Tag: tax benefits

Beware of Phantom Income

Posted by Simon Filip on

Real Expenses vs. Phantom Expenses

As a real estate investor, it is essential to know the difference between a real expense and a phantom expense. An investor might think a $1,000 roof repair is a good thing since he or she can deduct it as an expense. What if you never had to make that repair in the first place? You would have $1,000 of taxable income in your pocket. Being taxed isn’t automatically a bad thing, since that means you are making money on the property.

real estate and phantom incomeWhat is a Phantom Expense?

Depreciation is the perfect example of a phantom expense since it allows an owner of real estate to recover the value of the building against rental income. The IRS allows a deduction for the decrease in value of your property over time, irrespective of the fact that most properties never really wear out. Simply put, depreciation allows you to write off the buildings and improvements over a prescribed period of time, providing a “phantom expense” that is used to offset rental income.

Residential real estate and improvements are depreciated over a 27.5 year period. Commercial real estate and improvements are depreciated over 39 years.

Debt Amortization

In addition to a depreciation deduction, the Internal Revenue Code allows for the interest portion of a mortgage payment to be deducted for income tax purposes. The principal portion of a mortgage payment is treated as taxable income or “phantom income“.

During the initial years of a typical mortgage loan, the principal reduction (debt amortization) is normally offset by depreciation deductions and interest expense, decreasing taxable income. In the later years of a typical loan amortization, principal reduction will exceed interest expense and depreciation, thereby increasing taxable income and generating a seemingly disproportionate tax liability (the dreaded phantom income).

Disposition of a Property

A taxpayer may incur phantom income upon disposition of a property. Phantom income is triggered when taxable income exceeds sales proceeds upon the disposition of real estate. Usually, this results from prior deductions based on indebtedness. You may have deducted losses and/or received cash distributions in prior years that were greater than your actual investment made in the property. If you are planning to dispose of a property and believe you are in this situation, there are strategies to minimize the tax impact including IRC 1031 exchanges, which are discussed in my blog Understanding IRC Code Section 1031 and why you should care.

Real estate investors who want to maximize their after tax cash flow need to be cognizant of phantom income and compare their cash flow to taxable income. This analysis should be undertaken regularly as it may impact their investment returns. If you have questions about phantom income and your real estate, contact me at sfilip@krscpas.com or 201.655.7411.

Family Limited Partnership May Result in Significant Estate Tax Reduction

Posted by Gerald A. Shanker on

 

When Natale Giustina died in 2005, he owned a 41% limited partner interest in a partnership named Giustina Land & Timber Co. Limited Partnership. The partnership owned 47,939 acres of timberland and had 12 to 15 employees.  It earned profits from growing trees, cutting them down, and selling the logs.  The partnership had continuously operated this business since its formation in 1980.

Keyboard with hot key for estate planningAll limited partners in Giustina Land were members of the same family, or trusts for the benefit of members of the family. The partnership agreement provided that a limited partner interest could be transferred only to another limited partner or to a trust for the benefit of another limited partner unless the transfer was approved by the two general partners.

Although this case has a long history, the final decision determined the value based entirely on the partnership’s value as a going concern, which is the present value of the cash flows the partnership would receive if it were to continue operations. To put it another way, the value was determined based on the cash that a partner would receive from company operations rather than would might be received if the partnership assets were sold and the proceeds distributed to the partners.

For twenty-five years, general partners Larry Giustina and James Giustina ran the partnership as an operating business.  The court was convinced that these two men would refuse to permit someone who was not interested in having the partnership continue its business to become a limited partner.  Therefore, the only cash flow available to limited partners is the cash flow from operations. In determining the value of the partnership, the court applied a 14% capitalization rate to $6,333,600 projected normalized pre-tax cash flows to arrive at a value of $45,240,000.  This value is over $105 million less than the value of the partnership assets.

Why the taxpayer prevailed

Valuation cases, especially those involving family partnerships, are very fact specific. The taxpayer prevailed in this case because the business had operated continuously for twenty-five years, and there was no indication that it would not continue to operate.  The asset value was not considered the valuation because the only way that a limited partner could receive the asset value was on the dissolution of the partnership, which the court concluded was unlikely.

The taxpayer’s position in this case was strengthened by the fact that the partnership had been operating a business for twenty-five years. There is no requirement that a partnership operate for this length of time, however, a partnership formed shortly before death or asset transfer may be more susceptible to successful IRS challenge.  Also, to be respected by the IRS, a family partnership must have a business purpose.  Tax reduction does not qualify as a business purpose.

With proper planning, a family limited partnership may be an effective option to reduce estate and gift taxes. However, there are many technical requirements.  If you are interested in establishing a family limited partnership, you should consult a tax professional.

Structuring a Business Sale to Minimize Income Taxes

Posted by Gerald A. Shanker on

Many of the considerations in structuring a business sale are dependent upon the type of entity that operates the business.

For the purposes of this post, we will limit our discussion to sales of businesses operating in the corporate form, either as S or C corporations.

Tax Advice Puzzle Shows Taxation Irs HelpIn a business sale, the seller prefers to sell the stock representing the business ownership, but the buyer prefers to purchase the assets of the corporation. The seller wants a stock sale because it generates a capital gain, taxed at a 20% rate.  The buyer prefers to purchase the assets because the full purchase price is allocated to the assets purchased, creating tax deductions for depreciation and amortization.  In a stock purchase, the buyer steps into the seller’s shoes, receiving no tax benefit from the price paid until the business is sold.  This issue is usually resolved by compromise, sometimes involving a price adjustment.

C corporation vs. S corporation asset sales

There is a significant difference between an asset sale by a C corporation and an asset sale by an S corporation. Sale by a C corporation results in double tax because the selling corporation is taxed on the gain on the asset sale, and the shareholders are taxed on the distribution to them by the corporation.  Sale by an S corporation that has been an S corporation for at least five years preceding the sale is subject to only one level of tax.  Because S corporations are pass-through entities that do not pay federal income tax, the entire gain is passed through to the shareholders for inclusion on their personal income tax returns.

If your business operates as a C corporation and you are contemplating sale, you should consider making an S corporation election.  This will allow you to avoid a double tax, but only if the corporation has been an S corporation for at least five years prior to the sale.  If the five-year requirement is not met, the S election will be disregarded for purpose of the sale and the sale will generally be treated as having been made by a C corporation.

In certain circumstances, a sale transaction can be structured in which the seller is taxed at favorable capital gains rates and the buyer receives ordinary deductions for a large part of the purchase price. This would occur if seller had personal goodwill, such as customer or supplier relationships not owned by the corporation.  In this structure, the seller would recognize capital gain and the purchaser would deduct the price paid for the goodwill over fifteen years.

Learn more about selling a business

For more information on this, see my article which may be accessed using the following link: http://krscpas.com/wp-content/uploads/2016/02/Business-Sales-and-Personal-Goodwill-G-Shanker.pdf

This article is intended to present general concepts in structuring the sale of a business. If you are considering the sale of a business, you should contact a qualified CPA for specific advice.

Foreign Withholding of Income Tax on Real Estate Transactions

Posted by Simon Filip on

Whether a person is considered a “U.S. person” or “non-U.S. person” will determine which income is subject to federal income tax. This also determines withholdings on that income, which may include earnings from real estate trade/business, passive rental income or sale of property.

Basic Rules

Foreign WithholdingNon-U.S. persons are subject to income tax only on their U.S. source income (income earned within the United States). According to the Internal Revenue Service, most types of U.S. source income paid to a foreign person are subject to a withholding tax of 30 percent, although a reduced rate or exemption may apply if stipulated in the applicable tax treaty.

What’s a U.S. or Non-U.S. Person?  A U.S. person includes citizens and residents of the United States. For income tax purposes, U.S. residents include green card holders or other lawful permanent residents who are present in the United States. A person is also a U.S. resident if he has a “substantial presence” in the States.

A non-U.S. /foreign person, or nonresident alien (NRA) includes (but is not limited to) a nonresident alien individual, foreign corporation, foreign partnership, foreign trust, a foreign estate, and any other person that is not a U.S. person. You can read more on these definitions here.

Withholdings on real estate ventures

If you are a non-U.S. person it is important to consult with tax and/or legal counsel to determine if you are subject to withholding. Below are several situations that could require U.S. withholding with respect to real estate.

  • Trade or business – A non-U.S. person is considered to be engaged in a U.S. trade of business if they regularly undertake activities such as developing, operating and managing real estate. If this is the case, the income is not subject to withholding; rather, the non-U.S. person files an income tax return and computes their applicable tax.
  • Passive rental income – Income from a rental property is typically considered passive income (refer to my previous blog on Passive Activity Losses for details). Rental income is subject to a 30 percent withholding tax unless it is reduced under an income tax treaty. The 30 percent withholding rate is applied to the gross rents and is reported on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding.
  • Sale of property – The Foreign Investment in Real Property Act (FIRPTA) requires a FIRPTA withholding tax of 10 percent of the amount realized on the disposition of all U.S. real property interests by a foreign person. A purchaser of U.S. real property interest from a foreign investor is considered the transferee and also the withholding agent. The transferee must find out if the transferor is a foreign person. If the transferor is a foreign (non-U.S.) person and the transferee fails to withhold, the buyer may be held liable for the tax.

Withholding on foreign partners in a partnership

In addition to filing an annual partnership tax return (Form 1065), if a partnership has taxable income that is effectively connected with a U.S. trade or business, it is required to withhold on income that is allocated to its foreign partners.

The withholding rate for effectively connected income that is allocable to foreign partners is 39.6 percent for non-corporate foreign partners and 35 percent for corporate foreign partners (2016 withholding rates). There are tax treaties with many countries that can reduce the withholding requirements and these should be reviewed.

Note that withholding is calculated on taxable income, not distributions of cash. A partnership needs to be aware before distributing cash to foreign partners that there may be a withholding obligation.

Are you a non-U.S. person with real estate interests in the United States? Or, are you a U.S. citizen or resident working or investing in real estate? I can answer your questions regarding tax issues around passive income losses and other real estate financial considerations; contact me at sfilip@krscpas.com or (201) 655-7411.

Passive Activity Loss and the Income Tax Puzzle for Real Estate Professionals

Posted by Simon Filip on

Does being a real estate professional have income tax advantages?

real estate professionalsIt all comes down to passive and non-passive activities related to property.

As  discussed in a previous post, the IRS recognizes two types of passive activities as they relate to investment real estate, one of those being “trade or business in which the taxpayer does not materially participate.” The other passive activity being rentals, including both equipment and rental real estate.

Generally, rental real estate activities are passive regardless of one’s participation but there is an exception for real estate professionals.

For most taxpayers, income and loss from real estate is considered passive, with passive activity losses generally limited to passive activity income. However, real estate professionals must treat rental real estate activities in which they materially participate as non-passive activities. Therefore, a real estate professional can deduct rental real estate losses from other non-passive income.

How the real estate professional designation affects income taxes

For income tax purposes, the real estate professional designation means you spend a certain amount of time in real estate activities. According to the IRS, real estate professionals are individuals who meet both of these conditions:

1) More than 50 percent of their personal services during the tax year are performed in real property trades or businesses in which they materially participate and  2) they spend more than 750 hours of service during the year in real property trades or businesses in which they materially participate.

real estate professionalsAny real property development, redevelopment, construction, reconstruction , acquisition, conversion, rental, operations, management, leasing or brokerage trade or business qualifies as real property trade or business.

It is important to note that services performed as an employee in real property trades or businesses do not count unless the employee is at least a 5% owner of the employer.

Once it is determined a taxpayer qualifies as a real estate professional (by meeting both of those criteria), non-passive treatment is available only for rental real estate activities in which the taxpayer materially participated. To meet the material participation standard, a taxpayer can elect to treat all interests in rental real estate activities as a single activity. If the election is made, material participation is determined for the combined activity as a group. Since these decisions have implications for one’s income tax liability and potential deductions, it is important to review these guidelines with your accountant and/or trusted tax adviser, and to gain a full understanding of the differences between passive/non-passive income and expenses.

Example

David owns a real estate brokerage firm. He works full time as a broker and also owns three rental properties. David  materially participates in his rental properties and does not employ any management company. HIs material participation comprises finding tenants for his rentals, overseeing repairs, and approving all leases.

Let’s assume that David’s income is $200,000 from the brokerage firm and rental losses associated with the properties he owns are $30,000. David would be able to deduct the $30,000 in full from his gross income because he is a real estate professional and materially participates in the rental properties. If he was not a real estate professional, the $30,000 of losses would be suspended until he had passive income from the properties.

Are you puzzled about whether or not you qualify for these deductions?

Need some help understanding how these passive or non-passive activities might relate to your income tax puzzle, as a real estate professional? I’m here to help; contact me at sfilip@krscpas.com for a consultation. You may also want to check out New Tax Law Explained! For Real Estate Investors.

Passive Loss Limitations in Rental Real Estate

Posted by Simon Filip on

If you think purchasing a rental property will make a great tax shelter, you may need to dig a little deeper into “passive loss limitations” and how they may affect your real estate investment.

rental property and passive loss limitationsFirst, consider that your rental property (like many other businesses) may not yield positive cash flow at first. Improvements to the property, tenant issues, and other expenses may end up putting you in the negative column. If you do end up with a rental loss, you are subject to complex IRS rules regarding how much of your rental losses you may deduct from other income you earn during the year.

Rental property ventures are treated differently than other business investments by the IRS. In the rental property investment realm, these are “passive loss” limitations.

What is a Passive Activity?

The IRS recognizes two types of passive activities:

  • Rentals, including both equipment and rental real estate, regardless of the level of participation.
  • Trade or businesses in which the taxpayer does not materially participate.

To that second point, you are considered to materially participate in an activity if you are involved in the operation of the activity on a regular, continuous, and substantial basis. Generally, real estate activities are passive activities even if you do materially participate. (There is an exception for real estate professionals, which I will discuss in a future blog.) Passive activity loss limitations are reported on your tax return using Form 8582. You can learn more here about passive and non-passive activities as defined by the IRS.

What Triggers Passive Loss Limitations?

Income tax losses from rental properties and limited partnership investments in which you do not materially participate are subject to the passive loss limitations. Generally, passive losses are limited to passive activity income. Any passive losses that have been disallowed are carried forward to the next taxable year.

Special Allowance for Rental Activities

There is a special $25,000 rental loss allowance but the real estate investor must meet two conditions to qualify, based on modified adjusted gross income (MAGI) and active participation in the activity:

1 – Taxpayers with MAGI of less than $100,000 may claim up to $25,000 in rental losses. For every dollar over $100,000 the allowance is reduced by 50%, and it is completely phased out/reduced to zero when the MAGI reaches $150,000.

2 – You must also actively participate in the running of your real estate. This is a simple level to attain.  You do not have to work any set number of hours to actively participate, you simply have to be the final decision maker about approving tenants, arranging for repairs, setting rents, and other management tasks.  If you manage your rentals yourself, you will likely satisfy this requirement.

Disposition of Interest

Time to sell? Generally, you may deduct the entire amount of previously disallowed passive activity losses in the year you dispose of your entire interest in the activity. If you dispose of your interest in a passive activity during a divorce or by gift, the suspended losses are not deductible and adjust the basis in the property.

If you are thinking of investing in rental property as a tax shelter, it is best to discuss this somewhat complex arrangement with a qualified tax or real estate professional, or certified public accountant with expertise in real estate transactions and accounting.

If you’d like some additional insights into passive loss limitations as they relate to real estate investments, contact me at sfilip@krscpas.com or (201) 655-7411.