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How to Make a Family Home Loan Interest Deductible

It is not uncommon for individuals to loan money to relatives to help them buy a home. In those situations, it is also not uncommon for a loan to be undocumented or documented with an unsecured note, and the unintended result that the homebuyer can’t claim a tax deduction for the interest paid to their helpful relative. The tax code describes qualified residence interest as interest paid or accrued during the tax year on acquisition indebtedness or home equity indebtedness with respect to any qualified residence of the taxpayer. It also provides that the term "acquisition indebtedness" means any indebtedness that is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and is secured by such residence.


There are also limits on the amount of debt and number of qualified residences that a taxpayer may have for purposes of claiming a home mortgage interest tax deduction, but those details are not covered in this article, which focuses on the requirement that the debt be secured.

Secured debt means a debt that is on the security of any instrument (such as a mortgage, deed of trust, or land contract):

(i) that makes the interest of the debtor in the qualified residence-specific security of the payment of the debt,

(ii) under which, in the event of default, the residence could be subjected to the satisfaction of the debt with the same priority as a mortgage or deed of trust in the jurisdiction in which the property is situated, and

(iii) that is recorded, where permitted, or is otherwise perfected in accordance with applicable state law.

In other words, the home is put up as collateral to protect the interest of the lender.

Thus, interest paid on undocumented loans, or documented but unsecured notes, is not deductible by the borrower but is fully taxable to the lending individual. The IRS is always skeptical of family transactions. Don’t get trapped in this type of situation.

Take the time to have a note drawn up and recorded or perfected in accordance with state law. In California it’s pretty easy. You can usually have the note created and recorded by escrow and/or title companies and they’re very inexpensive.

Finally, the terms of the note between family members should be at arm’s length, what a non-related lender would offer/provide to the borrower. For example, if the going mortgage interest rate based on the borrower’s credit score, down payment and finances is 5% but the family member is charging 2%, there could be a tax issue. This is beyond the scope of this article.

The above technical reference is provided as a courtesy to the reader by David Silkman, CPA, MST, Broker, Silkman & Associates Accountancy Corporation and SilkRoad Realty, Inc. The information is technical in nature, may not include all the details on a particular subject and may require review of the reader’s circumstances by a professional. You should consult with your tax advisor.

David S. Silkman is a CPA, has a Masters in Taxation (MST) and is a licensed real estate broker. He specializes in real estate tax laws and accounting. If you have any questions, please do not hesitate to call him at 310.479.7020 x301, email him at david@saacpa.com or visit www.saacpa.com or www.SilkRoadRealtyInc.com. Thank you.

Tax Break for Sales of Inherited Real Estate

Clients are usually pleasantly surprised by the answer—that special rules apply to figuring the tax on the sale of any inherited property. Instead of having to start with the decedent’s original purchase price to determine gain or loss, the law allows taxpayers to use the value at the date of the decedent’s death as a starting point (sometimes an alternate date is chosen). This often means that the selling price and the inherited basis of the property are practically identical, and there is little, if any, gain to report. In fact, the computation frequently results in a loss, particularly when it comes to real property on which large selling expenses (realtor commissions, etc.) must be paid. This rule is applicable to other inherited assets as well such as stocks.

This also highlights the importance of having a certified appraisal of the home to establish the home’s tax basis. If an estate tax return or probate is required, a certified appraisal will be completed as part of those processes. If not, one must be obtained to establish the basis. It is generally not acceptable just to refer to a real estate agent’s estimation of value or comparable sale prices if the IRS questions the date of death value. The few hundred dollars it may cost for a certified appraisal will be worth it if the IRS asks for proof of the basis.

For example, assume uncle Bill was a very smart person and he purchased a house in Los Angeles 50 years ago for $50,000. He passed away in 2014 and left the house to you. It had no mortgage or debt on it either. The fair market value of the house on the date of his death was $2,000,000. Assume you sell it sometime in 2014 for $2,000,000. After you pay selling expenses assume you net $1,900,000. The $1,900,000 is all tax free to you. And, its considered a long term asset. So if you sell it for more than the fair market value on the date of death, you pay long-term capital gains tax on the gain. The federal long term capital gain tax rate is 15% or 20%, it depends on your overall federal tax bracket.

Another issue is whether a loss on an inherited home is deductible. Normally, losses on the sale of personal use property such as one’s home are not deductible. However, unless the beneficiary, you, is living in the home, the home becomes investment property in the hands of the beneficiary, and a loss is deductible but subject to a $3,000 ($1,500 if married and filing separately) per year limitation for all capital losses with any unused losses carried forward to a future year.

In some cases, courts have allowed deductions for losses on an inherited home if the beneficiary also lives in the home. In order to deduct such a loss, a beneficiary must try to sell or rent the property immediately following the decedent’s death. In one case, where a beneficiary was also living in the house with the decedent at the time of death, loss on a sale was still deductible, when the heir moved out of the home within a “reasonable time” and immediately attempted to sell or rent it.

This treatment could change in the future, however. The President’s Fiscal Year 2016 Budget Proposal includes a proposal that would eliminate any step up in basis at the time of death and would require payment of capital gains tax on the increase in the value of the home at the time it is inherited.

The above technical reference is provided as a courtesy to the reader by David Silkman, CPA, MST, Broker, Silkman & Associates Accountancy Corporation and SilkRoad Realty, Inc. The information is technical in nature, may not include all the details on a particular subject and may require review of the reader’s circumstances by a professional. You should consult with your tax advisor.

David S. Silkman is a CPA, has a Masters in Taxation (MST) and is a licensed real estate broker. He specializes in real estate tax laws and accounting. If you have any questions, please do not hesitate to call him at 310.479.7020 x301, email him at david@saacpa.com or visit www.saacpa.com or www.SilkRoadRealtyInc.com. Thank you.

1031 Exchange

If you own real property that you could sell for a substantial profit, you may have wondered whether there’s a way to avoid or minimize the taxes that would result from such a sale. The answer is yes, if the property is business or investment related. Normally, the gain from a sale of a capital asset is taxable income, but Section 1031 of the Internal Revenue Code provides a way to postpone the tax on the gain if the property is exchanged for a like-kind property that is also used in business or held for investment. These transactions are often referred to as 1031 exchanges or like-kind exchanges and may apply to other types of property besides real estate, but the information in this article is geared toward real property.

It is important to note that these exchanges are not “tax-free” but are “tax deferred.” The gain that would otherwise be currently taxable will eventually be paid when the replacement property is sold in the future in a regular sale. As with all things tax, there are rules and regulations to be followed to ensure that the transaction qualifies, such as:

The property must be given up and its replacement must be actively used in a trade or business or held for investment, so a personal residence or a vacation home won’t qualify. However, under some circumstances a vacation home that has been rented out may qualify.
The properties must be of like kind. For instance, this means you can’t exchange real estate for an airplane. But the definition is quite broad for real property – for example, it is OK to exchange raw land for an office building, a single-family residential rental for an apartment building, or land in the city for farmland. Typically, the owner of a residential rental who participates in an exchange will trade for another residential rental. Both real estate properties must be located in the United States. Caution: Stocks, bonds, inventory, partnership interests and business goodwill are excluded from Sec 1031 exchanges.
It is unusual for two taxpayers to each have a property that the other wants where they can enter into a simultaneous exchange. Most likely, if you wanted to exchange your property, you may need to do a “deferred exchange,” which means you effectively sell your property and then find a suitable replacement property. In this case, the law is very strict. You must identify, in writing, the replacement property within 45 days of the date your property was transferred and complete the acquisition of the replacement property within 180 days of the transfer or, if earlier, by the due date, including extensions, of your tax return for the tax year in which your property was transferred. During this period you aren’t allowed to receive the proceeds from the sale of your property.
The property acquired in an exchange must be of equal or greater value to the one you gave up, and all of the net proceeds from the disposition of the relinquished property must be used to acquire the replacement property. Otherwise, any unused proceeds are taxable.
With this basic information about 1031 exchanges, you may still be wondering whether an exchange is right in your situation. So let’s consider some of the advantages and disadvantages of exchanges.

ADVANTAGES:

Tax deferral – The main reason most people choose to do a 1031 exchange is so taxes don’t have to be paid currently on the gain that would result from selling the property. The maximum federal tax rate paid on capital gains for most taxpayers is 15% (20% if you would otherwise be in the highest tax bracket of 39.6%). However, the part of the gain that is equal to the depreciation deduction you’ve claimed while you’ve owned the property is taxable at a maximum of 25%.

Leveraging the tax savings – When an exchange is used, the money that doesn’t have to be spent to pay the taxes that would have been owed on the gain from a sale can be used to acquire other property or higher-value property.

Asset accumulation – The money saved from not paying tax on the sale gain can be retained as part of your estate to be passed to your heirs, who would also get a new basis on the replacement property that is equal to its fair market value at your date of death. In this case, none of the postponed gain from the original property is ever subject to income tax. However, depending on the overall size of your estate, there could be estate tax considerations.

Potential management relief – Taxpayers sometimes decide to sell their property to get out from under the burden of managing and maintaining the property. An exchange may still accomplish this without an outright sale by allowing the taxpayer to acquire replacement property that has fewer maintenance requirements and associated costs or has on-site management.

DISADVANTAGES:

Added complexity and expense – An exchange transaction involves more complexity than a straight sale. The timing requirements noted above must be strictly met or the transaction will be taxable. To avoid tainting the transaction when there’s a deferred exchange, the proceeds from the original property must not be received by the seller, and a qualified intermediary, also called an accommodator, must be hired to handle the money and acquire the replacement property. The intermediary’s fees will be in addition to the usual selling and purchase expenses incurred.

There have been cases that the accommodator has either inappropriately invested the client’s exchange funds or outright stolen it. Thus when the time came to pay for the new property there were no funds available. Be sure to use a legitimate accommodator and do your due diligence on the company before using them.

Low tax basis – The tax basis on the property acquired reflects the deferred gain, so the basis for depreciation will be low. Thus, the annual depreciation deduction will often be much less than it would be if the property were purchased outright. Upon sale of the property, the accumulated tax deferrals will catch up, and the result will then be a large tax bill.

No property flipping – The intent of the law permitting exchanges is for the taxpayer to continue to use the replacement property in his trade or business or as an investment. An immediate sale of the replacement property would not satisfy that requirement. How long must the replacement property be held? In most situations there is no specific guideline, but generally 2 years would probably suffice. “Intent” at the time of the exchange plays a major role according to the IRS.

Unknown future law changes – When weighing whether to do a 1031 exchange, consider the known tax liability if you sold your property versus the unknown tax that will be owed on the deferred gain when you eventually sell the replacement property in the future. If you think tax rates may be higher in the future, you may decide to pay the tax when you sell your original property and be done with it. Recent proposals by various members of Congress and President Obama would severely curtail or even eliminate 1031 exchanges and increase the depreciation period of real property from 27.5 years for residential property and 39 years for commercial property to 43 years for both. These proposals may never pass, but they are an indicator of how 1031 exchanges are currently viewed in Washington, D.C.

1031 exchanges are very complex transactions, and the information provided is very basic.

The above technical reference is provided as a courtesy to the reader by David Silkman, CPA, MST, Broker, Silkman & Associates Accountancy Corporation and SilkRoad Realty, Inc. The information is technical in nature, may not include all the details on a particular subject and may require review of the reader’s circumstances by a professional. You should consult with your tax advisor.

David S. Silkman is a CPA, has a Masters in Taxation (MST) and is a licensed real estate broker. He specializes in real estate tax laws and accounting. If you have any questions, please do not hesitate to call him at 310.479.7020 x301, email him at david@saacpa.com or visit www.saacpa.com or www.SilkRoadRealtyInc.com. Thank you.

Beware of Trust Fund Penalties

The term “trust fund recovery penalty” refers to a tax penalty assessed against the directors or officers of a business entity that failed to pay a required tax on behalf of its employees. For example, employers withhold income taxes and FICA payroll taxes from employees’ wages. These funds actually belong to the government and are referred to as “trust funds.” They cannot be used by the employer to pay other business expenses.

Tax law provides that employers are personally responsible for remitting the trust funds to the government. If the employer is a business entity such as a corporation or a limited liability company, then any person who was “required to collect, truthfully account for, and pay over” the funds is liable “for a penalty equal to the total amount of tax” that went unpaid. Once assessed, these “trust fund penalties” cannot be discharged in bankruptcy, and the employer or responsible person(s) will be liable for them even if the business entity itself is liquidated. Other civil penalties, as well as criminal penalties, could also apply.

The trust fund recovery penalty (the amount of the tax that was collected and not paid) can be imposed on any person who:

(1) Is responsible for collecting, accounting for, and paying over payroll taxes; and

(2) Willfully fails to perform this responsibility. Willfulness involves a voluntary, conscious and intentional act to prefer other creditors over the U.S. Thus, if a responsible person knows that withholding taxes are delinquent and uses corporate funds to pay other expenses, such failure to pay withholding taxes is deemed “willful.”

In determining whether an individual is a responsible person, courts consider various factors, including whether the individual:

(1) Holds corporate office;

(2) Has check-signing authority;

(3) Can hire and fire employees;

(4) Manages the day-to-day operations of the business;

(5) Prepares payroll tax returns;

(6) Signs financing contracts; and

(7) Determines financial policy.

If you can be judged to be a responsible person, make sure the trust fund payments are made before any other expenses are paid, even if encouraged not to do so by someone else of authority within the company.

Otherwise you may be held responsible for the unpaid funds, and the liability could follow you for a very long time.

The above technical reference is provided as a courtesy to the reader by David Silkman, CPA, MST, Broker, Silkman & Associates Accountancy Corporation and SilkRoad Realty, Inc. The information is technical in nature, may not include all the details on a particular subject and may require review of the reader’s circumstances by a professional. You should consult with your tax advisor.

David S. Silkman is a CPA, has a Masters in Taxation (MST) and is a licensed real estate broker. He specializes in real estate tax laws and accounting. If you have any questions, please do not hesitate to call him at 310.479.7020 x301, email him at david@saacpa.com or visit www.saacpa.com or www.SilkRoadRealtyInc.com. Thank you.

Family Home Loan Interest May Not Be Deductible

It is not uncommon for individuals to loan money to relatives to help them buy a home. In these situations, it is also not uncommon for a loan to be undocumented or documented by an unsecured note, with the unintended result that the home buyer can’t claim a tax deduction for the interest paid to their helpful relative.

The tax code describes qualified residence interest as interest paid or accrued during the tax year on acquisition indebtedness or home equity indebtedness with respect to any qualified residence of the taxpayer. It also provides that the term "acquisition indebtedness" means any indebtedness that is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and is secured by such residence.

There are also limits on the amount of debt and number of qualified residences a taxpayer may have for purposes of claiming a home mortgage interest tax deduction, but those details are not covered in this article, which is focusing on the requirement that the debt be secured.
Secured debt means a debt that is on the security of any instrument (such as a mortgage, deed of trust, or land contract):

(i) that makes the interest of the debtor in the qualified residence specific security of the payment of the debt,

(ii) under which, in the event of default, the residence could be subjected to the satisfaction of the debt with the same priority as a mortgage or deed of trust in the jurisdiction in which the property is situated, and

(iii) that is recorded, where permitted, or is otherwise perfected in accordance with applicable state law.

In other words, the home is put up as collateral to protect the interest of the lender.

Thus interest paid on undocumented loans, or documented but unsecured notes, is not deductible by the borrower but is fully taxable to the lending individual. The IRS is always skeptical of family transactions. Don’t get trapped in this type of situation; take the time to have a note drawn up and recorded or perfected in accordance to state law. And, make sure to either issue or have the lender issue to you a Form 1098 to document the amount of interest that was paid.

The above technical reference is provided as a courtesy to the reader by David Silkman, CPA, MST, Broker, Silkman & Associates Accountancy Corporation and SilkRoad Realty, Inc. The information is technical in nature, may not include all the details on a particular subject and may require review of the reader’s circumstances by a professional. You should consult with your tax advisor.

David S. Silkman is a CPA, has a Masters in Taxation (MST) and is a licensed real estate broker. He specializes in real estate tax laws and accounting. If you have any questions, please do not hesitate to call him at 310.479.7020 x301, email him atdavid@saacpa.com or visit www.saacpa.com or www.SilkRoadRealtyInc.com. Thank you.