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Tax savings 2023

Strategic Insights for Employing Your Spouse

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Strategic Insights for Employing Your Spouse

If you own your own business and operate as a proprietorship or partnership (wherein your spouse is not a partner), one of the smartest tax moves you can make is hiring your spouse to work as your employee. 

But the tax savings may be a mirage if you don’t pay your spouse the right way. And the arrangement is subject to attack by the IRS if your spouse is not a bona fide employee.

Here are four things you should know before you hire your spouse that will maximize your savings and minimize the audit risk.

  1. Pay benefits, not wages. The way to save on taxes is to pay your spouse using tax-free employee benefits, not taxable wages. Benefits such as health insurance are fully deductible by you as a business expense, but not taxable income for your spouse. 

Also, if you pay your spouse only with tax-free fringe benefits, you need not pay payroll taxes, file employment tax returns, or file a W-2 for your spouse. 

  1. Establish a medical reimbursement arrangement. The most valuable fringe benefit you can provide your spouse-employee is reimbursement for health insurance and uninsured medical expenses. You can accomplish this through a 105-HRA plan if your spouse is your sole employee, or an Individual Coverage Health Reimbursement Arrangement (ICHRA) if you have multiple employees.
  2. Provide benefits in addition to health coverage. There are many other tax-free fringe benefits you can provide your spouse in addition to health insurance, including education related to your business, up to $50,000 of term life insurance, and de minimis fringes such as gifts. 
  3. Treat your spouse as a bona fide employee. For your arrangement to withstand IRS scrutiny, you must be able to prove that your spouse is your bona fide employee. You’ll have no problem if
  • you are the sole owner of your business,
  • your spouse does real work under your direction and control and keeps a timesheet,
  • you regularly pay your spouse’s medical and other reimbursable expenses from your separate business checking account, and
  • your spouse’s compensation is reasonable for the work performed.

The Kiddie Tax and How to Avoid It 

The kiddie tax was enacted by Congress to prevent parents from passing investment income to their children, who typically have a lower tax rate. Under the kiddie tax rules, a portion of a child’s net unearned income may be taxed at the parent’s marginal federal income tax rate. The kiddie tax applies to children up to age 24, assuming they meet certain criteria.

The kiddie tax can result in higher taxes on an affected child’s net unearned income than otherwise would apply. For example, if a child’s net unearned income exceeds the annual threshold of $2,500 for 2023, the portion of the income exceeding the threshold is subject to the kiddie tax. 

The kiddie tax does not apply if the child’s net unearned income for the year remains below the threshold for that year.

There are four primary criteria for the application of the kiddie tax, including the child not filing a joint return for the year, at least one parent being alive at year’s end, the child’s net unearned income for the year exceeding the threshold for that year, and the child not meeting the specific age rules.

With these rules in mind, there are several strategies to limit the kiddie tax’s impact on your child’s unearned income:

Exploit the unearned income threshold. Manage your child’s unearned income to ensure it remains below the annual threshold.

Pick the right investments. You can reduce unearned income by selecting investments with minimal or no dividends, such as growth stocks or tax-efficient mutual funds.

Invest in Series EE U.S. Savings Bonds. The accumulated interest income from these bonds is tax-deferred until cashed in, meaning no kiddie tax applies if the bonds are cashed in when the child is exempt from the kiddie tax.

Use a Section 529 College Savings Plan. Withdrawals from a Section 529 plan account are federal-income-tax-free, provided they’re used for qualifying education expenses.

Invest in life insurance products. Investment accounts included in life insurance products such as universal life policies allow tax-deferred accumulations and can be borrowed against for college costs.

Generate earned income. The kiddie tax does not apply to children aged 18-23 if their earned income exceeds 50 percent of their support for the year.

The QSEHRA Health Plan

If you’re a small employer (fewer than 50 employees), you should consider the Qualified Small Employer Health Reimbursement Arrangement (QSEHRA) as a good way to help your employees with their medical expenses.

If the QSEHRA is indeed going to be your plan of choice, then you have three good reasons to get that QSEHRA plan in place on or before October 2, 2023. First, this avoids penalties. Second, your employees will have the time they need to select health insurance. Third, you will have your plan in place on January 1, 2024, when you need it.

One very attractive aspect of the QSEHRA is that it can reimburse individually purchased insurance without subjecting you to the $100-a-day per-employee penalty that generally applies to the employer that reimburses employees for individually purchased insurance. The second and perhaps most attractive aspect of the QSEHRA is that you know your costs per employee. The costs are fixed—by you.

Eligible employer. To be an eligible employer, you must have fewer than 50 eligible employees and not offer group health or a flexible spending arrangement to any employee. For the QSEHRA, group health includes excepted benefit plans such as vision and dental, so don’t offer them either.

Eligible employees. All employees are eligible employees, but the QSEHRA may exclude

  • employees who have not completed 90 days of service with you, 
  • employees who have not attained age 25 before the beginning of the plan year, 
  • part-time or seasonal employees, 
  • employees covered by a collective bargaining agreement if health benefits were the subject of good-faith bargaining, and 
  • employees who are non-resident aliens with no earned income from sources within the United States.

Dollar limits. Tax law indexes the dollar limits for inflation. The 2023 limits are $5,850 for self-only coverage and $11,800 for family coverage. For part-year coverage, you prorate the limit to reflect the number of months the QSEHRA covers the individual.

If you have questions about Strategic Insights for Employing Your Spouse, don’t hesitate to contact me.

Act Now to Qualify for Your 2020 and 2021 ERC Money

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Qualify for Your 2020 and 2021 ERC Money

It’s 2023, but you still have the chance to qualify for the employee retention credit (ERC) for the 2020 and 2021 calendar years. This credit can potentially help you recover a significant amount of money.

The ERC is a refundable tax credit against certain employment taxes. To claim this credit, it is necessary to amend your payroll tax returns for 2020 and 2021. While this might seem like a cumbersome process, the financial benefits can make it well worth the effort. For instance, if your business has 12 employees and meets the qualifications for maximum tax credits, you could receive a total of $312,000.

There are two primary routes to qualifying for the ERC:

  1. A decline in gross receipts. The most straightforward way to qualify is by demonstrating a decline in your gross receipts during the years 2020 and 2021. It is important to note that the decline does not have to be directly caused by COVID-19.
  2. Government order causing more than a nominal effect. If a government order caused your business to fully or partially shut down, you might qualify for the ERC for the wages paid during the shutdown period.

The deadline to claim the ERC for 2020—April 15, 2024—is about 10 months away. We strongly recommend that you act promptly to maximize your potential benefits from this program.

Claim Your 2020 COVID Sick and Family Leave Credits Today 

You may have overlooked potential COVID-19 sick and family leave tax credits on your 2020 tax return. You might be eligible for up to $15,110 in tax credits, and the good news is that it’s not too late to claim them.

The IRS allows amended tax returns, so you can claim the credits today. Please be aware that you should act soon because the timeline for submitting amended returns is limited.

To realize the $15,110 in maximum tax credits, you must meet the following requirements:

  • Adequate 2020 income ($143,866 of net income if you’re self-employed, or equivalent W-2 income if you’re an employee of your corporation)
  • An inability to work in 2020 due to COVID-19
  • A son or daughter who is either under age 18 or incapable of self-care because of a mental or physical disability

The law divides the credits into two categories:

  1. Up to $5,110 for individuals unable to work due to COVID-19-related reasons
  2. Up to $10,000 for individuals who cared for a child due to COVID-19

If you are self-employed and qualify, you can claim the credits by amending your 2020 tax return and filing a completed 2020 Form 7202 (Credits for Sick Leave and Family Leave for Certain Self-Employed Individuals) along with IRS Form 1040-X.

For corporation owners, if your corporation paid you while you were not working due to COVID-19, your corporation may qualify for sick or family leave tax credits. If your corporation has not claimed the credits in its 2020 returns, it can amend its payroll tax returns using Form 941-X. Please note that there’s a three-year statute of limitations for correcting payroll tax overpayments on Form 941-X; for 2020, that means it expires on April 15, 2024.

Also, please be aware that you cannot receive double benefits. If you received assistance through the Paycheck Protection Program (PPP), the ERC, or similar programs, you cannot claim the same self-employed income or employee wages for the COVID-19 sick and family leave credits.

The Cleaning Lady and Your Home-Office Deduction

If you have an office in your home that qualifies for the home-office deduction and you employ a cleaning lady who maintains both your home and your home office, there are a couple of tax considerations to keep in mind.

The amount you pay your cleaning lady for her services can have an impact on your taxes. Let’s assume you pay her $200 every two weeks, totaling $5,200 annually. Say your office is 15 percent of your home. In this case, you pay her $780 to clean your office and $4,420 to clean your home.

Here are two key questions:

  • Should you pay your cleaning lady through a W-2 or a 1099 for the office cleaning?
  • Do you need to pay the Nanny Tax for the home cleaning?

The answers depend on whether the cleaning lady is considered an independent contractor or an employee.

Given the conditions of her work—she cleans with little or no direction, provides her own supplies, and cleans many other houses—she exhibits the characteristics of an independent contractor.

Accordingly, for the $780 you paid her to clean your office, you should provide her with a 1099-NEC form. On the personal front, you are not liable for the Nanny Tax because the cleaning lady qualifies as an independent contractor.

Please note that if you fail to file Form 1099-NEC, you could face an intentional disregard penalty of $630 or more for each missed form.

Shutting Down a C Corporation

There are several tax implications that you need to be aware of when shutting down a C corporation.

Complete liquidation of a C corporation is when it ceases to be a going concern, winds up its affairs, pays its debts, and distributes its remaining assets to the shareholder(s). In tax terms, the corporation redeems all its stock, and during the redemption, there can be one or more distributions pursuant to a plan. 

While not mandatory, having a written plan is advisable because it establishes a specific start date for the liquidation process. This helps differentiate between regular dividends and liquidating distributions.

There are three ways your corporation can achieve liquidation:

  1. Distribute all of the corporation’s assets to the shareholder(s).
  2. Sell all its assets, and distribute the proceeds.
  3. Sell some assets, and distribute the resulting sales proceeds and unsold assets.

The bottom-line federal income tax results for all these options are similar for the corporation and the shareholder(s).

If your corporation distributes property other than cash during liquidation, it must recognize taxable gain or loss as if the distributed property had been sold for its fair market value (FMV).

As a shareholder, you treat the liquidating corporate distribution as payment in exchange for your stock. You recognize taxable capital gain or loss equal to the difference between the FMV of the assets received and the adjusted basis of the stock you surrender.

The complete liquidation of a C corporation with appreciated assets often results in double taxation—once at the corporate level and again at the shareholder level. Hence, the timing could be critical depending on your situation and future changes in tax rates. As of 2023, the maximum individual federal income tax rate on long-term gains from a corporate liquidation is 20 percent, or 23.8 percent if the 3.8 percent net investment income tax applies.

Once you decide on a complete corporate liquidation, the Board of Directors should adopt a plan and file Form 966 (Corporate Dissolution or Liquidation) with the IRS within 30 days of adopting the liquidation plan. The corporation should then file its final tax returns.

If you have questions, don’t hesitate to contact me.

Tax Credits for Electric Vehicles: The Latest from the IRS

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Tax Credits for Electric Vehicles

The IRS recently issued new guidance on electric vehicles. There are four ways you can potentially benefit from a federal tax credit for an EV you place in service in 2023 or later:

  1. Purchase an EV, and claim the clean vehicle credit.
  2. Lease an EV, and benefit from the lessor’s EV discount.
  3. Purchase a used EV that qualifies for the used EV tax credit.
  4. Purchase an EV for business use, and claim the new commercial clean vehicle tax credit.

The new clean vehicle credit is available through 2032, with a maximum credit of $7,500. 

To qualify for the clean vehicle credit, you must meet specific criteria, including income limits, vehicle price caps, and domestic assembly requirements. The credit amount for vehicles delivered on or after April 18, 2023, depends on the vehicle meeting critical minerals sourcing and/or battery components sourcing requirements.

If you can’t find an EV that qualifies for the credit or your income is too high, you can lease an EV from a leasing company that can claim up to a $7,500 commercial clean vehicle tax credit. The leasing company may then pass on all or part of the credit to you through reduced leasing costs.

For used EV purchases, you can earn a credit of up to $4,000, but you must buy the vehicle from a dealer and meet the law’s income caps and other restrictions. 

Finally, if you purchase an EV for business use, you can qualify for the commercial clean vehicle tax credit, which is not subject to critical minerals or battery components rules, making it easier to qualify for this credit starting April 18, 2023.

To claim an EV credit, the seller must complete a seller’s report and provide a copy to you and the IRS. For the clean vehicle credit, you will file IRS Form 8936; for the commercial clean vehicle credit, you will file IRS Form 8936-A.

Using Family Loans to Secure Better Home Loan Interest Rates 

Here’s some information on how you can help a family member buy a home by making a loan to them while ensuring that you and the family member benefit from a tax-smart loan structure.

With the current national average interest rates for 30-year and 15-year fixed-rate mortgages at 6.81 percent and 6.13 percent, respectively, family loans can offer a much more attractive alternative. By charging the Applicable Federal Rate (AFR) as interest, you can give the borrower a good deal without giving yourself a tax headache.

The IRS issues new AFRs for term loans every month. The rates for April 2023 are as follows:

  • Short-term loan (three years or less): 4.86 percent
  • Mid-term loan (over three years but not more than nine years): 4.15 percent
  • Long-term loan (over nine years): 4.02 percent

Charging at least the AFR for a term loan to a family member allows you to avoid federal income tax and federal gift tax complications. 

But if you charge less than the AFR, you may need to navigate some tax complications. Two tax-law exceptions, the $10,000 and $100,000 loopholes, can help you avoid these complications, although they may not be suitable for all home loans.

It is crucial to document the loan with a written promissory note and secure it with the borrower’s home for them to claim deductions for qualified residence interest expenses. Make sure the borrower signs the note and that the note includes details such as the interest rate, a schedule of interest and principal payments, and any security or collateral for the loan.

In conclusion, family loans can provide homebuyers with better interest rates than commercial lenders offer, especially if family members charge the AFR. Remember to consider the loan terms and tax consequences when structuring the loan.

Basic Estate Planning

You need an estate plan, regardless of whether or not you are among the ultra-rich. As recent news has shown, even those who have won the lottery or have substantial wealth can fall victim to poor estate planning.

While federal estate taxes may not concern you, you need a will to have your wishes honored after your death. Without a will, state law dictates the distribution of your assets, which may not align with your intentions. Additionally, if you have minor children, a will allows you to name a guardian to care for them in the event of your untimely passing.

Your heirs will want to avoid probate because it can be a costly and time-consuming legal process. A living trust gives you a valuable tool to avoid probate. By transferring legal ownership of your assets to the trust, you can ensure that your beneficiaries receive them without suffering through probate. 

You can amend your living trust as circumstances change, providing flexibility and control over your assets.

It is also essential to keep your beneficiary designations up-to-date, as they take precedence over wills and living trusts regarding asset distribution. 

Additionally, if your estate will suffer from federal or state death taxes, you should plan to minimize your exposure.

Estate planning is not a one-time event but a process that you should review and update regularly to accommodate life changes and fluctuations in estate and death tax rules. It is recommended that you check your estate plan annually to ensure it aligns with your wishes and circumstances.

One Ugly Rule for S Corp Owners Deducting Health Insurance

When your S corporation covers or reimburses your more-than-2-percent-shareholder-employee health insurance expenses, it classifies the payments as box 1 W-2 wages but not box 3 or box 5 wages.

When calculating the amount eligible for the Form 1040 self-employed health insurance deduction, you must use your Medicare wages (listed in box 5 of Form W-2) as your “earned income” rather than the amount reported in box 1.

Here are two examples that show you the impact of this rule:

  • Ted’s S corporation pays him $0 in cash wages and reimburses him $18,000 for health insurance. His W-2 shows $18,000 as box 1 wages and $0 as box 3 and box 5 wages. Although Ted has $18,000 in taxable wage income from the corporation’s reimbursement of his health insurance, his Form 1040 self-employed health insurance deduction is $0 due to his lack of Medicare wages.
  • Janet’s corporation pays her $107,000 in cash wages and reimburses her $22,000 for health insurance. Janet’s W-2 from her S corporation shows box 1 wages of $129,000, box 3 wages of $107,000, and box 5 wages of $107,000. The IRS allows her Form 1040 self-employed health insurance deduction of $22,000 because her Medicare wages exceed the insurance cost.

To avoid unfavorable tax outcomes, ensure that your S corporation reports Medicare wages (box 5) equal to or greater than the health insurance costs paid or reimbursed.

If you have questions, don’t hesitate to contact me.

Holding Real Property in a Corporation

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Good or Bad Idea?

Holding Real Property in a Corporation

As the real estate market has cooled off in many parts of the country, investing in property may seem wise in the long run. But taxes can be a significant concern. 

Owning real estate in a C corporation may not be wise when considering taxes because it puts you at risk of being double-taxed. 

This means that if you sell the property and make a profit, the gain may be subject to taxation twice—once at the corporate level and again at the shareholder level when the corporation pays out profits to shareholders as dividends.

The Tax Cuts and Jobs Act reduced the double taxation threat, but with our current federal debt, you face the risk that lawmakers will hike the corporate tax rates and possibly also tax dividends at higher ordinary income rates.

To avoid this threat, I usually recommend using a single-member LLC or revocable trust to hold real property. A disregarded single-member LLC delivers super-simple tax treatment combined with corporation-like liability protection, while a revocable trust can avoid probate and save time and money.

If you are a co-owner of real property, it is advisable to set up a multi-member LLC to hold the property. The partnership taxation rules that multi-member LLCs follow have several advantages, including pass-through taxation.

In conclusion, holding real property in a C corporation can expose you to the risk of double taxation, and I don’t recommend it. Instead, consider a single-member LLC, revocable trust, or multi-member LLC, depending on your situation.

Helicopter View of 2023 Meals and Entertainment 

As you may already know, there have been some major changes to the business meal deduction for 2023 and beyond. The deduction for business meals has been reduced to 50 percent, a significant change from the previous 100 percent deduction for business meals in and from restaurants, which was applicable only for the years 2021 and 2022.

To help you better understand the current situation, see the table below:

Table for Holding Real Property in a Corporation

Are You a Regular Investor or a Tax-Favored Securities Trader?

As we navigate the recent volatility in the stock market, you may want to think about the possible favorable federal income tax treatment the tax code gives to a securities trader. 

Suppose you can qualify as a securities trader for federal income tax purposes. In that case, you deduct your trading-related expenses on Schedule C of Form 1040 and make the taxpayer-friendly mark-to-market election, which is not available to garden-variety investors.

The mark-to-market election has two important federal income tax advantages: 

  1. Exemption from the capital loss deduction limitation 
  2. Exemption from the wash sale rule

But there is a price to pay for these tax advantages. As a trader who has made the mark-to-market election, you must pretend to sell your entire trading portfolio at market on the last trading day of the year, which may have little or no tax impact if you have little or nothing in your trading portfolio at year-end.

Your trading activities must constitute a business for you to qualify as a securities trader, and you must meet both of the following requirements: 

  1. Your trading must be frequent and substantial.
  2. You must seek to profit from short-term market swings rather than longer-term strategies.

If you are a calendar-year taxpayer, the deadline to make the mark-to-market election for your 2023 tax year is April 18, 2023 (that’s right around the corner). You make the election by including a statement with your 2022 Form 1040 filed by that date or with a Form 4868 extension request for your 2022 return filed by that date.

Avoid This Family-Member S Corporation Health Insurance Mistake

There are two important issues related to health insurance deductions for S corporations. 

First, if you own more than 2 percent of an S corporation, there are three steps you need to follow to claim a deduction for health insurance:

  • Step 1. The cost of the insurance must be on the S corporation’s books.
  • Step 2. The corporation must include the cost of the health insurance premiums on your W-2 form as taxable income (but not subject to payroll taxes).
  • Step 3. If eligible, you must claim the health insurance deduction as an above-the-line deduction on Schedule 1 of Form 1040.

Second, this three-step procedure applies to your spouse, children, grandchildren, great-grandchildren, parents, grandparents, and great-grandparents if they work for your S corporation and the corporation covers them with health insurance. 

The three rules apply to the relatives listed above who work in the S corporation, even if they don’t own any stock directly. For health insurance purposes, the tax code attributes your stock ownership to them and deems that they own what you own.

It’s crucial to get this right, as failing to do so could result in a lost health insurance deduction for your family members and zero deductions or the S corporation.

If you or your S corporation did not handle this correctly in the past, you need to amend the returns to ensure that you create and protect the proper tax deductions.

If you have questions, don’t hesitate to contact me.

2023 Health Insurance for S Corporation Owners: An Update

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2023 Health Insurance for S Corporation Owner

Here’s an update on the latest developments in 2023 health insurance for S corporation owners. As a more-than-2-percent S corporation owner, you are entitled to some good news when it comes to your health insurance.

To ensure that your health insurance deductions are in order, and to avoid the $100-a-day penalties for violating the rules of the Affordable Care Act (ACA), you should take the following steps:

  1. Get the cost of the health insurance on the S corporation’s books, either by making the premium payments directly or through reimbursement.
  2. Ensure that the S corporation includes the health insurance premiums on the owner-employee’s W-2 form, including the additional compensation in box 1 but not in boxes 3 or 5.
  3. If you are an owner-employee with more than 2 percent ownership, claim the health insurance deduction as “self-employed health insurance” on line 17 of Schedule 1 of Form 1040. You must meet the two rules of not having access to employer-subsidized health insurance and having adequate salary.

For rank-and-file employees, the S corporation does not have to provide health insurance benefits, but if it does, it must use an acceptable ACA plan, such as (among others) the qualified small employer health reimbursement arrangement (QSEHRA) or the individual coverage HRA (ICHRA). 

The S corporation can reimburse more-than-2-percent owners for individually purchased insurance without any penalties, but if it reimburses rank-and-file employees without using the QSEHRA or ICHRA, it faces the $100-a-day penalty per employee.

If you are looking to provide health benefits to employees through the S corporation, there are many tax-advantaged options available. If the S corporation provides group health insurance to all employees, including the shareholder-employee, the same rules apply.

 

SECURE 2.0 Act Creates New Tax Strategies for RMDs 

 

As you are likely aware, if you have an IRA or other tax-deferred retirement account, you must start taking required minimum distributions (RMDs) once you reach a certain age. 

The SECURE 2.0 Act raises the age at which RMDs must first be taken, from age 72 to age 75, over the next 10 years. Specifically, the RMD age will be 73 for those born between 1951 and 1959 and 75 for those born in 1960 or later.

The purpose of RMDs is to ensure that you use the funds in your retirement accounts while you are still alive, rather than using those accounts as an estate planning device to pass money to your heirs tax-free.

The amount you are required to withdraw as an RMD depends on your age and the balance of your retirement account as of December 31 of the previous year. RMDs are required for traditional IRAs; SEP-IRAs; SIMPLE IRAs; solo 401(k) plans; and all employer-sponsored tax-deferred retirement plans, including 401(k) plans, 403(b) plans, profit-sharing plans, and 457(b) plans.

Your first RMD must be taken by April 1 of the year following the year you reach the age of RMD. For example, if you turn 73 in 2024, you have until April 1, 2025, to take your first taxable RMD. And then, including in 2025 and every year thereafter, you must take an annual RMD on or before December 31.

It’s important to note that taking two RMDs in one year could increase your tax bracket and even your Medicare premiums. If you are faced with this situation, it’s best to take the first RMD in the year you reach the age of RMD.

In the past, the IRS imposed an “excess accumulation” penalty tax of 50 percent if you failed to take your full RMD by the deadline. But starting in 2023, the SECURE 2.0 Act reduces the penalty to 25 percent. If you correct the shortfall within the “correction window,” you can reduce the penalty to 10 percent. The correction window begins on January 1 of the year following the RMD shortfall and ends on the earlier of 

  • when the IRS mails a Notice of Deficiency, 
  • when the penalty is assessed, or 
  • the last day of the second tax year after the penalty is imposed.

If the shortfall was due to reasonable error and you took reasonable steps to remedy it, you may request a penalty waiver by filing IRS Form 5329 and a letter explaining the reasonable error. Before filing the waiver request, you should make a catch-up distribution from your retirement accounts to make up for the RMD shortfall.

 

Plan Your Passive Activity Losses for Tax-Deduction Relevance

 

In 1986, lawmakers drove a stake through the heart of your rental property tax deductions.

That stake, called the passive-loss rules, causes myriad complications that now, 37 years later, are still commonly misunderstood.

 

The Trap

 

In 1986, lawmakers made you shovel your taxable activities into three basic tax buckets. Looking at the buckets from a business perspective, you find the following:

  1. Portfolio bucket for your stocks and bonds
  2. Active business bucket for your material participation business activities
  3. Passive-loss bucket for your rentals plus other activities in which you do not materially participate

This letter explains three escapes from the passive-loss trap so that you can realize the tax benefits from your rental losses.

 

Escape 1: Get Out of Jail Free

 

Lawmakers allow taxpayers with a modified adjusted gross income of $100,000 or less to deduct up to $25,000 of rental property losses. Once your income goes above $100,000, the get-out-of-jail-free loss deduction drops by 50 cents on the dollar and disappears altogether at $150,000 of modified adjusted gross income.

 

Escape 2: Changes in Operations

 

If you, or you and your spouse, have modified adjusted gross income that exceeds the threshold, you need a different plan to obtain immediate benefit from your rental property tax losses. 

To begin, let’s review how the tax-benefit dollars get trapped in the first place. As you may remember, to benefit from your rental property tax loss, you must either

  1. have passive income from other properties or another source, or
  2. both qualify as a real estate professional and materially participate in the rental property. 

Example. Say the taxable income on your Form 1040 is $200,000 and you have one rental property. Say further that rental has produced a tax loss of $10,000 a year for the past six years, none of which you have been able to deduct because you have no other passive income and you do not qualify as a tax-law-defined real estate professional.

So here you sit: $60,000 in tax deductions trapped in the passive-loss bucket—not available for deduction against the income from the other buckets.

 

Not Lost, Just Waiting

 

This is sad, no doubt, but there’s some good news even in this bucket as you now see it. The $60,000 is not going to drown, disappear, or lose its tax-deduction attributes in some other way. That $60,000 simply waits in the bucket for you to give it an escape route.

Here are four possibilities for the escape route:

  1. Generate passive income.
  2. Change the character of the rental to non-passive.
  3. Change your status to that of a real estate professional, and pass the material participation test for this property.
  4. Sell the property, as explained in Escape 3 below.

 

Escape 3: Total Release

 

The $60,000 that’s trapped in the passive-loss bucket is like money in the bank. You can tap the trap when you want to release the deductions. It’s really quite easy.

Here we are talking about releasing the entire $60,000 at once (a major jailbreak). You might want to do this right now, or you can wait. You have many options, and the good news is that you are the one in charge of this total release of your passive losses.

To release the losses, you need to make a complete disposition. For example, say you sell 100 percent of the property to a third party. Presto! You now deduct the entire $60,000 in trapped passive losses.

 

Takeaway

 

The one thing to know is that if you have rental property losses that are trapped by the passive-loss rules, you have some strategies available.

If you have questions, don’t hesitate to contact me.