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24 June 2018
With the thriving military bases in the region, Hampton Roads is blessed with many military retirees. (I find it ironic we are called ‘retirees’, since many of us work just as hard (or harder) after leaving the service as we did when we were on active duty!) Some interesting tax issues often arise in the year a member leaves military service. I lived a few of these issues, and see even more as a tax professional. Hopefully this article will help some of my newly retired (or about to retire) brothers and sisters in making transition to civilian life a little smoother.
That First State Tax Return Can Be a Doozy! Many of us took advantage of the Servicemembers Civil Relief Act (SCRA) to avoid paying state income taxes while we were on active duty. I sure did. At the beginning of my first duty station in Florida I marched down to the Duval County Courthouse and registered my domicile in Florida. Took that paper to my personnel office, and skipped out on paying state income taxes for the next 20 years.
Spouses weren’t covered by the SCRA back then, so my lovely wife Tade has been filing in Virginia since we moved here in 2001. I didn’t have to start filing here until I retired from the Navy in 2010. Even though many military spouses are now exempt from state taxes by the Military Spouse Residency Relief Act (MSRRA), I still see many couples in the situation Tade and I were in; one spouse is a Virginia resident, and the other is not.
In my opinion, Virginia handles this situation very sanely. Even if the married couple files their federal return jointly, Virginia allows them to file separately if one is a resident and the other is not. Not all states allow you to have a different filing status on your state return than you have on your federal return. Virginia makes it the only correct way to file if one of you is not a Virginia resident. I find that simple to comprehend. Unfortunately, most do-it-yourself tax software has a lot of trouble when you try to change filing status between your federal and state returns. I've had a few clients successfully figure out how to do this, but not many.
The more difficult situation arises in the year of retirement. We can continue to use my situation as an example. Tade was a Virginia resident all of 2010. Paul became a Virginia resident on December 1, 2010. How did we file our 2010 Virginia taxes?
Tade filed the same way she always did - her status was married filing separately, and she was a full-year resident (form 760). Paul also filed in Virginia as married filing separately, but on a Virginia part-year resident return (form 760PY). We had to use two different forms to file in Virginia! Good luck getting your do-it-yourself tax software to help you get to that conclusion.
Worse still are the state returns for folks whose transition meant they were part year a resident of one state, and part year a resident of another state. It can be quite challenging to get the interplay between the state returns to be right in these situations. I pay $1,200 annually for my tax software, and I’ve been known to throw my hands up (mutter some sailor-like words about the parents of the people who designed my software), download blank forms from a state website, and fill them out by hand to get the correct tax result.
The bottom line on this issue is that your state tax return(s) in the year of your transition out of the military can be more challenging to prepare than usual. Don't expect your off-the-shelf software solution to walk you to the right answer. They don't deal with this problem very often. (Fortunately, you don't either!)
Increased Income Means Increased Taxes. Many military retirees experience increased income when they leave the military. They get a job for as much as (or more than) they were making while on active duty. They also begin receiving their military retired pay. The increased stability of not having a military move looming in the future means spouses may also see a bump in pay as well. It is not uncommon for me to see a family’s income double within a year of a military retirement.
As I have previously written, there is an income zone (that I call ‘the crease’) where your income taxes will increase significantly faster than your income.* This zone sits just above the income level of many military families. When their income increases right after a military retirement, they can shoot into (or through) that zone, and the tax impact can be dramatic. One couple saw a 70% increase in income, but their tax bill more than tripled!
Higher incomes can (and probably should) lead to higher taxes, but there are ways to be proactive about managing the situation to keep your tax bill from exploding. The solutions are unique to the individual situation, but nearly all require advanced planning. Very little can be done to mitigate taxes after the tax year is over. You need to plan and act ahead. Please contact me if you want assistance developing your tax strategy.
(* The revision of the federal tax laws that went into effect in 2018 (also known as the Tax Cuts and Jobs Act) made some changes that should help flatten out 'the crease' as described in my linked article from 2016. Notably, starting in 2018 the child tax credit does not begin phasing out for families until their adjusted gross income is more than $400,000.)
Your Military Pension is Taxable in Virginia. The Commonwealth offers some generous tax breaks to military personnel, but not much after you retire. Virginia will tax your military retired pay as regular income. The DoD will follow your instructions and/or the withholding tables provided to them by Virginia to determine how much to withhold for Virginia taxes. IT’S ALMOST NEVER ENOUGH.
Here’s how this scenario frequently plays out: You leave the military after 20+ years of service, having not paid state income taxes for decades. You get a civilian job. The pay is good, but there’s that new line on your pay stub/earnings statement for “Virginia Tax Withheld”. It isn’t much, but it’s a bit annoying since you never paid it before. You also start getting retirement pay (Woo hoo! Free money!) There’s that annoying line on your retiree statement for Virginia taxes, too. Then you file your first Virginia income tax return and find out you owe them thousands of dollars because neither your employer nor the DoD were withholding enough to cover your Virginia tax bill. It happened to me, and I’m pretty knowledgeable about taxes!
Setting up your tax withholding is another area that requires a little prior planning. It can be tricky. See me if you want some assistance with that. I learned my lessons on that one the hard way, but I learned them well!
If you bothered reading this article it’s probably because you are recently retired from the military, or you are about to retire. It’s an exciting time. I remember feeling a bit anxious about the future during the year of my transition. (Not about taxes, but life in general.) If I could do it over again I would relax a little bit and dream bigger from the start. I learned more in my decades of service than I knew. You probably did, too. Congratulations on getting to this next stage, and thank you for your service!
13 May 2018
I frequently encounter new landlords who are confused and/or frustrated by their tax situation. They decided to turn their house or condo into a rental business, but they didn't fully understand the tax implications of doing so. Now they are paying both financially and emotionally.
In an effort to save at least a few people from this fate, I am providing you with this quick “Top 5” list of tax issues you should consider before you decide to become a landlord.
1. Your Mortgage is Not Deductible. If life (or being a landlord) were simple, the mortgage on your rental property would be deductible. This would give you a simple formula to figure your rental income.
You take in $1200/month in rent;
You pay the bank $1,000/month for your mortgage
You make$200/month or $2,400 for the year
Boom - you’d be done!
In reality it’s not even close to being that simple!
A mortgage is typically paying 4 different things in one payment: (1) principal on the loan, (2) interest on the loan, (3) real estate taxes, and (4) insurance. You have to break out each of those expenses separately on your tax return. Interest, insurance, and real estate taxes are all deductible expenses as paid. The principal, however, is deducted through a cost recovery system that we typically refer to simply as ‘depreciation’. More on that later. For now just be aware you cannot directly deduct your mortgage payments on your tax return. It's not that simple.
2. You Must Track Everything. By renting your property you have opened a business. The IRS considers you to be operating a business. So does the Commonwealth of Virginia. If you aren’t treating it like a business, then you risk learning some expensive lessons down the road. Businesses need records, so get a record keeping system in place. (Hint: a box of receipts is NOT a record keeping system.) A spreadsheet will do if you just have 1 or 2 properties. More than that and you’re probably going to want some sort of accounting software.
Track all the expenses for the property. Once you’ve turned it into a business, everything you spend on the property is a business expense. Make sure it gets recorded in your spreadsheet (or bookkeeping system you adopt).
Get a separate bank account for your landlording activities. It’s a business, it deserves its own bank account. Don’t run personal expenses through the landlord account. Don’t run business expenses through your personal account. Keep them separate. It keeps the bookkeeping cleaner if you do, which makes it look like you’re treating your rental activities like a business.
3. You Can Be Creative with Expenses. Within reason, of course. You can’t take your kids to a Taylor Swift concert and then write it off as a business expense. There are, however, some reasonable ways to save on taxes and meet multiple goals. Here is one of my favorite examples.
The grass needs to be cut at the rental property. You have a 14-year-old son. Pay him $50/week to mow the grass. That’s what you’d pay a professional service to do it. Over the course of the mowing season your kid makes $1,200. You have to issue him a W-2. However, his income is below the threshold for paying federal or state income tax. Because he is your child and under the age of 18, he does not have to pay Social Security or Medicare taxes, either. (So you don't have to bother with withholding these taxes.) He now has $1,200 of earned income tax free. You have a $1,200 deductible expense against your rental property business.
Open a Roth IRA for him and put the $1,200 in it. He can contribute the entire amount of his earned income up to $1,200. When he is ready to go to college he can pull that $1,200 out and spend it on college with no tax consequences. Long story short - you just got a $1,200 tax deduction for saving money for your kid’s college.
If you think you have a creative idea on how to get the most out of the tax benefits of being a real estate investor, it’s probably best to get a professional opinion on them first. Creative is good, until it crosses the line into illegal. Nobody wants that.
4. If You Earn Over $150K, Your Losses are Suspended. Our beloved government has classified rental activity as passive activity. (Which I find ironic, because most landlords I know are working their tails off!) When you lose money at a passive activity it is known as passive activity losses (PAL). PAL are only deductible against passive incomes....UNLESS the PAL is from residential real estate and your modified adjusted gross income is less than $100,000. If that is the case, then you are able to deduct up to $25,000 of PAL against other income (like your wages from a job). If your income is above $100,000 then the amount of PAL you can deduct is reduced. At $150,000 of modified adjusted gross income you can not deduct any PAL against other (non-passive) sources of income. However...
The PAL isn’t lost if you can’t deduct it. It is suspended. Suspended passive losses are carried over to future years. You can use the suspended passive losses against future passive income, or you can use them when you sell the property. I’ve written about this extensively elsewhere, but for now just be aware that your passive losses are suspended if your modified adjusted gross income is greater than $150,000 and that you still need to track those losses so that you can use them in the future.
5. Depreciation & Recapture. This is a very complicated topic, so I am just going to give you the two highest points in this article.
A. You must depreciate your rental property. I know you don’t want the value of your property to actually decrease, but that isn’t what depreciation means in this context. Depreciation is used to represent a method of recovery for the cost of your property. Instead of deducting the principal part of your mortgage, you deduct the cost of your property by taking a depreciation expense for it. Four things to remember about taking the depreciation expense:
(1) Only the building depreciates. The land does not depreciate. The land value must be removed from the overall value of the property when figuring your depreciation expense.
(2) If your building is residential rental property it depreciates in a straight line over 27.5 years. (Why 27.5 years? Because Congress says so.)
(3) If you make capital improvements to the building before it is placed in service as a rental property, the cost of those improvements is added to the basis of the building and depreciated over 27.5 years with the rest of the building.
(4) If you make capital improvements to the building after it is placed in service as a rental property, those costs are capitalized and depreciated separately over 27.5 years.
B. You must REPAY the depreciation expenses when you sell the property. Unless the property actually depreciated (which is rare). There are two things you should know about this:
(1) You can escape repaying the ‘depreciation recapture’ only if you die owning the property, or you do a 1031 exchange for another property.
(2) Even though repaying the depreciation is unpleasant in the year it is repaid, it is rare that taxpayers are net losers at the depreciation game. If you take the long view, even though you pay it back, you got an interest free loan from the IRS. How cool is that?
Despite number 5 having multiple parts to it, I am still going to call this my “Top 5” list. Being a landlord can be profitable. A big chunk of those profits is tied to the tax breaks you get for investing in real estate. Know what those tax breaks (and pitfalls) are before you blindly leap into landlording. If you have any questions or want some assistance in developing a real estate investing tax strategy, please contact me.
23 April 2018
Another tax season has officially come and gone. While I still have a couple dozen clients on extension to complete, I wanted to start blogging again. I like doing taxes, but only doing taxes for 12 hours a day, every day for weeks and weeks was starting to make me a little batty. I'm glad to mix it up a bit again.
I thought I’d kick things off with my annual tax season post mortem on the 5 biggest mistakes I saw taxpayers making during the tax season. These were either mistakes that were repeated often or mistakes that were so costly I want to ensure they remain very rare. Without further ado, let’s dig in!
1. Misunderstanding The Military Spouse Residency Relief Act
The military spouse residency relief act can be confusing, but I’m going to break down how Virginia implements it as simply as I can. If you are living in Virginia because your spouse is here on military orders, you have two options:
Several times this year I had clients tell me the military member (stationed in Virginia) was from (pick any state) Montana, but the spouse was a resident of (pick any other state) Ohio.
No. That isn’t how it works.
In this example, the non-military spouse can be from Montana or Virginia. To be from Montana the non-military spouse must have lived in Montana with the spouse and established residency in Montana before moving to Virginia.
There are dozens of details and permutations I have left out of this explanation, but that should cover 90% of the military families I see. Bottom line - as the spouse of a military member you don't have to pay taxes in Virginia if you are from the same state as the military member. Otherwise, you are paying taxes in Virginia.
2. Virginia Returns with the Non-Resident Military Member on Them
Nearly all married couples file their federal returns jointly. They will often get the most advantageous tax result by doing so. The do-it-yourselfers know this, so they prepare a joint federal return. Then it comes time to file their state taxes. He’s active duty and from Florida, and she is not. They know she has to pay taxes in Virginia, but he doesn’t. Let the battle with the software begin!
The states have a variety of ways to handle this situation. Virginia’s solution is that if one spouse is a VA resident and the other is not, then the resident spouse files separately in Virginia - even if they file jointly on their federal return. Most tax software hates that. It will try to steer you toward filing jointly in Virginia. Then his income shows up on the Virginia return and it doesn’t belong there. That’s when people come up with inventive ways to remove the non-Virginian's income from the Virginia return.
The fine folks in Richmond have no idea what your state of residency is. They only know that if you put somebody on the Virginia tax return and then invent some creative way to remove that person’s income, it’s wrong. They add it back on and send you a bill.
You have to remove the non-Virginian from the Virginia tax return. You can play with your software until you figure it out - a few people have cracked the code on that. (Don't ask me how they did it, though, I don't use that software.) Alternatively, you can paper-file your Virginia return. You can get downloadable forms for free from the Virginia Department of Revenue site.
3. Not Coordinating Withholding among Several Income Streams
Here is how this one normally goes: Martha earned $20,000 from her primary job during the year. She also started working a second job on nights and weekends, earning $20,000 from that. In addition, she receives $20,000 in pension benefits during the year. Altogether she has $60,000 of income. However, the HR folks at job 1, job 2. and the pension administrators don’t know about each other. As far as they know Martha is only earning the $20,000 per year they are paying her. They are withholding taxes as if her total tax bill is going to be based on $20,000 of income.
When Martha comes to see me and I figure her taxes based on the $60,000 she actually brought in, I am likely to find that she did not have enough taxes withheld and she is going to have to write checks to the IRS and VIrginia.
Getting your tax withholding right across multiple income streams can be tricky. The IRS online withholding calculator is pretty good at helping you figure it out. Just make sure you have pay stubs from all your income sources and your most recent tax return when you start. It will ask for a lot of data you won’t have at the ready in your memory banks.
4. Virginia Residents not Using VA529
I only saw this twice, but I hate to see any tax deductions go wasted, so I wanted to address it. Contributions to the Virginia 529 college savings plan are deductible from your Virginia income taxes. Despite this I noted 2 incidents where clients were paying taxes in Virginia and putting money into the 529 plan in another state.
There is no tax deduction for contributions to another state’s 529 plan. Virginia’s 529 plan has good choices, low fees, and can be used in other states, so I can’t think of a compelling reason not to use it if you are paying Virginia taxes. Unless, of course, you don’t like money. (Which would be a strange condition for somebody reading a tax blog!)
5. Charity Receipts
Those flimsy, blank receipts you get for donating items to Goodwill, The Salvation Army, Samaritan House, CHKD, DAV, etc. I have a real love-hate relationship with those things. I am glad the government is encouraging re-use of items, that people can get a tax break for donating their items to charity, and that poor people have access to a lot of used items at good prices to help them make ends meet. On the other hand many taxpayers are quite confused as to how to properly claim this deduction. They hand me their blank receipt, but when I ask what they had donated they look downright bewildered. They look at me as if to say, I gave stuff to charity and they gave me this blank receipt. Do something with it!
I can see how some confusion might happen. I can’t think of any other place where they hand you a blank receipt and expect you to know what to do. The thrift shop never explains it, either. The guy who takes in your stuff isn’t giving tax advice any time soon. He just hands you the receipt and you’re on your own. (The Thrift Shop isn't allowed to fill it out for you, btw. That's your job!)
You should take a few minutes and fill that out as soon as it is handed to you. The store isn’t going to fill it out for you. You aren’t going to remember what you donated 6 or 8 months later when it’s time to do your taxes. Take a little time to manage your taxes throughout the year. It is worth it!
That's my top 5 for this year. I hope you enjoyed it and there were some useful knowledge nuggets in there for you to use. If you have any questions don't hesitate to contact me.
08 January 2018
My plan is to write a new article for this tax blog at least once a week. It doesn’t always work out that way. Some interruptions to this plan are predictable. For example, I anticipate my blogging schedule will get interrupted during tax filing season (mid-January to mid-April). But this year the interruptions came earlier than expected. One thing that happened is that all my children came home for Christmas – that was a happy interruption.
There were a few others, too, but the biggest interruption (disruption?) I encountered is that just before Christmas something happened I was not anticipating – our federal government accomplished something. Both houses of Congress passed tax reform bills, they worked out the differences in a joint conference, and put a bill in front of the President – who signed it! (It was almost as if there was no dysfunction in Washington for a few days.)
Time will tell if this something our government accomplished with the new tax laws was a good thing or a bad thing. There were quite a lot of changes in the tax law, and I suspect we will ultimately judge some to be good and some to be bad. But since these changes are in effect NOW, people (like me) who plan tax strategies aren’t too keen on waiting to see how things work out in the long run. We need answers now to be able to plan and make strategies.
I have been reading (and reading and reading…) about this new tax law. I have a reasonably good understanding of it now, but there are some things that are just not yet knowable. The IRS has not yet had time to develop rules, forms, and instructions for the implementation of the new laws Congress handed them. The manner in which the IRS implements the changes will have a significant impact on future strategy.
Knowing that more is yet to be revealed, I still want to get some practical information about the new changes in this blog. I have received enough phone calls in the past few weeks to know there is an appetite for it. Instead of trying to eat the entire elephant I am going to stick to the issues I think will be of most interest to my clients and readers. These are the topics with which my clients have dealt with, or may need to deal with in the future. So, without further ado, here is my take on the provisions in the new tax law that will likely have the greatest impact on my clients. Remember, these are new rules for 2018. These changes will not impact the tax return you are about to file for 2017.
That’s where I am going to stop. It’s already a lot to process, and I am just scratching the surface of the tax law changes. The actual document is 1097 pages long, so it will take a lot of smart people a long time to fully digest it.
Fortunately, we have a year to ease into the changes. If new strategies arise during the year you can expect to hear from me. If you have questions, please contact me or ask during your tax prep appointment. I look forward to seeing you this year!
04 August 2015
Readers should be aware the tax law signed by the President on 22 December 2017 made many of these provisions obsolete.
Check out my oversimplified diagram of the federal income tax process. It shows the general flow of IRS Form 1040 so you can visualize where each of the tax terms I use fits into the actual process. I color-coded it to make it easier to follow (hopefully). In the blue we have various terms for income. In the green we have all things I call tax benefits (adjustments, deductions, exemptions, credits). In the red are the taxes.
When we are talking about adjustments or adjustments to income we are essentially talking about tax benefits that can reduce adjusted gross income (AGI). Most tax benefits (deductions, exemptions, and credits) are limited by AGI (or modified AGI (MAGI)). In other words, if your AGI is above a certain level you are disqualified from using that tax benefit. Adjustments can reduce your AGI, making you eligible for additional tax benefits. I am a big fan of adjustments.
You will sometimes hear adjustments referred to as above the line deductions. "The Line" being the point before AGI is calculated. It's an accurate term. Adjustments are essentially bonus deductions that can be taken in addition to the standard deduction or the Schedule A itemized deductions. But given their ability to reduce AGI I prefer to call them adjustments (to income).
Let's look at some of these adjustments in detail.
Educator Expenses. If you're a teacher and you spend money on supplies for your classroom you can claim an adjustment of up to $250. Married teachers filing jointly can claim up to $500. You can't have been reimbursed by the school to claim the adjustment. Expenses for home schooling do not qualify.
Certain Business Expenses of Reservists, Performing Artists, and Fee-Basis Government Officials. Virginia Beach reservists take note: if you travel more than 100 miles from home to perform your duties you can claim an adjustment for your expenses.
Health Savings Account Deduction. If you (not your employer) contributed to your HSA this year, you can claim an adjustment for it.
Moving Expenses. Did you move to Virginia Beach for a new job? If you had unreimbursed moving expenses you can take an adjustment for expenses you incurred. (If your employer paid for the move you don't qualify.)
Self Employed Adjustments - If you have your own business you can take adjustments for part of your self-employment tax, your retirement plan, and your health insurance premiums.
Penalty on Early Withdrawal of Savings. Needed to get your money out of a CD for an unforeseen expense? If the bank levied a fee for the early withdrawal you can write it off your taxes as an adjustment.
IRA Deduction. If you made qualified contributions to a traditional IRA you can take it off your taxes as an adjustment. You must have earned income to contribute to an IRA. Military members can count untaxed combat pay as earned income for taking this adjustment.
Student Loan Interest Deduction. With so much student loan debt this is a big one. You can deduct up to $2,500 for student loan interest you paid. This adjustment goes away when MAGI goes above $80K for individuals, $160K for joint filers. Married filing separately do not qualify for this adjustment. You must be legally responsible for the loan. In other words, paying off your grandchild's loan does not qualify you for this adjustment unless your name was on the loan documents.
Tuition and Fees Deduction. This one is rarely used because the American Opportunity Credit and Lifetime Learning Credits are usually more valuable. However, there is a narrow niche where it makes sense to take this adjustment. Most tax software will automatically compare the benefits between this adjustment and the tax credits for education and give you the best one, but check to make sure you are getting the best tax benefit.
Line 36 (Miscellaneous). This is a potpourri of various rarely used adjustments for things such as forfeited jury duty pay, reforestation expenses, and attorney fees for unlawful discrimination lawsuits. If you have a strange situation, ask your tax preparer, you might qualify for a miscellaneous adjustment.
The ability to reduce your AGI with adjustments can have a snowballing effect in reducing your total tax bill. Not only does it lower your taxable income, but it can also qualify you for additional deductions and credits on your tax return. Make sure you're claiming all of the adjustments for which you are eligible.
08 April 2016
Readers should be aware the tax law signed by the President on 22 December 2017 dramatically changed the applicability of this article. Most of these rules have changed or are obsolete. I have decided to leave it here for consistency and posterity.
Moving expenses, under certain circumstances, can be taken as an adjustment to income. Adjustments are my favorite variety of deductions, because you can use them even when you don't have enough other deductions to itemize - AND - adjustments lower your adjusted gross income, which may make you eligible for additional tax breaks.
The IRS refers to the adjustment for moving expenses as a deduction, so in order to keep things simple I will also refer to it as a deduction. Just be aware that this is an above-the-line deduction, so it does not go on Schedule A. It goes right on form 1040 in the adjustments section of the tax return.
You can deduct the unreimbursed costs of a move if it was work-related and you were not paid additional money by your employer to cover your costs for moving. By work-related the IRS means you moved in order to take a new full-time job in another location. It is not necessary to have the job before you move. It is just necessary that you start working once you get to the new location. In order to meet the IRS requirements to qualify for the moving expense deduction there are two tests, one for distance and one for time.
The Distance Test is simple, although when you first read the definition you can get lost in the words. The IRS writes, “Your move will meet the distance test if your new main job location is at least 50 miles farther from your former home than your old main job location was from your former home.” In other words, if staying in your home when you take a new job adds 50 miles to your commute, you can move and write off the unreimbursed expenses for the move.
Moves are often much farther than 50 miles, but it is not uncommon here in Hampton Roads for someone to be living on the peninsula, take a job in Virginia Beach or Chesapeake, and decide to relocate to avoid dealing with the bridge-tunnels every day. That’s when we have to break out the IRS rules and get very specific on the distances to see if your move qualifies. If you moved from Florida or Texas to Virginia, it’s a slam dunk.
The second part of the test is the Time Test. The time test is different depending on whether you are an employee or self-employed. Employees must work full time for at least 39 weeks of the first year after the move. If you move and start your own business (self-employment) you must work full time at least 78 weeks of the first two years, including 39 weeks in the first year. If you are married and file jointly only one of the spouses must meet the time test.
What if you moved in December? You have to file your tax return by April. Can you still deduct the moving expenses even though you have not yet met the 39-week time test? The IRS actually allows this. You can project that you will eventually meet the time test and take the deduction for moving expenses. However, if you subsequently fail to meet the time test you have to pay the IRS back by either amending your prior return or including the previous deduction as income on your next tax return. (The IRS makes exceptions to the time test in certain situations. See if you qualify for an exception before you pay back the moving deduction.)
Everyone is different, and unusual situations result. For example, a parent might relocate to take another job, and leave his or her spouse and children at their old house for several months to finish school before they also move. The IRS says that as long as the move happens within a year of the start of the new job it is deductible. Similar to the pirate’s code, though, this is more of a guideline than a rule. If you have extenuating circumstances as to why the move could not happen within a year of the start of the new job, then you can apply to the IRS to allow your moving expenses even if they happen more than a year after the new job starts.
You can deduct the cost of shipping your household goods and the costs of travel.
Household goods shipments include your personal property and effects, including pets. You can have a moving company transport your goods or you can rent a truck and move them yourself. You can also deduct the cost of storing and insuring your household goods for up to 30 consecutive days during the move.
Deductible travel expenses include lodging and transportation. Meals are not deductible as a moving expense. Lodging is typically hotels and motels, and can include nights spent in a hotel near your previous home because your household goods were in transit.
Transportation can be tricky. If you take your own vehicle, which is common, you can deduct the actual expenses for gas and oil OR you can take a deduction based on mileage. The 2015 rate is 23 cents per mile. If you have more than one car you can deduct the cost of driving each one as long as it was driven by someone who is a member of your household. Just be careful that you are only deducting the expenses for each member of the household one time. A person might make multiple trips from the old home to the new home, but you only get to deduct one of those trips from your taxes as a move.
Whether you use the mileage deduction or the actual gas and oil expenses you can also deduct any fees for parking or tolls that you paid along the route. You may not deduct expenses for repairs, insurance, or depreciation.
Some things the IRS specifically points out as NOT deductible include improvements to your home, car tags, house hunting expenses, return trips to the former residence, losses on your former residence, fees for breaking your lease, and security deposits.
Moving can be an exciting, but hectic time. There are always hundreds of things to do when you move. Just don’t forget to keep track your moving expenses. You’ll wish you had at tax time! If you have any questions about deducting moving expenses from your tax, please contact me.
08 October 2016
Readers shouldbe aware the tax law signed by the President on 22 December 2017 dramatically changed the applicability of this article. Most of these rules have changed or are obsolete. I have decided to leave it here for consistency and posterity.
One remarkable side effect from being a tax preparer is that it has enhanced my opinion of my fellow citizens. I used to feel like I was one of the few people left in America who wasn't lying on his tax return. Preparing taxes for other people has shown me that my previous suspicions about the rest of you weren't true. In my experience the great majority of taxpayers are honest. They are not trying to cheat on their taxes. They want to take all of the deductions to which they are entitled, and they don’t want to try to get away with claiming deductions for things they are not qualified to claim.
That observation leads me to believe the rules for deducting work-related clothing are misunderstood. Or, perhaps, do-it-yourself software doesn’t do a very good job of helping people through the process of claiming that particular deduction. Perhaps it is a combination of those two things. Either way, I review several tax returns every year that get this deduction wrong. The taxpayer didn’t claim the clothing deduction when they were qualified to do so. Or, the taxpayer deducted clothing expenses that don’t meet the IRS standard for being work-related. I will try to clarify.
The tax code allows self-employed taxpayers to deduct expenses related to their business. Similarly, taxpayers who are employees can deduct the business-related expenses of being an employee. Therefore, work-related clothing can be deducted by taxpayers regardless of whether they are self-employed or employees.
The IRS has a standard definition for work-related clothing. In order for an article of clothing to be work-related it must meet two tests:
1. It must be required by your employer.
2. It must not be suitable for use outside your place of work.
BOTH of these must be true in order for the clothing to be deductible. Let's look at each in greater detail.
This is an easy test to meet if you are self-employed. You are your employer and you wear what you require. If you are an employee it can be a little less straight forward, but is usually easy to determine. Perhaps you work in a restaurant and your manager requires khaki pants and a blue polo shirt. Perhaps you work as a mechanic and the manager requires you to wear a blue shirt with your name patch sewn on it. Perhaps you are in the military and you have uniforms to wear. These are all situations in which your employer required you to purchase and wear particular clothes for work.
I think this is the part that is misunderstood. If the clothing is suitable for use outside of work it is NOT work-related clothing - even if your employer required you to have it. Khaki pants and a blue polo shirt are suitable for wear outside of work. It doesn’t matter if you don’t wear them outside of work. It doesn’t matter if you would not be caught dead out in public in khaki pants and a blue polo shirt. They are considered suitable for use outside of work, and therefore NOT deductible as work-related clothing.
Many military uniforms are also considered suitable for use outside of work. If you can wear it off base it is not deductible as work-related clothing.
Of my previous examples, that leaves the mechanic with the blue shirt and name patch. This clothing is not suitable for use outside the place of work. People don’t typically walk around in public sporting their name and the company logo on their clothing. If the mechanic paid for these items himself, the shirt, the name patch, and the tailoring to attach the name patch to the shirt would all be deductible as work-related expenses by this employee.
I will often see people take a large deduction for clothing when they start a business or a new job. “I needed a new wardrobe,” they will tell me, “I am in sales. I see clients, it is essential to my job that I look professional.” "I only bought these clothes because of the new job."
I believe them, and I understand. I see clients. I try to look presentable. I spend money on suits, shirts, sport coats, and ties that I only wear at work. This does not make them deductible. It is clothing that is suitable to be worn outside of my work, and is therefore not deductible as work-related clothing on my tax return. Your new clothes, even though you bought them because of your job, are not work-related if they can be worn outside work.
When I was a young sailor we had uniforms that could not be worn off base.* There seem to be fewer of those today, but they still exist. Those uniforms would be deductible as work-related employee expenses, but only to the extent that you paid for them out of pocket IN EXCESS OF your annual uniform allowance.
Additionally, there are certain ceremonial items required by some military personnel that are not regular uniform items. Things like an officer’s sword or a flag-aide’s epaulets. These items are also deductible if they exceed your annual uniform allowance.
If you have qualifying work-related clothing you should be deducting it from your taxes. Just make sure that it meets the IRS definition of work-related. If it doesn’t your deduction will not hold up in an audit, and you’ll owe penalties and interest on top of the additional taxes. If you have questions or concerns about work-related deductions, please contact me.
*A short sea story: When I was a junior sailor we still wore the dungaree working uniform. It was not to be worn off base. The rule was you could drive to and from work wearing your dungarees as long as you did not get out of your car between home and work. I observed this rule stridently... except once. I lived about 40 miles from the base and stopped at a gas station near my home. I was low on gas and figured I could just pump the gas quickly, jump back in my car, and not have to go back out later. Standing there pumping the gas a car pulled up on the other side of the pumps. I could see that two-starred fouled anchor on his combination cover from a mile away. The Master Chief stepped out, gave me the stank eye, and asked which command I worked for. I told him, of course, then got in my car and drove off. I never heard anything else about it, but I also never stopped anywhere in that uniform ever again!
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.
26 November 2017
Readers should be aware the tax law signed buy the President on 22 December 2017 made this article obsolete. I leave it here for continuity and posterity.
As advertised last week, this week’s blog is about the ‘certain’ miscellaneous deductions you can take on Schedule A if you itemize your tax return. 'Certain’ miscellaneous deductions are subject to a “2% limitation” – meaning your deductions in this category must exceed 2% of your adjusted gross income (AGI) before they start to actually influence your taxes. Unreimbursed Employee Expenses are also subject to the 2% rule. Fortunately, Unreimbursed Employee Expenses and ‘Certain’ miscellaneous deductions are added together, so it makes it a bit easier to get above that 2% threshold to be able to get a deduction.
For example, Shawn is employed as an auto mechanic, and his 2017 AGI is $50,000. Like most auto mechanics he must bring his own tools to the job. Shawn spends $800 on tools in 2017. Shawn also has $900 of ‘certain’ miscellaneous deductions in 2017. Shawn’s combined Unreimbursed Employee Expenses and ‘Certain’ miscellaneous deductions is $1,700. 2% of Shawn’s AGI is $1,000 (.02 X $50,000). Therefore, Shawn can deduct $700 – the amount by which his combined Unreimbursed Employee Expenses and ‘Certain’ Miscellaneous Deductions exceeds 2% of his AGI.
Without further ado, here are the ‘Certain’ Miscellaneous Deductions:
Appraisal fees for a casualty loss or charitable contribution. Self-explanatory. If you have something appraised to claim it as a tax deduction, you can deduct the fee paid for the appraisal.
Casualty and theft losses from property used in performing services as an employee. While casualty and theft losses are deductible elsewhere on Schedule A, it may be more beneficial to take the deduction here if it was property used in the production of income. It can be added to other ‘certain’ miscellaneous deductions (and unreimbursed employee expenses) to help propel you over the 2% threshold. There is also a $100 per incident subtraction if the loss is claimed on the regular casualty and loss form - form 4684.
Clerical help and office rent in caring for investments. If you have investments generating taxable income and you need to rent office space or pay for clerical help to manage them, you can deduct those expenses.
Credit or Debit Card Convenience Fees for Paying Your Tax Bill. Both the IRS and Virginia will charge you a ‘convenience fee’ for using your debit or credit card to pay a tax bill. That fee can be deducted from your taxes.
Depreciation on home computers used for investments. If your home computer is helping you earn taxable income, you can claim a depreciation expense for it as a ‘certain’ miscellaneous deduction.
Excess deductions (including administrative expenses) allowed a beneficiary on termination of an estate or trust. If an estate’s total deduction in it’s final year exceed its income, the beneficiaries can deduct the excess losses on their individual returns.
Fees to collect interest and dividends. If you pay a broker or similar agent to collect interest or stock dividends for you, it can be deducted here. Note, this does not include the fee to buy or sell securities. That fee is used to adjust your capital gain or loss.
Hobby expenses, but generally not more than hobby income. If you have a hobby that generates income you can deduct the expenses of that hobby up to the amount of income it generates.
Indirect miscellaneous deductions from pass-through entities. If you are a member of a partnership, S-corporation, or a non-publicly traded mutual fund, you can deduct any passed-through deductions as miscellaneous deductions subject to the 2% limit.
Investment fees and expenses. You can deduct investment, custodial, and trust administration fees you pay for managing your investments that produce taxable income.
Legal fees related to producing or collecting taxable income or getting tax advice. If your legal fees are for income from your business, real estate investments, or farm, then it is better to deduct those as business expenses on the appropriate Schedule C, E, or F. However, if you received legal tax advice on a personal matter, such as your divorce, you can deduct it here.
Loss on deposits in an insolvent or bankrupt financial institution. If your bank or credit union becomes insolvent or bankrupt, you can deduct any lost deposits here. (Losses insured by FDIC are not deductible.)
Loss on traditional IRAs or Roth IRAs, when all amounts have been distributed to you. If you take a full distribution from your IRA and the amount you have recovered is less than the amount you contributed, you can deduct the losses on Schedule A.
Repayments of income. Repayments of taxable income received in a previous year of up to $3,000 are deductible, but subject to the 2% limit.
Repayments of social security benefits. If your repayments to SS in a tax year exceed the benefits received, you can deduct the net repayment from your taxes.
Safe deposit box rental, except for storing jewelry and other personal effects. The rental of a safe deposit box is only tax deductible if you are using it to store documents related to the production of income.
Service charges on dividend reinvestment plans. If you are a subscriber to a dividend reinvestment plan, you can deduct the service charges you pay to the plan for holding shares, reinvesting dividends, and keeping your records.
Tax advice fees. Ahem….AHEM! (But if you receive this advice for your business, real estate investments, or farm, then is it more efficiently deducted on the appropriate Schedule C, E, or F.)
Trustee's fees for your IRA, if separately billed and paid. The ordinary and necessary fees you pay to an IRA trustee are deductible if they are billed separately. This would normally apply to someone using a self-directed IRA.
That’s a rather long list, but if you worked your way through it you may have noticed a theme. These deductions are nearly all related to the production of income. The tax code our government has implemented would like to generously provide you with a tax break if you are trying to produce additional taxable income. As long as you exceed the 2% of AGI threshold, of course.
That 2% of AGI threshold is why I rarely get excited about ‘certain’ miscellaneous deductions (or unreimbursed employee expenses). A common scenario I deal with each year is a tax client asking me if they can deduct the $60 they spent on investment fees. The technical answer is ‘yes’, but in reality that $60 is never going to get over the 2% of AGI threshold, so even though we can record it as a deduction on your tax return, you are not receiving any benefit for it.
When I do get excited is when the deductions have exceeded the 2% threshold. That’s when clients probably feel like they are getting the third degree from me as I start asking additional questions, trying to unearth some additional ‘certain’ miscellaneous deductions. Hopefully, I explain everything sufficiently, so nobody thinks I am just sticking my beak into their business!
I’ll finish this ponderous post as I frequently do – with a reminder that taxes can be complex and confusing. Whenever you have any questions you can contact me. Don’t overpay your taxes because you are afraid to ask for help!
Paul D. Allen is a founding member of the Military Financial Advisors Association, as well as a 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 XY Planning Network. Paul is the Director of the CFP Board-Registered Program at The Regent University School of Law where he also teaches the Capstone Course in Financial Planning. You can read more about Paul's background here.