Non-stop learning

As I look back on this tax season I realize that I probably learned more during this season than any other. For me, that’s saying something because I’ve been at this for over 20 years.

Rules impacting the financial service industry are very much impacting the real estate world as well. Rules created to provide health insurance to all, also impose tax changes many of which are still in the process of being written.

It is not enough to watch and read the tax code. There are so many court cases and IRS private letter rulings that must be reviewed as well. Most states also impose an income tax and their rules vary widely and are also frequently changing.

To illustrate:

Imagine you live on a flat planet. The outer edges on all sides are less well defined. Segments are pulled and new segments appear. Some of these segments might quickly fall away while others slowly dissolve. Perhaps this is one of the most beautiful areas on the planet. The center of the world seems to change less and undergoes less radical change. Obvious the center of this world would be the safest place to live, but perhaps offer the least benefit.

The tax world is very much like this. While some areas of the law are very well defined there are other areas that are poorly defined. Even areas of the law that are well defined get muddied with special “facts and circumstances” issues.

There are many who might think they understand what a repair is. My guess though is that under the new rules you might be wrong. The new rules provide fewer bright line tests and will require more judgment.

A tax adviser can add some value by informing you of what is clearly within the law. They add more value though by shedding light on what is less clearly defined. It is not about trying to skirt the law, but about learning where you can safely operate.

The law allows many tax strategies: 1031 exchanges, cost segregation, installment sales, master lease arrangements, real estate in qualified retirement accounts and many others. Many of these strategies have tax pitfalls that go along with the advantages. Understanding where these pitfalls are is extremely important.

BawldGuy Here: That last sentence may be in the running for ‘Understatement of the Year’.

The real potential issue.

BawldGuy Axiom: In this age of uber-accessible information, finding answers to our questions is, generally speaking, not a major problem. What bites us where we sit are the answers to those questions we never knew to ask. Answers to unasked questions can be deadly.

One of the many ways you can look at your tax return is as a summary of the investment strategy(s) you’ve chosen to execute — purposefully or not. The question beggin’ to be asked is, 

“Is there a strategy that would’ve been far more beneficial for my circumstances?”

Over the years there’ve been countless times, when while perusing an investor’s tax return I’ve been able to pinpoint what appeared at first blush to be a less than optimal approach. Now understand, I don’t pretend to be a tax advisor or anything close, as a CPA is always close at hand when needed. But I do know quite a bit about the IRC as it relates to real estate investing. I’m like the birddog — smokin’ out weak links in an investor’s approach — if one exists. I tend to error on the side of, ‘We need to see what the tax guy has to say’.  There have been many, many times when I’ve literally stopped a tax related move by an investor, so as to prevent catastrophe. Most of the time those stories include botched or misunderstandings about tax deferred exchanges per section 1031 of the IRC.

It’s counterintuitive, but I’ve learned that half or more of the people who come my way either still do their income tax returns themselves, or use a tax preparer undertrained for the job. A surprise to many, I find that a large minority of investors who’ve hired CPAs, are unaware even the CPA isn’t fully cognizant of all the possible arrows available for their tax related quivers. This isn’t to say the CPA in question should know everything in the code. That’s an impossible dream if there ever was one. In fact, I’ll go a step further. I think CPAs as a group are unfairly charged, much like physicians and medicine, with knowing the entire tax code. Doctors don’t know everything about medicine, do they? Of course they don’t. Yet the same guy who wouldn’t dream of asking his buddy’s podiatrist about his shoulder problem, hires a CPA with strength in an area(s) other than real estate.

I have a friend who owns not only a couple retail operations but a nationwide wholesale firm. Wonder if a CPA expertly versed in the ins and outs of real estate tax law would be a solid choice for him? See what I mean?

Put another way, every year I personally witness, first hand, new clients who when introduced to a, you know, real estate savvy CPA, quickly learn they’re owed money from 1-3 past returns. Occasionally there are mistakes found that when rectified are pivotal in avoiding future unwanted IRS attention. Then there are the annual changes to what we think we already know about the tax code itself. Some years the changes are minor, other years they’re significant, and other years they’re literally worthy of front page headlines. Going into the last weeks before the Tax Reform Act of 1986 went into effect, the real estate investment world was almost literally operating a couple sandwiches short of a picnic. It was beyond chaos. More transactions closed in December of 1985 than pretty much any December I can remember.

With that picture in mind, think about all those real estate investors who realized how much better off they woulda been, had they done in 1985 what they’d planned for 1986. What a painful irony it musta been for those who had this epiphany while in their CPA’s office doing 1985′s tax return. I met more than a few of those folks in ’86, and it was indeed a sensitive subject.

I suspect Chuck Perkins might have a few thoughts on this topic. (That was me, not winning the battle to avoid dripping sarcasm.

So, thinkin’ we might put our heads together and improve your retirement plan? Sweet — gimme a call at 619 889-7100 and we’ll get started. I also like gettin’ emails, which is as easy as clicking on the Contact BawldGuy button at the top of the page. Have a good one.

In the last several years the IRS has been attempting to clarify and bring these various code sections back together. Several times they have issued proposed regulations. In December 2011 they finally issued temporary regulations that were supposed to fix many of these loopholes.

I believe that many investors will be surprised by what is in the new regulations. For one, investors will need to understand what the major components of a building are and track the extent of repairs to a major component. It will also be necessary to estimate the cost of a component that has been replaced.

You might ask, what does all of this mean in plain English and how does it impact your investments?

In the past an investor could replace nearly the entire roof of a building and it would be considered a repair. The new regulations see this differently. The roof would certainly be considered a major component of the building and so fixing and repairing 51% of the roof quite likely would need to be treated as a capital improvement. It will be necessary for investors to understand what the IRS might consider a major component. An example that I would clearly have expensed in the past might be adding a second layer of roofing over much or perhaps the entire roof.

Sea of gray?

The rules now allow for the disposal of a component of the building when it is replaced. This is going to be a challenging exercise for some. For those that have cost segregations it will be fairly easy to estimate the value of components that are disposed of. For the vast majority of investors in residential investment property this is going to be a quite tricky gray area. An investor who has all of the galvanized pipes in a home replaced is going to need to estimate the value of that component and capitalize the cost of the plumbing.
Some scenarios may actually not allow any disposal. A home that had little or no insulation might be such a situation. The new insulation would certainly need to be capitalized now, but if the home was purchased with no insulation it would not be possible to dispose of that component.

For those who can’t sleep here is some light reading on the new regulations:

http://www.journalofaccountancy.com/Web/20125301

You can also read Rev Procedure 2012-19 and 2012-20.

As the tax season winds down I will be spending more time reviewing these new regulations, some new case law on cost segregation, and a host of other issues. As some of this information gels in my mind I will share it and help you make some sense of it. There has been a surprising number of rules, proposals, cases, regulations passed that impact investors and I will help shed some light on how these impact you.

Then 2008 came and not only did it seem that many of these professionals became aware of such plans, it almost seemed that “self-directed” anything became the new buzz words.  Heck, it even seemed as if everyone wanted to set up such plans (evidenced by the fact that I have had more than a handful of people ask PGI if we could train them to enter the field).

So, I never thought I would be doing a post on this topic…hey, it’s been so long, I almost feel like I am going retro .  But, I was speaking to a new client this week and he actually told me that he reviewed a self-directed 401K with his broker first and was told that such a plan was “absolutely illegal.”  Feeling discouraged, he felt as if his broker may have selfish interests, so he reviewed it with his CPA.  Guess what?  Well, his CPA never said it was illegal, but said he had “never heard of it before.”

Before placing me on a three-way conference call with his CPA, the client (well, now he is a client) asked, “I’ve gone to  both my broker and my CPA and they both, basically, told me I couldn’t do this….why?”  Well, some of these individuals truly are ignorant of the IRS code and have never dealt with it.   As they say, sometimes it is just easier to take the path of least resistance.  However, especially as it relates to brokers, it MAY not be in their self-interest to encourage their clients to take money away from their management.  I mean, how do they make their commissions?!

So, the client, I think, undersood this concept, but still asked, “Well, once my broker DOES learn that this is legal, surely, he would give me the green light to move forward, right?”  Well, in theory, yes; however, mutual fund companies, insurance companies and security brokers don’t earn commisions when you buy non-traditional assets (e.g., real estate). It is kind of like the hamster wheel….the brokers keep telling us to get on the investment wheel and keep running strong.

This didn’t deter the next question….“Well, what about my local bank?  They should have an interest in setting up self-directed plans, right?  Or at least know about them?”  Well, I don’t think it is really any secret that banks make their money by using their clients’ deposits and loaning that money out to your neighbor…or maybe even you!  What a great deal, huh…well, maybe for the bank!  Think of it this way….if they are borrowing money from you and paying you 1%, that should mean that if they are really fair that they would loan the money out on that car loan for 1%, right?!  Or, anyone out there paying 1% interest on their credit cards?!  I didn’t think so.

We all have to “bring home the bacon”, but suffice to say that banks, brokers and insurance companies just don’t feel that, compared to their financial products, they can “earn” enough by offering self-directed plans.  As a result, they are not interested in providing this service.  And, for those of you who have worked with banks, trusts, etc. that are involved in non-traditional asset management, you KNOW their fees are very steep.

Will banks, brokers, etc. eventually get into the service of offering self-directed IRA and 401K plan?  The answer to that may very well depend on whether we have another 2008.  But, I will also make this proclomation…for anyone who has an interest in investing in both traditional and non-traditional assets, isn’t it nice to know that they can do BOTH from ONE account?!

1)  Some people, including myself, still believe that you can’t learn everything that you want to learn by just watching YouTube (sorry, YouTube).  Heck, even if you could, I think YouTube has the ‘ole “we are not responsible for content” disclaimer well established.

2)  If you are establishing a self-directed plan and utilizing a company like PGI (or any other company) to establish your self-directed IRA or 401K, NO company in the market place assumes responsibility for your self-directed decisions and investments.  And, yes, even for those custodians who “hold” your funds and assets…they clearly state in tiny, tiny print on their application, that they are not responsible for any investment you make, or your compliance with IRS regulations.

IRS Publications

So, that being established, what are some IRS publications you may want to review prior to and in conjunction with establishing your self-directed plan?  The following list represents some publications you might want to crack open (online) and peruse.  This is not to say that this is an in toto list, rather, just an initial list to get well educated.

IRS Publication 560 (Small Business Retirement Plans) — Especially if you are a sole proprietor or owner of a small business, you should review this publication as it will educate you on both the types of retirement plans available to small businesses and the regulations governing such plans.  Remember, the IRS doesn’t differentiate whether a plan is self-administered or not.  They just merely tell you what the rules are for a particular plan.

IRS Publication 590 (Individual Retirement Accounts) — Otherwise, known as IRAs.  Learn everything you may want to possibly know (or care to) about IRA accounts.

IRS Publication 575  (Pension and Annuity Income) — Okay, I will admit it, pretty dry stuff .  But then again, are pensions and annuities by their very nature, exciting?!

IRS Publication 529 (Miscellaneous Deductions) — I am kind of ignorant on this category as no one taught me the difference between what is miscellaneous vs. necessary.  That was my attempt at bad humor…read to your delight.

IRS Publication 550 (Investment Income and Expenses) — Again, being an investor, you may want to read up on what is and isn’t investment income and associated expenses with investments and investment income.  Believe it or not, there are many people who call me who automatically believe that “rental” income on a rental property is, and of itself, self-employment earnings.  If you are one of these folks, another good reason to read Pub. 550.

IRS Publication 598 (Tax on Unrelated Business Income of Exempt Organizations) – Investing into a business and think you can earn profits and not pay municipal, state or federal taxes on that profit?  You may wish to re-consider that notion and you may want to read this publication.  In short, income earned off an active business will “trigger” UBIT.  I always use this example when visiting with folks…..do you really think your State government and Uncle Sam would let you operate (there is a difference between operating a business and investing retirement funds) will let you run a business (think of that tire shop) and not pay taxes JUST because you claim that the business is just an investment from your retirement plan?  If you do, there are some folks out there who might want to visit with you about some ocean-front property in Arizona.

IRS Publication 3125 (Information on IRS-Approved Investments) — This piece is not earth-shattering news, but it does re-affirm that the IRS does not approve investments, etc.  Even in the world of companies establishing self-directed plans, there has been the occasional company that proclaims “Approved by the IRS”.  I always tell folks…when does the IRS approve anything or anyone?  Yes, you are correct, they don’t.  So, this piece is just a bit of sage advice from the IRS.

There you have it, folks.  Most interesting blog you have ever read?  Probably not.  If you are self-directing, might these publications be some of the most important information (along with Department of Labor (DOL) Advisory Opinions) you will ever read?  Absolutely.

Now, on to figuring out how I can improve upon the best pot roast recipe anyone will ever have…now, we are talking really serious business!

Well, first, what are “wrap” fees?

It is not meant to be an all-inclusive definition, but such fees can include transaction costs, broker’s fees and commissions, financial planning, investment advice and even discretionary account management activities.

Well, good question!

While this question isn’t exclusively intended for self-directed plans (e.g., IRAs), it is a very common question that people ask when establishing a self-directed plan. Typically, it comes up when they are paying a one-time fee or many account related fees and they ask if the IRA has to pay for the fees or can they as individuals. This is especially true with Roth IRA accounts, as just by the very nature of the account the account holder will want to keep as many Roth dollars in the account as possible.

Unfortunately, many companies have maybe incorrectly advised clients by advising them that ONLY, and ONLY the IRA can pay such expenses. Many of these companies take the position that if ANY source other than the IRA itself pays any fees, an inter-mingling of funds has occurred.

To be sure, inter-mingling of funds should be of chief concern to the account holder. That being said, however, in a recent IRS PLR (Private Letter Ruling), the IRS re-affirmed that such plans can have “wrap” fees paid by outside dollars, including the account holder.

Specifically, PLR 20110461 addresses several account arrangements related to fees where either a specific amount or percentage of assets is being charged. In most cases, these “wrap” fees included the aforementioned fees. The IRS concluded these expenses to actually be “ordinary and necessary” expenses of the plan and compared such expenses similar in nature to an IRA Trustee’s fees….which are deductible under Revenue Ruling 84-146. The IRS noted that “ordinary and necessary” expenses can be paid with outside dollars as necessary “expenses for the production of income” (for the plan).

Had the IRS not made this ruling, the utilization of monies outside the plan could have been ruled as a contribution which could negatively affect these plans. However, the IRS has appeared to remain consistent with its previous position on this matter as outlined in PLR 200507021.

Now…..where there is an additional benefit to the individual account holder….is that since these expenses are “ordinary and necessary”, it continues to appear that such payments outside the plan would be deductible as well to the individual on their respective tax return. Now, of course, this information is for educational purposes only and does not constitute any tax, legal, financial or investment advice. However, the opportunity to pay such fees with tax payer (vs. IRA) dollars and secure a deduction on one’s taxes is very appealing.

While one should not necessarily extrapolate that all “similar” expenses are permitted with outside dollars, it does appear that this recent ruling does continue to support the use of outside “wrap” dollars being used for expenses of IRAs.

Remember, as always, this information is for educational purposes and should not be construed in any manner to represent tax, legal, financial or investment advice.

I’m sure many of you are aware that business owners/real estate investors can take advantage of special financing through the SBA. The SBA 504 program can be a great way to buy investment property and purchase office space. The SBA 504 program can allow business owners to finance up to 90% of the acquisition cost of purchasing commercial real estate. The program allows for something less than 50% of the buildings to be used as leasable space. There is much more paperwork involved but this can be a great program for acquiring commercial investment property and expanding ones business.

New rules

Not too many investors are aware that for 2010 and 2011 new rules were enacted to encourage more investment in machinery, equipment and other personal property which also impacted real property. As part of Small Business Jobs Act it became possible to do a section 179 deduction for qualified leasehold improvement property, qualified restaurant property or qualified retail improvement property.

An important tax advantage that seems to have been underused in 2010 and 2011 is the ability to take up to 250K of leasehold improvement costs and expense them in the year the improvements were made rather than over a say 15, 30 or more years.

Qualified Leasehold Improvement Property

Leasehold improvements must meet several criteria to become “Qualified.”

• The property must have been leased by someone in the past at least 3 years (in other words the property can’t be new or recently converted to commercial space)
• The improvements must to the interior of a property and must be made pursuant to a lease
• An addition to a building would not be allowed. Nor would improvements to the building structure.
• There are special rules for related party transactions

An example

A real estate investor partners with several other investors to purchase a commercial office space. Two of the partners also are professionals with a formal practice that they move into this new office building. It was necessary to do some extensive improvements to the tenant space they would occupy, to the tune of 225K. Assuming that the professional practice doesn’t break any of the third party restrictions and otherwise qualifies, they could fully deduct the cost of this leasehold improvement in 2011.

1) The loan cannot exceed 5 years;

2) the loan must be secured in some manner;

3) amortized loan principal and interest must be paid in nothing less (or longer) than on a quarterly basis; and,

4) the loan must be repaid with a “reasonable amount of interest.”

Well, invariably, most plan sponsors will advise their clients when taking loan provisions that the reasonable interest definition is typically “prime plus (at least) 1 percent.”. Other plan sponsors may say that “less than prime is acceptable, plus 2%.” As you can see, since the IRS has never defined what actual and reasonable interest rates are, one can be mired in confusion on this topic. All plan sponsors are doing their best to provide advice for something that, at best, is murkily defined in the first place.

So, recently, the IRS has put some more definitiveness on this subject matter in coming out with some pointed instruction on the subject. While intended, however, to make things more clear, one could as easily be just or more confused with the new direction the IRS is giving….not a shock, right, folks?! So, what is this new direction in how to define a “reasonable interest rate” for 401K plan loans? Well . . .

. . . in their Winter 2012 edition of its “Retirement News for Employers”, the IRS does offer some methods on the best way to calculate “reasonable” interest for plan loans from the 401K plan. As such, in their attempts to provide greater clarity to a non-defined subject matter, the IRS quoted the Department of Labor (DOL) Reg. §2550.408b-1(e), which states:

“A loan will be considered to bear a reasonable rate of interest if such loan provides the plan with a return commensurate with the interest rates charged by persons in the business of lending money for loans which would be made under similar circumstances.”

To determine if a participant loan interest rate is reasonable, the IRS instructed plan administrators to ask the following two questions:

1) What current rates are local banks charging for similar loans (amount and duration) to individuals with similar creditworthiness and collateral?

2) Is the plan rate consistent with the local rates?

While taking something that maybe could have been defined with more ease and clarity (e.g., “prime plus 1%”), the IRS has unfortunately made this conversation piece a bit more difficult to administer. For example, utilizing the term “similar credit-worthiness”… does that mean that the employer has to verify an interest rate differently for someone with a 600 credit score vs. a 800 credit score. If so, one would assume that they would have to check the person’s credit score prior to the term of the loan being selected? Obviously, for a self-employed individual with a SD 401K plan, this is much easier to streamline, but it is still onerous.

The IRS did state that another resource to consider in determining a reasonable rate of interest for a plan is the daily summary of prime rates, to which the IRS regularly refers. Obviously, determining a reasonable rate of interest is imperative for plan loans —- they must do so in order to meet the prohibited transaction exemption under Code Section 4975.

But, isn’t there an easier way to define “reasonable?”

These regulations keep some of the rules that had been proposed, but have made some significant changes. I’m still digesting the 255 page regulations published in the federal register, and can share some highlights of the changes for now.

The IRS has established some new bright line tests as to whether expenses are to be capitalized or can be expensed. In the past one would look at the extent of improvement to the asset as a whole. Repairing any portion of the roof was considered a repair. Only if 100% of the roof was replaced did it require capitalization. Now the IRS requires businesses and investors to look at the components of an asset. If one were to do a 60% replacement of a roof it would be considered an improvement rather than repairs. Based on my initial read replacing a rotted bathroom floor might still be a repair, but replacing a hot water tank or shower quite likely would require capitalization.

Another important change has to do with component replacement. When an investor remodels a kitchen by replacing cabinets, flooring, countertops, etc, it used to be that the investor would continue to depreciate the old components and capitalize the improvement. Now, an investor can retire (dispose of) the replaced components while capitalizing the new. You might ask how that is going to be accomplished.

Good question — the answer is that any reasonable method is going to be allowed, but how the asset was set up is going play a big part in this.

When it takes 255 pages to clarify and simplify, you know that there are going to be many exceptions and gotchas. I promise to share more over the coming weeks as I better understand these new rules.

BawldGuy Here: Only the government must take over 250 pages to ‘clarify’ and ‘simplify’ an already fairly simple, universally understood concept.

Often times though real estate will be held in an entity such as a trust, partnership or corporation. All of these entities will require a special information return to be filed disclosing information to the IRS about this foreign entity.

Forms, there are forms

Investors also may setup a bank account or investment account in the country where there real estate is located. This may mean that an investor will be required to file two information returns (A form 8938 required in 2012 and an FBAR TD F90-22.1). Not all foreign bank accounts will require an information return but it is important to be aware and file if it is required. Form 8938 requires much of the same information that is on the FBAR but is not subject to the same disclosure requirements.

Penalties can be very significant for not filing these information returns. Not the least of these is the $10,000 fine for failure to report. There are several other penalties as well and they can add up fast.

If you are a US investor with real estate abroad I would strongly recommend seeking a tax professional familiar with these tax regulations. They can also review your foreign entities and financial investments to insure that any and all information returns are filed timely.

I will follow up next time with issues that a foreign investor should consider when investing in US real estate.