Immigration Reform and the Current Form I-9 Rules
Know Your Form I-9 Rules
Request the Right Document
Understand USCIS Receipts as Alternative Documents
Know What You are Not Responsible For
Immigration Reform and the Current Form I-9 Rules

Recent developments in the push for immigration law reform could affect employers in significant ways, as proposed legislation would call for penalties for employers who hire undocumented workers. Congress is considering approving a plan that would require employers to check every worker’s Social Security number or immigration work permit against a new federal computer database. With the prospect of significant immigration law reform in the near future, a review of the procedures for verifying a worker’s legal status is certainly appropriate. Here are some of the important points to remember:

Know Your Form I-9 Rules

The Immigration Reform and Control Act (IRCA) provides that, for each employee hired after November 6, 1986, both the employer and employee must complete a U.S. Office of Citizen and Immigration Services Form I-9, Employment Eligibility Verification. On the Form I-9, the employer attests that: (1) it has examined the documents presented by the employee, (2) the documents appear to be genuine, and (3) the employee began work as of a certain date, and, to the best of the employer’s knowledge, the employee is eligible to work in the United States.

Employers must ensure that Section 1 of Form I-9, Employee Information and Verification, is completed by the employee upon date of hire (i.e., first day of paid work). The signature and attestation under penalty of perjury portions of Section 1 are very important, and employers should take special care to ensure that employees complete these in full. Although employers are held responsible for deficiencies of information in Section 1 (i.e., where required information is not provided by the employee), they may not require employees to produce documents to verify Section 1 information.

Employers must retain the I-9 for the longer of (1) three years after the date the individual was hired, or (2) one year after the individual was terminated. Forms I-9 may be kept on microfilm or microfiche so long as they are readable and the employer makes available a reader-printer for inspectors [8 CFR 274a.2]. See RIA Payroll Guide ¶ 20,420 for common questions and answers about Form I-9.

Request the Right Document

An employer or referral agency must verify that an individual it has hired is authorized to work in the United States by examining documents that show both (1) the identity of the individual, and (2) the individual’s right to work in the United States. On the back of Form I-9 are three lists of documents. List A includes documents which establish both identity and work authorization, List B includes documents which establish identity only, and List C includes documents which establish employment authorization only. Employers may request documents from these lists only [8 USCS 1324b(a)(6)]. Once an employee produces the appropriate documents, employers cannot reject them and ask for different documents unless they know that the documents are fraudulent or do not relate to the applicant presenting them. See RIA Payroll Guide ¶ 20,385 for a complete discussion of verification documents.

Understand USCIS Receipts as Alternative Documents

When an applicant applies for a document, the U.S. Office of Citizen and Immigration Services initially issues a receipt for the application. These receipts generally are not acceptable as proof of identity or work eligibility. However, employers may accept the following receipts in lieu of Form I-9 documents:

(1) A receipt for the application of a replacement document if the required document was lost, stolen, or damaged. The replacement document must be presented within 90 days of the hire or, in the case or reverification, the date employment authorization expires.

(2) The arrival portion of the Form I-94 containing an unexpired temporary I-551 ADIT stamp (indicating temporary evidence of permanent resident status), with the worker’s picture attached, may be accepted as a receipt. Form I-94 is a form given to people whose employment is authorized pending a decision on an asylum or refugee claim, or whose stay in the United States is authorized by the USCIS under its power to grant hardship relief. This receipt satisfies the I-9 documentation presentation requirement until the expiration date on the Form I-94. If no expiration date is indicated, an employer may accept the receipt for one year from the issue date of the Form I-94.

(3) Form I-94 with a refugee admission stamp is acceptable as a receipt for 90 days, within which time the employee must present an unrestricted Social Security card, together with a List B identity document or an Employment Authorization Document (Form I-688B or I-766).

Know What You are Not Responsible For

Employers are not expected to ascertain the legitimacy of documents presented during the verification process. They need only verify that each document examined appeared on its face to be genuine and that they relied on it in good faith. Employer determinations of the authenticity of documentation will be judged on a “reasonable man” basis (i.e., could the average person reasonably believe that the document is authentic). If an applicant for employment or for employment referral cannot or will not produce identity or employment authorization cards, it is unlawful to hire or refer the individual. However, nothing in the law requires the employer or referral agency to alert immigration authorities or other agencies as to the individual’s possible status as an illegal or unauthorized alien.

Introduction

Foreign investors are attracted to U.S. real estate because it has many advantages including income potential, appreciation, and future gains upon sale. However the U.S. tax laws and regulations impose very complex rules and requirements on foreign investors and their agents, including withholding, reporting, and special taxes upon the sale of U.S. real estate. We have prepared this material to explain which transactions are subject to taxation, and the responsibility of the foreign investor and his agents

U.S. TAX ALERT

IRS reminder on foreign financial account reporting requirements

Fact Sheet 2007-15

Noting that more and more people in the U.S. have foreign financial accounts, an IRS fact sheet reminds them that they may have to report their accounts to the government, even if the accounts don’t generate any taxable income. The fact sheet explains who must report and when, and the penalties for noncompliance.

Who must report. A U.S. person who owns a foreign bank account, brokerage account, mutual fund, unit trust, or other financial account must file a Form TD F 90-22.1, Report of Foreign Bank and Financial Authority (FBAR), if (1) he has financial interest in, signature authority, or other authority over one or more accounts in a foreign country, and (2) the aggregate value of all foreign financial accounts exceeds $10,000 at any time during the calendar year.

RIA observation: Those who have a one or more foreign accounts holding assets that fluctuate greatly in value and that are close to the limit may have to monitor them very closely to know whether the $10,000 threshold has been exceeded at any time during a particular year. That’s because, if the threshold is exceeded on any day, reporting is required even if the value falls below the threshold for the rest of the year.

A U.S. person is a U.S. citizen or resident, or any domestic legal entity such as a partnership, corporation, estate or trust.

A foreign country includes all geographical areas outside the U.S., the Commonwealth of Puerto Rico, the Commonwealth of the Northern Mariana Islands, and the territories and possessions of the U.S. An account in an institution known as a “ United States military banking facility” is not considered an account in a foreign country.

When to report. The FBAR is not an income tax return and should not be mailed with any income tax returns. It must be mailed on or before June 30 of the following year to U.S. Department of the Treasury, P.O. Box 32621, Detroit, MI 48232-0621. Requests for an extension of time to file an FBAR are not granted.

Penalties for failing to file. Account holders who do not comply with the FBAR reporting requirements may be subject to civil penalties, criminal penalties or both. The maximum civil penalty for a willful violation of the FBAR reporting and recordkeeping requirements is now the greater of $100,000 or 50% of the balance in the account at the time of the violation. Non-willful violations can result in a penalty as high as $10,000 for each violation. Criminal violations can result in a fine and/or five years in prison.

U.S. TAX ALERT

FBAR—foreign bank account reporting obligations: a primer for the practitioner

While it is generally understood that U.S. persons are obligated to file income tax returns with IRS on an annual basis, it is not as well understood that such persons may have additional reporting requirements if they have an interest in a foreign financial account. Form TD F 90-22.1, the “Report of Foreign Bank and Financial Accounts” and more commonly known as the FBAR, must be filed by U.S. persons on an annual basis if at any point during the calendar year they have an ownership interest in or signature authority over a financial account (or several such accounts) in a foreign country, with an aggregate value in excess of $10,000 (the “FBAR requirements”). Failure to file the report is punishable by both civil and criminal penalties.

Even though many professionals may be aware of the need to file the FBAR, there is much confusion surrounding the breadth of the reporting requirement. For example, multiple persons may be responsible for filing a FBAR to report the existence of the same financial account. Additionally, there are questions regarding who qualifies as a U.S. person, what constitutes signature authority over a financial account, and what is classified as a foreign account.

Notwithstanding any ambiguity regarding the FBAR requirements, the responsibility to file a FBAR currently falls on the taxpayer. If, however, Section E of the report by the Joint Committee on Taxation entitled “Additional Options to Improve Tax Compliance” (the “JCT Report”) should be enacted, tax practitioners will be placed squarely on the front line. The JCT Report proposals would put the responsibility for determining whether a taxpayer has a FBAR filing requirement on tax preparers, by extending to the FBAR the Code Sec. 6695(g) due diligence requirement, which currently imposes the responsibility on preparers to determine a taxpayer’s eligibility for the earned income tax credit as well as the amount of the credit permitted. Consequently, preparers would have to become intimately familiar with the FBAR requirements. Practitioners would be liable for (1) discussing with taxpayers the FBAR filing requirement as well as the civil and criminal penalties for failure to file the FBAR, and (2) documenting taxpayers’ responses to such discussions as well as retaining such documentation for IRS’s possible use in an audit.

Origin of the FBAR requirements. The FBAR is a by-product of the Bank Secrecy Act (BSA), which was first enacted in ’70. Congress created the BSA because of concern that financial institutions in tax haven jurisdictions were being used by U.S. persons to hide the proceeds of their illegal activities, evade tax, and for other criminal purposes. BSA § 5314 required Treasury to create forms that financial institutions and individuals would have to file that ultimately could be used by the government to track the movement in cash in the economy and crack down on nonfilers. The BSA specifically imposed responsibility on Treasury to promulgate regulations that would promote compliance and be useful in criminal, tax, regulatory, intelligence, and counter-terrorism matters, as well as to counter money laundering. 31 C.F.R. § 103.24 contains the requirement for a FBAR to be filed:

“(a) Each person subject to the jurisdiction of the United States (except a foreign subsidiary of a U.S. person) having a financial interest in, or signature or other authority over, a bank, securities or other financial account in a foreign country shall report such relationship to the Commissioner of the Internal Revenue for each year in which such relationship exists, and shall provide such information as shall be specified in a reporting form….”

The FBAR is filed with IRS’s Detroit Service Center, and the information on the return is entered into a FBAR database that is administered by both IRS and Financial Crimes Enforcement Network (“FinCEN”). Once entered, the information can be accessed by multiple governmental authorities for purposes of tracking the flow of money.

Early in 2003, FinCEN delegated its enforcement authority for FBARs to IRS. The delegation was the culmination of a study imposed on Treasury by the USA Patriot Act to find ways to improve compliance with reporting requirements. IRS now has the ability to investigate noncompliance with the FBAR, assess and collect civil penalties associated with such noncompliance, and use the full investigative arsenal available to it.

Who is subject to the FBAR requirements? The FBAR requirements apply to any “ U.S. person,” which includes all U.S. citizens and resident aliens. Nonresident aliens are not required to file a FBAR. Consequently, an individual who otherwise would qualify as a nonresident alien must be careful to avoid being classified as a resident alien under the substantial presence test of Code Sec. 7701(b)(3) and thus subjected to the FBAR requirements (and related penalties for failure to comply).

The substantial presence test provides that an individual becomes a resident if he or she is physically present in the U.S. for 183 or more days during the current tax year. An individual not physically present in the U.S. for 183 days or more during the current tax year, still may satisfy the substantial presence test under a three-year look-back. The rule requires the individual to be physically present in the U.S. during the current tax year for at least 31 days, and for a total of 183 days over a three-year period that includes the two preceding calendar years.

For purposes of the FBAR requirements, a U.S. person also includes all U.S. estates, trusts, partnerships, and corporations. Thus, if any of these domestic entities has an interest in or authority over a financial account worth more than $10,000, the entity must file a FBAR. Similarly, it is possible that the authorized representative of any of these domestic entities will have a personal filing requirement as a result of the affiliation with the entity (discussed in greater detail, below).

LLCs are not specifically classified as U.S. persons under the FBAR requirements. Nevertheless, since these entities are taxed as corporations, partnerships, or to the entity owner (i.e., a single-member LLC treated as a disregarded entity), it would appear as though the members of such entities would have a reporting requirement based on the entity’s classification for income tax purposes. In the absence of specific IRS guidance, members of an LLC would be well advised to take the conservative approach and file a FBAR if the LLC otherwise meets the FBAR requirements.

U.S. jurisdictions. For purposes of proving residency in a U.S. possession, territory, or commonwealth (“U.S. jurisdictions”), Code Sec. 937 and the Regulations thereunder specify that time spent in a U.S. jurisdiction is deemed to be time spent outside of the U.S. Additionally, time spent in a U.S. jurisdiction will not qualify as time spent in the U.S. for purposes of the substantial presence test. By contrast, for FBAR purposes each U.S. jurisdiction is deemed to be part of the U.S. Consequently, contrary to what would be expected pursuant to Code Sec. 937 and Code Sec. 7701, financial accounts in U.S. jurisdictions are not deemed to be foreign accounts and thus are not subject to FBAR reporting.

What types of accounts have to be reported? Generally, any type of account that holds liquid assets or marketable securities will be a “financial account” for purposes of the FBAR requirements. Thus, everything from a cash account to a foreign mutual fund, such as an exchange traded fund, is classified as a financial account.

Signature or other authority. If an individual can order the distribution or disbursement of funds or other property from the institution where the funds or property are maintained, by signing a document providing such direction (or in conjunction with one other person signing the document), that individual has signature authority over the financial account. Similarly, if an individual can exercise the same control verbally or via other means of communication, the individual has other authority over a financial account.

These powers should not be confused with the power of investment. Individuals who can make investment decisions but who do not have the ability or discretion to make disbursements do not have a FBAR reporting requirement. Notwithstanding the foregoing, the JCT Report would treat a U.S. person as having signature or other authority over a foreign account if the U.S. person creates a trust with a foreign protector. Specifically, the JCT Report will attribute any duties and powers held by the foreign protector to the U.S. person.

In summary, an individual who holds a power of attorney or who is a custodian of an account for a minor would appear to have the ability to exercise sufficient powers that would cause the attorney-in-fact or custodian to have a FBAR reporting duty. Similarly, a trustee, personal representative, president of a corporation, president of a general partner or managing member of an LLC, to name but a few individuals by title, could be deemed to have signature authority or other authority over a financial account held by the entity and thus a reporting obligation.

Financial interest. The definition of what constitutes a financial interest for purposes of the FBAR is based on who owns the interest. For example, a foreign pension account satisfying the FBAR requirements and which is owned by an employer or a foreign government would not have to be reported by a U.S. person, since the U.S. person does not have any ownership over the pension account. If, however, the employer maintains individual accounts for each employee, similar to a Code Sec. 401(k) account, the employee would have a filing requirement.

Essentially, an individual has a financial interest in every account for which the individual is the owner of record or has legal title, whether the account is for the owner’s benefit or for the benefit of another. There can be many situations in which several persons have an obligation to file a report with respect to the same account. For example, if the account is owned by more than one person, such as a joint account or an account held by tenants in common, each person has a financial interest for purposes of the FBAR. Similarly, if a U.S. person who owns a foreign bank account gave a power of attorney to another U.S. person to sign over the account, both the owner of the account and the individual exercising the power of attorney would have a reporting requirement. Multiple filings also would be required from the trustees of a trust with several trustees if the trust has an interest in a foreign financial account.

Individuals serving as shareholders, partners, and trustees also may be deemed to hold a financial interest in an account if the account is owned by or the individual with legal title is any of the following:

(1) A person acting as an agent, nominee, attorney, or in some other capacity on behalf of the U.S. person.
(2) A corporation in which the U.S. person owns more than 50% of the total stock either directly or indirectly.
(3) A partnership in which the U.S. person owns an interest in more than 50% of the profits.
(4) A trust in which a U.S. person has either a present interest in more than 50% of the assets or from which the U.S. person receives more than 50% of the income.

Thus, while the domestic entity that has a financial interest that otherwise meets the FBAR requirements will have to file a FBAR, it also is possible that the shareholders, officers, or directors of foreign corporations, partners in foreign partnerships, grantors of foreign trusts, or beneficiaries of a foreign trust or estate also will have to file the FBAR.

Due dates for filing a FBAR. If a U.S. person has a foreign account that satisfies the FBAR requirements, the FBAR is due on June 30 of the following year (with no extensions). The form is filed with the Detroit Service Center. The duty to file the FBAR is independent of the obligation to file an income tax return even though the FBAR is cross referenced on Form 1040, Schedule B, Part III.

A foreign account that satisfies the FBAR requirements must be reported even if the account does not generate taxable income. Thus, a taxpayer who fails to file a FBAR because the account generates no taxable income will be subject to penalty. IRS has six years within which to assess a civil penalty related to a FBAR violation. It is unclear, however, whether the statute will toll if the FBAR is not filed.

Penalties for failure to file. A taxpayer who fails to file a FBAR may be subject to both civil and criminal penalties under Title 31 of the United States Code. The same violation may be punishable by both a civil and criminal penalty.

Civil penalties. Prior to the Americans Jobs Creation Act of 2004 (AJCA), civil penalties were imposed on willful violations of the reporting requirement. The minimum penalty was $25,000 and the maximum penalty was $100,000. After the AJCA, there is now a penalty of up to $10,000 for a non-willful failure to file the FBAR. If, however, the amount of the transaction or the balance of the foreign account is reported on the taxpayer’s Form 1040, the penalty may be eliminated as a result of the reasonable cause exception. Nevertheless, Form 1040, Schedule B, Part III instructs a taxpayer who indicates that he or she has a financial account in a foreign country to review the FBAR. To satisfy the reporting necessitated for the reasonable cause exception, the taxpayer must be certain to include on the Form 1040 any income generated by the foreign account and to the extent possible a detailed explanation of the transaction.

For a willful violation of the FBAR reporting requirement, the penalty is now a fine equal to the greater of $100,000 or 50% of the amount of the transaction or of the balance of the account at the time of the offense. Violations that are deemed to be willful are not subject to the reasonable cause exception. In the event the suggestions in the JCT Report are enacted in their present form, it would appear that the availability of the reasonable cause exception would be severely curtailed absent documentation of extenuating circumstances (such as the taxpayer’s tax preparer advising the taxpayer that the FBAR was not required).

Criminal penalties. While the AJCA did not change any aspect of the criminal penalties, such penalties are premised on the violation’s being willful. Thus, if the failure to file the FBAR is deemed to be a criminal violation, the penalty can include a fine of up to $250,000, imprisonment for up to five years, or both. If the failure to file is deemed to be part of a criminal activity (i.e., it occurs during the violation of another law or is part of an illegal activity involving more than $100,000 in a 12-month period), the maximum fine increases to $500,000 and the possibility of imprisonment increases to up to ten years. There is, of course, a possibility that both the $500,000 penalty and ten-year jail term will be applicable.

To establish willfulness, the government must prove that the taxpayer had knowledge of the reporting requirement and in spite of such knowledge chose to ignore the requirement. Some courts, however, have held that the government may prove willfulness by demonstrating that the taxpayer consciously or recklessly disregarded the law.

Conclusion. While the FBAR requirements include some ambiguities and could be clearer, the major issue for taxpayers and their advisors is the general level of ignorance with respect to both the filing requirement itself and the substantial and ongoing penalties that may follow noncompliance. It is not advisable to continue violating the statute in hopes that IRS will provide an additional amnesty program in the future.

Source: Federal Taxes Weekly Alert (preview) 05/17/2007, Volume 53, No. 20

RESIDENCE FOR MEXICAN TAX PURPOSES

INTRODUCTION

Mexico offers various investment and business opportunities for U.S. entrepreneurs. In order to take advantage of these opportunities it may be necessary for U.S. nationals to stay in Mexico, and thus it is important to know what tax consequences can arise. We have prepared this material in order to explain the residency rules for U.S. individuals and companies that are present in Mexico.

FOREIGN INDIVUALS SUBJECT TO MEXICAN TAXATION

Under Article 1 of the LISR, individuals that are residents of Mexico are subject to Mexican income tax on their worldwide income. Non-resident individuals, on the other hand, are subject to Mexican income tax only on income derived from Mexican sources.

Mexican tax law under Article 9 of the CFF states that individuals who have established an abode in Mexico are considered residents of Mexico, regardless of the time spent in Mexico. However, if the individual also maintains an abode in another country, the individual’s “center of vital interest” will be used as the criteria for determining residence for tax purposes.

Center of vital interest is deemed to be situated in Mexico when more than 50% of the total income earned by the individual is Mexican source income or when the individual’s professional activities are centered in Mexico.

US-MEXICO INCOME TAX TREATY

In the case that an individual is considered to be a resident for tax purposes of both the U.S. and Mexico, special tie-breaker rules from the Income Tax Treaty apply. However, it should be mentioned that unlike Mexico, the U.S. does not treat the Treaty as a primary source of tax law. Article 4 of the treaty states that where an individual is a resident of both contracting States, then his residence shall be determined as follows:

The individual shall be deemed to be a resident of the State in which that person has a permanent home available; if a permanent home is available in both contracting States, then the individual shall be deemed to be a resident of the State with which the person’s personal and economic relations are closer (center of vital interests);

If the State in which the center of vital interests cannot be determined, or if the person does not have a permanent home available in either State, then the deemed residence will be in the State in which the person has a habitual abode;

If a habitual abode exists in both States or in neither of them, then the deemed residence will be in the State of which the individual is a national;
In any other case, the competent authorities of the contracting States shall settle the question by mutual agreement.

These tie-breaker rules only apply to individuals, not to companies; if a company holds residence in both countries than it is deemed to not be a resident of either and therefore it cannot avail itself of the benefits of the tax treaty.

FOREIGN COMPANIES SUBJECT TO MEXICAN TAXATION

A company that is organized under the laws of a foreign country is presumed to be a nonresident for Mexican tax purposes and not subject to Mexican tax unless it establishes a nexus with Mexico that causes it to be subject to Mexican taxation.

Article 9 of the CFF states that a foreign company will be deemed to be a resident if it establishes its administration or place of management in Mexico, such as in the following circumstances:

1. If the shareholders’ or board meetings are held in Mexico;

2. If the individuals that make day-to-day management, control or administrative decisions for the legal entity are tax resident in Mexico or have their offices in Mexico;

3. If the entity has an office in Mexico at which the administration or control of the entity is carried out; or

4. If the accounting records are maintained in Mexico.

A company will cease to be a resident of Mexico for tax purposes when it establishes its administration or place of management in another country, giving rise to the following consequences:

In accordance with Article 12 of the LISR, the company will be deemed to have been liquidated, and must include in its tax base the assets of the establishment located in the foreign country, such assets will be valued at their fair market value on the date in which the residency was changed or the appraised value if the fair market value cannot be determined. This is to avoid the transfer of income to foreign countries which where generated in Mexico and are legally obligated to Mexican tax.

PERMANENT ESTABLISHMENT

A foreign company or individual will be subject to Mexican tax if it is considered to be operating in Mexico through a “permanent establishment.” The permanent establishment concept enables Mexico to tax income earned by foreigners that is attributable to a permanent establishment as if the foreign company or individual were a Mexican resident.

Article 2 of the LISR provides that a nonresident company will be treated as having a permanent establishment if it maintains a fixed place of business in Mexico through which it conducts business operations. A fixed place of business is defined as a branch, an agency, an office, a factory, a workshop, an installation, a mine, a quarry, or any other place of exploration or extraction of natural resources. The determination of whether a permanent establishment exists is based on the overall facts and circumstances.

Additionally the LISR under Article 2 provides that a nonresident company may be deemed to have a permanent establishment if it operates in Mexico through a dependant agent. A dependant agent is deemed to create a permanent establishment if the agent has the power to enter into contracts, in the name or on behalf of the nonresident company, with respect to business activities that are not preliminary or auxiliary to the nonresident company’s business activities. Further, an independent agent will create a permanent establishment if it is not acting in its ordinary course of business.

A fixed base of business is treated as a permanent establishment and is taxed in the same manner. A fixed base is any place where independent personal services of a scientific, literary, artistic, educational or pedagogical nature are rendered. A fixed place of business also includes any place where independent professional services are rendered.

A foreign corporation engaged in a construction, supervision or inspection project is considered to have a permanent establishment in Mexico if the project lasts for more than 183 days during a consecutive 12-month period. When a foreign resident performs construction related services in Mexico and a portion of these services are subcontracted, the time spent by subcontractors must be included in the calculation of the 183 days for purposes of determining whether a permanent establishment exists.

CONCLUSION

The determination of whether a U.S. national is subject to Mexican taxation on his or her worldwide income is based on whether “residency” exists. The determination of “residency” differs for individuals and companies. An individual must make a careful determination as to whether they have established an abode in Mexico and whether their center of vital interests lies in Mexico. A company’s residency is determined by the location of its administration or place of management. However, a non-resident individual or company may still be subject to Mexican income tax if it establishes a permanent establishment in Mexico as to its sources of income derived from the permanent establishment.

THE FLORES LAW FIRM
BUSINESS & TAX ATTORNEYS

Real Estate Professionals-Alert

This Client Alert is for investors that have a number of rental real estate properties that are generating losses and would like to deduct the losses against other income for tax purposes.

PASSIVE LOSS LIMITATIONS FOR REAL ESTATE

As you may be aware, the passive activity loss (PAL) rules would normally make this impossible. Under those rules, losses from passive activities—that is, activities in which you do not “materially participate” (see below)—cannot be deducted against nonpassive activity income (such as salary, professional fees, income from a business in which you do materially participate, interest, or dividends); and credits from passive activities cannot be used to reduce taxes on nonpassive activity income. For purposes of the PAL rules, rental real estate activities are automatically treated as passive activities, even if the owner “materially participates” in their management, operations, etc. As a result, tax losses from rental realty can’t be deducted against nonpassive income.

PASSIVE LOSS EXCEPTIONS

One important exception to this rule allows taxpayers to deduct up to $25,000 of losses and credits from passive rental real estate activities against nonpassive income, if they “actively participate” in those activities. (Active participation requires a lesser degree of participation than “material participation”). This exception phases out for taxpayers with adjusted gross income over $100,000.

EXCEPTION FOR REAL ESTATE PROFESSIONALS

There’s another exception to the above rule that’s even more potentially beneficial than the $25,000 active participation rule I just mentioned. If you qualify as a “real estate professional,” your rental real estate interests are not automatically treated as passive activities. As a result, if you materially participate in the rental real estate activity, the activity will not be treated as passive, and you will be entitled to deduct losses from that activity against nonpassive income. In addition, the amount of losses and credits allowed under the $25,000 active participation rule is determined after any recharacterization of rental real estate activities as nonpassive under the rules discussed above. As a result, if you’re a real estate professional, you can deduct against nonpassive income not only losses and credits from rental real estate that are nonpassive under the above rules, but up to $25,000 of losses and credits from “active participation” rental real estate activities that remain passive after application of those rules.

QUALIFICATION AS A REAL PROFESSIONAL

First, you must materially participate (see below) in a real estate business. The business of renting and leasing realty is a real estate business. Second, more than 50% of the personal services you perform in all businesses during the year must be performed in real estate businesses in which you materially participate. Third, your personal services in material participation real property businesses during the year must amount to more than 750 hours. For these purposes, you can’t count any work you perform in your capacity as an investor.

In determining whether you qualify as a real estate professional, each of your rental real estate interests is treated as a separate activity—that is, as a separate business—unless you make an election to treat all those interests as a single activity. Because of this rule, if you have multiple rental properties and you don’t make the election, you must establish material participation for each property separately, and must satisfy the more-than-50% test and the 750-hours test for each property separately in order to qualify as a real estate professional with respect to that property—and qualifying for one property wouldn’t mean you qualify for any other property. Thus, if you don’t make the election, qualifying as a real estate professional for all your properties becomes more difficult (and may become impossible) as the number of properties increases. But if you do make the election, you only have to establish material participation, and satisfy the more-than-50% test and the 750-hours test, for the combined properties as a whole.

PART TIME REAL ESTATE PROFESSIONALS

You don’t have to work full-time in real estate to qualify as a real estate professional. Even if you have another occupation, you can qualify if you materially participate in a real estate business, and spend more time, and more than 750 hours, on that business. (But remember, in this case, if you have multiple properties, it may be difficult or impossible to qualify unless you make the “single interest” election mentioned above.)

These tests are applied annually. This means that you may qualify as a real estate professional in some years but not in other years. As a result, the same real estate activity may generate passive losses in some years and nonpassive losses in other years.

If you qualify as a real estate professional, your rental real estate properties are not automatically treated as passive. This doesn’t mean that they are automatically treated as nonpassive—it means that, if you materially participate (as explained below) in the operation of a rental real estate property, then it will be treated as nonpassive, and you may deduct losses from that property against other nonpassive income.

But if the real estate business that qualifies you as a real estate professional is the renting or leasing of real property, as discussed above, you will already have established that you materially participate in that business—because if you don’t, you can’t qualify as a real estate professional on the basis of that business (see above).

MULTIPLE PROPERTIES – TAX ELECTION

As I mentioned above, if you have multiple properties, you may not be able to qualify as a real estate professional unless you elect to treat all your rental real estate interests as a single activity. If you make the election, it applies both for purposes of qualifying you as a real estate professional, and for all other purposes of the PAL rules. And, generally speaking, the election is irrevocable. This means that you can’t make the election in order to qualify as a real estate professional, and then revoke it with respect to a particular property later, when, for example, that property produces income, and you’d like to use that income to absorb losses from another non-real-estate-related passive activity. Making the election will also disqualify you from utilizing the $25,000 active participation rule mentioned above, because that rule applies only with respect to losses from rental real estate activities that are passive, and the election will—presumably—work to make your rental real estate properties nonpassive. (If making the election is the right course for you, I can make sure that it is made in a timely and proper fashion.)

MATERIAL PARTICIPATION REQUIRED

Material participation in an activity means involvement in the operations of the activity on a regular, continuous, and substantial basis. If a taxpayer passes one of the following seven tests, IRS accepts that as establishing material participation in an activity:
participating in the activity for more than 500 hours in the tax year (the most frequently utilized test);
participating in the activity if the taxpayer’s participation is substantially all of the participation in that activity by any individuals (including non-owners);
participating in the activity for more than 100 hours in the tax year, if nobody else (including nonowners) participated more;
participating significantly in the activity, if participation in all “significant participation” activities for the tax year exceeds 500 hours (but this test isn’t accepted for showing material participation in rental activities);
having materially participated in the activity during any five of the ten tax years before the year at issue;
with respect to personal service activities, having materially participated in the activity for any three years (not necessarily consecutive) before the year at issue;
showing regular, continuous and substantial participation on the basis of all the relevant facts and circumstances, but only if more than 100 hours of participation during the tax year can be shown (and management services aren’t taken into account for purposes of this test unless certain stringent requirements are satisfied).

RECORDS AND DOCUMENTATION OF MATERIAL PARTICIPATION

The extent of an individual’s material participation in an activity may be established by any reasonable means. But the most reliable means of showing material participation consists of contemporaneously kept appointment books, calendars, daily time reports, logs, or similar documents that provide a detailed account of what the taxpayer did with respect to an activity, when he or she did it, and how much time it took. Failure to substantiate material participation is one of the most common ways of losing the right to treat rental real estate activities as nonpassive.

This information is a presentation of the general rules and should not be used or relied upon for any particular investment or transaction. We recommend you consult your tax attorney or advisor for your specific situation. If you would like more information on these matters we would be glad to visit with you.

As required by United States Treasury Regulations, you should be aware that this communication is not intended or written by the sender to be used, and it cannot be used, by any recipient for the purpose of avoiding penalties that may be imposed on the recipient under United States federal tax laws.

THE FLORES LAW FIRM
Business & Tax Attorneys

U.S. TAX REFORM FOR 2008 – ALERT

INTRODUCTION TO 2008 TAX REFORM

As you probably know, Congress recently passed an economic stimulus package (the Economic Stimulus Act of 2008) which is intended to jump-start our economy, in part through tax incentives aimed at encouraging businesses to increase their investments in new equipment by the end of 2008. Under the Act, small businesses will be able to write off up to $250,000 of qualifying expenses in 2008. In addition, businesses will be able to deduct an additional 50% of the cost of certain investments in 2008. Here are the details.

SECTION 179 ELECTION IMMEDIATE EXPENSE FOR PROPERTY PURCHASED IN 2008

Under pre-Act law, taxpayers can expense (i.e., deduct currently, as opposed to taking depreciation deductions over a period of years) up to $128,000 for 2008. This annual expensing limit is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during 2008 exceeds $510,000. The expensing rules are eased for qualifying empowerment zone property, renewal property, and GO Zone property. The amount of the expensing deduction is limited to the amount of taxable income from any of the taxpayer’s active trades or businesses.

Under the Act, for tax years beginning in 2008, the $128,000 expensing limit is increased to $250,000, and the overall investment limit is increased from $510,000 to $800,000.

As a result of this incentive, most small businesses, and even some moderate-sized businesses with moderate capital equipment needs, will be able to obtain a full deduction for the cost of business machinery and equipment purchased in 2008, thereby reducing their effective cost for those assets. What’s more, there is no alternative minimum tax (AMT) adjustment with respect to property expensed under (Code Sec. 179 ).

BONUS DEPRECIATION FOR PROPERTY PURCHASED IN 2008

Bonus first year depreciation was first allowed following the terrorist attacks of 2001 but generally isn’t available for property acquired after 2004. (There are some exceptions, such as for qualified GO Zone property generally placed in service before 2008.)

The Act provides for bonus (accelerated) depreciation by allowing a bonus first-year depreciation deduction of 50% of the adjusted basis of qualified property placed in service after Dec. 31, 2007, and, generally, before Jan. 1, 2009. The basis of the property and the depreciation allowances in the year the property is placed in service and later years are appropriately adjusted to reflect the additional first-year depreciation deduction. The amount of the additional first-year depreciation deduction is not affected by a short taxable year. The taxpayer may elect out of additional first-year depreciation for any class of property for any taxable year.

The interaction of the additional first-year depreciation allowance with the otherwise applicable depreciation allowance may be illustrated as follows. Assume that in 2008 a taxpayer purchases new depreciable property and places it in service. The property’s cost is $1,000 and it is 5-year property subject to the half-year convention. The amount of additional first-year depreciation allowed under the provision is $500. The remaining $500 of the cost of the property is deductible under the rules applicable to 5-year property. Thus, 20 percent, or $100, is also allowed as a depreciation deduction in 2008. Accordingly, the total depreciation deduction with respect to the property for 2008 is $600. The remaining $400 cost of the property is recovered under otherwise applicable rules for computing depreciation.

Bonus depreciation is allowed for AMT purposes as well as for regular tax purposes. Additionally, bonus depreciation is permitted only for: (1) property to which MACRS applies that has an applicable recovery period of 20 years or less, (2) water utility property, (3) non-custom-made computer software, and (4) qualified leasehold improvement property. Original use of the property must begin with the taxpayer after Dec. 31, 2007. Additionally, the placed-in-service cutoff date is extended for an additional year (i.e., before Jan. 1, 2010) for certain property with a recovery period of ten years or longer and certain transportation and aircraft property.

LUXURY AUTO LIMITATIONS INCREASED

The otherwise applicable “luxury auto” cap on first-year depreciation is increased by $8,000 for vehicles that qualify.

I hope this information is helpful. If you would like more details about these aspects or any other aspect of the new law, please do not hesitate to call.

Very truly yours,

THE FLORES LAW FIRM
Business & Tax Attorneys

Dear Clients & Friends:

As you may know, Congress recently passed the Heroes Earnings Assistance and Relief Tax Act of 2008 (the 2008 Heroes Act). The Act provides targeted tax relief for military members and their families. What may be less widely known is that the tax benefits are offset (i.e., paid for) with tightened expatriation rules, a new rule requiring U.S. companies working under federal government contract to treat overseas employees as subject to employment taxes, and a higher failure to file penalty. Here is a quick overview of the revenue raising provisions in the new law:
Revision of tax rules on expatriation. U.S. citizens and long-term U.S. residents are subject to tax on their worldwide income. Taxpayers can avoid taxes by renouncing their U.S. citizenship or terminating their residence. The Act tightens the expatriation rules to ensure that certain high net-worth taxpayers can’t renounce their U.S. citizenship or terminate their U.S. residency in order to avoid U.S. taxes. Under this provision, high net-worth individuals are treated as if they sold all of their property for its fair market value on the day before they expatriate or terminate their residency. Gain is recognized to the extent that the aggregate gain recognized exceeds $600,000 (which will be adjusted for cost of living in the future). The provision, which applies for those who relinquish U.S. citizenship or terminate their U.S. residency on or after the enactment date, is estimated to raise $411 million over 10 years.
Certain domestically controlled foreign persons performing services under contract with United States government treated as American employers. The Act treats foreign subsidiaries of U.S. companies performing services under a U.S. government contract as American employers for employment tax purposes. Under the new law, the domestic parent is jointly liable for employment taxes imposed on the foreign subsidiary. The new provision applies to services performed in calendar months beginning more than 30 days after the enactment date and is estimated to raise $846 million over ten years.
Increases general failure to file return penalty. The Act increases the minimum penalty for a failure to file an individual tax return within 60 days of the due date to the lesser of $135 (up from $100) or 100 percent of the amount of tax required to be shown on the return, effective for tax returns required to be filed after 2008. The provision is estimated to raise $296 million over ten years.

I hope this information is helpful. If you would like more details about these provisions or any other aspect of the new law, please do not hesitate to call.

The Importance of an Appraisal

Provided By Leticia Smith

An appraiser is a professional person who can tell you what your home is worth. The appraiser will come to your house and list the number and size of the rooms and any extras, such as a fireplace, porch, pool, or garage. The appraiser will compare your home and property to other homes that have sold recently with similar features. The appraiser then estimates that your home might sell for approximately the same amount of money as similar homes. This is called an “appraisal.” In short, an appraisal is the estimated amount of money your home may sell for.

What is a Real Estate Appraiser?

A real estate appraiser is an impartial, independent third party who provides an objective report on the estimate of value of real estate. The appraisal is supported by the collection and analysis of data.

A real estate appraiser values real property (land, houses, buildings, etc.), not personal property (cars, jewelry, furniture). The appraiser determines the physical characteristics of the property to be appraised and estimates value based upon three common approaches to value:
Sales Comparison Market Approach
Cost Approach
Income Capitalization Approach
A state licensed real estate appraiser meets nationally established standards for education and experience, and successfully passes a comprehensive examination. A state licensed appraiser conforms to national ethical and professional standards, which establish the standards for ethics, competency and confidentiality governing professional appraisal practices.

Home Inspections Are Not Appraisals

A property appraisal is a document that provides an estimate of a property’s market value. Lenders require appraisals on properties prior to loan approval to ensure that the mortgage loan amount is not more than the value of the property. Appraisals are for lenders; home inspections are for buyers.

The Federal Housing Authority (FHA), which is part of the U.S. Department of Housing and Urban Development (HUD), requires lenders to obtain appraisals of properties securing FHA-insured loans. FHA requires appraisals for three reasons:
To estimate the market value of the property.
To make sure that the property meets FHA minimum property requirements/standards (health and safety).
To make sure that the property is marketable.

The FHA appraisal process will note property deficiencies that are readily observable and found not in compliance with HUD’s minimum property requirements/standards. These deficiencies may not be the same as those items noted in a home inspection report.

When Should I Use An Appraiser?

You will likely need the services of a real estate appraiser whenever an estimate of the value of your real estate is required. Most commonly, this occurs when you apply for a real estate loan, either to purchase or refinance your home. You may also need a real estate appraiser to assist in the appeal of your property tax assessment, for insurance purposes, for probate and estate settlements or other reasons.

What’s My Property Worth?

It is common to ask the appraiser this question as soon as the appraiser has inspected the property. The truth is at that time the appraiser doesn’t yet know. The inspection is the first step of many that the appraiser must complete before a value is determined.

The appraiser measures the house from the outside to determine square footage. The appraiser takes notes concerning the features of your house such as room layout, number of bedrooms, baths, etc. The appraiser also makes a determination of the general condition, appeal and functional layout of your house. All of these items are taken into consideration in the appraisal report.

How Long Does an Appraisal Take?

The physical inspection of a typical property usually takes about twenty to forty-five minutes. Sometimes an inspection can take longer if the house is difficult to measure or has some unique features that require additional investigation by the appraiser.

After the initial inspection of the property the appraiser spends time examining or analyzing the neighborhood or area. The purpose of this is to search for other properties that are similar to the property being appraised that have sold recently and examine neighborhood influences. When the fieldwork is finished, the appraiser completes the report at his office.

What Does The Appraiser Need to Know?

To help the appraiser complete the appraisal, you can provide some information that is helpful. Please tell the appraiser of any previous sale on the property within the last 12 months. Indicate if there is a pending contract to purchase on the property. Does the property have any right of way or other easements? Is there structural damage, or water leakage in the house? Is the property in a flood zone? Basically, inform the appraiser about any hidden features or detriments to the property.

How Do I Choose an Appraiser?

Although federal and state laws usually require that the lender must hire the appraiser when the appraisal is to be used for a real estate loan, some lenders will allow you to select an appraiser from their list of approved appraisers. For all other appraisals, you are allowed to select your own appraiser.

Licensed real estate appraisers can be found on the internet or by talking to your friends who have previously used an appraiser. Be sure to interview the appraiser carefully to determine if he or she is licensed and experienced in appraising your type of property.

Most licensed appraisers will provide an advance estimate of the cost to perform the appraisal, and many will commit to a fixed fee for the appraisal. It is always wise to obtain a written contract for services which includes a description of what is to be appraised, the scope of the assignment, the anticipated delivery date, the fee and terms of payment.

By Leticia K. Smith
Covenant Partners Realty

THE FLORES LAW FIRM
Business & Tax Attorneys

New law’s reduced homesale exclusion for nonqualified use will mean headaches for sellers years down the road

RIA Practice Alert

The “Housing Assistance Tax Act of 2008,” the 96-page tax title of the recently enacted “American Housing Rescue and Foreclosure Prevention Act of 2008” (P.L. 110-289) carries a couple of breaks for residential real estate—a new tax credit for “first-time” homebuyers and a new property tax deduction for nonitemizing homeowners—along with a controversial new restriction on the Code Sec. 121 exclusion. The restriction is intended primarily as a device to restrict or eliminate tax-free homesale profits for those who use the exclusion once on a principal residence sale and then convert a vacation home to principal residence use and sell the second home for another tax-free homesale profit. However, as this article illustrates, the complex new restriction on nonqualified use could create major headaches for those selling homes down the road, even those who never owned more than one home.

Homesale exclusion in a nutshell

Under Code Sec. 121(a), a taxpayer can exclude from income up to $250,000 of gain from the sale of a home owned and used by the taxpayer as a principal residence for at least 2 of the 5 years before the sale. The full exclusion doesn’t apply if, within the 2-year period ending on the sale date, the exclusion applied to another home sale by the taxpayer. Married taxpayers filing jointly for the year of sale may exclude up to $500,000 of homesale gain if (1) either spouse owned the home for at least 2 of the 5 years before the sale, (2) both spouses used the home as a principal residence for at least 2 of the 5 years before the sale, and (3) neither spouse is ineligible for the full exclusion because of the once-every-2-year limit.

Under an election available to qualifying members of the uniformed services, Foreign Service, and intelligence community (as well as certain Peace Corps volunteers and employees serving abroad after 2007), the 5-year period ending on the date of the sale or exchange of a principal residence does not include any period of up to 10 years during which the taxpayer or the taxpayer’s spouse is on qualified official extended duty.

The homesale exclusion doesn’t apply to gain attributable to post-May 6, ’97, depreciation claimed for rental or business use of a principal residence.

A reduced maximum exclusion may apply to taxpayers who sell their principal residence but (1) fail to qualify for the 2-out-of-5-year ownership and use rule, or (2) previously sold another home within the two year period ending on the sale date of the current home in a transaction to which the exclusion applied. If the taxpayer’s failure to meet either rule occurs because he must sell the home due to a change of place of employment, health, or to the extent provided by regs, other unforeseen circumstances, then he may be entitled to a reduced maximum exclusion. Under these circumstances, the maximum gain that can be excluded is equal to the full $250,000 or $500,000 exclusion times a fraction. Its numerator is the shorter of (a) aggregate periods of ownership and use of the home by the taxpayer as a principal residence during the 5 years ending on the sale date, or (b) the period of time after the last sale to which the exclusion applied, and before the date of the current sale. The denominator is 2 years (or its equivalent in months).

New restriction

For sales and exchanges after Dec. 31, 2008, the Code Sec. 121(a) rule excluding homesale gain if the two-out-of-five-year rule is met won’t apply to the extent gain from the sale or exchange of a principal residence is allocated to periods of nonqualified use. (Code Sec. 121(b)(4), as amended by Act § 3092) Generally, nonqualified use is any period (other than the portion of any period before Jan. 1, 2009) during which the property is not used as the principal residence of the taxpayer or spouse. For example, use of a residence as rental property or as a vacation home is nonqualified use (but see exceptions below).

RIA observation: It’s important to note that the exclusion isn’t reduced for nonqualified use; rather, it’s the gain potentially eligible for the exclusion. Thus, if the homesale gain is large enough, the seller may be able to use the full homesale exclusion despite extensive periods of nonqualified use.

RIA illustration 1: A single taxpayer buys a residence after 2008, uses it as a vacation home for four years, and then uses it as a principal residence for four years. If he then sells the home and a realizes a gain of $500,000, half of the gain will be allocable to nonqualifying use and subject to tax as long-term capital gain, but the other half will qualify for the full $250,000 homesale exclusion.

How to allocate to nonqualified use

For determining the amount of gain that is allocated to periods of nonqualified use, gain will be allocated to periods of nonqualified use based on the ratio which:
the aggregate periods of nonqualified use during the period the property was owned by the taxpayer, bears to;
the period the property was owned by the taxpayer. (Code Sec. 121(b)(4)(B))
According to the Committee Reports, gain allocated to periods of nonqualified use is the total amount of gain multiplied by a fraction: (1) the numerator of which is the aggregate periods of nonqualified use during the period the property was owned by the taxpayer, and (2) the denominator of which is the period the taxpayer owned the property.

RIA illustration 2: Jack Able, a single taxpayer, bought a home on Jan. 1, 2009, for $400,000, and uses it as rental property for two years claiming $20,000 of depreciation deductions (thereby reducing his basis in the home to $380,000). On Jan. 1, 2011, he converts the property to his principal residence. On Jan. 1, 2013, Jack moves out of the home and sells it for $700,000 on Jan. 1, 2014, and thus has a gain of $320,000 ($700,000 − $380,000).

Under pre-Act law, Jack would have had $20,000 of gain attributable to depreciation deductions included in income (taxed at 25% as “unrecaptured section 1250 gain”), and would have excluded $250,000 of his gain (because he had two full years of ownership). The $50,000 balance of his long-term gain would have been taxed at a maximum rate of 15%.

Under the Housing Act change, the same $20,000 of gain attributable to Jack’s depreciation deductions is included in income (and taxed at 25%). Of the remaining $300,000 gain, 40% (2 years ÷ 5 years), or $120,000, is allocated to nonqualified use and is not eligible for the exclusion (and is taxed at maximum rate of 15%). The remaining gain of $180,000 is excluded under Code Sec. 121 , since it’s less than the maximum excludible gain of $250,000. Thus, the new law change costs Jack $10,500 (.15 × $70,000).

RIA observation: Presumably, the fraction will be expressed in either days or months in the same manner as the fraction that applies for determining the amount of the reduced exclusion for certain taxpayers failing to meet the ownership and use requirements or for taxpayers who have sold or exchanged principal residences within two years.

RIA observation: A period of nonqualified use (as used in the numerator in the fraction above) will not include any period before Jan. 1, 2009. But, the denominator (i.e., the period that the taxpayer has owned the property) will include periods of ownership before Jan. 1, 2009.

What is nonqualified use?

Generally, nonqualified use is any period (other than the portion of any period before Jan. 1, 2009) during which the property is not used as the principal residence of the taxpayer or spouse.

RIA observation: After buying an existing residence, a taxpayer may take an extended period of time to remodel, improve and/or enlarge it before he actually moves into the home and begins to use it as a principal residence. During that remodeling period, the taxpayer would not be considered to be using the residence as his principal residence. Thus, that remodeling period could be construed to be a period of nonqualified use under Code Sec. 121(b)(4)(C)(i).

RIA observation: Under Reg. § 1.121-1(b), the determination of whether a property is used as a principal residence depends on the facts and circumstances. Under those rules, if a taxpayer alternates between two properties, using each as a residence for successive periods of time, the property that the taxpayer uses a majority of the time during the year ordinarily will be considered the taxpayer’s principal residence. However, this majority of the time test is not dispositive if other relevant factors indicate that another residence is the taxpayer’s principal residence.

Nonqualified use does not include use that falls into one of the following three categories:

(1) Post-principal-residence use. Nonqualified use does not include any portion of the Code Sec. 121(a) 5-year period which is after the last date that the property is used as the principal residence of the taxpayer or spouse. (Code Sec. 121(b)(4)(C)(ii))

RIA illustration 3: Jack Baker buys a principal residence on Jan. 1, 2009 and moves out on Jan. 1, 2019. On Dec. 1, 2021, he sells the property and realizes a $200,000 gain, all of which will be excluded from gross income. The property’s use following Baker’s departure from the property (e.g., as rental property, or vacant and held for sale) is immaterial.

RIA observation: As a practical matter, in order to qualify for the full homesale exclusion under the Code Sec. 121(a) two-out-of-five year ownership and use rule, the nonqualifying use after the owner leaves his principal residence can’t exceed three years.

(2) Qualified official duty exception. Nonqualified use doesn’t include any period (not to exceed an aggregate period of 10 years) during which the taxpayer or spouse is serving on qualified official extended duty. (Code Sec. 121(b)(4)(C)(ii)) Qualified official extended duty means duty as a member of the uniformed services or the Foreign Service, or as an employee of the intelligence community. (Code Sec. 121(b)(4)(C)(ii)(II))

The Code Sec. 121 suspension election for members of the uniformed services, members of the Foreign Service, and employees of the intelligence community is the same as it was under pre-2008 Housing Act law. (Committee Reports)

RIA illustration 4: Jean Cody buys a house in Virginia in Year 3 (a year beginning after Dec. 31, 2008) that she uses as her principal residence for three years. For eight years, from Year 6 through Year 14, Cody serves on qualified official extended duty as a member of the Foreign Service in Germany. In Year 15, Cody sells the Virginia house. She elected to suspend the ownership and use five-year testing period for the Code Sec. 121 exclusion during her eight-year period of service in Germany (i.e., qualified official extended duty). Thus, the eight-year period is not counted in determining whether Cody used the house for two of the five years preceding the sale for purposes of the homesale exclusion (including the amount of gain allocated to periods of nonqualified use).

(3) Temporary absence exception. A period of nonqualified use will not include any other period of temporary absence (not to exceed an aggregate period of two years) due to change of employment, health conditions, or any other unforeseen circumstances as may be specified by IRS. (Code Sec. 121(b)(4)(C)(ii)(III))

RIA illustration 5: On Jan. 1, Year 2 (a year beginning after Dec. 31, 2008), Anne, a resident of New York, buys a house in Minnesota that she intends to use as her principal residence. Before she can move into the Minnesota house, Anne is seriously injured in an accident on Feb. 1, Year 2 and is unable to move to Minnesota until Jan. 1, Year 4. For the next three years (until Dec. 31, Year 7), she lives in the Minnesota house. On Jan. 1, Year 7, Anne sells the Minnesota house. Presumably, Anne’s absence from the Minnesota house will qualify for the temporary absence exception because the absence didn’t exceed an aggregate period of two years and was due to a change in health conditions (and also might have been due to unforeseen circumstances).

RIA observation: The language of the temporary absence exception is similar to the circumstances described in Code Sec. 121(c)(2)(B) that qualify for the reduced maximum exclusion (change in place of employment, health, or, to the extent provided in regs, unforeseen circumstances). RIA observation: Presumably, future IRS regs relating to the temporary absence exception will contain safe harbors similar to those provided for purposes of the reduced maximum exclusion. Thus, any safe harbors could include: a distance safe harbor for purposes of determining whether an absence is by reason of a change in place of employment; physician’s recommendation safe harbor for purposes of determining whether an absence is by reason of health; and involuntary conversion safe harbor for purposes of determining whether a change is by reason of unforeseen circumstances.

Coordination with recognition of gain attributable to depreciation

For determining the amount of gain allocated to nonqualified use of a principal residence, the following rules apply:
the rule providing that gain allocated to periods of nonqualified use does not qualify for the exclusion is applied after the application of Code Sec. 121(d)(6) (rules providing that gain attributable to post-May 6, ’97 depreciation does not qualify for the exclusion), and
the rules providing for the allocation of gain to periods of nonqualified use are applied without regard to any gain to which Code Sec. 121(d)(6) applies. (Code Sec. 121(b)(4)(D))