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Archive for September, 2012

If you are one of the 97% of Americans whose home is worth significantly less than when they purchased it, you’ve likely been seeking out some type of debt modification with your lender. Or perhaps things have gotten so bad that you’re contemplating a foreclosure or short sale.

Here’s the thing: anytime a mortgage is modified (i.e., reduced), the borrower is required to recognize cancellation of indebtedness (COD) income under Section 61(a)(12). Similarly, if a property is sold at foreclosure or in a short sale and the underlying mortgage is recourse (meaning the borrower has personal responsibility for any excess loan deficiency remaining after the sale), then to the extent the remaining deficiency is forgiven, the borrower will again recognize COD income.

In the foreclosure or short sale context, this COD income is NOT treated as gain from the sale of the property, and thus is not eligible for exclusion under Section 121 (allowing a $500,000 exclusion for MFJ taxpayers who have owned/used the home as their principal residence for 2 of prior 5 years).

When the sh*t hit the fan in the real estate market in 2006 Congress recognized that something had to be done, as it seemed patently unfair to tax homeowners on COD income when they couldn’t even afford to service the underlying mortgage. And while exclusions to COD income have always existed under Section 108, prior to 2007 those exclusions were only of use to a homeowner if the homeowner were insolvent or bankrupt.

As a result, in 2007 Congress enacted Section 108(a)(1)(E), which provides that a taxpayer that is neither insolvent nor in bankruptcy can still exclude up to $2,000,000 of COD income related to the discharge (in whole or in part) of qualified principal residence indebtedness. This exclusion applies where a taxpayer restructures his or her acquisition debt on a principal residence, loses his or her principal residence in a foreclosure, or sells a principal residence in a short sale.

For these purposes:

  • Qualified principal residence indebtedness is debt that meets the Section 163(h)(3)(B) definition of acquisition indebtedness for the residential interest expense rules but only with respect to the taxpayer’s principal residence (i.e., does not include second homes or vacation homes), and with a $2 million limit ($1 million for married filing separate taxpayers) on the aggregate amount of debt that can be treated as qualified principal residence indebtedness.
  • Acquisition indebtedness includes refinanced debt to the extent the refinancing does not exceed the amount of the refinanced acquisition indebtedness.
  • For purposes of these rules, a principal residence has the same meaning as under the Section 121 home sale gain exclusion rules.

Why do you care? Because as of today, this exclusion is set to expire on December 31, 2012. That means you have to ask yourself: How much do you trust Congress to get an extension done before year end? If you do, then by all means, take your time with your debt modification/foreclosure/short sale efforts. But if you don’t, you might want to get a sense of urgency about getting something done with your bank prior to year end, so you can take advantage of Section 108(a)(1)(e) while it’s here.

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Yesterday, Bloomberg’s Jesse Drucker published a piece detailing Mitt Romney’s use of an Intentionally Defective Grantor Trust (IDGT or “I Dig It” Trust) to pass tens — or perhaps hundreds — of millions to his heirs free of estate and gift taxes.

The story quickly caught the eye of the tax community, including TaxProf and Going Concern, with Caleb Newquist at GC describing the technique as follows:

Basically, it works like this (I’ll try to keep it brief) – A wealthy couple sets up a trust that is separate from their estate to benefit themselves during their lifetimes, but also to benefit their children and grandchildren. They put some assets that are illiquid or have little value into the trust to get things going, that way as Drucker notes, “[the grantors] can claim the gift tax obligation is low or non-existent since the declared value is low or zero.” When a taxable event occurs – let’s say, shares of stock are sold because they’ve appreciated a bazillion percent – the grantor (in this case, the wealthy couple) pays the tax owed but the trust gets the proceeds and can re-invest it from there for the future. Not bad, huh?

Newquist got much of the detail surrounding IDGT trusts from WS+B’s own estate and trust expert Hal Terr, who was quoted throughout the piece on GC:

What Drucker only mentions in passing but was explained to me in a little more detail by estate and trust expert Hal Terr of WithumSmith + Brown, is that “the payment of the income tax liability of the trust reduces the donor’s taxable estate.” In other words, the wealthy couple’s estate will take a deduction for the taxes they paid on behalf of the trust they created, so that the estate taxes owed will be lower after they die. Yep, I know.

When Newquist reached out to Terr, he was primarily concerned with the effect the publicity surrounding Romney’s use of the IDGT trust might have on tax advisor’s use of the technique, since until recently, the trusts had largely flown under the radar. Of specific concern was the following quote in the original Drucker article:

 …According to Stephen Breitstone, a wealth preservation expert that Drucker talked to for his article, all this attention to IDGTs may RUIN everything: Romney “uses every trick in the book,” Breitstone said. “It’s going to be harder to do tax planning in the future. He’s bringing attention to things that weren’t getting attention.”

WS+B’s Terr saw things the same way:

Terr agrees, telling me that “most life insurance trusts are grantor trusts and all those life insurance agents would not be happy if this tax benefit of grantor trusts was removed from the Code,” and “this publicity may help garner support for eliminating the ability of wealthy individuals to take advantage of this estate planning technique.” The crux is, if these strategies get axed, it could make estate planning much more difficult.

In a separate email to me, Terr added that the use of IDGT trusts, whether related to Romney or not, has recently become a target of President Obama:

The Obama administration, in its 2012 legislative proposal, is attacking grantor trusts and wants to eliminate the tax benefit of the grantor paying the income tax liability of the trust.   The IRS is also well aware of the technique of a Sale to a Defective Trust. The general public and Congress may not have been aware of the transfer tax benefit of this technique prior to the release of the Romney returns, however, and this publicity may help garner support for eliminating the ability of wealthy individuals to take advantage of this estate planning technique.   The Romney return is creating exposure to a perceived tax loophole, and if it gets enough attention that support for its closure swells, it would reduce the techniques available to estate planning accountants and attorneys to help clients manage their estate tax liabilities.

This begs the questions: how far will we have to go into the presidential debates before Romney’s use of IDGT trusts becomes a talking point? Once it does, it will become the same useless conversation as the one that surrounds Romney’s effective tax rate, because in using the trust, Romney has done nothing illegal; rather, he’s simply employed shrewd tax planning to minimize his income, estate, and gift taxes. And as I’ve mentioned before, while you may not like it, these are common rich guy solutions to rich guy problems.

Update: in response to Drucker’s article, Josh Barro authored an opinion piece at Bloomberg this morning defending Romney’s use of the trust on the same grounds that I do, stating:

We shouldn’t expect rich people to pass on perfectly legal opportunities to avoid taxes, any more than we would expect middle-class people to do so. And we shouldn’t expect to make transfer taxes work well given their long-standing track record of being ripe for avoidance. We should find a way to tax Mitt Romney, and others like him, without waiting around for them to transfer their assets.

 

 

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There are three things you’ll find in almost annoying abudance in every mountain town: soul patches on the men, dreadlocks on the women, and weed. Lots and lots of weed.

In Colorado, however, you can’t limit the love of marijuana to the denizens of its ski towns. To wit: in Denver — where medical marijuana has been legal since 2000 — there are more dispensaries within the city limits than there are Starbucks in the entire state.

Now, with state tax revenues lagging and criminal justice costs rising, Colorado is turning to an unlikely, albeit logical, solution to its woes: weed for all.

This November, residents of Colorado will vote on Amendment 64, which would legalize and regulate marijuana sales just as it’s done for booze and cigarettes. The goal, quite obviously, is to raise tax revenue. Just how much tax revenue is anyone’s guess:

State analysts project somewhere between $5 million and $22 million a year. An economist whose study was funded by a pro-pot group projects a $60 million boost by 2017.

The cause of the confusion, of course, is because buying recreational marijuana is currently illegal, nobody can be certain what the market for legal weed will be. Muddling matters further, there is no guarantee that those currently buying illegal marijuana would shift their loyalties to legalized outlets. After all, if I learned nothing else from the film “Pineapple Express” — and I didn’t — it’s that the pot smoker-drug dealer bond is a strong one forged through loyalty, trust and PlayStation, and is unlikely to be cast aside so capriciously.

Should the legislation pass — and right now, it looks possible but not likely — it will be fascinating to sit back and watch the state-wide elation greeting free-market marijuana be quickly destroyed by the heavy hand of the IRS. As we’ve discussed before, the Service has used a little known Code section, Section 280E to be specific, to deny all of the tax deductions related to medicinal marijuana dispensaries, effectively taxing the business on 100% of their revenues.

The same section would apply equally to legal recreational sales, because marijuana will remain on the federal controlled substance list, and thus the IRS would be able to wield Section 280E to deny any and all deductions related to “trafficking” in the drug. With a string of recent successes in the Tax Court featuring medicinal dispensaries, the IRS would have a strengthened resolve to pursue recreational sellers of the drug, and likely tax them out of existence.

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After spending three weeks in Aspen as my family’s indentured servants, my parents set off on their return to New Jersey this morning.  And let me tell you, there is no more relaxing, stress-free process than preparing two 70-year olds for a day of air travel. Reminds me of this bit of genius from The Onion:

Dad Suggests Arriving At Airport 14 Hours Early

On the tax front, we here at Double Taxation are determined to keep our comparison of the presidential candidates’ tax proposals as current and accurate as possible. But it’s not always easy. For example, the staple of Mitt Romney’s plan has been the “20% across-the-board” reduction in the individual income tax rates, resulting in a decrease of the top rate from 35% to 28%.

Romney has also promised that his tax cuts won’t increase the deficit, meaning he’ll raise an offsetting amount of tax revenue elsewhere, largely through the reduction of existing deductions and preferences.

As we’ve discussed, once the math-types put these two concepts together, they revealed a couple of glaring holes, the most publicized of which was the notion that the tax rates could not be reduced while remaining revenue neutral without shifting a significant amount — $86 billion — of the tax burden from those earning in excess of $250,000 to those with income below that threshold.

While Romney’s camp continues to question the accuracy of the criticism, they’ve now got a backup plan. According to advisor Kevin Hassett, Romney would rather back off his promised tax cuts then raise taxes on the poor.

If you think the base-broadeners don’t add up, if you think he can’t get to 28 percent, then the right thing that would happen, as you know, if you’re going to have a revenue-neutral reform, is that they would have a different change in rates.

Governor Romney says he can get to 28 percent. He believes he can get to 28 percent. When he’s in office, he’ll try to do it. But if Congress won’t give him the base-broadening he needs to get to 28 percent, there’s no way in hell that anyone believes that he’s going to increase taxes by $2,000 on people with incomes below $20,000. I just can’t believe that the Obama campaign would say that, and that an economist for the Obama campaign would be up here repeating these stupid and inane talking points.

What’s the point? This goes without saying, but simplifying the tax code will not be an easy process. Most experts agree that the optimal tax system is one defined by lower rates and fewer deductions, and that is most certainly not the system we have in place today.

Romney’s proposals are a step in the right direction, but voters need to understand that such an undertaking requires flexibility. The remarks from Romney’s advisor will likely be targeted by Democrats as a sign that Romney is going back on his campaign promises, but to hold Romney to the specific points he set forth in his proposals and not afford him several alternatives to reach the desired result — revenue-neutral tax simplification that maintains the progressivity of the Code — is an unfair reaction that serves only to stand in the way of much needed tax reform.

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Unless you’ve been living in a cave, you likely already know that Mitt Romney created a bit of an uproar when, behind closed doors, he suggested that because 47% of all Americans pay no income tax, they will vote Democratic “no matter what;” the theory being that Romney’s proposals to cut income tax cannot resonate with a group that pays no income tax.

Now, obviously, there’s no way to link tax filings to voter records to test the accuracy of Romney’s statement, but we can learn a bit more about who comprises this tax-indifferent 47 percent. And to that end, the Tax Policy Center’s got us covered with Five Myths About the 47 Percent.

Among the more interesting tidbits:

  • The TPC estimates that of the 47% percent, only 0.1% earn income in excess of $200,000. That would indicate that fewer taxpayers are “gaming the system” than some would have you believe.
  • Rather, the vast majority of people who pay no federal income tax have low earnings, are elderly or have children at home. Furthermore, fewer than half of individuals in households with incomes below $30,000 voted in 2008, compared with about 60 percent of people with higher incomes. And because these lower income taxpayers do — when they vote — tend to vote Democratic, it appears Romney may actually benefit, rather than suffer, from this tax-indifferent — and apparently — election-indifferent — portion of the population.
  • Many of the taxpayers who pay no income tax are not the beneficiaries of Democratic “safety net” legislation, but rather bipartisan efforts to help those in need.  For example, Presidents Ronald Reagan and Bill Clinton both favored the earned-income tax credit (EITC), which has helped millions of families stave off poverty.

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Maryilyn Noz and Gerald Maguire knew the secret to a good marriage: plenty of distance. Noz resided in New York, while Maguire called Sweden — and its bevy of blonde talent — home. Smart man.

Both Noz and Maguire were university professors, and because their areas of expertise overlapped, they jointly published numerous books, chapters, and articles.

In order to collaborate on their published works — and because, you know…they were married — Maguire made eight trips from Sweden to NY during 2006, while Noz returned the favor and made five trips to Sweden. During these trips, Maguire and Noz always stayed together in the host’s apartment, where they worked together on their writing. Their trips were almost all business; for example, when Noz visited Maguire in Sweden, she worked five or six days a week, and when they weren’t collaborating on writing efforts, Noz would work on projects related to her permanent employment as a professor, though it was not required that she be in Sweden to perform those duties.

On their joint 2006 tax return, Noz and Maguire deducted $18,000 in travel expenses related to their trips to see one another as unreimbursed employee expenses. The IRS denied the expenses and assessed a tax deficiency.

Relevant Law:

Pursuant to Section 162(a)(2), a taxpayer may claim a deduction for travel expenses if such expenses are reasonable, necessary, and directly attributable to the taxpayer’s business. If the trip is undertaken for both business and personal reasons, travel expenses are deductible only if the primary purpose of the trip is business.[i] Whether the primary purpose of the trip is business or personal depends on all the facts and circumstances, in particular, the amount of time during the trip that the taxpayer devoted to business and personal activities.

The Tax Court concluded that the trips made by Noz and Maguire were predominately personal in nature, and thus none of the expenses related to the trips were deductible. In reaching its decision, the consideration given the most weight was the most obvious of all the “facts and circumstances:” Noz and Maguire were married. And as a married couple, the trips allowed them to spend a significant portion of the year together, despite living in separate countries.

While the court conceded that Noz and Maguire did in fact work during their times together, much of the travelling party’s time was devoted to work activities unrelated to their research collaboration that did not necessitate overseas travel.

Lastly, as is often the case in situations such as these, substantiation was sorely lacking. Neither Noz nor Maguire offered any details concerning the nature of their research collaboration, the collaborative activities undertaken, their research objectives, or how the travel expenses contributed to the accomplishment of these research objectives. While they both testified that their travel allowed them to collaborate with each other and researchers at other institutions, they did not identify a single one of the other researchers by name, nor did they identify a single meeting with another researcher that took place during any of their trips.

Based on these three damning pieces of evidence, the Tax Court had no choice but to disallow the travel deductions:

On the basis of the frequency of travel, the personal relationship between the petitioners, and the petitioners’ failure to offer any evidence, beyond broad generalities, of how the trips advanced any stated business purpose, we find that the New York-Stockholm trips were motivated primarily by personal concerns. The petitioners are therefore not entitled to deduct the costs of their flights between New York and Stockholm.

The lesson? When travel is motivated by both business and personal reasons, the dreaded “facts and circumstances” test applies. Thus, in order to strengthen your position that the purpose of the travel was predominately business, you must maintain proper documentation not only for the cost of your trip, but for the work performed on the trip; and just as importantly, why the travel was required to perform the work.


[i] Treas. Reg. 1.162-2(b)(1).

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Under the tax law, taxpayers are afforded favorable treatment when instead of selling appreciated property, they “exchange” it for other property; the idea being that the taxpayer has not cashed out its investment in the property, but rather simply changed the form of the investment.

Specifically, Section 1031(a) of the Code provides that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”

Stated simply, a taxpayer recognizes no gain if instead of selling appreciated property, they exchange it for property that is “like kind.” And this, as you can imagine, is where issues arise. What is “like kind” property? The regulations offer scant guidance:

Section 1.1031(a)-1(b) of the regulations provides that the words “like kind” have reference to the nature or character of the property and not to its grade or quality. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class.

This much is clear, however: This like-kind requirement precludes a taxpayer from exchanging real property for personal property, or vice versa.

As a result, over the years numerous court cases have sought to answer the question of whether Property A was “like kind” to Property B by looking to state law classifications. For example, in Commissioner v. Crichton[i], the 5th Circuit determined that a mineral right was real property under Louisiana state law and thus of like kind to other real property. Similarly, in Peabody Natural Resources Co. v. Commissioner[ii], the Tax Court determined that under New Mexico law, coal supply contracts constituted real property interests and were of like kind to the relinquished gold mine.

These decisions have led some practitioners to question whether state law classifications are in fact determinative in concluding whether two properties are of like kind. Last Friday, in PLR 201238027, the IRS clarified that state law classifications, while relevant, are not determinative of whether properties are of like kind. Rather, all facts and circumstances should be considered.

In the Ruling, the IRS presented four scenarios. In each of the four scenarios, similar properties were exchanged for one another. Under state law, however, the properties were classified differently. For example, in Case 1, a natural gas pipeline in State A (constructed along a right of way on real property) that was classified as personal property in State A was exchanged for a State B natural gas pipeline that was  constructed along a right of way on real property and that was classified as real property in State B. (The right of ways associated with the exchanged pipelines in State A and State B are also exchanged.)

The IRS declined to base its decision as to the like kind nature of the properties solely on their respective state law classifications. Instead, the Service looked to certain informative sections of the Code to glean how they classified property as personal or real, specifically, Sections 48, 263A, and 1245:

For example, § 1.263A-8(c)(1) of the regulations provides, in part, that real property includes land, unsevered natural products of land, buildings, and inherently permanent structures. Section 1.263A-8(c)(3) describes “inherently permanent structures” as including “property that is affixed to real property and that will ordinarily remain affixed for an indefinite period of time, such as swimming pools, roads, bridges, tunnels . . . telephone poles, power generation and transmission facilities, permanently installed telecommunications cables, broadcasting towers, oil and gas pipelines, derricks and storage equipment. . . .”

Section 1.48-1(c) of the regulations provides in part, that for purposes of § 1.48-1, the term “tangible personal property” means any tangible property except land and improvements, including structural components of such buildings or structures. It further provides that “production machinery, printing presses, transportation and office equipment. . . contained in or attached to a building constitutes tangible personal property for purposes of the credit allowed by section 38.”  

Finally, § 1245(a)(3) provides that “§ 1245 property” is any property which is or has been subject to depreciation under § 167 and which is either personal property or other tangible property used as an integral part of certain activities, including manufacturing.  

Acknowledging that relying solely on state law classifications could yield absurd results – for example, in Case 1 where identical pipelines are exchanged but their respective states classify them as personal and real property, respectively, treating the properties as not being like kind would make little sense — the IRS concluded the basic nature and character of the property involved should override the state law treatment.

Applying these concepts to Case 1, since both pipelines were inherently permanent structures that were affixed to real property that will remain for an indefinite period of time, they both qualified as real property under the definition found at Regulation Section 1.263A-8(c)(1). Thus, the exchange of one pipe line for the other qualified as a like kind exchange under the meaning of Section 1031.


[i] 122 F.2d 181 (5th Cir. 1941).

[ii] 126 T.C. 261 (2006).

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