Tax Break for Commercial Real Estate Investors

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COVID-19 impacted the economy dramatically, and commercial real estate was no exception in terms of decreased values. Often, the real property could no longer service the debt used to finance it. This debt restructuring and resulting debt forgiveness can result in taxable income.

Taxable Income and Debt Cancellation

If you have an $80,000 loan and the bank reduces the amount you owe down to $50,000, then you have an economic benefit of $30,000, which should be treated as taxable income. This is indeed how the cancellation of debt is treated, but there are exceptions, such as in the case of bankruptcy or insolvency. There is another unique scenario that applies only to commercial real estate.

Assuming that the taxpayer is not a C-corporation, debt cancellation is excludable from taxable income if it results from qualified real property business indebtedness (QRPBI). QRPBI is debt taken on to buy real property used for commercial purposes. Starting in 1993, debt used for building or improving a property also qualifies.

As we all know, there is no such thing as a free lunch. For debt cancellation to not be considered current taxable income, the taxpayer must reduce their basis in the real property by this same amount. This does not cancel the income; instead, it defers its recognition and helps cash flow as a result. Below, we look at an example of how this works.

Illustrative Example

Assume David bought a property in 2017 and he uses it for business purposes. In 2022, the property has a first mortgage of $200,000 and a second mortgage of $100,000 (both with the same bank), with a fair market value (FMV) of $240,000. He negotiates with the bank to reduce the second mortgage down to $20,000, resulting in income from the cancellation of debt of $80,000.

The amount of debt cancellation that can be deferred is equal to the amount of the second mortgage before the debt cancellation, less the FMV minus the first mortgage. In David’s case, before debt cancellation, the FMV ($240k) minus the first mortgage ($200k) was $40,000. The balance of the second mortgage ($100k) exceeded this by $60,000. Out of the total debt cancellation of $80,000, this $60,000 is subject to deferral, with only the remaining $20,000 reported as immediate taxable income.

The $60,000 is not considered as taxable income only to the extent that David has sufficient adjusted tax basis in the depreciable real property to absorb this as a reduction in basis. Assuming this is the case, the basis reduction applies the first day of the tax year after the debt cancellation (unless the property is sold before year-end — then it applies immediately).

In the example above, David would include the $10,000 of cancellation of debt income on his 2022 tax return and adjust his basis in the real property by $60,000 as of Jan. 1, 2023.

Filing Mechanics

For real estate held via partnerships instead of by individuals, determining if a debt is QRPBI qualified happens at the entity level, although reductions of basis are done at the individual level for each partner, allowing individual planning. The election to defer the cancellation of debt income is recorded on Form 982.

Conclusion

The COVID pandemic caused many real estate investors to restructure their debts. The option to defer debt income cancellation offers a great tax planning opportunity by delaying taxable income and improving cash flows.

How to Calculate the Cash Conversion Cycle

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The Cash Conversion Cycle, also known as the Net Operating Cycle, answers the question, “How many days does it take a company to pay for and generate cash from the sales of its inventory?” However, before an analysis like this can take place, it’s important to consider the company’s primary line of business.

If the company sells software, it's more challenging to measure performance because it generates revenue primarily on intellectual property — by developing computer code and licensing its use to clients. For online marketplaces, especially those that make the majority of their profits from third-party sellers that manage product sourcing, listing their inventory and shipping products on their own won't measure the online marketplace's inventory. Since these types of businesses don't act like a manufacturer that produces and sells products to other businesses or the general public, this type of analysis will be less helpful.

The formula for the Cash Conversion Cycle (CCC), is calculated as follows:

CCC = Days of Sales Outstanding (DSO) + Days of Inventory Outstanding (DIO) – Days of Payables Outstanding (DPO)

Days of Sales Outstanding, Defined

DSO is the average number of days it takes a company to collect payment once a sale has been completed. The beginning and ending Accounts Receivable figures from a fiscal year are added together and then divided by two. Then revenue from the income statement for the entire fiscal year must be divided by 365 days to get a daily average.

DSO = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2 = Revenue / 365 days

The fewer the days, the better; however, it can't be so fast that such tight payment terms push customers away.

Days of Inventory Outstanding, Defined

DIO is the average number of days a business keeps its inventory before it's purchased.

The beginning and ending inventories of a fiscal year are added together and divided by two to find an average. The resulting figure is then divided by the daily average of the cost of goods sold over a fiscal year, which is often 365 days.

DIO = (Beginning Inventory + Ending Inventory) / 2 = Cost of Goods Sold / 365 days

The lower the number, the faster inventory is sold. While there's nothing wrong with moving inventory quickly, there is the danger that orders might not be able to be fulfilled.

Defining the Operating Cycle

As the CFA Institute explains, putting DIO and DSO together constitutes the Operating Cycle. This is defined as the period of days that it takes a business to transform basic materials and/or goods into stock and obtain money from the completed transaction. When this number is small, it means the product is moving and customers have no issue making prompt payments.

Days of Payable Outstanding, Defined

Days of Payable Outstanding refers to the number of days a business takes to fulfill its debts to suppliers.

DPO = (Beginning Accounts Payable + Ending Accounts Payable) / 2 = Cost of Goods Sold / 365 days

Considerations for DPO include finding a balance between how long a business can take to pay their suppliers, but also not missing out on pre-payment discounts or being penalized with late fees, financing charges, etc.

Going Beyond the Results

Analyzing the Cash Conversion Cycle for the right type of company can provide great insight into that organization’s efficiency in regards to collecting billings, the length of time that inventory is up for sale, and the time it takes to become current with its own suppliers. Depending on the results of the CCC analysis, performing financial analyses can provide insight into not only how the company is performing financially, but why the company is performing financially.

 Sources

https://blogs.cfainstitute.org/insideinvesting/2013/05/21/a-look-at-the-cash-conversion-cycle/  

R&D Tax Credits for Startups

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This article explains the significant benefits that startups in 2022 receive when using R&D tax credits. For companies to qualify for R&D tax credits, their ideas must be a new or improved business component for a permitted purpose, include activities technological in nature, have elimination of uncertainty, and use the process of experimentation. The amount companies get back in R&D research “depends on the sum of your Qualified Research Expenses (QRE), which can include wages, contractor costs, and supply costs.” Start-ups can now use the R&D tax credit to offset up to $250,000 of their FICA payroll tax for their first five taxable years. Less than one-third of companies are aware that they qualify for the R&D tax credit. Be sure to hit the link for more information on the benefits of R&D tax credit!

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Gas Saving Tips for Your Summer Travel

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This article explains the best money-saving methods for travelers hitting the road this summer. All 50 US states have hit the $4 per gallon mark, and the national average is currently at $4.59. According to AAA spokesperson Andrew Gross, “gas prices are now $1.56 more than a year ago and $1.05 more than they were when the war in Ukraine started in February.” Several tips to help save on the high gas prices include filling up your tank in the middle of the week rather than on Friday, getting your car a tuneup so that it may run smoothly, keeping the windows up, and setting your vehicle to cruise control. More suggestions include downloading a gas tracking app, paying with cash instead of a credit card, signing up for gas station chain loyalty programs, and traveling closer to your home. To learn more on ways to save money on traveling this summer, click the link!

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The Pros and Cons of Running a Business with Family

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This article explains how hiring family members can have their strengths and weaknesses. It is much easier to hire a family member rather than a stranger because each person can usually be reliable and dependent on the other. However, in order to keep a happy family, there are several guidelines that can keep the business running smoothly. Firstly, it is essential to develop clear job descriptions in order for each member to know exactly what their tasks are. Next, keeping the family schedule in order is necessary because families often have crazy schedules, so be sure to make working hours clear and even on paper. The article also recommends agreeing on pay, putting everything in writing so that it is clear, discussing where you're going to work (if working away from home), having an agreed-upon decision-making process, figuring out how to give feedback, and finally keeping family dynamics out of the workplace. To find out more information on how to improve your family business, click the link!

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Tips for Hiring and Retaining Employees

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This article discusses how running a small business can be a difficult task, especially when managing your most important asset, the employees. However, by following tips such as upgrading your onboarding checklist software, rewarding employees for their experience, running effective remote meetings, and inspiring through positivity, this task can be made easier. Every small business needs great employees in order to thrive, and this article outlines different strategies you can try. Be sure to check out this link for the full list and more details!

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8 Ways to Save Startup Money in 2022

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This article discusses how many start-up businesses eventually fail, but by utilizing the eight strategies outlined in this link, you will give your start-up business the best chance possible at succeeding and even flourishing. For example, spending the necessary time developing a marketing strategy is essential to engaging your target audience. Additionally, strategies such as partnerships and employee engagement are also essential in any successful start-up business. Be sure to check out this link for more information and the full list of strategies!

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Communication is Vital for CFOs

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In this article, a survey was conducted by Oracle NetSuite to get insights from numerous executives about the importance of each role and their communications skills. The survey “polled small and midsize company leadership in four categories: CFOs, nonfinance executives (other members of the C-suite), finance managers, and nonfinance managers.” The survey showed that the finance chiefs' proficiency in understanding the business was marked at a 72 on a 0-100 scale. However, CFOs believe their communication skills are better than other executives think. “Their rating on the 0-to-100 scale for communicating with employees and stakeholders was 73; other executives gave finance leaders a rating of 59.” The survey also found that CFOs are more interested in cutting costs to mitigate inflation than those in other roles are. To learn more about the results of the survey, click the link!

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How Can Your Small Business Take Action Against Rising Theft and Shoplifting?

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This article explains how shoplifters are stealing thousands of dollars from big and small retailers, and how the smaller retailers are handling the situation. Derek Friedman, a small business owner, says that since 2019 shoplifting has been a big financial issue with losses totaling over $200,000. Friedman also said he does not turn in all the claims to his insurance for fears of being dropped. Friedman has recently implanted a 1% crime-spike fee to help offset his losses at four of his hardest-hit Denver stores. Another small business owner, Caroline Cho, has been fighting off shoplifters at Sneaker City, which has been in her family for three decades. Her solution, for the time being, was to let customers only try on one shoe at a time. Check out the original article for more suggestions.  

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