Thursday, April 17th, 2014

What Does Active Really Mean? Two tax traps

The following article was written by our GO Zone tax advisor.

In my opinion, the requirement for the GO Zone property to be own by someone who is active in a trade or business creates an overall potential for investor benefit but contains two traps for the unwary.

Let’s go back to another section of 2006-77:

SECTION 3. SUBSTANTIALLY ALL AND ACTIVE CONDUCT REQUIREMENTS UNDER section 1400N(d)(2)(A)(ii)
.01 SUBSTANTIALLY ALL REQUIREMENT. Each depreciable property will meet the requirements of section 1400N(d)(2)(A)(ii) if substantially all of the use of the property is in the GO Zone and in the active conduct of a trade of business by the taxpayer in the GO Zone. For this purpose, the term “substantially all” means 80 percent or more during each taxable year. If greater than 20 percent of the use of the property either is outside the counties and parishes designated as being part of the GO Zone or is not in the active conduct of a trade or business by the taxpayer in the GO Zone, then the property is not GO Zone property and is not eligible for the GO Zone additional first year depreciation deduction.

I think there are two traps in this section.

First trap: The first, while a trap, is not that large for the typical real estate investor: The GO Zone property must be used more than 80% inside the GO Zone. This goes back to the discussion in Question 7 where the implied position of the legislation is to keep all of the benefits within the GO Zone.

The examples provided by the IRS relate mostly to a delivery truck which, although purchased by a business in the GO Zone, was not used within the GO Zone for more than 80% of its use. Due to a violation of the use requirement, the IRS disallowed the bonus depreciation.

It appears the typical real estate investor will only purchase portable property for direct use in the real estate and, therefore, it would almost always stay in place in the Go Zone. However, this 80% use factor is important to remember.

Second trap: The second trap is larger and more camouflaged. Consider the following example from Notice 2006-77. I know this is a long quote but it needs to be read and understood.

.02 ACTIVE CONDUCT OF A TRADE OR BUSINESS REQUIREMENT.

(1) TRADE OR BUSINESS DEFINITION. For purposes of section 1400N(d)(2)(A)(ii), the term “trade or business” has the same meaning as in section 162 and the regulations thereunder. Thus, property held merely for the production of income or used in an activity not engaged in for profit (as described in section 183) does not qualify for the GO Zone additional first year depreciation deduction.

(2) ACTIVE CONDUCT. Solely for purposes of section 1400N(d)(2)(A)(ii), the determination of whether a trade or business is actively conducted by the taxpayer is to be made based on all of the facts and circumstances. A taxpayer generally is considered to actively conduct a trade or business if the taxpayer meaningfully
participates in the management or operations of the trade or business. Furthermore, for purposes of section 1400N(d)(2)(A)(ii), a partner, member, or shareholder of a partnership, limited liability company, or S corporation, respectively, is considered to actively conduct a trade or business of the partnership, limited liability company, or S corporation if the partnership, limited liability company, or S corporation meaningfully participates (through the activities performed by itself, or by others on behalf of the
partnership, limited liability company, or S corporation, respectively) in the management or operations of the trade or business. Similar rules apply to other pass-thru entities such as trusts or estates.

(3) EXAMPLES. The following examples illustrate the provisions of section 3.02 of this notice.

(a) EXAMPLE 1. During 2006, MNO, a limited liability company, constructs and places in service a new apartment building in the GO Zone. MNO is treated as a partnership for federal tax purposes. B, a member in MNO, manages and operates this apartment building for MNO. Because B manages and operates the
apartment building for MNO, MNO meaningfully participates in the management and operations of the apartment building. Consequently, all of the use of the apartment building is in the GO Zone and in the active conduct of a trade or business by MNO in the GO Zone. Accordingly, the unadjusted depreciable basis
(as defined in section 1.168(b)-1T(a)(3)) of the apartment building qualifies for the GO Zone additional first year depreciation deduction (assuming all other requirements are met). However, limitation provisions of the Code (for example, section 469) apply and may limit the amount of the GO Zone additional first year depreciation deduction that may be claimed by the members of MNO.

(b) EXAMPLE 2. During 2006, C, an individual, places in service a new restaurant in the GO Zone and employs D to operate it. During 2006, C periodically met with D to review operations relating to the restaurant. C also approved the restaurant’s budget for 2006 that was prepared by D. D performs all the necessary operating functions, including hiring chefs, acquiring the necessary food and restaurant supplies, and writing the
checks to pay all bills and the chefs’ salaries. Based on these facts and circumstances, C meaningfully participates in the management of the restaurant. Consequently, all of the use of the restaurant is in the GO Zone and in the active conduct of a trade or business by C in the GO Zone. Accordingly, the
unadjusted depreciable basis of the restaurant qualifies for the GO Zone additional first year depreciation deduction (assuming all other requirements are met). However, limitation provisions of the Code (for example, section 469) apply and may limit the amount of the GO Zone additional first year depreciation
deduction that may be claimed by C.

(c) EXAMPLE 3. During 2006, PRS, a partnership, constructs and places in service a new small commercial building in the GO Zone and leases it to E, an unrelated party, who uses the building as a fast food restaurant. This building is the only property owned by PRS. The lease agreement between PRS and E is
a triple net lease under which E is responsible for all of the costs relating to the building (for example, paying all taxes, insurance, and maintenance expenses) in addition to paying rent. Because of the triple net lease, PRS does not meaningfully participate in the management or operations of the building and the building is not used in the active conduct of a trade or business by PRS in the GO Zone. Accordingly, the building does not qualify for the GO Zone additional first year depreciation deduction.

(d) EXAMPLE 4. Same facts as Example 3, except that PRS, during 2006, constructs and places in service two other new commercial buildings in the GO Zone and leases these buildings to F, an unrelated party, who uses the two other buildings as office space. The lease agreement between PRS and F is not a triple net lease. G, a partner in PRS, manages and operates the two office buildings for PRS. Because G manages and operates the two office buildings for PRS, PRS meaningfully participates in the management and operations of the two office buildings. Consequently, these two office buildings are used in the active conduct of a trade or business by PRS in the GO Zone. Accordingly, the total unadjusted depreciable basis of the two office buildings leased to F qualifies for the GO Zone additional first year depreciation deduction (assuming all other requirements are met). However, limitation provisions of the Code (for example, section 469) apply and may limit the amount of the GO Zone additional first year depreciation deduction that may be claimed by the partners of PRS with respect to the two buildings leased to F. Further, because the requirements of section 1400N(d)(2)(A)(ii) apply on a property-by-property basis, the building leased to E does not qualify for the GO Zone additional first year depreciation deduction, as provided in Example 3.

What is going on here?

The tax code sometimes defines words differently than we define them for common usage. The entire discussion about active is an example. The code is trying to find a balance between the functions of an investor (mostly passive such as accounting for the investment) and an active role in the investment (such as managing and operating business aspects of the investment). Admittedly, this is a very hard balance to always maintain.

Why does the IRS try and form these definitions? Because the tax benefits for a passive owner are materially weaker than for an active owner. You can really see that difference was you explore the classification matrix between passive and active in the legislations. In the above examples, to simply OWN a building in the GO Zone does not automatically qualify it for GO Zone tax advantages. Some ideas which can be drawn from the above using a building rented to a third party as the example:

1. For a building to qualify as GO Zone-allowable property for the owner, the owner must have a minimum level of involvement in the building.
2. A triple-net lease evidentially causes some problems for the IRS as noted in the above examples. Therefore, I would be very careful in using such a lease for a GO Zone located property.
3. Business entity structure is critical here as is the underlying lease between the owner and the tenant.
4. Even with the same ownership, an owner can find that one building qualifies for GO Zone treatment and another does not so qualify.

Bottom line?

Economic and legal structure is very important here. I would strongly advise that all legal documents (including leases) be reviewed by a component legal advisor to ensure they are in compliance with the GO Zone rules and regulations.

My opinion?

Many taxpayers will be caught in this trap and think just because they have ownership in an otherwise qualifying GO Zone property, that ownership will qualify them for GO Zone tax treatment. They will be very disappointed when they discover they lost their hoped for tax benefits because they did not structure themselves or the investment appropriately.