Real Estate CPA for Real Estate Tax Accounting

• Lease acquisition costs such as commissions, professional fees, tenant incentives for the lessor, and professional fees for the lessee must be amortized over the lease’s life.

• A real estate investor:
  • Has the intention to buy and hold the property.
  • Sale expenses are used to reduce proceeds.
  • Sale of real property is treated as capital gains and losses.
  • Able to defer gain recognition.
• A real estate dealer:
  • Purchases property with the intention to sell.
  • Expenses are treated as ordinary business deductions.
  • Gains and losses from the sale of property are ordinary.
  • Not able to defer gain recognition.
  • Sales are an integral part of the business.

• In general, real estate investors have tax advantages that are not available to real estate dealers. Real estate investors who hold a property for more than a year are taxed at the favorable capital gains rates compared to dealers taxed at the higher ordinary income rates. Investors can even defer their taxes by participating in installment sales and like-kind exchanges (§1031 exchange). Though dealers are subject to self-employment tax, they do get to deduct their losses without limitation faced by investors.

• The security deposit is not deductible by the lessee and is not included in the lessor’s income but held as a liability. If the security deposit is consumed for non-compliance with the terms of the lease, it will be included in income (lessor) or expense (lessee).

• A 1031 exchange is a tool used to defer income recognition on the sale of property. When selling property used for investment or in a business, a taxpayer can receive similar property in return instead of cash. The gain on the sale can then be deferred indefinitely.

• Beginning in 2018, the real property qualifies.
• The property transferred and the property received are either used both held for investment or both held for productive use in a business.
• The nature and character of both properties are the same.
• The form of the transaction is an exchange.

• Partnerships
• Individuals
• C Corporations
• S Corporations
• Trusts
• All other taxpaying entities

• Properties are considered like-kind if the properties are of the same nature, character, or class irrespective of the property’s quality or grade. For real property, most properties are eligible to be exchanged, such as a shopping mall exchanged for vacant land.

• Property held for personal use such as a second home.
• Property held outside of the United States.
• Real property held for stock in trade such as.
• Homes built by real estate developers and offered for sale.
• Investors rehabbing and flipping properties.

• The replacement property needs to be identified within 45 days from the date of the sale of the relinquished property. The exchange needs to be completed within 180 of the date of sale or the tax return due date, including extensions.

• It is possible to acquire up to three properties in a like-kind exchange. If acquiring more than three properties, then there are additional guidelines to follow.

• With the exception of land and property placed in service and disposed of in the same year, depreciation allows a taxpayer to recover the cost of property over time. Real estate entities calculate depreciation under the Generally
  Accepted Accounting Principles (GAAP) for financial reporting but use MACRS for tax depreciation.

• Residential real property – A building or structure that has 80% or more of its gross income from dwelling units. The recovery period for this type of asset is 27.5 years.
• Nonresidential property – Depreciable property which is not residential property and has a recovery period of 39 years.
• Qualified Improvement Property – Interior, non-structural improvements to nonresidential buildings were placed-in-service after the building was placed in service. In 2018, QIP, with a recovery period of 15 years, replaced the asset categories of Qualified leasehold Improvement Property, Qualified restaurant property, and qualified retail improvement property.

• Allowed depreciation is the depreciation claimed on an IRS accepted income tax return. Allowable depreciation is the depreciation allowed in the tax law that can be deducted from gross income.

• These rules limit the amount of losses that can be deducted in a specific year. Any unused portion is carried forward until there is enough limitation to allow its use. Closely held C corporations, S corporations, and partnerships are subject to the at-risk rules. At-risk basis is calculated annually with increases coming from income, contributions, and recourse loans, while losses, distributions, and reductions of recourse debt reduce it.

• Passive activity rules dictate when losses from a passive real estate activity are able to be deducted on a tax return. In general passive losses can only be offset against passive income. If passive losses exceed income, then the losses can be carried forward and used in future years.

• 469 defines passive activities with two separate categories
  i. A trade or business in which the taxpayer does not materially participate
  ii. A rental activity, with exceptions for real estate professionals.

• Material participation in an activity is achieved if a person works on a regular, continuous, and substantial basis in the activity’s operations. This is doing the work that the business owner would typically perform, such as making operational or management decisions.

There are seven participation tests that the IRC provides. Meeting only one will qualify for material participation.

1. The taxpayer and or spouse work 500 hours or more during the year in the activity.
2. The taxpayer does all the work in the activity substantially.
3. The taxpayer works more than 100 hours in the activity, and no one else works more than the taxpayer.
4. The activity is a significant participation activity, and the sum of SPAs is greater than 500 hours for the year. SPAs are activities with more than 100 hours of active participation.
5. The taxpayer materially participated in the activity in any five of the prior ten years.
6. The activity is a personal service activity, and the taxpayer materially participated in any of the three prior years.
7. The taxpayer participates in the activity on a regular, continuous, and substantial basis during the year.