Real Estate Advisor - June, 2017

May 30, 2017

Time for a 1031 exchange primer

Your records could make — or break — your tax deductions

Embracing the “sharing” economy

Signs of tenant distress — and what to do about it

Leverage Our Expertise

Time for a 1031 exchange primer

If you’ve been in the real estate business for even a short amount of time, you’ve probably heard of Section 1031 exchanges. This transaction allows you to sell property and then buy a different property — known as a “like-kind” exchange — as part of what the IRS calls a nonrecognition transaction. Let’s take a deeper look at what you need to know.

What’s a 1031 exchange?

Internal Revenue Code Sec. 1031 allows you to exchange business or investment property (the relinquished property) for business or investment property of a like kind (the replacement property) without recognizing any gain or loss until the disposition or liquidation of the replacement property occurs. The simplest type of exchange is a simultaneous swap of one property for another. Deferred exchanges are more complex but allow for additional flexibility.

The provision allows a deferred, or “forward,” exchange where you transfer the relinquished property before acquiring a “replacement property.” You must identify the replacement property within 45 days of when you transfer the relinquished property. You also must acquire the replacement property within 180 days of the transfer or by the due date of the applicable tax return (including extensions) for the year in which you transfer the relinquished property, if sooner (the exchange period).

The same time limits apply to “reverse” exchanges. In a reverse exchange, you acquire the replacement property first, and then “park” it with an exchange accommodation titleholder (the accommodator) before transferring the relinquished property.

What about some guidance?

In a memo from the Office of Chief Counsel (Memo No. 200836024), the IRS considered a scenario in which a taxpayer structured two separate exchanges. In the first, a reverse exchange, the replacement property was acquired and parked with the accommodator, and the taxpayer identified the relinquished property in a timely manner (within 45 days).

The relinquished property had a much higher value than the replacement property, so the taxpayer planned to engage in a second transaction — a deferred exchange — to defer the gain that remained after the relinquished property was exchanged for the replacement property.

A qualified intermediary (QI) was retained to execute the transfers of the properties in both exchanges. The QI followed all guidelines to ensure the taxpayer wasn’t in constructive receipt of any of the exchange funds during the two 180-day exchange periods.

The IRS memo concluded that, as long as you follow the regulations, you can use the same relinquished property in both forward and reverse exchanges — even though allowing this structure could result in up to 360 days between the day you park the replacement property at the beginning of the reverse exchange and the day you complete the deferred exchange.

Caution, though: An Office of Chief Counsel memo is specific to the particular facts that it addresses and has no binding effect on future cases. But it can serve as a guideline for how to structure such a transaction.

How about an example?

Imagine you decide to take advantage of property values and buy an investment property in Florida for $550,000 in February 2017. You park it with an accommodator so you can determine which property you’d like to sell in order to reap the benefits of a reverse exchange.

Within 45 days, you identify a property in Colorado. In August 2017 — within 180 days of parking the Florida “replacement” property — you sell the Colorado “relinquished” property for $950,000, completing the reverse exchange.

You begin executing a deferred exchange within 45 days, identifying additional like-kind replacement properties to buy with the remaining $400,000 of proceeds from the relinquished Colorado property. And you have 180 days from the close on the Colorado property to close on one or more identified replacement properties.

So you don’t have to close on those properties and complete the deferred exchange until February 2018 — nearly a year after you bought the Florida property.

Learn more

Does a 1031 exchange sound too good to be true? It’s not. But whether it’s right for your real estate portfolio may not be so clear. Talk with your real estate and tax advisors to find out more.

Your records could make — or break — your tax deductions

A recent decision by the US Tax Court in a case involving a married couple’s real estate activities included both good and bad outcomes for them on some of their deductions. On both counts, though, the court’s ruling came down to their record keeping.

The challenged deductions

The couple filed the case after receiving a notice of deficiency from the IRS for almost $48,000 in underpaid taxes for the 2008 to 2011 tax years. The husband was a full-time pilot, and the wife was a part-time ski instructor. They owned three rental properties in Vermont.

The wife oversaw all rental and management activities for the rental properties. She participated extensively in repairs to and renovation of the properties. Other than occasional help from her husband, no one else assisted in overseeing and managing the properties. For the years at issue, the wife spent 1,003, 1,228, 835 and 864 hours on the rentals, respectively, compared with only 199.25, 53.25, 90.75 and 96.25 as a ski instructor.

The couple claimed losses from the properties on their tax returns for each of the years. After examination, the IRS disallowed the losses on their rental activities, as well as some depreciation expenses taken on a truck used in the rental business.

Rental activity losses upheld

Section 469(a) of the Internal Revenue Code generally only allows deductions for passive activity losses to the extent of passive income from other sources — such as positive operating income from other rental properties. One significant exception to this rule is that up to $25,000 of losses may be deducted, although the exception itself has exceptions in that the ability to deduct the losses from passive activities is subject to a phaseout based on AGI. A passive activity is any trade or business in which you don’t materially participate. Rental activity is generally treated as passive regardless of whether you materially participate in it.

But rental activity won’t be treated as passive if you can show that:

1. More than half of the personal services you provided during the year were worked in a rental activity in which you materially participated, and

2. You worked more than 750 hours during the tax year in a rental activity in which you materially participated.

In the case of a joint return, one of the spouses must satisfy both requirements on his or her own.

The court found that the wife had materially participated in all of her real estate activities during the relevant years. Moreover, she had maintained contemporaneous logs of the time spent on the rental properties, showing more than 750 hours of work for each year. The IRS agreed that she’d worked less than 200 hours as a ski instructor each year, so more than one-half of her work was in the rental activities. (The court also noted that the wife had summarized her logs into activity summaries to support the claimed deductions.)

Depreciation deductions defeated

Turning to the couple’s depreciation deductions related to a truck, the court noted that taxpayers are required to maintain records sufficient to substantiate the expenses underlying their deductions. In the case of deductions on property used as a means of transportation, you must substantiate:

• The amount of the underlying expense,

• The time and place of travel or use of the property,

• The business purpose of the expense, and

• The business relationship of the people using the property.

The couple claimed almost $18,000 in depreciation deductions on the truck, but didn’t provide a mileage log for it. In addition, the husband testified that his wife didn’t like to drive it and that he would park it at the airport for up to two weeks at a time while he traveled for his work. The court therefore concluded that they’d failed to substantiate the expenses related to the truck.

Document, document, document

It really can’t be said enough — if you want your deductions to hold up to scrutiny, you need to keep adequate records. For rental activities, that means logs of the amount of, and how you spent, your time working on them. For vehicle expenses, you’ll also need detailed records. Ask your tax advisor for specifics in your situation.

Sidebar: Poor records can lead to penalties, too

If your tax deductions are disallowed, it’s not just back taxes you have to worry about — you could also end up on the hook for penalties, including “accuracy-related” penalties. The IRS can impose a penalty of 20% of the portion of underpayment of tax attributable to the taxpayer’s negligence, disregard of rules or regulations, or substantial understatement of income tax. “Negligence” includes any failure to make a reasonable attempt to comply with tax laws, such as the failure to keep adequate books and records.

You may be able to avoid accuracy-related penalties by proving you had reasonable cause for underpayment and acted in good faith. Relevant factors include:

• Your effort to assess the proper tax liability,

• Your knowledge and experience, and

• Any reliance on the advice of a professional, such as an accountant.

Generally, the most important factor is your effort to assess the proper tax liability.

Embracing the “sharing” economy

Over the past several years, Uber and Airbnb have become an accepted part of life in the new economy. The so-called “sharing” (or collaborative) economy optimizes the idle time of a variety of assets, including vehicles and real estate, to suit the needs of people who own such assets and those who are interested in access to them. This article looks at how this shift may affect the commercial real estate industry.

Space sharing on the rise

Not only residential property is shared these days. Collaborative workspaces also are on the rise. Companies that own or lease blocks of office space divide them into smaller units they can lease or sublease to start-ups, independent contractors and others looking for short-term rentals or smaller spaces.

A customer might rent an entire office suite or space at an unassigned desk with access to high-speed Internet, office equipment and large common areas, along with amenities like coffee bars and dining options. The operators can charge premium rates on short-term space, while helping their customers contain their costs by renting space on an on-demand basis.

These arrangements appeal to independent contractors who seek the camaraderie of the workplace, as well as the cost efficiencies of sharing certain expenses associated with top-notch office space. But space sharing has spread beyond one-person or small businesses. Corporations are drawn to the opportunity to reduce the costs of lengthy long-term leases, especially as remote work and flextime opportunities grow.

Implications for landlords

The effects of space sharing may be felt first in lease negotiations. Standard leasing provisions may contain several issues for landlords and their tenants who provide office sharing. For example, office sharing will likely affect building infrastructure from increased elevator use. Sharing could also increase utility, insurance and other overhead costs.

In addition, office leases usually have restrictions on permitted uses, subleasing and assignment. Shared office space companies, though, might be able to get around this by using licensing or membership fees with their clientele. This may result in landlords having less control over their tenant mix.

On the other hand, building garages with paid parking might fill up much more quickly as more people make use of the same amount of office space, increasing dollars for landlords. Office sharing configurations could revitalize properties in up-and-coming areas. Moreover, some tenants that start out sharing space may eventually grow enough to need dedicated space, and they may find it convenient to simply move into another space in the same building.

Implications for developers

Developers may need to configure projects to take advantage of the office sharing trend. For example, they might construct more flexible spaces that could easily be converted for sharing purposes and include perks, such as gyms, dining options and expansive communal space.

Hotels may also need to adapt in the sharing economy. Although the success of Airbnb could have an adverse effect on vacancy rates for standard rooms, the rising popularity of space sharing in the business world could give hotels a way to recoup their short-term lodging losses. Renting out conference and meeting rooms to businesses interested in short-term space sharing could provide an opportunity to supplement hotel revenue.

The future is now

The sharing economy shows no signs of going away. Landlords and developers need to plan now for how best to respond to protect and improve their bottom lines.

Signs of tenant distress — and what to do about it

The economy may be on the upswing, but many businesses are still struggling. That puts landlords at risk of tenants filing for bankruptcy, leaving them in the lurch for past and future rents due. This article discusses how to recognize hints of financial distress, which may help landlords minimize losses from tenant bankruptcies.

Recognize red flags of distress

How do you know that a tenant may be struggling? If tenants pay the rent late, request extensions, make partial payments or ask you to hold their checks for a few days, they might be having some cash flow issues. Failing to satisfy maintenance and similar obligations can be another sign of insufficient cash flow.

Visit your tenants on a regular basis and look for reductions in operating hours, customer foot traffic and inventory levels. And don’t forget to keep your ears peeled in the local business community. For instance, you might hear rumors on the golf course or at a Rotary Club meeting that creditors have taken action against a tenant, such as filing a lawsuit. In that case, a race to the courthouse can’t be far behind, as creditors line up to get priority in a bankruptcy filing.

Know your rights

If a tenant does file for bankruptcy, protect your interests and stay on top of important deadlines, such as when a tenant must assume or reject an unexpired lease. In a Chapter 7 liquidation bankruptcy, a tenant has 60 days to assume or reject the lease, unless the court extends that period. If the tenant fails to make all payments due during the decision period, ask the court for permission to seek remedies, including repossession. Consult an attorney about obtaining a court order to evict a tenant, however, rather than taking unilateral action.

An attorney also can bring you up to speed on the rules regarding assumption or assignment of the lease. For example, a tenant must remedy lease defaults before assuming a lease. In addition, the tenant must provide “adequate assurance” of the lease’s future performance, typically in the form of a deposit or letter of credit.

You might be entitled to damages if the tenant rejects a lease with at least one year left in the term. Damages will equal the greater of a year’s rent or 15% of the rent over the remaining term, not exceeding three years.

Stay Alert

Tenants rarely tumble into bankruptcy without showing battle signs as they fight to survive. By staying alert, you can reduce the risk of being caught off guard.

Leverage Our Expertise

Marks Paneth LLP has served the real estate industry for more than 100 years. We assist many of the industry’s premier commercial and residential real estate owners, developers, builders, REITs (real estate investment trusts) and property managers. With more than 100 professionals who focus on the real estate industry, we bring deep expertise to every engagement.

For More Information

If you have any questions, please contact William Jennings, Partner-in-Charge of the Real Estate Group, at 212.503.8958 or wjennings@markspaneth.com.