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Michael Gray, CPA's

Real Estate Tax Letter

October 19, 2009

© 2009 by Michael C. Gray
ISSN 1930-0387

A monthly report focusing on tax issues for the homeowner and real estate investor.

Table of Contents

Itís time for year-end tax planning.

Since the year-end will soon be here and holidays and vacations are limiting our availability, now is the time to reserve your year-end planning appointment time. Most of us believe tax increases are ahead, and that the estate tax will be reinstated for 2010. Now may be the time to take steps to avoid increased tax bills later. Call Dawn Siemer on Mondays, Wednesdays or Fridays at 408-918-3162 to make an appointment.

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Financial Insider Weekly broadcast schedule for October and November.

Financial Insider Weekly is broadcast on Wednesdays at 4:30 p.m., Pacific Time. You can watch it on Comcast channel 15 if you live in San Jose or Campbell, California. The show is broadcast as streaming video at the same time at www.creatvsj.org.

Here are the scheduled interviews for the rest of October and November:

October 21, Peggy Martin, CLU, "Long-term healthcare insurance"
October 28, Craig Martin, CFP, "How to outlive your retirement savings"
November 4, Steve Reiss, CPA, "The role of the business valuation specialist"
November 11, attorney Naomi Comfort, "Handling retirement accounts after a death"
November 18, Kathleen Wright, American Red Cross, "Financial preparation for a disaster"
November 25, attorney John Hopkins, "Legacy planning" (Benefits of charitable giving)

Past episodes of Financial Insider Weekly are posted at YouTube. The easiest way to watch them is to go to our web site, www.financialinsiderweekly.com, and click on "past episodes."

Eventually we will offer DVDs of the interviews for sale.

Let me know any ideas that you have for topics or guests. Guests will usually have to be located in or near the Silicon Valley in California.

Hope you can watch or record the show. Please tell your friends about it!

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Follow me on Twitter!

If you enjoy Twitter, please follow me at www.twitter.com/michaelgraycpa. I would especially appreciate retweets of our messages announcing episodes of Financial Insider Weekly.

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First-time homebuyer credit expiring November 30.

The first-time homebuyer credit is a great tax break in the right circumstances. The credit is scheduled to expire on November 30, 2009, so thereís not much time left. Interest rates have been low and home prices have also been low. See my explanation at www.realestateinvestingtax.com/first.shtml.

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IRS allows rollbacks of retirement plan distributions.

Required minimum distributions have been suspended for most qualified retirement plans, including IRAs, for 2009. Since many taxpayers have already taken what they believed were required minimum distributions for 2009, the IRS is allowing taxpayers to rollover or return those distributions without penalty or tax until November 30, 2009. (Rollovers usually have to be completed within 60 days after distribution.)

The IRS has also published sample language that plan sponsors may adopt to stop or continue 2009 required minimum distributions.

(Notice 2009-82.)

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Listed transaction moratorium extended through December 31, 2009.

The IRS has extended through December 31, 2009 its moratorium on collecting penalties for failure to report a "listed transaction" when the tax benefit from the transaction is less than the mandatory $100,000 penalty ($200,000 for taxpayers other than individuals.) These "naughty" items are listed at the IRSís web site.

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IRS regulations say basis overstatement can result in six-year limitations period.

The IRS has issued temporary and proposed regulations asserting that a taxpayer who understates taxable income by reporting a basis overstatement, such as for a sale of real estate, will be subject to a six-year statute of limitations if the overstatement of tax basis results in underreporting more than 25% of gross taxable income. The usual statute of limitations during which the IRS can assert an increased tax liability for a taxable year is three years.

The regulations are contrary to court opinions in Bakersfield Energy (CA-9, 2009-1 USTC ∂ 50,448) and Salman Ranch (2009-2 USTC ∂ 50,528). The IRS is trying to bolster its litigating position with the new regulations.

(T.D. 9466.)

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IRS allows home equity interest deduction for principal mortgage.

The IRS Chief Counsel has approved deducting interest for an additional $100,000 of a loan used to purchase a principal residence to be deductible as home equity debt. This means interest can be deducted for $1.1 million of mortgage indebtedness secured by a residence used to purchase the residence. (Interest for up to $1 million of mortgage indebtedness secured by a residence is deductible as "home acquisition indebtedness.")

Most tax return preparers who comply with the rules for deducting home mortgage interest were already following this procedure. There were two Tax Court decisions that disagreed with it.

(CCA 200940030.)

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Roth canít be an S Corp shareholder.

The Tax Court has found that a Roth IRA isnít an eligible shareholder of an S corporation. The year at issue was 2003. The Tax Courtís analysis was based on legislative history. The IRS adopted Treasury Regulations Section 1361-1(h)(1)(vii) on August 14, 2008, which states, "Individual retirement accounts (including Roth IRAs) are not otherwise eligible S corporation shareholders."

(Taproot Administrative Services, Inc. 133 TC No. 9.)

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Like kind exchanges disallowed.

The 9th Circuit Court of Appeals disallowed two like-kind exchanges because they were structured to avoid consequences resulting from exchanges between related parties. The exchanges violated a rule against "basis shifting." When the dust settled and the exchange was completed, one of the related parties had cash from the sale of its property. The tax-deferred exchange rules generally require that gain is recognized when one of the related parties sells its property received in the exchange within two years after the exchange. In this case, the company that received cash and recognized gain on its side of the transaction had a large net operating loss to offset the gain.

(Teruya Brothers, Ltd. V. Commissioner, CA-9, 2009-2 USTC ∂ 50,624, September 8, 2009.)

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Tax Court develops new threshold for FLP gift planning.

Judge Halpern of the Tax Court has developed a new test in evaluating whether the IRS can attack an estate plan based on lifetime transfers of fractional interests in family limited partnerships (FLPs) or LLCs. According to Judge Halpern, the person who transfers assets to the FLP must have a risk of economic loss for an indeterminate amount of time, depending on the volatility of the investment assets contributed to the entity, before making gifts of interests in the entity. If the test isnít met, the IRS could succeed in attacking the arrangement as a step transaction or indirect gift.

Two 2008 cases asserting this theory were Bianca Gross v. Commissioner, T.C. Memo 2008-221, and Holman v. Commissioner, 130 TC No. 12. More recently, the IRS was upheld by the Tax Court in Roger D. Malkin v. Commisioner, T.C. Memo 2009-212.

Be sure your estate planning team is addressing this new test when developing an estate plan for you using a family limited partnership or LLC.

(Notes from the Clearwater by Owen Fiore, September 7, 2009. www.owenfiore.com.)

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Governor vetoes California tax conformity.

Governor Scwartzenegger has vetoed legislation that would have conformed many of Californiaís tax laws with the Federal tax laws. California has generally not adopted federal tax provisions enacted after December 31, 2004. Not conforming will result in many more errors on California income tax returns and confusion when planning for California transactions, especially for tax practitioners located outside California who donít keep up with the differences between federal and California laws.

The Governor said he vetoed the legislation because it would impose penalties on taxpayers who filed refund claims without a reasonable basis.

(Spidell Publishing flash mail, 10-12-09.)

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Commission recommends California tax changes.

Since California faces problems balancing its budget year after year, partly because of inconsistent revenue from its tax system, a commission was formed to make recommendations for changes to the system. The Commission on the 21st Century Economy released its report on September 29.

These are only recommendations that will be debated in Californiaís state legislature. Governor Schwartzenegger says he supports the recommendations.

The commission recommended:

  • Reduce the personal income tax. Under the proposal, there would only be two tax brackets: 2.75% for taxable income up to $56,000 for joint filers ($28,000 for single) and 6.5% for taxable income over those thresholds.
  • Eliminate the corporate franchise tax and $800 minimum tax.
  • Eliminate the 5% state sales tax, except for gasoline and diesel fuels, over a five-year period.
  • Establish a business net receipts tax of up to 4%. Small businesses with gross receipts less than $500,000 would be exempt from the tax.
  • Create an independent tax dispute forum. At this time, the initial place for hearing tax disputes is the State Board of Equalization, which administers the tax laws. There is obviously a conflict of interest in this forum.

These proposals represent a significant shift for state revenues, so there will be heated arguments on both sides about whether they should be adopted. They could go nowhere.

Eventually, California will have to "face the music" and solve its budget problems.

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Questions and Answers

Question

I am considering short selling a rental house located in California.

I bought it for $145,000 as a private residence in 2001. Then I got married and moved into my wifeís house and we rented my house out.

Since then, I refinanced the house for a total of about $240,000 of debt with an interest-only payment. The rent doesnít cover the monthly payments. Only about $3,000 of the money received from refinancing the mortgage was used to fix up the house.

The house is now worth about $150,000 to $170,000.

If the unpaid balance of the mortgage is cancelled in a short sale, will the cancelled debt be taxable income?

Answer

Possibly. Remember there are other ways to qualify for an exclusion of cancelled debt, including insolvency and bankruptcy. See my article on short sales and foreclosures at www.realestateinvestingtax.com/shortsale.shtml and IRS Publication 4681 at www.irs.gov.

If you donít qualify for an exclusion, the income will be taxable.

Remember to consult with a real estate attorney to be sure the debt will in fact be cancelled after the short sale.

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Michael Gray regrets he can no longer personally answer email questions. He will answer selected questions in this newsletter.

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.

Many other questions relate to short sales and foreclosures. See our article on that subject at www.realestateinvestingtax.com/shortsale.shtml.

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For general tax developments, tax planning ideas, business development ideas and book reviews, subscribe to Michael Gray, CPA's Tax & Business Insight at taxtrimmers.com/subscribe2.shtml.

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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 October 2009 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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