THE WHALEN GROUP
Combine Home Sale with the 1031 Exchange
You don’t often get the opportunity to even consider making a tax-saving double play. But your personal residence combined with a desire for a rental property can provide just such an opportunity.
The tax-saving strategy is to combine the tax-avoidance advantage of the principal residence gain exclusion break with the tax-deferral advantage of a Section 1031 like-kind exchange. With proper planning, you can accomplish this tax-saving double play with full IRS approval.
The double play is available if you can arrange a property exchange that satisfies the requirements for both the principal residence gain exclusion break, and tax deferral under the Section 1031 like-kind exchange rules.
The kicker is that tax-deferred Section 1031 exchange treatment is allowed only when both the relinquished property (what you give up in the exchange) and the replacement property (what you acquire in the exchange) are used for business or investment purposes (think rental here).
Let’s say your principal residence—owned for many years by you and your spouse—is worth $3.3 million. You convert it into a rental property, rent it out for two years, and then exchange it for a small apartment building worth $3 million plus $300,000 of cash boot paid to you to equalize the values in the exchange.
Your basis in the former residence is only $400,000 at the time of the exchange. You realize a whopping $2.9 million gain on the exchange: proceeds of $3.3 million (apartment building worth $3 million plus $300,000 in cash) minus basis in the relinquished property of $400,000.
Now, let’s check on your tax bite. You can exclude $500,000 of the $2.9 million gain under the principal residence gain exclusion rules. So far, so good!
Because the relinquished property was investment property at the time of the exchange (due to the two-year rental period before the exchange), you can defer the remaining gain of $2.4 million under the Section 1031 like-kind exchange rules. Nice! No taxes on this deal.
Pay No Income Taxes Ever
If you hang on to the apartment building until you depart this planet, the deferred gain will be eliminated from federal income taxes thanks to the date-of-death basis step-up rule. Under the date-of-death rule, the tax code steps up the basis of the building to its fair market value as of the date of your death.
Example. You die. Your heirs inherit the building at its new stepped-up basis. They sell the building for its date-of-death fair market value. Presto, no income taxes.
Of course, you do need to consider estate taxes if your estate is greater than $11.4 million.
Know These Tax Rules If Your Average Rental Is Seven Days or Less
If you own a condominium, cottage, cabin, lake or beach home, ski lodge, or similar property that you rent for an “average” rental period of seven days or less for the year, you have a property with unique tax attributes.
Seven days example. Say you have a beach home and you rent it 15 times during the year, for a total of 85 days. Your average rental is 5.7 days. That’s an average of seven days or less for the year.
The right type of beach home or vacation cottage can produce great tax results when the average rental period is seven days or less. But it’s tricky because when the average rental period is seven days or less, the property is not a rental property as defined by the tax code. Instead, the property is a commercial hotel type property that you report on Schedule C of your tax return if you provide services in connection with the rentals, or
a weird in-limbo property that you report on Schedule E when you don’t provide services.
If the property shows a loss, you can deduct that loss on either Schedule C or Schedule E if you can prove that you materially participate. With the seven-days-or-less-average rental, you likely have only two ways to materially participate:
- The combined participation by you and your spouse constitutes substantially all the participation in the seven-days-or-less-average rental activity when you consider all the individuals who participated (including contractors).
- The combined hours of participation by you and your spouse in the seven-days-or-less-average rental activity are (a) more than 100 hours and (b) more hours than the participation of any other individual.
Example. Your seven-days-or-less beach rental produces a $20,000 tax loss for the year. On this rental, you spend 65 hours during the year. No other person works on the rental. You materially participate in this rental, and the $20,000 is deductible—period (regardless of its location on Schedule C or E).
If you have a profit on the rental, you likely have a Section 199A deduction when you report the rental on Schedule C as a business. Although not deemed a business by Schedule E reporting, the Schedule E rental could rise to the level of a business as defined for the Section 199A deduction.
Avoid This S Corporation Health Insurance Deduction Mistake
If you own more than 2 percent of an S corporation, you have to do three things to claim a deduction for your health insurance:
- You must get the cost of the insurance on the S corporation’s books.
- Your S corporation must include the health insurance premiums on your W-2 form.
- You must (if eligible) claim the health insurance deduction as an above-the-line deduction on Form 1040.
The three-step health-insurance procedure also applies under attribution rules (and this could be a surprise) to your spouse, children, grandchildren, and parents if they work for your S corporation, even if they don’t own a single share of S corporation stock directly.
You need to get this S corporation health-insurance thing right. Without the W-2 treatment, the S corporation does not get a tax deduction.
With the correct W-2 treatment, the more than 2 percent shareholder who finds the health insurance premiums on his or her W-2 can claim the self-employed health insurance deduction on Form 1040, provided he or she is not eligible for employer-subsidized health insurance through another job or a spouse’s job.
QBI Issue When Your S Corp Is a Partner in a Partnership
It’s common to consider making your S corporation (versus yourself) a partner in your partnership: it saves you self-employment taxes.
Does this affect your Section 199A deduction? It does.
Guaranteed payments are not qualified business income (QBI) for the Section 199A deduction. The non-QBI guaranteed payment rule applies whether the partner receives the payment as an individual or as pass-through income from an S corporation.
Your only options to claw back your Section 199A deduction with the S corporation as a partner are to reduce or eliminate the partnership’s guaranteed payments and then take the income pro rata based on ownership percentage, or to use a special allocation of partnership tax items.
Keep the S corporation self-employment tax savings in mind when considering your partnership activity. Often the self-employment tax savings can make the S-corporation-as-a-partner strategy well worth it.
Can the IRS Require Odometer Readings with the Mileage Rate?
Do you claim your business miles at the IRS optional rate? If so, imagine you are now being audited by the IRS for your business mileage. The IRS has requested odometer readings for your vehicle. You might wonder if the IRS can do this.
The answer is yes. The tax code says that you must substantiate your business vehicle deductions by adequate records or by sufficient evidence corroborating your own statement, including the time and place of the travel and the business purpose.
The standard mileage rate does not reduce the need for vehicle mileage records. In other words, the need for the records that prove business mileage does not change when you use the IRS standard mileage rate. They are the same mileage records you need with the actual expense method.
Here’s what the IRS, in its Internal Revenue Manual, tells its examiners to do when looking at business miles:
To verify total miles for the year, the taxpayer should provide repair receipts, inspection slips or any other records showing total mileage at the beginning of the year as well as at the end of the year.
The bottom line here is that the burden of proof is on you to prove your business mileage as required by the law. Thus, make sure that you retain odometer readings at or near the beginning and end of the year from oil changes, vehicle inspections, and repairs.
A GOVERNMENT SURPLUS – The US government ran a $160.3 billion surplus during the month of April 2019. The surplus was the difference between $535.5 billion of tax receipts (the largest monthly amount collected in our nation’s history) and $375.2 billion of outlays (source: Treasury Department).
A GOVERNMENT DEFICIT– The Social Security Trust Fund paid out $853.5 billion in 2018, more than the $831.0 billion the fund produced in total income. The 2018 deficit breaks a streak of 34 consecutive years (1984-2017) of “income exceeding cost.” As recently as 2009, the annual surplus was $134 billion (source: OASI Trust Fund).
Required Minimum Distribution (RMD) – RMD’s can have a number of benefits for those that are 70 ½ years or older an have to take the distribution. Some people are fortunate and would rather not have to take the mandatory distribution, however, let’s examine some uses that can benefit those who do not need the distributions to live on:
- IRA distribution direct to charities, if you make a distribution to a charity direct from your IRA (from custodian to the charity not to you) the distribution is NOT subject to tax and still counts toward your RMD up to $100,000 total per year. This type of distribution will not contribute to your modified adjusted gross income that may cause more of your social security to be taxed or force capital gains to be taxed at a higher rate as well as other MAGI negatives.
- Use the excess (after tax proceeds) to fund life insurance for a child or grandchild. There are multiple benefits that can be gathered from this; the life insurance gets an immediate multiple return on investment (cash investment vs. death benefit, chronic care benefit and long-term care benefit). Life insurance is a great way to fund education expense needs and is not limited to tuition only needs. EXAMPLE – When a grandchild is born make after tax distributions from your IRA to contribute to life insurance in the name of the parent. The parent can use the excess cash build up to fund the educational needs of the grandchild and if willing continue funding for retirement benefits for the themselves.
- Estimated tax may be reduced or avoided entirely by withholding on the RMD up to the full amount of the distribution if necessary. You can direct the custodian to withhold any percentage up to the entire amount of distribution, therefore, avoiding having to make quarterly estimated tax payments.
- If you have grandchildren that are working this summer you may want to contribute to a ROTH IRA for them. The contribution limit for 2019 is $6,000 maximum to a ROTH IRA not to exceed their earnings. Remember ROTH IRA do not get an income tax deduction, however, they grow tax deferred and at age 59 ½ or older they can withdraw both principal and earnings tax free. PLANNING NOTE: For first time home buyers they can even withdraw up to $10,000 of earnings tax free, therefore they could use principal and up to $10,000 of earnings tax free. Before age 59 ½ they can withdraw principal (contributions) not earnings out tax free at anytime for any purpose. This is a great way to start a liquid fund for emergencies or a great jump on retirement building for their young portfolios.
- Expect congressional changes in this area – A bill has recently been introduced in the upper chamber that would incrementally hike the age for taking RMDs to age 72 in 2023 and to age 75 by 2030.
“The difference between death and taxes is death doesn’t get worst every time Congress meets.” – Will Rogers
Point of Interest – As of 3/31/2019, there were 6.2 million unemployed Americans and 7.5 million job openings. Back on 7/31/2009, there were 14.6 million unemployed Americans and 2.1 million job openings (source: Department of Labor). Looks like in this robust economy the focus needs to be on training and education so the available jobs may be filled by qualified individuals.
IRS Issued IRR-2018-211 on November 1, 2018. that increases the contribution limits for ROTH IRAs, and traditional IRAs it increased from $5,500 to $6,000 for under age 50 and add an additional $1,000 age 50 or older. For 401(k), 403(b), most 457 plans and government’s Thrift Saving Plans. The contribution increased from $18,500 to $19,000 and you get to add another $6,000 if age 50 or older. The above IRS Notice also sets new limits on Defined Benefit Plans and Defined Contribution Plans. Remember there are phase outs based upon MAGI (modified adjusted gross income) for IRAs and ROTH IRAs those limits have been increased.
UNDER AGE 50 AGE 50 OR OLDER
ROTH IRA $6,000 $7,000
TRADITIONAL IRA $6,000 $7,000
401(K), 403(b) $19,000 $25,000
457 & Govt Thrift $19,000 $25,000
IMPORTANT ELECTIONS TO CONSIDER – IRS Elections can save time and/or increase current deductions:
- SAFE HARBOR TO EXPENSE ASSETS – You can elect the de minimis safe harbor to expense assets costing $2,500 or less ($5,000 with applicable financial statements).
The safe Harbor election eliminates the burden of tracking those small dollars cost assets, depreciating and/or Section 179 expensing them in your tax returns and book of account, and then making sure to remove them from your books when you remove the assets from your business.
You must make the election on your tax return every year you want to use the safe harbor. To make the election, you must attach a statement to your federal return and file that tax return by the due date (including extensions).
Election should state: “Taxpayer hereby elects under Reg. Section 1.263(a)-1(f) de minimis safe harbor expensing of up to $ 2,500.”
- ELECTION TO DEDUCT BUSINESS START-UP COST – Expenses incurred prior to starting a new business are not But a taxpayer can elect to deduct up to $5,000 of startup expenses in the year in which the trade or business begins. Specifically, the taxpayer is allowed a deduction for the tax year in which the active trade or business begins in an amount equal to the lesser of:
- The amount of startup expenditures for the active trade or business; or
- $5,000, reduced (but not below zero) by the amount by which the start-up expenditures exceed $50,000.
The remainder of startup expenditures are deductible over an 180- month period beginning with the month in which the active trade or business begins.
The IRS deem that you made the election, to amortize your start-up expenses for the taxable year the business began. In other words, if you do nothing, you have made the election.
- ELECTION TO CAPITALIZE CARRYING COST OF VACANT LOT AND UNPRODUCTIVE LAND – If you own a vacant lot or unproduction land, the first step that’s needed is to determine whether you will or will not get a tax deduction for the interest, property taxes, and other carrying cost (cutting grass, removals of debris, insurance, ) If you can get a deduction then take it, however, if it is not currently deductible then capitalizing those cost will reduce the gain on the sale of the property later.
The election to capitalize is a formal election, and you need to make it for every year you want to capitalize one or more of the cost of the vacant lot or unproductive land. The election to capitalize is an annual election that you should consider every year, and when you capitalize, you need to file the election for that year
Election should state: “Taxpayer hereby elects under Code Section 266 and IRS Regulation 1.266-1(b)(1)(i) to capitalize, rather than deduct, property taxes on the (address of property).”
REMEMBER: If you are considering any of the above tax planning issues seek additional help for complete details by calling 702-878-3900 there is no charge for consultation.
Al Whalen, EA, ATA, CFP®
Web Site: www.whalengroup.com