Palm Springs Tax and Trust Lawyers

Let's See Some 1031 Tax-Free Exchange Examples for Canadians Swapping Palm Springs Real Estate. Oh Wait, Canadians Can't Use IRC Section 1031...

Wed, 16 May 2012 14:56:55 -0800

So we're still on a parallel track with our main blog (these will separate again after we complete the FBAR amnesty discussion). We're talking about when a Canadian snowbird can sell an appreciated property (like a property in Indian Wells that has increased in value) and close to simultaneously buy a new property (our Canadian purchases a Palm Desert property), and not pay any tax on the first sale. This is done under IRC Section 1031. What Canadians should take away from this discussion (and the 2 previous blog entries) is its very unlikely Canadians can use 1031 and get the tax free treatment on the sale of the first property. Why so unlikely? Because Canada does not have a tax provision like 1031. So while the Canadian might be able to exchange a US property he or she is using as a rental property (remember, a vacation house won't work probably unless the Canadian snowbird uses it no more than 14 days a year) for another US rental property (must be US, can't be exchanged for a property in another country), and qualify for 1031 on their US tax return, Canada will still tax them immediately upon the sale of the first property. What good are nonrecognition provisions in one country if they are not observed in the other country (and the treaty doesn't mandate Canada honor US Section 1031)? The answer is: no good at all. Canadians buying property in the US must worry about both how the US and Canada taxes the transaction. Canadians, until your government adopts 1031 (or a provision like it), you cannot utilize the favorable treatment of the IRC Section 1031, even for property exchanges in the US.

The remainder of this entry is copied from our general blog on 1031 examples.

Let's do some basic (and not so basic) 1031 examples. Again, before we start, remember that in addition to a rising real estate market (no sure thing the last few years, although in the Palm Springs area we might finally be turning the corner), in order to qualify for 1031 you need property either: held for (a) investment or (b) productive use in a trade or business.
Also remember vacation homes are unlikely to qualify as either: held for (a) investment or (b) productive use in a trade or business, unless the owner or the owner's family uses the vacation house not more than 14 days a year. A property used as rental property will qualify for Section 1031 because the IRS deems rental properties as held for productive use in a trade or business.

Basic 1031 Examples

Here's a basic example (1): Tom purchases a Palm Desert house in 2001 for $500k. Tom sells it in 2006 for $1,000,000. Shortly thereafter in 2006, Tom purchases an Indian Wells home for $1,000.000. In 2012, Tom sells the Indian Wells home for $1,250,000. Assuming the Section 1031 requirements met, Tom's taxable income in 2006 is $0, and Tom's taxable income in 2012 is $750,000.

When the taxpayer receives cash in the transaction, the taxpayer must recognize gain (at least to the extent of the cash received).

Basic example (2): Tom exchanges real estate held for investment (i.e., the general rule is he or his family uses it not more than 2 weeks a year), which he purchased in 2000 for $500,000 which now (in 2012) has a fair market value of $800,000, for other real estate (to be held for productive use in a trade or business) worth $600,000, and $200,000 in cash. The gain from the transaction is $300,000 (Tom bought a property for $500,000 and is now exchanging it for a new property worth $600,000 plus $200,000 in cash), but the $300,000 gain is only recognized to the extent of the cash received: $200,000. Tom must recognize $200,000 in 2012 when he engages in the exchange.

And let's do one more example (with a little more complexity, including two assets transferred (only one of which qualifies under 1031)), plus the question of what is the basis in the new property:

Basic example (3): In 2007, Tom transfers real estate he used exclusively as a rental property which he purchased in 2002 for $1,000,000 in exchange for other real estate (to be held as rental property) which has a fair market value of $900,000, an automobile which has a fair market value of $200,000, and $150,000 in cash. Tom realizes a gain of $250,000 (bought property in 2002 for $1,000,000 and sold it in 2007 for property plus a car plus cash all worth $1,250,000). Tom must recognize (ie pay tax on) the entire $250,000 gain because he received items other than another real property (the car plus the cash) worth a total of $350,000. The basis of the new rental property received in exchange is the basis of the transferred real estate ($1,000,000) decreased by the amount of money received ($150,000) and increased in the amount of gain that was recognized ($250,000), which results in a basis for the property received of $1,100,000. This basis of $1,100,000 is allocated between the automobile and the real estate received by Tom. The basis of the automobile must remain its fair market value at the date of the exchange- $200,000, with the basis of the real estate received being the remainder: $900,000. So at the end of the transaction, the basis in new property is only $900,000 ($100,000 less than the basis in the old property).

How Do I Sell My House, Buy Another, and Not Pay Tax?...Let's See Some Examples:

Mon, 14 May 2012 14:38:09 -0800

Let's do some basic (and not so basic) 1031 examples. Again, before we start, remember that in addition to a rising real estate market (no sure thing the last few years, although in the Palm Springs area we might finally be turning the corner), in order to qualify for 1031 you need property either: held for (a) investment or (b) productive use in a trade or business.
Also remember vacation homes are unlikely to qualify as either: held for (a) investment or (b) productive use in a trade or business, unless the owner or the owner's family uses the vacation house not more than 14 days a year. A property used as rental property will qualify for Section 1031 because the IRS deems rental properties as held for productive use in a trade or business.

Basic 1031 Examples

When the taxpayer receives cash in the transaction, the taxpayer must recognize gain (at least to the extent of the cash received).

Basic example (2): Tom exchanges real estate held for investment (i.e., the general rule is he or his family uses it not more than 2 weeks a year), which he purchased in 2000 for $500,000 which now (in 2012) has a fair market value of $800,000, for other real estate (to be held for productive use in a trade or business) worth $600,000, and $200,000 in cash. The gain from the transaction is $300,000 (Tom bought a property for $500,000 and is now exchanging it for a new property worth $600,000 plus $200,000 in cash), but the $300,000 gain is only recognized to the extent of the cash received: $200,000. Tom must recognize $200,000 in 2012 when he engages in the exchange.

And let's do one more example (with a little more complexity, including two assets transferred (only one of which qualifies under 1031)), plus the question of what is the basis in the new property:

A Little More On When a Canadian May Sell His Palm Springs Vacation Home and Not Pay US Tax...

Mon, 16 Apr 2012 11:33:36 -0800

Before we show mathematical examples of how a 1031 exchange works, let's look a little more at when a Canadian snowbird may exchange their Palm Springs home (which we are assuming has appreciated in value) for a new Rancho Mirage home, and not pay any US tax. Recall the problem is that home must be "used in trade or business" or "held for investment" in order to be eligible for 1031 tax free exchange treatment. The IRS does not generally view the typical vacation house as either used in trade or business or held for investment. However, the IRS did issue a safe harbor in Revenue Procedure 2008-16, which states that vacation properties may qualify for a 1031 if:
(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange; and
(b) Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
(ii) The period of the taxpayer's personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
In addition, the replacement property must meet the same requirements for the two years after the exchange (i.e., must be rented out and not used too much for personal use).

But keep in mind, Rev. Proc. 2008-16 is just a safe harbor, you don't have to fit within its confines to get 1031 tax free exchange treatment, right? Well, it is possible for a vacation home to qualify for 1031 exchange even if the owner uses the house more than 14 days a year (for example). But it is the IRS' position that if only the owner (and/or his or her relatives) uses the property (and never rents it out to unrelated individuals), 1031 tax free exchange treatment is not available. And while the IRS' position is not necessarily the bottom line, taxpayers (including Canadian snowbirds) must be prepared for the IRS to challenge any occasion where the taxpayer claiming 1031 tax free treatment does not fit within the confines of Rev. Proc. 2008-16.

So when can the Canadian snowbird unequivocally own an appreciated US property and exchange it for another US property and not pay taxes under 1031? Clearly if the Canadian snowbird bought a Palm Springs house, and does not use it personally and strictly rents it out to (unrelated) individuals, then 1031 treatment is available. That is a good example of where the property is clearly used as a trade or business. What about the other permissible use under 1031: holding for investment? There is no clear test for this. The taxpayer must be prepared to show the primary motive in owning the vacation home is profit, and not personal use. The taxpayer who uses the property a lot personally (even though they may have a big desire for profit) will lose the primary motive is profit argument. A dual goal of personal use and profit will not qualify under 1031. Also, abandoning the house for personal use and then trying to sell it shortly thereafter (and claiming it is now held primarily for investment) is likely not sufficient under 1031 (although holding the property for a while after abandoning it for personal use may work...see Moore v CIR (2007)). In short, the Canadian snowbird must prepared to argue the overwhelming primary motive in buying and holding the Palm Springs home is profit, not personal use. This is very difficult to do (unless the Canadian snowbird or his or her relatives really don't use the property at all). If at all possible, fit within the safe harbor of Rev. Proc. 2008-16.

Next entry, we'll get to the computations....

How Do I Sell My House, Buy Another, and Not Pay Tax?

Sat, 14 Apr 2012 10:52:03 -0800

We're taking a break from speaking about the FBAR amnesty program (we will return to this topic shortly), but were going to continue to parallel (for now) our Canadian Snowbird Blog. So the topic at hand is how do I sell my house (we're assuming the house has gone up in value), buy a new house, and not pay tax? Let's assume, for the sake of discussion, that I sell a La Quinta home which has appreciated in value by $500,000 since I bought the house in 1997.

Question #1- Can I sell the house in La Quinta (for $500k more than he bought it for) and buy the Palm Desert replacement property without paying any US tax?
The general answer is yes. Internal Revenue Code Section 1031allows me to exchange, tax free, US real property for other US real property, if several requirements are met.

Question #2- What are the general requirements for a Section 1031 exchange?
In order for me the taxpayer to exchange real property for other real property, and not pay tax:
A) The Property must be exchanged for "like-kind" property. "Like-kind" simply means that real property must be exchanged for real property. But Section 1031 also mandates both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment. Thus, I cannot exchange into or out of my own personal residence, because that is not deemed held for productive use in a trade or business or for investment. Vacation homes may qualify if they are rented out to unrelated persons, or held primarily for investment rather than personal use. For example, in the 2007 case of Moore v. CIR, the Tax Court held that an exchange of vacation homes did not qualify for nonrecognition under § 1031(a)(1) because neither home was held for investment: "the mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence." Subsequent to the Moore case, the IRS issued Rev. Proc. 2008-16, which provides vacation properties may qualify for a 1031 if:
(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange; and
(b) Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
(ii) The period of the taxpayer's personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
In addition, the replacement property must meet the same requirements for the two years after the exchange (i.e., must be rented out and not used too much for personal use). So if I have a vacation home for (primarily) personal use, I will have a difficult time taking advantage of Section1031 tax free exchange treatment.
B) It's not as simple as selling my property one day (let's assume for a gain), and buying a replacement property down the road, and not paying tax on the gain. First, the replacement property must be identified not later than 45 days after the sale of the first property. What does it mean to indentify a property? You identify a property in writing, giving the writing to an independent party (a qualified intermediary). Second, the replacement property must be received not later than 180 days after the sale.
We'll pick it up here in our next post, reviewing some examples of how the tax treatment works....

Are Canadians Eligible To Exchange US Real Estate in a Tax Free Transaction (a Section 1031 Transaction)?

Wed, 04 Apr 2012 13:32:35 -0800

We've been on a little bit of a break for the busy "season" of February, March and into April. Let's also take a break from talking about the FBAR amnesty program (we will return to this topic shortly).

A question we frequently get comes from a Canadian snowbird who owns (for example) a house in La Quinta. The Canadian then wants to sell the La Quinta property, and purchase a Palm Desert property to take its place. Let's assume, for the sake of discussion, that the La Quinta home the Canadian snowbird is selling has appreciated in value by $500,000 since the snowbird bought the house in 1997 (we will think optimistically).

Question #1- Can our Canadian citizen sell the house in La Quinta (for $500k more than he bought it for) and buy the Palm Desert replacement property without paying any US tax?

The general answer is yes. The nonrecognition provisions of Internal Revenue Code Section 1031 apply to the disposition of a United States real property only if the United States real property is exchanged for other United States real property. But real property located in the United States and foreign real property are not property of like-kind, and therefore do not qualify for Section 1031. So our Canadian snowbird cannot sell the La Quinta house and purchase a Vancouver house and receive Section 1031 nonrecognition treatment.

Question #2- What are the general requirements for a Section 1031 exchange?

In order for a taxpayer (whether American, Canadian, or from any other country) to exchange their property in the US for another property in the US, and not pay tax:

A) The Property must be exchanged for "like-kind" property. "Like-kind" simply means that real property must be exchanged for real property. But Section 1031 also mandates both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment. Thus, the taxpayer cannot exchange into or out of the taxpayer's own personal residence. Vacation homes may qualify if they are rented out by the taxpayer to unrelated persons, or held primarily for investment rather than personal use. The Canadian snowbird needs to watch this requirement carefully. For example, in the 2007 case of Moore v. CIR, the Tax Court held that an exchange of vacation homes did not qualify for nonrecognition under § 1031(a)(1) because neither home was held for investment: "the mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence." Subsequent to the Moore case, the IRS issued Rev. Proc. 2008-16, which provides vacation properties may qualify for a 1031 if:

(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange; and
(b) Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
(ii) The period of the taxpayer's personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
In addition, the replacement property must meet the same requirements for the two years after the exchange (i.e., must be rented out and not used too much for personal use). So Canadian snowbirds with a vacation home for(primarily) personal use will have a difficult time taking advantage of Section1031 tax free exchange treatment.

B) It's not as simple as selling your property one day (let's assume for a gain), and buying a replacement property down the road, and not paying tax on the gain. First, the replacement property must be identified not later than 45 days after the sale of the first property. What does it mean to indentify a property? You identify a property in writing, giving the writing to an independent party (a qualified intermediary). Second, the replacement property must be received not later than 180 days after the sale.

We'll pick it up here in our next post, reviewing some examples of how the tax treatment works....

US Tax Residents- Have You Failed to Report Your Foreign Bank Accounts? IRS Offers a 2012 Amnesty Program, But It's Tricky (Part II)

Thu, 16 Feb 2012 09:34:38 -0800

We're speaking about US citizens or residents (and US tax residents can be citizens of any country who happen to stay in the US too long in a given year, this could be citizens from any country outside of the US who may visit Palm Springs, or Rancho Mirage or Palm Desert long enough for a given year that they are deemed a US tax resident; we are also speaking of citizens of foreign countries who are US green card holders). US citizens and residents must declare to the Department of Treasury their foreign bank accounts (provided they have over $10,000 in aggregate foreign bank accounts/ assets...not a high bar). They must file these information returns (called "FBARs") by June 30 of each year. Many US citizens and tax residents (particularly those who are current or former citizens of another country) are unaware of the FBAR requirement, which was enacted in 2003. That is why the IRS amnesty programs can be so valuable. In 2012, the IRS is again offering a FBAR amnesty program. This is the third such amnesty program. There is no guarantee there will be a fourth.

Structure of the IRS Amnesty Program
Although the IRS has yet to provide (much) specific guidance on the 2012 amnesty program, it will almost certainly follow the framework provided in the 2011 program. So it makes sense to review generally the 2011 program (the "OVDI Program"). Taxpayers who made voluntary disclosures under the 2011 OVDI Program could expect the following penalties/payments:

Path One- the No Questions Asked Path requires the taxpayer to pay 27.5% (for the 2012 program...under the 2011 OVDI Program it was only 25%) of the highest aggregate overseas account balance in the highest year. So if the aggregate overseas account balance in the highest year (when the individual did not file a FBAR) was $2,000,000 (and by the way, when we say highest aggregate overseas account balance we are including the value of overseas assets- such as a house- plus the value of overseas accounts), the individual is volunteering to pay a penalty to the IRS of $550,000 (27.5% x $2,000,000), plus the unpaid income tax (if any), plus penalties for failure to file or pay income tax (if any). So, under Path One, the easy/no risk path, the individual with undeclared overseas accounts (and assets) of $2,000,000 must pay a penalty of $550,000 at an absolute minimum...THIS IS A STIFF AMNESTY PENATLY!!!

Path Two- Opt Out of the 27.5% No Questions Asked Penalty, and Ask the IRS for a Lesser Penalty Path Ahh, this sounds better. Let's ask for a lower penalty than the 27.5% general amnesty penalty (which required a payment of at least $550,000 for a $2,000,000 overseas aggregate account balance above). But here's the catch: you can ask the IRS for a lesser penalty, and they might agree (and the individual might end up owing almost nothing to the IRS)...on the other hand, under Path Two, if the IRS doesn't agree, they can take every penny of your overseas aggregate account balances!!! Quite a gamble under Path Two.

More on the Path Two, and the decision making process which an individual must undertake when deciding between Path One and Two (or not taking part in the amnesty program at all)...in Part III of this series coming up.

Canadian Snowbirds in Palm Springs Who are US Tax Residents- Have You Failed to Report Your Canadian Bank Accounts? IRS Offers a 2012 Amnesty Program, But It's Tricky (Part II)

Mon, 13 Feb 2012 16:56:32 -0800

We're speaking about US citizens or residents (and US tax residents can be citizens of any country who happen to stay in the US too long in a given year, with special attention paid to in this blog Canadian citizens who may visit Palm Springs, or Rancho Mirage or Palm Desert long enough for a given year that they are deemed a US tax resident; we are also speaking of citizens of foreign countries who are US green card holders). US citizens and residents must declare to the Department of Treasury their foreign bank accounts (provided they have over $10,000 in aggregate foreign bank accounts/ assets...not a high bar). They must file these information returns (called "FBARs") by June 30 of each year. Many US citizens and tax residents (particularly those who are current or former citizens of another country) are unaware of the FBAR requirement, which was enacted in 2003. That is why the IRS amnesty programs can be so valuable. In 2012, the IRS is again offering a FBAR amnesty program. This is the third such amnesty program. There is no guarantee there will be a fourth.

Structure of the IRS Amnesty Program
Although the IRS has yet to provide (much) specific guidance on the 2012 amnesty program, it will almost certainly follow the framework provided in the 2011 program. So it makes sense to review generally the 2011 program (the "OVDI Program"). Taxpayers who made voluntary disclosures under the 2011 OVDI Program could expect the following penalties/payments:

Path Two- Opt Out of the 27.5% No Questions Asked Penalty, and Ask the IRS for a Lesser Penalty Path Ahh, this sounds better. Let's ask for a lower penalty than the 27.5% general amnesty penalty (which required a payment of at least $550,000 for a $2,000,000 overseas aggregate account balance above). But here's the catch: you can ask the IRS for a lesser penalty, and they might agree (and the individual might end up owing almost nothing to the IRS)...on the other hand, under Path Two, if the IRS doesn't agree, they can take every penny of your overseas aggregate account balances!!! Quite a gamble under Path Two.

US Tax Residents- Have You Failed to Report Your Foreign Bank Accounts? IRS Offers a 2012 Amnesty Program, But It's Tricky (Part I)

Mon, 06 Feb 2012 13:17:38 -0800

In January, the Internal Revenue Service reopened the offshore voluntary disclosure program to help people hiding offshore accounts get current with their taxes. Although details of the 2012 program were not immediately available, the parameters will likely be very similar to the 2011 Offshore Voluntary Disclosure Initiative ("OVDI"). While 2011 OVDI Program seemed straight-forward, it turned out it was anything but straight-forward.

US Citizens or Tax Residents Must File a FBAR Annually

US tax citizens or residents must file a "FBAR" (a "Report of Foreign Bank and Financial Accounts") annually, provided the US citizen or tax resident has over $10,000 in financial account(s) which are not located in the United States. The term financial account is broadly defined and includes any bank, securities derivatives, or other financial instrument accounts. It also includes any savings, demand, checking, deposit, or other account maintained with a financial institution in addition to certain annuity and life insurance contracts, commodities and precious metals and safe deposit accounts. The FBAR is filed on a US Treasury Form TD F 90-22.1. The FBAR is filed with the US Department of Treasury by June 30 of the year after the US citizen or resident had a non-US account. The FBAR requirement has been in existence since 2003.

2012 Program Will Likely Be Similar to the 2011 Program

Although the IRS has yet to provide details, it's a fairly safe assumption that the 2012 will look very similar to the 2011 OVDI Program. So, for taxpayers who went through the 2011 OVDI Program, what were the penalties?

Non-Willful Failure to File a FBAR

The general penalty for a "non-willful" failure to file a FBAR for a given year is $10,000 per year.

Willful Failure to File a FBAR
A willful failure to file a FBAR is far more significant. In the case of a willful failure to file a FBAR, the penalty can be as high as 50% of the aggregate balance of the overseas account(s) per year. This is steep. Let's look at this example published last year by the IRS in their 2011 Offshore Voluntary Disclosure Initiative Frequently Asked Questions and Answers (Q&A 8):

We start with an account balance in 2002 or $1,000,000

Year Interest Income Account Balance
2003 $50,000 $1,050,000
2004 $50,000 $1,100,000
2005 $50,000 $1,150,000
2006 $50,000 $1,200,000
2007 $50,000 $1,250,000
2008 $50,000 $1,300,000
2009 $50,000 $1,350,000
2010 $50,000 $1,400,000

If the taxpayers didn't come forward, when the IRS discovered their offshore activities, and the IRS deemed the failure to file "willful", they would face up to $4,543,000 in tax, accuracy-related penalty, and FBAR penalty. The taxpayers would also be liable for interest and possibly additional penalties, and an examination could lead to criminal prosecution.

The civil liabilities outside the 2011 Offshore Voluntary Disclosure Initiative potentially include:

FBAR penalties totaling up to $4,375,000 for willful failures to file complete and correct FBARs (2004 - $550,000, 2005 - $575,000, 2006 - $600,000, 2007 - $625,000, 2008 - $650,000, and 2009 - $675,000, and 2010 - $700,000),

So, if the IRS deemed the failure to file a FBAR was willful in this case, the IRS could impose a penalty of $4,543,000, even though the taxpayer's account was only as high as $1,400,000 (i.e., the penalty is 3 times higher than the highest overseas aggregate account value)!!!

We discuss what constitutes a willful failure to file, and what the 2012 amnesty program offers taxpayers, in future posts. But the key take-away for US citizen/residents with foreign bank accounts is: you better participate in the 2012 amnesty program, because the possible penalties for not filing FBARs are huge.

Canadian Snowbirds in Palm Springs Who are US Tax Residents- Have You Failed to Report Your Canadian Bank Accounts? IRS Offers a 2012 Amnesty Program, But It's Tricky (Part I)

Fri, 03 Feb 2012 10:26:50 -0800

Canadian Snowbirds Who Are US Citizens or Tax Residents Must File a FBAR Annually

US tax citizens or residents (i.e., Canadians who are in the US a little too much in a given year) must file a "FBAR" (a "Report of Foreign Bank and Financial Accounts") annually, provided the US citizen or tax resident has over $10,000 in financial account(s) which are not located in the United States. The term financial account is broadly defined and includes any bank, securities derivatives, or other financial instrument accounts. It also includes any savings, demand, checking, deposit, or other account maintained with a financial institution in addition to certain annuity and life insurance contracts, commodities and precious metals and safe deposit accounts. Canadian snowbirds will likely have no shortage of these back in Canada. The FBAR is filed on a US Treasury Form TD F 90-22.1. The FBAR is filed with the US Department of Treasury by June 30 of the year after the US citizen or resident had a non-US account. The FBAR requirement has been in existence since 2003.

2012 Program Will Likely Be Similar to the 2011 Program

Non-Willful Failure to File a FBAR

The general penalty for a "non-willful" failure to file a FBAR for a given year is $10,000 per year.

We start with an account balance in 2002 or $1,000,000

The civil liabilities outside the 2011 Offshore Voluntary Disclosure Initiative potentially include:

Canadian Snowbirds Who Spend Too Much Time in the US May Become US Tax Residents. All US Tax Residents Must Disclose Their Non-US Bank Accounts, or Face Possible Draconian Penalties.

Tue, 31 Jan 2012 11:47:18 -0800

We've discussed previously how, if the Canadian visitor to Palm Springs is not careful, he or she can inadvertently find themselves subject to US taxation on income earned anywhere in the world (worldwide income). In any calendar year in which a foreign citizen stays in the US over 183 days, the person may become subject to tax in the US on their worldwide income (the person may become a US resident for tax purposes at least for that year, but the US-Canada Tax Treaty does offer potential relief for the Canadian citizen being deemed a US tax resident in this scenario). Also recall that if over a three year period the Canadian citizen is in the US so much that he or she fails the "substantial presence" test (and does not file the closer connection Form 8840...big mistake), the individual may also be considered a US tax resident for that year. On the plus side, even if the Canadian is deemed a US tax resident for the year and the US taxes the Canadian citizen on all his or her worldwide income, there's a good chance Canada will credit most (if not all) the US taxes paid. So for the Canadian who stays a little too long in the US there probably won't be much, if any, double tax between the US and Canada (although the individual could easily end up paying the higher rate of tax between the two countries).

What else does being a US tax resident for a given year mean? Many people are surprised to find out it means you must provide the US Department of Treasury information about all your foreign bank accounts. Well, for the Canadian snowbird visiting the Coachella Valley, there's a good chance most if not all his or her bank accounts are in Canada, so this becomes a significant required disclosure.

US Citizens or Tax Residents Must File a FBAR Annually

US tax citizens or residents must file a "FBAR"( a "Report of Foreign Bank and Financial Accounts") annually, provided the US citizen or tax resident has over $10,000 in financial account(s) which are not located in the United States (which will be a certainty for the Canadian snowbird). The term financial account is broadly defined and includes any bank, securities derivatives, or other financial instrument accounts. It also includes any savings, demand, checking, deposit, or other account maintained with a financial institution in addition to certain annuity and life insurance contracts, commodities and precious metals and safe deposit accounts. The FBAR is filed on a US Treasury Form TD F 90-22.1. The FBAR is filed with the US Department of Treasury by June 30 of the year after the US citizen or resident had a non-US account. That means, in any year in which a Canadian snowbird is deemed a US tax resident, he or she must file a Form TD F 90-22.1 by June 30 of the following year.

What are the Penalties for Failure to File a FBAR?

For a "non-willful" failure to file a FBAR, the penalty will not exceed $10,000 per violation. In the case of a non-willful violation, no penalty should be imposed if the failure is due to reasonable cause and the account was properly reported. We will discuss what constitutes a "non-willful" failure to file in future posts. For each willful violation, the maximum penalty that may be imposed is the greater of $100,000 or 50% of the aggregate value of the non-US account(s) at the time of the violation. THAT'S CORRECT, FAILURE TO FILE A FBAR CAN LEAD TO A PENALTY OF 50% OF THE AGGREGATE VALUE OF THE NON-US ACCOUNT(S) AT THE TIME OF THE VIOLATION!!! Not 50% the taxable amount, 50% of the account balance!!

Wow, for a "willful" failure to file a FABR, the US can (try) to take 50% of the Canadian citizen's account balances of non-US accounts for a given year. As you can see, the potential damage is staggering for the Canadian snowbird who spends a little too much time in Palm Springs (or anywhere in the US) in a particular year or years (if the failure to file is deemed "willful", to be discussed...). There is, however, currently an IRS amnesty program for the non-FBAR filer, which we will discuss in the next post.

How Can Canadians with Houses in Palm Springs (and all of the US) Be Subject to the US Estate Tax, Part II

Tue, 10 Jan 2012 09:50:43 -0800

So let's get into some real detail on the US estate tax, and how the IRS imposes it on Canadians with homes and other assets in Palm Springs (and the entire US). The estate tax is imposed only on the value of US assets (not the value of worldwide assets) of Canadians (provided they are not "domiciled" in the US). This will be most Canadian snowbird visitors to the Coachella Valley. But is it imposed on every dollar's worth of assets a Canadian dies with in the US? No. Canadians (and Americans) are permitted to exclude a certain amount of assets from the estate tax.

How Much Assets May an American Exclude From the Estate Tax?
For 2011 and 2012, American citizens and residents may exclude their first $5M in worldwide assets (notice the distinction again here as Canadian snowbirds will only be subject to the estate tax on their US assets). What this means generally is that an American who dies in 2012 with $2M is total worldwide assets must recognize $0 estate tax. And, as you will see, a Canadian who dies in 2012 with $2M is total worldwide assets (even if they're all in the US) must also recognize $0 estate tax.

How Much May a Canadian Exclude From the Estate Tax?
If an American can exclude $5M in (worldwide) assets from the estate tax, how much can a Canadian exclude in (US) assets? At least for the year 2012, if a Canadian citizen were to die with worldwide assets of less than $5M, that individual is not subject to the US estate tax. This high (generous) threshold will surely go down in future years. But again, at least in 2012, a Canadian snowbird with worldwide assets of less than $5M and is not subject to the US estate tax (even if all the assets are located in the US).

Ok fine, but what about the Canadian who dies in 2012 with worldwide assets worth 10M and US assets (a house) worth 1M. How much of the $5M exemption available to Americans can the Canadian citizen use? The US Canada Tax Treaty tells us to use a simple mathematical formula to derive the answer- $5M (for 2012) total possible exemption multiplied by a fraction: the numerator of which is the Canadian citizen's total US assets ($1M) and the denominator of which is the Canadian citizen's total worldwide assets ($10M). In our example the formula is: $5M x ($1M / $10M) or $5M x 1/10= $500,000. So the Canadian citizen with a US home worth $1M who dies in 2012 can exclude $500,000 from the US estate tax, but the other $500,000 is subject to the tax. Taxed at a 35% rate means an actual tax paid to the IRS of approximately $175,000. The 35% is a gradual rate maximizing at 35% (taxed at a lower rate for the lower portions of the taxable estate, so the actual estate tax is likely less than $175,000).

And the Estate Tax is Scheduled to Get Much Worse
Note that in 2013, the exemption amount is scheduled to go back down to $1M, and the highest rate of estate tax is scheduled to return to 45%. So after 2012 the US estate tax will likely impact many more Canadians (and Americans).

How Can Canadians with Houses in Palm Springs (and all of the US) Be Subject to the US Estate Tax, Part I

Tue, 03 Jan 2012 09:54:35 -0800

In a previous post, we introduced the concept that Canadians with property located in the US are potentially subject to the US estate tax upon their death. This is true even though the Canadian snowbird may never spend enough time in the US to make themselves US residents for tax purposes. In fact, this can be true of the Canadian who spends almost no time in the United States. That's because the US levies its estate tax on a foreign citizen's property located in the US. Ultimately, it's the US location of the property that matters. But note, not all property located in the US is included in the estate tax computation.

What's Included?
Canadians are generally subject to US estate tax on their assets located within the US (US "situs property") upon their death. The following types of property constitutes US situs property for the purposes of the US estate tax:
1) All real estate located in the US (this is generally the big one);
2) Tangible personal property located in the US (these are objects which can be moved touched or felt, such as jewelry, boats and art (which the Canadian citizen might hang in their US home));
3) Shares of stock of a US corporation; and
4) Golf Club Memberships.

What's Not Included?
Not all property located in the US is subject to the estate tax. Property located in the US, but not included in the computation of the US estate tax, includes:
1) Money kept in US bank accounts, either checking or savings, up to certain limits (any funds protected by the FDIC is exempt); and
2) Life insurance issued by a US insurer.

Also, very important, nonrecourse debt (debt where the only security is the house; the borrower is not personally liable) is subtracted from the value of the house in determining the value of the total US estate subject to the estate tax. This gets us to an interesting planning discussion on how to best avoid the estate tax, which we will discuss in a later post.

Americans Who Die in 2011/2012 Are Permitted to Exclude Their First $5M in Assets From the Estate Tax
One of the most hotly contested issues in American politics is how much an individual should be able to exclude from his or her estate for the estate tax computation. In 2011 and 2012, the answer is $5M. That means generally that each individual who dies with $5M or under in 2011 and 2012 will owe no estate tax. Note, before 2011 the exclusion limit was $3.5M. It is possible after 2012 the exclusion amount will drop significantly, perhaps to as little as $1M or even $0 (which would mean, if changed to $1M, people who die in 2013 with assets over $1M would be subject to the estate tax ...i.e., it is quite possible in the future a lot more estate taxes will be going to the IRS).

So How Are Canadian Snowbirds Affected by the US Estate Tax?
As we discussed before, the IRS will count the Canadians included assets (see above) in the US estate tax computation. So the real question is, how much of the $5M exclusion amount (again, this amount could go down significantly in the future) can a Canadian citizen (non-US resident) claim? That answer is governed by the US-Canada Tax Treaty, and is the subject of our next post.

California Taxpayers: Failed to File a Gift Tax Return for a Property Transfer to a NonSpouse Relative From 2005-2010? The State of California is About to Tell the IRS All About It

Wed, 28 Dec 2011 11:20:25 -0800

A district court has now granted the IRS permission to issue a summons to the State of California Board of Equalization, as part of a gift tax enforcement initiative to detect transfers of real property between nonspouse relatives that weren't reported on gift tax returns. California now joins Connecticut, Florida, Hawaii, Nebraska, New Hampshire, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Tennessee, Texas, Virginia, Washington, and Wisconsin, as states where the state governments must turn over records about property transfers to the IRS. If you transferred property to nonspouse relatives and did not complete the appropriate gift tax return, the State of California may be on the verge of telling the IRS all about you.

Gift Tax Background
Intra-family transfers of property are extremely common. Remember that in 2011, decedents can exclude up to $5 million of their estate before having to pay estate tax on the remainder. Likewise, in 2011 individuals can "gift" up to $5 million and not pay a tax on the gift amount (the Internal Revenue Code therefore "unifies" the estate tax and the gift tax.) However, any individual who makes gifts to any one donee during a calendar year above the $13,000 annual exclusion must file a gift tax return (an IRS Form 709). A return must be filed even if no tax is payable (due to the $5 million lifetime exclusion).

When the IRS issues a Summons to the State of California, what Information can it Gather about You?
With a summons served upon the state of California, the IRS can uncover transfers of real property to nonspouse family members. How? Property transfers in California generally constitute a "change in ownership" so that the county assessor may reassess a property for property tax purposes. Absent a change in ownership, the state may only increase a California property owner's taxes by 2% per year. In order to claim an exclusion from the change in ownership reassessment rule, California taxpayers must file Forms BOE-58-AH (Claim for Reassessment Exclusion for Transfer Between Parent and Child) or BOE-58-G (Claim for Reassessment Exclusion for Transfer Between Grandparent and Grandchild). These forms are filed with the local county assessor's office. California property owners are generally very diligent about completing these forms, because they do not want their property reassessed for fear of considerably higher property taxes. The state of California maintains a statewide database of the information garnered from these forms. And now the IRS has access to the Forms BOE-58-AH and BOE-58-G filed by California transferors of property (to relatives) seeking to avoid a reassessment of the property.

California tells the IRS of the Property Transfer, now the IRS is Looking for The Transferor's Form 709
The rest is relatively simple. The state of California allows the IRS to review the Forms BOE-58-AH and BOE-58-G, and the IRS simply follows up by seeing whether that individual completed a Form 709 (and paid gift taxes, if appropriate). IRS survey results concluded that at least 50% and up to 90% of individuals who transferred property to nonspouse family members failed to file a Form 709.

California residents- if you transferred property since 2005 to a nonspouse family member, and you should have filed a Form 709 and didn't (and didn't pay the appropriate gift tax, if any), go file it now. Because there is a very good chance the IRS is going to find this out anyway, and the penalties of their discovering your lack of compliance will be much worse if you have not already rectified the situation.

Tax Court: Professional Gamblers Can Deduct More on Their Tax Return Than Recreational Gamblers

Fri, 23 Dec 2011 12:53:41 -0800

Visitors to the Coachella Valley often spend some time at our local casinos: such as the SPA Casino in Palm Springs or the Agua Caliente Casino in Rancho Mirage. When the gambler has a single win of at least $1,200, the casino is required by law to issue the big winner a W-2G, which notifies the IRS of the win (great, thanks a lot casino). The Internal Revenue Code does allow a taxpayer to deduct gambling losses from gambling winnings (but not below zero) on an annual basis, but as we've discussed before, proving gambling losses can be difficult. After all, unlike the big win, the casino never notifies the IRS when the gambler has a big loss. The IRS has traditionally accepted a daily log or journal kept by the taxpayer detailing the gambling activity of the day as proof of gambling losses, but how realistic is keeping a daily journal? In our high-tech modern era, the best evidence a taxpayer can use to show the IRS that he or she was, in fact, a big loser (and not a big winner) is the casino issued "players card". The card allows the casino to electronically track the individual's gambling winnings and losses. This serves as excellent evidence when proving gambling losses to the IRS. So gamblers, always get and use the casino issued player's card, because the day might easily come when you need to prove your gambling losses to the IRS.

Special Rules For Deductions of "Professional Gamblers"

As discussed above, the Internal Revenue Code permits individuals to deduct gambling losses to the extent of gambling winnings (but not below zero). But here we're talking about gambling loses (i.e., wagering losses). What about expenses incurred in gambling? Can an individual who gambles for a living deduct gambling expenses just like a regular business expense (the rest of us seem to be able to deduct our business expenses)? If so, does the amount of gambling winnings have any bearing on the amount of expenses the professional gambler may deduct?

The US Tax Court addressed theses issues in the recent case of Mayo v. Commissioner, 136 TC 81 (2011). In that case, the taxpayer in question was in the business of "gambling on horse races"(i.e., a professional gambler). Although a facts and circumstances test, a professional gambler is generally one who gambles for profit, and not for recreation. The taxpayer in the case had substantial losses from the gambling on races, but the taxpayer also had significant expenses associated with the gambling activity. Such "business" expenses included meals, telephone costs, horse racing periodicals and admission fees into the horse racing grounds. If the taxpayer were allowed to deduct his total gambling losses and expenses, the total deduction would, in fact, exceed his total gambling winnings on the year.

The Tax Court held that these amounts may be deducted by the professional gambler. So gamblers with heavy losses and expenses are far better off classifying themselves as professional gamblers than recreational gamblers. This categorization permits the individual to deduct gambling losses (up to the amount of gambling winnings, as with any gambler), and expenses associated with gambling (below the gambling winnings threshold...fantastic!).

When Canadians Rent Out Their US Home, Do They Owe Tax in the US?

Mon, 19 Dec 2011 11:42:58 -0800

Let's take the case where a Canadian citizen is careful not to spend so much time in the United States so that he or she is not considered a US resident for tax purposes. Therefore this Canadian individual is not paying tax in the US on their worldwide income. This individual will still have to pay tax on their "US source income", and this will include rental income from their property owned in the US. So how will the US tax the Canadian citizen who owns property in the US and rents that property out, but otherwise does not spend too much time in the US so as to be deemed a US resident for tax purposes?
Taxation of Rental Income- General Rule
As a general rule, the Canadian who rents out their US property is subject to a 30% withholding requirement of the gross amount of each rental payment. In other words, the general rule on rental income is that 30% of each rental payment made to a Canadian-citizen landlord should be withheld, and forwarded to the IRS. Technically, it is the renter (likely a US citizen) who has the legal requirement to withholding from the rental payments made to the Canadian citizen-landlord. As a practical matter, the IRS will look to both the renter and the landlord for the withholding amount. To the extent the Canadian citizen hires a US property manager (extremely common for the Canadian snowbird), the property manager will be responsible for withholding on the rental amounts and remitting the tax to the IRS. Since the Canadian citizen must also report this amount on his or her Canadian tax return, a foreign tax credit on the Canadian tax return should be available for the US taxes paid, so this should not result in double taxation.
Electing to Pay Tax on the Rental Income Like A US Citizen
The Canadian renting US property, however, has an alternative to the general withholding rule described above. Instead of the general withholding provision, the Canadian may choose to pretend he or she is a US taxpayer. How does this work? The Canadian files a 1040NR tax return. Why file a 1040NR? Because now, the Canadian taxpayer is taxed like a US taxpayer (at least with respect to the rental income from the US property), and that means the Canadian can take deductions against the income just like a US taxpayer does. What kind of deductions? Well, for example, the Canadian taxpayer may deduct property taxes and mortgage interest from the gross rental income. After taking deductions, the rental income may result in little to no taxable US income. Choosing this route will likely lead to the Canadian paying less US taxes because under this scenario only the rental "profits" are taxed in the US (and not the gross rental amount). The 1040 NR (together with a Schedule E for rental income) should be filed by June 15 of the year after receiving the taxable rental income. For property located in California, the Canadian taxpayer would also file a Form 540NR.