Happy Thanksgiving

Caught In A (IRS Mortgage) Trap

Sometimes it seems that the tax Code is a trap waiting to spring on some unfortunate.  This time let’s talk about a trap involving mortgages.

(1) Chris and Jennifer bought a house in 2001 for $365,000.

(2) In 2003 they borrowed money ($427,333) from Jennifer’s mom. The note carried interest of 4.5%, and there was a document titled “Mortgage Note.”

(3) They also signed a second document titled “Mortgage.” This document included the following language:

“… hereby grant, convey and assign to … the property with the address of …..”

The document was signed, but it was not notarized or recorded at the courthouse.

(4) In 2008 Chris and Jennifer borrowed $200,000 from a bank. The bank required a note and mortgage. The bank recorded the mortgage.

(5) In 2009 Chris and Jennifer paid her mom $19,320 on her note and the bank $1,138 on theirs. They deducted the sum ($20,368) as mortgage interest on their tax return.

(7) The IRS audited their 2009 return.

What is there to look at?

The Code does not allow one to deduct personal interest. It used to, and people could deduct interest on their car loans and credit cards. That law changed in 1986, and the Code now restricts which types of interest are deductible.

One type is qualified residence interest. This is interest paid or accrued during the taxable year on acquisition indebtedness or home equity indebtedness secured by the qualified residence of the taxpayer. You and I call that a mortgage.

On first impression, it seems that Chris and Jennifer met this requirement.

Let’s look further at the definition of “acquisition indebtedness”:

(i)       In general – The term “acquisition indebtedness” means any indebtedness which –

(I)                Is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and

(II)             Is secured by such residence.

Regulation 1.163-10T(o) defines secured debt as “… recorded, where permitted, or is otherwise perfected in accordance with applicable State law.’

There is the trap. 

The debt has to be “perfected” under state law. The concept of “perfected” means that the secured creditor has a preferred position relative to an unsecured (or perhaps just a later) creditor. The money from that house goes to that mortgage holder, as he/she is first in line. Anyone else has to wait his/her turn.

Chris and Jennifer lived in Massachusetts, which requires a mortgage be recorded at the courthouse to be “perfected.”

Let’s start the unraveling:

(1) The mortgage was not perfected, meaning

(2) The debt to mom could not be “acquisition indebtedness,” meaning

(3) The interest on the debt could not be mortgage interest

The IRS – adding to its reputation of stabbing the dead – also charged Chris and Jennifer with the accuracy penalty. This is a “super” penalty and applies when the error trips certain dollar or percentage thresholds.

I cannot help but feel that the penalty was unnecessary. Is the IRS expecting people to be tax pros before they can fill-out their own tax returns? What are they going to do with me if I make a mistake on my return – shoot me?

I worry about this mortgage trap when working with intrafamily loans involving someone’s house. It can be tempting to cheat on attorney fees and not properly document or record the loan and mortgage.

If audited, one can expect the IRS to be as sympathetic to them as the IRS was to Chris and Jennifer.

Senator Baucus Revs Up Tax Reform Discussion

Today (November 21, 2013) Senator Baucus released the third in a series of staff discussions on tax reform. This discussion focuses on depreciation (also called “cost recovery”) and tax accounting methods.

Not the most exciting topics, and I will not miss Thursday Night Football reading up on them. Let’s review them quickly.

The Senator leads off with:

America today is using a bloated tax code that was built for businesses close to 30 years ago. The code is completely outdated and acting as a brake on economic growth.  More must be done to simplify tax rules, lessen the burden on small businesses and jumpstart job growth.”

I cannot disagree with him, but I am not optimistic about politicians – today, tomorrow – keeping their hands off any tax reform. Remember that Chief Justice Roberts deemed ObamaCare to be a “tax” – even though the White House itself did not present brief or argue it to be a tax. With that level of verbal schizophrenia, I would wager that any “reform” would last about as long as when the first politician needs to get reelected.

Baucus is proposing the following depreciation changes:

(1) Reduce the number of depreciation classes to four: three for short- to mid-term property and one for longer-lived assets. There would be only one permitted depreciation method.

a.     By longer-lived, think real estate, which Baucus proposes to depreciate over 43 years.

COMMENT: There goes the never-worked-in-the-real-world-crowd again. I have thirty years in this business, and I have never seen a proposed real estate investment analyzed over a 43-year recovery. Doesn’t happen, folks.

(2) Slow depreciation from double-declining balance to declining balance. Real estate would remain straight-line.

(3)  Allow expanded general asset accounting. This means that asset categories are pooled, and depreciation is calculated by…

a.     Starting with last year’s asset pool balance

b.     Increased by additions and improvements

c.      Decreased by proceeds from asset sales and dispositions

d.     And multiplying the result by a depreciation factor

(4)  Repeal like-kind exchanges.

COMMENT: Yipes.

(5) Repeal depreciation recapture for pooled assets.

COMMENT: Yay!

Treat all gain from disposition of pooled assets as ordinary income.

          COMMENT: Nay!

(6)  The maximum cost of mixed- use vehicles is capped at $45,000.

a.     That means that – if a car is used for both business and personal use – the maximum cost that can be depreciated is $45,000. That amount in turn is depreciated over 5 years.

b.     I am not overly surprised. There is still a lot of abuse – truly – in this area.

Then there are some tax accounting changes:

(7) Repeal expensing for research and development expenses. The default treatment will be to capitalize and depreciate over 5 years.

COMMENT: This cannot make business sense. You want to explain this proposal change to Apple, Samsung, Pfizer, or any number of research-intensive companies?

(8) Disallow the deduction for advertising. In its place, you would deduct one-half immediately and then amortize the balance over 5 years.

COMMENT:  This makes no sense to an accountant. I associate depreciation and amortization with assets that have use or value over more than one year. Advertising doesn’t make that cut. Does anyone talk about the commercials from last year’s Super Bowl, for example?

(9) Treat “qualified extraction expenditures” the same way as research and development.

COMMENT: Think fracking. The United States is increasingly moving to energy independence (Bakken Shale, for example), even under a hostile Administration. Do you think this change is going to help or hurt that effort?

(10)  Repeal percentage depletion.

COMMENT: Same comment as (9).

(11)  Make permanent Section 179 expensing.

a.     The maximum expensing would be set at $1,000,000, with the phase-out beginning at $2,000,000.

COMMENT: Frankly, it’s about time.

(12)  The Section 197 amortization period is increased from 15 to 20 years.

(13)  All business with less than $10 million in annual gross receipts can use the cash basis of accounting and not account for inventory.

          COMMENT: Wait for it...

(14)  If you are not described in (13) then you are on the accrual basis of accounting.

COMMENT: When the government talks about accrual basis, they means that they want you to pay taxes on your receivables before you actually collect them.

(15)  Businesses described in (13) do not have to suffer through the Section 263A uniform capitalization calculations.

        COMMENT: Good. 

(16)  LIFO is repealed.  

COMMENT: I do not particularly care for LIFO, but I acknowledge that major industries use it extensively, and it is considered GAAP when auditors render their auditors’ report. The government is not chasing this down because they had brilliant debates while in accounting theory class. They want the jack.

(17) The completed contract method of accounting (think contractors) is repealed, except for small construction contracts.

Overall, Baucus is trying to reduce corporate tax rates. At 35%, the United States has the dubious distinction of having the highest corporate tax rate in the world. There are consequences to having the highest rate, such as having less business.  To reduce rates, he has to raise money somewhere, and we see some of those sources above.

And remember folks: these are only proposals.