On-Demand: Real Estate Year-End Tax Strategies
- Dec 5, 2019
This webinar discusses the latest tax issues that impact the real estate industry, as well as planning opportunities for year-end.
Michael Torhan: Great, thank you. So here's the agenda for today's webinar. My colleague Neil Tipograph is going to start off with some of the big issues that we noted over this last year with the Tax Cuts and Jobs Act. And you'll hear us reference this tax law in a few ways during this webinar, or we might refer to it as the tax bill, or tax reform, but in all such instances we'll be referring to the Tax Cuts and Jobs Act. So he'll briefly discuss some of the key items from that tax bill, including qualified improvement property, bonus depreciation, some of the new deductions, such as the 199A deduction, as well as some of the new limitations. Then I will speak later in the webinar about some other general real estate tax related issues for real estate professionals. We'll touch briefly on qualified opportunity funds, and then we'll close the webinar with some issues we see coming up for the new year in terms of tax return reporting requirements that appear to be changing after this tax season that's coming up. Here's Neil Tipograph to start with the next discussion.
Neil Tipograph: Thank you, Michael. I open with a quote from one of my two heroes in life, it's a quote by Albert Einstein. "If you can't explain it simply, you don't understand it well enough." And for us today, that has two meanings. One, Michael and I need to explain our topics to you in a very simple manner, and two, as tax professionals, we need simple explanations of the tax reform bill in order for us to understand the context for the law changes and the intent of the new laws. By understanding the context and the intent, we then understand the words of the law.
So after every major tax act, Congress publishes a blue book. In the olden days when they used to print books, the book would always have a blue cover. And I must say, I mentioned that I have two heroes in life. I forgot to mention the other hero, it's Sheldon from the Big Bang Theory. I'll get to that in a minute. So getting to the blue book explanation of the Tax Cuts and the Job Act. What's interesting about the blue book explanation is that it highlights many of the drafting errors in the new law. And these drafting errors create both problems and opportunities for taxpayers and their advisors.
Qualified improvement property, or QIP, is very important to owners of office, retail, and restaurant buildings. Prior to 2018, QIP property was treated as 15-year property, and subject to bonus depreciation. Due to a drafting error in the new law, QIP is now treated as 39-year property and not subject to bonus depreciation. However, the blue book clearly states that QIP property is 15-year property subject to bonus depreciation. However, the IRS is following the literal language of the Internal Revenue Code. We call that textualism. Textualism is a word you only hear in two cases, one in the national spelling bee, T-E-X-T-U-A-L-I-S-M. And also you hear about it in the news, when commentators are discussing how the Supreme Court Justices view the Constitution. So the IRS said, "These are the words that the new law, and the words say that QIP no longer is subject to 100% bonus depreciation, and QIP is no longer 15-year property." So in this example, so as we can see, that the IRS is following a drafting error which is anti-taxpayer. So my question is, what about the drafting errors which are pro-taxpayer?
So with the QIP drafting era, the IRS is following the literal words of the law and is ignoring the clear intent of the law. This is a major problem for owners of commercial real estate buildings. And by the way, we had hoped for a technical correction during 2019 to fix this problem, but that did not occur, and we're not aware of any legislation right now that is going to pass and correct the situation.
Bonus depreciation. Bonus depreciation is a way to greatly accelerate depreciation in year one. Bonus depreciation has been around for a long time, but what's new about bonus depreciation is that under the new tax law, used property qualifies for bonus depreciation. So when you go out and you buy a new commercial or residential building, that is considered used property, and part of your purchase price may be subject to bonus depreciation. What we found in 2018 is that for certain real estate acquisitions with significant short life property, what resulted was a substantial loss to the owners due to these new bonus depreciation rules. We also see, as it relates to private equity funds investing in real estate, that certain fund managers are now seeking to specially allocate a portion of these losses ultimately back to the fund managers, by way of inserting a DRO, or a deficit restoration obligation, language in their partnership agreements.
However, not all owners can currently utilize real estate losses. There's been a rule on the book for many years called the Passive Loss Limitation rules, or we refer to them as the PAL rules. They came to be starting in the year 1987, and with the new tax law, there is a new level of business loss limitation rules which come into play. Now Michael, later in our discussion, will talk about the real estate professional rules as a way out of the PAL limitation rules. But even real estate professionals now have to deal with the new business loss limitation rules.
Even worse, related to this particular topic, is that certain taxpayers end up picking up phantom income on their state income tax returns, whose laws decouple from federal bonus depreciation. And New York is one such state that has this rule. And I'm going to give you an example. It'll involve my friend Michael, who is sitting next to me. So Michael, although he's a real estate tax professional, Michael is not considered a real estate professional under the tax rules of the tax law. So Michael has an investment in a building, and in 2018 that building was subject to the new bonus depreciation rules, and Michael gets a K-1 showing a $1 million loss on it. Since the property is located in New York state, and since Michael is a New York state resident.
So Michael, besides getting a federal K-1, is getting a New York state K-1. Federal K-1 shows a loss of $1 million, that makes Michael very excited. And then on his New York state K-1, it shows a similar add back of $1 million, because New York state does not allow for bonus depreciation. It decouples from the rules. Michael does his tax return, and lo and behold, his $1 million federal loss is disallowed currently under the passive loss rules, but when he goes to do his New York state return, nonetheless, he must add back to his income $1 million for the New York state add back. We call that situation creating phantom income, and it may have caused a surprise to many taxpayers out there.
Reliance on the tangible property regulations, the repair regs, can avoid the state-level phantom income situation. Under the repair regulations, certain capital improvements, which normally would end up on a balance sheet and on a fixed asset schedule, are now deducted as repair and maintenance expenses. And what you will learn very soon, the repair regs may negatively impact one of the new benefits under the tax law. So we have some action items for you. So what you should consider doing at the end of this year is to review your 2019 asset acquisitions for a significant short life property assets, and determine whether to elect out of bonus depreciation. By electing out of bonus depreciation, you avoid the state-level phantom income that I just described. You should also consider getting cost segregation studies for new acquisitions and significant improvements. Cost segregation studies are engineering studies which identify short life property and buildings.
So, this new tax law is very complicated, I think everyone knows that, but sometimes it's important not to miss the simple stuff. So I quote Dr. Seuss: "Sometimes the questions are complicated and the answers are simple." Who knew that we would look to The Cat in the Hat for tax advice. But this is very important advice. If we go to most real estate entities or partnerships, and so Michael and I are very familiar with forms 1065, which is the partnership form. And if you look at page one, the upper left hand corner of the partnership form, you're going to see three boxes. They're listed as A, B, and C. the first box is principal business activity, and typically for real estate, we put in the words real estate. Box B is principal product and service. We typically put in real estate.
And then comes to box C. Box C is called the business code number, and its official name is the Principal Business Activity Code or the PBAC. And these codes are designed to classify an enterprise by the type of activity in which it is engaged, to facilitate the administration of the Internal Revenue Code. So the key words here is, "Facilitate the administration of the Internal Revenue Code." And what that means is the IRS is going to be looking at these codes, and determining whether positions taken on the tax return are consistent with those codes.
So, on page 17, taxpayers are taking various filing positions related to section 199A, the QBI deduction, and the 163(j) Business Interest Limitation. And based on prior practices, we expect that the IRS may red flag taxpayers whose PBACs are inconsistent with the tax return treatment. The following slides will show examples of consistent and inconsistent codes. So, an excellent year-end action item is to pull out your 2018 tax returns, and look at the PBACs on page one, and make sure they're conforming to the filing positions that were taken on the 2018 tax return. You may find they did not, and you may want to consider changing the codes starting on the 2019 tax returns.
Qualified Business Income, or the QBI deduction. So, let's just take a step back and say, what is the goal, or what are some of the goals of the Tax Cut and Jobs Act? One of the goals is to increase employment of wage earners, and another goal is to increase manufacturing and construction activities within the US. The 199A QBI deduction is an up to 20% deduction for certain types of business activities. And generally speaking, the QBI deduction is optimized, meaning it gets to a 20% deduction for entities that are paying sufficient wages and are owning sufficient tangible property. So note, before I spoke about the repair regs, one of the things the repair regs does is it removes tangible property from your balance sheet and from your fixed asset schedule, and doing so may potentially hurt your QBI deduction. So you should just keep that in mind.
So, there is a filing position that management fee income related to the direct or indirect management of trade or business assets is eligible for the QBI deduction. So for a real estate management company, or for a real estate private equity fund, the codes that we think are consistent with the position that management fee income can avail itself to the 20% deduction, we believe codes which talk about other activities related to real estate, and we provide you the code number. We believe that's a consistent code. An inconsistent code would be discussing certain investment activities. Generally, investment activities are not subject to the QBI deduction.
And I just want to take a 30 second commercial here. Recently, EisnerAmper acquired RESIG. RESIG Is a fund administrator for private equity funds that specialize in real estate. So if you are a private equity fund manager out there, and you're interested in bringing in a third party administrator who specializes in real estate funds, I recommend you give us a call. Back to our show.
So, we found that, with the QBI deduction, there is a way to maximize the deduction. And the way it's maximized is through this process called aggregation. Aggregation can be done on the individual return, or it can be done on a partnership return. And what happened was, we ran a few tax returns without doing aggregation, and in the returns that I was involved with, I found that the QBI deduction was only 10% of the Qualified Business Income before aggregation. And when we did the aggregation, we were able to boost the deduction to 20%. So we find that aggregation is good under section 199A. The rules can be difficult to follow. And what we find is, even on the partnership level, in certain cases, it was beneficial to aggregate. So our year-end action item is that when we have a less than optimal QBI deduction, let's take a look at the 2018 tax return, and see what could be done to maximize the deduction for 2019. Michael?
Michael Torhan: Great, Neil, these are all great points on the new QBI deduction. Something I just wanted to add in, you had mentioned the wages and unadjusted basis are the two key thresholds or requirements to be able to take advantage of the 20% deduction. Another year-end action item relates to what we call unadjusted basis of assets immediately after acquisition. So the way the law works is, if you sell a property, you are not able to utilize that unadjusted basis, because you did not hold the property at the end of the tax year. So for example, if you have a property that's generating net taxable income, which you would otherwise be able to utilize the deduction, if you sell that property and you don't have wages, and generally the real estate industry, you don't have a significant amount of wages for rental properties. By selling the property, you are removing that option to also utilize the unadjusted basis of your assets.
So one planning opportunity, or one analysis that needs to be done, if you're planning to sell a property before year-end, if it would be possible to move that sell into the next taxable year, you may have more basis, or you would have basis for this 20% deduction. Otherwise, you're looking at your wages that you had for the year, and that would be utilized for the 20% deduction, if you have enough wages. Really depends on each particular situation.
Neil Tipograph: Of all of the new tax laws, I believe the business interest rules are the most complicated. I believe that even Einstein and Sheldon would be troubled by these rules. Michael, do you agree that these are quite difficult?
Michael Torhan: Absolutely, Neil. I think the 163(j) business interest limitation rule is probably one of the most complex items for this last tax year. Not only because the actual law is complex, but the guidance that we've received hasn't been complete, I would say.
Neil Tipograph: Correct. So again, let's just take a step back. What was the objective of tax reform with respect to business interest deductions? And basically, our political leaders in Washington have concluded that overleveraged companies are not good for the economy, and so that the IRS will no longer allow a current interest deduction in excess of 30% of adjusted taxable income. Adjusted taxable income is a concept similar to EBITDA, earnings before interest, depreciation, and amortization.
So fortunately, as it relates to real estate, the new law does provide an out for business use real estate, for interest expense used on business use real estate. And there's a special election which is made under section 163(j), electing real property trade or businesses, who do make the selection, must slow down depreciation. So there is a cost of making this election. By making the election, the real estate entity is not limited on its business interest expense, but it does lose or slow down its depreciation by switching to ADS. ADS is a slow method of depreciation. Now, there is a bit of good news here. The QIP property which was placed in service prior to 2018 is still treated as 15-year property, even though the real property trade or business made the special election, and that's due to a drafting error.
There's also a small business exception, which allows for many businesses not to be subject to the 163(j) limitation, and that small business exception deals with an entity with gross revenue under $25 million. Well, you would think, "Oh, that's a very good rule. That will certainly cause my entities to be excluded, because they don't have revenue of over $25 million." But unfortunately, there is a very complicated aggregation rule which says that, in the most simplistic terms, says that commonly controlled entities need to be aggregated for purposes of figuring out this $25 million threshold. And so regulations under Section 52 should have caused many closely-held businesses with common control to aggregate their various business enterprises. And again, we look at these laws now very carefully, and we find there's a typo in the law, and there's a typo that existed for 30 years. And the IRS said, "Oh, there is a typo in the law, and so the aggregation regulations under Section 52 for 2018 and 2019 do not need to be followed." The IRS has since corrected the law, and starting in 2020, we again will have to follow these extremely difficult aggregation rules.
Okay. Also with respect to the 163(j), I'm now on page 22. Also with respect to 163(j) business interests limitations, these rules do not apply to entities that have triple net lease property. So you may have a single real estate entity that owns a single triple net lease property, or it may own a few triple net lease properties. And triple net lease properties, under these rules, are treated as investment property and not trade or business property. And again, I'm going to get back to the principal business activity codes. If you do have a triple net lease property, make certain you're using the correct principal business activity code to support your position that the business interest limitation rules do not apply to you.
Now also with triple net lease properties, the up to 20% 199A deduction does not apply, because that deduction only applies to trade or business properties. So if you do have a triple net lease, you should not be taking the 199A deduction, you are not subject to the business interest limitation rules, and we believe you should put the proper code on the front of the return to reflect these positions. So year-end action item, again, look back to your 2018 tax returns for those returns that had triple net lease properties, and confirm that you did things consistently, and if not, consider making certain changes on your 2019 tax return. And we do expect to see final regulations under 163(j) sometime soon.
Business loss and NOLs. So, there is now this new business loss limitation rule. In a certain respect, it acts similarly to the passive loss limitation rules that we've had on the books for a long time. And whenever you have a piece of real estate that you are planning to take a very large bonus depreciation deduction, you need to consider how these new business loss limitation rules come into play. In a bad situation, they may come into play in a way which is unexpected, and the unexpected consequence is that you may have phantom income recognized at the state-level. And I discussed how that happened previously.
And finally, Section 216 real estate tax deduction. Section 216 relates to the pass-through of the real estate tax deduction for an owner of shares in a co-op, in a cooperative housing corporation. So in New York City, many of the buildings are cooperative buildings, and the tenants/shareholders at the end of the year get a letter from the building saying, "Your share of the real estate taxes is X." Now there is a new law which applies to individual taxpayers starting in 2018, where the state and local tax deductions are being limited to $10,000, and if you have real estate tax deductions, it is subject to this limitation.
There has been at least one very technical, well-drafted article that came out in Bloomberg at the beginning of the year, and there have been other people that have said that the new law does not address Section 216. And sure enough, when we go into the blue book, it tells us that the new law did not properly address the Section 216 tax deduction. And so based on these findings, certain people believe that you can still take the Section 216 co-op real estate tax deduction on your individual tax return and not subject it to this new $10,000 limitation. So a year-end action item, discuss with your tax advisor whether you want to take this deduction on your 2019 tax return. Yes, Michael.
Michael Torhan: So we have a question that has come in from an attendee. The question goes back to the 163(j) business interest expense limitation. The question is, "Can rental real estate businesses qualify as a small business, or is rental real estate considered a tax shelter, and hence not qualifying for a small business exemption?"
Neil Tipograph: Ah, very good question. You bring up a technical issue I was trying to avoid, because I don't want to get too technical today. Your normal real estate operation per se is not structured as a tax shelter. So I don't want to, let's not call it a tax shelter. But unfortunately, what you are very likely discussing is that there have been commentary and discussions among tax professionals that whenever a business enterprise has a loss, and a certain portion of that loss is allocated to what we'll call non-managing members, or limited partners of the enterprise, then under a rule that's out there, the enterprise is considered a tax shelter, if it has a loss.
So many tax advisors, including myself, and Michael, I imagine you've been following this rule also. When we have a real estate partnership tax return for 2018, and it showed a loss, and we a certain number of the partners were limited partners or non-managing member partners, we did say that the partnership is considered a tax shelter, only because of this one particular section of the tax law. And we did say that the small business exception, this $25 million rule which I've been discussing, does not apply, by virtue of the fact that the partnership had a loss in 2018. Note, if that particular partnership has income in 2019, it is no longer considered a tax shelter. It's a year-by-year test. I don't know if you have anything to add to that, Michael?
Michael Torhan:Yeah, Neil, I totally agree with you. I think at the beginning of the tax season last year, most of us thought that the small business exception would apply until this limitation for tax shelters, again, tax shelters for this $25 million purpose. And I believe most of the tax professional industry out there has followed this. And this has been discussed, and I believe there's been letters written to the Treasury to get more clarification. So hopefully when those final regulations are released that Neil mentioned, we'll get some more clarity as to, is that a true statement in these circumstances?
Neil Tipograph: I hand it over to Michael.
Michael Torhan: Thank you Neil. So, just continuing on, again going back to the main purpose of this webinar in terms of a year-end real estate tax strategy session, we'll talk a little bit about what it means to be a real estate professional. In general, when you have rental real estate, the income or loss from the rental real estate is generally subject to the passive activity loss limitations. And what that means is, if you have a loss from a rental real estate property, and you're not a real estate professional, and you don't materially participate, which we'll get into in a second, those losses are unable to offset other non-passive income. So for example, if you have a loss of $50 from a rental property that's a passive activity, you can't offset that loss against, for example, portfolio income.
One of the exceptions to the passive activity loss limitations is qualifying as a real estate professional. There's a number of steps, a number of requirements that a taxpayer would have to meet in order to be considered a real estate professional. And then once you're considered a real estate professional, there's still another hurdle that you have to pass, to be able to deduct losses from rental activities against other non-passive sources of income. So just a review of the requirements to be a real estate professional. Number one, you have to perform more than 50% of your personal services in real property trades or businesses, where you materially participate. Number two, you have to incur more than 750 hours of service in these businesses. So once you meet these two requirements, the analysis is not done yet. You then have to materially participate in each specific rental real estate activity that you want to deduct the losses as not being passive.
So one might question, if you have several rental activities, and you may not materially participate in each one of those, there's a solution for that. There's an aggregation election where you can treat all of your rental activities as one activity in order to meet that material participation test.
So what are the year-end action items for real estate professionals, or those taxpayers that are trying to meet the requirement to be a real estate professional? Number one, you should review the rules before year-end to determine if you are eligible for the 2019 tax year to be treated as a real estate professional. For example, if one of the requirements appears to be borderline, let's say the 750 hour requirement, let's say you're at 730 hours as of this week. You might want to take a look at the rest of the weeks of the year to see if you could pass that requirement. Now is the time also to be having discussions with your accounting team, about not only the real estate requirements to be considered a real estate professional, but also some of these other loss limitations. Like my partner Neil mentioned earlier today, it's not just the passive activity loss rules that apply anymore, there's other business loss rules that now apply.
So while being a real estate professional will allow you to overcome the passive activity loss limitations, you still have to think about the new excess business loss limitations that will still apply. So even though you're a real estate professional, you materially participate in your activities, and therefore you have non-passive losses, you may still be limited in using those losses against other income. So, now's the time, as you start planning for your fourth quarter estimated payments, which are due January 15, have some discussions with your CPA, with your other accounting professionals to see what kind of benefits you're getting from losses, or what limitations might apply.
My last year-end action item for real estate professionals is, make sure you're gathering support, including documentation, or calendar entries, so should the IRS come in and audit you one day on your real estate professional status, you want to make sure that you have records that are easily accessible and complete, so that it's not a process of looking back a couple of years trying to accumulate the records at that time.
Another area of the tax reform act that really hit home during this last tax season was the new suspension on miscellaneous itemized deductions, subject to 2% of AGI limitations. Historically, these deductions were those that were really for expenses paid for the production of income, or for the management and maintenance of property held for the production of income. So really, that's a technical definition of portfolio expenses. So think of things like your investment advisory fees for your stock portfolios, or even your tax preparation fees. There were a wide variety of expenses that were previously allowed for taxpayers once they exceeded 2% of your adjusted gross income.
These expenses were beneficial for some taxpayers in the past, but they weren't for others. For example, these expenses were not allowed for the AMT, the alternative minimum tax. So there's a whole group of taxpayers that did not receive a benefit for these expenses in the first place. But on the other hand, there was another group of taxpayers that did receive a benefit. So if you were not subject to AMT, you were getting a benefit from these 2% deductions. These are now suspended for tax years 2018 through 2025. And one note I do want to add in, is expenses that were attributable to trades or businesses, those were not subject to a 2% limitation.
So what do we want to think about in terms these 2% deductions that are now suspended? So from a year-end action planning standpoint, number one, you should consider any expenses that you previously treated as miscellaneous itemized deductions subject to this 2% limitation, you want to confirm that they are in fact portfolio deductions. And on the contrary, consider all expenses previously deducted, whether for the production of rents, or trade or business expenses, to confirm that they are in fact trade or business expenses and not portfolio deductions, and therefore suspended now. So you really want to go back and look at the expenses that you are deducting or not deducting, and just to make sure they fall into the right buckets.
And just one other example of what the two types of expenses might be. In the real estate space, for example, if you incur expenses for holding REIT stock, those are treated as portfolio deductions, and therefore not currently deductible. On the contrary, if you have a rental property, any expenses you incur that are directly connected to that rental income, those would be deducted. And whether they're deducted as for the production of rents or trade or business expenses, that's a pretty lengthy discussion that we could probably spend a couple of hours on, so we're not going to delve that much into that detail, but this is just two general themes to keep in mind as you go through this next a couple of months.
Michael, I just want to say that, as it relates to real estate private equity funds, we have funds that invest in both real estate equity investments in real estate, and then make investment loans, they are lenders of investor loans. So we traditionally had expenses at the fund level, which we would allocate between the real estate trade or business activities and the investor loan activities. For 2018, we re-examined our allocation methodology, and in certain cases determined that there were a better methodologies which could produce a better answer for the taxpayers.
Michael Torhan: So, the next topic we want to touch on is in regards to qualified opportunity funds. Now we're not going to go into that much detail regarding the basics, or all of the benefits or requirements, because that could be an entire whole webinar. We actually, we did do a number of other webinars in the past on qualified opportunity funds, so if anybody's interested, feel free to look on our website, or reach out to any of us, and we could provide you with more information. And we also have a real estate investor guide for qualified opportunity funds, which is a comprehensive manual that really discusses a lot of the requirements and benefits in a lot of detail.
Just a quick overview of the benefits of this program. Three main things. There's a tax deferral on capital gains, and that deferral is until the 2026 tax year. Likewise, there's a possible reduction of that original taxable gain on your original gains invested into these funds, and that may be either 10% or 15%. And lastly, which is what I think we've been seeing as the most significant benefit of the program, is a tax-free gain in the future on any additional appreciation. And that tax-free gain would require holding your investment in one of these QOF entities for at least 10 years.
So from a year-end planning perspective, December 31, 2019 is a really important date. Like I mentioned, number one, for the reduction of the taxable gain, in order to get the 15% reduction, one would have to invest in a QOF on or before December 31st, 2019. And the reason for that is in order to get that full 15% reduction, you have to hold your investment for at least seven years prior to that 2026 taxation date. And as a result, the last day would actually be December 31st, 2019. Likewise, for any Section 1231 gains, which most gains in the real estate industry do tend to be Section 1231 gains, those are gains on the sale of depreciable property, those gains can only be invested beginning on the last day of a tax year. So for example, if any depreciable property was sold during the year, that gain can only start to be invested on December 31st, 2019.
So things to keep in mind as we approach the end of the year for qualified opportunity funds. Number one, if you are looking to take advantage of that 15% reduction in gain, for QOF investors, start preparing for those investments on December 31st. If you're going to go to the last minute, or for example, if you're trying to invest 1231 gains, start speaking with the qualified opportunity fund now, to get your wiring instructions in place, to get the legal documents in place. No one wants to go through this last minute rush on December 31st, where you may miss that deadline.
For qualified opportunity fund entities, start thinking about the compliance matters, if you're already in existence, think about the December 31st testing date. There are various 70%, 90% testing requirements for the qualified opportunity fund program, so just start planning for those as we approached year-end. Likewise, a lot of qualified opportunity funds are going to be taking an advantage of the working capital safe harbor. Make sure you either have already documented that, or if you haven't already, start preparing that plan, because that is something that you want to have in place in order to meet each of those testing dates that are out there in this tax law.
In addition to new regulations for the business interest expense limitation that Neil mentioned, we have heard some commentary in the industry that additional regulations for qualified opportunity funds are coming out in the next month or two. And one thing I heard, Neil, is that these regulations might be a couple hundred pages.
Neil Tipograph: Yes, I'm looking forward to reading them during the holiday break. I'm sure you are also.
Michael Torhan: Yes, along with various other regulations, I think the service is really trying to get a lot of guidance out there to taxpayers, not only on qualified opportunity funds, the business interest limitation, I've also heard of guidance coming out on the new carried interest requirements. That we don't touch upon here, but just for the tax professionals on the call, I would stay tuned to the industry news in the next couple of weeks and months.
Another point we want to touch on is 1031 exchanges. Again, this is a pretty detailed topic, which we won't get into the details on. For a lot of the real estate professionals on the call, historically 1031 exchanges were the go-to tax opportunity for deferral, whereas now we also have the qualified opportunity funds. Something that is not always considered with these 1031 exchanges is that there's a lot of requirements in terms of the timing involved in completing a successful 1031 exchange. There's a 45-day requirement to identify new property, there's a 180-day requirement to acquire new property. So one can ask, what happens if any of these requirements are not met, and therefore the exchange is a failure? When is the gain recognized, if the original exchange would have crossed over a taxable year?
For example, if you sell a property in October, and you hope to acquire a new property by February of the second year. And February 1st of the second year, you realize that you're not going to acquire the new property, or something doesn't pan out, your 1031 exchange has now failed. So the question arises, when do you have to pick up that original gain? Do you have to pick it up in the original year when you sold their property, or are you able to defer some or all of that gain into the subsequent year when you actually realized that the 1031 exchange failed?
So the answer is, some of it might be recognized in the original year, and some of it might be recognized in the subsequent year. There's an installment sale method of reporting certain gains in the tax code. For 1031 exchanges, since most exchanges utilize a qualified intermediary, the cash proceeds from the original sale is held by the QI until the replacement property is purchased. Therefore, the taxpayer does not have access to that cash.
So there is guidance out there. If you meet all the requirements, for example, if there really was a bona fide intent to execute a 1031 exchange, you may be able to use the installment sale to report some or all of the gain in the subsequent year when you actually received the cash. So this is just something to consider as you really look at any 1031 exchanges you have open at the end of the year, and to see if this is an option for any failed 1031 exchanges. One thing to keep in mind for an installment sale in that scenario, if there's any mortgage that was paid off on sale, that mortgage would be considered boot, which means that that gain would be picked up when the original sale took place.
Another topic we want to touch on is new reporting requirements going forward. So this last year, a lot of the tax professionals out there, a lot of the CPAs, enrolled agents, other tax preparers, we were really busy with all of the changes from the Tax Cuts and Jobs Act. And so we have one year down, and so we're all much more comfortable with the new reporting requirements. And now the service has released some of the draft forms for the 2019 year, and many of us are slowly learning about the additional complexity that we're going to be faced with in the upcoming year.
So there's a lot of changes on the new schedules and forms. I really want to focus in on one of them, which is a new requirement to report partner capital accounts on the tax basis. And so I want to remind everybody that these forms are still draft, so they're not final yet. I'm assuming if they do become final, the requirement to report partner capital accounts on a tax basis is probably expected to require a lot of additional time in this upcoming tax season. Historically, tax capital accounts were reported on a variety of methods, whether the GAAP method, 704(b), other methods, as well as the tax basis method. Now, it appears you will be required to report capital accounts on the tax basis.
So for all the partnerships out there that have been historically reporting on a different basis, now is the time to be looking at, number one, do we have work papers and supporting documentation for those tax basis capital accounts? And two, if you do not, those calculations should be performed as soon as possible, and now is the time to start working on those. Especially for those partnerships that go back a number of years, this might be a significant task for all the tax preparers out there. So really, as we approach the year-end and January, have discussions with your tax preparers, and for the tax professionals on the call, start having discussions with your clients, to really look if this is a project that can be completed now before we really head into the busy period of tax season.
Great, thank you. So, this is an interesting result. We are 53% of the attendees have started to consider the reporting changes. We highly stressed looking at these additional reporting requirements because we do expect there to be a lot of time that's necessary in certain circumstances to comply with the new reporting.
So our last section of this webinar is just a review of the additional footnote disclosures that we had in 2018, as well as what we expect for 2019. So this last tax reporting season, I'm sure many of you that receive K-1s, or if you prepare K-1s, you might've noticed that your K-1 that might have been maybe three or four pages in the past was a double the length, if not more, for 2018. So there's a lot of new reporting that's required for a lot of the tax reform code sections. 163(j) for business interest expense limitations, the 199A deduction. So a lot of these code sections require items for the partners to be able to report on their own returns. And something that we noticed while preparing a lot of our returns this last tax season was, the consistency of either the reporting, or the lack thereof, on other K-1s, what wasn't there. We saw some K-1s included a lot of information, some of the K-1s included a little less. And so we had a lot more questions and back and forth with some of our clients, and their other CPAs.
So what we recommend, again, while we prepare for this upcoming tax season, is take a look back at what information you received immediately, and what information you had to ask for, and maybe consider adding those additional items to your open item list. And likewise, as you have your tax planning and kickoff meetings, and again, this is both for individuals in the real estate industry, whether you're an owner or a manager, as well as for the tax professionals preparing the returns, include these items on your tax planning meetings, because I think it will make things a lot easier and more streamlined for the tax season. And it would really help professionals get K-1s out quicker, and investors will be a lot happier as well getting K-1s on a timely basis.
Transcribed by Rev.com
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Michael Torhan is a Tax Partner in the Real Estate Services Group. He provides tax compliance and consulting services to clients in the real estate, hospitality, and financial services sectors.
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