Although real estate can provide powerful tax advantages, it is always disheartening to encounter clients who have fallen into readily avoidable tax traps. In some cases, they must unexpectedly pay tax because they failed to properly structure their affairs, and in other cases they simply pay more tax than is required. The following is an explanation of six of the most common real estate tax traps.
1. Failing to Plan for Service Partner’s Tax Bite.
A partner who receives an interest in partnership capital as compensation for his future services to the partnership is taxed on the value of that interest. He is taxed either immediately or when the right to a share of partnership capital becomes “substantially vested.”
Corporate and real estate attorneys may mistakenly believe that because (for example) the par value of the limited liability company units is set to a low dollar amount, the service partner who receives an interest (and takes such interest with a zero basis) will pay nominal, if any, taxes. For tax purposes, however, the stated value of a partner’s units is irrelevant; it is the true value of his interest in the partnership that is dispositive.
In order for a service partner to avoid the negative tax result of having to pay tax upon receipt of his interest, two options exist. The first option is to simply delay income recognition by delaying the time at which the service partner’s right to partnership capital becomes substantially vested. This requires the inclusion of certain technical tax provisions in the partnership or operating agreement.
The second option is for the service partner to make an election under Section 83(b) of the Code. Under Section 83(b), the service partner may elect to include the value of non-vested property in income at the time of receipt. Once making the Section 83(b) election, the service partner will not recognize any additional compensation income when the property becomes substantially vested.
Whether or not the service partner should make a Section 83(b) election depends upon a number of factors, including the likelihood of the partnership interest being forfeited prior to becoming substantially vested, and the length of time that the service partner intends to retain his interest subsequent to vesting.
2. Failing to Properly Segregate “Investment” Property from “Dealer” Property.
Property that is deemed held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business is considered “dealer” property subject to ordinary income treatment, rather than “investment” property subject to capital gain treatment.
In order to avoid losing the preferential capital gain tax treatment on properties earmarked as investments, it is important for brokers and developers threatened with dealer status to properly segregate their investment and dealer properties. Segregation into separate entities is not conclusive, as the surrounding circumstances are examined for substantiation, but proper segregation is an important structural step in avoiding dealer classification and the loss of capital gain treatment.
3. Failing to Plan for Income Imputation from Original Issue Discount or Unstated Interest.
In general, if a debt instrument of any kind (including bonds, debentures, notes, certificates of deposit, or loans) is acquired from an issuer for an amount (the “issue price”) less than its face value (its “stated redemption price at maturity”), the difference is Original Issue Discount (“OID”). Regardless of the holder’s method of accounting, he must generally (and subject to certain de minimis rules) report part of the OID amount as interest income in each tax year that the debt instrument is held, even through the OID will not be paid until maturity.
In real estate transactions, OID may arise not only when a debt instrument provides for a below-market interest rate, but also where a debt instrument’s at-market interest rate is actually payable at a lower rate, such as with balloon or lump-sum payments at maturity.
Similarly, whenever there is an issuance of a debt instrument with deferred payments or installment sales in conjunction with a sale or exchange of property, certain sections of the Internal Revenue Code require that adequate interest be charged and paid on the obligation. If adequate interest is not charged and currently paid, part of the payments received will be treated as unstated interest taxable to the seller, regardless of the parties’ intentions.
4. Failing to Price Tenant’s Tax Costs in Lease Sales and Subleases.
From an economic standpoint, it is often irrelevant to a landlord whether his lease agreement provides for a lease sale or a sublease.
For tax purposes, however, the distinction between a lease sale and a sublease is very important. While a tenant’s sale of its leasehold interest generally results in capital gain, a sublease creates ordinary rental income to the tenant. Not only is the difference in tax cost significant to the tenant who must actually pay the tax; sophisticated landlords can demand price premiums for agreeing to help tenants avoid the tax costs associated with a sublease by restructuring the sublease as a lease sale.
It is not always easy for tax purposes to distinguish between a sale of a lease from a sublease. In general, if a tenant is divested of its entire interest in the lease, the transaction will be classified as a sale for tax purposes. However, certain rights, options, existing subleases, and types of payment structuring can inadvertently cause the transaction to be re-characterized as a sublease for tax purposes. With proper provision and tax drafting, both landlord and tenant frequently can benefit from structuring a sublease as a lease sale.
5. Failing to Understand Who Gets the Depreciation.
When partners enter into real estate ventures, they often mistakenly assume that, as “partners,” they are equally entitled to depreciation deductions according to their proportionate interests in the partnership.
In reality, partners’ shares of partnership liabilities and corresponding allocations of depreciation depend upon whether liabilities are “recourse” or “nonrecourse.” Those active in the real estate business are certainly familiar with these terms. But for tax purposes, definitions of the terms “recourse” and nonrecourse” are more technical and restrictive than might otherwise be expected.
Recourse liabilities are allocated in accordance with the partners’ economic risk of loss, so liabilities are recourse to the extent that a partner bears the economic risk of loss if the liability is not satisfied by the partnership. A partner generally bears such economic risk of loss to the extent that he is required to make a contribution to the partnership (including the obligation to restore a deficit capital account) or pay creditors in a theoretical liquidation of the partnership. In effect, a partner’s economic risk of loss is measured by his ultimate responsibility to pay a partnership creditor or to contribute additional funds to the partnership.
A partner is not considered to bear the economic risk of loss if he is entitled to reimbursement from other partners or from the partnership, such as through an indemnification agreement or a state law right to subrogation. Moreover, limited partners cannot be allocated recourse liabilities in excess of their respective capital contributions (and future contribution obligations) unless they have properly agreed to restore capital account deficits or to indemnify other partners for their debts with respect to a liability. It should also be noted that separate rules apply in the case of nonrecourse debts of the partnership where a partner is the lender or has guaranteed repayment of the debt.
By contrast, a nonrecourse liability is a liability for which none of the partners bears the economic risk of loss, and none of the partners has issued a personal obligation to repay the loan on the part of any of the owners. A partner’s share of nonrecourse liabilities equals the sum of: (1) the partner’s share of partnership “minimum gain,” (2) the partner’s share of taxable gain upon constructive liquidation, and (3) the partner’s share of excess nonrecourse liabilities.
Mechanical rules do limit how, and to what extent, partners may share items of depreciation, but partners can maximize their depreciation deductions with proper planning and careful drafting.