TAXING MATTERS
Volume 1, Issue 2 :: Summer 2006
Getting capital gains on real estate
If you hold land that has gone up in value quite a bit, you might be thinking about selling it to a developer at the right time. But you might also entertain the idea of developing it yourself, perhaps in a joint venture with a developer.
Normally, when you sell undeveloped land that you've held for more than one year, the tax on your profit will be at capital gains rates (currently 15% federal for most of us). However, a developer is often ineligible for long term capital gains tax rates, and instead must pay taxes at ordinary income rates instead (35% is the top federal tax rate). Careful planning is thus essential.
Dealer vs. Holder.
To get capital gains rates, there has to be a "capital asset" that is sold at a gain. Capital assets do not include property held primarily for sale to customers in the ordinary course of a trade or business.
Typically, developer-owned lots or units that are intended to be sold to various buyers are not considered capital assets. Sometimes a developer owns real estate that is not clearly a capital asset and not clearly ordinary income property either. In that event, a set of court cases tell us to look at seven critical factors in determining whether the real estate is indeed a capital asset.
The Seven Factors.
These are the 7 factors:
1. the nature and purpose of the acquisition of property and the duration of ownership;
2. the extent and nature of sales efforts;
3. the number, extent, continuity and substantiality of sales.
4. the extent of subdividing, developing and advertising to increase sales;
5. the use of a business office for sales;
6. the taxpayer's control over sales representatives; and
7. the amount of time and effort habitually devoted to selling.
Of these factors, no single one is determinative; nor do you test this on a best of seven approach. Sales to related parties can cause conversion of capital gains to ordinary income under certain circumstances as well.
If you are a developer with respect to some real estate but not with other parcels of real estate, the IRS will sometimes try to treat all the real estate as being dealer-orientated and thus tax gains at ordinary income rates.
In order to avoid the risk that the IRS will challenge capital gains treatment, some landowners engage in a pre-development "bailout".
Pre-development Capital Gains "Bailouts"
In such a transaction, the owner of the land sells the appreciated real estate to a development company. When doing so, you draw a line between the capital asset appreciation pre-development as opposed to profits from development activities. The case law on such transactions is not well settled, but if structured properly a bailout can yield an impressive tax benefit to the seller.
Tax free exchanges with real estate
A tax savings technique approved by the IRS for business and investment property owners is a "like-kind exchange." You may have also heard this arrangement referred to as a "tax-free exchange," a "1031 exchange," or a "Starker exchange." The tax savings from participating in a like-kind exchange can be huge.
A like-kind exchange pro-vides a seller with a terrific alternative to paying capital gains taxes. With a like-kind exchange, you avoid gain recognition through the exchange of qualifying, like-kind properties. The gain on the exchange of like-kind property is effectively deferred until you sell the property you receive.
The IRS allows the tax deferral because it recognizes that since your economic position remains the same (you have merely exchanged one property for another), you should not have to incur taxable gains. You will, however, have to recognize gain on any money or unlike property that you receive in the exchange.
Only certain types of property qualify for like-kind treatment, and how you use the property also matters.
To qualify, both the property you give up and the property you receive must be held by you for investment or for productive use in your trade or business. Buildings, rental houses, land, and even trucks and machinery are examples of property that may qualify.
Like-kind exchanges provide a valuable tax planning opportunity if you are looking to attain the following goals:
1. You want to avoid recognizing taxable gain on the sale of property that you could replace with like-kind property;
2. You wish to diversify your real estate portfolio (for instance) without tax consequence by acquiring different types of properties with proceeds from the exchange;
3. You wish to participate in a very useful estate planning technique (continued like-kind exchanges allow you to permanently avoid recognition of gain); or
4. You would generate an alternative minimum tax liability if you had a large capital gain in that rare situation where the gain would not otherwise be taxed.
Update on illegal immigrants
A few bills have been introduced into the Georgia legislature addressing the illegal immigrant situation.
One such bill, Senate Bill 529, has been passed and signed into law by Governor Perdue this year.
Here's a rundown of two of the key provisions of this legislation affecting clients:
1. Contractors or subs who do business with the state must participate in the federal work authorization program to verify information of all new employees. This provision has the following effective dates:
a. 7/1/07 -- 500 employees
b. 7/1/08 -- 100 employees
c. 7/1/09 -- all contractors and subcontractors.
2. After January 1, 2008, no business may take a Georgia tax deduction for labor services rendered in this state by an employee unless that person is authorized to be employed under U. S. law or has a valid Georgia drivers license or ID card. This law will apply to both W-2 employees and 1099 subcontractors.
Spotlight on Asset Protection
Groundbreaking legislation was signed into law by Governor Perdue on May 5, 2006, which gives Georgians more asset protection benefits than they had in the past.
Specifically, HB 1304 was enacted and this bill provides that certain types of insurance products are exempt from attachment, garnishment or other legal process that may be pursued by creditors. The asset protection features of this legis-lation apply to the following products:
1. Annuity Contracts
2. Life Insurance Policies (including both proceeds from the policies and the cash surrender value of the policies.)
Under prior law, there was only limited protection for these insurance products. For example, an annuity had to be payable to someone other than the annuity owner.
There are exceptions for things like fraud or situations where the insurance product is pledged. Also, if you fail to designate a beneficiary who survives you, the proceeds will be payable to your estate, and as such would be available to creditors of your estate. \In light of this new law, it makes good sense to have your policies reviewed to see if any changes are warranted.
Getting cash from a building via cost segregation
“You can even file for a change in accounting method - the result might be a big tax refund!!”
“You can even file for a change in accounting method - the result might be a big tax refund!!” Commercial buildings typically have a depreciable life of 39 years. So for a $390,000 building, you can deduct about $10,000 per year of depreciation. Most taxpayers never even get to fully depreciate their buildings for tax purposes.
Here's where a cost segregation study can make sense. In such a study, there would be documentation that supports a speedier time span for depreciation. The primary goal of a Cost Segregation Study is to identify all construction-related costs that can be depreciated over 5, 7 or 15 years. For example, 30% to 90% of the total electrical costs in most buildings can qualify as personal property (depreciated over 5 or 7 years). Reducing tax lives results in accelerated depreciation deductions, plus a reduced tax liability, and increased cash flow.
You can even file for a change in accounting method for a building that was constructed several years ago--and the result might be a big tax refund!! The key is to have appropriate documentation. If you are interested in getting such a study performed, let us know, and we will get it done.
Inside Corner: Focus on L&G Staff
Here are some updates on what some of our staff are doing:
Many members of our L&G family have taken the plunge into marital bliss over the past several months. Most recently, Arthur Benz, who is a partner in our sister firm Keystone Financial Group, married Laura Wahoske on July 22, 2006 in Atlanta, Georgia.
Debbie Cook Mason married Jon Mason on November 13, 2005 in Helen, Georgia. Heather Harvey Seebald married Benjamin Seebald on November 18, 2005 in Marietta, Georgia.
On the professional level, Joseph Skalski gave a seminar for the National Business Institute entitled “Compliance and Operation Strategies for Tax-Exempt Organizations” on June 13, 2006. Joe, like other senior staff members at L&G, enjoys reaching out to the community of builders and contractors through various seminars and classes.
In September, Large & Gilbert will host their annual Surety Seminar, which will feature many speakers from our firm.
Jeff Aldridge, Gary Fortier, and Paul Schmidt are spear-heading our upcoming project of “Going Paperless.” We hope to enhance our services for our clients by maintaining the most up-to-date method of storing your tax returns and other information.
Frequently Asked Questions
Q1: Are there any loopholes in the illegal immigrant worker law that would allow me to claim a state income tax deduction in Georgia for work performed by an illegal immigrant?
A1: There is no independent subcontractor exception. However, Code Section 78-7-21.1(e) of the new law says that if the individual is not being "directly compensated or employed" by your company, then the loss of the tax deduction would not apply to you. This would conceivably cover a situation where you contract with a corporation or limited liability company that provides the worker labor.
Q2: Does that mean that if an illegal immigrant forms a corporzation or limited liability company, and my company engages that company to perform services, we would be exempt from the tax deduction take-away?
A2: We do not know for sure. The Commissioner of the Georgia Department of Labor is authorized to issue regulations, and perhaps they will provide more guidance. However, the plain language of the law does seem to say just that.
Q3: If my company employs an illegal immigrant, would my federal tax dedzuction be lost?
A3: No. The new law applies only to your state return, not your federal, as long as you issue a valid W-2 or 1099 form, as required. Since the state tax rate is only 6% compared with perhaps a 35% U.S. tax rate, the loss of a deduction is significant but not overwhelming.
Q4: Any update on estate tax relief?
A4: There are some bills that may or may not go through. We will update you with an email blast as soon as we learn of a development with reasonable certainty.
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