In this Issue:
Key Tax Facts and Scenarios
John Henry is engaged in an IRS audit, and he has a big problem with his entertainment deductions.
John’s first visit with the IRS was unsatisfactory. He did not have any proof of his entertainment costs. The auditor allowed him to return for a second visit, at which point he would have the opportunity to prove his entertainment expenses.
John returned home and made extensive lists detailing entertainment in the past 12 months: who attended the events, when and where they occurred, and what was discussed. He showed these lists to the IRS auditor, but she did not like them.
She wanted proof of where the cash came from to pay for the entertainment. Since John did not spend any more than $75 on a single entertainment event, he didn’t need receipts because of the $75 rule.1
Can the IRS require John to prove where he got the cash to pay for this entertainment?
Yes, if things look really fishy. We’ll get to that in a minute, but first we have to note that John started with a significant problem with his entertainment expenses.
The golden rule is write down the who, where, and why within a week.2 Fail this test and the law, the courts, and the IRS come down on you really hard.
The fact that John had to list after the fact the who, what, when, where, and why of his entertainment hoists the “give me trouble” flag. Generally, answering the questions above on a timely basis in your daily planner satisfies the five elements of support the auditor wants.
From John’s story so far, it appears that he did not write down the information when he should have written it down. At this point, the IRS auditor could just disallow the deductions because of John’s failure to meet the law. So consider his good luck, such as it is, that the IRS auditor let him make the list.
Now, the fact that the IRS auditor does not like John’s list stands to reason. First, he had to make up the record after the fact—in direct violation of the law. John is standing in “no deduction for this” land.
And then there is the fact that John has no receipts. John is right—the law does not require entertainment receipts for entertainment costing less than $75. But deducting lots of entertainment, all under $75, with no receipts appears suspicious. In fact, this is the “fishy” part.
Think of this: If John were in court with the conditions we have described, John would get zero deductions, because he failed the writing-it-down-within-a-week test (the timely records test). This auditor is not pushing that button, so John’s entertainment deductions are still alive.
John needs to remove the auditor’s suspicion that he did not make up this stuff. Can John tie his ATM and check cashing to the money he used for his entertainment expenditures? If so, that helps John prove that he had the cash in his hands to spend for the entertainment.
Since all the IRS auditor is looking for at this point is proof of where John got the cash, proving that he had the cash might end this matter, in spite of his fatal violation of the “timely” records requirement.
Daily Planner Resource
If you are not currently tracking your entertainment, you might consider using Tax Diary System. You can download a free PDF of the system; just click here.
You can also download a Tax Diary System Excel spreadsheet where you can enter your totals for the day.
The spreadsheet then automatically aggregates your daily amounts for the month and year. Click here.
If you are using an app, make sure that it asks (requires is better) your answers to the who, where, and why questions when you enter the deductible amounts.
To ensure your entertainment tax deductions, always do this:
Write down the who, where, and why of every entertainment expense immediately (perhaps on the receipts).
Forget the $75 rule and obtain receipts (for most, the under-$75 rule, which applies only to entertainment, travel, and vehicles, is a dangerous trap).
If you are going to use the under-$75 rule, make sure you can show where you got the cash to pay for the entertainment.
1 Reg. Section 1.274-5(c)(2)(iii); Notice 95-50; News Release 95-59 where Margaret Milner Richardson, commissioner of the IRS, stated before the
House Committee on Small Business: “But even more exciting is the fact that, last month, we announced perhaps the most significant change in the record-keeping area in years. Since 1962, the threshold for which businesses are required to have a receipt for a travel or entertainment expense had been $25. Effective on October 1, 1995, we raised that threshold to $75. We know that, for small businesses in particular, the $25 threshold had been difficult. The new threshold should make record keeping a lot less challenging for both businesses and employees and is part of our ongoing efforts to make government work better and cost less for everyone.” 2 Reg. Section 1.274-5T(b)(3) gives the requirement details of the who, where, and why.
The IRS has ruled that you “may deduct daily transportation expenses incurred in going between your residence and a temporary work location outside the metropolitan area where you live and normally work.”
In this favorable ruling, you find two possible impediments:
Temporary work location
You learned last month in Don’t Let IRS Mileage Rules Destroy Your Vehicle Deductions that the “temporary work location” is a location where you realistically expect that the work at this location will, and does in fact, last for one year or less. You also learned that the temporary work location rule applies both inside and outside your metropolitan area.
In this article, which is Part 2 in a series of articles on how to create and protect your business miles, you will learn
why you need to define your metropolitan area,
how to define your metropolitan area, and
how to totally eliminate the metropolitan area problem.
Why You Need to Define Your Area
Let’s start with how the IRS has defined the metropolitan area.
In an audit of Edward Harris, a surveyor, the IRS disallowed 23,000 business miles because Harris was inside his metropolitan area when he drove from his home to work locations that required round trips of 100 to 162 miles. In this audit, the IRS considered the Los Angeles Metropolitan Area as Harris’s metropolitan area.
Harris took the IRS to court, where he lost.1 But Harris thought the court decision unfair; he appealed it, and the Ninth Circuit in an unpublished opinion overruled the lower court on the metropolitan area definition and remanded the case back to the tax court.2
Result. Harris kept the 23,000 deductible business miles for his trips from his home that were outside his metropolitan area.
In Wheir, 3 Corey Wheir asserted at trial a 35-mile radius as his metropolitan area. The IRS did not use the metropolitan area but instead asserted two alternatives to the metropolitan area test:
First, that Wheir commuted when he drove within 80 miles of his home in Wisconsin Rapids, Wisc. The IRS called this Wheir’s “normal work area.”
Second, that Wheir commuted whenever he drove anywhere in the state of Wisconsin.
The court ruled for Wheir because he set forth a 35-mile radius from Wisconsin Rapids as his metropolitan area. The IRS failed because it did not use a metropolitan area test and it did not convince the court that its alternative tests were of value.
In Marple, 4 the court accepted Daniel Marple’s 45-to-50-mile radius from his home as his metropolitan area.
As you can see, the concept of metropolitan area can do great damage to your mileage deductions. This means you need to either establish the boundaries of your metropolitan area or set yourself up so that the metropolitan area does not apply to you (as we discuss later).
How to Define Your Metropolitan Area
Remember, according to IRS regulations, the cost of commuting from home to work is a nondeductible expense.5 In Don’t Let IRS Mileage Rules Destroy Your Vehicle Deductions, you learned how to overcome the commuting rule with an office in the home.
If you don’t have a principal office in your home and don’t have a regular office outside your home, your trips from home to business locations are personal. But trips from your home to temporary work locations outside the metropolitan area where you live and normally work create business miles.6
Ted works from home but does not claim a home-office deduction and doesn’t have an office outside the home. At the end of the year, Ted has 11,000 personal miles for trips inside his metropolitan area and 13,000 business miles for trips outside his metropolitan area.
What is Ted’s metropolitan area? You saw earlier how the lack of a clear definition of “metropolitan area” can create trouble. First, metropolitan area is not the metropolitan statistical area or any other defined area.
In the IRS ruling, your metropolitan area is where you live and normally work.
From what we see, your metropolitan area is based on your facts and circumstances, and there’s no one clear answer. The IRS states: “Generally, a metropolitan area includes the area within the city limits and the suburbs that are considered part of that metropolitan area.” This could be of help, depending on your facts and circumstances.
Fifty miles from your home may be a good rule of thumb because:
IRC Section 162(h) defines 50 miles as the local area for state legislators.7 Section 5e.274-8(a) defines 50 miles as the local area for a member of Congress.8
The federal government defines “metropolitan area” for IRS personnel and other federal employees
as a mileage radius of not greater than 50 miles within or outside the limits of the physical location of an IRS office. This is consistent with the regulations in 5 CFR 550.112(j) and 5 CFR 551.422(d), and it’s found in the Internal Revenue Manual Section 6.5184.108.40.206—Time Spent Traveling (last revised: 12-10-2009).9
How to Totally Eliminate the Metropolitan Area Problem
If you have an office in your home that qualifies as a principal place of business within the meaning of section 280A(c)(1)(A), you may deduct daily transportation expenses incurred in going between your home and another work location in the same trade or business, regardless of whether the other work location is regular or temporary and regardless of the distance.10
The principal office in the home creates:
Business miles for trips from your home to your regular office
Business trips to all temporary stops, whether inside or outside your metropolitan area—regardless of the distance
Note that with a principal office in your home, you eliminate (a) your commuting to your regular office outside the home, (b) metropolitan area issues, and (c) the temporary stop issues.
For a good and easy explanation of the principal office rules under Section 280A(c)(1)(A) and how that section gives you two ways to qualify for the home office, see Shedding Doubts about the Home-Office Tax Deduction.
If you operate your business as an S or C corporation, see Lock in the Home-Office Deduction for Your S Corporation and Q&A: S Corporation Reimbursement of My Home-Office Expenses for the special rules that apply to you as an employee of your corporation.
When you use your vehicle for business, you face
Temporary stop rules
Metropolitan area rules
The rules prove difficult in many ways, but if you can claim a home-office deduction that qualifies your office as a principal office, you automatically overcome all the difficulties imposed by the rules above.
With the home office, you don’t have to worry about defining your metropolitan area.
With the home office, you don’t have to worry about the one-year or more temporary stop rules.
It’s pretty straightforward. With the home office as a qualifying principal office, most of your mileage is going to be worry-free business mileage.
1 Edward Harris, TC Memo 1980-56.
2 Harris v Commissioner, T.C. Memo 1980-56, aff’d in part and rev’d in part, 679 F.2d 898 (9th Cir. 1982).
3 Corey L. Wheir v Commr., TC Summary Opinion 2004-117.
4 Daniel P. Marple v Commr., TC Summary Opinion 2007-76.
5 Reg. Sec. 1.262-1(b)(5).
6 Rev. Rul. 99-7.
7 IRC Section 162(h).
8 Reg. Section 5e.274-8(a).
9 Internal Revenue Manual 6.5220.127.116.11—Time Spent Traveling (last revised: 12-10-2009).
10 Rev. Rul. 99-7; IRC Section 280A(c)(1)(A).
I have not filed a tax return for the past five years. I’m not worried about it because I know that tax penalties are assessed based on the dollar amount owed. Since I owe nothing, I face no penalties. Do you have any thoughts on this?
Yes, we have thoughts. Thanks for helping with the deficit. Unknowingly, you have made some cash gifts to the government.
You have joined 1 million or so people due refunds of more than $1 billion who, as of April 3, 2017, had not filed federal income returns for 2013.1
You are right—there is no penalty, other than losing your tax refund, for not filing when you are due a refund.
Filing for a Refund
If you are due a refund and have not filed a tax return, you generally must file your tax return within three years from the date the return was due, including extensions, to get the refund.2
Example. You did not file a 2014 tax return. That return would give you a $1,200 refund if you filed it. You have until April 17, 2018, to file that return or say good-bye to your refund.
Waiting longer than the three years lets the statute of limitations expire and lets you make your missed tax refund a contribution to the government.3
The office-in-the-home deduction produces good-to-excellent cash benefits when it eliminates commuting mileage. That’s the result you achieve when you claim an administrative office in your home.1
To qualify for the home-office deduction, you must use the office exclusively for the business or businesses for which you are claiming the deduction.
Your ability to qualify for the office-in-the-home deduction is straightforward if you have no spouse and only one business.
Add a spouse or another business to the equation and this deduction can become more complicated.
Adding a Second Business to the Home Office
In Hamacher, 2 the Tax Court ruled in a precedent-setting regular decision that
Hamacher could deduct a home office that he used for more than one business, but should any one business use of that home office not qualify for the office in the home deduction, then
Hamacher would get no deduction for the office in the home.
Because this is a regular decision of the Tax Court, this is the rule you need to follow: All business uses ofthe home office must pass the tests for a qualified home-office deduction or you get no deduction for that home office. In other words, one personal use or one unqualified business use of the home office destroys the home-office deduction.
In the Hamacher case, Mr. Hamacher had both an employee use and an independent contractor use of the home office. He failed to follow the home-office rules for his employee use. This failure tainted his independent contractor use and destroyed his home-office deduction.
Rule to Follow
If you are going to have more than one business use of your office in the home, make sure each business use separately qualifies on its own merits for the home-office deduction.
If you are married, all uses of the same office by the spouses must be deductible uses or the office fails the exclusive-use test.
If one spouse uses one half of the room and the other spouse uses the other half of the room, then each spouse is responsible only for his or her use of that half.
Sally uses her half of the room for qualified business uses. She gets to deduct her half. George uses his half for his fantasy sports leagues, which he obviously can’t deduct, but because he does this in his half of the room, he does not destroy Sally’s home-office deduction.
What the IRS Publication Says
In its office-in-the-home publication, the IRS uses Tracy White as an example.3 Ms. White is a school teacher who also operates a jewelry business on the side.
Ms. White uses an office in her home to correct student papers and to conduct her jewelry business. To deduct the office, Ms. White must use the home office in ways that qualify for deduction both for her work as an employee teacher and as a jewelry business. If either business fails to qualify for the home office, Ms. White gets no home-office deduction.
Planning. Ms. White should consider grading papers at the kitchen table and using the office only for the jewelry business.
The IRS Audit Guide
Here is what the IRS MSSP Training Guide says about multiple business activities:4
When a taxpayer has multiple business activities, all of the activities for which the office is used must meet the qualifications. If any of the activities uses the home office and does not meet the requirements, the exclusive use test is not met and no deduction is allowed.
In this guide, the IRS makes it clear to its audit personnel that a taxpayer’s failure to win the home-office deduction generally calls for disallowing some business mileage, as trips from home to the office are now personal trips.
First, make sure that all uses of the home office qualify for the home-office deduction. You need exclusive business use of the home office for the business for which you are claiming the deduction.
If you use the office for more than one business, then each business must qualify. No exceptions.
It’s okay for spouses to split a room and one spouse not to qualify so long as this is a physical split. If one spouse does not qualify for the home deduction and uses your space, your space does not qualify.
You have to admit that this tax rule is straightforward and easy to understand. So make sure that you follow the rule and earn your rightful cash rewards from your home office.
Does your rental property activity meet the definition of a trade or business activity?
If yes, your rentals produce the best possible tax benefits.
In general, you report your rental properties on Schedule E of your tax return. When your activity rises to the level of a business, you continue to report the rentals on Schedule E, but with the business classification, you qualify for
tax-favored Section 1231 treatment;
business use of an office in your home;
business (versus investment) treatment of meetings, seminars, and conventions; and
Section 179 treatment of your business-use assets.
Rental as a Business
In Levy,1 the court ruled that the trustees of this estate, by renting the real estate, were engaged in a trade or business. The court then went on to say this:2
Courts have consistently held that the rental of real estate is a “trade or business” if the taxpayer-lessor engages in regular and continuous activity in relation to the property. It has been held that a taxpayer who rents only a single parcel of real estate is engaged in the “trade or business” of renting real estate if his activities are regular and continuous. The fact that the trustees employed agents to manage the real property does not make any difference.
In Elek, 3 the taxpayer purchased an apartment building in Hungary, appointed his father manager, left
Hungary, came to the United States, and became a citizen. During this time, the Hungarian government by decree nationalized his property because it was owned by a capitalist.
The court granted Mr. Elek a business loss on this rental because it considered his rental apartment activity a trade or business for which nationalization caused his net operating loss.
In Cottle, 4 the court ruled that Mr. Cottle bought three fourplexes in what was for him a new trade or business of renting apartments.
In Jephson, 5 the court ruled that George Jephson had a business when he bought a house to rent, listed it for rent, and showed it to prospective tenants but never rented it.
Tax-Favored Section 1231 Treatment
In a private letter ruling, the IRS sums up its view of property that qualifies for tax-favored Section 1231 treatment with these comments:6
The mere rental of real property does not constitute a trade or business under Section 1231 of the Code.
In order to constitute property used in a trade or business under Section 1231, the income or gain must be derived from properties used in the active conduct of a trade or business as opposed to property which is reasonably expected to generate passive income such as portfolio investments.
The two big tax benefits of Section 1231 treatment are:
Tax law treats net Section 1231 losses as ordinary losses that you use to offset ordinary income.
Tax law treats net Section 1231 gains as long-term capital gains.
This gives you the best of both worlds: ordinary losses and long-term capital gains.
Beware. If you have a net Section 1231 gain within five years after you have a net Section 1231 ordinary loss, you must recapture the gain as ordinary income to the extent of the losses and pay taxes at the recapture rates.7
Planning. Keep Section 1231 long-term capital gains and ordinary losses in your pockets. Avoid the five year recapture problem.
You may claim a home-office deduction only for trade or business activities.8 Investment activities are not trade or business activities.
In Curphey, 9 the Tax Court ruled that Dr. Curphey’s ownership and management from his home of three condo units, two townhouses, and one single-family home rose to the level of a trade or business for purposes of his claiming the home-office deduction.
In this case, Dr. Curphey, a dermatologist, worked 40 hours a week at the hospital and also managed the six units, where he
sought new tenants,
otherwise prepared the units for new tenants.
Planning note. Dr. Curphey reported his rental property deductions on Schedule E, not Schedule C. The fact that he is in the rental business does not alter his reporting of the rentals as rentals on Schedule E.
Investment Seminars, Meetings, and Conventions
Tax law grants no deduction for travel or other costs of attending a convention, seminar, or similar meeting unless the activity relates to a trade or business of the taxpayer.10
Thus, if your rental property is an investment, kiss goodbye those deductions for rental property conventions, seminars, and similar meetings.
Tax law is clear: You may not deduct registration fees, travel and transportation costs, and meal and lodging expenses incurred in connection with attending an investment seminar or similar meeting relating to investments, financial planning, or other activities for the production or collection of income.11
Planning. Make sure your involvement in your rental property rises to the level of a trade or business if you
plan to deduct your attendance at rental property investment seminars and meetings.
Section 179 Expensing
With respect to rental properties and Section 179 expensing, you need to pay attention to the following three rules, which can impact your expensing:
You may not claim Section 179 expensing on most assets used to furnish lodging.12
To qualify for Section 179 expensing, you must purchase and place the property in use in the active conduct of your business.13
You may claim Section 179 expensing on qualified assets purchased and placed in service for use in transient lodging facilities (where the average stay of renters is less than 30 days).
Lodging. When you have residential rentals, your Section 179 possibilities run into the lodging problem.
Here’s how one taxpayer got surprised and what that can mean for you. This case took place during those tax years when you could claim the investment tax credit on a new business car.
Dorothy LaPoint bought a new BMW and used it to travel to inspect and repair her residential rental properties. The court ruled that Ms. LaPoint used her car to furnish lodging and that use violated the no-tax credit-for-lodging rule; therefore, Ms. LaPoint did not qualify for the investment tax credit.14
The old investment tax credit rule that prohibited lodging use is the same rule that prohibits Section 179 expensing for residential rentals.
Example. You own a new BMW X5 on which you want to claim $25,000 of Section 179 expensing. If you use the X5 more than half the time for your lodging properties, you don’t qualify for Section 179 expensing.
Planning. If you have a vehicle you deduct for both business and rental use, try to minimize residential rental property use. For example, you might make stops at the rentals on the way to and from the office, which could mean zero or very little rental mileage.
Business of residential rentals. When you have residential rental activities that qualify as a business, you might have two types of furniture and equipment:
Qualifying Section 179 business furniture and equipment, such as the computers, desks, and chairs in the business office you use to run the lodging activities
Non-qualifying Section 179 furniture and equipment used for or in connection with the furnishing of lodging, such as the beds and dishwashers in your apartment building
Business properties. If you own commercial buildings or shopping centers, you don’t run into the lodging problem. For example, say you spend $20,000 on a parking lot sweeper for use at your shopping center.
This sweeper qualifies for Section 179 expensing.
Planning. If this sweeper were used at a residential apartment building, the sweeper would not qualify for
Section 179 expensing. It would qualify for depreciation but not expensing.
Transient exception. Your rental property might qualify as a Section 179 tax-law-defined hotel under the transient exception. If so, then your purchases of Section 179 equipment would qualify for expensing without facing the lodging problem.
You have a hotel when your rental is used predominantly to furnish lodging to transients.15
“Predominant” means more than one-half.16
“Transient” means the average rental period is less than 30 days.17
Example. You rent your beach home for 27 weeks to 16 tenants. The average stay per tenant is 12 days
(27 times 7 divided by 16). The used dishwasher and new living room furniture you purchased for the beach home this year qualify for Section 179 expensing.
You can see that you want your rental activity to rise to the level of a business activity so that you can gain
tax-favored Section 1231 treatment;
business use of an office in your home;
business (versus investment) treatment of meetings, seminars, and conventions; and
Section 179 treatment of your business-use assets.
The more rentals you can qualify this way the better.
And remember that you report the rentals on Schedule E whether or not they rise to the level of a business.
1 Laurence H. Levy, Trustee v U.S., 11 AFTR 2d 998 , 215 F Supp 631 , 63-1 USTC 9310 (is also listed under Macado as the case name with the same citation—the case involved Macado and Levy as trustees).
3 Peter S. Elek v Commr., 30 TC 731.
4 Donald R. and Julia A. Cottle v Commr., 89 TC 467.
5 George Jephson v Commr., 37 BTA 1117 (1938).
6 Private Letter Ruling 8350008.
7 IRC Section 1231(c); IRS Notice 97-59.
8 IRC Section 280A(c).
9 Curphey v. Commr., 73 T.C. 766, 772.
10 Notice 87-23.
12 IRS Pub., 946, How to Depreciate Property (2016), Dated February 27, 2017, p. 18.
13 IRC Section 179(d)(1)(C).
14 Dorothy LaPoint v Commr., 94 T.C. 733 (1990).
15 Reg. Section 1.48-1(h)(2)(ii) [P.L. 101-508 repealed IRC Section 48, but the regulations still apply as in this exception for Section 179 expensing.].
Ronnie Craft owned 50 percent of an S corporation. Both he and the other owner took salaries of $50,000 a year from the S corporation.
The corporation adopted a resolution requiring Ronnie to pay for and supply his own office space and vehicles for use on behalf of the S corporation’s business. In other words, the corporation wanted Ronnie to incur employee business expenses while promoting and taking care of the corporation’s business, but the corporation was not going to reimburse Ronnie for those expenses.
Ronnie incurred $17,604 of employee business expenses, but instead of claiming them as miscellaneous itemized deductions on Schedule A, he put them on Schedule C of his Form 1040.
Please Audit Me
This was a mistake. By reporting his expenses improperly, he brought himself to the attention of the IRS.
Imagine how Ronnie’s tax return looks:
S corporation income from the K-1 on Schedule E
W-2 income from the S corporation on the first page of Form 1040
Schedule C income of zero, but expenses of $17,604
The naked expenses (no income) would stand out by themselves, but when Ronnie added the S corporation name as the Schedule C business name, he definitely brought himself to the IRS’s attention.
You might ask, “Why didn’t Ronnie just put the expenses on his tax return as employee business expenses, where they belonged?”
We don’t know, but we would guess that he did that before he filed his return, saw the ugly result, and decided to take his chances on Schedule C.
If you claim employee businesses expenses as miscellaneous itemized deductions on Schedule A of Form 1040, you can suffer in two ways:
Lose 2 percent. Tax law takes 2 percent of your adjusted gross income and subtracts that from your miscellaneous itemized deductions.
Lose the entire deduction. The alternative minimum tax (AMT) does not allow any miscellaneous itemized deductions. These deductions, which are allowed for the regular tax, are disallowed for the AMT.
Ronnie and his fellow 50 percent shareholder put together the S corporation no-reimbursement policy using a totally wrong strategy—a strategy that put legitimate business expenses at risk, because now business expenses become employee expenses subject to the double threat described above.
That is exactly what the court ruled. Ronnie had to treat the expenses as employee business expenses subject to all the dreaded rules that apply to such expenses.1
What to Do
Make your corporation reimburse you for employee business expenses. This is the key to maximum benefits. With the expenses on the corporate return, the corporation gets the full deductions and you escape the
2 percent pain and
In your tax planning, avoid pain and slaughter whenever possible.
Other Points to Consider
Here are some other points to keep in mind:
For tax purposes, a corporation is an entity totally separate from its shareholders.
The voluntary payment of corporate expenses by the shareholders or employees may not be deducted by those shareholders or employees on their individual tax returns. (To deduct these personally, you need the corporation to make them your expenses by resolution or policy.)
A corporate resolution or policy that requires a corporate officer to assume certain expenses shows that those expenses are the individual’s expenses incurred on behalf of the corporation to further the corporation’s business.
The current tax reform proposals would eliminate the AMT—a tax that’s totally ugly and unfair because it taxes deductions that the regular law allows.
(You have to ask why tax deductions are allowed in the first place if you are going to tax people and entities for claiming them. The AMT is just not logical. And the cause of the AMT as it affects us today is the Tax Reform Act of 1986.)
We don’t know whether Ronnie Craft put his deductions on Schedule C to avoid the AMT or the 2 percent of adjusted gross income floor. (The 2 percent floor could disappear if the current tax reform proposals become law. And making that unfair 2 percent floor disappear would be another good thing.)
But the real takeaway here applies regardless of what happens with tax reform, and that takeaway is to obtain good tax advice before creating a special carve-out of corporate or partnership expenses. Had Ronnie Craft known how the deductions would work on his personal return, he likely would have bargained for either a different salary or a lesser salary and corporate payment of the expenses.
1 Ronnie O. Craft v Commr., TC Memo 2005-197.
Can you create and make available to us a desktop PDF with the 2017 tax rates for quick reference?
Yes, we have done just that. You can download the file at this link: Desktop Reference 2017.
Paying taxes on the sale of your real estate is voluntary. You do not need to volunteer. Real estate investors use Section 1031 to avoid taxes when acquiring bigger and better properties. But now, when you want to cash out, Section 1031 is not the vehicle of choice. So what do you do?
This article gives you three strategies to help you cash out your real estate profits:
Use the combination of a charitable remainder trust and a wealth replacement trust to avoid taxes, increase personal cash flow, and increase the estate distribution to your children.
Use IRC Section 721 to invest the old property in a real estate investment trust and defer taxes.
Use an installment sale to pay taxes slowly.
Use Charitable Remainder and Wealth Replacement Trusts
The combination of charitable remainder and wealth replacement trusts can create more estate value for your heirs and cash for you than can selling the property and paying taxes now. The steps that follow explain how this works and how you receive benefits.
Step 1. Donate the property to a newly created charitable remainder trust under terms that grant you and your spouse income from the trust—either a fixed income or a percentage of the trust income—during your lifetimes.1
Step 2. Stipulate in the trust that when the second spouse dies, the remaining balance of the trust goes to one or more designated charities.
Benefit 1. More cash is working for you. Had you sold the property, you would have paid taxes and had only the after-tax money to invest.
Benefit 2. You create an immediately deductible charitable contribution.
Limits. The law limits charitable deductions to various percentages of adjusted gross income, depending on the type and nature of the contributions.
Carryover. If the charitable contribution exceeds the limits for the current year,2 you have five additional years to take advantage of the deductions.3
Write-off. Your charitable write-off is based on the present value of the remainder interest you donate to the charity. Tax law gives you life expectancy tables that you use to value the remainder interest and the interest you give away. These are the numbers that give you the value of your charitable contribution.4
Step 3. Create a wealth replacement trust.
The wealth replacement trust is a life insurance trust that uses term life insurance with a second-to-die policy that insures both husband and wife.
The insurance trust is the
applicant for the insurance policy,
owner of the insurance policy, and
payer of the insurance premiums.
When the surviving spouse dies, the insurance company pays the death proceeds to the insurance trust, which in turn passes the proceeds to the heirs.
Benefit 3. The insurance is the “have your cake and eat it too” part of the strategy.
Without the insurance, your heirs get nothing.
With the insurance, you might give them as much as or more than you would without the charitable remainder trust.
Planning tip. To make the insurance part work, you and your spouse must be insurable. If only one is insurable, the plan can still work but generally not quite as well.
Six benefits. Here are six benefits from the combined charitable remainder and wealth replacement trusts:
No capital gains taxes on the property transfer to the charitable remainder trust
Higher income stream because you invest the pretax value
Good-sized charitable deduction
Income to pay for the insurance policy
Cash to your heirs as if you gave nothing (or little) to charity
Big smiles all around as you benefit your favorite charity and heirs while you pay little or nothing to the federal, state, and local taxing authorities
Example. You and your spouse own real estate worth $1 million. If you sell, you would pay $300,000 in taxes to the various taxing authorities. That would leave you with $700,000 that you could invest in certificates of deposit at 2 percent for an annual pretax return of $14,000.
Alternatively, you could create a charitable remainder trust that sells the real estate for $1 million and arranges for a 5 percent return in the investment portfolio of the college that is going to be the recipient of this trust.
In this case, the trust creates a
$94,000 charitable deduction, and
annual cash flow of $50,000.
From the $50,000 annual cash flow, you take $15,000 a year to fund a $1 million term life insurance policy payable to your children.
Planning tip. Note how this plan adds $21,000 a year in extra income ($50,000 minus $14,000 minus $15,000) and a $94,000 tax deduction for our taxpayer in the example.
Use Section 721
Section 721 says that when you contribute property to a partnership in return for a partnership interest, neither you nor the partnership or partners recognize any gain or loss.5
Section 721 includes property transferred to an operating partnership (OP) of a real estate investment trust (REIT). In this circumstance, the REIT with its diversified realty holdings becomes the equivalent of a mutual fund in real estate.
The OP units you receive in return for the property contribution entitle you to periodic distributions from the REIT. Further, you may convert the OP units into shares of the REIT.
The REIT investments not only avoid taxes on the transfer of your property but also provide liquidity.
The transfer to a special kind of REIT can solve the problem that triggers tax on a property transferred with a mortgage liability in excess of the property’s basis. With the excess mortgage, you recognize gain to the extent of that excess mortgage.6
The special REIT, called an UPREIT, is designed to guarantee an equivalent portion of the liabilities of the REIT so as to make the excess mortgage a nonissue and allow you to avoid taxes on the transfer.
Use an Installment Sale
A regular installment sale of real estate is an easy way to increase net worth.7
Your main benefit of “holding paper” is obtaining a secured note at an interest rate much higher than you could earn from your local financial institution.
In an installment sale, you earn interest on the gross amount because you have not yet paid the taxes. With an installment sale, you pay the taxes as you get paid.
Caution. You pay taxes up front when you have to recapture 8
depreciation in excess of straight-line depreciation or
investment tax credits on low-income or certain rehab properties.
Rule. You make an installment sale when you dispose of property and then receive at least one payment for that property after the close of the taxable year in which the disposition occurs.9
Payments you receive in an installment sale consist of three parts:
The taxable part of the principal payment
The nontaxable part of the principal payment
Example. You sell investment land for $250,000 (net of selling expenses). The land has a tax basis of $125,000. For installment sale purposes, you divide the profit of $125,000 ($250,000 minus $125,000) by the $250,000 net sales proceeds. This gives you a gross profit percentage of 50 percent. Thus, every receipt of principal is 50 percent taxable gain.
At closing, you collect a down payment of $30,000. This down payment is 50 percent return of capital (your basis) and 50 percent taxable gain.
Next, you receive a payment that includes $700 of principal. For tax purposes, you divide the $700 into its 50 percent taxable part ($350) and its 50 percent nontaxable part ($350).
Minimum interest. Tax law requires that you charge a minimum rate of interest on an installment contract equal to the lower of 9 percent or the applicable federal rate (AFR), which the IRS publishes monthly.10 (For December 2017, the minimum annual interest for a 15-year installment note is 2.64 percent.11)
Make more money. To make the most money on your owner-takeback installment note, look for the highest interest rate that the seller will pay, and then add points if possible.
Whenever you can, avoid the outright taxable cash sale of investment property. To avoid taxes while you build your portfolio of real estate investments, use the Section 1031 exchange.
If you want to cash out, move on, and also take care of your estate, consider combined charitable remainder and wealth replacement trusts.
If the trusts don’t grab your fancy, consider the IRC Section 721 REIT and UPREIT strategies to defer taxes on the disposition of your old real estate investment and to gain liquidity.12
If you don’t mind paying the taxes but would like the tax payments spread out over a number of years, consider a Section 453 installment sale.
You have choices. Pay tax, pay no tax, or pay tax at your own pace.
1 The percentage is known in tax jargon as a charitable remainder unitrust (CRUT) [IRC Section 664(d)(2)]. Tax law refers to the flat amount as a charitable remainder annuity trust (CRAT) [IRC Sections 664(d)(1) and 453(b)]. A CRAT cannot accept future contributions of property [Reg. 1.664-2(b)].
However, a CRUT can be the recipient of future transfers [Reg. 1.664-3(b)].
2 IRC Section 170(b)(1)(A).
3 IRC Section 170(d)(1)(A).
4 Regs. 20.2031-7A(f); 1.664-4.
5 IRC Section 721.
6 IRC Section 357.
7 IRC Section 453.
8 IRC Section 453(i).
9 IRC Section 453(b)(1).
10 See IRC Sections 483 and 1274; IRS Pub. 537, Installment Sales (2016), Dated January 13, 2017, p 11, says that for sales or exchanges of property
(other than new Section 38 property, which includes most tangible personal property) involving seller financing of $5,664,800 or less, the test rate for
determining minimum interest cannot be more than 9 percent, compounded semiannually.
11 Rev. Rul. 2017-24.
12 IRC Section 721.
Two scary words in tax reform are “fairness” and “simplification.”
In most cases, this combination raises your taxes and makes the law more complex.
The Tax Reform Act of 1986 gets high marks for its political shrewdness, but tax professionals agree that this reform was both unfair and excessively complex (consider that the 1986 Act created the passive-loss rules and revised the alternative minimum tax to great inequities, including taxing the deduction you claim for state income taxes).
As you likely know, tax reform is in the air again, and it will bring its share of good and bad news. But for your rental real estate loss deductions, the good news is that the reform being considered does not alter the beneficial strategies that are in this article.
This article takes the complexity out of a portion of those passive-loss rules and helps you put this information to use for your benefit.
In general, rental properties are passive activities subject to the dreaded passive-loss rules.1
You may not deduct a passive activity rental loss unless one of the following applies:
You have passivity activity income. (The law allows passive loss deductions to the extent of passive income.2)
You actively participate in the rental real estate and qualify for the $25,000 special allowance as explained in Qualifying for Rental Real Estate’s Tax-Favored $25,000 Allowance.
You dispose of your entire interest in the passive activity to an unrelated third party, which allows the release of your suspended passive losses.3
Your rental property activities qualify you for “real estate professional” status as discussed in Deduct More of Your Rental Property Losses by Qualifying as a Real Estate Real Estate Professional—Even If You Don’t Work in Real Estate!
Here are four things to know about equipment and/or vehicle rentals:
Most equipment rentals are passive activities regardless of material participation.
Equipment rentals do not qualify for the special $25,000 offset that applies to real property rentals.
You may not group equipment rentals with real estate rentals for passive-loss purposes.
You do not report equipment and/or vehicle rentals on Schedule E. Instead, you report them on either page 1 of your Form 1040 or, if a business, on Schedule C.
The regulations contain six non-rental exceptions to the definition of rentals. In most cases, the non-rental exceptions are, for tax purposes, businesses.
As a business, you must materially participate in order to deduct the losses. If you fail the material participation tests, your business and other non-rental losses are passive losses subject to the passive-loss rules.
Exception 1—Seven Days or Less
Properties that you rent for customer use for an average period of seven days or less are not rental properties subject to the rental real estate rules.
Example. You rent property 11 times for a total of 60 days during the tax year. The average stay is 5.45 days.
This is a business property.
It is not a rental eligible for the $25,000 offset.
It is not subject to the real estate professional rules.
You must materially participate to deduct losses
Examples of this type of property include ski cabins, condo rentals, beach homes, lake cabins, tuxedo rental companies, car rental companies, and tool and equipment rental companies.
Exception 2—30 Days or Less
You have a business, like a hotel or motel, when your average period of customer use is 30 days or less and you provide significant personal services with the rental.
The regulations provide the following example of a property that fails the significant services test and thus becomes a rental subject to the rental property rules:4
The taxpayer is engaged in an activity of owning and operating a residential apartment hotel. For the taxable year, the average period of customer use for apartments exceeds seven days but does not exceed 30 days.
In addition to cleaning public entrances, exits, stairways, and lobbies and collecting and removing trash, the taxpayer provides a daily maid and linen service at no additional charge. All of the services other than maid and linen service are excluded services, because such services are similar to those commonly provided in connection with long-term rentals of high-grade residential real property.
The value of the maid and linen services (measured by the cost to the taxpayer of employees performing such services) is less than 10 percent of the amount charged to tenants for occupancy of apartments. Under these facts, neither significant personal services nor extraordinary personal services are provided in connection with making apartments available for use by customers. Accordingly, the activity is a rental activity.
Note. Where the average stay of less than 30 days produces 80 percent or more of the rents, you have a commercial rental property where the personal property is eligible for MACRS depreciation and Section 179 expensing.5
Exception 3—Extraordinary Personal Services
You do not have a rental property when you provide extraordinary personal services when making the property available for use by customers (without regard to the average period of customer use).6
You provide extraordinary personal services only if the services are performed by individuals and if the use by customers of the property is incidental to the receipt of such services (for example, in hospitals, nursing homes, and boarding schools).7
You do not have a rental property when the principal purpose for holding the property during a taxable year is to realize gain from the appreciation of the property, and when the gross rental income from the property for such taxable year is less than 2 percent of the lesser of 8
the unadjusted basis of such property or
the fair market value of such property.
Similarly, you do not have a rental property activity when you rent property to a business in which you have an interest and when the property was predominantly used in the business during the taxable year (or during at least two of the five years immediately preceding the taxable year) and the gross rental income from the property for such taxable year is less than 2 percent of the lesser of 9
the unadjusted basis of such property or
the fair market value of such property.
See Tax Tips on Equipment Leases to C a Corporation for an interesting example of how this exception saved a lawyer more than $140,749 in taxes.
In addition, the rental of lodging for the convenience of the employer is not considered a rental activity. It is considered incidental.10
Exception 5—Rental for Customer Use of Facility
Under this exception, you customarily make the property available during defined business hours for nonexclusive use by various customers11 (for example, golf courses, health clubs, spas). Here is an example of this non-rental, from the regulations:12
The taxpayer operates a golf course. Some customers of the golf course pay greens fees upon each use of the golf course, while other customers purchase weekly, monthly, or annual passes. The golf course is open to all customers from sunrise to sunset every day of the year except certain holidays and days on which the taxpayer determines that the course is too wet for play.
The taxpayer thus makes the golf course available during prescribed hours for nonexclusive use by various customers. Accordingly, under paragraph (e)(3)(ii)(E) of this section, the taxpayer is not engaged in a rental activity, without regard to the average period of customer use for the golf course.
Exception 6—Providing Property
You do not have a rental property activity when you provide (not rent) property for use in a non-rental activity of your own S corporation or joint venture. The key phrase here is “provide, not rent.”
Example. A shareholder provides property for use by an S corporation in which he has an interest. This non-leasing transaction with the corporation is not a rental.13 (Also, it is likely a mess for tax purposes because the corporation is a separate legal entity.)
Beware of Material Participation
The fact that you escape rental property classification does not mean that you have a tax-deductible loss for the non-rental activities.
To deduct a business loss from a business activity, you must materially participate in the activity.
Answer the Audit Questions
If you were being audited by the IRS on your material participation in a business, a rental property, or a non-rental, the IRS would ask you the following questions, which we took from the IRS audit guide.14 The questions apply to each individual activity and to each tax year.
You need to answer “yes” to one of the questions below in order to have materially participated in the activity under examination. If you grouped activities, apply the questions to the group.15
Did you and/or your spouse work more than 500 hours a year in this activity? (If “yes,” the quiz is over, and you may deduct your business losses.)
Did you and/or your spouse do most of the work in this activity? If you and/or your spouse do not meet the 500-hour test, but your and your spouse’s participation is the only work activity in the business, you materially participate. For example, the sole proprietor with no employees could do all the work in a proprietorship.
Did you and/or your spouse work more than l00 hours while no one else (including nonowners or employees) worked more hours in this activity? For example, if you put in 175 hours during the year and you have an employee who works 190 hours during the year, you do not pass this material participation test.
Do you and/or your spouse participate in several passive activities for more than 100 hours and less than 500 hours, and does this combination produce more than 500 hours? For this test, do not include activities in which you work more than 500 hours, rental activities, or activities involving portfolio or investment income.
Did you and/or your spouse pass the material participation tests on this activity in any five of the 10 preceding years (the years need not be consecutive)? For example, you retired, and your children now run the business.
Is this activity a personal service activity, and did you and/or your spouse materially participate in this personal service activity for any three prior years (which need not be consecutive)? Personal service activity includes fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting.
Did you and/or your spouse work more than 100 hours in this activity, and do the facts and circumstances indicate that you and/or your spouse are materially participating in the activity? You may not apply this test if you paid any person to manage the activity or if any person spent more hours than you and/or your spouse managing the activity.
Reminder. You need to answer one of the questions “yes” to meet the material participation standard and deduct your passive losses.
If you answer “no” to all seven questions, you fail the material participation standard and your losses are passive, deductible only to the extent of passive income or when you totally dispose of the activity.
Special rule for limited partners. In general, tax law treats limited partners as engaged in passive activities.16 Tests 1, 5, and 6 above are exceptions to the limited partner rule. If you hold both a general and a limited partner interest, you have all seven tests available.
Reminder. Rental properties are always passive if you don’t pass the test for classification as a real estate professional. Once you are a real estate professional, you must pass the material participation rule to deduct a rental loss.
For grouping purposes, you may group rentals, but you may not group rentals with businesses or nonrentals.
There is an exception. If you own a property that you rent to your business, see Self-Rental Trap Still Costing Business Owners Tax Dollars.
When you deduct your business and rental property losses against other taxable income, the government gives you cash in the form of lower taxes or perhaps even a tax refund. The sooner you get the cash, the sooner you can put it to work earning more cash.
The early arrival of cash and the appropriate investment or reinvestment of that cash add to your net worth.
Therefore, take care to ensure your loss deductions and use those tax benefits to build your net worth. The rentals in this article escape the onerous real estate professional rules for deducting losses, and that’s a very good thing. But you still have that material participation hurdle that you need to pass.
Often, simply knowing that you have that material participation hurdle and then reading the rules in this article will make it easy for you to materially participate and realize your tax loss cash benefits.
1 IRC Section 469(c)(2).
2 IRC Section 469(d)(1).
3 IRC Section 469(g).
4 Reg. Section 1.469-1T(e)(3)(viii), Example (4).
5 IRC Section 168(e)(2)(A); transients have an average rental period of less than 30 days.
6 Reg. Section 1.469-1T(e)(3)(ii)(C).
7 Reg. Section 1.469-1T(e)(3)(v).
8 Reg. Sections 1.469-1T(e)(3)(ii)(D); 1.469-1T(e)(3)(vi)(B).
9 Reg. Sections 1.469-1T(e)(3)(ii)(D); 1.469-1T(e)(3)(vi)(C).
10 Reg. Sections 1.469-1T(e)(3)(ii)(D); 1.469-1T(e)(3)(vi)(D).
11 Reg. Section 1.469-1T(e)(3)(ii)(E).
12 Reg. Section 1.469-1T(e)(3)(viii), Example 10.
13 Reg. Sections 1.469-1T(e)(3)(ii)(F); 1.469-1T(e)(3)(vii).
14 Passive Activity Loss Audit Technique Guide (ATG), Training 3149-115 (02-2005), Catalog Number 83479V, pp. 4–12.
15 For rental groupings, see IRC Section 469(c)(7)(A); for business groupings, see Reg. Section 1.469-4(c)(2).
16 IRC Section 469(h)(2).
17 Reg. Section 1.469-4(d)(1).