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Michael Gray, CPA's

Real Estate Tax Letter

April 25, 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 birthday, Dawn!

Wednesday was Dawn Siemerís birthday. Dawn edits this newsletter and emails it to you, maintains our web sites and is our office manager. She is also my oldest child. A major advantage of having my own business is to spend a lot of time with Dawn. She is also one of the most efficient and effective workers Iíve had to pleasure of working with.

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After April 15 status check.

Do you need help? We had a very good tax season, and new clients are coming to us with extended income tax returns. One of them didnít pay 90% of his expected tax with his extension request, so he has "late filing" status. He also has a calendar year corporation and didnít file his corporate extension forms by March 15, so the corporate income tax returns are also late.

I hope your tax filings and payments are up to date. If you need help, call Dawn Siemer weekday afternoons at 408-918-3162 to make an appointment.

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Michael Grayís upcoming vacation.

I will be out of the office from Monday, May 5 and return on Monday, May 12.

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Current deduction, depreciable improvement or non-deductible capital expense? The IRS issues guidelines.

The IRS withdrew proposed regulations issued on August 21, 2006 and issued new proposed regulations about capitalization and expenditures relating to tangible property on March 10, 2008. The proposed regulations wonít be effective until they are finalized, but they are still important as guidelines of the current thinking at the IRS on these issues.

My printout of the proposed regulations and the preamble (IRS summary) is about 51 pages. I canít cover them in detail.

There are new conformity rules when a taxpayer has applicable financial statements, such as financial statements required to be filed with the SEC or a governmental agency, or other audited financial statements.

Materials and supplies are eligible to be currently deducted. They are tangible property used or consumed in the taxpayerís operations that meet one of four tests Ė

  1. Not a "unit of property" (such as spare parts, other than rotable or temporary spare parts, for repairs);
  2. A unit of property that has an economic useful life of 12 months or less;
  3. A unit of property that has an acquisition or production cost of $100 or less; or
  4. Is identified by the IRS in an announcement as materials and supplies.

Rotable or temporary spare parts may only be deducted when they are ultimately disposed of or scrapped.

Another example in the proposed regulations of an item that is "not a unit of property" is a broken window in a building that is replaced. The replacement qualifies for a current deduction as materials and supplies.

When materials and supplies are used to improve a property, such as for rehabilitating a "fix up" property in preparation for sale, they must be capitalized.

The IRS has stated the "plan of rehabilitation" doctrine that disallows a current deduction for repairs made as part of a general plan of renovation or rehabilitation will be obsolete when the proposed regulations become effective. Repairs that do not improve the property will be currently deductible even when performed at the same time as other repairs that must be capitalized as an "improvement".

There is a special rule for amounts paid by a taxpayer in the process of investigating or otherwise pursuing the acquisition of real property permitting the current deduction of expenses relating to the process of determining whether to acquire real property and which real property to acquire. However, "inherently facilitative costs", such as getting an appraisal of a property, must be capitalized and may be deducted when the acquisition is abandoned or added to the purchase price of the property when it is acquired.

I recommend that advisors study these proposed regulations and that taxpayers consult with their advisors about how the new proposed regulations would affect them.

(REG-168745-03.)

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Senate tax proposals include real estate benefits.

The Senate has passed H.R. 3221, the "Foreclosure Prevention Act of 2008". Some tax proposals include:

  1. Extend the net operating loss carryback period for losses incurred in tax years 2008 and 2009 from two years to four years. Taxpayers who elect the longer carryback period would forgo increases in the depreciable assets expense allowance and bonus first-year depreciation.
  2. Create a standard deduction for property taxes paid by taxpayers who donít otherwise itemize theirdeductions. The deduction would be $500 for single filers and $1,000 for joint filers. The deduction would not be available if the local jurisdiction raised taxes after April 2, 2008 and before December 31, 2008.
  3. Create a $7,000 tax credit for taxpayers who buy within one year of the date of enactment and use as their principal residence a foreclosed home. The credit would be claimed ratably over two years.
  4. Provide an additional $10 billion of tax-exempt private activity bond authority to be used to refinance subprime home loans, provide mortgages for first-time homebuyers, and for multifamily rental housing. The interest income from these bonds would be tax exempt from both the federal regular tax and alternative minimum tax.

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California considering tax relief for mortgage forgiveness.

The California legislature has tax relief legislation in process Ė too late for the April 15 tax return deadline. The maximum debt relief for California would be $1 million ($2 million is the federal limit) and $500,000 for married filing separate returns ($1 million is the federal limit).

The last day for relief under the California proposal is December 31, 2008. Under the federal tax law, itís December 31, 2009.

Call your representatives in Sacramento to support SB 1055. If it is enacted, you qualify for relief and you already have filed your 2007 California income tax return, you will need to file an amended return.

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IRS Chief Counsel says qualified joint venture rental real estate income isnít subject to self-employment tax.

As we pointed out in our February 4, 2008 newsletter (Choice of business entity for spouses more confusing, effective 2007), there has been a controversy about how rental income and deductions should be reported when spouses elect to report their shares of income from a joint venture on their personal income tax returns instead of on a partnership income tax return.

The IRS instructions for the partnership income tax returns indicate the income should be reported on Schedules C (trade or business income) and the income may be subject to self-employment tax.

The IRS Chief Counsel now says the income and deductions should be reported on the same forms that it otherwise would Ė Schedule E for rental income and deductions Ė and net rental income is not subject to self-employment tax.

There may be some amended income tax returns to be filed under this announcement. It could also spoil or disqualify contributions to retirement plans and IRAs based on the "conversion to self-employment income" theory.

(This might not be the last word on this subject. We might see some litigation on the issue in the future.)

(Chief Counsel Advice 200816030.)

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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

Can I include my home in India as my vacation home in my U.S. income tax returns. I am a resident alient with a valid H1 B (specialty workers) visa. If yes, what proof or documents are required by the IRS?

Answer

Under the rules for deducting interest at Internal Revenue Code Section 163(h)(4), a qualified residence includes a vacation home, as defined in Internal Revenue Code Section 280A(d)(1). There is no requirement that the residence be located in the United States. The home must have been used for personal purposes for a number of days which exceeds the greater of (a) 14 days, or (b) 10% of the number of days for which the unit is rented at a fair rental.

Personal use includes use for personal purposes by the taxpayer or any other person who has an interest in the unit, or by any member of the family (including brothers, sisters, spouse, ancestors and lineal descendents) of the taxpayer or such other person. An exchange arrangement for the use of another dwelling unit for personal use (time share) qualifies as personal use. Use by another person (family friend) when no rent is charged also qualifies as personal use.

Foreign real property taxes are tax deductible as an itemized deduction on your federal income tax return.

For documentation, you should have invoices or statements for the interest and taxes that you paid. You should also keep records of the use of the house. If you are staying at the vacation home, keep your flight records. These items are not submitted with your income tax returns, but should be kept with your tax records in the event of an income tax audit.

Question

We live in California and have a home in Washington State that we have rented since 2003. We have been told that we should not sell the Washington home due to the tax liability. We would need to live in the home two out of five years before we sell the home. To do that we would have to leave our California jobs and move back to Washington. How can we stop this vicious cycle?

Answer

Since you have been renting the home since 2003, it is investment property that qualifies for a tax-deferred exchange. How about exchanging it for another property that generates cash flow or better appreciation or is located closer to you? Consider exchanging for a tenant-in-common interest.

If you receive cash for selling the property, you arenít going to be able to avoid income taxes. As California residents, you are subject to California tax on your worldwide income.

Question

I inherited real property appraised at $900,000 at the time of my motherís death. I recently sold the property for $500,000. Can I claim this loss?

Answer

It depends on how the property was used after your motherís death. If you moved into the home and used it as a personal residence, the loss is not deductible. If you rented the house for someone else to use at a fair market value rent, the loss is deductible. If you sold the house a few months after your motherís death and nothing was done with the house in the interim, the loss probably is still a non-deductible personal loss and the accuracy of the appraisal may be questionable.

Question

I was told that in order for full tax benefits for a married couple who own a house together the title for the house must be as community property, not as joint tenants. Otherwise, the IRS will disallow one-half of the increase in tax basis to fair market value at the date of death for one-half of the residence when the first spouse dies.

We have always held our property jointly, but never as community property. Supposedly, this new IRS ruling trumps California Community Property Law.

Could you address this in one of your newsletters?

Answer

This is not a new ruling, but an old one.

There is a difference in the tax basis adjustment after death for spouses for community property compared to joint tenancy. As you said, the tax basis for the entire property is adjusted to the fair market value as of the date of death for community property, but only one-half for property held by two joint tenants.

With the exclusions available for gains from the sale of a principal residence, this isnít as big of a benefit as it once was, but it can still be significant.

This is not a matter of "trumping" California Community Property Law, itís based on old community property law concepts. The rules that apply for property division in a divorce are different.

You and your spouse should consult with an attorney before making a change in title. There are other legal issues involved aside from this tax benefit.

(By the way, the title to my home is community property.)

Question

My elderly parents have deeded a condo to me that I have been renting from them for the past 10 years. Will I pay taxes other than regular property taxes on this?

Answer

Assuming youíre a U.S. person, the receipt of gifts is not subject to income tax. Your parents should file gift tax returns for the transfer.

(Generally I donít favor gifts of appreciated real estate by elderly parents to their children. If a reader is considering making such a gift, be sure to get tax and legal counsel before going ahead.)


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 April 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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