Do you buy and use computer software in your business? Do you develop computer software for use in your business, or for sale or lease to others? Then you should be aware of the complex rules that apply to determine the tax treatment of computer software and of the expenses of developing computer software.

Purchased software. The time for depreciating the cost of "separately stated software"—software whose price is not included in the cost of hardware (for example, a computer or printer)—is three years, with one major exception. If, as part of your purchase of all or a substantial part of a business, you bought software that's not commercially available to the general public, the software may be an "amortizable section 197 intangible" that has to be amortized using the straight-line method over 15 years. Certain elections are available that may help you avoid this lengthy amortization period.

Software development costs. If you incur costs for developing computer software, you may account for those costs for federal tax purposes using any of the following methods:

• You may capitalize those costs and treat them in the same way as any other costs of producing business property.

• You may treat those costs, if they qualify, as "research or experimental expenditures" under the special rules of Code Sec. 174.

• Using the special methods of accounting for software development costs allowed by IRS, you may either (a) write off your software development costs in the year you incur them, or (b) capitalize those costs and amortize them, using the straight-line method, over five years. If you can clearly establish that the developed software has a useful life of less than five years, you may use that shorter period.

The choice of the appropriate method for recovering software development costs can be quite complex and involves the consideration of many factors. We would be happy to review the details of your situation and assist you in determining which of the above methods would be the most advantageous method for your business to use to handle those costs.

For purposes of the PAL (passive activity loss) rules, rental real estate properties generally are treated as passive investments regardless of the owner's level of involvement. As a result, if rental realty produces a tax loss (deductions exceed income), its owner generally cannot use the loss to offset non-passive income (such as interest, dividends, or salary). One exception allows taxpayers to use up to $25,000 of losses (or credits in deduction equivalents) from "active participation" rental real estate activities to offset nonpassive income, but this annual loss allowance phases out for those with adjusted gross income above $100,000 (special phaseout rules apply to certain credits). In contrast, non-rental-activity businesses are treated more liberally—the PAL rules only apply to passive owners.

Qualifying real estate professionals are, however, subject to more liberal PAL rules. If you're one of them, your rental real estate properties generally are treated like any other non-rental-activity business. As a result, if you materially participate in the properties, losses generated by them aren't branded with the "passive" label. That means you can use the losses to offset non-passive income (such as interest, dividends, or salary). In general, material participation means substantial and ongoing involvement under one of a number of tests carried in IRS regulations.

How do you qualify as a real estate professional? The tests basically are straightforward. First, more than 50% of the personal services you perform in all businesses during the year must be performed in real estate businesses in which you materially participate. Second, your personal services in material participation real estate businesses during the year must amount to more than 750 hours. These tests are applied annually. "Real estate businesses" include such enterprises as building, rebuilding, buying, renting, operating, managing and leasing realty, as well as realty brokerage businesses.

Like many exceptions to tough tax rules, the real estate professional's exception carries a number of complications. For example:

• A real estate property in which you are a material participant may carry suspended losses from years in which you didn't qualify as a real estate professional. This type of property is treated as a former passive activity. That means the suspended losses can only offset income from the activity that produced the loss, or passive income from other investments. In general, the suspended losses can't be used to offset nonpassive income until the property is sold.

• For purposes of applying the PAL rules, you can choose to combine all of your rental real estate activities into one activity, or treat each one separately. The right choice will depend on a number of complex factors we should review in person.

By renting property to your closely-held corporation, it's been possible to create tax-advantaged passive income. But an IRS training manual on passive losses has called this strategy into question. Here's why.

Under the passive loss limitation rules, passive activity losses—losses from an activity in which you do not "materially participate"—can only be deducted against passive activity income. They can't be deducted against active income, such as salary, or against investment income.

If you have passive losses, it's good tax planning to generate some passive income against which the losses can be deducted. In a sense, the additional income will be tax-free. But, IRS has the power to prevent this by recharacterizing certain passive income as nonpassive.

One potential type of passive income is income from renting property to a closely-held corporation (other than an S corporation) or to a personal service corporation in which you materially participate. IRS has been of two minds about whether to recharacterize this rental income as nonpassive income.

The original regulations that IRS issued said that the rental income isn't recharacterized. That position favors taxpayers by allowing the income to be used to offset passive losses. But a later set of regulations removed the passage on which taxpayers had relied, leading some to believe that IRS's position had changed. A training manual that IRS has issued to its agents has confirmed this view. The manual clearly states that rental income from a closely-held corporation or personal service corporation must be recharacterized as nonpassive.

The line of demarcation between the two IRS positions is May 10, 1992. For tax years beginning after that date, the new regulations, which require recharacterization, apply, unless the rental income was earned under a written contract entered into before February 19, 1988.

In general, in order to deduct points paid in connection with a residential mortgage, the points must be "qualified residence interest." In addition, even where points are deductible, certain other requirements, as discussed below, must be satisfied in order to deduct them in the year they are paid (as opposed to being written off over the term of the mortgage).

In order for interest (including points) paid in connection with a refinancing mortgage to be "qualified residence interest," the mortgage must be with respect to, and secured by, either your principal residence or one second residence which you select. In addition, the mortgage proceeds must either be used to make substantial improvements to the home, or must not exceed the principal amount of your old mortgage by more than $100,000 ($50,000 if you are married and file a separate return).

Even where "points" paid on a refinancing are "qualified residence interest," they will only be deductible in the year paid (1)if they relate to your principal residence (not a second residence); (2)to the extent that they are consistent with local business practice on this type of loan; and (3)to the extent they relate to the portion of the mortgage which is used to finance improvements to the home.

In other words, points attributable to the portion of the new mortgage which is used to repay the old mortgage cannot be deducted when paid, but may be deducted over the life of the new mortgage (or when it is prepaid). Similarly, to the extent the proceeds of the new mortgage exceed the principal amount of the old mortgage and are used for purposes other than improving the property, no current deduction is permitted; however, the points may be deducted over the term of the new loan to the extent the excess principal amount does not exceed $100,000.

Congratulations on the purchase of your new home.

You (or the seller) may have paid "points" to your mortgage lender. Since a current tax deduction for points in the year in which they are paid would be a significant benefit, I'd like to take this opportunity to explain how the rules in this area operate.

Ordinarily, the costs of borrowing money (including amounts paid as "points") cannot be deducted in the year they are paid, but instead can only be deducted over the life of the loan to which the costs relate. However, IRS has set forth a "safe harbor," under which points can be deducted in the year they are paid if all of the following requirements are satisfied:

• You must be on the cash method of accounting for tax purposes.

• The points must be paid in connection with the acquisition of your principal residence.

• The mortgage loan must be secured by that residence.

• You must have paid the points directly from funds that you did not borrow, or else the seller must have paid the points on your behalf. In other words, no current deduction is available if the amount of the points was withheld from the loan proceeds by the lender.

• There must be an established business practice in your area of charging points on loans of this type, and the amount you paid must not exceed the amount generally charged in your area.

• The points must be clearly designated as such on the Uniform Settlement Statement prepared in connection with the closing.

• The amount of the points must be computed as a percentage of the stated principal amount of the mortgage.

Selling one's residence and moving into a smaller home or condo is seldom an easy decision, but at least part of the decision-making process just got a little easier. As part of the Taxpayer Relief Act of 1997, Congress included a provision that will eliminate most people's federal tax liability on gain from the sale or exchange of their homes.

Under the new law, up to $250,000 of the gain from the sale of single person's principal residence is tax-free. For certain married couples filing a joint return, the amount of tax-free gain doubles to $500,000. Thus, you no longer have to reinvest the sales proceeds by buying a more expensive house in order to "roll over" (i.e., avoid paying tax on) your gain. Also, the new rules replace the one-time exclusion of $125,000 of gain that applied to people over age 55. Since most people will not owe any tax on the gain from the sale of a principal residence under the new rules, the hassle of trying to document costs, expenses, and prices involving various residences over the years should be alleviated.

Like most tax laws, however, the exclusion has a detailed set of rules for qualification. Besides the $250,000/$500,000 dollar limitation described above, the seller must have owned and used the home as his principal residence for at least two years out of the five years before the sale or exchange. In most cases, taxpayers can only take advantage of the provision once during a two-year period. However, a reduced exclusion is available if the sale occurred because of a change in place of employment, health, or other unforeseen circumstances (that IRS may specify in future regulations). The rules can get pretty complicated if you marry someone who has recently used the exclusion provision, if the residence was part of a divorce settlement, if you inherited the residence from your spouse, if you sell a remainder interest in your home, or if you have taken depreciation deductions on the residence.

Not everyone will be happy with this new law. Homeowners who sell at a loss still will not be able to claim a deduction. Also, homeowners with profits of more than the $250,000/$500,000 limits could have to pay more tax under the new law since Congress repealed the provision allowing owners to defer gains by rolling over home-sale proceeds into a new home costing the same or more.

On balance, though, the news is good. We finally have a tax break that most of us can actually use, and the tax savings can be substantial. Please contact us at Tax Tech Support if we can be of assistance.

Many individuals and families (particularly those with school-age children), use personal loans or credit cards to buy cars or vans, finance private schooling, take vacations, etc.

If you are making significant payments on these kinds of debts, you know you can't deduct the "personal interest." That means you are paying the interest portion with after-tax dollars (and perhaps at very high rates as well).

There's a way to convert your nondeductible interest payments into deductible expense. You can get this tax break if you own your own home.

Specifically, you can take out a home equity loan (in the normal way, from your bank for example) and use the proceeds to pay off your nondeductible debts. You will probably be paying at a lower rate, since many lenders are charging near prime on these loans. And the interest payments will be deductible even though you don't use the loan for anything connected with the house .

Of course, before you borrow against the equity in your personal residence, you should be certain that you actually get the tax deduction benefit. As always, there are various technical restrictions and limits that may apply, depending on your particular tax facts and circumstances.

Here is guidance on how long you should retain your personal income tax records. These records may have to be produced if the Internal Revenue Service (or a state or local taxing authority) were to audit your return or seek to assess or collect a tax. In addition, lenders, co-op boards, or other private parties may require that you produce copies of your tax returns as a condition to lending money, approving a purchase, or otherwise doing business with you.

Keep returns indefinitely and the supporting records usually for six years. In general, except in cases of fraud or substantial understatements of income, the Internal Revenue Service can only assess tax with respect to a year within three years after the return was filed for such year (or, if later, three years after the return was due). For example, if you filed your '94 individual income tax return on or before its unextended due date of April 17, '95, IRS could assess tax until April 17, '98. If you filed your return late, it has three years from the date you filed.

The problem with the three-year rule is that the assessment period is extended to six years if more than 25% of gross income is omitted from a return. Neither period begins to run until a return is filed. Therefore, if the Service claims that you never filed a return for a particular year, it can assess tax for that year at any time (even beyond three or six years), unless you can prove that you did file. Proving that you filed would, of course, be impossible after you have discarded your returns.

While it is therefore impossible to be completely sure that the Service will not at some point seek to assess tax, retaining tax returns indefinitely and important records for six years after the return is filed should, as a practical matter, be adequate.

Records relating to property may have to be kept longer than other records. Keep in mind that the tax consequences of a transaction that occurs in one year may depend on things that happened in earlier years-and that the period for which you should retain records must be measured from the year in which the tax consequences actually occur. This may be significant, for example, where you sell property that you bought years earlier.

For example, suppose you bought your home in '85 for $200,000 and made an additional $20,000 of capital improvements in '88. You then sell your home in January '97. In order to determine the tax consequences of the sale, it's necessary to know your basis, which depends on the earlier transactions. If your '97 return is audited, you may have to produce records relating to the purchase in '85 and the capital improvement in '88 in order to substantiate your basis. In effect, therefore, such records should be kept until six years after the '97 return has been filed-even though they relate to years long past.

When new property takes the basis of old property, records relating to the old property should be kept until six years after the sale of the new property is reported. For example, suppose you purchased a car for business use in '94 and you traded it in on a new car for business use in '97. You sell the new car in '99. Your basis in the new car will determine whether you have a tax gain or a tax lose on the sale. And your basis in the new car is determined, at least in part, by your basis in your old ('94) car. So records relating to your old car should be kept until 2006 (i.e., for six years after the '99 return is filed).

Similar considerations apply to other property which is likely to be purchased and sold-for example, stock, other securities such as mutual funds, etc.

And, because the calculation of the casualty and theft loss deduction is affected by your basis in the property, you'll need to have records to support that basis, until six years after you file the return containing the loss deduction.

In case of separation or divorce. If separation or divorce becomes a possibility, be sure you have access to any tax records affecting you that are kept by your spouse. Or better still, make copies of the tax records, since in such situations, relations may become strained and access to the records difficult.

Your records should include a copy of the divorce decree or agreement of separate maintenance, which may be needed to substantiate alimony payments and distinguish them from child support or a property settlement. Copies of all joint returns filed and supporting records are important, since the liability for tax on a joint return is joint and several and a deficiency may be asserted against either spouse. Your records should also include agreements or decrees over custody of children and any agreements of who should claim an exemption for them. Retain records of the cost of all jointly-owned property. And get from your spouse or former spouse records on the cost or other basis of all property transferred to you by him or her during your marriage or as a result of the divorce, because your basis in this property is the same as your spouse's or former spouse's was.

Loss or destruction of records. To safeguard your records against loss from theft, fire or other disaster, you might wish to consider keeping your most important records in a safe deposit box or other safe place outside your home. In addition, you may want to keep copies of the most important records in a single, easily accessible location so that you can grab them if you have to leave your home in an emergency.

If, despite your precautions, records are lost or destroyed, it may be possible to reconstruct some of them. For example, a paid tax return preparer is required by law to retain, for a period of three years, copies of tax returns or a list of taxpayers for whom returns were prepared. Most preparers comply with this rule by retaining copies (sometimes for a longer period than the legally required three years) and can furnish a copy if yours is not available. Similarly, other professionals who assisted you in a transaction may retain records relating to the transaction-for example, a stockbroker through whom you bought securities may be able to help you to determine the basis of the securities, and an attorney who represented you in the purchase of your home may retain records relating to the closing. Nonetheless, because you can never be sure whether those persons will actually have the records you need, the safest course of action is to keep them yourself, in as safe a place as possible.

IRS will audit about 1,000,000 individual tax returns this year. Although that represents less than 1% of all returns filed, this is little consolation if your return is among those selected for audit. But with proper preparation and planning, you should fare well.

The purpose of the audit is to verify items reported on a tax return. The easiest way to survive a tax audit is to prepare for one in advance. On an ongoing basis you should systematically maintain documentation—invoices, bills, cancelled checks, receipts or other proof—for all items to be reported on your tax return. Keep all your records in one place and hold on to your calculations.

The government normally has three years within which to conduct an audit, and often the audit won't begin until a year or more after you file your return.

The scope of an audit depends on the complexity of the return being examined. A return reflecting business or real estate income and expenses is likely to take longer to audit than a return reflecting only salary income. You can facilitate matters by having the necessary records arranged in an orderly and systematic fashion for presentation to the IRS agent. The typical IRS agent is experienced and knows his job. Trying to outsmart the agent or sidestepping questions is likely to create friction and raise suspicions in the agent's mind.

Representation. Even if you prepared your own return, it is often advisable to have a tax professional represent you at an audit. Your representative knows what issues the IRS agent is likely to focus on and can prepare accordingly. More importantly, a tax professional knows that in many instances IRS agents will take a position (for example, to disallow deduction of a certain type of expense) even though courts and other authority have expressed a contrary opinion on the issue. Because the representative knows and can point to the proper authority, the IRS agent may be forced to throw in the towel.

If you are facing a tax audit or simply want to improve your recordkeeping, our office stands ready to assist you. Please contact us at Tax Tech Support if you wish to pursue this or any other aspect of your taxes.

If IRS is after you to collect a tax liability that's beyond your ability to pay, you'll want to know about a technique that may allow you to settle your tax bill once and for all at a fraction of its face value. It's called an offer-in-compromise, and here's how it works.

Like any other creditor, IRS prefers a partial payment to no payment at all. Therefore, it is willing to settle a tax debt for less than face value if the taxpayer is unable to pay the full amount. A settlement will also be considered where there is doubt about how much tax is owed.

The way to begin the settlement process is by making an offer-in-compromise. This is an offer to settle a tax liability for less than its full amount. Certain information must be included in the offer. The offer must reflect what IRS could collect using the legal tools at its disposal.

IRS won't press for collection of the tax while it is considering a genuine offer-in-compromise. If it accepts the offer, it is barred from any further assessment of the taxes in question.

An offer-in-compromise may be just the solution to your tax payment problems. We would be glad to sit down with you to discuss this matter. Please contact us at Tax Tech Support  to set up an appointment.

Did you know that there is an IRS program that may help you to locate missing family members and retirement plan participants? IRS is prohibited by law from disclosing taxpayer addresses to the public. However, it will forward letters free of charge for "humane purposes," such as reuniting with a relative. It will also help retirement plan sponsors and administrators who are trying to find missing participants.

To take advantage of this program, you must have the missing person's social security number. You send the number, together with the letter to be forwarded and the reason for the request, to the Disclosure Officer at the IRS district office nearest you. There are special procedures, and a fee, for requests involving 50 or more persons.

If IRS has an address for the missing person, it will forward the letter. It adds a message saying that IRS has no involvement in the matter other than forwarding the letter and that it's entirely up to the recipient whether or not to respond.

Unfortunately, IRS won't tell you whether it sent the letter and, if it did, whether the letter was returned as undeliverable. You'll only get a response if the missing person receives the letter and chooses to reply.

Despite this drawback, the IRS program may be helpful in some cases.

If anyone you know has failed to file tax returns when due, here's important news: IRS wants nonfilers back on the rolls. IRS isn't offering amnesty, but it is leaning toward giving favorable treatment to nonfilers who come forward voluntarily.

Many nonfilers missed a year for one reason or another, and now are afraid to re-enter the tax system. But in fact, taxpayers who file overdue returns on their own are often treated reasonably well, much better than those who are caught.

For taxpayers who can't pay their entire tax bill at once, there's an installment payment option. Taxpayers can request an installment agreement for up to $10,000 without filing a financial statement.

Once a return is filed, IRS has three years in which to audit it. After that, the return is final. If no return is filed, there's no statute of limitations. IRS can come after the taxpayer at any time, even many years later.

Some nonfilers are actually entitled to refunds. But if they fail to file within three years from the due date of the return, they'll lose the refund.

Although taxes probably are the last thing on your mind right now, we should get together and discuss the tax aspects of your changed personal and professional circumstances. Depending on your situation, the tax aspects can be quite complex, and require you to make decisions that can affect your tax picture this year and for years to come. Here are just a few of the factors we should discuss in detail.

Although severance pay is taxable and is subject to federal income tax withholding, some elements of a severance package may be specially treated. For example:

• If you sell stock acquired by way of an Incentive Stock Option (ISO), part or all of your gain may be lightly taxed long-term capital gain, depending on whether you meet a special dual holding period.

• If you received or will receive what is commonly referred to as a golden parachute payment, you may be subject to an excise tax equal to 20% of the portion of the payment that's treated as an "excess parachute payment" under extremely complex rules.

• The value of job placement assistance you receive from your former employer usually is tax free. However, the assistance is taxable if you had a choice between receiving cash and outplacement help.

You should also be aware that under the so-called COBRA rules, most employers that offer group health coverage must provide continuation coverage to most terminated employees and their families. The cost of any premium you pay for insurance that covers medical care is a medical expense and as a general rule results in a tax benefit only if your total medical expenses exceed 7-1/2% of your adjusted gross income. However, if you have self-employment income following termination of employment, part of the cost of your medical insurance premiums may be deductible "above the line" (that is, deductible in arriving at adjusted gross income). And if your ex-employer pays for some of your medical coverage for a period of time following termination, you will not be taxed on the value of this benefit.