Essential Points of the Principal Residence Exclusion

Real Estate Property Capital Gains Exclusion Residence
Excluded Capital Gains

In our first essay on section 1031 we promised to explore other sections of the tax code – namely, 1033 and 121 – which may be of interest to our readers. As always with HTC, we are true to our word. In this essay we will discuss some of the basic facts of section 121.

Section 121 is referred to as the “principal residence exclusion” because it allows gains derived from the sale of one’s primary residence to be excluded from taxable income (up to certain limits). Under 121, real property owners are permitted to exclude up to $250,000 in capital gains from the sale of their principal residence; married couples intending to file jointly may exclude up to $500,000.

In order to qualify for section 121 treatment, property owners must prove that they have owned and lived in the property for at least 24 months during the last 60 month period. It is not necessary that these 24 months be consecutive. Hence, under current law, it is theoretically possible to utilize section 121 once every 2 years.

Real property owners who wish to take advantage of section 121 have to keep a close eye on the market trends which affect the value of their property. As we know, property values tend to fluctuate throughout the course of ownership, and if the value rises too high then the property owner may end up having a significant tax liability even after section 121 is invoked. If a property’s value rises too high, converting the residence into a rental property and then utilizing section 1031 after a certain period of time has passed may be an optimal strategy.

In later installments we will cover section 121 in greater detail by examining legal cases and viewing examples of how section 121 has been utilized in real-world scenarios.

*It is worth mentioning that section 121 is the successor to section 1034. Section 1034 allowed taxpayers to defer 100 percent of the capital gain derived from the sale of their primary residence provided that they subsequently acquired another residence of equal or greater value. This section was replaced with the provisions of section 121 in 1997.

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Tracing the Bounds of Section 1031 through Alderson v. Commissioner

Real Estate Property Exchange 1031 Tax
Real Estate

In our previous installment, we learned that whether a transaction falls under section 1031 of the Internal Revenue Code is an extremely important determination. Section 1031 enables taxpayers to receive non-recognition of capital gains when they exchange their real property for another property of like-kind. Real estate transactions can often result in gains of many thousands – and even millions – of dollars, and so receiving non-recognition of this sort under section 1031 can potentially remove very large tax liabilities. For this reason, the qualifications of section 1031 are narrowly construed by courts and so real property owners must carefully observe these qualifications to receive non-recognition treatment.

As with other areas of law, tax law is shaped by judicial opinions. Though the provisions of section 1031 originally emanate from the language of the tax code, the precise contours of these provisions are nonetheless informed and guided by the opinions issued in cases. This is the main reason Huddleston Tax Weekly has focused so heavily on highlighting tax, contract and property cases: it is important that our readers be aware not only of the various laws which may affect them, but also of how these laws apply in real-world scenarios.

The case of Alderson v. Commissioner (1963) gives us a sense of the level of conscientiousness required from the parties of a real estate exchange. As we will explore in detail below, Alderson shows that whether a cash payment is included as a contingency within an agreement is immaterial; the critical factor in determining 1031 treatment is whether an exchange of property of like-kind actually occurred. Alderson also demonstrates that property may be acquired specifically for the purpose of exchanging it as part of a 1031 transaction.

Facts

Alderson (the appellant) agreed to sell his property – referred to as Buena Park in the opinion – to a company known as Alloy Die Casting Company. Before the sale was concluded, Alderson decided he would prefer to exchange his property for another property which he discovered after the original agreement was made. This newly discovered property – Salinas – was then acquired by Alloy and transferred to Alderson in exchange for Buena Park.

The amended agreement between Alderson and Alloy included a contingency clause which stated that Alloy would pay cash for the Buena Park property in event that it could not furnish the Salinas property by a specific date.

Law

To receive section 1031 treatment, a transaction must involve the exchange of properties which are of like-kind. The transaction must also be reciprocal and involve a present transfer of ownership, the transfer cannot occur gradually or incrementally over a period of time.

Ruling

The court (U.S. Court of Appeals for the Ninth Circuit) overturned the opinion of the Tax Court and ruled in favor of Alderson. As noted above, the transaction between Alderson and Alloy was a bit convoluted and involved a formal amendment to the original agreement; two escrow accounts were created as a consequence of the decision made by Alderson to acquire the Salinas property. The Commissioner of Internal Revenue (the respondent) argued that the contingency clause provided evidence for the classification of the transaction as a sale rather than an exchange; the Commissioner also felt that the separate accounts provided evidence for this same conclusion. These arguments ultimately failed to persuade the court.

When determining whether a given transaction falls within the 1031 statute, the court considers the transaction as a whole and bases its decision on the true “substance” of the transaction. Though Alderson did initially agree to a cash sale, and the exchange was complicated by the opening of separate accounts, the substance of the transaction clearly reveals an intention to make an exchange of properties of like-kind. The court does not opine on hypothetical scenarios; the critical fact of Alderson was that the deeds for Buena Park and Salinas were exchanged, not that such an exchange may not have occurred if Salinas were not acquired.

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Property owners should view this video by Jessica Chisholm to learn more about the tax perks of homeownership

How Trump’s Tax Plan Will Affect Individuals

Trump Tax Plan Bracket System
Trump Tax Plan

The election of Donald Trump to our nation’s highest political office is undoubtedly one of the most surprising developments in U.S. history. This is a purely factual observation, completely removed from any sort of partisan bias. Many reliable polls taken just prior to the election showed Clinton with a firm advantage. And the fact that Mr. Trump is essentially a political outsider, having no prior political offices on his resume, seemed to cast serious doubt on the viability of his candidacy. Trump’s success has triggered a mass of heated reaction, both of a supportive and antagonistic nature. No matter how much the perception of his electoral success varies at the individual level, however, what is certain is that his victory will be regarded as one of the most unlikely in our nation’s history.

Trump’s staunchly pro-American standpoint captivated his followers and played a large role in building his base of voters. He repeatedly claimed that he would utilize the powers of the presidency to protect the American people – especially working and middle-class people – from internationalist economic policies and improve the American standard of living.

But how will these things be achieved? Trump has devised a tax plan which forms one part of his overall agenda for substantive change. But will his plan actually benefit the majority of American taxpayers? Let’s take a closer look at how the Trump tax plan will affect individual taxpayers.

New Tax Bracket System

Trump intends to reduce the total number of tax brackets from the current number of seven down to three. The three (ordinary) rates would be: twelve percent for individuals earning $37,500 or less; twenty-five percent for those earning between $37,500 and $112,500; and thirty-three percent for individuals earning above $112,500. Again, these thresholds apply to single filers, the income thresholds are doubled for married couples filing jointly.

This new bracket system may result in either a tax cut or a tax increase for middle income earners depending on which bracket they fell into the preceding year.

This system would give a substantial tax cut for high income earners as it would reduce the top rate of 39.6 percent down to thirty-three percent.

The full impact of the Trump tax bracket system is still impossible to determine because we currently are unaware of what sort of credits, limitations and qualifications the system will be coupled with. But at this point it appears that the new system will provide mixed results for middle income earners and generally positive results for very high income earners.

Increased Federal Deficit

Though Trump’s new tax bracket system may benefit quite a number of individual taxpayers, when combined with his corporate tax cuts this new system will add to the national deficit. If these cuts remain in place for the next ten years, projections show that federal revenue will decrease between $4.4 trillion and $5.9 trillion. Trump has stated that he plans to cut spending by approximately $1.2 trillion over the next decade; if these figures remain the same, they would result in an increase to the national deficit of around $5.3 trillion.

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Bailey v. Drexel Furniture Co. & the Child Labor Tax Law of 1919

Drexel Child Labor Tax Law Constitutional Penalty
Supreme Court

To most contemporary Americans, exploitative child labor practices seem like an ancient, prehistoric phenomenon far removed from the context of advanced civilization. But, crazy though it sounds to modern ears, such practices sadly occurred on a fairly regular basis in the not too distant past of our society. In fact, our society was grappling for ways to combat this problem less than 100 years ago. In 1919, Congress addressed this issue through its Child Labor Tax Law. The law imposed a tax of 10 percent on the net profits of companies which employed children (as defined by the age limits of the law).

With the Child Labor Tax Law, the Congress was attempting to curtail child labor by regulating business through its taxing power. In effect, Congress was “punishing” businesses for exploiting the labor of children through the tax.

One curious result of constitutional restrictions on government power is that occasionally good laws are thrown out. Obviously, no one in 1919 disputed the desirability of a law which aimed to prevent abusive child labor practices; the issue which arose in Bailey v. Drexel Furniture Co. (1922) was whether the Congress went beyond the bounds of its constitutionally delineated authority by using a “tax” to stop unethical behavior. As we will see, the Bailey case illustrates the difficulty involved with maintaining restrictions on government power even when such power is being tailored for good ends.

Facts

Drexel (plaintiff in original suit and respondent in appellate case) was a furniture manufacturing company which employed a child under the age of 14 during the 1919 tax year. In agreement with the Tax Law, Bailey (the tax collector for the government) assessed a tax of $6,312.79 for such behavior. Drexel paid the full amount and then sued for recovery.

Drexel argued that the tax was a covert “penalty” designed to punish undesirable behavior and that the law was therefore an unconstitutional attempt to regulate business. The government argued that the levying of the tax was fully consistent with its broad taxing powers as prescribed by Article One of the Constitution.

Law

The Congress has the power to lay and collect taxes as outlined by the Constitution. However, this power is not unlimited and when the Congress attempts to step beyond its bounds such attempts must be struck down.

Ruling

The Supreme Court ruled in favor of Drexel (as did the lower court). Although no issue was raised as to the desirability of the Tax Law, the court reasoned that the tax created by the law was in fact a disguised penalty and it was therefore impermissible. The court defined a “tax” as a source of revenue for the government, while a penalty is a punishment intended to deter certain behavior. Penalizing unethical behavior is not a function of the taxing power of the Congress but should be addressed through the criminal law of individual states.

The decision in Bailey was controversial in part because other taxes aimed at curtailing (or in some sense penalizing) certain behavior had been upheld. For instance, excise taxes on drugs and firearms have not been regarded as improper attempts by the Congress to regulate business. But the court in Bailey recognized that an overly broad reading of Congress’ taxing power could result in the obfuscation of its proper function and unfairly reduce the power of the states.

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Brushaber v. Union Pacific Railroad Co. & the Rise of the Federal Income Tax

Congress Tax Power Constitution Law
U.S. Congress

As we have learned in previous installments, for most of its history, the United States has recognized a distinction between direct taxes and indirect taxes, and this distinction informed our law prior to the adoption of the sixteenth amendment. After the sixteenth amendment, the Congress was no longer bound to ensure that direct taxes follow the rule of apportionment outlined by Article 1, Section 9, Clause 4 of the U.S. Constitution. And given that this rule of apportionment was the main reason behind the distinction between direct and indirect taxes, it follows that subsequent to the sixteenth amendment such a distinction was essentially meaningless.

Immediately after the rule of apportionment had been lifted, the Congress passed the Revenue Act of 1913 (also referred to as the Underwood-Simmons Act). In addition to lowering tariff rates, this act implemented a progressive federal income tax system. This income tax was originally intended to compensate for the deficit created by the reduced tariff rates, but soon after its implementation it became the chief source of revenue for the U.S. government. Consistent with the language of the sixteenth amendment, the tax on income could be derived from any source (wages, dividends, interest, rents, etc.). Amazingly, in its first several years of application, the federal income tax only applied to roughly 1 percent of the population as the other 99 percent did not meet the income threshold to qualify.

Even though the language contained in the sixteenth amendment was quite clear, not much time passed before the validity of the Revenue Act of 1913 was challenged. As we will see, the case of Brushaber v. Union Pacific Railroad Co. (1916) upheld the ability of the Congress to tax income (whether direct or indirect) without the traditional constraint of apportionment.

Facts

Mr. Frank Brushaber (plaintiff) owned stock in Union Pacific Railroad Company (defendant). The railroad attempted to pay a tax on Brushaber’s income and Brushaber brought a suit to prevent the railroad from doing so. Brushaber based his suit on several grounds: he argued that (1) the Revenue Act of 1913 violated the due process clause of the Constitution, (2) that the act was unconstitutional because it exempted specific types of income, and (3) that the act was unconstitutional because it failed to follow the rule of apportionment put forth by Article 1, Section 9, Clause 4.

Law

The Congress has always had the power to tax income. This power is derived from the Constitution and consequently there cannot be any conflict between this constitutionally conferred power and the due process clause.

The sixteenth amendment removes the requirement that direct taxes must be properly apportioned among the states according to population. Hence, the Congress is able to lay and collect taxes, both direct and indirect, without regard to the apportionment rule laid out by Article 1, Section 9, Clause 4.

Ruling

The Supreme Court threw out all three arguments made by Brushaber and ruled that the federal income tax created by the Revenue Act of 1913 was fully valid and did not violate the Constitution. In essence, the court in Brushaber simply reaffirmed the clear language of the sixteenth amendment. Following Brushaber, challenging the validity of the Revenue Act would have been a pointless endeavor.

The early twentieth century saw two extremely important developments in U.S. taxation: the consolidation of the taxing power of the Congress by way of the sixteenth amendment and the creation of the federal progressive income tax system. In our next installment, we will look more closely at the provisions of the Revenue Act of 1913 and discuss how the federal income tax system evolved up to its present form.

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A Note on Direct & Indirect Taxes

Money Tax System Direct Indirect
Direct & Indirect Taxes

In recent installments, we have discussed some of the legal and political issues surrounding the income tax. Upon reviewing these installments, there can be little doubt that the history of taxation in these United States is quite complex. Though the Congress has always had a power to tax, the precise scope of its taxing power has evolved in tandem with various social, economic and military events. The taxing power of the Congress was clarified a great deal by the sixteenth amendment – by way of this amendment, the Congress gained the power to tax income “from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

Before the sixteenth amendment, the Congress was limited in its ability to lay and collect “direct” taxes. Article 1, Section 2, Clause 3 of the U.S. Constitution states that direct taxes must be apportioned among the states according to their respective numbers; the rationale of this provision was to ensure that no state was disproportionately – and therefore unfairly – burdened by an oppressive tax system.

Every type of tax can be classified as being either a direct or indirect tax. Broadly speaking, a direct tax is one paid by the individual (or business entity) to the government; it is aimed specifically at the person who is paying the tax. By contrast, an indirect tax is one levied upon a transaction, it is not targeted to a specific individual. Sales tax, use tax and value added tax are all examples of indirect taxes. Historically, U.S. tax law regarded tax on labor (or wages) as an indirect tax.

Prior to the opinion made in Pollock v. Farmers’ Loan & Trust Co. (1895), tax on income derived from property (i.e. from real estate, stocks, bonds, etc.) was not considered a direct tax. The Pollock case overturned this consideration and ruled that such a tax was a type of direct tax and that therefore the income tax provision of the Wilson-Gorman act was unconstitutional. In effect, the Pollock decision made it essentially impossible for the government to impose a federal income tax without a constitutional amendment. The sixteenth amendment, which was ratified in 1913, was a direct response to the Pollock ruling: the politicians in the Congress came to understand the full implications of Pollock and so the sixteenth amendment simply did away with the longstanding requirements concerning direct taxes.

When viewed in proper historical context, the sixteenth amendment was a political act of truly monumental significance. Through this act, the dichotomy of direct and indirect taxes – a dichotomy which had shaped our system of taxation throughout our nation’s entire history – was suddenly made to have no meaning at all. Immediately subsequent to this act, the Revenue Act of 1913 was passed, and the progressive income tax system which we have come to know so well was implemented.

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Gruen v. Gruen: A Lesson on Gift Delivery

Painting Gift Tax Expensive
Expensive Gift

When we think of gift giving we tend to conjure a predictable set of ideas and images: we think of Christmas, birthdays, graduation ceremonies and other occasions in which gifts are exchanged. Seldom do we think of legal ramifications which may be triggered by the delivery of a gift. But when a gift is of exceptionally high monetary value, the act of gift giving can sometimes become a bit more complicated than normal. Gruen v. Gruen (1986) is an interesting case which involved the transfer of an extremely valuable piece of art from a father to his son; the ruling of the case clarified some of the uncertainty on the question of what constitutes proper or “valid” delivery of a gift. If you or someone you know is thinking about giving a gift of similar value, Gruen v. Gruen may be essential reading!

Facts

The father, Victor Gruen, attempted to make a gift of an oil painting by Gustav Klimt to his son, Michael Gruen, in 1963. The father wrote his son a letter in which he explained that, although he wished to transfer title of the gift, he wanted to retain physical possession of the painting for the duration of his life (in other words, retain a life estate in the painting). After being advised against this by his lawyer and accountant, the father wrote another letter to his son regarding the gift and omitted reference to his continued physical possession of the painting. The issue of the case is whether a valid transfer of title of the painting occurred given the fact that the son never took physical possession of the painting while his father was alive.

Ruling

The court (the Supreme Court of New York, upholding the decision of the appellate court) ruled in favor of the son. The son was attempting to establish ownership of the painting against another relative (Michael Gruen’s stepmother). The court found that the father had made a valid transfer of ownership despite the fact that he retained a lifetime interest in the painting. If someone wishes to transfer ownership of property specifically after their death, a will is required; the court reasoned that in this case present transfer of ownership occurred because there was a clear donative intent to bestow ownership upon the son.

Lessons

At the time the case was being tried, the painting by Klimt was worth approximately 2.5 million dollars – quite a birthday gift! The father was afraid that his son would have had to pay inheritance taxes on the gift if he (the father) continued to hold possession of it for the remainder of his life. As it turns out, his fear was without basis: Gruen v. Gruen shows that it is possible to make an inter vivos gift even without physical delivery of the property. As long as there is donative intent, physical or constructive delivery, and acceptance by the receiving party, a valid gift has been made.

Image credit: Bill Damon

The next time you plan to make a gift of an expensive item, don’t be worried about gift tax laws and instead be thankful your situation isn’t nearly as tricky as the one faced by the Gruen family!

Understanding Cost Basis

Money Cost Basis
Cost Basis

Cost basis is a tax concept which is used for determining the true amount which has either been gained or lost from the sale of a given commodity. When you sell property, basis is used to compute the correct amount of tax which is owed from the sale. Though cost basis is a relatively simple concept, it can be a bit difficult to apply in some situations. In this essay we will discuss the fundaments of the concept and explain why it can be a bit trickier than it may seem upon first glance.

Simple Definition

The IRS provides a simple definition of cost basis on its 551 publication: “Basis is the amount of your investment in property for tax purposes. Use the basis of property to figure depreciation, amortization, depletion and casualty losses. Also use it to figure gain or loss on the sale or other disposition of property. … The basis of property you buy is usually its cost.”

Thus, in its simplest form, cost basis is the purchase price of your property. In the real world, however, cost basis is more subtle as the value of property tends to change over time; also, not all property is acquired through sale, and in cases where it is not acquired through sale computing cost basis is less straightforward.

Practical Definition

If a person buys an item — say a piece of furniture, such as a sofa — for $100, then $100 is the cost basis of the item (the sofa) at the outset. If the person decides to sell the sofa at a later date for $100, and the sofa has retained its original value of $100, then no tax is owed because no profit was realized. However, if the person managed to sell the sofa for $150, then a capital gain has been realized and therefore a tax is due (on the $50 of profit).

In other words, cost basis is a mechanism which is intended to offset one’s investment in property so that an individual is not unfairly taxed. If an individual were taxed for a sale even when no profit was realized, the commercial world would literally be turned topsy-turvy.

However, as mentioned previously, the computation of cost basis is not always straightforward. Seldom does the value of property remain fixed; in many cases the value fluctuates over time as the market goes up and down. An asset’s basis can decrease or increase depending on the way its value fluctuates over the course of its life. If an asset either improves or declines in value it acquires an adjusted basis which is then used to compute the correct amount realized from its sale.

Manner of Acquisition

When property is not acquired through a traditional sale the determination of its cost basis is more involved. For instance, when property is acquired through inheritance, the cost basis of the property is its fair market value at the time of the decedent’s death. And when property is transferred by gift or trust, the cost basis can either be directly carried over from the donor (i.e. transferred basis or carryover basis) or it can be the fair market value of the property. Hence, these other means of acquiring assets add complexity to the determination of cost basis.

Final Thoughts

Basis is a foundational concept in U.S. tax law as it is used constantly to determine the true amount owed from sales. Although it is simple to understand in its most basic applications, it can be a bit subtle depending on the particular circumstances. We will explore this interesting concept in greater depth in a later post.

Cost basis is particularly relevant for owners of real estate. Readers who own real estate should consider viewing the following presentation on the tax issues of real estate ownership

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Washington State Plays Leading Role in the Recruitment of EB-5 Investors

EB-5 Investors

EB-5 Investors Washington
EB-5 Investors

EB-5 investors are foreign investors who have chosen to take part in the EB-5 visa program. The EB-5 visa was initially created as part of the Immigration Act of 1990. The EB-5 visa program created an incentive for foreign nationals to invest money in the United States: after investing a significant quantity of money (minimum of $500,000), the foreign investor would receive conditional permanent residency status. The goals of the EB-5 program were to stimulate economic development and promote domestic job creation.

Since 1990 there have been numerous changes to the program. These changes were made so as to encourage more EB-5 applicants and promote more investment in the U.S. economy.

Washington State and EB-5 Investment

Since its inception, a number of areas within the U.S. have benefitted disproportionately from the EB-5 visa program. The state of Washington plays a major role in attracting EB-5 investors. In point of fact, Seattle-based firms have recruited more than 10% of the total number of EB-5 investors who have been approved for green cards. When put in perspective, this figure is truly spectacular.

Foreign investors have funded many significant projects in the Seattle area and have played a major role in promoting the general health of the Seattle economy.

Tax Implications

Because of their unique situation, EB-5 investors have a particular set of tax issues which they need to address. Once they obtain conditional permanent residency, EB-5 investors are subject to federal income tax on their worldwide income; they are liable for other types of taxes as well, such as estate, gift and capital gains taxes. Given their relatively complicated tax situation, it is always important for EB-5 investors to seek out a qualified tax professional so that they can develop an optimal tax strategy.

Huddleston Tax CPAs has a history of assisting EB-5 investors and is conversant with their particular concerns and needs.

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Check out this video to learn more