Tax Provisions Expiring on December 31, 2013

We have been reviewing tax provisions scheduled to expire at the end of this year, December 31, 2013. This is an unhappy, contemporary development in federal taxation. Taxpayers in recent years have waited on Congress to come to the rescue, even if that rescue was in January and retroactive.  I am not optimistic for any breakthrough this year. The Senate nuclear-option fiasco last week tells you that the parties will not be sending Christmas cards across the aisle this year.

 (1)  Mortgage debt relief

The tax code considers the forgiveness of debt to be similar to you receiving a paycheck. Your wealth has gone up (in this case, because your debts have gone down), so the IRS considers this income to you. There has been an exception for debt discharged on your principal residence.

 (2)  Deduction for mortgage insurance premiums

You buy this insurance when you put down less than 20% on the purchase of a house.

 (3)  Teachers classroom expenses

This is the $250 deduction for unreimbursed teacher school supplies.

(4) IRA distributions to Charity

 If you are age 70 ½, the IRS requires you to take “minimum required distributions” from your IRA (but not from your Roth IRA). This provision lets you donate that distribution to charity without counting it as income. You don’t get the charitable deduction, of course, but it can stop you from being pushed into tax phase-outs because of the increase to your gross income.

(5)  State sales taxes

If you live in a state without income taxes (Florida and Texas, for example), this provision allows you to deduct sales taxes in lieu of income taxes.

 (6)  Research & development tax credit  

 It seems that this credit has been “extended” as long as I have been in practice. It will again, if only because some very powerful interests (think Apple and Intel) will make it so.

 (7)  Credit for construction of new energy efficient homes

This $2,000 credit goes to the contractor for building your energy-efficient new home. Granted, it has not meant as much in recent years, except perhaps to the cash-strapped contractor.

(8)  Credit for energy efficient home improvements

This is the $500 credit for doors, windows, insulation and exterior doors. There are other, less recognizable, categories, such as a biomass stove.

 (9) Expensing of depreciable assets

Also referred to as the Section 179 deduction, it is scheduled to drop to $25,000 next year from $500,000 this year.

 (10)     50 percent depreciation

You are allowed (for a brief remaining time) to immediately deduct 50% of a wide range of business assets, other than real estate.

 (11)     Work opportunity tax credit

Many people associate this credit with hiring welfare recipients, but it also covers military veterans. The credit can be as much as $9,600 per employee.

 (12)     Depreciation for certain leasehold, restaurant and retail  improvements

 Depreciation on real estate is brutal: the tax Code requires one to depreciate over 39 years. This break allows a business or restaurant (think Applebee’s or Kroger) to depreciate their build-out over 15 rather than 39 years.

(13)     Deduction for qualified tuition and related expenses

This is the deduction of up to $4,000 (not to be confused with the tax credit!) for you or your child attending college.

 (14)     Child tax credit

This is the credit for a child under age 17. It is worth $1,000 this year. It drops to $500 in 2014.

This is just stuff that is going away. We haven’t talked about new tax stuff, such as the increase in the maximum individual tax rate, the new capital gains rate, the 3.8% Obama tax on investments, the 0.9% Obama tax on your W-2, the disallowance of your itemized deductions, the disallowance of your personal exemptions, the ObamaCare individual mandate penalty for 2014, the new dollar limits on your FSA, and so on and so on.

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.