Q-1:

Subject: Salvage / Basis Reduction; Special Depreciation

Hi Kerry,

I can’t express how much I have appreciated all the knowledgeable responses you have posted. Hope you can answer my questions.

I have been taking a stronger interest in my financial affairs. I recently reviewed my taxes and am attempting to educate myself on the in and outs of the 1040. My question is in regards to Depreciation. My former accountant made a few decisions that I am unclear on. I own two rental houses and a R.V. He listed my rental houses as residential throughout my return except on form 4562 where he depreciated them under classification (i) Nonresidential real property, which is depreciated over 39 years (MM S/L) as opposed to classification (g) which is subject a 27.5 year schedule. He also placed $50,000 of the $200,000 Cost / Basis (purchase price) under Salvage / Basis Reduction, which reduced the Depreciation Basis to $150,000.

For my R.V. which I purchased in 2002 he placed almost $17,000 above the purchase price in the Special Depreciation Allow column, which increased the Cost / Basis by that same amount but reduced it Deprecation Basis back down to the purchase price. Then in subsequent years he used the larger Cost / Basis figure as the Deprecation Basis.

I no longer work with him, but I just wanted to ask him some informed questions about my return.

Thank you in advance for your time,

**Please note that you have my permission to reword or break my questions into multiply post. In fact, I would appreciate it if you would not use my actual figures but rather replace them with any figure you deem appropriate of useful. Thank you again for providing such a valuable service.

A-1:

These are really questions that you should be going over with your new tax advisor. In fact, it would a good item to use in screening potential new tax pros; having them review your depreciation schedules and explain to you what happened and what they would do about it. You can compare their responses to mine below.

If the properties are residential, it sounds like a computer coding error, if the 39 year life was used instead of the proper 27.5 years. The net effect for the prior years wouldn’t be enough to justify going back and filing amended tax returns. However, from this point forward, I would start using the correct 27.5 year life.

There are several methods used to determine the value of the non-depreciable land to set up as the property’s salvage value. Your prior accountant may have a standard percentage of the total purchase price that he uses or he may have used the percentage from one of your property tax bills. If you think that you have a better more accurate way to calculate this, use it and change the salvage value from this point forward. Again, this is too minor to justify filing amended tax returns for previous years.

On the RV, if you look on the 4562 and detailed depreciation schedule attached to your 2002 1040, you should see the $17,000 of first year bonus depreciation. This number is simply being carried forward by the tax software and is standard procedure. Most tax programs prepare detailed depreciation schedules that reflect the historical amounts for each item. There shouldn’t be anything to be concerned about, unless there was no bonus depreciation in 2002, and your most recent tax preparer didn’t also prepare 2002 and made a mistake when entering carryover assets into his tax program.

It sounds as if you are not reading the depreciation schedule properly. The actual depreciable basis of the RV should be the purchase price less the bonus depreciation and any Section 179 that was claimed. Again, your new (or potential) tax preparer should have no problem deciphering the schedules and explaining them to you, including any changes that need to be made. S/he will need to see the actual printed schedule rather than rely on your narrative of what it says.

I hope this helps.

Good luck.

Kerry Kerstetter

Q-2:

Kerry,

Thank you for your incredibly quick and informative response. I learned more in reading your email than I have in hours researching on the internet and speaking with accountants!

Unfortunately, my accountant made few large errors in my 2003 return. He forgot to include $11,000 in interest payments on my house and he forgot to include my CA state tax paid. I also reviewed the depreciation schedule for my RV in 2002 and he did in fact add the $16,950 bonus deprecation to the cost basis (so my depreciation is based on an inflated figure).

Anyways, I’m relieved to know that I can switch my depreciation schedule for my rental properties to 27.5 years. Do you think I should file amended returns for the $11,000 interest and CA state tax that was left out?

Thank you in advance for your time. I know you must have a million emails to respond so I understand that if in the process of allocating your time you are unable to respond. Please note that I really appreciated your useful advice and I will not take any more of your valuable time.

Regards,

A-2:

Financially, depending on your tax brackets, going back to pick up $11,000 of missed interest expense could very well be worth it to you. You have three years after the return to file it, and you are earning 8% interest on the refund all this while, so there is no immediate rush to do this.

However, you need to consult with your new personal tax advisor as to the climate in your area regarding IRS’s processing of amended returns requesting refunds. As I have written about over the past few years, they had been automatically initiating full blow audits on all amended tax returns claiming refunds. From isolated reports from some tax pros around the country, IRS seems to have eased up on this in the last few months; but your new tax pro should be more up to date on this for your specific area and IRS Service Center.

I hope this helps.

Good luck.

Kerry Kerstetter

Q:

Subject: Sale of home question

Hi Tax Guru,

Found your website while browsing for an answer to my question about a sale of a home I own with my parents. Here’s the situation:

Here are the circumstances:

My brother and I own a property with my parents. We are all on title as joint tenants (1/4 undivided interest to each of us and 50% undivided interest to my parents). The house was bought in 2000, my parents supplied the down and my brother and I have payed for the mortgage and taxes since. We’ve split the deductions every year between the two of us. My parents have used this as their primary residence since 2000 while my brother and I do not. We have considered it our 2nd home as we each own our own primary residence. We are now interested in selling the home and are wondering what is the best way to reduce the tax implications for everyone. I estimate the capital gains on the home to be approximately 300K.

Since my parents use it as their primary residence, would they be able to “claim” all the capital gains (300K) or do the gains have to be divided equally among the 4 owners? If it has to be divided, is there any way to get off the title so that my parents can take advantage 500K exemption without triggering gift tax consequences for my brother and I? Any suggestions on how we can either structure the title or the sale such that taxes are minimized for all parties? My parents income is low while my brother and I are in much higher brackets if we had to pay taxes.

Appreciate any insight you might have on mitigating the tax burden.

Thanks very much!

A:

This is an issue that you all really need to work on with the assistance of an experienced professional tax advisor because there are a number of ways in which it can be handled and several factors that need to be considered, such as the following.

It is obvious that your parents can qualify for the Section 121 tax free exclusion of the gain on their one half of the home’s net gain. The gain on the half that you and your bother own is a much more complicated issue.

Let me address the gifting option. You and your brother could gift your shares of the home to your parents. However, this would require you both to file gift tax returns to report it and either pay gift tax or use up part of your million dollar lifetime exclusion. Your parents would assume your cost basis in the 50% of the home they are given and would essentially be accepting full responsibility for your and your brother’s gain.

The half of the home that your parents are given will not qualify for the Section 121 tax free exclusion because the law requires the seller to both own and occupy it is their primary residence. While your parents have obviously met the occupied test, they would fail the ownership test and would thus be required to report the gain on their “new” 50% share as taxable long term capital gain (LTCG). Because they had been using all of the home for personal purposes, its sale cannot be structured as a Section 1031 like kind exchange, which is only available for business and investment property.

If you and your brother keep your share of the house, the gain is potentially taxable, depending on how you and he are classifying its ownership, which should be consistent with how you have been reporting the deductions for interest and property taxes on your 1040s.

If you have been treating the home as investment property, you can structure your disposal of your share of the home as a Section 1031 like kind exchange, which will require you to use the services of a neutral third party facilitator to reinvest the proceeds into new (to you) business or investment property within 180 days. These rules are all explained at tfec.com.

If you have been reflecting that you have been personally using the home, it will not qualify for Section 1031 and you will have a taxable LTCG.

You and your brother don’t necessarily have to report this in exactly the same way. The strategy for each of you and your brother could be different depending on your unique situations. For example, one of you may qualify for a Section 1031 exchange, while the other may not.

The actual tax hit on any taxable gain could be spread out over several years under the installment method if part or all of the sales price is carried back. Your personal professional tax advisor can show you how that would work with your numbers and sales terms.

I hope this gives you some idea of the various details that you all need to be evaluating with your personal professional tax advisors.

Good luck.

Kerry Kerstetter