The 3 Challenges
When you think about real estate tax issues, in general, sales tax concerns do not rise to the top. However, many states and cities have a complex set of sales tax rules that apply to the real estate industry and companies that are not complying could be drastically underpaying or overpaying sales tax.
Keeping up with the ever-increasing pace of changes of the more than 10,000 sales tax jurisdictions is an arduous task for even the most diligent tax professional. Three areas of concern for tax professionals in the real estate industry are:
- The taxability of rent and Common Area Charges (“CAM”)
- The taxability of ancillary services the property offers its tenants
- How the real estate owner is handling its own purchases of renovation, repairs, and improvements.
Sales Tax on Rent & CAM
In most jurisdictions, rent is not subject to sales tax. However, there are exceptions, especially when it comes to the rental of commercial space. Florida imposes sales & use tax on commercial rents at the same sales rate to which other taxable goods and services are subject. Tax is due on the total amount of rent paid unless there is a specific exemption (i.e. non-profit organization, government agency). This includes payments such as mortgage, ad valorem taxes, or insurance which the tenant makes on behalf of the landlord.
New York City does not impose sales tax but does impose commercial rent tax. The rent is charged to any business that occupies or uses a property for commercial activity in Manhattan, south of 96th Street, for any trade, business, profession, or commercial activity. The tax rate is 6% of the base rent, and the rent paid must be at least $250,000 annually. All taxpayers are granted a 35% base rent reduction, which reduces the effective tax rate to 3.9%. The base rent includes real estate taxes, water charges, and insurance charges but does not include amounts spent by the landlord to improve, repair, or maintain the property.
The term CAM generally represents the charges passed through by the landlord to commercial tenants on a triple-net lease. These charges are generally billed based on the square footage of space leased by each tenant. Building costs that are passed through could include common area utilities, waste removal, porter services, maintenance, and repairs. In general, most states consider CAM charges incidental to the lease and not subject to sales tax, or considered additional rent. Three states have issued specific guidance on CAM charges while most have not directly addressed the charges.
Please note, the purchase of these services by the landlord may be subject to sales tax.
Sales Tax on Ancillary Services
Even in jurisdictions where rents are not taxable, landlords provide other ancillary services that can be subject to sales tax. In New York State, the sale of electricity, rental of bicycle spaces, rentable storage space, some on-site gyms, and some amenity fees can be subject to sales tax.
The taxability laws of electricity vary in New York State for sales & use tax purposes; in addition to the rate varying by jurisdiction, the rate also varies based on whether the electricity is being purchased by a residential tenant or a commercial tenant. A landlord’s sale of electricity to its residential tenants are exempt from the state portion of the tax, as well as the tax imposed within the Metropolitan Commuter Transportation District. However, such sales are subject to the local portion of the sales tax imposed within New York City. The sale of electricity to commercial owners is taxable in all jurisdictions.
The taxability of the gym membership will vary on several facts, including whether or not the facility is open to the general public and whether the material purpose of the club is to organize or promote sports or athletic activities. Membership dues for admission to athletic clubs are taxable in New York State at the full sales tax rate.
Many building owners operate or lease space to operators of parking lots. Certain states and many cities charge sales tax parking services. Building owners should be aware that they may be liable to collect and remit sales tax on these charges. In many cases, the state may not apply a sales tax, but the city would. For example, although California does not have a state sales tax on parking, most of the larger cities such as San Francisco and Los Angeles have a tax.
Sales Tax on Capital Improvements vs Repairs vs Installations
The taxability of services performed on real property will vary depending on whether the service is deemed to be a repair, installation, or a capital improvement. The former two are subject to sales tax in most jurisdictions, and capital improvements are exempt from sales tax if they meet that specific jurisdiction’s criteria of capital improvement. In order to qualify as a capital improvement, most taxing jurisdiction have strict criteria that the service must meet.
For example, in New Jersey, capital improvements are installations of tangible personal property that increases the capital value or useful life of the real property and tangible personal property installed must be permanently attached to the real property. The New York State tax law is similar but has one additional condition that the service must meet. The service performed must result in the tangible personal property becoming part of the real property or permanently affixed to the real property, so that removal would cause material damage to the property or article itself. States such as Connecticut and Texas apply a narrow standard and only items that are considered new construction or expansion of a footprint qualifies as a capital improvement.
Here are taxability determinations for some sample services performed in New York State:
Capital Improvement - Exempt
Repair - Taxable
Replacement of a window
Replacement of a broken glass pane
Original installation of switches
Replacement of switches
Replacement or complete installation of vanities
Replacement of showerheads or faucets
Although not in the business of providing goods and services that are typically assumed to be subject to sale tax, real estate companies should be aware of what their exposure areas are. As states are increasing the frequency of audits to boost their revenue, real estate companies should at the very least conduct an internal review of their revenue sources and expenditures to determine the extent of their liabilities.