Archive for the ‘dividends’ Tag

Back to Basics – Part XX – Form 4952 – Investment Interest Expense

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 VI – Schedule B

Originally published in the Cedar Street Times

December 26, 2014

In this issue, we are discussing Schedule B – Interest and Ordinary Dividends.  Prior articles are republished on my website at www.tlongcpa.com/blog if you would like to catch up on our Back to Basics series on personal tax returns.

Interest you earn from the use of your money by others is reported in detail  in Part I of Schedule B and then summarized on Line 8a of Form 1040.  Interest is taxed as ordinary income depending on your tax bracket.  The most common form is interest earned from your banks or investment companies.  You will generally receive a Form 1099-INT telling you the amount you paid if the amount is over $10.  If it is under $10, there is no requirement for the payor to go through the hassle to report it to you and the IRS; technically that does not alleviate your responsibility to report it on your tax returns, however.  This holds true for all IRS reportings.  Some people think if no tax document is received, they are somehow relieved from the responsibility to report.  This is an incorrect notion.

Other forms of interest to report on Schedule B could be interest earned from personal loans made to friends or family, or loans made to a business.  In practice, you often will not receive a 1099-INT from individuals you loan money to, but they actually have the same requirements as a bank to file a 1099-INT for interest they pay to you, and they could be penalized for not doing so.

Another form of interest you need to report on Schedule B is interest earned from a seller-financed mortgage.  If you sold your home and carried back a note on the house from the buyer, the interest they pay you is reportable interest on Schedule B.  You are required to track the interest and report it properly.  You and the buyer are both required to provide your names, Social Security numbers, and addresses to each other for proper tax reporting and matching.  You list the buyer’s information in Part I of Schedule B next to the amount they paid you.  A buyer will do the same for reporting the mortgage interest on Schedule A.  A Form W-9 is the best document to request and provide Social Security Numbers.  Buyers and sellers could each be penalized if they fail to provide their Social Security numbers for this purpose or if they simply get it verbally, and it is incorrect.  A W-9 signed by the other party is a protection to you.

Be careful to not include any tax-exempt interest such as from U.S. Treasury Bonds or tax-free municipal bonds on Schedule B.  These would be reported on Line 8b of Form 1040 and are generally not taxable unless there are other adjustments such as those made for Alternative Minimum Tax on Form 6251.  Another source of interest to avoid reporting on your Schedule B is interest earned from investments in your retirement plan (I have see people make this mistake!).

There are other forms of interest or adjustments such as original issue discounts, private activity bond interest, amortizable bond premiums, and nominee distributions which are beyond the scope of this article.

Dividends are reported in detail in Part II of Schedule B and summarized on Line 9a of Form 1040.  Dividends are essentially a return of part of the profits of the business to the owners.  When you own shares of stock in a company, for instance, they may pay out a certain amount per share if the company is doing well.  You can reinvest the dividends and buy more shares or take the cash.  Either way, the dividends get reported on Schedule B.

Dividends are taxed at your ordinary income tax bracket rate unless they qualify for special capital gains rate treatment.  Then they are called qualified dividends.  To qualify for special treatment the dividends must be from U.S. corporations, corporations set up in U.S. Possessions, or in foreign countries with certain tax treaty benefits, or if readily tradable on U.S. stock exchanges.  If you have held the stock for less than a year, there are also some specific holding period requirements that could still allow the stock to qualify.

The portion of ordinary dividends that are considered qualified are reported on Line 9b of Form 1040, and don’t actually show up on the Schedule B.  This is a large advantage as people in the 10 percent or 15 percent income tax bracket pay no tax on capital gains and qualified dividends!  People in the top 39.6 percent bracket pay a 20 percent rate on qualified dividends and everyone in between pays 15 percent.

Part III of Schedule B consists of questions about any foreign accounts or trusts you own or have signature authority over.  These questions are EXTREMELY important to answer correctly.  If you have a foreign account you will also need to file FinCen Form 114 with the Treasury Department.  There are potentially massive penalties for failure to properly report on FinCen Form 114, even if unintentional, and possible jail time if you willfully do not report.  You may also need to file a Form 8938, a 3520 or other forms related to foreign assets.  If you have foreign assets, you should seek professional support that has experience in this area.  Getting caught is much worse than coming forward.

In two weeks we will continue our Back to Basics series with Schedule C – Profit or Loss from Business

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.

New Tax Impacts for Trusts with Capital Gains – Part II

Originally published in the Cedar Street Times

November 15, 2013

Two weeks ago I laid the groundwork of some of the basics on revocable and irrevocable trusts in order to start discussing new implications due to law changes in 2013.  Revocable trusts such as the common revocable living trust most people use for estate planning is disregarded for tax purposes as separate from the owner – in other words all of the income generated by its assets gets reported on your personal 1040 tax return.  Irrevocable trusts, such as a bypass trust commonly used in estate planning, or a gifting trust, are treated as separate tax paying entities, get their own taxpayer identification number, and file their own tax returns.

In early 2013 new laws were passed that increased the personal income tax rates from 35 percent to 39.6 percent on people in the highest tax bracket ($400,000 filing single or $450,000 married filing joint).  It also raised the capital gains rate to 20 percent for these same people (up from 15 percent).  In addition, a new 3.8 percent Medicare surtax is assessed on net investment income (think interest, dividends, capital gains, among others) for people making over $200,000 single or $250,000 filing joint.  Most people do not make $450,000 or even $250,000 a year, so this seems innocuous to many.

However, many people making less than these thresholds do have irrevocable trusts – most commonly after a spouse has passed away.  The problem with irrevocable trusts is that the thresholds to be impacted are so much lower.  Once your trust has just $11,950 (2013) of income, you have hit the top bracket and will be subject to the 39.6 percent income tax rate, 20 percent capital gains rate, and the 3.8 percent Medicare surcharge!  One stock sale could easily put you in the top bracket!  This effectively means an 8.8 percent tax increase on capital gains and 4.6 percent to 8.4 percent increase on other types of income.  That is a big hit every year, and will be something new to battle.

If you can avoid having the income taxed to the trust, and instead have it distributed out and taxed to the beneficiaries, you can probably save a chunk of taxes since it will be taxed at the lower rates on the beneficiary tax returns – assuming your individual beneficiaries are not in the top tax bracket!

Whether or not you have discretion or are required to distribute income to beneficiaries is defined in your trust document.  Even the very definition of “income” itself, for trust accounting purposes, is governed by your trust document primarily and the state’s principal and income act, secondarily.  The proper allocation of income and expenses to trust accounting income or principal is very important to beneficiaries (whether they realize it or not), since trust accounting income generally goes to one beneficiary, and the principal often goes to a different beneficiary down the road…so it determines the amount the beneficiaries receive.  Many common irrevocable trusts are written to require the distribution of trust accounting income each year to the current beneficiaries with rights to dip into principal as needed to maintain an ascertainable standard of living.  Upon death, the remaining principal goes to the remainder beneficiaries.

The California Uniform Principal and Income Act does not define capital gains as income, but as a principal transaction – basically an asset changing form – for instance from real estate to cash.  I hardly ever see trusts that even mention capital gains, much less defining it as a part of income.  In the absence of trust language, the principal and income act governs, therefore many trusts in California are not permitted to distribute capital gains to the beneficiaries.

It is amazing to me how many trust tax returns I have seen over the years that violate this – often because the preparer does not really understand trust taxation rules.  I have even run into cases where the prior preparer has never even asked for the trust document, and thus relies on the default settings in their tax software in conjunction with “the way we’ve always done it” to govern!  This would be analogous to creating a detailed shopping list and asking your neighbors to go shopping for you; in lieu of taking your list, they go on the internet and print out a list of common things people buy, and then supplement it with things they have bought for other neighbors in the past! Chances are pretty good; you will not get what you need!  Enforcement of correct trust income tax preparation comes much more often by threats of lawsuit against the trustee than by IRS audit. Keep in mind the remainder beneficiary’s attorney would be happy to sue the trustee for shorting his client’s share by not following the terms of the trust.

In two weeks we will conclude our discussion.

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

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

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.

Your Future Tax Return: Romney Versus Obama

Originally published in the Cedar Street Times

November 2, 2012

If tax positions would sway your Tuesday vote, here is what Obama and Romney would like to see.  Keep in mind, however, you don’t always get what you want!

Tax brackets: Romney reduce to 80% of current levels. Obama keep the same as 2012 except allow top bracket to split into two higher brackets like pre-2001. (Romney, Current 2012 Rates, Obama, 2013 rates if no congressional action ) (8%, 10%, 10%, 15%), (12%, 15%, 15%, 15%), (20%, 25%, 25%, 28%), (22.4%, 28%, 28%, 31%), (26.4%, 33%, 33%, 36%), (28%, 35%, 36% and 39.6%, 39.6%)

Capital gains, interest, dividends: Romney reduce tax rate to zero for AGI below $200K.  15% max if AGI above $200K. Obama increase long-term capital gains rate to 20% max and up to 39.6% on dividends – leave interest taxed at ordinary bracket rates.

2013 3.8% Medicare surtax on net investment income and existing 0.9% medicare surtax for married filers over $250K AGI and others over $200K: Romney repeal.  Obama keep.

Itemized deductions: Romney cap itemized deductions (maybe $17,000-$50,000 cap) and maybe eliminate completely for high income.  Obama reduce your itemized deductions by 3% of your AGI in excess of $250K married, $225K HOH, $200K single, and $125K MFS (up to 80% reduction of itemized deductions) and limit the effective tax savings to 28% even if you are in a higher bracket.

Income exclusions: Romney keep as is. Obama cap the effective tax savings to 28% on exclusions from income for contributions to retirement plans,  health insurance premiums paid by employers, employees, or self-employed taxpayers, moving expenses, student loan interest and certain education expenses, contributions to HSAs and Archer MSAs, tax-exempt state and local bond interest, certain business deductions for employees, and domestic production activities deduction.

AMT: Romney repeal. Obama keep but set exclusion to current levels and index for inflation.

2009 expanded Child Tax Credit, increased Earned Income Credit, and American Opportunity Credit: Romney – Allow to expire as scheduled 12/31/12.  Obama – Make permanent.

Buffett Rule: Romney “Not gonna do it.” Obama households making over $1 million should not pay a smaller percentage of tax than middle income families.  This is accomplished by raising the rates on capital gains and dividends as discussed earlier.

Temporary two percent FICA cut you have been enjoying in 2011 and 2012: Both candidates favor allowing to expire at 12/31/12.

Estate tax: Romney repeal.  Obama set at $3.5 million and index for inflation with top rate of 45% on excess.

Top corporate tax rates: Romney 25%. Obama – keep at 35% for 2013 but maybe reduce to 28% in the future.

Corporate international tax: Romney don’t tax U.S. companies on income earned in foreign countries. Obama discourage income shifting to foreign countries.

Corporate tax preferences: Romney extend section 179 expensing another year, create temporary tax credit, expand research and experimentation credit. Obama increase domestic manufacturing incentives, impose additional fees on insurance and financial industries, reduce fossil fuel preferences.

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

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

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.