TurboTax and Penalties

I am looking at a case that deals with recourse and nonrecourse debt.

Normally I expect to find a partnership with multiple pages of related entities and near-impenetrable transactions leading up to the tax dispute.

This case had to do with a rental house. I decided to read through it.

Let’s say you buy a house in northern Kentucky. You will have a “recourse” mortgage. This means that – if you default – the mortgage company has the right to come after you for any shortfall if sales proceeds are insufficient to pay-off the mortgage.

This creates an interesting tax scenario in the event of foreclosure, as the tax Code sees two separate transactions.

EXAMPLE:

          The house cost               $290,000

          The mortgage is             $270,000

          The house is worth        $215,000

If the loan is recourse, the tax Code first sees the foreclosure:

          The house is worth        $215,000

          The house cost               (290,000)

          Loss on foreclosure       ($75,000)

The Code next sees the cancellation of debt:

          The mortgage is worth  $270,000

          The house is worth        (215,000)

          Cancellation of debt       $55,000

If the house is your principal residence, the loss on foreclosure is not tax deductible. The cancellation-of-debt income is taxable, however.

But all is not lost. Here is the Code:

§ 108 Income from discharge of indebtedness.

(a)  Exclusion from gross income.

(1)  In general.

Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if-

(E)  the indebtedness discharged is qualified principal residence indebtedness which is discharged-

(i)  before January 1, 2018, or

(ii)  subject to an arrangement that is entered into and evidenced in writing before January 1, 2018.

The Section 108(a)(1)(E) exclusion will save you from the $55,000 cancellation-of-debt income, if you got it done by or before the December 31, 2017 deadline.

Let’s change the state. Say that you bought your house in California.

That loan is now nonrecourse. That lender cannot hound you the way he/she could in Kentucky.

The taxation upon cancellation of a nonrecourse loan is also different. Rather than two steps, the tax Code now sees one.

Using the same example as above, we have:

          The mortgage is             $270,000

          The house cost               (290,000)

          Loss on foreclosure       ($20,000)  

Notice that the California calculation does not generate cancellation-of-debt income. As before, the loss is not deductible if it is from your principal residence.

Back to the case.

A married couple had lived in northern California and bought a residence. They moved to southern California and converted the residence to a rental. The housing crisis had begun, and the house was not worth what they had paid.

Facing a loss of over $300 grand, they got Wells Fargo to agree to a short sale. Wells Fargo then sent them a 1099-S for taking back the house and a 1099-C for cancellation-of-debt income.

Seems to me Wells Fargo sent paperwork for a sale in Kentucky. Remember: there can be no cancellation-of-debt income in California.

The taxpayer’s spouse prepared the return. She was an attorney, but she had no background in tax. She spent time on TurboTax; she spent time reading form instructions and other sources. She did her best. You know she was reviewing that recourse versus nonrecourse thing, as well as researching the effect of a rental. She may have researched whether the short sale had the same result as a regular foreclosure.

COMMENT: There was enough here to use a tax professional.

They filed a return showing around $7,000 in tax.

The IRS scoffed, saying the correct tax was closer to $76,000.

There was a lot going on here tax-wise. It wasn’t just the recourse versus nonrecourse thing; it was also resetting the “basis” in the house when it became a rental.

There is a requirement in tax law that property convert at lower of (adjusted) cost or fair market value when it changes use, such as changing from a principal residence to a rental. It can create a no-man’s land where you do not have enough for a gain, but you simultaneously have too much for a loss. It is nonintuitive if you haven’t been exposed to the concept.

Here is the Court:

This is the kind of conundrum only tax lawyers love. And it is not one we've been able to find anywhere in any case that involves a short sale of a house or any other asset for that matter. The closest analogy we can find is to what happens to bases in property that one person gives to another.”

Great. She had not even taken a tax class in law school, and now she was involved with making tax law.

Let’s fast forward. The IRS won. They next wanted penalties – about $14,000.

The Court didn’t think penalties were appropriate.

… the tax issues they faced in preparing their return for 2011 were complex and lacked clear answers—so much so that we ourselves had to reason by analogy to the taxation of sales of gifts and consider the puzzle of a single asset with two bases to reach the conclusion we did. We will not penalize taxpayers for mistakes of law in a complicated subject area that lacks clear guidance …”

They owed about $70 grand in tax but at least they did not owe penalties.

And the case will be remembered for being a twist on the TurboTax defense. Generally speaking, relying on tax software will not save you from penalties, although there have been a few exceptions. This case is one of those exceptions, although I question its usefulness as a defense. The taxpayers here strode into the tax twilight zone, and the Court decided the case by reasoning through analogy. How often will that fact pattern repeat, allowing one to use this case against the imposition of future penalties?

The case for the homegamers is Simonsen v Commissioner 150 T.C. No. 8.

Roth IRA Recharacterizations Are Going Away

You may have heard that there has been a tax change in the land of Roth IRAs. It is true, and the change concerns recharacterizations.

And what does that seven-syllable word mean?

Let’s say that you have $50,000 in a traditional (or “Trad”) IRA. “Traditional” means that you got to deduct the money when you put it in. You did so over several years, and you now have – after compounding - $50 grand. Congrats.

You read that this thing is a tax bomb waiting to go off.

How?

Simple. It will be taxable income when you take it out. That is the bargain with the government: they give you the deduction now and you give them the tax later.

You decide to convert your “Trad” into a Roth. That way, you do not pay tax later when you take the money out.

You find out that it is pretty easy to convert, irrespective of what you hear on radio commercials. Let’s say your money is with Vanguard or T Rowe Price. Well, you call Vanguard or T Rowe and explain what you are up to. They will explain that you need a Roth IRA account. You will then have two IRA accounts:

          CTG Reader Traditional IRA, and

          CTG Reader Roth IRA

There is $50 grand in the Traditional IRA account.

You convert.

There is now $50 grand in the Roth IRA and $-0- in the Traditional IRA accounts.

You did it. Good job.

BTW you just created $50 grand of taxable income for yourself.

How? Well, you converted money from an IRA that would be taxable someday to an IRA that will not be taxable someday. The government wants its money someday, and that someday is today.

You didn’t think the government would go away, did you?

Let’s walk this thing forward. Say that we go into next year and your Roth IRA starts tanking. It goes to $47 grand, then $44 grand. The thing is taking on water.

It is time to do your taxes. You and I are talking. We talk about that $50 grand conversion. You tell me about your fund or ETF slipping. I tell you that we are extending your return.

Why?

That is what changed with the new law.

For years you have had until the date you (properly) file your return to “undo” that $50 grand conversion. That is why I want to extend your return: instead of having to decide on April 15, extending lets you wait until October 15 to decide. You have another six months to see what that mutual fund or ETF does. 

Let's say that we wait until October 8^th and the thing has stabilized at $43 grand.

You feel like a chump paying tax on $50 grand when it is only worth $43 grand.

I have you call Vanguard or T Rowe and have them move that money back into CTG Reader Traditional IRA. Mind you, this has to be done by October 15 as the tax extension will run out. We file your return by October 15, and it does NOT show the $50 grand as income.

Why? You unwound the transaction by moving the money back to the Traditional account. Think of it as a mulligan. The nerd term for what we did is “recharacterization.”

It is a nice safety valve to have.

But we will soon have recharacterizations no more. To be accurate, we still have it for 2017 returns but it goes away for later tax years. Your 2017 return can be extended until October 15, 2018, so October 15, 2018 will be extinction day for recharacterizations. It will just be a memory, like income averaging.

BTW there is a variation on the above that will continue to exist, but it is only a distant cousin of what we discussed. Let’s go to your 2018 tax return. In March, 2019 you put $5,500 in a Roth IRA. You will still be able to reverse that $5,500 back to a regular IRA by October 15, 2019 (remember to extend!).

But the difference is that the distant cousin is for one year’s contribution only. You will not be able to take a chunk of money that you have accumulated over years, roll it from a Trad to a Roth and have the option to recharacterize back to a Trad in case the stock market goes wobbly.

Sad in a way.

Using a 401(k) to Supercharge a Roth

Let’s talk this time about a tax trick that may be available to you if you participate in a 401(k). The reason for the “may” is that – while the tax Code permits it – your individual plan may not. You have to inquire.

Let’s set it up.

How much money can you put into your 401(k) for 2015?

The answer is $18,000. If you are age 50 or over you can contribute an additional $6,000, meaning that you can put away up to $24,000.

Most 401(k)’s are tax-deductible. There are also Roth 401(k)’s. You do not get a tax break like you would with a regular 401(k), but you are putting away considerably more than you could with just a Roth IRA contribution.

Did you know that you might be able to put away more than $18,000 into your 401(k)?

How?

It has to do with tax arcana. A 401(k) is a type of “defined contribution” (DC) plan under the tax Code. One is allowed to contribute up to $53,000 to a DC plan for 2015. 

What happens to the difference between the $18,000 and the $53,000?

It depends. While the IRS says that one can go up to $53,000, your particular plan may not allow it. Your plan may cut you off at $18,000.

But there are many plans that will allow.  

Now we have something - if you can free-up the money.

Let’s say you max-out your 401(k). Your company also contributes $3,000. Combine the two and you have $21,000 ($18,000 plus $3,000) going to your 401(k) account. Subtract $21,000 from $53,000, leaving $32,000 that can you put in as a “post-tax” contribution. 

Did you notice that I said “post-tax” and not “Roth?” The reason is that a Roth 401(k) is limited to $18,000 just like a regular 401(k). While the money is after-tax, it is not yet “Roth.”

How do you make it Roth?

Prior to 2015, there had been much debate on how to do this and whether it could even be done. The issue was the interaction of the standard pro-rata rules for plan distributions with the unique ordering rule of Code Section 402(c)(2).

In general, the pro-rata rule requires you to calculate a pre- and post-tax percentage and then multiply that percentage times any distribution from a plan.

EXAMPLE: You have $100,000 in your 401(k). $80,000 is from deductible contributions, and $20,000 is from nondeductible. You want to roll $20,000 into a Roth account. You request the plan trustee to write you a $20,000 check, which you promptly deposit in a newly-opened Roth IRA account. 

           Will this work?

Through 2014 there was considerable doubt. It appeared that you were to calculate the following percentage: $20,000/$100,000 = 20%. This meant that only 20% of the $20,000 was sourced to nondeductible contributions. The remaining $16,000 was from deductible contributions, meaning that you had $16,000 of taxable income when you transferred the $20,000 to the Roth IRA. 

I admit, this is an esoteric tax trap.

But a trap it was. 

There were advisors who argued that there were ways to avoid this result. The problem was that no one was sure, and the IRS appeared to disagree with these advisors in Notice 2009-68. Most tax planners like to keep their tires on the pavement (so as not to get sued), so there was a big chill on what to do.

The IRS then issued Notice 2014-54 last September.

The IRS has clarified that the 401(k) can make two trustee-to-trustee disbursements: one for $80,000 (for the deductible part) and another of $20,000 (for the nondeductible). No more of that pro-rata percentage stuff.

There is one caveat: you have to zero-out the account if you want this result.

Starting in 2015, tax planners now have an answer.

Let’s loop back to where we started this discussion.

Let’s say that you make pretty good money. You are age 55. You sock away $59,000 in your 401(k) for five years. Wait, how did we get from $53,000 to $59,000? You are over age 50, so your DC limit is $59,000 (that is, $53,000 plus the $6,000 catch-up). Your first $24,000 is garden-variety deductible, as you do not have a Roth option. The remaining $35,000 is nondeductible. After 5 years you have $175,000 (that is, $35,000 times 5) you can potentially move to a Roth IRA. You may have to leave the company to do it, but that is another discussion.

Not a bad tax trick, though.

Is It A Second Home Or A Rental?

There are certain tax issues that seem to repeat in practice.

A client asked me how we handled his rental this year.  The answer was that we had stopped treating it as a rental in 2013. He was no longer renting the property. It needed repairs, and he was saving money to fix it up. He intended to then let his son live there.

There comes a point – if one does not rent – that it is no longer a rental. It may have been a rental once, in the same capacity that we once played football or ran track in high school. We did but no longer do. We are no longer athletes. We certainly are no longer young.

Let’s tweak this a bit: when does a property first start as a rental?

Obviously, when you first rent it.

What if you can’t rent it?

You would answer that you would not have bought a property that you couldn’t rent, so the scenario doesn’t make sense. It is the tax equivalent of the Kobayashi Maru.

What if you owned the property as a non-rental but decided to convert it to a rental? You didn’t actually rent it, unfortunately, but in your mind you had converted it to a rental.

But is it a rental or is it not?

Granted, the passive loss rules have put a dampener on this tax issue, as one is allowed to deduct passive losses only to the extent of passive income. There is a break for taxpayers with income less than $150 thousand, but it is quite likely that someone with this tax issue has income beyond that range. There is still a tax bang when you sell the property, though, regardless of your income.

The Redisch case takes us to Florida. We are talking about second homes.

The Redisches are Michigan residents. They bought land in a private oceanfront community (Hammock Dunes) in Palm Coast, Florida. They rented an oceanfront condo while meeting with an architect for ideas for building on the land. They decided they liked oceanfront more than non-oceanfront, so they sold the land in 2003 and bought an oceanfront condo in 2004. It must have been a very nice condo, as it cost $875,000.

The condo was their second home, and they often spent time there with their daughter.

Their daughter passed away tragically in 2006.

The Redisches could not stay at the condo any more. The memories were too painful.

In 2008 they decided to sell the condo. You may remember that 2008 was a very bad year for real estate. They decided instead to rent the property for a while and allow the market to recover.

They contacted a realtor associated with Hammock Dunes to market the rental. Hammock Dunes itself was still under development, so any potential sale of the condo would have been competing with new construction. Renting made sense.

The Redisches hired a realty company. They figured they had gotten an edge, as most of the company realtors lived in Hammock Dunes themselves. The company operated an information center there, which would help to market their rental. The realty company even used the condo as a model, although they did not pay the Redisches for such use. They did however persuade the Redisches to change one of the bedrooms to a child’s room. There was hope that someone with a child (or, more likely, a grandchild) would be interested.

The Redisches received a couple of inquiries. One person wanted to rent the property for two months, but the condo association did not permit short-term rentals. The other person had a big dog, which also ran afoul of condo restrictions.

It was now a year later and the rental effort was going nowhere. Other owners in Hammock Dunes were losing their properties to foreclosure. The Redisches were becoming keenly concerned with selling the property while there was still something to sell. They switched realty companies. They had the property reappraised. They dropped to price to $725,000 and finally sold the condo in December 2010.

They claimed the condo as a rental on their 2009 and 2010 tax returns. They reported a long-term capital loss on the sale of the property. 

OBSERVATION: Which is incorrect. If the property was a rental, the loss would be a Section 1231 transaction, reportable as an ordinary loss on the tax return. If the property was a second home, then any loss would be disallowed.

And the IRS looked at their 2009 and 2010 tax returns.

The tax issue was whether the property was a rental.

What do you think: did the Redisches do enough to convert the property to a rental?

One the one hand, they had a valid non-tax reason to sell the property. There was a business-like reason to withdraw it from the market and rent it instead. They hired experts to help with the rental. They transacted with potential renters, but condo restrictions disallowed those specific rentals. What more could they do, as they themselves were living in Michigan?

On the other hand, the IRS wondered why they did not try harder. After all, if one’s trade or business is renting real property, then one goes to great lengths to, you know, rent real property. The IRS wanted to see effort as though the Redisches’ next meal depended on it.

Here is the Court:

After considering all the facts and circumstances, we find that the […] property was not converted to a rental property. The Redisches used the property for four years before abandoning personal use of it …. Although Mr. Redisch testified that he signed a one-year agreement with a realty company […], he did not provide any other evidence of such an agreement. Even if the Redisches had produced the contract, Mr. Redisch stated that the efforts of the realty company to rent out the Porto Mar property were limited to featuring it in a portfolio kept in the company’s office and telling prospective buyers that it was available when showing it as a model. 

It is unsurprising that this minimal effort yielded only minimal interest.”

Ouch.

The Court decided that the Redisches were not acting in a business appropriate manner, if their business was that of renting real property. The Court unfortunately did not indicate what they could have done that would have persuaded it otherwise. Clearly, just hoping that a renter would appear was not sufficient.