IRS Best Kept Secret- Major Tax Strategies
DEDUCTING ACCRUED INTEREST WHEN YOU’RE ON THE CASH BASIS
Some consider accrued interest to be the single most important deduction in apartment investing. However, many taxpayers are on the cash basis and can’t benefit from it unless they file on the accrual basis. The IRS has to be notified when this change is made, and there are restrictions. This area of real estate tax law is not well known. The requirements necessary to deduct accrued interest when you’re on the cash basis include considerations of:
• The all-events test and economic performance
• Accounting method
The All-Events Test and Economic Performance
In general, accrued interest expenses are not deductible for cash-basis taxpayers unless the accrual method of accounting is used and the all-events test is met, but not earlier than when economic performance with respect to when such items occur (Code Sec. 461[h]). The all-events test is met if all events have occurred that determine the fact of liability and the amount with reasonable accuracy.
Economic performance has special rules for tax shelters. Any entity, if more than 35 percent of its losses are allocable or any investment plan, the principal purpose of which is the avoidance or evasion of federal income tax (Code Sec. 461 [i]), is considered to be a tax shelter. Also, under the 1986 Tax Reform Act Code Sec. 448, a tax shelter may not compute its taxable income on the cash basis. Once under the tax shelter rules, the recurring item exception under economic performance does not apply. Generally, economic performance occurs within the shorter of a reasonable period after the close of such taxable year or eight and one-half months after the close of such taxable year. Economic performance occurs for a tax shelter at the time the property is pro-vided to the taxpayer by another person (Code Sec. 461 [h]  [ii]).
Accrued interest expense will qualify for the deduction at the time the apartment is purchased from the seller. Because (1) the property is purchased from another party, (2) the fact of the liability has been deter-mined with reasonable accuracy, and (3) economic performance occurs since the seller provides the property to the buyers.
Can an individual use the accrual method of accounting whose over-all method is on the cash basis? The code specifically provides that the IRS commissioner’s consent must be obtained before changing the method of accounting (Code Sec. 446 [e]). However, the regulations also provide that the first tax return on which the item involved is reported may incorporate any appropriate method of accounting without the commissioner’s consent. A taxpayer may adopt any permissible method of accounting in connection with each separate and distinct trade or business, the income from which is reported for the first time (Reg. 44-1[e] ). In addition, where a taxpayer has two or more separate and distinct trades or business, a different method of accounting may be used for each trade or business, provided the method used clearly reflects the income of that particular trade or business.
The method first used in accounting business income and deductions in connection with each trade or business, as evidenced in the taxpayer’s income tax return in which such income or deduction is first reported, must be consistently followed thereafter. No trade or business will be considered separate and distinct unless a complete and separate set of books and records are kept for such trade or business. Also, if by reason of maintaining different methods of accounting, there is a creation of shifting of profits or losses between trades or businesses of the taxpayer so that income of the taxpayer is not clearly reflected, the trades or businesses of the taxpayer will not be considered to be separate and distinct (Reg. 1.466.1 [d]). If the above rules are satisfied, the rental activity qualifies as a distinct trade or business; then the “change in method of accounting” rules will not apply since the activity involved will be reported for the first time. Consequently, the overall cash method of accounting for the individual doesn’t have to be changed.
It is important that a rental activity qualify within the definition of a trade or business. Neither the law nor the regulations provide a clear definition of what is meant by a “trade or business.” This is because no one definition can consistently apply to all situations. There are how-ever various tax cases that support rental property as being a trade or business (Hazard and Lagreide). Management activity and owner ship along with specific facts will determine this issue.
The investment interest deduction is limited to the taxpayer’s net investment income for the taxable year (Code Sec. 163 [d] ). However, under Code Sec. 162 (d)(3)(B), the term investment interest does not include any interest taken into account under Code Sec. 469 in computing income or loss from a passive activity. What is considered a passive activity? Any activity that involves the conduct of a trade or business and which the taxpayer does not materially participate (Code Sec. 469 [c] ) is passive activity. In addition, the definition includes any rental activity, whether or not the taxpayer materially participates (Code Sec. 469 [c] ).Rental activity is considered a passive activity. Under these rules, deductions from passive trade or business activities to the extent that they exceed income from all such passive activities generally may not be de-ducted from other income. However, relief is provided for rental real estate activities in which the taxpayer actively participates. If an individual qualifies under the active participation rules, up to $25,000 of passive losses can be deducted against income from non passive sources subject to the phase out previously mentioned.
YOU SHOULD ALWAYS DEFER PAYING TAXES
As a rule of thumb, it is best to defer payment of taxes to a later date because:
•You’ll be paying with inflated dollars. During periods of inflation, obligations paid at a later date are, in effect, paid with inflated dollars. For example, if a $100 tax bill can be deferred for five years, the purchasing power of those dollars, when paid, will only be worth $75 (assuming a 5 percent annual inflation).The IRS’s loss can be your gain if you’ve invested wisely during those five years.
•More investment dollars will be at your disposal. The fewer dollars expended for taxes, the more will be available to investments. “Before tax dollars” investments will net a higher rate of return than those made with “after tax dollars.” Simply, you have more money to work with. In a tax-deferred exchange involving “gross equities,” more investment dollars are available to work with to substantially increase your net worth.
•The government giveth and taketh away. Take advantage of every-thing and anything the IRS gives you whenever it’s given. You’ll never know whether or not it’ll be taken back. This has always been my philosophy. Make it yours, too.
HOW TO NOT PAY ANY TAXES ON CAPITAL GAINS
Based on a new tax law, you can avoid capital gains on the sale of apartment investments if you follow these strategies. Example one: If you have a rental income property and you sell it for$3 million and your cost is $1.5 million, your profit will be $1.5 million. Your taxes on the profit will be between $500,000 and $700,000. You and your spouse or significant other can avoid paying those taxes by trading for three single-family rental properties—Property A, Property B, and Property C. You then rent them out. If you try to rent Property A and you can’t, live in it for two years and sell it, the $500,000 profit based on the new tax law, is excluded. Then you move to Property B and live in it two years. When you sell it, you do not pay any taxes on the $500,000.Then, live in Property C for two years. Sell it and you don’t have to pay any taxes on the $500,000 either.
Example two: Sell your rental income property for $3 million to a limited partnership whose partners are not blood relatives. Take $1 down and a note for $2,999,999. The tax on that dollar is 33 percent. The limited partnership sells the apartment investment property for fair market value to an unrelated third party for $3 million. The tax is zero because the basis is $3 million. The partnership can pay you installment principal payments on your note, and you’d be paying percent taxes on that profit. But you’d bespreading income over a number of years. You can gift portions of that note to individuals, thereby spreading the income over entities. Or you can leave it in your estate; it is possible that you will not have to pay taxes on it at all.
New IRS tax laws allow you to take what’s called catch-up depreciation deductions that you have not previously taken. This procedure allows you to take the entire deduction on your real estate investment in the current year. The election must be made in the first half of the tax year in which the catch-up deduction will be taken. This method benefits anyone who is allowed to take a depreciation deduction. For example, if you didn’t take deductions in the prior years for one reason or another, and you decide, based on your in-come, to offset an anticipated increase in income with catch-up depreciation, you may do so. This is called grouping income and deductions.
LANDLORD/LEASEE TAX STRATEGIES
Instead of paying for the lease improvements, have your landlord pay for any lease improvements. The landlord can write these lease improvements off on your real estate investment over a 39-year period. If you made the lease improvements and paid the cost of the improvements, you would have to write them off over 39 years. To increase the deduction, pay for the cost of these improvements by increasing the rent. Therefore, you’re accelerating the rent expense instead of deducting the lease improvements over39 years. The landlord is reimbursed for the improvements in the form of rent payments and also enjoys the annual deduction for the appreciation. Instead of spreading the cost of these improvements over 39 years, you’re actually spreading them over the life of the lease which could be less than 39 years.
HOW TO MAKE A TAX DEDUCTIBLE GIFT
If you give your children a gift every year for tax purposes, it is not deductible. But you can instead treat your child’s home as your second home and make the mortgage payment on it. This only applies if you don’t own a second home yourself. The same strategy can be used to make gifts to your parents or certain other family members. Make the home mortgage payments for them and deduct the mortgage interest portion of the payment on your tax return. This will free up cash for your children or parents that they would otherwise have used for mort-gage payments. In this way, you’re indirectly making a tax-deductible gift to your children. Interest payments must be legally enforceable debt; therefore, you must co-sign the loan. This strategy is called spreading the income and deductions to entities. If your family members are in a higher income bracket, it won’t work. It doesn’t have to be made on the same house each year. For example, if you have five family members and you co-sign on all five loans, you can make loan payments in any one year to any one of the five. Children are not the only ones who qualify. You can also have this arrangement for your parents, grandparents, grandchildren, or your brother or sister.
GIVE THE BOOT TO BOOT
Based on an IRS revenue ruling, it is now possible to offset boot (see Glossary) with other transactional expenses. For example, if an investor traded down his real estate investment from a $500,000 property to a $400,000 property, a $100,000 boot would be recognized. When the transaction is reported, he automatically reduced the amount of the $100,000 boot by all transitional cost, such as commissions and other closing costs incurred.
UNLIMITED REAL ESTATE INVESTMENT LOSSES FOR
REAL ESTATE PROFESSIONALS
The new law now makes individuals eligible to deduct real estate losses if:
1. More than half of all personal services they perform during the year are for real estate trade or businesses in which they materially participate.
2. They perform more than 750 hours of service per year in those real estate activities.
Unlimited loss deductions are adjustment to adjusted gross income (AGI), and they’re not subject to the same limitations as deductions from adjusted gross income. Rules in a calculation can be complicated. For a specific advice, it’s recommended that you contact your accountant or your tax attorney.
LIKE-KIND EXCHANGES INCLUDE LEASES
General short-term leases (less than 30) do not constitute a like-kind ex-change with real estate property. However, lease hold interest with 30 years or more remaining at the time of transfer may be treated as a like-kind interest for the purpose of the 1031 tax-deferred exchange (see next section). Tax considerations may vary based on who gives and receives the lease as to rents and the nature of the transaction. Arrange the lease to be initially six years with five additional renewal options. The options are exercisable without obtaining consent from the lessor.
A fantastic way to take all of your profits from a sale of mid size apartments and put it into a new property without having to initially pay taxes is done through 1031 tax-deferred exchange. Funds from the sale should be held by a qualified intermediary or an accommodator until the exchange transaction is complete and the requirements have been met. You have 45days from the date escrow closes to identify an “up property” and 180 days to complete the exchange. The 180 days includes the 45-day identification period. If you receive cash or reduction in the mortgages, it’s considered boot and you have to pay capital gains taxes on it. One of the advantages of doing a tax-free exchange is that you retain more of the funds for investment and defer taxes to a later date. Postponing the taxes is a good investment tax strategy because, when the taxes are finally paid, they’re generally paid with inflationary dollars. The longer the payment is delayed, the lower the present value of the taxes and the larger the benefit of the deferment. Also, when the property is transferred at death, the basis is adjusted to current market values, thus all or mostly all of the deferred capital gains tax liabilities can be eliminated.
The IRS allows investors to do a tax-deferred exchange in reverse. Basically the guidelines are the same as a forward exchange. The reverse ex-change avoids both time and constraints by closing the purchase of the replacement property prior to the sale of the existing property. In doing a forward exchange, the investor cannot take control of the proceeds or the exchanged property. The accommodator takes control of the property and the proceeds. Basically, the “up property” is purchased prior to selling the existing property. The forward exchange and the reverse exchange are complicated and we recommend that you use the services of a qualified accountant or attorney and a qualified intermediary or an accommodator.
DEPRECIATING LAND COST
The cost of land cannot be written off for tax purposes until the land is sold. Yet under certain conditions, some land improvements can be depreciated over 15 years. This depreciation deduction can provide substantial tax savings.
Not all real estate property is real estate under Modified Accelerated Cost Recovery System (MACRS). For example, single-purpose agricultural structures are in the seven-year class. More importantly, land improvements are not included in the definition of 27.5-year residential property. Land improvements such as parking lots, sidewalks, roads, landscaping and fences have a 20-year midpoint, and are 15-year recovery properties under MARCS. Thus land improvements, a major expense of any large project appear to qualify for 150 percent declining balance recovery over a 15-year period.
PAYING CAPITAL GAINS...A GOOD STRATEGY
The capital gains rates at this printing are being reduced from 20 percent to 15 percent. It just might be wise for the real estate investor to pay the capital gains and take a greater basis for the depreciation deduction on the “up property.” This should be considered in your tax planning. On the other hand, if you happen to be in the 10 percent to 15 percent regular income tax bracket, the rate for capital gains starts at 8 percent. For assets held for at least a five-year period and sold after December 31, 2000, it might behoove you to just pay the capital gains taxes at the lower rate and not be subjected to the time constraints of a 1031 tax-deferred exchange. You might possibly find a much better deal given enough time.
This is by no means a complete guide to real estate taxation. Its primary purpose is to make you aware of areas in the tax codes that are important to investing in apartment buildings.
Choose a tax consultant knowledgeable in real estate taxation. The explanation of accrued interest is comprehensive because of its significance in tax savings. References to IRS codes will be of assistance toy our tax advisor.
Whenever you can get the IRS to underwrite your investment, you’ll be money ahead. When you apply this strategy, you’ll be working with what is known as “soft dollars.” This simply means that the IRS is paying for your investment, and the “hard dollars” (your own money) ex-pended will be fewer. Never forget, however, the IRS has the divine authority to broadly interpret the tax strategies and reserves this consecrated right to draw diverse conclusions.