Welcome to the Tax Blog

Updated September 2020 (originally posted 21 October 2015)

Update: Most of the original information in this article is the same as when it was first posted, but a few things have changed. Fortunately, I think they have actually changed for the better! I will put the updated information in italics.

How much is your time worth? Would you fill out a couple of forms that might take you 20 - 30 minutes for $230? If you will be paying college expenses one day and you pay taxes in the state of Virginia you can get that $230 every year if you want it. If you're really motivated, you might be able to fill out some additional paperwork and collect an additional $230 every time you do.

Here's the deal - the Virginia 529 plan offers Virginia residents the opportunity to deduct up to $4,000 annually from their Virginia Adjusted Gross Income for each Virginia 529 account they own and contribute to. You can deduct your contributions dollar-for-dollar up to $4,000 for each account you put money in, as long as you are also the owner of that account. The top marginal income tax rate in Virginia is 5.75%, meaning you can save $230 each time you deduct $4,000 from your Virginia AGI.

Virginia also allows a carryover of any unused deduction. If you contribute $10,000 to a single account in a year you can deduct $4,000 for that tax year, $4,000 in the next tax year, and $2,000 in the tax year after that.

Virginia 529 plans are individual in nature, and can only have one owner. But beneficiaries - the person you intend to use the money - can have multiple accounts as long as the total of all accounts for one beneficiary remains below $500,000 (was $350,000). Meaning...you can be the owner for an account for your child, and your spouse can be the owner of another Virginia 529 account for the same child. If you each contribute $4,000 to your respective accounts, then you can take $8,000 off the Virginia AGI on your joint state income tax return.  Have two children? If you and your spouse both open an account for each child and you put $4,000 in each of those four accounts, you can deduct $16,000 from your Virginia AGI in a single year. That's a tax savings of $920 that year! According to the Virginia 529 website FAQs, you can invest in multiple portfolios for a single beneficiary, and each portfolio is considered a separate account!

Here's a nifty concept: there is no minimum time requirement for your money to be in the Virginia 529 account to qualify for the tax benefit. In other words, you can deposit the money into the Virginia 529 account, take it out a week later, and still qualify for the state income tax deduction. Just make sure you have qualifying higher education expenses (QHEE) in the amount of the 529 distribution and your tax deduction is yours to keep.

Do-it-yourselfers want to look at the Invest529 plans. There is a broad selection of low-cost portfolios to choose from, including an FDIC-insured account that you would want to use for any short-term investing (called "Principle Protection" portfolio). For children who are years or decades out, you should look at the more aggressively invested portfolios. They have a nice selection of target-date portfolios that have low expense ratios, broad diversification, and a reasonable allocation among securities (In addition to being an Enrolled Agent, I am a CFP® Professional and a registered investment adviser in the Commonwealth of Virginia, so I've studied these concepts a bit.) 

The Virginia 529 plans have fully embraced the internet and internet banking concepts. You can now make deposits and withdrawals from your home computer. Those of you so-inclined can also use mobile apps, but I've never had a college funding situation that couldn't wait until I got home to resolve. But if you need or prefer to use your phone, it is available.

DO NOT take your money out of another 529 account and cycle it through another Virginia 529 account. That will count as 2 withdrawals for education. You will have to justify enough QHEE to cover both distributions or face the tax and penalties for an unqualified withdrawal.

529s are a great tax deduction, but if you qualify for the American Opportunity Credit or the Lifetime Learning Credit you will likely get a larger tax benefit using one of those tax credits. Make sure your use of the Virginia 529 does not interfere with your eligibility for those other more valuable tax credits for education. The good news is that unlike the AOC and LLC, you can use 529 money for room and board, so it is possible to take advantage of more than one tax break for education per student per year. You can get the AOC for the tuition expense and the 529 tax benefits for paying room and board. You just need to keep things organized and coordinated (and documented for tax purposes!). If you have any questions please contact me.

• Tax Credits
• Virginia State Taxes
• Education Tax Breaks

March 21, 2020

A short video to explain the changes to the filing deadlines release by the IRS and Virginia, and how the COVID-19 pandemic is impacting operations at PIM Tax Services.

PIM Tax Services will donate 100% of our profit from tax returns generated during the postponed period (4/15/2020 - 7/15/2020) to the Hampton Roads Community Foundation.

19 January 2019

I did not expect to be posting a blog article today, but much to my surprise, the IRS released a proposed Revenue Procedure late yesterday, and I felt like I needed to provide some information and guidance. (Treasury (the IRS) releases Revenue Procedures as formal guidance to taxpayers on how to apply the tax law.) The proposed Revenue Procedure is designed to clear up the confusion as to whether or not rental real estate qualifies for the new Section 199a “Qualified Business Income” deduction. I wasn’t surprised by the content of the proposed Revenue Procedure. I was surprised we received guidance before the tax season was officially underway! Clear guidance isn't nearly as abundant as I would like during normal times. With the government shutdown and big chunks of the IRS out on furlough I figured there was no way they could issue coherent and timely guidance. I was pleasantly surprised they gave us both. Let me break it down for you.

Background.

As part of the December 2017 tax reform - the Tax Cuts and Jobs Act (TCJA) - there is now a tax deduction written into the tax code known as the Section 199a deduction (cleverly named after the paragraph in the Internal Revenue Code that describes it.)  You might also see it referred to as the Qualifying Business Income deduction or QBI deduction because it is a deduction on Qualifying Business Income (QBI). It’s complicated, but in a nutshell, qualifying pass through business can deduct 20% of their income, essentially making that 20% insulated from federal income taxes. It is a REALLY good deduction. Landlords want to be able to claim it, but questions lingered as to whether residential rental real estate was considered a 'qualifying business'.

After interim regulations came out in August, most tax pros believed holding out real property for the purpose of generating rents (a.k.a. being a landlord) would qualify for the Section 199a deduction. Count me among them. It seemed like that was Treasury’s intent, but there was still room to interpret the new law in different ways.

Yesterday’s release of the new proposed Revenue Procedure finally put that to rest. 

What the Proposed Revenue Procedure Says

The proposed Revenue Procedure establishes a Safe Harbor for landlords looking to claim the Section 199a deduction. By establishing a Safe Harbor, the IRS is essentially saying, “If you have residential rental property and you comply with the following guidelines, then you will qualify for the Section 199a deduction.”

There are just 4 guidelines:

A) You must maintain separate books and records for your rental business.

(Paul’s interpretation: Do not run your real estate activities through your personal bank account. The Section 199a deduction is for BUSINESSES. You are expected to treat your real estate enterprise like a business in order to get this deduction.)

(B)(1) For tax years 2018 - 2022 you must work at least 250 hours per year on ‘rental services’. (I’ll explain rental services later.)

(B)(2) Beginning in 2023 you must work at least 250 hours per year for 3 of the previous 5 years on ‘rental services’. (I’m just trying to make it through January 2019, and they are giving me guidance on 2023 and beyond? Oy!)

(C) The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following:

(1) hours of all services performed

(2) description of all services performed

(3) dates on which such services were performed

(4) who performed the services

(Paul’s interpretation: You need to clock in and clock out when you are working on your rental property business.)

Such records are to be made available for inspection at the request of the IRS. The contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2019. (Paul’s interpretation: You don’t need these records for 2018.)

(D) You must attach a signed statement to your tax return indicating you are claiming the Section 199a deduction, and you are compliant with the proposed Revenue Procedure. It must also contain the following language:  “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”

Rental Services

The proposed Revenue Procedure describes rental services as follows:

1. advertising to rent or lease the real estate
2. negotiating and executing leases
3. verifying information contained in prospective tenant applications
4. collection of rent
5. daily operation, maintenance, and repair of the property
6. management of the real estate
7. purchase of materials
8. supervision of employees and independent contractors

The proposed Revenue Procedure is also careful to specifically exclude the following activities from qualifying as rental services:

1. arranging financing
2. procuring property
3. studying and reviewing financial statements or reports on operations
4. planning, managing, or constructing long-term capital improvements
5. hours spent traveling to and from the real estate

There was some additional guidance in the proposed Revenue Procedure about how to aggregate (or not aggregate) your properties for your business enterprise, as well as a prohibition on mixing residential and commercial properties in the same enterprise. Those are important to a few people, but I don’t want to get into that yet. For now I just want to make sure the majority of my landlords know there is concrete guidance on whether and how to claim the section 199a deduction.

The IRS was also quick to point out that you are not precluded from claiming the Section 199a deduction just because you don't qualify for the Safe Harbor. You may still qualify for the Section 199a deduction even if you violate the guidelines in the proposed Revenue Procedure. Your unique facts and circumstances would need to be analyzed when making that decision

Bottom Line: Separate books and bank accounts, start keeping records of your rental service activities, and enjoy your Section 199a deduction!

If you still have questions, ask! (757) 407-4189

• Business Deductions
• Residential Real Estate Deductions

02 January 2019

I don’t regret one minute of my Navy career, but if I had realized how much fun it is to be an entrepreneur and business owner, I would have done it a long time ago. Building this tax business (and now building Redeployment Wealth Strategies with Sean) has been, and continues to be, both fun and gratifying. One of the most enjoyable aspects of these new careers is the opportunity to meet other entrepreneurs/small business owners. We are a strange and interesting breed, and I like spending time with (and helping whenever possible) other members of my tribe.

A question I frequently receive from clients with their own start-up business is how to protect profits from taxation. This question typically comes in the second or third year of business operations. The first year is rarely profitable for a new business as the costs involved with starting the business usually take up all the available revenue. After two or three years, however, many new businesses start to show a profit and people start to wonder if they are being as efficient as possible with their taxes. (Managing taxes being an essential task of the small business owner.)

My favorite response for sole-proprietors is to establish a Solo 401K. Not only does it allow the entrepreneur to avoid a good chunk of state and federal income taxes, but it also serves another purpose - retirement planning. Starting a business tends to consume all of one’s mental resources for the first few years. That's how it was for me. It seems like all my waking time was spent thinking about the business. Who has time for retirement planning? Most of us either forget about it altogether, decide to think about it ‘later’, or just figure we like what we are doing so much we aren’t ever going to retire anyway! (A haphazard planning strategy that ruffles my financial planner's feathers!)

As the name implies, a Solo 401K is designed for one person. As with nearly all government regulations, however, there are exceptions to the rule. If both you and your spouse work for the business, you can have a Solo 401K. If you have formed a partnership where only the partners are working in the business, you may also have a Solo 401K. If you have common-law employees in your business, you cannot use a Solo 401K. (You would need to establish a different retirement plan in which your employees can also participate.)

Solo 401Ks are also surprisingly easy to establish. All the large online brokerages (Vanguard, Fidelity, Schwab, TD Ameritrade, etc.) have fast and simple online applications. They are also easy to maintain administratively compared to 'regular' 401K plans. While a regular 401K plan requires additional tax returns and compliance documents, the Solo 401K only takes filling in a few extra lines of your current tax return each year.

Solo 401K Contributions:

What makes the Solo 401K so powerful as a tax planning tool is the ability to make tax-free contributions to it. There are two categories of contributions to a Solo 401K if you are under 50 and three categories of contributions if you are 50 & over. Let’s take a look at each:

Elective Deferral: This is essentially the same contribution as the one you may have made as an employee. (If you were in the military and participated in the TSP retirement plan, your contributions were officially known as your elective deferrals.) In 2019 you can contribute up to $19,000 into your Solo 401K via elective deferral. The caveat is that you have to earn at least that much from the business in order to make the contribution. In other words, your elective deferrals are limited to the smaller of $19,000 or 100% of your profit/compensation from the business.  

Employer Contribution: If you were an employee you used to call this ‘matching money’. That’s the part you can put into the 401K as an employer. In 2019 that amount is limited to $56,000. Before you get delirious about that number, there are some important limitations to discuss. The first is that for self-employed people you are essentially limited to 20% of your total compensation net of the deduction you take for paying self-employment taxes. (There is a fancy formula and IRS worksheets to determine this limit, but 20% is pretty darn close. See IRS pub 560 is you want to see the formula and worksheets.) You also have to reduce that $56,000 limit by the amount of your elective deferrals. So, the combination of elective deferral and employer contribution into your Solo 401K cannot exceed $56,000. Note: the employer contribution for W-2 employees is 25% of compensation. If you have elected S-Corp tax treatment for your business, you are paid on a W-2, and only your W-2 income counts toward the Solo 401K limit. (The amount reported on your K-1 does not count as compensation for the purposes of calculating your Solo 401K contribution limits.)

Catch-Up Contribution: If you are 50 years old or older, you can also contribute an extra $6,000 to your Solo 401K. When you add that to your combined limit of $56,000 from your elective deferral and employer contribution, you have the potential to shelter up to $62,000 from state and federal taxes in 2019.

Here’s a table showing the types of Solo 401K contributions and the 2019 limit for each:

* Cannot exceed $56,000 when combined with Elective Deferral.

** Compensation does not include S-Corp shareholder payouts from K-1 (W-2 income only from S-Corp).

Examples:

Debbie, age 40, is the sole proprietor of a schedule C business.  She does not have any employees, and in 2019 her income net of the deduction for self-employment taxes is $50,000. Her 2019 Solo 401K contribution limit is $29,000.

She can contribute up to $19,000 as her elective deferral.

She can contribute $10,000 (20% of $50,000) as the employer contribution.

She is under 50 and cannot make the catch-up contribution.

Jerry, age 55, is a sole proprietor who has elected S-Corp treatment. He is the only employee of his S-Corp. In 2019 he pays himself $100,000 on his W-2 and takes another $200,000 as a shareholder distribution on his K-1. His 2019 Solo 401K contribution limit is $50,000.

He can contribute $19,000 as his elective deferral.

He can contribute $25,000 (25% of $100,000) as his employer contribution. (The money from the K-1 does not count toward the employer contribution limit.)

He can contribute an additional $6,000 for the catch-up contribution.

Monique, age 28, is an RN by day, but has a side business she works nights and weekends. She files on a schedule C and in 2019 her side business makes $300,000.  She contributes $8,000 to the 401K at her nursing job, and receives a 50% match from her nursing employer for $4,000.

She can contribute up to $48,000 to her Solo 401K

She can contribute $11,000 via elective deferral ($19,000 - $8,000; the elective deferral limit is cumulative no matter how many jobs one has.)

She can contribute up to $37,000 ($56,000 - $19,000) for the employer contribution. (The employer contribution limit is separate for unrelated employers, so the $4,000 match she received from her nursing job does not reduce the amount she can contribute to her Solo 401K.)

That last example was tricky, as I snuck in a couple of concepts without much explanation. While Solo 401ks are much simpler than regular 401Ks, there are still quite a few details. Strategies can also be tricky, as you may want to determine the path giving you the most advantageous tax situation if you need to pay self-employment taxes. I find modeling these scenarios is the best way to ensure you are getting the best tax result consistent with your retirement planning strategy. If you’d like to discuss strategies or run through a few scenarios with Solo 401K planning, give me a call.

• Retirement Planning
• Income
• Business Deductions
• Virginia State Taxes

22 December 2018

There are a multitude of TV shows these days dedicated to real estate flipping. Flipping, if you don’t know, is where you purchase a property, fix it up, and then sell it for a profit. I watch these shows from time to time. I notice they never talk about the tax implications of flipping houses. Probably because I might be the only person watching who would find a tax discussion interesting. That’s unfortunate, because the tax implications of real estate flipping have a significant impact on the flipper’s profitability - and I have found that most beginning flippers do not understand them.

Here’s the biggest tax issue with flipping houses (there are others, but this is the most misunderstood, and causes the most problems for new flippers): When you are in the business of flipping houses, the properties you are flipping are considered inventory. Selling inventory generates income taxed at regular income tax rates - not capital gains.

I think it is easy to understand why some people are not aware of this when they first start flipping houses. All their previous transactions with houses and property were treated as investments that generated capital gains or losses. If you buy a house to live in and then sell it, you can exclude the capital gain from the sale from your income. When you have a rental property for a few years, then sell it, you would have a capital gain or loss. Most beginning flippers have dealt with these scenarios, but have never dealt with a scenario where the house was treated as inventory.

In addition to being taxed as ordinary income, selling inventory also has two other attributes flippers need to know:

1. The income produced from the sale of inventory is subject to self-employment taxes - Social Security and Medicare. Unlike rents and capital gains - which are not subject to Social Security and Medicare taxes - flipping income is subject to self-employment (SE) taxes. You should count on Uncle Sam taking about 15% of your profits in SE taxes.
2. You deduct the cost of inventory from your taxes in the year the inventory is sold. That’s so important I’m going to write it twice, and underline it. You deduct the cost of inventory from your taxes in the year the inventory is sold. Let’s look at an example of how that gives some unsuspecting new flippers a horrible shock.

Jimmy finds a sweet flipping deal.  There’s a property available for $100,000. With about $20,000 in basic remodeling Jimmy figures he can sell it for $185,000. He buys the property in July 2018 with the intent to complete the remodel and flip it by October. As often happens, Jimmy runs into time and cost overruns. By February 2019 he has spent $40,000 on repairs and remodeling, and the house is still not ready to put on the market. Being over budget, his cash flow is tight. It’s time to file his 2018 tax return. A big refund would surely be helpful. At least he can deduct all that money he has spent on this flip property, right?

This is where I gently tell Jimmy he cannot deduct the expenses from this flip on his 2018 taxes. His inventory has not sold, so he cannot yet deduct the cost of it.

There is one comparatively big tax benefit to getting inventory tax treatment of your real properties. Unfortunately, you have to lose a lot of money on your deal(s) to use it. Capital losses are limited to $3,000 per year. Capital losses in excess of $3,000 must be carried over to future tax years. But losses on inventory aren’t capital losses. Whatever you lose on the house in the year of the sale can be completely deducted from your taxes in that year.  

You Probably do not Need an S-Corp.

Many flippers read somewhere they can save on taxes by electing taxation as an S-Corp, so they make that election prior to making their first flip.  They’ve nearly always wasted more money than they’ve saved by doing so. Electing S-Corp tax treatment generates additional expenses for your business - payroll, additional tax filings, legal assistance, etc.. Unless your tax savings are more than those additional expenses, you’re wasting money.

The amount of flipping income you need to be earning each year to make having an S-Corp worthwhile varies. Tax pros use rules of thumb based on regional factors. Here in Virginia Beach I tell people they should be grossing no less than $40,000 annually from their flipping business before they elect S-Corp tax treatment. If you’re making less than that every year the additional cost of maintaining the S-Corp outweighs the tax benefits and you are wasting money. (Much of that wasted money would be going into my pocket, so you know I'm telling the truth!)

I Meant to Rent, but then I Flipped - Am I a Flipper Now?

Unexpected events happen to people. (They seem to happen to real estate investors at an alarmingly high rate!) Sometimes you get into a deal thinking you’re going to hold the property for a rental, but you end up selling it right after you fix it up.  You make a bit of money on the deal. Is it taxed like a capital gain or as regular income? When you’re not sure if your activity makes you a flipper or a long-term investor, you should look at something called the Winthrop Factors.

The Internal Revenue Code does not specifically define when someone is a real estate investor (landlord) or when they are a dealer (flipper) in the trade or business of selling real estate. The courts have had to address this issue, and they have developed a set of guidelines known as the Winthrop Factors. These are the things to consider when determining the tax treatment of the activity:

1. The nature and the purpose of the acquisition of the property and the duration of ownership.
2. The extent and nature of the taxpayer’s efforts to sell the property.
3. The number, extent, continuity, and substantiality of the sales.
4. The extent of subdividing, developing, and advertising to increase sales.
5. The use of a business office for the sale of a property.
6. The character and degree of supervision or control exercised by the taxpayer over any representative selling the property.
7. The time and effort the taxpayer habitually devoted to the sales.

A review of the Winthrop Factors indicates the courts are most interested in the intent of the taxpayer when the property was purchased. Absent any other proof of your intent, the courts are going to look at your prior real estate activities and will likely conclude that the sale in question fit the prior pattern. If you’ve been a landlord, they are likely to assume you intended the property as a rental. If you’ve been a flipper, they are likely to assume you intended to flip this property all along.

There are several ways to be profitable in real estate. Whatever your preferred approach to real estate investing, be clear on the tax implications of buying and holding rental properties vs. flipping. Do not let an unanticipated tax surprise ruin your margins. Educate yourself or hire a tax professional who can help guide you through the process. If you have any questions, please feel free to contact me.

• Income
• Business Deductions
• Capital Gains and Dividends
• Common Tax Mistakes