The goal today is to accomplish three things:

Transcription

1 MARK SHERMAN, CPA

2 The goal today is to accomplish three things: 1. Educate you on The Mortgage Forgiveness Debt Relief Act of Show you how to save taxes on your real estate business. 3. Help you understand how to qualify for the Real Estate Professional Status.

3 1. Principal Residence Definition 2. Qualified Principal Residence Debt IRS definition Maximum amount Loan modification programs

4 What constitutes a home being a principal residence? Under the existing law, a home that someone lived in at least 2 of the last 5 years prior to the date of sale. For example, some of your clients may have moved out of their home and are still in the process of selling their home via short sale. This should qualify given the situation unless they have not lived in the home 5 years out from the date of sale.

5 IRS Definition o Debt used to buy, build or substantially improve the taxpayer s principal residence. o Debt used to refinance qualifying debt is also eligible for the exclusion, but only up to the amount of the old mortgage principal prior to the refinancing. Maximum Amount o The maximum amount you can treat as qualified principal residence indebtedness (QPRI) is $2,000,000. Loan Modification Program o This program is offered by a bank whereby the bank is willing to: Defer payments Defer principal Adjust interest Adjust principal o Covered under the tax act Second homes, rental property, business property, credit cards, or car loans do NOT qualify under this act.

6 Example Donald buys a home for $500,000. Donald decides he made a terrible decision, and he must short sell the home. His principal balance owing is $450,000 He ends up selling the home for $250,000. What is Donald allowed to exclude in total under the debt forgiveness act?

7 Example (continued) Donald is allowed to exclude $200,000 of what would normally be ordinary income under this tax act. Example: Donald Debt Owing 450,000 Less: Sale Proceeds (250,000) Debt Forgiveness 200,000

8 Example Donald purchased his house for $500,000 He attempted to short sale, but given the short time available, he had to allow the bank to foreclose on the house. His principal owing at the time of foreclosure was $400,000. The IRS would normally consider Donald s foreclosure to be a taxable sale, and the sales price would be the $400,000 he owed to the bank. He received a 1099-C, but had no tax consequences. What would happen without the tax act of 2007? Donald thought he could take a loss because he originally paid $500,000, but now had a forced sale for $400,000. Under IRS Publication 523, married couples can exclude up to $500,000 on the gain on the sale of their home, and single taxpayers can exclude up to $250,000. Due to this exclusion, the IRS does NOT allow you to take losses on a qualified principal residence. Donald is subject to ordinary income tax on the debt forgiveness income.

9 Example Charlie purchases a personal residence in He realizes five years later that it will take him a long time to recover the value of the home from the loss of the market in the last few years. He informs the bank that he wants to short sale. Charlie has been faithfully paying his mortgage and decides that he wants to prevent the short sale by reducing his principal balance owing. Charlie thought he was winning until he got a 1099-C.

10 Does Charlie have to pay any tax? No, his restructuring qualifies as debt reduced under the tax act. Note: Individuals who purchased a home with a mortgage larger than $2,000,000 may be able to qualify for debt exclusion under an insolvency claim.

11 1. How many of you have or had clients that invested in real estate rental properties between 2003 and 2006? Many of these people ended up with real estate that was under water, and in some cases, they had negative cash flow from renting the property. In order to stop the bleeding, many of them elected to short sale the property or let it go into foreclosure. These individuals could have subjected themselves to unnecessary income tax if there was not a debt relief act for this type of situation.

12 The IRS allows a tax payer to exclude cancelled qualified real property indebtedness from income. Qualified real property business indebtedness is debt that must meet the following qualifications: It was incurred or assumed in connection with real property used in a trade or business It is secured by that real property If a refinance, it cannot be greater than the original debt that was financed. Qualified property for purposes of this election is any property you use or hold for use in your trade or business or for the production of income, including rental income. The amount of cancelled qualified real property business debt you can exclude from income is limited under this law to the excess of the excluded debt over the fair market value of the property before the debt, less any other debt secured by that property.

13 Example Darth buys a six unit building for $500,000. He puts 20% down and took an interest only loan for $400,000. The tenants were only paying $500/unit and the entire investment had negative cash flow. Darth wasn t worried because the market was heading upward and he would end up selling the property for $650,000 (projected) by next year. Unfortunately, Darth s property was only worth $300,000, and he decided to short sale at that price. The bank sent a 1099-C to Darth for $100,000. May the force be with you Darth.

14 Darth s calculation: Example: Darth Sale Price 300,000 Cost 500,000 Less: Depreciation (50,000) Normal Cost Basis 450,000 Less: QRPBI of $100,000 Forgiven by the Bank (100,000) Adjusted Cost Basis 350,000 Actual Loss Recognized (50,000)

15 Example Darth buys a property for $250,000 and took a loan for $200,000. The market heats up and the property is now worth $800,000. Darth refinances to borrow $500,000 from the property to live on. One year later, the property value declines to $350,000 and is foreclosed on. Without considering any depreciation, transaction costs, or loan payments, Darth now has debt forgiveness income of $350,000. He also has $100,000 gain on sale. If he uses the exclusion of qualified real property business indebtedness, he can exclude up to $250,000 of the $350,000.

16 There are four main tax entities that businesses use to report their income. 1. Sole Proprietorship Reports all of its income on the personal return on a form called Schedule C. All net income from self-employment is then subject to selfemployment tax. 2. C Corporation (C means Closed) Separate legal entity that pays its own tax. Only way to take money out of the company is to receive wages, dividends, or employee benefits. 3. Partnerships Pass through entity. Used when two or more people own a business. All of the income of an active partner is subject to employment taxes on that partners share of net income from the partnership. 4. S Corporation (S means Sub Chapter S of the Internal Revenue Code) Pass through entity where the tax is still paid at the individual level, but the income and expenses are reported on a different tax return.

17 Of the four main forms, the S Corporation is one of the best in controlling self-employment tax and is used by many real estate professionals. If you do not have a corporation or LLC, you are paying more taxes than you need to be paying. If you make at least $30,000 after expenses, you will save money incorporating or setting up an LLC. For example, Peter grossed $60,000 in real estate commissions, but after expenses, has a net income of $30,000. Not only would he owe income tax on $30,000, but he would owe self-employment tax of 15.3% on the $30,000, or approximately, $4,600.

18 Peter would be better off electing S Corporation status with the IRS in order to control the amount of self-employment tax that he would be paying. Using the same example with Peter, here is how it would look had he elected to be taxed as an S Corp. Example: Peter Gross Commissions 60,000 Expenses (30,000) Net Income 30,000 Less: Reasonable Salary (15,000) Amount Subject to Income Tax 15,000 In this scenario, Peter paid himself a reasonable salary and only paid selfemployment tax on the rest of the $15,000. He saved $2,300 in taxes by using this strategy. With this strategy, the more you make, the more you save. What is a reasonable salary? According to the IRS, a reasonable salary is what would be customary in that industry for the level of business. The law is very vague in this area, but I can assure you, ZERO salary is not REASONABLE.

19 As a rule of thumb, use 50% of the net income after expenses as a guide for annual salary. Another benefit to incorporating or creating an LLC is that most individuals outside of the tax world do not know that the Schedule C is one of the most heavily audited schedules on an individual return. Conversely, the least audited entity by the IRS is an S Corporation. (historically)

20 Income taxes are one of the largest, if not the largest lifetime expense for any individual. Our country s tax structure was originally created to favor those who were in business for themselves versus those who work for someone else as an employee. For example, as a person who works for someone else, you may incur certain expenses like meals, entertainment, travel, automobile expenses, gifts, etc. If you own a business, many of these expenses can be deducted if you can prove that the expense was ordinary and necessary in your business. The main definition according to Publication 535 of the IRS is whether an expense was both ordinary and necessary in the course of business. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade and business.

21 In the field of real estate, just about anytime you are out and about, you are doing business. If you take a friend out to lunch and all you do is ask the words, How is business? You are now having a business lunch. Your job now is to make sure you properly document the lunch receipt with the nature of the meeting and whom you met with. When you go out of town for pleasure, take time to plan ahead and make the trip partially deductible. When you hold parties or entertain at your house, buy a sign-in log and take pictures. Invite fellow real estate agents and clients. If you purchase magazines that may have articles on real estate, deduct them as dues and subscriptions or books and periodicals. If your clients expect that you will keep up with the latest information in your field, so does the IRS. If you use computers for personal and business use, don t forget to deduct the business portion for the cost. Any expense with respect to advertising for your business is also deductible.

22 Reasonably estimate your business use percentage of your cell phone and deduct that portion (cost and monthly bills). It is hard to prove that 100% of your cell phone is for business use unless you have a separate phone for personal matters. Automobile expenses is one of the highest in dollars for real estate agents. The key here is keeping an auto mileage log. There are two ways of taking the deduction. 1. The actual expense or the mileage. 2. Regardless of which way you choose, a mileage log will be needed.

23 The actual expense method used to be the preferred method. Since the IRS has recently raised the standard mileage rate to 56.5 cents per mile, many people have chosen to use the standard mileage rate. If you choose the actual expense method, you simply take the total of the automobile business expenses multiplied by the business use percentage from the mileage log. If you choose the mileage method, you simply take the business miles driven for the tax year multiplied by the IRS standard mileage rate for that year and this becomes the automobile expense deduction. Date Beginning Odometer Reading Ending Odometer Reading Total Miles Driven Total Business Miles Business Purpose 1/31/ ,000 10, Lunch 2/1/ ,300 10, Model Visit 2/2/ ,609 10, Seminar 2/3/ ,927 11, Continuing Education 2/4/ ,255 11, Lunch 2/5/ ,593 11, Lunch 2/6/ ,941 12, Model Visit

24 Referral fees (commissions to others) are also deductible. If you pay others to help you, make sure to issue a 1099 to them if the total amount of compensation is over $600. Meals are 50% or 100% deductible depending upon the situation. If you bring in pizza for your sales team to keep them on the premises, it is 100% deductible. If you go out with a fellow real estate agent, it is 50%. There is also the Dutch Treat rule.

25 As a real estate agent, you may find great deals on properties and choose to become an investor yourself [and a landlord]. Sometimes there are losses associated with these rental properties. By following certain rules of documentation and of time and activity, you may be able to take these losses as non-passive losses. o Non-passive losses are losses you can use to reduce your ordinary income from other sources like your real estate sales business.

26 There are certain conditions that must be met in order to qualify as a real estate professional. You must materially participate as well as actively participate. Participate in the activity for more than 500 hours during the year. Participate in the activity for more than 100 hours during the year and no one else participates more than the tax payers, including individuals who do not have an ownership in the activity. Be the only person who substantially participates in the activity, including individuals who do not have an ownership interest in the activity. Material Participation Participate for more than 100 hours in each of several activities, and the total for all these activities is in excess of 500 hours. If any of the above situations is applied to the individual in 5 of the last 10 years, the individual is deemed to have materially participated this year. An individual who materially participates in a personal service activity for at least three years is considered a material participant for life.

27 Material Participation Based on all the circumstances above, this person participated in the activity on a regular, continuous, and substantial basis during the tax year and participated for more than 100 hours. However, participation in managing the activity does not count in determining whether the individual materially participated if anyone else received compensation for managing the activity or if anyone else spent more hours during the tax year than the individual spent in managing the activity. If married, the participation of both the tax payer and spouse in the business counts towards meeting the above tests.

28 Allow those in a real estate activity to offset up to $25,000 of rental losses each year against non-passive sources. Own at least 10% of the activity (including the spouse s interest) during the entire year. Additionally, there must be significant participation when making management decisions, such as approving new tenants, deciding on rental terms, or arranging to provide services or repairs. Active Participation If modified adjusted gross income (Modified AGI) is above $100,000, the $25,000 limit is reduced according to the formula: (Modified AGI - $100,000) X 50% = Reduction Amount For example, if Modified AGI is $130,000, the deduction would be reduced by ($130,000 - $100,000) X 50% = $15,000. The deduction is also limited for those who are married and filing separately. If a couple lives together at any time during the year and files separately, no deduction is allowed. If they live apart the entire year and file separately, each can deduct $12,500.

29 For purposes of a real estate activity, the IRS considers each property as a separate real estate activity that you have to separately qualify for non-passive status. This means that in order to qualify for non-passive status with a property, you have to be able to show that you spend at least 500 hours on that one property. For those who have multiple properties, you may file under a special election with the IRS in order to group the properties as one single real estate activity. Also as a real estate professional, you want to be sure to create a log of your time spent conducting real estate activities as proof. Example: Kermit has net income from real estate sales of $500,000 and owns 10 rental properties. The rental properties had net losses of $200,000 for the current year due to large repairs and depreciation. Kermit wants to take all of the losses because he knows he will have a large tax owing. Kermit spent more than 500 hours on all of the properties combined, but not separately. Kermit files the election to group all of his properties as one real estate activity. He also documents his hours which include previewing properties, education, selling, etc.

30 Kermit s $500,000 of income is reduced by $200,000.

31 If I can be of help to any one of you with respect to tax savings and planning, please call my office and schedule an appointment or leave me with your contact information. Address: 601 S. Rancho Dr. Suite D-32 Las Vegas, NV msherman@shermancpas.com Office: (702) Website: Yelp: This slide presentation can be found on my website under Publications

32 1. Which taxable entity has the lowest chance of being selected for audit by the IRS? a) Proprietorship-Schedule C b) Partnership c) C Corporation d) S Corporation 2. What is the limit of mortgage indebtedness that a home owner can claim an exemption for using the Mortgage Forgiveness Debt Relief Act of 2007? a) $1,000,000 b) $500,000 c) $250,000 d) $2,000, In order to qualify as a real estate professional under IRS rules, at least how many hours does the real estate professional need to perform annually in real property trades or business? a) 500 hours b) 100 hours c) 750 hours d) 2,000 hours