Under the new law, up to $250,000 of the gain from the sale of single person's principal residence is tax-free. For certain married couples filing a joint return, the amount of tax-free gain doubles to $500,000. Thus, you no longer have to reinvest the sales proceeds by buying a more expensive house in order to "roll over" (i.e., avoid paying tax on) your gain. Also, the new rules replace the one-time exclusion of $125,000 of gain that applied to people over age 55. Since most people will not owe any tax on the gain from the sale of a principal residence under the new rules, the hassle of trying to document costs, expenses, and prices involving various residences over the years should be alleviated.
Like most tax laws, however, the exclusion has a detailed set of rules for qualification. Besides the $250,000/$500,000 dollar limitation described above, the seller must have owned and used the home as his principal residence for at least two years out of the five years before the sale or exchange. In most cases, taxpayers can only take advantage of the provision once during a two-year period. However, a reduced exclusion is available if the sale occurred because of a change in place of employment, health, or other unforeseen circumstances (that IRS may specify in future regulations). The rules can get pretty complicated if you marry someone who has recently used the exclusion provision, if the residence was part of a divorce settlement, if you inherited the residence from your spouse, if you sell a remainder interest in your home, or if you have taken depreciation deductions on the residence.
Not everyone will be happy with this new law. Homeowners who sell at a loss still will not be able to claim a deduction. Also, homeowners with profits of more than the $250,000/$500,000 limits could have to pay more tax under the new law since Congress repealed the provision allowing owners to defer gains by rolling over home-sale proceeds into a new home costing the same or more.
On balance, though, the news is good. We finally have a tax break that most of us can actually use, and the tax savings can be substantial.
A special form (Form 2119) must be filed with your tax return for the year of sale.
If you have any questions regarding your specific situation, please e-mail us.
Free Tax Tip No. 2
Keogh plan for director's fees
If you serve as a director for one or more corporations, you may well be earning significant fees which are, of course, currently taxable. There is a way you may be able to defer taxes on some of this income which you may want to consider.
Directors fees are considered by IRS to be self-employment income. This means that this income can be the source of deductible contributions to a so-called Keogh plan. A Keogh plan is a retirement plan-either a pension plan or a profit-sharing plan for self-employed individuals. There are some special rules that apply to Keogh plans, but essentially deductible contributions of up to 20% of this income-up to a maximum of $30,000-may be made to one type of Keogh plan. Keogh pension plans are funded in much the same manner as employee pension plans. The amount of income that can be set aside under these plans is substantially the same as under regular employee pension and profit-sharing plans.
Another important point-participation in a Keogh plan would be in addition to any qualified pension and profit-sharing plan you may be presently participating in as an employee. Participation in an employee plan would not limit the amount you could contribute and deduct under a Keogh plan.
There have been some attempts in the past to treat fees earned by a director who is also an employee of the corporation-an "in-house" director as opposed to an "outside" director-as part to the compensation earned by an employee and not as self-employed income. But IRS has pulled back from this position, at least for the time being.
If you have any questions regarding your specific situation, please e-mail us.
Free Tax Tip No. 3
Simple retirement plans and simple 401(k) plans
We are writing to advise you of the availability of "SIMPLE" retirement plans, for tax years beginning after 1996. "SIMPLE" is an acronym for "savings incentive match plan for employees." This new type of plan was recently introduced by the Small Business Jobs Protection Act of 1996. It's targeted at businesses with 100 or fewer employees, and is designed to offer greater income deferral opportunities than individual retirement accounts (IRAs), with fewer restrictions and administrative requirements than traditional pension or profit-sharing plans.
Under a simple plan, any employee with compensation of at least $5,000 must be permitted to enter a "qualified salary reduction arrangement." Under this arrangement, an employee can elect to have a percentage of compensation (not in excess of $6,000 for the year, as indexed for inflation) set aside in an IRA, instead of receiving it in cash. Amounts taken out of the employee's salary for this purpose are not taxed to the employee until withdrawn from the simple IRA. Early withdrawals may be subject to a 10% penalty (25%, if the withdrawal is made within the first two years).
Under a qualified salary reduction arrangement, the employer must make "matching" contributions to the simple IRA. That is, the employer must make contributions to an employees' simple IRA in the same amount as the employer contributed under the employee's salary reduction election, up to 3% of the employee's compensation. For example, if an employee with compensation of $50,000 elects to have 10% of his pay contributed to the plan ($5,000), the employer must contribute an additional $1,500 (3% of $50,000). For these purposes, an employee's compensation is the amount reported on his Form W-2, plus the amount of elective deferrals (e.g., the amount of the salary reduction contributed to the simple IRA). But the matching contribution cannot exceed $6,000 (as indexed for inflation).
If an employer wishes to contribute less than 3%, he can give employees proper notice and drop the contribution to as low as 1% of compensation, as long as this isn't done for more than two years out of the five-year period ending with the year of reduced contributions.
Alternatively, instead of making "matching" employee contributions, the employer can simply contribute a flat 2% of "compensation" (limited to $150,000, as adjusted for inflation), for every employee eligible to participate in the plan, whether the employee elects to reduce his salary or not. Special notice must be given to employees if the employer wishes to take this approach.
Under the new law, instead of adopting a simple retirement plan, an employer can set up a simple 401(k) plan. By making matching contributions (or 2% nonelective contributions) and satisfying rules similar to those for simple plans, simple 401(k) plans will be considered to satisfy the otherwise complex nondiscrimination test for 401(k) plans. The contribution rules for simple plans apply to simple 401(k) plans, except that if an employer adopts the matching contribution approach (instead of the flat 2% option), the maximum contribution percentage cannot be dropped below 3%. Unlike a simple plan, a simple 401(k) plan is part of a qualified plan, and is subject to the qualified plan rules.
Simple plans have the advantages of simplified reporting requirements and the absence of the qualification rules prohibiting the plan from discriminating against lower-level employees. Some employers may consider the contribution requirements a disadvantage. Additionally, to be eligible to adopt a simple plan, an employer must not contribute to, or accrue benefits under, any qualified retirement plan for services provided during the year (or in any year after the qualified salary reduction arrangement takes effect). A similar restriction applies to simple 401(k) plans, but only for services provided by employees eligible to participate in the simple 401(k) plan.
If you have questions regarding your specific situation, please e-mail us.
Free Tax Tip No. 4
Simplified Employee Pensions (SEPs)
Are thinking about setting up a retirement plan for yourself and your employees, but are concerned about the financial commitment and administrative burdens involved in providing a traditional pension or profit-sharing plan? An alternative program you may want to consider is a "simplified employee pension," or SEP.
SEPs are intended as an alternative to "qualified" retirement plans, particularly for small businesses. The relative ease of administration and the complete discretion you, as the employer, are permitted in deciding whether or not to make annual contributions, are features that are especially attractive. Here's how these plans work.
If you don't already have a qualified retirement plan, you can set up a SEP simply by using the IRS model SEP, Form 5305-SEP. By adopting this model SEP, which doesn't have to be filed with the IRS, you will have satisfied the requirements for tax qualification. This means that you, as the employer, will get a current income tax deduction for contributions you make on behalf of your employees. Your employees will be taxed not when the contributions are made, but at a later date when distributions are made, usually at retirement. Depending on your specific needs, an individually-designed SEP-instead of the model SEP-may be appropriate.
When you set up a SEP for yourself and your employees, you will make these deductible contributions to each employee's IRA, called a SEP-IRA, which must be IRS-approved. You may contribute the lesser of 15 percent of compensation, or $30,000, to an employee's SEP-IRA. Because of the limits on the amount of compensation that can be taken into account, the maximum contribution is $22,500 for '96, and $24,000 for '97. The deduction ceiling applicable to an individual's own contribution to an IRA doesn't apply to your contributions to employees' SEP-IRAs. Your employees control their individual IRAs and IRA investments, the earnings on which are tax-free.
There are other requirements which you have to meet to be eligible to set up a SEP. Essentially, all regular employees must elect to participate in the program, and contributions can't discriminate in favor of the highly compensated employees. But these requirements are minor compared to the bookkeeping and other administrative burdens connected with traditional pension and profit-sharing plans. The detailed records that traditional plans must maintain to comply with the complex nondiscrimination regulations aren't required for SEPs. And employers aren't required to file annual reports with IRS-Forms 5500-which, for a pension plan, could require the services of an actuary. What record-keeping is required would be done by a trustee of the SEP-IRAs-usually a bank or mutual fund.
Beginning in `97, another option for a business with 100 or fewer employees is a "savings incentive match plan for employees" (i.e., a "simple" plan). Under a simple plan, an IRA is established for each eligible employee, with the employer making matching contributions based on contributions elected by participating employees under a qualified salary reduction arrangement. The simple plan is subject to much less stringent requirements than traditional qualified retirement plans. Or, an employer can adopt a "simple" 401(k) plan, with similar features to a simple plan, and automatic passage of the otherwise complex nondiscrimination test for 401(k) plans.
If you have questions regarding your specific situation, please e-mail us.
Free Tax Tip No. 5
Did you know that you can deduct "commuting" expenses between your home and temporary job locations? Daily transportation costs between your home and a regular work location are nondeductible commuting expenses. However, you may be able to deduct costs of going to and from your home and a temporary (not regular) job location if your work fits one of the following descriptions:
(1) You have one or more regular places of business outside your home, but sometimes travel to temporary work locations in the same trade or business.
(2) Your home is your principal place of business. That is, you meet the tests for deducting expenses of a home office. (E-mail us if you aren't familiar with those tests.) And, you travel to other work locations. These may be other regular or temporary work locations.
(3) You sometimes travel to a temporary work location outside the metropolitan area in which you live and normally work.
In addition, there is some authority for your being able to deduct daily transportation expenses of going from your home to temporary job locations even if your home isn't your principal place of business, and even if you don't have a regular place of business elsewhere. For example, say you have a workshop or office in your home, but it isn't your principal place of business because all of your services are performed in other people's homes. Although IRS disagrees, the Tax Court has allowed a deduction for travelling between the home and the temporary job sites in a similar situation.
If you have questions regarding your specific situation, please e-mail us.
Free Tax Tip No. 6
Computer software and development costs
Do you buy and use computer software in your business? Do you develop computer software for use in your business, or for sale or lease to others? Then you should be aware of the following developments in the tax treatment of computer software and of the expenses of developing computer software.
Purchased software. The time for depreciating the cost of "separately stated software"-software whose price is not included in the cost of hardware (for example, a computer or printer)-is three years, with one major exception. If, as part of your purchase of all or a substantial part of a business, you bought software that's not commercially available to the general public, the software may be an "amortizable section 197 intangible" that has to be amortized using the straight-line method over 15 years. Certain elections are available that may help you avoid this lengthy amortization period.
Software development costs. If you incur costs for developing computer software, you may account for those costs for federal tax purposes using any of the following methods:
· You may capitalize those costs and treat them in the same way as any other costs of producing business property.
· You may treat those costs, if they qualify, as "research or experimental expenditures" under the special rules of Code Sec. 174.
· Using the special methods of accounting for software development costs allowed by IRS, you may either (a) write off your software development costs in the year you incur them, or (b) capitalize those costs and amortize them, using the straight-line method, over five years. If you can clearly establish that the developed software has a useful life of less than five years, you may use that shorter period. In addition, the new reduced period for depreciating purchased software (mentioned above) may create other opportunities for reducing the time over which software development costs must be amortized, from five years to some shorter period.
Free Tax Tip No. 7
The $10,000 gift tax annual exclusion
Many of our clients inquire about the federal gift tax annual exclusion. As we will illustrate below, taxpayers can transfer substantial amounts free of gift taxes to their children or other donees through the proper use of this exclusion.
The exclusion covers $10,000 of gifts an individual makes to each donee each year. Thus, a taxpayer with three children can transfer a total of $30,000 to them every year free of federal gift taxes. If the only gifts made during a year are excluded in this fashion, there is no need to file a federal gift tax return. If annual gifts exceed $10,000, the exclusion covers the first $10,000 and only the excess is "taxable." Further, even "taxable" gifts may result in no gift tax liability thanks to the unified credit (discussed below). (Note, this discussion is not relevant to gifts made by a donor to his spouse because these are gift tax-free under separate marital deduction rules.)
Gift-splitting by married taxpayers. If the donor of the gift is married, gifts to donees made during a year can be treated as "split" between the husband and wife, even if the cash or gift property is actually given to a donee by only one of them. By gift-splitting, therefore, up to $20,000 a year can be transferred to each donee by a married couple because their two annual exclusions are available. Thus, for example, a married couple with three married children can transfer a total of $120,000 each year to their children and children-in-law ($20,000 for each of six donees).
Where gift-splitting is involved, both donor spouses must "consent" to it. Consent should be indicated on the gift tax return (or returns) the spouses file. IRS prefers that both spouses indicate their consent on each return filed. (Since more than $10,000 is being transferred by a spouse, a gift tax return (or returns) will have to be filed, even if the $20,000 exclusion covers total gifts. Please contact us regarding the preparation of a gift tax return (or returns), if more than $10,000 is being given to a single donee in any year.)
The "present interest" requirement. For a gift to qualify for the annual exclusion, it must be of a "present interest." That is, the enjoyment of the gift by the donee cannot be postponed into the future. For example, if you put cash into a trust and provide that donee A is to receive the income from it while he's alive and donee B is to receive the principal at A's death, B's interest is a "future" interest. Special valuation tables are consulted to determine the value of the separate interests you set up for each donee. The gift of the income interest qualifies for the annual exclusion because enjoyment of it is not deferred, so the first $10,000 of its total value will not be taxed. However, the gift of the other interest (called a "remainder" interest) is a "taxable" gift in its entirety.
Exception to present interest rule. If the donee of a gift is a minor and the terms of the trust provide that the income and property may be spent by or for the minor before he reaches age 21 and that any amount left is to go to the minor at age 21, then the annual exclusion is available (that is, the present interest rule will not apply). These arrangements (called Section 2503(c) gifts because of the Section in the tax code that permits them), allow parents to set assets aside for future distribution to their children while taking advantage of the annual exclusion in the year the trust is set up.
"Unified" credit for taxable gifts. Even gifts which are not covered by the exclusion and which are thus "taxable," may not result in a tax liability. This is because the first $600,000 of taxable gifts you make in your lifetime are covered by a tax credit that wipes out the federal gift tax liability. This credit, however, applies both for gift and estate tax purposes (that's why it's called "unified"). Thus, to the extent you use it against a gift tax liability, it is reduced (or eliminated) for use against the federal estate tax at your death.
Free Tax Tip No. 8
Series E bond interest that may be taxable
One of the principal reasons for buying U.S. savings bonds is the fact that interest can build up without the need to currently report or pay tax on it. The accrued interest is added to the redemption value of the bond and is paid when the bond is eventually cashed in. Unfortunately, the law does not allow for this tax-free build up to continue indefinitely. Series E bonds issued in 1956 reach final maturity after 40 years. Series E bonds issued in 1966 reach final maturity 30 years after issuance. Thus, bonds issued in those years reach final maturity this year. That means that not only will they stop earning interest, but all of the accrued and as yet untaxed interest is potentially taxable in 1996. A $1,000 E bond purchased in 1956 for $750 is now worth about $7,600. The entire difference (i.e., $6,850) is potentially taxable this year.
But there is a way to avoid having to pay tax now on all of the accumulated interest. This involves a special rule that permits further deferral if the E bond is exchanged for a Series HH bond. However, this exchange must be made within a prescribed time period.
We have found that many of our clients own Series E bonds that were purchased many years ago and which, except on occasional trips to the safe deposit vault, are rarely looked at or thought about. If you own bonds that are reaching final maturity this year, action is needed to assure that there is no loss of interest or unanticipated current tax consequences. Check the issue dates on your bonds and be aware of the potential income tax consequences if you have any that are maturing.
Free Tax Tip No. 9
Tax planning for college
As a parent with college-bound children, you are or will soon be concerned with either setting up a financial plan to fund for future college costs, or, if your children are already college age, with paying for current or imminent tuition, etc. bills. We'd like to address both of these concerns by suggesting several approaches that seek to take maximum advantage of tax benefits to minimize your expenses.
Planning for college expenses. In many cases, transferring ownership of assets to children can save taxes. You and your spouse can transfer up to $20,000 a year in cash or assets to each child with no gift tax consequences. For children over 13, the '96 income from the assets is taxed entirely to them at their lower tax rates (15% in most cases, after a $650 standard deduction). For children under 14, however, '96 income above $1,300 is taxed (under the "kiddie tax" rules) at your rates.
A variety of trusts or custodial arrangements can be used to place assets in your children's names. Note, it's not enough just to transfer the income to them, e.g., dividend checks. The income would still be taxed to you. You must transfer the asset that's generating the income into their names.
Tax-exempt bonds. Another way to achieve economic growth while avoiding tax is simply to invest in tax-exempt bonds or bond funds. Interest rates and degree of risk vary on these so care must be taken in selecting your particular investment. Some tax-exempts are sold at a deep discount from face and don't carry interest coupons. Many are marketed as college savings bonds. A small investment in these so-called zero coupon bonds can grow into a fairly sizable fund by the time your child reaches college age. "Stripped" munis carry similar advantages.
Series EE U.S. savings bonds. Series EE U.S. savings bonds offer two tax-savings opportunities when used to finance your child's college expenses: first, you don't have to report the interest on the bonds for federal tax purposes until the bonds are actually cashed in; and second, interest on "qualified" Series EE bonds may be exempt from federal tax if the bond proceeds are used for qualified college expenses.
To qualify for the tax exemption for college use, the bonds must be purchased by you in your name (not the child's) or jointly with your spouse. The proceeds must be used for tuition, fees, etc. (not room and board). If only part of the proceeds are used for qualified expenses, then only that part of the interest is exempt. But there's a danger: if your adjusted gross income (AGI) is too high, the exemption is phased out. Based on the 1996 rates, the exemption starts to "disappear" when your (joint) AGI hits $65,250 (for taxpayers filing joint returns) and is gone entirely if your AGI is at $95,250 or higher. (These figures are adjusted annually for inflation.) So for many taxpayers the savings bond exemption offers no tax savings.
Michigan-type educational trusts. Tax-favored treatment applies to qualified state tuition programs that allow parents to save for their children's college costs on a pre-paid basis. A number of states (starting with Michigan) have adopted what amount to "pre-payment" programs for college expenses. Under these programs, parents pay amounts into state-organized trusts well in advance of the time their children are due to enter college. The amounts vary depending on the age of the child-the younger the child, the smaller the payment. The trust then keeps and invests the money, and contracts with the parents to pay for the child's education at a state school (or, sometimes, at a private school within the state). The contributions are not treated as taxable gifts to the child. The earnings on the contributions accumulate tax-free until the college costs are paid from the funds. At that time the amounts are taxed to the child to the extent they exceed the amount contributed by the parents. Refunds are available under certain circumstances-for example, if the child dies before entering college, becomes disabled, or receives a scholarship. Refunds for any other reason must be subject to a penalty in order for the program to qualify for tax-favored treatment.
The above are just some of the tax-favored ways to build up a college fund for your children. If you wish to discuss any of them, or other alternatives, please call.
Paying college expenses. There's no deduction or credit available when you actually pay your child's college expenses. Indeed, even so-called flexible spending plans can't be used to pay college expenses from "pre-tax" earnings. But there are tax-advantaged ways of getting those expenses paid by others.
Scholarships. Scholarships (if your child qualifies for any) are exempt from income tax. For this exemption to apply, certain conditions must be satisfied. The most important are that the scholarship must not be compensation for services, and it must be used for tuition, fees, books, supplies and similar items (and not for room and board).
Employer educational assistance programs. If your employer pays your child's college expenses, the payment is a fringe benefit to you, and is taxable to you as compensation, unless the payment is part of a scholarship program that's "outside of the pattern of employment." Then the payment will be treated as a scholarship (if the other requirements for scholarships are satisfied).
Tuition reduction plans for employees of educational institutions. Tax exempt educational institutions sometimes provide tuition reduction plans for the children of their employees-tuition reductions for those children who attend that educational institution, or cash tuition payments for children who attend other educational institutions. If certain requirements are satisfied, the tuition reductions are exempt from income tax.
College expense payments by grandparents and others. If someone other than you pays your child's college expenses (and the payor cannot claim the child as a dependent), the payments are treated as gifts to the child, and are subject to gift tax. There are ways to avoid or reduce this gift tax liability, about which we can advise you.
Bank loans. You may of course take out loans to pay for your child's educational expenses. The interest on such loans is personal interest, which is not deductible. However, if the loan is "home equity indebtedness," and interest on the loan is "qualified residence interest," the interest is deductible for regular income tax purposes, although not for alternative minimum tax purposes.
Borrowing against retirement plan accounts. Many company retirement plans permit participants to borrow cash. This option may be an attractive alternative to a bank loan, especially if your other debt burden is high. However, the loan must carry an interest rate equal to the prevailing commercial rate for similar loans, and there's no deduction for the personal interest paid. Moreover, unless strict requirements are satisfied, a loan against a retirement account is treated as a premature distribution (withdrawal) that's subject to regular income tax and an additional penalty tax.
Withdrawals from retirement plan accounts. Qualified retirement plans and IRAs represent the largest cash resource of many taxpayers. IRA funds can be tapped at any time-with a penalty-but some qualified plans either don't permit withdrawals or restrict them. For example a 401(k) cash-or-deferred plan may allow distributions if the participant has an immediate and heavy financial need and lacks other resources to meet that need. IRS regs name a college education as such a need.
To the extent they represent previously untaxed dollars and earnings, amounts withdrawn from a retirement plan are fully subject to tax and are also hit by a 10% penalty tax if they are made before the participant reaches age 59 1/2.
A younger plan participant may avoid triggering the penalty tax by annuitizing payouts from an IRA or a SEP. This method doesn't work for 401(k) type plans. The strategy works because the penalty tax doesn't apply if annual or more frequent withdrawals are made in substantially equal payments over the life or life expectancy of the taxpayer (or the joint lives or joint life expectancies of the taxpayer and designated beneficiary).
Free Tax Tip No. 10
Maximizing your home office deductions
If you're self-employed and work out of an office in your home, you should know about an IRS ruling that explains when you can deduct your office-at-home expenses. The ruling shows how an increase in the time spent in your office at home can mean the difference between deducting your office expenses and getting no deduction.
The tax code allows you to deduct expenses of your office at home only if you qualify under strict tests. One test allows a deduction if your office at home is the principal place of business for the business you conduct there.
The meaning of "principal place of business" has been the source of many disputes between IRS and taxpayers. Taxpayers have tended to interpret the term expansively, while IRS has opted for a narrower reading.
In its January 1993 decision in Soliman, the Supreme Court tried to define "principal place of business." It said that the principal place of business is the place where (1) the most important activities are performed and (2) the most time is spent.
The Soliman decision, which was widely reported in the media, was supposed to resolve once and for all the nagging question of when an office at home is the taxpayer's principal place of business. But IRS is still sorting out the consequences of the Supreme Court's decision.
The IRS ruling deals with the relationship between the Supreme Court's two tests, namely the "relative importance" test and the "time" test. IRS says that it will first apply the "relative importance" test by comparing the activities performed at home with those carried on elsewhere. If this comparison clearly shows where the principal place of business is, there's no need to look further.
For example, consider a self-employed plumber who spends about 40 hours per week doing plumbing work in customers' homes and offices, and about 10 hours a week in an office in his home talking with customers by phone, deciding what supplies to order, and reviewing the books of the business.
IRS won't allow the plumber to deduct expenses for his office at home. The essence of the plumber's business is the work he does at his customers' homes or offices. The activities he performs at home are less important.
Or take the case of a self-employed author who spends 30 to 35 hours a week writing in her office at home, and another 10 to 15 hours a week at other locations doing research, meeting with her publishers, and attending promotional events.
Here, IRS concedes that the office at home is the author's principal place of business, since writing is the essence of her trade. Her other activities, while important, take second place to the actual writing.
In some cases, however, the "relative importance" test doesn't give a clear answer. Then, says IRS, the "time" test comes into play.
For example, take a retailer of costume jewelry who sells her wares at craft shows and by mail. She spends about 25 hours a week in her office at home filling mail orders, ordering supplies, and keeping her books. She also spends about 15 hours a week at craft shows. Both activities generate a substantial amount of income.
IRS says that the essence of the retailer's business is selling jewelry to customers. But the most important selling activities are performed in more than one location. Since the "relative importance" test doesn't resolve this case, the "time" test must be used. Here, since the retailer spends more working time at home than at craft shows, her office at home is her principal place of business.
As this example shows, proper planning can be the key to nailing down the deduction for office at home expenses. By understanding the rules and what IRS is looking for, you can increase your deductions to the legal maximum.
Free Tax Tip No. 11
Converting nondeductable personal
interest into a deductable expense
Many individuals and families (particularly those with school-age children), use personal loans or credit cards to buy cars or vans, finance private schooling, take vacations, etc.
If you are making significant payments on these kinds of debts, you know you can't deduct the "personal interest." That means you are paying the interest portion with after-tax dollars (and perhaps at very high rates as well).
There's a way to convert your nondeductible interest payments into deductible expense. You can get this tax break if you own your own home.
Specifically, you can take out a home equity loan (in the normal way, from your bank for example) and use the proceeds to pay off your nondeductible debts. You will probably be paying at a lower rate, since many lenders are charging near prime on these loans. And the interest payments will be deductible even though you don't use the loan for anything connected with the house.
Of course, before you borrow against the equity in your personal residence, you should be certain that you actually get the tax deduction benefit. As always, there are various technical restrictions and limits that may apply, depending on your particular tax facts and circumstances. In general, in order for debt on a mortgage to be deductible it must be considered qualified residence interest.
Qualified residence interest is interest that is paid or accrued during the taxable year on acquisition indebtedness or home equity indebtedness that is incurred with respect to any qualified residence of the taxpayer.
To qualify as either acquisition indebtedness or home equity indebtedness, a debt must be secured by a qualified residence. Qualified residence interest is only the amount of interest paid or accrued while the debt is secured by a qualified residence.
Acquisition indebtedness is debt that:
(a) meets the amount limitations; and either is secured by a qualified residence and is incurred in acquiring, constructing or substantially improving that qualified residence; or is refinanced debt that meets certain requirements. In addition, certain other indebtedness incurred before Oct. 14, '87 is treated as acquisition indebtedness.
In general the amount limitations are the aggregate amount of debt for any period that may be treated as acquisition indebtedness. It may not exceed $1,000,000 ($500,000 in the case of a married individual filing a separate return).
In the case of refinanced debt, the new debt must meet the following requirements:
(a) It is secured by a qualified residence, and It results from the refinancing of acquisition indebtedness, including acquisition indebtedness resulting from a previous refinancing. To the extent that it does not exceed both (i) the balance of the old debt that has been refinanced and (ii) the other dollar amount limitations. Generally, the overall dollar amount limitation of the debt is capped at $1,000,000.
As you can see, this area is complex and cannot be fully analyzed in a Tax Tip. If you believe you may be close to the limitations outlined above, we suggest you contact us (initially via E-mail) for a thorough analysis.
Free Tax Tip No. 12
Personal services and a charitable contribution deduction
You've mentioned that you intend to volunteer your time with one of your favorite charities and you've asked what tax benefit, if any, may be available to you for that effort.
Although no tax deduction is allowed for the value of services you perform for a charitable organization, some deductions are permitted for out-of-pocket costs you incur while performing the services (subject to the deduction limit that generally applies to charitable contributions). Away-from-home travel expenses while performing services for a charity aren't deductible, however, if there's a significant element of personal pleasure associated with the travel. And if your services for a charity involve lobbying activities, no deduction is permitted.
If you use your car while performing services for a charitable organization you may deduct your actual unreimbursed expenses directly attributable to the services, such as gas and oil costs. Alternatively, you may deduct a flat 12 cents per mile for charitable use of your car. In either event, you may also deduct parking fees and tolls.
You will want to keep track of your expenses, the services you were performing and when you performed them, and the organization for which you performed the services. You should retain receipts, canceled checks, and other reliable written records relating to the services and expenses.
No charitable deduction is allowed for a contribution of $250 or more unless you substantiate the contribution by a written acknowledgment from the charitable organization. The acknowledgment generally must include the amount of cash and a description of any property contributed. This would present a problem for out-of-pocket expenses incurred in the course of providing charitable services, because the charitable organization wouldn't know how much those expenses were. However, you can satisfy this requirement if you have adequate records to substantiate the amount of your expenditures, and get a statement from the organization that contains a description of the services you provided, the date the services were provided, a statement of whether the organization provided any goods or services in return (and a description and good-faith estimate of the value of those goods or services). You must get this statement by the time you file your tax return for the year of the contribution (or by the return date if you file a late return).
Free Tax Tip No. 13
Deducting your computer
You may be planning to buy a home computer and have asked whether you can deduct any of its cost. The deductibility of the cost of buying and operating a home computer, including related equipment such as printers, drives, scanners, modems, etc., depends on how you use the computer.
Strictly personal use. As you might guess, you get no tax deduction where you use the computer for entertainment, education, avocation, hobbies, and other personal purposes.
For your employer's work. You can deduct the operating expenses plus depreciation for a home computer that you pay for if the computer:
is required as a condition of your employment, and
is used for the convenience of your employer.
However, a computer at home, even if used exclusively for the employer's work, is subject to the so-called "listed property" deduction-limitation rules (unless you qualify under the "Office-at-home" rule, explained below, and the home-office is also a "regular business establishment"). Briefly this means that to the extent you use the computer for your employer's work:
(1) You can take accelerated depreciation over 6 tax years, plus (in the first year you place the computer in service) an expense deduction under a special Code election (plus related operating expenses) for the computer's cost, where the computer is predominately used (more than 50%) for your employer's work-50% or less work-related use downgrades your depreciation to straight-line and eliminates any expense election.
Your allowable deductions in (1), above, must be reduced by 2% of your adjusted gross income.
Investment or income-producing use. You can deduct operating expenses plus depreciation if you use your computer:
(a) to produce or collect income (for example, to keep track of your investments) even though the income-producing activity doesn't qualify as a trade or business;
(b) to manage conserve, or maintain property held for producing income; or
(c) to determine, contest, pay, or claim a refund of any tax.
The same deduction rules that apply to an employee (above) apply here except that the special expense deduction under (1), above, isn't allowed.
Home office business use. Not surprisingly, if you use the computer in an office at your home that qualifies as your "regular business establishment" you get the maximum deduction. You get the same deduction as the employee, above, but the 2% reduction rule in item (2), above doesn't apply, and the "listed property" limitation rules don't apply.
Use in business education. You can deduct operating expenses plus depreciation for the use of the computer as part of deductible business education. This education means the courses you take to maintain or improve your business skills or to meet the express requirements of your employer (study to meet minimum educational requirements or that qualifies you for a new trade or business doesn't count). You may, for instance use the computer to prepare assignments or use instruction in CD ROM medium.
Of course, to be assured of any deduction you must provide acceptable, detailed proof of use, etc.