How I Saved A Client Over $20,000 And Got The IRS To Pay For It

It is always stressful to receive a notice from the IRS.  It is far more stressful if the IRS is assessing you over $20,000 for additional taxes and penalties.  This was the situation of one client who I assisted a few months ago.

Image from forbes.com

This individual, who for the sake of her privacy I will refer to as X, had always prepared her own tax returns as she only had a W-2, some interest and dividends, and the occasional stock sale.  However, in early 2015 she received a Notice from the IRS that she owed over $20,000 of additional taxes and penalties relating to her 2012 income tax return.

She initially tried to resolve the issue with the IRS herself, but unfortunately did not get any positive results.  She then talked to a CPA who referred her to me.

I quickly discovered that she inadvertently did not report several stock sales in 2012.  The IRS knew the amount of proceeds she received from the transactions because of 1099s that were filed, but they did not know her basis (what she paid for the stocks in the first place).  The IRS took the position that X had no basis in the stock, and that the proceeds were 100% taxable gain.  This of course was not the case.

I worked with X and her financial advisor, and we discovered that X's basis in the stock was greater than her proceeds (she sold the stock at a loss).  I presented this information to the IRS, and prepared amended tax returns for 2012 and all the years subsequent to claim her newly discovered capital losses.

When everything was done, not only did X no longer "owe" the IRS over $20,000, but they owed her money.

If you have received a Notice from the IRS and would like to discuss it, please feel free to send me an e-mail.

Are Disability Insurance Proceeds Taxable?

In a July 2013 article, the Council for Disability Awareness published a statistic stating that over 1 in 4 people currently in their 20s will become disabled before they retire, and that 6% of working-age Americans are currently disabled.

According to the Insurance Journal's June 2011 article, only 49% of US workers have short-term disability insurance and only 44% have long-term disability insurance.

What are the tax consequences if you become disabled and receive disability insurance proceeds?

It all depends on who paid for the disability insurance policy.

The proceeds from a disability insurance plan will not be taxable if:

1. You pay all the premiums for the policy;
2. The disability insurance is provided through your employer, but the premiums are paid with after-tax dollars (effectively, you pay the premiums through your paycheck);
3. The disability insurance is provided through your employer's cafeteria plan; or
4. The proceeds are a reimbursement for actual medical expenses, permanent loss or loss of use of part of the body, or permanent disfigurement.

The proceeds from a disability insurance plan are taxable if your employer paid the premiums and the premiums were not taxable to you.

If you have any questions about this, please feel free to send me an e-mail.

Can You Do a 1031 Exchange With a Relative?

Are you allowed to do a 1031 exchange with a relative? Yes, you are. However, special rules do apply.

Image from firstnationaltitle.net

There is a 2 year test that applies when you perform a 1031 exchange with a related party (a term defined for this context in the Internal Revenue Code). Under this test, if either you or your related party disposes of the property received in the exchange, then the 1031 non-recognition of gain or losses is disallowed.

However, if that occurs the gain or loss would be recognized in the year in which the disposition occurred, not when the exchange took place.

For example, in March 2015 you performed a 1031 exchange with your brother. You traded your brother your Chula Vista rental property for his Escondido rental property. Then, in August 2016 (without your knowledge) your brother sold the Chula Vista property. Even though you had no control over the fact that he sold the property, you did not satisfy the 2 year test so your exchange would be treated as a sale and would be taxable in 2016.

Exceptions

There are 3 exceptions to what otherwise could be a very harsh rule.  These exceptions are:

1. Dispositions that occur after the death of the taxpayer or the related person; 
2. Compulsory or involuntary conversions, if the exchange occurred before the threat or imminence of such conversion; or
3. Dispositions with respect to which it is established to the satisfaction of the Treasury Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.

If you have questions about 1031 exchanges, please feel free to send me an e-mail.

Deferred 1031 Exchanges

All the 1031 exchanges that we have discussed so far have had the exchange of property occur simultaneously. However, it is possible, and in fact very common, for a property owner to relinquish his or her property and then subsequently receive a replacement property- even weeks or months later.

Two important requirements must be met in order for a deferred like-kind exchange to qualify for 1031 treatment:

   1) The replacement property must be identified within 45 days after the closing of the sale of the initial (relinquished) property; and

   2) The replacement property must be received within the earlier of 180 days of the closing of the sale of the initial (relinquished) property, or the extended due date of the taxpayer's tax return for the year in which the initial sale occurred.

In order to meet the 45-day identification requirement, you must identify and describe in an unambiguous manner the replacement property in a written document.  The written document must then be delivered to either the person obligated to transfer the replacement property or to any other person involved in the exchange.

As a precaution against identifying a property that is subsequently unable to be delivered to you (and thus not qualifying for Section 1031 treatment), you are allowed to identified more than one replacement property.  In fact, you are allowed to identify up to 3 replacement properties (without regard to their value) or any number of potential replacement properties as long as their aggregate fair market value does not exceed 200% of the aggregate fair market value of the relinquished property.

In order to meet the 180-day receipt requirement, you must actually receive the replacement property within the time period and it must be substantially the same property identified.

A significant potential problem is when people intend to do a deferred 1031 exchange and sell their property, receive the funds, and then use those funds to purchase a replacement property. Unfortunately, that is not a 1031 exchange and will be treated as a sale.

If you or a disqualified person receives, or constructively receives, any cash or non-like-kind property prior to receiving the replacement property it transforms the transaction into a taxable event or partially taxable event depending on the amount received.  If the amount was equal to the full consideration of the relinquished property, then the transaction is treated as a sale.  If the amount received is less than full consideration, then the transaction is treated as a partially taxable exchange.

There are a group of people who are considered disqualified persons because they are viewed as your agent or as related-parties. This group includes your employees, attorney, accountant, banker, and real estate agent/broker.

There are a number of qualifying arrangements that can be made to work around this limitation. One of which is the use a qualified intermediary.  A qualified intermediary is someone who is not a disqualified person and enters into a written agreement with you.  Under that agreement, the qualified intermediary acquires the relinquished property from you and then transfers the relinquished property to a 3rd party.  The qualified intermediary will then acquire the replacement property and transfer it to you.

Here is an example of how a deferred 1031 exchange may look.

You own a rental property in Santee with a fair market value of $550,000, but you would like a rental property closer to your home in Vista. You find a qualified intermediary and enter into an exchange agreement to perform a 1031 exchange. You then find a buyer for your property in Santee. Instead of selling the property directly to the buyer, you transfer the property to the qualified intermediary. The qualified intermediary then sells the property to the buyer.

Within 45 days, you find 3 properties that you may be interested in, and your provide their addresses to the qualified intermediary in a written document. After some negotiations with the sellers, you agree upon a purchase price of $600,000 for one of the properties. The qualified intermediary then goes into escrow with the seller to acquire the property, with you contributing an additional $50,000 cash to make the purchase as well as any exchange fees the qualified intermediary is charging you. After the qualified intermediary acquires the replacement property, it transfers the property to you completing the 1031 exchange.

If you would like to discuss deferred 1031 exchanges further, please send me an e-mail.

Whats Your Basis After a 1031 Exchange?

Over the past few weeks we have been discussing 1031 exchanges and the requirements that must be met in order to have a tax-deferred exchange of property. We also discussed boot, the taxable benefits that are received as part of a 1031 exchange.

So what happens when you sell the property you received in a 1031 exchange? How do you calculate your gain?

The gain is calculated by taking the sales price and subtracting from that amount your basis and the selling expenses (gain = proceeds - (basis + selling costs).

Generally, basis is your original purchase price plus the cost of capitalized improvements less the depreciation allowable over the years. But is it the original purchase price of the relinquished property or the replacement property? Do you factor in the capital improvements and depreciation on the relinquished property?

In order to determine what your basis is in the replacement property, you start with your adjusted basis in the relinquished property at the time of the exchange. By adjusted basis, I mean you start with the original purchase price and adjust that by any capital improvement and depreciation allowed.

Next, you increase your basis by: 

1. The amount of cash you paid to the other party;
2. The value of any other property given to the other party;
3. Any liabilities you assumed in the exchange; and
4. Any gain you recognize.

Finally, you decrease your basis by:

1. The amount of cash you are paid;
2. The value of any other property you receive;
3. Any liabilities assumed by the other party (that you are relieved of); and 
4. Any loss you recognize.

As you may have noticed, the adjustments to the basis is primarily boot.

Lets look at an example of how to calculate the basis of the replacement property.

Several years ago you purchased a property for $200,000. You paid $40,000 cash and financed the rest. Over the years you made $50,000 of capital improvements and have taken $30,000 of depreciation. You have also paid off $10,000 of the mortgage. Your property now has a fair market value of $500,000, and you enter into a 1031 exchange to acquire a property with a fair market value of $600,000. That property is subject to a mortgage of $200,000. You also agree to pay the other party $50,000 cash.

First, we have to determine what your basis in the relinquished property was. You purchased it for $200,000. We add to that amount the $50,000 of improvements and subtract the $30,000 of depreciation. That means your relinquished property had a basis of $220,000.

Next, we have to increase that basis by the cash you are paying to the other party and the debt you agreed to assume. That means you will be increasing the basis by $250,000 ($50,000 cash plus $200,000 liability assumed).

Finally, there was debt relief of $150,000. That means you decrease the basis by $150,000. That means your basis in the replacement property is $320,000.

If you have questions about this formula or about 1031 exchanges in general, please send me an e-mail.

What is Boot? Why Do I Have to Pay Taxes On It?

Over the last few posts, we discussed 1031 exchanges and how, if the requirements are met, they allow for tax-deferred exchanges of one property for another. I mentioned that even though the exchange of the property itself is tax-deferred, there may be other elements to the exchange that are taxable. Taxable benefits received as part of a 1031 exchange are referred to as boot.

Image from www.atlas1031.com

There are essentially two forms of boot. The first is any property received in the exchange that is not like-kind to the property relinquished. The most common form of this type of boot is cash, but it can be any type of property that is not like-kind.

For example, you own a rental property with a fair market value of $1.2 million. You are willing to exchange it for another rental property with a fair market value of $1 million, but you probably want to be compensated for the difference in values by receiving cash for $200,000. That cash is boot.

The second form of boot is debt relief. If the relinquished property is subject to debt and as part of the exchange you are relieved of that debt, you are treated as having received cash.

Lets say you own a commercial building with a fair market value of $1.5 million, but it has a mortgage of $500,000 attached to it. You exchange it for another property with a fair market value of $1.5 million. At first glance, it may look like there is no boot because nothing except for the rental properties were exchanged. However, you were relieved of $500,000 of debt and that is treated the same as if you had received that much in cash.

Of course, there could be boot going both ways in the transaction. In that case, there are rules that allows certain types of boot to be offset by other boot, leaving you with "net boot." These offsetting rules are:

1. Cash paid to the other party offsets cash received.
2. Cash paid to the other party offsets any mortgage (debt) relief.
3. Mortgage (debt) assumption offsets mortgage (debt) relief.
4. Exchange expenses offsets cash received.
5. Mortgage (debt) assumption does not offset cash received.

Furthermore, just because you have boot does not necessarily mean that it will be subject to tax. Boot is only taxable to the extent that there is gain. For 1031 exchanges, the amount of gain recognized is equal to the lesser of: 1) the amount of gain realized in the exchange; or 2) the value of the boot received.

Lets look at another example. Several years ago you purchased a rental property in San Diego for $700,000. The property now has a fair market value of $800,000 with a mortgage of $200,000. You enter into a 1031 exchange and receive a property with a fair market value of $500,000 with no debt and cash of $100,000.

If you had sold the original property in a traditional sale, you would have had a gain of $100,000 ($800,000 value less $700,000 purchase price). Because you did a 1031 exchange instead, you received a like-kind property with a fair market value of $500,000 and boot of $300,000 ($200,000 of debt relief and $100,000 cash). In this case, you would not be required to recognize all $300,000 of boot, only the $100,000 of gain that you would have recognized in a traditional sale.

Lets look at the same scenario, except that you had purchased the property for only $200,000. In this case, if you had sold the property you would realize a gain of $600,000. However, in a 1031 exchange you only have to recognize $300,000 of gain because that is the amount of boot you received.

If you have any questions about 1031 exchanges and boot, please feel free to send me an e-mail.

Can I Take Advantage of a 1031 Exchange?

As we discussed in the last blog post, a 1031 exchange is a tax-deferred, like-kind exchange of property held for productive use or investment for another property held for productive use or investment. In English, it allows you to trade one property for another property without paying income taxes at that time.

Image from www.kolotv.com

As you can imagine, this is a major benefit to taxpayers because it means that you can defer paying thousands of dollars (or far more) in taxes for years. Obviously, such a beneficial tax code provision is going to have very strict requirements that must be met in order to utilize it.

The first requirement is that the property that you are disposing of must have been held for productive use in a trade or business or for investment.  This means that it cannot be personal use property, such as your principal residence or a vacation home.

The second requirement is that the property that you are acquiring must be used either in a trade or business or for investment. How the other party used the property is irrelevant, the test is how you will use the property. The basic idea is that if you are going to be allowed to defer taxes from the "sale" of the relinquished property, you have to use the replacement property in a similar manner.

The next requirement is that the property cannot be: inventory, stock, bonds, notes or other evidence of indebtedness, interests in a partnership, certificates of trusts or beneficial interests, or choses in action.

Finally, the replacement property must be of a "like kind" to the property relinquished. All real estate located in the United States, whether it is improved or unimproved, is considered to be like-kind to other real estate located in the United States. However, real estate located in the United States is not like-kind to real estate outside of the United States.

Unlike with real estate, not all personal property (e.g., equipment, furniture, etc.) is considered to be like-kind to other personal property.  In order to be like-kind, the personal property must be in the same asset class (and if livestock, must be the same gender).  In addition, as with real estate, personal property located in the United States is not like-kind to personal property outside of the United States.

There are additional timing requirements that must be met if the property exchange does not occur simultaneously, but we will discuss that further in a future blog post.

If you would like to know if your transaction would qualify under Section 1031, please send me an e-mail.