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One of the major advantages of owning real estate in a partnership is the ability to leverage the real estate and distribute the proceeds of the borrowing to the partners on a tax free basis. 

FOR EXAMPLE: 

Individuals A & B equally own a Limited Liability Company that is treated as a partnership for tax purposes.  The LLC owns real estate with a tax basis of $1 million and a fair market value of $5 million.  The LLC borrows $3 million from a bank on a non-recourse basis, that is, the bank can only look to the property for repayment.  Neither partner is personally obligated to repay the bank.  Immediately after the borrowing, the LLC distributes the $3 million equally to the two partners.

As long as the non-recourse liability is allocated equally to the two partners, the withdrawal of $1.5 million by each partner is a tax free transaction.  This follows Section 752 of the Internal Revenue Code which states that any increase in a partner’s share of the liabilities of a partnership shall be considered a contribution of money by such partner to the partnership.  In effect, the partner’s outside tax basis is deemed to increase by his share of the increase in the partnership’s liabilities.  This increase can provide sufficient tax basis to allow a withdrawal of funds to be considered a tax-free return of basis. Additionally, such an increase in outside tax basis can permit the use of valuable deductions, the benefit of which may have been deferred absent the increase in liabilities and tax basis.     

While an increase in a partner’s share of partnership liabilities increases the partner’s outside basis, a decrease in the partner’s share of partnership liabilities decreases the partner’s outside basis.  Thus, it is important for partner A and B that their share of the partnership’s liabilities does not significantly decrease.  A significant decrease may have the same effect as withdrawing money in excess of tax basis, i.e. resulting in a current taxable gain. 

Thus, a partnership that is contemplating taking in new partners or contributing its property to a larger partnership (for example, a real estate venture fund) must examine how the reallocation of its liabilities will affect the tax liability of its current partners.

A partner who is facing a taxable event due to the reallocation of liabilities may find it beneficial to guarantee a portion of the partnership’s non-recourse liabilities.  A guarantee will convert a portion of the non-recourse liability to a recourse liability.  Partnership recourse liabilities are allocated to that partner who may be ultimately liable for the debt. Thus, by guaranteeing the debt, the partner may be able to maintain a sufficient allocation of partnership liabilities to avoid gain.     

While a guarantee of debt is good for tax purposes, most partners are not willing to take on a possible liability that they did not have previously.  A guarantee may not be a good economic choice.

BOTTOM DOLLAR GUARANTEE

A method of guaranteeing the debt while mitigating the economic risk of satisfying the guarantee is a so-called “bottom dollar guarantee.”  This is a guarantee where the partner agrees to repay partnership debt only if the bank collects less than the guaranteed amount from the partnership. In the example above, if partner A signs a bottom dollar guarantee for $1 million, partner A will only have to satisfy this guarantee if the bank cannot collect at least $1 million of the $3 million debt from the partnership.  Once the bank collects $1 million from the partnership, partner A is relieved of all further liability on the debt.  This is contrary to a normal guarantee, where the guarantor is liable for any and all amounts of the debt left unsatisfied by the partnership up to the stated guarantee amount.

The Internal Revenue Service has been struggling with the issue of whether a bottom dollar guarantee is a real guarantee and should be respected as such for tax purposes.  Recently released proposed regulations under Section 752 make it clear that the IRS will not recognize bottom dollar guarantees as valid guarantees of partnership debt. Under the proposed regulations, a partner only bears the economic risk of loss if the partner is liable for amounts that the partnership does not satisfy. 

The new proposed regulations will not be effective until published in final form.  However, for those partners who have bottom dollar guarantees in place at the time the regulations are finalized, a seven year transition rule is provided. In conclusion, the proposed regulations, if finalized in their current form, will provide that a partner is not able to both mitigate his or her economic risk and increase his or her outside tax basis when he or she guarantees partnership debt.  Accordingly, maintaining a partner’s share of partnership debt will require that the partner take on a real economic burden.  

By Robert E. Demmett, CPA, MS, Partner | rdemmett@withum.com

If you have any questions about this real estate update, please contact your WithumSmith+Brown professional or a member of WS+B’s Real Estate Services Group. 

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Way back near the end of May, which feels like a very long time ago, we published a couple of pages of overview on how to classify ownership interests in activities as passive vs. non-passive.  Somewhere in that article I promised to mention how real estate interests can qualify as non-passive activities.

This determination is key in the proper treatment of income and losses both for the purposes of the limitations under the passive activity loss rules and also for the inclusion in the calculation of the new Net Investment Income tax.

For an activity to be considered non-passive, the owner must materially participate in that activity and generally meet one of seven tests enumerated in Reg. Section 1.469-5T, explained previously.  Despite those requirements, rental activities are per se passive, that is, automatically treated as passive regardless of the level of the owner’s participation.  There are a couple of exceptions to that default which we mentioned in the earlier article for self-rental activities, holding a working interest in an oil and gas property, and where a grouping election would be allowed with a non-rental activity in only specific circumstances. However, the most frequently used (and risky) exception to the default treatment of real estate income or loss as passive is when an election is made for a real estate professionals.

Special rules are provided under IRC §469(c)(7) for rental activities commonly referred to as the real estate professional rules.  If the test is met, the rental activity of a real estate professional is treated as non-passive.  Treatment as non-passive is advantageous when a real estate rental activity is generating losses that can be used to offset other income such as interest, dividends and wages.  Conversely, the passive losses would not reduce other passive real estate income for purposes of the net investment income tax.  Planning to make this election should be well thought out in that it may not always be desirable to treat net rental real estate income or loss as non-passive and the election itself may invite increased IRS scrutiny.

Am I a real estate professional?

The real estate professional must satisfy two tests:

  • more than one half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
  • such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

At first glance, the test seems relatively easy to satisfy until you realize that for an activity to be counted towards the first and second test, the owner must materially participate in each activity to treat the income or losses as non-passive.  If there are interests in several real estate activities, this may be difficult to satisfy.  To help satisfy the material participation for each activity, a special grouping election can be made under Reg. Section 1.469-9 to treat all interests in rental estate as one activity. Once made, the election is binding for all future years the taxpayer is a qualifying real estate professional and is revocable only if there is a material change in facts and circumstances.  In case you missed the election, one can be filed with an amended return under Rev. Proc. 2011-34.

The rental estate activity is owned by a trust.  Can the trust be a real estate professional?

The Code nor the regulations address how material participation rules can be satisfied for taxpayers who are trust, estate or personal service corporations.  Under IRC §469(c)(7)(B) the requisite amount of service hours must be performed in real property trades or businesses, the performance of which the IRS has previously stated must be by a taxpayer who is a natural person and has the capability for physically performing such services.  In looking to case law for guidance, the U.S, Tax court in a recent decision, held that a trust taxpayer could meet the material participation standards through the performance of its trustees and thus qualify for the real estate professional exception under §469(c)(7). [Frank Aragona Trust, (2014) 142 TC No. 9.] In the case, the taxpayer was a trust that owned rental real estate properties and engaged in other real-estate activities.  The court ultimately rejected the IRS’ argument that a trust is incapable of performing personal services.  Rather, the Tax Court held that the trust is an arrangement whereby trustees have a fiduciary responsibility to manage assets for the benefit of the trust’s beneficiaries and therefore worked performed by an individual as part of their trustee duties are personal services for purposes of satisfying the section 469(c)(7) exception.

The trust was formed by a grantor who, after his death, was succeeded as trustee by his five children and one independent trustee.  All six trustees acted as a management board for the trust and made all major decisions regarding the trust’s property. In addition, a disregarded LLC, wholly owned by the trust, managed the trust’s rental real-estate properties.  The LLC employed several people, some of whom were the trustees.  The court ruled that not only were the activities performed by the individuals in their duties as trustee included as personal services performed in a real-estate trade or business, but also their time spent as employees of the LLC managing the rental real estate properties.

Because the requisite hours in real-property trades were met and the trust materially participated in the real property businesses, the trust met the exception to the per se passive treatment of rental real estate activities and was able to treat the income and losses from the activities as non-passive.

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One of the most common questions I get from clients relates to the structure of their potential real estate deals.  While almost everyone has heard the age old adage “Never put real estate in a C corporation,” many people seem to see LLCs and S corporations as equally acceptable pass-through alternatives for holding real estate.   In reality, this couldn’t be farther from the truth.  The following will outline five reasons why an LLC is preferable to an S corporation for holding real estate in the current environment.

  1. Number of shareholders – An S corporation is limited to only 100 shareholders.  Under Sec. 1361, members of a family (as defined within the Code) are considered one shareholder for purposes of this 100 shareholder test.   Conversely, there is no limit on the number of allowable members of an LLC.  While this wouldn’t seem like a major limitation for a majority of property owners, if a taxpayer were interested in syndicating interests in the pass through entity in an effort to raise capital this 100 shareholder cap could significantly limit their ability to do so.
  2. Type of shareholders – In addition to limiting the number of shareholders to 100, the Internal Revenue Code also limits the types of entities that can be shareholders of an S corporation.  For starters, nonresident aliens are not permitted to own stock in an S corporation and certain types of trusts are excluded as shareholders as well.  Neither C corporations nor partnerships and other entities taxed as partnerships under the default entity classification rules (multi-member LLCs) may not own shares in an S corporation.  With an LLC, any type of entity, domestic or foreign, is a permitted member.
  3. Only one class of stock – Many investors demand priority returns on their invested capital, as well as a priority return of their invested capital. In an S corporation, it is not possible to offer these benefits to investors.  S corporations are only permitted to issue one class of stock. While the rules will permit an S corporation to issue voting and nonvoting stock, it is not possible to provide distribution or liquidation preference to certain shareholders at the expense of others.  In an LLC, the allocations of cash are much more flexible and allow for these priority returns so long as the allocations meet the overall requirement of substantial economic effect.
  4. Basis concerns – Many real estate investments offer losses in early years as a result of the benefits of accelerated depreciation deductions.  These noncash deductions shield cash flow from taxation during the early years of the investment and generate losses that are allocable to the shareholders or members.  The investors are only permitted to deduct those losses to the extent that they have basis in the pass through entity.  I will avoid for now a long detour into the rules of both partnership and S corporation basis, but there is one major difference that is worth highlighting. Shareholders in an S corporation are only deemed to have basis in the pass through entity to the extent of any money invested into the entity and any loans made directly from the shareholder to the pass through entity. In an LLC, members are deemed to have basis for both their contributions into the entity and their ratable share of all liabilities of the entity. This allows members in an LLC to deduct losses in excess of their individual investment to the extent that they are allocable a portion of the liabilities of the entity.
  5. Basis adjustments – The last way in which the two past through types differ is in the allowable adjustment to basis under IRC Sec. 754.  This section of the Internal Revenue Code allows a partnership to adjust the basis of partnership property when there are taxable sales or exchanges of interests or redemptions of a partnership interest.  There is no similar adjustment available to shareholders of an S corporation.  This adjustment helps to keep a members’ outside basis in his or her partnership interest in line with the partnerships’ basis in the underlying partnership property. Since this opportunity does not exist for an S corporation, an S corporation shareholder can end up with a substantial variance in his or her basis in the S corporation stock, which could generate undesirable income tax consequences.

These five issues should be considered heavily when making a choice of entity.  In most cases, one or more of these factors will make the choice of entity obvious. In more cases than not, an LLC will be preferred entity type for real estate investment. With an LLC, there is no cap on the number of shareholder and no limitation on the types of shareholders.  In addition, a referred return on capital and a priority return of capital can be provided to investors without the fear of running afoul of the IRC rules.  If none of the other issues outlined makes the decision, the optional basis adjustment under Sec. 754 alone can be substantial enough to point to an LLC as the preferred entity type.  The Sec. 754 adjustment can provide significant tax advantages to an investor and should be given a good amount of weight in the choice of entity decision.

Authored by Brian Lovett

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Sometimes in life, when faced with a given situation, we say things simply as a matter of reflex. For example:

“What an adorable baby!”

“You have a lovely home here.”

“You’re a great gal, I’ll call you sometime. Now can you help me find my pants?”

Things are no different in the tax world. As advisors, we keep an army of axioms always at the ready to be used in response to client queries. Take, for example, the client who contemplates the type of entity that should be used to hold a piece of real estate. For most tax practitioners, this would elicit the following Pavolovian reaction:

“You should NEVER put real estate inside a corporation.”

And while there are very few NEVERS in the tax world, this one is pretty darn accurate. But do you really understand why you should never put real estate into a corporation? It’s because, as the ensuing discussion will reflect, while real estate can go into a corporation tax-free, it can never come out tax free. In today’s Tax Geek Tuesday, let’s peel back the layers of the statute and find out why.

Case study:  A, an individual, owns a building with a basis of $400,000 and a fair market value of $1,000,000. B, another individual, owns business assets worth $1,000,000. A and B would like to form a business that will use both the business assets owned by B and the building owned by A.  The entity will be owned 50/50 by A and B. Should the entity be a C corporation,  S corporation, or partnership?

Transfers to Controlled Corporations, In General

Under the general tax principles of Section 1001, the transfer of appreciated property triggers gain for the difference between the amount realized on the transfer less the adjusted tax basis of the property. Thus, barring a statutory exception, if A were to transfer the building to a corporation in exchange for the corporation’s stock, A would recognize $600,000 of gain ($1,000,000 fair market value less A’s $400,000 tax basis).

Section 351 is one such exception to the general rule of gain recognition, however, as it allows you to contribute appreciated property to a corporation in exchange for the corporation’s stock without recognizing gain provided you “control” the corporation immediately after the transfer.

For these purposes, “control” is defined as 80% of the vote and value of the corporation, with a couple of important distinctions. First, you don’t have to acquire 80% of the corporation; you simply must own 80% immediately after. A taxpayer who already owns say, 85% of a corporation may continue to transfer appreciated property to the corporation, and the gain will be deferred under Section 351.

In addition, Section 351 allows for a group of transferors. If you contribute appreciated property to a corporation in exchange for, say 20% of the corporation’s stock, but simultaneous to the transfer, another two individuals transfer cash or property to the corporation in exchange for an additional 65% of the stock, all three transfers are covered by Section 351 because on a combined basis, the transferor group controls the corporation immediately after the transfer.

Section 357(c)

Problems arise when the property contributed to a corporation is subject to a liability. Under Section 357(c), if you transfer property to a corporation that is subject to a liability and the corporation assumes that liability as part of the transfer, the transfer triggers gain to the extent the liability exceeds the tax basis of the property.

This provision is particularly problematic when the subject property is real estate, where mortgages are the norm. If, for example, A’s property were subject to a $700,000 mortgage, the transfer of the property to a corporation in exchange for corporate stock would generate $300,000 ($700,000 debt relief less $400,000 tax basis) of gain to A, even if the transfer were otherwise tax-free under Section 351.

Basis and Holding Period

When Section 351 applies to a transfer of property to a corporation, the gain is not excluded, it is merely deferred. This is accomplished through two statutory provisions that provide basis rules that ensure that any gain inherent in the building will be recognized if either you dispose of the corporation’s stock or the corporation disposes of the building.

Under Section 358, you must take a basis in the stock received equal to the basis in the property you transferred to the corporation. This is often referred to as a “substituted basis,” because the basis in the property received is determined in reference to the basis in the property relinquished.

In turn, Section 362 provides that the corporation must take a basis in the building equal to your basis in the building. This is often referred to as a “carryover basis,” because the corporation’s basis in the property remains unchanged from that which you held in the property.

Going back to our case study, if A and B simultaneously transfer property to a corporation in exchange for 50% of the corporation’s stock, Section 351 applies to the transfer. Despite the fact that A’s building has a fair market value of $1,000,000 and a tax basis of $400,000, no gain is recognized. 

Under Section 358, A takes a basis of $400,000 in the corporate stock received. Because the total value of the corporation’s assets is $2,000,000, A’s 50% stock ownership is presumably worth $1,000,000. If A sells the stock for its value of $1,000,000, A will recognize $600,000 of gain, the amount that was deferred when A transferred the building to the corporation.

Under Section 362, the corporation takes a basis in the building of $400,000. If the corporation sells the building for its value of $1,000,000, the corporation will recognize the $600,000 of gain deferred on the contribution.

Distributions and Liquidations of C Corporations, In General

The big problem with placing real estate in a corporation does not present itself until it’s time to get the property out, whether as a sale or distribution.

Sale

As mentioned above, if the corporation sells the building, courtesy of the basis mechanics of Section 362, the sale will generate $600,000 of gain. This gain will be taxed at the corporate level at a maximum federal rate of 35%, resulting in $210,000 of corporate-level tax.

The tax inefficiency is only exacerbated if A would like to get his hands on the remaining $790,000 ($1,000,000 less $210,000 tax liability) of purchase price.  If the corporation liquidates and distributes the net cash to A, A would be required by Section 331 to recognize capital gain for the difference between the amount distributed and A’s basis in the stock. A would recognize $390,000 of gain ($790,000 distribution less $400,000 stock basis) upon the liquidation, and assuming the stock were held longer than one year, would pay tax on the liquidation at a maximum rate of 23.8%, resulting in an individual tax bill of $93,000.

Thus, by selling the property in a C corporation and withdrawing the after-tax cash, A will incur a total tax liability in excess of $300,000.

Current Distribution

Alternatively, A may simply have second thoughts about dropping the building into a corporation, and wish to unwind the transaction. If the corporation transfers the building to A in a non-liquidating distribution, Section 311(b) governs the taxability of the transfer. Under this provision, when a corporation distributes appreciated property to a shareholder, the corporation recognizes gain as if it had sold the property for its fair market value. Thus, the distribution would trigger $600,000 of gain to the corporation — just as it did with a sale — which would be taxed at a maximum federal rate of 35%.

And just as seen with a sale, A isn’t through paying tax yet. Under Section 301, A must treat the fair market value of the distributed property as dividend income (to the extent of any corporate E&P, which will include the $600,000 of gain) where it will be taxed at a maximum rate of 23.8%.

Liquidating Distribution

Things are equally painful if the corporation distributes the property to A in a liquidating distribution. Under Section 336, when a corporation transfers appreciated property in a liquidating distribution, the corporation recognizes gain as if the property were sold for its fair market value. Thus, the corporation would once again recognize gain of $600,000, just as it did in the sale and current distribution examples, and once again pay corporate level tax of $210,000.

Under Section 331, A is treated as having received payment for his corporate stock equal to the fair market value of the distributed property ($1,000,000) less the corporate tax liability assumed by A in the liquidation ($210,000). A receives $790,000 of payment in exchange for his stock with a $400,000 basis, resulting in long-term capital gain of $390,000 that is taxed at a maximum of 23.8%. As you may have noticed, these are the exact same tax consequences that would arise if the corporation had simply sold the building for cash and distributed the after-tax proceeds.

Summary

In summary, while A can get his building into the corporation without triggering the $600,000 of appreciation, he cannot get it out of the corporation — by sale or distribution — without incurring a tax liability of approximately $300,000. For this reason, a C corporation is not the ideal entity choice for A and his building.

Application to S Corporations

Section 351 applies equally to C and S corporations. Unfortunately, Sections 311(b) and 336 also apply equally to an S corporation. This means that if the S corporation distributes the property to A in either a non-liquidating or liquidating distribution, the S corporation will be treated as if it sold the property for its fair market value of $1,000,000, triggering $600,000 of corporate level gain.

Of course, S corporations – at least S corporations that are not subject to the built-in-gains tax (future Tax Geek Tuesday idea!) – do not generally pay tax at the corporate level. Instead, the $600,000 of gain will flow through to A who will pay tax on the income at the individual level, and the gain will increase his basis from $400,000 to $1,000,000 under Section 1367(a)(1). As a result, the distribution will not be taxed a second time at the shareholder level. If the distribution were of the non-liquidating variety, A would simply reduce his $1,000,000 stock basis by the $1,000,000 value of the building. If the property were distributed in a liquidating distribution, under Section 331 A would be treated as having received property worth $1,000,000 in exchange for stock with a basis of $1,000,000, resulting in no further gain or loss. .

Even with the favorable single-level taxation afforded S corporations, however, because of Section 331 A cannot take the property out of the corporation without incurring a tax bill of nearly $150,000 ($600,000 flow-through gain * 23.8% rate on LTCG or 25% rate on unrecaptured Section 1250 gain).

Application to Partnerships

So, what is it that makes partnerships such an attractive entity choice for holding real estate? For starters, just like corporations, appreciated property can be contributed to a partnership in exchange for a partnership interest without the recognition of gain. This is accomplished by virtue of Section 721, which works just like Section 351, only without as many restrictive rules.

For example, while Section 351 requires the transferor or a group of transferors to own more than 80% of the corporation immediately after the transfer in order to obtain tax-free treatment, Section 721 carries no such ownership requirement. Instead, an individual can transfer appreciated property to a partnership in exchange for as little as a 1% interest without triggering any gain.

Like Section 351, Section 721 is a deferral provision rather than an exclusion provision. Moreover, there are basis rules in Section 722 and 723 that mirror those previously discussed in Sections 358 and 362. Under these rules, when a partner transfers property to a partnership in exchange for an interest in the partnership, the partner takes a substituted basis in the partnership interest equal to his basis in the property contributed, and the partnership takes a carryover basis in the contributed property equal to the partner’s basis in the property.

Applying Section 721, 722 and 723 to our case study, A recognizes no gain on the transfer of property with a basis of $400,000 and a fair market value of $1,000,000 in exchange for a 50% interest in the partnership. A takes a basis of $400,000 in the partnership interest received, and the partnership takes a $400,000 basis in the real estate.

Liability Relief

It is much less likely that transferring mortgaged property to a partnership will create gain, because there is no parallel to Section 357(c) in subchapter K. Instead, a transferor of mortgaged property to a partnership must apply the principles of Sections 731 and 752 to determine if gain is recognized on the transfer, and as shown below, gain can be avoided in the partnership context where it would be required in subchapter C.

Section 752 provides that a partner increases his basis in the partnership interest for his share of the partnership liabilities. Conversely, if a partner’s share of the partnership’s liability decreases, the reduction is treated as a distribution of cash to the partner. Why do we care?

Because Section 731 provides that a partner will only recognize gain on a distribution if the cash (or liability relief) distributed exceeds the partner’s basis in the partnership interest.

Combiningg these rules with the partner basis rules of Section 722, it becomes much less likely that a partner contributing leveraged property to a partnership will recognize gain.

To illustrate, assume the property A contributes to the partnership has a basis of $400,000, a fair market value of $1,700,000, and is subject to a $700,000 mortgage. If the property were transferred to a corporation, Section 357(c) would apply and A would be required to recognize $300,000 of gain on the transfer for the excess of the liability over the tax basis of the property.

The partnership rules yield a different result. Under Section 722, A takes an initial basis in the partnership interest of $400,000. Then, under Section 752, A increases his basis to reflect his 50% share of the $700,000 liability that now belongs to the partnership, or $350,000, raising A’s basis to $750,000. Finally, because A has been personally relieved of 100% of the liability upon transferring it to the partnership, this debt relief is treated as a distribution of cash to A by Section 752. Under Section 731, A must reduce his outside basis by the deemed distribution of $700,000. As a result, A’s final outside basis is $50,000 ($750,000 – $700,000).

Because the deemed distribution of $700,000 did not exceed A’s basis immediately before the distribution, no gain is recognized by A on the transfer.

Distributions and Liquidations of Partnerships, In General

While appreciated property can go into a corporation free from tax, as shown above, it can’t come out without the corporation being required to recognize gain as if the property were sold for its fair market value. Partnership law, however, provides deferral rules governing both the contribution of property to a partnership as well as the distribution of appreciated property from a partnership.

Sections 731 and 732 combine to provide that when a partnership distributes property to a partner in a current distribution, generally no gain or loss is recognized by either the partnership or the partner. Instead, the partner simply takes a basis in the distributed property equal to the lesser of:

  • The partnership’s basis in the distributed property, or
  • The partner’s outside basis in his partnership interest.

This nonrecognition treatment is extended to liquidating distributions as well. If a partnership transfers property to a partner in liquidation of the partnership, no gain is recognized by either the partnership or the partner; rather, the partner simply takes a basis in the property equal to the partner’s remaining basis in the partnership interest, after reduction for any cash received or debt relief.

And this is why partnerships are the vehicle of choice for holding real estate. Put a building in a C corporation, and it’s not getting out – either by sale or distribution – without triggering two levels of tax. Contribute the property to an S corporation instead, and the property can’t come out without triggering corporate-level gain. But place appreciated real estate into a partnership, and you receive the gift of flexibility; you can always undo your previous decision and distribute the building without recognizing gain at either the partnership or individual level.

Assume A and B transfer their respective properties to a partnership, and the value of the building increases from $1,000,000 to $2,000,000 while the tax basis of the building decreases from $400,000 to $300,000. Assume further that A’s basis in his partnership interest has also decreased from $400,000 to $250,000.

If the partnership distributes the building to A, neither A nor the partnership will recognize any gain on the distribution, despite the fact that the building’s fair market value of $2,000,000 greatly exceeds its tax basis of $300,000. Upon the distribution, A will take a basis in the building equal to the lesser of:

  • The partnership’s basis in the building of $300,000, or
  • A’s basis in his partnership interest of $250,000.

Thus, A reduces his basis in the partnership from $250,000 to zero and takes a $250,000 basis in the building.

If instead, the partnership liquidates and distributes the building to A in liquidation of his 50% interest, neither the partnership nor A will recognize gain. Instead, A will simply take a basis in the distributed building equal to A’s basis in the partnership interest, or $250,000.

Of course, these favorable distribution rules also operate on deferral principles; should A turn around and sell the property, the pre-distribution appreciation inherent in the building will be triggered by virtue or A’s modified carryover basis in the building. This still represents a tremendous advantage over the corporate regime, which forces the hand of the shareholder upon distribution by requiring the corporation to recognize all appreciation at the time of distribution. And that, above all other reasons, is why partnerships have become the entity of choice for holding real estate.

Got an idea for a future Tax Geek Tuesday? Send it along to anitti@withum.com or on twitter @nittigrittytax

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Remember the good ol’ days when the real estate market was so prosperous, every schlub on the street was buying land, building a spec home and selling for a tidy profit?

Those days are long gone, but pity those who built their spec home right before the crash, who instead of walking away with a pile of money were rewarded for their efforts with a large loss and financial ruin.

To soften the blow, many of these unfortunate investors will argue that they were in the trade or business of constructing spec homes — even when they only had one build on their resume  —  so as to deduct the loss as ordinary on their income tax return.

The IRS, of course, will argue the opposite: that the spec house was not constructed for sale in “the ordinary course of business” and thus was a capital asset, limiting the taxpayer to a capital loss that can only offset capital gains, plus an extra $3,000.

Now understand this: determining whether a piece of developed property is inventory — thus generating an ordinary loss — or an investment — generating capital loss — is not an open and shut analysis. This is, as much as any analysis in the tax law, an inquiry that is dependent on the facts and circumstances of each case.

Throughout the years, the courts have produced an impressive volume of case law on this “dealer versus investor” issue, and as a byproduct, a list of factors have evolved to aid in the analysis. While typically, the argument centers on the other, income, side of the equation —  with taxpayers pleading for capital gain treatment while the IRS pushes for ordinary income — these factors prove equally helpful in determining the character of a loss resulting from an isolated sale of developed real estate.

Consider the case of Darron (not a misspelling) Bennett, a self-described “serial entrepreneur” who decided to try his hand at developing a home in Carlton Banks’ hood — the Bel Air neighborhood of Beverly Hills.

In 1997, an old friend roped Bennett into taking a piece of raw land located in Bel Air off his hands. Bennett called Nevada home at the time, but he would spend 85% of his time at the Bel Air site handling the “design side” of the home construction.

In 1999, Bennett refinanced the property for $2,500,000, and on his loan documentation he indicated that he would occupy the home as his primary residence. One year later, he’d refinance again, this time indicating that he would not occupy the home as his primary residence.

In 2001, Bennett sold the unfinished home for $4,000,000, realizing a loss of $1,300,000 that Bennett deducted as an ordinary loss on his 2001 Form 1040.

The IRS denied the loss, arguing in the alternative that:

1. The house was intended to be Bennett’s primary residence, so any loss on the home was an unallowable personal loss under Section 165(c), or

2. The house was a capital asset — not a business asset — and thus the resulting loss was capital.

The Tax Court made short work of the first argument, holding that there was no evidence that Bennett intended to occupy the home as his primary residence. While he indicated on his loan application that he would do so, the court acknowledged that it is common practice for borrowers to fudge those applications in search of better lending terms, so the court disregarded this minor slip-up on Bennett’s part.

With regards to the second argument, a full-blown analysis was required. The following factors, developed by the Ninth Circuit, were used to determine if the Bel Air home was an investment property or inventory:

  1. The nature of the acquisition of the property,
  2. The frequency and continuity of sales over an extended period,
  3. The nature and the extent of the taxpayer’s business, and
  4. The activity of the seller about the property.

The Tax Court ultimately concluded that the Bel Air home was not built for sale in the ordinary course of business to customers, and thus generated capital, rather than ordinary loss. Relevant points for each factor were as follows:

1. The nature of the acquisition of the property:

The court decided this factor in favor of Bennett, concluding that because the home was not to be used as a primary residence, and because Bennett had enlisted the help of an architect/builder to help develop a saleable property, the Bel Air home was meant to be sold.

 2. The frequency and continuity of sales over an extended period:

While previous courts have held that very few sales can still reach the level of a trade or business, the Tax Court refused to do so in this case, deciding this factor against Bennett. There was no preexisting arrangement at the time Bennett acquired the property to quickly resell it, a fact that distinguished Bennett’s facts from previous taxpayer-friendly decisions.

3. The nature and the extent of the taxpayer’s business:

The fact that Bennett did not previously, or subsequently, engage in real estate development — exacerbated by the fact that he improperly reported the activity from the Bel Air property throughout the years on his tax return — convinced the court to decide against Bennett on this factor.

4. The activity of the seller about the property:

Bennett did himself no favors here. He hired a friend as his realtor. He never tried to advertise the property or prepare for the sale of the property. In fact, Bennett testified that he was “just trying to be rid of the property.” Add these up, and the court was obligated to decide against him here, and ultimately conclude that the property was not held for sale in the ordinary course of business.

What’s the lesson? If you’re one of the unfortunate souls still trying to unload a spec home you built pre-2008 and you’re angling to take an ordinary loss, you need to know the factors, and behave accordingly. Run it like a business, keeping books and records. Try like hell to sell the property through advertising, hiring unrelated brokers, etc… And for god’s sake, don’t admit you were “just trying to get rid of it.”

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Last week we discussed the Tax Court’s unfavorable ruling  in Amerisouth, in which the court deconstructed a cost segregation study performed on an apartment building. In our eyes, the most damning implication of the court’s decision was the requirement that all component assets of an apartment building be analyzed on whether they were essential to the operation or maintenance to a standard apartment building, rather than a generic shell building, thus forcing certain assets such as gas lines and kitchen sinks into a 27.5 year life.

The cost segregation community, however, has not shared our concern that Amerisouth was potentially a game changer; instead, the consensus has been that had the preparer of the cost segregation properly documented their findings and been adequately prepared to defend their reclassifications in front of the IRS, this harsh result could have been avoided. Below is a response sent from WS+B’s preferred cost segregation consultants —  Ernst & Morris Consultants Group — to all of its clients and partners, which reaffirms what we’ve been hearing elsewhere: The decision in Amerisouth was more a product of a sloppy study than a shift in the court’s approach to cost segregation:

To our valued clients,

On  Monday, March 12, 2012 the United States Tax Court released T.C. Memo 2012-67 regarding AmeriSouth XXXII, LTD. v. Commissioner  that has generated several emails to us from CPA’s around the country asking what’s our opinion on this case.  

AmeriSouth XXXII, LTD. purchased the Garden House Apartments in Mesquite Texas back in 2003 for 10.25 million and then spent another 2.0 million renovating the property. Garden House Apartments were originally constructed in 1970 and contain 366 units on 16 acres.  The taxpayer then hired MS Consultants to perform a Cost Segregation (CS) study. The study reclassified 3.4 million of the purchase price and subsequent renovations to 15 and 5-year MACRS property. The IRS disagreed with the taxpayer’s allocations, so the taxpayer filed a petition to challenge the IRS. The taxpayer then sold the property and discontinued further discussions with not only the IRS but with their legal counsel as well. In a rare move, the IRS allowed the taxpayer’s attorneys to be removed from the case since the taxpayer stopped all communications, so AmeriSouth was left to represent themselves in Court as they failed to file a post trial brief.

After reading the entire case, it’s obvious that the CS provider did a very poor job of defending his work in front of the IRS. They claimed the overhead incoming electric power lines as well as portions of the incoming utilities as 15-year MACRS property that the taxpayer did not own. Taking the costs associated with clearing and grubbing the site as 15 year depreciable property, qualifying the stove hood that they called a microwave exhaust, taking base molding along with many other mistakes obviously did not lend much credibility to the study. The CS provider claims that they had work papers but they were never admitted as evidence-wonder why?? In this case, it’s obvious that the CS provider did not provide enough evidence to prove that their allocations were valid and their report did not pass IRS scrutiny. The circumstances behind this case enabled the IRS to provide their positions with no rebuttal from the taxpayer. I’m sure the results would have been different if the taxpayer was more cooperative with the IRS.

As with every T.C. Memo, this case involves special circumstances between the taxpayer and the IRS. We will take these issues under consideration going forward. We do not anticipate changing how we perform CS studies for apartments. We emphasize to our clients the importance of having a qualified CS professional perform an engineering based study. Over the last few years during these tough economic times, some of our competitors started offering buy one study, get one free. The old saying of “you get what you pay for” definitely applies to this situation.

Every one of our studies provide a full narrative report, a set of cross referenced work papers and the support that we bring by defending our study for as long as it takes, at no charge. Feel free to visit the client testimonials regarding the defense of our work @ our website, www.costseg.com . Any questions or comments on this case or any CS issues you might have, please don’t hesitate to contact me @ 1-800-COST-SEG.

Thank you,

Michael P. Morris

Managing Director

Ernst & Morris Consulting Group, Inc.

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