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Arthur Auerbach
 

Tax Preparation Decisions for Preparers of Real Estate Partnership

The keys for your firm to planning the preparation of a real estate partnership or LLC return.

October 4, 2010
by Arthur Auerbach, CPA

This article discusses the tax preparation decisions for preparers of real estate partnership or limited liability company (LLC) returns with regard to the new forms and the additional related party disclosures and the emphasis on preparer accuracy in return preparation.

Basic Information Needed

A copy of the enabling agreements — a partnership agreement, operating agreement or the enabling documents — is required as initial information for the return. The key to accurate preparation is to follow what the co-venturers have agreed to and make sure the preparation follows those guidelines. In addition, CPAs should obtain an accurate list of the participants, their correct identification numbers and current addresses, prior to beginning the preparation of any return if possible. This information will cover situations where interests have been gifted or inherited or sold or transferred during the year. Accurate information about any relationships between the partners is important since the attribution rules might affect decisions about the preparation of the return. This includes the questions that have been added to Form 1065, U.S. Return of Partnership Income.


Reader Note: Don’t miss Arthur Auerbach’s session on Estate Tax Planning for Real Estate Owners & Investors at the upcoming AICPA National Real Estate Conference, November 11-12, in Las Vegas, NV.

Information about the situs of the property is essential to determine the state or local returns that may be required and any permits that may be necessary for the entity to operate. The next step would be to determine the type of property that you are dealing with, e.g., residential, commercial, farm, combination or mixed-use property. Also important for the preparer to know during these difficult economic times is the status of any debt or debt forgiveness because there are entity elections and certain debt forgiveness items that pass through to the participants.

Basis

After this basic information, obtain accurate information regarding basis. Basis usually has relevance in four situations for tax preparers:

  1. At-risk limitations;
  2. Gain or loss calculations;
  3. Depreciation calculations; and
  4. Passive activity loss calculations.

Each of these situations requires separate basis calculations. Initial contributions by the co-venturers can provide information regarding all these elements. The preparer should also determine the opening journal entry on formation of the entity, which can help establish the beginning of the capital at risk basis for each participant.

The next step in is to determine whether the participants have any direct loans to the venture and whether there are any side agreements between the participants to hold others harmless in the event of a default. The debt should then be broken down into recourse, non-recourse and qualified non-recourse pools. Together with the partnership’s or LLC’s capital percentages this can give the appropriate amount of debt to be allocated to each participant.

Section 754 Election

As a tax practitioner you have to answer a crucial question that affects capital accounts, tax basis, Section 704, book basis or other: Has a previous Section 754 election had been made by the entity, and if so, it should be revoked?

Participation

The level of participation of each of the co-venturers is the next item to be determined. This will help the preparer decide who the managing members or partners are and who the passive investors are. The application of the real estate professional rules possibly will be involved in this determination. Recent court decisions regarding the role of limited partners can impact whether the interests of LLC members are considered passive activity interests. The potential implications of the self-employment tax should be considered.

Current-Year Activity

The current-year activity now becomes the focus of the preparation. This includes how the current year activity was recorded in the books and records, the appropriate method of accounting (cash or accrual), and the proper recording of gross income and expenses.

The preparer should reconcile the bank statements with resulting gross receipts and find out whether form 1099s were received to verify the gross income; the IRS focuses on this. The preparer also needs to properly classify income between operating income, investment income, or passive income for reporting purposes. The application of the real estate professional rules and the self-employment rules is affected by the classification of income. The 1040 SE calculation sometimes requires the correct gross receipts from the appropriate reporting entity.

The preparer should next determine the proper recording and classification of expenses. Matching the expenses to the income is critical since the tax aspects of the reporting could severely alter the tax result on the individual returns of the co-venturers. Capitalization policy of the venture should be examined and the classification of assets should be reviewed to determine the appropriate asset classes and thus the write-off period for the assets. If appropriate, a depreciation study may be recommended. The review of the assets should also consider whether any of the assets are eligible for Section 179 treatment and whether bonus depreciation should be taken for the assets.

The preparer should also examine interest expense and properly classify the interest into appropriate categories, such as investment interest, mortgage interest or business interest. Some of this expense is matched at the entity level and other portions are passed through for deduction or matching on the participant’s individual return. The preparer should consider if there are expenses that need to amortized or capitalized for which an election needs to be made at the entity level.

Alternative Minimum Tax

The preparer should identify items related to the alternative minimum tax (AMT) to ensure they are properly reported on the return.

Credits

The final step in return planning would be to determine any credits that might be available for the entity and how they should be reported.

Conclusion

In summary, the preparation steps are as:

  1. Determine the type of activity being conducted. Use Section 469 as a guide to determine the activity type. In short, why do people pay the entity, what are they paying for?
  2. To each activity identified, assign gross receipts.
  3. To each activity identified, assign expenses, with the exception of separately stated items that require separate pass through and wages and interest expense.
  4. Assign wages to each activity, particularly for those which involve manufacturing and the application of the Section 199 deduction.
  5. Assign interest expense to each activity using the guidelines of Section 163 to determine which type of interest expense is involved. The categories are trade or business, mortgage, investment or portfolio, passive or personal.
  6. Identify AMT items that will require special reporting on the return.
  7. Assign any appropriate credits to each activity.

This should be an easy roadmap for return completion.

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Arthur Auerbach, CPA, is tax consultant with Goodman & Company specializing in tax consulting and estate and financial planning for individuals and closely held businesses. During his 40-plus years of experience, he has managed a tax department, taught accounting at Pace University as an adjunct professor, teaching Intermediate Accounting and Cost Accounting. Art is nationally known speaker and lecturer on a variety of income tax and employee benefit topics. He is currently a member of the AICPA Health Care Tax Force and the Individual Tax Resource panel.