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TOP TAX QUESTIONS OF THE MONTH

This is a monthly reference source. By providing these samples of questions and answers, we hope to help you understand that we provide a superior service in our ability to get answers to your questions. There are some general caveats that go along with this presentation. Understand that tax law is fluid and always changing; the answer that is correct today may be incorrect tomorrow. Also be aware that changing one small fact may change the entire answer. We are not trying to give a complete outline of any particular subject. We are attempting to give a general direction that can be taken to resolve a problem or obtain an answer. We can call and talk over your particular situation with the Research Department before we try to answer the specific problem YOU may have. You may not rely on any answer given to avoid a penalty assessed by IRS.

1. I lent my son and his wife $30,000 to start a business late last year. I have a note signed by the kids that calls for the payment of principal and interest, but payments have not started yet. My wife and I decided that we want to cancel the note. Is the cancellation of the note debt relief income to the kids?
   
   You may cancel the note to the children as a gift without causing the children to recognize debt relief income by you and your wife agreeing to join in a gift to the children and their wives. An individual may give up to $12,000 per donee, per year. The combination of gifts by you and your wife to your son and his spouse will more than “cover” the amount of the gift through the cancellation of the note. Remember, though, that the annual exclusion applies to all gifts given during the year including birthday and holiday gifts.
   
2. Over the last eight years I have lent $70,000 to my S corporation. There was a note, but interest has not been paid. I have not collected a salary over the same time due to cash flow problems. I was making a substantial amount of money from investments at the same time, so my personal cash flow was fine. The corporation went under early this year and after paying creditors other than me, there was nothing left. Can I write off the $70,000?
   
   You may treat the lost $70,000 as a non-business bad debt, which is treated as a capital loss to the extent you have any remaining basis in it. You must reduce basis in the loan if loan basis was used to pass through S corporation losses. To the extent of remaining basis, the loss may offset capital gain, with any excess loss applied against up to $3,000 of ordinary income per year. To receive business bad debt treatment (and ordinary loss treatment), you would have to be able to show the corporation was your primary means of support at the time the loans were made, and the documented loan, evidenced in the corporate minutes (and subject to interest at least equal to the applicable federal rate) was made to allow your status as an employee to continue. As you had other means of support and took no salary, the business bad-debt argument cannot be sustained. The capital loss may, however, offset capital gain from your successful investments.
   
3. I have a rental property that has a mortgage. I want to refinance the property and get cash back. Most of the cash will be used to improve the property, but some will pay some personal bills. Can I continue to write off 100% of the mortgage against the income from the rental property?
   
   You may take the expense associated with the new mortgage on Schedule E only to the extent the mortgage refinanced the old mortgage on the property or paid for improvements. In other words, the pro-rata portion of the mortgage interest attributable to the personal use of the mortgage is not deductible on Schedule E and may not offset the income from the rental property. As a sidelight, if you are amortizing points on the former mortgage, any remaining points attributable to that mortgage may be written off now. The pro-rata portion of the points attributable to the refinanced mortgage used for the rental property may be amortized over the life of the new loan.
   
4. I was married near the end of last year to a nonresident alien. She did not make any US income for the entire year. Can we file a joint return for 2007?
   
   You and your spouse may file a joint return for 2007. She would have to agree to elect to be taxed as a US resident for the entire year, which means she would have to declare her worldwide income for the entire year, if any, on the Form 1040.
   
5. I have a qualified retirement plan that I have been funding for years, and the account balance is now over $100,000. I believe that I must now file the Form 5500EZ. Is there a penalty if I do not file it?
   
   You must file Form 5500-EZ. The penalty for failing to file the Form 5500 or Form 5500EZ is $25 per day up to a maximum of $15,000 for each plan year. The penalty may be abated due to reasonable cause.
   
6. I was approached by a person who is trying to convince me I can avoid income tax on my wages and get deductions for the upkeep of my house by putting all of my assets in a special trust. Is this true?
   
   No. IRS has pledged in several releases that it will target abusive trusts for prosecution. The penalties cited in the release include potential prison time. One of the factors cited in the release as an indicator of an abusive trust is the (false) promise that otherwise nondeductible personal expenses will be “transformed” into deductible expenses. The promise of sheltering wages also indicates an abusive trust. You would have to get me more details regarding the proposal to be sure because there are legitimate business trusts- however given the details you have supplied extreme caution is in order.
   
7. I started leasing my former residence in the mid-1990s at arms length to an unrelated party. I prepared my own returns and neglected to claim any depreciation on the house. I am still renting it. Is there anything we can do now to correct my oversight?
   
   A Form 3115 may be filed with IRS to catch up on the foregone depreciation. The additional depreciation may be claimed on the current year return, as long as a Form 3115 is filed with the IRS national office before filing a copy with the timely filed return. Fiducial can prepare your current year return along with the preparation of the Form 3115.