2022 January

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Uncategorized

Real Estate Purchase Price Important

January 13, 2022

Importance of purchase price allocation in real estate transactions

By Jennifer M. Ray, CPA, Frazier & Deeter LLC, Tampa, Fla.

December 1, 2021

The bright pink house for sale was an eye-catcher. Built in the 1960s, this not-really-updated two-bedroom, one-bath house was purchased in 2001 for $100,000. In 2019, the asking price was $300,000, but it did not sell. Fast forward to 2021, and during a pandemic, the same house sold for $400,000. Could this little gem of construction really have increased so much in value in a couple of years? Or possibly was it the fact that it was on an extra-wide waterfront lot?

Suppose that this pink house was an income-producing property for the seller. When the property was originally acquired, the purchase price would have been allocated between the land and the building so that the building could be depreciated. Typically, in this situation the owner wants to be able to allocate as much purchase price as possible to the building so that the cost can be recouped (albeit ever so slowly) by depreciation. Often, this allocation is an afterthought and is done using the 20/80 rule of thumb (20% of the purchase price to the land and 80% of the purchase price to the building).

To calculate the gain on a sale, the same principle applies — the sales price needs to be allocated between the land and the building. Again, this allocation is typically done as an afterthought and, quite frankly, at the time the return is being prepared, potentially more than 1½ years after the sale. Here is where tax practitioners have a responsibility to advise their clients as to the significance of the land/building value allocation and what it means to the client’s tax bill.

Depreciable real estate, whether residential or commercial, that is used in a trade or business is Sec. 1231 property. The sale of Sec. 1231 property results in taxation at capital gain rates if there is a gain and ordinary income rates if there is a loss. Property owners are typically aware of the favorable tax rates they are allowed upon sale, but just like the rules of grammar, there is usually an exception to the rule. For depreciable real estate, the exception is in Sec. 1250, which provides that to the extent of depreciation taken (or allowed), the gain on the real estate sale is taxed at ordinary rates up to 25%. Depreciable real property is taxed at 25% up to the amount of depreciation taken and then taxed at capital gain rates. On the other hand, land is also Sec. 1231 property, but because it is not eligible for depreciation, it is not Sec. 1250 property.

To return to the little pink house on the extra-wide waterfront lot, which this analysis supposes is rental property: This more-than-50-year-old house was sold for four times its purchase price 20 years after acquisition. The tax practitioner likely did an easy 20/80 allocation to establish the house value for depreciation purposes. It would be easy enough to do the same for the sale and call it a day. The firm has other returns to get done, and this is just one more it can check off its list.

Under this approach, gain would be calculated on the sale first by allocating $320,000 of sale proceeds to the house and $80,000 to the land. Remember that the initial purchase price of $100,000 was allocated $80,000 to the house and $20,000 to the land. Assuming no closing costs and $60,000 of accumulated depreciation (for ease of calculation), the Sec. 1250 gain is $60,000 and the Sec. 1231 gain is $300,000 ($240,000 for the house and $60,000 for the land). Using the maximum capital gain rate, the tax on the sale is $75,000 (Sec. 1250 gain of $15,000 ($60,000 × 25%) and Sec. 1231 gain of $60,000 ($300,000 × 20%)). But is this really in the client’s best interest? Remember, it is the tax practitioner’s responsibility to advocate for the client.

In reality, the purchaser of this property has little to no interest in the ’60s-style pink house. The real value of this property lies in the large waterfront lot (sunsets included). With this in mind, a tax practitioner can rethink the purchase price allocation of the $400,000 sale proceeds and potentially allocate $20,000 to the house and $380,000 to the land. Using this method, the gain on the house is $0, and the entire $360,000 gain ($380,000 — $20,000) is on the land at capital gain rates. The resulting tax is $72,000 ($360,000 × 20%), a $3,000 cash-in-pocket savings over the 20/80 allocation method. Not only has the tax practitioner saved the client $3,000 (possibly more than the cost of the invoice), but he or she is also a tax hero, bound to receive numerous referrals from a happy client.

Note that it is important to properly document the allocation of value between the building and the land. Ideally, an appraisal would separately state the land and building values. Often, the tax practitioner finds out about a sale after the fact, and such an appraisal is not practical. In this case, the practitioner may look to the county tax assessor’s allocation, the advice of a knowledgeable real estate professional, or even an estimated replacement cost for the building (see Meiers, T.C. Memo. 1982-51).

In a year when real estate prices are soaring in many areas of the country, these easily overlooked allocations can have a significant tax impact. The above example is a relatively small dollar amount for real estate, and the tax savings could easily be multiplied for larger, more valuable properties. By using the proper land/building value allocation, tax practitioners can continue to do their best for clients.

EditorNotes

Todd Miller, CPA, is a tax partner at Maxwell Locke & Ritter in Austin, Texas.

For additional information about these items, contact Todd Miller at 352-727-4155 or taxclinic@cpamerica.org.

Contributors are members of or associated with CPAmerica Inc.

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Uncategorized

Hobby Rules Circumvented by S Election

January 11, 2022

Minimizing a hobby loss issue by electing S status

Editor: John Baer, CPA

December 1, 2021

If an activity is not engaged in for profit, the “hobby loss” rules of Sec. 183(a) provide that deductions in excess of gross income are not allowable. This statute specifically applies to activities engaged in by both individuals and S corporations. Accordingly, the mere form of conducting business is not the determinative factor in the hobby loss issue.

Due to the suspension of miscellaneous itemized deductions in the years 2018 through 2025, deductions for hobby expenses under Sec. 183 are not allowed in those years (Sec. 67(g), as added by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97). The inability of a taxpayer to deduct even a portion of the hobby expenses while recognizing all the hobby income in adjusted gross income makes establishing a profit motive for a hobby activity even more desirable.

The question of whether an activity is engaged in for profit involves a series of subjective interpretations regarding the business. The regulations list nine relevant factors to consider when determining whether an activity is engaged in for profit (Regs. Sec. 1.183-2(b)):

  • The manner in which the taxpayer carries on the activity, including such formalities as maintaining books and records;
  • The expertise of the taxpayer or his or her advisers;
  • The time and effort expended by the taxpayer in carrying on the activity;
  • An expectation that assets used in the activity may appreciate in value;
  • The taxpayer’s success in carrying on other similar activities;
  • The taxpayer’s history of income or losses with respect to the activity;
  • The amount of occasional profits that are earned;
  • The financial status of the taxpayer; and
  • The elements of personal pleasure or recreation involved with the activity.

Planning tip: Although an activity must be engaged in for profit to avoid the hobby loss rules, a predictable or highly probable expectation of profit is not required. For example, a taxpayer may well have a profit motive for investing in a very risky venture (e.g., wildcat oil and gas drilling or providing capital to startup businesses). The circumstances should indicate that the taxpayer entered into or continued the activity with the honest objective of making a profit, but even risky investments can be considered made for a profit motive.

The following example illustrates planning devices that can be used to reduce the chances that a hobby loss issue will arise.

Example. Planning to avoid the hobby loss issue: G owns a highly successful auto repair business that he operates in partnership with brothers N and J, who are unrelated to G. As a separate activity, G maintains several racing cars he enters in competitions on evenings and weekends. G’s auto racing activities have been increasingly successful, and last year he won prize money of about $10,000. He reports this activity on a Schedule C, Profit or Loss From Business, within his Form 1040, U.S. Individual Income Tax Return. Despite the increasing gross receipts of this proprietorship, the operating expenses, travel costs, and depreciation on several racing vehicles have resulted in large losses for the venture.

G expects his auto racing winnings to continue to increase, but he also recognizes that the deductions will continue to exceed the income for the next several years. He visits his tax practitioner and inquires whether he can minimize the risk of a hobby loss attack in case of an IRS audit. Will an S election assist in preventing a hobby loss determination?

If G’s car racing proprietorship was determined by the IRS not to have a sufficient profit motive, he would only be allowed to claim deductions to offset the gross income and would not be allowed to claim a loss within his personal tax return. In making this determination, the subjective factors listed above must be considered.

The first of these factors is clearly enhanced when a taxpayer conducts the activity in a business-like fashion, maintaining a separate checking account, accurate business records, and the other formalities normally associated with a for-profit trade or business. If G incorporates, he would be required to use a separate corporate checking account for the car racing activity and file a separate S corporation tax return. He would probably also become involved in the payroll tax system by issuing a Form W-2, Wage and Tax Statement, for the labor he provides to the corporate activity.

At a minimum, the existence of the S corporation would enhance the business-like appearance of the activity. In fact, by using the additional procedures associated with the formation of a corporation and expanding his recordkeeping requirements, G would likely improve his ability to meet the various subjective tests that go into the determination of a hobby loss issue. However, G must clearly understand that the mere formation of an S corporation provides no direct statutory assurance of overcoming the hobby loss question; the courts have held that losses incurred by an S corporation are deductible by the shareholders only if the corporation is in fact engaged in a for-profit trade or business (DuPont, 234 F. Supp. 681 (D. Del. 1964); Demler, T.C. Memo. 1966-117).

The tax practitioner would also advise G of the other advantages and disadvantages associated with S corporation status. For example, any salary G draws from the corporation for his labor would present additional Federal Insurance Contributions Act and Federal Unemployment Tax Act costs that would not exist in a proprietorship.

This case study has been adapted from the Checkpoint Tax Planning and Advisory Guide‘s S Corporations topic. Published by Thomson Reuters, Carrollton, Texas, 2021 (800-431-9025; tax.thomsonreuters.com).

Contributor
John Baer, CPA, is a specialist editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org. 

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Uncategorized

IRS SENDS CHILD CREDIT LETTERS

January 7, 2022

IRS issues information letters to Advance Child Tax Credit recipients taxpayers should hold onto letters to help the 2022 Filing Season experience

IR-2021-255, December 22, 2021

WASHINGTON — The Internal Revenue Service announced today that it will issue information letters to Advance Child Tax Credit recipients starting in December and to recipients of the third round of the Economic Impact Payments at the end of January. Using this information when preparing a tax return can reduce errors and delays in processing.

The IRS urged people receiving these letters to make sure they hold onto them to assist them in preparing their 2021 federal tax returns in 2022.

Watch for advance Child Tax Credit letter

To help taxpayers reconcile and receive all of the Child Tax Credits to which they are entitled, the IRS will send Letter 6419, 2021 advance CTC, starting late December 2021 and continuing into January. The letter will include the total amount of advance Child Tax Credit payments taxpayers received in 2021 and the number of qualifying children used to calculate the advance payments. People should keep this and any other IRS letters about advance Child Tax Credit payments with their tax records.

Families who received advance payments will need to file a 2021 tax return and compare the advance Child Tax Credit payments they received in 2021 with the amount of the Child Tax Credit they can properly claim on their 2021 tax return.

The letter contains important information that can make preparing their tax returns easier. People who received the advance CTC payments can also check the amount of their payments by using the CTC Update Portal available on IRS.gov.

Eligible families who did not receive any advance Child Tax Credit payments can claim the full amount of the Child Tax Credit on their 2021 federal tax return, filed in 2022. This includes families who don’t normally need to file a tax return.

 

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Tax Highlights

IRS Mileage Rates Increase

January 5, 2022

After decreasing two years in a row, the rate by which taxpayers may compute their deductions for costs of using an automobile for business purposes will go up to 58.5 cents per mile for the 2022 tax year, an increase of 2.5 cents per mile over the 2021 rate.

Notice 2022-03, in which the IRS announced the update on Friday, also provides the standard mileage rate for use of an automobile for purposes of obtaining medical care under Sec. 213, which will be 18 cents per mile, up 2 cents from 2021. The rate for providing services to a charitable organization remains the same, set by statute at 14 cents per mile (Sec. 170(i)).

The same rate as for medical care, 18 cents per mile, also applies to the deduction for moving and storage expenses under Sec. 217(g) by members of the armed forces on active duty who move pursuant to a military order and incident to a permanent change of station.

Taxpayers may use the business standard mileage rate for their use of an automobile as an ordinary and necessary business expense. Or they may claim actual allowable expense amounts if they substantiate the expenses, including by maintaining adequate records or other sufficient evidence.

The Tax Cuts and Jobs Act (TCJA), P.L. 115-97, suspended for tax years 2018 through 2025 the miscellaneous itemized deduction under Sec. 67 for unreimbursed employee business expenses, including those incurred in the use of an automobile. However, the business standard mileage rate can still be used during this period as the maximum amount an employer can reimburse an employee for operating an automobile for business purposes without substantiating the actual expense incurred.

The portion of the business standard mileage rate that is treated as depreciation for purposes of calculating reductions to basis will be 26 cents per mile for 2022, the same as for 2021.

Notice 2022-03 also provides the maximum standard automobile cost under a fixed-and-variable-rate (FAVR) plan of $56,100 for automobiles (including trucks and vans), up $5,000 from 2021. Under a FAVR plan, a standard amount is deemed substantiated for an employer’s reimbursement to employees for expenses they incur in driving their vehicle in performing services as an employee for the employer. The same amount also applies as the maximum fair market value of automobiles (including trucks and vans) first made available in calendar year 2022 for purposes of the fleet-average valuation rule in Regs. Sec. 1.61-21(d)(5)(v) and the vehicle cents-per-mile rule under Regs. Sec. 1.61-21(e).

The rates (other than for charitable mileage) are determined as the result of an annual study by an independent contractor that analyzes fixed and variable costs of operating an automobile, the notice stated.

— To comment on this article or to suggest an idea for another article, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.

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