TROUBLE BREWING; ESTATE TAX IN MD, DC AND VA

By: Jennifer Concino of Tobin, O'Connor, Ewing & Richard

With the average cost of a house rapidly rising in the DC Metropolitan area, it is especially important that homeowners recognize the need for tax and estate planning. Each and every homeowner should make sure that he has planned for his certain and eventual demise. For example, the estate of a resident of the District of Columbia with equity in a house of $1,500,000 could pay $64,400 in estate taxes to the District. Proper estate planning could help the homeowner defer, reduce or even potentially eliminate the tax.

The Federal Situation:
As you may already be aware, in 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) which, among other things, increased the federal estate tax applicable exclusion amount as follows:

Year -- APPLICABLE EXCLUSION AMOUNT
2006-2008 -- $2,000,000
2009 -- $3,500,000

EGTRRA eliminated the federal estate tax for individuals dying on or after January 1, 2010. However, unless between now and then, Congress and the President extend the law beyond December 31, 2010, or provide alternative tax relief, the estate tax as is existed in 2001, i.e. only a $1,000,000 applicable exclusion amount per person, will be reinstated on January 1, 2011, including a marginal rate of 55 percent.

Many of the documents drafted for our clients in the past include the establishment of a "by-pass trust" the funding of which is determined by a formula providing that the largest amount that can pass free of federal estate tax (the applicable exclusion amount) will fund such by-pass trust. By "forcing" the funding of a by-pass trust, each spouse is assured of utilizing his or her applicable exclusion amount thereby enabling each family to pass the largest amount possible of their estate to the next generation free of estate tax.

The States React:
Many states, facing deficits and losses in revenue as a result of EGTRRA, have taken action to prevent a similar increase in their exemption amounts for state death tax purposes. As such, the issue of "decoupling" has arisen. For example, even though the federal applicable exclusion amount is $2,000,000 this year, the State of Maryland and the District of Columbia have capped their exclusion amounts at $1,000,000.

Virginia has repealed its estate tax for individuals dying on or after July 1, 2007. Since many clients' estate planning documents include the forced by-pass trust formula, $2,000,000 (the federal applicable exclusion amount) would pass to the by-pass trust upon the death of the first spouse. This would result in no federal estate tax at the time of the first spouse's death, however, there would be a tax on the excess $1,000,000 in Maryland and the District of Columbia. The amount of that state death tax is pretty hefty; in 2007, the tax may be almost $85,000. For a death which occurs in 2009, where the federal applicable exclusion amount of $3,500,000 would pass to the by-pass trust (and Maryland and the District of Columbia continued to cap their exclusion amounts at $1,000,000) the state estate tax could be over a whopping $225,000! Maryland has, however, capped its estate tax to 16 percent of amounts over the $1,000,000 exclusion amount.

Our Response:
The current differences between the federal and state death taxes, as well as the differences among the local jurisdictions, require a case-by-case analysis for each client. For example, in some instances, it will be preferable to pay the state death tax assessed at the time of the first spouse's death by fully funding the by-pass trust with the federal applicable exclusion amount. Although this will accelerate the payment of state death taxes, the excess amount funded into the by-pass trust (i.e., $1,000,000 in 2007), including all appreciation thereon, will then be excluded from the surviving spouse's estate, thereby potentially sheltering significant wealth and saving federal tax at the top marginal estate tax rate which is 46 percent in 2007.

However, many clients may prefer to avoid the payment of state estate taxes upon the death of the first spouse and in such cases, it may be necessary to prepare new wills/revocable trusts. These new documents can provide that the by-pass trust will be funded with the lesser of the federal or state exclusion amounts. Another option provides that the entire estate would pass to the surviving spouse, subject, however, to the surviving spouse having a power to "disclaim" a portion of the bequest into the by-pass trust. This option would allow maximum flexibility on a post-mortem basis to the ever evolving estate tax landscape. Alternatively, the entire estate of the first spouse to die may be paid over to a marital trust for the benefit of the surviving spouse. In such case, the personal representative may determine after the death of the first spouse not to elect "marital deduction" treatment for any portion of the marital trust (the state estate tax exclusion amount or the federal estate tax exclusion amount).

Make an Appointment:
We recommend that each of our clients have their existing estate planning documents reviewed as soon as possible. Please contact us (202-362-5900) to arrange a time to discuss your documents and what changes, if any, are appropriate for your needs.

FIRPTA - How to protect your buyer

By: Joseph Gentile

What is FIRPTA?
The Foreign Investment in Real Property Tax Act (FIRPTA), 26 U.S.C. § 1445, provides that a buyer must withhold 10 percent of the amount realized by the foreign seller in the sale of an interest in U.S. real property. If the seller is a foreign person and the buyer fails to withhold, the buyer may be held liable for the tax.

My seller is a resident alien, does that mean FIRPTA applies?
A resident alien, for purposes of FIRPTA, is not a foreign person. FIRPTA defines a foreign seller as a non-resident alien individual, a foreign corporation not treated as a domestic corporation, or a foreign partnership, trust or estate. There are two ways to determine if a person qualifies as a resident alien under FIRPTA: 1) if a person has been issued an alien registration card ("green card") or 2) the substantial presence test that requires a person be physically present in the United States for a certain number of days a year. 183 days (pursuant to IRS Code).

My seller does not have a green card. What qualifies under the substantial presence test?
The short answer is that if your seller was physically present in the United States for at least 183 days in the previous calendar year, he or she qualifies as a resident alien and is not subject to FIRPTA withholding. Even if the seller does not meet this requirement, he or she might still be exempt from FIRPTA, by using the complicated formula found in IRS Code § 7701 that states that a seller qualifies as a resident alien if:

* the seller was present in the United States on at least 31 days during the calendar year, and
* (the number of days present in current year) + (the number of days present in preceding year x 1/3) + (the number of days present in 2nd preceding year x 1/6) equals or is greater than 183.

How do you determine the amount realized for FIRPTA?
The amount realized typically is the sales or contract price. Please note that the outstanding amount of any liability assumed by the buyer does not reduce the amount realized. If the property is owned jointly by foreign and non-foreign persons, the amount realized is to be allocated among the owner based on capital contributions, with spouses treated as having contributed 50% each. Generally, the amount to withhold is 10% of the amount realized, unless the seller is a corporation, partnership, trust, or estate in which case the amount may be 35%.

I am buying a house from a foreign person as defined by FIRPTA, what do I need to do now?
The buyer must use IRS Forms 8288 (www.irs.gov/pub/irs-pdf/f8288.pdf) and 8288-A (www.irs.gov/pub/irs-pdf/f8288a.pdf) to report and pay to the IRS any tax withheld on the purchase of U.S. real property interests. Generally, these forms need to filed with the IRS within 20 days of the date of transfer, defined as the date consideration is first paid, excluding earnest money or deposits. Failure of the buyer to withhold the proper amount may cause the buyer to be liable for the payment of the tax plus penalties and interest as well as possibly making the buyer subject to criminal penalties.

Even though the seller is a foreign national, are there any exceptions to the withholding?
Several exceptions do apply and exempt the buyer from withholding. Here is a partial list of the most common exceptions in a real property transfer:

* The property is purchased for $300,000.00 or less and is to be used by the buyer as his or her residence. The test for a residence is if the buyer is to reside in the property for at least 50% of the days in the next two 12 month periods.
* The seller provides to the buyer a Non-Foreign Status Certification containing the transferor's U.S. taxpayer identification number and stating that the transferor is not a foreign person. The buyer need not investigate the validity of the certification, but will be held liable if he or she has actual knowledge that it is false.
* The seller provides to the buyer a withholding certificate from the IRS that excuses or lowers the withholding amount.
* No consideration is paid (for example the property was transferred as a gift).
* An option to acquire real property is signed (however, withholding is required on the sale when the option is exercised).
* The purchaser is the United States, a U.S. state or possession or political subdivision, or the District of Columbia.
* The seller provides a notice signed under penalties of perjury stating that the seller is not required to recognize gain or loss on the transfer because of a nonrecognition provision of the Internal Revenue Code or a provision in a U.S. tax treaty.

Where can I get more information on FIRPTA?
We would be glad to answer any questions that you might have on FIRPTA, but additional information, applicable forms, the withholding certificate application process, and more, can be found at www.irs.gov.

Settlement proceeds may be subject to income tax withholding

Maryland Nonresident Sellers Beware:
Your Settlement Proceeds are Subject to
Income Tax Withholding

By: Jennifer Concino

A nonresident individual seller of Maryland real property may be surprised to learn that the check he walks away with from the closing table will be much less than anticipated; about six (6%) percent less than expected to be exact.

Surprisingly, many agents do not realize that their nonresident sellers may acquire a Certificate of Full or Partial Exemption from the tax, as discussed below. Indeed, we strongly advise agents to assist their nonresident sellers in applying for the Certificate of Exemption as soon as the contract of sale is executed; application for an exemption must be made to the Comptroller of Maryland no later than twenty-one (21) days before closing and with such a Certificate, the nonresident seller can walk away from settlement with all of his proceeds of sale.

In 2003, the Maryland Legislature passed an Act mandating the withholding of income tax on the sale of all real property by nonresident individuals and nonresident entities. Settlement officers are directed to ensure sufficient funds are withheld from the closing and are also required to pay the withheld tax to the recording office at the time the deed is submitted for recordation. The amount of tax currently required to be withheld is six (6%) percent of the "total payment" to a nonresident individual and 7% to a nonresident entity. Indeed, the Clerk of the Land Records office will not accept an instrument for recording unless the withheld tax is paid or the instrument refers to one of the exemptions from the withholding requirement.

Those exemptions are:

1. a certification under penalties of perjury or an acknowledgment in the deed that the seller is a resident of the State of Maryland;
2. a certification under penalties of perjury or an acknowledgment in the deed that the property sold is the seller's primary residence as determined under the Internal Revenue Code;
3. the property is transferred pursuant to foreclosure or a deed in lieu of foreclosure;
4. the property is transferred to the government;
5. a statement in the deed indicating that the consideration paid for the property is zero; and
6. a certificate issued by the Comptroller of Maryland stating that no tax or a reduced amount of tax is due on that particular sale or that the seller has provided adequate security to cover the tax liability.



With regard to exemption to number 6. (six), above, the Comptroller has noted several circumstances under which he will issue such a certificate. A sample of those circumstances are:

* The tax due has already been paid;
* The transfer is made on an installment sales basis under Section 453 of the Internal Revenue Code;
* The seller is a tax exempt entity under Section 501(a) of the Internal Revenue Code;
* The transfer is to a partnership in exchange for a partnership interest so that no gain or loss is recognized under Section 721 of the Internal Revenue Code;
* The transfer is a like-kind exchange under Section 1031 of the Internal Revenue Code; or
* The transfer is between spouses or incident to a divorce in accordance with Section 1041 of the Internal Revenue Code.

Frequently Asked Questions:

Is the amount of tax withheld calculated on the sales price or the net proceeds?
The "total payment" on which the Maryland income tax is withheld is equal to the total sales price for the property less (1) debts of the seller securing the property that are being satisfied at closing; and (2) expenses of the seller arising out of the sale of the property that are disclosed on the settlement statement. However, debts being satisfied at settlement that are secured within ninety (90) days of closing cannot be deducted from the "total payment" calculation.

How are taxes withheld where there are both resident and nonresident joint sellers?
The "total payment" will be divided into as many shares as there are sellers. Each seller's residency will then be separately determined and any share of a nonresident will be subject to withholding.

If income tax is withheld on the sale, does the nonresident seller still have to file a Maryland nonresident income tax return?
Yes.

If a nonresident seller believes too much money was withheld, can he request a refund before filing the nonresident income tax return for that year?
The seller may file an Application for Tentative Refund of Withholding on Sales of Real Property by Nonresidents with the Comptroller sixty (60) days or more after the tax was paid.

Is tangible personal property sold with the property by a nonresident seller also subject to withholding?
Yes.

Have you considered incorporating your real estate business?

Have You Considered Incorporating
Your Real Estate Business

By Stephen J. O'Connor of Tobin O'Connor & Ewing

A corporation or limited liability company (LLC) can be formed quickly and efficiently by filing standardized documents with the appropriate jurisdiction. A corporation that, after being formed, elects to be taxed as a "pass-through" entity under Subchapter "S" of Chapter 1 of the Internal Revenue Code is known as an S corporation.

So, why should you consider forming an S corporation or LLC to operate your real estate business? There are two principal reasons.

1. First, each of these entities may protect you from personal liability for the debts and obligations of your real estate business. By contrast, a self-employed real estate agent (often called a "sole proprietor") can be liable for damages and injuries caused by the business, such as a "slip and fall" incident. The sole proprietor real estate agent also may be legally responsible for the professional errors/omissions or negligent acts of other agents or staff he or she employs or engages. No liability-shielding entity, however, can protect your personal assets from debts and obligations arising out of your own professional errors/omissions or negligent acts.

2. Second, your overall income taxes may be lowered by choosing an entity to operate your real estate business. An LLC or S corporation, for the most part, is not subject to income tax at the entity level. Owners avoid "double taxation" by paying income taxes on the profits of the LLC or S corporation on a flow-through basis like a sole proprietor. While an LLC with just one owner (or "member") is disregarded as a separate entity for tax purposes (and therefore treated as a sole proprietorship), an LLC with multiple members can allocate profits/losses in any way they choose. In an S corporation, shareholders must receive dividends in proportion to their shareholdings, regardless of the amount of time or effort they "invest" in the business. The biggest tax advantage enjoyed by S corporation shareholders is that they pay employment taxes (FICA and Medicare) only on money received by them as wages or salary, but not on profits or dividends (a savings of up to 12.4% compared to an LLC or sole proprietorship). LLC members typically pay employment taxes on the entire amount of LLC profits (regardless of whether or not the profits are distributed to the members).

There are several noteworthy distinctions between an LLC and an S corporation.

For instance, an LLC is not required to hold meetings or to keep formal minutes, while an S corporation may be required to do so. Owners of an S corporation are limited to a maximum of 100 stockholders and cannot include nonresident aliens or other entities, while members of an LLC have no such restrictions. Stockholders of an S corporation may deduct "pass-through" losses only to the extent of their actual investment in the company, while members of an LLC may deduct "pass-through" losses not only up to the amount of their actual investment in the company, but their proportionate share of the company's borrowings as well.

If you are considering the formation of an entity to operate your business, you will want to organize the entity in the jurisdiction (i.e., Maryland, Virginia or the District of Columbia) in which you operate your business (not necessarily where you reside). This may eliminate the need to file tax returns in multiple jurisdictions relating to the business.

Lastly, an LLC is the definite choice of entity to hold your rental real estate. Since rental income is not subject to employment tax, an S corporation is of no avail for this business purpose.

For more information on planning your business, forming an LLC or S Corporation, please contact Stephen J. O'Connor at Tobin O'Connor & Ewing, 202-362-5900.