A. EXCLUSION OF GAIN FROM SALE OF PRINCIPAL RESIDENCE

1. Rules under Prior Code Sections 121 and 1034.
   1. Qualification requirements under former Section 121: The taxpayer must have (1) reached age 55 before the date of sale; (2) owned and used the home as a principal residence for a total of three years during the five year period preceding the sale; and (3) timely elected this option (it is not mandatory). If the taxpayer meets the above qualifications, up to $125,000 of gain may be excluded from gross income.
      1. Limitations:
         1. Election may be made only once in your lifetime
         2. There is no carryover of the unused portion, if any
         3. Single individuals could exclude up to $125,000 each but married couples were restricted to a maximum of $125,000
         4. Individual could lose opportunity to use exclusion by marrying a tainted individual (i.e., someone who already exercised his/her exclusion).
      2. Qualification requirements under former Section 1034: Gain realized on the sale of a principal residence will not be taxed (i.e., will be postponed) if within two years before or after the sale of the old residence, another principal residence is purchased for an amount that equals or exceeds the adjusted sales price of the old residence.
      3. Limitations:
         1. Gain is postponed not eliminated (although many taxpayers eventually eliminate gain by making $125,000 exclusion election or rolling over the gain. Until death when the estate's beneficiaries receive a "stepped-up basis equal to the fair market value on the date of death)
         2. More expensive residence must be purchased within two years or taxpayer is hit with full tax.
         3. Rollover is available only once every two years.
         4. Retired taxpayers often choose to sell their principal residence and move into a retirement complex.
         5. Trap for unwary divorcee: Spouse who moves out of residence prior to final divorce and sale of property may not qualify for rollover treatment.
      4. Benefits:
         1. No ceiling on amount of unrealized taxable gain that may be rolled over.
2. Prior Sections 121 and 1034 repealed and replaced by new Section 121. New Section 121 provides for an elective exclusion from income of up to $250,000 for individuals and $500,000 for married individuals of gain realized on the sale or exchange of a principal residence.
   1. Requirements: The taxpayer must have owned (the ownership requirement) and occupied (the use requirement) the residence as a principal residence for an aggregate of at least two of the five years before the sale or exchange.
   2. Limitation: The exclusion applies to only one sale or exchange every two years, but pre-May 7, 1997 sales are not taken into account.
   3. Holding Periods: In determining the period of ownership and use, taxpayers may include periods of ownership and use of all prior residences with respect to which gain was rolled over to the current residence under Section 1034.
   4. Special Proration Exception. If a taxpayer does not meet the ownership and/or use requirements, a pro rata amount of the $250,000 or $500,000 exclusion applies if the sale or exchange is due to a change in place of employment, health or unforeseen circumstances. The meaning of "unforeseen circumstances" will presumably be determined by IRS regulations. [PLEASE NOTE: THE 1998 ACT EXTENDED THIS EXCEPTION TO ALL TAXPAYERS UNDER ANY CIRCUMSTANCES. MOREOVER THE PRORATION IS BASED ON A FRACTION OF THE MAXIMUM EXCLUSION AND NOT ON A FRACTION OF THE GAIN REALIZED.]
      1. Example: On September 1, 1997, Joe and Janette buy a home in New York for $350,000. Janette subsequently receives an attractive employment offer in Santa Clara and on July 1, 1998 Joe and Janette sell their house for an adjusted sales price of $398,000. Joe and Janette realize a capital gain of $48,000. Because they owned and resided in their New York home for 10 months, they may exclude $20,000 of the gain from income ($48,000 x 10 / 24 = $20,000). [PLEASE NOTE: THIS EXAMPLE NO LONGER APPLIES AND IS BASED ON THE LAW PRIOR TO CLARIFICATION AND MODIFICATION BY THE 1998 ACT].
   5. Exception for Certain Grandfathered Transactions. A special exception provides that the exclusion is still available even if the ownership and use requirements are not met. To qualify for this special exception, two requirements must be met: (1) the individual must have held the residence on the date of enactment (August 5, 1997), and (2) the sale or exchange must occur during the two-year period that began on the date of enactment (August 5, 1997).
   6. Favorable Husband-Wife Rules. Whereas prior rules disfavored marriage, the new rules are neutral or, in some cases, favor marriage. The amount of excludable gain is increased to $500,000 for married individuals if the following requirements are met: (i) H and W file a joint tax return for the year of the sale or exchange; (ii) either spouse meets the ownership requirement; (iii) both spouses meet the use requirement; and (iv) neither spouse is ineligible by virtue of a sale or exchange of a residence within the past two years.
      1. The exclusion is determined on an individual basis. If H and W do not share a principal residence but file a joint return, each spouse can exclude $250,000 of gain from the qualifying sale of his or her principal residence. If a single taxpayer (H) who is eligible for the exclusion marries someone who has used the exclusion within two years of the marriage, H is allowed a maximum exclusion of $250,000.
      2. Divorced Taxpayers. In a transfer of property between spouses incident to divorce under Section 1041(a), the period the transferee spouse owns (not uses) the property includes the period the transferor spouse owned (not used) the property. If one of the spouses is granted use of the property under a divorce or separation instrument (as defined in Code Section 71(b)(2)), the non-occupant spouse is treated as using the property during the period of use of the property by the occupant spouse.
         1. Example: H and W get married and buy their first home on September 1, 1997. Exactly one year later, H & W get into a bitter fight and H storms out demanding a divorce. W continues to live at the residence and H rents an apartment down the street. On December 1, 1998, the Family Court issues an order stating that W shall be permitted to reside in the residence until the divorce is finalized. The house, which was originally purchased for $300,000 is now worth $400,000. If H wants to sell the house, when can he do so and take advantage of the $250,000 exclusion? H meets the ownership requirement on September 1, 1999 and the use requirement on December 1, 1998.
      3. Widowed Taxpayers. A taxpayer's period of ownership of a residence includes the period during which the taxpayer's deceased spouse owned the residence.
   7. Incapacitated Taxpayers. If an individual becomes physically or mentally incapable of self-care, the individual is deemed to use a residence as a principal residence during the time in which the individual owns the residence and resides in a licensed care facility. In order for this rule to apply, the taxpayer must have owned and used the residence as a principal residence for an aggregate period of at least one year during the the five years preceding the sale or exchange.
   8. Gain is recognized to the extent of depreciation. The exclusion does not apply, and gain is recognized, to the extent of any depreciation allowable with respect to the rental or business use of a principal residence after May 6, 1997.
      1. Hypothetical: Joe owns a principal residence and a residential rental property in San Jose. He purchased the rental property for $200,000 in 1993 and the property is now worth $400,000. Joe has taken depreciation deductions of $50,000 prior to May 6, 1997 and $10,000 since then. Can Joe sell his residence (utilizing the exclusion rule on any gain), move into his rental property and sell it after 2 years as his principal residence? What would be the tax on the prior depreciation taken? How will the IRS know if Joe took any prior depreciation on the residence?
   9. Effective Date. New exclusion and repeal of one-time $125,000 exclusion and Section 1034 rollover is effective for sales and exchanges after May 6, 1997. Taxpayers may elect to apply prior law to sales or exchanges prior to August 5, 1997 or binding contracts entered into prior to August 5, 1997.
   10. Exception to Real Estate Transaction Reporting Requirements.
   11. Possible tax abuses vs. tax planning strategies.
       1. Hypothetical: Suppose real estate market has an average annual appreciation of 5%. Sam Schemer, a single individual, owns a house currently worth $300,000 with a basis of $60,000. Sam comes up with an idea to sell his house to his brother for fair market value and buy it back after six months. Is this acceptable? What if Sam needs to take a temporary job out of the area for this six month period? Does it make a difference if there is no pre-arranged agreement with his brother for Sam to buy the house back after 6 months? What if Sam sells the property to an unrelated party but the buyer gives Sam a purchase option, exercisable within 2 years, to repurchase the property for an amount that is 10% over the sales price?
       2. Hypothetical: Suppose Sam Schemer owns a property worth $1,000,000 with a basis of $250,000. Can he sell the property to his brother for $500,000 and subsequently repurchase it for $750,000, reside in it for two years and then sell it for full value to a third party?
   12. Record-keeping Burden. One stated purpose of the new rule is to cut down on the burdens of keeping home sale and home improvement records for years and years while taxpayers elect the Section 1034 rollover.

B. CAPITAL GAINS

1. Reduction of Net Long Term Capital Gain Rate (28% to 20%, or 15% to 10%, rates apply to both regular tax and alternative minimum tax)
   1. New rates not applicable on certain sales or exchanges
   2. Effective Date - sales after May 6, 1997
2. Changes in Holding Period Requirements
   1. 8 month requirement to receive reduced rate if sale takes place post July 28, 1997. [PLEASE NOTE: THE 1998 ACT ELIMINATED THE SEPARATE 18-MONTH HOLDING PERIOD TO QUALIFY FOR LONG-TERM CAPITAL GAIN TREATMENT. THE CHANGE IS RETROACTIVE TO SALES OCCURRING ON OR AFTER JANUARY 1, 1998]
      1. If asset held 12 months or less, short term capital gain and taxed as ordinary income
      2. If asset held more than 18 months, the capital gain is treated as long term capital gain and taxed at the new maximum rates of either 20% or 10%
      3. If asset held more than 12 months but not more than 18 months, the gain is taxed at the former maximum long term capital gain rate (28% or 15%)
3. Exception for Assets Sold Between May 6, 1997 and July 29, 1997
   1. Will receive new capital gain rates if holding period exceeds 12 months
      1. Hypothetical #1 - On May 8, 1997 Bill sold 100 shares of ABC stock for $10,000. Bill had purchased the shares on January 6, 1996, for $4,000. Assuming Bill is in the 28% tax bracket, at what rate will the gain on his shares be taxed? What if he was in the 15% marginal bracket?
      2. Hypothetical #2 - Assume the same facts as in Hypo #1, except that Bill sold the shares on May 6, 1997. At what rate will the gain be taxed?
      3. Hypothetical #3 - On August 1, 1997, Betty, who is in a 39.6% marginal tax bracket, sold 1,000 shares of stock and recognized a net capital gain of $10,000. She had held the stock for 15 months. Does the maximum capital gain rate apply? If not, what capital gain rate will she use?
4. Rate Drops Further for Tax Years Beginning after December 31, 2000 for Assets Held More Than Five Years (rates reduced to 18% and 8%, rather than 20% and 10%)
   1. Requirements for reduced rates rates (post 12/31/00 purchases)
   2. Election to start new holding period (starts holding period on 12/31/00)
      1. Must recognize gain, losses disallowed
   3. Old holding period "tacks" if in lower bracket
      1. could come in handy for children over 14 years old
5. Depreciable Real Estate
   1. Long Term Capital Gain from the sale or exchange of depreciable real property that would be treated as ordinary income is taxed at a maximum rate of 25% for recapture amount
   2. Remaining LTCG taxed at 20%
   3. Expand on differences between Sections 1245 and 1250 under old law
6. Complication of Reporting Requirements for Pass Through Entities

C. SMALL BUSINESS STOCK (IRC Sections 1202 & 1223)

1. Holding Period in Excess of 5 Years, then 50% of Gain Excluded
2. Remaining Gain @ 28% Rate
3. New Tax Preference is 42% of Excluded gain Rather Than 50% Under Old Law
4. Possible Rollover of Gain From Sale of Qualified Stock
   1. Election available to roll over gain from qualified small business stock held for more than six months if you purchase other small business stock within a 60 day period beginning on the date of the sale.
5. Define "qualified small business".
   1. Hypothetical - Bill invests $500,000 in Z Corporation on October 5, 1997. ABC is a qualified small business. On September 1, 1998, Bill sells his Z stock for $750,000. On September 25, 1998, he purchases stock in newly formed T Corporation for $700,000. T is also a qualified small business. How much gain does Bill currently recognize? What is his basis in the shares of T Corporation? What is his holding period for the T Corporation shares?

D. SECTION 1031 TAX-FREE EXCHANGES

1. Provisions to change definition of "like kind" qualifying property to a much more restrictive "similar or related in service or use" test failed.
2. Rules regarding the 45 day identification period and the 180 day replacement period remain unchanged.
3. The only real change to Section 1031 occurred in the area of personal property. The new law eliminates exchanges between U.S. and non-U.S. personal property.

E. CHANGES IN ALTERNATIVE MINIMUM TAX (AMT) (IRC Sections 55(e) & 56(a)(1))

1. Repeal of Separate Depreciation Lives for Minimum Tax Purposes For Assets Placed in Service After December 31, 1998.
   1. Review of old law vs. new law
2. Corporations - AMT Repealed for Small Corporations
   1. Small Corporation Defined
      1. Average Gross Receipts of $5,000,000 or less for the three tax years, or period of existence if less, that ended with its first tax year (most recent) beginning after December 31, 1996.
      2. Example #1 - B Inc. had average gross receipts of $4,750,000 for the three year period that includes 1995, 1996, and 1997 tax years. For AMT purposes B is considered a small corporation for its 1998 tax year.
   2. Small Corporation status continues for AMT purposes as long as average gross receipts for the prior three years are less than $7,500,000.
   3. Loss of "Small Corporation" Status
   4. Only liable for AMT adjustments and preferences from transactions created in the year that the status is lost.

F. NET OPERATING LOSS (NOL) DEDUCTIONS

1. NOL Carryback and Carryforward Period Modified
   1. Carryback shortened from 3 years to two years
   2. Carryforward extended from 15 to 20 years
   3. If NOL relates to casualty and theft, or Presidentially declared disasters by farmers or small businesses, then 3 year c/back still applies
   4. Effective Date - For NOLs for tax years beginning after August 5, 1997. The provision does not apply to NOLs carried forward from prior tax years.

G. HOME OFFICE DEDUCTION (IRC Section 280A(c)(1))

1. Prior law: A home office deduction is allowed only for the portion of a home that is used regularly and exclusively: (i) as the taxpayer's principal place of business; (ii) as a place used to meet with customers, clients, or patients in the normal course of the taxpayer's trade or business; or (iii) in the taxpayer's trade or business if the portion used is a separate structure not attached to the dwelling unit. Further, if the taxpayer is an employee, a deduction is allowed only if the home office is maintained for the convenience of the employer.
2. Decision in Soliman, 93-1 USTC 50,014. U.S. Supreme Court narrowly construed principal place of business as the place where the taxpayer performed "the essence of the professional service." An anesthesiologist had no office at his place of employment. He performed his administrative and management duties at his home office (bookkeeping, correspondence, phone calls, reading journals, etc.). Supreme Court denied the deduction because the principal place of business is where the primary income-generating functions of the trade or business are performed--in this case the surgical procedures in the hospital.
3. New law expands the definition of "principal place of business." Under the new law, a home office qualifies as a taxpayer's principal place of business if:
   1. the office is used by the taxpayer to conduct administrative or management activities of the taxpayer's trade or business; and
   2. there is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities of the trade or business.
4. Committee Reports apply new rules expansively. If administrative or management activities are carried out at sites that are not fixed locations of the business (e.g. car or hotel rooms), second prong is satisfied. If substantial non-administrative and non-management activities at a fixed location, second prong can still be satisfied. If a fixed location is available for administrative and management activities but is not in fact actually utilized by the taxpayer, second prong is satisfied.
5. New rules significantly increase deductibility of home office for certain types of sole proprietors who perform income-generating activities outside of the office: contractors, software consultants, doctors, salespeople, teachers, painters, etc.
6. Deduction still limited for employees. For an employee, the use of a home office must still be for the convenience of the employer. If a fixed location for performing administrative and management activities at the employer's office is available to an employee, the IRS may take the position that the home office was not for the convenience of the employer.

H. UNIFIED CREDIT INCREASED FOR ESTATE AND GIFT TAX (IRC Section 2010)

1. Prior law: Unified credit of $192,800 on lifetime taxable gifts and the estate tax imposed at death. Effective exemption of $600,000 of taxable transfers.
2. New law applies to gifts made and deaths occurring after 1997. Phase-in of new exclusion amount as follows:
   • 1997.......................$600,000
   • 1998.......................$625,000
   • 1999.......................$650,000
   • 2000 and 2001.......$675,000
   • 2002 and 2003.......$700,000
   • 2004.......................$850,000
   • 2005.......................$950,000
   • 2006 and after......$1,000,000

I. FAMILY-OWNED BUSINESS EXCLUDABLE FROM GROSS ESTATE (New IRC Section 2033A)

1. If an estate qualifies, there is excluded from a decedent's gross estate the lesser of (i) the adjusted value of the decedent's qualified family-owned business interests or (ii) the excess of $1,300,000 over the applicable exclusion amount with respect to the decedent's estate. Note: Value of this exclusion will decrease as the unified credit increases under phase-in timetable.
2. Ownership Test. A qualified family-owned business is any interest in a trade or business, regardless of form, with a principal place of business in the U.S., the ownership of which is held (i) at least 50% by one family, (ii) 70% by two families, or (iii) 90% by three families. If held by more than one family, the decedent's family must own at least 30% of the trade or business. Members of the individual's family include (i) the individual's spouse, (ii) the individual's ancestors, (iii) lineal descendants of the individual, of the individual's spouse, or the individual's parents, and (iv) the spouses of any such lineal descendants.
3. 50% Liquidity Test. To qualify, the aggregate value of the decedent's qualified family-owned business interests that are passed to qualified heirs via lifetime gifts or at death must exceed 50% of the decedent's adjusted gross estate.
4. Participation Test. The decedent or members of the decedent's family must have owned and materially participated in the trade or business for at least 5 of the 8 years preceding the decedent's death.
5. Recapture Tax. A recapture tax is imposed if certain events occur within 10 years of the decedent's death (e.g. material participation by qualified heir ceases).
6. Other Limitations.
   1. Business does not qualify if it is publicly traded.
   2. Business does not qualify if more that 35% of its adusted ordinary income is personal holding company income in the year of the decedent's death.
   3. The value of a family-owned trade or business is reduced to the extent that the business holds certain passive assets or cash and marketable securities in excess of the reasonably expected day-to-day working capital need for the trade or business.

J. ROTH IRAs (New Section 408A)

1. Contributions (prior to April 15th of the following year) are nondeductible and grow tax deferred
2. Tax savings are backloaded
3. Maximum contribution to all IRAs is limited to $2,000
   1. Roth IRA more favorable than deductible IRS in most cases
4. Availability phased out at AGI limits between $95,000 and $110,000 single, $150,000 and $160,000 married filing joint
5. Qualified distributions are not included in gross income and not subject to10% early withdrawal penalty
   1. 5 year holding period; and
   2. made after the date on which the individual turns 59 1/2 ; or
   3. made to a beneficiary on or after the individual's death; or
   4. attributable to the individual being disabled; or
   5. a distribution to pay for "qualified first-time homebuyer expenses"
6. Ordering rules for Non-qualified distributions
   1. contribution base first
7. Rollovers and Conversions
   1. can rollover from "Roth IRA" to "Roth IRA"
   2. can rollerover from "current IRA" to "Roth IRA"
   1. Example: Bill is 40 years old and has an existing IRA balance of $100,000. Should Bill roll his existing IRAA into a Roth IRA? Factors to evaluate are as follows:
      1. tax bracket currently vs. Tax bracket at retirement
      2. rate if return on investments
      3. cash needs at retirement
      4. years to retirement
      5. flexibility at retirement could swing to ROTH IRAs favor
   2. If leaves in current IRA: 25 yrs, 10% return, FV = $1,084,470 if taxed at 28%, net = 780,098 (heirs could pay at much higher tax bracket)
   3. If rolls to Roth IRA: $100,000 taxes @ 28% = $28K in tax paid over 4 years/$72K invested for 25 yrs @ 10% = $780,098
8. Effective Date - Tax Years Beginning After December 31, 1997