REAL ESTATE REVIEW December 2015

Transcription

1 REAL ESTATE REVIEW December 2015 HIGHER RETURNS FOR INVESTORS USING SOME STANDBY TAX STRATEGIES - PART I PROPERTY TAX ASSESSMENTS TAX COURT CONSIDERS HOUSE FLIPPER S EXPENSE DEDUCTIONS IRS TACKLES INTERACTION OF GAIN EXCLUSION AND PAL TREATMENT HENDERSON HUTCHERSON & MCCULLOUGH, PLLC 1200 MARKET ST CHATTANOOGA, TN HHMCPAS.COM

2 Real Estate Review TAX STRATEGIES: HOW TO YIELD HIGHER REAL ESTATE INVESTMENT RETURNS By Kyle C. Christensen, CPA, CCIFP HHM REAL ESTATE Real Estate is providing even higher returns to investors based on a fundamental shift involving some old tax strategies. Investors have an opportunity to increase their return on real estate investments by leveraging traditional tax strategies. An investor primarily has two types of property in which to invest: 1. Already developed real property 2. Unimproved real property For developed real property, the investor is mainly seeking annual returns through distributions from rental income. There are four appealing tax strategies that could be explored for already developed real property: 1. Cost Segregation to Maximize Depreciation Deductions 2. Implementation of IRS new Tangible Property Regulations Finalized for 2014 Tax Years 3. Sales Allocation Planning 4. Like Kind Exchange via IRC 1031 COST SEGREGATION When an investor acquires an interest in a developed property (or when they construct a property to hold as rental activity), they should consider undertaking a cost segrega- 1 tion study (CSS). CSS came into vogue after the 1997 court decision to uphold the HCA Hospital cost segregation study as a proper method for establishing different depreciation class lives. The key benefit was to take advantage of deductions against ordinary income. Soon after, a small cottage industry blossomed offering these types of services to real estate investors. When the recession hit and Congress enacted the bonus depreciation rules and increased the Section 179 deduction substantially, many taxpayers deemed that they had enough depreciation deductions without engaging a CSS to produce additional benefits. However, as it has been demonstrated by Congress s systemic delay in renewing these provisions (as well as the reduction in benefits) this may be coming to end. Taxpayers should once again be considering CSS as a method to reduce their annual tax burden. TANGIBLE PERSONALTY PROPERTY REGULATIONS Although many tax strategists have failed to link the newly issued Tangible Property Regulations (TPR) to the fundamental taxpayer friendly HCA Hospital case rendered in 1997, the two are related. When the CSS cottage industry exploded in the mid 2000 s; the IRS was forced to begin staffing their offices to address the abundance of CSS based filings. In addition to the HCA decision, there are numerous tax court cases that also provide supplemental insight into how assets should be classified and how they should be depreciated. Many of these cases were utilized by the cottage industry, which strived to apply their principles to the situation at hand. This resulted in the Service having to address a lot of fact patterns without much clear guidance. Hence the TPR regulations were born. While these new regulations provided some much needed guidance for real estate investors, they are also somewhat generous as they provide taxpayers with more reasonable positions for treatment of certain expenditures as expenses that in prior years had to be capitalized under IRC 263. Although these are taxpayer-friendly, it really isn t a gift but more of a rectifying of

3 some long outdated and irrational tax positions that were still in force. One example would be that replacement of a single HVAC unit (in a property with multiple units) in prior years would have resulted in capitalization and depreciation over either 27 years or 39 years in most cases. However, under the new rules, in some instances this replacement can now be expensed. The prior rules did not have any economic reality as far as matching deductions to the actual useful life of the asset for tax purposes. Therefore, many practitioners, as well as the Service, were left struggling with understanding the correct depreciation methods. In order to begin applying these new regulations, investors will have to consider the need to file at least one, if not more, election(s) for a Change in Accounting Method to adopt some of these provisions. In addition, there is an often-overlooked benefit when considering filing for the Change in Accounting Method to adopt these provisions related to the depreciation recapture rules on disposition of property. However, two key strategies for the informed investor could reduce this impact substantially. STRATEGY 1: The first, which has been around for many years, provides for a maximum recapture rate of 25% (for property depreciated on straight line method), which is significantly below the maximum ordinary rate of 39.6%. 2

4 Real Estate Review STRATEGY 2: The second is new and relates to the TPR regs. This new strategy basically reexamines property that was capitalized and depreciated in prior years that now may be able to be characterized as an expense. By characterizing it to an expense, the potential depreciation recapture issue goes poof. By the way, poof is another technical definition often used in the real estate industry that simply means, it goes away. This would essentially provide that more gain is characterized as capital gain than at ordinary rates upon disposition. SALES ALLOCATION PLANNING Sales allocation planning on disposition of property does involve some strategic analysis, as the buyer and seller will truly derive different benefits based on how allocations are agreed upon. Although this allocation does not have to be disclosed to the IRS in some instances, a firm consensus between parties should be obtained and included as part of the closing. Most recently, in the 2012 Peco Foods case, the buyer attempted to reallocate costs that were previously agreed on. The tax court disallowed this as the allocations were done as part of the transaction process. One might draw the contrary analysis that if the Service takes the position that allocations done during a transaction cannot be subsequently reclassified, then this alternatively may lend support to the fact that educated taxpayers, as part of a 3 THIS NEW STRATEGY REEXAMINES PROPERTY THAT WAS CAPITALIZED AND DEPRECIATED IN PRIOR YEARS THAT NOW MAY BE ABLE TO BE CHARACTERIZED AS AN EXPENSE. negotiated disposition, could avail themselves to a favorable allocation during the closing process. In certain instances (typically involved in the sale of going concern business), both parties are required to submit a Form 8594 with their final and initial returns that coincides with the respective allocations. IRC SECTION 1031 LIKE-KIND EXCHANGES This relates to both developed property and undeveloped property as it goes back to a very favorable tax technique utilized primarily in the real estate industry. Prior to the reduction in capital gains rates to 15% in 2003, investors almost certainly considered utilizing a like-kind exchange arrangement whenever they were looking to replace existing investment property. By virtue of locating and acquiring like property, an investor is able to defer the recognition of taxable income until such time as they ultimately disposed of the replacement property. Although there are several strict rules regarding identification, timing, receipt of funds, etc., this is a very taxpayer friendly technique. However, before one makes any decisions, they would certainly need to involve an Exchange Accommodation Titleholder (EAT). This EAT functions similarly to an escrow agent to facilitate the transaction and ensure that the exchange is properly handled and that all requirements are met. [PLEASE NOTE: Being unaware of the various nuances when attempting to implement a qualified deferred exchange could result in the entire transaction being subjected to current taxation. You should be sure to consult your tax advisor before proceeding.] The fundamental principal now is that the long-term capital gains rate has increased to a maximum of 23.8%. For a savvy real estate investor that plans to continue on reinvesting in real estate, but for economic reasons needs to reposition their portfolio mix, this is a key strategy to avoid taxation on property exchanges. However, this may become a short lived opportunity for many as like-kind exchanges have been part of several discussions on Capitol Hill in recent years as an opportunity to raise taxes on a select group (the real estate industry). Recently, there have been two studies, which seek to counter the perception that the like-kind exchange tax provisions only affect the real estate industry. In fact, the Ling & Petrova study highlights key economic benefits that are derived from the inherent transactions associated with

5 like-kind exchanges. Due to the recent focus on finding tax offsets to allow for a lower corporate income tax rate, this will continue to be a target for some lawmakers. Obviously, real estate is an opportunity to implement some very favorable tax provisions provided the investor receives timely and accurate tax advice. It is paramount to consult a qualified real estate tax advisor prior to attempting to implement any of aforementioned tax strategies. HHM CPA s strive to keep clients informed about the latest tax trends and strategies across multiple servicesand industries. For more information about Real Estate tax strategies or any tax or audit related questions, please contact us at

6 Real Estate Review PROPERTY TAX ASSESSMENTS P roperty taxes often represent a significant chunk of an owner s annual expenses. Yet many taxpayers simply accept the billed amounts calculated by their assessors. That might not be wise, as a recent case in California illustrates. In SHC Half Moon Bay, Inc. v. County of San Mateo, the California Court of Appeals, applying property tax laws similar to those in some other jurisdictions, found that a county s assessment improperly inflated a hotel s value in turn improperly inflating the hotel s property taxes. HOTEL OWNER CHALLENGES PROPERTY TAX In 2004, SHC Half Moon Bay purchased the Ritz-Carlton Half Moon Bay Hotel for about $124 million. The purchase price included real and personal property (furniture, fixtures and equipment), as well as intangible assets and rights. As part of an income valuation approach, the San Mateo County assessor assessed the hotel at its purchase price and deducted the value of personal property. It ultimately reached a total value of about $117 million. SHC challenged the property tax assessment, asserting that it erroneously included the value of over $16 million in nontaxable intangible assets specifically, the hotel s assembled workforce, leasehold interest in the employee parking lot, agreement with the golf course operator and goodwill. It argued that simply deducting the hotel s management and franchise fee of $1.6 million wasn t enough to exclude intangible assets from the assessment, as required by state law. Instead, SHC contended, the assessor was required to identify, value and exclude the value of the intangible assets from the calculation. The county Assessment Appeals Board upheld the assessment. SHC then sued for a property tax refund, but the trial court also sided with the county. SHC appealed. COURT SIDES WITH OWNER The Court of Appeals began its review by noting that California law mandates that the quantifiable fair market value of intangible assets that directly enhance a property s income stream such as goodwill, customer 5

7 base and favorable franchise terms or operation contracts be deducted from an income stream analysis prior to taxation. (Many county laws similarly provide that property tax valuations should be based on the value of the real estate only.) The court concluded that the assessor s deduction of the management and franchise fee from the hotel s projected revenue stream didn t identify and exclude intangible assets. It pointed out that the assessor s expert had conceded to the appeals board that the assessor s methodology didn t remove all intangible assets and rights. His report stated that only the majority of the property s business value was removed by deduction of the fee. The report also acknowledged that the capitalized value of necessary preopening expenses (for example, the cost of assembling and training a workforce, preopening marketing expenses and working capital) is frequently deducted as an intangible value of a hotel. According to the court, the expert s report and testimony demonstrated that the assessor s methodology failed to attribute a portion of the hotel s income stream to the enterprise activity that was directly attributable to the value of the intangible assets and deduct that value prior to assessment. Therefore, the methodology was legally incorrect. The court did, however, uphold the Assessment Appeals Board s finding that the fee largely captured the goodwill. Although there may be situations where a taxpayer can establish that the deduction of a management and franchise fee doesn t capture goodwill, it said, SHC failed to do so here. APPEAL LEADS TO SAVINGS As a result of the appellate court s ruling, the board was required to recalculate the value of the property, applying the income method consistently with the court s findings. In other words, it will have to exclude the value of the hotel s assembled workforce, leasehold interest in the employee parking lot and agreement with the golf course operator which should produce substantial tax savings. Sidebar Unlike the property taxes at issue in SHC Half Moon Bay (see main article), which were the result of an individually tailored assessment, property taxes are often based on estimates derived from mass appraisal techniques. These techniques might prove accurate overall, but the individual estimates don t necessarily reflect specific properties characteristics. So don t just blindly pay your tax bill. Take a close look at the factors that were applied to your property and determine whether they actually do apply. For example, you might find errors in the property description, such as square footage, age, condition and construction materials. To contest an assessment, you can present testimony from a professional appraisal, financial data for the property (such as income and cash flow statements), current leases and assessments for similar properties. If you decide to appeal your assessment, pay attention to the relevant jurisdiction s deadlines. While some jurisdictions have a rolling appeals process, many observe strict deadlines. 6

8 Real Estate Review TAX COURT CONSIDERS HOUSE FLIPPER S EXPENSE With many real estate markets on the rebound, real estate investors are resuming house-flipping strategies to reap profits by, among other benefits, deducting large amounts of related expenses. But those expenses are deductible only if incurred in connection with a trade or business. And, as the taxpayer in the recent case of Ohana v. Commissioner learned the hard way, a trade or business requires more than just vague intentions to sell at some point. FLIPPER CLAIMS EXPENSES In 2005 and 2006, the taxpayer bought houses in Saratoga and Palo Alto, California. He initially lived in the Saratoga house and rented the Palo Alto house. During that time, he worked full-time in an executive position requiring long hours and extensive travel. Nonetheless, the taxpayer claimed to run a real estate business in which he planned to make money by flipping houses: that is, buying a 7 house with the intent to fix it up and sell it at a profit. To avoid the risk of a down market, his strategy was to move into the house and live in it until the market was more favorable. The taxpayer bought the Palo Alto house with the intent of tearing it down and building a new one. On the record deed, he checked a box indicating he intended to eventually make the house his primary residence; he also obtained a residential mortgage for the construction. In late 2009, he moved into the new Palo Alto house and rented out the now-renovated Saratoga house. The taxpayer claimed more than $280,000 in nonrental expenses in the years 2007 to The IRS filed notices of deficiency disallowing all of the claimed nonrental expenses, and he appealed. TAX COURT WEIGHS IN The U.S. Tax Court weighed whether the taxpayer s activities amounted to being in a trade or business. To be WITH MANY REAL ESTATE MARKETS ON THE REBOUND, REAL ESTATE INVESTORS ARE RESUMING HOUSE-FLIPPING STRATEGIES TO REAP PROFITS BY, AMONG OTHER BENEFITS, DEDUCTING LARGE AMOUNTS OF RELATED EXPENSES

9 Sidebar TAXPAYER S USE OF TAX PREPARER DIDN T PREEMPT PENALTIES In Ohana v. Commissioner, the U.S. Tax Court upheld the underpayment penalties assessed against the taxpayer. (See main article.) A substantial underpayment exists if the understatement exceeds the greater of 10% of the amount of tax required to be shown on the tax return or $5,000. An additional issue in the case was whether the taxpayer had a reasonable-causeand-good-faith defense. Among other things, the court considered whether he d actually relied in good faith on his tax preparer s judgment and concluded that he hadn t. The Tax Court noted the general rule that a taxpayer can t avoid his or her duty to file accurate returns by placing responsibility on an agent such as a tax preparer. Moreover, taxpayers have a duty to read their returns to ensure that all income items are included. Given this particular taxpayer s unusually focused attention to detail in other areas of his life, the court didn t find him credible when he said he d never once looked at his tax returns or checked his accounting records against his returns. engaged in a trade or business, a taxpayer must be involved in the activity in question with continuity and regularity for the purpose of garnering income or making a profit. Although the taxpayer in this case was heavily involved in his real estate projects, he wasn t continuously or regularly involved in the business of buying and selling real estate. As the court noted, he didn t sell or buy a single property during the relevant period. The Tax Court also found that the taxpayer s primary purpose in engaging in the real estate activity which revolved around properties that either were or became his homes wasn t for profit. It first considered the Saratoga house, observing that though the taxpayer had begun to rent it out in 2009 he d never tried to sell it. The court added that the taxpayer had failed to record any of his expenses for the home, so the deductions would have been denied for lack of substantiation. As to the Palo Alto house, the taxpayer argued that the expenses incurred in building the new home weren t personal because he intended to make a profit on its eventual sale. But, the court noted, referencing a prior case, if hoping to eventually sell a house at a profit was sufficient to establish a profit-making intent, rare indeed would be the homeowner who purchased a home several years ago who couldn t make the same claim. Regardless, the facts showed that the taxpayer had always intended to make the new Palo Alto home his personal residence. When he bought the property, he told third parties it was to be his primary residence. He enrolled his children in the Palo Alto school system for the 2008 and 2009 years. And, his loans were the type one would obtain for a primary residence. The court also pointed to minor touches that made the home less marketable for sale and more useful for the taxpayer. These included a custom-built door with a peephole low enough for the 5-foot, 4-inch taxpayer to see out of it. LOOK BEFORE YOU FLIP House flipping may seem like an easy path to great profits, but that s not always the case. Work with your tax advisor to ensure you can defend any deductions you take against IRS scrutiny. 8

10 Real Estate Review IRS TACKLES INTERACTION OF GAIN EXCLUSION AND PAL TREATMENT I t s not unusual for someone to convert a personal home into a rental property. But such conversions can raise some thorny tax questions when the home is subsequently sold. PROPER TAX TREATMENT Under Internal Revenue Code Section 469, passive losses are generally deductible only to the extent of passive income. Rental real estate activities typically are deemed passive activities. A passive activity loss (PAL) is the excess of your passive activity deductions over your passive activity gross income. Such disallowed losses are treated as a deduction allocable to passive activity in the next tax year what s commonly known as a suspended PAL. But Sec. 469 also provides that suspended PALs are fully deductible against nonpassive income if there s a qualifying disposition. Such a disposition occurs when the taxpayer sells his or her entire interest in a passive activity to an unrelated party, and all gain or loss realized is recognized. In these circumstances, the excess of any loss from the activity over any net income from all other passive activities is treated as a loss that s not from a passive activity. In a recent Chief Counsel Advice memo, the IRS weighed in on the proper tax treatment of suspended PALs from passive rental activity involving a taxpayer s former principal residence when the property is sold for a gain. In addition to addressing Sec. 469, the IRS considered Sec. 121 of the Internal Revenue Code. Under Sec. 121, a taxpayer can exclude from taxable income any gain from a sale or exchange of property that has been owned and used as the taxpayer s principal residence for two or more years over the five-year period preceding the sale. The allowable exclusion is up to $250,000 in gain per taxpayer; married taxpayers filing jointly may exclude up to $500,000. 9

11 SCENARIO IN QUESTION The Chief Counsel Advice described a scenario in which a taxpayer bought a principal residence for $700,000 and owned and used it as his principal residence for two years before converting it into a rental property. The related rental activity was the taxpayer s only passive activity for purposes of Sec During each year the property was rented, it produced $10,000 in suspended PALs. Within three years of renting the property, the taxpayer sold the property to an unrelated third party for $800,000, realizing a net gain of $100,000. The gain was excluded under Sec. 121, but what about the suspended PALs? Did the use of the exclusion block the release of PALs upon the qualifying disposition? Not according to the IRS. The agency held that, to the extent the suspended PALs exceeded any net income or gain from all other passive activities for the tax year of the sale, the losses should be treated as not from a passive activity. Because the $100,000 gain was excluded under Sec. 121, it wasn t part of passive activity income for purposes of Sec. 469, so the taxpayer had zero passive income or gain. Thus, the $30,000 was treated as a nonpassive loss that could be fully deducted. SOME CLARITY FROM THE IRS The Memo makes it clear that the gain excluded under Sec. 121 isn t treated as passive gain. It also confirms that the suspended PALs are freed up in the year of disposition. Although this eliminates some of the uncertainty surrounding the interplay between Sec. 121 and Sec. 469, each situation is a little different. If you re considering a sale of a former primary residence that has been converted to a rental property, be sure to consult your tax advisor to be sure you know exactly how the rules apply to you. 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 1200 MARKET STREET CHATTANOOGA, TN