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Michael Gray, CPA's

Real Estate Tax Letter

March 19, 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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Happy Easter!

Easter is early this year Ė March 23.

We wish you a very happy family celebration for Easter.

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Only 27 days until April 15!

We can still squeeze in a few more clients for preparing income tax returns, although weíll be preparing extensions for many who submit their information after March 15.

If you need to meet us in person, there are a few appointment times open. Call Dawn Siemer now at 408-918-3162 (weekday afternoons) to make your reservation.

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IRS allows exchange when there is minor personal use of home.

A controversial issue has been whether a "vacation home" qualifies for a tax-deferred (Section 1031) exchange. The Tax Court ruled against a taxpayer who tried to exchange a vacation home that was never rented in Moore v. Commissioner, T.C. Memo 2007-134.

The IRS has issued Revenue Procedure 2008-16 (2008-10 I.R.B.) outlining a safe harbor where it will not challenge whether a dwelling unit qualifies for a tax-deferred exchange.

Under the safe harbor, the relinquished property or the replacement property will qualify provided three tests are met. 1) The dwelling unit must have been owned by the taxpayer for at least 24 months immediately before the exchange for relinquished property, after the exchange for replacement property. During the two 12-month periods immediately before/after the exchange, 2) the taxpayer must have rented the dwelling unit to another person or persons at a fair rental for 14 days or more, and 3) the period of the taxpayerís personal use of the dwelling unit may not have exceeded the greater of 14 days or 10 percent of the days during the 12-month period that the dwelling unit was rented at a fair rental.

A "dwelling unit" is real property improved with a house, apartment, condominium or similar improvement that provides basic living accommodations including sleeping space, bathroom and cooking facilities.

If the taxpayer files an income tax return based on the expectation that the replacement dwelling unit will meet the 3 tests and it later develops the tests arenít met, the taxpayer should file an amended return and report the exchange as a taxable transaction.

Remember the other requirements for tax-deferred exchanges must still be met.

The revenue procedure is effective for exchanges of dwelling units occurring on or after March 10, 2008.

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Tax loss allowed for workshop attached to home.

The Tax Court allowed a couple who added a workshop to their home as an addition to their existing attached two-car garage to deduct a loss attributable to the workshop when they sold their residence. The workshop was added during 1999 and 2000 at a cost of $16,179. They sold the residence in 2001.

The IRS had disallowed a portion of the loss because of a disagreement about how to allocate the sales price for the residence. The IRS computation was based on square footage. The taxpayers based their allocation on the difference of the appraised value of the home in 1998 before the workshop was built, $199,000, and the 2001 sales price of $203,000.

The Tax Court disagreed with the IRS and with the taxpayers. It allocated the sales price based on two appraisals that specifically place a value on the workshop, $3,000 and $10,000. The Tax Court said it rejected the IRS approach because the workshop space was not as valuable as living space.

(Mallin v. Commissioner, T. C. Summary 2008-13 (2/11/08).)

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IRS form updated to exclude income from mortgage forgiveness.

The IRS has issued a revised Form 982 (revision 2-2008) to provide for claiming the exclusion from income for certain mortgage forgiveness for a principal residence.

New boxes to claim the exclusion are at Part I, line 1.e. and Part II, line 10.b. of the form.

(For details on the exclusion, see our article on "Short Sales vs. Foreclosures".

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IRS allows unusual structure for tax-deferred exchange.

A taxpayer, LP, was a limited partnership in the rental real estate business. It entered into an agreement for sale of real estate with a buyer for cash, and then assigned its right to the sale agreement to a qualified intermediary (QI) to make an exchange.

LP wanted to acquire as replacement property real estate owned by another limited partnership. It entered into an agreement to purchase the ownership interests of all of the partners and assigned that agreement to QI.

After QI acquires the replacement properties, they will be distributed to a single-owner LLC, owned by LP, that will be a disregarded entity for income tax reporting purposes.

The IRS ruled that LPís receiving the interests in the partnership holding real estate in the disregarded entity will qualify as a like-kind, tax-deferred exchange. Since the LLC is a disregarded entity, LP is treated as owning all of the interests in the partnership when the transaction closes. Since the acquired "partnership" has only one owner, it will no longer be classified as a partnership and will also be a disregarded entity.

(Letter Ruling 200807005.)

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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 have five houses in Florida purchased in 2006 and two in Arizona that I also bought in 2006. I stopped making payments on all properties two months ago.

I have HELOCs (home equity lines of credit) on four of the houses that total about $200,000 more than they would short sell for.

  1. Will the Debt Forgiveness Act of 2007 apply to me? Am I going to get a bill from the IRS to tax the $200,000 in HELOCs over the short sale or foreclosure price?


  2. If I donít care about my credit, would you advise short sale or foreclosure?


  3. How many months after missing payments will they come and change the locks?

Answer

  1. Itís the "Mortgage Forgiveness Debt Relief Act of 2007". Since it appears none of these homes are your principal residence, it appears the Act doesnít apply to you. If the lenders cancel the excess debt, you will owe income taxes on the cancellation amount.


  2. Iím not a lawyer or a credit counselor. If you choose foreclosure, the lender has to do most of the work. Tax wise, the consequences are similar.


  3. The answer to this question depends on the real estate laws of the particular state. You might find that lenders are less patient than in the past, because they are trying to protect their own positions in a bad situation. Consult with real estate attorneys in the states where the properties are located.

Question

I owned three "investment" houses. I sold one of them in December 2006, for a loss of $292,000. Iím now in the process of a "deed in lieu" or "short sale" on the other two.

  1. Can the $292,000 loss be used to offset the potential income of $190,000 from the deed in lieu or short sale of the other two?


  2. Can my investment of $108,000 and $191,000 in the two investment houses be used to offset any tax liability when they are short sold or transferred back to the lender?

Answer

  1. Possibly. If the nature of the investment was that the property was rental property, the loss would be a Section 1231 loss. Any Section 1231 loss in excess of Section 1231 income is deductible as an ordinary loss, which could make it available for a net operating loss carryover or carryback.


  2. Assuming the loans are recourse loans, the houses will be considered to be sold at fair market value (or actual short sale amount). Tax basis will be used to determine any gain or loss relating to the sale of the houses. If sold at a loss and the houses were rental houses, you might have Section 1231 losses that can be offset against ordinary income.

If you donít understand these rules, you should invest in getting help from a professional tax advisor familiar with real estate. (Thatís our business!)


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 March 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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