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July 7, 2006

© 2006 by Michael C. Gray

A monthly report focusing on tax issues for the homeowner and real estate investor.

Table of Contents

• S corporation gets basis for deductions with loan restructuring.
• IRS explains when estate tax may be deferred for real estate.
• Assets sold to family partnership included in decedent's estate.
• Should you submit an offer in compromise before July 17, 2006?
• 15% withholding rate for US real property interest passed through to foreign persons by U.S. partnerships, trusts or estates extended.
• Passthrough of qualified dividend income by RICs and REITs extended.
• Qualified investment entity FIRPTA exclusion is amended.
• Questions and Answers
  • Principal residence answers.
  • What are the tax planning strategies for selling an investment property?
  • What must I charge for rent to make a 1031 exchange?
  • If two people own a property, can one sell and one exchange?
• Do you have employee stock options?
• Subscribe/Remove yourself from this newsletter.

S corporation gets basis for deductions with loan restructuring.

An S corporation financed its losses with a bank line of credit guaranteed by its shareholder. The shareholder wasn’t able to deduct losses passed through by the S corporation on his individual income tax returns because a shareholder doesn’t receive basis (investment) for deducting losses from a loan by a third party. The shareholder borrowed funds personally from the bank, and loaned those funds to the S corporation, which used the proceeds to pay off the old loan. The IRS tried to disallow the deduction, but the Tax Court upheld the taxpayer as receiving the tax basis from the new loan to deduct the passed-through S corporation losses. (Miller v. Commissioner, T.C. Memo. 2006-125 (6/15/06).)

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IRS explains when estate tax may be deferred for real estate.

An executor may elect to pay estate tax attributable to a closely held business interest in up to ten equal annual installments starting no later than five years after the regular due date for payment when (1) a closely held business interest is included in the gross estate of a decedent who was a U.S. citizen or resident at the time of death; and (2) the value of the business interest is more than 35% of the decedent’s adjusted gross estate.

An interest in a closely held business includes

1. an interest a trade or business carried on as a proprietorship;
2. an interest of a partner in a partnership if either (a) 20% or more of the total capital interest in the partnership is included in the decedent’s gross estate or (b) the partnership had no more than 45 partners, or
3. stock in a corporation carrying on a trade or business, if either (a) 20% or more of the value of the corporations voting stock is included in the decedent’s gross estate or (b) the corporation had no more than 45 stockholders.

The IRS has issued Revenue Ruling 2006-34, listing factors that are relevant in determining whether a decedent’s activities with regard to real estate are sufficient to support finding that the real estate interest qualifies as a closely-held business interest.

Here is a list of the factors:

1. the amount of time the decedent or agents and employees of the decedent or entity devoted to the trade or business;
2. whether an office was maintained from which the activities of the decedent or entity were conducted, and whether the decedent or agents and employees of the decedent or entity maintained regular business hours for managing the real estate;
3. the extent to which the decedent or agents and employees of the decedent or entity was actively involved in finding new tenants and negotiating and executing leases;
4. the extent to which the decedent or agents and employees of the decedent or entity provided landscaping, grounds care, or other services beyond merely furnishing leased premises;
5. the extent to which the decedent or agents and employees of the decedent or entity personally made, arranged for, performed or supervised repairs and maintenance to the property; and
6. the extent to which the decedent or agents and employees of the decedent or entity handled tenant repairs and complaints.

No one factor determines whether the real estate activity qualifies as a closely-held business interest. The IRS includes several examples of situations where a real estate interest does and does not qualify.

(Revenue Ruling 2006-34.)

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Assets sold to family partnership included in decedent’s estate.

Lillie Rosen passed away during 2000 at age 92. Lillie’s representatives had previously transferred her cash and securities to a family limited partnership, and made gifts on her behalf to her descendents. Since Lillie had insufficient income and assets to pay for her care, the limited partnership advanced funds to pay her living expenses and additional cash gifts to family members.

The Tax Court held in favor of the IRS that the assets that Lillie had transferred to the limited partnership were included in her taxable estate. The court found the transfer was not a bona fide sale, and that the partnership was not formed for a legitimate and significant non-tax reason. The formalities of a business were not observed, and the assets were used to pay her personal living expenses. The transfer was simply a way to avoid federal estate and gift tax.

This case and a number of other rulings illustrate the importance of not being too "greedy" with estate planning transfers. If Lillie had retained sufficient assets outside the partnership to pay her personal living expenses and the partnership had been conducted properly, the tax benefits of the transfer probably would have held up in court.

(Estate of Rosen v. Commissioner, T.C. Memo. 2006-115 (6/1/06).)

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Should you submit an offer in compromise before July 17, 2006?

Offers in compromise can be used to reduce federal tax liabilities for taxpayers in financial distress. They can also be used to make settlements when there is a dispute over a tax issue (doubt as to liability). In the past, a feature of offers in compromise was to suspend collection activity by the IRS.

Effective for offers in compromise submitted on or after July 17, 2006, a payment of 20% of the proposed "lump sum" balance due must be paid when the offer is submitted. A lump sum offer is any offer of payments to be made in five or fewer installments.

Any periodic payment offer in compromise (to be paid in six or more installments) must be accompanied by the first proposed installment. The taxpayer must continue to make payments under the proposed schedule, or the offer will be considered withdrawn.

Considering the additional hardship of the requirement of making these payments before the offer is accepted by the IRS, anyone who is considering making an offer in compromise should submit their offer before July 17, 2006.

See your tax advisor or tax attorney. If you would like our help to prepare an offer in compromise, call Mike Gray at 408-918-3161.

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15% withholding rate for US real property interest passed through to foreign persons by U.S. partnerships, trusts or estates extended.

A U.S. partnership, a trustee of a U.S. trust or the executor of a U.S. estate is required to withhold tax on any gain realized on the disposition of a United States real property interest (USRPI) to the extent the gain is includable in the income of a foreign partner or foreign beneficiary of the entity. A grantor trust is also required to withhold tax for USRPI gain attributable to a foreign grantor.

The withholding rate is currently 15% to the extent provided by IRS regulations. The 15% rate was due to expire on December 31, 2008 and the 20% rate that applied before the 2003 Jobs and Growth Act were passed would become effective. The Tax Increase Prevention and Reconciliation Act extends the 15% withholding rate for USRPI through tax years beginning before January 1, 2011.

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Passthrough of qualified dividend income by RICs and REITs extended.

RICs (mutual funds) and REITs (real estate investment trusts) can pass through the tax status of dividends attributable to qualified dividends received by the RIC or REIT. A RIC is required to notify its shareholders the amount of qualified dividends distributed within 60 days after the end of the RICs taxable year.

This rule was scheduled to expire at the end of 2008. The Tax Increase Prevention and Reconciliation Act extends the rule through tax years beginning before January 1, 2011.

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Qualified investment entity FIRPTA exclusion is amended.

Nonresident aliens and foreign corporations are taxed on the gain or loss on the dispositions of a U.S. real property interest (USRPI) as if it was effectively connected with the conduct of a U.S. trade or business. USRPIs include real property interests in the U.S. and the Virgin Islands, and in a domestic corporation unless the taxpayer establishes that the corporation was not, during the 5-year period ending on the disposition date, a U.S. real property holding corporation (USRPHC). A USRPHC is a corporation in which the fair market value of its USRPIs is at least 50% of the fair market values of the sum of its USRPIs, non-U.S. real property interests, and other assets used or held for use in a trade or business. The sale of a regularly-traded corporation is not treated as a sale of a USRPI if the shareholder did not hold more than 5% of the corporation’s regularly traded class of stock. An interest in a domestically controlled qualified investment entity, for which foreign persons hold less than 50% of the stock for a five-year period is not a USRPI. Foreign persons that sell USRPIs are generally subject to a 10% withholding tax on the sale proceeds.

Before changes in the new tax law, distributions by a qualified investment entity to a nonresident alien or a foreign corporation are looked-through so the recipient is treated as recognizing gain on the recipient’s portion of the distribution attributable to the gain on the sale or exchange of USRPIs. Look-through treatment did not apply to distributions by REITs on a class of shares regularly traded on a U.S. established securities market to shareholders that held not more than 5% of the regularly-traded class of stock during the tax year of the distribution. Where look-through treatment did not apply, the distribution was treated as an ordinary dividend subject to 30% (unless reduced by treaty) federal income tax withholding. A qualified investment company meant any real estate investment trust (REIT) and any regulated investment company (RIC) with the inclusion of RICs terminating after December 31, 2007.

Under the Tax Increase Prevention and Reconciliation Act, effective for tax years of qualified investment entities beginning after December 31, 2005 (except no withholding required before May 17, 2006 if it wasn’t required under the old rules), the look-through of distributions to the entity applies to distributions to the other qualified investment entities, rather than just nonresident aliens and foreign corporations. Distributions to nonresident aliens, foreign corporations and other qualified entities result in gain recognition by the recipient to the extent of the recipient’s portion of the distribution attributable to the gain on the sale or exchange of USRPIs.

A RIC will be treated as a qualified investment entity even after December 31, 2007, so distributions that a RIC received from a REIT will be subject to look-through treatment and withholding after 2007.

The exception from look-through treatment for distributions by REITs that are regularly traded on a U.S. established securities market to shareholders that hold not more than 5% of the corporation’s stock is amended so that it applies to distributions by any qualified entity to nonresident aliens or foreign corporations on a regularly-traded class of stock, but only if the shareholder did not hold more than 5% of the regularly-traded class of stock at any time during the one-year period ending on the date of distribution.

The exception above does not apply to distributions to other RICs or REITs. The character of the distribution is retained and must be tracked by the recipient RIC or REIT. New distributions from the recipient RIC or REIT from amounts attributable to the original distribution are treated as capital gain by U.S. shareholders and FIRPTA gain (or dividend income, if the regularly-traded exception applies).

The withholding rates are amended. Withholding applies to portions of distributions by qualified entities that are treated under the look-through rules as gain for the sale or exchange of a USRPI. The withholding rate is 35% unless the IRS provides for a 15% rate or 20% for tax years beginning after December 31, 2010.

If the exception for distributions by regularly-traded qualified entities to shareholders owning not more than 5% of the stock applies to a distribution to a RIC, the amount of distribution that would otherwise be included in computing long-term capital gains for shareholders of the RIC are not included in long-term capital gains, but in dividend income for the shareholders from the RIC.

Also under the Tax Increase Prevention and Reconciliation Act effective for distributions relating to tax years of RICs beginning after December 31, 2004, the definition of a qualified investment entity is amended to include only a RIC which is a USRPHC or which would be a USRPHC if the exceptions (i) for shareholders with interests of not more than 5% of the corporation’s regularly traded class of stock and (ii) for shareholders of domestically controlled qualified investment entities didn’t apply. Look-through doesn’t apply unless 50% or more of the RIC’s value is represented by its USRPIs, including investments in USRPHCs. The RIC must include as USRPIs its holding of RIC or REIT stock if the RIC or REIT is a USRPHC without regard to the "not more than 5% of regularly traded stock" exception and without regard to the exception for domestically controlled qualified investment entities.

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Questions and Answers

Dear readers:

Many of your questions relate to the sale of a principal residence. We have an article at our web site, "Could your residence be the ultimate tax shelter?" (http://www.taxtrimmers.com/residence.shtml) where you should be able to find the answers to most of these questions.

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Question

I have a property that was quit claimed to me by two of my older siblings some 20 years ago. At the time (in 1986), the property was assessed at around $60,000. At that point I had been living in the home for about 9 years, but I haven’t lived in it for the last 12 years. Instead, I’ve rented the property since 1993. I’m at a point where I’d like to sell the property but would not like to make a Section 1031 exchange. I realize that I will have to pay income taxes for a capital gain based on the assessed value at the time of the quit claim and the selling price.

1. Since I’ve held the property for more than 20 years, will there be a tax break? (I’m in the 20% tax bracket.)
2. How would I go about finding the exact tax rate for long-term capital gains for my situation?
3. Are there any other tax planning strategies besides a 1031 exchange for my situation?

Answer

Your tax basis is not determined using the assessed value of the property when quit-claimed to you. It is the original investment of your siblings less accumulated depreciation during the rental period.

1. There is no special tax break for long-term holding except for long-term capital gains from holding the property more than one year.
2. The maximum federal capital gains rate for an individual in your bracket is 15%. Gain attributable to the accumulated depreciation for the real estate is taxed at 25%. Other rates may apply for your state (California). Consider having a tax consultant make a tax projection for your facts.
3. If you have other investments for which you would incur a capital loss, consider selling them in the same year that you sell the real estate. Also consider making an installment sale, where you carry the mortgage for the property. The gain is reported as principal payments are received, and you earn interest on amounts that would otherwise have already been paid for income taxes. Remember that long-term capital gains rates are scheduled to increase after 2010, so you will probably want to have the installment sale note paid off by December 31, 2010. For example, you could amortize the note on a 30-year schedule with a balloon payment on December 1, 2010.

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Question

If I make a 1031 exchange and buy a condo that I rent to my son, what is the amount of rent I must charge?

Answer

The rent has to be at fair market value based on similar properties in your area. The real estate agent who is helping you with the transaction may be able to help you compile information supporting the amount you charge. Make a written lease. (Why are you creating additional risk for a tax-sensitive transaction?)

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Question

Two brothers inherited some real estate 10 years ago. The property was worth $600,000 as of the date of death, and so no estate tax was due. The property has been rented out since it was inherited. The property is now worth $1,900,000.

A buyer wants to buy the property to tear it down and build condos.

The brothers want to separate their interests. One wants to receive cash. The other wants to exchange his interest into another property.

Can this be done? Do you handle such deals?

Answer

If the brothers have held the title to the real estate as tenants in common (undivided interests), it can probably be done.

If the brothers have operated the real estate as a partnership and filed partnership income tax returns, the partnership must make the exchange, which would spoil your deal. However, the partnership might be liquidated and, with some "seasoning" the transaction could be done at a later date.

We advise clients relating to these types of transactions and know qualified intermediaries for exchange transactions.

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Michael Gray regrets he can no longer personally answer email questions. He will answer selected questions in this newsletter.

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IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.