Caring for an Elderly or Incapacitated Individual

With individuals living longer, we frequently find ourselves in the position of caregiver for elderly or incapacitated individuals. Whether you’re caring for an incapacitated or elderly spouse, an elderly parent, or even a child, understanding potential tax advantages can relieve some of the financial burden associated with being a caregiver. The following are some tax aspects of taking on the care of an elderly or incapacitated individual.

Dependency exemption — You may be able to claim the cared-for individual as your dependent, thus qualifying for an exemption deduction. To qualify:

·           You⁽¹⁾ must provide more than 50% of the individual's support costs,

·           The individual must either live with you or be related,

·           The individual must not have gross income in excess of the exemption amount ($3,900 for 2013),

·           The individual must not file a joint return for the year (unless neither spouse would have a tax liability if separate returns were filed and the joint return is filed only to claim a refund), and

 

·           The individual must be a U.S. citizen or a resident of the U.S., Canada, or Mexico

⁽¹⁾ If the support test can only be met by a group (several children, for example, combining to support a parent), a “multiple support agreement” form can be filed to grant one of the group members the exemption, subject to certain conditions.

Medical expenses — If the cared-for individual qualifies as your dependent or medical dependent ⁽²⁾, you can include any medical expenses you incur for the individual along with your own when determining your medical deduction. 

Amounts paid to a nursing home are fully deductible as a medical expense if the principal reason that a person stays at the nursing home is medical in nature, as opposed to custodial or other care. If a person is not in the nursing home principally to receive medical care, only the portion of the fee that is allocable to actual medical care qualifies as a deductible medical expense. However, if the individual is chronically ill⁽³⁾, all of the individual’s qualified long-term care services, including maintenance or personal care services, are deductible.

⁽²⁾ A medical dependent is an individual who doesn't qualify as your dependent only because of the gross income or joint return test; you can still include these medical costs with your own. 

⁽³⁾ A chronically ill individual is one certified by a physician or other licensed healthcare practitioner (e.g., nurse or social worker) as unable to perform, without substantial assistance, at least two activities of daily living for at least 90 days due to a loss of functional capacity, or as requiring substantial supervision for protection due to severe cognitive impairment (e.g., memory loss or disorientation). Of course, a person with Alzheimer's disease qualifies

Filing status — If you aren't married, you may qualify for “head of household” status by virtue of the cared-for individual. If the cared-for individual: (a) lives in your household, (b) you pay more than half of the household costs, (c) the individual qualifies as your dependent, and (d) the individual is a relative, you can claim head of household filing status. If the person you’re caring for is your parent, he or she does not need to live with you as long as you provide more than half of your parent’s household costs and he or she qualifies as your dependent. For example, if a parent is confined to a nursing home and you pay more than half of the cost, you are considered as maintaining the principal home for your parent.

Household employee issues — If you hire individuals to help you care for an elderly or incapacitated individual in your home, you must treat them as employees, issue them a W-2 form, and withhold and remit certain payroll taxes to the IRS and your state. If you use a service company that sends its employees to provide care services, the service company will handle the payroll issue for these employees, relieving you of that responsibility. If you plan to hire help, please call this office to discuss your options in more detail.

Dependent care credit — If the cared-for individual qualifies as your dependent, lives with you, and physically or mentally cannot take care of him or herself, you may qualify for the dependent care credit for costs you incur for this individual’s care to enable you and your spouse to go to work. However, the same expense cannot be used as both a medical expense deduction and for the dependent care credit.

If you experience financial difficulties in funding the care, the tax code provides some specialized relief as described below. Generally, these forms of relief should be considered only when no other reasonable alternatives exist.  

Reverse mortgage as alternative to nursing home — It is often desirable for an elderly person to remain in his or her own home with proper in-home care rather than entering a nursing home. A reverse mortgage loan may make this a feasible alternative to a nursing home. If this approach is taken, don’t forget that household help is deductible in the same manner as nursing home expenses. In addition, household employees must be paid by payroll. 

Exclusion for payments under life insurance contracts — Any lifetime payments received under a life insurance contract on the life of a person who is either terminally or chronically ill are excluded from gross income. A similar exclusion applies to the sale or assignment of a life insurance contract to a person who regularly buys or takes assignments of such contracts and meets other qualifying standards.

The tax benefits and regulations related to caring for someone are complicated. If you are a caregiver and would like to discuss your situation and options further, please call our office.

 

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Renting Your Home or 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 Fewer than 15 Days – If you rent your home for fewer than 15 days during the tax year, the tax code says that you do not need to report the income and that 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 fewer 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 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.

 

Even though the income is tax-free, the property tax and interest for the period is still deductible, directly related rental expenses such as agent fees, utilities, post-rental cleaning, etc. are not deductible.  

• 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 – In this scenario, no rental tax loss is allowed. Let’s assume that the personal use of the home is 20%. As for the remaining 80%, it is used as a rental. The rental income is first reduced by 80% of the taxes and interest; if, after deducting the interest and taxes, there is still a profit, the direct rental expenses (such as the rental portion of the utilities, insurance and any other direct rental expenses) are deducted, but not more than will offset the remaining income. If there is still a profit, you can take depreciation, but it is again limited to the remaining profit. End result: No loss is allowed, but any remaining profit is taxable. The other personal 20% of the interest and taxes is deducted as an itemized deduction subject to mortgage interest and Alternative Minimum Tax (AMT) limitations. Take note that if the rental income becomes less than the business portion of the interest and taxes, the balance of the interest and taxes is still deductible as home mortgage interest and taxes
• Personal Use 10% or Fewer of the Rental Days – In this scenario, the home’s use would be allocated into two separate activities, a rental and a second home. Let’s say that the home is used 5% for personal use: 5% of the interest and taxes are treated as home interest and taxes that can be deducted as an itemized deduction. The other 95% of the interest and taxes are rental expenses, combined with 95% of the insurance, utilities, and allowable depreciation and 100% of the direct rental expenses. The result is a deductible tax loss, which is combined with all other rental activities and limited to a $25,000 loss per year for taxpayers with adjusted gross incomes (AGI) of $100,000 or less. This loss allowance is ratably phased out between $100,000 and $150,000 of AGI. Thus, if your income exceeds $150,000, the loss cannot be deducted; it is carried forward until the home is sold or there are gains from other activities that can be used to offset the loss.

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

Word of Caution – Beginning in 2013, passive rental income is subject to the new 3.8% tax on net investment income that is part of the Affordable Care Act (“Obamacare”). So if the net result from renting the home is a profit, in addition to being subject to regular tax, the profit will also be subject to the net investment income tax. The gain from the sale of your primary home (in excess of the allowable home gain exclusion) and the gain from the sale of your second home (even if you never had rental income from it) are also subject to the 3.8% tax on net investment income in addition to the capital gains tax.

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 call our office.

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Documenting Charitable Contributions

A frequently asked question is, “What records are required for charitable contributions?” In recent years, Congress has passed stringent recordkeeping rules for charitable contributions as well as harsh penalties for understating taxable income. The following is a summary of the recordkeeping rules currently in effect for a variety of contribution types. This list is not all-inclusive, so if you don’t see rules that apply to your particular situation, please give our office a call.

Cash Contributions — Cash contributions include those paid by cash, check, electronic funds transfer, or credit card (see special requirements for payroll cash contributions). You cannot deduct a cash contribution, regardless of the amount, unless you can document the contribution in one of the following ways.

1. A bank record that shows the name of the qualified organization, the date of the contribution, and the amount of the contribution. Bank records may include:
   1. A canceled check,
   2. A bank or credit union statement, or
   3. A credit card statement.
2. A receipt (or a letter or other written communication) from the qualified organization showing the name of the organization, the date of the contribution, and the amount of the contribution.

As a result, if you drop cash into a church collection plate each week at a worship service, you cannot legally deduct that donation on your tax return. The same goes for dropping a cash donation into the Christmas kettle. Instead, you should write a check to the charitable organization of your choice and put the check into the collection plate, or make other arrangements with the organization for giving your tax-deductible contribution to ensure that a bank record, receipt, or letter is provided.

Payroll Contributions — For contributions made by payroll deduction, you must keep:

1. A pay stub, W-2 form, or other document provided by your employer that shows the date and amount of the contribution, and
2. A pledge card or other document prepared by or for the organization to which you are donating that shows the name of this organization. If the employer withheld $250 or more from a single paycheck, the pledge card or other document must state that the organization does not provide goods or services in return for any contribution made to it by payroll deduction. A single pledge card may be kept for all contributions made by payroll deduction, regardless of the amount, as long as it contains all of the required information.

If the pay stub, W-2 form, pledge card, or other document does not show the date of the contribution, you must also have another document that does show the date of the contribution. If the pay stub, W-2 form, pledge card, or other document does show the date of the contribution, you need not keep any other records except those described.

Non-Cash Contributions

Non-cash contributions include the donation of property, such as used clothing or furniture, to a qualified charitable organization.

Deductions of Less than $250 — If you claim a non-cash contribution of less than $250, you must get and keep a receipt from the charitable organization showing:

1. The name of the charitable organization,
2. The date and location of the charitable contribution, and
3. A reasonably detailed description of the property that was donated.

You are not required to have a receipt if it is impractical to get one (for example, if the property was left at a charity’s unattended drop site). However, you still must document the contribution as described above.

Deductions of at Least $250 but Not More than $500 — If you claim a deduction of at least $250 but not more than $500 for a non-cash charitable contribution, you must have and keep an acknowledgment of the contribution from the qualified organization. If the contributions were made in more than one donation of $250 or more, you must have either a separate acknowledgment for each or one acknowledgment that shows the total contribution. The acknowledgment(s) must be written and should include the following:

1. The name of the charitable organization,
2. The date and location of the charitable contribution,
3. A reasonably detailed description (but not necessarily the value) of any property contributed,
4. Whether or not the qualified organization gave you any goods or services as a result of the contribution (other than certain token items and membership benefits), and
5. If goods and/or services were provided to you, the acknowledgement must include a description and good faith estimate of the value of those goods or services. If the only benefit received was an intangible religious benefit (such as admission to a religious ceremony) that generally is not sold in a commercial transaction outside the donative context, the acknowledgment must say so and does not need to describe or estimate the value of the benefit.

Deductions of over $500 but Not over $5,000 — If you claim a deduction of over $500 but not over $5,000 for a non-cash charitable contribution, you must get and keep the same acknowledgement and written records as for contributions of at least $250 but not more than $500 (as described above).

In addition, the records must also include:

1. How the property was obtained (for example, by purchase, gift, bequest, inheritance, or exchange).
2. The approximate date the property was obtained or, if you created, produced, or manufactured the item, the approximate date the property was substantially completed.
3. The cost or other basis, and any adjustments to the basis, of property held for less than 12 months and, if available, the cost or other basis of property held for 12 months or more. This requirement, however, does not apply to publicly-traded securities. If you are not able to provide information on either the date the property was obtained or the cost basis of the property, and there is reasonable cause for not being able to provide this information, a statement of explanation must be attached to the return.

Deductions over $5,000 — Because of special rules related to contributions over $5,000, please call this office for documentation requirements of the particular contribution before making the contribution.

Out-of-Pocket Expenses — If you render services to a qualified organization and have unreimbursed out-of-pocket expenses related to those services, the following three rules apply.

1. You must have adequate records to prove the amount of the expenses.
2. You must get an acknowledgment from the qualified organization that contains:
   1. A description of the services provided,
   2. A statement of whether or not the organization provided you with any goods or services to reimburse you for the expenses incurred,
   3. A description and good faith estimate of the value of any goods or services (other than intangible religious benefits) provided as reimbursement, and
   4. A statement that the only benefit received was an intangible religious benefit, if that was the case. The acknowledgment does not need to describe or estimate the value of an intangible religious benefit.
3. The acknowledgement must be obtained before the earlier of the following:
1. The date of filing the return for the year in which the contribution was made, or
2. The due date, including extensions, for the return.

Car Expenses — When you claim expenses directly related to the use of your car to provide services to a qualified organization, you must keep reliable written records. Whether the records are considered reliable depends on the facts and circumstances. Generally, your records will likely be considered reliable if made regularly and/or near the time the expense was incurred. The records must show the name of the organization being served and the date each time the car was used for a charitable purpose. If the standard mileage rate of 14 cents per mile is used, the records must show the miles driven for the charitable purpose.

If you deduct actual expenses, the records must show the costs of operating the car that are directly related to a charitable purpose. General repairs and maintenance expenses, depreciation, registration fees, or the costs of tires or insurance cannot be deducted.

Vehicle Donations — When the deduction claimed for a donated vehicle exceeds $500, IRS Form 1098-C (or another statement containing the same information as Form 1098-C) furnished by the charitable organization must be attached to your filed tax return. Without the 1098-C or other statement, no deduction is allowed. When the charity sells the vehicle, Form 1098-C (or other statement) must be obtained within 30 days of the sale of the vehicle.

CAUTION: With the exception of vehicle contributions, charitable gift acknowledgements must be obtained before the earlier of the following:

1. The date on which your return was filed for the year in which you made the contribution, or
2. The due date, including extensions, for filing the return.

If you have questions regarding charitable recordkeeping or what is deductible as a charitable contribution, please give our office a call.

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Turning 70½ This Year?

If you are turning 70½ this year, you may face a number of special tax issues. Not addressing these issues properly could result in significant penalties and filing hassles.

• Traditional IRA Contributions – You cannot make a traditional IRA contribution in the year you reach the age of 70½. Contributions made in the year you turn 70½ (and later years) are treated as excess contributions and are subject to a nondeductible 6% excise tax penalty for every year in which the excess contribution remains in the account. The penalty, which cannot exceed the value of the IRA account, is calculated on the excess contributed and on any interest it may have earned.

You can avoid the penalty by removing the excess and the interest earned on the excess from the IRA prior to April 15 of the subsequent year and including the interest earned on the excess in your taxable income.

Even though you can no longer make contributions to a traditional IRA in the year you reach age 70½, you can continue to make contributions to a Roth IRA, not to exceed the annual IRA contribution limits, provided you still have earned income, such as wages or self-employment income, at least equal to the amount of the contribution.

• Required Minimum Distributions (RMD) – You must begin taking required minimum distributions from your qualified retirement plans and IRA accounts in the year you turn 70½. The distribution for the year in which you turned 70½ can be delayed to the subsequent year without penalty, if the distribution is made before April 1 of the subsequent year. That means in the subsequent year two distributions must be made, the delayed distribution and the distribution for that year.

• Still Working Exception – If you participate in a qualified employer plan, generally you need to start taking required minimum distributions (RMDs) by April 1 of the year following the year you turn 70½. This is your required beginning date (RBD) for retirement distributions. However, if your plan includes the “still working exception,” your RBD is postponed to April 1 of the year following the year you retire.

Example: You reached age 70½ in 2011, but chose to continue working and did not retire until June of 2013. Provided your employer’s plan includes the option, you can make the “still working election” and delay your RBD until no later than April 1, 2014.

Caution: This exception does not apply to an employee who owns more than 5% of the company. There is no “still working exception” for IRAs, Simple IRAs, or SEP IRAs.

• Excess Accumulation Penalty – When you fail to take a RMD, you are subject to a draconian penalty called the excess accumulation penalty. This penalty is a 50% excise tax of the amount (RMD) that should have been distributed for the year.

Example: Your RMD for the year is $35,000 but you only take $10,000. Your excess accumulation penalty for failing to take the full amount of the distribution for the year would be $12,500 (50% of $25,000).

The IRS will generally wave the penalty for non-willful failures to take your RMD, provided you have a valid excuse and the under-distribution is corrected.

As you can see, turning 70½ can complicate your tax situation. If you need assistance with any of the issues discussed here, or need assistance computing your RMD for the year, please give our office a call.

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Mid-Year Tax Planning Checklist

All too often, taxpayers wait until after the close of the tax year to worry about their taxes, missing opportunities that could reduce their tax liability or help them financially. Fall is the perfect time for tax planning. The following are some events that can affect your tax return; you may need to take steps to mitigate their impact and thus avoid unpleasant surprises after it is too late to address them.

• Did you get married, divorced, or become widowed?
• Did you change jobs or has your spouse started working?
• Did you have a substantial increase or decrease in income?
• Did you have a substantial gain from the sale of stocks or bonds?
• Did you buy or sell a rental?
• Did you start, acquire, or sell a business?
• Did you buy or sell a home?
• Did you retire this year?
• Are you on track to withdraw the required amount from your IRA (age 70.5 or older)?
• Did you refinance your home or take out a second home mortgage this year?
• Were you the beneficiary of an inheritance this year?
• Did you have a child? Time to start a tax-advantaged savings plan!
• Are you taking advantage of tax-advantaged retirement savings?
• Have you made any significant equipment purchases for your business?
• Are your cash and non-cash charitable contributions adequately documented?
• Are you keeping up with your estimated tax payments or do they need adjusting?
• Are you aware of and prepared for the new 3.8% surtax on net investment income?
• Did you make any unplanned withdrawals from an IRA or pension plan?
• Have you stayed abreast of every new tax law change?

If you anticipate or have already encountered any of the above events, it may be appropriate to consult with our office, preferably before the event, and definitely before the end of the year.

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Did Your 2012 Roth-Converted Account Decline in 2013?

If you converted your traditional IRA to a Roth IRA during 2012 and paid (or will pay) the tax on the conversion and then watched the value of the account decrease in 2013, you still have an opportunity to do something about it.

If you filed your return on time or are on extension, you automatically receive a 6-month extension from the return’s original due date to recharacterize the Roth account back to a Traditional account, thereby avoiding paying taxes on IRA values that have evaporated. Once you make the recharacterization, you must wait 30 days before reconverting the IRA back to a Roth.

However, the deadline for both completing your recharacterization and filing or amending your 2012 return is October 15. So if you have questions or wish to implement this strategy, you will need to call our office right away.

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Installment Sale – a Useful Tool to Minimize Taxes

Two new laws that take effect in 2013 can significantly impact the taxes owed from the sale of property that results in capital gains. They include:

Higher Capital Gains Rates – Starting in 2013, capital gains can be taxed at 0%, 15%, or 20% depending upon the taxpayer’s regular tax bracket for the year. Therefore, if your regular tax bracket is 15% or less, the capital gains rate is zero. If your regular tax bracket is 25% to 35%, then the top capital gains rate is 15%. However, if your regular tax bracket is 39.6%, the capital gains rate is 20%.

Unearned Income Medicare Contribution Tax – This new tax is sometimes referred to as the “surtax on net investment income,” which more aptly describes this 3.8% tax on net investment income. Capital gains (other than those derived from a trade or business) are considered investment income for purposes of this tax. For individuals, the surtax is 3.8% of the lesser of (1) the taxpayer’s net investment income, or (2) the excess of the taxpayer’s modified adjusted gross income (MAGI) over the threshold amount for his or her filing status. The threshold amounts are:

• $125,000 for married taxpayers filing separately.
• $200,000 for taxpayers filing as single or head of household.
• $250,000 for married taxpayers filing jointly or as a surviving spouse.

Selling a property one has owned for a long period of time will frequently result in a large capital gain, and reporting all of the gain in one year will generally push the taxpayer’s income within the reach of these two new taxes.

This is where an installment sale could fend off these additional taxes by spreading the income over multiple years.

Here is how it works. If you sell your property for a reasonable down payment and carry the note on the property yourself, you only pay income taxes on the portion of the down payment (and any other principal payments received in the year of sale) that represents taxable gain. You can then collect interest on the note balance at rates near what a bank charges. To qualify as an installment sale, at least one payment must be received after the year in which the sale occurs.

Example: You own a lot for which you originally paid $10,000. You paid it off some time ago, leaving you with no outstanding mortgage on the lot. You sell the property for $300,000 with 20% down and carry a $240,000 first trust deed at 3% interest using the installment sale method. No additional payment is received in the year of sale. The sales costs are $9,000.

Computation of Gain

Sale Price     $300,000

Cost          < $10,000>

Sales costs < $9,000>

Net Profit      $281,000

Profit % = $281,000/$300,000 = 93.67%

Of your $60,000 down payment, $9,000 went to pay the selling costs, leaving you with $51,000 cash. The 20% down payment is 93.67% taxable, making $56,202 ($60,000 x .9367) taxable the first year. The amount of principal received and reported each subsequent year will be based upon the terms of the installment agreement. In addition, the interest payments on the note are taxable and also subject to the investment surtax.

Here are some additional considerations when contemplating an installment sale.

Existing mortgages – If the property you are considering selling is currently mortgaged, that mortgage would need to be paid off during the sale. Even if you do not have the financial resources available to pay off the existing loan, there might be ways to work out an installment sale by taking a secondary lending position or wrapping the existing loan into the new loan.

Tying up your funds – Tying up your funds into a mortgage may not fit your long-term financial plans, even though you might receive a higher return on your investment and potentially avoid a higher tax rate and the net investment income surtax. Shorter periods can be obtained by establishing a note due date that is shorter than the amortization period. For example, the note may be amortized over 30 years, which produces a lower payment for the buyer but becomes due and payable in five years. However, a large lump sum payment at the end of the 5 years could cause the higher tax rate and surtax to apply to the seller in that year – so close attention to the tax consequences needs to be considered in structuring the installment agreement.

Early payoff of the note – The buyer of your property may decide to pay off the installment note early, or sell the property, in which case your installment plan would be defeated and the balance of the taxable portion would be taxable in the year the note is paid off early or the property is sold, unless the new buyer assumes the note.

Tax law changes – Income from an installment sale is taxable under the laws in effect when the installment payments are received. If the tax laws are changed, the tax on the installment income could increase or decrease. Based on recent history, it would probably increase.

Installment sales do not always work in all situations. To determine if an installment sale will fit your particular needs and set of circumstances, please contact our office for assistance.

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Fast Write Off of Business Assets

Normally, when a business acquires an asset, it must be capitalized and depreciated over its useful life. However, tax law includes some provisions that allow the entire asset or some portion of it to be written in the first year it is placed in service, providing the opportunity for very large first-year write-offs. The following is a summary of those provisions.

Section 179 Expensing – Code Section 179 allows taxpayers to elect to treat the cost of Section 179 property as an expense deduction for the tax year in which the Section 179 property is placed in service, instead of having to capitalize the expense and recover the cost over several years. Generally, Section 179 property is acquired by purchase for use in the active conduct of a trade or business, and is generally tangible property to which accelerated cost recovery applies. The property must be used more than 50% for business.

The Sec 179 expense deduction was increased for tax years 2010 through 2013 so that a taxpayer can expense up to $500,000 of qualifying property, which includes machinery and equipment. For 2010 through 2013, the annual expensing limit is reduced by the cost of qualifying property that is placed into service during the year that exceeds a $2 million investment limit. The maximum Sec 179 deduction is scheduled to revert to $25,000 for qualifying property placed in service after 2013, and the investment limit cap will be $200,000.

Off-the-Shelf Computer Software – Off-the-shelf computer software placed in service 2003 through 2013 is property eligible for Sec 179 expensing.

Certain Real Property Can Also Be Expensed – Certain real property is also eligible for Sec 179 expensing. For property placed in service in any tax year beginning in 2010 through 2013, the up-to-$500,000 deduction of property expensed can include up to $250,000 of qualified real property (qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property).

Bonus Depreciation – For qualifying assets purchased and placed in service in 2012 and 2013, trades or businesses are allowed to depreciate an additional 50% of the cost of the assets.

Please call our office if you would like to discuss how these tax benefits apply to your business situation.

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“Flipping” Homes – A Reviving Trend in Real Estate

Prior to the recent economic downturn, flipping real estate was popular. With mortgage interest rates low and home prices at historical lows, flipping appears to be on the rise again. House flipping is, essentially, purchasing a house or property, improving it, and then selling it (presumably for a profit) in a short period of time. The key is to find a suitable fixer-upper that is priced under market for its location, fix it up, and resell it for more than it cost to buy, hold, fix up and resell it.

If you are contemplating trying your hand at flipping, keep in mind that you will have a silent partner, Uncle Sam, who will be waiting to take his share of any profits in taxes. (And most likely, Sam’s cousin in your state capitol will also expect a share, too.) Taxes play a significant role in the overall transaction, and tax treatment can be quite different depending upon whether you are a dealer, an investor or a homeowner. The following is the tax treatment for each in years after 2012.

• Dealer in Real Estate – Gains received by a non-corporate taxpayer from business operations as a real estate dealer are taxed as ordinary income (10% to 39.6% ), and in addition, individual sole proprietors are subject to self-employment tax of 15.3% of their net profit (the equivalent of the FICA taxes for a self-employed person). Higher-income sole proprietors are also subject to an additional 0.9% Medicare surtax on their earnings. Thus, a dealer will generally pay significantly more tax on the profit than an investor. On the other hand, if the flip results in a loss, the dealer would be able to deduct the entire loss in the year of sale, which would generally reduce his tax at the same rates.

• Investor – Gains as an investor are subject to capital gains rates (maximum of 20%) if the property is held for more than a year (long-term). If held short-term, ordinary income rates (10% to 39.6%) will apply. An investor is not subject to the self-employment tax, but could be subject to the 3.8% surtax on net investment income for higher income taxpayers. A downside for the investor who has a loss from the transaction is that, after combining all long- and short-term capital gains and losses for the year, his deductible loss is limited to $3,000, with carryover to the next year of any excess capital loss. The rules get a bit more complicated if the investor rents out the property while trying to sell it, and are beyond the scope of this article.

• Homeowner – If the individual occupies the property as his primary residence while it is being fixed up, he would be treated as an investor with three major differences: (1) if he owns and occupies the property for two years and has not used a homeowner gain exclusion in the two years prior to closing the sale, he can exclude gain of up to $250,000 ($500,000 for a married couple), (2) if the transaction results in a loss, he will not be able to deduct the loss or even use it to offset gains from other sales, and (3) some fix-up costs may be deemed to be repairs rather than improvements, and repairs on one’s primary residence are not deductible nor includible as part of the cost basis of the home.

Being a homeowner is easily identifiable, but distinguishing between a dealer and an investor is not clearly defined by the tax code. A real estate dealer is a person who buys and sells real property with a view to the trading profits to be derived and whose operations are so extensive as to constitute a separate business. A person acquiring property strictly for investment, though disposing of investment assets at intermittent intervals, is generally not regularly engaged in dealing in real estate.

This issue has been debated in the tax courts frequently, and both the IRS and the courts have taken the following into consideration:

• whether the individual is already a dealer in real estate, such as a real estate sales person or broker;
• the number and frequency of sales (flips);
• whether the individual is more committed to another profession as opposed to fixing and selling real estate; and
• how much personal time is spent making improvements to the “flips” as opposed to another profession or employment.

The distinction between a dealer and an investor is truly based on the facts and circumstances of each case. Clearly, an individual who is not already in the real estate profession and flips one house is not a dealer. But one who flips five or more houses and/or property and has substantial profits would probably be considered a dealer. Everything in between becomes various shades of grey and the facts and circumstances of each case must be considered.

If you have additional questions or need assistance with your specific situation, please give our office a call.

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Higher Income Taxpayers Hit with Exemption & Itemized Deductions Phase-out

Generally, taxpayers are allowed to deduct personal exemptions of $3,900 for themselves, their spouses and their dependents. In addition, taxpayers are allowed a standard deduction or, if their deductions are large, they can itemize their deductions.

The American Taxpayer Relief Act of 2012 included a provision to phase out, beginning in 2013, both the personal exemptions and itemized deductions for higher income taxpayers. The phase-out will begin when a taxpayer’s adjusted gross income (AGI) reaches a phase-out threshold amount.

The threshold amounts are based on the taxpayers’ filing statuses and are: $250,000 for single filers, $275,000 for individuals filing as heads of households, $300,000 for married couples filing jointly and $150,000 for married individuals filing separately. Here is how the phase-out will work:

• Personal Exemption—The otherwise allowable exemption amounts are reduced by 2% for each $2,500 or part of $2,500 ($1,250 for a married taxpayer filing separately) that the taxpayer’s AGI exceeds the threshold amount for the taxpayer’s filing status.

Example: Ralph and Louise have an AGI of $412,500 for 2013 and two children for a total of four exemptions totaling $15,600 (4 × $3,900). The threshold for a married couple is $300,000; thus, their income exceeds the threshold by $112,500. Dividing $112,500 by $2,500 equals 45. So 90% (45 × 2%) of their $15,600 exemption allowance is phased out, leaving them with a reduced exemption deduction of $1,560 ((100–90) × $15,600). Assuming Ralph and Louise are in the 33% federal tax bracket, the phase-out costs them an additional $4,633 ($15,600 × 90% × 33%).

Divorced or separated parents subject to the phase-out should consider relinquishing the exemption of a dependent child to the other parent. Where a taxpayer is a party to a multiple support agreement, the taxpayer may want to allow another contributing member of the agreement who is not hit by the phase-out to claim the dependent’s exemption.

• Itemized Deductions—The total amount of itemized deductions is reduced by 3% of the amount by which the taxpayer’s AGI exceeds the threshold amount, with the reduction not to exceed 80% of the otherwise allowable itemized deductions.

Not all itemized deductions are subject to phase-out. The following deductions are not subject to the phase-out:

• Medical and dental expenses
• Investment interest expenses
• Casualty and theft losses from personal-use property
• Casualty and theft losses from income-producing property
• Gambling losses

Thus, a taxpayer who is subject to the full phase-out still gets to deduct 20% of the deductions subject to the phase-out and 100% of the deductions listed above.

Example: Ralph and Louise from the previous example, who had an AGI of $412,500 for 2013, exceed the threshold for a married couple by $112,500. Thus, they must reduce their itemized deductions subject to the phase-out by $3,375 (3% of $112,500), but the reduction must not exceed 80% of the deductions subject to the phase-out. For 2013, Ralph and Louise had the following itemized deductions:

                                             Subject to Phase-out                Not Subject to Phase-out

Home mortgage interest:                   $10,000
Taxes:                                                  $8,000
Charitable contributions:                     $6,000
Casualty loss:                                                                                           $12,000
Total:                                                 $24,000                                           $12,000

The phase-out is the lesser of $3,375 or 80% of $24,000. Thus Ralph and Louise’s itemized deductions for 2013 will be $32,625 ($24,000 $3,375 + $12,000). Assuming Ralph and Louise are in the 33% federal tax bracket, the phase-out will cost them an additional $1,114 ($3,375 × 33%).

Conventional thinking is to maximize deductions. However, where taxpayers normally are not subject to a phase-out and have a high-income year because of unusual income, it may be appropriate, where possible, to defer paying deductible expenses to the year following the high-income year or perhaps pay and deduct the expenses in the preceding year.

If you have questions about how these phase-outs will impact your specific situation, you want to adjust your withholding or estimated taxes, or you want to make a tax planning appointment, please give our office a call.

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Employing a Family Member

A way to reduce the overall family tax bill is by employing family members through your business, which allows you to shift income to them and provide them with employment benefits.

• Employing your Spouse. Reasonable wages paid to your spouse entitle you to a business deduction. Although the wages are subject to income and FICA taxes, your spouse may qualify for Social Security benefits to which he or she might not otherwise be entitled. In addition, your spouse may also be entitled to receive coverage under the qualified retirement and health plans of your business, allowing you to obtain business deductions for contributions to your spouse’s retirement nest egg and health insurance premium payments made on behalf of your employed spouse. While maintaining the same family medical care coverage, you increase your business deductions by providing your spouse with family health insurance coverage as an employee.

• Employing your child. By employing your child, the income tax advantages include obtaining a business deduction for a reasonable salary paid to that child, thus reducing your self-employment income and tax by shifting income to the child. Since the salary paid to your child is considered earned income, it is not subject to the “Kiddie Tax” rules that apply to children under the age of 19, as well as some older children. The maximum standard deduction available to your child in 2013 is $6,100 (up from $5,950 in 2012) if he or she has at least that amount of earned income. Therefore, the standard deduction eliminates all tax on this income if you pay your child $6,100 (2013) in compensation. If your business is unincorporated, wages paid to your child under age 18 are not subject to social security taxes. Not only are there significant income tax advantages to employing your child, you may also provide him or her with fringe benefits such as group-term life insurance and qualified pension plan contributions.

Your child may also make deductible contributions to an IRA of the lesser of earned income or the annual limitation. These contributions can offset earned and unearned income. As example, in 2013 your child could receive $11,600 gross income ($6,100 earned and $5,500 unearned) by combining the IRA deduction ($5,500) with the standard deduction ($6,100) and pay no tax. You should consider giving him or her part or all of the money needed to fund the IRA (as part of your $14,000/$28,000 annual exclusion for gifts) if your child does not want to use his or her earned income to fund an IRA contribution.

Please keep in mind that, when you employ a family member through your business, the wages should be reasonable for the work performed and that the services performed are necessary to the business. Please call our office for additional information.

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July 2013 Business Due Date Reminders

July 1 - Self-Employed Individuals with Pension Plans

If you have a pension or profit-sharing plan, you may need to file a Form 5500 or 5500-EZ for calendar year 2012. Even though the forms do not need to be filed until July 31, you should contact this office now to see if you have a filing requirement, and if you do, allow time to prepare the return.

July 15 - Non-Payroll Withholding

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

July 31 - Self-Employed Individuals with Pension Plans

If you have a pension or profit-sharing plan, this is the final due date for filing Form 5500 or 5500-EZ for calendar year 2012.

July 31 - Social Security, Medicare and Withheld Income Tax

File Form 941 for the second quarter of 2013. 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 August 12 to file the return.

July 31 - Certain Small Employers

Deposit any undeposited tax if your tax liability is $2,500 or more for 2013 but less than $2,500 for the second quarter.

July 31 - Federal Unemployment Tax

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

July 31 - All Employers

If you maintain an employee benefit plan, such as a pension, profit-sharing, or stock bonus plan, file Form 5500 or 5500-EZ for calendar year 2012. If you use a fiscal year as your plan year, file the form by the last day of the seventh month after the plan year ends.

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July 2013 Individual Due Date Reminders

July 1 - Time for a Mid-Year Tax Check Up

Time to review your 2013 year-to-date income and expenses to ensure estimated tax payments and withholding are adequate to avoid underpayment penalties.

July 10 - Report Tips to Employer

If you are an employee who works for tips and received more than $20 in tips during June, you are required to report them to your employer on IRS Form 4070 no later than July 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.

July 15 - Social Security, Medicare and Withheld Income Tax

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

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June 2013 Business Due Date Reminders

June 17 - Employer’s Monthly Deposit Due

If you are an employer and the monthly deposit rules apply, June 17 is the due date for you to make your deposit of Social Security, Medicare and withheld income tax for May 2013. This is also the due date for the non-payroll withholding deposit for May 2013 if the monthly deposit rule applies.

June 17 - Corporations

Deposit the second installment of estimated income tax for 2013 for calendar year corporations.

June 30 - Taxpayers with Foreign Financial Interests

A U.S. citizen or resident, or a person doing business in the United States, who has a financial interest in or signature or other authority over any foreign financial accounts (bank, securities or other types of financial accounts), in a foreign country, is required to file Form TD F 90-22.1 with the Department of the Treasury.  The form must be received by the Treasury Department by June 30, 2013 for 2012 (Caution: Unlike other forms that must be postmarked by the filing due date, this form must actually be in the Treasury Department’s offices by the due date.) This filing requirement applies only if the aggregate value of these financial accounts exceeds $10,000 at any time during 2012. Contact our office for additional information and assistance preparing the form.

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June 2013 Individual Due Date Reminders

June 17 - Estimated Tax Payment Due

It’s time to make your second quarter estimated tax installment payment for the 2013 tax year. 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.

June 17 - Taxpayers Living Abroad

If you are a U.S. citizen or resident alien living and working (or on military duty) outside the United States and Puerto Rico, June 17 is the filing due date for your 2012 income tax return and to pay any tax due. If your return has not been completed and you need additional time to file your return, file Form 4868 to obtain 4 additional months to file. Then, file Form 1040 by October 15. However, if you are a participant in a combat zone, you may be able to further extend the filing deadline (see below).

Caution: This is not an extension of time to pay your tax liability, only an extension to file the return. If you expect to owe, estimate how much and include your payment with the extension. If you owe taxes when you do file your extended tax return, you will be liable for both the late payment penalty and interest from the due date.

Combat Zone - For military taxpayers in a combat zone/qualified hazardous duty area, the deadlines for taking actions with the IRS are extended. This also applies to service members involved in contingency operations, such as Operation Iraqi Freedom or Enduring Freedom. The extension is for 180 consecutive days after the later of:

• The last day a military taxpayer was in a combat zone/qualified hazardous duty area or served in a qualifying contingency operation, or have qualifying service outside of the combat zone/qualified hazardous duty area (or the last day the area qualifies as a combat zone or qualified hazardous duty area), or
• The last day of any continuous qualified hospitalization for injury from service in the combat zone/qualified hazardous duty area or contingency operation, or while performing qualifying service outside of the combat zone/qualified hazardous duty area.

In addition to the 180 days, the deadline is also extended by the number of days that were left for the individual to take an action with the IRS when they entered a combat zone/qualified hazardous duty area or began serving in a contingency operation.

It is not a good idea to delay filing your return because you owe taxes. The late filing penalty is 5% per month (maximum 25%) and can be a substantial penalty. It is generally better practice to file the return without payment and avoid the late filing penalty. We can also establish an installment agreement which allows you to pay your taxes over a period of up to 72 months.

Please contact our office for assistance with an extension request or an installment agreement.

June 30 - Taxpayers with Foreign Financial Interests

A U.S. citizen or resident, or a person doing business in the United States, who has a financial interest in or signature or other authority over any foreign financial accounts (bank, securities or other types of financial accounts), in a foreign country, is required to file Form TD F 90-22.1 with the Department of the Treasury.  The form must be received by the Treasury Department by June 30, 2013 for 2012 (Caution: Unlike other forms that must be postmarked by the filing due date, this form must actually be in the Treasury Department’s offices by the due date.) This filing requirement applies only if the aggregate value of these financial accounts exceeds $10,000 at any time during 2012. Contact our office for additional information and assistance preparing the form.

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