On January 5, 2012, in Notice 2012-8, the IRS significantly modified the rules for spouses seeking Innocent Spouse Relief under Internal Revenue Code Section 6015(f), which is also known as “Equitable Relief.” Notice 2012-8 is effective immediately and supersedes the old rules in Revenue Procedure 2003-61. The IRS will evaluate all new and pending Section 6015(f), Equitable Relief cases under the rules in Notice 2012-8, even if the IRS already denied a pending case under the old rules.

According to Notice 2012-8, generally, the IRS will consider similar factors it considered in past years. These factors include marital status, knowledge, economic hardship, abuse, tax compliance, etc. The biggest changes Notice 2012-8 makes are to the definitions of each factor and the weight the IRS places on each factor when considering whether to grant Equitable Relief. Some of the rule changes include:

1.  The IRS is now considering the nonrequesting spouse’s control over financial affairs as a factor that can mitigate other factors that might otherwise weigh against granting Equitable Relief.

2.  The IRS is offering “streamlined” Equitable Relief for requesting spouses who can prove they meet the marriage, knowledge, and economic hardship factors as defined in Notice 2012-8. This provision is similar to the “Safe Harbor” provision of Revenue Procedure 2003-61, except definitions have changed.

3.  The economic hardship factor can no longer weigh against Equitable Relief. If the requesting spouse cannot show economic hardship, the factor is neutral.

4.  Economic hardship is more difficult for the taxpayer to prove. Now, if the taxpayer can partially satisfy the tax obligation as defined in Notice 2012-8, they cannot meet the economic hardship factor.

5.  In “underpayment” cases, the requesting spouse now must show that, at the time he or she signed the joint return, he or she reasonably expected the nonrequesting spouse to pay the tax liability at that time or “within a reasonably prompt time after the filing of the return.” We expect that the courts will help define what is a “reasonably prompt time.”

6.  The IRS will now consider abuse other than physical abuse when evaluating whether the abuse factor weighs in favor of relief.

7.  The IRS will weigh the requesting spouse’s legal obligation to pay the taxes. In the past, the IRS only weighed the nonrequesting spouse’s legal obligation. If a divorce decree holds the requesting spouse responsible for the tax obligation, this factor will weigh against the requesting spouse. If both spouses are responsible, or the divorce decree is silent, the factor is neutral.

8.  A requesting spouse cannot demonstrate that they did not receive a “significant benefit” if they enjoyed the benefits of a lavish lifestyle, such as owning luxury assets or taking expensive vacations.

9.  If the requesting spouse is still married, the compliance factor can only weigh in favor of relief if he or she files “Married filing separately” in future years and timely pays any obligations. If the married requesting spouse files jointly on a timely basis and pays all future obligations, the IRS will consider the compliance factor neutral.

According to the IRS , due to the Notice 2012-8 changes, more taxpayers who filed their tax return “Married filing jointly” status will qualify for Equitable Relief. Taxpayers who might not have been eligible for relief in the past should reevaluate the strength of their case under these new rules.

Purchasing and renting real estate can be profitable. It can also generate significant tax benefits. However, the Internal Revenue Code limits some of the tax benefits to taxpayers who are not “real estate professionals,” as defined in IRC Section 469(c)(2).

In most circumstances, real estate rental activities are passive activities. The losses from a passive activity can only be deducted from passive income. They cannot be used to offset ordinary income. But, a “real estate professional” can deduct all rental real estate losses without limitation. They can also offset their real estate losses against non-passive income. Therefore, it is important to know what an individual must do to be a “real estate professional.”

Internal Revenue Code Section 469(c)(7), defines a“real estate professional as someone who:

1.    Performs more than one-half of their personal services, performed in trades or businesses during such taxable year, in real property trades or businesses in which they materially participate, and

2.    Performs more than 750 hours of services during the taxable year in real property trades or businesses in which they materially participate.

Unfortunately, meeting these requirements is just the first step. If the taxpayer has more than one rental property, the IRS and state evaluate the time the taxpayer spends on each property individually unless the taxpayer files a statement specifically electing to group the properties. I.R.C. § 469(c)(7)(A)(ii).

The IRS and state will not combine the time each spouse spends on the real estate activity to meet the material participation requirement. Each spouse must materially participate based on their own time spent. This can eliminate the tax benefits for both spouses if neither meets the requirement on their own. I.R.C. § 469(c)(7)(B)(ii). Please look for future blog articles discussing the nuances of the “material participation” requirements.

We encourage you to review the following court decisions for guidance on what it takes to be a “real estate professional” and receive the associated tax benefits.

1.    Harnett v. Comm’r, T.C. Memo. 2011-191.
2.    Bosque v. Comm’r, T.C. Memo. 2011-79.
3.    Perez v. Comm’r, T.C. Memo. 2010-232.

In Scharf v. Comm’r 32 T.C. Memo 1247 (1973) acq, in result, 1974 WL 36031, the United States Tax Court decided, and the IRS had acquiesced to the decision, that a charitable contribution deduction was available for the donation of a building (albeit partially destroyed) to a volunteer fire department for demolition in firefighter training exercises.

Taxpayers and their tax advisors use this case to support a charitable contribution of their home, often a lake home, to a local fire department. The situation usually involves an older home on a very valuable piece of land. The taxpayer enters an agreement with a fire department allowing the department to use the home for training purposes, including destroying the structure. The taxpayer takes a charitable deduction for the contribution to the fire department and then builds a new home on the property.

The state or the IRS can claim that the value of the contribution has been overstated. Their arguments may include:

1. The Appraisal Did Not Properly Calculate the Fair Market Value of the Contribution. Too often, the appraisal simply separates the value of the structure from the value of the land, and then claims the value of the structure as the deductible amount. This rarely represents the Fair Market Value and often results in an excessive value for the contribution.

“[F]air market value” for this purpose “is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” Sec. 1.170A–1(c)(2), Income Tax Regs. Restrictions on the property’s use or marketability on the date of the contribution must be taken into account in the determination of fair market value.Rolfs v. C.I.R., 135 T.C. 471, 480-81 (2010)

The state and the IRS want the taxpayer to demonstrate how much a good faith third party would pay for the structure, separate from the land. They may require the appraiser to include the cost of removing the structure from the land, as a third party buyer could not leave the structure in place.

2. The Taxpayer Received Something of Value for the Contribution. The state or the IRS will often claim that the taxpayer is receiving valuable demolition services in exchange for the contribution. They will likely cite the United States Supreme Court decision in United States v. Am. Bar Endowment, 477 U.S. 105, 116, 106 S.Ct. 2426, 91 L.Ed.2d 89 (1986). “The Am. Bar Endowment test examines whether the fair market value of the contributed property exceeded the fair market value of the benefit received by the donor. . . . Instead, we must consider whether the value of the lake house as donated exceeded the value of the demolition services petitioners received.” Rolfs v. C.I.R., 135 T.C. 471, 487-88 (2010). The taxpayer needs to deduct the value of the demolition services from the value of the contribution. This can result in eliminating the charitable deduction as the value of the demolition services can exceed the value of the rights contributed to the fire department.

Contributing a structure to a fire department is valid transaction, but , to be deductible as a charitable contribution, it needs to be done properly and the value of the rights contributed must be supported.

In the early 1980s, there was an almost endless supply of tax shelters promising deductions and credits that produced benefits far in excess of the investor’s contribution. These shelters were not just for wealthy, promoters pushed them on the average income earner as both a great business opportunity and an investment that would more than pay for itself with tax deductions and tax credits. Many of these shelters led to disastrous results for the investors. The transactions had some basis in tax law, but they were so poorly structured, managed, and over valued, that they could not withstand even the slightest IRS scrutiny. Many investors had to repay all the tax benefits, plus penalties and interest, at historically high rates, and were left with a worthless interest in a valueless “business.”

The demand for shelters has not gone away, but the promoters understand that the IRS is on the watch for the abusive shelters. The courts are also watching and have produced many decisions eliminating or reducing the values of these investments. A benefit of these decisions is that the courts are giving us a roadmap to spotting the good investments that will deliver the promised deductions and credits.

One shelter providing tax benefits that can exceed the amount invested is the Historic Preservation Conservation Easement. This usually involves an investor providing funds to rehabilitate a certified historic structure. As part of the rehabilitation, the investment entity grants a conservation easement to a charitable organization for conservation purposes. A common example of this is the “facade easement,” prohibiting anyone from changing the facade of the building. There are many ways this shelter can fail, including not meeting the strict requirements of the Internal Revenue Code Section 170, but the most likely problem will be the valuation of the contribution.

The taxpayer can use a variety of methods to value of the charitable contribution, but a common valuation method is the “before and after” method: comparing the value of the building before the owner granted the easement and the value of the building after the owner granted the easement. The greater the difference, the greater the charitable deduction and the greater the tax benefit, subject to the IRS limitations on charitable deductions. Experienced, qualified, and honest appraisers can, and often do, produce significantly different values. Thus, the IRS will almost always be tempted to challenge the value, unless it is extremely conservative.

To understand more about the IRS challenges to these investments, we encourage you to review the decisions of the various courts in the following cases:

1. Whitehouse Hotel Ltd Partnership v C.I.R, 615 F 3d 321 (5th Cir. 2010)
2. C.I.R v. Simmons 646 F. 3d 6 (D.C. Cir. 2011)
3. Bruzewicz v. U.S., 604 F. Supp. 2d 1197 (N.D. Ill. E.D., 2009)
4. Richmond v. U.S., 669 F. Supp. 578 (E.D. LA., 1988)
5. 1982 East, LLC v. C.I.R, T.C. Memo 2011-84
6. Evans v. C.I.R.., T.C. Memo 2010-207
7. Schneidelman v. C.I.R., T.C. Memo 2010-151

Parties to a divorce action may dispute the intent or impact of their agreement or the court’s order. One area of dispute is the character of a payment as alimony/maintenance or a property settlement. The payment of alimony/maintenance is deductible by the payor while the payment of a property settlement is not deductible.

This issue can arise even when the parties seem to agree to the treatment of the payments at the time of their divorce. The parties can enter a Marital Termination Agreement (MTA) that seems to clearly address the issue but, if the language of the MTA does not meet the technical prescriptions of the Internal Revenue Code (Code), one of the parties could change their mind and claim the payments are alimony/maintenance while the other party reports them as a property settlement. This creates a “whipsaw” situation for the IRS and will most likely lead to an audit of both taxpayers’ returns.

Assume the following facts:

1. The MTA stated that neither party shall pay or receive spousal maintenance.
2. The MTA also states that, beginning on a certain date, as part of a property settlement, the former husband, Joe, will pay his former wife, Jane, a monthly payment for 60 months.
3. The MTA does not specify how the parties are to treat the payment for tax purposes.
4. The MTA also does not specify whether the payment ceases upon the death of the recipient.
5. Joe made the payments as specified in the MTA each month in the first year of the agreement. In the second year, he notified Jane that he intended to treat the payments as spousal maintenance and deduct them on his Form 1040.
6. Because these payments were specified as payments for a “Property Settlement” in the MTA, Jane never reported the payments as income.

Internal Revenue Code (Code) Section 215 allows for the deduction of spousal maintenance payments, Code section 71 defines “spousal maintenance” or “alimony” as:

Any payment in cash if–

A. Such payment is received by (or on behalf of) a spouse under a divorce or separation instrument,
B. The divorce or separation instrument does not designate such payment as a payment which is not includible in gross income under [Section 71] and not allowable as a deduction under Section 215,
C. In the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and payor spouse are not members of the same household at the time such payment is made, and
D. There is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse.

If one of these four statements is not true for Joe’s payment to Jane, then the payment is part of a property settlement and not deductible by Joe nor includible in Jane’s gross income.

Under the former Code Section 71, labels for payments to an ex-spouse were insignificant. The parties’ intent controlled. The 1984 and 1986 revisions were intended to “eliminate the subjective inquiries into intent . . . in favor of a simpler, more objective test.” See Nelson v. Comm’r, T.C. Memo 1998-268. Since the revision of Section 71, the courts focus solely on the parties’ intent as reflected in the divorce or separation instrument. Baker v. Comm’r, T.C. Memo 2000-164. See also, Estate of Goldman v. Comm’r, 112 T.C. 317 (1999); Clarence v. Comm’r, T.C. Memo 2000-214; Fields v. Comm’r, T.C. Memo 2008-207; Richardson v. Comm’r, 125 F.3d 551 (7th. Cir. 1997); Baker v. Comm’r, T.C. Memo 2004-164; Nelson v. Comm’r, T.C. Memo 1998-268.

Using this approach, what dispute could there be between Joe and Jane? The payment certainly appears to be a property settlement.

1. The MTA shows that they intended the payments to be a nontaxable property settlement.
2. The MTA has two separate sections for spousal maintenance and property settlement. The payment in question is included in the “Property Settlement” section.
3. Joe and Jane agreed to waive any right to spousal maintenance, which is additional evidence that the parties intended the payment to be treated as a property settlement.
4. Joe treated the payment as a Property Settlement in the first year.

However, Joe will argue:

1. The MTA contained no express language regarding the tax treatment of the payment.
2. The MTA contained no express language about the continuation of the payment upon the death of Jane.

This matter will most likely be resolved through audit, appeal or Tax Court litigation, but an audit may have been avoided had the additional issues, which seem addressed by the other language, been specifically addressed in the MTA.

When drafting an MTA, be certain to address all of the issues raised in Code section 71.