Purchasing and renting real estate can be profitable. It can also generate significant tax benefits. However, the Internal Revenue Code limits some of the tax benefits to taxpayers who are not “real estate professionals,” as defined in IRC Section 469(c)(2).

In most circumstances, real estate rental activities are passive activities. The losses from a passive activity can only be deducted from passive income. They cannot be used to offset ordinary income. But, a “real estate professional” can deduct all rental real estate losses without limitation. They can also offset their real estate losses against non-passive income. Therefore, it is important to know what an individual must do to be a “real estate professional.”

Internal Revenue Code Section 469(c)(7), defines a“real estate professional as someone who:

1.    Performs more than one-half of their personal services, performed in trades or businesses during such taxable year, in real property trades or businesses in which they materially participate, and

2.    Performs more than 750 hours of services during the taxable year in real property trades or businesses in which they materially participate.

Unfortunately, meeting these requirements is just the first step. If the taxpayer has more than one rental property, the IRS and state evaluate the time the taxpayer spends on each property individually unless the taxpayer files a statement specifically electing to group the properties. I.R.C. § 469(c)(7)(A)(ii).

The IRS and state will not combine the time each spouse spends on the real estate activity to meet the material participation requirement. Each spouse must materially participate based on their own time spent. This can eliminate the tax benefits for both spouses if neither meets the requirement on their own. I.R.C. § 469(c)(7)(B)(ii). Please look for future blog articles discussing the nuances of the “material participation” requirements.

We encourage you to review the following court decisions for guidance on what it takes to be a “real estate professional” and receive the associated tax benefits.

1.    Harnett v. Comm’r, T.C. Memo. 2011-191.
2.    Bosque v. Comm’r, T.C. Memo. 2011-79.
3.    Perez v. Comm’r, T.C. Memo. 2010-232.

In Scharf v. Comm’r 32 T.C. Memo 1247 (1973) acq, in result, 1974 WL 36031, the United States Tax Court decided, and the IRS had acquiesced to the decision, that a charitable contribution deduction was available for the donation of a building (albeit partially destroyed) to a volunteer fire department for demolition in firefighter training exercises.

Taxpayers and their tax advisors use this case to support a charitable contribution of their home, often a lake home, to a local fire department. The situation usually involves an older home on a very valuable piece of land. The taxpayer enters an agreement with a fire department allowing the department to use the home for training purposes, including destroying the structure. The taxpayer takes a charitable deduction for the contribution to the fire department and then builds a new home on the property.

The state or the IRS can claim that the value of the contribution has been overstated. Their arguments may include:

1. The Appraisal Did Not Properly Calculate the Fair Market Value of the Contribution. Too often, the appraisal simply separates the value of the structure from the value of the land, and then claims the value of the structure as the deductible amount. This rarely represents the Fair Market Value and often results in an excessive value for the contribution.

“[F]air market value” for this purpose “is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” Sec. 1.170A–1(c)(2), Income Tax Regs. Restrictions on the property’s use or marketability on the date of the contribution must be taken into account in the determination of fair market value.Rolfs v. C.I.R., 135 T.C. 471, 480-81 (2010)

The state and the IRS want the taxpayer to demonstrate how much a good faith third party would pay for the structure, separate from the land. They may require the appraiser to include the cost of removing the structure from the land, as a third party buyer could not leave the structure in place.

2. The Taxpayer Received Something of Value for the Contribution. The state or the IRS will often claim that the taxpayer is receiving valuable demolition services in exchange for the contribution. They will likely cite the United States Supreme Court decision in United States v. Am. Bar Endowment, 477 U.S. 105, 116, 106 S.Ct. 2426, 91 L.Ed.2d 89 (1986). “The Am. Bar Endowment test examines whether the fair market value of the contributed property exceeded the fair market value of the benefit received by the donor. . . . Instead, we must consider whether the value of the lake house as donated exceeded the value of the demolition services petitioners received.” Rolfs v. C.I.R., 135 T.C. 471, 487-88 (2010). The taxpayer needs to deduct the value of the demolition services from the value of the contribution. This can result in eliminating the charitable deduction as the value of the demolition services can exceed the value of the rights contributed to the fire department.

Contributing a structure to a fire department is valid transaction, but , to be deductible as a charitable contribution, it needs to be done properly and the value of the rights contributed must be supported.

In the early 1980s, there was an almost endless supply of tax shelters promising deductions and credits that produced benefits far in excess of the investor’s contribution. These shelters were not just for wealthy, promoters pushed them on the average income earner as both a great business opportunity and an investment that would more than pay for itself with tax deductions and tax credits. Many of these shelters led to disastrous results for the investors. The transactions had some basis in tax law, but they were so poorly structured, managed, and over valued, that they could not withstand even the slightest IRS scrutiny. Many investors had to repay all the tax benefits, plus penalties and interest, at historically high rates, and were left with a worthless interest in a valueless “business.”

The demand for shelters has not gone away, but the promoters understand that the IRS is on the watch for the abusive shelters. The courts are also watching and have produced many decisions eliminating or reducing the values of these investments. A benefit of these decisions is that the courts are giving us a roadmap to spotting the good investments that will deliver the promised deductions and credits.

One shelter providing tax benefits that can exceed the amount invested is the Historic Preservation Conservation Easement. This usually involves an investor providing funds to rehabilitate a certified historic structure. As part of the rehabilitation, the investment entity grants a conservation easement to a charitable organization for conservation purposes. A common example of this is the “facade easement,” prohibiting anyone from changing the facade of the building. There are many ways this shelter can fail, including not meeting the strict requirements of the Internal Revenue Code Section 170, but the most likely problem will be the valuation of the contribution.

The taxpayer can use a variety of methods to value of the charitable contribution, but a common valuation method is the “before and after” method: comparing the value of the building before the owner granted the easement and the value of the building after the owner granted the easement. The greater the difference, the greater the charitable deduction and the greater the tax benefit, subject to the IRS limitations on charitable deductions. Experienced, qualified, and honest appraisers can, and often do, produce significantly different values. Thus, the IRS will almost always be tempted to challenge the value, unless it is extremely conservative.

To understand more about the IRS challenges to these investments, we encourage you to review the decisions of the various courts in the following cases:

1. Whitehouse Hotel Ltd Partnership v C.I.R, 615 F 3d 321 (5th Cir. 2010)
2. C.I.R v. Simmons 646 F. 3d 6 (D.C. Cir. 2011)
3. Bruzewicz v. U.S., 604 F. Supp. 2d 1197 (N.D. Ill. E.D., 2009)
4. Richmond v. U.S., 669 F. Supp. 578 (E.D. LA., 1988)
5. 1982 East, LLC v. C.I.R, T.C. Memo 2011-84
6. Evans v. C.I.R.., T.C. Memo 2010-207
7. Schneidelman v. C.I.R., T.C. Memo 2010-151

Reducing or Eliminating the Tax Impact of the Forgiven Debt

What are the tax implications when someone forgives debt that you legally owe? Is the amount forgiven taxable income to you? It really depends on a variety of facts. In this article, we will briefly address some of the things every taxpayer should know about debt forgiveness. If you have been, or expect to be, the recipient of debt forgiveness, for example, you have sold your house in a short sale or are in negotiations with your bank to receive a discount in the amount of your mortgage, you should work closely with your accountant or tax planner to make sure you properly report the transaction and qualify to exclude the debt forgiven from taxable income.

General Rule. If a debt for which a taxpayer is personally liable, recourse debt, is canceled or forgiven, other than as a gift or bequest, the taxpayer must include the canceled amount in income. However, this realized income may be excluded from taxable income if it meets certain requirements.

Examples of Forgiveness of Indebtedness.