Potential Tax Savings if Your Vacation Home Qualifies as a Rental Property

Do you own a vacation home? If you both rent it out and use it personally, you might save tax by taking steps to ensure it qualifies as a rental property this year. Vacation home expenses that qualify as rental property expenses aren’t subject to the Tax Cuts and Jobs Act’s (TCJA’s) new limit on the itemized deduction for state and local taxes (SALT) or the lower debt limit for the itemized mortgage interest deduction.

Rental or personal property?

If you rent out your vacation home for 15 days or more, what expenses you can deduct depends on how the home is classified for tax purposes, based on the amount of personal vs. rental use:

Rental property. If you (or your immediate family) use the home for 14 days or less, or under 10% of the days you rent out the property, whichever is greater, the IRS will classify the home as a rental property. You can deduct rental expenses, including losses, subject to the real estate activity rules.

Your deduction for property tax attributable to the rental use of the home isn’t subject to the TCJA’s new SALT deduction limit. And your deduction for mortgage interest on the home isn’t subject to the debt limit that applies to the itemized deduction for mortgage interest. You can’t deduct any interest that’s attributable to your personal use of the home, but you can take the personal portion of property tax as an itemized deduction (subject to the new SALT limit).

Nonrental property. If you (or your immediate family) use the home for more than 14 days or 10% of the days you rent out the property, whichever is greater, the IRS will classify the home as a personal residence. You can deduct rental expenses only to the extent of your rental income. Any excess can be carried forward to offset rental income in future years.

If you itemize deductions, you also can deduct the personal portion of both property tax and mortgage interest, subject to the TCJA’s new limits on those deductions. The SALT deduction limit is $10,000 for the combined total of state and local property taxes and either income taxes or sales taxes ($5,000 for married taxpayers filing separately). For mortgage interest debt incurred after December 15, 2017, the debt limit (with some limited exceptions) has been reduced to $750,000.

Be aware that many taxpayers who have itemized in the past will no longer benefit from itemizing because of the TCJA’s near doubling of the standard deduction. Itemizing saves tax only if total itemized deductions exceed the standard deduction for the taxpayer’s filing status.

Year-to-date review

Keep in mind that, if you rent out your vacation home for less than 15 days, you don’t have to report the income. But expenses associated with the rental (such as advertising and cleaning) won’t be deductible.

Now is a good time to review your vacation home use year-to-date to project how it will be classified for tax purposes. By increasing the number of days you rent it out and/or reducing the number of days you use it personally between now and year end, you might be able to ensure it’s classified as a rental property and save some tax. But there also could be circumstances where personal property treatment would be beneficial. Please contact us to discuss your particular situation.

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How to Reduce the Tax Risk of Using Independent Contractors

Classifying a worker as an independent contractor frees a business from payroll tax liability and allows it to forgo providing overtime pay, unemployment compensation and other employee benefits. It also frees the business from responsibility for withholding income taxes and the worker’s share of payroll taxes.

For these reasons, the federal government views misclassifying a bona fide employee as an independent contractor unfavorably. If the IRS reclassifies a worker as an employee, your business could be hit with back taxes, interest and penalties.

Key factors

When assessing worker classification, the IRS typically looks at the:

Level of behavioral control. This means the extent to which the company instructs a worker on when and where to do the work, what tools or equipment to use, whom to hire, where to purchase supplies and so on. Also, control typically involves providing training and evaluating the worker’s performance. The more control the company exercises, the more likely the worker is an employee.

Level of financial control. Independent contractors are more likely to invest in their own equipment or facilities, incur unreimbursed business expenses, and market their services to other customers. Employees are more likely to be paid by the hour or week or some other time period; independent contractors are more likely to receive a flat fee.

Relationship of the parties. Independent contractors are often engaged for a discrete project, while employees are typically hired permanently (or at least for an indefinite period). Also, workers who serve a key business function are more likely to be classified as employees.

The IRS examines a variety of factors within each category. You need to consider all of the facts and circumstances surrounding each worker relationship.

Protective measures

Once you’ve completed your review, there are several strategies you can use to minimize your exposure. When in doubt, reclassify questionable independent contractors as employees. This may increase your tax and benefit costs, but it will eliminate reclassification risk.

From there, modify your relationships with independent contractors to better ensure compliance. For example, you might exercise less behavioral control by reducing your level of supervision or allowing workers to set their own hours or work from home.

Also, consider using an employee-leasing company. Workers leased from these firms are employees of the leasing company, which is responsible for taxes, benefits and other employer obligations.

Handle with care

Keep in mind that taxes, interest and penalties aren’t the only possible negative consequences of a worker being reclassified as an employee. In addition, your business could be liable for employee benefits that should have been provided but weren’t. Fortunately, careful handling of contractors can help ensure that independent contractor status will pass IRS scrutiny. Contact us if you have questions about worker classification.

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Do you need to make an estimated tax payment by September 17?

To avoid interest and penalties, you must make sufficient federal income tax payments long before your April filing deadline through withholding, estimated tax payments, or a combination of the two. The third 2018 estimated tax payment deadline for individuals is September 17.

If you don’t have an employer withholding tax from your pay, you likely need to make estimated tax payments. But even if you do have withholding, you might need to pay estimated tax. It can be necessary if you have more than a nominal amount of income from sources such as self-employment, interest, dividends, alimony, rent, prizes, awards or the sales of assets.

A two-prong test

Generally, you must pay estimated tax for 2018 if both of these statements apply:

1. You expect to owe at least $1,000 in tax after subtracting tax withholding and credits, and

2. You expect withholding and credits to be less than the smaller of 90% of your tax for 2018 or 100% of the tax on your 2017 return — 110% if your 2017 adjusted gross income was more than $150,000 ($75,000 for married couples filing separately).

If you’re a sole proprietor, partner or S corporation shareholder, you generally have to make estimated tax payments if you expect to owe $1,000 or more in tax when you file your return.

Quarterly payments

Estimated tax payments are spaced through the year into four periods or due dates. Generally, the due dates are April 15, June 15 and September 15 of the tax year and January 15 of the next year, unless the date falls on a weekend or holiday (hence the September 17 deadline this year).

Estimated tax is calculated by factoring in expected gross income, taxable income, deductions and credits for the year. The easiest way to pay estimated tax is electronically through the Electronic Federal Tax Payment System. You can also pay estimated tax by check or money order using the Estimated Tax Payment Voucher or by credit or debit card.

Confirming withholding

If you determine you don’t need to make estimated tax payments for 2018, it’s a good idea to confirm that the appropriate amount is being withheld from your paycheck. To reflect changes under the Tax Cuts and Jobs Act (TCJA), the IRS updated the tables that indicate how much employers should withhold from their employees’ pay, generally reducing the amount withheld.

The new tables might cause some taxpayers to not have enough withheld to pay their ultimate tax liabilities under the TCJA. The IRS has updated its withholding calculator (available at irs.gov) to assist taxpayers in reviewing their situations.

Avoiding penalties

Keep in mind that, if you underpaid estimated taxes in earlier quarters, you generally can’t avoid penalties by making larger estimated payments in later quarters. But if you also have withholding, you may be able to avoid penalties by having the estimated tax shortfall withheld.

To learn more about estimated tax and withholding — and for help determining how much tax you should be paying during the year —  contact us.

© 2018

Back-to-School Time Means a Tax Break for Teachers

31When teachers are setting up their classrooms for the new school year, it’s common for them to pay for a portion of their classroom supplies out of pocket. A special tax break allows these educators to deduct some of their expenses. This educator expense deduction is especially important now due to some changes under the Tax Cuts and Jobs Act (TCJA).

The old miscellaneous itemized deduction

Before 2018, employee expenses were potentially deductible if they were unreimbursed by the employer and ordinary and necessary to the “business” of being an employee. A teacher’s out-of-pocket classroom expenses could qualify.

But these expenses had to be claimed as a miscellaneous itemized deduction and were subject to a 2% of adjusted gross income (AGI) floor. This meant employees, including teachers, could enjoy a tax benefit only if they itemized deductions (rather than taking the standard deduction) and all their deductions subject to the floor, combined, exceeded 2% of their AGI.

Now, for 2018 through 2025, the TCJA has suspended miscellaneous itemized deductions subject to the 2% of AGI floor. Fortunately, qualifying educators can still deduct some of their unreimbursed out-of-pocket classroom costs under the educator expense deduction.

The above-the-line educator expense deduction

Back in 2002, Congress created the above-the-line educator expense deduction because, for many teachers, the 2% of AGI threshold for the miscellaneous itemized deduction was difficult to meet. An above-the-line deduction is one that’s subtracted from your gross income to determine your AGI.

You don’t have to itemize to claim an above-the-line deduction. This is especially significant with the TCJA’s near doubling of the standard deduction, which means fewer taxpayers will benefit from itemizing.

Qualifying elementary and secondary school teachers and other eligible educators (such as counselors and principals) can deduct up to $250 of qualified expenses. If you’re married filing jointly and both you and your spouse are educators, you can deduct up to $500 of unreimbursed expenses — but not more than $250 each.

Qualified expenses include amounts paid or incurred during the tax year for books, supplies, computer equipment (including related software and services), other equipment and supplementary materials that you use in the classroom. For courses in health and physical education, the costs of supplies are qualified expenses only if related to athletics.

Many rules, many changes

Some additional rules apply to the educator expense deduction. Contact us for more details or to discuss other tax deductions that may be available to you this year. The TCJA has made significant changes to many deductions for individuals.

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Choosing the Right Accounting Method for Tax Purposes

The Tax Cuts and Jobs Act (TCJA) liberalized the eligibility rules for using the cash method of accounting, making this method — which is simpler than the accrual method — available to more businesses. Now the IRS has provided procedures a small business taxpayer can use to obtain automatic consent to change its method of accounting under the TCJA. If you have the option to use either accounting method, it pays to consider whether switching methods would be beneficial.

Cash vs. accrual

Generally, cash-basis businesses recognize income when it’s received and deduct expenses when they’re paid. Accrual-basis businesses, on the other hand, recognize income when it’s earned and deduct expenses when they’re incurred, without regard to the timing of cash receipts or payments.

In most cases, a business is permitted to use the cash method of accounting for tax purposes unless it’s:

1. Expressly prohibited from using the cash method, or
2. Expressly required to use the accrual method.

Cash method advantages

The cash method offers several advantages, including:

Simplicity. It’s easier and cheaper to implement and maintain.

Tax-planning flexibility. It offers greater flexibility to control the timing of income and deductible expenses. For example, it allows you to defer income to next year by delaying invoices or to shift deductions into this year by accelerating the payment of expenses. An accrual-basis business doesn’t enjoy this flexibility. For example, to defer income, delaying invoices wouldn’t be enough; the business would have to put off shipping products or performing services.

Cash flow benefits. Because income is taxed in the year it’s received, the cash method does a better job of ensuring that a business has the funds it needs to pay its tax bill.

Accrual method advantages

In some cases, the accrual method may offer tax advantages. For example, accrual-basis businesses may be able to use certain tax-planning strategies that aren’t available to cash-basis businesses, such as deducting year-end bonuses that are paid within the first 2½ months of the following year and deferring income on certain advance payments.

The accrual method also does a better job of matching income and expenses, so it provides a more accurate picture of a business’s financial performance. That’s why it’s required under Generally Accepted Accounting Principles (GAAP).

If your business prepares GAAP-compliant financial statements, you can still use the cash method for tax purposes. But weigh the cost of maintaining two sets of books against the potential tax benefits.

Making a change

Keep in mind that cash and accrual are the two primary tax accounting methods, but they’re not the only ones. Some businesses may qualify for a different method, such as a hybrid of the cash and accrual methods.

If your business is eligible for more than one method, we can help you determine whether switching methods would make sense and can execute the change for you if appropriate.

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The Big, Bad Kiddie Tax

Once upon a time, some parents and grandparents would attempt to save tax by putting investments in the names of their young children or grandchildren in lower income tax brackets. To discourage such strategies, Congress created the “kiddie” tax back in 1986. Since then, this tax has gradually become more far-reaching. Now, under the Tax Cuts and Jobs Act (TCJA), the kiddie tax has become more dangerous than ever.

A short history

Years ago, the kiddie tax applied only to children under age 14 — which still provided families with ample opportunity to enjoy significant tax savings from income shifting. In 2006, the tax was expanded to children under age 18. And since 2008, the kiddie tax has generally applied to children under age 19 and to full-time students under age 24 (unless the students provide more than half of their own support from earned income).

What about the kiddie tax rate? Before the TCJA, for children subject to the kiddie tax, any unearned income beyond a certain amount ($2,100 for 2017) was taxed at their parents’ marginal rate (assuming it was higher), rather than their own likely low rate.

A fiercer kiddie tax

The TCJA doesn’t further expand who’s subject to the kiddie tax. But it will effectively increase the kiddie tax rate in many cases.

For 2018–2025, a child’s unearned income beyond the threshold ($2,100 again for 2018) will be taxed according to the tax brackets used for trusts and estates. For ordinary income (such as interest and short-term capital gains), trusts and estates are taxed at the highest marginal rate of 37% once 2018 taxable income exceeds $12,500. In contrast, for a married couple filing jointly, the highest rate doesn’t kick in until their 2018 taxable income tops $600,000.

Similarly, the 15% long-term capital gains rate takes effect at $77,201 for joint filers but at only $2,601 for trusts and estates. And the 20% rate kicks in at $479,001 and $12,701, respectively.

In other words, in many cases, children’s unearned income will be taxed at higher rates than their parents’ income. As a result, income shifting to children subject to the kiddie tax will not only not save tax, but it could actually increase a family’s overall tax liability.

The moral of the story

To avoid inadvertently increasing your family’s taxes, be sure to consider the big, bad kiddie tax before transferring income-producing or highly appreciated assets to a child or grandchild who’s a minor or college student. If you’d like to shift income and you have adult children or grandchildren who’re no longer subject to the kiddie tax but in a lower tax bracket, consider transferring such assets to them.

Please contact us for more information about the kiddie tax — or other TCJA changes that may affect your family.

© 2018

Family Limited Partnerships & Succession Planning

One of the biggest concerns for family business owners is succession planning — transferring ownership and control of the company to the next generation. Often, the best time tax-wise to start transferring ownership is long before the owner is ready to give up control of the business.
A family limited partnership (FLP) can help owners enjoy the tax benefits of gradually transferring ownership yet allow them to retain control of the business.

How it works

To establish an FLP, you transfer your ownership interests to a partnership in exchange for both general and limited partnership interests. You then transfer limited partnership interests to your children.

You retain the general partnership interest, which may be as little as 1% of the assets. But as general partner, you can still run day-to-day operations and make business decisions.

Tax benefits

As you transfer the FLP interests, their value is removed from your taxable estate. What’s more, the future business income and asset appreciation associated with those interests move to the next generation.

Because your children hold limited partnership interests, they have no control over the FLP, and thus no control over the business. They also can’t sell their interests without your consent or force the FLP’s liquidation.

The lack of control and lack of an outside market for the FLP interests generally mean the interests can be valued at a discount — so greater portions of the business can be transferred before triggering gift tax. For example, if the discount is 25%, in 2018 you could gift an FLP interest equal to as much as $20,000 tax-free because the discounted value wouldn’t exceed the $15,000 annual gift tax exclusion.

To transfer interests in excess of the annual exclusion, you can apply your lifetime gift tax exemption. And 2018 may be a particularly good year to do so, because the Tax Cuts and Jobs Act raised it to a record-high $11.18 million. The exemption is scheduled to be indexed for inflation through 2025 and then drop back down to an inflation-adjusted $5 million in 2026. While Congress could extend the higher exemption, using as much of it as possible now may be tax-smart.

There also may be income tax benefits. The FLP’s income will flow through to the partners for income tax purposes. Your children may be in a lower tax bracket, potentially reducing the amount of income tax paid overall by the family.

FLP risks

Perhaps the biggest downside is that the IRS scrutinizes FLPs. If it determines that discounts were excessive or that your FLP had no valid business purpose beyond minimizing taxes, it could assess additional taxes, interest and penalties.

The IRS pays close attention to how FLPs are administered. Lack of attention to partnership formalities, for example, can indicate that an FLP was set up solely as a tax-reduction strategy.

Right for you?

An FLP can be an effective succession and estate planning tool, but it isn’t risk free. Please contact us for help determining whether an FLP is right for you.

© 2018

Do you qualify for the home-office deduction?

Under the Tax Cuts and Jobs Act, employees can no longer claim the home office deduction. If, however, you run a business from your home or are otherwise self-employed and use part of your home for business purposes, the home office deduction may still be available to you.

Home-related expenses

Homeowners know that they can claim itemized deductions for property tax and mortgage interest on their principal residences, subject to certain limits. Most other home-related expenses, such as utilities, insurance and repairs, aren’t deductible.

But if you use part of your home for business purposes, you may be entitled to deduct a portion of these expenses, as well as depreciation. Or you might be able to claim the simplified home office deduction of $5 per square foot, up to 300 square feet ($1,500).

Regular and exclusive use

You might qualify for the home office deduction if part of your home is used as your principal place of business “regularly and exclusively,” defined as follows:

1. Regular use. You use a specific area of your home for business on a regular basis. Incidental or occasional business use is not regular use.

2. Exclusive use. You use the specific area of your home only for business. It’s not necessary for the space to be physically partitioned off. But, you don’t meet the requirements if the area is used both for business and personal purposes, such as a home office that also serves as a guest bedroom.

Regular and exclusive business use of the space aren’t, however, the only criteria.

Principal place of business

Your home office will qualify as your principal place of business if you 1) use the space exclusively and regularly for administrative or management activities of your business, and 2) don’t have another fixed location where you conduct substantial administrative or management activities.

Examples of activities that are administrative or managerial in nature include:

  • Billing customers, clients or patients,
  • Keeping books and records,
  • Ordering supplies,
  • Setting up appointments, and
  • Forwarding orders or writing reports.

Meetings or storage

If your home isn’t your principal place of business, you may still be able to deduct home office expenses if you physically meet with patients, clients or customers on your premises. The use of your home must be substantial and integral to the business conducted.

Alternatively, you may be able to claim the home office deduction if you have a storage area in your home — or in a separate free-standing structure (such as a studio, workshop, garage or barn) — that’s used exclusively and regularly for your business.

Valuable tax-savings

The home office deduction can provide a valuable tax-saving opportunity for business owners and other self-employed taxpayers who work from home. If you’re not sure whether you qualify or if you have other questions, please contact us.

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401(k) Hardship Withdrawals

Many employers sponsor 401(k) plans to help employees save for retirement, but sometimes those employees need access to plan funds well before they retire. In such cases, if the plan allows it, participants can make a hardship withdrawal.

If your organization sponsors a 401(k) with this option, you should know that there are important changes on the way next year.

What will be different

Right now, 401(k) hardship withdrawals are limited to only funds an employee has contributed, and the employee must first take out a plan loan from the account. The employee also cannot participate in the plan for six months after a hardship withdrawal.

However, important changes take effect in 2019 under the Bipartisan Budget Act of 2018 (BBA). First, employees’ withdrawal limits will include not only their own contributed amounts, but also accumulated employer matching contributions plus earnings on contributions. If an employee has been participating in your 401(k) for several years, this could add substantially to the amount of funds available for withdrawal in the event of a legitimate hardship.

In addition, the BBA eliminates the current six-month ban on employee participation in the 401(k) plan following a hardship withdrawal. This means employees can stay in the plan and keep contributing, which allows them to begin recouping withdrawn amounts right away. And, for you, the plan sponsor, it means no longer having to re-enroll employees in the 401(k) after the six-month hiatus.

What remains the same

Some things haven’t changed. Hardship withdrawals are still subject to a 10% tax penalty, along with regular income tax. This combination could take a substantial bite out of the amount withdrawn, effectively forcing account holders to take out more dollars than they otherwise would have to, so as to wind up with the same net amount.

The BBA also didn’t change the reasons for which hardship withdrawals can be made. According to the IRS, such a withdrawal “must be made because of an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need.” This can include the need of an employee’s spouse or dependent, as well as that of a nonspouse, nondependent beneficiary.

The agency has said that the meaning of “immediate and heavy” depends on the facts of the situation and assumes the employee doesn’t have any other way to meet the need.

Examples offered by the IRS include:

  • Qualified medical expenses
  • Tuition and related educational fees and expenses
  • Burial or funeral expenses

The agency has also cited costs related to a principal residence as usually qualifying. These include expenses related to the purchase of a principal residence, its repair after significant damage, and costs necessary to prevent eviction or foreclosure.

Further guidance

If your organization sponsors a 401(k) plan that permits hardship withdrawals, be sure to read up on all the details related to the BBA’s changes. Our firm can provide more information and further guidance.

© 2018

What can you deduct when volunteering?

Because donations to charity of cash or property generally are tax deductible (if you itemize), it only seems logical that the donation of something even more valuable to you — your time — would also be deductible. Unfortunately, that’s not the case.

Donations of time or services aren’t deductible. It doesn’t matter if it’s simple administrative work, such as checking in attendees at a fundraising event, or if it’s work requiring significant experience and expertise that would be much more costly to the charity if it had to pay for it, such as skilled carpentry or legal counsel.

However, you potentially can deduct out-of-pocket costs associated with your volunteer work.

The basic rules

As with any charitable donation, for you to be able to deduct your volunteer expenses, the first requirement is that the organization be a qualified charity. You can use the IRS’s “Tax Exempt Organization Search” tool (formerly “Select Check”) at http://bit.ly/2KXWl5b to find out.

Assuming the charity is qualified, you may be able to deduct out-of-pocket costs that are:

  • Unreimbursed,
  • Directly connected with the services you’re providing,
  • Incurred only because of your charitable work, and
  • Not “personal, living or family” expenses.

Supplies, uniforms and transportation

A wide variety of expenses can qualify for the deduction. For example, supplies you use in the activity may be deductible. And the cost of a uniform you must wear during the activity may also be deductible (if it’s required and not something you’d wear when not volunteering).

Transportation costs to and from the volunteer activity generally are deductible, either the actual cost or 14 cents per charitable mile driven. But you have to be the volunteer. If, say, you drive your elderly mother to the nature center where she’s volunteering, you can’t deduct the cost.

You also can’t deduct transportation costs you’d be incurring even if you weren’t volunteering. For example, if you take a commuter train downtown to work, then walk to a nearby volunteer event after work and take the train back home afterwards, you won’t be able to deduct your train fares. But if you take a cab from work to the volunteer event, then you potentially can deduct the cab fare for that leg of your transportation.

Volunteer travel

Transportation costs may also be deductible for out-of-town travel associated with volunteering. This can include air, rail and bus transportation; driving expenses; and taxi or other transportation costs between an airport or train station and wherever you’re staying. Lodging and meal costs also might be deductible.

The key to deductibility is that there is no significant element of personal pleasure, recreation or vacation in the travel. That said, according to the IRS, the deduction for travel expenses won’t be denied simply because you enjoy providing services to the charitable organization. But you must be volunteering in a genuine and substantial sense throughout the trip. If only a small portion of your trip involves volunteer work, your travel expenses generally won’t be deductible.

Keep careful records

The IRS may challenge charitable deductions for out-of-pocket costs, so it’s important to keep careful records. If you have questions about what volunteer expenses are and aren’t deductible, please contact us.

© 2018