Michael Gray, CPA's

Real Estate Tax Letter

January 23, 2013

© 2013 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 preparation materials have been sent.

If we prepared your tax returns last year and you haven’t received instructions or you would otherwise like to receive instructions, call Dawn Siemer on a Monday, Wednesday or Friday at 408-918-3162.

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Make your tax preparation appointment now.

If you would like to schedule an appointment for a tax preparation interview, also please call Dawn Siemer on a Monday, Wednesday or Friday at 408-918-3162.

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W-2s, 1099s and DE 542 reminder.

Remember that most 2012 annual information returns, such as W-2s and 1099s, should be issued to payees by January 31 and sent to the tax authorities by February 28.

Amounts paid using a credit card should not be included on Form 1099. Those amounts are being reported by the merchant companies.

Also remember that Form 542, Report of Independent Contractors, should also be submitted for ongoing independent contractor arrangements by January 20. The due date is the earlier of 20 days after the date $600 or more of payments have been made to the independent contractor or the date a contract has been entered for $600 or more of services during a calendar year.

Although requirements for real estate operators to issue Forms 1099 were repealed, real estate operators that are real estate professionals should prepare them anyway. Some taxpayers who weren’t concerned about qualifying as real estate professionals will want to for 2013 to avoid the Medicare tax for investment income. See your tax advisor for details.

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California withholding for real estate sales increases.

California requires income tax withholding for most real estate sales when the property is located in California. The withholding is reported on California Form 593.

The seller has a choice for withholding: 1) Withhold 3.3% of the gross selling price, or 2) withhold at the maximum tax rate times the gain from the sale.

Since the maximum tax rate for individuals has increased from 9.3% to 12.3%, the form has been updated to indicate 12.3% of the net gain should be withheld.

The withholding is claimed as a payment on an individual income tax return, so an overpayment can be recovered as a refund.

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Michael Gray quoted in San Jose Mercury News.

Michael Gray was quoted in two page one San Jose Mercury News articles, “Impass may put 2012 tax on table” on Friday, December 28, 2012 and “Take-home pay will feel pinch” on Thursday, January 3, 2013.

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Please share your good experiences with Michael Gray, CPA.

As you know, more and more people are going to the internet to find information about service providers. We hope you will share some good words about experiences that you have had with our firm. Some of the sites where you can share your experiences include yelp.com, siliconvalley.citysearch.com, and Google+.

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Congress finally passes “Fiscal cliff” tax extensions.

President Obama signed the American Taxpayer Relief Act of 2012, HR 8, on January 2, 2013. This legislation solves the tax part of the “fiscal cliff” dilemma, but the budget part still remains to be done.

I have written a brief summary of the legislation at http://michaelgraycpa.com/2013/01/02/congress-finally-passes-tax-extenders-including-amt-relief/

Subscribers for the print edition of this newsletter will receive a printout of the summary.

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Tax changes for 2013 mean more emphasis on deferral strategies, real estate professionals.

The maximum federal regular tax rate in the “fiscal cliff” legislation is 39.6% The maximum federal tax rate for long-term capital gains is 20%. (Remember long-term capital gains attributable to accumulated depreciation for real estate are subject to a 28% federal tax rate.) Phase outs of itemized deductions and personal exemptions apply at certain income thresholds. The Medicare tax on investment income for certain high-income taxpayers is 3.8%.

With higher tax rates in general, high-income taxpayers will want to avoid or postpone paying income taxes for sales of real estate, or spread gains to be below the high tax rate thresholds. That means Section 1031 tax-deferred exchanges will become even more popular, and installment sales will be more widely used.

S corporations that pay reasonable compensation can be useful to avoid self-employment taxes.

Real estate professionals that can demonstrate exemption from the passive activity loss limitations may be able to avoid the Medicare tax on rental income by claiming it’s not investment income. In the past, we only were concerned about establishing real estate professional status to avoid passive activity loss limitations. Now, we will also seek real estate professional status to avoid the Medicare tax.

Investing in real estate inside of IRAs, Roth accounts and qualified retirement plans will be favorable in generally deferring or avoiding income taxes for unleveraged real estate investments.

Many of these items are targets for scrutiny by the IRS, so documentation will be critical. Work closely with your tax advisor to prepare in advance for a potential tax audit and litigation.

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Elections briefly available to avoid tax for some 2012 IRA distributions.

The American Tax Relief Act of 2012 includes an election to exclude from taxable income certain IRA distributions received by individuals age 70 ½ or older, up to $100,000. One election is to treat direct distributions from an IRA to a charity made during January 2013 as a 2012 distribution qualifying for the exclusion. The second election is to treat IRA distributions made during December 2012 as qualifying for the exclusion provided the funds are transferred to a qualified charity by January 31, 2013. See your tax advisor for details.

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Payroll tax letter available.

We have prepared a letter summarizing requirements for payroll tax withholding and annual information returns. If you would like a copy, please call Dawn Siemer at 408-918-3162.

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Watch FUTA “credit reduction.”

California is one of the states where a “make up” amount, called a “credit reduction” is due with the year-end federal unemployment tax return, Form 940. The “credit reduction” results from high unemployment claims. For California, the “credit reduction” amount is 0.6% of FUTA wages, effectively doubling the tax.

The credit reduction is reported at line 11 of Form 940 and is computed on Schedule A for Form 940.

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Remember to “reset” payroll on January 1.

Software providers will issue updates including the new payroll tax tables as of January 1, 2013. Be sure you have installed those updates before processing your first payroll for 2013. With the tax rate changes in the new tax law, you will probably need to do these updates more than once this year.

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Interest deduction for land limited to residential amount.

John and Elizabeth Norman bought a house and 9.875 acres of land in Warrenton, Virginia. Their intention was to keep the house and 3 acres and develop the remainder of the land.

They incurred about $1.8 million in debt for the property, and deducted the interest for the mortgage as residential housing interest for 2005 and for 2006 they deducted $86,816 of residential housing interest and $17,951 of investment interest.

The Tax Court upheld the IRS in limiting the deduction to the amount of interest for $1.1 million of residential housing indebtedness, $42,673. The Court said the taxpayer failed to substantiate the allocation of the interest. No actual development was done for the excess land, and substantial renovations were done for the home.

(Norman v. Commissioner, T.C. Memo. 2012-360, December 27, 2012.)

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Taxpayer was not a real estate professional and subject to passive activity limitations.

The Eleventh Circuit Court of Appeals upheld the Tax Court in finding that William Harnett failed to document that he performed at least 750 hours of service relating to his real estate activities in 2003, 2004 and 2005. Therefore, the losses from those activities were subject to the passive activity loss limitations and not currently deductible.

(Harnett v. Comissioner, 2012-2 U.S.TC. ¶ 50,665. November 14, 2012.)

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Self-rental rule partially not applicable for S corporation arrangement.

Francis Dirico leased certain properties to his wholly-owned S corporation.

The Tax Court found that rental income relating to land leases were not passive activity income under the “30 percent test,” and therefore not eligible for the “self-rental rule” allowing an offset of the income against passive activity losses.

The S corporation sub-leased telecommunication towers. Since the income from that activity was a rental activity and not a trade or business, it was a passive activity.

The taxpayer tried to aggregate its properties to determine a net passive activity income or loss. The Court ruled that each “item of property” had to be evaluated for its passive activity income or loss.

(Dirico v. Commissioner, 139 T.C. No. 16, November 13, 2012.)

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Below-market rental to family member didn’t disqualify exchange.

William Adams did a poor job of managing his affairs, including failing to file his income tax return.

The IRS proposed to disallow a tax-deferred exchange that was completed in 2004.

The taxpayer’s son, who had experience in renovating homes, occupied the property that was received in the exchange and cleaned it up. He paid rent for occupying the property of $1,200 per month, which the IRS claimed was below market rent.

The Tax Court found that, despite a below-market rent, William’s intention was for the property to be an investment property, and that it qualified for the tax-deferred exchange.

(Adams v. Commissioner, T.C. Memo. 2013-7, January 10, 2013.)

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Community public access television needs our help.

As you can see below, public access television is a vital part of our educational outreach to various communities. These are usually nonprofit, charitable organizations, like public television stations. Unlike those stations, most of the programming for the public access stations comes from local producers.

This programming includes the local arts, productions by students at local schools, community outreach by churches, independent local producers discussing current social issues, educational programming by local providers like ourselves and much more. In other words, public access television makes a unique, important contribution to the communities it serves.

With the difficult times we are experiencing, many public access stations are facing severe financial challenges, and might not survive without more community financial support. I urge you to consider making a donation to your local public access television station. Here is a link for a list of public access television stations in California: www.communitymedia.se/cat/linksca.htm.

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Financial Insider Weekly broadcast schedule for November and December.

Financial Insider Weekly is broadcast in San Jose and Campbell on Fridays at 8:00 p.m., Pacific Time. You can watch it on Comcast channel 15 for San Jose and Campbell. The show is broadcast as streaming video at the same time at www.creatvsj.org.

Here are the scheduled interviews for January and February:

January 25, 2013, attorney John Hopkins of Hopkins & Carley – “How to promote community giving as a family value”
February 1, 2013, attorney John Hopkins of Hopkins & Carley – “Succession planning for a family business”
February 8, 2013, David Beck, CFP® of Bay Area Planners, “How to prepare for the challenge to families of financing a college education”
February 15, 2013, Professor Patricia Cain of Santa Clara University School of Law, “Tax developments for same sex couples”
February 22, 2013, Professor Patricia Cain of Santa Clara University School of Law, “Estate and gift tax planning for same sex couples”

Financial Insider Weekly is also broadcast as follows:

Back episodes available at https://www.youtube.com/user/financialinsiderweek.

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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Michael Gray regrets he can no longer personally answer email questions. He will answer selected questions in this newsletter. Write mgray@taxtrimmers.com.

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Michael Gray, CPA
2482 Wooding Ct.
San Jose, CA 95128
(408) 918-3162
FAX: (408) 938-0610
Hours: 8am - 5pm PDT Monday - Friday

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