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10 November 2016
I stumbled across this interesting quote while reading a recent blog post about taxes. It comes from the Tax Court Judge's opinion on a case he had decided:
Deductions and credits are a matter of legislative grace, and taxpayers must prove entitlement to the deductions and credits claimed.
I'm not altogether happy with the term legislative grace to describe tax deductions and credits. Congress writes deductions and credits into the code to encourage behaviors they have deemed beneficial. Congress wants us to buy houses, so they create a deduction for mortgage interest. Congress wants us to be educated, so they create tax credits for higher education. I'm not sure grace accurately describes that situation. But I digress...
The real point the judge is making is that taxpayers aren't entitled to claim a deduction or credit just because they exist. You have to qualify for them; and, if asked, you have to provide evidence that you qualified for the ones you have claimed. If you can't provide such eveidence, then your right to the deduction or credit does not exist.
A paper trail is almost always the best. Receipts, invoices, financial statements, proper bookkeeping, and journal (or log) entries make very compelling arguments in favor of your right to claim the deduction or credit. It may seem bothersome to keep track of and keep up with these things, but not nearly so bothersome as getting your tax deduction revoked by the IRS and getting a bigger tax bill (with penalties and interest).
How you retain and organize your document trail is up to you. The IRS does not dictate any specific record keeping system. (They have been known to accept notes written on a paper plate!) However, good record keeping can save you (and me) a lot of headaches at tax time. Accordion files are inexpensive and you can even get them with tabs to help you sort your documents. Get one and start saving your tax documents in it. If you're not sure whether or not to save a document, save it. It is much easier to throw away documents that aren't needed than it is to locate a copy of something you've thrown away.
If you're handy with technology you might consider going paperless. You can scan in your receipts and other documents and save them digitally. Just be sure to use a logical file naming method. DSC2016-0798.jpg isn't a very helpful file name to describe a hotel receipt. It would take quite a while to find that hotel receipt mixed in with a bunch of other files named DSC2016-XXXX.jpg. You should also maintain different file folders to sort your receipts by the tax category they fall under, and then keep those tax category folders within another folder for each tax year.
There are also computer programs and apps for smart phones that can help you store, organize and keep track of your tax documents. It doesn't really matter how you do it - it just matters that you do it.
So, keep good records. If you still don't know what that means, or how to do it, come see me. I will get you squared away.
Nerdy Tax History Stuff
It is sometimes possible to claim deductions without a paper trail. It's known as the Cohan Rule, named after the composer, playwright, and Broadway producer George M. Cohan. (That's a picture of his statue in Times Square.) Mr. Cohan had a lot of business-related expenses. As a Broadway big shot he traveled frequently and had to wine and dine lots of folks for business purposes. He claimed these as legitimate business expenses on his income tax return. He wasn't very good at keeping records, though. When the IRS asked to see proof of his business expenses he could not produce any. The IRS agreed that such expenses were legitimate in Mr. Cohan's business, but since he couldn't prove when or how much he had spent on travel and entertainment for clients the IRS revoked ALL of his unsubstantiated business deductions.
Mr. Cohan disagreed with the disallowance of all his business expenses for which he could not prove an exact amount, and took the IRS to court. The U.S. Circuit Court of Appeals agreed with Mr. Cohan. Judge Learned Hand (possibly the best-named judge in US History) wrote in his opinion:
...there was basis for some allowance, and it was wrong to refuse any, even though it were the travelling expenses of a single trip. It is not fatal that the result will inevitably be speculative; many important decisions must be such...
Today the Cohan Rule can be applied as justification for deducting some business expenses for which there is no paper trail so long as the expenses are reasonable and credible. But if you find yourself trying to use the Cohan Rule to defend some of your deductions, you probably need a lawyer, not an Enrolled Agent. Keeping good records is so much cheaper!
25 October 2016
I was contacted by a couple of clients yesterday who had suffered losses at the hands of Hurricane Matthew. One was particularly impacted. Her home was flooded and she and her children are currently displaced. Her insurance is not covering all her expenses. She is thankful no one was hurt when they evacuated their flooded home, but she is dealing with the added expense of a hotel room (that accepts pets), the expense and stress of arranging repairs to her home, replacing her damaged furniture and appliances, and working full time through all this to stay financially afloat. She was exhausted and I could hear her frayed nerves in her voice. She wanted to know if there is something that might help her financially. Something, perhaps, in the tax code.
Casualty losses due to flooding (and other natural disasters) can be deducted from your taxable income, lowering your tax bill, and/or increasing your refund. This is accomplished when you file your return, which I explain in greater detail later.
I wrote two versions of this article. One for the folks like my client who are dealing with a lot of [poop] right now, and don’t have time to digest a long tax article. For them I present the “Bottom Line Up Front”. Two paragraphs on what to do right now so that you have the documentation available at tax time to claim your casualty loss deduction.
For those with more time and interest I wrote “The Long Version”. I hope you find one or the other (or both) helpful.
If Matthew tore up your home and you’re displaced to a hotel or a friend’s house, here’s what you should do:
1. Keep all your paperwork. Every estimate, every insurance notice, every invoice, every receipt. Keep it all. Put it in a folder and bring it with you when we prepare your taxes in the spring. Don’t worry about whether you should save something or how to sort it. You have too many other urgent things going on right now, so just put it in a folder and bring it to me. I’ll go through it. I know what I’m looking for.
2. Take pictures. Most of us have a camera on our phone. Use it. Take pictures of all the damage and keep them. Download them to a folder on your computer. I’ll explain how to get them to me later when we prepare your taxes. They will become part of your tax record for 2016. We want to do this for two reasons: 1) my objective eyes might see something in them that you don’t, and 2) if the IRS wants proof you suffered casualty losses, pictures are a great tool to satisfy them.
Just do those two things for now, then focus on the other more urgent things. We’ll sort you out at tax time.
Hurricane Matthew came and went a few weekends ago, but many of us are still cleaning up and restoring our lives. Tade and I suffered little. Our daughter spent Saturday night in her old room because she lost power at her apartment. We woke up Sunday to find the electricity had been off briefly during the night (the flashing digital clocks always let us know) and the cable was out. There were a few branches down and the neighbor’s shutter was on our lawn, but that was about it. We missed a little football, but were otherwise no worse for the wear.
I have several friends and clients who suffered property damage. Something few of them knew before talking to me is that you can deduct casualty losses (for which you are not compensated by insurance) on your tax return. It doesn’t make up for all your losses, but it can help take some of the sting out of your tax bill, or increase your refund.
The biggest bummer about this tax deduction is that it must exceed 10% of your adjusted gross income before it starts to count. That’s a big hurdle to get over, but don’t let it dissuade you from claiming it. I have clients who suffered significant property damage in 2015. Deducting it from their taxes increased their 2015 tax refund by about $14,000. Not everyone can expect such dramatic results, but I mention it to highlight this is not a tax benefit you should ignore.
How it works
Casualty (and theft) losses are itemized deductions on Schedule A of the Form 1040 – meaning you have to itemize your tax deductions in order to claim it. If you take the standard deduction you can’t claim the casualty losses. It is legal to claim your deductions any way you want to, so (as always) we want to file your tax return in the manner that is LAMA (legal and most advantageous) to you.
You also need to claim this in the year that it happened. Matthew came through in 2016, so you need to claim any casualty losses from Matthew on your 2016 tax return. There are some provisions in the law to enable taxpayers to claim the damages on a prior year return, but Matthew happened late in 2016, so claiming casualty losses associated with Matthew are best handled on the 2016 tax return. There is no provision in the law to delay claiming the losses until you file your 2017 taxes.
There is a heavy paperwork lift to claiming this deduction correctly. The IRS wants to know:
a. How much you paid for your damaged property
b. Insurance reimbursements received for the damages
c. The Fair Market Value of the property before it was damaged
d. The Fair Market Value of the property after it was damaged (Salvage value)
I bet if you’re reading this because you had casualty losses that list just pushed your frustration level up a couple of notches. Again, don’t let it dissuade you. It’s not as hard as it looks. Take a couple of deep breaths and keep reading.
Of course you don’t remember how much you paid for each item in your home. Nobody does. That line is really there for any personal property you have that might have appreciated (increased) in value since it was purchased. For most people this would only be their house – and you probably remember what you paid for your house. (If you don’t you can easily find out). Nearly all other personal property (furniture, cars, clothes, etc.) depreciates (decreases) in value from the time it is purchased. For those items, a reasonable estimate of the purchase price will suffice.
If you were reimbursed by insurance there should be a statement from the insurance breaking down the reimbursable items. Typically, however, there are only two categories: the house and the contents. Nearly all of us have the contents of our houses listed as “unscheduled property” with our insurance companies. That means we haven’t listed each individual item with the insurance company, but instead we accept a flat rate (usually 10% of the house’s replacement value) as the insured value of all the contents of the house. It’s easier than updating your insurance policy every time you buy a chair, but the downside is that you can easily have losses exceeding the insured value of your home’s contents.
Knowing the Fair Market Value of your property is also something that few people can easily do. Unfortunately, this is where we are going to need to spend some time to get it right because this is the amount you can deduct from your taxes (after adjusting for salvage value, see below). Fair Market Value is NOT replacement cost. The Fair Market Value is the price you could have sold the property for the day before it was damaged.
The IRS uses the following example in their guide:
You bought a new chair 4 years ago for $300. In April, a fire destroyed the chair. You estimate that it would cost $500 to replace it. If you had sold the chair before the fire, you estimate that you could have received only $100 for it because it was 4 years old. The chair wasn't insured. Your loss is $100, the FMV of the chair before the fire.
Fair Market Value after the property was damaged is also known as “salvage value”. If your property was ruined after Matthew and you have it hauled off to the landfill, then its salvage value is $0. However, if it was damaged, but still usable, then it has some salvage value. You have to estimate this if you keep the item, or keep track of what you sold the item for if you sell it. If you donate the item to a charity, the salvage value is the same as the amount you claim as a deduction for the charitable donation.
We use all of the above numbers to figure out your actual losses. Then, strangely, we subtract $100 from it. It’s like the IRS has a $100 deductible. Then we subtract 10% of your adjusted gross income, and you can deduct the remainder from your taxes. If you had large casualty losses relative to your income for the year it can make a big difference to your tax bill.
Losses from a casualty can be devastating both emotionally and financially. Some things have more sentimental value than cash value, and might be irreplaceable. I hope this didn’t happen to you, but if it did, I hope you at least found a few answers in this article that help put your mind at ease.
I covered a lot of information in this post. There is a lot more to claiming casualty losses that I left uncovered. If you have questions, please contact me.
21 October 2016
Criticizing the IRS is an American pastime. Most of us do it at least a little. Some of us do it a lot. How awesome would it be to get paid to criticize the IRS? To actually look at how the IRS does business and tell them how they are getting it wrong. There is someone who has this great gig, and her name is Nina Olson. She is the National Taxpayer Advocate. Not only does she get paid to provide feedback to the IRS on how they can improve service to taxpayers, but she has an army of 2,000 tax professionals to help her do it!
The Office of the Taxpayer Advocate, more commonly known as the Taxpayer Advocate Service (TAS), was created in 1996. It is an independent office within the Internal Revenue Service with two Congressionally mandated functions. 1) Provide help to individual taxpayers in dealing with the IRS, and 2) Provide systemic help to the IRS to improve service to taxpayers.
If you are having significant issues in dealing with the IRS to resolve a tax problem, you may be able to get help from the Taxpayer Advocate Service. They have offices in all 50 states, DC, and Puerto Rico. If the TAS takes your case, you are assigned a specific representative who will personally work with you until a solution to your issue is found.
Just keep in mind the Taxpayer Advocate Service isn’t there to answer every tax question you might have. They are there to assist taxpayers who are experiencing abnormal difficulties. Cases the TAS will accept fall into four general categories:
1. Where a taxpayer is experiencing some financial difficulty, emergency, or hardship, and the IRS needs to move much faster than it usually does (or even can) under its normal procedures. In those cases, time is of the essence. If the IRS doesn't act quickly (for example, to remove a levy or release a lien), the taxpayer will experience even more financial harm.
2. Where many different IRS units and steps are involved, and the case needs a "coordinator" or "traffic cop" to make sure everyone does their part. TAS plays that role.
3. Where the taxpayer has tried to resolve a problem through normal IRS channels but those channels have broken down.
4. Where the taxpayer is presenting unique facts or issues (including legal issues), and the IRS is applying a "one size fits all" approach, isn’t listening to the taxpayer, or doesn’t recognize that it needs new guidance for those circumstances.
In their role of providing direct support to taxpayers the TAS is in a unique position to gather data on the most common issues causing taxpayer distress. These are the issues that may indicate a systemic problem in the IRS and the National Taxpayer Advocate is required to address these issues in an annual report to Congress.
In the 2015 Annual Report to Congress the National Taxpayer Advocate highlighted 24 serious problems at the IRS. Below are some of the comments Ms. Olson made about the IRS to Congress:
• TAXPAYER SERVICE: the IRS has developed a comprehensive “Future State” plan that aims to transform the way it interacts with taxpayers, but its plan may leave critical taxpayer needs and preferences unmet.
• IRS USER FEES: the IRS may adopt user fees to fill funding gaps without fully considering taxpayer burden and the impact on voluntary compliance.
• REVENUE PROTECTION: hundreds of thousands of taxpayers file legitimate tax returns that are incorrectly flagged and experience substantial delays in receiving their refunds because of an increasing rate of “false positives” within the IRS’s pre-refund wage verification program.
• PREPARER ACCESS TO ONLINE ACCOUNTS: granting un-credentialed preparers access to an online taxpayer account system could create security risks and harm taxpayers [Paul’s Note: Seems like a great reason to make sure you’re hiring an Enrolled Agent to prepare your taxes!]
• AFFORDABLE CARE ACT (ACA): the IRS is compromising taxpayer rights as it continues to administer the premium tax credit and individual shared responsibility payment provisions.
• IDENTITY THEFT (IDT): the IRS’s procedures for assisting victims of IDT, while improved, still impose excessive burden and delay refunds for too long.
Of course, not all systemic failures are the IRS’s fault. They don’t write the tax laws; they just implement them. Assisting thousands of taxpayers each year will sometimes uncover problems, discrepancies, or inconsistencies in the underlying tax law. So, in addition to telling the IRS how to get better, the National Taxpayer Advocate gets to tell Congress how they screwed up the tax law. The 2015 Annual Report to Congress contains 15 recommendations to Congress on how to fix the tax laws to protect taxpayer rights, reduce taxpayer burdens, minimize IRS waste, and improve the Whistleblower program to enhance compliance.
I think I would thoroughly enjoy a job where I got paid to tell Congress and the IRS how they are messing up. Especially when I am learning how they are messing up by helping individual taxpayers get their tax issues resolved - which is something I already enjoy doing.
If you think you might qualify for assistance from the Taxpayer Advocate Service, get in touch with them. It is your right as a taxpayer. Just remember that you need to exhaust all ordinary means of resolving your situation first (unless you are about to suffer grievous financial damage at the hands of the IRS – then you get head-of-the-line privileges).
If you are having an issue with the IRS (or a state taxing authority) you can give me a call and I will help you get it resolved. Don’t delay. The IRS starts a timer as soon as they send you that letter, so the sooner we get to work your problem, the better. In fact, being ahead of the IRS timelines can help to put us in an advantageous position with respect to getting a favorable outcome to your issue.
18 August 2015
Inheritances are generally not taxable to the recipient. When due, estate taxes should be paid by the estate before the beneficiary receives the assets. An exception to this rule is with traditional Individual Retirement Arrangements (IRAs) when inherited by someone other than the spouse of the deceased. When a traditional IRA is inherited by a non-spouse the recipient must pay income taxes on it for the year they take a distribution of the money from the IRA.
Roth IRAs are different. If the inherited IRA is a Roth IRA then the money should be tax free for the beneficiary to withdraw at any time. (The exception would be if the Roth IRA was less than 5 years old when the original owner died.)
Given that spouses can inherit IRAs tax free, and Roth IRAs can also be inherited tax free, the rest of this post is about non-spouses inheriting traditional IRAs.
When a non-spouse inherits a traditional IRA there are some choices to be made - and those choices may have significant tax consequences. The beneficiary chooses whether to liquidate the IRA right away, or turn it into a "stretch IRA" by taking Required Minimum Distributions (RMDs) each year. The amount of the RMD each year is calculated using IRS actuarial tables for life expectancy on this handy worksheet.
If the decedent was over 70 1/2 when they died the beneficiary has a choice between taking the RMD based on their own age, or taking the RMD based on the decedent's age. The younger the person taking the RMD is, the lower the RMD they must take each year. Lower RMDs mean a longer stretch of the IRA. The chart below summarizes the options for the beneficiary. (I stipulated individuals because the rules are different if the beneficiary of the IRA is an estate or trust.)
The most tax efficient option is to stretch the distribution of the inherited IRA for as long as possible. Distributions from an inherited IRA are counted as income. Liquidating the IRA within 5 years triggers income taxes on the distributions in the year(s) they are received. If the IRA is sizable you may find yourself paying taxes in a higher tax bracket than you ordinarily pay. If your normal AGI is $50K and you take $100K out of an inherited IRA, your AGI will jump to $150K that year, resulting in a much higher tax bill. Additionally, you lose the tax-deferred growth opportunity of leaving the bulk of the money in the IRA. Liquidating an inherited IRA should only be done if you have an urgent need for the money.
If the Deceased was over 70 1/2 when they died and you elect to stretch the IRA by taking RMDs, you can choose to take RMDs based on your age or the age of the Deceased. The most tax efficient choice is to take RMDs based on the age of the younger person. If you were older than the Deceased when they died, then you would use the Deceased's age to calculate RMDs. Otherwise, use your own age.
If you intend to stretch the IRA and take RMDs, you are on the clock. If you fail to take an RMD before 31 December of the year following the year the person died, then you are forced to liquidate within 5 years.
I have prepared the taxes for a few people who had liquidated an inherited IRA and were shocked to discover they had given themselves a substantial tax bill as a result. The states with income taxes will also tax IRA distributions. Even military service members need to beware. Your home of record might not tax your military pay, but they may very well want a piece of that inherited IRA.
If you have questions the time to ask is before you select how you want to handle the inherited IRA. Once you have received the distribution it is generally too late.
15 September 2016
My daughter, a senior in college, recently asked me a reasonable question about whether or not printer cartridges were eligible expenses under the 529 program. This led to a broader discussion of the process I use to keep track of her qualified higher education expenses and their corresponding tax breaks. It occurred to me that might be good information for other taxpayers to have as well. I’ll use our specific situation to illustrate my method, but with generic numbers.
The big picture is that I have to keep track of three things with respect to my daughter’s college:
1. Tax Break 1 - Daughter qualifies for the American Opportunity Tax Credit (AOC).
2. Tax Break 2 - We have money in a Virginia 529 account that remains tax free as long as it is used for her education.
3. Expenses - Tracking qualified higher education expenses (QHEE) and matching them with the correct tax break of the two listed above.
There are a lot of different expenses when it comes to college. It should come as no surprise the IRS has rules regarding the expenses you can use to get tax breaks for education. They refer to them as qualified higher education expenses (QHEE), meaning they qualify for the tax break. What might come as a surprise is the rules are not the same for the two tax breaks that concern me most (AOC and 529). The list of qualified higher education expenses for the AOC is more restrictive than the list of QHEE for the 529 plan. (You can’t really blame the IRS for that. Congress legislates this stuff.)
The chart below lists the most common higher education expenses and whether or not they are qualified for the AOC and/or the 529 plan. (Costs to commute to and from campus and parking permits are not qualified under either tax break, but I included them because I often get asked about the eligibility of those two expenses.)
Like most taxpayers, the AOC is more valuable to us than the 529 tax break. Therefore, I am careful to make sure the AOC is accounted for first. In our situation this is not a problem because my daughter is a full-time student at a four-year university. Tuition each year is over $9,000. Tuition is also a QHEE for the AOC.
The maximum amount of QHEE needed to get maximum benefit from the AOC is $4,000. (At $4,000 the AOC is 'maxed out'.) Therefore, I count the first $4,000 of tuition against the AOC and that valuable tax credit is taken care of.
Remember: Double-dipping is not allowed. I can’t claim all $9,000 of the tuition against the 529 money and then also claim $4,000 of it for the AOC. That would be claiming the same expense against two different tax breaks, and it is not allowed. That $4,000 of tuition money that gives us the maximum AOC benefit must come from some place other than the 529 account.
This is where it gets a little tricky. We have non-qualified money in a savings account that is used to fund the college expenses, which is then reimbursed from the 529 plan money. Tuition gets paid right before the start of each semester. Other QHEE for books, room & board, etc. get paid throughout the semester. At the end of the semester I pull money out of the 529 account to reimburse the savings account for all of the expenses EXCEPT for the first $4,000 of tuition, which is reserved to qualify for the AOC. I made a graphic to help explain my method.
The graphic is essentially 3 stacked timelines showing the order of the money flow over the course of a calendar (tax) year from the 529 account to the savings account to the expenses associated with college. Reading from left to right, tuition and other expenses get paid from the savings account and then at the end of the semester the savings account gets reimbursed from the 529 plan.
While the tuition gets paid in a lump sum just before the start of each semester the “Other QHEE” is a number of payments throughout the semester. My daughter has elected to live off campus, so she pays rent and utilities and buys groceries. She can claim all of these as QHEE (against 529 money) as long as the total does not exceed what the university would have charged for on-campus room and board. She has a roommate, so this has never been an issue. If she were living a lavish lifestyle in a penthouse condo and her actual expenses exceeded what the university charges for room and board, her QHEE (for room and board) would be limited to the amount the university charges.
There are other ways to manage this process, but this works for me. I can be sure I will not take too much from the 529 account because I already know what the expenses were for the previous semester. I protect the AOC in the spring by withdrawing $4,000 less from the 529 than the actual qualified expenses were for the spring. That ensures I used non-qualified money for $4,000 of the tuition, which means I can apply that toward the AOC when I am filing tax returns the next year.
We are fortunate to be able to pay out-of-pocket each semester and reimburse ourselves from the 529 plan. (Fortunate because we made a plan and nothing derailed that plan.) We started saving for our children’s education when they were very young. Daughter did her first two years of school at the local community college and then transferred to the university, significantly reducing the overall bill for a bachelor’s degree. She has also worked full time during her schooling and contributes financially to her own education. I’ll be there when she graduates from the Strome College of Business at Old Dominion University next spring. I’ll be the one beaming.
This is a complex issue, which is probably why I write so often about 529 plans. If you have questions about the American Opportunity Tax Credit, qualified higher education expenses, your 529 plan, or any other tax breaks for college, please contact me.
30 August 2016
I do free reviews of individual income tax returns. Two couples took me up on this last week, and my perfect record remains intact. When it comes to rental properties I have found amendable errors on 100% of the tax returns I have reviewed. (It's baseball season, so I guess we should say I am batting 1,000 at finding mistakes on Schedule E.)
These couples didn't know each other (still don't), but there were some unusual similarities in their tax returns. Both involved residential rental properties. Both of their tax returns had the same, somewhat uncommon error, that I don’t see too often. And, this error was costing both of these hard working, tax paying couples some money.
Their mistake? Both of them were deducting the mortgage interest for the rental property on schedule A (as an itemized deduction) instead of schedule E (as a deductible expense of the rental business).
Can’t You Just Deduct Rental Property Mortgage Interest on Schedule A?
The short answer to this question is “no”. In order to deduct mortgage interest on Schedule A the mortgaged property must be a qualifying main home or second home. The IRS defines these terms on page 4 of Pub 936.
Main home. You can have only one main home at any one time. This is the home where you ordinarily live most of the time.
Second home. A second home is a home that you choose to treat as your second home.
Second home not rented out. If you have a second home that you do not hold out for rent or resale to others at any time during the year, you can treat it as a qualified home. You do not have to use the home during the year.
Second home rented out. If you have a second home and rent it out part of the year, you also must use it as a home during the year for it to be a qualified home. You must use this home more than 14 days or more than 10% of the number of days during the year that the home is rented at a fair rental, whichever is longer. If you do not use the home long enough, it is considered rental property and not a second home. [emphasis mine]
Essentially, unless you are also using the rented home for personal use, it is not a qualified home, and you cannot deduct the mortgage interest for it on schedule A. But, that’s OK, because it may be more advantageous to you to deduct it on schedule E anyway.
Why is it Usually More Advantageous to Deduct the Mortgage Interest on Schedule E?
The short answer is because deducting the mortgage interest on schedule E lowers your adjusted gross income (AGI). For tax purposes it is usually better to have a lower AGI than it is to have higher itemized deductions on Schedule A.
Married couples filing jointly start to lose significant tax benefits when their (modified) adjusted gross income gets over $100,000. (Taxpayers with different filing statuses lose these tax benefits at different thresholds.) Of note, the Child Tax Credit and Lifetime Learning Credit start to phase out at $110,000, the Student Loan Interest Deduction starts to phase out at $130,000, and the American Opportunity credit starts to phase out at $160,000.
If your income falls into that range, then you want to lower your adjusted gross income to qualify for as many (and as much) of these tax benefits as possible. If you claim the mortgage interest deduction for your rental property on Schedule A it comes off your taxes well after your AGI has been calculated. If you deduct it as an expense on schedule E, then it lowers your AGI, and can increase the value of the tax benefits listed above.
That is exactly the case for the two clients I saw last week. One client was able to get a larger Child Tax Credit once we moved the mortgage interest deduction from Schedule A to Schedule E, netting over $300 of additional tax refund. The other client was able to get maximum value for the American Opportunity Credit, which netted them about $425 in additional tax refunds.
What If Your Rental Property IS a Qualified Home?
If you used your rental property during the year and it is a qualified home, it might be more advantageous to deduct the mortgage interest on Schedule A. This would only be if all of the following are true:
a. You don’t qualify for any of the previously mentioned tax credits
b. The rental property is losing money (after depreciation)
c. You make too much to deduct passive (i.e. rental) losses (AGI of about $150,000 for MFJ couples)
That’s a narrowly defined set of criteria, but there are taxpayers in that situation. If that is your situation, then you may want to deduct the mortgage interest for the rental property on Schedule A so you can get some tax benefit for it in the current year.
Taxes are complex, and I have just hit the high points on this topic. There are quite a few variables, and each situation is unique. It might be worth your while to have a tax professional give you a hand. I review tax returns for free, so if you’d like me to take a look at yours, just give me a call to set up a time.
06 August 2016
Charitable giving is a wonderful thing. You can provide targeted assistance to other members of our society who need a helping hand. It's a cost-effective way to help make the world a better place. It’s such a wonderful thing the government encourages it by providing tax breaks for those who give to charity. If you itemize your deductions, you can subtract your contributions to charity from your taxable income and lower your tax bill. Most of my clients take advantage of that tax incentive and give some money to charities each year.
If you pay state income taxes in Virginia, you get a double bonus. The charitable deductions from your federal tax return also carry over to your Virginia return. Not only do you not pay federal income taxes on the money you donate to qualified charities, but you don’t pay Virginia income taxes on it either.
If you think about it, that’s fairly generous on Virginia’s part. You might be giving money to the Boys and Girls Clubs in San Bernardino, California, and you still get a Virginia tax break for it. The Boys and Girls Clubs of San Bernardino is a worthy charity, I’m sure, but it doesn’t really help any Virginians for you to donate money to charities out of state. You still get a Virginia tax break for it, though.
The fine folks in Richmond recognized this overtly generous situation and decided they wanted to provide a separate incentive to encourage Virginians to donate their money to local (Virginia) charities. What they came up with was a humdinger of a tax credit called the Neighborhood Assistance Program (or the Neighborhood Assistance Act Credit). If you make a contribution to a Neighborhood Assistance Program (NAP) qualified charity you can get up to a whopping 65% Virginia tax credit for your donation.
Let’s look at a quick example to see just how staggering that number (65%) really is:
John and Jane Doe are Virginia residents. Their top marginal federal tax rate is 25%, and their Virginia marginal rate is 5.75%. They give $1,000 to a NAP-qualified charity and are eligible for a 65% tax credit on their Virginia taxes.
They gave $1,000 to charity and it lowered their taxes by $957.50. Total cost to them was only $42.50.
The NAP is complex, so don’t just start throwing money at a local charity and expect a big tax credit. Virginia makes you work for this, but given how generous the program is I don’t really blame them.
The minimum donation for individuals is $500. That’s a bit steep for many, but I find quite a few clients who give more than that annually, they just break it up into smaller pieces and spread it throughout the year. If you plan ahead to make one large donation you may be better off in the long run. (Oh, and if you’re interested, the maximum amount an individual can give under this program is $125,000/year. Dare to dream.)
Next you have to find a NAP-qualified charity. The Virginia Department of Social Services posts a list of them every year. YOU NEED TO CONTACT THE CHARITY FIRST BEFORE YOU QUALIFY FOR THE CREDIT. Virginia puts a fixed dollar cap on the available credits, and wants to spread the money somewhat evenly across all of the qualified charities. To help this along they put the charities in the driver's seat. The qualified charities each get a certain value of credits for the year they can award to donors. If you give money to one of these charities, you need to make sure they have credits available to award you for your donation. The list of charities with credits to give comes out in July. You should contact your preferred charity in July to secure your credits. By August many charities are out of credits, but you can probably still find some if you call around.
Once you have verified the organization you want to support has available tax credits, make your donation. You can’t have any strings attached to your donation or receive anything of value from the organization in return. The charity should then provide you with a Contribution Notification Form (CNF) that you fill out and return to them. The charity forwards your CNF to the Virginia Department of Social Services and the VDSS issues you a tax certificate proving you are entitled to the NAP Tax Credit.
When you file your Virginia taxes you include the information about the donation on Schedule CR, and you are done.
Virginia puts a fixed dollar cap on the amount of credits they will refund each year. In the event the total credits claimed exceed the fixed cap everyone claiming the credit will see a reduction in the credit. In other words, the credit might only be 60% or 62%, or 58%. You won’t know until all of the credits are counted in Richmond for the year.
The credit is non-refundable. If it takes your total Virginia tax liability down to zero and you still have unused credit, the difference won’t be refunded to you. However, any excess unused credit can be carried forward to the next tax year (for up to 5 years).
You can also give to programs approved by the Virginia Department of Education to receive the NAP credit. Your tax certificate will come from the Superintendent of Public Instruction (vice the VDSS) if you give to an educational charity.
Virginia allows both 501(c)(3) and 501(c)(4) organizations to participate in the NAP. Donations to 501(c)(4) organizations are not deductible from taxes (there are a few rare exceptions), but you would still qualify for the Virginia NAP tax credit. Be sure you know the tax exempt status of the charity you are giving to before you make your donation.
This is a really powerful tax incentive. Virginia wants these charities to receive your money so that it stays at work here in Virginia. I hope to see more people taking advantage of this generous credit next year. If you want more information about the program, please contact me.
24 July 2016
As part of my service here I provide a free review of a client’s prior year tax returns. Most of the time I find errors that can be corrected by amending the prior year return, usually resulting in a refund from the IRS. Most of the time the tax return was self-prepared by the taxpayer, but I also find mistakes made on returns prepared by other tax professionals.
I thought I would make a post of the most common errors I found on tax returns this past year. If you’re preparing your own taxes it might give you an idea of some things to watch out for.
I commonly find this on the tax returns of military personnel. The military member has a home of record in a state that doesn’t have an income tax. When they itemize their tax deductions on Schedule A, they leave line 5 empty. But line 5 allows you to choose between deducting state income taxes or sales tax. If you can’t take a state income tax deduction because you don't pay state income taxes – then for Heaven’s sake, take the sales tax deduction!
For some military families where the spouses file jointly, it is still better to take the sales tax deduction than the state income tax deduction even if they do pay state income taxes. It's rare, but it happens. It depends on the relative incomes of the individual spouses. Take some time to figure it out – it’s worth real money! (Read more about this.)
Reviewing my records for this post I found only one landlord in the past two years who did his own taxes and correctly calculated the depreciation on his property. I’m not going to try to explain how to figure depreciation here, but given the number of errors I see by do-it-yourselfers, it is clearly complicated. One of the things that makes it so complicated is that the forms the IRS provides are not very helpful in explaining how to fill in the blanks.
If you’re trying to calculate depreciation on a rental property for yourself and you get stuck, get help from a tax professional. The IRS will make you rectify your depreciation numbers when you sell the property and I have seen some significant tax consequences to taxpayers who thought they understood depreciation but did not.
The typical scenario here is that Grandma opened a Unified Gifts to Minors Act (UGMA) account in Junior’s name and put some stock or a mutual fund in it. Junior is now six years old and receives a 1099-DIV for the $120 in dividends he earned. The parents include that money in their income and pay taxes on it. This is a mistake.
Junior is his own tax entity. His money is his money – it isn’t your money. You don’t have to pay taxes on it. Even better – Junior doesn’t have to pay taxes on it either until his interest and dividends (unearned income) reaches $1050. Once you get above $1050 the rules get strange fast. If you have questions about those rules just ask, but stop paying taxes on your kid’s $120. It isn’t necessary. (And UGMA's aren't that great, either. There are usually better options for grandparents who want to help. You can ask me about that, too.)
Here’s how this one usually goes: John and Mary had $3,000 withheld for state income taxes in 2014, but their actual state income taxes owed for 2014 was $4,000. To pay it they stroked a check to Virginia for $1,000 in April 2015.
In 2015 John and Mary had $3,000 withheld from their income for state income taxes. They itemize their FEDERAL tax return and claim the $3,000 that was withheld as their state income tax deduction on Schedule A.
The problem is that John and Mary actually paid $4,000 to Virginia in 2015 – the $3,000 they had withheld and the $1,000 they paid in April to settle their 2014 tax bill. They should be claiming a $4,000 deduction for state income taxes, not just the $3,000 that was withheld from their income. Don't forget to deduct the amount you paid in addition to the wage withholding!
Many taxpayers have more than one job, or they need to drive for work. Both of these situations can create an opportunity for the taxpayer to deduct expenses for using their own vehicle. I wrote a complete post about this previously, so you can get the additional details here.
This isn’t really a tax preparing error – the IRS doesn’t require you to use your HSA. However, for most people it’s a big mistake to not use it. You’re missing out on an enormous tax benefit. You can put money into it tax free, growth of the money in the account is tax free, and as long as you use the money for medical expenses you can take the money out tax free as well. Free when it goes in, free while it grows, free when it comes out - that’s Tax Nirvana!
When it comes to taxes I’d rather have an HSA than an IRA. There’s no income limit on getting a deduction for your contributions to an HSA – not true for an IRA. You can just about guarantee that your medical expenses will be significant in retirement, so being able to use it for medical expenses is a very solid bet. And, if you’re fortunate enough to have good health for your entire life, you can still take the money out after you are Medicare eligible and not have to pay any penalties on the withdrawal. You’ll pay normal taxes if you don’t use it for medical expenses, but you’d do that with an IRA anyway. You are essentially making a free bet that you’re going to have medical expenses – but if you don’t have medical expenses you’re no worse off tax-wise than if the money was in an IRA.
I am stunned when I see taxpayers with unused cap space on their HSAs. They are missing a real opportunity to save money on taxes by not fully utilizing this great tax benefit.
I offer to amend returns when I find errors. I charge a fee for that, of course. I am running a business here, after all. But just because I am running a business doesn’t mean I want people who prepare their own taxes to make errors that cause them to overpay the IRS. The tax code has built in protections and benefits for taxpayers. Everyone should be taking advantage of them.
If you have questions or want me to review your taxes, please contact me.
10 July 2016
US taxpayers working and living abroad may qualify for the Foreign Earned Income Exclusion. I won’t get into how one qualifies for it here – that’s a whole different set of (highly complex) rules. Suffice it to say you essentially have to be working out of the United States for a year before it starts to become a possibility.
It’s a really good tax benefit, but not as good as I think it should be. I’ve completed the tax returns for several people who claimed it in 2015, and it’s never quite as good as they think (or hope) it will be either. There are two main reasons for that, and they are somewhat complicated. I’m going to break those two reasons down and make them easier to understand.
The amount of foreign earned income that can be excluded from your income for tax purposes is capped. In 2015 it was $100,800. The maximum amount is indexed for inflation, so it goes up every year. The issue here is the cap is also limited by the amount of time you actually worked in a foreign country during the year. The only way to get the full $100,800 exclusion is to be in the foreign country all 365 days of the tax year. That’s not very common.
Let’s say a person worked in a foreign country from July 1, 2015 until June 30, 2016, and they meet the requirements to qualify for the Foreign Earned Income Exclusion. That span covers two tax years. The foreign earned income received from July 1 – December 31, 2015 goes on the 2015 tax return. The foreign earned income received from January 1 – June 30, 2016 goes on the 2016 tax return. This person earned $100,000 from July 1 – December 31, 2015. That’s below the 2015 cap of $100,800 for the Foreign Earned Income Exclusion, but that entire $100,000 cannot be excluded – even though it was all foreign earned income.
We have to apply the ratio of days in 2015 in the foreign country to the amount of foreign earned income to determine how much can be excluded.
From July 1 – December 31 is 184 days.
184/365 = .504 (the tax code has us round to 3 places)
.504 X $100,800 = $54,432
The maximum amount this individual can exclude as foreign earned income in 2015 is $54,432 - well below the $100,000 they earned overseas.
The second reason this tax benefit isn’t as good as it could be is the IRS uses a special calculation to figure the tax on income that is reduced by Foreign Earned Income Exclusion. It’s right there on page 42 of the 2015 Form 1040 Instructions: If you claimed the foreign earned income exclusion, housing exclusion, or housing deduction on Form 2555 or 2555-EZ, you must figure your tax using the Foreign Earned Income Tax Worksheet. Below is the important part of that worksheet:
Essentailly the worksheet has you add the foreign earned income back to your taxable income. Then you find the tax on that amount. Then you find the tax on the amount of the excluded foreign income and subtract that amount from the tax on the total.
This matters because the IRS is not treating this excluded income like a deduction. Deductions come off the top of your income, and you receive the tax benefit at your top marginal rate. What this fancy little worksheet does is rearrange things to take the Foreign Earned Income Exclusion off the bottom of your income. Your tax savings come at your lowest marginal rates instead of your highest marginal rates.
That’s a bit of a tough concept to comprehend, so I made some graphics that I hope will clarify it for you. We will stick with the numbers from the first example. Our hero – the taxpayer – made $100,000 in 2015, of which $54,432 qualifies for the Foreign Earned Income Exclusion. We exclude that from his income. Let’s also assume that through other deductions and exemptions his taxable income on line 43 comes to $30,000. We’ll also make him single and use the tax rates for taxpayers filing as single.
First, let's look at the marginal tax rates for a single taxpayer in 2015:
Now let's take a look at a graphic showing the difference between his foreign earned income being treated as a regular deduction (How it should be) vs the way the Foreign Earned Income Tax worksheet treats the Foreign Earned Income Exclusion (How it is):
The left side shows the taxpayer's total taxable income stack next to the tax rates chart. When we exclude the foreign earned income from the top (as if it were a normal deduction) the remaining $30,000 of income is taxed at the lowest tax rates.
The right side shows nearly the same thing, except that the foreign earned income is excluded from the bottom of the income stack. That leaves the remaining $30,000 being taxed at the taxpayer's highest rates.
If that seems insignificant, it is not. If the taxpayer could just figure his tax on the $30,000 as if the foreign earned income was treated like a deduction (How it should be), then his tax bill would be $4,043. By using the worksheet and taking the Foreign Earned Income Exclusion off the bottom (How it is) the taxpayer has a tax bill of $7,500. A difference of $3,457. That little Foreign Earned Income Tax Worksheet calculation creates an 85.5% increase in the taxes owed by the taxpayer!
Don't get me wrong - it's still a HUGE tax benefit to use the Foreign Earned Income Exclusion. Without it our hero's tax bill would have been $16,900 instead of $7,500. How it is still reduced the tax burden by $9,400 for this taxpayer. That's significant money. It just irks me that our government comes up with this additional way to calculate the tax that prevents the benefit from being as good as it could be. (With the added bonus of making the tax calculation nearly incomprehensible to most taxpayers.)
On a happier note - Virginia doesn't bother with this fancy calculation for state tax returns. Like many states, Virginia's state income tax calculation begins with the Federal Adjusted Gross Income. Since the foreign earned income is removed prior to the federal AGI calculation, that income never even makes it onto the Virginia tax return. In essence, it has come off the top for Virginia tax purposes.
If you qualify for the Foreign Earned Income Exclusion, make sure you are using it. If you have questions about the Foreign Earned Income Exclusion 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.