Posted on Feb 2, 2019

Over the years, real estate has proven to be a lucrative investment for many households. And, in some parts of the country, current market values have surpassed levels seen prior to the 2008 financial crisis.

If your principal residence has appreciated significantly in value, you may be subject to capital gains tax when it’s sold. If your gain will be too big to be sheltered by the federal home sale gain exclusion, you might consider a tax-deferred Section 1031 like-kind exchange. However, this strategy isn’t for everyone, and executing it requires some proactive planning.

Timing is Critical

Substantial tax savings can be reaped on the sale of a highly appreciated principal residence when you can combine the home sale gain exclusion and Section 1031 like-kind exchange breaks. To cash in, a former principal residence must be properly converted into a rental property; then it must be swapped for replacement property in an exchange, as described in the main article.

This strategy can’t be done overnight. Without explicitly saying so, IRS guidance on like-kind exchanges has apparently established a two-year safe-harbor rental period rule. A shorter rental period might work, but it could be challenged by the IRS.

Time is also limited on the rental period. That is, a former principal residence can’t be rented out for more than three years after you vacate the premises. To qualify for the home sale gain exclusion, a property must have been used as the taxpayer’s principal residence for at least  two years during the five-year period ending on the exchange date.

Avoid Tax with the Home Sale Gain Exclusion

If you have a capital gain from the sale of your principal residence, you may qualify to exclude up to $250,000 of that gain from your federal taxable income, or up to $500,000 of that gain if you file a joint return with your spouse.

To qualify for this exclusion, you must meet both the ownership and use tests. In general, you’re eligible for the exclusion if you’ve owned and used your home as your main residence for a period aggregating at least two years out of the five years prior to its date of sale. You can meet the ownership and use tests during different two-year periods. However, you must meet both tests during the five-year period ending on the date of the sale.

Generally, you’re not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home.

Defer Tax with a Like-Kind Exchange

If your gain exceeds the $250,000/$500,000 home sale gain exclusion, you might consider combining the exclusion tax break with a Sec. 1031 like-kind exchange. With proper planning, you can accomplish a tax-saving double play with full IRS approval.

This strategy is available to homeowners who can arrange property exchanges that satisfy the requirements for both the principal residence gain exclusion break and tax deferral under the Sec. 1031 like-kind exchange rules. The kicker is that like-kind exchange treatment is allowed only when both the relinquished property (what you give up in the exchange) and the replacement property (what you acquire in the exchange) are used for business or investment purposes.

That means you must show that you have converted your former principal residence into property held for productive use in a business or for investment before you make the exchange. According to IRS guidance, such a conversion takes two years.

Important note: The Tax Cuts and Jobs Act disallows Sec. 1031 like-kind exchange treatment for exchanges of personal property (not real estate) that are completed after December 31, 2017. However, properly structured exchanges of real property completed after that date still qualify for tax-deferred Sec. 1031 treatment.

The Mechanics

According to the IRS, the principal residence gain exclusion rules must be applied before the Sec. 1031 like-kind exchange rules when you’re able to combine both breaks.

In applying the Sec. 1031 rules, “boot” (meaning cash or property other than real estate received in exchange for your relinquished former personal residence) is taken into account only to the extent the boot exceeds the gain that you can exclude under the home sale gain exclusion rules.

In determining your tax basis in the replacement property, any gain that you can exclude under the principal residence gain exclusion rules is added to the basis of the replacement property. Any cash boot that you receive is subtracted from your basis in the replacement property.

The gain that’s deferred under the like-kind exchange rules is also effectively subtracted from your basis in the replacement property. But that’s OK, because you’ve successfully deferred what would have been a taxable gain upon the disposition of your former personal residence.

Let’s Look at an Example

To illustrate how this strategy works, suppose you and your spouse have owned a home for several years. Your basis in the property is $400,000. But, it’s worth $3.3 million today, so you’re rightfully worried about the tax hit when you sell.

Rather than sell now, you decide to convert your home into a rental property. You rent it out for two years, and then exchange it for a small apartment building worth $3 million plus $300,000 of cash boot (paid to you to equalize the values in the exchange).

When the property is sold in 2021, you realize a $2.9 million gain on the exchange. That’s equal to the sale proceeds of $3.3 million (apartment building worth $3 million plus $300,000 in cash) minus your basis in the relinquished property of $400,000.

On your joint federal income tax return for the year of the exchange, you exclude $500,000 of the $2.9 million gain under the principal residence gain exclusion rules.

Because the relinquished property was investment property at the time of the exchange (due to the two-year rental period before the exchange), you can defer the remaining gain of $2.4 million under the Sec. 1031 like-kind exchange rules.

You aren’t required to recognize any taxable gain, because the $300,000 of cash boot you received is taken into account only to the extent it exceeds the gain you excluded under the principal residence gain exclusion rules. Since the $300,000 of boot is less than the $500,000 excluded gain, you have no taxable gain from the boot.

Tax results from the exchange can be summarized as follows:

Amount realized: $3,300,000

Less basis of relinquished property: ($400,000)

Realized gain: $2,900,000

Home sale gain exclusion: ($500,000)

Deferred gain under Sec. 1031: $2,400,000

Your basis in the apartment building (replacement property) is $600,000 ($400,000 basis of relinquished former principal residence plus $500,000 gain excluded under principal residence gain exclusion rules minus $300,000 of cash boot received). Put another way, your basis in the  apartment building equals its fair market value of $3 million at the time of the exchange minus the $2.4 million gain that’s deferred under the like-kind exchange rules.

Important note: Tax on the gain has only been deferred, not avoided. You’ll owe tax on the $2.4 million gain when the property is eventually sold (unless you execute another like-kind exchange, which further defers the tax hit). However, if you hang on to the replacement property (the apartment building in the example) until you die, the deferred gain will be eliminated thanks to the date-of-death basis step-up rule.

Under that rule, the basis of the building is stepped up to its fair market value as of the date of your death (or the alternate valuation date, which is six months after you die). So, your heirs could sell the building shortly after you pass away and owe little or no tax on the sale. They would owe tax only on postdeath appreciation, if any.

Right for You?

Under the right circumstances, combining the home sale gain exclusion with a tax-deferred Sec. 1031 like-kind exchange can save significant taxes if you plan to sell a highly appreciated principal residence. If you think this strategy might work for you, consult your tax advisor to discuss the right time to convert your home into a rental property. He or she can help execute this strategy under current tax law.

Posted on Mar 5, 2018

Do you own residential or commercial rental real estate? The New Tax Law – Tax Cuts and Jobs Act (TCJA) brings several important changes that owners of rental properties should understand.

In general, rental property owners will enjoy lower ordinary income tax rates and other favorable changes to the tax brackets for 2018 through 2025. In addition, the new tax law retains the existing tax rates for long-term capital gains. (See “Close-Up on Tax Rates” in the right-hand box.)

Close-Up on Tax Rates

If you own property as an individual or via a pass-through entity — meaning a sole proprietorship, a limited liability company (LLC) treated as a sole proprietorship for tax purposes, a partnership, an LLC treated as a partnership for tax purposes, or an S corporation — net income from rental properties is taxed at your personal federal income tax rates.

For 2018 through 2025, the TCJA retains seven tax rate brackets, but six of the rates are lower than before. The 2018 ordinary income rates and tax brackets are as follows:

Bracket Single Married, Filing Jointly Head of Household
10% tax bracket $0 – $9,525 $0 – $19,050 $0 – $13,600
Beginning of 12% bracket $9,526 $19,051 $13,601
Beginning of 22% bracket $38,701 $77,401 $51,801
Beginning of 24% bracket $82,501 $165,001 $82,501
Beginning of 32% bracket $157,501 $315,001 $157,501
Beginning of 35% bracket $200,001 $400,001 $200,001
Beginning of 37% bracket $500,001 $600,001 $500,001

In 2026, the rates and brackets that were in place for 2017 are scheduled to return.

In addition, the new law retains the current tax rates on long-term capital gains and qualified dividends. For 2018, the rate brackets are:

Bracket Single Married, Filing Jointly Head of Household
0% tax bracket $ 0 – $38,600 $0 – $77,200 $0 – $51,700
Beginning of 15% bracket $38,601 $77,201 $51,701
Beginning of 20% bracket $425,801 $479,001 $452,401

These brackets are almost the same as what they would have been under prior law. The only change is the way the 2018 inflation adjustments are calculated.

Additionally, as under prior law, you still face a 25% maximum federal income tax rate (instead of the standard 20% maximum rate) on long-term real estate gains attributable to depreciation deductions.

Unchanged Write-Offs

Consistent with prior law, you can still deduct mortgage interest and state and local real estate taxes on rental properties. While the TCJA imposes new limitations on deducting personal residence mortgage interest and state and local taxes (including property taxes on personal residences), those limitations do not apply to rental properties, unless you also use the property for personal purposes. In that case, the new limitations could apply to mortgage interest and real estate taxes that are allocable to your personal use.

In addition, you can still write off all the other standard operating expenses for rental properties. Examples include depreciation, utilities, insurance, repairs and maintenance, yard care and association fees.

Possible Deduction for Pass-Through Entities

For 2018 and beyond, the TCJA establishes a new deduction based on a noncorporate owner’s qualified business income (QBI) from a pass-through business entity — meaning a sole proprietorship, a limited liability company (LLC) treated as a sole proprietorship for tax purposes, a partnership, an LLC treated as a partnership for tax purposes, or an S corporation. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels.

While it isn’t entirely clear at this point, the new QBI deduction is apparently available to offset net income from a profitable rental real estate activity that you own through a pass-through entity. The unanswered question is: Does rental real estate activity count as a business for purposes of the QBI deduction? According to one definition, a real property business includes any real property rental, development, redevelopment, construction, reconstruction, acquisition, conversion, operation, management, leasing or brokerage business.

Liberalized Section 179 Deduction Rules

For qualifying property placed in service in tax years beginning after December 31, 2017, the TCJA increases the maximum Section 179 deduction to $1 million (up from $510,000 for tax years beginning in 2017). Sec. 179 allows you to deduct the entire cost of eligible property in the first year it is placed into service.

For real estate owners, eligible property includes improvements to an interior portion of a nonresidential building if the improvements are placed in service after the date the building was placed in service. The TCJA also expands the definition of eligible property to include the expenditures for nonresidential buildings:

  • Roofs,
  • HVAC equipment,
  • Fire protection and alarm systems, and
    Security systems.

Finally, the new law expands the definition of eligible property to include depreciable tangible personal property used predominantly to furnish lodging. Examples of such property include:

  • Beds and other furniture,
  • Appliances, and
  • Other equipment used in the living quarters of a lodging facility, such as an apartment house, dormitory, or other facility where sleeping accommodations are provided and rented out.

Important: Sec. 179 deductions can’t create or increase an overall tax loss from business activities. So, you need plenty of positive business taxable income to take full advantage of this break.

Expanded Bonus Depreciation Deductions

For qualified property placed in service between September 28, 2017, and December 31, 2022, the TCJA increases the first-year bonus depreciation percentage to 100% (up from 50%). The 100% deduction is allowed for both new and used qualified property.

For this purpose, qualified property includes qualified improvement property, meaning:

  • Qualified leasehold improvement property,
  • Qualified restaurant property, and
  • Qualified retail improvement property.

These types of property are eligible for 15-year straight-line depreciation and are, therefore, also eligible for the alternative of 100% first-year bonus depreciation.

New Loss Disallowance Rule

If your rental property generates a tax loss — and most properties do, at least during the early years — things get complicated. The passive activity loss (PAL) rules will usually apply.

In general, the PAL rules only allow you to deduct passive losses to the extent you have passive income from other sources, such as positive income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you 1) have sufficient passive income or gains, or 2) sell the property or properties that produced the losses.

To complicate matters further, the TCJA establishes another hurdle for you to pass beyond the PAL rules: For tax years beginning in 2018 through 2025, you can’t deduct an excess business loss in the current year. An excess business loss is the excess of your aggregate business deductions for the tax year over the sum of:

  1. Your aggregate business income and gains for the tax year, plus
  2. $250,000 or $500,000 if you are a married joint-filer.

The excess business loss is carried over to the following tax year and can be deducted under the rules for net operating loss (NOL) carryforwards.

Important: This new loss deduction rule applies after applying the PAL rules. So, if the PAL rules disallow your rental real estate loss, you don’t get to the new loss limitation rule.

The idea behind this new loss limitation rule is to further restrict the ability of individual taxpayers to use current-year business losses (including losses from rental real estate) to offset income from other sources (such as salary, self-employment income, interest, dividends and capital gains). The practical result is that the taxpayer’s allowable current-year business losses (after considering the PAL rules) can’t offset more than $250,000 of income from such other sources or more than $500,000 for a married joint-filing couple.

Loss Limitation Rules in the Real World

Dave is an unmarried individual who owns two strip malls. In 2018, he has $500,000 of allowable deductions and losses from the rental properties (after considering the PAL rules) and only $200,000 of gross income. So he has a $300,000 loss. He has no other business or rental activities.

Dave’s excess business loss for the year is $50,000 ($300,000 – the $250,000 excess business loss threshold for an unmarried taxpayer). The $50,000 excess business loss must be carried forward to Dave’s 2019 tax year and treated as part of an NOL carryfoward to that year. Under the TCJA’s revised NOL rules for 2018 and beyond, Dave can use the NOL carryforward to shelter up to 80% of his taxable income in the carryforward year.

Important: If Dave’s real estate loss is $250,000 or less, he won’t have an excess business loss, and he would be unaffected by the new loss limitation rule.

Like-Kind Exchanges

The TCJA still allows real estate owners to sell appreciated properties while deferring the federal income hit indefinitely by making like-kind exchanges under Section 1031. With a like-kind exchange, you swap the property you want to unload for another property (the replacement property). You’re allowed to put off paying taxes until you sell the replacement property — or you can arrange yet another like-kind exchange and continue deferring taxes.

Important: For 2018 and beyond, the TCJA eliminates tax-deferred like-kind exchange treatment for exchanges of personal property. However, prior-law rules that allow like-kind exchanges of personal property still apply if one leg of a personal property exchange was completed as of December 31, 2017, but one leg remained open on that date.

Need Help?

The new tax law includes several expanded breaks for real estate owners and one important negative change (the new loss limitation rule). At this point, how to apply the TCJA changes to real-world situations isn’t always clear, based solely on the language of the new law.

In the coming months, the IRS is expected to publish additional guidance on the details and uncertainties. Your tax advisor can keep you up to date on developments.

 

Posted on Feb 26, 2018

Let’s say you own a C corporation that needs to raise some cash and you’re considering the sale of a warehouse that has been depreciated to zero. But the company still uses the warehouse and doesn’t want to lose control of it.

Think about entering into a sale-lease transaction. You buy the warehouse personally and then lease it back to the company.

Advantages:

Your company raises the cash it needs and retains control of the warehouse. In addition, the lease payments are deductible by your company so they generate tax benefits from a property that was no longer providing depreciation deductions. Meanwhile, you get a source of income and can start a new depreciation schedule based on what you paid for the warehouse.The deductions provide a tax shelter for some of your lease income.

This plan may hold particular appeal to you if you are close to retirement because you can get a regular income without giving up equity in the company. When you’re no longer active in the business, the payments will become “passive” income, which could be offset by passive losses from tax-shelter investments. If you eventually sell the property, you’ll probably owe tax of 25% on depreciation you’ve taken and a maximum of 15% on long-term capital gains from appreciation.

But if your corporation continued to own the warehouse, subsequent appreciation probably would have been taxed at 34%. What’s more, any future gains go to you, not to the company, so you can collect cash without having to take a nondeductible dividend from the company.

In order for this deal to work, the property’s useful life must exceed the lease term. All the terms of the transaction — sale price, lease rates, renewal rates, repurchase option — must be at fair market value.

The Bottom Line:

You must assume the risk of losing money and have a real chance of making money, in order for the tax benefits to be sustained. As with all complex transactions, consult with your tax adviser to help you structure the deal.

Posted on Sep 25, 2017

Are you thinking about divesting a real estate investment and then replacing it with another property? If you sell appreciated property outright, you’ll incur a taxable gain, which lowers the amount available to spend on the replacement property. But you may be able to defer your tax bill (or even make it disappear) with a Section 1031 like-kind exchange.

Unfortunately, there are rumors that upcoming tax reform legislation could eliminate the time-honored like-kind exchange privilege. So, while tax breaks for like-kind exchanges are still in place, it could be a good idea to complete any like-kind exchanges that you’re considering sooner rather than later. Here’s what you need to know about like-kind exchanges under the current tax rules.

Beware of the Boot

To avoid any current taxable gain in a like-kind exchange, you must not receive any “boot” in the transaction. Boot means cash or other property that isn’t of a like kind to the relinquished property. When mortgaged properties are involved, boot also includes the excess of the mortgage on the relinquished property (the debt you get rid of) over the mortgage on the replacement property (the debt you assume).

If you receive any boot, you’re taxed in the year the property is sold on a gain equal to the lesser of:

  1. The value of the boot, or
  2. Your overall gain on the transaction based on fair market values.

So, if you receive only a small amount of boot, your exchange will still be mostly tax-free (as opposed to completely tax-free). On the other hand, if you receive a significant amount of boot, you could have a large taxable gain.

The easiest way to avoid receiving any boot is to swap a less valuable property for a more valuable property. That way, you’ll be paying boot, rather than receiving it. Paying boot doesn’t trigger a taxable gain for you.

What Constitutes Like-Kind Property?

You can arrange for tax-free real property exchanges as long as the relinquished property (the property you give up in the exchange) and the replacement property (the property you receive in the exchange) are of a like kind. Under Internal Revenue Code Section 1031 and related guidance, “like-kind property” is liberally defined. For example, you can swap improved real estate for raw land, a strip center for an apartment building or a boat marina for a golf course.

But you can’t swap real property for personal property without triggering taxable gain, because real property and personal property aren’t considered like-kind. So, you can’t swap an apartment building for a cargo ship. You also can’t swap property held for personal use, such as your home or boat. Inventory, partnership interests and investment securities are also ineligible for like-kind exchanges. As a result, the vast majority of tax-free like-kind exchanges involve real property.

In 2002, the IRS clarified that even undivided fractional ownership interests in real estate (such as tenant-in-common ownership interests) can potentially qualify for like-kind exchanges. For example, if you sell an entire commercial building, you don’t need to receive an entire commercial building as the replacement property in order to complete your tax-free exchange. Instead, you could receive an undivided fractional ownership interest in a building as the replacement property.

What Happens to the Gain in a Like-Kind Exchange?

Any untaxed gain in a like-kind exchange is rolled over into the replacement property, where it remains untaxed until you sell the replacement property in a taxable transaction.

However, under the current federal income tax rules, if you still own the replacement property when you die, the tax basis of the property is stepped up to its fair market value as of the date of death — or as of six months later if your executor makes that choice. This beneficial provision basically washes away the taxable gain on the replacement property. So your heirs can then sell the property without sharing the proceeds with Uncle Sam.

The like-kind exchange privilege and the basis step-up-on-death rule are two big reasons why fortunes have been made in real estate.

However, as noted earlier, the like-kind exchange privilege could possibly be eliminated as part of tax reform. Even if that doesn’t happen, the estate tax might be repealed, which could also ultimately reduce the tax-saving power of like-kind exchanges.

Why? An elimination of the step-up in basis at death might accompany an estate tax repeal. For example, with the 2010 federal estate tax repeal (which ended up being temporary and, essentially, optional), the step-up in basis was eliminated, and that could happen again. An elimination of the step-up in basis would mean that a taxpayer inheriting property acquired in a like-kind exchange would have the same basis in the property as the deceased, and thus could owe substantial capital gains tax when he or she ultimately sells the property.

What’s a Deferred Like-Kind Exchange?

It’s usually difficult (if not impossible) for someone who wants to make a like-kind exchange to locate another party who owns suitable replacement property and also wants to make a like-kind exchange rather than a cash sale. The saving grace is that properly executed deferred exchanges can also qualify for Section 1031 like-kind exchange treatment.

Under the deferred exchange rules, you need not make a direct and immediate swap of one property for another. Instead, the typical deferred like-kind exchange follows this four-step process:

  1. You transfer the relinquished property (the property you want to swap) to a qualified exchange intermediary. The intermediary’s role is to facilitate a like-kind exchange for a fee, which is usually a percentage of the fair market value of the property exchanged.
  2. The intermediary arranges for a cash sale of your relinquished property. The intermediary then holds the resulting cash sales proceeds on your behalf.
  3. The intermediary uses the cash to buy suitable replacement property that you’ve identified and approved in advance.
  4. The intermediary transfers the replacement property to you.

This series of transactions counts as a tax-free like-kind exchange, because you wind up with like-kind replacement property without ever taking possession of the cash that was transferred in the underlying transactions.

What Are the Timing Requirements for Deferred Like-Kind Exchanges?

For a deferred like-kind exchange to qualify for tax-free treatment, the following two requirements must be met:

1. You must unambiguously identify the replacement property before the end of a 45-day identification period.

The period starts when you transfer the relinquished property. You can satisfy the identification requirement by specifying the replacement property in a written and signed document given to the intermediary. That document can list up to three properties that you would accept as suitable replacement property.

2. You must receive the replacement property before the end of the exchange period, which can last no more than 180 days.

Like the identification period, the exchange period also starts when you transfer the relinquished property.

The exchange period ends on the earlier of: 1) 180 days after the transfer, or 2) the due date (including extensions) of your federal income tax return for the year that includes the transfer date. When your tax return due date would reduce the exchange period to less than 180 days, you can extend your return. An extension restores the full 180-day period.

Will Like-Kind Exchanges Survive Possible Tax Reform Efforts?

Under the current tax rules, like-kind exchanges offer significant tax advantages, but they can be complicated to execute. Your tax advisor can help you navigate the rules.

Looking ahead, it’s uncertain when and if tax reform will occur and whether the tax benefits of a like-kind exchange will survive any successful tax reform efforts. So, if you own an appreciated real estate investment and you’re contemplating swapping it out, it may be advisable to enter into a like-kind exchange sooner rather than later.

Posted on Aug 21, 2017

Are you thinking about divesting a real estate investment and then replacing it with another property? If you sell appreciated property outright, you’ll incur a taxable gain, which lowers the amount available to spend on the replacement property. But you may be able to defer your tax bill (or even make it disappear) with a Section 1031 like-kind exchange.

Unfortunately, there are rumors that upcoming tax reform legislation could eliminate the time-honored like-kind exchange privilege. So, while tax breaks for like-kind exchanges are still in place, it could be a good idea to complete any like-kind exchanges that you’re considering sooner rather than later. Here’s what you need to know about like-kind exchanges under the current tax rules.

Beware of the Boot

To avoid any current taxable gain in a like-kind exchange, you must not receive any “boot” in the transaction. Boot means cash or other property that isn’t of a like kind to the relinquished property. When mortgaged properties are involved, boot also includes the excess of the mortgage on the relinquished property (the debt you get rid of) over the mortgage on the replacement property (the debt you assume).

If you receive any boot, you’re taxed in the year the property is sold on a gain equal to the lesser of:

1. The value of the boot, or

2. Your overall gain on the transaction based on fair market values.

So, if you receive only a small amount of boot, your exchange will still be mostly tax-free (as opposed to completely tax-free). On the other hand, if you receive a significant amount of boot, you could have a large taxable gain.

The easiest way to avoid receiving any boot is to swap a less valuable property for a more valuable property. That way, you’ll be paying boot, rather than receiving it. Paying boot doesn’t trigger a taxable gain for you.

What Constitutes Like-Kind Property?

You can arrange for tax-free real property exchanges as long as the relinquished property (the property you give up in the exchange) and the replacement property (the property you receive in the exchange) are of a like kind. Under Internal Revenue Code Section 1031 and related guidance, “like-kind property” is liberally defined. For example, you can swap improved real estate for raw land, a strip center for an apartment building or a boat marina for a golf course.

But you can’t swap real property for personal property without triggering taxable gain, because real property and personal property aren’t considered like-kind. So, you can’t swap an apartment building for a cargo ship. You also can’t swap property held for personal use, such as your home or boat. Inventory, partnership interests and investment securities are also ineligible for like-kind exchanges. As a result, the vast majority of tax-free like-kind exchanges involve real property.

In 2002, the IRS clarified that even undivided fractional ownership interests in real estate (such as tenant-in-common ownership interests) can potentially qualify for like-kind exchanges. For example, if you sell an entire commercial building, you don’t need to receive an entire commercial building as the replacement property in order to complete your tax-free exchange. Instead, you could receive an undivided fractional ownership interest in a building as the replacement property.

What Happens to the Gain in a Like-Kind Exchange?

Any untaxed gain in a like-kind exchange is rolled over into the replacement property, where it remains untaxed until you sell the replacement property in a taxable transaction.

However, under the current federal income tax rules, if you still own the replacement property when you die, the tax basis of the property is stepped up to its fair market value as of the date of death — or as of six months later if your executor makes that choice. This beneficial provision basically washes away the taxable gain on the replacement property. So your heirs can then sell the property without sharing the proceeds with Uncle Sam.

The like-kind exchange privilege and the basis step-up-on-death rule are two big reasons why fortunes have been made in real estate.

However, as noted earlier, the like-kind exchange privilege could possibly be eliminated as part of tax reform. Even if that doesn’t happen, the estate tax might be repealed, which could also ultimately reduce the tax-saving power of like-kind exchanges.

Why? An elimination of the step-up in basis at death might accompany an estate tax repeal. For example, with the 2010 federal estate tax repeal (which ended up being temporary and, essentially, optional), the step-up in basis was eliminated, and that could happen again. An elimination of the step-up in basis would mean that a taxpayer inheriting property acquired in a like-kind exchange would have the same basis in the property as the deceased, and thus could owe substantial capital gains tax when he or she ultimately sells the property.

What’s a Deferred Like-Kind Exchange?

It’s usually difficult (if not impossible) for someone who wants to make a like-kind exchange to locate another party who owns suitable replacement property and also wants to make a like-kind exchange rather than a cash sale. The saving grace is that properly executed deferred exchanges can also qualify for Section 1031 like-kind exchange treatment.

Under the deferred exchange rules, you need not make a direct and immediate swap of one property for another. Instead, the typical deferred like-kind exchange follows this four-step process:

1. You transfer the relinquished property (the property you want to swap) to a qualified exchange intermediary. The intermediary’s role is to facilitate a like-kind exchange for a fee, which is usually a percentage of the fair market value of the property exchanged.

2. The intermediary arranges for a cash sale of your relinquished property. The intermediary then holds the resulting cash sales proceeds on your behalf.

3. The intermediary uses the cash to buy suitable replacement property that you’ve identified and approved in advance.

4. The intermediary transfers the replacement property to you.

This series of transactions counts as a tax-free like-kind exchange, because you wind up with like-kind replacement property without ever taking possession of the cash that was transferred in the underlying transactions.

What Are the Timing Requirements for Deferred Like-Kind Exchanges?

For a deferred like-kind exchange to qualify for tax-free treatment, the following two requirements must be met:

1. You must unambiguously identify the replacement property before the end of a 45-day identification period. The period starts when you transfer the relinquished property. You can satisfy the identification requirement by specifying the replacement property in a written and signed document given to the intermediary. That document can list up to three properties that you would accept as suitable replacement property.

2. You must receive the replacement property before the end of the exchange period, which can last no more than 180 days. Like the identification period, the exchange period also starts when you transfer the relinquished property.

The exchange period ends on the earlier of: 1) 180 days after the transfer, or 2) the due date (including extensions) of your federal income tax return for the year that includes the transfer date. When your tax return due date would reduce the exchange period to less than 180 days, you can extend your return. An extension restores the full 180-day period.

Will Like-Kind Exchanges Survive Possible Tax Reform Efforts?

Under the current tax rules, like-kind exchanges offer significant tax advantages, but they can be complicated to execute. Your tax advisor can help you navigate the rules.

Looking ahead, it’s uncertain when and if tax reform will occur and whether the tax benefits of a like-kind exchange will survive any successful tax reform efforts. So, if you own an appreciated real estate investment and you’re contemplating swapping it out, it may be advisable to enter into a like-kind exchange sooner rather than later.

Posted on Jul 10, 2017

Have you ever thought about becoming a landlord? This option may be tempting if your local real estate market is surging and rental rates are strong, especially if you’re already planning to relocate or downsize to a smaller home.

Ideally, you’ll be able to shelter most or all of the rental income with tax deductions and eventually sell the property for a higher price than you originally paid. In the meantime, however, it’s important to understand the confusing tax rules that apply when a personal residence is converted into a rental.

Special Basis Rule

Once you become a landlord, you can depreciate the tax basis of the building part of a residential rental property (not the basis of the land) over 27.5 years. In plain English, this means you can deduct from your taxable income a portion of the building’s value every year for the next 27.5 years. However, a special basis rule applies to a rental property that was formerly a personal residence.

Under the special rule, the initial tax basis of the building portion of the property for purposes of calculating your postconversion depreciation write-offs equals the lower of:

  • The building’s fair market value (FMV) on the conversion date, or
  • The building’s regular basis on the conversion date.

Regular basis usually equals original cost plus the cost of any improvements (excluding any normal repairs and maintenance).

When You Sell

The rules become really confusing when you sell the property. To determine if you have a deductible loss, a similar special basis rule applies. That is, you must use the lower of:

  • The property’s FMV on the conversion date, or
  • The property’s regular basis on the conversion date.

Additionally, you must reduce the initial basis by depreciation deductions taken during the rental period. The special basis rule and the depreciation deductions greatly reduce the odds of having a deductible loss on a sale, especially when property values are below historical levels. With property values recovering in many areas, however, the chances of reporting a taxable gain have increased.

Your tax basis for purposes of calculating whether you have a taxable gain on a sale is simply the property’s regular basis on the sale date. Regular basis generally equals the original cost of the land and building, plus the cost of any improvements minus depreciation deductions claimed during the rental period.

Sellers in Limbo

When a converted property is sold, you must use the special basis rule to determine if you have a deductible loss on the sale, but you must use the regular basis rule to determine if you have a taxable gain. Following two different basis rules can sometimes cause sellers to have neither a taxable gain nor a deductible loss. This happens whenever the sale price falls between the two basis numbers.

Confused? Here are some examples of how to calculate gains and loss to help clarify.

Example 1: No tax gain or loss on sale

To illustrate how this works, suppose you convert your home to a rental while the market is recovering — but it hasn’t returned to its previous peak by the time you sell. Here’s how the numbers might shake out:

Regular basis on conversion date $300,000
Postconversion depreciation deductions ($13,000)
Regular basis for tax gain $287,000
FMV on conversion date $235,000
Postconversion depreciation deductions ($13,000)
Special basis for tax loss $222,000

If the net sale price is between $222,000 and $287,000, you have no tax gain or loss, because the sale price falls between the two basis numbers.

Example 2: Modest gain on sale

Alternatively, suppose you convert a property in a market that’s still in the early stages of recovery, and you intend to hang onto it for a while before selling.

Regular basis on conversion date $300,000
Postconversion depreciation deductions ($32,000)
Regular basis for tax gain $268,000
FMV on conversion date $285,000
Postconversion depreciation deductions ($32,000)
Special basis for tax loss $253,000

If the net sales price is above $268,000, you have a taxable gain. For example, with a net sale price of $345,000, you must report a taxable gain of $77,000 ($345,000 – $268,000). That is because, in this example, the postconversion depreciation deductions reduced the regular basis and the value of the property jumped. As a result, the sale price exceeds the regular basis, which produces a modest taxable gain on the sale.

Example 3: Big gain on sale

Now, let’s suppose you convert a property in a strong market. You’ve owned it for years and its FMV never fell below what you paid for it. In this case, the special basis rule for determining if you have a tax loss does not apply.

Regular basis on conversion date $235,000
Postconversion depreciation deductions ($26,000)
Regular basis for tax gain $209,000
FMV on conversion date $285,000

Assuming the property is sold for $360,000, your taxable gain would be a whopping $151,000 ($360,000 – $209,000). In this example, the postconversion depreciation deductions reduced the property’s basis and the value jumped after the conversion. So the sales price substantially exceeds the basis, generating a significant taxable gain on the sale.

Principal Residence Gain Exclusion

Fortunately, some landlords may be able to shelter their gain on the sale of a recently converted property with the principal residence gain exclusion. When allowed, the gain exclusion really helps: Unmarried property owners can potentially exclude gains of up to $250,000, and married joint-filing couples can potentially exclude up to $500,000.

Important note: If you qualify for the gain exclusion, you can’t use it to shelter the part of a gain that’s attributable to depreciation deductions. In the previous example, if the gain exclusion applied, the taxpayer must still report a taxable gain of $26,000, which equals the amount of the postconversion depreciation deductions. But that’s much less than the total gain of $151,000.

To qualify for this exclusion, the tax rules require that you use the property as your principal residence for at least two years during the five-year period ending on the sale date. So, it’s impossible to meet the two-year usage requirement once you’ve rented the property for more than three years during that five-year period.

So, this tax break is allowed only if you’ve rented the property for no more than three years after the conversion date at the time you sell.

Ready to Convert?

Home-to-rental conversions can be a lucrative financial proposition for some property owners. But the tax rules can be confusing. To help understand the rules and evaluate whether you should become a landlord, contact your tax advisor. He or she can help decide what’s best for your situation. Beyond taxes, your tax pro will help you factor other considerations into your decision.

Posted on Jul 6, 2017

Although a regular audit of financial statements and disclosures can help property managers prepare for a HUD-sanctioned management and operating review (MOR), there are some differences between HUD Audit Guidelines and the questions covered in a management review through HUD 9834.

There are rather obvious differences on HUD 9834, like lead-based paint compliance, vacancy monitoring, or receipts — by unit — of appliance purchases. Those questions aren’t included in HUD audit guidelines. However, items like documentation of outside contractors and the reconciliation of accounts payable seem like they should be similar for an audit or MOR. They aren’t exactly.

We have highlighted a few of the grey areas here that property managers of HUD-funded properties should be aware of when reviewing HUD 9834. Did your recent audit cover all the obvious and not so obvious questions you may be asked during an on-site review, or do you have some work to do?

1. Condition of the Property

  • Lead-based paint compliance – inspection, maintenance, abatement and protection of tenants and their belongings?
  • Repairs – paid consistently from right operating expense account and eligible items reimbursed by reserve?
  • Tools – satisfactory inventory system to account for them (and keys?)
  • Appliances – secured to prevent theft?
  • Maintenance backlogs – backlog of work orders?
  • Unit Readiness – assess occupancy readiness of vacant units?
  • Signage – clear and adequate for tenants and visitors?

2. Financial Health

  • Project operating costs – reasonable compared to a similar property?
  • Principals and Board – received HUD 2530 approval and meet regularly?
  • Mortgage – any past restructuring?
  • Owner – eligible for incentives?
  • Reserve and General Operating accounts – adequate to meet future needs?
  • Operating expenses – regularly reviewed to make sure property is paying best possible rates, including taxes and utilities?
  • Bad debts – procedure for write-offs reasonable?
  • Centralized accounting – approved by HUD?

3. Rent Increases

  • Requests – submitted promptly to HUD?
  • Reserve for Replacement analysis – performed before submitting budget-based rent increase?
  • Rent adjustments – documented last adjustments?
  • Special rent increases – previously approved?

4. Vacacy Rates

  • Vacancy activity – documented for the last 12 months and how many each month?
  • Rates – vacancy rates on the date of the MOR on-site visit?

5. Staffing

  • Vacancy – staffing issues impacting vacancy rates?
  • Vendors – maintain a list of outside contractors and bills paid in time to maximize discounts?
  • Enterprise Income Verification (EIV) – proper controls with regard to staffing access to sensitive tenant data in the EIV system?
  • Management – can staff adequately perform management and maintenance functions, and do they receive regular training?
  • After Hours – after hours and emergency phone numbers posted?
  • Supervision – process for field supervision of staff?
  • Tenant employment – efforts to employ tenants under Section 3?

6.  Tenants

  • Sex offender status – does application ask if applicant or any member of applicant’s household is subject to a lifetime of state sex offender registration?
  • Previous residence – does application ask about list of previous residences?
  • HUD 92006 – attached to application?
  • Application denial – different appeals reviewer than the person who denies the application?
  • Wait list – number of applicants listed for each type of unit?
  • Fees and charges – other charges assessed besides security deposits?
  • Tenant Rental Assistance Certification System (TRACS) – data secure and up to date?
  • Private information – tenant personal information stored according to HUD document retention guidelines and access limited to only certain personnel?
  • Unit size – unit sizes adequate for household composition?
  • Eligibility exceptions – exceptions granted to ineligible households?
  • Pets – pet deposits in acceptable range and payments allowed?
  • EIV – income discrepancies documented and resolved?
  • Utilities – certifications reflecting the correct utility allowances, and  reimbursements distributed within five days of receipt of housing assistance payments?
  • Intent to Vacate – notices received in writing?
  • Rejections – rejection letters inform applicants of the right to appeal and appeals documented and handled properly?

By paying attention to these particular questions at your properties — in addition to conducting a regular HUD audit — your ability to answer questions during a MOR desk review or on-site review will be stronger. For additional questions or concerns, talk to the Audit team at Cornwell Jackson.

Download a copy of the HUD 9834 or view the source list on the whitepaper for additional HUD forms and guides.

Download the whitepaper: Are You Ready for MOR? Affordable Housing Audit Tips to Meet HUD Standards

Scott Bates, CPA, is a partner in Cornwell Jackson’s audit practice. He provides consulting to clients in real estate, including HUD-funded properties. Contact Scott at scott.bates@cornwelljackson.com or 972-202-8000.

Posted on Jun 22, 2017

Over the past eight years and now into the era of the new Republican White House, scrutiny on affordable housing developers, owners and management companies has increased. Whether the reasons are to root out abuses of Section 8 funding or to justify cutting the US Housing and Urban Development budget, politics have put pressure on HUD inspectors to increase their review of funding recipients. Based on a recent presentation we attended on the return of the HUD Management & Occupancy Review (MOR), we outline ways that owners and managers of HUD-funded properties can prepare for a potential MOR.

Based on our experience with audits of HUD-funded properties and organizations, preparation and elements of a MOR are fairly similar. Let’s walk through the key areas of risk and review.

In the course of preparation, we recommend setting up a separate paper filing system and an online file to organize and store information relevant to a MOR, including a complete HUD 9834 form, your most recent REAC filing, audit of financial statements and disclosures, documentation on resolving any previous audit or MOR issues and general management documents such as leasing renewals (as requested in HUD 9834).

The top 10 risks that the MOR desk review will emphasize include:

  • PASS Score (physical property conditions)
  • FASS Score (financial condition)
  • Loan Payment Status (late payments, etc.)
  • Management Review Score (tenant complaints, staffing practices)
  • SOA (sex offender audit issues)
  • Overdue AFS (audit of financial statements)
  • OHAP watch list (program restructuring notifications)
  • FASS Referrals (financial restructuring)
  • EH&S (health and safety violations)
  • Management Condition (discrimination, falsification)

Any previous red flags, notifications or issues should be resolved — or documented as in process of being resolved —prior to another MOR. Findings that earlier issues have not been resolved can put a project/program/property on HUD’s radar as a bad partner. That puts future funding at risk.

After the desk review comes the on-site review. This review can include questions about transactions that occurred since the last MOR. If your project’s last MOR was in 2011, that’s a lot of ground to cover.

Even the best, well-run properties can experience grey areas that may be flagged. Items we have found during our financial statement audits include improper verification of income or handling of surplus cash. We have also noted contract issues in which an individual property or management company does not have its own separate HUD contract. Even wait lists can be scrutinized for possible discrimination.

The goal of any property should be to receive a “Superior” or “Above Average” MOR performance rating.  This means the property/program is adhering to HUD policies and is operating a safe, fair and financially sound operation for providing affordable housing to the community. A “Satisfactory” rating means that there are some minor corrections to make. Anything below a rating of 70 is below average or unacceptable.

There are many good property management companies in the Dallas/Fort Worth area — whether for-profit or nonprofit — that run tight ships and schedule regular audits or reviews. Our recommendation to them is third-party validation. Have a CPA firm with knowledge and experience with HUD-funded properties walk staff through HUD 9834 documentation or at the least review their answers and addendums.

Continue Reading: MOR Questions Your Audit May Not Catch

Scott Bates, CPA, is a partner in Cornwell Jackson’s audit practice. He provides consulting to clients in real estate, including HUD-funded properties. Contact Scott at scott.bates@cornwelljackson.com or 972-202-8000.

Posted on Jun 6, 2017

Over the past eight years and now into the era of the new Republican White House, scrutiny on affordable housing developers, owners and management companies has increased. Whether the reasons are to root out abuses of Section 8 funding or to justify cutting the US Housing and Urban Development budget, politics have put pressure on HUD inspectors to increase their review of funding recipients. Based on a recent presentation we attended on the return of the HUD Management & Occupancy Review (MOR), we outline ways that owners and managers of HUD-funded properties can prepare for a potential MOR.

In 42 states including Texas, HUD Management and Occupancy Reviews (MORs) have not been conducted on Section 8 properties since 2011. After a series of lawsuits and protests brought by the Performance-Based Contract Administrators (PBCAs) who perform MORs on behalf of HUD, it looks like things have been resolved for now. MORs will be conducted in these states once again. Some may have already occurred in the second half of 2016. They may be annual or more frequent, but they are always random and with little notice.

The purpose of a MOR includes:

  • Maintaining housing for target populations
  • Protecting FHA insurance funds
  • Ensuring satisfactory management
  • Ensuring good physical and financial health of properties
  • Reviewing compliance with HUD rules
  • Proper administration of subsidy contracts

At-risk projects are more likely to get notification of a MOR, but in many cases a PBCA has approval to conduct a review on 100 percent of the portfolio under its jurisdiction in the state. If your property or organization has not already received notification of a pending MOR, it still makes sense to prepare as though it’s already happening.

The reason for this is the extensive paperwork and reporting required during a MOR. However, if your organization has conducted a thorough financial audit, you already have much of the information available to prepare and share during a MOR. Some of the primary items include:

  • General physical appearance of property and security
  • Follow-up and monitoring of project inspections
  • Maintenance and standard operating procedures (SOPs) in place
  • Financial management and procurement processes
  • Leasing & Occupancy compliance
  • Tenant/management relations
  • General management practices

Prior to a MOR field visit, the PBCA will conduct what they call a Desk Review, which includes looking at the project’s previous MOR findings. Any issues with the physical property, timely reporting of financials or audit findings along with the history of operating expenses will be noted. In a side-by-side comparison of HUD’s primary MOR document, “Management Review for Multifamily Housing Projects”— known as HUD 9834 — the items listed for review are very similar to a general financial audit of a HUD-funded organization.

It, therefore, makes sense to prepare for a MOR not only by reviewing and answering the questions listed on HUD 9834, but also by reviewing and using your audit findings to make improvements. With some early preparation, you can be ready for MOR.

Continue Reading: Prepare for a Management & Occupancy Review (MOR)

Scott Bates, CPA, is a partner in Cornwell Jackson’s audit practice. He provides consulting to clients in real estate, including HUD-funded properties. Contact Scott at scott.bates@cornwelljackson.com or 972-202-8000.

Posted on Mar 13, 2017

In a significant case, homebuilders that want to realize income under the completed contract accounting method based on an entire development won a victory.

The United States Court of Appeals for the Ninth Circuit upheld a lower court ruling affirming that a homebuilding group could defer tax under the completed contract method rather than use the percentage-of-completion accounting method.

Background

A long-term contract covers the manufacture, building, installation, or construction of property, if not completed in the tax year in which the contract is signed. Although there are certain exceptions, contractors with these contracts generally must use the percentage-of-completion method, realizing income over time.

Under the regulations for long-term contracts, a job is complete on the earlier of:

1. When the subject matter of the contract is used by the customer for its intended purpose and at least 95% of the total allocable contract costs have been incurred by the taxpayer (the 95% test), or

2. When there is final completion and acceptance.
With the completed contract method, however, contractors don’t report any income until a contract is complete, although payments are received before completion. The completion date is determined without regard to whether secondary items in the contract have been used or finally completed and accepted.

The completed contract method may be engaged instead of the percentage-of-completion method in home construction and other real property construction contracts if the contractor:

Estimates that the contracts will be completed within two years of the start date, and

Meets a $10 million gross receipts test.
A home construction contract is one where 80% or more of the estimated total contract costs is reasonably expected to be attributable to the building, construction, reconstruction, or rehabilitation of dwelling units contained in buildings containing four or fewer dwelling units, and to improvements to real property directly.

Facts of the Case

Shea Homes Inc. and several subsidiaries formed an affiliated group of corporations. The group built and sold homes in master planned community developments in Arizona, California and Colorado. The communities ranged in size from 100 homes to more than 1,000. The group’s business model emphasized the special features and amenities of master planned communities, which can include parks, golf courses, lakes, bike paths, and jogging trails.

The purchase price of each home included the building, lot, improvements to the lot, infrastructure and common area improvements, financing, fees, property taxes, labor and supervision, architectural and environmental design, bonding and other costs. Income from the sale of homes was based on completion of the entire development, rather than on the sale of each individual home. The IRS disagreed with the group’s use of that accounting method and assessed deficiencies. Eventually, the case went to court.

Round 1. The Tax Court looked at eight representative developments out of 114 that the group built during the tax years in question.

The group contended that completion and acceptance didn’t happen until the last road was paved and the final performance bond required by state and municipal law was released.

The IRS argued that the subject matter of the taxpayers’ contracts consisted only of the houses and the lots upon which the houses were built. Under the tax agency’s interpretation, the contract for each home met the completion and acceptance test when escrow was closed for the sale of each home. It also said that these contracts, which were entered into and closed within the same tax year, weren’t long-term contracts.

But the U.S. Tax Court upheld the group’s interpretation of the completed contract method. It also held that the subject matter of the contracts consisted of the home and the larger development, including amenities and other common improvements.

The court rejected the IRS argument that the subject of the contract was just the lot and the house, and that the common improvements in the development were only secondary items that didn’t affect completion of the contract.

Court’s Interpretation of the Primary Subject

The primary subject matter of the contracts included the house, lot, improvements to the lot, and common improvements to the development, the court ruled. The amenities were crucial to the sales effort and buyers’ purchase decisions as well as to obtaining government approval for the development. Accordingly, the amenities were an essential element of the home sales contracts.

Round 2: On appeal, the IRS tried a different argument. It conceded that the group’s home construction contracts encompassed more than just individual homes and lots and included common improvements of each planned community that the group was contractually obligated to build.

But it asserted that the group had applied the 95% test incorrectly.

The IRS argued that each contract pertained to the particular home and lot plus the common areas, but not the other homes in the community. By taking this approach, the IRS reasoned that the 95% test would be met only when the group incurred 95% of the budgeted costs of the home, lot and common amenities, but not the costs of the other homes.

The Ninth Circuit Court didn’t buy that argument. It said that the group’s application of the 95% test clearly reflected income because the purchasers of the homes were contracting to buy more than the homes’ mere “bricks and sticks.” . They were paying a premium because they expected to enjoy benefits and a certain lifestyle from the community’s amenities.

The Ninth Circuit affirmed the Tax Court’s decision.

A Victory for Deferring Taxes

This case clearly signals a victory for homebuilders that want to realize income under the completed contract method based on an entire development, not the separate sales of individual homes. However, other considerations may come into play. Consult with your tax advisor about the facts of your specific situation. (Shea Homes, Inc., No. 14-72161, CA-9, 8/24/16).

Another Circuit Court Sides with the IRS

The IRS prevailed in a similar case, but with a couple of important differences.

The Fifth Circuit Court of Appeals upheld a U.S. Tax Court decision that a residential land developer’s sale and custom lot contracts constituted long-term construction contracts, but weren’t home construction contracts as defined by tax law. Thus, the developer couldn’t use the completed contract method.

There are two critical distinctions in this case from the Shea Homes case before the Ninth Circuit Court of Appeals:

1. The taxpayer in this case wasn’t a homebuilder, but rather a land developer that sold finished lots to builders that sold the homes to consumers.

2. The tax deferral resulting from the use of the completed contract method by the Shea group was, on average, less than five years. In contrast, the deferral period in the Fifth Circuit case was much longer in a number of instances. (Howard Hughes Company, LLC, 805 F.3d 175, CA-5, 10/27/15)