Welcome to the Tax Blog

News, information, and opinions about:

  • Federal, State, and Virginia Beach Taxes
  • The Tax Preparation Business
  • Tax Planning

If you have a question or comment, please drop me a line. Paul @ PIM Tax.

13 August 2017

Virginia beach tax preparation 401K loansI am a big fan of employer-sponsored retirement plans (401K, 403B, TSP, etc.). They are a great way to save for your retirement. You can take a current year tax break for the money you save (traditional) or you can take your tax break in the future (Roth). Whether you should choose traditional or Roth is usually a combination of personal preference and your current circumstances, but either provides advantages over saving in a non-qualified account.

Most employer-sponsored retirement plans have some provision for the employee to take out a loan. The theory is you are in a financial bind and need temporary access to your money. You borrow it from your retirement account and then pay it back over a period of time – typically with a payroll deduction. I am not such a big fan of these loans. I suppose it is good to be able to access the money in the event of an emergency, but all too often I find people are using them for situations that are not emergencies. This degrades the account’s primary purpose of retirement savings. Even though the amount borrowed must be paid back, money taken from the account as a loan loses some very valuable compound growth potential. Borrowing the money now nearly guarantees having less money in retirement.

The rules on 401K loans are also very strict. You could even call them draconian. (I have Game of Thrones fever as I am writing this!) 401K loans are governed by both the Department of Labor and the IRS, and neither is very forgiving as government agencies go. The money borrowed has to be repaid in relatively equal increments over the period of the loan. If a payment is missed it must be made up within a fixed “cure” period. If just one loan payment falls outside the cure period the entire loan is considered to be in default and is no longer a loan. It is now a distribution (withdrawal) from the retirement account – and all applicable taxes and penalties will apply.

If you have taken, or are considering taking, a loan against your 401K, you need to be very careful. You will be held accountable for the loan payments even if it isn’t your fault the loan payment isn’t made. Just ask Mrs. F from New York.

Mrs. F and Her 401K Loan

Mrs. F worked for 'Company G'. She was a participant in Company G’s 401K plan, which was administered by 'MOA'. In 2012 Mrs. F arranged for 12 weeks of maternity leave from Company G. She had enough leave time accrued to be paid for the first 5 weeks, but the last 7 weeks would be without pay. Just prior to her maternity leave she also took a loan from her 401K. She arranged to repay the loan by having money withheld from her Company G paychecks over the period of the loan.

Mrs. F went on maternity leave. Someone in Company G payroll neglected to set up the withholding for the 401K loan repayment from Mrs. F’s pay. While on leave Mrs. F received her paychecks via direct deposit, but did not notice the loan repayment amount was NOT being withheld. She did not notice the loan payments were not being withheld until after she returned to work following her maternity leave. At that time she made a triple-sized payment followed by several over-sized payments until the amount repaid was caught up to the amount that should have been withheld from the beginning. Once caught up she continued repaying the loan through payroll withholding per the loan agreement.

It was too late. When she missed the initial payment, and did not make it up during the cure period, MOA declared the loan in default. Unfortunately, they didn't tell Mrs. F. In January 2012, they issued Mrs. F a 1099-R, but didn’t mail it to her. They posted an electronic version to their website. Mrs. F did not routinely check the MOA website, so she was unaware the 1099-R had been issued. In fact, she continued to repay the loan into 2014 – and MOA continued to receive the payments without telling her the loan had defaulted and she was not required to repay it.

In 2014 the IRS notified Mrs. F she had not declared all her income from 2012. They charged her taxes on the amount of the defaulted loan from her 401K, a 10% penalty for early withdrawal, interest on the above, and a 20% accuracy penalty for negligence. Mrs. F petitioned the US Tax Court for relief.

Things did not go well for Mrs. F at Tax Court. The judge ruled it was her responsibility to ensure the payments were made before the cure period expired, and she did not. Therefore the tax, 10% penalty, and interest must be paid. It didn’t matter that Company G screwed up on the withholding for the loan repayment. It didn’t matter that MOA never made sure she knew her loan had defaulted. It was her responsibility and she did not follow through.

Fortunately for Mrs. F, the judge found there was a reasonable basis for Mrs. F to believe she did not owe tax on her loan. Therefore, he removed the 20% accuracy-related penalty for negligence.

In my opinion Mrs. F got a raw deal. She was at home birthing a baby. I think it is a reasonable expectation on her part to assume her employer is going to get the pay withholding correct and the 401K administrator would make a little effort to ensure she knew the payment was late. It was their negligence, not hers, that caused this situation. Perhaps she can get some restitution from Company G or MOA via other legal channels.

But the rest of us should learn a valuable lesson from Mrs. F’s experience. 401K loans come with tax rules attached.The IRS is unforgiving. Tax rules are tax rules – and it is the responsibility of every taxpayer to ensure they are compliant with those rules. Failure to do so can have expensive consequences.

If you have questions about taking a 401K loan, please contact me.


Virginia beach tax breaks section121 exclusion

06 August 2017

The Section 121 Exclusion is one of the biggest, best, most widely-used tax breaks in the Internal Revenue Code. It is the exclusion of capital gains taxes from the sale of a primary residence. The Department of Treasury estimates this tax break will save US Taxpayers more than $66 Billion in taxes in 2017.

Whenever we are discussing taxes the government is involved. So, of course, there are rules, restrictions, and limitations on how much gain can be excluded and who qualifies to take the exclusion. Then there are some exceptions to those rules – several of which apply specifically to military personnel. The purpose of this article is to help clarify some of the rules so you can make decisions on your home sale that put you in the best position to take advantage of the Section 121 tax break.

What Is It?

If you sell something for more than you paid for it, you have made a profit known as a capital gain. The federal government considers capital gains a form of income and taxes them. Fortunately (in terms of taxes) not many things we buy for personal use increase in value. Nearly everything we buy decreases in value as soon as it is purchased. Don’t all of us have a crusty Uncle who gives advice like, “Never buy a new car! You lose thousands of dollars just for driving it off the lot!” Uncle Crusty is referring to the fact that cars decline in value quickly in the first year of ownership. Most things we buy (clothes, furniture, kitchenware, etc.) follow a similar pattern. You are never going to be able to resell them for anything close to the price you paid for them.

Houses (including condos, townhomes, etc) are the rare exception. Houses often increase in value over time. Selling them generates a capital gain for the seller, and that capital gain would be taxable except for the Section 121 exclusion.

Section 121 says you can exclude up to $250,000 of capital gains from the sale of your home as long as all the following apply:

1. You owned the home for at least 2 years of the 5 year period ending on the date of the sale
2. You used the home as your primary residence for at least 2 years of the 5 year period ending on the date of the sale
3. You have not used the Section 121 exclusion for the sale of another property in the last 2 years.

If you are married and filing a joint return, you can exclude up to $500,000 of capital gain from the sale of your home as long as
1. At least one spouse owned the home for at least 2 years of the 5 year period ending on the date of the sale
2. BOTH spouses have used the home as their primary residence for at least 2 years of the 5 year period ending on the date of the sale
3. NEITHER spouse has used the section 121 exclusion for the sale of another property in the past 2 years.

Those are the basics – you can exclude up to $250,000 ($500,000 for married filing jointly) as long as you own and live in the property for 2 out of the previous 5 years and have not used the exclusion for at least 2 years. Now let’s look at some specific scenarios to discuss limitations and exceptions.

Transfer of Ownership and Residence Time to Surviving Spouse

Ginger marries Thurston and moves into the house Thurston has owned and lived in for 10 years. 1 month later Thurston dies and Ginger inherits the house. Ginger wishes to sell the house 2 months later. She has only owned it for 2 months and has lived in it for 3 months, but Ginger still qualifies for a $500,000 exclusion. Under Section 121 a surviving spouse inherits the deceased spouse’s time of ownership and use along with the house. Although Ginger is now technically single, she can use the full $500,000 exclusion if she sells the house within 2 years.

Period of Non-Qualified Use

George Jetson buys two houses in 1999. He lives in House A and uses House B as a rental property. In 2017 he moves into House B. He uses House B as his primary residence for 2 years and then sells it in 2019. Even though George meets the “2-in-5” ownership and primary residence tests, George has created a “period of non-qualified use”. Any time you owned the house, but were not using it as a primary residence PRIOR TO the last period of time you used the house as a primary residence is considered a “period of non-qualified use”. In this case George can only take the Section 121 exclusion on the ratio of his ownership time that was ‘qualified’ for Section 121. He had 2 years of qualified time and owned the house for 20 years total. Therefore, he can exclude 2/20 or 10% of his capital gains from the sale of House B.

Ten-Year Extension for Military Personnel

Greg and Marcia are on active duty with the US Navy. They buy a house in Virginia Beach, and live in it for 4 years before receiving PCS orders to Jacksonville. Thinking they may return to Virginia Beach one day, they decide to turn their home into a rental property. They end up spending the rest of their Navy careers down in Jacksonville (6 years) and decide to remain there permanently. They owned the home for 10 years total, and lived in it for the first 4. In the 5 year period ending on the date of the sale they had not lived in the property at all. However, Greg and Marcia still qualify to exclude $500,000 of the capital gains when they sell the house. Section 121 allows military personnel transferred more than 50 miles from their home to add up to 10 years to the 5 year period. Instead of living in the home 2 of the previous 5 years Greg and Marcia only need to have lived in the house 2 of the last 15 years. They meet that criteria and qualify for the exclusion.

Military Personnel Exception to Period of Non-Qualified Use

Similar scenario as above – Greg and Marcia buy a house in Virginia Beach, live in it 4 years, get transferred to Jacksonville, and live there for 6 years. In this scenario after the 6 years in Jacksonville they move back to their Virginia Beach house for 2 years and then sell it. Greg and Marcia still qualify for the full $500,000 exclusion. George Jetson had created a period of non-qualified use by living in his property after not using it as a primary residence, but there is an exception in Section 121 for military personnel. Greg and Marcia DID NOT create a period of non-qualified use by living in their home after using it as a rental property because Section 121 makes an exception for military personnel who received PCS orders more than 50 miles from their homes.

These rules are complicated. I have only touched on the high points in this article, trying to focus on the most common scenarios I see. If you have additional questions about the Section 121 exclusion of capital gains for your primary residence, please contact me.



30 July 2017

Virginia beach tax prep military homecomingMilitary personnel who pay taxes in Virginia often overlook a very helpful tax benefit afforded by the Virginia tax code. It is called the Military Basic Pay Subtraction. It doesn’t apply to everyone, but thanks to a ruling by the Virginia Tax Commissioner, it applies to a much larger segment of the military population than is commonly thought.

As a guy who prepares a lot of tax returns every year I appreciate that Virginia closely follows the federal model for computing adjusted gross income (AGI). To get to your Virginia adjusted gross income you start with your federal adjusted gross income and then apply a handful of Virginia-specific rules for adding to or subtracting from the federal AGI to determine your Virginia AGI. I like that Virginia uses the term ‘subtractions’ to identify the things that can be subtracted from your federal AGI. Nice, simple, clean language. So rare in the tax business!

The Subtraction’s the Thing

One of the subtractions you can apply under Virginia’s tax laws is the Military Basic Pay Subtraction. Using this subtraction, military personnel can subtract up to $15,000 of their basic pay received during the taxable year, provided they were on active duty for more than 90 consecutive days.

Note that “up to $15,000” part. You only get the full $15,000 if you made exactly $15,000 in basic pay. Here’s why – you can subtract every dollar of basic pay you earn up to $15,000, but once you go over $15,000 you reduce the maximum subtraction by a dollar for every dollar you are over $15,000. In other words, if you earn $15,001 of basic pay, you get a $14,999 subtraction on your Virginia tax return. If you earned $20,000 of basic pay, you get a $10,000 subtraction. At $30,000 the benefit of the subtraction is completely gone.

virginia beach tax preparation military basic pay subtraction

Looking at the military basic pay charts for 2017 it appears only very junior enlisted personnel earn less than $30,000 per year in basic pay. This limits this Virginia tax benefit to a small (although highly deserving) portion of the military population if they are on active duty and collecting basic pay for the entire year.

Fortunately, the law does not stipulate that you have to earn basic pay for the entire year. This opens up the potential for a benefit to people who enter active duty during the year, people who leave active duty during the year, and reservists. Let’s look at some examples:

1. Master Chief Grit (a Virginia resident) retires at the end of February 2017. He earned $14,230 of military basic pay in 2017. All $14,230 could be subtracted on his Virginia income tax return.

2. Master Chief Grit and his spouse, Chief Grit, (both Virginia residents) both retire at the end of February 2017. Master Chief Grit earned $14,230 of military basic pay in 2017. Chief Grit earned $9,133 of military basic pay in 2017. Even if they jointly file their 2017 Virginia income tax return they can subtract all $23,363 of their combined military basic pay. Virginia allows each spouse to qualify for (and claim) the subtraction separately on joint returns.

3. Sergeant Hammer (a Virginia resident) decides to return to the Marine Corps after several years as a civilian. He goes back on active duty on 01 July 2017. From July – December he earns $19,282 in military basic pay. He can subtract $10,718 ($15,000 – ($19,282 - $15,000)) from his 2017 Virginia income tax return.

4. Captain Junker (a Virginia resident) is a USAFR officer who does a six month tour of active duty from September 1, 2016 until March 1, 2017. In January and February 2017, he earns $11,882, all of which can be subtracted from his 2017 Virginia income tax return. (He may have also qualified for a Military Basic Pay Subtraction in 2016.)

Something important to note in that last example is that Captain Junker was not on active duty for 90 consecutive days in 2017, but he still qualifies for the subtraction. The Virginia Tax Commissioner ruled last year that the 90 consecutive days of active duty time can cross over multiple tax years and the taxpayer will still qualify for the Military Basic Pay Subtraction in an individual tax year.

It’s a nifty way to lower your Virginia taxes if you qualify to use it, but there are a few additional rules to be aware of:

1. Do not confuse this with the Virginia subtraction for Virginia National Guard Income – it is not the same subtraction.
2. You can’t use this subtraction on income that is already not taxable – such as if your income was not subject to taxation because of the combat zone tax exclusion.
3. If you claim this subtraction you cannot also claim the Virginia Credit for Low-Income Individuals or the Virginia Earned Income Credit.
4. You do not need to be stationed inside Virginia to claim this subtraction.

The Wrong Way to Apply This Subtraction

I will sometimes see this subtraction incorrectly used by someone to remove a military member’s income from a jointly filed Virginia tax return because the spouse is required to file in Virginia, but the military member is not. They file their federal return jointly, and their software automatically prepares a joint Virginia return with both spouses on it. They realize the military member’s salary is not taxable in Virginia, so they use the military basic pay subtraction to remove it from the joint Virginia return. That’s not the right way to file, and will likely get you some letters from Virginia asking you for more money.

If one spouse has to file in Virginia, but the other does not, the correct method is to create a married filing separately return for Virginia and only include the income and deductions for the spouse required to file. I think by the time people get to that point in the tax prep process they are getting a little anxious to wrap it up and start looking for short cuts. Don’t try that one, though. Virginia will ‘fix it’ by adding the military member’s income back into the return and sending you a bill for the taxes on it. Then you end up paying someone like me to fix it for you.

If you are filing your own Virginia tax return, use code 38 when claiming the Military Basic Pay Subtraction. If you have any questions, please contact me!



23 July 2017

Omer FriedaI was very fortunate to have grandparents until I was 50. My grandparents were hard-working, stayed healthy, and lived long lives. By the end, however, my grandfather’s legs were not working very well and he was falling frequently. He had lived in his house for more than 60 years. The family knew he was most comfortable there and would have preferred to spend his final months there. We tried, probably for too long, to make staying in his home work. In the end the halls and doors were just too narrow to accommodate walkers or wheelchairs. The tub and shower were not safe enough. No one could bear picking him up again. We were forced to move him into a nursing home.

This is the kind of heartbreak millions of families are currently dealing with. Not only can it be heartbreaking, it can be wallet-breaking as well. Those nursing homes aren’t cheap. It cost more than twice as much for my grandfather’s nursing home care than it cost to bring someone in every day to help care for him in his own home. It was literally costing more for him to be in a place he liked less. It’s the kind of thing that makes you shake your head in disbelief.

A solution may have been to make his home safer and more accommodating for him to stay in. If his doors could have been widened for wheelchair access, and his bathroom remodeled with a safer tub and some grab bars, perhaps he could have stayed in his own home until the end. He was on a tight budget, though, so coming up with the money to make those home improvements would have been a challenge.

Residents of Virginia have access to a program my grandfather in Ohio didn’t have. A tax credit that can help make houses more livable for seasoned citizens. The Commonwealth has implemented the Livable Homes Tax Credit. This tax credit is designed to improve the accessibility and “universal visitability” in Virginia’s residential units. The credit is for up to $5,000 and can be used to either purchase a new place to live or to pay 50% of the cost (up to $5,000) to retrofit your current residence.

You Can’t Just Claim the Credit. Pre-Approval is Required.

Virginia’s legislature got a little fancy with this program, so don’t just retrofit your home and then try to claim the credit when you file your Virginia income tax return. You must be pre-approved by Virginia’s Department of Housing and Community Development. Essentially, the Department of Housing and Community Development has been given authority to grant this tax credit, so unless your retrofitting project meets with their approval, you won’t be able to claim the credit from the Department of Taxation.

It’s a government program involving tax credits, so the rules are complex. I’m going to hit the highlights on how to get approval, but if you’re interested in pursuing this I encourage you to do your own research into the nuances of the program.

For your retrofit of an existing residence to qualify you must have installed at least one of the following:
• Accessible route to a zero-step entrance to a residence (i.e. a wheelchair ramp)
• Zero-step entrance to the residence
• 32-inch-wide doorways
• 36-inch wide hallways
• Accessible light switches, electrical outlets, or climate controls
• Accessible bathroom
• Accessible kitchen
• Lift/elevator
• Sensory modification (i.e. timer on stove with flashing light for hearing impaired)

Additionally, your modifications must meet existing government standards for utility of the accessibility feature. (Think ‘Americans with Disabilities Act’ compliant)

You complete the application available on the Department of Housing and Community Development website. You must include copies of purchase contracts, invoices, cancelled checks, construction contracts, and proof that the person applying for the tax credit actually paid for the retrofitting work. You send all your documentation to the Department of Housing and Community Development not later than 28 February of the year after the construction/retrofitting was completed. You will be notified by 01 April if your Livable Homes Tax Credit is approved. If it is, you can file for the credit on your Virginia income tax return.

If your Livable Homes Tax Credit is larger than your tax owed to Virginia you can carry over any unused portion of the credit for up to seven years.

I don’t want to get too schmaltzy, but I hope as many Virginians as possible take advantage of this tax credit. My Grandfather was from The Greatest Generation of Americans. When his country called, he kissed his pregnant bride goodbye and sailed across the Atlantic Ocean to liberate Europe with Patton’s Third Army. He came home in 1946 and introduced himself to the daughter he had not yet met – my mother. He raised his family, worked hard, went to church, paid his taxes, and was as extraordinary as all the other parents and grandparents out there. All of whom deserve to leave this world in the quiet comfort of their own homes if that is what they want. Hopefully this Virginia tax credit will make it possible for a few more of them to live out their days as they choose. If you have any questions about how to apply for this tax credit, please contact me.



15 July 2017

Virginia beach tax preparation accidental Virginia resident militaryThere is a provision in the Servicemembers Civil Relief Act (SCRA) that creates a nice loophole allowing many military personnel to avoid paying state income taxes. The provision wasn’t placed in the SCRA for the purpose of creating a tax loophole. It was put there to prohibit the states from taxing the incomes (and personal property) of military personnel who are living in the state only to comply with military orders. However, many military servicemembers are using this provision to avoid paying any state income taxes. Congress added a paragraph to the SCRA in 2009 that extended this same benefit to qualifying military spouses.

I don’t refer to it as a “loophole” to imply that people who use this provision are being sneaky or dishonest. This is a completely legal and legitimate tax maneuver. I used this tactic when I was in the Navy, and I encourage military personnel (and their spouses) to use it whenever possible. In fact, the point of this article is make sure no one inadvertently disqualifies themselves from being able to use it!

How It Works:

Here is what the first 2 paragraphs of SCRA (Section 571) say:

(1) In general. A servicemember shall neither lose nor acquire a residence or domicile for purposes of taxation with respect to the person, personal property, or income of the servicemember by reason of being absent or present in any tax jurisdiction of the United States solely in compliance with military orders.
(2) Spouses. A spouse of a servicemember shall neither lose nor acquire a residence or domicile for purposes of taxation with respect to the person, personal property, or income of the spouse by reason of being absent or present in any tax jurisdiction of the United States solely to be with the servicemember in compliance with the servicemember’s military orders if the residence or domicile, as the case may be, is the same for the servicemember and the spouse.

In short, if you are in the military and under orders to work in another state (not your home state), that state can’t make you pay taxes there just because you are present in their state. The same goes for the spouse, if the spouse is a resident of the same state as the servicemember.

I think these are fair and reasonable protections to afford military families. They work hard, move often, and sacrifice much. It is not unreasonable to allow them to maintain their tax home in the location of their choice.

Here’s the Loophole: It doesn’t prevent the servicemember from establishing residency in a state where the tax laws are advantageous – such as in a state without a state income tax. So, that is exactly what I did...

I enlisted in the Navy in 1987 from my home state of Ohio. Under the SCRA I retained my status as an Ohio resident even though the Navy had relocated me to Florida. At that time Ohio was taxing the incomes of military personnel who claimed status as Ohio residents. It didn’t take me long to figure out that Florida had no income tax and it would benefit my wallet to become a Florida resident. I marched my Buckeye behind down to the Duval County Courthouse and declared Florida as my legal domicile. Then I took the certificates they gave me to my personnel office and they changed me over to Florida for pay purposes. Despite multiple moves, I retained my status as a Florida resident throughout my Navy career.

SCRA Protections are Limited.

Many servicemembers falsely believe the SCRA gives them total immunity from the taxing authority of the states in which they live and serve. This is simply not true. What the SCRA says is that the state can’t consider them a resident for tax purposes solely because they are stationed/posted there under military orders. This presumes the servicemember intends to return to their state of legal residence after their military career. If the servicemember (or spouse) takes other actions indicating they intend to stay in the new state, then that state can legally consider them a resident even if they are still serving in the military.

Let’s look specifically at Virginia.

Virginia uses the term domicile. Under Virginia tax law your domicile is the place where you permanently live, even if you are currently not residing at your domicile. It is the place you intend to return to at some point in the future. If you are a member of the armed forces and move to Virginia to comply with military orders you are presumed to maintain your legal domicile as indicated in your military records. In this situation, Virginia cannot tax your military income or your personal property.

There are things you could do, however, to change this situation. If you take actions consistent with establishing your domicile in Virginia, then Virginia has the legal right to declare you a resident of Virginia and make your military income subject to Virginia taxes.

While there is no precise formula for establishing a domicile in Virginia, the Tax Commissioner of Virginia has consistently used the following factors to determine whether or not a servicemember has crossed the line and established a Virginia domicile:

1. Obtaining a Virginia Driver’s License. This tends to be a showstopper. The Virginia Code section 46.2-323.1 requires all applicants for a Virginia driver’s license furnish a statement certifying they are a resident of Virginia. Furthermore, members of the armed forces stationed in Virginia are not required to obtain a Virginia driver’s license. Doing so is completely voluntary and shows strong intent to remain in Virginia.
2. Voter Registration. Another showstopper. Federal law requires all states to provide absentee ballots to military members who cannot be present in their home state to vote. To be qualified to vote in Virginia you must be a resident of the precinct in which you vote. Thus, a servicemember registering to vote in Virginia is committing a voluntary act that indicates intent to establish domicile in Virginia.
3. Maintaining Contacts in Your Home State. Do you still own property, have family, a business, registered cars, driver license, and maintain your voting registration in your home state? These indicate continued connections to your home state and intent to return there someday.
4. Other Indicators. Have you purchased property in Virginia, registered your cars in Virginia, or exercised other benefits of being a Virginia resident? These are not showstoppers, but may indicate a pattern of intent to remain in Virginia.

If your intent is to retain your residence in your home state outside Virginia, then you need to make an effort to maintain ties to that state. On the flip side, if you voluntarily make ties to Virginia, then Virginia has the right to claim you have abandoned your previous domicile and established a new domicile in Virginia – making you a Virginia resident subject to Virginia income taxes.

As always, if you have questions, please contact me.

03 July 2017

Tax Court(This could so easily have happened to one of my clients...)

Decisions of the US Tax Court are made available to the public online, and I read them whenever I get a chance. They are a great source of information on how the courts are interpreting the Internal Revenue Code, and I often learn things I can apply to the benefit of my clients.

All Tax Court opinions, memos, and summaries are formatted similarly. They start with a narrative on the pertinent facts of the case, discuss any evidence presented to the court, discuss the pertinent articles of the Internal Revenue Code and any precedents in case law, and then the Judge renders his or her judgment.

This format allows me to make a bit of a learning game out of reading the court documents. I can read the narrative of the case and try to predict how the judge will rule. After dozens of cases I am getting rather good at guessing the outcome, but I read one last week that I missed by a mile.

Taxpayers wind up in Tax Court because they dispute a determination of the IRS. In Tax Court the taxpayer is always The Petitioner – that is, the taxpayer initiates the case against the IRS by petitioning the court to hear their case. The Commissioner of the IRS is The Respondent. This arrangement exists because the IRS has told a taxpayer they owe taxes (and possibly penalties) and the taxpayer disagrees. After exhausting other options to get the IRS to stop trying to impose the taxes, the taxpayer has the right to petition the Tax Court to resolve the dispute.

However, with rare exceptions, the IRS is presumed to have determined the correct amount of tax on the taxpayer. Therefore, the burden is on the taxpayer to prove to the Tax Court the IRS has made a mistake.

In this case, the taxpayer, Mr. Z., was employed as an event organizer for a software company. He made a good wage travelling around setting up conferences and training seminars for his employer. In 2013, he got the idea to start a side business that would hold small film festivals in different college towns. There were a lot of startup costs and the idea was slow to catch on. For tax year 2013 Mr. Z claimed his new business on Schedule C of his individual income tax return, showing gross receipts of $690 and expenses of $32,747.

The IRS audited Mr. Z’s 2013 tax return and disallowed the $32,747 in business expenses because they determined Mr. Z’s activities were better classified as a hobby, not a business. Hobby losses cannot be written off against any income other than hobby income, so Mr. Z’s expenses in excess of $690 were disallowed. Mr. Z petitioned the Tax Court for relief.

After reading the narrative I was convinced Mr. Z had started a business (not a hobby) and would be granted relief from the IRS determination by the Tax Court. So convinced, in fact, that I skipped over the judicial arguments section and went straight to the end of the document to read the ruling. When I discovered Mr. Z had lost his case I scrolled back up to read more and find out how the Judge could come to such a different conclusion.

In the Opinion, Judge Guy lays out 9 points to ponder when determining whether an activity is a business or a hobby. They are:

1) Manner in which the taxpayer carries on the activity
2) Expertise of the taxpayer
3) Time and effort expended by the taxpayer on the activity
4) Expectation assets used in activity will appreciate in value
5) Taxpayer’s success in carrying on similar activities
6) History of income or losses with respect to the activity
7) Amount of occasional profits earned
8) Financial status of the taxpayer
9) Elements of personal pleasure

Judge Guy then goes point-by-point (for a dozen or so paragraphs) in creating a scorecard for Mr. Z with respect to each of these determining factors. (As there were no assets in the business to appreciate, point 4 was not considered.)

Remember, in Tax Court the burden is on the taxpayer to prove the IRS determination is not correct. In this case the IRS determined Mr. Z’s business was a hobby. Therefore, Mr. Z had to provide evidence to support his claim that his activities were a business and not a hobby.

Mr. Z was unable to provide such evidence. Like many of the small business owners I know, he did not keep good records. Judge Guy determined that only the amount of time and effort expended by Mr. Z (point 3) favored classifying the activity as a business. For everything else, there was insufficient evidence available to change the IRS determination the activity was a hobby.

Throughout the Opinion Judge Guy discusses the lack of records, business plans, profit projections, budgets, and the other documents business people are expected to produce when they start a business. Without those documents Mr. Z was unable to demonstrate his activities were those of a business. Without those documents Judge Guy was unable to change the determination of the IRS.

Most of the new business startups I see follow a similar pattern to Mr. Z. They have a good idea and they just want to run with it. The need to properly document their activities is barely considered. They do not generate budgets or business plans, and many are just horrible at keeping records. If the IRS determined their activities were a hobby instead of a business, they would not be able to provide sufficient evidence to get a Tax Court judge to overturn the IRS ruling. They could very easily find themselves in Mr. Z’s shoes, owing additional taxes and penalties years after they thought the matter was settled.

Mr. Z paid $13,028 in additional taxes and penalties for the luxury of not keeping good business records. How much are you willing to pay for that luxury? If your answer is $0, then you need to seriously consider getting professional assistance in establishing your record keeping standards and processes. You may need it to one day prove you are actually running a business.



Virginia Beach Tax Preparation adjusted basis in asset24 June 2017

My cultural reference du jour is a nod to Ms. Meghan Trainor’s very catchy 2014 tune about her backside. Whilst I have always been appreciative of such assets, this article is about appreciating assets of an entirely different nature. We are talking about assets that increase in value (specifically houses), making them taxable, and how you might mitigate or avoid paying the taxes on them altogether.

The first thing we need to do (after we stop with the 'basis' and 'assets' puns) is make sure we are all speaking the same language. I’m going to throw some words around and I want to make sure you know what I mean when I use them. I looked at the dictionary definitions, but I decided to explain these terms in my own words.

Appreciate – In this context appreciate means increase in value. If I say I have an appreciated asset that means I have an asset that is worth more now than when I acquired it.

Asset – that’s a thing I own that has monetary value. My house is an asset. My truck is an asset. My stock and bond funds are assets.

Basis – This is the dollar amount of your investment in the asset. This is often the purchase price of the asset – but not always. Sometimes things happen that adjust (change) your basis in the asset. (This can be confusing and it’s the reason I am writing this article.)

Capital Gain – When you sell an asset for more than you paid for it you have a capital gain.

Capital Gain Taxes - When I sell an asset that has appreciated I have a capital gain. Generally speaking, capital gains are considered income and are subject to income taxes. The tax rate on capital gains depends on the type of asset you own and the length of time you have owned it.

Depreciate – In this context depreciate means to decrease in value. It is the opposite of appreciate.

Fair Market Value (FMV) – The current value of the asset on the open market.

Tax Basis (or Taxable Basis) – This is your investment in the asset for tax purposes. This can be confusing because at times it appears to have nothing to do with the actual amount of your investment or the value of the asset.

Taxable Gain – Generally speaking, taxable gain is (Sale Price – Tax Basis)

Step-up in Basis – When someone dies all their assets are transferred to (inherited by) beneficiaries. The beneficiary’s basis in the inherited asset is the fair market value of the asset on the date the previous owner died. If the asset appreciated since it was acquired by the previous owner, then the beneficiary receives a “step-up in basis”.

Let’s Focus on Residential Real Property (like houses and condos).

As an asset class houses are large and complex. People tend to own them for long periods compared to other asset classes. They also do things with them that can change the tax basis of the asset. If a house owner improves the house (by, say, adding an additional room) s/he can increase their tax basis in the property. If the house owner uses the house in a business s/he can take a business expense for depreciating the property and lower their tax basis in the property.

While far from universal, houses tend to appreciate over time. Selling them generates a capital gain for the homeowner. Fortunately, Congress decided to give us a tax break on our homes. Capital gains up to $250,000 for single filers and $500,000 for couples filing jointly are excludable under section 121 of the tax code if the house is used as a primary residence.

Let’s look at a scenario in which these tax concepts come into play:

John and Mary purchased their house in 1971 for $80,000, and have lived in it ever since (original basis $80,000). They raised their 3 children in that house. In 1992 they spent $20,000 to add a mother-in-law suite so Mary’s elderly mother could move in with them. (Their adjusted basis is now $100,000 because they spent $20,000 to improve the property.)

Mary’s mother passed in 1998. John and Mary paid off the mortgage to the house in 2001 and now own it free and clear. By 2017 John and Mary are elderly and could use some assistance. Their house is now their most valuable asset, valued at $380,000. John and Mary want to stay in their house and would like their daughter Debbie to come over every day to help care for them. To entice Debbie they offer to transfer the house to her name.


There is a significant tax difference between transferring assets while you are alive and transferring them when you are dead. John and Mary’s tax basis in the house is $100,000. If they transfer the house to Debbie while they are still living, John and Mary’s tax basis transfers to Debbie. This house IS NOT Debbie’s primary residence. When she sells it she will have to pay taxes on any capital gain from the sale. If she were to sell the house for $380,000, her taxable gain would be $280,000. Even at the best capital gains tax rate, Debbie may owe somewhere in the neighborhood of $42,000 in taxes from the sale of the house.

If John and Mary want Debbie to receive the greatest possible financial benefit from the house they should keep it in their names and make sure it transfers to Debbie when they both pass. If they do that, when Debbie inherits the property she receives a step-up in basis to the FMV of the property as of the date of the last remaining parent’s death. Let’s assume this was still $380,000. If Mary has a tax basis of $380,000 and sells the property for $380,000, then she has no capital gain (and therefore owes no tax on the sale).

Let's continue with this scenario...

It’s 2020 and the house has appreciated to be worth $400,000. John and Mary have both passed and Debbie inherits the house with a step-up in basis to $400,000. Debbie sells the house to Paul for $400,000. Paul immediately places the house into service as a rental property. The county tax assessor has indicated that the value of the property is based on the land being worth $125,000 and the house being worth $275,000. Because the property is now being used in a business it can be depreciated for tax purposes. Per the Internal Revenue Code land does not depreciate, therefore the depreciable basis for the property is Paul’s basis in the building - $275,000.

For tax purposes residential real estate depreciates linearly over 27.5 years. Therefore, Paul is entitled to claim a $10,000 depreciation expense deduction for this rental property each year. Paul owns the rental property for 10 years and then decides to sell it. He never made any other capital improvements to the property.

Over the 10 years he has owned it Paul has taken a total of $100,000 of depreciation expense on this property. When he sells it he must adjust his basis in the property to reflect this depreciation deduction. His original basis was $400,000. With $100,000 of depreciation adjustments his adjusted basis is now $300,000.

Paul sells the property for $500,000. Paul has $200,000 of gains, but he actually has 2 different types of gains. The first $100,000 is essentially recapturing the depreciation expense. This is (confusingly) known as “unrecaptured section 1250 gain”. The second $100,000 of gain is a capital gain, and is taxed at the capital gains rate. (Paul never lived in this house, so he does not qualify for the section 121 exclusion.)

If you’ve read this far and your head hurts, you’re probably going to hate what I am about to say next. I have kept these examples very simplistic to highlight some of the concepts used in adjusting basis. I wanted to keep the math easy. In reality, there are several additional factors (such as selling/buying costs) that would need to be considered when figuring the adjusted basis on a house.

These can be difficult concepts, but they are also very important. The value of a house is typically significant relative to the total of a person’s assets. House sales can also have significant tax implications, so you want to make sure the basis is correctly calculated and you are paying the correct tax bill each year. As always, if you have questions, call me.



17 June 2017

Virginia beach tax preparation avoiding penaltiesUsing tax-advantaged accounts (IRA, 401k, 403b, TSP, etc.) is a great way for most Americans to prepare for their retirement. You can either take a tax break now (traditional) or enjoy your tax break later (Roth). If you have a plan sponsored by an employer you may be able to receive some matching money from the company or agency you work for to increase your retirement savings. That can help you achieve the goals of your retirement plan even faster.

Unfortunately, life does not always cooperate with our plans. Some people find it necessary to tap into their retirement accounts to pay for things prior to retirement. Medical expenses, divorce, accidentally over-contributing to an account, college tuition – if you can think of an expense, someone has probably had to tap into their retirement account to pay for it.

Congress generally imposes a penalty for using retirement funds to pay for non-retirement expenses. Not only do you have to pay income taxes on your tax-deferred withdrawals as though they are regular income, but there is also a 10% penalty tax on top of that. I’ve seen firsthand how shockingly fast those taxes can add up. (There’s a reason I keep a box of tissues on my desk.)

Our government of the people, by the people, and for the people is not completely heartless, however. Congress has made exceptions to the 10% penalty for some pre-retirement withdrawals. But...in typical Congressional fashion, those rules are not uniform. They vary depending on the type of expenditure and the type of account the money comes from. I study taxes for a living and I have a difficult time keeping them straight. That’s why I made the chart below – so I can keep track of when a retirement account distribution is going to trigger a penalty tax.

The chart covers traditional retirement plans only. Roths are different, and more straightforward. The only difference is whether your Roth account is sponsored by your employer (Roth 401(k), Roth 403(b), Roth TSP) or if it is a Roth IRA. In both employer-sponsored Roths and Roth IRAs you receive no tax benefit for the money you contribute to the account. Therefore you can also take it out without paying taxes on it. It’s like putting money into your bank and then taking it out – you don’t pay tax on the deposit or the withdrawal. The catch is that you must have owned the account for at least 5 years before you make the withdrawal. While it works like a bank, the government does not want you using it like a bank. And remember – you can only take out your contributions tax free. Any earnings or profits withdrawn for non-retirement expenses are going to get you the 10% penalty tax.

This brings us to a difference between employer-sponsored Roths and Roth IRAs. With a Roth IRA you can stipulate that you are withdrawing only contributed money. With an employer-sponsored Roth you cannot. Your withdrawal will be part contribution and part earnings, and the earnings part will be subject to taxation if they are deemed not qualified.

For traditional retirement accounts refer to the chart below. I tried to keep it simple, but it is a complex problem that does not readily lend itself to simplification.


Your Situation

Employer Plans (401(k), 403(b), etc.)



You are at least 59 1/2 years old when you withdraw.

No Penalty

No Penalty


You were automatically enrolled in a plan and you didn't want to participate, so you withdrew your money

No Penalty

No Penalty for SIMPLE IRAs and SARSEPs


You contributed more than you were allowed to your account and you withdrew some before the deadline

No Penalty

No Penalty


Original account owner dies and you inherit it.

No Penalty

No Penalty


You have become totally and permanently disabled.

No Penalty

No Penalty


Money is withdrawn due to the property settlement of a divorce (Qualified Domestic Relations Order)

No Penalty

Not Applicable


You use the money to pay for college (or other qualified higher education)

10% Penalty

No Penalty


You establish and receive a "series of substantially equal periodic payments" from your account

No Penalty

No Penalty


Dividend pass through from an ESOP

No Penalty

Not Applicable


Up to $10,000 for Qualified First-time Homebuyers

10% Penalty

No Penalty


The IRS forces you to take a distribution to pay a tax bill (IRS Levy)

No Penalty

No Penalty


You used the money to pay unreimbursed (no insurance coverage) medical expenses that exceeded 10% of your AGI

No Penalty

No Penalty


You used the money to buy health insurance while you were unemployed.

10% Penalty

No Penalty


You were a military reservist called to active duty for more than 179 days and you made the withdrawal during the time you were called for active duty

No Penalty

No Penalty


You decide to withdraw your IRA contribution before the due date of the tax return

Not Applicable

No Penalty


You withdraw the EARNINGS on an IRA contribution

Not Applicable

10% Penalty

You withdrew the money and then contributed it to another qualified account as a qualified rollover within 60 days of the withdrawal.*

No Penalty

No Penalty


Employee takes withdrawals after he or she separates from service (quits/retires) during or after the year the employee reaches age 55 (age 50 for public safety employees of a state, or political subdivision of a state, in a governmental defined benefit plan)

No Penalty

10% Penalty


Probably the most important thing I can tell you is that if you have questions – ask! And ask BEFORE you take money out of your retirement account. Once you make the withdrawal you nearly always have to live with the consequences. Give me a call if you have questions. 

 * This is also known as an indirect rollover. You can only do 1 indirect rollover per 12-month period. If you do more than 1, then you are going to pay taxes and penalties on the subsequent withdrawals. 


virginia beach tax prep rental placed in service

03 June 2017

I see a lot of landlords during tax season. One of the things they frequently have trouble understanding is when their rental property is “placed in service” and/or “taken out of service”. I thought I would write a quick article to address this issue because using the wrong date is costing taxpayers money.

As a depreciable business asset a rental property is placed in service whenever it is placed in a state of readiness and availability for use in the taxpayer’s trade or business (Brown vs Commissioner, TC Memo 2009-171

Notice that the definition of placed in service does not include used in the trade or business in the definition. The property does not have to be rented to be in service, is just has to be ready and available. For residential rental properties this typically means the date the property was made available to be rented. You can use the date the property was first advertised for rent as the placed in service date. If you use a property manager you can use the date the property management company was contracted for service.

For example, Jimmy placed a ‘for rent’ sign on his property on May 1. On August 7 he signed a lease with, and received his first rent check from, his first tenant. Jimmy’s property was placed in service May 1.

I often see do-it-yourself tax preparers use the date the property was rented as the date it was placed in service. This is costing them money. If Jimmy was preparing his own taxes and he used August 7 as the date the property was placed in service he would have needlessly deprived himself of 3 months of rental property expense deductions for the tax year the house was placed in service.

The placed in service date is also important in determining the tax treatment of certain items of repair and upkeep. Repairs made before a property is placed in service are classified as ‘capital expenditures’. These must be added to the depreciable basis of the property and deducted as depreciation expenses over the lifetime of the property – 27.5 years. Repairs made after a property is placed in service are considered business expenses and can be deducted in the year they are accomplished.

Let’s look at two similar scenarios.

Mary bought a house and placed it in service on April 1. On April 15 she replaced one of the windows in the house. The window replacement cost $400. Because the window was replaced after the property was placed in service Mary can deduct the entire cost of the window on the tax return for the year the window was replaced.

Ed buys a house on April 1. He replaces one of the windows on April 5. The cost of the window replacement was $400. On April 15 Ed places his property in service as a rental property – meaning he made the unit available to be rented. Because the window was replaced before the house was placed in service the cost of the window must be capitalized and added to the depreciable basis of the property. Residential rental properties depreciate over a 27.5 year period. Ed can only deduct $10.30 for the window in the year he had it replaced (($400/27.5)(8.5/12)). The rest of the cost of replacing the window can be deducted over his next 27 tax returns.

Judging from the reactions of some of my clients, Ed is likely to find the tax treatment of his window replacement highly irritating. He is going to wish he had known to place his rental property in service prior to the replacing the window.

Don’t try to get fancy, though. You can’t buy a property, place it in service, and then gut the kitchen for a two-month remodeling project. Remember – part of the definition of placed in service means placed in a state of readiness. A house with no kitchen cannot reasonably be considered to be in a state of readiness.

Taking a property out of service follows a similar logic, but in reverse. When the property is no longer available or ready to be a rental property it is no longer in service. Often people will use the last date the property was actually rented as the last day the property was in service, which can cause them to short themselves on their tax return. Another example:

Terry and Tina have a residential rental property. The tenants move out on April 30. They advertise the property for rent, but they do not acquire new tenants. Frustrated with their experience as landlords, they sell the property on October 15.

The property was taken out of service the day it was sold, October 15. Even though Terry and Tina had the property for sale before that date they also had it available to rent. If they had acquired tenants before buyers they could have easily delisted the property for sale. If Terry and Tina had said the last day the property was in service was April 30 they would have missed the opportunity to claim the rental property deductions for 5.5 months of the year the property was sold. This could result in them paying more taxes than necessary.

There are significant tax benefits to owning residential rental property. There are also some ‘tips and tricks of the trade’ you should know to maximize the tax benefits available to you as a landlord. If you are unaware of those tips and tricks, please give me a call. I am always happy to discuss your situation.


Information in the Tax Blog is current as of the day it was posted. Tax laws change frequently, and it is likely that as time passes acts of Government will make some of the older blog content out of date.

The information provided is for education purposes only. It is general in nature and may not pertain to the Reader's situation. Every taxpayer's circumstances are unique. Reader's are urged to do some research or talk to a tax professional before acting on any of the information posted in this blog.

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.

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Common Acronyms

ACTC - Additional Child Tax Credit

AGI - Adjusted Gross Income

AMT - Alternative Minimum Tax

APTC - Advanced Premium Tax Credit

AOC - American Opportunity Credit

CTC- Child Tax Credit

EIC - Earned Income Credit

HoH - Head of Household

LLC - Lifetime Learning Credit

MFJ - Married Filing Jointly

MFS - Married Filing Separately

MAGI - Modified Adjusted Gross Income

PIM - Plan of Intended Movement

PTC - Premium Tax Credit

QC - Qualifying Child

QHEE - Qualifying Higher Education Expenses

QR - Qualifying Relative

QW - Qualifying Widow(er)


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