Tuesday, February 03, 2004

How do you correct depreciation errors for back years? The IRS has issued temporary regulations and revenue procedures giving guidance for how to make corrections for depreciation errors for back years. Here is an oversimplified summary. See the source documents for details. Under Revenue Procedure 2003-50, the time for making the election has been extended for taxpayers that missed the expense election for the tax year that included September 11, 2001. Since December 31, 2003 has passed, a taxpayer may make the election by filing a Form 3115 (Change of Accounting Method) with the taxpayer's timely filed federal income tax return for the second taxable year after the taxable year that included September 11, 2001. The fiscal year must end on or before July 31, 2004, and the taxpayer must have owned the property as of the first day of that taxable year. Under final and temporary regulations issued with Treasury Decision 9105, "catch up" depreciation adjustments can generally be made as automatic accounting changes by filing Form 3115 (Change of Accounting Method) with the income tax return for the year of correction. A change in useful life is not a change of accounting method, so no Form 3115 is required for this change. Adjustments relating to a change in useful life are made in the current and future years, not as a Section 481(a) (catch-up) adjustment. Under Revenue Procedure 2004-11, prior-year depreciation errors may be adjusted for the year an asset is sold, even when the asset hasn't been depreciated for two years by including Form 3115 with the income tax return for the year of sale. 2004 last chance for bonus depreciation? Remember that some of the recent tax law changes have short effective dates because they are economic stimulus provisions. For example, 50% bonus depreciation is scheduled to expire on December 31, 2004. There are some advantages of bonus depreciation compared to the expense election. For example, trusts qualify to claim bonus depreciation but not the expense election. Also, there are no limits for the total amount of bonus depreciation that can be claimed. Remember, only new assets qualify for bonus depreciation. Also remember California and most other states do not allow a deduction for the federal bonus depreciation amount. 6:16:29 PM

A number of readers have asked about this. Just a different name for the same thing? Far from it. If you and another party--your spouse, child, relative, friend, business partner, etc. want to co-own property, both forms can be used. But the legal consequences are very different. If you and a friend own property as joint tenants, the property automatically passes to the survivor on the death of the other party. Good news? You don't need a will. Bad news? A will won't change the outcome. And, no matter how many co-owners are involved, it's assumed that each has an equal share. Thus, if Fred, Sue and Dick purchase a rental as joint tenants, each will have a 1/3 share. Finally, in the case of jointly owned property, no owner can sell his or her share without the other parties' consent. On the other hand, if the property is owned as tenants in common, the ownership shares can be different and each party is considered to own his or her share and can dispose of it as they wish. For example, if Fred puts up 20% of the purchase price, Sue puts up 50% and Dick puts up 30%, that's what their ownership interests will be--20%, 50%, and 30%. Each party can leave his or her shares to any beneficiary on death or sell their interest to any other party without the consent of the other owners. Each party can also encumber (borrow on) his or her interest in the property (the rule here varies by state). All parties should keep a record of the expenditures they pay, paying attention to the type of expenditure. That is, whether the funds were used for general upkeep (maintenance, property taxes, etc.) or to pay the mortgage or for capital improvements. Keep in mind that each owner is jointly and severally liable for the mortgage. That means, should the other parties not pay, you can be responsible for the entire amount. What happens if you haven't chosen a form of ownership after purchasing property with another party? In some states, ownership as tenants in common is assumed. There are several other ways to jointly own property. The first is called tenancy by the entirety with right of survivorship. It's similar to joint tenancy (the surviving spouse automatically inherits the property on the death of the other spouse), but is only available to married couples, and only about half the states allow it. Some married couples automatically choose this option. But that's not always the best approach. The second is by setting up a partnership. This is more expensive. You'll have to draft a partnership agreement, file papers with your state, file federal and state tax returns for the partnership, set up a bank account, etc. But there are a number of advantages here. First, your partnership interests can be very different. For example, Fred puts up 30% of the funds to buy the property and Dick puts up 70%. But Fred agrees to manage the property and cover 50% of the maintenance expenses. Fred could have a 30% capital interest (e.g., he gets 30% of the proceeds on the sale), but is entitled to 50% of the profits and losses. In situations like this, a partnership makes particular sense. Second, should Fred decide to leave, he can simply sell his partnership interest without selling the underlying property. That's important if more than one property is involved. (Selling a partnership interest isn't all that simple, but it's easier than dealing with joint ownership.) Because of the cost of dealing with a partnership, it probably doesn't make sense for a vacation home that's not rented for profit, particularly if the parties are relatives. The big disadvantage of a partnership is that the partners are jointly and severally liable for the debts of the partnership. (A limited partnership avoids that problem, but is more complicated. You can also avoid the problem by organizing as an LLC.) An LLC (limited liability company) is similar to a partnership in that it exists as a separate entity, files tax returns, and is generally taxed as a partnership. The big difference is that LLC owners are generally not responsible for the liabilities of the entity. You might consider setting up a trust. This approach is very popular way to hold real estate in some states, but it's often not as flexible. It can be a good way of holding real estate for appreciation, or a vacation home or simple rental property. A S corporation is sometimes used as an alternative to a partnership, but it's not the most attractive choice. There is no such thing as separate capital and profits interests. The big advantage is the limited liability for shareholders and ease of transferring ownership (you can simply sell your stock). A C corporation can be used for holding and renting property, but there are a number of disadvantages including the double taxation of profits and gains, the inability to currently use losses, etc. That generally makes it a poor choice. What's the best method? There's no one answer here. Certainly if you're looking at multiple properties, particularly if this is a business venture, a partnership or LLC is an attractive option. The set-up and annual costs are spread over several properties. That's especially true if there's no easy division of profits and losses and sales proceeds, or if one party is providing more or less labor and more or less capital. A trust can be a way of relatives holding a family vacation home or rental property. Joint ownership generally only makes sense between close relatives. For example, a mother and daughter holding family property. No matter what form you select, you may not be able to avoid problems without a side agreement if there's a disgruntled co-owner. Even in an S corporation, a shareholder who owns 20% of the stock may be able to stonewall actions, or transfer shares to someone you don't want as a shareholder. The only solution is a side agreement restricting the sale of shares, a partnership interest, etc. Consider a buy-sell agreement where any co-owner wanting to get out has to sell to the other co-owners at the appraised, book, or other prior agreed-on approach. In the case of joint ownership, consider a legal agreement on how and when to dissolve the co-ownership. Get good legal advice before committing. It's a small price to pay to avoid a costly legal battle in the future.   4:31:39 PM