FINANCE AND ACCOUNTING - Case Study Example

FINANCE AND ACCOUNTING (Your (Year) Memorandum The Managing Partner Tax consultant Date: 29th October 2011 Subject: capital gains tax on inherited property Facts; Wilma inherited a house from her Uncle John who passed away recently. Bob had taken a reverse mortgage on the house indicating that he was paid money each month until his death and the amount paid to him plus interest accrued formed the total balance on the mortgage upon his death which amounted to $210,000. The mortgage can only be enforced on Bob’s house and not any other asset and the beneficiaries of Bob including Wilma cannot be held liable for the debt.

The fair market value of the house upon Bob’s death was $90,000 Issues; To establish the tax basis of the inherited property To establish the effect of taxation on her three options and to calculate the amount of taxable capital gains in each of the three options namely; 1. Walking away and letting the bank foreclose the house. 2. To offer to settle the loan with the bank in cash at the home’s fair market value of $90,000 and then staying in the home herself. 3. To sell the house to her neighbors at the cost of $90,000, incur 7% realtor fees and closing costs, pay the bank a negotiated amount totaling to $80,000 therefore remaining with $3,700.

Analysis; Based on the Internal Revenue Services’ (2011), if an individual sells an inherited property for more than its fair market value, then he/she is liable for capital gains tax because the property will result to a capital gain (IRS, 2011). The tax basis of inherited property may be determined using the fair market value or the executor’s valuation however the executor’s valuation cannot exceed the fair value of the inherited property at the time of death (CCH Tax Law Editors, 2011).

Therefore for purposes of this analysis, the tax basis of the home will be the fair value at the time of Bob’s death which is $90,000 (IRS, 2011). Based on Cranes vs. Commissioner Case, the court decided that in case the mortgage holder receives payments on a mortgage, he is personally liable for the debt thereof and the debt cannot be passed on to his/her descendants incase of death (Bittker, 1978). This indicates that the payments made to Bob are his personal liability as debts towards the mortgage and as such cannot be passed on to Wilma as a descendant who inherited the property.

This supports the IRS, 2011 tax basis on inherited property which is equal to the fair market value of the home. This indicates the difference between the amount received on the mortgage of $210,000 and the fair market value of $90,000 is treated as tax deductible depreciation. Based on the Commissioner vs. Tufts, 461 U.S. 300 (1983) Case, the court decided that the amount of taxable income on mortgaged property includes the amount received as mortgage debt and the fair market value of the property therefore the basis of Bob’s home for tax purposes would be the difference between the amount received and the fair market value which is equal to $210,000 - $90,000 (FindLaw, 2011).

However this can only apply on Bob as an individual and cannot be passed to the descendants in case of death indicating that the tax basis for Wilma is the fair market value of the home which is $90,000 (Justia US Supreme Court Center, 2011). Section 1001(a) of the Internal Revenue Code states that, the gain or loss from sale or other disposal of property is the difference between the amount realized on the disposal of such property and the property’s adjusted basis for tax purposes. This indicates that the amount received by Wilma from Bob as inheritance is equal to $90,000, the amount realized on disposal will depend on the option taken (IRS, 2011b).

Option 1; if she walks away and lets the bank foreclose the house, the capital gain from such foreclosure will be equal to $90,000 - $90,000 which is equal to zero because she received a value of $90,000 from her uncle as inheritance and she cannot be held liable for her uncle’s debt indicating that the bank can only foreclose the house at its fair market value and the capital gain will be on Bob who is already dead (IRS, 2011). In this option she will not lose any monetary value on capital gains tax on the house but she will lose the house (Yin, 2002) Option 2; if she offers to settle the loan for the fair market value of $90,000 and stay in the house, the loan will be cancelled and she will own the house.

The capital gains arising from the house will only occur if she later disposes the house. In this option, she will not lose any monetary value on capital gains tax and she will retain the house and incur $90,000 in cost of purchasing the house (IRS, 2011) Option 3; if she sells the house to the neighbors, she will receive an amount of $90,000, settle the mortgage for $80,000 and after paying realtor fees and closing costs she will remain with $3,700 which will be treated as capital gains for tax purpose?

In this option she will have a taxable capital gain of $3,700 and she will lose the house but will not incur the cost of buying the house (Yin, 2002). Conclusion Wilma will not be liable for her uncle’s debts, therefore the capital gains tax will apply on the difference between the fair value of the house and the proceeds received from the sale of the house if she decides to sell it. Based on the analysis above, option 3 is the best option for her since she will not incur the cost of purchasing the house; she will be liable for capital tax on the $3,700 and will lose the house.

References Bittker, B, L. (1978). Tax Shelters, Nonrecourse Debt and the Crane case. Faculty Scholarship Series. Paper 2294. Retrieved on 29th October 2011 from http://digitalcommons.law.yale.edu/cgi/viewcontent.cgi?article=3402&context=fss_papers&sei-redir=1&referer=http%3A%2F%2Fwww.google.co.ke%2Furl%3Fsa%3Dt%26rct%3Dj%26q%3Dcrane%252Bcase%26source%3Dweb%26cd%3D7%26ved%3D0CGQQFjAG%26url%3Dhttp%253A%252F%252Fdigitalcommons.law.yale.edu%252Fcgi%252Fviewcontent.cgi%253Farticle%253D3402%2526context%253Dfss_papers%26ei%3DSfSrTrz-Lozusga3rcn5Dw%26usg%3DAFQjCNFD_1toZKIQ26ecF9lyjZmqz9L_wA#search=%22crane%2Bcase%22 CCH Tax Law Editors. (2011). U.S. Master Estate and Gift Tax guide 2011.

New York: CCH Inc FindLaw. (2011). U.S. Supreme Court: Commissioner v. Tufts, 461 U.S. 300 (1983) 461 U.S. 300 Commissioner of internal revenue v. Tufts et al. Certiorari to the United States Court of Appeals for the fifth circuit. Retrieved on 29th October 2011 from http://caselaw.lp.findlaw.com/cgi-bin/getcase.pl?court=us&vol=461&invol=300 IRS. (2011). Gifts and inheritance. Retrieved on 29th October 2011 from http://www.irs.gov/faqs/faq/0,,id=199749,00.html IRS. (2011b). Topic 703: Basis of Assets.

Retrieved on 29th October 2011 from http://www.irs.gov/taxtopics/tc703.html Justia US Supreme Court Center. (2011). Commissioner v. Tufts, 461 U.S. 300 (1983). Retrieved on 29th October 2011 from http://supreme.justia.com/us/461/300/ Yin, G, K. (2002). The story of Crane: How a Widow’s misfortune led to tax shelters. In Caron, Paul L. Tax stories: An in-depth look at ten leading federal income tax cases. New York: Foundation press.