In this third and final installment of real estate taxation, we look at how tax considerations and strategies vary by specific types of real estate investments. As real estate is such a large and diverse asset class, there are significant differences in regulations, techniques, and applicability that have serious implications for real estate investment strategies. (See Parts 1-2: Tax Risks of Real Estate Investments and Tax Strategies of Real Estate Investments)
Vacant Land. An investor in vacant land may take various deductions, including real estate taxes, interest charges on indebtedness incurred to buy the land, and other expenses paid or incurred in connection with holding the land, subject to the “passive loss” rule or the “investment” interest limitation. If the vacant land is held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, taxes, interest, and other expenses paid or incurred in connection with the land must be included in inventory costs. Land is not depreciable, but expenses incurred in managing, conserving, or maintaining property held for the production of income and in connection with any business use of the land are deductible.
Characterization as Passive Activity. Investment in vacant land is treated as a passive activity if the activity is (1) a rental activity or (2) a trade or business in which the investor does not materially participate. The rental of property used in a trade or business is treated as incidental to a trade or business activity (rather than a rental activity) during any year if:
(1) The taxpayer owns an interest in the trade or business activity during the year,
(2) The property was predominantly used in the trade or business activity either during the year or in two out of the five preceding years, and
(3) The gross rental from the property for the year is less than 2 percent of the lesser of
a. the unadjusted basis of the property, or
b. the fair market value of the property.
Characterization as Investment Activity. Investment in vacant land is treated as an investment activity rather than a passive activity during any year in which the principal purpose for holding the property during such year is to realize gain from the appreciation of the property. The rental of investment property is treated as incidental to an investment activity rather than a rental activity if the gross rental from the property for the year is less than 2 percent of the lesser of (1) the unadjusted basis of the property, or (2) the fair market value of the property.
Example 1. A taxpayer holds for the principal purpose of realizing gain from appreciation 1,000 acres of unimproved land with an unadjusted basis of $210,000 and a fair market value of $350,000. He also rents the land for $4,000 per year to a rancher who uses the land to graze cattle. The rental of the land is treated as incidental to an investment activity rather than a rental activity. This is determined as follows:
- The lesser of the unadjusted basis ($210,000) or the fair market value ($350,000) is $210,000.
- Two percent of $210,000 equals $4,200.
- Gross rental of $4,000 is less than $4,200.
Example 2. In 2012, a taxpayer acquired vacant land for development purposes. During 2012, the taxpayer rented the land to a car dealer. In 2013, the taxpayer began construction of a shopping mall on the land. Since the land was acquired principally for purpose of development rather than held for appreciation, the rental of the land in 2012 cannot be treated as incidental to an investment activity. Also, the rental of the land cannot be treated as incidental to a trade or business activity because the land has never been used in a trade or business. The rental of the land is treated as a rental activity subject to the passive loss rule.
Accrual and Cash Basis. As a general rule, an accrual-basis lessor includes rent in income as it accrues over the term of a lease, while a cash-basis lessor includes rent in income when it is received. Similarly, an accrual-basis lessee deducts rental expense as it accrues over the term of the lease, while a cash-basis lessee deducts rental expense when it is paid. Under this general rule, if rent is deferred until the end of the lease term, or the rent is stepped up over the lease term, an accrual-basis lessee could take deductions over the lease term, but the cash-basis lessor would not have to include rent in income until payment was made. However, special rules require the accrual of rental income and expense in the case of certain deferred or stepped-rent lease agreements.
Deferred or Stepped-Rent Lease Agreements. The IRC requires lessors and lessees under certain deferred or stepped-payment lease agreements to report rental income and expense as it accrues, as well as interest on rent accrued but unpaid at the end of the period. Agreements are subject to this rule if at least one amount allocable to the use of property during a calendar year is to be paid after the close of the calendar year following the calendar year in which the use occurs, or if there are increases in the amount to be paid as rent under the agreement. However, the rule does not apply unless the aggregate value of the payments and other consideration to be received for use of the property exceeds $250,000. When Rent Accrues. As a general rule, rents will accrue in the tax year to which they are allocable under the terms of the lease. Regulations provide that the amount of rent taken into account for a taxable year is the sum of:
(1) the fixed rent for any rental period that begins and ends in the taxable year,
(2) a ratable portion of the fixed rent for any other rental period beginning or ending in the taxable year, and
(3) any contingent rent that accrues during the taxable year.
In either of two situations, rent will be deemed to accrue on a level, present-value basis (“constant rental amount”) rather than under the terms of the agreement:
1. The rental agreement is silent as to the allocation of rents over the lease period; or
2. The rental agreement provides for increasing rents and one of the principal purposes for increasing rents is tax avoidance and the lease is either
a. part of a leaseback transaction, or
b. for a term in excess of 75 percent of the “statutory recovery period” for the property subject to the lease.
A constant rental amount is the amount that, if paid as of the close of each lease period under the agreement, would result in an aggregate present value equal to the present value of the aggregate payments required under the agreement. The regulations provide a formula to facilitate the computation of the constant rental amount.
A leaseback transaction is one involving a lease to any person who had an interest in the property (or related person) within the two-year period before the lease went into effect. The statutory recovery period is essentially the period provided for depreciation under the accelerated cost recovery system (ACRS), except that a fifteen-year period may be substituted for twenty-year property, and a nineteen-year period may be substituted for residential rental property and nonresidential real property.
The regulations provide comparable rules for agreements calling for decreasing rates and rules applicable to contingent payments.
Under the regulations, certain rent increases are not considered made for tax avoidance purposes. These would include increases determined by reference to price indices, rents based on a percentage of lessee receipts, reasonable rent holidays, and changes in amounts paid to unrelated third persons.