REAL ESTATE. Summer 2018

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1 REAL ESTATE Summer 2018 IS A PROSPECTIVE COMMERCIAL TENANT CREDITWORTHY? CROSSING THAT BRIDGE LACK OF PROFIT OBJECTIVE DOOMS DEDUCTIONS FOR REAL ESTATE ACTIVITIES YOUR RECORDS COULD MAKE OR BREAK YOUR TAX DEDUCTIONS HHMCPAS.COM CHATTANOOGA, TN MEMPHIS, TN

2 Real Estate IS A PROSPECTIVE COMMERCIAL TENANT CREDITWORTHY? Smart residential property landlords run a credit check before entering a lease agreement with a new tenant to help evaluate whether he or she will pay the monthly rent. Commercial tenants even those backed by well-known, longstanding corporations typically merit even more scrutiny. After all, financially stable, creditworthy tenants are essential if you re going to make the most of your real estate investments. CREDIT MATTERS Why is a tenant s credit so vital to the financial success of your real estate? It s not just about the steady income stream from rental payments. A tenant s creditworthiness can affect your ability to borrow against your property, which in part depends on your tenants financial fitness. It s also relevant in buildout situations. A significant buildout can sometimes make it difficult to relet the property if the tenant defaults. Performing a credit check before leasing space to a tenant with specific buildout requirements provides added assurance that you won t be put in that position. FACTORS TO WEIGH Effective creditworthiness assessments take a comprehensive view. You should routinely consider a variety of factors both before you enter a lease and throughout the lease term. These factors include the tenant s: Business history Place of incorporation Financial statements (audited or reviewed statements are preferred to be compiled or internally prepared ones) Revenue sources and their sustainability Financial institution references Rent history and landlord references Legal history, including previous bankruptcy filings, liens and pending litigation Management team strength Required terms, including those related to buildouts or other improvements You also should look at the tenant s business plan to evaluate growth prospects and market share. Depending on location, a growing number of tenants are start-up or relatively young ventures that don t have a lengthy financial or credit history. In these cases, landlords need to look beyond the more traditional factors identified above to consider how these tenants earn their money and whether their investors are creditworthy. If the tenant is part of a national corporation, don t assume that they re as creditworthy as their parent company. Consider business unit level profitability. Corporations can run into trouble and suddenly close locations, long before their lease terms expire. The units that survive such corporate shutdowns are usually the profitable locations. On the other hand, commercial real estate leases for cost centers, such as offices, call centers, bank branches and distribution hubs, could be the first on a troubled company s chopping block. CREDIT ENHANCEMENTS Creditworthiness plays a prominent role when it comes to requiring credit enhancements from tenants who fall short of your criteria. The most common enhancement is a cash security deposit the less creditworthy the tenant, the greater the amount of cash deposit you ll require. The deposit requirement also should reflect costs to complete the transaction for example, those related to construction, broker commissions and administrative tasks. Some landlords go further, requiring letter of credit security deposits backed up by a third-party financial institution. The terms could allow you to draw on a letter of credit after tenant default without involving the tenant. Moreover, the financial institution may be obligated to pay you even if the tenant files for bankruptcy. However, some courts have ruled that letter of credit security deposits are part of the bankruptcy estate and, therefore, subject to the cap on landlord damages.

3 BE SAFE, NOT SORRY Every commercial tenant doesn t necessarily need a sterling credit history to lease space from you. But it s good to know what you re getting into ahead of time. Assessing credit helps you know when to add appropriate protections into a tenant s lease agreement. Sidebar When a guarantee can fill the credit gap Sometimes a prospective tenant doesn t meet your creditworthiness criteria and can t provide a substantial cash deposit or a letter of credit. But that doesn t necessarily mean you should walk away from the arrangement. A creditworthy third party may be willing to provide a guarantee to bridge the gap. The guarantor could be the tenant s corporate parent or affiliate or an individual like the majority owner of the tenant business. Ideally, you d like a full guarantee, but most guarantors will provide only a limited guarantee. For example, a guarantor might agree to a guarantee with a maximum dollar cap on its liability (based on the value of the lease and your potential loss in case of tenant default) or a cap based on a formula. That formula could reflect your out-ofpocket expenses (for example, lease brokerage fees), an unamortized tenant improvement allowance, an allowance for recovering and preparing the space, and past due and pending rent. Regardless of the guarantee type, review both the tenant s and the guarantor s financial information on a regular basis to ensure you continue to be protected.

4 Real Estate CROSSING THAT BRIDGE Investors and developers generally use bridge loans until they can secure long-term financing. As with any form of financing, there are advantages and disadvantages. WHAT S A BRIDGE LOAN? Investopedia defines a bridge loan as a short-term loan that is used until a person or company secures permanent financing or removes an existing obligation. Generally, commercial bridge loans are interim financing that s secured by commercial real estate and used to bridge gaps for borrowers between property transactions. Typical bridge loans involving commercial property are for a term of six months to one year. However, for a fee, many commercial lenders will give the bridge loan borrowers the option to extend for an additional six months to one year. A bridge loan is typically paid off when the owner places permanent financing on the property. Because of their short term nature, bridge loans usually don t have any prepayment penalties. And they re versatile: Bridge loans can be used to purchase or refinance many different types of projects, including apartment complexes, retail property, office buildings and hotels. For example, suppose you plan to renovate 50% of the units in a multifamily property by installing new kitchen appliances, granite countertops and new flooring. You might apply for a bridge loan at the start of the renovation project. Once you complete the renovations, you plan to raise rental rates given the units new, high quality finishes. Moreover, you hope that your improvements will stabilize the property s income stream by lowering the vacancy rate and tenant turnover. ARE THERE BENEFITS? Bridge loans are particularly attractive these days for investors in underperforming multifamily properties. Traditional lenders generally prefer more stabilized properties, making it difficult to obtain financing to increase occupancy, make improvements or retain smarter management. A bridge loan can give investors the opportunity to address the issues necessary to stabilize a property to the satisfaction of traditional lenders. Bridge loans are also appealing because of the borrower s ability to choose repayment options. A borrower can opt to repay the loan before or after long-term financing is found. A borrower can improve its credit rating by making the payments on time, thereby improving its odds of qualifying for long-term loans with favorable terms. If the bridge loan is to be paid off after long-term financing is secured, part of that financing can be applied to repay the loan. Additionally, bridge loans tend to require less income documentation than conventional loans and typically close quickly. So, bridge financing allows investors to jump on market opportunities before competitors who are using traditional financing. Bridge loans also can be nonrecourse, which helps protect the borrower s other assets. WHAT S THE DOWNSIDE? Not surprisingly, bridge loans usually feature higher interest rates, fees and penalties, and require a large balloon payment at the end of the term. Similar to other property loans, fees for these types of loans can include: Administration fees Appraisal fees Escrow fees Title Notary fees Wiring fees Loan origination fees Your closing costs will usually be high with a bridge loan; and, like other loans, you can t recover them if you find long-term financing sooner than expected. Generally, if you choose not to pay off the bridge loan after obtaining long-term financing, you ll incur greater interest expense, because you ll have two loans simultaneously on the same property. If your longterm financing falls through, and you have to make the balloon payment out of your own pocket but you re unable, the bank may ultimately decide to foreclose on the property. TIME TO DECIDE So, is a bridge loan what you need? In the right situation, a bridge loan may be the best way to proceed. Ask your financial advisor about whether this type of financing is right for you.

5 LACK OF PROFIT OBJECTIVE DOOMS DEDUCTIONS FOR REAL ESTATE ACTIVITIES Some people are drawn into the real estate game largely for the potential tax benefits done right, for example, you can leverage any real estate losses you sustain into some generous deductions for business expenses. There s a catch, though: You can t be engaged in your real estate activities just to generate losses. If the IRS finds that you lack a profit motive, it will limit and perhaps disallow your deductions altogether. One taxpayer recently learned that the hard way. IRS REJECTS REAL ESTATE DEDUCTIONS In Long v. Comm r, the taxpayer was issued a real estate broker s license in California in November He never generated any income from his real estate activity in the years at issue, 2010 and He did, however, claim deductions for expenses related to his real estate activity totaling $103,760 and $52,367 for 2010 and 2011, respectively. The IRS determined the taxpayer had income tax deficiencies based on the deductions and assessed accuracy-related penalties. The taxpayer appealed. TAX COURT FINDS NO PROFIT MOTIVE Tax law allows business loss deductions only if the taxpayer engaged in the underlying activity for profit. If the engagement wasn t for profit, the law limits deductions to the amount of gross income generated by the activity. In other words, if the taxpayer in this case wasn t trying to generate a profit from his real estate activities, he wasn t entitled to any of his claimed deductions because he reported no gross income from those activities. The U.S. Tax Court cited nine nonexclusive factors relevant to the determination of whether a taxpayer engaged in an activity for profit. It found that these factors weighed against the taxpayer s claim that he engaged in real estate activities for profit. Several factors worked against him: Manner in which the taxpayer carries on the activity. Did the taxpayer carry on the activity in a businesslike manner? The court didn t think so, noting, for example, that he d failed to maintain complete and accurate books and records, have a business plan or accounting system, or open a business bank account or credit card. Time and effort expended by the taxpayer. The taxpayer had a full-time job for much of 2010 and 2011, and was also enrolled full-time in a competitive MBA program most of the period. The court found it unlikely that he d spent as much, if not more, time on his real estate activities than his full-time job, as he claimed. Amount of occasional profits. The amount of profits in relation to the losses incurred can suggest the taxpayer s intent. Because the taxpayer didn t report any gross receipts or profits, instead reporting only substantial losses, this factor didn t indicate a profit objective for the real estate activities. Taxpayer s financial status. The lack of substantial income from other sources can indicate the activity is engaged in for profit. Conversely, reaping significant personal tax benefits from an activity, without other evidence it s engaged in for profit, indicates the activity isn t engaged in for profit. The taxpayer s reported income from salary or wages was $527,860 for 2010 and $117,888 for And he derived significant personal tax benefit from the real estate deductions $103,760 in 2010 and $52,367 in WALK THE WALK There s no such thing as a free tax break. If you want to take full deductions for losses on real estate activities, you ll need to be able to prove that you engaged in those activities for profit.

6 Real Estate YOUR RECORDS COULD MAKE OR BREAK YOUR TAX DEDUCTIONS A recent decision by the U.S. Tax Court in a case involving a married couple s real estate activities included both good and bad outcomes for them on some of their deductions. On both counts, though, the court s ruling came down to their record keeping. THE CHALLENGED DEDUCTIONS The couple filed the case after receiving a notice of deficiency from the IRS for almost $48,000 in underpaid taxes for the 2008 to 2011 tax years. The husband was a full-time pilot, and the wife was a part-time ski instructor. They owned three rental properties in Vermont. The wife oversaw all rental and management activities for the rental properties. She participated extensively in repairs to and renovation of the properties. Other than occasional help from her husband, no one else assisted in overseeing and managing the properties. For the years at issue, the wife spent 1,003, 1,228, 835 and 864 hours on the rentals, respectively, compared with only , 53.25, and as a ski instructor. The couple claimed losses from the properties on their tax returns for each of the years. After examination, the IRS disallowed the losses on their rental activities, as well as some depreciation expenses taken on a truck used in the rental business. RENTAL ACTIVITY LOSSES UPHELD Section 469(a) of the Internal Revenue Code generally only allows deductions for passive activity losses to the extent of passive income from other sources such as positive operating income from other rental properties. One significant exception to this rule is that up to $25,000 of losses may be deducted, although the exception itself has exceptions in that the ability to deduct the losses from passive activities is subject to a phaseout based on AGI. A passive activity is any trade or business in which you don t materially participate. Rental activity is generally treated as passive regardless of whether you materially participate in it. But rental activity won t be treated as passive if you can show that: 1. More than half of the personal services you provided during the year were worked in a rental activity in which you materially participated. 2. You worked more than 750 hours during the tax year in a rental activity in which you materially participated. In the case of a joint return, one of the spouses must satisfy both requirements on his or her own. The court found that the wife had materially participated in all of her real estate activities during the relevant years. Moreover, she had maintained contemporaneous logs of the time spent on the rental properties, showing more than 750 hours of work for each year. The IRS agreed that she d worked less than 200 hours as a ski instructor each year, so more than one-half of her work was in the rental activities. (The court also noted that the wife had summarized her logs into activity summaries to support the claimed deductions.) DEPRECIATION DEDUCTIONS DEFEATED Turning to the couple s depreciation deductions related to a truck, the court noted that taxpayers are required to maintain records sufficient to substantiate the expenses underlying their deductions. In the case of deductions on property used as a means of transportation, you must substantiate: The amount of the underlying expense The time and place of travel or use of the property The business purpose of the expense The business relationship of the people using the property The couple claimed almost $18,000 in depreciation deductions on the truck, but didn t provide a mileage log for it. In addition, the husband testified that his wife didn t like to drive it and that he would park it at the airport for up to two weeks at a time while he traveled for his work. The court therefore concluded that they d failed to substantiate the

7 expenses related to the truck. DOCUMENT, DOCUMENT, DOCUMENT It really can t be said enough if you want your deductions to hold up to scrutiny, you need to keep adequate records. For rental activities, that means logs of the amount of, and how you spent, your time working on them. For vehicle expenses, you ll also need detailed records. Ask your tax advisor for specifics in your situation. Sidebar IRS Accuracy Related Penalties If your tax deductions are disallowed, it s not just back taxes you have to worry about you could also end up on the hook for penalties, including accuracy-related penalties. The IRS can impose a penalty of 20% of the portion of underpayment of tax attributable to the taxpayer s negligence, disregard of rules or regulations, or substantial understatement of income tax. Negligence includes any failure to make a reasonable attempt to comply with tax laws, such as the failure to keep adequate books and records. You may be able to avoid accuracy-related penalties by proving you had reasonable cause for underpayment and acted in good faith. Relevant factors include: Your effort to assess the proper tax liability Your knowledge and experience Any reliance on the advice of a professional, such as an accountant Generally, the most important factor is your effort to assess the proper tax liability. CALL THE HHM REAL ESTATE ACCOUNTING TEAM FOR MORE INFORMATION KYLE C. CHRISTENSEN, CPA, CCIFP KCHRISTENSEN@HHMCPAS.COM TRIP FARMER, CPA, CCIFP TFARMER@HHMCPAS.COM TRAVIS HORTON, CPA, MBA THORTON@HHMCPAS.COM

8 WE SPECIALIZE IN AS YOU MOVE FROM ONE PHASE TO THE NEXT, YOUR ACCOUNTANT BECOMES YOUR MOST TRUSTED ADVISOR. HHM accountants are ready to help you and your business through any transition. HHMCPAS.COM CHATTANOOGA: MEMPHIS: