1 Real Estate advisor May June 2015 Property tax assessments Court of appeals weighs in on tax assessment Tax Court disallows property owner s bad debt deduction Investor vs. dealer Understanding the difference is key Ask the Advisor How can I benefit from carbon credits?
2 Property tax assessments Court of appeals weighs in on tax assessment Property taxes often represent a significant chunk of an owner s annual expenses. Yet many taxpayers simply accept the billed amounts calculated by their assessors. That might not be wise, as a recent case in California illustrates. In SHC Half Moon Bay, Inc. v. County of San Mateo, the California Court of Appeals, applying property tax laws similar to those in some other jurisdictions, found that a county s assessment improperly inflated a hotel s value in turn improperly inflating the hotel s property taxes. Hotel owner challenges property tax In 2004, SHC Half Moon Bay purchased the Ritz-Carlton Half Moon Bay Hotel for about $124 million. The purchase price included real and personal property (furniture, fixtures and equipment), as well as intangible assets and rights. As part of an income valuation approach, the San Mateo County assessor assessed the hotel at its purchase price and deducted the value of personal property. It ultimately reached a total value of about $117 million. SHC challenged the property tax assessment, asserting that it erroneously included the value of over $16 million in nontaxable intangible assets specifically, the hotel s assembled workforce, leasehold interest in the employee parking lot, agreement with the golf course operator and goodwill. It argued that simply deducting the hotel s management and franchise fee of $1.6 million wasn t enough to exclude intangible assets from the assessment, as required by state law. Instead, SHC contended, the assessor was required to identify, value and exclude the value of the intangible assets from the calculation. The assessor assessed the hotel at its purchase price and deducted the value of personal property. It ultimately reached a total value of about $117 million. The county Assessment Appeals Board upheld the assessment. SHC then sued for a property tax refund, but the trial court also sided with the county. SHC appealed. Court sides with owner The Court of Appeals began its review by noting that California law mandates that the quantifiable fair market value of intangible assets that directly enhance a property s income stream such as goodwill, customer base and favorable franchise terms or operation contracts be deducted from an income 2
3 stream analysis prior to taxation. (Many county laws similarly provide that property tax valuations should be based on the value of the real estate only.) The court concluded that the assessor s deduction of the management and franchise fee from the hotel s projected revenue stream didn t identify and exclude intangible assets. It pointed out that the assessor s expert had conceded to the appeals board that the assessor s methodology didn t remove all intangible assets and rights. His report stated that only the majority of the property s business value was removed by deduction of the fee. The report also acknowledged that the capitalized value of necessary preopening expenses (for example, the cost of assembling and training a workforce, preopening marketing expenses and working capital) is frequently deducted as an intangible value of a hotel. According to the court, the expert s report and testimony demonstrated that the assessor s methodology failed to attribute a portion of the hotel s income stream to the enterprise activity that was directly attributable to the value of the intangible assets and deduct that value prior to assessment. Therefore, the methodology was legally incorrect. Should you challenge your property taxes? Unlike the property taxes at issue in SHC Half Moon Bay (see main article), which were the result of an individually tailored assessment, property taxes are often based on estimates derived from mass appraisal techniques. These techniques might prove accurate overall, but the individual estimates don t necessarily reflect specific properties characteristics. So don t just blindly pay your tax bill. Take a close look at the factors that were applied to your property and determine whether they actually do apply. For example, you might find errors in the property description, such as square footage, age, condition and construction materials. To contest an assessment, you can present testimony from a professional appraisal, financial data for the property (such as income and cash flow statements), current leases and assessments for similar properties. If you decide to appeal your assessment, pay attention to the relevant jurisdiction s deadlines. While some jurisdictions have a rolling appeals process, many observe strict deadlines. The court did, however, uphold the Assessment Appeals Board s finding that the fee largely captured the goodwill. Although there may be situations where a taxpayer can establish that the deduction of a management and franchise fee doesn t capture goodwill, it said, SHC failed to do so here. Appeal leads to savings As a result of the appellate court s ruling, the board was required to recalculate the value of the property, applying the income method consistently with the court s findings. In other words, it will have to exclude the value of the hotel s assembled workforce, leasehold interest in the employee parking lot and agreement with the golf course operator which should produce substantial tax savings. n 3
4 Tax Court disallows property owner s bad debt deduction A long-time real estate investor who also made occasional loans has learned the hard way about what does and doesn t qualify as deductible business bad debt. In ruling that he couldn t deduct about $153,000 in outstanding debt, the U.S. Tax Court in Langert v. Commissioner clearly explained the requirements that must be satisfied before a taxpayer can claim a bad debt deduction. Property loan goes bad The taxpayer had been involved for about 30 years in one or more activities involving real property, including buying, selling and renting real property and providing management services. During that period, he made six loans, but he never advertised himself as a moneylender or kept a separate office or separate books and records relating to any of the loans. The taxpayer claimed a deduction for his loss on Schedule C of his 2009 tax return. The IRS subsequently issued the taxpayer a notice of deficiency that disallowed the deduction. In 2003, he transferred about $157,000 to an individual to help finance the purchase of some property. The individual and his mother signed a document titled Unsecured Note. They weren t required to provide collateral. The taxpayer never checked his credit ratings and didn t require any financial statements or other pertinent financial information. He also failed to verify the source of funds that would allow him to comply with the terms of the note. After making 28 monthly payments, the debtor defaulted on the loan. The taxpayer/lender asked him orally, not in writing, to pay the outstanding debt. He didn t ask the debtor s mother to pay the debt, nor did he pursue any legal remedy for the default. When the debtor filed for bankruptcy, the taxpayer didn t file a claim for the debt with the court. He also didn t contact the foreclosure trustee or file a claim when the property went into foreclosure auction. The taxpayer claimed a deduction for his loss on Schedule C ( Profit or Loss From Business ) of his 2009 tax return. The IRS subsequently issued the taxpayer a notice of deficiency that disallowed the deduction. 4
5 Court nixes deduction In Tax Court, the taxpayer claimed he was entitled to a deduction for a business bad debt because he had made the loan for the sole purpose of obtaining interest income. As the court noted, for all or a portion of a debt to be deductible as a bad debt, the debt must, among other things, constitute 1) a debt created or acquired in connection with a trade or business or 2) a debt from which the loss is incurred in the taxpayer s trade or business. The mere fact that a taxpayer makes a loan solely to obtain interest income, the court said, doesn t on its own lead to a finding that the loan is deductible. Moreover, for a taxpayer to be entitled to a bad debt deduction in connection with the trade or business of lending money, the debt must have been sustained in the course of loan-making activity that was so extensive and continuous as to elevate that activity to the status of a separate business. The court found that making six loans over 30 years, during which the taxpayer conducted real property activities, didn t elevate the loan activity to the status of a separate business. In support, it cited a previous case where the court found that making eight or nine loans over four years didn t elevate the activity to separate business status. The tax implications As the court pointed out in its ruling, under typical circumstances the taxpayer would be able to treat the bad debt as a capital loss. In such situations, the deduction is subject to the strict annual limit of $3,000 in net capital losses. n Investor vs. dealer Understanding the difference is key Knowing whether you re an investor or a dealer in the world of real estate is critical. Why? Because the way the IRS treats you could have a significant impact on your tax liability. There s a fine distinction between the two. Vive la différence! Real estate investors enjoy several tax advantages that aren t available to those deemed to be real estate dealers. Perhaps foremost, an investor s gains on sales of property held long term (more than one year) are subject to tax at capital gains tax rates. Investors also may be able to engage in tax-free Section 1031 (like-kind) exchanges and installment sale transactions that allow for the deferral of taxes. Dealers face steeper taxes in many instances. Under Internal Revenue Code Section 1221, real property held by a taxpayer for sale to customers in the ordinary course of a trade or business that is, property held by a dealer isn t a capital asset. Dealers, therefore, must treat gains as ordinary income, which is taxed at substantially higher rates than long-term capital gains. In addition, unless a dealer has set up a separate entity to reduce taxes, the dealer s ordinary income (including gain on the sale) will also be subject to self-employment tax. On the plus side for dealers, their losses are considered ordinary losses, so they aren t subject to 5
6 the taxpayer has owned the property is critical. For example, if you hold a single property for more than a year, the IRS is likely to consider you an investor. If you hold multiple properties for less than a year, expect to be designated as a dealer. Courts also look at the nature and purpose for which the taxpayer acquired, held and sold the property, as well as the nature and extent of the taxpayer s efforts to sell the property. Plus, the extent of subdivision, development and improvements made to the property to increase sales will be evaluated. A court might weigh whether a business office and brokers are used to sell property, the character and degree of control by the taxpayer over the individual(s) who sells the property and the extent of advertising the property. Last, courts will consider whether the taxpayer has experienced a change of plans such as a divorce or relocation that modified the original intent regarding the property. Also important is how the taxpayer holds itself out to the public (that is, as a dealer or as an investor). restrictions that limit the amount of capital losses a taxpayer can offset against ordinary income to reduce tax liability. Dealers also are allowed to deduct their full interest expense on property from ordinary income; investors can t claim an interest expense deduction greater than the amount of their net investment income. And dealers can offer rent-to-own lease programs, in lieu of installment sales, to defer recognizing gains. No definitive criteria So how do the IRS and the courts distinguish between an investor and a dealer for tax purposes? There s no definitive list of criteria. Based on various court decisions, though, relevant factors include the taxpayer s sources and amounts of income and the value, volume and frequency of the taxpayer s real estate transactions. Generally, investors purchase properties and hold them with a long-term perspective. Dealers buy and sell properties relatively quickly. So how long Generally, investors purchase properties and hold them with a long-term perspective. Dealers buy and sell properties relatively quickly. Due to the facts-and-circumstances nature of these items, you need to maintain appropriate documentation to evidence your activities, plans and intent. No single factor or combination of factors will settle the issue. You could even qualify as an investor for one property and a dealer for others, depending on how you structure your transactions. Bring in a professional It s critical that you contact your tax advisor before going into unknown territory regarding the investor vs. dealer quandary. He or she can help you understand the law. n 6
7 Ask the Advisor How can I benefit from carbon credits? As more building owners have begun to explore the advantages of pursuing energyefficient or green initiatives in their properties, some might wonder how carbon credits come into play. Although these credits have received a lot of attention over the past decade or so, many business owners don t understand how they work and how they can benefit owners. How the credit works Carbon credits are generally earned by offsetting carbon dioxide (CO2) emissions through conservation, alternative energy and other technologies. A single carbon credit represents a metric ton of CO2 or CO2-equivalent gases removed or reduced from the atmosphere. The credits represent transferable rights to emit greenhouse gases and can be traded (or sold) on voluntary and compliance carbon markets. Compliance markets include legally binding mandatory emission-trading mechanisms established under, for example, the Kyoto Protocol. Regional compliance markets can also be found in areas of the United States and Australia. Businesses purchase the credits to offset their own emissions, whether to meet their corporate social responsibility goals or external carbon reduction goals. Increasing numbers of companies are experiencing stakeholder pressure to improve their emissions. To earn credits, a property owner would first need to set verifiable audit baselines through an investment-grade audit (a type of audit used to justify investment in a capital-intensive energy-efficient initiative). The audit would identify opportunities to improve energy efficiency and generate credits that can be traded on a market. Such opportunities can range from behavioral changes, such as powering down computers overnight, to capital projects, such as installation of solar panels. Credits generated in the United States typically can be traded domestically or abroad. Benefits of carbon credits Carbon credits produce favorable financial results on several fronts. A building with energy-efficient features will obviously reap savings on energy costs and could trigger tax breaks. That, in turn, would reduce operating expenses while increasing net operating income and internal rates of return. Increasingly, such buildings come with a competitive edge, as growing numbers of potential tenants consider sustainability when selecting their spaces. Moreover, trading or selling credits on a voluntary or compliance market provides an owner with additional revenues. Win-win? Carbon markets aren t yet commonplace, and an eventual mandatory cap-and-trade system in the United States isn t a given. But the bottom-line benefits of energy-efficient efforts have been clear for some time now, and the potential of carbon credits to build revenues can be a bonus. n This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use REAmj15 7