Have You Jeopardized Your Self Directed IRA?

Self directed IRAs have gained in popularity in the past five years as individuals sought to take control over their investments.  For those of you unfamiliar with this term, a self directed IRA is an IRA (ROTH or Traditional) that allows the IRA owner to direct his investments.  In a non self directed IRA, the type offered by most institutions, the IRA owner’s investment choices are often limited to specific investment choices offered by the select institution.  The attraction of being able to invest an IRA in real estate, tax liens, closely held business interests, private placements, or just about anything that catches the IRA owner’s fancy has catapulted the self directed IRA to revered status.

The flexibility offered by the self directed IRA is indeed attractive if utilized properly.  It is vitally important for every investor to know the limitations of his IRA, which unfortunately requires your becoming partially if not fully versed in the IRA, prohibited transaction rules.  A violation of any of these rules can result in a loss of your IRA’s tax deferred status.  Ernest Willis unfortunately found this out the hard way when he decided to take control over his IRA investments and did not receive adequate counsel on prohibited transactions. 

Ernest Willis filed for relief under Chapter 7 of the Bankruptcy Code on Feb. 16, 2007. He claimed exemptions under Bankruptcy Code for the full value of his three self directed IRAs: 1) a Merrill Lynch IRA valued at $1,247,000, 2) an AmTrust Bank IRA valued at $109,000, and 3) a Fidelity Federal IRA valued at $143,000.  Initially, it appeared Mr. Willis would be able to retain his sizeable IRAs but a creditor objected and successfully argued that Mr. Willis improperly directed the investments of his IRA, thereby disqualifying the IRA funds from exempt status.

The rule all self directed IRA owners must be wary of is Code Sec. 4975.  Under this section, if an IRA owner, a disqualified person with respect to his IRA, engages in a prohibited transaction during a tax year, the IRA is disqualified as of the first day of that tax year, and the IRA owner is treated is having received a taxable distribution equal to the fair market value of all of the assets in the account as of the first day of the tax year. A prohibited transaction includes the lending of money or other extension of credit between a plan and a disqualified person, and any transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan.

The Court found that Mr. Willis undertook various actions in his IRA and these constituted prohibited transactions under Code Sec. 4975. Mr. Willis’ actions included borrowing from his IRA and using its assets to pay off a mortgage on real estate in order to acquire the real estate and later sell it. As a result, the IRA lost its exempt status as of Jan. 1, ‘93.  To further Mr. Willis’ distress, the court also found that even though the transaction took place in the Merrill Lynch IRA the other two IRA’s were not exempt because these IRA’s were funded with rollover assets from the Merrill Lynch IRA after its lost its exempt status.

When investing with your IRA remember your ABC’s, “Always Be Careful” because you risk jeopardizing your IRA’s exempt status if the transaction is considered to be a prohibited under Code Sec. 4975.  Sound asset protection savvy dictates dividing your IRA into different accounts to reduce your risk should one account be disqualified. 

For additional information on sound IRA investing contact Clint Coons at 800.706.4741.

Posted by Clint Coons, asset protection attorney, Seattle, WA

Cash For Clunkers “GM Welfare” Might Get an Increase

In a surprise move, the House of Representatives voted to provide an additional $2 billion for the “cash for clunkers” program – otherwise known as General Motors welfare program.  It is unclear if the Senate will be so generous and take up the measure. 

The “cash for clunkers” provision gives a cash incentive for individuals and businesses to trade in older gas-hogging vehicles for new, more fuel-efficient ones. The incentive comes in the form of a voucher of $3,500 or $4,500 depending on the type of vehicle traded in and the fuel efficiency of the vehicle purchased. Different rules apply to passenger cars, and various categories of trucks. The new vehicle must be purchased between July 1 and November 1 of 2009. The $3,500 or $4,500 voucher is not treated as gross income for purposes of the Code, or for federal or state assistance programs.

A total of $1 billion was allocated to the trade-in initiative by P.L. 111-32, but the interest in the initiative was so strong that the money was used up almost immediately.

Eligible trade-in vehicles are those that at trade-in time: are in drivable condition; have been continuously insured and registered to the same owner for at least one year; were manufactured less than 25 years before the trade-in date; and in the case of an auto, achieve a combined fuel economy of 18 mpg or less. A single person may get only one trade-in voucher and only one voucher is available for joint registered owners of a single eligible trade-in vehicle.

Sale of Lots Does not Result in Ordinary Income

Generally, when a person sells lots (vacant tracts of land) the gain from their sale is taxed as ordinary income despite the taxpayer’s holding period. The standard presumption is the property was held for sale to customers in the taxpayer’s ordinary course of business. In making this determination several factors are considered including:

(1) the taxpayer’s purpose in acquiring the property;
(2) the purpose for which the property was later held;
(3) the taxpayer’s everyday business and the relationship of the income from the property to his total income;
(4) the frequency, continuity, and substantiality of property sales;
(5) the extent of developing and improving the property to increase the sales;
(6) the extent to which the taxpayer used advertising, promotion, or other activities to increase sales;
(7) the use of a business office for the sale of property;
(8) the character and degree of supervision or control the taxpayer exercised over any representative selling the property; and
(9) the time and effort the taxpayer habitually devoted to the sales. (David Taylor Enters., Inc. TC Memo 2005-127).

In a recent case the Tax Court has held that where a husband and wife purchased a parcel of property containing a number of lots to build a home and then sold the property they didn’t need, those excess lots were held for investment purposes and the proceeds of their sale resulted in capital gains and losses. The excess lots weren’t held primarily for sale to customers in the ordinary course of business and their sale didn’t result in ordinary income.

Facts. Bruce and Donna Rice purchased some 14.4 acres of undeveloped property in a desirable location near a preserve to build their dream home. The property was for sale as a unit. It wasn’t subdivided, and they couldn’t purchase only a portion of it. While they initially wished to keep the entire property for themselves, they eventually decided to sell the excess lots.

Other than sales of their own personal residences, the Rices had never engaged in the sale of real estate before (or since). They hired consultants for zoning, access, water and wastewater service, construction, and environmental issues. After they decided to subdivide the property, they hired a consultant to provide a subdivision layout and applied for and received a zoning change to subdivide and develop the property. They divided the property into ten smaller lots, reserving eight lots for homes and two lots for environmental purposes.

They sold all their lots through word of mouth rather than advertising. Their only advertising for the sale of the property was a wooden sign at the entrance to the subdivision. Among the eight lots suitable for construction, they eventually sold one lot in 2000, three lots in 2004, one lot in 2005, one lot in 2007, and one lot in 2008, and they held one in reserve for their daughter.

In 2004 the Rice’s reported their gain from the lot sales as capital gains and the IRS challenged their characterization contending that the lots were held primarily for sale to customers in their ordinary course of business. Happily for the Rices, the Tax Court found otherwise holding the Rice’s bought the property as an investment and not as property held for customers in the ordinary course of business. The gain from the sale of the excess lot was entitled to capital gains treatment.

In reaching this conclusion the Court found that even though Rices made significant improvements to develop and sell the excess lots, many of those improvements would have been necessary even if they hadn’t subdivided the property. The Rice’s advertising efforts were minimal, they sold primarily to friends and family and the number of lots sold was to small and infrequent to rise to a business status. Further, the Rices each held full time jobs and the proceeds from the sale of the lots was not invested in other real estate.

Thoughts. This decision is a great framework for when ordinary income versus capital gains treatment will apply when selling lots. As with most tax related issues it comes down to intent. Is it the taxpayers intent to buy and later sell the property for gain or is the intent to hold for investment. The sale of property purchased for investment does not change its character unless the taxpayers actions betray their intent e.g., immediately listing the property for sale or improving the property then selling. What investors should glean from this article is documenting your intent and actions can go along way in defining your intent if you happened to be audited in the future.

Posted by Clint Coons, asset protection attorney, Seattle, Washington

Sometimes the Courts do Get It Right

I find myself often writing or speaking about absurd lawsuits that result in ridiculous decisions in favor of an undeserving plaintiff who, but for a simple minded jury that was most likely concerned more about missing a Jerry Springer episode than delivering a just verdict, receives unjust enrichment
off the back of a hardworking citizen who’s only mistake was to have assets. So it is with great enthusiasm and minor perturbance that I write about a just verdict in a ridiculous case. In Petrone v. Fernandez (a case that made it all the way up to the NY court of appeals
) a mail carrier’s middle finger was injured when she, running away from a barking dog, tried to jump through the open window of her car legs first. As she flung her right leg through the open window, she jammed her right middle finger on the outside of the doorframe where the window comes down as she executed this maneuver. She ended up stuck in an awkward position — with her right leg inside the car and her left leg outside — and "screaming . . . for someone to help."

The plaintiff sued the dog owner and the owner of the apartment building where the dog owner was a tenant for continued pain and suffering in her finger. Thankfully, the Court found the defendant property owner was not liable to the plaintiff for her injured finger.So why my perturbance? This case should have never seen the light of a courtroom. How could someone reasonably believe a jammed finger suffered from personal behavior that was reckless in light of a non existent threat, give rise to liability for a property owner? Simple. This is America and in this country attorneys are a dime a dozen so there is never a shortage of liars, excuse me I meant lawyers, to take a case with the hope an insurance company will settle and pay the undeserving plaintiff and her attorney go-away money. Who is hurt right? If you think about it only a big heartless insurance company that has more money than it knows what to do with will take the fall. Unfortunately this is the mind set of the "have nots" of this world because in the end it is the property owner who experiences increased insurance costs or is dropped altogether or possibly the tenant who must pay higher rent to cover the landlord’s increased insurance costs. I guess we can conclude the property owner was lucky he did not live in an injury favored state like California or dog fright resulting in a jammed finger may be an expensive proposition. As James Thurber once stated "The dog has seldom been successful in pulling man up to its level of sagacity, but man has frequently dragged the dog down to his."

Posted by Clint Coons, asset protection attorney, Seattle, WA

Taxing Cell Phone Use

You may not be aware that employers must include in an employee’s W-2 income the value of employer-provided cell phones unless the employee satisfied convoluted rules. Over the past few years, the IRS has increasingly raised this issue on audit, with the result that many employers, were hit with a tax bill plus penalties. As every small business owner knows, cell phones are essential to conducting business and recent IRS statements have triggered a backlash recently. After several weeks of distress over the IRS’s taxation of employee cell phone use of employer provided cell phones, the service released a statement on Tuesday clarifying their position:

Statement of IRS Commissioner Doug Shulman

This month, the Internal Revenue Service asked for comments on ways to simplify compliance with rules related to employer-provided cellular telephones. The current law, which has been on the books for many years, is burdensome, poorly understood by taxpayers, and difficult for the IRS to administer consistently. Some have incorrectly implied that the IRS is "cracking down" on employee use of employer-provided cell phones. To the contrary, the IRS is attempting to simplify the rules and eliminate uncertainty for businesses and individuals.

Although some of the proposed changes would add clarity, the current law will inevitably leave widespread confusion among employees and businesses. Therefore, Secretary Geithner and I ask that Congress act to make clear that there will be no tax consequence to employers or employees for personal use of work-related devices such as cell phones provided by employers. The passage of time, advances in technology, and the nature of communication in the modern workplace have rendered this law obsolete.

This is good news for all small business owners and should make tax preparation much easier.

Posted by Clint Coons, asset protection attorney, Seattle, WA

Converting a 401k to a ROTH IRA

A question I often receive from individual contemplating rolling money out of their 401k is "can I roll directly into a ROTH IRA?" The answer is "YES" and if you have already begun a rollover into a traditional IRA you can change your mind and roll over your balance to a ROTH IRA instead per the IRS’s Spring issue of its “Retirement News for Employers."

Background. Rollovers from a regular IRA to a Roth IRA have been permitted for a long time, as have rollovers from qualified plans (including 401(k) plans) to regular IRAs. However, rollovers from qualified plans to Roth IRAs have only been permitted for post-2007 distributions. Rollovers to a Roth IRA (whether from a regular IRA or a qualified plan) are permitted only if the taxpayer’s modified adjusted gross income (AGI) doesn’t exceed $100,000, and he isn’t a married individual filing a separate return. However, in 2010 the $100,000 modified AGI limit on rollovers to Roth IRAs is eliminated and the best part is (2) married taxpayers filing a separate return may make rollovers to Roth IRAs. However, under Code Sec. 408A(d)(3)(A), a complex income inclusion rule applies that unless you elect otherwise, none of the income from the conversion will be included in income in 2010. Rather, half of the income resulting from the conversion will be includible in gross income in 2011 and the other half in 2012.

Posted by Clint Coons, asset protection attorney, Seattle, WA

Tax Court Denies Real Estate Investor’s Education Expenses

A recent Tax Court decision dealt with an individual who spent a large sum of money on travel and real estate education classes but was not entitled to deduct his expenses under Code Sec. 162 because they were incurred before his business began and because the lion’s share of them were for nondeductible educational expenses.

As an attorney who teaches several workshops a month on asset protection for real estate investments a common question always arises from the attendees – “can I deduct my education costs for attending workshops on real estate investing?  I was told I could.”  I have repeatedly stated that the education is non-deductible unless the expense is considered to be an ordinary and necessary business expenses directly connected with or pertaining to an existing trade or business.  The key concept here is the enterprise must be functioning as a business when the expenses are incurred. Until the business is functioning as a going concern, expenses related to it are not ordinary and necessary Code Sec. 162 expenses but, rather, startup expenses that may be deductible over a period of time under Code Sec. 195.  In other words if you are not already involved in real estate investing or brokering, the expenses incurred for educational workshops are not deductible on your 1040 schedule C.  This is exactly what Thomas Woody discovered when he was audited.

Facts. In early 2004, Thomas J. Woody started investigating the real estate market so that he could buy properties for investment or rental purposes. He created a name for his sole proprietorship venture (Value Property Investments) and began marketing his services via business cards, flyers, and word of mouth. Mr. Woody went so far as to create a business plan outlining his strategies, markets, and other items.  However, by late 2004 Mr. Woody had not yet purchased or sold any real estate.  Mr. Woody decided that he needed to sharpen his real estate investment skill and in October of 2004 he paid $21,490 to the Wealth Intelligence Academy for certain training classes, which he subsequently attended.

Despite taking courses, obtaining an EIN number for his business, obtaining a small business loan, and credit cards in the name of his business, Mr. Woody did not engage in any actual real estate activity until Dec. 30, 2004, when he bought an investment property.

On his 2004 tax return Mr. Woody claimed $23,373 of expenses on Schedule C, consisting of the cost of his training classes and expenses for car expenses, supplies, meals and entertainment, and computer and software costs. The IRS denied the claimed expenses on the grounds that Mr. Woody was not engaged in the active conduct of a trade or business.  Mr. Woody appealed to the Tax Court.

No business deductions until business actually commences. The Tax Court pointed out that in determining whether a trade or business exists, the courts have examined: (1) whether the taxpayer undertook the activity intending to earn a profit; (2) whether the taxpayer was regularly and actively involved in the activity; and (3) whether the taxpayer’s activity actually commenced. The Tax Court found Mr. Woody failed to satisfy the 3rd element of the test.  The Court stated that until Mr. Woody actually began to buy, remodel, or rent— i.e., to perform the activities for which he organized Value Property Investments—he was not carrying on a trade or business for Code Sec. 162 purposes. And until that time, none of his expenses could be claimed as Code Sec. 162 expenses.

The Tax Court found that plausibly Mr. Woody’s activities did not rise to the level of a trade or business until he purchased investment property in December of 2004, and subsequently began renting it out. Thus, the Court held that expenses incurred prior to the start of his active trade or business began would be, by definition start-up expenses under Code Sec. 195 rather than ordinary and necessary business expenses under Code Sec. 162.

Further, the Tax Court stated that the $21,515 for workshops and training—was an educational expense incurred to prepare for a new career, i.e., real estate investor and renter, rather than to maintain or improve skills in an ongoing business or career. It was therefore not deductible under Code Sec. 162. If Mr. Woody wanted to amortize his expenses as a start up expenses under Code Sec. 195, the expenses could be deductible if Mr. Woody incurred the expense in connection with the operation of an existing active trade or business.  Mr. Woody did not have an existing active trade or business set up for real estate investing e.g., a corporation established specifically for this activity.   Thus, because Mr. Woody lacked an existing active trade or business the Court looked to Mr. Woody to determine if he was personally involved in a real estate and found he was not.

This case illustrates how important it is for individuals who wish to start a real estate career must get their business set up ASAP before incurring costs; otherwise, they may find their costs are non deductible. 

A copy of this case can be found in the Documents of Interest section of our website.

Posted by Clint Coons, asset protection attorney, Seattle, WA

How to Handle a Loss on the Sale of A Personal Residence

Thinking about selling your personal residence for a loss? Think again before you rush into a sale. Most people are aware of the capital gains exclusion on the sale of a personal residence. If you sell your personal residence you may exclude up to $250,000 of your gain for single status filers and $500,000 of your gain for married filing joint status. What is often overlooked is the tax loss. Few taxpayers realize, until it is too late, that the loss on the sale of a personal residence is not allowed because your personal residence is not deemed an investment property.

To be considered an investment property you must move out of your personal residence and put it up for rent (yes, you must actually rent out your home for a reasonable period of time), thereby effectively establishing an intent to abandon the use of the property as your personal residence. Why must you go through this procedure? Because if your real estate is not your principal residence, it can be deemed an "investment property" and normal capital gains and loss rules apply. When your converted property is later sold, if a loss is recognized on the transaction you will most likely be able to deduct the loss as an (allowable) ordinary tax loss on Form 4797.

As with everything the devil is in the details so check with your CPA before employing this strategy because certain restrictions may come into play, e.g., when you convert your property to a rental property (income-producing use) you are supposed to use the lower of cost or fair market value (FMV).

Posted by Clint Coons, asset protection attorney, Seattle, WA

Recent Housing Issues of Note

Frustration with lax lending practices that led to homeowners being placed in homes they could not afford by lending institution seeking to make a quick profit, or the inability of the legal system to process the multitude of foreclosures has led the Supreme Court of South Carolina to issue an injunction barring foreclosures until lenders make a good faith effort to evaluate if homeowners may actually qualify for loan modifications. In a recent WSJ article "State Court Puts Foreclosures on Hold" it seems that the South Carolina Justices are sending a clear message to lenders that they need to work with homeowners in the midst of a crisis the lenders helped create.

In other areas of the mortgage debacle some property owners are finding Short Sales are not achieving the desired result. In a typical short sale scenario a financially troubled homeowner negotiates with their lender to accept, in lieu of foreclosure, any amount the homeowner can reasonably attain from selling their house. In the typical short sale scenario, the bank avoids the cost and hassle of a foreclosure and the borrower walks away from his mortgage. However, the WSJ in "A Short Sale May Not Mean You’re Home Free" reports that banks are increasingly reluctant to play by the old rules and instead, are electing to make the homeowner sign a promissory note for the difference between the short sale proceeds and the amount owed on the loan. For some homeowners in areas hard hit by the decline in home values, the amount owed can be staggering. If you or someone you know is considering a short sale be sure to negotiate this point up front so as not to be surprised on closing when a lender drops a promissory note and indicates “sign or else”.

Posted by Clint Coons, asset protection attorney Seattle, WA

A Good Case For Why Insurance Won’t Protect You

When purchasing insurance for your investments, you would be well served to fully review your policy’s exclusions". An exclusion is an occurrence giving rise to damages to property or person that your insurer will not cover. Many attorneys and accountants not fully versed on asset protection theories will often recommend their clients avoid entities in favor of ample insurance. A reason often cited is "insurance is cheap". Think about this for an minute – do you really believe something that is "cheap" will protect you in the event of disaster? I for one do not because insurance companies make money by mitigating losses i.e., claims, and investing premiums. When claims increase and investments in the stock market sour, insurers are adamant about covering any claim that might possibly fit into one of its policy exclusions. In the U.S. 5th Circuit Court of Appeals case of Nautilus Ins. Co. v. Country Oaks Apts. Ltd., No. 08-50652 an apartment owner found out first hand how much protection his policy offered when carbon monoxide seeped into an apartment and tragically harmed a fetus that was later born with mental and physical defects. The apartment owner believed his insurer would protect and defend him in the face of a lawsuit but instead he found himself battling his insurer over the dreaded "exclusion." In this case the exclusion pertained to whether the carbon monoxide entering the apartment building was a "pollutant" under the policy’s pollution exclusion. The court found that the carbon monoxide was considered a pollutant and its “discharge, dispersal, seepage, migration, release, or escape” was excluded under the policy. The court in a footnote went on to state that the reasonable expectations of the insured is not something the court need consider when deciding insurance cases. In summary, be sure to read your policy and ask for an explanation of any exclusion your are unsure of, or better yet have it reviewed by an attorney.

Posted by Clint Coons, asset protection attorney, Seattle, WA