What did we do before we had computer technology to handle these complex alternative computations?

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2015 YEAR-END PLANNING

DECEMBER 2015

1 · FTI Consulting, Inc. CRITICAL THINKING AT THE CRITICAL TIME™

Is it the Calm before the Storm?

With an election year ahead of us, conventional wisdom holds that near term significant tax reform is very unlikely. But, rest assured, we’ll still hear plenty of rhetoric as several candidates have already presented their plans as talking points. Considering that, combined with the inevitable rise in interest rates, our general view is that now may be the best opportunity to refocus on current holdings, tax structures, and explore the related planning opportunities that are available under current tax law and interpretations while they still exist. With a nod to David Letterman in his retirement, here is a “Top 10 List” of our recommended considerations during this year-end planning cycle, as well as an update of the handful of laws which have passed this year with tax implications:

10. Investment Interest Expense

As a general rule, interest paid on investment debts is deductible, but only up to the amount of Net Investment Income. With the introduction of the Net Investment Income Tax (“Obamacare Tax”) in 2013, some odd interactions often occur between it and AMT and a simple election can often result in significant tax savings.

Here’s how it works. Because certain itemized deductions are disallowed for AMT, the deduction limitation on investment interest expense is often notably lower for regular tax purposes compared to AMT. The limited investment interest expense is carried over to the following year(s) for regular tax purposes. In particular years, by electing to include long term capital gains and qualified dividends in Investment Income, a taxpayer can increase their investment interest limit in that year. Interestingly, the resulting benefit can be a substantial reduction in the Net Investment Income Tax, not the regular tax. Many considerations go into when the election is most advantageous, and therefore lots of scenarios need to be considered.

What did we do before we had computer technology to handle these complex alternative computations?

9. Real Estate Professional Status

The U.S. real estate industry has enjoyed meaningful statutory tax advantages historically. In order for individual taxpayers to enjoy those advantages, Congress has enacted, and Courts have supported the rules to limit those benefits for all but those who meet the activity requirements of real estate professionals. Beginning in 2013, meeting those requirements has also kept real estate professionals away from the 3.8% Net Investment Income (NII) Tax on the gains from their real estate activities.

There are two distinct tests which an individual must meet in order to be treated as a real estate professional for income tax purposes. However, an advantage for married taxpayers is that if one qualifies, any real estate income of the other also qualifies. This obviously broadens the potential application to same sex couples who can now file as married taxpayers based on the Supreme Court ruling earlier this year.

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The two tests are summarized as follows:

1. The active participation test in a real property trade or business. This requires that an individual spend at least 750 hours during the year in a real estate oriented trade or business. However, the catch is that hours working as an employee (generally, someone who receives a W-2) do not count unless the taxpayer owns 5% or more of the company.

2. The material participation test in the rental activity. This test is often harder to meet than the first. This test requires 500 hours of participation in each real estate rental activity. Since exceeding 500 hours in each individual real estate building is difficult, tax regulations were promulgated to allow the taxpayer to elect to group real estate activities into a “reasonable economic unit” to meet the 500 hours.

It is essential that both of these tests be met in any year that real estate professional status is claimed. Hours spent meeting one test may also count for the other depending on the facts and circumstances, but not always. For example, an architect who qualifies as a real estate professional based upon his or her 750 hours in that profession can only use the hours actually worked in their rental activity toward the 500 hour test. Because the tax savings can be significant, we recommend maintaining daily records of time spent on these activities for IRS review in the event of an audit.

8. Reverse 1031 Exchanges: Another Way to Think About Like Kind

Exchanges

Like-kind exchanges under IRC §1031 are a common way to change ownership of property without incurring a taxable event and is especially useful for real estate investors. Generally, the requirements are that a replacement property (or properties) be identified within 45 days and the exchange completed within 180 days. Typically, taxpayers look to replace a property when the time comes, for investment or other reasons, to sell one or more of their holdings.

However, we are more frequently seeing taxpayers considering like-kind exchanges when they buy, rather than when they sell, a property.

Referred to as a “Reverse 1031 Exchange,” a taxpayer can acquire replacement property before selling the property to be replaced. The same 45 and 180 day requirements must be met, and a qualified intermediary holds title to the acquired property rather than the funds from the sale as is typically the case. Sophisticated real estate investors have been increasingly taking advantage of this technique as a way to diversify and upgrade assets on a tax free basis. And remember, as is the case with all like-kind exchanges, properties with higher value can be purchased, but not lower.

7. Individual Retirement Accounts

An increasing number of our clients are investing in IRAs, especially the younger generations that are not full time real estate

professionals. While on the surface, an Individual Retirement Account is a straightforward retirement vehicle, they can quickly become complicated. An IRA is, at its most basic level, an account that allows for retirement savings while deferring, and in some cases eliminating, taxes.

If you’re interested in using an IRA to save for retirement, you should know that there are multiple types of IRAs. The most common ones are traditional and Roth IRAs. A traditional IRA is an account where contributions are made pre-tax and are only taxed on withdrawal – hopefully when you’re retired and in a lower tax bracket. Contributions to Roth IRAs are made with after tax dollars, and therefore can grow and be withdrawn tax-free – a better option if you expect to be rolling in taxable income in your later years.

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There are other types of IRAs too, including rollover, custodial, and inherited, that all have different attributes and advantages, as well as different contribution limits and withdrawal rules. Therefore, the tax consequences must be considered based on a number of factors, including the type of IRA and the age of the beneficiary.

6. Family Office

Family offices are all the rage. Wealth creators and their families have long considered how to best simplify and manage their increasingly complicated lives. With technology and savvy planning, the options, and related costs, have become much more broadly accessible.

So, what is a family office compared to a multi-family office; what are the costs, as well as the pros and cons of each, and when would it make sense to consider creating or joining an existing one?

A thoughtful process which considers each family member’s current and potential future needs and life’s desires would help a family answer these questions. This process is typically undertaken by a family as a result of a significant family transition or liquidity event. Here are some examples of the general services which can be performed by a family office:

 Centralizing oversight and reporting of family portfolio and business assets;

 Preserving family wealth through proactive income and estate tax planning;

 Advising family members regarding the impact of financial decisions, including marriage and family, investing, and philanthropy;

 Handling administrative tasks like travel coordination, managing household employees, and other “concierge” services;

 Coordinating with professionals, including attorneys, insurance professionals, investment advisors, and CPAs;

 Educating family members to understand complex business and personal aspects of their wealth.

Ultimately, once the need and desires for a family office have been agreed to, costs and efficient tax structuring can be considered.

5. Estate and Gift Taxes

Ever since 2010, when the current gift and estate tax regime was made “permanent,” the practitioner community has been learning the rules and adjusting to a life of indexed exemptions. The current lifetime exemption amount, that which can be transferred free of Federal estate tax will be increasing from $5.43 million in 2015 to $5.45 million in 2016. Such a small increase is an indication of the low rate of inflation in our economy this year.

The amount that can pass free of New York estate tax is still in flux, i.e., the exclusion amount is increasing annually from $3,125,000 today until 2019 when it will be tied to the Federal exclusion.

Of course, there are still plenty of planning opportunities available, especially in light of the possible changes to the valuation rules described later in this update.

4. IRS Matters

The IRS may not be your favorite governmental agency (is that an oxymoron in itself?) but it’s important to keep up with what’s going on with the tax version of the Grinch. Anecdotally, we can tell you that fewer individuals are being audited than before, and this seems to be supported by recent studies which show that audit levels are the lowest they’ve been in a decade.

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For anyone complaining about our inefficient government, here is something noteworthy. A recent study by the Budget Committee Office showed that for every $1 that is spent on IRS enforcement efforts, an incremental $6 of tax revenue is earned. Notwithstanding that, the IRS budget has been reduced annually for the past several years, cutting enforcement personnel by nearly 10,000 employees since 2010. The only sense that we can make of this is that nobody in Washington wants to be known for supporting the pursuit of anyone in their districts, even at the cost of government revenues.

Another recent change in IRS enforcement relates to exceptions to the application of the general 3 year statute of limitations. Generally, if you’ve filed a return more than three years ago and haven’t had an auditor knocking on your door demanding back up documentation, you’re probably safe. The 3 year limit applies to taxpayers filing for a refund and the IRS assessing taxes on filed returns too. In some special cases, the statute of limitations is longer – for example, the IRS has 6 years to audit you if you omit to report 25% of your income or more.

Congress recently decided to change the time limit for assessing and collecting tax related to over reporting the amount of basis in property from three years to six years, making it the same as underreporting income. In doing so, they overruled a 2012 U.S. Supreme Court case which explicitly held the limitation to three years.

Note that there is no statute of limitations on tax evasion or tax fraud

3. The Bipartisan Budget Act of 2015

On another IRS enforcement note, a new rule passed in the Bipartisan Budget Act of 2015 allows the IRS to make audit adjustments and assess the related tax at the partnership entity level for partnerships with more than 100 partners. Previously, any adjustments made to partnership returns flowed through to the individual partners. Now, the IRS can administer the adjustment more easily and the partnership will report the adjustments and related tax payments to each partner. This IRS convenience eliminates complexities for the IRS, but may result in the need for partners to claim refunds if their actual tax liability related to the partnership adjustment is less than that paid on their behalf.

2. The Tax Increase Prevention and Real Estate Investment Act of

2015 (Pending Ratification)

This law (affectionately known as “TIPREIA”) was released by the Ways and Means Committee the evening of Monday, December 7th. The Act amended certain previous Acts and extended some important tax provisions. First, TEPREIA extended 50% bonus depreciation for property acquired and placed in service through the end of 2016. Second, the Act included an extension of the current 15 year depreciation for leasehold improvements through the end of 2016, as well as other real estate related provisions (including tax credits, mortgage debt forgiveness exclusions, etc.). Finally, the act proposed some favorable changes to the Foreign Investment in Real Property Tax Act (FIRPTA), to the delight of US based real estate companies.

The changes liberalize and therefore encourage investments by foreign investors in the stock of U.S. based publicly traded companies, including REITs. The Joint Tax Committee estimates the increased revenue from these FIRPTA changes could be $4 billion dollars over ten years. Clearly this is a win-win situation.

1. Closely Watched Future Legislative Changes

So, what does the future hold? Irrespective of the upcoming election season, and indeed the result, there are several significant tax changes which will get a lot of attention. Among them are:

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CRITICAL THINKING

AT THE CRITICAL TIME™

Mark Rubin

Senior Managing Director 646.632.3836

mark.rubin@fticonsulting.com

Mark Halpern Managing Director 646.632.3837

mark.halpern@fticonsulting.com Mark Golden

Managing Director 646.632.3838

mark.golden@fticonsulting.com

About FTI Consulting

FTI Consulting, Inc. is a global business advisory firm dedicated to helping organizations protect and enhance enterprise value in an increasingly complex legal, regulatory and economic environment. FTI Consulting professionals, who are located in all major business centers throughout the world, work closely with clients to anticipate, illuminate and overcome complex business challenges in areas such as investigations, litigation, mergers and acquisitions, regulatory issues, reputation management and restructuring.

Senior Consultant 646.632.3863

rebeccah.fontaine@fticonsulting.com

1. Carried interests have provided low income tax rates for gains of hedge fund managers and real estate professionals continue to receive much attention. While we don’t expect that to change near term, to the extent practical, triggering gains while rates are low should be considered.

2. An idea considered troubling by many REITs and indeed flow-through entities more broadly, has been the recent suggestion that these entities begin to be taxed at the entity level, to put them on parity with corporate taxpayers. Notwithstanding the reduced rate on qualified dividends, double taxation on corporations does exist and has long been a source of frustration for US publicly traded companies.

3. In the estate and gift tax arena, a significant change in valuing family controlled entities may be imminent. Under current law, the value of non-managing, non-controlling interests in family owned businesses , regardless of whether they own operating businesses or investment portfolios, may generally be discounted when gifted or sold for factors including lack of

marketability and lack of control. There has been discussion throughout 2015 by Treasury Department representatives predicting the issuance of regulations which would reduce or eliminate those discounts. As of yet, no such regulations have, however, been issued.

So, there you have this year’s top 10 list. Please feel free to reach out to us if you have questions or desire clarification.

The views expressed herein are held by the authors and are not necessarily representative of FTI Consulting, Inc. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual, entity or transaction. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.