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.

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.

What is an IRA?

Everyone keeps telling you that you need to save for your retirement, but your company does not have a 401(k).  What are you supposed to do?  You can contribute to an Individual Retirement Account (IRA)!

 

The advice that everyone is giving you is right, you need to make sure you save for your own retirement.  One estimate projected that the Social Security trust fund will be exhausted by 2037 if not sooner.  I discussed this and provided advice for your retirement savings plan in Plan for Your Retirement: No One Else Will.

 

If your employer does not provide a company 401(k) plan, you will want to talk to your financial advisor about establishing an IRA.  But what is an IRA?

There are 2 basic types of IRAs:

 

1) Traditional IRA

 

Qualified contributions to a Traditional IRA help to reduce your taxes because they are tax-deductible.  Contributions to a Traditional IRA are one the few ways in which you can actually reduce your tax bill after the year ends.  The governments allows you to make a contribution up until April 15th of the following year, and to take the deduction in the preceding year.

 

The amount you are allowed to contribute to a Traditional IRA changes frequently as it is adjusted for inflation, but in 2013 you are allowed to make a contribution up to $5,500, or $6,500 if you are age 50 or over.

 

Once invested into a Traditional IRA, all of the funds grow without being taxed.  You will not be taxed until you withdraw the funds! 

 

There are a few basic requirements in order to make a contribution to a Traditional IRA:

• The contributor must be an individual (not a trust, company, etc.)
• You must be under the age of 70.5
• You must have sufficient earned income or compensation (at least as much as you contribute to your IRA)

 

Be careful though.  The ability to make a tax-deductible contribution phases out based upon whether or not your employer provides a company retirement plan, your tax filing status, and your income level. 

 

2) Roth IRA

 

The principal difference between Traditional IRAs and Roth IRAs are that with Traditional IRAs the contributions are tax-free while with Roth IRAs the distributions are tax-free.

 

In 2013, you are allowed to make a contribution up to $5,500 or $6,500 if you are age 50 or over.  However, the contribution limitation changes based upon your tax filing status and your income level.

 

Once invested into a Roth IRA, all the funds grow tax-free.  Furthermore, all of the distributions are tax-free provided that you are over the age of 59 1/2 and have had the Roth IRA account for at least 5 years.

 

Again, there are a few basic requirements in order to make a contribution to a Roth IRA:

• The contributor must be an individual (not a trust, company, etc.)
• You must have sufficient earned income or compensation (at least as much as you contribute to your IRA).

 

You will notice that unlike with Traditional IRAs, there is no age restriction on being able to contribute to a Roth IRA.

 

Of course these are only the 2 most basic types of IRAs.  You may want to discuss non-deductible IRAs, SEP IRAs, and SIMPLE IRAs with a financial advisor to determine what type of IRA makes the most sense for your situation.  If you need a referral to a great financial advisor, please do not hesitate to ask me.

 

If you have any tax questions that I can answer, please send me an e-mail.

 

Please feel free to leave your feedback below.

 

Business Networking

Want to grow your business?

There are a number of ways that you can promote yourself and your business.  In my opinion, one of the most effective methods is to network.

By going to a networking event, you are likely to meet someone who is either interested in your services or who knows someone who would be interested in your services.  Of course it is difficult to get a new customer/client based on one meeting, but it can be the first step to creating a new relationship.  I have met a number of professionals at various local events, and have followed up with them through e-mails and meetings in order to find out how we both can help each other.  You never know what chance encounter you may have at a networking event that can be a major benefit to your business.

So why I am talking about business networking in a tax blog? 

It is because the costs of business networking are tax deductible.  Like other forms of advertising, the IRS treats networking as an ordinary and necessary business expense and allows you to deduct it on your tax return.

The cost of admission to a networking event...deductible.

The cost of taking someone you met at a networking event to lunch to talk business... 50% deductible.

The dues paid to a business referral group...deductible.

The cost of traveling to a networking event or business referral group... deductible.

The requirements to claim these deductions are very simple.  First, you have to be able to prove you spent the amount you are deducting (save your receipts).  Second, you have to have had a valid business purpose.  For example, if you take someone you met at a networking event out to lunch you have to talk business with that person.  You cannot simply talk about sports and the weather.

If you have any tax questions, please do not hesitate to send me an e-mail.

What are some of your favorite networking events?  Please let me know in the comment section below.

Why Have a 401(k)?

What financial advice have you been given?

Throughout my life I received 2 main pieces of financial advice.  1) Save for my own retirement.  2) Contribute enough to a 401(k) plan to maximize the employer match.

Every 401(k) plan is different as businesses set them up in order to best meet their needs and the needs of their employees.  However, a typical arrangement is for employers to match their employees contributions to their 401(k) plans $0.50 on the dollar, up to 3% of the employees gross salary.

If that is how your 401(k) plan works, you should contribute at least 6% of your gross salary to your 401(k) plan.  That effectively increases your salary by 3%! Why would you want to leave money on the table?

I would encourage you to actually contribute more than that to your 401(k) plan, as long as you can afford to do so.  In a previous blog post, Plan For Your Retirement: No One Else Will, I discussed why you should contribute to your own retirement and the significant advantages to doing so.  Please read that post and see why you should contribute what you can afford to your qualified retirement plan.

But what is in it for employers?  As an employer, why should you set up a 401(k) plan and put your money into your employee's retirement fund?

• $1,500 Tax Credit. Employers are entitled to claim a tax credit equal to 50% of the cost to set up and administer the plan, and to educate employees about the plan.  The credit is worth a maximum of $500 per year for each of the first 3 years of the plan.  If you are unable to use this credit in any given year, the unused portion can be carried back or forward to other tax years.  There are a few basic requirements that you should discuss with a CPA.
• Tax Deduction.  Every penny that an employer contributes to a 401(k) plan, including to his or her own, is a tax deduction.  As an employer, you are also able to deduct the cost of administering the plan and educating your employees about the plan.  This is because the IRS considers the operation of a 401(k) plan to be an ordinary and necessary business expense.
• Better Employee Recruitment and Retention.  For any business, having great employees is essential.  They represent you, so it is important that you are able to recruit the best possible employees and retain them once you have them.  All else being equal, I would choose to work for a company that has a 401(k) plan over one that doesn't.  It shows employees that you care about them and their retirement.  It helps to build loyalty to your company.

If you would like to discuss the tax benefits of establishing and operating a 401(k) plan, or you have any questions, please send me an e-mail.

I would also be happy to refer you to a great financial advisor who can discuss all the non-tax aspects of your existing 401(k) plan or help you to establish a new 401(k) plan.

I appreciate your feedback.  Please feel free to leave a comment below.

Is Working From Home an Option for You?

Because of advances in technology, it is increasingly easy for people to work from home and save money doing so.

Having a home office means that you do not have to spend hours every month sitting in traffic trying to get to work, and you do not have to spend as much on fuel for your car.  It also means, if you own your own business, that you can save thousands of dollars in rent.  But it also is a tax deduction.  By claiming the home office deduction, you are allowed to deduct a portion of your living expenses such as utilities, that would otherwise be non-deductible.

This deduction is available to you whether you own your own business or work for someone else.  But if you are an employee, you must be working from home for your employer's convenience and not your own.  If your employer requires that you work from home, then that test is met.

Unfortunately, this deduction has been greatly abused by taxpayers and now the IRS is very strict in ensuring that your home office meets all of the requirements for the tax deduction.

The home office deduction is only permitted if the home office is used exclusively on a regular basis either: 1) as the principal place of business for any trade or business of the taxpayer; 2) as a place of business that is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his or her trade or business; or 3) in the case of a separate structure that is not attached to the dwelling unit, in connection with the taxpayer's trade or business.

To qualify under the "regular use" test, the home office must be used on a regular basis.  Working from home once a month does not count.

To qualify under the "exclusive use" test, you must use a specific area of your home exclusively for your business.  Even after "business hours," you cannot use the space for non-business purposes.  Something as simple as your children "hanging out" in that room when you are not conducting business disqualifies the whole deduction.

However, if your home office meets these tests, the deduction can be substantial.  Under a new safe-harbor, the deduction is $5 for every allowable square foot, up to 300 square feet.  The deduction can be even greater if you keep track of all of your actual expenses, such as your mortgage, property taxes, and utilities.

If you have a home office, or are thinking about having one, and you want to make sure that it qualifies for the tax deduction, please send me an e-mail.  I will walk you through what qualifies, explain how the deduction is calculated, and answer any other questions you have about this deduction.

I can also recommend a great IT consultant.  It is improved technology that is allowing so many more people the opportunity to work from home, so you need to make sure that you are properly set up to do so.

I would love to get your feedback through the comment section below.