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Posts Tagged ‘interest’

My father-in-law came to visit this week, and over Friday night pizza, the conversation turned to politics; specifically, Mitt Romney’s much-ballyhooed 13.9% effective tax rate in 2010.

Being a tax guy, I wanted my father-in-law to understand exactly why Romney’s rate was so low given his $21,000,000 of AGI, which required a primer on the taxation of carried interest. [For your own primer, click here.]

As the discussion advanced, my father-in-law understandably struggled to understand why the profits received by private equity fund managers on their carried interest were taxed any differently than, say, the wages he earned over his 40-year career working for an insurance carrier.

Even after I advanced the standard arguments for a 15% rate on carried interest — the equity fund manager’s risk, the uncertainty of the profit stream, the “sweat equity” element, etc… — my father-in-law’s opinion remained blissfully simple:

“It still sounds like compensation to me.”

Now, my father-in-law is a staunch Republican in every way, shape and form. But yet, he failed to see how a 15% tax rate is justified on the income received by fund managers to do what they do: manage funds. Of course, my father-in-law is not the final arbitrator on such matters: after all, this is the same man who once advised me to buy a house located squarely within the Delaware River’s floodplain.

So perhaps you should decide for yourself. To facilitate your decision-making process, the Wall Street Journal has published this point/counterpoint on the carried interest tax issue, with Michael Graetz, a professor of tax law at Columbia Law School, arguing for carried interest to be taxed as ordinary income, while David Tuerck, executive director of the Beacon Hill Institute and a professor and chairman of the economics department at Suffolk University in Boston, argues that the preferential capital gains rates should be preserved.

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In a case with damaging implications for wealthy gay and unmarried couples, the Tax Court held yesterday that the $1,100,000 limitation on mortgage debt for purposes of determining deductible interest expense must be applied on a per-residence, rather than a per-taxpayer basis.

As we discussed in a previous post, I.R.C. § 163(h)(3) allows a deduction for qualified residence interest  on up to $1,000,000 of acquisition indebtedness and $100,000 of home equity indebtedness. Should your mortgage balance (or balances, since the mortgage interest deduction is permitted on up to two homes) exceed the statutory limitations, your mortgage interest deduction is limited to the amount applicable to only $1,100,000 worth of debt.

Now assume for a moment that you and your unmarried girlfriend/lifemate/Japanese body pillow go halfsies on your dream house, owning the home as joint tenants. And assume the total mortgage debt — including a home equity loan of $200,000 –is $2,200,000, with each of you paying interest on only your $1,100,000 share of the debt.

Are each of you entitled to a full mortgage deduction — since you each paid interest on only $1,100,000 of debt, the maximum allowable under Section 163 — or is your mortgage deduction limited because the total debt on the house exceeds the $1,100,000 statutory limitation?

The answer, according to the Tax Court, is the latter. In Sophy v. Commissioner, this issue was surprisingly addressed for the first time in the courts (it had previously been addressed with a similar conclusion in CCA 200911007), with the Tax Court holding that the $1,100,000 limitation must be applied on a per-residence basis.

Thus, in the above example, even though the joint tenants each paid mortgage interest on only the maximum allowable $1,100,000 of debt, each owner’s mortgage interest deduction is limited because the maximum amount of qualified residence debt on the house — regardless of the number of owners — is limited to $1,100,000. Assuming the joint tenants each paid $70,000 in interest, each owner’s limitation would be determined as follows:

$70,000 *  $1,100,000 (statutory limitation) = $35,000

                 $2,200,000 (total mortgage balance)

Instead of each owner being entitled to a full $70,000 interest deduction, the mortgage interest deduction is limited for both because the total debt on the house exceeds the statutory limits. The court reached this conclusion after examining the structure of the statute and determining that the plain language required the applicable debt limitation to be applied on a per-residence basis:

Qualified residence interest is defined as “any interest which is paid or accrued during the taxable year on acquisition indebtedness with respect to any qualified residence of the taxpayer, or home equity indebtedness with respect to any qualified residence of the taxpayer.” Sec. 163(h)(3)(A) (emphasis added).

The definitions of the terms “acquisition indebtedness” and “home equity indebtedness” establish that the indebtedness must be related to a qualified residence, and the repeated use of the phrases “with respect to a qualified residence” and “with respect to such residence” in the provisions discussed above focuses on the residence rather than the taxpayer.

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On Wednesday, Facebook filed S-1 documents in advance of its initial public offering,  in which the web giant seeks to raise a cool $5 billion. And while the bulk of the 300 pages serve primarily to sicken readers with the realization that hundreds of 20-somethings will become overnight millionaires simply for designing a place for people to share baby pictures and take joy in how much weight their exes have gained, there are some interesting tax tidbits to be gleaned from the filing:

  • Despite recognizing $1.7 billion in pre-tax book income in 2011, Facebook anticipates that it will generate a net operating loss (NOL) in 2012. How is that possible? Through its employees’ exercise of nonqualified stock options, that’s how.

 After the IPO, hundreds of millions of shares of NQ options previously granted to employees are expected to be exercised. As a reminder, these forms of compensation are generally not taxable under I.R.C. § 83 until exercise, provided that the stock is freely transferable and not subject to a substantial risk of forfeiture at that time. If these requirements are met, upon exercise the employee must recognize income equal to the excess of the FMV of the stock over the exercise price, with the employer getting a corresponding deduction.

 Assuming Facebook stock reaches a price of $40 per share on the open market, the corporate deduction related to the exercise of employee options will be in the billions; large enough not only to enough to wipe out the comany’s 2012 taxable income, but also –according to the prospectus — to generate an NOL that will be carried back to generate $500 million in tax refunds.

  • Because the income recognized by employees upon the exercise of NQ options is taxed as compensation, Facebook is anticipating using a good portion of the $5 billion in proceeds raised from the IPO to pay its required tax withholding obligations.
  • In addition to its public offering, the prospectus indicates that CEO and Founder Mark Zuckerberg will also sell a significant amount of his common stock to the public. Why would he do it? To pay a tax bill.

In the most startling information contained in the S-1 comes the news that Zuckerberg will be exercising options to purchase 120 million shares of Facebook stock after the IPO. These shares have an exercise price of 6 cents per share, so if the stock price reaches $40 per share as anticipated, Zuckerberg stands to make $4.8 billion in compensation upon exercise. That’s right…billion. The tax bill on that $4.8 billion — between federal and California — could reach nearly $2.0 billion, so Zuckerberg will have to sell additional shares to generate some cash. Needless to say, collecting state income tax of this magnitude from Zuckerberg and other Facebook employees could provide a temporary reprieve to the long-struggling California economy.  

  • This could be Zuckerberg’s last tax bill for a while, however. The prospectus indicates that while he was paid $500,000 in 2011 for his work as CEO (he also received a $220,000 bonus and $783,000 related to his personal use of the company jet), Zuckerberg’s base salary beginning in 2012 will be reduced to one dollar. Facebook also announced in its filing that it has no intention to pay dividends on its stock anytime soon. Take these two items in tandem, and Zuckerberg’s adjusted gross income could be extremely small in the coming years. Then throw in the fact that Zuckerberg has long stated his desire to donate much of his fortune to charity, and he may well end up generating a net operating loss in 2013 and beyond.
  • It appears from the financial data contained within the prospectus that Facebook was generating federal NOLs until 2007 or 2008. In 2009, there was a decrease to the valuation allowance reserved against Facebook’s deferred tax assets (DTA) of $76 million. In all likelihood, the bulk of this DTA related to a large NOL carryforward that the company determined in 2009 would be fully utilized in the future against taxable income, so a valuation allowance was no longer necessary.
  • Interestingly, based on the large current tax provisions booked in 2010 and 2011, one could reasonably conclude that Facebook fully utilized its NOLs in 2009 or 2010. However, the tax footnote also indicates that Facebook has $7 million of federal NOL remaining as of 12.31.2011. How could the company, with $2.8 billion of pre-tax book income 2009 and 2010 not fully utilize its NOL carryforward? One possibility is that the pre-2009 NOLs were subject to limitation under I.R.C. § 382, and thus could not be utilized in full to offset taxable income.

In brief, Section 382 applies an annual limit to the amount of pre-change NOL carryforward that may be utilized after a corporation undergoes an “ownership shift” — essentially a more than 50% change in its stock ownership over a three-year period in terms of value. Perhaps during its start-up phase the need to raise capital from outside sources caused Facebook to undergo such a shift, which limited the amount of its pre-2009 NOL available to offset its 2010 and 2011 taxable income. This could explain why the company would have large current tax provisions in both 2010 and 2011 but yet still have an NOL carryforward as of 12.31.2011.

  • Assuming that I’m wrong, however, and Facebook’s $7 million NOL carry is not currently subject to I.R.C. § 382, it shouldn’t be even after the IPO. While the IPO may well trigger an ownership change, the I.R.C. § 382 limit is computed by multiplying the long-term tax-exempt rate in place on the shift date by the value of the company  immediately prior to the ownership change. As Facebook’s value is into the billions, any I.R.C. § 382 limitation would be well in excess of the $7 million remaining NOL.

Some interesting non-tax notes:

  • Fact: There are $2.7 billion likes and comments posted on Facebook every day. Also Fact: 97% of them serve no purpose other than to make the world a dumber place.  
  • Facebook made business acquisitions totaling $68 million in 2011, which was deemed “not material to the consolidated financial statements.”
  • Facebook generates 12% of its revenue from users who purchase virtual tools for use in certain online games. If you’re one of these people, your loneliness saddens me.
  • Facebook gave Mark Zuckerberg’s father $2 million shares of stock for helping keep the company afloat during its infancy. At a total potential value of $80 million, that really makes the $200 beach cruiser I gave my old man on his birthday look like crap. Sorry Dad.
  • Apparently, Facebook is not allowed in China or Iran. Then who is the Mahmoud Ahmadinejad that keeps “liking” all of my old lifeguarding pictures?

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Pop quiz, hotshot. Can a taxpayer deduct mortgage interest on a home that’s never actually built?

Well, if you’d bothered to read my title, you’d already know the answer. And that answer, according to the Tax Court’s decision today in Rose v. Commissioner, T.C. Summary Opinion, 2011-117, is a resounding “yes.”

Facts

  • In 2006, Mr. Rose (Rose) purchased land and a home on beachfront property in Florida for $1,575,000. Rose didn’t want the house; he wanted to build his own. Thus, as part of the contract, the existing house was torn down prior to Rose’s purchase.
  • To purchase the property, Rose took out a $1,260,000 mortgage.
  • Florida required a lengthy permit application process before Rose could build on beachfront property. Before an application could even be submitted, Rose was required to perform survey work and provide core samples to the State.
  • To further the application process, Rose put together a team of architects, engineers, and designers who prepared and submitted the construction and site plans.
  • In early 2008, a full two years after Rose purchased the land, his permit to build was approved. Unfortunately, by that time the local real estate and lending markets had crashed, and Rose couldn’t obtain the necessary financing.
  • As a result, the house was never built, and Rose sold the raw land in 2009, taking a $850,000 bath.

On his 2006 and 2007 tax returns, Rose deducted the interest on the 2006 mortgage to purchase the raw land as “qualified residence interest.” The IRS disallowed the deductions, posing the logical argument that a home cannot qualify as a qualified residence — and thus mortgage interest can never be deducted — if it’s never built.  

 The Tax Court disagreed, siding with Rose and allowing the mortgage deductions.

 Relevant Law

Qualified residence interest is any interest that is paid or accrued during the taxable year on acquisition debt or home equity debt. Acquisition debt is any debt secured by the qualified residence of the taxpayer and incurred in acquiring, constructing, or substantially improving the qualified residence.

Section 163(h)(4)(A)(i) defines a qualified residence as the principal residence of the taxpayer and “one other residence of the taxpayer which is selected by the taxpayer.”

 Pursuant to section 1.163-10T(p)(5), a taxpayer may treat a residence that is “under construction” as his or her second residence for up to 24 months “commencing on or after the date that construction is begun”.

Tax Court Decision

To determine if Rose’s 2006 and 2007 mortgage interest was deductible, the Tax Court had to determine whether “construction” had begun with regards to Rose’s planned Florida home. In reaching its decision, the Tax Court held that Rose’s construction activity began even before he owned the land.

For all practical purposes, petitioners were responsible for the demolition work, and it came about as a direct result of their purchasing the property. The fact that petitioners did not hold legal title to the property at the time that the work occurred does not negate its relevance to our inquiry… Therefore, we find that by causing an entire house to be demolished and by clearing the lot so that it would be suitable for a new residence, petitioners undertook significant steps in the process of constructing their vacation house, as early as January 2006.

The court also determined that Rose’s two-year effort as part of the permit application process constituted continued “construction” on the home.

The work petitioners were required to complete before filing the application was extensive and required the labor of multiple building and design professionals. Petitioners undertook significant work in preparing to obtain a construction permit, and that work was a necessary component of the overall process of construction. We hold that the property was “under construction” as a residence during 2006 and 2007.

Lastly, the Tax Court was left to decide whether Rose’s failure to ever build the house negated the mortgage interest deductions in 2006 and 2007. Reaching the logical conclusion, the court held that it didn’t, as in 2006 and 2007, Rose would not be aware that the home would eventually fail to be built.

Section 1.163-10T(p)(5)(i) and (ii) allows qualified residence interest to be deducted for the 24-month period following the commencement of construction. In the event the residence under construction has not been completed and is not ready for occupancy by the end of the 24-month period, the residence under construction ceases to qualify after that 24-month period ends. If petitioners intended to claim the deduction for interest during the construction period, they had to claim it on their returns for the years immediately following the commencement of construction in January 2006…[in those years], it would be impossible for petitioners or the Internal Revenue Service to have known that the proposed residence would never become ready for occupancy.

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