TaxTalk tips: repair vs. maintenance, "tax-free" distributions and more.

A common occurrence among partnerships that own appreciated property is refinancing the property, then distributing the proceeds to the partners.

The question that occasionally has been posted on TaxTalk is whether or not anything special has to be done with the interest on the increased indebtedness.

The answer is, yes. The interest attributable to the money from the refinancing that was distributed to the partners has to be stated separately on the K-1s. It is not an operating expense to be reflected in the amount shown as net rental income on line 2 of Form 1065-K-1.

Nor is it to be entered on line 9 of the Form 8825, Rental Real Estate Income and Expenses of a Partnership or S-Corporation, that feeds into the K-1.

The proper disclosure is: "Interest attributable to a debt financed distribution." The partners will determine the deductibility of their individual portions and that will be a function of how they used the money. (Notice 89-35, 1989-1, CB 675. See Part V.A., "General Allocation Rule.")

Just in Time

The widow of a Vietnam veteran came to a member's office many years ago with a form letter from the Department of Defense she found among her late husband's papers. The letter told him that because he was in a combat zone, a certain amount of his W-2 could be excluded.

She appeared at the member's office the day before the statute of limitations was to expire. He had never seen the woman before, and neither of them had copies of the returns involved.

Our hero prepared a Form 1040X, showing the exclusion on line 1, col. B, and with all other lines labeled "unknown."

He attached an explanation, and a copy of the form from the Department of Defense, had the widow sign the 1040X, and submitted it.

He figured the worst that could happen would be a denial. But the refund check arrived a few months later.

A 'Roof Job' on a Rental Property

In common parlance, the term "roof job" means that the work consists of stripping off the old roof material and replacing it with new material. There may be some peripheral replacement of boards where appropriate.

The IRS position always has been that this is not a repair, but must be capitalized and depreciated.

The tide is starting to turn against the IRS because it has lost two Tax Court cases on this question--Northern v. Comm., TCS 2003-113, in which a $98,616 roof replacement was held to be a repair; and Campbell v. Comm., TCS2002-117.

Although these are summary decisions and can't be cited as precedent, they indicate how the Tax Court is thinking in the matter, and the cases that the judges cited in their decisions are precedential.

The reasoning, which seems obvious to almost all people who own rental property, is that a roof repair is simply normal maintenance--to restore the building to its state when originally acquired. It does not extend the building's useful life or increase its value.

However, if not repaired, the value of the building will decline dramatically due to leakage and the resulting dry rot.

This reasoning does not apply when the roof repair is part of the selling process, in which case it would be a sales expense.

As of presstime, the IRS has neither acquiesced in these decisions nor indicated that it will change its position. It's anyone's guess as to whether it'll just let the matter die or keep taking on taxpayers one at a time.

Partnerships With "Tax-Free" Distributions

Several TaxTalk participants have noted that people selling interests in gas pipeline or oil and gas drilling partnerships are telling prospects that they will receive "tax-free" distributions. Whether or not the salespeople intend it, prospects are interpreting this as a tax benefit unique to those investments.

However, there are no tax-free distributions that are unique to those partnerships. The tax-free distributions usually are a return of capital which, as we know, simply is the investor's own money being returned.

This is an old sales pitch going back at least to the 1970s, when limited partnerships were being sold as "tax shelters," but with little regard to their real worth as investments. In too many cases, the promoters got rich as the investors lost their funds.

In one instance, the promoters of a building project told investors they would get a 6 percent return on their money while the project was being built.

The obvious question was what was the source of the 6 percent return?

Well, in the disclosure documents, which showed where the investors' money was going, there was a line item that read: "Reserve for investor distributions" which, by some strange coincidence, was 6 percent of what the investors had invested.

So, once again, the investors were getting their money back with a smile, while the promoters bragged about their genius in investing those funds.

Thanks to the following TaxTalk participants for their contributions to these discussions: Don Yamagishi, JD, and CPAs Jim Bonk, Steve Kramer, Ed Melia, Elaine Raitt, David M. Reff and Ed Zollars.

By Leonard W. Williams, CPA 

Leonard W. Williams, CPA is a Sunnyvale-based sole practitioner. A member of CalCPA's Committee on Taxation, the AICPA Tax Division and a former Peninsula Chapter president, you can reach him at [e-mail].

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