Why Does The IRS Want A Disabled Veteran To Work Faster?

Sometimes I read a tax case and ask myself “why did the IRS chase this?”

Lewis is one of those cases.

Let’s explain the context to understand what the IRS was after.

It will soon be three decades that Congress gave us the “passive activity” (PAL) rules. A PAL is a trade or business that you do not sufficiently participate in – that is, you are “passive” in the business. This means more when you have losses from the activity, as income is going to be taxed in any event. It was Congress’ intention to take the legs out from the tax shelters, and with PALs they have been largely successful.

The PAL rules got off to a rocky start. One of the early problems was Congress’ decision to classify real estate activities as passive activities. Now, that concept may make sense if one own a duplex a few streets over, but it doesn’t work so well if one is a home builder or property manager.

Say, for example, that a developer builds a hundred condo units. The real estate market reverses, and he/she cannot sell them as quickly as planned. The developer rents the units, waiting for the market to improve.

Most of us would see one activity. Congress saw two, as the rental had to be segregated. There was no harm if both were profitable. There was harm if only the development was profitable, however, as the rental loss would just hang in space until there was rental income to absorb it.

That was the point of the passive activity rules – to disallow the use of passive losses against nonpassive income.

Real estate professionals screamed about the unfairness of the law as it applied to their industry.

And Congress changed the law by making an exception for real estate people who:

(1) Work more than 750 hours during the year in real estate, and

(2) More than one-half of all hours worked were in real estate.

If you meet both of the above tests, you can deduct losses from your real estate activities to your heart’s content.

Bill Lewis is a Vietnam veteran. He took injuries as a Marine, retaining 50 percent use of his right arm and 70 percent of his feet, requiring him to wear orthopedic shoes. The military gave him a disability pension. He now needs knee surgery, and he has difficulty seeing. He is married.

He and his wife own a triplex next door to their residence. The property also has a washhouse, although I am uncertain what a washhouse is. There are six 64-gallon recycling bins, and several large walnut trees. Mr. Lewis does not ask anyone to take care of his property. He takes care of it himself.

1.  Every morning he walks around and inspects for trash, as they are located very close to a homeless area.  This takes him about a half hour daily.
2. Also on Mondays he scrubs down the washhouse. That requires him to haul water and takes him about three hours. 
3. On Tuesdays and Thursdays he landscapes, cleans the outside of the buildings and the garbage cans and rakes the yard. This takes about two hours on each day.
4. Depending on the season, he has more raking to do, as he has walnut trees on the property.
5. On Wednesdays he takes the recycling bins out to the curb. One by one, as he has mobility issues.
6. On Thursdays he returns the recycling bins. Same mobility issues.
7. He prefers to do repairs himself. If he needs outside help, he schedules and meets with that person. 
8. He follows a set routine, rarely if ever taking a vacation.

The Lewis’ claimed rental losses for 2010 and 2011. The IRS disallowed the losses and wanted almost $11,000 in taxes in return. The IRS said this was the classic passive activity.

The IRS should have also taken candy from a child and kicked a dog and made this a trifecta of bad choices.

Mr. Lewis was disabled. He did not have a job. As a consequence, he did not have to worry about spending more than half of his work hours in real estate. For him, all of his work hours were in real estate.

But Mr. Lewis ran into two issues:

(1)  He did not keep a journal, log or record of his activities and hours; and

(2)  The IRS did not believe it could possibly take more than 750 hours to do what he did.

Issue (1) is classic IRS. I have run into it myself in practice. The IRS wants contemporaneous records, and few people keep time sheets for their real estate activities. The IRS then jumps on after-the-fact records as “self-serving.” The IRS has been aided by people who truly could not have spent the hours they claimed (because, for example, they have a full-time job) as well as repetitively fabulist time records, and the courts now routinely side with the IRS on this issue.

But not this time. The judge was persuaded by the Lewis’ testimony and the few records they could provide. This was a rare win for the taxpayer.

The IRS had a second argument though: it should not have taken as long as it took Mr. Lewis to perform the tasks described.

The judge dismissed this point curtly:

Petitioner husband and petitioner wife testified credibly that because of petitioner husband’s disabilities all of the activities took him significantly longer than might ordinarily be expected.”

The Lewis’ won and the IRS lost.

Good.

These were very unique facts, though. Unless one truly works in the real estate industry, many if not most are going to lose when the IRS presses on contemporaneous records for the 750 hours. Mr. Lewis was a sympathetic party, and the judge clearly gravitated to his side.

Which raises the question: why did the IRS pursue this? They were anything but sympathetic chasing a disabled veteran for taking too long while performing his landlord responsibilities.

Yes, I am sympathetic to Mr. Lewis too.

What Does It Take To Exclude Foreign Income?

At this point of the tax season I usually lament not having won the lottery since last year’s tax season. I would travel extensively, most likely overseas.

That would put me out of the country, and you may have heard that there is a tax “break” for people who work outside the country.  I sincerely doubt it would apply to me in my imaginary lottery-fueled world, but let’s talk about it.

If you work overseas, you get to exclude up to $100,800 of earned income – such as salary – from U.S. tax. This sounds like a great deal, and usually it is, but remember that you would have been allowed a credit for income taxes paid the other country. If the foreign taxes are the same or higher than the U.S. taxes, the effect of the income exclusion is likely a push. If the other country has lower taxes than the U.S., however, this could be a very sweet deal for you.

There are ropes to claiming this exclusion. You have to meet one of two tests. The first test is being outside the U.S. for at least 330 days during the year. Think about this for a second. You take a job in Japan for a couple of years, but your family stays in the U.S. This means that you can see them up to 35 days a year – or forfeit the exclusion. I suppose they could travel to Japan instead, but you get the idea.

There is a second way, and that is to be a “bona fide” resident of the foreign country. This is hard to do, as it means that your home is there and not here. “Home” in this context does not just mean a place where you hang clothes and keep food in the refrigerator. The tax Code wants more: it wants your “main” home to be overseas.

Does this happen much? You bet. Think an American expatriate – perhaps retired military or someone who married overseas. I have family for example who have lived in England for decades. They have gone to school, worked, married and raised children there. They would easily qualify for the foreign income exclusion under the bona fide test.

What if one works overseas but still maintains ties to the U.S.? Can one also be a bona fide citizen of another country?

You can expect the IRS to be skeptical, especially if you leave a house or family behind. This is the IRS equivalent of New York Department of Revenue not believing you when you tell them you moved to Florida.

Let’s look at one someone who recently tried to make the bona fide argument.

Joel Evans took a job on Sakhalin Island in Russia, which has to count as going to the end of the world. He was working the oil rigs, both on land and offshore. His normal schedule was 30 days on followed by 30 days off. A 30- day stretch gave him the flexibility to return frequently to the U.S.  

He had a house in Louisiana, and somewhere in there he got divorced. His daughter moved into his house for a while. He returned to Louisiana whenever he could. He eventually married a second time, and his wife moved into, and his daughter moved out of, his house in Louisiana.

He claimed the foreign income exclusion for years 2007 through 2010. The IRS said no and wanted over $31,000 in back taxes from him

He had absolutely no chance under test one, as he spent way more than 35 days annually in the U.S. He argued instead that he was a bona fide resident of Russia.

I give him credit, I really do. It was his only argument. He spent a lot of time in Russia. He learned a little Russian. He fixed up a place to stay. He made friends. He even dated some Russian women, which I presume he ceased doing when he got remarried.

But that isn’t the test, is it?

The test is where his main home was. He pretty much gave his hand away when he kept returning to Louisiana almost every thirty days.

The Tax Court agreed with the IRS and disallowed his foreign income exclusion. He was not a bona fide resident of Russia, and he could not exclude his foreign earned income. He had failed both tests.

Let’s state the obvious: he had no chance winning this one.

In my practice, almost everyone relies on the 35-day test, and it is common to monitor the 35 days like a hawk. I suppose if I were an expat (that is, living overseas) preparing taxes for other expats, I would see the bona fide test more frequently. There are not too many bona fides who would need my services in Cincinnati.

Which rule – the 35 day or the bona fide – would trip me up when I hit the lottery?

Neither. It takes earned income – think self-employment or a salary – to power the foreign earned income exclusion. I have no intention of working.

An Interim Report On Tax Season

I was speaking with a colleague earlier this week who wants to set up a tax storefront. That means a place that prepares taxes, probably only individual taxes and only for a few months a year. Think H&R Block, but without a franchise involved. I suspect he would be successful, but like any business start-up the cash drain is difficult to pull off.

And he asked me if tax seasons are getting “harder.” Yes, he is younger than me. I am getting to that age.

I hesitated on his question, as my long-standing position is that the accounting firm determines the difficulty of the season for its employees. Some firms do a good job, and other firms simply do not care. It is one of the reasons that the average career of an accountant in a CPA firm is little more than that of an NFL player.

Bet you did not know that.

Still, there are issues for tax practitioners that did not exist a few years ago – or even last year.

I was speaking this week with a good friend about whether it was safe for him to prepare his personal tax return on TurboTax. Depending upon the year and other factors, he prepares a draft return and I review it for him. Last year he changed jobs and states, so I expect I will review his return this year.

Why TurboTax? It turns out that a number of states experienced suspicious electronic filing activity this year and, upon investigation, in many cases the electronic return was filed using TurboTax.

Let’s be fair, though. That does not mean that the information came from TurboTax. There have enough recent breeches of data security that the information may have come from elsewhere.

Intuit, the parent of TurboTax, responded aggressively to this development, as you would imagine. A number of states, including Kentucky and Minnesota, temporarily halted the processing of electronically filed returns.  Meanwhile TurboTax encouraged its customers to log-in and review their accounts. They instructed their customers to review their direct-deposit information specifically.

Makes sense.

Why the states? In the past, fraudsters have targeted the IRS rather heavily. The IRS responded with stricter identity measures, including lockdowns on any tax refunds and the required use of security passwords. Florida was so hard-hit, for example, that one can request a federal security PIN number under a pilot program – even if one was not the victim of identity theft.

It may be that the fraudsters saw easier picking elsewhere.

Then we have the information documents to prepare a tax return.

I am reading that the federal health insurance marketplace has sent out approximately 800,000 erroneous Forms 1095-A. This is not insignificant and represents approximately one-in-five people using the marketplace. These forms are new and are issued by the exchanges to individuals who purchased insurance there. They include information on any government subsidy, so they are an important tax document.  For example, even if you are not otherwise required to file a tax return, you must file if you received a subsidy.

The error concerns the “benchmark plan” premium and doesn’t concern the amount of subsidy itself. The “benchmark plan”” is the second lowest cost silver plan for where one lives, and it is part of the arithmetic to settle-up whether one received too much or too little subsidy. As you know, if you received too much subsidy you have to pay it back.

Taxpayers who received Forms 1095-A are encouraged to wait until March before filing their individual tax returns. Not a problem. Surely these are people who do even meet with their tax advisors until March.

Meanwhile, it has finally dawned on some politicians that people may not realize the effect of ObamaCare on them until they file their 2014 taxes. There will be rude surprises for those who did not acquire insurance and now have to pay the penalty. Perhaps they acquired insurance but were over-subsidized, and now they have to repay the excess subsidy.

Wait until they learn that the penalty will go up every year.

Then there is a problem with the timing of obtaining health insurance. ObamaCare requires everyone to have insurance in place by February 15 – which of course is two months earlier than April 15, when taxes are due. That may be the first time people understand this Rube Goldberg contraption foisted 50-shades-of-grey style upon society. What happens then? Well, in addition to owing the penalty for 2014 it would appear that one would also owe a penalty for some part of 2015 – at least until one can acquire health insurance. The penalty goes month by month.

Many politicos – not the brightest class emerging from natural selection – are now up in arms, demanding that deadlines be changed, penalties ameliorated and so on. I suppose there is a nuance there, but it escapes me. 

Somewhat on cue, on February 20 the Center for Medicare and Medicaid Services declaimed that the enrollment period shall reopen from March 15 to April 30.

To which I have two questions:

1. What happened to the period from February 15 to March 15?
2. Why is the Center for Medicare and Medicaid Services changing the law?

On February 13 - which seems a lifetime ago at this point - the IRS finally provided some guidance on how to comply with the new repair Regulations effective with the 2014 tax returns. Considering that their first pass at the Regulations required almost everyone with real estate or other depreciable property to file for a change in accounting method - a change which the IRS mandated, by the way - the IRS then had the temerity to say that we also had to formally ask them for permission to change. I had and have a stack of real estate partnership returns in my office waiting on their guidance. Forests have been felled by tax practitioners divining for weeks and months what the IRS wanted from us this year in order to comply with their new Regulations. 

Do you ever wonder if our government is suffocating under the weight of people who - having accomplished little more than going to a name school or playing at politics - think they now have the chops to bludgeon those of us who actually accomplish something every day? 

Back to our initial question though: are tax seasons getting “harder?”

I don’t think “harder” is the word I would use for for it.

Distinguishing Capital Gains From Ordinary Income

The holy grail of tax planning is to get to a zero tax rate. That is a rare species. I have seen only one repeatable fact pattern in the last few years leading to a zero tax rate, and that pattern involved not making much money. You can guess that there isn’t much demand for a tax strategy that begins with “you cannot make a lot of money….”

The next best plan is capital gains. There is a difference in tax rates between ordinary income (up to 39.6%) and capital gains (up to 20%). A tax geek could muddy the water by including phase-outs (such as itemized deductions or personal exemptions), the 15% capital gains rate (for incomes below $457,600 if you are married) or the net investment income tax (3.8%), but let’s limit our discussion just to the 20% versus 39.6% tax rates. You can bet that a lot of tax alchemy goes into creating capital gains at the expense of ordinary income.

The tax literature is littered with cases involving the sale of land and capital gains. If you or I sell a piece of raw land, it is almost incontrovertibly a capital gain. Let’s say that you are a developer, however, and make your living selling land. The answer changes, as land is inventory for you, the same as that flat screen TV is inventory for Best Buy.

Let’s say that I see you doing well, and you motivate me to devote less energy to tax practice and more to real estate. At what point do I become a developer like you: after my second sale, after my first million dollars, or is it something else?

The tax Code comes in with Section 1221(a), which defines a capital asset by exclusion: every asset is a capital asset unless the Code says otherwise.

For purposes of this subtitle, the term “capital asset” means property held by the taxpayer (whether or not connected with his trade or business), but does not include—

(1)  stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;

Let’s take Section 1221(a)(1) out for a spin, shall we? Let’s talk about Long, and you tell me whether we have a capital asset or not.

Philip Long lives in Florida, which immediately strikes me as a good idea as we go into winter here. From 1994 to 2006 he operated a sole proprietorship by the name of Las Olas Tower Company (LOTC). Long had a drive and desire to build a high-rise condominium, which he was going to call Las Olas Tower.

He is going to build a condo, make millions and sit on a beach.

Problem: he doesn’t own the land on which to put the condo. Solution: He has to buy the land.

He finds someone with land, and that someone is Las Olas Riverside Hotel (LORH). LORC and LORH are not the same people, by the way, although “Las Olas” seems a popular name down there. Long enters into an agreement to buy land owned by LORH.

Long steps up his involvement: he is reviewing designs with an architect, obtaining government permits and approval, distributing promotional materials, meeting with potential customers. The ground hasn’t even been cleared or graded and he has twenty percent of the condo units under contract. Long is working it.

LORH gets cold feet and decides not to sell the land.

Yipes! Considering that Long needs to land on which to erect the condo, this presents an issue. He does the only thing he can do: he sues for specific performance. He needs that land.

He is also running out of cash. A friend of his lends money to another company owned by Long to keep this thing afloat. Long is juggling. Who knows how much longer Long can keep the balls in the air?

In November, 2005 Long wins his case. The Court gives LORH 326 days to comply with the sales agreement.

But this has taken its toll on Long. He wants out. Let someone finish the lawsuit, buy the land, erect the condo, make the sales. Long has had enough. He meets someone who takes this thing off his hands for $5,750,000. He sells what he has, mess and all. 

    QUESTION: Is this ordinary or capital gain income?

The difference means approximately $1.4 million in tax, so give it some thought.

The closer Long gets to being a developer the closer he gets to a maximum tax rate. The Courts have looked at the Winthrop case, which provides factors for divining someone’s primary purpose for holding real property. The factors include:

1. The purpose for acquisition of property
2. The extent of developing the property            
3. The extent of the taxpayer’s efforts to sell

The Tax Court looked and saw that Long had a history of developing land, had hired an architect, obtained permits and government approvals and had even gotten sales contracts on approximately 20% of the to-be-built condo units. A developer has ordinary income. Long was a developer. Long had ordinary income.

Is this the answer you expected?

It wasn’t the answer Long expected. He appealed to the Eleventh Circuit.

What were the grounds for appeal?

Think about Long’s story. There is no denying that a developer subdivides, improves and sells real estate. Long was missing a crucial ingredient however: he did not have any real estate to sell. All he had was a contract to buy, which is not the same thing. In fact, when he cashed out he still did not have real estate. He had won a case ordering someone to sell real estate, but the sale had not yet occurred.

The IRS did not see it that way. As far as they were concerned, Long had found a pot of gold, and that gold was ordinary income under the assignment of income doctrine. That doctrine says that you cannot sell a right to money (think a lottery winning, for example) and convert ordinary income to capital gains. You cannot sell your winning lottery ticket and get capital gains, because if you had just collected the lottery winnings you would have had ordinary income. All you did was “assign” that ordinary income to someone else.

The problem with the IRS point of view is that someone still had to buy the land, finish the permit process, clear and grade, erect a building, form a condo association, market the condos, sell individual units and so on. Long wasn’t going to do it. There was the potential there to make money, but the money truck had not yet backed into Long’s loading dock. Long was not selling profit had had already earned, because nothing had yet been “earned.”

Long won his day in Appeals Court.

He had ordinary income in Tax Court and then he had capital gains in Appeals Court.

Even the pros can have a hard time telling the difference sometimes.