“If all the economists were laid end to end, they would not reach a conclusion.” — Warren Buffett

By now almost all of you have heard about this tax act, hurriedly passed in the waning hours of 2007 — and a few of you may even really understand it. Unfortunately, a number of of you may have been caught in the sub-prime adjustable rate mortgage debacle and bumped up against the provisions of this law. And some of you have found out to your absolute horror that this high-sounding law would not be of the slightest help to you! The supposed highlight of this law is a three-year exception to the normal law on debt forgiveness — but whom does it apply to and really help?

The Old Rules on Debt Discharge

Here is an example of the way it used to work (and still does for many unsuspecting individuals, as we will later discuss). EXAMPLE: Assume a $350,000 mortgage, an individual whose adjustable rate mortgage payment just went up another $1,500 a month, so he or she stopped making mortgage payments, the house went into foreclosure and has now been sold by the bank in the terrible falling home market for $275,000.

The shortfall and loss to the bank is $75,000 ($350,000-$275,000). That “forgiveness of indebtedness income” is reported to the IRS and then is legally ordinary income in the year of the sale to the individual that defaulted on the mortgage. So you had this poor soul who just lost his house also owing the IRS (and probably the state) ordinary income taxes on the $75,000. This is the situation that is (somewhat) addressed by this law.

The New Law

The new law (effective January 1, 2007) is intended to grant forgiveness from those old rules that created taxable income, as in the example just described. But here are the restrictions that you must understand — and that can prevent many of you from qualifying for any relief:

• The forgiven mortgage debt rules only apply to your principal residence. Not one penny of help for a second (or third) residence (i.e., vacation home property) or investment property.
• As much as $2 million can be excluded from debt discharge-forgiveness income — but only for the years 2007, 2008 and 2009 (or $1 million for a married individual filing separately).
• BIG RESTRICTION TRAP: The discharged-forgiven mortgage debt (secured by the primary residence) must have been entirely used to purchase, improve, or build your principal residence. This provision will probably kill the chances for more people than it will help! CAUTION: This means that home equity loans and/or “cash-out refinancing” loans do not qualify for the mortgage waiver (unless the additional funds were also used to improve your primary residence — highly unlikely). So the refinanced mortgage for a higher amount or home equity loan used to pay off credit cards, buy a car, take a trip and similar will not qualify for forgiveness!
• The amount of forgiveness is pro-rated in cases where only part of the indebtedness qualifies as just described. However, in many/most cases it will be the increased refinancing debt that does not qualify for forgiveness (see following for an example).
• The old rules that enable one to avoid taxable income on debt forgiveness still apply. They are insolvency and/or farm or business debts. The new exclusion does not exactly apply to Chapter 11 bankruptcy, although insolvency usually results.

Remember the constant ads on radio and television that went about like this? “Why pay 20 percent in credit card interest? Refinance and increase your mortgage at only 6 percent, or take a home equity loan, and either way use those additional proceeds to pay off all those credit cards? How can you lose?” Now it’s exactly those people who cannot qualify to avoid taxable income if they default on their mortgage. To reiterate: You can only qualify for a full tax-free cancellation of a mortgage default if (among other conditions) the entire forgiven mortgage funds were used to purchase, improve or build your principal residence.

PREDICTION: Given these regulations, my best estimate is that only about 5 percent-15 percent of those unfortunate individuals will qualify for this debt income forgiveness. However, since these new rules apply all the way up to December 31, 2009, perhaps you should save this article in case you fall into this kind of tax trap.

Pro-Rated Forgiveness Example

As stated above, only part of your mortgage may qualify for forgiveness. EXAMPLE: Primary residence was purchased for $600,000 in early 2005 with a mortgage granted at that time for $550,000. However, in late 2006 they refinanced and obtained a new mortgage for $650,000. The extra $100,000 was spent to pay off all credit cards, a new car, and a vacation in Europe.

In early 2008 they could not make the increased mortgage payments and the house was foreclosed. The bank sold the house for $525,000 (its fair market value). The total forgiveness of indebtedness income is $125,000 ($650,000 mortgage less $525,000 selling price/market value).

Under the new law, for federal tax purposes, they are only forgiven $25,000 ($550,000 original acquisition debt mortgage less $525,000 selling price). They still have $100,000 of ordinary income from forgiveness of indebtedness that did not qualify under this new law. Which, of course, is the exact amount that they took from the mortgage increase and did not spend it to improve the existing house.

Finally, if they live in California (or a number of other states), they must report the entire $125,000 as ordinary income. Why? Because (at this writing and probably never) California and other states did not conform to (i.e., “recognize”) this new federal law.

And, of course, the owners in this example have a non-deductible personal loss on the sale of a personal residence.

Other Provisions of the Three Last-Minute Tax Laws

The Alternative Minimum Tax (AMT) “patch” applies to your 2007 tax returns only. It increased the AMT exemption to $66,250 from the 2006 exemption of $62,550 (joint tax returns). If you want to see if and how much AMT you paid for 2007, go to Page 2, Form 1040, and see Line 45. The IRS cleverly moved the AMT figure from Page 1 (where it was easy to notice), to Page 2 a few years ago. How many of you even noticed? Neither Congress nor the Bush Administration seem to be able to find a permanent solution to the growing application of the AMT to more and more taxpayers. The problem is money, since the AMT brings in incredible amounts of additional tax dollars. How can they replace that income if they eliminate the AMT?

Under limited time and circumstances, there is now a possible deduction for qualified mortgage insurance.

Starting January 1, 2008, the sale of a residence that was jointly owned and occupied by both the surviving and deceased spouse is entitled to a $500,000 gain exclusion (rather than $250,000), provided the sale occurs no later than two years after the death of the deceased spouse. The old law required the sale to be in the same year as the death of the spouse, or otherwise the survivor only got a $250,000 profit exclusion. This is a good one.

Effective on date enacted in 2007, the penalty for failure to file on time (but filing for extensions can save you) is increased to:

• For partnerships: $86 per partner, per month — for up to 12 months. (The Mortgage Forgiveness law increased it to $85 and the Virginia Tech Victims law increased it another $1 — and a lot of tax writers missed that second dollar.)
• For S corporations: $85 per shareholder, per month — for up to 12 months.

The Energy Bill extends the additional 0.2 percent Federal Unemployment Tax surtax through 2008, for a total rate of 6.2 percent.

The U.S. Treasury’s fiscal year 2008 budget was set at $12 billion, of which $4.8 billion is for “enforcement activities.”

Undoubtedly more tax bills will have been passed by the time you read this.

Mortgage Workouts — A Suggested Possibility Only

The forgiveness tax act discussed earlier suggests possible mortgage workouts for some taxpayers — without any mandatory rules. Consider this: “When a lender determines that foreclosure is not in its best interest, it may offer a mortgage workout under which the terms of the mortgage are changed to result in a lower monthly payment.”

A suggested workout plan endorsed by the Bush Administration and some lenders, would forgo adjustable rate resets (to otherwise higher monthly payments) for up to five years. (Interestingly, this could result in forgiveness of indebtedness income that may or may not be taxable — depending on how one qualified under this new mortgage law.) There are other workout proposals being discussed, but keep in mind these are optional with the lender and not mandatory. Quite possibly you could have a lender who simply refuses to discuss or offer a workout plan at all.

Even the proposed Administration mortgage rate-freeze plan only would apply to borrowers who took out loans between January 1, 2005 and July 30, 2007 — and whose rates are scheduled to rise between January 1, 2008 and July 31, 2010. Also:

• If your rate has already reset, you are ineligible and stuck with that higher payment.
• Homeowners who are in arrears by more than a month, or those who have been 60 days late more than once in the past 12 months are ineligible for any relief.
• Homeowners who are already in foreclosure, or those who have already refinanced their loan are also ineligible.
• Only homes occupied by owners can even possibly qualify — no “flippers” or second vacation homes.

As you can see, the lenders have a lot of discretion in deciding who gets relief and who does not. My cynical comment: I call this “political jawboning” to get points with the public — and just limited help for some.

Increased IRS Audits of Schedules C

As we have warned a few hundred times or so, the filing of Schedule C (i.e., sole proprietor, self-employed) with your individual tax return is subject to the very highest percentage of IRS audits of any category. The IRS now estimates that the non-farm self-employment income is underreported on Schedules C by an estimated $68 billion. In response, the IRS plans to increase by September 30, 2008, the number of Schedule C audits by another seven percent — and still another five percent increase by September 30, 2009.

To reprint some of our previous advice:

“Operating as a sole proprietorship generally results in unlimited liability and exposes all your assets to lawsuits, judgments, etc. Consider incorporation of your Schedule C business (as either a C or S corporation), for liability protection; and to substantially lower the statistical chances of an IRS audit; and usually for better fringe benefits. This is particularly true for that audit category of over $100,000. At this point you are running a true “business” and the many advantages of other forms of business entities become more and more attractive for many reasons.

If you absolutely refuse to give up your Schedule C status, you have nothing to lose by becoming a “one person Limited Liability Company (LLC).” Talk to your lawyer about this option, as you could shelter some of your assets from your present unlimited liability; and still continue to file that Schedule C as always. (CAUTION: We have been told that a single-member LLC affords less protection from personal liability than a multiple member LLC, but it’s better than nothing.) As far as avoiding IRS audits, a partnership is also much better than filing Schedule C, and frequently it also helps in protecting your assets as well.”

Form 8919 Opinions

We previously reported on the new (complicated) Form 8919 that can be filed by anyone classified as an “independent contractor” who really feels he or she is really an “employee.” Here are some preliminary opinions from tax professionals:

• This form is asking a person usually without any expertise in making this complex determination — to make the distinction between an independent contractor and an employee.
• This form encourages the filing of Form SS-8 in conjunction with the Form 8919. This is a complicated, slow, and extensive process.
• This form has the potential of being abused by those seeking unwarranted employee coverage.

My own opinion: The form is far too complicated for the average person. It should have been simplified (about 90 percent) as a “first shot” to the IRS — subsequently more information could have been developed/requested by the IRS if warranted.

Paying Your Taxes by Credit Card

You can make your federal, state or local tax payment by credit card — and use your American Express, Master Card, Visa or Discover cards. The cost is 2.49 percent of the tax payment amount (in California) and you will have to decide if that’s worth it or not.

Both individual and business tax payments can be made using these credit cards — but not for federal deposit tax payments. Over 30 states will accept such payments. Further information is available at 1-800-272-9829 or www.OfficialPayments.com.

Tenant in Common (TIC) Tax‑free Exchanges

As I have previously written, there is a proliferation of tax-free exchanges under IRS Section 1031, in which a regular real estate interest is exchanged for a TIC interest (and I cautioned to be careful) as the number of such offers and sales pitches has become somewhat alarming. Keep in mind those nice fellows giving free “educational seminars” about TIC exchanges are getting a commission for signing you up. While a TIC interest is considered like-kind (Sec. 1031) exchanged property — a partnership interest is not — and therein lies the danger.

IRS Revenue Procedure 2002-22 lays out the TIC rules in order to qualify for the tax-free exchange and avoid partnership classification:

• Each TIC owner must hold title to the property.
• There can be no more than 35 co-owners.
• The group cannot file a partnership or corporation tax return or conduct business under a common name.
• Co-owners must retain the right to hire and fire managers, sell the property or refinance the property; and
• Co-owners must share profits proportionately.

It’s quite possible that a TIC agreement exactly conforms to the above rules and can still be classified as a partnership. For example, in actuality the authority for the business operations are then signed over to one owner — similar to a general partner. Then the entire tax-free exchange could be disallowed.

Be careful.

IRS News

Former IRS Commissioner Everson resigned his position to become president and CEO of the American Red Cross (probably for a lot more money and less aggravation). Not long after in November 2007, the Red Cross announced that Everson had resigned because he had “engaged in a personal relationship with a subordinate employee.”

Sorry, I know you are all expecting one of my usual bad jokes about this news, but I never joke about anything to do with the IRS.