Investment Interest Relief

PLR 201016032

If you are someone who invests on margin PLR 201016032 might be of interest to you (pardon the unintentional pun).  Back in the good old days interest used to be just deductible.  Yeah they got upset if you used it to buy tax exempt bonds, but other than that it was cool.  It hasn't been that way for quite a while.  Interest expense falls in several different classes.  In general which class the interest falls under is determined not by how the money was borrowed, but by what it was spent on.  There are fairly mind numbing regulations, that tell you how you are supposed to trace borrowed money.  If a residence is involved it can be important as to how the debt is secured. 

Investment interest is deductible as an itemized deduction, but only to the extent of your investment income.  If the interest exceeds investment income it is carried over to the next year.  The carryover never expires.  A problem, though, is that the definition of investment income does not include long term capital gains or qualified dividends.  I will overcome my reticence on commenting on logic having anything to do with taxes to point out that capital gains and qualified dividends are taxed at a preferential rate.  What if the only investment income you ever have is long term capital gain and qualified dividends ?  You are allowed to elect to treat that income as investment income.  The cost of the election is that you don't get the preferential treatment on the income you reclassify.  The election has to be made on a timely filed return.

The taxpayer in the ruling managed to find a preparer who wasn't aware of the election. Neither was the taxpayer until contacted by the preparer - light having dawned on Marblehead - two years later.  The Service allowed the taxpayers sixty days from the date of the ruling to amend their return and make the election.

If you invest on margin or otherwise have investment interest  ( You may for example have received a debt financed distribution from a partnership which you deposited into your brokerage account), take a look and see if your return has Form 4952 attached.  On Part III Line 7, there may be a number showing your carryover of investment interest.  If that number is a NUMBER, you may want to discuss with your preparer whether you might benefit from the election in the future.  If it is REALLY A NUMBER, it may be worth amending even if you have to request permission for a late amendment.

Threat to Parsonage Exclusion

FREEDOM FROM RELIGION FOUNDATION, INC. v. GEITHNER, 105 AFTR 2d 2010-2577

One of the hazards of the CPA designation is that whenever you get involved with a not for profit, they want you to chair the finance committee or be the treasurer or something like that.  I used to resist, but eventually I just resigned myself to it.  So of course during the years that I was a member of a small congregation that ran through a lot of ministers, I learned the practical side of the parsonage exclusion.  Code Section 107 excludes from the income of "ministers of the gospel" the rental value of their parsonages or, even better, amounts designated as housing allowance that they actually spend on housing.  The amount of the exclusion cannot exceed the fair rental value of the residence.   It can work out great for a small congregation where the rev is not the main family earner.  A question I never resolved was whether you can make their whole compensation housing allowance. Something told me that was pushing it too far. If they are purchasing a house, they get to double dip in a sense since the amount spent on interest and taxes is still deductible.  Military people get the same deal on their housing allowances.

One big difference between the military housing allowance and parsonage is that it is set by statute and is thereby limited.   More importantly, except for some really far out militia types, nobody can have much objection to the government saying who is or is not in the military.  Having the government say who is or is not a "minister of the gospel" is a little disturbing. but of course they also have to decide what is or is not a church or an Indian tribe for that matter.  I've never run into someone who qualified for a parsonage allowance who felt at all embarrassed by it.  Of course my general attitude toward tax rules is that they are what they are.  And before long they will likely be something else.  Clearly not everybody feels that way particularly the folks at Freedom From Religion Foundation Inc.

FFRF, Inc has sued in district court alleging that Code Section 107 violates the establishment clause in the first amendment.  Back in December, Pastor Michael Rodgers petitioned to intervene in the case on behalf of himself and 100 unnamed beneficiaries of the exclusion.  He didn't think the US government and the state of California would do a good enough job defending the constitutionality of the exclusion.  The intervention was not allowed

More recently the case has withstood a motion to dismiss.  The court noted that:

The Supreme Court has long held that plaintiffs alleging an injury that arises solely out of their federal taxpayer status generally do not have standing in federal court.

In other words, if we were allowed to sue Congress for wasting our money, the courts wouldn't have a lot of time left for anything else.  There is an exception to that rule, however, where a taxpayer is alleging a violation of the establishment clause.  So the case survives.

If I was still tied up in worrying about a small congregation with an underpaid minister, I'd definitely be rooting for this thing to just go away.  Also I think the plaintiff has a really disturbing name.  Intellectually though the whole thing is really interesting and it should be fun to watch as the case develops.







Pastor Michael Rodgers
FREEDOM FROM RELIGION FOUNDATION, INC. v. GEITHNER, Cite as 105 AFTR 2d 2010-2572, 12/01/2009

It's Not Just Us Taxapyers That's Confused

CCA 201012048 is short enough to reproduce in full (except for the secret parts of course) :

From: —————————- Sent: Wednesday, February 24, 2010 8:48:29 AM To: ————————- Cc: ———————————————— Subject: RE: TEFRA



Section 465 (at risk limitations) do not apply to partnerships. Hambrose v. Commissioner, 99 T.C. 298 (1992). Section 704(d) (limiting losses to amount of basis) does. Agents sometimes conflate or confuse the two terms, but they are separate concepts with only basis limitations applying at the partnership level.

There are probably many possible analogies you could make about the tax code, but the one that comes to mind from the above is "arms race".  Although there are provisions thrown into the code to encourage us to do or not do this that or the other thing, generally the idea is that we should go about maximizing our pre-tax profits and then figure out how much of them we should pay in tax. Of course clever people are always trying to figure out ways to maximize what they get to keep.  They come up with clever ideas and the code is amended.  So they come up with some more clever ideas and the code is amended again.  Unfortunately the special rules to combat abuses generally have to be applied universally.

The successive attacks on tax shelters have created a series of hoops that one must jump through in order to recognize a loss from an entity that will shelter income.  The first hoop is that the transaction has to be one entered into for profit.  Next the allocation of the loss to you has to have substantial economic effect.  Next you must have basis.  Then you must be "at-risk".  Finally the loss has to be from an activity in which you materially participate (unless it is sheltering income from other activities that you do not participate in).

Suppose, though, that you invest in a partnership and that that partnership invests in some other partnership.  What happens is that the partnership you invest in jumps through hoops and then you jump through hoops.  The ruling above is reminding agents that the basis hoop and the "at-risk" hoop even though they look a lot alike are not exactly the same.  Only individuals and closely held corporations need to be at-risk.

They're From the Government and They're Not There to Help You

CCA 201012041 


I like high aspirations, even though I know, as humans, we do not always live up to them.  Mission statements often represent those aspirations. A really good mission statement will serve as a touchstone.  So I decided to see what the mission statement of the Chief Counsel of the IRS was.  I think its a pretty good one:

Serve America's taxpayers fairly and with integrity by providing correct and impartial interpretation of the internal revenue laws and the highest quality legal advice and representation for the Internal Revenue Service.

I wonder if the annonymous author of CCA 201012041 remembered to check the mission statement went he or she started work on February 18.  The statement is short enough to quote in full


From: —————————- Sent: Thursday, February 18, 2010 10:01:56 AM To: —————————- Cc: ————————————————— Subject: RE: Advice




I agree that we can assert increased income and leave it to taxpayer to raise his entitlement to disputed losses.

Tax Court Crafts Ultimate Pick Up Line

Free Fertility Foundation v. Com 135 TC 2


I had originally thought of calling this "You  Can't Make This Stuff Up", but I figured I'll get in enough trouble without quoting Don Imus. Free Fertility Foundation v. Com 135 TC 2 sounds like something you might read in Onion, but it is a genuine tax court decision.  I had noted its precursor back when I was not tax blogging and might have got around to it.  PLR 200736307 and related PLR 200737044 revoked the exempt status of a nameless organization whose charitable purpose was the provision of donated sperm to worthy women.  The IRS (they don't say how) determined that 88% of said sperm, if you will excuse the expression, came from the same donor, who along with his father founded and ran the organization,  The canned language of one of the rulings invites the organizers to apply to the Tax Court for declaratory judgment. Apparently they did.

So we are able to get details.  Failure to obtain exempt status has not put the foundation under.  You can get all the details on http://www.freedonr.com/.  The donor catalog (which has one entry) has extensive information on the intellectual achievements of the donor including for example :

4th grade: 3rd place in school science fair with science project entitled "Using Red Cabbage Juice to Determine Acidity".


I guess that is something that a prospective mom would want to know about.

At any rate the tax court went along with the IRS on this one.  It boils down to his exempt purpose not benefiting a broad enough class of people.  The petitioner claimed it was a very broad class indeed namely all women in the world capable of  bearing children.  The tax court thought the class somewhat more limited - namely women who want to bear his children.  In prefacing their decision they did however make the following observation :


"The free provision of sperm may, under appropriate circumstances, be a charitable activity."

Just Because They Won't Let You Do it Doesn't Make it a Good Idea

 I promised the above title in my last installment, so I will stick with it.  I apologize if it seems that I am being disrespectful to someone who is barred from being married. In my defense, when it comes to taxes, my viewpoint is totally pragmatic.  It is what is is.  Whenever I hear somebody say that "That doesn't make sense", my resposnes is "That is not a requirement."  In my last installment, I commented on CCA 201021050 which indicates that registered domestic partners in California should be splitting their community income in filing federal tax returns.  This will often given them a better deal than if they were married filing a joint return.  I have seen commentary that the ruling should apply to California same sex married couples who are barred from federal joint filing by DOMA.  I indicated that there are signifiant tax planning opportunities for unmarried couples in all states.  As in my previous post, I find it easiest to talk about this in terms of a hypothetical couple called Robin and Terry.  Gets around those awkward pronoun problems.  Robin and Terry are a highly committed couple who view themseves as an economic unit. For some reason or other, they are not married.  So what can they do that a married couple can't ?



1. The standard deduction - Even if property is held jointly, either one can pay the real estate and mortgage interest and deduct it. (You cannot deduct somebody else’s taxes, but you can deduct all of the taxes on a property you own part of, if you pay all of it.) Robin and Terry each maintain a separate checking account. (This is a step I have found some couples find difficult to implement.). Robin pays for the groceries, home repairs, country club dues, etc. Terry makes the mortgage payments, pays the real estate taxes and makes their charitable contributions. (Terry cannot pay Robin’s state income tax, but if they have a significant diversified portfolio, Robin should own the US obligations and exempt obligations of their state of residence.) Through these steps, Robin and Terry will between them be able to deduct all their itemized deductions and one standard deduction.

2. The deferred salary - If Robin owns a C corporation (call it Robco), Robco can employ Terry. Robco should pay Terry once a year. If Robco is an accrual basis corporation it can accrue the salary due to Terry and pay it to Terry, a cash basis taxpayer in the subsequent year.

3. The free basis step-up - If Robin owns a rental property, Terry can buy it by giving Robin a long-term installment note. Robin will recognize no income until the principal is paid. Terry will have a stepped up basis for purposes of depreciation or even sale. (Thus it would even be worth doing with a vacation property, if it is likely to be sold.)

4. The basis swap - If Robin owns a high basis property and Terry owns a low basis property and they wish to sell the latter, they can do a like-kind exchange prior to the sale, thereby reducing the gain.

5. The wash sale - If Robin wants to maintain a securities position but harvest capital losses, Terry can purchase the identical security on the same day that Robin sells.

6. Forget the trade-in - If Robin has a luxury automobile that is used for business, that they would like to hang onto, Robin can sell it to Terry at loss, which unlike depreciation is not subject to luxury limitations.


If a couple chooses to use any of these techniques, the most likely way they would fail on audit is through poor execution. Everything must be done in the same way as it would be done in a truly arms-length transaction. If there is a note for a property sale a mortgage should be recorded. Payments should be made regularly as defined by the terms of the contract. Separate accounts should be maintained and receipts and disbursements should be scrupulously deposited or disbursed from the correct account (e.g. After the free basis step up, rents should go into Terry’s account and property expenses, including the interest due Robin, should be paid out of that account).

A further caveat is that I have not worked out how CCA 201021050  might affect the workings of theses techniques for California registered domestic partners.

Windfall For "Unmarried' Couples

CCA 201021050


CCA 201021050 may provide a significant windfall for some unmarried couples.  It is directed toward registered domestic partners in California and some commentators indicate that it is logically applicable to California same sex married couples.  The ruling emphasizes the point that state law determines ownership of property and that the taxation of income follows the ownership of that income.  California is a community property state and effective in 2007 the community property laws were amended so that registered domestic partners were required to file joint California returns even though they would not be considered married for federal income tax purposes.

I've thought a bit about the tax advantages that an unmarried couple might have even prior to this ruling.  I find it easier to refer to a hypothetical couple I call Robin and Terry.  How exciting is this ruling ?  It really depends on how high Robin and Terry's income is and also how unequal.  For the sake of simplicity I'm going to assume that neither Robin nor Terry itemize (probably unrealistic since the California income tax alone might put one of them over the threshold) and have a total gross income of $250,000.  Computations are for 2009  If all the income is earned by Robin the total federal tax would be $64,830.  This compares to $54,150 if they were allowed to file a join return.  Under the new interpretation they are each deemed to have income of $125,000 resulting in a tax of $26,102 each for a total of $52,204.  If one of them can qualify as head of household the total becomes $49,205. 

Unlike the filing of a joint return by a married couple, the ruling indicates that this income splitting is not elective.  It also indicates that people who have already filed do not need to amend their returns, but that they are permitted to.  The ruling is applicable to years after 2006.  The amended return option is the part that I find very interesting. Suppose Robin had grossed $200,000 and Terry $50,000.  Their total tax would be $54,150, slightly less than a married couple with the same income, but still a bit more than they would pay income splitting with one another.  What if Robin amends to claim a refund of $22,068 ?  Is there a mechanism to force Terry to amend.  I don't think the IRS even has the right to tell Terry what Robin did.  This gets somewhat less exciting if Robin is an employee, since withholdings track to community property income so Robin's amended return would show reduced withholding.

It will be interesting to see if the IRS issues more formal guidance on this issue.  In the mean time all those Robins and Terries out there might want to dust off their returns and crunch some numbers.  They have until April of 2011 to amend their 2007 returns, but have a heart for your tax professionals and don't go asking them to amend old returns during crunch time.

I'm planning on my next post to be about the tax opportunities that "unmarried" couples have generally. It will be titled "Just Because They Won't Let You Do It Doesn't Make It a Good Idea".(It's now available.)

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