Monthly Archives: May, 2016

Self-Directed IRAs

May 31st, 2016 Posted by Tax No Comment yet

Traditionally IRAs invest in stocks and bonds.  However, through the use of self-directed IRAs, it is possible to have your IRA invest in real estate and businesses.

 

Self-Directed IRAs

What is a Self-Directed IRA?

Self-directed IRAs are simply IRAs whose custodian permits a wide array of investments beyond bonds and securities and provides for maximum control by the account holder.  Self-directed IRAs can include any investment, other than life insurance and collectibles, that are not specifically prohibited by federal law.

As with all other IRAs, self-directed IRAs must comply with various rules and regulations, including a rule against “prohibited transactions”.

 What is a Prohibited Transaction?

There are several types of transactions that the federal government have determined to be improper if conducted with the IRA account holder, his or her beneficiaries, or any disqualified person.

Disqualified Persons

The Internal Revenue Code defines disqualified persons as:

  1. A fiduciary of the plan (an IRA owner who exercises discretionary control over an IRA’s investments is a fiduciary);
  2. A person providing services to the plan;
  3. An employer whose employees are covered by the plan;
  4. An employee organization whose members are covered by the plan;
  5. A direct or indirect owner of 50% or more of any entity that is described in numbers 3 or 4 above.
  6. A family member of any of the above;
  7. A corporation, partnership, trust, or estate that is more than 50% owned directed or indirectly by any person described in numbers 1 through 5 above;
  8. An officer, director, 10% or more shareholder, or highly compensated employee (earning 10% or more of the employer’s yearly wages) of a person described in numbers 3, 4, 5, or 7 above;
  9. A 10% or more partner or joint venture of a person described in numbers 3,4, 5, or 7 above; or
  10. Any disqualified person who is a disqualified person with respect to any plan to which a multiemployer plan trust is permitted to make payments under Section 4223 of ERISA.

Prohibited Transactions

There are several types of transactions that are prohibited if done between the self-directed IRA and a disqualified person.  Here are a few examples (this is by no means a comprehensive list):

  • Selling property to or from the IRA;
  • Lending money to or borrowing money from the IRA;
  • Receiving unreasonable compensation for managing the IRA;
  • Using the IRA as security for a loan; or
  • Buying property for personal use with IRA funds.

What are the consequences if there is a prohibited transaction?

The penalties for engaging in a prohibited transaction are severe!  The Internal Revenue provides that if any prohibited transaction occurs, the account is no longer an IRA and it will be treated as if the assets within the account were distributed on the first day of the taxable year in which the prohibited transaction occurs.  This will trigger a 10% early withdrawal penalty, tax on the constructive distribution, and often an accuracy-related penalty for each of the tax years affected.

Let’s look at an example:

In 2010, Mark decided to roll over all $2,000,000 from his 401(k) plan to a self-directed IRA.  On July 1, 2011, the IRA purchased a rental property for $400,000 and left the remaining assets invested in securities. The IRA then hired Mark to manage the property and agreed to pay him 10% of the total rents received. Mark managed the property until late 2013 when the IRA sold it for $450,000.  For the years 2011 through 2013, Mark reported his “management fee” as income, but did not report any of the rental income or the gain on the sale of the property because he knew that income earned by an IRA is tax-deferred.

In 2014, Mark received a notice from the IRS informing him that he was being audited for the tax years 2011, 2012, and 2013.  After its audit, the IRS concluded that the IRA’s hiring of Mark and providing him compensation were prohibited transactions.  As a result, there was a deemed distribution of all of the IRA’s assets on January 1, 2011 (not only the $400,000 used to purchase the rental property).  Mark was assessed the following penalties:

  • Tax on $2,000,000+ deemed distributed to him on January 1, 2011 (plus penalties and interest);
  • 10% early withdrawal penalty on the $2,000,000+ deemed distributed;
  • 20% accuracy related penalty in 2011;
  • Tax on the 2011, 2012, and 2013 rental income (plus penalties and interest)
  • Tax on any interest, dividends, and capital gains from securities in 2011, 2012, and 2013 (plus penalties and interest);
  • Tax on the capital gains from the sale of the rental property in 2013 (plus penalties and interest); and
  • 20% accuracy related penalty in 2013.

It is not my intent to discourage anyone from using self-directed IRAs as investment vehicles.  However, it is very important to understand that it can be very easy for someone to engage in a prohibited transaction and incur very severe penalties as a result.  Therefore, if you are thinking about utilizing a self-directed IRA, talk to a tax professional to ensure that everything is done properly.

Home Office

May 23rd, 2016 Posted by Tax No Comment yet

Because of advances in technology, it is increasingly easy for people to work from home and save money doing so.

Having a home office means that you do not have to spend hours every month sitting in traffic trying to get to work, and you do not have to spend as much on fuel for your car.  It also means, if you own your own business, that you can save thousands of dollars in rent.  But it also is a tax deduction.  By claiming the home office deduction, you are allowed to deduct a portion of your living expenses such as utilities, that would otherwise be non-deductible.

This deduction is available to you whether you own your own business or work for someone else.  But if you are an employee, you must be working from home for your employer’s convenience and not your own.  If your employer requires that you work from home, then that test is met.

Home Office

Unfortunately, this deduction has been greatly abused by taxpayers and now the IRS is very strict in ensuring that your home office meets all of the requirements for the tax deduction.

The home office deduction is only permitted if the home office is used exclusively on a regular basis either: 1) as the principal place of business for any trade or business of the taxpayer; 2) as a place of business that is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his or her trade or business; or 3) in the case of a separate structure that is not attached to the dwelling unit, in connection with the taxpayer’s trade or business.

To qualify under the “regular use” test, the home office must be used on a regular basis.  Working from home once a month does not count.

To qualify under the “exclusive use” test, you must use a specific area of your home exclusively for your business.  Even after “business hours,” you cannot use the space for non-business purposes.  Something as simple as your children “hanging out” in that room when you are not conducting business disqualifies the whole deduction.

However, if your home office meets these tests, the deduction can be substantial.  Under a new safe-harbor, the deduction is $5 for every allowable square foot, up to 300 square feet.  The deduction can be even greater if you keep track of all of your actual expenses, such as your mortgage, property taxes, and utilities.

Rental Real Estate

May 16th, 2016 Posted by Tax No Comment yet

There are a number of different ways that financially successful people obtain their wealth, but once they have it most will tend to diversify their investments among stocks, bonds, and rental real estate.  They diversify their assets in order to reduce the risk that any particular type of financial calamity will have too large of an impact on them.

So what makes rental real estate an attractive investment vehicle?

It could be the simple business model.  Person A needs a place to live.  Person B owns an extra house.  Person A pays Person B to live there.

It could be that it is a tangible investment.  An investment simply feels more real if you can see it before your eyes.

Or it could be that the investor expects the property value to rise and wants to finance the property through others paying rent.

In addition to all those reason, I think the tax incentives that the government gives rental property owners is a big factor.

Rental Real Estate

There are a number of tax advantages to owning rental real estate.

  • Depreciation.  When you are renting out real estate, you are entitled to depreciate the full value of the building over a number of years (how many depends on whether it is a residential or non-residential property).  This means that you can depreciate both the amount of cash you paid plus the amount that you borrowed on the property.  Note: Only the building is depreciable, not the value of the land.
  • Expenses are deductible.  All the expenses you incur in renting the property are deductible.  This includes mortgage interest, property taxes, a property manager, HOA fees, utilities, etc.  Of particular value is the mortgage interest deduction.  As I mentioned above, you are already allowed to depreciate the mortgage, but this deduction allows you to deduct the interest paid as well.
  • Capital Gains.  When you eventually sell the property, assuming that you purchased as a rental and operated it in that manner, any gain will be taxed at capital gains rates which are significantly lower than ordinary income tax rates.

Taking advantage of these incentives means that in some years investors may have a positive cash flow but little to no taxable income.

There are some limitations on these benefits.  Because of tax games that were played in the 1980s, Congress has categorized all rental income as “passive income” and only allows passive losses to offset passive income.  There are two exceptions.

The first is for real estate professionals, which we will not discuss here.  The second exception allows individuals to deduct up to $25,000 of rental losses if they actively participated in the real estate activity.  This exception phases out for individuals with modified adjusted gross incomes of greater than $100,000.

Child Care Tax Credit

May 11th, 2016 Posted by Tax Planning No Comment yet

If you own a business, you know how important it is to retain your top talent.  You can offer great pay, benefits, and interesting work, but your employees may decide that it is cheaper to stay home than to pay for child care.  How can you compete with that?

One option may be to provide child care for your employees, and the federal government will help pay for it through the Employer-Provided Child Care Tax Credit.  This tax credit is equal to 25% of qualified child care expenditures and 10% of qualified child care resource and referral expenditures, up to a maximum tax credit of $150,000.

Child Care

Qualifying expenditures include:

  • Costs to acquire, construct, rehabilitate, or expand the property that is being used as a qualified child care facility, as long as it is not part of the principal residence of the employer or any of the employer’s employees;
  • The operating costs of the qualified child care facility; and
  • Contracts with a qualified child care facility to provide services to employees.

The operating costs of the facility includes, in addition to all normal expenditures for this type of facility, the cost to train employees and to offer scholarship programs.

To get a better understanding of how this tax credit operates, lets look at an example:

XYZ Corporation has been experiencing a high turnover rate because of the number of young parents that it employs.  In an effort to retain a greater number of its most valued employees, it decided to convert some unused office space into a daycare facility at a cost of $300,000.  XYZ Corporation hired several individuals with extensive training in the field to operate the facility at a cost of $200,000 per year.

XYZ Corporation can claim a federal income tax credit of $125,000 (25% of the qualified expenses) in the first year, and a $50,000 tax credit (25% of the operational costs) in the following years.

Green Vehicle Tax Credits

May 9th, 2016 Posted by Tax Planning 3 comments

Is “going green” important to you?  Do you not only want to make your home energy-efficient, but drive a green vehicle as well?

The federal government has made that desire more affordable by offering 2 different tax credits to you, depending upon the type of “green vehicle” you are purchasing.

Green Vehicle

  1. Alternative Motor Vehicle Tax Credit.  This tax credit is available to individuals who purchase a qualifying fuel cell motor vehicle.  These vehicles are propelled by the power derived from one or more cells that convert chemical energy directly into electricity.  Generally, you can rely on the manufacturer’s certification that a vehicle qualifies for this credit.

    In order to qualify for this tax credit, you must: 1) be the owner of the vehicle; place the vehicle into service during the tax year; 3) the vehicle must be new (its “original use” must begin with you), 4) you must purchase the vehicle to use or lease to others; and 5) you must use the vehicle primarily in the United States.

    This credit is currently scheduled to expire at the end of 2016.

  2. Plug-In Vehicle Tax Credit.  This tax credit is available to individuals who purchase or lease a qualifying, four-wheeled plug-in electric vehicle manufactured primarily for use on public streets.  The value of this credit ranges from $2,500 to $7,500.  The base credit is $2,500, and an additional $417 for each kilowatt hour of battery capacity starting at 5 kilowatt hours, up to a maximum of $7,500.

    This credit will begin to phase out for a manufacturer’s vehicles when at least 200,000 qualifying vehicles have been sold for use in the United States, determined on a cumulative basis.  However, at this time no manufacturer has come close to selling 200,000 qualifying vehicles.  Click here for the IRS’s list of cumulative sales by manufacturer.

    To qualify for this credit, the vehicle must: 1) be manufactured primarily for use on public roads; 2) weigh less than 14,000 pounds; and 3) be able to exceed a speed of 25 miles per hour.

Solar Energy Tax Credit

May 6th, 2016 Posted by Tax Planning 4 comments

Do you want to use solar energy or another renewable energy source to power your home?  There is a tax credit available to help make that transition affordable for you.

Solar Energy

The Residential Energy Efficient Property Tax Credit is available to taxpayers who install qualified equipment to their home.  It does not have to your main residence (it can be on a second/vacation home).  Qualified equipment includes:

  • Solar Electric Equipment (i.e., solar panels);
  • Wind Turbines; and
  • Solar Hot Water Heaters.

The tax credit is equal to 30 percent of the cost of the alternative energy equipment that you have installed at your principal residence.

Unlike most other tax credits, there is no limit on the amount of credit available for most types of property.  However, this tax credit is non-refundable.  That means if you are not able to use the entire tax credit, then the unused portion is carried forward to the next year.

The Residential Energy Efficient Property Tax Credit is available for any qualified equipment that is installed before December 31, 2023.

Example

Gary and Karen had solar panels installed on their principal residence on June 1, 2016 for a total installation cost of $90,000.  They are entitled to a tax credit of $27,000 (30% of the $90,000 installation cost).

Every year, Gary and Karen have a total federal income tax due of $12,000.

For the 2016 tax year, their usual $12,000 federal income tax bill was reduced to $0.  Gary and Karen will be receiving a tax refund from the IRS for any income tax withholdings or estimated tax payments that they made during the year.  They also have an unused tax credit of $15,000 that will be carried forward to 2017.

For the 2017 tax year, again their usual $12,000 federal income tax bill was reduced to $0.  Again, instead of writing a check to the IRS they will be receiving a refund for any income tax withholdings or estimated tax payments they made during the year.  They have an unused tax credit of $3,000 that will be carried forward to 2018.

For the 2018 tax year, they will finally exhaust their remaining tax credit but only have to pay $9,000 of federal income tax.

What is an IRA?

May 4th, 2016 Posted by Tax Planning No Comment yet

Everyone keeps telling you that you need to save for your retirement, but your company does not have a 401(k).  What are you supposed to do?  You can contribute to an Individual Retirement Account (IRA)!

IRA

There are 2 basic types of IRAs:

1) Traditional IRA

Qualified contributions to a Traditional IRA help to reduce your taxes because they are tax-deductible.  Contributions to a Traditional IRA are one the few ways in which you can actually reduce your tax bill after the year ends.  The governments allows you to make a contribution up until April 15th of the following year, and to take the deduction in the preceding year.

The amount you are allowed to contribute to a Traditional IRA changes frequently as it is adjusted for inflation, but in 2016 you are allowed to make a contribution up to $5,500, or $6,500 if you are age 50 or over.

Once invested into a Traditional IRA, all of the funds grow without being taxed.  You will not be taxed until you withdraw the funds! 

There are a few basic requirements in order to make a contribution to a Traditional IRA:

  • The contributor must be an individual (not a trust, company, etc.)
  • You must be under the age of 70.5
  • You must have sufficient earned income or compensation (at least as much as you contribute to your IRA)

Be careful though.  The ability to make a tax-deductible contribution phases out based upon whether or not your employer provides a company retirement plan, your tax filing status, and your income level.

2) Roth IRA

The principal difference between Traditional IRAs and Roth IRAs are that with Traditional IRAs the contributions are tax-free while with Roth IRAs the distributions are tax-free.

In 2016, you are allowed to make a contribution up to $5,500 or $6,500 if you are age 50 or over.  However, the contribution limitation changes based upon your tax filing status and your income level.

Once invested into a Roth IRA, all the funds grow tax-free.  Furthermore, all of the distributions are tax-free provided that you are over the age of 59 1/2 and have had the Roth IRA account for at least 5 years.

Again, there are a few basic requirements in order to make a contribution to a Roth IRA:

  • The contributor must be an individual (not a trust, company, etc.)
  • You must have sufficient earned income or compensation (at least as much as you contribute to your IRA).

You will notice that unlike with Traditional IRAs, there is no age restriction on being able to contribute to a Roth IRA.

Of course these are only the 2 most basic types of IRAs.  You may want to discuss non-deductible IRAs, SEP IRAs, and SIMPLE IRAs with a financial adviser to determine what type of IRA makes the most sense for your situation.

Why Have a 401(k)?

May 2nd, 2016 Posted by Tax Planning 2 comments

Most financial experts will give you 2 main pieces of financial advice: 1) start saving for your retirement early, and 2) contribute enough to a 401(k) plan to maximize the employer match.

Every 401(k) plan is different as businesses set them up in order to best meet their needs and the needs of their employees.  However, a typical arrangement is for employers to match their employees contributions to their 401(k) plans $0.50 on the dollar, up to 3% of the employees gross salary.

If that is how your 401(k) plan works, you should contribute at least 6% of your gross salary to your 401(k) plan.  That effectively increases your salary by 3%! Why would you want to leave money on the table?

You should consider contributing even more than that to your 401(k) plan, as long as you can afford to do so.  As we discussed previously, due to compounding interest your retirement account can grow significantly.  The more you are able to contribute while young, the more growth you are likely to see.

401(k)

But why should an employer set up a 401(k) plan for the employees?  You may like the idea of helping your employees save for retirement, but do you want to deal with the cost and extra administrative burden?  That is up to you, but there are a few tax and non-tax benefits to setting up a plan:

$1,500 Tax Credit. Employers are entitled to claim a tax credit equal to 50% of the cost to set up and administer the plan, and to educate employees about the plan.  The credit is worth a maximum of $500 per year for each of the first 3 years of the plan.  If you are unable to use this credit in any given year, the unused portion can be carried back or forward to other tax years.  There are a few basic requirements that you should discuss with a CPA.

  • Tax Deduction.  Every penny that an employer contributes to a 401(k) plan, including to his or her own, is a tax deduction.  As an employer, you are also able to deduct the cost of administering the plan and educating your employees about the plan.  This is because the IRS considers the operation of a 401(k) plan to be an ordinary and necessary business expense.
  • Better Employee Recruitment and Retention.  For any business, having great employees is essential.  They represent you, so it is important that you are able to recruit the best possible employees and retain them once you have them.  All else being equal, I would choose to work for a company that has a 401(k) plan over one that doesn’t.  It shows employees that you care about them and their retirement.  It helps to build loyalty to your company.