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Michael Gray, CPA's
Real Estate Tax Letter
August 9, 2006
© 2006 by Michael C. Gray
ISSN 1930-0387
A monthly report focusing on tax issues for the homeowner and real estate investor.
Table of Contents
- Casualty loss disallowed for heavy rain damage
- City grants to preserve older neighborhoods were taxable income.
- Rental income of S corporation wasn't disqualifying investment income.
- Taxpayer wins! Valuation testimony of IRS expert disregarded.
- Property qualified for QPERT.
- Questions and Answers
- Do you have employee stock options?
- Subscribe/Remove yourself from this newsletter.
Casualty loss disallowed for heavy rain damage.
Michael Gregorian owned a second home in Hawaii that was damaged from a flood caused by heavy rains. Michael claimed a $21,127 casualty loss for damage to the home on his 2001 income tax return.
The IRS disallowed the deduction.
In Tax Court, Michael said the loss was based in the decrease in the value of the home. He estimated it was worth $240,000 before the flood and $210,000 after. He never explained how the amount of $21,127 was determined. He made repairs after the flood, but also made substantial improvements beyond flood repairs. Michael said he "may have erred" in claiming the $21,127 loss.
The IRS said that the loss was not a casualty loss because flooding over a period of weeks was not a closed and completed transaction. Michael didn’t submit documentation required to substantiate his loss, such as independent appraisals.
The Tax Court agreed that the loss didn’t meet the "sudden" requirement for a casualty loss and he had not substantiated the amount of the loss, and disallowed the deduction.
City grants to preserve older neighborhoods were taxable income.
A city had a program for converting multiple dwelling units that were originally single-family residences or duplexes back to their original use. The purpose was to restore and preserve older neighborhoods. Qualifying owners receive payments intended to compensate them for the costs of conversion and lost rental income.
Under the general welfare exclusion, amounts paid to individuals under legislatively-provided social benefit programs are not taxable income. In order to qualify for exclusion, the payments must (1) be made from a governmental fund, (2) be for the promotion of the general welfare (based on individual or family needs), and (3) not represent compensation for services.
The IRS previously ruled that payments to low income individuals to subsidize home improvements necessary to correct building code violations qualify under the general welfare exclusion. (Revenue Ruling 76-395.) Payments to reimburse businesses for uncompensated losses from a natural disaster did not qualify and were taxable income. (Revenue Ruling 2005-46.)
In this case, the IRS said that, since there were no income restrictions on eligibility and the payments weren’t made to meet building codes, the payments didn’t fit the fact pattern of Revenue Ruling 76-395. Most of the properties for which reimbursements were made were rental properties. The program mostly provides benefits for a business or investment activity. Therefore the payments were similar to those covered in Revenue Ruling 2005-46, and are taxable income.
The city is required the issue information returns to non-corporate payees with a notification that the payments are taxable income.
(Letter Ruling 200625006.)
Rental income of S corporation wasn’t disqualifying investment income.
When S corporations with accumulated C corporation earnings and profits have passive investment income exceeding 25% of gross receipts for three consecutive taxable years, their S election is revoked.
An S corporation owned and operated rental real estate. The S corporation provided, either directly or through its independent contractors, maintenance, management and operating services for the rental properties. The IRS ruled that the rental income from the properties was from the active trade or business of renting property and was not disqualifying investment income.
(Letter Ruling 200628005.)
Taxpayer wins! Valuation testimony of IRS expert disregarded.
The Kohler family owns the stock of the company that is well-known for its plumbing fixtures. The company also manufactures cabinetry, tile, home furnishings, generators, engines, transfer switches and switchgear, and also owns hospitality and real estate businesses.
A dispute came before the Tax Court about the value of 975 shares of Kohler common stock included in the taxable estate of Frederic Kohler, who was deceased in 1998. The Kohler Estate reported a value of $47,009,625 on the alternate valuation date. The IRS claimed the value was $144,500,000.
The Tax Court was impressed with the valuation expert hired by the Kohler estate, but not with the IRS’s expert. The court noted he was not a member of the American Society of Appraisers nor the Appraisal foundation. The IRS expert’s report was not submitted in accordance with the Uniform Standards of Professional Appraisal Practice (USPAP), and did not provide the customary USPAP independence certification.
The Court disregarded the testimony of the IRS’s expert and found in favor of the tapayer.
Moral: It pays to do your homework and hire qualified experts who do a thorough job.
(Kohler v. Commissioner, T.C. Memo 2006-152(7/25/06).)
Property qualified for QPERT.
A taxpayer owned a property with two buildings – one a vacation home and the second a guest house. Neither structure was rented out and used for compensation.
The taxpayer proposed to transfer the property to a qualified personal residence trust. A qualified personal residence trust is only permitted to own either the taxpayer’s primary residence or a second residence. The purpose of the transfer is usually to achieve estate and gift tax savings for a transfer to other family members. (For more details, see your estate planning advisor.)
The IRS ruled the property qualified for transfer to a QPERT.
(Letter Ruling 200626043.)
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.realestateinvestingtax.com/residence.shtml) where you should be able to find the answers to most of these questions.
Question
How do I figure more or less what I will be taxed on if I sell my rental property located in San Jose, California.
Answer
Subtract from the sale proceeds the tax basis of the property and selling expenses, add the accumulated depreciation. This is the gain from the sale. The amount of the gain up to the accumulated depreciation may be federal taxable at 25%. Any additional gain may be federal taxable at 15%. California will tax the entire gain at 9.3%.
There may be some adjustments for these figures based on your other taxable income.
I recommend that you have a tax advisor help you with this exercise, because the facts of your individual situation are important.
Question
We are in the process of selling our home. We have owned the home since 1995 and plan on moving to Kentucky from Florida. What capital gains tax will we have to pay for the sale of our home and will we have to pay them if we reinvest the proceeds in a new home?
Answer
See the above article, "Could your residence be the ultimate tax shelter?"
You should qualify for the exclusion of gain from the sale of a principal residence, $250,000 for an individual or $500,000 for married, joint. The maximum federal tax rate for long-term capital gains is currently 15%. If you sell the home while you are still Florida residents, before you move, there should be no income tax. Buying a replacement residence no longer qualifies for a tax deferral on the sale of a residence.
Question
I live in Illinois, not California. If I sell my condo for $155,000, do I have to invest all the profit in a new place?
Answer
See the answer to the last question. Illinois appears to follow the federal tax law on the exclusion of gain from the sale of a principal residence.
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.
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