The Profit Statement
Winter 2011
What investors need to know about fair value accounting for real estate By Karyn Heckman, CPA, Reznick Group
In 2006, the Financial Accounting Standards Board issued Statement No. 157, Fair Value Measurements (SFAS 157), which provides guidelines for determining the fair value of assets that may be reported at fair value. SFAS 157 is based on the idea that, for investors, fair value is a more meaningful measure of an asset’s worth than historical cost. While all companies can elect fair value accounting for financial assets, such as mutual funds and stocks owned, current
U.S. accounting standards permit fair value reporting for nonfinancial assets only for certain entities: for example, pension funds that invest in real estate such as hotels and office buildings. In these situations, the value of the real estate is adjusted to fair value at each reporting date. SFAS 157 requires additional disclosures by companies concerning fair value and how it was determined. While these disclosures can be confusing, they provide investors with important information. continued on page 2
In This Issue n What
investors need to know about fair value accounting for real estate
n The
pros and cons of converting to a Roth IRA
n Secure
your customers’ credit card data — or pay!
n Don’t
just clean your property. Green-clean it!
1 1 4 5
The pros and cons of converting to a Roth IRA Starting in 2010, the income limit on converting a traditional IRA to a Roth IRA has been lifted. As a result, many more taxpayers can now do a conversion, even if their incomes are too high to make a Roth IRA contribution. Switching to a Roth IRA can provide both income tax and estate planning benefits. But a conversion doesn’t always make financial sense. Here are some things to keep in mind when deciding whether a Roth IRA conversion is right for you. When you’ll owe tax on withdrawals With a traditional IRA, contributions are tax deductible and earnings grow on a
tax-deferred basis, but withdrawals are subject to ordinary income taxes. Roth IRA contributions aren’t deductible, but qualified withdrawals are tax free. When you do a Roth conversion, however, you have to pay income taxes on the amount you convert. Therefore, your decision about converting to a Roth IRA will hinge on whether you’re better off paying the tax now or later. If you convert before the end of 2010, you can defer the income and report half of it on your 2011 return and the other half on your 2012 return. So if you expect your tax rate to be higher in retirement than it is now, converting to a Roth
Kerry Balagtas n 301-280-2730 n kerry.balagtas@reznickgroup.com n www.reznickgroup.com
can be a good move, provided you can afford to pay the tax using funds from outside an IRA. You may also be better off converting and paying the tax now if the value of investments in your IRA is depressed. This will enable you to minimize your current tax liability and avoid taxes on any future appreciation. But if you expect your tax rate to be lower in retirement, you may want to leave your savings in a traditional IRA or employer-sponsored plan. Under those circumstances, your overall tax liability will be lower if you pay the taxes later. continued on page 3
The Profit Statement
2
... accounting for real estate continued from page 1
Understanding SFAS 157 disclosures SFAS 157 establishes three levels of input for determining fair value, based on the degree to which subjective factors were used to establish that value. Companies must now disclose which levels were used to determine the fair value of the assets they report. Level One inputs are quoted prices in active markets for identical assets, such as shares of stock. Level One inputs are the most accurate and nonsubjective. But the use of these inputs in property valuations is rare because no two buildings or parcels are identical. Level Two inputs are quoted prices for similar assets in active or inactive markets: for example, actual recent sales data for properties that are similar to the subject property. Level Two requires more judgment from owners and those determining fair value. In the last few years, real estate sales have declined significantly. As a result, Level Two inputs are often not available. Also, many sales that did occur were driven by financial distress, so they are not good indicators of fair value. Therefore, Level Three inputs are now increasingly being used in the real estate industry to determine fair value. Because these inputs are based to a considerable
extent on subjective, nonobservable factors, they merit closer examination here. Level Three inputs The most common way to determine fair value under Level Three is with a discounted cash flow model. The typical model uses projected cash inflows and cash expenditures from the subject property for the next 11 years. A presumed
Editorial Board n
Atlanta
n
Baltimore
n
Kenneth E. Baggett, CPA 404-847-9447
n
John Woodbury, CPA 847-324-7612
William T. Riley, Jr., CPA 410-783-4900
n
n
B ethesda Managing Editor Kerry Balagtas 301-280-2730
Charlotte
Anthony V. Portal, CPA 704-332-9100
Chicago
Sacramento
Beth Mullen, CPA 916-442-9100
n
Tysons Corner
Ernie Sanders, CPA 703-744-6700
sales price is determined based on 11thyear cash flows and a capitalization (CAP) rate. Net cash flows for the first 10 years and the presumed sales price are then discounted using a market internal rate of return (IRR) to determine the fair value of the real estate. The IRR is the rate of return an investor expects on an investment. Riskier investments, such as those where cash flows are volatile or construction is not complete, will require a higher IRR. When real estate markets are inactive, companies do not have easy access to IRR and CAP rate information. So they rely on third-party brokers to provide a range of rates. CAP rates have risen significantly due to buyers’ skepticism of the market and tighter financing. Factors that determine the CAP rate for properties include location, age, size, features and existing tenants. Property owners are responsible for reviewing the information provided by continued on page 3
3
... accounting for real estate continued from page 2
brokers and determining which rates most closely line up with the characteristics of their real estate. Since there is a significant amount of subjectivity in this area, owners should clearly document: n All of the information received from
brokers,
n The degree to which that information
applies to their property, and
n The reasons for choosing the IRR and
CAP rates used to determine fair value.
... converting to a Roth IRA continued from page 1
How much money you’ll need in retirement With a traditional IRA, you must take required minimum distributions (RMDs) starting at age 70½, but you can leave funds in a Roth IRA as long as you want. So, if you won’t have to tap your IRA funds for living expenses during retirement, converting to a Roth IRA may be a smart move even if you expect your tax rate to go down. Although your estate may be taxable, your beneficiaries will receive your Roth IRA income tax free.
Also, Level Three inputs are subject to volatility. A reliable Level Three valuation depends on accurate projected cash flows and accurate IRR and CAP rates. A 0.5% change in the IRR or CAP rate could change a property’s value significantly. If an owner has not clearly documented these factors, a valuation may be unreliable. What this means for investors Investors should realize that the determination of fair value with Level Three inputs is essentially the owner’s estimate. In other words, investors
Incentive Match Plan for Employees (SIMPLE) IRA to a Roth IRA. (But be careful: Distributions from SIMPLE IRAs that are less than two years old could be subject to penalties.) And if your 401(k), 403(b) or 457 retirement plan permits a conversion, you may be able to roll over funds from the plan to a Roth IRA. If you inherit an IRA (or, in some cases, an employer-sponsored plan) from your spouse, you can roll the funds into your own traditional IRA and then convert it to a Roth. If you inherit an IRA from someone other than your spouse, you’re not eligible for a Roth conversion on those funds. But if you inherit an employer-sponsored plan from someone other than your spouse, you may be able to have those funds distributed directly to an inherited Roth IRA.
Because Roth IRAs aren’t subject to RMDs, you can allow the funds in them to continue growing tax free until they pass to your loved ones as part of your estate. Although your estate may be taxable, your beneficiaries will receive your Roth IRA income tax free. This feature makes a Roth IRA an ideal estate planning tool. By comparison, an inherited traditional IRA will come with a sizable income tax liability.
What you think the future will bring If, like some economists, you think future income tax rates will be higher, a Roth conversion is the way to go. But what if your tax rate drops? As a hedge against tax-rate uncertainty, you may want to convert only a portion of your traditional IRA or employer-sponsored plan into a Roth IRA, so you save some tax no matter which way rates go.
What IRA you’re converting You can also convert a Simplified Employee Pension (SEP) IRA or a Savings
Note that you can cancel a Roth IRA conversion up until your tax return due date, including extensions, for the year
should keep in mind that the valuation is based on subjective factors, as well as factors subject to change. The increased transparency required by SFAS 157 will help investors better understand how the reported fair value of real estate was determined. And that should help them make more informed investment decisions. Karyn Heckman, CPA, is an audit manager in the Baltimore office of Reznick Group. She can be reached at Karyn.heckman@reznickgroup.com. n
you make the conversion. So if the market takes a turn for the worse prior to the due date, you can undo the conversion and avoid having to pay taxes on assets that have disappeared. Whether you consulted an advisor As you can see, converting an IRA or other eligible funds to a Roth IRA is not something to do without carefully considering the tax implications. If you would like assistance with this, please give us a call. We would be glad to help you weigh the pros and cons of a Roth conversion and decide on a course of action that seems best for you. n
4
Secure your customers’ credit card data — or pay! Because of consumer concerns about the security of their credit card information, major credit card companies in 2004 formed the Payment Credit Industry (PCI) Security Standards Council to develop uniform controls for protecting credit card data captured by merchants. The result is the Payment Card Industry Data Security Standard (PCI DSS), which has been updated several times over the past few years. While compliance with the PCI DSS is not governed by federal law, the PCI Security Standards Council requires all merchants that process at least one credit card transaction to meet the standard. So, even small companies and not-for-profit organizations must comply. Also, some states have laws requiring compliance with at least some PCI DSS requirements. Failure to comply with the PCI DSS can result in the loss of card-processing privileges, significant fines (by the PCI Security Standards Council) and liability for civil damages in the event of a breach. Therefore, it’s important to make sure your organization meets PCI DSS requirements. What’s involved The PCI DSS covers many aspects of credit card processing, including security policies, processes, and management, as well as network architecture and software design. The standard’s 12 basic requirements (numbered below) can be grouped into these categories: n Network
security
1. Install and maintain a firewall to protect cardholder data.
2. Don’t use vendor-supplied defaults for passwords or other security measures.
n Cardholder
data
3. Protect stored data.
4. Encrypt transmission of data across open public networks.
n Vulnerability
management
5. Use and regularly update antivirus software.
6. Develop and maintain secure systems and applications.
n Access
control
7. Restrict access to cardholder data on a “need-to-know” basis.
8. Assign a unique ID to each person with computer access.
9. Restrict physical access to cardholder data.
n Monitoring
and testing
10. Monitor all access to network resources and cardholder data. 11. Regularly test security systems and processes. n Security
policy
12. Maintain a policy that addresses information security. Also, you must validate your organization’s compliance with the standard. Validation rules vary according to your annual processing volume and the credit card issuer’s specific requirements. How to check compliance If your company doesn’t have a large number of credit card transactions,
you can determine your current level of compliance by completing the PCI DSS Self-Assessment Questionnaire. You may then want to engage a Qualified Security Assessor (QSA) or other experienced consultant to help you analyze the results and take appropriate steps to achieve compliance. But if your company annually processes more than 6 million credit card transactions, you generally must conduct annual onsite assessments using a QSA. (In some cases, though, you may use internal audit staff.) Large-transaction organizations must also have quarterly network vulnerability scans performed by an Approved Scanning Vendor. Don’t be caught unawares If your organization doesn’t adhere to the PCI DSS requirements, you risk more than penalties. You could incur costly lawsuits and damage to your business’s reputation, as well as to its bottom line. So don’t be caught unawares. Make sure you not only comply with the standard, but also validate your compliance. And let us know if you have any questions about PCI DSS or would like assistance in meeting these important credit card data security requirements. n
5
Don’t just clean your property. Green-clean it! By Vince Elliott, BS, MHS
The professional cleaning industry strives to make the indoor environment clean and hygienic. But harmful effects on health and safety are associated with certain cleaning products and practices. Commercial property owners should therefore consider environmental impacts when buying cleaning supplies and managing cleaning services. The problem A review of information on the impact of cleaning chemicals tells a troublesome story. About 6%–7% of cleaning staff suffer some kind of chemical-related injury — roughly 180,000 workers annually! These injuries can cost employers a lot more than just lost productivity: In one case, a cleaning worker was awarded $6,700,000 for a chemical-related injury. Those who occupy the offices cleaned with various chemicals don’t fare any better. About 20% of the 64 million office workers in the United States suffer a workplace-generated health problem, and half of those affected have immune system aggravation caused by poor indoor air quality. Environmentally, we’ve got some serious work to do. According to the Green Clean Institute, the average U.S. building dumps
1,600 gallons of cleaning chemicals into the environment each year. This contributes to an estimated 400,000,000 to 6,000,000,000 pounds of contaminants annually. As a result, we’ve polluted roughly two-thirds of the country’s streams — not a good thing for the water that we and wildlife drink.
Green cleaning uses chemical dilution and substitution to achieve real environmental benefits for all of us.
The solution Fortunately, because of the leadership of pioneers like Steve Ashkin, President of The Ashkin Group, LLC, the “Green Cleaning” movement has produced cleaning products that are safer and healthier and have less impact on the environment than conventional products. And, thanks to organizations like the International Sanitary Supply Association (ISSA), the Internet, retail outlets and a large JanSan distributor network, obtaining green cleaning products has never been easier.
Green cleaning uses chemical dilution and substitution to achieve real environmental benefits for all of us — while being very effective, too. How do we know? The International Executive Housekeepers Association’s (IEHA’s) Integrated Cleaning and Measurement (ICM) initiative verifies manufacturer claims about environmental safety and cleaning effectiveness in controlled lab testing and live field studies. The work that needs to be done So, are we now totally “green” in the cleaning technology? Not yet, but innovative product and equipment manufacturers continue to bring new cleaning technology to the marketplace. Commercial cleaning is now moving beyond “green cleaning” to “extreme green” and chemical-free cleaning. Scientifically, “chemical free” means no toxins, carcinogens or residues, as well as being compliant with EPA, FDA, TURI, CSA, UL and OSHA requirements. So, what cleaning methods might qualify for the “chemical free” designation? Some that are being developed include: n Electrolyzed water and steam products, n Microfiber and HEPA-filtered
vacuums, and
n Liquid ozone and UV light cleaning
alternatives.
All are chemical free, and science is proving these cleaning strategies to be amazingly effective, safe for users, healthy for occupants and better for the environment. They definitely are the wave of the future. Make your properties “green clean” In addition to environmental benefits, green cleaning can make properties more attractive to environmentally conscious occupants and help prevent potentially costly lawsuits or worker compensation claims. Isn’t it time for you to start greencleaning your properties? For more information on green cleaning, contact velliott@ealtd.com. n
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About Reznick Group Reznick Group is a national leader in accounting, tax and business advisory services. We work in a broad spectrum of industries, including affordable housing, commercial real estate, emerging business and entrepreneurial enterprises, government agencies, nonprofit organizations, professional services, Real Estate Investment Trusts (REITs), renewable energy, and residential home builders. A national leader in providing accounting, tax and business advisory services, Reznick Group serves clients in a broad spectrum of industries. Reznick Group is ranked among the top 20 public accounting firms in the country and maintains offices nationwide. To learn more about Reznick Group’s services, seminars and conferences, or to view our insights on issues that may impact your industry, visit reznickgroup.com.
PLAN TO ATTEND Business professionals look to Reznick Group, a respected leader in the real estate, renewable energy and affordable housing industry, to provide timely information and updates on the latest trends and opportunities in the market, as well as the business implications of key legislative issues. Our conferences and events offer significant networking and business-building opportunities with industry veterans, presentations from thought leaders, and training sessions on industry fundamentals. The following is a schedule of our upcoming events. Conference dates, topics and venues have been posted to help you plan your schedule. All dates are subject to change. Complete event information can be found on our website, www.reznickgroup.com. 2011 New Markets Tax Credit Summit May 4-6, 2011 Miami, FL For more information, visit www.reznickgroup.com.