A Winter Barge and Depreciation

 

The question comes up with some frequency: when is an asset placed-in-service for tax purposes?

Generally one is talking about depreciation. Buy an expensive asset near the end of the year, allow for delivery (and perhaps installation) time and one becomes quite interested with the metaphysics of depreciation.

Let me give you a couple of situations:

·      You finish constructing an office building near the end of the year. It is ready-to-go, but your first tenant doesn’t move in until early the following year. When do you start depreciation?

·      You are a pilot and buy a plane through your business. It is delivered in the last few days of December. There is no business travel (as it is near year-end and between holidays), but you take the plane up for its shakedown flight. When do you start depreciation?

The numbers can become impressive when you consider that we presently have 100% bonus depreciation, meaning that a qualifying asset’s cost can be depreciated/deducted in full when it is placed in service.

And what do you do in COVID 2020/2021, if you buy an asset but government orders and mandates restrict or close the business?

There is a classic tax case that goes back to the 1960s. It distinguished between an asset being ready and available for use and actually being placed into use. Why the nitpicking? Because life happens. In general, a place-in-service date occurs when the asset is ready and available for use.  

Well, that rule-of-thumb would help with COVID 2020/2021 issues.

On to our case.

A company in New York bought a barge from a builder in Louisiana.

The barge made it to Rome, New York.

It was outfitted and ready to go by the end of 1957.

Winter came. The canal froze. The barge was stuck in a frozen New York canal until spring of 1958.

When was the barge placed-in-service?

You know the IRS was on the side of 1958. They had persuasive arguments in their favor, and that – plus the sheer cost of a barge – meant the matter was going to be litigated.

Here is the Court:

… the barge was ready for charter or for use in the taxpayer’s own distribution business by December 1, 1957, but could not be used until May, 1958, because it was frozen into the water of an upstate canal. This was certainly not a condition which the taxpayer desired to bring about.”

And here is the staying power of the case:

… depreciation may be taken when depreciable property is available for use ‘should the occasion arise,’ even if the property is not in fact in use.”

Common tax issue + dramatic facts = memorable tax law.

Our case this time was Sears Oil Co., Inc v Commissioner, 359 F.2^nd 191 (2d Cir 1966).

Like-Kind Exchange? Bulk Up Your Files

I met with a client a couple of weeks ago. He owns undeveloped land that someone has taken an interest in. He initially dismissed their overtures, saying that the land was not for sale or – if it were – it would require a higher price than the potential buyer would be interested in paying.

Turns out they are interested.

The client and I met. We cranked a few numbers to see what the projected taxes would be. Then we talked about like-kind exchanges.

It used to be that one could do a like-kind exchange with both real property and personal property. The tax law changed recently and personal property no longer qualifies. This doesn’t sound like much, but consider that the trade-in of a car is technically a like-kind exchange. The tax change defused that issue by allowing 100% depreciation (hopefully) on a business vehicle in the year of purchase. Eventually Congress will again change the depreciation rules, and trade-ins of business vehicles will present a tax issue.

There are big-picture issues with a like-kind exchange:

(1)  Trade-down, for example, and you will have income.

(2)  Walk away with cash and you will have income.

(3)  Reduce the size of the loan and (without additional planning) you will have income.

I was looking at a case that presented another potential trap.

The Brelands owned a shopping center in Alabama.

In 2003 they sold the shopping center. They rolled-over the proceeds in a like-kind exchange involving 3 replacement properties. One of those properties was in Pensacola and becomes important to our story.

In 2004 they sold Pensacola. Again using a like-kind, they rolled-over the proceeds into 2 properties in Alabama. One of those properties was on Dauphin Island.

They must have liked Dauphin Island, as they bought a second property there.

Then they refinanced the two Dauphin Island properties together.

Fast forward to 2009 and they defaulted on the Dauphin Island loan. The bank foreclosed. The two properties were sold to repay the bank

This can create a tax issue, depending on whether one is personally liable for the loan. Our taxpayers were. When this happens, the tax Code sees two related but separate transactions:

(1) One sells the property. There could be gain, calculated as:

Sales price – cost (that is, basis) in the property

(2) There is cancellation of indebtedness income, calculated as:

Loan amount – sales price

There are tax breaks for transaction (2) – such as bankruptcy or insolvency – but there is no break for transaction (1). However, if one is being foreclosed, how often will the fair market value (that is, sales price) be greater than cost? If that were the case, wouldn’t one just sell the property oneself and repay the bank, skipping the foreclosure?

Now think about the effect of a like-kind exchange and one’s cost or basis in the property. If you keep exchanging and the properties keep appreciating, there will come a point where the relationship between the price and the cost/basis will become laughingly dated. You are going to have something priced in 2019 dollars but having basis from …. well, whenever you did the like-kind exchange.

Heck, that could be decades ago.

For the Brelands, there was a 2009 sales price and cost or basis from … whenever they acquired the shopping center that started their string of like-kind exchanges.

The IRS challenged their basis.

Let’s talk about it.

The Brelands would have basis in Dauphin Island as follows:

(1)  Whatever they paid in cash

(2)  Plus whatever they paid via a mortgage

(3)  Plus whatever basis they rolled over from the shopping center back in 2003

(4)  Less whatever depreciation they took over the years

The IRS challenged (3).  Show us proof of the rolled-over basis, they demanded.

The taxpayers provided a depreciation schedule from 2003. They had nothing else.

That was a problem. You see, a depreciation schedule is a taxpayer-created (truthfully, more like a taxpayer’s-accountant-created) document. It is considered self-serving and would not constitute documentation for this purpose.

The Tax Court bounced item (3) for that reason.

What would have constituted documentation?

How about the closing statement from the sale of the shopping center?

As well as the closing statement when they bought the shopping center.

And maybe the depreciation schedules for the years in between, as depreciation reduces one’s basis in the property.

You are keeping a lot of paperwork for Dauphin Island.

You should also do the same for any and all other properties you acquired using a like-kind exchange.

And there is your trap. Do enough of these exchanges and you are going to have to rent a self-storage place just to house your paperwork.

Our case this time was Breland v Commissioner, T.C. Memo 2019-59.

An Engineer Draws A Tax Penalty

We have spoken in the past about clients I would not accept: one with an earned income credit, for example. The tax Code requires me to go all social worker, obtaining and reviewing documents to have reasonable confidence that there is a child and said child lives in given household. There are penalties if I do not.

Not happening.

Did you know that I can be penalized for not signing a tax return as a paid professional? Yep, it is in Section 6694 for the home gamers.

I saw a penalty recently under Section 6701. That one is a rare bird.

The 6701 penalty can reach someone who is not a preparer but who “aids,” “assists” or “advises” with respect to information, knowing that it will be used in a material tax situation.

Here is an example: you gift majority control of your (previously) wholly-owned business to your kids. This would require a valuation, which in turn requires a valuation expert. That expert is probably not preparing the gift tax return, but the preparer of the gift tax return is relying – and heavily – on his/her work.

The penalty is $1,000 for each incident. Pray that you are not advising a corporation, as then it goes to $10,000 per incident.

The IRS recently trotted out Section 6701 in Chief Counsel Advice (CCA) 201805001. Think of a CCA as an IRS attorney advising an IRS employee on what to do.

The situation here involved a “tax-consultant engineer” who analyzed a taxpayer’s assets to determine the classification of property for depreciation purposes.

In the trade, we call this type of work “cost segregation.”

If you have enough money tied-up in certain types of depreciable assets, a “cost seg” may be a very good idea.

What drives the cost seg is an abnormally-long tax life for commercial property: usually 39 years.  It is a tax fiction, divorced from any economic analysis to build or not build or from a bank decision to lend or not lend.

The grail is to “carve out” some of that 39-year property into something that can be depreciated faster. There is room. The parking lot and landscaping, for example, can be depreciated over 15 years. Upgraded wiring to run equipment can be depreciated with the equipment. The additional plumbing at a dentist’s office? Yep, that gets faster depreciation.

But it probably requires a cost seg. Realistically, an accountant can do only so much. A cost seg really needs an engineer.

The engineer in this CCA must have left the plot, as the IRS was nearly out-of-its-mind over his classification into five-year property. The word they used was “egregious.”

Unfortunately, we are not told what he “egregiously” misclassified.

We are however told that he is getting the Section 6701 chop.

What is the math on this penalty?

Well, his misclassification affected five years of individual returns. The penalty would be 5 times $1,000 or $5,000 for each individual client. Hopefully this was a one-off, as $5 grand should be enough to get his attention.

Can you imagine if it had been a corporation? 

Why is Kinder Morgan Buying Its Own Master Limited Partnerships?

I am reading that Kinder Morgan, Inc (KMI) is restructuring, bringing its master limited partnerships (MLPs) under one corporate structure. We have not spoken about MLPs in a while, and this gives us an opportunity to discuss what these entities are. We will also discuss why a company would reconsolidate, especially in an environment which has seen passthrough entities as the structure of choice for so many business owners.

As a refresher, a plain–vanilla corporation (which we call a “C” corporation) pays tax at the corporate level. The United States has the unenviable position of having one of the highest corporate tax rates in the world, which is certainly a strike against organizing a business as a C corporation. Couple this with the tax Code’s insistence on taxing the worldwide income of a C corporation (with certain exceptions), and there is a second strike for businesses with substantial overseas presence.

A passthrough on the other hand generally does not pay tax at the entity level. It instead passes its income through to its owners, who then combine that income with their personal income and deductions (for example, salary, interest and dividends, as well as mortgage interest and real estate taxes) and pay taxes on their individual tax returns. This is a key reason that many tax professionals are opposed to ever-higher individual tax rates. The business owner’s personal income is artificially boosted by that business income, pushing - if not shoving - him/her into ever-higher tax rates. This is not generally interpreted as an admonition from our government to go forth and prosper. 

MLPs are relatively recent creations, entering the tax Code in 1986. They can be the size of publicly-traded corporations, but they are organized instead as publicly-traded partnerships. They are required to generate at least 90% of their revenues from “qualifying sources,” commonly meaning oil, natural gas or coal. The stock market values MLPs on their cash flow, so the sponsor (in this case, KMI) has great incentive to maximize distributions to the unitholders. MLPs have consequently become legitimate competitors to bonds and dividend-paying stocks. You could, for example, purchase a certificate of deposit paying 1.4%, or you could instead purchase a MLP paying 7%. Introduce a low interest rate environment, couple it with expanded activity in shale and natural gas, and MLPs have been in a very favorable investment environment for a while.

One of the granddaddies of MLPs is Kinder Morgan Inc, which placed its operating activities in three principal MLPs: Kinder Morgan Energy Partners, Kinder Morgan Management and El Paso Pipeline Partners. To say that they have done well is to understate.

There is a tax downside to MLP investing, however. A MLP does not pay dividends, as Proctor & Gamble would. Instead it pays distributions, which may or may not be taxable. You do not pay tax on the distributions per se. You instead pay tax on your distributable income from the MLP, reported on a Schedule K-1. A partner pays tax on his/her income on that K-1; by investing in a MLP you are a partner. To the extent that the K-1 numbers approximate the distribution amount, your tax would be about the same as if you had received a dividend. That, however, almost never happens. Why? Let’s look at one common reason: depreciation. As a partner, you are entitled to your share of the entity’s depreciation expense. Depreciation reduces your share of the distributable income. To the extent that there is heavy depreciation, less and less of your distribution would be taxable. What type of entity would rack up heavy depreciation? How about a pipeline, with hundreds of millions of dollars tied-up in its infrastructure? 

This leads to an (almost) win:win situation for the investor. To the extent there is outsized depreciation, or perhaps depletion or tax credits, you can receive generous distributions but pay tax on a considerably smaller number. There is a tax downside however. To the extent that the distributions exceed the K-1 income, you are deemed to have received a return of your capital. This means that you are getting back part of your investment. This matters later, when you sell the MLP units. Your “basis” in the MLP would now be less (as your investment has been returned to you bit by bit), meaning that any gain on a subsequent sale would be larger by the same amount. Many MLP investors have no intention of ever selling, so they do not fear this contingency. No later sale equals no later tax.

Almost all MLPs pay someone to actually manage the business, whether it is a pipeline or timberland. That someone would be the sponsor or general partner (GP). The general partner receives a base percentage to manage the operations, and many MLPs also further pay an incentive distribution right (IDR) to the general partner, which amount increases as the MLP becomes more and more profitable. For example:

·        A GP receives 2% base to manage the business

·        Then there is an IDR at certain steps

o   At step one, the GP receives 15% of the increment over the first step,

o   At step two, the GP receives 25% of the increment over the second step

o   At step three, he GP receives 35% of the increment over the third step

How high can this go? Well, KMI and its MLPs have done so well that approximately 50% is going to an IDR payment.

This means that KMI is receiving up to 50% of the MLP income it is managing, so 50% comes back to the KMI (a C corporation) anyway. One really has not accomplished much tax-wise as far as that 50% goes.

But that leaves the other 50%, right?

MLPs can have difficulty borrowing money because they pay-out such an outsized percentage of their income, whether as IDRs or distributions. A banker wants to see a profitable business, as well as see the business retain some of that profit, if only to repay the bank. This leads to complicated bank loans, as the GP has to step in as a borrower or a guarantor on any loan. Banks also like to have collateral. Problem: the GP does not have the assets; instead the MLP has the assets. This causes banking headaches. The headache may be small, if the MLP is small.  Let the MLP grow, and headaches increase in intensity. 

Remember what we said about KMI? It is one of the granddaddies of MLPs. Banking and deal making have become a problem.

So KMI Inc has decided to do away with its MLP structure. It has proposed to buy back its MLPs in a $44 billion deal, bringing everything under the corporate roof. It now becomes the third largest energy company in the United States, behind only Exxon Mobil and Chevron.

The stock market seemed to like the deal, as KMI’s stock popped approximately 10% in one day.

What is the tax consequence to all this? Ah, now we have a problem. Let us use Kinder Morgan Energy Partners as an example. These investors will have a sale, meaning they will have to report and pay taxes on their gains. Remember that they have been reducing their initial investment by excess distributions. I have seen estimates of up to $18 tax per KMEP MLP unit owned. Granted, investors will also receive almost $11 in cash per unit, but this is a nasty April 15th surprise waiting to happen.

The restructuring should reduce KMI’s taxable income as much as $20 billion over the next dozen years or so, as KMI will now be able to claim the depreciation on its corporate tax return. In addition, KMI will be able to use its own stock in future acquisitions, as C corporations can utilize their stock to structure tax-free mergers. Standard & Poor’s has said it would upgrade KMI’s credit rating, as its organizational chart will be easier to understand and its cash flow easier to forecast. KMI has already said it would increase its dividend by approximately 10% annually for the rest of the decade.

By the way, are you wondering what the secret is to the tax voodoo used here? Kinder Morgan is bringing its MLPs onto its depreciation schedule, meaning that it will have massive depreciation deductions for years to come. There is a price to pay for this, though: someone has to report gain and pay tax. The IRS is not giving away this step-up in depreciable basis for free. It is however the MLP investors that are paying tax, although KMI is distributing cash to help out. To the extent that KMI optimized the proportion between the tax and the cash, the tax planners hit a home run.   

When Can You Take That Deduction?

Sometimes the most mundane things can cause a tax issue. For example, an asset must be “placed in service” before one can claim depreciation. Consider that 2013 was the last year one could claim 50% bonus depreciation, and you can see how someone would want that big-dollar asset in service by year-end.

But what does “place in service” mean?

Let us go through a couple of examples.

Let’s say that you purchase a single-family home. You know someone who wants to rent. With that in mind you purchase the property, incur approximately $10 thousand in repairs and then verify the credit worthiness of the potential renter. You are surprised and disappointed with the result, and decide not to rent to that individual.

It is now the following year. The next applicant is eligible for Section 8 assistance. HUD sends an inspector, who unfortunately wants additional repairs before approving the application. You do the repairs. HUD approves. You have a renter.

The issue here is that expenses must be associated with a trade or business (or an income-producing activity) that is up and running in order to be deductible. Prior to then, the expenses are likely “start up” expenses, which are not immediately deductible. The classic example is a restaurant “dry run,” which occur before the restaurant opens to the public. Family and friends are invited to put the kitchen and service through its paces.

Most accountants would take the position that the house was placed in service (that is, its “activity” as a rental had started) when it was available to be rented. You had a renter lined up. Granted the renter did not pass the credit test, but there was a house, you were willing to rent the house and someone wanted to rent the house. Unfortunately, you did not otherwise try to “market” the house, perhaps by listing it on Craig’s List or advertising in the newspaper.

Oh, by the way, you did not start depreciation until the HUD renter moved in, which is year two in our example.

     Question: Can you deduct the $10 thousand in repairs?

Let’s go on to example #2.

There is a life insurance salesman who specializes in the uber-wealthy. He generally sells life policies of $10 million or more. He has developed quite the network of CPAS and other insurance agents. When prospective clients appear he will charter planes rather than rely on commercial flights. He had a bad experience when a commercial flight ran late, causing him to miss an important meeting and costing him a possible $8 million commission.

He decides to purchase his own plane. He needs to fly nonstop from cost-to-coast, as many of his clients are on the west coast. He eventually finds a $22 million Bombardier Challenger 604 that fits the bill. Unfortunately it is closing in on December 31, and he needs that bonus depreciation deduction. Problem is he also wants to customize the plane. He wants a conference table, for example. He wants to be able to work while he is flying coast-to-coast.

What to do? He tells the company that he absolutely positively needs the plane before year-end. On December 30, he gets the plane. He makes a trip to Seattle for a business lunch, then to Chicago to meet with another insurance agent. He gets in that business use.

He then returns the plane so the modifications can be made. He wants that conference table. He also wants 20-inch display screens rather than the standard 17-inch screens. Who wouldn’t?

     Question: When would you start depreciating the plane?

How would I have handled these two cases? In the first example I am inclined to start depreciation on the house in year one, the same year that the potential renter flubbed his credit check. The house was ready for rent, evidenced by have a potential renter wanting to rent.

And I would have been wrong. The Court decided that the house was not ready for rent in year one. It needed repairs, for example. The Court also observed that the potential renter was lined-up before the purchase of the house. After the credit check, the landlord did not resort to referrals and other means to rent the house. Instead she applied for Section 8 approval. Since HUD would not approve the house until repairs were made, the house could not be placed-in-service before then.

I understand the Court’s position, and I disagree with the Court. Unless the landlord bought the house specifically for Section 8, then HUD’s approval or disapproval sways me very little. Having a potential renter sways me a lot. Were the repairs substantial enough to prevent a renter from moving in? We do not know.

The Court also observed that the landlord did not try “other” means to rent the house, such as newspapers or Craig’s List. That bothers me. Just about every small landlord I know rents exclusively by word of mouth and referral. The idea of “advertising” their duplex or fourplex would be unimaginable, especially given today’s litigious environment. I have run into this position before on audit, so it does represent the IRS party line.  Can you rebut the position? You can, but it may require documentation of one’s efforts to rent the property. In my case, the IRS wanted my client’s referral sources to document her efforts to obtain a tenant.

And I suspect that the taxpayer’s decision to delay depreciation until year two may have been fatal.

What about the plane? It seems to me that the purpose of a plane is to fly, and that plane flew by December 31. Unless the flights were not really business-related and constituted only smoke and mirrors, I would say that plane was placed in service by December 31.

And I would have been wrong. The Court decided that the plane was not placed-in-service until the modifications were made, and the modifications were not made until the following year.

The Court is not without basis. IF those modifications were really THAT IMPORTANT to the insurance salesman, then one could reason that the plane was not ready for use in his trade or business as an insurance salesman. It was not enough to fly. It was necessary that he fly with a conference table. I get the nuance.

I do not think that was it, though. The Court went on to talk about how the salesman had understated his income by tens of millions of dollars and how he used nominees to conceal ownership and control of entities from the IRS. He had created false paperwork to support illegitimate deductions. Me thinks that he had hacked off the Court, and the Court – seeing an opportunity to disallow millions of dollars of depreciation – took the opportunity.

I tell you what I would have recommended to the salesman: do not give the plane back immediately. Wait three or four months. Use the plane extensively. Then install the conference table. Tax accountants refer to this as “cool down.”

Yes, sometimes tax planning is that simple.

Tax Provisions Expiring on December 31, 2013

We have been reviewing tax provisions scheduled to expire at the end of this year, December 31, 2013. This is an unhappy, contemporary development in federal taxation. Taxpayers in recent years have waited on Congress to come to the rescue, even if that rescue was in January and retroactive.  I am not optimistic for any breakthrough this year. The Senate nuclear-option fiasco last week tells you that the parties will not be sending Christmas cards across the aisle this year.

 (1)  Mortgage debt relief

The tax code considers the forgiveness of debt to be similar to you receiving a paycheck. Your wealth has gone up (in this case, because your debts have gone down), so the IRS considers this income to you. There has been an exception for debt discharged on your principal residence.

 (2)  Deduction for mortgage insurance premiums

You buy this insurance when you put down less than 20% on the purchase of a house.

 (3)  Teachers classroom expenses

This is the $250 deduction for unreimbursed teacher school supplies.

(4) IRA distributions to Charity

 If you are age 70 ½, the IRS requires you to take “minimum required distributions” from your IRA (but not from your Roth IRA). This provision lets you donate that distribution to charity without counting it as income. You don’t get the charitable deduction, of course, but it can stop you from being pushed into tax phase-outs because of the increase to your gross income.

(5)  State sales taxes

If you live in a state without income taxes (Florida and Texas, for example), this provision allows you to deduct sales taxes in lieu of income taxes.

 (6)  Research & development tax credit  

 It seems that this credit has been “extended” as long as I have been in practice. It will again, if only because some very powerful interests (think Apple and Intel) will make it so.

 (7)  Credit for construction of new energy efficient homes

This $2,000 credit goes to the contractor for building your energy-efficient new home. Granted, it has not meant as much in recent years, except perhaps to the cash-strapped contractor.

(8)  Credit for energy efficient home improvements

This is the $500 credit for doors, windows, insulation and exterior doors. There are other, less recognizable, categories, such as a biomass stove.

 (9) Expensing of depreciable assets

Also referred to as the Section 179 deduction, it is scheduled to drop to $25,000 next year from $500,000 this year.

 (10)     50 percent depreciation

You are allowed (for a brief remaining time) to immediately deduct 50% of a wide range of business assets, other than real estate.

 (11)     Work opportunity tax credit

Many people associate this credit with hiring welfare recipients, but it also covers military veterans. The credit can be as much as $9,600 per employee.

 (12)     Depreciation for certain leasehold, restaurant and retail  improvements

 Depreciation on real estate is brutal: the tax Code requires one to depreciate over 39 years. This break allows a business or restaurant (think Applebee’s or Kroger) to depreciate their build-out over 15 rather than 39 years.

(13)     Deduction for qualified tuition and related expenses

This is the deduction of up to $4,000 (not to be confused with the tax credit!) for you or your child attending college.

 (14)     Child tax credit

This is the credit for a child under age 17. It is worth $1,000 this year. It drops to $500 in 2014.

This is just stuff that is going away. We haven’t talked about new tax stuff, such as the increase in the maximum individual tax rate, the new capital gains rate, the 3.8% Obama tax on investments, the 0.9% Obama tax on your W-2, the disallowance of your itemized deductions, the disallowance of your personal exemptions, the ObamaCare individual mandate penalty for 2014, the new dollar limits on your FSA, and so on and so on.