gain on the sale is taxed at the favorable long term capital gains rates, currently 15% or 20% depending upon income (plus the 3.8% net investment income tax, if applicable).

When real estate dealers sell their properties, those properties are considered inventory and any gains are taxed at the dealers’ ordinary income tax rates. Currently, Federal ordinary income tax rates can be as high as 39.6%.

The Internal Revenue Code offers general guidelines regarding activities that reach the level of a trade or business. However, Internal Code does not provide specific guidance regarding real estate activities. Consequently, court cases have been the primary source for defining what level of activity determines a trade or business in real estate development and, therefore, the nature of the income.

The main factor in determining if a taxpayer is a real estate investor or a dealer is his or her intent with respect to the property. The mere fact that an individual holds a piece of property for a short period of time does not automatically cause him or her to be a dealer. Often an individual purchases real estate with the intent of holding it for investment purposes, but sells it earlier due for financial or economic reasons.

Consider the Winthrop Factors

A case often cited when determining dealer vs. investor status is United States v. Winthrop. In determining whether the gain from sales was ordinary or capital in nature the court relied on a series of facts and circumstances in the Winthrop case. These have become commonly referred to as the “Winthrop Factors.”

Subsequent court cases have enumerated the following 9 Winthrop Factors:

  1. The purpose for which the property was initially acquired
  2. The purpose for which the property was subsequently held
  3. The extent of improvements made to the property
  4. The number and frequency of sales over time
  5. The extent to which the property has been disposed of
  6. The nature of the taxpayer’s business, including other activities and assets
  7. The amount of advertising/promotion, either directly or through a third party
  8. The listing of the property for sale through a broker
  9. The purpose of the held property at time of sale; the classification as an investor or dealer is determined on a property-by-property basis.

Talk to your tax professional

With such a wide disparity between the maximum capital gains tax rate of 20% (plus the net investment income tax 3.8%) and the tax rate on ordinary income of 39.6%, it is important to consult your tax advisor regarding newly acquired real estate assets and established investments.

Passive Activity Loss and the Income Tax Puzzle for Real Estate Professionals

Does being a real estate professional have income tax advantages?

real estate professionalsIt all comes down to passive and non-passive activities related to property.

As  discussed in a previous post, the IRS recognizes two types of passive activities as they relate to investment real estate, one of those being “trade or business in which the taxpayer does not materially participate.” The other passive activity being rentals, including both equipment and rental real estate.

Generally, rental real estate activities are passive regardless of one’s participation but there is an exception for real estate professionals.

For most taxpayers, income and loss from real estate is considered passive, with passive activity losses generally limited to passive activity income. However, real estate professionals must treat rental real estate activities in which they materially participate as non-passive activities. Therefore, a real estate professional can deduct rental real estate losses from other non-passive income.

How the real estate professional designation affects income taxes

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 percent 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.

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

It is important to note that services performed as an employee in real property trades or businesses do not count unless the employee is at least a 5% owner of the employer.

Once it is determined a taxpayer qualifies as a real estate professional (by meeting both of those criteria), non-passive treatment is available only for rental real estate activities in which the taxpayer materially participated. To meet the material participation standard, a taxpayer can elect to treat all interests in rental real estate activities as a single activity. If the election is made, material participation is determined for the combined activity as a group. Since these decisions have implications for one’s income tax liability and potential deductions, it is important to review these guidelines with your accountant and/or trusted tax adviser, and to gain a full understanding of the differences between passive/non-passive income and expenses.

Example

David owns a real estate brokerage firm. He works full time as a broker and also owns three rental properties. David  materially participates in his rental properties and does not employ any management company. HIs material participation comprises finding tenants for his rentals, overseeing repairs, and approving all leases.

Let’s assume that David’s income is $200,000 from the brokerage firm and rental losses associated with the properties he owns are $30,000. David would be able to deduct the $30,000 in full from his gross income because he is a real estate professional and materially participates in the rental properties. If he was not a real estate professional, the $30,000 of losses would be suspended until he had passive income from the properties.

Are you puzzled about whether or not you qualify for these deductions?

Need some help understanding how these passive or non-passive activities might relate to your income tax puzzle, as a real estate professional? I’m here to help; contact me at [email protected] for a consultation. You may also want to check out New Tax Law Explained! For Real Estate Investors.

Tangible Property Regulations and the IRS

Repair regulations provide guidance for classifying repairs and improvements

Deductible Repairs or Capital Improvements?

Are your property repairs deductible? The Internal Revenue Code, the Internal Revenue Service (IRS), and taxpayers have been in conflict over whether expenditures on tangible property are deductible now, or must be capitalized and recovered through depreciation over time. The distinction between deductible repairs and capital improvements has been determined largely through case law and is based upon facts and circumstances.

In an effort to reduce disputes with taxpayers, the IRS issued final regulations in September 2013. These are commonly referred to as the “repair regulations”, and provide rules regarding the treatment of expenditures for acquiring, maintaining, or improving tangible property.

Under the repair regulations, the IRS provided guidance to  determine whether an expenditure made for a building is an improvement. The first step is to determine the identifying unit of property.  In real estate, the unit of property would commonly be considered the building; however, there are special rules to determine the unit of property for buildings.

Determining the Unit of Property

When applying the improvements standards, the unit of property for a building comprises the building and its structural components (doors, windows, roof, etc.) plus each of the eight specifically defined building systems:

  1. Heating, ventilation, and air conditioning systems (HVAC)
  2. Plumbing systems
  3. Electrical system
  4. All escalators
  5. All elevators
  6. Fire protection and alarm systems
  7. Building security systemsfire protection systems can be considered a capital improvement
  8. Gas distribution systems

Improvement Standards

Once you have determined the unit of property, the next step is to determine whether an expenditure for the unit of property is a deductible repair or capitalizable improvement. An expenditure is a capitalizable improvement if it can be qualified as a betterment, restoration, or adaptation. They are defined as follows:

  • Capitalizable betterment:
    • Corrects a material condition or defect that existed before the taxpayer’s acquisition of the unit of property.
    • Is a material addition (including physical enlargement, expansion, extension, or addition of a major component) or a material increase in capacity of a unit of property?
    • Is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of a unit of property.
  • Capitalizable restoration:
    • Returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use.
    • Results in the rebuilding of the unit of property to a like-new condition after the end of its class life.
    • Replaces a part or a combination of parts that are a major component or a substantial structural part of a unit of property.
  • Capitalizable adaptation:

The amounts paid to adapt a unit of property to a new or different use that is not consistent with the taxpayer’s ordinary use of the unit of property at the time it was originally placed in service. For a building to qualify for the adaptation standard, the amount paid to improve it must adapt the building structure or any one of its building systems to a new or different use.

The Takeaway

The repair regulations attempt to resolve the controversies that have arisen over the years between the IRS and taxpayers over how to classify certain costs that are deductible in a current tax year versus fixed assets that have to be capitalized and depreciated over a number of years.

If you have any questions about whether improvements to your tangible property are currently deductible or must be depreciated over time, contact Simon Filip for a consultation at 201.655.7411 or [email protected].