A personal note

I’m primarily a software professional who works in the tax field as a secondary profession. For professional reasons I haven’t been writing here lately, but that’s going to change. It is my intention to bring my technical expertise to bear in the world of tax software systems, and I am making changes in my life to allow that to happen. So…

I will be writing here frequently. I will be answering tax questions on Quora, LinkedIn, and Facebook. And I will be making an effort to respond to you, the reader, on a frequent basis in whatever forum we can engage.

And I expect to have good news to report about my professional life in the near future.

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Selling your home – ask a tax pro BEFORE you sign

It’s been a busy year, and kind of an unusual one. The regular job (AKA “the one that pays the bills”) has been eating into my writing time, and what time I’ve been able to spend on tax matters has been mostly occupied answering questions on . However, there is one issue that has come to the forefront, more or less, and it’s prompted me to write this post.

The housing market still hasn’t recovered from the great meltdown of 2006-2007. Would-be buyers find that they can’t qualify for a mortgage, and would-be sellers find themselves stuck with a home that they can’t sell and can’t afford to keep. It’s not a surprise that people are looking for ways out of their predicaments – and not a surprise that there are others out there who are more than willing to “help” them – for a fee, of course.

For the first time in my 20+ years of doing tax prep, I’ve actually had to deal with people who have become sufficiently concerned about the situation that they are willing to do some form of seller-financed deal. What sellers – and buyers – don’t always realize is that those deals come with tax consequences (surprise!), and the tax consequences can be sticky for both parties.

If you are the seller in one of these deals, you must:

Claim the interest portion of the payments you receive from the buyer as interest income on Schedule B of Form 1040.

List the name, address, and Social Security number of the buyer as the payer of the interest on Schedule B.

Not deduct interest on an existing mortgage that you still have on the property as home mortgage interest on Schedule A. That interest is deducted as investment interest on line 23 instead, and only the amount of that interest (plus other Line 23 expenses) that exceed 2% of you AGI can be deducted.

Figure your gain on the sale (if any), and determine whether you want to treat this as an installment sale for tax purposes. Normally, if you have a gain on the sale of a personal residence, all or part of the gain will be excludable. If you can’t exclude the gain (either because it’s not a personal residence or because you didn’t live in it long enough), you can spread it over the life of the contact by using Form 6252, Installment Sale Income, in the year of the sale and each year thereafter.

If you are a buyer, the one thing that you need to be sure happens is that the seller records the mortgage in accordance with state law. If the seller does not do that, you will not be able to deduct the interest that you pay the seller. You will also need to list the the name, address, and Social Security number of the seller on your Schedule A to claim the mortgage interest deduction. Note that this is reported on line 11 of Schedule A, not line 10.

Both buyers and sellers need to be aware that the vast majority of mortgage agreements include a “due on sale” clause – which means simply that the balance of any current mortgage on a property being sold is due to the current mortgage holder when title to the property is transferred. Most mortgage holders, in the current climate, are willing to look the other way as long as they are being paid – but if interest rates start going up, look out, because there’s a good chance the mortgage holder will be more inclined to call the loan if they can get a better deal with someone else.

Don’t just take the deal to an attorney – get your tax pro involved if you’re thinking about doing a wraparound mortgage, a land contract, or even a straight seller-financed mortgage. You’ll be happy that you did.

Should the government provide tax prep software for free?

Chris Bergin at tax.com thinks so:

Since the government has provided its citizens this ridiculous income tax system whose purpose is to take our money, it seems to me the least the government can do is make the process easier.

The government should provide taxpayers with official tax preparation software at no cost. That will not only make things easier, but less “sleazier” as well.

Now, I work for H&R Block, but I’m not a blind apologist for the company. I get the concerns about eliminating a competitor and reducing to a duopoly in the field, and I get that it’s not a good thing for the industry going forward. However, Mr. Bergin’s proposed solution – to provide taxpayers with official tax prep software for free – has its own set of issues:

1. The IRS’s track record in software development is, to say the least, a mixed bag. The agency has been trying to modernize its own internal processing systems for a LONG time, and the target date moves out years at a time (from 2006, to 2012, to 2018-2020). It takes months for the IRS to get its own systems reprogrammed and ready for each year’s batch of tax changes. Now add the complexity of managing a large, no-cost tax preparation front end to what the IRS already has on its plate. Say this for the private companies – they are far better at churning out yearly updates than the IRS probably can ever be.

2. In addition to Federal tax preparation, you have state tax preparation. There are 43 states with income taxes, many of which are based off the Federal form. Who manages the integration of all of those separate entities into a free software base?

3. As a long-time software developer and quality assurance specialist, I understand that even the simplest-looking program on the surface can be extremely complex underneath, and that’s doubly true when the problem being solved – in this case tax preparation – is itself a complex issue. We get literally dozens of updates every week during tax season to our office software, and I am sure the online providers update theirs at least as often. I can imagine the uproar – although I don’t have to – if a program error in a government-supplied tax preparation package led to taxpayers getting mega-dollar refunds to which they were not entitled, especially if that error were NOT caught in a timely manner. The IRS is always under pressure for distributing refunds erroneously, and if the government took over the provision of tax prep software the probability – and visibility – of those errors would just increase the pressure on the agency.

I should note that the big online providers (and others) offer free filing to low-income taxpayers, and I don’t see that changing any time soon. (For information on free filing, check out the IRS Web Site) The IRS could, and maybe should, work with those companies to extend the Free File program to more taxpayers. But I think that asking the government to just step in and take over the tax prep software business kit and kaboodle will create more issues than it will address, and that’s not a headache the government needs right now.

Why tax preparers turn gray

A long-time client of mine brought me something new this year – a Schedule K-1 from a limited partnership (formed through the company that employed the client) that was liquidated this year. Normally, a Schedule K-1 isn’t a big deal – you key the information from the form, it carries to the appropriate schedules on the 1040 and the state return, and you are done. However, this one was a big deal – the partnership reported income allocations to 28 different states, and not only did they report that income to those states but they also paid state taxes to most of them.

Initially, I was still thinking this wouldn’t be a big deal – most of the income amounts were small, and I thought that most if not all of them wouldn’t even require that the client file a return. Turns out I was wrong – I wound up generating 17 separate nonresident state tax returns. The reason? Many states require nonresidents to file a tax return if the taxpayer has *any* income from sources in those states, no matter how little.

It turns out that the client got small refunds from most of those states – refunds which the client would have been more than happy to forego under the circumstances, because the amount of effort required on both the client’s part (signing all of the forms) and mine (generating them) was considerable. And when you factor in the amount of effort on the part of the receiving states to process the return and the refund – even though most of these are E-file/direct deposit – it’s still a lot more effort than is necessary.

My client’s company did their best to ensure that the investors understood that they are likely to have multiple tax obligations (I saw a copy of their letter to their shareholders), but I have to wonder how many of these shareholders are going to take the time and effort to dig out their actual state tax obligations – and what the odds are that at least some of them will get letters from various states asking about their failure to file returns. And I also have to wonder why state tax agencies can’t apply some sort of reasonable minimum dollar amount on nonresidents before requiring that they file – as they usually do for residents. Especially in this case, where the company actually paid state taxes on the income.

“Can I deduct…?” part 2

In Part 1, I talked about “above the line” deductions – deductions available directly on form 1040 for any taxpayer who qualifies. There are other deductions that are available to taxpayers who itemize on Schedule A.

Let me start with some things that are NOT deductible, and about which I get asked:

Personal loan interest. This includes interest you pay on your credit cards, car loans, and most other types of borrowing other than student loan interest (deducted above the line) and the types of interest mentioned below.

The value of your time or services that you donate to charitable organizations. You might spend a couple of days per week volunteering at your child’s school, and you might work very hard in doing so while saving the school some money on teaching assistants – but the cost of your time isn’t deductible.

Donation of the right to use property, as opposed to the property itself. For example, if you have a week at a timeshare, and one year you decide to donate it to your church to be auctioned off, you can’t deduct the FMV of the timeshare for that year, because you are retaining the property and only donating the right to use it.

Homeowner association dues. Even though the HOA might act like a government agency, it’s not one.

Donations to foreign charities. If the charity is registered in the US, you can deduct the contribution even though it’s for use overseas; if the charity is not registered in the US (except for certain Canadian, Mexican, and Israeli charities), you cannot. This is especially important now with the relief efforts going on in Japan.

Vehicle registration fee. Again, this might seem like a tax, but when they are not based on the value of the vehicle being registered (and usually they are not), they are not deductible.

So what can you deduct on Schedule A?

Qualified home mortgage interest. To qualify, the mortgage must be secured by your main home or a second home and either (a) the mortgage proceeds were used to build, buy, or improve the home – AKA acquisition debt; or (b) the mortgages totaled $100,000 or less ($50,000 or less if married filing separately), and no more than the fair market value of your home reduced by any acquisition debt.

Example: You buy a house for $150,000, paying cash for it. Two years later, the FMV of the home is $200,000, and you find yourself need cash to invest in your business, so you take out a loan for $150,000, secured by the house. Because you did not use the proceeds from the loan to build, buy, or improve the home, you can only deduct the interest on $100,000 of the loan.

Investment interest. If you borrow money to buy property that you hold for investment – stocks, bonds, collectibles, unimproved land that you are holding for some future unspecified use – the interest on that loan is deductible, up to the amount of your net investment income.

State and local income taxes. Any income taxes that you paid in 2010 to your state or local taxing authority can be deducted here. This includes withholding from your paycheck, any amount due you paid when you filed, any prior-year refund that you applied to your 2010 taxes, and any estimated taxes that you paid during the year. If you live in a state that requires your employer to withhold taxes for certain benefit funds, such as unemployment insurance or disability insurance, those are deductible as well. In my experience, these are often included as notes in box 14 of the W-2; look for notations such as “SDI” and “SUI”.
If you got a refund in 2010 for state taxes paid in a prior year, you usually have to include some or all of the refunded taxes back into your income in the year in which you receive it if you took this deduction in that prior year.

Real estate taxes. This includes any tax that is imposed on the assessed value of real property and imposed at a uniform rate to all such property by the taxing authority. Note that if you bought or sold property during the year, you are allowed to deduct only the taxes paid during 2010 that applied to the period of time during which you owned the property (with the buyer considered to have owned the property beginning on the date of sale), regardless of who actually paid those taxes. Most of the time, this is addressed in closing – one reason to bring the closing statements for the property you bought and sold in the tax year with you when you visit your tax professional.

Personal property taxes. Like real estate taxes, they are deductible when they are imposed on the assessed value of personal property, and imposed at a uniform rate by the taxing authority to all such property. As an example – in Wake County, North Carolina where I live, we pay a rate of 0.614% on the assessed value of vehicles (whether licensed in NC or not), boats, mobile homes, and aircraft.

Qualified medical and dental expenses. Broadly, medical expenses include any cost related to diagnosing, curing, mitigating, treating, or preventing disease or that affect any part of the body, as well as any equipment, supplies, and/or diagnostic devices needed for these purposes, plus most health insurance premiums that you pay out-of-pocket with post-tax dollars. You can only deduct these expenses to the extent that they exceeds 7.5% of your adjusted gross income.

The caveats on deductible medical expenses are worthy of a blog post in and of themselves. Most people with employer-provided health care plans don’t have enough expenses out-of-pocket to reach the 7.5%-of-AGI threshold.

Charitable contributions. You can deduct charitable contributions that are made to a qualified organization based in the US. Both cash donations and the fair market value of property donations made to an organization or for its use can be claimed. If you benefit from a contribution (e.g. you buy a ticket to a charity ball, or a box of Girl Scout cookies), only the portion of your contribution beyond the FMV of the benefit you receive can be deducted. You can also deduct the costs of driving your personal vehicle to and from volunteer work that you perform for a qualified organization, either the actual costs of gas and oil or 14 cents per mile (keep a written record).

You have to be able to substantiate any charitable contribution you make. IRS Publication 1771 describes the substantiation requirements.

Nonbusiness casualty and theft losses. If you lost personal property as the result of a casualty or theft, you may be able to deduct some or all of the lost value. “Casualty”, in this context, refers to a loss from a sudden, unexpected, and unusual event, not something that results from gradual wear and tear. Termite damage to your house wouldn’t be considered a casualty – but a tree falling on your roof during a sudden windstorm would be. You need proof that the loss actually resulted from a casualty or theft (the mere disappearance of money or jewelry isn’t enough proof), and there are a number of reductions that you must apply before you can take any deduction.

Miscellaneous deductions subject to 2%-of-AGI. To the extent the total exceeds 2% of your adjusted gross income, you can deduct:

Unreimbursed employee expenses. These are expenses related to your work as an employee that you pay out of pocket and for which your employer does not reimburse you. This can also include costs related to a job search, dues to professional societies to the extent that those help you carry out your job responsibilities, and professional licensing fees. It includes protective gear, and work clothes and uniforms only to the extent that those are required by your employer and are not suitable for regular wear.

Tax preparation fees. This includes the cost of software or an online provider, if you file that way.

Expenses of producing taxable income. If you have a hobby that generates taxable income, for example, this is where you’d deduct expenses related to that hobby, up to the limit of your hobby income.

Miscellaneous deductions not subject to 2%-of-AGI. This is where casualty and theft losses go, also gambling losses up to the level of gambling income declared on line 21 of form 1040. There are some other things that can go here – you can look them up in IRS Publication 17 if you are interested.

If after you’ve done all of this, the sum total exceeds your standard deduction – itemize. Otherwise, take the standard deduction – but check your state’s laws, too, because some of these may become deductible on your state’s return if you don’t itemize.

Next: tax credits.

Knowing where to put the ‘X’

Trish McIntire on one of the issues we all have:

Pop Test! One question; what is a simple tax return? Correct answer; whatever return the caller has. Their goal is to get you to under price the return. This will be something they will hold you to no matter how much they mislead you.

I’m reminded of the story of the consultant who walked into a plant that was having problems keeping the assembly line operating. The consultant looked around for about 10 minutes, put an ‘X’ on a particular component and told the plant manager that all he had to do was replace that component and the line would function smoothly. The manager did as asked and the line started running smoothly. A week later he received a bill from the consultant for $10,000 for consulting services. Given the time he spent on the problem, the manager thought that was more than a bit high, so he asked the consultant for a detailed invoice. Three days later this came back:

Time spent identifying the problem: $10
Knowing where to put the ‘X’: $9990

You’re asking us to do your return because we know where to put the ‘X’. The more complicated your situation, the harder it becomes to know exactly where to place it. It may not seem all that hard to you (especially after we do it) but that doesn’t mean that it isn’t complicated.

You can certainly price-shop, and you can certainly do your return yourself. But just keep in mind the possibility that when you do so, you might wind up with the ‘X’ in the wrong place when the IRS comes to take a look.

“Can I deduct…?” part 1

At this time of year, we start getting a steady stream of clients who are worried about owing come April 18. The most common question we get starts out with three little words:
“Can I deduct…??”

There are two different classes of deductions: above the line deductions, which can be taken by any taxpayer who qualifies, and itemized deductions, which can be taken by any taxpayer who chooses to file Schedule A instead of taking the federal standard deduction. There is a third category of tax preferences – tax credits – which are deducted directly from the tax that you owe, rather than being deducted from your income before the tax due is determined, and which can also be taken by any taxpayer who qualifies.

So – what “can you deduct…”? These are above the line deductions, sone of which are well known, some of which are not:

Moving expenses. I wrote about this last year, so you can read Part 1, Part 2, Part 3, and Part 4 for details.

Educator expenses. If you are an eligible educator (defined as a kindergarten through grade 12 teacher, instructor, counselor, principal, or aide who worked in a school for at least 900 hours during a school year), and you had out-of-pocket expenses for books, supplies, equipment, and other materials used in the class, you can deduct up to $250 of those expenses on line 23 of your 1040. You need proper documentation to substantiate those expenses, and you can’t deduct for anything that would not be considered to be a common expense for an educator.

Self-employment. You not only get to deduct half of the self-employment tax that you are required to pay, but you may also get to deduct contributions to a SEP or SIMPLE plan that you establish for yourself, and you may also get to deduct the cost of health insurance that you paid for yourself and you family. You can only deduct these if you have net earnings from self-employment. Check out IRS Publication 560 for details on setting up a retirement plan.

If you had a penalty for an early withdrawal of savings from a CD or other savings instrument, you can deduct that penalty on line 30 of form 1040. Your 1099-INT (or 1099-OID if you have one of those) will show the amount of the penalty.

If you paid interest on a student loan, and your adjusted gross income was less than $75,000 ($150,000 if married and filing jointly), you can deduct up to $2500 of the interest you paid. You cannot file as married filing separately, and no one else can be claiming you as a dependent. The loan must have been for yourself, your spouse, or your dependent, and must have been for expenses paid during the time in which the individual was enrolled at least half-time in a degree program.

If you paid tuition and fees for higher education in 2010, you are not married filing separately or qualify as a dependent of someone else (whether or not that person actually claims you is immaterial), and you cannot take, or choose not to take, an education tax credit for those expenses, you can deduct up to $4000 of those expenses. These expenses must be for you or your spouse or dependent, must be required by an eligible institution as a condition of enrollment, and your adjusted gross income cannot exceed $80,000 ($160,000 if married filing jointly). You must file Form 8917 with your return.

If you (or your spouse if married filing jointly) had earned income in 2010, and contributed to a traditional IRA, you may be able to take a deduction for those contributions. Note that this does not include 401(k) contributions or rollovers from another retirement plan. If you are covered by another retirement plan, either through work or as a self-employed individual funding a SEP or SIMPLE plan, your contributions to an IRA may be nondeductable as well. See IRS Publication 590 for details.

I’ll talk about itemized deductions and credits in later posts.

Helping the tsunami victims

Remember that for your contribution to be tax-deductible it must be directed to a US-based charity. Check out this link at About.com for more information.

UPDATE: Stacie Clifford Kitts has some more suggestions for you.

Does “biggest refund” = “best tax value”?

Apparently, according to CPA Success:

We knew it. The profession knew it. Anyone who has ever worked with a CPA knew it.

Now, the rest of the country knows it, too.

“It” is simply this: The best bang for your tax preparation buck comes from a CPA.

Here’s the problem with the video: We don’t know what refund the couple should have received if they took all legal deductions and credits, because we know almost nothing about the information they presented to the various tax services. The only thing that we do know – that they recently started a business for which they tried to deduct expenses and for which they were told they could not until 2011 by the H&R Block preparer – tells us nothing about whether they actually could have deducted the expenses legally or not. (Full disclosure: I work for Block.) We don’t know what the CPA found that led to a $4000 refund, nor what Block didn’t find that made the refund smaller. We don’t know if the couple presented the same information to the CPA that they did to Block, or entered the same information into TurboTax.

Yes, I’m defending my fellow Block preparer here. I don’t doubt that Mr. Kane did a good job based on the information that he had, but what I don’t know – and more to the point, what CPA Success doesn’t know – is whether the Block preparer failed to gain access to the same information because he/she didn’t ask the right question, or because the clients didn’t have (or know how to present) the information when they saw the Block preparer.

Furthermore, by presenting this as “biggest bang for the buck”, CPA Success leaves the impression that it’s primarily about the size of the refund, and we all know how dangerous a proposition THAT can be. Again, not questioning Mr. Kane one bit – but does CPA Success really want to embrace the proposition that the most important thing is how much money the preparer can “get back”, rather than that the preparer has given the client the best tax advice for his situation? I look at the value proposition differently – I want my clients to get the biggest refund to which they are legally entitled, based on the deductions and credits that they can support if the IRS comes calling. And if they can’t support a home office deduction or that the miles they drive from home to a job site aren’t commuting miles (which are by far the two biggest questionable deductions I see on CPA-prepared returns), then I tell them they shouldn’t take them, because it’s on them if the IRS reviews their return.

For the record: most CPAs are excellent at what they do…but so are we. Like anything else, you should vet your preparer thoroughly whether it be a CPA or someone at a brick-and-mortar tax prep house like ours.

Energy-efficient, tax-inefficient

Scott Hodge of the Tax Foundation Tax Policy Blog (italics mine):

Bloomberg recently reported that:

“Whirlpool Corp. will claim $300 million this year in U.S. tax credits for making energy- efficient appliances, collecting almost four times the government’s estimate for what all companies would receive from the tax incentive.

The credit will generate about one-third of Whirlpool’s earnings this year, according to the company’s projections.

Company filings show that as of Dec. 31, 2010, Whirlpool had $555 million in stockpiled business credits and $2 billion in tax losses. Both can typically be used to offset up to 20 years of future income and taxes.”

There are so many issues raised by this story it is hard to know where to begin. But it provides a good learning moment for why we should not use the tax code to incentivize economic behavior – no matter how noble the cause.

I couldn’t agree more. Unfortunately, it’s all too easy for our elected representatives to give the appearance of doing something by inserting a preference into the tax code to achieve some desired behavior – only to find that it becomes difficult or impossible to sunset the preference later without blowing up someone’s means of livelihood.