Monthly Archives: March 2013

Deducting Bad Loans to Family Members

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Loans often exist among family members.  It is not unprecedented that some of these loans don’t get paid back.  When loans among family members aren’t paid back, it is possible for the lender to take a tax deduction for the bad debt.

While the IRS allows people to claim bad debt deductions for loans to family members, because of the close relationship between lender and borrower, the deductions are subject to close scrutiny.  Unless the lender can prove that a bona debt exists, the loan will be treated as a gift to the borrower and no deduction will be allowed.

Proving the Amount Loaned is a Real Loan and Not a Gift

To establish that a family debt is bona fide, the intent of the parties to create a binding debt is significant as well as how similar the loan arrangement is to normal commercial arrangements.

The following characteristics help establish that a debt is bona fide:

  • A written loan agreement
  • A reasonable rate of interest is charged
  • There is a fixed payment schedule
  • Security or collateral is obtained
  • The borrower is solvent when the loan is made
  • The borrower makes payments on the loan
  • The lender makes a demand for repayment when the borrower is delinquent

Legal action is not required to show that an effort was made to collect on the loan.  If the circumstances indicate that legal action would be futile, worthlessness of the loan can be established without legal action.

Rules for Nonbusiness Bad Debts

A loan between family members will generally be considered a nonbusiness bad debt.  As such, it is treated as a short term capital loss.  Short term capital losses are deductible against capital gains, then against up to $3,000 of ordinary income each year.  If the lender does not have capital gains (or can’t sell assets to create capital gains) it may take several years to fully deduct the bad debt.

Example:  Tina lends $50,000 to her son, Timmy, so he can start a business.  There is a written loan agreement, a reasonable interest rate is charged, and Timmy makes monthly payments on the loan.  After a year Timmy’s business fails and he is insolvent.  The loan balance is $45,000.  Tina makes a demand for payment, but Timmy can’t pay her back.  Legal action will probably be futile since Timmy is insolvent and near bankrupt.  Tina can probably claim a $44,000 nonbusiness bad debt.  If Tina has no capital gains, she can only deduct $3,000 of this bad debt per year.

Example 2: Tina has $10,000 in capital gains in the year Timmy defaults.  Here, Tina can offset the $10,000 of capital gains with the bad debt and she can deduct an additional $3,000 of the bad debt against her ordinary income.  The remaining balance of the bad debt deduction can be carried forward.

Example 3: Same facts as example 1, except that Tina has no current capital gains.  She does; however, have stock that has appreciated $40,000.  She can sell this stock, recognize a $40,000 capital gain, offset $40,000 of the capital gain with the bad debt deduction, and deduct an additional $3,000 of the bad debt against her ordinary income.  The remaining $1,000 of bad deduction will be carried forward.

It is important to keep in mind that the family member who’s loan is being forgiven may have debt forgiveness income.  However, the debt forgiveness income may be tax-free if the borrower is insolvent, bankrupt, or in certain other circumstances.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

The IRS is Offering Relief Because of Delayed Tax Forms

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On January 2 of this year, Congress passed the American Taxpayer Relief Act of 2013.  Many provisions of this tax law applied retroactively to 2012.  The IRS had to update its 2012 tax forms to reflect the changes and update their computer systems to be able to process these updated forms.

These updates caused delays in the availability of these forms and in the IRS’ ability to accept the forms for processing.  These delays may affect the ability of some taxpayers to timely estimate and pay their 2012 tax liabilities.

Make Sure to File an Extension

Taxpayers who are filing later than normal are encouraged to file an extension.  However, an extension only extends the due date for filing the tax return–it does not extend the due date for paying the tax.  To qualify for an extension, taxpayers must estimate their tax liability using any available information and report that tax liability on the extension application.

When taxpayers are late in paying their taxes, the IRS automatically assesses the late payment penalty (0.5% per month) and sends notice and demand for payment to the taxpayer.  The IRS also charges interest in addition to the penalty.  Penalties may be avoided if taxpayers demonstrate reasonable cause for paying late and that they lacked willful neglect to pay late.

Penalty Relief Available

For taxpayers who file an extension to file their 2012 tax return that includes one of the forms below, the IRS will deem the taxpayer to have demonstrated reasonable cause and lack of willful neglect.  Taxpayers must  put forth a good faith effort to properly estimate the tax liability on the extension application, the estimated tax amount must be paid with the extension, and any additional tax must be paid when the tax return is filed by its extended due date.)

The IRS will grant relief from late payment penalties only—it will still charge interest on any late tax payment.  Additionally, this relief is not automatic—the IRS will still send notices even if proper extensions with payments were filed.  Relief has to be requested by submitting a letter to the IRS explaining the taxpayer’s eligibility for relief, identifying which of the tax forms below was included with the taxpayer’s return, and referencing “Notice 2013-24” in the relief request.  Finally, this relief does nothing to prevent the State of Michigan from assessing its own late payment penalty if Michigan taxes are paid late.

The affected forms include:

•    Form 3800, General Business Credit
•    Form 4136, Credit for Federal Tax Paid on Fuels
•    Form 4562, Depreciation and Amortization (Including Information on Listed Property)
•    Form 5074, Allocation of Individual Income Tax to Guam or the Commonwealth of the Northern Mariana Islands
•    Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations
•    Form 5695, Residential Energy Credits
•    Form 5735, American Samoa Economic Development Credit
•    Form 5884, Work Opportunity Credit
•    Form 6478, Alcohol and Cellulosic Biofuels Credit
•    Form 6765, Credit for Increasing Research Activities
•    Form 8396, Mortgage Interest Credit
•    Form 8582, Passive Activity Loss Limitations
•    Form 8820, Orphan Drug Credit
•    Form 8834, Qualified Plug-in Electric and Electric Vehicle Credit
•    Form 8839, Qualified Adoption Expenses
•    Form 8844, Empowerment Zone and Renewal Community Employment Credit
•    Form 8845, Indian Employment Credit
•    Form 8859, District of Columbia First-Time Homebuyer Credit
•    Form 8863, Education Credits (American Opportunity and Lifetime Learning Credits)
•    Form 8864, Biodiesel and Renewable Diesel Fuels Credit
•    Form 8874, New Markets Credits
•    Form 8900, Qualified Railroad Track Maintenance Credit
•    Form 8903, Domestic Production Activities Deduction
•    Form 8908, Energy Efficient Home Credit
•    Form 8909, Energy Efficient Appliance Credit
•    Form 8910, Alternative Motor Vehicle Credit
•    Form 8911, Alternative Fuel Vehicle Refueling Property Credit
•    Form 8912, Credit to Holders of Tax Credit Bonds
•    Form 8923, Mine Rescue Team Training Credit
•    Form 8932, Credit for Employer Differential Wage Payments
•    Form 8936, Qualified Plug-in Electric Drive Motor Vehicle Credit

 

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional be

Tax Rules for Household Employees

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Household employees include caretakers, housekeepers, maids, babysitters, gardeners, and others who work in or around your private residence as your employee.

Social Security and Medicare Taxes (Federal Insurance Contributions Act – FICA)

If you pay a household employee cash wages of more than the amount specified by law in a tax year ($1,800 for 2012 and 2013), you generally must withhold Social Security and Medicare taxes from all cash wages you pay to that employee. You should withhold 7.65% of the gross wages paid to the employee to cover Social Security and Medicare taxes.  If you decide to pay the employee’s Social Security and Medicare taxes, this amount will be additional income to the employee.

HOWEVER, DO NOT withhold or pay Social Security and Medicare taxes from wages you pay to:

  • Your spouse,
  • Your child who is under age 21,
  • Your parent, unless an exception is met; or
  • An employee who is under age 18 at any time during the year, unless performing household work is the employee’s principal occupation. If the employee is a student, providing household work is not considered to be his or her principal occupation.

If you do withhold Social Security & Medicare taxes, pay the amount you withhold to the IRS with an additional 7.65 percent for your share of the taxes. If you pay your employee’s share of social security and Medicare taxes from your own funds, the amounts you pay on your employee’s behalf count as additional wages for purposes of the employees’ income tax. However, they are not counted as Social Security and Medicare wages or as wages for federal unemployment tax.

Federal Income Tax Withholding

You are not required to withhold federal income tax from wages you pay to a household employee. However, if your employee asks you to withhold federal income tax and you agree, you will need a completed Form W-4, Employee’s Withholding Allowance Certificate from your employee.

Form W-2, Wage and Tax Statement

If you must withhold and pay social security and Medicare taxes, or if you withhold federal income tax, you will need to complete Form W-2, Wage and Tax Statement, for each employee. You will also need a Form W-3, Transmittal of Wage and Tax Statement.  To complete Form W-2 you will need to apply for an employer identification number (EIN) and report your employees’ social security numbers.

Federal Unemployment Tax Act (FUTA)

If you paid cash wages to household employees totaling more than $1,000 in any calendar quarter during the calendar year or the prior year, you generally must pay federal unemployment tax (FUTA) tax on the first $7,000 of cash wages you pay to each household employee. However, do not count wages paid to your spouse, your child who is under the age of 21, or your parent. The amounts you pay to these individuals are also not considered wages subject to FUTA tax.

Michigan Unemployment Tax

Household employment in a private home is subject to Michigan unemployment tax if the employee is paid $1,000 or more in any calendar quarter of the current or proceeding calendar year for such service.  You will have to register as an employer with the Michigan Unemployment Insurance Agency.

Schedule H, Household Employment Taxes

If you pay wages subject to FICA tax, FUTA tax, or if you withhold federal income tax from your employee’s wages, you will need to file Schedule H, Household Employment Taxes. Attach Schedule H to your individual income tax return. If you are not required to file an income tax return, you must still file Schedule H to report household employment taxes.

Estimated Tax Payments

If you file Schedule H along with your Form 1040, you can avoid owing taxes with your return if you pay enough tax before you file your return to cover both the employment taxes for your household employee and your income tax. If you are employed, you can ask your employer to withhold more federal income tax from your wages during the year. You can also make estimated tax payments to the IRS during the year using Form 1040-ES.

You may have to pay an estimated tax underpayment penalty if you do not pay your household employment taxes during the year.

 

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional be

Deducting Out-of-Pocket Expenses for Charity

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The IRS does not allow charitable deductions for donating services to a charity.  However, the IRS does allow charitable deductions for out of pocket expenses incurred while donating services to charity.  The expenses must be nonpersonal, directly connected with, and solely attributable to performing the donated services.

Examples of deductible unreimbursed expenses include:

  • Uniforms unsuitable for everyday use
  • Equipment
  • Copying charges
  • Office supplies
  • Phone charges
  • Postage
  • Transportation
  • Travel expenses

Travel expenses and lodging (including meals subject to the 50% disallowance rule) are deductible only if:

  1. There is no significant personal pleasure, recreation, or vacation in the travel AND
  2. The performance of services is substantial

Example:  Tommy volunteers on a church project where he fixes up houses for the indigent.  Tommy buys small tools, cleaning supplies, and drives from house to house.  Tommy can claim charitable deductions for his out of pocket expenses for the small tools, cleaning supplies, and transportation expenses.

Example 2:  Johnny goes on a trip with his church group to Italy.  They attend mass in several churches and spend a significant amount of time sight-seeing.  In this case, it seems that Johnny derives significant personal pleasure from the trip so the travel expenses and lodging would not be deductible. 

The use of a vehicle for charity is deductible at a rate of 14 cents per mile.  Alternatively, taxpayers can deduct the actual gas and oil usage directly related to the charitable transportation.  Parking fees and tolls are also deductible whether the standard mileage rate or the actual expenses method is used.

 

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

New 2013 Rules for Medical Deductions

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Unreimbursed medical expenses are allowed as itemized deductions.  However, medical expenses tend to be difficult to deduct because these expenses have to exceed 7.5% of adjusted gross income.  For example, if a taxpayer has $100,000 in adjusted gross income, her medical deductions are only deductible to the extent they exceed $7,500.  The reason medical expenses are so difficult to deduct is because the deduction is intended to be a hardship deduction—allowed when medical expenses are very high compared to income.

Unfortunately, medical expenses will be more difficult to deduct beginning in 2013 because they now have to exceed 10% of adjusted gross income.  The person in the above example could now deduct medical expenses only to the extent they exceed $10,000.

Relief for Taxpayers Age 65 or Older

There is temporary relief from the increased adjusted gross income threshold during 2013 to 2016 for individuals or their spouses if one of them is at least 65 years old by the end of the tax year.  For these people, the adjusted gross income threshold remains at 7.5% until 2016.  At 2017, they will be subject to the 10% adjusted gross income threshold like everyone else.

Married taxpayers do not have to file a joint to be eligible for the relief—they may also file married filing separately.

The relief is available during 2013 to 2016 for the first tax year the taxpayer reaches age 65 old.

So…

  • Taxpayers who are at least 65 during 2013 will be eligible for the relief from 2013 to 2016
  • Taxpayers who reach age 65 during 2014 will be eligible for relief from 2014 to 2016
  • Taxpayers who reach age 65 during 2015 will be eligible for relief from 2015 to 2016
  • Taxpayers who reach age 65 during 2016 will be eligible for relief for 2016

Example:  Freddie turns 65 in 2015.  During 2013 and 2014, he will be subject to the 10% of adjusted gross income threshold.  During 2015 and 2016, he will be subject to the 7.5% of adjusted gross income threshold.  Beginning in 2017, all taxpayers (even if age 65 or older) will be subject to the 10% of adjusted gross income threshold.

One more fun fact—the 10% of adjusted gross income threshold has always existed under the Alternative Minimum Tax (AMT).  The above relief provision does not apply for AMT purposes.

 

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Buying a Building? Make Sure You Maximize Depreciation Deductions!

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depreciation

When purchasing real property such as office buildings, apartment buildings, factories, shopping centers, and restaurants, taxpayers often fail to allocate the purchase price in a way that maximizes depreciation deductions.  The purchase price can be allocated to land, land improvements, buildings, and personal property.

There are different depreciation rules for each of these classifications: often fail to allocate the purchase price in a way that maximizes depreciation deductions.  The purchase price can be allocated to land, land improvements, buildings, and personal property.

There are different depreciation rules for each of these classifications:

 

  • Land is not depreciable
  • Land improvements are depreciated over 15 years using 150% declining balance (accelerated depreciation)
  • Nonresidential buildings are depreciated over 39 years using straight-line depreciation
  • Residential rental buildings are depreciated over 27.5 years using straight-line depreciation
  • Equipment tends to be depreciated between 3 to 7 years using 200% declining balance (really accelerated depreciation)

A three step process can help taxpayers allocate as much of the purchase price to classifications that are depreciated most quickly:

  1. Make an initial land to building cost allocation
  2. Separate land improvements from overall land costs
  3. Use a cost segregation analysis to separate personal property costs from building costs

Make an Initial Land to Building Cost Allocation

The allocation should be based on relative market values of the land and the building.  This allocation may be agreed upon by the buyer and seller and included in the sales contract.  The allocation may also be based on a qualified appraisal.  As much as possible, costs should be allocated to the building since land is not depreciable.  However, it is preferable if costs can be allocated to land improvements rather than to the building because land improvements are depreciated more quickly than building costs.

Identifying Land Improvements

Land improvements include such assets as sidewalks, roads, drainage facilities, bridges, fences, landscaping and shrubbery.  Only landscaping that is adjacent to the building is depreciable.  Landscaping around the perimeter of the land tract is treated as a pure land cost and is not eligible for depreciation.

Use a Cost Segregation Study to Allocate Costs from the Building to Equipment

Equipment is depreciated much more rapidly than building costs.  A closer examination of building costs often shows that part of the building cost actually relates to equipment, which is eligible for faster depreciation deductions over a shorter period of time.  A cost segregation study is the process of reviewing the costs incurred to identify the specific types of assets being placed into service.  For example, electrical and plumbing systems are typically depreciated over the building’s depreciable life.  However, a cost segregation study may reveal that specialized plumbing and electrical systems are related to equipment and should be depreciated over the equipment’s shorter life.  An example would be a hospital whose equipment requires specialized electrical wiring.

Example:  ABC Corp buys a commercial building for $1 million.  It does a rough cost allocation and allocates $200,000 to land and $800,000 to the building.  The $200,000 land cost is not depreciable.  The $800,000 building cost is depreciated straight line over 39 years at $20,512.

Total first year depreciation:  $20,512

Example 2:  Same facts as above except that ABC Corp does a more thorough allocation.  It determines that $60,000 of the $200,000 land costs are actually land improvements.  After a cost segregation study is done, it finds that specialized electrical and plumbing work costing $50,000 should be depreciated as equipment.

The depreciation for each classification is as follows:

  • Land of $140,000 is not depreciable
  • Land improvements of $60,000 are depreciated over 15 years using 150% declining balance method
  • Specialized wiring and electrical costs of $50,000 are depreciated over 7 years using 200% declining balance method
  • Building costs of $750,000 are depreciated straight line over 39 years

Total first year depreciation: 

  • Land Improvements                 $8,000
  • Equipment                            $14,250
  • Building                                $19,230
  • Total                                              $41,480

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

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