Tax 9930 Real Estate Taxation Chapter 3 (Fall 2024) PDF

Tax 9930 Real Estate Taxation Chapter 3 Baruch College Fall 2024  Financing Acquiring real estate is an expensive proposition. Tax rules can be complex. Our coverage will only provide a brief overview In addition to cash, property, or services that are...

Tax 9930 Real Estate Taxation Chapter 3 Baruch College Fall 2024  Financing Acquiring real estate is an expensive proposition. Tax rules can be complex. Our coverage will only provide a brief overview In addition to cash, property, or services that are exchanged, an acquisition often requires financing from banks or other third parties. Financing is commonly in the form of a basic mortgage: – Borrower holds title to the property – Lender has the right to foreclose on the property if the borrower fails to adhere to the terms of the loan agreement Financing may also involve a sales-leaseback or other leasing type arrangements.  Mortgage Financing Original basis includes the amount of any mortgage used to pay for the purchase Amount realized on the sale will include the amount of mortgage the seller pays back to the lender or is relieved of having to pay back (i.e. mortgage is assumed by the buyer). Basis is not affected if the owner either takes out a mortgage on existing property or refinances an existing mortgage. Loan proceeds do not constitute income as there is an obligation to repay the debt.  Mortgage Costs The borrower/mortgagor and lender/mortgagee often incur a variety of costs in connection with the mortgage loan: – Legal fees, appraisal costs, title searches, property surveys, commissions, etc. Borrower costs are not part of the cost of the property. They are considered capital expenditures that relate to the loan, and which are amortized on a straight-line basis over the life of the loan. Not entirely clear how to treat partial prepayments of the loan. Follow the rule in the text which presumes that if the prepayment shortens the term of the loan, the unamortized costs should be re-amortized over the new shorter period that remains on the loan.  Mortgage Costs If the loan is instead pre-paid in full, the unamortized costs are deductible at that time. The same rule applies if the property is sold or disposed of before the costs are fully amortized and the loan is transferred and assumed by the buyer. Unamortized loan costs incurred by a corporation are deductible when the corporation distributes assets to its shareholders in liquidation. – NOTE: The cases cited in the text involve complete liquidations but the rationale would seem to apply as well to a partial liquidation where the real estate subject to a mortgage was distributed to the shareholders but the corporation continued to operate. The corporate taxpayer “having shifted the burden of its mortgage to other shoulders”, stands in the same position as if he had paid it off and therefore should be allowed to deduct the remaining unamortized costs.” For an individual, the balance of unamortized loan costs may be deducted in the year of the individual’s death.  Mortgage Costs A lender who is involved in the business of regularly making loans, will usually deduct most costs associated with the loans. However, in two rulings, the IRS ruled that finders’ fees and buying commissions that are paid by banks to obtain an acceptable applicant for a mortgage are considered part of the loan acquisition costs and are amortized over the term of the loan. A lender who is NOT regularly involved in the business of making loans, should amortize costs associated with the loans.  Mortgage Costs In general, paying off a mortgage will have no tax consequences. When lenders charge a prepayment penalty for paying off a loan early, the prepayment penalty is treated as interest and the penalty is deductible if the interest would be deductible. Even when a loan is paid off with one lender and the borrower is charged a pre-payment penalty, and a new loan is secured from a different lender, the loans are considered independent, and the penalty is deductible in the year paid. However, if the original loan is refinanced and a fee paid to refinance the existing loan with the same lender, the fee will be required to be amortized. The lender who receives the prepayment penalty treats the payment as interest income.  Mortgage Costs A mortgage which is issued by the seller to the purchaser of real estate is called a purchase money mortgage (PMM). (Also often called owner or seller financing). If the PMM is subsequently reduced and the borrower is solvent, the reduction is treated as an adjustment in the purchase price rather than recognized as income as a discharge of debt. No income is recognized, the purchaser-borrower reduces its basis in the property and the seller-lender reduces its sales price. Only applies to PMM between the original purchaser and seller. It does not apply if either the debt or property has been transferred to a third party or the mortgage is held by someone other than the seller. There are special rules under IRC section 108(e) if the borrower is insolvent or bankrupt. See, Chapter 12.  Mortgage Costs Generally, a discharge of mortgage indebtedness that is not PMM, will require the borrower to recognize income to the extent of the discount, regardless of whether the fair market value of the property is greater than or less than the outstanding mortgage balance. – There are some cases that have held that the borrower does not recognize income but instead reduces the basis in the property if the mortgage is satisfied for less than the amount of the mortgage but for more than the fair market value of the property. – Note that the Second Circuit, has limited this rule to circumstances where the negotiations directly relate to the purchase price rather than the debt itself.  At-Risk Rules Rule is designed to limit the abuse of claiming tax losses through the use of tax shelters. Tax shelters often used nonrecourse financing to generate tax benefits beyond the amount of economic investment. Rule applies to most activities, including real estate investments. Losses in excess of the amount at risk may not be deducted. At-risk is defined as the amount of a taxpayer’s economic investment in an activity:  The amount of cash and adjusted basis of property contributed to the activity, and  Amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged as security property not used in the activity  At-Risk Rules At-risk amount does not include nonrecourse debt unless the activity involves real estate – For real estate activities, qualified nonrecourse financing is included in determining at-risk limitation Tax basis is generally not affected by the at-risk rules.  At-Risk Rules Taxpayers subject to the rules: – Individuals – Shareholders in S Corporations – Closely held corporations where one-half of the value is owned by 5 or fewer shareholders – Exceptions are made for certain C corporations actively involved in an active trade or business (other than certain specified activities). (Note there is a special rule for a corporation involved in equipment leasing) – The active trade or business exception for C corporations does not apply to personal holding companies and certain personal service corporations  At-Risk Rules Each activity is treated separately but may aggregate income and losses from otherwise separate activities if the activity is a trade or business, and: – The person claiming the loss actively participates in the management of the business – In a partnership or S Corporation, 65% or more of the losses go to partner/shareholders who actively participate in the management of the business – If a partnership or S Corporation is engaged in leasing equipment, all leasing activities are treated as a single activity Aggregation rules generally apply to the holding of real property.  At-Risk Rules The aggregation rules allow an individual who actively manages several partnerships, each engaged in a separate real estate business, to aggregate the activities and treat them as one activity for purposes of the at-risk rules.  At-Risk Rules At-risk limitation Can deduct losses from activity only to the extent taxpayer is at-risk Any losses disallowed due to at-risk limitation are carried forward until the at-risk amount is increased Previously allowed losses must be recaptured to the extent the at-risk amount is reduced below zero At-risk limitations must be computed for each activity of the taxpayer separately There is a special ordering rule for deductions that applies when losses exceed the amount at risk  At-Risk Rules If the activity generates income, the at-risk limitations do not apply (unless there are carryover losses from prior years) Previous losses allowed against amounts at risk must be recaptured if an amount previously at risk is no longer at risk (or is converted to a nonrecourse liability).  At-Risk Rules Increases to a taxpayer’s at-risk amount: o Cash and the adjusted basis of property contributed to the activity o Amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged as security property not used in the activity o Taxpayer’s share of amounts borrowed for use in the activity that are qualified nonrecourse financing (real estate) o Taxpayer’s share of the activity’s income  At-Risk Rules Decreases to a taxpayer’s at-risk amount: o Withdrawals from the activity o Taxpayer’s share of the activity’s deductible loss o Taxpayer’s share of any reductions of debt for which recourse against the taxpayer exists or for reductions of qualified nonrecourse debt (real estate)  At-Risk Rules Amounts borrowed from either a person who has an interest in the activity (other than as a creditor), or one who is related to the borrower are not included in the amount at risk. Loans guaranteed by a taxpayer are generally not included in the amount at-risk since the taxpayer is not personally liable for the debt. – The taxpayer retains legal rights to recover from the primary obligor. Only when the taxpayer no longer has any remaining rights against the primary obligor may the taxpayer increase the amount at risk.  At-Risk Rules The IRS retains authority to disregard arrangements designed to avoid the at-risk limitation rules. (E.g., converting recourse to nonrecourse debt). Proposed regulations focus on whether there is a valid business purpose for the arrangement and sets forth several other circumstances the IRS will consider. Recourse debt that may converted to nonrecourse debt will generally not be considered an amount at risk. – May be considered at risk if conversion is tied to a substantial economic event; the underlying property is of sufficient value to cover the debt; or substantial payments were due and paid upon conversion of the note.  Qualified Nonrecourse Financing Is considered at-risk for real estate if: – The borrowing is for the activity of holding real property which includes the holding of personal property and providing services that are incidental to the holding of real property. – Borrowing must be from a qualified person or a governmental instrumentality or guaranteed by the government. Qualified persons include those regularly engaged in the business of lending (banks, credit unions, etc.). Does not include those from which the taxpayer acquires the property (seller); or those who receive a fee from the investment (seller or promoter financing). – No person may be personally liable for the financing (except as provided in regulations). – The borrowing may not be convertible debt.  Interest The technical tax definition for interest is compensation for the use or forbearance of money. – The cost paid for use of another person’s money.  Interest Income & Expense Interest received by a lender is taxable income. – Mortgage, note, bond, bank account, etc. Reported in the year received by a cash basis taxpayer or in the year earned by an accrual basis taxpayer. – Prepaid interest is taxable upon receipt. The deductibility of interest expense is often limited or denied by various tax law provisions. Must generally be paid on indebtedness of the taxpayer. Deducted in the year paid by a cash basis taxpayer or ratably over the term of the loan for an accrual basis taxpayer. – An accrual basis taxpayer is placed on the cash basis if the loan is from a related cash basis person.  Prepaid Interest Generally allocated and deductible over the term of the loan and to the period to which the use of money occurs and the interest cost of using borrowed funds for both a cash basis and accrual basis taxpayer. Points are additional interest when a loan is closed. Often used to reduce the interest rate charged by the lender. – Treated as prepaid interest and deductible over the term of the loan unless for services provided by the lender. – May be immediately deducted if used for the purchase or improvement of the taxpayer’s principal residence (but not for refinancing).  Investment Interest Investment interest definition: Interest on loans whose proceeds are used to purchase investment property (stock, bonds, land, etc.) Deduction for investment interest expense is limited for non-corporate taxpayers to the lesser of the investment interest paid or net investment income Net investment income: Investment income less investment expenses allowed as deductions.  Investment Interest Investment income: Gross income from interest, certain dividends, annuities, and royalties not derived from a trade or business Net capital gains and qualified dividends are treated as investment income only if elected – Amount elected as investment income is not eligible for the preferential rates that otherwise apply to net capital gain and qualifying dividends Income and interest on debt attributable to rental real estate activities do not enter into the computation of the investment interest limitation. – May instead be limited under the passive loss rules.  Investment Interest Investment expenses: o All expenses directly related to investment income that are allowed as a deduction o Investment expenses do not include interest expense and any expenses that are miscellaneous itemized deductions from 2018 through 2025 (not deductible) Investment interest disallowed in current year due to limitation is carried forward to future years until ultimately used o Deductibility is subject to net investment income limitation in carryover years  Investment Interest If a taxpayer actively participates in rental real estate activity under the passive activity rules, interest is not subject to the investment interest rules. – Real estate activity constituting a passive activity are limited under the passive activity rules and not the investment interest rules Treatment of vacant land is subject to the facts & circumstances in acquiring and holding the land. If held for investment, interest will be subject to the investment interest rules.  Tracing Debt Proceeds Due to limitations and restrictions on the deductibility of interest, interest expense needs to be classified into various categories. Interest on debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. The allocation is not limited by the type of property used to secure the debt (other than a qualified residence). Any debt proceeds a non-corporate taxpayer receives in cash is allocated to personal expenditures. – But, a cash expenditure made within 15 days of receiving the cash may be treated as made on the date the cash was received.  Tracing Debt Proceeds Deposits made to an account are treated as an investment expenditure even if the account does not earn interest. The debt is reallocated as withdrawals are made for other expenditures. There is an ordering rule when proceeds from multiple loans are in the same account. The rule generally treats withdrawals as coming first from debt proceeds in the account, with expenditures generally treated as coming from debt on a FIFO basis. – Taxpayer may always use the 15-day rule to treat an expenditure as coming from deposited debt proceeds.  Tracing Debt Proceeds There is also an ordering repayment rule when debt is repaid and when debt proceeds have been allocated to more than one expenditure. – The debt is treated as repaid first for amounts allocated to personal expenditures. Special rules apply when the debt is refinanced, or where debt is allocated to an asset which is disposed, and the proceeds are used for another expenditure.  Business Interest After 2017, interest paid or accrued on debt incurred in a trade or business is limited to the sum of business interest income; 30% of adjusted taxable income (ATI); and floor plan financing interest (car dealers). ATI is regular taxable income without regard to any item (income, gain/loss, deduction) not allocable to a trade or business, business interest or business interest income; the amount of any NOL deduction; the 20% QBI deduction; and some other adjustments. – For taxable years beginning before 2022, deductions for depreciation, amortization, or depletion are not taken into account in calculating ATI. The limit was increased to 50% of adjusted taxable income for 2019 and 2020. The 50% ATI limitation does not apply to partnerships for 2019.  Business Interest Regulations are very extensive and provide that any business interest that is limited may be carried forward indefinitely and treated as business interest in future years. Section 163(j) thus permits floor plan financing interest to be fully deductible while effectively limiting the deduction for net interest expense (after floor plan financing interest) to 30% of adjusted taxable income.  Business Interest An exception to the limitation is made for farming or real property trades or businesses for years in which an election is made and for all subsequent years. – Must use the alternative depreciation system (ADS) for certain property which provides for a longer useful life. The limitation also does not apply to small businesses that meet the $25 million gross receipts test – average annual gross receipts for the prior three tax years not exceeding $25 million (indexed for inflation). Any interest that is disallowed under the limitation is carried forward indefinitely and treated as business interest in the subsequent tax year.  Below Market Loans Will generally occur outside of a normal lending arrangement with an independent third party. Loan is recharacterized as an arm’s length loan. Interest is imputed, using Federal government rates, when a loan does not carry a market rate of interest Imputed interest = The difference between the amount that would have been charged at the Federal rate and the amount actually charged Applies to: Gift loans Compensation-related loans Corporation-shareholder loans  Below Market Loans The table below presents the effect of certain below- market loans on the lender and borrower  Below Market Loans Gift loans Exemption for loans of $10,000 or less between individuals If gift loan proceeds are used to purchase income- producing property, the following limitation applies: On loans of $100,000 or less between individuals Imputed interest is limited to borrower’s net investment income for year No imputed interest if net investment income is $1,000 or less Will only apply if one of the principal purposes for the loan is not tax avoidance  Below Market Loans If the gift loan is payable on demand, then the amount of foregone interest is treated as a gift by the lender to the borrower and borrower receives a gift. (A new gift is made every year). If the gift loan is instead payable over a period of time (term loan), the lender is treated as having made a gift on the date the loan is made. – The amount of the gift is equal to the difference between the amount loaned and the present value of all required payments using the federal rates. – Results in one gift being made at the time of the loan. – The borrower is still treated as making interest payments over the term of the loan.  Below Market Loans A $10,000 exemption also applies to compensation-related and corporation- shareholder loans No exemption if principal purpose of loan is tax avoidance Makes practically all loans of this type suspect Interest expense imputed to borrower may be deductible  Below Market Loans If the compensation-related loan is payable on demand, then the amount of foregone interest is treated as interest income by the lender and deductible compensation by the lender to the borrower. The borrower receives taxable compensation. If the loan is instead payable over a period of time (term loan), the borrower is treated as receiving taxable compensation equal to the difference between the amount loaned and the present value of all required payments using the federal rates. The lender is treated as having made a compensation payment on the date the loan is made. – The borrower is still treated as making interest payments over the term of the loan and the lender treated as receiving interest payments over the term of the loan.  Below Market Loans Below market loans between corporations and shareholders follow the same rules as compensation- related loans except the forgone interest is treated as a dividend instead of compensation. (Note: A corporation may not generally deduct a dividend). A similar rule applies on an installment or deferred payment sale of real estate. – Designed to prevent taxpayers from converting ordinary income into capital gain income (taxed at a lower rate) by not charging interest on a sale and instead charging a higher sales price which would compensate seller for interest the seller would receive.  Sale-Leaseback Leasing transactions serve as a substitute for traditional financing. In a typical sale-leaseback, the owner of real property sells the property and immediately leases it back from the buyer usually on a long-term net lease (lessee/seller pays part or all of the taxes, insurance, and maintenance costs plus rent). The buyer may finance the purchase through a mortgage. Seller retains use of the property and buyer is provided with a guaranteed rate of return.  Sale-Leaseback At the end of the lease, the buyer owns the property and may need to negotiate a new lease. Assuming the sale-leaseback is treated as a sale and lease for tax purposes, the seller will recognize a gain or loss on the sale and deduct the full amount of rent payments. The purchaser has rental income which is offset by expenses and depreciation. The seller may have greater deductions for rent expense than depreciation and interest especially if the property has already been fully depreciated or is leased for less than its useful life.  Sale-Leaseback The transaction must be treated as a sale and leaseback rather than a financing transaction to obtain the tax benefits. If treated as a financing transaction (secured loan) the seller could not deduct the lease payments and payments would be treated as payments on a loan. Seller could claim depreciation as the owner. Buyer would be the mortgagee and could not claim depreciation or other deductions. May require extensive financial projections to determine if there will be a benefit to the parties.  Sale-Leaseback Often difficult to determine whether a transaction should be treated as a sale-leaseback or a financing arrangement. The Supreme Court has found the following to constitute a sale-leaseback: – A genuine multiparty transaction (financing was obtained from an outside source) with economic substance: – The sale-leaseback was encouraged by business or regulatory considerations and not merely for tax avoidance; and – The lessor retained significant and genuine attributes of the traditional lessor status. If the buyer did not obtain outside financing and the seller retained a repurchase option, transaction would probably be treated as a financing arrangement.