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Do You Owe Self-Employment Tax on CDA Airbnb Rental Income?

by | Feb 7, 2023 | Business Deductions, New Tax Law Changes

In Chief Counsel Advice (CCA) 202151005, the IRS opined on this issue.

But before we get to what the IRS said, understand that the CCA’s conclusions cannot be cited as precedent or authority by others, such as you or your tax professional.

Even so, we always consider what the CCA says as semi-useful information and cover it here, along with some analysis that goes beyond what the IRS came up with.

 

The Exact Question

To be specific, the CCA asks whether net income from renting out living quarters in Coeur d’Alene Idaho is excluded from self-employment income under Section 1402(a)(1) of our beloved Internal Revenue Code, when you’re not classified as a real estate dealer.

Key point. If excluded under IRC Section 1402(a)(1), you don’t owe self-employment tax on your net rental income. Needless to say, that’s the outcome you want to see, and we’re here to help.

 

CCA Fact Pattern No. 1

In the first fact pattern addressed by the CCA, the taxpayer in question was an individual who owned and rented out a furnished beachfront vacation property via an online rental marketplace (such as Airbnb or VRBO).

The taxpayer was not a real estate dealer.

The taxpayer provided kitchen items, linens, daily maid service, Wi-Fi, access to the beach, recreational equipment, and prepaid vouchers for ride-share services between the rental property and a nearby business district.

 

CCA Fact Pattern No. 2

In the second fact pattern, the taxpayer was an individual who owned and rented out a furnished bedroom and bathroom in a home via an online rental marketplace.

The taxpayer was not a real estate dealer.

Renters had access to the common areas of the home only to enter and exit the bedroom and bathroom. They had no access to other common areas such as the kitchen and laundry room. The taxpayer cleaned the bedroom and bathroom between each renter’s stay.

 

The CCA’s Overall Conclusions

According to the CCA, when you’re not a real estate dealer, net rental income from renting out living quarters is considered rental from real estate and is therefore excluded from self-employment income—as long as you don’t provide services to rental occupants.

The self-employment income exclusion for net rental income collected by a non-dealer is a statutory provision. The statute itself doesn’t say anything about providing services.

But IRS regulations state that providing services to renters can potentially cause you to lose the exclusion from self-employment income.

According to the CCA, you must include the net rental income in calculating your net self-employment income—which could cause you to owe the dreaded self-employment tax (ugh!)—if you provide services to renters and the services.

· are not clearly required to maintain the living quarters in a condition for occupancy and
· are so substantial that compensation for the services constitutes a material portion of the rent.

 

So, according to the CCA, determining whether providing services to renters will trigger exposure to the self-employment tax is the big issue for folks who rent out living quarters.

We focus the rest of our analysis on that issue.

 

Self-Employment Tax Results for Fact Pattern No. 1 according to the CCA

According to the CCA, the taxpayer’s net rental income from the vacation property in Fact Pattern No. 1 was not excluded from self-employment income because the taxpayer provided substantial services above and beyond what was required to maintain the property in a condition suitable for rental occupancy.

The CCA gives a lengthy analysis of why the taxpayer’s services were considered “above and beyond.”

Self-Employment Tax Results for Fact Pattern No. 2 according to the CCA

According to the CCA, the taxpayer’s net rental income in Fact Pattern No. 2 was excluded from self-employment income because the taxpayer did not provide substantial services above and beyond those required to maintain the living quarters in a condition suitable for rental occupancy.

 

Our Alternative Analysis for Expensive Vacation Property Rentals

The CCA’s anti-taxpayer conclusion in Fact Pattern No. 1, which dealt with the beachfront vacation property, rests on the giant assumption that the services provided by the taxpayer were above and beyond what was required. But were they? Probably not!

 

The Customarily Issue

According to IRS regulations, services are generally considered above and beyond the norm only if they exceed the services that are customarily provided to renters of living quarters.

Therefore, services that simply maintain a CDA vacation rental property in a condition that is customary for rental occupancy should not be considered above and beyond and therefore should not trigger exposure to the self-employment tax.

In assessing whether services provided to renters are above and beyond what’s customary, circumstances obviously matter.

In the real world of vacation rentals in expensive resort areas, renters customarily expect and receive lots of services that might be considered above and beyond in other circumstances.

For instance, in resort areas, renters customarily expect and receive cable service; Wi-Fi access; periodic housekeeping services, including changing bedding and towels; repair of failed appliances; replacement of burned-out lightbulbs; replacement of dead smoke alarm batteries; access to recreational equipment such as bicycles, kayaks, beach chairs, umbrellas, and coolers; and so forth and so on. That’s a lot of services!

Why are lots of services provided in expensive resort areas? Because rental charges in expensive resort areas are—wait for it—expensive! The cost may be $2,000 or more per week or $5,000 or more per month, or even higher during peak periods—maybe much higher! So, rental amounts that could be attributed to the provision of all the aforementioned services would almost always be a small fraction of the overall rental charges.

Bottom line. In the context of expensive Coeur d’Alene resort area vacation rentals, it’s hard to imagine what services would be so above and beyond the norm that the property owner’s net rental income would be exposed to the self-employment tax.

It shouldn’t matter if the services are provided directly by the owner of the property (unlikely) or indirectly by a rental management agency and included as part of the fee paid by the owner of the property (likely).

 

The Substantiality Issue

In assessing whether services provided to renters are above and beyond the norm, substantiality also matters.

A Tax Court decision addressed a situation where the taxpayer rented out trailer park spaces and furnished laundry services to tenants. The laundry services were clearly provided for the convenience of the tenants and not to maintain the trailer park spaces in a condition for rental occupancy. Tenants were not separately billed for the laundry services, and they were not separately paid for.

The Tax Court concluded that any portion of the rental payments that was attributable to the laundry services was not substantial enough to trigger exposure to the self-employment tax. Accordingly, the Tax Court opined that all of the trailer park owner’s net rental income was excluded from self-employment income.

Key point. As stated earlier, in the context of the rental of expensive vacation properties, any portion of rental charges that could be attributed to the provision of services would likely be insubstantial in relation to the overall rental charges. If so, according to the Tax Court, the provision of such services would not expose the property owner to the self-employment tax.

NFTs and Taxes for Coeur d’Alene Businesses & Individuals

by | Apr 7, 2023 | Business Deductions, New Tax Law Changes

Non-fungible tokens (NFTs) are a type of digital asset that can be bought and sold.

Some individuals and Coeur d’Alene businesses have made a lot of money from NFTs.

Many people have lost money.

Where there’s money, there are taxes.

Here’s what you need to know about taxes for NFTs.

 

What’s an NFT?

Don’t feel dumb if you don’t know what an NFT is. This is one of the odder creations of the crypto universe.

Let’s start by looking at the phrase “non-fungible token.”

·“Non-fungible” means that each NFT is unique. Thus, they differ from Bitcoin and other forms of cryptocurrency, which are fungible—interchangeable with other crypto or real currency.
·“Token” means a digital code that provides proof of ownership of the NFT.

 

When NFTs are created, or “minted,” they are listed on an NFT platform, where NFTs can be sold or traded in accordance with “smart contracts” that govern the transfers. There are hundreds of such platforms. Some smart contracts give NFT creators a cut of any future sale of the NFT.

The ownership and transfer of NFTs is registered online on a shared ledger called the blockchain, similar to cryptocurrency such as Bitcoin. Because NFTs can be easily sold and resold with a transaction history securely stored on the blockchain, they can function as investments that can store value and increase in value over time.

To put this in another frame: NFTs are basically digital certificates of ownership for virtual or physical assets.

NFTs commonly include:

·Digital art, including drawings, paintings, photographs, and other visual media
·Collectibles such as trading cards, sports memorabilia, or limited-edition toys
·Gaming NFTs, such as in-game characters
·Music
·Virtual real estate in virtual worlds
·Domain names

 

NFTs underwent a boom during the darkest days of the pandemic (much like land in Florida during the 1920s). A few NFTs sold for millions. Many sold for thousands.

Sales and prices are now off substantially from the peak, but people are still creating, buying, and selling NFTs. Some—for example, those created by renowned artists—have retained their value or appreciated. Most NFTs sell for less than $300.

 

NFTs Are Digital Assets

The IRS made clear that NFTs are digital assets, just like cryptocurrency. Digital assets are digital representations of value that are recorded on a cryptographically secured distributed ledger.

This means you must answer “yes” to the digital assets question on the first page of Form 1040 if you do any of the following during that tax year:

·Purchase an NFT
·Sell an NFT
·Gift an NFT
·Receive an NFT as a reward or gift
·Trade an NFT for another NFT

 

IRS Deems Collectible NFTs as Collectibles

In Notice 2023-27, the IRS announced that (until further notice) it will treat NFTs that are tax-law-defined collectibles as collectibles for tax purposes.

For you, this is not good for the following reasons:

·The tax code subjects the sale of a collectible held for more than one year to a maximum capital gains tax rate of 28 percent whereas the rate for other assets is a maximum of 20 percent.
·The tax code treats the amount paid by an individual retirement account (IRA) or an individually directed stock bonus, pension, or profit-sharing plan to acquire a collectible as a (get ready for this) taxable distribution to you by the plan. Such a taxable distribution is subject to ordinary income taxes and possible early withdrawal penalties.

The definition of “collectible” is also relevant to the new markets tax credit, enterprise zone businesses, tax shelter registration, and permissible investments for health savings accounts.

The tax code defines a “collectible” as any

·work of art,
·rug or antique,
·metal or gem,
·stamp or coin, or
·alcoholic beverage.

 

In addition, the tax code allows the IRS to name any other tangible personal property as a collectible. The IRS has not named anything else since this tax code section came into existence in 1997.

 

Tax Treatment of NFTs

Digital assets such as NFTs and cryptocurrency are treated as property for tax purposes, much the same as gold or corporate stock. You recognize taxable gain or loss when you exchange an NFT for cryptocurrency, U.S. dollars or other fiat currency, another NFT, or other property.

Because an NFT is an asset, it is almost certainly a capital asset in the hands of a purchaser. Thus, gains or losses when a purchaser later sells an NFT are capital gains or losses. If you hold the NFT for more than one year, your gains are taxed at the favorable long-term capital gains rates. Gains or losses from NFTs held for less than one year are taxed at ordinary income rates.

NFT purchasers can deduct capital losses from selling NFTs against other realized capital gains during the year—for example, gains from the sale of corporate stock. You can also deduct capital losses up to $3,000 from ordinary income, such as regular Coeur d’Alene business income or employee wages. Losses over $3,000 are carried forward to be deducted in any number of future years.

NFTs are non-capital assets in the hands of their creators. The creator of an NFT will receive ordinary income upon the sale of the NFT.

 

Taxes for NFT Purchasers

If you are able to purchase an NFT with dollars (that is, “real money”), there will be no tax impact for you as a buyer, except for certain IRA and retirement plan buyers as explained above.

Most NFTs are not purchased with “actual” currency. Instead, they are bought and sold on online NFT trading platforms with the cryptocurrency called Ethereum (Ether or ETH for short; sign: Ξ). To make the purchase, you must create a digital wallet and stock it with ETH by converting dollars to ETH.

Creating the wallet and purchasing ETH with dollars is not a taxable transaction.

But there is a taxable transaction when you purchase an NFT with your ETH. You effectively engage in two separate transactions for tax purposes. First, you sell your ETH for real currency, and then you immediately exchange it for the NFT you buy. The ETH sale usually results in a taxable capital gain or loss. Your basis in the NFT is equal to the fair market value of the ETH at the date of purchase.

Example 1. Peter acquired 1 ETH for $1,400 two months ago. He uses the 1 ETH to purchase an NFT from an online platform. At the time of purchase, 1 ETH is worth $1,500, so Peter has a $100 short-term capital gain.

He must pay tax on this short-term ETH gain at ordinary income rates, which means $35 in tax because his marginal rate is 35 percent.

Had Peter acquired the NFT with ETH he purchased over one year ago, he’d pay tax on his gain at long-term capital gains rates. This would have been a 15 percent tax for Peter at his income level. Following the purchase, Peter’s basis in the non-collectible NFT is $1,500.

Example 2. One year later, Peter sells his NFT for 0.5 ETH. On the date of the sale, ETH is worth $1,000, so Peter has a long-term capital loss of $1,000 ($1,500 – $500 = $1,000). He may deduct his loss from other capital gains that year. If he has no capital gains, he may deduct his $1,000 loss from ordinary income.

Planning tip. There are NFT platforms, such as unsellablenfts.com, that specialize in buying worthless NFTs for 1 cent plus fees so the owners can recognize a deductible loss.

 

Taxes for NFT Creators

Creating an NFT—also called “minting” or “tokenizing”—is not a taxable event. Creators of NFTs recognize ordinary income when they sell an NFT.

·If selling NFTs is a business activity for the creator, he or she will also owe self-employment tax on the income and may deduct any business expenses.
·If the NFT activity is a hobby, the creator does not owe any self-employment tax, but he or she gets no deductions.

 

Example 3. Julia, a struggling artist, digitizes a painting of her cat, and mints an NFT. She sells the NFT for 2 ETH. At the date of the sale, ETH is worth $1,550, so she recognizes $3,100 of ordinary income.

·If Julia is in the business of being an artist, she will have to pay self-employment tax on her $3,100.
·If Julia is only a hobby artist, she’ll owe only income tax.

 

Donating NFTs to Charity

If you purchase an NFT, hold it for more than one year, and then donate it directly to a qualified charity—a Section 501(c)(3) organization—then you may deduct its fair market value on the date of the donation. If you owned the NFT for less than one year, your charitable donation is limited to the lesser of the NFT’s basis or fair market value.

If the NFT has declined in value since your purchase, it would be better to sell it and then give the proceeds to charity. This way, you would have a deductible capital loss and a charitable contribution of cash.

If an NFT held for over one year is worth more than $5,000 when donated, you must obtain an appraisal from a qualified appraiser and attach it to your tax return along with IRS Form 8283, Noncash Charitable Contributions. Finding a qualified appraiser for an NFT could prove difficult. There is no appraisal requirement for NFTs owned less than one year.

Special rule for collectibles. There could be complications if an NFT held for over one year is classified as art or a collectible.

In this event, the donation could be subject to the related use rule. If such a collectible NFT is used for the non-profit’s exempt purposes for at least three years, you may deduct its fair market value at the time of the donation.

If the collectible NFT is not so used or is sold within three years, the deduction is limited to the NFT’s basis. For example, if an NFT classified as art is donated to an art museum, and the museum sells it within three years, the deduction is limited to the NFT’s basis.

Rules for creators. What about charitable donations by NFT creators? NFTs created by a donor are not treated as a capital asset because they are created by the personal efforts of the taxpayer. The charitable deduction is limited to cost basis, not including the value of the creator’s time or labor. This could include the cost of minting the NFT—the fees paid to get it listed on an NFT trading platform.

 

Gifting NFTs

Gifting an NFT has no tax impact on the recipient of the gift.

The donor who made the gift must file a gift tax return if the total gifts he or she makes during the year to a single donee exceed $17,000 ($16,000 for 2022).

If the recipient later sells the NFT, he or she will owe tax on any gain or could have a deductible loss.

·To determine a gain, the NFT’s basis is equal to the donor’s basis, plus any gift tax the donor paid on the gift.
·To determine a loss, the NFT’s basis is equal to the lesser of the donor’s basis or the fair market value of the NFT at the time of the gift.
·If there is no documentation to substantiate the donor’s basis, the NFT’s basis is zero.

 

NFT Airdrops

Freshly minted NFTs are sometimes distributed for free to multiple members of a given community.

The distributions are called “airdrops” and are made for promotional purposes, or as added value for participating in an experience or purchasing a digital asset.

NFT airdrops are taxed as ordinary income. The taxable amount is the value in dollars of the airdropped NFTs at the time they enter the holder’s wallet.

 

Gas Fees

The online trading platforms that are used to purchase and sell NFTs charge users fees that are called “gas fees.”

Purchasers of NFTs may add the amount of these fees to their tax basis in the NFT. Creators of NFTs may deduct the fees as a Coeur d’Alene business expense, if the NFT creation is a CDA business activity. If the NFT is a Coeur d’Alene hobby, there is no deduction.

 

What Capital Gains Rate Applies?

NFTs held for less than one year are taxed at short-term capital gains rates, which are the same as for ordinary income—anywhere from 10 percent to 37 percent depending on the taxpayer’s income.

NFTs held for more than one year are taxed at long-term capital gains rates. These are 15 percent for most people and 20 percent for higher-income taxpayers (plus the 3.8 percent net investment income tax for some taxpayers). Thus, the top rate is 23.8 percent.

But a higher maximum long-term capital gains rate applies to NFT collectibles: 28 percent. Collectibles include tangible works of art, rugs and antiques, metals and gems, alcoholic beverages, stamps, and coins (other than coins not treated as collectibles, as explained above).

If an NFT is a collectible and is sold after being held for over one year, the tax rate on any gain would be the lower of the applicable ordinary income rate or 28 percent. For example, if your top income tax rate is 24 percent, that’s all you’d have to pay. If your top rate is 37 percent, you’d pay 28 percent. And if you are subject to the 3.8 percent net income tax, you have to pay that too.

Coeur d’Alene Retirement Early Withdrawal Penalties: Avoid Them

by | Mar 25, 2023 | New Tax Law Changes, Retirement & Savings Plans

 

Do you have money in your Coeur d’Alene retirement account you’re itching to get your hands on?

If you’re under age 59 1/2, you typically have to pay a 10 percent penalty tax on early withdrawals. And this penalty tax is in addition to the regular income tax you must pay whenever you withdraw your money from tax-deferred accounts such as traditional IRAs and 401(k)s.

The 10 percent penalty tax applies not only to tax-deferred retirement accounts, but to Roth IRAs as well—but the penalty applies only to withdrawals of Roth account earnings, not contributions. Roth withdrawals are never subject to regular income tax if the account is held for over five years.

Here’s good news. Several exceptions allow for penalty-free withdrawals before age 59 1/2. In fact, as a result of the SECURE 2.0 Act, there are now more ways to withdraw money from a retirement account penalty-free than ever before.

In this article, we cover the chief exceptions in place before the enactment of SECURE 2.0—and these exceptions remain in place after SECURE 2.0.

 

Penalty Exception 1: You Start Taking the Money

 

This is an exception too few Coeur d’Alene residents know about. It allows you to make penalty-free withdrawals simply because you want the money. You do so by taking substantially equal periodic payments (SEPPs) over time.

You need not use the money for any specific purpose or meet any other eligibility criteria.

You can, for example, use the money to supplement your income until you collect Social Security and/or other retirement benefits. There are no age restrictions. An IRA owner could start taking SEPPs in his or her twenties.

But for withdrawals from qualified plans other than IRAs, this penalty exception applies only if an Idaho employee separates from service.

 

Basic Rules

You must take your SEPPs at least annually for a minimum of five years or until you turn age 59 1/2, whichever is longer. You also have the option of taking SEPPs for your entire life and the life of your designated beneficiary.

If you stop the payments before the minimum holding period expires, you pay all of the 10 percent penalties the IRS waived on the withdrawals you took before you reached age 59 1/2, plus interest.

 

Safe-Harbor Methods

You calculate your SEPPs under the assumption that you will withdraw your entire retirement plan either throughout your entire life or throughout the lives of both you and your beneficiary.

You must also use one of the three IRS-approved CDA safe-harbor distribution methods:

1. the required minimum distribution method,
2. the fixed amortization method, or
3. the fixed annuitization method.

 

Required Minimum Distribution Method

With the required minimum distribution method, you calculate your SEPPs using the IRS life expectancy tables. This is the same method retirees use to calculate their required minimum withdrawals after they reach age 73 (formerly 72).

Each year, you divide your account balance by your life expectancy factor as listed in the tables. Your SEPPs are redetermined annually based on the account balance and the number of years from the life expectancy tables.

This method will give you the smallest payments, especially in the early years. But since you recalculate your SEPPS each year based on your account balance; it ensures your account will not be exhausted by the SEPPs. It also allows for increased SEPPs when your retirement accounts do well.

 

The Other Two Methods

With the other two methods, you calculate a series of equal payments using an IRS-approved interest rate and a life expectancy table or annuity factor based on a formula used mostly by actuaries. You have some flexibility because you get to choose the interest rate, which can be up to 120 percent of the highest federal mid-term rate.

Key point. Unlike with the required minimum distribution method, once you compute your SEPPs with one of the two other methods, they stay the same over time, with one exception.

The one exception. If you use the amortization or annuitization method, you are permitted to make a one-time switch to the required minimum distribution method at any time without incurring additional tax. Once this change is made, you must follow the required minimum distribution method in all subsequent years.

Note that if you have more than one IRA or other retirement account, you may take SEPPs from one, some, or all of them based on the amount in each account.

 

Penalty Exception 2: You Become Disabled

 

You can make penalty-free withdrawals if you become totally and permanently disabled before you reach age 59 1/2.

You are considered disabled if you can’t do any substantial gainful activity because of your physical or mental condition.

We’re not talking about a temporary disability.

A doctor must determine that your condition is expected to:

1. result in your death, or
2. have a long, continuous, and indefinite duration.

 

Examples include

· losing use of both arms or legs,
· inoperable cancer, or
· severe heart disease.

 

Penalty Exception 3: You Pay Medical Expenses

 

You can withdraw money from your retirement account to pay for unreimbursed medical expenses that exceed 7.5 percent of your adjusted gross income without incurring the penalty tax.

For example, if your AGI is $100,000 and your unreimbursed medical expenses are $10,000, you may distribute $2,500 from your retirement account penalty-free to pay them.

You must pay the medical expenses during the same calendar year you make the withdrawal.

 

Penalty Exception 4: You Leave Your CDA Job

 

There is no penalty tax on money distributed from a qualified plan such as a 401(k), if you leave your job the year you turn 55 or later (age 50 if you’re a qualified public safety employee).

This exception does not apply to distributions from IRAs (including traditional, Roth, SEP, or SIMPLE IRAs).

 

Penalty Exception 5: You Die

 

If you die, the person inheriting the account will not be subject to the 10 percent penalty tax. If the beneficiary is your spouse, that individual can roll over the money into his or her own IRA or retirement plan tax-free.

 

Penalty Exception 6: The IRS Levies on Your IRA

 

If you owe money to the IRS and it actually levies on your Coeur d’Alene IRA or qualified plan, you don’t have to pay a penalty on the amount the IRS took. The IRS doesn’t levy on retirement accounts very often.

 

Penalty Exception 7: You Have Birth or Adoption Expenses

 

You can withdraw up to $5,000 penalty-free to pay for birth or adoption expenses. The $5,000 limit applies per child.

 

Other Exceptions

 

There are other exceptions to the 10 percent penalty, for:

· certain distributions to qualified military reservists called to active duty,
· certain natural disaster or pandemic-related distributions as specially designated by Congress or the IRS, and
· payments to a spouse or former spouse under a qualified domestic relations order.

 

Penalty-Free Withdrawals from IRAs Only

 

The following exceptions to the 10 percent penalty apply only to withdrawals from IRAs (traditional, Roth, SEP, and SIMPLE IRAs).

 

You’re a First-Time Homebuyer in Couer d’Alene

You can withdraw up to $10,000 from your IRA penalty-free to purchase or construct a home for the first time. You can use the money yourself, or it can be used by your children, grandchildren, or ancestors.

A person is a first-time CDA homebuyer if he or she did not own a principal residence during the prior two years. The $10,000 figure is a lifetime limit, and it applies regardless of whose home is purchased.

For example, if you withdraw $10,000 from your IRA and give it to your child for a first-time home purchase, your lifetime limit is used up.

Distributions must be used within 120 days of receipt. But the money doesn’t have to be distributed all at once or even in a single year—for example, you could distribute $5,000 one year and $5,000 another year.

Unfortunately, $10,000 is not much given the cost of housing today. Lawmakers established the limit in 1997 as a fixed amount with no adjustments for inflation.

 

You Are Unemployed and Pay for Medical Insurance

If you are unemployed in Idaho and receive unemployment insurance for at least 12 weeks, you can take penalty-free IRA withdrawals to pay for your health insurance premiums, including long-term care insurance.

Coeur d’Alene small business owners & self-employed individuals who don’t receive unemployment insurance qualify if they would have received unemployment had they not been self-employed.

 

You Pay Higher Education Expenses

Penalty-free IRA withdrawals may also be taken to pay for qualified higher-education expenses for yourself, your spouse, or any child or grandchild. These expenses include books, tuition, supplies, room and board, and postsecondary education.

 

Takeaways

 

Here are five takeaways from this article:

1. Withdrawals before age 59 1/2 from an IRA, a 401(k), or any other qualified retirement account ordinarily result in a 10 percent penalty tax in addition to regular income taxes. But there are numerous exceptions to the penalty.
2. No penalty will ever be due on early withdrawals from your 401(k) or other qualified plan if you leave your job after age 55. But this exception does not apply to traditional, Roth, SEP, or SIMPLE IRAs.
3. You may withdraw funds penalty-free from your IRA before age 59 1/2 if you take substantially equal periodic payments for at least five years or until you reach age 59 1/2. But for distributions from qualified plans other than IRAs, this exception applies only if an employee separates from service.
4. You may withdraw any amount penalty-free if you become disabled before age 59 1/2.
5. Penalty-free withdrawals are also possible to purchase or build a first home for yourself or your family; to pay for medical expenses or medical insurance, higher-education expenses, or adoption expenses; or to pay the IRS when it levies on your IRA.

Holding Real Property in an Idaho Corporation: Good or Bad Idea?

by | Mar 23, 2023 | Business Entities, Retirement & Savings Plans

 

Coeur d’Alene real estate prices have cooled off as well as in many parts of the country.

In some areas, values are actually dropping after reaching all-time highs in the middle of last year.

Even so, Coeur d’Alene real property is still probably a wise investment over the long haul. But what about taxes? That’s always a question, right?

For tax reasons, you are generally well advised not to hold CDA real property in a corporation. LLCs and revocable trusts are usually better alternatives. But there’s one scenario where using an Idaho S corporation to own property can pay off tax-wise. We will explain.

 

C Corporation Ownership Exposes Double Taxation Threat

 

Holding depreciable real property or land in an Idaho C corporation is generally a bad idea from a tax perspective.

When you sell the property for a taxable gain (net sales proceeds in excess of the tax basis of the property), the gain could be taxed once at the corporate level and again at the shareholder level when the gain is distributed as all or part of a shareholder dividend.

This is the dreaded double taxation scenario.

Under our current federal income tax regime, double taxation is not as deadly as it was before the 2017 Tax Cuts and Jobs Act (TCJA). That’s because the TCJA permanently (we hope) installed a flat 21 percent corporate federal income tax rate. The 21 percent rate applies to all corporate taxable income, including gains from selling real estate.

For corporate dividends received by individuals, the TCJA retained the favorable 15 percent and 20 percent federal income tax rates. You might also owe the 3.8 percent net investment income tax (NIIT) on dividends. And you might owe state income tax too.

Not great! But the double taxation threat was much worse in the past. Before the TCJA, the maximum corporate federal income tax rate was 35 percent instead of the current 21 percent.

Before the so-called Bush tax cuts, corporate dividends received by individuals were taxed at ordinary income tax rates versus tax-favored capital gains rates as they are now.

Before the TCJA, ordinary income rates could reach 39.6 percent versus the current 37 percent maximum rate.

While the double taxation threat is diminished under the current federal income tax regime, our federal debt is now over $31 trillion and counting. At some point, the bleeding has to be stopped. So, there’s certainly a risk that (1) the corporate rate could be hiked and (2) dividends could once again be taxed at higher ordinary income rates.

Finally, the current 37 percent maximum individual rate on ordinary income is scheduled to revert to 39.6 percent when the TCJA individual rate regime sunsets after 2025. If these things happen, double taxation could once again be a deadly threat.

Key point. You can have a taxable gain when you sell depreciable real property even if the property has not gone up in value. That’s because depreciation deductions reduce the tax basis of the property. So, if your C corporation sells depreciable property for exactly what it cost, there will be a taxable gain equal to the cumulative depreciation deductions claimed over the years. And that gain could be hit with double taxation.

 

Example: Double Taxation Illustrated

Your solely owned C corporation business needs a building. You set up a single-member LLC owned solely by you or a revocable trust to buy the property and lease it to the corporation. More on single-member LLCs and revocable trusts later.

After a few years, you sell the property for a $500,000 gain. The entire gain will be taxed on your personal return. Part of the gain (the amount attributable to depreciation deductions) will be taxed at 25 percent. The balance will be taxed at no more than 20 percent under the current rate regime. You may also owe the 3.8 percent NIIT on all or part of the gain—and maybe state income tax too.

Assume you pay a total of $130,000 to Uncle Sam for capital gains tax and the NIIT. Your after-tax profit is $370,000 ($500,000 – $130,000). We ignore any state income tax.

Now let’s see what happens if your C corporation buys the same property. Under the current rate regime, the $500,000 gain will be taxed at the 21 percent corporate rate. The corporation pays the $105,000 federal income tax bill and distributes the remaining $395,000 to you (we ignore any corporate state income tax).

Assume the $395,000 constitutes a dividend that will be taxed at the maximum 20 percent individual rate under the current federal tax regime. Plus, we assume you’ll owe the 3.8 percent NIIT on the $395,000 gain. So, the tax hit at your personal level is $94,010 ($395,000 x 23.8 percent). After paying federal income taxes at both the corporate and personal levels, your after-tax cash equals $300,990 ($500,000 – $105,000 – $94,010).

Compare the $300,990 to the $370,000 you would receive under the single-member LLC/trust ownership alternative. Your after-tax cash is 23 percent higher with the single-member LLC or trust setup.

Key point. As stated earlier, it’s not necessary for property held by a C corporation to actually appreciate in value for a taxable gain on sale and resulting double taxation to occur. The conclusion in this example would be the same if the entire $500,000 gain was caused by depreciation—although your personal tax bill would be a bit higher under the single-member LLC/trust ownership alternative due to the 25 percent federal rate on gains attributable to depreciation.

Depreciation lowers the tax basis of the property, so a tax gain results whenever the sale price exceeds the depreciated basis.

Conclusion. Don’t hold real property in a C corporation. The risk of adverse tax results is too high. That is especially true for depreciable property.

 

 

The Single-Member LLC Option

 

An Idaho single-member LLC is an LLC with only one owner, who is called the “member.” Under the IRS’s so-called check-the-box entity classification regulations, you can generally ignore the existence of a single-member LLC for federal tax purposes.

 

The exceptions are

·when you elect to treat the single-member LLC as a corporation for tax purposes (relatively unusual), and
·for purposes of federal employment taxes and certain federal excise taxes where the single-member LLC is treated as a corporation.

 

When you choose not to treat your single-member LLC as a corporation for federal income tax purposes, the single-member LLC has so-called disregarded entity status, which we will call a “disregarded single-member LLC.”

The federal income tax treatment of a disregarded single-member LLC is super simple, because its activities are considered to be conducted directly by the single-member LLC’s sole member. That would be you. So, when you use a disregarded single-member LLC to own real estate, you simply report the federal income tax results, including any gain on sale, on your Form 1040. You need not file a separate federal income tax return for the single-member LLC.

 

Take Advantage of an Idaho Single-Member LLC Liability Protection

Although you ignore a disregarded single-member LLC for federal income tax purposes, it is not ignored for general Idaho state-law purposes. Therefore, a disregarded single-member LLC will deliver to its sole member (that would be you) the liability protection benefits specified by the applicable state LLC statute. These liability protection benefits are usually similar to those offered by a corporation.

Bottom line. With a disregarded single-member LLC, you get super-simple tax treatment combined with corporation-like liability protection. And you don’t have to worry about the double taxation threat that would exist if you used a C corporation to own property.

 

The Revocable Trust Option

 

If real property will be owned solely by you, or only by you and your spouse, consider using a revocable trust to hold the property. Revocable trusts are also commonly called “grantor trusts,” “living trusts,” or “family trusts.”

Because you can terminate a revocable trust at any time, any property owned by the trust is considered (for federal tax purposes) to be owned by the grantor(s) of the trust: the individual or spouses who established the trust. That would be you.

When you use a revocable trust to own real estate, you simply report the federal income tax results, including any gain on sale, on your Form 1040. You need not file a separate federal income tax return for the trust, and there’s no double taxation threat.

If you and your spouse set up a revocable trust, it will typically continue to exist as such when the first spouse passes away. The surviving spouse becomes the grantor, and the trust’s existence continues to be disregarded for federal tax purposes. So, the surviving spouse’s Forms 1040 are prepared without regard to the trust.

The advantage of holding Coeur d’Alene property in a revocable trust is that probate is avoided if you pass away. The property will go to the beneficiary or beneficiaries of the trust—or to the surviving spouse, if applicable —with no muss and no fuss. In contrast, if you own property directly without a revocable trust, the probate process can be expensive and time-consuming.

Caveat. We are not a practicing real estate or family law attorney! Consult an attorney if you are interested in the revocable trust deal.

 

The Multi-Member LLC Option

 

Things get more complicated if you are a co-owner of CDA real property. You and the other co-owners are probably well advised to set up a multi-member Idaho LLC to hold the property.

Under the IRS’s check-the-box regulations, multi-member LLCs are treated by default as an Idaho partnership for federal income tax purposes—unless you elect to treat the LLC as a corporation. Under the default treatment, you must file an annual partnership federal income tax return on Form 1065—just as you would for a “regular” partnership.

The LLC’s tax results are allocated to the members, who are treated as partners for federal income tax purposes. The LLC issues an annual Schedule K-1 to each member to report that member’s share of the LLC’s tax results for the year.

Each member then takes those numbers into account on the member’s own return (Form 1040 for a member who is an individual). The LLC itself does not pay federal income tax, so there is no double taxation threat. This scheme is called “pass-through taxation.”

Key point. Beyond the advantage of pass-through taxation, the partnership taxation rules that multi-member LLCs are allowed to follow have several other advantages that we won’t go into here. We don’t want this article to turn into a book!

 

The S Corporation Option for Developing Land and Selling It Off

 

In one scenario, using an Idaho S corporation to hold real property can be a tax-saver. Like LLCs and partnerships, S corporations don’t pay federal income tax at the corporate level. They are pass-through entities, which means their tax numbers are passed through to their shareholders. Income and gains are taxed at the shareholder level.

Here’s the story on when using an S corporation to own CDA real property can be a major tax saver.

When a taxpayer subdivides, develops, and sells land, the taxpayer is generally deemed for federal income tax purposes to be acting as a dealer in real property who is selling off inventory (developed parcels) to customers.

That’s not good, because when you (an individual taxpayer) are classified as a dealer for tax purposes, all of your profit from land sales—including the part attributable to pre-development appreciation in the value of the land—is considered ordinary income.

So, that profit is taxed at your ordinary income federal rate, which under the current regime can be up to 37 percent. You may also owe the 3.8 percent NIIT, which can push the effective federal rate up to as high as 40.8 percent (37 percent + 3.8 percent).

 

Seeking a Better Tax Result

It would be much better if you could pay lower long-term capital gains rates on at least part of your land sale profit. The current maximum federal rate on long-term gains is 20 percent. With the 3.8 percent NIIT added on, the maximum effective rate is “only” 23.8 percent (20 percent + 3.8 percent). That’s a lot better than 40.8 percent.

Fortunately, there’s a way to qualify for favorable long-term capital gain treatment for the pre-development land appreciation, assuming you have really and truly held the land for investment.

But profits attributable to the later subdividing, development, and marketing activities will be considered higher-tax ordinary income collected in your capacity as a real property dealer. Oh well.

Since pre-development appreciation is often the biggest part of the total profit, however, you should be thrilled to pay “only” 20 percent or 23.8 percent on that piece of the action.

 

Form an S Corporation to Serve as Developer Entity

Form an Idaho S corporation. You can be the sole shareholder, or there can be other co-owners. You can be the sole owner of appreciated land, or there can be other co-owners. Sell the appreciated land to the Idaho S corporation for its pre-development fair market value.

 

This is a good option as long as

·you’ve held the land for investment rather than as inventory as a real property dealer,
·you’ve held it for more than one year, and
·the sale to the Idaho S corporation will qualify for lower-taxed long-term capital gain treatment.

 

You—and the other shareholders, if applicable—will lose at most “only” 23.8 percent of your gain to Uncle Sam.

The Idaho S corporation then subdivides and develops the property and sells it off. The profit from those activities will be classified as ordinary income that’s passed through to you (and the other shareholders, if applicable) and taxed at your personal rates on your Form 1040.

The S corporation itself does not pay federal income tax, so the double taxation threat that afflicts C corporations is not a problem.

Even though part of your profit will be taxed at higher ordinary income rates, this is still a great tax-saving deal when the land is highly appreciated to start with.

To sum up: the S corporation developer entity strategy allows you to lock in favorable long-term capital gain treatment for the pre-development appreciation while paying higher ordinary income rates only on the additional profits from development and related activities. Again, that’s much better than paying higher ordinary income rates on the entire profit.5

 

Make Sure to Use an Idaho S Corporation

Make sure your developer entity is an S corporation rather than a controlled partnership or a controlled multi-member LLC that’s treated as a partnership for federal tax purposes. Why?

Because a little-known provision mandates high-taxed ordinary income treatment for gains from sales to a controlled partnership or a controlled LLC that’s treated as a partnership for tax purposes, when the asset in question is not a capital asset in the hands of the partnership or LLC.6

Since the land in your situation would be inventory and not a capital asset in the hands of a controlled partnership or LLC—the partnership or LLC would be classified as a dealer in real property—the sale to the partnership or LLC would result in high-taxed ordinary income for you.

Solution. Use an S corporation as the developer entity. Don’t use a controlled partnership or an LLC treated as a partnership. Also, don’t use a C corporation as the developer entity, because that could result in double taxation, as explained earlier.

 

Takeaways

As a general rule, don’t use a C corporation to own real property, because of the double taxation threat.

When owning real property for investment, single-member LLCs, revocable trusts, and multi-member LLCs are better alternatives from a tax perspective.

And don’t overlook this possibility: using an S corporation to develop raw land and sell off parcels can be a big tax saver in the right circumstances.