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Michael Gray, CPA's

Real Estate Tax Letter

September 26, 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

October 15 is the final extended due date for calendar year 2006 non-corporate income tax returns.

Remember that 2006 income tax returns for calendar year individuals, estates, trusts and partnerships for which an extension of time to file has been made must be filed by October 15, 2007 to be timely filed. Thi Nguyen and I will be out of town on September 28 and October 1, and I will be out of the office for seminars for three days during this period. That will make time very tight to finish income tax returns during this period.

If you need help with your extended income tax returns, call Dawn Siemer at 408-918-3162 for an appointment immediately!

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IRS posts guidance for taxpayers with home foreclosures.

The IRS has posted a frequently asked questions (FAQs) section to its web site to help taxpayers who lose their homes in a foreclosure.

Notably, the site does not currently discuss “short sale” transactions.

(IR 2007-153, 9/17/2007.)

See questions and answers, below for help relating to a “short sale” with a non-recourse mortgage.

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President Bush endorses proposed exclusion for some mortgage cancellation of debt income.

President Bush has promised to work with Congress to temporarily eliminate taxation of cancellation of debt income in certain situations.

The proposed legislation has been introduced as H.R. 1876 in the House of Representatives and S. 1394 in the Senate. Under the proposed legislation cancellation of “qualified residential indebtedness” would be excluded from taxable income. The amount excluded would be up to the excess of the outstanding principal amount of the indebtedness immediately before the discharge over the sum of the amount realized from the sale of the real estate securing the indebtedness, less the cost of the sale, plus the outstanding principal amount of any other indebtedness secured by the property. The exclusion of gain from the sale of a principal residence would be reduced by the amount excluded for cancellation of qualified residential indebtedness.

“Qualified residential indebtedness” (i) was incurred or assumed by the taxpayer in connection with real property used as a residence and is secured by the real property; (ii) was incurred or assumed to acquire, construct, reconstruct or substantially improve the real property; and (iii) for which the taxpayer makes an election for exclusion. Refinanced indebtedness would qualify to the extent it doesn’t exceed the amount of indebtedness being refinanced. (“Cash out” from refinancing wouldn’t qualify for the exclusion.)

The exclusions for bankruptcy or insolvency would take precedence over this exclusion provision.

This proposed legislation would give substantial relief for taxpayers who otherwise might not qualify because they had a recourse debt or a “short sale”.

If you are in this situation, you should contact your representatives in Congress and request that they support the proposed legislation.

Another proposal in the House of Representatives, H.R. 3506, would exclude a maximum of $50,000 of cancellation of debt income for a mortgage secured by a principal residence, and only taxpayers with a maximum adjusted gross income of $100,000 or $200,000 for married persons filing a joint return, would qualify for the exclusion. This proposal isn’t nearly as beneficial as the other two, especially for taxpayers in California.

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Senator Grassley asks IRS to help homeowners with loan forgiveness tax bills.

Senator Chuck Grassley, R-Iowa, who is the ranking minority member on the Senate Finance Committee, has sent a letter to the Treasury Department and the Internal Revenue Service asking for help for homeowners who face big tax bills because of home loan debt forgiveness on a principal residence. Grassley asked that the IRS accept offers in compromise to eliminate or reduce the taxes for these transactions.

Grassley reminded the IRS that they may compromise to promote effective tax administration where compelling public policy or equity considerations identified by the taxpayer provide a sufficient basis for compromising the liability.

(Similar requests were ignored when taxpayers suffered tax disasters relating to stock option transactions during the stock market crash of 2000 and 2001.)

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Real estate transferred to family partnership included in transferor’s estate.

The Ninth Circuit Court of Appeals has affirmed a Tax Court ruling that real estate transferred to a family limited partnership was includable in the transferor’s taxable estate when the tranferor continued to receive economic benefits from the property, including payments secured by the real estate for which the transferor was personally liable. Payments to or for the decedent were recorded as interest-free loans by the partnership. The partnership never made distributions to the other partners before the decedent’s death, and the transfer of the real estate would have left the transferor in an impoverished financial condition.

The Tax Court had said the “decedent’s use of partnership income to replace the income lost because of the transfer of the … property to the partnership shows that there was an implied agreement between decedent and her children that she would retain the right to the income from the… property.

The family limited partnership was disregarded and valuation discounts were disallowed.

The result in this case is a reminder that the IRS has discovered an effective weapon in attacking family limited partnerships. The transferor must retain sufficient assets to maintain his or her accustomed standard of living. With longer life expectancies and high costs of long-term care, this can be a challenging requirement to meet.

(Estate of Bigelow v. Commissioner, 100 AFTR 2d ¶ 2007-5271 (9th Cir. 9/14/07.)

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IRS says material participation for passive activity limitation is based on activity of trustees.

A trust appointed special trustees to perform tasks relating to a business, which generated a tax loss. The special trustees did not have the capacity to legally bind or commit the trust to any transaction or activity. The trust claimed the tax loss as from an active business.

In a technical advice memorandum, the IRS rejected the reasoning in Mattie K. Carter Trust v. United States, 256 F. Supp. 2d 536 (N.D. Tex. 2003). In that case, the court concluded that the activities of the employees of the trust should be included in determining whether the activities of the trust were sufficient to be considered an active trade or business.

The IRS pointed out that the activities of employees are not attributed to other individual taxpayers, and so they shouldn’t be attributed to trustees of a trust.

Although regulations have not been issued defining material participation for trusts, the IRS examined the legislative history of the provision to conclude that only the activities of the trustees should be considered to determine whether participation by the trust was material.

Since the special trustees didn’t have necessary discretionary powers to act on behalf of the trust, they were not fiduciaries and their activities shouldn’t be considered in determining material participation. (The IRS also questioned whether their activities were sufficient to be material participation.)

The activity of the trustees of the trust was also held to be insufficient to be material participation, so the loss was deemed a passive activity loss and suspended.

(Letter Ruling 2000733023, 8/27/2007.)

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Santa Clara County keeps property tax break for taxpayers age 55+.

The Santa Clara County Board of Supervisors voted unanimously to keep a property tax break for homeowners who move into Santa Clara County from other parts of the state.

There is a one-time election under Proposition 90 to keep the Proposition 13 property tax base from a former principal residence when another principal residence of equal or lower value is purchased within two years in certain counties that elect to participate. If the homes are owned by spouses, only one of the spouses needs to be at least age 55 to qualify.

Currently, the only counties that are participating are Alameda, Los Angeles, Orange, San Diego, San Mateo, Santa Clara and Ventura. (Source – San Jose Mercury News, September 26, 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?” (http://www.realestateinvestingtax.com/residence.shtml) where you should be able to find the answers to most of these questions.

Question

We are thinking about forming an LLC to buy and manage real estate. One of the partners lives in Delaware and the rest in the San Francisco Bay Area. We are considering forming the LLC in Delaware. (1) Will California tax our business income? (2) If the LLC is set up in Delaware, will the individual members have to pay tax in both states or the state with the higher income tax?

Answer

You have stumbled into a hornet’s nest.

First, when a member lives in a state that imposes an income tax, the state of residence generally imposes the income tax on the worldwide income of the resident. There may be an offsetting state tax credit if another state imposes tax on the same income.

If real estate is located in a state that imposes an income tax, any income relating to the property is generally taxable in that state.

The California Franchise Tax Board has been very aggressive in finding that an LLC that has members who are California residents are subject to tax in California, requiring them to pay an $800 tax plus a fee based on “worldwide” gross receipts. These positions are in litigation right now.

Before you go ahead, consult with an attorney and a qualified tax advisor who is familiar with these issues.

Question

I’m working through a “short sale” for one of my clients.

I found a case, Briarpark v. Commissioner (T.C. Memo 1997-298, 6/30/1997), where the Tax Court held a short sale was equivalent to a foreclosure because the borrower was relieved from debt and relinquished the property in the same transaction. As a result, the non-recourse debt was included in the sale proceeds, resulting in a capital gain.

The Fifth Circuit Court of Appeals upheld the Tax Court’s decision (99-1 USTC ¶ 50,209, 1/6/1999), making this case more recent that Rev. Rul. 92-99, cited in your article.

Did you consider Briarpark when writing your article? Am I missing something?

Richard Ogg, EA

Answer

Thank you for writing.

It looks like I’m the person who missed something. The Briarpark decision was buried in cases under Internal Revenue Code Section 1001 (Computation of Gain or Loss), while I was mostly studying Section 108 (Cancellation of Debt Income).

There isn’t much discussion of this situation in the literature, presumably because in the past “short sales” weren’t common.

First, taxpayers will be interested to know the IRS took the position that the nonrecourse debt that Briarpark was relieved from incidental to its sale should be included in sale proceeds. Briarpark evidently wanted to exclude the debt cancellation under the insolvency exclusion.

The IRS and Fifth Circuit found that since the buyer and seller both made a condition that the debt be cancelled, the debt cancellation was in fact an integral part of the sale. The bank/lender documented making a business decision that its best alternative was to permit the cash sale. Under Treasury Regulations Section 1.1001-2, the amount realized from a sale of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition, regardless of the fair market value of the security. The portion of the liability resulting in a taxable discharge of indebtedness (recourse debt in excess of the fair market value of the property) is excluded from the sale proceeds.

Thank you, again Richard, for bringing this to my attention. You have performed a valuable service for the readers of this newsletter. (And I get to eat humble pie!)


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 September 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
2190 Stokes St., Suite 102
San Jose, California 95128-4512
(408) 918-3162
Fax (408) 998-2766
email: mgray@taxtrimmers.com
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