Margin Account Interest; Gift Tax Audit Rates; Discharging Taxes in Chapter 13

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, May 14 , 2000.

Copyright 2000  Robert L. Sommers, all rights reserved.

Question: My friend uses a stock margin account ( a loan account secured by stock held by the brokerage) to pay for expenditures. If he uses the money for personal expenditures, may he deduct the interest?

Answer: No. Whether or not interest is deductible depends on how the money is used. For instance, if you borrow against your margin account to buy a personal automobile, the interest paid will not be deductible. If however, you use the money to purchase additional stock, the interest paid may off-set any "investment" income (typically interest and dividends from stock or securities) received. Note: You cannot borrow against your stock, purchase tax-exempt bonds and then write-off the interest.

It sounds like your friend is using a margin account as a bank’s line of credit. It is not and he could lose his entire stock account if its value plummets and the brokerage firm makes a "margin call" (a demand for immediate repayment of the loan). During the recent market downturn, brokerage houses were not shy about selling the stock in investors’ accounts to repay margin loans.

Example: Suppose you acquired 1,000 shares of your employer’s stock for $0.10/share and while your stock is worth $100,000, you borrow against it to purchase a $50,000 automobile. Then, the value of your stock drops to $50/share and your broker liquidates your shares (sells the stock at $50/share to repay the loan). You’ll have a tax liability on your capital gain of $49,900, even though your stock account has been wiped-out. This can occur even though you were making all required interest payments on the loan.

In conclusion, it is extremely dangerous to borrow against a margin account unless you are an experienced and sophisticated investor or someone with sufficient assets. A sudden downturn in the market could cause your loan to become immediately payable in full and if you cannot pay it, the brokerage company may sell your stock at its low point to satisfy the loan.

Question: I made a gift of a minority interest in real estate to my grandchildren. I valued the gift at $500,000, which amounts to a 40% discount from the fair market value of the property. What are the chances the IRS will audit me?

Answer: The odds are very low that IRS will audit the gift; it does not have the personnel to do it. In 1999, there were 78 IRS examiners assigned to 271,000 gift tax returns. That is 3,474 returns per auditor! For gifts claimed under $600,000, only 0.3% were audited. Gifts between $600,000 and $1,000,000 were audited 1.8% of the time. However, gifts exceeding $1,000,000 had a 75.3% chance of audit. Thus, taxpayers are finding it advantageous to be aggressive in valuing their gifts as low as possible to avoid or minimize gift taxes. Gifts and estates are taxed under the same tax rate schedule.

Question: If I file a Chapter 13 bankruptcy, may I discharge my federal income taxes, even if those taxes are less than three years old?

Answer: No, but you may stretch out the payments. In a Chapter 13 bankruptcy, you propose a monthly payment plan, usually for three years, to a judge. Your monthly payment is based on your "disposable income" (income exceeding your basic needs). If approved, you make payments to a trustee who in turn pays your creditors. At the end of the plan’s term, you are discharged from your debts, which may include tax debts if the taxes were due more than three years before you file for Chapter 13 relief and were assessed more than 240 days before you filed.

Because your taxes are less than three years old, your payment plan must provide for full payment to IRS. Note: If IRS recorded a lien on your assets before you file, it may sell those assets to collect the taxes due; the bankruptcy discharges only your personal obligation to pay those taxes, it does not extinguish IRS liens that may exist on your property.

Under Chapter 13, penalties and interest stop accruing once you file. Also, a judge may permit you to discharge fraud and amounts you may personally owe for employment taxes in connection with your business.

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All contents copyright 1995-2003 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.