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Michael Gray, CPA's

Real Estate Tax Letter

August 22, 2007

© 2007 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 for leased property deductible when paid.

A taxpayer suffered damage from a casualty to property that it used in its trade or business, but did not own. The property was leased. The taxpayer expects to have a loss exceeding its insurance reimbursement. Claims relating to the casualty were in dispute.

The taxpayer asked the IRS for guidance about when it may deduct its casualty losses.

The IRS said no losses are deductible until the dispute is settled with the insurance company, because it is unknown how much reimbursement will be received.

The taxpayer may eventually be able to deduct a loss for the amount paid to replace the property up to the tax basis, less the reimbursements received. The loss is deductible when the expenses are paid and the reimbursement amount can be determined.

(Letter Ruling 200730010.)

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Taxpayer fails real estate professional test.

A taxpayer had a full-time job as a youth counselor and worked part time as a college professor. She claimed to be a full-time real estate professional, which is an exception to the passive activity loss limitations.

Her real estate activity related to managing a fourplex that she owned. She maintained the property, showed apartments, processed rental applications and collected the rent.

The Tax Court found she did not satisfy the requirements of proving that she worked more than 750 hours on real estate activities and that more than one-half of the personal services performed in trade or businesses by the taxpayer were performed in real estate trades or businesses.

She documented 775 hours (which the Court didnít accept), but she didnít prove she worked more on her real estate business than her full-time job.

(T.C. Summary 2007-127 (7/26/07.)

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Vacation home didnít qualify for exchange.

Barry and Deborah Moore purchased a second home during 1988. The home was principally used on weekends during the spring and summer for recreational purposes.

They moved their principal residence in 1995 or 1996, and it became impractical for them to make the commute to their second residence, so, in 1999, they agreed to purchase another vacation home located closer to their new principal residence.

The acquisition was structured as a Section 1031 tax-deferred exchange of the home acquired in 1988 for the home acquired in 1999.

The taxpayers claimed the residence qualified for a tax-deferred exchange, because one of their motives in acquiring the vacation homes was for investment, because they expected the value of the homes to appreciate and to realize a profit when they were sold.

The Tax Court found the taxpayers were in error in their understanding of the requirements to qualify for a Section 1031 exchange. In order to qualify, the taxpayerís primary purpose must be for trade or business use or investment. The exclusive use of property by the owner as a residence contradicts any claim by him that the property is held for investment.

In this case, the homes were used exclusively by the family of the taxpayers as vacation retreats.

Tax-deferred exchange reporting was disallowed.

If you want to qualify recreational property or a second home for a tax-deferred exchange, you should minimize your personal use of the property.

(Moore v. Commissioner, T.C. Memo. 2007-134, 5/30/07.)

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Sometimes sale by family member after an exchange is OK.

When the father in a family died, the mother inherited parcel 1 of land, and parcels 2 and 3 were transferred to a trust. The trust held parcels 2 and 3 for the benefit of the mother during her lifetime, and equal remainder interests for the children after the motherís death. After the fatherís death, the mother made a gift of three 25% undivided interests in parcel 1 to her three children and kept a 25% interest.

The trustees of the trust and the children decided to sell their interests in the land. The mother didnít want to sell all of her real estate.

The parties agreed that the fair market value of the motherís 25% interest in parcel 1 was equal to the fair market value of parcel 3.

The mother exchanged her 25% interest in parcel 1 for 100% of parcel 3. Then the trust and children sold their remaining interests in the properties.

The IRS found that the tax basis of the exchanged interests were about the same, because the properties had received a "stepped up" basis at the death of the father.

Since there was no basis shifting of the exchanged interests, the IRS was satisfied that avoidance of federal income tax was not a principal purpose of the exchange. Usually a sale of property received by a related party in a tax-deferred exchange within two years of the exchange results in recognition of the gain, but the taxpayers satisfied an exception under Internal Revenue Code Section 1031(f)(2)(C).

Therefore, the mother was not required to recognize gain relating to her exchange.

(Letter Ruling 200706001, 10/31/2006.)

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Rules released for depreciation of property received in an exchange.

The IRS has issued final regulations explaining how property received in a tax-deferred exchange or an involuntary conversion should be depreciated. The regulations are effective on February 26, 2007. Some of the provisions apply retroactively to when the regulations were proposed on February 27, 2004.

Under the regulations, if both the recovery period and the depreciation method are the same for both the relinquished and the replacement property, the property is continued to be depreciated using the same depreciation method over the remaining recovery period.

If the replacement property has a longer recovery period than the relinquished property (for example: 39 years for a commercial building versus 27.5 years for a residential building), the depreciation is computed based on the remaining recovery period. For example, an exchanged residential building has been depreciated for 10 years, and has a remaining undepreciated basis of $100,000. The annual depreciation would be $100,000 / 29 (39 years Ė10 years) = $3,448.

If the replacement property has a shorter recovery period than the relinquished property, the depreciation is depreciated over the remaining recovery period of the relinquished property. For example, an exchanged commercial building has been depreciated for 10 years, and has a remaining undepreciated basis of $100,000. The annual depreciation would be $100,000 / 29 = $3,448.

Any basis in excess of the carryover basis from the exchanged property is treated as a separate property placed in service by the acquiring taxpayer in the year of replacement. For example, if a taxpayer invested an additional $150,000 in a residential building, the depreciation would be computed using the 27.5 year MACRS table for residential real estate.

Land is not depreciable.

A taxpayer may elect to not apply the modified asset cost recovery system (MACRS) depreciation rules described above for property received in an exchange, and just compute the depreciation as if it was newly-acquired property. This would make the computation much simpler, but also would result in smaller depreciation deductions.

(See Treasury Regulations Section 1.168(i)(6). TD 9314, 72 FR 9245, March 1, 2007.)

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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?" (www.realestateinvestingtax.com/residence.shtml) where you should be able to find the answers to most of these questions.

Question

I have a negative amortization loan for my principal residence. The lender only reports the interest paid on Form 1098.

When I looked at the rules for deducting interest, I didnít see that it was required to be paid to claim a tax deduction.

Since the lender is advancing the funds to "pay" the interest and add it to my mortgage balance, I think it should be deductible.

What do you say?

Answer

In order to claim a deduction for the unpaid interest, you would be required to adopt the accrual method of accounting.

Under the accrual method of accounting, income is reported when it is earned, whether it has been paid or not. Expenses are also deductible when they are incurred, subject to limitations based on "economic performance" and "all events" Ė more involved than I want to get here. The accrual method is mostly used by businesses Ė especially when they have inventories.

Under the cash method of accounting, income is mostly taxable when the payment is received and expenses are mostly deductible when they are paid.

Almost all individuals use the cash method of accounting. This makes tax reporting easier, because you can then "match" information on your income tax returns with the amounts on the information returns that you receive, including Form W-2, Form 1099 and Form 1098. Although you might have a lower tax from adopting the accrual method, you would probably be creating an accounting nightmare for yourself.

On the cash method of accounting, when you "borrow" from the same lender the amount to "pay" interest, it isnít considered to be paid. (By the way, this also applies to margin accounts and equity lines of credit!)

In short, stick with deducting the amount based on Form 1098 from the lender, subject to the other limitations that apply to home mortgage interest.

Question

My wife is a U.S. citizen. Her parents gave her some land in Pakistan more than 10 years ago. Now she wants to sell the land and transfer the funds to the U.S.

Is this a taxable transaction? What tax rate applies?

Where can I find this on the IRS web site?

What if it was handled as a gift from her parents?

Answer

As a U.S. citizen, your wife is subject to U.S. tax on her worldwide income. She might be eligible for a foreign tax credit for any Pakistan income tax on the transaction.

Assuming this wasnít depreciable real estate, the transaction should be reported as a long-term capital gain, eligible for the 15% maximum federal tax rate.

Also assuming the title is in your wifeís name, you shouldnít try to characterize the transfer as a current gift from her parents.


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 August 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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email: mgray@taxtrimmers.com
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