Tax Deferrment Stategy

[TaoWanderer]

I bought a 4 acre real estate in Riverside County, California on 3/29/05 with an old mobile home on it for $77,000. I lived there and in Reno, NV over the past 28 months, but spent most of my time at the property in California. I am now selling the property for $195,000 with $20,000 down and I’m carrying the a note for $175,000. At 10% for 7 years. I am about to close on escrow in the next couple of days and am frantically researching my options regarding tax deferment i.e. declaring it as principal residence via IRS code §§ 121, 1031 exchange, structured settlement, income averaging, other.

Declaring it as a principal residence would be the easiest because it would defer all of the capital gains tax (gain of $118,000). I have been living there most of time for the past 28 months and as soon as I bought the property I turned on the electricity in my name on 3/30/05. I turned off the electricity on 10/18/06 and switched to using a generator. The property has a well and septic and a use a cell phone only, so there is no other utility bills as proof of residence. The factors that are working against me are:
• NV drivers license
• Did not file CA state tax return
• Address on Federal 2005 and 2006 Tax return was in Reno, NV at my parents house where I was getting my mail.
• Not registered to vote in CA
• Did not mark as primary residence on letter sent to me by Riverside County.

Would it be safe / wise to declare as a principal residence or am I asking for trouble i.e. automatic red flags, audit?

Does the IRS stick my return in a computer that looks for red flags?

If I declare as a principal residence would it bring up an automatic red flag by the IRS’s computer check system?

If I was audited what would happen?

Would I be able to prove that I lived there for 2 years?

If I want to do a 1031 exchange would that work if I am carrying a note?

Not sure what a structured settlement is but read that it was an alternative to 1031 exchange, is this a good option?

My income in the past 3 years has been below the standard deduction so would income averaging be a possibility?

Are the any other options that I haven’t thought of yet?

Do I have to pay CA state tax when I sell the property if I’m a NV resident?

Is the address on the Federal Tax return meant to be a mailing address or a residence address?What is the name of your state?

 

[abezon]

1. You can't do a 1031 exchange because the property was personal use, not business use.

2. You can certainly claim the primary residence exclusion. In the unlikely event you get audited and lose, you end up paying the taxes that you'll pay anyway if you don't claim the exclusion..... Your evidence is likely sufficient to disprove fraud, anyway. Save all evidence until 5 years after the final mortgage payment. In a safety deposit box. Also, gather any other evidence, such as affidavits that you did not live at your parents' house even though you used them as your mailing address for tax purposes.

3. If you elect to just pay the tax, your likely income tax each year is very low because you *are* using a structured settlement -- you're just calling it "carrying a note." Here's what's going to happen -- you will file a return for 2007 with an installment sale contract. You'll declare the contract price, the basis, whether the capital gains are exempt from tax, and how much you received in principal payments & interest payments. The principal payments are either ignored (claim exclusion) or go on part 2 of the installment sale form. The interest payments are fully taxable and are reported on Schedule B each year.

You will not attempt to file this return yourself; you will hire a professional who has done taxes for a few installment sales.

You will also pay a contract servicing escrow company to accept the monthly mortgage payments & make the property tax & insurance payments each year. That way both parties are protected from tax liens & insurance lapsing 2 weeks before the next forest fire. The company will also send both parties a statement of the year's total interest & taxes paid. The fee is usually less than $10/month & worth every penny.

You will part with some cash to have an attorney look over this contract before signing it. You need to make sure that your rights of reposession are protected. You need the contract to be absolutely clear that the buyer loses all equity if s/he misses 2 payments in a row. What is the late payment penalty? Etc. You also definitely want a prepayment penalty. After all, if the capital gains are taxable, you will have an income spike should the buyer refinance or sell in 4 years, which may give you an unpleasant tax spike. You may not get it in the negotiations, but you want it. Your real estate agent is not an attorney.

4. Since you are claiming primary residence in CA, file back CA returns for 2005 & 2006. Since your income is so low, this will not cause you to owe back taxes. Bingo, your tax filings now match your position that your primary residence was in CA.

5. Since the land is in CA, CA gets to tax the sale, period. Again, declaring the place your primary residence means no tax on the capital gains, although CA can tax the interest income as long as you are resident in CA. Should you leave CA for good, be sure to document that fact carefully with objective proof like re-registering your car in another state & tracking the exact day you left CA.

6. Income averaging has been dead for years unless you're a farmer.

 

[TaoWanderer]

I forgot to mention:

• I have been a NV resident my whole life, I am 27
• My 2 vehicles half owned by me are registered in Oregon where the other owner pays the insurance.

 

[tranquility]

Would it be safe / wise to declare as a principal residence or am I asking for trouble i.e. automatic red flags, audit?

Residency is a facts and circumstances test. You will not pass that test, and if caught the 121 deduction would be denied. You may set yourself up for criminal sanctions as well as you would be swearing under penalty of perjury you are a resident of a state during the time you didn't appropriately file resident tax returns for that state (if required). Which would make a lot of sense in that CA requires income taxes and NV does not. I suggest you don't go this route on your return as it may cause the authorities to look into what appears to be tax fraud.

Does the IRS stick my return in a computer that looks for red flags?

I am uncertain why so many worry about "red flags." The function of the discrimination engine is to compare return results with statistical guidelines for cheating. If found, a letter often goes out which the honest taxpayer gives a response to, thus closing the case. It's a hassle, but I encourage everyone to properly report their actions on the return even if it causes it to go outside the norm.

If I declare as a principal residence would it bring up an automatic red flag by the IRS’s computer check system?

While my office reports Sec. 121 sales on schedule D, it is not required. There is nothing you would have to report on your return unless you took some depreciation or made it a home office or something.

If I was audited what would happen?

You would lose the exemption and be charged taxes, penalties, and penalties (because of the amount, extra penalties would be added) and interest on the capital gain amount. Because of the nature of everything, you may be interviewed by the men in suits. Men in suits from the IRS are bad. They may report you to the state. That would be bad too. While unlikely, there is a distinct possibility of criminal charges from the feds (if they think you are a resident of NV) or the state of CA (if they think you are a resident of CA).

Would I be able to prove that I lived there for 2 years?

If you proved you used it as your personal residence for 2 years, the State of California would like to talk with you as to why you haven't been filing your tax returns rather than claim you were a resident of a non-income tax state.

If I want to do a 1031 exchange would that work if I am carrying a note?

You couldn't because you could not exchange to a like-kind property without more facts. The note is not relevant.

Do I have to pay CA state tax when I sell the property if I’m a NV resident?

Is the address on the Federal Tax return meant to be a mailing address or a residence address?

While it could be one factor in determining your residence, it is a mailing address.

 

[TaoWanderer]

1. You can't do a 1031 exchange because the property was personal use, not business use.

If I don't claim it as a primary residence, then it could be considered an investment property, right?

3. If you elect to just pay the tax, your likely income tax each year is very low because you *are* using a structured settlement -- you're just calling it "carrying a note." Here's what's going to happen -- you will file a return for 2007 with an installment sale contract. You'll declare the contract price, the basis, whether the capital gains are exempt from tax, and how much you received in principal payments & interest payments. The principal payments are either ignored (claim exclusion) or go on part 2 of the installment sale form. The interest payments are fully taxable and are reported on Schedule B each year.
You will not attempt to file this return yourself; you will hire a professional who has done taxes for a few installment sales.

I have been using Turbo Tax the past few years. Do you know if Turbo Tax can handle it?

You will also pay a contract servicing escrow company to accept the monthly mortgage payments & make the property tax & insurance payments each year. That way both parties are protected from tax liens & insurance lapsing 2 weeks before the next forest fire. The company will also send both parties a statement of the year's total interest & taxes paid. The fee is usually less than $10/month & worth every penny.

There is only a very old mobile home on the property which has no value and it would probably be a blessing if it burnt down. I have never had insurance on the property.
I wouldn't be liable in any way once the property is sold (e.g. if the new owner falls and breaks a leg), would I?
If she fails to pay the tax, then it goes to the tax auction and I bid it up to the equity that I still have in the property, because the county would have to pay off the note first, right?
I really appreciate your advice, but also I do not make very much money, is why I try to follow the "penny saved is a penny earned" philosophy. Of course, I don't want to do something stupid trying to save a few dollars that will cost me thousands later. I'm only 27, but I try to do my research thoroughly and do things myself.

You will part with some cash to have an attorney look over this contract before signing it. You need to make sure that your rights of repossession are protected. You need the contract to be absolutely clear that the buyer loses all equity if s/he misses 2 payments in a row. What is the late payment penalty? Etc. You also definitely want a prepayment penalty. After all, if the capital gains are taxable, you will have an income spike should the buyer refinance or sell in 4 years, which may give you an unpleasant tax spike. You may not get it in the negotiations, but you want it. Your real estate agent is not an attorney.

We didn't use any real estate agents. We just agreed on the terms and went to an escrow company. The escrow company drew up the note and we all kind of signed everything pretty quickly. The escrow is pending right now waiting for the buyer to come up with the funds. I guess I figured I could trust the escrow company to write the note correctly. Did I do wrong? Does it look like I have rights of repossession and that buyer loses all equity if they default?

Following is the text from the note:

DO NOT DESTROY THIS NOTE: When paid, this note and the Deed of Trust must be surrendered to ORANGE
COAST TITLE COMPANY with request for reconveyance.
INSTALLMENT NOTE
(INTEREST INCLUDED)
$175,000.00 Temecula, California,•July 27, 2007
In installments and at the times hereinafter stated, for value received I/We Promise(s) to pay to
#####################, A SINGLE MAN
or order, at ####################################
The principal sum of ONE HUNDRED SEVENTY-FIVE THOUSAND AND 00/100 Dollars, with interest from
________ on the amounts of principal remaining from time to time unpaid, until said principal sum is paid,
at the rate of 10.00 percent, per annum. Principal and interest due in monthly installments of TWO THOUSAND NINE
HUNDRED FIVE AND 21/100 Dollars, ($2,905.21), or more on the same day of each and every month, beginning on
the day of , and continuing until the __ day of , 2014 , at which
time any remaining principal balance and accrued interest shall be due and payable in full.

Each payment shall be credited first, on the interest then due: and the reminder on the principal sum; and interest shall
thereupon cease upon the amount so credited on the said principal sum. Should default be made in the payment of any
of said installments when due, then the whole sum of principal and interest shall become immediately due and payable at
the option of the holder of this note.

DUE ON SALE: If the trustor shall sell, conveyor alienate said property, or any part hereof, or any interest therein, or
shall be divested of his title or any interest therein in any manner or way, whether voluntarily or involuntarily, without
the written consent of the beneficiary being first had and obtained, beneficiary shall have the right, at its option, except
as prohibited by law, to declare any indebtedness or obligations secured hereby, irrespective of the maturity date
specified in any note evidencing the same, immediately due and payable.

LATE CHARGE: A late charge of 20% of the monthly payment shall be due in the event payment is received later than
10 days from which it is due.

Should suit be commenced to collect this note or any portion thereof, such sum as the Court may deem reasonable shall
be added hereto as attorney's fees. Principal and interest in lawful money of the United States of America. This note is
secured by a certain DEED OF TRUST to ORANGE COAST TITLE COMPANY, a California corporation, as
trustee.

 

[LdiJ]

If I don't claim it as a primary residence, then it could be considered an investment property, right?

Yes

I have been using Turbo Tax the past few years. Do you know if Turbo Tax can handle it?

This is not a return I would recommend doing on Turbo Tax, and quite frankly, for installment sales you really should be using a tax professional.

There is only a very old mobile home on the property which has no value and it would probably be a blessing if it burnt down. I have never had insurance on the property.
I wouldn't be liable in any way once the property is sold (e.g. if the new owner falls and breaks a leg), would I?
If she fails to pay the tax, then it goes to the tax auction and I bid it up to the equity that I still have in the property, because the county would have to pay off the note first, right?
I really appreciate your advice, but also I do not make very much money, is why I try to follow the "penny saved is a penny earned" philosophy. Of course, I don't want to do something stupid trying to save a few dollars that will cost me thousands later. I'm only 27, but I try to do my research thoroughly and do things myself.

None of these are tax questions. They are real estate questions and you should ask them on the real estate forum.



We didn't use any real estate agents. We just agreed on the terms and went to an escrow company. The escrow company drew up the note and we all kind of signed everything pretty quickly. The escrow is pending right now waiting for the buyer to come up with the funds. I guess I figured I could trust the escrow company to write the note correctly. Did I do wrong? Does it look like I have rights of repossession and that buyer loses all equity if they default?

Following is the text from the note:[/QUOTE]

 

[FlyingRon]

Hard to claim it as an investment if you are living there (even part time). Sounds like a vacation property to me.

A 1031 exchange doesn't sound like it is going to work anyhow. Where are you going to get the money to get the replacement property.

 

[TaoWanderer]

You will also pay a contract servicing escrow company to accept the monthly mortgage payments & make the property tax & insurance payments each year.

What are the possible consequences if the buyer just sends the payments to me directly?

What are the possible consequences if I let the buyer be responsible to make the property tax & insurance payments each year?

 

[TaoWanderer]

Residency is a facts and circumstances test. You will not pass that test, and if caught the 121 deduction would be denied. You may set yourself up for criminal sanctions as well as you would be swearing under penalty of perjury you are a resident of a state during the time you didn't appropriately file resident tax returns for that state (if required). Which would make a lot of sense in that CA requires income taxes and NV does not. I suggest you don't go this route on your return as it may cause the authorities to look into what appears to be tax fraud.

I decided to take the safe road and just pay the tax, lesson learned, and save myself a lot of possible future headaches. Also because it is spread over 7 years that helps.

So if I maintain my NV residence then the only thing I will owe CA is capital gains tax and not tax on the interest?

 

[TaoWanderer]

None of these are tax questions. They are real estate questions and you should ask them on the real estate forum.

Sorry about that I was unsure when I start the thread as to which forum to place it in.

Is there a way to place it in both or move it?

 

[abezon]

OK, round two....

1. Don't use turbo tax. Hire a professional at least in year 1. You could probably use turbo tax thereafter. Consider it part of the costs of sale, like state excise taxes & escrow fees & title insurance.

2. Tranq, I'm going to disagree with your residency conclusion. It is true that residency is a facts & circumstances test, however, *primary residence* is simply a "where so you sleep?" test. It is possible to have your primary residence & residency be in two different places. We get that in Washington with the snowbirds -- they are WA residents but may spend over half the year in AZ. However, since it's a temporary move, they remain residents of WA.

It sounds to me like this place was the guy's primary residence, regardless of whether he was a resident of NV or CA. Thus he is eligible to exclude $250,000 of gains on the sale of his primary residence. However, I'd recommend he take the tax position that he *was* a resident of CA in 2005 & 2006. It won't cost him a dime in state income taxes & makes his tax filings consistent. I'm not even sure the guy filed in 2005 or 2006, in which case there may be no inconsistent NV tax returns needing amending.

3. Unless you reside in CA, CA cannot tax the interest from the note. It can tax any reportable capital gains as they are received. If you haver excluded the gains under the primary residence rules, there are no taxable gains & CA can't tax anything unless you remain a resident. Even if you assert residency due to physical presence in CA for 2005-2007, you can sever residency by leaving the state before you get any interest payments, thereby removing CA's hand from your wallet.

4. I hope you're Irish, 'cause you're gonna need the luck. Did you at least get the property appraised before picking the sum of $195,000? Maybe it's worth more. Is the interest figured on a yearly, monthly, or daily basis?

How much will it cost to foreclose if the buyer misses payments? You'd best set aside that much of the initial proceeds in a savings account so you can at least enforce your rights. Unless you've saved the necessary funds or have other income, you can't count on the buyer's payments -- you're foreclosing because she stopped paying 3 months ago!

5. "If she fails to pay the tax, then it goes to the tax auction and I bid it up to the equity that I still have in the property, because the county would have to pay off the note first, right?" WRONG!!! Say she defaults on the taxes. By tax auction time, you've received $40,000 of principal & the note value is $155,000. You bid $155,000. The property is now worth $300,000, so someone else bids $160,000 & walks away with your land at a huge bargain.

Compare this to a mortgage default where you get possession automatically: You have $40,000 PLUS property worth $300,000, which you can turn around & resell for $300,000. See why a tax sale is horrible? Use a bloody escrow service! At the very least, verify directly with the county that the taxes were paid on time so you don't get hammered by this.

BTW, I don't see anything in the note about who's responsible for the taxes or if you can foreclose on the mortgage if she is delinquent on taxes but current in mortgage payments.

 

[tranquility]

2. Tranq, I'm going to disagree with your residency conclusion. It is true that residency is a facts & circumstances test, however, *primary residence* is simply a "where so you sleep?" test. It is possible to have your primary residence & residency be in two different places. We get that in Washington with the snowbirds -- they are WA residents but may spend over half the year in AZ. However, since it's a temporary move, they remain residents of WA.

I will have to counter disagree with you. While occupancy is necessary, I don't believe it is sufficient to establish the use as a primary residence test. I agree that temporary absences from the primary residence (even if for a whole season) would still count as use, but we still have the primary *residence* requirement--which counts under the facts and circumstances test. Since this is interesting to me, I'll spend a little time in research to see if my understanding is correct. If you have a cite, I would appreciate it as it would save me some time.

However, I'd recommend he take the tax position that he *was* a resident of CA in 2005 & 2006. It won't cost him a dime in state income taxes & makes his tax filings consistent. I'm not even sure the guy filed in 2005 or 2006, in which case there may be no inconsistent NV tax returns needing amending.

I agree filing CA income tax returns would go a long way towards establishing residence [CA term-domicile]. (But would not be determinative.) Why would you think no tax would be due? I missed the fact he had no income, was this in another thread? (NV has no personal income tax and he has to amend nothing.)

I still say he is a resident of NV and the CA property is not his primary residence. You are one of the very few on this list who can disagree with me on a tax issue and cause me to reconsider, so I will research farther. But I stand by my answer at this time.

 

[FlyingRon]

You may wish to read this:

http://www.irs.gov/taxtopics/tc705.html

about installment sales.

Tranquility is right. Just living there is not sufficient to determine PRIMARY residence and the IRS case law is full of this. They specifically look for you to establish it as primary (as opposed to a second) residence: Paid Taxes, Registered To Vote, etc...

 

[abezon]

OK tranq, I'll try.

First, let me state that I evaluate the facts with an eye towards not triggering the 'signing a fraudulent return' rules. Since audits are very rare, I don't worry if the evidence is dicey in the event of an audit. As any prosecutor or defense attorney will tell you, knowing a fact is one thing; proving it is quite another. As long as we don't trigger the knowing fraud rules, losing an audit just means the client has to pay the tax he was going to pay anyway. More on this later. (I explain the difference carefully to the client & let him decide.) But I digress.

Pub 523 uses the term 'main home,' not primary residence. Thus the word residence is not in there at all. The Pub. defines main home as "the home you live in most of the time." Other factors that may come into play include where you work/derive income, where your spouse & kids live, mailing address, address on official documents, locations of banks, location of recreational clubs & religious organizations (community ties).

Applying these: Poster definitely stated that he lived in the CA home most of the time, he's just short of proof. Therefore, we start from the position that this is his main home & see if other factors rebut this conclusion.

Poster didn't say where he works or derives income, but his income was below the gross income filing requirement anyway, so I'm not sure that this factor would be for or against main home status.

Poster appears to be single & 27 years old, so the family factor is neutral. Where his parents live is irrelevant. We don't know his mailing address. He had some mail sent to the house, mainly utility bills. Among other things, the electricity bill would show that usage was consistant with residency most of the month. (Can ya produce the bills or get copies from the electric company, poster?) Also, the cell phone bills can show where he was when making & receiving calls, which is fantastic evidence of main home status. (Poster, if you don't have these, contact your cell company for duplicates soon.) This factor supports main home status.

Official documents generally have a NV address. Can poster give a good reason why? Many people don't get a new license when they move to a new state, even though they're supposed to. I told at least 30 clients to get new licenses this tax season. The fed tax returns were filed using the NV address. However, filing CA returns would tend to rebut NV residency, even if filed from a NV address, since the guy just sold his house & may not have a new permanent address yet. The one I'm concerned about is voter registration -- the guy didn't register in CA, but is he registered in NV? Registering to vote/voting somewhere you don't live is a crime, so this could weigh heavily against main home status. (Although simply being registered in NV could be rebutted by the fact that the guy didn't actually vote in NV after 2005.) The car is registered in the home state of the co-owner. All in all, official documents could go either way. We don't have the info needed to evaluate properly.

We don't know where the guy banks. Presumably he has/had some account in Riverside county. On the other hand, many banks are national now, and people don't bother moving the account, they just use it from a new location.

We have no idea what clubs this guy belongs to. If he belongs to any groups in CA, that would tend to support main home status. I'd also like to know if the guy belongs to any NV organizations. If he doesn't belong to anything anywhere, the factor is neutral.

I don't know if the IRS could rebut our poster's assertion that CA was his main home for two years. I think they'd find it especially hard to do if he files CA back tax returns for 2005 & 2006, and if he has his old cell phone bills, electric bills & the generator receipt showing why the electric stopped in 2006.


Another factor to consider is that this is an installment sale, so the actual tax at risk each year is small. There's an IRS presumption of fraud is you understate your income by 25% or if your revised tax increases by more than $5000. Poster will have a chunk of interest each year, but adding that year's share of the capital gains won't change his return enough to constitute presumed fraud. Thus the IRS can only proceed under the knowing fraud rules & will have a very hard time winning that case. Even if poster doesn't have the evidence to defeat an audit, he's got enough to negate fraud.

BTW poster, put 10-15% of each mortgage payment into a savings account for taxes so you have the money to write Uncle Sam a check each April.

 

[tranquility]

Code Sec. 121 says (in part) “and used by the taxpayer as the taxpayer’s principal residence”, so for our discussion, lets use “principal residence” and leave the publications to others who are less legally inclined. I think we will all agree even without looking up the case law that a person can have only one principal residence. The regulations at 1.121-1(b) clearly make the test a facts and circumstances test for “residence” and provides some of the factors.

(1) "IN GENERAL. Whether property is used by the taxpayer as the taxpayer's residence depends upon all the facts and circumstances. "[and so on, and:]
(2) "PRINCIPAL RESIDENCE. In the case of a taxpayer using more than one property as a residence, whether property is used by the taxpayer as the taxpayer's principal residence depends upon all the facts and circumstances. If a taxpayer alternates between 2 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. In addition to the taxpayer's use of the property, relevant factors in determining a taxpayer's principal residence, include, but are not limited to—"

The regulations then list some of the factors. The place of employment; principal place of abode of family members; address listed on taxpayers’ federal and state tax returns, drivers’ license, automobile registration, and voter registration card; mailing address for bills and correspondence; location of banks; and location of religious and recreation organizations person is a member of.

This clearly shows it is not mere use, but use as a *principal residence* which is determinative.

Now, I come to a different conclusion to the facts and circumstances. OP has a clear knowledge of tax laws and listed:

• NV drivers license
• Did not file CA state tax return
• Address on Federal 2005 and 2006 Tax return was in Reno, NV at my parents house where I was getting my mail.
• Not registered to vote in CA
• Did not mark as primary residence on letter sent to me by Riverside County.

• I have been a NV resident my whole life, I am 27
• My 2 vehicles half owned by me are registered in Oregon where the other owner pays the insurance.

These things combined tell me he made a conscious choice to make NV his residence. He might come up with some other factors, but the great bulk is that he is not a resident of CA.

Now, let’s be realistic. Was the Riverside address his actual residence? Yes, I bet it was. I bet he lived there with the intent for it to be his residence, but he doesn’t like to pay taxes. Knowing NV does not have personal income taxes, he manipulated the facts to be able to claim he was not a resident of CA but NV. I believe his fear of “red flags” and his obvious knowledge of the law shows *intent* to an otherwise quite convenient set of circumstances. (“Convenient” in the way the Dana Carvey as the church lady on Saturday Night Live would use with the pursed-lipped “how convenient” to a person’s explanation.)

The time for cleverness has now ended as the OP wants to sell the property. He wants to disappear all the facts he has developed through the years and change them to his current advantage and worries about if the government will find out. At least, that’s my take. What’s yours?