REAL ESTATE REVIEW March 2016

REAL ESTATE REVIEW March 2016 HOW A TRUST QUALIFIED FOR AN EXCEPTION TO PAL RULES ORDINARY INCOME VS. CAPITAL GAIN TAX COURT DISALLOWS PROPERTY OWNER S BAD DEBT DEDUCTION SMART INVESTORS LOOK BEYOND NOI HENDERSON HUTCHERSON & MCCULLOUGH, PLLC 1200 MARKET ST CHATTANOOGA, TN 37402 423.756.7771 HHMCPAS.COM

Real Estate Review HOW A TRUST QUALIFIED FOR AN EXCEPTION TO PAL RULES In a favorable decision for trusts that hold real estate assets, the U.S. Tax Court has held that such a trust qualified for the real estate professional exception and was therefore exempt from the limitations on passive activity losses (PALs). The court s holding also means the trust can avoid the new 3.8% net investment income tax (NIIT) that applies to passive activity income. REAL ESTATE PROFESSIONAL RULES Passive activity is defined as any trade or business in which the taxpayer doesn t materially participate. Material participation is defined as involvement in the operations of the activity that s regular, continuous and substantial. Rental real estate activities are generally considered passive regardless of whether you materially participate. Internal Revenue Code Section 469 grants an exception from restrictions on PALs for taxpayers who are real estate professionals. If you qualify as a real estate professional and you materially participate, your rental activities are treated as a trade or business, and you can offset any nonpassive income with your rental losses. You may also be able to avoid the NIIT as long as you re engaged in a trade or business with respect to the rental real estate activities (that is, the rental activity isn t incidental to a nonrental trade or business). To qualify as a real estate professional, you must satisfy two requirements: 1 2 More than 50% of the personal services you perform in trades or businesses are performed in real property trades or businesses in which you materially participate, and you perform more than 750 hours of services in real property trades or businesses in which you materially participate. THE IRS CHALLENGE In Frank Aragona Trust v. Commissioner of Internal Revenue, the trustee had formed a trust in 1979, with his five children as beneficiaries. He died in 1981 and was succeeded as trustee by six trustees the five kids and an independent trustee. Three of the kids worked full-time for a limited liability company (LLC), wholly owned by the trust, that managed most of the trust s rental properties and employed about 20 other individuals, as well. During 2005 and 2006, the trust reported nonpassive losses from its rental properties, which it carried back as net operating losses to 2003 and 2004. The IRS determined that the trust s real estate activities were passive activities, and the challenge landed in the Tax Court. A TRUST AS A REAL ESTATE PROFESSIONAL The IRS contended that a trust couldn t qualify for the real estate professional exception because a trust can t perform personal services, which regulations define as any work performed by an individual in connection with a trade or business. The Tax 1

Court rejected this argument. It found that, if a trust s trustees are individuals who work on a trade or business as part of their trustee duties, their work can be considered personal services that can satisfy the exception s requirements. INTERNAL REVENUE CODE SECTION 469 GRANTS AN EXCEPTION FROM RESTRIC- TIONS ON PALS FOR TAXPAY- ERS WHO ARE REAL ESTATE PROFESSIONALS. EVALUATING MATERIAL PARTICIPATION The IRS alternatively argued that, even if some trusts can qualify for the exception, the Aragona trust didn t, because it didn t materially participate in real property trades or businesses. The agency asserted that only the activities of the trustees can be considered, not those of the trust s employees. And the IRS claimed the activities of the three trustees who worked for the LLC should be deemed activities of employees and not trustees. The Tax Court didn t decide whether the nontrustee employees activities should be disregarded in determining if the trust materially participated in its real estate operations. But it held that the activities of the trustee employees should be considered. It also noted that trustees aren t relieved of their duties of loyalty to beneficiaries just because they conduct activities through a corporation wholly owned by the trust. BE PREPARED For technical reasons, the trust in this case wasn t required to prove that it satisfied the two-prong real estate professional test. Other trusts wishing to take advantage of the exception should be prepared to do so. Sidebar TRUSTEES MINORITY INTERESTS DIDN T UNDERMINE MATERIAL PARTICIPATION Two of the trustees in Frank Aragona Trust v. Commissioner of Internal Revenue (see main article) had minority interests in all of the entities through which the trust operated real estate holding and development projects. They also had interests in some of the entities through which the trust operated its rental real estate business. The IRS argued that some of their activities in managing the jointly held entities should be attributed to their personal shares of the businesses, rather than the trust s, when determining whether the trust satisfied the material participation requirements. But the Tax Court pointed out that the two trustees combined ownership interest in each entity wasn t a majority interest, nor was it greater than the trust s ownership interest. Further, their interests as owners were generally compatible with the trust s goal of helping the jointly held entities succeed. And the two trustees were involved in managing the day-to-day operations of the various businesses. The court, therefore, remained convinced that the trust materially participated in the real estate operations. 2

Real Estate Review ORDINARY INCOME VS. CAPITAL GAIN How to treat real estate sale proceeds. When the owner of real estate sells a property, he or she typically prefers that the proceeds be treated as a capital gain rather than ordinary income for tax purposes, thus meaning the real estate was investment property. But what if the owner originally purchased the property for development and subsequently treated it as investment property? In Allen v. United States, an owner discovered the undesirable tax consequences of his change in plans. OWNER SELLS LAND TO DEVELOPER A taxpayer purchased land in East Palo Alto in 1987. Between 1987 and 1995, he attempted to develop the property on his own, spending money on engineering plans and taking out a second mortgage on the property. His development company created about 10 sets of plans for the property as he attempted to find a partner to develop the land. In 1999, he sold the property to a developer for a lump sum and future contingent payments based on a percentage of profits from the future sale of developed units. His firm did some of the engineering work on the property until the developer changed the project s direction and hired another engineer. In 2004, the taxpayer received a final installment payment of $63,662 and reported the money as long-term capital gain. The IRS challenged this 3 treatment of the payment, asserting that the land was held primarily for sale to customers in the ordinary course of business. SALE PROCEEDS WERE ORDINARY INCOME The U.S. District Court for the Northern District of California sided with the IRS, finding that the taxpayer was a real estate dealer subject to ordinary income tax rates, rather than an investor subject to capital gains rates even though he d sold only a single piece of property. It reached this conclusion after weighing several factors that courts commonly consider to determine whether a property has been held as inventory or a capital asset: 1 2 3 4 5 The nature of the property s acquisition, The frequency and continuity of sales over an extended period, The nature and extent of the taxpayer s business, The seller s activity regarding the property, and The extent and substantiality of the transactions. According to the court, while some attention is paid to the reason for the property s purchase, particular weight is given to the purpose for which it was held. The court concluded that the first and fourth factors were determinative in this case. As to the first, the taxpayer testified that his intent to develop the property had changed to an intent to sell it because he lacked the requisite expertise to develop the land. The court acknowledged that a purchaser s intent toward property can change over time. But it wasn t convinced that the taxpayer s intent had changed, because he provided no evidence explaining how, when or why his goals for the property had changed. The court also found that the fourth factor favored the IRS position. The taxpayer engaged in significant development activity for the property, creating multiple development plans and seeking partners until shortly after the sale. Further, some of his debts to former partners were paid out of the sale proceeds. PROTECT YOURSELF Sometimes a downturn in the market or other circumstances will lead you to change your plans for property from development to investment. If you hope to take advantage of this change from a tax perspective, you ll need clear evidence of how, when and why your intent changed. 2014

Real Estate Review TAX COURT DISALLOWS PROPERTY OWNER S BAD DEBT DEDUCTION A long-time real estate investor who also made occasional loans has learned the hard way about what does - and doesn t - qualify as deductible business bad debt. In ruling that he couldn t deduct about $153,000 in outstanding debt, the U.S. Tax Court in Langert v. Commissioner clearly explained the requirements that must be satisfied before a taxpayer can claim a bad debt deduction. PROPERTY LOAN GOES BAD The taxpayer had been involved for about 30 years in one or more activities involving real property, including buying, selling and renting real property and providing management services. During that period, he made six loans, but he never advertised himself as a moneylender or kept a separate office or separate books and records relating to any of the loans. In 2003, he transferred about $157,000 to an individual to help finance the purchase of some property. The individual and his mother signed a document titled Unsecured Note. They weren t required to provide collateral. The taxpayer never checked his credit ratings and didn t require any financial statements or other pertinent financial information. He also failed to verify the source of funds that would allow him to comply with the terms of the note. After making 28 monthly payments, the debtor defaulted on the loan. The taxpayer/lender asked him orally, not in writing, to pay the outstanding debt. He didn t ask the debtor s mother to pay the debt, nor did he pursue any legal remedy for the default. When the debtor filed for bankruptcy, the taxpayer didn t file a claim for the debt with the court. He also didn t contact the foreclosure trustee or file a claim when the property went into foreclosure auction. The taxpayer claimed a deduction for his loss on Schedule C ( Profit or Loss From Business ) of his 2009 tax return. The IRS subsequently issued the taxpayer a notice of deficiency that disallowed the deduction. COURT NIXES DEDUCTION In Tax Court, the taxpayer claimed he was entitled to a deduction for a business bad debt because he had made the loan for the sole purpose of obtaining interest income. As the court noted, for all or a portion of a debt to be deductible as a bad debt, the debt must, among other things, constitute 1) a debt created or acquired in connection with a trade or business or 2) a debt from which the loss is incurred in the taxpayer s trade or business. The mere fact that a taxpayer makes a loan solely to obtain interest income, the court said, doesn t on its own lead to a finding that the loan is deductible. Moreover, for a taxpayer to be entitled to a bad debt deduction in connection with the trade or business of lending money, the debt must have been sustained in the course of loan-making activity that was so extensive and continuous as to elevate that activity to the status of a separate business. The court found that making six loans over 30 years, during which the taxpayer conducted real property activities, didn t elevate the loan activity to the status of a separate business. In support, it cited a previous case where the court found that making eight or nine loans over four years didn t elevate the activity to separate business status. THE TAX IMPLICATIONS As the court pointed out in its ruling, under typical circumstances the taxpayer would be able to treat the bad debt as a capital loss. In such situations, the deduction is subject to the strict annual limit of $3,000 in net capital losses. 4

SMART INVESTORS LOOK BEYOND NOI Seasoned real estate moguls understand the need to get the best deal. Many investors start with a simple calculation of a property s net operating income (NOI). NOI is simply the rental income of a property after operating expenses. Such expenses would include all operating expenses, including maintenance, janitorial, supplies, insurance, accounting and management, and so forth. The problem: This valuation tool isn t always what it s cracked up to be. Smart investment decisions may require extra due diligence, however. SEEING LAST YEAR THROUGH ROSE-COLORED GLASSES Unfortunately for unwitting buyers, the NOI that sellers provide isn t always reliable. They may skew those numbers by operating properties in a soon-to-be-sold mode in the year before the sale. For example, sellers may artificially inflate property income by billing in advance, basing billing on inflated estimates and collecting lump sum payments. Deferring repairs and classifying operating expenses as capital items are other ways for sellers to inflate NOI, and with it, property value. Smart investors can help counter these shortcomings by not relying on numbers that can t be independently verified. A zero-based budget with numbers that are developed by the investor can be a helpful tool. The goal is always to be aware of the maximum price the investor can pay and still receive a good rate of return in light of the associated risks. UNDERSTANDING NPV Additionally, it s sometimes wise to analyze values that are generated by more sophisticated analytical tools, such as net present value (NPV). NOI-based appraisal methods capitalize a single year of earnings. Alternatively, investments can be evaluated using NPV, which is a tool that considers the property s projected cash inflows (such as rental income, debt proceeds and eventually selling proceeds) and cash outflows (such as operating expenses, capital expendi- 5

tures, principal and interest payments, debt service and selling expenses). Net cash flow is often a more comprehensive, useful metric than NOI. The NPV method is sometimes used for rehab projects or for properties that are under construction, because it allows annual cash flows to fluctuate until the investment generates a more predictable income stream and qualifies for permanent financing. At the end of the projection period (which is usually three to seven years), appraisers calculate a terminal (or residual) value typically by capitalizing the expected cash flows in the final projection period. The terminal value essentially equals what the property could sell for at the end of the discount period, so it may also be calculated using replacement cost, comparable properties or NOI-based appraisal techniques. It takes annual projected cash flows for a proposed investment property and then determines each year s present value by applying a discount rate. NPV equals the sum of these present values, including the present value of the terminal value. The appropriate discount rate for real estate investors generally takes into account the opportunity cost, or the rate of return that the investor can earn on an investment that s comparable in size, risk and duration. A positive NPV indicates that the investment has good potential or a safety factor against future shortfalls. A negative NPV indicates that the property may fall short of the target yield and the investor needs to either withdraw the offer or lower it, find a way to increase the cash flow, or accept a lower rate of return. ANOTHER ANALYTICAL TOOL The internal rate of return (IRR) is one of the most popular methods for evaluating and comparing investment returns. It can be quite useful for comparing real estate opportunities with alternative investment options. Closely related to NPV, the IRR is the discount rate at which the NPV for an investment is equal to zero. DO YOUR HOMEWORK If you want to get the best price, it s critical that you do your homework. Working with your real estate and financial advisor is the first step. He or she can help you get the best deal to avoid overpaying. CALL THE HHM REAL ESTATE ACCOUNTING TEAM FOR MORE INFORMATION KYLE C. CHRISTENSEN CPA, CCIFP 423. 702. 7270 KCHRISTENSEN@HHMCPAS.COM TRIP FARMER, CPA, CCIFP 423. 702. 8148 TFARMER@HHMCPAS.COM TRAVIS HORTON, CPA, MBA 423. 702. 7268 THORTON@HHMCPAS.COM 1200 MARKET STREET CHATTANOOGA, TN 37402 423.756.7771 WWW.HHMCPAS.COM 6

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