Employers turn to third-party relocation companies for many reasons, but should tax savings be one of them?
Many employers today use third-party relocation companies to help their employees make job-related moves. While there are many good reasons to take advantage of such specialized expertise, tax benefits usually isn’t one of them.
Even before the new moving expense rules took effect on January 1, 1994, the tax issues surrounding employer-provided home sale reimbursements were a tremendous source of confusion for employers. The tax treatment of such reimbursements – both those made directly by the employer and those made through a third party – have been the subject of several court cases and many IRS rulings over the last 20 years.
The typical homesale arrangement
In a typical employee homesale program, the relocation company purchases the employee’s old residence at a fair market value, which is generally based on an average of two or three independent appraisals. The company pays the carrying costs and selling expenses until it ultimately sells the home. The employer pays a fee to the relocation company that is designed to cover a performance fee as well as the carrying costs and selling expenses. Most agreements also stipulate that the fee will include a reimbursement for any loss the relocation company realizes on the sale.
For tax purposes, the employee reports the sale of his home to the relocation company in the same way as he would treat an independently arranged sale. If he has a gain, it generally will qualify for deferral if he reinvests the proceeds in a new principal residence within the required time limits. The employer is entitled to deduct the entire fee paid to the relocation company as an “ordinary and necessary” business expense. Since no compensation is reportable, there are no gross-ups incurred.
Variations on the theme
Some programs provide that if the employee is able to arrange an independent sale at a higher price than the relocation company has agreed to pay, the company will buy the home at the higher price and resell it to the designated buyer. When this happens, and there are sales commissions that, according to local custom, are the seller’s responsibility, the employee will be charged with income to the extent the sales commissions are paid by the relocation company. Since real estate expenses are no longer deductible as moving expenses, this compensation will be subject to tax gross-up.
Another variation is where the relocation company agrees to repay the employer if the employee’s residence is ultimately resold at a gain. In such cases, the Internal Revenue Service has ruled that the relocation company is acting as the employer’s agent, and the employer is actually the purchaser and reseller of the employee’s home (Letter Ruling 9036003, 5/31/90). The home is treated as a capital asset held for investment by the employer, which means that the amounts paid to the relocation company for carrying costs, selling expenses, taxes, etc., are nondeductible capital expenditures that must be added to the basis of the property. The following example illustrates how this type of situation should be reported:
Example: Relo, Inc., buys Mr. Hobbs’ home for $155,000. Three months later, the home is sold for $175,000. During the three months between the purchase and sale dates, Relo, Inc., made the following payments:
Carrying costs $ 3,600 Repairs 300 Closing costs 800 Selling expenses 10,500 Transfer taxes 1,500 _______ Total $16,700
The gain on the sale of the home is $20,000 ($175,000 less $155,000). The employer paid Relo, Inc., $1,400 broken down as follows:
Service fee $ 4,500 Appraisal service fee 200 Carrying costs/repairs 3,900 Expenses re: sale 12,800 _______ Subtotal $21,400 Less: the credit for gain on sale (20,000) Total $ 1,400
The employer should report the transaction as follows:
Gain on sale Gross sales price $175,000 Less: Closing costs 800 Selling expenses 10,500 Transfer taxes 1,500 (12,800) _______ Net sales price $162,200 Less: Cost $155,000 Carrying costs/repairs 3,900 (158,900) Short-term capital gain $ 3,300 Ordinary and necessary business expense Service fee $ 4,500 Appraisal fee 200 _______ Ordinary deductible expense $ 4,700
Direct purchase and resale by employer
If the employer has a homesale program in which it purchases an employee’s home directly (i.e., without using a third-party relocation company), the tax result to the employee will be the same as if a relocation company had been involved. The employer recognizes a capital gain or loss, computed as shown in the earlier example. The only difference is that no ordinary deductible expense results since no service fees are paid.
The bottom line
The accompanying chart, Tax Treatment to Employer, summarizes the basic tax treatment to an employer of each element of an employee homesale program where (1) homes are purchased and resold by a relocation company, and (2) the employer buys and resells them directly.
The principal tax difference between the direct and third-party methods is that when the employer is the purchaser/reseller, the carrying costs, selling expenses, and ultimate gain or loss are all rolled up together and reportable as a net capital gain or loss, in contrast to being deductible as an ordinary expense. This may cause timing differences between when the cost is paid or incurred, and when it may actually be reported in a tax return; it may also create more administrative and accounting burdens, but generally, no tax impact will result.
TAX TREATMENT TO EMPLOYER HOMESALE PROGRAM
Tax Treatment to Employer
|Transaction Description||Relocation Company
|Employer Purchases Home|
|* Sale proceeds paid to employee||None||Acquisition of prop. held for investment|
|*Sales commissions paid on sale pre-arranged by employee||Compensation subject to tax gross-up||Compensation subject to tax gross-up|
|*Services fees paid to relocation company||Ordinary deduction||Not applicable|
|*Carrying costs paid to relocation company/directly by employer||Ordinary deduction||Added to home basis|
|*Selling expenses paid to relocation company/directly by employer||Ordinary deduction||Added to home basis|
|*Loss on home sale paid to relocation company/realized by employer||Ordinary deduction (see Note: below)||Capital loss|
|*Gain on home sale repaid to employer||All transactions treated as if employer purchases home||Capital gain, net of carrying costs and selling expenses|
Note: If the employer’s agreement with the relocation company provides that the employer will be reimbursed any gain on sale, all transactions will be treated as if the employer had purchased the home directly.