Realtors Treading Sharky Tax Waters

I received a call this morning from a client that was in a huff about some information that his real estate broker had given him about cancellation of debt income.  Discharge of indebtedness income, or cancellation of debt income, or COD income can be present in a short sale.  I am heartened that the Realtor was aware of the issue, but I think he started swimming into some deep waters when he started advising his client on the ramifications of the transaction.  Those waters don't have a readily identifiable bottom and that butt clenching feeling you have is directly correlated to the sharkiness of that water.

 If we get into the way back machine and head into 1931, the US Supreme Court decided the Kirby Lumber case giving rise to this kind of income.  It has since been codified, but with the codification, there were a number of exclusions that came along with it.  Not all debt is created equal in the sight of the law, and particularly the debt that is canceled because someone has met hard luck.  Up until the beginning of this year, the Mortgage Debt Forgiveness Relief Act of 2007 that had been extended through 2013 provided most owner occupied real estate a break if the property went back to the bank.  So, when dealing with short sales and foreclosures through last year, there was an exclusion available up to $2M on COD income derived from the loss of your personal residence. 

That provision was supposed to be extended, and had been expected to be extended by Congress, but because of the political infighting of our broken two party system, sensible provisions like this were held hostage by both sides and never extended.  Its not too late, but we are starting to fear this one is dead in the water going into midterm elections.  Consequently, short sales and foreclosures this year do not have a readily available exclusion.  This is where Realtors have lost that nice sandy bottom that they were standing on the water gets dark and deep fast.

The Internal Revenue Code has more loop holes than a fisherman's knot and this is where my Realtor friends are just treading deeper water.  My suggestion is that if you don't like swimming with the legal sharks in deep water, then simply point your client in the direction of competent counsel.  The Realtor that advised my client simply didn't know that when I had suggested short sale to my client it was with full knowledge that another exclusion was readily available.

This particular client had gone through a bankruptcy.  Again, the hard luck aspects of the exclusions softens the landing for the client that is losing his property.  There are also exclusions for those that have extensive debt and would qualify for relief because of insolvency. My favorite for investors in residential real estate has to do with such properties held outside of a C-Corporation because the insolvency is essentially limited to the single property and not the taxpayer's complete portfolio.

So, before you get your client all worked up over tax issues on his short sale or foreclosure, have him speak with the sharks in deep water, preferably by phone, sometimes its hard to tell food and friends apart.

The Tax Cookie Jar

Did you ever grow up with a cookie jar?  My mom had a cookie jar, and that jar had a lid, and it was noisy when you took it off.  In retrospect, I believe that was on purpose, because lets face it, my mom liked cookies as much as I like cookies and she wanted to make sure there were enough cookies for everyone.  She could hear every time that tin lid came off and I can still hear in my mind, my mother's voice yelling, "Put it back!"  As a dutiful son, I would put the cookie back and then skulk off knowing that I had been thwarted in my effort to get more cookies than someone else.

As the owner of your business, you need to view some of your bank accounts like that cookie jar.  When you have made enough money that there is plenty of money to go around, it doesn't seem like a big deal that a few extra cookies make it off to God knows where.  However, problems come when cash flows get tight and there are simply not enough cookies to go around.

There is a temptation in business to look at those cash flush accounts that were earmarked for sales tax, employment taxes, and even B&O taxes that you think that if you sneak a little now, you will be able to put it back later.  Worse, is when your business manager thinks the same thing.  This is where Mom has to yell into the kitchen and say, in no uncertain terms, "Put it back!"

Despite the rhetoric in the national news about improving economies, higher employment, and a general anathema of saying anything negative about business prospects, I am here to tell you that main street businesses and their owners are not seeing overwhelming recovery.  I would say, that in the last five years of advising businesses, we still haven't seen pre-recession revenues, much less profits.  Business is still scrapping and fighting for every dollar and sometimes there just does not seem to be enough dollars to go around.

So who gets the cookie?  We tend to think that because of the self reporting aspect of the tax system and that it will be at least another year before you have to come clean to the Department of Revenue, or the Internal Revenue Services.  You think that you should take from those accounts to cover your short term cash gap.  The reason why I tell my business owners to not do that, is for the simply reason that you have no proof that you will make that money back.  I am not a pessimist, but the reality is that if you cannot pay for it now, taking essentially a credit loan  from the DOR and IRS is not your best business practice.  There are better creditors to use, and ones that will not attach the moniker of tax avoidance to your transaction.

Here is an analysis of the why and how.  Suppose that your business goes belly up six months from the time you take the cash from these tax accounts.  (Again, I am not a pessimist, but we are planning for worst case scenarios.)  Under Washington law, you can wind up the business, shutter the doors, and walk away from the business held debts.  Except that you cannot in regard to the debts to the DOR and IRS.

In Washington, you must receive a clearance from DOR to close the business.  Until DOR has been paid, you are on the hook and subject to the harassment of the creditors.  Additionally, DOR has a right to the sales tax proceeds your took.  Remember, Sales Tax is not your tax, but the tax from your customer.  You hold it in trust on behalf of the State.  If you fail to pay that amount, Washington law allows the DOR to reach past your now defunct business venture and into your pockets as a responsible individual for the business.

Likewise, the 940 and 941 employment taxes that you are to remit are the taxes of your employee, not your taxes.   You again stand as a fiduciary for that payment.  Failure to pay timely can create a situation where the IRS can reach past your business and into your pockets.  Federal Tax Lien anyone?

The next part of the analysis is in looking at personal liability.  Say you were required to personally guarantee the lease, your equipment purchase, your supplier's account, and the company credit card.  Each of those entities, once the business has been wound down, have unsecured claims against you.  Each of those are dischargeable in a bankruptcy.  Guess which two accounts are not dischargeable?  That's right genius, the DOR and the IRS accounts will haunt you even through a bankruptcy.

Now, that we have travelled the dark road and know what the pessimistic view looks like, we can plan in the present; the noisy lidded cookie jar.  It is the recommendation that a separate account be established to hold sales tax and employee taxes.  These should have greater protections on them, such as dual signature checks, or at least unlinking them from the general business account so that transfers cannot be easily made from those accounts to your primary business accounts.  You may also want to create alerts on your smart phone for when transfers come from the accounts.

This protects the accounts certainly from the inadvertent use of the funds, but more importantly forces the owner and the managers to make a conscious decision to pilfer the account.  Remember, that money is not your money, Fiduciary.  The extra work will ensure that extra thought will be put forth and hopefully thought will provoke good behavior toward your business.  Every time that you open that transfer window on your bank's website, I want you to hear my mother's voice yelling at you across time and space, "Put it back!"