In Part 1, Managing Tax Risks of Real Estate Investments, we discussed general tax considerations for real estate including types of real estate ownership and general tax considerations. In this second of three installments, we delve into specific real estate strategies for investors to minimize, defer or to reduce their tax liabilities, all of which have a positive impact on real estate returns and values.
Tax Deferral for Gain: Like-Kind Exchange. On the disposition of the property, the owner may defer tax on the gain by exchanging it for “like-kind” property. Real property held for productive use in a trade or business or for investment may be exchanged for property of a like kind that is also to be held either for productive use in a trade or business or for investment, and neither gain nor loss will be recognized on the exchange.
In order to qualify for like-kind exchange treatment, the transaction must meet the following requirements:
(1) The taxpayer must identify the property to be received in the exchange within forty-five days after he transfers the property he relinquishes in the exchange, and
(2) The taxpayer must receive the like-kind property within 180 days after the date of his transfer or, if earlier, before the due date of his tax return for the tax year (not including extensions).
However, a gain will be recognized to the extent money or other non-like-kind property, including net relief from debt, is received in the exchange. Also, gain or loss will generally be recognized if either property exchanged in a like-kind exchange between related persons is disposed of within two years.
It is possible for an exchange to be tax free for one taxpayer but not for the other if a taxpayer did not meet the requirements that the property exchanged be held for productive use in a trade or business or for investment but the other party did meet this requirement.
The like-kind exchange rules do not apply to property held for personal use. However, other tax-advantaged rules apply to the sale and replacement of a taxpayer’s principal residence.
Properties Must Be of the Same Nature or Character. To be like-kind, the properties must be of the same nature or character, but not necessarily of the same grade or quality. Unproductive real estate held by one other than a dealer for future use or future realization of increase in value is considered held for investment. Property held for investment may be exchanged for property held for productive use in a trade or business and vice versa. Unimproved land may be exchanged for improved land. City real estate may be exchanged for a ranch. Rental real estate may be exchanged for a farm.
The Internal Revenue Service (IRS) issued a favorable determination letter to a taxpayer who held an empty lot adjoining his house as investment property, listing it for sale to developers. A developer sought to purchase the empty lot, along with another lot owned by a neighbor, in order to construct four townhouses. Two of the townhouses would be exchanged for the empty lot. The lot owner would then use the townhouses as rental property. The IRS determined that the exchange of two townhouses for the empty lot qualified as a like-kind exchange.
Even partial interests in real estate have been held like-kind property, including the following examples:
- Two leasehold interests have been held like-kind property.
- A lease for thirty years or more may be exchanged for an entire (fee simple) ownership interest.
- A remainder interest in real property held for investment qualified as like-kind to a fee-simple interest in real property held for investment or use in a trade or business.
- Undivided interests in three parcels of land held by three tenants in common were exchanged so that each received a 100 percent interest in one parcel in a nontaxable like-kind exchange.
- The fractional tenancy-in-common interests of related parties may be exchanged for a fee-simple interest in real estate.
Surrender of the interests of tenant-shareholders in a housing cooperative (stock and proprietary leases with thirty or more years to run) in exchange for condominium interests in the same underlying property qualified as a like-kind exchange.
Holding for Trade, Business, or Investment Requirement. Nonrecognition of gain from a like-kind exchange will be denied unless the property is “held for productive use in a trade or business or for investment” and is exchanged for property to be likewise “held for productive use in a trade or business or for investment.” This “holding” requirement is not met when an individual acquires property in the exchange for the purpose of selling it or otherwise liquidating it.
The IRS takes the position that the “holding” requirement is not met unless the property is owned over a period of time with the intention of making money rather than for personal reasons. The IRS determined in a letter ruling that the holding requirement was met when an individual acquired property in an exchange with the intent to hold the property for use in a trade or business or as an investment for at least two years and then to sell it. However, the IRS also takes the position that when an individual acquires the property in order to exchange it, the transfer will not qualify with respect to that individual because the property is not held for business or investment purposes. Correspondingly, property received in the liquidation of a corporation and immediately exchanged did not qualify for a tax-free exchange because it had not been held for productive use in a trade or business or for investment by the taxpayer.
Property can qualify for a tax-free exchange even when the owner has sold to the other party an option either to purchase the land or to exchange similar property for it. However, if the like-kind exchange is between related persons, an option could operate to extend the two-year period during which nonrecognition is defeated by a disposition of the property.
Exchange Requirement. For a tax-free like-kind transaction, an “exchange” must occur. A sale followed by a purchase of similar property is not an exchange. The exchange of nonqualifying property (“boot”) does not make the transaction any the less an “exchange,” but simply requires recognition of any gain to the extent of the nonqualifying property.
The simplest form of exchange, one in which parties “swap” properties they already own, is not necessarily the most common. Frequently, a person (A) who wishes to make an exchange can find a buyer (B) for his property, but not one who has the property he wants in return. The IRS has permitted a three-cornered solution to this problem as follows: A transfers his property to B, B transfers his property to C, and C transfers his property to A. Courts have also permitted a number of variations on the three-cornered exchange.
In a two-party exchange, the IRS determined that the buyer (B) could acquire the property from a third person or construct a building specifically in order to exchange it for A’s property and that the resulting exchange could qualify with respect to A, provided B did not act as A’s agent. Such a transaction does not qualify as an exchange for B, who did not hold the property for business or investment but acquired it for exchange.
Deferred Exchange. A deferred exchange is any exchange in which, pursuant to an agreement, the taxpayer transfers property held for productive use in a trade or business or for investment (i.e., the “relinquished property”) and subsequently receives property to be held for productive use in a trade or business or for investment (i.e., the “replacement property”). When B wants title to A’s property before suitable replacement property has been located, the IRC specifies a limited period of time that may elapse after property is relinquished in a transfer and the replacement property to be received is identified and transferred.
The IRC states that to be treated as “like-kind,” the replacement property must be “identified” and “received” within the following specific time frames:
1. identified as the property to be received in the exchange on or before the forty-fifth day after the property relinquished in the exchange is transferred (i.e., the “identification period”), and
2. received within 180 days after the transfer of the property relinquished or, if earlier, the due date (including extensions) of the transferor’s income tax return for the tax year in which the transfer of the relinquished property occurred (i.e., the “exchange period”).
Determining Basis. The tax basis of like-kind property received in a tax-free (or partially tax-free) like-kind exchange is generally equal to the adjusted tax basis of the like-kind property given. There are, however, two exceptions.
First, if an individual transfers cash or non-like-kind property or assumes a liability of the other party to the exchange (i.e., the transferee) that exceeds the liabilities (if any) assumed by the transferee, the individual’s tax basis in the like-kind property received is equal to his adjusted tax basis in the property given increased by the sum of (1) the amount of cash and the fair market value of non-like-kind property given and (2) the net liability assumed. Second, if liabilities assumed by the transferee exceed the liabilities (if any) assumed by the individual (transferor) and no other cash or boot is transferred by the individual, the individual’s tax basis in the like-kind property he receives is equal to his adjusted tax basis in the like-kind property given decreased by the net amount of liabilities assumed by the transferee.
The tax basis of any non-like-kind property received in a like-kind exchange is the fair market value of the non-like-kind property on the date of the exchange.
Taxation of Gain or Loss for Nonrecognition. When the taxpayer receives only like-kind property in the exchange, no taxable gain or loss is reported on his income tax return as a result of the exchange regardless of his tax basis in and the value of the respective properties.
However, if in addition to like-kind property, the taxpayer receives cash or other property that is different in kind or class from the property he transferred (i.e., non-like-kind property–often referred to as “boot”), any gain he realizes in the exchange will be taxable to the extent of the sum of the amount of cash and the fair market value of the non-like-kind property received. Yet, any loss realized in such an exchange may not be taken into account in calculating the taxpayer’s income tax.
Gain on an exchange of property that fails to qualify for nonrecognition treatment under the like-kind exchange rules may be reportable under the installment method. This became effective for exchanges made after April 20, 1994.
If the taxpayer receives only like-kind property, but transfers cash or other non-like-kind property as part of the exchange, regulations indicate that the nonrecognition rules apply to the like-kind properties, but not to the “boot.”
Tax Deferral for Gain: Installment Method. A taxpayer may be able to spread out over years a taxable gain by using the installment method of reporting. However, an interest surcharge applies to certain installment sales of property with a sales price exceeding $150,000. The installment method of reporting is unavailable for sales of real property held by the taxpayer for sale to customers in the ordinary course of the taxpayer’s trade or business.
Treatment as Section 1231 Gain or Loss. Gain or loss on property used in a trade or business, including rental real estate, is not “capital gain or loss” but instead is referred to as “Section 1231” gain or loss. Generally, the losses on the disposition of real estate may be treated as ordinary losses instead of as capital losses, and thus are unlimited by the $3,000 cap for ordinary income to be offset by capital losses.
When all the taxpayer’s Section 1231 gains in a year exceed the Section 1231 losses, then the net gain is treated as a long-term capital gain. However, the net gain must be treated as ordinary income to the extent of the taxpayer’s net Section 1231 losses in the five most recent years. When Section 1231 losses exceed Section 1231 gains, then the net loss is treated as ordinary loss.
Tax Credits. Some types of real estate investment, such as low-income housing and rehabilitation of old or historic structures, provide tax credits that directly reduce the tax on an individual’s income. Because investment in real estate is generally a passive activity, such tax credits may normally offset only taxes from passive activities of the taxpayer, although passive losses and the deduction-equivalent of credits with respect to certain rental real estate activities may offset up to $25,000 of nonpassive income of an individual. Tax credits can offer absolute shelter of income that would otherwise be spent for taxes, provided the property is held long enough. If not, there is some recapture of the credit previously taken. Even if some of the credit is recaptured, the deferral can be a benefit. Use of these credits may be subject to certain limitations.
Limitation of Deductions, Credits, and Losses
At-Risk Limitation. The “at risk” rule limits the deduction an investor may claim for the investor’s share of net losses generated by the real estate activity to the amount that the investor has at risk in the activity. The rule does not prohibit an investor from offsetting the investor’s share of the deductions generated by the activity against the income received from the activity.
An investor is initially “at risk” to the extent that the investor is not protected against the loss of money or other property contributed to the investment. An investor is considered at risk with respect to certain qualified nonrecourse financing with respect to the holding of real property.
The “at risk” rule applies to losses incurred after 1986 with respect to real estate placed in service after 1986. However, in the case of an interest in an S corporation, a partnership, or other pass-through entity acquired after 1986, the “at risk” rule will apply to losses incurred after 1986 no matter when the real estate is placed in service.
Passive Loss Rule. The passive loss rule limits the amount of the taxpayer’s aggregate deductions from all passive activities to the amount of his aggregate income from all passive activities; credits attributable to passive activities can be taken only against tax attributable to passive activities. The rule is intended to prevent taxpayers from offsetting income in the form of salaries, interest, and dividends with losses from passive activities. However, the benefit of the disallowed passive losses and credits is not lost, but rather is postponed until such time as the taxpayer has additional passive income or disposes of the activity.
Rental real estate activities are considered passive activities subject to the “passive loss” rule. However, a real property business of a taxpayer is not automatically considered a rental activity subject to the passive loss rules for the year if during that year (1) more than half of the personal services performed by the taxpayer in trades or businesses during the year is in real property trades or businesses in which the taxpayer materially participates, and (2) the taxpayer performs more than 750 hours of service during the year in such real property trades or businesses. Few investors in real estate syndications will qualify for this exception.
Material Participation in Business Activity. If the property is used in an activity in which the investor does not materially participate, deductions and credits are subject to the passive loss rule. However, if the property is used in a rental real estate activity in which an individual actively participates, a special exemption for up to $25,000 of passive losses and the deduction-equivalents of credits with respect to rental real estate activities may apply. Active participation is not required with respect to the low-income housing or rehabilitation tax credits. The $25,000 rental real estate exemption is not available with respect to nonrental property.
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