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Michael Gray, CPA's

Real Estate Tax Letter

July 26, 2007

© 2007 by Michael C. Gray
ISSN 1930-0387

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

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Welcome back! Tell your friends!

The Real Estate Tax Letter was previously issued on a paid subscription basis. I never got the "critical mass" to make it worthwhile. So I decided to offer it as a free email newsletter.

Now I need your help.

Tell your friends who are interested in investing in real estate about this letter. With your help doing some "viral marketing" I’m hoping to build a healthy subscriber base.

I’ll do my best to keep readers of this newsletter informed about current developments relating to tax considerations of investing in real estate and to answer questions that I think will be of interest to you.

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Family limited partnership doesn’t work – assets weren’t properly transferred.

When her husband died, a marital trust was established for Sylvia Gore. Their children set up a family limited partnership during 1996, and Sylvia executed a document early in 1997 to transfer most of the marital trust’s assets to the partnership.

Sylvia passed away on June 12, 1997.

There was no change in how the assets purportedly transferred to the trust were managed after the transfer to the partnership, and the titles to the assets were never changed to the name of the partnership. Sylvia’s bills continued to be paid using the funds from the assets.

Sylvia’s daughter, Pamela, tried to exclude the assets from Sylvia’s estate tax return. The IRS issued a deficiency notice, claiming the transfer to the partnership was incomplete.

The Tax Court held that, under local law, Sylvia’s continued exercise of control over the assets indicated the transfer was incomplete, and the assets were therefore includable in her estate.

This case illustrates the importance of paying attention to details when transferring assets to a family limited partnership. There must be a change in management and title, or the transfer will be disregarded.

(Estate of Gore v. Commissioner, T.C. Memo. 2007-169 (6/27/07).)

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For "small partnerships" to get centralized audit treatment, a formal election is required.

Larry and Sherilyn Wadsworth filed amended federal income tax returns for 2001 and 2002. The returns were principally amended to claim reductions in income reported on amended partnership information Schedules K-1 from Gold Coast Medical Services for those years. The IRS audited the amended returns and disallowed the reduction in partnership income.

The partnership wasn’t formally audited, but the facts supported the IRS finding that the partnership wasn’t entitled to the reduction of income claimed. No notice of final partnership administrative adjustment was issued.

The taxpayers filed a petition in Tax Court, claiming the IRS couldn’t make the adjustment at the individual level, but had to make the adjustment for the partnership under the partnership-level proceedings rules of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA).

The partnership only had two partners.

According to Internal Revenue Code Section 6231(a)(1)(B), the partnership-level proceedings rules don’t apply to a partnership with 10 or fewer partners unless the partnership makes a formal election to have the rules apply. The election is a statement to be signed by each person who was a partner at any time during the taxable year to which the return relates, and to be filed at the time and place prescribed for filing the partnership return. (Temporary Regulations Section 301.6231(a)(1)-1T(b)(2).)

On the federal partnership income tax returns for Gold Coast for 2001 and 2002, the following question was answered "no" – "Is this partnership subject to the consolidated audit procedures of sections 6221 through 6233?" However, Mr. Wadsworth was "designated as the tax matters partner".

The Wadsworths argued listing a tax matters partner was a deemed election to be subject to the partnership-level proceedings rule.

The Tax Court rejected the Wadsworths’ argument, stating "A taxpayer must clearly notify the Commissioner of the taxpayer’s intent to make an election."

The small partnership election to be subject to the partnership-level proceedings rule is an important one. It makes the administrative process for partnership audits much more straightforward to have it handled in one proceeding. If the proceeding is handled at the partner level, different partners may even reside in different states and have different conclusions from their examinations, which creates a very messy situation. Tax return preparers may gloss over this matter in the process of "filling in the boxes" to complete the return. Partnerships that don’t have their tax returns professionally prepared probably don’t even know what the question means.

When you are having your 2007 partnership income tax returns prepared, be sure to discuss this issue with your tax return preparer. Once the election is made, it continues to be effective for future years until it is revoked with IRS consent.

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Real estate activities "bust" qualification of charities.

The IRS audited two charities and found that they were principally involved in the purchase, rehabilitation and sale of real estate. Since these are not charitable activities, their tax-exempt status was revoked.

In the first case, the company applied for a tax exemption claiming it would be providing shelter, food and services to battered women and youth. A planned center was never opened and the services never provided. Instead, the company purchased eleven properties at a 30% discount from the Department of Housing and Urban Development, rehabilitated the properties and sold them to the highest bidder at fair market value. The profit was paid as compensation to the sole officer of the corporation. (Letter Ruling 200726032, 03/23/2007)

In the second case, the company applied for a tax exemption claiming it would purchase distressed real estate, rehabilitate the real estate and sell it to individuals qualified to receive low cost housing alternatives at no profit. Properties were purchased and rehabilitated, but real estate sale listings for the properties did not include a condition that the buyer qualify for low cost housing, and no attempt was made to confirm that buyers of the properties qualified for low cost housing. The properties, which were apartment buildings, were sold at market prices to individuals at a profit. (Letter Ruling 200729042, 01/18/2007.)

Charitable entities must in fact serve a charitable function or their tax exempt status will be revoked. Charitable status is not a "shield" from tax for investment activities.

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Credit by real estate broker to a buyer is a sales price adjustment.

As part of its agreement to act as agent for buyers, a real estate broker paid part of the commission it received from the seller either in cash or as a credit on the escrow statement. The IRS ruled the buyer should treat the amount received by the buyer as a reduction in the purchase price of the real estate. Since the item is not taxable income, no information return (Form 1099) is required to be issued for the transaction. (Letter Ruling 200721013, 02/09/2007.)

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Extension of time granted for single rental real estate activity election.

A taxpayer may elect to treat all interests in rental real estate as a single rental real estate activity under the passive activity loss limitation rules. The purpose of the election is to enable a qualified real estate professional meet the material participation standard necessary to treat rental real estate losses as nonpassive. The election should usually be filed with a timely-filed income tax return for the taxable year the election is to be effective.

Taxpayers, who filed a joint income tax return, didn’t include the required election statement in their income tax return. The IRS granted consent to extend the time for making the election. (Letter Ruling 200728016, 03/30/2007.)

Remember, there are some situations when a taxpayer who missed making an election can request IRS consent for making the election. The process may be expensive, but can be worth it to "save" significant tax benefits that would otherwise be lost.

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Reminder about California’s Real Estate Withholding Law.

California made significant changes to its withholding laws for sales of real estate, effective on January 1, 2007. The rules are explained in FTB Publications 677 and 677A. The publications are available at the Franchise Tax Board web site, www.ftb.ca.gov.

Most significantly, a seller may elect that, instead of having a flat 3 1/3% of the sale price withheld, to have withholding determined using its maximum tax rate (9.3% for individuals) and the calculated gain from the sale.

Sellers that are classified as corporations, partnerships or tax exempt entities under the tax laws are not exempt from the withholding requirement.

Special rules apply to tax-deferred exchanges and installment sales.

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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?" where you should be able to find the answers to most of these questions.

Question

I live in California and recently made a 1031 exchange of a duplex to three different "TIC" properties in other states.

I have LLCs holding each of the properties. The "principal business office" for the LLCs is my California residence, and the "Registered Office and Agent" is in Delaware. I make no decisions concerning the management of the properties, but I do have voting rights over the management company and sale of the property.

Do these LLCs have to be registered in California and then pay the $800 yearly minimum tax plus fees? I was originally told that using the Delaware LLC and having the registered office in Delaware would avoid this.

Answer

The State Board of Equalization has upheld the Franchise Tax Board position that, since the managing member of the LLC is located in California, the LLC is subject to California tax.

The $800 fee isn’t currently in dispute, but a San Francisco District Court has ruled the California LLC "fee" based on gross income, without apportionment, is an unconstitutional tax. The current "party line" is to pay the fee to the Franchise Tax Board and file a protective claim for refund.


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.

The July 2007 newsletter focusing on tax issues for the homeowner and real estate investor, by certified public accountants in California.

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Michael Gray, CPA
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San Jose, California 95128-4512
(408) 918-3162
Fax (408) 998-2766
email: mgray@taxtrimmers.com
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