Tax 9930 Real Estate Taxation Chapter 7 Baruch College Fall 2024 PDF

Tax 9930 Real Estate Taxation Chapter 7 Baruch College Fall 2024 Operating Expenses and Taxes Income tax is imposed on taxable income after allowable deductions. Common deductions in real estate include depreciation and interest expense. Allowable tax deductions are often li...

Tax 9930 Real Estate Taxation Chapter 7 Baruch College Fall 2024 Operating Expenses and Taxes Income tax is imposed on taxable income after allowable deductions. Common deductions in real estate include depreciation and interest expense. Allowable tax deductions are often limited. Common examples in the real estate industry include the application of the at-risk rules and limitations on passive activity losses. (Covered later in the semester). Taxpayer must use a consistent method of accounting and a specific accounting period.  Accounting Period An annual accounting period is used to compute taxable income. Most taxpayers use a calendar year tax accounting period, but some use a fiscal year. Some use a 52/53 week-year which is typically used by taxpayers in industries where the books are closed on a particular day of the week. Year is selected by a taxpayer on its first return. Use of a fiscal year is limited.  Accounting Period Generally, partnerships, S Corporations and personal service corporations have the same year as their owners unless a business purpose can be shown. IRS has issued procedures for corporations, partnerships, S Corporations and personal service corporations for the IRS to approve changes to tax years. The procedures also set forth a test to determine a “natural business year” that automatically establishes a business purpose for a fiscal year. IRS ruling also provides examples of factors used by IRS to determine whether a business purpose exists.  Accounting Period Partnerships Partnerships would often adopt a fiscal year which allowed partners to defer the reporting of income. This deferral is now prohibited by requiring a partnership to conform its tax year to that of its partners, unless there is a business purpose for a different tax year. Must use: – Same tax year as the majority partners (50%+ owners) – Individuals are almost always on a calendar year – If there is no combination of majority partners with the same tax year, must conform to tax year of principal partners – i.e. all partners with a 5% or more interest in profits and capital.  Accounting Period If the partnership can still not determine a tax year based upon the majority or principal partners, it must choose a tax year that results in the least aggregate deferral of income to the partners. Once the partnership’s tax year is fixed by the conformity rules or business purpose, the partners cannot change their tax years to a year other than that used by partnership unless a business purpose is established. Approval from the IRS Commissioner is also required.  Accounting Period S Corporations Must use a permitted year which is defined as one ending on December 31, or a year for an established business purpose. The tax year of the shareholders is not considered. Personal Service Corporation A C Corporation with a principal activity of providing services that are substantially performed by employee-owners who own more than 10% of the FMV of outstanding stock in the corporation. Must use the calendar year or a year for an established business purpose.  Accounting Period Partnerships, S Corporations and personal service corporations that have a required tax year as discussed, may elect to use a year other than their required year. Will need to file an election under section 444 and make either a required payment (partnerships, S corporations) or make minimum distributions to owner-employees (personal service corporations).  Accounting Period The entity must meet three conditions – Must not be a member of a tiered structure (de minimis exception is basically made for tiered structures consisting only of partnerships and S Corps (or both) which have the same taxable year) – Did not previously have an election under section 444 to use a year other than their required year – The elected tax year results in a deferral period of 3 months or less. Note: For a change in tax year, an election may be made only if the deferral period of the taxable year elected is not longer than the shorter of (A) 3 months, or (B) the deferral period of the taxable year which is being changed.  Accounting Period For partnerships and S corps making the section 444 election, a required payment is made that is intended to represent the value of any tax deferral that the owners of the partnership or S Corp receive. Payment is due by May 15 in the calendar year following the calendar year in which the elected tax year begins. A worksheet must be included when payment is made. Payment is waived if it is $500 or less.  Accounting Period A personal service corporation (PSC) that makes the election will be subject to deduction limitations under section 280H. No payments are required. Designed to eliminate the benefit of a tax deferral. Limits deductions for amounts paid to employee- owners unless certain minimum distributions are made to employee-owners before the end of the calendar year.  Accounting Period The election under section 444 is terminated if the entity: – Changes to its required tax year – Liquidates – Willfully fails to make the required payment or follow the minimum distribution requirements – Becomes a member a of tiered structure – An S Corp election is terminated (exception for S Corp that becomes a PSC) – PSC ceases to be a PSC  Accounting Method A taxpayers accounting method must clearly reflect income. Most common methods are the cash and accrual methods. Use of the installment method is often used as well. Use of hybrid methods are authorized by regulations. Many specific items of income or expense are subject to special rules. See, examples in text at ¶ 701.02.  Accounting Method Cash method requires income to be reported when actually or constructively received. May be in the form of cash, cash equivalents, property or services. Income must be reported under the doctrine of constructive receipt – when income is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available to the taxpayer. – E.g., taxpayer is on the calendar year basis and is given a check on December 31 but fails to deposit the check until January 2. Deductions are taken for the year actually paid. Used by most individuals and is easier to control the timing of income of deductions. There are some limitations.  Accounting Method Certain taxpayers may not use the cash method: – C Corporations – Partnerships with at least one C Corp as a partner – Tax Shelters (broadly defined) A small business taxpayer may use the cash method if its average annual gross receipts for the prior three-year period (or less if not in existence for three years) does not exceed $25 million. Includes: – C Corporations, and – Partnerships with at least one C Corp as a partner – But NOT a tax shelter Exceptions are also made to these limitations for farmers and ranchers and qualified PSCs.  Accounting Method Accrual method of accounting reports income when it is earned, whether or not the income has been actually or constructively received. Deductions are generally taken in the year incurred, whether, or not the deductions have been paid. The accrual method requires that deductions meet the all events test. – All events have occurred which determines the fact of liability, and – The amount of such liability may be determined with reasonable accuracy. The all events test Is not met until economic performance with respect to the item has occurred.  Accounting Method If the liability requires payment for property or services provided to; or the use of property by; an accrual method taxpayer, economic performance occurs when the property or services are provided; or the property is used. If the liability requires payment for property or services provided by an accrual method taxpayer, economic performance occurs when the property or services are provided by the taxpayer.  Accounting Method There is an exception to the economic performance rules for certain recurring items: – The all-events test is otherwise met – Economic performance occurs within a reasonable time, but not more than 8 ½ months after the close of the tax year – Item is recurring and similar items are treated as incurred in the year in which the all events test is met (without regard to economic performance) – Recurring item is not material, or the deduction better matches income and expenses  Accounting Method Similar to deductions, income under the accrual method is met if all the events have occurred which fixes the right to receive income and the amount can be determined with reasonable accuracy. After 2017, the all-events test for any item of income cannot be treated as met any later than when the item is included in revenue for financial statement purposes. – Exceptions are made for taxpayers without an applicable financial statement  Accounting Method An advance payment is basically a payment received for goods or services prior to required delivery of the goods or providing the services. – E.g., A dance studio on a calendar year basis receives full payment of $1,200 ($50 per month) on December 1, 2020, from a customer. In return the studio agrees to provide the customer monthly dance lessons for the period December 1, 2020, to November 30, 2022 (2 years). Advance payments have historically been included for tax purposes upon receipt Taxpayers may make an election to defer an advance payment for tax purposes Basically, under the election, the portion included in gross income for financial statement purposes must be included for tax purposes The balance that is deferred must be included no later than the year following the tax year in which it is received.  Accounting Method Exceptions are made for certain advance payments – notably for rents – which are included in income for the year of receipt regardless of the period covered or the method of accounting employed by the taxpayer. Taxpayer may elect to accrue real property taxes over the period of time to which it relates. – It election is not made, taxes accrue on the date when the tax becomes a lien on the property, when personal liability for the tax arises, or any appropriate basis based upon the situation.  Accounting Method Long Term Construction Contracts are contracts that cannot be completed within one year. Taxpayer must use the percentage of completion method of accounting. – Income is included based upon the gross contract price that corresponds to the percentage of the entire contract that has been completed during the tax year.  Accounting Method The determination of the percentage of completion of a contract generally may be made in either of the following ways: – by comparing, as of the end of the taxable year, the costs incurred with respect to the contract with the estimated total contract costs, or – by comparing, as of the end of the taxable year, the work performed on the contract with the estimated total work to be performed. Under the percentage of completion method, the indicated profit under the contract is accrued ratably according to the percentage of completion during the taxable year of the entire work under the contract.  Accounting Method Exceptions are made for small and home construction contracts. A small construction contract is one expected to be completed within a 2-year period and is performed by a TP whose average annual gross receipts do not exceed $25 million ($10 million for tax years before 2018). A home construction contract is a contract where 80% or more of the estimated contract costs are reasonably attributed to: (1) the building,, reconstruction or rehabilitation of dwelling units contained in buildings comprising 4 or fewer dwelling units, and (2) improvements related to such dwelling units and located on the site of such units.  Timing of Income and Deductions Taxpayers can often control the timing of income and deductions to achieve a desired tax result. – Cash basis taxpayers will generally have greater control than an accrual basis taxpayer Will usually seek to defer income and accelerate deductions – but not always! Refer to ¶ 701.03 for some common examples.  Related Party Transactions Transactions between related parties to create tax deductions or losses are not deductible. – Often used when different methods of accounting are used Losses on sales or exchanges are disallowed. – The basis of property to the transferee will be its cost (sales price) – Transferor receives no benefit from the disallowed loss  Related Party Transactions In the event, the original transferee later sells or disposes of the property at a gain, the amount of gain is reduced by the loss previously disallowed. – Applies only to original transferee to the property received from the related party or property received in exchange for that property in a tax-free exchange  Related Party Transactions For expenses or interest owed by an accrual method taxpayer to a cash basis taxpayer, the amount may be deducted when the related taxpayer is required to include the amount in income. (Matching) There are some additional rules for transactions between partners and partnerships and S Corps. and shareholders.  Related Parties List of common related parties (not exclusive): – Members of a family (siblings, spouse, ancestors and lineal descendants) – Individual and corporation if individual owns 50% or more in value of the outstanding stock – Two corporations that are members of the same controlled group (basically more than 50% ownership of one or more chains of corporations connected through stock ownership) – A corporation and a partnership if the same persons own more than 50 percent in value of the outstanding stock of the corporation, and more than 50 percent of the capital interest, or the profits interest, in the partnership; – An S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation; – An S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation. Constructive stock and partnership ownership rules apply as well as special rules for partnerships and S Corps.  Start-up Expenses Similar to the rule for organization costs. Start-up expenses would not be currently deductible and are capitalized Can elect to deduct up to $5,000 in start-up expenses in year business begins – reduced by the amount total expenses that exceed $50,000. The balance is amortized over 15 years. Election must be made on the tax return for year business begins. IRS will not allow any amortization if any election is not made or made for the wrong year  Start-up Expenses Costs incurred to investigate the creation or acquisition of an active trade or business are start-up expenses. These costs are typically incurred prior to making a final decision to acquire or create the business. May include market analysis, engineering and architectural surveys, and legal and accounting services. Typically, will not apply to acquisition of a bond, common stock, preferred stock, or limited partnership interest which are considered investments. (May apply if a stock acquisition is in substance an acquisition of the business – i.e. liquidated) Note: If the taxpayer is not in a business that is in the same or similar line of business as the one being investigated and does not acquire the business, the investigatory expenses are non-deductible.  Start-up Expenses Also, may include pre-opening expenses….but The IRS has however held that such expenses may be deductible under Section 162 as ordinary and necessary business expenses. – The opening of new stores is a part of the retailer's long-term expansion plans. The new stores are operationally indistinguishable from one another and from the retailer's other existing stores. Opening a new store takes only a brief period of time and the expenses are similar to those for operating established stores. Start-up expenses must relate to an active trade or business. Rental activities must include significant furnishing of services incident to rent to be an active trade or business. But, legislative history indicates that operation of residential or commercial rental property would be considered an active trade or business.  Real Estate Operating Expenses Operating expenses for a trade or business are normally deductible under section 162 as an “ordinary and necessary expense”. Even if an activity (such as holding real property) does not rise to the level of a trade or business, ordinary and necessary expenses are deductible under 212 for the management, conservation, or maintenance of property held for the production of income – Does not necessarily require the property to produce current income – Broadly applied but is limited based upon a facts and circumstances test. – Focus seems to be on profit-motive  Repairs Cost of repairing or maintaining real property is deductible under either section 162 or 212…if not otherwise required to be capitalized. Expenditures beyond incidental repairs that keep the property in ordinary efficient condition, that instead add to the value or prolong its life are not deductible. Supreme Court has focused on costs incurred in the original construction or subsequent enlargement and improvement. – Also, whether the expenditure generates significant long-term benefits beyond the taxable year. Addressed by the IRS in the repair regulations (effective as of 1/1/2014 but may be applied for 2012; also temp regulations may be applied to the 2012 & 2013 years).  Repair or Improvement Expenditures paid for a new building (purchase or construction) or for permanent improvements or betterments that instead add to the value of property or prolong its life or restore property or in making good the exhaustion of property for which an allowance (depreciation) has been made; are not deductible. Historically, the IRS has been aggressive in this area. Repair regs provide guidelines in this area. Improving a “unit of property” must be capitalized if: – Results in betterment of property – Restores the unit – Adapts the unit of property to a new or different use Focus for this class is on the safe harbor rules of the repair regulations  De Minimis Safe Harbor May elect not to capitalize tangible property with a limited cost under the section 263 repair regulations – But may still require to be capitalized under the section 263A uniform capitalization rules. (i.e. property produced or acquired for resale). TP with an audited financial statement (AFS) may elect to deduct up to $5,000 per item. TP without an AFS may only elect to deduct up to $2,500 per item. De minimis expensing may be elected by a TP with an AFS if: – Written accounting procedures treat amounts paid for property that cost less than a specified dollar amount (may be up to $5,000), or with a useful life of less than 12 months as an expense for non-tax purposes; and – Amounts are treated as an AFS expense  De Minimis Safe Harbor TP without an AFS do not need written accounting procedures but amount must be expensed on its books and records in accordance with its accounting procedures An AFS is a financial statement filed with SEC, a certified audited financial statement used for a substantial non-tax purpose, or required to be filed with federal or state government (other than SEC or IRS)  Small Taxpayer Safe Harbor TP with average annual gross receipts for the three preceding tax years of $10M or less May elect to deduct amounts paid during the year for repairs maintenance, improvements for a building if the total paid does not exceed the lesser of: – 2% of the unadjusted basis of the building; or – $10,000 Applies to the entire building or a part of the building that is a separate unit of property, and that has an unadjusted basis or $1 million or less. If total amounts exceed the limitations, the safe harbor is not available for that property. (Includes amounts not capitalized under de minimis safe harbor election).  Small Taxpayer Safe Harbor The unadjusted basis will generally be its cost, not reduced by depreciation or other amounts treated as an expense (such as a section 179 deduction). Leased property uses the total amount of rent (not discounted) that is expected to be paid over the term of the lease. (May include renewal periods of the lease if there is a reasonable expectation of renewal. (Regs provide a list of factors).  Routine Building Maintenance Routine maintenance is currently deductible. – Recurring expenditures to keep the building structure or systems in efficient operating condition – Considered routine if activities are reasonably expected to be performed more than once during a ten-year period (beginning when the property is place in service) – Does not have to be actually performed a second time during ten-year period – Factors considered include recurring nature of activity, industry practice, manufacturer’s recommendations, taxpayer experience with similar or identical property Examples include inspection, cleaning, testing of systems, replacement of damaged or worn parts  Election to Capitalize Routine maintenance or repairs may be capitalized if elected and if: – Incurred in a trade or business, and – Amounts are treated as capital expenditures on its books and records Election applies to all expenditures treated as capital on the taxpayer’s books and records  Pre-Repair Regs Repair regs do not set forth a clear and bright-line test May still need to use the particular facts and circumstance for expenditures based upon older court cases before the current repair regs. The case law is extensive.  Pre-Repair Regs Many repairs will add value to property, but the courts focus on whether the expenditure materially enhances the value, use, life, strength or capacity. Courts have also considered the size of an expenditure and whether the expenditure was forced on the property owner, although these factors have not generally been to be dispositive of the treatment. Expenditures to prolong the life of property, adapt the property to a new or different use, or as part of a plan of overall renovation are generally capitalized. The purpose of the expenditure will control with a focus on whether the expenditure added value to the property or resulted in a longer useful life.  Architectural Barriers The cost of removing architectural or transportation barriers to provide access to business facilities or public transportation vehicles by elderly and handicapped persons may be deductible, up to $15,000. Any excess over $15,000 is capitalized. TP must make an election and the removal must conform to standards set forth in the regulations.  Materials and Supplies Addressed by the repair regs and is effective for years after 1/1/2014 but may be applied for the 2012 or 2013 years. Cost may be expensed unless taxpayer maintains records of consumption or physical inventories. – Materials and supplies are deducted as consumed Special rule for rotable and temporary spare parts (allowed as deduction when part is disposed but there is an optional method). Materials & supplies are defined as tangible property that is consumed in a business that is not inventory.  Materials and Supplies In addition, materials and supplies is property that: – Is a component acquired to maintain, repair, or improve tangible property owned or leased by the taxpayer and that is not acquired as part of any single unit of tangible property – Consists of items that are reasonably expected to be consumed in 12 months or less (e.g., fuel, lubricants, water, etc.) – Is a unit of property that has a useful life of 12 months or less – Is a unit of property that has an acquisition or production cost of $200 or less (may be changed by the IRS in guidance) – Is otherwise identified in published guidance as materials and supplies (smallwares in the restaurant industry) A taxpayer may elect to treat as a capital expenditure the cost of materials and supplies.  Compensation Salaries and compensation paid for personal services is generally deductible Amounts must be reasonable and paid purely for services IRS scrutinizes reasonableness when the business and employee are related. IRS will look to comparable compensation in similar businesses. If excessive and paid to a shareholder, the excess Is not deductible and treated as a dividend. If paid to the seller/former owner, it may be treated as part of the sale. Generally, may otherwise be freely bargained, and includes salary, bonus, and vacation pay.  Reasonableness Typically, a question of fact. For corporate officers, the amount must be reasonable, bear a substantial relation to the services rendered and reflect true value. For children of a business owner, there may be certain tax savings by allowing a business to deduct amounts paid, while the child can earn up to his/her standard deduction without paying tax (or pay at a lower rate of tax). – Child must perform legitimate and useful services Spouses of a business owner do not usually present income tax savings but as an employee may be eligible to earn retirement benefits or fringe benefits.  Payroll Taxes Employing family members may have an added cost for social security taxes, medicare taxes (FICA) and unemployment taxes (FUTA). May provide an older member with sufficient earnings to be eligible for or increase social security benefits. (May also reduce benefit if member is already collecting social security). For an unincorporated business of a parent, employment of a child will be exempt from social security and FUTA taxes. A parent, employed in a child’s trade or business will be exempt from FUTA taxes.  Independent Contractors/Employees An employee is subject to payroll taxes and also income tax withholding and perhaps subject to coverage for worker’s compensation. An independent contractor is responsible for their own FICA and income taxes. IRS uses a common law test that focuses on control by the employer over the assignment of tasks and how tasks are assigned. Licensed real estate agents and direct salespersons are generally treated as independent contractors since compensation is determined by output (i.e., sales made). Will usually have a written contract.  Partners Payments to a partner for services will generally not be deductible as the payments will be made out of the partner’s pro rata distributive share. If services are provided not in the capacity of a partner (i.e. an outsider) the payments will be deductible. Basically, the partner is treated as an unrelated third party. A partner may however, receive guaranteed payments for either services or capital. The guaranteed payment is treated separately from the partner’s distributive share; is deductible by the partnership; and included by the partner in his or her gross income. Guaranteed payments are generally fixed in amount but may be based upon a percentage of a specific item of gross income (i.e. rents). Disguised Payment for Services Partnership may try to disguise a payment to a partner as a share of the partnership income rather than as compensation for services. Likely would happen when the compensation has to be capitalized (e.g., construction or organizational costs). The partnership would make a distribution payment to the partner thereby reducing the other partner’s share of income – providing the effect of a deduction to the other partners. If a partner provides services and receives a partnership allocation and distribution related to the performance of services, the transaction may be recharacterized as a transaction between the partnership and an outsider. Payment is treated as a payment to a non-partner and treated as made for services and if appropriate the partnership will capitalize the expenditure.  Commissions and Fees Usually deductible for services which produce a short- term benefit (e.g., broker and management fees). Will be capitalized if it provides a long-term benefit (e.g., fee for a long-term lease) Commissions for the acquisition of real estate are capitalized Selling commissions may be deducted by a real estate dealer. For a non-dealer, the commissions will offset the selling price.  Kickbacks Typically, illegal and not deductible May be deductible if ordinary and necessary, not illegal or not otherwise frustrate public policy against particular conduct. Insurance, Advertising and Legal Expenses Insurance is generally deductible but capitalized if paid for property under construction. If insurance coverage is beyond one year, a cash basis taxpayer must spread the deduction ratably over the period to which it relates. – One year coverage would be deductible in the year paid Advertising and legal expenses are generally deductible. Legal expenses to defend or perfect title are not deductible and considered additional costs to the land.  Real Estate Taxes Taxpayers may deduct state, local, foreign real property taxes; state and local personal property taxes; and either state and local income or sale taxes whether or not connected with a trade or business or held for investment. Individuals deduct these amounts as itemized deductions but are limited to $10,000. Taxes are fully deductible in carrying on a trade or business, or for the production of income even for an individual. Certain taxes are capitalized as part of the cost of the property or reduce the amount realized when imposed on either the acquisition or disposition of property (e.g., mortgage recording and transfer taxes).  Safe Harbors IRS has provided safe harbors for payments to charitable organizations in exchange for state or local tax credits. For a C corporation, the payment is deductible to the extent of any credit received. Excess may also be deductible. For a flow-through entity (partnership or S Corporation), the same rule will apply but only if that entity is subject to a state or local tax imposed on the entity.  Real Property Taxes The term “real property taxes” means taxes imposed on interests in real property and levied for the general public welfare, but it does not include taxes assessed against local benefits. Assessments, paid for local benefits such as street, sidewalk, city- created parking improvements, water main and sewer improvements, waste disposal system, and other like improvements, imposed because of and measured by some benefit inuring directly to the property against which the assessment is levied are not deductible as taxes. – Tax is limited to the property benefited and tends to increase value of property Assessments of a home-owners’ association or for sanitation services are not deductible as real property taxes.  Deduction of Real Property Taxes Real property taxes are deductible by the owner – not always the legal title owner but the equitable owner. Nominees are ignored. If a spouse files a separate return, the spouse may only deduct taxes they paid on property owned as joint tenants or tenants by the entirety. Taxes paid on a home owned by someone else is not deductible by the payor. (E.g., husband pays taxes on home owned by wife or son). Back taxes paid to redeem property that had been taken by the municipality are deductible if the taxpayer is personally liable.  Payments in Lieu of Taxes Government owned property does not pay taxes. Local governments then often impose a payment obligation on private developers who later become the owner. These equivalent payments are deductible as taxes if: – (1) payments are imposed at the same rate as property taxes – (2) payments are imposed by state law – (3) proceeds are used for a public purpose  Excess Business Losses If a non-corporate taxpayer has an “excess business loss” for the year, it is not allowed This provision is effective for tax years beginning after December 31, 2020, and before January 1, 2029. Any disallowed loss is carried forward and treated as part of the taxpayer’s net operating loss carryforward in subsequent years  Excess Business Losses An “excess business loss” is defined as: – The aggregate deductions for the year attributable to the taxpayer’s businesses – Less: The sum of aggregate gross income or gain of the taxpayer – Less: A threshold amount $500,000 for married taxpayers filing a joint return $250,000 for all other taxpayers (Amounts are indexed for inflation)  Excess Business Losses Aggregate deductions do not include and net operating loss deduction or losses from the sales or exchanges of capital assets Aggregate gross income does not include income or gains in performing services as an employee Gains from the sales or exchanges of capital assets in determining aggregate gross income may not exceed the lesser: – (1) capital gain net income from the trade or business, or, – (2) overall capital gain net income  Excess Business Losses Limits the amount of nonbusiness income that can be “sheltered” from tax as a result of business losses Applies to the aggregate gross income and deductions from all of a taxpayer’s trades or businesses If a married couple files a joint return, information from all of the couple’s trades or businesses must be consolidated The losses of one spouse can be used to offset the other spouse’s nonbusiness income (up to the $500,000 limit)  Excess Business Losses For partnerships or S corporations, the excess business loss limitation applies at the partner or shareholder level The excess business loss limitation is applied after the application of the passive loss rules