Taxing Foreign Investment In U.S. Real Estate

One of the Ps buzzed me about a dividend item on a year-end brokers’ statement.

P:      “What is a Section 897 gain?”

CTG: It has to do with the sale of real estate. It is extremely unlikely to affect any of our clients.

P:      Why haven’t I ever seen this before?

CTG: Because this is new tax reporting.

We are talking about something called the Foreign Investment in Real Property Tax Act, abbreviated FIRPTA and pronounced FERP-TUH. This thing has been around for decades, and it has nothing to do with most of us. The reporting, however, is new. To power it, you need a nonresident alien – that is, someone who is not a U.S. citizen or resident alien (think green card) – and who owns U.S. real estate. FIRPTA rears its head when that person sells said real estate.

This is specialized stuff.

We had several nonresident alien clients until we decided to exit that area of practice. The rules have reached the point of absurdity – even for a tax practitioner – and the penalties can be brutal. There is an encroaching, if unspoken, presumption in tax law that international assets or activities mean that one is gaming the system. Miss something – a form, a schedule, an extension, an election - and face a $10,000 penalty. The IRS sends this penalty notice automatically; they do not even pretend to have an employee review anything before mailing. The practitioner is the first live person in the chain, He/she now must persuade the IRS of reasonable cause for whatever happened, and that a penalty is not appropriate. The IRS looks at the file - for the first time, mind you - says “No” and demands $10,000.

And that is how a practitioner gets barreled into a time-destroying gyre of appealing the penalty, getting rejected, requesting reconsideration, getting rejected again and likely winding up in Tax Court. Combine that with the bureaucratic rigor mortis of IRSCOVID202020212022, and one can understand withdrawing from that line of work.

Back to Section 897.

The IRS wants its vig at the closing table. The general withholding is 15% of selling price, although there is a way to reduce it to 10% (or even to zero, in special circumstances). You do not want to blow this off, unless you want to assume substitute liability for sending money to the IRS.

The 15% is a deposit. The IRS is hopeful that whoever sold the real estate will file a nonresident U.S. income tax return, report the sale and settle up on taxes. If not, well the IRS keeps the deposit.

You may wonder how this wound up on a year-end brokers’ tax statement. If someone sells real estate, the matter is confined to the seller, buyer and title company, right? Not quite. The real estate might be in a mutual fund, or more likely a REIT. While you are a U.S. citizen, the mutual fund or REIT does not know whether its shareholders are U.S. citizens or resident aliens. It therefore reports tax information using the widest possible net, just in case.

Sometimes the IRS Just Doesn't Believe You

I was reading the following recently, and we will use it as a springboard for our discussion today:

In its continued assault on real estate investors, the Court held in Jafarpour and Prang v. Commissioner, …, the taxpayers were not actively involved in a real estate trade or business nor was she a real estate professional ….

Prang is just one more taxpayer to fall under the IRS’s aggressive assault on real estate investors.

That writer and I do not agree on Jafarpour and Prang (“Prang”).

We are talking today about the taxation of real estate activities. Ever since 1986 we have had the passive activity rules, which Congress used to address the problem of tax shelters. The overall concept is simple: if an activity is considered to be passive, then losses from the activity cannot be subtracted from income considered nonpassive. Here is an example: you will not be allowed to claim losses or tax credits from an Alpaca investment against your W-2 income and bonus.

There are exceptions for real estate activities. This is not surprising, considering how significant real estate is to the national economy. The exception that Prang wanted was the “real estate professional” exception. If she could attain that, then her real estate activities would be nonpassive. She could subtract losses to her heart’s content.

There are two basic requirements to being a real estate pro:

(1)   More than one-half of your work hours have to be real-estate related, and

(2)   You have to work more than 750 hours in real estate

We have several real estate pro clients. A builder or broker qualifies, for example. These guys work real estate full-time, so they are easy to identify. What if you mix real estate with non-real estate activities? Further, what if the total hours are close?  You had better keep good records. That gets us to Prang.

Jafarpour was the husband. He sold stock options in 2006.

Prang was the wife. She was a chiropractor. Unfortunately she got injured and sold her practice during the middle of 2006.

So Prang and her husband came into cash and were looking for something to do. They have some experience in real estate. They have rented a former residence in California for a decade, for example. She attended seminars on real estate investing, including a course at the community college. The community college instructor explained the additional depreciation available for Katrina-affected areas (referred to as the GO Zone).

Mrs. Prang liked the idea and they snapped up three properties in Louisiana and Alabama. They almost immediately signed contracts with management companies to handle the properties. After all, they live almost 2,000 miles away. They returned to California.

They claimed over $271,000 in real estate losses on their 2006 tax return. Surprisingly, this caught the IRS’ attention. They were audited.

Jafapour immediately admitted that he was not a real estate pro for 2006. Not a problem, as Mrs. Prang claimed that she was the real estate pro. The IRS said: let’s go through the math: how many hours did you work and how many hours were in real estate?

The way to prove this is to show a record or log, preferably kept contemporaneously, showing what you did and how long it took. Mrs. Prang had an appointment book at the chiropractic office, so that should establish the chiropractic hours. The IRS looked at it and had questions. Daily visits were often illegible. There were daily totals, but the IRS was unable to determine what the totals represented. The totals frequently did not coincide with the number of patients filled-in for the day or the hours Mrs. Prang was supposedly working. Prang deepened the hole by attesting that she left the practice after selling in June. However there were e-mails and notations that she was still involved.

The IRS moved over to the real estate logs. The log was divided into sections. Immediately they were curious because she wrote her activities in pen but the number of hours in pencil. Mrs. Prang explained that she did this so she could cross-reference her time with phone records and make adjustments. Flipping through, the IRS saw several times the same task recorded in multiple sections. More than once the amount of time seemed excessive for the task. For example, Prang noted that she spent one hour on November 8, 2006 reading the following e-mail:

Hi Lecia, I'm your loan processor and will be your main contact person from this point on. I received the FedEx package you sent back. I will review it and prepare the file for my underwriter to review. I will update you with the status within 3 business days."

So she was a slow reader. The IRS pressed on. They spotted several days where she said he worked 17 or more hours, which was impressive. Problem is that she noted the same tasks on more than one day. She described doing something while she was actually on a plane back to California, which would have been a Copperfield-worthy trick. Some of the e-mails she claimed to have sent were from her husband’s e-mail account - and electronically signed by her husband.

The IRS came to the conclusion that she manufactured the logs after-the-fact, which greatly weakened their credibility. She worked the logs to get the answer she wanted. The IRS trusted none of it, denied her real estate professional status and disallowed her loss.

Prang went to Tax Court. Here is the Court:

We would have to engage in complete guesswork to determine how much time Ms. Prang spent at her chiropractic business on a particular day during 2006, let alone the entire year. We decline to engage in such dubious speculation.”

We are not convinced that Ms. Prang contemporaneously recorded her actions in the real estate log. Petitioners' unreasonable assertions are so pervasive that the entire log is tainted with incredibility. Moreover, petitioners' appointment book is frequently illegible and generally ambiguous. While Ms. Prang may have invested a considerable amount of time in real estate activities during 2006, petitioners' records are simply too unreliable for us to draw any sound conclusion.”

The Tax Court found the logs unreliable. With them she couldn’t prove her real estate pro status. Without that status she could not claim losses. Without the losses she owed the IRS a lot of money. And she owed a big penalty.

My Take:  I have had a real estate pro audit before, and the IRS challenged the logs directly. I was younger and working under a partner at another firm. In that case, I felt that the examining agent and supervisor were being unreasonable. The client had maintained but had not assembled the data into a usable, calendar form.  The agent felt that fact impugned the log, whereas my argument was that the log was little more than an administrative compilation of existing data. The agent disallowed pro status, the group manager sided with the agent, we appealed and won in Appeals. Quite a hassle - and we had better facts than Prang. For all that the client fired us. It did not go as smoothly as he would have liked. I wasn’t too thrilled about it either.

I try to be blunter with clients these days about the hazards of tax representation. Lose the examiner’s trust, for example, and you may not convince him/her that the sun came up this morning. Catch the examiner on a pet peeve and he/she may raise the body more often than a Living Dead episode. You may have an examiner too green to realize that classroom examples rarely occur outside the classroom. You may run into a coordinated exam, in which a specialized group – not necessarily the examiner - is calling the shots.  A lot can go wrong.

Was Prang an “aggressive assault” on real estate investors? I do not see it. What I do see is someone gaming the system. They got caught. That’s all.

Get Ready for Stock Cost-Basis Reporting

There will be changes in how your stockbroker reports your stock trades for 2011.

Your broker now has to report the “cost” of your stock trades. This is a new rule for 2011. It came in as part of the 2008 Emergency Stabilization Act, also known as the bank bailout bill. You can anticipate that the purpose of this rule is to raise taxes.

There are three steps to the phase-in of this bill:

(1)    For 2011 (that is, the 2012 tax season), brokers are to report cost on all equity trades, if the equity was bought on or after January 1, 2011.

(2)    For 2012 (the 2013 tax season) brokers will report cost for mutual funds, dividend reinvestment plans and many exchange –traded funds bought on or after January 1, 2012.

(3)    For 2013 (the 2014 tax season), the rule will be extended to bonds and options.

There is a tax trap in here, so let’s go over it. The trap releases if you bought the security at different times and prices. Brokers refer to this as “accumulation.” Each time you buy the stock is called a “lot.”Let’s use the following accumulation as an example:

Let’s say you bought Sirius XM Radio at the following prices:

                January, 2010                     500 shares           $0.70

                May, 2011                           400 shares           $2.31

                August, 2011                      300 shares           $1.71                   

You sell 300 shares today at $1.77 per share. What is your cost for the 300 shares?

The IRS has provided four options:

(1)    First-in, first, out (FIFO).

a.       Under this rule, your cost would be 300 times $0.70 = $210.

(2)    Last-in, first out (LIFO)

a.       Under this rule, your cost would be 300 times $1.71 = $513.

(3)    Highest cost

a.       Under this rule, your cost would be 300 times $2.31 = $693

(4)    Specific identification

a.       You get to pick which shares you sold. All things being the same, you would probably select the May, 2011 lot and use $693 as cost.

Under our example, your answer could vary from a gain of $321 to a loss of $162.  It is quite a swing.

Where is the trap?

You have to tell the broker which method you are using, and you have to tell them before the settlement date of the trade. This is very different from the way it has been, which previously allowed the accountant to decide which method to use when preparing your return. We many times contacted a broker for lot dates, shares and cost when a client had accumulated a position in a stock. We had the luxury (if it could be called that) of doing so when preparing the return. This now has to be done within three business days of the trade date.

There is also another trap. If you do not select a method, the IRS will select it for you. The IRS will decree that you selected the first-in, first-out method. That is a fine method, but if you look back at our example, you will see that it is also the method that reports the least cost, and therefore the most gain, to the IRS. Remember what I said about raising revenue for the government?

 And the final trap? By the time you get to me, there is nothing I – as your tax CPA – can do.