REAL ESTATE REVIEW. October 2014 O C TO B E R R EAL ESTATE REVIEW

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1 O C TO B E R R EAL ESTATE REVIEW REAL ESTATE REVIEW October 2014 FREIGHT DEPOT 1200 MARKET STREET CHATTANOOGA, TN HHMCPAS.COM

2 REAL ESTATE REVIEW / October 14 THE TANGIBLE PROPERTY REGULATIONS In September 2013, the IRS finalized the Tangible Property Regulations (TPRs) which are among the most dramatic tax law changes in recent years. The TPRs affect any taxpayer who owns fixed assets, has depreciation, buys fixed assets, improves or disposes of fixed assets, and or/has material supplies. If you own a business, the TPRs affect you. If you own a rental property, the TPRs affect you. In essence, the TPRs impact every single taxpayer. Depending on your situation, there could be vast tax savings available to you because of the TPRs. There could also be huge tax and penalty consequences if you don t comply with the new rules. It is essentially a business requirement that you understand the new TPRs, and how they affect you. The mandatory changes necessary because of the TPRs are effective for 2014, and will necessitate a review of your business and investment property depreciation schedules. At a minimum the TPRs require that taxpayers adopt new accounting methods for the tax treatment of tangible property. These new accounting procedures necessitate additional filings with the IRS to show compliance with the mandatory TPR methods. The regulations are lengthy and very complex, covering repairs and maintenance, materials and supplies, and the acquisition, production and disposition of tangible property. The regulations have nearly 200 examples that attempt to illustrate the new rules. In general, the TPRs provide rules regarding the tax treatment of amounts paid to acquire, produce, or improve tangible property. The new regulations express the general rule that amounts paid to improve a unit of property must be capitalized. On the other hand, the regulations allow a current deduction for repairs and maintenance to property. The term repairs and maintenance is defined as costs that are deductible if they otherwise are not required to be capitalized under the regulations. The regulations focus on the Unit of Property definition as a fundamental determining factor in the expense vs. capitalize decision. In general, a Unit of Property is the property acquired, repaired, improved, or adapted to another use. The definition is modified based on a functional interdependence standard. The regulations spell out how the concept applies to various properties including real estate. Individual buildings are generally treated as a single Unit of Property that includes nine specific building systems. A capitalized improvement is defined by its effect on those systems. Materials and supplies are also affected by the new rules. A deduction is allowed for amounts paid to produce or acquire materials and supplies that are consumed during the year. Rules are provided for incidental and non-incidental materials and supplies. Incidental items are allowed to be immediately written-off, while non-incidental items are expensed in the year used, therefore, requiring the items to be inventoried. There is a safe-harbor rule for writing off materials and supplies. The de minimis safe-harbor capitalization rules apply for taxpayers with a capitalization write-off policy in place at the beginning of The safe harbor allows taxpayers to expense, rather than capitalize, amounts paid for invoiced items that cost up to a specified amount per item without being questioned by the IRS. The limit is $5,000 per item if the taxpayer has a capitalization policy and issues audited financial statements or if financials are submitted to a regulatory body, $500 if no audited financial statements but a policy is in place, and $200 if there is no policy. The regulations have new rules clarifying when a taxpayer is allowed to write-off old assets and removal costs relating to partial dispositions (for example, a building HVAC upgrade to part of an existing HVAC system). The rules provide guidance on computing the allocatable costs that may be written off. The TPRs offer an opportunity for current year tax savings related to property previously capitalized, that would have qualified to have been expensed under the new rules. During 2014, taxpayers have the opportunity to review their business depreciation schedules and write-off any items that may qualify under the new regulations as a repair. The tax reduction benefit of this additional deduction may be fully included on the taxpayer s 2014 tax return. In addition, the TPRs provide needed clarity that allows a current write-off of repairs, maintenance and supplies that in the past would have been capitalized on the taxpayer s depreciation schedule.

3 New annual elections, and tax compliance activity is required by the TPRs. The regulations require formal accounting method changes to conform to the new rules by the filing of IRS Form 3115, Application for Change in Accounting Method. The change request is an automatic change that does not require IRS approval. The form must be completed and filed with the IRS Service Center, with a copy attached to the taxpayer s 2014 tax return. These accounting changes are mandatory, and one or more Forms 3115 may need to be filed for every taxpayer engaged in a trade, business, or rental activity. If you file Form 1040 Schedules C, F, or E, these rules apply to you. If you are a partner or shareholder in a trade or business or engaged in a rental activity (Forms 1120, 1120S, 1065, and possibly Form 1041), filings may be required for these business entities as well. The IRS has stated that using inappropriate tangible property accounting methods, or not properly initiating an accounting method change, might cause an examination of the taxpayer s return. The TPRs are complex, and impact many areas of the tax accounting that is imperative to a business. Please contact your trusted tax and business advisor to ensure that you realize all tax benefits available, and also comply with the new tax rules. ASK THE ADVISOR: HOW IMPORTANT IS COMPLIANCE WITH DEBT-RELATED LOAN COVENANTS? The commercial mortgage arena is far from rosy. Lenders don t want to expose themselves to the types of losses they sustained when the real estate market crashed. To protect their interests, many lenders are insisting on the inclusion of debt-related loan covenants. Borrowers that violate them risk costly consequences. COMMON DEBT COVENANTS Borrowers should expect debt service coverage covenants and loan-to-value (LTV) covenants in their mortgage agreements. The former requires a borrower to generate sufficient net operating income to service its interest and principal obligations. Lenders often require a debt service ratio of 1.20 or greater, meaning that, for every $1 of debt a borrower must cover in a given period, it has $1.20 in net operating income (NOI) available to service it. If you own a building that goes through a high-vacancy period or incurs a temporary increase in operating expenses, your NOI could plummet, causing you to violate the debt service coverage covenant. The LTV covenant requires a borrower to maintain a specific ratio of the amount of the loan compared to the value of the financed property. So, if you owe $750,000 on your mortgage and you have a 75% LTV ratio, you ll violate the covenant if the property s value slips below $1 million. CONSEQUENCES OF NONCOMPLIANCE Any degree of noncompliance could lead to default or foreclosure. If the property s value causes a violation of the LTV covenant, you could be on the hook for payments that would bring the loan into compliance. Generally Accepted Accounting Principles also require you to disclose noncompliance with loan covenants in your financial statements, unless the lender agrees to waive the covenant. In the above scenario, if the property s value falls to $900,000, you could pay $75,000, reducing the amount you owe to $675,000 ($750,000 less $75,000) to satisfy the ratio ($675,000 $900,000 = 75%). If you amass that amount, the lender can foreclose or seek payment from any guarantor. On the other hand, you could refinance or renegotiate the loan, and give the lender more in-depth, frequent access to your books and records. WHEN EXPECTING NONCOMPLIANCE If you re nearing noncompliance with a loan covenant of any kind, inform your lender as soon as possible and explain how you hope to remedy the situation. If you have a solid plan, the lender may be willing to modify your terms or extend a grace period. Your financial advisor can help you devise a realistic plan that will appeal to your lender. Trust HHM to help you with financial advice. Call us today at or contact us online at

4 REAL ESTATE REVIEW / October 14 ASK THE ADVISOR: WHAT TYPE OF DUE DILIGENCE IS NECESSARY IN TODAY S MARKET? The commercial real estate market remains rocky. Historical assumptions about rent growth, lease renewals, and similar issues are less reliable than in the past. That means due diligence for new transactions will require more intensive effort and a broader, more conservative focus. WHICH INFORMATION MUST BE REVIEWED? Examine these categories of information: FINANCIAL DATA. Request at least three years financial statements, all loan documents, tax returns and bills, and any information on capital improvements. Consider how you could operate the property more efficiently, but don t be overly optimistic when estimating economies of scale and synergies with other properties. TENANTS AND LEASES. Obtain a certificate of occupancy for the property, lease agreements and data on tenant mixes. Compile rent rolls to assess future rental income and lease terms. For leases nearing expiration, consider whether to renegotiate terms or replace undesirable tenants. INSURANCE AND TITLE POLICIES. Scrutinize policies and riders as well as related risk assessments and claims history. If the policy hasn t been updated to reflect current market values, the property may be over insured. SHOULD YOU GO BEYOND THE TRADITIONAL DUE DILIGENCE? Qualitative assessments of the property are as important as quantitative data. Always visit the property, focusing on competing properties, traffic patterns and any neighborhood characteristics that could change your assumptions. For example, if a competitor has recently renovated, it might affect market rents or force you to improve your property. Know the comparables in the area, including current rental rates, selling prices, market saturation and vacancy rates. Outdated or dissimilar comps can lead to poor investing decisions. Then inspect individual units. Look for attributes that make a unit hard to lease, such as an unusual layout. Or you might discover that a tenant business is struggling. Can you count on that business to renew its lease or keep up with rent payments and maintenance? Finally, talk with tenants to find out if they re satisfied with the property and management, or if they have complaints that could affect renewal decisions. WHAT ELSE SHOULD DUE DILIGENCE COVER? Due diligence should also extend to zoning and land use issues, such as judgments, claims and liens; third-party contractual obligations (such as construction warranties); and environmental issues. More due diligence is required if the property s distressed. Neglected properties risk tenant default and might not comply with building and other codes. You can still land a good deal just work with your real estate and financial professionals to identify and reduce the risks. Aside from traditional accounting services, HHM s real estate team also offers: Financing and Capital Restructuring Forecasts & Projections Cost Segregation Studies Construction Cost Audits Troubled Debt Restructuring Lot Release Restructuring & Analysis Cash Forecasting & Cash Flow Models Exit Strategy Planning Strategies for New Entity Formations Detailed Project Operating Statement Analysis Operations & Software Review Comparative Lease Analysis & Alternative Strategies Call us today to see how we can help you.

5 DEALER VS. INVESTOR: IT S A TAXING SITUATION Juggling the daily ins and outs of the commercial real estate business, you might not give much thought to whether you re a dealer or an investor. But the distinction can have a significant impact on your bottom line because of the different tax treatments associated with each category. WHY IT MATTERS Real estate investors enjoy several tax advantages that aren t available to those deemed to be real estate dealers. Perhaps foremost, any gains on sales of investment property held long-term (more than one year) are subject to tax at capital gains tax rates. Under Internal Revenue Code (IRC) 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 taxable at a substantially higher rate (up to 39.6% currently) than long-term capital gains (generally up to 20% for higher incomes with higher rates applying to certain depreciation recapture). Absent having set up a separate entity to reduce their tax exposure, all of the dealer s ordinary income (including the gain on the sale) will also be subject to self-employment tax (a maximum of 15.3%, up to an FICA wage base of $117, for 2014, then 2.9% Medicare, and an additional 0.9% may apply.) Investors can also engage in tax-free Section 1031 (like-kind) exchanges and installment sale transactions that allow for the deferral of taxes, while dealers can t. And investors aren t required to pay self-employment tax on their gains. It s not all bad news for dealers, though. Their losses are considered ordinary losses, meaning they aren t subject to the 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 their ordinary income; an investor can t claim an interest expense deduction greater than the amount of its net investment income. And dealers can offer rent-toown lease programs, in lieu of installment sales, as a way to defer recognizing gains. ACTIONS SPEAK LOUDER THAN WORDS So how do the IRS and the courts distinguish between an investor and a dealer for tax purposes? Generally, investors purchase properties and hold them with a long-term perspective. Dealers, on the other hand, purchase and then sell their properties relatively quickly. Unfortunately, there is no definitive list of criteria for determining whether a taxpayer is a dealer or an investor in the IRC or any other authoritative source. Based on various court decisions, though, relevant factors include: The taxpayer s sources and amounts of income. The value, volume and frequency of the taxpayer s real estate transactions. How long the taxpayer has owned the property. How the taxpayer holds itself out to the public (that is, as a dealer or as an investor). The nature and purpose for which the taxpayer acquired, held and sold the property. The nature and extent of the taxpayer s efforts to sell the property. The extent of subdivision, development and improvements made to the property to increase sales. 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. The extent of advertising the property. Whether the taxpayer has experienced a change of plans such as a divorce or relocation that modified his or her original intent regarding the property.

6 For example, if you hold a single property for more than a year, the IRS is likely to consider you an investor. If, however, you hold multiple properties for periods of less than a year, expect to be designated as a dealer. However, 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. PLAN AHEAD Whether you re an investor or a dealer, your tax advisor can help you implement the tax planning strategies that will best accomplish your objectives, on taxes and otherwise. Just don t wait until you re selling property to consult your advisor by then, it might be too late. LET THE HHM REAL ESTATE TEAM HELP YOU TODAY Developers, owners and operators of real estate must rely on a trusted advisor to guide them through new and more complex methods of financing, tax planning, management, and operations. Henderson Hutcherson & McCullough s experienced, dedicated professionals help real estate organizations make operational and strategic improvements to enhance cash flow as well as keeping you informed of tax planning opportunities. Because our professionals are extremely responsive, thorough and educated in the real estate industry, we can identify what often goes otherwise undetected. Our value-added services, such as cost segregation studies and real estate specific tax credits and deferrals, help you realize significant savings that might otherwise be lost. By building a relationship that transcends traditional accounting services, HHM pro actively looks for opportunities for your success. If you have outgrown your current provider or need more specialized services, give the HHM Real Estate Team a call. Kyle C. Christensen CPA, CCIFP kchristensen@hhmcpas.com Trip Farmer CPA, CCIFP tfarmer@hhmcpas.com Travis Horton CPA, MBA thorton@hhmcpas.com To view all the Non-Traditional and Traditional real estate services HHM offers, visit: CALL THE REAL ESTATE SPECIALISTS AT HENDERSON HUTCHERSON & MCCULLOUGH, PLLC FREIGHT DEPOT 1200 MARKET STREET CHATTANOOGA, TN HHMCPAS.COM