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Michael Gray, CPA's

Real Estate Tax Letter

February 4, 2008

© 2008 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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Tax season is here! Make you appointment now!

There are only about two and one-half months left before the tax return due date. Time to get started now!

If we prepared your income tax returns last year, you should have already received instructions in the mail. If you havenít, please call Dawn Siemer at 408-918-3162.

To have us prepare your income tax returns, start with the online Tax Notebook organizer. Call Dawn Siemer at 408-918-3162 for instructions to get started. We also have a paper organizer if you prefer. We still need your documents (W-2s, 1099s, receipts for donations) to prepare your income tax returns.

We can prepare most income tax returns using information provided online and by mail. If you wish a personal meeting, please call Dawn Siemer at 408-918-3162 to schedule an appointment. Our calendar is filling up fast!

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Yes, we do prepare income tax returns!

With our free newsletters and the information we make available at no charge on the web, some people wonder how we make a living. We prepare income tax returns and provide tax and business consulting services. We are accepting selected new clients and are thrilled when our clients and friends refer their friends, associates and family members to us. To inquire about becoming a client of our firm, please call Dawn Siemer at 408-918-3162 or send an email to her at dgsiemer@taxtrimmers.com. We must receive your tax information by March 1 to guarantee delivery by April 15.

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Choice of business entity for spouses more confusing, effective 2007.

A tax simplification provision enacted as part of the The Small Business and Work Opportunity Tax Act of 2007 (SBA) on May 25, 2007 appears to have some unexpected consequences for spousal real estate operations.

Spouses conducting a family business wanted to eliminate the requirement to file a partnership income tax return to report their income, divide self-employment earnings and be able to set up separate retirement accounts.

The IRS previously allowed spouses in community property states to report their income on their individual income tax return in Revenue Procedure 2002-69. This election was not available in non-community property states.

The SBA included Internal Revenue Code Section 761(f), which permits a husband and wife who conduct a "qualified joint venture" and file a joint income tax return to elect to not have the joint venture treated as a partnership, and instead to report their shares of the income and deductions of the joint venture on separate Schedules C (business) or F (farm).

A qualified joint venture is any joint venture involving the conduct of a trade or business if (1) the only members of the joint venture are a husband and wife, (2) both spouses materially participate (under the passive activity loss rules, without attributing material participation of one spouse to the other) in the trade or business and (3) both spouses elect to report under this provision.

Another provision of the SBA is Internal Revenue Code Section 1402(a)(17), which says that the allocated income for each spouse under the 761(f) election is subject to self-employment tax.

On page 2 of the instructions for the U.S. Partnership Income Tax Return Form 1065, the IRS says this provision applies to rental income that would otherwise not be subject to self-employment tax.

The election appears to be made by simply including the two Schedules C or F for the business in the income tax return, and can only be revoked with the consent of the IRS.

So here are some consequences to consider from making this election:

  1. The taxpayers might save some fees by making the election.
  2. Preparing the individual income tax return will be more complicated, because each income and deduction for the venture must be prorated according to the contribution of each spouse (not necessarily 50-50).
  3. Rental operations will be subject to self-employment tax of 12.4% (social security) on the first $102,000 of income for each spouse and 2.9% (medicare) without limitation.
  4. The income should be eligible for retirement account contributions, such as a Simplified Employee Pension or a Roth 401(k).
  5. Some states, including California, havenít conformed to this law, which could make taking retirement account deductions in those states questionable.

Because of the long-term consequences, I would think about the matter long and hard before going ahead with this election. It doesnít look like a good deal to me.

Consider writing to your Congressman that it doesnít make sense to convert rental income to self-employment income as a consequence of this election. A technical correction should be made to continue to exclude rental income from self-employment income when the election is made.

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"Hard money" mortgage broker sent to prison.

Michael Schneider, a mortgage broker who wrote "hard money" mortgages using investorsí money through his business called California Plan, was sentenced to 28 years in prison by a Santa Clara County Superior Court on February 1 for stealing $43 million in an investment fraud on dozens of mostly elderly clients.

From 1995 to 2006, Schneider forged documents to cover the fact he never recorded deeds of trust on properties that allegedly secured "loans". Sometimes, the same properties were used as collateral on multiple loans.

The police havenít been able to trace where most of the missing money went. About $11 million in assets are tied up in bankruptcy court.

The hard lesson is that investors should confirm that their loans are being handled properly when using intermediaries for hard money loans. They should check the title, including their liens, at the county recorderís office where the property is located, and inspect the property themselves to assure there is value securing their loan. You can get also get comparable value information for homes in the area on the internet for free at realestate.yahoo.com/Homevalues, or hire your own appraiser for an independent study.

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California loses LLC fee appeal.

The First Appellate District of the Court of Appeals has affirmed a trial courtís opinion that Californiaís LLC fee violates the Commerce Clause of the U.S. Constitution, because the fee is not based on income apportioned to California but total income.

Northwest Energetic Services, LLC was required to pay the fee, despite doing no business in California.

The Court of Appeals agreed with the trial court that the LLC fee was a tax, not a fee. The fee was enacted to replace the expected tax revenues that would be lost from businesses that would otherwise be organized as corporations but would not be subject to tax as LLCs.

The Court said that even if the fee was not a tax, it was unconstitutional under the balancing test from U.S. Supreme Court case Pike v. Bruce Church, Inc. (1970) 397 U.S. 137. Under that test, (1) the fee must be imposed evenhandedly to effectuate a local public interest, (2) its effects on interstate commerce must be only incidental, and (3) its burden on interstate commerce must not be clearly excessive in relation to the putative local benefits. According to the Court of Appeals, the fee failed all of the tests.

The Court also rejected the argument of the Franchise Tax Board (FTB) that the taxpayer was precluded from raising a Commerce Clause argument because it elected to be taxed as an LLC rather than a corporation. The FTBís reasoning would prevent an unconstitutional tax from ever being challenged because it would preclude all LLCs subject to the fee from bringing a legal challenge.

The FTB hasnít announced whether it will appeal this ruling to the California Supreme Court.

California changed its LLC fee this year so that it is now based on apportioned income. Meanwhile, many claims for refund of back year fees are pending resolution of the issue.

If you paid a California LLC fee and havenít filed a claim for refund yet, do it now.

(Northwest Energetic Services, LLC v. Franchise Tax Board, California Court of Appeal, First Appellate District, No. A114805, A115841, and A115950, January 31, 2008.)

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Congress passes Recovery Legislation

Congress passed "The Economic Stimulus Act of 2008" (H.R. 5140) yesterday. President Bush says he will sign the Act next week.

The Act is more similar to the House proposal than the Senate proposal, but a reduced rebate is being extended to disabled veterans and taxpayers receiving Social Security benefits.

Rebate for individuals. The tax rebate will generally be the lesser of the (1) 2008 income tax liability or (2) $600 for single persons and $1,200 for married persons filing a joint return. It will be phased out based on 5% of adjusted gross income exceeding $75,000 for singles, $150,000 for married, filing separately.

The credit will be at least $300 ($600 for a joint return) when the taxpayer (1) has qualifying income of at least $3,000 or (2) has at least $1 of net income tax liability and gross income which is greater than the sum of the basic standard deduction ($10,900 joint, $5,450 married separate, $8,000 head of household, $5,450 singles) plus the exemption amount ($3,500) or twice the exemption amount for a joint return. Qualifying income includes earned income, social security benefits and federal disability benefits for veterans.

There is also a $300 per child rebate for qualifying children of a taxpayer.

The rebate will be paid in advance based on the facts on the 2007 federal income tax return, but not for income tax returns filed after December 31, 2008. Then the rebate will be recomputed based on the information on the 2008 income tax return. The taxpayer will not be required to repay any advance amount paid over the recomputed amount.

Only individuals with a valid social security number will qualify for the credit. Non-resident aliens and illegal aliens arenít eligible.

Temporary increase in federal "conforming" lending limits. The legislation includes an increase of the lending caps for U.S. government-insured loans from $417,000 to a temporary maximum for 2008 of $729,750, with lower limits applying to less expensive areas. (For example, the $729,750 limit would apply our area of San Jose-Sunnyvale-Santa Clara, Los Angeles, and San Diego but not to Sacramento or Riverside.) The limits apply to Federal National Mortgage Association (Fannie Mae) and Federal National Mortgage Charter Act (Freddie Mac) mortgages and also to Federal Housing Association (FHA) mortgages.

The increase in lending limits should make it easier for homeowners to refinance their mortgages in high cost areas. However, all major lenders have decreased their lending limits for any given property because of the increase in defaults. As a mortgage broker, I can tell you that even conforming rates have skyrocketed recently, partially in anticipation of the changes in limits just passed by Congress. Individuals applying for smaller loans may actually find interest rates increase as they compete with others applying for larger loans.

Expensing limit increased for 2008. The limit for businesses to expense equipment is being increased from $128,000 to $250,000 for property placed in service during 2008. The level where the expense election is phased out is increased from $510,000 to $800,000 for 2008.

Bonus depreciation restored for 2008. 50% bonus depreciation that was enacted after September 10, 2001 and expired January 1, 2005 is restored for business equipment purchased during 2008.

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

Question

I bought a condo in San Jose in July, 2007. Financially, things happened and the condo is now in pre-foreclosure/short sale and Iím now back home with my parents. If the home is sold, it will be for a lot less than I bought it for.

With a short sale, Iím assuming I will probably receive a 1099 and have to pay taxes on the difference lost? I donít think I will qualify for the Mortgage Forgiveness Debt Relief Act of 2007. With that law, I think you have to have lived in the home for at least 24 months.

Answer

I just posted an update on my article on short sales and foreclosures to cover the new Act at realestateinvestingtax.com/shortsale.shtml. (Remember California and many other states havenít conformed to the new law yet.) You donít have to have lived in the home for at least 24 months. Many of the people who are in foreclosure bought their homes recently. (But July, 2007? What were you thinking?)

However, the new Act wasnít designed for your situation. Since your mortgage was originated for the purchase of a residence in California, it is probably a non-recourse loan. This means you will be treated as selling the residence for whatever you get for it plus the debt forgiveness, which should result in a non-deductible loss, not income.

You might not be able to afford it, but you should go to a tax professional for help. Maybe Mom and Dad will help out with the fees.

Question

If I used an equity loan secured by my personal residence for personal expenses, and later rented that home out, would the interest still be deductible for the equity loan?

Answer

No. In order to qualify, the loan must be secured by a residence which is the principal residence or a second residence for the tax year when the interest was paid, limited to the fair market value of the residence over the acquisition/improvement mortgage amount and also limited to a $100,000 equity loan. Remember interest on an equity loan not used for purchase or improvement of the residence is not deductible when computing the alternative minimum tax.


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 February 2008 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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