2014 Tax Changes: No More Mortgage Debt Forgiveness Exclusion

Note: On December 19, 2014, Congress retroactively extended the mortgage debt forgiveness exclusion through the end of 2014.  It has expired again as of January 1, 2015.

With 2014 quickly coming to an end, you may be looking at ways to reduce your income tax liability. The first step in any good tax planning is understanding how the law changed from 2013 and how that affects you.

In this series, 2014 Tax Changes, I will give you an overview of the changes in the tax law that may affect you.  If you haven't already, please feel free to read the earlier posts in this series:

• Individual Mandate- discussing the Affordable Care Act's individual mandate that is now in effect;
• Pease Limitation- discussing how your itemized deductions may be limited; and
• Goodbye IRA Charitable Rollovers- discussing the expiration of a special rule that allowed seniors to roll over their IRA's minimum required distributions to a qualified charitable organization without negative tax consequences.

No More Mortgage Debt Forgiveness Exclusion

The general rule in the Internal Revenue Code is that when you owe someone money and that person forgives the debt, you are treated as having received income equal to the amount of forgiven debt.  This type of income is called "cancellation of indebtedness (COD) income".

While there are several exclusions that could potentially protect taxpayers from having to recognize COD income, one of the most popular was the mortgage debt forgiveness exclusion for individuals who had debt forgiven on their principal residence.  Unfortunately, this exclusion expired at the end of 2013.

As always, please leave your feedback in the comments section below.

2014 Tax Changes: Goodbye IRA Charitable Rollovers

Editor's Note: The IRA Charitable Rollover was extended retroactively for the 2014 tax year on December 19, 2014, but has expired again as of January 1, 2015.

There are less than 2 months left in 2014, and if you are going to minimize your income tax liability you need to understand what changes were made in the tax law.

In this series, 2014 Tax Changes, I will give you an overview of the changes in the tax law that may affect you.  If you haven't already, feel free to read the first post in this series, Individual Mandate, discussing the Affordable Care Act's individual mandate that is now in effect, or the second post, Pease Limitation, discussing how your itemized deductions are being limited.

Goodbye IRA Charitable Rollovers

Through 2013, seniors who would otherwise have to take a "minimum required distribution" from their IRA and report that amount as income could instead rollover up to $100,000 to a charitable organization of their choice.

I am sure you are wondering why this was a tax benefit.  As you may already know, when you make a charitable contribution you are allowed to deduct the contribution as an itemized deduction.  Wouldn't this mean that the $100,000 of income from the minimum required distribution would, effectively, be netted against the charitable contribution itemized deduction so that there would not be any net increase in taxes?  Well, sometimes, but not always.

You have to remember that there are limits on the amount of charitable contributions that you are allowed to take.

First, you may only deduct, as a charitable contribution, up to 50% of your adjusted gross income.  That means if your only income is the minimum required distribution, then even if you give 100% of the distribution to your favorite charity you are only allowed to take up to half of that amount as a charitable deduction.  Yes, you will carry forward the excess contributions to the next year, but if your only income is from the IRA minimum required distributions and you are donating 100% of it to charity every year then you will never be able to take full advantage of the charitable deduction.

The second limitation is that not every senior takes itemized deductions.  I was using $100,000 as an example of the amount that may be distributed as part of an IRA's minimum required distribution, but in most cases this amount will be much less.  If, for example, a senior has $8,000 of minimum required distributions from his IRA and contributes 100% of it to a charity, then he would have $4,000 of itemized deductions.  Assuming that he did not have any other itemized deductions, despite making the charitable contribution he would not itemize his deductions and therefore would not receive any tax benefit from making the charitable contribution.

Finally, as you read about in my last post, the Pease Limitation, reduces the benefit of charitable contributions.  If you are affected by the Pease Limitation, the value of your charitable contribution deduction is limited.

The special rule that expired at the end of the 2013 eliminated these problems by ensuring that a senior that made a direct rollover of his/her IRA minimum required distributions to a qualified charitable organization would not pay any federal income taxes on the distribution because the distribution would not be recognized as income (and the contribution would not be allowed as a deduction).

Unfortunately, without this special tax rule seniors may pay more in taxes or will have to engage in different tax planning strategies.  And sadly this may also have an impact on the amount of charitable contributions made this year.

If you are interested in learning more about 2014 tax changes, please send me an e-mail.

2014 Tax Changes: Pease Limitation

With only 2 months left in 2014, you have to act fast to put yourself in the best position to minimize your income taxes.

In this series, 2014 Tax Changes, I will give you an overview of the changes in the tax law that may affect you.  If you haven't already, feel free to read the first post in this series, Individual Mandate, discussing the Affordable Care Act's individual mandate that is now in effect.

You may already be familiar with the Pease Limitation from your 2013 tax return.  The Pease Limitation was first introduced in 1990 as a way of limiting popular itemized deductions, such as the home mortgage interest deduction and the charitable contribution deduction, indirectly.  This controversial item was phased out between 2006 and 2010, but came back in full force in 2013.

The Pease Limitation is subject to inflation, so for 2014 it will only affect individuals with incomes of $254,200 or more and married couples filing jointly with incomes of $305,050 or more.

How does the Pease Limitation work?

As I mentioned above, the Pease Limitation only affects individuals with incomes above a certain applicable amount, which in 2014 is $254,200 for single individuals and $305,050 for married couples filing jointly.

The Pease Limitation reduces the amount of applicable itemized deductions taxpayers are entitled to take by the lesser of:

• 3 percent (%) of the adjusted gross income above the applicable amount; or
• 80 percent (%) of the amount of the itemized deductions otherwise allowable for the tax year.

Example

Assume a married couple has adjusted gross income of $800,000 and total itemized deductions of $100,000.  In this case, the amount of itemized deductions they would be eligible to claim would be reduced by $14,849 to $85,151.

How did I arrive at that number?

1. This couple has adjusted gross income of $800,000 and the applicable threshold for married couples filing jointly is $305,050, so the amount that the adjusted gross income exceeds the applicable amount is $494,950.  3% of that amount is $11,848.50.
2. The couple has $100,000 of itemized deductions that would otherwise be allowable, and 80% of that amount is $80,000.
3. Because $11,848.50 is less than $80,000, the allowable itemized deductions is reduced by $11,849.

Example

Assume a single individual has adjusted gross income of $300,000 and total itemized deductions of $20,000.  In this case, the amount of itemized deduction that he would be eligible to claim would be reduced by $1,374 to $18,626.

How did I arrive at that number?

1. This individual has adjusted gross income of $300,000 and the applicable threshold for single individuals is $254,200, so the amount that the adjusted gross income exceeds the applicable amount is $45,800.  3% of that amount is $1,374.
2. This individual has $20,000 of itemized deductions that would otherwise be allowable, and 80% of that amount is $16,000.
3. Because $1,374 is less than $16,000, the allowable itemized deductions is reduced by $1,374.

If you believe that you may be affected by the Pease Limitation and would like to learn more about how it operates and would like to see how you can attempt to minimize its impact on you, please feel free to send me an e-mail.

As always, I appreciate your feedback in the comment section below.

2014 Tax Changes: Individual Mandate

The individual mandate that we have been hearing about for years is finally in effect.  What does that mean?

Beginning in 2014, taxpayers must have insurance that provides "minimum essential coverage."  A list of what health care plans that qualify as providing minimum essential coverage is provided on the healthcare.gov website.

If you do not have insurance that provided "minimum essential coverage", you are subject to a penalty.

In 2014, the penalty is the greater of:

• 1 percent (%) of your yearly household income; or
• $95 per adult and $47.50 per child under the age of 18.

In 2015, the penalty increases to the greater of:

• 2 percent (%) of your yearly household income; or
• $325 per adult and $162.50 per child under the age of 18.

In 2016, the penalty increases to the greater of:

• 2.5 percent (%) of your yearly household income; or
• $695 per adult and $347.50 per child under the age of 18.

After 2016 the penalty is adjusted annually for inflation.

Are there any exemptions from having to pay the penalty?

Yes, there are several exemptions available based upon your circumstances.  There are exemptions for the following situations:

1. You are uninsured for less than 3 months of the year;
2. The lowest-priced coverage available to you would cost more than 8% of your household income;
3. You don't have to file a tax return because your income is too low;
4. You are a member of a federally recognized tribe or eligible for services through an Indian Health Services provider;
5. You are a member of a recognized health care sharing ministry;
6. You are a member of a recognized religious sect with religious objections to insurance, including Social Security and Medicare;
7. You are incarcerated (either detained or jailed), and not being held pending disposition of charges;
8. You are not lawfully present in the United States; or
9. You qualify for a hardship exemption.

But I thought I heard that the implementation of the Individual Mandate has been delayed?

The Obama Administration announced earlier this year that it is delaying the implementation of the individual mandate until October, 2016 for millions of Americans who have lost their insurance coverage.  If you believe you qualify, you will want to discuss your situation with an expert in the medical insurance field and potentially apply for the "hardship" exemption.

The IRS's New Repair Regulations: Part 3

In the last few posts, we have discussed the new IRS repair regulations and the first safe harbor to these new regulations, the de minimis safe harbor.

In this blog, we will discuss another safe harbor to the new IRS repair regulations, the small taxpayers safe harbor.

Under this safe harbor, a qualifying taxpayer may expense the repairs, maintenance, improvements, and similar activities in the year the expense is incurred, as long as certain conditions are met.

Who counts as a "small taxpayer"?

To be considered a small taxpayer, in this context, you must have annual gross receipts for the 3 preceding years of less than $10 million.

However, if you have been in business for less than 3 years, then you will determine your average annual gross receipts for the number of years, including any short taxable years, that you have been in the business.  For short taxable years, you must annualize the gross receipts.

What buildings are eligible?

In order for a building to qualify under this safe harbor, the original unadjusted basis (i.e., the purchase price of the building) basis must be $1 million or less.  In addition to commercial buildings, single family residences, and multi-family residences, the definition of building includes, condominiums, cooperatives, or leased buildings or leased portions of a building.

What other conditions have to be met?

The aggregate cost of all the repairs, maintenance, improvements, and similar activities cannot exceed the lesser of $10,000 or 2 percent (%) of the unadjusted basis of the building.

This test is applied on a building by building basis.

How are qualifying expenditures treated?

If a taxpayer meets all of the above-listed qualifications, then the amount he/she spends on repairs, maintenance, improvements and other similar activities are able to be deducted that year.

What happens when the expenditures are greater than the safe harbor amount?

Like I mentioned before, the aggregate cost of all the repairs, maintenance, improvements, and similar activities cannot exceed the lesser of $10,000 or 2% of the unadjusted basis of the building. If it does, even by $1, then this safe harbor cannot apply to any of the expenditures related to that building.

How does a taxpayer claim the protection of the de minimis safe harbor?

If a taxpayer wishes to take advantage of the de minimis safe harbor, they must file an election with the IRS by attaching a statement to their timely filed original federal tax return, including extensions, for the taxable year the safe harbor is being claimed.  The statement must include:

• The title "Sec. 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers";
• The taxpayer's name;
• The taxpayer's address;
• The taxpayers identification number; and
• A description of each eligible building property to which the taxpayer is applying the election.

If the taxpayer is a partnership or an S corporation, then the election must be made at the entity level.

Examples of the Small Taxpayer Safe Harbor

Example 1

Adam, a qualifying small taxpayer, owns an office building.  Adam has an unadjusted basis of $850,000 in the building and during 2014 incurs $9,000 of repair, maintenance, improvements, and related expenses.

The building has an unadjusted basis of less than $1 million, so it is a qualifying building.  Similarly, the aggregate expenses of $9,000 is less than $10,000 or 2% of the unadjusted basis of the property ($17,000).  Therefore, if Adam elects to make the safe harbor election for small taxpayers", he may deduct the entire $9,000 in 2014.

Example 2

Barry, a qualifying small taxpayer, is a real estate investor.  He owns 2 rental properties, House A and House B.  House A has an unadjusted basis of $350,000, and House B has an unadjusted basis of $400,000.  In 2014, Barry spends $8,000 in repair, maintenance, improvement, and related expenses on House A.  Similarly, he spends $7,000 in repair, maintenance, improvement, and related expenses on House B.

Both buildings have an unadjusted basis of less than $1 million, so they are both qualifying properties.

While Barry spend less than $10,000 on House A, the $8,000 he did spend is greater than 2% of the unadjusted basis of the property ($7,000) so he is not eligible to make the safe harbor election for small taxpayers for his House A expenditures.

However, Barry is able to make the safe harbor election for small taxpayers for House B.  Barry only spent $7,000 on House B in 2014, which is less than $10,000 and 2% of the unadjusted basis in teh property ($8,000).

If you have any questions about the small taxpayers safe harbor, or about the IRS's new repair regulations in general, please send me an e-mail.

The IRS's New Repair Regulations: Part 2

Anyone who owns a building or business equipment knows that occasionally it is necessary to have some work done to keep it in good condition.  In the last post, we discussed the IRS's new repair regulations and how the IRS is attempted to clarify when a business owner or investor is able to expense a repair and when you are required to capitalize an improvement.  I also explained why many taxpayers would prefer to have the work done classified as a repair.

There are 3 safe harbors listed in the Internal Revenue Code's Regulations that allow a taxpayer to treat the expenditure as a repair.  In this post, we will discuss the first of these, the de minimis safe harbor.

Taxpayers that have a procedure in place to claim property as an expense on its books and records may be entitled to expense either $500 or $5,000 per item depending on whether the company has an applicable financial statement.

What is an "applicable financial statement"?

According to the Internal Revenue Code's Regulation, an applicable financial statement is:

• A financial statement required to be filed with the Securities and Exchange Commission;
• A certified audited financial statement that is accompanied by the report of an independent certified public accountant; or
• A financial statement required to be provided to the federal or a state government or any federal or state agency.

What does the Internal Revenue Code mean by a procedure in place to claim property as an expense on its books or records?

At the beginning of the taxable year, a taxpayer must have a written accounting procedure in place specifying how certain expenditures will be treated.  Essentially, the procedure must specify that expenditures for less than a specified amount or that have an economic useful life of less than 12 months will be treated as an expense on the taxpayer's books.  However, the decision to implement this procedure must be made for non-tax reasons.  In other words, there has to be a rationale for this procedure other than classifying the expenditure as a repair for taxes.

When can taxpayers expense $5,000 per item as a repair?

A taxpayer may expense up to $5,000 per item if:

1. The taxpayer has an applicable financial statement;
2. The taxpayer has at the beginning of the taxable year a written accounting procedure treating as an expense for non-tax purposes amounts paid for property costing less than a specified dollar amount or with an economic useful life of 12 months or less;
3. The taxpayer treats the amount paid for the property as an expense on its applicable financial statement in accordance with its written accounting procedures; and
4. The amount paid for the property does not exceed $5,000 per item.

When can taxpayers expense $500 per items as a repair?

A taxpayer may expense up to $500 per item if:

1. The taxpayer does not have an applicable financial statement;
2. The taxpayer has at the beginning of the taxable year a written accounting procedure treating as an expense for non-tax purposes amounts paid for property costing less than a specified dollar amount or with an economic useful life of 12 months or less;
3. The taxpayer treats the amount paid for the property as an expense on its books and records in accordance with these accounting procedures; and
4. The amount paid for the property does not exceed $500 per item.

What counts as part of the cost of each item?

Taxpayers electing to apply the de minimis safe harbor must include as part of the cost per item all the additional costs (delivery fees, installation fees, etc.) if these additional costs are included on the same invoice as the tangible property.  However, if they are not included on the same invoice as the tangible property they are not required to be included as part of the cost of the item.

How does a taxpayer claim the protection of the de minimis safe harbor?

If a taxpayer wishes to take advantage of the de minimis safe harbor, they must be aware that it is not selectively applied but instead applies to all amounts paid during the taxable year for applicable property.

Taxpayers must file an election with the IRS by attaching a statement to their timely filed original federal tax return, including extensions, for the taxable year the safe harbor is being claimed.  The statement must include:

• The title "Sec. 1.263(a)-1(f) de minimis safe harbor election";
• The taxpayer's name;
• The taxpayer's address;
• The taxpayer's ID number;
• A statement that the taxpayer is making the de minimis safe harbor election under Section 1.263(a)-1(f).

If you have any questions about the de minimis safe harbor election or about the IRS's new repair regulations in general, please send me an e-mail.

The IRS's New Repair Regulations: Part 1

Anyone who owns a house knows that it will periodically require work to keep it in good condition.  This work can often end up being very expensive.

The IRS allows business owners and investors to deduct as a business/investment expense the full cost of this work if it determines that it is an ordinary repair.  However, if the IRS determines that the work amounts to an improvement or that it extends the useful life of the property, it will not allow an immediate deduction and instead requires the work to be capitalized.

This has caused a lot of controversy between the IRS and taxpayers trying to determine what qualifies as an ordinary repair and maintenance and what is an improvement that must be capitalized.

Recently, the IRS issued new regulations to attempt to clarify the issue.  If you are a business owner or an investor who owns any property that occasionally requires repairs, you need to know about the IRS's new repair regulations that took effect on January 1, 2014.

As a general rule, you are required to capitalize:

• The cost of purchasing new property (e.g. buildings or equipment);
• The cost of making permanent improvements to buildings; or
• The cost of restoring property that has already been fully or partially depreciated to its original condition (essentially extending the useful life of the property).

What do you mean by capitalizing the cost?

As I mentioned before, if an expenditure is deemed to be an ordinary repair then the full cost of the repair may be expensed in the year that the cost is incurred.  However, if it is not deemed to be a repair it has to be capitalized.

If a cost is capitalized, it is transformed from being an expense into being a depreciable asset.  This asset is then depreciated (expensed) over the useful life of the asset.  The useful life of the asset is determined based upon what the asset is.  For example, a residential building is depreciated over 27.5 years while an "improvement" is depreciated over 15 years and office furniture is depreciated over 7 years.

Most people would prefer to deduct the entire cost of the work required to keep their property in good condition right away instead of over a number of years, so most taxpayers would prefer to have the work classified as a repair.

There are 3 safe harbors with the Internal Revenue Code Regulations that, if met, allow a taxpayer to treat their expenditures as repairs.  These safe harbors are:

1. The de minimis safe harbor;
2. The small taxpayer safe harbor; and
3. The routine maintenance safe harbor.

These safe harbors will be the subject of my next several blog posts.

If you have any questions about the IRS's new repair regulations, please send me an e-mail.

Employer-Provided Child Care Tax Credit

As we discussed in last week's blog, it is vitally important that employers find ways to retain their top talent.  A major reason that people leave the work force is that child care is so expensive that many parents end up feeling that they would just be working to pay for child care.  However, the Internal Revenue Code provides a great solution!  Employers that provide child care may claim the Employer-Provided Child Care Tax Credit and retain their talented employers!

An employer who provides child care may claim a federal income tax credit equal to 25% of qualified child care expenditures and 10% of qualified child care resource and referral expenditures, with a maximum tax credit of $150,000.

Qualified child care expenditures include:

• Costs to acquire, construct, rehabilitate, or expand the property that is to be used as a qualified child care facility, as long as it is not part of the principal residence of the employer or any of the employer's employees;
• The operating costs of the qualified child care facility; and
• Contracts with a qualified child care facility to provide child care services to employees

Example

XYZ Corporation has been experiencing a high turnover rate because of the number of young parents that it employers.  In an effort to retain a greater number of its highly talented employees, it decided to convert some unused office space into a child care facility (at a cost of $300,000) and hire several individuals with extensive amounts of child care training to operate the facility (at a cost of $200,000 per year).

XYZ Corporation can claim a federal income tax credit of $125,000 (25% of the qualified expenses) in the first year, and a $50,000 tax credit (25% of the operational costs) in the following years.

If you would like to learn more about the Employer-Provided Child Care Tax Credit and special rules that apply to it, please feel free to send me an e-mail.

As always, I appreciate your feedback.  Please leave your thoughts in the comment section below.

Employee Stock Options

As an employer, it is important to retain your top talent in a cost-effective way.  Stock options are one tool in your arsenal to be able to keep your employees happy.  In today's blog, we will discuss both what statutory and non-qualified stock options are, and the tax consequences that your employees will face upon their receipt.

A stock option gives employees the right to purchase a certain number of shares of the employer's stock at an established price. In general, the employer's goal in granting the stock options is to both incentivize the employee to remain with the company and work hard to increase the value of the company's stock.

There are 2 general types of stock options: 1) Statutory Stock Options and 2) Non-Qualified Stock Options.

Statutory Stock Option

A statutory stock option receives preferential treatment under our tax system.  Income is not recognized when the stock option is granted or even when it is exercised.  It is only recognized when the the stock is eventually sold.  Furthermore, unlike other type of compensation, the amount realized from the sale is generally treated as a capital gain or loss.

To qualify as a statutory stock option, the following requirements must be met:

• The individual granted the options must be employed by the company granting the option, or a related company, from the time the option is granted until the 3 months before the option is exercised.  However, in the case of incentive stock options (a specific type of statutory stock option), the individual granted the options must be employed by the company granting the option, or a related company, from the time the option is granted until a year before the option is exercised;
• The stock must be held for at least 2 years from the grant date and for at least 1 year from the exercise date; and
• The option may not be transferable except at death.

If the holding period requirement is not met, a portion of the gain will be treated as ordinary income.

Non-Qualified Stock Options

A non-qualified stock option is simply a stock option that is non-statutory.  Unlike a statutory stock option, it will be treated as compensation and taxed at ordinary income rates.  When it is subject to tax depends upon whether the stock's fair market value can be readily determined.  If it can, then the option is taxed to the employee as compensation at the time it is granted.  If it cannot, the employee will recognize compensation when the option is exercised.  The amount included in compensation is the difference between the amount paid for the stock and the fair market value at the time it becomes substantially vested.

If you are considering offering your employees stock options, or if you are an employee receiving stock options, and you have questions about the tax consequences, please do not hesitate to send me an e-mail.

As always, I appreciation your feedback.  Please leave your thoughts in the comment section below.

Green Vehicles Tax Credits

As we discussed in the previous blog post, there is a great tax credit available for individuals who install qualified energy efficient property, such as solar panels, to their homes.  You will be happy to know there are also great tax credits available to purchasing "green vehicles."

Currently, there are 2 different tax credits available depending upon the type of "green vehicle" you are purchasing:

1. Alternative Motor Vehicle Tax Credit.  This tax credit is available to individuals who purchase a qualifying fuel cell motor vehicle.  These vehicles are propelled by the power derived from one or more cells that convert chemical energy directly into electricity.  At this time, there are only 2 vehicles that qualify for this credit: 1) the Mercedes-Benz F-Cell; and 2) the Honda FCX Clarity Fuel Cell. However, as this technology continues to advance more vehicles may qualify and will be listed here.
   
   The value of this tax credit depends upon both the weight of the vehicle and when it is placed in service.  For instance, the base credit for vehicles under 8,500 pounds is $4,000 while the credit for heavy vehicles ranges from $10,000 to $40,000.
   
2. Plug-In Vehicle Tax Credit.  This tax credit is available to individuals who purchase or lease a qualifying, four-wheeled plug-in electric vehicle manufactured primarily for use on public streets.  The value of this credit ranges from $2,500 to $7,500.  The base credit is $2,500, and an additional $417 for each kilowatt hour of battery capacity starting at 5 kilowatt hours, up to a maximum of $7,500.
   
   This credit will begin to phase out for a manufacturer's vehicles when at least 200,000 qualifying vehicles have been sold for use in the United States, determined on a cumulative basis.  However, at this time no manufacturer has come close to selling 200,000 qualifying vehicles.  Click here for the IRS's list of cumulative sales by manufacturer.
   
   To qualify for this credit, the vehicle must: 1) be manufactured primarily for use on public roads; 2) weigh less than 14,000 pounds; and 3) be able to exceed a speed of 25 miles per hour.

If you are interested in learning more about "green energy" tax credits, please do not hesitate to contact me.

As always, I appreciate your feedback.  Please leave your thoughts in the comment section below.

Residential Energy Efficient Property Tax Credit

Have you considered installing solar panels to your home?  Have you heard that there is a tax "rebate" and want to know how that works?

The Residential Energy Efficient Property Tax Credit is available to taxpayers who install qualified equipment to their home.  It does not have to your main residence (it can be on a second/vacation home).  Qualified equipment includes:

• Solar Electric Equipment (i.e., solar panels);
• Wind Turbines; and
• Solar Hot Water Heaters.

The tax credit is equal to 30 percent of the cost of the alternative energy equipment that you have installed at your principal residence.

Unlike most other tax credits, there is no limit on the amount of credit available for most types of property.  However, this tax credit is non-refundable.  That means if you are not able to use the entire tax credit, then the unused portion is carried forward to the next year.

The Residential Energy Efficient Property Tax Credit is available for any qualified equipment that is installed before December 31, 2016.  However, it is currently unclear whether any unused portion of the credit will be allowed to be carried forward past the 2016 tax year.

Example
Gary and Karen had solar panels installed on their principal residence on June 1, 2014 for a total installation cost of $90,000.  They are entitled to a tax credit of $27,000 (30% of the $90,000 installation cost).

Every year, Gary and Karen have a total federal income tax due of $12,000.

For the 2014 tax year, their usual $12,000 federal income tax bill was reduced to $0.  Gary and Karen will be receiving a tax refund from the IRS for any income tax withholdings or estimated tax payments that they made during the year.  They also have an unused tax credit of $15,000 that will be carried forward to 2015.

For the 2015 tax year, again their usual $12,000 federal income tax bill was reduced to $0.  Again, instead of writing a check to the IRS they will be receiving a refund for any income tax withholdings or estimated tax payments they made during the year.  They have an unused tax credit of $3,000 that will be carried forward to 2016.

For the 2016 tax year, they will finally exhaust their remaining tax credit but only have to pay $9,000 of federal income tax.

If you are interested in learning more about the Residential Energy Efficient Property Tax Credit, or other tax credits, please do not hesitate to contact me.

As always, I appreciate your feedback.  Please leave your thoughts in the comment section below.

Casualty Losses and Insurance Reimbursement

Due to yesterday's wildfires, many of which are still burning as I write this, a large number of people have been evacuated from their homes and sadly a few people have lost their homes. Therefore, today I will be writing about the tax consequences of casualty losses and insurance reimbursement. 

However, I would first like to encourage everyone to begin to prepare now for future disasters by talking to an insurance agent about renter's insurance, home owner's insurance (which covers fires), earthquake insurance, and flood insurance.  Hopefully you will never need it, but I would urge everyone to at least consider it just in case.

A casualty loss, for tax purposes, is the damage, destruction, or loss of property resulting from an identifiable event (such as a fire) that is sudden, unexpected, or unusual.

Deductible Casualty Losses

The deductible portion of your casualty loss equals the lesser of:

• The adjusted basis in the property before the casualty or theft; or
• The decrease in the fair market value of the property as a result of the casualty or theft,
  Minus  any insurance or other reimbursement received or that is expected to be received.

Personal Use Property

For personal use property, like your home, there are 2 limitations applied to your deductible casualty loss.

1. There is a $100 reduction applied to each event that causes the casualty or theft.  This means that if your house and two cars are damaged in an earthquake, there would be a $100 reduction to the deductible casualty loss (not $300 because it was only one event).  However, if you were having a bad day and you got into a car accident and later there was an earthquake damaging your home, there would be two events so the reduction would be $200.
2. The aggregate of all your casualty losses must be reduced by 10% of your Adjusted Gross Income.  This reduction is applied after the $100 per casualty reduction.

Business and Income-Producing Property

Business and income-producing property does not have the same limitations placed on it that personal use property does.  If business property is completely destroyed, the deductible casualty loss is generally the cost of the property minus any accumulated depreciation.  If the property is damaged but not destroyed, then the loss is generally the decrease in the property's fair market value.

Employee Business-Use Property

An employee's business use property, such as an employee's personal laptop that is used exclusively for business purposes, may be deducted without any of the personal-use property limitations listed above, but it is only deductible as a miscellaneous itemized deduction.

Insurance Reimbursement

Any deductible casualty loss is reduced by the amount of actual insurance reimbursements received and any expected reimbursements.  If the property is covered by insurance, an insurance claim must be filed or the casualty loss will not be allowed.  If the insurance reimbursement exceeds the casualty amount, then the profit is taxable income unless the insurance reimbursement is reinvested in similar-use property.  Reinvestment generally must occur by the end of the second year following the insurance reimbursement.  However, taxpayers have 4 years to replace a principal residence in a federally declared disaster area.

Because the casualty losses are reduced both by the amount of actual insurance reimbursements and any expected reimbursements, occasionally there is a need to made adjustments in the following year.

If the actual reimbursement received was greater than the expected reimbursement, the excess amount is treated as ordinary income in the year received unless the prior year's casualty loss deduction did not reduce the taxpayer's tax liability.

If the actual reimbursement was less than expected, the difference is treated as a casualty loss in the year the taxpayer can reasonably expect no more reimbursement.

Federally Declared Disasters

There are special tax provisions that apply if the President declares a disaster to be eligible for federal assistance under the Disaster Relief and Emergency Assistance Act.  Those provisions are outside the scope of this blog, but be sure to ask your tax preparer about them if you are ever affected by a federally declared disaster.

So as you can see, the federal government does provide some support through the form of tax deductions if you are affected by a disaster.  However, it should also be clear to you that the tax relief that you would be eligible for generally does not compare to what you would receive through an adequate insurance policy.

If you have any questions about deducting casualty losses, please do not hesitate to contact me.

Also, please feel free to contact me if you would like a referral to a great insurance agent.

As always, I appreciate your feedback in the comments section below.

Self-Directed IRAs

Did you know it is possible to hold real estate and business entities through an IRA?  You can if your IRA's custodian is open to having "nontraditional" investments.

What is a Self-Directed IRA?

A self-directed IRA is simply an IRA whose custodian permits a wide array of investments beyond bonds and securities and provides for maximum control by the account holder.  Self-directed IRAs can include any investment, other than life insurance and collectibles, that are not specifically prohibited by federal law.

As with all other IRAs, self-directed IRAs must comply with various rules and regulations, including a rule against "prohibited transactions".

What is a Prohibited Transaction?

There are several types of transactions that the federal government have determined to be improper if conducted with the IRA account holder, his or her beneficiaries, or any disqualified person.

Disqualified Persons

The Internal Revenue Code defines disqualified persons as:

1. A fiduciary of the plan (an IRA owner who exercises discretionary control over an IRA's investments is a fiduciary);
2. A person providing services to the plan;
3. An employer whose employees are covered by the plan;
4. An employee organization whose members are covered by the plan;
5. A direct or indirect owner of 50% or more of any entity that is described in numbers 3 or 4 above.
6. A family member of any of the above;
7. A corporation, partnership, trust, or estate that is more than 50% owned directed or indirectly by any person described in numbers 1 through 5 above;
8. An officer, director, 10% or more shareholder, or highly compensated employee (earning 10% or more of the employer's yearly wages) of a person described in numbers 3, 4, 5, or 7 above;
9. A 10% or more partner or joint venture of a person described in numbers 3,4, 5, or 7 above; or
10. Any disqualified person who is a disqualified person with respect to any plan to which a multiemployer plan trust is permitted to make payments under Section 4223 of ERISA.

Prohibited Transactions

There are several types of transactions that are prohibited if done between the self-directed IRA and a disqualified person.  Here are a few examples (this is by no means a comprehensive list):

• Selling property to or from the IRA;
• Lending money to or borrowing money from the IRA;
• Receiving unreasonable compensation for managing the IRA;
• Using the IRA as security for a loan; or
• Buying property for personal use with IRA funds.

What are the consequences if there is a prohibited transaction?

The penalties for engaging in a prohibited transaction are severe!  The Internal Revenue provides that if any prohibited transaction occurs, the account is no longer an IRA and it will be treated as if the assets within the account were distributed on the first day of the taxable year in which the prohibited transaction occurs.  This will trigger a 10% early withdrawal penalty, tax on the constructive distribution, and often an accuracy-related penalty for each of the tax years affected.

Let's look at an example.

In 2010, Mark decided to roll over all $2,000,000 from his 401(k) plan to a self-directed IRA.  On July 1, 2011, the IRA purchased a rental property for $400,000 and left the remaining assets invested in securities. The IRA then hired Mark to manage the property and agreed to pay him 10% of the total rents received. Mark managed the property until late 2013 when the IRA sold it for $450,000.  For the years 2011 through 2013, Mark reported his "management fee" as income, but did not report any of the rental income or the gain on the sale of the property because he knew that income earned by an IRA is tax-deferred.

In 2014, Mark received a notice from the IRS informing him that he was being audited for the tax years 2011, 2012, and 2013.  After its audit, the IRS concluded that the IRA's hiring of Mark and providing him compensation were prohibited transactions.  As a result, there was a deemed distribution of all of the IRA's assets on January 1, 2011 (not only the $400,000 used to purchase the rental property).  Mark was assessed the following penalties:

• Tax on $2,000,000+ deemed distributed to him on January 1, 2011 (plus penalties and interest);
• 10% early withdrawal penalty on the $2,000,000+ deemed distributed;
• 20% accuracy related penalty in 2011;
• Tax on the 2011, 2012, and 2013 rental income (plus penalties and interest)
• Tax on any interest, dividends, and capital gains from securities in 2011, 2012, and 2013 (plus penalties and interest);
• Tax on the capital gains from the sale of the rental property in 2013 (plus penalties and interest); and
• 20% accuracy related penalty in 2013.

It is not my intent to discourage anyone from using a self-directed IRA as an investment vehicle.  However, it is very important to understand that it can be very easy for someone to engage in a prohibited transaction and incur very severe penalties as a result.  Therefore, if you are thinking about utilizing a self-directed IRA, talk to a tax professional to ensure that everything is done properly.

If you have any questions about self-directed IRAs, please do not hesitate to contact me.

As always, I appreciate you leaving your feedback in the comments section below.

Small Business Tax Credit

Small business owners need every tax credit that they can get.  One tax credit that you are likely entitled to but may not know about is the Small Business Health Insurance Premiums tax credit.

For tax years 2010 through 2013, the federal income tax credit was worth a maximum 35% of premiums paid by small business employers.

Starting in 2014, the federal income tax credit is worth a maximum 50% of premiums paid by small business employers.

 

There are a few qualifications that you must meet in order to claim this credit:

1. Starting in 2014, the premiums must be paid on a qualified health plan offered through a Small Business Health Options Program (SHOP) Marketplace.
   
   In California, there are, currently, 6 health insurance companies that are available for year-round enrollment in the SHOP program.  To view the list of qualifying health insurance companies and the available plans, click here.
   
   
2. There must be fewer than 25 full-time equivalent employees.
   It is important to understand that this does not mean less than 25 employees.  The number of full-time equivalent employees is a calculated figure that is determined by taking the total number of hours worked by all non-owner employees and dividing that number by 2,080.  The resulting figure is then rounded down to the nearest whole number.
   
   For example, if you had 13 employees and they all worked for a total of 1,500 hours during the year, you would have 9 full-time equivalent employees (13 x 1,500 = 19,500; 19,500 / 2,080 = 9.38; 9.38 rounded down is 9).
   
   
3. The average wages must be less than $50,000.
   
   To determine this number, you divide the total wages of the non-owner employees by the number of full-time equivalent employees.
   
   For example, if you paid your employees a total of $390,000 during the year, you would have average wages per full-time equivalent employee of $43,333 ($390,000 / 9).
   
   
4. The health insurance premiums must be paid through a qualifying arrangement.
   To be considered a "qualifying arrangement", the employer must pay at least 50% of the single-coverage insurance for its employees.  The IRS has ruled that the employer does not have to pay for the premiums covering the employee's spouse or children.  Generally, an employer must pay a uniform percentage of the premium cost for each enrolled employee's health insurance coverage.  However, exceptions exist for businesses who utilize either composite billing (uniform premiums paid rather than a uniform percentage) or list billing (differences in premiums exist for each employee based upon age or other factors).

The maximum credit is for 50% of the premiums paid in 2014 (35% in prior years).  However, it may be less than 50% if: 1) there are more than 10 full-time equivalent employees; 2) the average wages exceeds $25,000; or 3) actual health insurance premiums exceed average premiums paid for health coverage in the employer's area.

This tax credit can be carried back or forward to other tax years. 

In addition to the tax credit, an employer is entitled to claim a deduction for the excess health insurance premiums.  For example, if an employer pays $10,000 in health insurance premiums and claims a $5,000 tax credit, the employer would be entitled to take a $5,000 deduction for the remaining health insurance premiums.

If you have any questions about the Small Business Health Insurance Premiums tax credit, or if you would need assistance in claiming this tax credit, please do not hesitate to contact me.

As always, I appreciate you leaving your feedback in the comments section below.

Business or Hobby?

Are you living the dream?  Do you have a business that you are passionate about and that you cannot wait to get back to everyday?  You may think it is a business, but the IRS may think that it is your hobby.

What is the difference?

The main difference is that you are entitled to deduct all the ordinary and necessary expenses associated with operating a business.  However, your hobby related expenses may not be deductible, and to the extent they are the deduction is limited.

There are 9 factors used to determine if the taxpayer is engaged in a business or a hobby.

1. Whether the activity was conducted in a business-like manner.  Basically, did you have a business plan and keep financial records?  Did you keep a separate bank account for the activity?  Are you doing the types of things that a prudent business person would do?
2. The taxpayer's expertise or that of his advisors.  You need to have sufficient expertise to show that you know how to make that activity profitable.
3. The time and effort expended.  Essentially, is this activity something that you do during your free time, or are you devoted to it full-time?
4. The taxpayer's expectation that assets used in the activity may appreciate in value.  If your hobby involves the accumulation of assets, like coin collecting, you must show that you purchased the assets with the intention of eventually selling them for a profit.  A coin collector who knows that the coins will go up in value but has no intention of ever selling his coins is involved in a hobby, not a business.
5. The taxpayer's success in similar or dissimilar activities.  If you have been very successful in related ventures, then even if this activity is losing money it is likely a business.  On the other hand, if all your similar activities have lost money it is more difficult to prove that you are engaged in the activity with the hope of making money.
6. The taxpayer's history of income or loss.  This is similar to the prior factor, except that it looks only at this one activity.  If you made consistent income in the past it is more likely to be considered a business than if you had only sporatic income or consistent losses.
7. The amount of occasional profits.  The more income you earn from the activity, the more likely it is that it will be considered a business.
8. The taxpayer's financial status.  If most of your income is derived from other sources, then this activity will look like a hobby.  On the other hand, if most of your income comes from this activity it looks like a business.
9. The personal pleasure the taxpayer derives from the activity. This is a subjective factor.  You can love your job (and I would hope that you do), but if it looks like that is a greater motivation for you than money it will likely be deemed a hobby.

Outside of these factors, there is a safe harbor available to taxpayers.  If the activity has been profitable for 3 out of the last 5 tax years, including the current year, then the IRS will presume that the activity is carried on for profit (i.e., that it is a business).  If you breed, show, train, or race horses, you only have to be profitable for 2 out of the past 7 years in order to qualify for this safe harbor.

If you need help determining whether you are engaged in a business or a hobby, or if you have any other questions related to this please do not hesitate to send me an e-mail.

As always, I appreciate any feedback you have.  Please leave it in the comments section below.

Estate Tax Planning: QTIP Trusts

Do you care what happens to your assets after you die?

I suspect that it is very important to you.  You may want to make sure that your spouse is provided for, or that your children will be the ones that inherit your property.  What you probably do not want is to pay a penny more in estate taxes than you have to.

Everyone's situation is different, and an estate planning tool that may work for someone else may not work for you.  Therefore, it is very important that you work closely with an estate planning attorney and a CPA to come up with a plan that will best fit your needs.

A few months ago we discussed one estate tax planning tool, the portability election.  Today, I am going to go over the basics of the Qualified Terminal Interest Property (QTIP) trust.

What are the goals of a QTIP Trust?

While there are potential estate tax minimization benefits to this type of trust, the primary benefits to making the QTIP election are in maintaining control of the assets after death.  Specifically, it allows you to provide for your spouse during the remainder of his/her life, but ensure that ultimately the assets will go to the beneficiaries that you choose.

Because of this, QTIP trusts are very popular in situations where one spouse has children from a different relationship or where remarriage after the death of the first spouse is likely.

How does the QTIP Trust work?

Under the terms of the QTIP trust, all of the income earned by the assets placed in the trust goes to the surviving spouse.  In addition, most QTIP Trusts allow for the trustee to give the surviving spouse some of the trust principal (the assets) in addition to the income if it serves a specific purpose.  For example, if there is a medical emergency and the surviving spouse does not have enough money to pay for treatment, the trustee may be allowed by the trust to take assets out of the trust to pay the medical bill.

Upon the death of the surviving spouse, all of the trust assets will go to the beneficiaries named by the first to die (the spouse who originally funded the QTIP trust).

What are the estate tax benefits?

The assets placed into a QTIP trust qualify for the unlimited marital estate tax deduction.  This means that they will not be subject to the estate tax at the time of the first spouse to die's death.  However, these assets will be included in the surviving spouse's estate and subject to the estate tax at the surviving spouse's death.  If the portability election is made at the time of the first spouse to die's death, the surviving spouse will be able to use his/her prior deceased spouse's unused exclusion amount in addition to his/her own exclusion.

If you think that the QTIP trust is an estate planning tool that may work for you, I would be happy to refer you to a great estate planning attorney.

I would also be happy to answer estate tax planning questions that you have. Please just send me an e-mail.

As always, please leave your feedback in the comments section below.

Forced to do a Short Sale of Your Home?

In a letter to Senator Barbara Boxer, the IRS took the position that when a California homeowner sells the property through a "short sale" the mortgage will be treated as a non-recourse debt.

I know, you are wondering what that means, let alone if it is in English.

Let me try to break it down for you.

Under the Internal Revenue Code, when you owe someone money and that person forgives the debt, you are treated as having received income equal to the amount of forgiven debt.  This is known as "cancellation of indebtedness (COD) income".

Example:  Jill loans John $20.  A week later Jill tells John that he does not have to repay her the $20.  The IRS considers that $20 income to John because he would not have had it unless there was first a loan and then the loan was forgiven.

Why would a lender, like a bank, forgive your debt?  Typically, it is because the lender is convinced that you are unable to repay it.  In a housing situation, it may be because the house is "under water" and the bank has decided that it makes more financial sense to allow the homeowner to do a short sale (in which the bank approves a sale for less than the mortgage on the property, and forgives the debt on the excess mortgage) than risk having the homeowner stop making mortgage payments and be forced into a foreclosure.

For the past few years, Congress and California had an exception to the normal COD income rules.  The exception was that if the cancellation of indebtedness is for a mortgage on a person's principal residence, the COD income would be excluded from the person's taxes.  However, this exception expired in California on December 31, 2012, and it expired for the federal government on December 31, 2013.

The expiration of this exception was alarming to many.  It meant that not only would people be losing their homes, but they would have to pay the IRS and California significant amounts in taxes in order to lose their homes.  Senator Boxer reacted and sent the IRS a letter asking how it intended to treat California short sales.

The IRS responded (IRS Letter) that because under California law a lender cannot attempt to collect the excess mortgage from the seller in a short sale, the short sale effectively converts the mortgage into a non-recourse debt.

What does all this mean to you?

It means that, in California, a taxpayer who participates in a short sale does not have to recognize "cancellation of indebtedness" income.  The debt is forgiven and there are no adverse tax consequences as a result of the short sale.

California has indicated that they will follow the IRS's position on this issue.

Are you considering doing a short sale of your home?  If so, I would be happy to discuss this more with you.  Just send me an e-mail.

Also, I would be happy to refer you to a great realtor that specializes in short sales.

As always, please leave your feedback in the comments section below.

Update: The IRS has reversed its position and now does require taxpayers to recognize the cancellation of indebtedness income unless they fall into another exclusion.

Selling Your Home?

Are you looking to sell your home?  Then you may be able to take advantage of a major tax benefit!

You may be entitled to exclude $250,000 of gain from the sale of your personal residence.  If you are married, you may be entitled to exclude $500,000 of gain!

In order to exclude this gain, you must meet 3 tests.

1. Ownership Test.   You must have owned the home as a principal residence for at least 2 of the 5 years prior to the sale.  If married, either or both spouses can meet this test.
2. Use Test.  You must have used the home as a principal residence for at least 2 of the 5 years prior to the sale.  If married, both spouses must meet this test.
3. Frequency Test.  The exclusion applies to only one sale every 2 years.  If married, this test is not met if either spouse has claimed this exclusion within the past 2 years.

If both spouses do not meet the use and frequency test, then a portion of the exclusion may still be claimed.  In this case, instead of being able to claim the full $500,000 exclusion, the couple would only be able to claim the $250,000 if one spouse meets all 3 tests.

Even if you do not meet these tests, you may be able to claim a reduced exclusion!  A reduced exclusion is available if you sold your principal residence because of:

• A change in your place of employment;
• Health reasons; or
• Unforeseen circumstances.

There is a safe harbor rule defining what qualifies under each of these three exceptions.

Lets look at an example.  In April 2012, John and Jane Smith purchased a small, 2 bedroom house for $500,000.  In September 2013, Jane gave birth to twins and they decided that they needed a larger home to accommodate their larger family.  In October 2013, with the help of a great realtor, the Smiths sold the same house for $800,000.

The Smiths have $300,000 of gain on the sale of their home.  They are afraid they will have to pay taxes on the full $300,000, but they talk to a CPA and learn that they do not have to.  Although they did not meet the 2 year ownership and use tests, they qualified for a reduced exclusion because the birth of multiple children from the same pregnancy is considered an "unforeseen circumstance."  Because they owned and lived in the house for 18 months, they are able to take a reduced exclusion of $375,000 which is enough to eliminate their entire taxable gain.  They do not have to pay any tax on the sale and can use the extra $300,000 to buy a bigger house!

If you are considering selling your home and would like to learn more about this exclusion, please do not hesitate to send me an e-mail.  I would also be happy to talk to you about how having a home office or converting the house into a rental property will affect this exclusion.

Also, I would be happy to refer you to a great San Diego realtor.

As always, please leave your feedback in the comments section below.

Organizing Your Taxes

For many people, the most daunting part of having their annual income tax returns prepared is simply getting themselves organized.

 

 

At Reid, Sahm, Isaacs & Schmelzlen, LLP, we attempt to make this process easier on our clients by providing them with a tax organizer in early January.  The tax organizer simply reminds the client of the various tax forms that they will receive, and also provides a space for clients to provide other necessary information, such as how many business miles they drove during the year or what their total medical expenses were.

 

Just in case your CPA has not provided you with a tax organizer and you are feeling overwhelmed, here is some advice on how to organize your documents.  I would suggest creating 3 separate "piles".

1. Tax Documents

   Over the next month, you will be mailed a number of tax documents.  These include your W-2, and a number of documents that start with either the numbers "1098" or "1099".  It may also be a K-1 if you are a partner in a partnership or a shareholder in an S-Corporation.   To keep it simple, I would simply group these by type (all the W-2s together, etc.)  Your CPA will gather the necessary information from these forms directly, so unless there is something missing there is no need for you to do anything further with them.
   
   
2. Financial Statements
   

   If you own a business (as a sole proprietor) or rental property, you most likely are already keeping track of your income and expenses.  You may receive some tax documents, like a 1098 for the mortgage interest, but the most important numbers are located within your "books".  Just check these statements to make sure that they are accurate, and then provide them to your CPA.

    
3. Other Records
   

   In order to claim your deductions and credits, it is up to you to find the records proving that you are entitled to the deduction.  This means keeping track of your property tax statements, medical expenses, charitable contributions (you need to keep the acknowledgement letters you receive), and the amounts you spent as part of your job that you were not reimbursed for.  Don't forget to check your credit card statements because a lot of your deductions may be listed there for you.  This is the most challenging part of getting your documents ready for your CPA, but try to think of it as the most rewarding part because the receipts you find potentially mean the less taxes you will have to pay.

If you have any questions or need help preparing your 2013 income taxes, please do not hesitate to send me an e-mail.

 

As always, I appreciate all the feedback you leave in the comments section below.