REAL ESTATE REVIEW Summer 2017

REAL ESTATE REVIEW Summer 2017 DEMOLITION AND YOUR TAX BASIS: WHAT YOU NEED TO KNOW DON T GET CARVED UP ARE YOU READY FOR AN EMERGENCY? EFFECTS OF POTENTIAL TAX REFORM ON THE REAL ESTATE INDUSTRY HENDERSON HUTCHERSON & MCCULLOUGH, PLLC 1200 MARKET ST CHA TTANOOGA, TN 37402 423.756. 7771 6363 POPLAR AVE., STE. 405 MEMPHIS, TN 38119 901.585.0012 HHMCPAS.COM

Real Estate Review DEMOLITION AND YOUR TAX BASIS: WHAT YOU NEED TO KNOW With the commercial real estate market on the upswing in many parts of the country, investors and developers are again turning to properties with older buildings on them for development opportunities. But before you demolish a newly purchased building, you need to be aware of the tax implications particularly how Internal Revenue Code (IRC) Section 280B and changes in the final tangible property regulations work, so that you can preserve depreciation deductions. SECTION 280B AND DEMOLITION Sec. 280B generally disallows a loss or deduction when you demolish a structure. Instead, you must capitalize the demolition expenses (less any salvage 1 value) and the remaining tax basis to the underlying land, which isn t depreciable. The IRC provision includes an exception for building modifications; those costs are added to the basis of the demolished building, rather than the land. A building has been modified for purposes of the exception if at least 75% of the external walls, and at least 75% of the internal structural framework, are retained. Once you remove more than 25% of either the external walls or the internal structural framework, the exception doesn t apply, and you lose all future depreciation deductions for the remaining basis of the building. But you might be able to avoid the unfavorable tax treatment imposed by Section 280B by taking advantage of a general asset account (GAA), thanks to the final tangible property regulations. GENERAL ASSET ACCOUNTS TO THE RESCUE Under the tangible property regulations, you can continue to depreciate a building you plan to demolish by making an irrevocable election on a timely filed tax return to place the building in a GAA. The disposition of an asset in a GAA isn t recognized unless you elect to discontinue the GAA. Section 280B, therefore, doesn t apply even though you demolish the building. The election locks in the building s basis. You can continue to depreciate the building after its demolition because it s the GAA itself that is the

depreciable asset, not the building. Some important caveats apply, though. First, you generally must make the GAA election in the year that you acquire the property. (The election isn t available for properties that you buy and sell within the same year or for properties you don t use in a trade or business.) In addition, you want to be fairly certain that you will indeed completely demolish the building in a subsequent tax year. Once you place a building in a GAA, you forfeit the option to recognize a partial disposition of the building down the road, because the regulations don t allow partial dispositions of assets placed in a GAA. (See The tax benefits of partial dispositions. ) THE ROLE OF VALUATIONS When you buy a parcel that includes both land and a building, you ll need to allocate the purchase price between the two elements according to their relative fair market values. Experienced buyers know that sellers usually take a different position regarding the preferable allocation. Buyers generally want a higher allocation to buildings because the depreciation would reduce their taxable income in the future. Conversely, sellers seek to allocate more of the purchase price to non-depreciable land because a depreciated building could subject the seller to higher tax rates under the recapture rules. In such circumstances, consider obtaining an independent third-party valuation of the property, with separate values assigned to the land and the building. As the buyer, you might also want to obtain a cost segregation study to identify and reclassify any personal property elements in the building. PLAN AHEAD As property values continue to rise, opportunities to purchase parcels with older buildings ripe for demolition and development become increasingly appealing. By working with your tax advisor to plan ahead, you can enjoy depreciation deductions for both the demolished building and its replacement. Sidebar >> The tax benefits of partial dispositions Before the final tangible property regulations, renovation projects generally came with some unwelcome tax consequences: You couldn t write off the remaining basis of any replaced components. Instead, you had to capitalize and depreciate both the replaced and the replacement components. You couldn t take a loss on the old component unless and until you took a loss on the entire building. The final regulations allow taxpayers to elect to apply the property disposition rules to a building component. So you now can claim a partial disposition on the replaced component and take an immediate deduction on its remaining basis. You also might be able to avoid recapture tax down the road. When you sell the building, you could be subject to a capital gains recapture tax of 25% of the depreciation you ve claimed in the building. If you make the partial disposition election, you reduce the building s accumulated depreciation and, in turn, the recapture tax. 2

Real Estate Review DON T GET CARVED UP Dealing with nonrecourse loan carveouts Nonrecourse loans draw many borrowers because the arrangements can shield them from personal liability. But they don t always provide that protection. If borrowers violate carveouts in the loan document, they may be left with full liability. Here s how to use negotiations to handle nonrecourse loan carveouts and to minimize personal liability. NONRECOURSE LOANS IN A NUTSHELL Under a nonrecourse loan, the lender agrees not to hold the borrower personally liable on the loan. The result: The lender s only recourse in the case of default lies in the collateral generally real estate. In other words, your lender s only recourse is to seize the property that secured the loan. When you surrender the property, the transaction is generally treated as a sale to the lender for the amount of debt. Your capital gain or loss equals the difference between the amount of outstanding debt and your adjusted tax basis in the property. For example, if outstanding debt is $1 million and your tax basis is $700,000, your taxable gain would be $300,000. A discharge of nonrecourse debt doesn t result in any taxable cancellation of debt income because the lender has no right to pursue other corporate or personal assets. 3 CARVING EXCEPTIONS When negotiating a nonrecourse loan, the lender may include specific exceptions known as carveouts that will nullify the personal liability restriction. Common carveouts include: The borrower s fraud, Misapplication of insurance proceeds, Waste, or Intentional destruction of property. These are just some of the carveouts used today; the scope of carveouts has expanded over the years. Carveouts can also include bankruptcy filings, the failure to pay mechanic s liens or real estate taxes, and environmental damages. Proceed with caution, however: Few court cases have directly tackled the enforceability of carveouts in nonrecourse loans or the lender s ability to accelerate foreclosure and recover the full amount of the loan where a party violates a carveout. And remember that each state may interpret nonrecourse loans and their carveouts differently. NEGOTIATING TIPS So what should you do before entering a nonrecourse loan? Evaluate and negotiate any carveouts in the loan documents. Look for overly broad language and negotiate to make it as narrow as possible. Make sure to clearly define potential causes of default. Also watch out for springing guarantees. These trigger a guarantor s obligations to pay the full amount of debt, as opposed to only the damages proximately caused by a breach of a carveout. You ll want to limit such guarantees to intentional acts, excluding mere negligence or mistake. For example, limit a carveout for waste to intentional waste only. REVIEW THE CONTRACT AND IDENTIFY EACH CARVEOUT WITH YOUR ATTORNEY. Ideally, you ll want to try to limit liability under both springing guarantees and carveouts to only damages caused by the prohibited act, instead of the entire debt deficiency. Finally, negotiate for the inclusion of notice and cure periods to secure the opportunity to take corrective action before acceleration and foreclosure. Once you close on the loan, avoid taking actions that could violate carveouts, especially those that might affect the value of the collateral securing the loan. If you sell the property and the buyer assumes the loan, negotiate a release from liability so you aren t exposed to potential liability for the buyer s acts. (Note that

nonrecourse agreements frequently include a carveout requiring written consent from the lender before transferring mortgaged property.) REVIEW WITH AN EXPERT So what should you do to protect yourself from personal liability before entering into a nonrecourse loan? First, review the contract and identify each carveout with your attorney. It s also advisable to consult a financial expert who can crunch the numbers. This will help you estimate damages in the event of a loan carveout provision breach. ARE YOU READY FOR AN EMERGENCY? If you re a property manager, you have a lot on your mind, just dealing with the daily minutiae that never seem to let up. But you also have to think about the bigger challenges that lurk out there natural disasters, terrorism and other emergencies, such as the loss of heat in the dead of winter, a gas leak or flooding. You can take some steps now to minimize the fallout for both you and your tenants. too not just to identify potential risks but also to share information and coordinate emergency response if needed. Your insurer can provide valuable input, as well, based on its past experience with similar customers. Finally, establish a relationship with your local first responders. Get their advice on how to prepare for emergencies and ask them to review your emergency response plans. educate them on their roles and to assure them that you re on top of emergency planning. You might even want to involve vendors to determine whether they d be able to provide the resources you need postemergency, such as repairs, cleanup and technological services. Make sure you have the necessary support lined up ahead of time, or you could be in for a long wait. IT TAKES A VILLAGE Don t wait until an emergency strikes to think about how best to respond. Instead, identify and prioritize your risks now. This requires consulting with a variety of sources. Start by talking to your tenants to discover any particular risks associated with their general operations. Check in on tenants on a regular basis so that you can stay on top of situational risks, such as the recent termination of a hotheaded employee or an employee who has taken out a protective order against another person. Try to learn about the tenants and businesses in neighboring buildings, GAME PLAN IT Among other things, first responders can help you run through drills to assess how your plans would work in a real-life emergency. Ask them to attend regular meetings with your internal response team where staff is put in a position of making decisions and implementing plans under pressure. In addition to identifying gaps and failure points, doing so will help your team and the first responders get to know each other and familiarize responders with the building, which should make for a smoother response in an actual emergency. Have tenants participate, both to PREPARE FOR THE WORST Maybe you ve been lucky up to this point and have never experienced an emergency, but you can t let your good fortune thus far lull you into complacency. Be sure to talk to your financial advisor he or she can help identify and quantify risks, and make sure your insurance coverage is adequate. Think through your risks and plan accordingly you owe it to yourself and your tenants. 4

Real Estate Review EFFECTS OF POTENTIAL TAX REFORM ON THE REAL ESTATE INDUSTRY Now that the dust of a contentious presidential election cycle is settling, tax reform may be more likely in 2017 than in past years. There are currently two plans we can look to for guidance on reform: President Donald Trump s revised plan and the House GOP plan. Both contain significant reductions in individual and corporate tax rates, limitations on deductions and simplification of administration of the tax system. While the plans are summaries of proposed tax reform and give us a basic understanding of their intentions, neither plan answers all our questions concerning implementation for taxpayers. Provisions of each proposal may affect the real estate industry in the long term, including the current write-off of acquired property, limitations on the deductibility of interest expense and the overall reduction of tax rates. TAX RATE REDUCTION Arguably the most important potential tax reform for both individuals and corporations is tax rate reduction. The president s and the House GOP tax reform plans both call for significant tax rate reduction for both individuals and corporations. The two plans call for reduced corporate tax rates of 15 percent and 20 percent, respectively. Under the president s plan, business income earned by pass-through entities would also be taxed at a 15 5 percent rate. Under the House GOP plan, income from pass-through entities would be taxed at a maximum rate of 25 percent. It s not clear whether income from rental real estate would qualify as business income under the president s plan. Both plans call for a repeal of the corporate alternative minimum tax (AMT). To reduce business tax rates, the president s plan calls for the elimination of most business deductions and credits, except the federal R&D credit. The House GOP plan also calls for reducing business deductions, including the deduction for interest expense in excess of interest income. However, there is a proposal under the House GOP plan to allow immediate write-off of investment of both tangible and intangible assets, including property. REAL ESTATE COMPANIES CAN REVIEW POTENTIAL REFORMS NOW TO PREPARE FOR SCENARIOS THAT COULD BE AHEAD. CARRIED INTEREST The president s plan proposes altering the tax treatment of carried interest. Carried interests are commonly used when forming a real estate development partnership to compensate a promoter for services rendered to the partnership with an interest in the partnership. Ultimately, the promoter can be taxed using favorable capital gains tax rates. If carried interest taxation rules are changed, promoters may be required to pay taxes on receipt of carried interests using ordinary tax rates. PROPERTY DEPRECIATION The last rewrite of the Internal Revenue Code (IRC) in 1986 extended depreciable lives for commercial real estate from 19 years to 31 years. Depreciable lives now are set at 39 years for most properties acquired in 2017. As mentioned above, the House GOP plan includes immediate expensing of all acquisitions of tangible and intangible property. Therefore, commercial buildings and other real estate development would be fully written off in the year acquired or placed in service. A similar provision is included in the president s revised plan, which proposes full expensing of plant and equipment for manufacturers. But the plans also call for the elimination of deductions for net interest expense on debt. Thus, interest expense deductions would be disallowed to the extent they exceed the taxpayer s interest income. Taxpayers would have to weigh the benefits of the simplification of an immediate write-off of newly acquired property against the loss of tax

deductions for interest on the debt used to acquire the asset. Net operating losses resulting from the immediate expensing of commercial real estate would be able to be carried forward indefinitely, with no carry back allowed. MORTGAGE INTEREST DEDUCTION Currently, mortgage interest payments for acquisition debt up to $1 million and $100,000 in home equity debt are deductible. The president s plan calls for limitations or phaseouts of itemized deductions at $100,000 for single filers and $200,000 for married filers. The House GOP plan calls for the elimination of nearly all deductions except the mortgage interest deduction and charitable contribution deduction. ALTERNATIVE MINIMUM TAX/NET INVESTMENT INCOME TAX Under both the president s plan and the House GOP plan, AMT and the net investment income tax (3.8 percent on net investment income) would be repealed. LOOKING AHEAD: WE LL BE WATCHING While it is very early in the process of rewriting the IRC, the prospects of reform continue to grow stronger with a Republican White House and Republican control of the House and Senate. Real estate companies can review potential reforms now to prepare for scenarios that could be ahead. We will continue to monitor these preliminary tax reform plans, as well as others that may arise, in the coming months as the process unfolds. CALL THE HHM REAL ESTATE ACCOUNTING TEAM FOR MORE INFORMATION KYLE C. CHRISTENSEN CPA, CCIFP 423. 702. 7270 KCHRISTENSEN@HHMCPAS.COM TRIP FARMER, CPA, CCIFP 423. 702. 8148 TFARMER@HHMCPAS.COM TRAVIS HORTON, CPA, MBA 423. 702. 7268 THORTON@HHMCPAS.COM 1200 MARKET STREET, CHATTANOOGA, TN 37402 423.756.7771 WWW.HHMCPAS.COM 6363 POPLAR AVE., STE. 405, MEMPHIS, TN 38119 901.585.0012 WWW.HHMCPAS.COM 6

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