Mark E. Stroff v. Commissioner, TC Memo 2011-80
This was a run of the mill substantiation case, with an unusual feature. The Tax Court went with the Service on disallowing many expenses but they allowed casual labor expenses to some extent with fairly minimal proof.
Self-employed handyman was granted partial Code Sec. 162 deduction of claimed “casual labor” expenses: although lacking any proof of actual amounts paid, taxpayer did submit list of laborers that corresponded with names entered in his weekly planner, which was enough to allow Tax Court to make Cohan estimate of deductible amount.
It wasn't a very large number or they probably would have allowed the expenses and gone after him for back-up withholding and 1099 filing penalties.
Andrew R. Bosque, et ux. v. Commissioner, TC Memo 2011-79
There were a couple of issues in this case. One was the real estate professional issue which is starting to get really tedious. The main problem was substantiation of time spent. If you have another profession, I can't emphasize enough how important that is. The other was an attempt to double dip on the home office deduction. Interestingly they were allowed deduction for amounts paid to para-legals in husbands law practice. This strikes me as another case where I would be worried about 1099 penalties and back-up withholding.
Home office deductions—principal place of business—multiple businesses— double deductions. Attorney/real estate consultant and wife/nurse weren't entitled to home office deduction for husband's consulting business: deduction would amount to doublecounting because taxpayers had already taken home office deduction for same office space on husband's law practice business's Schedule C.
Attorney/real estate consultant and wife/nurse were denied deductions claimed on husband's consulting business's and law practice's Schedules C for rental or lease of business properties: taxpayers didn't offer any proof of those expenses. But, they were entitled to deduction for paralegal fees that were substantiated with check copies containing names of cases worked on, phrase “paralegal fees,“ and corroborative testimony.
Kurt Sollberger v. Commissioner, TC Memo 2011-78
One of my favorite comments on some schemes is "Sometimes you should just pay the taxes." Taxpayer had sold his closely held stock to an ESOP and purchased floating rate notes, which qualified for deferral. Then he met someone who "loaned" him 90% of the value.
Capital gains—deferred gain on sale of employer securities to ESOP; disposition of qualified replacement property; sale vs. loan. Manufacturing co. owner's transfer of floating rate notes to promoter of ostensible ESOP-QRP loan program was sale triggering deferred gain from prior ESOP stock sale: taxpayer's attempt to treat transfer as loan rather than sale was belied by evidence showing no material distinction between this and other sale cases wherein benefits and burdens of ownership clearly passed to promoter, which didn't then hold notes as collateral but rather immediately sold same and passed 90% of proceeds back to taxpayer.
Optech agreed under the MLSA to serve as the lender or as agent for another lender. The MLSA provided that petitioner, as the borrower, remained the beneficial owner of the FRNs posted as collateral during the term of the loan and the FRNs would not be subject to the claims of any of Optech's creditors. The MLSA stated, however, that the lender had the right to register the FRNs in the lender's name, and Optech could “assign, transfer, pledge, repledge, hypothecate, rehypothecate, lend, encumber short sell and/or sale” the FRNs during the term of the loan without notifying petitioner. Moreover, petitioner waived his rights in the MLSA to receive interest and other benefits from the FRNs during the term of the loan, and he could not prepay on the loan.
The question that intrigues me about this is what he did with the $900,000. If it was used for personal purposes then this deal would have been a bad deal even if it had worked since he would still be picking up the supposed interest on the notes, without having a corresponding deduction. Even if the interest was deductible as investment interest it still would not have been a wash because of the effect on AGI. Also even if the plan worked he was giving up something like half of his "savings" (and it was actually just a deferral) depending on what state he lived in.
IN RE: JOHNSON, Cite as 107 AFTR 2d 2011-XXXX
The whole discussion is a bit lawyerly for me, but the result is an important one. Inherited IRA's that were rolled over are exempt assets under federal bankruptcy law.
The Trustee, however, argues that the Inherited IRAs do not constitute “retirement funds” because they do not contain any contributions from the Debtor. 11 U.S.C. § 522(d)(12), however, contains no such requirement. “ Section 522(d)(12) requires that the account be comprised of retirement funds, but it does not specify that they must be the debtor's retirement funds.” Nessa, 426 B.R. at 314. The plain language of a statute is determinative under federal law. Patterson v. Shumate, 504 U.S. 753, 757, 112 S. Ct. 2242, 2246 (1992). By its plain terms, all that the Bankruptcy Code requires is that the funds at issue be retirement funds. Even though the Inherited IRAs do not contain the Debtor's own retirement funds, they were originally deposited by his parents as retirement funds and retained their status as such when properly transferred to the Debtor's account in compliance with the IRC.
Showing posts with label real estate. Show all posts
Showing posts with label real estate. Show all posts
Thursday, July 7, 2011
Wednesday, June 22, 2011
IRS Disses Doggie Diplomas and Other Developments
FISHER v. U.S., Cite as 107 AFTR 2d 2011-XXXX, 04/19/2011
There has already been a partial decision in this case which I mentioned in a previous post. The government got summary judgement on whether a restrictions on transferability discount would apply to a single asset family limited partnership. Apparently that was not the end of the story. After all there are still discounts for lack of marketability (even if they let you sell the damn thing nobody would want to buy it anyway) and minority interest. This particular decision, which is also not the end of the story is about evidence. The taxpayers want to bring into evidence what the IRS was originally willing to allow. The IRS doesn't think that relevant.
The present Motion in Limine seeks to preclude Plaintiff from introducing evidence of the minority interest and lack of marketability discounts used by the IRS in arriving at the February 13, 2006 assessments. See generally dkt. no. 101. The United States contends that because this case involves a de novo review of the fair market value of the property at issue, the calculations of the IRS at the administrative stage are irrelevant. Id. at 4. Plaintiff contends that evidence should be allowed in rebuttal if Mark Mitchell, CPA (“Mitchell”), the United States' expert, testifies that the minority discount should be seven percent rather than the nineteen percent purportedly used by the IRS in the February 13, 2006 assessment. Dkt. No. 105 at 3.
In this case, introduction of evidence of the minority interest discount used by the IRS in the February 13, 2006 assessment is irrelevant. The issue is what the correct minority interest discount is, not what it was previously determined to be. Accord. Janis, 428 U.S. at 440; see also R.E. Dietz Corp. v. United States, 939 F.2d 1, 4 [68 AFTR 2d 91-5238] (2d Cir. 1991) (“The factual and legal analysis employed by the Commissioner is of no consequence to the district court.”). The previously used minority interest discount has no baring on factfinder's de novo determination of the property's fair market value. Because evidence of the previously used minority interest discount is irrelevant, it must be excluded.
This reminds me a little of the Levy case. They were starting with a 30% discount and took it to a jury which allowed them 0%. (It was also a refund case so being stuck with the 30% was actually as bad as it could get.) In that case the taxpayers were trying to keep out the amount the family actually ultimately received.
Private Letter Ruling 201117036
This was an organization formed to provide credit counselling services that was denied exempt status.
Based on the information you provided in your application and supporting documentation, you are not operated for exempt purposes under section 501(c)(3) of the Code. An organization cannot be recognized as exempt under section 501(c)(3) unless it shows that it is both organized and operated exclusively for charitable, educational, or other exempt purpose. You failed to meet the operational test of section 1.501(c)(3)-1(a)(1) and section 1.501(c)(3)-1(c)(1) of the Regulations because you are organized for substantial private and commercial purposes, and operate in the same manner as a private commercial entity.
To qualify under IRC section 501(c)(3), an organization cannot have a non-exempt purpose that is more than insubstantial. Your primary activity is the provision of pre-bankruptcy certification and post-bankruptcy counseling for fees. You devote most of your time and activities to selling bankruptcy certifications to the general public under the guise of financial counseling. You have not shown that you are operated exclusively to educate individuals for the purpose of improving or developing their capabilities. Rather, the fact that no educational materials will be provided unless the client registers for a counseling session is an indication of operation for a primarily business purpose. Your primary focus is to expand your client base and to issue bankruptcy certificates as quickly as possible in order to generate revenue. Analogous to the organization described in Better Business Bureau of Washington D.C., Inc. v. United States supra, your activities appear to have an underlying commercial motive that distinguishes your educational activities from that carried out by a university or educational institution.
If you want to be recognized as a charity maybe you could kind of like do something charitable.
Private Letter Ruling 201117035
Here the IRS shows its narrow speciesism. Among the possible purposes that qualify for exemption is "education". It turns out, though, that it has to be human beings who are being educated. Doggy University (the name I made up for the anonymous ORG in this ruling) does not qualify.
ORG holds dog obedience training classes, and awards the dogs a degree after completion of the course and also award, them prizes at the shows events. While the owners received some instruction as to the training of the dogs, it is the dog that is primary object of the training.
The nature of obedience training requires that the owner of the dog appear at the classes so that the dog is trained to respond to his owner's commands. While the owner receives some instruction in how to give commands to his dog, it is the dog that is the primary object of the training. The dog is also the primary object of the subsequent training in sporting and show events. Therefore, the organization's training program for dogs is not within the meaning of educational as defined in the regulations.
Dog training in the manner you describe is not exempt purposes as described in IRC section 501(c)(3), because the organization's training program for dogs as well as its dog shows is not within the meaning of educational as defined in the regulations . In fact, you primarily serve the private interests of the dog owners and thus not operated exclusively for 501(c)(3) purposes.
Private Letter Ruling 201117011
Taxpayer was granted 120-day extension from date this letter was issued, to make election under Code Sec. 469(c)(7)(A); to treat all of his interests in rental real estate as single rental real estate activity effective stated year.
Rental activities are "per se" passive. There is an exception for people in real estate trades or businesses if they meet certain requirements. They still have to materially participate in the properties. Absent the election to aggregate the material participation standard can be challenging when there are multiple properties. Taxpayers who have failed to make the election can sometimes get relief with a late election as the taxpayer in this ruling did.
There has already been a partial decision in this case which I mentioned in a previous post. The government got summary judgement on whether a restrictions on transferability discount would apply to a single asset family limited partnership. Apparently that was not the end of the story. After all there are still discounts for lack of marketability (even if they let you sell the damn thing nobody would want to buy it anyway) and minority interest. This particular decision, which is also not the end of the story is about evidence. The taxpayers want to bring into evidence what the IRS was originally willing to allow. The IRS doesn't think that relevant.
The present Motion in Limine seeks to preclude Plaintiff from introducing evidence of the minority interest and lack of marketability discounts used by the IRS in arriving at the February 13, 2006 assessments. See generally dkt. no. 101. The United States contends that because this case involves a de novo review of the fair market value of the property at issue, the calculations of the IRS at the administrative stage are irrelevant. Id. at 4. Plaintiff contends that evidence should be allowed in rebuttal if Mark Mitchell, CPA (“Mitchell”), the United States' expert, testifies that the minority discount should be seven percent rather than the nineteen percent purportedly used by the IRS in the February 13, 2006 assessment. Dkt. No. 105 at 3.
In this case, introduction of evidence of the minority interest discount used by the IRS in the February 13, 2006 assessment is irrelevant. The issue is what the correct minority interest discount is, not what it was previously determined to be. Accord. Janis, 428 U.S. at 440; see also R.E. Dietz Corp. v. United States, 939 F.2d 1, 4 [68 AFTR 2d 91-5238] (2d Cir. 1991) (“The factual and legal analysis employed by the Commissioner is of no consequence to the district court.”). The previously used minority interest discount has no baring on factfinder's de novo determination of the property's fair market value. Because evidence of the previously used minority interest discount is irrelevant, it must be excluded.
This reminds me a little of the Levy case. They were starting with a 30% discount and took it to a jury which allowed them 0%. (It was also a refund case so being stuck with the 30% was actually as bad as it could get.) In that case the taxpayers were trying to keep out the amount the family actually ultimately received.
Private Letter Ruling 201117036
This was an organization formed to provide credit counselling services that was denied exempt status.
Based on the information you provided in your application and supporting documentation, you are not operated for exempt purposes under section 501(c)(3) of the Code. An organization cannot be recognized as exempt under section 501(c)(3) unless it shows that it is both organized and operated exclusively for charitable, educational, or other exempt purpose. You failed to meet the operational test of section 1.501(c)(3)-1(a)(1) and section 1.501(c)(3)-1(c)(1) of the Regulations because you are organized for substantial private and commercial purposes, and operate in the same manner as a private commercial entity.
To qualify under IRC section 501(c)(3), an organization cannot have a non-exempt purpose that is more than insubstantial. Your primary activity is the provision of pre-bankruptcy certification and post-bankruptcy counseling for fees. You devote most of your time and activities to selling bankruptcy certifications to the general public under the guise of financial counseling. You have not shown that you are operated exclusively to educate individuals for the purpose of improving or developing their capabilities. Rather, the fact that no educational materials will be provided unless the client registers for a counseling session is an indication of operation for a primarily business purpose. Your primary focus is to expand your client base and to issue bankruptcy certificates as quickly as possible in order to generate revenue. Analogous to the organization described in Better Business Bureau of Washington D.C., Inc. v. United States supra, your activities appear to have an underlying commercial motive that distinguishes your educational activities from that carried out by a university or educational institution.
If you want to be recognized as a charity maybe you could kind of like do something charitable.
Private Letter Ruling 201117035
Here the IRS shows its narrow speciesism. Among the possible purposes that qualify for exemption is "education". It turns out, though, that it has to be human beings who are being educated. Doggy University (the name I made up for the anonymous ORG in this ruling) does not qualify.
ORG holds dog obedience training classes, and awards the dogs a degree after completion of the course and also award, them prizes at the shows events. While the owners received some instruction as to the training of the dogs, it is the dog that is primary object of the training.
The nature of obedience training requires that the owner of the dog appear at the classes so that the dog is trained to respond to his owner's commands. While the owner receives some instruction in how to give commands to his dog, it is the dog that is the primary object of the training. The dog is also the primary object of the subsequent training in sporting and show events. Therefore, the organization's training program for dogs is not within the meaning of educational as defined in the regulations.
Dog training in the manner you describe is not exempt purposes as described in IRC section 501(c)(3), because the organization's training program for dogs as well as its dog shows is not within the meaning of educational as defined in the regulations . In fact, you primarily serve the private interests of the dog owners and thus not operated exclusively for 501(c)(3) purposes.
Private Letter Ruling 201117011
Taxpayer was granted 120-day extension from date this letter was issued, to make election under Code Sec. 469(c)(7)(A); to treat all of his interests in rental real estate as single rental real estate activity effective stated year.
Rental activities are "per se" passive. There is an exception for people in real estate trades or businesses if they meet certain requirements. They still have to materially participate in the properties. Absent the election to aggregate the material participation standard can be challenging when there are multiple properties. Taxpayers who have failed to make the election can sometimes get relief with a late election as the taxpayer in this ruling did.
Friday, March 18, 2011
Miss Is As Good As a MIle
Todd D. Bailey, Jr., et ux. v. Commissioner, TC Summary Opinion 2011-22
Quite a few cases about the passive activity loss rules show up in tax court. Frequently, the taxpayers seem a bit lame. There was the fellow who wanted to count the time that he was "on call" for his tenants. Also, the have to put up with their time estimates being considered "ballpark guesstimates", a robust term who's use in tax law seems to be limited to passive activity cases. The case of Pamela Bailey (she is the ux.) has none of that. Although I see the inexorable logic of the tax court, I think she got rather a raw deal.
The passive activity loss rules (Section 469) was the Tax Reform Act of 1986's knock-out blow to tax shelters as we used to know them. The rules require us to put our trade or business activities into various buckets. Losses within the "passive activity" bucket can only be used to the the extent there is gain in the passive bucket (Note. Some people say "offset", which can lead to error. A capital gain in the passive bucket is still a capital gain). There is a significant amount of complexity to the rules, which I will run roughshod over in discussing this case. A passive activity under these rules (The term is used in other areas, like S Corporations, and has different meanings.) is a trade or business in which the taxpayer does not materially participate. There are a variety of ways to meet that standard, but the one that is relevant here is 500 hours in a year. Then there are rental activities. Rental activities are per se passive. If you own rental property, please don't yell at me. I know it can be a lot of work. This is the tax law. It is what it is. Deal with it.
There is an exception to the per se passive rule for rental activities. People in real estate trades or businesses can treat rental activities like other businesses. There are a number of requirements, but the critical one for this case is 750 hours engaged in real estate activities.
Todd Bailey was an emergency room physician. He is one of the types of people I think about whenever I think I have stress. At any rate Dr. Bailey doesn't really enter into the case other than producing wages of $212,200 that might have been sheltered by real estate losses.
It was Mrs. Bailey who was handling the real estate. She had qualifications:
Petitioner's father was a builder. Her mother worked with her father as a bookkeeper and an interior decorator. This upbringing gave petitioner an “eye” for the housing market, and experience with building codes, architectural plans, and subcontractors. Beginning around 1980 and using mortgage financing and joint funds with petitioner husband, petitioner continuously was in the market to purchase property with potential for either resale or conversion into income- producing property.
She had four properties :
1. The Inn on Alisal Road
One of petitioners' rental properties was on Alisal Road, about 6 or 7 miles from the couple's home. They purchased the property in 2000. The structures consisted of a 1,200-square- foot, two-bedroom, 3/4-bath (no tub) front house, built in 1949 or 1950, and a smaller back unit that had been converted from a one-car garage into a separate residential dwelling.
Petitioner named this combined property “The Inn on Alisal Road” (Inn). As the name indicates, petitioner furnished the two units and offered them together or separately for short-term rent to overnight lodgers, usually for about 3 days at a time.
2. The Second Street Property
....... second of petitioners' rental properties was on Second Street (Second Street property), about two blocks from the Inn. Petitioners purchased the property in 2000 for $292,000. Similar to the Inn, the property included two structures. The front unit was a 1,149-square-foot, three-bedroom home, with 1-3/4 baths. The back unit was a one-car garage that petitioner converted in 2002 into a small residence with a three-quarter bath and a kitchenette.
This one turned out to be a classic property from hell. It could stand as a warning to those who see late night commercials promising that by adopting certain secret methods you can make a small fortune in real estate with no capital and little work :
By late 2000 petitioner's tenants in the front house noticed a mildew problem. The tenants moved out. They turned out to be petitioner's last tenants in the front unit. As petitioner began stripping away layers of linoleum to determine the extent of the mildew problem, she discovered that black mold was present throughout the entire underpinning of the home. By the end of 2001 petitioner was “at wits' end”. She eventually discovered that an earlier inspector had determined that the home has insufficient subvents. In addition, a prior owner built an addition that blocked some of the existing subvents. Further, the El Nino storm of 1997-98 soaked the carpets, flooring, and walls, compounding the problem. The toxic mold infestation was so bad that petitioner was unable to provide a warranty of habitability to any prospective tenant.
The type of real estate endeavors that Mrs. Bailey engaged in are probably one of the best ways that someone with little to start with can become fairly prosperous. It is by no means a sure thing, though. The requirement to be absolutely certain that you will make a small fortune in real estate is the same as in any other endeavor. Start with a large fortune.
3. Boise Property
The third of petitioners' rental properties was on Rose Hill Street, Boise, Idaho (existing Boise property). Petitioner became interested in Boise because she found that she liked the area from visiting a brother living there and a great uncle who lived nearby. The record is sparse about this property, other than that it was a single-family home that petitioner purchased in an earlier year and which one tenant or family rented for all of 2004.
4. New Acquisition in Boise
On August 25, 2004, petitioner paid $185,000 to acquire another one-story single-family home in Boise, on a 3/4-acre lot, also located on Rose Hill Drive (new acquisition in Boise). She financed the purchase with a $166,315 mortgage and joint funds. The house, built in 1941, is a “darling” home with a wood burning fireplace, crown molding, and a brick exterior made with “clinker bricks”. The main floor contains two bedrooms, one bathroom, and a small kitchen. Prior owners had converted the basement into an apartment for a person who took care of the owner. Petitioner did not begin renting the home to tenants in 2004.
Mrs. Bailey kept good track of her time and the IRS found her to be credible - no "ballpark guestimator". Time spent on real estate was as follows :
The Inn on Alisal Road 324
The Second Street property 358
The existing Boise property 24
The new acquisition in Boise 105
Researching potential acquisitions 192
Grand total for all properties 1,003
There was no issue raised about her not electing to aggregate. So she should be fine. Not so fast. The Inn on Alisal Road had rentals for, on average, three day periods. So it was not a "per se" passive rental activity. It was a non real estate trade or business reported on Schedule C. When those hours are kicked out she ends up with a total of 679 hours in real estate activities. Close to 750 hours, but the 750 is a "bright line" test. There are areas besides horseshoes and hand grenades where almost can count, but this is not one of them.
Mrs. Bailey did not get hosed quite as badly as she might have. Note that the 324 hours on the Inn is less than 500, which could make it a trade or business in which she did not materially participate. Fortunately she met an alternative test, probably that she put in more time than anybody else did on the activity. Of course if the Inn had been profitable, that would have hurt her.
All in all, this case covers a good bid of ground that would be of interest to landlords and their advisors.
Quite a few cases about the passive activity loss rules show up in tax court. Frequently, the taxpayers seem a bit lame. There was the fellow who wanted to count the time that he was "on call" for his tenants. Also, the have to put up with their time estimates being considered "ballpark guesstimates", a robust term who's use in tax law seems to be limited to passive activity cases. The case of Pamela Bailey (she is the ux.) has none of that. Although I see the inexorable logic of the tax court, I think she got rather a raw deal.
The passive activity loss rules (Section 469) was the Tax Reform Act of 1986's knock-out blow to tax shelters as we used to know them. The rules require us to put our trade or business activities into various buckets. Losses within the "passive activity" bucket can only be used to the the extent there is gain in the passive bucket (Note. Some people say "offset", which can lead to error. A capital gain in the passive bucket is still a capital gain). There is a significant amount of complexity to the rules, which I will run roughshod over in discussing this case. A passive activity under these rules (The term is used in other areas, like S Corporations, and has different meanings.) is a trade or business in which the taxpayer does not materially participate. There are a variety of ways to meet that standard, but the one that is relevant here is 500 hours in a year. Then there are rental activities. Rental activities are per se passive. If you own rental property, please don't yell at me. I know it can be a lot of work. This is the tax law. It is what it is. Deal with it.
There is an exception to the per se passive rule for rental activities. People in real estate trades or businesses can treat rental activities like other businesses. There are a number of requirements, but the critical one for this case is 750 hours engaged in real estate activities.
Todd Bailey was an emergency room physician. He is one of the types of people I think about whenever I think I have stress. At any rate Dr. Bailey doesn't really enter into the case other than producing wages of $212,200 that might have been sheltered by real estate losses.
It was Mrs. Bailey who was handling the real estate. She had qualifications:
Petitioner's father was a builder. Her mother worked with her father as a bookkeeper and an interior decorator. This upbringing gave petitioner an “eye” for the housing market, and experience with building codes, architectural plans, and subcontractors. Beginning around 1980 and using mortgage financing and joint funds with petitioner husband, petitioner continuously was in the market to purchase property with potential for either resale or conversion into income- producing property.
She had four properties :
1. The Inn on Alisal Road
One of petitioners' rental properties was on Alisal Road, about 6 or 7 miles from the couple's home. They purchased the property in 2000. The structures consisted of a 1,200-square- foot, two-bedroom, 3/4-bath (no tub) front house, built in 1949 or 1950, and a smaller back unit that had been converted from a one-car garage into a separate residential dwelling.
Petitioner named this combined property “The Inn on Alisal Road” (Inn). As the name indicates, petitioner furnished the two units and offered them together or separately for short-term rent to overnight lodgers, usually for about 3 days at a time.
2. The Second Street Property
....... second of petitioners' rental properties was on Second Street (Second Street property), about two blocks from the Inn. Petitioners purchased the property in 2000 for $292,000. Similar to the Inn, the property included two structures. The front unit was a 1,149-square-foot, three-bedroom home, with 1-3/4 baths. The back unit was a one-car garage that petitioner converted in 2002 into a small residence with a three-quarter bath and a kitchenette.
This one turned out to be a classic property from hell. It could stand as a warning to those who see late night commercials promising that by adopting certain secret methods you can make a small fortune in real estate with no capital and little work :
By late 2000 petitioner's tenants in the front house noticed a mildew problem. The tenants moved out. They turned out to be petitioner's last tenants in the front unit. As petitioner began stripping away layers of linoleum to determine the extent of the mildew problem, she discovered that black mold was present throughout the entire underpinning of the home. By the end of 2001 petitioner was “at wits' end”. She eventually discovered that an earlier inspector had determined that the home has insufficient subvents. In addition, a prior owner built an addition that blocked some of the existing subvents. Further, the El Nino storm of 1997-98 soaked the carpets, flooring, and walls, compounding the problem. The toxic mold infestation was so bad that petitioner was unable to provide a warranty of habitability to any prospective tenant.
The type of real estate endeavors that Mrs. Bailey engaged in are probably one of the best ways that someone with little to start with can become fairly prosperous. It is by no means a sure thing, though. The requirement to be absolutely certain that you will make a small fortune in real estate is the same as in any other endeavor. Start with a large fortune.
3. Boise Property
The third of petitioners' rental properties was on Rose Hill Street, Boise, Idaho (existing Boise property). Petitioner became interested in Boise because she found that she liked the area from visiting a brother living there and a great uncle who lived nearby. The record is sparse about this property, other than that it was a single-family home that petitioner purchased in an earlier year and which one tenant or family rented for all of 2004.
4. New Acquisition in Boise
On August 25, 2004, petitioner paid $185,000 to acquire another one-story single-family home in Boise, on a 3/4-acre lot, also located on Rose Hill Drive (new acquisition in Boise). She financed the purchase with a $166,315 mortgage and joint funds. The house, built in 1941, is a “darling” home with a wood burning fireplace, crown molding, and a brick exterior made with “clinker bricks”. The main floor contains two bedrooms, one bathroom, and a small kitchen. Prior owners had converted the basement into an apartment for a person who took care of the owner. Petitioner did not begin renting the home to tenants in 2004.
Mrs. Bailey kept good track of her time and the IRS found her to be credible - no "ballpark guestimator". Time spent on real estate was as follows :
The Inn on Alisal Road 324
The Second Street property 358
The existing Boise property 24
The new acquisition in Boise 105
Researching potential acquisitions 192
Grand total for all properties 1,003
There was no issue raised about her not electing to aggregate. So she should be fine. Not so fast. The Inn on Alisal Road had rentals for, on average, three day periods. So it was not a "per se" passive rental activity. It was a non real estate trade or business reported on Schedule C. When those hours are kicked out she ends up with a total of 679 hours in real estate activities. Close to 750 hours, but the 750 is a "bright line" test. There are areas besides horseshoes and hand grenades where almost can count, but this is not one of them.
Mrs. Bailey did not get hosed quite as badly as she might have. Note that the 324 hours on the Inn is less than 500, which could make it a trade or business in which she did not materially participate. Fortunately she met an alternative test, probably that she put in more time than anybody else did on the activity. Of course if the Inn had been profitable, that would have hurt her.
All in all, this case covers a good bid of ground that would be of interest to landlords and their advisors.
Wednesday, January 26, 2011
Group Home Qualifies for 27.5 Year Life
CCA 201049026
I always thought of group homes as something that would be run on a not for profit basis. According to the blurb for this book I was wrong:
This guide gives concise, step by step instructions for starting a group home. The demand for group homes far exceeds the supply in a lot of areas in the US. Because of the aging baby boomers, demand is likely to continue to grow as government and individuals look for cost effective alternatives to assisted living and retirement homes.
Regardless of that, this CCA caught my eye. These are just excerpts from it, but they get the main point across pretty well.
House used to operate adult home care business that cares full-time for adults who can't live on their own qualifies as IRC Sec(s). 168(e)(2) residential rental property, and consequently owners should determine depreciation for portion of house leased as dwelling units by its customers of adult home care business, but not portion of house that is owner-occupied, using a 27.5-year recovery period or 40-year recovery period if alternative depreciation system of IRC Sec(s). 168(g) applies.
In the facts in this advice, the rental units are bedroom apartments used to provide living accommodations within a building, and are not units in an establishment more than one-half of the units in which are used on a transient basis. Therefore, the rental units are dwelling units for purposes of § 168(e)(2). All units and associated common areas in the building, including the portions occupied by the taxpayers, are dwelling units, and no portion of the building is rented or used for commercial purposes outside of the taxpayers' adult home care business. Consequently, 100 percent of the gross rental income from the building is rental income from dwelling units, even after taking into account the use of the dwelling unit by the taxpayers. In applying the 80-percent test in this case, the $2,000.00 per month allocated to the services that the taxpayers provide for their residents does not constitute gross rental income from the building because the services (24 hour supervision and care for the residents, laundry service, maid service, transportation) are other than those usually or customarily rendered in connection with the mere rental of rooms 1. Thus, in this case, the building is residential rental property. case), it is unimportant whether a particular cost for services is included in rental income or not, as 100 percent of gross rental income from the building is necessarily rental income from dwelling units.
This Chief Counsel Advice does not address whether § 280A limits the taxpayers' deductions for the use of a portion of their residence for business purposes.
In addition, the term “dwelling unit” is defined differently under § 280A(f)(1) than under § 168(e)(2)(A)(ii)(I). The conclusions in this Chief Counsel Advice concerning whether the bedroom apartments used in the taxpayers' business are dwelling units are limited to the analysis under § 168, and no inference should be drawn from this Chief Counsel Advice that these bedroom apartments are dwelling units for purposes of § 280A.
Upkeep of the house and landscaping are services customarily rendered in connection of the rental of rooms, and a portion of the monthly $2000 charge must be allocated to these services and included in both gross rental income from the building and rental income from dwelling units. The exclusion of charges for services other than those usually or customarily rendered in connection with the mere rental of rooms is relevant in the application of the 80 percent test only in the case of a building or structure containing both rental dwelling units and commercial rental space other than dwelling units. In the case of a building or structure comprised solely of dwelling units and associated areas (such as the instant
I always thought of group homes as something that would be run on a not for profit basis. According to the blurb for this book I was wrong:
This guide gives concise, step by step instructions for starting a group home. The demand for group homes far exceeds the supply in a lot of areas in the US. Because of the aging baby boomers, demand is likely to continue to grow as government and individuals look for cost effective alternatives to assisted living and retirement homes.
Regardless of that, this CCA caught my eye. These are just excerpts from it, but they get the main point across pretty well.
House used to operate adult home care business that cares full-time for adults who can't live on their own qualifies as IRC Sec(s). 168(e)(2) residential rental property, and consequently owners should determine depreciation for portion of house leased as dwelling units by its customers of adult home care business, but not portion of house that is owner-occupied, using a 27.5-year recovery period or 40-year recovery period if alternative depreciation system of IRC Sec(s). 168(g) applies.
In the facts in this advice, the rental units are bedroom apartments used to provide living accommodations within a building, and are not units in an establishment more than one-half of the units in which are used on a transient basis. Therefore, the rental units are dwelling units for purposes of § 168(e)(2). All units and associated common areas in the building, including the portions occupied by the taxpayers, are dwelling units, and no portion of the building is rented or used for commercial purposes outside of the taxpayers' adult home care business. Consequently, 100 percent of the gross rental income from the building is rental income from dwelling units, even after taking into account the use of the dwelling unit by the taxpayers. In applying the 80-percent test in this case, the $2,000.00 per month allocated to the services that the taxpayers provide for their residents does not constitute gross rental income from the building because the services (24 hour supervision and care for the residents, laundry service, maid service, transportation) are other than those usually or customarily rendered in connection with the mere rental of rooms 1. Thus, in this case, the building is residential rental property. case), it is unimportant whether a particular cost for services is included in rental income or not, as 100 percent of gross rental income from the building is necessarily rental income from dwelling units.
This Chief Counsel Advice does not address whether § 280A limits the taxpayers' deductions for the use of a portion of their residence for business purposes.
In addition, the term “dwelling unit” is defined differently under § 280A(f)(1) than under § 168(e)(2)(A)(ii)(I). The conclusions in this Chief Counsel Advice concerning whether the bedroom apartments used in the taxpayers' business are dwelling units are limited to the analysis under § 168, and no inference should be drawn from this Chief Counsel Advice that these bedroom apartments are dwelling units for purposes of § 280A.
Upkeep of the house and landscaping are services customarily rendered in connection of the rental of rooms, and a portion of the monthly $2000 charge must be allocated to these services and included in both gross rental income from the building and rental income from dwelling units. The exclusion of charges for services other than those usually or customarily rendered in connection with the mere rental of rooms is relevant in the application of the 80 percent test only in the case of a building or structure containing both rental dwelling units and commercial rental space other than dwelling units. In the case of a building or structure comprised solely of dwelling units and associated areas (such as the instant
Wednesday, December 29, 2010
Ready, Fire, Aim
JAMES A. HILL, JR. v. COM TC Memo 2010-268
There were a number of issues in this case, not all of them interesting. For example, you have to report your share of S corporation income even though you don't receive any distributions. One issue was of some interest though. M. Hill and his wife had formed an LLC to purchase property that they intended to develop. The LLC was treated as an S corporation. (This gets me a little suspicious of the quality of the advice they were getting. One of my themes is that the partnership form is generally superior, particularly in real estate, but I don't have enough facts to second guess them here.) Mr. Hill also filed a schedule C for his real estate brokerage business.
Mr. Hill found a likely property for Parkwood and contracted to buy it. At the closing things got a little complicated::
Petitioner attended the real estate closing on February 7, 2003, in his dual capacity as broker and as the purchaser's representative. At the closing, Robert Garrison (Mr. Garrison), the closing attorney, credited to Real Estate North's account $10,000 in earnest money that Real Estate North had been holding in escrow from Parkwood. Mr. Garrison also tendered a check to petitioner, payable to Real Estate North, for $90,000. Petitioner informed Mr. Garrison that he did not want to accept a commission on the sale, and he asked Mr. Garrison to redraft the closing agreement to eliminate Real Estate North's commission. Mr. Garrison refused to redraft the closing documents. Instead, he asked petitioner to endorse the $90,000 check to Mr. Garrison's escrow account. Mr. Garrison then applied the $90,000 to the purchase price of the Huntington Park property. A February 7, 2003, closing statement signed by petitioner indicates that Real Estate North received a $100,000 commission in the transaction. Petitioner, however, did not report the $100,000 commission on his 2003 Form 1040, U.S. Individual Income Tax Return.
The IRS determined that Mr. Hill should recognize the $100,000 commission as income on his schedule C. Mr. Hill argued that he should be able to treat it as having been used to reduce his cost of the property purchased.
The Court sided with the IRS :
First, the record is clear that petitioner did, in fact, realize the commission. Petitioner testified that he asked Mr. Garrison to redraft the closing documents to eliminate the commission, but Mr. Garrison refused. Whatever discussions occurred at the closing, the fact remains that petitioner was tendered a $90,000 commission check and signed the closing statement affirming that Real Estate North received a $100,000 commission in the transaction. The commission was not subject to any limitations or restrictions. Thus, the commission was income when tendered. .....The fact that petitioner did not deposit the check into his or Real Estate North's bank account is immaterial. Petitioner cannot alter the tax consequences of the transaction by claiming, after the fact, that he did not want to accept the commission. ....
Second, both this Court and the U.S. Court of Appeals for the Eleventh Circuit have rejected the argument that a commission paid to a broker or agent who is purchasing for his own account is a purchase price reduction and is not income to the recipient. ..... Thus, even if petitioner had not received the $100,000 commission but instead transferred his rights to the money to Parkwood, the transfer would constitute an anticipatory assignment of income. ......
Finally, we note that “the Commissioner may bind a taxpayer to the form in which the taxpayer has cast a transaction.” ........Petitioner deliberately structured the purchase of the Huntington Park property so that Real Estate North would receive a $100,000 commission. Petitioner cannot avoid paying tax on the income by attempting, after the fact, to recharacterize the commission.
The moral of the story is to not wait till closing to do the tax structuring of a transaction.
.
There were a number of issues in this case, not all of them interesting. For example, you have to report your share of S corporation income even though you don't receive any distributions. One issue was of some interest though. M. Hill and his wife had formed an LLC to purchase property that they intended to develop. The LLC was treated as an S corporation. (This gets me a little suspicious of the quality of the advice they were getting. One of my themes is that the partnership form is generally superior, particularly in real estate, but I don't have enough facts to second guess them here.) Mr. Hill also filed a schedule C for his real estate brokerage business.
Mr. Hill found a likely property for Parkwood and contracted to buy it. At the closing things got a little complicated::
Petitioner attended the real estate closing on February 7, 2003, in his dual capacity as broker and as the purchaser's representative. At the closing, Robert Garrison (Mr. Garrison), the closing attorney, credited to Real Estate North's account $10,000 in earnest money that Real Estate North had been holding in escrow from Parkwood. Mr. Garrison also tendered a check to petitioner, payable to Real Estate North, for $90,000. Petitioner informed Mr. Garrison that he did not want to accept a commission on the sale, and he asked Mr. Garrison to redraft the closing agreement to eliminate Real Estate North's commission. Mr. Garrison refused to redraft the closing documents. Instead, he asked petitioner to endorse the $90,000 check to Mr. Garrison's escrow account. Mr. Garrison then applied the $90,000 to the purchase price of the Huntington Park property. A February 7, 2003, closing statement signed by petitioner indicates that Real Estate North received a $100,000 commission in the transaction. Petitioner, however, did not report the $100,000 commission on his 2003 Form 1040, U.S. Individual Income Tax Return.
The IRS determined that Mr. Hill should recognize the $100,000 commission as income on his schedule C. Mr. Hill argued that he should be able to treat it as having been used to reduce his cost of the property purchased.
The Court sided with the IRS :
First, the record is clear that petitioner did, in fact, realize the commission. Petitioner testified that he asked Mr. Garrison to redraft the closing documents to eliminate the commission, but Mr. Garrison refused. Whatever discussions occurred at the closing, the fact remains that petitioner was tendered a $90,000 commission check and signed the closing statement affirming that Real Estate North received a $100,000 commission in the transaction. The commission was not subject to any limitations or restrictions. Thus, the commission was income when tendered. .....The fact that petitioner did not deposit the check into his or Real Estate North's bank account is immaterial. Petitioner cannot alter the tax consequences of the transaction by claiming, after the fact, that he did not want to accept the commission. ....
Second, both this Court and the U.S. Court of Appeals for the Eleventh Circuit have rejected the argument that a commission paid to a broker or agent who is purchasing for his own account is a purchase price reduction and is not income to the recipient. ..... Thus, even if petitioner had not received the $100,000 commission but instead transferred his rights to the money to Parkwood, the transfer would constitute an anticipatory assignment of income. ......
Finally, we note that “the Commissioner may bind a taxpayer to the form in which the taxpayer has cast a transaction.” ........Petitioner deliberately structured the purchase of the Huntington Park property so that Real Estate North would receive a $100,000 commission. Petitioner cannot avoid paying tax on the income by attempting, after the fact, to recharacterize the commission.
The moral of the story is to not wait till closing to do the tax structuring of a transaction.
.
Wednesday, December 15, 2010
Flipping Properties
Wendell V. Garrison, et ux. v. Commissioner, TC Memo 2010-261
This case addresses an important issue that I run into from time to time. How do you distinguish between investing in real estate or acquiring for use in a trade or business as opposed to being in the business of buying and selling real estate ? If you are a pure investor your gain on sale will be capital gain, your loss will be capital loss and your expenses will be itemized deductions subject to a variety of limitations depending on which ones we are talking about. If you are holding the property as a rental your gain will be a capital gain (with gain attributable to accumulated depreciation subject to a special rate) and your deductions will go against adjusted gross income. If you have a net loss, it may be suspended by the passive activity loss rules. Loss on the sale of a rental property is ordinary. If you are in the business of buying and selling real estate all income and loss is ordinary and subject to self employment tax.
There is, of course, more to it than that. Investors and rental property holders can do tax deferred like-kind exchanges. Someone in the business of buying and selling can shelter some their income with a Keogh or SEP or something like that. Not that they ever will. Real estate flippers will only stop when they die or own all the real estate in the world (I used to include bankruptcy as another end point, but that is really just a brief interruption). I am also leaving out owning the real estate involved in a business that you operate. Frequently that ends up being a rental situation, although there are some special rules.
Wendell and Sharon Garrison filed returns that fell somewhere between investor and rental operation. They didn't claim any operating expenses, but reported sales of property on Form 4797, which is the form for reporting sale of assets used in a trade or business (which for this purpose includes rental). They claimed capital gain treatment. Since most of the sales were short term I wonder what difference this made. It can make a big difference to someone who has capital loss carryovers, but based on the rest of the facts that didn't seem that likely. More significantly they did not pay self-employment tax on their earnings.
It seems like Mr. Garrison, more or less, shot himself in the foot:
Petitioner husband testified: “I'm in the business of buying material, fixing houses and reselling them.”
Still the court got into the factors to consider.
Typically, the factors in making this determination include:
(1) The taxpayer's purpose in acquiring the property;
(2) the purpose for which the property was subsequently held;
(3) the taxpayer's everyday business and the relationship of the income from the property to the total income;
(4) the frequency, continuity, and substantiality of sales of property;
(5) the extent of developing and improving the property to increase the sales revenue;
(6) the extent to which the taxpayer used advertising, promotion, or other activities to increase sales;
(7) the use of a business office for the sale of property;
(8) the character and degree of supervision or control the taxpayer exercised over any representative selling the property;
(9) the time and effort the taxpayer habitually devoted to the sales.
Petitioners engaged in at least 15 sales over 3 years, and most of the sales occurred within 4 months after they purchased the property.
That pretty much summed it up. The case also got into substantiation of expenses. They had nothing so the additional expenses they claimed were not allowed. The Cohan Rule was not even mentioned.
My own rough guideline in this area is that when you do your third renovation sale your in the business of buying and selling property, particularly if the first two did not have any rental activity. If you are doing this to scale it is worth consulting the Phelan decision (Timothy J. Phelan, et ux. v. Commissioner, TC Memo 2004-206). By isolating different activities in different entities it is possible to get capital gains treatment on some of the economic return from a development even though related entities might be doing ordinary income type activities. In order for this type of thing to work though it is critical that the entities be treated with respect. As with family limited partnerships, the devil is in the details.
This case addresses an important issue that I run into from time to time. How do you distinguish between investing in real estate or acquiring for use in a trade or business as opposed to being in the business of buying and selling real estate ? If you are a pure investor your gain on sale will be capital gain, your loss will be capital loss and your expenses will be itemized deductions subject to a variety of limitations depending on which ones we are talking about. If you are holding the property as a rental your gain will be a capital gain (with gain attributable to accumulated depreciation subject to a special rate) and your deductions will go against adjusted gross income. If you have a net loss, it may be suspended by the passive activity loss rules. Loss on the sale of a rental property is ordinary. If you are in the business of buying and selling real estate all income and loss is ordinary and subject to self employment tax.
There is, of course, more to it than that. Investors and rental property holders can do tax deferred like-kind exchanges. Someone in the business of buying and selling can shelter some their income with a Keogh or SEP or something like that. Not that they ever will. Real estate flippers will only stop when they die or own all the real estate in the world (I used to include bankruptcy as another end point, but that is really just a brief interruption). I am also leaving out owning the real estate involved in a business that you operate. Frequently that ends up being a rental situation, although there are some special rules.
Wendell and Sharon Garrison filed returns that fell somewhere between investor and rental operation. They didn't claim any operating expenses, but reported sales of property on Form 4797, which is the form for reporting sale of assets used in a trade or business (which for this purpose includes rental). They claimed capital gain treatment. Since most of the sales were short term I wonder what difference this made. It can make a big difference to someone who has capital loss carryovers, but based on the rest of the facts that didn't seem that likely. More significantly they did not pay self-employment tax on their earnings.
It seems like Mr. Garrison, more or less, shot himself in the foot:
Petitioner husband testified: “I'm in the business of buying material, fixing houses and reselling them.”
Still the court got into the factors to consider.
Typically, the factors in making this determination include:
(1) The taxpayer's purpose in acquiring the property;
(2) the purpose for which the property was subsequently held;
(3) the taxpayer's everyday business and the relationship of the income from the property to the total income;
(4) the frequency, continuity, and substantiality of sales of property;
(5) the extent of developing and improving the property to increase the sales revenue;
(6) the extent to which the taxpayer used advertising, promotion, or other activities to increase sales;
(7) the use of a business office for the sale of property;
(8) the character and degree of supervision or control the taxpayer exercised over any representative selling the property;
(9) the time and effort the taxpayer habitually devoted to the sales.
Petitioners engaged in at least 15 sales over 3 years, and most of the sales occurred within 4 months after they purchased the property.
That pretty much summed it up. The case also got into substantiation of expenses. They had nothing so the additional expenses they claimed were not allowed. The Cohan Rule was not even mentioned.
My own rough guideline in this area is that when you do your third renovation sale your in the business of buying and selling property, particularly if the first two did not have any rental activity. If you are doing this to scale it is worth consulting the Phelan decision (Timothy J. Phelan, et ux. v. Commissioner, TC Memo 2004-206). By isolating different activities in different entities it is possible to get capital gains treatment on some of the economic return from a development even though related entities might be doing ordinary income type activities. In order for this type of thing to work though it is critical that the entities be treated with respect. As with family limited partnerships, the devil is in the details.
Saturday, December 4, 2010
More on Lien Releases
IRSIG SBSE-05-1010-054
My Monday post on PMTA 2010-058 seems to have been my first scoop. It concerns the IRS position on aspects of releasing liens to facilitate short sales. The idea is that a lien on a property with a first mortgage far in excess of value is worthless and should be released. The IRS was taking the position, though, that they were superior to carve-outs for transfer taxes. This creates a Catch-22 that would prevent the short sale unless the taxpayer/owner could come up with the transfer taxes. The statement (PMTA stands for Program Manager Technical Assistance) retreats from that position and recognizes that the transfer taxes are really coming out of the first lienholder. It also mentioned homeowners associations dues as something that the first lienholder might decide to allow to be cleared.
All week long nobody else seems to have picked up on this. I found an attorney in Florida who has a blog dedicated to short sales, who wrote me that he had been in "shouting matches" on this very issue. He wrote a post on it, crediting me with the discovery. I also found that there is a lot of misinformation out there on this issue with many in the blogosphere believing that the IRS has a super priority that can never be released. Really astounding when you consider how reliable random websites and blogs are on most other issues. (My son tells me that irony doesn't come across well in text. What do you think ?)
I also found that subsequent to the PMTA there is another IRS document which I am reproducing in full since it is pretty crisp:
IRSIG SBSE-05-1010-054
Certificates of Discharge in Short Sale Situations
October 4, 2010
Control Number: SBSE-05-1010-054
Expiration Date: October 5, 2011
Impacted : IRM 5.12.3
MEMORANDUM FOR DIRECTORS, COLLECTION AREA OPERATIONS DIRECTOR, ADVISORY, INSOLVENCY, AND QUALITY
FROM:
Frederick W. Schindler /s/ Frederick W. Schindler Director,
Collection Policy
SUBJECT:
Certificates of Discharge in Short Sale Situations
The purpose of this memorandum is to issue interim guidance for processing and approving requests for certificates of discharge in short sale situations. The impacted section of IRM 5.12.3 , Certificates Relating to Liens, will be revised to include the information in this memorandum. Please ensure that this information is distributed to all affected employees in your organization.
The authority of the Internal Revenue Service (IRS) to issue a certificate of discharge of property subject to the federal tax lien is found in Internal Revenue Code (IRC) section 6325(b). Among other conditions, the IRS may issue a certificate of discharge when the interest of the United States in the such property is determined to have no value ( section 6325(b)(2)(B)).
A short sale occurs when the senior lien holder agrees to accept less than the total amount owed as satisfaction for its lien claim. For example, a bank has a priority mortgage claim for $600,000, but, due to the significant decline in the real property market, the bank agrees to a sale of the mortgaged property for $300,000. Because the senior lien attaches to all the equity in the property, generally the lien interest of the United States in short sale properties is valueless. Therefore, applications for discharge for properties subject to short sales should be considered under IRC 6325(b)(2)(B).
To facilitate the sale of the property in these situations, the senior lien holder might negotiate the payment of expenses to be taken from its settlement amount. In certain situations, these expenses might be greater than normal closing costs allowed by the IRS and might include creditors that would otherwise be junior to Certificates of Discharge in Short Sales the IRS. This action by the senior lien holder to carve proceeds out of its priority claim to pay these expenses does not create an equity interest on the part of the taxpayer which may be reached by the IRS lien. Provided there is no fraudulent aspect to the payment distribution and the lien interests of the IRS in other properties of the taxpayer is not being harmed, the IRS has no authority to require payment of the sum that otherwise would have gone to the senior lien holder.
Following the previous example, the bank determines that out of the $300,000 sales price, it will allow $15,000 of expenses to be paid. Most of the $15,000 is for normal closing costs, but $5,000 of it is for a homeowner's association fee, which is junior in priority to the IRS, and $2,000 is for state transfer taxes. Because the payments made for the homeowner's association fee and the state transfer taxes are made from proceeds attributable to the bank's priority lien interest and the interest of the IRS in the property to be discharged is valueless, the IRS cannot condition discharge upon payment of any part of the amount going to these expenses.
Therefore, upon receiving an application for discharge of a property subject to a short sale, follow standard procedures outlined in IRM 5.12.3 to investigate the statements made in the application regarding the transfer, encumbrances on the property, property values, and proposed distribution of the proceeds. Additional documentation to complete the investigation may be requested if the information has not otherwise been provided. Presuming no issues are identified, the discharge application can be approved following existing IRM procedures.
In normal (non-short) sale situations, where the lien claim of the bank is fully paid and the federal tax lien attaches to surplus proceeds, the IRS's lien interest must be satisfied in accordance with IRC 6325(b) before the property can be discharged from the lien. Creditors junior to the IRS interest are not entitled to payment from the proceeds before the IRS lien interest is fully paid.
If you have any questions, please contact me, or a member of your staff may contact Kyle Romick, Senior Program Analyst.
I have to admit that I don't know what IRSIG stands for. SBSE is small business self employment. This would be more embarrassing except for the fact that IRS employees testifying in Tax Court on internal documents that have been put in evidence sometimes can't explain what their codes mean.
My Monday post on PMTA 2010-058 seems to have been my first scoop. It concerns the IRS position on aspects of releasing liens to facilitate short sales. The idea is that a lien on a property with a first mortgage far in excess of value is worthless and should be released. The IRS was taking the position, though, that they were superior to carve-outs for transfer taxes. This creates a Catch-22 that would prevent the short sale unless the taxpayer/owner could come up with the transfer taxes. The statement (PMTA stands for Program Manager Technical Assistance) retreats from that position and recognizes that the transfer taxes are really coming out of the first lienholder. It also mentioned homeowners associations dues as something that the first lienholder might decide to allow to be cleared.
All week long nobody else seems to have picked up on this. I found an attorney in Florida who has a blog dedicated to short sales, who wrote me that he had been in "shouting matches" on this very issue. He wrote a post on it, crediting me with the discovery. I also found that there is a lot of misinformation out there on this issue with many in the blogosphere believing that the IRS has a super priority that can never be released. Really astounding when you consider how reliable random websites and blogs are on most other issues. (My son tells me that irony doesn't come across well in text. What do you think ?)
I also found that subsequent to the PMTA there is another IRS document which I am reproducing in full since it is pretty crisp:
IRSIG SBSE-05-1010-054
Certificates of Discharge in Short Sale Situations
October 4, 2010
Control Number: SBSE-05-1010-054
Expiration Date: October 5, 2011
Impacted : IRM 5.12.3
MEMORANDUM FOR DIRECTORS, COLLECTION AREA OPERATIONS DIRECTOR, ADVISORY, INSOLVENCY, AND QUALITY
FROM:
Frederick W. Schindler /s/ Frederick W. Schindler Director,
Collection Policy
SUBJECT:
Certificates of Discharge in Short Sale Situations
The purpose of this memorandum is to issue interim guidance for processing and approving requests for certificates of discharge in short sale situations. The impacted section of IRM 5.12.3 , Certificates Relating to Liens, will be revised to include the information in this memorandum. Please ensure that this information is distributed to all affected employees in your organization.
The authority of the Internal Revenue Service (IRS) to issue a certificate of discharge of property subject to the federal tax lien is found in Internal Revenue Code (IRC) section 6325(b). Among other conditions, the IRS may issue a certificate of discharge when the interest of the United States in the such property is determined to have no value ( section 6325(b)(2)(B)).
A short sale occurs when the senior lien holder agrees to accept less than the total amount owed as satisfaction for its lien claim. For example, a bank has a priority mortgage claim for $600,000, but, due to the significant decline in the real property market, the bank agrees to a sale of the mortgaged property for $300,000. Because the senior lien attaches to all the equity in the property, generally the lien interest of the United States in short sale properties is valueless. Therefore, applications for discharge for properties subject to short sales should be considered under IRC 6325(b)(2)(B).
To facilitate the sale of the property in these situations, the senior lien holder might negotiate the payment of expenses to be taken from its settlement amount. In certain situations, these expenses might be greater than normal closing costs allowed by the IRS and might include creditors that would otherwise be junior to Certificates of Discharge in Short Sales the IRS. This action by the senior lien holder to carve proceeds out of its priority claim to pay these expenses does not create an equity interest on the part of the taxpayer which may be reached by the IRS lien. Provided there is no fraudulent aspect to the payment distribution and the lien interests of the IRS in other properties of the taxpayer is not being harmed, the IRS has no authority to require payment of the sum that otherwise would have gone to the senior lien holder.
Following the previous example, the bank determines that out of the $300,000 sales price, it will allow $15,000 of expenses to be paid. Most of the $15,000 is for normal closing costs, but $5,000 of it is for a homeowner's association fee, which is junior in priority to the IRS, and $2,000 is for state transfer taxes. Because the payments made for the homeowner's association fee and the state transfer taxes are made from proceeds attributable to the bank's priority lien interest and the interest of the IRS in the property to be discharged is valueless, the IRS cannot condition discharge upon payment of any part of the amount going to these expenses.
Therefore, upon receiving an application for discharge of a property subject to a short sale, follow standard procedures outlined in IRM 5.12.3 to investigate the statements made in the application regarding the transfer, encumbrances on the property, property values, and proposed distribution of the proceeds. Additional documentation to complete the investigation may be requested if the information has not otherwise been provided. Presuming no issues are identified, the discharge application can be approved following existing IRM procedures.
In normal (non-short) sale situations, where the lien claim of the bank is fully paid and the federal tax lien attaches to surplus proceeds, the IRS's lien interest must be satisfied in accordance with IRC 6325(b) before the property can be discharged from the lien. Creditors junior to the IRS interest are not entitled to payment from the proceeds before the IRS lien interest is fully paid.
If you have any questions, please contact me, or a member of your staff may contact Kyle Romick, Senior Program Analyst.
I have to admit that I don't know what IRSIG stands for. SBSE is small business self employment. This would be more embarrassing except for the fact that IRS employees testifying in Tax Court on internal documents that have been put in evidence sometimes can't explain what their codes mean.
Monday, November 29, 2010
IRS To Stop Lousing Up Short Sales
PMTA 2010-058
For the latest on this see my follow-up post
When I was a kid, my father worked on Wall Street. He was a Senior Order Clerk. I'm not sure whether his job still exists. It was not particularly lucrative, but I got these insights into high finance through the jokes that he used to tell me. Most of them I didn't "get" until I was in my thirties. One of my favorites is the little ditty "He who sells what isn't hissen, buys it back or goes to prison." That was about short sales as the term relates to securities.
The term means something else in real estate. If a property has a fair market value lesser than the mortgage, the secured party might let the property be sold for an amount lesser than the mortgage. This avoids the need for foreclosure. The owner may or may not remain liable for the balance, the discharge of which may or may not be a taxable event. Such is not the topic of this post.
When I was buying a condo, I found that buying property on a short sale tended to be fraught with delay. You would think that the pressure to sell would create pressure to move things along, but the pressure is not sufficient to overcome bureaucratic inertia. Not surprisingly people who have trouble paying their mortgages frequently have trouble paying their taxes. So it is not unusual for a property with an upside down mortgage to have IRS liens against it. In order for the property to transfer the IRS must release its lien.
Typically the first mortgage will have been in place before the IRS filed its liens. So the value of the lien is the lesser of the tax obligation or the taxpayers equity in the property. In the case of a short sale the latter amount is 0. So the IRS should release its worthless lien and let life go on. That is not what has happened though. Even though the IRS is behind the first mortgage, they are, or at least, believe they are ahead of everybody else :
Applications for Discharge Which Include Requests for Payment of Real Estate Transfer Tax....In cases where a filed notice of federal tax lien has perfected the interest of the United States in such property, the Service is asked to issue a certificate of discharge of federal tax lien to allow payment of the state's claim at closing. It is the Service's position that such taxes have no priority status under I.R.C. §6323(b)(6) against the filed notice of federal tax lien. ... Priority of the federal tax lien is defined exclusively in I.R.C. §6323. Under no circumstances will a discharge of federal tax lien be issued for less than the full value of the Service's claim on the equity in the subject property. The transfer tax will not be accorded priority status or treated as an expense of sale. Applications that include such provisions will be rejected.
Under this interpretation, the taxpayer/property owner has to come up with the transfer taxes in order to move the transaction on.
PMTA 2010-058 finds the above interpretation to be erroneous:
We disagree with the conclusion that the designation by the senior lienholder of some of its proceeds to be used to pay real estate transfer taxes in connection with short sales of real property somehow creates an equity interest in the property on the part of the taxpayer. Rather, these are expenses that the senior lienholder agrees to carve out of its priority lien claim as a matter of business prudence in order to facilitate the sale. Because this does not create an equity interest on behalf of the taxpayer that is subject to the federal tax lien, the authority of the Service to issue a certificate of discharge is under section 6325(b)(2)(B), where the interest in the United States is valueless. The Service has no authority under section 6325(b)(2)(B) to require payment of the sum that otherwise would be applied to junior real estate transfer taxes as a condition of discharge. Because the interest of the United States is valueless, the result would be the same even if the senior lienholder was choosing to use a portion of its mortgage proceeds to pay a junior creditor of the taxpayer (such as payment of homeowner's association fees).
Essentially they are saying that the carve-out for transfer taxes is coming out of the banks secured interest and does not create some sort of equity that makes the IRS lien worth something. This document a letter to the director of collection policy (PMTA stands for Program Manager Technical Assistance) was dated September 17, 2010, but only recently came up on RIA. I haven't seen anything else on this so I am making this a bonus post in the interest of timeliness. If you are involved in a short sale that is hanging because of the IRS, it might be a useful reference.
The letter was sent to the Director of Collection Policy for Small Business/ Self Employed. It was copied to Special Counsel of the National Taxpayer Advocate Program, Assistant Division Counsel (SBSE) and Associate Area Counsels for Ft. Lauderdale and Jacksonville. So this may be a problem that is peculiar to Florida although the principle is of general interest.
P.S.
In the comments below you will see feedback from Richard Zaretsky, an attorney specializing in short sales and related matters. He indicated to me that he has had shouting matches with the IRS on this issue. He has a blog dedicated to short sales. I've seen some misinformation on websites that would lead you to believe that an IRS lien will kill the possibility of a short sale. The relevant section of the Code is 6325(b)(2)(B) which indicates a lien with no value can be released and that in determining the lien's value other liens with priority will be taken into account.
For the latest on this see my follow-up post
When I was a kid, my father worked on Wall Street. He was a Senior Order Clerk. I'm not sure whether his job still exists. It was not particularly lucrative, but I got these insights into high finance through the jokes that he used to tell me. Most of them I didn't "get" until I was in my thirties. One of my favorites is the little ditty "He who sells what isn't hissen, buys it back or goes to prison." That was about short sales as the term relates to securities.
The term means something else in real estate. If a property has a fair market value lesser than the mortgage, the secured party might let the property be sold for an amount lesser than the mortgage. This avoids the need for foreclosure. The owner may or may not remain liable for the balance, the discharge of which may or may not be a taxable event. Such is not the topic of this post.
When I was buying a condo, I found that buying property on a short sale tended to be fraught with delay. You would think that the pressure to sell would create pressure to move things along, but the pressure is not sufficient to overcome bureaucratic inertia. Not surprisingly people who have trouble paying their mortgages frequently have trouble paying their taxes. So it is not unusual for a property with an upside down mortgage to have IRS liens against it. In order for the property to transfer the IRS must release its lien.
Typically the first mortgage will have been in place before the IRS filed its liens. So the value of the lien is the lesser of the tax obligation or the taxpayers equity in the property. In the case of a short sale the latter amount is 0. So the IRS should release its worthless lien and let life go on. That is not what has happened though. Even though the IRS is behind the first mortgage, they are, or at least, believe they are ahead of everybody else :
Applications for Discharge Which Include Requests for Payment of Real Estate Transfer Tax....In cases where a filed notice of federal tax lien has perfected the interest of the United States in such property, the Service is asked to issue a certificate of discharge of federal tax lien to allow payment of the state's claim at closing. It is the Service's position that such taxes have no priority status under I.R.C. §6323(b)(6) against the filed notice of federal tax lien. ... Priority of the federal tax lien is defined exclusively in I.R.C. §6323. Under no circumstances will a discharge of federal tax lien be issued for less than the full value of the Service's claim on the equity in the subject property. The transfer tax will not be accorded priority status or treated as an expense of sale. Applications that include such provisions will be rejected.
Under this interpretation, the taxpayer/property owner has to come up with the transfer taxes in order to move the transaction on.
PMTA 2010-058 finds the above interpretation to be erroneous:
We disagree with the conclusion that the designation by the senior lienholder of some of its proceeds to be used to pay real estate transfer taxes in connection with short sales of real property somehow creates an equity interest in the property on the part of the taxpayer. Rather, these are expenses that the senior lienholder agrees to carve out of its priority lien claim as a matter of business prudence in order to facilitate the sale. Because this does not create an equity interest on behalf of the taxpayer that is subject to the federal tax lien, the authority of the Service to issue a certificate of discharge is under section 6325(b)(2)(B), where the interest in the United States is valueless. The Service has no authority under section 6325(b)(2)(B) to require payment of the sum that otherwise would be applied to junior real estate transfer taxes as a condition of discharge. Because the interest of the United States is valueless, the result would be the same even if the senior lienholder was choosing to use a portion of its mortgage proceeds to pay a junior creditor of the taxpayer (such as payment of homeowner's association fees).
Essentially they are saying that the carve-out for transfer taxes is coming out of the banks secured interest and does not create some sort of equity that makes the IRS lien worth something. This document a letter to the director of collection policy (PMTA stands for Program Manager Technical Assistance) was dated September 17, 2010, but only recently came up on RIA. I haven't seen anything else on this so I am making this a bonus post in the interest of timeliness. If you are involved in a short sale that is hanging because of the IRS, it might be a useful reference.
The letter was sent to the Director of Collection Policy for Small Business/ Self Employed. It was copied to Special Counsel of the National Taxpayer Advocate Program, Assistant Division Counsel (SBSE) and Associate Area Counsels for Ft. Lauderdale and Jacksonville. So this may be a problem that is peculiar to Florida although the principle is of general interest.
P.S.
In the comments below you will see feedback from Richard Zaretsky, an attorney specializing in short sales and related matters. He indicated to me that he has had shouting matches with the IRS on this issue. He has a blog dedicated to short sales. I've seen some misinformation on websites that would lead you to believe that an IRS lien will kill the possibility of a short sale. The relevant section of the Code is 6325(b)(2)(B) which indicates a lien with no value can be released and that in determining the lien's value other liens with priority will be taken into account.
Friday, October 29, 2010
What's It Worth To Say Your Wine is From Long Island ?
CCA 201040004
One of the greatest sources of tax controversy is whether something is depreciable (in the case of intangible assets we say amortizable.) Land is one of the primary examples of non-depreciable property. So if someone comes up with a way to write off even some of the cost of land it is worth paying attention to. Land is by it's nature non-fungible, but frankly some land is more non-fungible than other land. At the most extreme end of this non-fungibility is land that you grow grapes on to make wine.
It so happens that my favorite beverage is Mountain Dew. The various chemicals that go into making it can come from just about anywhere and they probably do. It doesn't work that way with wine. There is something called the Napa Declaration on Place. It is a bunch of "Whereas's" like :
Whereas, it is generally acknowledged that there are a handful of truly extraordinary places on earth from which great wine is consistently produced.
finishing up with :
Therefore, be it resolved that we, as some of the world’s leading wine regions, join together in supporting efforts to maintain and protect the integrity of these place names, which are fundamental tools for consumer identification of great winegrowing regions and the wines they produce.
I was kind of vaguely aware of this, but I always thought it had to do with that weird country where they eat snails and think Jerry Lewis was a good actor. It turns out that the same thing goes on in the United States.. A geographic region can be designated an American viticultural area (AVA), by the Alcohol and Tobacco Tax and Trade Bureau (“TTB”) of the United States Department of the Treasury. Once that happens you can't put that place name on the wine bottle label unless 85% of the grapes come from that region.
The Chief Counsel has determined that the designation is a "license, permit, or other right granted by governmental unit and isn't interest in land". This makes it an intangible asset covered by Section 197, which means it can be amortized over 15 years. This is a taxpayer friendly ruling, so I am inclined to like it, but it is really a little challenging to wrap my head around. You buy some land in Napa Valley or Mendocino or, I kid you not, Long Island (Check the list)on which grapes grow and you get to allocate some of the cost to the right to stamp Long Island on the label and write that portion off over 15 years.
The Chief Counsel noted a problem with the ruling:
We have concerns about how a taxpayer would value the right to use an AVA designation. It is unclear whether the value of the right to use an AVA designation attaches to an acquisition of a particular vineyard within an AVA. The benefit in value from the right to use an AVA designation accrues to all land whose highest and best use is as a vineyard within such designated viticultural area. Consequently, all of the closest comparable vineyards share the same intangible benefit thereby making an appraiser's determination of the increment of value assigned to the intangible benefit and finding comparable vineyards outside of the particular AVA factually difficult.
My study of labels is limited to making sure that I don't make the mistake of buying Diet Mountain Dew, a wretched tasting concoction often hazardously located adjacent to the good stuff. I would hazard a guess though that stamping Southeastern New England on your wine bottles is not going to make them fly off the shelves and that there are probably very few AVA designations that have any value.
Nonetheless the concept is very interesting. There have been discussions about whether the names of landmark buildings might be separate intangible assets. Do the owners of the Empire State Building get royalties on all the little chachkies that are shaped like their building ? That would seem to have the makings of a 197 intangible.
One of the greatest sources of tax controversy is whether something is depreciable (in the case of intangible assets we say amortizable.) Land is one of the primary examples of non-depreciable property. So if someone comes up with a way to write off even some of the cost of land it is worth paying attention to. Land is by it's nature non-fungible, but frankly some land is more non-fungible than other land. At the most extreme end of this non-fungibility is land that you grow grapes on to make wine.
It so happens that my favorite beverage is Mountain Dew. The various chemicals that go into making it can come from just about anywhere and they probably do. It doesn't work that way with wine. There is something called the Napa Declaration on Place. It is a bunch of "Whereas's" like :
Whereas, it is generally acknowledged that there are a handful of truly extraordinary places on earth from which great wine is consistently produced.
finishing up with :
Therefore, be it resolved that we, as some of the world’s leading wine regions, join together in supporting efforts to maintain and protect the integrity of these place names, which are fundamental tools for consumer identification of great winegrowing regions and the wines they produce.
I was kind of vaguely aware of this, but I always thought it had to do with that weird country where they eat snails and think Jerry Lewis was a good actor. It turns out that the same thing goes on in the United States.. A geographic region can be designated an American viticultural area (AVA), by the Alcohol and Tobacco Tax and Trade Bureau (“TTB”) of the United States Department of the Treasury. Once that happens you can't put that place name on the wine bottle label unless 85% of the grapes come from that region.
The Chief Counsel has determined that the designation is a "license, permit, or other right granted by governmental unit and isn't interest in land". This makes it an intangible asset covered by Section 197, which means it can be amortized over 15 years. This is a taxpayer friendly ruling, so I am inclined to like it, but it is really a little challenging to wrap my head around. You buy some land in Napa Valley or Mendocino or, I kid you not, Long Island (Check the list)on which grapes grow and you get to allocate some of the cost to the right to stamp Long Island on the label and write that portion off over 15 years.
The Chief Counsel noted a problem with the ruling:
We have concerns about how a taxpayer would value the right to use an AVA designation. It is unclear whether the value of the right to use an AVA designation attaches to an acquisition of a particular vineyard within an AVA. The benefit in value from the right to use an AVA designation accrues to all land whose highest and best use is as a vineyard within such designated viticultural area. Consequently, all of the closest comparable vineyards share the same intangible benefit thereby making an appraiser's determination of the increment of value assigned to the intangible benefit and finding comparable vineyards outside of the particular AVA factually difficult.
My study of labels is limited to making sure that I don't make the mistake of buying Diet Mountain Dew, a wretched tasting concoction often hazardously located adjacent to the good stuff. I would hazard a guess though that stamping Southeastern New England on your wine bottles is not going to make them fly off the shelves and that there are probably very few AVA designations that have any value.
Nonetheless the concept is very interesting. There have been discussions about whether the names of landmark buildings might be separate intangible assets. Do the owners of the Empire State Building get royalties on all the little chachkies that are shaped like their building ? That would seem to have the makings of a 197 intangible.
Friday, October 8, 2010
They Also Serve
James F. Moss, et ux. v. Commissioner, 135 T.C. No. 18, Code Sec(s) 469; 6662.
God doth not need
Either man's work or his own gifts. Who best
Bear his mild yoke, they serve him best. His state
Is kingly: thousands at his bidding speed,
And post o'er land and ocean without rest;
They also serve who only stand and wait
So this is another post about a development in the passive activity loss rules. The rules require us to group our trade or business activities into different buckets depending on our level of participation. Losses in the passive activity bucket can be used against gains from passive activities, but a net loss is suspended until the related activity is fully disposed of. A special feature of the rules is that rental activities are "per se" passive. Persons who are in real estate trades or businesses can be exempted from this "per se" passive rule. They may need to make a special election to take advantage of this benefit.
I've discussed the election in a previous post. I've also discussed the biggest problem, people have, which is proving how they spend their time. James Moss has introduced a new angle. Mr. Moss worked full time at a nuclear power plant. The total hours worked at this job for 2007 came to 1900. Included in his work hours were 200 to 300 hours of "call out" or "standby time". Apparently, this was time where he had to be ready to go in, if they needed him. Maybe it was the days when Homer Simpson was working alone, but I'm pretty sure that's a different power plant.
Mr. Moss also rented out some property that he owned. There was a four unit apartment building and three single family homes. He apparently kept meticulous track of his time. (His "day job" involved planning the maintenance activities of a nuclear power plant, so the habits there may have carried over). He spent 507.75 hours working on his properties and 137.75 hours travelling two and fro for a grand total of 645.50 hours. The court noted that the IRS did not say that Mr. Moss failed to make the election to group his properties, so they figured he must have.
You guys who know all the answers, I need you to slow down here. Mr. Moss has done better than most real estate exception wannabees in tax court. The court isn't calling his time records a ballpark guesstimate and they are giving him credit for the election. It doesn't make him win, but he deserves a cheer. Sadly, one of the necessary, though not sufficient, conditions is that you have 750 hours in a real estate trade or business. So by his own meticulous records Mr. Moss loses. He has another argument, though. All the time that he wasn't working at the power plant, he was "on-call" for his tenants. That should easily put him over the 750 hours. OK wise guys. He actually has to beat 1900 hours, because another condition is that you spend more time in real estate than anything else. Well by my reckoning the "on-call" theory could be another 6,000 hours.
Sadly the tax court wouldn't buy it. So he has to pay the tax. He also got hit with an accuracy related penalty. He proffered two arguments. The first was that the penalty should be waived, because the IRS mistreated him. Sadly we don't get the details. The other was reliance on his CPA, but it is indicated that he did not tell his CPA how many hours he worked.
First reader to identify the poem above can chose the topic of a future post.
God doth not need
Either man's work or his own gifts. Who best
Bear his mild yoke, they serve him best. His state
Is kingly: thousands at his bidding speed,
And post o'er land and ocean without rest;
They also serve who only stand and wait
So this is another post about a development in the passive activity loss rules. The rules require us to group our trade or business activities into different buckets depending on our level of participation. Losses in the passive activity bucket can be used against gains from passive activities, but a net loss is suspended until the related activity is fully disposed of. A special feature of the rules is that rental activities are "per se" passive. Persons who are in real estate trades or businesses can be exempted from this "per se" passive rule. They may need to make a special election to take advantage of this benefit.
I've discussed the election in a previous post. I've also discussed the biggest problem, people have, which is proving how they spend their time. James Moss has introduced a new angle. Mr. Moss worked full time at a nuclear power plant. The total hours worked at this job for 2007 came to 1900. Included in his work hours were 200 to 300 hours of "call out" or "standby time". Apparently, this was time where he had to be ready to go in, if they needed him. Maybe it was the days when Homer Simpson was working alone, but I'm pretty sure that's a different power plant.
Mr. Moss also rented out some property that he owned. There was a four unit apartment building and three single family homes. He apparently kept meticulous track of his time. (His "day job" involved planning the maintenance activities of a nuclear power plant, so the habits there may have carried over). He spent 507.75 hours working on his properties and 137.75 hours travelling two and fro for a grand total of 645.50 hours. The court noted that the IRS did not say that Mr. Moss failed to make the election to group his properties, so they figured he must have.
You guys who know all the answers, I need you to slow down here. Mr. Moss has done better than most real estate exception wannabees in tax court. The court isn't calling his time records a ballpark guesstimate and they are giving him credit for the election. It doesn't make him win, but he deserves a cheer. Sadly, one of the necessary, though not sufficient, conditions is that you have 750 hours in a real estate trade or business. So by his own meticulous records Mr. Moss loses. He has another argument, though. All the time that he wasn't working at the power plant, he was "on-call" for his tenants. That should easily put him over the 750 hours. OK wise guys. He actually has to beat 1900 hours, because another condition is that you spend more time in real estate than anything else. Well by my reckoning the "on-call" theory could be another 6,000 hours.
Sadly the tax court wouldn't buy it. So he has to pay the tax. He also got hit with an accuracy related penalty. He proffered two arguments. The first was that the penalty should be waived, because the IRS mistreated him. Sadly we don't get the details. The other was reliance on his CPA, but it is indicated that he did not tell his CPA how many hours he worked.
First reader to identify the poem above can chose the topic of a future post.
Wednesday, September 29, 2010
You Don't Need a Matchmaker at the Family Reunion
I have these silly rules that I make up and then go ahead and break all the time. One is to not use the word only in association with any sum of money greater than $4.00 (Yes there is a decimal point. Four dollars). Another is to rule out of the discussion the concepts of "making sense" and "being fair" when discussing what the tax rules actually are. I compound this latter rule by not paying much attention to theories about what the tax laws should be. This comes from some hard experience I had in 1987, trying to keep straight what actually made it into the Tax Reform Act of 1986 as opposed to the "Treasury II Proposals".
I somewhat relax the "making sense" and "being fair" proscriptions for purpose of enunciating one of my general rules of tax planning. "Any clever idea you have has been thought of and probably ruled against." An extension of this is that most of the thing that you think don't make sense actually do make sense. They are there to squelch an abusive transaction dreamed up by someone even more clever than you are. All of this is just me apologizing for saying that the Eleventh Circuit's decision in Ocmulge Fields v. Com (106 AFTR 2d 2010-5820) makes sense.
The case concerns like-kind exchanges, a topic which I discuss here and there. At issue is the application of the related party resale rules. Suppose you owned two companies (Call them Highoco and Lowco)and each one owned a piece of real estate worth $1,000,000. Further suppose that the basis of one property (High-B)was $900,000 and the other (Low-B) was $100,000. Along comes buyer who perversely is willing to pay $1,000,000 for Low-B, but has no interest in High-B. Wouldn't it be nice if you could move the basis in High-B over to Low-B ? Well you can. Highco and Lowco can do a like-kind exchange. Highco's basis in Low-B will be $900,000, its basis in the property that it surrendered. Clever.
Unfortunately, if Highco disposes of Low-B within two years of the exchange Lowco has to recognize gain.
There is another set of rules involving like-kind exchanges. Since the person that has the property you want is rarely the person who wants your property many exchanges use qualified intermediaries. The qualified intermediary receives the money from the sale of your property and uses it to purchase another property. You have 45 days from the date of sale to identify the target property and you must receive it within 180 days of the sale (If the sale is later in the year you may have to extend your tax return in order to have the full 180 days).
Ocmulgee Fields Inc decided that they should go the qualified intermediary route. The hired Security Bank of Bibb County to serve as qualified intermediary. The bank received the proceeds for the sale of Ocmulgee's property known as Wesleyan Station to the McEachern Family Trust. Ocmulggee then searched high and low for a replacement property. They used up all of six days. Finally they identified a Barnes and Nobles. It just kind of happened, sort of by coincidence, that the Barnes and Nobles was owned by a company named Treaty Fields. Come to find out, Treaty Fields was pretty much owned by the same people as owned Ocmulgee.
Seems like since they already were acquainted with one another, they did not really need a qualified intermediary. Just as well they used one, though, since it got them out of that nasty related party resale rule. Well that's what they thought. It's not what the IRS thought, though. And the Tax Court and the Eleventh Circuit agreed with the IRS. Treaty Fields, surprise, surprise, had higher basis in the Barnes and Nobles than Ocmulgee had in the Weslyan property. But that's not all. Ocmulgee was a C corp and Treaty Fields was a partnership.
I would have been awfully upset if Ocmulgee won this case. Not because I root for the IRS. I would have been upset at myself for not telling my own clients about such an obvious end run around the related party resale rules. The resale rules have this nice little ending (1031(f)(4)), which disallows any exchange which is a part of a transaction or series of transactions to avoid the purposes of the resale rules. It reads:
This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection
Read by itself, it doesn't make a lot of sense. What it says is that you can't fix a bad exchange by throwing in a couple of extra seemingly good ones.
Friday, September 10, 2010
IRS Declines Rubbing Salt in The Wound
It's getting a little stale, so I think I should post now on Rev Proc 2010-14 (issued March 5, 2010) or forever hold this piece. Although it is a taxpayer favorable ruling, its recipients are probably not dancing in the streets. They are probably even more miserable than the beneficiaries of PMTA 2010-05 whom I discussed back in June.
We are talking here about like-kind exchanges. I'll give you just a bit of context. A common misconception is that you only have taxable income when you get money. In reality, the most general rule is that when you exchange one thing for anything else you should recognize gain or loss by comparing the fair market value of what you received to the basis (generally what you paid) of the thing you gave up. There are of course many exceptions. One of the better known is the like-kind exchange. It is well known enough that its section number 1031 has like 401(k) and 501(c)(3) become part of the language. (You will find wikipedia entries on each of those three. Don't go looking for 704(b) in wikipedia). In order for an exchange to be deferred under 1031 both the relinquished and acquired property must be held for investment or used in a trade and they must be of like-kind. Also there are several types of property that cannot be the subject of a like-kind exchange (e.g. securities, stock in trade and choses in action (whatever they are)). Whether property is of like kind can be a huge complicated question. There is, however, a huge simplification. All real estate in the United States is like-kind to all other real estate. So although you might have rental car companies exchanging their fleet vehicles and the like, much of the action and excitement in the 1031 area concerns real estate.
Out there in the real world you don't have many instances of the two farmers exchanging pasture land that are contemplated in the old 1031 regulations, The chance that someone who wants to buy your property would have a property for sale that you want is pretty slim. People began using middlemen to facilitate exchanges. There was a lot of creativity in the area. Beginning in 1984, which I guess is getting to be a while ago, the Code was amended to place limits on deferred exchanges. Cutting through a lot of complexity you can have a third party receive the money from the sale of your property. You have 45 days to identify a replacement property and they have to get it to you within 180 days (or by the due date of your return including extensions. (You can always get 180 days, but if the sale is later in the year you have to extend your return)).
There are rules about who can hold the money for you. A simple summary of the rules is that if it somebody who pops into your head, they probably can't do it. Can't be the realtor, can't be your lawyer or your accountant, etc. It doesn't matter. Exchange facilitation is an industry. You want to use a company that has done many exchanges. Now we are finally getting to Rev Proc 2010-14. What happens if some time during the 180 days your facilitator goes bankrupt ?
People used to worry that you would be really screwed if that happened. Since your exchange wasn't any good you would recognize gain from the sale of the property. Of course you wouldn't have any money from the sale to pay the tax, which is why you are really screwed. The IRS isn't quite as malevolent as some people make them out to be, though. Rev. Proc. 2010-14 says, in part :
The Internal Revenue Service and the Treasury Department are aware of situations in which taxpayers initiated like-kind exchanges by transferring relinquished property to a QI and were unable to complete these exchanges within the exchange period solely due to the failure of the QI to acquire and transfer replacement property to the taxpayer (a “QI default”). In many of these cases, the QI enters bankruptcy or receivership, thus preventing the taxpayer from obtaining immediate access to the proceeds of the sale of the relinquished property. The Service and the Treasury Department generally are of the view that a taxpayer who in good faith sought to complete the exchange using the QI, but who failed to do so because the QI defaulted on the exchange agreement and became subject to a bankruptcy or receivership proceeding, should not be required to recognize gain from the failed exchange until the taxable year in which the taxpayer receives a payment attributable to the relinquished property.
Whoopee. So now you are just screwed as opposed to really screwed.
There is really no excuse for people having gotten themselves in this situation. It is true that some facilitators have a sort of black box business model in which the money disappears when you sell the relinquished property. In that model, its none of your concern where the money is in the mean time as long as they deliver the target property. That is not the only the model though. It is also permissible for the funds to be segregated in separate bank accounts and some facilitators are affiliated with major banks. Your transaction costs might be a little higher, but it is definitely the way to go.
Monday, September 6, 2010
Real estate election relief
When I titled this blog Passive Activities and Other Oxymorons, it was by no means, because I intended to write only on the passive activity loss rules. If I was going to totally devote myself to one tax topic it would be the capital account maintenance rules of 704(b) (That blog would be titled "Minimum Gain - Maximum Pain"). Fortunately, I once saw the slides of a presentation of someone else who is passionate about those rules. I think they also had a thing for 704(c). One of the slides practically screamed "There is no such thing as negative basis". I feel a certain bond with that person, but I'm really not anxious to meet with them.
At any rate the passive activity loss rules do seem to be cropping up quite a bit. In a recent case which I'm thinking doesn't merit its own post (Gregory J. Bahas, et ux. v. Commissioner, TC Summary Opinion 2010-115) Linda Bahas tried to use the real estate professional exception. She hadn't made the aggregation election and the services she provided were as an employee not as a business owner. Other than that Mrs. Lincoln how did your enjoy the play ? At least she didn't have to put up with the court telling her she was ballpark guestimating her time.
There is some good news, though. A quick review of the context might be in order first. The passive activity loss rules were created more or less out of whole cloth by the Tax Reform Act of 1986. They require us to sort trade or business activities into those in which we materially participate and those in which we don't. One of the concepts in the rules is that rental activities are per se passive. This may have been an example of someone getting their notions about reality from watching TV infomercials about making a fortune in real estate with no capital and very little work. Regardless, my philosophy about tax rules is that they are what they are. In the early 1990's relief from the per se passive rule was granted to real estate professionals.
In order for this relief to be effective, though, it is frequently necessary for them to elect to aggregate all their real estate activities. Without the election they would have to establish material participation in each property. Donald Trask (TCM 2010-78) was able to establish that he spent enough time to be considered a real estate professional, but he had not made the election and his time was spread over 33 properties.
PLR 201033015 was addressed to taxpayers who were qualified, but had failed to make the election. Since they had relied on a tax preparer who had failed to advise them of the necessity of making the election, the service granted them an extension of time to make it.
If you have been posting negative numbers from real estate investments to your return on the theory that you or your spouse is a real estate professional, you should make sure that you have made the election. If not you may want to consider requesting relief. Furthermore, I generally believe in keeping tax returns indeefinitely, but if you must dispose of some of them, be sure to keep the return for the year that you made the election. It is relevant for all future returns in which you are claiming its effect and I know from experience that you cannot rely on the IRS to preserve it for you.
Friday, August 6, 2010
Guess me Out of the Ballpark
The case of Marcel Ajah (TC Summary Opinion 2010-90) is about the ultimate oxymoron - "passive activities". The concept of passive activities embodied in Section 469 is a creature of the Tax Reform Act of 1986's attempt to drive a stake through the heart of the tax shelter vampires after the silver bullet of the at-risk rules under 465 had failed to eliminate them. Oddly enough while the at-risk rules specifically excluded real estate, the passive activity rules specifically target it, by indicating that rental activities are per se passive. This was a source of real aggravation to people who actively manage their own real estate. In the 1990's there was a relaxation for people who spent most of their time in trades or businesses related to real estate.
In order to take advantage of the relief many taxpayers needed to make a special election to treat all their rental real estate activities as one activity. Otherwise, the exception to the "per se" passive rule would do them no good unless they were "materially participating" in each of their properties. Since the basic standard of material participation is 500 hours per year (there is a separate 750 hour requirement to be recognized as being in a real estate trade or business), even very hard working people can't materially participate in more than a couple. There are wonderful regulations that explain to you how to go about grouping your activities to keep track of whether you are meeting the material participation standard.
Marcel Ajah illustrates the Achilles heel of the whole system, though. Most people don't keep very good track of how they spend their time. The regulations do not specify a particular method, but the cases beginning with William Goshorn in 1993 (TCM 1993-578) seem to characterize any method that taxpayers use to reconstruct their time as being a "post-event ballpark guesstimate". "Ballpark guesstimate" which seems to me to be a fairly robust concept is apparently limited to estimates of time spent to satisfy material participation requirements.
Marcel Ajah and his wife owned two rental properties, the commercial building out of which he operated his medical practice in Jamaica, NY and a single family residence in Baltimore MD. They claimed that Mrs. Ajah qualified as a real estate professional. They lost the case on two grounds.
Mrs. Ajah argues that she qualifies as a real estate professional for the year in issue. She relies upon certificates from the Long Island Board of Realtors, Inc., the Multiple Listing Service of Long Island, Inc., and the State of New York Department of State Division of Licensing Services. These certificates reflect, respectively, that for 2005 she pledged to adhere to the realtor code of ethics, had completed required courses on broker rules and regulations, and was licensed as a real estate broker. Mrs. Ajah testified that she worked at least 20 hours a week for the 52 weeks of 2005 on the two rental properties. Mrs. Ajah did not offer any evidence as to the number of hours she worked as an attorney in 2005. No contemporaneous record, calendar, appointment book, or any other method of recording time spent between rental real estate activities and activities as an attorney was provided. Thus, the Court is unable to conclude that more than one-half of Mrs. Ajah's personal services were devoted to the rental properties.
We conclude that Mrs. Ajah's method of calculating her time spent participating in the rental activities constitutes an impermissible “ballpark guesstimate”.
The other problem was that the Ajahs had not filed the election to aggregate meaning that she would have to meet the 750 hour requirement on each of the properties which wasn't even in her ballpark.
Earlier in the year Donald Trask (TCM 2010-78) who owned 33 rental properties managed to convince the tax court that he spent more than 750 hours working on them, but he was hung by the failure to make the election to aggregate. The fact that he had aggregated the properties in reporting his income and loss was not sufficient.
It is not always advantageous for the real estate professionals to make the election, but it is definitely something that should be looked at. There is no question that if you are posting negative numbers from real estate or side businesses on your returns you should be doing something to keep a current record of your time. My own experience working with appeals on this issue is that the Service will characterize almost any reconstruction of time spent as being a "ballpark guesstimate". And they aren't handing out any peanuts or cracker jacks,
In order to take advantage of the relief many taxpayers needed to make a special election to treat all their rental real estate activities as one activity. Otherwise, the exception to the "per se" passive rule would do them no good unless they were "materially participating" in each of their properties. Since the basic standard of material participation is 500 hours per year (there is a separate 750 hour requirement to be recognized as being in a real estate trade or business), even very hard working people can't materially participate in more than a couple. There are wonderful regulations that explain to you how to go about grouping your activities to keep track of whether you are meeting the material participation standard.
Marcel Ajah illustrates the Achilles heel of the whole system, though. Most people don't keep very good track of how they spend their time. The regulations do not specify a particular method, but the cases beginning with William Goshorn in 1993 (TCM 1993-578) seem to characterize any method that taxpayers use to reconstruct their time as being a "post-event ballpark guesstimate". "Ballpark guesstimate" which seems to me to be a fairly robust concept is apparently limited to estimates of time spent to satisfy material participation requirements.
Marcel Ajah and his wife owned two rental properties, the commercial building out of which he operated his medical practice in Jamaica, NY and a single family residence in Baltimore MD. They claimed that Mrs. Ajah qualified as a real estate professional. They lost the case on two grounds.
Mrs. Ajah argues that she qualifies as a real estate professional for the year in issue. She relies upon certificates from the Long Island Board of Realtors, Inc., the Multiple Listing Service of Long Island, Inc., and the State of New York Department of State Division of Licensing Services. These certificates reflect, respectively, that for 2005 she pledged to adhere to the realtor code of ethics, had completed required courses on broker rules and regulations, and was licensed as a real estate broker. Mrs. Ajah testified that she worked at least 20 hours a week for the 52 weeks of 2005 on the two rental properties. Mrs. Ajah did not offer any evidence as to the number of hours she worked as an attorney in 2005. No contemporaneous record, calendar, appointment book, or any other method of recording time spent between rental real estate activities and activities as an attorney was provided. Thus, the Court is unable to conclude that more than one-half of Mrs. Ajah's personal services were devoted to the rental properties.
We conclude that Mrs. Ajah's method of calculating her time spent participating in the rental activities constitutes an impermissible “ballpark guesstimate”.
The other problem was that the Ajahs had not filed the election to aggregate meaning that she would have to meet the 750 hour requirement on each of the properties which wasn't even in her ballpark.
Earlier in the year Donald Trask (TCM 2010-78) who owned 33 rental properties managed to convince the tax court that he spent more than 750 hours working on them, but he was hung by the failure to make the election to aggregate. The fact that he had aggregated the properties in reporting his income and loss was not sufficient.
It is not always advantageous for the real estate professionals to make the election, but it is definitely something that should be looked at. There is no question that if you are posting negative numbers from real estate or side businesses on your returns you should be doing something to keep a current record of your time. My own experience working with appeals on this issue is that the Service will characterize almost any reconstruction of time spent as being a "ballpark guesstimate". And they aren't handing out any peanuts or cracker jacks,
Thursday, June 17, 2010
Sometimes You Should Just Pay The Taxes
PMTA 2010-05
PMTA 2010-05 is a reasonably taxpayer friendly statement. It is, however, reasonable to infer that the affected taxpayers are not exactly jubilant. PMTA stands for Program Manager Technical Assistance. True tax junkies are not satisfied with the various rulings issued by the IRS for public consumption - Revenue Rulings, Revenue Procedures, Notices, etc. We have to use the Freedom of Information Act to eavesdrop when the IRS is talking to itself. Of course Research Institute of America does the heavy lifting. The question that the PMTA addressed was :
Whether the temporary pooling of funds on a non-pro rata basis and the appointment of a tenant-in-common owner (“TIC Owner”) as a payment and/or communications agent because of the bankruptcy of the master tenant will cause the tenants-in-common to become partners in a partnership for federal income tax purposes?
The answer was no. With typical IRS hedging the no was qualified with the assumption that the arrangements weren’t actually partnerships to begin with.
I suspect that there are many sad stories hidden behind this ruling. The TIC structure is a creature of tax law. The most general rule of tax law is that when you exchange one thing for something else, you recognize gain, if any. There are of course exceptions. Several of them are collected in Part III of Subchapter O under the heading “Common Non-Taxable Exchanges” including Section 1031 which calls for non recognition of gain or loss when the properties exchanged are of “like kind”. Of course exceptions wouldn’t be real exceptions if they didn’t have their own exceptions. Among the items that cannot be on either side of a qualified like kind exchange along with stocks, bonds, animals of different sexes and “choses in action”(whatever they are) are interests in a partnership.
The 1031 exception is particularly significant in real estate because, for the most part, all real estate in the United States is like-kind to all other real estate in the United States. So if you trade your stallion for a brood mare that is not like-kind, but if you trade your horse farm for an office building it is. You can even exchange your whole horse farm for part of an office building. Which is where the partnership thing comes in. What is the difference between a piece of real estate owned by diverse persons and a partnership of diverse persons that owns a piece of real estate? Such questions keep tax attorneys awake at night and also well fed. Revenue Procedure 2002-22 tells your the conditions your arrangement must meet to be worthy of asking the IRS to rule that it is not a partnership.
That revenue procedure was part of the birth of a veritable industry. Someone selling rental or investment property had always had the opportunity to structure the sale as an exchange by inserting a third party facilitator and is even allowed time after selling the initial property to identify to the facilitator (45 days) the replacement property and for the facilitator to acquire the property (lesser of 180 days or the extended due date of the taxpayer’s return). Someone tired of being a landlord might however view that as exchanging one headache for another. By having a TIC interest as their target there was a broader range of properties available and there would be someone else to deal with all the tenant problems and repairs . Someone else to go bankrupt and leave the TIC members holding the bag.
The saddest part in the PMTA is the reference to the fact that there will be non-prorata cash contributions. Reading between the lines one can infer that some of the owners are bit resentful at having to kick money in to straighten out the mess that they have landed in.
A couple of observations and then a moral. Even if the subsequent events converted the TICs into partnerships, this should not affect the validity of the like kind exchanges that had the TIC’s as their targets. Presumably the investors did not have the master tenant’s bankruptcy as part of their plans, They might want the ruling anyways since preparing a partnership return in these circumstances would be somewhat challenging. Since 1031 defers both losses and gains, some investors might want to argue that the arrangement really was a partnership to begin with and the partnership interest they received was worth less than their basis in their relinquished properties. That would be a real tough argument to make though,
The moral is that tax savings are money. If buying something allows you to save taxes then the thing that you buy doesn’t cost you as much. It doesn’t make it free. And it is possible that , even with the discount that the tax savings creates the thing is not worth what you are paying for it. I might go so far as to speculate that if the thing is designed with tax savings in mind that the designer feels entitled to a goodly share of your tax savings. In some cases, it might be your tax savings and then some. In which case, as the title says, it would be better to have just paid the taxes.
Oh by the way :
Any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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