When you think of tax planning you think of someone who looks forward to helping you navigate your facts, circumstances and decisions, minimizing the tax liabilities of your investments and business operations. Unfortunately, many CPAs that advise clients look backward, reacting to the year’s events and shaking their heads that you have large tax implications as a result of the business decisions that you have made. This blog addresses those sinister CPAs and their even more sinister sisters- the CPA that confidently advises you – to make bad decisions!
Here are three common examples of how CPAs directly or indirectly impeded successful client tax deferral.
1. Over-focusing on Federal Capital Gains Tax Liability.
The major issue we see in this environment is client’s thinking they are potentially cashing out in a 15% capital gains environment. The client’s indicate, “I may as well cash out now rather than later, because capital gains is going up.” While this point is well-taken, clients are not appreciating the three taxes they defer via 1031 exchange: (1) Federal Capital Gains taxes (15%, soon to be 20%); (2) State Level Capital Gains (ranging from 0-9%); (3) Depreciation Recapture Tax (25-50% depending on straight-line or accelerated depreciation). These three taxes always add up to more than 15% unless you are selling non-depreciable property (land) in a no-state tax jurisdiction like Texas. However, if you have property in high state tax jurisdictions like NJ, NY, DC, or MD, you will want to drill down and determine your actual proposed tax liability before opting to cash out. A cocktail conversation with a CPA about capital gains should not suffice.
2. Simplifying the Personal Use Issues.
Beware of CPAs that speak in general rules. Any tax attorney or CPA that is wise usually answers questions with, “it depends”. We had a classic case of oversimplification last year when a client wanted to sell a North Carolina beach house. Under the taxpayer’s property settlement agreement with his ex-wife, he let her use it 5 weeks out of the year. Five CPAs gave oral advice to the client to cash out as the ex-wife’s use of the property constituted imputed personal use to the taxpayer. Thankfully, the business owner, stubborn and determined to get the accurate answer, asked us for our suggestions. We promptly referred the client (one week before settlement) to a regional 1031 exchange tax attorney superstar that issued a tax opinion for $1,500.00 indicating the ex-wife’s use was analogous to a creditor and that the property settlement agreement stipulations were not the equivalent of letting your brother or sister stay at your vacation property. Therefore the 47 out of 52 weeks of being held out for rent plus the ex-wife’s activity did not squelch the deal. Thankfully, the client deferred hundreds of thousands of dollars of gain and tax liability.
3. Not Adequately Understanding 1031 Tax Basis Issues.
This is where the horror stories come into play. While the prior two categories are a function of CPAs not being familiar with the details of tax deferral, this scenario is egregious beyond belief. A local tax preparer with a history in tax preparation at a major chain that employs more seasonal tax preparers than any other company (hint, hint) was indicating to at least twenty clients per year (he was a good marketer) to cash out of the relinquished property because 1031 exchanges used CARRYOVER basis and you will not get any benefit from new cash or new debt. For those of you who know the rules, you should fall out of your chair here. 1031 exchange uses SUBSTITUTED basis giving taxpayers credit for new cash or debt if they trade up in value. If a tax preparer tells you to simply sell and buy instead of exchange, seek a second and third opinion. The tax preparer was relying on the Form 8824 instructions for his understandings and he rationalized his advice by stating that it was “ambiguous” what replacement property basis would be. This tax preparer had no accounting training, just two summers in a strip mall preparing returns. He filed over 200 returns per year.