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 on the business use, create an investment for tax credits and even reduce some tax rates for qualified business income. Recent tax legislation has added some more issues to the sale of the real estate, making the tax results more dependent on how a sale is structured and whether the gain on the sale is taxable now or deferred by reinvestment.
Regardless of the reason for the sale and the scope of the business, be prepared to plan ahead if you are about to structure a sale of real estate for your business. Your preparation and careful tax planning may help determine whether the closing of the sale has significant tax issues.
Need to determine 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. 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, a 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 the tax consequences.
Other transactions may include a sale of a business with additional assets which include tangible personal property. When more than one type of asset is involved, there are additional tax issues with the sale, including how to allocate sales price and determine if the overall gain is properly related to the real estate or the other assets of the sale. Many purchase agreements should try to identify how the purchase price was negotiated and may need to be supported with a valuation of the business and the various categories of assets. If so, then the agreement may need to be explained in more detail since both the buyer and the seller should agree on the contract terms.
If personal property results in a gain, then the tax rates are likely to be higher when depreciation is also faster due to shorter asset life. With tax benefits from bonus depreciation and Section 179 expense elections for these assets, it is important to understand whether the gain results in ordinary income on any portion of the proceeds. It is also difficult to defer any of the taxable gain since many of the tax deferral strategies for Section 1031 (like-kind) exchanges do not apply to them. Beginning January 1, 2018, Section 1031 like-kind exchange tax deferral no longer applies to exchanges of tangible personal property. Under the Tax Cuts and Jobs Act, only real property will qualify for tax deferral in a like-kind exchange, so the amount and allocation of gain may need to be negotiated carefully between the buyer and seller.
Related Read: Like-Kind Exchanges: Proposed Regulations Clarify Definition of Real Property
Need to disclose asset allocations
Most tax returns have a special form to disclose the allocation and valuation of asset sales. Both the purchaser and seller of a group of assets that makes up a trade or business must report an asset sale, especially if goodwill or going concern value is involved in the sale and if the purchaser’s basis in the assets is determined only by the amount paid for the assets. Generally, both the purchaser and seller must file Form 8594 and attach it to their income tax returns when there is a transfer of a group of assets. This applies whether the group of assets constitutes a trade or business in the hands of the seller, the purchaser, or both. By doing so, the IRS expects there is consistency and support for them to rely on the value of assets sold in the exchange.
The disclosure of assets includes seven classes of assets:
- Class I assets are cash and general deposit accounts (including savings and checking accounts).
- Class II assets are actively traded personal property and include certificates of deposit, foreign currency, U.S. Government securities and publicly-traded stock.
- Class III assets are assets that the taxpayer marks to market at least annually for federal income tax purposes and debt instruments (including accounts receivable).
- Class IV assets are stock in trade of the taxpayer or other property of a kind that would properly be included in the inventory of the taxpayer if on hand at the close of the tax year.
- Class V assets include furniture and fixtures, buildings, land, vehicles and equipment that constitute all or part of a trade or business.
- Class VI assets are all Section 197 intangibles, except goodwill and going concern value, which form a separate Class VII.
An allocation of the purchase price of consideration must be made to determine the purchaser’s basis in each acquired asset and the seller’s gain or loss on the transfer of each asset. The amount allocated to an asset, other than a Class VII asset, cannot exceed its fair market value on the purchase date. The amount you can allocate to an asset is also subject to any applicable limits under the Internal Revenue Code or general principles of tax law. For example, cost segregation studies have been used to allocate buildings into their separate components, and the tax benefit of having separate assets is generally more favorable depreciation on assets with shorter lives.
Need to evaluate the tax consequences
Many taxpayers assume that the taxable gain from a transaction is determined as the sum of the parts. If all of the gain is from real estate, then there can be a decision made to reinvest proceeds into like-kind real property and defer the gain until a subsequent sale of the reinvested property. There are time limits for identifying replacement investments, choosing and closing on your new properties and protecting the sales proceeds with a qualified intermediary to avoid taxable funds.
If all of the gain is from capital gain assets, then recent tax law has allowed Opportunity Funds as a simple way for investors to contribute money in Opportunity Zones. These funds allow you to work with professionals and let them manage your reinvestment and defer the taxable income. Investors will create new capital gains or defer tax on prior eligible gains to the extent the money is invested into the Qualified Opportunity Zone.
Certain taxable transactions may be recognized on an installment method basis to report the gain as the proceeds are received. The installment gain is allowed to be deferred to match the timing of the proceeds. Since the deferral does not apply to ordinary gains, the tax consequences of the character and timing of gain are very critical to qualify for any tax deferral and benefits of a sale.
Related Read: Qualified Opportunity Zone Update: IRS Issues Additional Proposed Regulations
Consider the scenarios and options
Of course, choosing the best option is important if you have a business transaction that requires negotiation for both the sale and the reinvestment. It is best to determine how much time and help is needed to work through the process and whether you have considered all of your options.
If you have any questions or concerns, please contact your ORBA Advisor or Tom Kosinski at (312) 670-7444 to review your personal tax situation. Visit ORBA.com to learn more about our Real Estate Group.