Life Changing Events Can Impact Your Taxes

Throughout your life, there will be certain significant occasions that will impact not only your day-to-day living but also your taxes. Here are a few of those events:

Getting Married – If you just got married or are considering getting married, you need to be aware that once you are married you no longer file returns using the single status and generally will file a combined return with your new spouse using the married filing jointly (MFJ) status. When you file MFJ all of the income of both spouses is combined on one return, and where both spouses have substantial income, that could mean your combined incomes could put you in a higher tax bracket. However, when filing MFJ you also benefit by being able to claim a standard deduction equal to twice that of the standard deduction for a single taxpayer. It may be appropriate for a couple planning a wedding, or even those who just got married, to estimate the differences between filing as unmarried and filing married so there are no unpleasant surprises at tax filing time. It may be appropriate to adjust withholding to compensate for the MFJ status.

Be mindful that filing status is determined on the last day of the tax year, so no matter when you get married during the year you will be considered married for the entire year for tax purposes. Once married here are some tasks that should be done:

  • Notify the Social Security Administration − Report any name change to the Social Security Administration so that your name and SSN will match when you file your next tax return. Informing the SSA of a name change is quite simple and can be done on the SSA’s website. Alternatively, you can call the SSA at 800-772-1213 or visit a local SSA office. Your income tax refund may be delayed if it is discovered that your name and SSN don’t match at the time your return is filed.
  • Notify the IRS – If you have a new address, you should notify the IRS by completing and sending in Form 8822, Change of Address.
  • Notify the U.S. Postal Service – You should also notify the U.S. Postal Service of any address change so that any correspondence from the IRS or state tax agency can be forwarded to your correct address.
  • Notify the Health Insurance Marketplace – If either or both of you are obtaining health insurance through a government health insurance marketplace, your combined incomes and change in family size could reduce the amount of the premium tax credit to which you would otherwise be entitled, requiring payback of some or all of the credit applied in advance to reduce your monthly premiums. More complicated yet, if either or both of you are included on your parents’ marketplace policy, those insurance premiums must be allocated from their return to your return.

Here are a few tax-related items you should be aware of when filing a joint return:

  • New Spouse’s Past Liabilities – If your new spouse owes back taxes, past state income tax liabilities or past-due child support or has unemployment debts to a state, the IRS will apply your future joint refunds to pay those debts. If you are not responsible for your spouse’s debt and do not want your share of any tax refund used to pay your spouse’s past debts, you are entitled to request your portion of the refund back from the IRS by filing an “injured spouse” allocation form. As an alternative, you can file separately using the “married filing separate” filing status; however, that generally results in higher overall tax.
  • Capital Loss Limitations – If an individual has sold stock or other investment property at a loss, when filing as unmarried, each individual can deduct up to $3,000 of capital losses on their tax return for a possible combined total of $6,000, but a married couple is limited to a single $3,000 loss and if they file married separate, then the limit is $1,500 each.
  • Spousal IRA – Contributions to “Spousal IRAs” are available for married taxpayers who file jointly where one spouse has little or no compensation; the deduction is limited to the lesser of 100% of the employed spouse’s compensation or $6,000 (2022) for the spousal IRA. That permits a combined annual IRA contribution limit of a certain amount (up to$12,000 for 2022). The maximum amount is $7,000 if you or your spouse is age 50 or older ($14,000 if you are both 50+). However, the deduction for contributions to both spouses’ IRAs may be further limited if either spouse is covered by an employer’s retirement plan.
  • Deductions – The standard deduction in 2022 for a married couple (both spouses under age 65) is $25,900 and for a single individual is $12,950. So, if both of you have been taking the standard deduction, there is no loss in deductions. However, if in past years one of you had enough deductions to itemize and the other took the standard deduction, and after your marriage you’ll be filing jointly, you would either have to take the joint standard deduction or itemize, which likely will result in a loss of some amount of deductions.
  • Impact on Parents’ Returns – If your parents have been claiming either of you as a dependent, they will generally lose that benefit. In addition, if you are in college and qualify for one of the education credits, those credits are only deductible on the return where your personal exemption is used. That generally means your parents will not be able to claim the education credits even if they paid the tuition. On the flip side, unless your income is too high, you will be able to claim the credit even though your parents paid the tuition.

Buying a Home – Buying a home, especially your first home, can be a trying experience. Without a landlord to take care of repairs and upkeep of the property those tasks will become your responsibility as a homeowner. When you rent, you are responsible for making a rental payment that is not tax deductible. On the other hand, when you own a home, in addition to being responsible for its maintenance, you have to make homeowner’s insurance, mortgage, and real property tax payments. While routine upkeep costs aren’t tax deductible, the interest on the mortgage and the property taxes you pay may be tax deductible, providing you with a significant saving in income tax. However, if the standard deduction amount for your filing status exceeds the total of all itemized deductions the law allows you to claim, you won’t get a tax benefit from the home mortgage interest and property tax payments. So, when figuring if you can afford a home be sure to take into account whether you’ll benefit from those home-related tax savings.

Also, consider the long-term benefits of home ownership. Homes have generally appreciated in value in the past, so you can look forward to your home gaining value, and when you sell it, the gain of up to $250,000 ($500,000 for a married couple) can be excluded from income if the property has been owned and used as your primary residence for any 2 of the 5 years just prior to the sale.

Many taxpayers don’t feel the need to keep home improvement records, thinking the potential gain will never exceed the amount of the exclusion for home gains ($250,000 or $500,000 if both filer and spouse qualify) if they meet the 2-out-of-5-year use and ownership tests. Here are some situations when having home improvement records could save taxes:

(1) The home is owned for a long period of time, and the combination of appreciation in value due to inflation and improvements exceeds the exclusion amount.

(2) The home is converted to a rental property, and the cost and improvements of the home are needed to establish the depreciable basis of the property.

(3) The home is converted to a second residence, and the exclusion might not apply to the sale.

(4) You suffer a casualty loss and retain the home after making repairs.

(5) The home is sold before meeting the 2-year use and ownership requirements.

(6) The home only qualifies for a reduced exclusion because the home is sold before meeting the 2-year use and ownership requirements.

(7) One spouse retains the home after a divorce and is only entitled to a $250,000 exclusion instead of the $500,000 exclusion available to married couples.

(8) There are future tax law changes that could affect the exclusion amounts.

Everyone hates to keep records but consider the consequences if you have a gain and a portion of it cannot be excluded. You will be hit with capital gains (CG), and there is a good chance the CG tax rate will be higher than normal simply because the gain pushed you into a higher CG tax bracket.

Having or Adopting Children – Besides the loss of sleep, changing diapers, middle-of-the-night feedings, and constant attention, a newborn also brings some tax benefits, including a maximum $2,000 child tax credit which can go a long way in reducing your tax liability. If both spouses work, you will no doubt incur childcare expenses which can result in a maximum (can be less) credit of between $600 and $1,050 for one child or twice those amounts for two or more children. The credit amounts are based on a maximum child care expense of $3,000 for one child and $6,000 for two or more multiplied by 20 to 35 percent of the expense based upon a taxpayer’s income. (The amounts noted apply for 2022; there were temporary increases in the credits as part of Covid pandemic relief for 2021. Congress may extend the enhanced credits.)

Of course, the medical expenses are deductible if you itemize your deductions but only to the extent, the medical expenses exceed 7.5% of your adjusted gross income. Although rarely encountered, the expense of a surrogate mother is not deductible.

If you adopt a child under age 18 or a person physically or mentally incapable of taking care of himself or herself, you may be eligible for a tax credit for qualified adoption expenses you paid. The credit, which is a maximum of $14,890 for 2022, is not refundable, but if the credit is more than your income tax, you can carry over the excess and have 5 years to use up the credit. If the child is a special needs child, the full credit limit will be allowed for the tax year in which the adoption becomes final, regardless of whether you had qualified adoption expenses. The credit phases out for higher-income taxpayers.

It is also time to begin planning for the child’s future education. The tax code offers two tax-favored education savings accounts, the Coverdell account allowing a maximum contribution of $2,000 per year, and the Qualified State Tuition plan, more commonly referred to as a Sec 529 plan, which allows large sums of money to be put aside for a child’s education. There is no federal tax deduction for contributing to either of these programs, but the earnings from the plans are tax-free if used for qualified education expenses, so the sooner the funds are contributed the greater the benefit from tax-free earnings.

Getting Divorced – If you are recently divorced or are contemplating divorce, you will have to deal with or plan for significant tax issues such as asset division, alimony, and tax-return filing status. If you have children, additional issues include child support; claiming of the children as dependents; the child, child care, and education tax credits; and perhaps even the earned income tax credit. Here are some details:

  • Filing Status – As mentioned earlier your filing status is based on your marital status at the end of the year. If on December 31, you are in the process of divorcing but are not yet divorced, your options are to file jointly or for each spouse to submit a return as married filing separately. There is an exception to this rule if a couple has been separated for all of the last 6 months of the year, and if one taxpayer has paid more than half the cost of maintaining a household for a qualified child. In that situation, that spouse can use the more favorable head of household filing status. If each spouse meets the criteria for that exception, they can both file as heads of household; otherwise, the spouse who doesn’t qualify must use the status of married filing separately. If your divorce has been finalized and if you haven’t remarried, your filing status will be single or, if you meet the requirements, head of household.
  • Child Support – Is support for the taxpayer’s children provided by the non-custodial parent to the custodial parent. It is not deductible by the one making the payments and is not income to the recipient parent.
  • Children’s Dependency – When a court awards physical custody of a child to one parent, the tax law is very specific in awarding that child’s dependency to the parent who has physical custody, regardless of the amount of child support that the other parent provides. However, the custodial parent may release this dependency to the noncustodial parent by completing the appropriate IRS form.
  • Child Tax Credit – A federal credit of $2,000 is allowed for each child under the age of 17. This credit goes to the parent who claims the child as a dependent. Up to $1,400 of the credit is refundable if the credit exceeds the tax liability. However, this credit phases out for high-income parents, beginning at $200,000 for single parents.
  • Alimony – For divorce agreements that are finalized after 2018, alimony is not deductible by the payer and is not taxable income for the recipient. Because the recipient isn’t reporting alimony income, he or she cannot treat it as earned income for the purposes of making an IRA contribution.
  • Tuition Credit – If a child qualifies for either of two higher-education tax credits (the American Opportunity Tax Credit [AOTC] or the Lifetime Learning Credit), the credit goes to whoever claims the child as a dependent even if the other spouse or someone else is paying the tuition and other qualifying expenses.

Death of Spouse – Losing a spouse is difficult emotionally, and unfortunately, can be accompanied by a number of tax issues that may or not apply to the surviving spouse. Here is an overview of some of the more frequent issues:

  • Filing Status – If a spouse passes away during the year, the surviving spouse can still file a joint return for that year if the surviving spouse has not remarried. However, after the year of death, the surviving spouse will no longer be able to jointly file with the deceased spouse and will have to use a less favorable filing status.
  • Notification – If the deceased spouse is receiving Social Security benefits the Social Security Administration must be immediately notified. Likewise, payers of pensions and retirement plans of the deceased spouse need to be advised of the spouse’s death.
  • Estate Tax – Where the deceased spouse’s assets and prior reportable gifts exceed the current lifetime inheritance exclusion ($12.06 million for deaths in 2022), an estate tax return may be required. However, the lifetime inheritance exclusion can be changed at the whim of Congress. Even when an estate tax return isn’t required because the value of the deceased spouse’s estate is less than the exclusion amount, it may be appropriate to file the estate tax return anyway, as there could be an impact on the estate tax of the surviving spouse when he or she passes.
  • Inherited Basis – Under normal circumstances, the beneficiary of a decedent’s assets will have a tax basis in those assets equal to the fair market value of the assets on the date of death. Thus, generally, a qualified appraisal of the assets is required. However, for a surviving spouse, this can be more complicated depending upon whether the state of residence is a community property state and how title to the property was held.
  • Changing Titles – The title to all jointly held assets needs to be changed to the survivor’s name alone to avoid complications in the future.
  • Trust Income Tax Returns – Many couples have created living trusts that, while they are both alive, don’t require a separate tax return to be filed for the trust and can be revoked. But upon the death of one of the spouses, this trust may split into two trusts, one of which remains revocable and the other becomes irrevocable. A separate income tax return for the latter trust will usually have to be prepared and filed annually.

These are just a few of the issues that must be addressed upon the death of a spouse, and it may be appropriate to seek professional help.

If you have questions about the tax impact of any of your life-changing situations, be sure to give our office a call for assistance.

Inflation and an Economic Slowdown: A Double Whammy for your Finances

Newspapers and media reports have been filled with talk of inflation and recession. Experts are arguing about the definition of the latter. Pundits are pondering whether the slowdown reflected in the latest consumer price index report means that inflation has peaked. You, in the meantime, are still staring in disbelief at the numbers that are rolling by as you fill your tank with gas or the total tally when you buy a few bags of groceries.

Are We in a Recession?

It really doesn’t matter what anyone calls the nation’s economic condition when you’re having trouble paying your household bills – or worrying that’s where you’ll find yourself soon. Though gas prices have been dropping steadily and retailers like Walmart, and Home Depot are reporting strong financial results, there is some concern that higher prices may be driving their gains, and there is only so long that consumers will be able to maintain their spending habits.

That diminished spending on goods and services is one of the top signs of recession, along with cuts in manufacturing and production, increases in unemployment, and stagnating or dropping income. As frightening as each of these elements sounds, it is when you personally experience a combination of them that you feel a real impact. The good news is that there are steps you can take to prepare.

Can You Recession-Proof Yourself?

Recessions impact everybody one way or another, but they are definitely more painful for those who aren’t prepared. Here are a few things that you can do to minimize the financial impact on your family:

Review your financial plan. If you have been investing, now is the time to take a look at your short- and long-term goals and weigh them against the potential of a shifting economy. If you have too much money in one particular investment, now might be a good time to diversify, and if you are anticipating needing to take a significant amount of cash out in the short term, it’s a good idea to make sure that your investments aren’t particularly vulnerable to market volatility.

Take a close look at your spending and make adjustments. We all give ourselves a bit of grace when it comes to our budgets, but if you have reason to believe that rising prices are going to do more than make you wince, now is a good time to analyze what you’re spending on and see what you can eliminate or cut down on. Refinancing loans, canceling subscriptions, and being a bit more frugal in your habits are just a few examples of things that can make a big difference.

Have a contingency plan, and the savings to back it up. Do you have an emergency savings fund? Is there enough in it? Most experts advise calculating your monthly expenses and then putting away at least three times that amount to carry you through a job loss or some other economic crisis.

Pay down debt. If you are carrying credit card debt, or have any other loans that are charging you high-interest rates, double down on paying them off. It may hurt to skip a luxury in favor of putting more into paying down your debt, but if you face a job cutback, you’ll be glad for every dollar less that you owe.

Find extra income. It may sound more easily said than done, but if you can find a way to earn some money on the side, it will cut into the impact that rising prices are having on your lifestyle – or help you pay down debt or boost your savings.

The good news is that most recessions end in less than a year. We’ve been here before and we’ll get through it again, but that doesn’t mean that it will be easy. If you need financial advice to help you navigate the challenge, contact our office today to set up an appointment.

Not All Interest Is Deductible For Taxes

A frequent question that arises when borrowing money is whether or not the interest will be tax deductible. That can be a complicated question, and unfortunately, not all interest an individual pays is deductible. The rules for deducting interest vary, depending on whether the loan proceeds are used for personal, investment, or business activities. Interest expense can fall into any of the following categories:

  • Personal interest – is not deductible. Typically this includes interest from personal credit card debt, personal car loan interest, home appliance purchases, etc.
  • Investment interest – this is interest paid on debt incurred to purchase investments such as land, stocks, mutual funds, etc. However, interest on debt to acquire or carry tax-free investments is not deductible at all. The annual investment interest deduction is limited to “net investment income,” which is the total taxable investment income reduced by investment expenses (other than expenses related to investments that produce non-taxable income). The investment interest deduction is only allowed to taxpayers who itemize their deductions.
  • Home mortgage interest – includes the interest on debt to purchase, construct or substantially improve a taxpayer’s principal home or second home. This type of loan is referred to as acquisition debt. For the interest to be deductible the debt must be secured by the home purchased, constructed, or substantially improved. A secured debt is one in which the taxpayer signs a mortgage, deed of trust, or land contract that makes their ownership in a qualified home security for payment of the debt; provides, in case of default, that the home could satisfy the debt; and is recorded under any state or local law that applies. In other words, if the taxpayer can’t pay the debt, their home can then serve as a payment to the lender to satisfy the debt.
    • For Debt Incurred Before 12/16/2017 – the debt for which the interest is deductible is limited to $1,000,000 ($500,000 for married separate).
    • For Debt Incurred After 12/15/2017 – the debt for which the interest is deductible is limited to $750,000 ($375,000 for married separate).
  • Passive activity interest – includes interest on debt that’s for business or income-producing activities in which the taxpayer doesn’t “materially participate” and is generally deductible only if income from passive activities exceeds expenses from those activities. The most common passive activities are probably real estate rentals. For rental real estate activities, there is a special passive loss allowance of up to $25,000 for taxpayers who are active but not necessarily material participants in the rental. The $25,000 phases out for taxpayers with adjusted gross income between $100,000 and $150,000.
  • Trade or business interest – includes interest on debts that are for activities in which a taxpayer materially participates. This type of interest can generally be deducted in full as a business expense.

Because of the variety of limits imposed on interest deductions, the IRS provides special rules to allocate interest expenses among the categories. These “tracing rules,” as they are called, are generally based on the use of the loan proceeds. Thus interest expense on a debt is allocated in the same manner as the allocation of the debt to which the interest expense relates. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures, i.e., “follow the money.”

These tracing rules, combined with the restrictions associated with the various categories of interest, can create some unexpected results. Here are some examples:

Example 1: A taxpayer takes out a loan secured by his rental property and uses the proceeds to refinance the rental loan and buy a car for personal use. The taxpayer must allocate interest expense on the loan between rental interest and personal interest for the purchase of the car, and even though the loan is secured by the business property, the personal loan interest portion is not deductible.

Example 2: The taxpayer borrows $50,000 secured by his home to be used in his consulting business. He deposits the $50,000 into a checking account he only uses for his business. Since he can trace the use of the funds to his business, he can deduct the interest as a business expense.

Example 3: The taxpayer owns a rental property free and clear and wants to purchase a home to use as his personal residence. He obtains a loan on the rental to purchase the home. Under the tracing rules, the taxpayer must trace the use of the funds to their use, and as the debt was not used to acquire the rental, the interest on the loan cannot be deducted as rental interest. The funds can be traced to the purchase of the taxpayer’s home. However, for interest to be deductible as home mortgage interest, the debt must be secured by the home, which it is not. Result: the interest is not deductible anywhere.

As you can see, it is very important to plan your financing moves carefully, especially when the equity in one asset is being used to acquire another. Please call our office for assistance in applying the various interest limitations and tracing rules to ensure you don’t inadvertently get some unexpected results.

President Biden Signs Inflation Reduction Act into Law

On August 16, President Biden signed the Inflation Reduction Act (IRA) into law. The enormous bill—clocking in at 725 pages—contains a wide range of provisions and comes with a nearly $750 billion price tag. “The bill is fighting inflation and has a whole lot of collateral benefits as well,” said former Treasury Secretary Larry Summers, who reportedly helped craft the legislation.

Read on for an overview of the key items contained in the new act.

Provisions for Funding the IRA

In order to cover the $750 billion price tag of the IRA, authors of the legislation included a variety of savings- and revenue-related provisions. Here is a breakdown of how the IRA will be funded (please note that the numbers are estimates from the Joint Committee on Taxation and the Congressional Budget Office):

  1. Savings in the Healthcare Arena ($288 billion)
    1. Repeal of a Trump-era drug rebate rule
    2. An inflation cap on drug prices
    3. An allowance for Medicare to negotiate certain drug prices
  2. New Revenue
    1. A new 15% corporate minimum tax for corporations with financial statement (“book”) income exceeding $1 billion ($313 billion)
    2. Increased revenue as a result of IRS tax enforcement funding ($124 billion)
    3. A 1% excise tax on corporate stock buybacks
    4. Methane and Superfund fees

How IRA Funds Will be Spent

So how will the $750 billion raised via savings and new revenue be spent? Here is a brief overview of initiatives included in the IRA (please note that the numbers are estimates from the Joint Committee on Taxation and the Congressional Budget Office):

  1. Climate & Energy Spending ($369 billion)
    1. Creation of new clean manufacturing tax credits
    2. Establishment of additional clean electricity grants and loans
    3. Creation of a new “Clean Energy Technology Accelerator”
    4. Incentivization of clean agriculture
    5. Incentivization of clean electronic vehicle manufacturing
    6. Additional energy and climate provisions
  2. Healthcare Spending ($64 Billion)
    1. A three-year extension of Obamacare subsidies for health care insurance costs
    2. A redesign of Medicare Part D and additional health care provisions
  3. IRS Funding
    1. Funding for increased IRS enforcement (namely, to enhance IT systems and compensate specialized employees—for more details, read IRS Commissioner Charles Rettig’s letter on the intended use of funding and plans for enforcement)
  4. Other Spending
    1. Reducing the Federal deficit ($300+ billion)

What’s Next?

Please be assured that your FIRM accounting advisors are keeping a close watch on the progress of the IRA and how it will impact your particular situation. You can reach out to your advisor if you have any specific questions regarding the new law.

Sources

  1. https://www.washingtonpost.com/us-policy/2022/07/28/manchin-schumer-climate-deal/
  2. https://finance.yahoo.com/news/inflation-reduction-act-how-a-new-bill-would-lower-costs-for-americans-200724803.html
  3. https://www.whitehouse.gov/briefing-room/speeches-remarks/2022/07/28/remarks-by-president-biden-on-the-inflation-reduction-act-of-2022/
  4. https://www.vox.com/policy-and-politics/23282983/inflation-reduction-act-kyrsten-sinema-josh-gottheimer
  5. https://www.cnn.com/2022/08/07/politics/senate-democrats-climate-health-care-bill-vote/index.html
  6. https://www.democrats.senate.gov/imo/media/doc/inflation_reduction_act_one_page_summary.pdf
  7. https://abcnews.go.com/Politics/senate-democrats-pass-climate-tax-health-care-bill/story?id=88067862

 

 

Don’t Overlook Your Charitable Contributions

Your charitable contributions include a wide variety of tax-saving opportunities, some you may not be aware of, and some that are frequently overlooked. And there are some contributions that you may believe are deductible that really are not. Being knowledgeable of what is and is not a qualified charity, a qualified charitable contribution, and charitable giving strategies can go a long way toward maximizing your charitable tax deduction.

To be deductible the contributions must be made to qualified charitable organizations, which generally only include U.S. nonprofit groups that are religious, charitable, educational, scientific, or literary in purpose or that work to prevent cruelty to children or animals. You can ask any organization whether it is a qualified organization, and most will be able to tell you. You can also check by going to IRS.gov/TEOS. This online tool will enable you to search for qualified organizations.

Also, to be able to deduct charitable contributions, one must itemize their deductions. This means that to achieve any tax benefit from your charitable donations, you cannot use the standard deduction, which for example is $12,950 for those filing single, $19,400 filing head of household, and $25,900 for married individuals filing jointly for 2022. The standard deduction is adjusted annually for inflation.

If the total of all your itemized deductions does not exceed the standard deduction amount for the year, then you are better off taking the standard deduction, but in doing so, you will get no tax benefit from your charitable contributions. Congress did revise the law to allow limited amounts of cash contributions made in 2020 and 2021 to be deducted without itemizing, but this was only a temporary provision and doesn’t apply in other years.

Bunching – If your charitable deductions are not enough to bring your itemized deductions greater than your standard deduction, the bunching strategy may work for you. When employing the bunching strategy, a taxpayer essentially doubles up on as many deductions as possible in one year, with the goal of itemizing deductions in one year and then taking the standard deduction in the following year. Because charitable contributions are entirely payable at your discretion, they fit right into the bunching strategy.

For example, if you normally tithe at your church, you could make your normal contributions throughout the current year and then prepay the entire subsequent year’s tithing in a lump sum in December of the current year, thereby doubling up on the church contribution in one year and having no charitable deduction for the church in the next year. Normally, charities are very active with their solicitations during the holiday season, giving you the opportunity to decide whether to make contributions at the end of the current year or simply wait a short time and make them after the end of the year. Be sure you get a receipt or acknowledgment letter from the organization that clearly shows the year when the contribution was made.

As a rule, most taxpayers just wait until tax time to add up their potential deductions and then use the higher standard deduction or their itemized deductions. If you want to be more proactive, here are some strategies that might work for you.

Qualified Charitable Distribution – If you are age 70.5 or older, you can make charitable contributions by transferring funds from your IRA account to a charity, which are referred to as qualified charitable distributions (QCDs). The only hitch here is the funds must be transferred directly from the IRA to the charity, meaning your IRA trustee will have to make the distribution to the charity. The tax rules don’t set a minimum amount that needs to be transferred but your IRA trustee may do so. The maximum of all such transfers is $100,000 per year, per taxpayer. Also, note that distributions to private foundations and donor-advised funds don’t qualify for the QCD.

Thus, this strategy allows you to make a charitable contribution without itemizing deductions; since these distributions are tax-free, you can’t also claim a deduction for them. Even better, QCDs also count toward your minimum required distribution for the year. Because QCDs are nontaxable, your AGI will be lower, and you can benefit from tax provisions that are pegged to AGI, such as the amount of Social Security income that’s taxable and the cost of Medicare B insurance premiums for higher-income taxpayers.

Caution: Any IRA contributions made after reaching age 70.5 can diminish the tax benefits of this strategy. If any post-age 70.5 IRA contributions have been made, consult with this office before employing this strategy.

If you decide to make a QCD, check with your IRA custodian on the IRA’s rules for how to request the QCD and be sure to give the IRA custodian ample time to complete the process if you are making the request toward the end of the year. Always get a written acknowledgment from the charity, for tax-reporting purposes.

Donor-Advised Funds – Contributing to a donor-advised fund is a way to make a large (and generally deductible) charitable contribution in one year and put funds aside to satisfy the donor’s social obligations to make charitable contributions in future years, without incurring the expenses of setting up a private foundation and satisfying annual filing and other private foundation requirements.

While generally considered a tax strategy for those with an unusually high income for the year, donor-advised funds are available to everyone, although most such funds set up through brokerages have minimum donation requirements, often $5,000–$25,000. Although they may bear the donor’s name, donor-advised funds are not separate entities but are mere bookkeeping entries. They are components of a qualified charitable organization. A contribution to a charity’s donor-advised fund may be deductible in the year when it is made if it isn’t considered earmarked for a particular distributee. The charity must fully own the funds and have ultimate control over their distribution. To document the contribution, the taxpayer must get a written acknowledgment from the fund’s sponsoring organization that it has exclusive legal control over the contributed assets. Although the donor can advise the charity, which generally will follow the donor’s recommendations, the donor cannot have the power to select distributees or decide the timing or amounts of distributions. The charity must also ensure that all distributions from the fund are arm’s length and do not directly or indirectly benefit the donor.

Example: Don and Shirley donate $25,000 to a donor-advised fund in one year. The $25,000 can be in the form of cash or even appreciated stock. Don and Shirley get a deduction for the full $25,000 as a charitable contribution on their return for the year of the contribution and can suggest the amounts of distributions from the donor-advised fund that should be made to various charities over a number of years. Thus, Don and Shirley achieve a large charitable contribution in one year that can be used to fund their charitable obligations over several years and can claim the $25,000 as an itemized deduction on their return for the year when they made the donation. They do not get a charitable contribution deduction when the funds are paid out from the fund to the various charities.

Volunteer Expenses – If you volunteered your time for a charity or governmental entity, you probably qualify for some tax breaks. Although no tax deduction is allowed for the value of services performed for a qualified charity or federal, state or local governmental agency, some deductions are permitted for out-of-pocket costs incurred while performing the services. The following are some examples:

  • Away-from-home travel expenses while performing services for a charity, including out-of-pocket round-trip travel costs, taxi fares, and other costs of transportation between the airport or station and hotel, plus 100% of lodging and meals. These expenses are only deductible if there is no significant element of personal pleasure associated with the travel or if your services for a charity do not involve lobbying activities.
  • The cost of entertaining others on behalf of a charity, such as wining and dining a potential large contributor (but the costs of your own entertainment and meals are not deductible).
  • If you use your car or another vehicle while performing services for a charitable organization, you may deduct your actual unreimbursed expenses that are directly attributable to the services, such as gas and oil costs, or you may deduct a flat 14 cents per mile for the charitable use of your car. You may also deduct parking fees and tolls.
  • You can deduct the cost of the uniform you wear when doing volunteer work for the charity, as long as the uniform has no general utility. The cost of cleaning the uniform can also be deducted.

Misconceptions – There are some misconceptions as to what constitutes a charitable deduction, and the following are frequently encountered issues:

  • No deduction is allowed for contributions of cash or property to the extent the donor received a personal benefit from the donation. Often, the IRS attributes at least some (if not total) personal benefit to amounts spent for items like dinner tickets, church school tuition, YMCA dues, raffles, etc. To determine the allowed contribution amount, subtract the FMV of the “personal benefit” item from the cost and deduct the remainder. Most charities now allocate the deductible, non-deductible portions.
  • Taxpayers who have purchased tickets for benefit football games, youth-group car washes, parish pancake breakfasts, school plays, etc., with no intention of attending these events, may think they can deduct the expense as a direct contribution to the sponsoring institution. The IRS does not allow such deductions. On the other hand, if the taxpayer returns the ticket to the organization for resale and does not receive a refund of the cost of the ticket, the entire amount paid for the ticket is deductible.
  • No deduction is allowed for the depreciation of vehicles, computers or other capital assets as a charitable deduction.

    Example: Kathy volunteers as a member of the sheriff’s mounted search and rescue team. As part of volunteering, Kathy is required to provide a horse. Kathy is not allowed to deduct the cost of purchasing her horse or to depreciate the value of her horse. She can, however, deduct uniforms, travel, and other out-of-pocket expenses associated with the volunteer work.

    However, a taxpayer may deduct the cost of maintaining a personally owned asset to the extent that its use is related to providing services for a charity. Thus, for example, a taxpayer is allowed to deduct the fuel, maintenance, and repair costs (but not depreciation or the fair rental value) of piloting his or her plane in connection with volunteer activities for the Civil Air Patrol. Similarly, a taxpayer—such as Kathy in our example, who participated in a mounted posse that is a civilian reserve unit of the county sheriff’s office—could deduct the cost of maintaining a horse (shoeing and stabling).

  • A taxpayer who buys an asset and uses it while performing volunteer services for a charity can’t deduct its cost if he or she retains ownership of it. That’s true even if the asset is used exclusively for charitable purposes.

No charitable deduction is allowed for a contribution of $250 or more unless you substantiate the contribution with a written acknowledgment from the charitable organization (including a government agency). To verify your contribution:

  • Get written documentation from the charity about the nature of your volunteering activity and the need for related expenses to be paid. For example, if you travel out of town as a volunteer, request a letter from the charity explaining why you’re needed at the out-of-town location.
  • You should submit a statement of expenses to the charity if you are paying out of pocket for substantial amounts, preferably with a copy of the receipts. Then, arrange for the charity to acknowledge the amount of the contribution in writing.
  • Maintain detailed records of your out-of-pocket expenses—receipts plus a written record of the time, place, amount, and charitable purpose of the expense.

Household Goods and Used Clothing – One of the most common tax-deductible charitable contributions encountered is that of household goods and used clothing. The major complication of this type of contribution is establishing the dollar value of the contribution. According to the tax code, this is the fair market value (FMV), which is defined as the value that a willing buyer would pay a willing seller for the item. FMV is not always easily determined and varies significantly based upon the condition of the item donated. For example, compare the condition of an article of clothing you purchased and only wore once to that of one that has been worn many times. The almost new one certainly will be worth more, but if the hardly worn item had been purchased a few years ago and has become grossly out of style, the more extensively used piece of clothing could be worth more. In either case, the clothing article is still a used item, so its value cannot be anywhere near as high as the original cost. Determining this value is not an exact science. The IRS recognizes this issue and in some cases requires the value to be established by a qualified appraiser.

Remember that when establishing FMV, any value you claim can be challenged in an audit and that the burden of proof is with you (the taxpayer), not with the IRS. For substantial noncash donations, it might be appropriate for you to visit your charity’s local thrift shop or even a consignment store to get an idea of the FMV of used items. The next big issue is documenting your contribution. Many taxpayers believe that the doorknob hanger left by the charity’s pickup driver is sufficient proof of a donation. Unfortunately, that is not the case, as a United States Tax Court case (Kunkel T.C. Memo 2015-71) pointed out. In that case, the court denied the taxpayer’s charitable contributions, which were based solely upon doorknob hangers left by the drivers who picked up the donated items for the charities. The court stated that “these doorknob hangers are undated; they are not specific to petitioners; they do not describe the property contributed; and they contain none of the other required information.”

Documenting Charitable Contributions – The IRS provides requirements for documenting both cash and non-cash contributions.

Cash Contributions – Taxpayers cannot deduct a cash contribution, regardless of the amount, unless they can document the contribution in one of the following ways:

  1. A bank record that shows the name of the qualified organization, the date of the contribution, and the amount of the contribution. Bank records may include a. A canceled check, b. A bank or credit union statement, or c. A credit card statement.
  2. A receipt (or a letter or other written communication) from the qualified organization showing the name of the organization, the date of the contribution, and the amount of the contribution.
  3. Payroll deduction records.

Cash Contributions of $250 or More – To claim a deduction for a contribution of $250 or more, the taxpayer must have a written acknowledgment of the contribution from the qualified organization that includes the following details:

  • The amount of cash contributed;
  • Whether the qualified organization gave the taxpayer goods or services (other than certain token items and membership benefits) as a result of the contribution, and a description and good faith estimate of the value of any goods or services that were provided (other than intangible religious benefits); and
  • A statement that the only benefit received was an intangible religious benefit if that was the case.

If the acknowledgment does not show the date of the contribution, then the taxpayer must have one of the bank records described above that does show the contribution date. If the acknowledgment includes the contribution date and meets the other tests, it is not necessary to also have other records.

The acknowledgment must be in the taxpayer’s hands before the earlier date the return for the year the contribution was made is filed, or the due date, including extensions, for filing the return.

Noncash Contributions Deductions of Less Than $250 – A taxpayer claiming a noncash contribution with a value under $250 must keep a receipt from the charitable organization that shows:

  1. The name of the charitable organization,
  2.  The date and location of the charitable contribution, and
  3. A reasonably detailed description of the property. The taxpayer is not required to have a receipt if it is impractical to get one (for example, if the property was left at a charity’s unattended drop site).

Noncash Contributions Deductions of At Least $250 But Not More Than $500 – If a taxpayer claims a deduction of at least $250 but not more than $500 for a noncash charitable contribution, he or she must keep an acknowledgment of the contribution from the qualified organization. If the deduction includes more than one contribution of $250 or more, the taxpayer must have either a separate acknowledgment for each donation or a single acknowledgment that shows the total contribution. The acknowledgment(s) must be written and must include:

  1.  The name of the charitable organization,
  2. The date and location of the charitable contribution,
  3. A reasonably detailed description of any property contributed (but not necessarily its value), and
  4. Whether the qualified organization gave the taxpayer any goods or services because of the contribution (other than certain token items and membership benefits).

Noncash Contributions Deductions Over $500 But Not Over $5,000 – If a taxpayer claims a deduction over $500 but not over $5,000 for a noncash charitable contribution, he or she must attach a completed Form 8283 to the income tax return and must provide the same acknowledgment and written records that are required for contributions of at least $250 but not more than $500 (as described above). In addition, the records must also include:

  1. How the property was obtained (for example, purchase, gift, bequest, inheritance, or exchange),
  2. The approximate date the property was obtained or—if created, produced, or manufactured by the taxpayer—the approximate date when the property was substantially completed, and
  3. The cost or other basis, and any adjustments to this basis, for property held for less than 12 months and (if available) the cost or other basis for property held for 12 months or more (this requirement, however, does not apply to publicly traded securities).

If the taxpayer has a reasonable case for not being able to provide information on either the date the property was obtained or the cost basis of the property, he or she can attach a statement of explanation to the return.

Deductions Over $5,000 – These donations require time-sensitive appraisals by a “qualified appraiser” in addition to other documentation. When contemplating such a donation, please call this office for further guidance about the documentation and forms that will be needed.

Caution: The value of similar items of property that are donated in the same year must be combined when determining what level of documentation is needed. Similar items of property are items of the same generic category or type, such as coin collections, paintings, books, clothing, jewelry, privately traded stock, land, and buildings. For example, say you donated $5,300 of used furniture to 3 different charitable organizations during the year (a bedroom set valued at $800, a dining set worth $1,000, and living room furniture worth $3,500). Because the value of the donations of similar property (furniture) exceeds $5,000, you would need to obtain an appraisal of the furniture to satisfy the substantiation requirements—even if you donated the furniture to different organizations and at different times during the year. The IRS has strict rules as to who is considered a qualified appraiser.

Do not include items of de minimis value, such as undergarments and socks, in the deductible amount of your contribution, as they specifically are not allowed.

Please give our office a call if you have questions or would like to develop a charitable contribution strategy.

Will Your Planned Retirement Income Be Enough after Taxes?

That is an important question because the actual money you have to spend when you retire depends upon the after-tax sources of your retirement income. Thus it is important to understand how the various retirement vehicles are taxed. There is significant diversity in taxation since a retiree must consider both Federal and state taxes on retirement income. Of all the states one might consider retiring to, there are eight that have no state income tax. These are Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. However, to make up for no revenue from individual income taxes these states may be funded by other types of taxes, such as property taxes, sales taxes, or excise taxes.

Social Security Benefits – Social Security is probably the leading source of retirement for most retirees, and determining the federal taxation can be somewhat complicated the IRS provides a worksheet. Without using the worksheet we know that no more the 85% of Social Security benefits are subject to federal taxation and in many lower-income situations, none of the Social Security benefits are taxable. The actual calculation involves adding your other income to half of your annual Social Security benefit. If the amount is less than $32,000 for married tax filers or less than $25,000 for single filers in 2022, you will avoid federal taxes on your benefits. However, those filing Married Separate will find that 85% of their Social Security benefits are always taxable.

State Tax – Besides the states that have no state tax, there are 30 that do not tax Social Security benefits, The balance, VT, CT, RI, WV, MO, MN, ND, NE, KS, CO, UT, NM, and MT, tax Social Security benefits based on factors such as age and income or a modified amount. See the Tax Foundation Map.

Roth IRA Retirement Account – Roth IRA contributions are limited to the lesser of earned income or the annual limit which is $6,000 ($7,000 if age 50 or over). With a Roth IRA, a taxpayer gets no tax deduction when contributions are made. However, what the taxpayer gets is tax-free accumulation, and after age 59-½, all distributions are tax-free, including the account earnings, provided the 5-year holding period has been met. Since the earnings are also tax-free once the age and holding period requirements are satisfied, the sooner an individual begins making contributions, the greater the benefits at retirement. However, contributions to Roth IRA are restricted for higher-income taxpayers.

Traditional IRA Retirement Account – Like Roth IRA contributions, traditional IRA contributions are limited to the lesser of earned income or the annual limit which is $6,000 ($7,000 if age 50 or over). Unlike Roth IRAs, generally, contributions are deductible in the year of the contribution. Thus future distributions are fully taxable including the earnings. Where an individual also has a qualified retirement plan, the deductibility is phased out for those with higher incomes. However, they can still make non-deductible contributions, in which case a prorated amount of the distributions will be non-taxable. In addition, individuals can elect to make non-deductible contributions which may be appropriate when an individual intends to subsequently convert the traditional IRA to a Roth IRA as discussed next.

Spousal IRA – Generally, IRA contributions are only allowed for taxpayers who have compensation (the term “compensation” includes wages, tips, bonuses, professional fees, commissions, taxable alimony received, and net income from self-employment). Spousal IRAs are the exception to that rule and allow a non-working or low-earning spouse to contribute to his or her own IRA, otherwise known as a spousal IRA if their spouse has adequate compensation. The maximum amount that a non-working or low-earning spouse can contribute is the same as the limit for a working spouse.

Example: Tony is employed, and his W-2 is $100,000. His wife, Rosa, age 45, has a small income from a part-time job totaling $900. Since her own compensation is less than the contribution limit for the year, she can base her contribution on their combined compensation of $100,900. Thus, Rosa can contribute up to $6,000 to an IRA.

Back-Door Roth IRA – Where a high-income individual would like to contribute to a Roth IRA but cannot because of the high-income limitations, there is a workaround, commonly referred to as a back-door Roth IRA, that will allow funding of a Roth IRA for some individuals. Here is how a back-door Roth IRA works:

  1. First, an individual contributes to a traditional IRA. For higher-income taxpayers who participate in an employer-sponsored retirement plan, a traditional IRA is allowed but is not deductible. Even if all or some portion is deductible, the contribution can be designated as not deductible.
  2. Then, since the law allows an individual to convert a traditional IRA to a Roth IRA without any income limitations, the individual can convert the non-deductible Traditional IRA to a Roth IRA. Since the Traditional IRA was non-deductible, the only tax related to the conversion would be on any appreciation in the value of the Traditional IRA before the conversion is completed.

Potential Pitfall – There is a potential pitfall to the back-door Roth IRA that is often overlooked by investment counselors and taxpayers alike that could result in an unexpected taxable event upon conversion. For distribution or conversion purposes, all IRAs (except Roth IRAs) are considered as one account and any distribution or converted amounts are deemed taken ratably from the deductible and non-deductible portions of the traditional IRA, and the portion that comes from the deductible contributions would be taxable.

This may or not may affect the decision to use the back-door Roth IRA method but does need to be considered prior to making the conversion.

Saver’s Credit – Low- and moderate-income workers can take advantage of a special tax credit that helps them save for retirement and earn a special tax credit. This credit helps offset part of the first $2,000 workers voluntarily contribute to traditional or Roth Individual Retirement Arrangements (IRAs), SIMPLE-IRAs, SEPs, 401(k) plans, 403(b) plans for employees of public schools and certain tax-exempt organizations, 457 plans for state or local government employees, and the Thrift Savings Plan for federal employees.

Employer Pensions – Generally, since employer pension plans are fully funded by the employer, pension payments will be fully taxable.

Employee Funded Retirement Plans – These include plans such as 401(k) plans, 403(b) plans, self-employed plans, and SEP IRAs. Since these plans are funded with pre-tax dollars the individual receives a current tax deduction (income deferral); thus, the income and accumulated earnings will be taxable when withdrawn for retirement, after reaching age 59½ or later.

Health Savings Accounts (HSA) – Although the tax code refers to these plans as “health” savings accounts, an HSA can act as more than just a vehicle to pay medical expenses; it can also serve as a retirement account. For some taxpayers who have maxed out their retirement plan options, an HSA provides another resource for retirement savings—one that isn’t limited by income restrictions in the way that IRA contributions are.

Since there is no requirement that the funds be used to pay medical expenses, a taxpayer can pay medical expenses with other funds, allowing the HSA to grow (through account earnings and further tax-deductible contributions) until retirement. In addition, should the need arise, the taxpayer can still take tax-free distributions from the HSA to pay medical expenses. Unlike traditional IRAs, no minimum distributions are required from HSAs at any specific age.

Withdrawals from an HSA that aren’t used for medical expenses are taxable and subject to a 20% penalty, with one exception: an individual age 65 or older will pay income tax on non-medical related distributions from their HSA but won’t owe a penalty for using the funds for other than medical expenses.

Example: Henry, age 70, has an HSA account from which he withdraws $10,000 during the year. He also has unreimbursed medical expenses of $4,000. Of his $10,000 withdrawal, $6,000 ($10,000 – $4,000) is added to Henry’s income for the year, and the other $4,000 is both tax- and penalty-free. If Henry had been 64 years old or younger, he’d be taxed on the $6,000 and pay a penalty of $1,200 (20% of $6,000).

Brokerage Accounts – Some individuals invest in stocks and mutual funds for their future retirement. These investments, if held more than a year, will produce long-term gains or losses. Long-term gains are taxed at zero, 15% or 20% depending on the individual’s total income for the year. However, investments held for less than a year will be taxed as ordinary income (taxed at the individual’s regular tax rate, which could be as high as 37%). In addition, a surtax may apply on the individual’s investment income. It is 3.8% of the lesser of the taxpayer’s net investment income or the excess of their modified adjusted gross income over $250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 for all others.

Bond Investments – Those who are approaching retirement or have already retired may wish to switch their retirement investments into less uncertain investments since they may not have the longevity to stay the course for recovery. Bonds provide a safer alternative. Generally, income from municipal bonds is exempt from taxation for federal purposes. In addition, interest earned from municipal bonds issued by an individual’s home state is also exempt from state income taxes.

Home Equity – Provided a retiree has not used up their home equity, that equity can provide a source of retirement income by selling the home and taking advantage of the home gain exclusion of $500,000 for married couples ($250,000 for others). They can do this by downsizing or selling and renting. To qualify for the exclusion the individual must have owned and lived in the home for at least two out of the last five years before the sale. For married taxpayers filing jointly, both spouses must have used the home as their main residence for two of the five years before the sale, while only one spouse needs to be the owner for two of the five years.

Reverse Mortgage – As an alternative to selling the home, homeowners aged 62 and older can stay in their home while converting the home equity via a reverse mortgage. With a reverse mortgage, the lender pays the homeowner rather than the homeowner making payments. In addition, since the payments constitute home equity they are not taxable.

Whole Life Insurance Cash Value – Cash value accumulated in an insurance policy can also provide a source of income during retirement. The income will be tax-free up to the amount that was paid into the policy.

For some individuals, there may be other available sources of retirement income. Please call our office for assistance in your retirement planning.

Divorce and Taxes – What Are the Implications?

This article explains the precautions to take when getting a divorce, and several tax concerns that need to be addressed to ensure that taxes are kept to a minimum and important tax-related decisions are properly made. Five issues to consider in the process of divorce include alimony or support payments, child support, personal residence, pension benefits, and business interests. Each spouse could save thousands on their home, up to $500,000 of avoidable tax, if they owned and used the residence as their principal residence for two of the previous five years. Another issue to consider if getting a divorce is deciding how to file your tax return. For more information on divorce accounting, click the link!

To view this article, click here to access the original content.

Does Your Small Business Have the Right Tech Tools for the Future?

This article explains that the current state of the economy and the Covid-19 pandemic has drastically changed the way consumers behave. It’s extremely important for small businesses to capitalize on digital transformations. A Bill.com survey showed that “75% of SMBs took actions ranging from price changes, new business models, new customer outreach, and new product offerings and services.” The rise of e-commerce is significant, especially for those ages 65 and up, because, by January of 2021, they became the fastest-growing category of e-commerce shoppers. Mobile payment options also soared because of worries over the coronavirus. Digital wallets are not expected to be the main form of payment. For more insight on adaptions for small businesses, click the link!

To view this article, click here to access the original content.

Foreign Income and Tax Reporting Issues

We have a worldwide economy and with that comes a variety of tax issues. Some of these may be relevant to you. The following issues, some of which you may not be aware of, apply to individuals. In addition, some are subject to severe penalties when not complied with.

Non-Resident Alien Spouse

It is becoming more frequent that a U.S. citizen or U.S. resident alien is married to a nonresident alien. In this circumstance the couple has filing options for U.S. tax purposes. Generally, a U.S. citizen or a U.S. resident alien (sometimes referred to as a green card holder) who is married to a nonresident alien must file their U.S. tax return using the filing status Married Filing Separate. This filing status has higher tax rates and certain limitations that do not apply to other filing statuses. The nonresident alien spouse would have to file a nonresident U.S. tax return on any U.S. source income.

However, tax law allows a person who is a nonresident alien at the end of the taxable year, and who is married to a U.S. citizen, or a U.S. resident alien, to be treated as a U.S. resident for income tax purposes and file a Married Filing Joint return, if both spouses so elect. In doing so both spouses must agree to subject their worldwide income for the taxable year to U.S. taxation.

Once made, and as long as one of the spouses is a U.S. citizen or resident alien, the election applies for the election year and all future years until it is terminated. If the election is terminated, neither spouse is eligible to make the election for any subsequent tax year.

Making this election requires a careful analysis of the tax ramifications of combining incomes, not only for the current year but all future years. Also, the couple could be subject to an FBAR filing requirement discussed later.

Foreign Rentals

Generally, foreign rental property is reported on the U.S. tax return in the same manner as a domestic rental. However, there are some differences in rental depreciation. For residential property, if the property were in the U.S. the depreciable recovery period would be 27.5 years but for a foreign rental the recovery period would be 30 years straight line. Similarly, for commercial rentals 40 years instead of 39.5.

The passive loss rules apply to a foreign rental in the same manner as a domestic rental so any consolidated net losses are limited to $25,000 but this limit is reduced (phases out) for taxpayers with an adjusted gross income (AGI) between $100,000 and $150,000.

If the landlord hires a non-resident alien in the foreign country to perform services related to the foreign rental activity, there are no U.S. reporting or withholding requirements. However, the foreign person providing those services should complete Form W-8BEN and return it to the landlord as proof that the individual is not subject to U.S. taxation.

Last, but not least, if a foreign bank account is maintained to receive rental income and disperse rental expense payments, and the owner of the property has signature or other authority over the account, then there may be an FBAR reporting requirement discussed later.

Foreign Pensions

A foreign pension or annuity distribution is a payment from a pension plan or retirement annuity received from a source outside the United States such as a:

  • foreign employer;
  • trust established by a foreign employer;
  • foreign government or one of its agencies (including a foreign social security pension);
  • foreign insurance company;
  • foreign trust or other foreign entity designated to pay the annuity.

Just as with domestic pensions or annuities, the taxable amount generally is the gross distribution minus the cost (investment in the contract) unless there is a tax treaty provision covering the taxation of the pension.

Another issue is whether the pension is taxable to the U.S., the individual’s country of residence, other country or the pension’s country of origin. This is commonly determined by the tax treaty between the U.S. and the country of origin. Generally, most tax treaties allow the country of residence to tax the pension or annuity under its domestic laws. This is true unless a special treaty provision specifically amends that treatment.

The following are some commonly encountered treaty provisions:

  • Canada – Canadian Old Age Security (OAS) pensions and Canada/Quebec Pension Plan (CPP/QPP) benefits received by U.S. residents are treated for tax purposes as if they were U.S. Social Security payments. U.S Social Security benefits received by a Canadian resident are taxable to Canada. Beneficiaries of a Canadian RRSP, RRIF, Registered Pension Plan, or deferred profit-sharing plan are taxable to the U.S. if the recipient is a U.S. Resident.
  • United Kingdom – UK pensions received by a U.S. resident are taxable to the U.S. and U.S. pensions received by a resident of the UK are taxable to the UK. Each country can only tax the amount that would have been taxed in the other country.

CAUTION: These treaty provisions are with the U.S. Federal government and not with the individual states. Consult the individual state’s rules.

Foreign Income Exclusion

U.S. citizens and resident aliens are taxed on their worldwide income, whether they live inside or outside of the U.S. However, qualifying U.S. citizens and resident aliens who live and work abroad may be able to exclude from their income all or part of their foreign salary or wages, or amounts received as compensation for their personal services. In addition, they may also qualify to exclude or deduct certain foreign housing costs.

To qualify for the foreign earned income exclusion, a U.S. citizen or resident alien must:

  • Have foreign earned income (income received for working in a foreign country, including payroll disbursements from a U.S. employer and self-employment income);
  • Have a tax home in a foreign country; and
  • Meet either the bona fide residence test or the physical presence test.

The foreign earned income exclusion amount is adjusted annually for inflation. For 2021, the maximum is $108,700 ($112,000 for 2022) per qualifying person. If the taxpayers are married and both spouses (1) work abroad and (2) meet either the bona fide residence test or the physical presence test, each one can choose the foreign earned income exclusion. Together, they can exclude as much as $217,400 for the 2021 tax year ($224,000 for 2022), but if one spouse uses less than 100% of his or her exclusion, the unused amount cannot be transferred to the other spouse.

In addition to the foreign earned income exclusion, qualifying individuals may also choose to exclude or deduct a foreign housing amount from their foreign earned income. The amount of qualified housing expenses eligible for the housing exclusion and housing deduction is generally limited to 30% of the maximum foreign earned income exclusion. The housing amount limitation is $32,610 for the 2021 tax year ($33,600 for 2022).

Generally, to qualify, most individuals use the physical presence test which requires the taxpayer to be physically present in a foreign country for 330 full days during a consecutive 12-month period (not a calendar year). Where the 330-day period overlaps two years the exclusion is prorated for each year.

Foreign Account Reporting Requirements (FBAR)

All United States entities (including citizens and resident aliens as well as corporations, partnerships, and trusts) with financial interests in or authority over one or more foreign financial accounts (e.g., bank accounts and securities) need to report these relationships to the U.S. Treasury if the aggregate value of those accounts exceeds $10,000 at any time during the year. Failure to file the required forms can result in severe penalties.

The U.S. government wants this information for a couple of pretty obvious reasons. One, foreign financial institutions may not have the same reporting requirements as U.S.-based financial institutions. For example, they probably won’t issue the 1099 forms to report interest, dividends and sales of stock. By requiring those in the U.S. to divulge their foreign account holdings, the IRS can more easily cross-check to see if foreign income is being reported on the individual’s tax return. The second (and probably more significant) reason is that the information in the report can be used to identify or trace funds used for illegal purposes or to identify unreported income maintained or generated overseas.

This reporting requirement is not included with a tax return but is a separate filing with the U.S. Treasury’s Financial Crimes Enforcement Network. The due date of the report is the same as the April filing date for individual tax returns, April 18, 2022, for 2021 returns (except for residents of Maine and Massachusetts where the due date is April 19, 2022), and there is an automatic extension to the October individual extended due date, October 17, 2022, for 2021 returns.

A civil penalty of up to $10,000 may be imposed for a non-willful failure to report; the penalty for a willful violation is the greater of $100,000 or 50% of the account’s balance at the time of the violation. Both the $10,000 and $100,000 amounts are subject to inflation adjustment, which, as of January 24, 2022, brings them to $14,489 and $144,886, respectively. A willful violation is also subject to criminal prosecution, which can result in a fine of up to $250,000 and jail time of up to five years.

CAUTION: On Schedule B of the Form 1040 tax return, you must state whether you have a financial interest in or signature authority over one or more foreign financial accounts. If you answer yes but don’t file the FBAR, your failure to file may be considered willful, which could subject you to the larger fine and jail time.

You may have an FBAR requirement and not even realize it. For instance, say that you have relatives in a foreign country who have put your name on their bank account in case of an emergency; if the value of that account exceeds $10,000 at any time during the year, you will need to file the FBAR. The same would be true if your name was added to several of your foreign relatives’ smaller-value accounts that add up to more than $10,000 at any time during the year. As another example, if you gamble at an online casino that is located in a foreign country and your account exceeds the $10,000 limit at any time during the year, you will need to file the FBAR.

Statement of Specified Foreign Financial Assets

You may also have to file IRS Form 8938, which is similar to the FBAR but applies to a wider range of foreign assets and has a higher dollar threshold. This form is filed with your income tax return. If you are married and filing jointly, you must file Form 8938 if the value of your foreign financial assets exceeds $100,000 at the end of the year or $150,000 at any time during the year. If you live abroad, these thresholds are $400,000 and $600,000, respectively. For other filing statuses, the thresholds are half of the amounts above. The penalty for failing to file Form 8938 is $10,000 per year; if the failure continues for more than 90 days after the IRS provides notice of your failure to file, the penalty can be as high $50,000.

Credit for Foreign Tax Paid

With the worldwide economy we are all living in, more and more individuals are making investments in foreign countries, and may pay a foreign tax on their foreign earnings. These earnings are also taxable to the U.S. To compensate for potentially being taxed twice on the same income, the U.S. allows a tax credit, or an itemized deduction if the taxpayer itemizes their deductions, for the foreign income taxes paid. CAUTION: if you are a partner in a partnership or a shareholder in an S corporation you should contact your managing partner or shareholder before filing a Form 1116 to claim a foreign tax credit. Filing the Form 1116 on your 1040 or 1040-SR can have ramifications related to the filing of the partnership or S corporation tax returns.

Reporting Receipt of Foreign Gifts or Bequests

Foreign gifts or bequests received by a U.S. person, other than an exempt organization, must be reported to the federal government on Form 3520 if the gift exceeds $100,000 from a nonresident alien individual or a foreign estate, including foreign persons related to that nonresident alien individual or foreign estate.

In addition, amounts more than $16,815 for 2021 ($16,649 in 2020 and $17,339 for 2022) from foreign corporations or foreign partnerships, including foreign persons related to such foreign corporations or foreign partnerships, that are treated as gifts must be reported on the Form 3520.

Reporting Ownership or Transactions with Foreign Trusts

Form 3520 is also used to report ownership in a foreign trust or transactions carried out with a foreign trust. Failure to file Form 3520 or providing incomplete or incorrect information can be subject to some severe penalties.

Annual Information Return for Foreign Trust with U.S. Owner

A foreign trust with a U.S. owner must file Form 3520-A in order for the U.S. owner to satisfy its annual information reporting requirements. Each U.S. person treated as an owner of any portion of a foreign trust is responsible for ensuring that the foreign trust files Form 3520-A and furnishes the required annual statements to its U.S. owners and U.S. beneficiaries.

Ownership or Voting Power in Foreign Corporation

Generally, a U.S. citizen or resident alien (or one who files a joint return with a U.S. citizen or resident alien) who owns a 10% or more interest in a foreign corporation or commands control over more than 50% of the voting power in a foreign corporation must file Form 5471.

Please contact our office if any of the discussed issues might apply to you so we can help you take advantage of the benefits and comply with the reporting requirements.

Changes to Bonus Depreciation Rules

This article explains that bonus depreciation rules have been changed over several years. In 2016 and 2017, under the IRS Revenue Proclamation (Rev. Proc.) 2019-33, Section 5.02 Section – Deemed Election states: “a taxpayer that timely filed its federal tax return for the 2016 taxable year or the 2017 taxable year also will be treated as making the §168(k)(7) election for a class of property that is qualified property acquired after September 27, 2017 by the taxpayer and placed in service by the taxpayer during its 2016 taxable year.” For 2018, 2019, or 2020, “there was no deemed election out of bonus depreciation for these years. If the taxpayer failed to take bonus depreciation and qualified, then they are using an impermissible method.” In 2021, “As final regulations specify, the election out has to be made on your original return. If you missed bonus depreciation and discovered it in a later year, you can amend it if you catch it in 2022. If you catch it in 2023 or later, file 3115 under Rev. Proc. 2015-13.” To gain further knowledge on these updates on bonus depreciation in cost segregation, click the link!

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