Non-Financial Assets Tax and Other Special Rules

Wealth Strategy Report Non-Financial Assets Tax and Other Special Rules OVERVIEW Because unique attributes distinguish them from other asset classes, nonfinancial assets may offer you valuable financial benefits while often also providing personal benefits. The U.S. Trust Specialty Asset Management group has extensive experience managing timber, farm and ranch land, oil, gas and mineral interests 1, real estate and private businesses, and can work with your U.S. Trust team to integrate them into your overall plan and investment portfolio. We can help you realize your objectives with non-financial assets you already own, or help you acquire specific assets to take advantage of their income, capital growth and diversification potential whether you own these assets outright or they are held in trust. Because of their unique nature, ownership of non-financial assets requires consideration of various tax and other special rules. This report is designed to help you become familiar with the most common of these rules. GENERAL REAL ESTATE PROVISIONS 1 Many real estate investments offer the potential for both income and capital gains. An investment in any type of real estate may offer attractive after-tax yields and may provide a powerful tool to defer capital gains taxes on its sale as well. Certain operating expenses, such as mortgage interest, taxes, insurance, maintenance and property management, may be deductible, maximizing the after-tax yield. An investment property may also qualify for depreciation, thereby further reducing the annual income tax paid. Additionally, Section 1031 2 of the Internal Revenue Code allows an owner to sell a qualified real estate property and reinvest in a like-kind property while deferring capital gains taxes. If a sale is warranted, a properly structured 1031 exchange may offer you favorable tax advantages. Section 1031 tax deferral applies to an exchange of likekind property. The exchanged properties must both be currently held for productive use in trade or business or for investment. Therefore, personal use property, such 1 Oil, gas and mineral interests are not available for direct investment through U.S. Trust. 2 Numbers refer to the section of the Internal Revenue Code that contains the tax law being summarized. as a residence used solely by the taxpayer as their principal residence or vacation home, will not qualify. Like-kind real estate relates only to the nature or class and not to its grade or quality. Therefore, for example, raw land held for investment and townhouses to be used as rental property are like-kind properties for this purpose. Ordinarily, a transaction constitutes an exchange if there is a reciprocal transfer of property, as distinguished from a transfer of property for money. Under Section 1031, however, the transfer of property is not required to be simultaneous. In a qualified exchange, the taxpayer must not receive money from the sale. The taxpayer, however, may designate an intermediary to hold the funds until an exchange property is obtained. For this delayed exchange to qualify, the like-kind property must be identified as property to be received in the exchange within 45 days from the date the taxpayer transfers the property relinquished in the exchange. Additionally, the like-kind property must be received on the earlier of (i) the day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (ii) the due date (determined with regard to extensions) for the transferor's tax return for the taxable year in which the transfer of the relinquished property occurs. 1

For currently owned real estate, a qualified conservation easement may entitle you to a charitable income tax deduction as well as a reduction of estate taxes. A conservation easement is a perpetual restriction that you place on your real estate for public benefit. The easement is granted to a qualified charity and outlines the specific uses of the land or the specific prohibited uses of the land. Granting a conservation easement is not considered a sale of your property. You may continue to own the property, live on the property and use the property. Your continued ownership, occupation, and use, however, must be consistent with the terms of the easement. With a conservation easement you retain the right to sell the property in the future. However, the purchaser must take the property subject to the easement. For a detailed description on conservation easements, see the separate Wealth Strategy Report; Conservation Easements. TIMBER One of the primary incentives for investing in timberland is the ability to obtain capital gain tax treatment instead of ordinary income from the sale of the timber. Various criteria are used to determine how your timber sale will be taxed. The first step in determining whether timber sales result in capital gain or ordinary income to the owner depends on the nature of the owner s relationship to the property whether the owner treats it as personal use, investment, or business property. Gains from standing timber sales or timberland held for personal use (such as hunting) or as an investment, receive capital gains treatment. Similarly, gains from cut timber sales held for personal use or investment are entitled to capital gains treatment. Timber used for business purposes is beyond the scope of this report. If the sale qualifies as capital gain, then the next step is to determine if the gain is classified as short-term or longterm. Like other investments, you are required to own the timberland for more than one year before the sale will qualify for long-term capital gains tax treatment. As mentioned, timber landowners fall into three different taxpayer categories: hobby owners, investors, and business owners. Each situation differs in how expenses are deducted and income reported. The appropriate category depends on the owner s desire to produce income from growing timber and how involved the owner is in the management of the timberland. Hobby Owners/ Personal-Use Owners A typical hobby owner owns the land for personal-use activities (for example, hunting or recreation) and does not intend to make a profit from growing and selling timber. A hobby owner s timber sales do qualify for capital gains treatment. A hobby owner, however, may not deduct operating expenses except against income from the property. Some expenses may be capitalized and deducted from future timber sales. Capitalization is the process of entering costs in an account so they may be deducted in the future when the property is sold. To avoid being classified as a hobby owner, it is important to demonstrate a profit motive. Actions should reflect the investor s desire to make a profit any investments in the timberland should be expected to pay for themselves through increased growth or eventual profit. Investors If a taxpayer owns timberland and intends to sell timber in the future for a profit or grow the timber for capital appreciation, but is not an active manager, the owner may be deemed an investor. A typical investor has limited timber sales maybe one or two sales every three or four years. Investor sales will be taxed as capital gain and investors may qualify for the federal tax programs for reforestation. With these reforestation tax programs, all site preparation and reforestation costs are deductible immediately in an amount up to $10,000 ($5,000 if married filing separately) and the remaining costs are deductible over a seven-year period. General Tax Rules Tax efficiencies for investors come through the treatment of timber and timberland sales. Revenue from these sales generally qualifies as long-term capital gains. Gain from the sale of timberland, like other real estate, may be deferred through installment sale treatment, or through the use of a 1031 exchange (described above). In addition, timber depletion similar to the depreciation of tangible assets may shelter a substantial portion of timber sales revenue, particularly in the early years of a newly acquired property. When a timberland acquisition is made, the purchase price is allocated proportionately between the standing timber and land. The cost basis associated with the land is recovered when the land is sold. The cost associated with the standing timber can be recovered as the timber is harvested and sold through depletion. The depletion unit value is calculated by dividing the allocated timber 2

basis by the inventory to get a depletion rate. As the inventory is sold, the depletion amount related to that inventory reduces the proceeds from the sale to determine the amount subject to capital gain tax. Example. Assume the basis for the timber is $500,000, and the beginning inventory of timber is 25,000 tons. The depletion unit value is calculated by dividing the basis, $500,000, by the inventory, 25,000 tons, to get a depletion rate of $20/ton. If in the year following the property s purchase 4,000 tons are harvested, the amount of depletion is determined by multiplying the volume sold by the depletion unit value (4,000 tons x $20/ton), which is $80,000. If the proceeds from the sale generate $150,000, $80,000 would be shielded from current tax by the depletion allowance, while $70,000 would be subject to capital gains tax. OIL, GAS AND MINERAL INTERESTS Thanks to ever-advancing technology, more and more people are finding themselves bearing the title of oil and gas owner. Oil and gas ownership can manifest itself in many unique and diverse forms. Some of the more common economic interests that an investor in oil and gas may encounter include: (i) royalty interests; (ii) overriding royalty interests, (iii) participating interests; (iv) operating interests (called working interests), and (v) net profits interests. Likewise, an investment in oil and gas can take many forms, including: (i) publicly traded stock of a company in the oil and gas industry; (ii) units in a master limited partnership; (iii) an interest in a royalty trust; (iv) investment in a private equity fund focused on the oil and gas space; and (v) ownership of oil and gas interests and minerals in place. In addition to the advances in technology, the proliferation of oil and gas investment has been fueled by several major tax benefits benefits that are found exclusively in the oil and gas area. While a review of all of the tax incentives provided to the oil and gas investor is beyond the scope of this report, three of the most impactful tax benefits are depletion, intangible drilling costs ( IDC ), and the working interest exception to the passive active loss rules. Depletion Oil and gas is a wasting asset in that it is consumed or depleted as it is extracted and produced. As such, the Internal Revenue Code enables the owner of an economic interest in oil and gas to deduct a depletion allowance in calculating taxable income. Generally, depletion is calculated using one of two methods: cost depletion or percentage depletion. Cost depletion utilizes a unit of production method where the cost of the oil and gas property is divided by the estimated recoverable reserves to arrive at a cost per unit. That per unit cost is then multiplied by the number of units sold during the year to arrive at the depletion expense. Percentage depletion, on the other hand, is simply a specified percentage (equal to 15%) of the investor s gross income from the property (limited to 100% of the investor s taxable income from the property and 65% of the investor s income from all sources). Percentage depletion is unrelated to the expected production, may exceed the taxpayer s adjusted basis in the oil and gas property (unlike cost depletion) and often produces the larger deduction. Percentage depletion may be claimed by independent producers and royalty owners on a limited amount of annual domestic production. Taxpayers who qualify to use both cost and percentage depletion, can elect the depletion method that provides the greatest deduction for any particular calendar year. Intangible Drilling Costs ( IDC ) There are many costs incurred in developing (as opposed to acquiring or operating) an oil and gas well. For tax purposes, these costs are generally classified into two categories: IDC and tangible equipment costs. The distinction between these two costs is very important since they are treated differently for tax purposes. IDC are expenditures for drilling wells or developing wells (preparing them to produce) which are intangible, or which have no salvage value in themselves. Tangible drilling costs, on the other hand, are costs which have salvage value. Examples of IDC are wages, fuel, repairs, hauling, and supplies, which are incident to and necessary for the drilling of wells and preparation of the well for oil and gas production. Whereas tangible drilling costs must be capitalized and recovered through a depreciation deduction, a working interest owner can elect to currently deduct all IDC in the year they are incurred. It is not uncommon for 70% or more of the costs associated with the drilling of a well to constitute IDC thereby providing a significant income tax benefit to the investor early in the investment lifecycle. 3

Working Interest Exception to Passive Activity Loss Rules Passive activity loss rules are generally applicable when a taxpayer does not materially participate in a business activity or if the activity involves rental activities. Specifically, the passive activity loss rules deny any net losses or tax credits from passive activities as an offset to active income (salaries and business income, for example) or investment income (dividends, interest, etc.). Instead losses and credits from passive activities may only reduce income generated from other passive activities. An important exception to the passive activity loss rules is the working interest exception. Specifically, any working interest in an oil and gas property held any time during a taxable year which does not limit the liability of the taxpayer with respect to that interest will not be considered a passive activity regardless of whether the taxpayer materially participates in the activity. Accordingly, any net losses generated by this working interest would be available to offset the investor s other active or investment income. General Tax Rules Much of the income generated by an oil and gas investment constitutes ordinary income for federal income tax purposes, thereby subjecting that income to the investor s marginal income tax rate. For example, the following payments attributable to oil and gas ownership are characterized as ordinary income for federal income tax purposes: (i) bonus payments (received upon executing an oil and gas lease); (ii) delay rentals (payment for the right to defer drilling or producing oil and gas); (iii) shut-in royalties (payment for the right not to produce from a well capable of production); and (iv) royalties (payments attributable to oil and gas production). Given the ordinary income characterization of this income, the deductions described above can be particularly valuable to an oil and gas investor. Upon the disposition of an oil and gas investment, capital gain will be recognized to the extent the amount realized on the disposition exceeds the investor s income tax basis in the property. However, the oil and gas depletion and intangible drilling costs could be subject to recapture and taxed as ordinary income. As with other real property transactions (discussed above), oil and gas property can be utilized in a Section 1031 like-kind exchange. However, if the replacement property is not natural resource recapture property, IDC and depletion recapture will be recognized. Upon death of the owner, an oil and gas investment is includable in the estate of the owner at its fair market value. However, many of the techniques described elsewhere in this report to reduce the value of the estate can also be applicable to oil and gas interests. FARM AND RANCH LAND Farming and ranching involve both the real estate provisions discussed above, as well as many of the tax considerations of operating a business. The real estate provisions apply where the farmer or rancher owns the property; business operating tax considerations apply regardless of property ownership. Ownership of farm or ranch real estate will require the payment of real estate taxes, which are generally deductible by the person who owns the property and pays the taxes. An owner will either operate the farm or ranch or lease the property to a third party operator. In the latter case, the owner is entitled to the rental received from the property, taxable as ordinary income. Farm and ranch rental activity is not limited to what is customarily thought of as farming or ranching activities, as the property may also be leased for other rural-compatible activities such as hunting and fishing. Income from these activities will also be taxed as ordinary income. Any losses that pass through to the owner will most likely be considered passive (discussed above). Upon sale of the land, the owner will be subject to capital gain tax for the excess of proceeds received over the amount of adjusted cost basis. This amount may be deferred through installment sale treatment, or perhaps through the use of a 1031 exchange (also described above). Farm and ranch land is ideal for conservation purposes, and any such conservation purposes that qualify as a conservation easement, or other type of land use restriction, may qualify for an income tax deduction. Reference is again made to the separate Wealth Strategy Report; Conservation Easements. Upon death of the owner, farm and ranch land is includable in the estate of the owner at its fair market value. That value may be reduced in several ways. First, a conservation easement may have been put in place, which will reduce the value of the property, from its highest and best use, to a lower value depending on the restrictions placed on future development of the property. Second, if a conservation easement was not in place at the time of death, the estate may, under certain 4

circumstances, grant the easement which may reduce the value of the land by 40%, not to exceed $500,000. Third, as discussed below, farm and ranch land used by the owner in his business may be further reduced in value for estate tax purposes. In short, there are favorable provisions in the tax law to reduce the value of real property used in a family business, including farming and ranching, to lessen the impact of estate taxes. CLOSELY-HELD BUSINESS PROVISIONS The federal income tax law has three main provisions designed to encourage investment in closely-held businesses. For a detailed description of these provisions, see the separate Wealth Strategy Report; Special Income Tax Provisions for Business Owners. The federal estate tax law also has three main provisions designed to soften the estate tax burden imposed on business owners. For a detailed description of these provisions, see the separate Wealth Strategy Report; Special Estate Tax Provisions for Business Owners. All of these provisions are briefly discussed below. Income Tax Provisions Section 1244 Stock Entitled To Favorable Loss Treatment Section 1244 of the Internal Revenue Code is one of the oldest provisions enacted to give special tax breaks to owners of businesses. To understand the benefit offered by Section 1244, you need to understand that for tax purposes, ordinary losses are usually more beneficial than capital losses, such as losses from stock investments. Capital losses can offset only capital gains; they cannot offset ordinary (non-capital) income such as salary, interest, and dividends. Thus, without more, if you were to form a business corporation and have the misfortune to have the stock lose value, selling that stock (or liquidating) for a loss would generate only a capital loss. Section 1244 changes that normal rule. Under this provision, if the loss on the sale or exchange of stock in your business would otherwise be a capital loss, you can nevertheless treat it as an ordinary loss if you meet certain limited requirements contained in Section 1244. However, the amount of loss you can claim as an ordinary loss is limited to $50,000 per tax year ($100,000 in the case of a husband and wife filing a joint return). QSB ( Qualified Small Business ) Stock There are two special tax provisions applicable to stock in a qualified small business, or a QSB. In order for your stock to be considered QSB stock, you must satisfy certain limited requirements contained in Section 1202. Exclusion of Gain for QSB Stock Under Section 1202, if you hold QSB stock for more than five years, then you can exclude a certain percentage of the gain on sale of the stock, subject to limitations. The percentage has been changed several times by recent legislation and ranges from 50% to 100% depending upon the date the QSB stock was issued. This exclusion provision is not elective; you have no choice but to apply the rates described above. For each QSB in which you own stock, the gain that can be excluded is limited to the greater of (i) $10 million ($5 million if married filing separately) or (ii) 10 times your cost basis in the QSB stock. Rollover of Gain on Sale of QSB Stock Under Section 1045, if you purchase QSB stock (it does not have to be original issue as is the case for the exclusion of gain described above) and more than six months later sell it for a capital gain, you can defer that gain if you rollover the proceeds by purchasing stock in another QSB within 60 days after the sale. Unlike the 50% exclusion for gain, this rollover treatment is elective. Also note that in order to qualify for this rollover provision, you need only have owned the stock more than six months, even though stock will qualify for long term capital gains only if owned more than one year. Estate Tax Provisions Section 6166 -- Deferral of Estate Tax Generally the estate tax is due 9 months after death. If your taxable estate includes an interest in a closely-held business that constitutes more than 35% of the value of your adjusted gross estate, then, if certain other conditions are met, the estate can elect to pay the tax caused by that closely-held business over 14 years. Interest only, at favorable rates, is payable for the first 4 years, and thereafter the tax can be paid in 10 annual equal principal installments (plus interest). The interest rate is (i) 2% on the estate tax generated by the first $1,430,000 3 of value of the business, and (ii) 45% of the 3 The value of $1,430,000 is for 2013 and is indexed annually for inflation. 5

usual underpayment rate (a floating rate) on any remaining estate tax generated by the business. The rationale behind this special rule is to avoid a forced liquidation. It allows the business cash flow to pay for the tax over a reasonable period of time. Certain events will accelerate some or all of the deferred tax, either because the rationale for deferral would no longer apply or because the estate has violated a condition of deferral. Section 303 -- Redemption Taxed as Sale Rather Than Dividend Under Section 303, if certain conditions are met, the estate can redeem stock in order to pay taxes and estate administrative expenses, and the redemption will be taxed for income tax purposes as a sale even if it would normally be taxed as a dividend. Sale treatment is better if dividends are otherwise taxed at ordinary income rates. Additionally with sale treatment, income tax would apply only to the capital gain -- the excess of the proceeds over the shareholder s basis in the redeemed stock. Furthermore, due to the step up in basis at death, a redeeming estate would have little or no capital gain exposed to the capital gain tax. In contrast, if the redemption were treated as a dividend, the entire proceeds could be subject to income tax. Section 2032A Special Valuation of Real Estate Another estate tax relief provision addresses the issue of having real estate that is used in a family farm/business overvalued due to its potential development value. If certain conditions are met, then your estate can elect to have family business real estate valued based on its actual use in the family farm/business rather than based on its higher potential value if developed. The maximum decrease in value allowed under this special rule is $1,070,000 4. Because this provision is intended to help when real estate is used by your family in a farm or business, this estate tax break will be recaptured if, within 10 years after death, either (i) the real estate is disposed of outside of the family, or (ii) the real estate stops being used by your family in the business. CONCLUSION Integration of the non-financial assets discussed above into your overall portfolio can provide for great diversification and offer you access to alternative ways for generating income and growth. If you have an existing concentration in one or more of these asset classes, the tax benefits described in this report can help assess the tax-efficiency of diversifying into additional asset classes. These tax benefits should also be considered when you are planning to reallocate non-financial assets into financial assets. No matter where you are in this process, let our experience help. Our team of specialists can provide complete turnkey services including identifying and purchasing real property and providing for its ongoing management. Contact your local U.S. Trust team to get started. National Wealth Planning Strategies Group Any examples are hypothetical and are for illustrative purposes only. 4 Note: This is not a solicitation, or an offer to buy or sell any security or investment product, nor does it consider individual investment objectives or financial situations. Information in this material is not intended to constitute legal, tax or investment advice. You should consult your legal, tax and financial advisors before making any financial decisions. If any information is deemed written advice within the meaning of IRS Regulations, please note the following: IRS Circular 230 Disclosure: Pursuant to IRS Regulations, neither the information, nor any advice contained in this communication (including any attachments) is intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. While the information contained herein is believed to be reliable, we cannot guarantee its accuracy or completeness. U.S. Trust operates through Bank of America, N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC. Apr 2013 ARB2E62C 4 The value of $1,070,000 is for 2013 and is indexed annually for inflation. 6