Category Archives: Tax Talk

Joint mortgage, but only one SSN on 1098?

What's mine is yours and what's yours is mine!

What’s mine is yours and what’s yours is mine!

So maybe you purchased a home with your fiance, spouse, parents, friend or business partner.  Each of you pays half (or some other portion) of the mortgage throughout the year.  When it comes time to file your taxes, you plan to file a return separate from the other person, but there is just one problem.  Then 1098 that was provided either list both of your names and the other persons SSN OR it simply just list the other parties information all together.  So how do you go about claiming your piece of what is reported on the 1098?

Figure Your Share
If you and another party (or multiple parties) were liable for, and make payments towards, a mortgage in which another party received the Form 1098, the first thing you must do is figure out each party’s share.   Technically the person that received the From 1098 should do this and provide the amounts to you, but in reality either party may do it.  So, for example, if each person paid 50% of the payments that yielded $9,825 of interest being reported on the Form 1098, then each one is entitled to deduct $4,912.50 on their tax return.

Attach A Statement To Your Return
To report the $4,912.20 of mortgage interest paid, each person should attach a statement to their tax return explaining this. Show how much of the interest each person paid, and give the name and address of the person who received the form. Your share of the interest is then reported on Schedule A (Form 1040), line 11, along with the words “See attached” next to the line.  The person may also deduct their share of any qualified mortgage insurance premiums on Schedule A (Form 1040), line 13.  If the property in question is a rental property, then you can follow the same procedures stated above, but enter “See attached” on line 12 of Schedule E.

For more information on the above, or reporting home mortgage interest in general, see Publication 936; Home Mortgage Interest Deduction  and refer to the section “How To Report.”

 

How To Report A 1099-A

short sale

If you borrow money from a lender to purchase a property, the lender may require the loan to be secured by the purchased property.  If the lender later acquires the secured property from you or has reason to know that you abandoned or stopped using the secured property, the lender may send you a Form 1099-A (PDF), Acquisition or Abandonment of Secured Property.  So just how do you then use this from to report the sale to the IRS?  What types of tax consequences are involved?  Is there different treatment if the form is issued in connection with you principal residence versus a rental property?  Read on to find out.

Property Sales and Capital Gains
When a property is foreclosed or abandoned, it is treated as a sale from a tax standpoint. This means that one will have to calculate what their gain or loss on the disposition of the property is.  This is usually calculated by taking the sales price and subtracting the cost (or basis) in the property.  The only problem is that unlike a normal sale, there’s no “selling price”  with regards to what the lender paid to buy the property back from you.  This is where Form 1099-A comes into play.

The Information on Form 1099-A
Form 1099-A provides you with the date of sale and the “selling price” of the property.  Taxpayers will use either the fair market value of the property or the outstanding loan balance on the property for the selling price.  Both these figures are reported on the form.

  • If the loan is recourse (one where the borrower is personally liable for the balance), the sales price will be the lesser of outstanding debt reduced by any amount for which the taxpayer remains liable, or FMV of property
  • If the loan is non-recourse, the sales prices will be the full amount of debt regardless of the FMV of property

While this is not an absolute indicator, the loan was probably a recourse loan if the bank has checked “yes” in Box 5, which asks “Was borrower personally liable for repayment of the debt?”

Reporting the Sale
Assuming the foreclosed/abandoned property was your personal residence, you must prepare and file Form 8949 and Schedule D with your tax return. Use the date of the foreclosure in Box 1 of the 1099-A as your date of sale. Then indicate the selling price. This will be either the amount in Box 2 or the amount in Box 4.

Calculate your gain by comparing the “selling price” you used to your purchase price, which is your cost basis in the property. The purchase price and date can be found on the HUD-1 closing statement you received when you purchased the property. The difference between the selling price and your cost basis is your gain or loss.  However, if you have a gain, you  may be able to exclude it so that it’s not taxable.  If you have a loss, it will be considered a a “non-deductible loss” because it is personal in nature.  The following post will go into greater detail.

Investment Properties
If the foreclosed property was used as a rental, then you will need to use Form 4797. For those who have had a rental property foreclosed upon, we advise them to seek assistance from a tax professional because there are additional factors to take into consideration, such as depreciation recapture, passive activity loss carryovers and reporting any final rental income and expenses on Schedule E.

Do You Need Help Reporting Your 1099-A?
If you’ve received a form 1099-A and don’t feel like dealing with the hassle of reporting it, why not give us a call?  We’ve handled this situation numerous times and would be happy to assist you.  Just shoot us an email via the address below or call us at 773-239-8850.

Discharging Taxes In Bankruptcy

bankruptcy

Sometimes a taxpayer finds themselves in the position where they can’t pay their tax liability.  Those taxpayers may come to us and ask us if they qualify to have their taxes discharged in bankruptcy.  Our reply is that while we do help taxpayers deal with resolving their tax debt, they are best advised to consult with an attorney to investigate the bankruptcy option.  You see, only legal counsel, or someone admitted to practice before the tax court, can represent a taxpayer in tax court.  With that being said, we typically help taxpayers with administrative tax resolution methods, which the client should pursue first. These include innocent spouse relief, a request for abatement of penalties, an installment agreement or an offer in compromise (OIC).

However, if those options are insufficient, bankruptcy may be the best way for a taxpayer to either secure a reasonable payment plan (Chapter 11 or Chapter 13) or to liquidate their assets to pay off all or a portion of their tax debt (Chapter 7). Using administrative tax resolution methods help a taxpayer avoid having a “black mark” on their credit history. However, a federal tax lien listed on the debtor’s credit report may damage their credit rating just as much as a bankruptcy notation.  Needless to say, if you think you may qualify based on the information shown below, one is advised to contact an attorney who specializes in bankruptcy law.

What tax debts may be discharged in bankruptcy?
To be dischargeable, individual income tax liabilities must meet the following “technical” rules of 11 USC §§ 523(a)(1) and 507(a)(8):

  • More than three years must have elapsed since the tax return generating the liability was due, including extensions.
  • The tax return must have been filed more than two years earlier than the bankruptcy petition (generally applicable to late-filed returns). Note, however, that IRS-prepared substitute for returns (SFRs) are not considered filed returns for this purpose, and thus a tax liability assessed from them would not be subject to discharge (IRC § 6020(b)).
  • At least 240 days must have elapsed since the date of an IRS assessment (generally applicable to audit adjustments and amended returns). This time frame is extended by an OIC.

Bankruptcy Basics
A bankruptcy court filing immediately stops the collection efforts of all creditors, including the IRS. This legal protection is called the “automatic stay.” At the end of the proceedings, some or all of the petitioner’s debts—including, in some instances, tax liabilities—may be discharged, meaning they are eliminated or no longer legally enforceable. There are two types of bankruptcy:

Liquidation.   A filing under Chapter 7 liquidates assets that are not exempted under federal or state law and distributes pro rata amounts to unsecured creditors. (Keep in mind that proceeds from the forced sale of nonexempt assets in a liquidation bankruptcy may be significantly less than in an arm’s-length transaction outside of bankruptcy.) Any unsecured debts remaining after such distribution are discharged, including certain tax debts. The court forces all creditors (including the IRS) to accept the proceeds of the liquidation in full settlement of all dischargeable liabilities included in the petition. However, a tax lien recorded before the bankruptcy was filed survives the bankruptcy to the extent it attaches to property owned by the debtor at the time of the bankruptcy. Eligibility for a Chapter 7 bankruptcy is limited to debtors whose income is below a “means tested” amount or whose “non-consumer” debts exceed their “consumer” debts.

Deferred payment plans. This type of filing (Chapter 11 for individuals or Chapter 13 for businesses) forces a payment plan on debtors through a trustee. Creditors (again, including the IRS) must accept an installment schedule that pays at least as much of the dischargeable debt as would have been paid in a Chapter 7 proceeding, and which fully pays all secured and priority creditors within five years (11 USC § 1322). Nondischargeable taxes are often priority debts, which must be paid in full over the life of the plan. To qualify for Chapter 13, the debtor must have a steady stream of income: Wages, Social Security, pension payments and receipts of an independent contractor all qualify.

The key takeaways?

  • In order to be dischargable in bankruptcy, the taxes generally have to be “old” in nature.
  • The primary “tax-related” downside to filing for bankruptcy protection is the additional collection time it allows the IRS. Once taxes are assessed, the IRS normally has a total of 10 years to collect them, along with penalties and interest. Therefore, once a bankruptcy case is over, the IRS will retain whatever time remained on the original 10 years, plus the time the bankruptcy case was pending, plus an additional six months (IRC 6503(h)(2)).

How To Report The Sale Of Your Home To The IRS

sold_sign

Sometimes when a homeowner sales their primary residence there can be tax reporting requirements. Generally, this occurs when you have a capital gain on the sale of the home or you sell a home that is not your primary residence (e.g. a vacation home).  However, simply having a gain may not be one of the reporting “triggers” so to speak.  So when do you have to report your sale and just how do you go about doing so?  Read on my friend, read on.

When you must report your sale.
Generally, there are three scenarios where you will be required to report the sale.  These are:

  • The sale results in a gain and you do not qualify to exclude all of it,
  • The sale results in a  gain and you choose not to exclude it, or
  • The sale results in a gain or a loss and the taxpayer received a Form 1099-S

The exclusion of the gain is discussed below so we won’t elaborate on it here. We’re not sure why you would NOT want to exclude the gain, so we won’t address that point either. But we will spend some time on the last point, if you receive a Form 1099-S: Proceeds from Real Estate Transactions.

Form 1099-S is used by the party that closes the real estate transaction to report it to yourself and the IRS.  This may include the settlement agent, the mortgage company, the attorney or the lender.  The key point to remember is that if you received the form, the IRS has received it as well. Now this doesn’t mean that the gain is taxable, but it does mean that you have to go through the hassle of reporting it to the IRS.  What happens if you don’t?  Well, the IRS through it’s matching process is probably going to send you a letter when they don’t see it on your tax return.  As such, we recommend that you avoid the hassle and just deal with it on the front end.

Understanding the gain exclusion.
Generally, to qualify for the exclusion, you must meet both the ownership test and the use test. These test are considered me IF you have owned and used your home as your main home for a period totaling at least two out of the five years prior to its date of sale. You can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale. Another thing to note is that, generally, you are not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home.

If these test are met, a taxpayer can exclude up to $250,000 of the gain if using the single or Head of Household filing status ($500,000 on a return that is Married Filing Jointly).

How to report the sale.
To report the sale, you must know the sales price, the adjusted basis and the resulting gain.  The sales price will be pretty easy to determine.  The adjusted basis is essentially what you’ve invested in the home; the original cost plus the cost of capital improvements you’ve made.  These would include things such as a new roof, a remodeled kitchen, a swimming pool, or central air conditioning. You add these expenses to your original cost to increase your adjusted basis.  Conversely, you will also need to subtract any depreciation, casualty losses or energy credits that you have claimed to reduce your tax bill while you’ve owned the house.  Once you know the adjusted basis, you subtract it from the sales price and that will be the gain you will report.

To begin the reporting process, you would need Form 8949 Sales and Other Dispositions of Capital Assets.  Since the resulting gain is one that transpired during a period longer than one year, it is considered long term.  As such, home sales are reported using Part II of the form.  Items A-E of the form are pretty self explanatory, but it is items F-H that you will want to pay attention to.  Once the proceeds from the sale and the cost are entered, you will have the resulting gain.  Column F is where you enter in the code to enter in why you are adjusting the gain.  For home sales, this is code H.  In column G you enter in the amount of gain that you are excluding as a negative number.  Any remaining gain (which is taxable) would then be reported in column H and carried to Schedule D.

Other items to be aware of.
As with anything tax related, nothing is always as simple as it seems.  With that being said, here are some more obscure things to keep in mind when it comes time to report your sale:

  • The home sale exclusion generally does NOT apply to rental properties.  However, if you convert a former rental property to your principal residence, you may be able to exclude a portion of the gain.
  • If you or your spouse serve on “qualified official extended duty” as a member of the uniformed services, you can choose to have the five-year-test period for ownership and use suspended for up to ten years.
  • In certain cases, you can treat part of your profit as tax-free even if you don’t pass the two-out-of-five-years tests.  The key to remember with this is that this doesn’t mean that you can only exclude a portion of your gain.  It means that the $200,000/$500,000 exclusion is reduced based on the amount of time you spent in the home during the qualifying period.
  • If you inherited your home from your spouse or someone else after their death, your basis will generally be the fair market value of the home at the time the previous owner died.  Note that their are special considerations if you live in a community property state or you jointly owned the home with you spouse.
  • It is possible to extend the break to a second home by converting it to your principal residence before you sell.  However, note that 1) not all the gain will be excludable and 2) calculations will have to be performed to determine how much time the property was used as a rental (if any), primary residence and how much of this occurred after 2008 (when the rules changed)

When Both Parents Claim A Child On A Tax Return

In todays day and age, it’s not uncommon for a child’s parents to live apart (i.e. in separate homes).  This fact can sometimes cause “problems” when it comes tax time and determining who will claim the child as a dependent.  A child can only be a claimed as a dependent by one parent. Furthermore, this parent must provide more than 50% of the financial support that the child receives and the child must reside with them for more than half the tax year.

Sometimes the parents try to solve the issue by “agreeing” to trade off who gets to claim the child in what year.  Sometimes, less agreeable parents will simply try to file their tax return before the other parent, thus effectively blocking them from claiming the child.  This in itself can cause problems.  Why?  Well, if the child is claimed by both parents on two separate returns, the IRS will typically “reject” the second parents return (almost instantaneously if they are e-filing) alerting them that the child had already been claimed on another’s return.  The second parent then usually has to fix their return (or amend it if paper filed) to remove the dependent and the associated exemption.

But what if the second parent disagrees that the first parent was entitled to claim the child?  Well, the IRS is then likely to require proof from the first parent that the child either lived with them or that they had the other parent’s consent.  The latter is where Form 8332 comes in.

Form 8332 – Release of Claim to Exemption for Child by Custodial Parent
The “custodial parent” (for IRS purposes) is generally the one with whom the child lived for the greater number of nights during the year.  But if you don’t have to file a tax return, or you reach an agreement with your child’s noncustodial parent, you can let the “noncustodial parent” take the exemption by filling out Form 8332.  All that’s needed is your child’s name, the tax year, your Social Security number, your signature and date. If you prefer to release your claim to your child’s exemption for more than one tax year, enter the same information in part two rather than part one. Once complete, give the form to your child’s noncustodial parent to file with their tax return. If you release your claim for multiple tax years, you only need to fill out the form once: the other parent will attach copies of the original to their return each year.

Taking your child’s exemption back
If you decide to start claiming the exemption again after you’ve released it to the noncustodial parent, you can do so by completing part three of Form 8332. You can do this for a specific tax year or all future years.  Reclaiming the exemption isn’t effective until the tax year following the calendar year in which you complete Form 8332 and give it to the other parent. In other words, if you provide the form in 2016, the earliest you can reclaim the exemption is on your 2017 tax return which you will file in 2018.

What if someone else claimed your dependent?
If you tax return is rejected because someone else claimed your child as their dependent on their tax return, this does not necessarily mean that you do not have the right to claim the dependent.  What this does mean is that the IRS systems cannot apply the tiebreaker rules on an electronically filed return.  With that said, follow these steps:

  1. Call the IRS support line at 1-800-829-1040 and inform them of the situation.
  2. Print your tax return, sign and date it, attach any required forms, and mail it to the IRS.
  3. The IRS will examine your return and that of the other taxpayer, apply the tiebreaker rules, and inform you of the results. This process may take 8-12 weeks.

What are the Tie-Breaker rules for claiming a dependent?

  1. Relationship Test: If only one of the taxpayers claiming the child is the child’s parent, then the child will be the qualifying child of the parent.
  2. Residence Test: If both parents claim the child but do not file jointly, then the child will be the qualifying child of the parent with whom the child lived for a longer time during the year.
  3. Income Test: If the child lived with both parents for an equal amount of time, then the child will be the qualifying child of the parent with the higher adjusted gross income (AGI).
  4. No Parent Can Claim: If no parent qualifies to claim the child, the child will be the qualifying child of the person claiming the child who has the highest AGI.
  5. No Parent Chooses to Claim: If either parent qualifies to claim the child, but they choose not to, the child will be the qualifying child of the claiming person with the highest AGI, but only if their AGI is higher than that of either parent (if the parents are married and filing jointly, use one half of their combined AGI).
  6. Special Rule for Unmarried Parents: If the parents are not married but lived together with their child all year and the child meets all qualifying tests for both parents, then the parents may decide which parent will claim the child as a dependent.

Uber, Lyft and Filing Your Income Taxes

We’ve all been there.  The thought of being  your own boss and leaving the 9-to-5, Monday-through-Friday grind to someone else.  Some of us take that jump and for others, the confines of a nice cubicle and a predictable  deposit into their bank account are more than enough.  But what if you are thinking of striking out on your own and joining one of those ride share companies?  Well, we strongly urge you to read this post as it has a LOT of information in it for you to consider before you take the plunge.

Worker Status
The first thing to know is that when you work for Uber or Lyft, you are not doing so as an “employee.”  Instead, you will be classified as an independent contractor.  As presented on Uber’s website:

“All Uber partners are independent contractors, so we do not withhold any taxes and partners are entirely responsible for their own tax obligations.  If you’re a partner based in the United States, you will receive a 1099-K and/or 1099-MISC form to report income you earned with Uber. You’ll receive one or both depending on the type of payment you earned in the calendar year.”

In this post we discuss the implications of being paid as an independent contractor versus an employee.  The big difference comes down to the fact that as an independent contractor 1) no taxes are taken out of the pay received and 2) the fact that the individual has to pay self-employment taxes in addition to income taxes.

Tax Considerations
In this post we talk about how those who are “self-employed” typically file their taxes and some of the issues they face.  What we’ll now discuss are those items specific to “drivers for hire” like taxi, livery and ride share operators.

Income  This one is pretty straightforward.  You report all of the money that you received while operating, including tip income.  Where we see people get into trouble is when they under report.  What do we mean?  Well, the IRS is going to get a copy of that 1099-K or 1099-MISC that you received.  If you report at least the amount that is shown on the document then you probably won’t hear anything from the IRS.  But if you report an amount that is LESS than what is shown, expect the IRS to come a knocking.  Why?  Well the IRS is going to ask you ” why did you only report $4,000 of income but Uber says you made $8,000?  We think you made at least that much but your return doesn’t reflect that.”

Now what if you say “I didn’t get a form so the IRS doesn’t know what I made!”  Can we say tax evasion?  So make sure you report every red cent that you made to stay out of trouble okay?

Operating Expenses  This one is the complicated one.  A taxpayer who uses an automobile for business purposes can figure their deduction by comparing the standard mileage rate with actual expenses and choosing the larger amount.  One would perform this analysis in every year and take the larger amount.  However, if the actual expense method is chosen in the first year, it must be used in all subsequent years until the vehicle is no longer used for business.

If the standard mileage rate method is used, the deduction is calculated by multiplying the number of business miles driven by the applicable standard mileage rate. The standard mileage rate eliminates the need to keep track of actual costs.   It is used to replace the “actual” cost of depreciation, lease payments, maintenance and repairs, gasoline, oil, insurance, and vehicle registration fees.   It does not include:

  1. Interest expense for a self-employed individual
  2. Personal property taxes
  3. Parking fees and tolls

The expense above would (depending on the circumstances) be claimed in addition to the amount calculated via the standard mileage rate.  Now, sometimes people (and tax practitioners) wonder if a “driver for hire” can use the standard mileage rate. Well back in 2010, the IRS issued Rev Proc 2010-51 and within it you can find that Rev Proc 2009-54 was modified as follows:

“Section 4.05(1) is modified to allow taxpayers to use the business standard mileage rate to calculate the amount of deductions for automobiles used for hire, such as taxicabs.”

You can also find language under the standard mileage discussion of Publication 463 that reads that “you can elect to use the standard mileage rate if you used a car for hire (such as a taxi) unless the standard mileage rate is otherwise not allowed, as discussed above.”

Now, If you decide to base your deduction on your actual expenses, note that you should keep track of the following:

  • Business Percentage: The taxpayer must calculate the business percentage of vehicle expenses. Keep track of business miles driven for the year and divide that amount by the total miles driven for the year.
  • Cost of depreciation (leave this to your tax software or gal/guy)
  • Lease payments
  • Registration fees
  • Licenses
  • Gas
  • Oil
  • Insurance
  • Repairs
  • Tires
  • Garage rent
  • Tolls
  • Parking fees
  • Sales tax paid on the purchase of a car is added to the basis of the car and deducted through depreciation.
  • Fines for traffic violations are never deductible, even if incurred while driving for business.

Business Expenses  This is for all of the items that aren’t directly related to the cost of vehicle operations, but are allowed.  Buy bottles of water for your riders?  Have to pay a monthly cell phone bill so that riders can hail you?  Both are deductible expenses.  We suggest that you consult Publication 535 to see what is allowed.  The one thing to keep in mind is that if an item is used for both business and personal use, you should keep track of your business use as that is the percentage of the expense that you may deduct.

Comprehensive Example & Sample Tax Return
If you click this link, you will be able to download the sample tax return that is used in this example.  Having it handy will help you quickly follow along with what we’re about to discuss. Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.  Okay, the lawyers are happy now.  Shall we begin?

Need a Lyft?

Need a Lyft?

So, our good friend Memphis Raines has decided to earn some extra cash with one of the ride share companies.  He’s pretty good at what he does, get’s passengers to their place really fast and makes sure that he keeps and IRS Compliant Mileage Log (he doesn’t want the tax court disallowing his deduction).  During the year he raked in close to $63,000 in income for all that driving.  So what does Memphis’ tax return look like?  Let’s examine it.

Page 3 shows Mr. Raines’ Schedule C or Profit or Loss From Business.  He completes the top section listing all the pertinent information for his business.  If you look at the form, you will see that it contains very little information.  Looks like he spent close to $16,000 on car expense, another $143 on meals (drinks for his passengers) and another $2,000 for his business cell phone.  But let’s look a little closer at the car expense.

As indicated above, Memphis is allowed to take the larger of his actual expenses OR the amount calculated by using the standard mileage rate.  If you look at page 6, you can see all of the expense that Memphis spent to make that $63,000 in revenue.  But the thing to note is that he used his car 80.4% for business. The rest of those miles?  Well, let’s just say they were spent with his kid brother Kip and some girl named Sway!  Anyway, looks like he spent $13,000 (ignoring the fact depreciation isn’t a cash expense) to make all that money.  It also looks like he drove about 27,000 miles in a year – ouch!  So if you take the standard mileage deduction ($0.56 in 2014) and multiply in by the business mileage, you get a deduction of around $15,000.  Since that is larger than the actual expense deduction of $13,000, which do you think he will take?

Was it worth it?
So Memphis had fun driving around all year.  But was it worth it?  Only he knows the answer to that, but what we can analyze is the financial impact.  Page 1 shows that Memphis had a net profit from business of around $45,000 (i.e. $63,000 in revenue less $18,000 in expenses).  As Mr. Raines is single, he has very little other deductions.  He takes the standard deduction and receives one exemption.  This leaves him with taxable income of around $32,000.  On this income, he has to pay $4,335 in income taxes.  But wait, Memphis is his own boss right?  Well, that means that he has to pick up the share of Social Security and Medicare taxes that an employer usually has to pay for each employee it has.  The bill?  Another $6,400 in taxes!  So Memphis winds up with a whopping tax bill of around $11,000.  As he did not make estimated tax payments he’ll need to come up with a way to pay the IRS.

So in looking at this from another angle, Memphis took in $63,000.  He spent another $11,000 in real cash to make all that money.  He also has to pay the IRS around $11,000 in taxes.  So net, he took home around $41,000 when it’s all said and done.  Not bad for being your own boss.  But he did put about 27,000 miles on that sweet car of his, which will make selling it harder once it’s days as a ride share vehicle are done and it’s just hanging out in videos by The Cult.

Well, if all of this sounds like way too much to handle on your own and you’d rather let a professional deal with it, why not give us a call or shoot us an email?  We’d be happy to help make sure that you stay on Uncle Sam’s good side!

What Is Depreciation Recapture?

House

The term “depreciation recapture” refers to the amount of gain that is treated as ordinary income upon the sale or other disposition of property.  Gain that is treated as capital gain is not depreciation recapture.  If you do your own taxes and you never heard of “depreciation recapture” – it’s time to get an accountant. If you already have an accountant and they never discussed “depreciation recapture” with you – you need a new accountant!  Either way, this post will walk you through some of the basics.

A Simple Example
Let’s begin with an example. You bought a rental property in 2007 for $200K. True, this was right before the “great financial crisis” and your property is worth less, but that is besides the point (for the moment).  In 2014, you manage to sell it for $175K. If life was simple, you could get away with the following calculation: your loss is the $175K sales prices less the $200K purchase price, or $25K. You held the property more than a year, therefore it’s “long-term.” Done right?  Not so fast my friend.

Unfortunately, it is not so simple, and instead of having a loss, you actually have a gain. How come? Because of depreciation. Every year since 2007 you were depreciating the property, correct?  Well, that depreciation lowered your tax bill and you received a benefit because of it.  But if you think you got a free ride from the government, think again.  What you were saving on depreciation comes back to haunt you now when you sell the property. So (for simplicity) let’s assume that each year you received $7,272 in depreciation. This is approximately $51K of depreciation over the 7 years.  Thus, the building wasn’t really wrth $200K for tax purposes, but only $149K.  SInce you sold the building for $175K, you really had a $26K gain!

It gets worse. Under “normal” circumstances, the tax rate on most net capital gain is no higher than 15%. Some may be taxed at 0% if you are in the 10% or 15% ordinary income tax brackets. However, a 20% rate on net capital gain applies in tax years 2013 and later to the extent that a taxpayer’s taxable income exceeds the thresholds.  Furthermore, there are a few other exceptions where capital gains may be taxed at rates greater than 15%:

  1. The taxable part of a gain from selling section 1202 qualified small business stock is taxed at a maximum 28% rate.
  2. Net capital gains from selling collectibles (like coins or art) are taxed at a maximum 28% rate.
  3. The portion of any unrecaptured section 1250 gain from selling section 1250 real property is taxed at a maximum 25% rate.

In case you missed it, it’s that last bullet that refers to depreciation recapture.  And yes, it’s taxed at 25% versus 15%!

The actual calculations can get quite involved depending on the amount of the gain, the amount of depreciation taken and the tax bracket you fall into.  But once again for simplicity (and illustration), since you took $51K of depreciation, the entire $26K gain would be considered depreciation recapture and you could pay $9K in taxes related to it.

If you’re tired at this point, we don’t blame you. Albert Einstein is quoted as saying that the hardest thing in the world to understand is the income tax.  As seen above, the IRS does a pretty good job proving his point!

Tax Planning Tips for Depreciation Recapture
So just how can you get out of depreciation recapture?  The short answers is you can’t, but there are things that can help or delay it’s payment.  For example, when a rental property is sold, any passive activity losses that were not deductible in previous years become deductible in full. This can help offset the tax bite of the depreciation recapture tax.

By the way, you’ve heard of 1031 exchanges, haven’t you?  Next time, you may want to think about using one before you sell your property.  When a rental property is sold as part of a like-kind exchange, both capital gains and depreciation recapture taxes can be deferred until the “new” property is disposed of.

There’s one tax strategy, however, that will not help. Since depreciation is recaptured when the asset is sold, it is reasonable that some people would think that by avoiding claiming depreciation they can also avoid the recapture tax. This strategy does not work, because the tax law requires depreciation recapture to be calculated on depreciation that was “allowed or allowable” (Internal Revenue Code section 1250(b)(3)).

Deducting Business Start Up Cost

Business organizational costs are amounts paid, or incurred, to create a corporation or partnership business entity.  Start-up costs are those paid or incurred for investigating or creating an “active” trade or business. Start-up and organizational cost include:

  • Analysis or survey of potential markets, products, labor supply, transportation facilities, etc.
  • Expenses incurred while investigating the purchase of a business.
  • Training wages for employees who will work in the business.
  • Travel and other necessary costs for securing prospective distributors, suppliers, or customers.
  • Cost of professional services, such as executives and consultants.
  • Legal fees incident to the organization
  • Accounting fees incident to the organization
  • Filing fees.

If you need a template to track your startup or organizational cost prior to deducting them, use this one from the fine folks over at Entrepreneur.com.

Deductibility.
Unlike expenses incurred as part of the normal ongoing operations of a business, one must “elect” to amortize (i.e. deducted over a period of time) organizational and start up cost  in order for them to be deducted.  The current rules allow for the following:

  • You are able to deduct up to $5,000 of your qualifying start-up costs in the first year.
  • The first-year deduction starts to phase-out $1 for $1 when your expenses reach $50,000.  Once your expeneses reach or exceed $55,000, the first year deduction is fully phased out.
  • Up to $55,000 of start-up expenditures can be deducted ratably over a 180-month period beginning with the month in which the active trade or business begins.

To aid in understanding how the above works, here is how you would make your first year deduction:

If start-up costs are $52,000, $3,000 can be deducted in the first year.  You can amortize the remaining start-up costs over 180 months starting with the month business begins.

Making the Election Electing the deduction.
The election to currently deduct up to $5,000 of start-up or organizational costs (or both) is made by claiming the deduction on the tax return for the tax year in which the trade or business begins.  Note that the tax return must be timely-filed, including extensions.  Furthermore, no separate statement is required for making this election.

Electing to amortize.
The election to amortize start-up or organizational costs (or both) is made by filing Form 4562, Depreciation and Amortization, and completing Part VI. Make sure that you:

  • Attach a statement listing a description and amount of each cost, date incurred (for organizational costs), month the business began or was acquired, and the amortization period (generally 180 months).
  • Use separate statements for start-up costs and organizational costs.

Correcting an omitted election.
An election to deduct or amortize costs that was omitted on a timely-filed return (including extensions) can still be made by filing an Amended Return within six months of the original due date of the return (excluding extensions).

Home Office Tax Deduction Requirements

Home Office

If you use part of your home for business, the IRS will generally allow you to deduct certain expenses come tax time. The home office deduction is available for homeowners AND renters, and applies to all types of homes.   In order to take the deduction, there are two basic requirements that you must satisfy:

Regular and Exclusive Use
You must “regularly” use part of your home “exclusively” for conducting business.  For example, if you use an extra room to run your business, you can take a home office deduction for that extra room.  The exclusive portion of the equation usually means that you can’t use that room for other things.  Meaning, if the room is your den and you also use it for entertainment or other social activities, then the deduction will not be allowed.  Also, if the room or space isn’t used on a regular basis (i.e. you only have business meetings in that room once a quarter), the deduction will also not be allowed.

Principal Place of Your Business
In addition to the above, you must show that you use your home as your principal place of business. If you conduct business at a location outside of your home, but also use your home substantially and regularly to conduct business, you may qualify for a home office deduction. For example, if you have in-person meetings with patients, clients, or customers in your home, even though you also carry on business at another location, you can deduct your expenses for the part of your home used exclusively and regularly for business. You can deduct expenses for a separate free-standing structure, such as a studio, garage, or barn, if you use it exclusively and regularly for your business.

How to claim the deduction
Generally, deductions for a home office are based on the percentage of your home devoted to business use.   Thus, if you use whole or part of a room for conducting your business, you will generally need to figure out the percentage of your home devoted to your business activities.  However, note that there are TWO methods for you to determine the deduction:

Simplified Method
For taxable years that started on or after, January 1, 2013 (filed beginning in 2014), taxpayers have the option of using the simple method per IRS Revenue Procedure 2013-13.  The standard method (discussed next) has some calculation, allocation, and substantiation requirements that some consider complex and burdensome for small business owners. The simplified option can significantly reduce the recordkeeping burden by allowing a qualified taxpayer to multiply a prescribed rate by the allowable square footage of the office.   In most cases, the deduction is calculated by multiplying $5, the prescribed rate, by the area of your home used for a qualified business use. However, note that the area you use to figure your deduction is limited to 300 square feet.  So if your office is larger than this number, you may want to take the time to use the next method.

Regular Method
Taxpayers who use the regular method (required for tax years 2012 and prior), must determine the actual expenses associated with their home office.  These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation.  Once the amount spent on each category is determined, one must then allocate them between the space used in connection with their business and the rest of the dwelling.  To do this, one will use IRS Form 8829.

Where to deduct
Where you take the deduction on your tax return depends on how you conduct your business:

  1. If you are self-employed: report the entire deduction on line 30 of Schedule C (Form 1040). Whether you need to complete and attach Form 8829 to your return depends on which method you used above to perform your calculation.
  2. If you are an employee: you must itemize deductions on Schedule A (Form 1040) to claim the deduction, generally on line 21 (unreimbursed employee business expenses).
  3. If you are a member of a partnership, multimemeber LLC or S-Corp: take a look at this post for more information on how to claim the deduction.

To learn more about the following, we suggest that you take a look at IRS Publication 587:

  • Types of expenses you can deduct.
  • How to figure the deduction (including depreciation of your home).
  • Special rules for daycare providers.
  • Tax implications of selling a home that was used partly for business.
  • Records you should keep