Real Estate Tax & Accounting Insights for Year-End Planning

Join EisnerAmper to hear our professionals discuss tax and accounting matters the real estate industry needs to know before year-end.

In this webinar from EisnerAmper, our professionals discuss tax and accounting updates for the real estate industry, including:  

• The impacts of high interest rates  
• How to reach claim real estate professional status  
• Mitigating potential losses with strategies such as debt restructuring  
• How the fair valuing of assets and going concern can help organizations better navigate the current market  

Rules and Exceptions to Claiming Real Estate Professional Status  

There has been an increase in IRS audits scrutinizing real estate professional determinations. Typically, rental activity is passive, so if a realtor has passive losses, they only offset against other passive incomes. The losses carry over until the activity disposes, or if there is passive income from another activity, which can cancel it.  

An exception to this rule is the professional designation test. Passing the professional designation test is the goal of most real estate professionals, but the test is difficult to pass. To meet the test requirements, one must: 

• Perform 50% of services in real property trades or businesses. 
• Complete the de minimis, meaning 750 hours in real property trades or businesses. 
• Show that they materially participate in each rental activity.  

Once you meet these quantitative tests, you become a real estate professional and start to receive benefits like activities turning from passive to nonpassive and an exemption from net investment income taxes.  

It is important to note that just because you are a real estate professional does not mean the rental activity is automatically nonpassive. For it to be nonpassive, real estate professionals must show they materially participated in those activities. There are seven tests for material participation, but only one of the seven needs to pass. To be best prepared for the tests, showing that you participate in day-to-day activities like advertising, negotiating the lead, and collecting the rent payment is vital.  

Impacts of Higher Interest Rates on Commercial Real Estate  

Interest rates increased in 2023, which directly affected capitalization rates. The impact of higher interest rates on property values is twofold. Properties are valued on a cap rate of NOI, net operating income, and rising interest rates, which is the current scenario.  

The impact of higher interest rates is the dominant force in commercial real estate right now, and the repricing of income streams has created a frozen transaction landscape. Owners currently prefer to hold, and most buyers prefer to wait for an even lower price.  

Debt Restructuring   

The accounting impact of debt restructuring depends on the surrounding facts and circumstances and requires companies to navigate complex accounting guidance. Several models can be applicable, depending on the circumstances, including, troubled debt, restructuring, debt extinguishment, or debt modification.  

For example, suppose the transaction is not considered troubled and is still with the same lender. In that case, the next step is determining whether the transaction is a debt extinguishment or modification. The determination should be based on the economic substance of the transaction, regardless of its legal form. This analysis requires a present value calculation to determine if the change in contractual cash flows between the original debt and the restructured debt is 10% or greater. 

Debt restructuring or modification is the most common mitigating event. However, unlike in the past, where refinancing was more accessible, the risk in the current environment is extremely high. Therefore, companies need to demonstrate the status of how they are working with their lenders to address this concern.  

Other possible but less common mitigating tools are available, such as obtaining other forms of funding or, more drastically, changing the business operations. 

Fair Valuing of Assets 

In real estate, fair valuing of assets appears as part of an impairment analysis or as part of a purchase price allocation. Given the current economic environment, there is more scrutiny on companies' underlying calculations to arrive at an asset's fair value.  

The two most common valuation methods are the market and income approach. The market approach utilizes third-party appraisers who conduct valuations by comparing the values of recently sold comparable properties in the area. The income approach involves developing a model to value the property's future cash flows.  

Going Concern 

Going concern is an analytic report created to show that a company can sustain itself. Indicators that could be a potential going concern include: 

• Maturing debt 
• Trends of negative cash flows from operations 
• Significant loss of a tenant for whom you have low or struggling occupancy or sunken assets 

The presence of one or more of these indicators does not necessarily mean that you have a going concern. There are a variety of mitigating factors that can alleviate a going concern.