Archive for September, 2011|Monthly archive page

Losses on 401(k)s, IRAs, and 529 Plans

Originally published in the Pacific Grove Hometown Bulletin

September 21, 2011

 

The stock market seems like a pinball these days bumping off financial forecasts and being paddled by fiscal policy promises.  Unable to stomach some of the lows over the past few years more than a few people gave up the game and pulled money out of investments seeking the “security” of cash.   Others may have felt they had no choice, and cashed out their retirement savings to live on; some realizing they contributed more money to the plan than they got back!  Perhaps this happened to your retirement or education savings accounts, or will happen at some point.  But can you get a tax deduction for the loss in value you have incurred?

Well, it depends.  The chief determining factor is whether or not you have basis in your account.  Basis in a retirement or education account is created if you make contributions for which you receive no tax deduction when contributed.  For example – Roth-IRA contributions are not deductible when they are made, so the original contribution amount each year adds to your basis.  Education savings through section 529 plans and Coverdell Education Savings Accounts are the same way.   Many employers now offer a Roth contribution option within a 401(k) plan.  These contributions also create basis.

Traditional 401(k), SEP IRAs, SIMPLE IRAs, and traditional IRA contributions provide you with an immediate tax deduction, so they provide no basis.  However, if you were over a certain income threshold and tried to make traditional IRA contributions, you may have been allowed to contribute to the account, but prohibited from taking the deduction.  This is termed a “nondeductible IRA contribution;” it would have created basis; and it is tracked on Form 8606 in your tax returns.

If it is determined you do have basis, and for a strategic reason (or by necessity) you end up liquidating the IRA (all IRAs of the same type must be liquidated for this to work), and the value of the IRA is less than your basis in the account, then you are eligible to take the loss as a miscellaneous itemized deduction subject to the two percent threshold.  If you have more than one section 529 plan, the calculation is a little different.

Liquidating your retirement accounts to get a possible tax deduction is not typically an advisable course of action for many reasons, and you would want to discuss this with your tax professional and investment advisor first.  However, sometimes, this can be a strategic move.  More often, it will have been done out of perceived necessity or by accident.  If it happens, however, you certainly want to make your tax professional aware of your losses and take the deduction if you are eligible.

Two quick examples:  1) Melissa, a parent, starts a 529 account (only has one) and contributes $10,000 towards her child’s future education.  A year later, the investments have fallen, and the account is only worth $6,000.  Melissa could liquidate the account and take a $4,000 loss on Schedule A.  Then she could start a new 529 plan putting the $6,000 back into the plan.  Melissa has just harvested a $4,000 loss. 2) Joseph opened his first Roth-IRA three years ago and contributed $14,000 over the three years.  He received some bum advice from a friend and invested most of it in a penny stock mail-order belly-dancer business that went belly-up.  Joseph’s account is now only worth $1,000.  He could liquidate his Roth-IRA and take a $13,000 loss on Schedule A.

There may be other circumstances and specific rules that affect you, and you should consult with a qualified tax professional regarding your tax situation.  Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950. He can be reached at 831-333-1041.

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Foreclosures and Short-Sales – Part VI – Rental Properties

Originally published in the Pacific Grove Hometown Bulletin

September 7, 2011

The last five issues I went over the basic concepts of foreclosures and short-sales, an overview of ways to exclude the resulting taxable income, the effects of recourse/nonrecourse debt, and principal residence and insolvency exclusions. If you missed these articles they are re-published on my website at www.tlongcpa.com/blog. This issue I will specifically discuss the exclusion typically available for rental properties.

When someone loses real property through short-sale or foreclosure, potential taxable income can result since recourse cancelled debt is taxable income.  As I have discussed in prior issues, there may be ways to exclude this income on the tax return.  With solid, early planning, we may be able to even change the characteristic of a property and drive the outcome to the most tax favorable result should a short-sale or foreclosure occur.  All or part of the cancellation of debt income associated with losing a rental property may qualify for the Qualified Real Property Business Indebtedness exclusion assuming you are not going through a bankruptcy and you are not insolvent, in which case other exclusions take precedence.  Another key issue is whether or not a rental property is a business.  This concept is requisite to use the exclusion.  The courts have a long history of upholding this construct, but the IRS does not always agree, and it comes down to facts and circumstances.

Notice the word, “Qualified,” in the name of the exclusion.  This is a subtle hint that certain criteria must be met to receive this treatment, and is sometimes misunderstood by preparers not well-versed in the governing code sections.  As with other exclusions discussed in past articles, the cancelled debt must have been used to purchase or construct the property, additions, remodels, etc.  If you borrowed against the equity in the property to finance your personal life or to purchase or renovate another property, that portion will not qualify for the exclusion.  There are also limitations on the amount of income that can be excluded relating to the fair market value of the property, basis in depreciable property, and other factors.

The amount determined to be excludable then becomes a reduction of your cost basis in the property (the timing and calculation of this basis reduction is affected by several other factors as well).  This is important, because we also have to calculate a gain or loss when you dispose of the property, and yes, in ugly situations, you can have a gain on sale even if you owe a lot more than the property is worth.  Ouch!  For example, ignoring transaction costs, depreciation, loan payments, etc., assume you bought a property for $250K, refinanced and took another $400K out to live-on as the property value soared to $750K and now it is only worth $350K and is foreclosed.  You have $300K ($650K Debt – $350K Value) of cancelled debt and a taxable gain of $100K ($350K Value – $250K Cost).

When handling one of these transactions, it is a bifurcated process whereby we handle the cancellation of debt issue on the one hand, and the gain/loss calculation on the other.  The two dance a bit, but are generally separate calculations.  The beauty of rental properties, unlike personal residences, is if a loss is generated, it may be deductible, whereas, losses created by the disposition of personal residences are nondeductible.   This is where planning comes in to play.

This is just a summary of some of the key provisions. There are many other circumstances and specific rules that could affect you, and you need to consult with a qualified professional to review your situation. Consult as soon as you can foresee the possibility of losing a home in order to plan the most tax efficient way to lose it.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, Pacific Grove, CA, 93950. He can be reached at 831-333-1041.