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28 July 2015
A long time ago, in a galaxy far, far away...
Nearly everyone got married, settled down, had a few kids, and stayed together forever. That's how the story goes, anyway. That 'traditional' model still happens, but in the world I woke up in this morning things are very different for many people. Sometimes parents never marry. Sometimes they divorce. Sometimes they remarry. Sometimes they don't. One thing remains constant, though - regardless of our personal circumstances we are required to pay taxes on income, and a complex personal situation can add complexity to an income tax return.
To demonstrate this I am going to tell you a true story from right here in Virginia Beach. I did the 2014 tax returns for these folks. I have changed the names to protect their privacy.
Jerry and Janet are married - just not to each other. Jerry separated from his wife in 2012 and Janet separated from her husband in 2013. Jerry and Janet lived together for all of 2014 with their 5 children - all minors. Two are Jerry's from his marriage, three are Janet's from her marriage. Jerry had wages of about $30,000 in 2014. Janet worked part-time and had wages of about $9,000. They asked me if I could help them find the most advantageous way to file their taxes.
Despite the fact they were both still married the IRS has a provision that allows them to be considered unmarried for tax purposes. They both met the requirements for that provision, and there were no legal constraints in place, so we didn't have to consider their soon-to-be-former spouses for tax purposes in 2014. They could both be single, however, Jerry paid for more than half the upkeep on the home (and his children lived with him), so he could file as Head of Household. Janet's income was below the filing threshold, and she was not required to file. However, she had taxes withheld from her pay and her earned income gave her the potential for some refundable tax credits, so it was in her best interests to file. She did not pay for more than half the upkeep of the home, so she filed as single. Now, what to do about all those kids?
There were basically two ways to go:
1) Jerry could claim all five of the children as dependents on his tax return. His two natural children are his qualifying children under IRS rules. He could also claim Janet's three children as qualifying relatives because they lived with him ALL year AND he paid for more than half their support AND because Janet would only be filing to get back the taxes that had been withheld from her paychecks. Janet cannot claim the refundable credits in this scenario, but Jerry would have 6 exemptions (himself plus the 5 kids).
2) Jerry claims his two children on his tax return and Janet claims her three children on her tax return. Janet CAN claim the refundable credits in this scenario.
Both situations are permissible under the law. Jerry and Janet were interested in receiving the largest combined refund, so I calculated their taxes both ways. As it turned out, it was more beneficial for Janet to claim her three children on her return. Jerry's tax bill was slightly higher that way, but the refundable credits Janet received more than compensated for Jerry's lost exemptions
Modern blended families can be complex. In an effort to keep up with every possible situation the IRS rules for dependents, exemptions, and tax credits are just as complex. If you have a blended situation you may have multiple legal ways to file. If you want to find the one that is most beneficial to you, come see me. We'll figure it out.
25 July 2015
If you saw the Harry Potter movies you might recall Mr. Olivander telling Harry, "The wand chooses the wizard, it's not always clear why." Something similar happens in tax preparation - the tax form chooses you. Or, rather, the software chooses the best tax form for you based on your tax situation. In either case, the taxpayer doesn't choose which form to file. Although, each year I have a few who try. They note the 1040-EZ is the cheapest option to have me prepare and tell me to go ahead and use that form for their taxes. It is my sad duty to crush their dream of saving a few bucks on tax preparation for the year by informing them their tax situation is too complex for the 1040-EZ.
It's getting harder and harder to qualify to use the 1040-EZ. To help clarify the requirements the IRS provides this handy 11-item checklist the taxpayer can use to see if they can file their taxes on Form 1040-EZ. ALL of the items in the checklist must apply.
That's quite a list of qualifications to let a taxpayer use the EZ form!
The next step up from the 1040-EZ is the 1040A. With the 1040A you can claim more sources of income, some of the adjustments to income, and many of the tax credits. Your taxable income still has to be less than $100,000 and you can't itemize your deductions. To itemize you'll need form 1040 and a schedule A. You must also use form 1040 if any of the following are true:
-You received any of the following types of income:
-You can exclude any of the following types of income:
-You have an alternative minimum tax adjustment on stock you acquired from the exercise of incentive stock optios.
-You received a distribution from a foreign trust.
-You owe the excise tax on insider stock compensation from an expatriated corporation.
-You owe household employment taxes. (Schedule H)
-You are claiming the adoption credit or received employer-provided adoption benefits.
-You are an employee and your employer did not withhold social security and Medicare tax.
-You had a qualified health savings account funding distribution from your IRA.
-You are a debtor in a bankruptcy case.
-You must repay the first-time home buyer credit.
-You had foreign financial assets in 2014
-You owe Additional Medicare Tax or had Additional Medicare Tax withheld.
-You owe Net Investment Income Tax.
-You have adjusted gross income of more than $152,525 and must reduce the dollar amount of your exemptions.
-You received a Form W-2 that incorrectly includes in box 1 amounts that are payments under a Medicaid waiver program, and you cannot get a corrected W-2, or you received a Form 1099-MISC that incorrectly reported these payments to the IRS.
Another atrociously long list. Is it any wonder most people are quite happy to have the software select the correct tax form for their tax situation? If you have any questions please contact me.
21 July 2015
I enlisted in the Navy from my home state of Ohio back in 1987, making Ohio my official home of record for military pay purposes. At that time Ohio would tax my Navy income even though I wasn't living in Ohio. I didn't care for that, so when I was stationed in Florida I marched my behind down to the Duval County courthouse and became a legal permanent resident of Florida - one of the handful of states that do not have a state income tax.
Many service personnel do what I did and change their home of record to a state without an income tax. However, there's a secondary effect that goes along with changing your home of record that many military members fail to take advantage of on their federal income taxes. Probably because it is a little complex...
Taxpayers can take a deduction on Schedule A for state (and local) income taxes OR sales taxes. If you are a resident of a state that doesn't have an income tax, then you should be taking the deduction for the sales tax. You take the sales tax deduction based on the area where you live, not your state of legal residence or home of record. Military members stationed in Virginia can deduct the Virginia sales tax from their federal taxes, even if their home of record is Texas or Florida.
There are two ways to figure the Virginia sales tax deduction. The first is to actually track the sales tax you pay all year. That level of record keeping sounds quite horrible to me, but I do know one person who does it that way and he gets a somewhat larger deduction as a result. The second way is to estimate your sales tax deduction based on your income. The IRS has a handy online calculator to assist with this.
This next part is important, so read it twice:
While some of your compensation (like BAH) is not exposed to income taxes, the IRS recognizes that you are paying sales taxes when you spend that money. Therefore, you can add your untaxed income into the calculation for the sales tax deduction. It gets you a larger deduction.
The higher your income, the more sales tax you are presumed to have paid and the higher the deduction you'll be able to claim. You'll want that deduction to be as large as possible, so be sure to include all of your BAH and BAS for the tax year, as well as any pay you received in a tax-free zone. I find it helpful to have an LES from the tax year when preparing a tax return for a military member.
The sales tax rate in Virginia Beach is 6%. That includes the 4.3% statewide rate plus the additional 1.7% rate we pay in Hampton Roads. Some software has you enter those numbers separately and some has you enter just the 6% number.
It's a valuable deduction. Last year a Warrant Officer asked me to look over his taxes after he had done them himself. He is a Florida resident living in Virginia and itemized his deductions on schedule A. The blank spot for the deduction for state income or sales tax jumped off the page at me. Adding that deduction increased his refund by a little over $200. If you're eligible for it, but not claiming it, you are paying more in federal taxes than you are required to pay.
18 July 2015
The Earned Income Tax Credit (EIC) is an anti-poverty measure in the tax code that provides a refundable tax credit to low income working Americans. While it has its roots in the 1970s, I am old enough to remember that EIC was largely expanded in the tax reform measures of 1986. President Reagan called the EIC , "the best antipoverty, the best pro-
Like any law the EIC is imperfect, of course, and I find some of the unintended consequences of the EIC to be quite troubling. First among them is that some tax preparation firms take advantage of the EIC to line their own pockets. In a nutshell, EIC made it profitable to serve low income clients. Far too many people with simple income tax returns became willing to swallow a $400 tax preparation fee when informed they can get a $5,000 refund. The prospect of having some extra money is exciting, and the hefty fee gets lost in the excitement.
After the EIC was enacted tax prep firms started springing up in low income neighborhoods all over America. When I was in the Navy it was well-known that near any Navy base you could find plenty of bars, pawn shops, and payday lenders. Thanks to the EIC you can add tax preparation firms to that list. There are at least 10 within a mile of the main gate for JEB Little Creek-Fort Story.
It's not that I think low income people shouldn't have access to professional tax preparation. I just object to the outrageous fees most places charge to do an EIC return - a fee they can only charge because the return will generate a large refund, giving the low income taxpayer a means to pay for the tax preparation. The tax credit is supposed to help Americans out of poverty, not enrich the corporate tax mills.
A second problem with EIC is that it's paid as a lump sum. I am a professional financial planner, but if you handed me 4 or 5 months' worth of salary all at once I'd be hard pressed to put it to use in an entirely efficient manner. Lump sums are just flat hard to deal with for anyone, let alone someone who may not have the financial knowledge to use it effectively. If the person receiving it doesn't have good money management skills the EIC might be good money thrown after bad. We want EIC to help lift people permanently out of poverty, not just give them a brief respite from it.
And finally, there's fraud. Billions of dollars in fraud. There are some taxpayers (and tax preparers) who are willing to lie to get EIC. It's frustrating. The IRS has put additional measures in place to try to stop it, and it still happens. To a degree it is to be expected, but we should never accept it. Nor do I think we should throw the baby out with the bath water. Some people abusing the rights and privileges of a prosperous society shouldn't be the reason we start withholding rights and privileges from everyone else.
I am a firm believer that every taxpayer should claim every credit and deduction they are entitled to. If you meet the requirements for EIC, I'll help you claim it. I don't try to enrich myself on EIC returns at PIM Tax Services. I charge a bit extra because there is an additional "due diligence" form the IRS requires me to complete. The form is a fraud prevention measure, and I take it seriously. In addition to being a tax preparer I am also a financial planner, so I can offer clients some ideas on how to make the most efficient use of large tax refunds. There are some problems with the EIC, but it's nothing we can't handle face-to-face in my office at tax time.
11 July 2015
I have prepared tax returns for more than a few first time landlords - people who are in their first year of collecting rents for a house or condo (or co-op). Often these folks had never intended to be landlords. They originally purchased the property to live in and then later determined it was in their financial interests to put it on the rental market rather than sell it. That decision was never reached lightly, but it was frequently reached without understanding the tax implications of residential real estate rentals. Hopefully this post will shed some light on that.
The first thing to keep in mind is that once you put your property up for rent it is a business, and you are a business owner. All of the rents you collect are revenue, and every nickel you spend on that property is an expense. Your revenue and expenses for your property are reported to the IRS on Schedule E, and the difference between the two passes through to Form 1040 of your individual tax return as income.
Rents - Expenses = Rental Income
You will pay income taxes on that rental income, therefore, it is important to keep track of all of the expenses for your property so you pay taxes on the correct amount of rental income. The most common mistake I see first time landlords make is not tracking their expenses. They sit across from me at tax time, eyes rolled up toward the ceiling, trying to recall if, what, and how much they had spent on maintenance, repairs, etc. They were not aware they needed to keep track of expenses in order to reduce their tax bill.
Deductible rental property expenses include:
If you're renting out a real estate property be sure you're keeping track of those expenses throughout the year.
Depreciation is a difficult concept for many first time landlords. It seems counter-intuitive. We want our properties to appreciate (go up in value), not depreciate (go down in value). It's important to understand, though, that depreciation for tax purposes isn't related to the actual change in value of your property. Depreciation for tax purposes is about claiming a current tax benefit by writing down your basis in the building. (For most people the basis is the amount they paid for the building - land is not depreciable for tax purposes.)
Taxpayers are not required to take the tax benefit of depreciation, but THEY SHOULD. Here's why - whether you take the depreciation or not, the IRS is going to treat you like you did. When you sell the property you will have to pay tax on the amount of depreciation that is recaptured in the sale price - even if you never took the depreciation tax benefits in the first place. It is as if the IRS extends a bowl of money to you and says, "You can take some if you want, but even if you don't we are going to tax you as if you took it." In that situation the only rational response is to take the money.
Because the land does not depreciate the taxpayer must know the value of the house without the land. This can normally be found in local property tax records. In Virginia property values are public records, and can be found online. I have found property values online for other states as well, but I have not checked all 50 of them. (Virginia Beach Property Values website). For recently purchased properties we can also find the needed information in the appraisal documents.
If you made significant improvements to the property (i.e. new roof, new HVAC, remodeled kitchen...) before putting it on the rental market it changes your basis, so we would need to know those costs as well to get to the right number for your basis in the property. If you make significant improvements after you put the house in the rental market the improvement is depreciated separately and the depreciation on the house and the depreciation on the improvement are added together for schedule E.
Knowing your expenses and the value of the building you are renting (so we can figure your basis and depreciation) is a big help to your tax preparer. It's a fairly complex subject, though, so expect to spend some extra time with your tax professional the first time you file as a landlord. It's confusing to most people in the beginning, and I am happy to take the extra time to help you understand the tax implications of your rental property.
14 July 2015
The process of withholding tax preparation fees from the refund is called a Refund Anticipation Check or RAC. They are a convenient way for many people to pay for their tax preparation service. Despite that, I don't offer them at PIM Tax Services.
The primary reason is that I can't do it without charging a fee of $25 to $35 dollars for it. RACs get processed through a bank, and the bank charges for that service. Ordinarily (no RAC) the IRS will send your refund directly to your bank via direct deposit. There are no fees involved in this transaction.
With a RAC the IRS sends your refund to another bank. That bank sends the fees to the tax preparer, takes their own processing fee, and then sends what's left of your refund to your bank.
The IRS will only send your money to your bank account. In order for the IRS to send the money to the RAC bank you must open an account at that bank. If you've had a RAC in the past, that's what all of that paperwork you signed was for. You opened a bank account at another bank and told the IRS to send your refund there. That bank received your refund, took out the fees and then forwarded the remainder to your regular bank. It added a few days to the time it takes to get your refund and cost you some extra money - neither of which is very efficient.
The second reason I don't like RACs is because very little is known about that middle-man bank. Several years ago the IRS stopped letting tax preparers and banks know in advance whether there was a tax lien against a taxpayer's refund. (Tax liens are typically issued if there are back taxes or child support owed, or if federal student loans are in default.) If there is a tax lien then the IRS doesn't send the refund to the taxpayer, they send it to the creditor the taxpayer owes money to. If that happens to a RAC transaction neither the bank nor the tax preparer get paid because the money never comes from the IRS. This policy change by the IRS ran the most reputable banks out of the RAC business. The banks remaining in the RAC business increased their fees (to compensate for their increased risk) and kept marching on.
What do we know about those banks that offer RACs? Typically very little. If you've had a RAC in the past do you even know the bank's name? (You have an account there!) They are real banks, regulated in the USA, so we could find out about them if we are willing to do some research. (Who has time for research?) Do they have good cyber security in place? You have to send them a lot of information to open a bank account. How are they taking care of it? Do they sell your e-mail address and phone number to marketing firms? There are too many unanswered questions for my taste.
I am not opposed to convenience. If I can find a way to process RACs for free (or nearly free) using a bank I know and trust I'll start offering them. Until then, I prefer to do business like most places in America and take care of the fees at the point of service. Cash, check, credit, or debit - quick, easy, and secure.
30 JUNE 2015
For the most part I enjoy preparing taxes. Each return is like a new puzzle to solve. There is a solution that gives the lowest possible legal tax, and I want to find it. Some people like Sudoku, I like tax returns.
Soon after I started working as a tax preparer for one of the national tax mills I noted the fees being charged seemed inconsistent. I might spend 25 minutes completing a simple return and the fee would be $275. I could spend 90 minutes on a more complex return and the fee would be $140. It puzzled me, so I set about trying to solve the puzzle. What I found rubbed me the wrong way.
Fees were set by the corporate office, and I had virtually no power to change them in any way. Nor could I accurately predict them. I found out the fee for a tax return at the same time as the client. The software worked sequentially. The screen showing the fee was near the end of the process, after all of the tax prep work was completed. Before progressing to the fee screen I would silently try to guess what the fee would be. I would often have to suppress my shock when the fee was revealed. It was not uncommon for my guess-timate to be off by 50% or more. (And I was the one doing the actual work!)
Most tax prep firms charge by the form, and we were no different. At first glance this seems like a fair way to charge for tax preparation service. The more forms required for a tax return, the more work the tax preparer has to do, right?
In fact, this is rarely the case. The software we use auto-populates all of the forms from a single entry of client data. For example, once I enter your child's SSN and birth date, your W2 information, and the amount you spent on daycare all of the forms and worksheets to calculate your child credit, child care credit, additional child credit, etc. are done for me by the software. I don't have to lift a finger. There is no direct correlation between the forms generated and the effort required to generate them.
While I was never able to accurately predict the fees for the returns I was working, I did note some trends:
Essentially, the clients paid more when they could afford it or when they were running out of options to get their taxes completed on time. I think that's ridiculous.
I believe the fee charged should directly relate to the service rendered. I also believe both the client and the tax preparer should be able to accurately figure out what the fees will be as soon as the structure of the tax return is known - not wait to find out what the costs are after the return is completed. It seems so basic. I'm not sure why it isn't universal.
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.
PIM Tax Services LLC is a professional tax planning and preparation service in Virginia Beach, but through the magic of the internet, we serve clients around the world!