Real Estate Advisor - February, 2017By William H. Jennings
February 17, 2017
Marks Paneth has published the latest issue of Real Estate Advisor.
When taxpayers contribute property to charitable institutions, they generally follow up by claiming a charitable deduction on their tax returns. But that deduction isn’t a given — you must comply with the IRS’s strict requirements. Many contributions, for example, require that the donor obtain, and possibly submit, a “qualified appraisal” of the donated property. Failure to do so can cost you the deduction and possibly lead to steep penalties. A Chicago couple learned this the hard way.
The couple owns a house listed on the National Register of Historic Places. In 2007, the National Park Service certified it as a “certified historic structure” for a charitable contribution for conservation purposes.
The couple decided to pursue a façade easement on the home. The donation of a historic façade easement in perpetuity to a qualified charitable organization entitles the donor to a charitable deduction for the easement’s value. The couple donated the easement to a nonprofit landmark preservation organization.
After an appraiser valued the easement at $108,000, the couple deducted that amount on their tax return. But when they attached IRS Form 8283, “Noncash Charitable Contributions,” they failed to include an appraisal.
The IRS subsequently rejected the entire deduction. It also imposed penalties of $10,770 due to the nearly $27,000 in tax underpayment that resulted once the deduction was denied. The couple appealed, but the US Tax Court sided with the IRS.
The appraisal requirement
Generally, you must obtain a qualified appraisal for any contribution of property valued at more than $5,000. You need not submit the appraisal with your tax return, but you must complete Section B of Form 8283 (which draws on information found in an appraisal) and attach that form to your return. However, you must also submit an appraisal for property contributions of more than $500,000.
The IRS treats use restrictions that encumber certain properties differently, though. Under IRS rules, a donor who contributes a use restriction (such as the façade easement) that encumbers a certified historic structure in a registered historic district must include a qualified appraisal with the tax return for the year of the contribution.
The definition of a qualified appraisal
The law defines a qualified appraisal as one that:
- Is prepared no earlier than 60 days before the date of contribution and no later than the due date (including extensions) of the tax return on which you claim the deduction,
- Is prepared, signed and dated by a qualified appraiser,
- Doesn’t base the appraisal fee on the appraised value, and
- Includes the information required by the tax regulations.
When an appraisal is for a real estate donation, it must include a complete description of the property in sufficient detail to allow someone to identify the property even if they’re not familiar with it or the area. For example, it would be helpful to list the street address, legal description, lot and block number, physical features, condition, dimensions, zoning and permitted uses, the property’s actual use, and its potential for other higher and better uses. You may also wish to include photographs. Note that, in the case of a contribution of an easement — as in Gemperle v. Commissioner, discussed here — the requirements are more stringent.
A “qualified appraiser” is someone who has earned an appraisal designation from a recognized professional appraisal organization or satisfied certain minimum education and experience requirements. For real property, the appraiser must be licensed or certified for the type of property being donated in the state where the property is located.
Additionally, a qualified appraiser is someone who regularly prepares appraisals for pay and demonstrates verifiable education and experience in valuing the type of property appraised. The appraiser must also not have been prohibited from practicing before the IRS in the three years leading up to the appraisal date, and can’t receive fees based on a percentage of the appraised value.
A small misstep can prove costly when it comes to charitable donations. You could end up on the hook for more taxes, plus penalties that range from 20% to 40% of your tax underpayment. Don’t let the failure to obtain a qualified appraisal trip you up.
The façade easement donated in the Gemperle v. Commissioner case (see main article) was an example of a qualified conservation contribution — basically, a legally-binding permanent restriction on a property’s use. While you generally can’t deduct a charitable contribution of a partial property interest like an easement, you can deduct the contribution of a qualified real property interest to a 501(c)(3) organization, exclusively for conservation purposes.
In addition to meeting the general requirements for charitable deductions, you must record a deed that:
- Describes the specific conservation purpose, restrictions and permissible uses of the property, and
- States that the restrictions remain on the property forever and are binding on current and future owners of the property.
You must obtain a qualified appraisal for easements of more than $5,000 and must submit it with your tax return for easements of more than $500,000 or façade easements not listed on the National Register of Historic Places.
In an uncertain economy, commercial landlords understandably look for ways to protect themselves from financial exposure. One approach is the inclusion of gross-up provisions in leases. A properly drafted gross-up provision can help ensure that tenants pay their share for operating expenses when some units are vacant, while also protecting tenants from unexpected cost increases.
Rationale for gross-up provisions
Commercial landlords of multitenant properties typically require that tenants pay — in addition to rent — their share of the property’s operating expenses, including taxes, insurance, utilities,maintenance and trash removal. Each tenant’s share is generally based on the percentage of the property’s total rentable square footage it occupies. If a property isn’t fully leased, the landlord ends up carrying the burden of the operating expenses allocated to the vacancies.
But the operating expenses will usually be much higher for the occupied units than the unoccupied. Unoccupied units, for example, use few utilities, may not require janitorial services and don’t generate trash. As a result, the landlord will be subsidizing some of the tenants’ operating expenses — because the tenants continue to pay based on their square footage, rather than on their actual variable expenses.
How the provisions work
A gross-up provision permits a landlord to calculate and allocate operating expenses as if the property were fully occupied. Essentially, the landlord will “gross-up,” or overstate, the operating expenses that vary depending on occupancy (for example, utilities) to reflect full or almost full occupancy; the most common standards are 95% or 100% occupancy. Each tenant’s share will be based on the grossed-up expenses.
For example, a fully occupied property has $17,000 in variable expenses and $3,000 in fixed expenses, for a total of $20,000 in operating expenses. A tenant that occupies 10% of the property will pay operating expenses of $2,000 (and the landlord pays none of the expenses).
What if the building is vacant except for that tenant, and the variable expenses fall to only $2,000? The total expenses will be $5,000 ($2,000 plus $3,000). Without a gross-up provision, the tenant’s share would be only $500 (10% of $5,000), despite the fact that it incurred all of the variable expenses — leaving the landlord to pay $4,500 in operating expenses.
With a gross-up of variable expenses to 100% (or $17,000), though, the total expenses would be $20,000 — as if it were fully occupied — and the tenant would pay $2,000 (all of its variable expenses). The landlord would still pay $3,000, but save $1,500, compared to the lease without the gross-up provision.
Benefits to tenants
On the flip side, gross-up provisions can protect tenants from fluctuations in operating expenses over the course of their leases, especially if a tenant pays operating expenses according to a base year amount. Once the parties agree on the base year (usually the first year of the term), the landlord charges the tenant based on the annual operating expenses that exceed that threshold.
If the property isn’t fully occupied the first year and the lease doesn’t include a gross-up provision, base-year expenses will be relatively low. If the property subsequently fills up, the tenant’s share will be based on the higher operating expenses that come with full occupancy. By contrast, a gross-up provision would allow the landlord to gross-up the variable operating expenses for the base year, so, going forward, the baseline threshold for operating expenses would be higher and the tenant’s share would be smaller.
It’s a win-win
A carefully drafted gross-up provision can be advantageous for landlords and tenants alike. The landlord spreads around some of the costs associated with vacancies, and the tenant avoids dramatic jumps in operating expense charges.
Owners need to know the condition of all residential and commercial properties. When was the last time you performed regular maintenance? Do you have a regular maintenance schedule? To avoid headaches and possible lawsuits, make sure you know the answers to those questions.
How to track progress
To ensure that your maintenance program covers all the bases, regularly take stock of every piece of equipment on each property, including elevators, HVAC systems, pumps and motors. Be sure to include structural components, such as roofs and supports.
For the exterior of a building, check the foundation walls (including waterproofing) and window seals (repairs and possible replacements). Inspect the fasciae and soffits, and take a look at the condition of the exterior painting. Finally, review the grading and drainage around the building.
Interior “hotspots” that deserve attention include:
- Moisture control systems,
- Drywall installation and repair,
- Interior painting,
- Carpet replacement,
- Mechanical system repair, and
- Plumbing and electrical repair.
Keep an inventory that describes each item fully, including the manufacturer, operating procedures (if applicable), location within the property, and any details about purchase and existing warranties. The inventory should also state where to obtain needed parts and service. This schedule can help management quickly assess the condition of fixed assets and helps transition the task if a new person is put in charge of repairs and maintenance.
When to schedule inspections and repairs
Determine the types of inspections and preventive maintenance that should be performed on each piece of equipment and structural component. Note how frequently these tasks should be done. You’ll need to check some maintenance items weekly, while you can inspect others less often. Program routine maintenance reminders into a smartphone calendar — or write it in a day planner — to stay on schedule.
For equipment items, develop a schedule that outlines when each item needs to be cleaned, lubricated, serviced or overhauled. Keep a list of spare parts that should be kept readily on hand. For structural items, add a to-do list for periodic inspections related to painting, patching or similar maintenance issues.
Work with your property manager and maintenance supervisor to develop a realistic schedule for needed tasks. Create a formal schedule for fixed asset repair and maintenance, and assign your property manager to update this schedule. Create checklists that facilitate daily, weekly, monthly or even seasonal reports. Then implement a system for issuing work orders and monitoring task completion.
How to estimate costs
Assess how much time the preventive maintenance program will require and develop cost estimates that are realistic for both the budget and level of work involved. In some cases, it may be cheaper to replace an outdated asset, rather than maintain it.
For example, many older buildings use old electrical or plumbing systems that might be expensive to maintain. You may be able to reduce monthly utility bills by replacing the entire systems. Moreover, equipment will likely last longer, deferring replacement costs, and major equipment breakdowns will be less frequent.
The building owner might also benefit from a tax credit for energy-saving equipment, together with Section 179 expensing or other increased depreciation writeoffs, in the event of an equipment upgrade. But before you start upgrading at random, make sure you evaluate whether the financial benefits of the upgrades, over the long term, outweigh the costs.
Maintaining accurate records will help you determine whether time, money — or both — can be saved by simply performing certain maintenance activities less frequently, or whether certain items should be inspected more often. Keeping good records can also help verify whether your maintenance personnel are performing needed tasks to your satisfaction.
How to avoid headaches
Performing routine inspections and maintenance is more than an occasional occurrence. Stay on top of repairs and maintenance on all your buildings to avoid unnecessary headaches.
The IRS generally considers rental real estate investments as passive activities, meaning taxpayers can use any related losses only to offset income from passive investments. The tax code does grant an exception for rental activity losses incurred by real estate professionals, but it’s not enough just to qualify as a real estate professional. As the US Court of Appeals for the Ninth Circuit recently ruled, you must also prove that you materially participated in the rental properties.
The taxpayer’s argument
A married couple deducted rental losses on their 2006 and 2007 federal income tax returns. The wife is a licensed real estate agent who worked for a real estate brokerage during those years.
The IRS audited their returns in 2009, and they submitted documents establishing that the wife was a “real estate professional” under the exception. The IRS requested a written log of all rental-related activities supporting the deductions, and the couple submitted two undated one-page notes estimating the hours the wife spent working on their rental properties in 2006.
Concluding that the couple failed to show they materially participated in the rental properties, the IRS disallowed the rental losses. After making the necessary payments, the couple sued for a refund.
They argued that the wife’s status as a real estate professional rendered their rental losses automatically nonpassive and therefore deductible, regardless of material participation. The district court dismissed the lawsuit before trial, and the couple appealed to the Ninth Circuit.
The court’s reasoning
The appellate court rejected the couple’s argument, finding that Internal Revenue Code Section 469(c)(7) didn’t support their interpretation. According to the court, the real estate professional exception is an exception only from the general rule that rental activity is “per se” passive activity — but the activity is nonetheless passive unless the taxpayer materially participates.
The Ninth Circuit cited the relevant statute, the regulations implementing that statute and a case decided by the U.S. Tax Court in support of its ruling. One regulation, for example, states that “a real estate professional’s rental real estate activity is a passive activity unless the professional materially participates in the activity.” According to the Tax Court, case law requires that a real estate professional claiming rental real estate loss deductions meet the “material participation” requirement.
Proceed with caution
If you’re planning to take advantage of the real estate professional exception, don’t assume that qualifying as such a professional alone satisfies your burden. You’ll need proper documentation of your material participation in the rental property for each tax year you claim a deduction.
Peter Loi, CPA, is a Director at Marks Paneth LLP. Bringing more than 15 years of public accounting experience to the position, Peter’s areas of expertise in real estate and construction industries include providing audit and tax services to commercial and residential real estate clients and to high-net-worth individuals. He works closely with clients to provide value-added advisory services to address both current and emerging accounting and tax-related issues.
Peter is also a member of the firm’s China Desk, a cross-disciplinary team of professionals who can assist both Chinese businesses and individuals looking to work, invest, raise capital or do business in the United States.
Peter enjoys family dinners with his wife and two children, as these moments lend themselves to great conversation and bonding. He resides with his family in Brooklyn, New York.
About William H. Jennings
William H. Jennings, CPA, HCCP, is the Partner-in-Charge of the Real Estate Group, China Desk, and the Florida Office. He is also a member of the firm’s Executive Committee, which sets policy and strategy. With more than 35 years of experience in public accounting and a keen focus on the real estate industry and its needs, Mr. Jennings has spent nearly his entire career with Marks Paneth and its predecessor firms. During this time, he has... READ MORE +