What Not to Do When Donating Property

Charitable donations can provide real estate owners with valuable tax deductions provided that donors meet IRS requirements for taking such deductions. Click here to read a case in which the US Tax Court disallowed a couple’s charitable deductions for their donations of real estate due to their failure to comply with IRS appraisal requirements — despite the fact the donors likely undervalued the donations on their income tax returns.

It’s not uncommon for real estate owners to incorporate charitable donations as part of their estate planning. In addition to satisfying their philanthropic urges, these gifts can provide valuable tax deductions provided that donors meet IRS requirements for taking such deductions.

A married couple who donated six properties worth at least $18.5 million recently learned the hard way that proper documentation is critical to sustaining a charitable contribution upon an IRS audit. The U.S. Tax Court disallowed the couples’ charitable deductions for their donations due to their failure to comply with IRS appraisal requirements — despite the fact that they likely undervalued the donations on their income tax returns.

The Donations and the Deductions

In Mohamed v. Commissioner, a real estate broker, certified real estate appraiser and prominent entrepreneur who had amassed a fortune in real estate formed a charitable remainder unitrust (CRUT) with his wife to dispense their wealth.

CRUTs allow taxpayers to claim an immediate deduction for a portion of the value of property placed in the trust. The CRUT income goes to the donor (or another beneficiary) for life or for a term not to exceed 20 years, with the remainder going to charity.

In 2003 and 2004, the couple donated real estate worth millions of dollars to the CRUT and claimed charitable deductions on Form 8283, “Noncash Charitable Deductions,” with their 2003 and 2004 tax returns. The husband completed the tax returns himself and included his own appraisals of the donated properties, which totaled just over $18.5 million for the two years.

The IRS began an audit of the 2003 return in April 2005 and questioned the husband’s self-appraisal of such high-value properties. The couple responded by obtaining independent appraisals of the properties, which valued them at more than $20.2 million. Arm’s-length sales of some of the properties after the donations were made also supported the taxpayer’s values.

The IRS subsequently discovered that the taxpayer had made several mistakes in filing Forms 8283 for 2003 and 2004. It asked the Tax Court to deny all charitable deductions for the CRUT.

Requirements for Charitable Deductions

Taxpayers can claim certain charitable deductions only if they fulfill the substantiation requirements. Specifically, a donor who claims a deduction for asset donations in excess of $5,000 ($10,000 for closely held stock) must 1) obtain a qualified appraisal of the property, 2) complete the appraisal summary in Section B of Form 8283, and 3) maintain certain records. For deductions of more than $500,000, the donor must also attach the qualified appraisal to the tax return (though this requirement didn’t apply at the time the taxpayers in Mohamed filed their returns).

The appraisal must be made no more than 60 days before the donation and no later than the tax return’s due date. It must be performed by a qualified appraiser, who can’t be the donor, the taxpayer claiming the deduction or the donee ( recipient) of the property.

Where They Went Wrong

The Tax Court wasted no time in pointing out that the taxpayer, who performed the appraisals, was both the donor and the taxpayer claiming the deductions. In his capacity as trustee of the CRUT, he was also the donee.

The court therefore concluded that “there is no way we can possibly find that he was a qualified appraiser for the gifts.” Moreover, the taxpayer omitted several required items of information in the appraisal summary section of Form 8283, including the basis of each property and declarations by a qualified appraiser.

The court observed that, if the taxpayer had hired a qualified appraiser, the lack of sufficient appraisal summaries might not have been a problem. U.S. tax regulations allow the IRS to request missing summary information. In such an instance, the taxpayer can still receive the deduction if the information is submitted within 90 days of the request — as long as the appraisal was conducted before the tax return was due. The independent appraisals here, however, came too late to be considered either qualified appraisals or remedial appraisal summaries.

How to Avoid Harsh Results

The Tax Court’s decision underscores the importance of consulting qualified appraisers before donating real estate. As the court warned, “A taxpayer relies on his private interpretation of a tax form at his own risk.”

IRS Clarifies Capitalization of Leasehold Improvements

Leasehold improvements can pose some tricky tax issues for all parties involved. In a recent legal memorandum, the IRS addressed one such issue — the proper capitalization treatment of indirect costs incurred by a lessee to construct real property it then leased. Click here to read about a case involving Internal Revenue Code (IRC) Section 263A, Capitalization and Inclusion in Inventory Costs of Certain Expenses, and IRC Sec. 263(a), Capital Expenditures, in which the lessee lost the battle.

It’s a fact: Leasehold improvements can pose some tricky tax issues for all parties involved. In a recent legal memorandum, the IRS addressed one such issue — the proper capitalization treatment of indirect costs incurred by a lessee to construct real property it then leased.

The Lease Arrangement

In the matter addressed in Internal Legal Memorandum (ILM) 201220028, a lessee entered a sublease and construction agreement with a lessor. The agreement provided that the lessee would lease certain real property and its improvements. It also provided that the lessee would construct additional real property and improvements that it would lease from the lessor after construction.

Under the agreement, the lessor would own all of the real property and most of the real property improvements constructed. The lessee would own all of the personal property and some of the real property improvements constructed.

The lessee was required to pay for some indirect costs associated with construction of the real property and improvements owned by the lessor. The agreement didn’t provide that the costs incurred by the lessee associated with the construction of the leased property were a substitute for rent.

The lessee relied on Internal Revenue Code (IRC) Section 263A, Capitalization and Inclusion in Inventory Costs of Certain Expenses, to capitalize indirect costs associated with the construction of the leased property to the basis of the property the lessee produced and owned. The Large Business and International (LB&I) division of the IRS, however, contended that Sec. 263A allowed the lessee to capitalize only the costs that related to the property it produced and owned. The LB&I division sought guidance from the Chief Counsel of the IRS.

Bad News for the Lessee

Sec. 263A provides that taxpayers that produce real or tangible personal property must capitalize the property’s properly allocable share of indirect costs. A taxpayer isn’t considered to produce property unless it’s an owner of the property.

Under IRC Sec. 263(a), Capital Expenditures, if a lessee makes a leasehold improvement that isn’t a substitute for rent, the lessee is generally required to capitalize the cost of the improvement.

The Office of the Chief Counsel found that the lessee’s costs (including indirect costs) for the property owned by the lessor must be capitalized as leasehold improvements under Sec. 263(a), rather than capitalized under Section 263A to the basis of the property produced and owned by the lessee.

It further explained that only indirect costs that directly benefit or are incurred to produce property owned by the lessee may be charged to the basis of that property. Indirect costs incurred that relate to both the property produced and owned by the lessee and the leased property must be allocated between the two types of property.

The Bottom Line

Capitalization issues continue to confound many in the real estate industry, despite (or perhaps because of) the IRS’s issuance late last year of temporary regulations on capitalization vs. expensing of costs related to tangible property. These temporary regulations are being reviewed again by the IRS and are subject to clarification and certain additional changes in 2013. Your tax advisor can help you navigate these sometimes rough waters.

The Pros and Cons of Leveraging: How to Use Other People’s Money to Invest in Real Estate

Investors can make a lot of money by leveraging other people’s money to invest in real estate. But it’s possible to have too much of a good thing, as many are discovering in the wake of the credit crisis. Lower property appraisals, combined with the tightening of loan-to-value ratios, have made cash much harder to come by. Click here to read how to avoid overleveraging.

For years, real estate investors have leveraged other people’s money to finance deals. And it’s a good tactic: The investors can make a lot of money — fast. Plus, using leverage can help in other ways, such as lowering taxes. But it’s possible to have too much of a good thing, as many are discovering in the wake of the credit crisis.

Credit Crunch Is Taking a Toll

The long-term effects of the latest real estate bust are still playing out. But one thing’s certain: banks’ tighter loan requirements are here to stay. Because many loans are based on fair market value (FMV) and the value of most properties have dropped, investors have less to borrow against. Lower property appraisals, combined with the tightening of loan-to-value (LTV) ratios, have made loans much harder to come by.

Many loans established when the market was booming five or six years ago will mature in the next year or so. Those investors looking to refinance may have trouble, especially if their property values and net operating income have declined substantially.

Consider the strip mall that was appraised for $80 million in 2012, down 20% from $100 million in 2006. The owner needs to refinance its $65 million mortgage before year end. The bank’s maximum LTV ratio is 65%, or $52 million. The property now faces bankruptcy because it has a financing shortfall of $13 million.

Even if you’re not looking to refinance, you may find that some distressed properties are in violation of their LTV or debt coverage ratios. If so, an uncooperative bank may decide to foreclose or call the loan.

Avoid Overleveraging

Small differences in personal circumstances and preferences can lead to vastly different investing choices — there’s no “right amount” of leverage to use. But while each investor may have a different situation and risk tolerance, there are limits to the amount of leverage that should be applied.

Over leverage in the real estate market, unrealistic market expectations, lax due diligence and the failure of banks to maintain adequate cash reserves all contributed to the current credit crisis. Investors who wish to maximize profits through leverage shouldn’t repeat those mistakes.

One method for determining the appropriate amount of leverage is to apply a “stress test” to cash flow projections for a property. Change key variables one by one and evaluate how each change affects cash flow. For example, what would happen if your vacancy rate jumped to two or three times its normal level? What would happen if you had to lower the rental rate or make significant concessions just to attract new tenants?

Also prepare best-, worst- and most-probable-case scenarios for each investment. Would the property still have sufficient positive cash flow to cover a worst-case scenario for a year? If not, would you have enough cash in the bank to survive?

Time to Reconsider?

The fact that a bank won’t approve a traditional loan for your latest investment may be merely the result of today’s conservative banking environment. On the other hand, it could also be a “red flag.”

If the only type of financing available to you is “exotic” or “extremely creative,” it may be time to reconsider whether you might be overleveraged.

The safest strategy is to never leverage a property beyond the cash flow breakeven point of your worst-case scenarios. In other words, plan your investments so that even if rents and occupancy rates are down, cash flow will cover the property expenses, including debt and a reserve for major repairs. This way, you won’t have to dip into cash reserves to meet the operating expenses of an investment that’s teetering on the brink of negative cash flow.

Five or 10 years ago, some banks and private equity funds accepted LTV ratios of 70% to 80% — or higher. A common rule of thumb in today’s more conservative credit environment is 60% to 65% LTV. Such a ratio will provide you with the advantages of leverage without putting cash flow or reserves at excessive risk and thereby making the quest to achieve financing less difficult.

Be a Cautious Investor

As vacant properties keep stacking up, be careful about what you invest in — and when. Take your time and do your homework, and you’ll likely end up with a solid investment.

Ask the Advisor: Should I Invest in Triple-net Lease Property?

Properties with triple-net leases can be quite attractive to real estate investors, but they aren’t as straightforward as they might seem. Click here to read what a triple-net lease is and the advantages it can bring to investing.

Properties with triple-net leases can be quite attractive to real estate investors, but they aren’t as straightforward as they might seem. Due diligence is critical, as changes often can’t be made once the lease has been signed.

The Nuts and Bolts

Under a triple-net lease, the tenant assumes responsibility for the property’s ongoing operating costs (taxes, insurance, maintenance and in some leases, certain capital improvements) in exchange for a long-term lease. The tenant also pays the landlord monthly rent. Triple-net leases are used for a variety of properties, such as office, industrial and multiunit residential.

Triple-Net Benefits

A property with a triple-net lease offers some advantages associated with a traditional real estate investment, such as appreciation and tax benefits, but many investors prefer triple-net leases because the leases allow them to avoid day to day operating responsibilities.

The leases can also provide long-term, steady streams of income similar to an annuity. They typically have a low tenant turnover rate, which helps reduce marketing and leasing costs. Often, triple-net leases involve prominent anchor tenants, which increases predictability and lowers risk. Because these leases are fairly stable investments, banks may offer sweeter terms, such as lower mortgage rates and down payments, than they give other types of real estate ventures.

Properties with triple-net leases are also good for property owners who want to sell existing properties and reinvest in a Section 1031 like-kind exchange to defer capital gains tax.

Potential Risks

Like most real estate investments, triple-net properties have some drawbacks. In particular, inflation could create a nightmare if rent doesn’t keep pace with market rates. The effect could worsen if the tenant has options to extend a lease for additional periods, as option periods generally come with scant rent increases. And good luck selling a property shackled with long leases and relatively low rents.

On the flip side, compare the rent to those for comparable triple-net properties to determine whether it’s currently above market, especially as the lease nears expiration. If you can’t obtain that rate in the future from another tenant, your net yield will likely drop.

Negotiate With Care

A triple-net lease property can pay off as long as you negotiate carefully. In addition to the risks, bear in mind factors like your investment objectives and the tenant’s credit rating and likelihood of continued profitability.

Spotlight on Marks Paneth

COUNTING DOWN THE DAYS TO OUR NEW NYC HEADQUARTERS

Marks Paneth is delighted to announce the opening of our new midtown Manhattan headquarters. Effective January 21, 2013, our new address will be:

685 Third Avenue

New York, NY 10017

Our telephone, fax and emails will all remain the same. We look forward to serving you from our new state-of-the-art offices.

Marks Paneth Thought Leadership Videos

Marks Paneth has launched the first in our ongoing series of short videos. These videos feature several of our senior professionals and thought leaders commenting on their individual areas of expertise:

• Investing in real estate as a limited partner – Abe Schlisselfeld, Partner, Real Estate Group
• Cloud computing and tax implications – Steven P. Bryde, Principal, Tax Group
• For entrepreneurs, having a great idea is not enough – Jeanne P. Goulet, Senior Consultant, Emerging Growth Companies Group Leader

The videos are hosted on our Marks Paneth YouTube page.

About William H. Jennings