New Rulings Impact 2009 Form 1040

The biggest tax story of 2009 is, of course, the American Recovery and Reinvestment Act of 2009, the economic stimulus law enacted in February of 2009.. The new law has resulted in major changes on the upcoming Form 1040. However, 2009 has also seen a number of important new rulings from the IRS and the courts. These new rulings may have a significant impact on the returns of certain clients.

Home Mortgage Interest

Acquisition Debt and Home Equity Debt. A taxpayer can claim an itemized deduction on Schedule A, Form 1040 for "qualified residence interest" paid during the year. Qualified resident interest is interest paid on an "acquisition" debt or a "home equity" debt. Acquisition debt is defined as any debt which is (1) incurred in acquiring, constructing, or substantially improving a qualified residence of the taxpayer and (2) secured by the residence. The term "home equity debt" means any debt, other than acquisition debt, that is secured by a qualified residence to the extent the amount of the debt does not exceed the difference between the fair market value of the residence and the amount of acquisition debt for the residence.

The deduction is available only for debts securing a principal residence and one other residence selected for the taxpayer. And the deduction can be claimed only for interest attributable to the first $1 million of the aggregate acquisition debt and the first $100,000 of the aggregate home equity debt.

New Ruling. A taxpayer purchases a home and secures a single mortgage in excess of $1.1 million. Can the taxpayer treat $1 million as acquisition debt and another $100,000 as home equity debt?  The IRS ruled a mortgage used to buy, build or improve a qualified residence can be treated as "home equity" debt to the extent that it exceeds $1 million, subject to the $100,000 and fair market value limits. The IRS said that the $1 million cap on acquisition debt is part of the definition of acquisition debt. Thus, debt in excess of $1 million used to acquire a home is not "acquisition" debt for tax purposes and can qualify as home equity debt (CCA 200940030).

There's more on the topic of home mortgage interest.

Another New Ruling. On a separate occasion in 2009, the IRS ruled that the $1 million cap applies to all owners of a home collectively and not to each owner separately. The ruling involved the sole owner of a home who transferred the home to a joint ownership with another individual who was not the owner's spouse. The second individual also became jointly liable on the home's mortgage and paid a portion of the mortgage interest. The mortgage exceeded $1 million.

The owners argued that the $1 million limit should be interpreted to allow each owner to deduct the interest on up to $1 million of acquisition debt on which the owner is personally liable. The IRS said that "the plain language of the statute does not support this interpretation." Acquisition debt is defined as debt incurred in acquiring a qualified residence of the taxpayer--not as debt incurred in acquiring the taxpayer's portion of a qualified residence. Thus, each owner's interest deduction is equal to the amount of interest paid multiplied by a fraction ($1 million divided by the amount of the mortgage) (CCA 200911007).

Credit and Debit Card Fees

Expenses paid or incurred by an individual in connection with the determination, collection, or refund of any tax can be deducted as a miscellaneous itemized expense on Schedule A, Form 1040. The IRS recently ruled that this deduction includes "convenience" fees charged when taxpayers use a credit or debit card to pay their taxes electronically.

This is a reversal of position by the IRS. In 2001, the IRS said that Congress intended to allow a deduction in connection with determining the extent of a tax liability or in contesting a tax liability. It did not intend to allow a deduction for the expenses involved in paying that liability after its extent has been determined. But this year the IRS decided that the convenience fees, including those associated with estimated tax payments, can be included as a miscellaneous itemized expense. Of course, miscellaneous expenses are deductible only to the extent that they exceed two percent of a taxpayer's adjusted gross income.

Casualty Loss

To claim a casualty loss deduction on Form 4864, the loss generally must be the result of an event that is sudden, unexpected, or unusual in nature. Many homeowners recently have complained of problems associated with drywall manufactured in China. For example, homes containing Chinese drywall have shown evidence of extreme and unusual corrosion of pipes, air conditioning coils, and electrical appliances. In addition, the drywall may emit a putrid smell and gas that can cause a variety of health problems. The Environmental Protection Agency (EPA) and the Consumer Product Safety Commission (CPSC) are currently investigating the problem and as this article is written, the CPSC is expected to issue a report in November 2009.

In a letter to Congress, IRS Associate Chief Counsel George Blaine said that a deduction can be claimed for a loss resulting from the Chinese drywall if the EPA and CPSC determine that the drywall is the source of unusual damage. The amount of the casualty loss would be equal to the decline in a home's fair market value due to the drywall, but not more than the taxpayer's adjusted basis for the home (Letter from George Blaine to Senator Bill Nelson, 7/2/09).

IRA Distributions

Distributions from an individual retirement account (IRA) before age 59½ are generally subject to a 10% penalty tax that is computed on Form 5329. However, there are some exceptions to the penalty. For example, there is no penalty if the distributions are part of a series of substantially equal periodic payments made for the life expectancy of the IRA owner or the joint life expectancies of the owner and his or her designated beneficiary. If the series of substantially equal periodic payments is modified (e.g., reduced or increased) within 5 years of the date of the first distribution (other than by reason of death or disability), then the 10% penalty is applied retroactively to prior distributions made before the IRA owner attained age 59½.  This retroactive tax also applies when a modification occurs after the initial 5-year period but before the employee has attained age 59½.

A separate exception to the 10% penalty applies to IRA distributions for qualified higher education expenses. In 2009, the Tax Court was faced with the situation where a taxpayer, before reaching age 59½, chose to receive equal IRA distributions each year amounting to $102,311. Then a couple of years later she also withdrew $22,500 to pay for her son's qualified higher education expenses. The IRS contended that this additional withdrawal was a prohibited modification of the substantially equal requirement, thus triggering the retroactive penalty tax.

The Tax Court ruled that a distribution that satisfies the exception for higher education expenses is not a violation of the substantially equal requirement. The court pointed out that the tax code specifically provides that the amount of distributions attributable to higher education expenses does not include distributions qualifying as substantially equal periodic payments. In other words, an IRA owner only has to rely on the higher education exception to the extent that distributions exceed the substantially equal periodic payments. Thus, Congress realized that distributions could qualify under more than one exception. The court held that the taxpayer did not "modify" her substantially equal periodic payments by also withdrawing funds that qualified for the higher education exception [Benz, 132 T.C. No. 15].

Energy-Saving Purchases

Section 25D of the tax code provides a tax credit to individuals who buy certain qualifying "residential energy efficient property" (e.g., property that uses solar power to generate electricity in a home or qualifying geothermal heat pump property). The credit is generally equal to 30% of the purchase price and is computed on Form 5695.

Certain energy standards must be met to qualify for the credit. The IRS recently announced that a manufacturer of property may certify to a taxpayer that the property meets these standards and that the taxpayer may rely on this certification to claim the credit. If it is later determined that the property does not meet the standards, property purchased before that determination remains credit-eligible.  A taxpayer should retain the certification with his or her tax records [Notice 2009-41, 2009-19 IRB 933].

Investment Losses

The IRS issued a ruling in 2009 detailing the tax consequences for investors who suffer losses from investing in fraudulent Ponzi-like schemes, such as the one organized by Bernard Madoff.

The IRS said that a loss from criminal fraud or embezzlement in a transaction entered into for profit is a theft loss claimed on Form 4684. It is not treated as a capital loss. As a result, the loss can be deducted against ordinary income without regard to the $3,000 limit on capital loss deductions. A theft loss from a transaction entered into for profit is also not subject to the deduction thresholds (e.g., 10% of adjusted gross income) that apply to theft losses of personal use properties.

The theft loss is deductible in the year it is discovered. The amount of an investment theft loss is the basis of the property (or the amount of money) that was lost. However, the deduction must be reduced to the extent that there is a claim for recovery or reimbursement which has a reasonable prospect of success. To the extent that a deduction is reduced by the claim, recoveries on the claim in a later year are not includible in the investor's gross income. If the investor recovers a greater amount in a later year, the recovery is includible in the investor's gross income to the extent of the earlier deduction [Rev. Rul. 2009-9, 2009-14 IRB 735].

Loss from Rental Activities

With some exceptions, Section 469 of the tax code generally disallows any loss from a "passive" activity. Rental activities are generally treated as passive activities per se, even if the owner is actively involved in the operations. However, a special exception allows an active participant in a "real property trade or business" to deduct rental losses as long as he or she materially participates in the rental activity.

A "real property trade or business" is defined as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. The Tax Court recently ruled that an individual can qualify as a "broker" for the special exception for real property trade or business even though he or she is not technically a broker under state law. A real estate agent or salesperson who sells property, negotiates the terms of a real estate contract, procures prospective buyers and performs similar broker-like activities is considered a broker for purposes of the passive loss exception [Agarwal, TC Summ. Op. 2009-29].