Washington Watch

One of the companies who is handling payments received by the IRS with credit cards has mistakenly coded some payments for 1998 estimated taxes as 1999 estimated taxes. Resulting in penalties for 1998, and an overpayment in 1999. The IRS says the error was caused by US Audiotex, the company handling those transactions. Maybe the IRS has stumbled onto something to keep them from catching all of the heat.

Estate tax elimination is being debated again in the Senate Finance Committee. Senators Jon Kyl (R-Ariz.) and Bob Kerry (D-Neb.) have introduced the Estate Tax Elimination Act which provides that no estate tax would be due upon the death of an individual. If the decedent passes on a business or other property, that asset would only be taxed if sold by the heir. It would be taxed at the capital gains rate the decedent would have paid had the decedent sold the asset before death. While this appears to eliminate estate taxes, which can be as high as 55%, this measure does not seem to have retained the provision of granting a "step-up" in the tax basis of assets to the fair market value at the date of death. It is also unclear as to whether or not there would be any exemption from capital gains tax. Currently individuals with estates valued at less than $650,000 would pay no estate tax, and their heirs could sell any of their assets after their death with no tax implications. If there is no similar exemption, this bill clearly doesn’t have a chance of passing. As a side note, Chuck Robb (D-Va.) is one of the sponsors of the bill.

The IRS is shifting some of its focus from auditing taxpayers to educating them. Over the past several years, the IRS has met with several groups on various issues to explain their position on the topics discussed, hear the groups positions and thoughts on the topics, and hammer out more understandable and easier to follow regulations and procedures. Examples of this approach are efforts by the Service on the issues of independent contractor classification and tip reporting in recent years. The emphasis on education is hoped to yield better compliance, with less negative press than the old operating procedure of auditing everything that moves and scaring us into compliance. The Service has shifted its focus to more flagrant violations of such issues.

Congress is looking into expanding tax incentives for education. One proposal is giving tax credits to offset tax impacts when Education IRA’s are used for college. They are also looking at extending the pay-in deadline for Education IRA’s from December 31 to April 15. Another proposal is extending the time period that you can deduct interest on education loans beyond the current 60 month period. All of these proposals have a pretty good chance of being implemented and becoming effective for 2000.

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Retention of Tax Records

We are frequently asked for guidance on how long you should retain your personal income tax records. These records may have to be produced if IRS (or a state taxing authority) were to audit your return or seek to assess or collect a tax. In addition, lenders, or other private parties may require that you produce copies of your tax returns as a condition to lending money, approving a purchase, or otherwise doing business with you.

Keep returns indefinitely and the supporting records usually for six years. In general, except in cases of fraud or substantial understatements of income, IRS can only assess tax within three years after the return for that year was filed (or, if later, three years after the return was due). For example, if you filed your '96 individual income tax return by its original due date of April 15, '97, IRS would have until April 15, 2000 to assess a tax deficiency against you. If you filed your return late, IRS generally would have three years from the date you filed the return to assess a deficiency.

The problem with the three-year rule is that the assessment period is extended to six years if more than 25% of gross income is omitted from a return. In addition, the assessment period does not begin to run until a return is filed. Therefore, if IRS claims that you never filed a return for a particular year, it can assess tax for that year at any time (even beyond three or six years), unless you can prove that you did file. Proving that you filed would, of course, be impossible after you have discarded your returns. While it's impossible to be completely sure that IRS will not at some point seek to assess tax, retaining tax returns indefinitely and important records for six years after the return is filed should, as a practical matter, be adequate.

Records relating to property may have to be kept longer. Keep in mind that the tax consequences of a transaction that occurs in one year may depend on things that happened in earlier years—and that the period for which you should retain records must be measured from the year in which the tax consequences actually occur. This may be significant, for example, where you sell property that you bought years earlier. For example, suppose you bought your home in '80 for $100,000 and made an additional $20,000 of capital improvements in '88. To determine the tax consequences of the sale, it's necessary to know your basis (i.e., original cost plus later capital improvements). For example, if you sell your home in '98, and your return for that year is audited, you may have to produce records relating to the purchase in '80 and the capital improvement in '88 to be able to show what your basis is. Therefore, those records should be kept for at least six years after your '98 return has been filed instead of just six years after the transactions they relate to occurred. Even though as much as $250,000 of home sale gain can now escape tax (up to $500,000 for joint return filers), you should still retain all records relating to home purchases and improvements. There's no telling how much the home will be worth when it's sold, and there's no guarantee that the home sale exclusion will still be available when the future sale takes place.

When new property takes the basis of old property, records relating to the old property should be kept until six years after the sale of the new property is reported. For example, suppose you purchased a car for business use in '95 and you traded it in on a new car for business use in '98. If you sell the new car in '99, your basis in the new car will determine whether you have a tax gain or a tax loss on the sale, and your basis in the new car is determined, at least in part, by your basis in the car you traded in during '98. Accordingly, records relating to your old car should be kept until 2006 (i.e., for six years after your '99 return is filed).

Similar considerations apply to other property which is likely to be purchased and sold-for example, stock in a business corporation or in a mutual fund, bonds (or other debt securities), etc. In particular, remember that if you reinvest dividends to purchase additional shares of stock, each reinvestment is a separate purchase of stock, and the records of each reinvestment should be kept for at least six years after the return is filed for the year in which the stock is sold.

Because the calculation of the casualty and theft loss deduction is determined in part by your basis in the damaged or stolen property, you'll need to have records to support that basis, until six years after you file the return claiming the loss deduction.

If separation or divorce becomes a possibility, be sure you have access to any tax records affecting you that are kept by your spouse. Or better still, make copies of the tax records, since in such situations, relations may become strained and access to the records difficult. Your records should include a copy of the divorce decree or agreement of separate maintenance, which may be needed to substantiate alimony payments and distinguish them from child support or a property settlement. Copies of all joint returns filed and supporting records are important, since the liability for tax on a joint return is joint and a deficiency may be asserted against either spouse. Your records should also include agreements or decrees over custody of children and any agreements as to who is entitled to claim an exemption for them. Retain records of the cost of all jointly-owned property. Also, get records as to the cost or other basis of all property your spouse or former spouse transferred to you during your marriage or as a result of the divorce, because your basis in that property is the same as your spouse's or former spouse's basis in it was.

To safeguard your records against loss from theft, fire or other disaster, you should consider keeping your most important records in a safe deposit box or other safe place outside your home. In addition, consider keeping copies of the most important records in a single, easily accessible location so that you can grab them if you have to leave your home in an emergency. If, in spite of your precautions, records are lost or destroyed, it may be possible to reconstruct some of them. For example, a paid tax return preparer is required by law to retain, for a period of three years, copies of tax returns or a list of taxpayers for whom returns were prepared. Similarly, other professionals who assisted you in a transaction may retain records relating to the transaction. For example, a stockbroker through whom you bought securities may be able to help you to determine the basis of the securities, and an attorney who represented you in the purchase of your home may retain records relating to the closing. Nonetheless, because you can never be sure whether those persons will actually have the records you need, the safest course of action is to keep them yourself, in as safe a place as possible.

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Buy That Vacation Home

You have wanted that vacation home for years. With the possibility of renting out the house for part of the year, you think you may be able to swing it. There are a few things that you should consider.

GETTING A MORTGAGE: Unless you have saved the cash, you are going to need a mortgage. The interest rates for second homes are typically one quarter to one half of a percent higher than the rates for a primary residence. You will generally pay more points as well.

You might be able to fund all or part of your vacation home purchase with a home-equity line of credit on your main home. But remember that interest rates on these loans usually float at a point or two above the prime rate, so you could pay more over the life of the loan than if you had taken out a second-home mortgage. Project the after-tax costs of all borrowing options before making a decision.

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TAX RULES: Don’t start barbecuing those steaks yet. If you plan to rent out your vacation property, you will have to contend with a special set of tax rules. The tax treatment can vary from year to year depending on your use of the home.

Primarily personal use means that your home is rented for fewer than 15 days a year. Personal use includes use by you, a relative, or anyone having an ownership interest in the property. Rental income is not reported, and qualified mortgage interest and property taxes are deductible.

Primarily rental use applies if your home is rented for 15 days or more in a year, and personal use does not exceed the greater of 14 days or 10% of the rental days. Rental income is includable in gross income, and only the personal portions of property taxes (not mortgage interest) is allowed as an itemized deduction. Rental portions of interest, taxes, and other expenses are deductible in determining income or loss from the rental activity.

Part rental/part personal use applies if the home is rented for 15 days or more in a year, and personal use exceeds the greater of 14 days or 10% of the rental days. Rental income is includable in gross income, and expenses must be allocated between personal and rental use.

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