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CHAPTER 3

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CHAPTER 3

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  1. CHAPTER 3 Business Expenses & Retirement Plans

  2. Objective Be familiar with the tax rules for rental property and vacation homes

  3. Rental Income/Expenses • Net Rental Income or Loss is part of Gross Income • Report on Schedule E • Vacation Homes - must allocate expenses, if both personal and rental use of residence • Residence defined as anything providing shelter and accommodations for eating/sleeping (therefore ‘residence’ can be houseboat, mobile home, etc.) • Personal use is: 1. Use by taxpayer or taxpayer’s family 2. Any use by party who doesn’t pay FMV rent 3. Reciprocal agreement use

  4. Homes With Dual Use as Rental and Personal • Three Categories • Primarily Personal use • Rented for < 15 days • Primarily Rental use • Rented > 15 days and personal use does not exceed greater of 14 days or 10% of total vacation days • Dual uses of property • Rented > 15 days and personal use does exceed greater of 14 days or 10% of rental days

  5. Primarily Personal Use • Treated as a personal residence • Rent income is not taxable • Mortgage interest/taxes reported on Form 1040, Schedule A • Other expenses are nondeductible

  6. Primarily Rental Property • Must allocate expenses between rental and personal use, based on • Rental days / Total days used = Rental % • Expenses x % = Deductions • If rental loss, can deduct against other income, subject to passive loss rules • Personal % of mortgage interest and real estate taxes always included on Schedule A

  7. Dual Use Property • Allocate expenses between rental and personal based on • # of rental days / total days used = Rental % • Deduct rental expenses up to amount of rental income only, as follows • Taxes and interest (can calculate % as Rental days/365 - thereby taking more to Schedule A) • Utilities/maintenance (only allowed up to amount of rental income) • Depreciation (only up to remaining rental income) • Any loss can be carried forward

  8. Example of Rental/Personal Use Step 2: taxes/interest = $4,500 x 50/75 = $3,000 deduction on E Step 3: other expenses = $6,000 x 50/75 = $4,000 deduction on E Step 4: depreciation = $12,000 x 50/75 = $8,000 but limited to $3,000 ($10,000 - 3,000 - 4,000 = $3,000) because dual use property can’t create a loss situation Step 5 = What amount goes to Schedule A? (4,500 – 3,000 = $1,500) Step 6 = What is the loss carry-forward? (8,000 – 3,000 =$5,000) Facts: Ski cabin Personal use = 25 days Rental use = 50 days Income = $10,000 Taxes = $ 1,500 Interest = $ 3,000 Utilities = $ 2,000 Insurance = $ 1,500 Snow removal =$ 2,500 Depreciation = $12,000 Step 1: personal use is > 14 days or 10% of rental (5 days); therefore, does exceed the greater number and this is dual use property

  9. Objective Understand the general treatment of passive income and losses

  10. Passive Loss Limitations • Rule: When taxpayer is not actively involved in an activity – losses are “passive” and may not be deducted in excess of passive gains, but • Loss can be carried forward and deducted in future years,or • Can deduct when property is sold • Report on Form 8582

  11. Passive Loss Limitations • Rental property, by nature, is passive • Special Rule: If taxpayer rents real estate as a profession, he/she is not subject to passive loss limitations

  12. Passive Loss Limitations -Rental Real Estate Exception • When taxpayer isactively involvedin rental activity (screens tenants, repairs and maintains property, etc.) • May take up to $25,000 of rental loss against ordinary income • The $25,000 loss capability is reduced by 50 cents for each $1 AGI exceeds $100,000 • Doesn’t apply to Real Estate Limited Partnerships

  13. Rental Loss Exception Example Taxpayer actively participates in rental activity that has a rental loss of $20,000. AGI before the loss is $118,000. What amount of the rental loss can be claimed? $118,000 - $100,000 = $18,000 excess, thus $25,000 allowable loss is reduced: $25,000 - ($18,000 x 50%) = $16,000 Only $16,000 of the rental loss can be deducted.

  14. Objective Know the tax treatment of various deductions for AGI

  15. Bad Debts • If income was included in past - worthlessness of a debt is deductible up to basis Q: Can a cash basis taxpayer deduct a bad debt? A: No, because revenue was never included in income

  16. Bad Debts • Two types of bad debts • Business bad debts are fully deductible (for partial or full worthlessness) - reported on Schedule C • Non-business bad debtsareshort term capital losses, which are netted against other capital gains and losses - reported on Schedule D • need to show bona fide debtor/creditor relationship and have proof (for example, bankruptcy proceedings) • can use specific write-off only (no estimates) and any future recovery would be income

  17. Inventories • LIFO, FIFO, and Specific Identification are all acceptable for calculating cost of inventory • Choose one method and apply consistently • If LIFO is used for tax, LIFO must also be used for financial statement purposes • Form 970 used to elect LIFO • Why do most companies choose LIFO?

  18. Net Operating Losses (NOL) • NOLs result from business and casualty losses only • Taxpayer may carry loss back 2 years and file amendments for prior years (1040X) or 1045 (for quick refund), or may elect to carry forward 20 years • May make an irrevocable election to forgo carry back, but must elect this in year of loss • NOLs from 2001 or 2002 carry-back 5 years • Pre 8/97 NOLs are carried back 3 years and forward 15 • Enter NOLs on line 21 of the Form 1040 as a negative number

  19. Objective Know the current treatment of Individual Retirement Accounts (IRAs)

  20. Kinds of IRAs • Regular IRAs (deduction for AGI) • Nondeductible IRAs (regular IRAs, but taxpayers cannot deduct because AGI exceeds requirements) • Roth IRAs • Educational “IRAs” (covered in Chapter 5)

  21. Regular IRAs • Contributions may be deductedfor AGI • Earnings are not taxed until distribution • Must begin taking distributions by age 70.5 and can’t begin before age 59.5 • 10% penalty plus income tax for early withdrawal • May take distribution before age 59.5 penalty free up to $10,000 for first time home purchase, higher education expenses or medical expenses > 7.5% of AGI • Can make contributions up to tax return due date (through April 15, 2003 for 2002 deduction)

  22. Deductibility of Contributions • If neither spouse is in a qualified plan at work (e.g., 401(k)), may deduct up to $3,000 per year per person • A spouse with no earned income will be able to contribute up to $3,000 annually to an IRA • Taxpayers age 50 and over may add an additional $500 • If both spouses are in qualified plans, the phase out for deductibility is based on filing status (see tables in text)

  23. Deductibility of Contributions • If one spouse is in a qualified plan: • That spouse’s deduction is phased out based on AGI (see tables in book) • Other spouse (one not in a plan) doesn’t hit phase out until AGI > $150,000 MFJ • Even if deductibility is phased out, can still make a nondeductible IRA contribution • Important to track, because some distributions may be tax free return of capital (if taxpayers had nondeductible contributions due to phase outs above)

  24. Roth IRA • Contributions, lesser of $3,000 or earned income for year, are nondeductible • Taxpayers 50 or older may add $500 • Phase outs for AGI from $95,000 to $110,000 for single and $150,000 to $160,000 for MFJ • Qualified distributions are tax free as long as Roth IRA was open for 5 years and if: • Distribution is made after age 59.5 or due to a disability • Distribution is used for a first time home buyer

  25. Catch-Up Contributions • Contribution limits will gradually increase each year through 2008 • Taxpayers over age 50 will be able to make catch-up contributions of $500 per year

  26. Objective Understand the general rules for qualified retirement plan contributions

  27. Keogh Plan • For self employed individuals • Tax free contributions are limited to lesser of 20% of earned income or $40,000 • Cannot take distributions prior to age 59.5 • Must begin distributions by age 70.5

  28. Qualified Retirement Plan • Qualified retirement plan - primarily deferred compensation not to exceed $11,000/year for all salary reduction plans (includes Section 401(k) plans) • Taxpayers 50 and older may defer $12,000 maximum • Employee isn’t taxed on earnings in account or amount contributed by employer • To achieve qualified plan status, the plan must: • Be for the exclusive benefit of employees • Be nondiscriminatory • Have certain participation and coverage requirements • Have uniform distribution rules • Have minimum vesting requirements

  29. Qualified Retirement Plan • Funding a deferred compensation plan • Employee can contribute • Employer may match and will be allowed a deduction for the amount contributed • Maximum contribution is $11,000 ($12,000 if 50 or older) or 15% of gross wages • reduce max $ for $ for any other salary reduction plan for employee • maximum will increase by $1,000 each year from 2003 to 2006 • 10% excise tax is charged on excess contributions • When pensions are distributed, taxpayer gets 1099R

  30. Direct Transfer Rollovers • No backup withholding necessary because $ goes right from one plan to another • Unlimited number of direct transfers per year Plan 1 Plan 2 Taxpayer

  31. Distribution Rollovers • Taxpayer has 60 days to get 100% of the $ from one plan to another • 20% backup withholding is mandatory, so taxpayer must make up the 20% withholding and then wait until year end to get refund on 1040 • Unlimited number of rollovers allowed per year Plan 1 Taxpayer Plan 2

  32. Savings Incentive Match Plan for Employees(SIMPLE Plans) • Designed for use by employers with less than 100 employees • Can be SIMPLE-IRAs or part of 401(k) • Great plan for employers to maximize retirement contributions • Employee may elect % of gross wages to contribute (up to $7,000 per year; $7,500 if age 50 or older) • Employer must either: • match employees’ contributions $ for $ up to 3% of gross wages, or • contribute 2% of gross wages of all employees who make over $5,000 per year (even if they don’t elect salary deferral)

  33. Examples of SIMPLE Example 1 Sue makes $70,000 and chooses 8% of her salary; therefore, she makes a $5,600 SIMPLE contribution through salary reduction. Her employer matching = $2,100 ($70,000 x 3% maximum match) Example 2 John has a small computer consulting business and has a salary of $5,000. He can contribute 100% of this to his SIMPLE. The employer matching is $5,000 x 3% = $150; for a combined SIMPLE contribution = $6,150

  34. The End