Tax Tips Blog

David owns a $50,000 municipal bond that he bought at face value less than a year ago. The bond has a 3% coupon rate. Because of rising interest rates, the bond is currently selling at 95, or $47,500. If David sells the bond in 2006, he will recognize a $2,500 capital loss. He can then invest the $47,500 of proceeds in a new municipal bond paying interest at 4%. David’s effective tax rate is 33%. If David were to do this it would enable him to currently benefit from the $2,500 decline in the bond’s value. He has a short term capital loss, which is a tax savings of $825 ($2,500 X 33%) against his ordinary income. Although David would then have bonds that will pay $2,500 less at maturity, he may more than offset this with the increase in current municipal bond income ($1,800 per year with the new bond versus $1,500 per year with the old bond) and the current tax savings from the capital loss.

Jessica sold her home on August 31, 2005 and excluded her gain on her 2005 Federal Income Tax Return. She bought a new home on the same day. On February 18, 2006 she accepted a job transfer approximately 400 miles away. She sold her new house on May 31, 2006, and realized a $15,000 gain. Since Jessica moved because of a change in place of employment, Jessica is allowed a partial exclusion on the sale of her home. Jessica owned and occupied the residence for 170 days, and at the time of sale it had been 272 days since she last used the exclusion. The shortest of these two periods is 170 days so Jessica is entitled to exclude up to $58,219. Since Jessica’s gain was only $15,000 she is able to exclude her whole gain even though it’s been less than 2 years since she used the exclusion. There are other reasons (or exceptions) that allow you to exclude part or all of the sale of your home even though you lived in or owned the home less than 2 years, so if this is your situation, please ask your tax consultant if your situation is an exception.

Joe is a sole proprietor who owns an Auto Shop. He needed new equipment for his shop and a loan to buy it. He decided to take out a home equity loan of $25,000 to buy this equipment. When Joe goes to prepare his tax return he has two options as to how to handle this loan. Since it’s a home equity loan less than $100,000 he can deduct the interest as an itemized deduction on Schedule A of his tax return, subject to the itemized deduction phase-out rules. Joe will still have $75,000 of home equity debt that he could later take as a tax break on additional loans. This may be beneficial if Joe is able to itemize his deductions, but under Joe’s circumstances, a better way to go would be to elect not to treat the debt as secured by his residence. This is an irrevocable election. If he were to make the election not to treat the debt as home equity debt, then he would deduct it under what is called “general tracing rules”. This would make the interest expense from the $25,000 loan fully deductible as business interest on his Schedule C. Using this election, the interest expense will reduce his regular and self-employment tax. It also decreases his adjusted gross income (AGI), which may increase AGI sensitive deductions and credits. Making this election also preserves the full $100,000 of home equity debt available to use as a tax break on other loans.

Sam, informed me that his 78 year old father is very ill and is not likely to live more than a few more years. His father’s current income is not sufficient to cover his normal living expenses and his additional out-of-pocket medical bills including his medications. Sam’s father has considered various options and has decided he wants to take out a reverse mortgage. Knowing Sam’s financial condition I convinced Sam to consider funding his father’s reverse mortgage himself, eliminating the middleman and having the ability to maintain his father’s home in their family, which he could later use as a rental to supplement his own income. Sam and his father entered into an agreement whereby Sam will pay his father $750 per month for the next 5 years. This should provide Sam’s father with more than enough additional income to pay his bills while continuing to live in his own home. The agreement is structured as a reverse mortgage and as such Sam has taken a security interest in his father’s residence. The residence was appraised at $60,000. Interest will accumulate monthly at the applicable federal rate (AFR) and is added to the principal balance. Sam’s father will owe the entire balance, including interest, at the end of the 5 year term. Assuming Sam’s father continues to use the home as his principal residence for the entire five year period, Sam’s father would not be able to deduct the interest until it is actually paid at the end of the fiver year period, but he doesn’t have enough itemized deductions to exceed his standard deduction, so this is not an issue for him. On the other side, Sam would not have to report any interest income until he receives the payment at the end of the five year term. Reverse mortgages are extremely complex and should not be entered into lightly. A good explanation of reverse mortgages can be found at the AARP website. Just because it works for one family does not mean this situation would work for yours. Please consult a qualified professional before pursuing such a strategy.

Jamie has a home in Arizona during the winter months and Michigan during the summer months and would like to know which home he should claim as his primary residence. Usually your principal residence is the place where you spend most of your time. However, rarely are things that easy, espeically when you’re dealing with taxes. When the IRS is trying to figure out where you live they consider several factors including:

• where you work
• where your family lives
• where your place of worship or recreational activities (country club, golf club, etc.) are located
• the address you put on your tax returns - Federal and State
• the address you have on your voter registration card
• the address you have on your vehicle registration, driver’s license and insurance
• the address you use for your mail - where are you getting your bills?
• the location of your bank

It’s amazing how the easiest questions become complex issues when you’re dealing with taxes. This of course, is why it’s always best to consult with a tax professional when you have more than one residence.

Ron and Patricia’s live on Lake Palestine, in Bullard, Texas. They are planning a vacation next summer and wanted to know what the tax ramifications would be if they rented their primary home while they go on vacation. They are hoping to rent it for $2,000 per week. Because the home is their personal residence, if they rent it for fewer than 15 days during the year, the rental income is not taxable. You read it correctly, if they rent their home for 14 days and collect $4,000 - they will not be taxed on that $4,000 of income. Of course, any rental expenses they incur will not be deductible. However, they would still be allowed to fully deduct their qualified residential interest expense and real estate taxes on Schedule A (subject to the overall limitation on itemized deductions). However, if they rent their primary residence for more than 14 days, the calculation become much more complex. There are a set of ordering rules that must be followed to determine which expenses can be deducted and to what extent. It is best to consult with your tax advisor in this situation.

A new dental client, “Joe” was planning on purchasing a dental practice from “Bob”. Bob and Bob’s practice sale’s consultant advised Joe to form a new corporation, I’ll call it Dental, Inc. with a capital contribution of $1,000 and then have Dental, Inc. purchase the assets of Bob’s dental practice, which includes dental equipment, furniture & fixtures, land and a building. Thankfully Joe called me (and an attorney) before he signed any of the documents that were already drawn up with this plan in mind. Since Joe has to personally guarantee the loans to purchase Bob’s assets, Joe should consider personally owning the assets and then leasing them to Dental, Inc. This way, Dental, Inc., will be reducing their taxable income by paying rent to Joe, that Joe would otherwise have to withdraw from the corporation in the form of compensation. By leasing the assets instead of having Dental, Inc. purchase the assets, Joe avoids payroll taxes (if the payments were compensation) and double taxation (if the payments were dividends) and helps to reduce the net income (taxed at professional service corporation rate of 35%) on the rent amounts. Also, by not transferring the land to the corporation, Joe will avoid double taxation later when he sells the appreciated land. This is a simplified example of a complex web of plans that can be employed with multiple entities. Since it is complex, it should never be approached without the advice of qualified professionals.

My client, Janet, just purchase some of her company’s stock for $10 a share and wanted to know if she should make a Section 83(b) election. Janet purchased 1,000 shares and the FMV of her company’s stock is $23 per share. Janet must return the stock if she leaves the company within the next 5 years. Generally, income is not recognized when an employee receives restricted stock. If the employee decides to make the Section 83(b) election then the employee has to include in their income the amount that the FMV of the stock, at the date of transfer, is greater than what they paid for the stock. In this case that would be $13 per share times 1,000 shares or $13,000. Janet would have to pay income and employment taxes on this amount. Why would anyone want to make this election? By making this election now, there are no tax consequences when this stock vest, in Janet’s case, 5 years from now. So one reason to make the Section 83(b) election is if you believe that the stock will be worth more when the stock vests than it is worth on the date of transfer. Any appreciation in the stock’s value is not recognized until the date the stock is sold and then it is taxed at capital gains rates. Also, if the company pays any dividends on the stock, once the Section 83(b) election is made they are treated as dividends, instead of compensation, avoiding some payroll taxes. Why wouldn’t you want to make this election? If you think the stock will not vest – in this case if Janet isn’t sure she will be with the company for 5 years. If you don’t think the stock will have a substantial increase in value. If you think the stock might decrease in value. If you don’t have the cash to pay the taxes necessary by making this election. Since no one can predict the future, each taxpayer has to decide for himself or herself which direction they want to go.

I fired a client recently because he wanted me to allow his corporation to deduct his living expenses.  Living expenses are NOT deductible and never have been.

He is an engineer and had no problem understanding why personal expenses are not an allowable business deduction, but he thought that in his particular situation they should be.

So, I spent a considerable amount of time researching his specific situation and I couldn’t find any justifiable reason why he should be able to deduct his living expenses. I was able to recommend a few other legal ways to reduce his taxes, but that was not sufficient for him. He wanted to deduct his living expenses on his corporate tax return.

At this point I had to tell him that I couldn’t prepare his corporate return and that if he prepared it claiming those deductions he would be looking at some pretty stiff and severe penalties. He said he didn’t care about penalties because “the IRS abates penalties for bad advice from a tax professional”. The problem was that I wasn’t giving him bad advice, he was giving himself bad advice.

Honest tax professionals will NOT help you cheat on your taxes.

However, tax professionals are human and they do make mistakes in interpreting the tax laws. Because of this the IRS does allow taxpayers who honestly relied on the advice of a qualified tax professional possible abatement of their penalties. Taxpayers must provide the IRS with “reasonable cause” as to why they prepared their tax returns incorrectly. The IRS has to believe that you truly believed you were complying with the law and it was reasonable for you to believe that the advice you relied upon was accurate and specific to your situation.

The IRS now suggests that whenever tax professionals write about tax information they include a disclaimer (not unlike the tag line at the top of this page), such that it is clear to anyone who reads what they write, that what is written cannot be used to avoid penalties, because tax articles, memos, emails, etc. are not professional tax opinions.

This does not mean that the advice provided in an article is not accurate. It just means that every taxpayer’s situation is different, so the advice may not apply to you. The easiest way for you to know if something you read will apply to your specific situation is to ask your tax professional.

Living in a small town, it’s not uncommon to hear people willing to trade their goods or services for your goods or services, but it’s not only happening in small towns. It’s everywhere…including the Internet.

The Internet term is “ebartering”, which can take various forms. There are message boards where people post ads saying they are willing to exchange web site design services (or whatever they have to offer) in exchange for printing or advertising (or whatever they want that you have to offer).

There are also bartering exchanges, a central location, where people from all over sell their goods and services for “barter credits” that they can then use to purchase goods and services from other members.

Some people are under the assumption that since no cash is trading hands there are no tax consequences to these transactions. They are wrong.

The IRS considers barter exchanges as if they were “cash exchanges” and therefore they are completely taxable and possibly deductible. When you exchange your goods or services you are required to report the FMV of your goods or services as income received.

If you exchanged your goods or services for a deductible business expense, like office supplies or advertising, then you are allowed to deduct the FMV of what you received.

If you exchanged your goods or services for something personal in nature, like a round of golf, then you still have to report the barter income your business received, but you are not allowed to deduct the round of golf.

The IRS requires you to report and pay taxes on your barter income in the year in which it accrues, whether you are on the cash basis or the accrual basis of accounting. This is why businesses try to spend all their barter credits before the year ends; otherwise, they will be reporting income from the barter, but no related expense.

If you can’t find anything in your barter exchange that you want to spend your barter credits on, see if you can contribute your barter credits to a charity such that you can take a charitable donation as your business deduction.