Minimize your taxes and maximize your potential.
We provide a process to establish your real estate business. We have the legal and accounting knowledge to safely buy and sell any property.
Services for Real Estate Agents
Koontz & Associates provides business services to agents.
You recently earned your license, and you're eager to sell some property. But have you established yourself as a seperate entity? Have you thought about how you will run your business?
So many agents think they need to sell several properties before they get serious about their business. Big mistake.
We have provided many resources below to help answer any questions you have. You can also contact us from our website.
Speak to a real estate attorney at the beginning of your home hunt. An attorney is as beneficial as a Realtor in the process of buying or selling property. It is important to know that real estate agents and attorneys are equal partners in a search for property. The relationship is symbiotic and will ultimately save you money, heartache and headache by uncovering unexpected issues as early as possible.
Your real estate attorney will review documents pertaining to your loan, land survey, title and other documents. These can be complicated and, if not carefully reviewed, may end up costing you more than you ever thought.
If you're in a situation in which you have to walk away from a sale or purchase of a house, your money will be left on the table. An attorney will have the best chance of getting it back for you or keeping you from losing more.
Working with a real estate attorney that offers title insurance will save time. Your attorney only benefits from the sale of title insurance because they know you are properly covered. Before the sale of insurance, your attorney will provide a title search to make sure the property you are buying is clean.
Finally, you will have peace-of-mind when you work with your real estate attorney. You will know for sure the property you are buying will be rightfully yours.
Don't wait to contact an attorney. Contact Jo Ann Koontz at the beginning of your home hunt or the sale of your home.
Lease Option or Lease Purchase Agreements, commonly referred to as “Lease-to-Own” Agreements are mistakenly used interchangeably, although they are vastly different. These agreements allow a potential buyer to occupy the seller’s property for a period of time before completing the sale. This arrangement can assist either or both parties in meeting their goals and needs with respect to the transaction and their specific circumstances. In some instances, these agreements may even allow a buyer the opportunity to build a bit of equity in the home as well.
It is important to understand the distinction between a Lease Option Agreement (“Lease Option”) and a Lease Purchase Agreement (“Lease Purchase”).
A Lease Purchase consists of two separate contracts:
- The residential lease which provides for the tenant-buyer’s lease of the property for a specified term; and
- The contract for sale which obligates each party to the typical terms of a residential purchase agreement upon the expiration of the specified lease term.
Typically this kind of agreement provides what are referred to as cross-default provisions to ensure that a breach of one of the agreements will result in an automatic breach of the other. As the tenant-buyer has contracted to purchase the property in the context of a Lease Purchase, oftentimes the lease will provide that the tenant-buyer is responsible for maintenance and repairs which are typically the duty of the landlord.
A Lease Option operates very similarly to a Lease Purchase in that it consists of two agreements and theoretically allows for the tenant to ultimately purchase the property. However, the tenant does not sign a contract for sale but instead enters into an option agreement (“Option Agreement”).
An Option Agreement provides the tenant-option holder the right to purchase the property at an agreed price during the lease term or other specified term, also called the “Option Period”, in exchange for a fee paid to the seller called the “Option Fee.”
This looks very similar to a deposit on a contract for sale which is why the Lease Option and Lease Purchase are so often confused. A Lease Option also provides for the cross-default provisions, and the Option Fee referenced above is typically non-refundable. Upon a tenant-option holder’s election to exercise their option to purchase the property, the Option Fee is usually credited to the purchase price, however, there may be an additional deposit required upon the parties’ execution of the contract for sale.
A key distinguishing factor of the Lease Option is that the agreement does not obligate the tenant to purchase the property, but does obligate the seller to sell the property if and when the tenant properly exercises the option to purchase.
Both the Lease Purchase and Lease Option create landlord-tenant relationships. Therefore, if the tenant defaults, the landlord-seller would evict the tenant-buyer or tenant-option holder like a normal tenant. An issue that may arise in the context of an eviction of a tenant to a Lease Purchase or Lease Option is an equitable interest claim. Although not typically successful, a tenant may assert an ownership interest in the subject property, which is grounded in the idea that a Lease Purchase or Lease Option is essentially the equivalent of a sale, similar to an installment land contract (or contract for deed), whereby the seller retains title to the property as security until the balance is paid by the buyer. If an equitable interest argument prevails, the landlord-seller will be required to remove the tenant by way of foreclosure action, as opposed to a more simple eviction.
What to consider before an agreement
To avoid a potential successful equitable interest claim, a seller should consider certain things when constructing the Lease Purchase or Lease Option:
- Structure of Lease Purchase or Lease Option should not resemble a contract for deed;
- Limit the lease term to one year or less;
- Provide for a security deposit (sellers don’t take security deposits, landlords do);
- Seller should continue to pay taxes and insurance on the property;
- Do not give large rent credits (this only creates more equity the tenant can claim);
- Refrain from using the words “credit”, “seller” and “buyer” in the lease agreement and/or option agreement portion of the Lease Option; and
- Will the tenant-buyer/option holder be making improvements, and what will the value be of such improvements?; and
- What is the difference between the tenant-buyer/option holder’s option price and the fair market value of the property? The closer these amounts, the more equity one could claim.
If you have questions regarding Lease Purchase, Lease Option or any real estate transaction, please contact us.
Selling real estate in this precarious market can be quite a task in and of itself. When the dust clears, sellers often are left to navigate through a maze of issues, not sure what to expect next. Many sellers have no idea what tax forms to expect from the lender, so they have no way of knowing if they received them.
Two forms in particular, the 1099-A and 1099-C, create much of the confusion for sellers, their lawyers and their financial advisors.
Notifying the IRS
Every time real property is sold or transferred, the IRS must be notified. In a traditional sale of property, the seller will receive a Form 1099-S (Proceeds from Real Estate Transactions) to report the sale of the property to the IRS. This form is used to determine whether there is a gain or loss on the sale of the property. In a short sale or deed in lieu of foreclosure, the seller also receives a 1099-S because the property is sold willingly.
1099-A: Acquisition or Abandonment of Secured Property
However, in the case of a foreclosure, no 1099-S is issued because the “sale” is involuntary. Instead, the seller will receive a 1099-A (Acquisition or Abandonment of Secured Property) to report the transfer of the property. The 1099-A reports the date of the transfer, the fair market value on the date of the transfer and the balance of principal outstanding on the date of the transfer. Just like the 1099-S, the 1099-A is used to determine whether there is a gain or loss on the sale of the property.
Many sellers mistakenly believe that if their property is sold in a foreclosure auction, they will not have any capital gain. This is not always the case. As a result of the adjustments to cost basis in certain situations, there may be a capital gain on property that is sold in a foreclosure auction. This may cause yet another source of unexpected tax liability that the seller is unable to pay.
1099-C: Cancellation of Debt
Now that short sales have become so common, many sellers understand they may receive a 1099-C (Cancellation of Debt), to report the cancellation of debt resulting from a short sale or deed in lieu of foreclosure. What comes as a surprise to many sellers is that they may receive a 1099-C as a result of foreclosure sale as well. Some sellers believe that if they allow their property to go into foreclosure, they will avoid the tax consequences of the cancellation of debt. However, the tax ramifications are the same for cancellation of debt income, whether it is generated from a short sale, deed in lieu of foreclosure or foreclosure.
At the time the seller/borrower obtained the loan to purchase or refinance the property, the loan proceeds were not included in taxable income because the borrower had an obligation to repay the lender. When that obligation to repay the lender is forgiven or cancelled, the amount that is not required to be repaid is considered income by the IRS. The lender is required to report the amount of the cancelled debt to the borrower and the IRS on Form 1099-C, when the forgiven debt is $600 or greater.
There are certain exclusions that can be used to reduce or eliminate the cancellation of debt income from taxable income. This includes discharge of the debt in bankruptcy, insolvency of the seller before the creditor agreed to forgive or cancel the debt, or, if the seller qualifies, relief pursuant to the Mortgage Forgiveness Debt Relief Act (MFDRA).
To summarize, any sale or transfer of property, whether voluntary or involuntary, must be reported to the IRS. Form 1099-S is used for a traditional sale, short sale or deed in lieu of foreclosure; Form 1099-A is used for a foreclosure. A lender may forgive or cancel debt in any case – where it’s a short sale, deed in lieu of foreclosure, or foreclosure – which will result in the issuance of a 1099-C. In order to properly report these transactions on the tax return, sellers should seek advice from an experienced tax professional.
We understand you have many options when partnering with a real estate attorney. Every attorney will tell you the same thing: they are the best in town and they have you and your client in their best interest.
Not every attorney is also an accountant.
When you partner with Koontz & Associates you also get an accounting perspective. Your closing is going to have a strong impact on how you file your taxes. Wouldn't you want an accountant at the table when you close?
Buyers and Sellers may save money by having both an attorney and an accountant at the closing table. We are a comprehensive fabric. Nothing will "fall through the cracks."
Most importantly, we'll come up with questions that you never knew you should ask. You may be distracted by the millions of loose ends you need to tie up during the closing process. We are here to help you tie those knots and make sure everything is tight.
What are you waiting for? Get in touch and find out why it's better when you close with us.
Foreign real property owners are subject to certain withholding requirements when selling their U.S. property. In a real estate transaction involving a foreign seller, the Foreign Investment in Real Property Tax Act (“FIRPTA”) requires ten percent of the gross sales price be withheld from the sales proceeds received at closing. This withholding is remitted to the Internal Revenue Service as a deposit on the income tax liability generated from the sale. When the actual Income tax resulting from the sale is reported on the seller’s tax return, the withholding will be applied and the seller will either remit a sum to satisfy the outstanding balance or will receive a refund of any excessive withholding.
The withholding requirement does not apply to sales of real property that do not exceed $300,000 if the purchaser intends to make personal use of the property as a residence for at least fifty percent of the time the property is in use, for at least two consecutive years following the date of purchase. This exception is not available to business entities, trusts, or the sale of unimproved property.
FIRPTA also applies to short sale transaction and may present hurdles in negotiations with the lender. If a short sale does not qualify for the above-referenced FIRPTA exception, the seller should take the necessary steps to apply to the IRS for a withholding certificate which grants a reduction or elimination of the ten percent withholding requirement. Application and processing of a withholding certificate requires additional time and should be considered when negotiating the terms of a short sale contract.
On the other side of the transaction, a foreign purchaser of real property should also consider the benefits of different forms of real estate holding. There are varying income and estate tax consequences for foreign individuals and foreign-owned business entities holding, renting, transferring and devising U.S. real estate. These consequences depend on a number of factors, including the domicile of the owner, value of the property, and the income produced from the property. Each owner’s circumstances and goals should be evaluated to determine the most beneficial way to take title to real property.
Tenancy by the Severalty
When ownership of real property is in the hands of an individual or corporation it is referred to as a severalty estate. The law considers a corporation an individual which must act by corporate resolution with official decisions by the board of directors. The word severalty is used here in the sense of “severed” or separated as rights exclusive to the individual.
Law regarding property ownership may be statute law (state legislated) or common law (court precedent), depending upon the state. When two or more people are involved in ownership they may own as either Tenants in Common, or as Joint Tenants, or as Tenants by the Entireties.
#1. Tenants in Common
Tenants in Common exist when two or more people own an undivided interest in the whole of the property. That is, they each own a percentage share, which may or may not be equal, but does not represent a specific physical part of the property. The shares in a tenancy in common are independent of each other and shares may be sold or even separately mortgaged or devised.
#2. Joint Tenants
Joint Tenants also own an undivided interest in the whole, but shares must be equal, and may not be inherited since there is a right of survivorship. This means that upon the death of one of the parties, their share is automatically vested equally in the surviving partners. The shares may be sold, but if they are, that portion of the joint tenancy is dissolved and the new party becomes a tenant in common. In most states, a joint tenancy must specifically state “with rights of survivorship”, otherwise, it may be considered a tenancy in common. A joint tenancy will have:
- Unity of Time, meaning the parties have acquired the title at the same time;
- Unity of Title, meaning all interests are on the same deed;
- Unity of Interest, meaning that the shares are equal; and
- Unity of Possession, meaning there is equal right of possession. Since the title automatically vests in the survivors, no probate action is necessary.
Both Joint Tenancy and Tenancy in Common may be terminated through partition action. The dissolution of a joint tenancy is known as partition.
#3. Tenancy by the Entirety
Tenancy by the Entirety is joint tenancy specifically for a married couple. Upon the death of a spouse, the title will automatically vest in the surviving spouse. It differs from a joint tenancy in that the shares cannot be sold to a third party and the right of survivorship cannot be extinguished. Only creditors against both husband and wife can enforce a lien against the property. Married couples may choose to act as Tenants in Common or as Tenants in the Entirety. If they choose Tenants in the Entirety, then both names must appear on the deed as a married couple.
Considerations for Foreign Buyers:
The way in which foreign buyers hold title in their home country or other foreign countries may be vastly different than property ownership and the methods of taking title in the United States. For example, in the United States, there are no requirements for a specific number of days or a dollar amount for taking title.
It is best to determine the preferred method of taking title to the property prior to signing a contract to purchase property. To be fully informed, foreign buyers should meet with a real estate attorney before making an offer on real property so that the title will be correctly recorded on the deed. If title needs to be changed after the completion of the transaction, additional documentary stamps will be due on the later transfer. If it is handled correctly initially, there will not be the need for additional expense later.
Foreign buyers should be aware that the way a property is used, affects its taxation. For example, properties used for investment, rental income, vacation, or as a second home, may have different tax considerations.
Real estate sales associates, brokers, and attorneys should advise foreign buyers of the Foreign Investment in Real Property Tax Act (FIRPTA) prior to closing. When foreign buyers are aware of the tax upon purchase, they are less likely to be surprised about the tax upon selling.
At Koontz & Associates, we are committed to helping real estate professionals do two things:
- Minimize your taxes
- Maximize your deductions.
This guide will explain what type of business entity real estate professions should create, how to report to the IRS (quick reference infographic) and why you should do it this way.
Very few real estate agents know that they can make more money by creating a business entity and not filing Schedule C of their 1040. You may be under the impression that it is confusing and expensive. We are here to debunk these myths and show you that partnering with Koontz & Associates will help you earn more money each year.
Types of Business entities for real estate agent
The most popular entities to set up are Professional Association (PA) or a Professional LLC (PL). Ultimately, the decision of what entity to establish is based on size of your company, the nature of your business, your legal relationships and your tax consequences. For real estate professionals, these factors almost always result in the creation of a PA or PLLC.
Establishing your entity is the first step to reducing your tax liabilities. Now let's see how to properly use your entity.
Using your entity
One of the biggest mistakes many agents make is forming a PA or PL, but never changing their license with Florida Real Estate Commission (FREC). The problem is that commission checks will continue to come to your individual name and you wont reap the benefits of your business entity.
Here is how to property use your entity:
- Obtain TAX ID Number
- File an election for the LLC to be taxed as an S-Corp (more information below).
- Change your name with FREC to the name of the LLC.
- Change your name with your broker to the name of the LLC to ensure checks are paid to the LLC and not your individual name.
- Open a bank account for the LLC and obtain credit or debit card.
Ultimately, you will be acting as a business rather than an employee. Why? If you don't act like a business, the IRS, nor any court, will treat you like a business.
Tax your entity properly
80% of agents report their income on a Schedule-C of their 1040, which is the best way to ensure you are paying the highest tax.
We recommend taxing your PA or PL as an S-Corp for two big reasons:
- Save 7.65% - the employer portion of the employment tax.
- Certain deductions are less interesting to IRS for audit purposes.
As an S-Corp, you will still be a PL, but taxed differently. Most agents don't know about this or they think it's too complicated. It's not! Here is how to do it:
- Form an entity (PA or PLLC)
- Send application to FREC to move license to that entity.
- Inform broker so commission is paid to entity.
- File form 2553 within 60 days to notify the IRS. If not, your entity will be disregarded and you will still be filing on Schedule C of your 1040.
- Keep a separate business bank account.
Get in touch with one of our attorneys immediately if you have any questions. You can begin using your entity benefits as soon as you establish it. There is no benefit to waiting until next year.
Filing as an S-Corp is almost always in your best interest as a real estate professional. Koontz & Associates works with hundreds of attorneys to properly file. Additionally, Jo Ann frequently speaks with real estate office and the Realtor® Association of Sarasota and Manatee.
Short sales, principal reduction loan modifications, deeds in lieu and foreclosures all present unique tax consequences, and they vary from one person to another. Much of what we are hearing from clients, which they are hearing from others, is either not true or not true for them.
Here are my Top 10 Myths --and the corresponding truths-- in this area. With a few exceptions, the myths stem from a grain of truth. But just like the game of telephone, the fact that it began as truth doesn’t mean what you’re hearing is reliable.
Myth #1 - “I won’t owe any income tax because this is homestead property.”
This myth began with the passage of the Mortgage Debt Forgiveness Relief Act (“MDFRA”) in December 2007, which does provide some relief to those taxpayers who face debt forgiveness (which would otherwise be taxable) relating to their real estate. There are significant limits on the relief, however. Here are the requirements:
- The debt applies to a principal residence as defined in Internal Revenue Code Section 121. (Principal residence is NOT necessarily homestead property in Florida.)
- The debt was used to acquire, construct or substantially improve the principal residence (as defined in Internal Revenue Code Section 163(h)).
- The amount of the forgiven debt is not included in the taxpayer’s income, but it reduces the taxpayer’s basis in the property. (This will increase the gain on the sale if the property is sold, and that gain is taxable).
- The amount of the forgiven debt also reduces, dollar for dollar, the amount of gain that can be excluded under other provisions (IRC Section 121).
- Only the first $2 million of forgiven debt is excluded from income.
A principal residence for IRS purposes is not the same as homestead property under Florida law. A principal residence is property which has been owned and used, during the 5-year period ending on the date of the sale or the debt forgiveness, as the seller’s primary residence for a total of at least 2 years. Often, a seller did not use the property as a principal residence for 2 years or more during the prior 5 years, even if he declared it as homestead property. If it’s not a principal residence under this definition, there is no tax relief under the MDFRA.
The other requirement that is often not met is the use of the debt to acquire, construct or substantially improve the principal residence. Many property owners refinanced to access cash for reasons unrelated to the property: they started a business, paid off a car loan or credit cards, or took a vacation. Any part of the funds used for those purposes remains taxable. However, if the proceeds were used to add a pool, renovate a kitchen or replace the roof, that portion of the debt forgiven will be excluded from taxable income.
Myth #2 - “I’ll have a loss on the property, so I don’t need to worry about tax.”
Capital losses resulting from the sale of the property will not offset the income resulting from the forgiveness of debt. Also, sellers often believe they have a “loss” on their property when in fact they don’t – selling it for less than you owe isn’t the test. If your basis is less than the debt forgiven, you can actually have a gain. This often happens in the short sale situation, due to the reduction of basis (see 1c above).
Myth #3 - “I can use the $500,000 capital gain exclusion to wipe out any taxable income from the short sale.”
The $500,000 exclusion (for married filing joint, $250,000 for single taxpayers) is a capital gain exclusion only. Income from debt forgiveness is ordinary income, not capital gain. This exclusion is only helpful if a capital gain results from the reduction in the basis of the property. But beware, (as mentioned in 1d above) the amount of the forgiven debt which is excluded from taxable income also reduces the amount of gain that can be excluded under this provision, dollar for dollar.
Myth #4 - “I’m in a low tax bracket, so the tax won’t be that much.”
Before the transaction in question, the seller probably was in a low tax bracket. If the debt forgiven is large (and it’s not unusual these days to see amounts of $50,000-$150,000 and higher), this increases the seller’s taxable income by that amount. It’s like getting a big fat paycheck that you never see, and it puts many sellers into higher tax brackets than their historical rates.
Myth #5 - “I have no assets, so I’m insolvent and don’t need to worry about the tax consequences of a short sale.”
This is true as far as it goes: Section 108 of the IRC indeed provides for excluding forgiven debt from income to the extent the seller is insolvent. However, just because a seller is upside down on their property doesn’t mean they’re insolvent for this purpose. The extent of insolvency for IRS purposes is the difference between the outstanding liabilities and fair market value of the assets (this is all assets, including protected assets such as retirement accounts) owned by the Seller on the date of the short sale. It is virtually impossible to reach a conclusion on insolvency for this purpose without a detailed analysis of all of the seller’s assets and liabilities, including those unrelated to the property, as well as the basis reduction that would occur in the short sale.
The good news on this one is that, unlike the MDFRA, the insolvency exclusion applies to investors. This is an important aspect to explore for them particularly.
Myth #6 - “I heard that the IRS isn’t going after people due to the economic climate.”
Ok, this one doesn’t stem from a grain of truth; it’s just wishful thinking. The IRS is actually increasingits enforcement and collection efforts in the current economic climate. It’s primary purpose is to collect revenue; and the government needs revenue as much as anyone else these days.
Myth #7 - “I’ll just tell the lender that I don’t want a 1099.”
Good luck with that. The 1099-C requirement is not negotiable: it’s the law. If the debt is forgiven, the tax liability has been generated. The lender must report it, and so must the property owner (even if they don’t receive a 1099-C by January 31 of the year following the short sale). Sellers can be subject to a 25% reporting penalty if they don’t report the debt forgiveness; this is not one to be taken lightly.
Myth #8- “I heard on the news that there is no tax on short sales any more.”
See Myth #1. And stop watching the news.
Myth #9 - “I’ll just let the property go into foreclosure, rather than do a short sale, to avoid the taxes.”
This wouldn’t necessarily help you. The tax is the same regardless of how the debt forgiveness comes about: a short sale, principal reduction loan modification, deed in lieu of foreclosure or foreclosure all have the same effect. The only potential difference is the amount of the debt forgiven. For example, default interest, attorney’s fees and costs continue to add up during a foreclosure, which might be avoided or reduced in a short sale, typically making the unpaid balance of the loan (and resulting debt forgiveness) in a foreclosure higher than if a short sale were completed.
Myth #10 - “If I end up owing tax, I’ll just file bankruptcy.”
Despite the growing number of property owners participating in a short sale, loan modification, deed in lieu or foreclosure, there is still quite a bit of confusion regarding the tax consequences for borrowers. Forgiveness of debt, in full or in part, is typically approved by short sale lenders and occasionally following foreclosures. Debt forgiveness is certainly welcomed by most borrowers but unfortunately may result in harsh tax consequences.
If a lender chooses to release a borrower from some, or all, of an outstanding loan obligation, it is required to issue a Form 1099-C which reports the cancellation of debt. Although the borrower is not receiving cash, the IRS considers the extinguished debt obligation to be taxable income. In order to understand the problem and the potential solutions, it is important to understand the reason that forgiven debt is treated as income. At the time the loan was made, the loan proceeds were not included in the taxable income of the borrower because there was an obligation to repay the loan. However, when the debt is forgiven, the obligation to repay the loan goes away, and taxable income is triggered. For example, if the seller borrowed $300,000, the lender receives $200,000 in proceeds from a short sale and forgives the remaining $100,000 balance, the IRS’ position is that the seller has $100,000 of income that no tax has been paid on. IRS does not consider the fact that the loan proceeds were “spent” on the property, which has lost value. The result is phantom income, meaning that the seller has not received cash from the sale proceeds with which to pay the tax. The amount of debt forgiven by lenders, particularly in short sales, can be substantial, and may result in unexpected taxable income and higher tax rates.
To provide some relief to struggling homeowners potentially facing crippling tax liability, Congress passed the Mortgage Debt Forgiveness Relief Act (the “Act”) in December of 2007. The Act offers relief to borrowers by excluding some or all of the forgiven debt from taxable income, subject to certain conditions. To be eligible, a borrower must establish that the debt forgiven was incurred to purchase, construct, or substantially improve the borrower’s principal residence, as defined in Internal Revenue Code Sections 121 and 163(h). A further limitation of the Act holds that the exemption only applies to the first $2 million of debt released. The Act has been extended several times, but is currently set to expire December 31, 2012. Congress has not yet indicated whether it will again be extended.
Borrowers often mistakenly believe that a Principal Residence, as defined by the IRS, is synonymous with a homestead, as defined by Florida law. However, one should never assume that a designated homestead will qualify as a Principal Residence for IRS tax purposes. A Florida homeowner has the ability to designate their newly purchased property as their homestead as soon as they begin to occupy the property as their main home, whereas property may only be considered a Principal Residence if the residence has been owned and occupied by the homeowner as their main home for at least two of the last five years immediately preceding the date the debt is forgiven. In the context of a short sale, the date the debt is released may or may not be the date of closing as, in some instances, the deficiency is negotiated after completion of the short sale.
As stated above, to qualify for relief provided by the Act the loan proceeds must have been used for the purchase, construction, or substantial improvement of the property. This requirement disqualifies debt, or any portion thereof, incurred and used for any other purposes, such as vacations, business investments, or to pay off credit cards or car loans. This is especially problematic where homeowners obtained home equity lines of credit (HELOC) or second mortgages which could be used for any purpose.
Cancellation of debt income, when exclusions do not apply, can cause other complications to the seller’s tax return as well. Not only is additional taxable income a possibility, but the result may also be an adjustment in tax rate or bracket, which can phase the taxpayer out of certain deductions they are accustomed to taking. Although one may traditionally fall into a lower tax bracket, cancellation of debt may substantially increase a seller’s taxable income and their total income could be taxed at a higher tax rate. It is not uncommon to see as much as $150,000, or more, granted in debt forgiveness which could easily result in a higher tax rate for many borrowers.
The Internal Revenue Code also provides for an insolvency exclusion which exempts forgiven debt for a taxpayer, to the extent of their insolvency. Insolvency is the difference between the taxpayer’s outstanding liabilities and the fair market value of all assets held on the date of sale or debt forgiveness. To the extent that the taxpayer’s liabilities are greater than the value of the assets, that difference can be used to exclude cancellation of debt income from taxable income. For example, assume the taxpayers liabilities, including the mortgage debt forgiven, total $500,000 and the fair market value of all the assets, including the property sold, total $400,000. The difference ($500,000-$400,000) of $100,000 is the extent of their insolvency. That means up to $100,000 of 1099-C income can be excluded from taxable income. Assets used in this calculation include creditor protected assets, such as retirement accounts. A borrower should never assume that they qualify for this exemption by virtue of the fact that there is negative equity in their home. To determine eligibility for the insolvency exclusion, a detailed analysis of a taxpayer’s assets and liabilities would need to be performed. Unlike the exemption provided by the Act, this exclusion is available for investors.
Lenders are required by law to report on Form 1099-C any release of debt greater than $600 and have no discretion to withhold such information. The resulting tax liability occurs upon the release of loan obligation, not upon the issuance of the 1099-C. Not only does the lender have a reporting obligation, but the borrower must also report this liability on their tax return for that year. Failure to do so can result in a 25% underreporting penalty and an increased audit period from three to six years.
Some borrowers believe that foreclosure may allow them to circumvent tax liability, but release of debt may occur following completion of a foreclosure. Again, the borrower has no ability to request the lender not issue the 1099-C, and if the lender chooses to release the debt following the foreclosure action, either on its own accord or in response to post-deficiency negotiations, the debt forgiven will likely be much larger and the incidental tax liability much greater due to the additional costs and fees that accumulate and grow the balance of a loan throughout a foreclosure action.
Borrowers also believe bankruptcy to be a potential solution to tax liability. This may be accurate depending upon when the borrower files bankruptcy. Income tax liability is not typically dischargeable and if the forgiveness of debt occurs prior to the bankruptcy filing, it will likely remain.
Tax consequences resulting from short sales, loan modifications, and foreclosures are fact specific and should always be evaluated by a professional. In many cases, tax planning can help a seller legally avoid or minimize the tax consequences of their transaction. If the seller proceeds without planning for the tax impact of the transaction, they are often unpleasantly surprised with the outcome.
To that dilemma many ask- why not just take title as an individual and thereafter transfer title to my LLC? Most lenders include language in the loan documentation preventing this practice and provide that upon the sale or transfer of title of the real property, the lender has a right to accelerate the loan and demand repayment in full.
The best manner in which to purchase real property is dependent upon a number of factors, which vary with each buyer. Consideration of the above, as well as tax considerations, should be discussed with an attorney to achieve the optimal protection of your investment.
Real Property Ownership in an LLC - Taxation
The Limited Liability Company (LLC) has become an increasingly popular vehicle for the foreigner buyer, or real estate investor seeking to establish a level of personal liability and asset protection, while minimizing their tax liability.
An LLC with foreign members has the flexibility to decide whether to be taxed as a partnership, C corporation or, in the case of a single-member LLC, it can elect to be disregarded as an entity for federal tax purposes. If an LLC chooses to be taxed as a partnership, or if a single-member LLC elects to be disregarded as an entity, the LLC's profits and losses are ultimately reported on the member's personal federal income tax return. If an LLC chooses to be taxed as a C corporation, the corporation reports the income earned and pays tax on it at the high corporate rate and the shareholder will also be taxed on any distributions received from that corporation. In order to avoid this double-taxation, most multi-member LLCs choose to be taxed as a partnership and most single-member LLCs elect to be disregarded as an entity for federal tax purposes.
A partnership does not pay tax, but it does compute income, deductions and credits on an annual basis. Information about the business is reported to the IRS on Form 1065 and to the individual partners on separate Schedule K-1. The partners report the partnership income on their own returns and pay any taxes due based on their own tax rates. A single-member LLC reports its income on Schedule C of their own returns filed with IRS and do not need to send another separate form.
There are no upper limits on the number of LLC members and no restrictions on the type of persons or entities that may be members. There are also no restrictions on ownership of subsidiary entities. LLCs are not restricted to a single class of stock, so LLC members have an ability to allocate gains, losses, deductions, and credits according to agreed-upon special allocations.
Losses from an LLC activity that is a passive activity of an LLC member are generally deferred until the member has passive income to offset the loss. These passive activity loss rules apply to most rental activities, except for some real estate rental activities in which a taxpayer "actively participates" and to trade or business activities in which the taxpayer does not "materially participate." Any losses that are not limited by the passive rules can be claimed to the extent of the member’s basis in the LLC. Basis is discussed below.
When an LLC distributes its property to a member or partner, there is generally no recognition of gain or loss until the member or partner disposes of the distributed property.
The rules governing transfers of interests in an LLC classified as a partnership for tax purposes indicate that gain or loss is generally recognized to the extent that the sales price exceeds, or is exceeded by, the selling member's basis in the interest sold. The gain or loss on the sale is treated as capital gain or loss.
This contradicts the common misconception that one can sell the company holding the real estate and avoid capital gain.
Sales of an LLC interest generally do not terminate the LLC for tax purposes. However, an LLC will terminate for tax purposes if there is a sale or exchange of 50 percent or more of the total interests in LLC capital and profits within a 12-month period. Generally, the LLC's operating agreement will determine what events will lead to dissolution.
As mentioned above, the sale of an LLC interest is nontaxable to the extent of the member or partner's basis in the LLC. The basis of a member's interest is the initial capital contribution increased by the LLC's profits (or reduced by losses). In addition, a member of an LLC qualifying as a partnership can include his or her allocable share of the LLC's liabilities in the basis of his or her LLC interest. This basis increase gives the LLC member the ability to have a greater amount of money received on the sale of the interest distributed tax free and a greater amount of allowed losses to be claimed on member’s personal tax return.
For any investor considering a purchase of US real property, it is strongly recommended they consult with a US attorney or tax advisor experienced in this area of law to assist in structuring any transaction.
We are a full service commercial real estate law firm that can assist you with a wide range of real estate matters from the purchase of raw land to the sale of a developed property and everything in between. We can help you take your project from start to finish.
If you are considering buying, selling, leasing, or investing in commercial real estate property you should consult our firm to ensure that your transaction is structured in the most beneficial way.
Our firm advises and represents buyers, sellers, landlords, tenants, investors and lenders in all aspects of commercial real estate transactions, including:
- Provide title insurance commitments and policies. The firm is an authorized agent for Old Republic National Title Insurance Company
- Conduct commercial real estate closings
- Prepare and review closing documents
- Title searches and examinations – Buyers may want to review the state of title prior to making an offer on a property
- Draft & review commercial purchase contracts
- Draft & review commercial lease agreements
- Review and analysis of easements and restrictions affecting real property
- Easements – Review & analyze or draft easements & restrictions
- Survey Review
- Draft & review commercial promissory notes and mortgages
- Entity selection and formation for real estate investment
- Mortgage-Based Financing Transactions
- Private Financing
- Seller Financing
- Mortgage issues
- Landlord/tenant matters
Documentary Stamp Taxes are assessed on documents that transfer interest in Florida real property, such as warranty deeds and quit claim deeds. Additional taxes are charged for fuels, tobacco products, communications services, and more. For a full of account of taxes charged in Florida, see the Florida Department of Revenue website. There are also documentary stamps and intangible tax on obligations such as notes and mortgages.
From Chapter 201, of the State of Florida Statutes:
Documentary stamp tax is levied at the rate of $.70 per $100 (or portion thereof) on documents that transfer interest in Florida real property, such as warranty deeds and quit claim deeds. (The Miami-Dade County rate is $.60 on all documents plus $.45 surtax on documents transferring anything other than a single-family residence). This tax is usually paid to the Clerk of Court when the document is recorded. The Clerks of Court send the money to the Department of Revenue and the Department distributes the funds according to law.
A reference sheet is available to help determine the correct amount of documentary stamp tax due on documents that transfer an interest in Florida real property.
Documentary stamp tax is also levied at the rate of $.35 per $100 (or portion thereof) on documents that are executed or delivered in Florida, for example:
- Notes and other written obligations to pay
- Certain renewal notes
- Bonds (original issuance)
Florida law limits the maximum tax due on notes and other written obligations to $2,450. However, there is no limit on the documentary stamp tax due for mortgages or liens filed or recorded in Florida. Tax is paid to the Clerk of Court if the document is recorded, or sent directly to the Department of Revenue if the document is not recorded.
Documentary stamp tax is payable by any of the parties to a taxable transaction. If one party is exempt, the tax must be paid by the nonexempt party. United States government agencies; Florida government agencies; and Florida's counties, municipalities, and political subdivisions are exempt from documentary stamp tax.
Koontz & Associates, PL Can Help When Documentary Stamps Need to Reviewed and Paid