Author: Leon Clinton

When you think of the reverse mortgage, you may not think of using it as a tax planning tool. 

If you are house rich but cash poor, the reverse mortgage can 

• give you the cash you desire, and
• save you a boatload of both income and estate taxes when used in the right circumstances.

With a reverse mortgage, you as the borrower don’t make payments to the lender to pay down the mortgage principal over time. Instead, the reverse happens: the lender makes payments to you, and the mortgage principal gets bigger over time. 

You can receive reverse mortgage proceeds as a lump sum, in installments over a period of months or years, or as line-of-credit withdrawals. After you pass away or permanently move out, you or your heirs sell the property and use the net proceeds to pay off the reverse mortgage balance, including accrued interest. 

So, with a reverse mortgage, you can keep control of your home while converting some of the equity into much-needed cash.

In contrast, if you sell your residence to raise cash, it could involve an unwanted relocation to a new house and trigger a taxable gain far in excess of the federal home sale gain exclusion break—up to $500,000 for joint-filing couples and up to $250,000 for unmarried individuals. 

The combined federal and state income tax hit from selling could easily reach into the hundreds of thousands of dollars. 

For instance, the current maximum federal income tax rate on the taxable portion of a big home sale gain is 23.8 percent—20 percent for the “regular” maximum federal capital gains rate plus another 3.8 percent for the net investment income tax. And that’s just what you have to pay the feds.

With the reverse mortgage, you can avoid paying income taxes on the sale. And perhaps even better yet, you can avoid estate taxes. 

The federal income tax basis of an appreciated capital gain asset owned by a deceased individual, including a personal residence, is stepped up to fair market value as of the date of the owner’s death or (if the estate executor chooses) the alternate valuation date six months later. 

When the value of an asset eligible for this favorable treatment stays about the same between the date of death and the date of sale by your heirs, there will be little or no taxable gain to report to the IRS—because the sale proceeds are fully offset (or nearly so) by the stepped-up basis. Good!

If you would like to discuss the reverse mortgage, please don’t hesitate to call me on my direct line at 408-778-9651.

• By Leon Clinton
• February 26, 2022

Here’s a client story that I believe you will find of interest.

Facts

Henry and Heide own an S corporation 50-50. For more than five years, the corporation has operated a successful $10 million-a-year restaurant. 

Henry, Heide, and Harry formed a new S corporation that started a new restaurant in June 2021. The ownership is 35 percent for Henry, 35 percent for Heide, and 30 percent for Harry. 

During the four months of June through September of 2021, the new restaurant had gross receipts of $300,000. During the quarter ending December 31, 2021, the restaurant had gross receipts of $800,000. So for it’s seven months of operation it has $1.1 million in gross receipts.

Question

Will the new S corporation’s restaurant qualify for the start-up employee retention credit (ERC) of up to $50,000 for the fourth quarter? 

Answer

Yes. Here’s why.

The new restaurant is a new business that started after February 15, 2020, with a new set of owners and its own set of books. It clearly qualifies as a new business—the first step to qualifying as a recovery start-up business.

The second step is for average annual gross receipts to not exceed $1 million—using tax law’s calculation which in this case excludes the fourth quarter. 

The tax code calculated average annual gross receipts for 2021 that precede the calendar quarter for which the restaurant determines the credit are $900,000 and therefore do not exceed $1,000,000. Here’s how you make the calculation: $300,000 x 12 ÷ 4 = $900,000. Also, note that you apply the gross receipts test to the four-month period of existence because that’s how long the new restaurant had been in existence before the last quarter of 2021.

You don’t have to aggregate the new restaurant with the existing restaurant because the two S corporations fail the single employer test. 

Under the single employer test, corporate taxpayers that are members of a controlled group of corporations are treated as a single employer. A brother-sister controlled group of corporations is two or more corporations where

1. five or fewer persons who are individuals, estates, or trusts own at least 80 percent of the total voting power of all classes of stock entitled to vote, or the total value of shares of all classes of stock of each corporation; and 
2. the same five or fewer persons, taking into account ownership only to the extent that it is identical with respect to each corporation, own more than 50 percent of the total voting power of all classes of stock entitled to vote, or the total value of shares of all classes of stock of each corporation.

Because Henry and Heide each have 35 percent ownership in the new corporation and they have 50 percent each in the existing corporation, the corporations are not a controlled group.

Key point. Had Henry and Heide formed the new corporation 50-50 (no third-party Harry), they would have had to aggregate the two corporations. The aggregation would make them exceed the $1 million in gross receipts and would have denied them any ERC for a recovery start-up business. 

A Sad Deal

The requirement to aggregate along with the $1 million in receipts limit means that few new businesses will qualify for the recovery start-up business ERC.

From a compliance and clarity standpoint, it’s sad that the IRS in Notice 2021-49 did not address the aggregation rule other than with a mention in an afterthought manner on page 11. We all would have liked an example or two.

If you would like to discuss the ERC, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• February 8, 2022

When you use a home for both rental and personal use, regardless of that home’s location at the beach or in the city, you run into the tax code’s vacation home rules that make that home either a residence or a rental property. 

It’s a residence when you

• rent it for more than 14 days during the year and
• use it for personal purposes for more than the greater of 14 days or 10 percent of the days that you rent the home out at fair market rates.

Example. You own a beachfront vacation condo. During the year, you rent it out for 180 days. You and members of your family stay there for 90 days. The property is vacant the rest of the year except for seven days at the beginning of winter and seven days at the beginning of summer, which you spend maintaining the property. Your condo falls into the tax code–defined personal residence because

• you rented it out for 180 days, which is more than 14 days, and 
• you had 90 days of personal use, which is more than 14 days and more than 10 percent of the rental days. 

Disregard the 14 days you spent maintaining the place.

The fundamental principle that applies when your vacation home is a personal residence is that expenses other than mortgage interest and property taxes allocable to the rental use cannot exceed the gross rental income from the property. In other words, rental operating expenses and depreciation cannot cause a tax loss on Schedule E of your Form 1040 for the year in question.

If you have such a property and want to discuss some planning strategies for its use, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• February 4, 2022