Tax Planning Opportunities for Real Estate Developers and Investors
By Kenneth H. Bridges, CPA, PFS February 2016
Federal income tax rules have long been mostly favorable for real estate developers and investors. Having a basic understanding of the general rules applicable to real estate developers and investors is critical to being able to take full advantage of these favorable provisions.
Use of flow-through entities – Most real estate projects are structured through LLCs (treated as partnerships for income tax purposes). The LLC is not subject to income tax (avoiding the risk of double taxation), tax losses can be passed through to the owners, tax losses deducted by the owners can often exceed their investment in the entity (due to an allocation of the entity’s liabilities), appreciated property can generally be distributed out of the entity to the owners without triggering the gain, there are essentially no limitations on who can be an owner of the entity, and you can generally (subject to the “substantial economic effect” rules) allocate income, loss, distributions, etc. amongst the owners in any manner in which the owners agree. If the LLC has only one owner, then it is disregarded altogether for income tax purposes (which can be advantageous in the context of IRC 1031 like-kind exchanges). S-corps are sometimes useful in the real estate world, but come with many more limitations (in terms of ownership structure, inability to specially allocate items, inability to deduct losses in excess of investment, inability to distribute out appreciated property without triggering gain, etc.), so are generally not appropriate for ownership of real estate. In the publicly-traded sector, real estate investment trusts (REITs) can be a tax-advantaged way to own real estate. Ownership of real estate in a C-corp should generally be avoided if possible.
Carried interests – The taxation (or lack thereof) of “carried interests” has gotten much attention in the press in recent years, largely because of the use of this technique by hedge fund managers to characterize much of their income as capital gain. Current tax rules provide that where a partner (e.g. a developer) receives an ownership stake in a venture in connection with his or her performance of services you value the ownership stake for income tax purposes based on its immediate liquidation value. Accordingly, any “future profits” or appreciation in value in the ownership is not taxed until the profits are realized, and then often at the favorable capital gains rates.
Financing – Most real estate projects involve debt. Loan fees generally should be capitalized and amortized over the life of the loan (with an accelerated write-off if the loan is refinanced or paid off early). Interest expense incurred during the development/construction phase generally must be capitalized into the cost of the project (under the “avoided cost method”, and looking through tiers of ownership), whereas interest expense incurred after completion of construction can generally be expensed. Interest expense associated with debt incurred to finance distributions to the partners may have to be passed through separately to the partners, with tax deductibility determined at the individual partner level based on how they used the distributed proceeds. If a borrower with a floating rate obligation decides to hedge the interest rate risk by swapping it for a fixed rate, then an asset or liability may need to be recorded on the books if market interest rates increase or decrease. For income tax purposes, the borrower continues to deduct the interest expense as incurred, but may have a write-off if a swap termination fee is paid.
Depreciation – The cost of land is generally not tax deductible until you later sell it, but most of the costs incurred in adding value to it can be depreciated. Current tax rules provide fairly lengthy depreciation lives for structures (27.5 years for residential buildings and 39 years for commercial buildings), but land improvements (e.g. sidewalks, paving, fencing, landscaping) and nonstructural items (e.g. carpet, cabinetry, appliances) can be depreciated over much shorter lives using accelerated methods. “Bonus depreciation” rules enacted over the past few years have permitted an initial year write-off of 30% to 100% (depending on the year, but currently 50%) for assets other than the land and structure. These deductions can be taken even though the overall value of the project is hopefully increasing.
Amortization – Financing costs should typically be capitalized and amortized over the life of the related loan. Lease commissions should be capitalized and amortized over the life of the lease. The unamortized portion can be written off if the loan or lease are terminated.
Passive activity loss rules – Prior to the Tax Reform Act of 1986, real estate deals were frequently used as tax shelters. A combination of very high ordinary income tax rates, much lower capital gains rates, accelerated depreciation rules, investment tax credits, and favorable treatment of real estate related debt meant that the tax benefits associated with a real estate investment often exceeded the amount of the investment itself. TRA ’86, however, effectively eliminated these benefits through a combination of longer depreciation lives, equalizing the ordinary and capital gains tax rates (no longer the case), repealing the investment tax credit, subjecting real estate (with important exceptions) to the “at-risk rules”, and, perhaps most importantly subjecting losses to the passive activity loss (PAL) rules. Under the PAL rules, generally tax losses from rental real estate (or any business in which you do not “materially participate”) can only be offset against net income from similar activities. However, real estate professionals can make an election to essentially be outside the PAL rules with respect to projects in which they actively participate.
Low-income housing tax credits – In order to encourage developers to build, manage and maintain affordable rental housing for lower income persons, Federal tax law provides a very generous tax credit, and some states (e.g. Georgia) provide a similar or matching credit. The Federal tax credit is generally 9% per year of the eligible cost of the buildings each year for a 10-year period (i.e. a total Federal tax credit equal to 90% of the eligible cost of the buildings). The occupants must have income below certain maximum levels, and rent is restricted based on the occupants’ income. Because of limitations on the ability of individuals to utilize the Federal credit, the primary investors in these projects are typically large companies (frequently banks, because of the added incentive of getting credit under the Community Reinvestment Act). The state credit, which does not necessarily have to be allocated to the same investor as the Federal credit, is often allocated to individuals or insurance companies.
Striving for long-term capital gain treatment – Long-term capital gains have historically (with brief exceptions) enjoyed a lower tax rate than that imposed on ordinary income. Real estate generally qualifies as a capital asset, unless held for sale in the ordinary course of business or being developed for sale. Accordingly, if an owner of real estate can position themselves as an investor, and not as a dealer or developer, and get a holding period of at least 12 months, they may enjoy a substantial tax break on the gain (or be able to defer tax on the gain completely by use of a like-kind exchange).
IRC 1031 like-kind exchange – Tax rules provide that property held for investment or used in a trade or business can be exchanged tax-free for other property of like-kind which will be held for investment or used in a trade or business. Real estate is defined very broadly for these purposes, such that basically all real estate is considered to be like kind with other real estate (e.g. you can exchange raw land for an apartment complex), so long as you meet the other tests for like-kind exchange treatment. Exchanges can be multi-party (i.e. the buyer of your property and the seller of the replacement property you desire do not have to be the same) and do not have to be simultaneous. Via the use of a Qualified Intermediary (for “delayed” or “forward” exchanges) or an Exchange Accommodation Titleholder (for “reverse” exchanges) you can have up to 180 days after you sell your property to acquire replacement property, or acquire your desired replacement property up to 180 days before you sell your property. While the section 1031 rules are complex, the basic fundamentals are pretty simple. First, both the property you are relinquishing and the replacement property you are acquiring must be used in a trade or business or held for investment. Second, in order to enjoy full tax deferral, the property(s) you are acquiring must be equal to or greater in value than that of the property you are selling.
Fee income – Developer fees, management fees and commissions are important income streams and sources of current cash flow for those in the real estate business. Unfortunately, from an income tax perspective, these are typically treated as ordinary income, with no shelter other than the related operating expenses. However, since real estate professionals are generally not subject to the passive loss rules with respect to projects in which they actively participate, they may be able to shelter their fee income from tax using losses from projects in which they have an equity stake.
Sale of land by single-family residential developer to related S-corp – Developers of single-family residential lots and homes often do not enjoy the long-term tax deferral and capital gains rate opportunities enjoyed by developers of apartments, office buildings, warehouses, shopping centers and hotels. However, an SFR developer which owns land which has appreciated prior to commencement of development and subdivision may be able to limit the tax on the predevelopment appreciation to the capital gains rate by structuring a sale of the property to a related S-corp before beginning active development.
Charitable donations – A gift to a charitable organization of appreciated real estate which has been held for investment can result in the donor receiving a tax deduction for the full fair market value of the asset, and no one paying tax on the appreciation. A “bargain sale” to a charitable organization (i.e. a sale for less than the appraised value) can result in both cash flow to the seller and an income tax deduction (for the amount by which appraised value exceeds the selling price).
Conservation easements – If you are willing to grant a perpetual conservation easement to a qualified organization (effectively giving up or limiting your rights to develop the property), then the tax law will reward you with a tax deduction. The amount of the deduction is the difference between the appraised value of the land assuming its highest and best use value before the granting of the conservation easement and its value after granting the conservation easement. Note that you must reduce your deduction, however, by the amount of any value enhancement to adjacent property you own enjoys as a result of the conservation easement. Caution is in order when considering a conservation easement, as the IRS perceives that there has been abuse in this area and often carefully scrutinizes deductions for conservation easements.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.