Adventures in 199A for Real Estate Investors


Farhad Aghdami and I presented “Getting Your Hands Dirty with Real Estate Investors” at the 52nd annual Heckerling Institute on Estate Planning last Thursday, January 25, 2018.  I caused a bit of a stir in my summary of new Internal Revenue Code Section 199A as it applies to real estate, and the accountants in the room corrected me afterwards.  This was just one of many examples of how all tax professionals need to come together to understand the most expansive tax legislation we’ve had in decades.

At issue is the language in Section 199A(b)(2)(B)(ii) that gives pass-through entities that pay no W-2 wages the ability to deduct the lesser of 20% of their qualified business income or “2.5 percent of the unadjusted basis immediately after acquisition of all qualified property”.  Section 199A(b)(6) defines the term “qualified property” to mean, “with respect to any qualified trade or business for a taxable year, tangible property of a character subject to the allowance for depreciation under Section 167” (emphasis added).

In our presentation, I emphasized that the 2.5% calculation only applies to tangible property depreciable under Section 167, and implied that this did not include real estate holdings.  But, thankfully for our real estate investor clients, this was only approximately 20% true and 80% false.

Real estate consists of both land and improvements.  Estate planners are accustomed to the word “tangible” as it applies to tangible personal property – meaning, items that can be picked up and moved around.  As accountants know, however, improvements such as buildings, parking lots, docks, swimming pools and the like are also tangible, and they are subject to wear, tear and decay, which means that these improvements are depreciable under Section 167.  Because land is not a wasting asset (although people living on the coastline may disagree), it is not depreciable under Code Section 167.

Treasury Regulation 1.167(a)-2 clarifies that the depreciation allowance “in the case of tangible property applies only to that part of the property which is subject to wear and tear, to decay or decline from natural causes, to exhaustion, and to obsolescence.  The allowance does not apply to … land apart from the improvements or physical development added to it.”

The end result is good news for real estate owners, who often hire management companies to manage the real estate assets and, as a result, can pay very little in W-2 wages to employees.  Consider the following example:

Bob Sponsor owns a 50% interest in a commercial real estate property through an LLC.  Bob’s share of the rental income of the LLC is $2,000,000.  The LLC pays no W-2 wages, rather, it pays a management fee to an S corporation that Bob controls.  The management company pays W-2 wages, but it breaks even, passing out no net income to Bob.  Bob’s share of the total unadjusted basis of the buildings and improvements immediately after acquisition of the commercial property is $15,000,000.  Bob is entitled to a deduction of $375,000, which is the lesser of: (a) 20% of qualified business income of $2,000,000 (or, $400,000), or (b) 2.5% of the unadjusted basis of $15,000,000 (or, $375,000).

There is a rule of thumb in the real estate world that 80% of the purchase price of an improved property is attributable to the building, and only 20% to the land.  Hence, the reason for the statement above that I was only 20% correct that the 2.5% calculation does not include real estate.  However, this rule of thumb should not be relied upon for purposes of the 2.5% calculation or for depreciation, especially in populous areas where the value of the land may be higher than the building that sits on it.

In a 2017 Tax Court case called Nielsen v. Comm’r, T.C. Summary Opinion 2017-31, the IRS challenged a taxpayer’s allocation of the purchase price to land versus buildings, and the Tax Court sided with the IRS, finding the Los Angeles County tax assessor’s value of the land to be more reliable and persuasive than the taxpayer’s own estimate.

If the purchaser of real estate does not want to pay for the commission of a separate appraisal of the land being purchased, separate and apart from the structures on it, then the real estate owner should at least rely on the county tax assessor’s allocation, applying to the purchase price the same land-to-total-value ratio arrived at by the assessor.

The purchase price or “acquisition cost” of buildings and other improvements will be critical to the calculation of a real estate pass-through entity’s Section 199A deduction.  As a result, it will be more important than ever for accountants and business owners to more accurately allocate a purchase price to land versus buildings and other improvements.


Congress Passes Tax Reform

The legislation formerly known as the “Tax Cuts and Jobs Act” (the “Act”) has passed the House and Senate and is headed to the President for signature.[1]  Here are some of the ways the Act will impact estate planning.

Increased Exemptions
The Act will increase the estate, gift and generation-skipping transfer (“GST”) tax exemptions to $10 million per person, adjusted for inflation.  Beginning January 1, 2018, the exemptions will be $11.2 million per person and $22.4 million for a married couple.  The tax rate remains unchanged at 40%, and the GST tax exemption is still not “portable” between spouses.  These exemptions will expire at the end of 2025 and will return to current levels (adjusted for inflation) unless Congress acts to make the change permanent.
Here is our planning advice:

  • Do not rely on these exemptions remaining permanent.  If you have a taxable estate even at the increased exemption levels, consider making gifts in 2018 of your increased exemption amount.
  • If you have an existing trust that is not fully GST exempt, consider making a late allocation of your increased GST tax exemption to such trust in 2018.
  • If you are married and your estate plan utilizes your GST tax exemptions by creating “Descendants Trusts”, “Dynasty Trusts” or other trusts for the lifetimes of your children, grandchildren and more remote descendants, we should examine how your assets are titled to ensure that both spouses have assets up to the new exemption amounts in their own names.
  • Although rare, some of our clients have estate plans that distribute the estate tax or GST tax exemption amount directly to children and/or grandchildren, thus skipping the spouse or in some cases, skipping children.  If your plan includes this element, you should consider putting a cap on the amount passing pursuant to this provision, as you may not have intended for the full $11.2 million to skip your spouse or children.

Annual Exclusion from Gift Tax
The Act makes no changes to the annual exclusion from gift tax, but we note that it has increased for inflation to $15,000 for 2018.  You can give any one person $15,000 without having to use any of your new $11.2 million gift tax exemption, and without having to file a gift tax return.  If you are married, your spouse and you can give $30,000 to any one person in 2018, but a gift tax return will be required to report gift-splitting if the gift is made by only one spouse.

Charitable Contributions
Under the Act, you can donate cash to public charities and operating foundations and receive a charitable contribution deduction for up to 60% of your adjusted gross income (“AGI”).  The current limit is 50%.  The limit for contributions of appreciated property such as stocks and real estate remains unchanged at 30% of AGI, and the limit for contributions to private foundations of 30% of AGI for cash and 20% of AGI for appreciated property also remain unchanged.
Because your income tax rate will likely be reduced in 2018, your charitable contributions may have more overall impact in 2017.

529 Plans May be Used for Elementary and Secondary Education
The Act amends Section 529 of the Code to allow certain amounts from 529 plans to be used for elementary and secondary education. Owners of 529 plans will be able to distribute up to $10,000 per child per year for enrollment or attendance at an elementary or secondary public, private or religious school.  If a child has multiple 529 accounts created by parents and grandparents, the amount distributed to the child from all accounts in a calendar year cannot exceed this $10,000 threshold, so coordination among family members will be required.

Planning opportunity:  Some clients hold back on funding 529 accounts to the maximum amount permitted under state law because of the prior limitations on what was considered a qualified educational expense.  Now that the use of 529 accounts has been broadened by the Act, clients should consider making increased gifts to 529 accounts.  If you make the election to use 5 years’ worth of annual exclusions, you can fund a 529 account in January 2018 with $75,000 per recipient (or $150,000 per recipient if you are married).  This 5-year election must be made on a timely-filed gift tax return.

Pay Estimated State Income Taxes for 2017 before Year End and Pre-Pay Property Taxes
The Act limits the amount of property taxes and state and local income taxes you can deduct to $10,000 per year.  As a result, you should pay all of your estimated state income tax for tax year 2017 before year-end.  If you have a property tax bill due and payable, or if you can pre-pay any of your 2018 property taxes, you should also make these payments before year-end.  Note, however, that if you are subject to the alternative minimum tax (“AMT”), these deductions may not be helpful to you.

Congress anticipated that some of us may try to prepay our 2018 state and local taxes, and it closed that loophole by disallowing deductions on your 2017 income tax returns for prepaid 2018 state and local taxes; however, property taxes are not mentioned and should be able to be pre-paid if the local jurisdiction allows it.

Retirement Accounts
It is worth noting that the Act makes no changes to retirement accounts.

Please Contact Us
We hope to meet with you in 2018 to discuss ways to take advantage of the increased gift and GST tax exemptions.  Please contact us to schedule an appointment.

Thank You
Thank you to those of you who responded to our charity poll.  Here are the results:

  • 47% to Washington Area Women’s Foundation
  • 28% to Tahirih Justice Center
  • 25% to Lucky Dog Animal Rescue

Each organization will receive a meaningful check from us in the coming days.

Happy holidays, and best wishes for a prosperous, peaceful and happy New Year!

Your team at Birchstone Moore

[1] The official name of the new law will be: “To Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018”.

Ethical Wills-Antidote to the Rich Fool

Parable of the Rich Fool

In the Bible, Jesus tells the parable of the “rich fool” after one of his followers requests help convincing his brother to share an inheritance.  The rich fool was a man who had such an abundant farm, he decided to tear down his existing barns and build bigger ones to store all the grain he had harvested.  The rich fool went to bed happy with this decision, thinking he had ample goods built up to allow him to eat, drink and be merry for many years.  But, alas, that was the man’s last night on earth.  He was a fool for treasuring his things, and not his blessings.Blog 2- Image.jpg

In the Jewish tradition, the “Zava’ah” is a document used by Rabbis and laypersons to pass ethical values from one generation to the next.  President Barack Obama famously wrote this legacy letter to his daughters on the eve of his first inauguration, January 18, 2009.  These are examples of Ethical Wills – the dissemination of knowledge, rather than money and things.

As estate planners, we focus our attention almost exclusively on our client’s material possessions, rather than their values.  But we are uniquely positioned to set our clients on a path to creating their true family legacy – a set of core, shared beliefs that are passed along the generations.  We can and should introduce our clients to the concept of an Ethical Will.

An Ethical Will is not a legal document.  In fact, it should be written by the you, the client, not your attorney.  An Ethical Will can take many shapes – a spiral-bound notebook, a Word document, a scrapbook, a voice recording or a professionally-produced video.  The purpose of an Ethical Will is to communicate with your children, grandchildren and other loved ones your beliefs, lessons learned, family history, expressions of love and gratitude.  An Ethical Will can even end a long-held grudge by expressing forgiveness.

Getting Started

Without a doubt, the most difficult thing about an Ethical Will is starting.  The second hardest thing may be knowing when to stop.  If you allow yourself a quiet space and time to think about an Ethical Will, your thoughts are likely to spin off in a thousand different directions.  In your lifetime, hundreds upon hundreds of events have shaped you.  The tapestry of your family history is complex and not easily unraveled.  A blank canvas is daunting.

My former colleague, David Rutstein, has written and spoken extensively on the topic of Ethical Wills.  When clients are interested in embarking on this noble mission, I give them Dave’s materials as a starting point.  Here are the potential subjects he suggests for an Ethical Will:

  1. Introduction. Briefly state why you are creating the Ethical Will.  What is your objective?
  2. Statements of Value. What ideals are most important to you?
  3. Lessons Learned. What significant experiences or relationships have shaped you and how?
  4. Major Influences. What people and events have been meaningful to you and why?
  5. Thoughts about Religion.
  6. Family Lore. What family stories need to be memorialized for posterity?
  7. Advice. What do you wish you had been told when you were young?
  8. Personal. Specific expressions of love, gratitude, appreciation and forgiveness.
  9. Blessings and Hopes. Your hopes and wishes for the future.

Expanding on any one of these topics is better than nothing.  So is an unfinished draft.  Many people who have successfully written Ethical Wills have done so bit by bit rather than in one sitting.  They might carry around a notebook and jot down ideas or stories as they think of them.  After some time, they might have enough recorded thoughts to identify common themes that can help them write a beginning, middle and end.  Others may block off a whole day and force themselves to start and finish by the end of the day because that is how they work best.  Know yourself, and set a goal that is realistic for you.

Use Examples and Stories

As with performance evaluations at work, the use of examples is more impactful than making broad generalizations.  If you are trying to impart the values that have best served you during life, you might tell stories revealing the traits you admire most in others – the time your friend stuck by you, the day your spouse used humor to diffuse a tense situation, the nanny who went out of her way to treat your siblings and you fairly.  Just like religious parables, stories will help make the lessons memorable.

Be Yourself

Don’t use an Ethical Will to try to remake your image into the saint you always wanted to be.  If you are known to have a flaw, admit it and explain how that flaw has impacted you.  Use humor if that comes naturally to you.  The Ethical Will is also an opportunity to explain yourself.  If you are famous for always wearing pearls or a bowtie, explain why you have done so all these years.  If you have a family motto (ours is “Southern hospitality meets Western adventure”) explain it – even if you think everyone already knows why it is the family motto.  Like the game of telephone, things get lost in translation.

Be Nice

While you may use an Ethical Will to discuss your own flaws, take care not to point out those of others.  If you hurt someone’s feelings, there is no opportunity to reconcile after you are gone.  Generally, it is best not to single out any one family member in the Ethical Will, unless they are part of a family story (see above).  If you talk about how proud you are of grandson Johnny for his artistic talents, your granddaughter who secretly believes she is a better artist than Johnny may never forgive you.  If you think you might devote a paragraph to each child or grandchild, you invite scrutiny over things you could never imagine – “she used more words in my paragraph” or, “he was funny in Jane’s paragraph but serious in mine, so he must like Jane/me better”.  An Ethical Will should serve up inspiration, not criticism.

Now or Later?

Once you have finished your Ethical Will, do you read it or discuss it with your family, or do you give it to your lawyer to be revealed after you’ve passed away?  That is a personal choice, but most experts agree that the closest families are those that communicate.  By sharing the Ethical Will while you are living, you will start a family dialogue, perhaps be asked for more details about your stories, and hopefully receive hugs and thanks.  If your family or friends plan a “roast” or retirement party for you, that is a good time to share your Ethical Will, when everyone is gathered and focused on you.  This can be the gift you give them in return.  The process of making an Ethical Will can also be a gift to yourself  – inspiring you to live in a manner that matches your own expectations for others, and providing an opportunity to focus on your blessings instead of material things.