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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
Readers should be aware the tax law signed by the President on 22 December 2017 changed the deductibility of home equity loans.
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.
08 October 2017
There are several significant differences between investing in real estate and investing in stocks, bonds, or mutual funds. One of those differences is the amount of hands-on, direct involvement real estate investing requires. While I advocate passive investing in traditional securities (i.e. stocks, bonds, mutual funds, and etfs), it would be quite costly to be passive about your real estate portfolio; possibly even disastrous. Fortunately, this is not a problem for most of the real estate investors I meet. They seem to like the direct involvement in their real estate investments. I suspect having the ability to exert a high level of control over their portfolios is what drew them into real estate investing in the first place.
Taxes is another area that differentiates real estate investing from securities investing. There are numerous ways in which the tax code gives preferential treatment to income from real estate over income from other sources. I'm not going to try to describe all those ways to you, but let me give you one example.
Dave is single and has a home business building furniture. After taking all his expenses and exemptions into consideration, Dave has $50,000 of taxable income. Using 2016 rates, Dave will owe the IRS $15,731 in taxes for that $50,000 of taxable income.
Debbie is single and owns residential rental properties. After taking all her expenses and exemptions into consideration, Debbie also has $50,000 of taxable income. Using 2016 rates, Debbie will owe the IRS $8,271 in taxes for her $50,000 of taxable income.
Same amount of taxable income, HUGE difference in the total tax bill. The reason for the big difference here is that Dave’s income is subject to self-employment taxes (Social Security and Medicare), but Debbie’s rental income is not. For that reason alone Debbie has $7,460 more dollars to save, invest, travel, whatever. It's hers to do with as she pleases.
The point of this article is not to illustrate all the tax advantages of real estate investing.There are entire books written on that topic. The point I am hoping to make is there are many ways in which the tax code provides for preferential treatment of real estate investing, and taking full advantage of that preferential treatment can make a significant impact on your bottom line as a real estate investor.
I would also like to impress upon real estate investors the cost-effectiveness of having a professional help you with your taxes. I find it difficult to convince many real estate investors they can save money by spending money. They tend to be rugged individualists and hardcore do-it-yourselfers. One of the things they seem to like about real estate investing is their ability to control costs. They see paying a tax professional as a cost. They don’t see it as an investment – but it is.
I offer free reviews of prior year tax returns. Every year I have landlords bring me the tax returns they personally prepared for their own real estate investments. As of this writing I have found errors on 100% of those returns I have reviewed. All of them. Every single one. In all but one case I recommended filing an amended return that resulted in money being refunded to the taxpayer. We amended 3 years of returns for one landlord who received just under $10,000 back from the IRS. He was not unhappy to pay my fee, and did not see it as a burdensome expense.
Sadly, many professional tax preparers also make errors in the tax returns of real estate investors. I had a new client this year who recently moved to Virginia Beach from Florida. He had a CPA firm preparing his returns in past years, but he likes to sit across the table from his tax preparer, so he brought his 2016 return to me. He also brought me his 2015 return, and while reviewing it I noticed the previous preparer had not taken several large and legitimate expenses for his rental property in 2015. When I asked the taxpayer about it he said the CPA firm had told him not to worry about it because he made too much money from his day job to claim the losses anyway. Without going into the details of suspended losses for passive activities rules, this thinking by his former preparer is very wrong. This gross misunderstanding was going to cost this taxpayer north of $7,000 at some point in the future, so we amended his prior year return to make sure all his suspended losses were captured for future use.
Real estate investing is somewhat of a niche specialty within the tax preparation business. The rules for real estate don’t always fit the standard rules. As a result, many tax professionals are not familiar with them. This can lead to costly mistakes for the taxpayer who is a real estate investor.
One last point to make about real estate investing and taxes - plan ahead. Once you’ve taken an action with an investment property – bought, sold, repaired, placed in service, flipped, refinanced, etc. – the tax consequences of that action are pretty much fixed. You can’t sell a property, find out what the tax consequences of the sale are, and then undo them because you don’t like them. It does not work that way. You need to plan. You need to have a tax strategy in place before you take action.
The easiest way to put a tax strategy in place is to work with a tax strategist. Someone who can help you integrate taxes into your overall investment strategy. Be particular about the tax professional you choose. Your tax strategist should have two primary qualities. 1) You want someone who is knowledgeable about the nuances of the tax code with respect to real estate investing. 2) You want someone who will sit down with you and discuss your investing goals. The more familiar someone is with you and your investment strategy, the better able they will be to help you create a tax strategy that leads to the fulfillment of your investing objectives.
A significant portion of the money to be made in real estate investing comes from the tax advantages built into the Internal Revenue Code. If you are a real estate investor, or thinking of becoming one, make sure you are taking full advantage of tax breaks available to you. If you would like to further discuss your real estate investments, schedule a free consultation.
01 October 2017
IRS Form 1040 (the individual tax return) can be monstrous to understand if you try to take it in all at once. That’s how most people do it, though. Once a year they look at their entire tax return, get confused and frustrated, and then ignore it for another year.
It’s important for your overall financial well-being to understand your taxes, so let’s look at just a piece of the tax return today. A small bite we can comprehend in one sitting. Specifically, we are looking at the section at the beginning of the form where all your income is listed. Even more specifically, we are going to look at the income line items that are split into segment a and segment b.
If you use tax software to prepare your taxes you might not have noticed some of the income categories are split into two parts. It is much more apparent if you look at the form 1040 income section.
• Line 8a is for taxable interest and line 8b is for tax-exempt interest.
• Line 9a is for ordinary dividends and line 9b is for qualified dividends.
• Line 15a is for IRA distributions and line 15b is for the taxable amount of the IRA distribution.
• Line 16a is for pensions and annuities, and line 16b is for the taxable portion of the distribution.
• Line 20a is for your Social Security benefits received, and line 20b is for the taxable amount of your Social Security benefits.
If It’s Tax-Exempt, Why Do I have to List It on My Tax Return?
The answer to that (very reasonable) question varies with the source of the income. Get comfortable while I explain it to you.
Line 8 Interest Income. Interest income typically comes from the interest on your bank accounts, or from owning bonds. Some interest, such as the interest on municipal bonds (bonds issued by city and state governments to raise revenue), is not taxed by the federal government. If you have interest income over $10 you should be issued a 1099-INT from the institution holding your account(s). The 1099-INT will tell you how much of your interest is taxable and how much in tax-exempt. The reason you must report tax-exempt interest is it might influence your tax situation, even if it isn’t being taxed directly. (Such as when figuring how much of your Social Security is taxable. More on that later.)
Line 9 Dividend Income. Dividends are paid by stocks and mutual funds. Virtually all dividends are known as Ordinary dividends. This amount goes on line 9a. Dividends paid more than 60 days before or after the stock was purchased are known as Qualified dividends. Qualified dividends receive preferential tax treatment – they are taxed at a lower rate than ordinary income. You are being rewarded for assuming the risk of holding the stock for at least 60 days and not just buying right before the dividend is paid and selling right after it is paid. Qualified dividends are a subset of ordinary dividends. The portion of your dividends that are not qualified will be taxed at ordinary tax rates.
Line 15 IRA Distributions. When you take money out of your IRA it is known as a distribution. Your distribution may or may not be taxable. It is usually, but not always, easy to figure out how much of your IRA distribution is taxable. If it came from a Roth IRA, then none of it is taxable. If it came from a traditional IRA where all the contributions were tax deductible, then all the distribution is taxable. Where it gets tricky is when a taxpayer has made contributions to a traditional IRA and did not receive a tax deduction for it. In that case the withdrawal of the contribution is not taxed, but the withdrawal of the earnings is taxable. If you made non-deductible contributions to an IRA you should have been tracking these contributions on form 8606. Dig up your last form 8606 and it should tell you your total IRA contributions, and how much was deducted when the contributions were made.
Line 16 Pensions and Annuities. This is similar to the situation for IRA distributions. If you are receiving a pension or annuity that you paid for, then the portion of your pension that represents your contribution is not taxable. The portion you did not pay for is taxable. My Navy pension is 100% taxable because I did not pay into a pension fund to earn that pension. Federal civilian employees earning a pension under the Federal Employee Retirement System (FERS) are paying into the pension fund. When they receive a payment from the pension fund the portion of that payment that is a return of their contribution is not taxable.
Line 20 Social Security Benefits. One of the most difficult questions clients ask me is how the taxable portion of their Social Security benefits is calculated. There is no simple way to explain it. There are 4 different worksheets used to figure the taxable portion of your Social Security, and you use the one specific to your situation. The shortest answer is that the more income you have from NON-Social Security sources, the more your Social Security benefits will be taxed.
The Reader’s Digest condensed version goes like this: For 2016, if the total of half your Social Security plus all your other income was greater than $34,000 ($44,000 if married filing jointly), then 85% of your Social Security is exposed to tax. All your other income includes your tax-exempt interest. So even though your tax-exempt interest is not directly taxable, it can make more of your Social Security taxable (which is why you have to report your tax-exempt interest, as explained above).
If your only source of income is Social Security, then your Social Security benefits will not be taxed. Unless you are married filing separately and you lived with your spouse for even 1 day. In that case 85% of your Social Security is taxable regardless of your other sources of income. (I think I mentioned that figuring the taxable portion of social security is frightfully complex.)
Congratulations for making it through that article. It was a bit of a slog to write, so it was undoubtedly a slog to read as well. Your commitment to learning about taxes should be rewarded. The first person to tell me they read this entire article will get 50% off their next tax preparation bill at PIM Tax Services. If you have questions, please contact me.
26 September 2017
Note:A tax conference and a vacation interrupted my blogging for a few weeks. Happy to be getting back on track. The conference gave me dozens of article ideas!
Everyone I know has had a bill they couldn’t pay at some point during their life. Sometimes it’s due to a work interruption. Sometimes it’s a wake-up call to get a grip on your budget. Sometimes it’s caused by circumstances beyond your control. Whatever the reason, most of us have ‘been there and done that’.
When Tade and I were just starting out together it seemed like we never had enough money. We were living pretty well while we were dating, but then she quit her good-paying job to follow this sailor around the country and we got behind in a hurry. There were many months when I had to decide which of our creditors wasn’t going to get paid. I never pre-coordinated any of this with them, of course. I was too proud and embarrassed to tell them they weren’t getting paid. I would just not send them a payment and then catch it up whenever I could. It isn’t the best way to approach this situation, but it worked out OK.
This worked because my creditors were credit card companies and utilities. Can you handle a tax debt in this same manner – bobbing and weaving, dodging bills some months and sending some money the next? What do you do when it’s the IRS you can’t pay? You figure your taxes for the year and you discover you owe an amount you cannot pay? Do you treat the IRS like any other creditor – just sort of ignore and avoid them until you can afford to make it up later?
The IRS is NOT just any creditor. The IRS is the most potent creditor on the planet. Congress has granted them collection superpowers. Your credit card company has to prove to a judge that you owe them money before they can put a lien on your property. The IRS does not. If the IRS says you owe them money, they are presumed to be correct. They can levy your bank account, garnish your wages, and put a lien on your property without going through the courts. Fortunately, it is easy to avoid these harsh measures by staying as compliant with the tax laws as possible, even if you can’t afford to pay your entire tax bill.
What to Do If You Can’t Pay Your Taxes
1. File your tax return. The IRS can charge penalties for failing to file your tax return, and those penalties are initially TEN TIMES HIGHER than the penalties for failing to pay your taxes. 5% of the tax owed per month up to 25% of the total tax can be charged for failing to file your tax return. Failing to pay your taxes is only a 0.5% penalty per month. Trying to hide from the IRS by avoiding filing your tax return will end up costing you more in the long run.
2. Pay as much as you can at the time you file. I see news stories from time to time about the IRS confiscating someone’s home or bank account, shuttering their business, or some other draconian method of enforcing a tax bill. The press does a good job of making the IRS look like a bunch of power-drunk cowboys, but this is rarely the case. The IRS will work with you to get your tax bill paid with the minimum disruption possible to your life, but you have to make some effort to cooperate. Paying part of your tax bill when you file demonstrates your intent to be cooperative.
3. Apply for an installment agreement. The IRS can authorize a payment plan (installment agreement) for paying your tax bill. There is an application fee and you will be charged interest until the balance is paid in full, but it allows the taxpayer some breathing space to pay down the tax bill over time. The application fee varies by how you file the application and how you intend to pay. Paper applications cost $225, or $107 if you agree to make the payments via direct debit of your bank account. Online applications are $149, but only $31 if you agree to pay via direct debit. If your tax bill is over $50,000 you cannot apply online. Your request for an installment agreement cannot be denied if:
a. You owe less than $10,000
b. You propose to pay it back within 3 years
c. You are not delinquent on any other tax year
d. You do not already have an installment agreement for another tax year
e. All your tax returns have been filed
4. Make your payments. If you default on the installment plan the IRS can elect to call the entire debt. If you are having difficulty making the payments you may be able to restructure your installment agreement to reduce the amount of your monthly payments. The IRS charges $89 for restructuring an installment agreement. (They charge the same amount to reinstate and agreement if you let it lapse, so you may as well as for restructuring.)
5. Offer in Compromise. The IRS must collect taxes owed within ten years from the time the tax return assessing the tax is filed. If there is no way for you to be able to pay your tax bill within this time frame you can request an offer in compromise. An offer in compromise is a negotiation between you and the IRS to reduce the tax you owe to an amount you can afford to pay. Essentially, you present the IRS with an amount you are able to pay, and they will determine whether to accept or reject your offer. The IRS will evaluate your ability to pay by analyzing your financial status; your assets, income, and expenses. If the amount you offer to pay represents the most the IRS believes they can collect from you within a reasonable time period they can approve your offer.
Death and taxes are certain. If you can’t pay your tax bill don’t try to hide from the IRS. Be proactive and engage with the IRS. Things will often go better for you if you do. If that seems too stressful or too much bother, hire someone to represent you. You will most likely be happy you did. If you have any questions, please contact me.
19 August 2017
Active duty military members and reservists from the same branch of the service look and act similarly. They wear the same uniforms, attend the same schools, get the same basic training, have the same grooming standards, etc. It can be hard to tell them apart.
Until you gave me their tax returns. I could probably tell them apart in just a few seconds by looking at their tax returns. Active duty and reserve military personnel are treated very differently by some aspects of our tax code. Nowhere is this more pronounced than in the tax treatment of travel related expenses.
I was active duty Navy for nearly 24 years, and during that time I never paid for any of the travel associated with my job. From my first day until my retirement day, if the Navy wanted to send me somewhere they paid for my tickets and lodging and gave me money for meals. I never even had to think twice about it. Little did I know my brothers and sisters in the reserves did not always have it so good. When they need to travel for training or drill they often must pay for that travel out of their own pockets.
That puts reservists in the position of having unreimbursed employee business expenses. Those expenses are deductible on their tax return, but there are two pre-conditions associated with deducting employee-related business expenses:
1. You must itemize your deductions in order to claim them
2. The unreimbursed employee business expenses must exceed 2% of your adjusted gross income (AGI) before they start to count
Those conditions make difficult obstacles for most reservists to be able to claim the tax deduction for their travel expenses. Many young reservists don’t yet own a home, so it is more advantageous to them to claim the standard deduction than to itemize their deductions. Conversely, many older reservists have climbed the private sector ladder to decent salaries, meaning the 2% over adjusted gross income threshold would have them paying quite a lot out of pocket for their travel before receiving any benefits from deducting their unreimbursed employee business expenses.
That’s Why There Are Separate Rules for Military Reservists
Fortunately, Congress carved out a loophole for reservists to bypass the pre-conditions mentioned above. Travel expenses for reservists can take a ‘shortcut’ to the front of the form 1040 individual income tax return, allowing reservists to receive a tax benefit for their travel related expenses without having to itemize or worry about that 2% of AGI threshold.
There is one little hitch, though – that ‘shortcut’ can only be used for travel that takes you more than 100 miles from your home.
There’s a paragraph in IRS Pub 3 on page 9 that explains how this shortcut works. It is so confusingly worded I was tempted to reprint it here just for comedic value. I’m a tax professional and I had to read it 4 times before I understood it. Let me attempt to explain it in terms I hope will be easier to understand.
If you are a reservist, you report ALL your unreimbursed travel expenses (those go on form 2106) just like everyone else. However, if you had a mix of short (less than 100 miles) travel and long (more than 100 miles) you must be able to figure these separately. You add all your travel expenses together on form 2106, then the expenses for travel over 100 miles are carried over to form 1040 line 24. The expenses for the short travel are carried to Schedule A.
Schedule A is for listing your itemized deductions. If you do not itemize your deductions you won’t have a schedule A, and your travel expenses for trips less than 100 miles are not going to get deducted even if they are clearly related to your employment as a reservist.
If you do itemize, the total of your unreimbursed employee business expenses will need to exceed 2% of your adjusted gross income before they start to count as deductions.
The portion of your reservist travel expenses that moved straight to line 24 on your form 1040 goes to work right away. That’s the section of the tax return for special deductions known as adjustments. Like deductions, adjustments reduce the amount of your income exposed to taxation. Adjustments also have two big advantages over regular deductions:
1. You can use them even if you use the standard deduction. You don’t need to itemize your deductions in order to use an adjustment.
2. They are deducted from income before your AGI is calculated. This is an important benefit because eligibility for many other deductions and tax credits are based on your AGI. An adjustment can help make you eligible for additional tax breaks.
A Real Example From My Practice
“John and Rita” were new clients of mine this year. They moved to Virginia Beach from the DC area during 2016. John is a Navy reservist who drills with a reserve unit down in Texas. They brought their 2015 tax return with them when they dropped off their 2016 tax documents. While reviewing their 2015 return I noticed that all of John’s travel was documented on form 2106, but it was all carried to Schedule A as an itemized deduction. None of it made it to the front of their form 1040. After talking to John and Rita I determined all $6,000 of John’s travel expenses were related to travel more than 100 miles from home, and qualified for the special reservist rules.
John and Rita’s 2015 AGI was about $145,000, so 2% of their AGI was $2,900. Moving the reservist travel expenses to their correct location on the tax form lowered their 2015 taxable income by $2,900. As they were in the 25% top marginal rate, this lowered their tax bill by $725. But wait, there’s more!
John and Rita had a son in college in 2015. They claimed the American Opportunity Tax Credit, but their AGI at $145,000 reduced the amount of the credit they could claim. By moving the $6,000 in travel expenses to the front of form 1040 we reduced their AGI from $145,000 to $139,000. This increased the value of their American Opportunity Credit by more than $500. When combined with the $725 in lower taxes from the reduced taxable income, John and Rita shaved nearly $1,250 off their 2015 taxes by using the full value of the reservist travel expense deduction. We filed an amended 2015 tax return and the IRS sent John and Rita a refund.
If you are a reservist make sure you are getting the proper tax deduction for your travel, and make doubly sure your expenses for reservist-related travel over 100 miles are showing up on the front page of your form 1040. It can make a significant difference when figuring your tax bill.
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.