Archive for Rental Real Estate
You are allowed deductions for ordinary and necessary expenses incurred in the course of business under §162, but you must also keep adequate records to substantiate expenses which can at times seem esoteric if not convoluted. Deductible travel expenses for example under §274(d) are based on whether or not the travel relates to a business activity or is for pleasure, while §162(a)(2) specifically states the amounts cannot be lavish or extravagant under the circumstances.
No single factor or set of factors can determine if you are engaged in a business activity for profit, but all facts and circumstances must be taken into account §183-2(b). Three common questions are considered when determining whether or not the activity is for profit or a hobby subject to the hobby loss rules under §183.
• Did you conduct the activity in a manner similar to comparable activities that are profitable?
• Did you maintain complete and accurate books and records for the activity?
• Did you change operating procedures, adopt new techniques or abandon unprofitable methods to ensure profitability of the activity?
According to Douglas Rundlett, et ux. v. Commissioner TC Memo 2011-22, even though you may conducted an activity in a businesslike manner you should also demonstrate that you adopt new techniques or strategies to limit future losses or risk being viewed as being engaged in a not for profit activity or hobby.
Under §1221(a)(1), property held by a taxpayer primarily for sale to customers in the ordinary course of a trade or business is excluded from the definition of a capital asset. Accordingly, if you by acreage to subdivide, develop and sell, the transaction would not meet the definition of a capital asset under §1221(a)(1) since his purpose was to sell the subdivided lots.
In Mathews v. Commissioner the Tax Court held that a taxpayer may hold land primarily for sale to customers in the ordinary course of a trade or business and hold other land as investment at the same time. In order to determine if land is held for investment or for sale to customers in the ordinary course of a trade or business, certain factors need to be considered. While no single factor or combination of factors is determinative, the Court has considered factors such as:
• The purpose for which the property was acquired.
• The purpose for which the property was held.
• The extent of improvements that were made to the property by the taxpayer.
• The frequency, number and continuity of sales by the taxpayer.
• The number, frequency and substantiality of sales.
• The nature and extent of the taxpayer’s business.
• The extent or lack of advertising to promote sales.
• The extent of listing property for sale directly or through brokers.
The Tax Court was persuaded that the taxpayer intended to use the lots for his multifamily rental activity and not for his building and selling activity. Therefore, the three lots in question were considered to be capital assets, which generated a short-term capital gain when sold. This gain was not subject to self-employment tax.
Pre-production costs of a property are required to be capitalized under §263A. Interest, however, is not required to be capitalized under §263A(f) until physical production begins. Physical production activities do not include planning and design activities. Therefore, the mortgage interest expense was not required to be capitalized pursuant to §263A(f).
Generally co-ownership in rental property does not require the formation of a partnership when the following conditions are met.
1. Each co-owner must hold title to the property as a tenant in common (TIC) under local law. This usually doesn’t apply community property. Although the title to the property can’t be held by an entity, an individual tenant-in-common should be able to own his TIC interest through a single member limited liability company (SMLLC). A co-owner is defined as any person that owns an interest in the property as a tenant in common.
2. The number of co-owners cannot exceed 35 people as per Code Sec. 7701(a)(1). A husband and wife are treated as a single person and all persons who acquire interests from a co-owner by inheritance are treated as a single person.
3. The co-ownership must not execute a partnership agreement and the co-owners must not hold themselves out as having formed a partnership or other form of business entity. In addition, the co-owners must not have held interests in the property through a partnership or corporation immediately before the formation of the co-ownership.
4. The co-owners may enter into a limited co-ownership agreement that may run with the land and the co-owners must retain certain voting rights. However certain restrictions on the alienation of a co-owner’s interest are allowed.
5. If the co-tenancy property is sold, any debt secured by a blanket lien must be satisfied and the remaining sales proceeds distributed to the co-owners.
6. Each co-owner must share in all revenues generated by the property and all related costs in proportion to the co-owner’s undivided interest in the co-tenancy property. For example the co-owners must share in any indebtedness secured by a blanket lien in proportion to their undivided interests.
7. A co-owner may issue an option to purchase another co-owner’s undivided interest, provided that the exercise price reflects the fair market value of the co-tenancy property at the time the option is exercised.
8. The co-owners’ activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property.
9. The co-owners can make management or brokerage agreements that are renewable annually or longer.
10. All leasing arrangements must be legitimate leases for federal tax purposes. Rents paid by a lessee must reflect the fair market value for the use of the property.
11. The lender on any debt that encumbers the property or on any debt incurred to acquire an undivided interest in the property is not a related person to any co-owner, the sponsor, the manager, or any lessee of the property. This is where many people seem to get dinged particularly when a parent or other related party lends money to a child so that the child can buy an undivided interest in the property even if the parent isn’t a co-owner.
A related person is a person bearing a relationship described in Code Sec. 267(b) which bars the deduction of losses on sales to related persons or Code Sec. 707(b)(1) which bars losses on sales between partnerships and controlling partners or related partnerships.
12. The amount of any payment to the sponsor for the acquisition of a co-ownership interest reflects the fair market value of the acquired co-ownership interest and does not depend on the income or profits derived by any person from the property. A sponsor is any person who divides a single interest in the property into multiple co-ownership interests for the purpose of offering those interests for sale.
The point of this post is that because partnership interests are not eligible for like-kind exchanges when co-owning real estate it is important to understand the interests of the other co-owners before engaging.
Generally you are eligible to exclude the gain from income if you have owned and used your home as your main home for two years out of the five years prior to the date of its sale.
If you have a gain from the sale of your main home, you may be able to exclude up to $250,000 of the gain from your income ($500,000 on a joint return in most cases).
You are not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home.
If you can exclude all of the gain, you do not need to report the sale on your tax return.
If you have a gain that cannot be excluded, it is taxable. You must report it on Form 1040, Schedule D, Capital Gains and Losses.
You cannot deduct a loss from the sale of your main home.
Worksheets are included in IRS Publication 523, Selling Your Home, to help you figure the adjusted basis of the home you sold, the gain (or loss) on the sale, and the gain that you can exclude.
If you have more than one home, you can exclude a gain only from the sale of your main home. You must pay tax on the gain from selling any other home. If you have two homes and live in both of them, your main home is ordinarily the one you live in most of the time.
If you received the first-time homebuyer credit and within 36 months of the date of purchase, the property is no longer used as your principal residence, you are required to repay the credit. Repayment of the full credit is due with the income tax return for the year the home ceased to be your principal residence, using IRS Form 5405, First-Time Homebuyer Credit and Repayment of the Credit. The full amount of the credit is reflected as additional tax on that year’s tax return.
When you move, be sure to update your address with the IRS and the U.S. Postal Service to ensure you receive refunds or correspondence from the IRS. Use IRS Form 8822, Change of Address, to notify the IRS of your address change.
When a rental home secured by a recourse loan is sold short you incur a loss on the disposition of the rental properties requiring the report of a sale as well as any income from the cancellation of debt. The cancellation of debt income is excluded from gross income to the extent you demonstrate insolvency. If for example you demonstrate insolvency in excess of the debt cancelled, none of the cancellation of debt income is included in gross income. Instead, IRS Form 982 Reduction of Tax Attributes Due to Discharge of Indebtedness but not below zero.
A worksheet for determining insolvency is available in IRS Publication 4681 – Canceled Debts, Foreclosures, Repossessions, and Abandonment.
If you do not qualify for cancellation of debt income exclusion, the cancelled debt that is included in gross income is reported on IRS Form 1040, Schedule E, line 3. Attach a statement that explains that the entry reported includes both regular rental income as well as cancellation of debt income.
A foreclosure on rental property technically involves the sale of the property back to the lender. Form 1099-A Acquisition or Abandonment of Secured Property reports that the lender has repossessed or foreclosed on the property. Box 2 is the amount of the outstanding mortgage debt, and box 4 is the fair market value of the property. If the value of the foreclosed property exceeds the amount of outstanding debt, the debt is considered fully satisfied because the value of the property exceeds the outstanding debt meaning that there would be no debt to cancel after the lender acquires the property.
However if the lender also cancels debt associated with the transaction, there may be income to report from the cancellation of debt on IRS Form 1099-C.
When a foreclosed property is ‘sold’ back to the lender the gain or loss on that transaction is realized by the property owner or taxpayer. The gain or loss is the difference between the amount realized when the property is sold and the taxpayer’s adjusted basis or cost in purchasing and upgrading the property. IRS Publication 551 Basis of Assets is a good source of information on how the basis in the property might be increased or decreased during ownership.
The realized amount is contingent on whether the debt is recourse debt or non-recourse debt. If the debt is non-recourse debt the lender essentially cannot claim assets of the debtor if the secured property does not fully satisfy the outstanding debt. If the debt is recourse debt the lender essentially claims assets of the debtor when the secured property does not fully satisfy the outstanding debt. When the foreclosure involves recourse debt the amount realized is the smaller of the outstanding debt immediately before the foreclosure reduced by any amount of recourse debt for which the taxpayer was liable, or the fair market value of the property.
It is important to remember that Sec. 1245 property in the rental unit may be subject to depreciation recapture which is taxed as ordinary income and also that Sec. 1250 property does not necessarily require depreciation recapture particularly if the straight-line method is used. Sec. 1231 basically says that if the property is foreclosed or ‘sold’ at a loss, the loss is categorized as an ordinary loss not a capital loss.
The sale of the property is reported on IRS Form 4797 Sales of Business Property. The sale of the building is reported in Part I of Form 4797 if sold at a loss and in Part III if sold at a gain. Report the sale of the land separately in Part I, whether sold at a gain or loss. Any non-recaptured Sec. 1250 gain is entered in Part III of Schedule D Form 1040 Capital Gains and Losses.
A husband and wife formed a Limited Liability Corporation (LLC) that invests in rental real estate to protect themselves in event of a lawsuit. They want to know if they formed the most appropriate business structure and whether their rental activity is reported on IRS Form 1040 Schedule E. To answer this question I turned to my friend and all around great guy, Michael P. Merrion, who has supplied this blog its first guest post. Please contact me directly for information on how to reach out to him.
Pursuant to the rules of professional conduct set forth in US Treasury Department Circular 230 nothing contained in this blog was intended to be used by any taxpayer for the purpose of avoiding penalties that may be imposed by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.
This question raises a number of collateral issues which are not readily apparent from the skeletal statement of facts, but which require some consideration when addressing the underlying issues.
Income from a rental property owned by one person is generally reported on page 1 of Schedule E. The same is true if the rental property is owned by a husband and wife who elect to be treated as a single taxpayer by filing a joint return. However, if the property is owned by two or more persons who are not spouses, and who cannot therefore elect to file jointly, the reporting treatment depends upon the nature of the activity in the venture (addressed more fully below).
In the present case, however, the rental property is actually owned by the limited liability company which is, in turn, wholly owned by the spouses. This tiered ownership structure adds a level of complexity to the analysis. If only one spouse owned the entire LLC interest, then the LLC would be considered to be a “disregarded entity” for tax purposes and the rental activity would still be reported on page 1 of the Schedule E. However, if the LLC is owned by two persons, it is not considered to be “disregarded” and the LLC would have a separate tax filing requirement. In that case, each “partner” would receive a form k-1, and the income from the venture (partnership) would be reported on page 2 of the taxpayers’ Schedule E.
But wait! What if the only owners of the LLC holding the rental property are spouses who elect to be treated as one taxpayer (by filing jointly). Are they entitled to any special consideration in determining whether the interests must be reported as a separate entity? Sadly, they are not. With one notable exception, an LLC owned by two persons, regardless of their relationship, is considered a separate entity for filing purposes.
With regard to the “notable exception” mentioned above, one should note that the above discussion assumes that the spouses are not living in a community property state. The IRS has acknowledged that spouses living in a community property state may elect to treat their co-ownership of a business entity formed under the laws of that state as a disregarded entity for federal tax purposes. In this limited instance, the spouses could elect to disregard the entity in the same manner as a sole member of an LLC in any other state, and report the income on page 1 of Schedule E.
That said, there are several provisions in the Code and Regulations that raise interesting possibilities and to which one might be drawn when counseling the taxpayers in this case. The tempting nature of these provisions warrant some additional discussion.
Anytime there is an association of persons engaged in an endeavor, and the participants have not taken the additional step of formalizing the terms of the venture, perhaps with formal organization (i.e., a corporation or LLC), or simply with a formal document (partnership agreement, etc.), a certain amount of confusion must necessarily follow. It appears that the principal reason for the amount of confusion which typically accompanies an analysis of a client’s “joint venture” is the terminology itself. For tax purposes, the term “joint venture” has been defined as a “special combination of two or more persons, where in some specific venture a profit jointly sought without any actual partnership or corporation designation.” Thus, the tax compliance requirements which more naturally accompany the formal organization of a corporation or LLC, or even the imposition of a simple partnership agreement, become more obscure when dealing with a joint venture, or even mere co-ownership of property.
Under the “check-the-box” regulations, the default classification of a joint venture is a partnership. It is encouraging, however, that those regulations also acknowledge that mere co-ownership of property does not necessarily create a separate entity. Something more is needed to raise the ownership to the level of a reporting partnership. For example, mere cost sharing arrangements, or even co-ownership of property that is maintained, kept in good repair and rented does not constitute a separate entity for tax reporting purposes. But if the venture is a trade or business, or is a co-ownership venture which also provides services in connection with a mere rental activity (whether directly or through an agent), the venture assumes the mantle of a reporting entity. The problem in the case before us, is that there is no co-ownership of the rental property. It is clearly wholly owned by the LLC. The co-ownership is of the LLC, which is treated in much the same manner as that of co-ownership of a corporation.
Another tempting provision is contained in IRC §761(a), which provides a definition of what constitutes a partnership for federal tax filing purposes (including a “joint venture”), and also provides that members of an unincorporated organization may elect out of Subchapter K (partnership reporting requirements) in three limited instances, one of which arises where the venture is availed of for investment purposes only, and not for the active conduct of a business. This election requires that the co-owners (1) own the property as co-owners, (2) reserve the right separately to take or dispose of their shares of any property acquired or retained, and (3) do not actively conduct business (whether directly or through an agent). Again, the co-ownership requirement limits the application of the provision in this instance. The use of a state recognized entity such as a corporation or LLC disqualifies the taxpayer from using this provision.
There has also been some confusion regarding the application of the “Qualified Joint Venture” (“QJV”) rules of IRC §761(f) which became effective for tax years beginning after 12/31/2006 and which allow a husband and wife to report a jointly owned trade or business on separate schedule C’s rather than having to a separate file partnership return. This election is only available where (1) the only members of the joint venture are a husband and wife, (2) both spouses materially participate (within the meaning of IRC §469(h), i.e., the “passive activity rules”), and (3) both spouses elect the treatment. It also requires that the spouses be conducting a trade or business: mere joint ownership of property does not qualify for the election. In addition, the election to be treated as a QJV is not available when the venture is held in the name of a state law entity such as a partnership or LLC.
Thus, unless the owners elect some other entity classification under the “check-the-box” regulations, the spouses in our case will be required to file a partnership return for the LLC and each report their share of the financial activity of the LLC on page two of their joint Schedule E.
 Presumably, if the amount of rent related activity rises to the level of a trade or business, even rental income would be seen to be a trade or business, reportable on schedule C and subject to SE tax.
 See Treas. Reg. 301.7701-2(c)(2)(i).
 See Rev. Proc. 2002-69, 2002-2 CB 831 (10/9/2002).
 See Haley v. Commissioner, 203 F.2d 815, 818 (C.A. 5, 1953); Aiken Mills v. United States, 144 F.2d 23 (C.A. 4, 1944); Tompkins v. Commissioner, 97 F.2d 396 (C.A. 4, 1938).
 See Treas. Reg. 301.7701-1(a)(2).
 One sees this argument particularly in connection with like kind exchanges under IRC §1031, in cases where the “partners” wish to liquidate the property and some want to utilize the §1031 deferrals, while others just want to “cash-out.” This is a problem as the like-kind exchange can only be accomplished by the owner (i.e., the LLC) and will impact all of the partners in the same manner.
 We will ignore the other two instances where taxpayers can elect out of Subchapter K, as they are not relevant to this discussion.
 See Treas. Reg. 1.761-2(a)(2).
 An LLC owned by more than one person is treated as an “other business entity” pursuant to Treas. Reg. 301.7701-2(c), i.e., not a corporation and not a disregarded entity for tax purposes.
 Treas. Reg. 1.761-2(a)(1) specifically excludes from this election out of Subchapter K “Any syndicate, group, pool, or joint venture which is classifiable as an association, or any group operating under an agreement which creases an organization classifiable as an association.”
 There is an additional collateral issue if QJV spouses elect to treat rental properties as QJV’s. Since they are, in essence, taking the position that the activity constitutes a business reportable on schedule C, the question arises as to whether the net rental income is then taxable for self-employment purposes. In a 2008 Chief Counsel Advice (CCA 200816030, 4/18/2008), the IRS, deferring to IRC §1402(a)(1), has clarified that if income is otherwise excludible from net earnings from self-employment under §1402(a), the election of QJV status does not convert such income to net earnings from self-employment.
 See CCS 200816030, Ibid.
 See page 2 of the 2010 instructions for form 1065.