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Back to Basics Part XXVI – Form 8606 – Nondeductible IRAs
Filed under: Back to Basics | Tags: 59.5, basis, carryovers, contribution, Form 1040, Form 1099-R, Form 5498, Form 8606, inherited IRA, Nondeductible IRAs, phaseout, recharacterization, Roth conversion, Roth-IRA
Leave a comment 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
Filed under: Back to Basics | Tags: active participation, AMT, earned income, Form 8582, material participation, Passive Activity Loss Limitations, passive income, portfolio income, real estate professionals, rental real estate, Section 469, suspended losses, Tax Reform Act of 1986, tax shelter
Leave a comment 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.
Back to Basics Part XXIV – Form 8283 – Noncash Charitable Contributions
Filed under: Back to Basics, Charitable Donations | Tags: $5000, 30 percent, 50 percent, appraiser, appreciated securities, Form 8283, household, noncash, Noncash Charitable Contributions
Comments (2) Originally published in the Cedar Street Times
October 2, 2015
The donation of noncash charitable items such as clothing, furniture, toys, books, etc. to thrift shops run by organizations such as Goodwill Industries or The Salvation Army are nearly ubiquitous with people who itemize deductions. We all have stuff we no longer use or enjoy, and in lieu of the effort involved with a garage sale we find it extremely convenient to drop it off or have it picked up, and hopefully get a tax benefit from it as well. Note that as of a few years ago, the IRS requires that the items be in “good” condition or better to get a deduction – so no more deducting your junk!
Noncash donations do not just include household items, but could also include the house itself – real estate! Other examples would be donations of stocks, bonds, vehicles, as well as intangible items such as copyrights or patents. Essentially anything you give to a qualified charitable organization other than money would be a noncash charitable donation. If your aggregate noncash charitable donations for the year are below $500, you can deduct them directly on Schedule A. If they aggregate more than $500, you have to use Form 8283 to report them.
Depending on the type and amount of donation, you may need a qualified appraisal by a licensed appraiser, and you may or may not need to attach it to the tax return. There are also many very specific details about appraisal requirements to review should you be donating a high value item. (My experience has been that licensed appraisers sometime do not even know what the IRS technically requires for certain appraisals.)
For household items, the threshold to require an appraisal is $5,000. Unless you are trendy and have expensive tastes you probably will not have this problem. But people sometimes cleaning out an entire house for a move or after someone passes away could run into this issue. The rub is that it is a cumulative limit through the whole year. So theoretically if you gave away things in the early part of the year, and then do a major clean-out at the end of the year, putting you over the threshold, the IRS would expect you to have an appraisal covering the items you already gave away – good luck!
Knowing this rule, you might plan to split large donations between two tax years instead of giving the items away all at once.
The standard for donation value is generally fair market value at the time of the gift, although there are exceptions to this, especially when you give away things that are worth more than what you paid for them or you are donating depreciable assets. If you give away property, that if sold, would have resulted in ordinary income, such as donating inventory you bought at wholesale or donating self-created works of art, or if you give away a capital asset held for a year or less that would have resulted in a short-term gain, you have to back out the amount that would have been taxable if you had sold it. Essentially you are limited to deducting your adjusted cost basis in the property.
For instance, an artist, cannot paint a painting, donate it, and then take a deduction for the price he or she would have listed it for in a gallery. The deduction is essentially limited to the cost of the canvas and oils, since anything in excess of that would have been ordinary income. Another way to think about this, is that charitable deductions are typically available for donations of after-tax dollars or things purchased with after-tax dollars. The government is essentially rebating you for tax you already paid when you donate to a charity. So if you haven’t ever paid tax on the money, as in the case with the artist, there is no tax to rebate, so no deduction available.
Sometimes you can have your cake and eat it too. If you give away property that would have resulted in a long-term capital gain, you can generally deduct the fair market value in full (such as a piece of jewelry that has appreciated, or appreciated stock held more than a year), but you are subject to a 30 percent limit of your adjusted gross income instead of the normal limitation of 50 percent. Most working-class people are not giving away 30 percent of their adjusted gross incomes every year, so that is a non-issue for most.
However, later in life, people will sometimes give away substantial assets. Since excess charitable contributions can only carry forward for five years, this limit becomes a bigger problem. The IRS allows you to make an election to choose the 50 percent limit instead of the 30 percent limit, but if you do, you give up the ability to deduct it at its fair market value, and are instead limited to the adjusted cost basis. But this can still be useful given the right circumstances. For instance, recently inherited assets that are given away will often have a cost basis similar to the fair market value, so it could be an easy decision to make the election in such a case.
The donation of vehicles was tightened up substantially a few years back after the IRS noticed a huge gap between the aggregate amount of deductions taxpayers were claiming for vehicle donations versus what charities were reporting as received. Now your deduction is limited to the amount the charity actually sells the car for, and you must report specific information from a Form 1098-C which must accompany the tax return. Pretty much the only time you can use a Blue Book price is when the charity uses the vehicle internally, instead of selling it, and you get a certification of this fact.
The Form 8283 is a two page form. Part I of the first page handles most small donations. Part II handles donations when you have attached strings to the donation, such as conditions that must be followed for the donation to be considered complete. Page two handles larger donations which typically require an appraisal. Parts I and II handle the details of the item(s). Part III is a signature block for the appraiser, and Part IV is a signature block for the donee organization.
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.
Travis H. Long, CPA, Inc. Blog 