Rich Shavell
In tough economic times it is important to maintain positive cash flow. One of the best ways to do this is by paying less money in taxes to the IRS. Below are seven strategies that can help the commercial property developer save tax dollars right now.
1. Accelerate Your Depreciation Deductions
Commercial real property must be depreciated over 39 years. To accelerate these tax deductions, consider the benefits of a Cost Segregation Study (CSS). With a qualified CSS you can reclassify items such as tangible personal property to shorten their depreciation period for taxation purposes. Certain costs such as portions of the electrical system, and exterior improvements such as sidewalks and landscaping, can be depreciated over 5, 7 and/or 15 years. Moreover, for 2008 there is bonus depreciation that may be applicable to new construction resulting in immediate tax savings up to 50 percent of the cost of some of the segregated items.
2. Delay Paying Tax When Selling Real Property
If you own a building that has appreciated in value, then selling it may subject you to a substantial tax liability. If you plan on buying a new building after selling the “old” one, then you’ll want to consider a like-kind exchange (also known as a 1031 exchange) to defer the gain from the sale of the “old” building into the taxable basis of the new building.
Stringent rules must be followed to qualify for a like-kind exchange. Some of these rules include ensuring that the cash from the first sale must not make it into the hands of the seller of the new property. Also, a qualified intermediary must hold the money and apply it to the subsequent purchase, which must be completed within 180 days.
3. Save Money By Keeping Your Real Property Out of a Corporation (Or S Corporation)
Placing your real property in a Corporation can cause certain negative tax consequences. To maximize your tax position and provide flexibility, real property is typically placed in an entity that is taxed as a partnership such as a limited partnership, limited liability partnership or a limited liability company (LLC).
The sale or transfer of appreciated real estate held in a C Corporation may face double-taxation. The corporation pays tax on the gain and then after the net proceeds (i.e. after tax) is distributed, the shareholder pays tax again on the net amount received. Moreover, the sale of real estate (and other capital assets) in a C Corporation is not afforded favorable capital gains rates, which are currently at 15 percent. While double taxation would not be the case for an S Corporation, this entity choice may limit flexibility if related party transfers are later contemplated. S Corporations also do not permit flexible income and loss sharing arrangements. The general rule is: keep real property out of corporations.
4. Avoid the Passive Activity Loss Trap By Electing to be a Real Estate Professional
Rental activities are generally subject to passive activity loss rules permitting you to only apply passive losses against passive income. If you qualify as a “Real Estate Professional” you can deduct rental losses in excess of rental income with no limitation.
To qualify as a real estate professional you must spend a minimum of 750 hours per year engaged in qualified real estate activities and these activities must be more than 50 percent of the personal services you perform in all trades or businesses. Qualified real estate activities include any activities in which you, “develop, redevelop, construct, reconstruct, acquire, convert, rent, operate, manage, lease, or sell real estate.”
5. Pay Less Estate Tax by Forming a Family Limited Partnership
A valuable tool for effective estate planning is the family limited partnership (FLP). Typically, the FLP permits the older generation-donor to move assets or gifts to the younger generation-beneficiary under certain circumstances at discounted values. This reduces the impact to gift and estate tax exemptions.
The donor would contribute assets into the FLP that he would have normally gifted to the beneficiary. For the contribution the donor receives general and limited partnership interests in the FLP. The donor then gifts some or all of the limited partnership interests to the beneficiary.
The FLP provides the donor with the opportunity to significantly discount the value of the gifted partnership interest. Typically a lack of marketability discount and a minority interest discount may be applied if the transaction is effectively structured. To mitigate IRS challenges of the discount taken, an appraisal by a valuation professional should be included with each year’s gift tax return.
6. Avoid Paying Tax on Cancellation of Debt
In our current economy, foreclosures have been an issue, and the party that is relieved of the debt (in exchange for the property) may be subject to pay tax on this Cancellation of Debt (COD) income. A lender may submit a Form 1099 to the IRS for the difference in value they received compared to the debt written off. But a taxpayer facing COD income may be able to exclude this income if he or she is technically insolvent under the regulations. Generally, the taxpayer is insolvent if immediately before the debt is discharged his or her liabilities exceed the fair market value of his or her assets.
And while the taxpayer may not face tax on these amounts, certain tax adjustments must be applied when using the insolvency exception. These include reductions of carry-forward of credits and losses and the reduction in the basis of depreciable assets.
7. Pay Less Tax By Achieving Capital Gain Status
The difference between ordinary income tax rates (up to 35 percent) and capital rates (15 percent) is substantial. This difference provides incentive to taxpayers to seek capital gains treatments on sale of real property. Generally, hold the capital asset for a year and a day and the more favorable rates apply. But be alert: if the property has been depreciated, a recapture tax rate of 25 percent applies to the amount depreciated. With potentially three rates applying before you sell that property, make sure you know your after-tax cash result.
In any market — but especially in our current economic market — it is imperative that you find ways to increase cash flow. As with any tax planning opportunity you need to carefully consider all potential situations with the assistance of a qualified tax advisor. Such a tax advisor can help you apply some of the above tax strategies to put more money in your pocket now and in the future.
— Rich Shavell, CPA, CCIFP, is president of Shavell & Company, P.A.