In a recently decided case 3 University Plaza SPE, LLC v. City of Hackensack 5002-2014, 1670-2015, 3553-2016, 1163-2017, 3768-2018, 12891-2019 – 3 University Plaza SPE LLC, et al. v. Hackensack City (njcourts.gov) concerning a large 225,000 square foot class A office building, the Tax Court addressed the valuation community’s on-going debate as to whether certain reoccurring expenses (such as tenant improvement allowances and brokers’ commissions) should be treated as so called “above” or “below” the line adjustments when calculating the all-important net operating income of an asset.  Due to the fact that the Income Approach to value is the well-recognized leading methodology employed when dealing with income-producing properties, the determination of a property’s stabilized net operating income is critical to arriving at an appropriate and supportable fair market value determination.

Because the 3 University Court concluded that these categories of expenses are “in the competitive market” “annually reoccurring” operating expense and “needed to stabilize occupancy and preserve the value” of the property, they must be treated as “above-the-line” adjustments affecting net operating income.  In addition, because the Tax Court recognized that the major industry surveys report capitalization rates based upon the survey participants’ treatment of tenant improvement allowance and brokers’ commission expenses as “below-the-line” adjustments, (therefore not impacting net operating income), these surveys (e.g., American Council of Life Insurers Investor Bulletin Tables and PwC Real Estate Investor Survey) cannot be relied upon in concluding appropriate capitalization rates for use in the Income Approach valuation method.

On the other hand, the Band of Investment technique for deriving capitalization rates is a method that relies upon market determinations of appropriate mortgage interest rates and equity dividend rates, neither of which are directly impacted by a property’s net operating income and the divergent treatment of tenant improvement allowance expenses or brokers’ commissions.  As such, the Court concluded that the Band of Investment technique “provides the most accurate and reliable method of deriving a capitalization rate because it is not polluted or impacted by questions of how potential survey recipients perceived hypothetical transactional questions or how a market perceives an annually reoccurring operating expense.”

As a result, the Tax Court’s holding in this case, although a trial level decision and not binding on other courts, does provide a well-reasoned analysis and approach that should serve to better guide the valuation community as to best practices when determining stabilized net operating income and fixing appropriate capitalization rates  — two integral components of the Income Approach to value.

The IRS released Revenue Procedure 2021-45 which announces the increase in 2022 of the estate, gift and generation-skipping transfer tax applicable exclusion amounts from $11.7 million to $12.06 million.  The applicable exclusion amounts currently remain scheduled to expire on December 31, 2025, which would result in a reduction in the exclusion amounts to $5 million (adjusted for inflation).  However, there is always a possibility that new law will be passed that could adjust these exclusion amounts sooner.

In addition, in 2022, the gift tax annual exclusion amount for gifts to any person (other than gifts of future interests to trusts) will increase to $16,000, while the gift tax annual exclusion amount for gifts to a non-citizen spouse will increase to $164,000.

The New York basic exclusion amount will also increase in 2022 from $5.93 million to $6.11 million.

The Connecticut estate and gift tax applicable exclusion amount will increase from $7.1 million to $9.1 million in 2022.  This amount remains scheduled to meet the federal estate and gift tax exclusion amount in 2023.

We have had several matters recently with “Accidental Americans” – that is, non-US persons who became US tax residents by staying in the US for a sufficient number of days.

This frequently happens in an understandable way, and involves a non-US person who has family in the US. The non-US person comes to visit his or her family in the US for some period of time every year. He or she may stay for a few months at a time. With covid, medical or other reasons, he or she may have stayed for a longer period of time recently. And then, at some point and usually unwittingly, the non-US person satisfies the “substantial presence” test for US tax residency.

The “substantial presence” test is a day count test.  If a person is present in the US for 183 days or more in a calendar year, then he or she meets the substantial presence test and is treated as a US tax resident for US income tax purposes.

Also, if a person is present at least 31 days during the current calendar year, and those days, plus 1/3 of the days present during the preceding calendar year, plus 1/6 of the days present during the second preceding calendar year is equal to or greater than 183 days, then the person also meets the substantial presence test.

There are possible exceptions to the substantial presence test.  The exceptions include (1) the “closer connection” test, (2) the “exempt individual” test and (3) the “treaty tie-breaker” test.  These tests are not described in detail in this post.

The substantial presence test is important because a person who is a US tax resident must pay US tax on all of his or her worldwide income (subject to a credit for foreign taxes paid), whereas a non-US person is only taxed on his or her US source income.  Being subject to US tax on worldwide income can be an unwelcome surprise for an Accidental American.  One consequence of this test is that, if a person is in the US every year (eg, seasonally), he or she should be present for fewer than 121 days each year to avoid the rule.

In addition, a US tax resident also must comply with relatively complex tax reporting requirements for his or her foreign assets.  These include:  (1) foreign bank account reports (Form FinCen114) to report foreign bank accounts, (2) Form 8939 to report “specified foreign financial assets,” (3) Form 5471 for “controlled foreign corporations and (4) other possible reporting forms.

The penalties for not filing these information returns can be substantial.  On the other hand, the penalties can be abated if the taxpayer has “reasonable cause” for the non-filing.

Becoming an Accidental American also can mean exposure to state income tax.  For example, a non-US resident who spends sufficient days in New York also may owe New York income tax on his or her worldwide income.

Individuals in this type of situation should consult a tax professional to review their tax residency issues carefully.

On June 12, 2021, New York’s new Power of Attorney law (A.5630-A/S.3923-A) went into effect.  As a reminder, the law simplifies New York’s Power of Attorney form and implements penalties for improper rejection of a New York Power of Attorney by third parties.  A Power of Attorney that was executed under a prior version of the law remains effective and does not need to be re-executed at this time.  Here is a link to our previous article with a substantive outline of the specific changes to the law.

This short article outlines the requirements for starting an active business in a qualified opportunity zone (“QOZ”).

The US tax legislation that created QOZs was enacted in early 2018, and is intended to encourage long-term investment in economically distressed communities.  The IRS issued two substantive sets of proposed regulations outlining rules for QOZ investments (in October, 2018, and April, 2019), and finalized the regulations in December, 2019.  Investors and entrepreneurs are still absorbing these rules.  Nevertheless, the tax benefits from a successful QOZ investment in an active business can be substantial.  These primarily include (1) a deferral of tax on the amount of gain that is reinvested into a QOZ investment until 2026, and (2) the ability to sell a QOZ investment held for 10 years on a tax-free basis.

Real estate has been the main focus for QOZ investors, and a cottage industry in QOZ real estate investments has emerged.  In addition, an entrepreneur who is starting a new business would do well to consider whether he or she can locate the new business in a QOZ and comply with complex rules to qualify as a QOZ business.

The main definitions and applicable rules are summarized below:

  1. A “QOZ Fund” is an investment vehicle formed as a partnership or corporation for the purposes of investing in an eligible QOZ Property. The QOZ Fund is required to hold at least 90% of its assets in QOZ Property.
  2. “QOZ Property” means: (a) QOZ stock, which is original issue stock in a domestic corporation acquired for cash where the corporation is a QOZ Business, (b) QOZ partnership interest, which is any capital or profits interest in a domestic partnership acquired for cash where the partnership is a QOZ Business, or (c) “QOZ Business Property,” which is tangible property used in a trade or business of the QOZ fund, where the original use of the property in the QOZ begins with the QOZ Fund, or the QOZ Fund “substantially improves” the property (generally, a 30 month test to double the value of the property).
  3. A “QOZ Business” is generally an active trade or business where substantially all (ie, more than 70%) of the tangible property owned or leased by the taxpayer (through the QOZ Fund) is QOZ Business Property. In addition, a QOZ Business is a business where:
    1. at least 50% of the total gross income of such trade or business is derived from the active conduct of such trade business within a QOZ (the “50% gross income test”),
    2. a substantial portion of the intangible property of such trade or business is used in the active conduct of such trade or business in the QOZ, and
    3. less than 5% of the average of the aggregate unadjusted tax bases of the property of such trade or business is attributable to nonqualified financial property.

While there was initially significant uncertainty around the 50% gross income test, the Regulations provide more clarity by providing three safe harbor tests.  Based on the Regulations, a QOZ business will satisfy the 50% gross income test if any of the following apply:

  1. More than 50% of the service hours performed for the business by its employees and independent contractors are performed within the QOZ,
  2. More than 50% of the compensation and/or independent contractor expenses for the business are incurred by its employees and independent contractors within the QOZ, or
  3. The QOZ Business locates both tangible property and its management or operations within a QOZ that are necessary to generate 50% of the gross income of the business.

A business that does not meet the safe harbor tests also may meet the 50% gross income requirement based on a facts and circumstances test if, based on all the facts and circumstances, it can demonstrate that at least 50% of the business’ gross income is derived from the active conduct of the business in the QOZ.

The Regulations contain an example of a tech company.  The business is a startup business that develops software applications for global sale and is located in a QOZ.  A majority of the total hours of the startup’s employees and contractors developing software applications are performed in the QOZ.  The example provides that the business would satisfy the 50% gross income test, even though the business makes the vast majority of its sales to consumers located outside of the QOZ.

There are many additional issues for entrepreneurs to consider in starting a QOZ Business, including timing issues to invest capital, valuation issues to satisfy the IRS’ tests, leasing issues if property is leased, related party issues if property is purchased or leased from a related party, and tax reporting issues.  It also may be possible to move an existing business into a QOZ, though this requires careful planning and additional investment.

Note that the state income tax treatment of a QOZ interest may be different than the federal income tax treatment.  For example, New York recently decoupled its tax law from the federal QOZ law with respect to the deferral of gains that are reinvested in QOZ Businesses (although New York appears to have retained the exclusion of gain from taxation on the sale of QOZ Businesses held for more than 10 years).

Despite the complexity of the law, the overall benefits to distressed communities, and the tax benefits, for QOZ Businesses can be substantial.

If you are interested in starting an active business in a QOZ, you should speak with a tax attorney to guide you through the requirements of the QOZ rules.