Archive for September 28th, 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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