Real Estate advisor. Tax Court finds property owner wasn t a real estate professional. November December Ask the Advisor

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1 Real Estate advisor November December 2013 Tax Court finds property owner wasn t a real estate professional Stop and think before you surrender property A budding valuation consideration Explore the world of green building features Ask the Advisor Is a reverse exchange right for me? Mount Arlington Office Newton Office

2 Tax Court finds property owner wasn t a real estate professional A property owner who qualifies as a real estate professional stands to reap more tax benefits than ever these days. If you satisfy the requirements, you may be able to offset some nonrental income with rental losses, as well as avoid the new 3.8% Medicare tax on net investment income. Satisfying the requirements, though, is no small task. In Hassanipour v. Commissioner, the owner and manager of rental units recently learned that lesson the hard way. Owner claims net rental losses In 2008, the owner/manager was employed full-time as a research associate. He signed and submitted monthly timesheets to his employer, reporting a total of 1,936 hours worked. He also owned 28 rental apartment units in seven buildings in Vallejo, Cal., and had a 50% interest in a single-family residence in Lake Tahoe. He performed various duties in relation to the rental properties, including repairs, administrative tasks, researching landlord/tenant law and preparing tax returns. On their joint 2008 Form 1040, the owner/ manager and his wife reported combined wages of $239,037 and claimed net rental losses of $120,540. The IRS, however, disallowed the rental losses as passive activity losses and found that the couple had underpaid taxes by $38,067. Real estate professional rules Passive activity is defined as any trade or business in which the taxpayer doesn t materially participate. Material participation is defined as involvement in the operations of an activity that s regular, continuous and substantial. Rental real estate activities are generally considered passive activities regardless of whether you materially participate. The Internal Revenue Code grants an exception from restrictions on passive activity losses for real estate professionals. If you qualify as a real estate professional and materially participate, your rental activities are treated as a trade or business, and you can offset any nonpassive income with rental losses, thereby reducing your taxes. You may also be able to sidestep the 3.8% Medicare tax on net investment income as long as you re engaged in a trade or business with respect to the rental activities. To qualify as a real estate professional, you must satisfy two requirements: 1) More than 50% of the personal services you perform in trades or businesses are performed in real property trades or businesses in which you materially participate, and 2) you perform more than 750 hours of services in real property trades or businesses in which you materially participate. Real 2

3 property trades or businesses include those that develop or redevelop, construct or reconstruct, acquire, convert, rent, operate, manage or broker real property. The property owner s claims At trial in this case, the owner/manager argued the hours he d spent on rental activities exceeded his time spent working for his employer. He claimed that he d worked 35 hours per week for the employer for a total of 1,610 hours. To prove that his hours spent on rental activities related to the Vallejo apartments, he presented estimates, summaries and a generic calendar that wasn t dated 2008, but which he d allegedly kept contemporaneously on dates starting on Dec. 31, The calendar showed 1,182.9 total hours. He hadn t kept a contemporaneous record of time spent on the Lake Tahoe property but estimated that he d spent 150 to 200 hours on that property and more than 500 hours performing tasks not reflected on his calendar. Court sides with IRS Participation in an activity can be established by any reasonable means you aren t required to keep daily time reports, logs or similar documents. A reasonable system could include appointment books, narrative summaries or calendars. However, in this case, the U.S. Tax Court rejected the owner/manager s evidence as unreliable. For starters, his 2008 calendar was copyrighted in 2009 and appeared to be reconstructed, rather than contemporaneous. And his testimony regarding his 35 hours per week work for his employer was contradicted by his monthly timesheets. And some of the estimates he added to the hours recorded in the calendar duplicated tasks or time that was already logged in the calendar. Participation in an activity can be established by any reasonable means. The court concluded that the owner/manager had failed to establish that he was a real estate professional in 2008, without needing to consider the material participation aspect. His rental activities, therefore, were passive, and he couldn t offset his rental losses against other income. The challenge It can be difficult to satisfy all the requirements to qualify as a real estate professional, particularly if you have another full-time job. Contemporaneous records may not be required, but they ll go a long way toward helping build your case. n Property owner s underpayment leads to $7,600 penalty The IRS imposes a 20% accuracy-related penalty on any underpayment of federal income tax that s attributable to a substantial understatement of income tax. An understatement of income tax is substantial if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. The IRS assessed a $7,600 penalty against the owner/manager in the case described in the main article for his rental loss related underpayment of taxes for Because the understatement of income tax was substantial, he had the burden of showing the penalty was inappropriate because he d acted with reasonable cause and in good faith. He argued that he should be excused from the penalty because the rules are complicated. The court disagreed, noting that he hadn t consulted competent tax professionals, and had failed to show good faith or reasonable cause. Therefore, he was liable for the penalty. 3

4 Stop and think before you surrender property Although much of the nation has seen an uptick in home sales, there are still areas in the United States that are dealing with sluggish markets. Those folks may be better off if they surrender their properties rather than try to satisfy their loan obligations. But if you re in this situation, be careful. Why? Because discharging that debt may lead to unwelcome consequences. Avoiding dire circumstances If you default on a nonrecourse loan, your lender s recourse is to seize the property that secured the loan. When you surrender property, the transaction is generally treated as a sale to the lender for the amount of debt. Your capital gain or loss equals the difference between the amount of outstanding debt and your adjusted tax basis in the property. For example, if outstanding debt is $1 million and your tax basis is $700,000, your taxable gain would be $300,000. A discharge of nonrecourse debt, however, doesn t result in any taxable cancellation of debt income (CODI) because the lender has no right to pursue other corporate or personal assets. Surrendering property If you default on a recourse loan, the lender can hold the corporation or the owners liable for the outstanding debt (if they ve signed personal guarantees or if the business is structured as a pass-through entity). When you surrender property financed with recourse loans, the net amount of taxable gain or loss is the same, but it s categorized differently. The capital gain or loss generally equals the difference between the fair market value (FMV) of the property and your tax basis in the property. So, in the example above, if the FMV is $750,000, the taxable gain would be $50,000 ($750,000 $700,000). In addition, CODI (calculated as the amount of outstanding debt less the property s FMV) is realized when the debt is discharged following the surrender of the property. CODI is taxable as ordinary income. Here, it would be $250,000 ($1 million $750,000). The Internal Revenue Code allows taxpayers to exclude CODI after surrendering property in some circumstances, including bankruptcy. CODI generally is excludable if the taxpayer s debts have been discharged in a Title 11 bankruptcy proceeding or if the taxpayer is insolvent both before and after the debt is discharged outside of a bankruptcy proceeding. In this case, insolvency is determined by deducting the value of the taxpayer s assets from its liabilities. 4

5 If the indebtedness is incurred in connection with trade or business real estate, however, the taxpayer can elect to reduce the basis of depreciable property rather than recognizing CODI, thereby reducing future depreciation deductions. The reduction will be recaptured as ordinary income. If CODI is excluded from taxable income under one of the exceptions, though, the taxpayer must reduce certain tax attributes to reflect the amount excluded. He or she can elect to reduce the tax basis of depreciable property (including real property inventory) before reducing tax attributes such as tax credits or net operating losses. If all tax attributes are reduced to the point of elimination, any outstanding CODI is permanently excluded. These exceptions aren t available at an entity level for pass-through entities. So, for example, in a limited liability company (LLC), the availability of the first two exceptions turns on the bankruptcy or insolvency of the members, not the LLC. Similarly, it s not the LLC s tax attributes that are subject to reduction if CODI is excluded from taxable income. The individual members tax attributes are reduced. CODI is realized when the debt is discharged following the surrender of the property. Do your homework Surrendering property may be the best option for you, but before doing so, tap into the expertise of your CPA or financial advisor. He or she can help you potentially minimize any adverse tax effects. n A budding valuation consideration Explore the world of green building features With sustainability becoming more common in both residential and commercial real estate, appraisers are increasingly asked to weigh in on buildings with green features. While green valuations haven t yet come fully into bloom, the seeds have clearly been planted for environment-related features to affect property value. Why green matters At this point, many valuators are reluctant to incorporate green features in their valuations. After all, most sustainable or green buildings are relatively new, so there s a lack of data on sales and returns. But the growing demand for such properties means this aspect can t be ignored for long. Many companies and governments these days are requiring certain LEED or Energy Star ratings on new construction and rental property, including the federal government s General Services Administration. Energy Star certified buildings net an average rental premium of 4% and an average sales price premium of 26%, according to one study, Green Noise or Green Value? Measuring the Effects of Environmental Certification on Office Values. 5

6 Moreover, the University of California, Berkeley, found that, among Energy Star certified buildings, saving $1 in energy costs is associated with gaining a 4.9% premium in market valuation. This translated into an average increase in transaction price of $13 per square foot. And the U.S. Green Building Council has estimated that 40% to 48% of commercial construction by value will be green by With sustainability becoming more important to tenants and buyers, it seems likely that lenders will eventually get on board, too. Their due diligence and underwriting may well expand to reflect the benefits and risks associated with green properties. Valuing green In recognition of the growing green role in residential valuations, the Appraisal Institute recently released an updated form intended to help appraisers analyze the value of energy-efficient homes. The Residential Green and Energy Efficient Addendum is an optional addition to Fannie Mae Form 1004, which is the valuation profession s most widely used form for mortgage lending purposes. The five-page document offers a list of factors that valuators consider when appraising residential properties with green features, including: n Certifications by LEED or similar organizations, n Energy-efficient items (insulation, water systems, windows, lighting, appliances and HVAC), n Energy ratings, n Indoor air quality, n Utility costs, n Solar panels, and n Federal, state and local incentives that offset costs. The Appraisal Institute s form also considers the property s amenities, including pedestrian friendliness, access to public transportation, orientation and landscaping. Geographic location is also critical. Certain markets such as New York, Washington, D.C., Chicago, San Francisco, Seattle and Portland, Ore. have a higher green demand. Cities like Detroit and Cleveland are less focused on sustainability, at least for now. A green property also may be more valuable in locations with higher utilities costs, including water, electricity and natural gas charges. How appraisers quantify the added value of sustainability varies significantly. For instance, the unique attributes of a green property might require a wider comparable radius to find similar properties. In the absence of comparables, an appraiser might add a green premium based on the replacement cost of energy-efficient items. For commercial properties valued using the income approach, cost savings and financial incentives of being green will generate a higher net operating income. If so, the appraised value may already include a green premium implicit in the capitalization methodology. Care should be taken not to double-count the benefits. Overcoming challenges Comparables are often the basis for both residential and commercial property appraisals. While it s still difficult to find green comparables, this situation will surely change as more sustainable and retrofitted properties go on the market. In the meantime, make sure your property appraiser is up to speed on green features, technologies and practices and knows how to incorporate them in a valuation. n 6

7 Ask the Advisor Is a reverse exchange right for me? Real estate investors interested in enjoying the tax benefits of a like-kind exchange may consider a reverse exchange where the replacement property is acquired before the investor transfers the relinquished property. These transactions come with certain advantages and disadvantages, however. Reverse exchanges There are two versions of reverse exchanges, each with its own rules: 1. Exchange-first transaction. An exchange accommodation titleholder (EAT) purchases the relinquished property from the investor, with funds lent by the investor, before closing on the replacement property. A qualified intermediary (QI) uses the proceeds to acquire the replacement property. The EAT holds title to the relinquished property until the investor sells it to a third party. 2. Exchange-last transaction. The EAT purchases the replacement property with the investor s funds. When the taxpayer has a contract to sell the relinquished property, a QI sells it to the buyer and uses the proceeds to purchase the replacement property from the EAT. At closing, the EAT receives the proceeds, which it uses to pay off the loan to the investor. With each version, closing must happen within 180 days of the EAT taking title to the relinquished property. Pros and cons The principal benefit of the exchange-first structure is that it eliminates the need for the EAT s participation in the financing process for the replacement property. If, however, there s existing financing secured by the relinquished property, the lender may have a right to approve the transfer to the EAT. Another drawback is the possibility of underestimating the sales price, which could lead to taxable excess proceeds. With an exchange-last transaction, the investor can borrow the funds it expects to get from the relinquished property and pay down the loan after the relinquished property closes but before taking title to the replacement property. This allows the investor to invest all of the exchange funds in the replacement property and defer all taxes. On the other hand, the EAT will need to sign loan documents if the investor borrows money secured by the replacement property, and the loan must be nonrecourse to the EAT. The investor may need to personally guarantee the loan. Get the big picture If you re considering an EAT, weigh the cost of potential environmental factors, taxes, closing costs, and similar issues. Your financial advisor can help you decide if you should pursue a reverse exchange. 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 REAnd13 7

8 Mount Arlington Office Newton Office An Employers Dilemma: Is an Individual an Employee or Independent Contractor? By Eric Fernandes, CPA The IRS is aware that organizations sometimes willfully or negligently classify workers as self-employed rather than as employees. Failure to recognize employee status can result in serious tax consequences to the employer. It is always not so simple to determine whether an employer-employee relationship exists. The courts have considered many facts in deciding whether a worker is an employee or independent contractor. The relevant facts fall into three main categories: Behavioral control: Does the service recipient have the right to direct and control the worker? Financial control: Is there significant investment, reimbursement of expenses and opportunity to earn profits? Relationship of the parties: Are there employee benefits? Is there a written contract that show business intent? Over the years, The IRS has developed a list of 20 factors that may be examined in determining whether an employer-employee relationship exists. 1. An employer-employee relationship would exist if the service recipient has the right to require the worker to comply with instructions. 2. Worker training indicates employee status, as the service recipient wants the service to be performed in a particular manner. 3. Integration of worker s services into the business operation of the service recipient is an indication of employee status. 4. If services are performed personally, it indicates that the service recipient has an interest in the methods used to accomplish the work, indicating employee status. 5. Hiring, supervision and paying assistants. 6. Continuing relationship. 7. Set hours of work. 8. A worker devoting substantially full time to the service recipient s business would indicate that the worker is an employee. 9. Doing work on the employer s premises. 10. If the worker must perform services in the order or sequence set by the service recipient. 11. Oral or written reports: Example timesheets. 12. Payment by hour, week or month, indicates employee status; payment by job or commission indicates independent contractor status. 13. Payment of business and or travelling expenses. 14. Furnishing tools and materials. 15. Investment in facilities used by the worker indicates independent contractor status. 16. Realization of profit and loss generally indicates the worker is an independent contractor. 17. Works for more than one firm at a time. 18. If a worker makes his or her services available to the public on a consistent or regular basis, then this would indicate independent contractor status. 19. Right to discharge a worker indicates the worker is an employee. 20. Right to terminate the relationship with the service recipient at any time he or she wishes, without incurring liability, would indicate employee status. If you determine an individual to be an employee, then you must withhold income tax, employment taxes and provide a form W2. If you determine an individual to be a contractor, then you may be required to provide the individual a Form 1099-Misc. You are not responsible for the individuals estimate income tax payments and self-employment taxes. Payments to independent contractors are not subject to workers compensation insurance, unemployment insurance, or disability insurance. Payments to independent contractors are also not eligible for pension plan or any employment fringe benefits. If an employer misclassifies an individual, as an independent contractor instead of an employee, the employer could later be liable for all the past benefits as a result of the misclassification. If you are still unsure, a request for determination can be made by completing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Tax and Income Tax Withholding. It is best to reach out to your trusted Certified Public Accountant, who will guide you with options that would best suit your business needs. Eric is a Senior Accountant in our Commercial Tax Department. He can be reached on (973) or efernandes@nisivoccia.com. Mount Arlington Office Newton Office