As we move into the middle of September an ominous tax date is looming for some folks. If you filed an extension before the tax deadline this year your extended dead line is quickly approaching. The deadline for the extension is October 16th. For the procrastinators, your time is quickly dwindling to file your extended tax return.
You don’t automatically get an extension if you miss the April tax deadline, you must actually notify the IRS of your need to extend. Taxpayers do this by filing form 4868 with the IRS. Form 4868 will ask basic identifying information and whether or not they expect to owe tax or receive a refund. The form can be filed by mail but is preferred by the IRS to have it electronically. If you didn’t file an extension, time is of the essence. The IRS imposes steep fines and penalties for taxpayers who have not filed their return or an extension. The fines and penalties continue to increase the longer you take to file the return. In general, the penalty for filing late is 5% of the unpaid tax owed to the IRS, per month, up to a maximum of 25%.
Extension to pay?
A tax extension is an extension to file, not an extension to pay. You should have paid the bulk of your tax bill by the original filing date. The failure to pay penalty is smaller than the failure to file penalty, it is only .5% of the tax due to the IRS each month. In cases where you have a failure to file and failure to pay penalty imposed the max penalty is 5% per month.
The IRS has given limited allowance to people in affected disaster zones to extend their deadlines. Check the IRS website for counties which are being given this extended deadline.
The truth behind IRS tax audits.
Probably some of the most feared words in the US are Tax Audit and IRS. Why? Do most Americans cheat on their tax returns? Is the IRS all powerful? Most Americans do all they can to comply with the Tax Code of the United States. The code is confusing and not easy to fully understand. The audit process is full of mystery and fear to most Americans. A mystery because few have any experience in responding to them and full of fear because most Americans think the IRS has almost omnipotent power.
What is a tax Audit?
All that a tax audit does is confirm the correct reporting of income, deductions and credits. The IRS compares your return to accepted averages of returns that match your situation. Looking for large differences and if enough differences are found selecting that return for an audit to confirm the numbers are correct. It does not go into the audit assuming you are wrong, that you made anything up or that you are a tax cheat. It just asks to make sure your amounts are correct. The bulk of audits are correspondence audits. The IRS uses computers to match your return to information provided by other parties, notices a difference and generates a notice to you to remind you that you forgot something or made some sort of clerical mistake. A recent client of mine received a notice from the IRS that he owed about $100,000 in taxes on income that he had not reported. When I reviewed his tax return, his W2 and the IRS notices I found a mistake in how the tax preparer had coded a part of his W2 which caused the error. I contacted the IRS and explained it to the IRS employee who saw the mistake and corrected the information. Most times the initial contact from the IRS is a completely automated notice. No human does a sanity check and once a human looked at the information it was clear what had happened. While the correspondence audit is the most common, probably the audit which strikes fear in the heart of every American is the face to face audit.
Face to face audits.
The face to face audit is where the potential for an assessment of additional taxes explodes exponentially. The majority of returns selected for this type of audit are chosen based on the differences between the tax payers returns and the IRS established averages. Additionally, the IRS has areas of tax focus based on their experience with the amount of abuse that occurs. A recent one has been the Earned Income Credit. Because of the potential for abuse the IRS has focused audit effort on these returns. Face to face audits are serious business, I would suggest to a tax payer that is subject to a face to face audit to retain the services of an enrolled agent or CPA that specializes in tax representation. Numbers have shown that taxpayers who represent themselves, on average, pay significantly more penalties that those that have been represented.
What the IRS considers in a face to face audit.
During a face to face audit the will attempt to discover unreported income and disallow taken credits and deductions. The auditor will review your bank records. A common error the IRS makes in trying to discover unreported income is to double count deposits. So for example, say you get paid each month into your checking account, the auditor will review that account and match it with your W2. But then say you deposit money into the account from the check you received when you sold your old car. The auditor could try to bring that amount into unreported income forcing the taxpayer to prove it is not income and it is in fact a deposit from the sale of his old car. Because of the multitudes of deductions and credits and the confusing way that most of the rules surrounding this area are written the Auditor has many ways to disallow valid deductions. For example, a common deduction is vehicle mileage for a person who has rental property. The IRS requires that the tax payer keep records that allow the taxpayer and the IRS if audited to determine the correct amount of the deduction/credit. In this case a written log listing date, mileage, and trip information would suffice as would an electronic app that tracks the mileage. However, if your written or electronic log does not allow the auditor to accurately determine the amount of deduction the auditor could disallow it. The point is nowhere in the IRS code will you find a line saying what specific information is needed to prove or disprove the deduction. Not all but most deductions use the same definition to define whether the deduction or credit is valid.
The IRS Audit is simply a check to ensure the correctness of your return. Defending yourself against a face to face audit with the IRS could potentially result in a large penalty being levied against you. It is good to go into an audit knowing your rights and understanding the process. It is also recommended that your retain an Enrolled Agent or CPA specializing in tax representation.
It does not matter if you are a bookkeeper, Enrolled Agent, CPA, Attorney or an employee of the IRS, the tax code is daunting and easy to misinterpret. Even if you understand it, the application of a definition presents further complications. A commonly seen area in my tax practice where mistakes are routinely made is in the application of the title “Real Estate Professional”. Section 469 of the IRS code deals with this specifically.
Being defined as a real estate professional is very advantageous to the tax payer. The biggest advantage is that the passive activity loss limitations no longer apply. Also, real estate professionals are able to exclude rental income from the additional 3.8% tax on net investment income.
What are the key conditions to be considered a real estate professional by the IRS?
A few common questions I get from clients regarding their TSP are:
The TSP is great in that it automatically withdraws funds from your pay, almost without you seeing it. Additional funds are added almost transparently to you based on a percentage of your pay that you pick. This is great in situations like getting a pay raise, since you'll automatically begin putting more into retirement savings. So with the contribution portion of the TSP on autopilot, why not put the investing side on autopilot too?
Automating asset allocation is the purpose and goal of the lifecycle fund. What is a life cycle fund? You may ask. It is relatively simple. A lifecycle fund automatically adjusts your investment mix to match a model that is based on your expected retirement date.
The L funds in the TSP allow you to pick a fund that is closest to your expected retirement date. All you do is invest funds into that particular fund. When you are younger the fund would be more aggressive to take advantage of time in an attempt to get you a better return. As you become closer to retirement the fund becomes more conservative, with the idea of protecting your money as you enter your final couple years before retirement.
A fault that I see many clients make when using the L fund is to have their money invested into many different funds. The whole idea of the life cycle fund is that you invest all your money in that fund and let it do the spreading across different assets for you. By picking individual funds in different asset classes, it might make you over-weighted in a particular asset class when combining the amount the L fund has invested in that particular investment class.
To recap, the TSP is a great investment plan. It allows you to put your investment contributions on “Autopilot”. Putting your asset allocation on “Autopilot” is the next logical step, allowing you to meet your retirement goals and not spend the night worrying about what you have your investment account invested in.
When preparing to move to a new area, one of the first considerations is whether to buy or rent. Most people have heard about the different advantages of buying versus renting, one of which is the ability to deduct mortgage interest from my taxes. But is the mortgage interest deduction really as valuable as real estate agents claim? The reality is, for most Americans it's not.
The value of the home mortgage interest deduction cannot be understood unless you understand the standard deduction and Schedule A of the 1040. Every person filing taxes is afforded a standard deduction based on filing status. The standard deduction is an amount issued annually by the IRS. The taxpayer decides whether to take the standard deduction or itemize deductions depending on which is most advantageous to the tax payer. The schedule A is the form we compute the total of itemized deductions. Mortgage interest is included as a line item on Schedule A. Other items on the schedule A are the charitable deduction, unreimbursed employee expenses, and healthcare costs to name a few.
The value of itemized deductions, which mortgage interest is a part of, is only the amount it exceeds the standard deduction. For 2017 the standard deduction for a person filing “Married filing Jointly” will be $12,700. So if your itemized deductions equal $12,700 there is no advantage, but if your total itemized deductions equal $12,800 you will have saved an additional $100 on your taxes…. that would be wrong. That additional $100 in itemized deductions would have saved you a lesser amount, likely around $25 depending on your tax bracket.
So probably the best way to illustrate this is with an example;
The key thing is that the IRS gives every person the ability to use their standard deduction. This means that whether or not you buy a home and take advantage of the mortgage interest deduction you get a comparable amount in the standard deduction. The ability to deduct mortgage interest increases in value as the value of the home increases.
If you are paying attention you may say “Well I will just use my other itemized deductions to make it worthwhile”. Yes, the other itemized deductions are added in on top of the mortgage interest deduction to get a total amount. The downside is a lot of those other itemized deductions are not very easy to use. Take for instance the medical and dental expense deduction. You are only able to deduct expenses that are not reimbursed by insurance. And you can only deduct the medical and dental expenses that exceed 10% of your Adjusted Gross Income. Another possible deduction to add to you total to exceed the standard deduction is the charitable deduction. This deduction must have been donated to a qualified organization and comes with its own specific requirements to value the donation if it is not a cash donation.
The mortgage interest deduction provides no economic benefit to the bulk of Americans. The standard deduction generally is a better deal for most Americans. For tax filers with extreme health care costs, extreme charitable contributions or who pay above average mortgage interest costs itemizing deductions can provide a very meaningful deduction but is limited to use in very specific situations.
The 2016 tax season has ended and most people have filed their returns. The IRS has processed millions of returns and selected returns for further investigation. This leads to the question, “How does the IRS choose who to audit?” and further, “What can I do to avoid an audit next year?”
The IRS uses technology for the bulk of its audit decisions leading to a correspondence audit. The most basic form of audit is created by a computer checking the amounts on your return against what is reported by others. If the W2 your employer provides to the IRS says one thing and the amount reported by you on your returns says another, that would possibly generate a flag by the computer system. In that case, you would probably receive a letter notifying you of the problem and asking for further information from you. Then, the necessary adjustments would be made to your return to reflect the proper amounts.
The IRS conducts face-to-face audits of approximately 1% to 2% of all returns filed in a given year. The most common method a return is selected for a face-to-face return is via the IRS computer system which measures your return, line by line, against their respective averages. Each time your return falls outside of the accepted averages, that difference is given a score. The higher your “Total Score”, the more likely your return is to be selected for a face-to-face audit. The IRS also uses a randomized selection system that picks a small percentage of returns for face-to-face audits. Finally, the IRS selects returns for face-to-face audits by focusing on specific compliance areas. An example of this is the recently held belief that the IRS focuses audits on people taking advantage of the home office deduction. This deduction was found to have been abused by taxpayers and so the IRS has focused attention on it to deter those abuses.
Here are 4 ways to help reduce the chances of your return being selected for an audit and/or reduce the pain if your return is selected:
Ultimately, only a tiny fraction of a percent of people who file a return will be selected for a full on, face-to-face audit. The IRS seeks to focus these audits on the most likely violators. The tiny amount of random audits probably is the most likely way the average person will be selected for an audit and since it is random there are no steps to take to avoid that possibility.
A lot of college freshman are in the process of filing their taxes, and they only have about 2 more weeks to file them. The first time filing taxes as a college freshman can cause a lot of questions for the student as well as the parents. If those questions are answered incorrectly, those questions can become quite costly from improper tax filings. Here are 5 common questions of 1st year college freshman that can save you unnecessary tax costs.
Attending a college outside your home state? Where do you file state taxes? The federal return is easy. It needs to be filed with the IRS based on your permanent address. State returns are a different animal. Generally, a student files state returns with their home state. If the student works in the same state as the college, and that state has income taxes which are taken out of the students pay then it is necessary to file what is generally known as a “Non Resident” state return in that state to receive a refund of the taxes taken out of the students pay.
For students lucky enough to have been awarded scholarships. Do you pay taxes on those scholarships? Generally, you do not pay taxes on those scholarships if they are used to cover the cost of tuition and required fees. Scholarship money in excess of required fees which is used for room and board, travel, research and equipment is taxable. This amount should be included with wages even if the additional funds are not accounted for in a W2 form.
For those paying for college are there any credits or deductions available to you to reduce the cost of attending college? There are two main credits. The first is the American Opportunity Tax Credit. This credit is good for the first 4 years of a student’s post-secondary education. Post-secondary is a fancy way of saying after high school. This credit allows up to a $2,500 credit for filers with an adjusted gross income of less than $80,000 if filing singly or $160,000 filing jointly. The second credit is the life time learning credit. The credit 20% of the first $10,000 of college expenses up to $2,000. It is used after the American Opportunity tax credit is used up. You cannot take both credits in the same year for the same student. Generally, you must have a modified adjusted gross income of less than $65,000 if filing single or $130,000 filing jointly.
Now that I know all about the taxes, when is my tax return due? This one is easy. Your tax return is due on the 15th of April. If you are running short on time you can file for an extension. The IRS provides an immediate 6-month extension. Filing this extension is easy and can be done online.
Finally, how do you file your taxes? It is best not to use one of the big box tax firms. They pop-up every tax season in grocery stores, strip malls and temporary offices. They charge a small fee to file and will try to “sell” you a product to get your return faster.
Keep in mind the IRS provides free tax filing that is available to most tax payers via the IRS website. This method of filing is generally more correct than the returns filed by the big box tax firms. If you no longer qualify for free tax filing with the IRS or your tax situation begins to get complicated, it is recommended that you employ a tax professional such as a CPA or Enrolled Agent. Both have education and training in preparing taxes and will ensure your return is correct and filed timely, saving you money and providing you peace of mind.
Ride sharing using services such as Uber and Lyft have become more and more common. A lot of clients I have been working with this tax season have become involved in these services with little understanding of the tax ramifications. A little understanding of the rules and loopholes associated with the ride sharing economy will allow you to get the most out of the service you provide.
The first consideration when providing services such as these is for you to understand that you are not an employee but an independent contractor. As a contractor you are responsible for all taxes associated on your net earnings. You will pay Self-employment taxes and income taxes, this will all be reported on Schedule C of your 1040 which feeds line 12 on your personal tax return.
The taxes are figured on your “Net Income”. Net income is your income minus your expenses. So what expenses are allowed to be deducted from your net income? There are generally 2 different ways to account for costs related to using your personal cars for the business purpose of your ride sharing. The first is the “Actual” cost method. The actual cost method is just like it sounds, recording all the costs associated with your ride sharing to deduct from the income earned. You could include gas, tolls, and parking fees for example. Also you could record expenses for things such as maintenance, vehicle depreciation and registration fees that most people wouldn’t naturally think to include. The main drawback of the actual cost method is the accounting nightmare of recording these expenses. The second, and preferred method of recording cost is just to forgo all the afore mentioned accounting nightmare and using the “Mileage Standard rate”. This method all you have to record is the mileage associated with your ride sharing. The current government rate for 2016 is 54 cents per mile. You may think, that is easy, but one thing to keep in mind about the standard mileage rate only includes expenses for operating the car itself. So if your ride sharing company requires a smart phone, the costs associated for that percentage of use are deductible as is fees and charges the ride sharing company may charge.
So what records do you need to prove this to the IRS in the case of an audit? The good thing about most ride sharing companies is the records of you picking up and dropping off riders will provide a key source of proof to the IRS. With regards copies of any fees, mileage or other expenses related to the operation of the vehicle will help. Additionally, if you deduct other expenses for the ride sharing such as the use of a smart phone and the phone service associated with it then keeping statements as well as a usage log would provide a basis that would likely stand up to an IRS audit.
Questions about the 1099-Misc. So generally the ride sharing companies will provide a 1099-Misc at tax time to show the amount you made in Gross income. If you made less than $600 the companies are not required to provide a 1099-Misc, but you are still required by the IRS to report that income. If you made over $20,000 through ride sharing the company in that case will provide you a 1099-K. All of these are reported on schedule C of your 1040.
The increased use of ride sharing has been viable side business for many. Reporting the taxes and income associated with this side business is essential. Computing a correct net income will allow you to minimize the tax you pay ultimately keeping more in your pocket.
A common dream of many Americans is to have a vacation home. Whether your dream vacation home is a hide away on a ski slope or a bungalow by the beach, there are some deductions for taxes that can make owning a vacation home less demanding. A vacation home is anything that has sleeping space, a toilet, and a kitchen. This could make the purchase of nonstandard vacation homes a possibility, for example, a boat with those minimum qualifications could qualify as a home as could a mobile home.
Probably one of the biggest expenses in a vacation home would be the interest. Most Americans think of deducting the interest on their primary home but most don’t realize that rule applies to your vacation home as well, with some caveats. The first is that the loan must be for the acquisition of a home or home equity indebtedness. An acquisition loan is a loan to purchase a primary home or vacation home. Home equity indebtedness would be a traditional home equity loan taken out with your primary home securing the loan allowing you to buy a vacation home. These requirements are pretty broad, but they do rule out a deduction for interest when using products such as signature loans, credit cards and other means of financing. The second caveat that can catch a few people is the overall limit to the total loan amount. Generally, the max amount of the combined loans cannot exceed $1 million. The third is that if you rent out the second home for more than 14 days you must use the second home for 14 days or 10% of the rental days whichever is more. Finally, this deduction is allowed only for 2 homes. If you have a 3rd home, you cannot deduct the interest from that home in the same year as the other 2. However, you are allowed to switch which home is considered as your second home to take advantage of the interest deduction which is more profitable for you on a year by year basis.
What if you rent the 2nd home out? About a quarter of vacation homes are rented to other people throughout the year. For taxes, the IRS has created what is called the 14-day or 10% rule. The way you divide time between personal use of your vacation home versus the amount of time you rent it is the key to determine your status in the eyes of the IRS. If you rent your vacation home for less than 14 days a year you can pocket the income without declaring it to the IRS. If you use the vacation home more than 14 days or more than 10% of the number of days the home is rented out, whichever is longer, it is considered your vacation or personal residence. If you use it for less than 14 days or less that 10% of the time it is rented to others it is considered a rental property and you are considered a land lord. These definitions determine the amount of expenses you can deduct and the income you have to declare. If you are considered a land lord by the IRS by staying in your vacation home less than 14 days or 10% of the rented time you can operate the vacation home as a traditional rental. Allowing you to take the usual deductions and depreciation of a rental property against the rental income received. If your personal use exceeds the 14 day or 10% limit you are allowed to deduct up to the amount of the rental income received. The IRS uses a broad definition of “personal” use. This definition includes yourself and immediate family, parents, grandparents and grandchildren. The IRS considers any day you rent the property for less than fair market value as a personal day, trading your vacation home to stay at another, and donating it for charitable use. If you sell your vacation home, if you didn’t reside in it as your primary residence for 2 of the prior 5 years you will owe taxes on the gain. If you have owned the property for 18 months or longer you will be eligible for long term capital gains treatment currently at 15%. As is true with other real estate investments if you took depreciation on the property you will be subject to depreciation recapture currently at 25%.
There are two more considerations when owning a vacation home. The first is that if you operate your property at a loss you can deduct up to $25,000 against your earned income. Once your AGI exceeds $100,000 you are phased out of the ability to deduct the $25,000 against your earned income ultimately becoming ineligible at an AGI of $150,000. This loss does not disappear however. You can carry the loss forward to years where you are eligible to use it and if you sell your vacation property you can ultimately reduce your cost basis in the home by the amount of loss that has not been allowed. Finally, you must actively manage the property. The IRS generally considers a broad definition of what is active management. So generally as long as you are making key decisions on the property such as approving tenants, rental terms, repairs and improvements you would be considered as being active.
The tax advantages of a second home can make owning a vacation home less financially onerous. Ultimately, while finances play a role in the decision, the only factor is not financial and is often more of a lifestyle choice.
Real estate investing provides numerous tax benefits, one of which is depreciation. In order to make the most of this benefit, it is crucial to be aware of, fully understand, and plan for this tax benefit.
Depreciation is one of the biggest tax advantages that owning a real estate investment provides. Depreciation allows you to deduct a portion of the cost of the investment each year for the length of its IRS designated life span. The depreciation computation is figured based on the value of the improvements, not on the land underneath the improvements. This necessitates the requirement that you be able to determine the value of the land and the value of the improvements. This determination is generally included in the multitude of closing documents you have received. It is essential that you keep your closing documents. There are additional costs that can be expensed and that have to be amortized involved in the closing itself. Very often a real estate investment that is cash positive will turn to become a loss once depreciation is included in the cost. This “Loss” of up to $25,000 is allowed to be deducted against your earned income if you meet the AGI requirements. When you eventually sell the property the IRS will impose what is called “Depreciation Recapture”. The depreciation recapture portion of your capital gain is taxed at the ordinary tax rate. Now if you are keeping track the lowest rate for capital gains tax is 15% and pretty average ordinary tax rate is about 24% the thinking man may say “Well since depreciation recapture is more than capital gains I just won’t take any depreciation” and on the face of it that makes sense. The IRS has thought about this and created a rule that when a person sells an investment property the depreciation recapture tax is computed on the amount of depreciation taken or the amount of depreciation that should have been taken. So the IRS will tax you on depreciation recapture whether or not you take it so it makes sense to take it.
So since one of the biggest questions I get in relation to depreciation is “How do you compute depreciation recapture?” I will attempt to simplify and explain it. The first thing you will need is the basis of the property. This should have been computed at the very beginning when you started taking depreciation. Generally, this amount is somewhat close to what you originally paid for the property. Next you need to compute the depreciation that you took or that should have been taking. If you had a professional prepare your taxes this is probably included as a schedule in your last year’s tax filing. A lot of the online tax software programs miss this information. Then you subtract the amount of depreciation taken or that should have been taken from the the original cost basis. This is known as the “adjusted cost basis” of your property. Next you need the amount you sold the property for minus any fees or commissions and this is known as your “Net proceeds”. Subtract the adjusted cost basis from your net proceeds. This is the amount of “Gain” you have realized. Compare your realized gain with your depreciation expense, the lower of the two is the amount the IRS considers subject depreciation recapture at the ordinary income tax rate.
The depreciation deduction is a very valuable real estate investor benefit. When taken, it can provide an immediate deduction that greatly reduces an individual’s tax liability.
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