Tax Savings Strategies

Deducting Miles Driven on Behalf of a Charity

2006-03-30T18:55:00.000-05:00

A taxpayer may usually deduct 14 cents per mile for all miles driven on behalf of a charity (Section 170(i)). The primary purpose of the travel must be to contribute to the mission of the charity. In addition, the travel must not provide the taxpayer with any significant amount of personal pleasure, recreation, or vacation (Section 170(j)). Further, a taxpayer may not deduct the miles driven on behalf of a charity, other than a church, if the purpose of the travel is to influence legislation (Section 170(f)(6)).

For example, if a taxpayer drove her personal automobile a total of 500 miles to procure and distribute wheelchairs on behalf of a qualified charitable organization such as LifeNets http://www.lifenets.org/, the taxpayer could deduct $70.00 (500 miles x 14 cents per mile). However, if a scoutmaster took a troop of Boy Scouts to summer camp and spent a week there with them, the scoutmaster may not deduct the miles because the trip to the summer camp has a significant element of personal pleasure, recreation, or vacation.

For miles for miles driven for relief efforts related to Hurricane Katrina after August 25, 2005, through December 31, 2006, a taxpayer may deduct 70 percent of the standard mileage rate in effect for business miles If a taxpayer receives a reimbursement from a charity for miles driven for relief efforts related to Hurricane Katrina after August 25, 2005, through December 31, 2006, the taxpayer may exclude the reimbursement from gross income up to 100 percent of the standard mileage rate for business miles.

The standard mileage rate for business miles was 40.5 cents per mile from August 25, 2005, through August 31, 2005. The standard mileage rate for business miles increased to 48.5 cents per mile from September 1, 2005, through December 31, 2005. The standard mileage rate for business miles driven in 2006 is 44.5 cents per mile (Rev. Proc. 2005-78).

If a taxpayer does not receive any reimbursement from a charity for miles driven for relief efforts related to Hurricane Katrina, the taxpayer may deduct 29 cents per mile for miles driven from August 25, 2005, through August 31, 2005; 34 cents per mile for miles driven from September 1, 2005, through December 31, 2005; and 32 cents per mile for miles driven in 2006 (Rev. Proc. 2005-78).

If a taxpayer receives reimbursement from a charity for miles driven for relief efforts related to Hurricane Katrina, the taxpayer may exclude from gross income up to 40.5 cents per mile for miles driven from August 25, 2005, through August 31, 2005; 48.5 cents per mile for miles driven from September 1, 2005, through December 31, 2005; and 44.5 cents per mile for miles driven in 2006 (Rev. Proc. 2005-78).

In addition to the standard mileage rate, a taxpayer may deduct the cost of parking fees and tolls incurred while driving an automobile on behalf of a qualified charitable organization (Rev. Proc. 2005-78).

If a taxpayer has any doubt about the status of an organization as a qualified charity, the taxpayer may consult IRS Publication 78 at the IRS Web site: http://www.irs.gov/.

A taxpayer claims the deduction for miles driven on behalf of a charity on Schedule A of Form 1040. The deduction for miles driven on behalf of a charity is included with the amounts for cash contributions on the same line of Schedule A of Form 1040.

A taxpayer should have good records such as a mileage log to document the deduction. The burden of proof is on the taxpayer to prove the amount of all deductions claimed.

If the taxpayer's total itemized deductions do not exceed the standard deduction amount, the taxpayer will usually not receive any benefit from the deduction for miles driven on behalf of a charity.

Second Homes--Tax Benefits and Potential Tax Pitfalls

2006-03-27T14:46:00.000-05:00

Many people are buying a second home. They might do so to have a vacation home with the possibility of selling it at a substantial gain in the future. Another reason people buy a second home is to use it in the future as a primary home, perhaps in retirement. They might prefer to purchase the second home now to avoid the possibility of having to pay considerably more for it in the future.

What are the tax benefits and potential tax pitfalls in purchasing a second home? The first benefit is that the real estate taxes on a second home are deductible as an itemized deduction. However, a potential pitfall exists if the taxpayer is subject to the alternative minimum tax (AMT). Real real estate taxes are not deductible for AMT purposes.

The mortgage interest is also deductible as an itemized deduction on mortgage loans up to a maximum of $1,000,000 on loans used to acquire, construct, or substantially improve the taxpayer's primary home and the taxpayer's second qualified home. A refinancing of acquisition debt is considered acquisition debt to the extent that it does not exceed the balance before refinancing.

Another tax benefit for owning a second home is that the taxpayer may deduct interest on home-equity loans up to a maximum loan amount of $100,000. A home-equity loan is considered as an acquisition debt if the taxpayer uses it to make a substantial improvement to the primary home or second home. The loans may be secured by the primary residence and/or the second home. For tax purposes, a home-equity loan includes the excess of the balance of a refinanced acquisition loan over the balance before the refinancing unless the taxpayer uses the excess to make a substantial improvement to the home.

A tax pitfall is that the interest on a home-equity loan is generally not deductible for AMT purposes. An exception applies if the taxpayer uses the proceeds of the loan of the loan to make a substantial improvement to the property.

If a taxpayer rents a second home to a tenant for 14 or fewer days during the year, the rent income is not taxable. The taxpayer may still deduct the real estate taxes. The taxpayer may deduct the qualified mortgage interest as long as the taxpayer used the second home for personal purposes for a number of days that exceeds the greater of 14 days or 10 percent of the number of days the taxpayer rented the house to a tenant at a fair rental. If the taxpayer does not meet this test, the second home might be considered as rental property.

A potential tax pitfall on a second home is that any gain on the sale of a home that is not the taxpayer's principal residence is taxable. It would be taxable as a capital gain because a personal use asset such as a second home is a capital asset.

The exclusion of gain up to $250,000 ($500,000 on a joint return) on the sale of the taxpayer's home applies only to the sale of a home that that the taxpayer owned and used as the taxpayer's principal residence for at least two of the five years before its sale. A taxpayer may have only one principal residence at a time.

A good tax savings strategy would be for the taxpayer to sell the primary home and exclude the gain up to the limit. Then, the taxpayer would move into the second home and use it as a primary residence for at at least two of the five years before the taxpayer sells it. By doing so, the taxpayer could use the exclusion of gain provision on both homes. The potential to exclude the gain on the sale of both homes up to the limit using this strategy is a major tax benefit.

Another potential tax pitfall on owning a second home is that any loss on the sale of a home used as the taxpayer's residence, whether as a primary home or as a second home, is not deductible because the loss is on the sale of an asset used for personal purposes.

An individual should consider many factors before buying a second home, such as cost, convenience, and potential gain. The tax benefits and potential tax pitfalls are some other key factors to consider before buying a second home.

How to Deduct Start-up Costs

2006-03-22T13:44:00.000-05:00

A new business owner incurs start-up costs before beginning the business. Under Section 195(c)(1), start-up costs are costs the taxpayer incurs to investigate the creation or acquisition of a business or in creating a business. The costs must be costs that would be deductible as an ordinary and necessary business expense if the taxpayer was actively conducting the business.

In general, a taxpayer may not deduct start-up costs until the taxpayer sells the business. That is the default rule of Section 195(a). However, for start-up costs paid or incurred after October 22, 2004, a taxpayer may elect to deduct start-up costs to the extent allowed by Section 195(b)(1)(A). Under Section 195(d)(1), a taxpayer has until the due date of the tax return, including extensions, to make the election.

A taxpayer makes the election by claiming the deduction on the appropriate form. For example, a taxpayer who is a sole proprietor would claim the deduction on Schedule C of Form 1040. The taxpayer should attach a statement to the form showing the start-up costs for which the taxpayer is making the election.

If a taxpayer failed to make the election when the taxpayer filed a timely tax return, the taxpayer has six months to file an amended return and make the election under Regulations Section 301.9100-2(b). The IRS has no authority for allowing any other late elections.

If the taxpayer elects to deduct start-up costs, the taxpayer may deduct up to $5,000 of startup costs in the year the taxpayer begins the active conduct of the business. If the new business owner determines that start-up costs might exceed $5,000, the business owner might want to do what is necessary to begin the active conduct of the business more quickly. By doing so, more of the costs would be ordinary and necessary business expenses rather than start-up costs.

However, if the start-up costs exceed $50,000, the $5,000 limit on the deduction for start-up costs is reduced by the amount by which start-up costs exceed $50,000. For example, assume that the start-up costs are $52,000. The taxpayer may claim an immediate deduction of $3,000 [$5,000 - ($52,000 - $50,000)]. If the start-up costs are $55,000 or more, the taxpayer may not deduct any of the start-up costs in the year the taxpayer begins the active conduct of the business except as an amortization deduction as explained below.

The taxpayer may deduct the remaining start-up costs ratably over 180 months beginning in the month in which the taxpayer begins the active conduct of the business under Section 195(b)(2). For example assume that a taxpayer's start-up costs were $23,000. The taxpayer may deduct $5,000 immediately. In addition, the taxpayer deducts the remaining $18,000 of start-up costs at the rate of $100 a month [($23,000 - $5,000) / 180].

The ratable deduction of start-up costs over 180 months is called an amortization deduction. A taxpayer claims an amortization deduction on Form 4562 and then carries the total deductions on Form 4562 to the appropriate form.

If the taxpayer sells the business before deducting all of the start-up costs, the taxpayer may deduct the remaining start-up costs as a loss as allowed by Sections 165 and 195(b)(2).

A taxpayer should take advantage of these rules to ensure the highest possible tax deductions. Because the time for making the election is quite limited, a taxpayer should be sure to make the election in a timely manner.

Avoid the Tax on Capital Gains by Donating the Property to Charity

2006-03-21T01:15:00.000-05:00

A taxpayer can avoid the tax on long-term capital gains by donating the property to a recognized charity. If the sale of the property would result in a long-term capital gain, but the taxpayer donates the property to charity, the taxpayer avoids the tax on the long-term capital gain and also receives a charitable contribution deduction equal to the fair market value of the property at the time of the donation.

A long-term capital gain occurs when the taxpayer sells or exchanges a capital asset that the taxpayer has held for more than one year for an amount that exceeds the asset's adjusted basis (usually cost). Most long-term capital gains are taxed at a maximum rate of 15 percent. This rate is much lower than the maximum 35-percent rate that applies to ordinary income.

However, a taxpayer can avoid even the 15-percent tax rate on a long-term capital gain by contributing the property to a recognized charity. In such a case, the taxpayer does not have to recognize the gain. In addition, the taxpayer may deduct the fair market value of the property as a charitable contribution.

For example, assume that a taxpayer bought land for investment two years ago at a cost of $6,000. The land is now worth $16,000. The taxpayer donates the land to a recognized charity. The taxpayer does not have to recognize the $10,000 ($16,000 - $6,000) long-term capital gain. In addition, the taxpayer may deduct $16,000 as a charitable contribution.

The deduction for charitable contributions of an individual is generally limited to 50 percent of the taxpayer's adjusted gross income (AGI). However, for contributions of long-term capital gain property, the limit is 30 percent of the taxpayer's AGI unless the taxpayer elects to deduct only the adjusted basis of the property rather than its fair market value.

The taxpayer may carry over any charitable contributions that exceed the annual limit to the next five tax years. The current year's contributions are deducted before any contributions carried over from a prior year.

If the property is tangible personal property, such as a work of art the taxpayer had purchased, the charitable contribution deduction is limited to the taxpayer's adjusted basis in the property. The taxpayer may not deduct the fair market value of such property if it exceeds the property's adjusted basis. In addition, the deduction for contributions of property to private nonoperating foundations is limited to the adjusted basis of the property.

If the property is ordinary income property or property the sale of which would result in a short-term capital gain, the deduction is also limited to the adjusted basis in the property. However, the taxpayer would not have to recognize the appreciation as a gain.

Taxpayers should not donate property to charity on which they would realize a loss if they sold the property. The deduction for the charitable contribution would be limited to the fair market value of the property, and the taxpayer would not recognize the loss. The taxpayer would achieve a more favorable tax result by selling the property to realize the loss and contributing the cash proceeds to the charity. Of course, losses on the sale of personal use assets such as clothing are not recognized.

While the deduction of net capital losses of an individual or married couple is limited to $3,000 a year, the taxpayer may carry over any unused net capital losses to future tax years indefinitely.

The ability to contribute long-term capital gain property to a charity to avoid the tax on the long-term capital gain while deducting the fair market value of the property as a charitable contribution is a great tax planning strategy. Taxpayers who want to contribute to charity should seriously consider using this strategy.

However, the tax law has numerous exceptions and limitations. Therefore, a taxpayer should consult a competent tax professional before donating any significant amounts of property to a charity.

Newspaper Carrier Under Age 18 Is Not Subject to Self-Employment Tax

2006-03-19T18:51:00.000-05:00

The income of a newspaper carrier who is under age 18 is not subject to the self-employment tax (Sections 1402(c)(2)(A) and 3121(b)(14)(B)). This rule also applies to carriers of magazines who are under age 18.

The carrier must distribute the newspapers or magazines to the ultimate consumer for a fixed price. The compensation of the carrier must be based solely on the difference between what the price the carrier sells the newspapers or magazines to the consumer and their cost to the carrier.

The newspaper or magazine may guarantee a minimum amount of compensation to the carrier or credit the carrier with unsold and/or returned newspapers or magazines. The newspaper or magazine may not pay the carrier an hourly wage or a fixed salary. A written contract must provide that the newspaper or magazine will not treat the carrier as an employee for federal tax purposes.

If a teenager makes over $400 in adjusted net income from most other self-employment activities, the teenager would be subject to self-employment tax. The self-employment tax rate is 15.3 percent. The adjusted net income from self-employment is the net income from the business multiplied by 92.35 percent. Therefore, to have a self-employment tax liability, the net income from the activity must exceed $433.13 ($400 / 0.9235).

Once the self-employment income exceeds this amount, the self-employment tax rate applies to it until the amount of the self-employment income reaches the maximum amount for the 12.4 percent old age, survivors and disability insurance (OASDI) portion of the self-employment tax. This maximum amount is $94,200 for 2006. Because this amount represents the amount after multiplying the net self-employment income by 92.35 percent, the unadjusted amount of self-employment income subject to the OASDI portion of the self-employment tax is $102,003.24 ($94,200 / 0.9235).

The unadjusted self-employment income is the amount of the net income reported on Schedule C of Form 1040 (Schedule F for a farmer). No ceiling applies to the 2.9 percent portion of the self-employment tax for Medicare purposes.

The exemption from the self-employment tax for newspaper or magazine carriers who are under age 18 makes the choice of doing such work more attractive to such teenagers who need a part-time or summer job.

Six Month Extension Available Beginning in 2006

2006-03-19T15:10:00.000-05:00

Taxpayers may request an automatic extension of time to file their individual income tax returns on Form 4868. The form is available on the IRS Web site. In previous years, the automatic extension was good for four months. Taxpayers could request an additional extension of two months by filing Form 2688 and stating a good reason why they needed the additional two months. This year the IRS decided to eliminate the time and cost necessary to process these second extension requests by allowing an automatic six-month extension to taxpayers who request it on Form 4868.

Taxpayers who would like an extension must file Form 4868 by the regular due date of their individual income tax returns. This year the regular due date for 2005 individual income tax returns is April 17 because April 15 is on a Friday. In a few states, taxpayers have until April 18 to file their tax returns or application for automatic extension because of Patriot Day. Special rules apply to taxpayers who are out of the country on the due date. The instructions that come with Form 4868 have the details.

Taxpayers may e-file their extension request using tax preparation software or a service provided by a tax preparer. Taxpayers may also mail Form 4868, but a taxpayer should not e-file Form 4868 and also mail it. The address where a taxpayer should mail Form 4868 is on the instructions to Form 4868.

If a taxpayer mails the extension request, using certified mail, return receipt requested is always a good idea. The taxpayer should staple the green and white certified mail receipt from United States Postal Service on the copy of Form 4868. When the green return receipt card arrives from the IRS in the mail, the taxpayer should also staple it to the copy of Form 4868 and file carefully so that the taxpayer could prove to the IRS that the extension request was filed timely in case they challenge it.

The taxpayer does not have to sign Form 4868 or send any payment with it. However, a taxpayer must make a bona fide estimate of the taxpayer's tax liability for 2005 and show any payments already made such as through withholding and estimated payments. If a taxpayer does not make a bona fide estimate of the tax liability, the IRS may disallow or revoke the extension.

A taxpayer may send a payment with the extension request. If the taxpayer e-files the request, the taxpayer may send a payment by electronic funds transfer or credit card. If a taxpayer mails the extension request, the taxpayer may include a check or money order. Checks should be made payable to "United States Treasury." The taxpayer should write "2005 Form 4868" on the check or money order. The check or money order should not be stapled or attached to Form 4868.

Taxpayers should not attach a copy of Form 4868 to their returns. Taxpayers who obtain an extension should file their returns by the extended due date of October 15. Taxpayers who fail to do so are subject to the penalty for failure to file a timely return unless they have reasonable cause.

The penalty for failure to file a timely return is five percent per month or part of a month on the net tax due for each month the taxpayer files the return late. The maximum penalty for failure to file a timely return is 25 percent. If the taxpayer with an extension does not file the return by the October 15 extended due date, the calculation of the penalty for failure to file a timely return begins after April 17, not after October 15. Therefore, the taxpayer would be subject to the maximum penalty for failure to file a timely return of 25 percent of the net tax due.

If there is a balance due with the return, the IRS will charge interest from the original due date of April 17. In addition, the taxpayer will be subject to the failure to pay penalty unless the taxpayer has paid in at least 90 percent of the tax due by the original due date or has reasonable cause. The penalty for failure to pay is one half of one percent per month or part of a month on the net tax due beginning after the original due date (April 17 in 2006). The maximum failure to pay penalty is 25 percent of the net tax due.

Filing an extension request can be a good tax savings strategy for some taxpayers. The tax law allows taxpayers until the extended due date to make a number of tax elections. For example, if a taxpayer is self-employed, the taxpayer has until the extended due date to set up a Simplified Employee Pension (SEP) plan, fund it, and attribute the contribution to the previous tax year. However, a taxpayer has only until the regular due date of April 17 to set up a traditional IRA.

Filing an application for automatic extension can save taxpayers from the penalty for failure to file a timely return if they do not have their return prepared by the regular due date. An extension also allows a taxpayer more time to decide whether to make a number of different tax elections. In past years, the automatic extension was good for four months. This year the IRS allows an automatic extension of six months for taxpayers who file Form 4868 by the regular due date and make a bona fide estimate of their tax liability.

Minimizing the Income Tax on the Receipt of Lump-Sum Social Security Benefits

2006-03-15T13:24:00.000-05:00

Sometimes a taxpayer will receive Social Security benefits in one lump sum. A taxpayer might have to pay income taxes on up to 85 percent of these benefits. However, a taxpayer may make an election under Section 86(e) of the Internal Revenue Code to minimize the income tax on the receipt of the lump-sum Social Security benefits.

Why would a taxpayer receive lump-sum Social Security benefits? A taxpayer could have been receiving Supplemental Security Income (SSI), which is tax free. Then, the Social Security Administration determines that the taxpayer should have been receiving Social Security disability benefits for the last several years instead of SSI. Another reason that a taxpayer could receive Social Security benefits in one lump sum is that the Social Security Administration may have initially denied the individual's application for Social Security disability benefits, but the individual wins those benefits on appeal.

Social Security benefits are not taxable for taxpayers with relatively low amounts of adjusted gross income. At moderate levels of adjusted gross income, 50 percent of the Social Security benefits are taxable. At high levels of adjusted gross income, 85 percent of Social Security benefits are taxable.

This graduated system for including Social Security benefits in gross income and the progressive nature of income tax rates can have a very bad effect on individuals who receive lump-sum Social Security benefits. Such individuals might have to pay a much larger amount of income taxes than they would have if they had received the Social Security benefits when they should have received them. If the taxpayer does not take action to make an election allowed by Section 86(e) of the Internal Revenue Code, that is what will happen.

Sometimes the taxpayer does not receive any cash for the lump-sum payment. For example, if the taxpayer had been receiving SSI and the Social Security Administration determines that the taxpayer should have been receiving Social Security disability benefits, the Social Security Administration will reduce the disability benefits by the amount of the SSI paid to the taxpayer. The taxpayer will receive a Form 1099-SSA showing the amount of the lump-sum Social Security disability benefits and yet the taxpayer received little, if any, cash.

Section 86(e) of the Internal Revenue Code allows a taxpayer who receives lump-sum Social Security benefits to elect to include in gross income only the sum of the Social Security benefits that the taxpayer would have included in gross income in prior years if the taxpayer had received the benefits in the years to which the lump-sum payment is attributable. A taxpayer may also make the election if the taxpayer received Railroad Retirement benefits in one lump sum.

Section 86(e)(2)(B) states that the taxpayer should make the election in the manner prescribed by the Secretary of the Treasury in regulations. However, the Secretary of the Treasury has not issued any regulations under Section 86. Once a taxpayer makes the election, the taxpayer may not revoke it with the consent of the IRS.

Because no regulations exist that prescribe the manner of the election, a taxpayer should make the election according to the guidance the IRS provides in IRS Publication 915, "Social Security and Equivalent Railroad Retirement Benefits." IRS Publication 915 has helpful worksheets and other information about making this election. Taxpayers who received Social Security benefits or Railroad Retirement benefits in one lump sum should consult IRS Publication 915 and determine whether the election will reduce their taxes.

How to Deduct Points on a Mortgage Loan

2006-03-12T07:18:00.000-05:00

A point on a mortgage loan is one percentage point of the loan. For example, two points on a $200,000 mortgage loan would be $4,000 ($200,000 x 2%). Points represent prepaid interest.

A taxpayer who uses the cash method of accounting may deduct points paid on a loan to buy or improve a principal residence as long as the points are a normal business practice in the area, are reasonable in amount, and the loan is secured by the residence (Sections 163(h)(3)(B) and 461(g)(2)). Interest, including points, on a loan to acquire or improve the taxpayer's residence is limited to the interest on the first $1,000,000 of the mortgage loan.

The limit on deductibility of interest on a loan to acquire a residence applies to the taxpayer's principal residence and one other residence (Section 163(h)(4)(A). However, a taxpayer may deduct points paid in the year paid only in connection with a mortgage loan on the taxpayer's primary residence (Section 461(g)(2)). If a taxpayer pays points on a mortgage loan to purchase a second home, the taxpayer must amortize the points over the life of the loan.

A taxpayer claims the deduction on Schedule A of Form 1040. A buyer may deduct the points even if the seller pays them (Rev. Proc. 94-27, 1994-1 CB 613). A taxpayer who uses the accrual basis of accounting must amortize the points over the life of the loan.

If a taxpayer pays points on a home equity loan, the taxpayer may not deduct the points immediately unless the taxpayer uses the proceeds of the home equity loan to improve the property. If the taxpayer does not use the proceeds of a home equity loan to improve the property, the taxpayer must amortize the points over the life of the loan (Sections 163(h)(3)(C) and 461(g)(1)).

The deduction of interest, including points, on a home equity loan is limited to the interest on a home equity loan up to $100,000 unless the taxpayer uses the home equity loan for business purposes. If the taxpayer pays the loan off early, the taxpayer may deduct the unamortized points in the year paid (Temp. Regs. Sec. 1.163-10T(j)(3)).

The same rule that applies to a home equity loan also generally applies to a refinancing of a taxpayer's mortgage loan. The taxpayer may not deduct the points immediately. The taxpayer must amortize the points over the life of the loan. If the taxpayer pays the loan off early, the taxpayer may deduct the unamortized points in the year paid.

However, for taxpayers who live under the jurisdiction of the U. S. Court of Appeals for the Eighth Circuit, if the taxpayer pays points on a mortgage loan and uses the proceeds to pay off a short-term bridge loan, the taxpayer may deduct the points in the year paid (Huntsman v. Commissioner, 90-2 USTC Para. 50,340, CA-8, 1990, rev'g 91 TC 917). The U. S. Court of Appeals for the Eighth Circuit has jurisdiction over taxpayers in the states of Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota, and South Dakota.

If a taxpayer pays points on a mortgage loan to acquire undeveloped land, a commercial building, or rental real estate, the taxpayer must amortize the points over the life of the loan. If the taxpayer pays the loan off early, including a sale of the property, the taxpayer may deduct the unamortized points in the year paid.

Taxpayers should remember to deduct points paid in connection with a mortgage loan to purchase or improve their principal residence, whether the purchaser or seller pays the points. For points paid in connection with a refinancing of a mortgage, to obtain a home equity loan, or to obtain a mortgage loan on rental or commercial property, taxpayers should remember to deduct the points over the life of the loan and deduct the unamortized points in the year the taxpayer pays the loan.

Save Taxes with the Section 179 Deduction

2006-03-10T13:29:00.000-05:00

A taxpayer who conducts an active trade or business can save income tax with the Section 179 deduction. Section 179 of the Internal Revenue Code allows a business to deduct immediately the cost of tangible, personal property that the business purchased and placed in service in a trade or business. Therefore, a taxpayer may claim the Section 179 deduction on business equipment, office furniture, and machinery used in the business. In addition, off-the-shelf computer software qualifies through 2007. However, if the taxpayer uses such assets in connection with rental real estate, they do not qualify for the Section 179 deduction.

A taxpayer must use the asset for more than 50-percent business use to claim any Section 179 deduction. If the usage is greater than 50 percent but less than 100 percent, the taxpayer may claim the Section 179 deduction on the percentage of the cost of the asset that is used for business. A taxpayer claims the Section 179 deduction by making the election on Form 4562.

This deduction reduces taxable income and therefore saves income tax. If the taxpayer is a self-employed individual, the Section 179 deduction also reduces self-employment income and therefore saves self-employment tax.

Vehicles purchased and placed in service in a business are eligible for the Section 179 deduction. However, the total deduction for depreciation and the Section 179 deduction on most vehicles is severely limited. Therefore, claiming the Section 179 deduction on car used in a business is usually not the best use of the Section 179 deduction.

However, if the taxpayer purchases and places in service a sport utility vehicle (SUV) that has a gross vehicle weight of more than 6,000 pounds, the taxpayer may claim a Section 179 deduction up to $25,000. In addition, the taxpayer may claim a depreciation deduction on the remaining cost. If a taxpayer purchases and places in service a pickup truck with a gross vehicle weight of more than 6,000 pounds, the taxpayer may claim all of the cost of the pickup as a Section 179 deduction, subject only to the annual limit and the taxable income limit as explained below.

The Section 179 deduction reduces the adjusted basis of the property. However, if the taxpayer has any cost remaining after subtracting the Section 179 deduction, the taxpayer may take depreciation deductions on the remaining cost, including in the year of purchase.

The maximum Section 179 deduction allowed in 2006 is $108,000 (Rev. Proc. 2005-70). This limit is the aggregate limit on the cost of all eligible property and not the limit on each item of eligible property. If a taxpayer purchases more than $430,000 of eligible property during 2006 (Rev. Proc 2005-70), the maximum Section 179 deduction is reduced by $1 for each $1 of the cost of eligible property over the $430,000 limit.

In addition, the Section 179 deduction is limited to the taxable income derived for any business before considering the Section 179 deduction. For this purpose, wages and salaries count as income from a business. Therefore, someone who is employed may start a part-time business and claim the Section 179 deduction even if the business makes little money or suffers a loss in the first year or two. The taxpayer may carry forward to the next tax year any Section 179 deduction that exceeds the taxable income limit. There are also special rules for certain kinds of property called listed property.

If a taxpayer disposes of property on which the taxpayer has claimed the Section 179 deduction, the Section 179 deduction is subject to recapture in the same manner as depreciation. A taxpayer reports the sale of such property on Form 4797. The recapture of depreciation and the recapture of the Section 179 deduction on a sale of the property are not subject to the self-employment tax (Section 1402(a)(3)(C)).

If the taxpayer converts the asset to 50-percent or less business use before the end of its depreciable life, however, the taxpayer must recapture part of the Section 179 deduction for income tax purposes and self-employment tax purposes. A taxpayer reports such recapture on the same form on which the taxpayer claimed the deduction. For a self-employed individual the form would be Schedule C of Form 1040 because the Section 179 deduction claimed on Form 4562 flows to Schedule C.

The Section 179 deduction is one of the best deductions allowed to a taxpayer who operates a business. Claiming the Section 179 deduction accelerates the deduction for depreciation that the taxpayer would have to claim over several years. Money does have a time value. In addition, a self-employed individual usually saves self-employment tax with the Section 179 deduction, but the recapture of the Section 179 deduction increases only income tax, not self-employment tax.

While claiming the Section 179 deduction is usually a good decision, in some cases it may not be wise. Therefore, a business owner would be wise to consult a competent tax professional before claiming the Section 179 deduction.

Take a Two-Week Vacation and Rent Your Home for Tax-Free Income

2006-03-09T21:24:00.000-05:00

The tax law provides that if you rent your home for fewer than 15 days a year that the rental income is not included in your gross income (Section 280A(g)). That means that you can take a two-week vacation, rent your home while you are gone, and the rental income is not taxable. What a great way to pay for your vacation.

The tax law provides that all income is included in gross income and therefore taxable unless the item of income is specifically excluded from gross income. There are a number of these exclusions and some are commonly known such as the fact that health insurance premiums paid by your employer are excluded from your gross income. However, this exclusion for renting your home out for 14 days or fewer during the year is not as well known.

If you live near where a major sporting event, convention, or other major event is taking place, you might be able to rent your home for a large sum of money. For example, if you lived near where the Super Bowl or World Series was going to be played, you might be able to rent your home for much more than the average hotel rate in your city.

If you live in a resort area, you might be able to rent your home out during the peak tourist season when the hotels are at full occupancy. Because you may rent your home for a maximum of 14 days a year for the income to be tax free, you want to earn the highest rental rate possible.

Be sure to check with your attorney to make sure that there is no problem with zoning or other legal prohibitions for renting your home for up to 14 days a year. Local law might require that you obtain a license or collect sales or occupancy tax from the tenant. You will also want to hire a property manager to handle the rental while you are gone. You or the property manager will want to verify the tenant's references. You will also want to obtain a reasonable security deposit.

Although the rental income is not taxable if you rent your home for 14 or fewer days during the year, you may not claim any deductions attributable to the rental activity (Section 280A(g)(1)). Thus, you may not deduct property management fees, repairs, cleaning, insurance, or depreciation attributable to the rental. You may, however, deduct the mortgage interest, real estate taxes, and any casualty or theft losses as itemized deductions just as you otherwise could.

The ability to rent your home to a tenant for up to 14 days a year and have the rent income be tax free is one of the many tax benefits that the tax law allows homeowners. If you live near a major sporting event or in a resort area, this rule allows you to generate significant tax-free income each year while enjoying a nice vacation. Just be sure that the tenant understands that 14 days is the maximum term of occupancy. If you rent the home for 15 or more days during the year, all of the rent income is taxable.

Use Accountable Plans for Employee Business Expenses

2006-03-06T12:08:00.000-05:00

Employees of a business often incur expenses on behalf of the business. The best way for the business to reimburse such expenses is to use an accountable plan as described in Regulations Section 1.62-2. If the business uses an accountable plan, the reimbursements received by the employee are not incuded in the employee's gross income. Therefore, they do not appear on the employee's Form W-2. The reimbursement is not subject to income tax withholding or payroll taxes. The employee may not deduct the reimbursed expenses. The business deducts the expenses, except that the business may generally deduct only 50 percent of business meals and entertainment.

The employee may deduct any expenses not reimbursed as a miscellaneous itemized deduction, except that the employee may generally deduct only 50 percent of business meals and entertainment. The taxpayer must reduce total miscellaneous itemized deductions by two percent of adjusted gross income. In addition, itemized deductions generally do not provide a benefit to a taxpayer unless total itemized deductions exceed the standard deduction. Therefore, the employee may receive little, if any, tax savings from the deduction.

To qualify as an accountable plan, the employee must substantiate the expenses to the employer. The employee must document the time, place, business purpose, and amount of each expense. The employee must also return any unused advances within a reasonable time.

Some businesses use nonaccountable plans. They give each employee a certain amount that the employee may spend for business purposes. The employee may or may not be able to keep any excess depending on the plan.

While a nonaccountable plan has the advantage of simplicity, it has tax disadvantages for the employer and for the employee. Under this type of expense account arrangement, any amount the employer provides to the employee is taxable as compensation. This treatment means that the employee is subject to income tax withholding, Social Security tax, and Medicare tax on the expense account. In addition, the employer is subject to payroll taxes on the amount. The employee may deduct the actual expenses incurred, except that the employee may deduct only 50 percent of business meals and entertainment.

However, the employee may not receive any tax benefit from the deduction because employee business expenses are deductible only as a miscellaneous itemized deduction. The employee must subtract two percent of the adjusted gross income shown on the return from the total miscellaneous itemized deductions. Only the excess over this reduction is deductible. The employee's total itemized deductions must generally exceed the standard deduction to provide any tax benefit. In addition, miscellaneous itemized deductions are not allowed for purposes of calculating the alternative minimum tax.

The best way to handle employee business expenses is to establish an accountable plan that complies with the requirements of Regulations Section 1.62-2. An accountable plan provides tax benefits to the employer and to the employee. These tax benefits should be greater than any increased bookkeeping burden.

Minister's Housing Allowance

2006-02-28T22:45:00.000-05:00

Churches often provide ministers of the gospel with the free use of a home, which is often called a parsonage. The value of the parsonage is not subject to income tax up to the rental value of the home. The value of the parsonage is subject to self-employment tax.

Alternatively, a church may provide a minister with a cash housing allowance as a part of the minister's compensation. Such a housing allowance, up to the fair rental value of the house and associated furnishings, is not subject to income tax. In addition, money the minister receives from the church for utilities is not subject to income tax. However, the minister's housing allowance is subject to self-employment tax.

Who is a minister for the purpose of this exclusion? While determining who is a bona fide minister for this purpose dependsd on the facts and circumstances, a minister is usually an individual who conducts worship services, serves as a church administrator, or teaches at a religious school or seminary.

Although a taxpayer usually cannot deduct expenses incurred in connection with the production of tax-free income, a minister may deduct mortgage interest and real estate taxes for income tax purposes on a home the minister owns. The law allows the minister these deductions even though the housing allowance is not subject to income tax.

If the minister owns and lives in the home as the minister's primary residence for two or more years out of the last five years, and then sells it, the minister may use the exclusion of the gain on the sale of the home up to $250,000 if single or up to $500,000 if married.

A minister receives all the benefits of owning a home that any other homeowner receives. The ability to avoid income tax on a housing allowance adds to the benefits of owning a home for a minister. Therefore, a minister should generally prefer to own a home rather than receive the free use of a home owned by the church.

The exclusion from gross income of a housing allowance for a minister is a generous provision of Section 107 of the Internal Revenue Code. The tax benefits allowed to a minister are magnified with the ability to deduct mortgage interest and real estate taxes and exclude up to $250,000 ($500,000 if married) of the gain on the sale of the home. Ministers of the gospel should take advantage of these provisions so that they can minimize what they must render unto Caesar.

Health Savings Accounts

2006-02-27T23:05:00.000-05:00

A taxpayer who is covered by a high deductible health insurance policy may establish and contribute to a health savings account (HSA). The contributions the taxpayer makes are deductible in calculating adjusted gross income, so a taxpayer does not have to itemize deductions on Schedule A of Form 1040 to receive the deduction. Contributions made by an employer are not taxable to the employee.

For 2006, for individual coverage, a high-deductible policy must have an annual deductible of at least $1,050. For 2006, for family coverage a high-deductible policy must have an annual deductible of at least $2,100. A plan may have a lower deductible for preventive care. The annual out-of-pocket expenses are limited to $5,250 for an individual or $10,500 for a family.

The maximum monthly contributions an individual may make to an HSA in 2006 are the lesser of 1/12 of the deductible or $2,700. The maximum monthly contributions allowed to an HSA for a family plan in 2006 are the lesser of 1/12 of the annual deductible or $5,450. Individuals who are age 55 or older may contribute up to an additional $700 in 2006, $800 in 2007, $900 in 2008, and $1,000 in 2009 and later years.

Distributions from the HSA used to pay medical expenses, other than most health insurance, are not taxable. The medical expenses may be those of the taxpayer, the taxpayer's spoouse, the taxpayer's dependents, and certain individual who would be dependents except that they failed certain of the requirements for being a dependent.

If the taxpayer receives a distribution from the HSA and it is not for medical expenses, the distribution is taxable. If the taxpayer receives a distribution from an HSA for other than medical expenses, the distribution is taxable and the taxpayer must pay a 10-percent penalty unless the taxpayer is age 65 or older, disabled, or dead.

Medical expenses include optical, dental, and certain non-prescription drugs as well as expenses for physicians, hospitals, prescription drugs, and other traditional medical expenses. A taxpayer may not pay for a medical expense from an HSA and also deduct the same amount as a medical expenses on Schedule A of Form 1040.

Special rules apply to married taxpayers where each has health insurance. If only one spouse has family health insurance, both spouses are deemed to have family coverage. if both spouses have family health insurance under separate plans, the law treats each spoouse as having a family policy with the lower deductible.

Taxpayers who are interested in the tax benefits of an HSA should consult a competent tax professional and an insurance agent.

No Self-Employment Tax on Notary Income

2006-02-23T09:45:00.000-05:00

The work of notaries public is in demand with all so many people buying or refinancing their homes. A notary must attest to many signatures in the closing of a purchase or refinancing of real estate. A notary public serves as a state official who is a bonded witness of a signature. In Florida and perhaps in other states, a notary public can also perform a marriage.

While the net income of a notary public is subject to federal income tax, it is not subject to self-employment tax. Section 1402(c)(1) of the Internal Revenue Code and Regulations Section 1.1402(c)-2(b) provide that the income of a notary public is not subject to self-employment tax.

If a notary public has another business as a self-employed individual, the notary public must pay self-employment tax on the net income from the other business. The notary public must keep a separate account of the income and expenses of each separate business.

A self-employed notary public reports the income and expenses from serving as a notary public on Schedule C of Form 1040. However, the net income from serving as a notary public does not go on Schedule SE because the net income from serving as a notary public is exempt from the self-employment tax.

If the taxpayer has erroneously paid self-employment tax on the net income from serving as a notary public in previous years, the taxpayer should consider filing an amended return on Form 1040X to claim a refund for all open years. In general, a taxpayer has two years from the time the taxpayer paid the tax or three years from the date the taxpayer filed the return, whichever is later, to claim a refund. Taxpayers should consult a competent tax professional before filing an amended return.

Where to Deduct Tax Preparation Fees

2006-02-22T00:16:00.000-05:00

Where should an individual taxpayer deduct tax preparation fees? The obvious answer might be on Schedule A of Form 1040 as a miscellaneous deduction. Are tax preparation fees deductible only on Schedule A for all taxpayers? Thankfully, the answer is no.

Deducting tax preparation fees on Schedule A will provide little or no benefit for most taxpayers because the total miscellaneous deductions must exceed two percent of the taxpayer's adjusted gross income to provide any benefit. In addition, the taxpayer's total itemized deductions must usually exceed the standard deduction amount to provide any tax benefit.

The IRS ruled in Rev. Rul. 92-29 that taxpayers may deduct tax preparation fees related to a business, a farm, or rental and royalty income on the schedules where the taxpayer reports such income.

A taxpayer who is self-employed may deduct the portion of the tax preparation fees related to the business, including schedules such as depreciation schedules, on Schedule C of Form 1040 as a business expense. The tax preparation fees deducted on Schedule C save the taxpayer income tax and self-employment tax.

A taxpayer who is self-employed as a farmer would deduct the portion of the tax preparation fees related to the farm on Schedule F of Form 1040. The tax preparation fees deducted on Schedule F save the taxpayer income tax and self-employment tax.

A taxpayer who has rental and/or royalty income reported on Schedule E of Form 1040 would deduct the portion of the tax preparation fees related to the rental and/or royalty income on Schedule E. The tax preparation fees deducted on Schedule E save the taxpayer income tax. However, the tax preparation fees deducted on Schedule E do not save the taxpayer any self-employment tax because the rental and/or royalty income reported on Schedule E is not subject to self-employment tax.

A taxpayer may not deduct all of the tax preparation fees on Schedules C, E, and F of Form 1040. The tax preparer should provide a statement to the taxpayer that indicates how much of the tax preparation fee was related to the taxpayer's business, farm, and/or rental and/or royalty income. The taxpayer may deduct the remainder of the tax preparation fee only on Schedule A.

If the tax preparer does not provide the taxpayer with a detailed statement showing how much of the tax preparation fee was for the taxpayer's business, farm, and/or rental and/or royalty income, the taxpayer shoud ask the tax preparer for an itemized statement. If the tax preparer will not provide an itemized statement, the taxpayer should use a reasonable allocation. In that case, the taxpayer should seriously consider using a different tax preparer next year.

Here is an example. Assume that the taxpayer is self-employed and also owns rental real estate. The tax preparation fee for the taxpayer's Form 1040 and related schedules for 2005 was $600. The tax preparer states that of the $600 total fee, $300 was related to the taxpayer's business, $200 was related to the rental real estate, and the remainng $100 was related to other parts of the taxpayer's income tax return. The taxpayer paid the $600 in February 2006.

On the taxpayer's income tax return for 2006, the taxpayer may deduct the $600 tax preparation fee as follows: $300 on Schedule C, $200 on Schedule E, and $100 on Schedule A as a miscellaneous deduction.

Converting Retirement Plans to Life Insurance

2006-02-21T01:22:00.000-05:00

Assume that an older, fairly wealthy widow(er) has a substantial amount in tax-deferred retirement plans such as defined contribution pension plans, 401k plans, 403b plans, and traditional IRAs. The widow(er) wants to leave the retirement plans to his or her children.

The problem is that when the children inherit the retirement plans and take distributions from them, the distributions are fully taxable to the children. The retirement plans are income in respect of a decedent (known as IRD), which is taxable. In addition, the balances in the retirement plans are fully included in the decedent's gross estate for estate tax purposes.

Is there any way to achieve the parent's goal of having enough money to pay living expenses and yet leave a good inheritance to the children? The answer is yes if the older, fairly wealthy parent is insurable for life insurance purposes.

Here is how the solution would work. The parent obtains a life insurance policy large enough to replace the balances in all the tax-deferred retirement plans. However, the parent is not the owner of the life insurance. The parent forms an irrevocable life insurance trust that has a "Crummey Powers" clause, and the irrevocable life insurance trust owns the life insurance policy. This technique will keep the value of the life insurance out of the decedent's gross estate.

A "Crummey Powers" clause gets its name from a court case. It has to do with whether a gift is subject to gift tax. Gifts that are less than the annual exclusion amount are exempt from gift tax as long as the gift is a present interest in property. A "Crummey Powers" clause allows the beneficiary of a life insurance trust the right to withdraw gifts made to the trust that the donor intends to pay for life insurance premiums. As long as the beneficiary has the right to withdraw the donation under the "Crummey Powers" clause, it is a gift of a present interest in property.

Assume that the beneficiary does not exercise the right to withdraw the donation. The irrevocable life insurance trust will use the donation by the parent to pay the premiums on the life insurance.

Where does the parent obtain the money to donate the money to the trust to pay the life insurance premiums? The parent converts the balances in the retirement plans into a life annuity. Therefore, the parent receives payments for life and uses part of them to pay the insurance premiums through the trust. At the parent's death, the annuity is worth zero. Therefore, the children do not have any income in respect of a decedent. Nothing from the annuity is included in the gross estate.

The life insurance company pays the children the proceeds of the life insurance policy. The proceeds are not subject to income tax. They are not subject to estate tax because the decedent did not own the policy.

This plan allows the parent to have an income stream during life from the annuity. The annuity payments would be fully taxable unless the individual has any basis in the annuity. The children receive money from the life insurance policy and do not have to pay any income tax or estate tax on it.

This plan converts amounts that would be subject to income tax and estate tax to amounts that are not subject to income tax or estate tax in the hands of the children. The parent can donate money to charity or engage in additional income tax planning to minimize the income tax on the annuity payments during life.

This strategy requires the services of a tax advisor, attorney, and a life insurance agent. They all must be competent and exercise great care in implementing the strategy. However, if done correctly, this strategy can result in substantial tax savings. It also gives the parent more peace of mind knowing that the children will not have to pay taxes on the life insurance.

New for 2006, the Roth 401k

2006-02-20T10:46:00.000-05:00

One of the new tax strategies available in 2006 is the Roth 401k. A taxpayer may place up to $15,000 ($20,000 if age 50 or older) in a Roth 401k instead of a regular 401k plan in 2006. The 401k plan needs to have the provision that allows contributions to go into a Roth 401k. Just because the tax law allows a Roth 401k plan does not mean that all employers will revise their 401k plans to allow Roth 401k contributions.

The Roth IRA has been one way to invest to generate tax-free income for retirement. A taxpayer does not receive a deduction for placing money into a Roth IRA, but the taxpayer may take the money out at retirement free of federal income tax. The new Roth 401k works in much the same way except that a taxpayer may contribute a larger amount to a Roth 401k

The problem with the Roth IRA has been that the law has not allowed many taxpayers to have Roth IRA because their incomes were too high. The new Roth 401k does not have this problem. A taxpayer may contribute to a Roth 401k no matter how high an income the taxpayer has.

Traditional IRAs, 401k plans, and other pension plans provide for tax-deferred income. The contributions made by the taxpayer are either deductible or excluded from gross income at the time of contribution. However, when the taxpayer withdraws the money, it is fully taxable. A taxpayer receives no deduction for amounts that go into a Roth IRA or a Roth 401k plan, but the taxpayer may withdraw the money at retirement completely free of federal income tax.

The Roth 401k plan is especially good for younger taxpayers. They have a longer time to invest their money wisely and generate a large amount of tax-free earnings on their contributions. Taxpayers should carefully consider the Roth 401k plan in 2006 with the assistance of a competent tax advisor.

Tax Free Gain on the Sale of Your Own Home

2006-02-19T21:14:00.000-05:00

When a single taxpayer sells his or her principal residence that he or she has owned and used as a principal residence for at least two of the previous five years, the taxpayer may exclude up to $250,000 of the gain from gross income. A married couple who meets the conditions may exclude up to $500,000 of gain.

This means that the gain is never taxed. The taxpayer does not have to purchase a new home for the exclusion to apply. However, if the taxpayer has ever used the home or any part of it for business purposes, the taxpayer must pay taxes on the gain due to depreciation recapture.

While many people are aware of this exclusion provision contained in Section 121 of the Internal Revenue Code, few people have thought about how to use it as a strategic wealth-building tool. The way to use it as a wealth building tool is to buy a home below market value, such as a foreclosure or probate property, sell the home a little over two years later, and then repeat the process.

Another way to use this provision to its maximum is to act as one's general contractor and build a home. Individuals who act as their own general contractors can often build a home for 80 percent or less of its value. There are books available that explain how to do so.

The advantage of buying a home below market value or building a home is that the taxpayer has a gain from the beginning. If the property appreciates more from the date of purchase or completion of construction, that is even better. The exclusion applies not only to the appreciation from the date of purchase or completion of construction, but it also applies to the gain from buying or building below value.

While moving is a chore, by moving every two to three years, a taxpayer can realize substantial gains that are free from federal income tax and Social Security tax. "Keep moving" is not only a good slogan for physical fitness, it also can be good for fiscal fitness.

If a taxpayer has some extra cash left over after selling a home and buying another one, the taxpayer can place money into a Roth IRA up to the maximum amount allowed if the taxpayer is eligible to do so. Doing so allows the taxpayer to generate even more tax-free income.

For many taxpayers, tax deductions are becoming less valuable because of the alternative minimum tax (AMT). The gain on the sale of a principal residence that is excluded from gross income is not subject to the AMT. Taxpayers should use this generous tax provision to build wealth and minimize their tax obligations. The ability to exclude the gain on the sale of a principal residence is a great tax savings strategy.