Tax ‘Fairness’ Feud Rages On

New Tax Law Has a Catch: Depreciation Recapture Rate Is Unchanged – This catches a lot of people by surprise.  The 25% Federal tax on depreciation recapture is usually higher than the normal capital gain tax.  It is a crucial issue to evaluate when deciding to dispose of property as a taxable cash-out sale or to do a Section 1031 tax deferred exchange.   

Sleep? Play Golf? Pay Your Bills Late? You May Be a Patron of the Arts – Hidden taxes are literally everywhere.

Lower Capital-Gains Tax Boosts Attraction of Custodial Accounts

 

 

Tax Returns Are For Self Defense

One of the biggest mistakes many people make is assuming that because a sale of assets didn’t result in any taxable gain, that they don’t have to report it on their tax returns, or even file a tax return at all if they didn’t have much other income.  That is a very incorrect and dangerous assumption.

I have seen cases where people have had huge stock market losses and assumed they didn’t need to report the sales on their tax returns.  I have seen cases where people qualified for the tax free residence sales or Section 1031 tax deferred exchanges and assumed they didn’t need to show them on their 1040s.  I have also seen cases where recently inherited property was sold and the heirs didn’t report the sales on their 1040s because they knew that the stepped up cost basis of the property resulted in no net gain.   

In almost all of these cases, the individuals came in for a rude awakening when they received bills for taxes, interest and penalties on those sales from the IRS and/or State tax agencies. This is because the 1099 information that is provided to the tax agencies only provides half of the equation, the gross sales price.  IRS and the States have very efficient document matching programs that compare the gross income items reported on tax returns with the 1099s that have been received.  When items have been left off (or no tax return even filed), they assume that it was unreported income and that the sales price represented 100% profit, and assess taxes accordingly.  They have no information on the cost basis of the assets sold.  If you want them to know that you had a net loss, or qualified for the primary residence exclusion, you must report the sale on Schedule D with your tax return and include that additional information.   

KMK

Certified Exchange Specialist

After a few years of discussion and planning, the Federation of Exchange Accommodators, the professional organization of 1031 exchange facilitators, is kicking off its new certification program.  The first certification exam is scheduled for two months from now, on May 16 in Washington, DC.  There will be 120 multiple choice questions in a two and a half hour testing period.  You can see more details and download an application for the exam on their new special website.    

I’ve already asked Sherry if she is interested in taking the test and she answered just as I had expected.  She hates tests and since her business is already very well established, she doesn’t see the need for some new letters after her name. 

While I have always done very well in tests (acing the CPA on my first try), I doubt that I will be taking it.  I already have more credentials than can fit on my letterhead and more work than I can possibly keep up with.  However, there is an exam scheduled for October 2 in Las Vegas, a place neither of us has been to; so anything is possible.

KMK

Swap ‘Til You Drop

I often hear of people who think doing 1031 (aka Starker) exchanges on real estate is a waste of money because it just postpones and doesn’t actually eliminate the inevitable payment of capital gains taxes.  It is not true that the tax will always eventually be due.   It will be if you end up selling the property before you pass away.  Likewise, if you gift the property to someone else, that person will also receive your cost basis and potential capital gain.

However, if you pass away and leave the property in your estate, all of the accumulated gains are literally wiped off the books.  Your heirs receive the property at a stepped up cost basis of its fair market value as of the data of death.  Because inheritances are tax free to the recipients, your kids can sell inherited property and have no capital gain.  In fact, they often end up with capital losses after counting the selling costs, such as Realtor commissions.  We call this the ultimate escape from taxes.  The phrase we like to use to describe this is “swap ’til you drop.”

This is definitely a big win-win deal for people whose estates are under the taxable threshold.  For those people with estates subject to estate tax, there is room for some tax strategizing in terms of valuations to use on the 706.  Since estate tax rates are higher than capital gains rates, lower values on the 706 generally reduce the overall tax hit.   

There may or may not be a change in this escape from taxes.  The currently phasing in changes to the estate tax is scheduled to eliminate the step-up basis in 2010 and require heirs to carry over the same cost basis as the decedents.  That will only become real if our rulers in DC don’t mess with that law between now and 2010, which is not too likely to be the case.

KMK

1031 Exchanges

I’ve updated the website for Tax Free Exchange Corporation and added some new questions and answers to the FAQ section.

Non-Resident State Taxes

I’ve written a lot on establishing a tax home in a low-tax or no-tax state, such as Texas, Florida, Nevada or Washington. While that kind of step exempts most kinds of investment income from state income taxes, it doesn’t necessarily eliminate state taxes on income that was earned within a taxable state from services rendered or from property located inside that state. Rent income earned from a property located in a taxable state has to be reported on a tax return with that state, regardless of where the owner lives.

Likewise, when property inside a taxable state is sold, a tax return has to be filed reporting the resulting profit, loss or tax deferred exchange that was done. For example, we have helped hundreds of people dispose of high gain real estate located in the PRC and reinvest the proceeds into new properties in low or tax free states. All of the tax on the profits from the PRC properties is deferred and rolled over into the replacement property. If those people ever sell the replacement property and don’t do a 1031 exchange, they will technically have to report the previously deferred gain to the PRC and pay the tax on that. However, there is an element of the honor system in this because if the property is located in another state, the California Franchise Tax Board will literally be out of the loop in terms of knowing anything about the sale, unlike the situation for sales of California property.

Compensation for personal services is a little trickier and depends on how your employer reports it. As this article in the Wall Street Journal discusses, many states have what they call a “Jock Tax” to get their share of income tax from highly paid athletes and entertainers who perform inside the state. Their income for the year has to be prorated between the various states in which they performed and they have to file income tax returns for all of those that have income taxes. While many athletes and entertainers have established Florida as their official tax home, they are still keeping their tax preparers quite busy preparing tax returns for each of the states in which they earned income.

There are tricks that can be used to disguise where the income was actually earned. A good creative and aggressive tax advisor can help set those up.

KMK

1031 Exchanges

Although delayed like kind (aka Starker) exchanges have been legal since 1984, we still come across people every day who are unclear as to how they work. The scariest thing is that many of the uninformed are tax and real estate professionals. Sherry turned me on to this excellent article on the history, rules and procedures for tax deferred exchanges. I have to admit it’s a more complete article than what we have on the Tax Free Exchange Corporation website.

KMK

PRC Shell Game

(This is a little lengthy and, while specifically describing the situation in California, its points are relevant to other states that follow the PRC’s examples.)

In their typical incompetent fashion, the rulers of the PRC have painted themselves into a corner with their budgets. When the dot-com stocks were flying high, the geniuses in Sacramento made the assumption that they would continue to rise in value every year from then until eternity, and then set up new generous government programs to spend that money. When reality hit, the capital gains taxes dried up and the revenues slowed accordingly. However, the spending is still increasing, putting them into a position of having a deficit of anywhere from $16 to $20 billion for the upcoming fiscal year. While this is a mere drop in the bucket for the Feds, California, as with most States, is required by law to have a balanced budget every year. They can’t print money to cover their shortfalls, as can our masters in DC.

Another illustration of how incompetent the PRC rulers are at financial matters is with the few times when the State government has had a budget surplus, which has happened a few times over the past 25 or so years. Rather than hold the excess money over to compensate for future leaner years, they set up an inefficient multi-million dollar program to send taxpayers rebate checks of around $65 each. Then, a year or two later, when they are desperate for money, they have to raise taxes and fees; which is where they are right now. They are playing all kinds of financial tricks to try to get close to a balanced budget, almost every one of which would land a corporate executive in prison for doing the exact same things.

One trick that they are using to get interest free loans from the taxpayers is to force many people to prepay much more in taxes than they will really owe through mandatory over-withholding. Even though much of that money will end up being refunded back to the taxpayers, it will be in a later fiscal year than when the money was received. It’s the same kind of classic shell game that has sent several corporate executives to prison. However, when our rulers do it, it’s considered a work of genius. For those of you not too bored by such minutia, here are the details.

This latest trick that caught my attention was in an announcement from Spidell Publishing that the rulers of the PRC have widened the scope of mandatory tax withholding from sales of California real estate. This subject is something I have been very familiar with since it was first started in the mid 1980s.

During the mid-1980s, as California real estate values were skyrocketing, many people from outside of the state were making a lot of money by buying and selling property. The tax law had always required that they share those profits with the rulers of the PRC by filing Calif. non-resident income tax returns. However, many people didn’t do that, either out of ignorance of the law or just the knowledge that there was nothing that the FTB (Franchise Tax Board) could do to them for not filing.

In what was actually a wise move, the PRC rulers passed a law requiring that income tax be withheld by the escrow companies from sales of Calif. real estate of $100,000 or more by people or companies that had addresses outside the State. The withholding was set at 3.333 percent of the gross sales price. I can still remember the panic this caused among the Realtor community because I was teaching real estate seminars around the Bay Area back then. They were freaking out, calling this a new tax on real estate. I had to explain that it was not a new tax; but a method of motivating real estate sellers to comply with the already existing tax law and file Calif. tax returns to report the sales.

Because the withholding is based on the gross sales price, when the sellers actually file their tax returns and report their net profit or loss on the sales, they normally get part or all of the withheld money back from the FTB. After the PRC blazed this trail, other states, such as Virginia, instituted the exact same kind of mandatory withholding for sales by out of state parties.

The rule had always had some exceptions to the withholding, such as a sales price of less than $100,000, use by the seller as a qualifying primary residence, and if the seller is doing a Section 1031 tax deferred exchange. This latter exception is one I have been very familiar with as part of my duties assisting Sherry in her exchange work. We have handled several exchanges where people disposed of rental properties in the PRC and reinvested the proceeds into properties in other States. We filed Form 597-E with the FTB to have them issue a waiver of the withholding. Overall, I must say that the FTB has been very cooperative with these requests.

Now for the change.

Beginning January 1, 2003, the mandatory withholding rule will also apply to sellers inside California. Escrow companies will be required to withhold 3.333 percent of the gross sales price of any real estate sold for more than $100,000 that was not a qualifying primary residence, and not part of a 1031 exchange, 1033 involuntary conversion or a foreclosure. The only exception to the withholding requirement is if the seller signs under penalty of perjury that there is a loss on the sale. This means that even if there is just one dollar of gain on a sales price of $400,000 (for example), the escrow company must withhold $13,332 and remit it to the FTB within 20 days following the close of escrow. Unlike current law for nonresident real estate withholding, the FTB cannot allow a reduced amount of withholding based on the true gain.

Some tips to deal with this:

Cost Basis

Keep track of the cost basis of your properties. I am constantly asked how much tax someone will have to pay on the sale of a property based on a certain sales price. My very first question is to determine what is the cost basis of the property. Almost nobody knows what the cost basis means; and if they do know what that means, they still have no clue as to the dollar amount. Income and capital gains taxes are calculated on the net profit or loss, not the gross sales price. The cost basis is the most important aspect of determining whether or not there will even be a taxable gain. With this new withholding rule, if you can prove that you are selling for a net loss, you will avoid having thousands of dollars needlessly withheld from your transaction. This is the reason I always give all of my clients a complete detailed depreciation schedule, showing the depreciated basis of all assets. It frustrates me to no end that so many other tax preparers refuse to provide their clients with this valuable information.

Accumulate Losses

I prepare several tax returns for people who have left the PRC, but still have rental properties there. With depreciation and other expenses, these normally generate net losses, with no State income tax. I still prepare California non-resident tax returns in order to show those losses and let them accumulate over several years. By the time the property is to be sold, there is often $100,000 or more of carried forward losses that can be used to offset the gain that would otherwise be taxable to the PRC, including recapture of depreciation. I consider this the long term approach to tax returns. While not required to be filed each year, the documentation of accumulated losses will pay off in the long run.

As I said earlier, you can be sure that other States will copy this trick and start requiring taxes to be withheld from more types of real estate sales by State residents.

Adjust Tax Payments

If you are caught by the mandatory withholding, and you have determined that those additional amounts will be more than enough to cover the tax on the gain from that sale, you should modify your other State tax payments, such as reducing your estimated tax payments or adjusting your W-4 with your employer to have less tax withheld from your paychecks. As I constantly have to remind people, getting a large tax refund is nothing to brag about. It just means that you loaned the government some of your hard earned money at a zero percent interest rate.

KMK

Blinders On

This is really becoming a war between those of us who believe in freedom, capitalism and private property rights and those who support big government and communistic philosophies.

This article by Beverly Goodman from TheStreet.com (supposedly a capitalist website) is wrong in its claim that the estate tax is good for everyone, for a number of reasons.

First is the often used defense of the estate tax that it only affects a small minority of Americans. Such an argument is offensive on its surface. It is nothing short of mob rule and blatant discrimination and persecution of a minority. If it’s okay to do evil things to the richest two percent of the nation’s citizens, why can’t we also justify doing nasty and immoral things to other groups of people that make up a small percentage of the overall population?

Ms. Goodman puts far too much focus on one aspect of the recent change in the estate tax law, the change in the carryover basis for heirs.

As I have advised for decades, the biggest tax saving opportunity is to use the swap ’til you drop strategy when investing in certain assets, such as real estate. Instead of selling property and paying Uncle Sam a chunk of the gain, all of the profits can be rolled over into new real estate without any income tax bite. Savvy real estate investors routinely use Section 1031 (aka Starker) exchanges to accomplish this. While we usually call these tax free exchanges, they are actually tax deferred exchanges. This means that if an investor were to sell off replacement property while alive, all of the cumulative gain that had been deferred previously would become taxable.

However, as I often advise, patience has some big tax benefits. The big payoff is that when a person dies (drops), all of his assets are given a tax cost basis for the heirs of their fair market value as of the date of death. This is called a stepped up basis. This literally wipes out all of the capital gains that accumulated during the decedent’s lifetime. This applies to all assets, not just real estate.

As Ms. Goodman points out, the new tax law will eliminate the stepped up basis as of 2010 and replace it with the same kind of carryover basis that currently applies to assets transferred as gifts. I agree that this is not a good move in terms of reducing taxes. However, retaining the immoral estate tax just to keep the stepped up basis is very short sighted. In fact, as the current law stands, when the estate tax comes back to life in 2011 with a measly one million dollar exemption per person, the stepped up basis won’t also be coming back. Our rulers in DC have to pass another law to reinstate the stepped up basis rule, which is unlikely.

I don’t mean to dump on Ms. Goodman; but she is also wrong to say that we should all support the Federal estate tax because some states will probably raise theirs. I discussed that issue a few months ago, where some states are planning to uncouple their estate tax from the Federal system and make it a stand alone tax because they don’t believe they can survive without that revenue stream. Even if that happens, the state tax will be smaller than the up to 60% that IRS takes.

KMK

Primary Residence Sales

It’s been more than five years since the rules for tax free sales of primary residences were drastically changed. It amazes me how few people are aware of this and are still under the assumption that the old replacement rules still apply. What’s scariest is that many of these people are tax and real estate professionals who are spreading their ideas as if they are legitimate.

I’m doing my part to keep people up to date. I will be giving a mini-seminar to a real estate office in Fayetteville on Wednesday to discuss the rules for primary residence sales and for Section 1031 (aka Starker) tax deferred exchanges. In preparation for this, I have expanded my analysis of the residence sale rules.

We are planning to tape the seminar and if everything works properly, we will make copies available on CDs and cassette tapes for purchase. It’s been a few years since we have recorded a seminar and it will be good to have a more current one available.

KMK