Tax and Business Alert - August 2004

Use the Installment Method to Defer Taxes on Property Sales

When at least one payment is received after the tax year in which the sale occurs, you can use the installment method to defer a portion of the income tax due on a gain from the sale of property such as an apartment or office building. Under the installment method, the seller recognizes a portion of each payment as gain when received. Typically, each payment the seller receives consists of three parts:

(1) a return of basis (investment) in the property sold, (2) gain (profit) on the sale, and
(3) interest on the installment note. Only the gain and interest portions of each payment are taxable to the seller.

Reporting gain from the disposition of property under the installment method allows the seller to report the taxable gain and spread the tax over several years rather than all in the year of sale. Thus, the seller's payment of tax corresponds with the actual cash flow generated from the sale.

Example: Deferring taxable gain using the installment sale method.
Mark is a real estate investor, but is not a dealer in real property. In February 2004, he sold an apartment complex for $5 million, receiving $500,000 cash and a $4.5 million note. His basis (investment) in the property was $3 million. The note calls for annual installment payments beginning in February 2005. He will receive interest on the note commensurate with the market and the buyer is not a related party. Mark will use the installment sale method to report his taxable gain.

Mark's total gain on the sale of the apartment complex is $2 million (the $5 million sale proceeds less his $3 million basis), which is 40% (gross profit ratio) of the selling price. For 2004, he will report a taxable gain of $200,000 computed by multiplying the $500,000 received in cash during 2004 by the 40% gross profit ratio. The remaining $300,000 is a nontaxable return of Mark's original investment. As installment payments are received beginning in 2005, he will report any interest received and 40% of the principal payment as taxable income. The remaining 60% of the principal payment is a return of his investment.

There are several restrictions and limitations on the use of the installment method. But, as the example indicates, significant tax deferral can be achieved using this method to report qualified property gains. Please call us to discuss this and other appropriate tax saving and deferral techniques for you and your business


How Health Savings Accounts Interact with Other Health Arrangements

Individuals are prohibited by federal regulation from contributing to a health savings account while covered by general purpose flexible spending arrangements (FSAs) or health reimbursement arrangements (HRAs). However, recent IRS guidance clarifies how individuals can access FSAs and HRAs and, in addition, maintain their eligibility for contributions to health savings accounts.

New IRS guidance indicates that eligible individuals can contribute to a health savings account (HSA) while covered by certain types of employer-provided plans, including:

· limited purpose FSAs and HRAs that restrict reimbursements to certain benefits such as vision,    dental, or preventative care benefits;
· suspended HRAs where the employee has elected to forgo health reimbursements for the coverage period;
· post deductible FSAs and HRAs that only provide reimbursements after the annual minimum deductible has been satisfied; and · retirement HRAs that only provide reimbursements after an employee retires.

Combinations of these arrangements can be provided without disqualifying an individual
from contributing to an HSA. In addition, the IRS indicated that individuals with coverage by an FSA and an HRA, as well as an HSA, can reimburse expenses through the FSA or HRA prior to taking distributions from the HSA, as long as they do not seek multiple tax-favored reimbursements for the same expense.

Social Security Earnings Limitations Increased for 2004

If you are younger than your full retirement age and working while receiving social security or survivor's benefits, you can earn a little more in 2004 before your benefits are reduced. You can earn up to $11,640 in 2004 (increased from $11,520 in 2003) before $1 is withheld from your benefits for every $2 you earn. If you reach full retirement during 2004 (age 65 and 4 months), $1 will be withheld for every $3 you earn over $31,080 until the month you turn age 65 and 4 months. After reaching full retirement age, you can receive your full benefit amount no matter how much you earn.

Interesting Websites for Economic Information

The Bureau of Economic Analysis (BEA) at www.bea.doc.gov is one of the world's leading statistical agencies. BEA produces some of the most closely watched economic statistics that influence decisions made by business people, governmental officials, households, and individuals. BEA's economic statistics provide an up-to-date picture of the U.S. economy and are key factors in decisions affecting monetary policy, tax and budget projections, and business investment planning. BEA presents essential information on such key issues as economic growth, regional economic developments, industry relationships, and the U.S. position in the world economy.

The Pros and Cons of Some Probate-avoidance Strategies

Estate taxes can take a huge bite out of the assets we leave to our heirs, so most of us plan to minimize those taxes as much as possible. However, depending on the assets in your estate, another potentially large expense that will be borne by your heirs is the cost of probating your will and administering your estate. Generally, probating a will requires the services of an attorney, and the executor charges a fee to manage the assets that go through probate until they are actually distributed. There are many strategies to remove assets from your probate estate. All, however, have consequences that may affect your financial and estate planning goals. Also, removing an asset from your probate estate does not necessarily remove it from your taxable estate. The following paragraphs briefly describe some probate-avoidance techniques; their benefits and drawbacks.

Removing life insurance and retirement assets:
The proceeds of any life insurance you own, as well as assets in your retirement plans [e.g., profit-sharing or 401(k) plans and IRAs] can easily be excluded from probate by designating a beneficiary other than your estate. Then, although the assets are generally included in your taxable estate, they pass to your beneficiary as a matter of law, outside the probate process.

A person's estate is sometimes named as beneficiary of life insurance proceeds to ensure liquidity. However, you can name a trust as beneficiary so that, if properly structured, probate is avoided, but the proceeds remain available to fund the estate's liquidity needs.
If estate tax and liquidity are not issues, it may be simplest to designate an individual such as your spouse or child, as your life insurance beneficiary; however, simply naming an individual as beneficiary generally does not remove the insurance proceeds from your taxable estate.

Using alternative methods of property ownership:
Another way to avoid probate is to own property as joint tenants with right of survivorship or tenants by the entirety with the person to whom you would leave the property. Then, at your death, your interest in the property passes automatically to the survivor, outside of the probate process. While this is effective, it is important to make sure enough assets will be subject to your will to fund a credit shelter or qualified terminable interest property (QTIP) trust if these are part of your estate plan. Joint ownership may also be inappropriate if the survivor does not have the experience or skill to manage the property.

Transferring assets to a revocable living trust:
Revocable living trusts are popular with some financial planners as a method to avoid probate. Transferring some or all of your assets to a trust that is completely revocable during your lifetime (but becomes irrevocable at your death) can also avoid a need for a guardianship if you ever become incapacitated. The trust instrument instructs the trustee in managing the assets and distributing funds after you die or become incapacitated. Because the probate process requires a listing of your assets to become public information, a revocable living trust can provide privacy. However, it's important to remember that assets in the revocable living trusts are fully includable in your taxable estate. And, setting up the trust can be expensive, especially if the titles of numerous assets must be changed to the trust's name. Finally, during the trust's term, all your assets are legally owned by the trust, even though you usually have complete control over them. This can be cumbersome if you try to sell or borrow against the assets

Excluding Gain from a Residence Following Divorce

A taxpayer can generally exclude from taxable income up to $250,000 ($500,000 for qualifying joint filers) of gain from the sale of a home owned and used as a principal residence for at least two of the five years before the sale (the ownership and use tests). The exclusion is further limited to taxpayers who have not previously claimed the exclusion for a minimum of two years ending on the date of the current sale or exchange (the one-sale-every-two-year rule).

A residence with substantial equity is often a married couple's most significant asset. As a result, monetary and tax considerations for property settlements related to the marital residence are usually very important to divorcing taxpayers.

Residence sold as part of divorce proceedings. The divorce agreement may specify that the residence must be sold as part of the divorce process so that the proceeds can be split between the spouses. If the property is owned jointly or is community property, each spouse is considered to have sold half the property.

If each spouse independently meets the two-out-of-five-years ownership and use tests, and the one-sale-every-two-year rule, then each spouse's share of the gain can be sheltered by the up-to-S250,000 exclusion. The fact that the spouses file separate returns for the year of sale, or are divorced and file as single persons, does not make a difference.

Ownership transferred incident to divorce. Neither spouse recognizes gain or loss with the transfer of ownership of the principal residence from one spouse to the other during marriage or in divorce. The receiving spouse's basis in the residence is the combined basis of both spouses before the transfer. Even in those circumstances where the transferring spouse receives other assets or cash to even out the property settlement, there is no gain or loss or change in the basis of the residence.

If a taxpayer transfers a residence to a spouse or former spouse incident to a divorce, the transferee's ownership period includes the transferor's ownership period. This rule helps the transferee meet the ownership test, but not the use test. That is, the transferee will not pass the use test unless he or she occupies the residence for at least two out of five years ending on the date of sale.