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by Paul D. Pearlstein (1)
This chapter will highlight a few of the basic tax laws that affect real estate. There will be no attempt to deal with the complexities of tax law in any great detail. However, a bibliography at the end of the chapter will point the reader toward a more sophisticated discussion of the various topics.
II. Taxes Affecting and Involving Home Ownership:
When purchasing a home there are a number of tax benefits that the potential homeowner should know about to help them make an informed decision. Four main benefits are:
a) deductible mortgage points; b) deductible mortgage interest and real estate taxes; c) the homesale exclusion; and, d) paying the lower capital gains rates at sale.
A. Home Purchase
1. The Deductibility of Points
The first tax benefit that the buyer will experience comes when they apply for a loan. Many lenders require the buyer to pay "points" in order to secure a loan and/or for a lower interest rate on their loan.
The term "points" is used to describe money paid, or treated as paid, by a borrower to obtain a mortgage. Points may also be called loan origination fees, maximum loan charges, loan discount, or discount points.
Points are only deductible as interest if they are solely for the use of money and not as a charge for services. (IRS Pub. 936) This includes points on a Veteran Affairs or Federal Housing Authority home mortgage. Points are not deductible as interest if they are paid for services of the lender in lieu of specific service charges (e.g. a one point-charge for an appraisal) or if the points are paid to secure a lender’s agreement to make a future loan.
a. Points Paid by Purchaser
The general rule is that a home purchaser cannot deduct the full amount of points in the year paid. Because points are considered prepaid interest, the homeowner must deduct them over the life of the mortgage. However, there is an exception allowing the points to be deducted in the year paid if the purchaser meets all of the following nine tests:
1) The loan is secured against the purchaser’s main home.
2) Paying points is an established business practice in the area where the loan is made.
3) The points paid were not more than the points generally charged in that area.
4) The purchaser uses the cash method of accounting. (Meaning they report their income in the year they receive it and deduct expenses in the year they pay them.)
5) The points were not paid in place of amounts that ordinarily are stated separately on the settlement statement, such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes.
6) The funds the purchaser provided at or before closing, plus any points the seller paid, were at least as much as the points charged.
7) The purchaser used the loan to buy or build their main home.
8) The points were computed as a percentage of the principal amount of the mortgage.
9) The amount is clearly shown on the settlement statement as points or an expense charged for the acquisition of the mortgage. (2)
Points may also be deducted in the year paid on a loan to improve the owner’s main home, if test (1) through (6) are met. (IRS Pub. 530).
b. Points Paid by Seller
The seller cannot deduct points they pay for a purchaser. The points may be treated as a selling expense, thereby reducing the seller’s amount realized by increasing their adjusted basis. The buyer may treat the seller’s paid points as if they paid the points, thereby making them deductible in the same year if the buyer meets the above criteria. (Rev. Proc. 94-27, IRS Tax Topic 504, IRS Pub. 936).
The IRS allows a homeowner to deduct two major expenses: some interest payments related to the home and real estate taxes. The amounts that may be deducted from the taxpayer’s income tax are interest that qualifies as home mortgage interest and real estate taxes actually paid to the taxing authority.
1. Tax Deductible Interest
a. Home Mortgage Interest:
The homeowner can deduct from their individual federal income tax return each year the entire interest portion of their mortgage payment, as long as the homeowner itemizes their deductions. (I.R.C. § 163) However, the deduction may be limited if the total mortgage balance is more than $1 million ($500,000 if filing individually), or if the homeowner took out a mortgage for reasons other than to buy, build, or improve their home. (IRS Pub. 530) To be deductible, the interest that the homeowner pays must be on a loan secured by their main home or a second home. The loan can be a first or second mortgage, a home improvement loan, or a home equity loan.
b. Interest on Home Equity Loans:
Tax deductible qualified residence interest also includes interest on home equity loans. These loans utilize the personal residence of the taxpayer as security. Because the funds from home equity loans can be used for personal purposes such as buying a car or for medical expenses, what would otherwise have been nondeductible consumer interest becomes deductible qualified residence interest. However, interest is deductible only on the portion of a home equity loan that does not exceed the lesser of: (1) The fair market value of the residence, reduced by the acquisition indebtedness, or (2) $100,000 ($50,000 for married persons filing separate returns). (I.R.C. § 163(h)(3))
2. Real Estate Taxes:
State and local real estate taxes are deductible from your individual federal income taxes if the real estate tax is ad valoreum (based on the assessed value of the real property and the homeowner is charged a tax based on the same uniform rate as all other property in its jurisdiction). (IRS Pub 530)
For federal income tax purposes the seller is treated as paying the property taxes up to, but not including, the date of the sale. The buyer is treated as paying the taxes beginning with the date of the sale. At settlement, real estate taxes are generally divided so that the buyer and seller each pay taxes for the part of the property tax year that they owned the home. Each party may fully deduct the share they paid (or were assumed to have paid) of the real estate taxes. (IRS Pub 530) If the buyer pays the taxes for the part of the year they did not live in the home, they cannot deduct those taxes but instead should add them to the basis of the home.
C. Selling your Home
There are several tax breaks available for individuals who are selling their personal residence. The largest tax deduction is known as the homesale exclusion, passed by Congress as part of the Taxpayer’s Relief Act of 1997.
1. Homesale Exclusion:
I.R.C. §121 allows an individual, if they satisfy the conditions of ownership and use, to exclude up to $250,000 ($500,000 if filing jointly and both parties meet the requirements) of gain they have received on the sale of their principal residence. Taxpayers may use the exclusion repeatedly as long as there is a two-year interval between sales. If the home is sold because of a change in employment, health, or due to some unforeseen circumstances, some or all of the gain may be excluded even if a seller does not pass the test required for a full $250,000 (or $500,000) exclusion. The exchange of one two-year principal residence for another is treated in the same way as a sale for purposes of the I.R.C. §121 exclusion.
a. How to Qualify for the Homesale Exclusion:
An individual may exclude from income up to $250,000 of gain realized from the sale or exchange of his home if: (1) during the five years ending on the sale date, he owned and used it as a principal residence (3) for periods aggregating at least 2 years (I.R.C. § 121(a)); and (2) within the two-year period ending on the sale date, there was no other home sale (or exchange) by the taxpayer to which the exclusion applied. (I.R.C. § 121(b)(3)).
b. Use and Ownership Test for Homesale Exclusion:
During the five-year period ending on the date of the sale, the home must have been owned and used by the taxpayer as his principal residence for periods aggregating two or more years. Most taxpayers will meet those requirements simultaneously, but the period of ownership and use need not be satisfied simultaneously nor does the time have to be continuous. (I.R.C. § 121(c)(1)).
Some taxpayers may qualify for the full exclusion without fulfilling the test. Taxpayers that replaced their home for a home involuntarily converted, as defined under I.R.C. §1033, can tack on the period of time they spent in the home that was destroyed with the time they spent in the new home to realize the necessary time period to qualify for the homesale exclusion. (4) Also people who meet the homeownership test but not the residency test because they are placed in a facility for health reasons are exempted from the residency requirement. (5) Additionally divorced spouses if they individually meet the two-year use and ownership requirements but would be ineligible because of the prior use of the exclusion are still eligible to exclude their $250,000. Also there is a favorable "tacking on" rule for divorcees who did not own the home jointly but were awarded the home in the divorce proceeding, allowing them to tack on the previous owner’s years. (I.R.C. § 121(d)(3))
c. Up-to-$500,000 Homesale Exclusion for Married Couples:
Married taxpayers may exclude up to $500,000 of gain from the sale of a principal residence if they file a joint return for the year in which the home is sold and: (1) either spouse owned the property for periods aggregating two or more years during the five year period ending on the date of the sale of the property; (2) both spouses used the property as a principal residence for periods aggregating two years or more during the five year period ending on the date of the sale of the property; and (3) neither spouse used the homesale exclusion on a previous sale (or exchange) of a home during the two year period ending on the sale date. (I.R.C. § 121(b)(2)) If the above conditions are met, up to $500,000 of gain may be excluded even though only one spouse owns the home. If one of the spouses does not qualify for the exclusion the other (who does qualify) may still exclude up to $250,000 from their gain.
d. Excluding Homesale Gain under the Partial Exclusion Rule:
A taxpayer who fails to meet the home ownership test may also receive some relief if they can prove they are changing their residence due to health, employment, or other unforeseen circumstance. Although they will not receive the full exclusion, they are entitled to receive part of the $250,000 exclusion. (I.R.C. § 121(c)) The amount of the exclusion depends on the length that the taxpayer lived in the home (as primary residence), the length of time they owned the home, and whether or not they have sold another home during the 2-year period ending on the date of the current sale. (I.R.C. § 121(c)(2)). The formula used to determine the available amount of the exclusion is the amount of the exclusion available ($250,000 or $500,000) multiplied by the portion that the shorter of (1) the aggregate periods during which the ownership and use requirements were met during the five-year period ending on the date of the sale or (2) the period after the date of the most recent sale or exchange to which the exclusion applied bears to two years.
2. Capital Gain Rate for Sales
If the gain on the sale of a principal residence is entirely excluded under I.R.C. §121, the transaction does not have to be reported on the seller’s income tax return (IRS Pub 523) unless the home was also used for business or income-producing purposes. However, if there is taxable gain on the sale, then the home sale must be reported. A realized gain can be categorized as one of the following: 1) the amount that exceeds the I.R.C. §121 homesale exclusion; or 2) any gain the seller elects not to use from the I.R.C. §121 exclusion; or 3) the gain calculated from the taxpayer claimed depreciation attributable to the post-May 6, 1997 periods.
a. Determining Homesale Gain or Loss:
Before determining whether part or all of a gain is excluded under I.R.C. §121, the home seller must first determine the amount of gain realized, which is the amount realized from the home sale less the adjusted basis in the home. The amount realized from the home sale includes the cash received from the sale as well as the fair market value of any other value received, minus those items which properly offset the consideration received upon the sale (e.g., commission and expenses that come with the sale of property, advertising expenses, cost of preparing the deed, and other legal expenses). (IRS Pub 17)
The basis in the home before adjustment is: (1) the price paid for the home including purchase expenses such as settlement fees and closing costs; or (2) if the home is received as a gift, the basis will be the donor’s basis in the home, increased by any gift tax paid by the donor (I.R.C. § 1015); or (3) if the home is acquired from a decedent the basis is the fair market value on the date of the decedent’s death. (I.R.C. § 1014)
ii. Calculating Adjusted Basis:
Basis may be adjusted in a number of ways. The basis of the home may be increased by expenses, including the cost of additions or other improvements having a useful life of more than one year. (I.R.C. § 1016) Examples of improvements that fall into the category of adjusted basis are: adding a room, patio, deck or garage to the home; finishing the basement; new landscaping, adding a sprinkler system, and fences; installing new heating or central air conditioning; a new roof, plumbing or wiring; installing new storm windows or doors; installing a security system, installing new flooring or wall-to-wall carpeting; and paving or expanding the home’s driveway. A taxpayer cannot increase their basis for the cost of repairs or routine upkeep expenses. However, the repair expenses may be added to basis if they are part of a general rehabilitation plan of the property. (IRS Pub. 523).
A homeowner must make a basis reduction if they postponed the gain on the pre-May 7, 1997 sale of a home under prior law’s I.R.C. §1034 homesale rollover rule.(6) A homeowner must also reduce basis if they depreciate some portion of their home used for business or rental purposes. Basis must also be reduced if they received money: for an easement or right-of-way on the property; for insurance reimbursements for casualty losses; for residential energy credits; and, for a first time homebuyers credit.(7)
iii. Title Costs:
Costs incurred while acquiring and perfecting title to the home are capital expenditures that may be added to the basis. (I.R.C. § 1016) Such costs include architects’, attorneys’, and surveyors’ fees, in addition to the costs of defending title and removing clouds on the title. These capital expenditures are not deductible but should be added by the homebuyer to the purchase price to increase the basis. (I.R.C. § 1012; Reg. § 1.1012-1(b); Rev. Rul. 68-528) The only costs related to the title that are deductible in the year paid are the expenses incurred by the homeowner to protect against adverse possession.
D. Other Tax Advantages of Owning a Home
In addition to those described above, there are other tax advantages of owning a home such as: home office deductions and the ability to make like-kind exchanges. Both concepts and options are discussed below.
1. Home Office Deductions:
To deduct expenses related to home office space, the homeowner must meet specific requirements. The business part of the home must be exclusively and regularly used for business purposes; additionally the space must be either the taxpayer’s principal place of business, a place where the taxpayer meets or deals with patients, clients, or customers in the normal course of their business, or the space must be a separate structure (not attached to their home) that is used in connection with their business. If the taxpayer is an employee and using part of their home for business they must meet the above test plus two other criteria: a) their business use must be for the convenience of the employer; and, b) the taxpayer must not pay rent on any part of their home to the employer. (IRS Pub. 587) (I.R.C. § 280A(c))
a. Calculating the Deduction
To determine the business percentage deductible for the home, divide the area used for business purposes by the total area of the taxpayer’s home. The IRS also allows the taxpayer, if the rooms of the home are about the same size, to simply divide the number of rooms used for business by the total number of rooms in the home. After figuring out the percentage of the home used for business, the taxpayer must then divide the expenses of operating their home between business and personal use. (IRS Pub. 587)
There are three categories of expenses: a) direct, b) indirect, and c) unrelated. Direct expenses are paid solely for the business part of the taxpayer’s home and those expenses are deductible in full. Indirect expenses are the cost of upkeep and running the entire home and those expenses are deductible based on the percentage of the home that is used for business purposes. The third and final category, are unrelated expenses. These expenses are only for the parts of the home not used for the business and these expenses are not deductible.
2. Like-Kind Exchanges of Investment Property (Starker Exchanges):
The circumstances may arise where (1) an owner of investment real estate has
a low basis in real estate that has appreciated in value and (2) desires to
dispose of the real estate, but does not want to pay tax on the large gain and
(3) does not require the cash from the sale for other purposes. In such cases
the tax-deferral of a like-kind exchange
s may be the answer.
a. Definition of Like-Kind Property
Properties are of like kind if they are of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. Properties generally are of like kind, regardless of whether the properties are improved or unimproved (i.e., commercial property, whether improved or unimproved, can be traded for other commercial property but not for residential property).
I.R.C. §1031 et seq. allows exchanges of A property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.@ (I.R.C. § 1031(a)(1)) These rules are not restricted to real estate but excluded from the like-kind exchange provisions are (i) stock in trade, (ii) stocks, bonds and notes, (iii) other evidences of indebtedness, (iv) partnership interests, (v) certificates of trust, and (vi) chooses in action. (I.R.C. § 1031(a)(2)) On the negative side, therefore, is the fact that the exchange of partnership interests in a real estate limited partnership is excluded from like-kind exchange treatment under the statute.(8)
b. The Operation of Like-Kind Rules
When the two properties have been determined to be of like kind then the transaction must be documented and structured through a qualified intermediary to provide for independence between the relinquished and the replacement properties. The replacement property must be identified, in writing, within 45 days of the sale of the original property, and the exchange or replacement property must be acquired by the 180th day after the sale of the original property. At no time during the exchange may the transferor have actual or constructive receipt of the funds.
i. Reverse Starker Exchange
It is often difficult for an investor to identify a replacement property within 45 days of the sale or take title within 180 days. In 2000, the IRS created an acceptable procedure to purchase a replacement property before selling the investment property. The new replacement property must be held in a qualified exchange accommodation arrangement (QEAA). Within 45 days after the transfer, the taxpayer must identify the property to be sold. Within 180 days after the transfer to the QEAA, the replacement property must be conveyed to the taxpayer. Reg. § 1.1031(k)-1, Rev. Proc. 2000-37, and 26 CFR 1.1031(a)-1.
All like-kind exchanges are closely scrutinized and the exact procedures of the IRS must be followed or no tax deferral will result.
III. Real Estate Holding Entities
There are many different entities that can hold and own property. This section will define the various entities and explore some of the basic tax ramifications of holding real estate for investment purposes. The basic tax elements for residential property have been discussed in Section II above and most but not all will also apply for investment properties.
The simplest and most basic form of ownership is by the individual. When an individual owns investment property they alone are responsible for paying the costs and taxes, and the individual also directly receives all the benefits of the ownership. A major tax advantage of sole proprietorship is that the taxable income and losses related to the ownership flow through to the individual’s income tax return. Therefore an individual can deduct from their taxes the interest they pay on the mortgage for the investment property and the taxes they pay on the property. Another major advantage of sole proprietorship lies in its simplicity to set up and operate.
However, there are some major disadvantages facing the individual owner. The investor places their personal assets at risk. The investor must actively manage the property to receive the full tax benefits. The individual’s ability to finance new acquisitions will be limited by the net worth of the individual.
B. Tenants in Common
Tenants in common are two or more people who purchase land and have separate but undivided interests in the property. Each tenant in common owns an undivided share of the whole. There are no rights of survivorship between tenants in common and each interest is descendible and may be conveyed by deed or will without restriction.
An advantage of owning investment property as a tenant in common is the ability to pool the financial resources of multiple investors. Each individual investor has a partial ownership in a larger property with appreciation, cash flow, and annual depreciation benefits. Purchasers are allowed to sell their interest in the property without the consent of the other co-owners. Due to the freedom tenancy in common provides, it has become a popular method of making 1031 Exchanges easier. (See www.1031.org) Tenancy in common allows investors to trade their portion in a tenancy in common for someone else’s portion in another tenancy in common of the same dollar amount without having to pay taxes on the exchange.
In order to maintain the status of tenants in common with the IRS, there are a number of restrictions on ways in which the tenants in common may conduct their business. They may not file a partnership or corporate tax return. They may not conduct business under a common name. They may not execute an agreement identifying any or all of the co-owners as partners, shareholders, or members of a business entity.
C. Joint Tenants
Our joint tenancy (with rights of survivorship) originates from the old English common law. There is no limit to the number of joint tenants. Four unities (or characteristics) are required to occur in order to create a joint tenancy. Those unities are: 1) time, 2) title, 3) interest, and 4) possession. The unity of time means that the interest of each joint tenant must be acquired or vest at the same time. The unity of title means that all joint tenants must acquire title by the same instrument or by joint adverse possession. The unity of interest means that all the co-owners must have equal undivided shares and identical interest in the property. The unity of possession means that each co-owner must have a right to possession of the whole property. If all four unities exist at the time of creation but are later severed then the ownership reverts to a tenancy in common.
The main advantage to holding property as joint tenants is that it allows automatic survivorship. The property need not pass through a will, and therefore the party who receives the property does not have to be bothered with a probate administration as to that asset.
The basis of the property to the survivor will depend upon the amount contributed by each joint tenant toward the original purchase price and in the case of depreciable property, the manner in which income is divided under local law. (Reg. § 20.2040-1(a)) If the parties in the joint tenancy are husband and wife, and they are the only joint tenants, then one-half of the fair market value acquired after 1976 is included in the deceased spouse’s estate regardless of the amount contributed by the surviving spouse (I.R.C. §2040(b)) The surviving spouse’s basis in the remaining portion of the property is one-half the original cost reduced by any depreciation deductions that are allocable to the surviving spouse. (IRS Pub. 559)
When property is held in joint tenancy with a right of survivorship, income from the property (and gain or loss upon its sale) is divided between the owners insofar as each is entitled, under state law, to share in the income.
One of the disadvantages of owning property as joint tenants is that a person must share control. Both tenants must consent and join any action regarding the property before it can occur in order to preserve the joint tenancy. If the owners do not consent to an action then one may sever the joint tenancy and revert the arrangement to tenancy in common.
In most instances there will be a tax consequence when one of the joint tenants dies and the other becomes the sole owner. Another disadvantage is that owning land as joint tenants does not protect the property from the creditors of one or all of the joint tenants. A creditor of one may partition the property in order to execute on his claim.
D. Tenants by the Entirety
Tenants by the entirety are very similar to joint tenants but it may only exist between a husband and wife. To establish tenants by the entirety all four unities must exist and the parties seeking to own property as tenants in the entirety must be married. The right of survivorship remains (as with joint tenants) and neither party can dispose of their share of the property without the other party’s consent. Unlike joint tenants however, property owned as tenants by the entirety is protected in many states from the creditors of only one of the tenants.
A trust is a man made entity whereby a property owner transfers the title to a trustee (individual or entity) for the benefit of others. Everyone may make their own rules on how their trust will operate subject to their state’s trust law. An owner can determine the amount and kind of property of the trust, the number of years the trust will operate, who will receive benefits, how much, how often, and the condition under which the benefits will occur. Trusts are taxed on "taxable income" (I.R.C. § 1(e)) but the tax reaches the maximum (now 38.6%) rate at much lower amounts of taxable income than for individuals.
If income is required to be distributed currently or is properly distributed to a beneficiary, the estate or trust is regarded as a conduit with respect to that income. It is allowed a deduction for the portion of gross income that is currently distributable to the beneficiaries. The beneficiaries are then generally taxed on the amount distributed to them and the trust is taxed on the portion it has accumulated.
The two most common kinds of trusts are living (revocable and irrevocable) and testamentary trusts. The living trust becomes effective during the grantor's lifetime and may continue in operation after their death if continuation is provided for. The testamentary trust is written into a will and becomes effective only upon the grantor's death.
The irrevocable living trust may be used to both: minimize estate, inheritance or income taxes; and, to arrange a private transfer of an estate rather than a transfer of the assets through the public probate. A trust may provide professional managers (as a bank) for a trust or they may use individuals as Trustees.
1. Revocable Trusts
The revocable trust allows the grantor freedom to control his assets through a trust or have someone else handle his estate during his lifetime. Revocable trusts also allow the grantor to review the management of the estate and adjust it if their situation or goals change.
One advantage of a revocable trust is that if the trust is functioning and all the grantor’s assets are in the name of the trust at the time of the grantor’s death then there is no need to conduct a probate at death. Another advantage is privacy, a probated will becomes a matter of public record while a trust document does not become a matter of public record.
The greatest disadvantage of a revocable trust is that it does not offer any income or state tax advantages and all trust assets will remain in the grantor’s estate for federal estate tax purposes. A second disadvantage is that in order to avoid probate, the grantor must transfer the ownership of all their assets to the trustee. Unless the grantor has all of their assets in the trust at death, there is still a need for a will and those remaining assets will have to go through probate. (Real property may be transferred from the grantor to the revocable trust without transfer and recordation taxes in the District of Columbia, Maryland and Virginia.(9)All tax treatment of the real property will pass through to the grantor individually. It is important to note that there is no asset protection to the grantor by placing his asset in a trust revocable by the grantor.
2. Irrevocable Trusts
As the name implies, the grantor may not change the terms of an irrevocable trust once the transfers are made to the Trustee. The main advantage to an irrevocable trust is that the property transferred is removed from the grantor’s estate for federal estate tax purposes. A grantor may lower his income taxes by removing income producing assets from his possession and by removing highly appreciate assets that would result in large taxable gain if sold.
There are a myriad of irrevocable trusts available for holding and controlling assets for tax relief and estate planning purposes (e.g., Grantor defective trust, Charitable Remainder Uni-Trust, Charitable Remainder Annuity Trust, etc.). An estate planning professional can best offer guidance with these and other types of trusts.
A corporation is a statutory entity composed of shareholders who hold stock and operate under a common name. A corporation can be declared a corporation for tax purposes simply by checking the appropriate box in the IRS check-the-box system on its tax returns. (Reg. § 301.7701-2) Entities formed under a corporation statute are automatically classified as corporations.
There are a number of advantages of setting up a corporation to control purchasing property. The largest of these advantages is that there is no individual liability for the stockholders in the corporation for the actions of the corporation (as long as a person keeps their personal finances separate from the finances of the corporation); a corporation unlike a partnership is not a "flow through" entity. Therefore, the proverbial corporate veil is created to shield the stockholders of a corporation from the corporation itself.
If a person transfers property to a corporation (any type of corporation) in exchange for stock in that corporation (other than nonqualified preferred stock) and immediately afterward the person takes control of the corporation, the exchange will generally not result in any gain or loss on the transfer and the person will not be taxed. (I.R.C. § 351) This rule applies to both individuals and groups who transfer property to a corporation; it also applies whether the corporation is already established or is forming.
However, it does not apply in the following situations: 1) the corporation is an investment company; 2) the property is transferred in a bankruptcy in exchange for stock to pay off creditors; 3) the stock is received in exchange for the corporation’s debt that accrued while the transferor held the debt. (For more information see Reg. § 1.351-3)
To be in control of the corporation the person who transferred the property or the group who transferred the property must own, immediately after the exchange, at least 80% of the total combined voting power of all classes of stockholders and must control at least 80% of the outstanding shares of each class of nonvoting stock in the corporation. (IRS Pub. 542)
There are two types of corporations a C corporation and an S corporation.
1. C Corporations
The most significant non-tax advantage of a C corporation is it offers limited liability protection for its shareholders. Absent an agreement to the contrary (i.e., a loan guarantee), C corporation shareholders are generally not held personally liable for the corporation’s obligations. Additionally, C corporations do not have limitations on the number of potential shareholders or who may be a shareholder. Shareholders may include individuals, partnerships, trusts, and corporations. Without an agreement to the contrary, shareholders are also free to sell or transfer their interests in the corporation to another individual.
A C corporation is a separate entity from its owners for tax purposes. Gains and losses on income, deductions, and credits are accounted for only at the corporate level. Therefore, a C corporation must file its own tax return and pays taxes on its profits (the tax rates are found at I.R.C. § 11 and § 1201). When the corporation then distributes dividends to its shareholders, the shareholders pay a tax on their personal income tax returns (this is often referred to as a "double tax"). The profits however, are not taxed to the shareholders until they are distributed. The corporation pays tax on its "accumulated taxable income" minus the sum of the dividends (see I.R.C. § 561-565) and the sum of the accumulated earnings credit (see I.R.C. § 535). The first $50,000 of a C corporation is only taxed at a rate of 15%. (See I.R.C. § 11 and § 1201). If the profits are not distributed but instead retained, the corporation’s profits will not be "double taxed."
Another tax aspect of a C corporation is that they do not permit special allocations of tax benefits to owners (as is possible with partnerships). Therefore, owners are not encouraged to inject additional capital into the corporation except by purchasing additional stock or by a loan and promissory note from the corporation.
2. S Corporations
An S corporation is essentially identical to a C corporation in terms of the way it functions and in regards to the non-tax consequences of doing business in corporate form.
However, the C corporation and the S corporation differ dramatically with regards to tax matters. Unlike a C corporation, S corporations are pass-through entities, i.e., entities where normally taxation is not levied at the corporate level but paid pro rata (based on the number of shares owned) by the shareholders on their individual income tax returns. Therefore, double taxation of corporate earnings is avoided because there is generally no corporate-level income tax.
Like a partnership, it files an informational return and the shareholders report their share of profit or loss on their personal income tax return. S corporations must: a) limit the number of corporate shareholders to 75 (35 shareholders for tax years before 1997); b) stipulate that all shareholders be U.S. citizens; and, c) require that shareholders must be individuals rather than other corporations, partnerships, or trusts (the only exception being tax-exempt, charitable organizations).
While the C corporation is allowed to deduct benefits such as health insurance, and life insurance, an S corporation can deduct only 30% of such benefits for an owner-employee who owns 2% or more of the corporate stock.
Many tax and legal experts recommend S corporations for smaller entities and start-ups because it can provide the taxpayer with corporate liability protection (as long as they do not mix personal and corporate funds and finances). In addition, any loss that the corporation suffers passes through to the taxpayer’s personal income tax return and will therefore lower the amount the taxpayer will owe to the Internal Revenue Service. However, most real estate investments are not held in either corporate form, although a General Partner in a Limited Partnership is often a corporate entity.
This section will discuss two types of partnerships: general partnerships and limited partnerships. Some of the tax issues are the same for both types of partnerships; such as both types are pass-through entities. As pass-through entities the partnership passes its income or loss to the partners directly, for them to include on their individual income tax returns. The taxable income of a partnership is computed in the same manner as for an individual, except that a partnership may not: (1) deduct an amount for personal exemptions, (2) deduct for foreign taxes paid, (3) utilize the net operating loss deduction, (4) deduct for charitable contributions, (5) take advantage of individuals’ itemized deductions (listed in I.R.C. §211-219), (6) use the capital loss carryover, and (7) take the depletion deduction under I.R.C. §611. (See I.R.C. Sec 703(a) and Reg. § 1.703.1).
1. General Partnerships
A general partnership is a non-corporate entity comprised of two or more owners that requires no formalities in order to exist. There is generally no limit on the number or type of owners in a partnership. However, unlike a C or S corporation, partners in general partnerships are personally liable for the partnership’s obligations.
As previously stated, general partnerships are pass-through entities, and although the partnership must file an informational return and characterize certain tax items at the partnership level, the partners, not the entity, deduct partnership losses or add partnership gains onto their income tax returns. (I.R.C. § 701) An important feature of the partnership entity is that it is a very flexible entity, which allows tax benefits to be specifically allocated to specific partners. However, unlike shares of a corporation, a partner’s interest in a partnership is greatly restricted and not easily transferable.
The formation of a partnership is generally a tax-free event for both the entity and its owners. No gain or loss is recognized upon the contribution of property to a partnership in exchange for a partnership interest. (I.R.C. §721(a)) However, if a party transfers services to the partnership in exchange for a partnership interest, the partner must recognize income to the extent of the value of the partnership interest received. (Reg. §1.721-1(b)(1))
Because a partnership is a pass-through entity, all items of income, deduction, loss and credit pass through the entity to the partners and are allocated in accordance with the partnership agreement. If the partnership agreement does not provide for the allocation of partnership items the partner’s distributive share is determined in accordance with their interest in the partnership. (I.R.C. §704) Any item that passes through the entity retains its tax character in the hands of the partner. A partner’s share of these items is called the partner’s distributive share, even though these items are not actually distributed.
As a general rule, a partnership recognizes no entity level gain or loss on a distribution of property or money to a partner. (I.R.C. §731) The distributee partner recognizes no gain as well, except to the extent that the amount of money distributed exceeds the partner’s basis in their partnership interest immediately before the distribution, in which case the excess is treated as a capital gain. (I.R.C. §731)
A major drawback to the general partnership entity is the limitation
on the transferability of a partnership interest. Also for tax purposes, a partnership
terminates when: (1) no part of the business is carried on by any of the partners
in the partnership; or (2) within a twelve-month period, there are sales or
exchanges totaling 50% or more of the total interest in the partnership capital
or profits. (I.R.C. §708(b)(1))
2. Limited Partnerships
A limited partnership offers the benefit of a partnership with the limited liability protection of a corporation. Limited partners in a limited partnership are not personally liable for the obligations of the partnership; instead, their liability is limited to their financial investment in the enterprise. The only members of a limited partnership who remain personally liable are the general partners and possibly limited partners who participate in management. For this reason, most general partners are corporations whose limited assets are at risk. In addition, limited partnerships are pass-through entities that have no restrictions on the number or types of partners who may participate.
A drawback to a limited partnership is that limited partners cannot participate in the management of the partnership in any significant way. A limited partner who participates can lose the benefit of limited liability. Another drawback is that the limited partners are subject to the passive loss rule of I.R.C. §469, thereby severely restricting the limited partner’s ability to benefit from the tax credits and losses the entity may generate.
H. Limited Liability Companies (LLC)
A limited liability company (LLC) is a hybrid entity: it is treated like a corporation for limited liability purposes but for tax purposes it may be treated like a partnership. An LLC may consist of a single member and for tax purposes those LLCs are treated as a sole proprietorship. LLCs afford members limited liability even if the members participate in day-to-day management. Also, an LLC is subject to only one level of taxation if properly structured and there are no restrictions on the type or number of members.
Because an LLC is a creation of legislative statute the exact legislation and rules regulating LLCs can vary from state to state. This lack of uniformity results in some unresolved tax and non-tax issues. Specifically, the uncertainty centers around whether there is a risk of personal liability in states that impose limits that are not imposed by the entity’s state of organization.
Assuming the LLC is taxed as a partnership, a contribution of property in exchange for a membership interest ordinarily will not result in the recognition of gain or loss. (I.R.C. §721(a))
Since its inception, the LLC has replaced the limited partnership as the entity of choice for most real estate investments.
I. Real Estate Investment Trusts (REITs)
The purpose of the REIT is to allow a small investor, in theory, to invest in a diversified portfolio of real estate investments. The main benefit of an REIT is that dividends that the REIT pays out to its investors are deductible by the REIT and thereby establishing the expectation that the REIT will serve as a pass-through entity with no taxation at the REIT level. In addition if an REIT desires to it can make distributions in excess of income. Those distributions are treated first as a nontaxable return of capital to the REIT investors and then as capital gains.
An REIT may be a corporation, a trust, or an association that meets the following criteria:
(1) For the entire taxable year, one or more of the trustees or directors must manage the REIT.
(2) For the entire taxable year, the beneficial ownership of the REIT must be evidenced by transferable shares, or by transferable certificates of beneficial interest.
(3) For the entire taxable year, except for the REITs provisions, the entity would be taxable as a domestic corporation.
(4) For the entire taxable year, the entity can neither be a financial institution nor an insurance company to which the provisions of I.R.C. subchapter L apply.
(5) With the exception of the first taxable year, the beneficial ownership of the REIT shares must generally be held by 100 persons or more during at least 335 days of the taxable year of 12 months or during a proportionate part of a taxable year if it is a tax year of less than 12 months. If an entity qualifies as an REIT then the income distributed to the investors is taxed to the investors and there is no entity or REIT tax. The REIT is subject to the corporate tax rates on the income it does not distribute, and on certain foreclosure income from property.
(6) With the exception of its first taxable year, the REIT cannot be closely held as determined by I.R.C. § 856(h).
In addition to the above outlined criteria in order to qualify as an REIT the entity must meet the following I.R.C. §856(c) requirements.
(1) The entity must file an election to be treated as an REIT with its return for the taxable year.
(2) At least 95% of the entity’s gross income must come from the following sources: dividends; interest; rents from real property; gain from sale of real property, stocks, or securities; abatements and refunds of taxes on real property; income and gain realized from foreclosure of real property; amounts received for securing loans; and gain from the sale of a real estate asset that is not a prohibited transaction.
(3) At least 75% of the entity’s gross income must come from the above sources or a qualified temporary investment income.
(4) At the end of each taxable quarter at least 75% of the value of the REIT’s total assets must be represented by real estate assets, cash and cash items, and not more than 25% of the value of the REIT’s total assets must be represented by securities.
If a REIT meets all the above criteria then the REIT’s taxable income is taxed at corporate rates. Determining the taxable income requires another test.
(1) An REIT is entitled to deduct all dividends paid.
(2) An REIT is not entitle to the 70% deduction for dividends received from other corporations.
(3) A REIT’s taxable income does not include "net income from foreclosure property", the taxable income is reduced by certain taxes relating to the REIT’s failure to follow the 95% and 75% income tests.
(4) An REIT must pay out dividends at least to the sum of the 95% income in order to deduct its dividends.
(5) The dividends paid out by the REIT count toward the entity’s earnings and profit for tax purposes.
(6) The REIT is subject to the capital gains tax rates on its capital gains.
(7) There is a 100% taxation rate on income derived from an REIT’s prohibited transaction laid out in I.R.C. §857(b)(6).
2. Types of REITs
There are three basic categories of REITs.(10)
a. Equity REITs
Equity REITs invest in and own properties. Their revenues come principally from their properties’ rents. (They constitute approximately 96.1% of all REITs.)
b. Mortgage REITs
Mortgage REITs deal in investment and ownership of property mortgages. These REITs loan money for mortgages to owners of real estate, or invest in (purchase) existing mortgages or mortgage backed securities. Their revenues are generated primarily by the interest that they earn on the mortgage loans. (Approximately 1.6% of all REITs).
c. Hybrid REITs
Hybrid REITs combine the investment strategies of Equity REITs and Mortgage REITs by investing in both properties and mortgages. (Approximately 2.3% of all REITs).
Most REITs are publicly traded and they are often used as income equities in a diversified securities portfolio. They tend to be conservative investments but that will depend on the general economy and the portfolio of the individual REIT.
Beers and Cutler, "Reduction in Taxes on Capital Gains and Dividends" Insight Newsletter, Volume 2 2003.
Bender, "Chapter 41: Acquisition and Ownership of Property" Federal Income, Gift and Estate Taxation, 2003.
Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, Warren,
Gorham and Lamont.
Branoff, Sheldon, Frost, Steven, and Keating, Robert, "Defining ‘General Partner’ and ‘Limited Partner’ For Federal Tax Purposes," Tax Notes 1019 (2/19/96).
Brown Brothers Harriman Trust Companies, "Generation Skipping Trusts," Estate Planning Techniques (12/2002).
CCH, "Taxpayer Relief Act of 1997: Law and Explanation" Federal Estate and Gift Tax Reports No. 12 August 14, 1997.
IRS, Tax Publication 530, "Tax Information for First-Time Homeowners," 2002.
IRS, Tax Publication 523, "Selling Your Home," 2002.
IRS, Tax Publication 551, "Basis of Assets," 2002.
IRS, Tax Publication 936, "Home Mortgage Interest Deduction," 2002.
IRS, Tax Publication 587, "Business Use of Your Home," 2002.
IRS, Tax Topics 504, "Home Mortgage Points, 2002.
Jeffery Maine, "Evaluating Subchapter S In A Check-the-Box World," 51 Tax Lawyer #4, p.717 (1998).
Jerome Ostrov, Tax Planning with Real Estate, Practising Law Institute (March 2003).
Loffman & Presant, Taxation of Real Estate Investment Trusts, MICPEL Advanced Tax Inst. (Nov. 1997).
Mark Lee Levine, Real Estate Transactions: Tax Planning and Consequences, West Publishing (2003).
O’Grady, Edward, "Tax Advantages of Owning a Home." The Legal Intelligencer March 2, 1992 p. 4.
RIA, "Making the Most of the Homesale Exclusion" Tax Planning and Practice Guide, March 2003.
RIA, Federal Tax Handook, 2002.
RIA, Choice of Entity, 2000.
Richard Levine, Advanced Real Property Institute, 2002 MICPEL.
Silverman, Mark, et. al., "Use of Limited Liability Companies in Corporate Transactions," Tax Notes 1469 (9/21/98).
Stephen F. Mount, Real Estate Investment Trusts, 742-2 Tax Mgmt. Portfolio (BNA) §V.
VA CLE- 18th Annual Real Estate Practice Seminar (2000)
VA CLE- Real Estate Exchanges Under §1031 IRC (1999)
VA CLE- 7th Annual Advanced Real Estate Seminar (2003)
Vivian Marino, "Homeownership Provides Many Types of Shelter: With Lower Mortgage
Rates, Many Take Advantage of Tax Breaks." The Legal Intelligencer February 17, 1994 p. 8.
www.1031.org - The official webpage for the Federation of Exchange Accomodators with information and links on 1031 exchanges.
www.apiexchange.com - A good site for information on §1031 Starker exchanges.
www.freddiemac.com/corporate/ownership/ - A useful site for homeowners.
www.gcaar.com - The official website for the Greater Capital Area Association of Realtors, the site also includes a series of useful legal articles.
www.govspot.com/tax/home.htm - A useful website to homeowner tax sites and official government web pages.
www.hud.gov - The official website for the Department of Housing and Urban Development.
www.nareit.com - The official webpage of the National Association of Real Estate Investment Trusts.
www.realtor.com - The official website of the National Realtor Association.
www.reitnet.com/reits101 - Information about REITs.
www.taxesindepth.com – Basic tax information and forms.
www.toolkit.cch.com/text/P07_2700.asp - A good website for information on home office deductions.
www.trustsandestates.com - A good source for information on trusts with links to its monthly publication.
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