Tag: IRS

Can Real Estate Professionals Pay No Income Taxes (a la Donald Trump)?

real estate professionals can deduct tax losses resulting from their real estate activities

As a CPA with a substantial real estate practice, I found the recent controversy regarding Donald Trump’s tax losses and the possibility that he paid no federal income tax to be quite interesting.  Although we do not know what part, if any, of the losses arose from Mr. Trump’s real estate activities, it is not unusual or illegal for real estate professionals to deduct tax losses resulting from their real estate activities.

News reports indicate that Donald Trump’s 1995 federal income tax return reflected a tax loss of approximately $916 million dollars, which may have been carried forward to offset income and reduce Trump’s taxes in succeeding years. As this revelation appears to be the source of public outrage, I wanted to explain taxation of rental real estate and how owners and investors may legally benefit from losses.

Trump most likely operates many of his business ventures as “pass-through” entities, such as partnerships and limited liability companies. Pass-through entities pass through all of their earnings, losses and deductions to their owner, for inclusion on their personal income tax returns. In the case of losses, the owner or member can use these losses to offset other income and carry forward any excess to future years. As with all things taxes, there are requirements that must be met (see Passive Loss Limitations in Rental Real Estate).

Owners of rental real estate are not only allowed to deduct for mortgage interest, real estate taxes and other items, but also depreciation. The Internal Revenue Code allows for depreciation of assets used in a trade or business, which include rental real estate. This is an allowance for the wear and tear of the building and astute taxpayers can further benefit from depreciation by accelerating their depreciation deductions (see my blog, The Tax Benefits of Cost Segregation in Real Estate). While many properties are increasing in value, the owners are receiving an income tax benefit in the form of an annual tax deduction for the wear and tear of the building.

If certain requirements are met, a real estate professional, as defined by the Internal Revenue Code (there is no reference to “Mogul” in the Code) can offset other items of income with losses generated by their real estate activities. I have more details on the income tax advantages of being a real estate professional in a previous blog posting, Passive Activity Loss and the Income Tax Puzzle for Real Estate Professionals.

Donald Trump invested in many business ventures during the 1980s and 1990s and real estate may have only been a small part of the substantial loss reflected on his 1995 tax return. Without Mr. Trump’s tax returns, we will never know. As an accountant, I’m more curious about the transactions that gave rise to the loss and the application of the specific tax law provisions permitting deduction of these losses.

What are your thoughts regarding the ability of real estate professionals to offset other items of income with their losses from real estate activities?

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.

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 Loss Limitations in Rental Real Estate

If you think purchasing a rental property will make a great tax shelter, you may need to dig a little deeper into “passive loss limitations” and how they may affect your real estate investment.

rental property and passive loss limitationsFirst, consider that your rental property (like many other businesses) may not yield positive cash flow at first. Improvements to the property, tenant issues, and other expenses may end up putting you in the negative column. If you do end up with a rental loss, you are subject to complex IRS rules regarding how much of your rental losses you may deduct from other income you earn during the year.

Rental property ventures are treated differently than other business investments by the IRS. In the rental property investment realm, these are “passive loss” limitations.

What is a Passive Activity?

The IRS recognizes two types of passive activities:

  • Rentals, including both equipment and rental real estate, regardless of the level of participation.
  • Trade or businesses in which the taxpayer does not materially participate.

To that second point, you are considered to materially participate in an activity if you are involved in the operation of the activity on a regular, continuous, and substantial basis. Generally, real estate activities are passive activities even if you do materially participate. (There is an exception for real estate professionals, which I will discuss in a future blog.) Passive activity loss limitations are reported on your tax return using Form 8582. You can learn more here about passive and non-passive activities as defined by the IRS.

What Triggers Passive Loss Limitations?

Income tax losses from rental properties and limited partnership investments in which you do not materially participate are subject to the passive loss limitations. Generally, passive losses are limited to passive activity income. Any passive losses that have been disallowed are carried forward to the next taxable year.

Special Allowance for Rental Activities

There is a special $25,000 rental loss allowance but the real estate investor must meet two conditions to qualify, based on modified adjusted gross income (MAGI) and active participation in the activity:

1 – Taxpayers with MAGI of less than $100,000 may claim up to $25,000 in rental losses. For every dollar over $100,000 the allowance is reduced by 50%, and it is completely phased out/reduced to zero when the MAGI reaches $150,000.

2 – You must also actively participate in the running of your real estate. This is a simple level to attain.  You do not have to work any set number of hours to actively participate, you simply have to be the final decision maker about approving tenants, arranging for repairs, setting rents, and other management tasks.  If you manage your rentals yourself, you will likely satisfy this requirement.

Disposition of Interest

Time to sell? Generally, you may deduct the entire amount of previously disallowed passive activity losses in the year you dispose of your entire interest in the activity. If you dispose of your interest in a passive activity during a divorce or by gift, the suspended losses are not deductible and adjust the basis in the property.

If you are thinking of investing in rental property as a tax shelter, it is best to discuss this somewhat complex arrangement with a qualified tax or real estate professional, or certified public accountant with expertise in real estate transactions and accounting.

If you’d like some additional insights into passive loss limitations as they relate to real estate investments, contact me at [email protected] or (201) 655-7411.

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].