Tag: real estate investments

Tax Rules for Vacation Home Rentals

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Tax Rules for Vacation Home RentalsGet the most from your vacation home rental property by knowing the tax rules

Summer is the time of family vacations, sun, sand and beaches. It’s also the time when a vacation home may be used to generate additional cash flow through rental.

Part-time landlords need to remember that, in many cases, the Internal Revenue Service expects them to report the extra income.

Short-Term Rentals

In general, if a taxpayer rents their vacation home for fewer than 14 days out of the year, the income is tax free and the property is considered a personal residence.  Under this scenario, taxpayers are not required to report any rental income on their tax return.  However, expenses attributable to the rental cannot be deducted, such as cleaning fees or rental commissions.

More than 14 Rental Days

If a taxpayer’s rental days are above the 14-day threshold, the income is required to be reported. Under this scenario, a taxpayer can also deduct a variety of direct rental expenses such as licenses, advertising and rental commissions.

Other expenses such as repairs, mortgage interest, property taxes and utilities are deductible on a prorated basis based upon the number of days a taxpayer rented the home out.

Claiming Expenses on Rental Property

When filing taxes on a rental property, an individual will use IRS Schedule E: Supplemental Income and Loss. The IRS provides an extensive listing of deductions in Publication 527, however common expenses include:

  • Real Estate/Property Taxes
  • Insurance
  • Cleaning
  • Repairs and Maintenance
  • Depreciation
  • Legal and Professional Fees
  • Advertising
  • Utilities
  • Commissions

We’ve got your back

For additional information on the taxability of your vacation home rental, contact Simon Filip, the Real Estate Tax Guy, at [email protected] or (201) 655-7411.

Qualified Joint Venture between Spouses

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Qualified Joint Venture between SpousesAn unincorporated business jointly owned by a married couple is generally classified as a partnership for federal tax purposes. However, in 2007, there was an addition to the Internal Revenue Code that excludes from partnership status a Qualified Joint Venture (“QJV”) conducted by a married couple who file a joint return. This was enacted by Congress to alleviate what was considered an unnecessary burden of filing partnership returns where the only members of a business joint venture are a husband and wife filing a joint income tax return.

Definition of a Qualified Joint Venture

QJV is defined as any joint venture involving the conduct of a trade or business if:

  1. the only members of the joint venture are married;
  2. both spouses materially participate;[1] and
  3. both spouses elect the application of QJV treatment.

A qualified joint venture, for purposes of the provision enacted in 2007, includes only businesses that are owned and operated by spouses as co-owners and not in the name of a state law entity (including a limited partnership or limited liability company). If the business is owned and operated by spouses as co-owners, it will not qualify for the election. There are special rules for married couple state law entities in community property states.[2]

Filing requirements for qualified joint ventures

As a result of utilizing the QJV election each spouse should file a separate Schedule C reporting his or her respective share of the items of the venture. There is no prescribed form for making the election.  The election is deemed made on a jointly filed Form 1040 by dividing all items of income, gain, loss, deduction, and credit between each spouse in accordance with each spouse’s respective interest in the joint venture, and each spouse filing with the Form 1040 a separate Schedule C (Profit or Loss from Business).

QJV implications for real estate

Now that you have the basics of a QJV, you might be thinking, “isn’t this a real estate blog?”

You’re correct, this is a real estate blog.

If you and your spouse each materially participate as defined under the at-risk and passive activity limitations and you file a joint return for the tax year, you may elect to be taxed as a qualified joint venture instead of a partnership. By making the election, you will not be required to file Form 1065 Return of Partnership Income, for any year the election is in effect and will instead report the income and deduction directly on your joint return.

To make this election for a rental real estate business, check the “QJV” box on line 2 for each property that is part of the qualified joint venture.

The confusion surrounding a QJV typically arises in non-community property states, including New Jersey and New York, where spouses jointly own interests in an LLC.  The LLC purchases a rental property, which now needs to be reported on a partnership return instead of Schedule E of the individuals’ 1040s. As noted above, the QJV will not apply to a venture that is in the name of a state law entity.

We’ve got your back

If you are considering not filing a partnership return because of the QJV election, you should contact your preparer to review the rules, especially related to rentals owned by LLCs where spouses are the only members.

With Simon Filip, the Real Estate Tax Guy, on your side, you can focus on your real estate investments while he and his team take care of your accounting and taxes. Contact him at [email protected] or 201.655.7411 today.

[1] IRC Section 469(h).

[2] Rev. Proc. 2002-69.

Qualified Opportunity Zones under the Tax Cuts and Jobs Act

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QO Zones offer incentives for investment in low income communities

Qualified Opportunity Zones under the Tax Cuts and Jobs Act

The Qualified Opportunity Zone Program (“QO Program”) enacted as part of The Tax Cuts and Jobs Act is a new incentive designed to promote investment in low-income communities by allowing taxpayers to defer, reduce, and potentially exclude gain recognition on certain investments made in Qualified Opportunity Zones (“QO Zones”).

Qualified Opportunity Funds (“QO Funds”)

Investors wishing to utilize the Opportunity Zone Program must invest their gain in a QO Fund. In order to meet the criteria of a QO Fund, 90% of the assets held by the vehicle on the last day of the fund’s taxable year (and the last day of the first six month period of the fund’s taxable year) must be qualified opportunity zone property (“QOZ Property”) within a QO Zone acquired after December 1, 2017.

The Act requires the Treasury Secretary to establish guidance for the certification process of QO Funds, which will likely be administered by the Department of Treasury’s Community Development Financial Institutions Fund (“CDFI Fund”).

What are QO Zones?

The QO Program requires a QO Fund to make direct or indirect investments in a QO Zone. Qualified Opportunity Zones (QO Zones) are defined as certain low-income communities that are experiencing uneven economic development, resulting in pockets of disinvestment and unemployment.

In New Jersey, Governor Murphy nominated 169 low-income tracts in 20 counties for designations a QO Zones. On April 9th, the U.S. Department of Treasury approved Governor Murphy’s designation of such tracts as QO Zones.

Tax Benefits of Investing in Opportunity Zones

The QO Program offers three tax benefits for investing in low-income communities through a QO Fund:

  1. A temporary deferral of inclusion in taxable income for capital gains reinvested in an Opportunity Fund. The deferred gain must be recognized on the earlier of the dates on which the opportunity zone investment is disposed of or December 31, 2026.
  2. A step-up in basis for capital gains reinvested in an Opportunity Fund. The basis is increased by 10% of the investment in the Opportunity Fund is held by the taxpayer for at least 5 years and an additional 5% is held for at least 7 years, thereby excluding up to 15% of the original gain from taxation.
  3. A permanent exclusion from taxable income of capital gains from the sale or exchange of an investment in an Opportunity Fund if the investment is held at least 10 years. This exclusion only applies to gains accrued after an investment in an Opportunity Fund.

Other Highlights

Some important items to note under the QO Program:

  1. Gains must be reinvested within 180 days in order to qualify for tax deferral under the QO Program.
  2. There is no “like-kind” requirement as part of the program. An investor could sell a mutual fund and reinvest gains into a QO Fund that will develop real estate in one of the selected census tracts.
  3. The program is still being formulated. The next step is for the Treasury Department to promulgate regulations for the establishment of Opportunity Funds, the vehicles which QO Zones investments will be made.

We’ve got your back

Like many other aspects of the new tax law, QO Zones can get complicated. With Simon Filip, the Real Estate Tax Guy, on your side, you can focus on your real estate investments while he and his team take care of your accounting and taxes. Contact him at [email protected] or 201.655.7411 today.

The Tax Cuts and Jobs Act (TCJA) and Code Section 1031

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The Tax Cuts and Jobs Act (TCJA) and Code Section 1031The Tax Cut and Jobs Act (TCJA) was signed into law on December 22, 2017, and took effect on January 1, 2018. Included in the political promise of tax simplicity and historically large tax cuts to middle-income households were amendments to existing tax code, including Code Section 1031. Investment property owners will continue to be able to defer capital gains taxes using 1031 tax-deferred exchanges, which have been in the tax code since 1921.

What changes under the new tax law?

The tax law repealed 1031 exchanges for all other types of property that are not real property. This means 1031 exchanges of personal property, assets that can no longer be exchanged including collectibles, franchise licenses, and patents, aircraft, machinery, boats, livestock, and artwork.

What didn’t change for 1031 exchanges?

Real estate exchanges are subject to the same rules and requirements as prior law. Taxpayers must still identify their replacement within 45 days and exchange within 180 days. All real estate in the United States, improved and unimproved, also remains like-kind to all other domestic real estate.  Foreign real estate continues to be treated as not like-kind to real estate.

Are there timing considerations?

Pursuant to the transition rules, a personal property exchange to be completed in 2018 would be afforded tax deferral under the prior law if the relinquished property was sold or the replacement property was acquired by the taxpayer prior to December 31, 2017.

What about cost segregation?

A cost segregation study identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which reduces current income taxes. Taxpayers entering into a 1031 exchange who are contemplating a cost segregation study, need to consider the disallowance of personal property as like-kind to real property. Reclassifying asses to shorter recovery periods will increase annual depreciation deductions, but can potentially cause gain recognition from the exchange.

We’ve got your back

The new tax code is complex and every taxpayer’s situation is different, especially when real estate is involved – so don’t go it alone! Check out the New Tax Law Explained! for Individuals and then contact me at [email protected] or 201.655.7411 to discuss tax planning and your real estate investments under the TCJA.

 

The Tax Act and the Real Estate Industry

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The Tax Act and the Real Estate IndustryTax Cuts and Jobs Act (“TCJA”)

On December 20, 2017 Congress passed the most extensive tax reform since 1986, which was subsequently signed into law by President Trump. Included in the TCJA are changes to the Internal Revenue Code (“Code”) that impact taxpayers engaged in the real estate business, and those who otherwise own real estate.

Individual tax rates

The TCJA lowers the marginal (top tax bracket) tax rate applicable to individuals from 39.6% to 37%. The net investment income tax (NIIT) and Medicare surtax of 3.8% and 0.9%, respectively, remain. The reduction in tax rates is not permanent like the corporate tax rate reduction, and is scheduled to expire after 2025. The tax rates applicable to long-term capital gains of individuals remains at 15% or 20%, depending on adjusted gross income (AGI).

Deduction for qualified business income of pass-through entities

The TCJA creates a new 20% tax deduction for certain pass-through businesses. For taxpayers with incomes above certain thresholds, the 20% deduction is limited to the greater of (i) 50% of the W-2 wages paid by the business, or (ii) 25% of the W-2 wages paid by the business, plus 2.5% of the unadjusted basis, immediately after acquisition, of depreciable property (which includes structures, but not land).

Pass-through businesses include partnerships, limited liabilities taxed as partnerships, S Corporations, sole proprietorships, disregarded entities, and trusts.

The deduction is subject to several limitations that are likely to materially limit the deduction for many taxpayers. These limitations include the following:

  • Qualified business income does not include IRC Section 707(c) guaranteed payments for services, amounts paid by S corporations that are treated as reasonable compensation of the taxpayer, or, to the extent provided in regulations, amounts paid or incurred for services by a partnership to a partner who is acting other than in his or her capacity as a partner.
  • Qualified business income does not include income involving the performance of services (i) in the fields of, among others: health, law, accounting consulting, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or (ii) consisting of investing or investment management, trading, or dealing in securities, partnership interests or commodities.
  • Qualified business income includes (and, thus, the deduction is applicable to) only income that is effectively connected with the conduct of a trade or business within the United States.
  • The deduction is limited to 100% of the taxpayer’s combined qualified business income (e.g., if the taxpayer has losses from certain qualified businesses that, in the aggregate, exceed the income generated from other qualified businesses, the taxpayer’s deduction would be $0).

Interest expense deduction limitation

For most taxpayers, TCJA disallows the deductibility of business interest to the extent that net interest expense exceeds 30% of Earnings before Income Taxes Depreciation and Amortization (EBITDA) for 2018 through 2022, or Earnings before Income Taxes (EBIT) beginning in 2022. An exemption from these rules applies to certain taxpayers with average annual gross receipts under $25 million.

A real property trade or business can elect out of the new business interest disallowance by electing to utilize the Alternative Depreciation System (ADS). The ADS lives for nonresidential, residential and qualified improvements are 40, 30, and 20 years, respectively.  All of which are longer lives, resulting in lower annual depreciation allowances.

Immediate expensing of qualified depreciable personal property

The TCJA includes generous expensing provisions for acquired assets. The additional first year depreciation deduction for qualified depreciable personal property (commonly known as Bonus Depreciation) was extended and modified. For property placed in service after September 27, 2017 and before 2023, the allowance is increased from 50% to 100%. After 2022, the bonus depreciation percentage is phased-down to in each subsequent year by 20% per year.

Expansion of Section 179 expensing

Taxpayers may elect under Code Section 179 to deduct the cost of qualifying property, rather than to recover the costs through annual depreciation deductions. The TCJA increased the maximum amount a taxpayer may expense under Section 179 to $1 million, and increased the phase-out threshold amount to $2.5 million.

The Act also expanded the definition of qualified real property eligible for the 179 expensing to include certain improvements to nonresidential real property, including:

  • Roofs
  • Heating, Ventilation, and Air Conditioning Property
  • Fire Protection and Alarm Systems
  • Security Systems

We’ve got your back

The new tax code is complex and every taxpayer’s situation is different, especially when real estate is involved – so don’t go it alone! Contact me at [email protected] or 201.655.7411 to discuss tax planning and your real estate investments under the TCJA.

An Update: Real Estate Professionals and Passive Losses

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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.

Excluding Gain on the Sale of a Principal Residence

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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.

Investing in Foreign Real Estate? Here’s What You Need to Know

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Investing in Foreign Real Estate? Here’s What You Need to Know

Much is written about tax compliance and withholding imposed upon a foreign entity or person owning real estate in the United States. The fact that many U.S. taxpayers own real estate outside of the country is often disregarded.

The intent of this post is to touch upon some of the differences of which an investor or potential investor in foreign real estate should be aware.

Depreciation and foreign property holdings

One of the main differences in holding a U.S. rental property compared to a foreign rental property is depreciation. The Internal Revenue Code requires any tangible property used predominantly outside the U.S. during the year to use the Alternative Depreciation System (“ADS”). Residential rental property located in a foreign country must use ADS, resulting in depreciation over a 40 year recovery period compared to the 27.5 year recovery of U.S. residential property.

1031 exchanges aren’t allowed

I have discussed the tax deferral afforded by entering into a 1031 like-kind exchange in previous posts. However, the Internal Revenue Code does not allow taxpayers to exchange U.S. investment property for foreign investment property.  U.S. property is limited to the 50 states and the District of Columbia only. Property located in U.S. territories, such as Puerto Rico, is not like-kind to property located within the United States. There are limited exceptions, under certain circumstances for property located within the U.S Virgin Islands, Guam and the Northern Mariana Islands.

Taxpayers can obtain deferral afforded by a 1031 exchange when trading U.S. property for U.S. property, but not U.S. property for foreign property. However, foreign property is deemed liked-kind when exchanged for other foreign property, thus qualifying for 1031 exchange treatment.

Preventing double taxation

If a taxpayer operates a property abroad as a rental property, taxes will be owed in the country where the property is located. To prevent double taxation, a U.S. taxpayer can claim a credit on the U.S. tax return for taxes paid to the foreign country relating to the net rental income. It is important to note that a taxpayer cannot claim a credit for more than the amount of U.S. tax on the rental income.

The foreign tax credit is also available if the property is sold and there is any capital gains tax in the foreign county.

Additional reporting obligations

A U.S. taxpayer may have additional filing obligations with their tax return as a result of the foreign rental activity.

For example, if a U.S. taxpayer establishes a foreign bank account to collect rent and the aggregate value of the account is $10,000 or more on any given day, an FBAR (Report of Foreign Bank and Financial Accounts) is required to be filed.

If the property is held in a foreign corporation, Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations) is required to be filed. If the property is held in a Foreign LLC, then Form 8858 (Information Return of U.S Persons with Respect to Foreign Disregarded Entities) may be required.

We’ve got your back

Don’t go it alone if you’re an investor in foreign real estate. Contact me at [email protected] or 201.655.7411 for assistance with tax planning for your international holdings.

Special Tax Allowance for Rental Real Estate Activities

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Special Tax Allowance for Rental Real Estate ActivitiesIf a taxpayer fails to qualify as a real estate professional, losses from rental activities may still be deductible. While real estate professionals are afforded beneficial tax treatment enabling them to deduct losses from their real estate activities, real estate nonprofessionals taxpayers may still benefit.

Exception for rental real estate activities with active participation

If a taxpayer or spouse actively participated in a passive rental real estate activity, they may be able to deduct up to $25,000 of loss from the activity from nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities.

What determines active participation?

A taxpayer actively participated in a rental real estate activity if the taxpayer (and spouse) owned at least 10% of the rental property and made management decisions or arranged for others to provide services. Management decisions that may count as active participation include approving new tenants, deciding on rental terms, and approving expenditures.

Having a property manager will not prevent a taxpayer from meeting the active participation test. A taxpayer’s lack of participation in operations does not preclude qualification as an active participant, as long as the taxpayer is still involved in a significant sense. For example, the service vendors and approving tenants must be approved by the taxpayer before the property manager can commit to a service or lease contract. In other words, the taxpayer is still treated as actively participating if they are involved in meaningful management decisions regarding the rental property.

Maximum special allowance

The maximum special allowance is:

  • $25,000 for single taxpayers and married taxpayers filing jointly
  • $12,500 for married taxpayers who file separate returns
  • $25,000 for a qualifying estate reduced by the special allowance for which the surviving spouse qualified

If the taxpayer’s modified adjusted gross income (MAGI) is $100,000 or less ($50,000 or less if married filing separately), they can deduct losses up to the amount specified above. If MAGI is more than $100,000 (more than $50,000 if married filing separately), the special allowance is limited to 50% of the difference between $150,000 ($75,000 if married filing separately and your MAGI). If MAGI is $150,000 or more ($75,000 if married filing separately), there is no special allowance.

Modified Adjust Gross Income (MAGI)

For purposes of calculating the special allowance for rental real estate activities, modified adjusted gross income is computed by deducting the following items from Adjusted Gross Income (AGI):

  • Any passive loss or passive income
  • Any rental losses (whether or not allowed by IRC § 469(c)(7))
  • IRA, taxable social security
  • One-half of self-employment tax
  • Exclusion under 137 for adoption expenses
  • Student loan interest
  • Exclusion for income from US savings bonds (to pay higher education tuition and fees)
  • Qualified tuition expenses (tax years 2002 and later)
  • Tuition and fees deduction
  • Any overall loss from a PTP (publicly traded partnership)

We’ve got your back

Learn about all the tax benefits you may qualify for if you invest in real estate. Contact me at [email protected] or 201.655.7411.

Defer Taxes with Monetized Installment Sales

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Many potential sellers are concerned about the amount of taxes that would be payable upon the sale of an appreciated asset, including an operating business, investment properties, or a home with a low tax basis.

Defer Taxes with Monetized Installment SalesWhat is an installment sale?

The tax law allows for installment sales, under which a seller takes back a note (sometimes referred to as seller carryback financing). This is discussed in detail in my previous blog post How to Defer Taxes on Capital Gains. Under the installment method, each year gain is recognized as payments are received.

A risk of the traditional installment sale is buyer default due to business failure or diminution in the value of the property due to economic conditions or poor management.

Monetization loan with an installment sale

The Internal Revenue Service permits capital assets to be sold without the immediate gain recognition via a monetization loan with an installment sale. Instead of the traditional installment sale structure, a seller can use the monetized installment sale (formerly known as a collateralized installment sale) strategy to defer taxable gain recognition. In 2012 the Chief Counsel of the IRS approved this form of transaction.

Under a monetized installment sale the seller agrees to sell the business or property to a dealer who resells the property to a final buyer using the original terms. Typically, the seller has already found the ultimate buyer and agreed upon terms, which the dealer follows. The seller takes back an installment contract from the dealer. The buyer pays the dealer in cash at closing, which is held in an escrow account.

The seller receives a limited-recourse loan from a third-party lender nearly equal to the sales price (usually 95%). This is a no-money-down, non-amortizing, interest-only loan. Sellers can then invest non-taxable loan proceeds as they see fit. Monthly interest payments on the installment contract will usually equal the seller’s loan interest payments.  The final due dates on the installment contract and the monetization loan will typically be aligned, and the principal paid at the end equals or exceeds the outstanding principal balance the seller owes on the loan. When the installment contract ends the seller will recognize the gain from the installment sale.

When is the tax bill paid?

The monetized installment sale strategy does not eliminate the capital gains tax, rather it defers the payment. At the end of the installment contract between the seller and the dealer, the capital gains tax will be due.

It is important to note the monetized installment sale strategy defers tax on capital gains. Under the Internal Revenue Code, gain that would be taxed as ordinary income from depreciation recapture must be reported in the year of sale, even on an installment sale. This situation is common where depreciation deductions have been taken on a piece of machinery or equipment and consequently the fair market value now exceeds the tax basis. Those prior depreciation deductions are recaptured at ordinary income tax rates upon sale.

We’ve got your back

A monetized installment sale can be an effective way to defer taxes, but typically requires a professional tax advisor’s assistance. To learn more about setting up this strategy, contact me at [email protected] or 201.655.7411.