Avoiding Tax Return Miscalculations in Property Re-Development - BRUCE SCAMBLER : CPA CFF FCMA

 A CPA with proven experience in forensic accounting, taxation and consulting services.  Experience covering many different cases, including insurance, SEC, oil and gas and corporate malfeasance investigations concluding in litigation support and  other engagement

Real Estate ‘asset’ (re-)development property (whether for commercial properties or domestic homes) as a subject topic of the tax code, comprises some of the most complex in the Tax Code, with thousands of applicable rules and regulations.  At the same time, if you follow the rules accurately, it can be one of the most favorable areas for the tax payer. 

 

Here is one of the rubs, re-developers and designers with creative brains,  do not think at all like that of an accountant or CPA.  They are not experts in all these rules.  Many such taxpayers were also left ‘without normal available accounting help due to covid’, and are struggling to comply through 2021 and 2022 return periods.  Taking care of the bookkeeping to prepare tax returns for property development is a skilled service.  We can advise on how to get the most in tax avoidance, applying the more favorable aspects, while ensuring you of being in compliance.  Providing you get us accurate information, or what you have we can apply forensic tests to get returns prepared. 

Here are some of the opportunities, and following are a sample of the tax preparation rules and checks required to cover these projects, and report them most favorably in your tax returns. If you would like a more in-depth discussion please email or call.

 

1)          Importance of Accurate Bookkeeping and Records

   It is very important to keep accurate records, for each project separately, and over the whole life to the conclusion and disposal of the project.  Given the accounting and tax analysis for extended property developments can cover multiple years, (many run one to five (1-5+) or more years) you need to have comprehensive recording systems and record keeping.  The re-development and re-design needs careful budgeting, detailed record keeping, accurate and timely bookkeeping and accounting.  From these records and accounts highly complex tax reviews and calculations need to be performed and completed. 

 

   Property development is an area that the IRS review frequently.  High on the list is to ensure that mortgage and loan allowances are not exceeded, and that “primary” residence rules are in compliance.  Failure to keep accurate records can lead to IRS examinations and then a 531 Notice of deficiency leading to US Tax Court.

 

   If you have not kept accurate accounting records you could be at a disadvantage to avoid the deficiency tax payment.  The Tax Court is not the appropriate forum to try to take up valuable Court time in reviewing low level multiple transactions and reconciliations.  If you are in a poor records situation, consider using forensic accounting to recover the records and recompile.  We can perform forensic accounting to ensure you have accurate records.  If you are in Tax Court, then with forensically recompiled numbers you can argue matters of law, settle disputes get to a favorable resolution.  This article stresses how to get to accurate records, even if you suffered a loss, flood or fire, and avoid paying tax deficiencies on the basis of inaccurate records.

 

2)          Compilation of Accurate Records

 

   The property development sector does need accurate records, and there are times after floods, hurricane storms, tornadoes, fires, earthquakes and other disasters where forensic work is required to recompile lost or damaged records. 

 

   This area of the tax code and subject matter of real estate asset development property is some of the most complex (with thousands of applicable rules) in the Code.  At the same time it is one of the most favorable for the tax payer.

 

Here is what we are covering:   

(i)              Outlining the scope of the records required

(ii)            Detailing compilation, tests and other work to prepare the property tax parts of income tax returns

(iii)          Reaffirming obligation to file Amended Returns and

(iv)           Dealing with the effect of the limited time allowed by the IRS -Service.  

 

 

(i)                   Outlining the scope of the Real Estate Accounting and records required

 

Likely the last thing as a real estate developer you want to bother with is to track your numbers metrics and financial and keep accurate records.  You may dream of avoiding all of this, but in reality, you need to get support, software and services to do this.  You must stay compliant with income tax reporting requirements.  The other benefits include understanding the current profitability (or losses) of the projects, prepare reports to attract investors or obtain financing, and frankly sleep better at night.  Not having IRS examinations and audits is a lot more restful.  You need to ensure you approach real estate to include accounting, and understand that this improves your ability to run your business successfully. 

 

Real estate accounting is quite complex.  There are a lot of different factors and parts, not found in standard retail sales or marketing businesses.  As a developer, we recommend for you as a client, to think of this as a dash-board or scorecard.  The real estate accounting process requires you to manage multiple costs and constantly identify strategies for savings. For example, you may want to find ways to reduce costs in the vendor procurement process.  You can keep a better eye on the situation if you use a seven (7) factor balancing scorecard.  This will help you run your business more effectively. 

 

1.         Set up optimal key accounts

 

Make sure you get best advice when you set up your real estate accounting, whether you use generic or real estate specific software.

 

The most important part here is to ensure that you identify the accounts that give you the most efficient insights into your development operations.

 

Another example, a commercial building developer should set up accounts for accounts payable, banking cash, construction-in-progress (CIP), work-in-progress (WIP), account receivables, investment, loans and equity, identifying all loan rates and terms whether long-term debt, or short-term debt (less than 1 year), retainage, and many others.

 

By contrast a landlord who rents out property will after the property is rented no longer track CIP/WIP, but they may need to add accounts that allow them to track specific expenses related to their rental operations.

 

2.         Focus on the key measures for your reports

 

When you are driving, you need speed, distance, lane control, gas remaining, cruise control and mpg to get optimum and safe driving.  The key measure reports for real estate focus on similar aspects.  The key measure reports you need can vary, based on what objectives and type of project’s in progress.  

 

If you are a home investor who plans to buy a property at a low cost, develop and flip you will typically focus on the project profitability.  You need accurate original and rework costs, labor and vendor costs and amounts owed. You need a report which provides an overview of the development’s profitability based on the you ‘assets and liabilities’, what you have in the project, and what you owe.  Added time taken will increase your interest on loans so you need to measure whether you are on time. 

 

If your project is to re-develop the house to make a rental or AB&B, you will need during the reworks, accurate original and rework costs, labor and vendor costs and amounts owed.  When the property is rented you need a report which provides an overview of the development’s profitability based on what you have in the project, and what you owe,  which will generate rental income, reports and records should focus more closely on the profit-and-loss (P&L) report, which helps you see the expenses versus revenues during any time period. 

 

In both of these examples good accounting will allow you to generate the right reports where your real estate activities will dictate which key measure in reports you should review most carefully.  We can advise.

 

 

3.         Track Cost of Goods Sold (COGS)

 

            A real estate developer needs to be somewhat like a manufacturer and track the Cost Of Goods Sold (COGS).  When you set up the accounts these are items that change as your property sales value changes.  Not indirect expenses, but direct on the real estate sales.  COGS covers all direct expenses involved in developing your property.  We advise putting direct labor in this category, including paying contractors, electricians,  architects, obtaining permits, and buying building materials. Where you can get smarter with software and better records is to break down COGS line items per square foot, or use numbers to create profitability ratios. This will let you to compare the profitability of different development projects.  The fact is that the better you understand your costs, and the dash board the more effectively you will be able to generate profit for this and make projections and estimates for future projects.  Limit indirect expenses, to more fixed costs like paying someone to run the office for your real estate development firm, office electricity, company insurance, but not project insurance, or direct project and interest. 

 

4.         Cross analyze to identify hard or soft costs

 

In addition to Direct and Indirect Costs (COGS), real estate developers need to separate and identify hard and soft costs.  This is an advanced layer technique.  Tracking hard or soft expenses separately helps you better understand how these different element types affect the overall budget and final outcome of your project.

 

Hard costs are the physical tangible construction parts of the project, which includes labor, materials, environmental, hazardous materials abatement, and equipment such as scaffolding, cranes, trash systems or slips. 

 

Soft costs, are the rest, so not the physical building. They include consultants, architects, permits, inspection fees, and financing costs.

 

Where hard or soft identification matters, is that each different project can vary.  Doing multiple same projects should give you a general rule of thumb, where you can allocate soft costs over several projects.  Hard costs may in a housing development make up 90% to 95% of a project’s budget.   For one off projects soft costs may be higher and make up 20% to 30%.  Having these parts identified can help you better identify your profitability.

 

5.       Compiling a Budget, Tracking and Making  Financial Projections

 

For the more experienced developers you are aware that real estate accounting starts long before you buy the land.  Before you ever ‘break ground’ on a project, you need to have made your best estimated  financial projections.  Making prospective property development includes data on acquisitions, market data, construction costs, and your proposed work schedule. You need a budget, and a plan and write out assumptions. This plan details the sources and use of funds from your initial cash requirements through works out to the end of the project.

 

While the project proceeds you will need to track actual costs and liabilities while also continuing to make estimates and projections about the future.  Key to your dash board is your burn rate.  Get help if you need it to create rolling cash flow projections so you can be up to date in identifying potential shortfalls early and make a plan to avoid them.

 

6.       Use Financial Projections to refine development decisions

 

There is nothing worse than wasting time comparing actual to old budgets.  As new and better information comes in revise the budget and financial projections.  But, mind you review the reasons as your project moves forward.  The updated information will allow better decisions to find a ‘balance’.  We term this the balanced scorecard report.  It balances between your design development and what you can afford per your revised budget/forecast.  We believe best practice means that during the project, you to produce numerous revised budgets.  At each revision you need to refine your development design choices to stay in line with these forecasts.  This information is designed to let you strike a balance that allows you to minimize both delays and cost increases while maintaining the quality of your project, and maximizing profits,

 

7.       Use Specific Real Estate software to refine development decisions

 

Real estate ‘accounting’ software helps you stay on top of your projects.  These seven (7) elements should help you analyze everything.  You need to get good reports, get above line-item variances to aggregate costs and up to a balanced scorecard or “dashboard report”.  We have consultants who know how to implement and utilize real estate accounting software. It can be very challenging.  You may want to work with a consultant specialist.  There is nothing worse than wasting time getting an implementation wrong.  Get to understand how to use accounting software, this is a critical part of this process.

 

(ii)            detailing compilation, tests and other work to prepare the property tax parts of income tax returns

Our clients have a range of different processes and software to prepare accounts.  Whichever is used, we apply standardized tests to these calculations and compilations.  We go through extensive checklists and tests, to check we have applied the relevant tax rules correctly.  To give you an idea of what is required and performed, the detailed tests are set out below.  It may seem  dry read to anyone not involved in real estate accounting and taxation.  It is however what is necessitated by the complexity and extensive Code compliance.  To relate to these tests the following scenario has been created.

 

Scenario (based on real life)

You are a property developer of a multi-unit development.  You are selling units when they are ready, and renting some units that are slow in selling.  Revenue inflows are from  multiple sources, the expenditures are posted through multiple accounts.  You have multiple bank accounts, and multiple funding equity partners, and different bank and private loans.  Your bookkeeper got long term Covid and has not updated the QuickBooks for several months.  With so many bank accounts going, you can not keep separate track of what was what in one project account or another.  You are paying in and out from which ever account had enough money to cover the expense, accounting for everything through one ‘bucket’.  There were also issues with contractors who stole tools, took decorations, billed for work that was sub-standard and required redo-over, and worse billed for work not completed.  There were some insurance claims (erroneously booked to income).   Primarily due to Covid, accounting was a mess and that part made it very difficult to maintain profit and cost center accounting.  Like many sole proprietors during Covid, developer had to manage 'no-shows', find replacement contractors to be on site, when they could be found.  Keeping all transactions posted was as best as could be done in the circumstances.  Developer was working super hard to stay afloat.  It seems the coding suffered, and the loan receipts were not identified as loans.  Your replacement tax preparer booked your loans and equity deposits to income, and filed your taxes without telling you about it.  Go figure what do you do?

 

Scenario Review

What the developer was doing was Property Development and Interior Design.  This project design, work-wise, with building, renovating building and operating the rental business on the property.  This is a summary of the compilation, tests and other work to rectify the practitioner errors,  

 

The developer’s starting point, upon being informed of the error(s) by the IRS examiner, was to engage a forensic CPA.  To show the scope of the work required, covering several years below are a summary of the forensic CPA work and procedures.  These test details are those performed per checklists that included the following checks and procedures to review the Resort and other projects:  

 

Checklist of Review Tests

 

(1)       Review the acquisition purchase contract and purchase closing statement, check postings to ledgers

(2)       Review purchase position when the property was acquired and examine any photos to see how it was. (put copy on file) Determine if vacant, a run - down or other condition. 

(3)       Review available budgets and plans.

(4)       Review income and receipts in the bank statements, and perform proof of cash.

(5)       Review available expense receipts and expense postings, from purchase to date.

(6)       Review the credit card statements as available, from purchase to date.

(7)       Compile income reconciliations and detail out loans, and apply use of funds to proof of cash, from purchase to date.

(8)       Determine the project scope of circa ‘gross budget’ for ‘n’ years, contractor works and amounts expended in excess of the net sales prices, from purchase to date.

(9)       Review the initial budget expectation to renovate it to get it to “operation” within the realm or neighborhood of budget, 

(10)     Schedule out loans and compile basis. 

(11)     Determine the adjusted basis of business property back when it was acquired, from purchase closing documents.  (Adjusted Basis includes not just the cost of the asset, determined under Section 1012). 

(12)     Determine any exchanges, barters or trades where taxpayer can also rely on a substituted basis if the property was in part acquired in any exchange transaction (Section 358(a)(1) and Section 1031(d)).  

(13)     Compile the cost basis (including cash payments for property plus the fair market value of noncash property given in payment, and costs directly related to the acquisition of property) which all must be included in its initial basis (include freight, purchase commissions, title fees, transfer taxes, and sales taxes (Regs. Sec. 1.263(a)-2(f)).

(14)     Review expenses for cost basis, to includes any costs incurred to get the asset ready for its intended use (Section 263 and Regs. Sec. 1.263(a)-2), including installation, Interior Design, renovations, implementations, and showing or testing costs. 

(15)     Review real property taxes apportioned to or owed by the seller and paid by the purchaser which can also be included in the purchaser's tax basis (Regs. Sec. 1.1012-1(b)).

(16)     Review the amount of any liability incurred by the taxpayer Petitioner to acquire the property included in basis (Regs. Sec. 1012-1).

(17)     Review transactions borrowing money.  Identify traditional mortgage loans and others. Review to ensure loans all based on prevailing commercial terms. 

(18)     Review application of rule of Section 1231 (allows where a net combined result of all sales and exchanges of Section 1231 assets during the tax year(s) is a net loss, the loss is an ordinary loss (Section 1231(a)(2))).  Where the result is a net gain, the gain is treated as a long-term capital gain (Section 1231(a)(1)).  (This asymmetric rule offers the best of both worlds to the business taxpayer Petitioner - ordinary loss or capital gain on the sale of operating assets).  With this preferential rules result the application ordinary losses are fully deductible in computing taxable income, whereas capital losses are subject to limits on deductibility.  All else equal, capital gains are preferred to ordinary gains; ordinary losses are preferred to capital losses.

(19)     Compile computation for Section 1231 netting process (critical to determining the ultimate impact of Section 1231 gains and losses on taxable income).  The tax result of a Section 1231 asset sale cannot be fully determined until after year-end of the year in which project sale occurs, after application of the netting process.  This was running through to Resort sale in 2021. 

(20)     Perform such adjustments applicable to business property, where basis was increased for expenditures property chargeable to a capital account. (Such expenditures include those improvements capitalized under Section 263(a)).    Where basis was reduced by depreciation deductions allowed or allowable in computing taxable income compute the basis reduction for depreciation as the greater of amounts allowed as deductions in computing taxable income or the amount allowable, even if not claimed as a deduction.

(21)     Review all the “Lenders” who were contracted for the loans with terms albeit some were personal friends

(22)     Review basis computation to include debt assumed by the owner of property and debts to which the property continues to be subject after the acquisition, including nonrecourse debt.  

(23)     Complete a review compilation of all loans, apply Regs. Sec. 1.1001-2, where the amount realized from a sale or other disposition of property includes any amount of liabilities from which the seller is discharged as a result of the sale or disposition.  (i)  Debt discharge is generally included in amount realized whether the liability is recourse or nonrecourse.  Review requires detailed document reviews to see if the owner of the property could have been held personally liable. (ii)  Alternatively, identify nonrecourse liability (where the lender can look only to the property securing the debt in satisfaction of the liability).  The extent of complexity in these circumstances includes that the amount of debt included in the property's tax basis must be determined under either the original issue discount OID rules of Section 1274 or the unstated interest rules of Section 483.  The OID rules are extremely complex. Consider Section 1274 applies to debt instruments issued as consideration for the sale or exchange of property when there is not adequate stated interest or, if there is adequate stated interest, the instrument's stated redemption price exceeds the stated principal amount.  Review needed to identify any instruments are excluded from these requirements, including (i)  instruments with terms less than six months, (ii) instruments from sales of personal residences, (iii) instruments from sales involving total payments of $250,000 or less, and publicly traded instruments. These instruments excluded from Section 1274 are subject to Section 483.

(24)     Complete a review of Section 1274 applicability, (where the amount of a debt instrument included in amount realized equals the issue price of the debt).  If the debt instrument bears adequate stated interest, the issue price equals the stated principal amount. Otherwise, the issue price must be determined by calculating an imputed principal amount. The goal of the imputation process is to separate payments to be received under the debt instrument between principal and interest using an applicable federal rate instead of the stated interest amount.

(25)     Review loans to apply Section 1274, (where the imputed principal amount will be less than $x million); this lower amount will be included in amount realized on the sale. As payments are received on the note, a portion of such payments will be treated as interest for tax purposes, taxed to Petitioner at the time accrued or received under its method of accounting.  Computing the imputed principal amount being the sum of the present value of all payments to be received under the debt instrument, determined as of the date of the property disposition.  Present value is computed using the applicable federal rate, compounded semiannually. (Applicable federal rates are those published monthly by the Treasury and vary depending on the term of the debt instrument).

(26)     Make a compilation of the imputed principal amount, including comparing to the stated principal amount to determine if the debt instrument bears adequate stated interest.  Ascertain if the imputed principal amount is greater than or equal to the stated principal amount, wherefore there is adequate stated interest, and the issue price equals the stated principal amount.  Ascertain if not, the issue price (and the amount included in amount realized on the disposition of the property) is equal to the imputed principal amount. Amounts paid in excess of the issue price are considered interest, recognized over the life of the debt instrument.

(27)     Review the debt instruments if subject to the unstated interest rules of Section 483 instead of Section 1274. Determine the debt amount included in amount realized under Section 483.  (Apply similar test to the approach applied under Section 1274).  Note: Section 483 applies only to sales and exchanges not covered by Section 1274, where any payments are due more than one year after the sale or exchange. Section 483 exempts sales for $3,000 or less, certain sales of personal property, and sales of patents with contingent payments.

(28)     Review Real property taxes apportioned to or owed by the seller and paid by the purchaser also have to be included in the seller's amount realized (Section 1001(b)(2)). Real property taxes apportioned to the purchaser but paid by the seller, for which the seller receives reimbursement, are not included in amount realized on the sale. Such taxes related to periods subsequent to the purchase are typically deductible by the purchaser, either as ordinary and necessary business expenses (Section 162) or as an itemized deduction (Sections 63 and 164). (Note that effective January 1, 2018 an itemized deduction for state and local income or sales tax and property tax is limited to $10,000 (or $5,000 for married taxpayer Petitioners filing separate returns).

(29)     Apply Section 61(a)(3) which specifies that gross income includes "gains derived from dealings in property." Conversely, Section 165(a) allows a deduction for "any loss sustained during the taxable year and not compensated for by insurance or otherwise." In combination, these two rules require taxpayer Petitioners to include gains and losses from property transactions in the computation of taxable income.

(30)     Apply Section 1001, where realized gain or loss from a disposition of property is computed as: Amount realized on disposition - Adjusted tax basis of property = Realized gain or (loss) From prior computations apply the realization principle of accounting.  (Increase or decreases in the value of assets which are not accounted for as income).  Such unrealized gains or losses are considered after an asset is converted to a different asset through an external transaction with another party.

(31)     Review all loans to see is a party received any purchaser debt instrument as part of the consideration for a property disposition, the amount of such debt included in amount realized is generally the issue price of the debt.  For the amount of debt included in the property's tax basis determined under either the Original Issue Discount (herein “OID”) rules of Section 1274 or the unstated interest rules of Section 483. The OID rules are themselves extremely complex. Their application here is detailed only to the extent necessary to explain their impact on the cost basis of the acquired assets.

(32)     Review Section 1274 application to debt instruments issued as consideration for the sale or exchange of property when there is not adequate stated interest or, if there is adequate stated interest, the instrument's stated redemption price exceeds the stated principal amount. Review instruments which are excluded from these requirements, including (i) instruments with terms less than six months, (ii)  instruments from sales of farms for less than $1 million, (iii) instruments from sales of personal residences, (iv) instruments from sales involving total payments of $250,000 or less, and publicly traded instruments. These instruments excluded from Section 1274 are subject to Section 483. 

(33)     Perform compilation review tests to check for debt instruments which per Code are subject to the unstated interest rules of Section 483 (instead of Section 1274). The test approach used to determine the debt amount included in amount realized under Section 483 (similar to the approach used under Section 1274).  The tests sought to see if there were any sales and exchanges (not covered by Section 1274), where any payments are due more than one year after the sale or exchange.  (NB:  Section 483 exempts sales for $3,000 or less, and some sales of personal property).

(34)     Test and identify any Real property taxes apportioned to the purchaser but paid by the seller, for which the seller receives reimbursement, are not included in amount realized on the sale. Such taxes related to periods subsequent to the purchase are typically deductible by the purchaser, either as ordinary and necessary business expenses (Section 162) or as an itemized deduction (Sections 63 and 164). Effective January 1, 2018 an itemized deduction for state and local income or sales tax and property tax is limited to $10,000 Petitioner).

(35)     Review capital improvements made to the business property,  (accounted for in the Amended returns) checked to provisions of Section 263(a) which requires that the cost of such improvements be capitalized to the tax basis of the asset. 

(36)     Review Grubb accounting on an item-by-item basis capitalized amounts, (which can't be ignored as they were by the previous CPA preparer) critical to computing allowable cost recovery of business assets.  Review for application and depreciation effects.  When the Resort property was sold in 2021, the adjusted tax basis of the property determined the resulting gain or loss on sale.  Petitioner, having been apprised of these relevant professional capital gain/loss filed Amended Returns  (Profit (net of losses) on the sale or exchange of a capital asset or Sec. 1231 property, is subject to favorable tax rates, and loss on such sales or exchanges (net of gains) deductible against $3,000 of ordinary income per Section 1231 netting process.

(37)     Compute inclusion of debt instruments for the amount of such debt to be included in the tax basis of the property.  (The complexity here is to apply on a loan-by-loan basis criteria to determine under the OID rules of Section 1274).

(38)     Apply Section 1274, the amount of a debt instrument included in amount realized equals the issue price of the debt.  However, per rule only if the debt instrument bears adequate stated interest, the issue price equals the stated principal amount.  Alternatively, the issue price must be determined by calculating an imputed principal amount.  The imputation process is a detailed calculation, to separate payments to be received under the debt instrument between principal and interest using an applicable federal rate instead of the stated interest amount.

(39)     Review all debt instruments, schedule stated principal amounts for adequate stated interest, wherein the issue price the entire amount of which is included in amount realized on the sale of the building, applying Section 1016 required adjustments to tax basis.  These basis adjustments are applied to the initial basis of the property, whether a cost or substituted basis.  (Practitioner notes: there were exceptions where a few of the debt instrument had low interest.  In these cases, the annual installment payments required by the debt instrument, even though characterized as principal, economically represent both a repayment of borrowing (principal) and a payment for the use of the borrowed funds (interest).  Under Section 1274, the imputed principal amount will be less than; this lower amount will be included in amount realized on the sale. As payments are received on the note, a portion of such payments will be treated as interest for tax purposes, taxed to Petitioner at the time accrued or received under its method of accounting).

(40)     Review imputed principal amount as the sum of the present value of all payments to be received under the debt instrument, determined as of the date of the property disposition.  Present value was computed using the applicable federal rate, compounded semiannually.  (Applicable federal rates were those as are published monthly by the Treasury and vary depending on the term of the debt instrument).  The imputed principal amount was compared to the stated principal amount to determine if the debt instrument had adequate stated interest. When the imputed principal amount was greater than or equal to the stated principal amount, then adequate stated interest existed.  Then the issue price equals the stated principal amount.  When lower than the stated principal amount, the Debt ‘issue’ price (and the amount included in amount realized on the disposition of the property) was set as equal to the imputed principal amount.  Amounts paid in excess of the issue price were considered interest, recognized over the life of the debt instrument. 

(41)     Apply provisions of Section 61(a)(3) which specifies that gross income includes "gains derived from dealings in property."  Conversely, Section 165(a) allows a deduction for "any loss sustained during the taxable year and not compensated for by insurance or otherwise."  In combination, these two rules require taxpayer Petitioners to include gains and losses from property transactions in the computation of taxable income.

(42)     Under Section 1001, realized gain or loss from a disposition is computed as:  Amount realized on disposition - Adjusted tax basis of property = Realized gain or (loss).  This computation is complex requiring use of the realization principle of accounting. Under this principle, increases or decreases in the value of assets are not accounted for as income. Such unrealized gains or losses are not considered until an asset is converted to a different asset through an external transaction with another party.

(43)     Review transactions from purchase.  Where the market value of the asset has increased, estimate gain as not reported any of the accrued economic gain on tax returns.   (The issue is in most (but not all) cases, realization is a necessary prelude to recognition of gains and losses on the tax return. Therefore, the realization principle gives Developer control over the timing of gain or loss recognition.  Owners of devalued property can accelerate the deduction of loss and the related tax savings by disposing of the property as soon as possible. The amount realized on a disposition of property is defined in Section 1001(b) includes the following items all of which need to be reviewed)

i.          Cash received.

ii.         Fair market value of noncash property received.

iii.       Relief of seller liabilities (Regulation Section 1.1001-2).

iv.        Issue price of purchaser debt issued in exchange for the property (Regs. Sec. 1.1001-1(g)).

(iii)      obligation to file Amended Returns

 

(iii)                                 reaffirming obligation to file Amended Returns

            In nearly all cases, given the complexity of the code, forensic review will identify revisions to income, expenses and overall tax liability.  You will need to report this change.  The standard method to make a change is to file an amended return. You are obliged to do this if there's a change to Income, Deductions, Credits, Tax liability.  Correcting an over-assessment, or an over-payment of taxes for error is a good reason to file Amended Returns.

 

            The IRS or ‘Service’ has a policy of encouraging voluntary disclosure. Although voluntary disclosure creates no substantive or procedural rights for taxpayers, you are entitled to correct and avoid Tax Court litigation and penalties.  Not all Service examiners are the same.  Do not anticipate your voluntary disclosure will guarantee acceptance and correction; historically taxpayers used to have to face a potential hazard of filing an Amended return with a tax controversy pending. Some forty (40) years ago the US Supreme Court, stated in Badaracco v. Commissioner, 464 U.S. 386 (1984), that amended returns are "a creature of administrative origin and grace."  The Service view was that a taxpayer who is already under ‘audit’ or ‘review’ could be considered as revealing the semblance of being considered an admission of the taxpayer.  

 

            A more current view is that preparation mistakes, especially during Covid years, are very common place.  Preparers working at home often filed returns remotely without obtaining all the necessary information from taxpayer clients.  Correcting these mistakes is a necessity. It is most prudent to get the record straight.  You need to file an Amended income tax return.  Amended returns are mentioned in Treasury Regulation §§ 301.6211–1(a), 301.6402–3(a), 1.461–1(a)(3)(i). Section 6213(g)(1) and Section 1.451-1(a))  that require Amended tax returns to be filed. 

 

Treasury Regulation 1.451-1(a), does provide an obligation to file an amended return: 

 

§ 1.451-1 General rule for taxable year of inclusion.

 

(a) General rule.  Gains, profits, and income are to be included in gross income for the taxable year in which they are actually or constructively received by the taxpayer unless includible for a different year in accordance with the taxpayer's method of accounting. Under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy (all events test). Therefore, under such a method of accounting if, in the case of compensation for services, no determination can be made as to the right to such compensation or the amount thereof until the services are completed, the amount of compensation is ordinarily income for the taxable year in which the determination can be made. Under the cash receipts and disbursements method of accounting, such an amount is includible in gross income when actually or constructively received. Where an amount of income is properly accrued on the basis of a reasonable estimate and the exact amount is subsequently determined, the difference, if any, shall be taken into account for the taxable year in which such determination is made. To the extent that income is attributable to the recovery of bad debts for accounts charged off in prior years, it is includible in the year of recovery in accordance with the taxpayer's method of accounting, regardless of the date when the amounts were charged off. For treatment of bad debts and bad debt recoveries, see sections 166 and 111 and the regulations thereunder. For rules relating to the treatment of amounts received in crop shares, see section 61 and the regulations thereunder. For the year in which a partner must include his distributive share of partnership income, see section 706(a) and paragraph (a) of § 1.706–1. If a taxpayer ascertains that an item should have been included in gross income in a prior taxable year, (s)he should, if within the period of limitation, file an amended return and pay any additional tax due. Similarly, if a taxpayer ascertains that an item was improperly included in gross income in a prior taxable year, (s)he should, if within the period of limitation, file claim for credit or refund of any overpayment of tax arising therefrom.

 

There are many reasons to file an Amended return.  Avoiding Service 'prosecution' litigation should be a good reason.  Consider an example, where an inexperienced bookkeep during Covid, Working From Home (‘WFH’) booked all receipts on the bank statements to income.  Unfortunately some of those transactions (fifteen (15)) were where the receipt was of personal loan funds, which looked much like payments from private clients project work. When these were incorrectly booked to income (in error), income was overstated over one million (1,000,000.00) dollars.  The taxpayer only found out this error had occurred after the Service local examination concluded, due to Covid.  per Treasury Regulation 1.451-1(a), (s)he should, (if within the period of limitation which it was), file “claim for credit or refund of any overpayment of tax arising therefrom” for which the correct form is “an Amended Return”.

 

(iv)                               dealing with the effect of the limited time allowed by the IRS -Service.  

The service do not grant and examination extended time in many instances.  Examinations are pushed along, which explains why the time it takes to perform the error correction review, after it has been discovered, can be longer than allowed.  If the records on hand are not accurate it can take a little longer than the limited time allowed by the Service.  The sooner we can be engaged the more we can accomplish/

 

This is a really complex area of code. In making the corrections, if we do not have enough time, there will not be time to lay out detailed litigation presentation reconciliation schedules.  When the Service ends the local review, there may not be time for schedules to be produced.  If they are required more time has to be allowed to provide such information to the Service.  It is important to try and ensure the Service does not ‘close’ the normal review channels for such detailed discussion, closing local review and instigating these proceedings. 

 

 

Please call if you require assistance. 

 

 

 

B. J. Scambler  CPA  CFF  FCMA

CPA Tax Counselors  P.L.L.C.,

Certified Public Accountants

Tel Cell/Mobile 405 820 2711

Tel Office 405 608 2700

Email: bruce@cpataxcounselors.com

 

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