Real Estate Professionals – Section 469(c)(7) – Getting it right

This article is written by CPE Link instructor Annette Nellen as a follow up to her Live Webcast Passive Loss Rules and Real Estate Professionals.

We continue to see cases involving Code §469(c)(7) on real estate professionals.  One commonality is that the taxpayers lose because they clearly do not meet the definition of a real estate professional, often because they have full-time employment outside of the real estate industry and have few rental properties.  A recent case involved a couple with three rental properties located out of state. This case has lessons both for taxpayers and their preparers.

Ballesteros, TC Summary Opinion 2013-108, involved a working couple. The wife (W) was a full-time nurse and the husband (H) was a full-time employee of an aerospace company. The couple lived in California and owned three rental properties in Georgia and Florida. They deducted approximately $12,000 loss per year for these grouped properties. They had logs showing time spent for phone calls, paying bills, going to the Post Office, and social events. Most tasks were reported in block of 2 or 4 hours.  The hours reported were as follows:

Wife

Husband

2008

2,199

901

2009

3,025

1,005

2010

2,248

851

 

W indicated that both she and her husband were real estate professionals. The IRS and court questioned the logs and time spent. Per the court:

“We need not accept petitioner’s testimony and may and do reject it because of the many indicia of unreliability. … Petitioner’s logs are unreliable because the hours she recorded for specific tasks, such as telephone calls and writing and mailing checks, were improbable in that they were excessive, apparently duplicative (charging the same hours to each rental property), and always the same. The total hours recorded are unrealistic in view of petitioners’ full-time employment.”

The court upheld a substantial understatement of tax penalty. Per the court, “exaggerated logs negate the good faith” of H and W. W stated that their return preparer provided a checklist of questions which confirmed that she was a real estate professional. The preparer did not testify, but the court noted that the preparer likely only had erroneous information from the couple.

Tax Season Relevance:

If an individual has a full-time job outside of real property trades or businesses, they are unlikely to be a real estate professional.  A full-time job is likely 2,080 hours per year (perhaps more). So, to be a real estate professional, the person would have to work more than 2,080 hours in real property trades or businesses.  If the person only has rental properties (not a real estate broker or developer, for example), they would need many rental properties to possibly be spending over 40 hours per week on all of them.

If a person’s answer to the question – what is your profession, is something outside of real property trade or businesses, they likely are not a real estate profession. One of the actions IRS examiners are to take in auditing a §469(c)(7) issue is to look at the occupation noted on the signature line of the taxpayer’s return to see if it indicates a real estate profession (IRS audit guide page 2.5).

Ask questions of clients with rental properties who tell you they are real estate professionals – what is there profession, how many rental properties do they have, do they have legitimate logs noting realistic time spent on the rentals?  Share the Ballesteros case (or other similar cases) with them, highlighting the penalty imposed upon the taxpayer.

 

Offer-in-Compromise – Fundamental Concepts

Our U.S. tax system is built on the premise that all taxpayers are expected to report their tax liabilities accurately and pay them on time. However, the Internal Revenue Code (§7122) gives the IRS the authority to “compromise” (i.e., settle based on a taxpayer’s adverse economic circumstances) a tax liability for less than its stated amount at certain times when 1) Doubt exists as to the liability; 2) Doubt exists as to the liability’s collectibility; or 3) It would advance effective tax administration to settle the liability.

Defining the 3 OIC Fundamental Concepts

  1.  “Doubt as to liability”—Doubt as to liability exists when there is a real dispute about the existence or amount of the correct tax liability of a taxpayer.

    Such doubt doesn’t exist, though, if the liability has been settled by a final court decision or judgment concerning the genuineness or amount of the liability. But an offer under the “doubt as to liability” category can’t be rejected just because the IRS can’t locate the taxpayer’s return or information to verify the liability (IRC 7122(c)(3)(B)). The IRS indicates it will consider an offer based on doubt as to liability if it reasonably reflects the amount the IRS could expect to get by going to court. Since trying to predict the outcome of a court case is far from an exact science, the IRS relies on “discretion” in determining what it will consider as a reasonable offer (Rev. Proc. 2003-71, 2003-2 C.B. 517).

  2. “Doubt as to Collectibility”—Doubt as to Collectibility may be present in any case when a taxpayer’s assets and income are less than the full amount of the assessed liability. To determine doubt as to Collectibility, the IRS considers the taxpayer’s ability to pay. In settling such a case, the taxpayer must be allowed to preserve sufficient funds to pay for his/her basic living expenses. To determine settlement, IRS considers expenses only to the extent they are necessary for health and welfare of the taxpayer and family or are needed to produce income (Rev. Proc. 2003-71).

    In general, the IRS won’t consider an offer based on doubt as to Collectibility if the ability of the government to collect the tax is not in doubt. This kind of offer is considered appropriate when liquidation of assets or maximum levy of income isn’t enough to pay the tax. The assets of a non-liable spouse generally aren’t considered to determine a taxpayer’s ability to pay unless those assets have been conveyed to the spouse in order to defraud creditors (or unless state law makes the spouse’s assets available to creditors, such as in community property states). However, action against the spouse’s assets must be weighed against how such action will affect the standard of living of the taxpayer and family.

    The IRS publishes schedules of national and local living expense standards to help evaluate family needs (Publication 1854, How to Prepare a Collection Information Statement (Form 433-A)). They use these standards based on the individual facts and circumstances of each individual case. The standards aren’t used if the amounts they prescribe would deprive a taxpayer of adequate support for basic living needs.

  3.  “To promote effective tax administration”—If the IRS finds no grounds to compromise based on the two previously described categories, they may enter into a compromise to promote effective tax administration. This could happen when collection of a full tax liability creates economic hardship. Alternatively, it could result where detrimental public policy or unfairness to the taxpayer provide basis for a compromise. Although acceptance of a compromise under this standard may occur where full collection would undermine public confidence in the tax law, a compromise would not be accepted if it would undermine compliance with the tax laws by taxpayers.

    Congressional intent with this provision was that the IRS would take into account factors like equity, hardship, and public policy in the tax administration process. Factors that may be considered in determining hardship might include serious illness that depletes a family’s financial resources (Reg. Section 301.7122-1(c)(3)(i)(A)). On the other hand, a compromise of a tax shelter liability would be one that could undermine rather than promote compliance within the tax system.

Excerpt from 2013 Taxes: Affordable Care Act and Other Special Circumstances by Lee T. Reams, Sr.

Affordable Care Act (ACA): Supreme Court Rules Health Care Bill Constitutional. Penalty for No Insurance Is Really a “Tax!”

On June 28, 2012, the Supreme Court, in a five to four decision, held the insurance mandate and, thus, the Affordable Care Act (ACA) to be constitutional. Although political rhetoric continues, this Supreme Court decision means that we must prepare for what the Treasury Inspector General calls the biggest tax act in 20 years. What does ACA mean to you and your clients?

Health Care Reform Impacts Most Businesses and Individuals
The Affordable Care Act (P.L. 111-148), signed by the President on March 23, 2010, as amended by the Health Care and Education Reconciliation Act of 2010 (P.L. 111-152) and signed by the President on March 30, 2010, implements fundamental health care reforms and requires many of the 32 million uninsured individuals to obtain health care coverage or pay penalties. Most lower-income individuals, along with some middle-class families, will receive government help to pay for health insurance purchased at state Exchanges.

ACA contains more than $400 billion in new taxes and revenue raisers on employers and individuals. Major changes you and your clients can expect include:

  1. Individuals without health insurance will owe a penalty (tax) starting in 2014;
  2. Employers with 50 or more full-time employees must offer affordable health insurance to their employees beginning in 2015 or pay a penalty;
  3. State insurance exchanges will be established to allow clients to shop for insurance;
  4. Employee Medicare tax increases by 0.9% (total of 2.35%) on annual wages for married couples with an AGI over $250,000 and singles with an AGI over $200,000 starting in 2013;
  5. A new Medicare tax of 3.8% applies on net investment income for married couples with AGI over $250,000 and singles with AGI over $200,000 starting in 2013;
  6. Extensive new penalties apply on tax shelters;
  7. The “haircut” to deduct medical expenses increases from 7.5% to 10% of AGI starting in 2013;
  8. FSA contributions for medical expenses are limited starting in 2013 to $2,500. and
  9. Children under age 27 may be insured under their parent’s health insurance policy.

This article is an excerpt from Vern Hoven’s Federal Tax Updates Series. 

Test Your Tax Treatment Knowledge

Tax Treatment of Individual Retirement Arrangements
Q: Helen, age 60, made total contributions of $60,000 to a Roth IRA she established 15 years ago. Five years ago she withdrew $10,000 tax-free. How much income must she recognize if she takes a complete distribution from the Roth IRA this year when its value is $90,000?

A. $0
B. $30,000
C. $40,000
D. $90,000

A: The correct answer is C Except in the case of a spousal IRA, a taxpayer may not contribute an amount to an IRA in excess of his or her earned income for the year. For purposes of the IRA rules, earned income includes salary, fees, tips, bonuses, commissions, and alimony. Since the taxpayer’s earned income, including alimony, exceeds the maximum IRA contribution, she may make a contribution not exceeding $5,500.

Tax Treatment of Life Insurance Proceeds
Q: Bob has owned his participating life insurance policy for many years and receives substantial policy dividends each year that he takes in cash. What tax treatment would be given to the dividend he receives  this year, if his total policy premiums were $10,000 and his total dividends were $12,000?

A. The dividend would be tax-free as a return of premium
B. The dividend would be taxable at capital gains rates
C. The dividend would be considered ordinary income
D. Taxation of the dividend would be deferred until policy surrender

A: The correct answer is C. Bob’s dividend this year would be considered ordinary income. Dividends received under a life insurance policy are generally income tax-free until the total amount received or credited exceeds the aggregate premiums paid for the policy. Any dividends paid or credited in excess of the total gross premiums paid for the life insurance policy are considered taxable income in the year in which received.

Tax Treatment of Sickness & Injury Plans
Q: An Archer MSA rollover may be made no more frequently than once every _____ months.

A. 6
B. 12
C. 18
D. 24

A: The correct answer is B. An Archer MSA rollover may not be made more frequently than every 12 months. The applicable rollover rules are much like those that apply to IRA rollovers and rollovers from qualified plans. Accordingly, an Archer MSA rollover must follow the rules below:

  • The rollover must be made within 60 days of the individual’s receipt of the Archer MSA distribution; and
  • Only one MSA rollover may be made each year. (The “year” in the case of an Archer MSA rollover is a rolling 12-month period, rather than a calendar or tax year.)

Q: For which of the following individuals would qualified long term care insurance premiums NOT be deductible without reference to adjusted gross income?

A. A partner in a law firm
B. An owner of an S corporation
C. A sole owner of a regular corporation
D. An owner of a limited liability company

A: The correct answer is C. An owner of a regular corporation is not considered self-employed for purposes of long term care insurance premium deductibility. A self-employed person, for purposes of long term care insurance premium tax-deductibility, includes sole proprietors, partners, and owners of S corporations, limited liability partnerships and limited liability companies. Thus, a sole owner of a regular corporation could not deduct premiums for qualified long term care insurance premiums without reference to his or her adjusted gross income.

These questions were pulled from Paul Winn’s Tax Treatment of Health Plans, IRAs, and Life Insurance Proceeds courses.

Simplifying the Reporting Process

For many small business owners, the issuance of financial statements is nothing more than a necessity to satisfy the bank or other third party user. Although the small business client may be willing to pay higher fees to accountants for effective tax planning or management consulting, most owners are unwilling to pay for a high-priced compilation or review engagement that is perceived as a commodity rather than a value-added service.

An accountant may wish to consider existing reporting options that offer practitioners a means to reduce the time spent on completing an engagement. Here is a list that may be useful depending on the client’s needs and circumstances:

1. Compile OCBOA financial statements (e.g., cash or income tax basis)
2. Compile GAAP financial statements with no footnotes and statement of cash flows
3. Issue management-use financial statements in accordance with SSARS No. 19:

  • Compiled financial statements without a compilation report
  • Financial statements are not distributed to parties other than management (e.g., not issued to the bank)

4. Issue a compilation report with only selected footnotes:
SSARS No. 19 permits an accountant to report on financial statements under which a select few disclosures are included provided the notes are labeled:

“Selected Information-Substantially All Disclosures Required by Accounting
Principles Generally Accepted In the United States Are Not Included.”

5. Use a compilation report at interim periods that list the departures from GAAP.
Example: Assume that an accountant prepares monthly financial statements for a client, and these statements consistently have certain GAAP departures such as missing accruals, allowance for bad debts, etc. The accountant may prepare a standard compilation that makes reference to the GAAP departures and can use this report, without modification, from month to month.

At year-end, the accountant may adjust the departures to GAAP and issue a standard compilation or review report.

6. Compile only one financial statement (e.g., balance sheet), and not the full set of financial statements

7. Apply options that are excluded from SSARS No. 19 for which a compilation or review report is not required:

  • Provide selected monthly information requested by the client such as account balances (e.g., cash or accounts receivable) or operating information (e.g., number of meals served for the month)
  • Provide a client or other third party users with a copy of the client;s tax return.An accountant is not required to report on a tax return.

8. Issue financial statements with one or more GAAP departures.

This list was an excerpt pulled from Steven Fustolo’s course 2013 Practice Issues: Compilation & Review Update.

How Much is Expected to be Raised from the 2013 New Affordable Care Act Taxes

Guest Article from CPE Link Instructor Annette Nellen

During the January 15, 2014 Quarterly Tax Update webcast, I was asked how much revenue was expected to be generated from the Additional Medicare Tax and Net Investment Income Tax, both of which go into effect in 2013. I did not remember so said I would look it up. Well, in March 2010, a revenue estimate report of the Joint Committee on Taxation estimated that both of these taxes combined would generate $20.5 billion in 2013, increasing to $38.5 billion in 2019. This is the significant tax increase included in the Affordable Care Act.  You can see the estimates of other ACA provisions in JCX-16-10 (3/18/10).

A JCT report from the week before (JCS-10-10; 3/10/10), estimated that the Additional Medicare Tax be itself would generate $13.3 billion in 2013 and $15.2 billion in 2019.  So, the NIIT is the greater revenue generator.

Because these taxes have special forms (Form 8959 for the Additional Medicare Tax, and Form 8960 for the NIIT) as well as line 60 on Form 1040, the IRS will be able to collect actual data, which I assume they will do and report it on their IRS Stats page. Then we can see how close the 2010 revenue estimates were.

Annette Nellen

Resolve to Automate Repetitive Excel Tasks in 2014

By CPE Link Instructor David Ringstrom, CPA

A number of years ago I coined the phrase “Either you work Excel, or it works you.” I can’t count the number of knowing nods I’ve gotten when spreadsheet users relate to the latter. Even proficient Excel users can sometimes get snarled into a quagmire of repetitive work in Excel. However, for those up to the challenge, Excel does offer a way to lighten your workload.

Depending upon your desktop version of Excel, there’s a Record Macro button tucked away on the View tab or the Tools menu. Think of this is a built-in video camera in Excel, except that instead of simply recording a video of what you’re doing in Excel, it actually transcribes your actions into programming code that you can play back on demand. Even if you’ve never even seen a line of programming code, you can use the Macro Recorder to take your first step into a new realm of possibilities in Excel.

In simple terms, a macro is one or more lines of programming code that can be played back. A macro can be as simple as centering text across a range of columns, or an elaborate arrangement of programming code that takes minutes or even hours to complete. Many users shy away from macros in the same way that they eschew pivot tables in Excel—the terms are seemingly incomprehensible and unapproachable. Fortunately the macro recorder offers an easy on-ramp for anyone ready to get his or her feet wet. As for Pivot Tables, Excel 2013 has your back there as well. Click anywhere within a list of data, and then choose Recommended Pivot Tables from the Insert tab of the ribbon to receive point-and-click assistance.

Back to macros—you’re only moments away from creating your first one:

  • Excel 2007 and later: Choose View, Macros, and then Record Macro.
  • Excel 2003 or Excel for Mac 2011: Choose Tools, Macro, Record New Macro.

Carry out these actions in the Record Macro dialog box:

  • Enter MyFirstMacro in the name field.
  • Choose This Workbook from the Store Macro In list.
  • Click OK to start recording.

Next, type the words “Hello, World!” in any blank worksheet cell, press Enter, and then turn off the Macro Recorder:

  • Excel 2007 and later: Choose View, Macros, and Stop Recording.
  • Excel 2003 and Excel for Mac 2011: Choose Tools, Macro, Stop Recording.

To test your work, carry out these steps in a blank worksheet:

  • Excel 2007 and later: Click the Macros button on the View tab.
  • Excel 2003 or Excel for Mac 2011: Choose Tools, Macro, Macros.

Next, double-click on MyFirstMacro in the Macro dialog box to run the macro. The words “Hello, World!” should appear in the active cell within your worksheet.

To save a macro for later playback, activate the workbook within which you recorded the macro, choose File, Save As, and then:

  • Excel 2007 and later: Choose either Excel Macro-Enabled Workbook or Excel 97-2003 Workbook from the File Type list, and then save your workbook.
  • Excel 2003 and Excel for Mac 2011: Simply save the workbook in the usual fashion.

Your macro can now be played back anytime the workbook is open in Excel, and even better, the macro can be run in any other workbook that is open at the same time as the macro workbook. You’re now among the initiated, so try using the Macro Recorder to automate repetitive tasks that you encounter, such as removing extraneous rows from an accounting report that you’ve exported, or adding your contact information to the bottom of a spreadsheet that you’re about to send out of the building. You’ll quickly find that there are limits to the Macro Recorder, but if you find creating macros intriguing, there’s a whole new world in Excel available for you to explore. If nothing else, being aware of Excel’s automation capabilities means you can seek help in the future when repetitive spreadsheet tasks become part of your daily grind.

Do note that in Excel 2007, 2010, or 2013 that if you save your workbook as an Excel Workbook—with the .xlsx extension—that your macros will be discarded. If you catch yourself doing this accidentally, immediately resave your workbook as a Macro-Enabled Workbook (.xlsm extension) or Excel 97-2003 Workbook (.xls extension) to preserve your work.

For more Macros tips, view David’s online CPE tutorials Introduction to Excel Macros or join him in his Live Webcasts.

About the author:
David H. Ringstrom, CPA, heads up Accounting Advisors, Inc., an Atlanta-based software and database consulting firm providing training and consulting services nationwide. Contact David at david@acctadv.com or follow him on Twitter. David speaks at conferences about Microsoft Excel, teaches webcasts for CPE Link, and writes freelance articles on Excel for AccountingWEB.

Federal Tax Updates are here!

Part 1: Individual Income Tax
Learn about new tax legislation passed in 2013, extender bill provisions, the individual mandate for health coverage and associated penalties, individual tax credits, including the AMT patch which has been made permanent, the new tax return filing requirements for same-sex couples and Registered Domestic Partners after the Supreme Court’s decision on DOMA and much more…

Topics Covered:

  • The new tax legislation passed in 2013
  • The extender bill provisions
  • The top tax bracket — it’s back to 39.6% starting this year
  • The new tax return filing requirements for same-sex couples and Registered Domestic Partners after the Supreme Court’s decision on DOMA
  • The myriad of adjustments to gross income such as health savings accounts and prepaid tuition accounts
  • The ways divorce attorneys can screw up the alimony requirements
  • The return of the personal exemption phaseout and itemized deduction phaseout haircuts
  • The retention of the 0% and 15% capital gain rates and the introduction of the 20% capital gain rates on high income taxpayers
  • The stock basis reporting on the new Form 1099-B and the redesigned Form 8949
  • How to avoid the 3.8% Medicare tax on unearned income
  • The new FBAR and FATCA reporting forms and requirements for both foreign income and foreign assets
  • The increase of the medical AGI haircut from 7.5% to 10%
  • The individual mandate for health coverage and associated penalties
  • Which individuals are exempt from the individual mandate
  • The itemized deductions including the charitable contribution rules, the home mortgage rules, and allowable medical expenses
  • Which form to use for Ponzi-type losses
  • The general rules on both casualty losses and theft losses
  • The individual tax credits, including the AMT patch which has been made permanent

Proposed IFRS Impairments Will Be More Subjective

IFRS proposals for loan-loss provisioning should accelerate impairment costs for banks and drive them to report asset values more prudently than under existing rules, in a statement released by the Fitch Ratings agency. But an expected loss approach could increase management judgment in the provisions taken

The new standard should be more forward-looking and better reflect managements’ own loss expectations, as it removes the barrier to factoring forecast changes in economic conditions into the impairment charge. But this will involve considerable judgment. We expect many banks to calculate their credit losses using estimates of probability of default and loss given default.

The categorization of loans into three “buckets” for the purposes of setting provisions also involves subjectivity. The proposals require banks to provide initially for losses expected over the next 12 months. If the credit quality of the loan then deteriorates, it passes into bucket two…and full lifetime losses are used instead. The third bucket is for loans deteriorated to the point where there is objective evidence of impairment.

It is unclear how the three buckets correspond to the performing and non-performing categories banks already use. Without further explanation of the differences between the various categorizations, and details on the migration of loans between the buckets, analyzing asset quality may be challenging despite improved information available to investors under the new standard.

Nevertheless, we believe increased disclosure from the new IFRS will improve transparency and benefit users, particularly when these are combined with the take-up of recommendations around credit risk reporting by the Enhanced Disclosure Task Force.

Meaningful comparisons between provisions reported by US GAAP and IFRS banks are also likely to be difficult.

The International Accounting Standards Board will now need to agree the exposure draft before it becomes a standard.

The Ultimate Lean Budget

If you are willing to modify the reporting system, decision making, and organizational structure of a business, it is entirely possible to not only operate without a budget, but to thrive while doing so. Thus, the ultimate lean budget is to have no budget at all.

Operating without a Budget
In order to have a properly functioning organization that operates without a budget, it is necessary to make alterations in four areas. They are:

  •  Forecast. The forecast is a rolling forecast that is updated at frequent intervals, and especially when there is a significant event that changes the competitive environment of the business. The forecast is simply the expected outcome of the business in the near term, and is intended to be an early warning indicator of both threats and opportunities. It is completely detached from any compensation plans.
  • Capital budgeting. Requests for funds to buy fixed assets are accepted at all times of the year. Funding allocations are based on expected results and the needs of the requesting business unit. There is no formal once-a-year capital budgeting review.
  • Goal setting. Employees jointly set targets that are relative to the performance of other business units within the company, and against other benchmark organizations. If there is a bonus plan, it is based on these relative results.
  • Compensation. Bonuses and other compensation are based on the ability of the company as a whole to improve its performance relative to its competition or some other relevant performance baseline.

A key point is that the forecast and capital budget are not related to targets. By separating these processes from any corporate targets, there is no incentive for employees to fudge their forecasts or fixed asset funding applications in order to earn bonuses.

From the management perspective, it is critical that senior managers step away from the traditional budget based command-and-control system and replace it with a great deal of local autonomy. This means that local managers can make their own decisions as long as they stay within general guidelines imposed by senior management. The focus of the organization changes from short-term budgets to medium-term to long-term financial results. There is no emphasis on budget variances, since there is no budget.

Also, senior management must trust its employees to spend money wisely. The expectation is that an employee is more likely to question the need for any expenditure, instead of automatically spending all funds granted under a budget allocation.

From a more general perspective, if a company abandons budgeting, how does it maintain any sort of direction? The answer depends upon the structure of the business and the environment within which it operates. Here are several examples of how to maintain a sense of direction:

  • Margin focus. If a business has a relatively consistent market share, but its product mix fluctuates over time, it may be easier to focus the attention of managers on the margins generated by the business, rather than on how they achieve those margins. This eliminates the structural rigidity of a budget, instead allowing managers to obtain revenues and incur expenses as they see fit, as long as they earn the net profit margin mandated by senior management.
  • Key value drivers. If senior management believes that the company will succeed if it closely adheres to specific value drivers, then it should have the company focus its attention on those specific items, and not hold managers to overly-precise revenue or profit goals. For example, the key to success in an industry may be an overwhelming amount of customer support; if so, focus the entire company on maximizing that one competitive advantage.
  • Few products and very competitive environment. If a business relies upon only a small number of products and is under constant competitive pressure, then decisions to change direction must be made quickly, and the organization must be capable of reorienting its direction in short order. This calls for a centralized management environment where a small team uses the latest information
    to reach decisions and rapidly drive change through the organization. In this case, a budget is not only unnecessary, but would interfere with making rapid changes. Thus, keeping employees focused on the operational direction given by senior management is vastly more important than meeting revenue or expense targets; taken to an extreme, employees may never even see the financial results of their areas of responsibility, because the focus is on operations, not financial results.

This article is an extract from Steven Bragg’s Lean Accounting Guidebook.