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Preparing for the New Surtax

As part of the Affordable Care Act (the new health care legislation), a new tax kicks in this year. The official name of this tax is the Unearned Income Medicare Contribution Tax, and even though the name implies it is a contribution, don’t get the idea that it is voluntary or that you can deduct it as a charitable contribution. It is actually a surtax levied on the net investment income of taxpayers in the higher income brackets. And although it is perceived as an additional tax on higher-income taxpayers, it can affect even those who normally don’t have higher income if they have a large income from the sale of real estate, stocks, or other investments.

The surtax is 3.8% on whichever is less: your net investment income or the excess of your modified adjusted gross income (MAGI) over a threshold based on your filing status. Net investment income is your investment income reduced by investment expenses; MAGI is your regular AGI increased by income excluded for working out of the country.

The filing status threshold amounts are:

· $250,000 for married taxpayers filing jointly and surviving spouses.

· $125,000 for married taxpayers filing separately.

· $200,000 for single and head-of-household filers.

Example: A single taxpayer has net investment income of $100,000 and MAGI of $220,000. The taxpayer would pay a Medicare contribution tax only on the $20,000 amount by which his MAGI exceeds his threshold amount of $200,000, because that is less than his net investment income of $100,000. Thus, the taxpayer’s Medicare contribution tax would be $760 ($20,000 × 3.8%).

Investment income includes:

· Interest, dividends, annuities, and royalties,

· Rents (other than derived from a trade or business),

· Capital gains (other than derived from a trade or business),

· Home-sale gain in excess of the allowable home-gain exclusion,

· A child’s investment income in excess of the excludable threshold if, when eligible, the parent elects to include the child’s investment income on the parent’s return,

· Trade or business income that is a passive activity with respect to the taxpayer, and

· Trade or business income with respect to trading financial instruments or commodities.

Investment income does not include distributions from IRAs or qualified retirement plans.

Planning Note: For surtax purposes, gross income doesn’t include interest on tax-exempt bonds. Thus, one can avoid or reduce the net investment income surtax by investing in tax-exempt bonds.

Investment expenses include:

· Investment interest expense,

· Investment advisory and brokerage fees,

· Expenses related to rental and royalty income, and

· State and local income taxes properly allocable to items included in Net Investment Income.

Do you think you will never get hit with this tax because your income is way under the threshold amounts? Don’t be so sure. When you sell your home, the gain is a capital gain, and to the extent that the gain is not excludable using the home-gain exclusion, it will add to your income and possibly push you above the taxation thresholds. And, since capital gains are investment income, you might be in for a surprise. The same holds true for gains from selling stock, a second home, or a rental. So when planning to sell a capital asset, be sure to consider the impact of this new surtax.

The surtax also applies to the undistributed net investment income of trusts and estates, and there are special rules applying to the sale of partnership and Sub-S Corporation interests.

Example: A taxpayer has owned a residential rental property for a number of years, planning to use the rental’s increased value to help fund his retirement. The taxpayer normally has income well below the threshold for this new tax. The taxpayer sells the rental and has a substantial gain. The gain from the rental sale gives the taxpayer a one-time windfall that pushes his income above the threshold for the new tax, and he ends up having to pay the regular capital gains tax plus an additional 3.8% tax on the appreciation that is attributable to the increase in value that occurred over several years.

If this surtax will apply to you in 2013, you may need to increase your income tax withholding or estimated tax payments to cover the additional tax so you can avoid or minimize an underpayment of estimated tax penalty when you file your 2013 return.

Example: A taxpayer has owned a residential rental property for a number of years, planning to use the rental’s increased value to help fund his retirement. The taxpayer normally has income well below the threshold for this new tax. The taxpayer sells the rental and has a substantial gain. The gain from the rental sale gives the taxpayer a one-time windfall that pushes his income above the threshold for the new tax, and he ends up having to pay the regular capital gains tax plus an additional 3.8% tax on the appreciation that is attributable to the increase in value that occurred over several years.

If your income normally exceeds the threshold for this new tax, or you have or are contemplating a large capital gain and would like to explore options to mitigate the impact of the tax, please give us a call.

The above technical reference is provided as a courtesy to the reader by David Silkman, CPA, MST, Broker, Silkman & Associates Accountancy Corporation and SilkRoad Realty, Inc. The information is technical in nature, may not include all the details on a particular subject and may require review of the reader’s circumstances by a professional. You should consult with your tax advisor.

David S. Silkman is a CPA, has a Masters in Taxation (MST) and is a licensed real estate broker. He specializes in real estate tax laws and accounting. If you have any questions, please do not hesitate to call him at 310.479.7020 x301, email him atdavid@saacpa.com or visit www.saacpa.com orwww.SilkRoadRealtyInc.com. Thank you.

What is Basis

An important tax term that everyone should know is “basis”, especially if you’re in real estate. The odds are very high that you will encounter the term sometime during your lifetime, and it can have a profound impact on your tax liability.

Simply stated, “basis” is the monetary value from which a taxable gain or loss is calculated when an asset is sold. For example, you purchase 100 shares of ABC stock for $10 a share. Your basis for those shares of stock is $1,000 (100 x $10). Then, if the stock were sold for $1,500, you’d have a gain of $500, which is determined by subtracting your basis from the sale price. However this is a very simplistic example of basis. Determining basis, as you will see from the following explanation, can be complicated.

Cost Basis – This is the simplest form of basis and is what you originally pay when you purchase stock, other financial securities, a house, rental property, cars, business assets, land, and other assets. However, even cost can be a little tricky as it includes the asset acquisition costs such as: brokerage costs, escrow closing costs, acquisition travel, legal services, title charges, sales tax, etc. So in our earlier example, let’s say you paid a broker $50 to purchase the ABC stock; then your cost basis would have been $1,550.

Adjusted Basis – After purchasing an asset your basis will change, either up or down, if you make improvements to the asset, suffer damage due to casualty losses, or claim business depreciation or amortization. One example of how your basis increases would be purchasing your home and then adding a pool, family room or other improvements; the cost of the improvements would increase your basis. Keep in mind that routine maintenance is not considered an improvement and does not increase your basis in an asset.

Depreciated Basis - An example of when your basis decreases would be a business asset that you are depreciating (deducting as a business expense the cost of the asset over its useful life). In this case, the basis is reduced by the amount of the depreciation you have deducted against your rental or business income. Examples of assets where basis is typically adjusted downward due to depreciation include rental property, business vehicles, tools, business machinery, etc. In some cases, business assets can actually be 100% deducted (expensed) in the year they are acquired, in which case the asset’s basis is reduced to zero.

Inherited Basis – When you inherit an asset, you inherit it at its fair market value (FMV) at the decedent’s date of death. This is because the FMV is included in the value of the estate of the decedent and taxed if the estate’s value exceeds the exemption credit. This is not necessarily the basis for a future sale because there may be subsequent improvements, casualty losses, and perhaps depreciation taken after the inheritance. If the inherited asset was used in business before the inheritance, all prior depreciation is disregarded in the hands of the beneficiary.

Gift Basis – If someone gifts an asset to you, your gift basis generally is the same as the giver’s basis; however, the gift comes with some potential tax strings attached since you’ll also be receiving the giver’s built-in gains at the time of the gift. Thus, unlike inherited basis, you assume the tax liability for built-in gains.

For example, say your aunt gave you 100 shares of stock for which her basis was $1,000. Thus, your basis is $1,000. At the date of the gift, the stock was worth $2,500. You sell the stock for $5,000 a couple of years after receiving it. Your tax gain is $4,000 ($5,000 - $1,000), which includes the $1,500 ($2,500 - $1,000) gain your aunt would have had if she had sold the stock on the date she gave it to you, plus the $2,500 ($5,000 - $2,500) gain from the date you received the stock.

This is called the “gain basis.”

However, there is also the “loss basis” that must be calculated. The loss basis is the lower of:

a) the adjusted basis of the property prior to the date of the gift or

b) its fair market value at the time of the gift.

For example, assume David purchases a property for $100,000. Couple of years later he gifts the property to Raymond when the fair market value is $70,000. Assume no gift tax was paid on the transfer. Assume Raymond sells the property for $60,000. Raymond’s basis is $70,000 (the lower of fair market value or David’s adjusted basis). Therefore, Raymond’s loss is $10,000 ($60,000 - $70,000).

Note that if David had sold the property for $70,000, his loss would have been $30,000, not $10,000. That is because the loss basis rules prevent the person receiving the gift to receive a tax benefit from the decline in the fair market value of the property while the property was held by the person making the gift. The reason is that if this rule didn’t exist, there would be whole another economy created through gifts to shift properties with losses through gifts to others that would benefit from the loss more than the owner.

Also in some cases neither a gain nor a loss is recognized on the sale of the property received by gift because the selling price is less than the basis for gain and more than basis for loss.

For example, assume David purchases a property for $100,000. Couple of years later he gifts the property to Raymond when the fair market value is $70,000. Assume no gift tax was paid on the transfer. Assume Raymond sells the property for $80,000. The application of the gain basis rules produce a loss of $20,000 ($80,000 - $100,000). The application of the loss basis rules produce a gain of $10,000 ($80,000 - $70,000). Therefore, Raymond recognizes neither a gain nor a loss because the sells price or amount realized is between the gain basis and the loss basis.

If the giver paid a gift tax on the property he or she is gifting, then the rules are a bit more complex and not covered in this article.

Determining your basis and the resulting gain or loss when an asset is sold can be complicated, and of course, good records are needed to verify the basis, including improvements and other adjustments in case of an audit or the sale of that asset.

The above technical reference is provided as a courtesy to the reader by David Silkman, CPA, MST, Broker, Silkman & Associates Accountancy Corporation and SilkRoad Realty, Inc. The information is technical in nature, may not include all the details on a particular subject and may require review of the reader’s circumstances by a professional. You should consult with your tax advisor.

David S. Silkman is a CPA, has a Masters in Taxation (MST) and is a licensed real estate broker. He specializes in real estate tax laws and accounting. If you have any questions, please do not hesitate to call him at 310.479.7020 x301, email him atdavid@saacpa.com or visit www.saacpa.com orwww.SilkRoadRealtyInc.com. Thank you.

Are You Required to File 1099s

A business that pays an independent contractor $600 or more in a year must file Form 1099-MISC. Form W-9 is used to collect the independent contractor’s data. Deadlines for issuing 2013 1099-MISCs are January 31, 2014 (to independent contractors) and February 28, 2014 (to the IRS).

If you use independent contractors to perform services for your business and you pay them $600 or more for the year, you are required to issue them a Form 1099-MISC after the end of the year to avoid facing the loss of the deduction for their labor and expenses. The 1099s for 2013 must be provided to the independent contractor no later than January 31,2014.

It is not uncommon to have a repairman out early in the year, pay him less than $600, and then use his services again later, and have the total for the year exceed the $600 limit. As a result, you may overlook getting the information needed to file the 1099s for the year.Therefore, it is good practice to have individuals who are not incorporated complete and sign the IRS Form W-9 the first time that you use their services. Having properly completed, and signed, Form W-9s for all independent contractors and service providers eliminates any oversights, and protects you against IRS penalties and conflicts.

IRS Form W-9, Request for Taxpayer Identification Number and Certification, is provided by the government as a means for you to obtain the data required tofile the 1099s from your vendors. It also provides you with verification that you complied with the law should the vendor provide you with incorrect information. We highly recommend that you have a potential vendor complete the Form W-9 prior to engaging in business with them. The form can either be printed out, or filled out onscreen and then printed out. The W-9 is for your use only and is not submitted to the IRS. If you don’t have a W-9 for a vendor you used in 2013 and paid $600 or more, you should make every attempt to obtain one. You can download a copy of Form W-9 at http://www.saacpa.com/info_center.html?page=Nw==

In order to avoid a penalty, copies of the 1099s need to be sent to the IRS by February 28, 2014.

The above technical reference is provided as a courtesy to the reader by DavidSilkman, CPA, MST, Broker, Silkman & Associates Accountancy Corporation andSilkRoad Realty, Inc. The information is technical in nature, may not includeall the details on a particular subject and may require review of the reader’scircumstances by a professional. You should consult with your tax advisor.

David S. Silkman is a CPA, has a Masters in Taxation (MST) and is a licensed realestate broker. He specializes in real estate tax laws andaccounting. If you have any questions, please do not hesitate to call himat 310.479.7020 x301, email him atdavid@saacpa.comor visit www.saacpa.com orwww.SilkRoadRealtyInc.com. Thank you.

 

What is the Alternative Minimum Tax AMT

The alternative minimum tax, originally created to curb tax shelters and tax preferences of the wealthy, can now apply to the average taxpayer. Six commonly encountered deductions routinely cause the average taxpayer to be hit by the AMT. Incentive stock options can also have a profound impact on the AMT.

There are two ways to determine your federal tax liability - the regular way that most everyone understands, and the alternative minimum tax method. Your tax will be the higher of the two.

So what is the alternative minimum tax and why are you getting hit with it? Well, many, many years ago, Congress, in an effort to curb tax shelters and tax preferences of wealthy taxpayers, created an alternative way of computing tax that disallows certain tax deductions and preferences, and called it the alternative minimum tax. Although originally intended to apply to the wealthy, years of inflation caused more and more taxpayers to be caught up in the tax. It now no longer just affects wealthy taxpayers and can apply to almost any taxpayer if the conditions are correct. Congress has been discussing AMT reform for years but has failed to take any action.

Depending on the amount of your “taxable excess,” AMT basically taxes you starting at either the 26% or 28% federal rate while the regular tax brackets start at 10% then it increases to 15% and then to 28%, 33%, 35% & 39.6%.

The list of tax deductions and preferences not allowed when computing the AMT is substantial and at times complicated. However, the following six items routinely cause the average taxpayer to be hit by the AMT:

1. Medical Deductions – Prior to 2013, medical deductions were allowed to the extent they exceeded 7.5% of a taxpayer’s income for regular tax purposes and 10% for the AMT computation. However that difference, except for the elderly, has been eliminated now that the Affordable Care Act raised the 7.5% to 10% for regular tax, making it the same as for the AMT. For taxpayers aged 65 and older, the regular tax adjustment remains at 7.5% through 2016, and that creates a medical AMT adjustment for seniors affected by the AMT.

2. Tax Deductions – When itemizing deductions, a taxpayer is allowed to deduct a variety of taxes, including real property, personal property and state income tax. But for AMT purposes, none of the itemized taxes are deductible. For most taxpayers, this represents one of their largest tax deductions, and frequently triggers the AMT. If you are affected by the AMT, conventional wisdom would dictate deferring tax payments to a subsequent year when the AMT may not apply. When deferring, care should be exercised with regard to late payment penalties and interest on underpayments for certain taxes. In addition, taxpayers can annually elect to capitalize taxes on unimproved and unproductive real estate. This means foregoing the deduction currently and adding the tax paid to the cost basis of the real property which decreases future gains.

3. Home Mortgage Interest – For both the regular tax and AMT computations, interest paid on a debt to acquire or substantially improve a main home or second home is deductible as long as the debt limit (generally $1 million) isn’t exceeded. This is true of refinanced debt, except that any increase in debt is treated as equity debt. For regular tax purposes, the interest on up to $100,000 of equity debt on the two homes can also be deducted. However, equity debt is not deductible against the AMT; neither is the acquisition or equity debt interest on a motor home or boat that qualifies as a second home. Therefore, taxpayers should exercise caution when incurring home equity debt. Generally, loan brokers are not aware of these limitations, and there are numerous pitfalls.

4. Miscellaneous Itemized Deductions – The category of miscellaneous deductions, which includes employee business expenses and investment expenses, is not deductible for AMT purposes. For certain taxpayers with deductible employee business expenses, this can create a significant AMT. Employees with significant employee business expenses should attempt to negotiate an “accountable” reimbursement plan with their employer. Under this type of plan, the reimbursement for qualified expenses is tax-free. Because the employee has been reimbursed, he or she no longer claims a deduction for the expenses, thus eliminating the miscellaneous deduction. Or, to defer the expenses to a year not affected by the AMT. Another strategy is to either become self-employed or start an entity such as an S Corporation or a limited liability company (LLC) and have your employer pay your entity versus you as an employee. Then you can deduct your employee business expenses through the entity and it will offset against your income. You will pay taxes on the net amount. However, there are other issues and concerns regarding having your own entity that are beyond the scope of this article.

5. Personal Exemptions – Personal exemptions for dependents provide no benefit when taxed by the AMT method. Therefore, divorced or separated parents should carefully consider which party should claim the exemption for a dependent child.

6. Standard Deduction – Since the regular tax standard deduction is not allowed as an AMT deduction, taxpayers affected by the AMT should always itemize. While the benefit of some deductions will be lost, there is still a partial advantage. Even the smallest of charitable deductions will benefit at a minimum of 26% (the lowest bracket for the AMT).

Deductions Not Affected by AMT
1. Charitable Contributions – Donations made to charitable organizations are deductible for both the regular and AMT tax calculations.

2. Investment Interest – Such as margin interest are deductible for both the regular and AMT tax calculations.

Incentive Stock Options (ISO) & AMT - If an option is a qualified option (also known as an incentive stock option), then for regular tax purposes, no amount of income is included in income
either at the time the option is granted or at the time it is exercised. Income or loss is recognized when the stock is sold. However, to qualify for this treatment, the stock acquired under the option must be held for:

• More than 1 year after the stock option was exercised, AND
• More than 2 years after the option was granted.

The gain or loss from the sale of ISO stock is generally a capital gain or loss. The gain for regular tax purposes will be the difference between the exercise price and the sales price. If the stock is sold prior to the required holding period, the income to the extent of the bargain element will be treated as ordinary income (wages).

For AMT purposes, taxpayers recognize alternative minimum taxable income (AMT preference income) equal to the excess of the fair market value of the stock on the exercise date over the exercise price. This creates three effects for AMT purposes:

• Preference income in the exercise year, and
• A different stock basis for AMT gain or loss (AMT basis = Exercise price and REG tax basis equals
grant price), and
• Since the ISO preference is a deferral item of preference, an Alternative Minimum Tax Credit
carryover may also be generated.

Finally, some state like California have their own version of the AMT tax too!

The above technical reference is provided as a courtesy to the reader by David Silkman, CPA, MST, Broker, Silkman & Associates Accountancy Corporation and SilkRoad Realty, Inc. The information is technical in nature, may not include all the details on a particular subject and may require review of the reader’s circumstances by a professional. You should consult with your tax advisor.

David S. Silkman is a CPA, has a Masters in Taxation (MST) and is a licensed real estate broker. He specializes in real estate tax laws and accounting. If you have any questions, please do not hesitate to call him at 310.479.7020 x301, email him atdavid@saacpa.com or visit www.saacpa.com orwww.SilkRoadRealtyInc.com. Thank you.

Can You Take a Home Office Deduction

If you run your business out of your home, you may want to “write off” many of your household expenses. But how do you know what is deductible and what is not?

Generally, expenses related to the rent, purchase, maintenance and repair of a personal residence are not deductible. However, if you use part of your home for business purposes, you may be able to take a deduction for the business use of your home on your self-employed business schedule. This deduction is commonly referred to as the home-office deduction, but it need not necessarily be an “office” to qualify.

Expenses that can be deducted include the business portion of real estate taxes, mortgage interest (but not principal payments), rent, utilities, insurance, painting, repairs, gardener, pool service and depreciation. Expenses that are for both the business-use and non-business-use areas of the home (example: real estate tax) are prorated, generally in the ratio of the square footage of the office area to total square footage of the home, unless an expense is exclusive to the office (example: painting only the office area). As an alternative, the IRS provides a safe harbor deduction as explained below.

In order to claim a deduction for the business use of your home, you must use part of your home exclusively in your trade or business on a regular, continuing basis. You must be able to provide sufficient evidence to show the use is regular. Exclusive use means there can be no personal use (other than de minimis) at any time during the tax year. Use of only a portion of a room is acceptable as long as the taxpayer shows that section is totally for business. In addition, one of the following must apply:

It is the principal place of business for a trade or business of the taxpayer;
It is used for storing inventory for a wholesale or retail business for which the taxpayer’s home is the only fixed location of the business;
It is a place where the taxpayer meets with customers, patients or clients (just telephone contact with clients isn’t enough to meet this test);
It is used as a licensed day care center; or
It is in a separate structure not attached to the taxpayer’s home.
If you work as an employee you can claim this deduction only if the regular and exclusive business use of the home is required by and for the convenience of your employer and the employer does not rent that portion of the home. If the home-office deduction is challenged by the IRS, an employee will have to provide documentation from the employer that the employer requires the employee to have a home office as a condition of employment.

“Exclusive use” means a specific area of the home is used only for trade or business. “Regular use” means the area is used regularly for trade or business. Incidental or occasional business use is not regular use. In addition, employees must deduct the office as a miscellaneous itemized deduction, which has three additional limitations: the employee must itemize deductions (can’t take the standard deduction), this type of miscellaneous deduction is reduced by 2% of AGI (income), and it is not deductible at all to the extent the taxpayer is subject to the alternative minimum tax (AMT).

Non-business profit-seeking endeavors, such as investment activities, do not qualify for a home office deduction, nor do not-for-profit activities, such as hobbies.

Example: An attorney uses the den in his home to write legal briefs or prepare clients’ tax returns. The family also uses the den for recreation. The den is not used exclusively in the attorney’s profession, so a business deduction cannot be claimed for its use.

As an alternative, where taxpayers (either self-employed or employees) meet the qualifications for deducting business use of the home, they can elect a simplified deduction rather than itemizing expenses. This simplified method is referred to as the “safe-harbor” method and allows a deduction of $5 per square foot with a maximum square footage of 300. Thus, the maximum deduction is $1,500 per year. This method can be used in any year in lieu of the regular method.

The above technical reference is provided as a courtesy to the reader by David Silkman, CPA, MST, Broker, Silkman & Associates Accountancy Corporation and SilkRoad Realty, Inc. The information is technical in nature, may not include all the details on a particular subject and may require review of the reader’s circumstances by a professional. You should consult with your tax advisor.

David S. Silkman is a CPA, has a Masters in Taxation (MST) and is a licensed real estate broker. He specializes in real estate tax laws and accounting. If you have any questions, please do not hesitate to call him at 310.479.7020 x301, email him atdavid@saacpa.com or visit www.saacpa.com orwww.SilkRoadRealtyInc.com. Thank you.