Tag: rental income

Real Estate Rentals, the Sharing Economy and Taxes

Taxpayers renting out homes or spare rooms should be aware of the tax implications of these rentals.

When is the rental of a primary residence or vacation home taxable?

Real Estate Rentals, the Sharing Economy and TaxesThe Internal Revenue Code provides the rental of a property that is also occupied by the owner (“host”) as a residence for less than 15 days during the year is not taxable. The host is considered to use the property as a residence if they use it for personal enjoyment during the tax year for more than the greater of (1) 14 days or (2) 10% of the total days during the year they rent it to others.

The tax rules are more complicated when the vacation home is used by the host for more than 2 weeks and also rented for a substantial part of the year.

For example, a host spent 60 days last year in their ski cabin in Vermont. For the remainder of the year it was rented for 180 days.  The host can deduct 75% (180 days out of 240 days) of the ski cabin’s qualifying rental expenses against the rents collected. It is important to note that if expenses exceed rental income, the loss is not deductible.

Where is income from short-term rentals reported?

Many rental services, such as Airbnb, report the rental payments they send to hosts by filing IRS Form 1099-MISC. The IRS matches these 1099’s to tax returns to verify that rental income was reported.

If the host’s property is rented for more than 14 days per year, the exception noted above will not apply. Instead, the host will have to report and pay income tax on the rental income by filing IRS Schedule E along with the tax return. The host will also be allowed to deduct rental-related expenses, subject to limitations

Do hotel taxes apply to short-term rentals?

Lodging or transient occupancy taxes, which are commonly referred to as hotel taxes will typically apply to rentals of 30 days or less in some areas. Some jurisdictions will impose taxes for rentals that exceeds 30 days, such as Florida which taxes rentals of six months or less. These taxes are separate from any income tax they may be owed on profits from renting the property.

Airbnb will collect the applicable lodging taxes on behalf of its “hosts.” For instance, Airbnb has made an agreement with the Vermont Department of Taxation to collect the Vermont Meals and Rooms Tax on payments for lodging offered by its hosts. However, many other rental listing sites, such as HomeAway, will not collect the taxes for property owners. An internet search or browsing of the listing company’s website will provide their policy on collecting the taxes.

There are services available, such as Avalara’s MyLodgeTax, that assists hosts with filing and remitting their lodging taxes. These services are offered for monthly fees.

We’ve got your back

Ready to become a part of the sharing economy? If you’re considering renting out even part of your home, reach out to KRS so that we can help you stay on top of the tax rules. Contact me at [email protected] or (201) 655-7411.

You can also download my free Tax Tip Sheet for more ways to save taxes when buying or selling a rental property.

Will President Trump Benefit or Distress Real Estate?

What will Trump's impact be on the real estate industry?The presidential campaigning has finally ceased and the transition to the Trump presidency has begun. Many questions are being asked in real estate circles, but mostly, how will President Trump’s policies impact real estate in this country?

Here are my thoughts.

Immigration

Throughout the presidential campaign, Trump was firm about deporting immigrants. It is quite common that immigrants who come to this country find work in the construction industry.  A large immigrant deportation effort would put pressure on the number of skilled workers available in the real estate industry, especially in residential real estate.

A labor shortage in the construction industry will force builders to compete for skilled workers with higher wages. Those costs would most likely be passed on to buyers in the form of higher new home prices.

Mortgage Interest Deductions

Trump’s tax plan effectively limits the mortgage interest deduction, without eliminating it entirely. This is accomplished by increasing the standard deduction from $6,300 to $15,000.

Under the current system, for example, a homeowner paying mortgage interest of $10,000 would itemize the deduction and receive a greater tax benefit, because their interest deduction would be greater than the standard $6,300 exemption.

Under Trump’s potential changes, however, there would be no need to itemize the $10,000 mortgage interest, as the proposed standard deduction is already greater. Americans therefore may be less incentivized to buy homes as their taxes would not be significantly different than if they had rented.

Real Estate Agents and Brokers

If housing prices soar due to a lack of skilled labor force and the value of a mortgage interest deduction is diminished, residential real estate brokers and agents may find transactions and commissions drying up. A decrease in real estate activity will affect the bottom line for brokers and agents alike.

Commercial Real Estate

I would be doing a disservice to the real estate ‘mogul’ without mentioning the potential impact on commercial real estate.

There is a potential for a pullback on new construction for commercial projects, large residential and mixed-use developments. If the capital markets experience a shock – which could be interest rates, inflation, or regulation – the difficulty of obtaining construction financing coupled with a muddy economic outlook may push some developers to abandon plans for new projects.

What are your thoughts on the Trump presidency and how it will impact the real estate industry?

Trending Now: Real Estate Crowdfunding

Ever hear of real estate crowdfunding? If not, maybe you should take a look.

crowdfunding for real estateIn my practice as an accountant and trusted advisor I often receive inquiries from clients and their advisors because real estate is an important element of a diversified portfolio. Until recently, opportunities to invest in real estate were limited to acquiring a rental property directly, participating in a real estate investment group, flipping properties or a joining a real estate investment trust (REIT).

Investing through a real estate investment group was limited to accredited investors – those who have a net worth of $1 million or earn at least $200,000 a year. The Securities and Exchange Commission’s Title III of the JOBS Act opened the doors to non-accredited investors, who were previously unable to participate in this new asset class.

As a result of the JOBS Act, crowdfunding platforms have become available which offer options for investing in real estate. In these platforms investors can join others to invest in a rental property – either commercial or residential.

An Entry Point to Real Estate

Private real estate deals have historically been the domain of high net-worth investors who possessed the right connections to gain access to a particular property. Real estate crowdfunding provides an entry point into the real estate market, enabling investors of all ages, risk profiles and wealth levels to acquire real estate investment.

Real Estate Crowdfunding Benefits

Larger geographical scope. Investing in real estate in the past relied upon developing networks of personal and industry connections in your local area. The real estate crowdfunding platforms are opening up access to deals outside of personal contacts and local areas. A potential investor can now browse deals from all over the country.

Lower entry point. Historically, investing in real estate required writing a large check to become part of a deal. Typically, a real estate operator would want to syndicate deals with minimum investments of $100,000 or more to keep the process simple. However, through the technology in these crowdfunding platforms and the JOBS Act, investors are able to invest with a minimum of $1,000, depending on the platform. This allows real estate investors to spread their funds over multiple projects at any one time. From a risk perspective, this is less risk than investing larger amounts in fewer projects.

Drawbacks of Crowdfunding

You don’t really own real estate. Investing in crowdfunded real estate does not actually make you an owner of real estate. Rather, you become a member of a Limited Liability Company that holds title to real property. Ownership in the LLC is considered personal property rather than real property and the rights to share in income and distributions are governed by the Operating Agreement.

Less liquidity. Investing in crowdfunded real estate is different that investing in real estate stock. When you invest in a REIT, you invest in a company that owns and operations various real estate investments. REITs offer liquidity, whereas they can be sold on the stock market, while crowdfunded real estate you are locked in until an exit event such as the sale of the property.

If you are considering investing in real estate every investor should consider how to participate. Along with that decision the tax consequences of the different options should be considered in the analysis.

How to Ruin a Like-Kind Exchange

How to ruin a 1031 exchangeRecently, I had a taxpayer call me regarding the sale of a rental property. The taxpayer sold the property for approximately $500,000 and there was approximately $100,000 of tax basis remaining after depreciation. The combined federal and state tax exposure was almost $100,000.

The taxpayer indicated he wanted to structure the sale as a like-kind (IRC 1031) exchange as he had already found a replacement property and wanted to defer the income taxes. My first question was, “Did you already close on the sale?” The taxpayer’s response was, “Yes, I received the funds, and deposited the check directly into my bank account.”

It was not fun for me to relay this to the taxpayer, but I had to let him know his receipt of the funds caused a taxable event. I further explained that to structure a 1031 exchange properly, an intermediary was needed to handle the sale and related purchase of the replacement property. Once the taxpayer received the funds, it became a taxable event.

Getting a Like-Kind Exchange Right

To avoid the same error, taxpayers should contact their advisors before completing the sale transaction. I have worked with taxpayers who did not realize a like-kind exchange was available to them, and was able to properly structure the transaction in mere days before the closing of their property.

Following the specified guidelines to completely defer the tax in a like-kind exchange are critical. If you anticipate a sale of real estate and want to defer gain recognition, consult with your tax advisor before closing the sale.

We’ve Got Your Back

Check out my previous blog, Understanding IRC Code Section 1031 and Why You Should Care for more details on properly deferring tax in a like-kind exchange transaction. If you have questions about this type of transaction, give me a call at 201.655.7411 before you close on the sale.

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?

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.

Foreign Withholding of Income Tax on Real Estate Transactions

Whether a person is considered a “U.S. person” or “non-U.S. person” will determine which income is subject to federal income tax. This also determines withholdings on that income, which may include earnings from real estate trade/business, passive rental income or sale of property.

Basic Rules

Foreign WithholdingNon-U.S. persons are subject to income tax only on their U.S. source income (income earned within the United States). According to the Internal Revenue Service, most types of U.S. source income paid to a foreign person are subject to a withholding tax of 30 percent, although a reduced rate or exemption may apply if stipulated in the applicable tax treaty.

What’s a U.S. or Non-U.S. Person?  A U.S. person includes citizens and residents of the United States. For income tax purposes, U.S. residents include green card holders or other lawful permanent residents who are present in the United States. A person is also a U.S. resident if he has a “substantial presence” in the States.

A non-U.S. /foreign person, or nonresident alien (NRA) includes (but is not limited to) a nonresident alien individual, foreign corporation, foreign partnership, foreign trust, a foreign estate, and any other person that is not a U.S. person. You can read more on these definitions here.

Withholdings on real estate ventures

If you are a non-U.S. person it is important to consult with tax and/or legal counsel to determine if you are subject to withholding. Below are several situations that could require U.S. withholding with respect to real estate.

  • Trade or business – A non-U.S. person is considered to be engaged in a U.S. trade of business if they regularly undertake activities such as developing, operating and managing real estate. If this is the case, the income is not subject to withholding; rather, the non-U.S. person files an income tax return and computes their applicable tax.
  • Passive rental income – Income from a rental property is typically considered passive income (refer to my previous blog on Passive Activity Losses for details). Rental income is subject to a 30 percent withholding tax unless it is reduced under an income tax treaty. The 30 percent withholding rate is applied to the gross rents and is reported on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding.
  • Sale of property – The Foreign Investment in Real Property Act (FIRPTA) requires a FIRPTA withholding tax of 10 percent of the amount realized on the disposition of all U.S. real property interests by a foreign person. A purchaser of U.S. real property interest from a foreign investor is considered the transferee and also the withholding agent. The transferee must find out if the transferor is a foreign person. If the transferor is a foreign (non-U.S.) person and the transferee fails to withhold, the buyer may be held liable for the tax.

Withholding on foreign partners in a partnership

In addition to filing an annual partnership tax return (Form 1065), if a partnership has taxable income that is effectively connected with a U.S. trade or business, it is required to withhold on income that is allocated to its foreign partners.

The withholding rate for effectively connected income that is allocable to foreign partners is 39.6 percent for non-corporate foreign partners and 35 percent for corporate foreign partners (2016 withholding rates). There are tax treaties with many countries that can reduce the withholding requirements and these should be reviewed.

Note that withholding is calculated on taxable income, not distributions of cash. A partnership needs to be aware before distributing cash to foreign partners that there may be a withholding obligation.

Are you a non-U.S. person with real estate interests in the United States? Or, are you a U.S. citizen or resident working or investing in real estate? I can answer your questions regarding tax issues around passive income losses and other real estate financial considerations; contact me at [email protected] or (201) 655-7411.