Archive for the ‘section 121’ Tag

Relief if You Paid Tax on a Short-Sale 2011-2013

Originally published in the Cedar Street Times

February 21, 2014

Hopefully we are nearing the end of the short-sale and foreclosure saga that has continued since 2008.  My litmus test based on tax return filings is indicating that things are much closer to being back on track.  Prior to 2008, it was all about 1031 exchanges.  Those turned off like a faucet when the markets crashed, and then short-sales and foreclosures took center stage.  I have seen those tapering off over the last couple years, and I am starting to see 1031 exchanges again.  The cycles continue!

But before we leave short-sales and foreclosures in the dust, there is a possible silver-lining handed down by the IRS and FTB in the last few months.  Taxpayers that generated income tax as a result of a short-sale in California on their principal residence, retroactive to January 1, 2011, may be entitled to a refund.

California Code of Civil Procedure Section 580b has been dubbed California’s “anti-deficiency laws” for years.  It had a positive effect on homeowners because it basically said if you had never refinanced your home and you lost it in a short-sale or foreclosure that you could not be pursued for the balance you still owed (the deficiency), and the remaining debt would not be taxable income to you because the debt was considered nonrecourse debt.

This, however, left many people out in the cold that had refinanced.  Suddenly, it was a different ball game if you had done a refinance (and who didn’t during the run of good years up through 2007!?), and the debts were then allowed by lenders to be treated as recourse debts and they could pursue your personal assets.  Alternatively they could cancel the debt if it was not worth pursuing, leaving you with taxable income for the amount cancelled.

Congress stepped in (and California generally conformed) during the housing crisis and enacted favorable legislation which said you could exclude cancellation of debt income generated by your personal residence.  The catch, however, was that the debt had to be “qualified debt.”  In short, if you lived off the equity in your house by refinancing to pull cash out and did anything with it other than improve the property, then you were not eligible for the exclusion on that portion and would still have to pay tax.

Then, a few years ago, California passed Senate bills 931 and 458 which were codified into law as California Code of Civil Procedure Section 580e as of January 1, 2011.  This resulted because some unscrupulous lenders were entering into short-sale agreements to allow sellers to go through with the sale of their property for less than the amount owed to the bank, but then still pursuing the seller for the remaining debt after the fact (often a big surprise to the seller).  California’s enactment of this law was good news for homeowners because it basically said, even if you had refinanced, but had entered into a short-sale agreement with a lender, then you could not be pursued for the remaining balance owed and that lenders would basically have to cancel the debt.  Of course, cancelling the debt could mean tax was owed, but that was still better than being pursued for the remaining balance!

Finally, in November 2013 a letter from the Office of the Chief Counsel at the IRS written to Senator Barbara Boxer, due to an inquiry from her, stated that the IRS would treat any debt pursuant to California’s 580e as nonrecourse debt!  The Chief Counsel’s office at California’s Franchise Tax Board followed up with their own letter a month later saying they will conform to the IRS interpretation.

This means that anyone who filed a tax return in 2011 or 2012, or even this year, and reported cancellation of debt income related to the short sale of a principal residence, should consider filing an amendment for a possible refund.  It is still possible to have income tax, primarily if you did not live in the house for two of the last five years prior to your short-sale.  The reason is that when a home is disposed of with nonrecourse debt, the total amount of debt outstanding at the time of the short-sale becomes the sales price of the home.  You then subtract your cost basis, and the difference is your gain on sale.  However, if you lived in the home for two of the last five years, then you get a $250,000 gain exclusion for filing as a single status, and $500,000 gain exclusion if married filing jointly, pursuant to IRC Section 121.

You need to act on this during the next year if your short sale was in 2011 as the statute of limitations expires three years after filing.

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 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Home Office Part I – New Option for 2013

Originally published in the Cedar Street Times

July 26, 2013

In January, the IRS issued Revenue Procedure 2013-13 which discusses a new option for calculating the home office deduction.  (You may want to clip this article and put it in your tax file as a reminder.) Instead of tracking the actual expenses of operating your home office such as water, utilities, garbage, repairs and maintenance, depreciation, etc., you can now elect a safe harbor $5 per square foot of qualified office space, up to 300 square feet ($1,500).  It is kind of like taking a standard mileage deduction on your car instead of tracking gas and repair receipts, and calculating depreciation expense.  Unlike vehicles, however, you can switch methods back and forth from one year to the next.

There are a few interesting provisions that will make it a good option for some people, and a bad option for others.  In other words, when preparing your return you will need to analyze the short and long term impacts, and determine which method is best each year. Since the $5 per square foot figure is not adjusted by region or for inflation, individuals living in high cost states like California are at a disadvantage.

If there is more than one person in the house, such as a spouse or roommate, they can each use the safe harbor as long as they are not counting the same space.  If one person has more than one office in the home for more than one business, the person can either use actual expenses for all the businesses, or the person must use the safe harbor for all the businesses.  However, the maximum deduction allowed is still $1,500 for all the businesses in the home combined, which may have to be allocated pro rata to the businesses based on square footage used by each. If one person has qualified home offices in more than one home, the person can use the safe harbor for one home, but must use actual expenses for the other home.

When claiming the safe harbor deduction, you are allowed to take your property taxes and mortgage interest in full as itemized deductions on Schedule A as well as claiming the safe harbor deduction.  On the surface this sounds like a plus, but for self-employed individuals you are effectively converting expenses that used to be on your Schedule C reducing self-employment taxes to itemized deductions which do not reduce self-employment taxes, and perhaps do not even reduce income taxes if you do not itemize.

Another big difference when claiming the safe harbor deduction is that no depreciation expense is allowed to be taken.  Traditionally, any depreciation expense taken on your home is required to be recaptured at the time you sell your house, and you must pay tax on it.  Even the section 121 exclusion ($250,000 tax-free gain for single/$500,000 for married couples) when living in the house for two out of the last five years will not exempt you from recapture taxes.  Occasionally that can produce negative results, but it is usually helpful because it often helps people avoid income AND self-employment tax which are typically higher than recapture rates.  Nonetheless, I regularly see tax returns where no depreciation was taken on a home office, to “avoid recapture.”  This is incorrect as recapture rules require you to recapture any depreciation “allowed or allowable.”  It does not matter whether you took the deduction or not, you are technically still on the hook for the recapture.

One other notable exception in the 15 pages of new rules explaining the safe harbor is that carryover expenses are not allowed for safe harbor years.  Ordinarily, if your business produces a loss, you are not allowed to create a bigger loss from business use of home expenses with the exception of the portion of mortgage interest, property taxes, or casualty losses which would have been allowed as itemized deductions even if you had no business.  The rest of the expenses get carried over to future years until you make a profit and can use the losses.  Using the safe harbor, any loss generated by the safe harbor disappears forever.  You would be better off in these years using actual expenses in order to preserve the losses for the future.

At the end of the day, you might as well just continue to track the actual expenses, and let your tax professional figure out which method will give you the best benefit each year.

In two weeks, we will go over the basic requirements in order to claim a home office deduction.

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 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Sale of a Residence After Death – Part II

Originally published in the Cedar Street Times

April 5, 2013

Two weeks ago we discussed the sale of a personal residence after someone passes away when held as joint tenants or community property.  We also discussed the concept of a cost basis step up (or down) to the current fair market value at death as it relates to joint tenancy, community property, and tenancy in common.  If you missed this article you can find it on my website at www.tlongcpa.com/blog.  This week we are going to discuss what happens when a sole owner or tenant in common passes away and the house or fractional interest in a house goes to their trust or estate.

Often children are tasked with figuring out what to do with mom or dad’s house after the second spouse passes.  Names like executor, executrix, and trustee get thrown around and sometimes you get to know your accountant and attorney better than if you had gone on a fishing trip together!  After death, the house typically become part of the estate if there was no trust in place, and if there was, then it becomes part of an irrevocable trust that has the task of winding up affairs and distributing the assets to the beneficiaries (or trusts for the beneficiaries).

If the surviving spouse held the house as a sole owner or in his or her revocable trust before death, the house receives a full step-up (or down) in basis to the current fair market value at death.  If the house is distributed outright to a beneficiary (or beneficiaries) and then the beneficiary immediately sells the home, you often will have a loss due to the real estate commissions and other sales expenses (or perhaps even a market decline between date of death and the sale as we saw so often over the past five years).  This loss, however, will generally be a nondeductible personal loss unless you first convert it to a rental property, and then sell it later.

If, however, it is decided the house needs to be sold while it is still in the estate or trust in order to pay debts or to distribute the proceeds to various beneficiaries, you may have a case to take a deductible loss on the sale of the property (which would offset other taxable income in the estate or trust, or perhaps flow through to the beneficiaries reducing their personal taxes).  Fair warning, the IRS and the courts disagree on this issue!

The IRS has taken the position that even a trust or estate cannot take a loss unless it is a rental property or converted to a rental property and then sold.  However, this conflicts with some of the instructions they provide regarding capital assets held by trusts and estates. The courts, on the other hand, have held that a trust or estate does not hold personal assets, and thus is allowed to take a loss on the sale of what used to be the decedent’s personal residence as long as no beneficiaries live in the property in the interim.  There are other issues to consider here, but in the right circumstances, strategic planning could create some large tax savings.

If a tenant in common passes away, his or her ownership percentage receives a step in basis to the current fair market value and the interest flows through to the estate or trust.  Similar results would occur as those just discussed for sole owners.  It is less common to find someone holding a personal residence as a tenant in common, especially with unrelated people.  It also comes with other, more complicated issues, since fractionalizing ownership in a house diminishes the value – basically, who wants to buy a house with other people you don’t know?  In all cases after someone passes away, date-of-death appraisals are requisite, and you may need specialized appraisers for fractional interest properties.

This really just scratches the surface of the issues you can encounter, and it is always best to find a CPA and attorney team that is equipped to handle these issues appropriately.

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 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Sale of a Residence After Death – Part I

Originally published in the Cedar Street Times

March 22, 2013

When a living individual sells a personal residence that results in a gain, many people are familiar with the rules which may allow an exclusion of the taxable gain of up to $250,000 ($500,000 if married filing joint) if the taxpayer lived in the property two out of the last five years as his or her primary residence.  In the depressed real estate markets over the past few years, many people have also learned (sometimes to much dismay) that a loss on a personal residence is not deductible.

But what happens when a house is sold after someone passes away?

The first thing we need to do is determine the cost basis.   At the date of death, the cost basis of the property changes to whatever the current fair market value (FMV) is (an appraisal is required – not a market analysis by a real estate agent).  If the house is held in joint tenancy or tenancy in common, only the decedent’s share of the home gets a step up (or down) in basis to the current FMV, and the basis for the survivor’s original share does not change.

If, however, it is held as community property, the entire interest in the house gets a step in basis to the current FMV.  If the property is held “with rights of survivorship” then the house passes immediately to the survivor which in turn inherits the new stepped up (or down) basis of the decedent to add to his or her own basis-in the case of joint tenancy or tenancy in common, or he or she takes the new FMV as the new basis if it was community property.

When the property is sold, the survivor reports the sales price less the new basis and selling expenses.  If it was sold soon after death, the survivor often realizes a loss due to sales expenses if they got a full step-up in basis (albeit nondeductible if maintained as a personal residence).  If the survivor realizes a gain, then, the survivor is eligible for the $250,000 exclusion assuming he or she meets all the normal rules.  If it was a spouse that passed away, then the widow or widower would have two years from the date of death to sell the house and still be eligible for the $500,000 exclusion.

In two weeks we will discuss the more interesting scenarios that play out when the property is not held “with rights of survivorship” and the property goes to the individual’s estate or trust, such as is often the case at the death of a single individual or the death of the second spouse.

Remember, it is always best to seek competent advice as everybody’s tax situation is unique and there are more rules that could affect you than just those mentioned in this article.

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 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Foreclosures and Short-Sales – Part IV – Primary Residence

Originally published in the Pacific Grove Hometown Bulletin

August 3, 2011

The last three issues I went over the basic concepts of foreclosures and short-sales, an overview of ways to exclude the resulting taxable income, and the effects of recourse/nonrecourse debt. 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 available to people losing a principal residence.

Due to the tsunami of defaults anticipated when the markets began to fall in late 2007, Congress enacted the Mortgage Forgiveness Debt Relief Act  on December 20, 2007 which resulted in an additional exclusion in IRS Code Section 108 trying to help people going through short-sales, foreclosures, or mortgage reductions on a principal residence. There is a lot of incomplete and incorrect tax advice that floats around regarding this exclusion – not only from water-cooler talk and media blurbs, but from ill-trained tax preparers as well.

As discussed in my previous articles, cancelled debt on recourse loans is taxable income to you. The Qualified Principal Residence Indebtedness exclusion allows you to exclude the resulting income if the home was your principal residence (you can only have one and it is determined by facts and circumstances) subject to limitations. One of the common oversights is not understanding that only “qualified” debt is eligible for the exclusion. Generally speaking, this is the original debt to purchase or construct the property as well as debt subsequently obtained to improve the property (such as additions or remodels). If you refinanced your home to get cash out, and used the money for a new car, vacations, for a down payment on another home or rental property, education, to pay down other debts, or to pay your living expenses or even the mortgage on your home, or anything else – none of this is qualified for the exclusion. Yikes! In addition there are different Federal and California limits for how much qualified debt you can exclude. Any amount you cannot exclude will be taxable as ordinary income to you unless you can qualify for another exclusion.

Any amount you can exclude reduces your cost basis in the home. When the home is sold or the bank forecloses, you also have to calculate your gain or loss on the disposition. If you bought the home shortly before prices fell significantly, chances are that even with the basis reduction, the sales price will be less than your cost basis resulting in a nondeductible personal loss. (In a foreclosure the “sales price” is the fair market value of the home when foreclosed.) In cases where the calculation results in a gain, you may be able to exclude the gain, or part of the gain per Section 121, if you lived in the home for two out of the last five years.

If your loan was nonrecourse, you do not have cancellation of debt income, but you still have to calculate the gain/loss on disposition. Unfortunately, the “sales price” in these cases is the amount of debt outstanding when the home was disposed – and not the low, actual sales price (or fair market value if foreclosed). This can create taxable gains, but Section 121 may help you here as well.

This is just a summary. 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.

If this exclusion does not help you completely, you may be eligible for the insolvency exclusion – next issue’s topic!

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.