REAL ESTATE: Understanding Tax Impact of Real Estate Transactions

Marcia Geltman, CPA, PartnerGlenn Schwier, CPA, JD

June 21, 2016

www.nisivoccia.com1

INCOME TAX DEDUCTIONS

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Mortgage Interest ExpenseDeductible mortgage interest expense is limited if the value of the mortgage exceeds $1 million ($500,000 if married filing separately). This applies to acquisition mortgage interest. Refinancing debt up to the amount of the original mortgage is still considered acquisition debt. (effects mortgages acquired after 10/13/87.)

Interest on home equity loan is limited is the loan exceeds $100,000 , but not greater than the remaining FMV of the house.

Example: house value $400,000. Acquisition mortgage $375,000. Home equity mortgage $50,000. Interest deductible only on $25,000 of the home equity mortgage.

Home Office DeductionMust be a portion of your home or separate structure used exclusively for business on a regular basis:- The principal place of business- As a place to see patients, clients, or customers in the

normal course of business OR

- In connection with the taxpayer’s business if a separate structure, not attached to the home.

For employees, it must be for the convenience of the employer.

Deduction for Home Office(cannot exceed business net income)

Two methods:-Percentage of actual expenses, including depreciation. RE tax and mortgage interest are deducted first.

Or-Simplified method - $5 per square foot up to 300 square feet $1,500 deduction.(Unused expense due to net income limitation can be carried over to subsequent years.)

DepreciationWriting off the cost of an asset generally over its useful life. IRS provides guidelines. Assets not used in business cannot be depreciated for tax purposes. Examples:Real Property• Commercial buildings generally 39 years• Residential buildings 27.5 years• Land – no depreciation

(v. Personal Property – for example- office furniture, cell phones 7 years, carpeting 5 years (rentals) or 7 years)Assets used for business must be depreciated for tax purposes. If you choose not to claim the depreciation, the IRS will treat it as if you did when you go to sell the property. The cost will be reduced by depreciation allowed or allowable.

Depreciation

• If you receive the benefit of depreciation, you will have an impact upon selling the property.

• Depreciation lowers basis. • In addition, any gain is subject to tax at either

ordinary tax rates (personal property)or 25% (real property) up to amount of depreciation claimed.

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IMPORTANT TODEFINE REAL PROPERTY

Real Property Defined – IRS Code Section 1250 –defines real property as any property subject to depreciation except property as defined in IRC Section 1245.!?!

(In English – real property is generally buildings or its structural components)

Depreciation Surprise

• Depreciation Recapture– Taxpayer purchased rental property for $550,000– Property being depreciation over 27.5 years

($20,000 per year)– Sells property for 600,000 in year 15– Does he have a gain?

• Basis: $550,000 - $300,000 = $250,000• Gain: $600,000 - $250,000 = $350,000 • $250,000 taxed at 25%, $100,000 capital gains rate.

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SALE OF PROPERTY USED IN BUSINESS1231 SURPRISE TOO

• IRC 1231 property – sale of depreciable property

– If gain – capital gain (held > 1yr)– If loss - ordinary loss– Sell property for capital gain

• 1231(c) Prior year took ordinary loss– Look back 5 most recent tax years– Taxed at ordinary income rate to extent of pr yr ord losses– Capital gains rate 15%/20%– Ordinary up to 39.6%– Beyond period no recapture

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RENTAL PROPERTY

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Rental Property

• Passive Losses• Active Participation• Self Rental• Vacation Home• Real Estate Professional

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Rental – Passive Activity

• Rental – Per se passive activity

• Exceptions – examples Hilton Hotel, Hertz

– Tax impact of being rental property• Losses not deductible against ordinary income• Passive losses deductible against passive income• Passive losses carry over if unused• Passive losses “free up” when property sold

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Active Participation

• MAGI under $100,000 – Allowed to take rental loss against non-passive income– Up to $25,000– Phased out if income over $150,000– If active participant

• Participate in management decisions in bona fide sense– Exercise independent judgment

» Management company• No specific hours requirement• Flow thru entity• Net lease• Limited partners and own less than 10%

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Recharacterize• Self Rental

– Rents property or equipment to trade or business– In which they materially or significantly participate– Non-Passive Income– Passive Losses– STOPS

• Taxpayer from creating passive income to take against • Passive losses• Not subject to NIIT

– Less than 30% rental property subject to depreciation• Income non-passive

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Self-Rental

• Example– Doctor owns property in LLC– Rents property to medical practice– Rental income non-passive– Loss passive– IRS

• Heads we win• Tails you lose

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Suspended Losses

• Sale of passive activity treated as passive income– Offset by current and suspended losses of other

passive activities

• $25,000• Activity disposed of in qualifying disposition

– Single activity– Entire interest– Taxable transaction– Unrelated party

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NON-QUALIFIED DISPOSITIONS

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Non-Qualifed Dispositionand Installment Sale

• Transfer to corporation, partnership or LLC

• Gift, Divorce equitable distribution or Trust distribution– losses are added to the done/beneficiaries’ basis– not deductible by the taxpayer/donor

• Installment sale– Passive losses allowed in same ratio as gain is reported

• Death of owner– Suspended losses exceeds step-up in basis– 1040 - Final return deduction

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Not Passive Income

• Gains are not passive and should not be used to offset passive losses:

– Sale of land (whether leased or held for investment)

– Sale of self-rented property

– Sale of a building not used in a passive activity in the year of sale

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Net Investment IncomeRental income is considered passive and is therefore, subject to NII rules.

3.8% of investment income over total income threshold. • $250,000 MFJ• $200,000 Single• $125,000 MFS

Example: MFJ - $240,000 wages and $15,000 rental income.NII would be $5,000. NII tax would be $190.

VACATION HOMES

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Vacation HomesCan’t use it personally for more than 14 days. (This includes renting it at less than FRV) or more than 10% of the total time rented. If so, rental expenses are limited to rental income.

For allowed rental losses, the current deduction is limited to $25,000 and begins to phase out once your adjusted gross income is greater than $100,000. The loss is suspended until either there are profits or until the property is sold.

Special rule if you rent the property for less than 15 days. Can ignore the income but can’t deduct any related expenses.

Vacation Home

Mixed use– Rental expenses capped at rental income

• Mortgage interest, mortgage insurance premium, real estate taxes, casualty loss, direct expenses (commission, advertising)

• Operating expenses – utilities, insurance repairs and maintenance

• Depreciation last

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CANCELLATION OF DEBT

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Cancellation of Debt

• Debt forgiveness is income– Personally liable– Form 982

• Exceptions– Qualified principal residence indebtedness– Bankruptcy– Insolvency

» Immediately before cancellation» To extent insolvent only

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Debt Forgiveness

• Qualified Real Property Business Indebtedness– In connection with real property used in trade or

business– Secured by real property– Before 1993 or– Qualified acquisition indebtedness

• Debt incurred to refinance real property debt only to extent amount of debt does not exceed refinanced amount

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Two Transactions

• Cancellation of debt income

• Sale - Gain or loss

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Basis Reduction• Election

– Reduce basis property held beginning of following year– Order

• Trade/business property or held for investment– Depreciable real property– Depreciable personal property– Other depreciable property– Real property held primarily for sale to customers if taxpayer elects to

treat as depreciable property on Form 982• Basis reduced not below Zero

– Basis recapture• Later sells property at a gain

– Ordinary income or – 1250 property 25%

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Tax Attributes Reduction

• NOL• General business credit• Minimum tax credit

– Credits reduced 33 1/3%

• Capital loss• Basis• Passive activity loss and credit carryovers• Foreign tax credit

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Recourse

• Sale– Lender takes title by

• Foreclosure, deed in lieu or short sale

– Deemed sale price is lesser of• FMV of property at time of foreclosure• Amount of secured debt

• Cancellation of debt income– Debt exceeds FMV of property

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Nonrecourse Debt

• Lender – Default – Collateral only– No personal liability

• Abandonment

• Sale price equal to balance of nonrecourse loan

• No COD income

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Bankruptcy

• Bankruptcy– Recourse debt– Still have gain– Nonrecourse debt can be disadvantage

• Debt higher than fmv• Recourse lesser of fmv or debt

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Cancelled Debt

• 1099-C– Interest

• Included in Box 2 and 3• Interest non-deductible

– box 2 amount included in income

• Interest deductible– COD is box 2 less box 3

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Qualified Principal Residence Indebtedness

• Vacation home does not qualify• Qualify for mortgage interest deduction

– 2 million– Any debt incurred in acquiring, constructing, or substantially

improving – secured by the principal residence

• Combination – COD income

• Nonqualified debt first• Then qualified debt

• Sale– Basis

• Reduced if continues to own home• Sell in year debt cancelled• Principal residence exclusion

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Qualified Principal Residence Indebtedness

• Refinancing Problem– Any debt secured by the principal residence

resulting from the refinancing of debt incurred to acquire, construct, or substantially improve a principal residence

– but only to the extent that the amount does not exceed the amount of the refinanced indebtedness

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Debt forgiveness

• Forbearance– Payment missed– Plan to bring payments current– Not debt forgiveness – entire debt paid back

• Loan Modification– Terms modified– Significant modification to be COD

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LIKE KIND EXCHANGES

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Like Kind Exchange (1031 exchange)

IRS Code Section 1031 – if you trade like kind property, no gain or loss is generally recognized. The gain is postponed until the subsequent property is sold.

Ex: bought land for $10,000Worth $100,000. Trade it for another Piece of land worth $150,000. No gain currently recognized.Basis of new land would be $10,000.

Doesn’t have to be two party exchange. Use of qualified intermediaries allows individuals to sell to one party and purchase replacement property elsewhere.

What is so great about 1031 exchanges?

Definition of like kind property is very broad.

Real property for real property – can be unimproved for improved or reverse. ex: vacant land for rental property. • Non income producing property can be converted to income producing

property.

• One strip mall can be converted to several office buildings to provide diversification.

• Property held by 3 individuals as TIC can be converted to 3 separate pieces of property each owned individually.

Must follow 1031 rules• Must be business property or property held for investment. Cannot be a

vacation home.

• Exchange property must be identified within 45 days from when the transferred property is relinquished.

• The exchange must take place within 180 days from when the transferred property is relinquished. (or if earlier, the due date of the tax return for the year of transfer, including extensions)

• A qualified intermediary must hold the funds. The seller cannot be in receipt of the funds at any time.

Identification of property

Can identify up to 3 properties or any number of properties whose total value doesn’t exceed 200% of the FMV of the transferred property.

Boot

Any boot received does not qualify for deferral of gain. Boot is:

• cash or

• Debt relinquished in excess of debt assumed. Ex: property transferred had a mortgage of $100,000. Property acquired had a mortgage of $80,000. Therefore, $20,000 is considered boot and is taxable.

SALE OF PRINCIPAL RESIDENCE

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Sale of Principal Residence

• Eating, sleeping, and bathroom facilities– House– Townhome– Condominium– Houseboat– Motorhome– Co-op

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Principal Residence

• Facts and circumstances– Place of work– Where Family members reside– Address on driver’s license, voter’s registration,

auto registration, tax returns– Banks– Mailing address– Religious organization and clubs

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Sale of Principal Residence Exclusion

• Test– Ownership for at least 2 of last 5 years– Use – principal residence for at least 2 of last 5 years– One sale in two years

• Exclusion– $250,000 single– $500,000 married if

• Either spouse meets ownership test• Both spouses meet use test• Neither spouse ineligible sale within 2 years

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Surviving Spouse – Principal Residence Exclusion

• Surviving Spouse– $500,000 principal residence exclusion

• Final 1040 – year of death• IRC 121(b)(4)

– Sale within 2 years of death– At time of spouse’s death met use, ownership and one sale in

two years test

• Example– Deceased Spouse – owned house alone– Double dip – 500k exclusion and step up in basis

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Principal Residence Exclusion• Trust and Estate – no principal residence exclusion

– Grantor Trust exception• Revocable Trust• Defective Grantor Trust• IRC 671-679

• Foreign principal residence

• Ownership exceptions– Tacking holding period

• Divorced spouses – equitable distribution• Deceased spouse

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Principal Residence Exclusion• Use test exception

– Out of residence care• Physically or mental incapable of self-care• Used at least one year during normal 5 year period as principal

residence• Treated as using property as principal residence period in state

licensed facility– Nursing home

• Example – Year 1 buys home and moves in– Year 2 moves into nursing home– Year 10 sells home

• Qualifies for principal residence exclusion• Years 2-10 deemed using as principal residence

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Principal Residence Exclusion

• Use test exception– Divorced or separated

• Continued ownership• Spouse or former spouse continues to use property• Under divorce or separation agreement• Considered using property as principal residence for

exclusion

– Military relief• Suspended while under extended duty• Up to 10 years suspension period

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Saving Principal Residence Exclusion

• Use test - 2 out of 5 years – Moved to Florida– 2 years running out

• Sale to S Corp

• Related Party – Prevents losses– Not gains

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Reduced - Principal Residence Exclusion

• Change in place of employment• Health reasons• Unforeseen circumstances

– Factors• Proximate in time• Suitability• Financial ability• Not reasonably foreseeable

• Pro rata reduction53

Nonqualified Use• Post 2008

– Vacation homes and rentals– Nonqualified use then converted to principal residence– Principal residence exclusion reduced by period of nonqualified

use– Nonqualified use period/total ownership period

• Nonqualified use after use as principal residence –– Does not reduce exclusion

• Temporary absences excluded– Health, vacation, employment and unforeseen circumstances

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Principal Residence Sale -NIIT

• Excluded gain $250,000/500,000– Not subject Net Investment Income Tax (NIIT)

• Gain above Principal Residence Exclusion – Subject to NIIT

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Brilliant Idea - Conversion Principal Residence to Rental

property in order to claim loss!

Won’t work - Can only claim loss incurred while rental property.

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Conversion Principal Residence

• Personal loss – nondeductible

• Rental– Purchase price

– Adjusted basis

– Current fair market value

– Lesser of adjusted basis or Fair Market value at time of conversion

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Real Estate Part 2Tuesday, September 20, 2016

• Real Estate Professional• Foreign Seller• New Jersey Exit Tax• Realty Transfer Tax• Bulk Sale• QPRT• Estate Planning – transfers during lifetime

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Thank You

Thank you for participating in our seminar.

Please do not hesitate to contact us should you have any questions or need assistance.

Glenn Schwier, CPA, JDMarcia Geltman, CPA

Nisivoccia LLP59

The End(s)

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