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10 December 2017
If you worked under a job covered by Social Security, but were then injured and unable to work for a year or more you may qualify for Social Security Disability payments. These payments can sometimes be the difference between solvency and insolvency for those who need them, but they can also cause tax complications. Nothing is easy when it comes to government programs, right? Social Security Disability Benefits are sometimes taxable, but sometimes not taxable. To further complicate things, there is such a backlog of claims your first payment might cover more than one year of benefits. If you were injured and applied for benefits in 2017 you might not receive any benefits until 2018, at which time you could receive a lump sum payment for benefits going back to the date you were injured. Under the tax code you generally pay taxes on money when it is received, so you could have a tax problem in the year you receive a large lump sum.
There is a way to fix a tax problem created by Social Security lump sum payments, but you must know the fix exists and how to use it. There is a provision known as Section 86(e) allowing you to elect to have the portion of the Social Security Benefit received for a prior year to be taxed as it would have been if it had been received in that prior year. You don't have to go back and amend that prior year return, you just have to calculate the tax as it would have been calculated on that return. This can provide a very nice tax benefit when it's needed. Let’s look at an example situation to take a closer look at how the problem develops and how it gets resolved.
John works in a job covered by social security. His wife Jenny is a school teacher, but their financial plan is for Jenny to take a few years off work to stay at home with their infant son. She may even stay out of work longer to have more children. Then life happens...in January 2016 John is injured. His doctor says he will not be able to work for at least a year, possibly longer. John applies for Social Security Disability Benefits.
Throughout 2016 John is unable to work. He is also unable to provide adequate care for their son on his own. Jenny stays at home to care for them both. They burn through their savings, but they make it. By early 2017 John is strong enough to look after their son, so Jenny goes back to work as a teacher, earning $48,000 for the year.
In July 2017 the Social Security Administration approves John’s application for disability benefits and pays him $15,000 to cover the period back to the time of his injury. $10,000 of this amount is for 2016, and $5,000 is for 2017. For the remainder of 2017 John receives disability benefits totaling an additional $5,000.
John receives a 1099-SSA from the Social Security Administration in January 2018 stating he received $20,000 in benefits from the SSA in 2016. While this is true, it is also a bit misleading, and poses a big tax disadvantage for John and Jenny. Social Security benefits are taxable based on the amount of other income you make. Up to 85% of the benefits can be taxed if you make more than $44,000 and file a joint return. ($34,000 if you file individually.)
In 2016 John was recovering and Jenny was taking care of her husband and son. They had very little income that year. If they had received $10,000 of the Social Security disability benefits during 2016 as they should have, they would not have to pay income taxes on any of it. But they didn’t receive it in 2016, they received it in 2017. In 2017 Jenny earned $48,000, so now 85% of the $20,000 Social Security benefit received in 2017 ($17,000) could be exposed to taxation.
Section 86(e) to the Rescue
There is a fix for this in Section 86(e) of the Internal Revenue Code, commonly called the “Lump Sum Election”. This allows the taxpayer to calculate the tax on the Social Security as it would have been calculated had it been received in a timely fashion. In our example, if John and Jenny had timely received the $10,000 of 2016 Social Security Disability benefits, that $10,000 would have been taxed at 0% (or, rather, it would not be included in taxable income). Therefore, they can claim a Lump Sum Social Security Payment Election under Section 86(e), and get the 2016 tax treatment on that amount on their 2017 tax return.
On their joint tax return John and Jenny will put the full amount ($20,000) from the 1099-SSA on line 20A. On line 20b (the taxable amount of their Social Security benefits) they will put $8,500. They arrived at $8,500 using worksheets in IRS Pub. 915. Essentially, they take the 2016 rate times the 2016 amount and add it to the 2017 rate times the 2017 amount. The 2016 rate was 0% times $10,000, plus the 2017 rate of 85% times $10,000.
The IRS has never issued guidance on how to formally make the Lump Sum Election, so taxpayers are advised to include a statement with their tax return indicating they have chosen the Lump Sum Social Security Benefit Payment Election Under Section 86(e). You may even want to show the math used to come up with the amount taxable you include on line 20b.
Be advised the election is not required. It is permissible to treat the entire lump sum as received in the current year if that is more advantageous to you. For example, if Jenny was still working in 2016, but not working in 2017, it would be more advantageous for them to pay the 2017 rate on the entire lump sum. In this situation, they would NOT elect to use Section 86(e) to apply the 2016 tax rate to part of the lump sum payment from Social Security.
Section 86(e) is one of those strange aspects of tax law that is highly useful, but not widely known. Most people never have to use it and virtually no one ever uses it more than once. It can save you quite a bit at tax time, though, if you can apply the Lump Sum Social Security Benefit Payment Exclusion to your advantage. If you find yourself in that position and you’re stuck, give me a call. If you know someone who received a large Social Security Disability payment covering multiple years, send them a link to this article. It might be very valuable to them!
03 December 2017
As I have written before, I am a fanboy of 529 plans in general and the Virginia 529 plan in particular. The Commonwealth has done an uncommonly good job at taking the federal guidelines for 529 plans and creating an efficient, effective, and user-friendly program. I like any program that gives us a tax break for education. What I particularly like about the 529 plans is that:
1. 529s are one of the few tax-advantaged higher education programs in which room & board is a qualified higher education expense. That’s good news if your child might eat or sleep at some point during their time at the university. I don’t know what planet our lawmakers are from when they don’t consider room and board necessary expenses for other college tax breaks. It was a significant chunk of what we spent on our children’s college educations, and we were glad we had the 529 plans in place to help us cover it.
2. Anyone can use the 529 plan. Most of the other tax breaks available for college have income limitations. Earn too much and you can’t take advantage of the program. Not so with the 529 plans. There is a limit to how much you can contribute, but there is no income barrier to participation.
3. Even if you don't plan far enough ahead to take advantage of the tax-deferred growth in a 529 plan, you can still get a tax break for your contribution by using the Virginia College Wealth program and running your education funds through a Virginia 529 account in the same year you make the payments. It's a nifty little loophole anyone can use.
As easy as Virginia 529 makes it to save for college, some mistakes can be made when you withdraw that will negate the great advantages you received for using a Virginia 529 plan. You can end up with a tax penalty if you aren’t careful. You can even wreck your eligibility for other (more valuable) college benefits. Here are 4 mistakes I see, and how to avoid them.
1. Using a 529 from a non-parent early in the student’s education. This is how this scenario frequently unwinds: Grandparents have a 529 for the student they started when they initially became proud grandparents. Now it's time for freshman year and Grandma and Grandpa take money out of the 529 and give it to the family to help with college expenses. That is unbelievably thoughtful and sounds wonderful, but it can have somewhat dire unintended consequences. Why? Because needs-based federal student aid is concerned with parent’s money and student’s money – and student’s money counts nearly 4 times as much as parent’s money when calculating eligibility for student aid. When Grandparents take money out of a 529 for a student, that counts as student money for federal student aid purposes. The grandparent’s helpfulness could get overshadowed by the student aid that gets lost as a result.
The solution here is to wait until the student’s junior year to tap into grandma and grandpa’s 529 money. There’s a built-in lag in income reporting to student aid. By the time the student aid folks are told about the grandparents 529 money, the student should be through their senior year.
2. Withdrawing money too early from the account. Here’s the scenario: You know the school is going to bill you on January 10th, so you withdraw money from your 529 plan on December 22nd so the money is ready and available when the bill arrives. Makes perfect sense, and you should be rewarded for being so prepared and organized. Except the IRS isn’t always concerned with what makes sense, or how this fits your personal method of organizing. Money withdrawn from a 529 in 2017 must be used to pay for college expenses in 2017. January is in 2018, so you can’t apply that 2017 withdrawn money against the 2018 college bill and keep it tax free.
The solution here is to wait until January to make the withdrawal for the January bill. You could also elect to do what we did, and withdraw from the 529 plan on a reimbursement basis. We would pay the college bills from current operating monies and then reimburse ourselves from the 529 after the fact. This had the added benefit of making our withdrawals more precise. We knew exactly how much we had spent on room and board by the time we made the withdrawal.
3. Withdrawing money to cover travel, commuting, and parking. As generous as the 529 plan is, there are still things that just aren’t covered. Travel, commuting, and parking are common expenses that are not allowable as qualified higher education expenses for the 529 program.
There is no solution for this. Plan ahead for these expenses, but not with your 529 money!
4. Assuming the 529 is only good for room and board if the student lives on campus. Every once in a while, I’ll find someone who believes you can only use the 529 money on dorm fees and pre-paid meal plans. It just isn’t so. You can use your 529 money for room and board off campus. The limitation is that you cannot claim a greater expense than what it would cost to put them in the dorms and buy the meal plan. If you want to put your son or daughter in the Ritz Carlton for a semester and let them eat caviar, knock yourself out. But...the most you can claim as a qualified higher education expense on your tax return is the same as it would cost to house and feed them on campus.
There isn’t a solution needed for this. Just be aware the student can live off campus and still use the 529 money. Also, be aware that it’s usually easier for me to take the posted on-campus rates from the university when I am calculating education expenses than it is for me to look at actual expenses.
The Virginia 529 plan is a great way tosave for college expenses. This is especially true if you know your student is going to be living on or near the campus. The important thing to remember is that you can accidentally make things worse with your 529 account if you aren't careful. When in doubt you should call me first.
26 November 2017
As advertised last week, this week’s blog is about the ‘certain’ miscellaneous deductions you can take on Schedule A if you itemize your tax return. 'Certain’ miscellaneous deductions are subject to a “2% limitation” – meaning your deductions in this category must exceed 2% of your adjusted gross income (AGI) before they start to actually influence your taxes. Unreimbursed Employee Expenses are also subject to the 2% rule. Fortunately, Unreimbursed Employee Expenses and ‘Certain’ miscellaneous deductions are added together, so it makes it a bit easier to get above that 2% threshold to be able to get a deduction.
For example, Shawn is employed as an auto mechanic, and his 2017 AGI is $50,000. Like most auto mechanics he must bring his own tools to the job. Shawn spends $800 on tools in 2017. Shawn also has $900 of ‘certain’ miscellaneous deductions in 2017. Shawn’s combined Unreimbursed Employee Expenses and ‘Certain’ miscellaneous deductions is $1,700. 2% of Shawn’s AGI is $1,000 (.02 X $50,000). Therefore, Shawn can deduct $700 – the amount by which his combined Unreimbursed Employee Expenses and ‘Certain’ Miscellaneous Deductions exceeds 2% of his AGI.
Without further ado, here are the ‘Certain’ Miscellaneous Deductions:
Appraisal fees for a casualty loss or charitable contribution. Self-explanatory. If you have something appraised to claim it as a tax deduction, you can deduct the fee paid for the appraisal.
Casualty and theft losses from property used in performing services as an employee. While casualty and theft losses are deductible elsewhere on Schedule A, it may be more beneficial to take the deduction here if it was property used in the production of income. It can be added to other ‘certain’ miscellaneous deductions (and unreimbursed employee expenses) to help propel you over the 2% threshold. There is also a $100 per incident subtraction if the loss is claimed on the regular casualty and loss form - form 4684.
Clerical help and office rent in caring for investments. If you have investments generating taxable income and you need to rent office space or pay for clerical help to manage them, you can deduct those expenses.
Credit or Debit Card Convenience Fees for Paying Your Tax Bill. Both the IRS and Virginia will charge you a ‘convenience fee’ for using your debit or credit card to pay a tax bill. That fee can be deducted from your taxes.
Depreciation on home computers used for investments. If your home computer is helping you earn taxable income, you can claim a depreciation expense for it as a ‘certain’ miscellaneous deduction.
Excess deductions (including administrative expenses) allowed a beneficiary on termination of an estate or trust. If an estate’s total deduction in it’s final year exceed its income, the beneficiaries can deduct the excess losses on their individual returns.
Fees to collect interest and dividends. If you pay a broker or similar agent to collect interest or stock dividends for you, it can be deducted here. Note, this does not include the fee to buy or sell securities. That fee is used to adjust your capital gain or loss.
Hobby expenses, but generally not more than hobby income. If you have a hobby that generates income you can deduct the expenses of that hobby up to the amount of income it generates.
Indirect miscellaneous deductions from pass-through entities. If you are a member of a partnership, S-corporation, or a non-publicly traded mutual fund, you can deduct any passed-through deductions as miscellaneous deductions subject to the 2% limit.
Investment fees and expenses. You can deduct investment, custodial, and trust administration fees you pay for managing your investments that produce taxable income.
Legal fees related to producing or collecting taxable income or getting tax advice. If your legal fees are for income from your business, real estate investments, or farm, then it is better to deduct those as business expenses on the appropriate Schedule C, E, or F. However, if you received legal tax advice on a personal matter, such as your divorce, you can deduct it here.
Loss on deposits in an insolvent or bankrupt financial institution. If your bank or credit union becomes insolvent or bankrupt, you can deduct any lost deposits here. (Losses insured by FDIC are not deductible.)
Loss on traditional IRAs or Roth IRAs, when all amounts have been distributed to you. If you take a full distribution from your IRA and the amount you have recovered is less than the amount you contributed, you can deduct the losses on Schedule A.
Repayments of income. Repayments of taxable income received in a previous year of up to $3,000 are deductible, but subject to the 2% limit.
Repayments of social security benefits. If your repayments to SS in a tax year exceed the benefits received, you can deduct the net repayment from your taxes.
Safe deposit box rental, except for storing jewelry and other personal effects. The rental of a safe deposit box is only tax deductible if you are using it to store documents related to the production of income.
Service charges on dividend reinvestment plans. If you are a subscriber to a dividend reinvestment plan, you can deduct the service charges you pay to the plan for holding shares, reinvesting dividends, and keeping your records.
Tax advice fees. Ahem….AHEM! (But if you receive this advice for your business, real estate investments, or farm, then is it more efficiently deducted on the appropriate Schedule C, E, or F.)
Trustee's fees for your IRA, if separately billed and paid. The ordinary and necessary fees you pay to an IRA trustee are deductible if they are billed separately. This would normally apply to someone using a self-directed IRA.
That’s a rather long list, but if you worked your way through it you may have noticed a theme. These deductions are nearly all related to the production of income. The tax code our government has implemented would like to generously provide you with a tax break if you are trying to produce additional taxable income. As long as you exceed the 2% of AGI threshold, of course.
That 2% of AGI threshold is why I rarely get excited about ‘certain’ miscellaneous deductions (or unreimbursed employee expenses). A common scenario I deal with each year is a tax client asking me if they can deduct the $60 they spent on investment fees. The technical answer is ‘yes’, but in reality that $60 is never going to get over the 2% of AGI threshold, so even though we can record it as a deduction on your tax return, you are not receiving any benefit for it.
When I do get excited is when the deductions have exceeded the 2% threshold. That’s when clients probably feel like they are getting the third degree from me as I start asking additional questions, trying to unearth some additional ‘certain’ miscellaneous deductions. Hopefully, I explain everything sufficiently, so nobody thinks I am just sticking my beak into their business!
I’ll finish this ponderous post as I frequently do – with a reminder that taxes can be complex and confusing. Whenever you have any questions you can contact me. Don’t overpay your taxes because you are afraid to ask for help!
19 November 2017
Schedule A of the individual income tax return is where taxpayers are invited to list their itemized deductions. The top part of the form contains the itemized deductions most Americans easily recognize; medical expenses, state and local taxes, deductible interest, and charitable contributions. Then come lines 21 – 27, mystically labeled: Certain Miscellaneous Deductions, and then there's line 28: Other Miscellaneous Deductions. Let’s take a closer look at those certain and other miscellaneous deductions. (And please forgive my cartoon - it amused me!)
The first thing you’re probably wondering is what’s the difference between certain miscellaneous deductions and other miscellaneous deductions? You probably suspect there is a reason the IRS calls them different things, but you don't know why. (You're right about that, of course.) The difference is that certain miscellaneous deductions must clear a 2% of AGI (adjusted gross income) threshold before they start to make a difference on your tax return. Lines 25-27 are actually for calculating your 2% of AGI threshold and seeing if you have enough cumulative certain miscellaneous deductions in excess of the 2% of AGI threshold.
Other miscellaneous deductions do not need to clear a 2% of AGI threshold before they start having an impact on taxes. Their effect is immediate. You just need to total your other miscellaneous expenses and record them on line 28.
There are fewer other (not subject to the 2% limitation) miscellaneous itemized deductions than certain miscellaneous itemized deductions. I will list the other (no 2% limit) miscellaneous deductions here and provide a brief explanation of each. I will do the same for the certain (subject to the 2% limitation) miscellaneous deductions in a subsequent article.
Other Miscellaneous Deductions (Deductions for which there is no 2% threshold or limit)
Amortizable premium on taxable bonds. That’s a mouthful, eh? Let me try to briefly explain. You pay a premium on a bond when you pay more for it than its face value. It may be possible for you to amortize that premium over the remaining life of the bond, and deduct it from your taxes. (I wouldn’t worry too much about this. If you are paying a premium for bonds, chances are good you are not preparing your own taxes!)
Casualty and theft losses from income-producing property. You can deduct casualty and theft losses for which you do not receive insurance compensation on your tax return. (We saw this quite a bit after Hurricane Matthew. Tax payers down in Houston and Florida are going to be dealing with this a lot this coming spring.) Normally this deduction is subject to the 2% rule. However, if the lost or damaged property was income producing property, then there is no 2% rule for the deduction.
Federal estate tax on income in respect of a decedent. Income in respect of a decedent is income that would have been paid to someone else, except they died. You were their beneficiary, so you received the income and included it on your tax return. When the deceased’s estate was made final that income was also included in the estate, so estate taxes were paid on it. In order to not double-tax that money the amount paid in estate taxes is deducted from your tax return. (So, if you inherit an IRA from someone whose estate paid estate taxes, you may not be liable to pay income taxes on 100% of the inherited IRA.)
Gambling losses up to the amount of gambling winnings. Gambling winnings are taxable income. You can deduct gambling losses, only up to the amount of your gambling winnings. For example, you went to Las Vegas in April and won $5,000. You went to Atlantic City in October and lost $12,000. You must claim the $5,000 of winnings as income, but you can deduct $5,000 as gambling losses on Schedule A. Even though you lost $12,000 you can only claim $5,000 of losses, because that was the extent of your winnings. (The IRS has serious record keeping requirements to be able to support claiming the gambling losses, so if you plan to claim gambling losses, start keeping really good records!)
Impairment-related work expenses of persons with disabilities. If you have expenses for special equipment or services to enable you to work, those expenses are deductible on your tax return. The example the IRS uses is their manual is that you have a job that requires reading, but you are blind. You hire the services of a reader to assist you at work. The expenses associated with the reader are deductible on your tax return.
Loss from other activities from Schedule K-1 (Form 1065-B), box 2. Form 1065 is a partnership return. Losses from partnerships are frequently, but not always, passive losses. Passive losses are reported in box 1 of the K-1, and are subject to passive loss limitations. Box 2 is for losses from other (non-passive) activities. These are not subjected to passive loss limitations, so they are deducted on Schedule A.
Losses from Ponzi-type investment schemes. If you were the victim of a Ponzi scheme you can deduct those losses on Schedule A of your tax return.
Repayments of more than $3,000 under a claim of right. As an example – you were paid $50,000 for a job in 2015. You claimed that money on your 2015 income tax return and paid taxes on it. You were subsequently sued because the person who hired you didn’t like the quality of the work you did. The court orders you to repay this person $30,000. Since you had already paid taxes on this money back when it was received you can deduct it from your taxes when you pay it back.
Unrecovered investment in an annuity. Another one that needs an example. Dan worked for Acme Company for 40 years. He participated in the Acme pension plan by contributing $1,000 each year toward his pension. When Dan receives his pension (annuity) the portion of the pension that was his own contribution to the plan is tax free. Dan receives pension payments from Acme, but when he dies he has only collected $2,000 of the $40,000 ($1,000 per year for 40 years) he had contributed. Acme must pay out the other $38,000 to Dan’s estate. This amount is then deducted on Dan’s final Schedule A as an unrecovered investment in an annuity.
Taxes can be complex and confusing. If you run into a situation that may have bearing on your taxes, it’s probably best to get a professional involved. You can always contact me with your questions or concerns.
12 November 2017
I told one of my sons I was writing about interest tracing and his response was, “I know both those words, but I don’t know what they mean when you put them together like that.” Like many things in the tax law, this is one of those concepts that doesn’t seem important to know until it applies to your personal tax situation. The strange thing is the rules for interest tracing apply to many more tax payers than you’d think, most just don’t realize it because they fall into special exceptions to the rules. Some of the recently proposed tax law changes could bring interest tracing to the surface for more tax payers – especially real estate investors - so I thought I’d get a head start on it.
Interest tracing rules involve the deductibility of loan interest expenses from your taxes. Some loan interest is deductible. The most commonly deducted loan interest is the mortgage interest from a tax payer’s primary residence. Some loan interest is not deductible. Interest payments on loans for your personal car fall into this non-deductible category. Many people are familiar with these common examples, which sets up the misconception that how you borrow the money determines its deductibility. Actually, it is (normally) just the opposite.
Under current tax law, how you spend the money is (nearly always) more important than how you borrowed the money. Most people believe the IRS cares more about the collateral used to secure the loan than how the money is spent. The bank (lender) cares a lot about collateral, but the IRS cares more about where the borrowed money ends up. The reason most people don’t know this is because a common way they typically borrow money and deduct loan interest (using their home as collateral) are the exceptions to the rule.
The Internal Revenue Code (Section 163) defines 5 types of interest:
• Qualified residence interest (mortgage interest on your residence and one vacation property)
• Business interest (money borrowed to support a business)
• Passive activity interest (interest on rental properties)
• Investment interest (money borrowed to purchase stocks or bonds, margin interest)
• Consumer interest (personal stuff – generally not deductible)
The General Rule
The general rule is the deductibility of the loan interest is a function of where the money was spent. As long as everything stays in its lane there is usually no confusion about this. For example, I borrowed money to purchase my residence, using the house as collateral for the loan. I deduct my qualified residence mortgage interest from my taxes as a personal deduction on Schedule A – simple and straightforward. Or…
I purchase a rental property with a loan using the rental property as collateral for the loan. I can then deduct the interest on that loan as a business expense on Schedule E of my tax return – also simple and straightforward.
Where things can get messy is when you ‘cross the streams’. Let’s look at some examples.
Example 1. I have a rental property worth $200,000 and my current mortgage on that property is $100,000. I refinance the property for $150,000. I use $100,000 of the new loan to pay the old loan. Then I take the extra $50,000 and buy a boat for my personal use. Can I deduct all the interest on the loan on my Schedule E?
No. When we trace the interest we find that 2/3 of the interest (interest on $100,000 of the $150,000 refinance loan) is used to finance the rental property (passive activity interest) and 1/3 was used for my boat (consumer interest). I can only deduct 2/3 of the interest on that loan on my schedule E. The $50,000 I spent on my boat has no connection to my rental property business and is not deductible on my taxes.
Example 2. Same as above. I owe $100,000 on my rental property and refinance for $150,000. I use the additional $50,000 to pay down the mortgage on my primary residence. I can deduct 2/3 of the interest on my Schedule E, but can I deduct the interest on the $50,000 I put into my personal residence?
No, you cannot. That $50,000 was not spent on the rental property, so it is not deductible on schedule E. While interest paid on a primary residence or second home can be deductible, the loan must be secured by the primary residence or a second home to be deductible on Schedule A. (This is the rare case where the IRS cares about collateral.)
Example 3. Same as above. I owe $100,000 on my rental property and refinance for $150,000. This time I put the extra $50,000 in my brokerage account and buy some mutual funds. Again, I can deduct 2/3 of the interest on my Schedule E, but can I deduct the interest on the $50,000 I invested in mutual funds?
The answer is ‘sort of’. Investment interest is deductible to the extent of investment income. If you had no investment income, you cannot deduct the investment interest. Unused investment interest deductions can be carried over to the next year’s return, so you’ll eventually get to use it (if your investments eventually make money), but it might not be this year. (The really bad news here is that if your investments lose money you suffer a double hardship of negative investment income and non-deductible interest. Investing in securities with borrowed money is not something I recommend.)
Example 4. I buy a new printer/scanner/fax machine for PIM Tax Services using a credit card. If I pay interest to the credit card company for that purchase is it deductible from my taxes?
Yes, this is a valid business expense. The interest for business-related purchases is deductible as a business expense on my Schedule C (or business return such as 1065, 1220S, or 1120.) The problem becomes proving the interest paid was for business expenses. This is nearly impossible if you put business and personal expenses on the same credit card, so keep them separate!
The Exception to Interest Tracing
Tax payers can borrow up to $100,000 in a home equity loan using their primary or second residence as collateral, spend it on anything they want, and deduct the interest on Schedule A as a personal deduction.
Example 5. I take out a home equity loan on my primary residence for $50,000 and buy a boat. Can I deduct the interest on the home equity loan from my taxes?
Yes, I can deduct this on schedule A as a personal itemized deduction.
Example 6. I take out a $200,000 home equity loan on my primary residence and buy a really big boat. Can I deduct the interest on the home equity loan on my taxes?
Partially. I can deduct the interest on up to $100,000 on a home equity loan. The other half is not deductible.
Example 7. I take out a $90,000 home equity loan on my primary residence and use it to purchase a rental property. Can I deduct the interest on the home equity loan?
Yes. Be careful here, though, because there are two legal ways to deduct this interest. You can deduct it on schedule A as a personal itemized deduction, or you can deduct it on Schedule E as a business deduction from your rental property. While either is legal, one may well prove to be more advantageous than the other. For example, if you have passive losses, but your adjusted gross income is too high to deduct passive losses, you may want to deduct the interest on Schedule A. In other situations it may be more advantageous to take the deduction on Schedule E as that will tend to lower your AGI, which can make you eligible for other tax benefits.
Taxes are definitely not easy, and interest tracing rules don’t make them any easier. If you have a situation where you aren’t sure if or how to deduct your interest expenses, please contact me. I’m just nerdy enough to enjoy an interest tracing discussion every now and again.
05 November 2017
The rigors of military life and the inherent lack of control over one’s personal schedule are well known to those of us who have lived them. You can’t always predict (or control) where you’ll be at a given time, or if you’ll have access to a computer or even your personal records and files. Fortunately, Uncle Sam has authorized the IRS to be a little lenient with military personnel when it comes to the tax filing deadlines. Some military personnel may even qualify for an extension to pay taxes owed – which is something the IRS doesn’t allow very often. Extending the tax deadlines could save you time and money - but you have to know them to take advantage of them.
In a Combat Zone
The greatest allowances are made for service members serving in a combat zone. The nature of modern warfare has filtered into the tax code such that contingency operations are also included as duty in a combat zone. Combat zones are declared by Executive Order, and the IRS is currently recognizing three named combat zones – The Afghanistan Area (which includes several countries quite far from Afghanistan, so be sure to check), the Kosovo Area, and the Arabian Peninsula.
If you are serving in a combat zone or contingency operation you are granted an extension of the deadline to file your return, pay any taxes owed, claim a refund, or take other actions (discussed later) with respect to your tax return. The extension starts the day you depart the combat zone and extends for 180 days plus any time you had left to file your return by the original due date after you were deployed. For example, if your tax return was due April 15 and you were deployed to a combat zone on March 31, your deadline extension would be 180 days plus 15 days (April 1 – April 15), or 195 days.
If you were injured in the combat zone your deadline extension starts the day you are released from the hospital. For example, Private Blazer was injured in a combat zone and evacuated to a military hospital in Germany. He was released from the hospital on July 15. His deadline extension clock starts ticking on the day he leaves the hospital (not the day he was evacuated from the combat zone).
What are some of those other actions (mentioned above) you might want to take impacting your taxes? How about:
What if You’re NOT in a Combat Zone?
If you are not serving in a combat zone you may still qualify for some deadline extensions. If you are stateside, you can use the automatic extension to file. You get this by timely filing form 4868 either on paper or electronically. If this form is received by the IRS prior to the original filing deadline you are granted a six-month extension TO FILE your tax return. This is only an extension to file the return. IT IS NOT AN EXTENSION TO PAY YOUR TAXES. Many people get that confused. Any taxes owed are to be paid when the extension is filed. If you owe and don’t pay when you request the extension, you will be subject to penalties and interest.
If you are serving outside the United States (and Puerto Rico) you can get an automatic 2-month extension to file without filing form 4868. When you file your tax return you must attach a statement showing you were serving in the military outside the United States on the date the tax return was due. If you owe taxes they should be paid by the original tax deadline. Tax payments received after the original tax deadline will be subject to interest.
If you are serving outside the United States (and Puerto Rico) and you need an extension to file greater than 2 months, you will need to file form 4868. This will give you an extension to file of 4 additional months. Form 4868 must be received by the IRS prior to the automatic 2-month extension expiring.
Not to be outdone, Virginia extensions are even more generous. If you qualify for an extension from the IRS due to service in a combat zone, the minimum extension period granted by Virginia is one year. “Members of the Armed Forces serving in a combat zone will receive either the same individual income tax filing and payment extensions as those granted to them by the IRS, plus an additional fifteen days, OR a one-year extension, whichever date is later.”
If you are not in a combat zone, Virginia will grant you an automatic six-month extension of time to file. There are no forms or applications for this six-month extension. Like the IRS, this is an extension to file. If you’re not in a combat zone and you owe Virginia taxes they must be paid by the original due date or you will be subject to penalties and interest.
North Carolina Residents
North Carolina follows the IRS with respect to the rules on extensions for military personnel serving in a combat zone. North Carolina is a bit more generous than the IRS when it comes to military personnel serving outside the United States (but not in a combat zone). Personnel serving outside the United States (and Puerto Rico) can receive an automatic four-month extension. You simply check the box that says, “Out of the Country” when you file your return. If you don’t pay your North Carolina taxes by the original due date they will accrue interest (but not penalties) through the extension period. If you need more than 4 months, you can request an additional 2 months by specifying your request on form D-410 by August 15.
Additional information on federal extensions can be found in IRS Publication 3, Armed Forces’ Tax Guide, which also contains a treasure trove of tax tips for military personnel. If you are in the military and prepare your own tax returns you should read all 37 pages of that guide annually. If you’ve got a complex tax situation, or you just want someone else to take care of your tax preparation – give me a call! That’s what I do!
29 October 2017
I was just a young lad when my grandmother told me, “If it sounds too good to be true, it probably is.” Apparently not everyone has access to such wisdom. Or maybe they do, but they don’t believe it extends to all professions or services. A taxpayer named Matthew Bell recently found out the hard way this age old expression most assuredly applies to paid tax preparers.
The IRS reviewed Mr. Bell’s 2014 tax return and assessed him an additional $18,011 in taxes and a $3,602 (20%) accuracy-related penalty. Mr. Bell conceded the $18,011 tax bill, but took the IRS to court over the $3,602 penalty. Here are the details:
In 2014 Mr. Bell worked as a sales rep for two different companies. He received two W-2s showing income totaling $127,858. Mr. Bell had used a tax preparer for several years, but his friend recommended Mr. Bell seek the assistance of a different tax preparer, Pam Williams. Mr. Bell sent Pam Williams his W-2s and received a reply from her later that day stating:
After taking a cursory glance at your W2’s, I will be able to get you a refund of about $20,000. My fee will be 20% so approximately $4,000. I would encourage you to see what your tax guy would be able to get you. If you like what I can do better and you’re willing to pay my fee then let me know and I will proceed. The way my fee works is since you’re a friend of Jeremy’s you pay me after you get the refund that I say I can get you.
Mr. Bell’s tax return was prepared and filed by Pam Williams. Although the return was not signed by Mr. Bell or the return preparer (Pam Williams), the IRS accepted it and processed a refund of $17,663 for Mr. Bell.
Upon review, the IRS discovered Mr. Bell’s return contained a Schedule C for a business called Sales Lead Generation for Marketing Companies, which had lost more than $54,000 in 2014. Additionally, Mr. Bell’s Schedule A claimed a deduction of nearly $30,000 for unreimbursed employee business expenses. The IRS issued a notice of deficiency disallowing $69,857 of these deductions, adjusted his return to show a tax owed of $18,011, and added the accuracy-related penalty of $3,602.
As previously stated, Mr. Bell did not dispute the disallowance of deductions or the $18,011 in tax due. He knew he didn’t have a business or unreimbursed employee expenses entitling him to take the massive deductions on his tax return. However, Mr. Bell believed he shouldn’t have to pay the 20% penalty because Pam Williams manufactured a fictitious business and a fraudulent tax return in his name and filed it without him seeing it. He argued he had acted reasonably, not negligently, by relying on a professional tax return preparer.
Long story short – Matthew Bell lost his case. He must pay the $3,602 accuracy-related penalty. Among other things the tax court made the following points in the summary judgment:
1. Return preparers who receive a fee based on the result of the tax return have an inherent conflict of interest, which essentially makes their advice unreliable. It was not reasonable for Mr. Bell to rely on the advice of a “promoter of a transaction”.
2. It was not reasonable for Mr. Bell to have never requested to see a copy of his tax return.
3. It was not reasonable for Mr. Bell to have never questioned how Pam Williams was able to get him such a large tax refund.
The court essentially told him that when Pam Williams promised something too good to be true, it was his duty as a taxpayer to make a sufficient effort to determine his true tax liability – something he never did. That makes him negligent and liable for the 20% penalty.
I look back to Pam Williams challenge/semi-taunt in her email reply to Mr. Bell. Knowing an honest preparer wouldn’t be able to come close to the refund she was promising she wrote, “I would encourage you to see what your tax guy would be able to get you.” Mr. Bell found out the hard way that one of the things his previous tax guy could get him was zero accuracy-related penalties to the tune of $3,602. Instead he chose to see what he wanted to see – a fat refund – and it ended up costing him in the end.
The Warning Signs of a Crooked Tax Preparer
Mr. Bell didn’t find the only tax preparer out there who is willing to lie on a tax return to get you a refund for which you aren’t truly eligible. How do you spot and avoid them? You need to realize that even if you pay someone to prepare your tax return, it is YOU who is ultimately responsible for the contents. Knowing that, it should be easy to apply some common sense to your relationship with your tax pro.
1. If it sounds too good to be true, it probably is. Ask around. Take your return to another professional for review.
2. How is your tax preparer getting paid? Are they getting a percentage of your refund? If so they are no longer a reliable advisor.
3. Make sure you review your return before it is filed. If a preparer files your return without reviewing it with you, notify the IRS that you do not recognize the return that was filed as yours.
4. When you review your return look for inflated expenses or dependents who aren’t yours to claim. Unscrupulous tax preparers will often pad returns with these things to inflate the refund.
5. Is your preparer encouraging you to have your refund deposited to the preparer’s bank account? Big. Red. Flag.
6. If you believe your tax preparer has engaged in misconduct or fraudulent activity, report them. The IRS has gone out of their way to make this easy for you.
I’m all about minimizing your tax bill and getting you the biggest refund possible, but it must be above board. The correct solution to your taxes is the one that is LAMA – legal and most advantageous. If it isn’t most advantageous you’re paying more taxes than necessary. If it isn’t legal you’re going to owe interest and penalties on top of your taxes. If you want to get the LAMA tax return, please contact me.
22 October 2017
In my mind the primary advantage of investing in residential rental properties (over starting some other type of business enterprise) are the tax benefits. As I talk to, and prepare tax returns for, real estate investors I find that most of them are aware there are tax benefits for real estate investing, but they don’t fully understand them. One of the most misunderstood concepts I run across concerns the suspension of passive losses. I am going to explain it here for those who want to learn. There are several related concepts at work, and my goal is to explain them sequentially.
Concept 1: Passive Income
The federal government has determined there are several ways to categorize income. Two of those classifications are active and passive. In lay terms, active income is income you work for. If you have a job where your earnings are reported on a W2, that is active income. If you start a business (like PIM Tax Services) you report your income on Schedule C, and that is also active income. In addition to state and federal income taxes, you must pay Social Security and Medicare taxes on active income.
If money is rolling in from a source and you’re (generally speaking) not working for it, then it is deemed passive income. Royalty payments for writing a book or song are passive income. Distributions from a trust or a limited partnership are passive income. Rents are passive income. Now – most of the landlords I know are working pretty dang hard to keep those rents coming in. That doesn’t change the fact that rents are considered passive income. Try not to take it personally. This is actually a good thing, because passive incomes are reported on Schedule E, and you do not have to pay Social Security or Medicare taxes on passive income. That is a significant tax benefit!
Concept 2: Passive Losses
As any savvy landlord knows, it’s not terribly difficult to have a rental property that has positive cash flow for the year, but shows a paper loss on their tax return due to the depreciation expense. Losses that come from passive income generating activities are known as passive losses. In general, passive losses can only be taken to the extent of passive income. In other words, if you have $5,000 of passive income in a tax year, you can only take up to $5,000 of passive losses that year. The rest of your passive losses are suspended and carried over to the next tax year (more on that later).
I say “In general” (above) because there is an exception made for passive losses coming from residential rental properties. If you materially participate in the business of renting your property, then you can deduct up to $25,000 of your passive losses against your other (active) income. That is a really good deal if you have a rental property with losses.
As with many things in our tax code, that good deal goes away if you earn too much money. If your MAGI is above $100,000, the maximum amount of passive losses that can be taken against active income is decreased $1 for every $2 your MAGI is above $100K. (i.e. if your MAGI is $110,000, the maximum passive loss you can claim against active income is reduced by $5,000 to $20,000.) By the time you reach an MAGI of $150,000 your ability to claim passive losses against active income this tax year are gone, and all your passive losses are suspended.
Concept 3: Suspended Passive Losses
Finally, we arrive at my point! Note the terminology in use – SUSPENDED passive losses. We don’t call them forfeited passive losses. They are not forfeited, they are suspended. They can come back later. Tom Brady got suspended from the NFL for 4 games. He didn’t get kicked out of the league, he just had to take a time out. Then he came back, went to work, and won the Super Bowl. Your suspended passive losses can also bounce back.
I stress the word suspended because I frequently see landlords lament they are 'not getting any tax benefit from their rental properties' because they make too much money to claim their passive losses. They lament their lost deduction. What they really mean is they can’t claim their passive losses and get the tax benefits THIS YEAR. They did not lose anything! Those passive losses are suspended and carried forward into the future.
Sadly, I also see some tax preparers who don’t understand suspended passive losses. I’ve seen tax preparers not claim all the rental property expenses on a tax return because “the taxpayer can’t claim them anyway”. Not only is that answer ignorant, but it also demonstrates a shockingly cavalier attitude about the client’s money. The taxpayer CAN claim those losses in the future, and it is the job of a tax professional to make sure they are properly recorded.
Concept 4: Using Your Suspended Passive Losses
There are two times you tap into those suspended passive losses and put them to work for you. The first is when you have some additional passive income. Let’s say you buy another rental property and it is cash flowing very nicely. At the end of the year it is showing a profit on your tax return. Instead of paying income taxes on that profit you go into your reservoir of suspended passive losses and reduce your income from that new property. You can reduce the income all the way down to $0 if you have enough suspended passive losses to count against the new source of passive income.
The other time you can use your suspended passive losses is when you sell the property. In the year you sell the property both the MAGI limitation and the $25,000 limitation are thrown out the window. You can take all your passive losses for a property in the year you sell. That can be quite a tax break!
For example, the Smiths have a rental property that has been showing passive losses of $12,000 per year. The Smiths have an MAGI of $200,000 from active sources, so all their passive losses are suspended. After 9 years they elect to sell the property. They have accumulated $108,000 of suspended passive losses. In the year they sell the property all $108,000 of the suspended losses (plus any losses from the current year) are deducted from their income. That is going to have a significant impact on their taxes in the year of the sale!
If you don’t remember anything else from this article, remember this – you can still get tax benefits from real estate investing even if you have a high income. You may have to wait longer to realize it, but the benefits are still there. If you have any questions about this, please contact me.
15 October 2017
A very nice couple I will refer to as 'The Creases' came to me earlier this year with a request to review their tax returns from 2014 – 2016. They were clearly frustrated and anxious about their taxes. They had confidently prepared their own tax returns for many years, but their taxes had risen so dramatically the past few years they were no longer certain they were preparing them correctly.They even wondered aloud if they were perceiving reality correctly. "Maybe we're crazy, but this just doesn't seem right."
My mission was two-fold – find out if they were filing correctly, and come up with a strategy to reduce their taxes. A challenge I eagerly accepted.
I found a few errors on their returns and we amended them for a refund. It’s always nice to get more of your money back from the government, but the errors I discovered were only a small fraction of their overall tax bill. These errors were not responsible for the large increase in their taxes over the past few years. Even after amending their returns their tax bill had increased considerably from 2014 to 2016. With both their 2014 and 2016 tax returns open on my computer monitor at the same time, I could clearly see what was going on with their tax situation. I am going to use their tax returns to show you what I mean by the crease.
The crease is my term for the point – usually between around $100K and $140K of income for married couples filing jointly – where your taxes are increasing at a faster rate than your income. You are making progress in your career, your pay goes up (which is good!), but your taxes go up even faster (which can leave you feeling frustrated and anxious like the Creases).
Let’s look at the Crease’s numbers (after they were amended) to see how this works. These are real numbers from real clients living right here in Virginia Beach. I screenshot and chipped their 2016 numbers and laid them next to their 2014 numbers.
If you’re a tax geek like me you love that picture, but I think it probably looks a bit overwhelming to most people. To make things easier to digest I pulled the important information off their tax returns and put them into a table to ‘declutter’ the numbers and make them easier to follow. The 2014 numbers are in blue. The 2016 numbers are in red.
Let’s start with the top line of data on my table. It is line 38 from their tax returns, a.k.a. their adjusted gross income (AGI). In 2014 the Creases’ AGI was $95,042. By 2016 their AGI had risen to $162,440. That’s a rise of 70.9% - good for them!
Now let’s look at the bottom line on my table. That is line 63 from their tax returns, their total federal income tax burden for the year. In 2014 it was $5,391. In 2016 it had risen to $22,501. That’s an increase of 317.4%. (You read that correctly - three hundred seventeen point four percent.) Their income increase of 70.9% resulted in an income tax increase of 317.4%.
You’re not crazy, rapid tax increases are really happening!
Why Do Taxes Increase So Quickly In 'The Crease'?
Let's dig a little deeper into the Creases' numbers. If you look at line 40 and line 42 you can see the Creases didn’t lose deductions or exemptions from 2014 to 2016. In fact, the amount of income they could deduct and exempt increased a little bit over that span. The problem is they can’t get much more work out of their deductions and exemptions. It's all applied to the 2014 numbers and it doesn't impact the additional income they had in 2016. Nearly all that additional 2016 income passed straight through to taxable income (line 43). Their AGI went up 70.9% from 2014 to 2016, but their taxable income (line 43) more than doubled.
Next comes the impact of our progressive tax system. In 2014 the Creases' top marginal rate was 15%. The additional taxable income they had in 2016 was nearly all taxed at a higher rate – 25%. Not only is ALL the new money taxed, but it is taxed more aggressively by the federal government.
Finally, let’s look at line 52. In 2014 the Creases had two young children, which qualified them for the Child Tax Credit of $2,000 ($1,000 per child). This tax credit directly reduced their taxes owed for 2014. In 2016 the Creases still had two young children. However, the Child Tax Credit is subject to a maximum AGI threshhold and their increase in AGI made them ineligible to receive it. No $2,000 reduction to their tax bill in 2016.
What To Do About It.
If you recall, the Creases also tasked me with finding a way to reduce their tax bill. I did, and I want to show you the results of my favorite easy-to-use tax-reducing strategy: increasing retirement plan contributions. Mr. and Mrs. Crease were both contributing to their respective 401K plans at work. He was saving $4K and she was saving $5K. The maximum allowable contribution is $18K each, so they had a combined $27K ($14K for him plus $13K for her) before they were both making maximum allowable contributions. Below is a table of the projected 2017 results if the Creases make no changes from 2016 other than to make maximum contributions to their 401K plans.
Look at the AGI on line 38, the top line of the table. 401K contributions are not reported to the IRS as income. (Neither are TSP or 403B contributions.) The Creases earned the same amount in both years, but they only have to report $135,440 in 2017 as compared to $162,440 in 2016.
I left their deductions and exemptions unchanged from 2016 to my 2017 projection. When we get to line 43 you can easily see the $27,000 additional contributed to their 401Ks comes directly off their taxable income. Lower taxable income equals lower taxes.
On top of that, their lower AGI will result in allowing them to reclaim $700 of their Child Tax Credit (line 52), reducing their total tax bill (line 63) from $22,501 to $14,986. That’s $7,515 in federal income taxes saved. While my table doesn’t show it, they will also save $1,552 on their Virginia taxes. Combined that is a tax bill lowered by $9,067.
I know…stuffing another $27,000 into your retirement accounts is a lot of money – but let’s look at these numbers a couple of ways to help you frame the advantages:
You put $27,000 into your 401K, but the government gave you back $9,067 to do it, so it really only cost you $17,933 to save $27,000 for your retirement.
You invested $27,000 and the government gave you back $9,067 to do it. That is an immediate, guaranteed 33.58% return on your investment. If you don’t like that 1-year ROI, don’t ever let me hear you complaining about CD rates. That’s a rare and fantastic deal!
The Creases liked my strategy and have implemented it. Their relatively quick income increases from 2014 to 2016 made these large contributions to their retirement plans easier for them to implement than most. Even if you aren't in a position to make maximum contributions to your retirement account(s), any increases you make will improve both your tax situation and your retirement planning.
OK, that’s enough of me nerding out on taxes and numbers for one post. Just remember, if you feel like your taxes are rising faster than your income, they probably are. ‘The Crease’ is real. There are also some things you can do to reduce your tax bill. If you’d like to discuss your tax strategy, come see me.
Paul D. Allen is a proud member of the National Association of Enrolled Agents, the National Association of Tax Professionals the Financial Planning Association of Hampton Roads, the National Association of Personal Financial Advisors (NAPFA), and The Tidewater Real Estate Investors Group. You can read more about Paul's background here.
Bought some software and then started having second thoughts? Stuck on a particular issue? Give me a call and ask about a consultation. I might be able to get you back on the path to finishing your own return.