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Archive for Real Estate

Personal Property or Rental Property: How to Get the Most Savings from Your Vacation Home

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

Your vacation home provides you with the benefits of relaxation and time away from the busy day-to-day responsibilities. But, if you play your cards right, it can also be a source of income and tax savings. After all, there’s no real reason to leave your vacation property sitting vacant when you’re not using it. And, this allows you to take advantage of the repair-day tax benefit.

IRS Rules Regarding Rental Property

You won’t be surprised to know that the IRS has a few rules about treating your vacation home as rental property. You see, just because you rent out the property doesn’t necessarily mean that it qualifies as a rental. It’s all about how the numbers play out. When your vacation home is used for both personal use and as a rental property, tax law still classifies your home as personal property if you use the home for personal purposes more than 1) 14 days, or 2) 10 percent of the number of days it was rented out (at a fair market price) to someone unrelated to you, whichever is greater.[1]

Here’s an example of how such a situation may play out:

Non-family members rent your vacation home for 180 days of the year. You personally stay in the home for 17 days out of the year. This gives you 90.6 percent rental use and 9.4 percent personal use. Regarding taxes, you’ll simply treat 90.6 percent of the property as rental property and the remaining percentage as a personal home.[2]

Figuring in Repairs

So, you’ve counted the rental days and the days of personal use. But, are any days used for something else? Certainly! If you’re renting out your property, you’re more than likely taking some days to make repairs. For tax purposes, the repair day counts in neither the personal nor the rental days. It’s a non-use day.[3]

In fact, as long as you spend the majority of any particular day making repairs, it counts as a repair day regardless of anything else that you or anyone else is doing on the property that day.[4]

To this IRS, this means:

  • Any day for which your primary purpose lies in making repairs or providing maintenance to your vacation home, you are not considered to be using the home for personal purposes;[5] and
  • Any time that you make repairs or provide maintenance to your vacation home on a substantially full-time basis for any given day, it is not a personal day. (Now, the IRS does not state this, but according to the law, your repair day counts no matter what the rest of your family is doing during the time you are working on repairs.[6])

Those regulations sound pretty good, so how do they play out in actual situations? Well, before we explain that, let’s just make clear that IRS regulations are not the law. Lawmakers have already passed legislation regarding repair days, and the IRS regulations are partly based on those laws. Here are a couple of examples of what the IRS regulations would mean for your repair activities:

  1. Let’s say that you and your spouse drive out to your vacation home and arrive on a Thursday evening in order to spend Friday and Saturday making repairs for the upcoming rental season. You eat dinner at the vacation property, but don’t start on any work Thursday night. On Friday and Saturday, you spend 8 hours each day working on property repairs. Your spouse helps out with a few tasks, but does not spend the majority of the time working. You both leave a little before noon on Sunday.

Which days count as repair days? All of the days do—Thursday through Sunday.[7]

  1. As another example, you own a mountain in the cabins and rent it out throughout most of the year. For one week, you and your family stay at the cabin, and you spend 3 to 4 hours each day performing maintenance. The rest of the time is spent relaxing, hiking, and fishing. Per the above regulations, you spent substantially full-time working on the cabin, so your entire week is a repair week, not personal use. The relaxation and leisure activities make no difference.[8]

Note that in each of the examples based on IRS regulations, all the family members (you included) worked at least a little bit in both examples. Under the actual laws regarding these situations, that is not required. According to the law, your family does not have to participate in any repairs to your vacation home in order for you to claim those days as repair days.[9] The IRS may try to make these rules sound vague, but the law is clear—you are entitled to use your repair days when counting personal versus rental use.

  1. IRC Section 280A(d) ↑
  2. IRC Section 280A(e)(1) ↑
  3. Prop. Reg. Section 1.280A-1(c)(1) ↑
  4. IRC Section 280A(d)(2) ↑
  5. Prop. Reg. Section 1.280A-1(e)(6) ↑
  6. Robert J. Twohey, TC Memo 1993-547; IRC Section 280A(d)(2) ↑
  7. Prop. Reg. Section 1.280A-1(e)(7), Example 3 ↑
  8. Prop. Reg. Section 1.280A-1(e)(7), Example 4 ↑
  9. IRC Section 280A(d) ↑
Categories : Real Estate, Rental Properties, Tax Planning, Vacation Homes

Rent Your Home to Your S Corporation and Get Double the Tax Benefits

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

S corporations are one of those funny structures that make you wonder if you’re living in another dimension. The corporation is a separate entity from you, but tax benefits pass through the corporation to your advantage. For a sole owner of an S corporation, the lines between individual and company can sometimes become blurred, even in terms of tax law.

Generally, the IRS is very strict about your making sure you keep your personal finances separate from those of your S corporation. That’s why it seems unbelievable that you could rent your home to your own S corporation and receive a tax advantage from this situation. Doesn’t that cross the lines of personal and business interests? Unbelievable or not, if you play your hand right, you may very well be able to pull off this rental deduction situation.

14-Day Rule for Free-Rent

According to the free-rent rule, you cannot take personal residence deductions against rental income when you rent your home for less than 15 days, and the income for that 14-day or less period is not taxable.[1] Furthermore, in Roy, the court ruled that for tax-free rental cases using the 14-day rule, it is not necessary for the rent to be at fair market value (although you probably should document that it is anyway for your S corporation).[2] The free-rent rule is in IRC Section 280A(g), and it provides you with two distinct tax advantages:

  1. On the personal side, you don’t have to report the rent as taxable income, and
  2. On the corporate side, your company gets to deduct the amount it spent on rent.

According to Section 280A, the tax-free residence-rental rule takes precedence over the other provisions in Section 280A. That means this particular tax code is the key to defending the rental of your personal home tax strategy. However, you are going to come up on several obstacles to getting these benefits. Let’s see what they are and how you can get around them.

You can’t get a deduction for renting to your employer.[3] Section 280A(c)(6) states that an employee cannot take a deduction when renting to the employer. For your S corporation, you are the employee; you are the employer. Therefore, you cannot rent to yourself without breaking this rule, right?

Not so fast. When using the 14-day rule, you as an employee are not entitled to any deductions anyway. So, this problem isn’t really a problem at all! Whether you can get personal deductions or not, you still get rental income tax-free. Additionally, as stated above, the 14-day tax-free rent rule overrides this because it is also a provision in Section 280A.

You can’t take deductions for entertainment facilities.[4] All this really means is you need to be careful about how you have your S corporation rent your home. What will it be using the space for? If your company will be entertaining prospects or customers (including patients), then this puts the brakes on your plan. Although there are exceptions, you’re better off just not renting your home to your business for purposes of entertaining. If you absolutely must use your home for entertainment, limit to those situations that are exempt from the entertainment facility rules.[5][6]

You can’t deduct rental to a related-party.[7][8] It turns out this is another one that’s actually not an issue at all. It seems like renting from yourself would count, but that’s not exactly what’s happening here. Your corporation is renting from you, and as a separate entity, your corporation is not you, and it is not related to you (as in the way your family is related to you).[9] Additionally, the related-party rule prohibits deductions when the recipient does not have to include income “by reason of the method of accounting.”[10] But, that’s not the case here. The reason you don’t have to include the income is because tax law says you don’t have to.

You can’t deduct personal, family, or living expenses.[11] Every business owner should be aware that you cannot deduct these kinds of expenses. However, renting out your home to a third-party is not a personal or family use. Tax law already recognizes that some uses of the home, such as a home office, are not included in these categories.[12]

You have to prove an ordinary and necessary business expense.[13] Renting space for business meetings and/or the annual holiday party is unarguably an ordinary and necessary business expense. Every year, businesses deduct these expenses with no problems. On your corporation’s side, the business purpose of this rental expense is clear. Tip: Document your business use of the space, perhaps even taking photos of the activities.

The IRS could consider this a bogus rental with the substance-over-form doctrine.[14] If you follow the advice of avoiding entertainment facility rules, charging fair market value rent, ensuring that business activities actually take place, and documenting all of this, there’s really no reason for suspicion of fraud. After all, tax law itself allows you to take the rent tax-free, and it’s not an issue of substance-over-form for your corporation to deduct rent for business meetings or a space for holiday parties.

There you have it—all of the information you need to justify your personal tax-free rent income and a business expense deduction for your S corporation. As long as you know the rules and document properly, you can come out ahead with your taxes. Remember, paying taxes is about paying what you owe—no more and no less. So, if tax law allows you to avoid taxes or take deductions, it’s your right to do so.

  1. IRC Section 280A(g) ↑
  2. Leslie A. Roy v Commr., TC Memo 1998-125 ↑
  3. IRC Section 280A(c)(6) ↑
  4. IRC Section 274(a)(1)(B) ↑
  5. IRC Section 274(e)(4) ↑
  6. IRC Section 274(n)(2)(A) ↑
  7. IRC Section 280A(d)(2) ↑
  8. IRC Section 267(a)(2) ↑
  9. IRC Section 280A(d)(2)(A) ↑
  10. IRC Section 267(a)(2)(A) ↑
  11. IRC Section 262 ↑
  12. IRC Section 280A; Rev. Rul. 76-287 ↑
  13. IRC Section 162 ↑
  14. Gregory v Helvering, 293 U.S. 465, 14 AFTR 1191 (1935); Frank Lyon Co. v United States, 435 U.S. 561, 573, 41 AFTR 2d 78-1142 (1978) ↑
Categories : Corporations, Home, Real Estate, Rental Properties, Tax Planning

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

Thinking of Renting Out a Property? Make It Easier with Shared Equity

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

Renting your real estate can be a wonderful way to increase your cash flow. However, rental properties can also cause you headaches and add a lot of responsibilities onto you, as landlord. After all, in order to rent your property, you have to deal with tenants and handle their needs. However, it turns out there is a way to share some of that ownership responsibility with your tenants. It’s called shared equity, or a rent-to-own agreement.

The Benefits of Rent-to-Own

Typically, as landlord you are 100 percent responsible for the upkeep of the property. You also take on all of the risk, such as being responsible for a mortgage when you have a vacancy. But, when your tenant shares in the ownership of the property,[1] you keep many of the advantages of owning a rental property and also gain additional benefits.

The benefits aren’t one sided, either. Your tenant shares in equity on the home, as well as putting a down payment on it. And, they get a wonderful opportunity to carefully inspect a home before committing to the purchase (and build equity while making their decision!). The tenants also receive tax deductions that they would not be entitled to as typical renters.

If your agreement gives you 65 percent ownership and the tenant 35 percent ownership, then the tenant pays you rent for your 65 percent. You can treat your share just as you would any other rental property. This arrangement is approved by tax law.

Here are some reasons to consider a rent-to-own situation:

  • The tenant shares responsibility for property upkeep. Normally, as a landlord, you would be responsible for any necessary repairs, including scenarios like an unexpected breakdown of the refrigerator that needs urgent attention. With shared equity, however, tenants have their own interest in keeping the property in shape, whether they exercise their purchasing option or agree to sell the property with you. The tenant has become tenant-owner, and they should be expected to provide most of the day-to-day repair work, like lawn care. So, you won’t be getting calls in the middle of the night about urgent repairs! In addition, they are less likely to cause damage to floors, walls, or other parts of the property because increasing the property’s value is now their goal as well as yours.
  • You don’t have to worry about vacancies, which cost you money. Aside from the lost influx of money, you’re also out the money and time spent finding a new tenant and preparing the property for them. If vacancy goes on for several months or more, it’s going to cost you a lot, but a rent-to-own situation ensures that your tenant is in for the long-haul. They’re not likely to just give up their share of the equity in a home they live in.
  • You have no management fees. Management fees are an optional expense, but for many landlords it becomes necessary, especially if you have another job or business. Typically, management companies are hired to take care of things like property inspection, advertising for tenants, and providing or scheduling repairs. With your tenant-owner, none of this is necessary. You have a long-term renter who will more than likely take good care of the property themselves.
  • You tenant has more reason to make their payments on time every month. In a shared equity situation, your tenant is paying towards an end-goal, whether it’s to own the property in entirety or to own their share of the equity at the time of sale. This means that for the duration of the agreement, you know how much rent you will receive and for how long. You also know the possible scenarios for when the rental term comes to an end. Basically, you have a much better idea of your financial outcome than most landlords do.

Your Tax Situation

But, what about the taxes? Here’s something you don’t hear very often. Tax law regarding shared equity is very straightforward. In fact, for the more than 30 years it’s been on the books, there’s only one private letter ruling to use as an example (PLR 8410038). In this ruling, the landlord made a 20 percent down payment and took half the mortgage; the tenant took the other half. At the end of five years, their agreement allowed for the tenant to buy out the landlord by 1) reimbursing the down payment and 2) paying 50 percent of what the equity increased by since the beginning of the agreement to the landlord. During those five years, the tenant paid the landlord both a rental fee and 50 percent of the mortgage.

The sharing of expenses is, likewise, straightforward and laid out in tax law. Any tax benefits must be divided according to ownership interest. In the above case, both the landlord and the tenant-owner would receive 50 percent of the tax benefits.[2] In addition, for most shared equity situations, the relationship between parties is considered tenants-in-common. That means you’ll have to follow state tax laws, which typically require expenses such as repairs, taxes, and interest to also be divided according to ownership interest. Since your tenant will likely be completing repairs, they do have the right to request reimbursement from you for half the cost. Regardless of whether they pay 50 percent or 100 percent, the tenant only gets tax benefits for their vested interest (as do you).[3] Of course, you’ll want to check your particular state’s tax laws in this area.

Pay attention to how you agree to divide expenses in your equity-share agreement. In one court case, the landlord owned 50 percent of the equity but paid 100 percent of mortgage interest and property taxes on two properties.[4] It didn’t matter how much he paid; he could only deduct 50 percent from his taxes. Just because each party pays 50 percent of the mortgage doesn’t necessarily mean your ownership percentage is 50 percent each. Other factors, such as down payment, can come into play. Always check with an attorney when signing an equity-share agreement.

Calculating the Rent

Tax law also specifies that you and your tenant will need to come to a rental agreement based upon “fair market rent”.[5] All of this planning in advance should make you one happy landlord. You’re getting a written guarantee of how much cash you’ll be receiving for years to come.

As you know, any situation that deals with tax law requires proper documentation. So, be sure to keep a file with all the necessary information. One thing you will need to provide is evidence that your rent price is fair. Some ways to do this are to clip ads for other rentals in the area, print online ads for your area, get a written opinion from a consultant or rental management company, or get information from nearby tenants on what they pay for rent (including their names).

You’ll probably do some of this research anyway in order to come to your determination. The key is to hang on to your research documents. Research you performed but didn’t document don’t count for anything with the IRS, and as landlord, you bear the burden of evidence.

Following the Rules

Once you’ve found the perfect tenant-partner, you’ll want to follow three rules in order to comply with tax law.

  1. The equity-share arrangement must be detailed in a written agreement.[6] This document must include details regarding ownership of the residence by two or more people; agreement that one of the parties must occupy the dwelling as their primary residence; and, agreement to rent payment.
  2. The relationship must be one of joint ownership. According to tax law, both parties will own the property even after the rental period ends. The tax law technically stipulates a period of 50 years of ownership, but what you really need to know is that you both must, in fact, own the property.[7]
  3. Tax benefits are earned according to ownership. As stated above, you can only claim benefits for your share of ownership in the property.

Before entering a shared equity situation, plan accordingly. You’ll want to choose someone trustworthy to enter into a long-term ownership with. Hire a real estate attorney to help make sure you consider all the possible scenarios, and get everything in writing. And, always, always keep your records. If you do rent-to-own right, you can make renting your property both easier and more profitable.

  1. IRC Section 280A(d)(3)(C)(ii)(I). ↑
  2. Prop. Reg. Sections 1.280A-1(e)(5)(iii)(B)(3); 1.280A-1(e)(5)(iii)(C) Example. ↑
  3. Estate of Boyd v. Commr., 28 T.C. 564 (1957). ↑
  4. Joseph J. James v Commr., TC Memo 1995-562. ↑
  5. IRC Section 280A(d)(3)(B)(ii). ↑
  6. IRC Section 280A(d)(3)(C). ↑
  7. IRC Section 280A(d)(3)(D). ↑
Categories : Investments, Leases, Real Estate, Rental Properties, Shared Equity, 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

Increase Deductions on Your Vacation Home with a Hidden Tax Technique

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

Usually, when you want to research which tax deductions are available to you, you go to the IRS’s publications and tax regulations documents. The IRS can even be pretty helpful at times by letting you know exactly what you need to do in order to get your deductions. However, the technique in this article won’t be found in any of the typical tax literature. In fact, you’d only find it if you’ve been reading up on old court cases or tax treatises.

The Precedent

So, how does this tax tactic help you if it’s not approved in IRS documents? Aside from the typical sources for supporting your deduction strategies, you can also use tax court precedents. In 1981, Dorance and Helen Bolton found their money trapped behind vacation home deduction limits, but they decided to get creative and find a way around those limits.

Because they set this precedent, you can legally use the same technique today, even though the IRS doesn’t publicize it for everyone’s use. In fact, the IRS’s calculation methods for vacation homes are much more stringent. Nevertheless, the IRS is required to allow the method used by the Boltons because the tax court has ruled it a legal tax strategy.

How this Money-Saving Strategy Works

Do you have a second home, a ski cabin or beach house for example, that you both rent out and use for your personal use? If so, you’ve probably found that the vacation home rules cap the deductions allowed for rental expenses.[1] Additionally, for properties that qualify as a “residence” those rules are at their most stringent. Your property is considered a residence for tax purposes if you take advantage of its personal use for the greater of the following two time periods:[2]

  • More than 14 days in a year, or
  • More than 10 percent of the days you rent it at fair rental price during the year.

You see, when your home qualifies as a residence, you have to split your deductions between residence and rental property, and that creates two primary disadvantages for you: 1) your rental expenses are limited to your rental income, and 2) part of your mortgage interest and property tax deductions are considered rental expenses, which—because of the limit in #1—reduces the amount of other rental expenses you are able to deduct.

Now, here’s what the Boltons did to mitigate these disadvantages. They were able to come up with a way to decrease the amount of mortgage interest and property taxes that counted as rental expenses. Let’s take a look at how their method differs from that of the IRS:

  • IRS Method—Count the property’s total use. That means of your tenants rent the property for 75 days and you personally use it for 25, you divide the rental use days by the total number of days, 100. The use percentages divide up as 75 percent rental and 25 percent personal. Assuming your mortgage interest and property taxes come to $10,000, you must count $7,500 (i.e. 75 percent of $10,000) towards the rental expense limit.
  • Bolton Method—Determine percentages for the entire year, not just for days of use. With this calculation, you take that same 75 days of rental use and divide it by 365 days, giving you only 21 percent rental use for the year. Again, given $10,000 in mortgage interest and property taxes, you now take 21 percent of that, getting a rental expense total of only $2,100. The Bolton method leaves you with an additional $5,400 of rental expenses that can be deducted.

To see how the numbers work out after deductions, here’s the Boltons’ case:[3]

  • 91 days of rental use
  • 30 days of personal use
  • 244 unoccupied days
  • $2,700 in gross rental income
  • $3,475 in expenses for mortgage interest and property taxes
  • $2,693 in expenses for rental property maintenance

The Boltons were able to claim an additional $1,738 in deductions. Adjusting for today’s dollars, you can save substantially more than that. This case has been on the books for more than 30 years and remains seldom-used, but the IRS is required by precedent tax law to allow it.[4] Now you know the secret, so start claiming your full rental deductions on your vacation home this year.

  1. IRC Section 280A(e). ↑
  2. IRC Section 280A(c)(5) and (d)(1). ↑
  3. Bolton v Commr., 77 TC 104, aff’d 694 F.2d 556 (9th Cir.). ↑
  4. McKinney v Commr., 732 F.2d 414. ↑
Categories : Investments, Leases, Passive Income & Losses, Real Estate, Rental Properties, Tax Planning, Vacation Homes

Getting the Most from Your Real Estate Options

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

Plenty of people will tell you that real estate options are a great way to make money. And, that can be true . . . if you have the right knowledge. By learning how to get the most from options on your real estate investments and rentals, you can increase your profits.

Stand-Alone Purchase Option

One category that can generate profit is the stand-alone purchase option. If you own a property, and someone would like the right to buy that property at a specific price and over a specific time period, this option allows you to receive cash from someone the day you authorize the option. Two things then may happen: 1) the buyer lets the option lapse, and you keep the cash and the property, or 2) the option is exercised, which means you sold your property (and often receive a selling-price bonus).

Here are some of the primary financial reasons people have for leasing their property with the option to buy:

  • Increase profits by fixing a higher rent price (typically applying some of this to the option amount).
  • Increase profits by requiring up-front cash for the option.
  • Protect your real estate by having a tenant who takes better care of the property (because it may eventually be theirs if they use the option).
  • Reduce costs by requiring the tenant to maintain the property and take responsibility for repair work.

Of course, if you are on the other side of the transaction and are buying the option, then you’ll want to arrange some kind of reward for yourself should you use the option. Often, people like to structure these options so that they get a better price on the property because they exercised the option (this is the most desirable outcome for the buyer).

Whether you’re buying or selling, options look pretty straightforward, but circumstances can complicate matters. Some options are structured to require that they be exercised. However, if you enter into such an option, it is viewed as a sales contract under tax law. If, for example, the rent for an option is so high that it forces a tenant to buy, tax law ignores the option, and your contract ends up as a sales contract as far as tax purposes are concerned. It turns out options are not as simple as they appear; varying scenarios can butt up against tax and legal obstacles.

In fact, even a lease without the option to buy can end up being viewed as a sale under tax law. How does this happen? If the tenant takes on the majority of rights, responsibilities, and enjoyment to the extent that they act as the owner of the property, the IRS ignores the lease.

Needless to say, it can come as quite a surprise when the IRS decides your lease is to be considered a sale. So, this article aims to provide some practical advice for securing your after-tax profits and navigating the additional rules associated with leases.

Keeping Control of Your Finances

Your after-tax financial results will depend upon how well you understand the rules regarding when a lease with an option to buy turns into a sale. The rules fall into three categories: 1) commercial real property, 2) personal property, and 3) a house or apartment used as the primary residence by the tenant.

By structuring your rent-to-own agreements so that they comply with tax law, you can avoid unpleasant legalities. These legal situations can result in additional consequences, such as negative articles on the front page of national newspapers, an attorney general investigation if you’re under Florida jurisdiction, or corrective legislation in a Texas jurisdiction.

Now that you have an idea of why you need to handle your options correctly, let’s look at a hypothetical scenario. You have a tenant who buys an option from you for $10,000 that allows her to buy your rental property for $300,000 at any point within the next 15 months. The tenant can do one of two things. She could exercise her option, in which case you treat the $10,000 as sales proceeds on the day the purchase option is used.[1] Or, she could choose not to use the purchase option, and you receive normal income from the $10,000 on the day the option lapses.[2]

Regardless of what your tenant decides, you get a good deal for several reasons:

  • You receive up-front payment for the option.
  • You can use the cash from purchase of the option on the day you receive it because it’s yours no matter which decision the tenant eventually makes.
  • You have no income taxes to pay for this money until the option lapses or is used.

As for your tenant, if she decides to exercise the option, the $10,000 acts as additional basis in the property for her. The lapse of the option depends on the nature of the property. If she intends to use it as a rental unit, the same rules apply that would apply to a loss on the sale of rental property.[3]

Given our hypothetical 15-month holding period, your tenant’s loss would be under Section 1231 (which applies only to long-term gains and losses). This is great for her because Section 1231 allows for:

  • Net section 1231 gains are tax-favored long-term capital gains, and
  • Net Section 1231 losses to be deducted as tax-favored ordinary losses.

However, if the tenant wanted to purchase the rental unit as a personal residence, she would not get the deduction for the option’s lapsing. That’s because a lapsed option for personal property generates a personal loss, which is not deductible.[4] So, options aren’t too difficult to figure out, but they can produce vastly different results under different circumstances.

Options that are Actually Conditional Sales

An option gives the purchaser the right to exercise a property purchase at terms and price that are determined at the start.[5] Some options, however, are actually masked sales. Obviously, any option that is exercised becomes a sale. But, if the option turns into a sale before it is exercised, then it is a sales contract rather than an option.

Here are a few examples that are not options:

  • Nonrefundable deposits—these do not specify terms for a continuing offer for a particular time period
  • High option prices that force the use of the option—the force makes it a sale from its beginning
  • Incidents of ownership and actions that convey possession imply a sale

You may have noticed that some of these are judged by the particular circumstances. For instance, what is considered a price that’s high enough to force a sale is somewhat subjective and depends upon the property and the parties involved. Because of this, issues of what is a sale or what is an option can be complicated. To add to the matter, an option that includes a lease gets even trickier.

In fact, sometimes the lease itself is considered a sale rather than a lease. That means you can really end up with results far different from what you intended when you combine a lease with an option, and either or both of them could end up actually being sales.

When it comes to taxes, a whole system of rules is in place to determine whether a lease is a lease or a sale. Here’s an example. Some public companies will use synthetic leases in order to make their profits look better to investors. These synthetic leases are reported as leases in their financial statements, but reported as purchases in their tax return. Because this strategy makes their profits look better, it increases the performance of the company’s stock. Because the tax return shows a purchase, the company can also depreciate the deductions.

Another example of a lease that’s considered a sale on taxes is a dealer’s rent-to-own program. One such contract’s status as a sale was determined in IRS private letter ruling 9338002. The IRS’s reasoning is that the lease-with-option-to-buy compels customers to make each of the monthly payments so they can own the item. Additionally, payments in such cases are usually high enough that customers pay market value for the item early on, at which point it makes no sense for them not to continue paying until they own the item. In fact, the IRS ruling states that such contracts produce substantially more revenue than if customers bought the item outright.

According to the IRS, the dealer does not have a true lease for tax purposes because:

  • The customer is effectively required to make a purchase by agreeing to the contract,
  • The rental payments end up far exceeding the amount necessary to transfer the title, and
  • The option price is zero, which contributes nothing towards the item’s fair value when the option is exercised (completion of payments).

The same set of criteria are used when judging real property leases.[6] First of all, the IRS defines three parties in a leveraged lease—the lessor, the lessee, and the lender to the lessor. The IRS will look at the following criteria to determine whether a lease is really a lease:[7]

  • The landlord (lessor) is at least 20 percent invested in the property;
  • The renter (lessee) cannot purchase the property for less than fair market value when the option is used; and
  • The lessee cannot have paid for property modifications, improvements, or additions.

Sometimes these criteria are out of your control. For example, it’s possible that after agreeing to an option, your property dramatically increases in value. That means that when the option is exercised, it will no longer reflect the fair market value, and does not meet the second criterion above. You should also watch out for vacation home tax rules, which you can run into when renting out a property, and are quite different from the tax laws for options.[8]

The purpose of setting up a lease with the option to buy is for you, as the current property owner, to make more money and ensure that your real estate is well care for by the tenant. In order to gain the financial benefits, you’ll need to understand the tax laws surrounding options. So, for your convenience, here’s a bit of advice for meeting the six standards in Revenue Ruling 55-540 and those in Revenue Procedure 2001-28:

  • Don’t apply the tenant’s rent to lessee equity.
  • Don’t give the property title to the lessee in exchange for a certain amount of rents or payments made.
  • If the option is relatively short, don’t make the payments a large portion of the total price to be paid.
  • Don’t allow rent prices to exceed fair market value substantially.
  • Don’t put add an interest equivalent to the rent due.
  • Have at least 20 percent invested in the property.
  • Require the option exercise price to be at least fair market value.
  • Don’t allow the lessee to make property modifications, improvements, or additions.

Take the right precautions, and you’re more likely for an IRS judgment to go the way you planned.

  1. IRC Section 1234(a)(1). ↑
  2. Reg. Section 1.1234-1(b). ↑
  3. Reg. Section 1.1234-1(a)(1). ↑
  4. Reg. Sections 1.1234-1(f); 1.1234-1(g) Example (2). ↑
  5. Black’s Law Dictionary, sixth edition, p. 1094. ↑
  6. Revenue Ruling 55-540 ↑
  7. Revenue procedure 2001-28 ↑
  8. IRC Section 280A(d)(2). ↑
Categories : Investments, Land, Leases, Real Estate, Tax Planning

Tax Topics