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Michael Gray, CPA's

Real Estate Tax Letter

November 27, 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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Happy Holidays!

We wish you and your family a joyous holiday season. We will be closed on December 24 and 25, and on January 1. Michael Gray will be out of the office from December 30 through January 4.

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Make your year-end planning appointment now!

The end of the year will soon be here, so make your year-end planning appointments now! Call Dawn Siemer at 408-918-3162 on weekday afternoons.

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Year-end withholding and estimated tax review.

Remember to review your withholding and estimated tax payments to be sure you avoid penalties for underpayment of estimated tax.

Withholding is considered made evenly during the year. Estimated tax payments are credited to a quarter according to when they are paid.

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Residential mortgage debt forgiveness in limbo.

The House of Representatives has passed H.R. 3996, which includes tax relief for residential mortgage debt forgiveness and increased exemptions for the alternative minimum tax. President Bush does not approve of offsetting tax increases in the legislation, and says he will veto it, if passed. The legislation is stalled in the Senate.

The tax-writing committees assure us this relief will eventually be enacted, but we are in suspense. It might not happen until next year. Meanwhile, the IRS is printing tax forms without the changes.

There will probably be many more mistakes on 2007 income tax returns as a result of this mess.

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California property tax installment due.

Remember the first installment for California property tax is due on December 10.

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Sale of property after death avoids gain.

An individual was in the process of negotiating the sale of real estate before his death. A contract of sale was actually completed, but a gas pipeline was discovered underneath the property before the closing date. The sale was delayed until a number of issues were resolved, including providing for an easement for the pipeline. The seller died before the issues were resolved, and the sale closed after his death.

The IRS ruled that the contract of sale wasn’t effective until the disputed issues were resolved after the seller’s death. Therefore, the property was eligible for a basis adjustment to the date of death value, and most of the gain from the sale was eliminated. (Letter Ruling 200744001.)

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IRS grants relief to victims of Southern California wildfires.

The IRS has extended the date for individuals and businesses in the Presidential Disaster Area affected by the California wildfires for filing returns and paying taxes for items due on or after October 21, 2007 up to January 31, 2008. The extended due date is January 31, 2008. The counties affected were Los Angeles, Santa Barbara and Ventura.

The main items that may be affected include payroll and excise tax deposits and forms and income tax returns and payments for fiscal year taxpayers.

The IRS disaster hotline is 1-866-562-5227.

In addition, disaster-related casualty losses may be claimed on income tax returns for either 2007 or 2006. If the loss is claimed on a 2006 income tax return, write “California Wildfires” at the top of the form.

(IR-2007-178 (10/30/07).)

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California passes change for computing LLC fee.

California has adopted AB 198, which changes how the LLC fee is computed, effective for taxable years beginning on or after January 1, 2007. Under the changes, the fee will be computed based on gross income derived from or attributable to California. The changes were made to satisfy U.S. Consitituional objections now being litigated under the rules before the changes, because the California “fee” was computed based on total (worldwide) income regardless of its source.

AB 198 also provides that refunds of LLC fees resulting from pending litigation are limited to the amount by which the fee paid exceeds the amount that would have been assessed if the fee had been apportioned.

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California property tax reassessment avoided for life estate.

The California Court of Appeals for the Second Appellate District ruled that a transfer of a life estate to a non-family member after the death of a property owner was not a change of ownership requiring a reassessment to determine the property tax after death. According to the statute, a “change of ownership” means a transfer of a present interest in real property, including the beneficial use thereof, the value of which is substantially equal to the value of the fee interest. The value of a life estate is not substantially equal to the value of the fee interest.

Property Tax Rule 462.060(a), which provides that the creation of a life estate in real property is a change in ownership unless the life estate is created for the transferor or the transferor’s spouse, was held to be invalid.

(Stenhart v. County of Los Angeles (B190957, 2nd Appellate District, September 28, 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

My wife and I purchased a rental property in 1975. We lived in it from 1975 to 1978, and then rented it out to the present.

Do we qualify for the capital gains exclusion if we sell the property in 2008?

Answer

No. The general rule is in order to qualify for the exclusion for the sale of a principal residence, you must have owned and used the property as your principal residence for periods aggregating two years or more during the five years ended on the date of the sale or exchange. Since it’s been nearly 30 years since you used the property as a residence, it doesn’t qualify for the exclusion.

Question

I read your article on tax consequences of foreclosures and short sales. How do you tell if your loans are recourse or non-recourse? Is it different from state to state?

Answer

The only certain way to find out is to consult with a real estate attorney. The rules do vary from state to state. In California, most mortgages that were originated for the purchase of a principal residence are non-recourse.

Question

In your explanation about foreclosures and short sales, I noticed the example showed the tax basis of the property was $300K and the non-recourse debt was $500K.

In California, non-recourse debt for a homeowner is purchase money debt, so the tax basis of the property would be the purchase price, and no gain would result.

Comment?

Answer

In most cases, you are right. I made the example consistent with the example for recourse debt for consistency and contrast.

The tax basis of a replacement residence for a sale before May 7, 1997 could have a tax basis below the cost, but most of those purchases have been refinanced.

Commercial properties can also have non-recourse loans in excess of basis.

I’ll add this information to the explanation on our web page.

Thanks for pointing this out!

Question

Thanks for your article on short sale v. foreclosure. What about a deed in lieu of foreclosure?

Answer

A deed in lieu of foreclosure is taxed the same as a foreclosure. The tax law focuses on settlement of debt by a transfer of property.

Question

In comparing foreclosures and short sales, what about selling expenses? Selling expenses for a $500,000 home could be over $30,000. Since the cancellation of debt income for a foreclosure would be the excess of the debt over the fair market value of the home, but the sale proceeds by which debt would be reduced in a short sale is the net sale proceeds, wouldn’t there be more taxable income in a short sale with a recourse mortgage?

Answer

The selling expenses in a foreclosure are added to the debt. See Jerry Myers Johnson v. Commissioner, TC Memo 1999-162, affirmed CA-4, 2001-1 USTC ¶ 50,391.

As highlighted in that decision, a difference can result when the sales price for the property is less than the agreed fair market value. However, the sale price in a foreclosure sale is evidence of the fair market value, Community Bank v. Commissioner, 79 T.C. 789 (1982) affirmed, 819 F.2d 940 (9th Circuit, 1987); Marcaccio v. Commissioner, T.C. Memo 1995-174.)

P.S. This foreclosure and short sale situation is horrific. Hopefully Congress will pass relief soon, but proposed relief legislation is tied up in the Senate. President Bush has said he will veto legislation passed in the House of Representatives. We might not see the conclusion until early next year.


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 November 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
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email: mgray@taxtrimmers.com
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