Special focus on real estate and construction tax issues (and opportunities) in Minnesota and beyond
Bedford/Source Advisors special report
As we steamroll into the hectic final months of 2021, many of you have clients aggressively seeking tax incentives before the Biden tax plan goes into effect.
Nobody knows exactly how the new tax environment will shake out, but you can bet policymakers will be stricter, not more lenient, with successful individuals, companies, and investors. The good news for your real estate and construction clients is that many of the existing provisions and credits should remain intact, and some even expanded. As the Treasury Department’s new Green Book illustrates, a myriad of credits and provisions will remain available for your clients if you know where to look.
“We’re looking at some of the biggest changes the tax regulation, code and stimulus in a generation,” observed presenter Rick Telberg, Founder and CEO of CPA Trendlines at the recent Minnesota Society of CPAs Virtual Real Estate & Construction Mini-Conference produced in association with Bedford Cost Segregation/Source Advisors.
Top row from left: Max Vignola, Greg Bryant, Josh Malancuk
Middle row from left: Karen Koch, Blake Christian, Rick Telberg
Bottom row from left: Stephen Lukinovich, Andy Ackermann
Green Book impact on energy provisions
When it comes to the Green Book, presenter Greg Bryant, CCSP Senior Managing Director of Bedford/Source Advisors said he is excited about the proposed changes on the energy front. He’s optimistic that the 45L residential tax credit will increase to $2,500 per dwelling unit from the current $2,000. And Bryant believes the 179D energy efficiency tax credit could be increased to $3 per square foot on commercial buildings from the current $1.80. “It’s a really good shot in the arm,” observed Bryant. “Even $1.80 is a great incentive for people to plan with energy efficiency in mind. It’s a great time to consider energy retrofits and use tax strategies to fund those retrofits” added Bryant.
Moderator Karen Koch, CPA, MT, Senior Director of Bedford/Source Advisors, said it’s all about how we fund the process of making buildings energy efficient. “CPAs and their clients really have to understand the application and design to qualify for these tax incentives to make the dollars work. Otherwise, it is difficult to get the financial payback,” noted Koch.
Whether we’re talking about energy credits, cost segregation or even R&D, it will take a team approach more than ever,” noted Telberg. “No individual CPA and very few firms can do it on their own. It’s just too complicated, too vast, too far-reaching, too fast-changing. You need to enlist specialist partners to help you,” added Telberg, especially when credit opportunities overlap.
One attendee asked the panel if there is a risk of depreciation recapture when combining a cost segregation study with an Opportunity Zone project. In the world of 100% bonus depreciation, Koch said that if you do a cost segregation study, you are “grabbing all of your accelerated deprecation” in the first year and it gives you (the CPA) a planning opportunity down the road. “Often times the deductions are so large that clients can’t absorb the full deduction. That’s good news for planning opportunities and for lowering tax liabilities. But you’re correct; there is always recapture,” Koch added.
Koch said you only trigger recapture if you have a sale and if you sell at a gain. “If you sell at a loss, there is no recapture,” noted Koch. “If you do a 1031 exchange there is no recapture. But, if you do cost seg and sell at a gain, then you are looking at recapture. If you DO have recapture, Koch said you will recapture your 1245 assets and your 1250 assets at different rates. That’s because 1245 assets are recaptured at ordinary rates and 1250 assets are capped at 25%.
“If you have clients in the 35% to 40% tax bracket, they actually made money. You’ve protected them on long-life assets,” explained Koch. “There’s always a play when it comes to how you structure the sale. You may be selling all the assets on the books, just be careful not to recapture assets that are no longer on the books. Make sure your fixed asset listing is cleaned up prior to a sale,” Koch added.
Presenter, Blake Christian, CPA/MBT, had good news as it relates to recapture for property in an Opportunity Zone.
Opportunity Zones and 1031s
Many attendees had questions about Opportunity Zones since they have clients selling their real estate assets to beat the likely higher tax rates in 2022. When selling property for a significant gain, more and more of your clients may be bypassing 1031 exchanges because they need more than 180 days to find replacement property—or because they’d like to roll their gains into one of the many Opportunity Zones Minnesota has to offer.
“Opportunity Zones are a great tool for turning off recapture,” explained Christian, tax partner of HCVT, LLP. He said Opportunity Zones allow investors to claim millions of dollars in depreciation expense. “If you meet the 10-year hold requirement, all of the appreciation is tax-exempt, and you don’t recapture your depreciation on your 1245 or 1250 assets.”
Christian also said that if a client sold a real estate project and didn’t do a 1031 exchange, the 1250 recapture is a capital gain for purposes of rolling into an OZ fund, but a 1245 is not. “So, you want to squeeze the balloon and push more air into the 1250 recapture. “I know it’s hard to believe, but if you get to the 10-year hold finish line in an OZ fund, there is absolutely no recapture,” Christian remarked.
Historical Tax Credits
Another growing area for CPAs is helping clients quality for tax credits for refurbishing historic buildings rather than demolishing them. One attendee asked if there was a limit to how much historical tax credit you can qualify for and claim.
Originally the limit was 20% earned based on the qualified rehabilitation expenses in the year the building was placed in service. However, presenter Andy Ackermann, CPA, CVA, a partner of MCM CPAs and Advisors said that after the Tax Reform Act of 2017 was passed, that 20% generally gets spread equally at 4% per year over the five-year compliance period.
Real estate professional elections
On a related matter, an attendee asked about professional real estate elections and why attorneys, lenders and other professionals often don’t qualify for “real estate professional status”—hence losing the ability to deduct passive losses on their real estate investments from ordinary income. Ackermann said they must meet two requirements in order to qualify as bona fide real estate professionals for tax purpose:
1. They must spend at least 750 hours a year on legit real estate activities.
2. They must devote more than 50% of their time on professional real estate activities
Even if they are a real estate attorney, if they don’t meet the two tests above, any losses they generate from their real estate activities won’t qualify, said Ackermann, adding that if you’re in professional real estate activities, you must own at least 5% of the company that is generating those activities. “If you’re just a W-2 employee (including brokers) working for a developer and you have a rental piece of property on the side, you’re not going to qualify for professional real estate activities, even though you may meet the 750-hour test,” added Ackermann.
Another attendee asked if you’re the inhouse CFO for a real estate developer and you’re a 5% owner, does that make you a real estate professional? According to presenter Stephen Lukinovich, CPA, PFS, CVA – MCM CPAs & Advisors, LLP it comes down to more than just the accounting. “You’re going to have to be involved in some of the management, decision-making, etc. to reach the threshold of half your time and 750 hours,” said Lukinovich. “If you’re an architect or an engineer, the IRS doesn’t like those categories as real estate professionals, however it doesn’t mean you won’t qualify. If you’re an architect or the right kind of engineer (i.e., not civil engineers) and in the field doing that kind of work, you’re probably okay.
When it comes to CPAs qualifying as real estate professionals, Lukinovich said that if you’re simply a tax preparer, you are generally not considered a real estate professional by IRS standards. “You must defend your position with careful documentation he said. “It all comes down to the facts and circumstances. “
Grouping elections and income tax planning
When it comes to structuring entities for income tax planning purposes, Lukinovich walked attendees through the four types of grouping elections you can use to mitigate taxes on your clients’ real estate activities:
- Economic Unit Election—can help with self-rental activities. “This election can convert passive losses, which can be limited, into non-passive losses,” said Lukinovich.
- Rental Real Estate Professional Aggregation Election. As mentioned earlier, this election permits qualifying rental real estate professionals (750+ hours) to treat passive (non-deductible) rental losses as ordinary non-passive losses (i.e., deductible) to offset wages or other income.
- Passive Rental Activity Analysis: Five 100-hour analysis grouping. Frequently overlooked by practitioners, it’s an annual analysis to determine if five or more of the taxpayer’s trade or business activities exceed 500 hours in total, enabling them to deduct the losses as non-passive, said Lukinovich.
- 199A Qualified Business Income (QBI) Aggregation Election. This election “helps clients maximize of the free 20% deduction that real estate ventures have been entitled to since 2018,” added Lukinovich.
Assisting clients with property taxes
Property taxes are always a hot button issue in Minnesota. One attendee asked is you can qualify for COVID relief if you own rental properties that need new roofs, and the cost of the roof is literally “through the roof” due to supply chain disruptions?
Presenter Josh Malancuk, CPA, CMI, President, JM Tax Advocates said that isolating roofing costs is really a matter of deferred maintenance. That’s always an issue with real estate valuations. Remember when all the Chinese siding suppliers were going defunct, Malancuk asked? Home buyers were certainly asking for big concessions from seller knowing what a headache it could be to replace that siding down the road. “We always look carefully at things like roofing, windows, asphalt, paving to gauge whether there’s a condition issue with the property relative to the assessment date (typically January 1),” he added.
Minnesota has high tax rates, which magnifies the effect of any reduction and creates a larger opportunity for you and your clients, Malancuk explained. “I find Minnesota to be an interesting state because you can bypass the local level altogether and just file in tax court by April 30th. That’s a good chance to take advantage of reduction opportunities for this year. If you missed the local window, you still have a crack at it come springtime next year,” Malancuk added.
Minnesota is home to many hotels, manufacturing plants and senior care facilities, all of which need help these days. “Don’t forget that reducing property taxes can free up hundreds of thousands, if not millions, of dollars in capital for your clients that could be put to better use,” Malancuk related.
Tax credits for your client’s R&D
More clients than you think can qualify for valuable R&D credits. For instance, many people in the construction, architecture and engineering professions don’t think about applying for R&D credits, but they’re essentially leaving money on the table.
One attendee asked if an engineering company outsources some work to an MEP contractor, who gets the R&D tax credit?
Max Vignola, CCSP, Director Technical Sales R&D, Bedford/Source Advisors, said the credit always goes to the company that owns the design and is the one bearing financial risk. If the general contractor is the one that owns the design, has its name on the line and is bearing the financial risk, that’s who is eligible for the R&D tax credit. “You don’t often see R&D tax credits in a construction company,” said Vignola, “but they do exist for companies writing software and for those with engineers on staff.”
Vignola added that if your construction client is doing a special project and needs to design a special type of scaffolding, it could be eligible for R&D tax credits. Value engineering is another area ripe for R&D tax credits, said Vignola. For instance, lumber prices are sky high right now. If your client designs a more efficient building with less reliance on lumber, that’s not easy, and they could be entitled to an R&D tax credit.
Vignola said space utilization is another big area for R& D credits, since developers not only want an affordable design, but want to utilize every square inch of space in a building. Considering the amount of expertise that goes into those areas, it all comes down to “who is bearing the risk financially and who is going to own the rights to all that design work so it can be used again on another project,” explained Vignola.
Koch said she and Vignola spend a lot of time looking at how contracts are written. “It’s all about the facts and circumstances and testing who is really at risk. “Ultimately you must ensure that your clients are the ones writing the contracts the right way or else they might be selling off their technology without realizing it,” said Koch.
There are two ways of thinking about it, said Vignola:
1. If you don’t have anything in writing, then nobody owns it.
2. If both parties own the design, then it comes down to who is bearing the financial risk
“It’s very important to write into every one of your clients’ contracts, who own the design and intellectual property and who is bearing the financial risk,” Vignola cautioned.
One attendee asked the panel about A&E firms that do specialty design of groundwork and support for buildings, and the importance of base years for obtaining the simplified credit. According to Vignola the answer is often Yes. The technical name of the tax credit he said is “The Credit for Increasing Research Activity. The government is looking for a continued investment in qualifying research and development activities. The longer you do it, the benefit becomes greater,” Vignola said. “So, by setting a base period under the alternative method or the regular method, your credit potential goes up.”
Koch agreed that the base period is very important. “Once you have established your base years, you want to make sure you have some research and development activities and expenditures each year to keep the credit growing,” she said.
From an A&E standpoint, Vignola said that much of what he sees is innovative design in foundation work, structural framework, and space utilization. “When you look at foundation and structure, a lot of it relates to the location of hazards such as hurricanes, flood damage, etc. Utilizing new materials and methods to avoid potential known faults or long-term issues that the foundation or structure could face, is absolutely a sign of qualifying innovation.”
In the A&E industry, both Koch and Vignola said qualifying innovation occurs when you look beyond existing proven designs and look for ways to improve on them. “An awful lot of engineers and architects are looking at the recent condo collapse in Florida and asking: ‘why did this happen?’ and ‘how can we prevent it from happening again?’” related Vignola. “That’s all R&D effort. Was the material or structure incorrect? Was the compaction of the subgrade not up to code? Was there a sinkhole below the foundation?” he asked.
As several panelists explained, when it comes to R&D, engineers, architects, and construction supervisors will tell you they’re just doing their job, but the federal government sees it as research qualifying activities. That’s a bonus for your clients in those sectors.
According to Koch, the big takeaway here is don’t skip a year. “Once you qualify for R&D and you have the three years built for your base years, keep the process going. Make sure you have R&D every year, even if it’s small. It can still help you qualify in the next year and you might even capture more.”
One attendee asked if you don’t want to do a cost segregation study, but you have historical knowledge of how assets were treated by a prior owner, can you apply those percentages going forward? Koch responded that the IRS does not allow carryover of percentages from a prior owner. The reason is because buildings change over time with renovations, Further, the cost basis changes when buildings are sold. A cost segregation study validates the costs of individual building assets at the time of acquisition or renovation.
According to Lukinovich, there are four significant factors to consider for a cost seg study to be worth it:
1. Is there ordinary income to offset ordinary loss?
2. Do you hold the property for three or four years?
3. Is there basis?
4. What’s the real estate professional status? If you have some partners who are passive and they don’t have other sources of passive income and they’re not real estate professionals, then we must see if it makes sense to do a cost seg study.
As we get closer to year end, Bedford/Source’s Bryant reiterated that now is a great time of year to ask clients what they’ve done in terms of improvement to their buildings during the current tax year. “You may be able to identify opportunities to expense items under general property regulations, or to “tee some things up for partial asset disposition.” Bryant advised getting a jump on that process so you can get a sense of what your clients have done in terms of capital improvements. “You want to realize the various safe harbors and strategies available to add value to your client relationships,” said Bryant. “Clients are counting on you.”
For additional questions or a copy of the slide presentations, contact Heidi Janssen email@example.comJanssen
Interested in contact the presenters directly?
- Greg Bryant, CCSP
Bedford/Source Advisors | Greg.firstname.lastname@example.org
- Blake Christian, CPA/MBT HCVT, LLP | email@example.com
- Karen Koch, CPA, MT Bedford/Source Advisors | Karen.firstname.lastname@example.org
- Stephen Lukinovich
MCM CPAs & Advisors | email@example.com
- Josh Malancuk, CPA, CMI
JM Tax Advocates | firstname.lastname@example.org
- Rick Telberg
CPA Trendlines | Rickt@telberg.com