Go-Zone – BASICS Of The Write-Off of a Lifetime

© 2007 by

Tax Attorney and Accountant – John Hyre

Go Zone = massive write-off’s and the word is spreading. In the aftermath of the Hurricane Katrina, the federal government was desperate to be seen as “doing something”. Given Congress’ tendency to encourage or discourage specific sorts of behavior using the tax code, targeted tax breaks to rebuild the devastated areas were the unsurprising result. And what tax breaks they are – perhaps so good as to occur only once in a lifetime. Specifically: certain investments in areas affected by Hurricane Katrina generate a first-year “bonus depreciation” deduction of 50% of the total qualifying investment--that’s fifty percent! For example, a $100,000 investment in a qualifying rental property would generate an immediate $50,000 write-off. Furthermore, losses in excess of present-year income can be applied to prior years1 for refunds or to subsequent years for continued tax savings. And this write-off will not create or increase Alternative Minimum Tax (“AMT”) issues. In short, GO-Zone bonus depreciation is a uniquely powerful tax reduction tool. Given that we are dealing with government, there are plenty of requirements and caveats. Let’s examine them, as they apply to residential & commercial rental property:

1) In Service Date: Property was placed “in service” no later than 12/31/08 (12/31/2010 for certain counties)2

• “In service” means that the property was ready to be rented (if not actually rented) by the date in question. Evidence that a property was “in service” by a given date includes certificates of occupancy and advertisements to prospective tenants.

• This requirement is strict – if the in service date was missed by an hour, the IRS will disallow the bonus depreciation.

• The bonus depreciation deduction occurs in the year the property was placed in service. For example, a purchase contract executed in 2006 for a property completed in 2007 that was first advertised for rental/issued a certificate of occupancy in 2008 would result in a deduction in 2008 because the property was not “in service” until 2008.

• Properties that must be placed in service by the extended 2010 date must be completed by 12/31/09….to summarize, complete by end of 2009 and advertised for rent or issued a certificate of occupancy by the end of 2010.

2) Original Use of the Property commences in the GO-Zone on or after 8/28/05. The word “original” is key. If the property was used in the GO-Zone prior to 8/28/05 (e.g., an existing rental property), then it does not qualify. Additions/renovations to an existing property made on or after 8/28/05 should count as “original” property. For example, the cost of buying a gutted rental used in the GO-Zone on or before 8/28/05 would not qualify, but renovations to that property made after 8/28/05 would meet the “original use” requirement.

3) Active Business Use: 80%+ of the property must be used in the active conduct of a “trade or business” in the Go-Zone. Rental property can constitute a “trade or business” or an “investment” under the tax code. Generally, the greater the degree of activity performed by the property owner is decisive, with greater activity indicating the “active conduct of a trade or business” (e.g., participating in selecting tenants, making repairs or at least closely controlling that process) and a lower level of activity indicating an “investment” (e.g., collecting rents on a triple net lease). Any activity conducted by or on behalf of a partnership (including most LLC’s) or S-Corporation is attributed to the partners/shareholders. As we shall see later in this article, if you qualify for an exception from “Passive Activity Loss” rules, you probably also made the grade for the active conduct of a trade or business in the GO-Zone. If the property is converted to less than 80% business use (e.g., used by the owner as a residence, etc.), then the depreciation deduction is “recaptured” – meaning you lose the bonus depreciation deduction taken to the extent it exceeded “normal” depreciation deductions.

4) Purchased: The property must be purchased or self-constructed. Special rules (well beyond the scope of this article) apply to sale-leasebacks, syndications, self-constructed property and property involving related parties (e.g., you bought it from your corporation or your father, etc).

5) No Pre 8/25/07 Contract: There was no written, binding contract to purchase the property was in effect before 8/28/05.

6) Prohibited Property: The bonus depreciation does not apply to:

• Private or commercial golf courses;

• Massage parlors;

• Hot tub facilities;

• Suntan facilities;

• Stores primarily in the business selling alcoholic beverages for consumption off premises;

• Gambling properties (casinos – not the condos in them);

• Animal racing properties.

7) Disposal Date: Property that is disposed of in the same year as it was placed in service does not qualify for the bonus depreciation. Likewise, property converted to personal use (e.g., you move in or let your friends use it) in the same year it was placed in service does not qualify.

There you have the basics. Follow the rules and generate write-offs that can reduce one or more years worth of income to a non-taxable zero. Of course, the above represents just the basics. For a more thorough analysis tailored to your personal situation, as well as other tax services focused on the needs of real estate investors, please contact us at www.realestatetaxlaw.com, johnhyre@ameritech.net, or (614) 207-2441. We have clients in approximately 30 states and would be glad to assist you.

8) Passive Loss Limitations are for many the hardest barrier to hurdle when attempting to qualify for Go-Zone Bonus Depreciation. Specifically:

A) What Are Passive Losses? Generally, if a taxpayer does not “materially participate” in an activity (for example, is only a silent investor), that activity is “passive” in character. Under the tax code, real estate rentals are always passive in nature. Any loss arising from a passive activity is a “passive activity loss”.3

B) How are Passive Losses Different from Ordinary Losses? Ordinary losses will generally offset any kind of income. Passive losses, however, only apply to reduce passive income. They do not reduce ordinary income or other types of non-passive income. For example, a taxpayer with $80,000 of W-2 income and $30,000 of ordinary losses would have a net income of $50,000. But a taxpayer with $80,000 of W-2 income and $30,000 of PAL’s would have $80,000 of net income because the PALs cannot be used to offset W-2 income.

C) What Happens to Unused PALs? In the example in B, above, $30,000 of PALs went unused. These losses are generally carried forward until one of three events occurs:

• Passive income is generated to offset the PALs. For example, if another passive activity were to generate income of $40,000, the “suspended” $30,000 loss could be used to reduce the net passive income to $10,000.

• The Passive Activity in question is sold. For example, rental properties are generally defined such that each constitutes its own “activity”. As such, when a rental is sold, the underlying PAL’s that have accumulated on that property over the years are available to offset any gain generated on the sale.

• One qualifies for an exception to the PAL rules (discussed below). For example, if a taxpayer qualifies as a real estate professional, then prior PAL’s are allowed in that year.

D) The “I’m Not Rich” Exception: When it first passed the PAL Rules, the Democratic Congress wanted to ensure that the rules applied on to the “Rich”. As such, they exempted anyone who makes less than $100,0004 to the extent of $25,000 in PAL’s. For example, if a taxpayer made $60,000 and generated $29,000 in PALs, his net taxable income before any other deductions would be $35,000 – that is, $60,000 less $25,000 in PALs. The remaining $4,000 in PALs would be carried over for use in subsequent years.

E) The “I’m Almost Rich” Exception: For every two dollars over $100,000 AGI, a taxpayer loses $1 of the $25,000 exception. For example, a couple with $110,000 in AGI would only be exempt from the PAL rules to the extent of $20,000. In other words, for every two dollars over $100,000 AGI that the couple earned (here, $10,000), they lost one dollar of the exception (here $5,000 lost, for a remainder of $20,000 available). At $150,000 AGI, the taxpayers would be completely unable to use this exception to the PAL rules.5

F) The caveat for D & E: Material Participation: For either of the above exceptions to apply, the taxpayer must “materially participate” in the rental activity. Material participation in an activity requires that the taxpayer be involved in the operations of the activity on a regular, continuous and substantial basis. Some pointers:

• Work done by your spouse counts as work done by you for purposes of the material participation standard.

• Reviewing, compiling or studying the finances of the rentals do not count unless the investor is directly involved in the day-to-day management or operations of the activity. For example, working on bookkeeping for a triple-net lease investment would not count as material participation, but doing the same for a rental that you manage (or help manage) on a day-to-day basis would count.

• 500 hours of participation in the activity automatically qualifies as “material” participation (remember, each rental property is an activity).

• If the owner participates in the activity for 100 or more hours and no other person (including managers) spend mores time than that on the activity, the material participation test is automatically met.

• If the taxpayer spends at least 100 hours on the activity per year and at least 500 hours on rental activities overall, the taxpayer meets the material participation test.

• The above represents a partial summary of the “material participation” rules – attempting to go through all of those rules would fill far too much space to cover in this article!

• One general pointer: It is very difficult to qualify for material participation if the property owner is paying a manager to run the property. Basically, the exceptions in D & E are designed for “mom & pop” operations.

• Another general pointer: In general, each rental property constitutes an “activity”. It is much easier to spend 100/500+ hours on a large multi-unit than on a single-family house. As such, it is easier to rise to the level of material participation on a large, multi-unit property than with a single family property.

G) The “We Give Money to Congress” Exception (a.k.a. “RE Professional”):

• If a taxpayer can qualify for this exception, all PAL’s can be used to offset any income.

• Realtors and their broker brethren give a lot of money to political causes, which is why Congress deems them to be “good” rich people.

• To qualify, a taxpayer must show that he qualifies as a full-time real estate professional.

• Real estate professions include only the following:

  • real property development;

  • real property redevelopment;

  • real property construction;

  • real property reconstruction; real property acquisition;

  • real property conversion;

  • real property rental;

  • real property operation;

  • real property management;

  • real property leasing; and

  • real property brokerage.

• To be full-time, an investor must:
  • Perform > 50% of their personal services in one of the above professions (or combination thereof); and
  • Spend at least 750 hours in one of the above professions.
  • The time spent must be at the level of “material participation”, described in F, above. The material participation is much easier to achieve as a real estate professional because all of the rental properties can be grouped into one “activity” IF the taxpayer properly elects to do so on his tax return.
• Basically, taxpayers who already qualify as fulltime real estate professionals (full time brokers, full time investors, etc., hereafter “RE Pro”) will not have a problem taking the GO-Zone Bonus Depreciation. Likewise, taxpayers who nearly qualify as RE Professionals before acquiring GO-Zone properties will likely qualify after adding in the time spent on the new properties. Taxpayers acquiring only GO-Zone properties and having them managed from a distance will have difficulty in qualifying because they will have trouble spending enough time (1/2 of their personal services time or 750 hours, whichever is greater) on material participation (i.e., doing more than accounting & checking on the manager).
• The relevant year to qualify is the year in which the properties are placed in service (i.e., ready to be rented)
• IRS is aggressively auditing this issue, so records of time spent are an absolute must. The records needn’t be fancy – a handwritten log of daily activities should take about 5 to 10 minutes per day to prepare.
• If spouses file a joint return, only one spouse need qualify as an RE Pro to exempt both spouses from the PAL rules.6 The qualifying spouse must qualify on his own – no adding the total hours of each spouse!