News On The Tax Front--The latest tax news.
Individual Tax Return Tips--Part II-- This is the second and last part of our tax preparation tips for your 1999 tax return. We'll return to our regular coverage in the next issue.
In Brief:--Tax, business, and personal finance tips.
Previously Reported In Daily Update
There's an important difference between business bad debts and nonbusiness ones. A business bad debt is deductible in full against your income; a nonbusiness one is only deductible as a capital loss, and that could be worth much less. In William J. Fleischaker and Donni L. Fleischaker (T.C. Memo. 1999-427) the taxpayer was a doctor who tried to set up a nursing home. The venture was far from a success. The Court held that he was not in the business of developing nursing homes, instead, he was a mere investor. For that reason it disallowed as a business bad debt payments he made on loan guarantees. In addition, the Court found that legal fees related to the loans were not deductible business expenses.
In James C. Weachock (T.C. Memo. 1999-428) the Court did not believe the taxpayer's claim that he mailed his return on time. The Court was suspicious because he was due a refund and although he did not receive it, he never questioned the IRS as to its status. Send it registered, return receipt requested, or use one of the approved private delivery services.
You may get some sympathy from the courts if your records are destroyed in a fire, flood, or some other casualty. Don't expect the same treatment if they're lost in an office move, etc. In Larry Charles Miller (T.C. Memo. 2000-1) the Tax Court disallowed an attorney's expenses where his bills, etc. were lost in such a situation. The Court found the canceled checks were not enough.
The IRS doesn't have to stop at your records when auditing your return. In Jerry L. Crabtree, et al. (T.C. Memo. 1999-423) the taxpayer's liquor store records agreed with the tax returns, however, the IRS went further and checked the bank deposits and found they were much higher than the reported gross income. In addition, state tax authorities found that the company's records were not adequate. The Court found that the taxpayers were not liable for the fraud penalty but were liable for the negligence penalty. While having inadequate records will almost assuredly cause the IRS to use an indirect method of checking your income (e.g., bank deposits), having what appear to be good records won't preclude the IRS from using that approach.
While this issue has been well litigated, some taxpayers continue to try to claim that loans from a third party that a S corporation shareholder guarantees add to their basis. In Thomas F. and Therese Grojean (T.C. Memo. 1999-425) the Court found that while the taxpayer was a participant in a loan agreement, his part in the transaction was really as a guarantor, not as a lender. The corporation would be indebted to the taxpayer only if it defaulted on the note and the bank sought payment by the shareholder.
In Nathan T. Olpin (T.C. Memo. 1999-426) the taxpayer claimed he filed a joint return with his wife for the year. However, neither he nor his wife signed the return. The IRS accepted the return as married filing separately (generally the worst filing status). While the law allows taxpayers to claim married, filing joint status if only one party signs the return and the parties intended to file a joint return, the Court found that, since neither party signed, that exception didn't apply.
The IRS is conducting a 2-year test of a binding arbitration procedure. This procedure allows taxpayers to request binding arbitration for factual issues that are already in the Appeals administrative process. The taxpayer and Appeals must first attempt to negotiate a settlement. If those negotiations are unsuccessful, the taxpayer and Appeals may jointly request binding arbitration. Binding arbitration will only be used to resolve factual disputes. This procedure is effective for requests for arbitration made during the 2-year period beginning on January 18, 2000. For complete details see IRS Announcement 2000-4.
In William J. Tully (T.C. Memo. 1999-422) the taxpayer was found liable for the civil penalty for failure to file his return on time since he could provide no reasonable excuse. In addition, the Court held the taxpayer liable for the fraud penalty because, by his own admission, he failed to report all the income from his business.
Don't take the job of a fiduciary lightly. You can be held personally liable by parties for who you act as a fiduciary as well as to the IRS, state tax authorities, etc. In William D. Little (113 TC--, No. 31) the IRS attempted to recover unpaid estate taxes from the personal representative of the estate. The IRS argued that the representative paid other creditors ahead of the IRS. Normally, that would have been enough for the IRS to sustain its position. However, the fiduciary was able to show he relied on the estate's attorney who advised him that no taxes would be due on the estate.
It took a while but it now appears that tax professionals, small business owners, Congress, lobbyists, etc. now generally realize the implications of the installment sale rules in the recently passed tax legislation. The IRS has just announced that they will issue guidance on the new rules this year and several congressmen have already indicated they will work for repeal.
The IRS has issued proposed regulations relating to the allocation of nonrecourse liabilities by a partnership. The proposed regulations revise tier three of the three-tiered allocation structure contained in the current nonrecourse liability regulations, and also provide guidance regarding the allocation of a single nonrecourse liability secured by multiple properties.
The IRS has issued temporary regulations relating to the allocation of purchase price in deemed and actual asset acquisitions of a trade or business. The temporary regulations determine the amount realized and the amount of basis allocated to each asset transferred in a deemed or actual asset acquisition and affect transactions reported on either From 8023 or 8594. The intended effect is to remove and replace many of the current temporary and final regulations under Sections 338 and 1060 (and renumber others).
The IRS has just published proposed regulations on the tax consequences of partnership mergers and divisions. The proposed regulations deal with partnership mergers of the "assets-over" form (where the terminating partnership transfers assets to the surviving partnership and the "assets-up" form (where the terminating partnership transfers assets to partners who contribute them to the surviving partnership). The regulations also address the tax consequences of a Section 752 liability shifts when two or more partnerships merger using the assets-over form and partner buyouts.
President Clinton has included over $60 billion in new tax breaks in his proposed 2001 budget. The breaks would include alternative minimum tax relief and a $30 billion tax break for higher education in the form of an expansion of the lifetime learning credit. Eligible taxpayers could claim either a tax deduction of up to $10,000 for tuition or a maximum credit of $2,800 when the provision is fully phased in.
The IRS has a good track record when it comes to winning court cases involving overstated deductions or unreported income, but providing fraud is much more difficult. The burden of proof is on the IRS and it has to meet that burden clearly and convincingly. Of course, if the IRS can show fraud, there is no statue of limitations; it can go back as many years as it wants. In J. Randall Groves and Jane B. Groves (T.C. Memo. 1999- 415) the Court felt the IRS didn't show fraud where the taxpayer underreported his income.
You've got to go some to convince a court that you've got a reasonable cause for filing your tax return late. In Robert C. and Diana J. Watts (T.C. Memo. 1999-416) the taxpayer argued that he was late filing for two years because his mother and daughter were ill and he often took them to the doctors. The Court noted that he was active in his business as an architect and that he should have been able to file the returns on time.
In an earlier article we discussed that you're not at risk for an investment you make in an S corporation if you borrowed the funds from a related shareholder. In Larry W. and Cynthia J. Van Wyk (113 TC--, No. 29) that's exactly what the taxpayer did. The taxpayer, a 50% shareholder in the corporation borrowed the funds he loaned to the company from a relative, another 50% shareholder. The Court found that he was not at risk with respect to the money he loaned the corporation.
The IRS has just released Publication 1212 (List of Original Issue Discount Instruments) for use in preparing 1999 returns. You can download the publication from the IRS website. Go to the Forms and Publication page and select the publication. Download as SGML text. The OID list is no longer available on the IRS bulletin board. The publication not only contains a list of original issue discount, but also explains how to find the correct amount to report on your return.
You try to include everything in a contract, but the lawyers leave something out in the final version. Are you out of luck? Not necessairly. In Sharewell, Inc. (T.C. Memo. 1999-413) the Tax Court found that the corporation intended to enter into a covenant not to compete with a former owner and allowed the corporation to amortize the covenant. The corporation was able to present evidence that the covenant was missing from the final agreement because of a mutual mistake of the parties. It was clear from other evidence that the covenant was part of the negotiations. Some notes. Don't count on convincing the court. Take special care to insure that all your points are in any contract. Trying to show that there was an honest error can be tough. Finally, whether or not you can use this approach may depend on state law.
If you want to take a worthless stock deduction you've got to be able to show your basis in the stock. In Wayne M. and Janet L. Johnson (T.C. Memo. 1999-412) the taxpayer was denied such a deduction because he couldn't prove his basis. In the same case the taxpayers were denied a deduction for their share of losses in several partnerships because they could not show the amount of the losses. In addition, they could not show their bases in the partnerships, so even if they could show the amount of the losses, the deduction would have been denied.
In Wayne M. and Janet L. Johnson (T.C. Memo. 1999- 412) the Tax Court denied the taxpayers a deduction for charitable contributions of property because they did not specify the items donated or their value.
The IRS has adopted final regulations relating to the passthrough of items of an S corporation to its shareholders, the adjustments to the basis of stock of the shareholders, and the treatment of distributions by an S corporation.
The IRS has adopted final regulations concerning separate share rules applicable to estates under sec. 663(c) of the Code. These regulations provide that substantively separate and independent shares of different beneficiaries are to be treated as separate estates for purpsoes of computing distributable net income and applying the distribution provisions of sections 661 and 662. The regulations also provide that a surviving spouse's statutory elective share of a decedent's estate and a pecuniary formula bequest are separate shares.
The IRS has just released a revenue procedure (Rev. Proc. 99-49) that updates the procedures by which a taxpayer may obtain automatic consent to change the methods of accounting described in the revenue procedure. The revenue procedure clarifies, modifies, amplifies and supersedes Rev. Proc. 98-60. It also consolidates automatic consent procedures for changes in several methods of accounting that were published subsequent to Rev. Proc. 98-60, and provides new automatic consent procedures for changes in several other methods of accounting. A taxpayer complying with all the applicable provisions of this revenue procedure has obtained the consent of the IRS to change its method of accounting.
In Notice 2000-1 the IRS issued a Notice of Proposed Rulemaking relating to the solely for voting stock requirement in a merger under sec. 368)a)(1)(C). The proposed regulations provide that preexisting ownership of a portion of a target corporation's stock by an acquiring corporation will not, in an of itself, prevent the solely for voting stock requirement in a "C" reorganization from being satisfied. The new rules would take effect after publication of the Treasury decision to adopt the regulations.
In what might be the longest Tax Court case ever (over 600 pages) the Court sided with the IRS in holding that the taxpayer engaged in sham transactions with a large number of different entities, had unreported income through kickbacks between entities, unreported income that the taxpayer tried to assign to other entities, had a tax avoidance motive in creating capital gains and related losses, used the installment between related parties, claimed research and development expenses where there was no prospect of entering into a trade or business, deducted personal expenses as business expenses, claimed an abandonment loss with a related party, engaged in a sham sale and leaseback, took bad debt deductions where a valid debt could not be proved, took capital losses without substance, and claimed an unsubstantiated worthless stock loss. The total deficiency was well over $10 million. Investment Research Associates, Ltd. and Subsidiaries, et al.; T.C. Memo. 1999-407.
If you or your business loans money to a related party, you generally have to charge interest. There are some exceptions. But, generally, if you fail to charge interest, the IRS will impute interest at the Applicable Federal Rate (AFR). In Roundtree Cotton Co., Inc. (113 TC--, No. 28) the Tax Court held that a corporation made loans directly and indirectly to shareholders was subject to these rules, even if the loans were made to minority holders.
Individual Tax Return Tips--Part II
This is the second and last part of our tax preparation tips for your 1999 tax return. We'll return to our regular coverage in the next issue.
Individual Retirement Arrangements
In general. Here are the most important points:
Nondeductible IRAs. These are the simplest. There are no restrictions on who can contribute as long as you or your spouse have enough earned income. You can contribute up to $2,000 (as can your spouse). The contribution is not deductible but the earnings are tax deferred until you withdraw the funds. If you can't make contributions to a deductible or Roth IRA, it may still make sense to contribute to a nondeductible IRA. If you do so you must complete Form 8606. There are penalties for failing to do so.
Deductible IRAs. Now also known as traditional IRAs, these may still make sense. The advantage is an up-front deduction. If you're currently in a high tax bracket, the deduction may be worthwhile. The disadvantage is all the amounts withdrawn will be taxable at ordinary income rates.
There are a number of restrictions on deductible IRAs if you or your spouse are covered by a pension plan. If you're covered by a plan, contributions to a deductible IRA are restricted if your AGI is over $51,000 if married filing joint or $31,000 if you're single or head of household.
If you're not covered by a plan but your spouse is, you can make a deductible contribution, but it's limited if your combined modified AGI is more than $150,000. If your modified AGI exceeds $160,000, no deduction is allowed. If neither of you are covered by pension plans, each of you can make and deduct $2,000 contributions.
Tax Tip--Business owners, or other individuals whose income can fluctuate widely, might benefit from a deductible IRA in years when your income is high. In the lean years, you could convert all or a portion of those IRAs to Roth IRAs, paying taxes on the income at a lower rate.
Roth IRAs. There's no deduction for a contribution to a Roth IRA, but any distributions (that meet the requirements) are tax free. You can make contributions to a Roth regardless of whether you or your spouse are covered by a pension plan. However, if your modified AGI exceeds $150,000 (married filing joint; $95,000 for taxpayers filing single or head of household), your contributions are limited. No contributions are allowed if your AGI exceeds $160,000 ($110,000 for single or head of household filers).
If you converted part or all of a traditional IRA to a Roth in 1999, you'll have to pay taxes on the entire amount. There's no 4-year spread available as there was in 1998. Use Form 8606. If you think you made a mistake, you may be able to undo it. It's called a recharacterization.
Spousal IRA. If you didn't have any earned income, but your spouse did, you may be able to make a total of $4,000 in deductible IRA contributions, if your earned income is at least that amount.
Withdrawals. Generally, distributions before age 59- 1/2 are subject to a 10% penalty tax (see From 5329 and the instructions). There are a number of exceptions to the penalty tax.
Publication 590. IRAs can be surprisingly complex. You can get more information from Publication 590.
Form 8606. You must file Form 8606 if you either made nondeductible contributions to a traditional IRA for 1999 or you received IRA distributions in 1999 and you have ever made nondeductible contributions to any of your traditional IRAs. If you overstate nondeductible contributions on your Form 8606 you'll be liable for a penalty of $100 for each overstatement. If you fail to file Form 8606 you'll be liable for a $50 penalty.
Excess contributions. If you make excess contributions to an IRA, you can be liable for a 6% excise tax. You can correct an excess contribution and avoid the penalty for 1999 by withdrawing the excess amount and paying the tax on the earnings by April 17.
Moving Expenses
In general. If your employer reimbursed you for qualified moving expenses the amount of the reimbursement will not be included in your income. If you received any reimbursement for moving expenses that were not qualified, they'll be reported on your W-2. Form 4782 is no longer in use.
You may be able to deduct some of your expenses for moving to a new home because you changed job locations or started a new job. You can qualify for the deduction whether you are self- employed or an employee, but you must meet certain requirements. You must generally satisfy two tests--the distance test and the time test.
You can deduct allowable moving expenses if your move is closely related to the start of work. You can generally consider moving expenses incurred within one year from the date you first reported to work at the new location as closely related. You may be able to extend the one-year period if you can show that circumstances existed that prevented the move within that time. For example, you delayed the move to a new location to allow your child to complete high school.
You can usually consider your move closely related in place to the start of work if the distance from your new home to the new job location is not more than the distance from your former home to the new job location. A move that does not meet this requirement can qualify if you can show that;
Distance test. Your move will meet this test if your new main job location is at least 50 miles farther from your former home than your old main job location was from your former home. For example, if your old job was 3 miles from your former home, your new job must be at least 53 miles from that former home. Measure the distance by the shortest of the more commonly traveled routes. The distance test considers only the location of your former home. It does not take into account the location of your new home.
Example--You move to a new home less than 50 miles from your former home because you changed job locations. Your old job was 3 miles from your former home. your new job is 60 miles from that home. Because your new job is 57 miles farther from your former home than the distance from your former home to your old job, you meet the 50-mile test.
If you go to work full time for the first time, your place of work must be at least 50 miles from your former home to meet the distance test.
If you go back to full-time work after a substantial period of part-time work or unemployment, your place of work must also be at least 50 miles from your former home.
If you have more than one job, it's your main job location that counts. Your main job location depends on the facts and circumstances. Important considerations are:
Time test. You've also got to meet a time test. That means you have to work a certain amount of time at the new job location. If you are an employee, you must work full time for at least 39 weeks during the first 12 months after you arrive in the general area of your new job location. You don't have to work for the same employer, but time as a self-employed person doesn't count.
If you are self-employed, you must work full time for at least 39 weeks during the first 12 months and for a total of at least 78 weeks during the first 24 months after you arrive at the new job location. You're not considered self-employed if you are semiretired, a part-time student, or work only a few hours a week.
Deductible moving expenses. If you meet the above tests, you can deduct the reasonable expenses of:
You can only deduct reasonable expenses. Thus, only the cost of traveling the most direct route counts. Side trips aren't deductible.
If you travel by car, you can deduct the actual expenses of operating the car or 10 cents per mile.
Moving costs. You can deduct the cost of packing, crating, and transporting your household goods and personal effects and those of the members of your household. You can deduct any costs of connecting or disconnecting utilities, shipping your car or pet, and the cost of moving your household goods and personal effects from a place other than your former home.
Nondeductible expenses. You can't deduct the following as moving expenses:
Time to deduct expenses. If you were not reimbursed, you can deduct the expenses either in the year you had them or in the year you paid them. If you where reimbursed, you can choose to deduct them in the year your employer reimburses you if:
For more information on moving expenses, see our 2-part article beginning our August 15, 1999 issue.
Medical Expenses
Self-employed health insurance premiums. If you're self-employed, you can deduct 60% of any health insurance premiums on the first page of form 1040. The remaining 40% may be deductible as a medical expense on Schedule A. If you enter the information in a computer worksheet, the program should handle the details. You're considered self-employed if you operate as a sole proprietorship, are a partner in a partnership, owner in an LLC, or a shareholder in an S corporation. The rules with respect to an S corporation are more complicated.
Qualified long-term care insurance. Qualified long- term care insurance contracts are generally treated as accident and health insurance and are deductible as medical expenses on Schedule A. However, your deduction is limited. The limitation is based on your age. Check the table in our Fast Facts page.
Medical insurance premiums. You can deduct premiums for policies that provide payment for:
Medicare. If you are covered under social security, you are enrolled in Medicare A. The payroll tax paid for Medicare A is not a medical expense. However, Medicare B is a supplemental medical insurance. Premiums you pay for Medicare B are a medical expense.
Meals and lodging. You can deduct as medical expenses the cost of meals and lodging at a hospital or similar institution if your main reason for being there is to receive medical care.
You may also be able to deduct the cost of lodging while away from home if you meet all of the following requirements:
The amount you deduct for lodging cannot exceed $50 for each night for each person. Lodging is included for a person for whom transportation expenses are a medical expense because that person is traveling with the person receiving the medical care. The maximum deduction for lodging expense for all parties is limited to $100 per night.
Example--You're receiving treatment in a medical facility 150 miles from your home. The treatments are daily and are provided on an outpatient basis. You can deduct up to $50 per night for your stay in a hotel.
Example--The facts are similar to the example above, but it's your 12-year old daughter who's ill and an outpatient. You accompany your daughter. You can deduct up to $100 per night of lodging.
Example--The facts are the same as in example 2, but this time your spouse accompanies you on the trip. Your lodging expense is still limited to $100 per night.
Meals are never deductible.
Car expenses. You can include out-of-pocket expenses such as gas, oil, etc. But you can't deduct insurance, repairs, etc. Alternatively, you can use the standard rate of 10 cents per mile.
Tax Tip--You might as well go with the 10 cents per mile. It's unlikely your actual expenses will be larger.
Deductible expenses. Here's a list of some deductible expenses:
Nondeductible items. You can't deduct:
Reimbursements. You must reduce your total medical expenses by all reimbursements you receive from insurance or other sources during the year. This includes payments from Medicare.
If you pay the entire premium for your medical insurance or all of the cost of a plan similar to medical insurance, generally you don't have to include an excess reimbursement in your income.
If your current or former employer pays the total cost of your medical insurance plan and your employer's contributions are not included in your income, you must report all excess reimbursements as other income.
Special rules apply if both you and your employer paid the premiums for medical insurance and your receive reimbursements in excess of your expenses.
If you are reimbursed in a later year for medical expenses you deducted in an earlier year, report as income the amount you received from insurance or other sources that is equal to, or less than, the amount you previously deducted as medical expenses.
Tax Tip--On the other hand, if you did not deduct a medical expense in the year you paid it either because you did not itemize or the total medical expenses didn't exceed the 7.5% of your AGI threshold, you don't have to include the reimbursement in income.
Damages for personal injury. If you receive an amount in settlement of a personal injury suit, the part that is for medical expenses deducted in an earlier year is included in income in the later year if your medical deduction in the earlier year reduced your income tax in that year.
Taxes
General rules. In order to deduct a tax it must be imposed on you and the tax must be paid during your tax year. Thus, if you pay the real estate taxes on your son's house, you can't claim a deduction because the taxes aren't imposed on you and he can't deduct the taxes because he didn't pay them. The best approach is to give the money to your son and let him pay the taxes.
The taxes are considered paid during the year if you mail the check by December 31.
Income taxes. You can deduct state and local taxes withheld from your pay during the year (the amount shown on your W-2) and any estimated payments, or payments for a prior year made during the year.
Example--Fred Flood made his last estimated payment for his 1998 state taxes in January 1999. That amount is deductible on his 1999 return. He paid $1,000 with his state return and made quarterly estimated payments of $2,000 in April, June and September, 1999. He can deduct all those amounts on his 1999 return. He made his final estimated payment in January, 2000. That amount is deductible on his 2000 return.
Real estate taxes. This one isn't as clear. Not all the amounts you pay for real estate taxes may be deductible. Deductible taxes include only taxes on real property levied for the general public welfare. The taxes must be based on the assessed value of the property and charged uniformly against all property under the jurisdiction of the taxing authority. Deductible taxes don't include charges for local benefits and improvements that increase the value of your property. For example, the following don't qualify as deductible taxes:
If you incur any of these charges, check your tax bill and reduce the total by the amount of the nondeductible charges.
Taxes for local benefits. Charges such as assessments for streets, sidewalks, water mains, sewer lines, public parking facilities, and similar improvements that increase the value of your property aren't deductible. However, they do increase the basis in your property. That will decrease your gain or increase your loss when you sell.
On the other hand, local benefit taxes for maintenance, repair, or interest charges related to those benefits are deductible.
Example--Your house is on a dead-end, unpaved road. The town assesses all the houses on your road a fee for paving the road. The fee is not deductible. On the other hand, future maintenance charges on the road are deductible.
Tax Tip--While the portion of your taxes that represent garbage collection may not be deductible as taxes, the amount should be included on Form 8829 as a home office expense.
Purchase and sale of real estate. If you bought or sold real estate during the year, the real estate taxes must be divided between the buyer and the seller. The amount is divided according to the number of days in the real property tax year that each party owned the property.
If you pay any delinquent taxes on the property, the amount is not deductible. Instead, add the amount to your basis in the property.
State and local personal property taxes. These are deductible if they are:
Sales taxes. These have not been deductible for some time, either for individuals or businesses. In the case of a business, the amount of the tax is added to your cost in the property and deducted as the cost of the property would be deducted.
Example--You purchase $100 worth of supplies for your business. In addition to the purchase price you pay $5 in sales tax. The tax is not separately deductible. However, when you deduct the supplies your deduction is $105. Similarly, if you purchase a computer for $2,000 and pay $100 in sales tax, you would take depreciation on $2,100.
Interest Expense
In general. Only certain types of interest are deductible, and even those are subject to restrictions. Interest on a first mortgage on your first and second (e.g., a vacation home) home is fully deductible. (There's a limit. No more than the first $1 million of debt counts. Mortgages taken out before October 14, 1987 don't have these restrictions.) Here are some of the other rules. You must be legally liable for the loan and both you and the lender must intend that the loan be repaid. In addition, the mortgage must be a secured debt on a qualified home. (Generally, that means that you put up the home as collateral.)
Other home mortgages. Home mortgages taken out to improve a first or second home generally qualify in full. However, you must be able to show you used the money for improvements.
Interest on home equity loans qualify for a tax deduction, but only on the first $100,000 of principal.
A boat can qualify as a second home if it has living accommodations such as a bath, kitchen, bedroom.
Intrafamily loans. You can deduct the interest on a loan from a family member, but it must be a bona fide loan. That is, there should be a promissory note, interest must be paid, etc. In the case of a home mortgage, the loan must be secured by the home. Record the mortgage with the county clerk or similar office. If you find later that you can't make the payments, check with your tax advisor.
Late charges and prepayment penalties. You can deduct as home mortgage interest a late payment charge if it was not for a specific service performed by the lender.
If you pay off the mortgage early, you may have to pay a penalty. You can deduct that penalty as home mortgage interest.
Sale of your home. You can deduct your home mortgage interest paid up to, but not including, the date of the sale.
Prepaid interest. If you pay interest in advance for a period that goes beyond the end of the tax year, you must spread this interest over the tax years to which it applies.
Graduated payment mortgage. In this type of loan, some of the interest in the early years is not paid, but added to the principal of the loan. Future interest is figured on the increased unpaid mortgage loan balance. You can only deduct the interest you actually paid during the year.
Reverse mortgage loan. A reverse mortgage loan is a loan that is based on the value of your home and is secured by a mortgage. The lending institution pays you the proceeds of the loan, either upfront or in monthly installments. The loan usually provides that the interest is added to the outstanding principal. You can deduct the interest on a reverse mortgage when you actually pay it, not when it is added to the outstanding loan balance. Any interest deduction is limited to the amount of the interest on the first $100,000 of principal amount, just like a home equity loan.
Points. If you pay points to get the mortgage, they may be deductible in the year you pay them. There are a number of rules, but, generally, the points have to be computed as a percentage of the principal amount of the mortgage, can't be for services rendered, must be for the acquisition or improvement of your principal home, and the payment of the amount of points paid must be an established practice in your area.
If you pay points on a second home or a refinancing, the points may be amortized over the life of the mortgage. If you refinance an existing loan and take down additional funds to improve the residence at the same time, you can allocate the points paid to the different portions of the loan. That is, a portion of the points paid would be deductible immediately and a portion amortizable over the life of the loan.
Seller pays points. If you are the seller and pay the points, you cannot deduct them. However, you can add them to the selling expenses of the home. If you're the buyer and the seller paid the points, you must reduce your basis in the house by the amount of the points.
Deducting unamortized points. If the mortgage ends early (e.g., you sell the house), you can deduct any unamortized points in full at that time.
More than one borrower. If you and at least one other person (other than your spouse) were liable for and paid interest on a mortgage that was for your home, and the other person received a Form 1098 showing the interest that was paid during the year, attach a statement to your return explaining this. Show how much of the interest each of you paid, and give the name and address of the person who received the 1098. Deduct your share of the interest on line 11 of Schedule A, and write 'see attached' next to the line.
Reporting the interest on Schedule A. If you received a 1098 for the interest, report the amount on line 10. If you paid more than the amount shown on the 1098, show the full deductible amount on line 10, but attach a statement. Write 'see attached' next to line 10. If you did not receive a 1098, report the amount on line 11. If you paid interest to the seller, show the seller's name, address, and taxpayer identification number on the dotted lines next to line 11. If you take a deduction for points that were not reported on a 1098, deduct the amount on line 12.
Mortgage proceeds invested in tax-exempt securities. You can't deduct home mortgage interest on grandfathered debt or home equity debt if you used the proceeds to buy securities or certificates that produce tax-free income.
Student loan interest. You can deduct up to $1,500 of interest paid on student loans. This isn't an itemized deduction. See line 24 of the front page of Form 1040.
Auto loan. Interest on an auto loan is generally not deductible. There's one exception. If you're self-employed and use the car in your business you can deduct the portion applicable to business use.
Investment interest. This interest is deductible up to the amount of your investment income. For example, you borrow $50,000 to invest in the stock market. You paid $5,000 in interest in 1999. All your stocks, bonds, savings accounts, etc. produce $4,500 in investment income. You can deduct $4,500 of investment interest on your tax return. The remaining $500 can be carried forward and deducted in subsequent years, subject to the same restrictions. Use Form 4952.
If you don't have sufficient income from interest, dividends and short-term gains, you can include long-term capital gains, but you must make a special election and forgo long-term capital gain treatment.
If you borrowed money to purchase an interest in a regular (C) corporation, even if it's your business, the interest is deductible only under the investment interest rules discussed above. If you borrowed funds and loaned the funds to your C corporation, the same rules apply.
However, if you borrowed money to purchase an ownership interest in an S corporation or partnership, the interest is fully deductible. Don't enter it here. Put the amount on Schedule E on the second page.
Allocating business interest. If you do business as a sole proprietorship and took out a loan where some of the proceeds were used for business purposes and some for personal purposes, you must allocate the proceeds and the associated interest payments.
Contributions
Qualifying organizations. Not all tax-exempt organizations qualify for a deduction. Legitimate churches always do. If you're unsure about the other organizations, get IRS Publication 78 (available at many libraries).
Contributions to fraternal societies, orders, and associations operating under the lodge system may or may not qualify. Your contribution is deductible only if it is to be used solely for charitable, religious, scientific, literary, or educational purposes, or for the prevention of cruelty to animals.
Foreign charities. Most foreign charities do not qualify for a tax deduction. Canadian and Mexican charities are a special exception. However, to deduct your contribution, you must have income from those countries.
Benefits you receive. If you receive a benefit as a result of making a contribution to a qualified organization, you can deduct only the amount of your contribution that is more than the value of the benefit you receive. There's an exception to this rule. If the benefit is nominal or the organization determines that the value of the item or benefit you received is not substantial and informs you of that, you can deduct the payment in full. If the value of the benefit you receive is more than $75, the organization must inform you of the value.
If you pay more than the fair market value to a qualified organization for the merchandise, goods, or services, the amount you pay that is more than the value of the item can be a charitable contribution. For the excess amount to qualify, you must pay it with the intent to make a charitable contribution.
Example--You go to an auction run by a charitable organization. The value of a doll is no more than $20, but you win it with a bid of $200. The excess amount, $180, is a charitable contribution.
Out-of-pocket expenses. If you do volunteer work for a charitable organization you can deduct your out-of-pocket expenses. In order to qualify the amounts must be unreimbursed, directly connected with the services, expenses you had only because of the services you gave, and not personal, living, or family expenses. Meal expenses associated with the performance of services are not deductible unless it is necessary for you to be away from home overnight.
For example, you purchase a uniform for use in your volunteer work. The cost of the uniform and laundering would be deductible, but only if the uniform is not suitable for everyday wear.
Car expenses are deductible. You can deduct out-of-pocket expenses such as the cost of gas and oil, but not general repairs, maintenance, depreciation, etc. Alternatively, you can take the standard mileage allowance of 14 cents per mile. Generally, you'll come out better using the standard mileage.
Conventions and travel. If you are a chosen representative attending a convention of a qualified organization, you can deduct actual unreimbursed expenses for travel and transportation, including a reasonable amount for meals and lodging. You cannot deduct personal expenses for sightseeing, theater tickets, etc. And you can't deduct your spouse's expenses.
You can claim a charitable contribution deduction for travel expenses incurred while you are away from home performing services for a charitable organization, only if there is no significant element of personal pleasure, recreation, or vacation in the travel. This applies whether you pay the expenses directly or indirectly. You are paying the expenses indirectly if you make a payment to the charitable organization and the organization pays for your travel expenses. You must have genuine and substantial duties throughout the trip.
Contributions to individuals. You cannot deduct contributions to specific individuals. For example, you make a contribution directly to a needy family whose home was destroyed in a flood. You can't take a deduction. On the other hand, if you contribute to a qualified organization that donates the money to the same family, you can take a deduction. You can't take a deduction if you can specify the needy family.
Payments to a member of the clergy that can be spent as he or she wishes are not deductible.
Payments to a hospital that are for services for a specific patient or for a specific patient's care are not deductible.
Other nondeductible contributions. You can't deduct contributions to chambers of commerce, or civic leagues and associations. However, these may be deductible as a business expense.
Tuition, or amounts you pay instead of tuition, even if you pay them for children to attend parochial schools or qualifying nonprofit day care centers aren't deductible. You can't deduct any fixed amount you may be required to pay in addition to the tuition fee to enroll in a private school, even if it is designated as a donation.
Property contributions. We discussed this topic in detail in an earlier issue, Charitable Contributions of Property. Go to there for more detail.
Here are some of the rules in a nutshell. If you made noncash contributions of less than $250, you must get a receipt from the organization showing:
You don't need a receipt if it's impractical to get one. For example, you deposit clothes in a drop-off bin.
If the contribution is at least $250 but not more than $500, you must get and keep an acknowledgment of your contribution from the qualified organization.
If the total of your noncash contributions is over $500, in addition to the above requirement, you've got to complete Form 8283. Read the instructions. If each individual contribution is under $500 you don't have to provide the date acquired, how acquired or the adjusted basis of the item.
If you contribute a group of similar items (books, stamps, etc.) during the year, even if to different charities at different times, and the claimed contribution exceeds $5,000 you'll need an appraisal.
When to deduct. If you mail a check, it's considered a contribution on the day mailed.
If you pay by credit card, take a deduction in the year you make the charge.
If you issue and deliver a promissory note or make a pledge, you can't take a deduction until the year you actually make payments on the note or pledge.
Recordkeeping. For each cash contribution that is less than $250 you need a canceled check or a diary or account statement notation that shows the check number, amount, date posted and to whom paid. If made by credit card, the amount, transaction date, and to whom paid.
If the contribution is $250 or more, you must get a written acknowledgment from the charity. The charity will know what information to include on the receipt. You must have the receipt on the earlier of, the date you file your return for the year your make the contribution or the due date, including extensions, for filing the return.
Casualty Losses
In general. Because a casualty loss must exceed 10% of your adjusted gross income (plus $100 per loss) in order to claim any deduction, you'll have to have a substantial loss before even considering a casualty loss. We won't go into detail here, just mention some high points. You must use Form 4684 to report a casualty or theft loss.
Amount of loss. The amount of your loss is the difference between the fair market value of the property before and after the loss. It's not the cost of repairs, although they can be a good indication of the amount of the loss.
Example--You incur $10,000 in auto repairs as a result of an accident. You weren't covered by collision. The value of the car before the accident was $20,000. The cost of repairs would be a good indication of the loss.
Example--The facts are the same as in the example above, but the value of the car before the accident was only $8,000. Your loss would be limited to $8,000.
Of course, in the case of a theft loss, there is no value after the loss.
Appraisal. There's a high probability the IRS will question a casualty loss. Getting an appraisal generally makes sense. The cost of the appraisal is deductible, but only as a miscellaneous itemized deduction subject to the 2% of AGI rule. In the case of auto, you can often rely on a recognized blue book. Be sure to take photos, get a police report, etc. You can't have too much documentation.
Cleanup costs. Like repairs, they're technically not part of the casualty loss, but they are an indication of the decrease in fair market value as a result of the casualty.
Nondeductible loss. Some losses are not casualty losses. They include accidental breakage, progressive deterioration, a car accident or other casualty if your willful negligence or willful act caused it, misplacing property, etc.
Employee Business Expenses
In general. If you're an employee (that includes an employee/owner in an S or regular corporation) you can only deduct unreimbursed business expenses if the employer has a policy of not reimbursing for some or all expenses. You won't have any deductible employee business expenses if all of the following are true:
Car expenses. You probably know the rules by now. You can take the standard mileage allowance or your actual expenses. For 1999, the standard mileage rate was 32.5 cents per mile from January 1, 1999 through March 31, 1999. From April 1 on it was 31 cents per mile. You can't take the standard mileage allowance if you ever used the actual expense method and depreciated the car using an accelerated method.
Not all travel is deductible. Generally, travel from your home to the office is commuting and not deductible. If you have two jobs, there's a good chance you'll be able to deduct at least some of your expenses. Here's a quick review:
Educational Expenses
There have been a number of changes to the rules for educational expenses in recent years. We've covered some of the changes in back issues. Here's a quick summary.
Work related courses. These may or may not be deductible. If your employer requires you to take courses, but won't pay for them, you should be able to deduct them. Generally, the courses must be necessary to keep your present salary, status, or job. The education must not be part of a program that will qualify you for a new trade or business. You must have already met the minimum education requirements for the job. CAUTION. The definition of a new trade or business is broad. An accountant taking courses to qualify to become a CPA is taking courses for a new trade or business.
If your education is not required by your employer or a law (such as continuing professional education requirements to keep a license), it must maintain or improve skills needed in your work.
If you meet the above criteria, you can deduct tuition, books, supplies, lab fees, certain transportation and travel costs, related costs such as the cost of research and typing when writing a paper. Meals and lodging may be deductible if you travel overnight to obtain the education and the main purpose is to attend a work-related course or seminar.
If you could have been reimbursed from your employer, but did not seek reimbursement, you can't deduct the expenses.
If you're an employee, you should generally start by putting the expenses on Form 2106. If none of your expenses were reimbursed, and you're not claiming travel expenses, you can put the amount directly on Schedule A as a miscellaneous itemized deduction.
If you're self employed, deduct the amount on Schedule C.
Employer education assistance program. If your employer has such a program, payments up to $5,250 per year for most educational expenses are excludable from your income.
Hope credit. If you paid education expenses for yourself or one or more of your children, you may be able to claim a Hope credit of up to $1,500 for the qualified tuition and related expenses paid for each eligible student. You can claim the maximum credit if you have at least $2,000 of qualifying expenses. The credit may be claimed for only the first two taxable years for each eligible student. The credit is phased out for taxpayers with incomes above $80,000 for a married couple filing jointly or $40,000 for a single individual. Use Form 8863.
Lifetime learning credit. The maximum credit per year, per family is limited to $1,000, but there's no requirement that the student take a certain work load (one course will produce a benefit), no restriction on the first two years, graduate-level courses qualify, etc. The credit is phased out above certain income levels. See the Hope credit. Use Form 8863.
Child tax credit. You're eligible for a $500 credit for each qualifying child you have. A qualifying child is:
The credit is phased out if your AGI is above $110,000 (married filing joint) or $75,000 for a taxpayer filing single or head of household.
If you have 3 or more qualifying children, you may be able to claim an additional credit.
Miscellaneous Deductions
In general. Miscellaneous deductions are generally subject to a 2% of AGI floor. That means only the amount that exceeds 2% of your AGI is deductible. There are some exceptions.
Here's a list of items that may be deductible, subject to the 2% floor:
Certain expenses are not subject to the 2% floor. They included:
If you're claiming gambling losses against your winnings, you must keep a diary with the following information:
More
There's plenty of extra help available. If you're going it alone, the first place to look is in the IRS publications. You can download them from the IRS website. Our Fast Facts page has a listing of the most important IRS publications and forms along with a host of other information.
Previously Reported In Daily Update
Section 179 not available to trusts and estates. . . You can write off up to $20,000 (2000 amount) of equipment every year. That's a plus since you recover your investment immediately rather than spreading it over a number of years. However, a number of special rules apply. One is that the benefit is not available to an estate or trust. That can be a problem if the trust or estate is a shareholder in an S corporation or partner in a partnership. In those entities (and LLCs) the section 179 deduction is passed through to the shareholders or partners. If a shareholder or partner is a trust or estate, the deduction is lost.
Sales tax on intercompany transactions . . . Profit on intercompany transactions may be deferred for income tax purposes, but the transaction may be subject to sales tax. Thus, if you have two related corporations and A performs services for B that are taxable, A must charge sales tax. That would not be true if the two entities were divisions rather than separate corporations. The rules vary from state to state and you may be able to avoid the tax. Check with your tax adviser.
Contributions to IRA accounts and pension plans . . . In March 2000 you could be making a contribution to your 1999 IRA or to your 2000 IRA. You can make a contribution to your Keogh or company pension as late as the extended due date of your tax return. For example, you could be contributing to your 1999 Keogh account as late as October 15, 2000. The clerk taking your contribution will probably figure the money is for the year 2000. Be sure to specify what year your contribution is for. That goes for IRAs, Keoghs, and company plans. Making a mistake could be costly. Make sure it's in writing and double check.
Request EIN number upfront . . . It's a rare business that doesn't have to file at least one 1099-MISC. Don't forget the filing requirement doesn't stop with the consultant you hired to design some special software. If the amount paid is $600 or more, you owe a 1099-MISC to your accountant, the garage that repairs your company cars, the electrician who added outlets in the shop, etc. You don't need to give a 1099-MISC to a business that operates as a corporation (except medical corporations and attorneys), nor to one that supplies only goods. The law requires you to get the company's federal I.D. number (EIN or TIN) upfront. You should ask the company to complete a W-9 before you give them the check. If you can't get the number, you're required to withhold 31% of the amount.
Protect the company jewels . . . It's not unusual for a small company to form a joint venture with a large one to develop a patent, engage in a project, etc. Make sure your company secrets are well protected and don't reveal more than you have to. Make sure your employees know the rules too. It's not unusual for one company to work closely with you just to get technology to use it its own business. Talk to your attorney before revealing details. You may be able to protect yourself with a confidentiality agreement. Also, make sure you have excellent documentation to support your ownership of the ideas. But, even if the facts are on your side, consider that a large company can use its resources to wear you down in the courts. The same advice applies in the case of a merger. It's not unheard of for a potential buyer to spend time looking over your books, processes, plant, etc. just to acquire knowledge and then break off the acquisition. Sure, that's bad faith, but it's tough to prove.
Breakup fee . . . Selling your business? Merging with another company? Selling any asset? Entering into a joint venture? If the deal is important enough, talk to your attorney about inserting a penalty clause in the contract. If the other side decides to cancel the deal, you collect monetary damages. Of course, the other party will want to collect if you cancel so you want to be sure there won't be any reason for you to cancel. Talk to your attorney and financial advisor.
Renting property to your business? . . . Holding real estate in your own name and renting it to your business makes sense. If you do business as a regular corporation, you can avoid a double tax, and make an eventual sale of your business much easier. In addition, there are likely to be some current tax benefits. The tax consequences of renting personal property (furniture, equipment, etc.) to your business is more complex. For one thing, as a noncorporate lessor you may not be entitled to the Section 179 expense writeoff unless you can qualify under some very strict rules. (Refer your tax adviser to IRC Sec. 179(d)(5)(B). In addition, the income may be subject to the self-employment tax. There could be other issues. Check with your tax advisor before proceeding.
Deduction available only when note paid . . . If, instead of paying cash, you pay with a note, you generally get no deduction until you pay the note. For example, you sign a note for a charitable contribution instead of making a cash payment. You can't deduct the amount until you make good on the note. What about a credit card? That's different. Credit card payments are deductible on the day made. Another alternative. If securing an immediate deduction is important and you don't have the cash, borrowing the money and making a cash payment will do the trick.
File insurance claim . . . While it often makes sense not to file a claim with your insurance company for minor damage, that advice may not extend to a situation where there's a potential for a bodily injury claim. For example, you're probably better off not filing a claim for the $700 of water damage to your kitchen ceiling (too many small claims and your carrier may not renew you). But $700 of damage to your car may be different if another party was involved. They may come back to sue you for bodily injury later. You may have a problem getting the insurance company to back you up if you didn't report the accident on time. This is one time when it may be better to risk an increase in your premium. That may be a small price to pay to avoid legal fees and potential damages on a big personal injury claim. The same advice also applies to any injuries where your homeowner's policy is involved. For example, your dog bites a neighbor.
Selling your home? . . . You know the general rule. If you've used the house as your principal residence for 2 out of the last 5 years, you can exclude up to $250,000 ($500,000 if married, filing joint) of the gain. But what if you receive the house in a divorce settlement? The time your spouse or former spouse owned the residence is tacked on to your ownership period. What if you own the house, but, as part of the divorce settlement you agreed to let your former spouse remain in the house and now want to sell? You are considered to have used the house as your principal during the time your spouse or former spouse is allowed to use the house as his or her residence, but only if that's part of the separation or divorce decree.
Copyright 2000 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536