Tag: tax benefits

Excluding Gain on the Sale of a Principal Residence

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

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

What is a principal residence?

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

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

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

How is gain or loss computed?

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

Gain exclusion requirements

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

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

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

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

Property used partially as business and partially as principal residence

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

Example – Home office impact on gain exclusion

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

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

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

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

Special Tax Allowance for Rental Real Estate Activities

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

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.

 

Wrap-around Mortgages Explained

Learn about wraps and structure better deals

A “wrap-around” mortgage (also referred to as a “wrap”) is a subsequent and subordinate mortgage secured by real property where a first mortgage remains outstanding and unsatisfied. A wrap differs from a conventional second mortgage in that it requires an agreement between the parties for payment of the first mortgage obligation by the lender. Consequently, the principal of the wrap-around loan is the sum of the outstanding indebtedness on the first mortgage and new funds advanced.

The wrap technique is typically employed in transactions involving large commercial loans. However the same financing technique is used in single family real estate investments.
Wrap around mortgages explained
Here’s an example:

Joe owns a commercial property with a $500,000 value and a mortgage of $150,000. He enters into a contract to sell the real property to Jane for $500,000. The contract consists of a note for the entire $500,000 payable to Joe.

Jane will make payments on the $500,000 loan directly to Joe.

Joe will in turn continue to make payments on the $150,000 underlying mortgage and retain the excess, if any.

Wraps and installment sales

Frequently in the sale of real estate, the seller may elect to receive payment in installments, providing the purchaser a convenient financing option while generating desirable tax benefits to the seller. As described in more detail in How to Defer Taxes on Capital Gains, installment payments can defer taxes on capital gains if the seller receives at least one payment after the year of a disposition. Use of an installment sale permits a seller to spread the recognition of taxable income over time and avoid recognizing the entire gain before actual payment is received.

Generally, if a buyer assumes a mortgage or purchases the property subject to an existing mortgage, the excess of that debt over the seller’s basis is treated as a payment received in the year of sale (triggering gain recognition). In addition, the assumed mortgage is not included in the contract price, resulting in a higher gross profit percentage, accelerating recognition of taxable income.

If a wrap mortgage is used, the contract price is the entire sales price, resulting in a lower gross profit percentage (and correspondingly less gain recognized in each year’s collections). Also, since the property is not taken subject to the seller’s mortgage, there is no tax on a phantom payment in the year of sale, even if the mortgage exceeds the seller’s basis.

Beware the due on sale clause

The due on sale (or acceleration clause) is a provision in most mortgage documents that allows the lender the right to demand payment of the unpaid loan balance when the property is sold. This is a right provided by the contract, not by law. This means if title to the property is transferred, the bank has the right, but not the obligation, to demand payment.

Benefits to buyers and sellers

Wrap-around mortgages can offer flexibility and tax benefits to both buyer and seller. The wrap also includes credit risk if the purchaser defaults or if the underlying mortgage lender calls the loan.

We’ve got your back

Are you considering using the wrap-around technique on your real estate transaction? You’ll need to consider both the tax and legal ramifications. At KRS, we’re pros at real estate taxes, so contact us to  discuss your plans at 201.655.7411 or [email protected].

 

What You Ought to Know about Affordable Housing

What You Ought to Know about Affordable Housing

The federal government used to build its own public housing. However, the government banned public housing construction in 1968 and began demolishing many of its buildings in the 1990s.

While the direct construction went away, the need for new units did not. The National Low Income Housing Coalition published in its 2015 report that one out of every four renter households is extremely low income (“ELI”). ELI households are those with incomes at or below 30% of area median income.

Recognizing the need for additional affordable housing, Congress developed a strategy to entice private developers to build such housing. Cognizant that developers would not pursue these projects when market-rate developments would offer higher returns, Congress included an incentive in the form of a tax credit. The National Council of State Housing Agencies (NCSHA) states nearly 3 million apartments for low-income households have been built because of the Low Income Housing Tax Credit (LIHTC). It estimates that approximately 100,000 units are added to the inventory annually.

Low Income Housing Tax Credits

The tax credits to which a developer is entitled are based on multiple factors including the investment made by the developer, the percentage of low-income units created, the type of project, and whether the project is funded by any tax-exempt private activity bonds.

Claiming the Credits

Following construction or rehabilitation and lease-up of a building, the developer submits a “placed-in-service” certificate showing it has complied with its application and project agreement. The certificate typically includes information on qualified costs incurred, the percentage of units reserved for low-income qualified tenants, and constructions agreements.

If the certificate is approved, the developer is issued IRS Form 8609. The credits can then be claimed on the federal tax return. The credit is a dollar-for-dollar reduction in federal income tax liability.

Types of  Low Income Housing Projects

A common misconception is that affordable housing is required to be new construction. The LIHTC can be used for:

  • New construction
  • Acquisition and rehabilitation
  • Rehabilitation of a property already owned by a developer.

Affordable Housing Development Tax Implications

The low-income housing tax credit program is an option for real estate professionals seeking to develop a rental property. The tax credit will reduce Federal income taxes or can be sold for equity, reducing the debt needed to develop a project.

If developing affordable housing is part of your real estate game plan, don’t go it alone! A real estate CPA can help you devise effective tax strategies around the Low Income Housing Tax Credit program. Contact The Real Estate Tax Guy at [email protected] or 201.655.7411.

How Your 1031 Exchange Can Benefit from a “Zero” Deal

In previous blog posts I’ve discussed benefits of entering into a 1031 exchange. Also known as a like-kind or tax deferred exchange, a 1031 exchange affords significant tax benefits to property owners.

How 1031 exchanges benefit from zero cash flow dealsSpecifically, a 1031 exchange allows a taxpayer to sell an investment property and reinvest in replacement property(ies) while deferring ordinary income, depreciation recapture and/or capital gains taxes. By deferring tax on the transaction, taxpayers will have more cash available for reinvestment.

What is a zero cash flow purchase?

In a zero cash flow or “zero” deal, the net operating income on a net-leased property matches the debt service, and the loan amortization matches the term of the lease. If the property is retained for the full term of the lease, there is no debt at the end of the term.

Many real estate investors purchase zeros to offset taxable income from other investments through losses associated with depreciation deductions and interest expenses. These transactions are not without drawbacks, as taxable income will occur when the annual loan amortization exceeds the annual depreciation.

Benefits of a zero in a like kind exchange

One of the largest benefits of a zero in a like kind exchange is the pay-down or re-advance feature, whereby the buyer can access cash from the exchange without triggering gain recognition. Once the property is acquired and the exchange is completed, the loan provides the owner an option to refinance a portion of the equity. The options are exercised within the existing loan documents, and there is no renegotiation of terms with the lender. The proceeds can then be deployed to cash-flowing assets.

For example, a taxpayer has a property worth $10 million, comprised of $4 million in equity and $6 million in debt. She found a zero property that can be purchased for $10 million, putting down $1 million as equity and assuming $9 million of debt. The buyer applies $4 million in cash to purchase the replacement, covering the equity requirement of the 1031 exchange. Of that, $3 million (excess of the $4 million of equity from the down-leg over $1 million of equity required for purchase of the property) is used to pay down the debt balance. The interim debt balance is $6 million, fulfilling the debt requirement of the buyer’s 1031 exchange. After closing, the debt is re-advanced from $6 million to the original $9 million, with loan proceeds of $3 million going to the buyer. The exchange has been completed, income deferred and the taxpayer has extracted $3 million in non-taxable proceeds.

We’ve got your back

If you’re interested in structuring a 1031 exchange as a zero cash flow purchase, be sure to consult a real estate broker who specializes in these investments. You’ll also want to coordinate the deal with your tax advisor so that you’re following all the 1031 exchange rules. That’s where the tax experts here at KRS can help and ensure that you receive the maximum tax benefits. For more information, contact me at 201.655.7411 or [email protected]

For Tax Savings, Consider an IC-DISC for Your Exporters

Did you know there is an underutilized tax incentive that can reap federal tax savings for manufacturers?

For Tax Savings, Consider an IC-DISC for Your ExportersOne middle-market manufacturer recently saved approximately $300,000 in current year federal taxes by implementing this tax incentive, which promotes exporting goods manufactured in the United States that have an ultimate destination outside of the U. S. The federal tax savings will continue to increase as this client expands its export operations. The tax saving strategy was executed by forming an interest charge-domestic international sales corporation (“IC-DISC”).

To determine if an IC-DISC might be beneficial for your client, all of the following should apply:

  1. Does the company sell or lease export property or provide services that are related to any exchange of property outside the United States?
  2. Is the company generating taxable profits?
  3. Is the company closely held?

An IC-DISC is typically formed as a wholly-owned U. S. corporate subsidiary of a domestic exporting company. The IC-DISC serves as the exporting company’s foreign sales agent (not to be confused with a Foreign Sales Corporation, which was discontinued in 2000).

After the IC-DISC is incorporated, it must file an election with the Internal Revenue Service to be treated as an IC-DISC, which is not subject to federal income tax and certain state income taxes. The election must be made within 90 days of incorporation and is made on Form 4876-A, Election To Be Treated as an Interest Charge DISC. All of the corporation’s shareholders must consent to this election.

Qualifying as an IC-DISC

To qualify as an IC-DISC, a corporation must maintain the following requirements[1][2]:

  1. Be incorporated in one of the 50 states or District of Columbia
  2. File an election with the IRS to be treated as an IC-DISC for federal tax purposes
  3. Maintain a minimum capitalization of $2,500
  4. Have a single class of stock
  5. Meet a qualified exports receipts test and a qualified export assets test.

To expand on the last requirement, at least 95 percent of an IC-DISC’s gross receipts and assets must be related to the export of property whose value is at least 50 percent attributable to U.S. produced content.

The newly formed IC-DISC enters into a commission agreement with the seller of export goods. By virtue of the C corporation meeting all of the IC-DISC qualifications, it is presumed to have participated in the export sales activity, and due to that participation, is entitled to earn a commission.

The related exporter is allowed to pay a tax-deductible commission to the IC-DISC, which is the greater of 4 percent of the company’s gross receipts from qualified exports, or 50 percent of the company’s net income from qualified exports.[3] The IC-DISC commission is a current deduction to the U.S. exporter at ordinary income rates (currently a maximum of 39.6 percent).

The IC-DISC, as a tax-exempt entity, pays no federal tax on the commission income. When the IC-DISC distributes its income to its shareholders, it becomes qualified dividend income taxed at the qualified dividend rate of 23.8 percent when including the new 3.8 percent tax on net investment income.

If the company is a pass-through entity, such as a partnership, S corporation, or LLC, you can form an IC-DISC as a subsidiary. Dividends the IC-DISC distributes will retain their character and be passed through to individual shareholders and qualify for the 23.8 percent qualified dividends rate (20 percent qualified dividends rate plus 3.8 percent tax on net investment income).

If your company is a C corporation however, you will need to have the corporation’s individual shareholders form the IC-DISC as a sister corporation to obtain the lower tax rate on dividends.

Tax Benefits for Shareholders

Assume an S corporation has $20 million in qualifying export sales and $5 million in net export income on those sales. If the company has an IC-DISC subsidiary, it can pay a deductible commission to the IC-DISC equal to the greater of 50 percent of its export net income ($2.5 million) or 4 percent of its export gross receipts ($800,000). In this case, the maximum commission is 50 percent of net income or $2.5 million.

The IC-DISC distributes the full $2.5 million of commission income as a dividend to its S corporation shareholder. The S corporation receives a $2.5 million dividend, which retains its character and passes through to the S corporation’s individual shareholders. The S corporation shareholders pay 23.8 percent federal income tax on the IC-DISC qualified dividend income. If the commission had not been paid, the S corporation individual shareholders would have additional ordinary income passed through to them taxable at a maximum 39.6 percent federal tax rate.

Federal Tax Savings:

Tax on $2.5 Million at 39.6% rate                               $990,000

Tax on $2.5 Million at 23.8% rate                               $595,000

Federal income tax benefit to shareholders               $395,000

Taxpayers can also use IC-DISCs to defer the recognition of income related to foreign sales, however the discussion above focused primarily on using an IC-DISC to convert ordinary income into qualified dividend income, reducing the income tax liability of a corporation’s shareholders.

We’ve got your back

It is important for practitioners and advisers to be aware of tax incentives available to their manufacturing and export clients that are producing goods in the United States and shipping them overseas. For help establishing an IC-DISC, contact me at [email protected] or 908.655.7411.

References

[1] Trea. Reg. 1.992-2(b).

[2] IRC Sec. 992(a)(1) and Treas. Reg. 1.992-1.

[3] IRC Sec. 994.

Income Tax Incentives for Land Conservation

Income Tax Incentives for Land ConservationConservation easements have been receiving increased press and scrutiny from the IRS, which is cracking down on easement donation abuse by tax shelter promoters.

At its very basis, conservation easements are meant to further the public good by encouraging taxpayers to donate property rights to organizations so the property can be conserved in its current form.

What is a conservation easement?

A conservation easement, also referred to as a conservation agreement, is a legal agreement between a landowner and a land trust or government agency.

When a landowner donates an easement to a land trust or public agency, he is giving away some rights associated with the underlying land. The easement acts to permanently limit the use of the land to protect its conservation values.

What kinds of property qualify?

It could be land that preserves open space or is deemed to be historically important. Land with a scenic vista, a critical water source or wildlife habitat may also qualify.

Does the landowner lose all rights to the property?

Conservation easements offer landowners the flexibility of protecting their land. A donating landowner can retain the right to harvest crops, while relinquishing rights to build additional structures on the conserved parcel.

It is the responsibility of the land trust to make sure the donating landowner adheres to the terms of the conservation easement.

What are the tax incentives?

If a conservation easement is voluntarily donated to a land trust or government agency it can qualify for a charitable tax deduction on the donor’s federal income tax return. To determine the value of the charitable donation, an appraisal is obtained for the value of the land “as-is,” and the value of the property as restricted by the easement. The difference between the two values is the amount of the charitable donation to the land trust.

Are there additional benefits?

The donating landowner may also realize savings in the form of reduced property taxes. A lowered property value assessment after the easement is granted can result in decreased real estate taxes. Additionally, some states, including New York offer their own tax incentives.

We’ve got your back

For additional information on the tax benefits of land conservation, please contact me at  [email protected] or (201) 655-7411.

How are start-up expenses treated for new rental properties?

When projecting taxable income from your new rental property be mindful of start-up expenses

Expenses incurred prior to the commencement of a business are not currently deductible. In the instance of rental real estate, costs incurred before a property is ready to be rented are considered start-up expenses.

What are start-up expenses?For tax purposes, be sure to track start-up expenses for your new rental property

Start-up expenses generally fall into three categories:

  1. Investigatory costs – amounts paid or incurred in connection with investigating the creation or acquisition of a trade or business.
  2. Formation/organizational costs – amounts paid or incurred in creating an active trade or business.
  3. Pre-opening expenses – amounts paid or incurred in connection with “any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business.”

How are start-up expenses treated for tax purposes?

Costs that have been identified as start-up expenses are treated differently for income tax purposes. The expenditures cannot be deducted automatically in a single year. Since these costs are deemed to provide a benefit over multiple years, they are treated as capital expenditures and must be deducted in equal amounts over 15 years. There is a special provision that allows taxpayers to deduct up to $5,000 in start-up expenses in the first year of active business, with the balance amortized over 15 years.

What about expenses to obtain a mortgage?

Certain settlement costs incurred in connection with obtaining a mortgage are required to be amortized over the life of the mortgage. Expenses such as mortgage commissions, loan processing fees, and recording fees are capitalized and amortized.

Points are charges paid by a borrower to obtain a loan or mortgage. Sometimes these charges are referred to as loan origination fees or premium charges. Points are essentially prepaid interest, but cannot be deducted in full in the year of payment. Taxpayers must amortize points over the life of the loan for their rental property.

When is a property deemed ready for rent?

There is considerable confusion about when property is ready for rent and rental activity begins for income tax purposes. It is important to establish this point in time as subsequent expenditures are no longer treated as start-up expenses requiring capitalization.

The rental activity begins when the property is ready and available for rent, not when it has actually rented. In other words, expenses incurred by the landlord while the property is vacant are not start-up expenses. For example, assume a taxpayer landlord has a vacant property that is being advertised for rental and has received a certificate of occupancy, but the landlord has not been able to find a tenant for three months. The costs incurred during that time period are not considered start-up because the property is ready and available for rent.

If a taxpayer does incur start-up expenses, they should be separated and capitalized in accordance with the Internal Revenue Code. Proper tax planning includes minimizing start-up expenses to the extent possible and/or keeping them below the $5,000 threshold.

We’ve got your back

If you have questions about start-up expenses for your new rental property, we’re here to help. Contact me at [email protected] or 201.655.7411.

Allocating Between Land and Building when Acquiring Rental Real Estate

How purchase value is divided up between land and buildings impacts the depreciation tax benefits you get as a real estate owner. Here’s what you need to know.

Depreciation for residential and commercial properties

Apportioning costs between the land and the building for favorable tax treatmentA tax benefit of real estate investing is the tax shelter provided by depreciation. Depreciation is an IRS acknowledgment that assets deteriorate over time. The IRS provides specific depreciable lives for residential and commercial property of 27.5 and 39 years, respectively.  Unlike other expenses, the depreciation deduction is a paper deduction.  You do not have to spend money to be entitled to an annual deduction.

Allocations favorable to taxpayers

When acquiring real estate, a taxpayer is acquiring non-depreciable land and depreciable improvements (excluding raw land, land leases, etc. for this discussion). In transactions that result in a transfer of depreciable property and non-depreciable property such as land and building purchased for a lump sum, the cost must be apportioned between the land and the building (improvements).

Land can never be depreciated. Since land provides no current tax benefit through depreciation deductions, a higher allocation to building is taxpayer-favorable. This results in the common query of how a taxpayer should allocate the purchase price between land and building. The Tax Court has repeatedly ruled that use of the tax assessor’s value to compute a ratio of the value of the land to the building is an acceptable way to allocate the cost.

For example, a taxpayer purchases a property for $1,000,000. The tax assessor’s ratios are 35/65 land to building. Using the tax assessor’s allocation the taxpayer would allocate the purchase price $350,000 and $650,000 to land and building, respectively.

Other acceptable methods used as basis for allocation include a qualified appraisal, insurance coverage on the structure (building), comparable sales of land and site coverage ratio.

Assessor’s allocation vs. taxpayer proposed values

In the recent U.S. Tax Court case, Nielsen v. Commissioner, the court concluded the county assessor’s allocation between land and improvements were more reliable than the taxpayer’s proposed values. Nielsen (the “petitioners”) incorrectly included their entire purchase price as depreciable basis, with no allocation between the improvements and the land.

When the petitioners were challenged they acquiesced and agreed the land should not have been included in their calculation of the depreciable basis. However, the petitioners challenged the accuracy of the Los Angeles County Office of the Assessor’s assessment as being inaccurate and inconsistent. Petitioners relied on alternative methods of valuation, which included the land sales method and the insurance method.  The Tax Court ruled the county assessor’s allocation between land and improvement values was more reliable than the taxpayer’s proposed values.

We’ve got your back

In Nielsen vs. Commissioner, the Tax Court chose the assessor’s allocation over those provided by the taxpayers. However, facts and circumstances may not support the assessor’s allocation in all cases. It is important for a taxpayer to have reliable support and documentation to defend an allocation if it should be challenged.

If you have questions about how to allocate value between land and building, we’re here to help. Contact me at [email protected] or 201.655.7411.