Back to Basics Part XXXI – Form 8863 Education Credits

Originally published in the Cedar Street Times

January 29, 2016

There are two main tax credits for qualified spending on degree seeking higher education: 1) the American Opportunity Credit (AOC), and 2) the Lifetime Learning Credit (LLC).  The AOC is generally the more valuable of the two.  It is a tax credit of up to $2,500 with $1,000 of that refundable to you even if you paid no tax and have no tax liability.  You get 100 percent of the first $2,000 spent, and 25 percent of the next $2,000 spent.  Whenever your hear “refundable credit,” think potential fraud.  So it is not only an opportunity for college kids, but an opportunity for criminals to make up false returns and claim fake credits.  Naturally increased scrutiny follows on behalf of the IRS.  But I digress.

The AOC is available to you only during your first four years of college as defined by the educational institution – so a 5th or 6th year senior would still qualify, except that you are only allowed to take the credit for a total of four times no matter how long it takes you to get through school!  With that in mind you may even choose to forgo claiming the credit in a particular year if for instance you were attending a community college and had less than the $4,000 of expenses to max out the credit, but knew you would be transferring to a more expensive school, and would still have the opportunity to claim the credit four times before graduating.

The AOC allows you to include tuition and required fees of the school, like athletic fees, and student activity fees (but not health fees or room and board) for the tax year at hand plus the first three months of the next year if paid in the current year, plus the cost of any books or school supplies whether or not bought from the school or any other seller.  You have to be enrolled half time in at least one academic period such as a semester or quarter in the tax year, or during the first three months of the next year if the payment was made in the current year for the following year school.

If your modified adjusted gross income (for most people this is the same as their AGI) is between $160,000 and $180,000 for married filing jointly ($80,000 – $90,000 for other statuses), the credit phases out.  If a parent is claiming you as a dependent, then you are not allowed to deduct it on your tax returns – only the parent would.  Even if a third party paid the fees for a student’s benefit (such as a relative, or an institution), as long as the parent is still claiming the child as a dependent, then the parent is eligible to claim the credit as well.  You would need a copy of the 1098-T to claim the credit (this is a new requirement signed into law by Obama in 2015 – all filers must have in their possession a 1098-T when filing their taxes to claim education credits).  Another interesting tenant is that you cannot claim the credit if you have been convicted of a felony possession or distribution of a controlled substance.

The Lifetime Learning Credit (LLC) is a nonrefundable credit of 20 percent of the first $10,000 spent – capping out the credit at $2,000.  The LLC is available to anyone in their life for an unlimited number of years for post secondary education – even if you just take one course at a time – so you don’t even have to be seeking a degree.  You just can’t claim the LLC and AOC in the same year for the same person.

The LLC is eligible for the same expenses as the AOC, except that books and supplies that are not absolutely required to be bought from the school, do not count.  The modified adjusted income phaseout is between $110,000 – $130,000 for married filing jointly and $55,000 – $65,000 for other statuses.  Also, it is nice to know that you can still smoke crack and deal heroin and be eligible for the credit, as there are no denials of the credit for felony possession or distribution of controlled substances with the LLC!

The form used to claim the expenses, Form 8863 – Education Credits (American Opportunity and Lifetime Learning Credits), is a two page form.  You start with the second page, which is basically a flow chart questionnaire determining what you are eligible for, and it also has you transfer some numbers to the first page.  The AOC is handled in Part I of page one and the LLC is handled in part II of page one, and these walk you through the credit calculation and limitations.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA, Inc. is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. Travis can be reached at 831-333-1041.

Get Ready for 2015 Taxes

Originally published in the Cedar Street Times

January 8, 2015

 

We are going to take a break from our Back to Basics series to address a few timely issues.

At the beginning of every year, I send each of my clients a tax organizer to assist in gathering all the information necessary to complete the tax returns in an efficient manner.  The tax organizer is customized for the client and includes his or her prior year amounts for comparative purposes (and it serves as a great memory jogger so nothing is left out).

There is also a questionnaire to assist in alerting us to items that may not occur every year, but that may be present in the current year.  I also ask clients additional questions about the status of things like their estate planning, retirement planning, assets, debts, insurance, health care directives, etc. in order to ensure that they are thinking about these important issues each year.

Organizers are a fairly common practice among CPA firms, and for good reason.  They result in more accurate and more efficient tax preparation which should translate into a more accurate calculation of your tax liability, less problems with the taxing authorities, and less cost to you in the long-run.  Some of you may find yourselves saying, “Oh, I never use the organizer.  My CPA knows how I do things, and I have been doing it this way for years, plus my tax stuff is very simple.”

Behind the scenes this translates into moments of, “Oh, yeah, I remember these yellow sheets with the small scribbles from the past – now where did she put the real estate taxes again?”  And then if there is staff involved, there may be an additional conversation, “Okay, now here is what you need to know about how Mrs. Jones organizes her information…”    Since time is a precious commodity, the more of it that is used in the process of assisting you, the higher your bill is going to be.  With some firms, you will see this reflected in your bill each year.  In other firms, your pricing will be more consistent, but will trend higher or lower as a result over a period of years.

Ask yourself, is the firm going to be faster at learning, remembering, and extracting information from hundreds of different client systems with information in different orders, or from one system which is perfectly ordered with its software and that it knows backwards and forwards?  You can minimize the fees related to data collection and entry, and just spend your money on the real value of strategy in preparing the returns.

That said, maybe it is worth it to you to keep doing it the way you have always done it.  A CPA firm is generally going to be intelligent enough to figure it out and let you know what is unclear or what else may be missing in most cases, it just might cost you a little more, and have a little more risk associated with it.

In addition to the organizer each year, I send clients an engagement letter for services to be provided, a limited tax power of attorney to speed up the process in case we need to resolve an issue on a client’s behalf, and an additional organizer letter.  The organizer letter explains new tax developments over the past year, as well as revisiting issues from prior years that remain important and still somewhat fresh.  This year’s organizer letter was six pages long.  I don’t expect clients to necessarily read it all, but it is laid out in an easier manner to skim the topics and see what might be important to read further.

Here is a high level summary of some of the issues from my organizer letter you may want to be aware of:

  1. The IRS took a clear position this year that businesses sending 1099 forms this January must send them to LLCs as well, unless the LLCs have made a special election to be taxed as a corporation.  Fees for not properly sending 1099s have doubled.
  2. President Obama signed a new law this year that requires anyone claiming education credits or education deductions to have a 1098-T when filing their tax returns.
  3. The PATH Act (Protecting Americans from Tax Hikes) was signed into law on December 18, 2015.  This was the extender bill for this year which we have grown accustomed to getting at the last minute each year from Congress.  Some notable provisions made permanent include the sales tax deduction as an option in lieu of state income taxes, the IRA‐to‐charity exclusion, enhanced child tax credit, enhanced American opportunity tax credit, enhanced earned income tax credit, above‐the‐line deductions for qualified tuition expenses, the section 179 depreciation deduction for up to $500,000, built‐in‐gains holding period of 5 years for s‐corporations, and enhanced exclusion of gain on sale of small business stock. The qualified tuition deduction, mortgage insurance premiums deductible as interest, and exclusion of income for debt on discharged principal residences where extended through 2016. Bonus depreciation and first‐year bonus depreciation on automobiles was extended through 2019.
  4. Do not do more than one indirect rollover from one retirement plan to another in any 365 day period (not calendar year based), or you will face penalties.  Indirect rollovers are where the retirement plan custodian issues you a check directly, and then you have 60 days to deposit the money with another retirement plan custodian or consider it a distribution.  (You can still do unlimited direct rollovers from one trustee to another.)
  5. Several tax return due dates are changing affecting 2016 returns (not 2015 returns) – due dates for partnerships move to March 15, c-corporations move to April 15, and FinCen 114 for foreign bank accounts move to April 15 and are now eligible for a six month extension.
  6. The new capitalization and repair regulations of 2014 were modified to allow taxpayers to have a capitalization policy of $2,500.  This means businesses can now deduct any item $2,500 or less as an expense without having to include it on a depreciation schedule or take a section 179 deduction for it.  You do not even have to have a written policy to this effect, but you do have to make an annual 1.263(a)-1(f) election on your returns each year to do this.
  7. Watch for 1095-A, B, and/or Cs this year as they will be much more prevalent and will be needed in the preparation of your tax returns to ensure you meet the health care insurance requirement.  Last year was lax.  This year the noose has been tightened.  If you did not have health insurance for all or part of the year, be aware, some exemptions from the health insurance mandate require you to apply to Covered California to get an exemption for use in your preparation.  In other words – get moving!

Prior articles are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA, Inc. is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. Travis can be reached at 831-333-1041.

Back to Basics Part XXX – Form 8829 Expenses for Business Use of Your Home

Originally published in the Cedar Street Times

December 25, 2015

Merry Christmas!

My vision of Santa’s workshop is that it is built into his home at the North Pole.  Being that it is quite chilly there, why would you want to leave the warmth of one building to go to another?  It is also highly unlikely that he would need a separate office “in-town” at the North Pole.  Betting on the idea that it is built into his home, he would certainly seem eligible for a home office deduction.

Whether or not he would use the Form 8829 – Expenses for Business Use of Your Home would depend on his legal structure, however.  Is he Santa Claus, sole proprietor?  Is it Santa Claus, Inc. of which he is a greater than 2% shareholder employee?  Or maybe it is Santa’s Workshop, LLC?  If it is an LLC, it is possible it could be a Single Member LLC if the North Pole has community property laws.  If that is the case, Santa and Mrs. Claus would be treated as one member and the entity disregarded for federal tax purposes.  Well, I suppose that is for Santa and the IRS to worry about!  Maybe we should focus on you instead…

If you use part of your home for business purposes, you may be able to claim a home office deduction using Form 8829 – Expenses for Business Use of Your Home.  The space must be used exclusively and regularly for business purposes and it must be your principal business location – meaning that it must be the main place where managerial activities occur for your business, and you have no other space where substantial managerial activities occur.

You can claim this deduction as a sole proprietor, but also as an employee, if your employer expects you to maintain an office in your home and provides no other fixed location for you to work.  It is best if this type of arrangement is spelled out in your employment agreement.

The Form 8829 is used specifically for sole proprietors filing a Schedule C.  If  you are an employee claiming a home office deduction, or a partner, or if you are filing in conjunction with a Schedule F for a farm, you must use the “Worksheet to Figure the Deduction for Business Use of Your Home” in Publication 587 to calculate the expenses instead.  It essentially accomplishes the same purpose, except whereas the Form 8829 is filed with the returns, the worksheet is not.

The Form 8829 and the worksheet in Publication 587 focus on calculating a deduction based on actual expenses.  There is a relatively new simplified method also.  It allows you to deduct a flat $5 per square foot up to a maximum of $1,500 a year.

We will now spend some time focusing on the Form 8829 itself.  If you would like to read a more in-depth analysis on the home office deduction discussed above, I wrote a three part series on this topic on July 26, August 9, and August 23 of 2013.  You can find them on my website at:

http://blog.tlongcpa.com/2013/07/26/home-office-new-option-for-2013/

Part I of the Form 8829 determines the business percentage you will use to apply to the home office expenses you incur.  You divide the business use square footage by the total square footage to determine the percentage that will be applied to the expenses.

Home daycare providers have special rules as they are allowed to use the space for both personal use and work use.  They have an additional calculation in Part I where they divide the total hours for the year that the space was used for daycare services, by the total number of hours in the year.  This percentage is then multiplied by the square footage percentage to finally arrive at the reduced percentage to apply to the expenses.

Part II of the Form 8829 is where you will list all your expenses of maintaining your home, such as property taxes, mortgage interest, insurance, utilities, repairs, etc.  The direct column is for expenses that were 100 percent deductible and should not have the business use percentage applied.  Perhaps you repainted your home office only.  This would be an example of a direct expense.  If you had painted the entire house, then you would list it under indirect expense.  The business use percentage would then limit your deduction to the relative portion of the home used for business.

A home office deduction is generally not allowed to create a loss on your schedule C with the exception of the portion related to real property taxes and mortgage interest since they would have been deductible on Schedule A anyway.  If the other operating expenses of your home office create a loss, that loss is suspended and carried over to future years.  Part II has additional lines to handle any carried over losses from prior years as well.  The amount of deduction from the bottom of Part II carries over to your Schedule C for deduction on that form.

Part III handles the depreciation expense on your home – basically its wear and tear over time.  Depreciation is a use-it-or-lose-it concept, so you are better off taking it if eligible.  Some tax preparers incorrectly advise people not to take depreciation expense on their home in order to avoid tax recapture problems when they sell.  What they are failing to grasp is that recapture is based on depreciation that was “allowed or allowable.”  So even if you do not take the depreciation expense when you were entitled to it, you have to treat it as if you did take it when you sell, and you would still be subject to any of the same recapture taxes.  Part III is a feeder calculation back into the depreciation expense line in Part II.

Part IV is essentially the final summary of any carryovers available for the next year.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA, Inc. is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. Travis can be reached at 831-333-1041.

Back to Basics Part XXIX – Form 8822 Change of Address

Originally published in the Cedar Street Times

December 11, 2015

If you are like most people, whenever you change addresses you will almost certainly notify the United States Post Office so they can forward any mail that is still being delivered to the old address.  Although you may have notified people and businesses prior to and just after your move, you will inevitably have those that are off your mental radar, and do not get notified.

Since people generally only file their taxes once a year, and it is sometimes an experience they want to forget (although never in my office, I am sure!), the IRS and any state taxing authorities often end up in the off-the-mental-radar list!

The fact that the USPS will forward your mail for up to a year after your move does assuage the need to update the taxing authorities since filing a new return with an updated address will also effect the same change.  Plus it seems the IRS and FTB (here in California) have an uncanny ability to track you down anyway, if you owe them money!

All of this said, you may not want to risk your private tax information and Social Security number  being delivered to the new people in your old house by mistake.  Not to mention, you may have action items that require attention within 30 days of the letter date.  Mail forwarding can sometimes take a good chunk of that time, or maybe it never makes it to you if accidentally delivered to the old address.

So what are your options?  Well, you could call the taxing authorities, but be prepared to wait.  These days I tell clients to find a time where they can put the phone on speaker, make some popcorn and watch a movie while they wait.

This is a sidebar discussion – but here is the reason for the long wait times…the IRS is considered a discretionary program in the US budget and it is funded by annual appropriations by Congress.  The IRS budget has been cut by about $1.2 billion in total over the course of the past five years (approximately 10 percent) according to the GAO.

You may recall the IRS revealed in 2013 that its nonprofit audit department had been targeting certain political groups.  Well, that did not help!  This caused an uproar and Congress has been unwilling to increase the IRS budget.  In fact it decreased it further since 2013.  By examining the disproportionately large declines in taxpayer services according to statistics at the IRS, in relation to their ten percent budget cut, it is speculated that the IRS reaction to Congress has been to focus its internal funding cuts on taxpayer services (think phone support, etc.) in order to gain sympathy in the public eye for more funding.  So taxpayers are caught in the middle of political chess.

Whenever I speak with the IRS representatives, I always try to be as courteous and supportive as possible while trying to get the information needed.  Although you may be frustrated with such a long wait, it is not the fault of the representatives answering the phone, and they are probably feeling pressure and get tired of talking to upset people all day.  Courtesy can go a long way sometimes.

Anyway, back to address changes – the easiest way is to mail a Form 8822 Change of Address to the IRS (FTB Form 3533 for California). The Form 8822 is a simple one-page form which you can download off the internet.  You essentially list your name and Social Security number, your old address, and your new address.  You sign and date it, and mail it in.  California FTB Form 3533 is pretty much the same except they manage to stretch it into two pages in order to cover business entities as well.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA, Inc. is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back to Basics Part XXVIII – Forms 8814 and 8615 – Reporting a Child’s Investment Income/Kiddie Tax

Originally published in the Cedar Street Times

November 27, 2015

 

In order to prevent people in higher tax brackets than their children from shifting money into their children’s names in order to pay tax at a lower rate, “Kiddie Tax” rules were enacted.  The government also allows you to simplify reporting in some cases where filing a separate return for children with a small amount of income is burdensome.

The quick summary is that if your child has less than $1,050 of unearned income (and assuming there is not enough earned income to trigger a filing requirement), there will be no tax paid on the unearned income, and nothing to file.

If there is over $1,050 and $2,100 of unearned income, the amount will be taxed at the child’s rate.  In this case , the child can file his or her own tax return or the parent has the option of filing a Form 8814 – “Parent’s Election to Report Child’s Interest and Dividends” to avoid filing a separate return for the child, and just report the tax on the parents’ return.

If the child has over $2,100 of unearned income, the parent can still file either way, but the amount over $2,100 will be taxed at the parents’ rate.  If the parents elect to file on their return using Form 8814, the calculation to tax at the parent’s rate for the income over $2,100 is included on that form.  If a return is filed for the child, instead, then a Form 8615 – “Tax for Certain Children Who Have Unearned Income” will need to be filed with the child’s return to perform the additional tax calculations.

In order to qualify to File Form 8814, your dependent child would have to be under age 19 (or under age 24 if a full-time student during at least five months of the year) to qualify.  A quirky rule to watch out for is if you have a child with a January 1 birthday.  In this case, on December 31 of each year they are considered to be another year older.  So if your child turned 18 on January 1, 2015, the child would be considered 19 at the end of the day on December 31 and thus not under age 19 for tax year 2015. (They are the only birthday that gets the short-end of the stick!)

Unearned income is defined as interest, tax-exempt interest, dividends, capital gains distributions from mutual funds, net capital gains from sales, rents, royalties, taxable Social Security or pension benefits,  taxable scholarships, unemployment income, alimony, and the like.    Note that capital gains distributions come from mutual funds, and they represent your share of the buying a selling inside the mutual fund which you have no control over.  The short-term sales actually get reported as dividends, and the long-term sales get reported as capital gains distributions.  Net capital gains would be the aggregate of your  gains and losses from the direct sale of a particular stock or bond, or the mutual fund itself in your account.

As summarized earlier, if your child has over the $1,050 of unearned income, you may wish to simplify and not file a separate return for the child.  The parents may elect to file (with the parents’ tax return) a Form 8814 – “Parents’ Election to Report Child’s Interest and Dividends” if  the child’s only unearned income was from interest, dividends, and capital gains distributions (note that rents, scholarships, unemployment, etc. are not included) and his or her gross income is less than $10,500.   Otherwise you have to file for the child. There are a few other requirements as well which you can read about in the instructions to the form.  The first $1,050 will not be taxed, but the rate on the child’s income between $1,050 and $2,100 will be ten percent.  The amount of tax is transferred from the bottom of the Form 8814 and added to the parent’s tax on Line 44 of Form 1040.

Keep in mind, that in some cases, you are better off still filing the child’s tax return even though you have the option to report it on your return, due to other tax incentives and credits the child may be eligible to receive.

If the child has over $2,100 of unearned income, the parents can still elect to file the child’s return with their return.  If they decide to file a separate return for the child using Form 8615 – “Tax for Certain Children Who Have Unearned Income,” the form will take the parent’s taxable income and add to it the child’s taxable income.  Using this combined amount the appropriate tax bracket is used to determine the additional tax related the child’s portion of the income.  This amount is added to Form 1040 Line 44 of the child’s return as additional tax, and the Form 8615 is attached to the child’s tax return.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA, Inc. is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back to Basics Part XXVII – Schedule 8812 – Child Tax Credit

Originally published in the Cedar Street Times

November 13, 2015

I believe the IRS was having an off-day when they created the “Schedule 8812 – Child Tax Credit.”  First, why did they call it a “Schedule?”  Anyone who grew up with Sesame Street during the past 40 years inevitably knew the song, “One of these things is not like the others…” and then you would have to pick out the one thing that was different on the TV screen.  Okay, it’s time for you to play: Form 1045, Form 2106, Form 3903, Form 6251, Schedule 8812, Form 8829, Form 9465.  Did you figure it out?  In my tax software there are well over 100 four-digit forms to choose from, and I believe the 8812 is the only one called a “Schedule.”   Schedules, on the other hand, all start with letters, such as Schedule A, Schedule B, Schedule C, etc.

The second reason I think the IRS was having an off-day, is that the name of the form – “Child Tax Credit,” is somewhat of a misnomer.  There are two related, but distinct credits, the “Child Tax Credit,” and the “Additional Child Tax Credit.”  For the vast majority of people the Child Tax Credit is determined on the Child Tax Credit worksheets in Publication 972.  The Additional Child Tax Credit is the one generally figured on the double poorly named, “Schedule 8812 – Child Tax Credit.”

So what are these credits and how can you get them?  The child tax credit is a nonrefundable tax credit up to $1,000 per child, and the Additional Child Tax Credit is a refundable tax credit that may be available if you qualified for the child tax credit but could not use some or any of the credit because you did not owe much or any tax.  Whenever you hear of a refundable tax credit, think fraudulent returns – because lots of them are filed whenever scammers figure they can get something for nothing.  Also remember, that tax credits are much more valuable than tax deductions.  Credits are a dollar-for dollar reduction of tax, whereas deductions just reduce the income upon which the tax is calculated.  So credits could be three to ten times more valuable than deductions depending on your tax bracket.

I know many of you are thinking, “What a deal! At an annual $1,000 a pop, where can I get more kids?”  Well, you can certainly birth them, adopt them, or foster them (through a court or qualified agency).  You could also get one or both of your parents to have another child and give it to you, or you could even have a step-parent give you his or her children to raise, or any of the decedents of these two categories.  The reverse is also true…parents, you can sweet talk your kids into having their own children to give to you, or if you are already a grandparent, just keep the grandkids the next time they are dropped off and don’t give them back!  There are so many wonderful options!  Please make sure the children are under 17; make sure they are U.S. citizens, U.S. nationals or U.S. resident aliens; and make sure that you meet all the tests to claim them as dependents as well.

You also cannot make too much money in order to qualify for the credit.  If you are Married Filing Joint you start to lose the $1,000 per child tax credit when your combined incomes hit $110,000.  By $130,000 it has been ratably phased-out.  If you are filing head of household, your phase-out range for the credit is $75,000 – $95,000 of modified adjusted gross income.

As mentioned earlier, if you qualify for the child tax credit, but you have more credit than tax owed to offset, you may be able to pick this difference up through the Additional Child Tax Credit and actually get a refund for money you never paid in to begin with.  In order to qualify for the Additional Tax Credit you do need to work.  The calculations are such that you need to have at least $3,000 of earned income (not investment or retirement income) to get anything.  You need to have about $10,000 of earned income to max out the credit if you have one child, and approximately an additional $7,000 for each additional child in order to max out the $1,000 per child credit.

There are lots of nuances to these rules depending on your circumstances, but they are fairly well addressed in the worksheets and the instructions when you actually go to fill them out.  Again, Publication 972 houses the Child Tax Credit worksheets (about 5-6 pages of worksheets) to see if you qualify for the Child Tax Credit.  Then, if you cannot utilize all of the credit for which you qualify due to income tax liability limitations, then you go to Schedule 8812 Child Tax Credit to see if you can qualify for the refundable Additional Child Tax Credit.

The Schedule 8812 is only 1-1/2 pages long.  Part I of the schedule is only used if your children do not have Social Security Numbers, and have ITINs instead.  Part II is the section where most people will go to calculate the Additional Child Tax Credit.  Part III is a special section for super humans that have three or more qualifying children.

In the meantime, I will be eagerly awaiting to see if a reader can enlighten me on some history that might explain the anomaly naming convention of Schedule 8812 – Child Tax Credit!

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA, Inc. is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

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Listen to Travis H. Long, CPA, featured on San Francisco based accountingplay.com, a resource for accounting students and those looking to get into the accounting field.

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Back to Basics Part XXVI – Form 8606 – Nondeductible IRAs

Originally published in the Cedar Street Times

October 30, 2015

If you have traditional or Roth IRAs, you owe it to yourself to understand what is meant by having “basis in your IRA.”  This is especially important for people that have switched tax preparers over the years or prepared returns themselves, as they may not have transferred or tracked the amounts properly from year-to-year, or preparer-to-preparer.  Failure to understand this concept could result in oversights that cost you thousands or tens of thousands of dollars in tax when you start withdrawing and using the money from those accounts.

Having basis in your IRA means that you have made a contribution to your IRA at some point over the years for which you did not receive a tax deduction when you made the contribution.  Since you did not get a tax deduction when you contributed the money, you should not have to pay tax when you withdraw the money.  Roth contributions, by nature, are those for which you receive no tax deduction when you put the money in, so all contributions create basis.  With traditional IRAs, you create basis when contributing if your income is too high and you are therefore disallowed from taking the tax deduction.  Having high income would not prohibit you from making the contribution to the account, but you would just not be allowed to take the tax deduction on the tax returns.

If you are unfamiliar with the related calculations and forms and do not review them carefully or discuss them with your return preparer (or just plain have no interest in doing so!), you could easily assume you are getting a deduction when you are not.  Financial advisors generally have no idea if you have basis in your IRAs because they do not typically obtain copies of your tax returns and verify the deductions each year – it is just not part of their job description.  Basis to them generally means, what did you pay for the stock, bond, or mutual fund (a different concept of basis relevant for regular brokerage accounts).

And you do not really need a lot of income to be phased out from the deduction; it is not just a problem for the rich.  For tax year 2015, people filing single or head of household that also contributed to a retirement plan through their work during the year (even if a trivial amount) or were eligible for a pension, are allowed to take the deduction in full until they reach only $61,000 of income.  Then the deduction starts to phase out and is completely phased out once they have $71,000 of income.  For married couples filing jointly, the combined income (of both spouses) phase out range is only $98,000 to $118,000 when determining the deductibility of a contribution when both spouses participates in a work plan.  In situations where one spouse participates in a work plan, and the other does not, the phaseout range for the deductibility of the contribution by the spouse that does not participate in a work plan is a combined income (of both spouses) of $181,000 – $191,000.  If neither spouses participates in a work plan during the year, there is no income phase out for the deduction that year.

The other way people get basis in their IRAs is if they are inherited.  Since IRAs do not get a step-up in basis upon the death of a decedent, you receive the basis the decedent had in the IRA (if any).  So it becomes very important to make sure you know what this is and hopefully have some documentation supporting it.

When you start withdrawing money out of your IRAs, the tax preparer determines the tax free portion of your withdrawal by dividing your total historical IRA basis by the total year-end values of all your SEP, SIMPLE and Traditional IRAs and multiplying that ratio by your IRA withdrawal amount.  If you or your past preparer(s) did not carefully track and pass this basis number on over the years, then your current preparer will generally assume there is no basis.  As such you have just set yourself up to be double taxed – once when the money was put in and you did not get the deduction and now again, when you take the distributions.

Sadly, I regularly see new clients come through my doors whose basis is missing, drastically lower than it should be, or at least suspect of being low; the client often has no idea why it even matters, has not kept records, and has changed investment advisors and tax preparers several times.  It becomes time consuming and expensive to recreate, if it can be done at all, or is even noticed in the first place.  Unless a nondeductible contribution is made during the year, the Form 8606 used to track the nondeductible contributions, is not filed and therefore not part of the return you may hand to your new preparer.  That individual has to have the presence of mind to ask about these carryovers.  I see these problems mostly with do-it-yourself and discount tax service chains.  Those options certainly have a right place and serve a need, but as a consumer, you need to understand the more you have at stake, the more detrimental is a mistake.

As mentioned before, with Roth IRAs, basis is created with every contribution.  What becomes important to track with Roth IRAs is the total amount of direct contributions made to the Roth versus Roth conversions and rollovers from traditional IRAs.  If you take any distributions before reaching age 59 1/2, or are over 59 1/2 but have had a Roth IRA for less than five years, these amounts become critical in order to calculate if a portion of your distribution is taxable.  There is a specific ordering method for withdrawals which is favorable.  As with traditional IRAs, Roth IRA basis is often forgotten about over the years.

The Form 8606 – Nondeductible IRAs does several things: 1)  it is used to calculate and track nondeductible contributions to traditional IRAs, 2) it is used to calculate the taxability of SEP, SIMPLE, and traditional IRA distributions when there is basis, 3) it is used to calculate the tax on Roth conversions, and 4) it is used to calculate the any possible tax on Roth distributions.  Part I of the is used for items 1) and 2) above.  Part II of the form is used 3), above and part III of the form is used to calculate item 4).

The instructions to the form also explain how to handle recharacterizations – this is where you  contribute money to an IRA and then later for that same tax year decide you want to “recharacterize” it as a contribution to a Roth IRA instead, or vice versa – it’s like a “do-over.”  In addition the instructions explain how to handle excess contributions or a return of contributions made during the year.

Even though the taxing authorities have theoretically received all your 8606s since 1987 when nondeductible IRAs were first permitted, I have never seen them point out to a taxpayer that he had basis in the past that was overlooked.  In fact, in the instructions to the form the IRS puts the burden on the taxpayer to retain the supporting documents from inception of your IRAs until your retirement accounts are fully distributed (plus at least three years for audit possibilities).

They ask that for the purpose of proving your basis in IRAs, you keep the first page of all 1040s, keep all Form 8606s,  keep all Form 5498s from your custodian showing the amounts contributed each year, as well as all 1099-Rs showing any distributions.  Now you know why, when people ask me how long I suggest keeping tax returns, I say, “Forever.”  I actually have scans of every one of my personal tax returns dating back to when I was 16, mowing greens, raking bunkers, and driving tractors in the summer for a golf course.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA, Inc. is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back to Basics Part XXV – Form 8582 – Passive Activity Loss Limitations

Originally published in the Cedar Street Times

October 16, 2015

 

Prior to the Tax Reform Act of 1986, both the nation and Congress were gripped with the ideas that the rich were not paying any taxes and that the tax code was overly complex.  Sound familiar?  The Tax Reform Act of 1986 was heralded as the biggest change to the income tax system since World War II.  It did have sweeping changes and drastic effects.  In the nearly 30 years since its enactment, all kinds of new exceptions and complexities have entered the code.  That said, there are still a lot of landmark changes that affect our tax system today.  One of these is in the area of passive losses.

Prior to 1986, wealthy individuals could invest in tax shelters which combined borrowed money and depreciation expense, while taking advantage of tax subsidies and tax preferences on certain types of investments to push out massive losses well in advance of their current, real economic investment and loss.  Some of the tax subsidies and preferences were true reductions in tax, and the tax deferral parts of these plans essentially created interest-free loans from the government.  The losses would then be used to offset income generating activities from wages, profitable business activities, and portfolio activities, virtually eliminating income tax for a lot of wealthy people.  Tax shelters were popping up faster than Starbucks coffee houses, and draining capital which could have otherwise been invested in productive activities in America.  There was also a lot of legal and accounting brain power being siphoned off to tax shelter creation.

The Tax Reform Act of 1986 (among many other things) setup three buckets for income, 1) earned income – such as from working for someone else or running a business yourself, 2) portfolio income – such as interest, dividends and capital gains from the sale of stocks, bonds, mutual funds, etc., and 3) passive income – such as investments in rental real estate properties and ownership interests of businesses in which you do not really work.  The basic tenant, is that the three buckets are generally kept separate, and in order to deduct losses in one bucket, you have to have offsetting income in that same bucket, otherwise the losses get suspended to be used at a future time.  Prior to 1986, there was just one bucket – income.  After this three bucket concept was introduced, most of these tax shelters became useless.  For some that managed to survive in other ways, another arm of the Tax Reform of Act of 1986 had to be reckoned with –  Alternative Minimum Tax (I discussed AMT in a prior article which is posted on my website at  www.tlongcpa.com/blog).

The passive activity rules are laid out in Section 469 of the Internal Revenue Code.  There are a lot of rules in Section 469, but the short of it is that you usually need to work at least 500 hours a year in a business you own to be considered a material participant and keep the income or losses in the earned income bucket.  So, if you own part of a business, but do not materially participate, any losses will be stuck in the passive activity bucket and get suspended until you have some passive activity income to offset, or until you liquidate your interest in the business.

For rental real estate activities, you generally have to spend 750 hours a year and have no other activity in which you spend more than 750 hours to throw the income or losses in the earned income bucket.  People meeting this rule are considered “real estate professionals.”  Rental real estate losses are a huge issue for California rental property owners, since massive losses accrue in the early years due to high mortgage interest and depreciation stemming from high purchase prices.  Real estate professionals are allowed to deduct all their losses from rental properties against their other earned income.  All other people are limited to using 0-$25,000 of losses per year against earned income depending on their modified adjusted gross income and whether or not they “actively participate.”  Active participation is a pretty easy standard to meet.  If you make managerial decisions, you are an active participant, and are eligible for the special $25,000 loss deduction.  (The act of simply choosing a property manager to handle everything for you is a managerial decision, for instance.)  If your modified adjusted gross income is over $125,000, however, the $25,000 active participation loss deduction starts to phase out.  By the time you reach $150,000, it is gone.

All of this bring us to the point of today’s article – the Form 8582 – Passive Activity Loss Limitations.  The Form 8582 is simply the vehicle used to track the activities in the passive income bucket and show which ones have suspended losses from year to year.  The form is three pages long.  The first page is the summary, and the second two pages are the detailed worksheets supporting page one.  Rental real estate activities are separated on the form from all other passive activities, since they have the special $25,000 active participation rule that must be applied.  Part I summarizes the items within those two categories and further breaks them down into activities with income, activities with losses, and prior year losses that have been suspended.  You then net everything within each of the two categories.  The rental real estate category then runs through Part II to see if you qualify for all or a portion of the special $25,000 loss allowance against earned income.  Part III deals with Commercial Revitalization Deductions, which are just a favorable twist on the $25,000 rule for people who are rehabilitating certain buildings in distressed communities.  Part IV sums the total losses that are allowed for the year.

The next two pages are the details for each business activity or rental property you own.  This is where you would look to see how much suspended losses you may have on each property.  Although you might not like the idea of having your losses limited each year, you will certainly enjoy the benefits down the road when you sell a property or business for a gain, and all those suspended passive losses come to your rescue!  And it is also nice to know that if you sell one property for a large gain and the losses freed up from that particular property are not enough to offset its gain, then the suspended losses from all other properties are drawn from on a pro-rata basis until exhausted to help offset the gain as well.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA, Inc. is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

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