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topten July, 2010

This is a monthly reference source. By providing 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. You should discuss your particular situation with your Fiducial Business Advisor to answer your specific problem or concerns. (You may not rely on any answer given to avoid a penalty.)


Q.1 I am selling my home this year. I have rented it out for the last 12 months, but before that I lived in the house for 14 years. Assuming settlement will be done next month, will I have to recognize a percentage of the gain on the sale due to the new rules concerning a sale of principal residence?

A.1 For sales of a principal residence made after December 31, 2008, gain that is attributable to a period of nonqualified use cannot be excluded from income. The term “period of nonqualified use” means any period after January 1, 2009 during which the property was not used as the principal residence of the taxpayer (or the taxpayer’s spouse or former spouse). Nonqualified use does not, however, include any portion of the five year period ending on the date of the sale of the property that is after the last date the property was used as a principal residence by the taxpayer or spouse. As your sale is within the five year period, gain will not have to be allocated. You will, however, be subject to recapturing any depreciation claimed on the rental of the property.

Q.2 My rental property was about to go into foreclosure, so I negotiated to surrender my deed in lieu of foreclosure. I received a Form 1099 that indicates the amount of the mortgage, the FMV of the property and that I am not personally liable for the excess of the debt over the FMV. My basis in the property is a little less than the mortgage (I have not owned the property for very long). Do I have relief of debt income?

A.2 It appears that you do not have relief of debt income. As you are not personally liable for the mortgage (i.e., a non-recourse mortgage), the security for the debt is the property itself. With that, on the surrender of the property to the mortgage holder, you are treated as if you sold the property for the amount of the debt (regardless of the FMV being lower). You should record the event as a sale of the property and you may offset the sales price by your basis. Depreciation is subject to recapture under Section 1250 (maximum rate of 25%) to the extent of the gain on the sale and if the gain exceeds the amount of depreciation taken, that excess gain is given Section 1231 (capital gain) treatment.

Q.3 My oldest just finished his junior (third) year of college. I was expecting to use the Lifetime Learning Credit as the Hope Credit applies to the first two years of college, but my 2009 return reflects a $2,500 credit. Is this correct?

A.3 For 2009 and 2010, the American Opportunity Credit modified the Hope Credit. A credit of up to $2,500 is allowed for qualified education expenses paid for each eligible student. The credit is 100% of the first $2,000 of qualified expenses and $25% of the next $2,000 paid for that student (maximum of $2,500). An eligible student includes one that has not completed the first FOUR years of postsecondary education.

Q.4 My son is in college and with the new American Opportunity Credit we decided not to claim him as a dependent so that he could take advantage of the 40% refundable amount of the credit. He did have some income for the year. IRS has disallowed his refund. Is IRS correct?

A.4 If your son was eligible to be claimed as your dependent, but you choose not to do so your son may claim the education credit, but the refundable portion of the American Opportunity Credit is not available.

Q.5 I have a rental property that has no mortgage (I own it free and clear). I am thinking of refinancing that property and using the proceeds to buy a new principal residence. Are there any potential pitfalls?

A.5 There is one significant issue of which you should be aware. Under the provisions allowing a deduction for mortgage interest, the debt instrument must be secured by the principal residence or a second home. If the debt to which the interest may be traced is secured only by a rental property, the interest is not deductible as qualified mortgage interest. In addition, as the debt is not being used for the rental property the interest is not deductible on Schedule E. For tax purposes, the interest becomes personal (non-deductible) interest. The key to avoid this is to either (1) not mortgage the rental property, or (2) make sure that the principal residence is added as security for the mortgage taken.
Q.6 My father died in March of 2010. We do not live in a community property state. I am trying to help my Mother after his passing. She is his sole heir. I understand that in 2010 there is no federal estate tax, but does that mean my Mother gets no step-up in the basis of the assets she inherits from my Father’s estate?

A.6 For 2010, the estate tax is repealed as you stated. Each estate will be permitted to increase basis on a decedent’s assets by up to $1.3 million - with up to an additional $3 million for property passing to a surviving spouse (e.g., decedent’s ½ interest in property jointly owned with the surviving spouse along with property owned solely by the deceased). The basis increase may not exceed fair market value of the assets passing through the estate, but for a surviving spouse that increase may be as much as $4.3 million. There is, therefore, a limited step-up in basis available. The basis increase does not apply to IRAs, annuities or similar assets (such as inherited installment notes).

Q.7 I have a rental property that I am going to substantially repair after my tenant moves out this month. I estimate the renovations will take quite a while. I plan to rent the property again when I finish the work on it. Do I have to stop depreciation on the property while it is being renovated?

A.7 As the property will be idle (temporarily unused) rather than permanently removed from service, depreciation is not stopped while the property is being repaired. If the property will merely be idle while repairs are being made and will be returned to service, depreciation is to continue (according to IRS Pub. 527) even if the property does not generate income during its idle period.

Q.8 My aunt passed away late last year. I was the executor and sole heir of her estate. The expenses incurred, such as probate fees and notice publication fees to settle the estate were more than the income, and the estate was closed early this year. Must I file a tax return for the estate?

A.8 If the estate had more than $600 of gross income it is subject to filing a return. As the estate was not closed until early this year (2010), the return would not be due until the 15th day of the fourth month following the closing of the estate (an extension may be requested). If the deductible expenses, such as probate fees, attorney’s fees, the fee for the accounting for the estate, etc, exceed the income it is to your advantage to file the estate’s first and final return. The excess expenses pass through to you (the sole heir) and may be deducted as an itemized deduction (subject to the 2% of AGI limitation) on your 2010 return.

Q.9 I am employed as a member of a small city police force. We are provided with a list of approved sidearms that we may carry, but must purchase them with our own funds. Is the cost of the pistol I purchase deductible?

A.9 You may either depreciate the pistol as 7 year MACRS property or expense the cost of the pistol under Section 179. The deduction (either depreciation or expense) is claimed as an employee business expense on Form 2106 and is subject to the 2% of AGI limitation.

Q.10 I currently have a sole proprietorship. I am forming a single member LLC that will be taxed as an S corporation. At present the liabilities of my business exceed the net book value of assets by about $6,000. Can I shift the assets and liabilities to the LLC, elect S corporation status and have no tax liability? An acquaintance suggested that I establish a loan to shareholder for the excess of the liabilities over the net book value of the assets.

A.10 IRS will consider the election S corporation status the equivalent to forming a corporation. To qualify for tax-free treatment on the formation, the net book value of assets treated as transferred to the corporation must be at least equal to the liabilities transferred. Otherwise the incorporation is treated as a taxable sale of assets. We advise that you retain enough liabilities outside of the LLC to ensure a positive “incorporation”. The interest paid on the retained business liability is deductible on Schedule C. IRS will attack an attempt to establish the net deficit in equity as a “loan to shareholder.” In addition, many states prohibit a negative incorporation.

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