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Mortgage Insurance Premium Deduction Retroactively Extended

Article Highlights

  • Appropriations Act of 2020
  • Amended Return for 2018
  • Qualifications for the Deduction
  • Qualified Mortgage Insurance

On December 20, 2019, President Trump signed into law the Appropriations Act of 2020, which included several tax law changes, including retroactively extending specific tax provisions that expired after 2017 or were about to expire, some retirement and IRA plan modifications, and other changes that will impact a large portion of U.S. taxpayers as a whole. This article is one of a series of articles dealing with those changes and how they may affect you.

For tax years 2007 through 2017, when taxpayers itemized deductions, they could deduct the cost of premiums for mortgage insurance on a qualified personal residence as home mortgage interest.

This deduction has been retroactively extended back to 2018 and through 2020. If you paid premiums for mortgage insurance in 2018 or were amortizing prepaid mortgage insurance premiums from an earlier year’s home purchase, you may be able to amend your 2018 return for a tax refund.

To be deductible:

  • The premiums must have been paid in connection with acquisition debt, which is debt incurred to purchase or substantially improve a home. (Note: acquisition debt includes refinanced acquisition debt but not equity debt.)
  • The mortgage insurance contract must have been issued after December 31, 2006.
  • It must be for a qualified residence (taxpayer’s first and second homes).
  • The premiums must have been paid or accrued after December 31, 2006, and before January 1, 2021.
  • The cost of the insurance does not affect the $1,000,000/$750,000 (or grandfathered debt) limitation for acquisition debt.
  • The deductible amount of the premiums ratably phases out by 10% for each $1,000 by which the taxpayer’s adjusted gross income (AGI) exceeds $100,000 (10% for each $500 by which a married separate taxpayer’s AGI exceeds $50,000). The deduction is totally phased out if the taxpayer’s AGI is over $109,000 ($54,500 for married filing separate).

Qualified mortgage insurance means mortgage insurance provided by the:

  • Dept. of Veterans Affairs (VA),
  • Federal Housing Administration (FHA), or
  • Rural Housing Services (RHS) as well as
  • Specific private mortgage insurance.

If you have any questions related to the mortgage insurance deduction or think you might qualify for the deduction in 2018 and would like to have an amended return prepared, please contact us.

Tax Issues Related to Hobbies

Article Highlights:

  • Hobby Losses
  • Not-for-Profit Rules
  • Determining Factors
  • Trade or Business Presumption
  • Hobby Tax Reporting
  • Self-Employment Tax

Generally, a hobby is an activity an individual enjoys for leisure, and without the goal of making money. A hobby is a way to describe an activity that is not known to create any income. Tax law generally does not allow deductions for personal expenses except those allowed as itemized deductions on the 1040 Schedule A, and this also applies to hobby expenses.

Some hobbyists try to get a tax deduction for their hobby expenses by treating their hobby as a trade or a business. For instance, if someone’s hobby expenses exceed their hobby’s income, they may try to report the difference between hobby income and expenses as a deductible business loss. To curtail hobbies being treated as businesses, the tax code includes rules that do not permit losses for not-for-profit activities such as hobbies. The not-for-profit rules are often referred to as the hobby loss rules.

The distinction between a hobby and a trade or business sometimes becomes blurred, and the determination depends upon a series of factors, with no single factor being decisive. All of these factors have to be considered when making the determination:

  • Is the activity carried out in a businesslike manner?
  • How much time and effort does the taxpayer spend on the activity?
  • Does the taxpayer depend on the activity as a source of income?
  • Are losses from the activity the result of sources beyond the taxpayer’s control?
  • Has the taxpayer changed business methods in attempts to improve profitability?
  • What is the taxpayer’s expertise in the field?
  • What success has the taxpayer had in similar operations?
  • What is the possibility of profit?
  • Is profit from asset appreciation possible?

Because determining these factors is so subjective, the IRS regulations provide that the taxpayer has a presumption of profit motive if an activity shows a profit for any three or more years during five consecutive years. However, if the activity involves breeding, training, showing, or racing horses, then the period is two out of seven consecutive years.

Making the proper determination is important because of the differences in tax treatment for hobbies versus trades or businesses. If an activity is determined to be a trade or business in which the owner materially participates, then the owner can deduct a loss on his or her tax return, and it is not uncommon for a business to show a loss in the startup years.

However, hobbies (not-for-profit activities) have special, unfavorable rules for reporting the income and expenses, which have been exacerbated by the 2017 passage of the Tax Cuts and Jobs Act (tax reform). These rules are:

  1. The income is reported directly on the hobbyist’s 1040;
  2. The expenses, not exceeding the income, are deducted as a miscellaneous itemized deduction. Thus, the expenses are only allowed if a taxpayer is itemizing deductions, rather than taking the standard deduction; and
  3. Due to tax reform, for tax years 2018 through 2025, miscellaneous itemized deductions that must be reduced by 2% of the taxpayer’s adjusted gross income – which is the category into which the hobby expenses fall – have been suspended (are not deductible). Thus, for those years, there is no deduction at all for hobby expenses, and any hobby income will be fully taxable. Example: Marcia has an income of $750 from her hobby (a not-for-profit activity) of coin collecting and expenses of $500. So, Marcia must include the $750 on her 1040. But because miscellaneous itemized deductions are currently suspended, she will not be able to deduct her $500 in expenses, leaving the full $750 as taxable income. 

Another concern for hobbyists who are reporting income from their hobby on their 1040 is whether or not that income is subject to self-employment tax. Luckily, there is an exception for sporadic or one-shot deals and hobbies, which are not subject to self-employment tax.

If you have questions related to how the not-for-profit rules may apply to your hobby, please contact us.

Get Those Kids a Job, and Take Advantage of Tax Breaks

Article Highlights

  • Higher Standard Deduction
  • IRA Options
  • Self-Employed Parent
  • Employing Your Child
  • Tax Benefits

Children who are dependents of their parents are subject to what is commonly referred to as the kiddie tax. This generally applies to children under the age of 19, or full-time students between the ages of 18 and 24.

The kiddie tax was enacted as part of the Tax Reform Act of 1986 to close a tax loophole where parents would put their investments under their child’s name and social security number so that their investment income would be taxed at a lower rate.  The kiddie tax declared that unearned income (investment income) in excess of a minimum amount was to be taxed at the parent’s highest marginal tax rate. As a result, children are taxed at fiduciary income tax rates, which generally amount to higher taxes on unearned income.

The tax reform legislation enacted in 2017 changed the way children are taxed by no longer having the children’s unearned income taxed at the parent’s top marginal tax rate. Instead, children are taxed at fiduciary income tax rates, which generally result in higher taxes on unearned income.

Tax-Free Income – On the bright side, a child’s earned income (income from working) is taxed at single rates, and tax reform just about doubled the standard deduction for singles. The standard deduction is $12,200 for 2019. This means that your child can make $12,200 from working and pay no income tax (but will be subject to Social Security and Medicare payroll taxes). If the child is willing to contribute to a traditional IRA, for which the 2019 contribution cap is $6,000, the child can make $18,200 from working—federal income tax free.

IRA Contributions – If your child is reluctant to give up any of their hard-earned money from their summer or regular employment, the amount of an IRA contribution could be gifted to the child. If you, a grandparent, or others have the financial resources, this ‘gift’ would give your child a great start toward their retirement savings.

Roth IRAs are a better alternative. Unlike traditional IRAs, they provide tax free income at retirement. However, the contribution to a Roth is not deductible, thus income in excess of $12,200 would not be tax free. Even if the tax rate at the lower income level is only 10%, it may be worth paying a small tax to gain the tax-free retirement provided by a Roth IRA.

Employing Your Child – If you are self-employed (an unincorporated business), rather than helping support your children with your post-tax dollars, you can instead hire them to work for your business and pay them with tax-deductible dollars. Of course, the employment must be legitimate and the pay commensurate with the hours and the job worked.

Wages paid to a child under age 18 are not to be subject to FICA—Social Security and Hospital Insurance (HI, aka Medicare) taxes—since employment for FICA tax purposes doesn’t include services performed by a child under the age of 18 when employed by a parent. Thus, the child will not be required to pay the employee’s share of the FICA taxes, and the business won’t have to pay its half either. In addition, by paying the child and reducing the business’s net income, the parent’s self-employment tax that is payable on net self-employment income may also be reduced.

Example: Let’s say you are in the 24% tax bracket and own an unincorporated business. You hire your child (who has no investment income) and pay the child $15,000 for the year. You reduce your income by $15,000, which saves you $3,600 in income taxes (24% of $15,000), and your child has a taxable income of $2,800 ($15,000 less the $12,200 standard deduction) on which the tax is $280 (10% of $2,800). A $2,800 contribution to your child’s traditional IRA would bring the child’s taxable income down to zero, and the child would owe no federal income tax.

By paying your child $15,000, you not only reduce your self-employment income for income tax purposes, but you reduce your self-employment tax (HI portion) by $402 (2.9% of $15,000 times the SE factor of 92.35%). However, if your net profits for the year were less than the maximum SE income ($132,900 for 2019) subject to Social Security tax, then the savings would include the 12.4% Social Security portion in addition to the 2.9% HI portion. In this case, the total SE tax savings would be $2,119.

A similar but more liberal exemption applies for FUTA, which exempts from federal unemployment tax the earnings paid to a child under age 21 while employed by his or her parent. The FICA and FUTA exemptions also apply if a child is employed by a partnership consisting solely of his or her parents. However, the exemptions do not apply to businesses that are incorporated or a partnership that includes non-parent partners. Even so, there’s no extra cost to your business if you’re paying your child for work that you would pay someone else to do anyway.

If you have questions related to your child’s employment or about hiring your child to work for your business, please contact us.

Does Your Tax ID Number Need to be Renewed?

Article Highlights:

  • Expiring ITINs
  • IRS Currently Accepting Renewal Applications
  • Family Renewal Options
  • How to Renew
  • Common Errors to Avoid

According to the Internal Revenue Service (IRS), about two million Individual Taxpayer Identification Numbers (ITINs) are set to expire at the end of 2019.

ITINs are used by people who file taxes or have payment obligations under U.S. law, but who are not eligible for a Social Security number. ITIN holders who have questions can visit the ITIN information page on the IRS website.

Any ITIN that has not been used on a federal tax return at least once in the last three consecutive years will expire on Dec. 31, 2019. In addition, ITINs with middle digits 83, 84, 85, 86 or 87 that have not already been renewed will also expire at the end of the year. ITINs with middle digits of 70 through 82 expired in past years. Taxpayers with these ITIN numbers who have not already renewed their ITIN can renew at any time. Note: It is important to understand that ITINs with middle digits 83 through 87 will expire regardless if they were used for filing returns in the last three years.

The IRS is currently accepting ITIN renewal applications – Taxpayers whose ITIN is expiring and who need to file a tax return in 2020 must submit a renewal application. Federal returns that are submitted in 2020 with an expired ITIN will be processed. However, exemptions and/or certain tax credits will be disallowed, and the taxpayers will be notified by mail advising them to renew their ITIN. Once the ITIN is renewed, any applicable exemptions and credits will be reinstated, and any applicable refunds will be issued. Therefore, renewing early will avoid these last-minute hassles and delays in receiving refunds.

Family renewal option – Taxpayers with an ITIN containing middle digits 83, 84, 85, 86 or 87, as well as all previously expired ITINs, have the option to renew ITINs for their entire family at the same time. Those who have received a renewal letter from the IRS can choose to renew the family’s ITINs together, even if family members have an ITIN with middle digits that have not been identified for expiration. Family members include the tax filer, spouse and any dependents claimed on the tax return.

How to renew an ITIN – To renew an ITIN, a taxpayer must complete a Form W-7 and submit all required documentation. Taxpayers submitting a Form W-7 to renew their ITIN are not required to attach a federal tax return. However, taxpayers must still note a reason why they need an ITIN on the Form W-7. See the Form W-7 instructions for detailed information. An application package can be submitted in one of three ways:

  1. By mail, along with original identification documents or copies certified by the agency that issued them, to the IRS address listed on the Form W-7 instructions. The IRS will review the identification documents and return them within 60 days.
  2. Work with Certified Acceptance Agents (CAAs) authorized by the IRS to help taxpayers apply for an ITIN. CAAs can authenticate all identification documents for primary and secondary taxpayers. They can also verify that an ITIN application is correct before submitting it to the IRS for processing and authenticate the passports and birth certificates for dependents. This saves taxpayers from mailing original documents to the IRS.
  3. In advance, call and make an appointment at a designated IRS Taxpayer Assistance Center to have each applicant’s identity authenticated in person instead of mailing original identification documents to the IRS. Each family member applying for an ITIN or renewal must be present at the appointment and must have a completed Form W-7 and required identification documents. See the TAC ITIN authentication page on the IRS website for more details.

Common errors to avoid – There are several common errors that can slow down ITIN renewal applications:

  • Mailing identification documentations without a Form W-7
  • Missing information on the Form W-7
  • Insufficient supporting documentation, such as U.S. residency documentation or official documentation to support name changes.
  • The IRS no longer accepts passports that do not have a date of entry into the U.S. as a stand-alone identification document for dependents from a country other than Canada or Mexico, or dependents of U.S. military personnel overseas. A dependent’s passport must have a date of entry stamp, otherwise the following additional documents to prove U.S. residency are required:
    • U.S. medical records for dependents under age 6,
    • U.S. school records for dependents under age 18, and
    • U.S. school records (if a student), rental statements, bank statements or utility bills listing the applicant’s name and U.S. address, if over age 18.

If you have questions or need assistance completing a renewal, please contact us.

How Does Combining a Vacation with a Foreign Business Trip Affect the Tax Deduction for Travel Expenses of a Self-Employed Individual?

Article Highlights:

  • Primarily Business
  • Primarily Vacation
  • Special Circumstances
  • Foreign Conventions, Seminars and Meetings
  • Cruise Ships
  • Spousal Travel Expenses

Effective for years 2018 through 2025, the Tax Cuts and Jobs Act of 2017 suspended the deduction of miscellaneous itemized expenses that must be reduced by 2% of the taxpayer’s adjusted gross income. Employee business expenses, including travel expenses, fall into this category. Therefore, this discussion only applies to self-employed individuals for years 2018-2025.

When a self-employed individual makes a business trip outside of the U.S. and the trip is 100% devoted to business, all the ordinary and necessary business travel expenses are deductible, just as if the business trip were within the U.S. On the other hand, if the trip also incorporates a vacation, special rules determine the deductibility of the travel expenses to and from the destination; when the other business travel expenses, such as lodging, meals, local travel and incidentals, can be deducted; and when they must be allocated. So, whether you are just visiting one of our neighboring countries or traveling to Europe or even more exotic locales, here are some travel tax pointers:

Primarily Vacation – If the travel is primarily for vacation and only a few hours are spent attending professional seminars or meeting with foreign business colleagues, none of the expenses incurred in traveling to and from the general business location are deductible. Other travel expenses must be allocated on a day-by-day basis, and only the business portion is deductible.

Primarily Business – If the trip is primarily for business and meets one of the conditions listed below, the expenses incurred in traveling to and from the business destination are deductible in full (same as for travel within the U.S.).

(1) The travel outside the U.S. is for a period of one week or less (seven consecutive days, excluding the departure day but including the day of return). In addition, all other ordinary and necessary travel expenses are fully deductible.

(2) Less than 25% of the total time outside the U.S. is spent on non-business activities. In addition, all other ordinary and necessary travel expenses are fully deductible. (If 25% of more of the total time is spent on non-business activities, a day-by-day allocation of all travel expenses between personal and business activities is necessary and only the business portion is deductible.)

(3) The individual incurring the travel expenses can establish that a personal vacation or holiday was not a major consideration. In addition, all other ordinary and necessary travel expenses are fully deductible.

(4) The taxpayer did not have “substantial control” over arranging the trip. (For self-employed taxpayers, who would generally have substantial control over the trip arrangements, this provision likely won’t apply.) In addition, all other ordinary and necessary travel expenses are fully deductible.

When determining what constitutes business and non-business time, business days include: days en route to or from the business destination by a reasonably direct route without interruption; days when actual business is transacted; weekends or standby days that fall between business days; and days when business was to have been transacted but was canceled due to unforeseen circumstances.

Non-business days are days spent on non-business activities as well as weekends, holidays and other standby days that fall at the end of the business activity, if the taxpayer remains at the business destination for personal reasons.

Foreign Conventions, Seminars or Meetings – Tax law does not permit a deduction for travel expenses to attend a convention, seminar or similar meeting held outside of the North American area unless the taxpayer establishes that:

(1) The meeting is directly related to the active conduct of the taxpayer’s trade or business, and
(2) It is “as reasonable” for the meeting to be held outside of the North American area as it is within the North American area.

The IRS defines “North American area” quite broadly and includes not just the U.S., Canada and Mexico, as you would expect, but also Bermuda, several countries in the Caribbean basin, U.S. possessions such as American Samoa and other Pacific island nations, and some Central American countries as well.

Cruise Ship Conventions – In order for a taxpayer to deduct the cost of attending a convention related to his or her trade or business on a cruise ship, the ship must be a U.S. flagship, and all the ports of call must be within the U.S. or its possessions. In addition, the maximum deduction is limited to $2,000 per attendee. Substantiation requirements include certain signed statements by both the taxpayer and an officer of the convention sponsor.

Spousal* Travel Expenses – Generally, deductions are denied for travel expenses for a spouse, dependent or employee of the taxpayer on a business trip unless:

  1. The spouse is an employee of the taxpayer, and
  2. The travel of the spouse, etc., is for a bona fide business purpose; and
  3. The expenses would otherwise be a deductible business travel expense for the spouse.*These rules also apply to a dependent or employee of the taxpayer.

Since a spouse, dependent or other individual who is an employee will be denied a deduction for business travel expenses in years 2018 through 2025, condition #3 can’t be met. This means that “spousal” travel expenses won’t be deductible for years 2018 through 2025.

However, the law allows a deduction for the single rate for lodging on qualified business trips, and frequently, there is no rate difference between one and two occupants. Thus, virtually the entire lodging expense for an accompanying spouse will be deductible. When traveling by car, the law does not require any allocation because the spouse is also traveling in the vehicle. Thus, if traveling by vehicle, the entire cost of the business-related transportation would be deductible. Generally, this would also apply to taxis at the destination.

As you can see, determining the tax deduction for a foreign business trip of a self-employed individual that is combined with a vacation can be complicated. If you need additional tax guidance or assistance planning such a trip, please contact us.

School’s Out – Who Is Going to Take Care of the Kids?

Article Highlights:

  • Child Age Limits
  • Employment-Related Expense
  • Married Taxpayer Earnings Limits
  • Disabled or Full-Time-Student Spouse
  • Expense Limits

Summer has just arrived, and working parents should know about a tax break. Many working parents must arrange for care of their children under 13 years of age (or any age if disabled) during the school vacation period. A popular solution — with a tax benefit — is a day camp program. The cost of day camp can count as an expense toward the child and dependent care credit. However, expenses for overnight camps, summer school, or tutoring programs do not qualify.

For an expense to qualify for the credit, it must be an “employment-related” expense; i.e., it must enable you and your spouse, if married, to work, and it must be for the care of your child, stepchild, foster child, brother, sister or stepsibling (or a descendant of any of these) who is under 13, lives in your home for more than half the year and does not provide more than half of his or her own support for the year. Married couples must file jointly, and both spouses must work (or one spouse must be a full-time student or disabled) to claim the credit.

The qualifying expenses are limited to the income you or your spouse, if married, earn from work, using the figure for whoever earns less. However, under certain conditions, when one spouse has no actual earned income and that spouse is a full-time student or disabled, that spouse is considered to have a monthly income of $250 (if the couple has one qualifying child) or $500 (two or more qualifying children). This means the income limitation is essentially removed for a spouse who is a student or disabled.

The qualifying expenses can’t exceed $3,000 per year if you have one qualifying child, while the limit is $6,000 per year for two or more qualifying persons. This limit does not need to be divided equally. For example, if you paid and incurred $2,500 of qualified expenses for the care of one child and $3,500 for the care of another child, you can use the total, $6,000, to figure the credit. The credit is computed as a percentage of your qualifying expenses; in most cases, 20%. (If your joint adjusted gross income [AGI] is $43,000 or less, the percentage will be higher, but it will not exceed 35%.)

Example: Al and Janice both work, each with earned income in excess of $40,000 per year. Janice has a part-time job, and her work hours coincide with the school hours of their 11-year-old daughter, Susan. However, during the summer vacation period, they place Susan in a day camp program that costs $4,000. Since the expense limitation for one child is $3,000, their child credit would be $600 (20% of $3,000).

The credit reduces a taxpayer’s tax bill dollar for dollar. Thus, in the above example, Al and Janice pay $600 less in taxes by virtue of the credit. However, the credit can only offset income tax and alternative minimum tax liability, and any excess is not refundable. The credit cannot be used to reduce self-employment tax, or the taxes imposed by the Affordable Care Act.

If the qualifying child turned 13 during the year, the care expenses paid for the child for the part of the year he or she was under age 13 will qualify.

If you have questions about how the childcare credit applies to your specific tax situation, please contact us.

Gift Tax Treatment of Tuition Plans

Article Highlights:

  • Purpose of Qualified Tuition Plans
  • Gift Tax Implications
  • Special Five-Year Election
  • Change of Beneficiary
  • Eligible Expenses
  • Direct Payment of Tuition

Qualified tuition plans (QTPs) provide a means for family members and others to save for the future educational needs of children. Investment earnings within a QTP account are tax deferred and not taxable when withdrawn if used to pay qualified tuition and certain other expenses.

Everyone’s contribution to a QTP (also sometimes referred to as a “Section 529 plan”) on behalf of a designated beneficiary is treated as a gift subject to the normal gift tax rules. Thus, no gift tax return is required for any contributor if the contribution is equal to or less than the amount of the gift tax annual exclusion for the year of the gift, which for 2019 is $15,000.

Special Election – When a donor’s total contribution to a QTP for the year exceeds the annual exclusion amount, the donor may make a special election treating the contributed funds as if they had been contributed ratably over a five-year period starting with the year of the contribution.

Example: Grandpa Lee contributes $75,000 to granddaughter Whitney’s QTP in 2019. By using the election, Grandpa’s contribution is treated as if the contribution was made equally over a five-year period – that is, as if he’d contributed $15,000 in each of 2019, 2020, 2021, 2022 and 2023. If Grandpa makes any more QTP contributions during those years, those contributions would then exceed the annul gift limit and require a gift tax return to be filed. The same would be true if Grandpa contributes other gifts to Whitney.

To make the five-year election, Grandpa must file a Form 709, Federal Gift Tax Return, for the calendar year in which the contribution is made.

The election is available only with respect to contributions not in excess of five times the annual exclusion amount for the calendar year of the contribution. Any excess is treated as a taxable gift in the calendar year of the contribution. However, that does not necessarily mean any gift tax will be owed since there is also a unified gift and estate tax lifetime exclusion (currently in excess of $11 million) that will shield most taxpayers like Grandpa from any gift tax.

If Grandpa were married, he and Grandma could make an election under the gift-splitting rules for the QTP contribution to be made one-half by each of them, thus allowing them to double up on the annual and the special 5-year amounts.

If in any year after the first year of the five-year period, the amount of the gift tax annual exclusion is increased for inflation, the donor may make an additional contribution in any one or more of the four remaining years up to the difference between the exclusion amount as increased and the original exclusion amount for the year or years in which the original contribution was made.

Example: In 2017 when the annual gift tax exemption was $14,000, Grandpa made a $70,000 contribution to his granddaughter’s QTP and made the 5-year election. For 2018, the annual gift tax exemption was increased to $15,000. Thus, Grandpa can make an additional $1,000 contribution for each of the remaining 4 years of the 5-year election period.

Change of Beneficiary – A change in the designated beneficiary, or a rollover to the account of a new beneficiary, is treated as a taxable gift if the new beneficiary is assigned to a generation below the generation of the old beneficiary. Such a transfer isn’t a taxable gift if the new beneficiary is a member of the family of the old beneficiary, and is assigned to the same generation, as the old beneficiary.

If the new beneficiary is assigned to a lower generation than the old beneficiary, the transfer is a taxable gift from the old beneficiary to the new beneficiary, regardless of whether the new beneficiary is a member of the family of the old beneficiary.

Additionally, the transfer would be subject to the generation skipping transfer tax (GST) if the new beneficiary is assigned to a generation which is two or more levels lower than the generation assignment of the old beneficiary. The five-year averaging election may be applied to a transfer.

Example: Suppose Whitney had not used the funds from the QTP, or has finished her higher education and had some funds left over in the plan, and Grandpa (or the trustee of the account if Grandpa is not the trustee) decides to change the account beneficiary to his great-granddaughter Annabelle. Since Annabelle is in a generation lower than Whitney, the change of beneficiary represents a gift from Whitney to Annabelle. However, the five-year averaging election may be applied to the gift.

Eligible Expenses – Distributions from QTPs, including earnings on the amounts contributed to a QTP, aren’t taxed for income tax purposes if they are used to pay qualified higher-education expenses of the account beneficiary. In addition to tuition, eligible expenses include the following:

  • Fees;
  • Books;
  • Supplies;
  • Equipment;
  • The purchase of computers or peripheral equipment, computer software, or internet access and related services that will be used primarily by the beneficiary while the beneficiary is enrolled at an eligible educational institution;
  • Room and board if the beneficiary is attending a qualified school at least half time; and
  • A special needs student’s expenses that are necessary to enable the student to enroll or attend an eligible educational institution.

When distributions exceed eligible expenses, the beneficiary of the QTP is the one who would include the nonqualified distributions in his or her income. The calculation of the taxable amount of the distribution can be complicated if the beneficiary received a tax-free scholarship. In some cases, a 10% penalty also applies on the taxable distribution that is included in income.

While QTPs are generally intended to be used for higher education expenses, for years after 2017, up to $10,000 distributed from a QTP for tuition expense (but not for related other expenses) paid so the beneficiary can attend an elementary or secondary school (kindergarten through grade 12) is considered a qualified education expense that would be tax-free. However, some states have not recognized this provision, and so such distributions would be at least partially taxable for state purposes.

Direct Payment of Tuition – Some potential contributors to a QTP for family members may wish to pay for the tuition when it is actually incurred rather than saving for it in advance. If that individual makes the tuition payment directly to a qualified school, college or university the gift tax does not apply.

If you have questions related to QTPs in general or changing beneficiaries, please contact us.

What to Do If You Receive a Dreaded IRS Letter

Article Highlights:

  • IRS Notices
  • CP Series Notice
  • Automated Notices
  • Frequent Errors
  • ID Theft
  • What You Should Do
  • What We Will Do

Now that most tax refunds are deposited directly into taxpayers’ bank accounts, the dream of opening your mailbox and finding an IRS refund is all but gone. However, the IRS still sends letters that can increase taxpayers’ heart rates; because of extensive computer matching, the IRS does most of its auditing through correspondence.

CP-Series Notice – When the IRS detects a potential issue with your tax return, it will contact you via U.S. mail; this is called a CP-series notice. Please note that the IRS’s first contact about a tax delinquency or discrepancy will never be a phone call or email. Such calls and emails are a common tool for scammers; if you get one, simply hang up the phone or delete the email. If you are concerned about the validity of a given message, please contact us.

Most commonly, CP notices describe the proposed tax due, as well as any interest or penalties. The notice will also explain the examination process and describe how you can respond.

These automated notices are sent out year-round, and they are quite common. As the IRS tries to close the tax revenue gap, it has become more aggressive in its collection efforts. In addition, as many taxpayers now use low-quality tax mills or do-it-yourself software, the number of notices sent because of preparer error have increased. Missed checkboxes, misunderstandings of available credits, and overlooked income all add up to more errors.

The first step in this automated process involves matching what you reported on your tax return to the data that third parties (e.g., employers, banks, and brokers) reported. When this information does not agree, the automated collection effort begins.

Don’t Panic – These notices often include errors. However, you do need to respond before the 30-day deadline or else face significant repercussions. The notice may even be related to suspected ID theft. For instance, someone may have gained access to your tax ID (or that of your spouse or one of your dependents) and tried to file a return using the stolen ID. The first step is to determine which type of notice you have received.

A CP2000 notice is very different from the other CP notices (which deal with issues such as identify theft, audits, and the earned income credit,). The CP2000 notice includes a proposed—almost always unfavorable—change to your tax return, and it gives you the opportunity to dispute the proposed change. Procrastinating or ignoring this notice will only cause the IRS to ratchet up its collection efforts, which in turn will make it more difficult for you to dispute the proposed adjustment.

Sometimes, the IRS will be correct. You may have overlooked a capital gain or income from a second job. It is also possible that the IRS has caught someone else using your SSN to work or otherwise stealing your identity. Quite frequently, however, the IRS is incorrect, simply because its software isn’t sophisticated enough to pick up all the information that you report on the schedules attached to your return.

When you receive an IRS notice, your first step should be to immediately contact us and provide us with a copy of the notice. We will review the notice to determine whether it is correct, and then we will consult with you to determine how best to respond. If you have any questions, please contact us.

Tax Treatment of a Room Rental

Article Highlights:

  • Vacation Home Rental Rules
  • Order of Deductions
  • Loss Limitations
  • Expense Prorating

With the shortage of affordable housing these days, many homeowners are renting out rooms in their homes, providing themselves with some additional cash. Questions that are often raised regarding room rentals include: Is the income taxable? If so, how is it reported? What deductions are allowed? Can a loss be claimed? Answers to these questions follow.

If a taxpayer rents rooms or other spaces in a home and the rented portion does not have facilities (a bathroom and a kitchen) that would make it a dwelling unit on its own, the taxpayer and the renter may be considered to be occupying one dwelling unit. Thus, the “landlord” is mixing personal expenses with business expenses, a situation in which the tax code does not permit a loss.

As a result, the income and expenses are treated under the same rules as vacation home rentals and are reported on Schedule E, with prorated expenses deductible against the rental income in a specific order and no loss being allowed.

The deductions are claimed in the following order:

  1. First, mortgage interest and taxes.
  2. Next, operating expenses (examples: advertising, repairs, utilities, maintenance, insurance).
  3. Finally, depreciation.

If the result is a loss, the expenses are only allowed until the income is reduced to zero.

But some unusable expenses may be carried over to the next year, where again they and the next year’s expenses will be limited to the next year’s rental income.

Because the expenses are taken in a specific order, home mortgage interest and property taxes paid for the home (which, for many taxpayers, would be deductible anyway) are first deducted from the rental income. Next come the operating expenses, of which only $1,300 of $1,417 is deductible in this example, because that amount reduces the rental income to zero. Thus, $117 of the operating expenses and the depreciation are not deductible.

Any reasonable method for dividing the expenses may be used. The two most common methods for allocating expenses, such as mortgage interest and heat for the entire house, are based on the number of rooms and square footage of the home.

If you have questions related to renting a room or a vacation home, or about short-term rentals of your home, please contact us.

Tax Reform Muted the AMT: Holders of Incentive Stock Options, Take Note

Article Highlights:

  • Alternative Minimum Tax
  • Deterrent to Tax Shelters
  • Tax Reform Changes
  • Tax Deductions and Preferences
  • Incentive Stock Options
  • Tax Planning Opportunity

Although Congress, as part of the recent tax reform, promised to do away with the alternative minimum tax (AMT), it only did so for C corporations; as a result, the AMT still applies to individuals.

Congress originally developed the AMT in 1969 to prevent high-income individuals from using tax shelters to reduce their taxes. For the AMT, federal income tax is calculated without certain deductions and tax preferences. This tax applies if it is greater than the regularly computed income tax. Although it has since been indexed to inflation, the AMT at one point began to apply to middle-income taxpayers, who are not the intended targets of this punitive tax.

The AMT computation includes a tax-exempt amount, but this amount begins to phase out for taxpayers whose adjusted gross income (AGI) exceeds a certain threshold (depending on their filing status). Although the tax reform did not eliminate the AMT, it did mute that tax considerably by increasing the AMT exemptions and by substantially raising the exemption-phaseout thresholds, as illustrated below. The exemptions and AGI phaseout thresholds will be inflation-adjusted in future years.

AMT EXEMPTIONS ($)
Status 2017 2018
Married Filing Jointly or Surviving Spouse 84,500 109,400
Single or Head of Household 54,300 70,300
Married Filing Separately 42,250 54,700

 

EXEMPTION-PHASEOUT AGI THRESHOLDS
Status 2017 2018
Married, Filing Jointly, or Surviving Spouse 160,900 1,000,000
Single or Head of Household 120,700 500,000
Married, Filing Separately 80,450 500,000

These are the tax deductions and preferences that most often affect the average taxpayer:

  • Some itemized deductions are allowed for the regular tax computation but not for the AMT computation.
  • Tier II miscellaneous itemized tax deductions are not allowed for the AMT computation; in addition, for the years 2018 through 2025, they are also not allowed for the regular tax computation. This category primarily includes employee business expenses, investment expenses, and legal fees. As these expenses aren’t currently deductible in either tax calculation, there is no adjustment for the AMT calculation.
  • The AMT computation does not allow the itemized deduction for interest on home-equity debt; such debt also is not deductible in the regular computation through 2025, which eliminates another difference in the two computations.
  • Employee incentive stock option tax preferences are also handled differently in the two computations, as is discussed in more detail later in the post.

As a result of the increased exemptions, the higher AGI thresholds for the exemption phaseout, and the reduction or elimination of differences in deductions, the AMT typically no longer affects average taxpayers.

Incentive stock options – Employers sometimes grant employees qualified stock options (i.e., incentive stock options), as motivation to become more involved in the company’s success and to share in the company’s stock appreciation.

For these options, the employer grants the employee an opportunity to purchase the company’s stock at a preset price on a future date. An option is usually accompanied by a vesting schedule that details the date when the options can be exercised (i.e., when the stock can be purchased). Once the employees have held these shares for more than a year—and for at least two years after the option was granted—any subsequent gains from sales of the stock are subject to the capital-gains tax instead of the ordinary (less favorable) income tax.

The Catch – The catch for incentive stock options is that, in the year when the employee exercises the option and purchases the stock, the difference (often referred to as the “bargain element”) between the stock’s current market value and the price that the employee paid as part of the option is treated as a tax preference. Thus, this difference is added to the employee’s AMT income but is not included in the regular tax income. In the past, this usually triggered the AMT, which meant that the employee had to pay tax on the phantom income in the year of the option, even though there was no actual stock sale. As a result, many employees have shied away from taking full advantage of incentive stock options; rather than holding the stock for the required qualifying period, they have been selling the stock in the year when they exercised the option, resulting in the profit being classified as ordinary income.

(Note that nonqualified stock options are not eligible for the beneficial tax treatment that incentive stock options are afforded. When a nonqualified option is exercised, the bargain element is included in the employee’s wages as ordinary income for the year when the option is exercised. However, this ordinary income is not a preference item for AMT purposes. Most employees who exercise nonqualified stock options immediately sell the stock so that they have money to pay the payroll taxes related to the resulting ordinary income. The paperwork that the employer provides when awarding the option states whether the option is qualified or nonqualified.)

Opportunity – The changes in the AMT present low to moderate-income taxpayers with an opportunity to exercise incentive stock options without triggering the AMT.

If you hold incentive stock options, it may be possible to develop a plan—perhaps a multiyear plan—that will allow you to exercise your options without incurring phantom income in the AMT calculation. Please contact us for assistance in developing such a plan.