Category: Get Real: Real Estate Life Cycle Insights

How Tax Reform Impacts Real Estate

Posted by Simon Filip on

How Tax Reform Impacts Real Estate

The Senate and House have passed similar tax reform plans, but the bill is not yet finalized. Legislators are still working to create a unified bill, and the real estate industry can expect significant changes under the “Tax Cuts and Jobs Act.” Key changes include:

Temporary 100% Bonus Depreciation

House Bill:

Modifies existing bonus depreciation rules under the “PATH Act” by increasing the rate to 100% through the end of 2022. It also makes bonus depreciation applicable to both new and used property, where it currently applies only to new property. The 100% bonus depreciation will not apply to real property trade or business (i.e., commercial and residential real estate).

Senate Bill:

Similar to the House bill, except the 100% bonus depreciation will apply only to new property and to real property trade or business.

Section 179 Expensing

House Bill:

The Section 179 expense limitations for 2018 will increase from $500,000 to $5 million while the phase-out limitations for assets placed in service will be increased from $2 million to $20 million.

Senate Bill:

The Section 179 expense limitations for 2018 will increase from $500,000 to $1 million while the phase-out limitations will increase from $2 million to $2.5 million. Qualified real property eligible for 179 expensing will be expanded to include improvements to certain buildings systems including roofs, HVAC, fire and alarm systems, and security systems.

Real Estate Recovery Periods

House Bill:

No changes to current depreciation recovery periods of 27.5 years for residential and 39 years for non-residential real property.

Senate Bill:

Nonresidential real and residential rental property depreciable lives would be shortened to 25 years.

Like-Kind (1031 Exchanges)

House bill:

1031 exchanges will continue for real property, but not for tangible personal property. CAUTION: The proposed rules will trigger 1245 recapture for tangible personal property.

Senate Bill:

Same as House bill.

An updated version of the Tax Cuts and Jobs Act must be approved by both the Senate and House before going to the president to be signed into law.

We’ve Got Your Back

At KRS, we’ve been tracking tax reform legislation closely and are ready to assist you in your tax planning and preparation when it is finally signed into law. Don’t lose sleep wondering what impact the tax changes will have on your real estate holdings. Contact me at 201.655.7411 or SFilip@krscpas.com.

Update: Tax reform has now been passed into law. Stay up-to-date on how it impacts real estate investors by checking out the New Tax Law Explained! For Real Estate Investors.

Investing in Foreign Real Estate? Here’s What You Need to Know

Posted by Simon Filip on

Investing in Foreign Real Estate? Here’s What You Need to Know

Much is written about tax compliance and withholding imposed upon a foreign entity or person owning real estate in the United States. The fact that many U.S. taxpayers own real estate outside of the country is often disregarded.

The intent of this post is to touch upon some of the differences of which an investor or potential investor in foreign real estate should be aware.

Depreciation and foreign property holdings

One of the main differences in holding a U.S. rental property compared to a foreign rental property is depreciation. The Internal Revenue Code requires any tangible property used predominantly outside the U.S. during the year to use the Alternative Depreciation System (“ADS”). Residential rental property located in a foreign country must use ADS, resulting in depreciation over a 40 year recovery period compared to the 27.5 year recovery of U.S. residential property.

1031 exchanges aren’t allowed

I have discussed the tax deferral afforded by entering into a 1031 like-kind exchange in previous posts. However, the Internal Revenue Code does not allow taxpayers to exchange U.S. investment property for foreign investment property.  U.S. property is limited to the 50 states and the District of Columbia only. Property located in U.S. territories, such as Puerto Rico, is not like-kind to property located within the United States. There are limited exceptions, under certain circumstances for property located within the U.S Virgin Islands, Guam and the Northern Mariana Islands.

Taxpayers can obtain deferral afforded by a 1031 exchange when trading U.S. property for U.S. property, but not U.S. property for foreign property. However, foreign property is deemed liked-kind when exchanged for other foreign property, thus qualifying for 1031 exchange treatment.

Preventing double taxation

If a taxpayer operates a property abroad as a rental property, taxes will be owed in the country where the property is located. To prevent double taxation, a U.S. taxpayer can claim a credit on the U.S. tax return for taxes paid to the foreign country relating to the net rental income. It is important to note that a taxpayer cannot claim a credit for more than the amount of U.S. tax on the rental income.

The foreign tax credit is also available if the property is sold and there is any capital gains tax in the foreign county.

Additional reporting obligations

A U.S. taxpayer may have additional filing obligations with their tax return as a result of the foreign rental activity.

For example, if a U.S. taxpayer establishes a foreign bank account to collect rent and the aggregate value of the account is $10,000 or more on any given day, an FBAR (Report of Foreign Bank and Financial Accounts) is required to be filed.

If the property is held in a foreign corporation, Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations) is required to be filed. If the property is held in a Foreign LLC, then Form 8858 (Information Return of U.S Persons with Respect to Foreign Disregarded Entities) may be required.

We’ve got your back

Don’t go it alone if you’re an investor in foreign real estate. Contact me at sfilip@krscpas.com or 201.655.7411 for assistance with tax planning for your international holdings.

Special Tax Allowance for Rental Real Estate Activities

Posted by Simon Filip on

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 sfilip@krscpas.com or 201.655.7411.

Wrap-around Mortgages Explained

Posted by Simon Filip on

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 sfilip@krscpas.com.

 

What You Ought to Know about Affordable Housing

Posted by Simon Filip on

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 sfilip@krscpas.com or 201.655.7411.

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

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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 sfilip@krscpas.com.

Real Estate Rentals, the Sharing Economy and Taxes

Posted by Simon Filip on

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

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

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

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

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

Where is income from short-term rentals reported?

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

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

Do hotel taxes apply to short-term rentals?

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

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

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

We’ve got your back

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

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

Income Tax Incentives for Land Conservation

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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  sfilip@krscpas.com or (201) 655-7411.

What Is the New GAAP Lease Accounting Standard?

Posted by Simon Filip on

In February 2016, the Financial Accounting Standards Board (FASB) issued an Accounting Standard Update (“ASU”), ASU 2016-02, Leases (Topic 842).

New GAAP Accounting Rules for Leases
For public companies, ASU 2016-02 is effective for fiscal years beginning after December 15, 2018. For all other entities, this update is effective for fiscal years beginning after December 15, 2019. Early adoption is permitted for all entities, using a modified retrospective approach.

ASU 2016-02 impacts all entities that lease property, plant, or equipment. ASU 2016-02 defines a lease as a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment for a period of time, in exchange for consideration.

What will change?

Currently, operating lease obligations (for example, a lease of office space for 10 years) are disclosed in a company’s financial statement footnotes, but not recorded on the balance sheet. Under the new guidance, a lessee will be required to report on its balance sheet assets and liabilities related to lease obligations with lease terms of more than 12 months. This differs from current GAAP, which requires only capital leases to be recognized on the balance sheet.

How will the change impact financial reporting?

Companies will have to report their leases (finance leases and operating leases) as both assets and liabilities on their balance sheets. This must be done regardless of the lessee’s (tenant’s) intent to vacate the space at the end of its lease term. Rent obligations that were previously disclosed in the footnotes of financial statements will be reflected on the balance sheet as debt. Debt impacts a company’s credit, compliance with debt covenants and other capital requirements.

What about the lessor (landlord)?

For lessors, the impact of ASU 2016-02 is largely unchanged from current GAAP. For example, the vast majority of operating leases should remain classified as operating leases. In general, lessors should continue to recognize lease income for those leases on a straight-line basis over the lease term.

We’ve got your back

Not sure how the new FASB lease reporting standards impact accounting for your real estate leases? The real estate accounting experts at KRS CPAs are here to help. Reach out to me for a complimentary initial consultation at sfilip@krscpas.com or (201) 655-7411. 

How Does the Net Investment Income Tax Apply to Rental Real Estate?

Posted by Simon Filip on

Taxpayers should be mindful that their rental income may be subject to taxes in addition to ordinary income tax.

What is the Net Investment Income Tax?

Net Investment Income Tax and Rental Real EstateThe Net Investment Income Tax (NIIT) is a surtax that took effect in 2013. The NIIT was intended to boost tax revenue from Medicare payroll taxes on earned income by broadening its reach to unearned investment income.

Net Investment Income Tax basics

The NIIT only applies to certain high-income taxpayers. Specifically, taxpayers with adjusted gross income of more than $200,000 (single filers) or $250,000 (joint filers) are subject to the surtax on investment income that exceeds the thresholds. Note that these amounts are not indexed for inflation.

NIIT imposes a 3.8% surtax on income from investments. Investments includes portfolio income items such as interest, dividends and short-term and long-term capital gains. Royalties, rental income and business income from activities that are treated as passive are also subject to the surtax.  Read my post on passive activities in rental real estate to learn more.

What about self-rentals?

It is common for recipients of rental income, which include taxpayers who own rental properties directly or through pass-through entities (partnerships, LLCs or S Corporations), to also be involved with the business operations conducted on the property. The common scenario is a business owner that also owns the real estate in which he operates. The real estate is held in a separate entity that collects rents from the operating entity. Check out my previous post on IRS rules for self-rentals to learn more.

The NIIT is intended to apply to passive investment income, rather than income generated from an active trade or business. Therefore, it should not penalize a taxpayer who separates its real estate from business operations. This was clarified in an Internal Revenue Bulletin that made it clear that, if an individual derives rental income from a business activity in which the individual is materially participating, the 3.8% tax will not apply.

Does the surtax apply to real estate professionals?

While losses from real estate activities are passive per se, the losses of a real estate professional are considered ordinary losses and available to offset other ordinary income. Net rental income is generally included in the calculation of NIIT and is therefore subject to the 3.8% surtax. There is an exception if the following three conditions are met:

  • the taxpayer is a real estate professional
  • the rental activity rises to the level of trade or business; and
  • the taxpayer materially participates in the trade or business.

If all three of the conditions are met, the income from the rental real estate activity can be excluded from the calculation of net investment income.

What about sales of real estate?

Gains from the disposition of property (other than property held in an active trade or business) is subject to NIIT, including gain on the sale of stocks, bonds, mutual funds and real estate. The gain from the sale of rental property is also subject to NIIT unless the rental activity is part of an active trade or business.

If the real estate activity is considered a passive activity, any gain on the sale of property would generate gain that would be subject to the net investment income tax. However, if the taxpayer qualifies as a real estate professional, and the activity is considered an active trade or business, any gain on the sale of the property may be exempt from the net investment income tax. The characterization of the property for purposes of taxation of the gain on disposition is determined based on the treatment of the property during its operation.

With the 3.8% Medicare surtax on net investment income, real estate professionals should have a renewed focus on tax implications relating to their level of participation in real estate businesses.

We’ve got your back

If you’d like some additional insights into net investment income tax as it relates to real estate investments, contact me at sfilip@krscpas.com or (201) 655-7411.