Any way to avoid capital gains tax (from K-1) using married filing separately?

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MisterBill
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Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by MisterBill » Sat Jul 22, 2017 6:59 pm

OK I will start by saying I know I should talk to an accountant about this but I don't have one and don't have a lot of knowledge in this area, so I figured I'd ask here as a start.

My wife's mother passed away a few years ago and we've been getting distributions from the estate. Earlier this year, the estate sold a piece of real estate that she owned. Because of how the estate would have been taxed, the estate's accountant decided that they would not pay capital gains on the sale and would instead pass them onto my wife and her brother (they each got 50%). We just got a K-1 in my wife's name showing a net long-term capital gain of almost $500k. The K-1 is in my wife's name. Box 12 A shows an AMT Adjustment is -300 and also 12 D is -300 (AMT Adjustment attributable to net long-term capital gain).

I'm wondering if we can file as married filing separately to avoid paying taxes on the capital gain (or at least pay less). My wife retired earlier this year (and didn't make much anyway) so she'll be the 10% tax bracket if she files separately(which if I read things correctly does not have to pay capital gains, but maybe that doesn't apply to K-1 gains). I am currently in the process of retiring but will probably be in the 25% tax bracket this year.

As I said, I need to talk to an accountant about this, but for now I'd like to get some opinions here. Of course, I could be completely wrong, and the IRS is way ahead of me on this and what I want to do won't work.

Gill
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by Gill » Sat Jul 22, 2017 7:42 pm

Are you saying the LTCG was about a million dollars? Was there no step up in basis in the estate? How did the accountant "decide" you would be taxed on the gain? There are rules governing this. Also, you might try running a pro forms tax return using MFS but it will probably result in more tax than MFJ.
Gill

MisterBill
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by MisterBill » Sat Jul 22, 2017 7:51 pm

Gill wrote:Are you saying the LTCG was about a million dollars? Was there no step up in basis in the estate? How did the accountant "decide" you would be taxed on the gain? There are rules governing this.
Gill
I was not the executor of the estate, my brother-in-law was and told us that the law firm and their accountant determined that it would cost more for the estate to pay the CG taxes than it would for it to be passed onto us. We had gotten a K-1 last year for some income generated by the property (it was a small apartment building, not MIL's residence and she only owned half of it, so presumably the LTCG was almost $2m, and I had no visibility into how they determined that amount). We received a distribution for more than the LTCG amount when the sale closed earlier this year and another $200k or so when the estate was closed (which I put in a one year CD to be able to pay taxes, forgetting that I might need some to pay estimated taxes this year.

Gill
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by Gill » Sat Jul 22, 2017 7:58 pm

I would at least ask the question why there was no step up in basis of her one-half interest in the property.
Gill

MisterBill
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by MisterBill » Sat Jul 22, 2017 8:13 pm

Gill wrote:I would at least ask the question why there was no step up in basis of her one-half interest in the property.
Gill
I'll speak to the person who worked on it. Meanwhile, I went into 2016 Turbotax and just entered a Form 1041 K-1 with the amounts on my form, and it tells me that I owe around $70k in tax, married jointly but with no other income in the return. Included in that is $1683 in AMT and almost $8700 from Form 8960 line 17 since only $250k is apparently exempt there.

Update: it gets better. I went into the NY state portion of Turbotax and I end up owing $32k to them.

bsteiner
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by bsteiner » Sat Jul 22, 2017 9:27 pm

Gill wrote:I would at least ask the question why there was no step up in basis of her one-half interest in the property.
Gill
In for a penny in for a pound. I would ask the lawyer both questions (the basis step-up, and how the estate was able to pass the capital gain through).

It's possible there was no basis step-up (if she had signed a contract to sell the property before she died). It's possible that there was a basis step-up and still a large gain. If the sale was in the estate's final taxable year, then the capital gain would pass through.

trueblueky
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by trueblueky » Sat Jul 22, 2017 9:38 pm

To answer your title question: Given the situation, MFJ is pretty certain to be better than MFS, but it's not hard to run the numbers both ways to doublecheck.

Capital gains that are within the 15% bracket total have no tax. $500,000 is far outside the 15% bracket of any filing status. She'd pay 20% federal on much of it.

Flora
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by Flora » Sat Jul 22, 2017 10:12 pm

You entered the gain wrong because $250k is not exempt unless it is your own personal residence.

EddyB
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by EddyB » Sat Jul 22, 2017 10:52 pm

Flora wrote:You entered the gain wrong because $250k is not exempt unless it is your own personal residence.
Form 8960 is NIIT, not capital gain. NIIT applies to net investment income for taxpayers with MAGI over the applicable threshold ($250,000 for married taxpayers filing jointly).

letsgobobby
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by letsgobobby » Sat Jul 22, 2017 11:01 pm

in general, does the characteristic of trust income maintain itself when the income is distributed to the beneficiaries? ie, rental income is rental income, qualified dividends are qualified dividends, etc?

MisterBill
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by MisterBill » Sun Jul 23, 2017 2:17 am

bsteiner wrote:
Gill wrote:I would at least ask the question why there was no step up in basis of her one-half interest in the property.
Gill
In for a penny in for a pound. I would ask the lawyer both questions (the basis step-up, and how the estate was able to pass the capital gain through).

It's possible there was no basis step-up (if she had signed a contract to sell the property before she died). It's possible that there was a basis step-up and still a large gain. If the sale was in the estate's final taxable year, then the capital gain would pass through.
I'll try to do that on Monday. The property sale was not in progress before she passed away. In fact, she was at least partially living off the rental income. Her husband had bought this with a friend/business partner many years ago. I believe it was owned by a partnership, which was dissolved after the property was sold. Is it possible that arrangement made it impossible to do the normal step up in basis? I'm personally wondering why there wasn't more expense tracked over the years to reduce the capital gain amount.

bsteiner
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by bsteiner » Sun Jul 23, 2017 8:56 am

MisterBill wrote:... The property sale was not in progress before she passed away. In fact, she was at least partially living off the rental income. Her husband had bought this with a friend/business partner many years ago. I believe it was owned by a partnership, which was dissolved after the property was sold. Is it possible that arrangement made it impossible to do the normal step up in basis? ....
That explains it. When a partner dies, the deceased partner's estate and beneficiaries get a basis step-up for her partnership interest. However, unless the partnership makes a Section 754 election (named after the Code section permitting this election), the partnership's basis in its assets doesn't change.

If the partnership makes this election, then the partnership gets a stepped-up basis in its assets with respect to the deceased partner.

The partnership makes the election on its tax return for the year of death. Once the partnership makes this election, it remains in effect for subsequent deaths or sales of partnership interests. The IRS will automatically grant a 1-year extension of time to make this election. After that, the partnership has to apply to the IRS for a ruling granting permission to make the election. The IRS is generally liberal in granting such rulings. I've obtained such rulings several times.

In this case, since the partnership was wound up several years later, the deceased partner's estate or beneficiaries would have a capital loss on the dissolution of the partnership (since they would get a stepped-up basis for the partnership interest, and their gain on the sale of the property would further increase their basis in the partnership interest). However, it might still be worth applying for a ruling since that would provide additional depreciation deductions during the period between the date of death and the sale of the property.

I haven't considered whether the dissolution of the partnership would affect the ability to obtain a ruling. Before filing a ruling request, the lawyer may want to ask the IRS whether they would rule on this in a case where the partnership has been dissolved.
Last edited by bsteiner on Sun Jul 23, 2017 12:25 pm, edited 1 time in total.

cas
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by cas » Sun Jul 23, 2017 9:06 am

MisterBill wrote: My wife retired earlier this year (and didn't make much anyway) so she'll be the 10% tax bracket if she files separately(which if I read things correctly does not have to pay capital gains, but maybe that doesn't apply to K-1 gains).
gill and bsteiner are the experts on that big capital gain seeming odd, so I'll leave that to them.

But, getting to the question you asked, from the way you phrased things, I think you might have a common misunderstanding about how LTCG are taxed. Threads on this common misunderstanding arise every few weeks, it seems, and there is a rather grouchy one going on right now: viewtopic.php?f=1&t=223864&newpost=3461008 ("Please explain capital gains after retirement").

The post on that one that seemed to cause the light to go on for the OP on that thread is this one by c1over8:
Google "how do capital gains affect your tax rate" and you'll find many explanations. The second result has a good explanation:
If my ordinary income puts me in the 15% tax bracket, can I receive an unlimited amount of long-term capital gain at the 0% rate?

No, the 0% rate applies only to the amount of long-term capital gain and qualified dividend income needed to “fill up” the 15% tax bracket. For example, if your ordinary income is $4,000 below the figure that would put you in the 25% bracket and you have a $10,000 long-term capital gain, you’ll pay 0% on $4,000 of your capital gain and 15% on the rest.

http://fairmark.com/general-taxation/your-tax-bracket/
Beyond that, I am far from an expert, but I think you are also going to run into a lot of new tax topics with a LTCG that is as big as yours is. Among them:

1. Net Investment Income Tax (NIIT) - the Form 8960 thing you have already noticed.

2. Alternative Minimum Tax (AMT) - AMT has so many interactions that I never can predict exactly what it will do, but I'm pretty sure that big LTCG is going to cause your AMT exemption to phase-out all the way to $0. Plus AMT allows a lot fewer deductions and exemptions than the standard tax code. The net effect, I think, is going to be that you will likely have to pay AMT and your ordinary income is going to be taxed at 26% starting just a few thousand dollars in and the usual 10%, 15%, 25% brackets will be irrelevant to your ordinary income. (But, confusingly, the usual 10%, 15%, 25% brackets will continue to be relevant for determining the 0%/15%/20% tax rate on your LTCG.)

I'm sure all that was as clear as mud. Maybe try one of these articles for more info:
"AMT and Long-Term Capital Gains" http://fairmark.com/general-taxation/al ... ital-gain/

"Is the AMT costing me more in capital gains taxes" http://ibd.morningstar.com/article/arti ... ,%20brf295

If I understood, you haven't added any ordinary income to your test Turbotax return. Start adding some ordinary income to the return, and I think you're going to start seeing some unwelcome interaction of the AMT, big LTCG, and ordinary income.

3. Possibly Income Related Medicare Adjustment Amount (IRMAA): You said your wife is retired and you are retiring soon. Will either you or your wife be on Medicare in 2019? If so, I recommend reading up on IRMAA. Medicare Part B and D premiums go up with high income. IRMAA won't show up on your tax return, but it can be thousands of $ and your 2019 IRMAA is is linked to the (modified) adjusted gross income on your 2017 tax return.
"Medicare Premiums: Rules For Higher-Income Beneficiaries" https://www.ssa.gov/pubs/EN-05-10536.pdf

How does all the above affect your question on MFJ vs MFS, especially when you throw state (and local?) income taxes into the mix? I have absolutely no idea. Best bet is to do test Turbotax returns like you are doing (although that won't alert you to the IRMAA implications.).

MisterBill
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by MisterBill » Sun Jul 23, 2017 10:14 am

cas wrote:
MisterBill wrote: But, getting to the question you asked, from the way you phrased things, I think you might have a common misunderstanding about how LTCG are taxed. Threads on this common misunderstanding arise every few weeks, it seems, and there is a rather grouchy one going on right now: viewtopic.php?f=1&t=223864&newpost=3461008 ("Please explain capital gains after retirement").


3. Possibly Income Related Medicare Adjustment Amount (IRMAA): You said your wife is retired and you are retiring soon. Will either you or your wife be on Medicare in 2019? If so, I recommend reading up on IRMAA. Medicare Part B and D premiums go up with high income. IRMAA won't show up on your tax return, but it can be thousands of $ and your 2019 IRMAA is is linked to the (modified) adjusted gross income on your 2017 tax return.
"Medicare Premiums: Rules For Higher-Income Beneficiaries" https://www.ssa.gov/pubs/EN-05-10536.pdf

How does all the above affect your question on MFJ vs MFS, especially when you throw state (and local?) income taxes into the mix? I have absolutely no idea. Best bet is to do test Turbotax returns like you are doing (although that won't alert you to the IRMAA implications.).
Thanks for the detailed response. Only good news so far is that we won't be eligible for Medicare until 2020.

And yes, i got confused by a table I found online showing that with income less than some amount, LTCG are not taxed. Clearly I am not the only one.

At least I have $200k in a CD (maturing in Marc) specifically earmarked for taxes, so the hit won't be THAT painful. But i will have to find money to pay the estimated tax this year, which I hadn't considered and obviously should have (plus if I'd just put it in index funds, I would have made more by now tan the 1.4% I'm getting on the CD, but I didn't want to take that chance at the time).

pshonore
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by pshonore » Sun Jul 23, 2017 11:29 am

If this real estate was owned by a partnership (since dissolved after death) did anyone receive a K1 from the partnership, and what was passed through? Or was the only K1 from the estate?

tibbitts
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by tibbitts » Sun Jul 23, 2017 11:41 am

I'm very impressed by the sophistication of replies in this thread, but more impressed by the need to keep finances simple so as to not pass on a mess.

Gill
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by Gill » Sun Jul 23, 2017 11:46 am

pshonore wrote:If this real estate was owned by a partnership (since dissolved after death) did anyone receive a K1 from the partnership, and what was passed through? Or was the only K1 from the estate?
The partnership K-1 would have gone to the estate.
Gill

pshonore
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by pshonore » Sun Jul 23, 2017 11:52 am

Gill wrote:
pshonore wrote:If this real estate was owned by a partnership (since dissolved after death) did anyone receive a K1 from the partnership, and what was passed through? Or was the only K1 from the estate?
The partnership K-1 would have gone to the estate.
Gill
So thats where the cap gains showed up and were subseqently passed on via K1 to the OP from the 1041?

bsteiner
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by bsteiner » Sun Jul 23, 2017 12:29 pm

Gill wrote:... The partnership K-1 would have gone to the estate.
pshonore wrote:... So thats where the cap gains showed up and were subsequently passed on via K1 to the OP from the 1041?
Yes, assuming that the capital gain was in the estate's final taxable year.

However, if the partnership didn't make a Section 754 election (and doesn't want to apply for a ruling for an extension of time to make the election), the estate will have a capital loss on its partnership interest corresponding to the pre-death appreciation. (If the partnership is able to make the election, the estate will have less of a gain from the partnership.)

MisterBill
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by MisterBill » Sun Jul 23, 2017 11:57 pm

bsteiner wrote:However, if the partnership didn't make a Section 754 election (and doesn't want to apply for a ruling for an extension of time to make the election), the estate will have a capital loss on its partnership interest corresponding to the pre-death appreciation. (If the partnership is able to make the election, the estate will have less of a gain from the partnership.)
Can you explain the part about the estate's capital loss? Shouldn't that have been passed onto me as well? or is it possible that it was factored into what was reported to me as a LTCG?

BTW what sort of costs are involved in requesting a ruling for the section 754 election extension? I see from your earlier post that they are generally liberal in granting them.

pshonore
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by pshonore » Mon Jul 24, 2017 8:34 am

The final K1 produced by the Real Estate partnership should have a lot of information in conjunction with final 1041 Estate return. Deciphering that will not be easy unless you are familiar with partnership taxation.

bsteiner
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Re: Any way to avoid capital gains tax (from K-1) using married filing separately?

Post by bsteiner » Mon Jul 24, 2017 9:59 am

MisterBill wrote:
bsteiner wrote:However, if the partnership didn't make a Section 754 election (and doesn't want to apply for a ruling for an extension of time to make the election), the estate will have a capital loss on its partnership interest corresponding to the pre-death appreciation. (If the partnership is able to make the election, the estate will have less of a gain from the partnership.)
Can you explain the part about the estate's capital loss? Shouldn't that have been passed onto me as well? or is it possible that it was factored into what was reported to me as a LTCG?

BTW what sort of costs are involved in requesting a ruling for the section 754 election extension? I see from your earlier post that they are generally liberal in granting them.
You should be able to tell from the numbers whether they've netted the loss on the dissolution of the partnership against the gain from the sale of the property (or, alternatively, made the Section 754 election).

For example, suppose (for simplicity, ignoring depreciation deductions, depreciation recapture, income, distributions, and valuation discounts) the decedent was a 50% partner, and that the partnership bought the property for $2 million ($1 million for the decedent's share), it was worth $10 million when the decedent died ($5 million for the decedent's share), and it was sold for $12 million (($6 million for the decedent's share). You should have a net gain of $1 million.

The estate would get a $5 million basis for the partnership interest at death. If the partnership made a Section 754 election, the partnership's basis in the property would be $5 million for the decedent's share and $1 million for the other partner's share. The partnership would have a $6 million gain on the sale, allocable $1 million to the estate and $5 million to the other partner. The estate's $1 million share of the gain would increase its basis in its partnership interest to $6 million, so it would have no gain or loss on the disposition of its partnership interest.

If the partnership didn't make the Section 754 election, the partnership's basis in the property would remain $2 million. The partnership would have a $10 million gain on the sale, allocable $5 million to the estate and $5 million to the other partner. The estate's $5 million share of the gain would increase its basis in its partnership interest to $10 million, so it would have a $4 million loss on this disposition of its partnership interest. The estate's net capital gain would be $1 million ($5 million gain from the partnership's sale of the property, and $4 million loss from the disposition of its partnership interest). Of course, if the partnership didn't liquidate until the year after the sale, the estate would have a $5 million gain in one year and a $4 million loss in the following year.

The benefit of the Section 754 election is that there would be additional depreciation between the date of death and the sale of the property. The depreciation would be an ordinary deduction, whereas the corresponding gain would likely be capital gain. The benefit would be greater if the partnership retained the property instead of selling it.

The IRS user fee for a ruling would be $10,000 ($7,600 if the partnership's gross income is under $1 million, or $2,400 if the partnership's gross income is under $250,000). There would also be a fair amount of legal work, depending on the time needed to gather the facts, deal with the client, and respond to any questions from the IRS. The accountant would probably have to fall on his/her sword and sign an affidavit basically saying that the election fell between the cracks or that he/she didn't realize it had to be made. A general partner would probably also have to sign an affidavit saying that he/she relied on the accountant, and saying how the failure came to light.

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