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Archive for Capital Gains

Advice for Real Estate Investors—Maximize Your Tax Savings with Installment Sales

By Kim M. Larsen EA CTFS
Saturday, February 28th, 2015

If you’ve been looking at tax strategies regarding your real estate investments, one of the first lessons you probably learned is that it’s good to defer your taxes. Why? Because even if you eventually have to pay those deferred taxes, you get a chance to invest more money early on and take advantage of that growth, rather than losing it right away to taxes.

How the Installment Sale Works

If you’re a real estate investor (sorry dealers—this one’s not for you), you can take advantage of installment sales in order to defer part of the taxes you owe on the sale of your real estate property (or personal property). Doing it this way, you as the seller don’t have to report all the gains on the sale before you actually receive all the sale proceeds. The only catch is that at least one payment in the installment must be received after the year that’s taxable regarding the sale. If the payments are so large that the entire amount is paid within the same taxable year, you lose out on this advantage.

Here’s the easy formula for how much you’ll report each year in taxable gains on the installment payments:

Total Annual Principal Payments x (Gross Profit / Total Contract Price)

Those principal payments include any of your existing loan indebtedness that the buyer is subject to, to the extent that it exceeds your adjusted tax basis. In the case that you do have an existing loan, the buyer is not personally liable to your lender (in contrast to when a buyer assumes a loan). This is called a wraparound mortgage because the buyer is taking a loan on a property on which you already have a mortgage loan, and instead of you receiving the full amount of the sale proceeds to pay off your existing mortgage, your lender continues to receive payments.

To get the gross profit amount for the equation above, you take the selling price minus the property’s basis and selling expenses. This number is the total gain you will report of the course of the installment period.

Total contract price is the sum of all principal payments you will receive throughout the entire course of the installment period. It is calculated by taking the selling price minus liabilities assumed by the buyer that do not exceed your basis (including selling expenses).

Advantages

There are two primary advantages to using the installment method for a wraparound mortgage:

  1. You may be able to reduce the amount of the payments you receive in the year of the sale (during which time your existing mortgage may exceed your basis).
  2. The contract price may include the face amount of the wraparound mortgage (increasing the contract price in the equation above decreases the percentage of gains you pay taxes on).

You may notice that these advantages do not reduce the amount of gains you will pay taxes on in total. However, they do help you to defer a larger amount of your taxes. You will only incur tax as each installment payment is actually made on the principal (including any down payment). If you get the buyer to agree to pay the closing costs, you can get even bigger tax savings. How? It’s because the closing costs come out of the down payment paid by the buyer.

For example, if the buyer was paying you $35,000 as a down payment, and you pay the closing costs, then the entire $35,000 is taxable. However, if you get the buyer to agree to pay closing costs (and reduce you reduce the sales price and down payment accordingly), they could still pay $35,000, but you will only pay taxes on that amount less the closing costs.

In order for this to work, you cannot be liable for the brokerage commissions. If you are, then having the buyer pay those costs means they are assuming your liability. And, the tax court has ruled that if a buyer assumes your obligation to pay brokerage commissions, that money counts as a payment received by you in the year of the sale. Pay attention here: that negates any tax benefit you would receive from having the buyer pay closing costs.

So, how do you fix this? It’s actually quite easy. When your broker lists the property for sale, make it clear that they should look to the buyer for payment of the brokerage commission rather than making these costs part of the bargaining between you and the buyer. When you plan ahead and state this up-front, you don’t have any obligation for the buyer to assume (i.e. you were never obligated to pay this in the first place). It shouldn’t be too hard for you to get a buyer to agree to such a situation. They will still be in pretty much the same financial scenario either way. But, the second strategy gives you a tax break in the year of sale.

Seller Beware

The main benefit of this whole strategy is your tax-deferral ability. While you are deferring these taxes, you are also earning interest on the installment payments. But, the IRS knows that you are earning interest on its deferred tax dollars. So, you should be aware that for large transactions, you can be charged interest on that deferred tax under installment reporting law (for situations where the sales price is more than $150,000 and the total installment obligations are more than $5 million).[1]

Several court cases have attempted to disallow this strategy; however, the sticking point in these cases has been the documentation. When you’re considering the installment method with a wraparound mortgage, make sure you hire a legal professional to help you draft all the documentation. The buyer’s obligation to pay closing costs should be clearly stated in the purchase agreement, so that you can keep the additional tax savings. Above all, make sure the installment method is the right method for your situation by checking the numbers and seeing what kind of tax savings you’re looking at.

  1. IRS Publication 537 ↑
Categories : Capital Gains, Installment Sales, Investments, Real Estate, Rental Properties, Tax Planning

How to Shift Corporate Ownership and Save on Taxes

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

It pays to plan ahead in almost any situation in life, and the future of your corporation is no different. You have multiple options for what to do with your business when you’re ready to step aside, but we’re going to focus on one in particular that provides you with a nice tax-saving strategy. In a private letter ruling, one man who owned 100 percent of his company’s stock was able to gift some of his stock to his children and then sold the rest to his corporation.[1] The great news is you can use the strategy with anyone—not just your kids.

Here’s how it worked for him:

  • He had a third-party appraiser determine the per-share value of the corporation.
  • His two children wanted to own and run the company, so he gifted shares to each of them.
  • Right after that, the corporation redeemed the remaining stock, providing the man with cash and a promissory note. This last move is important because it means that the children then owned 100 percent of the corporation and the father had the promise of future payments, as well as immediate cash.

What It Means in Terms of Taxes

In a situation like the one above, the recipients are not subject to any taxes for the gifts. The previous owner may be subject to taxes, depending upon how much each of the shares was worth. You pay no gift taxes for amounts less than $14,000 in 2014.[2] Anything over that amount dips into your estate tax and lifetime gift tax exemptions.[3]

Now, another thing to consider is how you will be taxed. You want to be taxed at the tax-favored capital gains rate for selling the stock to your corporation. In order to make this happen, you’ll need to file the right IRS-required elections for complete termination, as well as those that will allow you to avoid stock attribution rules on the shares given to the gift recipient(s).[4]

Without the termination election, you will be subject to taxes at the dividend rate, and you would receive no offset for your basis. Capital gains, on the other hand, are offset by your basis so that you are only taxed on the net gain. In addition, the cash plus promissory note combination is an installment sale, meaning the taxes will be paid on the cash only in the first year, and then tax payments will be made each year after that on the gains and interest received. As for the corporation itself, it will be able to deduct the interest it pays on the promissory note.

Of course, you should check the applicable mid-term minimum federal interest rates for such situations.[5] These rates can be used for your calculations when planning your retirement strategy. Also, you’ll want to use appropriate rates when you establish the promissory note.

In summary, by using this particular strategy for shifting corporate ownership, you’ll get up-front cash, interest on the promissory note, and tax-favored capital gains treatment on taxes. The recipient or recipients of your business have no tax burden on the transaction, and the corporation gets to deduct the interest payments made to you on the promissory note. This strategy works well if, like the man in the private letter ruling, you plan to transfer your corporation to your children. But, it works just as well for transferring the company to an employee, colleague, or current shareholder. Exiting your business should be planned just as carefully as every other decision you have made along the way.

  1. Private Letter Ruling 201228012 ↑
  2. IRC Section 2503(b); Tax Foundation ↑
  3. IRC Section 2010(c)(3); Tax Foundation ↑
  4. IRC Section 302(c)(2)(A)(iii) as specified by Reg. Section 1.302-4(a) ↑
  5. http://apps.irs.gov/app/picklist/list/federalRates.html ↑
Categories : Capital Gains, Corporations, Retirement, Tax Planning

Selling a Piece of Real Estate? You Don’t Have to Pay Taxes, Even if You Don’t Use Section 1031

By Kim M. Larsen EA CTFS
Friday, February 20th, 2015

Overpaying taxes puts a damper on anyone’s mood. You should be paying precisely what you owe—no less, and no more. When it comes to selling your real estate, you really don’t have to pay taxes on that sale right away. One way to avoid the taxes is by using a Section 1031 exchange, but you actually have other options. This article will show you how to take advantage of them.

Option 1

With this option, you combine the strategies of creating a charitable remainder and a wealth replacement trust rather than selling the property. Then, voila! You don’t have to pay any taxes. Here are the steps:

  1. Create a charitable remainder trust and donate the property to the trust. With the donation, include terms that grant income to your and your spouse for the remainder of your lives. This can be either a percentage of the trust income (charitable remainder unitrust) or a fixed income (charitable remainder annuity trust).[1] The former type can accept future property donations to the trust.
  2. In the trust, designate one or more charities to receive the remainder of the trust’s balance upon the death of the second spouse.
  3. Establish a wealth replacement trust. This is a term-life insurance trust. It should include a second-to-die policy so that both wife and husband are covered. The trust acts as the insurance policy applicant, owner, and payer of premiums.

How does this option save you money? First, you avoid paying taxes on the sale of the property, which would have reduced the amount available from the proceeds for future investments. Second, you’re able to deduct the charitable expenses right away. Of course, you will be subject to the limits on charitable donations. However, if you exceed that limit for the current tax year,[2] you can carry the remainder over for the next five years.[3] Additionally, you get a tax write-off on the remainder interest that you gave away to the charity. Tax law includes expectancy tables to calculate this value, which is the value of your charitable contribution.[4]

This strategy also has another benefit, which comes from establishing the wealth replacement trust. You see, this trust receives the insurance proceeds when the surviving spouse passes away. The trust then gives those proceeds to the heirs, so you increase what is left for your children.

To sum up the benefits of this combined strategy:

  • You don’t pay capital gains taxes for transferring the property to the charitable remainder trust.
  • You invest at the pre-tax value rather than only have the after-tax amount to invest.
  • You get a deduction for your charitable donation.
  • The trust provides income to pay the insurance premiums.
  • Your heirs receive a significant amount of money.
  • You benefit your favorite charity, your heirs, and yourself, and pay nothing (or close to nothing) in taxes.

What kind of numbers are we talking about? If your real estate is worth $1 million and you sold it, you would pay $300,000 in taxes. You could then invest the remaining $700,000 in CODs (at 2 percent interest) and make $14,000 annually, pre-tax. But, with the charitable remainder trust strategy, the trust sells the real estate for $1 million and sets up a 5 percent return for you in the charity’s investment portfolio. In this scenario, you get a $94,000 deduction for the donation, plus annual income of $50,000. You can then pay $15,000 per year from that $50,000 for a $1 million life insurance policy with your children as the beneficiaries. Which do you think is the better deal?

Option 2

Another option for business-savvy individuals is to use Section 721, which involves transferring the property to a partnership. Section 721 negates any gain or loss (to you, the partnership, or its partners) when you contribute property and get partnership interest in return.[5] One way to do this is transfer your real estate to an operating partnership (OP) of a real estate investment trust (REIT). The REIT then acts like a real estate mutual fund with diversified holdings. Since you receive OP units as part of the exchange, you are then entitled to periodic distributions of the REIT. Additionally, these units can be converted into shares of the REIT. The primary benefit of this method is that you both avoid taxes and the transfer and increase the liquidity of your investment.

Normally, when you transfer property that has a mortgage liability that exceeds the property’s basis, you trigger taxes. That’s because the excess mortgage is considered a gain. How do you avoid the taxes? You simply need to know about a special REIT called a UPREIT.[6] The UPREIT guarantees an equivalent liability portions to the REIT, making excess mortgage cease to be an issue. Therefore, you pay no taxes.

Option 3

Another way to reduce your tax burden is to use a regular installment sale to dispose of your real estate.[7] This method is also called “holding paper”, and your primary benefit is an increase in net worth by holding a secured note at a higher interest rate than you would get at a financial institution. It works like this: you pay taxes as you get paid. That means you can earn interest on the gross amount since you don’t have to pay the taxes right away.

But, you may encounter situations where you do have to pay those taxes up front:[8]

  1. If you have to recapture depreciation that exceeds straight-line depreciation, or
  2. If you have to recapture low-income or rehab property investment tax credits.

The IRS considers your disposition an installment sale if you sell the property and then receive at least one payment after the close of the taxable year in which the sale occurs.[9] The payments are comprised of three parts: 1) a taxable portion of the principal payment, 2) a nontaxable portion of the principal payment, and 3) interest.

So, how much does this help your bottom line? Let’s say you sell a piece of investment property for $250,000 after selling expenses. The property’s tax basis is $125,000, so your profit would be the remaining $1250,000. With an installment sale, you divide that profit number by the $250,000 net proceeds, giving you a gross profit percentage of 50 percent (i.e. every receipt of principal is a 50 percent taxable gain). Upon closing the sale, you receive a down payment of $30,000, which is 50 percent return of capital (from your basis) and 50 percent taxable gain.

Afterwards, you receive a payment of which $700 is principal (the rest is interest). For tax purposes, you again divide the principal into 50 percent taxable and 50 percent nontaxable. As far as that interest is concerned, you are required by tax law to charge interest at a minimum rate for installment contracts—the lower of the Applicable Federal Rate (AFR) or 9 percent. The AFR is published monthly by the IRS.[10] To get the most from your installment sale, keep an eye on the interest rates and wait until you can get a higher rate. Then, add points to the interest rate if you can.

When selling your real estate, it’s usually best to avoid paying up-front taxes. The 1031 exchange is an efficient way to do this, but it only works if you plan to replace the property in order to continue building your real estate portfolio. In contrast, each of these options is a strategy to reduce or completely get rid of the taxes you would pay upon sale. This leaves you with more money to invest and grow in other opportunities. When it comes to real estate, you always have choices about when to pay taxes or even whether to pay them at all.

  1. IRC Sections 664(d)(1-2) and 453(b) ↑
  2. IRC Section 170(b)(1)(A). ↑
  3. IRC Section 170(d)(1)(A). ↑
  4. Regs. 20.2031-7A(f); 1.664-4. ↑
  5. IRC Section 721. ↑
  6. IRC Section 357. ↑
  7. IRC Section 453. ↑
  8. IRC Section 453(i). ↑
  9. IRC Section 453(b)(1). ↑
  10. IRC Sections 483 and 1274; IRS Publication 537 on Installment Sales (2008), page 10 ↑
Categories : Capital Gains, Real Estate, Retirement, Tax Planning

Selling and Repurchasing Stock the Right Way

By Kim M. Larsen EA CTFS
Tuesday, February 3rd, 2015

There’s a big difference between the interest you earn on your bank account and that earned from your stock investments. Specifically, you have to pay taxes every year on the interest from your bank account, but tax law allows you to wait until a “taxable event” (like when you sell it, for instance) to pay taxes on your stock gains. This is a huge advantage, and may allow you to save a ton on capital gains taxes if you use your advantage right.

How Low Can You Go?

It’s up to you to determine when you’ll pay taxes on your stock gains, so make the most of it! When is the best time to pay taxes? The best time is when they’re the lowest, of course. And, capital gains taxes can go all the way down to zero percent.

You can be one of those people who qualifies for the zero percent tax bracket on capital gains. This advice will guide you through the process. Would you like to know something even better? You won’t even have to permanently dispose of your stock to do this; you can keep right on earning from it.

Understanding the Rules for Stock Sold at a Gain

All right, so you want to avoid high capital gains taxes, and you’re thinking about selling and repurchasing your stock to accomplish that goal. But wait, won’t that be a wash sales transaction that’s disallowed by tax law?

It’s not! For any stock that you sell at a gain, the wash sales tax rules don’t apply.[1] It is perfectly legal (and smart) for you to sell stock that has appreciated and repurchase it right away.

Let’s take a look at how that works. For our example, you purchased $1,000 worth of stock several years ago that is now worth $10,000. You also notice that you are currently in the zero percent tax bracket for capital gains. You sell the stock for its current value ($10,000) and turn around and re-purchase it for the same price. Under tax law, this is a taxable event. You may now pay taxes at the zero percent rate (i.e. you pay no taxes).

Had you been in a higher tax bracket, you would have paid taxes on $9,000 (the gains you made from selling a $10,000 stock bought at $1,000). By doing this, you not only pay no taxes, but you have also re-established your stock’s basis as $10,000, meaning if you have to pay taxes in the future, it will be on subsequent gains. You have permanently banished taxes on that $9,000 in gains! (And, if your stock value decreases in the future, you can sell for a tax loss.)

Which Bracket Do You Fit In?

Okay, so you’d probably like to know whether you fit into this magical zero percent tax bracket. The brackets for capital gains (long-term) range from 0 to 20 percent.[2] In 2014, the zero percent bracket applies to these levels:

  • Single filers with taxable income from $0 to $36,900 and
  • Joint filers with taxable income from $0 to $73,800.

Taxable income is the dollar number you get after taking certain deductions that are available to all. You can also figure the numbers using adjusted gross income (AGI):

  • Single filers with AGI from $0 to $47,050[3] and
  • Joint filers with AGI from $0 to $94,100.[4]

Important note: To qualify for capital gains rates, you must hold the stock for a minimum of one year before selling it. If you don’t, you’ll be paying taxes at the much higher ordinary income rates. It’s a good idea to play it safe. If you buy stock on July 31 of this year, hold onto it at least until August 1 next year. Don’t get in a rush. Make sure you’ve owned that stock for a year before selling—remember, investments are long-term.

By planning your stock sales correctly, you can save thousands of dollars in taxes over the years. You don’t have to sell all of your stock shares at once, by the way. Just calculate the amount of gain you can safely recognize without paying taxes, and only sell that amount. Tax law allows you this benefit, so take advantage of it by selling intelligently.

  1. IRC Section 1091. ↑
  2. Rev. Proc. 2013-35. ↑
  3. $36,900 + $3,950 (exemption) + $6,200 (standard deduction) = $47,050. ↑
  4. $73,800 + $7,900 (exemption) + $12,400 (standard deduction) = $94,100. ↑
Categories : Capital Gains, Investments, Tax Planning

You Can Do 1031 Real Estate Exchanges

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

Have you heard about 1031 real estate exchanges? It turns out they are a great way to save money on taxes. You may not realize this, but paying income taxes on the disposition of rental, business, or investment real estate is voluntary. You have another option!

Even people who have heard of 1031 real estate exchanges often don’t take advantage of them. Perhaps it’s because the name makes it sound like something too difficult to mess with. The truth is that the process is simple; don’t let the word “exchange” fool you.

The Basics of the 1031 Exchange

Here is what you need to know: the Section 1031 tax-deferred exchange is merely a sale and a purchase. It involves four parties: 1) the seller (you), 2) the buyer, 3) the seller of your new property, and 4) a qualified intermediary who knows how to qualify your sale and purchase as tax-deferred. The process requires only a few necessary steps:

  • Hire an intermediary.
  • When you sell to the buyer, the intermediary holds onto the money. Don’t touch the money yourself.
  • You then purchase your new property using the funds being held by the intermediary.
  • All of the taxes are deferred as long as you receive no cash and do not obtain debt relief!

Who Can Act as Intermediary

For your sale and purchase to qualify for tax-deferred status, your intermediary must be someone impartial who does not benefit from the exchange. Specifically, you cannot have had a business relationship with the person in the last two years[1]. That means the ordinary people you may think of to help with your finances—your attorney or accountant—won’t work.

Don’t get discouraged. Professional intermediaries are available who specifically handle these kinds of situations on a daily basis. You can do a quick online search for “1031 intermediary” and find plenty of candidates. Because they are fairly common, you can usually get a fairly good price (perhaps less than $500) on hiring an intermediary.

Tip: Be aware that like any purchase of services, hiring an intermediary does carry risk. They are a business, and although it’s not common, it is possible to come across dishonest intermediaries who steal their clients’ money. Be sure you check the company’s background. Also, intermediaries can go bankrupt. This would entirely throw off your sale and purchase if the funds from the first sale are missing. That means you won’t be able to complete the exchange. You’ll have to pay the taxes, and you won’t have the money from the sale—bad news all around.

Most professional intermediaries are legitimate companies that make their money through helping clients to save on taxes. However, you should always protect yourself and your investments. Make sure you go with a company with an established reputation, and check into options to protect your money, such as bonds or an insurance policy. Also, ask the intermediary if they offer some type of protection for your funds.

Time Limits on Making an Exchange

Okay, so most of this doesn’t sound too complicated. Don’t let the simple process make you get lax. Section 1031 sets hard, fast rules about how long you can take to complete an exchange. Be efficient; meet the deadlines. If you don’t, you lose out on your tax-deferred advantage, no exceptions or second chances. Here’s the information you need:

  • Start Date—The date on which you close the sale for the property you are selling triggers the “initial transfer date”. Once you have relinquished the property, the Section 1031 exchange officially begins.
  • Identify Date—Yes, you have a time limit on how long you can take to identify the property you intend to buy. You should formally identify your possible choices by the forty-fifth day after the initial transfer date[2]. Please note that this is not the date by which you must purchase the property; you merely need to have a few specific options picked out.
  • Close Date—The close date is not the day you close the sale on your new property. It is actually the date on which the exchange is fully completed and you have identified the new property title in your name. The closing of the exchange must be completed within whichever of the following two time frames is shorter[3]: 1) 180 days after the initial transfer date, or 2) the due date of your tax return.

Before you begin to panic, remember that you are allowed to extend the due date of your tax return. You may even be able to get the full 180 days by extending your return. So, if your exchange closes after October 17, file the extension to get more time to complete process.

Other options also exist to buy you a little time. When you know it may take a while to find a suitable replacement property, you can delay the start date. How? One way is to offer your potential buyer a triple net lease to occupy the property until you’re ready to close[4].

How to Prove Identification

You may have noticed that you need to formally identify a property by the forty-fifth day after initial transfer. Ugh, more paperwork, right? Fortunately, it’s easy enough to record your identification of a property. Just put down the earnest money, and you have your evidence that purchase of the replacement property is in process. If you haven’t put down earnest money, you’ll have to sign a document that you provide to the qualified intermediary[5].

Keep in mind that you’re allowed to identify up to three replacement properties regardless of fair market value, whether you’re selling one or multiple properties[6]. You can identify more than three new properties if the total fair market value of the properties does not exceed 200 percent of the fair market value of the properties you sold. The deadlines may be strict, but these rules allow plenty of flexibility in choosing new properties. Even better, the Section 1031 rules work for pretty much any real estate (rental buildings, vacant land, business facilities), as long as it’s domestic and not for personal use[7].

In fact, you can even build on vacant land or rehab a building with a build-out or construction exchange[8]. When identifying the replacement property, you simply include plans for the structure or build-out you will have constructed (make sure this is completed within the designated 180-day period). The qualified intermediary then pays out the funds to the contractor as work is completed.

All you have to remember to qualify for tax-deferral is that all of the proceeds from your original sale must be used to acquire a replacement property. Do not collect cash on the deal. Do not attempt to reduce your debt through the exchange. If the property you purchase is a fixer-upper and did not cost the full amount you sold the original property for, simply complete enough improvements (through your intermediary) within the 180 days in order to use up all the funds. Otherwise, you have all the same options for selling real estate that you normally would, including owner take-backs[9], also completed through the intermediary.

Special Rules about Buyers and Sellers

You may be wondering if certain individuals, like relatives, are excluded from taking part in the sale and purchase. The good news is you are allowed to make the exchange transaction with someone you are related to, but you will be disqualified for tax deferral if an exchanged property is sold again within the next two years[10]. This only applies in cases of siblings (full and half), parents, grandparents, spouse, and descendants (biological and adopted)[11]. Entities in which you own (directly or indirectly) more than fifty percent in value are also considered related parties for this purpose.

Selling a property is not always easy. You’ll be happy to know that Section 1031 also allows “reverse exchanges”[12]. This simply means your intermediary can buy the new property with money you put up in advance before you have sold your original property. Be aware: the 180-day time frame still applies, with the start date taking place once you close on the new property. You’ll need to sell your original property by then to avail the tax advantage.

If you’d like to take advantage of these tax savings, be sure to contact a knowledgeable intermediary who can ensure the correct process is followed. Special rules exist for particular types of property, such as those being converted to rental properties, so make sure you’re working with someone who has experience with your type of situation and understands all the details. The rules get more complicated when you start trying to exchange personal property (e.g., office equipment) or intangibles like a business personality. Keep it simple with real estate exchange to get maximum return for the least effort.

  1. Reg. Section 1.1031(k)-1(k). ↑
  2. IRC Section 1031(a)(3)(A). ↑
  3. IRC Section 1031(a)(3)(B); Reg. Section 1.1031(k)-1(d). ↑
  4. Private Letter Ruling 8118023. ↑
  5. Reg. Section 1.1031(k)-1(c)(2). ↑
  6. Reg. Section 1.1031(k)-1(c)(4)(i). ↑
  7. IRC Section 1031(h). ↑
  8. PLR 200842019. ↑
  9. IRC Section 453(f)(6). ↑
  10. IRC Section 1031(f)(1). ↑
  11. IRC Sections 1031(f)(3); 267(b); 707(b)(1). ↑
  12. Revenue Procedure 2000-37. ↑
Categories : Capital Gains, Exchanges, Rental Properties, Tax Planning

How to Protect Your New Business Investment and Deduct It from Income Taxes

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

Buying a business is an exciting time. You’re sure to feel the promise of new success; however, don’t let that rush of adrenaline get the best of you. When you invest in a business, remember to keep your head in order to protect your investment.

How You Buy

You have two primary options for buying a business. The simplest way is to just buy all of the company’s stock. If you’re interested in a corporation, all you have to do is purchase 100% of the current owner’s stock. Presto! You now own the corporation.

The other option is to purchase the company’s assets, which can be more complicated. If the business you’re interested in is a sole proprietorship or a single-member LLC (that is taxed as a proprietorship), then stocks are not an option; you will buy assets[1]. However, you can also buy assets when purchasing a corporation. Hint: See the tips below for why you may want to do this.

The big advantage to an asset purchase is that the money you invest increases the basis of the individual assets. What this means for you is that you can depreciate them and eventually recover the investment cost. Any premium you pay that’s in excess of the assets’ value can also be deducted[2].

Your Purchase Affects Your Taxes

One thing to keep in mind is that you usually have multiple options for purchasing. And, each decision you make regarding your business will affect your taxes. So, make sure you understand these two things:

  • Making an Asset Purchase—If you purchase a corporation through stocks, your investment money goes towards basis in the stock. This means you don’t own the company’s assets; the corporation does. However, this is not the best situation for you because you cannot depreciate the stock. The only tax benefit you will get from stock is when you sell it. Furthermore, the corporation’s assets will already have a depreciation schedule.
  • Making Use of Your Depreciation—What you can do instead, to help recover the cost of your investment, is make a hybrid purchase[3]. However, a hybrid purchase is a complicated process, and you will need your tax advisor and an attorney to assist you along the way. Basically, a corporation you already own, or a corporation you form, buys the stock of an S corporation[4]. The difference is you will then treat the purchase like an asset purchase for tax purposes. You will set up the basis of the assets, as normal.

After purchasing the S corporation’s stock, you’ll have to sign an IRS Form 8023[5]. Just keep in mind that all stockholders will need to sign the form[6]. This includes those of the buyer, the seller, and (if you live in a state with community property laws) the stockholders’ spouses.

Issues When Purchasing Stocks

A primary concern when purchasing stocks is protecting yourself from liability, both future and past. If you go the stock purchase route, you could be liable for any problems caused by the previous owner. That’s right—you just bought the history of the company. That means any past grievances brought up by employees and any product issues brought up by consumers can be stacked up against you, and the victims have a right to sue you.

To avoid these situations, make sure you address them in your stock purchase contract. The seller should agree to pay all past debts and taxes. Also, make sure the seller includes language to indemnify you from lawsuits that arise from the time period of previous ownership. Of course, this does not stop people from suing you. They still can. What the contract ensures is that you can then get the previous owner to pay any costs incurred under this liability.

Things to Consider When Purchasing Assets

When you purchase assets, it means you are buying each bit of the company separately. You buy the name, the property, the inventory, etc. During this process, you may have to deal with third parties, which can be a headache. Third party transactions can also end up costing you additional money. Make sure you’re away of the details, including whether you will have to substitute your name on future documents, before signing the final contract.

On a positive note, asset purchase differs from buying stock in that you are free from past liabilities of the business. You buy the business’s parts, not the entity itself. The benefit of this is that any issues arising from past ownership stay with the previous owner; they are not your responsibility. Just play it smart; antifraud laws can protect creditors. You may be at risk for accepting liability in the following cases[7]:

  • You specifically agree to take on past liabilities;
  • The sale is made as a “de facto” merger;
  • Your official status is a “continuation” of the previous owner’s business;
  • The purpose of the sale is to evade liability;
  • The product you manufacture is the same as the seller did.

If one of these situations applies, be sure to made release of liabilities a part of the contract. Just as with a stock purchase, the seller should agree to indemnify you from lawsuits and pay accumulated debts.

Understanding the Seller’s Incentives

Of course, your business purchase is not going to be beneficial only to you. If that were the case, the seller would not go through with the deal. The best transactions are those that are mutually beneficial. So, what exactly is the seller looking for?

Capital Gain

Sellers are looking to make capital gains rather than ordinary gains (those from the operation of the business). The capital gains are taxed at a lower rate, which means the seller benefits when the sale can be classified as such[8]. With a sale of assets, the seller ends up with a mix of gains from income and capital (including losses).

This doesn’t mean a seller won’t negotiate with you on the type of sale, but they will probably raise the price to cover their losses. One situation in which the seller’s return may be negatively affected is the hybrid corporation sale method. If you find yourself in the position of seller, you should check with your attorney and your tax advisor about what tax rates will apply (especially if you face a gains tax from previously operating as a C corporation[9]).

Remember that with the new Obamacare tax (3.8 percent on net investment income), your stock and asset sales will be taxed. If you operate as a C corporation, you cannot avoid this. As an S corporation, you may be able to reduce this tax in the case that the income was active rather than passive[10].

Protection from Future Liability

Just as you want to protect yourself from past liability, the seller wants to be protected from future liability at the hands of your ownership. For this reason, the stock purchase is usually the preferred method for a seller. It means you have taken over responsibility for the company as an entity.

Whether buying or selling, consider the benefits of each purchase type. Gaining an understanding of the options helps to protect your investments and protect you from undue liability. Remember, always have a professional look over the contracts with you.

  1. See Rev. Rul. 99-5, Situation 1 for LLCs. ↑
  2. The amount is generally considered a goodwill amount, which you amortize over 15 years. IRC Section 197(a); (d)(1). ↑
  3. IRC Section 338(h)(10). PLR 200649015. Also see Reg. Section 1.338(h)(10)-1(c)(2). ↑
  4. Reg. Section 1.338(h)(10)-1(c)(1); (d). ↑
  5. Form 8023, Elections Under Section 338 for Corporations Making Qualified Stock Purchases, Rev. February 2006. ↑
  6. Reg. Section 1.338(h)(10)-1(c)(3). ↑
  7. CCA 200847001; Dayton v Peck, Stow and Wilcox Co., 739 F.2d 690, 692 (1st Cir. 1989). ↑
  8. Reg. Section 1.338(h)(10)-1(d). ↑
  9. See this article on built-in gains. ↑
  10. Prop. Reg. Section 1.1411-7(a)(1). ↑
Categories : Business Expenses, Capital Gains, Receipts, Records, Start Up, Tax Planning

What the Statute of Limitations Means for Your Tax Records

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

When you went into business, chances are you weren’t imagining grand evenings filled with paperwork. Maybe you thought tax records were a thing you would think about once a year and have your accountant deal with. But, the truth is, as you progress in business, you come to realize that record-keeping for your taxes needs regular maintenance. In fact, even after you breathe a sigh of relief once that return has been double-checked and sent off to the IRS, you may need to make a change to the document.

That’s where the statute of limitations comes in. It refers to the periods of time during which both you and the IRS may make changes to your tax return (not just audits). Those time frames are clearly delineated in IRS publications[1].

Here they are:

  • No limit if you did not file a return
  • No limit if you filed a fraudulent return
  • Three years after filing if you filed on time (or with extensions), you did not understate your income by 25 percent or greater, and you did not file fraudulently
  • Six years after filing if you filed on time (or with extensions) but you understated your income by greater than 25 percent
  • If you filed an amended return or already made changes to the original return (like a quick refund claim), either three years after filing or two years after paying the tax
  • Seven years from filing for a claim filed for a bad-debt deduction or loss from worthless securities

Keeping Appropriate Records

Aside from letting you know how long you have to make changes to a return, the statute of limitations also lets you know how long the IRS has to audit your return. If an audit occurs, you are going to need all of your tax records to prove your deductions. What does this mean for your record keeping habits? Hang on to those records until any chance of audit has passed.

The following are a few guidelines for making sure you hold on to the appropriate records long enough:

  • Employment Tax Records—If you have employees, you need to save your employment tax records for four years after whichever date comes later, the date payroll taxes were paid or the date they were due. An easy way to do this is simply to keep six separate drawers in your filing cabinet for each tax year. Every year, discard the sixth drawer when it’s statute of limitations expires.
  • Records for Assets—You have certain assets that are pertinent to your tax return for as long as they remain in the depreciable category. Examples of such assets include your office building, computers, desks, and even your car. If you are depreciating those assets, they will be on your tax return. Otherwise, if you are using Section 179 to expense the assets, you may be able to recapture the depreciable class life.

For example, let’s say you purchased a desk for $1,500 and depreciate it over the seven year Modified Accelerated Cost Recovery System (MACRS) life, which takes eight years. You’ll still have to prove depreciation in the eighth year. So, you need the record of the original purchase in the eighth year and through the eleventh year to meet the three year statute of limitations (the time during which this purchase is subject to auditing). The example works the same if you used Section 179. Any assets with more than a one year class life should be kept in a separate, permanent file so they don’t get tossed out with files whose statutes of limitations have expired.

Record Keeping Tips

As mentioned in the section on employment tax records, you can simplify your file system by devoting separate drawers for each tax year. In those drawers, you’ll put any information on assets, income, and other information applicable to your return. The first drawer will be where you put all documents as you acquire them throughout the year. The next drawer is last year’s tax documents. The drawer after that contains documents from three years ago, and so on until you reach the year at which your statute of limitations expires.

In order to use this method, it’s important that you file your taxes on time or file an extension so you know for sure your specific time frames. At the end of each year, the last drawer gets dumped and you move the other drawers down, starting a new drawer for the current year. It’s really simple once you put the system in place. Record-keeping may seem tedious, but remember, it shows you where your business has been and where it’s going, like a runner trying to improve their time. You can’t improve the numbers if you don’t know what they are.

  1. IRS Pub. 583, Starting a Business and Keeping Records (Rev. December 2011), Dated Feb. 17, 2012, p 12. ↑
Categories : Audits, Business Expenses, Capital Gains, Payroll, Receipts, Records, Tax Planning

Are You a “Dealer” or “Investor” for Tax Purposes?

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

Tax law is forever classifying people and making structures that either create benefits or disadvantages on your tax return. Part of getting the most from your return is about understanding the definitions of the IRS. Two that seem very similar, but have distinctly different consequences on your taxes, are real estate dealer and real estate investor.

What’s the Downside of Each?

We’ll start by discussing the disadvantages. That’s right—there is no golden choice when trying to figure out if you classify as a dealer or an investor. In either case, there will be some disadvantages.

As a real estate dealer:

  • Your profits are taxed at both the ordinary income rates (up to 35 percent) AND the self-employment rates (up to 14.13 percent).[1]
  • You may not depreciate property that you are holding with the intention of selling.
  • You may not use the tax-favored installment method to report dispositions of your property.
  • And, you may not use the Section 1031 exchange to defer taxes on properties you hold as a dealer.

As a real estate investor:

  • You are subject to the net capital losses limit of $3,000 (applied after gains are offset against losses).
  • You must treat selling expenses as a reduction in sales proceeds, which means those expenses produce benefits at the capital-gains tax rates only.

Admittedly, the dealer gets the lesser deal when it comes to disadvantages. The investor does get to depreciate property, is allowed to sell using the tax-favored installment method, and may choose to use a Section 1031 exchange, thereby deferring taxes on a disposition.

What about the Up Side?

Every coin has a heads and a tails. And, it’s the same with tax designations. Both dealers and investors gain some advantages from their respective positions.

Advantages for real estate dealers include:

  • You are treated as a business and may treat most expenses as ordinary business deductions (advertising, commissions, legal fees, real estate sales, etc.).
  • Your property sale losses are not limited capital loss cap of $3,000 that limits investor properties.
  • Your losses are deducted as ordinary losses.
  • You get to deduct the entire loss (either immediately or using the net operating loss rules to deduct it over time—these rules allow you to carry back your losses up to five years and forward up to twenty years).

Advantages for real estate investors include:

  • Your sales profits are taxed at 15 percent or less, a tax-favored capital gains rate.
  • You are not subject to the self-employment tax.

Practical Application

So, what does all this mean for you and your business? Let’s run through some example numbers. For the example, we’ll say you have a $90,000 profit from a property sale. Based on the tax rates mentioned above, your taxes as a dealer could be as high as $36,370.[2] Your taxes as an investor might be as high as $13, 500.

You can clearly see that having your properties qualify as investment sales generates a considerable tax savings—potentially $22,870!

However, depending upon your business structure and activities, it may not be possible to define all of your property sales as investment sales. No problem. The IRS has no qualms with an individual taxpayer acting as part dealer and part investor. You read that right; you can balance the pros and cons of each situation. It’s simply a matter of taking each property on a case-by-case basis.[3]

Not so fast. You may think the IRS is giving you some kind of free gift by allowing this pick and choose method, but it’s not quite as unstructured as all that. You will be required to make a clear distinction in your record books. You didn’t think the IRS was going to let you off without documentation, did you? And, this means you must decide before-hand which route you’re going with each property sale. You cannot simply go back over your sales at tax time and assign designations. You will have to establish what your intent was with the sale—dealer sale or investment sale.

Tips on Documentation

Good documentation of your purpose and activities helps you to establish your case with the IRS. You should determine, and make note of, your intent for the property throughout the process:

  • When you purchase the property;
  • During your ownership; and
  • At the time you sell it.

If you keep records throughout the process (not just at the time of sale) it gives your case credibility. It’s important to keep in mind, however, that if your return is challenged in court, they will likely examine the sale when they rule on whether you acted as a real estate dealer or real estate investor on a particular property.[4] None of this means that your purpose may not change between the time you buy a property and sell it, but at least you will be prepared to understand and plan for such a scenario.

The All Important Point-of-Sale

Important: The point-of-sale is the most critical part of the process in determining your investor or dealer status. It’s often the deciding factor in IRS decisions. Although a single piece of real estate can have features of both dealer and investor property, it can only be treated as one or the other. Take a look at the characteristics of each from a tax standpoint.

  • Real Estate Dealer—First off, dealer property is held with the intention of being to customers in the ordinary fashion of business or trade.[5] If you buy and sell many properties throughout the year, you are likely a dealer regarding those properties.[6] Unfortunately, the IRS has not established any set number for determining dealer status, so it’s all about making your case. In fact, number is only one factor, and in previous rulings:
  1. A company earned dealer status with only one sale because it had already agreed on sale to a third party prior to purchasing the property itself;[7]
  2. A taxpayer, Mr. Goldberg, did not earn dealer status even with 90 home sales in a year.[8] In his case, the homes were built for rentals and used as such prior to the time of sale.

However, in the majority of cases, more sales equal dealer properties. In addition to the influence of the number of properties sold, real estate that you subdivide also has an increased chance of achieving dealer status,[9] except under Section 1237.[10] Removing a lien can also make a property more salable under the ordinary processes of business[11] (recall that dealer property is sold in the ordinary course of business).

Several other traits indicate a dealer business transaction over investment actions. They include active marketing and sales activities,[12] property held for a short period of time (indicating the intention to turn over the property for profit),[13] generally making your living as a dealer,[14] regularly buying and selling real estate for your own account,[15] and buying property with the proceeds from another property.[16]

  • Real Estate Investor—In contrast to dealer property, investor property is held with the intention of producing rental income[17] or appreciating in value. This means that investor properties are typically held for longer periods of time[18] and are not often sold, unlike the quick turnover of a dealer property.[19] Other situations in which a court may rule your property is an investor property include acquiring the real estate by inheritance,[20] dissolution of a trust,[21] or a mortgage foreclosure.[22] It’s even possible for you to make improvements to such property prior to selling it and still retain investor status.[23] [24] Just don’t put the proceeds into more real estate or subdivide the property[25] if you want to maintain that status.

If you don’t make clear in your documentation which type of property sale you are making, the IRS will make the decision based on their interpretation, and that is not the best situation for you! So, look at those characteristics above again. Since you’re going to know at the outset what your purpose is with each property, you can make sure to include as many of the appropriate features as possible well before the sale.

  1. The usual self-employment tax rate times the Schedule SE adjustment. ↑
  2. Assuming the real estate profits were your only income. ↑
  3. Tollis v Commr., T.C. Memo 1993-63. ↑
  4. Sanders v U.S., 740 F2d 886. ↑
  5. IRC Section 1221(a)(1). ↑
  6. Sanders v U.S., 740 F2d 886; Suburban Realty Co. v U.S., 615 F2d 171. ↑
  7. S & H, Inc., v Commr., 78 T.C. 234. ↑
  8. S & H, Inc., v Commr., 78 T.C. 234. ↑
  9. Revenue Ruling 57-565 ↑
  10. IRC Section 1237. ↑
  11. Miller v Commr., T.C. Memo 1962-198. ↑
  12. Hancock v Commr., T.C. Memo 1999-336. ↑
  13. Stanley, Inc. v Schuster, aff’d per curiam 421 F2d 1360, 70-1 USTC paragraph 9276 (6th Cir.), cert den 400 US 822 (1970); 295 F. Supp. 812 (S.D. Ohio 1969). ↑
  14. Suburban Realty Co. v U.S., 615 F2d 171. ↑
  15. Armstrong v Commr., 41 T.C.M. 524, T.C. Memo 1980-548. ↑
  16. Mathews v Commr., 315 F2d 101. ↑
  17. Planned Communities, Inc., v Commr., 41 T.C.M. 552. ↑
  18. Nash v Commr., 60 T.C. 503, acq. 1974-2 CB 3. ↑
  19. Rymer v Commr., T.C. Memo 1986-534. ↑
  20. Estate of Mundy v Commr., 36 T.C. 703. ↑
  21. U.S. v Rosbrook, 318 F2d 316, 63-2 USTC paragraph 9500 (9th Cir. 1963). ↑
  22. Cebrian v U.S., 181 F Supp 412, 420 (Ct Cl 1960). ↑
  23. Yunker v Commr., 256 F2d 130, 1 AFTR2d 1559 (6th Cir. 1958). ↑
  24. Metz v Commr., 14 T.C.M. 1166. ↑
  25. U.S. v Winthrop, 417 F2d 905, 69-2 USTC paragraph 9686 (5th Cir. 1969). ↑
Categories : Audits, Business Expenses, Capital Gains, Depreciation, Exchanges, Investments, Land, Leases, Passive Income & Losses, Receipts, Records, Rental Properties, Self-employment Tax, Tax Planning

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