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Tax
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Answers To Tax-Efficient Investing Questions From Advisors |
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Wednesday, October 19, 2011 19:38
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Tags: real estate | tax planning | Tax-efficient investing What do you think of investments in real estate investment trusts (REITs) in the current economic environment? Are low-income housing tax credits a viable tool for long term tax planning? How is estimated tax affected by selling a low-basis, concentrated stock position late in the year?
This Website Is For Financial Professionals Only
This blog entry answers questions raised by advisors in the recent Introduction to Tax-Efficient Investing webinar. Advisors4Advisors members can see a free on-demand replay of the webinar, which is the first of a four-part series. The other three sessions can be viewed on demand for $20 each for A4A members and $30 each for non-members.
1. What do you think of investments in Real Estate Investment Trusts (REITs) in the current economic environment?
REITs are companies that buy, manage, develop, and/or sell real estate such as shopping malls, office buildings, apartment complexes, or housing developments. They make money from rental income, profits on the sale of property, and fees for services provided to tenants. REITs are traded on major exchanges and investors can buy ownership interests in them in the same way they could buy shares of stock in a corporation. They have both advantages and disadvantages.
Advantages of REITs
- Make it possible for the average investor to invest in a diversified real estate portfolio
- More liquid than a direct investment in real estate because they are traded on major stock exchanges
- Tend to have low correlation coefficients with stocks and bonds, making them an excellent asset to diversify a portfolio
- Professional management
- Provide current income (at least 90% of income must be distributed)
- Also create capital gains, providing a hybrid return that may appeal to some investors
Disadvantages of REITs
- Vulnerable to declines in the real estate market (either lack of renters or low sale prices)
- Vulnerable to rising interest rates that affect borrowing costs
- Limited use as a tax shelter because they are not allowed to pass losses through to their investors
REITs invested to produce rents from apartment buildings and professional offices are generally doing reasonably well and may be a good addition to a portfolio because of their diversification potential. REITs invested in rental buildings that are more sensitive to economic downturns like retail and office buildings may not be doing so well. Sale prices for buildings are also depressed.
2. Are low-income housing tax credits a viable tool for long term tax planning?
The Low Income Housing Credit (LIHC) is an economic incentive to produce affordable rental housing. The credit rate is approximately 9% per year for new construction and 4% for either rehabilitation projects or federally subsidized buildings and is claimed over a 10-year period. The calculation is complicated by the fact that the tax credit rate is not actually 9%, but the rate necessary to make the present value of the payment stream equal to 70% of the eligible basis. As interest rates drop, the amount of the annual credit could drop significantly below 9%.
The economic effect of the LIHC is to lower a taxpayer’s opportunity cost of capital (OCC). Whether taking advantage of the credit makes sense depends on the taxpayer’s opportunity cost of capital (OCC). The OCC for a project is the rate of return an investor could earn on the next best alternative investment having comparable risk. Suppose, for example, that a taxpayer (T) is thinking of investing $100,000 in Project X and could otherwise invest the $100,000 in Stock Y, having comparable risk and producing an expected return of 6%. Given the 6% OCC, it would only make sense for the taxpayer to invest in Project X if the expected return was at least 6%.
The effect of the LIHC is to reduce the OCC for the eligible investment because, in effect, the taxpayer needs to invest less capital to get the same return. Consider the following simplified example.
T is thinking about investing $1,000,000 in a low-income housing project. T believes it can earn 3% ($30,000/year) on the project. T’s opportunity cost of capital is 9%. This means that T would only invest if the return from the project was at least $90,000/year. Without the LIHC, T would never invest in the project because the expected return is far below T’s OCC. But, with the LIHC T, in effect, needs to invest only $300,000 to get the $30,000 return. T keeps the other $700,000 because of the tax credit. This makes the effective rate of return for the low income housing project 10% ($30,000/$300,000 invested). Because the expected rate of return now exceeds the OCC, T might consider investing. [1]
The answer to the question, then, is that the LIHC might make sense if the return on a project exceeds the taxpayer’s OCC after the LIHC is taken into account. To make this determination, the taxpayer will have to estimate both its OCC and the expected return on the low income project.
3. How is estimated tax affected by selling a low-basis, concentrated stock position late in the year?
Recognizing a large gain at the end of a tax year would generally create no estimated tax problems. To avoid an underpayment penalty, an individual must make quarterly installment payments based on the amount of the required annual payment. This required annual payment is the lesser of (1) 90% of the tax shown on the current year return or (2) 100% (110%, for high-income individuals) of the tax shown on the previous year’s return. Thus, provided the annual payments were at least 90% of the prior year’s tax, there would be no penalty regardless of how large the year-end gain was.
After that, check out the other three parts of the Tax-Efficient Investing Webinar Series:
[1] The simplified example may understate the effect of the LIHC on the OCC. The Congressional Research Service estimated a 79.1% reduction under similar facts. For a more comprehensive calculation of the OCC see Congressional Research Service Report RS 22917, February 2, 2009.
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Answers To Roth IRA Conversion Questions From Advisors |
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Wednesday, October 12, 2011 00:23
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Tags: roth ira conversion | tax efficient investing How would a flat tax affect the Roth IRA conversion decision? What's a good way to offset income generated by a Roth IRA Conversion? This post answers questions raised by advisors at a recent webinar on tax-efficient investing.
This Website Is For Financial Professionals Only
1. In the unlikely event of a flat tax, what would be the effect on the Roth IRA conversion decision?
To understand the effect of a flat tax on the Roth IRA conversion decision, it is first necessary to understand the Roth conversion decision under current law. If tax rates are the same at the time of conversion and when distributions are made, IRA assets must be used to pay the tax on the conversion and the taxpayer needs to take out at least the required minimum distribution (RMD) each year after retirement, the basic economics of a traditional IRA and a Roth IRA are the same. The following simplified example illustrates this point.
Example 1. Taxpayer (T) has $100 in a traditional IRA. T is currently in the 28% marginal income tax bracket and expects to be in the same bracket in 20 years when IRA distributions begin. The IRA assets are expected to triple in value over this period of time. If T makes a Roth conversion now, T will pay $28 in tax from the IRA, leaving $72. This $72 will grow to $216 in 20 years. T can receive the $216 tax-free at that time, leaving T with $216 after tax. If T elects not to do the conversion, the $100 will grow to $300 in 20 years. T will then pay a tax of $84 on a distribution (.28 x $300), leaving the same $216.
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Conversion
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No Conversion
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Beginning amount
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$100
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$100
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Current tax
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28
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0
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Left after tax
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72
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100
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Value after 20 years (x3)
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216
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300
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Tax payable on distribution
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0
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84
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Net to beneficiaries
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$216
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$216
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If the taxpayer can pay the conversion tax with outside assets (side fund), however, the Roth conversion will produce superior tax results even though the tax rates are the same for the conversion and for the distributions.
Example 2. Assume the same facts as in Example 1, and also that T has $28 in a side fund that can be used to pay the tax on the conversion. Also assume that because it will be invested in taxable investments, the money in the side fund will only grow to 2.5 times its current value at the end of the 20-year period. The after-tax amounts passing to beneficiaries are shown below.
Traditional IRA
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IRA
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Side Fund
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Beginning amount
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$100
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$28
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Current tax
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0
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0
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Left after tax
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100
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28
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Value after 20 years (x3)
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300
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70
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Tax payable on distribution
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84
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79
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Net to beneficiaries
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$216
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$70
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Total net to beneficiaries
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$286
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Roth IRA Conversion
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IRA
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Side Fund
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Beginning amount
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$100
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$28
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Current tax
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0
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28
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Left after tax
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100
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0
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Value after 20 years (x3)
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300
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0
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Tax payable on distribution
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0
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0
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Net to beneficiaries
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$300
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$0
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Total net to beneficiaries
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$300
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The $14 advantage of the Roth IRA is due to the different growth rate for the assets inside the IRA (3x) and the taxable growth rate of the taxable account (2.5x).
If the conversion tax can be paid with outside funds, a Roth conversion may be superior to leaving the funds in a traditional IRA even if the applicable income tax rate drops significantly between the time of the conversion and the time distributions are made.
Example 3. Assume the same facts as in Example 2, except that T’s marginal income tax rate drops from 28% at the time of the Roth conversion to 25% at the end of 20 years.
Traditional IRA
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IRA
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Side Fund
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Beginning amount
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$100
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$28
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Current tax
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0
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0
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Left after tax
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100
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28
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Value after 20 years (x3)
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300
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70
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Tax payable on distribution
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75
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0
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Net to beneficiaries
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$225
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$70
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Total net to beneficiaries
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$295
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Roth IRA Conversion
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IRA
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Side Fund
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Beginning amount
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$100
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$28
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Current tax
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0
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28
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Left after tax
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100
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0
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Value after 20 years (x3)
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300
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0
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Tax payable on distribution
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0
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0
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Net to beneficiaries
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$300
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$0
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Total net to beneficiaries
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$300
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As the rate drop becomes more substantial, however, the traditional IRA would begin might produce superior tax results.
Example 4. Assume the same facts as in Example 3 except thatT’s marginal tax rate decreases from 28% at the time of conversion to 15% when distributions are made.
Traditional IRA
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IRA
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Side Fund
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Beginning amount
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$100
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$28
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Current tax
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0
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0
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Left after tax
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100
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28
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Value after 20 years (x3)
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300
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70
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Tax payable on distribution
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45
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0
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Net to beneficiaries
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$245
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$70
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Total net to beneficiaries
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$325
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Roth IRA Conversion
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IRA
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Side Fund
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Beginning amount
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$100
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$28
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Current tax
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28
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28
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Left after tax
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72
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0
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Value after 20 years (x3)
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300
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0
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Tax payable on distribution
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0
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0
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Net to beneficiaries
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$300
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$0
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Total net to beneficiaries
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$300
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The amounts shown in the charts above represent the total wealth under the two options as of a particular date, before any distributions have been made. If T does not need to take out at least the RMD, slower distributions from the Roth IRA will enable T to accumulate more wealth for heirs. The money can continue to grow tax-deferred in the account, creating an important estate planning advantage for the Roth IRA.
If the U.S. enacts a flat tax, the marginal tax rate for a taxpayer will be the same when the conversion decision is made and when distributions begin. This would simplify the conversion decision, leading to the following conclusions:
- If the taxpayer cannot pay the conversion tax with outside funds and will take distributions at least equal to the RMD, converting will be a matter of indifference for the taxpayer.
- If the taxpayer has outside funds to pay the tax on the conversion or will not need the full amount of the RMD, converting will always be the better choice.
- Leaving the money in the traditional IRA might produce the same economic result as converting, but it will never be better.
- Under current law, it might make sense to convert only that portion of a traditional IRA that does not push the taxpayer into a higher tax bracket. With a flat tax, this issue would disappear.
2. Are there any good ways to generate losses to offset income generated by a Roth IRA conversion?
Perhaps the best way to offset income generated by a Roth IRA conversion is with intangible drilling costs (IDCs) associated with oil and gas investments. IDCs are costs of developing a well that will not be part of the final operating well, like clearing ground, draining land, road building, surveying, hauling, repairs, fuel, supplies, and wages. Unlike most costs that must be capitalized over future periods, up to 80 percent of IDCs can be deducted in the current year. Thus, for example, if a taxpayer converts a $160,000 traditional IRA to a Roth IRA, a $200,000 investment in an oil or gas well could offset all of the conversion income.
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The Special Needs Trust Exception |
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Friday, September 09, 2011 04:24
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Tags: IRS | tax planning | trusts In PLR 201116005, the Internal Revenue Service demonstrated a trait that is not at the forefront of most taxpayer’s minds: compassion.
This Website Is For Financial Professionals Only
In PLR 201116005, the Internal Revenue Service (the Service) addressed whether an IRA designated beneficiary’s transfer of an IRA to a special needs trust, which the designated beneficiary was a beneficiary of, was a sale or disposition for federal income tax purposes or a transfer for the purposes of IRC §691(a)(2). The Service ruled the transfer was not a sale or disposition for federal income tax purposes or a transfer for the purposes of §691(a)(2).
In this ruling, the decedent owned several IRAs. The designated beneficiaries of these IRAs were the children of the IRA owner — including a disabled child. The disabled child intended to transfer his share to a trust. This trust was a special needs trust set up to benefit the disabled child.
The taxpayer asked whether an IRA designated beneficiary’s transfer of an IRA to a special needs trust, which the designated beneficiary was a beneficiary of, was a sale or disposition for federal income tax purposes or a transfer for the purposes of §691(a)(2).
§ 691(a)(1)(B) of the Code provides in part:
“… all items of gross income in respect of a decedent which are not properly includible in respect of the taxable period in which falls the date of his death… shall be included in the gross income, for the taxable year when received, of:…the person who, by reason of the death of the decedent, acquires the right to receive the amount...”
§ 691(a)(2) of the Code provides:
“If a right, described in [§ 691(a)(1)], to receive an amount is transferred by the estate of the decedent or a person who received such right by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent, there shall be included in the gross income of the estate or such person, as the case may be, for the taxable period in which the transfer occurs, the fair market value of such right at the time of such transfer plus the amount by which any consideration for the transfer exceeds such fair market value. For purposes of this paragraph, the term “transfer” includes sale, exchange, or other disposition, or the satisfaction of an installment obligation at other than face value, but does not include transmission at death to the estate of the decedent or a transfer to a person pursuant to the right of such person to receive such amount by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent.”
Furthermore, if the right conferred pursuant to § 691(a)(1) is given to another as a gift, the fair market value is subject to income tax. § 1.691(a)-4(a). A distribution to an IRA beneficiary is also subject to income tax. Rev. Rul. 92-47, 1992-1 C.B. 198.
Also, § 677(a) of the code provides in part:
“The grantor shall be treated as the owner of any portion of a trust, whether or not he is treated as such owner under section 674, whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, may be— (1) distributed to the grantor or the grantor’s spouse;
(2) held or accumulated for future distribution to the grantor or the grantor’s spouse…
Pursuant to § 691(a)(2) the value of the IRA transferred to the trust should be included in the gross income of the disabled child. However, the Service ruled that the value of the IRA did not need to be included in the disabled child’s income to transfer the IRA to the trust. The IRS has carved out an exception for special needs trusts, by ruling that moving the IRA into the trust was neither a sale, nor disposition for the purposes of § 691(a)(2). This ruling speaks to the significant discretion held by the IRS. On a lighter note, it also speaks to a trait of the IRS that is not at the forefront of most taxpayer’s minds: compassion.
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IRS Denies Post-Mortem Rollover |
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Wednesday, August 24, 2011 14:06
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In PLR 201123048, the Internal Revenue Service addressed a late rollover request from the widow when her late husband failed to accomplish a rollover on a timely basis. In a surprising move, and certainly devastating to this family, the Service denied such a rollover.
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The deceased husband (Taxpayer B) retired from his employer and, unbeknownst to him, his pension plan had a “cash out” provision that required a one hundred percent distribution of Plan assets upon the participant reaching age 65. The surviving spouse (Taxpayer A) represented that her husband received a check from the pension plan and initiated a rollover into an IRA. The surviving spouse further represented that the purpose of this rollover was to maintain the funds in a tax-free environment. While waiting for the IRA to be established, Taxpayer B deposited one hundred percent of the funds in a joint account with his spouse. Unfortunately, before the rollover could be completed, Taxpayer B became ill and subsequently died. In this ruling, the surviving spouse desired to complete the rollover initiated by her husband.
Defining the precise issue is critical to understanding the Service’s negative ruling. According to the ruling, the issue before the Service was as follows:
“Based on the facts and representations, you request a ruling that the Internal Revenue Service waive the 60-day rollover requirement with respect to the distribution of ‘Amount 1’ contained in § 402(c)(3) of the Code in this instance and allow Taxpayer A to make a rollover contribution to a tax-deferred vehicle in her name.” [Emphasis added.]
Under § 402(c)(3)(a), the law provides that a rollover must occur within 60 days following the day which the taxpayer received the property. Furthermore, § 402(c)(3)(b) provides that the Government may waive the 60-day requirement under § 402(c) if failure to waive such requirement would be against equity or good conscience. The relevant portion of the statute reads as follows:
“…where the failure to waive such a requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to the requirement.”
The ruling points out that under § 402(c)(9) distributions to the spouse of the employee after the employee’s death permits a rollover to be available as if the spouse were the employee.
The ruling further analyzes Rev. Proc. 2003-16 which provides the following guidance:
"In determining whether to grant a waiver, the Service will consider all facts and relevant circumstances, including: 1) errors committed by a financial institution, 2) inability to complete a rollover due to death, disability, hospitalization, incarceration, restrictions imposed by a foreign country or postal error, 3) the use of the amount distributed (for example, in the case of payment by check, whether the check was cashed), and 4) the time elapse since the distribution occurred."
The Service provided the information presented and the documentation submitted by Taxpayer A (the surviving spouse) was consistent with her assertion that Taxpayer B’s failure to accomplish a timely rollover was caused by the death of Taxpayer B prior to a completed rollover. Just as this looks to be a routine ruling, the Service then provides “…since ‘Amount 1’ was received by Taxpayer B (the husband) prior to Taxpayer B’s death, Taxpayer A (the spouse) is precluded from rolling the funds over into a tax-deferred account in her name under § 402(c)(9) of the Code.”
In the analysis, the Service seems to be overly focused on the spousal rollover question posed rather than the legally correct result. The Service writes “because Taxpayer B is deceased, it is impossible for Taxpayer B to complete the proposed transaction. Since ‘Amount 1’ was received by Taxpayer B from Plan X prior to Taxpayer B’s death, Taxpayer A [surviving spouse] is precluded from rolling the funds over into a tax-deferred account in her own name.”
402(c)(9) reads as follows:
“Rollover Where Spouse Receives Distribution After Death of Employee –If any distribution attributable to an employee is paid to the spouse of the employee after the employee’s death, the preceding provisions of this subsection shall apply to such distribution in the same manner as if the spouse were the employee.”
In this instance, the taxpayer and her advisors appear to not have asked whether the rollover could be made into an inherited IRA in her husband’s name, but rather whether she would be allowed to roll it into an IRA in her own name under § 402(c)(3). It would seem that the taxpayer and advisors should have asked whether the IRA could be first finalized into an IRA in her husband’s name. Subsequent to rolling the IRA into her husband’s name, it is likely there would not have been a beneficiary form and that the IRA would have been payable to the default beneficiary. In all likelihood, the default beneficiary would have been either the decedent’s estate or the surviving spouse.
There are literally dozens of rulings allowing rollovers from estates or trusts and this does not seem to be a confusing issue. Even if the taxpayer/advisor asked the wrong question, I would respectfully suggest that the Service has at least some responsibility to help the taxpayer reframe the issues to achieve the result intended by Congress.
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IRS Allows Disclaimer of Retirement Account Despite Receipt by Beneficiary of Postmortem RMDs |
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Thursday, August 11, 2011 23:04
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Tags: Internal Revenue Service | RMDs
A recent Internal Revenue Service decision allowed a beneficiary to disclaim interest in retirement accounts despite receiving postmortem required minimum distributions.
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In PLR 201125009, the Internal Revenue Service addressed whether postmortem required minimum distributions automatically deposited into an account and the transfer of the balance of this account constituted acceptance of a retirement account within the meaning of IRC section 2518 thus precluding the transferee’s ability to disclaim an interest in the retirement account. The IRS allowed the transferee to disclaim the interest in the retirement accounts.
The decedent had reached his required beginning date prior to death. RMDs were periodically automatically deposited into a bank account held jointly with rights of survivorship by the decedent and his spouse.
The decedent died on day A. His spouse died on day C. On days B, D, and E RMDs were automatically deposited into the bank account. The bank account contained funds other than the RMDs that were deposited postmortem.
The court appointed an administratrix of the spouse’s estate. The administratrix closed the bank account and opened a new bank account, transferring the entire balance from the old bank account to the new bank account for the spouse’s estate.
The decedent’s will created a disclaimer trust which was to be funded by the retirement accounts if his spouse survived him and disclaimed interest in the retirement accounts.
The administratrix petitioned the court to disclaim the spouse’s entire interest in the retirement accounts and the spouse’s interest in the disclaimer trust. The court granted the petition. Also, the administratrix notified, in writing, the brokerage firms which managed the retirement accounts and the decedent’s estate that the spouse was disclaiming these interests.
The taxpayer represents that proceeds from the automatically deposited RMDs remained in the new bank account until the date the petition to disclaim was granted. Taxpayer also represented that no other proceeds have been distributed to Spouse or her estate from the retirement accounts.
The taxpayer asked for a ruling on whether postmortem required minimum distributions automatically deposited into an account and the transfer of the balance of this account to another account constitutes acceptance of a retirement account, thus precluding transferee’s ability to disclaim the remaining interest in the retirement account.
To make a qualified disclaimer IRC § 2518(b)(3) requires that the transferee has not accepted the interest of its benefits.
IRC § 2518-2(d)(1) provides: A qualified disclaimer cannot be made with respect to an interest in property if the disclaimant has accepted the interest or any of its benefits, expressly or impliedly, prior to making the disclaimer. Acts indicative of acceptance include using the property or the interest in property; accepting dividends, interest, or rents from the property; and directing others to act with respect to the property or interest in property. However, merely taking delivery of an instrument of title, without more, does not constitute acceptance.
IRC § 25-3(a)(1)(ii) provides: The disclaimer of all or an undivided portion of any separate interest in property may be a qualified disclaimer even if the disclaimant has another interest in the same property.
IRC § 25-3(c) provides: A disclaimer of a specific pecuniary amount out of a pecuniary or nonpecuniary bequest or gift which satisfies the other requirements of a qualified disclaimer under section 2518 (b) and the corresponding regulations is a qualified disclaimer provided that no income or other benefit of the disclaimed amount inures to the benefit of the disclaimant either prior to or subsequent to the disclaimer.
Rev. Rul. 2005-36 provides: A beneficiary's receipt of RMDs from an IRA constitutes acceptance of that portion of the corpus of such account, plus the income attributable to that amount. The beneficiary's acceptance, however, of these amounts does not preclude the beneficiary from making a qualified disclaimer with respect to all or a portion of the balance of the IRA.
The service ruled favorably regarding the spouse’s ability to disclaim the retirement accounts and postmortem automatic deposits of the RMDs into an account, and the transfer of the balance of this account to another does not constitute acceptance within the meaning of IRC § 2518. The IRS relied on Rev. Rul. 2005-36 which provides in part that acceptance of RMDs from an IRA does not preclude making a qualified disclaimer with respect to all or a portion of the balance of the IRA.
The Service determined the RMDs automatically deposited into the bank account after death and any interest accrued on those funds were accepted by the spouse and thus cannot be disclaimed.
This case is a reminder that even if RMDs are accepted by the beneficiary prior to a disclaimer, it does not prohibit such beneficiary from disclaiming the remainder of the account. This comes into play if an RMD is required to be taken before a decision has been made about whether a disclaimer will be executed.
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