Home Sales and the Post-2012 Medicare Contribution Tax

by Ken Weissenberg

A recent Congressional Research Service (CRS) Report tries to reduce fears that the 3.8% Medicare contributions tax on unearned income (added by the Health Care and Education Reconciliation Act of 2010) effective for tax years beginning in 2013, is a “real estate” or “home sales” tax. As noted below, part or all of the gain on the sale of a residence will be subject to this new tax, along with many other items of passive income.

The Medicare contribution tax is a 3.8% additional tax that is imposed on individuals, estates and trusts on the lesser of (i) unearned income and (ii) Modified Adjusted Gross Income (MAGI) in excess of a threshold amount. The threshold amount for married individuals filing jointly is $250,000 ($125,000 if filing separately) and $200,000 for all others.

The CRS report stresses that the tax is not limited exclusively to real estate transactions and does not apply to the portion of gain which is excluded from tax under Internal Revenue Code section 121. Currently, under code sec 121, when a taxpayer sells his or her principal residence, there is an exclusion from taxable income of up to $250,000 of the capital gain if single or $500,000 if married filing jointly. Certain ownership and use tests must be satisfied to qualify for the exclusion. Gains in excess of the section 121 exclusion will be treated as capital gain for regular tax purposes and investment income for purposes of the 3.8% Medicare tax. However, given the exclusion amount only a limited number of taxpayers would be affected, especially since many home owners have experienced a decline in the value of their homes in recent years. It should be noted that gains on the sale of second homes (i.e., those which are not a principal residence) will not be eligible for the exclusion and may very well be subject to the 3.8% Medicare tax, in addition to the regular income tax.

If you are planning on selling a primary residence with a significant gain in excess of the $250,000/500,000 or a second residence, it may be a better idea to sell before the end of 2012 to avoid this additional 3.8% tax. For sales after 2012, installment sales reporting may be helpful to spread the recognition of gain into more than one year. An installment sale would also spread the regular capital gains tax over more than one year, but you are also delaying the receipt of the cash. An unknown is what would happen if you made an installment sale of a home in 2012 with some of the proceeds payable in 2012. Would the portion of the gain reportable in 2013 for regular tax purposes be subject to the 3.8% Medicare tax?

Finally, for regular tax purposes a loss on the sale of a personal residence is not deductible. Will the same rule apply to the 3.8 % Medicare tax or can that loss be used to reduce the tax on other investment income?

1968 Law Garners Attention

by Aninda Dhar

Real state developers should be aware of an esoteric federal law garnering attention in the press. The 1968 law, the Interstate Land Sales Full Disclosure Act, has recently enabled a number of condominium purchasers to be released from their contracts without forfeiting their down payments. Generally under the Act, developers of condominiums with at least 100 units are required to provide buyers detailed property reports and file a report with the federal Department of Housing and Urban Development. With some exceptions, the purchaser may cancel the contract if the reports are not filed within two years. One key exception is that if the developer legally obligates itself to complete the project within two years, it does not have to file these reports. For more information on the Act, please click here. For recent press coverage on this Act, please click here.

The FASB Proposed New Lease Accounting

by: Aaron Kaiser

This past August, the FASB and its international counterpart, the IASB, responded to criticism (from sources unnamed) of the presently constituted GAAP model for lease accounting, that the present accounting model (paraphrasing from the exposure draft) omits relevant information and fails to provide a sufficiently faithful representation of leasing transactions. The Boards recently issued an exposure draft of this proposed new accounting standard as the first stage of their joint project to address this presumed deficiency by developing a new approach to lease accounting, one that would address the criticisms and provide that appropriate assets and liabilities arising from leases be presented in the balance sheet.

The deadline for comments on the exposure draft is December 15; the Boards are expected to issue the new final standard sometime in 2011. The new lease accounting standard will constitute a major change from present GAAP and the results of its application will be very DIFFERENT looking financial statements for most companies. Will these differences result in a BETTER presentation? That’s yet to be determined.

It’s DIFFERENT; Is it BETTER?

It’s Different:

• It will cover substantially ALL leases of PP&E.
• If services are included in consideration, you will generally have to bifurcate elements.
• The basic concept referred to internationally as the “right to use model” will require the lessee to recognize an asset representing the right to use the leased item for the lease term with a liability for the rent to be paid. This is effectively a financing model whereby amortization/interest expense will be recognized in the income statement each year, instead of rent expense (how boring). Interest expense will be highest in the earliest years of the lease and will reduce as the related obligation is deemed “repaid,” so forget the “straight-line” concept of old.
• The new lease asset generally would represent the present value of the future lease payments as well as initial direct costs (i.e., commissions, professional fees, etc.) incurred to negotiate/execute the lease--the liability will be the NPV of the estimated future payments.
• Present value will be determined using the lessee’s incremental borrowing rate, or if readily determinable (not likely in real estate transactions) the lessor’s built in rate.
• Complications and subjective judgments will come into play in determining the expected term of the lease to use in the computations as that number may be a moving target (principles vs. rules again, so make a good guess preparers).
• Ditto with respect to such rental payments which in the bad/good old days used to be considered “contingent” such as CPI adjustments, percentage rent payments, other escalations; they all get included in the estimate of future cash outflows to be made at the inception of the lease. (And of course they will all require adjustment “true-up” to the actual facts as they occur. This is not going to be easy/fun to implement and maintain, neither for preparers of financials or for their auditors.)
• Lessor accounting (which we will not get into here) essentially follows the same concept as lessee accounting and will vary only based on whether the lessor retains exposure to risk/loss during or at the end of the lease.
• Special rules for subleases but conceptually similar accounting as would apply to prime leases.
• Presentation matters: The Boards proposed specially segregating related lease assets, liabilities, amortization expense and interest on the face of the financial statements, but has left this matter open to public comment (i.e., footnote disclosure only). Cash flows related to leasing will be in the financing section of the cash flow statement, separately stated.
• All kinds of expanded footnote disclosure will be required, arising chiefly because of all the subjectivity introduced by the accounting and the required truing up to reality which will be an annual task.
• Once the standard is adopted, it will be required to present information retrospectively for prior periods presented (that will require a good deal of work). Certain prior capital lease obligations will be exempted from the requirements.
• If /when adopted, this standard is likely to be effective in 2013 or 2014 so there will be time to deal with the changes
• By the way, it would be prudent for all of us in the real world to estimate the impact of this likely new standard on our financial statement ratios, debt covenant compliance, etc., including (please consult with counsel) the possible impact on what was presumed to be prior years’ compliance in the case of an after-the-fact retrospective presentation of previously reported amounts. Get ahead of the curve, start doing the work and prepare for the negotiations ahead.

Is it BETTER?

• The idea behind the proposal is to better converge U.S. GAAP with International Accounting Standards, the better to facilitate the ultimate goal of switching everyone to IFRS.
• In general, there seems to be a continued self flagellation among the GAAP standard setters that somehow our “rules” are inferior to the world’s “principles.” Is this really so?
• Under GAAP, there are all kinds of disclosures made with respect to required cash flows and payments to be made by those accounting for operating leases. Are the users of those financials somehow less informed by the “just the facts” approach to those executory obligations? Is something really lost by not having these items on the balance sheet? Is someone somehow mis/underinformed? I doubt it.
• From a lessor/landlord perspective, how does adding a new asset/liability to the balance sheet, while still retaining the historical cost model otherwise, add to improved representation of reality and transparency?
• In the name of theoretical purity, all kinds of subjectivity (and wherever there is subjectivity there will eventually be a misuse and scandal to come, trust me) will be introduced into what had heretofore been a straightforward if imperfect exercise
• It’s not just about leasing. The overriding accounting concept of principle vs. rule is going to create a minefield for preparers, users and auditors and we may yet find that we have achieved less comparability, at higher cost and without achieving appreciable clarity for the users of the financial statement information. I hope I am wrong, but 35+ years of practice suggests otherwise.
• At least the banks will be happy. They will get to extract their ounce or two of flesh for agreeing to accommodate the new accounting in the covenant calculations where there has been NO change in the underlying economics. The power of the pencil emerges triumphant (at least for some)!!

Year-end Asset Purchases Get Big Write-offs

by Ken Weissenberg

The Small Business Jobs Act of 2010, (the "Act") signed into law on September 27, 2010, contains generous expensing allowances for new assets. First, the bonus depreciation deduction has once again been extended for new assets placed in service on or before December 31, 2010. The bonus depreciation deduction of 50 percent applies to new tangible personal property, qualified leasehold improvements, and certain restaurant and retail improvements. Qualified leasehold improvements are limited to nonresidential property in buildings which have been in service for at least three years and that meet certain other requirements.

In addition, the Act expands the expensing allowance of Internal Revenue Code Section 179 by increasing the amount allowed as a first year write-off to $500,000 for assets placed in service in 2010 or 2011. For the first time, qualified leasehold improvements, along with qualified restaurant property and qualified retail improvements, qualify for the Section 179 write-off as well. As much as $250,000 of the $500,000 cap can consist of these real property assets. The phase-out limitation for the Section 179 deduction was also increased for 2010 and 2011. The available Section 179 deduction is reduced dollar for dollar (but not below zero) by the amount of eligible property placed in service during the year in excess of $2,000,000. The amount of Section 179 property costs which can be expensed in a given year generally cannot exceed taxable income derived from an active trade or business in the year. It should be noted that, under the Act, Section 179 deductions attributable to qualified real property which are disallowed under the trade or business income limitation can only be carried over to tax years in which the definition of eligible Section 179 property also includes qualified real property.

Finally, an $8,000 Section 179 deduction is available for new cars, light trucks and vans placed in service during 2010, increasing the first-year deduction limit (which includes depreciation) for luxury cars to $11,060 and the first-year deduction limit for light trucks and vans to $11,160.

If you're planning on making any significant purchases in the near future, these tax law changes certainly sweeten the deal. Please contact Ken Weissenberg or your EisnerAmper advisor to see how you may benefit from these expanded deductions.

Observer Readers Recognize Firm Among Top in Commercial Real Estate

In an online poll, readers of The New York Observer recently lauded the firm for having one of the top three commercial real estate practices.

In addition, the Commercial Observer profiled "The Top Number Crunchers" featuring our own Ken Weissenberg.

Project Controls and Processes for Real Estate Developers

By Edward Opall

Real estate developers manage a significant amount of risk throughout their projects. Conceiving of a plan, locking in the variables, making the deals, and managing stakeholders are an "art" in this business. Managing the day-to-day aspects of a development project and realizing a profit are a different matter. Successful project execution requires effective controls and processes.

No matter the size of the organization, a strong control environment and an effective project management process is necessary. Multiple layers of staff and management increase the complexity and require more rigid policies with formal approvals. Smaller organizations should follow the same principles, taking into account their circumstances.

To read more about project controls and processes for real estate developers, click here.

Ken Weissenberg to speak at Commercial Real Estate Leases Seminar

Ken Weissenberg, a tax partner in EisnerAmper's real estate services group, will discuss tax and accounting concerns at the New York State Bar Association's conference, Commercial Real Estate Leases: Challenging Times and Opportunities in Leasing for Experienced Lawyers on Monday, September 13 at the Hotel Affina Manhattan in New York City.

Ken will discuss the new FASB standard addressing booking leases on balance sheets and its potential impact on lease negotiations and loan covenants. Coverage also includes tax insights which impact the drafting of leases.