Deducting Forfeited Down Payment
Subject: Forfeited Earnest Money - Tax Help
Hello Kerry/Tax Guru,
I am an avid follower of your blog for all the tax help - I made a down payment on a condo in FL as part of an investment in Jan of '06. However due to the slump of the real estate, the value of condo is really down that its worth like 40% of the original value. I hired a lawyer to negotiate with the developer on the price, but the developer recently filed for bankruptcy and it looks like at this stage the earnest money is forfeited.
Is there anyway I can use this as capital gains loss for my '09 filing - It's a huge amount (41,500), so it is kind of a big blow on my investments.
Thanks in advance for all your help!
It sounds as if you would have a capital loss for the amount of your down payment if you will be receiving no property or claim on property for that money and no part of the down payment in cash as part of the bankruptcy settlement.
You should be working with a professional tax advisor, who can explain the rules regarding deducting an uncollectible debt, especially in regard to the proper timing of that deduction.
If the bankruptcy case is still ongoing and there is a chance of your receiving something back from your down payment, you will have to wait until that is completed before you can claim the loss on Schedule D, which can possibly take several years.
If that kind of uncertainly is part of the equation, it may be possible to lock your loss up as being in 2009 if you were to sell your claim to the down payment to an unrelated party before 1/1/10 for a nominal amount, such as one dollar. You would then have a valid completed disposition to report on Sch. D.
Again, your own personal tax pro should be able to offer more specific assistance for your situation.
A Strategy For Capital Gains – Bruce Bartlett looks at a topic I have been following for decades, indexing the cost basis of capital assets for inflation. Expecting that to be done in light of 0bambi’s very vocal hatred of investors and any perceived special tax breaks for them, as well as the fact that neither Bush 41 nor Bush 43 had the balls to issue the executive order to allow this kind of indexing, mean that this is going to be an unfulfilled wish for at least several more years.
Cap. Gain Tax Worksheets
From a reader:
Subject: Capital Gains Rates
In the Tax Guru-Ker$tetter Letter of 02/15/09 titled "When you may want to show capital gains..." you write "Special Zero Percent Capital Gains Tax - For 2008, 2009 and 2010 sales by individuals, all or part of any long term capital gain is subject to a Federal tax rate of zero percent. "
Another factor which determines the tax rate on LTCG are the amount of qualified dividends. The "Qualified Dividends and Capital Gain Tax Worksheet-Line 44" on page 38 of i1040.pdf  calculates how Capital Gains plus qualified dividends are taxed above and below the 0% rate level. I just copy that worksheet into an Excel spreadsheet, add formulas, & enter the appropriate numbers.
That is an excellent point to make. Many of us forget the fact that the special zero percent tax rate has to be shared between long term capital gains and qualified dividends.
I will be posting a pdf copy of the IRS worksheet you referred to, plus a similar one from The TaxBook.
Thanks for writing.
Note for those individuals who will soon be doing their 2009 Estimated Tax [f1040es], your 2008IRSCapGainWS.pdf will work fine for 2009* by changing Line 8 using your "2009 Individual Income Taxes Federal - Form 1040" at http://taxguru.org/incometax/Rates/1040-09.htm as follows:
Single 2009=$33,950 [2008=$32,550]
MFJ/Qualifying Widower 2009=$67,900 [2008=$65,100]
HeadHousehold 2009=$45,500 [2008=$43,650]
*The above assumes that the tax rates for CapGains/QualDivds are not repealed.
Thanks for your input.
When you may want to show capital gains...
Many people just assume that they need to do a Section 1031 like kind exchange in order to save on their taxes. This decision may be premature if the taxpayers haven't had their professional tax advisors run the numbers to see if an outright sale would in fact cost them anything in taxes.
I have seen many cases where people assumed that a sale would result in taxes, when in fact that wasn't the case. Here are some of the most common reasons that a sale may not cost any actual taxes, starting with a new one that is just now starting to show up on tax returns.
Special Zero Percent Capital Gains Tax - For 2008, 2009 and 2010 sales by individuals, all or part of any long term capital gain is subject to a Federal tax rate of zero percent. The actual calculation of this is rather complicated and should be handled by your professional tax advisor's tax software.
While this has the potential to save large amounts of taxes and thus make doing a 1031 exchange unnecessary, there are some other factors to consider.
This is for Federal purposes only and most states have not gone along with this; so there could still be State taxes on a sale.
This only applies to the long term capital gain portion of a sale. It does not apply to short term capital gains for assets held less than 12 months. It also does not apply to gain attributable to depreciation recapture, which is still subject to a 25% Federal tax rate plus the State tax rate.
The other key consideration is the political environment. The new president said during his campaign that he wanted to eliminate any special tax breaks for capital gains and make them subject to the same much higher tax rates for other kinds of income. He said that he is will aware that this will reduce the government's revenues from capital gain taxes as more people take steps to avoid paying them; but he sees it as the Fair thing to do. He can't do anything to affect the tax on 2008 sales, but he could repeal the special tax break for 2009 and/or 2010 sales as he has been promising/threatening to do.
Loss Carry-forwards - Many people have large losses that they have been carrying forward for several years on their tax returns that can be used to offset gains from the sales of business and investment properties. These carryover losses include Capital Losses, Net Operating Losses and Passive Activity Losses. There should be some kind of schedule with your latest tax return showing how much of these kinds of losses are being carried over into the current tax year. Similarly, your professional tax preparers should have those losses already set up in their tax return software when running proforma tax calculations of a possible sale.
Basis Mistakes - To determine whether you have a gain or loss on a sale, it is critical to understand the proper cost basis to use for the asset. One of the most common mistakes has to do with inherited property. The cost basis for the heir is the asset's fair market value at the time of the previous owner's death. This means that an inherited asset being sold shortly after it has been received will normally result in no gain, and possibly even a loss after deducting selling costs. Doing a 1031 exchange only makes sense if there is a profit to defer.
On the flip side, the other common basis mistake has to do with items received as gifts from living persons. In those cases, the cost basis to the recipient is the same as it was for the giver. While the actual receipt of a gift is tax free for the recipient, recipients are essentially accepting responsibility for future capital gain taxes on it. It is important that the giver provides the cost basis info to the recipient along with the gift.
As always, no tax oriented transaction, especially dealing with capital gains and 1031 exchanges, should be attempted before the numbers have been run by your professional tax advisor. Any fees they charge will be minimal compared to the potential tax savings.
Accelerating capital gain taxes?
I received this from a reader back in early September:
Subject: possible link of interest for your blog
This is an online interactive calculator that addresses whether one should sell now to take advantage of lower capital gains rates that now exist.
I Wrote back:
Thanks for passing that along. It's an interesting calculator, albeit with too many assumptions required to be realistically practical.
I was surprised not to see any part of your discussion or calculation that takes into account the zero percent LTCG rate for sales in 2008, 2009 & 2010. That is a very real issue, as opposed to the possible future rate increases, and is a question we tax pros have been receiving frequently for the past year or so.
Your calculator could cover such an analysis as whether the transaction costs of selling now to tax advantage of the zero percent bracket justify it, plus the fact that there will still be tax on the portion of the gains that are above the new zero percent rate bracket.
To date, no reply has been received
Subject: Question on Selling Investment Property (Land)Kerry, in '07 I sold a vacant lot that I had owned for 2+ years. Originally, I intended to build on it, but a job took me elsewhere and I sold. Can I book a deduction for all the mortgage interest paid to date as part of the adjusted cost basis to offset the net proceeds? This wasn't clear for me as I read through the IRS documents.Regards,
You really should be discussing this kind of thing with your own personal professional tax advisor who can assist you better than I possibly could. You shouldn't be trying to interpret the tax laws in matters such as this. That is what tax pros are for.
There are a number of ways in which to handle the interest paid on investment property. It can be deducted on Schedule A as investment interest via Form 4952.
Another option is to capitalize it as part of the cost of the property and thus later on reduce the capital gain when it is sold. Here is how this is explained on Page 4-14 of The TaxBook via their WebCD:Carrying Charges—Election to Capitalize Interest and TaxesThis is for background info only and should be applied in your case consistently with your previous years' tax returns and with the assistance of a professional tax advisor.
A taxpayer may elect to add real estate taxes and interest to the cost basis of unimproved land rather than claim a current deduction.
Situations where this election might benefit the taxpayer include:
Standard deduction. If a taxpayer claims the standard deduction, the deduction for interest and taxes is lost. The taxpayer will benefit from the election to capitalize the amounts, which will increase the basis of the property.
AMT. If taxes reported on Schedule A would be added back to income as a preference item for AMT, the taxpayer may not realize a benefit from the deduction. In this case the election to capitalize and add the amounts to basis would benefit the taxpayer.
A statement listing the expenses capitalized must be attached to the original return for the year the election is made. The election is made on a year-by-year basis. (Reg. §1.266-1)
It looks like you may have screwed up the treatment of the interest on the earlier tax returns and amended returns may be required. Again, a professional tax advisor should be used to help you with this. Don't compound your mistakes by continuing to try to stumble your own way though the tax maze.
When to deduct investment losses...
From a client when sending in info for her 2007 tax returns:
… Also faxing a new item to consider - statement from manager of an LLC I own shares in, in which original investment was $15,000, showing a gradually-declining value of the company to a supposedly-possible low of $0.20 on the dollar. This whole deal is in turmoil with questionable value. Please let me know if some of this decreased-value loss can be deducted on the 2007 return and if some can be carried over or taken in future years...
In regard to the offer to buy out your shares in the LLC, there can be no tax breaks until you actually make the sale. Just the fact that the value of the shares has declined does not justify any kind of loss deduction on your tax return.
This may seem unfair; but it works in both directions. Fluctuations in values of assets do not trigger tax consequences in either direction. Just as the fact that real estate with a very low cost basis may be worth $500,000 right now doesn't trigger a tax on the increased value until you actually sell the property, it is exactly the same thing with decreased values. Since there is always the potential for the value to go back up, you can't claim an actual loss on your tax return until you sell the shares.
This is actually a common issue with many people who evaluate their investment portfolios at year end in the hopes of harvesting some tax losses that can be used to offset other gains they may have. In order to avoid abuses in this area, IRS does have what they call the Wash Sale rule. If the loss stock is repurchased within 30 days of the sale, no deduction is allowed for that loss and it has to actually be added to the cost basis of the replacement shares. I just mention this in case you may be considering selling your shares to lock in the loss and then buying them back. You can do this and claim the loss, as long as you wait more than 30 days to make the repurchase.
I hope this is clear. Let me know if you have any more questions.
Capital gains double standard...
Subject: Re: INFLATION ADJUSTMENTS [LACK THEREOF]
Dear Tax Guru Blog,
Kerry, since I've only been a CPA since 1990, I asked an "old-timer" how long the $3,000 capital loss per annum limitation has been in place...
yes, that's right... since 1951.
I don't know a way to verify this, I just wanted you know how ridiculous the term of this limitation has been. Feel free to cut loose on a rant about this; because, as we know, this never hurts wall street insiders or white collar slicksters, it only hurts the working class, the weak, and the elderly.
Here's wishing you and yours the best of health,
I've done more than my share of ranting about this extremely unfair double standard in the tax code over the past decades.
I'm not sure about that 1951 starting date. My recollection of when I started preparing tax returns in the mid 1970s was that the annual limit was only $1,000 per person; but I can't lay my hands on a full history of this idiotic rule right now.
The aspect of this that has always fried me the most was the fact that unused capital loss carry forwards evaporate upon death. I have written on a few occasions about a client who was in his 80s and had almost a million dollars of stock market losses that I knew would end up going to waste at the measly $3,000 per year rate of use. He passed away in the middle of 2007 and I have had to break the news to his heirs that those unused losses are gone forever as well.
Unfortunately, we don't hear any of our supreme rulers in DC mentioning changing any part of this ridiculous rule; so we'll just have to continue living with it for the foreseeable future.
Thanks for writing and good luck with this tax season.
Inflation and the Tax Man – Another look at the issue of indexing the cost basis of assets for inflation, a topic I have been writing about for a very long time, such as this piece from the era of Bush 41. The current President Bush has the same option his father passed up; to show some guts and just issue an executive order redefining cost basis to include inflation adjustments. Unfortunately, his well documented fear of confrontation with the Dims will prevent him from taking this bold step.
[Update] More on this topic from David Freddoso at National Review Online – Inflate This
Selling gifted property
Subject: Tax QuestionKerry,
First, thanks for your blog. You’re a great resource for all of us out there. I have a question regarding some gifted property- I’m grasping at straws at this point, but I’m hoping that you can help:
First, my wife and I live in California and make ~$150K/year. We just bought our first house and we have no children. Just in case these detail help.
Now to our “problem” – in Nov. 2005, my wife’s parents gifted us a piece of land worth ~$700K on which to build a home. This is bare land, purchased in ~1978, and has a basis of ~$10K. After spending ~$60K on permits, engineering, and architecture we decided against building a home on the land. We’re now planning to sell the land and we’re trying to minimize our tax exposure.
I think that we did this in the worst possible way, as I think we’re going to take the cap. gain hit on the delta between my in-laws’ basis and the sales price (minus our expenses) and my in-laws estate will be hit for the full $700K against their $2M of tax free estate (yes, they’re likely to exceed that $2M). Other than a 1031, is there any way to minimize either the taxes or the amount counted toward my in-laws estate? Are there creative ways to minimize the state or federal tax exposure? Is there anything that would allow us to invest any/all of this money in a tax-free retirement account? I know that I’m grasping at straws.
Is there anything we can do????
If you have been reading my stuff for any length of time, you should know that you need to be working directly with a professional tax advisor to ensure that you do things properly.
You do have a bit of a messy situation here in regard to the built in capital gain you accepted from your in-laws.
You do really need to review various scenarios with a tax pro to see if any of them could assist.
A 1031 exchange could possibly be appropriate if you can make the case that the old property was used for investment and not personal purposes. You would then have to work with an exchange accommodator to use the proceeds to acquire new business or investment real estate; not personal use property.
I'm a little confused by your wording as to the status of your in-laws. Are they still alive or have they passed away? Another option that you may want to explore if they are still alive is to give the property back to them and possibly have them sell the property to you rather than gift it. That could get messy; so their professional tax advisor would definitely need to be in on those discussions. There are special tax breaks for them and you if they were to sell the property to you on the installment basis (carryback note) and then have that note as part of their estate after they pass away.
If you do sell the property, another way to spread the tax bite out is to carry back as much of the price as you can so that taxes can be spread out over the years in which you collect the payments.
These are just a few of the issues that you all need to discuss with your own professional tax advisors.
2008 Taxes On Dividends
Subject: '08 tax rate scheds
Thanks for info on the new bracket breaks. I have one comment on your page. I believe dividend income that would otherwise be in the 10-15% brackets (pre-JGTRRA) is taxed at 0% (just like LTCG) not 5%. That's what the CBO says, but please let me know if the 5% on dividends is new information (for instance, I may have stale information).
While that CCH article I quoted on the new inflation adjusted tax rate schedules didn't specifically mention the rate for qualified dividends, you are correct that they receive the same Zero tax rate as do long term capital gains for people in the lowest tax brackets. In fact, here is how QuickFinder Online describes it:"Tax on qualified dividends is the same rate as long-term capital gains for dividends received after 2002 and before 2011 (5% for taxpayers in the 10% and 15% tax brackets, and 15% for taxpayers in the 25% and above tax brackets). A zero percent rate applies to taxpayers in the 10% and 15% brackets for 2008 – 2010."I will add this info to the 2008 tax rate page on my website.
I appreciate your bringing this item to my attention.
How to kill economic growth...
For anyone who thinks I am overly paranoid about the future of special tax rates for long term capital gains, check out this prediction of DemonRat plans, including raising the current 15% rate to 35%.
Tax free capital gains?
I have read that the long term capital gains tax will be zero for the year 2008. Is this true? If so I may delay selling my remodeled house until next year. Please advise.
It is true that there is a Federal tax reduction on long term capital gains scheduled for sales in 2008, 2009 and 2010 under current tax law. This could very easily be repealed, possibly retroactively, if the DemonRats have their way; so there is no guarantee that anyone will actually be able to benefit from this.
Assuming our rulers can keep their hands off of this tax break, the actual size of the benefits is still very limited. As with all tax matters, the reality of its application is much more complicated than we all wish.
Under current Federal tax law, people with long term capital gains that would normally be in the 10% or 15% bracket only have to pay 5% Federal tax on just that portion of the gain in those lower brackets. The portion of the gains that push the taxable income into the higher brackets is taxed at 15%. You can see the 2007 brackets on my website. The 2008 inflation adjusted Federal brackets should be released in a few weeks.
Now for the special tax break. For sales in 2008, 2009 and 2010, that portion of long term capital gains that would otherwise be subject to a 5% Federal tax rate will have a zero Federal tax rate. The portion of the gain above the 15% bracket will still be subject to a 15% rate. In addition, depreciation recapture is not considered to be a capital gain and it will still be subject to a 25% Federal tax rate. State taxes will also still be applicable on the full gains; so the overall tax savings may be relatively minor, especially for the sale of highly depreciated property, such as rental homes. As Sherry mentioned earlier, 1031 exchanges will still be a very important tool for real estate investors wishing to minimize their taxes.
I hope this isn't too confusing; but out imperial rulers in DC seem to like to keep the rules as muddy as possible.
Let me know if you have any more detailed questions.
Capital Gain or Ordinary Income?
From a Reader:
Since when is annuity income anything other than ordinary income under IRC Sec. 72 ? If there is capital gains treatment it's a new one to me. The typical deal on taking a lump sum from a deferred annuity is that the amount received net of any surrender charge less the amount invested in the contract is ordinary income shown on 1040 line 16b.
If the surrender of the annuity were reported on a 1099-R, you would be correct.
However, there were more assumptions contained in my analysis of the situation than I had time to explicitly spell out. My main one was that this was not a deferred comp retirement account that was being cashed in, but an investment vehicle sold by an insurance company that would have produced ordinary annuity income during its life.
When it was sold back to the insurance company, that would be treated as the sale of a capital asset, much like the sale of a stock or bond that also produces ordinary taxable dividend or interest income during its holding period.
I have actually had several real life cases of this kind of transaction with clients over the years. Reporting those sales (redemptions) on Schedule D never once created a problem with IRS; so this is more than just a theory on my part.
This is why it is so important for the taxpayer to have a tax professional review the actual transactions and the underlying documents to know with more certainty how something should be reported.
I hope this better clarifies my answer to that reader.
Thanks for writing.
Annuities Cashed In
Subject: Annuity question
I recently had to cash in/surrender an annuity with a insurance company. Naturally, I had to pay a surrender charge. Is all or part of this charge a deduction using schedule D of capital gains/loss form? Thanks.,
I'm assuming this annuity was in your personal name and not in an IRA or other kind of retirement account.
Just like a commission and other selling costs, the surrender charge would be added to the annuity's cost basis figure on your Schedule D; thus reducing the net taxable gain.
You really should be asking your personal professional tax advisor questions like this. This is especially important for planning the best use of capital gains and losses for the year.