Category Archives: Real Estate

Need to sell real property? Try an installment sale.

Is an installment sale right for you?

TJCIf you or your company owns real property, you may not always be able to dispose of it as quickly as you’d like. One avenue for perhaps finding a buyer a little sooner is by financing it yourself through an installment sale.

Benefits and risks
An installment sale occurs when you transfer property in exchange for a promissory note and receive at least one payment after the tax year of the sale. Doing so allows you to receive interest on the full amount of the promissory note, often at a higher rate than you could earn from other investments.  The installment sale rules allow the seller to defer the recognition of gain on the sale of the property in a manner that mirrors the receipt of the installment payments.

This deferral can be a very favorable tax benefit for sellers, but there may be some risks as well. For instance, the buyer may default on the loan, and you may have to deal with foreclosure.

Methodology
You generally must report an installment sale on your tax return under the “installment method.” Each installment payment typically consists of interest income, return of your adjusted basis in the property and gain on the sale. For every taxable year in which you receive an installment payment, you must report as income the interest and gain components.

Calculating taxable gain involves multiplying the amount of payments, excluding interest, received in the taxable year by the gross profit ratio for the sale. The gross profit ratio is equal to the gross profit (the selling price less your adjusted basis) divided by the total contract price (the selling price less any qualifying indebtedness — mortgages, debts and other liabilities assumed or taken by the buyer — that doesn’t exceed your basis).

Facts:
Proceeds  $1,000,000
Basis   $650,000
Realized Gain  $350,000

Year 1 Principal $68,000
Year 1 Interest  $54,000

Gain Calculation:
Year 1 Principal $68,000
X Gross Profit Ratio 35%
Year 1 Gain   $23,800

The selling price includes the money and the fair market value of any other property you received for the sale of the property, selling expenses paid by the buyer and existing debt encumbering the property (regardless of whether the buyer assumes personal liability for it).

You may be considered to have received a taxable payment even if the buyer doesn’t pay you directly. If the buyer assumes or pays any of your debts or expenses, it could be deemed a payment in the year of the sale. In many cases, though, the buyer’s assumption of your debt is treated as a recovery of your basis, rather than a payment.

See the example below for how recognized gain is calculated.

Facts:
Proceeds  $1,000,000
Basis   $650,000
Realized Gain  $350,000

Year 1 Principal $68,000
Year 1 Interest  $54,000

Gain Calculation:
Year 1 Principal $68,000
X Gross Profit Ratio 35%
Year 1 Gain   $23,800

It is important to note that items that are required to be recaptured at a different rate on the sale still need to be recognized.  For example, Section 1245 or Unrecapture Section 1250 gain need to be recognized in the year of the sale.

Complex rules
The rules of installment sales are complex. The best advice we can offer is:  “Don’t go it alone.” The Ciuni & Panichi, Inc. team has over 40 years of experience helping business owners and individuals make sound business and financial decisions. For real estate and construction advice and/or accounting services, contact Tony Constantine, CPA, Partner, at 216-831-7171 or tconstantine@cp-advisors.com

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© 2017

Why flip real estate when you can exchange it?

Real Estate:  Flip or Exchange?

JRKsmallersmallerThere’s no shortage of television shows addressing real estate these days. Many emphasize “flipping” properties when an adequate gain is reached. But, if you’re ready to move one of your investments, you might prefer to exchange it rather than flip it.

Reviewing the concept
Section 1031 of the Internal Revenue Code allows you to defer gains on real or personal property used in a business or held for investment if, instead of selling it, you exchange it solely for property of a “like kind.” In fact, these arrangements are often referred to as “like-kind exchanges.” The tax benefit of an exchange is that you defer tax and, thereby, have use of the tax savings dollars until you sell the replacement property.

Personal property must be of the same asset or product class. But virtually any type of real estate will qualify as long as it’s business or investment property. If you wish to exchange your personal residence (including a vacation home), you’ll have to first convert it into an investment property.

Executing the deal
Although an exchange may sound quick and easy, it’s relatively rare for two investors to simply swap properties. You’ll likely have to execute a “deferred” exchange, in which you engage a qualified intermediary (QI) for assistance.

When you sell your property (the relinquished property), the net proceeds go directly to the QI, who then uses them to buy replacement property. To qualify for tax-deferred exchange treatment, you generally must identify replacement property within 45 days after you transfer the relinquished property and complete the purchase within 180 days after the initial transfer.
An alternate approach is a “reverse” exchange. Here, an exchange accommodation titleholder (EAT) acquires title to the replacement property before you sell the relinquished property. You can defer capital gains by identifying one or more properties to exchange within 45 days after the EAT receives the replacement property and, typically, completing the transaction within 180 days.

Proceeding carefully
The rules for like-kind exchanges are complex, so these arrangements present some risks. If, say, you exchange the wrong kind of property or acquire cash or other non-like-kind property in a deal, you may still end up incurring a sizable tax hit. Mortgaged properties require special planning.

To avoid the landmines that will cost you money and take advantage of the tax benefits of a real estate exchange, call Jim Komos, CPA, Partner-in-Charge of the Ciuni & Panichi, Inc. Tax Department. His team is dedicated to helping businesses and individuals adhere to tax rules and increase their business. Be sure to call us especially when exploring a Sec. 1031 exchange and definitely before executing any documents.

Contact Jim at 216-831-7171 or jkomos@cp-advisors.com.

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Tax Reform Saves Time, Money, and Headaches

What House Bill 5 Means to Your Business

By Joshua Schering and Nick Leacoma

ohio stateOhio businesses will experience fewer headaches when tax reform House Bill 5 (HB 5) goes into effect on January 1, 2016. The relief comes from standardization of multiple municipality tax policies and a reduction in the number of returns you may need to file. This change eases some burdensome requirements that affect real estate and construction companies doing business in several municipalities.

Here’s how the reform works
HB 5 increases the number of days a large business (annual revenue over $500,000) employee can work in a municipality from 12 to 20 days before city tax withholding is required for that city.

The 20-day exemption only applies if:

  • The employee worked 20 or fewer days in a municipality outside of the employee’s principal work place
  • The employer does not withhold taxes where the employee worked for 20 or fewer days
  • A refund of taxes withheld is not requested by the employee from the municipality where the principal place of work is located
  • To allocate an employee’s time, the bill provides a determination test. One day spent in a municipality is defined as working in that municipality more than in any other. The following activities are considered performed at the principal place of work:
  • Commuting to and from work
  • Traveling time to pick up, load, move, and/or deliver the employer’s product (unless said products are attached to real estate not used, controlled, or owned by the employer)

Small business employers (under $500,000 in annual revenue) are only required to withhold municipality taxes where their principal business is located.

This alleviates additional payroll tax filings for a number of companies with short term projects in other municipalities.

Net Operating Losses (NOLs) rules are standardized
HB 5 requires municipalities to allow NOL deductions and carryforwards for five years in taxable years beginning after December 31, 2016. If the NOL occurs before 2017, it is only allowed if the municipality adopts an ordinance allowing it. Net operating losses do not include losses from basis, passive activity loss limitations, and at-risk losses.

The NOL deduction and carryforward is limited to 50 percent of the full amount allowed for the first five years (years 2018 – 2022). The 50 percent limit doesn’t apply to NOLs incurred prior to 2017 and under an ordinance that allows the deduction and carryforward of NOLs. The portion of the NOL that was not deducted may then be carried forward. Tax years that begin after taxable year 2023 allow the full NOL deduction.

Net profit calculation is standardized
Pass-through entities must compute their net profit as if they were a C corporation. They are not allowed to deduct the following in re-computing their net profit:

  • Guaranteed payments paid or accrued to an owner (or former owner)
  • Payments or accruals to a qualified self-employment retirement plan
  • Amounts paid or accrued for health insurance or life insurance plans for owners or owner-employees

To preclude NOLs from being deducted twice individuals are required to disregard NOLs carried forward by the entity to reduce the current year’s net profits.

Other noteworthy changes

  • The sales apportionment factor has changed to include income from rental property
  • If a taxpayer owes $10 or less to a municipality with their annual return they are not required to pay the tax but are still required to file a return

In conclusion
Ohio has long strived to be a pro-business state but maintained a burdensome municipal tax system. This latest round of municipal tax reform makes compliance easier and more cost effective. To learn about other changes that could affect your business, contact Ciuni & Panichi, Inc. at 216-831-7171 or cp-advisors.com.

Nicholas Leacoma, CPA, is a senior manager and Joshua Schering is a senior accountant in the Real Estate and Construction Services Group at Ciuni & Panichi, Inc. The Ciuni & Panichi, Inc. team provides audit and accounting services, tax compliance and consulting, management advisory services, wealth management, growth management, and retirement planning.

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New Ruling for Real Estate Trusts

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© 2015

 

New Ruling for Real Estate Trusts

How a trust qualified for an exception to PAL rules

us tax courtIn a favorable decision for trusts that hold real estate assets, the U.S. Tax Court has held that such a trust qualified for the real estate professional exception and was therefore exempt from the limitations on passive activity losses (PALs). The court’s holding also means the trust can avoid the new 3.8% net investment income tax (NIIT) that applies to passive activity income.

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 the activity that’s regular, continuous and substantial. Rental real estate activities are generally considered passive regardless of whether you materially participate.

Internal Revenue Code Section 469 grants an exception from restrictions on PALs for taxpayers who are real estate professionals. If you qualify as a real estate professional and you materially participate, your rental activities are treated as a trade or business, and you can offset any nonpassive income with your rental losses. You may also be able to avoid the NIIT as long as you’re engaged in a trade or business with respect to the rental real estate activities (that is, the rental activity isn’t incidental to a nonrental trade or business).

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.

The IRS challenge
In Frank Aragona Trust v. Commissioner of Internal Revenue, the trustee had formed a trust in 1979, with his five children as beneficiaries. He died in 1981 and was succeeded as trustee by six trustees — the five kids and an independent trustee. Three of the kids worked full-time for a limited liability company (LLC), wholly owned by the trust, that managed most of the trust’s rental properties and employed about 20 other individuals, as well.

During 2005 and 2006, the trust reported nonpassive losses from its rental properties, which it carried back as net operating losses to 2003 and 2004. The IRS determined that the trust’s real estate activities were passive activities, and the challenge landed in the Tax Court.

A trust as a real estate professional
The IRS contended that a trust couldn’t qualify for the real estate professional exception because a trust can’t perform “personal services,” which regulations define as “any work performed by an individual in connection with a trade or business.” The Tax Court rejected this argument. It found that, if a trust’s trustees are individuals who work on a trade or business as part of their trustee duties, their work can be considered personal services that can satisfy the exception’s requirements.

Evaluating material participation
The IRS alternatively argued that, even if some trusts can qualify for the exception, the Aragona trust didn’t, because it didn’t materially participate in real property trades or businesses. The agency asserted that only the activities of the trustees can be considered, not those of the trust’s employees. And the IRS claimed the activities of the three trustees who worked for the LLC should be deemed activities of employees and not trustees.

The Tax Court didn’t decide whether the nontrustee employees’ activities should be disregarded in determining if the trust materially participated in its real estate operations. But it held that the activities of the trustee employees should be considered. It also noted that trustees aren’t relieved of their duties of loyalty to beneficiaries just because they conduct activities through a corporation wholly owned by the trust.

Be prepared
For technical reasons, the trust in this case wasn’t required to prove that it satisfied the two-prong real estate professional test. Other trusts wishing to take advantage of the exception should be prepared to do so.  Contact our Construction and Real Estate Services Group (CARES) at 216.831.7171 or Tony Constantine at tconstantine@cp-advisors.com for more information and assistance.

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© 2014

Considering a Change to REITs and RICs

real estate trustNew regs tackle property transfers from C corps to REITs and RICs

Last fall, the IRS issued long-awaited final regulations providing guidance on the recognition of built-in gains when the appreciated property of a C corporation becomes the property of a real estate investment trust (REIT) or regulated investment company (RIC). Such a situation can arise when a C corp becomes a REIT or RIC or because it transfers its property to a REIT or RIC in a “conversion transaction.” The regs include two important exceptions to the general rule on gain recognition.

The general rule:  Unlike C corporations, REITs and RICs usually aren’t subject to corporate income tax when they dispose of appreciated property, such as real estate. The general rule limits the ability of C corporations to avoid corporate-level taxes by converting into a REIT or RIC and having the new entity sell appreciated assets or contributing such assets to a REIT or RIC in a tax-free contribution. If a C corporation’s property becomes the property of a REIT or RIC, the REIT or RIC is subject to tax on the net built-in gain in the converted property.

The general rule, however, doesn’t apply if the C corporation transferor makes a “deemed sale election,” which accelerates the gain. Under the election, the C corporation recognizes gain and loss as if it sold the converted property to an unrelated person at fair market value. The REIT or RIC then takes a fair market value basis in the converted property.

The proposed exceptions:  In April 2012, the IRS released proposed regulations with two exceptions to the general rule:

  1. Exchange exception. A REIT or RIC isn’t subject to the built-in gains tax if the conversion transaction qualifies for nonrecognition treatment as a like-kind exchange or involuntary conversion into similar property or money, where the C corporation replaces the transferred property with other property with the same basis as the transferred property.
  2. Tax-exempt exception. If the C corporation falls within one of eight categories of tax-exempt entities (including charitable remainder trusts), the transaction isn’t subject to the general rule if the tax-exempt entity wouldn’t be subject to tax (such as under the unrelated business income tax rules) on gain resulting from a deemed sale election if the election had been made.

The final regs retain these exceptions, with some critical clarifications in response to feedback on the proposed regulations.

The final regs’ clarification of the proposed exceptions:  The IRS acknowledged that the proposed regs may have been unclear about whether the tax-exempt exception applies to a transaction where some of the gain from a deemed sale election would be subject to tax if such an election were made, while some of it wouldn’t be.

The final regs clarify that the general rule doesn’t apply to a conversion transaction in which the C corporation that owned the converted property is a tax-exempt entity to the extent that gain wouldn’t be subject to tax if a deemed sale election were made. In other words, if the tax-exempt entity would have been subject to the unrelated business income or similar tax on only a portion of the gain if the entity had made the election, the built-in gains tax applies only to that portion of the gain — not the entire built-in gain.

The IRS also considered a requested clarification that the exchange exception applies to certain multiparty like-kind exchanges involving intermediaries, including reverse like-kind exchanges (where the replacement property is acquired before the relinquished property is transferred). The IRS declined to change the proposed regulations. But it stated in the preamble to the final regulations that the exception operates to exclude any realized gain that isn’t recognized by reason of either a like-kind exchange or an involuntary conversion regardless of the transaction’s form.

More guidance:  While the final regs are intended to prevent the avoidance of corporate-level taxes, the exceptions do provide some protections. Your financial advisor can help you determine the best tactics for minimizing your liability for built-in gains tax.

Sidebar: The rejected exception:  In its recently issued final regulations (see main article), the IRS weighed inclusion of a new exception to the general rule. This exception addresses the situation where a real estate investment trust (REIT) or regulated investment company (RIC) purchases appreciated property from a C corporation for cash or other consideration equal to the property’s fair market value.

A commenter on the proposed regulations asserted that, if the entity doesn’t have a continuing relationship with the corporation, the entity has no way of knowing the extent to which the C corp might not recognize any gain. The commenter contended and the IRS agreed that, because the entity’s basis in property purchased in an arm’s-length transaction generally is its cost, the entity generally shouldn’t have any built-in gain in the converted property.

The IRS found a new exception unnecessary. It explained that, if the REIT or RIC subsequently sold the property at a gain during the recognition period, the entity should be able to otherwise establish that the gain recognized isn’t built-in gain.

John Troyer and the real estate experts at Ciuni & Panichi, Inc. can help guide you through this complicated change.  Contact John at 216.831.7171 or jtroyer@cp-advisors.com.

 

© 2014

How Real Estate Professionals Protect LLC Investments

real estate bldgReal estate owners and developers often form limited liability companies (LLCs) to hold title to property. One key reason for making the switch is that LLCs limit personal liability — only the LLC members’ equity investments are usually at risk. While these entities do offer protection from personal liability for the debts and liabilities of the entity itself, some exceptions exist that could drain an owner’s or developer’s personal finances.

Environmental Liability
Environmental liability is a common concern when purchasing property, and use of an LLC to make the purchase doesn’t make that concern moot. The Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) imposes strict, joint and several liabilities — no showing of negligence or intent is required — for cleanup costs on past and present owners and operators of facilities where hazardous materials have been released. An LLC member who had the authority to control the operations or decisions involving the disposal of hazardous substances could be held liable for cleanup.

Personal Guarantees and Contracts
LLC members who personally guarantee the company’s debts or obligations will be held liable for their nonpayment or breach. This is a true risk when entering contracts or financing agreements before the LLC legally comes into existence because the other party insists on some guarantee.

To minimize the risk of personal liability, always act in the name of the LLC. When you sign contracts, for example, do so solely as an agent of the LLC, making sure to identify the LLC as the principal in the document. Similarly, make sure that the LLC’s other agents and employees act as representatives of the entity and not of you personally. For extra protection, members might consider adding a personal umbrella policy to the LLC’s traditional business insurance coverage.

Certain loan defaults may also create personal liability. Carefully review all loan documents to make sure you completely understand the consequences of all potential covenant violations.
Wrongful acts

An LLC won’t protect a member from liability for his or her own negligent or otherwise wrongful acts that cause injury to another, such as assault or fraud. That could include negligent hiring or supervision of employees if an employee causes some type of injury and the member hired the employee in his or her own name, rather than in the name of the LLC.

Also note that, if an LLC member commits a wrongful act that causes injury while acting as an agent or employee of the LLC, it’s not just the member’s personal assets that could be targeted by the injured victim. The victim could also go after the assets of the LLC, under a theory of vicarious liability (also known as “respondeat superior liability”) for its agent’s acts.

A Pierced Veil
On rare occasions, a court will “pierce the corporate veil” to impose liability for an LLC’s debts and obligations on its members. This typically occurs when closely held and small businesses fail to observe corporate formalities such as holding regular board meetings, keeping minutes, adopting bylaws and ensuring company finances are separate from those of members. It could also happen if the LLC engaged in reckless conduct or fraud or was inadequately capitalized from the beginning. In all of these circumstances, a court might conclude that the LLC is merely a sham to shield its members from liability.

Protect Yourself
LLCs come with their benefits, but they don’t provide a total defense for members’ personal assets. The rules governing LLCs vary from state to state. Consult with your attorney and financial expert to devise asset protection strategies for your individual needs.

Ciuni & Panichi has experts in the construction and real estate field.  Contact John Troyer at 216.831.7171 or jtroyer@cp-advisors.com to learn how we can help make sure your financial position is safe.

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