Rumor has it (I’ve yet to see anything authoritative from the IRS about this) that the IRS auditors are taking the position that Form 1099-As are all they need in some cases to assess cancellation of debt income.

Please look at the last blog article I posted “IRS Quietly Issues New Instructions for Reporting When You Dump Bad Real Estate” for a quick synopsis of how it is supposed to work.

The problem is that the lenders aren’t issuing Form 1099-Cs like they are supposed. I’m not sure that’s why the IRS is now relying on Form 1099-As to report COD income, but I suspect it is.

If you receive a Form 1099-A that shows the loan is non-recourse to you, or if the property is in a state that is non-recourse then you will likely have Cancellation of Debt income. The problem is that in most cases the values given on the Form 1099-A are ridiculous. We tend to see amounts that are hundreds of thousands of dollars more than fair market value or $0. It’s all or nothing and neither is right.

In reality, fair market value is determined by what a willing buyer and a willing seller determine it to be. So a lender’s guess isn’t necessarily going to be accurate anyway.

And finally, the question of recourse or non-recourse isn’t a simple yes-no. In most states it depends on the type of mortgage and the type of foreclosure. A lawyer needs to make that determination. For the person who has just had their real estate portfolio decimated and likely exhausted personal resources just trying to stay afloat, getting the advice of a lawyer and a CPA with experience in real estate matters and particularly this issue, may be too much.

Those are all the reasons why I don’t like the position that the IRS is taking on some audits. I suspect they are taking this position just to see what happens. If they get challenged and lose in Tax Court, they’ll roll back. Meanwhile, if you’re one of those people who got Form 1099-As and never got a Form 1099-C, you may be soon getting an audit notice.

The way it’s supposed to work:

If you have property that you lose in foreclosure or deed-in-lieu of foreclosure, you are supposed to get a Form 1099-A. The form is supposed to indicate the total debt amount, which may or may not be right, the fair market value of the property, which is almost certainly wrong and whether the debt is recourse. In other words, whether the lender can come after you for any remaining debt after the property is sold. Then when the deal is done, if there is debt, the lender has the choice to write it off and send you a Form 1099-C with the Cancellation of Debt income. This is taxable to you, unless you qualify for one of the exclusions which need to be reported on Form 982.

We’ve seen hundreds of cases of wrong Form 1099-As and Form 1099-Cs and taxpayers left wondering how to report.

The IRS has issued new instructions for Form 982, which clarify this all a little bit.

The Form 982 gives you 4 exceptions to paying tax on COD income. I’m ignoring the special farm exemptions and other items. I’ll assume that this is real estate and it was either your principal residence, a vacation residence, an investment property or a rental property.

There is an exclusion from tax if the debt was associated with your principal residence and was original debt. If it’s a second mortgage, you may have a tax issue. And remember just because the IRS says it’s exempt, it doesn’t mean the state will say it is. If you get a Form 1099-C that relates to your principal residence and you don’t owe tax on the income, report it on Form 982.

There is also an exclusion if the property was listed in a bankruptcy or you were insolvent at the time of the property loss. If you receive a Form 1099-C, you will also need to report it on Form 982.

If you missed doing the Form 982 and there is a Form 1099-C that the IRS is now chasing with you, the good news is that you can go back and amend to file the Form 982 for these three instances: primary residence, insolvency or bankruptcy.

There is also another option on the Form 982 if you have COD income as a result of restructuring with your lender. This applies if you have a real estate business, so you have more than one property and they are investments or rentals. In this case, you can apply the COD write-down to reduce the basis on remaining property.

This Form 982 exception is tricky, though. You need to take this election with the original filing of your return, or within 6 months after you’ve filed it. You can go back after that and file an amendment.

Make sure you read the next USTaxAid article dealing with the rumored new IRS audit target for real estate investors.

1. A New Hampshire tire retailer was fined $109,000 by the state of Massachusetts. The reason? The retailer was selling tires to Massachusetts residents, who were crossing state lines to buy tires in sales tax-free New Hampshire. This one wound up in court. It also resulted in a new NH law prohibiting outside state tax departments from trying to force NH retailers into collecting taxes on sales to non-New Hampshire residents.
2. In New York State, some 33 businesses and individuals were charged with criminal tax fraud and prosecuted during the fiscal period 2006-2007. In 2009-2010, that number increased to 327. This was due to New York redefining what it meant to do business in the state. If they decided you did business and you didn’t file (even if you didn’t know you should), they decided you not only owed tax money but that in some cases, it was a criminal charge as well.
3. Wholesalers beware! States are targeting you for audit. Why? Because many wholesalers don’t have the proper exemption certificates in place for all states in which they are operating, or aren’t keeping up with proper exemption certificate reporting and confirmation.

Learn more about this new massive effort by states to take your money at http://www.CrossBorderTaxGrab.com.

Make no mistake, states want your money and they are using every opportunity they can to assess taxes on you, especially if you don’t live in their state.

You might ask, though, “Even if they find me, how can they get anything anyway? I don’t live in that state or have any assets in that state.”

Here’s how:

1. Lawsuits. Generally speaking, states won’t allow other states to sue their residents over unpaid taxes. So if you live in Nevada and owe California taxes, the California government can’t necessarily file a lawsuit against you in Nevada. Does that mean you’re off the hook, free and clear? No. If you fail to defend yourself, or if you defend yourself in California and lose, the state CAN take that judgment and come to Nevada to have it enforced.
2. Reciprocity Statues. Many states depend on reciprocity statutes instead. A reciprocity law essentially says that states will uphold each other’s laws, unless doing so would be unconstitutional or directly conflicts with existing state laws. It also means that where two states have reciprocity statutes, you could find yourself defending a collection lawsuit in either state, where normally a lawsuit wouldn’t be allowed.
   States with Reciprocity Laws include: Alabama, Alaska, Arizona, Arkansas, California, Colorado, Connecticut, South Dakota, Tennessee, Texas, Utah, Vermont, Virginia, Washington, west Virginia, Wisconsin and Wyoming.
3. Collection Agencies. States can and will send judgments to collection agencies, as well as engaging attorneys to begin collection actions. California recently set aside a large sum of money earmarked for out-of-state legal fees to begin collection actions over its new economic nexus laws that started on January 1, 2011. If your state sends your judgment to collection, you can also expect it to increase. Agencies are typically authorized to add another 20% onto the total bill as part of their collection fee.
4. Seizure, Business Closures. Once a state has a legal right to collect from you, they have a wide range of ways to enforce that collection. It’s not uncommon to see businesses closed down for failure to pay sales taxes. In Rhode Island, for example, some 1200 businesses were recently shut down by tax collectors over unpaid debts. The shut down procedure involved tax collectors appearing at the business location, with a lock and chain, to shut down and secure the doors. Even businesses that had paid their taxes were closed down until they could prove that the taxes had been received by the state.
5. Help from Unexpected Sources. In a recent ruling, the U.S. Securities and Exchange Commission got into the tax collection and penalty act. A public company, which had spun off from its parent company in 2003, had some major sales tax collection issues, due to outdated and inadequate tax software. They cleaned up their act in 2007, and paid a total of $4 million in taxes and penalties, before being pronounced fully compliant in 2008. But some 3 years later (in January of 2011), the SEC got involved and fined the company another $200,000, for failure to comply with securities laws that require companies to obey all state laws and pay taxes on time.

Learn more about the Cross-Border Tax Grab and, more importantly, what you can do about it, at http://www.CrossBorderTaxGrab.com

Most business structures are considered flow-through. That means that the income and losses from the business ultimately end up on your tax return. There is no federal income tax paid at the structure level. Theoretically most states (exception Tennessee) went along with that. But we’re seeing more and more ‘non-tax’ taxes like California’s franchise tax, Texas Margin Tax, Ohio’s CAT and Washington’s B & O.

For purposes of this discussion, though, let’s talk just about federal tax. All entities except the C Corporation are flow-through. That’s one big reason to have a C Corporation. If your income is at the highest tax rate, you can move income from the high tax bracket to the low tax bracket by having the C Corporation pay tax at its own rate. The first $50,000 of taxable income is taxed at 15%. So if your highest personal rate is 35%, you’ll save $10,000 right off the bat by using a C Corporation for $50,000 of the business profit.

The C Corporation also gives the owner/employee a lot more benefits that are deductible. As an example, a lot of our clients love the Medical Expense Reimbursement Plan (MERP) which allows the corporation to take a full deduction, directly against income, for all medical expenses.

The C Corporation can be a little more complicated to set up and run, but in the right situation, it definitely can be a winner!

• Tax Free (and almost Tax Free) Benefits From Your Business
• Operation Guide for Your Corporation
• Filing Your C Corporation Tax Return

There is an exception, if you qualify. That’s by taking the Real Estate Professional deduction. If you haven’t heard of this before, please search on this site for “real estate professional” and you’ll find a lot of information on how to legally qualify.

Today, I want to talk about taking and keeping a Real Estate Professional deduction on your tax return. It can mean big tax savings. But there are definite rules to taking this deduction. Unfortunately, some people got greedy with this tax strategy. It brought on IRS scrutiny for both people who legally took it and those who did not.

Let’s assume that everything is legal and you’ve taken the real estate professional deduction correctly. The IRS began targeting real estate professionals for audits back in 2008. They aggressively denied the deduction and some cases went on to Tax Court.

The dust has now settled on these cases and we have better guidance on what you can and can’t do. Here are some of the highlights.

New proposed regulations from late 2011 tell us that the business entity that you hold your real estate in can have a significant impact on your deductibility of real estate losses. Avoid being just a limited partner in a limited partnership or a member in a member-managed LLC. The IRS us that those structures and set-ups turns these losses into passive losses. It doesn’t matter if you are a real estate professional, you won’t be able to take any passive losses against your active income

The solution in this case is to hold a general partnership interest as well as a limited partnership interest in the LP or change your member-managed LLC to a manager-managed one and make sure you’re a manager.

The IRS has also been closely looking at what constitutes real estate activity. One of their early claims was that real estate agents could not use their activities as a real estate activity. That is even though the Code tells us that ‘brokering a deal’ was a legitimate activity. They further argued that you had to be a Real Estate Broker in order to broker a deal. The IRS was shut down on that one. The Tax Court said that a real estate agent could broker a deal and that meant that was a legitimate deduction.

Another possible concern was the need for 500 hours per property for material participation. You could aggregate the properties to avoid the ‘per property’ requirement. The IRS has loosened the need to make that election on a timely basis, allowing taxpayers to make the election after the fact. But there can be a downside to taking the aggregation election if you later sell one of the properties at a loss. You won’t be able to take that loss against other income. This could especially be compounded if you have a foreclosure or other form of debt forgiveness income involved.

This is a hotly contested area of tax law. Keep up to date on the changes! There are bound to be more coming.

• Tax-Free Real Estate Investments
• Tax Strategies for Real Estate Investors
• The IRS Survival Guide for Real Estate Professionals with Real Estate Investments

Nothing happens until you start. You won’t make money from your business until you start. You won’t create a passive income stream until you start. And you can’t get tax deductions until you start.

In the case of a business, you can get stuck investigating and training. Maybe you spend tens of thousands of dollars on courses, seminars and research. How much is deductible? None of it. At least none of it is deductible until you start that business.

In the case of real estate, you likely will spend even more money getting training and then researching markets. At the end of the year, you happily show your records to your CPA so you can get all the write-offs. Your CPA is then going to ask, “When did you start?” And that’s where you stuck. If you didn’t start, none of it is deductible.

Once you start, the training that helps you improve is deductible. Once you start, the travel to investigate new markets and make new connections is deductible.

I recently received a note from someone who had bought a real estate property near the end of 2011. They had spent money fixing it up in 2011 and intended to sell it as a fix-n-flip in early 2012. They did sell it. Now the question was, “How much of the money spent to fix the property in 2011 was deductible?”

The answer is ZERO.

There are two possible issues with real estate repair/improvements. First, is the expense a currently deductible repair or an improvement that increases the value and/or life of the property? In the case of an improvement, you need to capitalize and then depreciate the asset. The repair cost is currently deductible.

The second issue is the real problem. When did that property START being an investment that is in service? When did they start? In the case of improving something for sale, it’s just an asset until it’s sold. So, like any kind of inventory you buy for a store, it’s not deductible until you sell it.

If you had put the property into service by renting it, the start date is when it’s available for rent.

Start quick for the best deductions.

• Tax Benefits From Your Home
• Tax Strategies for Real Estate Investors
• The IRS Survival Guide for Real Estate Professionals with Real Estate Investments

The tax is on more than just real estate, but it’s not on the total gross income, as has been reported. Here are some quick facts on the new 2013 tax:

• Tax begins 1/1/2013
• Effective for individuals with AGI above $200K or married, filing joint taxpayers above $250K
• 3.8% surtax, separate from other federal and state income taxes
• Applies to interest, dividend, net rental income (less expenses), net capital gains (after capital loss deduction)
• Applies to lesser of investment income or excess of AGI over threshold amount

New taxes and tax law changes often bring a lot of confusion in the beginning. This new tax is no exception. For example, at this point, we do not know whether a like-kind exchange (Section 1031) will save you from this tax.

Normally, as long as you roll over all of the proceeds and invest in another real estate property worth at least as much as the property you just sold, you can defer the taxes. But right now, we don’t know if that will mean that you also can defer the surtax.

• Insider’s Guide to Tax-Free Real Estate Investments
• Tax Strategies for Real Estate Investors
• Easy Accounting for Real Estate Investors

The assumption in the marriage penalty tax is that you are married to someone who makes about the same amount of money that you do. Under current law, you’ll pay less tax being married, or at least the same amount of tax as opposed to being single and filing two separate returns. In almost every case I can think of, it will be more tax if you are married and choose to file separately. There is a reduction in the amount of deductions you can take as a married filing separately and the tax rates are higher than if you’re single.

But starting this next year (2013), we’re going to roll back to some old tax rate tables. There is a new 3.8% surtax coming into play and we’re going to lose some of our deductions.

The current tax rate tables are set up so that you do not pay more in tax if you are married, then if you and your spouse were single. The problem is that the old tax rate tables, the ones we’re about to revert back to, are set up so that married people will pay more. If one spouse makes a lot more then the other, the marriage penalty is not as impactful or might not even exist.

The new 3.8% surtax is effective for every single person who makes over $200,000 and every married filing joint couple who makes over $250,000. So, if you both make $150,000, there is no surtax if you’re single. But combined, you’re at $300,000 and so if you’re married, you will pay the tax.

It’s not only the high income tax earners that are getting hit by this marriage penalty tax. Look for a lot of people suddenly discovering that 2013 is their toughest tax year in a long time.

• How to Get Money For Your Business
• Smart Business, Stupid Business
• Tax Benefits from Your Home

Learn how helpful these Series LLC can be for growing entrepreneurs and real estate investors.

There were a few questions that we weren’t able to cover in the webinar that I want to cover today.

Q: Can foreign investors also own Series LLC?

Yes. You’ll need to have a Social Security Number or ITIN from the IRS. Leave a note here on the blog if you’d like to find out more.

Q: If I already have a Series LLC, can an operating agreement be augmented?

Yes. Generally, you’ll need to amend the Operating Agreement to add in clauses that should have been covered the first time. This is not a do-it-yourself project, though, hire an expert. You can contact us through http://www.LegalShelfCompany.com for more information on how we can help.