Tax and Business Alert - January 2003

House-rich Americans are using title equity from their primary residence to purchase second homes at a record pace. Homeowners are refinancing their primary residences at extremely low interest rates and often take out additional cash from their equity to purchase a second home. (Interest rates, fees, and other expenses on owner-occupied primary residences are generally lower than those on second or vacation type homes.) Reasons often cited for this phenomenon include the previously mentioned low mortgage rates, house-rich baby boomers, and the poor performance of alternative investments. Second homes continue to be purchased for the potential appreciation as an investment, but more and more buyers are just seeking a place to get away with their family and friends.

In light of the number of second homes being purchased, we thought this would be a good time to revisit the tax ramifications of owning that second home. You may view your second home purchase as purely for personal pleasure, or as an investment for tax benefits and appreciation. Perhaps you are somewhere in between. But, regardless of how you view your second home, planning for its tax implications will enable you to either own the property in the most tax-efficient way possible or, if your purchase is somewhat tax driven, maximize the allowable deductions the property generates. A second home can fall into one of three categories for tax purposes depending on how it is used during the year. These categories are a personal residence, vacation home, or rental property. Here is a brief summary of tile pertinent tax rules for each category. After reviewing this general information, please call us with specific questions prior to investing in a second home.

Personal Residence

Property used for personal purposes more than 14 days during the year (or more than 10% of the rental days, if greater) is considered to be a residence. If this residence is rented for fewer than 15 days during the calendar year, it is considered to be solely a personal residence. You are not entitled to deduct rental expenses, if any, but rental income received is not taxable. However, interest expense (to the extent it is qualified residential interest) and real estate taxes are fully deductible subject to the overall limitation on itemized deductions.

Vacation Home

If the property is considered a residence (see above) and is rented more than 14 days during the calendar year, the reporting of income and deductions is subject to limitations. This is typical for many owners of second homes. In this situation, interest, taxes, and casualty losses are normally fully deductible-either as a rental expense or an itemized deduction. Other property related expenses are deductible to the extent of rents received, but only after first considering the interest, taxes, and casualty losses previously mentioned.

Rental Property

When personal use does not exceed 14 days (or 10% of rental days, if greater) and the property is rented for at least 15 days, the second home is considered to be rental property. For second homes classified as rental property, interest, taxes, casualty losses, and other operating expenses are fully deductible. However, these expenses must be prorated for any period of personal use, and the property is subject to the passive activity loss rules and at-risk limitations.

Due Dates

January 15--Individual taxpayer's final 2002 estimated tax payment is due unless by January 31, 2003, the return (Form 1040) is filed and any tax due with the return is paid.

January 31 - Mail Forms W-2 to employees and Forms 1099-MISC to independent contractors. Other Form 1099 series information returns, such as for interest and dividend payments, also must be mailed to the payees by this date.

February 28--The government's copy of Forms W-2 and Form 1099 series returns (along with the appropriate transmittal form) should be sent in by today. However, if these forms will be filed electronically, the due date is extended to March 31.

March 17--2002 income tax returns must be filed or extended for calendar-year corporations. If the return is not extended, this is also the last day for calendar-year corporations to make 2002 contributions to pension and profit-sharing plans.

--And, finally, file the final 2002 Form 941, Employer's Quarterly Federal Tax Return, and annual Form 940, Federal Unemployment Tax Return, by today. (If all taxes were deposited when due, the filing of either form can be delayed until February 10.)

The Web Isn't Only for the Young

The Mature Generation can benefit from www.wiredseniors.com, a portal to dozens of sites of interest to seniors and their friends and families. It provides links to discussions and bulletin boards, discounts and shopping, travel and dating, and plenty of other information and services to keep retirees and wannabes busy for hours.

Many states have established programs to provide prescription drugs to low-income seniors and disabled citizens who don't qualify for Medicaid. Find out if your state is one of them at the National Conference of State Legislature's website www.ncsl.org/programs/health/drugaid.htm .

The Department of Housing and Urban Development (HUD) has a link to housing issues for seniors and their families at www.hud.gov/groups/seniors.cfm. It provides information about home repairs and modification, finding an apartment, nursing homes, retirement communities, discrimination, fraud, and many other topics.

New Rates for 2003

FICA/Self-employment Tax Wage Base: $87,000 (up from $84,900 in 2002)

Social Security Earnings Ceiling (Below which benefits are not reduced):
Below age 65--$ 11,520 (up from $11,280 in 2002) Age 65 and up--no limit (however, if you turn 65 this year, a $30,720 annual limit applies to earnings in the months prior to your birthday)

Mileage Rates:

Business use: 36 cents/mile (down from 36.5 cents/mile in 2002)

Charitable use: 14 cents/mile (unchanged from 2002) Use related to seeking medical care or for a tax deductible move: 12 cents/mile (down from 13 cents/mile in 2002)

Retirement Plan Elective Deferral Limits:
401(k) and 403(b) plans: $12,000 (plus an extra $2,000 if at least age 50 by year-end) SIMPLE IRAs: $8,000 (plus an extra $1,000 if at least age 50 by year-end)

Estate and Gift Tax Exemption:
$1,000,000 (unchanged from 2002)

Dynasty Trusts

Dynasty trust is a popular term used to describe a multigenerational trust arrangement (i.e., a trust designed to benefit two or more generations). In states that have eliminated the rule against perpetuities (see below), dynasty trusts are sometimes referred to as perpetual trusts. A basic dynasty trust arrangement would provide income only (no principal) to your children and continue for your grandchildren or terminate at the death of your children and be distributed to your grandchildren.

Rule against Perpetuities

Most states have enacted a rule against perpetuities (RAP) that sets a finite limit on the duration of a trust. In most of these states, a trust must terminate and distribute assets no later than a specified time, usually 21 years after the death of the last beneficiary who was living at the time the trust was created. The last beneficiary will normally be a grandchild and remaining trust assets would be distributed to the great-grandchildren 21 years after the death of the last grandchild.

Some states, including Alaska, Delaware, Wisconsin, Ohio, Idaho, Illinois, Maryland, and South Dakota, have eliminated the RAP in whole or in part. Theoretically, dynasty trusts created in these states may be perpetual. You, as a grantor, can domicile a trust in any of the 50 states without regard to your own personal domicile. So, for example, if a Texas resident decides to establish a dynasty trust that will last beyond the period allowable under Texas RAP, he or she can establish the trust in South Dakota, Delaware, or any other non-RAP state.

To make the trust subject to the law of another state you must ensure that certain state-specific requirements are followed to connect the trust to the particular state desired. Although each state's jurisdictional requirements may differ, at a minimum, at least one trustee should be a resident of the state you select. Additional connections include in-state management of your trust or the presence of your trust's real and/or personal property within the state. A dynasty trust can be divided into separate shares for each of your children. In that case, a child's income and principal benefits are paid only from such child's share. Then, at the child's death the separate share is divided into separate shares for the child's descendants. Alternatively, a group trust that pays benefits to all potential beneficiaries can be used. A group trust provides flexibility for distributions from the entire principal if one of your beneficiary's needs are greater than your other beneficiaries'.

Funding

A dynasty trust can be created either during your lifetime or upon your death. If appreciating assets are used to fund the trust, the post transfer appreciation will be removed from your gross estate, if the trust is funded during your lifetime. The transfer of up to the applicable exclusion amount, $ 1 million in 2003, can be sheltered from gift tax using your applicable credit amount or up to $2 million by adding your spouse's $1 million credit. The use of discounts and other leveraging techniques may allow for substantially greater amounts to be contributed. To completely shelter the trust property, including future appreciation, you must also use your generation- skipping transfer (GST) exemption (up to $ 1,120,000 in 2003 for you and $2,240,000 if your spouse is included).

Observation: with the scheduled repeal of the estate and GST taxes after 2009, estate tax benefits associated with dynasty trusts may be eliminated. However, a dynasty trust should still be considered for non-tax reasons (e.g., asset protection as discussed later) or as a hedge against the reinstatement of the estate and GST taxes.

Asset Protection

In addition to the transfer tax benefits previously mentioned, dynasty trusts have powerful asset protection characteristics. Once your family's assets have been transferred into a dynasty trust, they are insulated from a host of threats including divorce, debts, and judgments against you and/or your beneficiaries. Dynasty trusts are typically irrevocable and contain both spendthrift and discretionary trust provisions. Since distributions are discretionary, there is no tangible interest created in any beneficiary that may be attached by a creditor. The asset protection benefits of these trusts can be improved even further by empowering the trustee to make payments on behalf of the beneficiaries and to purchase assets for the use of beneficiaries.

For example, the trustee may purchase a home for the beneficiary and hold title to the home in the trust. The beneficiary has full use and enjoyment of the home, but has no ownership interest in it. Accordingly, the beneficiary's creditors cannot reach the home to satisfy their claims. These measures reduce the personal net worth of each beneficiary, making them less appealing targets for creditors and their attorneys.

Other Advantages

Dynasty trusts often yield efficiencies of scale when a group trust's assets (previously discussed) are pooled for investment and management as a single fund. Even if the trust has separate shares and each share has an investment account to accommodate the individual beneficiaries' different investment objectives, discounted fee schedules may be available since the multiple accounts relate to a single trust.