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How the Wash Sale Rules Prevent Losses

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Let’s say you own stock that you bought years ago for $5,000 but is now worth only $2,000.  You believe that the stock will eventually increase in value; however, you would like to recognize the $3,000 loss.  You sell the stock, recognize the $3,000 loss, and then immediately buy the same stock at $2,000.  You are in the same position you were before the sale, but you now have a $3,000 tax loss.

Unfortunately, Congress didn’t like the above transaction so it created the wash loss rules.  Under these rules, taxpayers cannot deduct the loss realized on the sale of stock or securities (including shares in a mutual fund) if taxpayers purchase substantially identical stock or securities within the period beginning 30 days before and ending 30 days after the sale.

For the wash sale rules to apply, the stocks or securities must be substantially identical.  Ordinarily, stocks or securities of one corporation are not substantially identical to stocks and securities of another corporation.  For example, you could sell stock of Microsoft at a loss and purchase shares of Google within 30 days and still claim the loss on Microsoft stock.

A loss that is not recognized under the wash loss rules is not permanently banned; it is deferred and can be recognized on a future sale.  This is done by increasing the basis of the substantially identical stock or securities.  The holding period (which determines whether the sale generates long term or short term capital gain) of the substantially identical stock or securities includes the holding period of the original stock or securities sold.

Example:  In the fact scenario above, the $3,000 will be disallowed because identical stock was purchased within 30 days of the sale of the original stock (in the above scenario, the identical stock was purchased immediately after the original stock was sold).  The disallowed loss of $3,000 is added to the basis of the identical stock cost of $2,000 for a basis in the new stock of $5,000.   The long term holding period of the original stock is now applied to the identical stock. 

A wash sale can be used to generate long term capital gain if the stock increases in value after the original shares are sold.

Example:  In 2004 Toby purchased stock for $8,000.  In 2012, the stock is worth $7,000.  Toby sells the stock for a $1,000 loss.  Two weeks after Toby sold the stock, it continued to decline in value and is now worth $5,000.  Toby believes the stock is undervalued and buys it for $5,000.  Since Toby purchased identical stock within 30 days of the original sale, the $1,000 loss is disallowed.  The disallowed loss of $1,000 is added to the purchase price of the identical shares of $5,000 for a total basis of $6,000.  Now assume the stock skyrockets in value two months later.  If Toby sells the identical stock for $8,000 he would have a long term capital gain of $2,000.  The gain is long term even though Toby only held the new stock for two months because the holding period of the original stock applied to the later purchase of the identical stock.

The wash sale rules can cause trouble when an investor disposes of several blocks of stock and at the same time and some blocks were sold at gains and the rest were sold at losses.  Wash sale rules only apply to losses.  The gains will be recognized, but the losses will be disallowed (i.e., the gains and losses cannot be netted against each other).

The fact that wash sale rules do not apply to gains can be used to your advantage.  Capital losses are deductible against capital gains and against $3,000 of ordinary income each year.  If you have a large capital loss and no capital gains, it may take a while to fully deduct that large capital loss when you can only use it to offset $3,000 of ordinary income per year.  The following strategy can help:

Example:  John has a $60,000 capital loss carryover.  It would take him 20 years to fully deduct this loss if he has no capital gains.  John also owns shares of Apple that he purchased in the 1990s at $30 per share and the shares are now worth $600 per share.  John could sell 105 shares at $600/share for $63,000.  His basis in those shares is $3,150.  His capital gain is therefore $59,850.  John immediately repurchases the 105 shares of Apple at 105 for $63,000. 

Up to $59,850 of the capital loss carryforward will offset John’s capital gain, and because of the repurchase, John will still own the same amount of Apple stock.  John can offset the remaining $150 capital loss against his ordinary income.  Additionally, John’s basis in the new Apple shares is based on the purchase price of $105 rather than the pre-sale basis of $30.  The wash sale rules will not block this transaction because the Apple shares were sold at a gain. 

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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.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

 

Defer Tax with an Installment Sale

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When you sell an asset on installment, you may be able to avoid paying tax in the year of sale and instead pay tax on your gain as you receive payments over future years.  Under the tax law, an installment sale is any sale of property where at least one payment is received after the tax year in which the sale occurs.

Each payment is allocated between a tax-free return-of-cost, taxable gain, and interest.  The allocation between return-of-cost and gain is based on a gross profit percentage calculated as the gain divided by the contract price multiplied by the principal payments.  Interest accrues normally on the unpaid balance.

Example 1:  John owns investment real estate worth $300,000.  He purchased the land for $120,000.  John has no debt on the property.  In December 2012, he enters into a land contract to sell the property for $30,000 down and $270,000 paid over three years beginning January 2013.

To determine how much of each payment is taxable, John must first calculate his gross profit percentage by dividing his gain on the property by the contract price.  John therefore divides his gain of $180,000 by the sales price of $300,000 for a gross profit percentage of 60%.

60% of each payment represents gain.  In 2012, John recognizes $18,000 ($30,000 down payment multiplied by 60% gross profit).  From 2013 to 2015, John will report the remaining 162,000 of gain as principal payments are received.  John will also report any interest income as additional income.

 

Example 2:  Same facts as above except John has a $100,000 mortgage on the property.  The buyer assumes the mortgage and pays John $200,000.  John will receive $30,000 in 2012 and the remaining $170,000 over the next three years.  The tax law does not require John to recognize on the $100,000 mortgage assumption immediately.  Instead, the mortgage assumption is taxed as payments are received.  This is accomplished by a downward adjustment to the contract price.

Here, the contract price of $300,000 is reduced by the $100,000 assumption to $200,000.  The gross profit percentage is calculated as the gain of $180,000 divided by the contract price of $200,000.  Notice how the gross profit percentage is increased to 90%.  John will recognize $27,000 of gain in 2012 ($30,000 down payment multiplied by 90%) and $153,000 gain over the next three years for a total gain of $180,000.

Traps to Watch Out For

Depreciation recapture:  When property is sold at a gain, the gain will usually be taxed at capital gain rates.  However, when depreciable property is sold at a gain, part of that gain will be recharacterized as ordinary income (and taxed at higher rates) to the extent of prior depreciation.  Any depreciation recapture income must be included in income in the year of sale (i.e., it cannot be deferred into future years as payments are received).

Section 1250 gain:  Section 1250 gain applies to certain depreciation recapture on real estate.  It is taxed at a 25% capital gain rate.  If the installment sale gain includes both 25% and 15% capital gain, all 25% capital gain is recognized before any 15% capital gain is recognized.

Sales of property between a taxpayer and a business she controls do NOT qualify for installment sale treatment if the property is depreciable by the purchaser:  The IRS is concerned that the seller recognizes capital gain over a number of years, but the business he controls takes an immediate depreciation deduction for the cost of the property.

Deferred gain on installment sales between related parties must be recognized immediately if the property is resold within 2 years of the sale between related parties:

Example:  John sells property to his son on installment for $100,000 payable $10,000 per year for ten years.  John’s son immediately sells the property for his $100,000 cost.  John’s son recognizes no gain because he sold the property for its cost.  If this disallowance rule did not apply, John would still defer the gain over ten years even though his family as a whole received $100,000 for the property immediately.

Gain will not be accelerated under the 2 year rule if:

  • The second disposition is the result of an involuntary conversion (e.g., condemnation of the property) and the sale to the related party occurred prior to the threat of conversion
  • The second disposition occurs after the earlier of the death of (1) the related buyer or (2) related seller
  • There was no tax avoidance motive in the second disposition.  An example is where the terms of the second sale are equal to or longer than the term of the first sale.  Here, there is no immediate cash receipt as there was in the above example

When the total balance of certain installment receivables exceed $5 million, the IRS requires interest to be paid on deferred gains.

If you need help with small business taxes,

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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.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

 

Deducting Entertainment Expenses

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The IRS is fairly strict when it comes to entertainment expenses.  When a taxpayer incurs entertainment expenses to entertain a client, employee, vendor, or other business associate, she must satisfy the following requirements:

  • Ordinary and Necessary: An ordinary expense is one that is common and accepted in the taxpayer’s business.  A
  • necessary expense is one that is helpful and appropriate, although not necessarily indispensable, to the taxpayer’s business
  • Lavish or Extravagant: Lavish or extravagant entertainment will not be allowed
  • Substantiation:  Taxpayers must substantiate entertainment expenses.  Proper substantiation includes tracking
  •  the time, place, and with whom the taxpayer attended the meeting.  No substantiation usually means no deduction.
  • Taxpayer’s Presence:  The taxpayer or representative must be present when the activity involves meals; otherwise, the cost of the meal is nondeductible.
  • Business Connection:  This is the most complex requirement.  There must be a connection between the business
    event and the entertainment.  The taxpayer must prove a valid business purpose for the business event that occurs either before, during, or after the entertainment.

Meeting the Business Connection Requirement

There are two tests for meeting the business connection requirement:

  • Directly Related Entertainment
  • Associated-with Entertainment

Directly Related Entertainment

Under this test, the entertainment and business event take place simultaneously.  To be deductible, the following requirements must be met:

  • Main Purpose:  The main purpose of the combined entertainment-business event is the active conduct of the taxpayer’s business.  Spending more time on business than on entertainment is not required.  However, if the business event is minimal, this requirement will likely not be met.
  • Active Business:  The taxpayer engages in a business meeting, discussion, or negotiation during the entertainment period
  • Profit Expectation:  The taxpayer had more than a general expectation of getting income or some other specific business benefit from conducting the business event.  Generating goodwill is not sufficient—there must be some
    more definite profit expectation.

Examples of discussions meeting the profit expectation requirement could include:

(1)    Andy is an attorney.  He takes his client, Barney, out to lunch to discuss updating Andy’s estate plan.

(2)    Fred is a real estate broker.  He takes Wilma out for a round of golf.  During golf, they discuss purchasing properties together.

(3)    Zeus takes his employee, Hercules, out to lunch.  They discuss what equipment to purchase for an upcoming expansion.

Associated-with Entertainment

Under this test, the entertainment either precedes or follows a substantial business discussion.  A substantial business discussion meets the following requirements:

  • The primary purpose of the combined entertainment and business activity was the active conduct of the taxpayer’s business
  • The taxpayer actively engaged in a business meeting, discussion, or negotiation
  • The taxpayer had more than a general expectation of getting income or some other specific business benefit from conducting the business discussion (other than goodwill)

Please note that the preceding three requirements apply only to the business discussion portion of the test.  For the taxpayer to qualify for a deduction, the entertainment portion of the test requires that the entertainment is associated with the active conduct of the taxpayer’s business.  If the taxpayer can prove a clear business purpose for the entertainment expense, it will be allowed.  For the entertainment portion, generating goodwill is considered a valid business purpose.

Example:  Cagney is an architect and meets with her client, Lacy, at Cagney’s office.  They discuss Lacy’s building designs.  After the meeting, Cagney takes Lacy out to lunch.  They don’t discuss business during the lunch; however, Cagney believes this lunch will establish goodwill with Lacy.  Cagney meets the associated-with test because there was a substantial business discussion at Cagney’s office followed by entertainment with a clear business purpose (establishing goodwill with a client).

Example 2: Same facts as example one, except that Cagney and Lacy do not have a business meeting at Cagney’s office.  Here, Cagney does not meet the associated-with test because there was no substantial business discussion.  Cagney also does not meet the directly related test because establishing goodwill does not meet the profit expectation requirement, plus she did not actively conduct business during the lunch.

Suspect Locations Issue for Directly Related Entertainment

Because directly related entertainment combines entertainment and business, the IRS will disallow entertainment expenses in locations where, because of substantial distractions, there is little chance of engaging in business.  These locations include:

  • Night clubs, theaters, cocktail parties, and sporting events
  • If the taxpayer meets with a group of people that includes nonbusiness associates–cocktail lounges, country clubs, golf and athletic clubs, and vacation resorts
  • Hunting or fishing trips, yachts and other pleasure boats

For the preceding locations, the presumption is that the entertainment is not directly related to the active conduct of the taxpayer’s business and is therefore not deductible.  While the taxpayer can refute this presumption, the heavy burden of proof is on the taxpayer.

If you need help with small business taxes,

sign up for a FREE tax consultation.

 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.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

 

Tax Rules for Renting Out a Second Home

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People who own second homes often rent the homes for a portion of the year to help recoup some of the home’s cost, or just to make a little extra money.  For tax purposes, not all second homes that are rented are treated the same way by the IRS.

Under the tax law, there are three classifications of rental homes:

  • Personal Residence
  • Vacation Home
  • Rental Property with Personal Use

Personal Residence Classification

Personal residences are rented for less than 15 days during the year and are used personally for 15 days or more.  If a rental home qualifies as a personal residence, the only expenses that may be deducted are real estate taxes and mortgage interest.  Any rental income received is tax-free.  Seriously.  Again, remember that the rental home has to be rented for less than 15 days during the year.

This rule tends to benefit homeowners who rent out their homes for short term events such as Mardi Gras, Super Bowls, etc.  This rule applies to a taxpayer’s principal residence as well as a second home.

Example: Ralph and Alice live near a lake.  In July of this year, they went on a 14 day vacation.  During this period, they rented out their personal home for $3,500.  Since they rented their home for less than 15 days and used the home personally for more than 15 days, the $3,500 rental income is tax free.  Ralph and Alice may deduct their real estate taxes and mortgage interest, but cannot deduct any other expenses for renting their home.

Vacation Home

Vacation homes are rented for 15 days or more AND are used personally for more than the greater of:

  • 14 days OR
  • 10% of the days the home is rented

Basically, this is a rental home with substantial personal use.  Taxpayers who rent out these homes must include the rental income in their taxable income.  Taxpayers may deduct real estate taxes and mortgage interest.  Taxpayers may deduct other rental expenses, but these expenses are limited to rental income after deducting mortgage interest and real estate taxes.  Therefore, losses on these rental properties are not allowed; however, losses may be carried forward to future years (where they can be used to offset future years’ rental profits from the property).

Additionally, the expenses are deductible in a certain order:

  1. Mortgage interest, taxes, casualty losses, and nonoperating expenses (e.g., commissions and advertising)
  2. Operating expenses (e.g., utilities, repairs, travel, etc.)
  3. Depreciation

Finally, expenses have to be prorated based on the number of rental days compared to the total number of days the home is occupied (either rented or used personally).

Example: Darrin and Samantha rent out a second home for 160 days.  They use it personally for 21 days.  Since the personal use exceeds the greater of (1) 14 days and (2) 10% of 160 rented days (16) and it is rented for more than 14 days, it is a vacation home.

They charge rent of $5,500.  The mortgage interest and property taxes for the year are $6,000.  They pay advertising fees and commissions of $4,000.  Depreciation on the property is $7,000.

Based on the rental days to total-use days, 88% of the expenses are allocated to rental use (160 rental days divided by 181 total-use days (160 rented days plus 21 personal use days).

After proration, the expenses are:

  • Mortgage Interest & Property Taxes       $5,280
  • Advertising & Commissions                    $3,520
  • Depreciation                                     $ 6,160

The ordering rules are applied as follows:

Rental Income                                                   $5,500

Mortgage Interest & Property Taxes                     $ 5,280

Balance                                                           $    220

Operating Expenses                                           $    220 (limited to income after interest & taxes are deducted)

Income                                                          $      0

No loss can be recognized.  The remaining $720 of mortgage interest and property taxes may be deducted as itemized deductions.  The remaining operating expenses and depreciation will be carried forward into future years.

Rental Property with Personal Use

Rental properties are rented for 15 days or more AND are not used personally for more than the greater of:

  • 14 days OR
  • 10% of the days the home is rented

Under this set of rules, taxpayers may be able to claim rental losses.  Therefore, the above expense ordering rules do not apply as they did for vacation homes.  However, these rental losses may be difficult to deduct because of the passive activity loss rules.  The expenses still must be prorated based on rental days to total-use days.  Any mortgage interest expense allocated to personal use will not be deductible.  Mortgage interest may be deducted on a principal residence and on a second home.  Since the personal use of rental properties is less than 15 days or 10% of rental days, the property will not qualify as either a principal residence or a second home.  This is a trap for many taxpayers.

If you need help with small business taxes,

sign up for a FREE tax consultation.

 

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.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230