Wednesday, August 4, 2010

Q&A: Business Expenses and Tax Deductions

Question: A friend of mine recently told me that he deducts most of his meals with his family because he is self-employed and his wife helps him out with his business. Thus, any of these meals are deductible because they discuss some business while eating. Is this true?

Joe B, Phoenix, AZ

Answer: No, this is definitely not true and is certainly not recommended. In order to deduct your business meals, you must make sure that your business discussion is both “substantial” and “bona fide.” Your friend would fail both of these tests. First, while there are no rules telling you how much time during the meal you must discuss business matters (i.e. it does not need to be a majority of the time), you must be sure that the business discussion is the primary purpose of having the meal. This does not mean that you cannot have a relationship with the person being entertained, but you had better have a valid business relationship with the person before you try to claim any tax deductions. In addition, the IRS would most certainly argue successfully that the primary purpose of your meal was not business related. When you entertain family members, you may be able to show a legitimate business purpose, although this will certainly be more difficult than someone who was not related to you. You should be sure to remember these rules, as it is up to you to prove that you are entitled to deduct the entertainment expenses as legitimate business expenses.

Tuesday, August 3, 2010

Q&A: Rental Property and Tax

Question: I have a rental property that I have been renting out since 2006. I plan on moving into the home next year and want to sell it in a few years. What are my tax consequences of this plan?

Nancy S, Nashville, TN

Answer: There are no tax prohibitions to moving into a rental property and subsequently obtaining the tax benefits of the capital gain exclusion under Section 121 of the Internal Revenue Code. When you sell the rental property, you will need to pay taxes on the amount of depreciation that was claimed while it was a rental property. The tax rate of this “depreciation recapture” is 25%. In addition, any gain that you have on then property (after depreciation) for any period of time after 2008 that it was a rental property is not excludable. For instance, if you rented out the property in 2009 and 2010 and the property increased in value by $20,000 during these 2 years, the $20,000 would be taxable as a gain and not excludable. The good news here, especially if you convert from a rental to a personal residence in 2010, is that it is likely that the property did not go much (if at all) in these 2 years due to the current real estate conditions. As long as you live in the home at least two years as your personal residence after converting it from a rental property, you will be eligible for a capital gains exclusion of $250,000 (single) or $500,000 (married filing a joint tax return).

Monday, August 2, 2010

Q&A: Assistance Dogs and Tax Deductions

Question: I have a dog that I use for medical reasons. Are the costs of this dog tax deductible?

Sarah Y, Vancouver, WA

Answer: Yes. The IRS has ruled that any service dogs used for medical purposes are tax deductible. These animals have been used for a long time to assist blind and deaf citizens.

Now, the IRS has extended this to include those with mental disabilities, including depression and post-traumatic stress disorder. In order to back up this tax deduction, make sure that you have something in writing from your medical professional so that you can prove that the dog is a medical necessity rather than a strictly personal expense. Please also remember that any medical expenses are limited to amounts over and above 7.5% of your income and you must itemize tax deductions in order to claim this deduction at all. It could also be reimbursed under a medical reimbursement plan with a business.

Sunday, August 1, 2010

August: Greetings from the IRS

If you have employees, you will be required to report the value of any health insurance you paid for the employee’s benefit beginning with 2011. Thus, you will need to be able to track these amounts beginning in January 2011.

The IRS Treasury Inspector has reported many compliance issues relating to the homebuyer tax credit. For instance, 256 taxpayers took a tax credit for homes at just five addresses. Several prisoners filed claims and had them approved (where their housing should have been a bit easier to verify!). Many amended returns filed questionable claims and the IRS did not devote resources to examining these returns. And if this wasn’t enough, more than 100 current IRS employees filed claims for the credit when they were not entitled to receive this credit. They are now under an internal investigation! And on a related matter: Congress has extended the time to claim the $8,000 first time homebuyer credit or $6,500 credit for longtime owners. This credit was set to expire on April 30 but now any contracts that were signed prior to April 30, 2010, will have until September 30, 2010, to actually close on the transaction. This extension was done to relieve the backlog of homes trying to close before the prior deadline (delays due to lenders and the federal government administering the lending programs). Congress did NOT extend the deadline of April 30 to contract for the purchase of the home.

The IRS offshore income probes just got a bit stronger, with Swiss bank UBS agreeing to turn over more than 4,000 accounts to the IRS where U.S. tax fraud is suspected. If you have an offshore account and did not report any income earned, you may want to talk to a tax professional about your options, as it does not appear that the IRS is slowing down in any way in the offshore tax fraud investigations.

The IRS has released filing data for the 2007 tax year (the most recent year available) and it showed that 4,535,623 US taxpayers reported an Adjusted Gross Income of at least $200,000. This represented about 3.2% of all individual tax returns filed. The actual number and percentage were record highs. Interestingly, more than 10,000 of these tax returns showed no US income tax liability. The IRS has attributed this to tax-exempt income being earned, along with numerous tax deductions (primarily Schedule A itemized deductions).

The IRS has announced that it will be doing more than 1,000,000 audits via mail this year, as it had a great deal of success with last year’s audits (i.e. they raised a lot of new revenue!). They are going to focus on unreimbursed employee business expenses, large charitable donations, earned income credit and advertising and car expenses for self-employed taxpayers.

August Tax Tips

As we have recently reported, Congress is making some major tax law changes now that will impact taxes for many years in the future.

One of the biggest changes will occur after 2012 and will involve a 3.8% Medicare tax on investment income. First, this tax will apply only to those single taxpayers who earn at least $200,000 and any married couple earning at least $250,000 ($125,000 if filing separately- just another example of a marriage penalty in our tax code). The tax also applies to estates and trusts (but not to any charitable trusts that are otherwise exempt from paying taxes).

For purposes of this new tax, “investment income” includes income from interest, dividends, annuities, capital gains, royalties and rents. For any rents and royalties, the tax would only apply to a net amount (after expenses). The tax does NOT apply to tax-exempt bond interest and gains from the sale of a principal residence (unless there is a tax due after the exclusion has been claimed). Thus, if you are planning to sell your primary residence in the next year or two and will have a taxable gain (if the gain exceeds the $250,000 or $500,000 exclusion amounts for single or married taxpayers), it would be wise to consider selling the home before 2013 so that the gains are not hit with an extra 3.8% tax. The tax savings could be huge, depending upon the extent of the overall gain that is taxable.

This same rule applies to sales of second homes or other investment real estate (not rental properties). Thus, if you are planning on selling a second or vacation home soon, it may make a lot of sense to sell before 2013 if there will be a taxable gain.

Given that tax-exempt municipal bonds are exempt from this tax, we are expecting many financial planners to be recommending these tax-favored investments when the new 3.8% tax goes into effect. Furthermore, this 3.8% tax increase will be in addition to any other tax increases in the future. We continue to expect the tax rates to increase, certainly before 2013.

For instance, we are expecting the taxes on long-term capital gains to increase from 15% to at least 20%. Beginning in 2013 for high-income taxpayers, this tax will actually be 23.8% (assuming our 20% rate prediction is correct). Thus, this new tax will certainly cause us to think about selling appreciated assets before the tax increase goes into effect.

There are a few other planning opportunities present here as well. The new tax does not apply to business income earned from a trade or business. It does not matter how the business is set up, as this will not apply to business income from a sole proprietorship, partnership, LLC or S corporation. It will apply to any business that results in passive income, so entities such as limited partnerships may be subject to this extra tax. We are awaiting additional IRS guidance on this issue.

One investment that is specifically excluded is distributions from tax-favored retirement plans, including individual retirement accounts (IRA) and qualified employer plans (such as 401(k) or 403(b) plans). This will make these plans even more advantageous than they are today.

If you are not fully funding a retirement plan at work or contributing the maximum to an IRA every year, it would be a good idea to review this plan and see if you can now fully fund these plans. If you fund a taxable account and then receive dividends or capital gains, this income would be subject to the 3.8% tax. But if you make these same exact investments in a retirement plan, these will NOT be subject to the 3.8% tax. This again leads us to favor IRAs in general and Roth IRAs in specific, as a Roth IRA will not generate any taxable income in most situations and thus the 3.8% tax will not apply to Roth IRA distributions. If you have been considering a rollover to a Roth IRA from a regular, traditional IRA, it again should be done before 2013 as this rollover will count in your overall income for purposes of the threshold for the 3.8% tax. Thus, if you are married filing jointly and your income is $250,000 (the threshold), converting an IRA to a Roth IRA would push your income over the threshold and subject some of your investment income to the extra taxes. Thus, tax planning will become even more key in the upcoming years as we work to find ways to legally avoid these new taxes.