Land for Love and Money

by Reid Lance Rosenthal

  For now, however, it is what it is. As this book goes to press there is political screeching about changes in rates, the expiration of President Bush’s Tax Cuts, and a host of other tax variables. This uncertainty is not helpful to the real estate market or to the economy in general. Uncertain people are not great at making decisions. It’s a fact of life. In all likelihood, portions of this chapter will be outdated come January 1, 2013. I plan to update these volumes on the Land for Love and Money website (www.landforloveandlovemoney.com) according to its terms, and in future printings of these volumes, so that they’re always fresh and current, known as “evergreen” in the publishing industry.

  If tax is your biggest expense in life and in real estate, it makes sense that you should pay attention to the tax effect of your decisions regarding the likely largest asset in your portfolio, i.e., the real estate you already own, and land and real estate that you plan to purchase or sell. I’m amazed at how few people take into account the dramatic tax whack to their land and real estate oriented revenues. Even at the lowest 15% capital gains rate, the tax that you’re paying on your gain is 9% higher than the commission you paid your realtor (assuming you’re represented) on that portion of the transaction.

  The government is now talking about additional real estate taxes. A hidden 3% tax when you sell real estate that would go to Obamacare, a potential national sales tax on real estate, and a host of other discussions. All these also remain uncertain. Many have been voiced for decades. Other than to make you aware that there are potential additional tax gotchas being discussed for the future, they are not worth your time or mine. More relevant are the basic types of tax paid under current law on real estate, real estate transactions, and real estate income, whether on raw or improved land. If your plan for your property does not integrate tax projections—do a new plan.

  I want to emphasize, I’m not a CPA or tax expert. Everyone’s tax situation is different just as everyone’s real estate is different. Even if your only land and real estate asset is a lot with a house, it is worth a few hours discussion with your CPA or tax preparer to review tax savings you are probably leaving on the table, and the tax effect of decisions you may make in the future.

  A Menu of Rates for a Smorgasbord of Matters—

  Looking at the Big Picture

  Capital Gains—The Best

  When you sell a property (and if you are not a “dealer”), and you have held the property for at least a year and a day, any profit is called long-term capital gains. The tax rate is 15%. The taxable gain may be more or less than the cash you get at the closing table. If there is taxable gain for which you don’t receive cash, it is known as “phantom income.” There are other factors such as depreciation, mortgage and similar deductions, certain exclusions as to part of the gain for married couples or single folks if the sale property is your primary residence—up to $250,000 for an individual and $500,000 per couple. A sizable tax savings.

  There’s Land and Structure—And Other Stuff

  All real estate has certain assets other than land or structures which will not last the life of the real estate. They fall into a number of classes. Rather than bog us down with all of them, I will just term this group of real estate related assets “personal property.” Personal property can be depreciated. In other words, it has a finite useful life in the eyes of the tax man. Each year it is worth less. The “decrease in remaining useful life” becomes a deduction. Certain types of assets have a three year depreciation life, some five, some seven. The pro-rata annual depreciation that you take as deduction reduces your taxable income.2

  As an example, let’s say you have a $7,000 hot tub. Its useful life is seven years. In the most simplistic terms, your accountant is depreciating that asset $1,000 a year. If you are in a 20% tax bracket, that is saving you $200 in taxes a year. However there’s a flipside to the depreciation benefit. When you sell your property, good advisors will segregate capital gains assets from the depreciable assets and they’ll be listed separately in the contract. As a seller you always want to keep that number as low as possible. Using our hot tub example if you owned the property for five years before you sold, you’ve depreciated the hot tub $5,000. If the hot tub in your sale is valued at $5,000, you have a $3,000 phantom income depreciation recapture. You don’t get 15% capital gains on that “gain”. You pay at the highest ordinary income rate. As a fun aside—if you have a medical condition and a bona-fide certification from a doctor that a hot tub, or similar improvement, is prescribed for that condition—you can deduct its purchase as a medical expense. Ask your CPA!

  The larger your piece of land, the more personal assets you might have. Think of gates, fences, entryways, equipment, machinery and sprinklers that “run with” or are sold with the land and a host of other items. I’ve actually seen real estate transactions where, if you segregated out the tax on the depreciation recapture, it was higher than the capital gains tax on the gain of the property, mostly because somebody was lazy, didn’t do their homework or take the time to properly assess the personal property part of the transaction. This can mean significant dollars out of your pocket.

  The buyer wants the highest possible value on personal property. A buyer should list out, or at least aggregate, the legitimate value of personal property as an item separate from the land at the time of purchase. Why? Because the purchase price is what it is. That means the greater the value attributed to personal property the less the value or cost of the land and real estate. When it comes time to sell, less cost in the land and real estate increases capital gain that is taxed at a lower rate. This is another example of the “PPPPP” rule.

  Remember that buyers and sellers are working from opposite extremes when it comes to personal property. It will take some negotiation, the final result has to be legitimate and substantiated, but in over forty years of real estate I’ve never seen a deal lost over the valuation of personal property.

  If the Feds Don’t Get You, the Locals Will—

  Cash Flow Is as Much Savings as Income!

  Real estate carries with it an ugly fact of life. Property taxes. Property taxes in some locations can be astronomical. A $1 million property in Connecticut on several acres could easily be paying (particularly in the southern part of the state), $30,000 or more in property taxes per year. That same property, if you could pull a Harry Potter and apparate it to a more remote region in the Midwest or the Rockies, would be subject to property tax—depending on location—of under $5,000. If the property has acreage enough to generate minimum agricultural income, usually about $1,500 year (though that can vary from locality to locality) it can qualify for Agricultural Exemption, and that $5,000 tax bill will be less than $2,000+/- year.

  Remember our discussion about investigations into the area in which you want to purchase property? Add property taxes to your list of what to check out. Property taxes are an income mainstay of municipal governments that are mostly starved for cash. They’re based on the localities’ appraisal—called an assessment—of the value of your property, times a rate that is called the millage or mill rate. I’m going to resist the temptation to eat up many pages on this topic. Suffice it to say that the higher the assessment, and the higher the mill rate, the more tax you pay. Your property taxes go to municipal administration, municipal services, schools and a host of other services. More and more of your money is also going to bloated pension obligations—paying the costs of workers who are no longer even in “your employ.”

  An extra bit of land and a little effort to create bona-fide income from that land can save you a multiple of the actual income in property taxes. A check you don’t write is a check you receive. The old colloquialism “a penny saved is a penny earned” applies. Savings on property taxes is like getting a check. Improvements like fencing to create or enhance pasture, starting a commercial vegetable garden, feeding the neighbor’s horse, can create a level of income qualifying you for the exemptions. Your land, no matter how small the tract, is beginn
ing to work for you—generating and/or saving significant cash flows.

  Dealer Status—Not a Good Thing

  People who “flip” multiple properties in short terms (under one year) as their livelihood, hold properties for less than a year, sell multiples of lots as a developer, or homes as a builder are regarded as “dealers” by the Service. Cash-strapped state governments have lately been trying illegitimately and mostly unsuccessfully to tag others who are in no way dealers with “dealer status” because like the Feds, the state gets higher tax revenues from a dealer transaction than from a capital gains transaction. Some startling stories on that in Volume Two.

  Talk to your CPA and attorney if you’re involved with more than one piece of real estate so that you never have to defend against a governmental claim, no matter how bogus, that you are a dealer.

  Work the Land—Make the Land Your Partner

  Work the tax angle of your real estate. Ask your CPA what tax benefits your real estate can generate for you. If you have a home office in the ranch or farm house, or any residential structure, it can save you tax. If your home office is two hundred square feet, and your home is two thousand square feet, very simply speaking, you can get certain benefits on 10% of your home expenses.

  Thinking of putting in an improvement? Check its depreciable life. Not all, but a portion of the improvement can be paid for over time with depreciation tax benefits. But, remember the recapture.

  If you have several acres or more you can form a LLC or S-Corp. and put a portion of the land under its name. Be sure this is not a default under your mortgage or any other document or covenant on the land. If your entity is legitimately “for profit”, trying to make income and profit off the land through pasture, crops, etc, then there are expenses that you can write off via the LLC related to those efforts that you could not take as simply residential. This can be far more advantageous than merely allowing the acres to sit there as residential. Review your plan with your CPA! Basically, you’ve taken a portion of a personal asset, and converted it to a business asset. There are benefits to business assets and running a business. Besides money, there’s a love thing going on here, too!

  Land that you care for, improve, become involved with, nurture and put to work for you, becomes a part of you, creates a bond, a mingling of energy, and for most people a deep sense of satisfaction.

  Your own vegetables always taste best!

  Tax with a Twist

  There are bewildering assortments of provisions in the Code that allow you to shelter gain when you sell a property at a profit. These are tactical, advanced, and complicated. Always employ a competent attorney and CPA when employing these mechanisms.

  The “Easy” One—The 10313

  The first is what’s known as a 1031 tax-deferred exchange. The seller takes all or part of the gain from the sale of one property and invests it into the purchase of a similar “like kind”4 property. Whatever amount of the gain you invest in the new property is not taxable, that is until eventually the property is sold and you don’t buy another. Then tax is owed on the 1031 gain or gains that were previously deferred. Note this—your personal residence will not qualify for 1031 treatment.

  When writing a real estate purchase offer or sales contract, even if neither party contemplates a 1031 exchange or other tax-deferred mechanism, it’s worthwhile to provide in the contract that either party may invoke a tax-deferral strategy so long as that election is at no cost to the other party. Life happens. “PPPPP”. Is it worth taking one minute to add a paragraph of boilerplate language beneficial to buyer and seller (even if its use is not contemplated), for a potential tax savings in the thousands, hundreds of thousands or even millions of dollars on a large property? You bet it is. “PPPPP”.

  The Facilitator Is Your Friend

  An integral part of a 1031 and other similar types of exchanges is the exchange agent, also known as the facilitator. They handle all the documents. They take title to the exchange property, even if it’s just for minutes, in the transition of the deed from buyer to seller. They receive and disperse all monies. All of the exchange mechanisms have strict time limits. In a 1031 exchange, you have forty-five days after closing to identify up to three potential like-kind replacement properties. They must be designated in writing via the facilitator. You have one hundred twenty days after the expiration of the forty-five day designation period to close on one or more of the replacement properties. In the meantime, the sales proceeds from the property sold are held by the facilitator. Cash not used for the purchase of the exchange property is returned to you as “boot”. The cash never passes through your hands. Nor does the deed. The deed of the property sold goes from the facilitator and the facilitator gives you a deed to the new land.

  Sound confusing? In reality it’s not, but if you’re not familiar with it, your first several exchanges can feel bewildering. Again, make sure you have a good team assembled that includes competent tax and legal counsel. They will know the good facilitators and exchange agents. The better your exchange agent, the smoother the transaction. And, the more secure your tax deferral.

  From Twisty to Twisted

  There’s an even more complicated exchange animal in the deferred tax zoo. These are called Starker Exchanges. If you really want to have your eyes cross, dig into Reverse Starker Exchanges. That’s when you buy going backward. Starker exchanges work well in situations where the replacement property cannot be purchased within the shorter time guidelines of the 1031. A good example: You are selling your land and residence, but instead of buying a new piece of land with an existing residence you want to build your dream house. Obviously your dream house can’t be built in the approximate one hundred and sixty five day time allowed by a 1031. The Starker Exchange through various mechanisms, also involving a facilitator, extends that time frame out significantly. There is more paperwork, but it can buy you up to two years to use the funds on which you wish to defer taxes.

  Reverse Starker exchanges are not used often, but there are situations in which they are the perfect solution for a seller who has a large real estate gain, wants it sheltered and has a specific real estate target in mind for acquisition, but the purchase can’t be completed for one reason or the other for an extended period of time. There are exchange mechanisms which entail purchasing the exchange property prior to your sale of the property generating the gain you are deferring. There are several good websites on the reference page at the end of Volume One, if these concepts intrigue you and you wish to learn more about them. Again, I emphasize—no one should attempt a 1031 Exchange, a Starker Exchange, and particularly a Reverse Starker Exchange without professionals on your team who are familiar with those transactional processes.

  The King of Them All—Conservation Easements

  Section V of Volume One is dedicated entirely to conservation easements. There will be sections on conservation easements in all the volumes of Land for Love and Money, and the sections will be updated on the Land for Love and Money website and new editions of these volumes from year to year as conditions warrant.

  Conservation easements can save you money on federal income tax and estate tax and, in certain states, on state income tax. In other states an easement can actually generate tax credits, the most valuable form of tax benefit.

  A deduction lessens your taxable income and therefore lowers your tax.

  A tax credit applies dollar for dollar against the tax bill you owe.

  Credits generated by easements are highly transferable and salable in certain states. In Colorado, they can command up to 80 cents per dollar of credit. You may shake your head, but think about it. Somebody who’s living in Colorado and has a high Colorado tax liability can buy the tax credit from the Grantor of a conservation easement who can’t use it, pay 80 cents on the dollar in December and four months later, in April save 20 cents of tax for each dollar of credit they purchased. 5% a month or 20% over four months is not a bad return. Again, make sure you have people on your team w
ho know the ins and outs. Treatment of conservation easements, deductions, and tax credits vary widely from state to state.

  Since the 2003 Bush Tax Cuts, conservation easement grants have received extra favorable treatment. This will likely diminish, or may perhaps revert to the old pre-Bush levels of benefit in January 2013. That too is discussed in Section V.

  It Doesn’t Happen over Night

  Conservation easements are not things that are in place at the snap of a finger. You must have held the property for a year and a day to get full market value for the donation. It takes time to locate the proper Grantee and negotiate the easement document. The negotiation of that document is critical not only to the success of the easement, but to the future value and salability of the property you’re going to be encumbering with the easement.

  Conservation Mineral Experts and Field Researchers

  or Hydrologists, Geologists, Biologists! Oh My!

  There are a number of consultants who come out to check all aspects of the property, (kind of the due diligence of the Grantee.) In certain states, there will be mineral experts because mineral rights affect the drafting of the document and the grant. There will be field researchers who put together a baseline study indexing all of the resource attributes the property has as of a specific point in time. The baseline study is the document by which the Grantee monitors change on the property in perpetuity. In some ways it’s also the control mechanism to make sure you don’t do what the easement prohibits. If the property is collateral for loans, the banks or other lenders will have to subordinate to the easement for the easement to be effective. That also generally takes time to process or negotiate (unless you built the provision into your loan docs at closing). “PPPPP”!