Don’t Claim Depreciation?? Part V: Depreciation Recapture

This final installment in the series on whether to claim depreciation on a rental property or home office clarifies the term depreciation recapture. Since depreciation is an ordinary expense, without depreciation recapture a taxpayer could get an ordinary tax deduction in one year and then sell the asset in a later year and pay capital gains tax on the income that results from the basis reduction from depreciation. In addition to shifting income to a later year, this converts ordinary income into capital gain. This a great deal for the taxpayer. To prevent this, the depreciation recapture rules say that the portion of the gain that results from depreciation is taxed as ordinary income instead of capital gain. However, this is yet another area of the tax law where real estate investments really shine. Unlike other business assets, only the real property gain attributable to depreciation in excess of straight line depreciation is recaptured. Since real estate put into service after 1986 generally must be depreciated using the straight line method, there is typically no depreciation recapture on real property. However, there is unrecaptured Section 1250 gain, which is similar to depreciation recapture but uses a special “capital gains” tax rate not to exceed 25%. Since this is a capital gains rate, it is not technically depreciation recapture. While 25% is not as good as the capital gains rates for most assets, it sure beats paying tax at an ordinary rate of up to 35%.

© Michael Fitzsimmons, CPA, San Diego, CA http://fitz-cpa.com/

Don’t Claim Depreciation?? Part IV: Passive Activity Rules

Continuing the discussion of whether to claim depreciation on a rental property or home office… The passive activity rules can suspend the deduction for depreciation so that it is not immediately available to offset ordinary income from such items as salary, interest, non-qualified dividends, self-employment earnings, and retirement/pension. Since rental losses are passive, it will still offset other passive income, either from the same property, other properties, or a flow-through entity such as a partnership, limited liability company (LLC), S-corporation, estate, or trust. But any suspended deduction is carried forward until adjusted gross income drops below $150,000, or positive passive income is realized, or the property is sold. So even if the depreciation deduction is suspended under the passive activity rules, you are almost always no worse off than if you did not claim the depreciation, and will usually be much better off.

Automobile Mileage Tax Deduction – Mileage Logs

A recent court case illustrates the importance of automobile mileage logs. A self-employed salesperson did not keep a mileage log and instead tried to prove his business use of automobile by such means as a random sampling of invoices and odometer readings at beginning and end of year. This evidence fell far short of the strict record-keeping requirements for business use of automobile tax deductions, which require the date, location, business purpose, and number of miles for each trip. Douglas A. Royster v. Commissioner, (2010) TC Memo 2010-16. IRS standard mileage rates provide deductions for business use of an automobile of $0.55 per mile for 2009 and $0.50 for 2010.

Don’t Claim Depreciation?? Part III: Time Value of Money

Previous installments of this series discussed depreciation concepts for rental real estate property owners and taxpayers claiming the home office deduction, including “allowed or allowable” and capital gain vs. ordinary tax rates. Another reason to claim the depreciation when allowed is the time value of money. If you claim a depreciation deduction now and offset your salary or other ordinary income, but you don’t pay tax on the related capital gain until you sell the property, maybe 10 years or more in the future, you effectively earn interest or an investment return on the amount of deferred tax during the interim. This is a basic wealth-building concept that should be employed whenever possible. To take it one step further, you may use a Section 1031 exchange to defer the capital gain indefinitely or use the ultimate tax strategy: die while still owning the property and get a step-up in basis for your heirs so that the tax gain just disappears.

How is a the Income of a Decedent’s Estate Taxed?

Many people know that the estate tax applies only to estates of several million dollars, but that doesn’t mean that an estate has no tax obligations. An estate must file an income tax return and, depending on the timing of distributions, pay income tax. Typical items of taxable income include interest, dividends, and capital gains. An estate reports income and deductions similarly to a complex trust on IRS Form 1041. However, there are some important differences, such as choice of fiscal year, quarterly estimated tax payments, and rental real estate losses. Often a person dies with assets held in a revocable trust and some or all of the trust becomes irrevocable upon death. Typically this results in the creation at death of two taxable entities, the decedent’s estate and the irrevocable trust. If proper procedures are followed, income tax law allows these two entities to be combined for income tax return purposes. This usually results in more favorable tax rules, and, since only one income tax return is required per year, saves on professional tax preparation fees.

Business Use of Cell Phone Record-Keeping Required

Cell phones are used all the time in business. What many people don’t know is that tax deductions for business use of cellular phones are not guaranteed. Since cellular telephones are "Listed Property" under Internal Revenue Code Sections 274 and 280F, the IRS can require taxpayers to produce detailed records to justify the business tax deductions. Tax regulations require evidence of the amount, date/time, and the business purpose of each business use of a cellular phone. Most expenses other than the purchase of the phone will be listed on your cellular phone bills, which will provide the dollar amounts and dates/times of usage. However, the law technically requires taxpayers to prove the business purpose of each call. Although this is an unreasonably burdensome record-keeping requirement, it is the letter of the law. Luckily, this may change this year. Commissioner of the IRS Douglas Shulman recently stated that he is optimistic that Congress will pass a law this year so that personal use of employer-provided cell phones is not taxable.

When is a Trust Income Tax Return, Form 1041, Required?

For income tax purposes, the IRS does not recognize that a trust exists when it is revocable. Accordingly, all of a revocable trust’s income and tax deductions are reported on the grantor’s personal income tax return. No trust income tax return, IRS Form 1041, needs to be filed unless the trustee is someone other than the grantor. Because of this, a revocable trust typically does not need to obtain a tax identification number, or FEIN (Federal Employer Identification Number). When a revocable trust turns into an irrevocable trust, which typically occurs when the grantor dies, a trust income tax return, IRS Form 1041, usually must be filed each year. However, no trust income tax return is required if all of these conditions are met: there is no taxable income, gross income is less than $600, and there is no nonresident alien beneficiary. When a trust tax returns is filed and there is a distribution or deemed distribution to a beneficiary, the beneficiary receives a Schedule K-1 showing the share of income and tax deductions. http://fitz-cpa.com/trust_estate.aspx

Don’t Claim Depreciation?? Part II: Tax Rates

My previous entry in this series explained that rental real estate property owners and taxpayers claiming the home office deduction have to pay tax on the depreciation that they could have deducted even if they didn’t claim it on their tax returns over the years. Ouch! Luckily, there is a provision in the tax law that allows you to catch up your depreciation deductions in the year you sell the property. What does it matter if you get a deduction in the year of sale for the same dollar amount as the extra gain it relates to? It can be of huge importance because the depreciation deduction first offsets your ordinary income, such as rental income, salary, interest, non-qualified dividends, self-employment earnings, and retirement/pension income that is taxed at your highest marginal ordinary tax rate, whereas the gain attributable to the depreciation is taxed at a maximum capital gains tax rate of 25%. That’s a great deal: the deduction offsets other ordinary income and the corresponding income is a capital gain. This is the core of the foolishness of not claiming depreciation to which you are entitled. A future installment in this series will discuss how the passive activity rules can delay the ordinary tax deduction. http://fitz-cpa.com/real_estate.aspx

2009 Tax Deduction for Haiti Earthquake Donation

Haiti earthquake relief donations can be deducted on either the 2009 or 2010 income tax return. As with other charitable contributions, the taxpayer must itemize deductions on Schedule A. The contribution must be fully earmarked for the relief of victims in areas affected by the Jan. 12 earthquake in Haiti. Generally, only contributions to U.S. charities are tax-deductible. Most such organizations are listed in an IRS searchable, online database available under “Search for Charities” (http://www.irs.gov/charities/article/0,,id=96136,00.html ). But some organizations, such as churches or government agencies, may be qualified even though they're not listed on IRS's website. Contributions to foreign organizations generally aren't deductible.

GAO S Corporation Report

The U.S. Government Accountability Office (GAO) recently released the report “Actions Need to Address Noncompliance with S Corporation Tax Rules.” The report included compilation of statistics on S corporation income tax returns, return preparation errors, and ideas on squeezing more payroll or self-employment taxes from S corporation shareholder-employees.

From tax year 2000 to 2006, the total number of S corporations increased 35% to almost 4 million. S corporations grew from 11.4% of all entities in tax year 2000 to 12.6% in tax year 2006. The S corporation is the most popular business entity. Although an S corporation can have up to 100 shareholders, in tax year 2006, 60% had just a single shareholder, 89% had two or fewer shareholders, and 94% had three or fewer shareholders.

Regarding the accuracy of S corporation tax return reporting, 68% of returns filed for tax years 2003 and 2004 (the years data were available) misreported at least one item. About 80% of the time the misreporting provided a tax advantage to the corporation and/or shareholder. Common reporting errors included shareholder distributions, personal expenses, and unsubstantiated deductions. The GAO estimated that 71% of S corporations that used a paid preparer for their returns were noncompliant.

The GAO estimated that 13% of S corporations paid shareholder wage / salary compensation that was not reasonable (too low), resulting in just over $23.6 billion in net underpaid wage compensation to shareholders. The median misreporting adjustment for underpaid shareholder compensation was $20,000. The GAO also found that the fewer the number of shareholders, the more likely an S corporation was to pay an unreasonable salary to a shareholder-employee.

The report recommended a number of tax law changes to mitigate the S corporation tax return errors, including subjecting to self-employment tax the entire net income of the S corporation, or of service sector S corporations, or income attributable to majority shareholders. Other alternatives include subjecting to payroll taxes not just shareholder wages but also distributions, or all payments up to a certain dollar amount.

These ideas have been kicked around for years, and although there is a threat that taxes may increase, there is no specific tax law change on the horizon that would hamper the huge self-employment / payroll tax savings that can be achieved through an S corporation.

Trust Modification – Court-Approved

In a recent private letter ruling, the IRS determined that a court-approved modification of a revocable trust created by a decedent and spouse doesn’t provide the surviving spouse with a “general power of appointment”. Therefore, the value of assets in by-pass trust won't be included in surviving spouse's gross estate. Trust assets were to be divided upon death of first spouse among by-pass trust, marital trust, and survivor's trust. (PLR 201002013)

LLC Member’s Income Subject to Self-Employment Tax

Tax law had been unclear for years to what extent self-employment tax must apply to income earned by a Limited Liability Company member. Taxpayers and the IRS over the years have taken positions that LLC units are the same as limited partnership interests, general partner interests, or sometimes one and sometimes the other. Congress has not passed any law to clarify the issue. Recently, however, an important Tax Court case, Garnett (132 T.C. No. 19), provided some clarification. Although the case was about the application of the passive activity rules to LLC income, the court’s conclusion on the nature of LLC units impacts self-employment tax. The tax court found that LLC units are not the same as limited partnership interests under federal tax law. In the past some had argued that LLC income is not subject to self-employment tax because LLC interests are the same as limited partnership interests, which are by definition not subject to self-employment tax. In light of this new court case, that argument is no longer valid.

2009 Tax Deduction for Haiti Earthquake Donation

A charity contribution tax deduction may be possible on 2009 tax returns for donations to 501(c)(3) nonprofit organizations providing relief to the Haiti earthquake victims, even though the donations are made in 2010. Leaders in congress have made it known that they intend to introduce legislation to make this tax law change. Similar tax rules were made for January of 2005 donations to charity organizations helping victims of the Dec. 26, 2004, Indian Ocean tsunami.

Don’t Claim Depreciation?? Part I: Allowed or Allowable

“Don’t take depreciation because you will have to have pay tax on it when you sell the property.” I have heard this from many real estate rental property owners and taxpayers claiming the home office deduction. What they don’t realize is that you have to pay tax on the depreciation you could have claimed even if you didn’t claim it. What? Yes! The tax law on this has been around for many years and is very well established. If you doubt it, just look at Line 22 of IRS Form 4797, “Sales of Business Property” (home office and rental real estate are Internal Revenue Code Section 1250 business property for this purpose). The cost basis of the property sold must be decreased (and therefore the gain increased) by the amount of depreciation allowed or allowable, whichever is higher. “Allowed” means what you claimed on your tax returns over the years. “Allowable” means what you could have claimed. Future discussion of this topic expands on this issue, discussing catching up missed depreciation, capital gains and ordinary tax rates, and the time value of money.

Trust Income Tax Return Distributions – 65-Day Rule

Since trust income tax rates are generally higher than the beneficiaries’ income tax rates, it is often beneficial to have the income taxed to the beneficiaries rather than the trust. Unique to trust income tax returns (IRS Form 1041), the concepts of fiduciary accounting income distributable net income affect who is liable for the tax. Typically, a trust must distribute income to beneficiaries in order for it to be taxed at their (usually lower) rates. However, a special provision in the trust income tax law allows the fiduciary to elect to treat some or all of the distributions made in the first 65 days of the following tax year as if they were made in the preceding tax year. So if there were not enough distributions in 2009 to cause all of the estate or trust income to be taxed to the beneficiaries, fiduciaries should consider making this tax election. These are the trust income tax rules applicable to trusts taxed as “complex trusts” and also generally apply to a decedent’s estate income tax return, which is made on the same IRS Form 1041, but do not apply to what is considered a “simple trust” under tax law.

As in much of the tax law, there is some gray area that allows for planning / wiggle room. The pertinent trust income tax return law uses the term “properly paid or credited”. The trust income tax return regulations are unclear as to what “properly credited” means and the Tax Court has allowed distributions that were made after the 65-day period where they were shown to be “credited”. Nonetheless, the prudent action is actually pay the distributions within the first 65 days of the estate or trust’s tax year.

Although the foregoing applies equally to California trust income tax returns, the structure of the tax rates applicable to California trust income tax returns differs such that the issue is usually mute.

2010 Business Income Tax Depreciation / Research Credit

As of today, the following business tax breaks expired at the end of 2009 and are no longer available in 2010: 50% bonus depreciation on new business equipment / fixed assets, including the extra $8,000 automobile first-year depreciation deduction; research credit. Also, IRC Section 179 “depreciation” / “expense election” of $250,000 drops to $134,000 (California tax amount is still $25,000) and the phase-out starts at $540,000 rather than $800,000 (California tax amount remains at $200,000).