Tax and Business Alert - December 2001

Deductible IRA Losses? 

This year's-stock market has been tough on most IRA owners invested in equities. That gives rise to an interesting question: Can the tax rules be used to soften the pain investors have suffered from the losses in their accounts?

If we were talking about investments held outside an IRA, the answer would be fairly simple. Capital losses can offset capital gains, plus a few thousand more of ordinary income. Thus, other than watching out for the wash sale rule (that disallows the loss if you buy the same stock or mutual fund shares within the 30-day period before or after a sale), triggering a deductible loss in a taxable account is normally pretty straightforward.

But what about tax-favored investments? Can you claim a deductible loss from something such as a traditional or Roth IRA?

A Loss Is Possible, But. . .

Taxpayers who suffer a loss in a traditional IRA can potentially recognize the loss on their tax returns.  However, this is only true if (a) the full amount in all of their traditional IRAs has been distributed and (b) the total distributions are less than their unrecovered basis, if any. The only way taxpayers can have a basis in their accounts is from having made nondeductible contributions to one or more traditional IRAs. Thus, for many taxpayers, even if the values of their traditional IRAs drop to zero, they'll receive no deduction from the losses because they never made any nondeductible contributions to a traditional IRA.

Many taxpayers will find it easier to claim a loss related to their Roth IRAs simply because such IRAs are newer and taxpayers don't have as many of them to clean out before a loss is allowed.  In addition, contributions to Roths are always nondeductible, so taxpayers generally have basis in them (unless they've previously taken distributions equal to their basis, in which case all that's left in the Roths are earnings). However, just as with traditional IRAs, even if you have basis in your Roth IRAs, a loss isn't allowed unless all your Roth IRA accounts have been distributed and the distributions are less than your unrecovered basis.

Example: Harold has one Roth IRA to which he has made a single contribution of $2,000. After its value drops to $750, he closes the account. He has a $1,250 deductible loss ($2,000- $750).

Claiming the Loss

Suppose you're one of the relatively few taxpayers with a deductible IRA loss based on the rules just discussed. The next issue is where you claim it on your return.

Because an IRA is presumably a capital asset, it makes sense that the loss should be a capital loss. However, there's no official support for this conclusion. Even worse, unofficially, the IRS maintains that any allowable loss from a traditional or Roth IRA is only deductible as a miscellaneous itemized deduction. Such deductions only provide a benefit when collectively they exceed 2% of your adjusted gross income (the number at the bottom of page 1 of your return). Thus, although IRAs might be a great tax favored retirement savings vehicle, the tax rules make it tough to squeeze a deductible loss out of them.

New Tax Credit for Employers
 
One of the lesser-known provisions of the 2001 Tax Act is a new tax credit for employers. Effective for tax years beginning after 2001, the credit is available to businesses that (1) pay part or all of their employees' child care expenses or (2) assist employees in finding appropriate child care services. The credit applies at the rate of 25% of qualifying child care expenses and 10% of qualified referral expenses for helping employees find appropriate child care services--up to a combined maximum credit of $150,000 per year.

For business owners who are paying for their own children's child care expenses, the new credit can offer an attractive alternative to the current law's dependent care credit that is normally $480 for one child or $960 for two or more children. Not only does the dependent care credit have a much lower maximum credit, taxpayers must also spend after-tax dollars to earn it.

In contrast, with the new employer-provided child care credit, the employer pays the child care expenses with funds that are never taxed to the employees who receive the benefit. In addition, the new credit can be claimed for the expense of contracting with a third-party child care provider, as well as the costs of building and operating a child care facility on the employer's premises.

As you would expect with such a favorable provision, certain restrictions apply. For example, the credit is only available if child care expenses are paid for employees on a nondiscriminatory basis. In addition, the credit is subject to recapture in certain situations. Overall, though, the credit could be highly favorable in the right circumstances. Call us if you'd like to discuss whether the new credit makes sense in your situation.

Interesting Websites

Holding down auto insurance costs. You don't want to shop for auto insurance on price alone (service and reliability are also important in case you have to file a claim). However, no one likes to pay more than they have to for appropriate coverage. A site sponsored by the Insurance Information Institute (www.iii.org/individuals/auto/b/savemoney/) offers tips on ways to hold down your costs from comparison shopping to checking rates on various makes and models before purchasing a new or previously owned car. In addition, the site includes a list of more than 10 different discounts you may want to ask about as you're checking on rates.

Required federal employment-related posters. The sheer volume of rules and regulations small businesses must contend with can be overwhelming. One government agency that's trying to help with this problem is the U.S. Department of Labor (DOL). At www.dol.gov/elaws/posters.htm, the DOL has an online software program that by having you answer a short series of questions can generally tell you which federal posters your business is required to display in the workplace. Then it provides a link to the appropriate posters. There's also a link to the various state departments of labor for guidance on what they require.

IRS Hot Buttons with Consultants

The IRS recently published a new audit guide dealing with specific tax issues that commonly apply to business consultants. The guide is intended as a training manual for IRS examiners. However, it also serves as fair warning to consultants or other self-employed professionals regarding several "hot buttons" the IRS will almost certainly push if they're selected for audit.

As you have probably heard, the IRS is now committed to increasing the percentage of taxpayers that will be audited after a long period of declining odds of being selected. As part of this program, you can expect increased emphasis on auditing small business taxpayers.

In this context, the new audit guide provides some useful guidance about how to avoid problems if you are, in fact, chosen for an audit. The guide lists the following as potential audit hot buttons: travel expenses, meal and entertainment expenses, expenses reimbursed by clients/customers, lack of profit motive, personal service corporations, and independent contractor versus employee status.

We recommend taking this opportunity to perform a self audit of your business activities to identify and shore up weak areas that could cause trouble if you are subjected to an IRS audit. We would be pleased to assist you in this project.

If you are interested in the self-audit concept or have any questions about the new IRS audit guide and what it means for you and your business, please contact us.

Corporate Real Estate Spin-offs

It is not uncommon for closely-held C corporations that have been around for a while to own valuable real estate that for whatever reason the corporation no longer needs in its business. In this situation, the corporation's owners may be interested in selling the property and using the funds for their own purposes.

Unfortunately, it's difficult to convert such an asset into cash that can then be distributed to shareholders without paying tax at both the corporate and shareholder levels (double taxation). However, an IRS Revenue Ruling released earlier this year illustrates a creative way to get cash from the sale of real estate assets into shareholders' hands with only a single (rather than double) layer of taxation.

Here’s the Strategy

The C corporation first contributes its appreciated real estate assets tax-free to a new corporation that elects to be taxed under the special rules for real estate investment trusts (REITs). Next, the REIT stock is spun off tax-free to the C corporation’s shareholders.

After the spin-off, the REIT rents its real estate assets back to the C corporation, which provides the REIT with substantial cash flow. The REIT then effectively functions as a pass-through entity by distributing as dividends essentially all of its taxable income and capital gains to the REIT shareholders (who are also owners of the C corporation).

As you may know, this is similar to the way a mutual fund operates. As long as these and all the other REIT guidelines are met, there is no federal income tax at the REIT level.

Dividend distributions consisting of the REIT's long-term capital gains are taxed at the shareholder level at favorable rates. (Again, this is similar to the way mutual funds work.)

Of course, there are some tax-law ground rules that must be followed. Beginning with the second tax year after a REIT is formed, it cannot be closely held, and must have at least 100 shareholders. Therefore, the shareholders of the original C corporation that spins off the REIT will generally have to sell some of their REIT shares and pay the resulting capital gains taxes. In addition, there are a number of strict guidelines that must be complied with in order for the REIT to maintain its tax-favored status.

What do you gain?

When all is said and done, the REIT spin-off strategy can deliver the following financial planning and tax benefits:


-The liquidity of the C corporation's shareholders is increased by the proceeds  from selling some of the REIT shares and by subsequent REIT cash dividend distributions from income generated by renting the real estate back to the C corporation.

-The C corporation's value is reduced, making it much easier to pass the company along to the next generation without incurring enormous capital gains, gift tax, or estate tax hits.

-The C corporation's taxable income is reduced by deductible rent payments to the REIT. Once again, this reduces the value of the C corporation. It also reduces the C corporation's taxable income, thereby avoiding potential double taxation problems in the future.

-The original C corporation effectively distributes its appreciated real estate assets to the shareholders without triggering double taxation.

-The REIT becomes a tax-efficient vehicle for distributing cash flow and capital gains from its real estate holdings to the shareholders of the original C corporation (because there is only a single level of tax at the shareholder level and because REIT capital gain dividends retain their tax-favored status).

CONCLUSION

As you can see, although it's a complex transaction (and, thus, probably not worth it for small deals) a REIT spin-off strategy can be extremely advantageous in the right circumstances. If you are interested, we'd be happy to conduct an analysis of the pros and cons in your specific situation. Please call us for more details.


Refinancing Your Home Mortgage

Mortgage rates have dropped significantly this year as the full effects of the Fed's numerous rate cuts and the slowing economy are factored in. This makes it worthwhile for a growing number of homeowners to consider refinancing their mortgages. Here's a look at some of the tax implications of that decision.

Treatment of Points

Points paid to refinance a home mortgage are nothing more than prepaid interest on the new loan. As such, the tax rules for home mortgage interest apply, but with a few twists because the interest in question is being prepaid.

When the new mortgage simply replaces the old one on a principal residence or second residence (i.e., no additional debt is taken on), the points paid for the new mortgage are capitalized and then amortized ratably over the life of the new loan. The resulting amortization deductions are then written off on your return as qualified residence interest for both regular tax and alternative minimum tax (AMT) purposes.

Under an exception to this general rule, homeowners can immediately deduct refinancing points allocable to additional mortgage debt if the debt is used to pay for additions or improvements to the homeowner's principal residence. (The debt must be secured by the residence and there's generally an overall limit of $1 million on all debt qualifying as incurred to acquire, construct, or improve a qualified residence.)

To claim an immediate deduction under this exception, cash-basis taxpayers must actually pay for the points out-of-pocket (i.e., they cannot be rolled over into the principal balance of the new loan). If the preceding conditions are satisfied, the allocable points can be deducted in full on your return in the year they are paid.

Interest Expense on New Loan

Under both the regular tax and the AMT rules, interest expense is deductible to the extent the debt proceeds are used to: (1) acquire, (2) construct, or (3) substantially improve a taxpayer's first or second residence. Interest on a new mortgage taken out to refinance another mortgage is also qualified housing interest to the extent the principal of the original mortgage generated qualified housing interest. Thus, such a refinancing should have no affect on your ability to continue deducting the mortgage interest.

Unamortized Points from the Old Loan

That brings us to a potentially big deduction related to the refinancing. If you previously refinanced your mortgage and were amortizing the related points, the unamortized balance can be immediately deducted when the related loan is refinanced with a new lender (to the extent the points were amortizable in the first place under the regular tax and AMT rules explained above).