Final Real Estate State of the Art Tax Planning Strategies

CCH® CPELinkReal Estate:

State of the Art Tax Planning Strategies

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Real Estate: State of the Art Tax Planning Strategies

Real Estate:

Greg White, CPA


©2020, CCH Incorporated. All Rights Reserved.

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Real Estate:State of the Art Tax Planning Strategies

Overview The Life Cycle of RE

4Real Estate:


Overview

• “Life cycle” of RE

1. Beginning: Acquisition/Development.

a. Purchase price allocation.

2. Owners: Operation.

a. Interest expense.

b. Repairs/de minimis/partial dispositions.

c. Depreciation.

3. Maturity: Dispositions.

a. Taxable.

b. Like‐kind exchanges.

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Life Cycle – Acquisition of Real Estate


Purchasing Real Property

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7Real Estate:


Assessed Value

• Assessed value – tends to overstate the value of land.

Preference Reason

Buyers Don’t want assessed value Land is non‐depreciable

Sellers Prefer assessed value. No recapture or 25% rate on land.

8Real Estate:


Written Allocations

• Courts and IRS

Generally accept parties agreed upon allocations,

Provided “adverse tax interests” as to allocation. Senate Explanation, '86 TRA, PL 99‐514

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9Real Estate:


Adverse Interests

• Apartment building sold.

Buyerwants high allocation to §1245 property.

Sellerwants high allocation to land.

Adverse interests –alloc. generally respected.

10Real Estate:


Written Allocation

• Purchasers – include in written alloc.

Land = $____

Building = $____

Land improvements = $______

§1245 property = $______

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Amerada HessAll Valuations Are Estimates

12Real Estate:


Amerada Hess and DeVito

• Amerada Hess:

FMV always an approximation.

• Albert DeVito:

“All valuation is necessarily an approximation.”

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13Real Estate:


Ultimate Issue

• Question:

What are top and bottom of ranges of FMV?

14Real Estate:


Range

Because FMV is a range...

• There are tax planning opportunities.

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Allocations Land, Building, Land Improvements, Personal Property

16Real Estate:


How to Allocate Cost Based upon FMV

• Rough justice is better than no justice.

Not just a quote from 1980’s Steven Segal movie.

• Courts and IRS follow.

“Rough” estimate better than no allocation at all. GCM 39838 (see cases cited therein supporting quote).

Note: these slides assume there’s no written allocation of purchase price.

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17Real Estate:


Step 1

Divide cost between

1. Land, and

2. Improvements.

18Real Estate:


Step 1: Allocating between Land and Improvements

• Methods of Allocation between land and bldg.

1. Replacement Cost of Bldg.= FMV. Meiers (TC Memo 1982‐51).

• IRS argued for “assessed” value. Court disagreed.

2. Reproduction cost less refurbishment cost:

• FMV older building = reproduction cost less cost to refurbish “modern contemp. office structure.”Westory (6 AFTR 2d 5392).

• Some cases use a “percentage approach” – reduce reconstruction cost by percentage.

3. Appraiser’s letter. Rev. Rul. 73‐410.

4. Assessed Value: use if no better evidence. Conroe Office Bldg. TC Memo 1991‐224.

5. Average of:

• CPA’s estimate (Purch. price – land = building), and

• Assessed value. Aarol Irish, TC Memo 1969‐45.

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19Real Estate:


Step 2

• Divide cost of improvements among

1. Building,

2. Land improvements (driveways, fences, etc.),

3. Personal property (carpeting, drapes, appliances ...)

20Real Estate:


Cost Segregation Studies

• IRS generally accepts “cost segregation” studies.

1. Preferable for large projects.

2. Cost prohibitive if small project (e.g., duplex).

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21Real Estate:


Cost Segregation Studies

• Note: Incorrect to depreciate carpeting, appliances over 27.5 yrs.

In theory, just as incorrect as depreciate a bldg. over 5 yrs.

But taxpayers have burden of supporting deductions.

22Real Estate:


Rule of Thumb Allocations

• 6 types of cost seg. studies in IRS’s “Cost ATG”

One method: “Rule of thumb” approach (lowest type):

• “... uses little or no documentation and is based on a preparer's ‘experience’ . . .

• “... estimate[s] IRC § 1245 property as a fixed % of project cost [using] ‘industry averages’ (e.g., 40% for a manufacturing facility).”

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23Real Estate:


IRS’s Position on Rule of Thumb Allocations

• Ground rules

1. Rough justice is better than no justice.

2. Incorrect to depreciate appliances, carpet. → 27.5 yrs.

3. Sometimes cost doesn’t justify a cost seg.

4. Regs don’t even mention cost seg studies approvingly.

a. Not required.

5. Taxpayers have burden of proving deductions.

24Real Estate:


Possible Ways Out of the Maze

Two approaches

1. “Rule of thumb” ‐‐ Approximate allocations based on historical cost seg. study avg. approach, or

2. Use “questionnaire” cost seg study (approx. $400).

• Some cost seg firms offer.

• For large projects, recommend an actual cost seg study.

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25Real Estate:


Aggregate Cost Segregation Numbers

Property Type 5‐year 7‐year 15‐year 27.5‐year 39‐year

Multifamily Residential (Garden Style)

15% ‐‐ 10% 75% ‐‐

Office Bldg.* 12% 0% 11% ‐‐ 77%

Restaurant (high end) 25% ‐‐ 12% ‐‐ 63%

Warehouse ‐‐ 5% 10% ‐‐ 85%

Source: Cost seg website a number of years ago. Note: I’ve got another chart from a different cost seg firm – very similar.* Cost seg study from another firm (“average” – also showed “conservative” and “optimistic”).

26Real Estate:


Additional Thoughts

• Possible approaches

1. Reduce allocations by allowance (conservative).

2. Ask clients – is their particular property is “average.”

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27Real Estate:


Adjusting “Average” Numbers

CategoryAvg. %

(earlier slide)Adj. Factor Adjusted %

Property cost (excl. land) Allocation

5‐year 15% 75% 11.25% $500,000 $56,250

15‐year 10% 75% 7.5% $500,000 $37,500

27.5‐year 75% N/A 81.25% $500,000 $406,250

To be a bit more conservative, or property is subpar

Apply a reduction to %’s on prior slide?

28Real Estate:


Is This Too Aggressive?

• Observations on “Rule of Thumb”

1. The IRS doesn’t rule it out.

2. Follows “rough justice” favored by courts & IRS.

3. You could always get cost seg study if audited.

• You might get more depreciation.

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MergingWritten Allocation and Rule of Thumb

30Real Estate:


Combining Allocations and Rule of Thumb

• Consider combining

1. Agreed‐up allocations with

2. Rule of thumb cost seg. study

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31Real Estate:


Combining Allocations with Rule of Thumb

Example

Client calls – buying rental property (duplex).

You perform “rule of thumb” allocation.

• Example: Personal prop = $50,000, Land improvements = $35,000

Use “rule of thumb” #’s ‐ written alloc. in purch. agrmt.*

* Otherwritten forms of alloc. Incl. letters, emails should work.


Life Cycle – Adulthood Operating Real Estate

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§163(j)


Who’s Subject to §163(j)

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35Real Estate:


Entities Subject to §163(j)

1. Business w/trailing 3‐year avg gross receipts > $25 million.

Must aggregate businesses under common control.

2. Tax shelters.

This is where most of concern comes from for real estate.

36Real Estate:


Types of Tax Shelters

Explanation

1. Securities registration required (federal or state).

Broadly defined. Includes entities that must file notice of exemption.

Ask attorney who formed entity if subject to securities registration.

2. “Syndicate” – 35% of losses > 35% of losses allocated to limited partners or limited entrepreneurs (not active in business).

3. §6662(d)(2)(C) Targeted to traditional tax shelters ‐‐almost none exist anymore.

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37Real Estate:


“Active Participation”

• 35% loss rule originally enacted in 1981 (hedging rules).

TCJA incorporated it into §163(j).

• Not treated as LP or a limited entrepreneur if:

Actively participates at all times in management,

• Participation of close relative satisfies test (spouse, children, parents).

Actively participated in management for at least 5 years.

38Real Estate:


Deemed “Active Participation”

Deemed active participant

• IRS (by regs or otherwise) may treat as active participant, and

Determines entity & interest not used for tax‐avoidance. §1256(e)(3)(C).

• This is a significant provision.

• IRS limited by “abuse of discretion” standard. Butler v. Comm’r., 114 TC 276.

• Legislative history provides:

The statute “the Secretary must determine that the facts and circumstances in the specific case indicate the that ... exemption is not sought, nor could it be exploited, for tax avoidance purposes.” 1981‐2 CB pg. 513.

• My view: Passive activity rules passed in 1986, no abuse potential.

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39Real Estate:


“Deemed” Active Participation

• Example

• Bethe and Holly bought apt. building in 2016.

• Each owns 50% of LLC, apt. building has ~ $15,000/year in losses.

• Bethe is very active in management.

• Holly is not involved at all.

• Neither Holly nor LLC had tax avoidance motive.

• In fact, Holly can’t deduct losses (she’s passive).

• On surface, this should be a tax shelter (50% alloc → inac ve).

• In my view, IRS is required to “deem” Holly to be “active.”

• So not a tax shelter.

• §163(j) does not apply and not required to use accrual method.

40Real Estate:


AICPA Letter on “Syndicates”

• Feb 13, 2019 letter – AICPA requested waiver “syndicate” rule.

Same basis as we just covered.

Broad waiver for §163(j) rule.

Might be included in final regs.

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Computation of Limit (if Subject to §163(j))

42Real Estate:


Business Interest Expense

• Business interest expense limited to

1. 30% x adj. taxable income (“ATI”) +

• Increased → 50% for 2019 and 2020.

• Can use 2019 ATI for 2020 calculation.

• Special rule for p’ships: 30% applies, partner deducts ½ of 2019 EBIE.

2. Business interest income +

3. Floor plan financing (for auto dealers, etc.).

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43Real Estate:


Business Interest Expense

• Examples assume no business interest income.

And no floor plan financing.

44Real Estate:


Business Interest Expense (General)

• ATI = taxable income

Plus (common adj.)

• Business interest exp.,

• Depreciation, amort. if not COGS (through 2021 only),

• NOLs, §199A ddns., cap losses c/o’s. non‐business items.

Minus (common adj.)

• Business interest income and floor plan financing,

• Lesser of gain on sale or cumulative depr. added back above.

─ Usually lets disallowed interest to pass through upon sale.

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Real Estate Businesses: Electing Out of §163(j)

46Real Estate:


RE Election

• Tax cost of election.

Must use ADS.

• Tax cost varies.

Type of property.

• Residential vs. commercial.

Date acquired property.

• Affects ADS life.

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47Real Estate:


Electing Out of §163(j)

• Real prop. businesses can elect out of §163(j).

Includes rentals, developers, etc. Prop. Reg. 1.163(j)‐1(b)(12) and §469(c)(7)(C).

Must be made on timely filed original return. Prop. Reg. 1.163(j)‐9(c).

48Real Estate:


Property Affected by Election (Switch to ADS)

Required ADSif Election?

Personal property No

Land improv. No

Qual. improvements prop. Yes*

Buildings ‐‐ residential Yes

Buildings ‐‐ commercial Yes

* ADS life (20 years) < rather than recovery period (15 years).

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49Real Estate:


Switching to ADS (if Make Election)

• Switching to ADS.

Not accounting method change.

• As long as make change first year of election.

Just spread net tax basis over new ADS life.

50Real Estate:


Property Affected by Election (Switch to ADS)

Depreciation Affected?

Personal property Not affected – use regular deprec. and bonus

Land improv. Not affected – use regular deprec and bonus.

Buildings ‐‐ residential Yes ‐‐ Slow down depreciation on structure

Buildings ‐‐ commercial YesLose bonus on QIP*QIP ADS = 20 years.Slow down deprec on structure to 40 yrs.

* CARES Act change: QIP now eligible for bonus depreciation (retro to 1/1/18).

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51Real Estate:


Considerations: Making Election

Property§163(j) limitsinterest exp? Date Acquired Tax Cost Election Election?

Any type No Any date Switching to ADS (varies)

Don’t elect out. §163(j) ‐ No tax cost.

Residential Yes Before 2018 27.5 yr SL → 40 yr SL

Run numbers*.

Residential Yes After 2017 27.5 yr → 30 yr SL Likelymake election. Election ‐‐Low cost.

Office bldg. Yes Any date • Lose QIP bonus• 39‐ yr SL → 40‐yr.

SL

Likely don’tmake election. Loss of bonus on QIP.

* Consider 1. Slower deprec. 2. How much interest exp. limited. 3. Projected inc.

52Real Estate:


Cost of ADS

MACRS ADS Lost depr/yr

Original Cost (1/1/99) $2,750,000

Accumulated dprn. 1/1/18 ($1,900,000)

Net tax basis $850,000

Remaining life (40‐year ADS) ÷ 20

Depreciation/year $100,000 $42,500 $57,500

Apartment building acquired January 1, 1999 for $2.75 million.

• Subject → §163(j) ‐‐ $10,000/year int. exp. disallowed.

• Is benefit of extra deduction of interest expense ($10,000) worth slower depreciation deductions ($57,500/yr)?

• How long until interest deductible? Increased rents, sale of building, etc.

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53Real Estate:


Update

• CARES Act fixes the “glitch” of TCJA.

1. Qualified improvement prop. now qualifies for bonus dpr.

2. If §163(j) “real property business” election in 2018 or 2019.

• And have nonresidential property.

─ Now probably wish you hadn’tmade election.

• Because election will prevent you from claiming bonus on QIP.

3. Allowed to retroactively revoke election.

• Also allowed to make late real property business election.

• See Rev. Proc. 2020‐22.

54Real Estate:


Example

Example

• REP, LLC owns office building (nonresidential real property).

• Elected out of §163(j) in 2018 (real property business election).

QIP wasn’t bonus eligible in 2018, so no big deal.

• CARES Act changes everything.

Now REP wishes it hadn’t elected out.

REP can revoke its 2018, 2019 or 2020 “real property business election.”

Treated as if “never made.”

• Can take bonus depreciation on QIP. Rev. Proc. 2020‐22, §5.

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Should You Wait?

56Real Estate:


Waiting

1. Treasury has announced final regs will be issued.

Spring 2020.

Consider waiting to file 2019 returns until final regs issued?

2. Might possibly be waiver of 35% syndicate rule.

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Debt‐Financed Distributions When a Partnership Refinances


Transforming Interest ExpensePlanning to Increase Interest Deductions

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59Real Estate:


Debt‐financed Distributions

Can be utilized to change the character of interest.

Interest deductible by entity to extent of its expenditures.

“Optional method.” Notice 89‐35, §IV, D.2.

Borrowings of pass‐thru distributed to owners:

60Real Estate:


Example – Debt‐financed Distributions

• Example (Notice 89‐35)

Karen and Sue own very profitable 25‐unit apt. bldg. in LLC.

• Total expenditures/year for apartments = $1 million.

• Karen and Sue ‐‐ credit card interest, mortgage debt > $1.2 million.

Solution: 2018 LLC borrows $1.2 million distributes.

• Karen and Sue pay off credit card debt and excess mortg. debt.

• LLC deducts interest on $1 million of debt (up to annual expend).

─ Extra $200,000 nondeductible (Karen and Sue used to pay off N/D interest).

─ Should they have waited until 2019 to distribute the extra $200,000?

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61Real Estate:


Limits

• Regs to be issued would deny if

Passthrough entity formed or availed of with a principal purpose

• Avoiding or circumventing rules of Treas. Reg. 1.163‐8T. Notice 89‐35, §III.


BuildingsImprovements vs. Repairs

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Focus Buildings and Building Systems

64Real Estate:


Super Quick, Shortcut SheetIn Materials

• Background

I’ll cover repairs vs. improvements quickly.

• Problem: repairs complicated, and unclear.

• Percentages I’ll use are based upon regs.

• But, regs don’t provide actual “bright line” percentages.

If very large dollar amounts, see handouts.

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65Real Estate:


What Is “It”?

• Focus: We’ll cover buildings and building systems.

Not personal property (carpets, etc.).

Not land improvements (parking lots, etc.).

• Personal property and land improvements qualify for bonus dpr.

66Real Estate:


Super Quick, Shortcut Sheet

• Review ‐‐ super short, shortcut sheet.

• 3 steps

What is it? (i.e., “unit of property”‐ UOP)

Repair: Must clear all 4 hurdles.

Improvement (not repair): Planning.

• De minimis;

• Partial disposition costs;

• Removal costs.

• Bonus depreciation.

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67Real Estate:


What Is “It”?

• Step 1 – What is it?

• What are we checking for improvement?

Is it the wall?

Or all the walls?

Or the whole building?

68Real Estate:


What Is “It”?

Step 1 – What is it?

• It (UOP)– any of the following?

1. Building systems

a. The HVAC building system,

b. The plumbing building system, and

c. The electrical building system.

d. Elevators, escal., gas dstrbn., fire/ safety, security.

2. If not building system, then building structure.

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69Real Estate:


Step 2 – Clear 4 hurdles

4 hurdles (must clear all for repair)

1. Is it 10% better (efficiency, strength, quality, etc.)?

2. Replace > 20% portion of it?

3. Replace > 40% of “important part” of it?

4. Did one of specified unusual situations apply?


Exercises Repairs v. Improvements

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71Real Estate:


Comments

1. Answers are suggested.

2. Auditors, appeals officers and judges might disagree.

a. We need to make decisions or we can’t practice.

b. Make a decision, go home, walk your dog, relax.

c. Client’s call ‐‐ if “grey” area, take risk?

3. IRS’s National Office accepts “reasonable” positions.

a. Author thinks these positions are reasonable.

4. Assume in all exercises‐ no “unusual situations*.”

* See list of unusual situations in shortcut sheet, fn 5.

72Real Estate:


Example 1

• Remove 1 wall, build 2 new walls. Building has 30 walls.

Step 1‐What is it? • Not building system, so it’s building and structural components.

Step 2‐ 3 hurdles (no 4th hurdle –no unusual conditions)

• Is it 10% better (effic., productivity, quality, strength) or materialaddition?

─ Clear hurdle – bldg. not 10% better or mtl. addn‐Author’s opinion.

• Did you replace > 20% portion of it?

─ Clear hurdle. Far less than 20% of building.

• Did you replace > 40% of an “important part ” of it?

─ Clear hurdle– not > 40% of walls. Repair.

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73Real Estate:


Example 2

• Replace 50% of sinks (w/similar sinks) in office bldg.

Step 1‐What is it? Plumbing system.

Step 2‐ 3 hurdles (no 4th hurdle ‐no unusual conditions)

1. Is it 10% better (effic., productiv., quality, strength) or material addition?

• Clear hurdle – plumbing system not 10% better or mtl. addn.

2. Did you replace > 20% portion of it?

• Clear hurdle? < 20% of plumbing system (pipes, toilets, etc.).

3. Did you replace > 40% of an “important part ” of it?

• Trip over hurdle– > 40% of sinks (important part). Improvement.

74Real Estate:


Example 2

Since sink replacements were capitalized:

Step 3

1. Does de minimis rule allow all or portion as expense?

If sinks ≤ $2,500, author believes so.

2. Take partial dspsn. loss, deduct removal costs.

To extent de minimis rule doesn’t apply, take:

• Partial disposition loss,

• Removal costs.

• §179 expense (nonresidential, not internal struct. framework, etc.)

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75Real Estate:


Example 3

• Replace only furnace in apt. building. Similar furnace.

Step 1‐What is it?

• HVAC system.

Step 2‐ 3 hurdles (no 4th hurdle since no unusual conditions)

1. Is it 10% better (effic., productiv., quality, strength) or materialaddition?

─ Clear hurdle – not 10% better or mtl. addn. (Similar.)


─ Clear hurdle? < 20% of HVAC system (furnace, vents, etc.).

3. Did you replace > 40% of an “important part” of it?

─ Trip over hurdle– > 100% of furnace (important part).

─ Improvement – tripped over 3rd hurdle.

76Real Estate:


Example 3

• Since new furnace was improvement

• Step 3

1. Does de minimis rule apply to all or part? (expense)

• Very unlikely.

2. Take partial dspsn. loss, deduct removal costs.

• To extent de minimis rule doesn’t apply, take partial disposition loss, removal costs.

• No §179 expense (residential property).

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77Real Estate:


Example 4

Replace 2 of 10 HVAC units for hotel. Each is 10% more energy efficient than HVAC models replaced.

Step 1‐What is it? HVAC system.


1. Is it 10% better (effic., productiv., quality, strength) or material addition?

─ Clear hurdle – only 2% better or mtl. addn. (10% x 2/10=2%)


─ Clear hurdle. < 20% of HVAC system (other HVAC’s, vents, etc.).

3. Did you replace > 40% of an “important part ” of it?

─ Clear hurdle– > 20% of HVAC units (important part).

─ Repair. Based on Treas. Reg. 1.263(a)‐3(j)(3), example 20

78Real Estate:


Example 5

• Add insulation to apt. bldg. walls. 50% more energy efficient.


• Not building system, so building structure.


• Is it 10% better (effic., productiv., quality, strength) or materialaddition?

─ Trip over hurdle –50% more efficient.

• Did you replace > 20% portion of it?

─ Clear hurdle. No replacement at all (incl. fixtures, panels, etc.).

• Did you replace > 40% of an “important part ” of it?

─ Clear hurdle– No replacement at all.

─ Improvement. Based on Treas. Reg. 1.263(a)‐3(j)(3), example 21.

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79Real Estate:


IRS Audit Technique Guide

Replace all shingles on roof w/similar shingles.

• Repair (Audit Technique Guide, pg. 134).

Different if replace decking, etc. (capitalize)

Different answer if replace w/much better shingles (capitalize)

80Real Estate:


Example 3

• Replace only furnace in apt. building. Similar furnace.


• HVAC system.


1. Is it 10% better (effic., productiv., quality, strength) or materialaddition?

─ Clear hurdle – not 10% better or mtl. addn. (Similar.)


─ Clear hurdle? < 20% of HVAC system (furnace, vents, etc.).

3. Did you replace > 40% of an “important part” of it?

─ Trip over hurdle– > 100% of furnace (important part).

─ Improvement – tripped over 3rd hurdle.

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81Real Estate:


Review Questions 1-6


TCJA: Fast Depreciation

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83Real Estate:


TCJA Fast Cost Recovery

84Real Estate:


Slower Depreciation

Some exceptions to immediate write off

1. Residential buildings – 27.5 years.

Mixed use – Residential if > 80% of rents for residential.

2. Non‐residential buildings – 39 years.

But now get bonus on QIP.

• Note: Can speed up deprec. with cost seg. studies.

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85Real Estate:


De Minimis

Never capitalize a refrigerator or stove again

Deductmost improvements

86Real Estate:


De minimis Rules – Residential Rentals

• De minimis rules – important for residential RE.

§179 not allowed for residential RE real property.

• Just for tangible personal property.*

* Beginning in 2018 (calendar year taxpayers), §179 applies to personal property used in lodging.

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87Real Estate:


Safe Harbors

$2,500/$5,000 Safe Harbor if elect, etc.

We’ll cover this.

1

“Eligible Bldg.” ‐‐ < of 2% or $10K if elect.

• Rarely applies.

•Won’t cover today.

2


The Basics

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89Real Estate:


De Minimis Election –Purchased Items and Improvements

Taxpayers with Audited Financials (“AFS”)

≤ $5,000 per invoice (or per item, substantiated by invoice).

Must have written policy used for financial accounting.

Book conformity requirement– must expense on AFS.

90Real Estate:


De Minimis Election for Purchased Items

2. No Audited Financial Statements

$2,500*

• Per invoice, or

• Per item, as shown on invoice.

Need

1. Election.

2. Financial accounting policy (can be unwritten).*

3. Book conformity.

* Sample in materials. Written policy recommended (auditors are directed to request).

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91Real Estate:


De Minimis Election for Purchased Items

• Examples (no AFS)

Example 1‐ No AFS, invoice = $2,495. Deduct.*

• Even if other invoices result in cost of UOP being > $2,500.

Example 2‐ Invoice > $2,500, look at invoice items.*

• Invoice > $2,500,

• 11 desks listed on invoice (items) @ $2,490/ea., deduct.*

* Assumes election made, book conformity, accounting policy met.

92Real Estate:


Scope of Election

Potentially applies to 2 types of expenditures

1. Improvements ‐‐ otherwise capitalizable.

Example‐ AFSw/$2,400 invoice for building insulation.

• Materially improves energy efficiency.

• Normally capitalizable, but can deduct.

• We’ll discuss this more in the next section.

2. Purchases of property otherwise capitalizable.

• Example‐ Taxpayer (AFS) buys truck for $2,000. Deduct.

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93Real Estate:


Anti‐abuse RuleTreas. Reg. 1.263(a)‐1(f)(6)

• Can’t artificially get low $ invoices to abuse safe harbor.

Example

• Taxpayer gets invoices that separately bills for truck components usually acquired as single UOP (e.g., truck costs $6,500, asks for separate invoices for chassis, tires, engine and trailer). Treas. Reg. 1.263(a)‐1(f)(7), example 11.


Required Book Conformity De Minimis

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95Real Estate:


Book Conformity

Book conformity required under de minimis rule.

1

Book conformity notrequired for bonus deprec. or §179.

2

96Real Estate:


Book ConformityExample

• Apartment building – replace all kitchen cabinets.

Cabinets separately listed on invoices.

Cost = ≤ $2,500.

• Capitalized for book purposes.

Client wants income higher for bank purposes.

Can’t use de minimis for tax.

• But may still get bonus or §179.

Personal property. Treas. Reg. 1.263(a)‐3(j)(3), Ex. 5.

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Improvements and the De Minimis Rules

98Real Estate:


The Controversy

2014‐2017

• Author believes substantial authority

Treating improvements under de minimis rule

• If you agree, it’s client’s call.

• See memo in materials.

• IRS didn’t like this position (informally).

But administrative guidance supported. Notice 2015‐82.

Issue involved interaction of de minimis rules and §263A.

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99Real Estate:


Possible Problem Solved for Most Taxpayers

• 2018 and after (improvements)

Any possible prior controversy gone.

• 2018 ‐‐ de minimis for improvements.

• For almost all taxpayers.

─ 2018‐ almost all exempt from §263A.

Can’t be tax shelter, or

Trailing 3‐year avg. gross receipts not > $25 million. §263A(i).

• Aggregation applies.

100Real Estate:


Example

• 2018: John replaces every window in apt. bldg.

Qualifies as “small taxpayer.”

• Cost per window shown on invoice ‐‐ $795.

• Windows are real property (27.5‐year life).

Won’t qualify for bonus or §179.

• Will qualify for de minimis, if policy and

Make election, have accounting policy, and

Expense on financials (book conformity).

99

100



101Real Estate:


Example

Cost /item Labor –separate invoice

De minimis exp.?

Granite slab $2,600 $500* No, capitalize both*

Cabinets $750 ea. (6 total)

$300 ea. Expense cabinets and labor

New light fixtures $325 ea. (4 total)

$225 ea. Expense fixtures andlabor

Remodel kitchen, no AFS, make election, etc. to meet de minimis rule, invoice substantiates each item.

* See memo – special “additional costs” rule doesn’t apply to improvements.

102Real Estate:


Up‐front CodingDe Minimis Rule

101

102



103Real Estate:


Working w/BookkeepersExample

• Invoice $6,000 for 6 computers ($1,000 ea.).

• Request bookkeeper codes to special account

“Items with cost ≤ $2,500”.


Defense Using De Minimis to “Back Up” Your Repairs Expense

103

104



105Real Estate:


Repairs “Backup” Position

Substantial lack of clarity in repair regs.

• Taxpayers prefer repairs.

No ordinary income treatment on sale.

• De minimis rules provide “backup” position.

106Real Estate:


Backup for RepairsExample

• Replace 40% of sinks in office building.

Each sink = $1,100 (per invoice).

IRS auditor says “improvement” not repair.

• Backup argument –Deduct as de minimis.

Must make election and expense on books.

105

106




De Minimis ItemsDiscussing with Clients

108Real Estate:


Coaching ClientsExample

• Client is changing cabinets in rental triplex.

• Total cost = $5,400 ($540/cabinet).

• Advise client ‐ invoice should show cost/cabinet.

107

108




TCJA and Bonus Depreciation

110Real Estate:


TCJA and Bonus Depreciation

New rules

• 100% ‐ qual. prop. acq’d. and PIS after 9/27/17.

Can elect 50% for PIS 9/28‐12/31/17 (calendar yr. taxpayers).

• Used property.

Prop. acq’d. and PISA 9/27/17.

50% election (above) wouldn’t change.

New anti‐abuse rules. ‐‐ not inherited or received by gift.

• And not acquired from related parties.

109

110



111Real Estate:


Bonus Depreciation %’s

Placed in Service* Bonus %**

9/28/17‐12/31/17 100%***

2018‐2022 100%

2023 80%

2024 60%

2025 40%

2026 20%

2027 None

*Property must also be acquired after 9/27/17.** Special rule applies to longer prdn. period prop. and certain planes.*** Can elect to use 50%.

112Real Estate:


Bonus: Recovery Period ≤ 20 yrs.§168(k)(2)(A)(i)(I)

• Personal property.*

Equipment, carpeting, drapes, cabinets, etc.

• Land improvements.* §168(c) and Rev. Proc. 87‐56, §6, asset class 00.3.

Fences.

Landscaping (but not on property’s perimeter).

Driveways, sidewalks.

Drainage.

• Qualified improvement property. CARES Act fix.

* Used property qualifies under TCJA.

111

112



113Real Estate:


Land ImprovementsExample

• Seth acquires rental duplex on Sept. 30, 2018.

Originally constructed in 2002.

• Bonus deprec. on land improv. (unless elect out).

Even though “used” property.

Also bonus for personal property.

114Real Estate:


Bonus and Residential RP Improvements Example

• Seth buys a used duplex in 2018 for $205,000.

• Purchase price is allocated as follows

Cost Bonus

Land $50,000 No

Building $120,000 No

Land Improvements $20,000 Yes

Personal property $15,000 Yes

113

114




Qualified Improvement Property

§179 and Bonus Depreciation

116Real Estate:


Definition – QIP

1. Requirements

a. Interior portion of a building,

b. Non‐residential real property,

c. Improvement placed in service after bldg.

2. Exclusions

a. Enlargement of building,

b. Elevators and escalators,

c. Internal structural framework.

115

116



117Real Estate:


Definition – Internal Structural Framework

• Includes all load‐bearing internal walls, and

• Any other internal structural supports, including

Columns, girders, beams, trusses, spandrels, and

All other members essential to stability of the building.” Treas. Reg. 1.48‐12(b)(3) [note: regulation refers to prior version of Treas. Reg. 1.48‐12, before, amendment, but this shouldn’t affect use of this definition]. Treas. Reg. 1.168(k)‐1(c)(3)(v).

118Real Estate:


Example – QIP

• Accounting firm owns* its building (built 2016)

Makes improvements to interior of bldg. in 2018, incl.

New non‐loadbearing walls,

Lighting fixtures,

Replace all pipes, wiring and all ceiling tiles,

New furnace.

• All the above qualify as QIP. Rev. Proc. 2017‐33, §4.02(5) Ex. 2 and Rev. Proc. 2019‐8.

* Same result if CPA firm leases the building.

117

118



119Real Estate:


Definition – QIP

1. Requirements

a. Interior portion of a building,

b. Non‐residential real property,

c. Improvement placed in service after bldg.

2. Exclusions

a. Enlargement of building,

b. Elevators and escalators,

c. Internal structural framework.

120Real Estate:


Example – QIP

• Accounting firm owns* its building (built 2016)

Makes improvements to interior of bldg. in 2018, incl.

New non‐loadbearing walls,

Lighting fixtures,

Replace all pipes, wiring and all ceiling tiles,

New furnace.

• All the above qualify as QIP. Rev. Proc. 2017‐33, §4.02(5) Ex. 2 and Rev. Proc. 2019‐8.

* Same result if CPA firm leases the building.

119

120



121Real Estate:


Purchases of Partnership InterestsBonus Depreciation

122Real Estate:


Partnerships and Bonus Depr.

• Sec. 743 adjustments eligible for bonus.

• Just sales.

• Not for step‐ups from death.

• Selling partner can’t be related (179 (d)(2)(A), (B),(C)).

• Can elect out of bonus depreciation for step‐up.

• Sec. 732 and 734 adjustments not eligible for bonus.

121

122



123Real Estate:


§743 Step Ups

Example

• 2018 – Bill pays $100 for seller’s 50% LLC interest.

• Seller’s share basis = $50 ($10 land; $30 bldg.; $10 land impr.; $0 pers. prop.).

• §754 election in force.

FMV Seller’s NBV Step Up Bonus

Land $20 $10 $10 $0

Building $50 $30 $20 $0

Land improv. $15 $10 $5 $5

Pers. prop. $15 $0 $15 $15

Total $100 $50 $50 $20


Partial DispositionsReplacing Roofs and WallsTreas. Reg. 1.168(i)‐8(d).

123

124




The Mystery of the Two Depreciating Roofs

126Real Estate:


Mystery of the Two Depreciating RoofsExample

• 1995 (1st roof)‐‐ Purchase rental house.

One of major components is roof structure.

Roof’s cost included in purchase price of building

Depreciating original roof as part of cost ‐like walls, etc.

• 2018 (2nd roof)‐‐ replace original roof covering, decking, joists, etc. for $35,000

Capitalize new roof‐‐ Replaced “major component.”

125

126



127Real Estate:


Client is Now Depreciating Two Roofs

1. Original roof ‐‐ Part of building in 1995 (roof’s cost included in purchase price).

2. New roof ‐‐ that was installed in 2018.

WITUH????? (This is a common acronym used by tax professionals–it’s short for “What in the unholy heck?”)

128Real Estate:


New Regulations Solve this Puzzle

Treas. Reg. 1.168(i)‐8.

• Deduct net tax basis of original roof purchase cost.

Allocate part of purchase price of house to roof.

• Mystery solved! Only one roof is depreciated.

Net book value of original roof (1995) written off in 2015.

New roof added to depreciation schedule.

127

128



129Real Estate:


Mechanics of the Election

1. Time– Elect by tax return due date (incl. extens).

2. Manner‐ Simply take loss on tax return.

3. No Form 3115 required.

130Real Estate:


The Election

129

130



131Real Estate:


Amount of Loss on Partial Disposition

1. If can identify actual cost, must use it.

Example ‐‐ Contractor tracked actual cost of components.

2. Otherwise, any reasonable method. Treas. Reg. 1.168(i)‐8(f)(3).

3 methods deemed reasonable

• PPI, replace. cost, cost study.

132Real Estate:


Example – Reasonable Method

Replacement Cost

Replacement cost of improvement

÷

Replacement cost of entire asset.

131

132



133Real Estate:


Replacement Cost Method

• Facts

Replace entire roof (decking, etc.) = $100,000

Cost to replace building* in 2016 = $1,000,000.

Net tax basis of building = $656,450.

Loss = $65,645.

*Note: call contractor or internet search for replacement cost of building.

134Real Estate:


IRS Audits

• IRS is moving to “issue‐based” examinations.

• One “campaign” ‐‐ Partial dispositions for buildings

Identify partially disposed “asset”

• Difficult for remodels and renovations.

• But ATG says any reasonable method okay.

• Determined adjusted basis of the disposed portion (loss)

• Proper reduction of asset for the disposed portion.

Source: https://www.irs.gov/businesses/irs‐announces‐rollout‐of‐five‐large‐business‐and‐international‐compliance‐campaigns

133

134




Partial DispositionsRemodels

136Real Estate:


Partial Dispositions – Remodels

Remodel PD requirements*

1. Resulted in disposition of parts,

2. Use any reasonable method,

3. Allocation → disposed parts ≤ building basis.

* IRS Audit Technique Guide: Capitalization of Tangible Property

135

136



137Real Estate:


Partial Dispositions – Remodels

• Total remodel cost = $450,000.

New circular staircase = $50,000 (addition –not replacement).

Net on replacement assets = $400,000.

• Replacement cost of building = $4 million.

10% disposition

$400,000 ($450,000 ‐ $50,000 ) ÷ $ 4,000,000.

• Building net tax basis = $500,000.

$1 million cost.

$500,000 accum. dprn.

138Real Estate:


Effect on Depreciation Schedule

Beforeremodel

Partial disposition

(10%)

Afterremodel

Cost $1,000,000 ($100,000) $900,000

Accum. dprn. ($500,000) $50,000 ($450,000)

Net tax basis $500,000 ($50,000) $450,000

Notes:

1. Deduction = $50,000 (10% of net tax basis).2. Accum. dprn. ↓ $50,000 – less 25% recapture on sale.

137

138




Mixed‐Use Property

Residential?

OrNonresidential?

140Real Estate:


Mixed‐Use Buildings

• Some buildings have retails stores at street level.

And residential dwellings* above.

Question

• Are these buildings residential, nonresidential, or both?

Answer

• Residential: If ≥ 80% of rents is from dwelling units.

• Nonresidential: If < 20% of rents is from dwelling units.

* Dwelling units ‐ residences not used for transient lodging (hotels, etc. not residential).

139

140




Mixed‐Use Property

Residential?

OrNonresidential?

142Real Estate:



• Some buildings have retails stores at street level.

And residential dwellings* above.

Question

• Are these buildings residential, nonresidential, or both?

Answer

• Residential: If ≥ 80% of rents is from dwelling units.

• Nonresidential: If < 20% of rents is from dwelling units.

* Dwelling units ‐ residences not used for transient lodging (hotels, etc. not residential).

141

142



143Real Estate:



Answer:

Residential: If ≥ 80% of rents is from dwelling units.

Nonresidential: If < 20% of rents from dwelling units.

Some buildings have retails stores at street level and residences above.

Question:

• Are these residential, nonresidential, or both?

144Real Estate:


Mixed‐Use BuildingExample

• ABC, LLC owns a building.

Street level ‐‐ retail stores.

Floors 2‐6 ‐‐ Apartments.

Gross rents from dwelling units = 81% of total rents.

• So ≥ 80% of rents are from dwelling units.

This is a residential property.

Consequences: 27.5‐year life, but no “qualified improv. prop.”

143

144




§179

146Real Estate:


§179 Property ‐‐ Changes

2017** 2018**

Qualifying LH Improv. Yes No

Qual. Rest. Prop. and QRI prop. Yes No

Qual. improvement prop. (“QIP”)* No Yes

Non‐residential roofs* No Yes

Non‐residential HVAC & A/C* No Yes

Lodging personal prop (apts.) No Yes

*Only if placed in service after the building.** For calendar year taxpayers.

145

146



147Real Estate:


§179 Expense Amounts

2017* 2018*

Maximum §179 expense $500,000 $1,000,000

Phaseout begins at $2,000,000 $2,500,000

* New rules effective for property placed in service in taxable years beginning after 12/31/17. For calendar year taxpayers, this is the calendar year 2018.

148Real Estate:


Must Be “Purchased”

• Any acquisition except from

“Related” person §267/707(b) (special definition of “family”).

Gift.

Inheritance.

If 1031 or 1033, only increase in basis, not carryover basis. §179(d)(2) and Treas. Reg. 1.179‐4(c) and (d).

147

148




§179Qualified Real Property

150Real Estate:


Qualified Real Property

• Can elect §179 ‐‐ “qualified real prop.” (“QRP”)

Qualified improvement prop. (“QIP”) ‐‐ nonresidential,

Nonresidential roofs,

Nonresidential HVAC’s,

Nonresidential fire protection and alarm systems, and

Nonresidential security systems

149

150



151Real Estate:


QRP Requirements

• Has to be nonresidential. Includes

Retail stores.

Restaurants.

Warehouses.

Office buildings.

Hotels and motels. §168(e)(2)(A)(ii)(I) and §168(e)(2)(B).

• Must be placed in service after building.

• PIS in tax years beginning after 12/31/17.

152Real Estate:


§179 – QRPExample

2018 – Replace shingles & decking – office bldg.

• QRP, can elect §179 – non‐residential, PISA building.

• But if it were apartment building wouldn’t qualify.

151

152



153Real Estate:


§179 – QRPExample

2018 – Replace HVAC unit (top of retail store).

• QRP, can elect §179 – non‐residential, PISA building.

Portion inside the building is QIP.

• But, if it were apartment building wouldn’t qualify.

154Real Estate:


§179 and Residential RP Improvements Example

• Michelle buys a duplex in 2018 for $205,000.

• Purchase price is allocated as follows

Cost Eligible §179

Land $50,000 No

Building $120,000 No

Land Improvements $20,000 No

Personal property $15,000 Yes

153

154



155Real Estate:


§179 – Business Requirement

1. To qualify, property must be used in business. §179(d)(1)(C).

“Business” has same definition as §162. Treas. Reg. 1.179‐(a).

We’ll discuss later in QBID portion of course.

2. Is real property rental a business? Tax Court ‐ Curphey

“This Court has held repeatedly ... rental of even a single piece of real property ... income constitutes a ... business.”

• We’ll discuss more in QBID area later.

3. Non‐corporate lessors must meet additional requirement.

In my view they meet test, because they “produced” QRP. §179(d)(5)(A).

156Real Estate:


§179 – Business Requirement

• Caution (higher standard)

Triple net leases if landlord doesn’t perform any services (tenant pays RE tax, insurance, repairs). Union Bank of Troy, PLR 8350008.

CA2– single rental not always sufficient. Grier v. U.S.

155

156




QRPBuilding Placed in Service First

158Real Estate:


Building in Service First

§179 QRP, building must be placed in service first

• Initial purchase of building – can’t expense roof.

• Because taxpayer doesn’t place building in service first.

Building and roof placed in service when buy property.

157

158



159Real Estate:


§179 QRP – Building in Service FirstExample

• Buy existing commercial building.

• Two weeks later, replace entire roof (decking, etc.)

• Can elect §179 for QRP and expense entire new roof.

• Placed in service 2 weeks after building.


Partial Dispositions and §179

Can You Have Your Cake and Eat It Too?

159

160



161Real Estate:


Having and Eating Cake

• It’s acceptable to

Write off partial dispositions of real estate.

Expensing improvements to nonresidential property.

Can you do both?

162Real Estate:


Having and Eating Cake

Taxpayers can presume no “unstated limitations.”

• If Congress wants limitations, it expresses them. CGG Americas,

Inc.

Same interpretation rules apply to regs issued by Treasury. Shea Homes, Inc. 142 TC 60.

161

162



163Real Estate:


Cake

• §179 “QRP” rule doesn’t mention partial dispositions.

No express limit.

• Therefore, there is no limit.

You can take both §179 and partial disposition loss.

IRS Chief Counsel’s Office gave the same answer.

• Informal phone call, not precedential.

Could the IRS challenge?

• Of course. But there’s substantial authority.

164Real Estate:


Example

Bob puts new roof on retail store (nonresidential).

• Substantial authority.

Taking §179 and partial disposition.

• Also, bonus depreciation replacing land improvements.

163

164




RolesFast Write Off RulesSpecial Roles Played by §179, Bonus and De minimis.

166Real Estate:


Special Roles

• Ray Bolger played in many movies and Broadway shows

But, there’s one role nobody else could have played

Scarecrow in The Wizard of Oz

But he wouldn’t have been good in a Kung Fu movie

The fast write off rules are a bit like that too

• Each has a role that it can play, and no other provision can

165

166



167Real Estate:


Special Roles

1. §179 – Covers non‐residential QIP (at least for now)

QIP — Interior non‐resid. bldg (non‐load bearing walls, furnaces)

Non‐residential roofs, non‐residential HVAC’s

Typically cost of these too high for de minimis

2. Bonus – Land improvements (incl. used)

When de minimis doesn’t apply

3. De minimis – improvements to residential property

If invoice/item on invoice ≤ $2,500

168Real Estate:


Special Roles — Bonus Example

• Matt buys a used duplex in 2018

• $20,000 allocated to land improvements

• Bonus only

Unlikely get de minimis

§179 doesn’t apply

167

168



169Real Estate:


Special Roles — §179Example

• Karen owns a retail strip mall

Not a triple net lease

• In 2018, she hires a contractor to replace the roof

Shingles and decking

Single invoice, without detail = $35,000

• §179 provides deduction

• Bonus won’t work – this is real property

• De minimis won’t work – Invoice too high, lacks detail

170Real Estate:


Special Roles – De minimisExample

• Residential

Replace all sinks and windows in apartment building

Invoices — cost of each sink and each window ≤ $2,500/ea.

Can use de minimis if ≤ $2,500 test, elect out, conformity ...

§179 won’t apply

• QIP applies only to certain nonresidential real property

Bonus won’t apply

• Only applies if recovery period ≤ 20 years (this is 27.5 yrs)

169

170




Placed in ServiceBuildings Are Different

172Real Estate:


Placed in Service – Buildings

• New buildings, placed in service

Final regs

• Construction is substantially complete, and

• Building in state of readiness and availability. Treas. Reg. 1.167(a)‐11(e) and Rev. Rul. 76‐238.

• Can be prior to opening for business.

Proposed regulations, IRS ATG, and case law

• When get certificate of occupancy (“COO”). Prop. Reg. 1.168‐2(e)(3) , Stine, LLC (115 AFTR 2d 2015‐637), IRS Audit Technique Guide for Rehab Credits.

• COO’s are issued when a building is suitable for occupancy.

171

172



173Real Estate:



Final regulations Treas. Reg. 1.167(a)‐11(e) and Rev. Rul. 76‐238.

• Factory building placed in service when

Construction is “substantially complete.”

• Stine case ‐‐ “substantially complete” if COO.

Condition of readiness and availability.

Even if equipment it will contain is not in service.

174Real Estate:



• Stine, LLC (DC LA 115 AFTR 2d 2015‐637, 2015).

Stine operated home improvement store.

Received COO before end of 2008.

• Allowed store to receive equipment, shelving, etc.

• Shelves and equipment not yet installed.

Wanted to take “GO Zone” bonus depreciation.

Court held placed in service in 2008.

173

174



175Real Estate:



IRS Position – Action on Decision 2017‐02.

• IRS didn’t appeal Stine, LLC.

Justice Dept. makes decisions on appeals.

• Instead, IRS issued nonacquiescence.

Will continue to litigate this issue.

• Instructor’s position.

• There’s substantial authority to follow Stine, LLC.

176Real Estate:



• Why does it matter?

• To claim §179 for “qualified improvement prop.”*

Building must be placed in service before improv.

Note: Bonus doesn’t apply to QIP PISA 12/31/17.

*PIS after 12/31/17

175

176



177Real Estate:


Why is COO Important?Example

• LLC constructs office building.

Receives COO on March 3, 2018.

Finishes tenant improvements on April 30, 2018.

Tenant moves in May 1.

• Outcome

If Stine, LLC is right, §179 for all tenant improvements.

If IRS is right, no §179.

178Real Estate:



177

178




QBID – Overview

180Real Estate:


QBID

New §199A

Qualified

Business

Income

Deduction

179

180




Do Real Estate Rentals Qualify for QBID?

182Real Estate:


Threshold QuestionIs the Rental a Business?

181

182



183Real Estate:


Business

• Most important word on preceding slide:

• “Business.”

• Regs use business definition in §162. Treas. Reg. 1.199A‐1(b)(14).

• Exception: some “self rentals” deemed to be businesses.

184Real Estate:


Exception: Self Rentals

• Example (rental → commonly controlled business)

RE broker rents land (triple net) → 100% owned S corp.

Rental income is deemed to be QBI.

• Not tested under §162 standard.

183

184



185Real Estate:


Tax Court, 7th Circuit (and Sometimes IRS)

• Courts have different views of “business”

Tax Court and 7th Circuit (and sometimes the IRS).

• Merely requires “regular and continuous” activity.

• However, Tax Court appears to impose higher standard for

Prior personal residences held out for lease, but never actually leased.

Land leases (if just one piece of land).

186Real Estate:


2nd Circuit (and Sometimes IRS)

• Courts have different views of “business”

• 2nd Circuit (NY, CT, and VT) (and sometimes the IRS).

Also require some degree of substantial activity.

185

186



187Real Estate:


QBID and Rental Real Estate

1. Real estate rentals qualify if they’re businesses.

a. Business – Use §162 definition. Preamble pg. 9.

2. Tax Court “repeatedly held”

a. Rental of a “single piece of real property [is] a ... business.” Curphey v. Comm’r, 73 TC 766.

• Curphey involved 162.

b. But, declined to hold that all rentals are businesses.

• Later decision said this didn’t signify change in philosophy. Balsamo.

188Real Estate:


Rental Real Estate: Good Cases

Facts Business? Venue/comments

Murtaugh v. Cmr. 2 timeshares, mgt. co. had subst. activity

Yes Tax Court/mgrs. activity counts)

LaGreide v. Cmr. Inherited, single‐family residence

Yes Tax Crt/rental single prop.= business.

Hazard v. Cmr. Single‐family, taxpayer lived in different city.

Yes Tax Crt/rental of single property = business.

Jephson v. Cmr. Held for rent, but neverrented. Paid maintenance

Yes BTA (predecessor to Tax Court).

Reiner v. U.S. Single‐family, mgt. co. Yes CA7/cited LaGreide.

187

188



189Real Estate:


Tax Court – Not a Business

Facts Business Venue/comments

E.R. Fenimore Rental of a small portion of residence formerly occupied as a residence.

No Tax Court.

Coykendall Former residence, offered for sale of rent, never actually rented.

No. Tax Court.

Horrmann Former residence, attempted to rent, never actually rented.

No Tax Court.

190Real Estate:


Rental Real Estate: Land


Good v. Comm’r. Lease of land. Rented continuously for 20 years. Also owned other rental land.

Yes Tax Court/Followed Hazard case. Seemed to rely upon continuousrental of land.

Durbin v. Birmingham Lease of land. No. DC, Louisiana.

Emery v. Comm’r. Lease of land No. Tax Court/Failed to provide evidence.

PLR 8350008 Triple net, owned land only, tenant owned and maintained building.

No. Non‐precedential administrative guidance.

Anderson v. Comm Leased single piece farm land

No Tax Court/tenant – all work

189

190



191Real Estate:


Rental Real Estate: 2nd Circuit


Grier v. U.S. Single‐family, inherited, only one tenant, made repairs.

No CA2/ Circuit has least favorable position.

Balsamo v. Comm’r.

Inherited, no repairs, sold 3 mos. after inherit.

No Tax Court used CA2 law, bound by Golsen.

Union Bank of Troy Triple net lease, tenant maintained bldg.

No. Distr. Ct. NY. (cites Grier, appealable to CA2)

PLR 8350008 Triple net lease, owned landonly, tenant owned maintained building.

No. Non‐precedential administrative guidance. This taxpayer in 2nd

Circuit (see GCM 39126).

192Real Estate:


Rental Real Estate: Triple Nets


Fegan v. Comm’r. Rented hotel building to controlled corporation. Tenant maintained interior, landlord exterior (“2 ½ net”).

Yes Tax court/He also rented other part of same building.

Rev. Rul. 60‐206 Rented equipment, noactivity at all with respect to property.

Yes §513. Sole activity was to receive rental income. Lessee maintained.

Neill v. Comm’r. Inherited property, tenantconstructed building, paid triple net expenses.

No §871 case. Similar to land lease (in that tenant constructed building).

Rev. Rul. 73‐522 Supervised negotiation of L‐T lease identical to prior lease, lessee paid all exp, incl. landlord’smortgage.

No §871 case. Appears taxpayer didn’t own underlying land (had to pay ground lease).

191

192



193Real Estate:


Important Guidance – Triple Nets

• Rev. Rul. 60‐206

1. Addresses §513 “unrelated business income.”

• Affects not‐for‐profit entities.

2. Lessor of personal prop. just collected rent checks.

• Tenant operated and maintained rail cars.

3. IRS concluded this was a business.

194Real Estate:


Rev. Rul. 60‐206Is it Too Big a Leap?

193

194



195Real Estate:


Rev. Rul. 60‐206

Rev. Rul. 60‐206

1. §162 RE rental business definition used in §513 cases. Clarence Labelle Post No. 217 v. United States, 580 F.2d 270 and Ohio County & Independent Agricultural Societies.

2. §513 regs use same definition as §199A regs.: §162. T.R. 1.513‐1(b).

3. Cases use RE “business” standard for personal prop. Miller, 85 TC 1064.

4. Taxpayers can rely on revenue rulings. Rauenhorst v. Comm’r. , 119 TC 157.

• IRS can’t dispute its own revenue rulings.

• Treated as a concession of issue.

196Real Estate:


IRS Seems Unsure

195

196



197Real Estate:


IRS Is Uncertain – Regs

• Twice ‐‐ Treasury dodged issue of rental as business

1. §199A regs.

2. NIIT regs.

“Treasury Department and the IRS do not believe that the rental of a single piece of property rises to the level of a trade or business in every case as a matter of law.”

The Treasury Department and the IRS decline to provide guidance on the meaning of trade or business solely within the context of section 1411.” TD 9644.

198Real Estate:


Rental Real Estate – Is It a Business?

• Regs ‐‐ Relevant factors (rental) might include

1. Type of rental (residential vs. commercial).

2. # properties rented.

3. Owner’s or agents’ day‐to‐day involvement.

4. Types/significance of ancillary services under the lease.

5. Terms of lease (net lease vs. traditional). Preamble to final regs., pg. 16.

197

198



199Real Estate:


199A Regulations

Might?

Include?


Clearing the FogTriple net leases and the 2nd Circuit

199

200



201Real Estate:


My View

• Substantial authority in almost all cases.

Even for rental of single‐family home.

Unless former residence, and don’t rent, or rent a small portion.

• More difficult in 2nd Circuit.

Even if reside in 2nd circuit, still “substantial authority.”

• All circuits weighed equally, irrespective of residence. Treas. Reg. 1.6662‐4(d)(3)(iv)(B).

─ Unless taxpayer’s own circuit decision is favorable to taxpayer.

• Triple nets

1. Higher risk if tenant supervises and responsible for repairs.

• Consider Form 8275.

2. Net lease of land – Difficult. Consider Form 8275.

202Real Estate:


Foggy Areas

• Regs just say it’s “facts and circumstances” test.

• Treasury

Declines to rule that all rentals are businesses. Preamble pg.16.

Doesn’twant to imply land leases are, or are not businesses. Preamble pg.

18.

• Arguably substantial authority (Rev. Rul. 60‐206).

• Consider 8275 – (drops standard to reasonable basis).

But discuss with client first.

201

202



203Real Estate:


Safe HarborRP 2019‐38

204Real Estate:


Building Blocks1. Hold “interest” in RP

• Directly (including TIC’s*), or

• Disregarded entity (like SMLLC).

2. “RREE”

• Rental real estate enterprise.

• Single property, or

• Group all “similar” use (consistency req’d):

1. Residential.

2. Commercial. §3.02.

* Not explicitly stated but meets definition of direct interest.

203

204



205Real Estate:


Grouping

• Advantage

• Easier to meet 250‐hour requirement

• Disadvantage

• Might want to argue one rental isn’t a business (losses)

206Real Estate:


Example (Grouping)

• Chiyun has two duplexes.

• She can document 150 hours of time on each duplex.

• Neither duplex, by itself, meets 250 hours.

• If grouped, meet 250‐hour requirement.

• She will want to group.

206

205

206



207Real Estate:


Example (Grouping)

• Keesha owns two commercial buildings.

1. Commercial office building – lots of income.

• Provides janitorial services to tenants, repairs, etc.

2. Warehouse – loses money.

• Triple net, no activity except collect checks.

• Don’t group ‐‐may want to argue warehouse isn’t a business.

• And losses on warehouse aren’t QBI (QBID will be higher).

• Grouping will mean warehouse losses treated as QBI.

208Real Estate:


Separate Books and Records

Requirements

1. Separate books and records for each RREE.

2. Service hours.

3. Contemporaneous time keeping.

4. Attaching statement to tax return.

207

208



209Real Estate:


Separate Books and Records for Each RREE

• Separate books and records for each RREE.

• Reflect income and expenses for each RREE.

• If > than 1 property, separate accounting OK, then consolidate.

210Real Estate:


Safe Harbor Requirements

Requirements


2. Service hours.



209

210



211Real Estate:


Whose Services Count?

• Services by all the following count

1. Owners (including owners of entity),

2. Employees,

3. Independent contractors.

212Real Estate:


Qualifying Services

Category Includes

Qualifying Services Rental services 1. Advertising to rent, 2. Negotiating and executing leases; 3. Verifying info in tenant applications; 4. Collection of rent; 5. Daily operation, maintenance, repair,

including purchasing materials/supplies; 6. Management of real estate; and 7. Supervise employees/indep. contractors.

Nonqualifying (don’tcount for 250 hours)

Financial or investment mgt.

activities

1. Arranging financing, procuring property; 2. Studying/reviewing financial stmts. or

reports on operations; 3. Improving prop under § 1.263(a)‐3(d); 4. Hours spent traveling to and from RE.

211

212



213Real Estate:



Requirements


2. Service hours.



214Real Estate:


Record Keeping

Contemporaneous? Records

Owners Beginning in 2020

Not req’d 2018 or 2019

Form: time reports, logs, similar documents.

Info: all services:1. Hours,2. Description, 3. Dates performed, 4. Who performed.

Employees and contractors

No Description of rental services performed by each employee and IC,

Amount of time “generally spent” by employee or IC,

Time, wage or payment records.

213

214



215Real Estate:


Contemporaneous Record Keeping

Contemporaneous records req’d?2018F 1040

2019F 1040

2020 and later

Owner No No Yes

Employees and indep. contractors No No No*

* Best interpretation of §3.03(C) in my opinion, although it’s not entirely clear.

• Taxpayers can rely on “plausible interpretations” of IRS guidance. Corn Belt Hatcheries of Arkansas, 52 TC 636.

216Real Estate:


Example

• Chuck has 8 single family rental properties.

• Chuck groups these for safe harbor (statement attached to return).

• Management company does all work. Chuck documents1. Rental services provided,

2. Amount of time mgt. co. generally spends performing such services.

3. Payment information for management co.

• Chuck meets 250 hours record keeping.

215

216



217Real Estate:



Requirements


2. Service hours.



218Real Estate:



• Statement

1. Description of all RRE properties included in RREE.

• Including address and rental category.

• If more than one RREE, submit separately for each.

2. Description of RRE properties acquired/disposed.

• Including address and rental category.

3. Representation that requirements met.

217

218



219Real Estate:


Triple Net Lease Exclusions

• “Includes” lease that requires tenant to pay

1. Taxes,

2. Fees,

3. Insurance,

4. Maintenance,

5. Utilities.

220Real Estate:


Triple Net Lease Exclusions

• Would changing terms of lease work?

• E.g., rent up, but tenant doesn’t have to pay insurance?

219

220



221Real Estate:


Just a Safe Harbor – Don’t Have to Meet for §199A QBID

222Real Estate:


Harbor –Alaska

• I know the harbormaster in Petersburg, AK.

• And I trust her.

• If asked to name an extremely safe harbor, I’d say Petersburg.

• You might point out it’s a long distance away.

• And you’re not sure your boat could make journey to Alaska.

• That’s okay.

• I know lots of other ports.

• Maybe not quite as safe as Petersburg.

• But lots of people have moored at other ports successfully.

221

222



223Real Estate:


Rentals and the QBID Are Like Petersburg

• Yes, Rev. Proc. 2019‐38 is like Petersburg.

• It’s just a safe harbor.

• But there are lots of other places to moor a boat.

• The QBID and rentals properties are like that.


Ambiguity

It’s a

“Two‐Edged” Sword

223

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225Real Estate:


Two‐Edged Sword

Taxpayers may use uncertainty in rental area to advantage.

• If have losses from rentals, may prefer nonbusiness treatment.

226Real Estate:


Two‐Edged SwordExample

• Taxpayers has QBI from restaurant = $115,000.

• Taxpayer has a rental property.

2021 – sells rental.

• $115,000 in post‐2017 suspended passive losses allowed.

• If rental not “business,” get full QBID from restaurant.

If rental losses not from business, don’t affect QBI.

225

226




It’s Never Too Late

To Make an Accounting

Method Change

228Real Estate:


Statute of Limitations Doesn’t Apply to Accounting Method Changes

1. No statute of limitations for accounting methods. GRAFF CHEVROLET CO. 12 AFTR 2d 5907 (aff’d CA5)

2. Can simply file Form 3115 in later years.

a. This is an automatic change.

i. No fee.

ii. See Form 3115 instructions.

227

228



229Real Estate:


Facts in Sample Form 3115

• Used property

• No bonus if before 9/28/17

• Or binding contract before that date.

• Facts

• “Year of change.”

• 2019

• It’s on 2018 tax forms because 2019 not yet available.

• Accumulated depreciation therefore compared as of 12/31/18.

• Current (27.5 years) vs. proposed (5‐year and 15‐year lives).

• Small business taxpayers have reduced disclosure.

230Real Estate:


Inapplicability

• Can’t make this change in some circumstances1. If subject to §263A, must make concurrent change under §12 to capitalize

relevant portion of deprec.

2. Changes in use.

3. Changes in placed‐in‐service date.

4. Property for which the taxpayer claimed a credit.

• E.g., rehab credit.

5. Others – See §6.01(c) (most are rare).

229

230



231Real Estate:




SE Tax and Real Estate

231

232



233Real Estate:


Internal Revenue Code

• FAQ: if real estate rental is business, do you have to pay SE tax?

• General rule: SE tax on all businesses.

Almost all real estate is a business. Curphey v. Commr.

But: exception from SE tax for almost all rental real estate.

• Generally, no SE tax, even if business.

Real estate dealers don’t qualify for this exception.

• Property held for sale to customers.

234Real Estate:


Regulations

• Rental income – self‐employment income if

Substantial services provided to tenants.

• “Substantial” if material part of income from services.

• Disregard some services

If to maintain space in condition for occupancy.

233

234




Mobile Home Parks

Bobo v. Commissioner 70 TC 706

236Real Estate:


Bobo v. Commissioner., 70 TC 706

Backstory

• Novato, CA

North of San Francisco, Marin County

Hit hard by the great depression.

After WWII, homebuilding, rapid development.

• Fabian and Flo Bobo.

Fabian owned construction co. with brother.

1946 bought land in Novato.

1952 developed mobile home park.

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236



237Real Estate:


Bobo v. Commissioner., 70 TC 706

• Mobile home park

46 spaces.

• 38 mobile home pads rented.

• Bobos owned 8 mobile homes and rented out.

─ Cleaned mobile homes when vacant and available for rent.

• Provided laundry facility for tenants.

Income approx. $18,000/year.

• $106,000 in 2018 dollars.

On‐site manager.

• Collected garbage, swept leaves, cleaned laundry facility.

238Real Estate:


Bobo – Arguments

IRS

• Rev. Rul. 72‐331 says SE tax applies.

Note: Revenue Rulings

• If pro‐taxpayer, can use as “shield.”

• But courts don’t have to follow. Rauenhorst, 119 TC 157.

Bobos

• Providing laundry services not “substantial.”

• “Vacant trailer” maintenance “maintaining” for occupancy.

237

238



239Real Estate:


Tax Court Holding

Bobos win

• Laundry services were “to” tenants.

But not “substantial” enough.

• Cleaning, sweeping to maintain for occupancy.

Doesn’t count towards “substantial services.”


Tourist Housesand Maid Service

239

240



241Real Estate:


Airbnb

• Form 1040

Some preparers report on Sch. E.

Some report on Sch. C.

• “Tourist house”

• Maid services ‐ important indication. Treas. Reg. 1.1402(a)‐4(c)(2).

But, “to” customer?

• Cleaning trailers (between tenants) in Bobo

Didn’t cause SE tax.

242Real Estate:


Choosing to Pay SE Tax

Might want to pay SE tax.

• Especially if high 35‐year average < $67,000.

Social security benefits usually > costs.

• Also, may have loss on Airbnb.

And want to offset SE income like Hopper.

Not “per se” if average rental period ≤ 7 days.

May meet material participation test.

241

242



243Real Estate:


Use of Rental for Personal Purposes

244Real Estate:


Personal Use

• How much “personal use” must taxpayers make of a rental property to subject themselves to the “no loss” rule of §280A?

The taxpayers’ personal use must exceed the greater of 14 days or 10% of the days it is rented at fair value. §280A(d)(1).

243

244



245Real Estate:


Personal Use

When is a taxpayer considered to make “personal use” of a dwelling unit?• She or her family members use the property (even if the family

members pay a fair rental value).

• Use by any person who has an interest in such unit (this would include other owners in a time share).

• Taxpayer’s who swap use of their unit for use of another unit (even if rent is paid). This would include the following circumstances: your neighbor has a condo in Hawaii and you have one on the Washington Coast. You agree to swap one week’s use of the condos.

• Use by any individual unless fair rental is paid (this would include allowing friends to use the property without paying a fair rental, or the use that arises when you contribute a week’s stay at the beach house as part of a charity raffle).

246Real Estate:


Personal Use

• Retired merchant marine wasn't entitled to Code Sec. 212 deductions for expenses of home he allegedly rented to friend during years he was largely at sea: taxpayer, who left his furniture in home and didn't show amount of time he wasn't at sea or where he lived then, failed to establish that he didn't use property as personal residence under Code Sec. 280A(d)(1) or that he rented it for fair rental value; rather, facts that he set rent at amount friend could pay and only collected single payment despite renting to her for number of years, showed he charged less than fair rental value.

• Hunter, Harrison, (2014) TC Memo 2014‐164

245

246



247Real Estate:


Personal Use

• How are days counted when the unit is used for repairs or annual maintenance? If both spouses are present must both of them spend a substantial part of the day on repairs or maintenance?

These are not counted as personal use days. This can include some days when no repairs are involved (e.g., when arrive on a Thursday, work on repairs Friday and Saturday, don’t work on repairs on Sunday, you may treat all four days as repairs days). Senate Report, PL 97‐119, Amended Prop. Reg. 1.280A‐1(e)(6).

Only one spouse needs to spend a substantial portion of time on repairs. Amended Prop. Reg. 1.280A‐1(e)(6).


Passive Activities

247

248




Rental Activities


Automatically PassiveThe “Per Se” Rule

249

250



251Real Estate:


Per Se Rule

• Rental activities are generally per se (automatic) passive.

Generally, can’t deduct net rental losses unless

• Have passive income from other sources, or

• Dispose of entire activity.

Material participation is irrelevant.


Exceptions“Per Se” Rule

251

252



253Real Estate:


Exceptions (Not “Rental Activities”)

• Common exceptions to per se rule. 1.469‐1T(e)(3)(ii)

1. Avg. period customer use ≤ 7 days;

2. Group insubstantial rental w/business in which materially partic.

3. Real estate professionals*.

4. Others we won’t cover today.

254Real Estate:


Exception 1: 7‐Day Exclusion

Average use ≤ 7 days exception

• Not “rental activity” if avg period of use ≤ 7 days.

So, not “per se” passive.

• Often applies to beach homes Hawaii, etc.

Also, Airbnb.

253

254




Restrictions

Grouping

Rentalswith Non‐rental Activities

256Real Estate:


General Rule

Generally, can’t group rental activity w/ business activity.

Exceptions

1. Activities grouped are “appropriate economic unit” and

2. Any of the following

a. Rental activity insubstantial to business.

b. Business activity is insubstantial rental; or

c. Each owner of business activity has same % ownership in rental activity.

255

256



257Real Estate:


Grouping Rental with Non‐rentalsExample

• Dentists owns part of dental office bldg. LLC.

They lease building to S corp. w/dental practice.

Can group w/dental practice (AEU, insubstantial).

Good: allows losses on rental to be deducted.

No NIIT – material participation activity.

258Real Estate:


Inappropriate Grouping

Example (inappropriate grouping)

• Attorney is a sole practitioner.

Also owns 100% residential rental‐ rents to college kids.

Law practice is business activity.

RE is rental activity, is insubstan al →law prac ce.

Law practice and real estate not “appropriate economic unit”.

• Therefore, can’t group law practice and RE. Treas. Reg. 1.469‐4(d)1)(ii) example 2.

257

258




Rental LossesUsually Trapped in “Passive” Cage

260Real Estate:


Rentals

• Rental income or loss is usually “per se” passive.

• Even if taxpayer materially participates.

• Still treated as passive loss (or income).

259

260



261Real Estate:


Per Se PassiveExample

• Michelle is a CPA, also owns a duplex.

• Duplex has 2018 loss of ($24,580).

• 2018 ‐‐ spends 525 hrs. managing/repairing duplex.

• She materially participates.

• Most businesses, could deduct loss.

• But rentals are usually per se passive.

• Therefore, losses are passive and suspended.

262Real Estate:


Review

• Qualified RE prof. not subject to “per se” rule. §469(c)(7)(A)(1).

Don’t automatically get losses.

Take losses if materially participate in rentals.

261

262




Real Estate Professionals Freed from “Per Se” Passive Cage

264Real Estate:


Real Estate Professionals

• RE professionals freed from “per se” passive cage. Treas. Reg. 1.469‐9(e).

But doesn’tmean rentals losses always deductible.

263

264




Okay

You’re Freed from the Passive Cage

Can Now Deduct All Rental Losses?

266Real Estate:


Can You Now Deduct All Rental Losses?

• Can you now automatically deduct all rental losses?

Heck No!

265

266



267Real Estate:


Real Estate Professionals

• RE professional status – possible to deduct rental losses.

But, like all businesses must still materially participate. Perez v. Com’r., TC

Memo 2010‐232.

268Real Estate:


Real Estate ProfessionalsExample

• Karen owns RE development co. (2,000 hrs./yr).

Qualifies as a RE professional.

• She also owns a rental property – big losses.

Hires mgt. co., she spends 50 hours each yr. on rental.

Doesn’t materially participate.

• Even though she’s a RE prof., can’t deduct rental losses.

She doesn’t materially participate.

267

268




RE Professional: Clearing 2 Hurdles

270Real Estate:


The Tests

Qualified RE Professionals – Meet both tests

1. Test 1 (50% personal services)

> 50% personal services in “real property businesses” in which taxpayer materially participates, and

2. Test 2 (750 hours) ‐‐ > 750 hrs during year in “real prop. businesses” in which materially participate.

269

270




Special RuleMarried – Real Estate Professionals Only

750 Hour and 50% Tests

One Spouse AloneMust Meet

272Real Estate:


One Spouse Must Satisfy 50%/750 hrs.

• Unlike material participation (spouse’s time combined).

Just one spouse (by him or herself) must satisfy both

• 50% and

• 750 hour tests. Tom Miller v. Com’r., TC Memo 2011‐219 and §469(c)(7)(B).

271

272




Common Types: RE Professionals

274Real Estate:


Commons Situations – ContractorExample

• Lisa is a contractor. Builds custom homes.

~ 2,000 hrs./yr. and income = $300K/year.

• Also owns rental house.

• Provides substantially all services for rental.

Test 2 material participation.

• Rental house produces loss of ($15,000)/year.

• Lisa can deduct rental losses.

But only because she materially partic. in rental.

273

274



275Real Estate:


Common Situations – Spouse MainlyWorks on RentalsExample

• George is full‐time CPA ($300,000/yr. income).

• He and spouse own 8 rentals.

Spouse’s onlywork ‐‐managing rental properties.

Spouse spends 100 hrs/yr. on each rental (800 hrs total).

• Make grouping election.

• Rental properties combined loss = ($70K)/year.

• Can offset rental losses against George’s CPA inc.

276Real Estate:


Common Situations – RE Agent/BrokerExample

• Joanne is a RE agent‐‐ independent contractor.

• Works 1,300 hrs/year as RE agent, earns $250K.

• Owns 5 rental houses. $60K/year in losses.

• Materially participates in rentals (“substantially all”).

• Can deduct rental losses. Agarwal v. Com’r.

275

276




Definition“Real Property Business”

278Real Estate:


Real Property Trades or Businesses Include

1. Development

2. Redevelopment

3. Construction

4. Reconstruction

5. Acquisition

6. Conversion

7. Rental

8. Operation

9. Management

10. Leasing or

11. Brokerage

Note ‐‐ regs say some businesses can be combined to measure material participation.

277

278



279Real Estate:


Must Materially Participate in Real Estate Business

• Time in RE business only counts if taxpayer materially participates in that business. Treas. Reg. 1.469‐9(c)(3).

280Real Estate:


Time Spent as Employee

• Employee time does not count unless employee owns ≥ 5% (under §416(i)(1)(B)). Treas. Reg. 1.469‐9(c)(5)

279

280




Material Participation

Substantially All Test (Test 2)

FITCH V. COMM’R.TC MEMO 2 0 1 2 ‐ 3 5 8

282Real Estate:


Substantially All Participation TestFacts

• Don Fitch ‐‐ CPA.

Aneurism in 2003, had to sell practice.

• Brenda Fitch – RE agent (> 750 hours).

• Don and Brenda owned 8 rental properties.

• Didn’t elect to aggregate rental activities.

• Brenda performed almost all tasks related to rentals.

Bookkeeping, repairs, screen tenants, insurance, etc.

Occasionally hired a contractor (e.g., an electrician).

281

282



283Real Estate:


Substantially All Participation TestIssue

• Did they materially participate in each rental.

Brenda was “RE professional,”

Hadn’t elected to group

Had to show materially participation in each rental.

284Real Estate:


Substantially All Participation TestHolding

• Fitches materially participated in each rental.

Met Test 2 –“Substantially all” participation.

Occasional hiring of electrician or engineer not fatal.

283

284




RE Professionals – Election to Group RentalActivities

286Real Estate:


Special Rules

• Each rental prop. separate activity, unlessmake election.

Sometimes called a “RE professional” election.

This is a misnomer.

• Either RE professional or not RE professional (no election required).

Election is to aggregate rentals to check material participation.

• Election may qualify clients as material participants.

Butmay “freeze” passive losses on disposition of just one property.

285

286



287Real Estate:


Qualify as Material ParticipantExample

• Client has 14 rental properties.

• Spends 60 hrs/yr. on each property (840 hrs).

• Hires mgt. co. (so can’t meet subst. all or 100 hrs.).

Won’t meet any mat’l. partic. test unless elect to group.

If she groups rental activities, will meet 1st test (500 hrs).

288Real Estate:


Backfiring!!Example

• Michelle owns duplex and a triplex.

$30,000 in suspended losses duplex (2014‐2017).

• She becomes RE agent in 2018, qualifies as RE prof.

No management company, could qualify under “substantially all” rule.

• She makes “aggregation” election for 2018.

• She deducts rental losses in 2018.

• In 2019, she sells duplex for $10,000 loss.

No loss allowed, duplex loss passive losses stay suspended.

Didn’t dispose of entire activity (since duplex and triplex one activity).

287

288



289Real Estate:


Limits on Grouping Election

• Some rentals aren’t included in the grouped activity.

Excluded from “grouping,” won’t count for material partic.

1. Rentals w/avg. period customer use ≤ 7 days. Bailey v. Com’r.

─ Example – most Airbnb’s.

2. Self‐rentals.

─ Example – Physician owns bldg., leases to medical practice.


Life Cycle – Maturity Sales, Exchanges and Step Up’s

289

290




Allocations

292Real Estate:


Legislative History to §1060

• Courts and IRS ‐‐ generally accept parties’ allocation of FMV provided they have “adverse tax interests” w/respect to allocation. Senate Explanation, '86 TRA, PL 99‐514

291

292



293Real Estate:


Treas. Regs

Sales w/personal prop. and other property (e.g., bldg.)

• In general, any arm's‐length agreement between buyer and seller will establish the allocation if they have adverseinterests. Treas. Reg. 1.1245‐1(a)(5).

294Real Estate:


Treas. Reg. 1.1250‐1(a)(6)

• Same rule applies to allocations between

Depreciable real property, and

Land. Treas. Reg. 1.1250‐1(a)(6)*.

* Incorporates respect for adverse interests rule on preceding slide.

293

294



295Real Estate:


Overall Point

Use allocations that produce win/wins.

296Real Estate:


Land Improvements

Strategy for land improvements.

• Large allocation to land improv. cuts combined taxes.

Not crazy allocation though.

Seller may have little gain on land improvements.

Buyer can take bonus depreciation.

295

296




The Mechanics of Allocations

298Real Estate:


Method of Allocation

Preference: Include allocation in PSA.

• Any form of allocation probably works:

• “Side letter.” Schmitz, 51 TC 306, §1060(a) (merely needs to be written).

Email exchange should work.

297

298




Are You Bound by the Allocation?

300Real Estate:


Parties Generally Bound by their Agreement

• Are you bound?

Yes.

• Real estate rentals almost always a business.

So §1060 controls whether allocations are binding.

Danielsen standard applies.

• Must follow written allocation unless: duress, fraud, mutual mistake…

299

300




No “Agreed” Allocation?Don’t Sweat the Details

302Real Estate:


Lecturer’s Conviction

“One need not get all twisted up in one’s own undergarments to resolve allocation issues.” Your instructor.

• If no agreed allocation – need to do some work.

• But no need to lose sleep.

301

302



303Real Estate:


Written AllocationsExample

• The parties agree to allocate price

Building ‐‐ $470,000.

Land ‐‐ $330,000.

Land improvements ‐‐ $23,000.

§1245 prop. ‐‐ $7,000.

304Real Estate:


Building vs. Land – Assessed Value

• Sellers usually prefer assessed value.

Typically provides > allocation to land.

More capital gain, less 25% tax rate.

Support for assessed value: Conroe Office Building, TC Memo 1991‐224.

Strategy: Don’t agree to allocation.

• Use assessed value to allocate.

303

304



305Real Estate:


Some Case Law Supports Assessed Value

• “As the Tax Court noted in footnote 5 in ... Creston Corp.

• [T]he assessed values of properties may be used ‘in determining the relative value’ of properties.” PLR 9110001.

306Real Estate:


Regulations – Formula

• If no agreement between parties, fact & circumst. incl.

Original cost, reprdn. cost (construction, installation ...),

Remaining economic useful life,

State of obsolescence, and

Anticipated costs to maintain, renovate, or to modernize. Treas. Reg. 1.1245‐1(a)(5).

305

306



307Real Estate:


Practical Approaches – Personal PropertyExample

• Sell apt. building, land improv. and personal property.

Total sales price = $1 million.

• No written agreement on allocation of sales price.

• Carpeting (9 yrs old ) cost $25,000, est’d life = 10 yrs.

Obsolete – newer carpet is much better.

FMV = $1,250 [cost x 10% (remaining life) x 50% (obsolete)].


Aging and Tax Step‐ups

307

308



309Real Estate:


The Role of Taxpayers’ Ages

Possible step‐ups important as get older.

• Older taxpayers – carefully consider

Holding real property until pass away.

Like kind exchange if must sell.


Like Kind Exchanges

309

310




Tax Issues – Like Kind Exchanges and LLCs

TICS AND “DROP AND SWAPS”

312Real Estate:


Partnerships Interests

• Partnership interests don’t qualify for §1031.

• Taxpayers use “drop and swaps” to avoid this.

Distribute RE to owners as tenants in common.

Then those partners who want §1031’s can do so.

Others can use taxable sales to “cash out.”

311

312



313Real Estate:


Background

• Mere co‐ownership of property can avoid partnership status for tax purposes. Rev. Rul. 75‐374

• Including tenancy in common.

314Real Estate:


Observations

1. Safe harbor for clients to “play it safe.”

a. Rev. Proc. 2002‐22 provides PLR’s if meet standards.

b. Client who wants certainty should get PLR.

2. QI’s do the heavy lifting in this area.

a. You discuss w/client possibility of using “drop and swap.”

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315Real Estate:


Before §1031 Exchange

What’s Your SignificantlyBetter Replacement

Property?

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§1031 ‐‐ Better Value Proposition

• We all get phone calls about §1031 exchanges

Clients thinking about selling property ‐‐ should they do §1031 exchange?

Something to ponder:

• Would replacement property provide significantlymore upside?

─ Selling expenses usually about 8% of gross sales price (+ cost of QI).

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317Real Estate:


Example

• Jim is thinking about selling rental property (roughly $300,000).

Should he do a §1031 exchange?

• Question: Why are you selling?

Great time to sell? Probably a bad time to buy.

Or if want to reinvest, Jim will be worth approx. $26,000 less.

• Selling costs ($24,000) + exchange facilitator fee ($2,000).

• So unless replacement property is incredible deal, why sell original property?

─ Holding on to existing property might make more sense?


IntentReplacement Properties

A view towards retirement

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319Real Estate:


An Eye Towards the Future

• Common to consider future personal use.

Does such future intent wreck §1031?

Example

58 year‐old client has busy life.

Reinvests proceeds of duplex → rental on beach.

Hopes to retire there.

320Real Estate:


Losing Arguments

Tony Goolsby v. Comr., TC Memo 2010‐64.No research if covenants

allow rental. Minimal efforts to

rent. Move in 2 mos.Tony loses.

Jessie G. Yates III v. Comr., TC Memo 2013‐28.

Move in 3 days after acq (pers. res.)

Not “business or investment” → 1031.

Jessie loses.

What doesn’t work:

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Winning Argument

PLANNED FUTURE USE AS RESIDENCE.

REESINK V. COMR.

322Real Estate:


Winning Argument

Patrick Reesink v. Comr., TC Memo 2012‐118.

• Patrick owns apt. bldg. w/brother – SF.

• Brothers don’t get along.

• Patrick said brother:• Attacked him, strangled him.

• Tried to poison him (cleaning fluid in drinking wtr.).

• Patrick sued brother, collected $60K.

Background

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323Real Estate:


Reesink v. Comr.

Already had principal residence in SF.

Wife didn’t want to move.

Kids would have to change schools.

Sells interest in apt. building §1031.

Buys rental house in Sonoma Valley.

324Real Estate:


Replacement Property

After 8 mos. no rental, sells SF residence, moves to Sonoma.

Places rental fliers in town (no ads).

Shows prop. → 2 possible renters.

Can’t rent, won’t lower rent/mo.

Financial pressure builds.

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Patrick’s Brother

A Rat Testifies for IRS.

326Real Estate:


Future Plans

Brother testified for IRS

• Patrick plannedmove → Sonoma a er kids grown.

• IRS – Patrick therefore lacks investment “intent.”

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327Real Estate:


OutcomeTax Court

• Brother’s testimony helps Patrick.

At time of exchange, eldest son was age 14.

Supports intent as investment property.

• Patrick wins!

• Possibly never pay tax? (§1014 step up)

328Real Estate:


IRS Safe Harbor

• Safe harbor: IRS won’t challenge §1031 where both

• Relinquished residence, and

• Replacement residence meet “qualifying use” test

• For at least 24 months immediately

• Before exchange and

• After exchange (Rev. Proc. 2008‐16).

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329Real Estate:



330Real Estate:


Thank You for Attending Today’s Program

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331Real Estate:


Final Exam

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Final Real Estate State of the Art Tax Planning Strategies

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Transcript of Final Real Estate State of the Art Tax Planning Strategies