Defer Gains with Qualified Opportunity Funds

If you have a large capital gain from the sale of a stock, asset, or business and would like to defer that gain with the possibility of excluding some of it from taxation, you may want to check out the new investment vehicle created by tax reform, called a qualified opportunity fund (QOF).

Congress, as a means of helping communities that have not recovered from the past decade’s economic downturn, included a provision in the Tax Cuts and Jobs Act intended to promote investments in certain economically distressed communities through QOFs. Investments in QOFs provide unique tax incentives that lawmakers designed to encourage taxpayers to participate in these funds.

Reinvesting Gains – Taxpayers who have a capital gain from selling or exchanging any non-QOF property to an unrelated party may elect to defer that gain if it is reinvested in a QOF within 180 days of the sale or exchange. Only one election may be made with respect to a given sale or exchange. If the taxpayer reinvests less than the full amount of the gain in the QOF, the remainder is taxable in the sale year, as usual. Only the gain need be reinvested in a QOF, not the entire proceeds from the sale. This is in sharp contrast to a 1031 exchange where the entire proceeds must be reinvested to defer the gain.

The gain income is deferred until the date when the QOF investment is sold or December 31, 2026, whichever is earlier. At that time, the taxpayer includes the lesser of the following amounts as taxable income:

a. The deferred gain or
b. The fair market value of the investment, as determined at the end of the deferral period, reduced by the taxpayer’s basis in the property. (Basis is explained below.)

A taxpayer who holds a QOF investment for 10 years or more before selling it can elect to permanently exclude the gain from the sale that is in excess of the originally deferred gain (i.e., the appreciation).

Qualified Opportunity Fund Basis – The basis of a QOF that is purchased with a deferred gain is $0 unless either of the following increases apply:

(a) If the investment is held for 5 years, the QOF’s basis increases from $0 to 10% of the deferred gain.

(b) If the investment is held for 7 years, the QOF’s basis increases from $0 to 15% of the deferred gain.

If, on December 31, 2026, a taxpayer holds a QOF that was purchased with deferred gains, the original deferred gain, or if less, the difference between the fair market value of the QOF reduced by the basis, must be included as gross income on that taxpayer’s 2026 return; the basis of the investment will then be increased by the amount of this included gain.

If the QOF investment is held for at least 10 years before being sold, the taxpayer can elect to increase the basis to the property’s fair market value. This adjustment means that the QOF’s appreciation is not taxable when it is sold.

Example 1: On June 30, 2018, Phil sold a rental apartment building for $3 million, resulting in a gain of $1 million. Within the statutory 180-day window, he invested that $1 million into a QOF and elected to defer the gain from the building’s sale. On July 1, 2026, he then sold the QOF for $1.5 million. Because Phil held the investment for over 7 years, its basis is enhanced by $150,000 (15% of $1 million). Because the investment’s fair market value is greater than the original deferred gain, he must include a taxable gain of $1.35 million ($1.5 million – $150,000) in his 2026 gross income. 

Example 2: The facts here are the same as in Example 1, except Phil waited to sell the QOF until 2030, meaning that he held it for nearly 12 years. On December 31, 2026, the fair market value of the QOF was $1 million. Because he had the investment on December 31, 2026, he was required to include $850,000 ($1 million – $150,000) of deferred gain on his 2026 return, the lesser of the $1 million gain he deferred or the FMV less his basis. He then increases his basis in the QOF from $0 to $850,000. After selling the QOF for $1.5 million in 2030, Phil elected to permanently exclude the gain by increasing his basis to $1.5 million (the fair market value on the date of the sale). Thus, he has no gain ($1.5 million – $1.5 million) in 2030.

Mixed Investments – If a taxpayer’s investment in a QOF consists of both deferred gains and additional investment funds, it is treated as two investments; this provides the tax benefits of both types: the temporary gain deferral and the permanent gain exclusion (which applies only to the deferred gain).

Qualified Opportunity Funds – To defer capital gains-related taxes through the recently enacted opportunity-zone program, taxpayers must invest in a QOF – an investment vehicle that is organized as a corporation or a partnership for the purpose of investing in properties within qualified opportunity zones. These investments cannot be in another QOF, and the properties must have been acquired after December 31, 2017. The fund must hold at least 90% of its assets in the qualified-opportunity-zone property, as determined by averaging the percentage held in the fund on the last days of the two 6-month periods of the fund’s tax year. Taxpayers may not invest directly in qualified opportunity zone property.

Partnerships – Because a QOF that is purchased with deferred capital gains has a basis of zero, taxpayers who invest in QOFs that are organized as partnerships may be limited to deducting the losses that these partnerships generate.

Qualified Opportunity Zones – A low-income census tract can be specifically designated as a qualified opportunity zone after a nomination from the governor of that community’s state or territory. Once the qualified opportunity zone nomination is received in writing, the U.S. Treasury Secretary can certify the community as a qualified opportunity zone. Once certified, zones retain this designation for 10 years.

If you have a capital gain or potential gain and would like to explore the tax ramifications for your particular situation of deferring the gain into a QOF, please call us.

Start Off on the Right Foot for the 2019 Tax Year

Individuals and small businesses should consider various ways of starting off on the right foot for the 2019 tax year.

W-4 Updates – If you are employed, then your employer takes the information from your Internal Revenue Service (IRS) Form W-4 and applies it to the IRS’s withholding tables to determine the amount of income tax to withhold from your wages in each payroll period. This process did not work all that well in 2018 because, in the wake of the tax reform, the IRS did not have time to properly redesign Form W-4 and adjust its withholding tables. In fact, the IRS has announced that this task will not be completed until it issues the 2020 versions of Form W-4 and the withholding tables.

Thus, the problem from 2018 continues into 2019; if your 2018 refund or balance due was not the desired amount, then please consider adjusting your withholding based on your projected tax for 2019. If you need assistance, please call this office.

W-9 Collection – If you are operating a business, then you are required to issue a Form 1099-MISC to each service provider to which you have paid at least $600 during a given year. It is a good practice to collect a completed W-9 form from every service provider (even if you are paying less than $600), as you may use that provider again later in the year and may have difficulty getting a W-9 after the fact—especially from providers that do not plan to report all of their income for the year.

Estimated Tax Payments – If you are self-employed, then you prepay each year’s taxes in quarterly estimated payments by sending 1040-ES payment vouchers or making electronic payments. For the 2019 tax year, the first three payments are due on April 15, June 17, and September 16, 2019, and the final payment is due on January 15, 2020. Generally, these payments are based on the prior year’s taxable income; if you expect any significant changes in either income or deductions relative to the previous year, please contact this office for help in adjusting your payments accordingly.

Charitable Contributions – If you marginally itemize your deductions, then you can employ the bunching strategy, which involves taking the standard deduction one year but itemizing your deductions in the next. However, you must make this decision early in the year so that you can make two years’ worth of charitable contributions in the bunching year.

Required Minimum Distributions – Each year, if you are 70.5 or older, you must take a required minimum distribution from each of your retirement accounts or face a substantial penalty. By taking this distribution early in the year, you can ensure that you do not forget and accidentally subject yourself to penalties.

Gifting – If you are looking to reduce your estate-tax exposure or if you just want to give some money to family members, know that, each year, you can gift up to $15,000 to each of an unlimited number of beneficiaries without affecting the lifetime estate-tax exclusion amount or paying a gift tax.

Retirement-Plan Contributions – Review your retirement-plan contributions to determine whether you can afford to increase your contribution amounts and to make sure that you are taking full advantage of your employer’s contributions to the plan.

Beneficiaries – Marriages, divorces, births, deaths, and even family clashes all affect whom you include as a beneficiary. It is good practice to periodically review not just your will or trust but also your retirement plans, insurance policies, property holdings, and other investments to be sure that your beneficiary designations are up to date.

Reasonable Compensation – With the advent of the 20% pass-through deduction, which is available to most businesses other than C-corporations, the issue of reasonable compensation takes on a whole new meaning, particularly for S-corporations’ shareholders. This has been a contentious issue in the past, as it has allowed shareholders who are not just investors but who are actually working in the business to take a minimum salary (or no salary at all) so that all their income passes through the K-1 as investment income. This strategy allows such shareholders to avoid payroll taxes on income that should be treated as W-2 compensation. A number of issues factor into a discussion of reasonable compensation, including comparisons to others in similar businesses and to employees within the same business, as well as the cost of living in the business’s locale. This is a subjective amount, and it generally must be determined by a firm that specializes in making such determinations.

Business-Vehicle Mileage – Generally, vehicles with business use also have some amount of nondeductible personal use in a given year. It is always a good practice to record a vehicle’s mileage at the beginning and at the end of each year so as to determine its total mileage for that year. The total mileage figure is then used when prorating the personal- and business-use expenses related to that vehicle.

College-Tuition Plans – Contribute to your child’s Section 529 plan as soon as possible; the funds begin accumulating earnings as soon as they are in the account, which is important because the student will likely begin using that money at age 18 or 19.

Only a few of the tax-related actions that you take during a year will benefit yourself or others. The most important of these actions is keeping timely and accurate tax records; for businesses in particular, this is of the utmost importance. Those who have well-documented income and expense records generally come out on top when the IRS challenges them.

Please call us if you have any questions related to your taxes or if would like an appointment for tax projections or tax planning.

Short-Term Rental, Special Treatment

With the advent of online sites such as Airbnb, VRBO, and HomeAway, many individuals have taken to renting out their first or second home through these online rental sites, which match property owners with prospective renters. If you are doing that or are planning to do so, there are some special tax rules you need to know.

These special (and sometimes complex) taxation rules are based upon the length of time you rent your property out and with varying tax outcomes. In some situations, the rental income may be tax-free. In other situations, your rental income and expenses may need to be treated as a business, as opposed to a rental activity. The following is a general synopsis of the rules governing short-term rentals (those rented for average rental periods of 30 days or less).

Rented for Fewer Than 15 Days during the Year – When a property is rented for fewer than 15 days during the tax year, the rental income is not reportable, and the expenses associated with that rental are not deductible. Interest and property taxes are not prorated, and the full amounts of the qualified mortgage interest and property taxes are reported as itemized deductions (as usual) on the taxpayer’s Schedule A.

The 7-Day and 30-Day Rules – Rentals are generally passive activities. However, an activity is not treated as a rental if either of these statements applies:

A. The average customer use of the property is for 7 days or fewer—or for 30 days or fewer, if the owner (or someone on the owner’s behalf) provides significant personal services.

B. The owner (or someone on the owner’s behalf) provides extraordinary personal services without regard to the property’s average period of customer use.

If the activity is not treated as a rental, then it will be treated as a trade or business, and the income and expenses, including prorated interest and taxes, will be reported on Schedule C instead of Schedule E, the IRS form used to report longer-term real estate rentals. IRS Publication 527 states: “If you provide substantial services that are primarily for your tenant’s convenience, such as regular cleaning, changing linen, or maid service, you report your rental income and expenses on Schedule C.” Substantial services do not include furnishing heat and light, cleaning public areas, collecting trash, and such.

Exception to the 30-Day Rule – If the personal services provided are similar to those that generally are provided in connection with long-term rentals of high-grade commercial or residential real property (such as public area cleaning and trash collection), and if the rental also includes maid and linen services that cost less than 10% of the rental fee, then the personal services are neither significant nor extraordinary for the purposes of the 30-day rule.

Profits and Losses on Schedule C – Profit from a rental activity is not subject to self-employment tax, but a profitable rental activity that is reported as a business on Schedule C is subject to this tax. A loss from this type of activity is still treated as a passive activity loss unless the taxpayer meets the material participation test – generally, providing 500 or more hours of personal services during the year or qualifying as a real estate professional. Losses from passive activities are deductible only up to the passive income amount, but unused losses can be carried forward to future years. A special allowance for real-estate rental activities with active participation permits a loss against nonpassive income of up to $25,000 – but phases out when one’s modified adjusted gross income is between $100K and $150K. However, this allowance does NOT apply when the activity is reported on Schedule C.

These rules can be complicated; please call us to determine how they apply to your particular circumstances and what actions you can take to minimize the tax liability and maximize the tax benefits from your rental activities.

Big Tax Changes for Divorce Decrees after 2018

Welcome to 2019 and a delayed provision of the tax reform, also known as the Tax Cuts and Jobs Act (TCJA). For divorce agreements entered into after December 31, 2018, or pre-existing agreements that are modified after that date to expressly provide that alimony received is not included in the recipient’s income, alimony will no longer be deductible by the payer and won’t be income to the recipient.

This is in stark contrast to the treatment of alimony payments under decrees entered into and finalized before the end of 2018, for which alimony will continue to be deductible by the payer and income to the recipient.

Having the alimony treated one way for one segment of the population and the exact opposite for another group of individuals seems unfair and may ultimately make its way into the court system. But in the meantime, parties to a divorce action need to be aware of the change and compensate for it in their divorce negotiations, for a decree entered into after 2018.

This is not the first time Congress has tinkered with alimony. Way back in the mid-1980s, the definition of alimony was altered to prevent property settlements and child support from being deducted as alimony. Under the definition of alimony since then, payments:

(1) Must be in cash, paid to the spouse, the ex-spouse, or a third party on behalf of a spouse or ex-spouse, and the payments must be made after the divorce decree. If made under a separation agreement, the payment must be made after execution of that agreement.

(2) Must be required by a decree or instrument incident to divorce, a written separation agreement, or a support decree that does not designate payments as non-deductible by the payer or excludable by the payee. Voluntary payments to an ex-spouse do not count as alimony payments.

(3) Cannot be designated as child support. Child support is not alimony.

(4) Are valid alimony only if the taxpayers live apart after the decree. Spouses who share the same household can’t qualify for alimony deductions. This is true even if the spouses live separately within a dwelling unit.

(5) Must end on the death of the payee (recipient) spouse. If the divorce decree is silent, courts will generally consider state law, and where state law is vague, judges may make their own decision based on the facts and circumstances of the case.

(6) Cannot be contingent on the status of a child. That is, any amount that is discontinued when a child reaches 18, moves away, etc., is not alimony.

Taxable alimony payments under pre-2019 decrees and agreements are treated as earned income for IRA contribution purposes, allowing the spouse receiving the alimony to make IRA contributions based upon the alimony. The ability to make IRA contributions under pre-2019 decrees and agreements remains unchanged. However, for alimony received as a result of a post-2018 decree or agreement, the alimony can no longer be used as a basis for making an IRA contribution.

To summarize:
Pre-2019 Decrees – For decrees entered into before 2019 and unmodified after 2018:

  • Alimony continues to be deductible by the payer spouse/ex-spouse.
  • Alimony is includable in the income of the recipient spouse/ex-spouse.
  • The recipient spouse/ex-spouse can make IRA contributions based upon the alimony received.

Post-2018 Decrees– For decrees entered into after 2018 (and pre-2019 decrees that are modified and include the TCJA alimony rules): Alimony is not deductible by the payer-spouse/ex-spouse.

  • Alimony is not includable in the income of the recipient spouse/ex-spouse.
  • The recipient spouse/ex-spouse cannot make IRA contributions based upon the alimony received.

One additional complication is if state tax treatment is different than that at the federal level. Some states, such as California, have not conformed to the TCJA; as a result, the state treatment of alimony paid under both pre-2019 and post-2018 decrees in these states will continue to follow pre-2019 law, with alimony payments continuing to be deductible and alimony received being taxable.

If you have questions related to alimony or about how your state will tax alimony beginning in 2019, please give us a call.

Getting the W-4 Right Is Important

As they do at the beginning of every year, employers will request that employees complete the IRS Form W-4. Its purpose is to provide employers with the information they need to determine the amount of federal income taxes to withhold from an employee’s paycheck. So, it is very important that the form is completed correctly.

The problem is that as simple as the form looks, getting those entries on the form to produce the desired withholding amount can be tricky. The passage of the tax reform added additional complications, and the IRS has delayed a major revision of the W-4 until the 2020 tax year. In the meantime, taxpayers must get along as best they can using the old version of the W-4.

Even though the W-4 form itself appears to be simple, the instructions come with an extensive worksheet, which may or may not produce the desired results. In addition, there are other issues to consider, such as:

  • Perhaps you desire to have a substantial refund when your taxes are completed next year. This generally requires custom W-4 adjustments, to produce excessive withholding. Keep in mind: when you have a large refund, you have provided Uncle Sam with an interest-free loan.
  • Your spouse may also work, and your combined incomes may put you in a higher tax bracket. Although the IRS provides a special worksheet for married taxpayers if both spouses work, it may not always provide the desired results.
  • In addition to payroll income, you may also have self-employment income, which is subject to both income tax and self-employment, and so you may require a combination of payroll withholding and estimated tax payments, adding additional complications to the W-4.
  • These are just the tip of the iceberg, as there may be investment income or losses, business losses, tax credits, special deductions and loss carryovers, just to name a few more situations that could impact your tax prepayments and withholding for the year.

If you are concerned about getting your withholding correct, please contact us. We can project your 2019 tax liability and complete your W-4 after taking into account multiple employments, a working spouse, self-employment income and other tax issues unique to your specific tax situation.

IRS Giving a Break to Some Taxpayers Who Under-prepaid Their 2018 Taxes

Taxpayers are required to pre-pay their taxes for any tax year through payroll withholding, estimated tax payments or a combination of the two. Employees and retirees generally accomplish this through withholding, and self-employed individuals and those with investment income by paying quarterly estimated payments.

The late-2017 passage of tax reform that became effective for 2018 and its radical changes added considerable confusion for taxpayers trying to determine how much they should prepay for 2018. This confusion was made worse because the existing W-4 that employees complete and that their employers use to determine the correct withholding was designed for prior law and does not work well with the new tax law. As a result, there has been ongoing concern by the IRS that many taxpayers will end up owing tax this year when they file their 2018 returns, even though they got a tax reduction due to the tax reform changes, simply because their pre-payments through withholding and estimated tax payments were not enough.

For most of 2018, the IRS was issuing alerts that taxpayers may be under-withheld because of tax reform and the fact the W-4 could no longer be relied upon to produce a correct withholding amount.

Taxpayers whose pre-payments are less than certain safe harbor amounts are penalized. Those safe harbors are:

  • 90% of the current year’s tax liability; or
  • 100% of the prior year’s tax liability (110% where the prior year AGI is over $150,000 ($75,000 if married and filing separate returns).

Recently several members of Congress have called upon the IRS to waive underpayment penalties for 2018. On January 16, 2019, although not waiving the penalties entirely, the IRS did change the current year safe harbor from 90% of the 2018 tax liability to 85%, providing a break for some taxpayers.

Even if you don’t meet one of the safe-harbor exceptions, a waiver of the penalty for 2018 may apply if you:

  • Retired (after reaching age 62) or became disabled in 2017 or 2018.
  • You did not make payments because of one of the following situations and it would be inequitable to impose the penalty:
    a. Casualty
    b. Disaster, or
    c. Other unusual circumstance.

There are two other exceptions to the penalty for 2018:

  • If the total tax shown on your 2018 return minus the tax that was withheld is less than $1,000, you will not owe a penalty.
  • If you had no tax liability in 2017, were a U.S. citizen or resident alien for all of 2017, and your 2017 return was for a full 12 months (or would have been had you been required to file), you won’t be charged an under-prepayment penalty.

In addition, where your tax liability and /or tax pre-payments were uneven, the penalty amount may be mitigated by figuring it on a quarterly basis.

If you have questions or would like to make sure your withholding and estimated payments are adequate for 2019, please give us a call.

Important — Rental Owners! Guidance Related to the 20% Pass-Through Deduction

Ever since tax reform was passed over a year ago, taxpayers have been uncertain whether rental property will be classified as a trade or business for purposes of qualifying for the new IRC Sec 199A 20% pass-through deduction (commonly referred to as the 199A deduction).

Finally, on January 18, 2019, the IRS issued a notice which provided “safe harbor” conditions under which a rental real estate activity will be treated as a trade or business for purposes of the 199A deduction.

It’s important to note that this notice prescribes several conditions that must be met for a rental real estate enterprise (a tax term introduced by the IRS in this notice) to be deemed to be a trade or business and eligible for the section 199A 20% deduction. For purposes of this safe harbor, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties.

Failure of the taxpayer to satisfy the requirements of this safe harbor does not preclude a taxpayer from otherwise establishing that a “rental real estate enterprise” is a trade or business for purposes of section 199A. The following are the requirements that must be satisfied for the safe harbor:

  1. Separate books and records must be maintained for each rental real estate enterprise;
    a. A real estate enterprise can consist of a single or multiple real estate rentals.
    b. Commercial and residential rentals cannot be combined in the same real estate enterprise.
  2. For years prior to 2023, at least 250 hours of rental services must be performed by the taxpayer and workers for the taxpayer for the year in question with reference to each rental real estate enterprise.
    A three-year lookback rule applies for taxable years for 2023 and following. It specifies that the taxpayer must meet the 250-hour requirement for the rental enterprise for any three of the five prior consecutive taxable years; and
  3. The taxpayer must maintain contemporaneous records, including time reports, logs, or similar documents, to document the following:
    a. hours of all services performed;
    b. a description of all services performed;
    c. dates on which such services were performed; and
    d. who performed the services.Because the safe harbor requirements were issued after the close of 2018, the requirement for contemporaneous records for 2018 will not apply.

    Rental services that may be counted toward the 250 hour requirement include: (i) advertising to rent or lease the real estate; (ii) negotiating and executing leases; (iii) verifying information contained in tenant applications; (iv) collecting rent; (v) daily operation, maintenance, and repair of the property; (vi) management of the real estate; (vii) purchase of materials for operation such as repairs; and (viii) supervision of employees and independent contractors.

    However, rental services do NOT include financial or investment management activities, such as arranging financing; procuring property; studying and reviewing financial statements or reports on operations, planning, managing, or constructing long-term capital improvements; or hours spent traveling to and from the real estate.

    Rental services counted toward the 250 requirement may be performed by owners or employees, agents, and/or independent contractors working for the owners.

Triple net Leases are not eligible for safe harbor. Real estate rented or leased under a triple net lease agreement is not eligible for this safe harbor. A triple net lease includes a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities. Also ineligible for the safe harbor is a property leased under an agreement that requires the tenant or lessee to pay a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.

Vacation rentals are not eligible for safe harbor. Real estate used as a residence by the taxpayer for any portion of the taxable year is not eligible for the safe harbor rules.

The Statement must be attached to the tax return. A statement signed by the taxpayer, or the person responsible for keeping the records with personal knowledge of them, must be attached to the return declaring that all of the safe harbor requirements have been met and must include the following language: “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”

Double-edged sword. The 199A deduction is 20% of a taxpayer’s qualified business income from all of the taxpayer’s trades or businesses subject to certain limitations. Many rentals do not show a profit and a rental that is treated as a trade or business that shows a loss for the year will reduce the qualified business income of other trades or businesses of an individual, and as a result, reduces the 199A deduction of that individual.

If you have questions regarding rentals as a trade or business or other issues related to this new 199A deduction, please call us to schedule a consultation.

Tax Time Is Around the Corner! Are You Ready?

Tax time is just around the corner, and if you are like most taxpayers, you are finding yourself with the ominous chore of pulling together the records for your tax appointment. The difficulty of this task depends upon how well you have maintained your tax records throughout the year. No matter how good your record keeping was, arriving at your tax appointment fully prepared will allow more time to:

  • Consider every possible legal deduction;
  • Evaluate which income reporting methods and deductions are best suited to your situation;
  • Explore current law changes that are affecting your tax status; and
  • Talk about tax planning alternatives that could reduce your future tax liability.

New for 2018 – There are a number of new complications this year, including:

  • To combat tax fraud, the IRS is requiring all tax preparers to verify their clients’ identity with a government picture ID, although there is an exception for clients if the preparer has had a multi-year business relationship with a client AND has previously verified the client’s identity with a government picture ID. Since that was not previously required, it will be necessary for all clients this year, so be sure to bring a picture ID (also a requirement for a spouse) to your appointment.
  • Although the federal government changed its tax rules with the tax reform, many states with state income tax, such as California, have not conformed to the federal changes, which means a separate set of rules may apply to your state and federal tax returns.
  • The tax reform added a new 20% deduction for pass-through income from business activities. In some cases, the computation can be very complicated and will take additional time.

Choosing Your Best Alternatives – The tax law allows a variety of methods of handling income and deductions on your return. The choices you make as you prepare your return will often affect not only the current year but also future returns. Topics these choices relate to include:

  • Sales of property – If you’re receiving payments on a sales contract over a period of years, you can sometimes choose between reporting the whole gain in the year you sell or over a period of time as you receive payments from the buyer.
  • Depreciation – You’re able to deduct the cost of your investment into certain business properties. You can either depreciate the costs over a number of years or, in certain cases, deduct them all in one year.

Where to Begin – Preparation for your tax appointment should begin in January. Right after the New Year, set up a safe storage location, such as a file drawer, cupboard, or safe. As you receive pertinent records, file them right away, before you forget or lose them. Make this a habit, and you’ll find your job a lot easier on your appointment date. Other general suggestions to prepare for your appointment include:

  • Segregate your records according to income and expense categories. File medical expense receipts in one envelope or folder, mortgage interest payment records in another, charitable donations in a third, etc. If you receive an organizer or questionnaire to complete before your appointment, fill out every section that applies to you. (Important: Read all explanations, and follow the instructions carefully. By design, organizers remind you of transactions you may otherwise miss.)
  • Call attention to any foreign bank account, foreign financial account, or foreign trust in which you have an ownership interest, signature authority, or controlling stake. We also need to know about foreign inheritances and ownership of foreign assets. In short, bring any foreign financial dealings to our attention so we know if you will have any special reporting requirements. The penalties for not making and submitting required reports can be severe.
  • If you acquired your health insurance through a government marketplace, you will receive Form 1095-A, issued by the marketplace, which will include information needed to complete your return. In addition, you will need to provide proof of insurance to avoid a penalty or qualify for one of the many exemptions from the penalty. If you received a hardship penalty exemption from the marketplace, you will have been issued an exemption certificate number (ECN), which must be included on your tax return. The 1095-A and ECN documentation need to be included with the other material you bring to your appointment. If your insurance coverage was through an employer and the employer issued a Form 1095-B, Form 1095-C, or substitute form detailing your coverage, bring it to the appointment.
  • Keep your annual income statements separate from your other documents (e.g., W-2s from employers; 1099s from banks, stockbrokers, etc.; and K-1s from partnerships). Be sure to take these documents to your appointment, including the instructions for K-1s!
  • Write down your questions so you don’t forget to ask them at the appointment. Review last year’s return. Compare your income on that return to your income for the current year. A dividend from ABC stock on your prior-year return may remind you that you sold ABC this year and need to report the sale, or that you haven’t yet received the current year’s 1099-DIV form.
  • Make sure you have Social Security numbers for all of your dependents. The IRS checks these carefully and can deny deductions and credits for returns filed without them.
  • Compare deductions from last year with your records for this year. Did you forget anything?
  • Collect any other documents and financial papers that you’re puzzled about. Prepare to bring these to your appointment so you can ask about them.

Accuracy Even for Details – Make sure you review personal data to ensure the greatest accuracy possible in all detail on your return. Check names, addresses, Social Security numbers, and occupations on last year’s return. Note any changes for this year. Although your telephone number and e-mail address aren’t required on your return, they are always helpful should questions occur during return preparation.

Marital Status Change – If your marital status changed during the year, you lived apart from your spouse, or your spouse died during the year, list the dates and details. Bring copies of prenuptial, legal separation, divorce, or property settlement agreements, if any, to your appointment. If your spouse passed away during the year, you should have a copy of his or her trust agreement or will available for review.

Dependents – If you have qualifying dependents, you will need to provide the following for each (if you previously provided us with items 1 through 3, you will not need to supply them again):

  1. First and last name
  2. Social security number
  3. Birth date
  4. Number of months living in your home
  5. Their income amounts (both taxable and nontaxable). If your dependent is your child over age 18, note how long the child was a full-time student during the year.

For anyone other than your child to qualify as your dependent, they must pass five strict dependency tests. If you think one or more other individuals qualify as your dependents (but you aren’t sure), tally the amounts you provided toward their support vs. the amounts they provided. This will simplify the final decision.

Some Transactions Deserve Special Treatment – Certain transactions require special treatment on your tax return. It’s a good idea to invest a little extra preparation effort when you have had the following types of transactions:

  • Sales of Stock or Other Property: All sales of stocks, bonds, securities, real estate, and any other property need to be reported on your return, even if you had no profit or loss. List each sale, and have purchase and sale documents available for each transaction.
    The purchase date, sale date, cost, and selling price must all be noted on your return. Make sure this information is contained on the documents you bring to your appointment.
  • Gifted or Inherited Property: If you sell property that was given to you, you need to determine when and for how much the original owner purchased it. If you sell property you inherited, you will need to know the original owner’s death date and the property’s value at that time. You may be able to find this on estate tax returns or in probate documents; otherwise, ask the executor.
  • Reinvested Dividends: You may have sold stock or a mutual fund for which you participated in a dividend reinvestment program. If so, you will need to have records of each stock purchase made with the reinvested dividends.
  • Sale of Home: The tax law provides special breaks for home sale gains, and you may be able to exclude up to $500,000 of the gain from your primary home if you file a married joint return and meet certain ownership, occupancy, and holding period requirements. The maximum exclusion is $250,000 for others. Since the cost of improvements made on your home can also be used to reduce any gains, it is good practice to keep a record of them. The exclusion of gains applies only to a primary residence, so keeping a record of improvements to other property, such as your second home, is important. Be sure to bring a copy of the sale documents (usually the final closing escrow statement).
  • Purchase of a Home: Be sure to bring a copy of the final closing escrow statement if you purchased a home.
  • Vehicle Purchase: If you purchased a new plug-in electric car (or cars) this year, you may qualify for a special credit. Please bring the purchase statement to the appointment with you.
  • Home Energy–Related Expenditures: If you installed a solar, geothermal, or wind power-generation system in your home or second home, please bring the details of the purchase and manufacturer’s credit qualification certification to your appointment. You may qualify for a substantial energy-related tax credit.
  • Identity Theft: Identity theft is rampant and can impact your tax filings. If you have reason to believe that your identity has been stolen, please contact this firm as soon as possible. The IRS provides special procedures for filing if you have had your identity stolen.
  • Car Expenses for Business: If you used one or more automobiles for business, list the expenses of each business vehicle separately. When claiming vehicle-related business expenses, the government requires your total mileage, business miles, and commuting miles for each business vehicle to be reported on your return, so be prepared to have those numbers available. Job-related vehicle expenses are not deductible by employees on their federal returns in years 2018 through 2025. However, some states, including California, still allow them. So if you have unreimbursed employee business expenses, continue to provide the information noted above in case the deduction is allowed for state taxes, and if you were reimbursed for mileage through an employer, know the reimbursement amount and whether it was included in your W-2.
  • Charitable Donations: You must substantiate cash contributions (regardless of amount) with a bank record or written communication from the charity showing the name of the charitable organization, date, and amount.
    Unreceipted cash donations put into a “Christmas kettle,” church collection plate, etc., are not deductible. For clothing and household contributions, donated items must generally be in good or better condition, and items such as undergarments and socks are not deductible. You must keep a record of each item contributed that indicates the name and address of the charity, the date and location of the contribution, and a reasonable description of the property. Contributions valued under $250 and dropped off at an unattended location do not require a receipt. For contributions above $500, the record must also include when and how the property was acquired and your cost basis in the property. For contributions above $5,000 and other types of contributions, please call this office for additional requirements.

If you have questions about assembling your tax data prior to your appointment, please call us.

Are You an S Corporation Stockholder? Are You Taking Reasonable Compensation in the Form of Wages?

S corporation compensation requirements are often misunderstood and abused by owner-shareholders. An S corporation is a type of business structure in which the business does not pay income tax at the corporate level and instead distributes (passes through) the income, gains, losses, and deductions to the shareholders for inclusion on their income tax returns. If there are gains, these distributions are considered return on investment and therefore are not subject to self-employment taxes.

However, if stockholders also work in the business, they are supposed to take reasonable compensation for their services in the form of wages, and of course, wages are subject to FICA (Social Security and Medicare) and other payroll taxes. This is where some owner-shareholders err by not paying themselves a reasonable compensation for the services they provide, some out of unfamiliarity with the requirements and some purposely to avoid the payroll taxes.

The Internal Revenue Code establishes that any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes. S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.

If the S corporation does not pay its working stockholders a reasonable compensation for their services, then the IRS generally will treat a portion of the S corporation’s distributions as wages and impose Social Security taxes on the deemed wages.

There is no specific method for determining what constitutes reasonable compensation, and it is based upon facts and circumstances. Generally, it is an amount that unrelated employers would pay for comparable services under like circumstances and based upon the cost of living in the area where the business is located. The following are just some of the many factors that would be taken into account in making this determination:

  • Training and experience
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Dividend history
  • Payments to non-shareholder employees
  • Timing and manner of paying bonuses to key people
  • What comparable businesses pay for similar servicesCompensation agreements
  • The use of a formula to determine compensation

The problem here, of course, is that it is easy for the IRS to list contributing factors used by the courts in determining reasonable compensation and leave it to the corporation to quantify these factors into a reasonable salary but still have the ability to challenge the selected amount later if an auditor, off the top of their head, decides the compensation is unreasonable.

The IRS has a long history of examining S corporation tax returns to ensure that reasonable compensation is being paid, particularly if no compensation is shown being paid to employee-stockholders.

Reasonable Compensation in the Spotlight – With the passage of tax reform, reasonable compensation will be in the spotlight because of the new deduction for 20% of pass-through income. This new Sec. 199A deduction is equal to 20% of qualified business income (QBI) and will figure intro the shareholder’s income tax return. The QBI for the stockholder of an S-corporation is the amount of net income passed through to the stockholder and designated as QBI on the K-1, but the stockholder may not include the reasonable compensation (wages) he or she was paid as QBI. Thus, wages paid to stockholders actually reduce the QBI because the S corporation deducts the wages as a business expense, therefore reducing the corporation’s net income and QBI. But that does not mean wages can be arbitrarily adjusted to maximize the Sec. 199A deduction.

IRC Sec. 199A Deduction – Here are some details about how the 199A deduction works and the impact of the reasonable compensation wages on the Sec. 199A deduction.

  • The S corporation’s employee-stockholder’s wages are NOT included in qualified business income (QBI) when computing the 199A deduction. Thus, the larger the wages, the smaller the K-1 flow-through income (QBI) and thus the smaller the 199A deduction, which is 20% of QBI. In this case, an S corporation would tend to pay the stockholder a smaller salary to maximize the flow-through income and, as a result, the 199A deduction.
  • If married taxpayers filing a joint return have taxable income that exceeds $315,000 ($157,500 for other filing statuses), the 199A deduction begins to be subject to a wage limitation, and once the taxable income for married taxpayers filing a joint return exceeds $415,000 ($207,500 for other filing statuses), the 199A deduction becomes the lesser of 20% of the QBI or the wage limitation. For these high-income taxpayers, an S corporation will tend to pay stockholders less wage income for them to benefit from the Sec. 199A deduction.
  • If an S corporation is a specified service trade or business, the Sec. 199A deduction phases out for married taxpayers filing a joint return with taxable income between $315,000 and $415,000 (between $157,500 and $207,500 for other filing statuses). And although the wage limitation is used in computing the phase out, once the taxpayer’s taxable income exceeds $415,000 ($207,500 for other filing statuses), the taxpayer will receive no benefit from the wage limitation and therefore would again want to minimize their reasonable compensation to minimize FICA taxes. Specified service trades or businesses (SSTBs) include those in the fields of health, law, accounting, actuarial science, performing arts, athletics, consulting, and financial services (for more information on what constitutes an SSTB, please call us).

Of course, taxpayers cannot pick and choose a reasonable level of compensation to minimize taxes or maximize deductions. Therein lies a trap for taxpayers who do not consider the factors related to reasonable compensation. There are commercial firms that have the data necessary to determine reasonable compensation and specialize in doing so. These firms can be found by searching the Internet for “reasonable compensation.” Even the IRS has employed these firms to provide reasonable compensation data in tax court cases.

If you want additional information related to reasonable compensation, please call us to schedule an appointment.

If You Are a Recreational Gambler, Here Are Some Tax Issues You Need to Know

Gambling takes many forms: casino games, horse racing, sports book betting, lotto tickets, scratchers, bingo, etc. For virtually everyone, gambling is a recreational activity and, as such, is done for fun. For most gamblers, their losses for the year will exceed their winnings, and since losses in excess of winnings are not deductible, most gamblers don’t bother to report either, which isn’t in-line with the tax law’s filing requirements.

If your winnings at one time hit certain levels, the government requires the gambling establishment to collect your Social Security number and report your winnings to Uncle Sam on a Form W-2G. Gambling establishments will issue a Form W-2G if you:

  • Win $1,200 or more on a slot machine or from bingo.
  • Win $1,500 or more on a keno jackpot.
  • Win more than $5,000 in a poker tournament.
  • Win $600 or more from all other games, but only if the payout is at least 300 times your wager.

Reporting Winnings – Many individuals believe that they only have to report the winnings for which they receive a Form W2-G. Unfortunately, the IRS has a different viewpoint. Although you may be able to offset your reported gains with gambling losses, the IRS anticipates that you will also have had gambling winnings that were under the W2-G reporting threshold and will raise this issue during an audit.

Gambling Losses – The good news is that you can deduct gambling losses if you itemize your deductions but only to the extent of your gambling income. In other words, you can’t have a net gambling loss on your tax return. Bad news: if you don’t itemize your deductions, you will have to pay taxes on the entire winnings, even if you have a net gambling loss, as is the case for most individuals.

GAMBLING GOTCHA #1 – Since you can’t net your winnings and losses, the full amount of your winnings ends up in your adjusted gross income (AGI). The AGI is used to limit other tax benefits, as discussed later. So, the higher the AGI, the more the tax benefits may be limited.

GAMBLING GOTCHA #2 – If you don’t itemize your deductions, you can’t deduct your losses. Thus, individuals taking the standard deduction will end up paying taxes on all of their winnings, even if they had a net loss. The recent tax reform brought us significantly higher standard deduction amounts and, for itemized deductions, limited the deduction for state and local taxes and eliminated the deduction for unreimbursed employee business expenses and investment expenses, among other changes. The anticipated result is that fewer taxpayers will be itemizing their deductions and more gamblers will be paying taxes on their winnings.

Documenting Losses – The next logical question is: how are you going to document your gambling losses, if audited? Don’t rush down to the track and start collecting discarded tickets, since they generally aren’t acceptable documentation because of their ready availability. The IRS has published guidelines on acceptable documentation to verify losses. They indicate that an accurate diary or similar record that is regularly maintained by the taxpayer, supplemented by verifiable documentation, will usually be acceptable evidence to substantiate wagering winnings and losses. In general, this diary should contain at least the following information:

(1) the date and type of each specific wager or wagering activity,
(2) the name of the gambling establishment,
(3) the address or location of the gambling establishment,
(4) the names of other persons (if any) present with the taxpayer at the gambling establishment, and
(5) the amounts won or lost.
Save all available documentation, including items such as losing lottery and keno tickets, checks, and casino credit slips. You should also save any related documentation such as hotel bills, plane tickets, entry tickets, and other items that would document your presence at a gambling location. If you are a member of a slot club, the casino may be able to provide a record of your electronic play. You might also obtain affidavits from designated gambling officials at the gambling facility. With regard to specific wagering transactions, your winnings and losses might be further supported by:
  • Keno – Copies of keno tickets you purchased and that were validated by the gambling establishment.
  • Slot Machines – A record of all winnings by date and time for each machine that was played.
  • Table Games – The number of the table at which you were playing as well as casino credit card data indicating whether credit was issued in the pit or at the cashier’s cage.
  • Bingo – A record of the number of games played, the cost of the tickets purchased, and the amounts collected on winning tickets.
  • Racing – A record of the races, entries, amounts of wagers, and amounts collected on winning tickets and lost on losing tickets. Supplemental records can include unredeemed tickets and payment records from the racetrack.
  • Lotteries – A record of ticket purchase dates, winnings, and losses. Supplemental records can include unredeemed tickets, payment slips, and winning statements.

Other Tax Side Effects of Gambling – Because gambling income is reported in full as income and the losses are an itemized deduction, gambling winnings increase a taxpayer’s AGI for the year. An individual’s AGI is used to limit other tax benefits, and having gambling income can have an adverse impact on your taxes. Here are some examples:

  • Social Security Income – For taxpayers receiving Social Security benefits, whether those benefits are taxable depends upon the taxpayer’s AGI for the year. The taxation threshold for Social Security benefits is $32,000 for married taxpayers filing jointly, $0 for married taxpayers filing separately, and $25,000 for all other filing statuses. If the sum of AGI (before including any Social Security income), interest income from municipal bonds, and one-half the amount of Social Security benefits received for the year exceeds the threshold amount, then 50–85% of the Social Security benefits will be taxable.
    GAMBLING GOTCHA #3 – So, if your gambling winnings push your AGI for the year over the threshold amount, then your gambling winnings – even if you had a net loss – can cause some (up to 85%) of your Social Security benefits to be taxable.
  • Health Insurance Subsidies – Under Obamacare, lower-income individuals who purchase their health insurance from a government marketplace are given a subsidy in the form of a tax credit to help pay the cost of their health insurance. That tax credit is based upon the AGIs of all members of the family, and the higher the family’s income, the lower the subsidy will become.
    GAMBLING GOTCHA #4 – Thus, the addition of gambling income to your family’s income can result in significant reductions in the insurance subsidy, requiring you to pay more for your family’s health insurance coverage for the year. Additionally, if your subsidy was based upon your estimated income for the year, your premiums were reduced by applying the subsidy in advance, and you subsequently had some gambling winnings, then you could get stuck paying back part of the subsidy when you file your return for the year.
  • Medicare B and D Premiums – If you are covered by Medicare, the amount you are required to pay (generally withheld from your Social Security benefits) for Medicare B premiums is normally about $130–$134 per month and is based on your AGI two years prior. However, if that AGI is above $85,000 ($170,000 for married taxpayers filing jointly), then the monthly premiums can more than triple. If you also have prescription drug coverage through Medicare Part D and your AGI exceeds the $85,000/$170,000 threshold, then your monthly surcharge for Part D coverage will range from $13.30 to $74.80 (2018 rates).
    GAMBLING GOTCHA #5 – The addition of gambling winnings to your AGI can result in higher Medicare B and D premiums.
  • Online Gambling Accounts – If you have an online gambling account, there is a good chance that the account is with a foreign company. All U.S. persons with a financial interest or signature authority over foreign accounts with an aggregate balance of over $10,000 anytime during the prior calendar year must report those accounts to the Treasury by the April due date for filing individual tax returns or face draconian penalties.
    GAMBLING GOTCHA #6 – Regardless of whether you were a winner or loser, if your online account was over $10,000, you will be required to file aFinCEN Form 114 (Report of Foreign Bank and Financial Accounts), commonly referred to as the FBAR. For non-willful violations, civil penalties up to $10,000 may be imposed; the penalty for willful violations is the greater of $100,000 or 50% of the account’s balance at the time of the violation.
  • Other Limitations – The forgoing are the most significant “gotchas.” There are numerous other tax rules that limit tax benefits based on AGI, as discussed in gotcha #1. These include medical deductions, child and dependent care credits, the child tax credit, and the earned income tax credit, just to name a few.

If you have questions related to gambling and taxes, please call us to schedule a consultation.