To: Mr. John Smith and Mrs. Jane Smith
From: Sarah Gong
Date: November 25, 2012
RE: 2011 Tax Strategy
Dear John and Jane,
Thank you for the opportunity to work on your behalf for tax preparation this year. Per our previous discussion, I have prepared this memo as a preliminary work on this year’s tax strategy. The three main sections are constructed according to inquiries made by each of you individually and, then, to conclude on the options available for you both and my recommendation.
1. John Smith tax issues
a) The $300,000 of attorney’s fee should be included in gross income and subject to federal and state tax. The Internal Revenue Code Section 61 (IRC 61, 26 ...view middle of the document...
So please do a thorough exam of all the expenses ever incurred for this case, as long as they are necessary and ordinary, they can be added together to lower your taxable income.
c) There is no quick answer regarding better to rent or buy the office building. The decision depends on how much you can deduct on tax returns under these two scenarios.
Firstly, regardless rent or buy, you can always deduct expenses such as insurances (rental insurance and ownership insurance may cost differently) and utilities (if you pay utilities as a lessee).
Secondly, while renting the office, you can deduct rental expense of $3,500 every month, which is $42,000 every year on the tax return. While owning the office, you can deduct mortgage interest, repair costs, depreciation expense. Depreciation expense can be a big portion of the total expense, but you can only depreciate real property over its useful life2.
Thirdly, buying the office building also involves financial consideration – if it will have negative impact on your cash flow. How much can you put in as down payment? How much will the monthly mortgage payment be?
In short, if you have money ready to purchase the office building, and you want to take advantage of more deductible expenses over years, purchasing the office building is a good option from tax perspective.
2. Jane Smith tax issues
a) In my opinion, selling the old house and use the money to purchase a new one is the better option. There are no benefits to fully paying off your old mortgage; it only occupies your cash resource. You will be able to deduct your property tax and your new mortgage interest payments with the new house. If you sell your primary residence, you may be able to exclude up to $250,000 of the gain ($500,000 for married taxpayers filing jointly) from your federal tax return and not pay tax on it.
b) You can’t utilize a 1031 tax exchange to buy a more expensive house because the properties exchanged must be held for productive use in a trade or business or for investment3. Properties used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like kind exchange treatment.
c) Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit4. IRS uses the "3-of-5" test to determine if you have profit motive. If your business made a profit in any three out of the past five consecutive years, it is presumed to have a profit motive, and your activity will be likely considered as a business. Per our discussion, you are thinking about adding new equipment to your activity, which is also evidence that your activity can be considered as a business.
d) If your hobby activity produces income, you owe tax on it. And if your hobby activity keeps bringing in income over years, you will have tax benefits to...