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.