Category: Tax and Financial News

The U.S. housing market has been extremely volatile over the past year. Year-over-year growth rates were at highs of 20.1 percent in April 2022, then declined to only 8.6 percent in November – the biggest drop in over 20 years. As a result, many homeowners who sold their homes in 2022 or plan to in 2023 may have either gains or losses depending on their location and timing. Below, we tackle the issues you need to know to properly account for the taxation of your home sale.

Only Some Gains Are Taxable

Not all gains on home sales are taxable, with the initial $250,000 or $500,000 exempt in certain circumstances. All you need to do is have lived in the home as a main residence for at least two out of the past five years before the sale.

A key factor is that the above exclusion applies only to the sale of your main home. If you own multiple houses, the one you spend the most time in typically counts as your main home.

Reporting

Just because the gain on a home sale qualifies for exclusion from taxation, it does not mean that you do not need to report the transaction and income. Often, you will receive a Form 1099-S; and in all cases, you need to report the sale on Schedule D and Form 8949 with your Form 1040.

Also, remember that part of your gains could be taxable. Even if a married couple qualifies for a $500,000 exclusion, if they have a $600,000 gain, then the $100,000 over the exclusion is taxable.

Figuring Your Gain

To understand if you have a gain or loss on the sale of a home, you will need to make a calculation. First, start with calculating your basis. This is the price you paid for the house plus any significant improvements. When you sell your home, your gain is the sales price (less taxes, realtor commissions, etc.) and this basis. It pays to keep good records of remodeling and additions.

Capital Gains Tax

Like any capital asset (a stock, for example), if you owned your home for one year or less before you sold it, then you have short-term capital gains, which are treated as ordinary income for tax purposes. If you owned it longer than one year, then your capital gain above the exclusion is long-term.

Losses

In the case where you have losses on the sale of your home and not a gain, then you are in a bit of a bad spot. There is no tax impact since you cannot claim a loss on the sale of a personal residence. This is the other side of the exclusion of gains.

Exceptions to the Rules

As always, with the tax law, there are exceptions. One example is when a home is transferred as part of a divorce settlement. Here there is no reportable gain or loss unless your ex-spouse is a nonresident alien.

Other exceptions that might affect the taxability of your gain include those involving taxpayers who died, empty land, or a home that was destroyed. If you believe you have unusual circumstances related to a 2022 or pending 2023 home sale, then it’s best to consult with your tax professional.

2023 Home Sales

Looking at the remainder of 2023, there are mixed opinions on the single-family housing market. The consensus is that there will be fewer homes on the market for sale; however, how far prices may decline is up for debate.

Some analysts believe home prices will not drop much in 2023, despite increased mortgage rates due to demand being supported by low inventory. Meanwhile, others think prices could decline quite a bit, especially in certain markets such as Florida, Texas, and the Southeast, where they’ve run up the most in recent years.

National home price averages, while statistically cited, are meaningless, with residential real estate being, so location dependent. Many homeowners who sell in 2023 may still have a profit on the sale of their home. Assuming no tax law changes, the same capital gains rules will apply in 2023 as they did in 2022.

The takeaway here is that if you are thinking about selling this year, start planning now. Gains realized in 2023 are not reportable or taxable until 2024. Figuring out your basis and adjustments now will save a lot of headaches next tax season.

According to the IRS, not only is your ignorance no excuse, but so is that of your tax preparer. In other words, the fact that your tax preparer made a mistake is no excuse and will not absolve you from compliance penalties.

Unfortunately, the penalty for making what could be deemed an innocent mistake can cost a taxpayer a significant sum. What is worse yet is that defending yourself against the IRS is a costly endeavor in terms of both time and money. Part of the problem is that taxpayers often do not have the option of making an appeal directly to the tax court and, instead, must first pay the IRS and then challenge it in either District Court or the Court of Claims. Stated plainly, the average taxpayer simply cannot afford to fight the IRS in tax court.

In the remainder of this article, we will look at two main areas that tend to be problematic for taxpayers: first, assorted penalties for misfilings and mistakes; second, obscure international forms.

Miscellaneous Mishaps and Mistakes

Taxpayers can get caught up in “gotcha” type situations where they inadvertently make a mistake in the type, accuracy or timing of the filings. Here is a checklist of some of most common issues in which taxpayers typically make unintentional errors that will not be forgiven by the IRS.

• Filing late and paying short: Filing a return late and underpaying the tax owed each carry separate penalties. Together, these penalties can add up to 47.5 percent of the original tax owed in a worst-case scenario.
• Careless Filing Details: If you make a mistake in filing your return and it results in tax liability in your favor, you can owe a penalty of 20 percent of the under-reported taxes. In the case of faulty appraisals for items such as donated property, the penalty can double up to 40 percent.
• Writing Bad Checks: Technically it does not matter if it is a physical check or another payment method, but if a taxpayer’s payment to the IRS is declined, the IRS will change an additional 2 percent penalty.
• Missing Checklists: Failure to file the two-page “due diligence” checklist before claiming certain credits, such as the earned-income or college credits, can result in a fine of $545 per credit.

Obscure International Forms

Many compliance-related rules related to international investments and banking activities were originally created to put a stop to drug dealers, terrorists and flagrant tax cheats. Unfortunately, the regulations are still in force, but apply to increasingly more taxpayers as the threshold amounts have not increased yet more U.S. citizens are working, living or retiring abroad. Moreover, the penalties can be severe. In this section, we will look at some of the most obscure and serious foreign tax compliance issues.

• Passive Foreign Investments: If you own mutual fund shares incorporated abroad you must file Form 8621.
• Personal Holding Companies: If you create a corporation to hold a foreign property, you will need to file Form 5471, for a Controlled Foreign Corporation.
• FBAR: If you have $10,000 or more in any combination of international bank and brokerage accounts, at any single point in the year, you need to file the FBAR form electronically. Note, the trigger here is that the bank or brokerage is outside the United States. If you hold securities of foreign companies or foreign currencies with a U.S. institution, the reporting is not required.
• Fatca Disclosures: Facta disclosures were created to combat money laundering, covering all manner of foreign financial assets, including insurance and retirement assets. It can overlap with the FBAR requirements, but the additional reporting here is triggered by higher thresholds starting at $50,000 in assets for single U.S. residents and up to $400,000 for couples residing abroad and filing joint returns.

Conclusion

Remember that ignorance of the tax law is no excuse, especially in the eyes of the IRS. It does not matter if a mistake you make is truly innocent; there is still a good chance that you will end up paying unpleasant fines and penalties and, in the worst case, a big mess. It is best to be timely and diligent in your filings.

The recent hurricane Ian impacted much of the southeast United States. As a result, it is good to know the general tax rules related to disaster victims. Below, we look at several tax topics for disaster area victims.

1. Tax Returns and Filings

Q: I am a disaster area victim and needed to move from my home. I might not be back for a long time or even at all. Which address should I use on my tax return?

A: A taxpayer should always use their current address in filing a tax return. In the situation where you move after filing your return, you need to update your address with the IRS. You can do this either by filing form 8822 or calling the IRS Disaster Hotline at 866-562-5227.

Q: I filed an extension for my form 1040, giving me until Oct. 15 to file. Are there any further extensions available?

A: Taxpayers who already filed for an extension until Oct. 15 and live in a federally declared disaster area of the recent hurricanes receive an automatic extension due date of Dec. 31.

2. Payments

Q: I have a balance due on my 2021 tax return and am currently accruing interest on it. Is there any relief for disaster victims on interest charges?

A: No, the IRS is not giving any forbearance or cancellation of interest on tax balance liabilities. The IRS is, however, willing to waive late payment penalties when the taxpayer can prove the reason they are late is caused by issues related to the disaster.

3. Property and Casualty Loss

Q: During a recent disaster we lost electricity and all the food in my refrigerator and freezers spoiled and I had to throw it away. My homeowners’ insurance reimbursed me, and it was for more than the food cost me. Do I have to report any income on the amount over my food costs?

A: No. The tax code makes a distinction between scheduled property and general reimbursements. For unscheduled property (general reimbursements), the taxpayer does not need to recognize income for reimbursements on personal property, even if it was more than the cost of the lost property.

Q: I need to prove the reasonable value (FMV) of my home. Am I allowed to use property tax assessments to substantiate the FMV of my home?

A: No, the only way a taxpayer can establish the FMV of a property is either with an appraisal by a credentialed appraiser or using the cost of repairs method.

4. Sale of Home

Q: My primary residence was destroyed and the cause was deemed to be a federally declared disaster. After clearing the lot, I sold the land alone for a gain. Do I have to pay taxes on the gain or is there an exclusion since it is where my primary residence used to be?

A: Selling a vacant lot does not qualify for the exemption on gains from primary residences. The exception to this rule is if the land previously had the taxpayer’s main residence on it. In this case, if the taxpayer would have qualified for the main residence exemption before the disaster, the gain on the sale of the vacant land would be exempt here as well.

5. Expenses

Q: I worked in a federally declared disaster area and had to move for my job at my own expense. Can I deduct my travel and related expenses?

A: The answer depends on whether or not the move is expected to last for more than one year. If you expect the move to be temporary, defined as less than one year, then there is no change in your tax home. In this case, you can deduct travel and related expenses to get you both to and back from your temporary work assignment. If the move is long-term, defined as more than one year, then the expenses are not deductible, regardless of whether your employer reimbursed you.

It is all about how much you keep after taxes – not what you earn from your job, a business or investments. While it is always great to see fabulous investment gains, the only financial metric that really matters is what is in your bank account at the end of the day. One of the ways you can influence this is by minimizing the taxes you pay on your investments.

Unfortunately, many people do not think about how taxes impact their investment returns until near the end of the year; however, you should act all year round. Taking part in investment tax planning throughout the year will give you opportunities to keep more of what you earn. Here are some rules and strategies to keep in mind.

Know When to Take Your Losses

Psychologically, many investors are averse to taking losses, holding out to “make their money back.” Instead of emotion, logic and investment acumen need to be applied here. If an investment does not have a fundamental reason to turn around, then you are better off selling it and taking a tax loss.

Losses reduce taxes on either your capital gains for the year or, when losses exceed gains, up to $3,000 on other income. Excess losses can be carried forward to future years. Plus, you will have the proceeds to reinvest in something more likely to produce a return.

Let Winners Run

Unlike long-term capital gains, short-term capital gains are taxed as ordinary income. This means your marginal income tax rate (the highest rate applied to you) can impact your investment gains.

While you should not let the tax tail wag the investment dog, ideally you want to hold a winning investment for at least a year and a day to benefit from long-term capital gains tax treatment. This means you will pay only a 20 percent maximum tax versus whatever your marginal rate is.

As with losses, the fundamentals of the investment are key. Therefore you should not sell a holding if you think the gains are at risk just to save on taxes. If you believe in the investment for the long term, then holding out for preferred capital gains treatment can be a clever idea.

Give the Gift of Appreciation

Making charitable donations you would not otherwise give is generally not a viable tax strategy. However, if you are already charitably inclined then consider donating stock or mutual funds instead of cash.

When you donate property such as stocks, your charitable deduction is based on the fair market value of the asset on the date of the gift. It is much better to do this than donate cash.

For example, if you have a stock you purchased for $35 and it is now worth $135, when you donate it you will receive a charitable deduction of $135. If you were to sell the stock first, you would have to pay tax on the $100 gains and then have only $103 to donate in cash – assuming you are in the 32 percent tax bracket. The only winner in this situation is the IRS; both you and the charity lose. This is because the charity is excluded from paying capital gains taxes on the appreciation that occurred while you owned the asset.

Hold Until You Die

This strategy does not benefit you directly, but rather your heirs. When someone inherits an asset such as real estate, stocks, bonds, mutual funds, etc., the cost basis of the asset is reset to the fair market value at the date of death.

This means that if you have stock in company XYZ that you bought for $50 and now it is worth $500, you would pay tax on the gain of $450 per share. However, your heir would pay $0 if he sold it on the day you died. If your heir continues to hold the stock, the benefit still applies as his cost basis in the stock of XYZ would reset to $500, so he will pay taxes only on gains over that amount.

Conclusion

While you should never cheat on your taxes or do anything unethical, it is foolish to pay any more than legally necessary to the IRS. Engage in investment tax planning year-round and you may see better after-tax returns and more money in your bank account.

One highlight of the recently passed Inflation Reduction Act of 2022 (IRA; HR 5376) includes modifications to what is more commonly referred to as EV credits. Specifically, Section 30D of the Act is where the most important modifications are, and where the present tax credit for electric vehicles is spelled out in the U.S. Code. There is also new stimulus for previously owned electric vehicles, industrial vehicles and “alternative fuel refueling property.”

According to the Joint Committee on Taxation’s estimates, in lieu of what was previously known as the credit for plug-in electric vehicles, there is now a new clean vehicle credit. It is expected to be worth $7.5 billion over the next decade. Other noteworthy tax credits include $1.7 billion for “alternative fuel refueling property,” $1.3 billion available for buying a previously owned qualified plug-in EV, and $3.6 billion in tax credits for qualified commercial clean vehicles.

How the IRA Changes Section 30D and EV Tax Credits

For eligible, new clean vehicles, purchasers may receive $7,500 in federal tax credits and $4,000 for similarly used vehicles. It is important to note that taxpayers who purchase such vehicles are eligible for this tax credit if their modified adjusted gross income (MAGI) during the current or preceding tax year is no greater than $300,000 for joint filers; $225,000 for heads of household; and $150,000 for single filers. It is also limited to pickup trucks, vans, and sport utility vehicles up to a MSRP of $80,000. All other vehicles costing up to $55,000 are similarly eligible.

Critical Mineral Standards

Another important qualification for this tax credit is if the vehicle’s battery has a minimum threshold of critical minerals and if it has been processed in the required geographies. Section 30D(e) requires progressively increasing percentages of critical minerals either processed or extracted in the United States or another country the U.S. has an existing free-trade agreement with. If the stated percentages are recycled in North America, a vehicle’s battery components may also qualify for the tax credit.

Once guidance is issued by the U.S. Treasury and before the start of 2024, there must be at least 40 percent of eligible critical minerals to qualify. Vehicles placed in service in 2024 must have at least 50 percent critical minerals in their batteries. Critical minerals must be 60 percent, 70 percent and 80 percent of a battery’s components in 2025, 2026 and after Dec. 31, 2026, respectively. Dependent on future guidelines developed by the Internal Revenue Service, manufacturers will have to sign off on battery component makeup.

Requirements for Battery Manufacturing/Assembly Requirements

According to Section 30D(e)(2), prior to Jan. 1, 2024, at least half of the components of an EV battery must be assembled or manufactured in North America. Starting in 2024 and through 2025, 60 percent of a battery must meet such requirements. Beginning in 2026 through 2028, this requirement will increase by 10 percent annually, eventually requiring 100 percent of a battery’s construction to meet these standards beyond Dec. 31, 2028.

Other Considerations for Tax Credit Eligibility

If any critical minerals were extracted, handled or recycled by a “foreign entity of concern,” it is prohibited by the IRA for tax credit eligibility. Similarly, final assembly also must take place within North America to retain eligibility for the tax credit. Being considered a “qualified manufacturer” is another requirement that is necessary to maintain tax credit eligibility. This is any manufacturer that adheres to the EPA’s Title II Clean Air Act rules.

With the push for cleaner and greener energy evolving, this is one of many tax credits for consumers and businesses alike to reduce emissions and navigate the U.S. Tax Code.

Despite borrowing massive amounts of money, the government still needs to find ways to raise revenue to pay for new programs and spending. The current democratically controlled Congress is looking to potentially implement new social programs and a climate bill. As a way of funding these initiatives, they are considering an expansion of the Net Investment Income Tax (NIIT).

The NIIT is proposed to raise revenue since it is seen as politically more palatable, given that it typically only impacts a small group of wealthier taxpayers. Critics, however, say the plan in its current form would also hurt small family businesses.

Who Pays NIIT Now?

Under the Affordable Care Act (ACA), the NIIT applied a 3.8 percent tax on investment income. Investment income includes both passive sources like dividends, capital gains, interest, royalties, and rents as well as passive business income. Under the ACA, the NIIT applied only to single taxpayers earning $200k or more and joint filers with $250k or more.

When it comes to the taxability of business income under the NIIT, because the law only captures passive business income, most owners of pass-through entities must pay the NIIT; however, active owners of S-corporations are exempt. Likewise, if someone qualifies as a real estate professional, their income is considered active and so their rental income is also exempt.

Who Would Pay Under the New Proposed Law?

The current version of the House bill makes two major changes. First, the NIIT expands to capture all business income. Essentially, S-corporation shareholders, limited partners, and pass-through entity owners that are currently exempt would be impacted.

Second, when it comes to removing the exemption on this business income, the income threshold rises from $200k to $400k for single filers and from $250k to $500k for taxpayers filing jointly. The effect of this would be to exclude most business owners from the tax, but make filing more complex for those impacted.

Under the new rules, the Tax Policy Center projects that in 2023 the tax hike would fall on those in the top 1 percent of household incomes or those making approximately $885k or more. Further, even among the top 1 percent, more than 50 percent of the tax increase would be borne by the top 0.1 percent for those making $4 million and up.

Impact No Small Businesses

Overall, about 14 percent of taxpayers report some form of business income on their federal tax returns. The amount reported, however, is usually not a material amount for most as a percentage of their income. For example, only approximately 5.5 percent of taxpayers with reported business income had this as the source of 50 percent or more of their total income. As a result, the impact will be mostly on a small percentage of small businesses. At the same time, as business income is far more variable than employment income, someone could easily fall in and out of the tax range.

Conclusion

Overall, the House bill looks to raise the threshold of where the NIIT expansion applies by the type of income it captures. We will have to wait and see if there are changes as the bill makes its way through – if it even passes at all. No matter what happens, there will certainly be tax increases of some kind.

COVID-19 impacted the economy dramatically and commercial real estate was no exception in terms of decreased values. Often, the real property could no longer service the debt used to finance it. This debt restructuring and resulting debt forgiveness can result in taxable income.

Taxable Income and Debt Cancellation

If you have a $80,000 loan and the bank reduced the amount you owe down to $50,000, then you have an economic benefit of $30,000, which should be treated as taxable income. This is indeed how cancellation of debt is treated, but there are exceptions such as in the case of bankruptcy or insolvency. There is another unique scenario that applies only to commercial real estate.

Assuming that the taxpayer is not a C-corporation, debt cancellation is excludable from taxable income if it results from qualified real property business indebtedness (QRPBI). QRPBI is debt taken on to buy real property used for commercial purposes. Starting in 1993, debt used for building or improving a property also qualify.

As we all know, there is no such thing as a free lunch. In order for debt cancellation to not be considered current taxable income, the taxpayer must reduce their basis in the real property by this same amount. This does not cancel the income; instead, it defers its recognition and helps cash flow as a result. Below, we look at an example of how this works.

Illustrative Example

Assume David bought a property in 2017 and he uses it for business purposes. In 2022, the property has a first mortgage of $200,000 and a second mortgage of $100,000 (both with the same bank), with a fair market value (FMV) of $240,000. He negotiates with the bank to reduce the second mortgage down to $20,000, resulting in income from the cancellation of debt of $80,000.

The amount of debt cancellation that can be deferred is equal to the amount of the second mortgage before the debt cancellation, less the FMV minus the first mortgage. In David’s case, before debt cancellation, the FMV ($240k) minus the first mortgage ($200k) was $40,000. The balance of the second mortgage ($100k) exceeded this by $60,000. Out of the total debt cancellation of $80,000, this $60k is subject to deferral, with only the remaining $20,000 reported as immediate taxable income.

The $60,000 is not considered as taxable income only to the extent that David has sufficient adjusted tax basis in the depreciable real property to absorb this as a reduction in basis. Assuming this is the case, the reduction in basis applies the first day of the tax year after the debt cancellation (unless the property is sold before year-end – then it applies immediately).

In the example above, David would include the $10,000 of cancellation of debt income on his 2022 tax return and adjust his basis in the real property by $60,000 as of Jan. 1, 2023.

Filing Mechanics

For real estate held via partnerships instead of by individuals, determining if debt is QRPBI qualified happens at the entity level, although reductions of basis are done at the individual level for each partner, allowing individual planning. The election to defer cancellation of debt income is recorded on Form 982.

Conclusion

The COVID pandemic caused many real estate investors to restructure their debts. The option to defer debt income cancellation offers a great tax planning opportunity by delaying taxable income and improving cash flows.