Avoid Fiscal Cliff Panic

As you can imagine, I have heard a lot of panic from clients since the election results came in last month.  Some panic is warranted, as most acknowledge that the 2% payroll tax reduction will not be extended, capital gains will likely be increased to 20% or 25% at most, and that tax rates will likely be increased for married couples with AGI over $250k.  However, when it comes to capital gains, panic can actually be very detrimental and cost you much more in taxes than you would think.

Naturally, you would assume accelerating a large capital gains to take advantage of the 15% rate would result in large tax savings, but unfortunately the alternative minimum tax erodes the tax savings if you are a high-income taxpayer.  In fact, most of the time it results in an overall tax rate between 20% and 25%.  Why this happens is very complex and even CPAs get frustrated in fully understanding the alternative minimum tax, but here is the best explanation I could find.  Basically, if a large amount of your income is long-term capital gain income and you are a high-income taxpayer, the AMT tax can kick in and erase the benefit of the 15% rate.  We witnessed this quite a bit back in 2010 when financial advisers worried about the expiration of the 15% rate and advised their clients to sell off their low basis stock.  It sounded like a great idea at the time, but when preparing the tax returns in 2011, many were surprised at how AMT tax erased much of the benefit.  Well, the same thing can happen for tax year 2012 if you give in to panic.

Before you make any big moves on capital gains before year-end, talk to your CPA and and have them run a projection to see what the true impact would be.  It may just be that there is no need to panic.

Obama vs. Romney Tax Policy Outline

The first 2012 Presidential debate will take place on Wednesday, and this time it will be focused on domestic policy.  One of the most important domestic issues right now is the “Fiscal Cliff” and tax reform that is long overdue.  I highly recommend you read through CCH’s outline of the tax policies of each candidate before Wednesday’s big event.  It was released back on 9/11/12 and provides great analysis that is easy to follow even if you are not a tax professional.

While actual tax reform will likely require a lot of compromise from both parties, it is good to have an understanding of both platforms, as ideas from each could end of shaping eventual reform in 2013 and beyond.

My guess is that most small business owners are a bit apathetic this election cycle, as we all know that some form of tax increase is just around the corner regardless of who wins the election.  After all, it is very likely that the 2% payroll tax holiday will be left to expire at the end of the year, and many high income taxpayers will have to starting paying the additional Medicare taxes resulting from the Health Care reform that the Supreme Court upheld in June.

Personally, I am a bit of a skeptic, as politicians have avoided substantial tax reform for years.  In fact, right now I am more interested in what Caleb Porter will bring to the Portland Timbers in 2013.  Tax increases will be a little easier to take if we make it to the playoffs next year. #RCTID

2009 Year-End Tax Planning – Part 1

Well, 2009 has flown by and it is time once again to start thinking about year-end tax planning and any opportunities available to lower your tax bill.  Whether you are have a complex business, investments, or just a simple individual tax return; you should take some time before the holidays get too busy to examine how things are looking for the year and look for any planning opportunities.

If you have not read the It’s Only Money column that was in the Sunday Oregonian entitled “Act Now to Save on 2009 Tax Bill”, make sure you check it out.  We had the opportunity to contribute to the small business section of the article, and it has some good information throughout.

There is a lot of ground to cover, but in Part 1 of this post I will concentrate on individual tax planning and opportunities related to your primary residence:

First-Time Home Buyer Credit Extension:

Most people are familiar with the existing first-time home buyer credit that was extended, but the new reduced credit for “long-time homeowners” is a great opportunity as well that some have not looked into.

  • $6,500 credit ($3,250 married filing separately)
  • Have to have owned and used the same principal residence for any 5 consecutive year period during the previous eight-year period ending with the date on which the new residence is purchased.
  • Income phase-outs have been increased and start at $125k for single and $225k for joint returns.  For taxpayers near the phase-out limits, eligibility can be met with some good year-end tax planning.
  • The extended date is 4/30/10; however, it is important that people realize that they just have to enter into a binding contract before 5/1/10 and close by 7/1/10.

I think that this will become popular for those looking to upgrade or downsize – especially after we get passed the holiday season.  However, one note of caution – if you are newly self-employed (within the last year or more), it is extremely to get a mortgage right now.  The new requirement is that you have to have two years of tax returns as a self-employed individual to prove the income.  If you have less than two years of self-employed returns, you may be looking at a serious road block keeping you from taking advantage of the new credit.

Residential Energy Property Credit:

This credit is 30 percent of the sum of expenditures for qualified energy efficiency improvements, including windows, furnaces, water heaters, heat pumps, and more, which are placed in service in 2009 and 2010, which is limited to $1,500 for 2009 and 2010.  The improvements must meet strict energy efficient standards, so taxpayers should do their homework on this one as a mistake could be costly.

Avoid an Unwelcome Surprise:

Lastly, if you are struggling financially due to a loss of a job or reduced income and are behind on mortgage payments and property tax on your primary residence, understand that this could change your 2009 taxes and you could be looking at an unwelcome surprise if you are significantly behind.  For many, interest and property taxes are very significant itemized deductions, so a few month’s worth of unpaid mortgage payments could really increase your tax liability.  It is not something you want to hear if you are in that situation, but it is something to be aware of, and if you can make a payment by the end of the year, it will help your tax situation.

Oregon 2009 Individual Income Tax Increases

In our previous post, we discussed the Oregon business tax increases resulting from House Bill 3405, which passed the Oregon Senate last Thursday.  Coupled with HB3405 is the sister bill regarding individual tax increases – House Bill 2649.  This bill is also headed for Governor Kulongoski, who has already made a statement of support for the bill, so now is the time to start looking at the details and adjusting your estimated tax payments if needed.


Individual Tax Rate Increases

For tax years beginning on or after January 1, 2009, the Oregon income tax rate increases for individuals with taxable income of more than $125k is as follows (previous tax rate was a flat 9% at these income levels):

  • 10.8% on excess taxable income over $125k but under $250k
  • 11% on excess taxable income over $250k

For tax years beginning on or after January 1, 2012, the 10.8% rate is reduced to 9.9% for excess taxable income over $125k but under $250k; however, the 11% rate for excess taxable income over $250k remains the same.

The tax rate on taxable income under $125k remains unchanged at 9%, so we are just talking about the income above $125k here.  For a more detailed breakdown of the rates at different income levels, see page 2 of HB2649.


Phase-Out of Federal Income Tax Subtraction

HB2649 also creates a new phase-out of the Federal income tax subtraction that starts at $125k for single taxpayers and $250k for married filing joint.  Under current law, there is no phase-out of the subtraction and as of 2008, the maximum deduction was $5,600 MFJ or $2,800 single/MFS.  Below are the phase-out windows for the subtraction under HB2649 beginning January 1, 2009:

  • Single/MFS – phase-out starts at $125k with complete phase-0ut at $145k.
  • MFJ –  phase-out starts at $250k with complete phase-0ut at $290k.


Not All About Tax Increases

There are some small “benefits” they threw into HB2649:

  • Oregon will exempt the first $2,400 of unemployment income received.
  • They will not charge penalty and interest to taxpayers that underpay as a result of the tax increases (how gracious of them).

I am sure they will be releasing more detailed information after the Governor signs this into law, but hopefully this helps give you an basic understanding of the new changes.  To get an idea of the impact of the tax increase, review these 2006 Oregon tax statistics.

If you will be affected by these tax increases, be sure to call your CPA or tax professional as you may want to revise your remaining Oregon estimated tax payments for 2009 – or at least get an estimate of the additional tax that will be due.

Self Rental Recharacterization

We have had passive activity rules for over 20 years and passive income recharacterization rules for close to 15 years, and it is surprising that there is still a lot of confusion and bad advice out there.  In paticular, self-rental income and recharacterization are a prime example – especially for business owners who lease real property to their business.

Let me setup a typical scenario to explain this:

Bob owns and materially participates in a successful contracting business organized as an S-Corporation, which leases a building and storage area owned by Bob personally.  Bob has the building and storage facility setup in a single-member LLC, he has a written lease agreement, and he pays a reasonable amount of rent from the corporation to the LLC.

Now, Bob also has five residential rental properties that he reports on his personal return, and on average the properties turn net losses because of high turnover and the large mortgages on the properties.  For simplicity sake, lets assume Bob has not filed any special elections and has an adjusted gross income over $150k.

Under passive activity income rules, the net losses from the rentals are not currently deductible on Bob’s individual tax return as he has no passive income to offset the losses and he is not allowed the special allowance of $25k in residential real estate losses because his AGI is over $150k.  These losses carryforward until Bob has a good year and receives some passive net income from the properties or sells them – otherwise the losses are kept separate from from the income Bob receives from his S-Corporation.

This has been a frustration for many taxpayers who have plenty of net income from their main business that they have to pay tax on and passive net losses from rental real estate that they cannot deduct or offset against that taxable income.  From 1987 to 1994, many taxpayers like Bob talked to their accountants and found that if they increased the rent the corporation paid them for the lease of the business facility, they could offset the net passive losses from the rental properties and essentially get to deduct all the losses against the active income from the corporation.  This worked great and was a fairly strong strategy.  Even shareholders who did not own property and only rented office space for their business would renew their leases in their personal name and them sublease to the corporation at a much higher amount – basically whatever was needed to cover the rental real estate losses.

However, this “loophole” was closed in 1994 by Regs. §§1.469-2(f)(6) and several court cases and “recharacterization” was officially born.  For self-rented property where the property was rented to active business, the net rental income from that lease became active and not passive, which means that it could not be offset against other passive losses.  For Bob in our example, this means that he cannot offset the net rental income from his facilities lease to the corporation against the passive losses from his residential rental properties.  The once great strategy is no longer plausible and we are back to taxable income from the corporation and passive net losses that are not currently deductible.

Why do I bring this up 15 years later?  Well, sadly many accountants and CPAs out there still use the pre-1994 strategy of offsetting the lease from the corporation against passive net losses from other rental real estate.  Some are aggressive and put more merit in prior dealings with IRS auditors and their ability to argue, while others may just be careless and uninformed.  Regardless, small business owners who also have rental real estate need to be aware of this issue and have a basic understanding of the rules as blaming your tax preparer is not going to get you off the hook with an IRS auditor.  In fact, talk to your CPA or accountant, ask questions, and make sure you understand the positions taken on your return.  Tax law is very complicated and often very dull, but in this case it is fairly clear and an incorrect position can result in a large IRS audit adjustment.

If you have any questions regarding your specific situation with passive net losses and recharacterization of self-rental property, feel free to email me to find out more about our consulting services.

American Recovery and Reinvestment Act of 2009, Part 2

As promised, below are some highlights of the individual tax changes from the Recovery and Reinvestment Act.  If you want to read the CCH Summary, here is the pdf:

CCH Summary

1) First-Time Homebuyer Credit – the new law increases the existing credit to a maximum of $8,000, but best of all it no longer needs to be paid back as long as you stay in the home for 36 months.  You have to purchase a primary residence between Jan. 1st – Dec 1st, 2009, and you must not have owned a residence in the past three years prior to the purchase.  The phase-outs on the credit is $75k single and $150k married filing joint.

Although this is a great deal – the flaw with the credit is that first-time home buyers need the funds to close on the house and not after they file a tax return.  Also, this may jump start the housing market for entry level homes, but it will most likely not affect the rest of the market.

2) Making Work Pay Credit – Stimulus check #2 is not as exciting this time around and many will not even really notice it.  If you make $6,451 or more in earned income ($12,903 married filing joint), but do not have adjusted gross income of $75k or more ($150k married filing joint), then you receive $400 or $800 married filing joint.  However, this will not be one payment – it will be a reduction of employee social security tax withholdings.  This will translate to roughly $15 extra per paycheck, with any remaining credit being refunded with the 2009 tax return.  Nothing really to get excited about unless you are ADP, Paychex, or another payroll processor that will be able to charge more because of all the complexities this will cause for payroll processing.

Other than that, the additional incentives are not that “stimulating”.  Sorry, but it is not very exciting thinking about the spending of our future wealth and the wealth of our children.

Taxation for Ministers – Part I

I have had a lot of experience over the years with local ministers from some of the largest churches down to new church “plants” and home churches.  Taxation for ministers can become very complicated and costly errors can easily be made.  It is very important you understand the rules – especially if you are minister that is not exempt from self-employment tax (FICA and Medicare).

Given that all requirements are met, most ministers have the option to exempt themselves from self-employment tax (SE tax).  Usually, the “career” ministers that plan to work as a minister until they retire select this option.  However, there are a lot of worship ministers and other types of assistant ministers that may have worked many years in other professions before becoming an ordained minister, or they are bi-vocational and work part-time as a minister.  This group often will not exempt themselves from self-employment tax, which actually creates some extra tax complexities.  If you are in this group, it is crucial you read this post and become very familiar with IRS Publication 517.  However, let me first issue a word of caution to those of you who are exempt from SE tax.

Ministers exempt from SE tax

There are good arguments for and against exempting yourself, and hopefully you talked to a CPA or accountant before making your decision.  What I would caution you with is to make sure you are religiously saving the 7.65% you would be paying and investing it for retirement.  Make sure you are not being like the politicians and borrowing from this fund no matter what the circumstance – you do not want to get to retirement with a suitcase full or IOUs.  Also, buy adequate term life insurance to protect your wife and children since they will be turned away from the social security office in the unfortunate event that you die.  Finally, you cannot depend on church pensions in this economy.  Yes, in the past churches and conferences were very generous in taking care of retired pastors; however, many churches and organizations have been forced to make cuts and are slowly changing their retirement benefits to more closely resemble similar plans found in private industry.

Now to the actual tax complications.  For those of you who receive a housing allowance and have employee expenses on a 2106 or expenses on a Schedule C that offset wedding, speaking, or other income, it is important that you calculate the non-deductible portion of your expenses allocable to the tax-free housing allowance.  In plain English, a portion of your expenses are actually non-deductible (see page 9 of Publication 517) because you are receiving tax-free income.  To calculate the non-deductible portion, multiply your expenses by total housing allowance divided by all ministry income.  For example, if you have a $24k housing allowance and $75k in total earnings, 35% of your expenses would be non-deductible.

For some of you this is a moot point as you do not pay income tax or would get no benefit from the deductions, but it is important to note since every minister’s situation is different.

Ministers not exempt from SE tax

I have a heart for this group – especially the worship ministers – as I have been involved with leading worship for over 15 years and I know that they do a lot of work in their jobs and it is a bit unfair that they get stuck with further tax complications.

First, since they are not exempt from SE tax, the housing allowance amount needs to be put Schedule SE and made subject SE tax.  The housing allowance is tax-free for income tax purposes, but not for SE tax as it is an entirely separate tax.  This can have a huge impact on your tax liability, so make sure your employer is taking out ample Federal withholding.

As with ministers exempt from SE tax, you will need to calculate the non-deductible portion of your expenses before completing your 2106 or Schedule C.  The only difference is that the non-deductible expenses are not a total loss in that they provide a small benefit for the non-exempt ministers.  The non-deductible expenses are then used to reduce the amount of housing allowance subject to SE tax.  For example, let’s say you had $18k in housing allowance subject to SE tax and $2k in non-deductible expenses.  The $2k in expenses otherwise lost would lower SE taxable income to $16k.  Even though the taxpayer would probably have better benefit claiming the expenses, at least some benefit can be taken for the non-deductible expenses.

This treatment is missed even by seasoned CPAs, so make sure you look at your return even if you use a CPA and review the comprehensive examples in the back of Pub 517.  The IRS publication also gives examples of the statements needed in the tax return and wording to be used.

I hope that helps!  If you have additional questions, feel free to comment or email me.  In part 2, I will discuss 1099s and go over the housing allowance in more detail.