Real Estate

Real estate investor vs. professional: Why it matters

Income and losses from investment real estate or rental property are passive by definition — unless you’re a real estate professional. Why does this matter? Passive income may be subject to the 3.8% net investment income tax (NIIT), and passive losses generally are deductible only against passive income, with the excess being carried forward.

Of course the NIIT is part of the Affordable Care Act (ACA) and might be eliminated under ACA repeal and replace legislation or tax reform legislation. But if/when such legislation will be passed and signed into law is uncertain. Even if the NIIT is eliminated, the passive loss issue will still be an important one for many taxpayers investing in real estate.

“Professional” requirements

To qualify as a real estate professional, you must annually perform:

  • More than 50% of your personal services in real property trades or businesses in which you materially participate, and
  • More than 750 hours of service in these businesses.

Each year stands on its own, and there are other nuances. (Special rules for spouses may help you meet the 750-hour test.)

Tax strategies

If you’re concerned you’ll fail either test and be subject to the 3.8% NIIT or stuck with passive losses, consider doing one of the following:

Increasing your involvement in the real estate activity. If you can pass the real estate professional tests, the activity no longer will be subject to passive activity rules.

Looking at other activities. If you have passive losses from your real estate investment, consider investing in another income-producing trade or business that will be passive to you. That way, you’ll have passive income that can absorb some or all of your passive losses.

Disposing of the activity. This generally allows you to deduct all passive losses — including any loss on disposition (subject to basis and capital loss limitations). But, again, the rules are complex.

Also be aware that the IRS frequently challenges claims of real estate professional status — and is often successful. One situation where the IRS commonly prevails is when the taxpayer didn’t keep adequate records of time spent on real estate activities.

If you’re not sure whether you qualify as a real estate professional, please contact us at (214) 696-1922. We can help you make this determination and guide you on how to properly document your hours.

© 2017

Real Estate Investing Podcast with Mark Patten and Mandy Thiebaud

Mark Patten, CPA and Mandy Thiebaud, CPA  of McKinnon Patten & Associates discuss with Old Capital Podcast how earned income and passive income are treated by the IRS, capitalizing versus expensing replacements & repairs, and why owning real estate is more than just a return on your investment. Find out about 1031 exchanges, like-kind exchanges as well as cost segregation and how it can benefit your real estate investment. http://bit.ly/2rzqU8L

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AVOIDING PASSIVE LOSSES

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Since the Great Recession of 2008, the nation’s rental market has been an economic bright spot for investors. The median rent for a new apartment climbed to $1,372 last year, a 26% increase from 2012. The 2008 housing crash led to stricter lending standards and thus to 37% of households renting their homes in 2014—the highest level in over 45 years. There are, however, caveats to owning rental property. One of the primary drawbacks of rental income is that Section 469 of the Code classifies all rental income as passive. This limits the amount of loss a taxpayer can claim on rental properties to the amount of passive income earned in the same tax year, with any excess loss carried forward to subsequent years or until disposition of the property.  Another drawback to rental properties is a result of the Affordable Care Act. The Act reduced the potential appeal of owning rental property by imposing a 3.8% surtax on certain taxpayers’ passive rental income. Individuals will owe the tax if they have Net Investment Income and also have modified adjusted gross income over the following thresholds:

Filing Status

MAGI Threshold Amount
Married filing jointly $250,000
Married filing separately $125,000
Single $200,000
Head of household (with qualifying person) $200,000
Qualifying widow(er) with dependent child $250,000

However, the IRS has carved out exceptions to this passive income treatment and created a “safe haven” from the surtax for “real estate professionals” that meet certain “material participation” requirements. To determine whether or not you meet this two part criteria, we must first determine who qualifies as a real estate professional.  The IRS criteria is as follows:

  • More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
  • You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.

These two criteria are designed to a) prove you truly derive your income primarily through real estate and b) disqualify retirees who spend a few hours a week managing rentals.  It should be noted however, that “real property trades or business” is defined by Sec. 469 (c)(7)(C) as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”  Qualifying as a real estate professional is only the first step—the next step is to determine if you “materially participated” in the rental activities.

Material participation tests.    You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests.

  1. You participated in the activity for more than 500 hours.
  2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.
  3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.
  4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you did not materially participate under any of the material participation tests, other than this test.
  5. You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
  6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.
  7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

You did not materially participate in the activity under test 7 if you participated in the activity for 100 hours or less during the year. Moreover, under this test your participation in managing the activity does not count in determining whether you materially participated if:

  • Any person other than you received compensation for managing the activity, or
  • Any individual spent more hours during the tax year managing the activity than you did (regardless of whether the individual was compensated for the management services).

If the real estate professional meets any one of the above criteria, not only can losses on a rental be counted against ordinary income, any profits from the rentals will be excluded from the Net Investment Income surtax of 3.8%.  It should be noted that taxpayers qualifying as real estate investors are allowed to group rental properties and treat them as a single activity.  In doing this, they can aggregate the hours they spend on multiple rental activities and avoid having to demonstrate that they materially participated in each property individually.

Although many rental property owners will find the “real estate professional” qualification impossible to meet due to other employment consuming more than 50% of their time, there is some relief for these individual tax payers.  There is a less stringent standard of participation in rental activities known as “active participation”.  Per the IRS, “ You actively participated in a rental real estate activity if you (and your spouse) owned at least 10% of the rental property and you made management decisions or arranged for others to provide services (such as repairs) in a significant and bona fide sense. Management decisions that may count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and other similar decisions.”  This qualification will allow you to deduct up to $25,000 of passive losses from your ordinary income.  It will not, however, exempt your passive income from the 3.8% NIIT if you meet the income thresholds.

 

If you are seeking advice on how to avoid passes losses, call 214-696-1922 and ask for Mark Patten.

McKinnon Patten is a Texas CPA that provides accounting and advisory services to a full range of real estate entities and property types including residential, commercial and industrial.

Repossessing Investment Property Sold in a Seller-Financed Deal

Let’s say you sold investment real estate in a seller-financed installment sale transaction. Later, you’re forced to repossess the property because the buyer fails to meet his payment obligations. What are the federal income tax consequences of the repossession? This article will provide the answer.

Repossession Tax Basics

Under Section 1038 of the Internal Revenue Code, repossessing investment real estate triggers a taxable gain if you’ve collected cash from the buyer (other than interest on the installment note) before the repossession occurs. Specifically, you must report the down payment and all interim installment note principal payments (meaning principal payments received before the repossession) as taxable gain — to the extent those payments exceed the amount of taxable gain you’ve already reported before the repossession.

This is a fair outcome, because you’re basically back where you started before the sale but with additional cash in hand from the down payment and/or installment note principal payments that were collected before the repossession.

Your repossession costs (attorney fees and so forth) are generally added to the tax basis of the repossessed property. So your post-repossession basis in the property will usually equal its basis at the time of the installment sale plus any repossession costs incurred to get the property back.

The amount of taxable gain reported before the repossession includes the total of:

  • Any ordinary income from depreciation recapture reported in the year of the installment sale;
  • Gain from the down payment (if any); and
  • Gain reported on the receipt of any interim installment note principal payments.

Important: Any interest collected on the installment note counts as ordinary income taxed at your regular rate. The taxable income from interest is in addition to the taxable repossession gain.

The Repossession Gain

The character of the repossession gain is the same as the character of the deferred gain from the installment sale. Therefore, the repossession gain will usually be a Section 1231 gain that is taxed at the same rate as a long-term capital gain.

Holding Period and Depreciation

Your holding period for the repossessed property includes your ownership period before the ill-fated seller-financed installment sale plus your ownership period after the repossession. It does not include the period that the buyer from whom the property was repossessed owned the property.

After you get it back, the repossessed property is depreciated as if it had never been sold. The IRS has not issued guidance explaining how repossessed MACRS property is supposed to be depreciated (MACRS is the current federal income tax depreciation regime, which has been in place since 1986). Presumably the post-repossession depreciation rules are analogous to the “old rules” for ACRS property (ACRS was the federal income tax depreciation regime before MACRS).

Under those “old rules,” post-repossession depreciation resumes using the remaining depreciation period and the applicable depreciation rate at the time of the ill-fated installment sale. Any basis in excess of the basis at the time of the installment sale (such as additional basis from repossession costs) is treated as the cost of a new asset and is depreciated under the current MACRS rules.

Requirements for Favorable Rules to Apply

The Section 1038 rules for calculating the repossession gain and the tax basis of the repossessed property are mandatory and they are taxpayer-friendly. However, the favorable Section 1038 rules only apply when all the conditions listed are met:

  • You must be the original seller of the repossessed property and the repossession must be undertaken to enforce your security rights in the property that you sold in the installment sale deal.
  • The installment note receivable must have been received by you as the seller in the original sale.
  • You cannot pay any consideration to the buyer to get the property back unless the reacquisition and payment of the additional consideration was provided for in the original sales contract or the buyer has defaulted or default is imminent.

What If the Section 1038 Rules Don’t Apply?

If all the preceding conditions are not met, you can’t use the taxpayer-friendly Section 1038 rules to calculate the taxable repossession gain and the post-repossession tax basis of the property. Instead the repossession gain (or loss) must be calculated using the “regular” tax rules (those that apply in the absence of the special Section 1038 rules).

Under the regular rules, the repossession gain (loss) equals the fair market value (FMV) of the property on the repossession date minus the basis of the installment note receivable at the time of the repossession minus any repossession costs (see the example below for how to figure the note’s basis). In many cases following the regular rules will result in a significantlylarger taxable repossession gain, which is why the Section 1038 rules are described as taxpayer-friendly. Finally, under the regular rules, the basis of the repossessed property equals its FMV on the repossession date.

Example: You sold a commercial building and underlying land on March 1, 2012 for $1.2 million. On that date, you received a $100,000 cash down payment and a $1.1 million installment note receivable that charged adequate interest according to IRS rules. The note called for annual principal payments of $40,000 to be paid for five years (2011-2015). On March 1, 2017, the remaining principal balance of $900,000 ($1.1 million minus $200,000 in principal payments) is scheduled to come due. (In other words, this was a balloon payment installment.)

You only received four $40,000 principal payments (in 2012 to 2015) before the buyer ran out of cash and stopped paying.

Assume your tax basis in the property at the time of the ill-fated seller-financed installment sale deal was $800,000. Therefore, your installment sale gross profit percentage was 33.333 percent ($400,000 gross profit/$1.2 million sale price). On December 1, 2016, you successfully repossess the property after incurring $24,000 in legal fees and related costs.

Your repossession gain and post-repossession basis in the property are calculated as follows:

Repossession Gain Calculation

Down payment ($100,000) and interim principal payments ($160,000) received: $260,000
Gain already reported ($260,000 times 33.333 percent) $ 86,667
Taxable repossession gain (line 1 minus line 2) $173,333

Repossessed Property Basis Calculation

Face value of installment note receivable on repossession date ($1.1 million minus $160,000 interim principal payments received) $940,000
Uncollected gross profit ($940,000 times 33.333 percent) $313,333
Adjusted basis of note (line 1 minus line 2) $626,667
Taxable repossession gain (see above calculation) $173,333
Repossession costs $ 24,000
Basis of repossessed property (line 3 plus line 4 plus line 5) $824,000

Bottom Line: After the repossession, you’re basically back in the same position as before the installment sale except:

1. You received $260,000 in cash from the down payment and the interim installment note principal payments (all of which you must report as taxable gain).

2. You incurred $24,000 in repossession costs (which are added to the basis of the repossessed property). You must report the $173,333 repossession gain on your 2016 tax return.

Conclusion

While the Section 1038 rules are fair, you might initially be surprised to discover that you have a taxable gain upon repossessing investment real estate after an ill-fated seller-financed installment sale deal. However, taxable repossession gains will often be larger in circumstances when the favorable Section 1038 rules do not apply. Consult with your attorney and tax adviser for details on the tax implications of real estate repossession transactions.

 

For assistance with residential, commercial and industrial property types call 214-696-1922 and ask for Mark Patten.
McKinnon Patten & Associates is a Dallas CPA firm that provides services for real estate industry companies. Our clients include real estate investors and real estate operators.

The National Jump In House Values and the Power of Home Improvements to Offset Capital Gains Taxes

Dallas-Fort Worth Home Real Estate Has Seen Dramatic Value Increases

asdfadsfHouse values continue to rise in the low interest rate, post-recession economy. Homeowners are experiencing this increase not only in East and West coast cities like New York, Los Angeles, Boston, and San Diego, but here in Dallas-Fort Worth as well.

In fact, according to Allie Beth Allman & Associates’ Weekly ALLMANAC for June 12, 2015, North Texas home prices jumped 14 percent in May 2015—one of the largest yearly gains on record. According to the local real estate leader, home prices in the Dallas-Fort Worth area have seen a more than 40 percent increase in the last five years. National surveys show that DFW has the largest annual price gains in the United States, rising about three times the long term average rate of residential appreciation for the area.

Partially offsetting the increase in home values, however, is one of the tax code’s best tax breaks, the home-sale exclusion. Through the tax code, the U.S. recognizes the importance of home ownership by allowing a homeowner to exclude up to $250,000 of his or her capital gain from taxation.  For married couples filing jointly, the exclusion is $500,000.  However, as home values continue to rise, capital gains on sales exceeding the exclusion amounts may result in hefty and unexpected federal taxes up to 23.8 percent.

Sizing the issue prompts the question: how many homes in DFW would be subject to tax if sold today? Zillow estimates that 1.2 percent of DFW homes currently owned by single homeowners would be subject to federal taxes for real estate gains of more than $250,000; and that 0.3 percent of homes owned by married homeowners would be subject to federal taxes for more than $500,000 in real estate gains. The percentages of homes sitting on taxable gains in DFW are not as acute as those in some parts of the country. In San Francisco, for instance, a quarter of all homes already have unrealized gains of more than $250.000. Similarly, in San Jose, California, more than one-third of the homes have a gain of more than $250,000.

In ten years, assuming a 3.5% annual increase in home values, zillow.com projects that the number of DFW homes that surpass the tax shield threshold will rise to 10.5 percent for single homeowners and 2.1 percent for married homeowners.  Again, the numbers are more dramatic in other regions of the country, particularly for coastal cities, where based on Zillow’s projection, 77.2 percent of the individually owned homes in San Francisco will see a tax bill. In San Jose, it’s 86.6 percent of homes.

As real estate prices climb, so could the percentage of homes subject to taxable gains. Conversely, the numbers could drop, if, according to Zillow, homeowners did not move houses or make home improvements during that period. Zillow’s projection also assumes there is no change to the $250,000 and $500,000 home sale tax exclusion during this ten year period.

As a rule of thumb, if you’ve owned a house long enough in a neighborhood with steadily increasing values—say in the Park Cities—you could have a taxable gain on the sale of your house.

Home Improvement Receipts to the Rescue

These increases in real estate value could certainly decrease individual’s projected income from selling their home; it could particularly affect those who plan to use that money to finance their retirement. But homeowners have a secret weapon – receipts for home improvements. The costs of home improvements count against the gains, sometimes as much as six figures for just one home remodeling project.

By way of background, IRS Publication 523 details the tax rules applicable to selling your home.  Generally, the gain on sale is calculated as the sales price less any fees and closing costs, less improvements, and less the home’s original purchase price. The tax rules for home sales can be complex, for example, although home owners normally don’t pay any capital gains taxes on amounts below the home-sale exclusion amounts, you must be living in the house for two of the five years before the sale in order to waive taxes if you are below the $250,000/$500,000 cut-offs.

Home improvement projects that can be deducted from capital gains above the $250,000/$500,000 limits include decks and patios, landscaping (including sprinkler systems), pools, new roof or siding, kitchen remodeling, insulation, installation of utility services such as fiber charges (bundled internet, telephone and television access). You can include any additional electrical outlets as well as legal, title, and recording fees from your home sale closing.

But here’s the home improvement caveat – repairs don’t count. Painting is maintenance, as is refinishing wood floors. If you install brand new wood floors, that is considered a home improvement. If you built your home from scratch, the purchase of the land, materials and fees paid to contractors all count as the original purchase price of your home. But if you did the project yourself, or cajoled friends to helping you, that doesn’t count.

Also, if you live in a condo or townhouse community with homeowners’ association fees, some of your monthly charges and special assessments may count. But again, you need receipts from the property management agent. In fact, you need receipts for every improvement you make, a fact that many homeowners aren’t told when it comes time to close the sale.

Like-Kind Exchanges Don’t Apply to Personal Residences

This is a good time to mention the like-kind exchange, as it applies only to investment and business properties and not to personal residences. The like-kind exchange provides an exception and allows you to postpone paying taxes on the gains from sales of real estate investment and business properties if you reinvest the proceeds into similar property.

IRS Publication 523 also has many carve-outs and exceptions, as well as exceptions to the exceptions, so it is best to consult a tax professional if you are: a member of the military, newly remarried couples who already own homes, people who moved due to job transfers, nursing home residents who kept the homes they used to live in, widows or widowers, people who rebuilt after a fire, flood or other natural catastrophe, and people who sold their homes before 1997 and then reinvested their capital gains into their current homes.

Also, if you acquired your home as a gift or an inheritance, if you used it as rental property at some point, or utilized it to run a business, you should check with a tax professional. If you received a first-time home buyer’s credit in 2008, you should also call your local tax professional.

Finally, there are a couple other points worth mentioning. A capital loss, such as from the stock market, can later be used to offset a large gain from a home sale.

Also, home sales in states where home values rose substantially, such as New York of California, is typically where people borrow money against their homes, spend it, thus depleting the equity. Then when they sell their homes and there’s a capital gain even after repaying the mortgage and the home equity loan, they find that there’s less money to keep because it has been eaten up by their tax bill.

Always keep in mind that house values could certainly elevate significantly in all parts of the country. So keeping abreast of home improvements and the federal taxes on capital gains is important no matter where you own a home.

Mckinnon Patten is an CPA firm with a full range of services, including providing comprehensive tax, accounting and advisory services to a full range of real estate entities and property types. If you have any questions, please contact us at 214-696-1922.