The IRS and Married Couples: Real Estate

Two new cases in 2017 have been recently decided by the US Tax Court, which involves married couples with Real Estate:

1. Asad, TC Memo. 2017-8: Husband & Wife who each owned rental property deducted large losses on their joint tax returns. They later divorced. As per the divorce agreement, the divorced couple wanted to split the taxes 50/50. The IRS successfully argued at trial that under the joint tax returns each spouse was jointly and severally liable for the taxes owed. The Tax Court ruled in favor of the IRS holding that the tax allocations set forth in the divorce agreement do not control the couple’s liabilities to the IRS.

Under Asad, the key issue is that the spouses filed joint income tax returns and therefore were jointly and severally liable for all taxes due. They each individually owed 100% of the taxes due and could not contract between each other to pro-rate the taxes on a 50/50 basis. In addition, the divorce decree did not supersede the IRS legal right to pursue collection against for both spouses for 100% of the taxes due, so if one spouse did not pay their share of the taxes due (50%), the other spouse could be obliged to pay the full 100% of the taxes due.

For married couples, the Asad is an example of the dangers in filing joint income tax returns which would not have been the case (for collection purposes) if the spouses had filed married filing separate tax returns in which case they would have been held liable for only the taxes due under their filed tax return.

2. Nielsen, TC Summ. Op. 2017-31: a couple who owned several rentals incorrectly included the cost basis of the land and the buildings in the computation of the depreciable basis (which is not allowed since land is non-depreciable). During the IRS audit, the IRS relied on county assessments to figure the cost apportionment between the value of the land and improvements and the Tax Court sided with the IRS stating their allocation was reasonable.

Taxpayers, who buy real estate, should specify in the contract of sale the total purchase price and how much is allocated for the building and for the raw land. The contract of sale then becomes their evidence of the depreciable basis of the property (i.e. Building not land). The Taxpayers should maintain copies of the contracts for the original acquisition and then use it for any future sale tax planning. Building depreciation is subject to recapture as ordinary income. Capital gains tax is recalculated at ordinary income tax rates to the extent of recapture of prior depreciation deductions and taxed as ordinary income. Since long-term capital gains tax rates are 20% and ordinary income tax rates are 39.6% (maximum federal tax rates) this tax planning is essential to minimize tax due on sale of real estate.

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