2009 aba real estate presentation final

“Three Things All Practitioners Should Understand”

Cary Rodin

John “Trey” Webb

Timothy J. Watt

Presented by:

Real Estate and Tax Law Joint Section BreakfastThursday, November 5, 2009

Debt Forgiveness Income

Goals for presentation

What constitutes debt forgiveness income?

What are the exceptions to debt forgiveness income?

To which taxpayers do the exceptions apply?


What constitutes debt forgiveness income?

Gross income – clearly realized accession to wealth Glenshaw Glass Co. 55-1 USTC ¶9308

Code Section 61 – Defines gross income IRC 61(a)(12) – Includes income from the discharge

of indebtedness


Types of debt forgiveness income

• Abatement or cancellation of debt by the lender

• Repurchase of the debt for less than full amount

• A related party repurchase of debt

• Substantial modification of the terms of the debt

• Contribution of debt to capital of the company

• Exchange of debt for equity in the company



Example One – Repurchase of debt by a related party

Two individuals are members of a partnership that owns a commercial building. Partner A (investor) owns 80% of the member units and Partner B (operator) owns 20%. The partnership owns a building that has a current FMV of $5 million and debt of $8 million. Partner A buys the debt from the lender for $4.5 million. The partnership has debt forgiveness income of $3.5 million.

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Example Two – Substantial modification of debt terms

Homebuilder S corporation is struggling to service its debt. The company owes $1.75 million on lots that are currently not being developed. The owner negotiates a workout with the bank to reduce the interest rate to zero and delay payments for two years at which time the entire remaining debt will be due. The FMV of the renegotiated debt instrument is $1.5 million. The S corporation has debt forgiveness income of $250,000.

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Exceptions to debt forgiveness income under 108(a)

1. Bankruptcy in a Title 11 case

2. Insolvency

3. Qualified Farm Indebtedness

4. Qualified Real Property Indebtedness

5. Qualified Principle Residence Indebtedness

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Bankruptcy Must be a Title 11 case Either discharged by the court or in a plan approved by the court No debt forgiveness income even if the taxpayer is made solvent

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Insolvency Measured by the excess of the total amount of outstanding debt over

the FMV of the total assets Abatement of income only to the extent of insolvency

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Example Three Taxpayer has total assets with a fair market value of $4 million and

total debt of $5 million. The lender forgives $2 million of unsecured debt. The taxpayer has $2 million of debt forgiveness income. $1 million can be excluded under the insolvency exception. If the debt was discharged in a Title 11 bankruptcy case, the entire $2 million of debt forgiveness income can be excluded.

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Big question for bankruptcy and insolvency exclusions – Which taxpayers bankruptcy or insolvency matters? For C corporations and S corporations, insolvency and bankruptcy are

viewed at the corporate level. For partnerships, insolvency and bankruptcy are viewed at the

partner level.

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Example Four Real estate company is in default on its debt. It is owned by two

individuals A & B. Individual A is personally insolvent and individual B has substantial other assets. Real estate company has assets with a FMV of $1 million and debt of $2.5 million. Individual A is personally insolvent due to other real estate investments to the extent of $5 million. The lender reduces the debt to the FMV of the property. The cancellation of debt income is $1.5 million.

If the company is an S corporation, no debt forgiveness income is recognized for tax purposes because insolvency is measured at the corporate level.

If the company is a partnership, the partnership reports debt forgiveness income to the partners of $750,000 each. Individual A is personally insolvent and can exclude the income. Individual B recognizes $750,000 of debt forgiveness income on his tax return.

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Reduction of tax attributes In bankruptcy and insolvency cases Ordering rules

1. net operating loss and net operating loss carryovers;

2. general business credit carryovers;

3. the minimum tax credit;

4. net capital loss and net capital loss carryovers;

5. the basis of the debtor's property (both depreciable and non-depreciable);

6. any passive activity loss or credit carryover from the taxable year of the discharge; and

7. foreign tax credit carryovers. Taxpayer can make an election to reduce the basis of depreciable

property first

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Ordering rules for reduction of basis of property Real property used in a trade or business or held for investment

(other than §1221(a)(1) real property) that secured the discharged indebtedness immediately before the discharge; 108

Personal property used in a trade or business or held for investment — but not inventory, accounts receivable, and notes receivable that secured the discharged indebtedness immediately before the discharge;

Remaining property used in a trade or business or held for investment — but not inventory, accounts receivable, notes receivable, or §1221(a)(1) real property;

Inventory, accounts receivable, notes receivable, and §1221(a)(1) real property; and

Property not used in a trade or business nor held for investment.

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Foreclosure, deed in lieu of foreclosure and abandonment of property

Recourse versus non-recourse debt If non-recourse debt, entire amount treated as a sale of the property If recourse debt, treated as sale up to lower of debt or FMV of

property Debt in excess of FMV is cancellation of debt income

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Example Five – Taxpayer transfers property with a basis of $5 million and a fair market value of $4.5 million to bank to avoid foreclosure. The current debt on the property is $7 million.

If the debt is non-recourse, the taxpayer has a gain from sale of property of $2 million

If the debt is recourse, the taxpayer has a loss of $500,000 and cancellation of debt income of $2.5 million

The difference in treatment can be significant if the taxpayer is insolvent or in bankruptcy.

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Qualified Real Property Indebtedness Taxpayer can make an election to exclude from income discharge of

indebtedness income related to qualified real property indebtedness. Election not available for insolvent taxpayers or discharges in

bankruptcy case. Debt that is acquired or assumed to acquire, construct or

substantially improve real property used in a trade or business. Limited to amount that debt exceeds FMV of the property. Taxpayer making election must reduce other depreciable property

used in a trade or business Partnership – qualification of debt determined at partnership level,

election is made at the partner level

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Purchase money debt Allows taxpayer to reduce the basis of acquired property in lieu of

recognizing debt forgiveness income Must be a note from original seller Not available if original seller has assigned note Taxpayer cannot be insolvent or in bankruptcy

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Deferral of income in certain restructurings Added by the American Recovery and Reinvestment Act of 2009 Taxpayer can elect to defer recognition of income Election will override other statutory exceptions COD income in 2009 and 2010 deferred until 2014 Income recognition spread over 5 years Applies to reacquisition of applicable debt instruments from a trade or

business Income is accelerated if taxpayer dies, liquidates or sells all of the

assets, or ceases to do business (including disposal of a pass-through entity interest).

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Election is made at the entity level ( causing problems for partners with varying circumstances)

Rev Proc 2009-37 provides relief for partnership Partnership can make a partial election Allocate deferred amount among partners in any manner

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Example Six – Election to defer income

Partnership has two partners that each own 50%. In 2009, the partnership has $100,000 of debt discharge income. Partner A is insolvent and does not want to make an election to defer the recognition of income. Partner B does not qualify for another exception and wants to make the election. The partnership can make a partial election for 50% of the COD income. The recognized income is allocated to Partner A and the deferred income is allocated to Partner B. If neither the partnership nor the partner take any action to accelerate the income, Partner B will recognize $10,000 of COD income in years 2014 – 2019.

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Passive Activities and Real Estate Professionals

Passive Activity Loss rules – Abbreviated Summary

Exception/Special Rules for Real Estate Professionals

Qualifying as a Real Estate Professional

Agenda

Tax Reform Act of 1986

Internal Revenue Code §469

Imposes a general restriction on currently deducting net tax losses from passive activities

Overview of Passive Loss Rules

Individuals

Estates and Trusts

Closely-held C corporations

Personal Service Corporations

NOT partnerships or S corporations, but partners and shareholders may be subject on their distributive share

Taxpayers Subject to §469

Passive losses are only deductible against passive income

If there is an aggregate passive loss, each passive loss is carried forward indefinitely

Unused suspended losses are deductible as a nonpassive loss upon a complete disposition in a taxable transaction

Effect of Passive Activity Limitations

Any trade or business in which taxpayer does not materially participate

“Any rental activity” (regardless of material participation)

For real estate professionals, a rental activity in which taxpayer does NOT materially participate

Definition of a Passive Activity§469(c)

Mr. A, an attorney, is a partner at a law firm where he logs over 1500 chargeable hours annually. Additionally, Mr. A is an equity owner/investor in two rental real estate LLCs (unrelated to his law practice) that generate significant pass-through losses each year. Mr. A has no involvement or participation in the management and operations of the RE LLCs other than being an equity owner/investor

Example #1

Regular, continuous, and substantial involvement

Generally, any work in an activity done by an individual (or spouse) who owns an interest in the activity

Exceptions to what constitutes “participation”

Material ParticipationIRC §469(h)

More than 500 hours

Substantially all

More than anyone else (and > 100 hours)

Significant participation activities exceed 500 hours

Nickel and dime test (5 of last 10 years)

Personal service activity (any 3 preceding years)

Facts and circumstances (and > 100 hours)

Seven Tests for Material ParticipationTemporary Treasury Reg. §1.469-5T(a)

Only need to meet one of the seven tests

Tests are exclusive

Applied annually on an activity by activity basis

Additional limitations imposed on Limited Partnership interests

Garnett v. Commissioner, 132 T.C. No. 19, (06/30/09) Thompson v. United States, 87 Fed. Cl. 728, 104 A.F.T.R. 2d

2009-5381 (07/20/09)

Material Participation, Cont’d

Mr. B owns and operates 10 rental houses. He devotes 150 hours per year to performing services at each house (Total of 1500 hours). These services consist of renting the properties, cleaning and repairing the houses, evicting tenants, collecting the rent, and various other activities. Mr. B also receives dividend and interest income for the year from investments, which does not constitute passive activity income. He incurs losses from each of the properties for the year. He would like to offset the losses from his real estate activities against his dividend and interest income, but he cannot do so if the real estate losses are passive activity losses

Example #2

Greater flexibility to currently deduct rental real estate losses

Rental real estate owned by a real estate

professional will NOT automatically constitute a passive activity

Instead, the rental real estate income or loss will be treated as non-passive if the taxpayer materially participates in the activity

Special Rules for Real Estate ProfessionalsIRC §469(c)(7)(B)

Taxpayer still must annually meet the material participation test for each rental activity, separately

General rule in the case of multiple rental activities

Each interest in rental real estate will be treated as a separate rental activity

Unless real estate professional taxpayer elects to aggregate all rental real estate activities into a single activity

Real Estate Professionals, Cont’d

To meet the material participation test when can’t meet the test for each rental activity separately

Includes rental activities owned through limited

partnerships

The more stringent material participation threshold for limited partnership interests may “taint” the taxpayer’s material participation test for ALL rental real estate activities

Election to Aggregate Rental Real Estate Activities

Trap for the unwary

Election formally made with the timely filing of taxpayer’s income tax return

Irrevocable unless there is a material change in the taxpayer’s facts and circumstances

Consequences of not filing or missing the election (as ruled by the courts) are strict disallowance of aggregation treatment

Former passive activities

Considered one activity for carryforward losses and treatment of gains

Election to Aggregate Rental Real Estate Activities, Cont’d

Satisfy two tests:

More than one-half of the personal services performed in trades or businesses by the taxpayer during such tax year are performed in real property trades or businesses in which the taxpayer materially participates

Such taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates

Year-by-year test

Qualifying as a Real Estate Professional

Real Property Trades or Businesses

Any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business

Qualifying as a Real Estate Professional, Cont’d

Mr. C owns 10 rental houses and devotes 150 hours of service per year to managing each property (Total of 1500 hours). He also sells life insurance and works 800 hours per year in that job.

Mr. C should make an election to aggregate all his rental real estate activities to be classified as a real estate professional under IRC §469(c)(7).

He satisfies the "more than half" test Likewise, he satisfies the "750-hour" test He materially participates in the real estate trade or business

under the “more than 500 hour” test

Example #3

Contemporaneous documents are not required if extent of participation can be established by other means

May include appointment books, calendars, or narrative summaries

Numerous cases addressing documentation Taxpayers were often not believable Hours could rarely be substantiated by the records provided

Documentation of Participation

When evaluating whether a taxpayer’s business activities are passive or non-passive, additional considerations should also be made

Definition of an activity Including grouping and combining activities that are an

appropriate economic unit and meet a facts and circumstances test, Reg. §1.459-4

Determination of participation in an activity Activities that are not rental, Reg. §1.469-1T(e)(3)(ii)

$25,000 offset for active participation in rental real estate, §469(i)

Former passive activities

Other Considerations

Limited partnership interests, §469(h)(2), Reg. §1.469-5T(e)

Working interests in oil and gas property, §469(c)(3)

Publicly traded partnerships, §469(c)(3)

Recharacterization of net income rules (self-rental) Choice of entity

Doing business through C corps. and Limited Partnerships may have less favorable results under the PAL rules

Senra v. Commissioner, T.C. Memo. 2009-79 (4/15/09)

State income tax conformity with PAL rules

Other Considerations, Cont’d

Business Formation Choice of Business Entity

Menu of business and legal formations

Considerations of the tax advisor

Income tax characteristics of LLCs, Partnerships,

C Corps. & S Corps.

Agenda

Sole Proprietorship General Partnership Limited Liability Company (“LLC”)

Including single member LLC (“SMLLC”)

Subchapter C Corporation (“C Corp”) Includes:

Personal Service Corp. Professional Corp.

Subchapter S Corporation (“S Corp”) Hybrid Ownership

Business and Legal Formations

Limited vs. Unlimited liability Number of tax levels Can current losses be used by the owners? What are the capital gain and ordinary tax rates

(Federal & state)? Ease of transferability of any appreciated property

(inside the entity) to beneficial owners Ability to make special allocations of income/loss

among the owners Eligibility requirements for being an owner Ease of maintaining a high tax basis for purposes

of deducting losses Transferability of ownership interests

Considerations for the Tax Advisor

Shopping Center

Direct Ownership

Profit/Loss Cash Flow

No Legal Entity

Sole Proprietorship

Mr. & Mrs. Jones

Taxed Entity

1. Simplest form – direct ownership

2. Unlimited liability to owner if something bad happens

3. Taxation 1 level Owner directly includes income (loss) of the venture on

Schedule E in Form 1040 Most instances: gets long-term capital gain treatment if

property is held more than 1 year Tax Rate

Capital gain 15%/25% + state Up to 35% if ordinary income or short-term capital gain

plus state tax

4. Transferability – if real estate has to be transferred, may attract transfer costs and perhaps banking issues regarding the debt, if any

Sole Proprietorship

Limited Liability Company

Mr. Jones Mrs. Jones

Shopping Center



80% 20%

Taxed Entity

1. Relatively simple to form

2. Can be single member or have multiple members

3. Operating Agreement Recommended if there are two or more members

4. Non-restrictive as to who can be a member Individuals Partnerships/LLCs Corporations US/foreign individuals or entities

5. Limited liability to members normally


6. Taxation 1 level of tax – member level Members include profit/loss and other tax attributes in

their respective tax returns Individual – Form 1040 Corporation – Form 1120/1120S

Tax rate depends on the legal form of the member Individual rates: 15% - 35% + state tax C Corporations (earning under $10 million) – up to

34% + state tax C Corporations have no special rates for long-term

capital gains


7. Transferability LLC member units can be sold without selling the real

estate New members can be easily added if cash or property is

required in the future Real Property can be transferred out of the LLC without

major tax consequences in most instances. Mortgage issues could create a problem on transfers of

the property itself


C Corporation

Mr. Jones Mrs. Jones

Dividends Cash Flow

Dividends Cash Flow

80% 20%

Shopping Center $10 Million Tax Level

Up to 34% + state tax

(C Corporation)

Taxed on Dividends

Easy to form – more complicated to operate from a legal standpoint

Non-restrictive as to who can be a shareholder Individuals Partnerships/LLC Corporations US/Foreign – individuals or foreign entities are OK

Transferability of shares is fairly simple. Transferability of appreciated assets out of the C Corp is difficult because of tax issues.

C Corporations should be used to hold real estate in only very unusual circumstances - AVOID

C Corporation

Tax Considerations

1. Double Taxation Corporate level Shareholder level – dividends

2. Tax Rates Graduated up to 34% (under $10 Million) +

state tax No separate long-term capital gain rates like

we have for individuals

3. Shareholders report no income from the corporation’s operations unless a dividend is paid

C Corporation

4. Losses are to be used only if the corporation: Becomes profitable in the future, Was profitable in the past and can carry the loss back to a

prior year , or Files a consolidated corporate tax return and other

corporate members included in the consolidated return are profitable.

5. Transfers of appreciated property to shareholders will result in gain recognition to the corporation and most likely to the shareholders. Treated as a sale or exchange at the corporate level.

C Corporation

6. Appreciated real estate in a C Corporation can cause major problems of the shareholder dies with a large taxable estate – creates both estate tax and income tax issues

C Corporation

Shopping Center

$10 Million (FMV)$2 Million ( Basis)

100%

C Corporation

Mr. Jones

(C Corporation)

FMV of stock - $7 Million

Assumptions

1.Taxable estate - $12 Million2.Husband is widowed3.FMV of stock is reduced because of embedded tax liability

Subject to Estate Tax

Subject to corporate level tax if real estate is

sold after death

S Corporation

100%

Hybrid Entities

U.S. Individuals

Management CompanyOwner

Keep Salaries LowReduce payroll taxes

Shopping Center

75%Corporate Investors

25%

LLC

Hybrid Entities

1. Use Pass-throughs only

2. Corporate owners will not allow S Corp election

3. Use two-tiers to place corporate owners as direct owners of the LLC

4. Reduce payroll taxes

CharacteristicSole

ProprietorshipSingle Member

LLC LLC Partnership Limited Partnership

Limited Liability

NO YES YES(unless provided

otherwise)

NO(General partners: unlimited liability)

YES/NO(General partners:

unlimited liability, Ltd Partners: no liability)

Levels of Taxation

One(Sch. C on 1040)

(Sch. E on 1040)

One(Sch. C on 1040)

(Sch. E on 1040)

One(flow thru)

(Sch. E on 1040)

One(flow thru)

(Sch. E on 1040)

One(flow thru)

(Sch. E on 1040)

Certainty of Tax Status

Yes Yes (Check the Box)

Disregarded entity

Yes (Check the Box)

Like a partnership

Yes (Check the Box)

Partnership

Yes (Check the Box)

Partnership

State Taxation

One Depends(Some follow

Federal, others treat as separate Corp)

Depends(Some tax as Corp., some impose fees)

Few / None(may withhold for

non-residents)

Few / None(may withhold for non-

residents)

Characteristics of Entity Types

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CharacteristicSole

ProprietorshipSingle Member

LLC LLC Partnership Limited Partnership

Self-Employment Tax

Yes Yes Depends(active members,

yes)

Yes Yes / No(General partners: yes,

Ltd Partners: no)

Participation No Restrictions

No Restrictions

No Restrictions

No Restrictions

State Dependent(General partners: no

restrictions, Ltd Partners: restricted)

Continuity of Life

N/A Yes Yes No(Partner withdraws, it’s dissolved – Vote of partners keep it)

No(Partner withdraws, it’s

dissolved – Vote of partners keep it)

Deduct Fringe Benefits

Health - Yes

Other - No

Health - Yes

Other - No

Health - Yes

Other - No

Health - Yes

Other - No

Health - Yes

Other - No

Characteristics of Entity Types, Cont’d

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CharacteristicLtd Liability

PtnshipLtd Liability

Limited Ptnship S -Corporation

Professional Corporation C- Corporation

Limited Liability

State Specific

State Specific YES(unless provided

otherwise)

YES YES(unless provided

otherwise)

Levels of Taxation

One(Sch. E on 1040)

One(Sch. E on 1040)

One (generally)

(flow thru)

(Sch. E on 1040)

Two Two

Certainty of Tax Status

Yes Yes (Check the Box)

Partnership

Yes (Timely filing of

election)

Yes Yes

State Taxation


non-residents)


non-residents)

Depends(may withhold for

non-residents)

Yes Yes


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CharacteristicLtd Liability

PtnshipLtd Liability

Limited Ptnship S -Corporation

Professional Corporation C- Corporation

Self-Employment Tax

Not Clear(probably Yes)

Not Clear(probably Yes,

General Ptnrs, No Limited Ptnrs)

No No No

Participation No Restrictions

State Dependent

(General partners: no restrictions, Ltd Partners: restricted)

No Restrictions

No Restrictions

No

Restrictions

Continuity of Life

No(Partner withdraws, it’s dissolved – Vote of partners keep it)

No(Partner withdraws, it’s dissolved – Vote of partners keep it)

Yes Yes Yes

Deduct Fringe Benefits

Health - Yes

Other - No

Health - Yes

Other - No

Health – Yes

Other – No(if >2% owner)

Health - Yes

Other - Yes

Health - Yes

Other – Yes


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QUESTIONS?

Business Formation & Choice of Business Entity

2009 aba real estate presentation final

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