Journal of Accountancy

Mortgage loan loss

Mortgage Loan Loss Can't Offset Real Estate Gain on Sale of U.K. Home

M r. and Mrs. Quijano were U.S. taxpayers who sold their home in the United Kingdom. They purchased it in September 1986 for 297,500, financing the entire amount with a mortgage, which two years later they increased to 330,000 and, in March 1990, to 333,180. They made capital improvements of 45,647 to the house, and, in July 1990, they sold it for 453,374-net of selling expenses-and retired the mortgage. On their 1990 joint federal income tax return, the Quijanos reported a capital gain of $308,811, using the exchange rate on the date of purchase ($1.49 to 1) to determine their cost basis but using the exchange rate at the date of sale ($1.82 to 1) to compute the sale price.

The couple later amended their 1990 return to claim a $30,610 refund. They arrived at the figure by using the exchange rate on the sale date to determine both the purchase and the sale price and to determine the cost of the capital improvements. This reduced the capital gain to $199,491. The Internal Revenue Service disallowed the amended refund claim, stating that the cost basis of the house had to be determined using the exchange rate on the purchase date and when each capital improvement was made.

The Quijanos argued that they suffered a loss on their mortgage loan transaction because the value of the dollar against the pound had declined between the time of purchase and the time of sale. They believed they should be allowed to offset this loss against the real estate transaction gain-the capital gain realized from the sale of the residence. The Quijanos argued the mortgage loan was part of a "hedging transaction" under Internal Revenue Code section 988(d)(1), so the loan transaction could be integrated with the real estate transaction. Under section 988(d)(1), this treatment is allowed if the taxpayer is borrowing under a debt instrument where he or she is obligated to repay the loan in a "nonfunctional currency."

Result: For the IRS. The Tax Court rejected the Quijanos' argument that the transaction qualified as a hedging transaction because (1) the mortgage loan transaction was not conducted by a trade or business and was not entered into for profit and (2) the Tax Reform Act of 1986 explicitly excludes the use of section 988 for foreign currency gains or losses recognized by U.S. individuals residing outside the United States to repay a foreign-currency-denominated mortgage on a principal residence.

The Tax Court also rejected the Quijanos' use of the exchange rate in effect at the time of sale to determine the sale and purchase prices. The Quijanos wanted to treat the pound as their functional currency or qualified business unit (QBU) under IRC section 985(b)(1). However, the Tax Court found the taxpayers did not use the pound as the unit of trade or business for which they maintained separate books or records, so it did not qualify as a QBU. The court concluded that the basis, sale price and the cost of capital improvements had to be determined using the exchange rate in effect when the purchase, sale or improvement took place.

Quijano (1st Cir. 1996).

Legal Fees Incurred to Recover Fire Insurance Proceeds Are Not Deductible

I n 1991, Mr. and Mrs. Jasko's residence was destroyed by fire. The loss was covered by fire insurance. The Jaskos incurred $71,000 in legal fees during 1991, 1992 and 1993 in a dispute with the insurance company over the home's replacement cost. In 1992, they paid $25,000 of those legal fees and deducted them on their 1992 tax return as a miscellaneous deduction. The IRS disallowed the deduction under IRC section 212(1), which allows individuals to deduct all ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income. Because the Jaskos did not hold their house for the production or collection of income, the legal fees were not deductible. The Jaskos conceded this point but claimed the insurance policy should be considered separate from the ownership of the home, and therefore the legal fees incurred to regain the house's full replacement cost should be deductible.

Result: For the IRS. The Tax Court rejected the Jaskos' argument that the insurance policy should be separated from the residence. Citing the "origin of claim" doctrine, the court said the policy was meant to reimburse the Jaskos by providing the replacement cost of a home. Without the home and the fire, the insurance policy would be meaningless, so the home and the fire were the origin of the Jaskos' legal claim. The Tax Court also concluded that the destruction of the house by fire was the equivalent of disposing of a capital asset or an involuntary conversion. Therefore, the legal fees were a nondeductible capital expenditure. They could, however, be used as an offset against any gain the Jaskos may have realized from the insurance proceeds.

Jasko , 107 TC no. 3 (1996).

Edited by Maria Luzarraga Albanese, JD, LLM, editor, AICPA client newsletters.

IRS restructuring commission

Restructuring Commission Holds More Public Hearings

T he National Commission on Restructuring the Internal Revenue Service held its second round of public meetings in November on the organizational structure and functions of the IRS, strategic planning and implementation, priority setting and performance measures. The commission also heard testimony on the burdens of an overly complex tax code on taxpayers and the IRS.

Congressman Rob Portman (R-Ohio), commission cochairman, said the group was still gathering information but should have an idea of the direction it would take in February. Among those testifying were former IRS senior staff members, representatives from the General Accounting Office and the American Institute of CPAs and a University of Chicago assistant law professor.

More oversight
Gene L. Dodaro, GAO assistant comptroller general, said the IRS needed stronger oversight, citing past failures of agencies and congressional committees in not having been tough enough in making the IRS determine how it would carry out its business vision. He said the commission should ensure the IRS will have effective implementation strategies.

Blueprint for simplification
Michael E. Mares, chairman of the American Institute of CPAs tax executive committee, said virtually every year Congress passes tax legislation of increasing magnitude and complexity. Treasury regulations interpreting those new provisions also are getting more complex. "As time passes, taxpayers, their advisers and the IRS face increasing uncertainty as to the correct tax treatment of an item." Mares said tax simplification would yield a number of benefits, including a more efficient IRS, better compliance and less frustrated and confused taxpayers.

Mares also told the commission the AICPA had established a task force that will submit additional comments and suggestions to the commission on the privatization of tax collection and processing as well as the need for a new approach to audit research, the modernization of tax systems and a business approach to IRS operations. For more information on the AICPA task force, contact Jean E. Trompeter, technical manager of the AICPA tax division, at 202-638-4512.

Six Core Issues
Jeffrey S. Trinca, the commission's chief of staff, told members attending the AICPA Federal Tax Conference in November that the commission would focus on the following six core issues as it examines the practices of the IRS in the coming year:

Service quality.
Organizational structure.
Workforce quality.
Technology.
Financial accountability.
Tax code complexity.

What's next
Jeffery S. Trinca, the commission's chief of staff, told members attending the AICPA Federal Tax Conference in Washington, D.C., that the commission would hold its next set of hearings in January and would hear from private-sector task forces in April. He also said the commission would perform a benchmarking study to examine various state and local tax collection processes. The restructuring commission is expected to issue its final report in July.

"The commission was given only one year," said Trinca. "We need to draw on the expertise of organizations such as the AICPA to point out problems and offer solutions."

Commission.com
More information on the National Commission on Restructuring the IRS is now on the World Wide Web. To read about the group's progress, objectives and issues as well as updated news and information on future meeting dates, visit its Web site at http://www. house.gov/natcommirs/main.htm.

GAO Studies Benefits of Alternative Tax System

A s many as 51 million taxpayers, or 45% of those who filed 1992 tax returns, no longer would have to prepare returns if the Internal Revenue Service adopted an alternative filing system, according to a report published by the General Accounting Office. Tax Administration: Alternative Filing Systems, published in October, examined the ramifications if the IRS prepared and mailed tax returns to taxpayers based on income reported by employers on form W-2 and the 1099 series information returns.

Not the best system for everyone
Under this alternative filing system, the IRS would mail returns and refunds or bills to taxpayers, who would then review the returns for accuracy and notify the IRS if they questioned the results. The GAO estimated that taxpayers could save up to 155 million hours on tax return preparation and the IRS could cut processing and compliance costs by as much as $37 million annually. However, professional tax preparers, financial institutions and employers could lose under this system. For example, the report said that preparers could lose millions of dollars in fees, and employers and financial institutions would be obligated to file information returns more quickly or electronically.

High hurdles remain
The IRS currently needs a long time to process information returns, so it is not likely that, under a tax reconciliation system in which the IRS would have to do even more return processing, taxpayers would receive their federal returns by the congressionally mandated April 15 deadline. The report said it was likely a return-free system could not be implemented until the IRS was prepared to meet the federal due date for filing tax returns.

The GAO also questioned the number of taxpayers that would voluntarily participate in the new system. Citing the results of a 1993 focus group, the report said the reconciliation system could fail because taxpayers did not trust the IRS to accurately prepare returns and they doubted procedures would be in place to obtain adjustments if they disagreed with IRS-prepared returns.

IRS urges more electronic filing
In response to the GAO report, IRS Deputy Commissioner Michael P. Dolan said the information to do a cost-benefit analysis might not be available and the costs of a tax agency reconciliation system would be higher than the costs to process electronically filed returns. Acknowledging the IRS's views, the GAO said there might be no need for the alternative filing system if the IRS could get most taxpayers to file electronically.

A free copy of the GAO report (GGD-97-6) can be obtained by calling the GAO order department at 202-512-6000.

New Form for Employers Hiring From Low-Income Groups

T he Internal Revenue Service developed form 8850 to help employers hiring certain low-income individuals determine if they are eligible for a tax credit. The Work Opportunity Credit Pre-Screening Notice and Certification Request was developed for the "work opportunity tax credit" in the Small Business Job Protection Act of 1996. The form is available through the IRS home page, http://www.irs.ustreas.gov , or by calling the IRS toll-free at 800-829-3676.

Under the 1996 act, employers hiring new employees from one of seven targeted low-income groups can receive a tax credit of up to $2,100 per employee. The credit applies to employees who start work after September 30, 1996, and before October 1, 1997, and was intended to give Congress, the Treasury Department and the Department of Labor the opportunity to assess the credit's effectiveness as a hiring incentive.

The target groups include

Qualified recipients of Aid to Families with Dependent Children.
Qualified veterans.
Qualified ex-felons.
High-risk youth.
Vocational rehabilitation referrals.
Qualified summer youth employees.
Qualified food stamp recipients.

Form 8850 must be signed by both the employer and employee and submitted to the state employment service agency for certification no later than three weeks after the employee begins work. The IRS recommends the employer keep copies of the form, transmittal letters and any other documentation related to the tax credit for three years after claiming the credit on a tax return.

FYI

The National Association of Enrolled Agents launched a new World Wide Web site to help taxpayers with tax-related questions. The Web site (http://www.naea.org) includes dozens of frequently asked questions, a directory of enrolled agents and a forum for "tax chats" where taxpayers can get answers for their questions on the spot.
The Internal Revenue Service said it would not impose penalties if logos are used on substitute forms 1099. Notice 96-62 said the IRS intended to change the regulations to allow the use of certain logos and identifying slogans on the substitute forms. The IRS is seeking comments on this issue, but it did not set a deadline.