Reap the Tax Benefits of Education Planning

The tax code includes a number of incentives that, with proper planning, can provide tax benefits while you, your spouse, or your children are being educated.

Education Financing – A major planning issue is how to finance your children’s college education. Those with substantial savings simply pay the expenses as they go, while others begin setting aside money far in advance of the education need, perhaps utilizing a Coverdell account or Sec. 529 plan.

Others will need to borrow the funds, obtain financial aid, or be lucky enough to qualify for a scholarship. Although student loans provide one ready source of financing, the interest rates are generally higher than a home equity debt loan, which can also provide a longer term and lower payments. When choosing between a home equity loan or a student loan, keep in mind the following limitations: (1) Interest on home equity debt is deductible only if you itemize and then only on the first $100,000 of debt, and not at all to the extent that you are taxed by the alternative minimum tax, and (2) student loans must be single-purpose loans; the interest deduction is limited to $2,500 per year, and the deduction phases out for joint filers with income (AGI) between $125,000 and $155,000 ($60,000 to $75,000 for unmarried taxpayers). Still unknown is whether Congress will extend the student loan interest deduction changes included in the Bush tax cuts. Unless extended, beginning in 2013:

• The AGI phase-out ranges (estimated with inflation adjustments) will be $65,000–$90,000 for joint filers and $50,000–$75,000 for other filers (except married separate filers, who are barred from claiming this deduction).
• The deduction will be limited to the interest paid on a qualified loan during only the first 60 months in which the interest payments are required.

Education Tax Credits – The tax code also provides tax credits for post-secondary education tuition paid during the year for the taxpayer and dependents. There are two types of credits: the American Opportunity Credit, which is limited to the first four years of post-secondary education, and the Lifetime Learning Credit which provides credit for years after the first four years of post-secondary schooling and can be used for graduate studies.

The American Opportunity Credit, in many cases, offers greater tax savings than other existing education tax breaks! Here are some key features of the credit:

• Tuition, related fees, books, and other required course materials generally qualify. In the past, books usually were not eligible for education-related credits and deductions.
• The credit is equal to 100 percent of the first $2,000 spent and 25 percent of the next $2,000. This means that the full $2,500 credit may be available to a taxpayer who pays $4,000 or more in qualified expenses for an eligible student.
• The full credit is available for taxpayers whose modified adjusted gross income (MAGI) is $80,000 or less (for married couples filing a joint return, the limit is $160,000 or less). The credit is phased out for taxpayers with incomes above these levels. These income limits are higher than those under the former Hope and current Lifetime Learning Credits.
• Forty percent of the American Opportunity Credit is refundable. This means that even people who owe no tax can get an annual payment of the credit of up to $1,000 for each eligible student. Other existing education-related credits and deductions do not provide a benefit to people who owe no tax. The refundable portion of the credit is not available to any student whose investment income is taxed at the parent’s rate, commonly referred to as the kiddie tax.

The bad news is that, without congressional intervention, 2012 is the last year for the American Opportunity Credit; it will be replaced by the Hope Credit, which provides only a lesser, non-refundable credit for the first two years of post-secondary education.

The Lifetime Learning Credit provides up to $2,000 of credit for each family each year. The Lifetime Learning Credit is phased out for joint filers with incomes between $104,000 and $124,000 ($52,000 to $62,000 for single filers) and is not allowed at all for married individuals filing separately. If the Hope Credit is reinstated, the phase-out ranges for it likely will be the same as those for the Lifetime Learning Credit.

Careful planning for the timing of tuition payments can provide substantial tax benefits. If Congress does not extend the American Opportunity Credit and you have not paid enough tuition to get the maximum benefit for 2012, you may consider pre-paying (in 2012) the tuition for the first quarter of 2013 so that it will count toward the 2012 credit.

Tax-Favored Savings Programs – For those who wish to establish a long-term savings program for educating their children, the tax code provides two plans. The first is a Coverdell Education Savings Account, which allows the taxpayer to make $2,000 annual nondeductible contributions to the plan. The second plan is the Qualified Tuition Plan, more frequently referred to as a Sec. 529 plan, with annual contributions generally limited to the gift tax exemption amount for the year ($13,000 in 2012). Both plans provide tax-free earnings if they are used for qualified education expenses. When choosing between a Coverdell or Sec. 529 plan, keep the following in mind: (1) Coverdell accounts can be used for kindergarten through post-secondary education and become the property of the child at the age of majority, and contributions are phased out for joint filers between $190,000 and $220,000 ($95,000 and $110,000 for others) of income (AGI), and (2) Sec. 529 plans are only for post-secondary education, but the contributor retains control of the funds.

Without congressional action, beginning in 2013, the contribution to a Coverdell account will be capped at $500 per year, and only post-secondary expenses will qualify.

Savings Bond Program – There is also an education-related exclusion of savings bond interest for Series EE or I Bonds that were issued after 1989 and purchased by an individual over the age of 24. All or part of the interest on these bonds is exempt from tax if qualified higher education expenses are paid in the same year that the bonds are redeemed. As with other benefits, this one also has a phase-out limitation for joint filers with income between $109,250 and $139,250 (between $72,850 and $87,850 for unmarried taxpayers, but those using the married separate status do not qualify for the exclusion).

If you would like to work out a comprehensive plan to take advantage of these benefits, please give our office a call.

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Inheritances Can Be Tricky

If you have received an inheritance or anticipate receiving one in the future, this article may answer many of your questions. The process of claiming an inheritance can be quite complex and it helps to understand the basics and to be aware of potential tax liabilities.

An inheritance is generally received after all applicable taxes have been paid along with any outstanding liabilities the decedent may have had. Exactly how the estate is handled will depend upon whether the assets were owned individually or in a trust. Without going into the intricacies of estates, trusts, and probate, the result for a beneficiary will generally be the same. Inherited items on which the decedent had already paid taxes and for which the estate tax (if any) has been paid will pass to the beneficiary tax-free. On the other hand, items of income that had not previously been taxed to the beneficiary and any appreciation or depreciation of assets acquired from the decedent will have tax implications. Some possible scenarios are provided below:

• Bank Account – Take, for instance, an inherited bank account worth $25,000, where the funds are not immediately distributed to the heir. The $25,000 account earns $375 of interest income after the decedent’s date of death. Out of the $25,375 that is received, the $25,000 is tax-free, but the $375 is taxable as interest income.
• Capital Asset –The basis for gain or loss from the sale of an inherited capital asset, such as stock, real estate, collectibles, etc., is generally based on the value of the asset at the time of the decedent’s death. This is one reason that qualified appraisals are so important.
  
  To explain this further, let’s assume that a vacant parcel of land is inherited with a date of death appraisal that values it at $15,000. If that property is sold for a net price of $15,000, there is neither gain nor loss and the $15,000 is tax-free to the beneficiary. If, on the other hand, the net sales price is more or less than the $15,000, there would be a reportable capital gain or loss. For capital gains tax purposes, the holding period is important. Assets held over one year are generally taxed at substantially less than those held for a shorter period of time. However, for inherited property, the beneficiary receives long-term treatment immediately, whether or not the decedent or the beneficiary had held it over one year. If there are expenses associated with selling the asset, then those expenses are deductible in figuring the gain or loss.
• IRA or other Qualified Plan – Suppose the decedent had a traditional IRA account and the distributions from that account were taxable to the decedent. If you inherit that account, the distributions will be taxable to you as the beneficiary. Why is that? Because the decedent had never paid taxes on the income that went to fund the traditional IRA and therefore you, the beneficiary, will be stuck with the tax liability. The good news is that there are options for taking the income over a number of years, which can soften the tax blow.
• Life Insurance Proceeds – Generally, the proceeds from a life insurance policy are tax-free to the heirs. However, if the policy is not paid immediately, as most are not, the insurance company will include interest. That interest is taxable to the heirs.
• Annuities and Installment Sale Notes – If the decedent purchased an annuity or had an installment sale note from the property he previously sold, the decedent’s basis will be tax-free, but the heirs will be obligated to pay tax on any amount received in excess of the decedent’s basis. For an annuity, the decedent’s basis would be what he paid for it. For an installment note, payments include: (1) a return of a portion of the asset’s cost (basis), which is not taxable; (2) a portion from the prior sale of the asset, which is taxable as a capital gain; and (3) taxable interest on the note.

A trust or estate is required to file an income tax return and to report income earned by the estate or trust after the decedent’s passing and before the assets are distributed to the heirs. Each heir will generally receive a form called Schedule K-1(1041). It will include that heir’s share of income and must be included on the heir’s individual tax return. Although infrequent because the taxes are generally higher, the trust or estate may pay the income tax on the income. The executor or trustee is responsible for making sure the required tax returns are filed and for sending K-1s to the heirs.

There may be taxable income to the heir even though the inheritance has not yet been received. In addition, there are other factors to consider that have not been discussed. Therefore, during your tax appointment, it is important to let us know if you are expecting an inheritance.

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Haven’t Filed an Income Tax Return?

If you have been procrastinating about filing your 2011 tax return or have other prior year returns that have not been filed, you should consider the consequences.

Taxpayers should file all tax returns that are due, regardless of whether or not full payment can be made with the return. Depending on an individual’s circumstances, a taxpayer filing late may qualify for a payment plan. All payment plans require continued compliance with all filing and payment responsibilities after the plan is approved.

Facts about Filing Tax Returns

• Failing to file a return or filing late can be costly. If taxes are owed, a delay in filing may result in penalty and interest charges that could substantially increase your tax bill. The late filing and payment penalties are a combined 5% per month (25% maximum) of the balance due.
• If a refund is due, there is no penalty for failing to file a tax return. But by waiting too long to file, you can lose your refund. In order to receive a refund, the return must be filed within three years of the due date. If you file a return and later realize you made an error on the return, the deadline for claiming any refund due is three years after the return was filed, or two years after the tax was paid, whichever expires later.
• Taxpayers who are entitled to the Earned Income Tax Credit must file a return to claim the credit, even if they are not otherwise required to file. The return must be filed within three years of the due date in order to receive the credit.
• If you are self-employed, you must file returns reporting self-employment income within three years of the due date in order to receive Social Security credits toward your retirement.

Taxpayers who continue to not file a required return and fail to respond to IRS requests to do so may be subject to a variety of enforcement actions, all of which can be unpleasant. Thus, if you have returns that need to be filed, please call our office so we can help you bring your tax returns up-to-date, and, if necessary, advise you about a payment plan.

Taxpayers who continue to not file a required return and fail to respond to IRS requests to do so may be subject to a variety of enforcement actions, all of which can be unpleasant. Thus, if you have returns that need to be filed, please call one of our professionals so they can help you bring your tax returns up-to-date, and, if necessary, advise you about a payment plan.

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What's Best, Tax-Free or Taxable Interest Income?

A frequent taxpayer question is whether it is better to invest for tax-free or taxable interest. Generally, taxable interest will provide a greater return, but this may not hold true after taking into account taxes on the income. Therefore, the question is really which provides the greater "after-tax" return.

Making a decision will take on another layer of complexity for higher-income taxpayers beginning in 2013 when the new surtax called the Unearned Income Medicare Contribution Tax is imposed on the unearned income of individuals, estates, and trusts. For individuals, the surtax is 3.8% of the lesser of:

1. The taxpayer’s net investment income, or
2. The excess of modified adjusted gross income over the threshold amount ($250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 for all others).

“Net” investment income is investment income reduced by allowable investment expenses. Investment income includes income from interest, dividends, annuities, royalties, rents (other than those derived from a trade or business), capital gains (other than those derived from a trade or business), trade or business income that is a passive activity with respect to the taxpayer, and trade or business income with respect to the trading of financial instruments or commodities. For surtax purposes, modified adjusted gross income does not include excluded items, such as interest on tax-exempt bonds, veterans' benefits, and excluded gains from the sale of a principal residence.

To avoid or minimize this new tax, higher-income taxpayers may wish to alter their investment portfolios to include more of the non-taxable investments described below.

There are basically four types of interest that can be excluded from income, either on the federal return or the state return, and each has its own special considerations.

Municipal Bond Interest – Interest earned from general-purpose obligations of states and local governments, which are issued to finance their operations, are generally tax-exempt for federal purposes. However, the various states usually only exempt interest from bonds issued by the state itself and local governments within the state. Hence, there are two categories of municipal bonds: the tax-free federal and state and the tax-free federal only. Individuals can invest in municipal bonds by directly purchasing a bond or through mutual funds that invest in municipal bonds. Some mutual funds invest in bonds issued only in a particular state, providing residents of that state with income that is excludable on their state returns as well as their federal returns.

For those drawing Social Security, you must also keep in mind that, even though the income itself is tax-free, it is included in the computation used to determine how much of your Social Security income is taxable.

Private Activity Bond Interest – Some municipal bonds, classified as Private Activity Bonds, are tax-free for the purposes of the regular federal tax but may be taxable for the purposes of the federal Alternative Minimum Tax (AMT). If a taxpayer is subject to the AMT, then the interest from these bonds may be taxable to some extent. The actual rate will depend upon your filing status and other AMT income but could be as high as 28% plus any state tax, if applicable.

U.S. Government Bond Interest – Under federal law, direct obligations of the U.S. government cannot be taxed by the states. This includes interest from U.S. savings bonds, U.S. Treasury bills, notes, bonds, or other obligations of the United States. Interest earned from the Federal National Mortgage Association (Fannie Mae), the Government National Mortgage Association (Ginnie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC) are not direct obligations of the U.S. government and, therefore, are not excludable from state taxation unless specifically allowed by state law, which is generally not the case. If you reside in a state with no state income tax, U.S. government bond interest provides no tax benefit.

If you do have a state income tax and the investment is tax-free in your state, then it also makes a difference whether or not you itemize your deductions on your federal return. Since having state tax-free income reduces your state tax, which is deductible if you itemize, the reduced state tax, in effect, reduces your itemized deductions and increases your federal tax.

If you have questions related to tax-free investment income or how the new surtax on investment income might impact you, please give our office a call.

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Assisting Your Child to Acquire a Home

If you are a parent who wants to assist your child in obtaining his or her first home, there are a number of ways you can help.

1. Help with the down payment - Real estate lending laws generally will not allow the parents to loan the down payment on the home, since that is considered part of the debt. However, you can make an outright gift of the down payment. Just keep in mind that to avoid reducing your lifetime gift tax exclusion and filing a gift tax return, the gift cannot exceed the annual $13,000 gift tax exemption. If you are married, the limit could double to $26,000 since both you and your spouse are allowed a separate $13,000 exemption. If your child is married, the gift limit could double again to $52,000, since the annual exemption limit applies to each donee, not the donor.
2. Buy the house in your name – Let your child make payments to you in order to buy the property. Over time, in most cases, the property will have appreciated enough in value to provide the necessary equity required for your child to obtain a favorable bank loan.
3. Slowly gift the home to the child - If you are financially secure, you could purchase the home and then gift a portion of the property to your child each year. By making these gifts over a period of time, you are able to take advantage of the annual gift tax exemption rules.

Sometimes, an elderly parent will transfer the title to their home to their children. Although this might seem to be a good idea at the time, it generally is not for the following reasons:

• If the home title is transferred to a child while the parent is still living, it constitutes a gift and a gift tax return will generally need to be filed.
• The tax basis (point from where gain or loss is measured) will be the parent’s basis. Had the child, instead, inherited the home, the child’s basis would be the fair market value of the home at the parent’s date of death, which means the child would have no taxable gain if the home is immediately sold. On the other hand, if the home had been previously gifted to the child, the gain would be measured from the parent’s basis.

Clients are encouraged to contact this office to determine the tax implications before transferring a title to property.

If you would like to help your child with purchasing his/her first home and need assistance with planning, please call our office.

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October 2012 Due Dates

October 2012 Individual Due Dates

October 10 - Report Tips to Employer

If you are an employee who works for tips and received more than $20 in tips during September, you are required to report them to your employer on IRS Form 4070 no later than October 10. Your employer is required to withhold FICA taxes and income tax withholding for these tips from your regular wages. If your regular wages are insufficient to cover the FICA and tax withholding, the employer will report the amount of the uncollected withholding in box 12 of your W-2 for the year. You will be required to pay the uncollected withholding when your return for the year is filed.

October 15 – Individuals

If you have an automatic 6-month extension to file your income tax return for 2011 file Form 1040, 1040A, or 1040EZ and pay any tax, interest, and penalties due.

October 15 - SEP IRA & Keogh Contributions

Last day to contribute to SEP or Keogh retirement plan for calendar year 2011 if tax return is on extension through October 15.

October 2012 Business Due Dates

October 15 - Electing Large Partnerships

File a 2011 calendar year return (Form 1065-B). This due date applies only if you were given an additional 6-month extension. March 17 was the due date for furnishing Schedules K-1 or substitute Schedule K-1 to the partners.

October 15 - Social Security, Medicare and withheld income tax

If the monthly deposit rule applies, deposit the tax for payments in September.

October 15 - Nonpayroll Withholding

If the monthly deposit rule applies, deposit the tax for payments in September.

October 31 - Social Security, Medicare and Withheld Income Tax

File Form 941 for the third quarter of 2012. Deposit or pay any undeposited tax under the accuracy of deposit rules. If your tax liability is less than $2,500, you can pay it in full with a timely filed return. If you deposited the tax for the quarter in full and on time, you have until November 13 to file the return.

October 31 - Certain Small Employers

Deposit any undeposited tax if your tax liability is $2,500 or more for 2012 but less than $2,500 for the third quarter.

October 31 - Federal Unemployment Tax

Deposit the tax owed through September if more than $500.

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Planning Your RMD and IRA Distributions For 2012

We spend most of our lives saving for retirement by putting funds away in tax-advantaged ways. But many of us forget about planning the withdrawals so that they are tax-advantaged as well.

Although there are exceptions, retirement funds generally cannot be withdrawn until we are age 59.5. If taken out sooner, there is a 10% penalty that applies in most cases. In addition, there may be a state penalty.

A large number of taxpayers do not take distributions until they are forced to do so at age 70.5, not realizing they might benefit tax-wise by taking money out sooner. For example, if you are in a low or zero tax-bracket this year, you can take a certain amount out with no or minimal tax cost. That is where planning your distributions can save a significant amount of tax dollars.

Even if you are under 59.5, if your income for the year is below the taxable income limit, you can withdraw an amount that brings you up just short of the taxable income threshold and only pay the penalty.

If you receive Social Security benefits keep in mind that Social Security income is tax-free for lower-income retirees but becomes taxable as income increases. IRA distributions can sometimes be planned in order to minimize the taxability of the Social Security income.

Once you reach age 70.5, you must start taking the required minimum distribution (RMD) from your Traditional IRA and other qualified pension plans. But you can still withdraw more than the required amount. If your income is low, it may be appropriate to take more than the minimum to save taxes in the future. Unfortunately, many people simply take the IRS-specified minimum amount without considering the tax-planning aspects of the distribution.

The penalty for not taking the RMD after reaching age 70.5 is an additional tax of 50% of the amount that should have been taken that year, based upon the IRS rules. The good news is that the IRS will generally, upon request, waive the penalty, provided that you show a corrective distribution was made in the subsequent year. So if you missed an RMD for the prior year, you should contact this office right away with regard to taking corrective action.

The RMD is determined by taking the IRA balance on December 31 of the prior year and dividing that total by your remaining life expectancy from the IRS table. If you have more than one IRA, figure the RMD for each one and then combine them to get the total required distribution for the year. (An owner of a Roth IRA is not required to take distributions at any age.)

For purposes of determining the minimum distribution, all Traditional IRA accounts, including SEP-IRAs, owned by an individual are treated as one, but the actual minimum distribution can be taken from any combination of the accounts. If the owner chooses not to take the minimum distribution from each account, it is not uncommon for IRA trustees to require written certification that the owner took the minimum distribution from other accounts.

If you have other qualified plans besides Traditional IRA accounts, the RMD for those must be figured separately for each type and withdrawn from those plans and cannot be combined with the distributions from IRAs or other qualified plans.

A taxpayer who fails to take a distribution in the year he or she reaches age 70.5 can avoid a penalty by taking that distribution no later than April 1st of the following year. However, that means the IRA owner must take two distributions in the following year, one for the year in which age 70.5 is attained and one for the current year.

If an IRA owner dies after reaching age 70.5, but before April 1st of the next year, no minimum distribution is required because death occurred before the required beginning date.

As you can see, there is more to the required minimum distribution than meets the eye, and there are some significant planning opportunities. Give our office a call if you have questions or would like to schedule a planning appointment.

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Naming Your IRA Beneficiary – More Complicated Than You Might Expect

The decision concerning whom you wish to designate as the beneficiary of your traditional IRA is critically important. This decision affects the minimum amounts you must withdraw from the IRA when you reach age 70-1/2, who will get what remains in the account after your death, and how that IRA balance can be paid out. What's more, a periodic review of whom you've named as IRA beneficiaries is vital to ensure that your overall estate planning objectives will be achieved in light of changes in the performance of your IRAs and in your personal, financial, and family situation.

The issue of naming a trust as the beneficiary of an IRA comes up regularly. There is no tax advantage to naming a trust as the beneficiary of an IRA. Of course, there may be a non-tax related reason, such as controlling a beneficiary’s access to money; thus, naming a trust rather than an individual(s) as the beneficiary of an IRA could achieve that goal. However, that is not typically the case. Naming a trust as the beneficiary of an IRA eliminates the ability for multiple beneficiaries to maximize the opportunity to stretch the required minimum distributions (RMDs) over their individual life expectancies.

Distributions from traditional IRAs are always taxable whether paid to you or, upon your death, paid to your beneficiaries. Once you reach age 70-1/2, you are required to begin taking distributions from your IRA. If your spouse is your beneficiary, the spouse can delay distributions until the spouse reaches age 70-1/2 if he or she is under the age of 70-1/2 when inheriting the IRA. The rules are tougher for non-spousal beneficiaries, who generally must begin taking distributions based upon a complicated set of rules.

Since IRS distributions are taxable to beneficiaries, beneficiaries usually wish to spread the taxation over a number of years. However, the tax code limits the number of years based on whether the decedent had or had not begun his or her age 70-1/2 required minimum distributions at the time of their death.

If the decedent had begun taking his or her age 70-1/2 minimum required distributions the non-spousal beneficiaries must begin taking distributions in the first calendar year following the decedent’s death. Using the Single Life Table provided by the IRS, the post-death distribution period used to determine the RMD is the longer of: (1) the remaining life expectancy of the deceased IRA owner using the deceased’s attained age in the year of death and subtracting one for each subsequent year after the date of death or (2) the remaining life expectancy of the IRA beneficiary using the beneficiaries' attained age in the year of death and subtracting one for each subsequent year after the date of death. So as long as the beneficiary is younger than the decedent at the date of death, the IRA distributions can be stretched out over the beneficiary’s expected life.

If the decedent had not begun taking his or her age 70-1/2 minimum required distributions, the non-spousal beneficiaries must begin taking distributions in the first calendar year following the decedent’s death over the lifetime of the beneficiary using the Single Life Table. Where there are multiple beneficiaries, the life expectancy of the oldest beneficiary must be used.

In either case, whether the decedent had begun taking the minimum required distributions or not, the beneficiaries have the option to take the entire amount, in any manner desired, within the first five years after the decedent’s death.

To ensure that your IRA will pass to your chosen beneficiary or beneficiaries, be certain that the beneficiary form on file with the custodian of your IRA reflects your current wishes. These forms allow you to designate both primary and alternate individual beneficiaries. If there is no beneficiary form on file, the custodian’s default policy will dictate whether the IRA will go first to a living person or to your estate.

This is a simplified overview of the issues related to naming a beneficiary and the impact on post-death distributions. There are some less frequently encountered rules not covered here, and it may be appropriate to consult with our office regarding your particular circumstances before naming beneficiaries.

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Renting Your Vacation Home

If you own a home in a vacation locale – whether it is your primary residence or a vacation home – and are considering renting it out to others, there are complicated tax rules, referred to as the “vacation home rental rules,” that you need to be aware of.

Generally, the tax code breaks a “vacation rental” into three categories, each with a different treatment for income and expenses:

• Rented Less Than 15 Days – If you rent your home for less than 15 days during the tax year, the tax code says that you do not need to report the income and you can still deduct 100% of the property taxes and qualified mortgage interest as an itemized deduction. Yes, you heard me correctly: the government is actually allowing you to ignore the income, regardless of the amount, if you rent the home for less than 15 days during the year. This rule offers some opportunities for substantial tax-free income, especially for more expensive homes. Here are some examples:
• Rental as a film location – typically, film production companies will pay substantial amounts (thousands per day) for the short-term use of homes as movie sets. Individuals with unique properties can register with a local film location company.
• Home in a vacation locale – individuals with homes in a popular tourist or vacation locales can rent their homes out to vacationers in their area while they are on vacation themselves.
• Home in the area of a special event – when a one-time or special event such as a major sports event (think the Super Bowl) or convention comes to town, hotel rooms may be scarce or even fill up. Homeowners in these locations may want to rent their homes short-term during the activity while getting out of town to avoid the crowds.

However, be careful; if the rental goes over 14 days, the income is no longer tax-free. When calculating the number of days, the definition of a day is generally “the 24-hour period” for which a day’s rental would be paid. Thus, a person using a dwelling unit from Saturday afternoon through the following Saturday morning would generally be treated as having used the unit for seven days even though the person was on the premises on eight calendar days.

• Rented 15 Days or More – When the home is rented 15 days or more, the income must be reported. However the tax treatment depends upon how many days you used the home personally:
• Personal Use More Than 10% of the Rental Days – If your personal use of the home totals more than 10% of the rental days, the expenses are allocated according to personal versus rental days. In figuring your rental profit, the expenses must be deducted in the following order: allocated taxes and interest first, then maintenance and other cash expenses, and, finally, depreciation. However, the net result is limited to zero; i.e., a loss cannot be claimed.
• Personal Use 10% or Less of the Rental Days – If your personal use of the home totals 10% or less of the rental days, the expenses are allocated according to personal versus rental days in the same manner as when the personal use exceeds 10% except that a loss is allowed, but the loss cannot include any amount attributed to depreciation.

When figuring the personal use days, include days used by an owner, co-owner, or family member of the owner/co-owner and days used under a reciprocal arrangement. However, you can exclude “fix-up” days, which are days spent repairing and maintaining the property.

A number of other rules apply to special situations not covered here. If you have questions about how the vacation rental rules will apply to your unique circumstances, please give tour office a call.

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Bunching Your Deductions Can Provide Big Tax Benefits

If your tax deductions normally fall short of itemizing your deductions or even if you are able to itemize, but only marginally, you may benefit from using the “bunching” strategy.
The tax code allows most taxpayers to utilize the standard deduction or itemize their deductions if that provides a greater benefit. As a rule, most taxpayers just wait until tax time to add everything up and then use the higher of the standard deduction or their itemized deductions.

If you want to be more proactive, you can time the payments of tax-deductible items to maximize your itemized deductions in one year and take the standard deduction in the next.

For the most part, itemized deductions include medical expenses, property taxes, state and local income (or sales) taxes, home mortgage and investment interest, charitable deductions, unreimbursed job-related expenses, and casualty losses. The “bunching strategy” is more commonly associated with medical expenses, tax payments and charitable deductions, although there are circumstances in which the other deductions might come into play. There are many opportunities to bunch deductions, and the following are examples of the bunching strategies most commonly used:

• Medical Expenses – You contract with a dentist for your child’s braces. The dentist may offer you an up-front, lump sum payment or a payment plan. By making the lump sum payment, the entire cost is credited in the year paid, thereby dramatically increasing your medical expenses for that year. If you do not have the cash available for the up-front payment, then you can pay by credit card, which is treated as a lump-sum payment for tax purposes. If you use a credit card, you must realize that the credit card interest is not deductible, and you need to determine if incurring the interest is worth the increased tax deduction. Another important issue with medical deductions is that only the amount of the total medical expenses that exceeds 7.5% of your adjusted gross income (AGI) is actually deductible. If you are caught by the Alternative Minimum Tax (AMT), then only the amount that exceeds 10% of your AGI is actually deductible. So, there is no tax benefit in bunching medical deductions if the total is less than 7.5% of your AGI (10% if taxed by the AMT).

If the current year is an abnormally high-income year, you may, where possible, wish to put off making medical expense payments until the subsequent year when the 7.5% (10%) threshold is less.

Special Note: Beginning in 2013, the medical income threshold increases from 7.5% to 10% for taxpayers under the age of 65, so that change needs to be factored into your planning.

• Taxes – Property taxes on real estate are generally billed annually at mid-year, and most locales allow the tax bill to be paid in semi-annual or quarterly installments. Thus, you have the option of paying it all at once or paying in installments. This provides the opportunity to bunch the tax payments by paying one semi-annual installment or two quarterly installments and a full year’s tax liability in one year and only paying one semi-annual installment or two quarterly installments in the other year. In doing so, you are able to deduct 1-½ year’s taxes in one year and 50% of a year’s taxes in the other. If you are thinking of making the property tax payments late as a way to accomplish bunching, you should be cautious. The late payment penalty will probably wipe out any potential tax savings.

If you reside in a state that has state income tax, the state income tax paid or withheld during the year is deductible as a federal itemized deduction. So, for instance, if you are paying state estimated tax in quarterly installments, the fourth-quarter estimate is generally due in January of the subsequent year. This gives you the opportunity to either make that payment before December 31st, and be able to deduct the payment on the current year’s return, or pay it in January before the January due date and use it as a deduction in the subsequent year.

A word of caution about the itemized deduction for taxes! Taxes are only deductible for regular tax purposes. So, to the extent you are taxed by the AMT, you derive no benefits from the itemized deduction for taxes.

• Charitable Contributions – Charitable contributions are a nice fit for “bunching” because they are entirely payable at the taxpayer’s discretion. For example, if you normally tithe at your church, you could make your normal contributions during the year and then prepay the entire subsequent year’s tithing in a lump sum in December of the current year, thereby doubling up on the church contribution one year and having no deduction for charity in the other year. Normally, charities are very active with their solicitations during the holiday season, giving you the opportunity to make the contributions at the end of the current year or simply wait a short time and make them after the end of the year.

If you think a “bunching” strategy might benefit you, please call our office to discuss the issue and set up an appointment for some in-depth strategizing.

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Important Times to Seek Assistance

Waiting for your regular appointment to discuss current tax-related issues can create problems or cause you to miss out on beneficial options that need to be timely exercised before year-end. Generally, you should call this office any time you have a substantial change in taxable income or deductions. By doing so, we can advise you about how to optimize your tax liability, avoid or minimize penalties, estimate and pre-pay required taxes, document deductions, and examine and explore tax options. You should call this office if you or your spouse:

• Receive a large employee bonus or award
• Become unemployed
• Change employment
• Take an unplanned withdrawal from an IRA or other pension plan
• Retire or are contemplating retirement
• Exercise an employee stock option
• Have significant stock gains or losses
• Get married
• Separate from or divorce your spouse
• Sell or exchange a property or business
• Experience the death of a spouse during the year
• Turn 70½ during the year
• Increase your family size through birth or adoption of a child
• Start a business or acquire a rental property
• Receive a substantial lawsuit settlement or award
• Get lucky at a casino, lotto, or game show and receive a W-2G
• Plan to donate property worth $5,000 ($500 if a vehicle) or more to a charity
• Plan to gift more than $13,000 to any one individual during the year

In addition, you should call whenever you receive a notice from the government related to your tax return. You should never respond to a notice without first checking with our office.

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September 2012 Due Dates

Individual Due Dates

September 1 - 2012 Fall and 2013

Tax Planning Contact our office to schedule a consultation appointment.

September 17 - Estimated Tax Payment Due

The third installment of 2012 individual estimated taxes is due. Our tax system is a “pay-as-you-go” system. To facilitate that concept, the government has provided several means of assisting taxpayers in meeting the “pay-as-you-go” requirement. These include:

• Payroll withholding for employers;
• Pension withholding for retirees; and
• Estimated tax payments for self-employed individuals and those with other sources of income not covered by withholding.

When a taxpayer fails to prepay a safe harbor (minimum) amount, they can be subject to the underpayment penalty. This penalty is equal to the federal short-term rate plus 3 percentage points, and the penalty is computed on a quarter-by-quarter basis.

Federal tax law does provide ways to avoid the underpayment penalty. If the underpayment is less than the $1,000 de-minimis amount, no penalty is assessed. In addition, the law provides "safe harbor" prepayments. There are two safe harbors:

• The first safe harbor is based on the tax owed in the current year. If your payments equal or exceed 90% of what is owed in the current year, you can escape a penalty.
• The second safe harbor is based on the tax owed in the immediately preceding tax year. This safe harbor is generally 100% of the prior year’s tax liability. However, for higher-income taxpayers whose AGI exceeds $150,000 ($75,000 for married taxpayers filing separately), the prior year’s safe harbor is 110%.

Example: Suppose your tax for the year is $10,000 and your prepayments total $5,600. The result is that you owe an additional $4,400 on your tax return. To find out if you owe a penalty, see if you meet the first safe harbor exception. Since 90% of $10,000 is $9,000, your prepayments fell short of the mark. You can't avoid the penalty under this exception.

However, in the above example, the safe harbor may still apply. Assume your prior year’s tax was $5,000. Since you prepaid $5,600, which is greater than the 110% of the prior year’s tax (110% = $5,500), you qualify for this safe harbor and can escape the penalty.

This example underscores the importance of making sure your prepayments are adequate, especially if you have a large increase in income. This is common when there is a large gain from the sale of stocks, sale of property, when large bonuses are paid, when a taxpayer retires, etc. Timely payment of each required estimated tax installment is also a requirement to meet the safe harbor exception to the penalty. If you have questions regarding your safe harbor estimates, please call our office as soon as possible.

CAUTION: Some state de-minimis amounts and safe harbor estimate rules are different than those for the Federal estimates. Please call our office for particular state safe harbor rules.

September 2012 Business Due Dates

September 1 - 2012 Fall and 2013 Tax Planning

Contact our office to schedule a consultation appointment.

September 17 - Corporations

File a 2011 calendar year income tax return (Form 1120 or 1120-A) and pay any tax, interest, and penalties due. This due date applies only if you timely requested an automatic 6-month extension.

September 17 - S Corporations

File a 2011 calendar year income tax return (Form 1120S) and pay any tax due. This due date applies only if you requested an automatic 6-month extension.

September 17 - Corporations

Deposit the third installment of estimated income tax for 2012 for calendar year corporations.

September 17 - Social Security, Medicare and withheld income tax

If the monthly deposit rule applies, deposit the tax for payments in August.

September 17 - Nonpayroll Withholding

If the monthly deposit rule applies, deposit the tax for payments in August.

September 17 - Partnerships

File a 2011 calendar year return (Form 1065). This due date applies only if you were given an additional 5-month extension. Provide each partner with a copy of K-1 (Form 1065) or a substitute Schedule K-1. September 17 Fiduciaries of Estates and Trusts File a 2011 calendar year return (Form 1041). This due date applies only if you were given an additional 5-month extension. If applicable, provide each beneficiary with a copy of K-1 (Form 1041) or a substitute Schedule K-1.

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Take Advantage of Education Tax Benefits

The tax code includes a number of incentives that, with proper planning, can provide tax benefits while you, your spouse, or children are being educated. Which of these options will provide the greatest tax benefit depends on each individual’s particular circumstances. The following is an overview of the various possibilities.

Student Loans—A major planning issue is how to finance your children’s education. Those with substantial savings simply pay the expenses as they go while others begin setting aside money far in advance of the education need, perhaps utilizing a Coverdell account or Sec. 529 plan. Others will need to borrow the funds, obtain financial aid, or be lucky enough to qualify for a scholarship. Although student loans provide one ready source of financing, the interest rates are generally higher than a home equity debt loan, which can also provide a longer repayment term and lower payments.

When choosing between a home equity loan or student loan, keep in mind the following limitations: (1) Interest on home equity debt is deductible only if you itemize, and then only on the first $100,000 of debt, and not at all to the extent that you are taxed by the alternative minimum tax; and (2) student loans must be single-purpose loans—the interest deduction is available even if you do not itemize but is limited to $2,500 per year, and the deduction phases out for joint filers with income (AGI) between $110,000 and $140,000 ($55,000 to $70,000 for unmarried taxpayers). After 2012, unless Congress extends the current rules, the income ranges at which the deduction phases out will be $60,000 to $75,000 for married joint ($40,000 to $55,000 for others), and the deduction will be limited to the first 60 months that the interest payments are required.

Gifting Low Basis Assets—Another frequently used tax strategy to finance education is to gift appreciated assets (typically stock) to a child and then allow the child to sell the stock to pay for the education. This results in transferring any gain on the stock to the child at a time when the child has little or no other income; tax on the gain is avoided or is at the child’s low rate. However, with the lowest of the long-term capital gains rates being zero for tax years 2008 through 2012, Congress moved to curtail income shifting to children by making most full-time students under the age of 24 subject to the “kiddie tax.” This effectively taxes their unearned income at their parents’ tax rates and makes the gifting of appreciated assets to a child less appealing as a way to finance college expenses.

Education Credits - The tax code provides tax credits for post-secondary education tuition paid during the year for the taxpayer and dependents. Currently, there are two types of credits: the American Opportunity Credit, which is limited to any four tax years for the first four years of post-secondary education and provides up to $2,500 of credit for each student (some of which may be refundable), and the Lifetime Learning Credit, which provides up to $2,000 of credit for each family each year. The American Opportunity Credit is phased out for joint filers with incomes between $160,000 and $180,000 ($80,000 to $90,000 for single filers). The phaseout ranges for the Lifetime Learning Credit are $104,000–$124,000 for married joint and $52,000–$62,000 for others. Neither credit is allowed for married individuals who file separately. Careful planning for the timing of tuition payments can provide substantial tax benefits. NOTE: Unless Congress takes action, the American Opportunity Credit will not be available for tax years after 2012, but the Hope Credit, which applied before 2009 and allows credit for only the first two years of college tuition and at a lesser amount, will be reinstated.

Tuition Deduction - Prior to 2012, another option—and one that could possibly be extended by Congress—was an above-the-line deduction for qualified higher education tuition and related expenses of the taxpayer, spouse, or dependents. The maximum deduction annually was $4,000 if income was no more than $130,000 for married joint filers or $65,000 for others. A lesser maximum deduction of $2,000 applied for joint filers with income over $130,000, but not more than $160,000; for other filers, the income range was over $65,000 and up to $80,000. No deduction was allowed if married filing separately. Whether this deduction will be extended by Congress is uncertain at the time of the writing of this article.

Education Savings Programs—For those who wish to establish a formalized long-term savings program to educate their children, the tax code provides two plans. The first is a Coverdell Education Savings Account, which allows the taxpayer to make $2,000 annual nondeductible contributions to the plan. The annual contribution limit will revert to $500 after 2012 unless Congress acts. The second plan is the Qualified Tuition Plan, more frequently referred to as a Sec. 529 plan, with annual contributions generally limited to the gift tax exemption for the year ($13,000 in 2012). Both plans provide tax-free earnings if used for qualified education expenses. When choosing between a Coverdell or Sec. 529 plan, keep the following in mind: (1) Coverdell accounts can be used for kindergarten through post-secondary education through 2012 and become the property of the child at age of majority, and contributions are phased out for joint filers between $190,000 and $220,000 ($95,000 and $110,000 for others) of income (AGI); and (2) Sec. 529 plans are only for post-secondary education, but the contributor retains control of the funds. If Congress does not extended current rules for Coverdell accounts, tax-free use of the funds for elementary and secondary school expenses will not apply after 2012, and the income phaseout ranges for limiting contributions by married joint filers will be lower.

Educational Savings Bond Interest—There is also an exclusion of savings bond interest for Series EE or I Bonds that were issued after 1989 and purchased by an individual over the age of 24. All or part of the interest on these bonds is exempt from tax if qualified higher education expenses are paid in the same year that the bonds are redeemed. As with other benefits, this one also has a phase-out limitation for joint filers with income between $109,250 and $139,250 ($72,850 and $87,850 for unmarried taxpayers, but those using the married filing separately status do not qualify for the exclusion). The exclusion is computed on IRS Form 8815, Exclusion of Interest from Series EE and I U.S. Savings Bonds Issued After 1989.

If you would like to learn more about these benefits and how the impending tax changes may affect your use of them, or to work out a comprehensive plan to take advantage of these benefits, please give our office a call.

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Middle-Class Tax Cuts: Will Congress Act Soon?

So who does President Obama see as the middle class? He has repeatedly used earnings of $250,000 for married couples and $200,000 for single individuals as the threshold for what he considers the wealthy and those who should not benefit from tax cuts.

He reiterated that on July 9 by calling for a one-year extension of the Bush-era tax cuts for those earning under $250,000 per year. However, the Republicans continue to insist on a one-year extension for all taxpayers. The Republicans argue that no one should see a tax hike this year, not families, not small businesses and other job creators.

The Republican-controlled house has indicated its intent to pass a one-year extension of the Bush-era tax cuts for all taxpayers while the Democratic-controlled Senate intends to pass an extension limited to taxpayers with incomes under $250,000 before the August recess. The result will be a stalemate. That means we will have to wait for a compromise bill later in the year.

This spring, at a speech before the National Press Club, the Commissioner of the Internal Revenue Service, Doug Shulman, warned of “a real disaster” if Congress misses the December 31 deadline to decide on major tax provisions. Mr. Shulman reminded everyone that the 2010 “lame duck” session deadlock to extend the Bush tax cuts for 2011 resulted in a delayed start for the 2011 tax season.

The Bush tax cuts currently set to expire at the end of 2012 include:

• Reduced individual tax rates (10%, 15%, 25%, 28%, 33%, and 35%).
• Reduced long-term capital gain rates (maximum 15%, but 0% for some taxpayers).
• Reduced qualified dividend rate (15%/0%).
• No phase-out for personal exemptions (the personal exemption phase-out, or “pep,” limitation).
• No phase-out for itemized deductions.
• Expanded tax credits, including the earned income tax credit (EITC), child tax credit, adoption credit, and dependent care tax credit.
• Reduced marriage penalty (i.e., increased standard deduction and upper limit of the 15% bracket for married taxpayers to 200% of that for singles and an increased income level at which the EITC begins to be phased out).
• Modified education tax incentives (including Coverdell education saving accounts, the American Opportunity Credit, the student loan interest deduction, favorable tax treatment of certain scholarships and fellowships, and an exclusion for employer-provided educational assistance).

What happens if those provisions are allowed to expire and what happens to taxpayers who earn more than $250,000 if Obama’s proposal succeeds?

• Individual income tax rates will rise to 15%, 28%, 31%, 36%, and 39.6%.
• Long-term capital gains will be taxed at a maximum rate of 20%.
• Dividends will be taxed as ordinary income.
• The limit on personal exemptions will be restored such that, for higher-income taxpayers, the total amount of exemptions that can be claimed will be reduced by 2% for each $2,500 by which the taxpayer's adjusted gross income (AGI) exceeds a certain inflation-adjusted threshold.
• The limit on itemized deductions will be restored such that, for higher-income taxpayers, the total amount of itemized deductions will be reduced by 3% of the amount by which the taxpayer's AGI exceeds a certain inflation-adjusted threshold.
• The child tax credit, adoption credit, and dependent care tax credit will all be cut back.
• The standard deduction and upper limit of the 15% bracket for married couples will fall from 200% to 167% of the deduction and upper limit for unmarried taxpayers, and married taxpayers will be subject to the same EITC phase-out levels as unmarried taxpayers.
• The education incentives will disappear altogether or be significantly cut back.

The Bush tax cuts are not the only things at stake. There are a number of other provisions that will change, most notably the alternate minimum tax, which, without an extension of the increased exemption amounts, will ensnare millions of middle-income taxpayers.

If you have questions or wish to explore strategies to hedge against whatever Congress decides to do – or not do – please give our office a call.

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Raising Cash in Tough Times

A housing market that has not recovered from the big price drops that began several years ago, long-term unemployment, and a still wobbly economy mean tough times for cash-strapped individuals seeking to raise money for an immediate financial need. Compounding the misery is the fact that many people have locked away the lion's share of their savings in a tax-favored retirement vehicle, such as a company profit-sharing or 401(k) plan, IRA, SEP, SIMPLE IRA, or Roth IRA. And getting at that money in order to resolve a pressing financial crisis before 59 1/2 years of age is not easy and can be financially painful.

In general, tapping into a profit-sharing plan, IRA, SEP, or SIMPLE IRA requires a taxpayer to pay the tax on the amount withdrawn and, unless a taxpayer meets one of the limited exceptions, a 10% early withdrawal penalty. To make matters worse, if the taxpayer lives in a state with an income tax and possibly a state early withdrawal penalty, the overall amount of the withdrawal that goes to pay taxes and penalties can approach 50% of the amount withdrawn. (Note: Certain amounts of Roth IRAs and some Traditional IRAs can be withdrawn without paying tax or penalty).

There are generally only two ways for active employees who are under 59 1/2 years of age to tap into their account balances in 401(k) plans: take a loan from the plan or take a hardship withdrawal, if they are eligible to do so. But just because the plan may permit a withdrawal for hardship does not mean that the withdrawal will avoid either being taxed or subject to the early withdrawal penalty.

401(k) Loans—Borrowing money is not considered a taxable event since it is merely a loan. However, loans must be paid back, and if a taxpayer subsequently defaults on a 401(k) loan, the loan becomes a taxable distribution that is subject to tax and penalties. An often-overlooked hazard to a 401(k) loan is the possibility of leaving employment with the plan’s sponsoring employer, at which time the loan would need to be paid in full or it would become a taxable distribution that is subject to the usual penalties.

Hardship Distributions—The law places limits on distributions to participants of 401(k) and similar plans, which are usually granted when the employee separates from service (retires, changes jobs), dies, becomes disabled, or reaches 59 1/2 years of age. For some plans, a hardship distribution may be permitted. A distribution is treated as made after an employee's hardship only if it is made on account of the hardship, which in turn requires the distribution to be:

• Made on account of an immediate and heavy financial need of the employee; and
• Necessary to satisfy that financial need.

What is an immediate and heavy financial need? According to IRS safe harbor rules, a distribution is treated as made on account of an immediate and heavy financial need if made for:

1. Expenses for (or necessary to obtain) deductible medical care (which includes expenses for the care of a spouse or dependent);
2. Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments);
3. Payment of tuition, related educational fees, and room and board expenses for up to the next 12 months of post-secondary education for the employee or the employee's spouse, children, or dependents;
4. Payments necessary to prevent the employee's eviction from his or her principal residence or foreclosure on the mortgage on that residence;
5. Payments for burial or funeral expenses for the employee's deceased parent, spouse, children, or dependents; or
6. Expenses for the repair of damage to the employee's principal residence that would qualify for the casualty deduction.

Maximum Distributable Amount—A hardship distribution cannot exceed the maximum distributable amount, which includes the employee's total elective contributions on the distribution date, reduced by any previous distributions of elective contributions. It also may include employer contributions, depending on how those contributions are made (i.e., matching or non-elective) and how the plan is organized. Not all plans are the same; thus, the employer will need to be consulted.

Obtaining a hardship distribution from a 401(k) plan is not easy and should not be used as a means of rising needed cash if other sources are available. The plan participant should keep in mind that:

• The taxpayer’s definition of hardship may not correspond with the plan's definition.
• If the plan uses the safe harbor method of treating a distribution as necessary to meet an immediate and heavy financial need, the plan participant will be barred from making elective contributions (and will therefore forfeit any matching contributions from the employer) for a period of at least six months.
• The taxpayer may need to take a loan from the 401(k) plan first before he or she can take a hardship distribution.
• Depending on how the plan is organized, the taxpayer may not be able to withdraw his or her entire balance.
• The taxpayer will lose the tax-deferred earnings buildup forever that would have accrued on the hardship withdrawal had it not been made.
• The taxpayer will have to pay tax at ordinary income rates on the withdrawal (assuming that he or she has made no after-tax contributions) and most likely a 10% premature withdrawal tax as well.

Using funds meant for your retirement can have long-term consequences that should be carefully considered. Before tapping into your retirement funds, we urge you to contact our office so that we can help minimize the damages and avoid penalties wherever possible.

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