Michael Gray, CPA's Real Estate Tax Letter

February 6, 2018

© 2018 by Michael C. Gray
ISSN 1930-0387

A monthly report focusing on tax issues for the homeowner and real estate investor.

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Have you received your tax preparation materials?

If you haven't received a tax data organizer or instructions to submit information online want tax return preparation service by my successor, Ms. Thi Nguyen, CPA, please call her at 408-286-7400, extension 206.

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Make your tax return preparation interview appointment now

Most personal interview appointments for preparing 2017 individual income tax returns will be scheduled in February. Many clients send their information without having an interview, but if you need that personal attention, you should schedule your interview appointment now. Call Ms. Thi Nguyen, CPA at 408-286-7400, extension 206.

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File your tax return early, if you can

Identity theft has become a rampant problem. Scammers are filing bogus income tax returns and claiming refunds for withholding and estimated tax payment of innocent taxpayers. It can take months to straighten out a duplicate filing situation. Your easiest defense is to be the first one to file an income tax return under your social security number. Individuals who have suffered from identity theft in the past can get a special identification number for electronic filing from the IRS. Meanwhile, many taxpayers must wait to receive documents like Schedule K-1 as late as September, and have to file for extension of time to file their tax returns.

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File 1099s for rental real estate operations.

In the past, many taxpayers were relaxed about submitting Form 1099 for their rental real estate operations. The Tax Cuts and Jobs Act of 2017 includes a 20% tax deduction for unincorporated businesses effective for tax years after 2017, subject to limitations. If you are planning on claiming this deduction relating to your real estate operations, I recommend that you file Form 1099-MISC for nonincorporated service providers and for legal services to which you paid $600 or more during 2017. Remember that fees paid using a credit card do not have to be reported on Form 1099-MISC. They are already reported by the credit card merchant companies.

The due date for Form 1099-MISC for services for 2017 was January 31, 2018.

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Great Recession leads to a tax nightmare for a real estate developer.

Barry Conner is a real estate developer. He owns AHP, an S corporation that builds custom homes in the eastern United States.

Mr. Conner owned several tracts of land through single-member LLCs. He had the properties surveyed and development plans were made for them, but no plans were executed. Due to the Great Recession, the properties were "warehoused", and two of them placed in conservation programs that temporarily prohibited development. The expenses incurred for the properties in 2012 and 2013 were carrying costs, such as property taxes and interest.

The IRS audited the Conners' 2012 and 2013 income tax returns, and "threw the book at them." The IRS recharacterized the business expenses claimed on Schedules C and E to investment expenses and investment interest. A loss from the sale of a property was recharacterized from a business loss to a (nondeductible) capital loss, a large charitable contribution for a bargain sale of land to a church was disallowed, a loss for sales of depreciable business property by AHP was disallowed, and Mr. Conner's status as a real estate professional was disallowed, resulting in suspended passive activity losses for rental properties. The IRS also recharacterized a net operating loss from 2011 to a passive activity loss carryover.

The Tax Court upheld the IRS for most of these adjustments.

Since there was no development for the real estate properties, they were investment properties. Interest expense for carrying them was investment interest expense, limited to net investment income. The other expenses were itemized miscellaneous deductions as investment expenses, subject to the 2% of adjusted gross income floor. (Note under the Tax Cuts and Jobs Act of 2017, these expenses would be nondeductible. The combined amount of real estate taxes and state income taxes is subject to a $10,000 annual limit, starting in 2018.)

Since only one property was a rental property, an election to aggregate the properties for the real estate professional test was disregarded. Mr. Conner wasn't able to substantiate to the Tax Court's satisfaction meeting the real estate professional tests, so the passive activity loss limitations applied for the rental property.

The Tax Court ruled the property sold was investment property, not property held for sale in a trade or business. The loss was a capital loss.

The Tax Court ruled against the IRS relating to the charitable contribution. The IRS tried to limit the deduction to tax basis as property held for sale to customers in a trade or business! The Tax Court ruled the property was investment property, eligible for a fair market value deduction.

The Tax Court also ruled in favor of the taxpayer, allowing a Section 1231 loss for the sale of business property by AHP.

The Tax Court also upheld the IRS in recharacterizing a net operating loss carryforward from 2011 as a suspended passive activity loss.

I think this was a very harsh case, and I believe there are many other developers who have had similar situations. The Conners might consider appealing this case, because the IRS and the Tax Court took a short-term view. As a developer of many properties over many years, Barry Conners had a reasonable argument that these properties were acquired for development years later. He shouldn't be penalized for an economic setback.

On the other hand, it's not an unusual structure for an individual to own property as investment property and sell it to a controlled S corporation at a long-term capital gain for development by the S corporation. When the carrying charges (interest and property taxes) are significant, the individual investor might want to rethink this strategy.

Tax return preparers should be alert for fact situations where their client's business losses could be disallowed as investment expenses, or subject to passive activity loss limitations. The deduction of non-corporate business losses are further limited under the Tax Cuts and Jobs Act of 2017.

Mr. and Mrs. Conners hired a CPA firm to prepare their income tax returns and to audit the financial statements of AHP. The Tax Court found the Conners had reasonable cause and acted in good faith for their understatements of tax liability and weren't subject to accuracy-related penalties.

(Barry Conner v. Commissioner, T.C. Memo. 2018-6, January 22, 2018.)

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Will an election to capitalize carrying charges "defeat" the limitations under the new tax law?

Taxpayers can elect under Internal Revenue Code Section 266 to capitalize interest, taxes and other carrying charges and add them to the tax basis of unimproved real estate. Any items that must be capitalized under the uniform capitalization rules must be accounted for under those rules before applying this election. (Under the Tax Cuts and Jobs Act, more taxpayers are exempt from the uniform capitalization rules.)

This election is valuable when the taxpayer would receive no tax benefit from claiming the carrying charges as current deductions on his income tax return, such as when the taxpayer has significant itemized deductions that would be wasted. (Under the Tax Cuts and Jobs Act, many itemized deductions have been eliminated or limited, reducing the value of this election.)

Some commenters have suggested making the Section 266 election to capitalize expenses, such as property taxes or investment expenses that formerly would be miscellaneous itemized deductions subject to the 2% of adjusted gross income floor, that otherwise wouldn't be tax deductible under the Tax Cuts and Jobs Act.

This strategy won't work. Under Treasury Regulations Section 1.266-1(b)(1), only expenses that would otherwise be tax deductible may be capitalized using the election. The IRS also stated in IRS Letter Ruling 201607005 that real estate taxes which otherwise aren't deductible when computing the alternative minimum tax (AMT) can't be capitalized and added to the AMT tax basis of the property.

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Financial Insider Weekly past episodes

After eight years of production, I have discontinued producing new interviews for Financial Insider Weekly. Doing the show has been a rewarding experience and I consider back episodes to be my legacy of financial literacy education to our community. Back episodes available at https://www.youtube.com/user/financialinsiderweek.

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Questions and Answers

Michael Gray regrets he can no longer personally answer email questions. He will answer selected questions in this newsletter.

Dear readers:

Many of your questions relate to the sale of a principal residence. We have an article at our web site, "Could your residence be the ultimate tax shelter?" (www.realestateinvestingtax.com/residence.shtml) where you should be able to find the answers to most of these questions.

Many other questions relate to short sales and foreclosures. See our article on that subject at www.realestateinvestingtax.com/shortsale.shtml.

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Michael Gray, CPA
2482 Wooding Ct.
San Jose, CA 95128
(408) 918-3162
FAX: (408) 938-0610
Hours: 8am - 5pm PDT Monday - Friday

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