Author: Mark Minassian

Four year-end tax strategies

The end of the year is crunch time for tax planning. Donald Trump’s tax plan will bring about lower tax rates starting next year, but it will also likely result in the elimination of certain tax deductions. And although his tax plan will be passed sometime in 2017, many experts believe that the changes will be made retroactive to January 1, 2017.

With that in mind, here a four quick-hit tax strategies that may help you as 2016 comes to a close:

1.Prepay your real estate taxes.

This deduction is expected to disappear under Trump’s tax plan, so get the most out of this deduction that you can while it is still available in 2016.

2.Defer any income or bonuses to 2017

Not only does deferring income until January give you an extra year to pay those taxes, since the tax rates are coming down, deferring the income to next year will result in a lower amount of taxes you will owe on that income.

3. Put off selling appreciated stocks to 2017

Even though the tax rate on capital gains isn’t expected to change next year, Trump is expected to repeal the 3.8% Obamacare investment surtax. This tax is currently assessed if you have investment income (including capital gains) and your income is over $200,000 (single individuals) or $250,000 (married couples).

4. Convert your traditional IRA to a Roth IRA next year

Converting a traditional IRA to a Roth IRA is a taxable event and if you hold off on the conversion until 2017 when the tax rates are lower, you will owe less taxes on the conversion.

Deferring income and accelerating deductions is a tried-and-true tax strategy, and it is even more important now with lower tax rates coming next year. And even though we don’t know the exact timing of when the tax cuts will take place, we do know that they are coming, and a little planning now can save you “bigly” on your tax bills for both this year and next year.

Oxfam International has released its list of the world’s worst corporate tax havens. These are countries that offer sweetheart deals and rock-bottom corporate tax rates to lure businesses to their jurisdictions.

Here are the worst offenders according to Oxlam:

1. Bermuda
2. Cayman Islands
3. Netherlands
4. Switzerland
5. Singapore
6. Ireland
7. Luxembourg
8. Curacao
9. Hong Kong
10. Cyprus
11. Bahamas
12. Jersey
13. Barbados
14. Mauritius
15. British Virgin Islands

What happens now?

Now that Donald Trump has won the Presidency and the Republicans have control of both the House and Senate, tax reform will be coming. The last major reform of the tax code was in 1986 under Ronald Reagan. Donald Trump has made tax reform a priority and he and Congress will tackle this during his first 100 days in office.

The House Republicans released a tax plan this past summer. It is more aggressive than Trump’s plan in some areas, but it also pulls back on some areas that Trump wants to change. But Trump and Congressional Republicans are in agreement that there will be tax reform for both individuals and businesses.

Individuals

The individual tax rates will be compressed to three brackets: 12%, 25% and 33%. These are higher than the 10%, 20% and 25% rates Trump originally proposed. He plans to eliminate the 0.9% and 3.8% Obamacare surtaxes too. He also wants to repeal both the estate tax and the alternative minimum tax (AMT), and House Republicans are on board with this.

Trump also plans to get rid of the Head of Household filing status and the personal exemption. This has garnered some press lately, as these two items provide tax relief for single parents. To compensate, Trump plans on raising the standard deduction to $15,000 for singles and $30,000 for married couples, as well as increasing the child tax credit and allowing deductions for childcare expenses.

Congressional budget rules dictate that any tax cuts must be offset in other tax areas. With Trump’s tax plan, the tax cuts will be offset by the elimination of various long-standing tax deductions, including the deductions for medical expenses, state and local income taxes, real estate taxes and most miscellaneous itemized deductions such as employee business expenses and investment expenses. The Holy Grails of tax deductions – mortgage interest and charitable contributions – will remain.

Trump has said that he wants to repeal and replace Obamacare, but he has also said there are certain elements of it he wants to keep. Whatever happens, it does appear that any change will be transitioned in and may pose a problem if Congress eliminates the surtaxes used to pay for the program.

Businesses

Trump’s tax plan for corporate tax reform is more aggressive than what House Republicans would like to see. Trump wants to lower the top corporate tax rate from 35% to 15%, and he wants the 15% rate to apply to LLCs, S-Corporations and self-employed individuals. The House GOP plan calls for the top corporate tax rate to be 20% and the rate for LLCs, S-Corporations and self-employed individuals to be 25%.

To pay for the business tax cuts, certain business deductions will be eliminated as well as levying a one-time tax between 8.75% and 14% on previously untaxed income held overseas by U.S. multinational corporations. This tax will then allow these companies to bring that money back to the United States without paying tax a second time.

When will all this happen?

The Democratic lawmakers will fight these changes hard. They are concerned about tax cuts for the wealthy as well as the lost revenue from the cuts, which is estimated to be $6 trillion over the next ten years.

Tax reform of this magnitude usually takes some time to implement, so it could be up to a year before these changes take effect. One things bears watching though: The Republicans don’t have enough votes to stop a Democratic filibuster in the Senate, so the tax changes will most likely get passed under the budget reconciliation rules, which only require a simple majority in the Senate to pass and not a 60-vote supermajority. Using budget reconciliation to pass tax cuts isn’t impossible – it has been used 20 times since 1980, including twice for the Bush tax cuts in 2001 and 2003 and in 2010 to pass the Affordable Care Act – but it can be tricky.

There is no doubt that tax changes will be coming, it is just a matter of when and not if.

There were tax initiatives on a number of state ballots this past election. The winners included  tax increases for high-income individuals in Maine and California, and soda taxes in four cities (San Francisco, Oakland, Albany, CA and Boulder, CO). Rejected initiatives included a corporate tax hike for large companies in Oregon and a carbon emissions tax in Washington.

It is time to pay serious attention to the candidates’ tax plans.

With the election two weeks away, it is time to really pay attention to the tax plans of both Hillary Clinton and Donald Trump. The winner will have a hand in shaping tax policy for at least the next four years, and their plans are total opposites of each other.

Hillary Clinton’s tax plan

Clinton has made her tax plan objectives clear from day one: tax the wealthy to ensure they are paying their fair share of taxes. Her tax plan will:

– Add a 4% surcharge on individuals earning over $5 million.

– Enact the “Buffet Rule” and establish a 30% minimum tax on individuals with incomes over $1 million

– Limit itemized deductions (primarily state taxes, real estate taxes, mortgage interest and charitable contributions) to 28% of income

– Implement a tiered tax structure on capital gains depending on the length of time the asset is held, with the tax rate ranging from 20% for assets held more than six years to 39.6% for assets held more than one year

– Increase the estate tax rate to 45% and lower the estate tax exemption to $3.5 million

Clinton wants to raise taxes on the wealthy and create more spending programs such as debt-free college and investments in infrastructure. And while her plan will raise revenues by approximately $500 million over the next ten years, many economists fear that the higher taxes will have a negative economic impact – specifically a slowdown in GDP, lower wages and fewer jobs.

I have a few issues with Clinton’s tax plan:

  1. Her tax plan will not provide any significant relief for the middle class (and the fact that she does not want to raise taxes on the middle class does not equate to tax relief). Her primary form of relief is an expanded child tax credit, which will not provide much benefit to the middle class and will not help taxpayers without young children.
  1. I think the tiered capital gains tax rates will be a disaster (one of Trump’s favorite words). Massachusetts did this exact same thing from 1998-2002 and the state Supreme Court ruled that the tiered structure was unconstitutional. The whole point of providing a lower tax rate on capital gains is to spur individuals to make investments, but this tiered structure will take away much of that incentive and may also lead to a slowdown in the real estate market.
  1. Clinton has pointed out many times in her speeches and debates that when Bill Clinton was in office, he raised taxes and the economy flourished. This talking point ignores two major factors: 1) the internet and technology sectors absolutely boomed during those years and that growth was the primary driver of the economic expansion; and 2) Bill Clinton actually signed into law significant tax cuts in 1997, many of which are still in play today (annual increases of the estate tax exclusion, the home sale exclusion and lower tax rates on capital gains).

Donald Trump’s tax plan

Like Clinton’s tax plan, Trump’s tax concept is also straightforward, just in the total opposite direction. He wants to cut taxes all across the board. His plan will:

– Establish three tax rate: 12%, 25% and 33% with the 33% rate starting at $225,000 of income for married couples ($112,000 for single individuals)

– Repeal the Alternative Minimum Tax (AMT), the estate tax and the Obamacare surtaxes

– Lower the top business tax rate to 15% for corporations and self-employed individuals

– Increase the standard deduction to $15,000 (singles) and $30,000 (married couples)

– Eliminate personal exemptions

– Cap itemized deductions at $100,000 for single filers and at $200,000 for married couples

Trump’s tax plan will reduce taxes for everyone, but it comes at a price. Federal revenue will decrease by $4 trillion over the next decade, so unless spending cuts are enacted to offset the decrease in revenue, the national debt will almost double. Trump said in the last debate that his tax plan will not increase the national debt, but he hasn’t said exactly how he will accomplish that.

I also have issues with Trump’s tax plan:

  1. While most people want to pay less in taxes, lowering the tax rate is only one part of the equation. Trump hasn’t really detailed his spending cuts (“believe me” does not qualify as a detailed spending cut), and he has in fact said that he wants to increase spending in areas such as military and defense. It is classic deficit spending. Our national debt right now is at $18 trillion. The thought of that potentially going up to $30+ trillion is beyond scary.
  1. Trump subscribes to the trickle-down economic theory that lowering taxes all around (especially at the corporate level) will jump start the economy and increase wages, jobs and GDP. This works if companies use the money they save to increase economic output and create more jobs domestically, but it has had mixed results over the last century (it all depends on who you ask). Trump wants to go all-in with this.
  1. By eliminating the estate tax, Trump will probably have to also eliminate one of the most cherished tax benefits: the basis step-up. Currently, if you inherit an asset that has appreciated in value (such as real estate), you inherit that asset at its fair market value at death. You can the sell the asset without incurring any tax. That tax benefit will most likely disappear when the estate tax is repealed.

Health insurance reform

No matter who wins the presidency, there will be changes to Obamacare.

Clinton said that Obamacare needs to be tweaked. Her proposals will offer increased tax credits to people who buy health insurance through an exchange and will also provide tax credits to individuals and families to help offset soaring out-of-pocket costs and deductibles. She would also expand the tax credits for small businesses that offer health coverage to their employees.

Trump wants to scrap Obamacare altogether and start over, relying on current Republican ideas such as allowing all taxpayers to deduct the health insurance premiums they pay regardless of income level and allowing insurance companies to compete across state lines. He would also incentivize more people to utilize Health Savings Accounts (HSAs).

What to make of all this

The two tax plans really speak to the overall philosophical differences in our tax structure. Do you favor higher taxes, redistribution of wealth and more spending on government programs? Or do you favor lower taxes with the hope that the money saved will lead to a more robust economy with more jobs and higher wages?

As with any candidate’s tax plan, what is presented will be adjusted and compromised. A lot of what will be implemented will also depend on the makeup of Congress. While a lot of attention has been given to the candidates’ personal issues, their tax plans will implement significant changes that will have lasting effects beyond the next four years. But the only thing we know for certain is that when we wake up on November 9th, we will still be paying taxes.

If you are one of the millions of people who have received fake calls from IRS imposters saying you owe back taxes, there is some good news. Police in India raided and shut down nine call centers in Mumbai where 770 employees were working. 70 individuals were arrested in the midnight raid and charged with fraud. Since the raid, complaints about this scam to the Better Business Bureau Scam Tracker have decreased by 95%.

What can we learn from Donald Trump’s tax returns?

There has been considerable controversy surrounding Donald Trump’s refusal to release his tax returns. He has provided his reasons for not doing so and it does not appear that he will be releasing them any time soon. While Trump not releasing his tax returns can bring about speculation of what is contained in those returns, there are a lot of misconceptions about what types of information his returns will show. There is no question that Trump’s tax returns will disclose significant financial information, but they won’t tell us everything.

What we will be able to learn from his tax returns:

  • His income. This is the most obvious information that his returns will show us, and they will disclose his income from all sources – salaries, interest, dividends, capital gains and the income from his more than 500 businesses. But this is, ironically, probably the least interesting information. We all know he is wealthy. Seeing how much income Donald Trump earns is probably less interesting than seeing how much income your next door neighbor earns. Trump has income from rentals, real estate sales, real estate development and real estate management among other entities. For someone like Trump, his income can vary greatly between years and I personally would be more interested in seeing how his income shifts from year-to-year rather than seeing a snapshot of income from one year. In some years, he may actually have no income since the majority of his income comes from his business entities and most of these businesses are passthrough entities, meaning the income (or losses) from these entities are reported directly on his tax returns. This also means that the losses can offset (and potentially exceed) the income.
  • How much he pays in income taxes. This is what most people really want to know. It has been documented that Trump has paid no (or minimal) taxes in prior years. As I wrote about in a prior post, the amount of taxes you pay has more to do with how you earn your income as opposed to how much income you earn. Individuals who earn the majority of their income through capital gains and real estate investments will pay taxes as a lower rate than those who earn the same amount of income through regular salaried jobs or self-employment. This is how our tax system is structured.
  • How much he donates to charity. The tax deduction for charitable contributions is one of this country’s most popular tax deductions, particularly for high-income individuals. We will be able to see how much he donated to charity in a given year and we may also be able to see the charitable organizations that he donated to depending upon the level of detail disclosed in his returns.
  • If he has bank or investment accounts outside of the United States. Any U.S. Citizen or Permanent Resident who has a bank or investment account outside of the U.S. with more than $10,000 in it must report that account to the Treasury Department.
  • How much he pays in taxes to foreign countries. Anyone who pays taxes to foreign countries can generally claim those taxes paid as either a deduction or credit on their U.S. tax return. However, these amounts are usually aggregated, so if he pays taxes to multiple foreign countries, the specific countries may not be individually listed.
  • If he has DIRECT investments in foreign corporations or partnerships. If he has personal direct investments in foreign partnerships or corporations, those are required to be disclosed on his returns. However, if he is invested in foreign business entities through one of his U.S. businesses (which is most likely the case), those investments would not be disclosed on his personal tax return. They would be disclosed on his business returns.
  • Where his money is invested. While individuals are not required to list their investment holdings on their tax returns, if he sold stocks or other investments, those would be reported on his return. Also, Trump’s money is professionally managed and most money managers for wealthy individuals will invest their clients’ money in complex hedge and/or private equity funds. Many of these funds must disclose information about foreign investments held in the fund.

What we won’t be able to learn from his tax returns:

  • His net worth. The tax return will not show the value of Trump’s assets. In fact, the only time where an individual is generally required to disclose asset values or account balances on their personal tax return is when foreign financial assets have to be reported. In addition, Trump’s net worth comes from multiple layers – the value of his business interests, the value of his real estate, the value of his personal brand, etc. It is very difficult to accurately determine his net worth.
  • His debts. The returns do not disclose debt balances or amounts owed to creditors. While many people would like to know if he owes money to Vladimir Putin or if Russian businesses financed the construction of Trump Soho, his tax returns won’t show that information. Most of his debts are owed through his business entities and those debts would appear on those tax returns.
  • His foreign real estate holdings. Although he is required to disclose his foreign bank/stock accounts, he is not required to disclose his foreign real estate holdings. Foreign real estate is specifically excluded from the list of foreign assets that must be disclosed by U.S. taxpayers.
  • INDIRECT investments in foreign businesses. As noted above, most of his international investments are held through his U.S. business entities, the details of which would not appear on his personal tax returns.
  • Details about the income and expenses from his businesses. The net income or losses from his passthrough businesses are reported on his individual tax returns. However, the details of the income from those businesses are reported on the tax returns for those entities. And since almost all of those business are partnerships (even where Trump is a 99% partner), the details are disclosed on the separately filed partnership tax returns.

Tax returns are one part of the puzzle in determining an individual’s overall financial picture and there is no question that Trump’s tax returns are complex and contain a lot of moving parts. His financial disclosure report filed with the United States Office of Government Ethics provides a better picture of his overall net worth and business holdings. In the meantime, we can wait for the Warren Buffet-Donald Trump tax return showdown (which will surely be broadcast in an hour-long, prime-time television special).

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The website taxhistory.org has copies of tax returns for past presidents and presidential candidates going back a number of years. In browsing through many of the returns, here are two  interesting things I noticed:

  1. The Clinton’s income jumped from $357,026 in 2000 (Bill’s last year in office) to $15.9 million in 2001. This is not unusual as former presidents make a lot of money on the lecture circuit. What I did find astounding is that even though the Clintons used a large Maryland CPA firm to prepare their taxes, there was absolutely no tax planning done. The Clintons had to write a check to the IRS for $5.9 million when they filed their 2001 tax return.
  2. Sarah Palin, while governor of Alaska in 2006 and 2007, used H&R Block to prepare her tax returns.

 

Tax Issues for Divorcing Couples

There are tax implications in almost every monetary transaction in a divorce. Whether you are going through a divorce yourself, helping a friend or family member go through a divorce or advising a client through a divorce, it is important to understand how these tax implications will affect the division of assets and future payments. This article will focus on some of the most important tax issues that spouses should be aware of during divorce proceedings.

  1. Know your tax filing status – Your tax filing status for the entire year is determined by your marital status on December 31 of the year. In the year your divorce is finalized, your filing status for the entire year will either be Single or Head of Household.

  2. What is Head of Household Status? – An individual who has custody of a child following a divorce will often qualify for Head of Household (HOH) filing status. To qualify for HOH status, a spouse must:

    • Be unmarried as of December 31st of the year.
    • Maintain a home for at least one unmarried child (or qualifying relative) for at least half of the year, and the home must be the child’s/relative’s principal residence.
    • Pay more than half the cost of maintaining the home.

    There are two important factors to keep in mind regarding the above rules:

    • The qualification for paying more the half the cost of maintaining the home is not the same as paying more than half the cost of supporting the child. Costs for maintaining the home include such things as real estate taxes, mortgage payments, maintenance and providing food on the premises. Such costs, however, do not include direct support for the child such as education, clothing and medical expenses.
    • Often times divorce agreements stipulate that the ex-spouses may claim the child as a dependent for tax purposes every other year. A divorced spouse may claim HOH status even if they are not eligible to claim the dependency exemption in a given year as long as the HOH qualifications above are met.

  3. Understand how marital assets are divided – There are three ways that marital property is divided in a divorce: Alimony, child support and property settlements.

    • Alimony – Alimony is tax-deductible by the payor spouse and is included as income by the recipient spouse. The alimony amounts are deductible and included in income regardless of the income levels of each spouse.
    • Child support – Child support is not deductible nor included in income by either spouse.
    • Property settlement – The division of marital assets in a divorce is almost always tax-free to both parties.

  4. What payments qualify as alimony? – Alimony is a very common type of payment made between ex-spouses. There are some important things that must be kept in mind when dealing with alimony:

    • Whether payments constitute alimony or not are determined by the Internal Revenue Code. A payment may be called “alimony” in a settlement agreement, but if it doesn’t meet the tax code qualifications of alimony, the payments won’t be considered such.
    • The terms “spousal support” and “spousal maintenance” are sometimes used in lieu of the term alimony, but they mean the same thing.
    • Alimony amounts and duration of payments are controlled by state law, and the laws vary from one state to another.

    To qualify as alimony under the Internal Revenue Code, the payments must adhere to the following specifications:

    1. The payments must be made under a written agreement.
    2. The spouses must live in separate households.
    3. The payments must be made in cash or cash equivalent.
    4. The payments must be made to a former spouse or to a 3rd-party on behalf of the former spouse. If payments are made to a 3rd party, the former spouses must agree in writing to that effect.
    5. The separation agreement must not state that the payments are not considered alimony.
    6. The spouses may not file a joint tax return with each other for the year.
    7. The payments may not continue after the death of the payor spouse.

  5. Most marital assets can be divided tax-free between spouses – Section 1041 of the Internal Revenue Code (IRC) covers the transfer of assets between spouses in a divorce. IRC 1041 stipulates that marital assets in a divorce are to be divided tax-free to both parties and that if property is transferred after the divorce is finalized, such transfers will be tax-free if the property is transferred:

    • Within one year after the divorce is finalized, even if it is not specified in the divorce decree.
    • In years 2-6 after the divorce is finalized, but only if it is specified in the divorce decree.


  6. What should you do with your principal residence? – A couple’s house is often the most valuable marital asset, and there are monetary and non-monetary considerations involved (such as emotional attachment or keeping the house because of children). A divorce does not preclude a spouse from utilizing the home sale exclusion when the property is sold. The qualifications for excluding the gain on the sale of a personal residence can be found in my blog on the topic here.
  7. The division of a marital home usually takes the format of one of the following paths:

    1. The residence is sold during the divorce proceedings and the proceeds are distributed to the spouses.
    2. Ownership is transferred to one spouse while the other spouse receives other assets to balance the property settlement. One major issue here is that if there is an existing mortgage on the property, the non-owner spouse may demand that the other spouse refinance the mortgage in his or her own name. This may not always feasible for the spouse remaining in the home.
    3. Sale of the house is delayed until a future year or upon the occurrence of an event, such as the children graduating high school. In this situation the divorce agreement will stipulate how the property will be maintained and how the sale proceeds will be divided.
    4. The higher-income spouse moves out but pays all of the expenses of maintaining the home, and when the house is sold, the division of the sale proceeds is adjusted accordingly.

  8. Dividing retirement plans – Retirement plans are often some of the most valuable marital assets. And while such plans can usually be divided tax-free, certain procedures must be followed  to ensure a tax-free split of the asset.

    • For qualified retirement plans such as pensions, profit sharing plans or 401(k)/403(b) plans, such asset divisions must be specifically divided using a Qualified Domestic Relations Order (QDRO).
    • IRAs cannot be divided under a QDRO, but they can be divided tax-free under a divorce or separation agreement.

    CAUTION: Unlike a traditional or Roth IRA, the division of inherited IRA will most likely have severe tax consequences for the spouse who inherited the IRA. Spouses need to be very careful in structuring settlement agreements when inherited IRAs are involved.

  9. Transferring business interests – The transfer of an interest in a business (either stock or a partnership interest) between spouses will not normally trigger any taxable gain or loss to either party. However, tax considerations of a sale of the business by either party down the road should be taken into consideration when structuring a settlement agreement. Often times, a spouse who owns an interest in a business will have a buy/sell agreement in place among the company and fellow business partners. Such agreements should be reviewed for how the business interest is valued because the stated value of the business in a buy/sell agreements usually gets disputed during  divorce proceedings.

  10. State courts cannot control IRS tax matters – Divorce courts are state courts, and state courts have little or no authority in making orders concerning IRS tax matters. Some of the tax issues that a state court cannot legally compel either spouse to do include making one spouse pay all of the outstanding tax on a previously filed joint tax return or compel either spouse to file a return a certain way (i.e. jointly or separately) during divorce proceedings. However, although a state court has no jurisdiction over IRS tax matters, many settlement agreements contain directives relating to how spouse should file their federal tax returns and/or how federal tax liabilities should be paid. And not complying with the separation agreement can bring about many problems. Tax issues should be carefully examined and agreed to by both parties.

Spouses going through a divorce with significant assets should be represented by qualified legal counsel, and a qualified accountant with divorce experience should also be part of the team as they can tell you the tax consequences of dividing assets both during the divorce and in future years after the divorce is finalized. Divorces can be complicated and the tax implications of dividing marital assets need to be well thought out and planned for – another area of expertise for Minassian CPA.

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A lot of media attention has been given to John Oliver (and rightly so) for buying $15 million worth of old medical debt for pennies on the dollar, and then subsequently forgiving all of the debt.Under most circumstances, if you have a debt that has been forgiven, the amount of the forgiven debt is taxable income to you. This is known as Cancellation of Debt (or COD) income. However, there is a provision in the tax code (Section 108(e)(2)) that says if the debt that is forgiven would have given rise to a tax deduction when paid, then there is no COD income to an individual when the debt is forgiven. Since out-of-pocket medical expenses are allowed as a tax deduction, there is no COD income when medical debts are forgiven. And even though a taxpayer’s ability to actually deduct out-of-pocket medical expenses is severely limited based on income levels, the IRS is not taking that into consideration.

The tax consequences of selling your home

For most people, their home is their biggest asset. A law change in 1997 made it possible for most people to sell their home tax free. However, a law change in 2008 took away a favorite loophole for people who owned multiple homes or rental properties. While most home sales are relatively straightforward, you should pay close attention if you own multiple homes or have unique circumstances.

  • General rule when selling your personal residence – If you have lived in your house for at least two of the previous five years and the house is used as your primary residence, you can exclude up to $250,000 of the gain when you sell the house if you are single and up to $500,000 if you are married and file a joint tax return. Any gain above $250,000/$500,000 threshold will be taxed at the regular capital gains rate. You can use this exclusion any number of times over your lifetime as long as you occupy the house as your principal residence for at least two years and you haven’t used the exclusion in the past two years, but read below to understand how the 2008 law change put some restrictions on those who hop among multiple properties and use the exclusion.
  • If you claimed a home office deduction – If you claimed a home office deduction on your tax return in prior years, the home sale exclusion rules still apply. However, during the years you claimed the home office deduction, you should have claimed depreciation deductions for the portion of your house used as your home office. When you sell the house, you have to pay tax on the depreciation previously deducted (this is known as “depreciation recapture”). Even if you didn’t claim the depreciation in the years that you were supposed to, the IRS will still make you recapture that depreciation and pay the tax on it. Depreciation recapture is taxed at a rate of 25%.
  • If your convert your home to a rental property – If you have lived in your house as a primary residence for at least two years, you can convert the property to a rental property and rent it out for the next three years and then sell it while utilizing the $250,000/$500,000 home sale exclusion. You will only pay the tax on the depreciation deducted in years 3 through 5. This is a nice way to shelter the capital gain on the sale of the property while collecting rental income for a few years.

2008 law change – Closing the loophole

The law change in 2008 affects people who own vacation homes or rental properties. The old strategy was to sell your personal residence and then move into your rental property or vacation home and make that property your personal residence for two years, sell that property and claim the home sale exclusion again.

The new law dictates that the years of use after January 1, 2009 must be divided between qualified use and non-qualified use. In essence, if the property was used as a vacation home or rental property before you converted it to your primary residence, the vacation/rental years after January 1, 2009 are considered non-qualified years and the non-qualified percentage of the gain will not be eligible for the exclusion.

Example: You purchase a rental property January 1, 2009 and rent it out until December 31, 2013. On January 1, 2014 you move into the house and make it your personal residence until December 31, 2015 and you sell the property in 2016.

  • Old law – The entire gain would be able to be sheltered by the exclusion amount and you would only pay tax on the depreciation deducted when the home was a rental property between 2009 and 2013.
  • New law – The five years that the property was a rental (2009- 2013) would be considered non-qualified use. Therefore 71% (5 years of non-qualified use / 7 years of total ownership) of the gain on the sale would not be eligible for the exclusion and you would still have to pay tax on the depreciation deducted between 2009 and 2013. The result would be the same if the property was used as a vacation home and not as rental property.

Non-qualified use does not include years of use before January 1, 2009 or for any years after the home was used as a principal residence. If you use a home as your principal residence for two years and then rent it out for three years, you can still use the exclusion on 100% of the gain from the sale. You would just have to pay tax on the depreciation deducted in years 3 through 5. Non-qualified use does not included periods when an individual is away on qualified official extended duty (up to 10 years) or for temporary absences due to health or employment (up to two years).

Below are some other situations that may arise when selling your residence:

  • 1031 exchanges – Personal residences do not qualify for a 1031 tax-deferred exchange. A vacation home may qualify if it has been rented out at fair market value and you can show that it was primarily used as a rental property and not merely a second home that was occasionally rented out. If you acquire a rental property in a 1031 exchange and you wish to convert it to your primary residence, you must hold the property for at least five years after the exchange while using it as your primary residence for two of those five years if you wish to use the home sale exclusion when you sell it. However, you still need to calculate the years of non-qualified use after January 1, 2009.
  • You haven’t lived in your primary residence for two of the last five years when you sell – You still may be able to claim a reduced exclusion if the sale is due to change of employment of at least 50 miles away, health reasons or unforeseen circumstances including a natural disaster, unemployment or divorce.
  • You get married and you move into your spouse’s house – Married couples can excluded up to $500,000 of the gain if they file jointly and at least one of the spouses used the house as a primary residence for any two of the preceding five years.
  • You qualify for the exclusion but your gain is more than $250,000/$500,000 – In this scenario, the amount of gain over the exclusion will be taxed at the long-term capital gain rate of either 15% or 20% (depending on how much other income you have) plus your state tax rate for long-term capital gains.
  • You sell a partial interest in your house – The exclusion applies if you sell less than 100% of your primary residence, and if you sell the remaining interest in a subsequent year, you can use any of the remaining exclusion if there is any available.

Most home sales will qualify for the full exclusion, but care needs to be taken if you own multiple properties. After the sale is too late to plan, so make sure you speak to a qualified CPA with experience in real estate taxation before you sell to understand the tax consequences of selling your property.

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A growing number of companies are helping their employees pay off their student loans as a means to attract and retain talent. Currently, such assistance is considered a taxable fringe benefit to employees. There is currently a bill in Congress that would allow student loan payments made by an employer to be tax-free to the employee.  I am not sure if this will become a law anytime soon, but it will provide much needed relief to college graduates burdened by student-loan debt.

Explaining the Alternative Minimum Tax

The Alternative Minimum Tax (AMT) has become a thorn in the side for many taxpayers. What began as a tax imposed on wealthy taxpayers to make sure they were paying their fair share of taxes has now become a runaway train affecting millions of taxpayers it was never intended to hit. While the earliest type of minimum tax was enacted in 1969, the AMT as we know it now came into effect in 1982.

The sad truth is that if you earn over $150,000 (approximately), live in a high tax state, pay high real estate taxes and have children, you are almost guaranteed to be subject to the AMT, and you really can’t do anything about it. If you do not deduct your state taxes and real estate taxes, you can probably avoid the AMT, but your regular tax liability will be higher and the net result will be the same. Rather than explain all of the components of the AMT, I find it more beneficial to illustrate the concept. In each column we will show how the tax is calculated.

Regular Tax AMT
Total income Total income
Less: Deductions such as personal exemptions, state taxes, real estate taxes and charitable contributions. Less: Deductions, but no deductions allowed for personal exemptions, taxes and miscellaneous itemized deductions.
Equals: Regular taxable income Equals: AMT Taxable income
Less: AMT exemption
Multiplied by your tax rate Multiplied by AMT tax rate (26% or 28%)
Equals: Your regular tax liability Equals: AMT tax liability

You pay the greater of the regular tax liability or the AMT tax liability

You or your tax preparer calculate the AMT alongside your regular tax when completing your tax return. The calculations differ in that when computing AMT you are not allowed certain deductions, most notably the deductions for your personal exemptions,  state income taxes, auto excise taxes and real estate taxes. You will pay the IRS whichever tax is greater between the regular tax and AMT.

The actual AMT calculation is quite complex and there are about 25 individual adjustments that can be made when computing the AMT such as depreciation, intangible drilling costs, incentive stock options and farm losses. But it is the loss of the deductions for taxes and personal exemptions that is making the AMT hit the type of taxpayers that it was never intended to.

There are some tactics that can be employed to shift income and deductions into later years that may help minimize the AMT impact, and you will want to be sure you work with a qualified tax professional in this area. In my practice, we run tax projections for our clients throughout the year so they will be in position to pay the least amount of taxes possible.

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On another note, Prince’s sudden death last month took the world by storm and while we still wait for the actual cause of death, something that has received less attention is the fact that he died without a will. And while it is safe to say that most adults have not done any estate planning, most don’t have $300+ million in assets. Prince’s estate will have to appoint a special administrator to probate the estate. This process will become a tax and accounting case study for certain.

What are your chances of getting audited?

The word “audit” makes most taxpayers nervous, and no one wants to be on the IRS radar for anything. But individual taxpayers may find solace in the fact that last year the number of IRS audits fell to an 11-year low. The IRS audit rate of individuals is approximately 0.84%, or about 1 of every 119 tax returns filed. IRS Commissioner John Koskinen attributes the low audit rates to budget cuts and reduced staff. As much as the IRS attempts to use technology in the audit process, they still need humans to perform the audits and fewer humans means fewer audits.  But just because audit rates are low doesn’t mean that taxpayers and their advisors should become brazen and make ill-advised decisions when filing their returns. Someone is going to be audited, and you want to do what you can to decrease the chances of that someone being you.

The main thing to remember is that for almost every form you receive in the mail reporting tax information to you (such as a W-2 or 1099), the IRS receives a copy too. So if your W-2 shows that you earned $75,000 in wages and you list $50,000 of wages on your return, you are almost guaranteed to receive a letter from the IRS. This type of letter, known as a CP2000 Notice, is spit out by the IRS computers when the information reported to them from a third party (such as your employer or bank) doesn’t match what you reported on your return. A CP2000 Notice isn’t really an audit; it’s just the IRS’s way of letting you know that something doesn’t match up. Now if you didn’t report the income or reported the wrong amount, then you will have to pay the additional tax due. But if there is an explanation as to why the amounts don’t match, you have a chance to explain why the amounts are different.

Your risk for being audited increases if you have more income and deduction items on your tax return that the IRS can’t verify from third parties. In other words, the more numbers that you have to come up with on your own (such as business income and rental expenses), the more likely your return could be selected for audit.

And while individuals with higher incomes are more likely to get audited, it has more to do with how you earn your income and not how much income you earn. If you earn a million dollar salary and it is reported on your W-2, the IRS doesn’t need to audit that because they have a copy of the W-2. But if you earn a million dollars from various sources that the IRS will have difficulty verifying (such as multiple partnerships and rental properties), your chances of getting audited are higher than the person who earned a million dollars on their W-2.

If you keep good records and can substantiate the numbers on your return, then you really have nothing to worry about even if you are audited. But if you try to, as my father used to say, “gild the lily” (I think he actually butchered a Shakespeare line with that phrase), you have to be careful. If you do that and your return gets selected for audit, make sure you have a good CPA on speed dial.

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Winners and losers from this past tax season:

Winners: Individuals that need to pay their taxes in cash. The IRS now allows individuals to pay their taxes in cash at over 7,000 7-Eleven stores nationwide. Slurpee anyone?

Losers: Attendees at the Coachella Music Festival who tried to mail their tax returns from the onsite “post office”. The post office there isn’t a real post office. Try e-filing next time.

Is this expense tax-deductible?

Accountants are often asked if certain expenses are tax-deductible. Sometimes the answer is a straight yes or no, but most times the answer is a definite maybe.

Below are some of the tax deductions I have frequently been asked about over the years and whether or not they are deductible.

  1. Commuting to workGenerally not – Commuting to your primary place of work is never deductible for IRS purposes, but some states (like MA) allow limited deductions for such things as tolls paid through an E-Z Pass account and for weekly/monthly commuter passes. Also, you can deduct travel expenses for visiting clients from your home or primary office.
  2. Medical expenses Yes, but… – Most out-of-pocket medical expenses such as prescription drugs and co-pays are allowed as a deduction, but only those expenses that exceed 10% of your income are actually deductible on your tax return. Most people do not hit this threshold. Also, medical insurance premiums you pay on a pre-tax basis through your employer are not deductible.
  3. Gifts to individuals No – A gift to an individual is never tax deductible, and if you make a gift to someone in excess of the annual exclusion ($14,000 in 2016), you need to file a gift tax return. You also need to file a gift tax return is you make a joint gift of any amount with your spouse to an individual.
  4. Dry cleaning – No, unless… – The rule is that if you can normally wear your work clothes away from your job (like a suit), you cannot deduct the cost of buying or dry cleaning the clothes. If you have a uniform specifically required for your work (like a police officer’s uniform or an opera singer’s costume), the dry cleaning costs are allowed, but the costs must generally exceed 2% of your income to be tax-deductible.
  5. The time you devote to charityNo – The value of your time is never allowed as a charitable tax deduction. You may deduct the cost of supplies and materials you use in your charitable work (for example, if you are a graphic designer and create signs for a charity event), but you cannot deduct the value of your time.
  6. Summer camp for the kids Maybe – If you send your kids to a summer day camp while you work or look for work, you are eligible to claim a tax credit for those expenses if you meet the income criteria. However, amounts spent on overnight camps are not eligible for the tax credit.
  7. Country club dues No  – Membership fees paid to any club organized for business, social or recreation purposes are not deductible. You may deduct expenses paid to entertain clients at such clubs (such as a client dinner), but the general membership dues are not deductible.
  8. Entertaining clients at sporting events Yes – If you bring a client to a sporting/entertainment event, you can generally deduct 50% of the expenses. For luxury suites, the rules are a little more complicated. For a one-time luxury suite rental used for entertaining clients, you can generally deduct 50% of the expenses. But if you rent a suite for more than one event at the same venue, you can only deduct 50% of the cost of a normal ticket at the venue and 50% of the food and beverage costs.
  9. Uncollectible accounts receivable (bad debts) Maybe – If a client doesn’t pay you, the ability to deduct the bad debt depends on how you report your income and expenses for tax purposes. Most small businesses report on the cash basis, meaning that income is recognized when payment is received and expenses are deducted when paid. If you report on the cash basis, you cannot deduct the bad debt because you never reported the income to begin with (you never received the money). If you report on the accrual basis, meaning income is recognized when you bill your customers and expenses are deducted when you receive a bill from a vendor, you can deduct the bad debt.
  10. Lease payments for a business vehicle Yes – You can deduct the lease payments for a vehicle used for business purposes, but if the car is your personal vehicle, you cannot deduct the whole payment (a vehicle used as your personal vehicle can never be considered 100% business use). If the car is used 80% for business, you can deduct 80% of the lease payment less a very small “lease inclusion amount” determined by the value of the car and when you placed it in service. In lieu of deducting your lease payments, you may use take a deduction using the IRS standard mileage rate. For 2016,  the rate is 54 cents per business mile driven. Also, if your employer provides you with an auto allowance or reimburses you for your auto expenses, you cannot deduct those expenses again on your tax return.

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While Donald Trump has talked about being under continuous audit from the IRS since 2002, audits of someone like Trump and the Trump Organization are not like audits of most taxpayers. The IRS Large Business and International (LB&I) Division handles audits of large business entities and high net-worth individuals. In many of these cases, the IRS will assign employees to work with these taxpayers year-round. They also have programs such as their Compliance Assurance Process in which they work with large businesses to address complex tax issues before the tax returns are filed.

What happens if you don’t pay the IRS?

The IRS is the most powerful collection agency in the world. The actions they can take without a court order are pretty staggering and the IRS has two huge weapons at their disposal they will use to collect the taxes you owe them: the tax lien and the tax levy.

A tax lien is a claim by the IRS against your property. A lien arises ten days after the IRS sends you a notice and demand for payment. But at that point, only the IRS knows about the lien and they will continue to send you letters reminding you of your tax debt with each letter being more serious than the previous one. If you do not contact the IRS or make any effort to pay your outstanding balance, the IRS can file a Notice of Federal Tax Lien (NFTL) with the registry of deeds in the county you live in. The NFTL serves notice to the world that you have a tax debt. The NFTL is public record and will appear on your credit report. The IRS will file a NFTL if you owe them more than $10,000 and it gives the IRS priority over all other unsecured creditors in your property. So if you attempt to sell or refinance your property, the IRS will be there waiting to collect what you owe them. A lien still exists if you owe less than $10,000, but it will not be a matter of public record.

A tax levy is when the IRS seizes your property. The most common type of levy is a wage garnishment. For those who don’t have a steady income or are self-employed, they can also levy your bank account or accounts receivable. For larger amounts due, they can seize larger assets such as cars and boats. Interestingly enough, while the IRS does not need a court order to place a lien on your property or levy your assets, they do need one if they want to seize your house. Unlike a tax lien, a tax levy is not public record. However, other people might know about a levy depending on what assets are being seized. Your employer will know if the IRS is garnishing your wages, your bank will know if your account is being levied and your customers or clients will know if the IRS levies your accounts receivable.

Although the IRS can be aggressive with liens and levies, there are things that a taxpayer can do to counteract these tactics:

1. Pay the debt in full.

2. Appeal the lien. You will have the show that the lien was filed incorrectly or that the debt doesn’t actually exist.

3. Enter into a payment plan (installment agreement) with the IRS. The tax lien will still be in effect, but the installment agreement will stop collection activities unless you default on your payments.

4, Apply for an Offer-in-Compromise (OIC). These are very difficult to get approved. You essentially have to show you own no assets and no ability to pay. Applying for an OIC will stop collection activities, but a NFTL may still be filed. If an OIC is approved, the tax lien will still be in effect until the OIC amount is fully paid.

5. Get the tax debt classified as Currently Not Collectible (CNC). Like an OIC, you basically have to show that you have no money, no income and no assets to obtain CNC status for your tax debt.

6. Watch the clock. All IRS debts have a Collection Statute Expiration Date (CSED). The CSED is generally ten years after you file your tax return. After ten years, your debt becomes noncollectable. But the IRS will do everything they can to make sure they collect from you in full before the CSED.

The IRS collection process can be complicated and it is always a smart move to hire a professional with experience in dealing with the IRS if you run into tax trouble. And while the IRS won’t be sending Stewie Griffin after you to collect their money, they can make your life miserable and will go to great lengths to collect from you.

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You generally will not go to jail if you don’t pay your taxes. Not paying your taxes is not a criminal offense unless you willfully defraud the IRS or are part of a tax evasion scheme. But while not paying your taxes won’t get you sent to the slammer, lying on your tax returns definitely can. More on this in a future blog post.

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