Archive for the ‘Back to Basics’ Category
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.
Back to Basics Part XXIII – Form 6252 – Installment Sale Income
Filed under: Back to Basics, Residence Sale | Tags: capital gain, contract price, depreciation recapture, Form 6252, gross profit percentage, installment sale, interest, loan assumption, related party, return of basis, seller-financed mortgage, tax deferral
Leave a comment Originally published in the Cedar Street Times
September 18, 2015
Let us assume you are ready to sell a personal residence or a rental property that you have held for many years and it has increased substantially in value from the time you purchased it. If a buyer comes in with all cash or obtains a loan from a bank to buy the property from you, you will recognize the full gain in the year of sale since you get paid in full in the year of sale.
This will skyrocket your income in the year of sale and reek havoc on your taxes. Even though the gain from sale will be considered a long term capital gain, having too much in one year could subject part of the capital gain to a 20 percent rate instead of the normal 15 percent rate. It will also make your adjusted gross income much higher. This will in turn effectively increase your tax on other income since many deductions and credits phase out based on your adjusted gross income. You could also hit an additional 3.8 percent tax on investment income which you may not have been subject to without the sale. There could be a lot of negative effects.
Spreading out income over a period of years is generally a more tax efficient strategy than having one banner year. So how can you avoid this? An installment sale, given the right circumstances, is your answer.
With an installment sale, you are basically telling the seller to pay you over a period of years instead of all at once. Of course, you are generally going to want some interest from the buyer as well if it is going to take a period of years for them to pay you off. With real estate this often takes the form of a seller financed mortgage. You are basically the bank.
In this scenario, you get to spread the taxable gain out over a period of years, thus not creating a bunch of extra tax due to a banner year, and you also create a nice stream of interest income for a period of years. The flip side is that you bear the risk of having to foreclose or repossess if they do not make good on their payments. Also, should you suddenly need the money from your loan to the buyer, you may have to sell the note at a discount to someone else to get your cash out.
If you choose an installment sale, generally a portion of each payment to you will be interest income, a portion will be capital gain, and a portion will be nontaxable return of basis.
Assume you bought a second home years ago for $400,000 and you find a buyer willing to pay $1 million. If they pay all cash or get a loan from a bank to pay you on the closing date, you have $600,000 of taxable capital gain that year and $400,000 nontaxable return of basis – that is a 60 percent gross profit.
Let us assume instead they give you a $250,000 down payment at the time of sale and you loan them the remaining $750,000 with a 15-year amortized note. The payment will be about $6,000 a month with roughly half of each payment consisting of principal and half of interest in the early years. The interest will be taxed as ordinary income as received. The down payment and the principal portion of all future loan payments will be 60 percent taxable capital gain and 40 percent nontaxable return of basis until the loan is paid off.
This is a wonderful way to defer taxation of the capital gains and spread it out over a period of years.
The mechanics of reporting an installment sale play out on Form 6252. The above example is the most basic version of an installment sale, but after reviewing the Form 6252 you will see some complicating issues which could come into play depending on the circumstances – such as sales to related parties, sales of depreciable assets subject to depreciation recapture, and buyers assuming debt(s) of the sellers.
If you dig into the instructions as well as Publication 537, dedicated to this topic, you will quickly realize that installment sales can become extremely complicated, and there are a lot of special rules to follow depending on the circumstances since the deferral of tax is enticing and could otherwise be abused. Installment sales that involve like-kind exchanges, contingent sales, sales of businesses, securities, or other things through the installment method, unstated interest rates in the loan term, dispositions of an installment sale, etc. all add additional complications.
Since installment sales require a higher risk tolerance for the seller, you often see them between related parties where trust is greater. There are can be some unfriendly rules for such transactions. You should consult with a tax professional prior to entering an installment sale with a related party.
The form itself is a one page form. The beginning asks general questions about the property including several on related party issues.
Part I of the form deals with calculating the gross profit percentage and the “contract price.” Note that the contract price is not necessarily the sale price you agreed to, but can be affected if the buyer assumes or otherwise pays off any debt of the seller. This section is only completed in the year of sale.
Part II deals with sorting out the capital gains versus ordinary income, versus recapture income and applying the gross profit percentage to the payments received each year. It is prepared each year.
Part III deals with specifically with related party transactions and necessary recalculations in certain of those circumstances.
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 XXII – Form 6251 – AMT
Filed under: Back to Basics | Tags: 6251, adjustment, Alternative Minimum Tax, Alternative Minimum Taxable Income, AMT, AMT patch, AMTI, depreciation, employee business expenses, ESPP, home equity debt, investment advisory fees, ISO, itemized deductions, minimum tax credit, mortgage interest, parallel, preference, real estate taxes, standard deduction, state taxes, Tentative Minimum Tax
Leave a comment Originally published in the Cedar Street Times
September 4, 2015
AMT, or “Alternative Minimum Tax” was enacted in 1969 in response to a disturbing report by the Secretary of the Treasury that 155 taxpayers with adjusted gross incomes over $200,000 paid zero tax on their 1967 tax returns.
In its simplest form, AMT is a separate taxation system with its own set of rules that runs parallel to the regular tax system. You are supposed to run the calculations under both systems, and if the AMT system says you owe more tax than the regular system, then you pay the incremental difference as “AMT.” That incremental difference shows up as additional tax on Line 45 (2014) of your Form 1040. The calculation of AMT is summarized on Form 6251 and accompanying worksheets, as well as AMT versions of traditional schedules.
The irony of the AMT system is that most of the loopholes it was originally designed to prevent, no longer exist, and it has become a tax that affects the middle and upper-middle class more than the wealthy, yet we still have it and all of its complications. Today, those who are subject to it, despise its existence, and not many people fully understand it, tax practitioners included.
For people still preparing returns by hand, AMT is an absolute nightmare since many of your other schedules have to be calculated a second time using AMT rules. For instance, depreciation rules differ between the AMT system and the regular system, as accelerated depreciation methods are generally not allowed. This means you have to keep an entirely separate set of depreciation schedules just for AMT. And to make matters more complicated, California does not conform to all of the Federal AMT rules either. So now you end up with four sets of depreciation schedules – Federal regular, CA regular, Federal AMT, and CA AMT.
I do not think I have ever seen a hand-prepared return done correctly when AMT is involved. (Actually, in the last ten years, I do not think I have seen any hand-prepared returns done correctly!)
So when do you hit AMT? It depends. AMT is calculated on taxable income under about $185,000 at a flat 26 percent rate, and income over that mark at 28 percent. There is a $53,600-$83,400 AMT exemption amount depending on filing status.
Compared to the regular system, the standard deduction is thrown out (meaning itemizing is your only option), your normal exemptions for yourself, spouse and dependents get the boot, as do many itemized deductions such as state taxes, real estate taxes, mortgage interest on home equity debt (if the funds were not used to improve your home), unreimbursed employee business expenses, tax preparation fees, investment advisory fees and more.
As mentioned before, depreciation methods are not as generous, also ISOs and ESPPs have less tax-friendly rules, investment interest can be hacked, and a whole bunch of other specific differences that apply to certain situations.
Since some people will have more AMT adjustments and preferences than other people, there is no set dollar threshold that will trigger AMT. That said, I feel that I rarely see it for a Married Filing Joint return with under $100,000 of adjusted gross income. It also starts phasing out for people with high incomes. The top AMT rate is 28 percent, but has fewer deductions than the regular system. Besides a handful of lower brackets, the regular system also has 33, 35 and 39.6 percent brackets, but with more deductions. At some point, however, the higher tax rates outweigh the additional deductions and the regular system results in more tax than the AMT system. You may pay no AMT once you get to $600,000 or $700,000 of income, depending on your AMT adjustments.
People in AMT that are employees often feel trapped, especially those in the sales industry that are used to generating a lot of deductions from vehicle mileage and other expenses their employers do not reimburse. It does not matter how many unreimbursed expenses they come up with, they will all get thrown out in the AMT system.
For people that flip back and forth between years of AMT and no AMT, there can be a minimum tax credit generated by the AMT you paid that can be helpful. If you paid AMT in one year, and the next year the regular tax system is higher than the AMT system, you can get a credit against your regular tax to the extent of the difference between the two tax systems limited to the credit amount generated by certain deferral type AMT adjustments/preferences. Got it? Just trust me, sometimes it can help! There are also sometimes when flipping can be a negative…fairness is not always the result of our tax system.
The best news we have had about AMT in recent years was that in 2013 Congress finally legislated an annual inflation adjustment for the AMT exemption. For years Congress was in a habit of passing an AMT patch in late December or January to make up for the fact that the exemption was not inflation adjusted, and would return to 1993 levels if nothing was done.
Tax professionals were biting their nails some years wondering if it would happen. The impacts on middle class Americans would have been tremendous, and many were oblivious. I read estimates in 2011 that 4 million taxpayers were subject to the AMT, but without a patch that number would have swelled to 31 million! I can remember running scenarios for a family making around $100,000 and realizing they would have a surprise tax bill of an additional $2,000 or so without a patch.
The form itself is only two pages. Part I is a summary of all the adjustments and preferences that differ from the regular tax system, to arrive at Alternative Minimum Taxable Income (AMTI). Part II deals with calculating your AMT exemption, your Tentative Minimum Tax (tax calculation under the AMT system), and then the AMT itself (the amount your Tentative Minimum Tax exceeds the regular tax system amount). Part III is a supplemental calculation that feeds into Part II when your return includes capital gains, qualified dividends, or the foreign earned income exclusion.
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 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 XXI – Form 5329 – Penalties on Retirement Accounts
Filed under: Back to Basics | Tags: 25%, 401(k), 457, 50%, 529 plan, 59.5, 70.5, Coverdell ESA, Early Distribution, Excess Contribution, Form 5329, HSA, IRA, MSA, nonqualified, penalty, Qualified Plan, Required Minimum Distribution, RMD, Roth-IRA, SEP-IRA, SIMPLE IRA, ten percent
Leave a comment Originally published in the Cedar Street Times
August 21, 2015
The official name for Form 5329 is “Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.” In other words, “penalties on incorrect contributions to or withdrawals out of retirement accounts, education accounts, and medical accounts.”
Most people are familiar with the fact that retirement accounts such as 401(k)s, 457 plans, IRAs, Roth IRAs, SIMPLE IRAs, SEP IRAs, etc. have limits on the amount of money you can contribute each year. They also limit your ability to withdraw money from those accounts until you are generally 59.5 years old, or meet one of a handful of limited exceptions.
Most people are also familiar with fact that you MUST begin taking distributions by the time you reach 70.5 years old (with a few exceptions such as for Roth IRAs, certain employees that have not yet retired from their job, or non-spouse inherited IRAs). You can delay the distribution in the year you turn 70.5 until April 1st of the following year, but if you do that, then you have to take two distributions that year. IRS instructions are often very poorly worded on this particular matter, and often people misunderstand this important point.
Education savings accounts such as 529 plans or Coverdell ESAs as well as tax favored medical spending accounts such as HSAs and Archer MSAs also have annual contribution limits. In addition, you must use the funds for qualified education or medical expenses, respectively.
If you fail to follow the rules, either by accident or out of necessity, you will generally incur penalties, which are calculated using Form 5329 for most of these infractions.
So, how much are the penalties? If you over-contribute to a retirement plan, education account, or medical spending account there is a six percent penalty on excess contributions if you do not withdraw the excess contribution (plus any related investment earnings) within six months of the original due date of the return, excluding extensions (so by October 15 for almost everybody). Any earnings generated by the over-contribution will be treated as distributions of cash to you in the tax year the correcting withdrawal actually occurs. The rules governing distributions (discussed later) will apply and you may be subject to penalties on that portion. The custodian of the account will calculate the related earnings that need to be pulled out of the account when you inform them of the need to withdraw funds.
If you over-contribute for multiple years in a row before realizing it, the penalty compounds. So you would file a Form 5329 for each of the past years (no 1040X needed) and pay six percent on the excess contributions for the year of the 5329 you are filing, plus any prior excess contributions that still had not been taken out. In other words, you pay six percent every year on the excess contribution until you take it out. Interest would also be assessed on top of the penalties.
If you fail to take a Required Minimum Distribution (RMD), the penalty is 50 percent of the amount that was supposed to be taken out, but was not. Unlike the six percent over-contribution penalty that applies every year until you take the funds out, the 50 percent penalty only applies once. But you would need to withdraw the funds and file a 5329 for each past year you failed to take an RMD. Interest would also be assessed on top of the penalties. Fortunately, the IRS has been pretty lenient with the steep 50 percent penalty, and you can often get them to waive the penalty for reasonable cause once you withdraw the money.
Early distributions for all retirement accounts that do not qualify for an exception are subject to a ten percent penalty, (plus inclusion as taxable income for the portion related to original contributions for which you received a tax deduction as well as on any earnings generated while in the account). SIMPLE IRAs have a special rule that increases the penalty to 25 percent if the date of your first contribution to the SIMPLE IRA was less than two years ago.
Distributions from education savings accounts for nonqualified purposes are subject to a ten percent penalty.
Distributions from medical spending accounts that are not used for qualified purposes are generally subject to a 20 percent penalty. These 20 percent penalties, however, are calculated on different forms (8889 for HSAs and 8853 for MSAs). With HSAs when you reach 65, you can use the money for whatever purpose you want, without penalty. You can also rollover an MSA into an HSA.
Regarding the Form 5329 itself, the first two parts deal with distribution penalties for retirement accounts and education accounts (health account distribution penalties are calculated on other forms). The third through seventh parts deal with excess contribution penalties for each different type of account. The final section, part VIII, deals with penalties on RMDs not distributed.
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 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 XX – Form 4952 – Investment Interest Expense
Filed under: Back to Basics | Tags: annuities, baseball cards, bonds, dividends, financial advisory fees, incidental, interest, investment expense, investment income, Investment Interest Expense, long-term, margin loans, net capital gains, passive activities, qualified dividends, royalties, safe deposit box, Schedule A, short-term, stocks, suspended, vacant land
Leave a comment Originally published in the Cedar Street Times
August 7, 2015
Today is my brother, Justin’s, birthday, and I know just what to get him. We were both avid baseball card collectors from the time we were seven and eight years old on up through our middle school years. Once, we even put on a “Kids Baseball Card Show” to buy, sell, and trade cards. We went around advertising the show with flyers on telephone polls all over the local neighborhoods, and secured the neighborhood pool clubhouse facility to host our show. It was a great success!
At the conclusion of my baseball card collecting career I had amassed over 10,000 cards with albums full of rookie cards and great players at the time. One of my most prized cards was a 1954 Topps Willie Mays. I remember wondering, how much money have I invested in all these cards over the years? Would I be able to retire after selling the cards years later? The Beckett Baseball Card Monthly price guide certainly made me think so based on the prices they listed and the rapid rates of increase. Old cards from the 1940s – 1960s were worth hundreds or even thousands of dollars each.
A few years after my interest in card collecting waned, a mass of new brands flooded the markets. That combined with other problems in baseball at the time sent the card market into an unrecoverable nose dive. Over 20 years later, most cards are still worth a tiny fraction of their peak.
Although my desire was primarily the personal fun of collecting, there were many adult investors that had serious money in cards. As with any investment bubble, I am sure there were collectors mortgaging their homes, running up credit card debt and borrowing from family in order to get a piece of the action.
As I reflect on that now, I see there would have been an opportunity for these people to take advantage of today’s topic – Form 4952 – Investment Interest Expense Deduction. 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 .
Investment interest expense is reported on Schedule A as an itemized deduction and is essentially interest paid on debt used to buy property that produces or hopefully will produce income at some point. It doesn’t include interest expense incurred in your trade or business, or for passive activities like most rental properties. These types of interest get reported elsewhere. So, borrowing money to buy investments such as stocks, bonds, or annuities would qualify. Many financial companies offer margin loans. The interest on these loans would certainly qualify as investment interest expense if the proceeds were used to buy more stocks and bonds. Borrowing money to buy the right to royalty income or to buy property held for investment gain, such as vacant land, art, or even baseball cards would also qualify, among other things.
Due to passive activity rules which limit or even eliminate current deductions on passive rental activities such as a home you rent out, many people would like to be able to deduct the interest as investment interest instead. However, interest on passive activities is specifically excluded from being classified as investment interest expense. The interest on vacant land can usually escape this clause, even if small amounts of rent are collected since the rent is incidental to the paramount investment purpose of appreciation. To be considered incidental, the principal purpose must be to realize gain from appreciation AND the gross rents received for the year must be less than two percent of the lesser of the property’s unadjusted basis or its fair market value.
The rub with investment interest expense is that it is only deductible to the extent that you have investment income! If you have no investment income, you can’t deduct the expense, and it gets suspended until a year you actually do have investment income. So what qualifies as investment income? Well, all of the things we just discussed for which you borrowed money and can deduct as investment interest expense – so interest, dividends, gains from property held for investment, etc. Prior to being applied against investment interest expense, the investment income figure is reduced by other investment expenses that you may have reported on Schedule A – such as investment advisory fees, safe deposit boxes, investment subscriptions, etc.
By default, your net capital gains (meaning net long-term capital gains in excess of net short-term capital losses) as well as qualified dividends are not included in investment income. This is done because both of these already get taxed at favorable lower capital gains rates, so the thinking is, “Why would you want to waste a deduction to offset income that is already getting a lower capital gains rate, when you could instead use it to offset ordinary income taxed at higher rates ?” The answer is that sometimes you may not be able to ever foresee having much ordinary investment income taxable at higher rates. And instead of just suspending the deduction and getting n0 current tax benefit, you elect to include your net capital gains and qualified dividends as investment income and use the deduction to help wipe that income out, thus saving you current taxes.
The Form 4952 itself is a rather simple form – only a half page in length. Part I is a summary of the gross investment interest expense including any current interest and past interest that was carried over. Part II helps you calculate the net investment income from interest dividends, gains, capital gains, less investment expenses from Schedule A. Part III compares parts I and II and calculates the investment interest expense that will be currently deductible, as well as the part that is being suspended to the future if there is not enough investment income to absorb the expenses.
As for the card collecting Justin and I did, I sure am glad we didn’t go into debt buying baseball cards and having to file 4952s! Now about that gift – how about a box of wax packs or a factory sealed set – I know just where to get them…
Travis H. Long, CPA 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 XIX – Form 4797 – Sales of Business Property
Filed under: Back to Basics | Tags: Capital Gains, code head, depreciation, Form 4797, recapture, Sales of Business Property, Section 1245, Section 179, tax accountants
Leave a comment Originally published in the Cedar Street Times
July 24, 2015
Imagine you are reviewing your recently completed personal tax returns in great detail…oh, wait – I am dreaming…imagine that just before fanning all the pages of your returns and stuffing them in a drawer with half used rolls of Scotch tape, a bag of cotton balls, and a few cat toys, your eye happens to land on line 14 on the first page of your tax returns – other income, with a $4,440 figure in it!
You are scratching your head trying to remember getting $4,440 for something. Your cat, perched above, is just staring at you…or maybe judging you. You take the bait and crack open the return to find the referenced Form 4797. “Oh, of course, the office equipment I sold! But wait, I bought it for $15,000 and sold it for $10,200 – isn’t that a loss? Why do I have $4,440 of income?”
Anyone that has ever had his or her own business or a rental property has almost definitely sold or disposed of an asset related to the activity. Some do it every few years, and others do it every year. Perhaps it was a piece of equipment as in our example above, or maybe it was an office desk, a vehicle, or a rental home. Whatever it was, and every year you did it, you were required to file a Form 4797 – Sales of Business Property – our topic for discussion today. If you would like to catch up on our Back to Basics series on personal tax returns, prior articles are republished on my website at www.tlongcpa.com/blog .
Although only a two-page form, the Form 4797 can be complicated to tame as it requires an understanding of a lot of concepts and code sections in order to put it to rest. There are also unique rules that apply to different industries, such as day-traders, farmers, financial institutions, and all of you that are in an industry generating deferred gains from qualifying electric transmission transactions (who has ever even heard of that?!). Reading much beyond the first page of the instructions will either put you to sleep or leave you with more questions than when you started.
The form itself can require you to be a bit of a “code head.” Tax accountants that memorize and relate everything to the Internal Revenue Code section numbers sometimes get this label. The whole second page of the form is a dedication to code heads and is meaningless to the average person. To fill out this page you have to know what code section the property you are disposing falls under.
Aside from the challenges presented in preparing the form, what most people need to know is that when business assets are disposed they are generally going to wind up on this form. It is also key to understand the interplay with past depreciation expense claimed.
Getting back to our example, the question remains why you had $4,440 of income related to selling equipment for less than it was purchased?
In this case, a $15,000 piece of equipment was purchased for your business. Under the normal rules, you are not allowed to take a $15,000 deduction in the year of purchase. Instead, you depreciate the equipment and spread the expense out over a number of tax years. You can elect a “straight-line” amount – meaning the same amount each year, but most people stick with the standard accelerated schedules which allow you to take the majority of the expense deduction in the early years.
In this case it would be MACRS 5-Year Property (which actually gets depreciated over six years). The first year you get to take 20 percent of the purchase price as an expense ($3,000). In the second year you get to take 32 percent ($4,800). So after two years you have already depreciated over half the cost – $7,800. This depreciation expense taken reduces your cost basis in the asset. So instead of saying your cost was $15,000, your new adjusted cost basis is $7,200 ($15,000-$7,800)
On the first day of the third year you decide to sell it. Due to depreciation rules you are allowed another $1,440 of depreciation expense for selling it in the third year further reducing your basis to $5,760. A buyer pays you $10,200. The sale price less the adjusted cost basis yields a taxable gain of $4,400 ($10,200 – $5,760). This gain is also taxed at ordinary rates (not lower capital gains rates) since when you took the deductions, you were able to deduct them against ordinary income. This is called depreciation recapture.
Be glad it was only $4,440 of taxable income. If you had taken a section 179 deduction to elect to write off the entire amount in the year it was placed in service, your basis would have been zero, and you would have had $10,200 of ordinary income.
If for some reason you were able to sell the equipment for more than you bought it for – say $16,000, you would have had the $4,400 of depreciation recapture at ordinary rates, plus a $1,000 long term capital gain. Tangible property such as this is called Section 1245 property.
The first section of the form generally deals with sales of items that have been held over one year. The second section generally deals with the sale of assets held less than a year, and the third section generally deals with calculating depreciation recapture for various types of property. You can also have asset sales that show up in parts one or two, but also in part three. Part four deals with recapturing depreciation under section 179 and when business use of assets drops below 50 percent.
Travis H. Long, CPA 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 XVIII – Form 4684 – Casualties and Thefts
Filed under: Back to Basics | Tags: business loss, Casualties and Thefts, CCH, Cedar Street Funding, Form 4684, Form 4797, fraud, Internal Revenue Code, IRS, IRS scam, lottery, Madoff, personal loss, Ponzi, Schedule A, Schedule D, Zubick
Leave a comment July 10, 2015
My colleague next door enjoys kidding me every two weeks when my next installment of Back to Basics comes out! Although there will not be 10,000 parts as he suggests, there could be! CCH, one of the leading publishers on tax research materials has about 75,000 pages in its Standard Federal Tax Reporter – a product which includes the code, regulations, court case cites, commentary, and other related information. So, if I cover it in 35 articles or so, I probably can’t even call it the “basics” – maybe introductory remarks would be more fitting!
Nonetheless, it is designed to be an overview for commonly used Schedules and Forms. It is also interesting to note with today’s connectivity that people all over the country and the world find the articles reposted on my website and I regularly receive calls and e-mails. Earlier this week I received this response, “Just wanted you to know how much I enjoyed your blog. I wish you were in my hometown in Louisiana!” Thanks for the message, Dianne!
This week we will touch on Form 4684 – Casualties and Thefts. If you would like to catch up on our Back to Basics series on personal tax returns, prior articles are republished on my website at www.tlongcpa.com/blog .
Casualty and theft sounds like language stolen from an insurance agent, and like a good insurance agent, Uncle Sam wants to help you too…sometimes. If you have a large personal financial catastrophe resulting from something like a fire, storm, wreck, robbery, embezzlement, etc. you can claim the loss on Form 4684. Hopefully you have insurance, but if not, or to the extent that it is not covered, such as your deductible, you can claim the unreimbursed portion on this form.
The wheels are already turning – “Wow, I have had several car accidents in the past and I had to pay a $500 deductible – you mean I could have claimed that?” The answer is, “Yes.” However, it likely would not have done you any good since the loss of personal use property has to be in excess of 10 percent of your adjusted gross income (AGI) plus $100. That is a relatively big number for most people. If your AGI is $100,000, for example, that would equate to a $10,100 out-of-pocket loss threshold. Everything over that amount would then go to Schedule A as an itemized deduction. But, if you are retired and not actively earning income that threshold could be much smaller.
Q. “What about a stock market crash, where my portfolio drops by 40 percent – can I claim my losses from that as a casualty/theft loss?” A. – If you have not sold anything, then no. When you do sell, that loss gets reported on Schedule D instead along with gains and losses from capital assets.
Q. “I parked my Ferrari at a sports event and my insurance had lapsed. There were so many parking lots, I never could find it. Can I deduct that loss?” A. – Losing or misplacing money or things (stupidity) is not deductible. Hopefully you will have realized it was stolen, filed a police report, and then the answer would be, “Yes,” assuming there was no reasonable expectation of recovery. If you claim the loss on your tax return, and then two years later the police locate it three states away you would then have to claim it as income when recovered.
Q. “I have been using my yacht for twenty-five years and it has finally worn out and has stopped working. Can I claim that as a loss?” A. – Wear and tear and breakage from normal use are not deductible.
The area where I have seen Form 4684 actually come to significant aid for taxpayers over the years has been regarding financial theft. It is often large and there is generally no insurance reimbursement. Caretakers that get access to accounts, telephone or e-mail scams, and Ponzi schemes are all examples of items that find some relief on the 4684. Local residents may recall Jay Zubick’s $16 million financial investment scheme in Monterey in 2007. Cedar Street Funding would be another example, as well as Bernard Madoff’s massive national scam.
Ponzi schemes are considered business or investment losses since the original intent was to earn a profit. As such they are not subject to the 10 percent threshold. The same would be true for other casualty/theft losses related to business or income-producing property. Caretaker financial abuse, telephone and e-mail scams bilking people out of their personal financial resources, however, are theft of personal assets, and the 10 percent threshold would apply.
Anyone who uses e-mail regularly has no doubt received a fake e-mail from a friend that is stranded in another country and needs money ASAP. This type of fraud would certainly go on the Form 4684. The IRS has warned of numerous scams of people posing as IRS collections agents. Sometimes scams are quite elaborate involving long time periods and multiple con-artists all painting a picture of legitimacy. Fake lottery and other winnings are common fodder for scams where they claim money is needed for fees to transport cash across state borders, or to pay taxes. Often the scammers will start with requests for small amounts of money. They are probing for susceptible people. When they find someone who bites, they start working other scams and raising the stakes each time to soak you for more money.
I have had several occasions to work with people that have had hundreds of thousands of dollars stolen through such means. In these situations, the Form 4684 allows the taxpayer to get a large deduction which can even create a net operating loss on the current year tax return. This net operating loss can then be carried back several years to recoup past taxes paid and/or carried forward to the future to reduce taxes then as well.
The Form 4684 is a three-page form. The first page deals with casualties and thefts related to personal property, and helps you calculate the amount of loss after the 10 percent plus $100 deduction to carry to Schedule A as an itemized deduction.
The second page helps you calculate the losses related to business or income-producing property. Depending on the exact type of business or income producing property, the loss could carry over to the Form 4797 and eventually make its way to page one of the Form 1040 and directly offset ordinary income and lower adjusted gross income. Other types still go to Schedule A where they may not be quite as beneficial, but still helpful.
The third page deals specifically with Ponzi type schemes. Note that there are many types of financial investment schemes out there, but to be deductible on the Form 4684 as such, they must fall under the definition the IRS uses. There are also special ways to calculate the losses since Ponzi schemes generally wind up in court for years while the records are sorted out and funds are attempted to be recovered.
Travis H. Long, CPA 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 XVII – Form 4562 – Depreciation and Amortization
Filed under: Back to Basics | Tags: 5-year, 7-year, ACRS, ADR, ADS, amortization, asset class, Asset Classes, bonus depreciation, conventions, declining balance, depreciation, Depreciation Policy, half-year, listed property, MACRS, mid-month, mid-quarter, Modified Accelerated Cost Recovery System, Section 179, special depreciation, useful life
Leave a comment Originally published in the Cedar Street Times
June 26, 2015
If you want to take a relatively simple concept and complicate it to the nth degree, then you will fall in love with depreciation expense! I am sure there have been numerous doctoral candidates in the accounting field that have written their dissertations on the topic of depreciation. There are so many angles – matching the expense of an asset with the revenues it generates, shifting economic policies, grandfathering of legacy rules, and of course politics and lobbyists. Today we will be talking about Form 4562 – Depreciation and Amortization. If you would like to catch up on our Back to Basics series on personal tax returns, prior articles are republished on my website at www.tlongcpa.com/blog .
At its core, the concept of depreciation expense is rooted in what accountants call the “matching principle.” You are trying to spread out the cost of purchasing an asset for your business or investment activity over the years that it is useful to you – thus allocating the expense to the periods of revenue that result from the asset. Take a pencil for example. You purchase the pencil at the beginning of the year. You use it to write notes, draft reports, and fill out forms, which lead to revenue throughout the year. By the end of the year you are left with a short stub, riddled with bite marks and a half-used blue pencil top eraser with a split down the side…so you throw it away. On your tax returns you have a $50,000 of revenue, offset by a $0.25 deduction for the pencil that helped generate the revenue. Clearly, the revenue and the expense were matched in the same period.
But what about the stapler that you also bought at the same time as the pencil? You bought a quality, metal stapler for $25. It could be sitting on your desk until you retire, and then get passed on to your successor! Let us assume it helps you earn revenue for 25 years before becoming the victim of a careless office prank. The matching principle would say you take the $25 and spread it out over the 25 years of its useful life, taking a $1 of expense each year against the revenue it helped you earn all those years. You would of course have to track the stapler on a schedule and each year update it for the depreciation expense taken. It would be helpful to have a column for the accumulated total of depreciation you had taken over the years so you know what is left to deduct as well.
That is depreciation expense in its simplest form. Unfortunately, the tax code is anything but simple – sometimes for good reasons, and sometimes for not so good reasons. A full explanation of depreciation rules would require thousands of pages of text. Here are some of the key concepts to help you swim with depreciation. It is important to note that depreciation is not a choice. There are choices within the depreciation laws, but you cannot just say – I do not want to participate.
Depreciation vs. Amortization – essentially a matter of semantics. Depreciation is the word used in association with tangible assets purchased; amortization is the word used in association with intangible assets purchased, such as goodwill, patents, and copyrights.
Depreciation Policy – it would be impractical to track every asset you buy that has a useful life of more than a year (like the stapler!), so depreciation policies are developed in accordance with limits established by law. For instance, everything over $500 will be depreciated, and everything below that will just be expensed in the year it is purchased.
Asset Classes – the IRS has pre-determined the periods and methodology for depreciating the vast majority of assets. The Modified Accelerated Cost Recovery System (MACRS) is the system used for depreciation today. Inside that there is the general depreciation system and the alternative depreciation system (ADS) (ADS is mainly used for assets held outside the U.S.). Inside the more common general depreciation system there are 3-year, 5-year, 7-year, 10-year, 15-year, etc. on up to 50-year asset classes. For instance, off-the-shelf computer software is 3-year property; machinery, equipment, and computers in a business are 5-year property; and land improvements are 15-year property.
So you do not just pick the expected useful life in your opinion – you use what the IRS says, instead. Of course there are always strange nuances – such as furniture in a business is 7-year property but furniture in a residential rental is 5-year property. Or the fact that the residential rental house you own is 27.5-year property, but an entire “motorsports entertainment complex” is only 7-year property (think NASCAR lobbyists). These classes are generally “accelerated” as well, meaning you do not simply divide the cost by the number of years and depreciate it ratably. That would be “straight-line depreciation.” Instead there are methods such as 200% Declining Balance and 150% Declining Balance that front-load the depreciation expense in the early years, resulting in less in the later year.
There are also “conventions” depending on the asset class and date it is placed in service during the year when you first acquire it. These include “half-year,” mid-quarter,” and “mid-month,” and determine how you calculate the depreciation in the first year. To make matters more complicated, the tax laws have changed over the years, but the system that was in place when you placed the asset in service governs it for life. MACRS was established in 1986. Prior to that, there were several other systems with their own sets of rules: the Accelerated Cost Recovery System (ACRS) was used from 1981-1985, and prior to that, the Asset Depreciation Range (ADR) system was used. It is still possible to have assets under ADR, ACRS, and MACRS! To say that software is necessary is an understatement. It certainly works wonders with the calculations, but you still have to understand the laws and options to make the right selections and decisions.
Section 179 Deduction – from year-to-year the political and economic environments dictate an incredibly powerful deduction under IRS Code Section 179. This code section is kind of like an override that allows you to elect to expense assets in their entirety in the year purchased rather than spreading the deduction out over a period of years. The code section was created in 1958 when it had a $2,000 cap. The amounts were slowly raised up to $25,000 by 2003. Since then, each year Congress has made huge overrides to the codified $25,000 amount jumping it to $100,000, $125,000, $250,000, and even $500,000 where it has been for the last five years, but it generally defaults back to the $25,000 figure where it currently sits for 2015, unless Congress “saves the day” again. Many business owners have come to rely on this for large purchases, but it is good to remember, it may not be there. Certain assets do not get 179 treatment or there are modified rules. Vehicles for instance are not eligible unless it is a vehicle with a gross weight rating of over 6,000 pounds. Even then, the depreciation amount has been capped at $25,000 in recent years on those particular vehicles. For assets you want to elect to claim the 179 treatment, you still must go through the formal process of setting them up on a depreciation schedule and reporting them on the Form 4562.
Bonus Depreciation/Special Depreciation – these are additional concepts that Congress has created over the years allowing more depreciation in certain circumstances. One of the concepts with special depreciation has been that the assets must be brand new (not purchased in used condition). This was certainly a policy implemented to try to stir the economy.
Other Rules – there are a host of other rules, such as how to handle assets that you exchange for other ones (like trading in a vehicle), what do you do if you convert the asset to personal use, or use assets for both business and personal use, what do you do when you sell assets, etc. And there are lots of very pointed rules that clearly address certain industry desires such as “qualified second generation biofuel plant property,” which apparently was important enough to the masses to warrant half a column among the sea of information that could have been presented in the condensed 22 pages of instructions to the Form 4562!
The Form 4562 itself is two pages long. The first section deals with reporting any assets for which you are electing to take a Section 179 deduction. The next section deals with Special Depreciation. The third section deals with reporting assets under the regular MACRS depreciation asset classes, but you only have to list the assets on the form during the first-year they are placed in service – not every year. Your separately maintained depreciation schedules will track them for all years. Depreciation schedules need not be submitted to the IRS with your returns, but should be maintained for reference and in the event of an audit. The fourth section is a summary. The majority of the second page deals with automobiles and listed property, which are required to be reported each year, since they have special limiting rules. Listed property includes certain types of property that often have mixed personal and business use, so the IRS wants to monitor these more closely. The final section is for amortizable assets. As with depreciable assets, you only have to list amortizable assets in the first year they are placed in service.
Keep in mind that besides the regular depreciation schedules, you also typically have to maintain separate state depreciation schedules, which can have their own rules. California, for instance, does not conform to Section 179 deductions among many other things. In addition, you should track Alternative Minimum Tax (AMT) versions of the federal and state schedules as they can differ as well, should you be impacted by AMT.
Travis H. Long, CPA 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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