For real estate operators, it’s crucial to understand the nuances of the promote interest rules and accurately classifying their interaction with Section 1231 property.  

The Tax Cuts and Jobs Act of 2017 introduced Section 1061 to the Internal Revenue Code, fundamentally changing how “promote interests” (also known as carried interests) are taxed. This provision extended the required holding period for long-term capital gains treatment from one year to three years for applicable partnership interests (APIs) held by investment professionals. 

Before 2017, investment managers across private equity, hedge funds, and real estate could receive promote interest allocations and qualify for long-term capital gains treatment after holding assets for just one year. The legislation targeted situations where professionals contributed little or no capital but received substantial compensation through profit-sharing arrangements upon asset sales. 

The tax impact is significant: Long-term capital gains are currently taxed at 20% for high income earners, while ordinary income is taxed at rates up to 37% at the federal level. This 17-percentage-point difference makes the distinction between capital gains and ordinary income treatment financially substantial for such real estate operators. 

When final regulations were issued in January 2021, they included a crucial exception for Section 1231 property. This exception allows real estate professionals to maintain the favorable one-year holding period for long-term capital gains treatment, even when holding promote interests. 

Section 1231 property encompasses depreciable business property held for more than one year, and real property used in a trade or business whether or not subject to depreciation allowances. For real estate investors, this typically includes: 

The key requirement is that the property must be “used in a trade or business.” Rental real estate that is acquired, managed, and held for a long period for the purpose of collecting rents is used in the business of rental real estate, and generally qualifies as Section 1231 property. Certain triple net lease arrangements may require additional analysis.  Real estate accounting firms working with real estate clients, understanding these classifications is essential for accurate tax planning and compliance. 

This is where many real estate professionals and real estate CPAs encounter confusion. While revenue-generating rental properties qualify as 1231 property, undeveloped land typically falls under Section 1221 property classification. 

Section 1221 property includes: 

When real estate professionals engage in land development or entitlement activities without establishing a trade or business use, the property remains classified as 1221 property, making it subject to the three-year holding period requirement under Section 1061. It’s imperative to understand this distinction in classification for real estate tax reporting. 

From a real estate CPA perspective, let’s examine two scenarios that illustrate how these rules work in practice: 

A real estate partnership acquires an office building for $2 million, holds it for 18 months while actively operating, managing, leasing and collecting rents, then sells it for $2.5 million. The promote interest holder receives their allocation as long-term capital gains because the office building qualifies as Section 1231 property, exempt from the three-year holding period requirement. 

The same partnership purchases undeveloped land for $1 million. It does not use the land in connection with a trade or business, rather obtains entitlements with the intention of selling the property upon completion. The final map is recorded 18 months later, and the partnership sells the land for $1.5 million. Since the land was not used in a trade or business, it is Section 1221 property, no 1231 exception available, and the promote interest holder’s allocation would be recharacterized as ordinary income under Section 1061. 

The intersection of promote interest rules and Section 1231 property classifications creates both opportunities and pitfalls for real estate investors when it comes to taxation of real estate. While rental properties and other business-use real estate maintain favorable tax treatment, land development and investment activities may face increased tax burdens. 

It’s important that you and your real estate CPA understand your options and take advantage of the most favorable outcome. The distinction between Section 1231 and Section 1221 property can mean the difference between 20% and 37% federal tax rates. 

If you have questions about how these promote interest rules apply to your specific real estate investments or need assistance with real estate tax planning strategies, contact Craig Shinozaki on the Haskell & White team. As an experienced real estate accounting firm, we specialize in helping real estate professionals navigate these complex regulations and optimize their tax positions.  

Inheriting a partnership interest in real estate can be a complex process, especially when it comes to understanding the tax implications. One of the most important considerations is the step-up in basis, which can significantly affect the amount of taxes owed.

Having provided real estate consulting and CPA services for numerous partnership properties, we’ve encountered many heirs who were unfamiliar with the process and had no idea how to navigate their inheritance. We developed this article to help guide such individuals. We’ll explain the step-up rules in real estate for a partnership inheritance and detail the steps we recommend taking after inheriting a partnership interest that is invested in real estate.

One term that’s helpful to understand when it comes to inheriting interests in partnerships is “adjusted basis”, which refers to the original cost of an asset for tax purposes—typically the purchase price—that is adjusted for improvements, depreciation, and other factors. Adjusted basis is crucial for calculating capital gains or losses when property is sold.

The Internal Revenue Code (IRC) Section 743 provides for basis adjustments to partnership property in specific circumstances, including when a partnership interest is sold, exchanged, or when a partner passes away. If a partnership has made a Section 754 election, the tax basis of the partnership’s property (the inside basis) can be adjusted to match the value of the partner’s interest in the partnership (the outside basis). Making this adjustment helps resolve disparities between the partner’s share of inside property tax basis and the outside tax basis of their partnership interest to ensure consistent taxation.

There are three scenarios under Section 743 that can trigger basis adjustments:

In real estate, property values often appreciate significantly over time. When a deceased partner’s interest in a real estate partnership is transferred to an heir, the heir’s basis in the property can be stepped up to the fair market value at the date of the partner’s death. This higher basis may provide larger depreciation deductions and reduced taxable gain upon later sale of the property.

Let’s look at an example: A partner passes away holding a partnership interest with a tax basis of $100,000 and a fair market value of $1,000,000. If the partnership does not have a 754 election in place, the beneficiary receives a tax basis in his partnership of $1,000,000, but there is no change to the tax basis of the partnership’s property.  However, with a754 election, the partnership may step-up the beneficiary’s share of adjusted basis of partnership property by $900,000, the difference between the partner’s tax basis in his interest and the fair market value of his interest. To the extent the appreciation is allocable to depreciable or amortizable assets, the beneficiary will be entitled to increased depreciation or amortization   If the partnership were to sell the property, any remaining undepreciated step-up basis will reduce the partnership’s gain allocated to the new partner.

A Section 754 election is a one-time election that allows the partnership to make adjustments to increase or decrease the adjusted tax basis of its property to match the new partner’s outside basis in certain circumstances. This election must be made by the partnership, typically at the discretion of the general partner (or manager if an LLC), and isn’t mandatory If there is no Section 754 election in place, the partnership can make the election on its tax return for the year, or it can choose not to adjust the basis as long as the property has not lost over $250,000 of value. Once a Section 754 election is made, the partnership is required to adjust the basis on all future scenarios that trigger basis adjustments. If there is a sale, exchange, or transfer upon death, the partners must notify the partnership within a specific amount of time. The respective timeframes are:

To keep things as straightforward and stress-free as possible, we recommend following these four steps upon inheriting a partnership interest. Based on our experience in real estate consulting, following this process will help you avoid future complications or tax discrepancies:

Inheriting a partnership interest in real estate can be financially advantageous, especially if you’re able to take advantage of the step-up rules. Understanding IRC Section 743 and the benefits of a Section 754 election is crucial for managing the tax implications of your inheritance. For more detailed information, refer to the IRS guidelines on basis adjustments.

By engaging CPA services and ensuring accurate appraisals and reporting, you can maximize the benefits of your inherited property. Contact us to learn more.

The CA Franchise Tax Board has announced that approximately 3,000 Pass-through Entity Tax (PTET) payments made for tax year 2022 have erroneously been applied to tax year 2021. The error resulted in refunds being issued to the affected taxpayers. As an initial payment of the 2022 PTET was required to be made by June 15, 2022, in order for a Taxpayer to be eligible to elect for the 2022 PTET program, the affected taxpayers should resubmit the initial 2022 PTET payments as soon as possible.

Please contact a member of your engagement team to resolve this issue. We look forward to resolving this quickly to preserve your PTET election. To reach the Tax Department Administrator please dial our main line (949)450-6200 and select option 2.

If your business is depreciating over a 30-year period the entire cost of constructing the building that houses your operation, you should consider a cost segregation study. It might allow you to accelerate depreciation deductions on certain items, thereby reducing taxes and boosting cash flow. And under current law, the potential benefits of a cost segregation study are now even greater than they were a few years ago due to enhancements to certain depreciation-related tax breaks.

Generally, business buildings have a 39-year depreciation period (27.5 years for residential rental properties). Usually, you depreciate a building’s structural components, including walls, windows, HVAC systems, elevators, plumbing and wiring, along with the building. Personal property — such as equipment, machinery, furniture and fixtures — is eligible for accelerated depreciation, usually over five or seven years. And land improvements, such as fences, outdoor lighting and parking lots, are depreciable over 15 years.

Often, businesses allocate all or most of their buildings’ acquisition or construction costs to real property, overlooking opportunities to allocate costs to shorter-lived personal property or land improvements. In some cases — computers or furniture, for example — the distinction between real and personal property is obvious. But the line between the two is frequently less clear. Items that appear to be “part of a building” may in fact be personal property, like removable wall and floor coverings, removable partitions, awnings and canopies, window treatments, signs and decorative lighting.

In addition, certain items that otherwise would be treated as real property may qualify as personal property if they serve more of a business function than a structural purpose. This includes reinforced flooring to support heavy manufacturing equipment, electrical or plumbing installations required to operate specialized equipment, or dedicated cooling systems for data processing rooms.

A cost segregation study combines accounting and engineering techniques to identify building costs that are properly allocable to tangible personal property rather than real property. Although the relative costs and benefits of a cost segregation study depend on your particular facts and circumstances, it can be a valuable investment.

The Tax Cuts and Jobs Act (TCJA) enhances certain depreciation-related tax breaks, which may also enhance the benefits of a cost segregation study. Among other things, the act permanently increased limits on Section 179 expensing, which allows you to immediately deduct the entire cost of qualifying equipment or other fixed assets up to specified thresholds.

The TCJA also expanded 15-year-property treatment to apply to qualified improvement property. Previously this break was limited to qualified leasehold improvement, retail improvement and restaurant property. And it temporarily increased first-year bonus depreciation to 100% (from 50%).

Fortunately, it isn’t too late to get the benefit of speedier depreciation for items that were incorrectly assumed to be part of your building for depreciation purposes. You don’t have to amend your past returns (or meet a deadline for claiming tax refunds) to claim the depreciation that you could have already claimed. Instead, you can claim that depreciation by following procedures, in connection with the next tax return that you file, that will result in “automatic” IRS consent to a change in your accounting for depreciation.

Cost segregation studies can yield substantial benefits, but they’re not right for every business. We can judge whether a study will result in overall tax savings greater than the costs of the study itself. Contact our real estate advisory team to find out whether this would be worthwhile for you.

© 2021

Real estate is top of mind when it comes to businesses that create passive income streams or losses. Ownership in other types of companies can also create passive income. Investments also produce passive income and losses. Understanding passive income streams and how to account for them is vital to creating tax planning strategies. A real estate CPA will analyze each of your activities to determine whether it is passive or nonpassive before embarking on creating an overall tax plan.

Passive activity rules are a set of regulations released by the Treasury intended to limit the allowance of losses from certain activities in which taxpayers don’t sufficiently participate against other types of income. To understand these rules, it’s important to know what activities the IRS constitutes as “passive income.”

Income or loss is considered passive where the taxpayer does not have a material role in the activity used to generate that income or loss. This lack of material participation is seen in activities such as trades, real estate and other rentals. Essentially, any business activity where you don’t materially participate constitutes a passive activity.

On the other hand, if you regularly and continuously participate in the day-to-day activities typical of an owner, then the income generated by the business is considered nonpassive.

The IRS has tests to determine material participation. Generally, if you participate more than five hundred hours in the activity, it’s nonpassive income. Other tests include where the taxpayer’s activity constitutes substantially all of the participation of all individuals, and where a taxpayer participates more than 100 hours during the year and not less than that of any other individual. Ensure you keep time reports, calendars or logs to establish how much time you have spent participating in the business. (Things get a little more complicated with rentals and accounting for real estate, but more on that in a minute.)

Depending on the underlying investment, some capital gains or losses can also be considered passive income. This is determined on a case-by-case basis, depending on the underlying investment.

If your venture is a passive activity, then the passive activity loss rules come into play. For one, these rules prohibit you from deducting losses that you generate from your passive income from the income you earn from materially participating activities or other nonpassive income streams. Nonpassive income includes: wages, annuities, dividends, interest, royalties, gas and oil royalties, and gains and losses from portfolio investment and nonpassive activities.  However, as we said above, there are cases when you can classify your capital gains or losses as passive income. For instance, one of our clients had $200,000 in capital gains due to capital investment, and we were able to free up a number of losses in this case by applying the passive activity rules.

While these rules might limit your ability to deduct losses in any tax year, any losses you can’t use one year can be carried over to the next, indefinitely. Additionally, when you dispose of a passive activity, you are able to release all the suspended losses. For example, say you own rental real estate with suspended losses going back several years. When you sell that property, you can release the suspended losses related to that property – no matter what. You can then deduct these suspended losses against other nonpassive income.

When it comes to rental real estate activities, all rental income is generally categorized as passive income, no matter how much you participate.

So, even if you materially participate in running your rental properties, you still can’t deduct those losses against other nonpassive income. That is, unless you meet one of the following exceptions:

If you participate in any passive income activity, either directly or through “pass-through” entities, these passive activity loss rules probably apply. We’re experts in tax planning and strategies for real estate businesses and navigating the passive activity rules.

If you want to ensure you’re structuring your activities in the best possible manner or you want to learn more about how these rules might apply to your business, contact our real estate CPAs today. Our real estate accounting experts can help.

Real estate transactions are showing no signs of slowing down, and part of the reason is a popular section of the tax code known as a 1031 Like-Kind Exchange.

Exchanges are go-to strategies for businesses looking to upgrade or relocate facilities, and investors moving upstream, into newer properties, or into different sectors. The 1031 Exchange allows taxpayers to sell properties and buy new ones without paying taxes on the profit from the sale.

This tactic works by exchanging real property used for business or held for investment, using the proceeds to purchase business or investment real property of a “like-kind”. To the extent proceeds from the sale are reinvested in the replacement property, and the debt incurred on the replacement property is at least equal to debt on the relinquished property, no gain is currently recognized. With the right advice from a real estate accounting firm, such a swap can be the perfect solution for businesses or investors looking to reposition their real estate holdings.

Businesses are using 1031 exchanges to move up in physical, technological or logistical capabilities not available in their old facilities. Exchanges are also being used to relocate to entirely new markets, or to shift excess capacity from concentrated areas to underserved markets. Exchanges may also be used to replace one type of property for another, such as an office building for a warehouse. It can also be part of a strategic plan to change businesses altogether. For example, a farmer transitioning from farmland to apartments.

Investors are taking advantage of 1031 exchanges to change their realty holdings for various reasons. For example, an exchange of unproductive land for commercial buildings in order to generate cash flow. Land may generate liquidity when sold, while commercial buildings generate rental income potentially sheltered by depreciation. Investors may also increase diversification with an exchange allowing them to trade property concentrated in certain markets (geographic, segment, size) for properties in different markets. Because there are no limits to how many times a taxpayer may rollover gain from 1031 exchanges, they are often part of a taxpayer’s estate plan. It facilitates growth on the gross equity over time, without reduction for taxes, thereby yielding a higher return. If the exchange property is held in the estate at the taxpayer’s death, the 1031 gain deferrals are often eliminated with the resulting basis step-up, allowing heirs to subsequently dispose of the property without income tax.

An experienced CPA with expertise in real estate can help you manage all the nuances, timing and other requirements in order to qualify under 1031. These include requirements such as a 45 day time period to identify potential replacement properties, a 180 day time period from sale to acquire the replacement property, a prohibition for taxpayer to have receipt of sale proceeds, an intention to hold the property, certain related party rules, and definition of like-kind. With such a tight calendar and so many points to negotiate, it’s critical for taxpayers to prepare in advance when embarking on a 1031 Exchange.

Whether you’re forming a new real estate entity, or whether you’re considering refinancing an existing one, owners and managers of real estate entities should recognize that this is an opportunity to consider changing their financial reporting method. New lender requirements can often be negotiated, and a possible change in reporting method may better fit your company’s circumstances. The majority of real estate companies have a choice on the method they use for financial reporting. The two most common methods include Generally Accepted Accounting Principles “GAAP” or Income Tax Basis Reporting.

In financial reporting for real estate, GAAP and Income Tax Basis Reporting often yield very different financial results. GAAP reporting is required if the real estate entity is a publicly traded company. Conversely, if there is no mandate, real estate owners can choose between the two methods of financial reporting.

While each has its advantages, it can be challenging to determine the best method for each company. The best place to start is by evaluating the key differences and reviewing some key considerations.

While each method has its advantages, there is no “right” choice for reporting. Management should review the facts and circumstances with an experienced real estate accountant to choose the best method for their business and their desired outcomes.

Does your real estate accounting firm provide you with all the options to ensure your business is successful? Contact us today for a free consultation.

Diane Wittenberg, CPA, is a Partner with Haskell & White. She works with many real estate clients, as well as clients in other industries. She provides audit and consulting services to both public and private companies. She can best be reached at 949-450-6334 or dwittenberg@hwcpa.com.

December 2017’s tax reform bill changed the taxation landscape dramatically, impacting the entire spectrum of taxpayers, from individual rates to corporate structures. Income taxes generally comprise a significant cost, negotiation point and hot topic for real estate operators, so understanding these changes and how they can impact the after-tax return on investment is crucial.

A few of the significant updates to the tax code that will influence tax planning strategies related to real estate investment and development are discussed below.

Tax code revisions resulted in not only a reduced corporate rate of 21% (down from 35%), but a new 20% pass-through deduction has been established for non-corporate taxpayers (partnerships, LLCs, S-Corps, and sole proprietorships) on qualified business income.  Numerous limitations exist, yet opportunities remain that expand the limitation threshold.

The relationship between carried interest (promote, kicker, sweat equity) and capital gain treatment has long been a point of contention between the real estate industry, Wall Street and Congress. As of January 1, 2018, a partnership interest held for less than three years will have its allocation of promote gain re-characterized as short-term capital gains which are taxed at ordinary rates. Regulations are forthcoming. Therefore a large gray area exists related to planning opportunities prior to the effective date of any regulations.

Congress voted to maintain 1031 exchanges for real property, the section of the tax code that allows tax-free property sales generally as long as proceeds are invested into new property purchases. This provision applies to real property only, and no longer will apply to personal property. Additional due diligence is needed to assess the impact of cost segregations and the potential allocation of purchase price to personal property.

Deduction of net business interest expense may be limited to 30% of adjusted taxable income (new term to be assessed) for companies or combined groups with gross receipts of greater than $25 million.  Does this mean that parking the old and cold partnership asset with a highly leveraged and structured deferred lease is no longer as strong of a tax deferral option?  How will this impact leverage ratios?  Exceptions exist but at the cost of slower depreciation.

Bonus depreciation and section 179 has been expanded. This treatment may not always be beneficial so make sure to conduct the analysis.

New amendments to the tax code can deliver significant benefits to real estate investors, but it’s important to take a close look at the details of how these changes will impact your specific operation before making any major decisions.