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Real Estate Professional – Do You Qualify and How Can You Prove It?

 

The IRS defines passive activities as:

1. Trade or business activities in which you don’t materially participate during the year.
2. Rental activities, even if you do materially participate in them, unless you’re a real estate professional.

The exception provided in the second definition is a tremendous tax advantage for individuals that meet the requirements of a real estate professional. This is because losses from passive activities can only offset passive income. In years that passive losses exceed passive income, the excess losses must be carried forward and applied against income from passive activities in future years. A real estate professional’s real estate activities are exempt from the general passive activity loss rules and losses resulting from such activities can be used to offset ordinary income.

The tests used by the IRS to determine if an individual qualifies as a real estate professional all revolve around the amount of time spent conducting real estate activities. Recent Tax Court rulings in favor of the IRS should reinforce the importance of having a strong understanding of what constitutes real estate activities and how to properly maintain records of time spent conducting such activities.

Below is a discussion of these recent rulings. For a detailed definition of real estate professional, see section “Real Estate Professional Requirements” below.

Recent Tax Court Rulings

A taxpayer’s rental real estate activities in which they materially participate (defined below) are not subject to limitation under the passive loss rules if: (1) more than half of all personal services performed in a tax year are in real property trades or businesses, and (2) they spend at least 750 hours performing such real property services. A taxpayer can use “any reasonable means” to prove the extent of his or her participation in real estate activities. “Reasonable means” may include identifying of services performed over a period of time and the approximate number of hours spent performing such services by using appointment books, calendars, or other narrative summaries. While IRS regulations do not prescribe specific recordkeeping requirements, they also do not allow a post-event “ballpark guestimate.”

In a recent Tax Court case, Penley v. Commissioner (TC Memo 2017-65), the IRS successfully argued that Penley did not qualify as a real estate professional because he could not properly substantiate his time spent performing real property trade or business.  The court found that Penley’s records of time spent on real estate activities were greatly exaggerated because he rounded to the nearest hour or half-hour, did not specify a start or end time, included time spent driving to and from properties, and did not separate out any time for meals or other breaks. Since Penley also had a non-real estate related job, once the court disallowed the majority of the time he claimed was spent on real estate activities, he no longer satisfied the requirement that more than 50% of the individual’s working time must be spent on real estate activities in which the individual materially participates. As a result, all passive losses were disallowed for the tax year in question, and a negligence penalty of 20% was assessed on the underpayment of taxes.

In the Tax Court case, Moss v Commissioner (135 T.C. 365 (2010)), the IRS got another favorable ruling when they argued that Moss did not qualify as a real estate professional because he improperly counted the number of hours spent conducting real estate activities. Moss contended that he satisfied the 750-hour rule by conducting 650 hours of actual real property services, and spending an additional 100 hours “on call” to perform services on the properties he owned. The court rejected Moss’ argument, noting that the language of IRC §469(c)(2)(iii) and Reg. §1.469-9(b)(4) literally required a taxpayer to “perform” the services that are counted toward the 750-hour threshold. Consequently, all passive losses were disallowed for the tax year in question, and an accuracy penalty of 20% was assessed on the underpayment of taxes.

Real Estate Professional Requirements

For an individual to qualify as a real estate professional, three (3) separate tests must be satisfied.

Test #1 (Material Participation) – Individuals satisfy the material participation test for a particular activity by participating throughout the year on a regular, continuous, and substantial basis. This can be demonstrated by meeting one of the following seven tests:

  1. The taxpayer participates in the activity for more than 500 hours during the year.
  2. The taxpayer’s participation in the activity for the tax year constitutes substantially all of the participation in the activity of all individuals (including individuals who are not owners of interests in the activity) for the year.
  3. The taxpayer participates in the activity for more than 100 hours during the tax year, and that participation is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for the year.
  4. The activity is a significant participation activity for the tax year, and the taxpayer’s aggregate participation in all significant participation activities during the year exceeds 500 hours. A significant participation activity is a trade or business activity in which the taxpayer participates for more than 100 hours during the tax year, but would not be treated as materially participating if not for the significant participation standard.
  5. The taxpayer materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years that immediately preceded the tax year at issue.
  6. The activity is a personal service activity and the taxpayer materially participated in it for any three tax years (whether or not consecutive) preceding the tax year at issue.
  7. Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during the year.

Test #2 (750 Hours) – Individuals must spend at least 750 hours per year in real property trades or businesses in which they materially participate. Qualifying real property trades or businesses include property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

  1. Personal services performed as an employee are not treated as performed in real property trades or businesses unless the employee owns five percent or more of the employer entity.

Test #3 (More Than 50% of Time) – More than 50% of the individual’s working time must be spent on real estate activities in which the individual materially participates.

By staying abreast of the latest real estate industry trends and issues, HLB Gross Collins, P.C. specialists are known for deep understanding of the ever changing, complex regulations our clients are facing.  Please do not hesitate to contact us for additional information.

Summary

Taxpayers that conduct real property trade or business and qualify as a real estate professional are exempt from the general passive activity loss rules. This is beneficial because losses resulting from such activities can be used to offset ordinary income. Recent Tax Court Rulings in favor of the IRS highlight the importance of properly maintaining records of time spent conducting real estate activities. Additionally, it is critical that time records accurately count only time spent actually performing real property services rather than “ballpark guestimates” that could include time spent traveling and meal breaks.

 

Contractors & the Research and Development Tax Credit

 

The R&D Tax Credit is one of the most beneficial tax credits available to contractors. Made permanent with the passage of the Protecting Americans from Tax Hikes Act of 2015, this non-refundable credit is available to businesses of all sizes and is designed to encourage the development of innovative and enhanced products, processes, and software in the United States. As both a federal and a Georgia credit, the R&D Tax Credit is one of the largest business tax incentives provided by the U.S. and state government.

The R&D Tax Credit is calculated at 20 percent of the excess of an eligible taxpayer’s qualified research expenses over a base amount. Qualified research expenses are comprised of all internal or contract research expenses paid or incurred by a taxpayer in carrying on trade or business. These expenses include (but are not limited to) salaries and wages, supply cost and contractor costs (i.e., contract research). In order to qualify as a qualified research expense, the research activities have to be conducted on U.S. soil and they must pass a four part test outlined in the Internal Revenue Code (IRC §41). The base amount is determined in reference to the total qualified research expenses for the previous three years. The R&D Tax Credit is incremental in nature – meaning that in order to realize greater benefits from the credit, a taxpayer must increase their research expenses over time.

The Georgia R&D Tax Credit is available to any business that increases its qualified research spending in the state. Just as the qualified research expenses have to be incurred on U.S. soil to be eligible for the federal R&D Tax Credit, the qualified research expenses have to be incurred in Georgia to be eligible for the Georgia R&D Tax Credit. Whereas the federal credit can be carried back one year and forward twenty years, the Georgia credit can be carried forward ten years and is able to offset 50% of net Georgia income tax liability.

Often times, taxpayers do not realize that the work that they are doing is innovative and qualifies for the R&D Tax Credit. The activity does need not be an “innovative” and have an industry-wide impact – as long as the R&D work is related to improving your businesses products or processes, it may be a qualified research and development expense. It is recommended that all business involved in some type of research and development activities have a feasibility study to determine the amount of the possible federal and state credits available to them. The credit can be taken for all open tax years. Thus, the tax benefits of conducting a research and development credit feasibility study and a R&D Tax Credit study could be tremendous and help to generate enormous tax savings over several years.

If you believe that your business is conducting some research and development activities eligible for either the federal or Georgia credit, HLB Gross Collins, P.C. can assist you.  HLB Gross Collins, P.C. has been serving some of the Southeast’s most prominent construction companies for nearly 50 years.  Our Construction Practice works closely with the clients to ensure that they are taking advantage of all available credits and savings opportunities.

June/July Dates to Remember

 

June 15

Individuals. If you are not paying your 2017 income tax through withholding (or will not pay enough tax during the year that way), pay the second installment of your 2017 estimated tax.

If you are a U.S. citizen or resident alien living and working (or on military duty) outside the United States and Puerto Rico, file Form 1040 and pay any tax, interest, and penalties due for 2016. If you want additional time to file your return, file Form 4868 to obtain four additional months to file. Then, file Form 1040 by October 16.

Corporations. Deposit the second installment of estimated tax for 2017.

Employers. For Social Security, Medicare, withheld income tax, and nonpayroll withholding, deposit the tax for payments in May if the monthly rule applies.

July 17

Employers. For Social Security, Medicare, withheld income tax, and nonpayroll withholding, deposit the tax for payments in June if the monthly rule applies.

July 31

Employers. For Social Security, Medicare, and withheld income tax, file Form 941 for the second quarter of 2017. Deposit any undeposited tax. If your tax liability is less than $2,500, you can pay it in full with a timely filed return. If you deposited the tax for the quarter in full and on time, you have until August 10 to file the return.

For federal unemployment tax, deposit the tax owed through June if more than $500.

If you maintain an employee benefit plan with a calendar year-end, file Form 5500 or 5500-EZ for calendar year 2016.

Why is a Prenup Important for Business Owners

 

Some people may think of prenuptial agreements as asset protection vehicles for wealthy individuals who are about to be married. When a wealthy individual gets engaged, a “prenup” can help safeguard the assets that individual brings into the marriage from passing to the future spouse in the case of a subsequent death or divorce.

Beyond such situations, prenups may be adopted by other about-to-be-weds. That’s especially true now that second (or even third) marriages are increasingly common, with children from prior unions to be considered.

Example: Jim Smith and Ann Jones have set their wedding date. Neither is considered wealthy, but they both own debt-free homes and have retirement plans, investment accounts, and other assets. In addition, Jim and Ann already have their own children from previous marriages.

In such situations, a well-crafted prenup can delineate specific assets that will go to those children after a possible divorce or the death of one spouse. Terms of the agreement will vary from one situation to the next, but one approach is to set aside certain assets brought into the marriage for each spouse’s children.

In addition to such an asset division, a prenup can address whether the couple will file a joint income tax return and who will pay the tax. Also, debts incurred before and after the marriage should be covered in the agreement.

Other uses

Even if children from a prior marriage are not an issue, prenups can be helpful. For example, for two people who enter a first marriage after they’ve both had careers and built up significant assets, a prenup can preserve those assets if the marriage doesn’t work. A business owner might want to provide for the retention of the company and a valuation method in case of a divorce; partners or co-shareholders may insist on prenups to keep a portion of their business from ex-spouses in the future. Wealthy parents might want to be sure that a son or daughter executes a prenup before the wedding ceremony.

However, saying that a prenup can do this or that is only a beginning. To be effective, a prenuptial agreement must be enforceable under the laws of the relevant state. Very generally, a prenup should be

  • formal. Ideally, the agreement should be drafted by an attorney with experience in this area.
  • voluntary. Compliance shouldn’t be coerced. Suppose the parents of the bride are paying for the wedding and the groom’s family produces a prenup once the out-of-town guests have arrived, asserting that the bride would get nothing in case of a divorce. Such a document may not stand up to a challenge in court.
  • One tactic that can help to produce a valid prenup is to discuss the issue as early as possible. A prenup that’s been agreed upon after both sides have had competent counsel is more likely to be upheld. For some marriages, the wealthier individual will hire the attorney to draft the agreement and the other party’s attorney will review it to suggest any changes.
  • fair. Full disclosure of assets may be required of both prospective spouses. If one party can show the other failed to reveal substantial assets, the aggrieved spouse may be entitled to more than the agreed-upon amounts.

Retaining romance

Of course, someone who is about to “live happily ever after” may not feel comfortable suggesting a prenup to a bride- or groom-to-be. One strategy to deflect the blame is to say that your CPA or your attorney is insisting on a prenup.

Solo 401(k) Plans for Companies Without Employees

 

Among major corporations, 401(k) plans have become common, but even the smallest of businesses can have a 401(k) plan for retirement. One-participant 401(k) plans, known by names such as Solo 401(k) and Uni-k, are available. For some business owners and self-employed individuals, Solo 401(k)s may offer a chance to save more for retirement with tax advantages compared with other small business retirement plans.

The name is somewhat misleading, as these plans are not necessarily limited to one person. A business owner’s spouse also can participate, if he or she is an employee of the business. Multiple owners or partners, and their spouses employed in the business, can participate in a Solo 401(k).

However, a business with any common-law employees is disqualified, so having an employee other than an owner, business partner, or shareholder will rule out a Solo 401(k). Note that independent contractors can be hired by the business, as well as part-time workers who get paid for less than 1,000 hours a year. Solo 401(k) plans are discretionary, so employers can cut back or even eliminate contributions in a given year, if that’s desirable.

Potent payoff

Assuming a business qualifies for a Solo 401(k), why choose this type of plan? The answer is simple: because contributions can be relatively generous. The underlying reason is that owner-employees’ accounts receive funding from two sources.

Example 1: Nick Martin, age 55, owns 100% of NM Corp., which has elected to be treated as an S corporation. NM Corp. has no full-time employees. With a Solo 401(k), Nick can contribute the same as any employee participating in a typical 401(k) plan: up to 100% of compensation (“earned income,” for the self-employed). The cap in 2017 is $18,000, or $24,000 if Nick is at least age 50.

In addition, Nick can make employer non-elective contributions up to 25% of his compensation, as defined by the plan. Assume that Nick earns $80,000 in W-2 wages from NM Corp. in 2017. He defers the maximum $18,000 in regular elective contributions this year, plus the $6,000 catch-up for those 50 and older. NM Corp. then contributes $20,000 (25% of Nick’s $80,000 earnings) to the plan, for a total of $44,000. If Nick’s wife works for NM Corp. and receives earned income, her account can receive 401(k) contributions.

Those with higher earned income can receive larger employer contributions. In 2017, the maximum is $54,000 from employee and employer contributions, or $60,000 with a $6,000 catch-up contribution.

Special rules for the self-employed

The calculation for Solo 401(k) contributions is a bit different for self-employed participants. Here, earned income is defined as net earnings from self-employment after deducting employee elective contributions and one-half of self-employment tax. The calculation can be complex, but the resulting employer contribution might be up to 20% of self-employment income.

Self-employed individuals who file Schedule C typically deduct both the employer and employee contributions to a Solo 401(k) on page 1 of Form 1040, not on Schedule C. Therefore, these deductions reduce adjusted gross income but not reported business income. Incorporated businesses generally can deduct Solo 401(k) contributions as a business expense.

For all types of participants, Solo 401(k) plans offer another appealing feature. There is no need to perform expensive nondiscrimination testing for the plan, because there are no employees who might have received disparate benefits. Such testing may be required with standard 401(k) plans and can result in reduced contributions to business owners’ accounts. Even though nondiscrimination testing isn’t required, a Solo 401(k) plan generally must file an annual report on Form 5500-SF if it has $250,000 or more in assets at the end of the year.

The deadline for establishing a Solo 401(k) for 2017 is December 31, or the end of the fiscal year for corporations.

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