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15 October 2017
A very nice couple I will refer to as 'The Creases' came to me earlier this year with a request to review their tax returns from 2014 – 2016. They were clearly frustrated and anxious about their taxes. They had confidently prepared their own tax returns for many years, but their taxes had risen so dramatically the past few years they were no longer certain they were preparing them correctly.They even wondered aloud if they were perceiving reality correctly. "Maybe we're crazy, but this just doesn't seem right."
My mission was two-fold – find out if they were filing correctly, and come up with a strategy to reduce their taxes. A challenge I eagerly accepted.
I found a few errors on their returns and we amended them for a refund. It’s always nice to get more of your money back from the government, but the errors I discovered were only a small fraction of their overall tax bill. These errors were not responsible for the large increase in their taxes over the past few years. Even after amending their returns their tax bill had increased considerably from 2014 to 2016. With both their 2014 and 2016 tax returns open on my computer monitor at the same time, I could clearly see what was going on with their tax situation. I am going to use their tax returns to show you what I mean by the crease.
The crease is my term for the point – usually between around $100K and $140K of income for married couples filing jointly – where your taxes are increasing at a faster rate than your income. You are making progress in your career, your pay goes up (which is good!), but your taxes go up even faster (which can leave you feeling frustrated and anxious like the Creases).
Let’s look at the Crease’s numbers (after they were amended) to see how this works. These are real numbers from real clients living right here in Virginia Beach. I screenshot and chipped their 2016 numbers and laid them next to their 2014 numbers.
If you’re a tax geek like me you love that picture, but I think it probably looks a bit overwhelming to most people. To make things easier to digest I pulled the important information off their tax returns and put them into a table to ‘declutter’ the numbers and make them easier to follow. The 2014 numbers are in blue. The 2016 numbers are in red.
Let’s start with the top line of data on my table. It is line 38 from their tax returns, a.k.a. their adjusted gross income (AGI). In 2014 the Creases’ AGI was $95,042. By 2016 their AGI had risen to $162,440. That’s a rise of 70.9% - good for them!
Now let’s look at the bottom line on my table. That is line 63 from their tax returns, their total federal income tax burden for the year. In 2014 it was $5,391. In 2016 it had risen to $22,501. That’s an increase of 317.4%. (You read that correctly - three hundred seventeen point four percent.) Their income increase of 70.9% resulted in an income tax increase of 317.4%.
You’re not crazy, rapid tax increases are really happening!
Why Do Taxes Increase So Quickly In 'The Crease'?
Let's dig a little deeper into the Creases' numbers. If you look at line 40 and line 42 you can see the Creases didn’t lose deductions or exemptions from 2014 to 2016. In fact, the amount of income they could deduct and exempt increased a little bit over that span. The problem is they can’t get much more work out of their deductions and exemptions. It's all applied to the 2014 numbers and it doesn't impact the additional income they had in 2016. Nearly all that additional 2016 income passed straight through to taxable income (line 43). Their AGI went up 70.9% from 2014 to 2016, but their taxable income (line 43) more than doubled.
Next comes the impact of our progressive tax system. In 2014 the Creases' top marginal rate was 15%. The additional taxable income they had in 2016 was nearly all taxed at a higher rate – 25%. Not only is ALL the new money taxed, but it is taxed more aggressively by the federal government.
Finally, let’s look at line 52. In 2014 the Creases had two young children, which qualified them for the Child Tax Credit of $2,000 ($1,000 per child). This tax credit directly reduced their taxes owed for 2014. In 2016 the Creases still had two young children. However, the Child Tax Credit is subject to a maximum AGI threshhold and their increase in AGI made them ineligible to receive it. No $2,000 reduction to their tax bill in 2016.
What To Do About It.
If you recall, the Creases also tasked me with finding a way to reduce their tax bill. I did, and I want to show you the results of my favorite easy-to-use tax-reducing strategy: increasing retirement plan contributions. Mr. and Mrs. Crease were both contributing to their respective 401K plans at work. He was saving $4K and she was saving $5K. The maximum allowable contribution is $18K each, so they had a combined $27K ($14K for him plus $13K for her) before they were both making maximum allowable contributions. Below is a table of the projected 2017 results if the Creases make no changes from 2016 other than to make maximum contributions to their 401K plans.
Look at the AGI on line 38, the top line of the table. 401K contributions are not reported to the IRS as income. (Neither are TSP or 403B contributions.) The Creases earned the same amount in both years, but they only have to report $135,440 in 2017 as compared to $162,440 in 2016.
I left their deductions and exemptions unchanged from 2016 to my 2017 projection. When we get to line 43 you can easily see the $27,000 additional contributed to their 401Ks comes directly off their taxable income. Lower taxable income equals lower taxes.
On top of that, their lower AGI will result in allowing them to reclaim $700 of their Child Tax Credit (line 52), reducing their total tax bill (line 63) from $22,501 to $14,986. That’s $7,515 in federal income taxes saved. While my table doesn’t show it, they will also save $1,552 on their Virginia taxes. Combined that is a tax bill lowered by $9,067.
I know…stuffing another $27,000 into your retirement accounts is a lot of money – but let’s look at these numbers a couple of ways to help you frame the advantages:
You put $27,000 into your 401K, but the government gave you back $9,067 to do it, so it really only cost you $17,933 to save $27,000 for your retirement.
You invested $27,000 and the government gave you back $9,067 to do it. That is an immediate, guaranteed 33.58% return on your investment. If you don’t like that 1-year ROI, don’t ever let me hear you complaining about CD rates. That’s a rare and fantastic deal!
The Creases liked my strategy and have implemented it. Their relatively quick income increases from 2014 to 2016 made these large contributions to their retirement plans easier for them to implement than most. Even if you aren't in a position to make maximum contributions to your retirement account(s), any increases you make will improve both your tax situation and your retirement planning.
OK, that’s enough of me nerding out on taxes and numbers for one post. Just remember, if you feel like your taxes are rising faster than your income, they probably are. ‘The Crease’ is real. There are also some things you can do to reduce your tax bill. If you’d like to discuss your tax strategy, come see me.
08 October 2017
There are several significant differences between investing in real estate and investing in stocks, bonds, or mutual funds. One of those differences is the amount of hands-on, direct involvement real estate investing requires. While I advocate passive investing in traditional securities (i.e. stocks, bonds, mutual funds, and etfs), it would be quite costly to be passive about your real estate portfolio; possibly even disastrous. Fortunately, this is not a problem for most of the real estate investors I meet. They seem to like the direct involvement in their real estate investments. I suspect having the ability to exert a high level of control over their portfolios is what drew them into real estate investing in the first place.
Taxes is another area that differentiates real estate investing from securities investing. There are numerous ways in which the tax code gives preferential treatment to income from real estate over income from other sources. I'm not going to try to describe all those ways to you, but let me give you one example.
Dave is single and has a home business building furniture. After taking all his expenses and exemptions into consideration, Dave has $50,000 of taxable income. Using 2016 rates, Dave will owe the IRS $15,731 in taxes for that $50,000 of taxable income.
Debbie is single and owns residential rental properties. After taking all her expenses and exemptions into consideration, Debbie also has $50,000 of taxable income. Using 2016 rates, Debbie will owe the IRS $8,271 in taxes for her $50,000 of taxable income.
Same amount of taxable income, HUGE difference in the total tax bill. The reason for the big difference here is that Dave’s income is subject to self-employment taxes (Social Security and Medicare), but Debbie’s rental income is not. For that reason alone Debbie has $7,460 more dollars to save, invest, travel, whatever. It's hers to do with as she pleases.
The point of this article is not to illustrate all the tax advantages of real estate investing.There are entire books written on that topic. The point I am hoping to make is there are many ways in which the tax code provides for preferential treatment of real estate investing, and taking full advantage of that preferential treatment can make a significant impact on your bottom line as a real estate investor.
I would also like to impress upon real estate investors the cost-effectiveness of having a professional help you with your taxes. I find it difficult to convince many real estate investors they can save money by spending money. They tend to be rugged individualists and hardcore do-it-yourselfers. One of the things they seem to like about real estate investing is their ability to control costs. They see paying a tax professional as a cost. They don’t see it as an investment – but it is.
I offer free reviews of prior year tax returns. Every year I have landlords bring me the tax returns they personally prepared for their own real estate investments. As of this writing I have found errors on 100% of those returns I have reviewed. All of them. Every single one. In all but one case I recommended filing an amended return that resulted in money being refunded to the taxpayer. We amended 3 years of returns for one landlord who received just under $10,000 back from the IRS. He was not unhappy to pay my fee, and did not see it as a burdensome expense.
Sadly, many professional tax preparers also make errors in the tax returns of real estate investors. I had a new client this year who recently moved to Virginia Beach from Florida. He had a CPA firm preparing his returns in past years, but he likes to sit across the table from his tax preparer, so he brought his 2016 return to me. He also brought me his 2015 return, and while reviewing it I noticed the previous preparer had not taken several large and legitimate expenses for his rental property in 2015. When I asked the taxpayer about it he said the CPA firm had told him not to worry about it because he made too much money from his day job to claim the losses anyway. Without going into the details of suspended losses for passive activities rules, this thinking by his former preparer is very wrong. This gross misunderstanding was going to cost this taxpayer north of $7,000 at some point in the future, so we amended his prior year return to make sure all his suspended losses were captured for future use.
Real estate investing is somewhat of a niche specialty within the tax preparation business. The rules for real estate don’t always fit the standard rules. As a result, many tax professionals are not familiar with them. This can lead to costly mistakes for the taxpayer who is a real estate investor.
One last point to make about real estate investing and taxes - plan ahead. Once you’ve taken an action with an investment property – bought, sold, repaired, placed in service, flipped, refinanced, etc. – the tax consequences of that action are pretty much fixed. You can’t sell a property, find out what the tax consequences of the sale are, and then undo them because you don’t like them. It does not work that way. You need to plan. You need to have a tax strategy in place before you take action.
The easiest way to put a tax strategy in place is to work with a tax strategist. Someone who can help you integrate taxes into your overall investment strategy. Be particular about the tax professional you choose. Your tax strategist should have two primary qualities. 1) You want someone who is knowledgeable about the nuances of the tax code with respect to real estate investing. 2) You want someone who will sit down with you and discuss your investing goals. The more familiar someone is with you and your investment strategy, the better able they will be to help you create a tax strategy that leads to the fulfillment of your investing objectives.
A significant portion of the money to be made in real estate investing comes from the tax advantages built into the Internal Revenue Code. If you are a real estate investor, or thinking of becoming one, make sure you are taking full advantage of tax breaks available to you. If you would like to further discuss your real estate investments, schedule a free consultation.
01 October 2017
IRS Form 1040 (the individual tax return) can be monstrous to understand if you try to take it in all at once. That’s how most people do it, though. Once a year they look at their entire tax return, get confused and frustrated, and then ignore it for another year.
It’s important for your overall financial well-being to understand your taxes, so let’s look at just a piece of the tax return today. A small bite we can comprehend in one sitting. Specifically, we are looking at the section at the beginning of the form where all your income is listed. Even more specifically, we are going to look at the income line items that are split into segment a and segment b.
If you use tax software to prepare your taxes you might not have noticed some of the income categories are split into two parts. It is much more apparent if you look at the form 1040 income section.
• Line 8a is for taxable interest and line 8b is for tax-exempt interest.
• Line 9a is for ordinary dividends and line 9b is for qualified dividends.
• Line 15a is for IRA distributions and line 15b is for the taxable amount of the IRA distribution.
• Line 16a is for pensions and annuities, and line 16b is for the taxable portion of the distribution.
• Line 20a is for your Social Security benefits received, and line 20b is for the taxable amount of your Social Security benefits.
If It’s Tax-Exempt, Why Do I have to List It on My Tax Return?
The answer to that (very reasonable) question varies with the source of the income. Get comfortable while I explain it to you.
Line 8 Interest Income. Interest income typically comes from the interest on your bank accounts, or from owning bonds. Some interest, such as the interest on municipal bonds (bonds issued by city and state governments to raise revenue), is not taxed by the federal government. If you have interest income over $10 you should be issued a 1099-INT from the institution holding your account(s). The 1099-INT will tell you how much of your interest is taxable and how much in tax-exempt. The reason you must report tax-exempt interest is it might influence your tax situation, even if it isn’t being taxed directly. (Such as when figuring how much of your Social Security is taxable. More on that later.)
Line 9 Dividend Income. Dividends are paid by stocks and mutual funds. Virtually all dividends are known as Ordinary dividends. This amount goes on line 9a. Dividends paid more than 60 days before or after the stock was purchased are known as Qualified dividends. Qualified dividends receive preferential tax treatment – they are taxed at a lower rate than ordinary income. You are being rewarded for assuming the risk of holding the stock for at least 60 days and not just buying right before the dividend is paid and selling right after it is paid. Qualified dividends are a subset of ordinary dividends. The portion of your dividends that are not qualified will be taxed at ordinary tax rates.
Line 15 IRA Distributions. When you take money out of your IRA it is known as a distribution. Your distribution may or may not be taxable. It is usually, but not always, easy to figure out how much of your IRA distribution is taxable. If it came from a Roth IRA, then none of it is taxable. If it came from a traditional IRA where all the contributions were tax deductible, then all the distribution is taxable. Where it gets tricky is when a taxpayer has made contributions to a traditional IRA and did not receive a tax deduction for it. In that case the withdrawal of the contribution is not taxed, but the withdrawal of the earnings is taxable. If you made non-deductible contributions to an IRA you should have been tracking these contributions on form 8606. Dig up your last form 8606 and it should tell you your total IRA contributions, and how much was deducted when the contributions were made.
Line 16 Pensions and Annuities. This is similar to the situation for IRA distributions. If you are receiving a pension or annuity that you paid for, then the portion of your pension that represents your contribution is not taxable. The portion you did not pay for is taxable. My Navy pension is 100% taxable because I did not pay into a pension fund to earn that pension. Federal civilian employees earning a pension under the Federal Employee Retirement System (FERS) are paying into the pension fund. When they receive a payment from the pension fund the portion of that payment that is a return of their contribution is not taxable.
Line 20 Social Security Benefits. One of the most difficult questions clients ask me is how the taxable portion of their Social Security benefits is calculated. There is no simple way to explain it. There are 4 different worksheets used to figure the taxable portion of your Social Security, and you use the one specific to your situation. The shortest answer is that the more income you have from NON-Social Security sources, the more your Social Security benefits will be taxed.
The Reader’s Digest condensed version goes like this: For 2016, if the total of half your Social Security plus all your other income was greater than $34,000 ($44,000 if married filing jointly), then 85% of your Social Security is exposed to tax. All your other income includes your tax-exempt interest. So even though your tax-exempt interest is not directly taxable, it can make more of your Social Security taxable (which is why you have to report your tax-exempt interest, as explained above).
If your only source of income is Social Security, then your Social Security benefits will not be taxed. Unless you are married filing separately and you lived with your spouse for even 1 day. In that case 85% of your Social Security is taxable regardless of your other sources of income. (I think I mentioned that figuring the taxable portion of social security is frightfully complex.)
Congratulations for making it through that article. It was a bit of a slog to write, so it was undoubtedly a slog to read as well. Your commitment to learning about taxes should be rewarded. The first person to tell me they read this entire article will get 50% off their next tax preparation bill at PIM Tax Services. If you have questions, please contact me.
26 September 2017
Note:A tax conference and a vacation interrupted my blogging for a few weeks. Happy to be getting back on track. The conference gave me dozens of article ideas!
Everyone I know has had a bill they couldn’t pay at some point during their life. Sometimes it’s due to a work interruption. Sometimes it’s a wake-up call to get a grip on your budget. Sometimes it’s caused by circumstances beyond your control. Whatever the reason, most of us have ‘been there and done that’.
When Tade and I were just starting out together it seemed like we never had enough money. We were living pretty well while we were dating, but then she quit her good-paying job to follow this sailor around the country and we got behind in a hurry. There were many months when I had to decide which of our creditors wasn’t going to get paid. I never pre-coordinated any of this with them, of course. I was too proud and embarrassed to tell them they weren’t getting paid. I would just not send them a payment and then catch it up whenever I could. It isn’t the best way to approach this situation, but it worked out OK.
This worked because my creditors were credit card companies and utilities. Can you handle a tax debt in this same manner – bobbing and weaving, dodging bills some months and sending some money the next? What do you do when it’s the IRS you can’t pay? You figure your taxes for the year and you discover you owe an amount you cannot pay? Do you treat the IRS like any other creditor – just sort of ignore and avoid them until you can afford to make it up later?
The IRS is NOT just any creditor. The IRS is the most potent creditor on the planet. Congress has granted them collection superpowers. Your credit card company has to prove to a judge that you owe them money before they can put a lien on your property. The IRS does not. If the IRS says you owe them money, they are presumed to be correct. They can levy your bank account, garnish your wages, and put a lien on your property without going through the courts. Fortunately, it is easy to avoid these harsh measures by staying as compliant with the tax laws as possible, even if you can’t afford to pay your entire tax bill.
What to Do If You Can’t Pay Your Taxes
1. File your tax return. The IRS can charge penalties for failing to file your tax return, and those penalties are initially TEN TIMES HIGHER than the penalties for failing to pay your taxes. 5% of the tax owed per month up to 25% of the total tax can be charged for failing to file your tax return. Failing to pay your taxes is only a 0.5% penalty per month. Trying to hide from the IRS by avoiding filing your tax return will end up costing you more in the long run.
2. Pay as much as you can at the time you file. I see news stories from time to time about the IRS confiscating someone’s home or bank account, shuttering their business, or some other draconian method of enforcing a tax bill. The press does a good job of making the IRS look like a bunch of power-drunk cowboys, but this is rarely the case. The IRS will work with you to get your tax bill paid with the minimum disruption possible to your life, but you have to make some effort to cooperate. Paying part of your tax bill when you file demonstrates your intent to be cooperative.
3. Apply for an installment agreement. The IRS can authorize a payment plan (installment agreement) for paying your tax bill. There is an application fee and you will be charged interest until the balance is paid in full, but it allows the taxpayer some breathing space to pay down the tax bill over time. The application fee varies by how you file the application and how you intend to pay. Paper applications cost $225, or $107 if you agree to make the payments via direct debit of your bank account. Online applications are $149, but only $31 if you agree to pay via direct debit. If your tax bill is over $50,000 you cannot apply online. Your request for an installment agreement cannot be denied if:
a. You owe less than $10,000
b. You propose to pay it back within 3 years
c. You are not delinquent on any other tax year
d. You do not already have an installment agreement for another tax year
e. All your tax returns have been filed
4. Make your payments. If you default on the installment plan the IRS can elect to call the entire debt. If you are having difficulty making the payments you may be able to restructure your installment agreement to reduce the amount of your monthly payments. The IRS charges $89 for restructuring an installment agreement. (They charge the same amount to reinstate and agreement if you let it lapse, so you may as well as for restructuring.)
5. Offer in Compromise. The IRS must collect taxes owed within ten years from the time the tax return assessing the tax is filed. If there is no way for you to be able to pay your tax bill within this time frame you can request an offer in compromise. An offer in compromise is a negotiation between you and the IRS to reduce the tax you owe to an amount you can afford to pay. Essentially, you present the IRS with an amount you are able to pay, and they will determine whether to accept or reject your offer. The IRS will evaluate your ability to pay by analyzing your financial status; your assets, income, and expenses. If the amount you offer to pay represents the most the IRS believes they can collect from you within a reasonable time period they can approve your offer.
Death and taxes are certain. If you can’t pay your tax bill don’t try to hide from the IRS. Be proactive and engage with the IRS. Things will often go better for you if you do. If that seems too stressful or too much bother, hire someone to represent you. You will most likely be happy you did. If you have any questions, please contact me.
19 August 2017
Active duty military members and reservists from the same branch of the service look and act similarly. They wear the same uniforms, attend the same schools, get the same basic training, have the same grooming standards, etc. It can be hard to tell them apart.
Until you gave me their tax returns. I could probably tell them apart in just a few seconds by looking at their tax returns. Active duty and reserve military personnel are treated very differently by some aspects of our tax code. Nowhere is this more pronounced than in the tax treatment of travel related expenses.
I was active duty Navy for nearly 24 years, and during that time I never paid for any of the travel associated with my job. From my first day until my retirement day, if the Navy wanted to send me somewhere they paid for my tickets and lodging and gave me money for meals. I never even had to think twice about it. Little did I know my brothers and sisters in the reserves did not always have it so good. When they need to travel for training or drill they often must pay for that travel out of their own pockets.
That puts reservists in the position of having unreimbursed employee business expenses. Those expenses are deductible on their tax return, but there are two pre-conditions associated with deducting employee-related business expenses:
1. You must itemize your deductions in order to claim them
2. The unreimbursed employee business expenses must exceed 2% of your adjusted gross income (AGI) before they start to count
Those conditions make difficult obstacles for most reservists to be able to claim the tax deduction for their travel expenses. Many young reservists don’t yet own a home, so it is more advantageous to them to claim the standard deduction than to itemize their deductions. Conversely, many older reservists have climbed the private sector ladder to decent salaries, meaning the 2% over adjusted gross income threshold would have them paying quite a lot out of pocket for their travel before receiving any benefits from deducting their unreimbursed employee business expenses.
That’s Why There Are Separate Rules for Military Reservists
Fortunately, Congress carved out a loophole for reservists to bypass the pre-conditions mentioned above. Travel expenses for reservists can take a ‘shortcut’ to the front of the form 1040 individual income tax return, allowing reservists to receive a tax benefit for their travel related expenses without having to itemize or worry about that 2% of AGI threshold.
There is one little hitch, though – that ‘shortcut’ can only be used for travel that takes you more than 100 miles from your home.
There’s a paragraph in IRS Pub 3 on page 9 that explains how this shortcut works. It is so confusingly worded I was tempted to reprint it here just for comedic value. I’m a tax professional and I had to read it 4 times before I understood it. Let me attempt to explain it in terms I hope will be easier to understand.
If you are a reservist, you report ALL your unreimbursed travel expenses (those go on form 2106) just like everyone else. However, if you had a mix of short (less than 100 miles) travel and long (more than 100 miles) you must be able to figure these separately. You add all your travel expenses together on form 2106, then the expenses for travel over 100 miles are carried over to form 1040 line 24. The expenses for the short travel are carried to Schedule A.
Schedule A is for listing your itemized deductions. If you do not itemize your deductions you won’t have a schedule A, and your travel expenses for trips less than 100 miles are not going to get deducted even if they are clearly related to your employment as a reservist.
If you do itemize, the total of your unreimbursed employee business expenses will need to exceed 2% of your adjusted gross income before they start to count as deductions.
The portion of your reservist travel expenses that moved straight to line 24 on your form 1040 goes to work right away. That’s the section of the tax return for special deductions known as adjustments. Like deductions, adjustments reduce the amount of your income exposed to taxation. Adjustments also have two big advantages over regular deductions:
1. You can use them even if you use the standard deduction. You don’t need to itemize your deductions in order to use an adjustment.
2. They are deducted from income before your AGI is calculated. This is an important benefit because eligibility for many other deductions and tax credits are based on your AGI. An adjustment can help make you eligible for additional tax breaks.
A Real Example From My Practice
“John and Rita” were new clients of mine this year. They moved to Virginia Beach from the DC area during 2016. John is a Navy reservist who drills with a reserve unit down in Texas. They brought their 2015 tax return with them when they dropped off their 2016 tax documents. While reviewing their 2015 return I noticed that all of John’s travel was documented on form 2106, but it was all carried to Schedule A as an itemized deduction. None of it made it to the front of their form 1040. After talking to John and Rita I determined all $6,000 of John’s travel expenses were related to travel more than 100 miles from home, and qualified for the special reservist rules.
John and Rita’s 2015 AGI was about $145,000, so 2% of their AGI was $2,900. Moving the reservist travel expenses to their correct location on the tax form lowered their 2015 taxable income by $2,900. As they were in the 25% top marginal rate, this lowered their tax bill by $725. But wait, there’s more!
John and Rita had a son in college in 2015. They claimed the American Opportunity Tax Credit, but their AGI at $145,000 reduced the amount of the credit they could claim. By moving the $6,000 in travel expenses to the front of form 1040 we reduced their AGI from $145,000 to $139,000. This increased the value of their American Opportunity Credit by more than $500. When combined with the $725 in lower taxes from the reduced taxable income, John and Rita shaved nearly $1,250 off their 2015 taxes by using the full value of the reservist travel expense deduction. We filed an amended 2015 tax return and the IRS sent John and Rita a refund.
If you are a reservist make sure you are getting the proper tax deduction for your travel, and make doubly sure your expenses for reservist-related travel over 100 miles are showing up on the front page of your form 1040. It can make a significant difference when figuring your tax bill.
13 August 2017
I 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.
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
Military 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.
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
I 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
• 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.
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.
Bought some software and then started having second thoughts? Stuck on a particular issue? Give me a call and ask about a consultation. I might be able to get you back on the path to finishing your own return.