REAL ESTATE TAXATION

by

Curtis L. Harrington

HARRINGTON & HARRINGTON

6300 State University Drive, Suite 250

Long Beach, CA 90815

(562) 594-9784, Fax: (562) 594-4414

http:/www.patentax.com E-mail: curt@patentax.com PATENTAX®

A

PATENTAX®

PRESENTATION

Disclaimer: Educational Only: This outline is Educational Only and no part of this presentation can be considered as federal or state tax advice, opinion, or position and is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the internal revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein, nor (iii) constituting guidance on any tax or intellectual property matter.

INTRODUCTION

I.	Introduction - DEFINITIONS

A.	Real Estate as Capital Asset (IRC § 1221(a))

1.	Capital assets include all assets held by the taxpayer except for assets listed in IRC § 1221(a).

2.	Property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business (inventory) is an exception to capital asset status. IRC § 1221(a)(2). Thus someone who buys and keeps property as inventory rather than investment, keeps an asset which is not a capital asset.

B.	Definition - Real Property Trade or Business?

1.	Real property held primarily for sale in the ordinary course of the taxpayer's trade or business doesn't qualify as a capital asset.

2.	Whether particular real estate sold is a capital asset is decided on a case by case basis taking into consideration factors including number and taxpayer's frequency of sales, subdividing and promotional activities.

C.	Five Year Land Subdivision Rule for non-corporate taxpayers

1.	An individual trust, estate or S corporation won't be treated as holding land primarily for sale to customers simply because the taxpayer subdivided a tract of land into lots or parcels and engaged in advertising, promotion, selling activities or the use of sales agents in selling lots in the subdivision if the taxpayer:

(a)	hasn't previously held any part of the same land primarily for sale to customers in the ordinary course of business, and in the year of the sale doesn't hold any other real estate for sale to customers;

(b)	doesn't ,while holding the land or as part of a contract of sale with the buyer, make "substantial improvements" on the land that substantially increase the value of the lot sold [unless, if elected improvements needed to make marketable, and if that has been held for ten years or more], and

(c)	either has owned the land for five years or more, or acquired it by inheritance or devise (IRC § 1237(a)).

(d)	however if more than five lots of parcels in the same tract are sold or exchanged, 5% of any gain from the later transactions is ordinary gain (IRC § 1237 (b)(1))

(e)	The sale or exchange of qualifying subdivided land that's business property can result in an ordinary loss (Reg. 1.1237-1(f))

II.	ACQUISITION

A.	Unimproved Land is Not Depreciable. For improved land the purchase is treated as a depreciable asset (the improvement) attached to the non-depreciable land.

B.	Improved Real Estate Acquisition costs are allocable based upon FMV (Reg. §1.167(a)-5). Techniques to attempt to allocate more value to the depreciable portion include:

1.	Estimated replacement cost (TC Memo 1982-51)

2.	Taxpayers own experience (TC Memo 1973-212)

3.	Governmental Tax Assessor Appraisals( PLR 9110001)

C.	Bonus Depreciation for newly acquired property.

1.	Improved Real estate acquired & placed into service in 2008 & 2009 is eligible for bonus depreciation allowance (IRC §168(k)).

2.	Improved Leased Property also qualifies for bonus depreciation allowance (IRC §168(k)(3)) where conditions are met:

(a)	Interior improvements (walls, carpet, special structural changes).

(b)	Non-residential property

(c)	Improvement is part of the lease even if made by a tenant, landlord, or jointly.

(d)	Interior improvements (walls, carpet, special structural changes).

(e)	The improvement is not part of the original building construction by virtue of greater than three years having elapsed since its original completion.

D.	Real Estate Investment Trusts (REITS)

1.	Corporation or Business Trust form

2.	Sub-types include equity REITS for exercising ownership of real property, mortgage REITS for exercising ownership of mortgages in real property, and hybrid REITS for combination of the two.

3.	General Tax Characteristics

(a)	Usually Operates Income Producing property including commercial retail property, industrial rental property or housing. The REIT entity is usually not taxed on its income unless earned amounts are not distributed. A REIT gets a tax deduction for dividends paid from earnings and profits. (IRC § 561 & 562).

(i)	Threshold for the deduction for dividends paid requires a distribution of 90% of the REIT income (a) cash or (b) 1031 failure exchange income (c) debt instrument cash, and (d) COD income..

(ii)	Generally, undistributed amounts retained by the REIT are taxed as C corporation income.

(iii)	Previously, undistributed capital gains were double taxed, once at the corporate rate to the REIT, and again upon distribution to the partner/owners. In 1997, IRC §857(b)(3)(D) was added to enable the REIT to pass through a credit for tax paid on retained capital gains, and it provides for a step-up in basis of shares representing the amount of retained capital gains.

4.	REITS have a number of specific requirements found at IRC §§ 856-859.

(i)	REITS are required to pay 90% of their taxable income to shareholders, and thus cannot take advantage of the retained earnings provisions of corporations.

(ii)	Beneficial ownership is held by 100 or more persons IRC § 856 (a)(5).

(iii)	95% of income is derived from dividends, interest, real property rents or gain from the sale of stock, securities and real property. (§ 856 (c)(2)).

(iv)	transferrable shares or transferrable certificates of beneficial interest are required.

(v)	Many other specific technical requirements are based upon hundreds of circumstances and the specifics are too numerous to mention here.

D.	Apportionment of real property taxes between purchaser and seller.

1.	Seller is charged with the allocation of property tax up to the day before the sale. (IRC § 164(d)(2)).

2.	Purchaser is charged with the allocation of property tax on the day of sale and thereafter (IRC § 164(d)(1)).

E.	Dealers in Real Estate

1.	Classification : dealer or investor?

(a)	A dealer - property is held primarily for sale to customers in ordinary course of trade or business

(b)	An investor - passive owner - holds property for future appreciation in value or for its ability to produce income

2.	Tax treatment for dealer or investor

(a)	Dealer - gains and losses are ordinary.

(b)	Dealer cannot use the installment method - gain must be recognized on lump sum of proceeds. Exception, However, dealers in timeshares or residential lots can elect to use the installment method, if they pay an interest charge on the deferred tax.

(c)	Investor - gains and losses are capital.

(d)	Dealer sales of property the seller used or produced in the farming business can be reported on the installment method without any interest charge. [IRC 453(l)]

(e).	Investor can use installment method - unless he elects out and then he has to report the entire amount of the gain in the year of the sale. [IRC 453(d)] Electing out (by using Schedule D or Form 4797 - Sale of Business Property), might be of benefit in a couple of instances:

(i)	Tax carryovers can be used to offset the gain from the sale - tax carryovers may occur when there is a net operating loss, charitable contribution or perhaps a business credit, or

(ii)	When the installment gain relates to a passive activity with suspended losses that exceed the amount of the gain.

(iii).	Taxpayer expects a rate increase due to tax law changes that could cause a higher tax if the gain is indeed deferred - retroactive elections are not allowed unless there was an error by the tax return preparer. [Revenue Ruling 90-46]

F.	Brief Overview of Acquisition by IRC §1031

1.	Both the property acquired and relinquished should be held for productive use in a trade or business, or for investment.

2.	Both the property acquired and relinquished should be of "like kind". Non-like kind property includes (a) foreign property and (b) personal property, (c) personal residence. (However, a mixed use second home has a more stringent set of rules outlined in Rev. Proc. 2008 -16)

3.	Each taxpayer's qualification under §1031 is determined separately.

4.	A two year holding period has been held to clearly satisfy the "held for" requirement, but lesser holding period does not per se disqualify the exchange.

5.	Excluded property includes (a) inventory, (b) partnership interests, (c) stocks and bonds, (d) goodwill, and (e) the exchange of one type of ongoing business for another type of ongoing business.

6.	Related Taxpayers who fail to keep the property for two years (under conditions of a voluntary exchange) trigger recognition. Related taxpayers include family members, persons who own more than 50% interested in a related corporation (S or C) or partnership.

III.	OPERATION

A.	Passive Activity Rules - Income

1.	Rental Activities are presumed to be passive activities (IRC §469(c)(2)). Income from passive rental is passive activity gross income. Rental losses from passive activities may only be used to offset passive activity income.

2.	Portfolio income is distinguished from passive income:

(a)	All gross income OTHER THAN income derived in the ordinary course of a trade or business.

(b)	Examples of portfolio income include dividends, royalties, annuities net income from publicly traded partnerships, gains, losses and expenses related to property that produces portfolio income, income, gain or loss from investment of working capital.

(c)	Income which would otherwise be portfolio income, is trade or business income if the trade or business is closely related to operation of the portfolio function. (Reg §1.469-2T(c)(3)(ii) & (iii).

3.	Certain categories of income are designated as non-passive:

(a)	Some portion of net passive income from each activity in which the taxpayer actively participates for more than 100 hours but less than material participation, IF passive activity income exceeds passive activity losses (Reg § 1.469- 2T(f)(2)(i) & (ii).

(b)	Net passive income from a rental activity in where less than 30% of the unadjusted depreciation remains depreciable (Reg § 1.469-2T(f)(3))

(c)	Rental from development activity property. (Reg §1.469-2(f)(5) & §1.469-
11(c)(2). (development of rental building improvements on real estate).

(d)	Self rented property (Reg §1.469-2(f)(6)

(e)	interest income from a lending activity (Reg §1.469-2(f)(4)

(f)	royalty income from intangible property held by partnership, S corp, estate or trust if taxpayer acquired ownership after creation of the intangible, (or performed substantial services or expenditures). (Reg §1.469-2T(f)(7). (all three circumstances point to an active business or creation role, with self created intangibles being presumed to be passive).

(g)	rental of rooms for less than 30 days where significant services (room cleaning, laundry, & room service) are performed.

(h)	situations where the rental is incidental to the non-rental activities, such as hospitals.

(i)	Non exclusive use, where land or improvements are made available to customers or potential clients.

4.	Tax Treatment for income when property is not rented for profit (such as occasional rental)

(a)	Deductions for rental expenses incurred allowed ONLY up to the amount of rental income. Excess rental expense CANNOT carry forward to the next year.

(b)	Where to report - Not for profit rental income should be reported on Form 1040, line 21.

(c)	Mortgage interest (if a main home or second home) , real estate taxes and casualty losses are reported on Schedule A of Form 1040 if deductions are itemized.

(d)	Other rental expenses can be regarded as miscellaneous expenses and listed on line 22 of Schedule A. The rule for deduction of these expenses is that they represent more than 2% of AGI.

(e)	Taxpayers may post pone the declaration of whether their rental property is a rental for profit through the filing of Form 5213. The 3 out of 5 rule - if income from rental exceeds rental expenses for AT LEAST 3 years out of 5 consecutive years - is used.

5.	Material Participation is another test to determine if a for-profit activity is passive. There are seven criteria for establishing material participation which will cause the activity not to be passive. (Reg §1.469-5T)

(a)	More than 500 hours spent on the activity per year.

(b)	Taxpayer is the sole participant in the activity.

(c)	The taxpayer spends more than 100 hours on the activity and no one other than the taxpayer spends more time on the activity.

(d)	The taxpayer met the material participation test for a total of any of 5 years out of the past 10 years.

(e)	The activity is personal service based and the taxpayer materially participated for any three prior years.

(f)	The taxpayer (1) participates for more than 100 hours, AND (2) taxpayer participation is regular, continuous and substantial. (Some specific activities are excluded from the test (Reg. § 1.469-5T(b)(2)(ii). Examples include management activities, compensated services, & non-trade or non-business activities.

B.	Passive Activity Rules - Deductions Beyond Passive Income

1.	At- Risk Rules for Real Property (first threshold)

(a)	Generally, a loss will not be allowed for any property, entity, or investment in which the taxpayer is not "at risk" in terms of experiencing a real economic losses. A taxpayer engaged in the activity of holding real property is subject to the at risk rules for losses on property placed in service after 1986. The at-risk rules also apply to a taxpayer's losses from real estate attributable to an interest in a pass-through entity that is acquired after 1986 regardless of when the entity acquired the real property. (IRC Section 465(c)(3))

(b)	Taxpayer is considered at-risk for his share of any "qualified nonrecourse financing" secured by the real property (IRC Section 465(b)(6)(A); this means financing:

(i)	Borrowed by the taxpayer with respect to the activity of holding real property (as specially defined)

(ii)	Borrowed by taxpayer from a qualified person(as specifically defined) or from any federal, state, or local government or instrumentality or that is guaranteed by any federal, state or local government

(iii)	Except as Regs provide, non-recourse loans on which no one is personally liable for repayment if the amount cannot be convertible to an ownership interest and borrowed from a person unrelated to the borrower. (Reg § 1.465-27(b)(3)).

2.	Timing & Reporting of Rental Income - Gross income includes all amounts received as rent, or any payment taxpayer receives for occupation or use of the property.

(a)	Key question - is taxpayer cash basis or accrual basis? If cash basis - rental income reported when actually or constructively received irrespective of when earned.

(i)	Definition - income is constructively earned when it becomes accessible either by deposit or credit to a bank account.

(ii)	Definition - accrual basis taxpayer reports income when earned rather than when received. Expenses are likewise deducted when they are incurred - not when paid.

(b)	Advance Rent - amount received before the time period covered and is included in income in the year received despite the method of accounting or the period covered. [Reg.§1.61-8(b)]

(c)	Security deposits - Not included in income when received if taxpayer's intention is to return the security deposit to the tenant when the lease ends [Indianapolis Power & Light Company, 65 AFTR 2d 90-394, (1990)]. An exception occurs if the tenant fails to live up to the terms of his lease; in that instance the taxpayer will include in income the amount kept. When or if money called a security deposit is designated as a final payment of rent, it is effectively considered advance rent and thus included in income when received.

(d)	Payment for canceling a lease - amounts paid to cancel a lease are considered rent. Payment is included in income the year received regardless of accounting method used. (Reg.§1.61-8(b))

(e)	Expenses paid by tenant - if a landlord's expenses are paid by a tenant, the payments are deemed rental income and included in income (Reg.§1.61-8(b)). If the expense qualifies as deductible rental expense it may be deducted. (Example: tenant pays water and sewage bill and deducts the amount from his rent. Terms of lease state that tenant does not have to pay the bill. Landlord will include the bill paid and amounts received as rent payment in his rental income. Landlord can deduct the payment made by the tenant as rental expense.

(f)	Property or services - if instead of money for rent, the taxpayer receives property or services, the fair market value of the property or services must be included in rental income. (Example: tenant is a painter who offers to paint landlord's rental property instead of paying 2 months of rent. Landlord accepts offer and includes in rental income the amount tenant would have equivalently paid for the 2 months of rent and can deduct the amount as a valid rental for painting her property.

(g)	Lease with an option to buy - if the rental agreement gives the tenant the right to buy the rental property, the payment received is classified as rental income. The tenant who chooses to buy the property would have payments received after the date of sale considered part of the selling price.

(h)	Rental of property also used as home. - the fewer than 15 days rule - if taxpayer rents property that also considered their home and it is rented fewer than 15 days during the tax year the rent received is not included in income and the rental expenses can not be deducted [IRC.§280A(g)]. Interest, taxes, casualty and theft losses allowable for non-rental property are deductible on Schedule A of Form 1040.

(i).	Partial interest - if a partial interest in a rental property is owned the taxpayer must proportionately report the income derived from the property.

3.	Rental Expenses - Rental Expenses

(a)	When to deduct - rental expenses are deducted in the year paid

(b)	Vacant rental property - ordinary and necessary expenses incurred in the maintenance , management and conservation of vacant property held for rental purposes is tax deductible. The exception is for the period of time the property is vacant the taxpayer cannot deduct any loss of rental income.

(c)	Pre-rental expenses - from the time rental property is made available for rent, a deduction for ordinary and necessary expenses for management, conservation or maintenance is allowed.

(d)	Depreciation - rental property can be depreciated when it is ready and available for rent.

(e)	Expenses for rental property that is sold - ordinary and necessary expenses incurred in management, conservation and maintenance of rental property are deductible until the sale of the property.

(f)	Partial interest - the part of expenses paid by taxpayer for a partial ownership in rental property can be properly deducted

C.	Improvements and Repairs

1.	Repairs - cost of repairs can be deducted while cost of improvements cannot.

a.	Repairs just keep property in good working order without adding materially to the property or extending its life.

b.	Examples - replacement of broken windows, fixing gutters, floors, leaks, plastering walls and repainting inside or outside of property

c.	If repairs are part of a more extensive remodeling or actually involve restoration then the project is considered an improvement.

2.	Improvements - add considerable value to the property in contrast to repairs discussed above. These costs that must be capitalized and then depreciated as per IRC 168. Examples of improvements include:

(a)	Additions to property - new bedrooms, bathrooms, decks, a garage, a porch, a patio.

(b)	Yard, lawn and grounds - swimming pool, sprinkler system, fence or retaining wall, sidewalk or walkway, driveway, landscaping.

(c)	Heating and air conditioning - central air conditioning, heating system, furnaces, central humidifier, filtration systems.

(d)	Plumbing - water heater, filtration system, water softening systems

(e)	Interior improvements - modernizing or updating of kitchen, adding built-in appliances, new flooring, wall-to-wall carpeting .

(f)	Insulation - adding insulation to attics, walls, floors and pipes.

(g)	Additional miscellaneous improvements - new roof, upgrades of wiring, security system, storm windows, storm doors satellite dishes

(h)	Demolition expenses or losses must be capitalized and added to the basis of the land (IRC §280B(1)).

(i)	Long term contracts for improvement must be accounted for under the "percentage of completion" method. (IRC § 460), however, exceptions exist for (1) home construction contracts, (2) contracts completeable within two years of starting date where taxpayer's three previous years receipts don't exceed $10 million.

C.	Basis and Depreciation. Basis for depreciation (when a personal asset has been converted to business use) is the lower of the adjusted basis at the date of conversion or the fair market value of the asset being converted at the time it is converted. [Reg. 1.168(i)-4(b)]

1.	What Type of Property Can Be Depreciated? In general, property should meet the following requirements:

(a)	The taxpayer is the owner of the property

(b)	It is used in income-producing sort of activity, such as a rental property, or in a business

(c)	Property has a useful, finite life

(d)	Property life should last more than a year

(e)	Property not excepted - property placed in service and disposed of in same year - also section 197 intangibles

(f)	Section 179 deduction not properly available for property being used to yield real estate rental income. [IRC 179(d)(1)]

2.	ACRS: 15, 18, 19 year real property with optional straight line recovery periods of (15, 35, 45); (18, 35, 45) or (19, 35, 45) year periods.

3.	MACRS: 15 year MACRS class: Property with class life of 20 - 25 years for non-
building land improvements (examples: sidewalks, roads, culverts, cell phone towers). Depreciated via the straight-line method (IRC § 168(b)(3)(G) & (H).

D.	MIXED-USE PROPERTY / VACATION HOME. Definition - a residence that is used personally and rented out by the owner. Example- vacation home used personally by owner as well as being rented out for a portion of the tax year. IRC 280A limits expenses that may be properly deducted dependent on the personal use aspect.

1.	Rental income - all rental income is reported on Schedule E. The exception here occurs when the property is rented for 14 days or less - the expenses are then not deducted and the income is not reported.

2.	Mortgage interest - Personal use portion deducted on Schedule A. Portion resulting from rental activity is deducted on Schedule E.

3.	When the dwelling unit is used as a home, the personal-use amount (treated as second home) is deductible on Schedule A and the amount from rental activity is deducted on Schedule E.

4.	Property taxes - for personal use property taxes are deducted on Schedule A. For rental property, rental activity amounts are deducted on Schedule E.

5.	For dwelling unit used as home rental activity portion is deducted on Schedule E and the personal use amount is deductible on Schedule A.

6.	Expenses directly related to the rental - for personal use property the expenses are nondeductible. For rental property expenses are deducted on Schedule E and are subject to passive activity loss limits.

7.	For dwelling unit used as a home, expenses are deducted on Schedule E and also subject to passive activity loss limits.

8.	Other rental expenses not deductible except for the rental activity (such as maintenance, insurance and depreciation) - for personal use property are nondeductible; rental property portion deducted on Schedule E and subject to passive activity loss limits. The personal use amounts are nondeductible.

9.	For dwelling unit used as a home, amount due to rental activity is deducted on Schedule E, limited to the gross rental amounts, less the other expense items discussed. The personal use portion is nondeductible.

10.	The Bolton Decision and Rental Expense Allocation

(a)	Expenses are usually allocated by a rather formulaic number of days rented at what is considered a fair rental value and this number is divided by the total number of days that the property is occupied. (Prop. Reg. 1.280A-3)

(b)	The Tax Court preferred a bit more of a hybrid method which allowed for a higher deduction for maintenance costs than the IRS was inclined to allow.

(c)	The Boltons had mortgage interest and tax allocated per number of days in the year while their maintenance expenses were allocated based on days of occupation. The result - low percentage of interest and taxes with a higher percentage of maintenance costs with the resultant aforementioned higher deduction for maintenance costs. The IRS was not pleased.

(d)	Tax Court's determination that the allocation method made sense because taxes and interest continuously accrue during the year. Maintenance costs however are more directly related to actual time occupied.[Bolton, 77 TC 104 (1981); aff'd. 51 AFTR 2d 83-305 (9th Cir. 1982)]

11.	Mortgage Interest Allowabilty where Several Homes are owned.

(a)	Personal use - if a home is the second residence with 14 days or less of rental use, the mortgage interest can be fully deducted on Schedule A.

(b)	Vacation home- qualified mortgage interest is fully deductible if a home is a second residence and rental use was more than the requisite 14 days and personal use was equal to not more than the greater of 14 days or 10% of rental days. The mortgage interest is fully deductible even if in fact is greater than the income gained from the rental.

(c)	Rental - rental portion of interest expense goes on Schedule E, subject to passive activity rules. The rule is that home use is not considered a residence and personal portion of interest expense is not deductible if the use part is not more than the greater of 14 days or 10%of rental days.

(d)	Third residence - the non-rental portion of mortgage interest on ant other home is nondeductible personal interest if a taxpayer owns two other residences.

E.	Determining whether Investment or Rental Activity

1.	The difference between holding property for rental and holding property for investment or potential appreciation has been addressed by the tax Court in Rivera, TC Summary Opinion 2004-81.

2.	Taxpayers involved preferred to rent only to friends or fellow employees and did so at a considerable discount - deemed far less that fair market rental value.

3.	When a dwelling is rented at less than a fair rental value it is deemed to have been used for personal use rather for profit. The IRS disallowed the rental losses based on IRC 183 prohibitions towards loss deductions from activities considered to be "not engaged in for profit."

4.	The Tax Court, however, in determination of whether there existed a profit motive, had taken into consideration the property's obvious appreciation in value as a factor. The property had in fact doubled in value since it had been acquired.

5.	The taxpayers in Rivera were held to be entitled to properly take the deduction for expenses which allocated between the nondeductible rental activities and the allowable investment portion since the finding was the property was held primarily for investment purposes.

F.	PASSIVE LOSS LIMITS ON RENTAL PROPERTIES

1.	Passive Losses - rental real estate is considered a passive activity despite the taxpayer's amount of participation in the rental activity, unless the taxpayer (subject to two exceptions, "real estate professional" and "special loss allowance" set forth below).

2.	Section 469 limits the deductions for passive activity losses to the income derived from passive activity. (IRC §469(b)) and losses that are not allowed are carried forward to future tax years. (IRC §469(f)).

3.	Passive activity losses are first subject to rules regarding at-risk activities. The amount of deductible losses from holding most real property placed in service after 1986 are limited by the "at-risk rules." However, losses which are not allowed because of "at risk rules" are still carried forward until the taxpayers "at risk" amount increases, at which time it may be deducted from the activity which generated the loss.

4.	For Limitations on Passive Activity Losses, Use Form 8582 for computation of passive losses allowed or disallowed losses; as well as Computation of rental real estate -active participation special loss allowances, and to Allocate of activities related to passive loss allowances as well as suspended loss carry forwards.

5.	Form 8582 not required if (a) There aren't any unallowed losses from any passive activities from a prior year, (b) The taxpayers lived apart from each other if they are married filing separately, (c) There are no current or prior year unallowed credits from passive activities, (d) There is $100,000 or less in modified adjusted gross income (or $50,000 or less if married filing separately), or (e) there no holdings in rental real estate as either a beneficiary of an estate or trust or rental real estate.

6.	Passive Losses - rental real estate is considered a passive activity despite the taxpayer's amount of participation in the rental activity, unless the taxpayer (subject to two exceptions, "real estate professional" and "special loss allowance" set forth below).

G.	SPECIAL EXCEPTION TO PASSIVE LOSS LIMITS ON RENTAL PROPERTIES

1.	While rental real estate is usually considered a passive activity, an amount of up to $25,000 may be deducted each tax year AGAINST income from income deemed non- passive such wages or portfolio income as noted in IRC 469(i).

2.	The criteria necessary for taking the loss allowances are:

a.	Active participation or at least 10% ownership of the rental property and "substantial involvement" in management of the rental

b.	Can't be a limited partner -ltd partner doesn't meet the test for active participation

c.	Netting income and losses from active participation in all rental activities to determine valid amount of loss

3.	That Special Allowance and Offsetting Credits

a.	A credits from active participation rental activities can be used by taxpayers to offset non-passive unrelated income induced tax liabilities.

b.	Calculation: convert the $25,000 to a tax amount based on the marginal tax rate of the taxpayer

4.	Special Loss Allowance Phase- Out : AGI Guidelines

a.	Special Loss Allowance is Phased out at a rate of 50% of adjusted gross income, beginning when adjusted gross income exceeds $100,000 (or $50,000 for married filling separately.) Allowance zeroes out when you hit $150,000.

b.	What is modified AGI? For this situation modified AGI is equivalent to AGI without any of the following items:

(i)	any net passive loss

(ii)	taxable social security and tier 1 railroad benefits

(iii)	deduction for fees and tuition

(iv)	deduction for student loan interest

(v)	deduction for IRA and other retirement plan contributions

(vi)	deduction for domestic production activities

(vii)	publicly traded partnership overall loss

(viii)	interest income exclusion for Series EE bonds for higher expenses

(ix)	excluded income under an employer's adoption assistance program

(x)	one-half self-employment tax deduction

(xi)	rental or passive income loss allowed due to material participation by a real estate professional

H.	REAL ESTATE PROFESSIONAL EXCEPTION TO PASSIVE LOSS LIMITS ON RENTAL PROPERTIES; LOSSES ARE NOT PASSIVE

1.	$25,000 active rental loss limitation does not apply to those professionals who materially participate in real estate activities.

2.	50% or more of personal services were performed in real property trades or businesses in which the taxpayer is considered to have materially participated

3.	750 hours or more of services spent in trades or businesses in which material participation is performed by the taxpayer.

(a)	All real estate projects or business are treated as combined to form a single activity.

(b)	An election is made by filing a declaration that the taxpayer qualifies for the tax year and is making an election under IRC §469(c)(7)(A)

(c)	Examples of trades or businesses include: property development, construction, conversion, rental operations management, leasing, or brokerage. Where the taxpayer is an employee of such a business, such employee must be an owner of greater than 5% of the business.

I.	REAL ESTATE DEALERS EXCEPTION TO PASSIVE LOSS LIMITS ON RENTAL PROPERTIES; LOSSES ARE NOT PASSIVE

A.	Real Property bought is treated as inventory and not depreciable.

B.	Sales Expenses - Dealer can treat sales expenses as ordinary business deductions under IRC § 167.

.	C.	Schedule C used to report rental activities as income or (loss) from a trade or business - if the rental houses are owned as inventory by a dealer.

D.	Non-dealers will not be treated as dealers simply because land is subdivided into lots, and with the lots held for seal to customers if the investor can show:

1.	No part of the same land was held primarily for sale to customers.

2.	Substantial Improvements are not made to each lot as it is sole (unless improvements are REQUIRED for marketability); AND

3.	Has owned the land for 5+ years or acquired it by inheritance (IRC § 1237(a)).

E.	Even where a non-dealer subdivides more than five parcels in the same tract, 5% of the gain from the 6th, 7th, 8th, parcels will constitute ordinary gain (IRC §1237(b)(1)).

J.	For Dealers And Professionals, Non Passive Losses Generated Are Net Operating Losses.

1.	Recent legislation allows small businesses to use extended 3,4,5 year carry back periods for 2008 net operating losses under (IRC §172(b)). Small business is defined as a corporation or partnership that meets a $15 million gross receipts test for the tax year in which the loss arose. Sole proprietors can meet the test when tested as if they were a corporation.

2.	For 2009 several revenue procedures clarify the rules on NOLs, including Rev Proc 2009-19 and Rev Proc 2009-26.

K.	SOME DIFFERENT RULES FOR NON-PROFITS

1.	Property leased to non-profits have special recovery periods.

2.	Property financed by tax-exempt industrial development bonds.

IV.	DISPOSAL

A.	Sale Producing a Gain or Loss

1.	Long term capital gains (IRC §1222) are for property held more than one year. Otherwise the gain is short term gain.

2.	Short Term Netting is the process where by short-term gains and losses are differenced from each other to produce a net short term gain or loss. (IRC §1222(5) & (6))

3.	Long Term Netting is the process where by long-term gains and losses are differenced from each other to produce a net short term gain or loss.(IRC §1222(7) & (8))

4.	If Long Term gains are greater than are greater than a net short term capital loss, the long term capital gain is decreased. (IRC §1222(11))

5.	Net Capital gains are currently set at a maximum rate of 15%.(IRC §1(H)(1)(B)&(C))

6.	Net Capital gains for the portion of gain which is un-recaptured gain, is 25%. Unrecaptured gain is the gain against which straight line depreciation was taken. The adjusted bases minus the purchase price is generally gain which is not recaptured at ordinary rates, but which is referred to as "unrecaptured" gain which is taxed at 25%.

7.	Net Capital gains for collectibles is 28% .(IRC §1(H)(1)(B)&(C))

8.	Short term capital losses are applied first against gains in the 28% group, then against losses in the 25% group and finally reduces gains from the 15% group. (The 5% group is not discussed).( IRC §1211)

9.	Capital losses are allowed only against capital gains except for an annual allowance of $3000.00.

10.	Capital loss carryforwards, regardless of group, over net long-term capital gain, become a short term capital loss in any succeeding year ( IRC §1212(b)(1)(A)

11.	Net long term capital loss carryforwards, less short term capital gain shall be a net long-
term capital gain in any succeeding year ( IRC §1212(b)(1)(B)

B	Depreciation Recapture 1250(a)

1.	Upon sale, a portion of the gain may be treated as ordinary gain, if it was not depreciated under the "straight line" method. (IRC § 1250(b)

2.	The "straight line" method, for property to which (IRC) section 168 applies using the applicable recovery period.

3.	With MACRS, real property is depreciated using a straight-line method. IRC §168(b)(3).

C	At Risk Depreciation Recapture IRC § 465(e). Where the taxpayers risk is less than zero, (basis has been allowed to go negative either due to mis-calculation, oversight, or re-adjustment, the taxpayer will realize an amount of income from such activity sufficient to bring the basis back to zero. IRC § 465(e)(1)(A). Since depreciation reduced ordinary income, at risk depreciation recapture adds back ordinary income.

D.	Condemnation IRC §1033(a)(2)(E)(ii)

1.	Replacement property must be of a like kind, rather than a "similar use" rule. (IRC §1033(g)(1)).

(a)	Property should be held for productive use in a trade or business.

(b)	Property can be held for investment.

(c)	Outdoor Advertising Displays are treated as real property for the purposes of the IRS condemnation rules (IRC §1033(g)(3)(A)

2.	Period of time for obtaining replacement property

(a)	Beginning upon either:

(i)	The date of disposition of the converted property (owner ceases to have ownership rights, or

(ii)	The earliest date that the property owner learns of the threat or imminence of requisition or condemnation.(IRC §1033(a)(2)(B) (i)

(b)	Ending upon:

(i)	Two years after the close of the first taxable year in which any gain is recognized, or

(ii)	A later date which the Secretary of Treasury may designate upon application/request of the taxpayer.(IRC §1033(a)(2)(B) (ii)

E.	Exclusion of Gain upon sale of residence.

1.	Single individuals exclude no more than $250,000 on the sale of their principal residence, while married couples can exclude up to $500,000 (IRC §121) if several tests are met:

(a)	Time Ownership & Use Test: Owned Property and used it as principal residence for two years of the five years immediately preceding the sale. The two year use need not be consecutive use years.

(b)	Frequency of Deduction: The exclusion must not have been utilized within two years prior to the sale in question.

(c)	If one spouse fails in the Time Ownership & Use Test, or the Frequency of Deduction Test: the EXCLUSION will be limited to the sum of the exclusions that each spouse could use if not married.

2.	Special rule allows a surviving spouse to have a $500,000 exclusion instead of the $250,000 exclusion for single taxpayers, IF the surviving spouse sells within 2 years of the death of their former spouse. This is for unmarried persons only, a re-marriage will cost the loss of this deduction, and will revert to the rule in (c) above to yield a single $250,000 exclusion.

3.	Rest Home Occupancy periods count as living at home if the home is occupied at least one year during the five year period prior to sale of the home.

4.	Destruction of the Home: if the taxpayers' insured home is condemned or destroyed, the insurance reimbursement payments are excludable on the same basis that gain would be excluded. Any excess gain may possibly be excluded under the involuntary conversion rules under IRC §1033 generally.

F.	Charitable Contribution of Real Property

1.	Qualified Conservation Contribution can be made under IRC §170(h) so long as a qualified property interest is donated to a qualified organization exclusively for conservation purposes.

(a)	Qualified property interest includes a non-mineral fee interest, remainder interest, or perpetuity restriction.

(b)	Qualified organization includes those in IRC § 501(c)(3) or IRC § 170(b).

2.	Simple Donation of Real property as an in-kind donation is subject to several limitations and complications. Some restrictions on personal property are relaxed for the donation of real property:

(a)	The requirement to contribute a taypayer's complete interest in property is relaxed; partial interests may be donated. (IRC § 170 (f)(3)(A))

(i)	A remainder interest can be donated.

(ii)	An undivided interest (tenancy in common) can be donated. Beware, the donation of joint tenancy property may destroy the joint tenancy.

(iii)	An interest that would be deductible if transferred in trust.

(b)	The donation of the present right to "use" property without conveying it is prohibited from taking a charitable deduction. (IRC §170(f)(3)(A).

(c)	Liabilities associated with a donated property which liabilities are assumed by the donee will reduce the charitable contribution by the amount of the liability.

(d)	Generally a deduction is based upon the Fair Market Value for property that would otherwise create long term capital gain if sold at its fair market value on the date of contribution. (Again reduced by any liabilities assumed by the donee).

(e)	Contributed property is still subject to depreciation recapture under IRC sections 1245 (personal property), 1250 (depreciable realty) & 1252 (farm land). Thus the contribution will be the FMV, reduced by any liabilities assumed, and also reduced by any recaptured gain.

(f)	Gifts of appreciated capital gain property results in a reduction in the percentage AGI limitations. Charities may be 50% charities and 30% charities, with the percentages being the limitation on contribution deduction by the donor. For gifts of appreciated capital gain property, the 50% limit is downgraded to a 30% limit. (IRC §170(b)(1)(C). Gifts to 30% charities are downgraded to a 20% limit (IRC §170(b)(1)(D).

(g)	Donation of more than $500, $5,000, and $500,000 dollars involves increased valuation responsibility for each increase. For $500-$5000, a description and any later documentation requests must be complied with; for $5,000-$500,000, information must be filed with the return, an appraisal is obtained and any later request for the appraisal must be complied with; and for donations greater than $500,000, a qualified appraisal must be attached to the return. (IRC §170(f)(11)(B)- (D)).

G.	Foreclosure or Repossession of a Property

1.	A lender may foreclose on a mortgage or repossess a property if a borrower (buyer) fails to make payments on a loan that is secured by the property.

2.	Or the borrower may abandon the property by voluntarily transferring the property to the lender.

3.	A repossession occurs when a creditor takes back property that secures a debt.

4.	Definition : personal property securing a debt is repossessed, real property is foreclosed.

5.	Computation of gain or loss from foreclosure or repossession is the difference between the adjusted basis in the transferred property and the amount realized.

6.	The amount realized is dependent on whether the loan involved is recourse or nonrecourse. (See chart below)

7.	The borrower may also recognize cancellation of debt income if recourse debt is redeemed by a repossession or foreclosure

8.	Income realized from the Cancellation of Debt

(a)	COD - Cancellation of Debt Income - income realized when FMV of property transferred is less than the balance of the loan in question the income realized is separate from the loss or gain realized from the repossession or foreclosure

Tax Result
Non-recourse	Recourse
Type	Borrower Not Personally Liable, regardless of property Market Value.	Personal Liability for amounts less than disposal value of property.
Reporting	1099A, Box 5 is "no"	1099A, Box 5 is "yes"
Gain/Loss	Realized	No Gain or Loss

regardless of lenders loss	Loss is lesser of FMV of

property or debt canceled
COD Income	N/A	Ordinary Income

(b)	COD - Exclusions from Income

(i)	Income not taxed if intended as a gift

(ii)	Borrower is either bankrupt or insolvent (IRC 108(a)(1)(A) or (B))

(iii)	Qualified farm debt

(iv)	Qualified real property business debt

(v)	Qualified principal residence indebtedness

9.	Mortgage Forgiveness Debt Relief Act of 2007 (IRC § 108(h))

(a)	For Qualified Principal Residence (uses the definition of IRC §163(h)(B)(3)[relating to deductibility of acquisition indebtedness] by substituting $2 million for $1 million ($1 million for $500,000 for separate return) . Must be single principal residence, not second home, as per IRC §121.(IRC § 108(h)(2)).

(b)	The relief is for acquisition indebtedness, not for amounts not qualifying for acquisition indebtedness. If there is a blend of acquisition and non-acquisition debt, only the acquisition portion is discharged (IRC § 108(h)(4)).

(c)	Insolvent taxpayers going through bankruptcy will utilize (IRC §108(a)(1)(A) rather than IRC § 108(h). Bankruptcy should not have been filed in order to use IRC § 108(h). Insolvent taxpayers who are not filing bankruptcy should use IRC §108(a)(1)(B).

(d)	Under (IRC §108(h)(1), the discharging taxpayer must reduce his basis in the home to the extent of the indebtedness discharged, but not below zero.

H.	Aliens

1.	For income which is not effectively connected with a U.S. trade or business, IRC §871(a) requires that the income will be subject to the flat 30% FDAP tax rate (with an exception as to the citizenship of the alien based upon the treaty rate between the U.S. and the Alien's home country).

2.	IRC §871(d) enables the taxpayer to elect to be treated as effectively connected with a U.S. trade or business.

3.	Real Property Purchasers who purchase from a non-resident alien are required to withhold 10% of the purchase price. Purchase price forms include (1) cash, (2) other property's FMV or (3) assumption of seller liabilities. This requirement is subject to the following exceptions:

(a)	Sales price is less than $300,000 and buyer will reside on the premises for 50% of the time over the succeeding two years.

(b)	The seller provides a certificate stating that he/she is not a foreign person	.

(c)	The seller provides an alternative certificate showing that a lesser amount. Form 8288-B and IRS Pub. 515 have further details.

(d)	The seller provides a written notice establishing that no gain or loss will be recognized on the sale due either to (a) a provision of the IRC, or (b) because the seller has no gain.

(e)	The property is acquired by a governmental entity.

(f)	The sale is related to certain other forms of interest in real estate.

I.	Real Estate Professionals

1.	Statutory Independent Contractor: Direct Sellers and Real Estate Agents are two professions which have been hard wired into the statute as automatically being independent contractors.

2.	Qualifications to be a statutory independent contractor:

(a)	Taxpayer Real Estate Professional must hold a valid real estate license.

(b)	At least 90% of the income of the Taxpayer Real Estate Professional must be based upon sales commissions.

(c)	The Taxpayer Real Estate Professional must have an employment agreement stating that the professional will not be treated as an employee (Prop. Reg. § 31.3508-1(b).

3.	Self-employment tax - regardless of the number of taxpayer-owned properties, rental income from the real estate holdings are not subject to self-employment tax UNLESS the rentals are received in business context as a real estate dealer - see IRC 1402(a)(1).

(a)	Example: Unincorporated hotel and boardinghouse income is subject to self-
employment tax due to the amount of services usually provided.

(b)	However, if no services are provided, a real estate professional could properly take the deduction for unlimited losses under the 750 hour service test still be qualified to forego the SE tax on his real estate activity.

Curtis L. Harrington

Office:	Harrington & Harrington; 6300 State University Drive, Suite 250, Long Beach, CA

90815; Tel. (562) 594-9784; Fax (562) 594-4414

curt@patentax.com PATENTAX®	http://www.patentax.com

Specialty:	High Technology Patent / Trademark / Intellectual Property Law & Taxation

Education:	B.S. Chemistry - Auburn University (1974)

M. S. Electrical Engineering - California State University Long Beach (1990)

M.S. Chemical Engineering - Georgia Institute of Technology (1977)

J.D. - University of Houston School of Law (1983)

M.B.A. - University of Oklahoma (1985)

LL.M. Taxation - University of San Diego School of Law (1997)

Admitted	Supreme Courts of California, Arizona, Texas, & Nevada

to Practice: U.S. Supreme Court;	U.S. District Court, Central District of California

Internal Revenue Service	U.S. Patent and Trademark Office

U.S. Court of Appeals for the Federal, Fifth & Ninth Circuits

California Department of Real Estate - Broker

Los Angeles County California EMT-Basic

U.S. Tax Court	FCC-Commercial & Amateur Extra

Certified by The State Bar of California Board of Legal Specialization: Taxation

Languages	Japanese Language Proficiency Examination, Approved by Japan Foundation, Level 4; Kanji Proficiency Exam of the Japan Kanji Aptitude Testing Foundation, passed Level 7, recognized by the Japan Ministry of Education, mastery of 640 kanji; some technical Russian reading ability.

Patents	Prepared and prosecuted more than 100 patents, in the electrical and

Prepared	chemical technologies; specialty areas include optics, fiber optics, cryogenics electromagnetics, natural gas processing and computers, & trademark and copyright preparation and prosecution. Patents include: Chemical: 4,957,634; 4,851,077; Electrical: 4,876,892; 4,833,351; 4,837,525; Mechanical: 4,879,895; 4,906,199; and Optical: 4,919,512; 4,898,468.

Litigation	Associate counsel in patent matters, trade secret litigation; Judge pro tem, Long Beach Municipal Court; Superior Court Mediation program, Long Beach; Attorney- Client fee Dispute Arbitrator, Long Beach Bar Association; Patent Panel, American Arbitration Association.

Teaching	Adjunct Law Professor, Golden Gate University School of Law, LL.M. Taxation Program; Georgia Institute of Technology - previously taught heat and mass transfer laboratories, and analog and digital computer laboratory.

Member:	State bars of California, Arizona, Texas and Nevada; Long Beach Bar Association

(Board of Governors, 1994-95); Orange County Bar Association, Taxation Section, (Co-Chair Technology Law Section 1996); Past Member, Orange County Chapter of California Society of Enrolled Agents - President 2003-2004; Fellow, National Tax Practice Institute; California Bar Association: CEB committee (1999-2000); Income & Other Tax subcommittee (Chair 2000-2002); Taxation Section Executive Committee (2002-2005); Vice Chair of the California Board of Legal Specialization Taxation Advisory Committee (member 2006-2011).