The Tax Crunch: Navigating the New Financial Landscape in 2013

After a blockbuster fourth quarter in investment sales spurred by imminent capital gains increases, real estate professionals are scrambling to make sense of the new real estate tax terrain as a number of other changes hit the industry.

Though accounting experts across the city are offering some tips and tricks to reduce exposure, most believe that the changes, against their warnings, will continue to guide real estate investment decisions.

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“High tax rates impact investment behavior,” said Maury Golbert, a partner with Berdon LLP, noting the mad rush in investment sales in the fourth quarter of 2012 in anticipation of the capital gains increases as a prime example. “There’s no doubt that a lot of that was driven by what people perceived about the coming changes.”

Capital gains increases will affect almost everyone in real estate, and certain rules, including the definition of a “real estate professional,” have gotten hairier.

Some property owners are also faced with an additional 3.8 percent rental income tax, known as the Net Investment Income Tax (NIIT) or the “Medicare Tax,” on interest, dividends, annuities, royalties and rents.

Luckily, “real estate professionals,” as defined by the IRS, are exempt from the Medicare Tax as long as they meet certain conditions, the most important being that they actively dedicate 750 hours per year and more than half their time on the business.

“It would be unfair to tax them the extra 3.8 percent,” said Neil Sonenberg, a partner at Rosen Seymour Shapss Martin & Company LLP.

But in one of the many finer details in current legislation, that also means family members and investors in a business would be subject to the tax if they don’t meet the new rules, and will thus pay the Medicare Tax on their investment income (if gross income exceeds $250,000 for married couples or widows with dependent children, or $200,000 for single individuals or heads of households).

“Now the IRS might challenge some people who always thought of themselves as real estate professionals,” said Matthew Bonney, a partner with accounting firm Citrin Cooperman, noting that new rules this year also ask owners to compartmentalize repairs, meaning that an electrical job might be written off while a plumbing job might not. “What we’ve all taken for granted will be taken into the light now … and the IRS has a reason to challenge.”

Capital gains taxes increased from 15 to 20 percent this year, signaled by the unprecedented rush by property owners to sell last year. Many experts and real estate professionals believe the number of 1031 exchanges will increase with this tax increase, just as the fourth quarter of 2012 saw a monumental investment sales surge.

The 2,598 sales in the fourth quarter was the highest figure in at least 25 years, according to The Elliman Report.

Mr. Golbert believes that property owners looking to sell—especially those subject to the additional 3.8 percent Medicare Tax—may also look to umbrella partnerships under real estate investment trusts, which will allow them to defer taxes, at least until shares begin to trade hands.

“I don’t think that additional 5 percent is enough to change behavior that much,” he said, referring to the capital gains increase from 15 to 20 percent.

But the additional 3.8 percent Medicare Tax, a 9 percent New York State tax and a 3.4 percent New York City tax (a grand total of 36.2 percent), surely will, he added, especially given that the rates seemingly have nowhere else to go but up.

The experts offered advice to keep ever-rising taxes in check. If for some reason you’re thinking about forming a C Corporation, think again, Mr. Sonenberg said.

C Corporations are taxed separately from a firm’s owners, meaning that income is taxed twice—once as a lump sum and again after it’s distributed to employees. Forming a limited liability company (LLC) is the way to go, as they are not subject to Federal Insurance Contributions Act (FICA) taxes.

The movement of income between accounts, tax-free gifts, “bonus depreciation” and the “65-day rule” are other loopholes in legislation that could offer relief, but many offer a slippery slope and warrant precise examination, experts said.

Trusts, for example, have a lower threshold at which funds are charged the maximum income tax. The threshold for trusts is $11,650, meaning that any amount over that figure—say, 12,000—is taxed at 35 percent. But the same $12,000 would incur only a 10 percent income tax in an individual account, which has a $388,350 threshold.

“The play here is that with complex trusts, you should distribute out the income from the trust to the individual,” Mr. Sonenberg suggested.

But unwinding a trust presents its own problems, as its purpose is to protect the money from falling to heirs or other individuals and potentially spurring lawsuits. These protections are not built into individual accounts, so some experts urged caution.

“You don’t want to give a 21-year-old control of two million dollars,” Mr. Bonney said. “Sometimes you shouldn’t do things for tax-motivated reasons.”

Also, assets given as gifts, valued up to $5.25 million, are tax-free. The number was increased from $5.12 million in 2012, despite talk that it would be reduced to $3 million or lower.

“There was a lot of fear, and that’s why a lot of people took advantage of it,” said Abe Schlisselfeld, a partner at Marks Paneth & Shron LLP. “If you want to get things out of your estate, it’s a tremendous savings.”

The rule was made “permanent,” though that should perhaps be taken with a grain of salt.

“They’ve made it permanent … until they change it,” Mr. Schlisselfeld quipped.

He cautioned further, “Don’t let taxes be your first and foremost decision-maker,” noting that even gift-giving can have hidden taxes.

Yet one perk, seemingly without a catch, is bonus depreciation, which will continue this year, after fears that it would expire December 31. It says that if a landlord makes an improvement in tenant premises, he may immediately write off 50 percent of the costs as tax-free.

The “65-day rule,” is a detail that can save real estate professionals money. It says that a distribution from a trust made during the first 65 days of 2013 can be filed for 2012, meaning that it is taxed based on 2012’s rates, experts said.

But despite these so-called perks—and the warnings from accountants to not do so—tax changes undoubtedly will continue to impact investment behavior.

“Not only are tax rates high, but they’re always going higher,” Mr. Golbert said. “People will clearly act differently.”

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