Current Options and Considerations for Real Estate Ownership  

Tom Kosinski, CPA, MST

In recent years, the tax law has focused on real estate as a complex asset to own, but even more complicated to sell.  The use of real estate in an operating business can create many tax benefits, including the ability to claim depreciation for the business, create tax credits for qualified uses and even reduce some tax rates when it impacts business or personal income for pass-throughs.  When real estate is used as an investment or generates rental income, the asset can qualify for a Like Kind Exchange of real property by providing an incentive to defer taxable gain on the sale and using a replacement property to rollover gain.  Some of the tax steps needed for an exchange include a 45-day period to identify replacement property, completing a reinvestment transaction within 180 days and using a QI (qualified intermediary) to maintain sales proceeds in escrow. 

When real estate is not business or investment, it can simply provide personal tax benefits, such as being eligible for a property tax exemption for a homeowner or being a primary residence that has exemption from capital gains tax on the sale.  One issue with personally owned real estate is that it may be at risk if personal issues are not protected from liability for claims and disputes.  So the question is whether real estate ownership has other alternatives or considerations.  This newsletter attempts to identify some of these factors that might be used in your personal planning.

LEGAL CONSIDERATIONS

Real estate is often a valuable asset that can be separated from other business and investment assets.  Even if you use insurance to identify and protect threats to your property, not all risks are covered by insurance.  It may be safer to hold real estate separately and keep it independent from the related use of the property.  Many asset protection plans are created for this ownership. A rental agreement is an example of a way to separate the property ownership and use if they can be agreed upon. Below are some common ways to legally own real estate.

Fee Simple
This is the most common type of interest. It is outright ownership. Even if you still owe money on your mortgage, as long as you have the right to sell the house, leave it to your heirs, and make alterations, your ownership is fee simple. A fee simple interest may be owned by one person or by several people jointly. Normally, when people are listed on a deed as the owners—even if they own the property as joint tenants, tenants in common, or tenants by the entirety—the ownership interest is in fee simple.

Life Estate
This is the right to possess and use property only during your lifetime. You cannot sell the property, give it away, or leave it to someone when you die. Instead, when you die, the property passes to whoever was named in the instrument (trust, deed, or will) that created your life estate. This type of ownership is usually created when the sole owner of a piece of real estate wants a surviving spouse to live on the property for the rest of his or her life, but then have the property pass to the owner’s children. In this situation, the surviving spouse has a life estate. Surviving spouses who are beneficiaries of AB, spousal, or marital bypass trusts have life estates.

Indirect Ownership
Some property is held in a partnership, limited liability company, or trust (i.e. living trust) which provides ownership to multiple persons or families.  The real estate can be managed under the terms of the trust or entity that holds the property directly or indirectly.  This may include how the property expenses will be funded, who may sell the property, and who may inherit the property after the ownership changes.  Some of these changes include the death or disability of an owner, a bankruptcy, or a subsequent sale or exchange of the real estate.

Future Interest
This property right comes into being sometime in the future. A common future interest is owned by a person who—under the terms of an instrument such as an irrevocable trust—will inherit the property when its current possessor dies. Simply being named in a will or revocable living trust does not create a future interest, because the person who signed the deed or trust can amend the document to eliminate your interest.

Contingent Interest
This ownership interest does not come into existence until one or more conditions occur. Wills sometimes leave property to people under certain conditions. If the conditions are not met, the property passes to someone else. For instance, a will may leave the house to a son provided that he takes care of her until her death. If the son does not care for her, the house passes to her daughter. Both son and daughter have contingent interests.

TAX CONSIDERATIONS

While indirect ownership is a common option to hold real estate, there are many popular options for tax purposes since ownership of real estate includes funding and payment for improvements and maintenance.  During the lifetime of the user, this may seem to be less important while they are able to manage and maintain the property.  Once they cannot manage it or are deceased, the terms of the instrument or agreement help to understand and identify the issues.

Living Trust
A living trust is a legal arrangement that is commonly used in estate planning. You create it to go into effect while you are still alive and use it to facilitate the transfer of assets after your death.  You will transfer ownership of assets to the trust, which becomes the new legal owner of your property. A trustee manages the assets and a named beneficiary will benefit from them.

Living trusts are created by individuals who are typically called grantors, settlors or trustors. The grantor who creates it will designate who are the beneficiaries and who should act as the trustee, as well as decide what assets to transfer into the ownership of the trust. The assets held within the trust can be transferred outside of the probate process upon the death of the grantor.

Irrevocable Trust
An irrevocable trust is also a legal document that you create that separates ownership from control. But it is very different from a revocable trust.  When you create an irrevocable trust, you generally name someone else as trustee besides yourself. You cannot change anything about the trust except in very limited circumstances. If you want to cancel or modify the trust, you usually need court permission and approval of all beneficiaries. Assets placed in an irrevocable trust are removed from your control and you can no longer spend or   use them. Irrevocable trusts can be a good choice for Medicaid planning and to protect a loved one with a special needs trust. Any assets moved into the trust are no longer considered part of the estate and may not be counted against Medicaid or Social Security eligibility requirements.  

Revocable Living Trust
A RLT can be changed or modified during the course of the grantor’s life. Since the grantor largely retains control over the assets, an RLT provides very limited asset protection compared to irrevocable trusts. Assets within it also can be subject to estate tax, even though they transfer outside of probate.  RLTs are very different from irrevocable trusts, which are much more difficult to modify and which provide more protection for assets as well as the ability to avoid estate tax in certain circumstances

Limited Liability Company
An LLC is a form of holding company that may have one or more owners.  As a single member LLC, it can be transparent for tax purposes and allow the single owner to maintain all of the tax attributes of ownership, including a residence, investment or business relationship.  An LLC can also add owners without transferring direct title in the property, such as gifting or selling units in the LLC rather than the property.  Once the LLC has two or more owners, then the tax rules generally treat the LLC as a partnership for tax purposes.  Using a partnership entity allows a group of owners or family members to participate and share in the real estate and decide how to share the costs and benefits of the entire LLC.

Need to determine the taxable gain

When the time comes to sell the property, the legal and tax decisions will have an impact on the taxable gain. The gain on real estate is based upon the original purchase price and related improvements and capitalized costs, and the original tax basis may need to be adjusted for the depreciation over the asset life of a business asset.  If the sale is simply for the real estate alone, then the seller may have a choice whether the proceeds are all realized and the gain will be taxable at lower tax rates.  If the seller is either a pass-through entity or an individual, taxable gain may be eligible for long term capital gain rates (15 or 20%) if the property was held for longer than a one year period, and some gain created from depreciation deductions may be eligible for a 25% tax rate as Section 1250 gain.  In this example, the tax rate on the sale may be favorable enough to accept current tax consequences.  The owners can consider whether the gain may be deferred by reinvesting the proceeds into a replacement property.  If eligible for deferral, a Like Kind Exchange is sometimes a tax beneficial option if the reinvestment makes sense.

Consider the scenarios and options

Of course, choosing the best option is important if you have a real estate asset that requires consideration for both the ownership and intended use of the property.  It is best to determine how much time and benefit will be needed to choose the best option for your personal situation.

If you have any questions or concerns, please contact your ORBA Advisor or  Tom Kosinski at [email protected] or 312.670.7444 to review your personal tax situation. Visit ORBA.com to learn more about our Real Estate Group.

What to Consider from a Tax Perspective for Ownership of Out of State Residential Rentals?

Joshua Goldschmidt, CPA, MST

If you own a residential rental property located in a state other than your state of primary residence there are a few things you may want to consider. Some of these considerations include income tax effect and whether you have a filing requirement in the non-resident state. Additionally, there are considerations on the year of sale such as if there is mandatory withholding for non-residents, if you need to pay income tax estimates, and if there is any tax planning available to reduce taxes.

Yearly Ownership – Income Taxes

Each year that a rental is placed in service, all associated income, expenses, and depreciation on the property should be reported on a federal income tax return. For an individual who owns an out of state rental, they must also determine if they have an income tax filing requirement to the state in which the rental is located. Most states have specific rules which lay out filing requirements for non-residents with activity in their state. Often there are minimum income thresholds which trigger filing requirements. Even if the rental is running at a loss, it is still worth looking at individual state rules as some states track losses and you need to file in loss years to preserve the carryforwards. The carryforwards can reduce future income, including gains on sale.

Subject To Other State Taxes

When you file a non-resident state income tax return, you are then subject to the state taxes of the non-resident state. State rules vary, but you typically receive get a credit for the taxes paid to non-resident states on your resident state tax return, which helps avoid double taxation on the same income. Please note that the credit is typically limited to your resident state’s tax rate, so you could end up paying a higher effective tax rate on this income.

Considerations For Selling

There are a few things to consider before you sell a rental. When fully disposing of a rental, all the prior year carryforwards and the current year loss become non-passive and can be claimed to the extent of basis. Additionally, depending on the amount of gain and depreciation that was claimed there could be gain taxed at both ordinary rates and capital gain rates. If the rental sold is in a state other than your primary residence, you may have additional considerations.

Mandatory Tax Withholding
Many states require withholding on sales of real property by non-resident individuals and some entities. These mandatory withholdings can often result in more tax being paid in as many are calculated using a flat rate based on the sale price. When they are calculated solely on the sales price you could end up paying withholding even on a sale that results in a loss. However, some states allow you to elect to withhold on the estimated gain as opposed to the sale price. There are also exemptions from withholding in some states. If you withhold more than necessary, you can have the excess refunded when you file your tax return, but it creates a timing difference. Some states with mandatory withholdings are California, New York, and New Jersey but there are plenty of others as well.

Quarterly Tax Estimates
If there is no mandatory income tax withholding due with a sale do not rejoice just yet. Income taxes may still need to be estimated and paid in the quarter of the sale. If you owe taxes for a quarter and do not pay in until you file your non-resident return, then you could be accruing penalties.

1031 Exchange
1031 exchanges allow owners to potentially defer all or part of their gain on a sale of real property. These transactions are where you essentially swap a real property for another qualifying real property. There are many requirements needed to qualify for these deferrals and the transactions are even more complicated if the properties you swap are not in the same state.

Conclusion

There are a few extra considerations for rental properties owned out of state. Before purchasing or selling these properties it is important to consider all the factors at play and consult with your tax advisor.

For more information, please contact Joshua Goldschmidt at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.