While enjoying a round of disc golf this week one of the players was talking about someone who had to live in a house he inherited for three years in order to avoid paying tax on the sale of the house. I may not have all the relevant details but it seemed confusing enough that I thought it would be a good idea to relay some tax information to others concerning home sales and a warning about tax traps.
There are three basic facts you should remember about home sales. The first thing should remember is that you only have to pay tax on the profit from a sale. The profit is based on the difference between the basis and the selling price. Generally, the basis is what the house was purchased for plus amounts paid for improvements. So, if you purchased the house at $75,000 and sold at $100,000, the profit would be only $25,000. It's only natural that you would make a profit on a home sale since inflation and appreciation increases the value of your home.
Secondly, current tax law allows owners to exclude $250,000 ($500,000 if married) of gain on a home sale. To qualify, the home must have been owned for two of the last five years, and used as a main home for two years out of the prior five years. So that taxable $25,000 becomes zero. Incidentally, that hasn't always been the case. See Income Averaging and Transitions in Tax Law for an interesting comparison with 1964 tax law.
Third, property inherited receives a basis equal to the fair market value of the home at the time of the decedent's death (with some exceptions). In this case, the heir would not qualify for the exclusion mentioned above since he didn't live there. However, even though he may not have paid anything for the house he inherited, his basis for calculating profit is the value at death, which should be close to the actual selling price. By definition, it's not likely that someone will purchase the house at very much over the "fair market value", so it should be rare to owe any tax on the sale. It's much more likely that you would be selling below fair market value just to get it sold.
Most people probably understand that you only pay tax on the profit, but many will not know about the exclusion or the treatment of inherited property. Of course, there may be other aspects of the sale to consider, but remembering these three facts may come in handy for you or someone you know.
There are many tax traps where you are liable for taxes you didn't know about, but there's probably more "traps" that involve taxes you paid that you didn't have to or credits you didn't claim.
For many years people, including many tax preparers were not aware of the benefits of education credits. You may think that's just for low-income taxpayers, but if you make less than $80,000 ($160,000 joint), you could qualify for up to $2500 in AOTC, often even if you received financial aid, and even if you didn't pay anything out of pocket. Plus, there are several other tax credits.
Education Tax Credits were so overlooked that I wrote a book on the subject two years ago. See Education Tax Credits. A few things have changed (technically) since then, but the credit is essentially the same. For example, you now have to have a 1098T, but the institutions will now have to provide one to you. If they don't you can still claim as if they did. You can see a summary article at Education Credits: Beyond the Basics.
One of the basic concepts of inheritance of property is that it gets a step-up in basis which usually means no taxes. Although inherited property gets a step-up in basis, if you receive an IRA as an inheritance, it is taxable and there is a significant penalty for cashing it in. There are other rules related to IRA management, and the institution may not warn you about them. Read more about Common IRA Traps.
Yet another thing that many people are not aware of is that taxpayers can normally amend (change) their tax returns for up to three years to get benefits they didn't claim when they first filed. Of course, there are some things you can't easily change with an amended return, such as uncashing in an IRA distribution.
In many tax cases you can consult a tax professional, but in some cases it may not be enough to consult one or two professionals. If it involves a large amount or tax, research it yourself and ask a lot of questions. Start with googling if you want, but refer to taxpayer publications or the tax code to verify what others are saying. Don't blindly rely on a website or even a tax preparer. Many times the tax forms and instructions will guide you through the calculations, while tax preparers way speedily just fill in the blanks.
]]>I have a little tax book that I pick up and read on occasion, How to Legally Avoid Paying Taxes by Sidney Walton. This book came out after the tax reform act of 1964. That year, the individual capital loss carryover was $1000 and carried over for unlimited years. Moving expense deduction was new. There was a deduction for political contributions. Capital gain rates were cut to as little as 7%. While some of the benefits of that era are not so impressive considering today's standards, one benefit had a lot of potential, income averaging.
For most types of income, taxpayers could have the ability to average their income over a five-year period. The benefit was only beneficial for taxpayers with fluctuations in income or those with windfall profits in a single year. The law did not apply to gambling, capital gains, and certain other income. Today that law doesn't exist except for specific industries. Instead, taxpayers have to effectively average their income by doing such things as taking losses in years they have gains, keeping funds invested, using IRA rollovers or recharacterizations, or grouping deductions in prosperous years.
The most discouraging part of this law were the complicated calculations. Remember this was before the introduction of the Personal Computer in the early 1980's. For the knowledgeable, it was a blessing. You could earn $40,000 is one year and average it with the $8,000 for each of the previous four years and you would pay tax based on the rate for less than $15,000 each year.
Years after the 1964 reform permitting income averaging, I remember reading a feature article (hard copy) about how one couple took advantage of the income averaging law. They would buy an old house, live in it and fix it up over several years. When they sold it, they income averaged the profits. Of course, there were issues relating to whether the gain was capital gain or ordinary income that had to be settled.
As mentioned, income averaging no longer exists, but those taxpayers may have an even better incentive for that. With the exclusion of captial gain on a home in the current law, that same couple could buy and fix up a house, sell it for a $500,000 gain and pay no taxes on it all. They have to have lived in it for 2 of last 5 years and meet some other requirements, but with proper planning it could be profitable venture.
Incidentally, home sales also had a exclusion in the 1964 law as well. That exclusion was a one-time event, and required the owner to live in it five of the last eight years, and be age 65 or older. The limit was based on a modified sales price of $20,000.
When Congress writes tax laws that provide a benefit, they generally are providing a reward for some action or activity, or a benefit for someone with a need. Inadvertently, some of those laws are used by others for whom the law was not intended. That's might be referred to as a loophole. The current fixer-upper business is something that some would call a loophole. However, the law was specifically written to permit this type of activity. The exclusion is available every two to five years. It could have been written like the 1964 law for home sales with an age requirement and a one-time limitation. It wasn't. In the end, a subsequent Congress will determine if it was a loophole and then attempt to close it.
]]>With most companies taking care of making distributions, most people don't have to worry about required minimum distributions (RMDs). But, that does not always happen. If the company doesn't, you have to remember to. The rules make it difficult to calculate and remember the date the RMDs start. The first one begins in the year you turn 70 1/2 (not 70 or 71). That one, and only that one, can be taken as late as April 1. After that, they have to be taken by December 31. Yes, there is forgiveness, but you have to catch up and if two RMDs are taken in the same year, you can end up in a higher tax bracket. Incidentally the penalty is 50% of what should have been taken.
Even if you don't have an IRA of your own, you may need to know the tax consequences of receiving a IRA due to someone's death. The bank could just send it to you without any further explanation. Then another bank may give you bad advice about what to do with it. That happened to one client. The bank told her to put it into a CD (What is the interest on CD's now?), and the person ended up with a hefty tax bill. If the person would have known, she would have rolled in over into another IRA.
Lump-sum distributions come with quite a large tax liability, but there is an apparently a grandfathered rule that allows recipients of an IRA paid due to death to calculate the tax on a 10-year basis. There are specific rules, including that the person must have been born before Jan 2, 1936. That date doesn't change each year. Both times I've encountered this, the tax savings were near $5,000. Who's going to know this rule? You should.
This issue also has another component if you are using a certain software package. Although this program calculated the taxable amount correctly based on Form 4972, instead of using that as the tax, it added it to the normal tax amount. No other software that I have used does that. That's another bit of advice. Know what your software is doing; it might not always be right.
Speaking of lump-sum distributions, carefully consider the tax that will be owed on the distribution. Just because a company is required to take 20% withholding on the distribution doesn't mean that is all the tax they will have to pay on it. It may just be a down-payment on their total tax liability. If it's an early distribution and there's not a good reason for it, there may also be an additional 10% penalty.
Unlike Traditional IRAs, Roth IRAs are not taxable. Usually, the company reports distributions on a 1099-R with a code indicating the type. It usually doesn't say Roth on it anywhere. In one case, a taxpayer came in with a form indicating a normal distribution, with a Code 7. He said it was a Roth IRA, in which case it should have had a different code. He insisted it was a Roth, and had a good argument to back that up. Keep good records, read them, and if it's a rollover know what type of rollover you are making. If it doesn't get tagged as a Roth, it becomes taxable all over again. Not good.
The side note here is to know your forms. They are not always right and if the wrong information is put in the software, you get a wrong result.
While there are traps, there are also opportunities with an IRA. There are exceptions for early withdrawals for certain dire needs, such as education, housing, and medical needs. You can also start retirement before 59 1/2 (SEPP) under certain circumstances. The one most overlooked is the Roth rollover. It always worth considering, especially in those years with limited income. If it doesn't work, it may be possible to undo it. The IRS has publications that cover IRAs. If you don't want to download them or read them on-line the IRS will mail them to you free if you request them.
The importance of knowing your finances is becoming more crucial with all the options that are available. It's not enough to know you have a good employer package or bank product. You need to know how to use it .. and how not to.
With the introduction of the Patient Protection and Affordable Care Act, commonly referred to as ACA, there may be issues to consider for the 3.8% Net Investment Income Tax (NIIT) imposed on higher levels of investment income. While the threshold is fairly high for individual taxpayers ($200,000 - $250,000 for single, married taxpayers), it is not so much for trusts. Investment income includes interest, dividends, rents, royalties, annuities. For 2014, $12,150 is the threshold for the highest tax rates and the NIIT. Because much of trust income is investment income it is even more important to know the tax liabilities. For a trust NIIT is imposed on investment income included in distributable net income (DNI) which is generally the excess of income over expense. While investment income distributed to beneficiaries is not taxable to the trust, it is subject to NIIT of the beneficiaries, but the threshold is much higher.
Capital gain is also considered investment income although its treatment has a few twists. Since the tax applies to income that is not DNI, whether or not income is included in DNI will be a deciding factor. Treasury Regs. Sec. 1.643(a)-3(b) covers capital gains in detail. If it is included in a distribution it would normally be taxable to the beneficiaries. If the gain is attributed to corpus activity the trust generally must pay NIIT. However, there are several other conditions where the trust could avoid the tax. Capital gains may not be taxable if the capital gains are included in financial accounting income and is normally set aside for beneficiaries. If capital gain is consistently treated as part of distributions, or actually distributed, it is not subject to NIIT. Unitrust provisions and the power to adjust statute are other instances where NIIT may not apply. Obviously grantor trusts and tax-exempt trusts like CRTs are generally not taxable within the trust.
http://journalofaccountancy.com/Issues/2014/Apr/trusts-estate-planning-20138750.htm
http://www.aicpa.org/Publications/TaxAdviser/2014/august/Pages/Tax_Clinic_03.aspx
http://www.irs.gov/irb/2004-05_IRB/ar08.html#d0e360
A notable tax court case this year involving a trust was at the intersection of Section 469 and Section 1411. According to Section 1411, NIIT does not include amounts earned in the course of a business or trade. Consequently, if the activities of an individual are considered a trade or business rather than an investment, the additional tax doesn't apply. At issue is the idea of material participation by the trust, and one notable Tax Court demonstrates what questions are involved.
Although Section 469 deals primarily with passive loss rules, it's definition of what is considered a trade or business also defines what is not passive, investment income. Since this trust met the requirements of Section 469(h), the activities of a trust can be considered trade or business. Furthermore, although the activity was a rental activity, because of the participation levels of trustees, it meets the requirements of being a real estate professional as outlined in Section 469(c)(7)(B).
Though not a subject of this case, it is also possible that trusts could benefit from the use of grouping rules to lump multiple activities into a group for purposes of calculating hours for material participation. Special IRS provisions allow taxpayers a one-time opportunity to redefine groups when they first become subject to the NIIT. Prop. Reg. Sec. 1.469-11(b)(3)(iv).
http://wealthmanagement.com/estate-planning/trusts-can-materially-participate-trade-or-business
http://www.journalofaccountancy.com/News/20149868.htm
http://www.aicpa.org/Publications/TaxAdviser/2014/October/Pages/Tax_Clinic_05.aspx
http://www.ustaxcourt.gov/InOpHistoric/FrankAragonaTrustDiv.Morrison.TC.WPD.pdf
Another trust issue that received some attention this year was miscellaneous deductions subject to the 2% floor. Following a win/loss at the Supreme Court 7 years ago, the IRS finally released regulations defining clearly what expenses are subject to the 2% floor for trusts. Before that, fees related to investment management were often considered to be subject to the 2% floor, even though trustee fees were not. Like the court decision, the IRS notes that expenses are fully deductible if they would not “commonly” or “customarily” be incurred by an individual holding the same property. That distinction is the overriding consideration in the rest of the regulations, and should be a good guide to remembering what items are subject to the 2% floor.
Section 67(e) regulations do attempt to define which fees are, and are not, subject to the 2% floor, as well as those fees not considered miscellaneous expenses. Five categories of fees are mentioned, including ownership costs, tax preparation, investment advisory fees, appraisal fees, and certain fiduciary fees. Whether or not fees are subject to the 2% floor, however, depends on the specific fee. Under ownership costs, for example, while condominium fees, insuranace and maintenance are considered 2% costs, other ownership costs are not mentioned (as previously included in the proposed regulation). Notably, one omission is real estate taxes, apparently because they are fully deductible. See the article referenced or the regulations for all the details.
One other issue covered in the new regulations involve bundled fees.When fees are bundled, it may be necessary to unbundle them to determine which expenses are 2% . The method used to allocate bundled fees, however, is not defined, and the regulations say any reasonable method is acceptable. There is also a specific test available when the fees are not based on an hourly rate. The regulations applies to tax years beginning on or after May, 9, 2014.
The long history of the controversy is also fascinating, though it appears the new regulations will finally settle all of the disputes. Or will it?
http://www.journalofaccountancy.com/News/201410110.htm
http://www.aicpa.org/Publications/TaxAdviser/2014/august/Pages/Cantrell_Aug14.aspx
http://www.irs.gov/irb/2014-22_IRB/ar05.html
http://www.forbes.com/2007/07/10/taxes-trusts-estates-biz-beltway-cz_ea_0711beltway.html
http://www.americanbar.org/publications/probate_property_magazine_home/rppt_publications_magazine_2008_so_Bekerman.html
While the news was generally limited to the few subjects above, I did learn some other things in 2014 related to trusts that you might find informative.
I've heard about Crummey trusts before, but I found it interesting that politicians decried the use of Crummey type trust strategies to avoid income tax. It was later found that the politician was using those same tactics in their own affairs. I, for one, don't blame politicians for using a legal tactic to minimize his taxable income. I take advantage of benefits that I don't particularly agree with. But I also believe crackdowns on trust manipulations will be quite slow, since so many in politics use them. This one, however, is more likely than others to see some regulation.
Essentially, Crummey trusts are funded by gifts to beneficiaries. When beneficiaries fail to claim their gift during the limited time available to do so (usually 30 days), the funds become part of the trust. The most popular use of Crummey trusts is as a way to set aside money for dependents in such a way that the beneficiaries cannot access it early and waste it. As an irrevocable trust, it escapes estate and GST taxes as well as creditors.
INGs have also been around, but with something of a new name. I first heard of the Incomplete Non-Grantor trust when it was called the DING (Delaware Incomplete Non Grantor trust). In one way, this is just the opposite of a Crummey. Instead of having contributions treated immediately as a gift, the trust is structured so that the contributions are incomplete gifts. The grantor does this be reserving powers over the trust, such as the ability to change beneficiaries.
The two main goals of INGs are to preserve terminal basis adjustment, and to escape the penalty of living in a high state income tax state. As irrevocable trusts, INGs are also protected from creditors. Delaware and Nevada are the two states that are most popular for this trust, and the IRS blessed the use of INGs in 2013.
http://www.northerntrust.com/documents/line-of-sight/wealth-advisor/incomplete-non-grantor-trusts.pdf
http://www.aicpa.org/Publications/TaxAdviser/2014/august/Pages/Tax_Clinic_02.aspx
http://wealthmanagement.com/estate-planning/new-private-letter-ruling-breathes-life-nevada-incomplete-gift-non-grantor-trusts
Yet another trust tactic is the (Intentionally) Defective Grantor Trusts (IDGT). The IDGT (supposedly pronounced "I dig it") is set up with an irrevocable gift of property to the trust. When the grantor reserves certain powers over the trust, it becomes defective. The grantor is taxed on the trust income, but the trust is not included in his gross estate.
http://www.cfcpas.com/business-gift-and-meals-and-entertainment-deduction-2/
http://www.estateplanning.com/drafting-defective-grantor-trusts/
Although this type of trust provides some protection from creditors, the primary use of the trust is often to preserve the assets of a deceased spouse for the survivor, avoiding state estate taxation. In Texas, credit shelter trusts are not as crucial as in other states with a state estate tax, however there are other reasons to set up a credit shelter trust, such as preserving inheritance for their children.
One of the popular subjects discussed in relation to the credit shelter trust is portability. Portability is the ability to use the remainder of one spouse's estate tax exemption. Instead of relying on portability, each spouse will leave their portion of the estate to the trust, providing income to the surviving spouse and meeting exceptional needs when necessary.
Another popular trust used to guard against actions of creditors is the domestic asset protection trust (DAPT), and it is now available in over a dozen different states. Trusts assets are protected against creditors after a certain period of time. In Nevada, that period is two years. With a DAPT, although an irrevocable trust, discretionary distributions can be made to a beneficiary. All distributions are made by a trustee, and no beneficiary can be a trustee. Based on Mr. Google's analysis of all DAPTs on the web, one common use of DAPTs is to protect assets in a divorce, or incidental to a prenup.
http://www.bakerdonelson.com/spotlight-on-mississippi-domestic-asset-protection-trust-legislation-07-09-2014/
http://www.forbes.com/sites/robertpagliarini/2014/05/15/how-to-protect-yourself-in-a-divorce-using-a-domestic-asset-protection-trust/
A Grantor Retained Annuity Trust is setup by contributing assets to a trust that makes (annuity) distributions to the grantor for a period of years with the remainder going to another beneficiary. Sounds simple except that the calculation of the value of a GRAT is based on Section 7502 rates (locked in), and that is taken in consideration when defining payments. Often however, the remainder, now valued at zero by the code, is often actually quite large when distributed.
If you've read anything about the history of the GRAT, you'd remember that the loophole the GRAT uses to shelter family wealth was created to close another trust loophole. And because the loophole is legal, court cases have repeatedly sided with taxpayers using GRAT techniques. Unlike a Crummey trust which generally limits the contributions to $225,000, millions can be contributed to a GRAT, and thus escape estate tax, that is, of course, if the grantor lives. If not, the remainder is included in his gross estate. But, then, that is where rolling GRATs come into play. With short-term GRATs, the final distribution from the GRAT becomes the asset to create a new GRAT.
By locating a GRAT in another state, the taxpayer can also avoid state taxatios, and South Dakota is the preferred site for creating a GRAT. The GRAT is another trust that is under verbal attack by polititians.
http://www.bloomberg.com/news/2013-12-17/accidental-tax-break-saves-wealthiest-americans-100-billion.html
https://tax.thomsonreuters.com/media-resources/news-media-resources/checkpoint-news/daily-newsstand/booming-stock-market-puts-spotlight-zeroed-grats/
http://www.accountingtoday.com/news/South-Dakota-Address-Helps-Richest-Shelter-Wealth-Forever-from-Taxes-69126-1.html
http://www.pierrolaw.com/_blog/Pierro_Law_Blog/post/rolling-grats/
A Charitable Remainder Trust (CRT) is just what it sounds like. The trust is set up with one or more beneficiaries who receive a regular distributions for a period of time. The remainder of the trust is then assigned to a charitable organization, or at least, that's the principle. Distributions are actually made at different tiers, with different levels of taxability. The trust itself, however, is not taxed.
Although there are various forms, the code only describes the Charitable Remainder Annuity Trust and the Charitable Remainder Unitrust is Section 664. CRTs have been around for many years and have been useful in reducing capital gain, but now with the NIIT, there's been a surge in its use. It is a popular alternative for funding retirement. Although a CRT is exempt from income tax, special rules do apply under Section 1411 for calculating investment income of beneficiaries. Also, a CRT may be subject to excise tax for UBTI.
One of the beauties of a CRT is that capital gains escape taxation, so contributing appreciated property is a primary means of funding the trust. Even better, when the contribution is finally made to a charitable organization it could be deductible. It's even possible to accelerate the deduction by terminating the CRT early. When that is done, the terms NICRUT, NIMCRUT, or Stan CRUT have important meanings and Section 7520 comes into play.
http://wealthmanagement.com/philanthropy/termination-charitable-remainder-trusts
http://www.aicpa.org/Publications/TaxAdviser/2014/may/Pages/clinic-story-02.aspx
http://www.financial-planning.com/fp_issues/44_01/new-ideas-for-charitable-remainder-trusts-2687602-1.html
http://www.financial-planning.com/30-days-30-ways/charitable-trusts-advanced-planning-tips-2688691-1.html
http://www.forbes.com/sites/ashleaebeling/2013/08/14/charitable-shelter-how-cruts-cut-capital-gains-tax/
It's obvious that a grantor can change a revocable trust, but an irrevocable trust can also be changed or corrected. Non judicial settlement agreements and decanting are two ways to accomplish that. I say "corrected" because the changes must accomodate some amount of similarity to the purpose of the original trust. By decanting the trust is changed to handle some incident or condition that was not considered when the trust was first drawn.
http://www.financial-planning.com/blogs/new-ways-to-change-irrevocable-trusts-2688571-1.html
http://wealthmanagement.com/estate-planning/irs-blesses-decanting
http://www.cpa2biz.com/Content/media/PRODUCER_CONTENT/Newsletters/Articles_2013/CPA/Dec/IrrevocableTrusts.jsp
A notable article in ultimate estate planner says trusts aren't just for the rich. While often used to shelter large sums of money, trusts are useful for insuring certain things or people are taken care of. Some trusts are set up to take care of disabled family members, or for members that might become physically or mentally incapacitated. Insuring against Alzheimer's is one concern that comes to mind.
At the same time, trusts could be used to provide for a spouse when there are no children or other family members. Trusts can be used to insure business continuity, and may be essential in small business partnerships. True, some provisions can be included in a will, but trusts may have characteristics that make it more useful, with less legal interaction. Finally, trusts can be used to provide for pets. Our 10-year old will says our pets should be taken care of, but it doesn't say how, or provide a means for providing that care.
http://ultimateestateplanner.com/2014/09/01/trusts-arent-just-rich-anymore/
http://savannahnow.com/exchange/2014-10-01/many-reasons-use-living-trust-not-just-rich
http://www2.deloitte.com/ie/en/pages/deloitte-private/articles/succession-planning.html
http://www.financial-planning.com/blogs/estate-planning-creating-a-pet-trust-2688947-1.html
http://www.professorbeyer.com/Articles/Animals.html
But, if you do hit it rich, like in the lottery, a trust could be very helpful. Aside from possibly allowing you to remain anonymous (in some states ), many lottery winners end up wasting all of their new found wealth. Creating a suitable trust not only protects you from others; it protects you from yourself.
http://blogs.findlaw.com/law_and_life/2013/12/for-lottery-winners-a-trust-can-really-pay-off.html
]]>The one thing that almost every retirement prospect will encounter is social security, and most people should know that the later you retire the more you get per month. The most common advice from financial planners, then, is that the benefits of waiting can be quite profitable. There is a significant penalty if retiring early and after full retirement age, benefits increase about 8% each year.
All of that, of course, hinges on life expectancy. If you don't expect to live past 80, there may not be much benefit in waiting. By realistically estimating your life expectancy, you can calculate your cumulative earnings and compare early, timely, and delayed retirement ages. Using a spreadsheet you can see when full and delayed retirement cumulative amounts exceed early retirement.
Undoing your social security is another of the things that you may have heard about. During the first year of drawing social security prior to full retirement ago, you can pay it back and start over later. There are rules that you need to be aware of, and you have to be careful to time the undoing to get it right. If you had to begin social security early, you might be able to recover amounts you would have lost by undoing early retirement. In fact, early retirement could be a method of getting a "short-term loan" to start a business.
While social security law is not near as complex as tax law, it is complex and has quite a number of choices that you may want to consider. File and suspend, spousal benefits, file and restrict are a few of the most common options promoted. But, don't wait until early retirement age to look into your benefits. Depending on other resources available, there may be many other things to consider at the same time you consider social security, such as IRAs and other retirement income. Retirement is also a good time to begin thinking about your estate, if you haven't already done so.
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