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The holiday season is upon us but before you go into party mode, sit back a moment and reflect upon your year. Financially, that is. Especially if you encountered a lot of financial changes – lost a job, got a new job, bought a house, sold a house, moved, got married or divorced, had a baby, went back to school, took an early distribution from a retirement plan, started a business or closed a business – then you need to crunch those numbers and see what kind of tax liability has been created. After all, better to know now than have that deer-in-the-headlights look in your eyes next April 15. And because the year isn’t over, you may likely counter some of the damage with additional tax planning to staunch the bleeding.

And who knows? After compiling your data, you may be pleasantly surprised. Maybe a financial event has gone in your favor tax-wise and you may be anticipating a refund.

Whatever the case, a projection of your anticipated liability is in order which may involve a visit to your tax pro. A review of your numbers might elicit some excellent advice for warding off the tax man and minimizing your tax liability.

Some things to consider:

  1. If you lost a job or changed jobs sometime during the year, your annual income may have increased or decreased and should be examined to determine if proper withholding has accumulated. Also, you may have been receiving unemployment benefits for part of the year. Did you know that these benefits are taxable income at the federal level? Yes, that’s right; they kick you while you’re down. They may also be taxable at the state level, depending on your state’s tax laws, but usually not. If you elected for federal withholding from your benefits, you may be okay. Otherwise, plan on paying additional taxes on the amount you received. Discuss this and the job change with your tax professional. A benefit in your favor is that all job seeking expenses and continuing education costs to improve existing skills are tax deductible if you are able to itemize deductions. If you moved because of a job, you may be able to deduct moving expenses.
  2. Buying or selling a home can affect your tax situation. Buying a home is always good news. Not only do you have the benefit and pride of home ownership but the transaction results in numerous tax deductions you didn’t enjoy as a renter. Any points (loan origination fees) paid is deductible. Mortgage interest, mortgage insurance (PMI), and property taxes are deductions that will save you money on your tax bill. Selling a home can result in a taxable capital gain if you didn’t live there two out of the last five years or if your profit exceeded $250,000 (single) or $500,000 (married filing joint). Ask your tax pro to analyze the bottom line and educate you on all the qualifiers to determine if your profit will be excluded from taxable income and if not, to learn how much you will owe so you can plan for it.
  3. Changes to your family structure can greatly affect your tax picture. If you marry, you gain another exemption. But you also gain this individual’s tax situation. It is always advisable to sit down with your tax pro to go over the pros and cons of filing jointly or separately and to determine the resulting tax liability if you were to combine your income and deductions. Having a child results in an additional exemption as well. Other tax benefits include the child tax credit and the dependent care credit. If you are in a low income tax bracket, you may receive a larger refund due to the Earned Income Tax Credit (EITC).
  4. If you went back to school last year, you will likely qualify for American Opportunity or the Lifetime Learning tax credits. If the schooling was in the form of continuing education to improve your current job skills, the costs associated with the training is deductible. Please note that any education costs to train you for a new position entirely are not deductible but if the education is pursued at a qualifying institution, you may enjoy one of the education tax credits.
  5. If you took an early distribution from your retirement plan, did you ask for taxes to be withheld? If not, review the numbers with your tax pro to determine the tax liability resulting from this transaction. Many people think that having withholding at the source automatically covers the additional tax liability but beware! This is not the case. Typically, the fund manager, upon request, will withhold 20%. But what if you are in a higher tax bracket? Not only that, but if you took the distribution prior to age 59 ½ and there are no exceptions to exclude the penalty, be advised that you can add another 10% penalty for early withdrawal. And don’t forget the state. If you live in a state that levies income tax you may be subject to state taxes and penalties as well. With the highest tax bracket at 39.6%, the tax liability including penalties could be more than 50% of the amount distributed to you.
  6. If you started or closed a business, I sincerely hope you ran straight away to your tax pro. If you are new to self-employment activities there is a lot to learn when it comes to pleasing Uncle Sam. The IRS Website provides plenty of information on this topic. Read up prior to visiting your tax professional. Not only will you receive free intel but you can subsequently compile a list of questions to pursue. Closing a business can result in a tax obligation. But generally if you are operating as a sole proprietorship, you needn’t worry about that.

Right now is an excellent time to contact your tax professional. Final extensions for the year were due October 15, so your tax pro has had time to unwind and is not enduring as hectic a schedule.  There is still time to implement a tax plan with the very little time we have left in this year.  Once you have that out of the way… Party on!

If you have children, you will be happy to learn that the tax code favors you. Whether you are single or married, there are benefits for folks with offspring. The child tax credit gives you a nice break of $1,000 per child subtracted from your tax liability. The Dependent Care Credit and the Earned Income Tax Credit for low income filers, which was enhanced several years ago to cover three or more children rather than two, provides even more of a tax break.

Here are some other tips parents should know:

 

  1. Check your filing status. Years ago my masseuse asked me to look over her tax return. “It’s odd; I’ve never had to pay before. I’ve always gotten a refund. This year my CPA says I owe two grand; that’s how much I usually get as a refund. There’s not much difference between my income this year and last year.” After reviewing the return, I realized that the problem was filing status. She was listed as single rather than head of household. Not only is the tax bracket higher for single, but a single filing status blew her out of the water for enjoying the Earned Income Tax Credit. Correcting her filing status provided her with a refund of $2,600. That’s quite a swing. If you are a single parent and your child is away at college and you pay for more than 50% of her support, you may still take the head of household filing status because the child’s absence is considered temporary.

 

  1. File first. If you suspect your ex will try to take your kid(s) as dependent(s) when you are entitled to the deduction, file your taxes first. The IRS will not get in the middle of a domestic dispute. Whoever files first gets the deduction. If the later-filing party is entitled to the deduction, he or she will have to make a case for it.

 

  1. Proof of Dependency. In conjunction with #2 above, keep important information relating to the validity of deducting your dependent in your tax file. This includes paperwork such as school records which show the child lived at your address and records to prove that you provided more than 50% of the child’s support.

 

  1. Dependent Care Credit.  You may accumulate up to $3,000 in child care expenses for each child under the age of 13. The maximum credit has been increased from 30% to 35% of total expenses. At year end ask your child care provider for a statement showing how much you paid. You must have the provider’s federal ID number or social security number and address in order to take the Dependent Care Credit. This credit also applies to a spouse or other dependent over the age of 13 that is incapable of self-care.

 

  1. Track alimony payments. This is taxable income for the recipient and must be reported on your income tax return. By the same token, alimony you pay to a former spouse is a tax deduction as long as it is court ordered. Child support is not taxable income to the recipient nor is it deductible for the one who pays it. Keep that in mind if you are getting a divorce so that support issues are structured fairly in the marital dissolution agreement.

 

  1. Tuition. Tax credits are available if you pay tuition to a qualified higher learning institution. Payments for books, computers, and fees also qualify for the credit. Room and board do not. Naturally, there are income limitations. It often works out to this: if you can afford to pay for your kid’s college education, you don’t qualify for the credit. Tuition for private schools for K-12 does not qualify for the deduction.

 

  1. Tutoring. If your child is diagnosed with a learning disability and special schooling or tutoring is required, you may be able to deduct those fees as a medical expense. Check with your tax pro. You will need a letter from your doctor to substantiate the deduction.

 

  1. Adoption Credit. Taxpayers who incur qualified adoption expenses may be eligible for this credit or, in the case of employer-provided assistance, an exclusion from income. In other words, it can qualify as a nontaxable fringe benefit. The dollar limitation of the credit has been increased to $13,190 per child for 2014.

 

  1. Employer-Provided Child Care. Employers that provide child care facilities may be eligible for a tax credit equal to 25% of qualified expenses plus an amount equal to 10% of qualified expenses for child care resource and referral services. The credit caps at $150,000 of annual qualified costs.

 

The Valley Fires in Middletown have wreaked havoc upon the landscape. We lost our home in Middletown and so did many of our friends.

The area has been declared a National Disaster area. According to a press release I received from FEMA, “the Regional Administrator for FEMA Region IX Office determined that the Valley Fire threatened such destruction as would constitute a major disaster. California’s request was therefore approved on September 12, 2015 at 21:30 PDT.  Fire Management Assistance Grants provide federal funding for up to 75% of eligible firefighting costs.”

And help is on the way from the Internal Revenue Service as well. The IRS has always gone to bat to help taxpayers affected by disasters. For one thing, filing deadlines are generally extended. I anticipate the October 15, 2015 deadline for filing 2014 individual income tax returns will be extended likely to January 15, 2016, though at this late date, nothing has come down yet.

Many who lost their paperwork to the fires will need time to reconstruct their data. If you find yourself in this situation, request a transcript of your tax documents from the Internal Revenue Service. Your W2s, 1099s, K-1s and other third party documents have been provided to the IRS and are available to you. You can make the request online at IRS Website – Get Transcript.

For data not provided to the IRS, such as payments you’ve made for property taxes, DMV fees, charitable contributions, medical expenses, and deductions, get copies of your bank statements to retrieve the amounts paid.

If you are self-employed, perhaps your data is being safely stored in the Cloud or in an on-line version of accounting software. If not, you will need to reconstruct your books to create a profit and loss statement suitable for reporting on your tax return.

There are specific guidelines in place to help those residing in the Middletown area or for anyone involved in a declared federal disaster. Refer to IRS Publication 547 to discover what you need to know with regard to your loss and your taxes.

Highlights from this publication specific to federally declared disasters:

Timing: Normally, you write off your losses in the year it occurred. “However, if you have a casualty loss from a federally declared disaster that occurred in an area warranting public or individual assistance (or both), you can choose to deduct that loss on your return or amended return for the tax year immediately preceding the tax year in which the disaster happened. If you make this choice, the loss is treated as having occurred in the preceding year.”

The reason the IRS allows this is because the loss will lower your tax liability for the previous tax year thus generating a refund which can be used to help rebuild.

Profit: If a reimbursement from your insurance company to repair or replace your main home results in a capital gain (ask your tax pro to crunch the numbers), you will be allowed to postpone the capital gain if you use the money to repair or replace that main home. Naturally, this break is fraught with rules so check out the section under “Gains Realized on Homes in Disaster Areas” in the Instructions for Form 4684.

Home made unsafe by disaster. According to Publication 547 “If your home is located in a federally declared disaster area, your state or local government may order you to tear it down or move it because it is no longer safe to live in because of the disaster. If this happens, treat the loss in value as a casualty loss from a disaster. Your state or local government must issue the order for you to tear down or move the home within 120 days after the area is declared a disaster area.” Here again, it is a good idea to ask your tax professional to crunch the numbers to accurately determine your loss. It will be reported on Form 4684.

My thoughts, and prayers go out to those who have lost everything.

From time to time every taxpayer will go head to toe with the Internal Revenue Service. Whether you are setting up an installment agreement, facing the auditor from hell, resolving a misunderstanding, or dealing with collectors on the phone or worse yet, on your doorstep, please heed the following suggestions.

1. You get more flies with honey. Remember what Mom used to say! Dealing with bureaucracy can be very frustrating. Especially now when the IRS has experienced so many budget cuts that customer service is at an all time low. Blame Congress not the overworked agent on the other end of the line. Park your bad attitude and anger at the door. Take a deep breath, demonstrate a cooperative attitude, and proceed in an orderly fashion. This will give you an advantage in resolving your issue. In my long career of dealing with the IRS, I have found that most IRS personnel are compassionate humans that will bend over backwards to find ways to resolve issues and help taxpayers. It’s true! It’s not like you won’t ever run into that power-hungry, condescending, or surly agent from time to time. If you do, you can always trade up to a more understanding and respectful model. Just ask for the manager.

2. Use IRS lingo. When you use IRS lingo the person you are speaking with will find you knowledgeable and may treat you with a little more respect. Here is some verbiage you may find useful:
a. Ask for penalties to be “abated” rather than removed.
b. Tell them, if it’s the case, that your failure to (pay or file or comply with a document request) was due to “reasonable cause.” Use this term if you didn’t just flake and have a good reason, which could include such things as unemployment, losing your records, losing your home, health problems, etc.
c. If you can’t pay a tax bill because you are suffering financial reversals you can ask to be deemed “Currently not collectible.” If you are granted this status, they will leave you alone while you get it together.
d. If you feel a spouse or former spouse should be responsible for a tax matter, ask to be treated as an “Innocent spouse.” There are certain criteria to determine if you qualify for this status. Do some research or discuss the issues with your tax pro to find out if you qualify. Because if you do, the IRS will not attempt to collect from you and instead will go after your former spouse.
e. If defending business deductions during an audit, the term “ordinary and necessary” business expense will help – but only if that’s really the case.
f. If you owe a lot of money, perhaps you qualify for the “Fresh Start” program. This program helps taxpayers resolve their liabilities by using more lenient guidelines.

3. Don’t talk too much. IRS agents are trained to draw as much information from you as possible. Answer questions truthfully, but keep your answers short, succinct, and to the point. There is no need to elaborate or discuss your personal life or disclose too much. This will only lead to misunderstandings and possibly investigations.

4. Always tell the truth. Lies have a way of uncovering themselves. Once you are caught in a lie, you will always be suspect. And when you are suspect, you lose the cooperation you would normally receive. Don’t hide assets, don’t run for cover. There are many ways to resolve tax problems using a straightforward and honest approach. Bear in mind that lies can lead to jail time.

5. Only make promises you can keep. This is especially true when it comes to paying your liability. If an IRS agent asks you if you can pay $200 per month on a tax balance and you know damn well that you can only afford $100, tell him so. Indicate that you will try to pay extra when you can. But you are not going to set yourself up for failure by promising more than you are able. If it’s the case, then add that you have always timely filed and paid liabilities in the past and now you need a break. Note that this will not work if their analysis of your financial situation indicates you can pay more.

6. Go to them before they come at you. If you are unable to keep a promise you make, call them and let them know immediately. They are usually so happy with the cooperation they will likely grant you the extensions you need. The collections department notes your file whenever you or your representative calls.

7. Stop the Interview. If at any time during an audit or a phone conversation you feel intimidated, disrespected, or out of your depth, simply say so and end the interview. Tell the IRS that you will be seeking representation and will get back with them soon. This will give you a chance to take a deep breath and discuss the matter with your tax pro. If you felt disrespected, you can always request a different agent. Or if it was a matter of a surly customer service rep you were speaking with on the phone, you can back in hopes of getting someone kinder or a little more understanding.

Will it ever happen?

I’ve made taxation a career for more than thirty years. Over the years, my hopes have been raised by promises and proposals by Presidents and Congress of an end to the complicated maze of tax regulations that burden business and individuals. An end to complexity. The ushering in of simplification.

Milton Friedman introduced a flat tax in 1962. It didn’t take.

This concept was also proposed in 1994 when Congressman Dick Armey (R-TX) introduced a flat tax of 17% for individuals as well as businesses. Virtually all deductions, credits, exclusions, and exemptions would have been eliminated. Dividends, interest, and capital gains would have been excluded from taxable income in order to encourage savings, investments, and capital formation. The tax return would be the size of a post card. Businesses would be allowed to take deductions for certain expenses against income. Everyone was excited about it. But the legislation failed to pass.

Shortly after taking office President Obama organized an economic coalition to study tax reform and recommend a new tax system. Under discussion was the elimination of income tax deductions accompanied by a reduction across the board of income tax rates. What everyone had in mind was a flat tax. Did it happen? No, of course not.

In 2011, Paul Ryan (R-WI) was set to introduce remarkably similar legislation with a transition period in which taxpayers could choose the current system or his proposed system for the next ten years. Rather than an across-the-board 17% tax rate, Ryan proposed a rate of 10% for incomes up to $100,000 and 25% for incomes above that level. A generous standard deduction and personal exemption (totaling $39,000 for a family of four) would have replaced the deductions and tax credits formerly enjoyed. The alternative minimum tax and the death tax would be eliminated.

Ryan’s plan included reform for the corporate income tax, currently the second highest in the industrialized world. It would have been replaced with a border-adjustable business consumption tax of 8.5 percent. This new rate is roughly half that of the rest of the industrialized world.

Jim DeMint (R-SC) planned to introduce a flat tax in 2012 – pretty much the same principal – one rate and a postcard size tax return.

None of these proposals have received any serious consideration.

Let’s face it; the current system needs to be burned to the ground. We’ve got approximately 100,000 pages of confusing, unfair, and contradictory tax code mired in shades of gray with the word “generally” used way too many times. According to the IRS, 47% of Americans pay no income tax whatsoever. Many of these “non-taxpayers” claim the Earned Income Tax Credit (EITC) and receive refunds of upwards of $6,000 depending upon family size and income level. According to statistics gathered from 2009 income tax returns, more than 25 million people claimed more than $57 billion in EITC refunds. Are there really that many people entitled to what we call a “reverse-welfare system?”

We all recognize that behind tax legislation is a motivation for certain societal behaviors. For example, if the tax code allows a deduction for charitable contributions, then more Americans will donate to worthy causes. A deduction for property taxes and mortgage interest propel Americans into the American dream of home ownership. The IRA deduction encourages people to save for retirement.

Imagine what would happen if these deductions were suddenly removed. Many nonprofits would cease to exist for lack of funding. The housing market may experience another decline. Why not be a renter and let someone else repair the leaky roof and dripping faucets? And with society becoming more mobile – the necessity of moving for work, renting has become attractive. And if taxpayers did not make IRA contributions would they reach old age only to live in poverty, relying on Social Security and the generosity of family to survive?

And what has happened with the IRS over the years? Because of severe continuing budget cuts along with the added burden of administering Obamacare, customer service has become a joke. As a practitioner I had become accustomed to calling the practitioner hot line and getting an IRS agent on the second ring. Now there are layers of menus followed by hold times of usually more than one hour. And oftentimes after holding that long the IRS disconnects before I’m able to speak to anyone at all. And practitioners supposedly enjoy priority service. I feel bad for my fellow Americans who probably have to hold for even longer periods of time.

To effect change, please write your Congressman!

Life is complicated. And that’s probably one big reason tax law is complicated. So many “what if’s” make for more and more legislation. Below are situations that may arise once you become a landlord. It’s important to understand the tax consequences in order to maximize your tax savings and to be in compliance with tax law.

Must I file 1099s if I pay a workman? No you don’t have to do that. Congress actually passed that requirement for landlords in 2011 but rescinded the legislation later on. Anyone who is self-employed is required to file Form 1099-Misc for payment for services in the amount of $600 or more. But if you are reporting your rental income and expenses on Schedule E then you needn’t worry about this obligation.

What if I am renting out to a family member? Renting to relatives can be a sticky wicket. The IRS views all transactions between related parties as suspect especially if the activity results in a loss that reduces your tax liability. In order to take all of the deductions to which you are entitled, and not have the rental reclassified by the IRS as “personal use,” make sure the rent is charged at fair market value and that you are treating the rental in a professional manner. So we’re talking rental or lease agreements on file as well as a bona fide business relationship. It would be advisable to obtain a list of comps in your area to substantiate that the rent you charge to your relative is what you would charge to a stranger. Keep that list in your tenant file along with the rental agreement in case of audit.

Renting part of your home is an interesting topic expanded upon in IRS Publication 527. Many people rent out spare rooms. This should be reported on your tax return if you your activity falls within the guidelines outlined in this publication. Allocate your expenses between personal use and rental purposes and claim your rental income and expenses on Schedule E. The rules listed in this publication also apply to vacation homes that are used for personal purposes as well as for rental. Speak to your tax adviser to work out the amounts you can deduct.

Limits on deductions apply to rental properties. Rentals are considered passive activities. Unless you are a real estate professional, you can deduct losses from these activities only against other passive income. Any unused losses and credits may be carried forward to future tax years. There is an exception: if you actively participate in the activity, you may deduct $25,000 in losses in the current year. If your modified adjusted gross income exceeds $100,000 ($50,000 if married filing separately), the amount of deductible loss will phase out. There is no deduction allowed currently if your income is greater than $150,000.

Depreciation is a deduction for the cost of the property, the cost of improvements, furniture, furnishings, machinery and equipment, expensed over the useful life. You cannot deduct depreciation for land or for any equipment you purchase to make improvements to the property. For example, if you buy a table saw so you can cut baseboard and other lumber for a remodel to the property, you cannot take a deduction, depreciation or otherwise, for the cost of the saw. You also cannot take a Section 179 deduction, in which you expense the full cost of furniture, fixtures, machinery, and equipment in the year of purchase. This special allowance is allowed only for businesses and not for a rental activity listed on Schedule E.

These are only a few examples of special situations. Because the tax laws governing rental properties are so complex, I would urge you to sit down with a tax professional to learn more so that your activity will pass all tests if you are under audit.

As a rental property owner, you are entitled to write off “ordinary and necessary expenses for managing, conserving, or maintaining rental property from the time you make it available for rent.”

The IRS has no definitive list of deductions. As a landlord, you should visit the IRS website and take a good look at Schedule E. This is where you will report the income and expenses for your rental property. Almost every deduction, certainly the obvious ones are listed: advertising, auto and travel, cleaning and maintenance, commissions, insurance, legal and professional fees, management fees, mortgage interest, other interest, repairs, supplies, taxes, utilities, and depreciation. Beyond that are five lines for “Other Expenses,” which might include bank charges, telephone, security, equipment rental, homeowner association dues, gardening, eviction expenses, among others. Think in terms of whether or not you would have spent the money if you didn’t have the rental property. If it’s an ordinary and necessary expense, it is deductible.

Timing is everything. You can deduct your expenses as soon as the property becomes available for rent. If you own a rental property that is sitting idle and you are not looking for tenants then your expenses with the exception of depreciation, are not deductible. Perhaps you are performing a major remodel or you don’t need the money and just don’t want to deal with tenants right now or you are using the property personally then you cannot take deductions for your expenses. But if the property is available and you are attempting to secure a tenant, you may. Keep a file of your advertising and other efforts incurred to secure a tenant in the event of audit as you may be required to prove intent.

If the property is vacant and listed for sale, you may deduct the expenses until it is sold.

Here are some special rules, tips, and background on certain deductions you may consider:

1. Travel expenses: if the primary purpose of a trip is to collect rental income or to manage, conserve, or maintain your rental property, the expense is deductible. For example, if you own a condo in Hawaii and drive by to make sure it’s still there while you’re on vacation, you don’t have a bona fide deduction. Obviously, vacation was your primary purpose. But if your primary reason for traveling there is to collect back rent or paint the exterior or figure out why the roof keeps leaking, you are entitled to the deduction. Keep in mind though, that if you are visiting the property to make major capital improvements, like remodeling the bathroom and kitchen, the expense is not currently deductible. You must add the cost of the trip to the cost of the improvements and depreciate it. Make sure to keep all documentation to prove intent.

Local travel is also deductible. If you own a property 45 minutes from your home and you visit it once a month to pick up the rent and make sure the tenant hasn’t burned the place down, you should track your mileage and take a deduction.

2. Taxes: Property tax is the obvious expense listed here. However, if local ordinance requires that a landlord pay for a business license, you may deduct this expense. However, you cannot deduct charges for taxes or assessments that increase the value of your property, such as charges for putting in streets, sidewalks or water and sewer systems. You also cannot depreciate these expenditures. But they don’t disappear. You add the cost to the basis of the property. They are essentially deducted when you sell the property.

3. Points: Points, aka loan origination fees, are basically considered prepaid interest and as such are amortized over the life of the loan. You cannot write off the deduction all at one time. Take a copy of the settlement paper to your tax pro when preparing the tax return. Other deductions may be listed on that statement that may be currently deducted.

4. Repairs versus improvements: While repairs are currently deductible, improvements must be depreciated over their useful life. A repair keeps your property in good working condition. Things like unstopping a toilet, fixing rain gutters, replastering the hole in the wall left by the last tenant’s fist when you raised his rent, replacing a broken window are all examples of repairs. Improvements add value to the property and include things like remodeling the kitchen or adding a swimming pool. In 2014, new incredibly complex regulations were passed changing the parameters covering the topic of repairs versus improvements. They were so complex that the IRS disbanded with enforcement for 2014. Be sure to contact your tax pro to determine the deductible status of any repairs and improvements you perform on your property this year.

5. Tax Return Preparation Fees: A portion of the total fee you pay for tax return preparation can be allocated and deducted on Schedule E for preparation of Schedule E. Deduct tax planning/projection fees relating specifically to the rental property and any fee paid to resolve a tax underpayment issue related to your rental property on Schedule E. The full tax preparation fee is deductible on Schedule A, so why bother allocating to schedule E? Bear in mind that on Schedule A you do not benefit from the entire deduction. It is listed as a Miscellaneous itemized deduction and is reduced by 2% of your adjusted gross income.

Publication 527 is available at www.irs.gov and will provide you with complete information on the deductibility and treatment of your rental expenses.

If this is the year you become a landlord, you will want to pay attention to the tax rules governing this investment. If you already own income property, you may want to review these IRS regulations to ensure that you are in compliance.

Unless you are in a partnership, your rental income and expenses are listed on your individual tax return on Schedule E.

The profit or loss from the activity is included in income and taxed at your ordinary income tax rate. It sounds pretty straightforward, doesn’t it? Not so fast. Watch and see just how tricky it can get.

First of all, what is rental income? If a prospective tenant pays first, last, and  a security deposit when moving into the property, not all of that is included in current year taxable income. Or is it? Here’s how it breaks down:

  1. First and last month’s rent are included in the current year income even if the last month’s rent will be applied in a future year.
  2. Advance rent – e.g. payment of next year’s today – is all included in income for the current year, regardless of what year the payments are for.
  3. Non refundable deposits are included in current year rent, even if a fee, for example, a nonrefundable cleaning fee, won’t be used until the tenant moves out in a future year.
  4. Security deposits need not be claimed as income if you intend to return the deposit to the tenant at the end of the lease term.
  5. Barter is income. If, for example, as part of the rent, your tenant agrees to maintain the gardens and pool, you must show the value of these services as rental income. By the same token, you may also deduct the same amount as a rental expense. I know it’s a push, but the IRS wants us to sharpen our pencils and do extra paperwork.
  6. Expenses paid by your tenant. See barter income above. Say you’re jet setting through Europe and the pipes spring a leak. Your tenant pays the plumber then deducts it from his rent. You must include the full rent in income and write off the plumbing expense against it. And again, it’s a push.
  7. Lease cancellation. If your tenant pays you to cancel the lease, include the payment as rental income.
  8. Option payments. If your tenant signs a lease with an option to buy, the option payments are generally rental income. But once the tenant exercises the right to buy the property, all payments received after the sale are considered part of the selling price.
  9. Here’s a little tax break for you: if you rent out part of your personal residence for fewer than 15 days, you need not include the rent you receive in your income.
  10. If you are renting space in your personal residence (including a vacation home) for more than 15 days, you must declare the income. But you should consult with your tax pro to determine how to properly allocate your rental expenses against the income you receive.
  11. If the property is unoccupied but available for rent, it is still considered a rental activity and as such, you may take all rental expenses against zero income. Be ready to prove it was available for rent. That includes keeping copies of ads you’ve run, etc.

Also make sure you keep all lease/rental agreements and tenant applications. If you are audited, the IRS will review these documents as part of the verification that this is indeed a rental property. Also keep all cancelled checks and credit card receipts for all rental expenses deducted on your tax return.

I have encountered so many misconceptions about what is deductible when you purchase, own, and operate a rental property or a personal residence for that matter. Here’s the list of misconceptions and the correct answers:

  1. Misconception: You are allowed to write off the down payment. Wrong! This expense is part of the basis of the property and is not deductible on your tax return. You still get the write off, albeit indirectly, via depreciation. Here’s how that works: you buy a property for $100,000. You put down $20,000 and pay $5,000 in closing costs. Your basis in the property is $105,000. After deducting the value of the land, you write off the remainder over 27.5 years for residential property and 39 years for commercial property. Depreciation applies only if the property is a rental activity; you cannot depreciate your personal residence. You are allowed, however, to depreciate the portion of the home used as a home office in an active trade or business.
  2. Misconception:Closing costs are deductible. No they are not. They are added to the basis of the property and are deducted via depreciation over the useful life of the property as described above. But take a close look at the closing costs. There may be some expenses listed there that you paid for, e.g. insurance, points, and property taxes which may be currently deductible. Always give closing papers to your tax pro, whether it’s for a purchase, refinance, or sale of a rental property or your own personal residence. Insurance is not deductible for a personal residence but it is an valid write-off for a rental or home office.
  3. Misconception: Points are always currently deductible. Points are only deductible in the year of purchase of a personal residence. For a rental property, points may be deducted ratably over the life of the loan. If you refinance your personal residence and pay points, you may amortize those over the life of the loan as well. It’s taken as a deduction on Schedule A under mortgage interest.
  4. Misconception: When you sell a property, your mortgage balance is deducted from the selling price to determine your taxable gain or loss. No, no, no! Your mortgage balance is not a factor in the equation. The IRS couldn’t care less if you financed or paid cash for a property. The basic formula is: selling price less selling costs and the basis in the property. If you sold the $105,000 rental property purchased in #1 for $205,000 and paid out $19,000 in closing costs and sales commissions plus $1,000 for a roof repair, your taxable gain would be $80,000. $205,000 – $105,000 – ($19,000+$1,000) = $80,000. You may also have depreciation recapture which will be included as income on your tax return. Check with your tax pro.
  5. Misconception: Income received from rentals owned in foreign countries is not taxable. Check with Charles Rangel (D-Harlem) on this one. He was confused about the taxability of rents received on his villa in the Dominican Republic. Why was he confused? “Because,” he says, “I don’t speak Spanish.” Hah! This was one of the reasons he was censured by Congress. Don’t get yourself censured. It’s taxable income, okay?

 

 

If you play the stock market, it is wise to know about the tax consequences of your securities transactions.

Capital Gains Tax First of all, any profit you enjoy from the sale of a stock held for at least a full year is taxed at the long term capital gains rate, which is lower than the rate applied to your other taxable income.  If you are in the 10%-15% tax bracket your rate on capital gains is 0%.  That’s right, zero. The 15% capital gains rate applies to those in the 25% tax bracket. Capital gains peaks out at 20% for higher income taxpayers. If the stock was held for less than a year, ordinary income tax rates apply. It is therefore beneficial tax-wise to hold the investment for longer than a year.

Dividends. The capital gains rate applies to “qualified” dividends. For dividends to be classified as “qualified” they must be paid by a U.S. corporation or a qualified foreign corporation and the holding period of the stock must be more than 60 days. There are plenty of other exceptions and definitions so check with your broker or tax advisor to see if the dividends for your stock holdings are “qualified” or not. Dividends on stock held in a qualified retirement plan are not taxable income.

Congress enacted the lower capital gains rate to drive investment. After all, most tax laws are passed as a form of directing social behaviors.

 

The Wash Rule Many investors benefit from selling a stock in a losing position to offset a gain, then turn around and buy the stock right back.

Well, the IRS will not allow an investor to claim a capital loss if you sell a stock and buy it back within 30 days. It is called the “wash rule” and does not allow for a capital loss. If you sell a stock and buy it back within 30 days, the IRS will disallow the capital loss and you will lose the offset.

Capital Losses One of the big limitations in stock investing is the amount of losses you are allowed to deduct on your tax return. If you sell stocks at a loss, you may deduct only $3,000 in losses per year. The remainder of the loss is carried forward to future years. You may apply capital losses against capital gains in the current and future years to net out the overall profit or loss.

Deductible Investment Expenses A tax deduction often overlooked by investors is the cost of management fees paid to brokers, usually for management of mutual fund accounts or for advisory services. You may deduct these fees as an investment expense on Schedule A of your tax return.  Some brokerage 1099s or year-end statements will state the total paid for the year.  But many do not. You may have to call your broker to find out how much you paid. Be sure to provide this information to your tax pro.

Stock Sales When determining your profit from a stock sale, it’s important to understand not only the formula but the meaning of the variables in the formula. Certain circumstances applied to the variables can reduce your tax liability when you sell. Many taxpayers believe they must pay taxes on the full amount of the check they receive from the sale. That is not true. You can subtract your basis.

The formula is: Sales Proceeds – Basis = Taxable Profit or Deductible Loss.

Sales proceeds can be reduced by commissions paid to the broker.

Basis is the cost of the stock plus any reinvested dividends and commissions paid for acquisition.  If you inherited the stock, the basis is the fair market value of the stock on the date of the decedent’s death or the alternate valuation date. If the stock was received as a gift, the basis is the lower of the fair market value or the basis of the donor at the time the gift was made.

Audit Taxpayers oftentimes forget about a stock sale when compiling their income tax return. This results in a CP-2000 letter from the IRS. The letter is about eight pages long and somewhere in the middle is a listing of omitted items and a calculation of the tax liability on those items. If you receive one showing an omitted stock sale, don’t just pay the tax bill. The IRS only knows about the stock sale; they have no clue as to what your basis in the stock is. Remember the formula earlier? You may actually have taken a loss on the stock and that means no tax liability whatsoever. In fact, you may be entitled to a refund. So call the phone number on the front of the letter and let them know that you will amend that tax return. The IRS may instruct you to complete a Schedule D declaring the details of the stock sale and ask you to fax it to them. They will adjust the tax due (if any) accordingly.

However, beginning January 1, 2011 as a part of the Emergency Economic Stabilization Act of 2008, brokerage firms are required to report the cost basis and gain/loss information to the IRS on their form 1099. This streamlines the tax preparation process considerably.

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©2013 Taxpertise | Bonnie Lee, E.A. | Ph: 707.935.1755 Fax: 707.938.1891 | 453 2nd Street West, Sonoma, CA 95476