Think twice before you do. There are a lot of disadvantages when purchasing real estate with your IRA funds even if you think property prices have bottomed out and you feel strongly that real estate is a good investment.

Higher tax rates – When you sell real estate within an IRA, any gain distributed is taxed at ordinary income tax rates. This rate can be much higher than the capital gains rate you would pay on the sale of real estate outside of the IRA.

No Depreciation – If you purchase a building with taxable (non-IRA) funds, you get to write-off depreciation. This is not the case with an IRA. Depreciation is a significant tax advantage, so why would you want to give it up?

No step-up in basis – Normally, if you die before the sale of investment property, your heirs would get a step-up in basis. They could sell it immediately and pay no tax. If it is in an IRA, there is no step-up in basis and they would pay taxes on the full amount of the sale at their ordinary tax rate.

Valuation – When you reach age 70.5, you are required to start taking Required Minimum Distributions (RMDs) from your IRA. The RMD amount is based on the value of your IRA assets as of 12/31 of the previous year. If you own real property, you would have to pay to get it appraised every year.

Liquidity – You would need to have enough additional funds in the IRA to take the RMD distribution every year starting at age 70.5. Which is not easily done if all of your IRA is invested in real property.

Personal Use – You can’t use the property for personal use, even if it’s a time share. You can’t rent if to lineal descendants.

Custodial Fees – Brokers and banks generally only allow traditional investments in your IRA like stocks and bonds. If you want to hold real estate, you’ll have to find a custodian that specializes in holding real estate. You’ll pay extra for that privilege.

Expenses – It is important that you only use IRA funds for all expenses associated with the property including taxes, repairs, and insurance. If rents don’t cover these costs, your IRA may be disqualified by the IRS.

Unrelated Business Taxable Income (UBTI) – If you purchase real estate within your IRA subject to a mortgage, you may be subject to UBTI, requiring the filing of a tax return and paying taxes on the income.

If you want real estate assets in your IRA for diversification, you can avoid all of these restrictions by purchasing shares in a Real Estate Investment Trust, real estate ETF, or real estate mutual fund. These are readily available through your current investment advisor or custodian.

Important changes to your 2011 tax filing

Individuals

Any taxpayer electing not to have his tax return filed electronically must sign and submit Form 8948, “Preparer Explanation for Not Filing Electronically”.

One-half of any Roth conversion made in 2010, must be reported on the 2011 income tax return unless an election was made to have it all taxed in 2010.

U.S. taxpayers holding foreign financial assets outside of the United States with an aggregate value exceeding $50,000 must report these assets on new Form 8938, “Statement of Specified Foreign Financial Assets”, and attach it to their 2011 federal income tax return.

All 2011 sales of  stocks, bonds, and mutual funds will need to be reported in detail on new Form 8949, “Sales and Other Disposition of Capital Assets”. The totals will be rolled-up to Schedule D.

If Form 8332, “Release of Claim to Exemption for Child by Custodial Parent” is used, it must be attached to the tax return.

Taxpayers must have contemporaneous written acknowledgement for charitable contributions over $250.

Small Business

The business mileage deduction for 2011 was $0.51 from 1/1/11 through 6/30/11 and $0.55 after 7/1/11.

Cell phones were removed from the definition of listed property to simplify record keeping.

Owners who accept credit/debit cards for their business can expect to receive a Form 1099-K, Merchant Card and Third Party Network Payments”, from the credit/debit card processor showing the amount collected in 2011. This information will need to be entered separately as an income item on the business tax return.

Healthcare Act changes affective for 2011

Over-the-counter medicines are no longer eligible under a Flexible Spending Account (FSA) or Health Savings Account (HSA). Prescription medicines and other medical supplies are still acceptable.

The penalty for non-qualified distributions from an HSA account has increased to 20%.

Summary of tax provisions expiring in 2011

Individuals

Once again set to expire at the end of 2011 is the deduction for qualified secondary education expenses up to $4,000 for AGIs up to $130,000 ($65,000 for single filers) or up to $2,000 for AGIs up to $160,000 ($80,000 for single filers).

The Alternative Minimum Tax (AMT) exemption amount currently at $74,450 for joint filers and $45,000 for single filers will decrease in 2012 to $48,450 and 33,750, respectively.  This has been a hot political potato for the last few years, with Congress and the President agreeing to increase the exemption on an annual basis.  Given that the 2012 election process has already begun and as of this writing the Congressional Super Committee has been unable to reach a consensus on the budget, the exemption amount may not be increased in 2012.

In 2012, nonrefundable personal credits, such as the dependent care credit and the elderly and disabled credit will no longer be available to offset the AMT liability.

The provision allowing for nontaxable IRA distributions to a charity, up to a maximum of $100,000 expires at the end of 2011.

The $250 “above the line” deduction for educators’ classroom expenses is due to expire at the end of 2011.

The credit for an energy efficient home and for energy efficient improvements, reduced to a total credit of $500, based on 30% of the cost of the materials, is set to expire at the end of 2011.  If $500 or more of the credit has been used in 2009 or 2010, the 2011 credit is not available.

The credit for Electric Vehicle Credit for Low-Speed Vehicles, Motorcycles, and 3-Wheeled vehicles, of 10% of the purchase price up to $2,500, is available through the end of 2011. The credit for electric vehicle conversion kits is also expiring at the end of 2011.

Up to the end of 2011, taxpayers have the ability to rollover funds from a Flex-Spending Account (FSA) or a Health Reimbursement Account (HRA) to a Health Savings Account (HSA). 

Expiring at the end of 2011 is the ability to utilize state sales tax instead of state income tax as a deduction on Schedule A.  This will make a huge difference for taxpayers that live in states with low or no state income tax – and those that are planning the purchase of high-ticket items subject to sales tax, such as motor homes, boats, and luxury vehicles.

Those who purchased a home with less than a 20% down payment, may have been required to pay mortgage insurance premiums. These previously deductible premiums are set to expire at the end of 2011.

The 2010 Tax Relief Act provided for a reduction in an employee’s social security withholding from 6.2% to 4.2%, providing a little extra cash flow every month.  Unfortunately, this tax benefit expires at the end of 2011 unless extended by Congress.

Small Business

Internal Revenue Code Section 179 is often used by small business to expense equipment purchased during the year.  Through 2011, the maximum amount allowed to be expensed is $500,000 with a total capital expenditure of $2,000,000.  In 2012, the maximum deduction for the purchase of equipment in one year is $139,000 with the maximum capital expenditure limited to $560,000.

The 100% bonus depreciation is also due to expire at the end of 2011.

2012 inflation adjustments for various tax items

Personal exemptions increase from $3,700 to $3,800 per person.

The annual gift exclusion remains unchanged at $13,000 per donee.

The elective deferral limit for employees participating in 401(k), 403(b) or 457(b) plans increase from $16,500 to $17,000 per year.

The Social Security wage base increases from $106,800 to $110,100.

The standard deduction for joint and single filers increases to $11,900 and $5,950, respectively.

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Oregon is another story altogether.  An Oregon Inheritance Tax Return must be filed for anyone owning real and personal property, tangible or intangible, located in Oregon if their total gross estate (both Oregon and Non-Oregon assets) exceeds $1 million. The inheritance tax is based on the percentage of assets located in Oregon.

The $1 million exemption seems ample, but by the time you include your home, life insurance, annuities, and other estate assets, you may exceed the exemption.

For 2011, the first $100,000 after the $1 million exemption is taxed as high as 41%, then the rate drops to 6.4%, and then it rises in several steps back up to 16%. This strange bulge just beyond the $1 million exemption will go away in 2012, at which time the Oregon Department of Revenue will change to a more normal progressive rate that slowly increases between 10% and 16%.

If you exceed the $1 million exemption, there are only three ways to reduce Oregon Inheritance Taxes:

Use special Oregon rules:

1. Natural Resource Credit – This is used primarily for farm, forestry, and fishing businesses.
2. Domestic Partners – a marital deduction is allowed for Registered Domestic Partners as a surviving spouse.
3. Qualified Business Assets – A special deduction is available for Qualified Family Owned Businesses.

Give your property away:

Oregon has an inheritance tax, but no gift tax. Federal taxable gifts before 2012 reduce much of the Oregon tax liability, but not dollar for dollar. Starting in 2012, federal taxable gifts up to the lifetime exclusion will be completely excluded from Oregon taxes.  Completed gifts are not included in the gross estate for inheritance tax purposes, but they also do not receive a step up in basis. Therefore, it wouldn’t make sense giving away appreciated property to save inheritance taxes at 10% while paying combined federal and state capital gains taxes at a higher rate. It does make sense to give away cash.

Move…and take your property with you:

California, Nevada, and Idaho currently do not have estate or inheritance taxes.  Washington has an estate tax, but it has a $2 million exemption (the gross estate includes gifts). It is important to note that these states could institute an estate tax in the future.  Oregon will tax any tangible assets remaining in Oregon.  If you should decide to use this method to avoid the inheritance tax, be sure of a clear “intent” to change domicile by registering to vote, obtaining a drivers license, paying taxes, and actually residing in the new state for the bulk of the year.

Estate and inheritance taxes are very complex, and without proper planning, can be costly. Please call us or your estate planning attorney if you have any questions about the Federal Estate or Oregon Inheritance Taxes.

More specifically, you must file a Form TD F 90-22.1 with the Department of Treasury if:

1. You are a US citizen or resident,
2. You have a financial interest or signature authority of financial accounts in a foreign country,
3. The aggregate value exceeds $10,000 at any time during the calendar year.

Foreign accounts include bank accounts, mutual funds, annuities, securities, and derivatives. The only exceptions are retirement accounts, military banking facilities, and publically traded entities.

If you have legal title to the account, you are required to file, even if it is for the benefit of non-US persons or a business entity such as a corporation, partnership, or trust.

The Form TD F 90-22.1 must be filed by June 30 of the following year. You can now file the form electronically by going to http://bsaefiling.fincen.treas.gov/Enroll_Individual.html. Joint account owners may both have to file a form.

The civil penalties for not filing range from $500 to $100,000, and criminal penalties can be as high as $500,000 and 10 years in jail. Fortunately, the Treasury has been very lenient, and is not enforcing penalties on filers who were not aware of this requirement. But they expect you to catch up on all missed filings.

Also, starting January 1, 2011, US taxpayers holding foreign financial assets outside the United States with an aggregate value exceeding $50,000 must report these assets on Form 8938 attached to their income tax returns.

If you have questions about these forms, or if you are unsure of your filing requirement, give us a call.

In a Wall Street Journal Weekend Investor Section article for September 3 and 4, 2011, Jack Hugh raised concern for bond fund investors in terms of fees when experts such as Pimco’s Bill Gross make “mistakes”.  While everyone makes mistakes, Hugh recommends that some investors look at a new breed of ETFs that buy bonds and hold them to maturity.  As we have noted above in our approach to the fixed income portion of portfolios, Hugh advocates the same approach to reducing costs and looking to buy either ETFs that hold bonds to maturity or if a portfolio is large enough,  buying individual bonds and holding them to maturity.

I do not see this as a 2008 market crash because the correction is not based on economic fundamentals, but pure emotion, made worse by a breathless media that amplifies the mood of the moment. Because of this emotion, people tend to buy when prices are going up, and rush for the exits when prices go down.

It is important to keep a level head and don’t make any dramatic moves. Your account statements are reflecting the drop in market value. However, this is a “paper loss” only. If you were to sell right now, you will be locking in real losses. If your investments are in a well-balanced, diversified portfolio, you have nothing to worry about. In fact, you should consider this an investment opportunity.

The fundamentals have not changed from a month ago. The Wall Street Journal recently stated that 80% of the S&P 500 companies reported quarterly earnings that were positive. Many companies have very strong cash positions and are raising dividends.

The United States GDP is greater than the GDP of all other AAA rated countries combined and U.S. debt as a percentage of GDP is about the midpoint of all the AAA rated countries.

I expect inflation-friendly policies from our government in near term, but I also foresee inflationary pressures as our economy picks up steam. Inflation will ultimately lead to an increase in interest rates and further tightening of borrowing requirements. Mortgage rates are now at a 50 year low, so this may be a good time to refinance if that option is available to you.

I can’t control what happens in Washington or what the folks at the S&P decide to do. Nor can I accurately predict what the markets will do in response, but here’s my prediction…a few years down the road, a lot of investors will look back at their participation in the herd mentality and wish they could have had the fortitude to buy when everybody else was selling.

“I have recently been through an experience of assisting a family member through her pre-death planning decisions and was encouraged by another planner-friend to share my experience with NAPFA friends.

I had helped my aunt through end-of-life issues, and one task was for my Aunt to obtain a Do Not Resuscitate (DNR) order from her family doctor, in accordance with her wishes. She was suffering from severe painful medical conditions, had lost her husband to death 18 months prior, had no children, and with no real quality of life, had no desire to go on in this world. The order was obtained and hung in my aunt’s new assisted living studio apartment. Subsequently, my Aunt was traveling to her old condo on an occasion to retrieve some items, when she sat down on a stool, and and succumbed to death. A friend who accompanied Aunt called 911, and the ambulance came. Finding no DNR order at the condo, where she had a strong desire to die, emergency medical staff resuscitated her, and took her poor frail body to the hospital and put her on life support machines.

Lesson for planners: make sure your clients with DNRs have more than one copy if they have multiple homes or maybe even suggest they carry a copy in a purse or wallet. I was able to convince the ER docs of my aunt’s true wishes, and eventually they let her go. I met resistance, but was aided by the fact that she had been without oxygen for a period of time before the ambulance arrived, and that they felt she was brain-dead. I don’t think I would have been successful if this hadn’t been the case.”

Updated IRS information systems are making it easier for them to match your sources of income from your employer and investment accounts. Income that is not accounted for properly will automatically generate notices from the IRS. Deductions that are excessive for your income level may be flagged and reviewed for further inquiry.

The most common notice is the CP2000 – Underreported Income Adjustment. This is triggered when the IRS computers find income listed with your Social Security number that wasn’t fully reported on your tax return. This could easily happen because:

• It was an oversight by the taxpayer and the income was omitted
• Someone else is using the taxpayer’s Social Security number
• The income was reported in a different (or the wrong) place on the tax return

Other types of notices you may receive:

• CP11 – Discrepancy in Earned Income or Other Credits
• CP12/CP13 – Math Error Notices (IRS Adjustments)
• CP14 – Changes in Return, Balance Due
• CP23/24 – Estimated Tax Discrepancies
• CP80/CP88 – Applied Credits or Refund Hold Do to Missing Tax Return
• CP90 – Final Notice of Intent to Levy
• CP91 – Final Notice Before Levy of Social Security Benefits
• CP515 – Notice that a Return is Overdue
• CP2501 – Income Verification Notice

You can find a complete list of IRS notices here

If you receive a notice, pay attention to the “Tax Year” shown on the notice. It is listed in the upper right heading of the notice just below the “Tax Form” in question. The IRS may be two or three years behind on issuing some notices.

Not all notices are accurate, and the IRS is prone to mistakes just as often as the taxpayer. But it is imperative that you (or your CPA) respond to the notice as soon as possible. Most issues can be solved by writing to the IRS. Expect several months to get a response (if you get one at all). Failure to respond will generate further notices, penalties and interest, and possibly a lien against your home or a levy against your wages or bank account, or even criminal action. If you do owe money, you can often set up an installment agreement with the IRS to pay your tax liability over time. There is an additional fee for this and penalties and interest will continue to accrue.

If you don’t respond to the first notice, you will receive a second notice, CP503 – Reminder of your Balance Due. A third notice, CP504, will be sent 30 days after the second. If you still fail to respond, a fourth notice will be sent by certified mail 30 days after the third notice is sent. This final and fourth notice also declares the IRS’s intent to levy and inform you of your right to a hearing. If payment is not received within 30 days of the fourth notice being received by you, the IRS has the right to seize your property or garnish your wages.

By signing a Power of Attorney form (Form 2848), you can authorize your CPA to represent you before the IRS on all tax matters. If you’re not sure how to deal with IRS notices, or if you get a letter requesting an audit, we are here to help.  Just give us a call.

¹Buttonow, Jim – Accounting Today: The Notice Boom, July 1, 2011