Q:

Subject:  1031 Exchange

Back in 2005 we sold a vacant property and had a gain of $130K and bought a $180K house using a 1031 exchange..  We have had it for a rental for 4 years. 

Due to our financial situation, we have to sell our primary residence at a loss of $40K and move into our 1031 rental house and make it our residence house.
 
Do we have to pay taxes on the original deferred gain on our rental house?    .

A:

Converting a business asset to personal use is not a taxable event, so no tax will be due for the year of the conversion.

However, down the road when you sell this property, you will need to possibly pay tax on some of the gain.  The law was recently changed to require a five year look-back period.  If you occupy the home as your primary residence for a full five years before selling it, you will be allowed to exclude up to $500,000 of profit on its sale.  If you sell the home after less than five years of personal occupancy, the tax free gain will be prorated according to the amount of time it was used as a primary residence.

Your own personal professional tax advisor should be able to explain this to you in more specifics for your unique circumstances.

Good luck.

Kerry Kerstetter

Q-1:

Subject:  Section 179 question

Can the date of purchase be defined as the date placed in service.  If payment is made this year, can it go toward next year’s expense if not placed into service until then?

A-1:

You seem to be confused about when depreciation and Section 179 expensing become available for business assets.  The key date is when the asset is placed into service; so there isn’t actually any choice here.  If you buy a new item this year and don’t actually start using it until next tax year, the only year you could possibly claim Section 179 would be next year.

Your own personal professional tax advisor should be able to explain this to you in more specifics for your unique circumstances.

Good luck.

Kerry Kerstetter

Q-2:

Thanks, but as a practical matter in my business (I sell software to dentists) the docs expense is when they write the check (or when they charge it to their credit card, or when the first lease payment is made.  Nobody comes around to see if it is being used and when it started being used.

So, you are saying they could opt to pay for it in 2008 and not place into service until 2009, therefore taking the deduction in 2009.  This is requested at the end of the year sometimes if the doc has used up as much 179 expense as he has profit for the current year.

A-2:

Normally, this question goes in the opposite direction.  People assume they can prepay for some business asset in December and claim Section 179 even though it isn’t received or set up for use until next year.

As we all know, the tax system has a lot of the “honor system” built into it in regard to people claiming their deductions in the proper years.  However, IRS does occasionally audit tax returns to verify that things have been handled properly.  A canceled check is not sufficient documentation for a piece of business equipment or expensive custom software.  Auditors will demand to see the purchase invoice and will check the delivery and installation dates to see if the year placed in service matches that shown on the tax return.

I have to say that you are sticking your neck out quite dangerously by daring to give tax advice to your customers.  While they may play fast and loose with the technicalities of the years in which they claim their deductions, you run the risk of being sued by them if any of them were to get into trouble with IRS based on any such advice you provide.  The smart thing for you to do is to advise each of your customers to consult with their own personal professional tax advisors who can work out appropriate strategies for when to pay for and deduct the costs of your software.

Good luck.  I hope this helps.

Kerry Kerstetter

Q:

Subject:  2008 Section 179

I found your info on the web. I have a quick question. I am looking at a cap gains tax on the capital account of an LLC which I left in January. The account is about $460,000 and the tax about $69,000.

I am considering starting a property restoration business and the equipment is about $20,000 to $30,000. I might also need a van. If I spend 30,000 on equipment, will that reduce my cap gains tax by $30,000 because I am deducting 100% up to $250,000?

Thanks,

A:

This is something that you need to work on with the assistance of your personal professional tax advisor because it is more complicated than you are assuming.

The first misconception you have is regarding how the Section 179 deduction reduces taxes.  It is a deduction and not a credit; so it reduces taxable income and that reduces the income tax only by a percentage.  It is not a 100% reduction of tax as a credit would be. The amount of actual tax savings will be based on your Federal and State tax brackets, along with several other factors.  So, a $30,000 Section 179 deduction may only reduce your net taxes by only $10,000; not by $30,000.

The other big issue that you need to deal with is the limit on the Section 179 that you can claim based on your business related income. Normal capital gain income does not qualify for the Section 179 purposes, so the gain on your LLC termination can’t be offset against new Section 179 unless it also includes business profit and depreciation recapture.

The best thing to do would be to have your personal professional tax advisor run some pro-forma 2008 figures for you based on the real info you have, as well as the different assumptions you want to test in order to get a realistic estimation of any potential tax savings from buying and starting to use new business equipment before the end of 2008.

Good luck.  I hope this helps.

Kerry Kerstetter

Follow-Up:

Yes very helpful.

Thanks a lot.