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Michael Gray, CPA's Tax and Business Insight

May 28, 2004

© 2004 by Michael C. Gray

ISSN 1539-395X

A monthly report to help you prepare for your financial future, keep more of what you earn by minimizing your taxes, and build an extraordinary business!

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Celebrating 30 years in public accounting.

Thirty years ago, I graduated with a degree in accounting from San Jose State University. As graduation approached, I had no job waiting for me. The job market was somewhat "tight" in 1974, but I had to find a job. I was married with a baby less than two months old (now camped out in the office next to mine. You know – the person who sees to it you have this newsletter each month!)

I called Paul Alto, a partner at Hurdman and Cranston. I felt we had made a connection during our interview. Paul suggested that I make many copies of my resumé and physically deliver them to as many CPA firms as possible. He invited me to reapply at Hurdman and Cranston after getting some experience.

I followed Paul Alto’s advice. When I delivered one of my resumés, Alex Berger briefly talked to me. After an interview with Doug MacAdam, I was hired as an accountant at Berger, Lewis and Company. (How do you spell relief?) Alex Berger said he saw me as a "diamond in the rough".

After a somewhat rocky start, I became a certified public accountant. Eventually, I became a tax manager at Main Hurdman, with an office next to Paul Alto’s, and was in charge of tax services for most of his auto dealer clients.

In 1986, I started a CPA firm partnership, Hubler, Gray and Associates, with Rich Hubler, and in 1996 my own CPA firm.

Thanks to mentors Alex Berger, Ken Wood, Ron Vlastelica, and Ed Galus, and inspirational teachers like Jerry Kasner. Thanks to Janet (my wife) and family for sticking by me with emotional support through difficult times. Thanks to my former partner, Rich Hubler, who shared an enormously educational experience with me. Thanks to professional colleagues, with whom I have enjoyed an ongoing dialogue of ideas. Thanks to Dan Kennedy, Paul Dunn and Ric Payne, who helped catapault me in my journey of marketing know-how. Most important, thank you to the clients who have made my career in public accounting a rewarding experience.

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Happy Memorial Day.

As our country faces new challenges at home and overseas, thank you to those who serve and have served in military service for your efforts in defending, to the best of your ability, the blessings of liberty for your fellow Americans.

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Happy Father’s Day.

Remember Fatherr’s Day is June 20. Be sure to express your appreciation to fathers.

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Estimated tax reminder.

The second estimated tax payment for calendar-year taxpayers, including most individuals and trusts, is June 15. If you have an estimated tax payment due, now is a good time to make it. If you have a situation requiring a change to your estimated tax payment, call your tax advisor now.

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What recession?

Despite the "bad news" in the media, I am seeing many clients who have been cashing in stock options for big gains. Home sales in Silicon Valley are at near record levels, with prices being bid up by competing buyers. As Zig Ziglar says, the economy is doing well or poorly between our own two ears. Let’s count our blessings.

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Michael Gray and Naomi Comfort give an encore performance for the Peninsula Silicon Valley CPAs.

Michael Gray and attorney Naomi Comfort will give a two-hour presentation on "Handling Retirement Accounts After A Death" for the Taxation Committee, Peninsula Silicon Valley CPAs. The luncheon presentation will be at noon on Tuesday, June 8 at the Provident Credit Union Conference Room, 303 Twin Dolphin Drive, Redwood Shores. (Note correction in location from the last newsletter.) The investment is $20 for CalCPA members; $30 for non-members. For details and reservations, call Jane Dunbar at 650-802-2465.

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Note the June schedule.

Michael Gray will be out of town from the afternoon of June 2 through June 6 and from June 12 through 20. If you need help, call Danny Quan at 408-918-3163.

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IRS provides help for small business retirement plans.

The IRS has posted "check up" lists of questions for retirement plans to help small business owners identify common potential problems. An employer newsletter, called "Retirement News for Employers" will also be issued periodically. You can find these resources at the IRS website, www.irs.gov. (IR 2004-69.)

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Income recognition postponed for more advance payments.

The IRS has issued guidance increasing the number of items that aren’t taxable in the year received. The new rules are effective for tax years ending after May 5, 2004. According to past guidance, mostly advance payments for goods (Reg. §1.451-5) and services (Rev. Proc. 71-21) could be postponed. Any payments not included in taxable income for the year received must be included the next taxable year. If a company reports the prepaid amount as income in its financial statements, it will also have to include it as income on its tax return. If the company doesn’t have financial statements, the amount reported in the year received is the amount that is earned in that year.

Advance payments can be for services; the sale of goods; the use of intellectual property; the occupancy or use of property that is ancillary to providing services; the sale, lease or license of computer software; guaranty or warranty contracts ancillary to any of the above items; subscriptions; memberships in an organization; or any combination of these items.

The following items aren’t advance payments qualifying for deferral.

  1. Rent (unless ancillary to another product or service)
  2. Insurance premiums
  3. Payments with respect to financial instruments, including prepaid interest
  4. Payments for service warranty contracts accounted for using the SWIM method under Rev. Proc. 97-38
  5. Payments for warranty and guaranty contracts with a third party as the primary obligor
  6. Payments subject to Internal Revenue Code Sections 871(a), 881, 1441, or 1442 (tax on nonresident aliens and foreign corporations)
  7. Payments in property to which Internal Revenue Code Section 83 (property transferred in connection with services) applies

Before adopting this deferral method, taxpayers should compare and consider the deferral available under the old rules.

(Rev. Proc. 2004-34)

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Final at-risk regulations issued.

The at-risk rules generally limit the deductions for a business, partnership or investment to the investment of the taxpayer. The investment financed using debt for which a taxpayer is not personally liable is generally not counted. Under old rules, the at risk limitations only applied to certain activities, including (1) holding, producing or distributing motion picture films or video tapes; (2) farming; (3) leasing any (§1245) personal property; (4) exploring for, or exploiting, oil and gas resources as a trade or business or for the production of income; or (5) exploring for, or exploiting geothermal deposits.

In 1978, Congress extended the at-risk limits to "new activities", which are any activities engaged in by a taxpayer in carrying on a trade or business or for the production of income that is not one of the old activities. The effective date of the change is the effective date of final regulations issued by the IRS.

The final regulations are effective May 3, 2004, 26 years after the law change was adopted by Congress!

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Questions and Answers

Question

If I buy a home as an owner-occupied property but then decide I’d like to rent it out (say after living there 3 months) and move into another place, can I make a 1031 exchange and buy another rental property when I’m ready to sell it?

I guess I’m wondering if personal property can be converted to investment property in the eyes of the IRS.

Answer

Yes, personal use property can be converted to investment property, qualifying for a 1031 exchange. This situation needs to be handled very carefully, including "seasoning" the property as rental property for some time, before making an exchange. If the IRS determines that this is just a plan to qualify for an exchange, it might try to attack the exchange as not qualifying. The reason for the change in circumstances resulting in a change to rental property should be documented.

Question

We have a purchase contract to buy rental property, for which we have made a down payment. We are also trying to enter an agreement to sell rental property and vacant lots to finance the purchase. We hope to have the money from the purchase before we finalize a note, for which we have applied. Can we still make a 1031 exchange, since we had a purchase contract for the property before selling the others? If we qualify, is there the 1031 exchange a one-time election, or is there a time constraint to use is again?

Answer

An exchange can be made when a contract for purchase has been entered before the contracts to sell. There is no holding period requirement for a 1031 exchange, and it is not a one-time election. I highly recommend that you pay for professional assistance if you decide to go ahead with an exchange. It’s too easy to foul an exchange up, resulting in an unexpected tax liability.

Question

I will have owned my home for two years on June 25, 2004. If I sell it on June 20, 2004, will I qualify for the exclusion for sale of a residence?

Answer

No.

Question

I sold my half of a house that I had for a little over one year because the relationship ended. I heard that if you buy another home within a certain amount of time you do not have to pay short-term capital gains. Is this true?

Answer

No. Someone may be thinking about rules that were repealed in 1997.

However, you may qualify for an exception allowing part of the exclusion for gain from the sale of a principal residence due to an unforeseen change in circumstances. See Treasury Regulations Sections 1.121-3 and 1.121-3T or IRS Publication 523, page 15.

Question

I know there is no federal luxury tax. Does California still charge a luxury tax on autos?

Answer

I’m not aware of there ever being a California luxury tax on autos.

Question

I bought a Ford Excursion during October, 2000. I paid $39,904.20 and was charged $273.29 in luxury tax. Recently, I was told by another dealership that I shouldn’t have had to pay that tax. I called the dealership where I bought it and they said if the tax they had collected had been sent to the IRS in error, that I would have received a check back from the IRS. Should I have had to pay the tax?

Answer

Passenger vehicles rated at more than 6,000 pounds gross unloaded vehicle weight were excluded from the tax. For trucks and vans, vehicles rated at more than 6,000 pounds gross vehicle weight were excluded. I don’t know if a Ford Excursion meets that definition. If it does, try applying for a refund using Form 843, but I think the statute of limitations may have expired and it’s too late.

Question

What is the maximum contribution to a SEP for 2003?

Answer

$40,000.

Question

My husband and I have been married for 4 years. We have been living an a small apartment and want to live in our first home. My husband had owned an investment property for 12 years with his sister and brother-in-law. Last year, they decided to sell the property, split the sales price and go their separate ways. In order to defer the taxes, we were forced to do a 1031 exchange.

We would rather move into the property than rent it for 2 years.

I was not part of the investment property, and I was not involved with the sale of that property, but my name is on the documents for the replacement property. Can I move into the property as the renter and have only my name on the bills? Then could my husband live there, too, without being taxed?

Answer

If you move into that property without renting it for some time first, you could blow up your husband’s exchange and you two will owe the tax on the sale of the apartments. Either you will have to be patient or "bite the bullet" and pay the tax.

Michael Gray regrets he can no longer personally answer email questions. He will answer selected questions in this newsletter.

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If you have employee stock options, have you subscribed to Michael Gray, CPA's Option Alert?

To subscribe or review past issues, go to Stockoptionadvisors.com.

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Visit our new articles!

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P.S.

My daughter and her husband, Holly and Dan Baker, have a Southern French Restaurant at 23 Ross Common, Ross, California, about 15 minutes north of the Golden Gate Bridge. The name of the restaurant is Marché Aux Fleurs and their website address is www.marcheauxfleursrestaurant.com. For the best meal of your life, call 415-925-9200 for a reservation and give them a try! For directions, visit our website at www.taxtrimmers.com/directions.shtml.

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P.P.S.

To receive the next issue of Michael Gray, CPA's Tax & Business Insight with more tax developments, another book review, and upcoming deadlines automatically via email, subscribe by filling out the form below.

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IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.
The June 2004 issue of Michael Gray, CPA's Tax and Business Insight.

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Michael Gray, CPA
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