Tax Tips Blog

Jim writes: I have just received a notice from the IRS stating that I did not report $4,000 of income. The detail shows that a bank had reported that amount as non-employee compensation. It turns out that the amount was for a settlement of a 2003 claim I filed under the Fair Credit Reporting Act. I never received a 1099. The IRS says that my tax increase along with penalties and interest amounts to $2,102. This includes “self-employment tax deduction.” I completely forgot about the settlement money. Now, how do I respond to the IRS? Throw myself on their mercy, dispute the characterization (re the self-employment) or what? I did have some expenses associated with the lawsuit, which hopefully would decrease the net amount that is taxable. They want a response soon, they say that my return is going to be examined….does that mean audited, or what? I am at a loss here. Any help would be greatly appreciated. Thanks, Jim

My response:Jim, the first thing you should do is hire a professional to help you correspond with the IRS. I have seen more people make things worse by trying to take care of notices themselves.

This time of year it’s going to be hard to find someone who is going to act fast, but you need that as well. A good tax consultant should be able to tell you if it was taxable at all or not.

Whether or not the settlement was taxable depends on the nature of your claim and what the settlement was for (IRS Publication 525 deals with judgment/settlement proceeds).

I agree that it doesn’t sound like it should be recorded as non-employee compensation and self-employment tax should not apply. Once you know the proper tax reporting of the item, then you can appropriately respond to the IRS and take care of the situation.

Best wishes, Gina

The IRS has announced that individual taxpayers have until April 17, 2007 to file their taxes, because April 15 is on a Sunday and April 16 is Emancipation Day.

Ted writes:My son is 20. He dropped out of college and has been home doing some Online School to try and get a degree, can I still claim him as my dependent child?

My response:Hello Ted, thanks for writing. Online School is not a qualified school, but you said that your son did go to college. If he attended college for at least 5 months during the year, being enrolled full-time, and the college is a qualified school (has a regular teaching staff, course of study, student body), then he will probably qualify as your dependent child.

It would be best to discuss this with your tax consultant.

Best wishes,

Gina

Shelley wonders:It has been recommended by my mother’s doctor that she get a 4-wheeled walker. Because she got one without wheels earlier in the year, medicare will not cover it. With the doctor’s note that it is medically necessary, can this be added to the medical expenses for the year ? (I know about the limit but this year, I suspect she will hit it.) thanks, Shelley

My reply: Thanks for writing Shelley! If your mother has a prescription for the wheelchair then it is deductible as a Medical Expense on Schedule A, subject to various limitations. I would keep a copy of the prescription with the tax return.

Best wishes,

Gina

As the TaxProf points out, several bloggers have already blogged regarding their opinion on the President’s proposal to allow a limited deduction for health insurance whether purchased themselves or through their employer.

As a break from my typical tax posting, I wish to comment on the President’s proposal regarding health insurance as well. William Perez from About.com and Kay Bell from Don’t Mess with Taxes have done a great job in summarizing the President’s proposal and how it would work, if it was passed by Congress.

With possible inclusion of some income, a single person would be entitled to a $7,500 tax deduction for health insurance, if they have health insurance and a family would be entitled to a $10,000 tax deduction if they were covered under a health plan.

First, I would like to say that I think this is a huge step in the right direction and I was happy to hear about the proposal. Sadly, I agree with William Perez when he stated that this will cause Americans to get the cheapest policy possible, such that they are entitled to their full tax deduction, trying to “pocket” the rest of the deduction. Americans will most likely do this by purchasing policies with extremely high deductibles or ones that leave off coverage that they may really need. I’m sure the insurance industry is already thinking up new policies and exclusions. Then when the taxpayer (or a member of the taxpayer’s family) gets sick they will not have the funds to pay their deductible or co-pay and it’s the doctor and/or hospital that will be forced to provide free care until their insurance kicks in. Yes, this may reduce the total amount of write-offs that physicians and hospitals face, since they are now providing all their care for free, but it won’t solve the problem.

In my opinion, if the taxpayers had to have health insurance and put their deductible in a Health Savings Account in order to obtain the tax deduction, it would be an even better plan. It seems to me that whenever health costs are discussed the only party who rarely, if ever, suffers a loss is the insurance company. They write the policies and place the dollar value on those policies to make sure they get paid and they get paid before any care is ever needed. They also inform the physicians and hospitals exactly how much they will pay them for tests and procedures that are covered. Then they try their best not to pay on their policy, forcing the patients to pay more and/or the physicians and/or hospital to write off more of their services.

I believe every business deserves to make a profit, but it should be an honest profit. In my opinion there is way too much opportunity for insurance companies to make a dishonest profit.

Just my opinion,

Gina

John from Oklahoma writes: Hello! I found your blog while search the net and was hoping you could answer a question for me. My wife is one of five beneficiaries of a trust established over 30 years ago by her father when he died. Her mom had access to the income generated since the trust was established. A couple of months ago her mom passed away and the trust will be divided among her and her four siblings. The trust investments are mostly stocks, some bonds and some cash. Each heir’s distribution will probably be in shares of the equities, thus getting a stepped-up basis for each stock. My question is will the trust have to pay capital gains tax on all stocks appreciation once the distribution to the heirs occurs? Thanks for any guidance.

My reply:Hello John and thanks for stopping by. I’m sorry to hear about your mother in law’s death. You and your wife should be discussing this with the attorney who is handling your mother in law’s estate, as well as the CPA who will be preparing the trust tax returns. You haven’t provided enough information to provide you an exact answer, as one can only be made, after reading the trust and will.

Usually and generally, a trust does not recognize a gain on distributions. Trusts can elect to recognize a gain on distributions by electing to treat the assets as being sold to the beneficiaries. There may or may not be a step-up in basis at your mother in law’s death. It depends on the type of trust and how it was set up.

If the trust was the subject of a QTIP (Qualified Terminable Interest Property) election at your father in law’s death (which is usually done to qualify the trust for the marital deduction), it would be includible in your mother in law’s estate, and subject to a basis step-up at her death. Trusts are extremely complex and should be handled by attorneys and CPAs.

Best wishes,

Gina

Megan asks: I have rental property which I plan on selling. I’m estimating that I’ll have about $100K in profit. How will this affect me taxwise? I would also like to know if I should buy another property or use the money to pay down my mortgage. Any suggestions? Please respond. Thanks in advance, Megan

My response: Hello Megan, thanks for writing. I think it’s excellent that you’re asking these questions BEFORE you sell your rental.

The problem is that these are questions that you should be discussing with your tax professional, because without knowing a lot more information (your age, whether or not you manage the property, your financial situation now and expected in the future, the state you live in, etc.), I really can’t give you any specific advice and my general advice may not be appropriate for your situation.

If you’re like my average client, you’re probably mistaken on what your taxable profit in your rental is likely to be. Most taxpayers forget about adjustments to their basis and simply assume their selling price less what they initially paid for the property is their gain or loss. Not so.

You should ask your tax professional to estimate your estimated tax liability on the sale of your rental. If you’ve made any permanent improvements over the years since you purchased your rental property, these improvements will usually increase your basis.

The largest deduction to your basis is usually depreciation, whether or not you claimed it.

If you live in any of the disaster areas, you may have incurred a casualty loss that modified your basis.

Your property may be subject to depreciation recapture, which would change the character of profit that you will have.

How much tax you will pay on the gain will depend on your particular situation. You may find that this gain has caused you to be in a high tax bracket. Your exemptions and deductions may be phased out. You may be unable to make a deductible IRA contribution. This may even put you in an AMT situation.

The best thing to do is to sit down with your tax professional and have him or her help you plan this out. After your tax professional has helped you figure out your potential profit and related tax liability, then it is time to consider you options.

If you decide to purchase another rental property then the smartest tax method for this is called a 1031 exchange. You have to set this up BEFORE you sell your current rental, but once you do you can postpone paying tax on the gain from the sale. This is a complex transaction and should not be done with professional help.

If you decide to put your net profits into your home or into any other investment which would be considered personal in nature (stock market, savings account, etc.), you will need to make an estimated tax payment to the IRS and your state.

Best wishes,

Gina

Maria wonders:I purchased a new shed for my backyard. Should I be keeping the receipt for the shed, and when I sell my house I’ll add that to the basis and it will potentially reduces the tax I will owe on the profits of the house?

My response: Unless you live in California or Florida or some other area where houses are appreciating very nicely, you probably don’t have to worry about paying tax on the profit of your house.

Taxpayers are allowed to exclude (for Federal purposes) up to $250,000 in profit from the sale of their main home as long as they owned the home and lived in the home for a minimum of two of the last five years before they sold the home.  That said, it is always wise to keep track of your basis, because tax laws change, and when you do decide to sell it, who knows what the law will be.

If the shed is a permanent addition to your property, then it should add to your basis in your home. If it’s small and easily mobile, then it would probably be classified as personal property and would not increase the basis of your home. If you use the shed for any business or rental purposes (profit making purposes), you should depreciate it. As always, it’s best to ask your tax consultant.

With tax software so cheap, so many online tax filing options, resources and help all over the Internet, why hire a tax professional?

Are you a leader or a follower? Do you need to be told what to do? Software does not have the ability to think for you, even if it seems like it does. Yes, the program is designed to ask you a bunch of questions, but you can’t discuss your specific situation with the tax software package and have it reply, “Well in your case….”. Instead you are stuck with the “online help” that has been programed in, hoping that it is not only accurate, and easy to understand, but also written with your specific situation in mind. It is not uncommon for tax software to gloss over areas of tax law, assuming that your situation is just like the majority of people they believe will purchase their program.

In addition, some tax software has a very hard time asking the appropriate questions regarding difficult areas of tax law, which include determining who qualifies as a dependent, whether or not you are entitled to the earned income credit, how to appropriately tax your investments, household employees, rental property and/or foreign income to name a few.

The “simple” tax forms that you are required to complete are based off of mountains of legal documents. Alright, maybe not “mountains”, but the entire U.S. Tax Code is now over 7,500 pages.

If you don’t like to read or don’t like to read legal or tax documents or if you have difficulty following directions, then you should consider hiring a tax professional.

You probably know if you like to read or not. And you probably know if you like to read legal or tax documents or not. But if you’re not sure if you have difficulty following directions the Wisconsin Job Center has a self-test, which you can take and see how well you do. It only takes 10 minutes. You can find it here: http://www.wisconsinjobcenter.org/publications/9482/9482.htm.

Every day tax law cases are decided, did any of those cases affect anything that may be on your return? You wouldn’t know unless you kept up with all the changes in the tax law – not only the changes passed by congress, but also all the new rulings the IRS comes out with and the decisions the judges make throughout the year.

Tax professionals subscribe to newsletters, alert services, research tools and take continuing education classes so they are aware of the changes and understand how they may affect taxpayers. Most other people have better things to do with their time.

If you own a business and intend on preparing your own tax return then you most certainly know and understand how “mid-quarter convention” and “recapture” work, when they apply and when they don’t. If these terms don’t scare you and you’re comfortable with payroll, employee benefits and the fact that more small businesses are being audited every year, then maybe you’re all set.

Do you ever need tax advice during the rest of the year? Ever wonder what kind of retirement plan would be best for your business? Ever wonder if you’re taking advantage of all the tax breaks available? Are you planning on getting married, divorced, having a child? Have you ever received a notice from the IRS? Ever worry about receiving one? Tax software in a box or online can’t help you the rest of the year.

Sure you may be able to find the answers you are looking for in a book or online, but will they be right for your particular situation? Do you really want to represent yourself or explain to an IRS agent why you thought your pet’s medical bills should be deductible?

If you’re thinking of hiring a professional, then before you do, make sure you pick the right professional. Ask to speak with the person who will be preparing your tax return. Ask them if they have experience in preparing returns like yours. See if you like talking to them. Find out if they are available the rest of the year.

If you send the IRS either a paper tax return or an electronically filed tax return before Feb. 3, 2007 and you are claiming a benefit from one of the “key tax provisions” (such as a deduction for local sales tax and educator expenses) which were enacted last December, your return will be accepted, but not processed. This of course, will delay the processing of any refund you may be entitled to receive. The IRS stated that they will begin processing those returns after Feb. 3, 2007 because that is when their computers are expected to be updated to include the provisions of the Tax Relief and Healthcare Act of 2006. The IRS once again informed taxpayers of the benefits of e-filing: “E-file is fastest, safest and most accurate way to file a tax return,” said IRS Commissioner Mark W. Everson. “People will get their refunds faster through e-file. E-file greatly reduces the chances for making an error compared to filing a paper 1040.”