Please note that the question and answer provided does not take into account all options or circumstances possible.
This week's question is brought to you by Chris Novak, CPA, from our Tax Knowledge Center.
March 6, 2014
Question: Dawn and Dave are married and have owned their principal residence since 1990. They would like a new house, but love the location of their current residence. Instead of selling their house and purchasing a new one, they are considering demolishing their house and rebuilding in the same location. If they go ahead with this and decide to sell the new house a year later, can they exclude the gain on the sale?
Answer: In general, they cannot exclude the gain on sale, unless they qualify for a reduced exclusion. To exclude the gain on the sale under §121, Dawn and Dave must have owned and used the residence as their principal residence for at least two of the five years immediately preceding the date of sale. The couple won't meet the ownership and use tests for the new house they built if they sell it one year later. It does not matter that they would have qualified for the §121 exclusion had they sold the original house instead of tearing it down [David A. Gates, et ux. v. Commissioner, 135 TC 1].
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February 27, 2014
Question: Your client engaged in a qualified §1031 exchange. He was told that to defer the entire gain, all he needed to do was reinvest the realized gain into the replacement property. Is this correct?
Answer: Unfortunately, the client was told incorrectly. A quick, accurate explanation would be that in order to potentially have a complete deferral of the gain, the taxpayer needs to buy replacement property equal to the sales price of the relinquished property minus any exchange expenses. The taxpayer is taxed on the lesser of gain realized or boot received.
Often people are unclear as to what boot received means so this might be why there is confusion. Often people are incorrectly told that all they have to do is reinvest the realized gain and they will be able to completely defer the gain. Boot can come in the form of cash received, reduced liabilities, non-exchange expenses paid out of escrow and the receipt of non-like-kind property. By purchasing replacement property at least equal to the selling price minus exchange expenses, you will eliminate taxable boot unless the taxpayer takes out more debt than is needed for the exchange and has cash distributed to him or her, pays non-exchange expenses out of the proceeds or something similar, which will be treated as boot received.
February 20, 2014
Question: Allegra opened her first and only Roth IRA in 2012 with a contribution of $5,000, but died in 2014 before the five-year period required for qualified distributions. Allegra’s cousin Flanders was the named beneficiary of the Roth IRA. When will distributions from the Roth IRA be qualified distributions not subject to income tax?
Answer: January 1, 2017. Qualified distributions from Roth IRAs are not taxable. A qualified distribution includes one that is received after the five-year period beginning with the first day of the first tax year for which a contribution is made to a Roth IRA and is made to the account owner's beneficiary (or estate) due to his or her death [IRC Sec. 408A(d)(2)].
For purposes of determining whether distributions received by a nonspouse beneficiary from an inherited Roth IRA meet the required five-year period for qualifying distributions, the five-year period is not redetermined following the owner's death. As a result, the period the Roth IRA is held in Flanders' name includes the period it was held by Allegra [Reg. 1.408A-6, Q&A-7]. The five-year period for the Roth IRA inherited by Flanders is determined independently of the five-year period for his own Roth IRAs [Reg. 1.408A-6, Q&A-7].
Because Allegra died before the required five-year period for qualified distributions elapsed and Flanders must begin taking minimum required distributions soon after her death, it is possible that Flanders will receive nonqualified distributions up until the five-year period ends. However, Allegra’s original contributions are deemed distributed first, and earnings are not deemed distributed until the distributions exceed Allegra’s contribution. Until then, the distributions will be nontaxable. So if Flanders does not withdraw more than $5,000 before January 1, 2017, none of the distributions will be taxable. Also, the 10% penalty normally imposed on nonqualified distributions does not apply since the distributions are made after the account owner's death [IRC Sec. 72(t)(2)(A)(ii)].
February 13, 2014
Question: In 2012, Paul and Joan earned $350,000 from their respective jobs. They incurred a total of $47,000 in itemized deductions including $25,000 in qualified mortgage interest, $10,000 state income tax, $7,000 real estate tax and $5,000 charitable contributions. Their taxable income was $295,400 and their income tax was $74,389.
In 2013, Paul and Joan earned the same $350,000 from their jobs. Their itemized deductions increased to $50,000 and included $24,000 in qualified mortgage interest, $11,000 state income tax, $7,500 real estate tax and $7,500 charitable contributions. Their taxable income was $296,820 and their tax was $74,264.
Paul and Joan are very upset with you. They had the exact same income as last year, increased itemized deductions and yet their tax only went down by $125. Paul thinks they should have gotten at least a $999 break on the tax ($3,000 x 33% tax rate). Why is there such a small difference?
Answer: For tax years 2010 – 2012, taxpayers were not limited by the phase-out for personal exemptions (PEP) nor limited as to their itemized deductions (Pease limitation). However in 2013, both of these limitations have returned.
Both limitations are based on adjusted gross income. For a married couple, both limitations kick in at an AGI of $300,000. Exemptions are phased out at 2% for every $2,500 the AGI exceeds the $300,000 threshold amount. Itemized deductions are reduced by the lesser of 3% of AGI in excess of $300,000 or 80% of the otherwise allowable itemized deductions (this does not affect medical, investment interest, casualty losses or gambling losses).
In Paul and Joan’s case, their exemption amount is limited to $4,680 instead of $7,800 as a result of the phase out. Their itemized deductions are reduced by $1,500 as a result of the “Pease limitation”. So, despite having an increase in their itemized deductions, their overall taxable income has increased. The tax brackets were adjusted for the year and thus their income tax is still lower, but not by much.
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