Is Now The Time To Consider a Real Estate Rental Property?

It is not uncommon for business owners to become so involved with their day-to-day operations that they overlook some important issues associated with being in business. Here are some tips to help you avoid making costly mistakes and to ensure that your business runs smoothly.

• Minimize personal liability. Individuals should try to avoid putting their personal assets at risk when they enter into a business venture whether solely or with others. Many overlook or dismiss the fact that personal liability can be minimized with the proper business structure. There are several types of entity forms that afford different degrees of protection, but there is no perfect entity that will provide an all-purpose, one-size-fits-all protection. Included among the various entity options for business owners are sole proprietorships, partnerships, corporations, s-corporations, and limited liability companies. In addition to liability protection, when choosing an entity, take into account the character of the business, the business partners you have, your options for exiting the business, and your estate plan.

• Consider a buy-sell agreement. When partners first go into business together, they do so with high expectations and mutual respect. A joint business venture is like a marriage, and often, it ends in a divorce. A binding buy-sell agreement is probably one of the most important documents that a business with multiple owners can have. Typically, a buy-sell agreement is entered into by the owners of a business, and possibly the business entity itself, to purchase or sell interests of the business at a preset price or formula in the event of a future occurrence that will impact the operation and continuance of the business. Such events are numerous and can include death, disability, divorce, disagreement, or retirement. Imagine your business partner passing away and his or her heirs or surviving spouse stepping in as a partner.

• Hold shareholder and board meetings. “Piercing the corporate veil” is terminology we hear associated with court cases when someone is attempting to go around the liability protection provided through an entity such as a corporation. Courts can “pierce the corporate [or business] veil” and hold the business owner personally liable for failure to conduct the business properly. Failure to hold the required meetings and maintain a minutes book is one indicator that a business is not being run as a corporation but rather by an individual or group of individuals. Bottom line…Hold the required meetings and maintain the minutes book.

• Plan for family business succession. Determine whether there is a desire by a family member or members to participate in the business. If family succession is anticipated, then the business should be organized in a type of entity that lends itself to transfers of entity interests to family members with little or no loss of management or control, such as family-limited partnerships, limited liability companies, and subchapter s-corporations. The main goal is to allow the donor to retain control and derive income from the entity while removing considerable estate value through gifts of interests or making gifts using the applicable exemption amount ($1 million) or the annual gift tax exclusion amount. An understanding of estate and gift tax ramifications of gifts of entity interests, such as valuation issues and available discounts, is also crucial.

• Understand the tax ramifications of your actions. Just about everything that we do that is related to business, investments, and retirement has tax ramifications. Many individuals fail to consider these ramifications, and they find themselves caught in tax traps or miss out on available tax deductions and credits, at significant cost. What we do know is that Congress has not, and probably will not, let a year go by without making changes to the tax code. Before making any major decisions such as purchasing a new business, making substantial purchases for an existing business, buying equipment for an existing one, setting up a retirement plan, selling a business or investment asset, or making investments, investigate the tax ramifications beforehand so that you can structure the course of action in a way that provides the most tax benefits.

If you need assistance with any of the above, please give our office a call so that we might help you directly or refer you to someone who can assist with your particular situation.

How does a taxpayer who uses his or her vehicle partly for business determine what portion of the vehicle’s operating expenses can be deducted for business use?  According to tax regulations, business use is determined by the number of miles traveled between two business locations.  The business expense allocation ratio is determined by dividing the business miles for the year by the total vehicle miles for the year.  Keep in mind that commuting expenses to and from your normal place of business are not deductible.  For example, let’s say you put 10,000 miles on the vehicle during the year.  If you drove 6,000 of those miles for business, then 60% of the auto expenses would be treated as deductible business expenses if you are using the actual expense method. 

When you use a vehicle for business purposes, the business portion of the operating expenses can be deducted on your self-employed business or, if you are an employee, as a miscellaneous itemized deduction. The tax code provides two possible options: using the standard mileage rate or using actual expenses. For vehicles purchased and placed into service during 2009, the recent Economic Stimulus legislation and inflation adjustments substantially increase the first-year write-offs for business use. The following is a summary of these changes for vehicles purchased in 2009.

Standard Mileage Rate Method: The standard mileage rate takes the place of fuel, oil, insurance, repair, maintenance, and depreciation (or lease) expenses. The rate varies from year to year; for 2009, the standard mileage rate is 55.0 cents per mile. In addition, the cost of business-related parking and tolls is deductible. Caution: If the standard mileage rate is not used in the first year in which the vehicle is placed into service, it cannot be used in future years. If, in a subsequent year, there is a switch to the actual method, the straight-line method for depreciation must be used. If the car is leased, the standard mileage rate must be used in future years.

Actual Expenses Method: To use the actual expense method, determine the entire actual cost of operating the car for the year first and then the business portion attributable to the business miles driven. Vehicle depreciation is included as part of the operating costs of a vehicle. Until this year, the depreciation was limited to about $3,000 for the first year. However, for 2009, the 50% bonus depreciation is back, which boosts the first-year allowable depreciation limit by $8,000, increasing the limit for passenger vehicles to $10,960 ($11,060 for small trucks and vans).

SUV Special Limits: Vehicles with a gross unladen weight of more than 6,000 pounds are not subject to the limitations that apply to passenger vehicles, small trucks, and vans. Instead, their business portion can be depreciated like any other type of business property, except that they are limited to $25,000 of the Section 179 expense deduction. However, by combining the Section 179 deduction with the new 50% bonus depreciation that applies to 2009, the purchase of an SUV for business can produce a substantial first-year write-off. The following is a representative example (assuming 100% business use) of the write-off for a newly purchased vehicle placed into service in 2009.

Caution: There has been some discussion in Congress about limiting the write-offs for heavy SUVs. However, Congress is sensitive to the negative effect that such a decision would have on U.S. car makers. So, we must wait and see! For those of you planning to purchase an SUV based upon this big write-off, be sure to call first to see the current status of the deduction and pending legislation.

A married couple that owns a joint business venture in which they both participate can elect to file two self-employed business schedules (Schedule C or Schedule F) on their personal income tax return, dividing the income and expenses instead of filing a partnership return. However, the IRS has made it clear that this special provision does not apply to state law entities, such as general or limited partnerships or limited liability companies. If you are interested in pursuing this option for 2008 and currently have employees, are also required to file other types of tax returns, or simply have questions about this option, please give this office a call.

Many individuals spend time away from their offices while calling on customers and vendors. As a result, they end up having to buy their lunch and want to deduct the cost of that lunch as a business expense. Unfortunately, the cost of meals can only be deducted when you are away from home overnight. However, you may be able to deduct the cost of your lunch as business-related entertainment if you take one of your customers to lunch with you. In any case, even when the meals are allowed, they are only 50% deductible.

Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. However, the tax code provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. These type of exchanges are commonly referred to as Sec. 1031 exchanges (referring to the tax code section that allows them), but it is important to understand that the tax on the gain is deferred and is not tax-free.

An exchange can include like-kind property exclusively or it can include like-kind property, along with cash, liabilities and property, that are not like-kind. If you receive cash, relief from debt, or property that is not like-kind, however, you may trigger some taxable gain in the year of the exchange. There can be both deferred and recognized gain in the same transaction when a taxpayer exchanges for like-kind property of lesser value.

Who qualifies for the Section 1031 Exchange?
Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section 1031.

What are the different structures of a Section 1031 Exchange?
To accomplish a Section 1031 exchange, there must be an exchange of properties. The simplest type of Section 1031 exchange is a simultaneous swap of one property for another.

Deferred exchanges are more complex but allow flexibility. They allow you to dispose of property and subsequently acquire one or more other like-kind replacement properties.

To qualify as a Section 1031 exchange, a deferred exchange must be distinguished from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction). Rather, in a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property. Taxpayers engaging in deferred exchanges generally use exchange facilitators under exchange agreements pursuant to rules provided in the Income Tax Regulations.

A reverse exchange is somewhat more complex than a deferred exchange. It involves the acquisition of replacement property through an exchange accommodation titleholder, with whom it is parked for no more than 180 days. During this parking period, the taxpayer disposes of its relinquished property to close the exchange.

What property qualifies for a Like-Kind Exchange?
Both the relinquished property you sell and the replacement property you buy must meet certain requirements.

Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.

Both properties must be similar enough to qualify as "like-kind." Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.

Real property and personal property can both qualify as exchange properties under Section 1031; but real property can never be like-kind to personal property. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real property. For example, cars are not like-kind to trucks.

Finally, certain types of property are specifically excluded from Section 1031 treatment. Section 1031 does not apply to exchanges of:

• Inventory or stock in trade
• Stocks, bonds or notes
• Other securities or debt
• Partnership interests
• Certificates of trust

What are the time limits to complete a Section 1031 Deferred Like-Kind Exchange?
While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet two time limits or the entire gain will be taxable. These limits cannot be extended for any circumstance or hardship except in the case of presidentially declared disasters.

The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you, and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.

Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.

The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above.

Are there restrictions for deferred and reverse exchanges?
It is important to know that taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make ALL gain immediately taxable.

If cash or other proceeds that are not like-kind property are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange. Gain may be taxable, but only to the extent of the proceeds that are not like-kind property.

One way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary or other exchange facilitator to hold those proceeds until the exchange is complete.

You cannot act as your own facilitator. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) cannot act as your facilitator.

Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligations to the taxpayer. These situations have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. The gain may be taxable in the current year, while any losses the taxpayer suffered would be considered under separate code sections.

How do you compute the basis in the new property?
Since, in an exchange, gain is deferred but not forgiven, your deferred gain will be taxed at a later time when the replacement property is sold. Thus, your basis in the replacement is reduced by the gain deferred. A collateral effect is that the resulting depreciable basis is lower (by the amount of the deferred gain) than what would otherwise be available if the replacement property were acquired in a taxable transaction.

When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

The foregoing is an overview of the provisions dealing with tax-deferred (Sec. 1031) exchanges. Clients are cautioned to consult with this office prior to entering into an exchange transaction to insure the exchange meets the strict requirements of tax-deferred exchanges. Clients should also be wary of individuals promoting like-kind exchanges without verifying the validity. Sales pitches may encourage taxpayers to exchange non-qualifying vacation or second homes. Many promoters of like-kind exchanges refer to them as “tax-free” exchanges, not “tax-deferred” exchanges. Taxpayers may also be advised to claim an exchange despite the fact that they have taken possession of cash proceeds from the sale.

Many taxpayers fail to understand the tax ramifications of disposing of personal property such as equipment, furniture and autos used in business and end up with unpleasant surprises at tax time. The tax consequences depend upon how the property was used, how long it was owned and the method of disposition. There are numerous ways of disposing of an asset, such as selling, scrapping, converting to personal use, contributing to a charity, exchanging for another like business item, or even giving it away. We cannot cover all of the aspects of dispositions here but we can give you an overview.

The key to knowing the tax ramifications of dispositions is understanding the tax term “adjusted basis.” Any gain or loss from the disposition of a business asset is measured from adjusted basis. Adjusted basis is generally the cost of the item reduced by any business deductions taken for the item. For example, you purchase computer equipment for $1,000 and it is in a class of business property that must be depreciated over 5 years. You can elect to write-off any portion of the item the first year (within the Sec. 179 expense limitations) and depreciate the balance over five years. If you elected to depreciate the item instead of taking the Sec. 179 expense election, your depreciation deduction would be $200, and your adjusted basis after the first year would be $800 ($1,000 - $200). If you then sold the equipment for $900, you would have a $100 ($900 - $800) taxable gain. Why? Because you recovered $100 of your cost as the depreciation you had previously taken as a deduction. On the other hand, if you had sold it for $500, you would have a $300 deductible loss. So, as you can see, you must take into account how much of the cost of the asset you have already written off to determine any subsequent gain or loss.

Favorite and frequently encountered deductions for taxpayers are non-cash contributions to charity. Although there are some special rules, taxpayers can generally deduct the lesser of cost or fair market value (FMV) for personal items contributed to a charitable organization. For business assets, adjusted basis is substituted for cost. For example, if a taxpayer contributes to charity a desk which was used only for personal purposes, and never for business, that had cost $150 and has a FMV of $50, the taxpayer can take a $50 charitable deduction. However, if the desk had been a business asset, and its cost had been fully deducted (depreciated), the taxpayer’s charitable deduction would be zero since the adjusted basis would have been zero and was less than the FMV.

When a business asset is exchanged (traded-in) for a like-kind item, generally any gain or loss that would have resulted from the sale of the asset increases or decreases the adjusted basis of the replacement property. Thus, where a sale would result in a gain, the gain can be avoided by exchanging the item, such as trading in one business vehicle for another. On the other hand, if a sale would result in a loss, it is probably to the taxpayer’s advantage to actually sell the business asset so a loss can be taken.

Gains and losses from the sale of business assets are not included on the business schedule in the tax return where net profit or loss from operating the business is figured, and generally do not affect the taxpayer’s self-employment tax. Generally, losses from selling business assets are fully deductible in the year of sale. Gains to the extent they are attributable to depreciation are generally treated as ordinary income (but still not taxable for self-employment tax purposes), and any additional gain is treated as capital gain. If the asset was held for over a year, the long-term capital gains rates will apply.

Sometimes you may simply scrap an item because it has no further use in your business and has no resale value. When this happens, you treat the disposition as a sale for no money, which will produce a loss equal to the balance of the adjusted basis at that time. If you stop using an item for business purposes and convert it to personal use, your personal basis becomes the adjusted basis at the time of conversion with no additional deduction for the business. If you subsequently dispose of the item, any amount received in excess of the adjusted basis would be taxable but any loss would not be deductible.

If you simply give the item away to an individual, neither the business nor you as an individual taxpayer is allowed a deduction. The general rule is that the recipient’s basis will be the asset’s adjusted basis at the time of the gift. However, where a sale in the hands of the recipient would result in a loss, the loss would be based on the lower of the item’s adjusted basis or FMV at the time of the gift. If the value of the asset, plus other gifts you give the same individual during the year, exceeds $13,000 (2010), a gift tax return generally will be required.

As you can see, disposing of personal property business assets can be complicated and the results might not be as you expect or would like. Please give us a call for additional information.

The Internal Revenue Service has developed a new form for employees who have been misclassified as independent contractors by their employers. Form 8919, Uncollected Social Security and Medicare Tax on Wages, will now be used to figure and report the employee’s share of uncollected social security and Medicare taxes due on their compensation.

Generally, a worker who receives a Form 1099 for services provided as an independent contractor must report the income on Schedule C and pay self-employment tax on the net profit, using Schedule SE. However, sometimes the worker is incorrectly treated as an independent contractor by their employer when they are actually an employee. When this happens, beginning for tax year 2007, Form 8919 will be used by workers who performed services for an employer but the employer did not withhold the worker’s share of Social Security and Medicare taxes.

In addition, the worker must meet one of several criteria indicating they were an employee while performing the services. The criteria include:

• The worker was previously treated as an employee by the firm and they are performing services in a similar capacity and under similar direction and control.

• The worker’s co-workers are performing similar services under similar direction and control and are treated as employees.

• The worker’s co-workers are performing similar services under similar direction and control and filed Form SS-8 for the firm and received a determination that they were employees.

• The worker has been designated as a Section 530 employee by their employer or by the IRS prior to January 1, 1997.

• The worker has filed Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, and received a determination letter from the IRS stating they are an employee of the firm.

• The worker has received other correspondence from the IRS that states they are an employee.

• The worker has filed Form SS-8 with the IRS and has not yet received a reply.

By using Form 8919, the worker’s Social Security and Medicare taxes will be credited to their social security record. To facilitate this process, the IRS will electronically share Form 8919 data with the Social Security Administration.

A completed Form SS-8 may be filed with the IRS by either the employer or an employee – with or without the knowledge or consent of the other party – to request a determination of the worker’s status as an employee. The IRS will only rule with regard to prior employment status, not on the individual’s prospective employment status as an employee or independent contractor. During the review of the information provided with Form SS-8, enough questions may be raised to result in an employment tax audit of the employer.

If it is determined in audit that the worker should have been treated as an employee and not an independent contractor, the employer may face some serious, and potentially expensive, consequences. In addition to having to pay the payroll taxes that should have been withheld, the employer must issue the employee a W-2 and revised Form 1099 for the years that are reclassified. The employer will also need to review any of its benefit plans to determine the consequences of the reclassification. For example, the employer’s qualified retirement plan could be disqualified because not all employees were covered.

While it may be tempting to classify a worker as an independent contractor to avoid paying the employer’s share of employment taxes or having to deal with the extra tax filings and paperwork that comes with employees, the consequences of having that person reclassified as an employee can be severe. Now that the IRS has provided employees with a convenient method to pay their share of the Social Security and Medicare taxes, and thus raise the “red flag” as to the classification, it is likely that the IRS will be more aggressive in following through with audits of the employers.

If you have any questions, please give this office a call.

Generally, for self-employed individuals, charitable contributions are not deductible on Schedule C as a business expense and can only be deducted as an itemized deduction on Schedule A. However, tax regulations state that transfers to a charity that are directly related to a taxpayer's business and are made with a “reasonable expectation of financial return commensurate with” the amount transferred may be deductible as a business expense. For example, if you pay a charitable organization to run an ad in their newsletter that is intended to generate new customers for your business, the cost of the ad would be an advertising expense, but not a charitable contribution expense.

You should contact this office if you have questionable contributions.

With lenders becoming more conservative, money tightening up, and the real estate market in decline, many homeowners and speculators find themselves faced with some unpleasant choices. One strategy is to wait until home prices rebound, but that could be some time and probably too far off for the owner with a variable rate or short-term introductory rate loan and increasing mortgage payments.

There are other reasons—such as job relocation, divorce, declining income or poor health—that can force a property owner to sell in a down market and possibly take a financial loss. This article explores the tax ramifications of selling a home or rental property at a loss. But first, here are some terminology and tax rules associated with selling property:

• Personal-Use Property - The general rule that applies to personal-use property is that gains are taxable as capital gains but losses are not deductible. Examples of personal-use property are the family car (no business use) and the family home or second home. So, if you sell your personal residence or second residence at a loss, that loss is not deductible.

• Investment Property – For investment property, generally, gains are taxable and losses are deductible as capital gains/losses. However, the amount of capital loss that can be deducted annually is limited. If, after combining all investment capital gains and losses, the result is a loss, the loss is generally limited to $3,000 per year. Examples of investment property include vacant land or improved real estate that is not a business property, home or second home.

• Business Property – The general rule for business property is that gains are taxable as capital gains and losses are deductible as ordinary income. Examples of business property include residential rentals, commercial rentals and an office-in-the-home.

• Primary Home Sale Gain Exclusion – Generally, an individual who owns and lives in a home for two of the prior five years can exclude $250,000 of home sale gain. This applies to each individual so a couple could exclude $500,000. In addition, an individual who does not meet the two-out-of-five requirements may still be able to exclude a lesser amount if the home was sold due to certain unforeseen circumstances.

Now let’s apply these general rules to some representative situations that are likely to occur in a down real estate market.

Example #1 – You sell your primary (or second) home for a loss when taking into consideration what you originally paid for the home, improvements and the sales costs. Bad news - your home is personal use property and losses from “personal-use property” are not deductible. Thus, there is no tax relief from having a loss on the sale of your primary or secondary home.

Example #2 – You purchased a residential or commercial property as a rental. Now the value has declined below your basis and a sale will result in a loss. Since it is business property, the entire loss will be deductible as ordinary income in the year of sale. Thus, you will achieve tax relief based on your tax bracket(s) in the year of sale. Caution: The depreciation of the real property that you claimed as a rental expense decreases your cost basis. This means that you could actually end up with a tax gain on the sale when you thought you would have a loss.

Example #3 – You purchased vacant land for an investment and need to sell it. Unfortunately, the sale will result in a loss. The good news is the loss is tax-deductible, but lacking any capital gains to offset the loss, you will only be able to deduct $3,000 ($1,500 if filing as married separate) of the loss in the sale year; the excess loss carries over to future years.

Example #4 – Your home that you are selling for a loss includes an office from which you conduct your business. The home office is deductible under the income tax rules, and represents 10% of the home. In this case, 10% of the loss would be deductible as an ordinary loss in the sale year. None of the remaining 90% of the loss is deductible due to the personal- use property rules.

Example #5 – Yes, we read your mind. You are planning to move out of your home that will sell for a loss and convert it to a rental thinking you could then deduct the loss. Problem with this strategy is that tax law requires you to use the fair market value (FMV) of the home at the time of conversion as the business basis if the FMV is less than your adjusted cost basis. Thus, the loss in value that occurred prior to the conversion will not be included in your loss when you sell the rental. However, if the market continues to decline, you will be able to take advantage of any future losses.

Example #6 – The property will sell for a loss, so you decide to just let it go into foreclosure. By doing this, you avoid the sales costs but destroy your credit rating for years to come. In addition, if the property sells at auction for less than the mortgage balance, you may, depending on some complicated rules, have to include in your income the difference between the loan amount and the sales price (referred to as debt relief income).

Example #7 – Let’s say you originally purchased your home for $200,000; it increased in value to $300,000, so you refinanced it for $240,000 and used the money to buy a car, go on vacation, pay off credit card balances, etc. Now your mortgage is higher than both your basis (cost) in the home and its current value. Your home sells for $225,000, and assuming you have $10,000 in sales costs, you end up with a tax gain of $15,000 rather than a loss, which may come as a surprise. The gain may or may not be taxable depending upon whether you qualify for the home sale gain exclusion. Bad news is you need to make up the $15,000 mortgage shortage and the $10,000 sales costs.

We strongly suggest you carefully weigh your options before selecting a course of action. A consultation appointment may be appropriate to see what option is the best for your particular tax situation. Please give us a call.