An Unexpected Surprise and Potential Capital Gains Tax Nightmare

You might think of bonds as a pretty safe long term investment. If you're not familiar with the different type of bonds out there, you may think of ordinary government saving bonds or Treasury bonds.

I spoke to a gentleman this week who had exchanged a real property for a type of tax free industrial bond several years ago. It was done as a structured sale with a non-profit organization, and the return rate was actually very good and supposed to last for 13 years. He was paying a bit of principle back each year, but most of his income was from the bonds and non-taxable.

Then came the nasty surprise. After only a few years, the bonds were being "called" by the non-profit organization. They had gotten a new bond issue for more than 3% less interest, and it was in the original agreement that they could replace or pay out at a date sooner than the original bond termination date.

Well, now this gentleman was no longer in such a great position. If he sold outright, he would pay 30.5% in taxes. If he allowed his bonds to be replaced, he would lose a good portion of his tax free income, and the new bond issue was backed with "shaky" projects. He could actually lose much more if not all of his substantial investment in the future.

In this case a Private Annuity Trust will suit him well. It will give he and his wife a substantial lifetime income. It will spread out his tax burden over the next approximately 26 years. He will be able to borrow back a portion of his investment through a loan agreement within the trust, and it will remove this property from his estate, so that his heirs will not be faced with a large estate tax burden when he and his wife pass away.

His attorney and CPA were not familiar with the PAT. This situation is all too common, and can place a party in a bad situation if the advisors they count on are not aware of effective capital gains tax saving strategies. In this case, I hope to educate all involved and turn this "unfortunate surprise" into a much more tenable situation for everyone.

Paula Straub
Educate Yourself on Tax Saving Strategies

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New Site for Real Estate Investors

I have just launched a new site for Real Estate Investors wishing to learn about Capital Gains Tax Saving Strategies. It is located at the link below

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You can sign up for a free report and be kept up to date with case studies and current news on how to structure your sales so that you will not owe huge amounts of capital gains tax when your highly appreciated property is sold.

Whether you are new to the Real Estate Investing game, or an old hat- don't lose your hard earned money.

Give me a call if you have any topics you'd like to see me cover or subjects for future articles and posts.

Paula Straub
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Capital Gains Tax Strategies Require Action

I spoke to a couple of people this past week that wish not to pay their capital gains tax, but they don't want to put any effort into the strategy on their end.

For example, a woman in her 70's is selling investment property. It is in escrow. She doesn't want to own another investment property but also doesn't want to consider doing a 1031 TIC exchange, a Private Annuity Trust or a Charitable Remainder Trust. The reason being she's just tired of the whole thing and doesn't want to do anything she hasn't heard of before.

Ok, that's great, but if she'd heard of any of these things and was familiar with them, she probably would already have put one of those strategies in place.

I wish I had a magic pill that would allow you to save all of your capital gains tax without any effort on your part. If your mind is closed to learning new concepts, I guess paying your taxes is the best option for you.

This particular lady will owe 100K if she just sells. She is retired and will never be able to recoup that money during her lifetime.

If this was my mother, I would encourage her to learn all she can about what her options are, and bring me, her tax person, attorney, or any other party she trusts in to help her understand and make her choice.

It really comes down to this. How important is 100K or whatever your amount of tax owed is to your future income stream and legacy.

If you won't miss it, then by all means give it to the IRS. They are happy to take all they can get. Just don't complain later because you didn't make the effort to educate yourself.

Paula Straub
http://www.Paula-Straub-Capital-Gains-Tax-Site.com

ps. Call me for your free consultation and know what your options are. (760)917-0858

Are Private Annuity Trusts Being Challenged by the IRS?

Does the IRS challenge Private Annuity Trusts? Of course they do.

Does that mean you shouldn't have one if it is in your best interest? Of course not.

The key here, like with anything, is to have it set up, funded and administered properly according to IRS tax rules. If it's done right, it won't be challenged.

What are some of the red flags that trigger IRS challenges? Here's a few. These are all things done by parties trying to "bend" the IRS rules to suit their individual or joint purposes.

1. If setting up the trust can be viewed as "Constructive Receipt". This basically means, the trust was thrown together at the last minute for no other purpose than to avoid paying capital gains tax. If done while in escrow, there needs to be evidence of contingencies of sale not yet met when the trust is created.

2. The funds are invested in volatile investments which show losses in annual tax audits. The funds are supposed to be invested in prudent vehicles so that the trust has enough funds to satisfy the payment schedule to the annuitant set up when the trust is established. Advisors and some family member trustees may see this as a place to gamble with the investments- not keeping in mind their fiduciary responsibility to the annuitant.

3. There is evidence that the annuitant is controlling the investments within the trust. The PAT is a non-grantor trust. The annuitant can have no say in how the monies are invested once the trustee is overseeing the funds. This isn't to say that the annuitant can't fire the trustee for mismanaging his funds, but he or she can't be calling up the trustee and telling him/her when to buy or sell assets within the trust.

4. The trust documents were not prepared and filed properly. This can happen when an attorney not familiar with the PAT draws up documents without the proper language, or doesn't follow proper federal filing procedures.

5. The trust's annual tax returns are not filed properly or on time. The trust is now its own entity and must file an annual return.

These are just a few reasons the IRS might challenge a PAT. In most cases, they should be challenged if someone did not do their job properly.

The future annuitant should work with experienced professionals who are fully aware of all aspects of the trust, the tax laws, and the financial and administrative details as well.

There are always a few bad apples that spoil the image of a perfectly good tax strategy and the sooner they are removed from the field the better.

Paula Straub
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Forgiveness of Debt is a Taxable Event- Whether you like it or Not :(

A fact that not many people realize, even tax professionals and attorneys, is that paying off a mortgage at time of sale is a taxable event. The IRS considers it "forgiveness of debt".

Many people think that because they owe 200K on a 500K sale, their gain is only 300K. But, if they bought the home for 100K, their gain is 400K and this is the amount that capital gains tax is due on.

They usually say, "but I don't own the mortgage, the bank does". True, but you have had use of this money and the gain it acquired along the way.

If you have borrowed against the property with a second mortgage, or line of credit, you may have what's called a mortgage over basis problem. This is when you owe more on the home than what you paid for it.

What this means is that a TIC or a PAT might not work for you, as you have too much debt and not enough equity.

This is another reason to carefully plan an exit strategy when investing in real estate.

Paula Straub
askpaula@savegainstax.com

http://www.paula-straub-capital-gains-tax-site.com


p.s. My Qualification Questionnaire is functioning again. I didn't realize it was broken (and no one can seem to figure out how it got that way), but a new version is up and running at http://www.savegainstax.com

FAQ- Can I control investments within a PAT?

The short answer is "no". This PAT is a non-grantor trust. The trustee (who cannot be you or your spouse) is responsible for investing the funds. The responsibility of the trust is to make the agreed upon payments back to you for the entire amount of time it was set up for.

This concept seems scary for some, as they are used to complete control over how their assets are invested. This is understandable, but should become comfortable if the proper steps are taken to protect your investments. You do have some input before the trust is created.

Although some advisors tout volatile investments such as stocks and mutual funds, caution should be taken with this approach. Just as these vehicles offer a large upside, they also have the possibility of major loss. Your trust could run out of funds and be unable to complete the payments due you.

Once you begin receiving payments from the trust they are fixed. The rate used to calculate your payments is the Federal MidTerm Rate. Even if the trust funds make more than this rate of interest, your payments don't vary. The extra money in your trust can continue payments to you if you outlive the IRS guidelines or pass to your heirs.

The PAT is not the place to speculate with volatile investments.

No two situations are identical, so there is no hard and fast rule for a specific investing strategy.

Common sense and a fair degree of conservatism are good ways to approach the trust investment strategy. Ideally, you should be able to sleep well at night knowing the trust will be able to meet the commitments it was designed for.

Paula Straub
Capital Gains Educational Resource
Free Report - 7 Secrets to help you hang onto your Capital Gains

$1 Gain can Trigger 20K+ Tax Bill - Really

Something very similar to the example in this article below by Robert Sommers happened to a woman I talked to last week. She bought her first investment property to fix up and sell at a profit. When she put it up for sale the market softened. She was carrying a $5500./mo loan and could only rent it for $2500./mo. By the time she lowered the price and paid realtor fees and was hit by the 3.3% Franchise tax, she owed over 16K at time of sale. She didn't have the money. I was unable to help. All this could have been avoided had she had the proper education before entering into the transaction.

Get the Capital Gains Tax Resource Now if you are in a situation that could come back to haunt you.

Be sure and read the highlighted parts.





THE TAX PROPHET: Hot Topics: April, 2004
New California Franchise Tax Board (FTB) Withholding Rules
Part 1 of a 2-part series
Introduction

Faced with unprecedented fiscal woes, the State of California is taking strong measures to ensure that those who receive income from property located within the state pay their taxes. California has instituted a wide-ranging withholding regime on income emanating from California sources and paid to non-California residents - regardless of whether the owner is an entity or individual. These new rules ensnare out-of-state landlords and property owners receiving non-residential rents and royalties on the use of their California property, and the compliance burden falls squarely on the backs of property managers.

New rules also apply to the sale of California real estate by resident individuals. A person living in California and owning a vacation or second home, commercial or investment property, should be prepared to pay 3 1/3% of the transaction value as a withholding tax when they close escrow on a sale. It is estimated that as many as 300,000 transactions will be affected by this new law.
Rents Paid to a Non-California Recipient
The New Income Withholding Rules
The California Franchise Tax Board (FTB) now requires that when making payments to non-California resident owners for rents paid in the course of lessee's business on California property, agents must withhold when distributions exceed $1,500 for a calendar year. This new procedure is required when distributions of California source income are made to nonresident beneficiaries. To avoid this rule, the withholding agent must receive authorization for a waiver or a reduced withholding rate from the Franchise Tax Board.

The withholding rate is 7% of gross rent or royalty payments made to California nonresidents. Although withholding agents are not required to notify nonresident payees about the withholding, agents should warn them anyway to avoid anger and surprise when funds are withheld from expected payments.

Types of income subject to withholding include payments of leases, rents and royalties for property (real or personal) located in California, and include not only payments to non-resident individuals, but also to corporations, limited liability companies, and partnerships that do not maintain a permanent location in the State. Withholding is required when all of the following conditions are met:

Payments on rents or leases must be made in the course of the lessee's business; (Tenants of residential property are not required to withhold on payments made to nonresident owners);
The rented or leased property must be located in California; and
The total payments in a calendar year must exceed $1,500.

Remember: Withholding only applies when the rent-payers are renting or leasing property from a non-California owner in the course of their business. Thus, payments by residential tenants are excluded. An agent who manages a purely residential building will have no withholding requirements with respect to rents received from that building, but an agent who manages properties containing one or more non-residential tenants must withhold on rents paid by those tenants. Therefore, the withholding obligation is determined on a building-by-building, unit-by-unit basis.

New Rules Regarding Withholding on Sales of Real Property

Effective January 1, 2003, individual taxpayers, regardless of residence, who sell California real property, including vacation homes (or any residence not considered their principal residence), business and investment real estate, may be subject to withholding. Buyers are now required to withhold 3 1/3% of the total sales price on any purchase of California real property over $100,000, regardless of the amount of actual profit, unless the property is -
A principal residence as defined in the Internal Revenue Code (IRC);
Involved in a tax-free exchange (although cash received in the exchange will be subject to withholding),

Subject to an IRC Section 1033 involuntary conversion, or
Involved in a foreclosure (but not a sale by the debtor in lieu of foreclosure).

To illustrate the reach of these withholding requirements, consider the sale of a vacation or rental property located in California for a total sales price of $650,000. The buyer must withhold $21,645.00 and pay that amount to the FTB immediately - even if the taxable gain is merely $1.00. To actually owe the $21,645.00 in state taxes, the seller would need a $232,742 profit (assuming a 9.3% tax bracket).

This disparity is akin to over-withholding on salary - a person is entitled to claim it as a refund, but they must wait until the following year to file their tax return. Unfortunately, if someone owes child support or taxes to IRS, California or another state, their refund may be used to offset those liabilities and they could receive nothing. Note: Oversized refunds could trigger federal Alternative Minimum Tax because state income and property taxes are not deductible under the AMT.

Because FTB retains the amount withheld until the taxpayer files for a refund in the subsequent year, those selling property at the beginning of the year will lose the time-value of the monies withheld for the entire year. In effect, the taxpayer is forced to make an interest-free loan to FTB for this period.
Also, transactions in which the seller receives little or no proceeds may fall through when the withholding tax is factored into the deal.
Example, assume that a taxpayer sells property for a total sale price of $300,000, with an adjusted basis of $100,000. The taxpayer will have a taxable gain of $200,000 upon sale (assuming no costs of sale). If the debt on the property is $300,000, then the taxpayer will walk away from the deal without payment. Under the new withholding rules, there needs to be an additional $10,000 paid to FTB ($300,000 gross proceeds x 3.33% = $10,000). This is true even if the taxpayer has sufficient losses from other transactions to offset the taxable gain on the transaction.
Note: Taxable gain is measured by the adjusted basis in property, not by the amount of debt owed - thus, sellers may receive no money from a transaction and still owe taxes.
As illustrated above, equity-thin sellers, when they discover that 3 1/3% of the sales price may be withheld, may attempt to back out of sales - possibly triggering lawsuits in the process. Other sellers may manipulate the sales process by re-titling property in the name of a single-member LLC, S Corporation or other entity that would be exempt from withholding.

Caution: Transferring the property to an entity to avoid withholding tax could trigger severe adverse federal and state income taxes, depending on the entity chosen and the property involved. For instance, transferring property to a C corporation could subject the gains to regular federal corporate tax rates, rather than favorable long-term capital gains rates. Also, efforts to deliberately defeat the withholding requirements through a sham transaction could subject the taxpayer to additional penalties, or worse.

All contents copyright © 1995-2004
Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.

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