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Helping Real Estate and Construction Clients Maximize Deductions and Increase Cash Flow

Bedford/Source Advisors Special Report

Navigating the new tax landscape.

As the Treasury Department’s new Green Book illustrates, there are a myriad of credits and provisions available for your clients if you know where to look. “We’re looking at some of the biggest changes the tax regulation, code and stimulus in a generation,” observed panelist Rick Telberg, Founder and CEO of CPA Trendlines at the recent Missouri Society of CPAs Virtual Real Estate & Construction Mini-Conference produced in association with Bedford Cost Segregation /Source Advisors.

 

 

 

 

 

 

 

 

 

Top row from left: Max Vignola, Greg Bryant, Josh Malancuk
Middle row from left: Karen Koch, Blake Christian, Rick Telberg
Bottom row from left: Stephen Lukinovich, Andy Ackermann

 

“It takes a team approach more than ever,” noted Telberg. “No individual CPA and very few firms can do it on their own. It’s just too complicated, too vast, too far-reaching, too fast-changing. You need to enlist specialist partners to help you,” added Telberg.

One attendee asked the panel if there is a risk of depreciation recapture when combining a cost segregation study with an Opportunity Zone project.

 

First let’s talk about how recapture may or may not impact a sale.

According to Karen Koch, CPA, MT, Senior Director of Bedford/Source Advisors, in the world of 100% bonus depreciation, if you do a cost segregation study, you are “grabbing all of your accelerated deprecation” in the first year and it gives you (the CPA) a planning opportunity down the road. “Often times the deductions are so large that clients can’t absorb the full deduction. That’s good news for planning opportunities and for lowering tax liabilities. But you’re absolutely correct, there is always recapture,” Koch added.

Koch said you only trigger recapture if you have a sale and if you sell at a gain.

“If you sell at a loss, there is no recapture,” noted Koch. “If you do a 1031 exchange there is no recapture. But, if you do cost seg and sell at a gain, then you are looking at recapture. If you DO have recapture, Koch said you will recapture your 1245 assets and your 1250 assets at different rates. That’s because 1245 assets are recaptured at ordinary rates and 1250 assets are capped at 25%.

“If you have clients in the 35% to 40% tax bracket, they actually made money. You’ve protected them on long-life assets,” explained Koch. “There’s always a play when it comes to how you structure the sale. You may be selling all the assets on the books but be careful not to recapture assets that are no longer on the books. Make sure your fixed asset listing is cleaned up prior to a sale.

Panelist, Blake Christian, CPA/MBT, has good news as it relates to recapture for property in an Opportunity Zone.

 

Opportunity Zones, 1031s and 501(c)3

Many attendees had questions about Opportunity Zones since they have clients selling their real estate assets to beat the likely higher tax rates in 2022. When selling property for a significant gain, more and more of your clients may be bypassing 1031 exchanges because they need more than 180 days to find replacement property—or because they’d like to roll their gains into one of the many Opportunity Zones Missouri has to offer.

“Opportunity Zones are a great tool for turning off recapture,” explained Christian, tax partner of HCVT, LLP. He said Opportunity Zones allow investors to claim millions of dollars in depreciation expense. “If you meet the 10-year hold requirement, all of the appreciation is tax exempt and you don’t recapture your depreciation on your 1245 or 1250 assets.”

Christian also said that if a client sold a real estate project and didn’t do a 1031 exchange, the 1250 recapture is a capital gain for purposes of rolling into an OZ fund, but a 1245 is not. “So, you want to squeeze the balloon and push more air into the 1250 recapture. Hard to believe, I know, but it’s true. If you get to the 10-year hold finish line in an OZ fund, there is absolutely no recapture.”

Christian explained that with OZ investing, you get all those tax benefits at ordinary rates and no recapture. The OZ program is very powerful and studies show it pops your internal rate of return (IRR) by 4% to 5% per year,” Christian added.

One attendee asked why you would want to use an Opportunity Zone instead of a 501c(3) for an economically depressed area?

“The problem with expecting 501c(3)s to rehabilitate economically depressed areas is that they have limited bandwidth and resources,” related Christian. “You cannot expect a 501c(3) to do a $10 million project like a civic center. They don’t have the borrowing capability and the inside personnel to make that happen.” By contrast, he said an OZ program puts the burden on the private sector that has the resources and personnel to manage larger civic projects. “The OZ program has already attracted tens of billions of dollars and it should easily attract $100 billion by the time we get to the 10-year mark. Again, it comes down to bandwidth,” Christian added.

That being said, the Biden administration is not likely to make any major changes to the OZ program, as some have feared. If anything, Christian said the Biden tax team is trying to make it easier for Opportunity Zones to partner with 501c(3)s in economically challenged areas.

 

Green Book Impact on Energy Provisions

When it comes to the Treasury Department’s aforementioned Green Book detailing the Biden Administration’s tax proposals, Greg Bryant, CCSP Senior Managing Director of Bedford/Source Advisors said he is excited about the proposed changes on the energy front. He’s optimistic that the 45L residential tax credit will increase to $2,500 per dwelling unit from the current $2,000. And he thinks it’s very likely the 179D energy efficiency tax credit could be increased to $3 per square foot on commercial buildings from the current $1.80. “It’s a really good shot in the arm,” observed Bryant. “Even $1.80 is a great incentive for people to plan with energy efficiency in mind. It’s a great time to consider energy retrofits and use tax strategies to fund those retrofits.”

Koch said it’s all about how we fund the process of making buildings energy efficient. “CPAs and their clients really have to understand the application and design to qualify for these tax incentives to make the dollars work. Otherwise, it is difficult to get the financial payback,” noted Koch.

 

Historical Tax Credits

Another growing area for CPAs is helping clients quality for tax credits for refurbishing historic buildings rather than demolishing them. One attendee asked if there was a limit to how much historical tax credit you can qualify for.

Originally the limit was 20% earned based on the qualified rehabilitation expenses in the year the building was placed in service. However, Andy Ackermann, CPA, CVA, a partner of MCM CPAs and Advisors said that after the Tax Reform Act of 2017 was passed, that 20% gets spread equally at 4% per year over the five-year compliance period, although there are some exceptions.

 

Real Estate Professional Elections

On a related matter, an attendee asked about professional real estate elections and why attorneys and real estate brokers do not qualify.

If you’re claiming to be a real estate professional for tax purposes, Ackermann said you must meet two requirements:

  1. Your client is spending at least 750 hours a year on legit real estate activities
  2. More than 50% of their time on professional real estate activities

Even if they are a real estate attorney, if they don’t meet the two tests above, any losses they generate from their real estate activities won’t qualify, said Ackermann.

If you’re in those professional real estate activities, you have to own at least 5% of the company that is generating those activities. “If you’re just a W-2 employee (including brokers) working for a developer and you have a rental piece of property on the side, you’re not going to qualify for professional real estate activities, even though you may meet the 750-hour test,” added Ackermann.

 

Grouping Elections and Income Tax Planning

When it comes to structuring entities for income tax planning purposes, Stephen Lukinovich, CPA, PFS, CVA – MCM CPAs & Advisors, LLP walked attendees through the four types of grouping elections you can use to mitigate client taxes on their real estate activities:

  1. Economic Unit Election—can help with self-rental activities. “This election can convert passive losses, which can be limited, into non-passive losses,” said Lukinovich.
  2. Rental Real Estate Professional Aggregation Election— According to Lukinovich, this election permits qualifying rental real estate professionals (750+ hours) to treat passive (non-deductible) rental losses as ordinary non-passive losses (i.e., deductible) to offset wages or other income.
  3. Passive Rental Activity Analysis: Five 100-hour analysis groupingFrequently overlooked by practitioners, it’s an annual analysis to determine if five or more of the taxpayer’s trade or business activities exceed 500 hours in total, enabling them to deduct the losses as non-passive, said Lukinovich.
  4. 199A Qualified Business Income (QBI) Aggregation Election— This election “helps clients maximize of the free 20% deduction that real estate ventures have been entitled to since 2018,” added Lukinovich.

 

Assisting Clients With Property Taxes

Personal property taxes are always an issue and it’s a different set of challenges in each state. One attendee asked is you can qualify for COVID relief is you own rental properties that need new roofs and the cost of the roof is literally “through the roof” due to supply chain disruptions?

Josh Malancuk, CPA, CMI, President, JM Tax Advocates said that isolating roofing costs is really a matter of deferred maintenance. That’s always an issue with real estate valuations. Remember when all the Chinese siding suppliers were going defunct, Malancuk asked? Home buyers were certainly asking for big concessions from seller knowing what a headache it could be to replace that siding down the road. “We always look carefully at things like roofing, windows, asphalt, paving to gauge whether there’s a condition issue with the property relative to the assessment date (typically January 1),” added Malancuk.

Malancuk said that in Missouri, there’s a relatively short window to appeal your client’s real and personal property tax assessments. The notice period in most jurisdictions is July 1st, he said. “Inaction or no action on those notices will lock in the tax value and property taxes for the coming year.” The only alternative is to go the appeals route, he added.

Related to real estate and tax deferral, one attendee asked how OZ investments can help clients with “blown” 1031 exchanges.

“We’ve done this many times,” explained HCVT’s Christian. “For instance, I recently helped a family with a $50 million 1031 transaction in California. They were able to identify about $40 million worth of replacement property, but that left them $10 million short. So, we were able to move that $10 million into an OZ fund and wipe out that big gain that they would have had to report.”

As Christian noted, we all deal with dysfunctional family partnerships at times. “The OZ program is a great way for clients to sell an asset, take their gains, and roll those gains into an OZ fund and re-partner with a smaller group with whom they get along with better—all while deferring tax on those gains.”

Christian said OZ funds are also helpful for clients who have real estate trapped in an S-Corp. “You can sell it, let the gain flow out to the S Corp shareholders, let them invest at the individual level and not be trapped in an S Corp.”

As Koch noted, OZ is a complex provision, but for clients with gains that qualify, “it’s an incredible program to help economically depressed areas that maximizes tax benefits for investors out there.”

 

Tax Credits for Your Client’s R&D

More clients than you think can qualify for valuable R&D credits. For instance, many people in the construction, architecture and engineering professions don’t think about applying for R&D credits for regular activities they conduct. But in many cases, they’re leaving money on the table.

One attendee asked if an engineering company outsources some work to an MEP contractor, who really gets the R&D tax credit?

Max Vignola, CCSP, Director Technical Sales R&D, Bedford/Source Advisors, said the credit always goes to the company that owns the design and that’s financially at risk. If the general contractor is the one that owns the design, has its name on the line and is bearing the financial risk, that’s who is eligible for the R&D tax credit. “You don’t often see R&D tax credits in a construction company,” said Vignola, “but they do exist for companies writing software and for those with engineers on staff.”

Vignola added that if your construction client is doing a special project and needs to design a special type of scaffolding, it could be eligible for R&D tax credits. Value engineering is another area ripe for R&D tax credits, said Vignola. For instance, lumber prices are sky high right now. If your client designs a more efficient building with less reliance on lumber, that’s not easy, and they could be entitled to an R&D tax credit.

Vignola said space utilization is another big area for R& D credits, since developers not only want an affordable design, but want to utilize every square inch of space in a building. “
There’s a lot of expertise that goes into making that happen,” said Vignola, adding that it all comes down to who is bearing the risk financially and who is going to own the rights to all that design work so it can be used again on another project. “That’s who is eligible for the R&D credit,” Vignola added.

Koch said she and Vignola spend a lot of time looking at how contracts are written. “It’s all about the facts and circumstances, and testing who is really at risk. “Ultimately you must ensure that your clients are the ones writing the contracts the right way or else they might be selling off their technology without realizing it,” said Koch.

There are two ways of thinking about it, said Vignola:

  1. If you don’t have anything in writing, then nobody owns it
  2. If both parties own the design, then it comes down to who is bearing the financial risk

“It’s very important to write into every one of your clients’ contracts, who own the design and intellectual property and who is bearing the financial risk,” Vignola added.

 

Conclusion

As we get closer to year end, Bryant said now is a great time of year to ask clients what they’ve done in terms of improvement to their buildings during this tax year. “You may be able to identify opportunities to expense items under general property regulations, or to “tee some things up for partial asset disposition.” Bryant advised getting a jump on that process so you can get a sense of what your clients have done in terms of capital improvements. “You want to realize the various safe harbors and strategies available to add value to your client relationships,” said Bryant.

For additional questions or a copy of the slide presentations, contact Denise Johnson (djohnson@mocpa.org)

Interested in contacting the presenters directly?