Below are some tax topics that we thought would be of interest to you.
The information below should be used for educational purposes only and it is not a complete list nor may it apply to your situation or circumstance. You should consult with your tax advisor to find out the tax ramification of the transaction that pertains to you.
If you have any questions or need information on any of the items below, please do not hesitate to call David Silkman, CPA, MST, Broker at 310.478.9200 x301 or email him at david@SilkRoadRealtyInc.com.
Installment Sale – a Useful Tool to Minimize Taxes
Two laws that can significantly impact the taxes owed from the sale of property that results in capital gains. They include:
Higher Capital Gains Rates – Capital gains can be taxed at 0%, 15%, or 20% depending upon the taxpayer’s regular tax bracket for the year. Therefore, if your regular tax bracket is 15% or less, the capital gains rate is zero. If your regular tax bracket is 25% to 35%, then the top capital gains rate is 15%. However, if your regular tax bracket is 39.6%, the capital gains rate is 20%.
Unearned Income Medicare Contribution Tax – This tax is sometimes referred to as the “surtax on net investment income,” which more aptly describes this 3.8% tax on net investment income. Capital gains (other than those derived from a trade or business) are considered investment income for purposes of this tax. For individuals, the surtax is 3.8% of the lesser of (1) the taxpayer’s net investment income, or (2) the excess of the taxpayer’s modified adjusted gross income (MAGI) over the threshold amount for his or her filing status. The threshold amounts are:
$125,000 for married taxpayers filing separately.
$200,000 for taxpayers filing as single or head of household.
$250,000 for married taxpayers filing jointly or as a surviving spouse.
Selling a property one has owned for a long period of time will frequently result in a large capital gain, and reporting all of the gain in one year will generally push the taxpayer’s income within the reach of these two taxes.
This is where an installment sale could fend off these additional taxes by spreading the income over multiple years.
Here is how it works. If you sell your property for a reasonable down payment and carry the note on the property yourself, you only pay income taxes on the portion of the down payment (and any other principal payments received in the year of sale) that represents taxable gain. You can then collect interest on the note balance at rates near what a bank charges. To qualify as an installment sale, at least one payment must be received after the year in which the sale occurs.
Example: You own a lot for which you originally paid $10,000. You paid it off some time ago, leaving you with no outstanding mortgage on the lot. You sell the property for $300,000 with 20% down and carry a $240,000 first trust deed at 3% interest using the installment sale method. No additional payment is received in the year of sale. The sales costs are $9,000.
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Computation of Gain
Sale Price $300,000 Cost < $10,000> Sales costs < $9,000> Net Profit $281,000 Profit % = $281,000/$300,000 = 93.67% |
Of your $60,000 down payment, $9,000 went to pay the selling costs, leaving you with $51,000 cash. The 20% down payment is 93.67% taxable, making $56,202 ($60,000 x .9367) taxable the first year. The amount of principal received and reported each subsequent year will be based upon the terms of the installment agreement. In addition, the interest payments on the note are taxable and also subject to the investment surtax.
Here are some additional considerations when contemplating an installment sale.
Existing mortgages – If the property you are considering selling is currently mortgaged, that mortgage would need to be paid off during the sale. Even if you do not have the financial resources available to pay off the existing loan, there might be ways to work out an installment sale by taking a secondary lending position or wrapping the existing loan into the new loan.
Tying up your funds – Tying up your funds into a mortgage may not fit your long-term financial plans, even though you might receive a higher return on your investment and potentially avoid a higher tax rate and the net investment income surtax. Shorter periods can be obtained by establishing a note due date that is shorter than the amortization period. For example, the note may be amortized over 30 years, which produces a lower payment for the buyer but becomes due and payable in five years. However, a large lump sum payment at the end of the 5 years could cause the higher tax rate and surtax to apply to the seller in that year – so close attention to the tax consequences needs to be considered in structuring the installment agreement.
Early payoff of the note – The buyer of your property may decide to pay off the installment note early, or sell the property, in which case your installment plan would be defeated and the balance of the taxable portion would be taxable in the year the note is paid off early or the property is sold, unless the new buyer assumes the note. Or, you can have a clause for an early prepayment penalty to deter the buyer from paying it off early.
Tax law changes – Income from an installment sale is taxable under the laws in effect when the installment payments are received. If the tax laws are changed, the tax on the installment income could increase or decrease. Based on recent history, it would probably increase.
Flipping Real Estate and its Tax Consequence
Prior to the recent economic downturn, flipping real estate was popular. With mortgage interest rates low and home prices at historical lows, flipping appears to be on the rise again. House flipping is, essentially, purchasing a house or property, improving it, and then selling it (presumably for a profit) in a short period of time. The key is to find a suitable fixer-upper that is priced under market for its location, fix it up, and resell it for more than it cost to buy, hold, fix up and resell it.
If you are contemplating trying your hand at flipping, keep in mind that you will have a silent partner, Uncle Sam, who will be waiting to take his share of any profits in taxes. (And most likely, Sam’s cousin state of California Franchise Tax Board will also expect a share, too.) Taxes play a significant role in the overall transaction, and tax treatment can be quite different depending upon whether you are a dealer, an investor or a homeowner. The following is the tax treatment for each.
Dealer in Real Estate – Gains received by a non-corporate taxpayer from business operations as a real estate dealer are taxed as ordinary income (15% to 39.6% in 2011), and in addition, individual sole proprietors are subject to self-employment tax as high as 15.3% of their net profit (the equivalent of the FICA taxes for a self-employed person). Thus, a dealer will generally pay significantly more tax on the profit than an investor. On the other hand, if the flip results in a loss, the dealer would be able to deduct the entire loss in the year of sale, which would generally reduce his tax at the same rates.
Investor – Gains as an investor are subject to capital gains rates (maximum 15% for 2010 and 20% for 2011) if the property is held for more than a year (long-term). If held short-term, ordinary income rates (15% to 39.6% in 2011) will apply. However, an investor is not subject to the 15.3% self-employment tax. A downside for the investor who has a loss from the transaction is that, after combining all long- and short-term capital gains and losses for the year, his deductible loss is limited to $3,000, with carryover to the next year of any excess capital loss. The rules get a bit more complicated if the investor rents out the property while trying to sell it, and are beyond the scope of this article.
Homeowner – If the individual occupies the property as his primary residence while it is being fixed up, he would be treated as an investor with three major differences: (1) if he or she owns and occupies the property for two years and has not used a homeowner gain exclusion in the two years prior to closing the sale, he or she can exclude gain of up to $250,000 ($500,000 for a married couple), (2) if the transaction results in a loss, he or she will not be able to deduct the loss or even use it to offset gains from other sales, and (3) some fix-up costs may be deemed to be repairs rather than improvements, and repairs on one’s primary residence are not deductible nor includible as part of the cost basis of the home.
Being a homeowner is easily identifiable, but distinguishing between a dealer and an investor is not clearly defined by the tax code. A real estate dealer is a person who buys and sells real property with a view to the trading profits to be derived and whose operations are so extensive as to constitute a separate business. A person acquiring property strictly for investment, though disposing of investment assets at intermittent intervals, is generally not regularly engaged in dealing in real estate.
This issue has been debated in the tax courts frequently, and both the IRS and the courts have taken the following into consideration:
1. Whether the individual is already a dealer in real estate, such as a real estate sales person or broker;
2. The number and frequency of sales (flips);
3. Whether the individual is more committed to another profession as opposed to fixing and selling real estate; and
4. How much personal time is spent making improvements to the “flips” as opposed to another profession or employment.
The distinction between a dealer and an investor is truly based on the facts and circumstances of each case. Clearly, an individual who is not already in the real estate profession and flips one house is not a dealer. But one who flips many houses and/or properties and has substantial profits can be considered a dealer. Everything in between becomes various shades of grey and the facts and circumstances of each case must be considered.
How You Can Qualify as a Real Estate Professional
I am often asked by my clients that are not “real estate professionals” how they can write off their real estate losses against their regular business incomes?
Under current federal tax laws, generally a real estate activity is considered a “passive activity”. Passive activity losses can only be deducted against passive activity income.
For example, D, a doctor has a full time medical practice that generates income. D’s income from his or her medical practice is considered non-passive. But, D owns a rental property that generates a loss which is considered, passive. Therefore, D cannot offset the loss from the rental property against the income from his or her medical practice. D will not lose the rental loss either. The rental loss will carry forward indefinitely until D has passive income to offset against it or when the property is sold.
Furthermore, there are three levels of participation/involvement you can have in regards to a real estate activity:
1. Passive Participation,
2. Active Participation or
3. Real Estate Professional.
1. Passive Participation
A real estate activity is considered passive when you have no involvement with its management or operations. For example, D, a doctor, decides to invest in a real estate partnership. D has no involvement in the partnership or the management of the property. D just made an investment as though he or she would have in IBM. In this example, D’s investment in the partnership investment is considered a passive activity. Thus, if the partnership generates a loss, D cannot offset that loss against his or her medical income. Again, the loss is not lost. It gets carried over to future years or until D either sells his or her interest in the partnership or the partnership sells the property. Which at that time, the loss that D accumulated over the years becomes available and D can offset it against his or her other types of income.
2. Active Participation
A real estate activity is considered active when you do make management decisions for it. Let’s take our example above. If D decided to purchase a 20 unit apartment buildings and D actively was involved with the management decisions of the property, then D would be considered as being actively involved in that property. Active involvement does not mean you cannot have a management company that manages the property. All it means is that at the end of the day, all major decisions of the property, such as accepting a tenant, authorizing repairs, remodeling and etc. are ultimately made by you.
When you are actively involved in a real estate activity, then you are allowed to write off a maximum of $25,000 of the loss from all of your real estate activities against your non-passive incomes. However, your modified adjusted gross income needs to be less than $100,000 to receive the $25,000 maximum loss deduction. If your modified adjusted gross income is more than $100,000 but less than $150,000, then a portion of $25,000 is deducted. If your modified adjusted gross income is over $150,000, none of the $25,000 loss is deductible. Again, you don’t lose the loss; it gets carried over to future years.
In our example above if D’s modified gross income was $99,000 and the property generated a $30,000 loss, he or she would be able to offset $25,000 of the rental losses against his or her medical practice income. But, if D’s modified gross income was $125,000, then $12,500 of the rental loss would be tax deductible. And if D’s modified gross income was over $150,000, none of the $30,000 rental losses would be deductible.
3. Real Estate Professional
If you qualify as a “real estate professional,” then your rental real estate interests are not automatically treated as passive activities. As a result, if you materially participate in the rental real estate activity, the activity will not be treated as passive, and you will be entitled to deduct losses from that activity against non-passive income.
How do you qualify as a real estate professional? In order to qualify as a real estate professional, you must satisfy all three requirements below:
1. Either you or your spouse, must materially participate in a real estate business. Material participation in an activity means involvement in the operations of the activity on a regular, continuous, and substantial basis.
2. More than 50% of the personal services you perform in all businesses during the year must be performed in real estate businesses in which you materially participate.
3. Your personal services in material participation real property businesses during the year must amount to more than 750 hours. For this purpose, you can't count any work you perform in your capacity as an investor.
What is considered a real estate business? Any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, brokerage or agency (real estate agents) is considered a real estate business.
For married couples filing a joint return, the spouses’ activities can be combined to determine whether they materially participate in their real estate business activities. But, one spouse must separately satisfy the more than 50% or personal services and the more than 750 hours requirements.
In determining whether you qualify as a real estate professional, each of your rental real estate interests is treated as a separate activity—that is, as a separate business—unless you make an election to treat all those interests as a single activity. Because of this rule, if you have multiple rental properties and you don't make the election, you must establish material participation for each property separately, and must satisfy the more-than-50% test and the 750-hours test for each property separately in order to qualify as a real estate professional with respect to that property—and qualifying for one property wouldn't mean you qualify for any other property. Thus, if you don't make the election, qualifying as a real estate professional for all your properties becomes more difficult (and may become impossible) as the number of properties increases. But if you do make the election, you only have to establish material participation, and satisfy the more-than-50% test and the 750-hours test, for the combined properties as a whole.
And, generally speaking, the election is irrevocable. This means that you can't make the election in order to qualify as a real estate professional, and then revoke it with respect to a particular property later, when, for example, that property produces income, and you'd like to use that income to absorb losses from another non-real-estate-related passive activity. Making the election will also disqualify you from utilizing the $25,000 active participation rule mentioned above, because that rule applies only with respect to losses from rental real estate activities that are passive, and the election will—presumably—work to make your rental real estate properties non-passive. The election must be made in a timely and proper fashion.
You don't have to work full-time in real estate to qualify as a real estate professional. Even if you have another occupation, you can qualify if you materially participate in a real estate business, and spend more than 50% of your time, and more than 750 hours, on that business. (But remember, in this case, if you have multiple properties, it may be difficult or impossible to qualify unless you make the “single interest” election mentioned above.)
These tests are applied annually. This means that you may qualify as a real estate professional in some years but not in other years. As a result, the same real estate activity may generate passive losses in some years and non-passive losses in other years.
Let us look at an example. Assume taxpayer D, a doctor, is married and they own several rental properties. D’s medical practice is very lucrative and every year it generates a net income. D does not qualify as a real estate professional because he or she cannot satisfy its three requirements. Furthermore, their modified adjusted gross income is over $150,000 thus they are not allowed to write-off the first $25,000 of their rental loss either under the active participation rule. Therefore, they are not able to offset any of the rental losses against their medical practice income. However, if D’s spouse can satisfy the real estate professional requirements, then they will be able to offset their rental losses against the income from the medical practice!
The extent of an individual's material participation in an activity may be established by any reasonable means and the IRS has established seven tests for it and as long as one is met, then material participation exists. But the most reliable means of showing material participation consists of contemporaneously kept appointment books, calendars, daily time reports, logs, or similar documents that provide a detailed account of what the taxpayer or spouse did with respect to an activity, when he or she did it, and how much time it took. Failure to substantiate material participation is one of the most common ways of losing the right to treat rental real estate activities as non-passive. Therefore, it is crucial that detailed and contemporaneous documents are kept at all times!
How to Qualify for Social Security Benefits as a Landlord
One major benefit of being a landlord is the fact that the net income you earn from your rental activities is not subject to social security tax because it is not considered self-employment income.
Social security tax has two parts: Retirement and Medicare. The retirement rate is 6.20% and the Medicare rate is 1.45%, for a total of 7.65%. Currently the social security tax rate for self-employed individuals is 15.30% (7.65% x 2). A self-employed individual is considered the employer and employee at the same time, therefore, the social security tax rate is double. However, social security tax rate of 15.30% is taxed on the first $106,800 of net self-employment earnings. Net self-employment earnings more than $106,800 is taxed at 2.90%, the Medicare portion only with no cap.
To qualify for social security benefits, you must earn 40 credits over your working life. The maximum number of credits that you can earn per year is 4. For 2010, the minimum amount of self-employment income that you must earn is $4,480 to earn 4 credits. The $4,480 is adjusted annually by the social security administrator. Therefore, you must work and report a minimum self-employment income of $4,480 per year or more for 10 years before you can qualify for social security benefits. For more information on social security, please visit social security’s website at http://www.ssa.gov.
Thus, as a landlord you never pay social security taxes on your net rental activity income, therefore, you will never qualify for social security benefits!
But, there is a way for you to qualify for social security benefits as a landlord. You start a management company for your properties. In this article, I will not go into detail about the advantages and disadvantages of an entity such as a S Corporation, C Corporation, Limited Liability Company (LLC) or a trust over another, that will be discussed in future articles.
Let’s look at an example. Assume landlord L owns numerous rental properties through a limited liability company and he or she nets approximately $100,000 per year from them. Also assume that taxpayer T owns a plumbing business and he or she nets a $100,000 from it. Assuming all other factors are equal, T will pay $15,300 ($100,000 x 15.30%) in social security taxes and L will pay zero since L is a landlord and his or her net rental income is not subject to social security tax. A bad tax outcome for T and a good tax outcome for L. Although, some might argue that being a landlord and all of its headaches is not such a good deal after all!
But, assume L creates L Management Company, Inc., that manages his properties for him. L Management Company, Inc. is owned and operated by L and is considered as a separate business for tax purposes. L Management Company, Inc. reports its income and expenses on a separate corporate tax return. Therefore, just like any other property management company, L Management Company, Inc. will receive a fee for its management services to the rental properties.
Thus, let’s assume L Management Company, Inc. grosses $15,000 for the year for management services and its only business expenses is a $15,000 salary it pays to L. Therefore, L now has a $15,000 salary that is subject to social security taxes and he or she qualifies for the maximum 4 credits per year for social security purpose. Furthermore, L’s net rental income after paying the management fee is now $85,000 ($100,000 - $15,000) not $100,000.
L is still paying personal federal and state taxes on a total income of $100,000; $15,000 of it as a salary that qualifies him or her for social security credits and ultimately benefits, and $85,000 as net rental income.
What are the advantages and disadvantages of having a management company?
The advantages are:
The disadvantages are:
The above is a simple example of what you can do to qualify for social security benefits. However, the real question is whether it’s worth it and will you benefit from it?
Owning Real Estate Through An LLC
There are many advantages and some disadvantages to owning real estate through an limited liability company (LLC) or a limited partnership (LP).
The LLC in Asset Protection - Limited liability companies and limited partnerships are frequently used in asset protection. Consider the following.
Any asset that you own (the asset is titled in your name or owned by you directly) can be seized by a creditor. For example, if you have an apartment building or a bank account, a creditor can seize those assets. Any asset that you do not own cannot be taken from you by a creditor. While that sounds like a simplistic statement, it lies at the heart and soul of asset protection planning. Any asset that is owned by a legal entity is not owned by you, even if you own and control the legal entity. For example, if you own a share of General Motors, you have no ownership in GM's assembly plant in Detroit or what is left of it. This concept applies to any legal entity, regardless of the percentage of the entity you own.
How does that benefit you? Once you transfer the ownership of an asset to a limited liability company or a limited partnership, you no longer own that asset. The asset is now owned by the LLC or the LP. All you own is an interest in this legal entity. So, why is it better to own an interest in a legal entity than to own the underlying asset directly?
Under the laws of all states, interests in limited liability companies and limited partnerships are protected by the so-called charging order protection. Pursuant to the charging order protection, a creditor cannot seize your interest in one of these entities. And if they cannot take your interest in the entity, they cannot get to the underlying assets.
Note, corporations do not offer you any charging order protection. If you own a corporation, which in turn owns valuable assets, a creditor will be able to seize your corporate stock, and then get to the valuable assets. Corporations will only protect you from lawsuits directed against the corporation itself. If the lawsuit is directed against the shareholder, there is no protection. If you are seeking to protect assets from claims of creditors, forget about corporations. Look into forming a limited liability company or a limited partnership.
Assets that our clients commonly protect by using limited liability companies and limited partnerships include investment and income producing real estate, intellectual property, valuable businesses, corporations, art and collectibles, airplanes, and other valuables.
By appointing you as the manager of the LLC we allow you full control over your assets, without compromising asset protection.
Limited liability companies and limited partnerships are easy to set up, have nominal annual costs, and provide you with a tremendous level of asset protection.
Example - Dr. Brown owns Apartment Building 1 and Apartment Building 2. Building 1 is owned through a corporation and Building 2 is owned through an LLC. Assume that a tenant in each building slips and falls and files a lawsuit. Each tenant would have to sue the owner of the respective building, which means the corporation and the LLC. Each legal entity will protect Dr. Brown and prevent the lawsuits from reaching his personal assets. Great result.
Now assume that Dr. Brown runs over a pedestrian and is being sued personally. The plaintiff obtains a judgment against Dr. Brown and looks for Dr. Brown's assets to pursue. What happens to the apartment buildings?
While the creditor would not be able to seize Building 1 directly, the creditor would be able to seize Dr. Brown's corporate stock, then liquidate the corporation and get to Apartment Building 1. Not a good result.
With respect to Apartment Building 2, the creditor will not be able to get Dr. Brown's interest in the LLC, and will not be able to get Apartment Building 2. Great result.
The Members Of An LLC - LLC's and LP’s flexibility allows unlimited number of members. And each member could have a different equity, profit or loss ownership percentage.
Example – Assume you purchase a rental property with three other investors. All of the members contribute the same amount of money to the LLC. Therefore, all of the members are 25% equity owners in the LLC. But, you manage the property and for your services to the LLC you are given 15% more of the profits of the LLC. Therefore, you are 40% profit owner while the three other members are each 20% profit owners. Furthermore, assume that one of the members really needs the loss to offset against another investment property that he/she owns which generates income. All of the members have agreed to have that member be 55% loss owner and the rest of the members each 15% loss owners. It is that flexible.
The LLC in Estate Tax Planning and Eliminating Probate - The LLC is an ideal way to transfer wealth amongst family members. The older generation (i.e. parents or grand parents) can retain control of the assets or business by eliminating third-party interests and restricting membership while eliminating estate and gift tax consequences. The LLC is a much more practical device for this purpose with no mandatory distributions to the younger generation (children).
Foreign Members – You can have either a foreign person or entity invest and be a member of your LLC. There is no citizenship requirement. And, the United States is the "offshore" for foreign entrepreneurs. Foreign investors consider the United States as their "offshore" tax-free, tax-haven jurisdiction due to favorite treatment of their investments and tax-free status afforded to them. For example, there are no capital gains taxes on securities purchased in the United States and sold by foreign investors.
The Tax Consequence to The LLC - The LLC or LP is a pass-through entity. It does not pay a federal tax. Its net income is reported to each member, and the members report that net income on their personal income tax returns and pay taxes personally. However, there are twp California state taxes: Franchise tax and a gross receipts tax . The franchise tax applies to both LLCs and LPs. The gross receipts tax only applies to LLCs. The franchise tax is $800 and it is paid annually. The gross receipt tax is based on the LLC's gross receipts and it is in addition to the $800 franchise tax. The gross receipts tax schedule is:
Gross Receipts Gross Receipts Tax
$0 to $249,999 $0
$250,000 to $499,999 $900
$500,000 to $999,999 $2,500
$1,000,000 to $4,999,999 $6,000
$5,000,000 to or more $11,790
The Tax Consequence to The Members Of The LLC – Each member of the LLC will report his or her share of the LLC’s net income on their personal income tax returns and pay personal federal and state income taxes on it. The member’s income however is not subject to social security tax. Therefore, by being a member of an LLC you avoid paying social security tax on your share of the LLC’s net income. However, generally each LLC will have at least one managing member who is in charge of the day to day operations of the LLC. That persona is referred to as the managing member. All other members are referred to as just members. The managing member’s share of the LLC’s net income may be subject to social security tax. But, there are conflicting tax rulings that may suggest otherwise. One way around the social security issue is to have an S Corporation to be the managing member of the LLC.
Tax Basis of the Member - In order to be able to write of a loss from an entity such as an LLC, the taxpayer must have “basis” in that entity. Basis is a tax term used to define how much of your own money you have actually invested in that entity. The tax code also allows you to receive basis for your share of the LLC debts. To calculate your basis in an LLC, your can use the following formula:
+ Investments Made to the LLC,
+ Your Share of the LLC’s Net Incomes,
+ Your Share of the LLC’s Debts
- Your Share of the LLC Net Losses,
- Withdrawals Received from the LLC
= Basis in LLC
Note that the tax code actually gives you basis for debt that the LLC incurs. No money came from you for it. It is a great tax loophole to be able to write off a loss without using your own money.
Example – Assume you contribute $10,000 to an LLC for 25% equity, profit and loss ownership. The LLC for its first year of operation had a $50,000 loss. Also, assume that the LLC had borrowed $60,000. Your share of the LLC is $12,500 ($50,000 x 25%). Your share of the LLC’s debt is $15,000 ($60,000 x 25%). Therefore, even though you only had invested $10,000 of your own money in the LLC, you may be able to write-off $12,500 of the loss that is allocated to you because you received additional basis for the amount of $15,000 from the LLC’s debt. For comparison purposes, is like you invest $10,000 in a stock, but the company loses $12,500 and you are able to write-off the $12,500. You just received an additional $2,500 deduction courtesy of the IRS. And to make it even more favorable to you, you are not liable for the debt of the LLC. If the LLC never pays back the $60,000 the creditor cannot come after you. However, IRS may be able to make you pay the tax on the $2,500 deduction you received in previous years if the LLC’s debt is canceled. It is called cancellation of debt income. But, in most cases there are tax loopholes for not paying tax on cancellation of debt income.
Cost Segregation
Cost segregation is the process of identifying personal property assets that are grouped with real property assets, and separating out personal assets for tax reporting purposes. A cost segregation study identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which reduces current income tax obligations.
Personal property assets include a building’s non-structural elements, exterior land improvements and indirect construction costs.
Analysis of capital expenditures is used to determine appropriate asset classifications. Cost segregation identifies building costs that would typically be depreciated over a 27.5 or 39-year period and reclassifies them to permit a shorter, accelerated method of depreciation for certain building costs. Costs for non-structural elements, such as wall covering, carpet, accent lighting, portions of the electrical system, and exterior site improvements such as sidewalks and landscaping, can often be depreciated over five, seven or 15 years, rather than over 27.5 or 39 years.
Tax Benefits of Cost Segregation - In addition to providing lower taxes, cost segregation can benefit businesses in a number of ways: Maximizing tax savings by adjusting the timing of deductions. When an asset’s life is shortened, depreciation expense is accelerated and tax payments are decreased during the early stages of a property’s life. This, in turn, releases cash for investment opportunities or current operating needs.
Creating an Audit Trail - Improper documentation of cost and asset classifications can lead to an unfavorable audit adjustment. A properly documented cost segregation helps resolve IRS inquiries at the earliest stages.
Playing Catch-Up -. Since 1996, taxpayers can capture immediate retroactive savings on property added since 1987. Previous rules, which provided a four-year catch-up period for retroactive savings, have been amended to allow taxpayers to take the entire amount of the adjustment in the year the cost segregation is completed. This opportunity to recapture unrecognized depreciation in one year presents an opportunity to perform retroactive cost segregation analysis on older properties to increase cash flow in the current year.
Additional Tax Benefits - Cost segregation can also reveal opportunities to reduce real estate tax liabilities and identify certain sales and use tax savings opportunities. Under certain circumstances, segregated assets may qualify for a special 30% bonus depreciation allowed by the Job Creation and Worker Assistance Act of 2002 or a 50% bonus depreciation allowed under the Jobs and Growth Tax Relief Reconciliation Act of 2003.
Active Real Estate Participant
If you own at least 10% of a rental and have substantial involvement in managing the rental, then you are considered an active participant and you can write-off up to $25,000 of the loss generated from that rental activity against your other incomes such as wages or interest income. However, your modified adjusted gross income cannot be more than $150,000. The $25,000 loss is reduced if your modified adjusted gross income is more than $100,000 and completely disallowed if its more than $150,000.
Substantial involvement in managing means that you make management decisions such as who to rent it to or which repair service company to call. Easy to qualify for.
Example - Assume you work for X Company as an employee. Your salary is $90,000 a year. You also own a rental property that generates a tax loss of $20,000 per year. You would be able to write-off the $20,000 rental loss against your wages of $90,000 and pay taxes on the net amount of $70,000.
Furthermore, it is possible to have a real estate investment that show a tax loss but has positive cash flow. In certain situations and if planned correctly, the depreciation expense may cause the property to show a tax loss while it actually has positive cash flow. Depreciation expense is a tax expense not an actual out of pocket expenditure.
Passive Activity Rules
When you own real estate, it is considered a passive activity unless you qualify under the Active Real Estate Participant rule discussed above or as a Real Estate Professional discussed below.
Passive activity losses can only be offset against passive activities that have income.
Now let's look at an example. Assume you are an investor in rental partnership that reports a tax loss and you are an investor in an internet company that reports income and in both investments are passive activities to you. You would be able to offset the loss from the rental activity against the income from the internet activity. You would pay taxes on the net amount if positive. If the net amount was negative, the loss was more than the income, then the excess loss would be carried over to the following year and would be used to offset future incomes from the passive activities. Basically, you do not lose the loss. It gets carried over to future years until it is all used up or when the asset is sold.
Real Estate Professional
If you qualify as a real estate professional, then the Passive Activity rule above will not apply to you and you will be able to write-off your real estate losses, no matter the amount, against all of your other sources of income such as wages, interest, capital gains and etc.
To qualify as a real estate professional, you have to meet the following two requirements:
Material Participation - To meet the material participation tests in items 1 and 2 above, you can elect to combine all interest in rental real estate and treat them as one. Otherwise, you would have to prove tests 1 and 2 above for each property separately.
Real Property Trade or Businesses - Any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage is considered a real property trade or business.
Tax Tips - As long as one spouse meets the above tests, then the he or she is considered a real estate professional and can use the loss to offset against the other spouse's non-real estate incomes such as wages, interest, business or capital gains.
Tax Tips - To prove that you are a real estate professional, you should keep a detail log through out the year to document your hours and involvement in your real estate activities. Without proper documentation, it will be difficult for you to prove your status as a real estate professional if every questioned or audited by the Internal Revenue Service.
Example - Assume the one spouse is a doctor and the other one a real estate professional. If the spouse that is a real estate professional has a loss for the year, she or he can offset that loss against the other spouse's medical income. Works great!
Qualified Principal Residence Trust
No asset is more important to shield from creditor claims than the house you live in. For most of us, the house represents the bulk of our fortune. It may also have great sentimental value.
The personal residence trust is the most commonly used structure to protect a home. This is a structure that is inexpensive to set up, simple, and exceptionally effective. They have never failed to achieve their desired objective. Let us take a look at how these trusts work.
A personal residence trust is an irrevocable trust. The word "irrevocable" scares many people. None of us want to do anything that is irrevocable, especially when we are talking about our most significant asset.
Fortunately, irrevocable simply means that no one (like a plaintiff or a creditor) would be able to force you to revoke the trust. You will always be able to do so, and quite easily, without going to court. For example, under California law there is an easy procedure to revoke an irrevocable trust that just requires the trustee of the trust and the beneficiary to sign a simple document.
Because the trust is irrevocable, the assets owned by the trust are not owned by you. At least not in the legal, technical sense. The trust now owns your home. Because you no longer hold legal title to the house you live in, it is not an asset that your creditor can reach. Your legal relationship with the house you live in becomes the same as your legal relationship to the Transamerica building in San Francisco. It is not your asset, and when you get sued, your creditor cannot attach either one.
The residence trust allows you to continue living in the house, rent free, usually for the rest of your life (technically, this period of time is measured in a specified number of years tied to your life expectancy). Your children or other family members would then become the beneficiaries of the trust. This structure is very similar to your living trust.
There are no income tax consequences on the transfer of the house into the residence trust. There are no property tax consequences and no property tax reassessment. Your bank cannot accelerate the mortgage (there is a federal statute that prevents the bank from doing anything with your mortgage when the ownership of the house is transferred to a trust).
Because the trustee of the trust will be a person you appoint (usually a friend or family member, but never you), you will retain the ability to sell the house or to refinance the house. Additional flexibility can be built into the trust to accommodate your specific needs.
The trust is not subject to any annual fees or filing requirements. Once it is done it is done.
To summarize, the residence trust is an inexpensive, easy to establish structure that allows you to continue living in your house, allows you to retain control over your house, but at the same time makes it unreachable to creditors (which has been tested in practice time and time again). It is no wonder that these trusts are our favorite asset protection technique for a personal residence.
Living Trust - What Is It And How It Could Help You
A trust is an arrangement under which one person, called a trustee, holds legal title to property for another person, called a beneficiary. You can be the trustee of your own living trust, keeping full control over all property held in trust.
A "living trust" (also called an "inter vivos" trust) is simply a trust you create while you're alive, rather than one that is created at your death. Different kinds of living trusts can help you avoid probate, reduce estate taxes, or set up long-term property management.
Most people want to leave as much of their money to their children, or other heirs, as possible -- and want to avoid a big chunk of that money going to probate lawyers. That's where living trusts come in -- they can eliminate the need for probate and probate fees.
Probate involves inventorying and appraising the property, paying debts and taxes,
The two most common types of living trusts are:
Unless you expect to owe federal estate tax at your death or your spouse's, a basic living trust to avoid probate is probably all the trust you need.
Converting a Rental to a Home
A $250,000 ($500,000 for joint filers) exclusion is available to offset the gain from the sale of a taxpayer's principal residence. This exclusion can be used repeatedly, provided the eligibility requirements are met, but generally not more than once every two years.
This often tempts owners of rental properties to sell their current home - their principal residence - to utilize the exclusion, and then occupy one of their rental properties until the requirements are met to be eligible for the exclusion again. If the taxpayer owned multiple rentals, the same process could be applied to each property, allowing the individual to benefit from the exclusion numerous times.
When the rental is not a place in which the taxpayer would want to live during the qualification period, the rental can be swapped through a tax-deferred exchange for a more suitable one, which the property owner must rent out for a reasonable period of time before occupying it to meet the exclusion qualifications. These types of transactions became so popular that Congress passed two laws to make it more difficult to achieve this tax-saving strategy.
Generally, to qualify for the gain exclusion, a taxpayer must own and use the home as a primary residence for two of the five years prior to the sale. However, if the home was acquired by means of a tax-deferred exchange, Congress increased the ownership requirement from two years to five years, thereby requiring the taxpayer to wait five years before being able to qualify for the home sale gain exclusion for the exchanged property.
Beginning in 2009, Congress added yet another roadblock to this strategy by making the gain attributable to nonqualified periods non excludable. "Nonqualified use" is when the home isn't used as the taxpayer's principal residence. Luckily, this restriction was not implemented right away. Instead, it was phased in by only counting periods of nonqualified use beginning in 2009, and grandfathered in periods before 2009 as qualified use. However, over time, this new law will diminish the benefits from this strategy.
Keep in mind that even when a home qualifies for the home gain exclusion, the gain attributable to the depreciation allowable after May 5, 1997 on the home, and prior rental in case of an exchange, is not excludable and will be taxable.
Home Office Deduction
Generally, a self-employed individual will qualify for a home office deduction if the office is a place where the taxpayer meets with customers, patients or clients, or is used on an exclusive and regular basis for administrative or management activities of his or her trade or business, and there is no other fixed location of the business where the taxpayer conducts substantial administrative or management activities of the business. Even if a taxpayer conducts administrative activities at a fixed location outside the home, he or she is still eligible to claim a deduction as long as the administrative activities conducted at the outside location aren't substantial. Space in the home used to store inventory for a wholesale or retail business also qualifies as business use of the home.
Deductible home office expenses fall under two basic categories: direct and indirect expenses. Expenses that are directly attributable to the home office, such as painting the office, repairs to the office space, etc., are 100% deductible to the business. The second category is indirect expenses that are attributable to the entire home, for which only a fraction of the total amount is allocated to the home. These include home mortgage interest, property taxes, insurance, certain utilities, property taxes, homeowners association dues, gardener, pool service and depreciation. If the home is rented, substitute rent paid for interest, taxes and depreciation. The fraction used to allocate business portions of the indirect expenses is determined by dividing the business use square footage by the total square footage of the home.
Example - Assume you are self-employed and you work out of your home. The total square footage or your home is 1,000 sq. ft. You have a room that is dedicated and used exclusively as an office and it is 200 sq. ft. Therefore, 20% (200/1,000) of all your home expenses including depreciation are tax deductible. And, it does not matter whether you own or rent.
The home office deduction is, however, limited to the gross income of the business derived from the use of the home for that business, and where the gross income is less than the expenses, certain expenses can be carried forward for the same trade or business in the subsequent years but cannot be used against a positive income from another business. Carryover never includes home interest, taxes and casualty losses because they are allowed without regard to the gross income limitation.
If the self-employed taxpayer owns the home, there is a negative aspect to the home office deduction that can create unexpected consequences when the home is sold. First, the allowable home office depreciation is never excludable under the $250,000 ($500,000 for joint filers) exclusion of gain for primary residences and will end up being recaptured as taxable income upon sale. But, the current maximum tax rate on the recapture is only 25%. Furthermore, if the office is located in a separate structure, then the home sale is treated as two sales, the sale of the home portion and a sale of the office portion. Any gain from the office portion would not qualify for the home gain exclusion and would be taxable.
Example - A married couple sells a home that includes a home office in a separate structure that is 20% of the total home square footage. The home, originally costing $150,000, is sold for $500,000. If the home office had never been claimed, or if the office had not been in a separate structure, the entire home gain, except recaptured depreciation, could be excluded from income. However, in this case, $70,000 (20% of the gain) becomes taxable income. (For this example, to keep it simple, we haven't taken into account improvements, selling costs, or depreciation.)
How to Qualify for Social Security Benefits as a Landlord
One major benefit of being a landlord is the fact that the net income you earn from your rental activities is not subject to social security tax because it is not considered as self-employment income.
Social security tax has two parts: Retirement and Medicare. The retirement rate is 6.20% and the Medicare rate is 1.45%, for a total of 7.65%. Currently the social security tax rate for self-employed individuals is 15.30% (7.65% x 2). A self-employed individual is considered the employer and employee at the same time, therefore, the social security tax rate is double. However, social security tax rate of 15.30% is taxed on the first $106,800 of net self-employment earnings. Net self-employment earnings more
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