Michael Gray, CPA's Tax and Business Insight

Table of Contents

• Happy Tax Season!
• Did you see us in the news?
• Brave New World?
• How do you correct depreciation errors for back years?
• 2004 last chance for bonus depreciation?
• Thinking of buying a California home?
• Definition of trust accounting income changed.
• IRS and Franchise Tax Board crack down on abusive tax shelters.
• New California withholding forms for real estate sales.
• Questions and Answers
  • What is the income cap for claiming a dependent?
  • How must I handle proceeds from an inherited property?
  • When do I deduct expenses to fix and maintain a property?
  • Do I have capital gains if I transfer my stock?
  • Can I claim a dependent if someone else has done so illegally?
  • Will I have to pay capital gains on my townhouse?
  • Do aliens qualify to make 1031 exchanges?
  • Do I qualify as self-employed even if I don't have a business?
  • Is it okay to claim fewer W-4 exemptions than I'm entitled to?
  • How can I avoid being taxed on the sale of my home?
  • Can I exchange a rental property for my primary residence?
  • Can I claim my child as a dependent if I live with my Mom?
• Do you have employee stock options?
• PS Marché Aux Fleurs
• Subscribe/Unsubscribe from Michael Gray, CPA's Tax & Business Insight

Happy Tax Season!

Yes, that wonderful time of year has arrived again!

In our CPA firm, February is mostly devoted to receiving client information to prepare income tax returns. If you are a client who has not received a tax organizer or information about our internet tax data organizer, please call Dawn Gray at 408-918-3162. You should also call Dawn to get instructions to use our internet tax data organizer if you are a new client who wants us to prepare income tax returns for 2003.

My calendar for February is already pretty full, but there are a limited number of times available for appointments with new clients or for tax planning consultations. To set an appointment, call Dawn Gray at 408-918-3162.

In order to complete your income tax returns by April 15, we should receive most of your information by March 1. In most cases, we will be filing extension requests when a client's tax information is received after March 1.

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Did you see us in the news?

Michael Gray, CPA was featured in a full-page article about IRA distribution planning after death on page 23 in the January 23, 2004 issue of the San Jose Business Journal. Michael Gray was also quoted in an article about bonus depreciation on page 5 of the January 26, 2004 issue of Car Dealer Insider.

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Brave New World?

Back in the late 1970s and early 1980s, when personal computers were introduced, they were a curiosity. What would people do with them? With the introduction of the VisiCalc spreadsheet, business use of personal computers exploded. But to have a personal computer in every home? With the introduction of the Mosaic browser, use of the internet became graphical and intuitive. (Notice the groundbreaking applications have become obsolete.) Now each person in my household has a personal computer and we just set up a wireless DSL network in our home. Amazing, isn't it?

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How do you correct depreciation errors for back years?

The IRS has issued temporary regulations and revenue procedures giving guidance for how to make corrections for depreciation errors for back years. Here is an oversimplified summary. See the source documents for details.

Under Revenue Procedure 2003-50, the time for making the election has been extended for taxpayers that missed the expense election for the tax year that included September 11, 2001. Since December 31, 2003 has passed, a taxpayer may make the election by filing a Form 3115 (Change of Accounting Method) with the taxpayer's timely filed federal income tax return for the second taxable year after the taxable year that included September 11, 2001. The fiscal year must end on or before July 31, 2004, and the taxpayer must have owned the property as of the first day of that taxable year.

Under final and temporary regulations issued with Treasury Decision 9105, "catch up" depreciation adjustments can generally be made as automatic accounting changes by filing Form 3115 (Change of Accounting Method) with the income tax return for the year of correction. A change in useful life is not a change of accounting method, so no Form 3115 is required for this change. Adjustments relating to a change in useful life are made in the current and future years, not as a Section 481(a) (catch-up) adjustment.

Under Revenue Procedure 2004-11, prior-year depreciation errors may be adjusted for the year an asset is sold, even when the asset hasn't been depreciated for two years by including Form 3115 with the income tax return for the year of sale.

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2004 last chance for bonus depreciation?

Remember that some of the recent tax law changes have short effective dates because they are economic stimulus provisions. For example, 50% bonus depreciation is scheduled to expire on December 31, 2004. There are some advantages of bonus depreciation compared to the expense election. For example, trusts qualify to claim bonus depreciation but not the expense election. Also, there are no limits for the total amount of bonus depreciation that can be claimed. Remember, only new assets qualify for bonus depreciation.

Also remember California and most other states do not allow a deduction for the federal bonus depreciation amount.

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Thinking of buying a California home? Get a loan pre-approval now.

Getting an approval in place before shopping for your home will help reduce the closing period so you can move in and enjoy your new home sooner.

Please remember we can provide financing for buying a California residence at very competitive interest rates. Because there are higher costs involved in financing a home purchase, there are costs for this type of loan.

Interest rates have been down recently, creating opportunities to reduce interest or monthly payments through refinancing existing home mortgages.

For details, please call Michael Gray at 408-918-3161. Agent for Wymac Capital, Inc. Michael Gray's California Real Estate Broker License number is 01269331.

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Definition of trust accounting income changed.

The IRS has issued regulations that change the definition of trust accounting income to reflect changes under many state laws. Under these rules, a "unitrust" concept can be applied to recharacterize certain principal items as income. Local principal and income laws will be respected. (TD 9102.)

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IRS and Franchise Tax Board crack down on abusive tax shelters.

The IRS and California Franchise Tax Board have both been making announcements about cracking down on tax shelters, including requiring onerous disclosure requirements. These rules can even "kick in" when you start a new business that generates a tax loss during its first two years of existence. One group that has been attacked is taxpayers who have credit cards issued by offshore banks. If you believe there is even a remote chance that you are participating in a "tax shelter" transaction, you really should consult with a tax professional -- possibly a tax attorney.

The California Franchise Tax Board has a Voluntary Compliance Initiative program under which you can "come clean" and avoid potential penalties. The program is only available January 1, 2004 through April 15, 2004.

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New California withholding forms for real estate sales.

The California Franchise Tax Board has issued new withholding forms for real estate sales that close in 2004. The new forms replace Form 597, Real Estate Withholding Tax Statement. The tax deposits are changing from a transaction-by-transaction basis to a monthly basis.

The new forms are Form 593, Real Estate Withholding Remittance Statement, which is used to submit the tax payments with copies of Form 593-B, Real Estate Withholding Tax Statement, used to report the real estate withholding for each seller.

Forms 593-C, Real Estate Withholding Certificate for Individual Sellers, 593-L, Real Estate Withholding-Computation of Gain or Loss, and 593-W, Real Estate Withholding Exemption Certificate and Waiver Request, have all been updated.

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Questions and Answers

Question

What are the income requirements if someone else (not a parent) is going to claim me as a dependent? Is it based on my W-2 income? Does that person have to bring my W-2 to his or her tax return preparer?: Do I have to go to the tax return preparer with that person?

Answer

The gross income for dependents other than student dependent children must be less than $3,050 for to qualify as a dependent for 2003. Gross income includes taxable income from all sources, not just W-2 income. Most income tax return preparers do not require having the dependent's Form W-2 to claim that person as a dependent. You do not have to be present at the interview. Your name and social security number will be reported on the tax return of the person who claims you as a dependent.

Remember that other requirements must be met in order to qualify as a dependent.

Question

My mother-in-law passed away late last year, and my brother-in-law is now buying her house from his sister (my wife) and his other brother. Quit claim deeds have been executed by all necessary parties. Brother #1 and the house are in Missouri, my wife and I live in Virginia, and brother #2 lives in California. My question has to do with how the proceeds from the buyout must be handled.

1. My wife and I would like to donate our proceeds to our church. Do we have to report the proceeds as income or capital gain, or can we just have the mortgage company transfer the money directly to the church?
   
   
2. Are there upfront taxes that have to be paid on this money (less than $30,000)?
   
   
3. If we report the money as income or capital gain, then donate it to the church, can we still claim an itemized deduction for the donation for 2004?
   
   
4. Is there a way to avoid reporting the proceeds as income or capital gain and still get a tax benefit for 2004?

Answer

Under Internal Revenue Code Section 1014, the tax basis (cost to determine gain or loss for income tax reporting) of inherited property is adjusted to the fair market value on the date of death or the alternate valuation date, if applicable. The acquisition date is the date of death, but the property is deemed to be held more than one year, qualifying for long-term capital gain or loss. Therefore, your wife should have little or no gain for the sale of her share of the property to her brother.

I didn't find any income tax withholding requirements for sales of real estate in Missouri. You can confirm this with the escrow company. If there is any, you can recover it when you file your income tax return. There is no federal withholding required for a sale like this. Other transfer taxes may apply.

You can have the escrow company pay the proceeds to your church on your behalf and claim a tax deduction for the charitable contribution. Remember to get a written receipt from the church, including a statement that no goods or services were received by you in exchange for the donation.

Question

I lived in a residence for two years, until October, 2003. From October, 2003 through January 15, 2004, I had expenses to fix and maintain the property. On January 20, 2004, I leased the property.

Should I deduct my expenses on my 2003 income tax return or my 2004 income tax return?

Answer

Repair and maintenance expenses are deductible when paid starting the date you make the house available for rent. That is also the date you start depreciating the residence. Improvements like carpeting, remodeling the bathroom or new appliances must be depreciated, not deducted. Remember the deductions may be subject to limitation under the passive activity loss rules. See Publication 527, Schedule E and instructions, and Form 8582 and instructions.

Question

1. On transferring (re-registering) a stock to another party, who is responsible for capital gains, if any?
   
   
2. If one is transferring the stock to satisfy a debt, what are the tax ramifications?

Answer

1. I'm not sure I understand this question. If you make a gift of stock, the person who receives the stock is responsible for reporting any gain or loss when it is later sold.
   
   
2. If stock is transferred to satisfy a debt, it is deemed to be sold for the amount of the debt. The person who transferred the stock will report a capital gain or loss based on the amount of the debt as the sales price less the tax basis of the stock. The person who received the stock will have a tax basis in the stock equal to the amount of the debt.

Question

My husband and I are separated and we have a daughter who resides with me. Without my consent, he claimed my daughter as a dependent on his 2003 income tax return. I was going to claim the exemption. He also falsely claimed to be a head of household.

What can I do about this matter? Should I claim my daughter, anyway, and risk getting audited, or is there something else I can do?

Answer

You can claim a dependent exemption for your daughter. As the custodial parent, you are entitled to the exemption and, if you maintain the residence for her, head of household status. If the tax authorities contact you with questions, tell them the facts. There is a good chance the Franchise Tax Board will question whether your husband qualifies as a head of household.

Question

In August, 2003, I sold the home that I lived in for the past 27 years. We bought it for $48,000 and I sold it for $275,000. I received net cash of $210,000 from the sale. I bought a townhouse in October, 2003 for $380,000, paying $180,000 down plus a mortgage. While the townhouse has potential, I think I have bitten off more than I can chew. I would like to sell it this spring and down size. Will I have to pay tax on capital gains, since I haven't lived here for two years?

Answer

Remember you have a cost or tax basis of $380,000 for the townhouse. After you pay the commission and selling expenses, you might not have any gain from the sale. If you do have a gain, it will be taxable. Be sure to have all of the facts for estimating the gain or loss. If you live in California, there probably be income tax withholding based on the total sales price. For this reason, you might want to wait until the end of the year to sell the house so you can recover overwithheld tax by filing your income tax returns shortly after the sale.

Question

Do aliens qualify to make 1031 exchanges?

Answer

They do under U.S. tax laws, but foreign real estate is not considered to be like kind to U.S. real estate.

Question

My income is principally from investments -- capital gains, interest and dividends -- and from a Roth conversion. Do I qualify as "self employed" for the 100% self employed health insurance deduction?

Answer

No.

Question

I computed that I qualify for 5 exemptions for my W-4 form. Is it OK to reduce it to 2?

Answer

Yes.

Question

My wife and I just purchased a house in Olivehurst, California. If we fix the house and decide to sell it, is there a way we can avoid being taxed on the sale?

Answer

If you live in the home as your principal residence for more than two years, you can exclude up to $500,000 of gain. If the house is investment property, you could exchange up into another house. If you just want to sell the house after you hold it for more than a year, you should qualify for a 15% maximum federal tax rate (excluding any depreciation previously claimed.) You could spread the gain by carrying financing as an installment sale. As you can see, you have a lot of choices.

Question

I recently exchanged a property I inherited for another and have rented it out for about 6 months. I am having a tough time keeping renters because the rent is high. I thought I could move into that house and rent out the home I am living in. Is that possible?

Answer

Messy, but possible.

Question

I am a 19-year-old college student with a 3-year-old child. I have been providing for my daughter, even though I stay with my mother. Can I claim my daughter as a dependent this year, since I have been working?

Answer

In order to claim your daughter as a dependent, you have to provide more than one-half of her support. It sounds like your mother is doing that.

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Michael Gray regrets he can no longer personally answer email questions. He will answer selected questions in this newsletter.

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If you have employee stock options, have you subscribed to Michael Gray, CPA's Option Alert?

To subscribe or review past issues, go to http://www.stockoptionadvisors.com/optionalert/.

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Visit our new articles!

• Selling the Invisible Book Review

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P.S.

My daughter and her husband, Holly and Dan Baker, have a Southern French Restaurant at 23 Ross Common, Ross, California, about 15 minutes north of the Golden Gate Bridge. The name of the restaurant is Marché Aux Fleurs and their website address is http://marcheauxfleursrestaurant.com. They are taking a well-deserved vacation in Italy for the first two weeks of January. For the best meal of your life, call 415-925-9200 after January 12 for a reservation and give them a try! For directions, visit our website at http://www.taxtrimmers.com/directions.shtml.

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P.P.S.

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IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.