Reconstructing You
Volume 6 Issue 1 --January/February 2002
How do you handle yourself? I am not talking about dealing with your weight or other sensitive issues. I mean, how do you deal with business issues involving your work, real estate and other activities? Sometimes a different — or reconstructive — approach to handling your affairs and an ounce of planning can save a ton of money in taxes and avoid headaches.
Flo, who is single, owns a personal residence on 25 acres, most of which she does not use for residential purposes. Flo has always gotten one tax bill for the entire parcel and has never considered the entire tract as anything other than part of the house. A builder offers Flo $2,000,000 for the tract. Flo can avoid gain on the sale of her house up to $250,000.
Can she do better, tax-wise? If Flo treats 23 acres as property held for business or investment, gain attributable to the 23 acres can then be rolled over tax-free to other real estate.
She should treat the 23 acres separately for real estate tax purposes by paying a percentage of the local property tax from a business bank account. Expenses related to that 23 acres, like planting trees, should be paid from the business account. She could also advertise the land for rent as farming or business property. Rental income attributable to such activities should be deposited in the business account. In other words, Flo should leave a trail of business or investment bread crumbs, if she wants to obtain favorable tax treatment.
Kirk, an Engineer, is also an excellent Violin Maker, but he fails to maintain records of his violin activities and commingles violin sales income and expenses with his W-2 income and personal expenses in one bank account. Kirk prepares his own return and fails to file a Schedule C (Profit or Loss from business) with his return. If Kirk is entitled to deduct expenses for supplies and subcontract labor, he may not be able to compute the deduction or, if audited, substantiate such expenses. Kirk, like Flo, should better separate and document his business and personal finances.
Zap, a Realtor, is required to treat real estate sales as ordinary income. Long-term capital gains, on the other hand, are taxed at lower rates. Can Zap avoid getting income tax zapped if he sells a piece of real estate, Swan Lake, he has owned for 15 years for investment purposes?
Zap has to plan in advance of the sale. He should have two bank accounts, one for investment activities, the other for sales in the normal course of business. Taxes and expenses related to the investment property should be paid from the investment account. If Zap wants to claim capital gain tax rates on the sale, he has the burden of proving that the property was held for investment purposes.
Lets say Zap is not a Realtor but a Teacher who inherited property and was not aware of the adverse effect of subdividing. If Zap subdivides the land, and ends up with six or more parcels of subdivided land he may be deemed to have inventory (the lots), and sales of the lots will be deemed to be ordinary income to Zap. What to do? If Zap wants to be sure he receives capital gain treatment on the whole property, he should sell the land in bulk, to one buyer in one sale.
Zed Partnership owns a piece of valuable real estate. Some Partners want to defer tax upon the sale of the property (via a tax-free like-kind exchange) and other Partners want cash, now, and tax recognition. The election to defer gain must be done by the Partnership, but the Partners cannot agree. What to do?
A possibility is to dissolve the Partnership and have the former Partners own their interests in the property as tenants in common (undivided percentage interests). The land should be held this way for a period of time, so tax officials cannot argue that the only reason for the retitling was to obtain tax benefits not otherwise available. When the property is eventually sold, each Partner can make a separate tax election to exchange his or her interest for other business or investment property. A more complicated approach is to physically divide the property into separate parcels.
Taxing authorities generally do not preserve records for taxpayers or suggest tax saving strategies. This means the “Reconstructed You” must preserve records of what you did in order to prove your point. For example, Flo and Zap must adequately separate their business or investment activities from their personal affairs and then keep and preserve suitable records. They must be prepared and able to prove that their reconstructed selves are bona fide.
Copyright 2002
Published by the law firm of Newland & Associates, PLC
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