Tax Research Paper

– This assignment is for someone who is expert in the U.S. tax law

-You will be required to do a tax research and write a file memo(file meme example in the attachments) on a problem a client is having (Problem will be given to you after accepting this assignment)

– You are required to ask the client at least 5 questions related to her issue to extract more info to help you to solve their problem

– It is better to have access a website that you can research U.S. laws related to the assignment

– The file tax memo should be at least 4 pages and it must be supported by good evidence

-The tax problem will be given after accepting the assignment and more detailed instructions

Sample Tax Research File Memo
Below is a sample of a tax research memorandum prepared as a student assignment. It is longer
than the cases you will be assigned for your major tax research case memo because it was a
joint project with several issues. Although there are a few missteps here and there, and the answer
may not be entirely correct based on current law, on the whole the memo is outstanding work. As
you review the sample, note the following:
• The memo is well-organized (facts, issues, analysis, and conclusion). Moreover, the issues
are logically developed.
• The memo tells a good story. There generally are enough facts about referenced cases that
the reader could appreciate the point that the authors were trying to make.
• Citations were ample and were in the proper form.
Tax Research Case
Rental of Home Prior to Sale
A302 (A551) Fall xxxx
December 5, xxxx
I. Facts
The taxpayer, Mr. Bud Gates, recently relocated to Atlanta and purchased a new home for
$350,000. In the meantime, he has had difficulty selling his old house in Indianapolis, which
has been his principal residence for the last ten years. Despite the continued efforts of his
realtor, he has not yet received an offer on the house, which has stood vacant since he and his
family moved out on March 1, 2000. Mr. Gates is experiencing significant financial hardship
from making mortgage payments on both homes. He would like to rent his old home out in
order to relieve the financial burden and continue trying to sell it. Mr. Gates’ basis in his old
home is $100,000, and his realtor has indicated that a reasonable market price for the house
would be $300,000. Mr. Gates is married, files a joint return, and has taxable income above
$283,150. He has not otherwise sold a home within the last two years.
II. Issues [You should not have this many issues in your assigned case. You might just have
one.]
1. Can Mr. Gates rent out his former residence without endangering the capital gains exclusion
for the ultimate sale of his home?
2. If he rents his home, what deductions may he take for rental expenses?
3. Will Mr. Gates be entitled to deductions should losses occur in his rental activities?
4. How is the depreciation determined, and will the depreciation be recaptured when the home is
ultimately sold?
5. When should a sale be recognized in a rent-to-own situation?
III. Analysis
Section 121(a) states that gross income shall not include gain from the sale or exchange of
property if, during the 5-year period ending on the date of the sale or exchange, such property has
been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating
2 years or more. A maximum cap of $500,000 for the exclusion applies under §121(b)(2) to
married taxpayers filing joint returns. In addition, §121(b)(3) prohibits a taxpayer from taking
advantage of the §121 exclusion more than once every two years unless a taxpayer’s move is
necessitated, as stipulated under §121(c)(2)(B) “by reason of a change in place of employment,
health, or, to the extent provided in regulations, unforeseen circumstances.”
Prior to 1997, §121 applied exclusively to individuals who had attained age 55. All other
individuals wishing to receive capital gains tax relief on the sale of a principal residence needed
to qualify under §1034. Congress repealed §1034 in the Taxpayer Relief Act of 1997, P.L. 10534, 8/5/97, and substantially changed the wording of §121 to apply to all taxpayers. Prior to being
repealed, §1034(a) read as follows:
If property (in this section called ‘old residence’) used by the taxpayer as his principal
residence is sold by him and, within a period beginning 2 years before the date of such sale
and ending 2 years after such date, property (in this section called ‘new residence’) is
purchased and used by the taxpayer as his principal residence, gain (if any) from such sale
shall be recognized only to the extent that the taxpayer’s adjusted sales price (as defined in
subsection (b)) of the old residence exceeds the taxpayer’s cost of purchasing the new
residence.
A critical point of difference between the current version of §121 and its predecessor §1034
concerns whether a house needs to be the principal residence of the taxpayer at the exact time it is
sold. Section 121’s reference to the sale of property used as a principal residence two years out of
five makes it clear that the property need not be used by a taxpayer as his principal residence at
the exact time of the sale.
Could the IRS argue, however, that Congress never intended the capital gains exclusion on
sale of a principal residence to apply to properties converted to business use or income-producing
activity? In the landmark case Robert G. Clapham, 63 TC 505 (1975), the Tax Court referenced
the legislative history of §1034 to note that Congress originally designed the capital gains
exclusion to apply to non-business properties:
The term ‘residence’ is used in contradistinction to property used in trade or business and
property held for the production of income. Nevertheless, the mere fact that the taxpayer
temporarily rents out either the old or the new residence may not, in the light of all the facts
and circumstances in the case, prevent the gain from being not recognized. H. Rept. No.
586, 82d Cong, 1st Sess, p. 109 (1951); S. Rept. No. 781 (Part 2) 82d Cong., 1st Sess. P. 32
(1951).
A similar intent can be implied to the §121 exclusion, which Congress originally enacted to provide
relief to elderly individuals scaling back their lifestyles similar to that available under §1034 to
young families trading up their homes:
While present law generally provides adequately for the younger individual who is for one
reason or another changing residences, it does not do so for the elderly person whose family
has grown and who no longer has need for the family homestead.
The IRS tried to use the legislative history of §1034 to argue that if a property qualified for the
capital gains exclusion under §1034 then it by definition was not being held for the production of
income. This argument was rebuffed by the U.S. Court of Appeals, Ninth Circuit in Bolaris v.
Commissioner, 85-2 USTC ¶9822, (CA-9, 1985). At issue was whether a homeowner who
qualified for a §1034 exclusion could also claim temporary rental expenses as business expense
deductions. The court not only stated that
We read the legislative history of §1034 as stating that a former residence could qualify for
non-recognition of gain even if the residence was temporarily rented and also qualified as
being held for production of income,
but also added:
Congress…easily could have included a provision stating that application of §1034
precluded rental expense deductions under §§167 and 212. Congress did not draft such a
provision and we refuse to imply one. We therefore reject the IRS’ argument that a
residence which qualifies for non-recognition of gain cannot also be held for the production
of income. If the IRS wants such a rule, it should ask Congress to enact it.
Bolaris’ reference to temporary rentals in its reading of legislative intent is problematic. As
the Tax Court noted under Clapham: “the difficult issue is what Congress meant by the word
‘temporary.’” In granting the Clapham taxpayers §1034 exclusion, the Tax Court emphasized the
following facts:
•
Rental was necessitated by the taxpayers’ financial circumstances when the house did not
initially sell;
•
One of the rental leases granted included a purchase option;
•
The property “stood vacant for substantial periods of time in order to facilitate sales efforts
by the real estate broker”;
•
The taxpayers accepted the first reasonable purchase offer they received.
Similarly, in that portion of the original Tax Court decision, Stephen and Valerie Bolaris, 81 TC
840 (1983), which was affirmed by the Ninth Circuit in Bolaris, the Tax Court noted that the
taxpayers:
• “Began trying to sell their old residence several months before their scheduled move”
•
“Always wanted to sell their house as soon as they had received a reasonable offer”
•
Experienced “a complete lack of offers to purchase the property and a continued need for
cash…arising from the ownership of both their old and new residences”
•
“Suspended their rental efforts and left the house vacant to facilitate its sale”
•
Accepted the first available offer to purchase the property.
In comparison, the Tax Court in Bolaris referenced R. Joe Rogers, 45 TCM 318 (1982), as an
example of a case where the facts and circumstances did not support a finding that rentals of a
residence prior to sale were temporary. In Rogers, the court found the following facts critical in
distinguishing the case in hand from Clapham:
• The taxpayers rented out their home “more or less continuously’ under 1-year leases
•
Attempts to sell the house were limited to short periods prior to the expiration of rental
leases
•
The “petitioners presented no evidence…that financial circumstances forced them to rent
out their home”
•
The asking price of the house was increased over time to reflect an escalating real estate
market
•
When the taxpayers did drop the asking price of the home, they did not sacrifice any
economic benefit, but passed the lower revenues onto their new realtor.
Similarly, the court under Rogers noted the following facts of Richard T. Houlette, 48 TC 350
(1967), as unfavorable examples: rentals were continuous; purchase offers were declined when
they did not meet the seller’s asking price, and efforts to sell the home were limited to short periods
of time between rentals.
It seems clear from existing case law that, under certain circumstances that can be characterized
as temporary, rentals of a principal residence, even if such rentals generate business income, do
not contradict Congressional intent in granting a capital gains exclusion under §1034 (and, by
extension, §121). Yet there is nothing in the Code itself or authoritative law to prevent a taxpayer
from claiming a §121 exclusion under other circumstances. One could echo the Ninth Circuit Court
of Appeals in Bolaris by stating “Congress…easily could have included a provision” clarifying its
intent regarding the interim rental of a home which ultimately qualifies upon sale for a §121
exclusion, and that “if the IRS wants such a rule, it should ask Congress to enact it.”
Section 162 authorizes a deduction for ordinary and necessary expenses of carrying on a trade
or business. Section 212 permits a deduction for all the ordinary and necessary expenses paid or
incurred for the production of income. Section 167(a) allows a depreciation deduction for property
that is either used in a trade or business or held for the production of income. To constitute a trade
or business or an income-producing activity, the activity must be entered into for profit (see Dogett
v. Burnett, 3 USTC ¶1090, (CA-DC, 1933)). A profit motive is the only requirement to establish
existence of an income-producing activity. But business status requires both a profit motive and a
sufficient degree of taxpayer involvement in the activity. The courts have held in Reg. §1.183-2(a)
that the taxpayer simply is required to pursue the activity with a bona fide intent of making a profit.
Mr. Gates’ rental activity may not qualify for a business activity if he does not devoted a major
portion of time to the rental activity or the rental activity may not be regular or continuous. But
will Mr. Gates’ rental activity be an income-producing activity?
In Bolaris, the taxpayers listed their old residence with a real estate broker in July 1977 and
began construction of a new residence. When the old residence was not sold within 90 days, they
rented it on a month-to-month basis and continued their efforts to sell. The property was rented
from October 1977 until May 1978 and was ultimately sold in August 1978. The IRS disallowed
claimed deductions for depreciation, insurance and miscellaneous expenses in excess of rental
income. As noted in the original Tax Court ruling, the reason was that the rental of the home “was
not entered into as a trade or business or for the production of income. In Held, the taxpayers did
not rent the old residence with the primary objective of making a profit.”
The decision denying depreciation and rental expense deductions was reversed and remanded.
The Ninth District Court of Appeals concluded that rental expense and depreciation deductions
were improperly denied. In William W. Grant, 84 T.C. 809 (1985), the Tax Court set forth a nonexhaustive list of five factors to be considered in determining whether an individual has converted
to property held for the production of income:
• The length of time the house was occupied by the individual as his residence before
placing on the market for sale;
• Whether the individual permanently abandoned all further personal use of the house;
• The character of the property (recreational or otherwise);
• Offers to rent;
• Offers to sell.
The Tax Court held that, several factors strongly support the conclusion that the Bolaris possessed
the requisite profit-motive based upon their rental of the old home. First, his case involved both
offers to rent and offers to sell. More importantly, the Bolaris actually rented their home at fair
market rental. As the Tax Court’s majority opinion recognized, “renting the residence at its fair
market value would normally suggest that the taxpayer had the requisite profit motive. Second, the
Bolaris permanently abandoned the old home when they moved to their new residence. Third, the
old home offered no elements of personal recreation.” The Tax Court viewed the Bolaris’ ancillary
desire to sell the old home as an insignificant factor in determining their profit motive. This
conclusion was supported by James J. Sherlock, 31 TCM 383 (1972). In Sherlock, the taxpayers
abandoned their old residence in Nov. 1964 and offered it for sale for the first ninety days. When
no offers to buy were received, the old residence was offered for rent or sale until it was finally
sold in Nov. 1966. The rental price sought was found to be reasonable but the home was never
actually rented. The Tax Court permitted rental expense deductions under §§167 and 212 even
though the taxpayers intended to sell the home.
The facts in Mr. Gates’ case are quite similar to the facts presented in Bolaris. Mr. Gates
had permanently abandoned the old home when his family moved to their new residence. The
rental of his old home will offer no elements of personal recreation. His rental activity is motivated
by his hope for profit because he needs to financially support the mortgages of both the old house
and the new house. But he has to rent his house at fair market value for the rental to be considered
for the production of income. Mr. Gates will bear the burden of proof for his profit motive. From
the above analysis, his rental activity is quite likely to be considered an income-producing activity.
As a result, property taxes and interest on mortgage of old residence are fully deductible as
itemized deductions. Depreciation expense, insurance, house maintenance and utilities and other
miscellaneous expenses are deductible as rental expenses.
Section 469(c)(2) specifies that passive activity includes any rental activity. Section 469(i)
provides an exception to the passive activity rules for rental real estate activities of the small
investor. Under the exception, a taxpayer who actively participates may deduct up to $25,000 of
losses attributable to rental real estate annually. But the $25,000 allowance is reduced by 50
percent of the excess of the excess of the taxpayer’s A.G.I. over $100,000. As Mr. Gates files a
joint return and has a taxable income of more than $283,150, he can deduct no losses from rental
his old home.
According to Reg. §1.167(g)-1, where property used for personal purposes is converted to use
in business or the production of income, the basis for depreciation purposes is the lesser of the fair
market value or the adjusted basis at the time of conversion. For Mr. Gates, the lesser will be the
adjusted basis at the time he rents out the house. Under §168(a), taxpayers generally must use
MACRS to compute depreciation for all tangible property, both real and personal, new or used, if
the property was acquired after 1986. Section 168(c) sets a uniform recovery period of 27.5 years
for residential rental property. Real property is depreciated using the straight-line method. Section
168(d)(2) specifies that mid-month convention apply to residential rental property. So if Mr. Gates
places his house in rental activity on April 4, 2000, the first year depreciation rate is 2.576% which
is straight-line rate (1/27.5) multiplied by mid-month convention (8.5/12).
Although §121 grants an exclusion of gain from the sale of the principal residence under certain
conditions, §121(d)(6) specifies that §121 shall not apply to so much of the gain from the sale of
any property as does not exceed the portion of the depreciation adjustments attributable to periods
after May 6, 1997. Section 1250(b)(3) defines depreciation adjustments as adjustments attributable
to periods after December 31,1963, reflected in the adjusted basis of such property on account of
deductions allowed or allowable to the taxpayer or to any other person for exhaustion, wear and
tear, obsolescence, or amortization. So after Mr. Gates takes depreciation deductions of rental
house, he can’t exclude the part of gain equal to any depreciation allowed or allowable as a
deduction at the time of sale.
Special consideration should be given to arrangements made with a purchaser under a rent-toown agreement. In considering the time frame stipulated under §121 during which a home must
be sold to qualify for the exclusion, a home may or may not be considered to have been sold based
on whether it was rented under an installment purchase plan or a lease with an option-to-buy
attached to it. The determining case is Baertschi v. Commissioner, 69-2 USTC ¶9461, (CA-6,
1969 ), in which the U.S. Court of Appeals, Sixth Circuit relied on another decision of the Sixth
Circuit, Commissioner v. Segall, 114 F.2d 706 (6th Cir. 1940), to reject a more restrictive measure
of when a sale has been consummated proposed by the Second Circuit in Commissioner v. Union
Pacific Railroad, 86 F.2d 637 (2d Cir. 1936). While Union Pacific required the seller to have the
unqualified right to sue the purchaser for full payment on default:
The delivery of the deed may be postponed and payment of part of the purchase price may
be deferred by installment payments; but for taxing purposes it is enough if the vendor
obtains under the contract the unqualified right to recover the consideration,
Segall asserted:
There are no hard and fast rules of thumb that can be used in determining, for taxation
purposes, when a sale was consummated, and no single factor is controlling; the
transaction must be viewed as a whole and in light of realism and practicality.
The court under Baertschi found the following facts compelling according to the standard of
Segall: the purchasers did not consider the contract they signed to be an option; had absolute right
to title on payment of the purchase price; had paid at least 29% of the purchase price as of the date
in question; and had received from the sellers “full control of the property,” including “full
responsibility for taxes and insurance” and the right to make or remove improvements to the
property without the sellers’ permission. A sale was therefore deemed to have taken place even
though the purchasers would have forfeited their previous payments and failed to gain title if they
had defaulted under the installment agreement. The court further noted that Segall had been upheld
by the Second Circuit in Morco Corp. v. Commissioner, 300 F.2d 245 (2d Cir. 1962).
The IRS cited Baertschi in Letter Ruling 8152103 (September 30, 1981) to grant a §1034
exclusion to a taxpayer wishing to date the purchase of his new home as of the date of a down
payment on an installment sales plan. In contrast, the Tax Court under James T. Ryan, 70 TCM
1502 (1995), expressly denied the taxpayers’ attempt to rely on Baertschi to treat an option
agreement as a sale:
the [purchasers] believed the agreement was an option agreement. The fact that and the
[purchasers] expected that the [purchasers] would exercise the option does not change the
fact that it was an option…Until the [purchasers] exercised the option, their payments of
petitioners’ mortgage (including property taxes and liability insurance) were rent payments
on the leasehold.
Although the purchasers under Ryan did have the right to obtain title upon payment of the full
purchase price, the court found that “an insufficient range of benefits and burdens of
ownership passed to the [purchasers] before title passed…for us to find that the date of sale
preceded that date,” noting, among other facts, that the “purchasers did not have the right to
improve the property without the petitioners’ consent.”
IV. Conclusion (note that the conclusions are numbered to match the issues)
1. Mr. Gates can rent his home while he is seeking to sell it without sacrificing his §121
exclusion. Under §121, Mr. Gates has until March 1, 2003 to sell his old home if he is to
qualify for the capital gains exclusion. The maximum possible gain on the sale easily falls
within the $500,000 cap for married taxpayers filing jointly under §121(b)(2). Rental
would be viewed especially favorably in light of Congress’ original intent in granting a
§121 exclusion if made on a short-term basis, accompanied by continuous efforts to sell at
the first reasonable offer. Mr. Gates should plan on living in his Atlanta home until at least
2 years after the sale of his Indianapolis home, unless he is forced to move because of a
change in employment, health reasons, or other unforeseen circumstance, which would
qualify under §121(c)(2)(B).
2. Mr. Gates’ home rental will quite likely to be considered an income-producing activity if
he rents out his home at fair market value. Property taxes and interest on mortgage of old
residence are fully deductible as itemized deductions; rental expenses, including
depreciation, property insurance, house maintenance and utilities and other miscellaneous
expenses are deductible, but only to the extent of the amount of rental income from the
property.
3. As Mr. Gates files a joint return and has taxable income over $283,150, he can deduct no
losses from rental of his old home.
4. The annual depreciation expense related to rental of the home should be calculated
according to the straight-line method, using a recovery period of 27.5 years and the midmonth convention. Gain attributable to depreciation is taxable at the time of sale of old
home.
5. If Mr. Gates plans to entertain an offer of rental towards purchase, he must be careful to
structure it as an installment sale and not as a lease with option-to-buy. Although the buyer
will forfeit any payments made under an installment sale without gaining title if he defaults
on the purchase, a sale will still be deemed to have been made.