In a recent MarketWatch article, I made the remark that rentals are a business. A reader disagreed. “Rental property is considered ‘investment income,’ and is filed on a Schedule E, not a Schedule C. But I understand your confusion on this matter because many people don’t understand the truth of the matter any more than you do. I know, I’m a real estate investor for 20 years now,” she wrote.
Despite investing her money in real estate, theoretically, to make a profit, this woman passionately believes that rentals are not a business. She’s not alone. Many people are confused because they’ve forgotten that the definition of a business is something that occupies your time, with the intention of making a profit. They’ve also forgotten the history of these taxes.
Shades of 1984
When Congress signed the Tax Reform Act of 1986 (TRA 86) the real estate investment climate was very different – people were chasing lucrative tax benefits, rather than profits. TRA 1986 introduced the concepts of “passive income” and “active participation,” “passive loss limitations,” “material participation” and “real estate professional” and “at-risk rules”.
The IRS urged Congress to include limitations on rental income because, at the time, rental limited partnerships were often designed to be tax shelters for the limited partners. They were sold purely for the tax benefits, not for the potential increase in property value. Not only did these limited partnerships become an abuse of the tax system, they created worthless investments. Those properties were never operated with a profit motive. They often sold the property for less than the purchase price, once the tax benefits were stripped.
Consider a typical California investment of the time. The partnership would buy a property for $2 million with 10% down. Back then, we had ACRS depreciation over 15 years – 19 years for real estate, with accelerated rates of 8% – 10% in the first three years. Mortgage interest rates were around 10% and so were management fees, usually paid to the general partners. A 10% investor would buy in for about $25,000 to cover the down payment and purchase costs.
The properties were bought for about eight times gross rents, so rental income would be $250,000. Deducting the cost of interest would be about $180,000 (10% of $1.8 million), management fees of $25,000 (10% of $250,000 rental income), and property taxes of $25,000. Operating expenses, like maintenance and utilities, would inevitably eat up the rest of the cash flow. However, depreciation would be around $90,000 ($1 million building value times 9%).
Now that you’ve met the April 18 tax filing deadline comes the good news – three-quarters of filers are expected to get refunds this year, and the average amount will be more than $3,000. That’s almost twice the $1,698 average it was in 1999, writes Wall Street Journal Tax Report columnist Laura Saunders.
Why the increase? A number of factors. People who lost jobs or investment income in recent years overpaid inadvertently. Consumers also didn’t adjust their withholdings after the addition of some tax benefits such as the American Opportunity education credit, the home-buyer credits or the expanded child credit.
Saunders writes that while conventional wisdom has discouraged large tax refunds because it amounts to an interest-free loan to the government, many consumers like the forced savings, especially when the money would earn little in the bank with interest rates so low. More importantly, that $3,000 check might not get frittered away if it comes all at once rather than “dribbled” in paychecks.
So how do most of us plan to spend the cash? Quite responsibly, according to a number of reports.
Almost half of consumers surveyed in March by Deloitte said they would use their refund to pay bills and credit cards. About 40% plan to save that money. Only 13% said they would spend it on a vacation or trip, and 8% plan to use to remodel a home.
Consumers pay an average of $434 a year to compensate for the estimated $100 billion lost overseas to tax havens, according to a new report by the U.S. Public Interest Research Group. “That’s enough money to feed a family of four for three weeks,” says the report.
While taxpayers from every state are picking up the tab, those living in Delaware and New Jersey shouldered the biggest state-wide averages of $920- and $752-a-year. “Abuse of tax havens inflicts a price on other American taxpayers, who must pay higher taxes now or in the future to cover the government’s revenue shortfall, or must deal with cuts in government services,” the report says.
How did PIRG come up with the $434? It divided $100 billion by the number of tax returns filed in 2010. Simple. And the big-bang smack-wallop figure of $100 billion? This comes from a 2008 U.S. report, Tax Haven Banks and U.S. Tax Compliance, which itself states, “This $100 billion estimate is derived from studies conducted by a variety of tax experts.”
It’s crunch time, but you may still be able to cut down your tax bill by making a last-minute deductible contribution to a Traditional Individual Retirement Account.
“You have until the [April 18] tax deadline to actually make the 2010 contribution,” says Maria Bruno, an analyst in Vanguard’s Investment Strategy Group. (You can file your return before a contribution is made but the contribution must generally be made by April 18).
Here’s how it works: Investors under the age of 50 can contribute up to $5,000 to a qualifying IRA account. That limit gets bumped up to $6,000 if you’re 50 or older. In order for the full IRA contribution to be tax-deductible, you must either not participate in a retirement plan with your employer. If you do participate in an employer plan, you must make less than $56,000 as a single filer or less than $90,000 as a married couple filing jointly to qualify for the full deduction. Married couples who make less than $110,000 and single filers who make less than $66,000 can qualify for partial deductions.
Just how much can you save? It depends on your tax bracket. Take someone in the 25% tax bracket who makes the maximum $5,000 contribution. He or she could get a tax deduction of about $1,250. “So you’re reducing your taxable income by that much,” says Bruno, and added that you may be able to double that deduction by making a contribution for your spouse.
Don’t qualify for the deduction? There are a few longer-term tax savings strategies within reach. You can still start contributing to a Traditional IRA and benefit from tax-exempt earnings growth.
Or you can consider putting the money into a Roth IRA. While your contributions are taxed, you do get the benefit of withdrawing tax-free income in retirement. You can contribute up to $5,000 directly to a Roth IRA, but that amount is phased out for married couples who earn between $169,000 and $179,000 and for single filers earning between $107,000 and $122,000.
I recently watched the documentary “Death or Taxes: The Sad Truth About Our American Tax System.”
The most interesting thing about this film, to me, was in the credits at the end. Filmmaker Roni Deutch includes a list of people at the Internal Revenue Service and the U.S. Treasury who refused to be interviewed for the film. That includes the current IRS Commissioner, Secretary of Treasury, and others. The film focuses on people who have committed suicide or done other dramatic and destructive things when faced with the IRS’s collections division and criminal investigation groups.
Anyone who has ever had a problem with the IRS can more than identify with the anger, helplessness and frustration.
While some of the stories are valid and utterly inexcusable, other cases are 100% the fault of the taxpayer in trouble. This film would have been much more effective if they had only included real victims.
Unfortunately, you can’t sell a film without including sensational names. For instance, Deutch sympathizes with Richard Hatch, the first Survivor millionaire and with Andrew Joseph Stack, III, who crashed into the IRS building – killing people. Including them destroys the credibility and effect of the film.
Looking at Richard Hatch. How did he not realize he had to pay taxes on his million-dollar prize? CBS sent him a 1099-MISC with $1,000,000 in box 3. Yet, Hatch claims the studio told him they would pay it. If that’s really true, Hatch should have filed and paid his tax return; then instantly sued the producers and the studio after getting that 1099. He didn’t have a contract with IRS letting him off from paying the taxes.
Where Hatch destroys his own case regarding tax evasion is by not paying tax on a variety of other income he earned either. He didn’t report income from a radio show, rentals and other sources either. Instead of paying about $475,000, Hatch now owes over $1.7 million dollars.
While the recently lowered unemployment rate shines a thin slice of hope on the state of the job market, plenty of Americans are still on the hunt or plan to start looking. (Initial jobless claims dipped by 10,000 to a seasonally adjusted 382,000 in the week ended April 2, according to the latest Labor Department data.) And seeing signals of an economy on the mend, 73% of professionals say they plan to shovel more resources into their job search, says Jennifer Merritt, citing a Glassdoor.com survey. Whether you’re a go-getter looking to strap a jet pack on your career, or you’re still stymied by recession-era layoffs, looking for a job can be costly. The good news? If you itemize deductions, many of those job-search expenses are deductible.
You can deduct job-search expenses as part of your miscellaneous itemized deductions, which—as a whole—are deductible if they exceed 2% of your adjusted gross income, as we previously reported. Keep in mind you can only deduct the amount exceeding that 2% figure, writes Merritt. None of this will fly if you’re searching for your first job, or if you’re new to a field.
Some job-search expenses automatically leap to mind, like resume-printing and mailing costs. But don’t forget the less-obvious and more-costly search-related expenses–out-of-state travel, career coaching, and even some childcare. The key nugget here, like most tax-related advice, is to keep fastidious records of your expenses.
Check out some of the items that topped Merritt’s list of deductions for job seekers.
Won’t be ready by the April 18, tax filing deadline? Don’t panic, writes Tom Herman in The Wall Street Journal.
It’s pretty easy to get an extension, he says. Most taxpayers are eligible for an automatic six-month filing extension from the Internal Revenue Service by completing Form 4868 and sending it in by this year’s longer than usual April 18, deadline. The form is on the IRS website (www.irs.gov), and you won’t need an excuse for the extension.
Getting more time is even simpler if you’re out of the country. You can receive two extra months to file even without asking for it. But waiting to file doesn’t let you off the hook if you owe taxes, warns Herman. Even if you extend your tax filing, you’ll need to pay-up by April 18, or owe interest and possibly some stiff penalties.
Don’t get complacent if you get an extension. As Herman reported earlier, you could miss out on credits or refunds if you don’t file your claim within three years after the date you filed your original return or within two years after the date you paid the tax, whichever is later.
The IRS reported earlier this year that it had $1.1 billion for nearly 1.1 million people who still hadn’t filed federal income-tax returns for 2007.
Life just got a lot easier for business owners worried about new laws requiring them to potentially issue hundreds of extra 1099 forms to vendors in 2013, instead of the few 1099s they currently send out.
In response to the flood of objections from many industries, the House and Senate passed.H.R. 4 this week. The new legislation negated two earlier laws, which were about to put a tremendous burden on business owners. The Patient Protection and Affordable Care Act (PPACA ) included a provision requiring businesses to issue a Form 1099-MISC to every single vendor of goods and supplies who was paid $600 or more, starting in 2013. A provision in the 2010 Small Business Jobs Act required rental property owners to start issuing 1099-MISC forms to anyone who provided services to the property – effective this year.
Although the new laws that related to all vendors wouldn’t have gone into effect until next year, companies have been setting up their bookkeeping systems this year. They also have been alerting their vendors to be prepared to provide taxpayer identification information (Form W-9) if they want to get paid in 2012.
Rental property owners have been trying to collect identification information from all their service suppliers – gardeners, pool guys, maintenance workers – for the first time ever.
The market downturn of 2008 is still sending shock waves to investors who had counted on insurance policies to cover estate taxes.
Many are receiving unwelcome surprises. Some of these variable life insurance policies are now failing. They began to unravel during the recession because they invest in baskets of mutual funds known as separate accounts. The damage is only now starting to surface for policy holders and the outcome can be startling - and expensive.
Volatile markets can undermine a variable life insurance policy and did just that to many of them after 2008, according to John Resnick, whose Harrisburg, Pa., firm provides life insurance to high-net worth clients.
Many policy holders are only feeling the effects now because the plans’ design can create a delayed reaction. A drop in cash value, together with rising mortality fees and expenses, will drain funds designed to sustain the death benefit.
Once the cash value goes to zero, “the policy will implode without value unless a much higher premium is paid,” says Resnick. Problems get worse as the insured gets older because mortality charges go up annually.
Someone who paid, say, $2 million into a policy may suddenly learn he has lost the cash value and won’t get a death benefit. The insurance company may send a notice requiring more money, and fast – within just 30 or 60 days – to keep the policy alive. Tax attorneys and insurance consultants say this has been happening for a while, but they are now seeing more failures.
Wouldn’t it be nice to write off that flight to Hawaii? Or what about the champagne-and-caviar-adorned soirée at Carnegie Hall? Maybe you can, says Doug Stives, a CPA from Red Bank, N.J., who re-engineered his life in 2006 to become the Most Tax-Efficient Man in America, as Tax Report columnist Laura Saunders writes. Stives shared a couple of practical, tax-saving suggestions with SmartMoney.com.
Get on someone’s payroll. Stives had been a partner at an accounting group for nearly four decades when he decided to take on a role as a tax and accounting professor at Monmouth University in central New Jersey. He also started his own consulting business on the side. While his paycheck is now 25% lower than it had been, his take home is nearly 90% as much, says Saunders. Stives estimates that the fringe benefits from working at the university – health insurance, disability insurance, life insurance, pension-plan coverage, unemployment coverage and workmen’s compensation coverage, among others – add up to about $40,000 a year.
Mix business and pleasure. Usually it’s a No. 1 professional no-no. But combining your work life with your personal life can slim the price tag of otherwise expensive vacations. As a part-time consultant and full-time teacher, Stives travels a considerable amount for seminars and teaching gigs, often to alluring vacation spots like Hawaii and Lake Tahoe. To deduct airfare, you need to spend more than half your working days on business, says Stives. Weekends don’t count, nor do travel days. If Stives leaves for Hawaii on a Friday, works three days mid-week and returns home the following Monday, he’s squeezed a mostly tax deductible 11-day trip out of three working days. (Hotels, meals, and rental cars are only partly deductible.) But make sure you don’t get carried away, he says. It’s a good idea to pay in full for at least some trips you take to show the IRS you don’t deduct everything.
The Tax Blog brings together a team of award-winning tax journalists from the Dow Jones network and around the web to examine the tax issues, changes and legislation that affect families, investors and small business owners. Our contributors include Tax Report columnist Laura Saunders (WSJ), Tax Guy columnist Bill Bischoff and senior reporter Jilian Mincer (SmartMoney.com), retirement-focused reporter Anne Tergesen (WSJ), wealth management writer Arden Dale (Dow Jones Newswires), TaxWatch columnist Eva Rosenberg and personal finance reporter Andrea Coombes (MarketWatch), and reporter Alyssa Abkowitz (SmartMoney). They’ll provide the latest news and insight, mine the tax code for tips and loopholes, and answer your questions about tricky tax situations. Contact the The Tax Blog with ideas, suggestions or tax questions at firstname.lastname@example.org.