Tax Laws Favor Real Estate Investments

Why own real estate? Because everyone wants to make money and no one wants to pay taxes. This is a given, and real estate has historically proven to be a solid investment with excellent moneymaking potential. You can make money and cut taxes while the investment is in your hands, and reap further tax-advantaged profits when you sell.

Under current tax law, real estate investments offer several advantages, including depreciation deductions and favorable capital gains treatment. Real estate can be given to charities outright or in trust, resulting in income tax deductions. Or, it can be used to provide needed cash in retirement, such as when you enter into a reverse mortgage. And as such, real estate investments deserve to be protected from creditors and casualties alike. Asset protection is not specifically a tax-focused tool, but something all property owners should consider.

Current tax laws favor owning your primary residence. Rent is a nondeductible personal expense, while there are special deductions for most mortgage interest expenses and real property taxes.

Homeowners can generally exclude up to $250,000 of otherwise taxable gain when the property is sold if you meet certain ownership and use requirements. The exclusion can double to $500,000 if you’re married. If you’re so inclined and the market is on your side, you can make tax-free money buying fixer-uppers, restoring them while living in them, and selling them every two years.

Property owners can make money or reduce taxes now while banking equity for the future. Residential landlords secure deductions normally denied to primary residential owners, while commercial landlords are entitled to business deductions whether they rent the property out or use it in their own ventures. It’s a lot of work, but the potential rewards are great. And you don’t have to go it alone - there are many ways to co-own real property with others or as part of a pool of investors.

To avoid paying capital gains tax on your real property investment upon selling, consider a tax-deferred swap. There are many ways to accomplish this, and the IRS has greatly relaxed some of the rules that formerly prohibited tax-deferred treatment of certain types of property trades.

Enlist the help of an experienced CPA to help untangle the web of real estate tax laws in your favor. With current tax codes leaning favorably to property ownership, the opportunities and the risks of ownership are as infinitely varied as the people who invest in real property. For more information about real estate tax tips, contact us today.

Valuable Tax Information for Expatriates
and Nonresident Alien Taxpayers

Clearly, today's tax laws are complicated. These guidelines help to create a better understanding of what tax rules affect you — the American expatriate and nonresident alien taxpayer.

For all expatriates — American citizens and resident U.S. aliens who live and/or work abroad – the IRS is very interested in how much money you made during the year. But beware: tax rules can be unique and confusing. The following pointers will help to ensure you’re following IRS tax rules for expatriates.

Report income in U.S. dollars. If you were paid in foreign currency, convert the amount into U.S. dollars at the average exchange rate for the year.

Report additional expenses. In addition to earnings, certain expenses such as reimbursements and allowances need to be counted as income. This includes the fair market value of benefits such as housing, cars, meals and so on. Attach a statement to your return that shows how you computed the value of any non-cash items. There is no need to attach a statement from your employer showing such items paid in money.

Keep good records. The IRS wants to know when you entered the foreign country or countries, when you left, and when you were in the United States during the time you lived overseas. The dates you provide will help determine your eligibility for, and the amount of, your foreign earned income exclusion.

Don’t forget foreign housing exclusions or deductions. If you included employer-provided amounts in your income, you can exclude (if you're an employee) or deduct (if you're self-employed) certain housing-related expenses. These include rent, utilities, repairs, insurance, parking at your residence, rental of furniture and appliances, and so on.

American citizens and resident U.S. aliens are taxed on their worldwide income, whatever its source. Don’t neglect the extras. That is, report all other income and deductions that aren't related to your job, such as interest, dividends, capital gains, charitable contributions, medical expenses, taxes, childcare, Social Security, retirement plan payments, etc. Exclusions and deductions apply of course.

Nonresident Alien Tax Issues

Yes, the IRS is interested in U.S.-source income that is subject to taxes. To ensure you’re following IRS tax rules for nonresident alien taxpayers, read the following helpful pointers:

Determine if income is U.S.-source or foreign-source. Divide your income first into that which is U.S.-source and that which is not. The U.S.-source income is subject to U.S. income tax; the foreign-source income is not.

Determine if U.S.-source income is "effectively connected" with a U.S. trade or business. Divide the income subject to U.S. tax further into two basic buckets: income that is "effectively connected" with a U.S. trade or business, and income that is not. Income in the first bucket is taxed at the same rates applicable to U.S. citizens and resident aliens. Income in the second bucket is taxed at a flat 30% rate, or a lower treaty rate if one applies. To report U.S.-source income, use IRS Tax Form 1040NR.

Performing personal services any time during a tax year in the U.S. This is usually considered as engaging in a U.S. trade or business, and thus your income falls under the "effectively connected" heading. There are exceptions for those who were employed by a foreign individual or business that meets certain conditions, and the amount of pay received is less than $3,000. Note that there are certain limited circumstances under which other types of income can also be considered effectively connected.

Will investment income help or hurt? There are many subtleties involved, with much room for interpretation. If subject to U.S. taxes, investment income is taxed at a flat 30%, or a lower treaty rate if applicable.

Consider one of two tests to determine treatment of investment income:

What about retirement pay? If retirement pay comes from a U.S. trade or business, it is considered effectively connected when received. Gain or loss from U.S. real property interests is also treated as effectively connected with a U.S. trade or business.

Factoring in personal property. If you sell personal property and you have a tax home in the U.S., the gain (personal losses are generally nondeductible) is treated as U.S.-source, and vice versa. A tax home is the general area in which you work, regardless of where your family home is. If you have no regular place of business, then your tax home is where you regularly live. If you don't fit either of these descriptions, your tax home reverts to wherever you work. For property that is inventory, income from sales in the United States is usually considered U.S.-source income, no matter where your tax home is. Sales outside the U.S. are, conversely, treated as sourced outside the U.S.

Determine whether to file separate or joint returns. If you're married, you may only file a joint return if one spouse is a resident alien or U.S. citizen. Otherwise, separate returns are required. If a joint return is an option for you, you can elect to treat the nonresident alien spouse as a U.S. resident, and that spouse is then subject to taxes on worldwide income. It pays to be careful when making this choice!

Limited itemized deductions. Although much more limited for nonresident aliens than for U.S. residents and citizens, nonresident aliens can deduct state and local income taxes, but not real or personal property taxes. They can deduct contributions to U.S. charities, casualty and theft losses, and the usual crop of miscellaneous deductions. Most, but not all, are subject to the 2% of gross income floor.

In conclusion, navigating the complicated tax rules and regulations for expatriates and nonresident aliens is complex indeed! Consider seeking professional services from a professional experienced in these areas. Preserving your wealth and providing peace of mind are very worthwhile investments.

Charitable Trusts Save on Taxes, Benefit Charities

Estate plans today can make the most of charitable giving while reducing taxes if you use the right vehicle for the right planned giving goal. Whether you gift real estate, stocks, retirement plans, long-term care insurance, or life insurance, this article explains how to effectively use charitable remainder trusts to implement your charitable giving goals.

Trust Basics
Setting up a trust is a practical vehicle for planned giving goals. Let’s first examine the basics of setting up a trust. Basically, the donor creates a trust, then transfers money or property to it, and designates a trustee to take charge of the trust’s rights and responsibilities. The donor names income beneficiaries to receive the income during the trust term and decides who gets the remainder interest, or that which remains after the trust term has expired.

Charitable Remainder Trusts
A popular tool in estate planning is the charitable remainder trust, or CRT. A donor sets up a trust and funds it with property, and may receive income from this trust for life. Upon the death of the last income beneficiary, the remainder goes to a charity or charities. CRTs can be created during the donor’s life or at death in the will. The income interest can be given to the children or any other non-charitable beneficiary or beneficiaries. Upon the death of the last income beneficiary, the remainder goes to charity.

Charitable remainder trusts offer donors flexibility. Donors may opt to create an organization to carry out its charitable goals or give gifts outright. CRTs can be set up as "charitable remainder annuity trusts" (CRATs) and as "charitable remainder unitrusts" (CRUTs). Basically, these terms denote different ways to structure income payouts.

Advantages of CRTs:

Disadvantages of CRTs:

Gifts of Real Estate

Real estate, whether residential or commercial, can be given outright or in trust. This can be accomplished in one fell swoop or by periodically deeding a portion of the total interest. The donor can continue to live in the house in the remaining years of life (life estate).

However, donors should create a contract to spell out rights and responsibilities during the donor’s life regarding mortgage payments, taxes, repairs, casualties, treatment of insurance proceeds, etc. It is important to clarify whether the life estate can be gifted to another or rented out.

What Gifts of Real Estate Accomplish:

Caution Areas for Gifts of Real Estate:

Gifts Through Retirement Plans
These are popular because the donor does not have to give up currently available assets or income. Naming a CRT as beneficiary of an IRA or qualified plan can provide significant income and estate tax benefits. The donor’s estate gets a charitable deduction for the value of the interest that passes to the charity. Distribution to a CRT will not carry an income tax cost to the trust since it is an exempt entity. During the trust term, the trust corpus also earns tax-free income. This can result in greater total payouts, as well as less total tax than with the accelerated payout period that would normally occur upon the death of the IRA or plan owner.

Naming a CRT as an IRA beneficiary where the IRA owner failed to name a designated beneficiary is a saving grace for the gift recipient. This is especially true if the donor used the annual recalculation method of distribution during the donor’s life. And, the non-charitable income beneficiaries of the CRT (e.g., owner’s children) can take distributions over the trust term, thus spreading out the income and the resulting income tax.

Caution Areas for Gifts Through Retirement Plans:

Gifts of Stock

Stock can be given to a charity outright or in trust. Given outright, gifts of stock produce immediate income tax deductions, remove the value of the gifts from the donor’s estate, and save capital gains taxes.

The benefits to the charity are obvious. It can sell the stock and take advantage of the appreciation while paying no tax, due to its exempt status. There should be no restrictions on what the charity can do with the stock.

Caution Areas for Gifts of Stock:

Gifts of Life Insurance

A donor can give a paid-up life insurance policy to a charity to remove its value from his or her estate. The charity will get the face value payout on the donor’s death. If a policy is to be given outright, the donor should name the charity as owner and beneficiary of the policy. This removes any incidents of ownership on the part of the donor, and thus any question of inclusion in the estate. This also removes any question of who is to pay the premiums if the donor stops doing so in the future. A lapsed policy is a problem for the charity - it either has to make the payments, thus using needed funds, or cancel the policy, which reduces the payout to the charity. A donor can also name a charity as beneficiary of the policy. His/her estate will get a charitable deduction for the face value given to charity.

Gifts of Long-Term Care Insurance

Like life insurance, a donor can gift a long-term care (LTC) insurance policy to a charity to remove its value from the estate. The charity will receive the face value payout upon the donor’s death. There are two types of LTC policies: health-based and life-based. The health-based policies operate much like health insurance: you pay your periodic premiums, and if you need the benefits, they’re there. If you don’t, the premiums you paid stay with the insurance company.

The life-based policies, on the other hand, are more like investment or savings vehicles. Purchased with lump-sum prepayments, the earnings are free of income tax. If you need the money, it is there. If you don’t, you can will the policy, give the benefits to charitable and/or non-charitable beneficiaries, and so on. Gifts to charitable beneficiaries reduce estate taxes to the extent the proceeds are donated to charity.

---

Preparation is Key When the IRS Comes to Call

It's the kind of letter no one ever wants to receive: a notice from the Internal Revenue Service informing you that your business's tax return has been selected for examination. What's it all about, and what should you do next?

Some of the returns the IRS chooses to audit are picked at random, while some are flagged because certain items catch the attention of their computers. In general, the IRS's systems are programmed to compare relationships between what's reported on the return and one of two basic things: IRS-established standards, and the other dollar amounts on the return. The random audits are generally more exhaustive, because the IRS uses them to develop the established standards just mentioned. These audits check pretty much every line item on a tax return. But depending on the reasons a return was pulled for audit, the other variety of examination can also be very thorough.

The Reality Check
IRS agents also look at the lifestyle you lead, not just your business's tax return. It's called the "economic reality" approach. In plain language, does what's on the return make sense in light of the examiner's assessment of you? Some of the most likely things an examining agent will look for include:

Where’s the Money?
If your business handles a lot of cash, such as a gas station or restaurant, the auditor is more likely to look for evidence of skimming. This means taking cash before it is even recorded on your books, so it isn't reported as income. Auditors are trained to analyze the figures on a business's return. For example, they'll scrutinize relationships between reported sales and the cost of goods sold, supplies, credit card merchant discounts and fees, bank deposits, and so on. They also use guides written by experienced auditors that deal with specific industries and types of businesses, and these guides carefully detail what to look for and how your overall tax picture should appear.

Deducting personal expenses is another audit gold mine. We're not talking about a few office supplies or personal long-distance phone calls. But if you wrote off your $5,000 Caribbean cruise vacation as a business trip, for example, or used materials your construction firm deducted to put a $50,000 addition on your house...and the auditor discovers what you did, they will disallow the deduction and often add a penalty to the additional tax you'll owe. The ground rule here is common sense.

Document Everything
The agent will likely also look for personal use of your vehicle disguised as business use. Almost everyone uses the business car or truck for personal errands...picking up the kids at school, runs to the grocery store, etcetera, and deducts those costs. But that doesn't mean that the IRS accepts it. They will dig in hard to be sure your auto expenses are backed up in the prescribed fashion and really were incurred for business. Document everything. Forewarned is forearmed!

Entertainment and meals are another department where auditors know they'll find plenty of deductions that aren't supposed to be there. If you treat your friends to a night on the
town and deduct it as business entertainment, you'll need to have a good explanation of
the business reasons for the expense, and the business relationship between your company and the people you entertained. You'll also be asked to produce records to support your assertions.

If you employ other people, the IRS agent will examine your records to be sure that the required payroll returns have been filed and the taxes paid. The agent is also likely to ask pointed questions about the nature of the relationship between your business and its independent contractors, because the IRS knows that it's much less work and much more financially advantageous to hire independents instead of employees.

The IRS routinely investigates businesses because it often finds that workers are "misclassified"; if the auditor determines that you've treated workers as independent when they're really employees, the resulting taxes and fines can be very heavy.

When an audit looms, good professional guidance is crucial. Most business owners are unfamiliar with IRS examination policies and procedures, not to mention tax laws and the requirements they impose on taxpayers. People tend to become emotional when they're frightened, and an audit is a sure way to upset anyone. A competent tax advisor will be cool under fire, up-to-date on the IRS's thinking, and can help keep them honest.

In summary, while it’s never pleasant to receive an audit notice from IRS, it shouldn't be cause for panic. Keep good records as you run your business, get professional tax guidance, and don't lose any more sleep than you have to!

---

When You Can’t Pay Your Taxes

In our last column, we dealt with taxpayers who haven't filed required tax returns. Now, let's assume you've filed everything demanded of you, and the taxes have all been assessed. The total debt, however, is more than you can pay. Perhaps you'll be able to pay it over time, but perhaps it's a larger amount than you can ever hope to eliminate.

What you don't want to do is ignore the situation, or to put off dealing with it. If not confronted promptly, tax debts have a way of growing over time. There are several possible courses of action. While none are guaranteed to rid you of the burden, you can salvage your credit, reduce the flow of taxing authority correspondence, and help you regain lost peace of mind.

The IRS, and its various state counterparts, have stacked the deck very heavily in their favor. The government writes the rules, and has secured for itself vast powers to obtain information about and to seize taxpayers' assets in order to pay their debts to it; most of the time, the government doesn't need to go to court to do that. The law compels individuals, businesses, and other classes of taxpayers to report their income, and turn over part of it, to the government. Should they fail to do so, the law adds interest and/or penalties to the original tax due.

Most tax issues operate in the arena of civil law, rather than criminal. Tax laws define desired taxpayer behavior and demand the performance of certain acts, such as filing tax returns and paying the taxes shown to be due, and impose sanctions for failure to behave as specified. We're constantly asked why taxpayers seem to be considered guilty until proven innocent, rather than the other way around. Isn't that un-American? What's missing here from many people's understanding is that the terms "guilt" and "innocence" are criminal terms, and are generally irrelevant where the great majority of tax matters is concerned.

In this article, we'll primarily address Federal taxes, those owed to the IRS, as its procedures tend to be far more clear-cut than those of the states and localities.

So, you've received a bill that's beyond your ability to pay. Keep in mind that you want to resolve the matter in as short a time as possible, and to avoid enforced collection action such as liens and levies. Communication is extremely important: never ignore a letter, notice, or bill from the IRS or any other tax authority. While taxpayers can and do handle collection matters on their own, we recommend that you seek professional guidance. It's easy to misstep if you aren't familiar with the rules by which IRS must abide, which are important just like your own obligations are.

It's been said that it's better to owe almost anyone rather than the IRS, and there's a lot of truth in that. If you can borrow, from private sources or a commercial lender, to pay off legitimate tax debts, it's definitely worth considering going that route. Some or all of the interest you pay may even be tax-deductible, and that never hurts! But if that isn't a valid option for you, "Plan B" is to take the tax bull by the horns and deal with the IRS directly.

What to expect from a tax professional

First, he or she will interview you, and ask for copies of the tax returns and all IRS correspondence relating to the matter at hand. No two cases are identical, and the more the tax advisor knows, the better he or she can determine the best way to proceed. The advisor will generally ask you about your line of work, education, health, family and financial circumstances, and other things that might not seem important on the surface, but which could have great impact on negotiations with the IRS. The tax advisor needs to understand why you owe the taxes in the first place, which will help him or her to formulate a plan of action to resolve your case. Whatever the official government posture, personalities can and do make a difference...after all, "the system" is run by human beings.

Your tax advisor will prepare a Power of Attorney, to enable him or her to represent you before IRS. This generally means discussing your account with IRS and obtaining information. He or she will need to determine the exact amount owed, and will compare IRS's records with your own to be sure that IRS's information is accurate. The advisor will also need to assess the collection actions IRS has taken to date, to evaluate how far the case has gone against you. He or she will likely also ask you to begin to gather documents and figures to prepare a Collection Information Statement. This is basically a roadmap of a taxpayer's assets, that the IRS can use to collect taxes due to it, although IRS won't tell you that. But they also usually won't play ball without a recently prepared and accurate CIS.

The advisor will often order transcripts from IRS, to track the previous steps in your case, and to satisfy him- or herself that you've been given credit for the payments you've made. We've seen many cases where payments were applied to another taxpayer's liability, or lost altogether, although the check was cashed by the bank. Taxpayers make mistakes, but so does IRS, and it's important to keep everything accurate and all parties on the same page.

Once your advisor has laid the groundwork and has gotten a good grasp of the situation, he or she will suggest alternatives. These might include requesting an installment agreement, applying for an offer in compromise, innocent spouse relief, bankruptcy, a short-term extension of time to pay, or other action depending on your particular circumstances.

Here's a brief overview of the most important tools in a tax professional's kit...

Installment agreements

This is an agreement between a taxpayer and the IRS, where the taxpayer pays the amount due in monthly installments that are at least as much as the difference between gross income and so-called "allowable expenses". The general rule is that you won't be asked to furnish a CIS for debts totaling $25,000 or less, but for amounts over $25,000, a CIS is required.

To enter into an installment agreement, you must be current in your filing and other payment requirements, and IRS generally will request a maximum 5-year payout term for the taxes plus interest due.

Offers in compromise

This is the mechanism by which IRS compromises a taxpayer's liabilities, or in other words, agrees to allow the taxpayer to pay a smaller sum than the full amount due in complete satisfaction of the debt. The grounds for compromise can include doubt as to liability ("I don't believe I owe"), doubt as to collectibility ("I can't pay"), or effective tax administration, which is relatively new on the scene, and is the most subjective of the grounds for compromise. In our experience, IRS is very much unfavorably disposed to compromise tax liabilities. IRS has set forth definitions of circumstances that fall into the various categories of grounds for compromise, but IRS seems unwilling to decide that a taxpayer's case meets the requirements. One of our clients, in our professional judgment, is a textbook case for compromise, but even so we have been meeting with obstacle after obstacle in the progress of this person's case. It can be done, but it's like getting a balky mule to move. They just don't wanna.

Innocent spouse relief

This is usually relevant in a divorce situation. When spouses sign a joint return, they are both and each - "jointly and severally" - liable for the full amount of tax due. Should one of the spouses believe that he or she is not liable for all of the tax, that spouse may request relief under the innocent spouse rules. The spouse who requests relief must meet all of the following conditions:

It seems simple, but it isn't easy to obtain such relief; new cases are always coming up in the various courts, that define and shape how the innocent spouse rules are applied in practice.

Bankruptcy

This is one of the most complex areas of US tax law, and anyone who owes taxes they are unable to pay should view it as a last resort. Bankruptcy, whatever form it takes, is an expensive and time-consuming process, with far-reaching consequences.

Taxes can be discharged in bankruptcy, although they must meet strict requirements. Briefly, once the bankruptcy estate is created by filing a petition, claims against it are put in order of priority. The particular rung of this ladder that the IRS stands on will determine whether the taxes in question are paid or discharged. Tax claims are separated into those relating to a year that ended before the filing of the bankruptcy petition, or prepetition taxes, and those relating to a year that ended after the filing of the petition, which are called postpetition taxes. While taxes in the first category are subject to the automatic stay of collections, those in the second bucket are not. Instead, postpetition taxes are treated as administrative expenses, which are given first priority in payment after secured claims are paid. Many other rules and regulations apply, and the assistance of an experienced bankruptcy lawyer is vital.

In conclusion, the best way to handle tax debts is not to incur them in the first place...but that isn't a lot of help if you're already in that position. The best thing any taxpayer. individual, business, estate or other entity, can do is to take prompt stock of the situation, hire competent professional counsel, and keep the lines of communication open on all fronts.

---

The American Jobs Creation Act Offers Benefits for Businesses & Individuals

A new bill approved by President Bush late last year could reduce taxes for manufacturers, farmers, and energy businesses, as well as for real estate investors and small businesses. Individual taxpayers could also benefit from the changes, which take effect on various dates.

Called the American Jobs Creation Act of 2004, AJCA, the bill was originally designed to repeal the extraterritorial income taxing regime, or ETI. The ETI was believed to violate trade agreements of the World Trade Organization. As a result, the European Union retaliated by imposing monetary sanctions on the United States. The passage of the AJCA eliminates those sanctions and is good news for many businesses.

The changes take effect on varying dates. Some of the AJCA’s provisions are retroactive, some were effective upon the signing of the bill, and some take effect on future dates. Below are key provisions of the new bill:

Although the Act is mostly good news for taxpayers of all types, there are many traps hidden among its various sections. For example:

A careful review of your personal and business tax picture is always a good idea, but especially now when so much is new and unfamiliar. A qualified tax advisor can be invaluable in navigating the waters of the tax seascape.

---

Employees on Military Duty

With so many troops on active military duty, you may have employees who have been called up also. Many businesses choose to continue paying an employee his or her full salary, or the difference between the salary and military pay. However, remember that the employment relationship ends for tax purposes when the employee is called for active duty. Therefore, payments you make while employees are in service are not “wages”. No Federal income tax withholding, FICA, or FUTA taxes are due on the payments. However, they are income to the employee, and you report them to him/her and to the IRS on Form 1099-MISC.
 
State laws tend to vary widely. Please check with us for specific information about your state.

---

In the News…
Catherine Nazarene Featured in the Frederick News-Post

Recently Catherine Nazarene, principal of the Catherine Ditman Group of Mt. Airy, Maryland (USA) spoke on dealing with divorce in real estate settlements to the Frederick County Association of Realtors® Ms. Nazarene, who is a frequent speaker to real estate groups, noted that constantly changing laws mean that anyone in a divorce situation with real property should consult not only a real estate professional, but also a lawyer and CPA.
"When property is divided between divorcing spouses, including the marital home, if it is transferred within one year of the date the divorce or separation becomes final according to state law, it is presumed to be 'incident to the divorce'. In a nutshell, such transfers do not result in gain or loss to either spouse. However, each transaction must be examined for potential tax effects, because there are many conditions and exceptions to every rule, no matter how simple it may seem...and the laws, especially tax laws, are constantly changing," Ms. Nazarene told the Frederick County, Maryland real estate agents' association.

Divorce changes a lot of the rules, even those affecting an otherwise normal home sale. Even if the property is mortgaged in excess of its basis, no gain or loss will result from its transfer between spouses if the transfer is "incident to the divorce". "Get everything in writing, no matter what it is," emphasized Ms. Nazarene.

For more information on the complexities of settling real property in divorce cases, or to inquire about having Ms. Nazarene speak to your group, click on “Contact Us” or call us at the phone number at the bottom of this page.

---

Disclaimer

These articles are not intended as professional tax advice, and we cannot accept responsibility for your use of this information. For specific advice tailored to your situation, please contact the Catherine Ditman Group at the numbers below.