Welcome to the Tax Blog
News, information, and opinions about:
- Federal, State, and Virginia Beach Taxes
- The Tax Preparation Business
- Tax Planning
If you have a question or comment, please drop me a line. Paul @ PIM Tax.
02 December 2015
It's that time of year when the retail companies of the world ban together to create shopping events. Black Friday - the oldest and most widely know of them - has been around for several decades. Small Business Saturday and Cyber Monday are relative newcomers to the scene. All three share a common purpose - they are all events designed to encourage you to get your Christmas/Holiday Season shopping up and running. In their opinions, it's time for you to go buy some stuff!
I'm a consumer (of course) and we celebrate Christmas with gift-giving in our home, but I am not a participant in these massive consumer events. Not my cup of tea. The crowds and the frantic atmosphere wear on my nerves very quickly. I am usually at home or work on those days. I am not opposed to shopping around for a bargain, I just don't want to feel like I am competing with others to do it.
It's impossible to ignore these major retail events completely, though. My Thanksgiving Day football games this year were sponsored by Target and Wal-Mart - and their amazing deals! Every commercial break that day was loaded with the suggestion that I was really going to be missing out if I didn't get out and buy some stuff within the next 24 hours.
It got me thinking - how valuable are these sales? How much are people really saving, and is it worth it? Is the advertising 100% hype or is there at least some truth to the matter?
In order to formulate a reasonable assessment I had to do about 15 minutes of research on the interwebs. Here is what I found: Experts recommend spending between 1% and 1.5% of your annual household income on Christmas. Every family and their traditions are different, of course, but let's use those percentages as an acceptable range.
A household with a total income of $80,000 should spend somewhere between $800 - $1,200 on Christmas. If you're able to save 50% of that amount by using the super shopping events right after Thanksgiving you would save between $400 to $600 dollars. That's not bad. That's significant money in a household with a total income of $80,000.
Given my line of work, though, something else was immediately apparent to me. $600 is also likely to be chump change compared to what that household could save if they engaged in tax planning. In my experience many households leave significantly more than $600 on the table in unused tax credits and deductions every year. Money they could have kept for themselves, but they gave to Uncle Sam instead.
Additionally, tax savings can have a lasting impact beyond the current year. Saving on Christmas gift purchases is a onetime deal. With tax planning the benefits can be realized both now and again in the future. A tax benefit taken this year can continue to be a tax benefit for years into the future. Some tax benefits you take this year could even benefit your children or grandchildren decades from now - even after you're gone. (And you don't have to camp outside the store overnight to get those tax breaks, either!)
Our TVs, radios, and internet-connected devices will constantly be reminding us for the next few weeks of super sales where we can save a few dollars on our holiday shopping. You won't see or hear very much about how to arrange for a lifetime of savings through proper tax planning, though. It's a shame, really, because it can truly be a gift you give your family that keeps on giving.
If you want to find out more about tax planning please contact me.
11 November 2015
By themselves state tax returns are usually not complicated. Most state forms are similar to the federal forms and many states also have helpful websites to answer your questions. Despite this, most of the problems I see (and experience) are related to the state tax return forms.
Tax software is designed to have you fill in the federal tax forms and then your state return should automatically fill from the information on your federal tax return. Most of the time that works just fine. But not always. If your federal and state tax returns are not being filed the same way - if the federal and state returns are different for some reason - the software can't always handle it. Mismatched state and federal tax returns are a common occurrence here in Virginia Beach due to the large population of military personnel in the region.
A situation I see quite often is a military person moves to Virginia from another state and gets married. The service member uses another state (let's say Florida) as his home of record, but his spouse is a Virginia resident. They file their federal return jointly. His income is not taxable in Virginia and he is not required to file a Virginia return. The spouse's income is taxable in Virginia and she must file a Virginia return. Virginia's solution to this situation is to have the spouse file her tax return as married filing separately.
While this is the correct (and most advantageous) way to file, most tax software puts up a fight when you try to change the filing status on your state return to something different than your federal return. When that happens you (or your tax preparer) can end up sitting there for quite a while trying to figure out how to get the tax software to produce the answer you know is right!
I have had several clients in past years who wanted me to file just their state return. They have filed their federal return, but they can't get their software to give them the right results for their state return. They give up fighting with their software and bring their problem to me so that I can fight with my software. (That's not a problem, by the way, I don't mind doing that. My software provider actually likes me because I keep providing them useful feedback on how to make their product better.)
Enough about the software, though, let's look at that situation again. My two-state couple files their federal return jointly, but only she has to file a Virginia return, and she is going to file it as married filing separately. I see some room in that situation for a little tax savings for couples who itemize their deductions. As a Florida resident he isn't going to file a state tax return. He doesn't need any deductions (or exemptions) in his name. That means we can overweight the deductions and exemptions in her name so she gets credit for them on her Virginia state income tax return. The software won't do this automatically, but we can manually override it for some additional tax savings.
I wouldn't recommend going overboard with this tactic and piling every single deduction from the federal return on her state return. The fine folks in Richmond are not going to believe that he made $50,000, she made $30,000, yet she can claim all $20,000 worth of deductions. (Virginia audits returns and requires proof just like the IRS does.) But if she has made some charitable contributions during the year, perhaps they can all go on her return. If a couple maintains separate bank accounts and she is paying the mortgage from hers, I think you can substantiate her claim on the mortgage interest deduction for her state return. If there are dependents, you should definitely put them on her return in this situation - unless it is completely unjustifiable for some reason.
Sometimes a military couple will need to file separately in two different states. In that case we would want to overweight the deductions on the state return where they would generate the most tax savings. Every situation is different, and needs to be considered based on its own merits, but I can often squeeze a few more dollars out of a state return using this technique.
If you want some assistance getting your state taxes filed, please contact me.
25 November 2015
Most taxpayers know what a form W2 is. If you're expecting a tax refund that's the form you're checking the mailbox for every day until it arrives because you can't file your taxes without it. (That's probably old school. Nowadays most people are probably checking to see when their W2 is available for download.)
It's official name is the Wage and Tax Statement. The IRS dictates who has to file them (employers) and by when (31 January). Your employer has until the end of January to have your W2 to you. If you don't have it by then, start asking questions at work.
I started writing a post to explain the W2, but it was starting to look like a book! Instead I decided to answer the 5 questions about the W2 that get asked the most.
1. I have two W2's, why do they look so different?
The IRS does not require a specific format for the W2, only general guidance is provided. Box 1 must have the same information on every W2 (wages, tips, and other compensation), but Box 1 can be anywhere on the form. The boxes don't have to be in order, and sometimes they aren't! As a tax preparer I am not a fan of W2 creativity. I see a large variety of W2 styles and I frequently need to hunt for the information I need.
2. Why did I receive so many copies of the same form?
The IRS specifies that you must receive 4 copies of your W2 - 1 for federal, 1 for state, 1 for municipal (in case you pay municipal income taxes), and 1 for you to keep. To save money, many W2 preparers have opted to put all 4 copies of the W2 on a single sheet. They can do this by reducing the font size and making the information quite difficult to read. It also makes losing a single detached W2 very easy when they are one-fourth (or smaller) of the size of a normal sheet of paper. This 4-copy system is a relic from the era of paper filing. Now that most filing is electronic, people usually end up with 3 or 4 copies of their W2 after their taxes are filed.
A generic W2 for reference:
3. Why is my income in boxes 1, 3, and 5 not the same?
Box 1 is the amount of your income exposed to federal income taxes. Box 3 is the amount of your income exposed to Social Security (SS) Taxes. Box 5 is the amount of your income exposed to Medicare taxes. The reason they are not the same varies, but I'll give the most common reasons I see. If Box 1 is larger than Box 3 and 5, it is often because you received a bonus or military specialty pays (or both). Those are subject to federal income tax, but not SS or Medicare taxes. If Box 1 is smaller than Boxes 3 and 5 it is often because you had money from your pay sent directly into an employer sponsored retirement account (401K, 403B, TSP, etc.). The pay going into your retirement plan is not subject to federal income taxes, but you still pay SS and Medicare taxes on it.
The most Box 3 can ever be (in 2015) is $118,500. That is the highest income you have to pay SS taxes on. There is no income limit on Box 5.
If your income in Boxes 1, 3, and 5 are different and the reason isn't stated above, come see me. We'll figure it out.
4. What's this stuff in box 12 mean?
It means the government wants to keep track of ALL of your compensation, not just the wages paid to you. Most commonly I see codes D and E, which are your 401K or 403B retirement plan contributions respectively. I also see code C, employer's taxable contribution to a life insurance plan. Code W, employer contributions to your cafeteria plan or health savings account. There are quite a few other codes. The W2 will sometimes have them written on the back (in very small font) or you can look them up online.
5. I am only doing 4 years in the military, why is Box 13 "Retirement Plan" checked?
Your participation in an employer-sponsored retirement plan impacts your ability to make tax-deductible IRA contributions. Even if you are not going to stay in the service long enough to get a pension, the IRS counts you as participating in the retirement plan for the purpose of your IRA contribution limits.
There's quite a bit more to form W2 than I covered here. If you have questions please contact me.
18 November 2015
Individual income tax return preparation is big business. The nation's largest retail tax preparation chain, H&R Block, reported $2.9 billion in revenues last year from income tax preparation. Block has over 11,000 offices worldwide. The other well-known names in this region, Liberty Tax and Jackson-Hewett, also reported strong revenues with nearly 10,000 offices between the two. My question is where are they now?
By now I mean in November as I am writing this. The H&R Block office closest to my house has been dark since April 16. The Jackson Hewitt office a little further up the road is also dark. I haven't seen anyone dressed as the Statue of Liberty waving at the side of the road in quite some time, either.
That office space isn't available on the rental market. The tax prep companies (or their franchisees) continue to hold onto their leases. Those offices are dark now, but they are waiting until next tax season to light the lights, open the doors, and invite us all to get our billions back.
How, do you suppose, these huge tax mills can afford to leave so many offices empty and unused for 8+ months out of the year? Could it be they actually make enough money during the 3-and-a-half months of tax season to pay their rent and utilities for the entire year?
That is exactly how they do it.
The largest tax preparation companies all have a similar business model: establish the brand, establish highly accessible offices, hire (and train) a ton of temporary help, and then charge enough to be able to sustain it all with just a few months of business each year. Given their recent revenue numbers it is a model that seems to be working. People are drawn to the stability a large company offers.
But...where are they now? If the IRS contacts you with questions about your tax return, where do you turn for help? How do you find your tax return preparer - the person that worked on your return. Fact is, if one of the big boys prepared it, you probably won't be able to find your preparer. Odds are pretty good they aren't currently on the payroll.
To be fair, you can get assistance from the big companies in the off season. They typically leave an office or two open in every region and keep a handful of tax preparers on payroll year round. The available office might not be in a convenient location for you, and it probably won't be the person who prepared your tax return, but you can get some help.
I am also a financial planner, so PIM Tax Services is open year round. If there's an issue to discuss with your taxes in November (or any other month) I am available to answer it and, if necessary, work on it. I don't need to earn enough in 3 months to last me all year long. I don't buy air time on network television so that my bow-tied spokesman can tell you how to get your tax refund. Nor do I have a board of directors and stock shareholders anxious to get their next dividend payment . All of this enables me to keep my prices low and provide top quality service to every single customer.
The big boys in the tax business want to prepare your tax return next year. I want to be your trusted adviser for life. We are wasting our time if we don't plan on working together 10 years from now. If you want to build a relationship with a tax preparer you can trust to be there for you, contact me.
09 September 2015
There are 79 numbered lines on a (2014) form 1040, and 3 of them are about getting a tax break for college education. Line 34 is the Tuition and Fees Deduction (which is actually an adjustment). Line 50 is for education credits from form 8863 - the American Opportunity Credit (AOC) and Lifetime Learning Credit (LLC). Line 68 is for the refundable portion of the AOC.
You can only use ONE of those credits for any given qualifying higher education expense (QHEE). So, what we all want to know is - which is the best?
The AOC is the best tax benefit for education available. If you qualify for it, you should use it. Unfortunately, the AOC is also the most restrictive. Not everyone qualifies to use it. It can only be used four times per individual, and is only for undergraduate education expenses. If a student is pursuing a graduate degree or is taking longer than four years to get an undergraduate degree you will run out of eligibility for AOC before you run out of college expenses. When that happens you need to choose between the Lifetime Learning Credit and the Tuition and Fees Deduction.
In most cases the Lifetime Learning Credit will provide the greatest tax advantage - but not always. There are times when the Tuition and Fees Deduction will be better. I made the flowchart below that gives some guidance on when LLC is always better, and when Tuition and Fees Deduction is always better. Unfortunately, that leaves some grey area where it might be one or the other, so I left that to "come see me". Any flow chart that covered all of the variables involved would be half eyesore and half comic mess. The flow chart I built is complex enough that I also built a slideshow (bottom of page) you can use to go step-by-step through the flowchart.
The value of the Tuition and Fees Deduction depends on your top marginal tax rate. Deductions reduce the amount of your income that is subject to taxes. If you had $4,000 worth of qualifying expenses and your top marginal tax rate was 25%, the benefit to you would be $1,000. But if your top marginal tax rate was 15%, those same $4,000 worth of qualifying expenses would only be worth $600.
Because the Tuition and Fees Deduction is completely phased out for MFJ taxpayers with modified adjusted gross income over $160,000 ($80,000 for single and HoH), the maximum top marginal rate you can be in and still qualify for the Tuition and Fees Deduction is 25%. The cap on qualifying expenses under the Tuition and Fees Deduction is $4,000. Therefore the largest possible benefit of the Tuition and Fees Deduction is $1,000 - the highest qualifying top marginal tax rate (25%) times the highest amount of qualifying expenses ($4,000).
By comparison, the LLC can be worth up to $2,000. It is a tax credit given at the fixed rate of 20% on the first $10,000 of QHEE. If you have the maximum qualifying expenses ($10,000) you can take a tax credit for 20% of that amount, or $2,000. Therefore, anytime your qualifying expenses exceed $5,000, you will always take the LLC, because your credit will be over $1,000 and eclipse the highest possible benefit of the Tuition and Fees Deduction which tops out at $1,000.
The Lifetime Learning Credit is phased out at a lower income threshold than the Tuition and Fees Deduction. If you're MFJ with an MAGI over $128,000 you cannot claim the LLC. $64,000 for single and HoH filers. (A reduction of the LLC benefit begins at $108,000 and $54,000 respectively.) If your income gets you completely phased out of LLC, you may still qualify for the Tuition and Fees Deduction.
The different phaseout ranges, different tax rates, and differing levels of qualifying expenses add too many variables to construct a flowchart covering ALL of the possibilities. If you don't fall into either the obviously Lifetime Learning Credit category (over $5,000 of qualifying expenses), or the obviously Tuition and Fees Deduction category (income too high for LLC) then you should come see me. I'll help you figure out the most advantageous tax benefit for your situation. With two children in college, tax credits for education are near and dear to my heart. They can be a bit complex, but I don't mind spending extra time discussing them. If you have questions, just ask.
04 November 2015
Many people have something they do (or could do) in addition to their regular job that can make some extra money. For example, I built some Adirondack furniture for use around my home. Some friends commented that they liked the pieces, so I made them some as a gift. Not long after that I had people offering to pay me to make some chairs. While I doubt I could ever support myself making Adirondack furniture, it could turn into a little side gig where I could make some additional money doing something that I enjoy.
If I began building chairs to sell - do I have a hobby that produces income, or have I started a business?
Unless it is specifically excluded, the IRS considers income from any source (including hobbies) to be taxable. However, the IRS treats hobbies and businesses differently, and the tax advantages and disadvantages between hobbies and businesses are also quite different. The IRS has some guidelines on how to differentiate between a hobby and a business, but the bottom line is that a business is actively pursuing a profit. If your business is persistently losing money it looks more like a hobby. If your hobby is highly profitable, it looks more like a business.
Below is a table of the relative tax consequences of declaring your activities a hobby vs a business.
Let me go into some additional detail on each of those issues.
The main advantage a hobby has over a business is being exempt from self-employment taxes. Self -employment taxes are the equivalent of payroll taxes for self-employed taxpayers. These are your Social Security and Medicare taxes. Not only do you have to pay your share as the employee, but when you are self-employed you must also pay the matching share as the employer. This is no small tax, amounting to 14.13% for most self-employed taxpayers. This is in addition to your federal and state income taxes. If you live in Virginia, and your federal top marginal rate is 25%, you are looking at paying 25% (federal tax) + 5.75% (Virginia tax) + 14.13% (payroll tax) = 44.88% of your business income in taxes. If your small business earns $1,000 above expenses, you can keep $551.20. If you have a hobby you don't pay self-employment taxes and your total tax rate is 25% + 5.75% = 30.75%. If your hobby earns $1,000 you can keep $692.50.
Businesses, on the other hand, have greater latitude for deducting expenses than a hobby. This is especially true with a hobby that requires some capital investments. Take my Adirondack furniture activities, for example. Say I decide to buy a new table saw with an increased capacity enabling me to produce chairs more efficiently. Can I write that off my taxes as a hobby expense? Only to the extent that I have hobby income in that year. Plus, I have taken steps to improve the profitability of my furniture building activity - making it look less like a hobby and more like a business to the IRS.Can I have a big fancy table saw as part of a hobby? Of course, but I should be prepared to explain myself to the IRS. On the other hand, if I declare my Adirondack production activities a business I can deduct (via depreciation) the cost of my new saw and the IRS won't bat an eye.
Your hobby cannot take a loss as a tax write off, either. You can only deduct expenses up to the amount of your hobby income. If I sell my chairs and take in $1,000, but I have $2,000 in expenses, I can claim only $1,000 of the expenses. Unlike losses from passive activities, unused hobby losses cannot be carried forward to future tax years. If they cannot be taken because they exceed hobby income, they are permanently lost. Additionally, hobby losses are deducted on Schedule A as miscellaneous itemized deductions subject to the 2% of AGI floor. That means if my AGI is $50,000 I don't get credit for my hobby expenses until they exceed $1,000 (2% of $50,000). Unfortunately, you apply other deduction limits prior to the 2% limit, therefore I apply the $1,000 hobby expense limit in this scenario (limited by hobby income) and then apply the 2% of AGI limit. This sequence means that unless my hobby income exceeds 2% of my AGI I can't take any hobby deductions at all!
A business, on the other hand, can write down losses in excess of business income. Your losses on Schedule C can be used to reduce your AGI, and the taxes you have to pay on income from other sources.
The Bottom Line
For tax purposes, if your activity is making money you want it to be a hobby so you do not have to pay self-employment taxes. If your activity is losing money you want it to be a business so you can get full credit for your expenses and deductions. You don't get to just pick and choose, however. The IRS looks closely at businesses that are losing money every year to determine if there is truly a profit motive, or if the person is just improperly writing his hobby activities off his taxes as a business. Likewise, if your hobby is persistently making money in increasing amounts, you can expect the IRS to check to see if you are really running a business.
If you want help determining whether your side gig is a hobby or a business, please contact me.
28 October 2015
I am very fortunate that I had a living Grandmother for so much of my life, but she passed away last week. She was withered and frail at the end, but her mind was still keen. She was widely revered in my family for her wit and wisdom. I am sure if I had ever asked her if she thought she was wise she would not admit to it. She would probably say she just had common sense. (Something that seems altogether less common in our society these days.)
I have been thinking of the things she used to do and say. Whatever you want to call it she taught me many life lessons, and one of them is to not be wasteful. She and my grandfather (who passed last year) lived comfortably on very little money. They knew how to stretch every nickel, and I learned from them how to do the same.
A penny saved is a penny earned is an old adage that I often heard growing up. I don't hear it as often these days, but I think it is just as valid as it ever was. Given the estimates on retirement savings rates I read about, it might be time to revive a penny saved is a penny earned. Saving & investing needs to be taught and encouraged with every generation of Americans.
Remarkably, some of my Grandmother's wisdom seems to have made it's way into the tax code. In some circumstances a penny saved can immediately be turned into more than a penny earned. To encourage individuals to save for retirement the government provides tax incentives. Certain types of saving can reduce your tax bill, resulting in an immediate gain on the amount you save.
Imagine that your top marginal rate is 25%. If you put $200/month into the retirement plan at work (or a traditional IRA) you would have $2400 saved at the end of one year. Since money put into an IRA comes off your taxes as an adjustment to income, you would also have reduced your tax bill by $600 (25% of $2400). That means it only cost you $1800 to save $2400. 180,000 pennies saved, 240,000 pennies earned. The guaranteed rate of return on your savings in that scenario is so incredibly high it boggles the mind. If an investment advisor promised you a 25% return on your investment I'd say run away as fast as you can, but in this case it's a certainty.
Let's not forget about state income taxes. In Virginia the top marginal rate is 5.75%. That saves you (if you're a Virginia resident) another $138 in taxes. That means it only cost you $1662 ($1800 - $138) to save $2400. Add to that total any matching contributions offered by your employer and you are in the investment return stratosphere right out of the gate.
To sweeten things even more for people at the lower end of the wage scale there is also a Saver's Credit. The Saver's Credit provides an additional retirement saving incentive in the form of a non-refundable tax credit of up to 50% of the amount saved. Income limitations and filing status impact the amount of the credit according to the table below.
Military members serving in a combat zone will often have an unusually low AGI because of the combat zone tax exclusion. What a great year to save that can be!
The federal government provides more incentives for paying for college than saving for college, but there are still some college savings tax benefits. These are found primarily in 529 college savings plans. 529 plans are sponsored by the various states and there is no federal tax benefits for your contributions to a 529 account. Most states, however, allow a state income tax deduction for your contributions. The Virginia 529 allows up to $4,000 to be deducted per account per year from your Virginia state income taxes. At a top marginal rate of 5.75% that is an immediate tax savings of $230 per $4,000 contributed. Or as I like to say, it only cost me $3,770 to save $4,000.
Money in a 529 plan grows tax free and is exempt from both state and federal taxes if it is used to pay for a qualifying higher education expense (QHEE). If you saved $166.67/month for 15 years ($2,000/year) and it grew at a reasonable 0.5% compounded monthly (6.168% APY) you would have invested $30,000 and have $48,470.75. The tax benefit of having that $18,470.75 (the growth on your $30,000 investment) growing tax free is $5,679.76 (marginal rate of 25% federal and 5.75% Virginia). $5,679.76 will buy you a semester of tuition at James Madison University. (I know, I just paid for one!)
The bottom line to all of this is that my Grandmother was right. A penny saved is a penny earned. And if your saving also gets you additional tax benefits your saved penny turns into pennies very quickly. If you want to explore ways to increase your tax savings, please contact me.
30 September 2015
I was on active duty with the US Navy for just under 24 years. During my service we relocated 7 times, finally ending up in Virginia Beach for my last three tours and retirement. (We like it here.) I was actually fortunate compared to many of my fellow service members. Most of my friends were moving more often than I was. Military families move a lot.
Moving that often makes home ownership a frightening prospect. You seem to just get settled and you're moving again. You have to put your house on the market and hope it sells for a price that doesn't wreck your family finances, or you have to deal with leasing it to someone that you hope takes decent care of your biggest investment. Then, when your house no longer qualifies as your primary residence, you end up owing capital gains taxes when you sell it. Many military families prefer to rent rather than buy just to limit the unknowns to their already strained family budget.
However - President Bush signed a law in 2003 that took some of the scariness out of home ownership for military personnel, If you haven't heard about it you may want to keep reading. It can be worth some decent money.
The Military Family Tax Relief Act, as it was called, suspends the primary residence use test rules for military personnel for up to 10 years. Under the use test rules, in order to qualify for the capital gain exclusion for the sale of your primary residence you must have lived in the house for at least 2 of the 5 years immediately prior to the sale. With the 10-year suspension under the Military Family Tax Relief Act you can meet the use test if you lived in the house for 2 of the 15 years immediately prior to the sale. To qualify for the suspension you must be on PCS orders more than 50 miles from your residence, or relocated to government provided housing.
I think an example is the best way to explain what all of that means. The couple pictured above are Duane and Lareese. I worked with Duane in 2011 when I was deployed as a civilian. I used their names and picture, but have completely manufactured the facts below in order to illustrate the specific tax benefit.
Scenario: Duane and Lareese are married. Duane is active duty military, stationed in Virginia Beach. They purchase a house for $250,000 and live in it for nearly 3 years and then Duane receives PCS orders to the west coast. They could sell their house for $250,000 and (more or less) break even, or they could rent it. Duane and Lareese decide to become landlords and lease their home to another family. Duane stays on the west coast for several tours. After being out of their Virginia Beach home for 12 years Duane and Lareese decide to sell it. The house has had some time to appreciate in value and sells for $350,000.
Tax implications:
1. Depreciation - net gain $17,455. As landlords, Duane and Lareese take a business deduction for depreciation on their house. When the house was placed in service as a rental unit their basis in it was $250,000 minus the value of the land. Only the building can be depreciated. The value of the land does not depreciate. The land was worth $90,000, so Duane and Lareese's basis in the house (for depreciation purposes) is $160,000. Residential rental properties depreciate over a period of 27.5 years. Over the 12 years it was a rental property the total depreciation was $69,818. In the 25% top marginal rate Duane and Lareese pocket $17,455 in tax savings over the 12 year period the house was rented.
2. Capital Gains Taxes - net gain $15,000. Using the 10-year suspension of the use test rules, the house still qualifies as Duane and Lareese's primary residence (they lived in it 3 of the previous 15 years). This allows up to $500,000 in capital gains to be excluded from capital gains taxes. They purchased the house and the land for $250,000 and depreciated the house by $69,818, so their basis at the time of sale was $180,182. They sold the home for $350,000 for a gain of $169,818. The portion of gain attributable to recapturing the depreciation is NOT excludable from taxes1, but the rest of the the gain is. Duane and Lareese would normally pay capital gains at 15%, but due to his military service they can avoid paying capital gains taxes on $100,000 of this sale. This results in a tax benefit of $15,000.
Add the depreciation and capital gains tax savings together and Duane and Lareese netted $32,445 in additional tax benefits for Duane's active duty service. That averages to over $2,700 per year they can keep in their pockets. That would have been darn good money to work into our family budget when I was on active duty. (It still would be!)
There are many additional factors when considering whether to convert your house to a rental property, but don't overlook this tremendous tax benefit available to military personnel. It might tip the scales. Everyone's specific situation is a different. If you have questions, please contact me.
1Some or all of the unrecaptured gain from the depreciation of the house while it was a rental property might be excludable from taxes, depending on your taxable income. A year you received a combat zone exclusion for your military pay might be the best year to sell to take advantage of some additional tax benefits.
14 October 2015
Payroll Taxes go by many names. Of the ones that are fit to print in a family blog you might know them better as social security taxes, medicare taxes, FICA, or self-employment taxes. These are all accurate to a degree, but payroll taxes covers all of them, so that's how I'll refer to them.
Payroll taxes are the federal taxes collected to support the Social Security and Medicare programs. The rate of taxation is 6.2% of wages up to $118,500 (in 2015) for Social Security (with a matching amount from your employer) and 1.45% of wages for Medicare (with a matching amount from your employer). There is no wage cap for the Medicare tax. There is, however, an additional Medicare tax of 0.9% on wages greater than $200,000 for single tax filers and $250,000 if you are married filing jointly. (Employers are not required to match the additional Medicare tax.)
Note that payroll taxes are paid only on wages, salary, or tips. Income from (real estate) rents or investments are not subject to payroll taxes. Although, the 3.8% Net Investment Income Tax to support Medicare definitely makes this a grey area.
For the majority of taxpayers - wage-earning employees earning less than $200,000 per year - payroll taxes are fairly straight-forward. You have 7.65% of your gross income withheld from every paycheck. That money is sent off to the government in exchange for the promise that when we are older there will be a retirement stipend and healthcare benefits waiting for us.
If you're not in that group of taxpayers working as employees for $200,000 or less, there are some additional complexities to the payroll tax system that you should probably know.
The Additional Medicare Tax
As previously stated, if you are single and earning more than $200,000 per year, or MFJ and earning over $250,000, you are required to pay an additional medicare tax of 0.9%. Your employer is required to withhold the additional tax from your salary and pay it to the trust fund for you. However, your employer might not be aware of all of your income. Let's look at some examples:
Stan is single and has two consulting jobs. ABC company pays him $140,000 per year and XYZ company pays him $175,000. Stan is required to pay the additional Medicare tax on $115,000 - the amount his combined $315,000 income exceeds the $200,000 threshold for single filers. But, neither ABC nor XYZ is withholding the additional Medicare tax from his salary. The companies' payroll departments are not aware that Stan's total income requires him to pay the additional Medicare tax.
Rita and Frank are married and file jointly. Rita makes $190,000 as a lawyer at the firm of Dewey, Cheatham & Howe. Frank also earns $190,000 per year as an engineer for Wobbles Construction. When they file they will owe the 0.9% additional Medicare tax on $130,000, the amount their combined $380,000 exceeds the $250,000 threshold for MJF taxpayers. Again, neither employer is withholding the additional Medicare tax.
If your employer does not withhold the tax you are still required to pay it. Your options for this are to adjust your withholding on your W-4 to account for the additional Medicare tax, make quarterly payments to the IRS, or pay it at the end of the year when you file your taxes. Be aware, however, that if you wait until the end of the year to pay it you could find yourself subject to a penalty for the under withholding of tax.
Self-Employment Taxes
People who are self-employed are required to pay both the employee and employer share of payroll taxes. When combined these are known as self-employment taxes. There is a bit of a strange formula for calculating the self-employment tax. If you just left it at 2 X 7.65% = 15.3% to cover the 7.65% paid by the employer and employee you would end up paying at a higher rate than an employed wage-earner. Instead, you need to account for the fact the 7.65% paid by the employer is never part of the employee's gross wages. Therefore the self-employment tax rate is [15.3% X (1 - 0.0765)] = [15.3% X .9235] = 14.130%.
I have added a few slides that better explain this formula:
Half of self-employment taxes are also taken as an adjustment to income on the front page of form 1040. This makes sense (hard to believe sense sometimes makes it into the tax code, but in this case it did!). People who work as employees are not required to pay federal income taxes on the amount their employer pays in payroll taxes on their behalf, so it is only fair the self-employed are afforded that same allowance.
One final note on payroll taxes. If you are an employer and you withhold payroll taxes from your employees, make certain you are paying those taxes to the government as required. The government takes a very stern stance on the matter. If you fail to pay your regular taxes it is considered stealing from the government, and you will pay a small penalty for doing it. However, if you fail to pay payroll taxes withheld from your employees it is considered stealing from your workers. The penalty for doing that is 100% of the tax owed and can also land you in prison. Business people are frequently creative financiers, but I would strongly caution you against getting creative with payroll taxes. It is not worth it.
If you have any questions about payroll taxes, 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.
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