Michael Gray, CPA's Tax and Business Insight

April 30, 2004

© 2004 by Michael C. Gray

ISSN 1539-395X

A monthly report to help you prepare for your financial future, keep more of what you earn by minimizing your taxes, and build an extraordinary business!

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Table of Contents

• We wuz robbed!
• Happy birthday to Dawn.
• Happy Mother’s Day.
• Handling Retirement Accounts After A Death Again.
• Tax preparers can now store electronic copies of client returns.
• Supreme Court will hear contingency fee dispute.
• IRS says stock devaluation isn’t a theft loss.
• District court allows deduction for interest on a bequest.
• Series H bonds are being discontinued.
• Questions and Answers
  • Can I do a tax-deferred exchange for my parents’ house?
  • Will withholding apply to a life insurance payment?
  • If I marry, will my husband have ownership rights in my house?
  • How are home sale gains exceeding $250,000 taxed?
  • Can I use the home sale exclusion for my rental property if I move there?
  • What is the tax basis of rented inherited property?
  • What should I do if my commercially prepared return is wrong?
  • How much should I reserve for taxes on my home sale?
  • Can I move into a 1031 exchanged property that was never rented?
  • Can I claim house cleaning serves as an expense deduction?
• Do you have employee stock options?
• Visit our new articles!
• PS Marché Aux Fleurs
• Subscribe/Unsubscribe from Michael Gray, CPA's Tax & Business Insight

We wuz robbed!

After spending a pleasant Easter Sunday afternoon with my family, I arrived at work on Monday morning and found the outside glass door to my office was shattered and my laptop computer was stolen. With the help of our computer technician and client, Steven Negrete of SMN Consulting, a replacement laptop was operational by noon. Our insurance agent, Mike Baxter of State Farm Insurance mailed an insurance reimbursement check that day. We finished on April 15 with a minimum of additional disruption.

How fast could you recover if this happened to you? Most of our critical information is on our server, which is backed up every night. I keep a back up tape for last week at home. What precautions do you have in place?

By the way, I am now storing my computer out of sight when I leave the office at night.

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Happy birthday to Dawn.

Another milestone has passed, my oldest child just turned 30. I feel very fortunate to have Dawn working with me. She is our webmaster and sees to it that these newsletters get out to you. She also has her own web placement consulting business, is an area governor for Toastmasters International and has been helping Grandpa Wally Bowers since Grandma Norrine passed away. Her mother and I are very proud of her.

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Happy Mother’s Day.

Remember Mother’s Day is May 9. Be sure to express your appreciation to mothers. If you haven’t taken care of it already, how will your mother or the mother of your children be provided for if something should happen to you? A good Mother’s Day gift might be to make appointments with your accountant, your attorney and your insurance agent to discuss this issue.

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Michael Gray and Naomi Comfort give an encore performance for the Peninsula Silicon Valley CPAs.

Michael Gray and attorney Naomi Comfort will give a two-hour presentation on "Handling Retirement Accounts After A Death" for the Taxation Committee, Peninsula Silicon Valley CPAs. The luncheon presentation will be at noon on Tuesday, June 8 at Hobees in Belmont. For details, call Stan Gross at 650-570-6331.

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Tax preparers can switch to storing electronic copies of client returns.

The IRS has issued final regulations allowing tax return preparers to keep electronic copies of client income tax returns and eliminating the requirement that paper copies be retained. The change was previously issued in temporary regulations and is effective for income tax returns and claims for refund presented to a taxpayer for signature after December 31, 2002. (T.D. 9119)

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Supreme Court will hear contingency fee dispute.

The Courts of Appeals are in dispute about whether the portion of an otherwise taxable lawsuit award that is paid to an attorney as a contingent fee can be excluded from taxable income. The Supreme Court will hear appeals of the Sixth Circuit decision in Commissioner v. Banks and the Ninth Circuit decision in Commissioner v. Banaitis to resolve the issue.

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IRS says stock devaluation isn’t a theft loss.

The IRS is disallowing deductions for theft losses relating to the decline in the market value of a company’s stock that result from corporate misconduct. The IRS says they are following a consistent pattern of rulings by the courts on this issue. (Notice 2004-27.)

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District court allows deduction for interest on a bequest.

A Texas district court ruled in a summary judgment that interest paid by an estate on a charitable bequest is deductible as an administration expense. In most states, interest is charged to an estate or trust when specific bequests aren’t paid within a certain period after death. Interest expenses generally are only deductible when they are for the purchase or improvement of a residence, relate to buying taxable investments, or are for a trade or business. The court ruled that interest for a late-paid bequest is also deductible as an administration expense. (Turner v. U.S., 93 AFTR 2d 2004-686.)

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Taxpayers who hold Series E and EE bonds will lose a tax break.

Owners of Series E and EE bonds have historically been able to extend the deferral of interest income when the bonds mature by trading them in for Series H bonds. Since Series H bonds are being discontinued by the Treasury Department, so this tax benefit will no longer be available after August 31. Owners of Series E and EE bonds should consider trading them in before September 1, but should be aware that Series HH bonds have been paying a very low rate of interest.

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Questions and Answers

Question

We are selling a rental house and would like to exchange it for our parents’ residence, which we would also use as a rental home. We have been told tax-deferred exchanges aren’t allowed in this situation. Is this correct?

Answer

Tax-deferred exchanges of real estate with related persons are difficult, because a sale of one of the properties by either of the parties within two years after the exchange will disqualify the exchange, resulting in taxable income. (Internal Revenue Code § 1031(f).) A direct exchange can work when both parties hold the properties more than two years after the exchange, The party exchanging a rental property must use the replacement property as business, rental or investment property. (Not as a personal residence.) The party who exchanges a principal residence doesn't qualify for tax deferred exchange treatment, and must rely on the exclusion of gain available for a principal residence.

When one of the parties ends up with cash, as often happens for "three-way" exchanges, the exchange is disqualified, resulting in taxable income.

Question

A deceased employee has a life insurance policy which the insurance company says has to be paid to the deceased employee’s 401(k) plan. The insurance company is sending the check to the deceased employee’s company and then the company is supposed to write checks to pay to the deceased employee’s beneficiaries. Is the company responsible for deducting taxes for the beneficiaries? Why wouldn’t the life insurance company pay the beneficiaries directly?

Answer

From what you are describing to me, it appears the life insurance policy was owned by the 401(k) plan, which would explain why the benefits are payable to the plan. (The plan was probably the beneficiary for the life insurance policy.) A payment which is a "non-periodic payment", such as a lump sum payment to a beneficiary other than a surviving spouse, is subject to 10% federal withholding by the plan, but the beneficiary can elect out of withholding for these payments. (Internal Revenue Code § 3405(b).)

A payment to a surviving spouse which qualifies for rollover is subject to mandatory 20% federal withholding by the plan, but the beneficiary can avoid the withholding by electing to have the distribution paid directly to an eligible retirement plan (such as an IRA). (Internal Revenue Code §3405(c).)

Withholding does not apply to any portion of a distribution which the plan believes is not subject to income tax, such as the deferred income of employer securities held by the plan and distributed to the beneficiary. (Internal Revenue Code § 3405(e).) (This exception does not apply to IRAs.)

Question

I live in California. I am a widow, soon to be remarried. My mother has chosen to bequeath to me the house I am living in, which she owns in a living trust. In the past year, I have met someone and we plan to be married soon. My mother says she will not leave the house to me because she is afraid my husband will get ownership rights in the home through the community property laws.

She says she will only leave the house to me if I promise never to marry again.

Any advice?

Answer

This is a legal question for which you need to consult with an attorney for proper advice.

Now I’m playing "Dear Abbey." Does your mother have a reason for disapproving of this marriage? If not, discuss with you attorney whether your mother has become incompetent. If she is not incompetent, she can do as she pleases with her property and you might have to make a choice.

Question

I’m selling my first home. I know that I qualify for a $250,000 exclusion as a single person who meets the requirements. How is any gain exceeding $250,000 taxed?

Some people told me that if I invest the excess gains in other real estate, I can avoid any tax. Is that right?

Answer

Assuming you have only used the home as a principal residence and not claimed any depreciation deduction with respect to the home, any excess gain will be taxable as long-term capital gains, eligible for a 15% maximum federal tax rate. Individuals in the 10% or 15% brackets are eligible for a 5% tax rate for part of the gain.

A sale of a principal residence doesn’t qualify for a tax-deferred exchange, so investing in other real estate won’t help you avoid tax on the gain.

Question

If inherited property that has been converted to rental property is eventually sold, would the tax basis of the property still be the fair market value as of the date of death?

Answer

Yes. The tax basis may be reduced for any depreciation claimed on the rental schedule after the death.

Question

I am planning to sell my principal residence this year and claim the $500,000 exclusion. If I move into my rental property and use it as a principal residence for more than two years, will I be able to claim the exclusion if I sell the former rental property?

Answer

Yes. Remember the exclusion doesn’t apply to accumulated depreciation claimed while you rented the property.

Question

I had my tax returns prepared by a commercial tax return preparation company this year. They didn’t include a schedule for self-employment tax and I am a self-employed independent contractor. What should I do?

Answer

Go back to the tax return preparation company and ask them to prepare an amended income tax return for you at no charge. As I recall, they guarantee that they will pay any penalties you incur as a result of their preparation services. If they refuse, have another preparer do it and file to recover your expenses in small claims court. Don’t panic, it’s going to be OK.

Question

My husband and I have lived in the same home since 1973. If we sold the home, we’d have a capital gain of about $1 million. Even with the $500,000 exclusion, there still will be a lot of tax (federal and California) to pay. I’m also worried about the AMT. Can you tell us how much to reserve for taxes?

Answer

You are right to be concerned about the AMT. The California tax is not deductible for AMT, so you will be subject to that tax. You should reserve about 25% of the gain in excess of the $500,000 exclusion for income taxes.

Question

We made a 1031 exchange about 6 months ago. The property that we received was a more expensive one, because we believed it would be easier to rent. After six months, we still haven’t been able to rent it. We discovered the house is located in a depressed area.

Our tax accountant says we could move into the rental property since we purchased it with the intention of renting it.

Could we move into the rental without having tax consequences?

Answer

I think you have a legal basis for doing so. This situation is one that is likely to get IRS attention. Do you want to live in "a depressed area"? Can you exchange from this property to another one? Maybe you should sell the property on an installment sale basis?

Question

Can I claim the money I pay to have my house cleaned as an expense deduction somewhere if I’m paying cash? By personal check?

Answer

No.

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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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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 www.marcheauxfleursrestaurant.com. For the best meal of your life, call 415-925-9200 for a reservation and give them a try! For directions, visit our website at 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.