Avoiding “The Boot” And Other Tax Surprises
Many tax rules are designed to be simple and easy to understand, but real estate activities are not always the same. Many of these transactions can create tax surprises if you do not plan ahead to review how taxes apply to your situation. Here are five common tax traps and surprises to avoid that often occur with our real estate clients.
- “The Seven Year Itch” – Many real estate ventures begin with the contribution of real estate and a couple of investors or partners. The contribution can generally be completed as a nontaxable transfer. But if a partner contributes real estate with appreciated value to a partnership, the property may later be sold or distributed at a gain. The original gain still belongs to that contributing partner for seven years – and the partnership cannot share that portion of gain with the other investors.
- “Getting the Boot”– Most taxes are due when property is sold at a gain and the money is received. So it is clear if you get the cash out of the deal, then you have money to pay the taxes. But if you swap properties and get no money, you may still have tax to pay. The tax is due on any “boot” received – the value of any money or tax benefit received, including a reduction of liabilities on the swap of the properties. Cash received and paid can be netted together, and debt relief can offset new mortgage debt to compute the net amount of taxable boot received. If you are planning a like-kind exchange, check if you are getting any “boot”.
- “Service Now, Pay Later” – Most service contracts are billed and paid in full when the service is completed. If you give services to your real estate activity, some investors are accepting ownership in the partnership rather than cash. If you receive equity, the services are still taxable (equal to the value of the equity), even if the bill for your services is not paid directly in the form of cash.
- “What Time Is It – Check your Calendar?” – If an investor in real estate losses money, some of the losses may not deductible if the investment is passive. A passive activity is one in which the investor does not materially participate and does not spend enough time on the activity. In order to be active (or become a real estate professional), the investor must exceed time tests based on the number of hours spent in the activity. In any given year, the best way to pass these tests is to keep an activity calendar and track your schedule and the number of hours. So if you want to deduct your real estate losses, keep your daily calendar full.
- “Trick or Treat – A Sale in Disguise” – If property is contributed into a real estate venture, a partner will get credit for a capital contribution. But the tax rules also consider if money or other property is being used for similar distributions. The two steps of contributing and distributing property may be unrelated, but within two years of the contribution, any distributions may be taxable if the steps look like a buyer and seller completed a sale by putting the two steps together.
Being aware of these tax traps can help you in avoiding some big headaches. Feel free to contact me with this or other tax questions you may have at 312.670.7444.