This is true because:  


The income of partnerships and LLCs (taxed as partnerships) is taxed directly to the partners and the LLC members. By contrast, a C corporation pays tax on its income and then the shareholders must pay tax again on the after-tax profits distributed by the corporation resulting in higher overall taxes.

 
While S corporations, unlike C corporations, are not taxable on their income, partnerships are still superior to S corporations because of the greater ability to deduct losses.  Partners can deduct losses up to the aggregate amount they invest in the partnership plus their share of the partnership’s debt.  By contrast, an S corporation shareholder may deduct losses only up to the amount that he or she actually invested in (or personally loaned to) the S corp. The is a big advantage because real estate ventures tend to generate tax losses in the early years even if they have positive cash flow.   


Example:  Assume Brad and Carl form a company to acquire a $1 million property with $100,000 contributed by each of Brad and Carl and with an $800,000 loan borrowed by the company. Assume further that in the first year, the company has $300,000 of losses (based on cost segregation and bonus depreciation). If the property was held in an S corporation, Brad and Carl could not deduct more than $100,000 each. However, if they held the property in a partnership, they could deduct up to the entire $300,000 of losses.  


Partnerships also have greater flexibility in ownership structure than S corporations.  For example, you cannot issue profits interests (aka promotes or carried interests) in an S corporation like you can in a partnership.

 
Bottom Line:   Absent a specific reason for holding real estate in a corporation (and there are some), you will almost always be better off holding it in a partnership (or LLC taxed as a partnership).  


“Just taught my kids about taxes by eating 38% of their ice cream.” — Conan O’Brien

For residential real estate, the cost of a building can be deducted in equal amounts (i.e. “straight line depreciation”) over 27.5 years and, for commercial real estate, over 39 years from the date the property is placed in service. Through proper planning, you can massively increase your depreciation deductions by conducting a cost segregation study of the property.

Your rental property can be divided up for depreciation purposes between its real estate components and non-real estate components, aka personal property (such as appliances, flooring, landscaping, etc.), and you can depreciate that personal property separately from the real estate elements of the property. These non-real estate items can be depreciated over a much shorter period e.g., 3, 5, 7, or 15-year periods, depending on the specific type of asset.

The ability to depreciate a portion of the cost of a building over a shorter time can result in a substantial increase in tax deductions.

Example: The depreciation deduction on $100,000 of residential real estate in a year would be approximately $3,636. If that same $100,000 were depreciated over 15 years, the deduction would be $6,667 and if depreciated over 5 years, it would be $20,000.

Not only does cost segregation allow you to depreciate components of the building over a shorter life, but it also allows you to depreciate it faster over that shorter life, thereby further increasing depreciation deductions. 

5-year property –which includes appliances, carpets, and furniture, can be depreciated using the 200% declining balance.  This method permits deduction of 200% of the allowable straight-line depreciation.  15-year property –can be depreciated 1.5 times faster using the 150% declining balance method.  The 200% or 150% declining balance methods are used to calculate the deduction until the time that the straight-line method would result in a greater deduction.

Moreover, the value of the personal property is also eligible for bonus depreciation.  While some of these amounts may need to be recaptured at the time of sale, the value of the tax deferral can nevertheless be very substantial.

Bottom Line:   Conducting a cost segregation analysis for your property can substantially accelerate the pace at which you can claim depreciation deductions and the proposed extension of the bonus depreciation rules could further increase the available deduction.

”Things may come to those who wait, but only the things left by those who hustle.” -Abraham Lincoln (?)

A common problem that arises in real estate partnerships is when there is an opportunity to sell and some partners want cash out and some partners want to defer tax by engaging in a like-kind exchange. The trick is to dispose of the property in a way that protects the exchanging partners from any tax on the cash received by the partners that want to cash out.  

One solution is to distribute an undivided ownership interest (a “tenancy in common” or “TIC” interest) in the real estate to the partners that want to exchange. This transaction can be effective, but it puts stress on two of the requirements for like-kind exchanges: (i) whether the TIC interest qualifies as real estate and (ii) whether the partner who exchanges property will be considered to have held it for investment or for use in a business prior to the exchange.  

A better solution is for the LLC to distribute the TIC interest to the owners who want to cash out (the “cash out members”). The LLC retains a TIC interest for the remainder of the property.  After the distribution, the LLC will be owned only by the owners who want to make the exchange. Then the LLC and the cash out members can each transfer their respective TIC interests in the property, with the LLC receiving real estate in exchange for its interest and the cash out members receiving cash. The LLC that conducts the exchange is the historic owner of the real estate,  so there is no question of whether it held it for investment or use in a business so provided the other requirements are met this is a good tax-free like-kind exchange. The cash out member receives cash and is the only person that is taxable on it.
 
Bottom Line:   While this is a simple description of a somewhat complicated transaction, it can be very effective for facilitating the receipt of cash by some members and receipt of property in a nontaxable exchange by others.  Also, it is important to distribute the TIC interests prior to entering into a purchase agreement.

 
“The only difference between a tax man and a taxidermist is that the taxidermist leaves the skin.” Mark Twain 

Assume that you want to make a tax-free exchange of your apartment building (the “relinquished property”) for a retail strip center (the “replacement property”). You located a great deal on a retail center, but only if you close in 30 days. However, your buyer for the apartment cannot get its financing for 90 days.

By using a “parking transaction” (sometimes referred to as a “reverse like-kind exchange”) you may be able to qualify the purchase and sale as a nontaxable exchange. Parking transactions are designed to “park” the desired new property (aka replacement property) with someone until you can transfer your existing property (aka the relinquished property) and exchange it for the replacement property. Under the safe harbor the IRS created for such exchanges, the “someone” that you park the property with is called the Exchange Accommodation Titleholder (“EAT”).

In the example above, you would arrange with an EAT to acquire the retail center for you and hold it until you can close on the sale of your apartment building. At the time of sale, you would transfer your apartment building to the EAT, who would sell it to the ultimate buyer, use the sale proceeds to pay down or payoff the loan on the retail center and simultaneously transfer it to you. Alternatively, the EAT could acquire the retail center, immediately exchange it with you for the apartment building, and then hold the apartment building until you are able to close on the sale of it to the ultimate buyer.

Under the IRS safe harbor, you must identify the relinquished property within 45 days after the EAT acquires the replacement property and the EAT must, within 180 days, either (a) transfer the relinquished property to a third party, or (b) transfer the replacement property to you, the exchanger, as applicable.

You can also enter into certain agreements with the EAT that may be necessary to facilitate the exchange such as (i) a loan to the EAT or a loan guarantee; (ii) an agreement to pay the expenses of the EAT; (iii) a lease; or (iv) a property management agreement.

Bottom Line: By using a parking transaction, you can acquire replacement property even before you sell your existing property and still qualify as nontaxable like-kind exchange.

“If your biggest tax deduction was bail money, you might be a redneck.”  Jeff Foxworthy

Loans that have interest that is not currently paid each year are treated as having “original issue discount” or OID.  These types of loans are common in mezzanine financing which can have rates ranging from 13-18% with 11-15% payable currently (typically monthly or quarterly)and the remaining interest (referred to a PIK interest) paid at a later date or at maturity.  Borrowers can deduct the PIK interest ratably over the term of the note (even though not paid).
 
However, if the rate of interest is high enough and the loan has certain other characteristics, the loan may be considered an “Applicable High Yield Discount Obligation” or AHYDO for short.  A borrower cannot deduct the “disqualified portion” of the PIK interest on an AHYDO, and the remaining PIK interest cannot be deducted by the borrower until paid.  A loan is an AHYDO if

The term of the loan is more than 5 years;
The borrower is a C corporation (or partnership with corporate partners);
The interest rate is at least 5% higher than the midterm Applicable Federal Rate (currently 4.06%); and
The debt has accrued but unpaid interest as of any accrual period ending after the 5th anniversary of the loan that exceeds one year’s interest. 
 
This potential limitation on the ability to deduct interest is commonly addressed by providing that the borrower is required to make a “catch up” payment of interest around the 5th anniversary so that total accrued and unpaid interest does not exceed one year’s worth of interest.  That removes the 4th element listed above.
 
Even if the note provides for payment of all the PIK interest as necessary to avoid
AHYDO treatment, sometimes subordination agreements with a senior lender prohibit the payment of any amount on the subordinate debt other than regular interest.  This
could prevent a borrower from paying deferred interest to avoid AHYDO treatment. 
While it appears that this should not impact the determination of whether the debt is
an AHYDO, there is no authority addressing whether this limitation could result
in the debt being recharacterized. 
 
Bottom Line:   As a borrower on mezzanine loan, it is important to be aware of the exceptions to AHYDO treatment and the potential impact of other agreements on the ability to comply with the 5-year payment safe harbor. 
 
“There are two rules for success:
Never reveal everything you know.” – Roger H. Lincoln
 

 
 
 
 

Under the “partial disposition rule,” if you replace a roof (or other structural component in a building such as an elevator), you can claim a tax deduction equal to the remaining tax basis (undepreciated cost) of that roof you replaced.  You then capitalize the cost of the replacement roof, elevator or other component and begin to depreciate it. You must elect to use the partial disposition rule to take this deduction, but you make the election simply by claiming the loss on your tax return for the year and by beginning to depreciate the replacement roof. Without the partial replacement rule, you would need to continue to depreciate the old roof over its remaining useful life (in addition to depreciating the new roof). Obviously, the ability to take a loss for the old roof can significantly increase your deductions for the year of replacement.

There is another benefit to the partial disposition rule.  By deducting the loss on partial disposition rather than continuing to depreciate the property, you can reduce the tax rate from 25% to 20% on a portion of the gain from a sale of the property.  This is because the portion of gain taxable at 25% which is known as “unrecaptured 1250 gain” is equal to the amount of depreciation previously deducted for the property. The loss that you deduct under the partial disposition rule is not depreciation.  Consequently, any gain attributable to the reduction in basis from deducting that loss is not included in the unrecaptured section 1250 gain and is taxable at 20% rather than 25%.

Bottom Line:  By electing to use the partial disposition rule you can accelerate deductions with respect to structural components that you replace and potentially reduce the tax rate applicable to some of the gain on a subsequent sale of the property.

The gain on sale of land that is held primarily for sale to customers in the ordinary course of business is taxable at ordinary income rates (and not at the more favorable capital gains rates).  In addition, those gains may be subject to self-employment tax.  The prospective increase in sale value from subdivision can suddenly become much less attractive given the increased tax burden.  Persons holding land for sale as described above are known as “dealers.”  Whether you are a dealer depends on the number of factors, including the purpose for which you acquired and subsequently held the property, the extent of improvements you make to the property, the frequency and number of sales and the extent of your efforts to sell the property. 

As you can see from this list of considerations, subdividing a parcel into multiple lots for sale could give rise to the owner being characterized as a dealer and taxed as ordinary income rates on any sale gain.  The tax code provides some relief for these situations in section 1237. Under that section, ordinary income treatment will not apply if the land was not previously held for sale, if the improvements are not substantial and the property has been held for at least five years.  Improvements such as surveying, filling, draining, leveling and clearing are not substantial.  Permanent structures and paved roads are substantial.  If you meet those three requirements, gain on the sale of up to five lots will be taxable as capital gain.  If you sell six or more lots within the same tax year, then 5% of the sales price (less sales expenses) will be taxable as ordinary income and the remainder is taxable as capital gain.

Bottom Line:  By tailoring your subdivision transaction to the requirements of Section 1237, you have a better chance of preserving capital gain treatment on the sale of parcels resulting from subdivision. Note that the foregoing is a very high-level description and a more thorough analysis of section 1237 should be undertaken in connection with any transaction.

“Back in my day, there was so much toilet paper and so many eggs that we gathered at night and threw them at the houses of our enemies.”  – Any baby boomer.

Content by Jim Duffy and Michelle DiVita

Minnesota (and other states) generally impose income tax on companies engaged in multi-state business on that portion of a company‘s income that is attributable to Minnesota. Minnesota makes this determination based on the percentage of sales a company makes within the state of Minnesota. Under Minnesota law, receipts from performance of services are attributed to the state where the services are received. If the location where services are received is not readily determinable, Minnesota applies a cascading set of sourcing rules that looks to the customer’s location or billing address.

In Humana Market Point, Inc. v. Commissioner of Revenue (11/21/2024), Humana, a Minnesota based corporation, entered into a contract with an affiliate that is located in Wisconsin to provide medical and drug insurance products and pharmacy benefits management services to the Wisconsin company’s plan members. The question before the court was whether the services were received by the affiliate business in Wisconsin or by plan members of the affiliate who were located in Minnesota. Generally speaking, Humana argued that the plan members of the Wisconsin affiliate should not be treated as the service recipients essentially because they were the customers of its customer (i.e. an indirect recipient of services) and as the party to the service contract, the Wisconsin affiliate received the services.

Based on the facts of the case and certain stipulations by the parties, the court disagreed with that argument and ruled that the sales would be treated as made within Minnesota and income would be apportioned accordingly. A similar conclusion was reached by the Maine Supreme Court in the 2023 Express Scripts case where the court ruled that sales occurred where patients picked up their prescriptions, not where the clients that hired Express Scripts to handle their prescriptions were based.

Bottom Line: Companies engaging in multi-state business should examine the facts of the Humana case to determine if it impacts how they allocate income for Minnesota state tax purposes.

“Have you ever noticed that anybody driving slower than you is an idiot, and anyone going faster than you is a maniac?” — George Carlin

As discussed in prior installments of Did You Know,  Section 1202 of the tax code makes the gain on the sale of certain corporate stock nontaxable.  This is not a deferral. It will never be taxed in the future. One of the many requirements for stock to qualify for this treatment is that it must be issued by a C corporation (not an S corporation).  Unfortunately, if you have an S corporation, simply terminating its S corporation status (i.e., converting to a C corporation) will not be effective with respect to stock issued while the corporation was an S corporation. Stock issued after conversion to a C corporation could qualify as section 1202 stock (if all the other requirements are met). However, any appreciation on the existing stock issued by the S corporation will not qualify for tax free treatment.

One way that it may be possible to get the benefit of Section 1202 for future appreciation of the outstanding stock of the S corporation would be for the S corporation to contribute its assets to a newly formed C corporation in exchange for stock. The stock issued by the C corporation in exchange for the assets may qualify as section 1202 stock (again if all other requirements are met).  When the S corporation (after 5 years) sells the Section 1202 stock, gain from appreciation on the stock accruing after the contribution will not be taxable (subject to applicable limits).  Note that for the contribution of the assets to the new C corporation to be a non-taxable transaction, it must be undertaken for bona fide business reasons other than just tax benefits.  For example, a potential business reason may be that the corporation was seeking to raise capital from an entity that is not eligible to be an S corporation shareholder.  Each case will need to be evaluated on its particular merits.

Bottom Line:   With careful planning, it may be possible to make future appreciation on S corporation stock tax free under Section 1202.  
“Wouldn’t exercise be more fun if calories screamed while you burned them”? –Bill Murray.

Content by Jim Duffy

The key advantage lies in the ability to avoid paying capital gains taxes on appreciated assets, such as real estate, stocks, or other investments. A donor can generally claim a charitable deduction for the full fair market value of the property. By contrast, if a donor sells these assets and contributes the sale proceeds, the donor would incur capital gains tax on the appreciation which would decrease the benefit of the deduction to the donor. However, when the property is donated directly to a qualified charity, the donor can bypass this tax liability.

For example, if a donor has stock worth $100,000 that they originally purchased for $50,000 in 2019 and they sold it in 2024 and contributed the $100,000 to charity that same year, the donor would have $50,000 of capital gain and a $100,000 charitable deduction. The donor is subject to a 20% federal capital gains tax (and potentially state tax) on the capital gain of at least $20,000. If we assume that the donor is in the 35% federal income tax bracket, the charitable deduction can save him $35,000 for a net tax benefit of $15,000 ($35,000- $20,000). By contrast, if the donor contributed the stock, they would have no tax but still be entitled to deduct the full $100,000 charitable deduction resulting in tax savings of $35,000.

The contrast is even greater if you compare a gift of cash that was earned as wages or business income because that income is taxed at higher ordinary income tax rates. Assuming the donor is subject to a 35% federal income tax rate, the charitable deduction would simply shelter the tax on the amount of income that is given away ($35,000 tax – $35,000 deduction benefit).

There can be limitations on the deductibility of appreciated property depending on the nature of the charity receiving the donation and whether the value of the gift would exceed certain percentages of the donor’s income, e.g. 30%. Accordingly, advance planning is advisable for significant gifts.

Bottom Line: Donating property to a charity can offer enhanced tax advantages compared to giving cash making it an appealing option for those with appreciated assets.

“I always wondered why somebody didn’t do something about that. Then I realized I was somebody.”– Lily Tomlin