LGH Consulting, Inc.

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Home sales: How to determine your “basis”

The housing market in many parts of the country is strong this spring. If you’re buying or selling a home, you should know how to determine your “basis.”

How it works

You can claim an itemized deduction on your tax return for real estate taxes and home mortgage interest. Most other homeownership costs can’t be deducted currently. However, these costs may increase your home’s “basis” (your cost for tax purposes). And a higher basis can save taxes when you sell.

The law allows an exclusion from income for all or part of the gain realized on the sale of your home. The general exclusion limit is $250,000 ($500,000 for married taxpayers). You may feel the exclusion amount makes keeping track of the basis relatively unimportant. Many homes today sell for less than $500,000. However, that reasoning doesn’t take into account what may happen in the future. If history is any indication, a home that’s owned for 20 or 30 years appreciates greatly. Thus, you want your basis to be as high as possible in order to avoid or reduce the tax that may result when you eventually sell.

Good recordkeeping

To prove the amount of your basis, keep accurate records of your purchase price, closing costs, and other expenses that increase your basis. Save receipts and other records for improvements and additions you make to the home. When you eventually sell, your basis will establish the amount of your gain. Keep the supporting documentation for at least three years after you file your return for the sale year.

Start with the purchase price

The main element in your home’s basis is the purchase price. This includes your down payment and any debt, such as a mortgage. It also includes certain settlement or closing costs. If you had your house built on land you own, your basis is the cost of the land plus certain costs to complete the house.

You add to the cost of your home expenses that you paid in connection with the purchase, including attorney’s fees, abstract fees, owner’s title insurance, recording fees, and transfer taxes. The basis of your home is affected by expenses after a casualty to restore damaged property and depreciation if you used your home for business or rental purposes,

Over time, you may make additions and improvements to your home. Add the cost of these improvements to your basis. Improvements that add to your home’s basis include:

  • A room addition,
  • Finishing the basement,
  • A fence,
  • Storm windows or doors,
  • New heating or central air conditioning system,
  • Flooring,
  • A new roof, and
  • Driveway paving.

Home expenses that don’t add much to the value or the property’s life are considered repairs, not improvements. Therefore, you can’t add them to the property’s basis. Repairs include painting, fixing gutters, repairing leaks, and replacing broken windows. However, an entire job is considered an improvement if items that would otherwise be considered repairs are done as part of extensive remodeling.

The cost of appliances purchased for your home generally doesn’t add to your basis unless they are considered attached to the house. Thus, the cost of a built-in oven or range would increase basis. But an appliance that can be easily removed wouldn’t.

Plan for best results

Other rules and requirements may apply. We can help you plan for the best tax results involving your home’s basis.

© 2021

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Tax advantages of hiring your child at your small business

As a business owner, you should be aware that you can save family income and payroll taxes by putting your child on the payroll.

Here are some considerations.

Shifting business earnings

You can turn some of your high-taxed income into tax-free or low-taxed income by shifting some business earnings to a child as wages for services performed. In order for your business to deduct the wages as a business expense, the work done by the child must be legitimate and the child’s salary must be reasonable.

For example, suppose you’re a sole proprietor in the 37% tax bracket. You hire your 16-year-old son to help with office work full-time in the summer and part-time in the fall. He earns $10,000 during the year (and doesn’t have other earnings). You can save $3,700 (37% of $10,000) in income taxes at no tax cost to your son, who can use his $12,550 standard deduction for 2021 to shelter his earnings.

Family taxes are cut even if your son’s earnings exceed his standard deduction. That’s because the unsheltered earnings will be taxed to him beginning at a 10% rate, instead of being taxed at your higher rate.

Income tax withholding

Your business likely will have to withhold federal income taxes on your child’s wages. Usually, an employee can claim exempt status if he or she had no federal income tax liability for last year and expects to have none this year.

However, exemption from withholding can’t be claimed if: 1) the employee’s income exceeds $1,100 for 2021 (and includes more than $350 of unearned income), and 2) the employee can be claimed as a dependent on someone else’s return.

Keep in mind that your child probably will get a refund for part or all of the withheld tax when filing a return for the year.

Social Security tax savings 

If your business isn’t incorporated, you can also save some Social Security tax by shifting some of your earnings to your child. That’s because services performed by a child under age 18 while employed by a parent aren’t considered employment for FICA tax purposes.

A similar but more liberal exemption applies for FUTA (unemployment) tax, which exempts earnings paid to a child under age 21 employed by a parent. The FICA and FUTA exemptions also apply if a child is employed by a partnership consisting only of his or her parents.

Note: There’s no FICA or FUTA exemption for employing a child if your business is incorporated or is a partnership that includes non-parent partners. However, there’s no extra cost to your business if you’re paying a child for work you’d pay someone else to do.

Retirement benefits

Your business also may be able to provide your child with retirement savings, depending on your plan and how it defines qualifying employees. For example, if you have a SEP plan, a contribution can be made for the child up to 25% of his or her earnings (not to exceed $58,000 for 2021).

Contact us if you have any questions about these rules in your situation. Keep in mind that some of the rules about employing children may change from year to year and may require your income-shifting strategies to change too.

© 2021

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Maximize your 401(k) plan to save for retirement

Contributing to a tax-advantaged retirement plan can help you reduce taxes and save for retirement. If your employer offers a 401(k) or Roth 401(k) plan, contributing to it is a smart way to build a substantial sum of money.

If you’re not already contributing the maximum allowed, consider increasing your contribution rate. Because of tax-deferred compounding (tax-free in the case of Roth accounts), boosting contributions can have a major impact on the size of your nest egg at retirement.

With a 401(k), an employee makes an election to have a certain amount of pay deferred and contributed by an employer on his or her behalf to the plan. The contribution limit for 2020 is $19,500. Employees age 50 or older by year-end are also permitted to make additional “catch-up” contributions of $6,500, for a total limit of $26,000 in 2020.

The IRS recently announced that the 401(k) contribution limits for 2021 will remain the same as for 2020.

If you contribute to a traditional 401(k) 

A traditional 401(k) offers many benefits, including:

  • Contributions are pretax, reducing your modified adjusted gross income (MAGI), which can also help you reduce or avoid exposure to the 3.8% net investment income tax.
  • Plan assets can grow tax-deferred — meaning you pay no income tax until you take distributions.
  • Your employer may match some or all of your contributions pretax.

If you already have a 401(k) plan, take a look at your contributions. Try to increase your contribution rate to get as close to the $19,500 limit (with an extra $6,500 if you’re age 50 or older) as you can afford. Keep in mind that your paycheck will be reduced by less than the dollar amount of the contribution because the contributions are pretax — so, income tax isn’t withheld.

If you contribute to a Roth 401(k)

Employers may also include a Roth option in their 401(k) plans. If your employer offers this, you can designate some or all of your contributions as Roth contributions. While such contributions don’t reduce your current MAGI, qualified distributions will be tax-free.

Roth 401(k) contributions may be especially beneficial for higher-income earners because they don’t have the option to contribute to a Roth IRA. Your ability to make a Roth IRA contribution for 2021 will be reduced if your adjusted gross income (AGI) in 2021 exceeds:

  • $198,000 (up from $196,000 for 2020) for married joint-filing couples, or
  • $125,000 (up from $124,000 for 2020) for single taxpayers.

Your ability to contribute to a Roth IRA in 2021 will be eliminated entirely if you’re a married joint filer and your 2021 AGI equals or exceeds $208,000 (up from $206,000 for 2020). The 2021 cutoff for single filers is $140,000 or more (up from $139,000 for 2020).

The best mix

Contact us if you have questions about how much to contribute or the best mix between traditional and Roth 401(k) contributions. We can discuss the tax and retirement-saving strategies in your situation.

© 2020

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Taking distributions from a traditional IRA

Although planning is needed to help build the biggest possible nest egg in your traditional IRA (including a SEP-IRA and SIMPLE-IRA), it’s even more critical that you plan for withdrawals from these tax-deferred retirement vehicles. There are three areas where knowing the fine points of the IRA distribution rules can make a big difference in how much you and your family will keep after taxes:

Early distributions. What if you need to take money out of a traditional IRA before age 59½? For example, you may need money to pay your child’s education expenses, make a down payment on a new home, or meet necessary living expenses if you retire early. In these cases, any distribution to you will be fully taxable (unless nondeductible contributions were made, in which case part of each payout will be tax-free). In addition, distributions before age 59½ may also be subject to a 10% penalty tax. However, there are several ways that the penalty tax (but not the regular income tax) can be avoided, including a method that’s tailor-made for individuals who retire early and need to draw cash from their traditional IRAs to supplement other income.

Naming beneficiaries. The decision concerning who you want to designate as the beneficiary of your traditional IRA is critically important. This decision affects the minimum amounts you must generally withdraw from the IRA when you reach age 72, who will get what remains in the account at your death, and how that IRA balance can be paid out. What’s more, a periodic review of the individual(s) you’ve named as IRA beneficiaries is vital. This helps assure that your overall estate planning objectives will be achieved in light of changes in the performance of your IRAs, as well as in your personal, financial, and family situation.

Required minimum distributions (RMDs). Once you attain age 72, distributions from your traditional IRAs must begin. If you don’t withdraw the minimum amount each year, you may have to pay a 50% penalty tax on what should have been paid out — but wasn’t. However, for 2020, the CARES Act suspended the RMD rules — including those for inherited accounts — so you don’t have to take distributions this year if you don’t want to. Beginning in 2021, the RMD rules will kick back in unless Congress takes further action. In planning for required distributions, your income needs must be weighed against the desirable goal of keeping the tax shelter of the IRA going for as long as possible for both yourself and your beneficiaries.

Traditional versus Roth

It may seem easier to put money into a traditional IRA than to take it out. This is one area where guidance is essential, and we can assist you and your family. Contact us to conduct a review of your traditional IRAs and to analyze other aspects of your retirement planning. We can also discuss whether you can benefit from a Roth IRA, which operates under a different set of rules than traditional IRAs.

© 2020

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Do you want to withdraw cash from your closely held corporation at a low tax cost?

Owners of closely held corporations are often interested in easily withdrawing money from their businesses at the lowest possible tax cost. The simplest way is to distribute cash as a dividend. However, a dividend distribution isn’t tax-efficient, since it’s taxable to you to the extent of your corporation’s “earnings and profits.” And it’s not deductible by the corporation.

Other strategies

Fortunately, there are several alternative methods that may allow you to withdraw cash from a corporation while avoiding dividend treatment. Here are five strategies to consider:

  • Capital repayments. To the extent that you’ve capitalized the corporation with debt, including amounts that you’ve advanced to the business, the corporation can repay the debt without the repayment being treated as a dividend. Additionally, interest paid on the debt can be deducted by the corporation. This assumes that the debt has been properly documented with terms that characterize debt and that the corporation doesn’t have an excessively high debt-to-equity ratio. If not, the “debt” repayment may be taxed as a dividend. If you make future cash contributions to the corporation, consider structuring them as debt to facilitate later withdrawals on a tax-advantaged basis.
  • Compensation. Reasonable compensation that you, or family members, receive for services rendered to the corporation is deductible by the business. However, it’s also taxable to the recipient(s). This same rule applies to any compensation (in the form of rent) that you receive from the corporation for the use of the property. In both cases, the compensation amount must be reasonable in terms of the services rendered or the value of the property provided. If it’s considered excessive, the excess will be a nondeductible corporate distribution.
  • Loans. You can withdraw cash tax-free from the corporation by borrowing money from it. However, to prevent having the loan characterized as a corporate distribution, it should be properly documented in a loan agreement or note. It should also be made on terms that are comparable to those in which an unrelated third party would lend money to you, including a provision for interest and principal. Also, consider what the corporation’s receipt of interest income will mean.
  • Fringe benefits. You may want to obtain the equivalent of a cash withdrawal in fringe benefits, which aren’t taxable to you and are deductible by the corporation. Examples include life insurance, certain medical benefits, disability insurance, and dependent care. Most of these benefits are tax-free only if provided on a nondiscriminatory basis to other corporate employees. You can also establish a salary reduction plan that allows you (and other employees) to take a portion of your compensation as nontaxable benefits, rather than as taxable compensation.
  • Property sales. You can withdraw cash from the corporation by selling the property to it. However, certain sales should be avoided. For example, you shouldn’t sell the property to a more than 50%-owned corporation at a loss, since the loss will be disallowed. And you shouldn’t sell depreciable property to a more than 50%-owned corporation at a gain, since the gain will be treated as ordinary income, rather than capital gain. A sale should be on terms that are comparable to those in which an unrelated third party would purchase the property. You may need to obtain an independent appraisal to establish the property’s value.

Minimize taxes

If you’re interested in discussing any of these ideas, contact us. We can help you get the most out of your corporation at the lowest tax cost.

© 2020

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Disability income: How is it taxed?

Many Americans receive disability income. You may wonder if — and how — it’s taxed. As is often the case with tax questions, the answer is … it depends.

The key factor is who paid for the benefit. If the income is paid directly to you by your employer, it’s taxable to you as an ordinary salary would be. (Taxable benefits are also subject to federal income tax withholding, although depending on the employer’s disability plan, in some cases aren’t subject to the Social Security tax.)

Frequently, the payments aren’t made by the employer but by an insurance company under a policy providing disability coverage or, under an arrangement having the effect of accident or health insurance. If this is the case, the tax treatment depends on who paid for the coverage. If your employer paid for it, then the income is taxed to you just as if paid directly to you by the employer. On the other hand, if it’s a policy you paid for, the payments you receive under it aren’t taxable.

Even if your employer arranges for the coverage, (in other words, it’s a policy made available to you at work), the benefits aren’t taxed to you if you pay the premiums. For these purposes, if the premiums are paid by the employer but the amount paid is included as part of your taxable income from work, the premiums are treated as paid by you.

A couple of examples

Let’s say your salary is $1,000 a week ($52,000 a year). Additionally, under a disability insurance arrangement made available to you by your employer, $10 a week ($520 for the year) is paid on your behalf by your employer to an insurance company. You include $52,520 in income as your wages for the year: the $52,000 paid to you plus the $520 in disability insurance premiums. In this case, the insurance is treated as paid for by you. If you become disabled and receive benefits, they aren’t taxable income to you.

Now, let’s look at an example with the same facts as above. Except, in this case, you include only $52,000 in income as your wages for the year because the amount paid for the insurance coverage qualifies as excludable under the rules for employer-provided health and accident plans. In this case, the insurance is treated as paid for by your employer. If you become disabled and receive benefits, they are taxable income to you.

Note: There are special rules in the case of a permanent loss (or loss of the use) of a part or function of the body, or a permanent disfigurement.

Social Security benefits 

This discussion doesn’t cover the tax treatment of Social Security disability benefits. These benefits may be taxed to you under different rules.

How much coverage is needed? 

In deciding how much disability coverage you need to protect yourself and your family, take the tax treatment into consideration. If you’re buying the policy yourself, you only have to replace your after-tax, “take-home” income because your benefits won’t be taxed. On the other hand, if your employer pays for the benefit, you’ll lose a percentage of taxes. If your current coverage is insufficient, you may wish to supplement an employer benefit with a policy you take out.

Contact us if you’d like to discuss this in more detail.

© 2020

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Divorcing couples should understand these 4 tax issues

When a couple is going through a divorce, taxes are probably not foremost in their minds. But without proper planning and advice, some people find divorce to be an even more taxing experience. Several tax concerns need to be addressed to ensure that taxes are kept to a minimum and that important tax-related decisions are properly made. Here are four issues to understand if you’re in the midst of a divorce.

Issue 1: Alimony or support payments. For alimony under divorce or separation agreements that are executed after 2018, there’s no deduction for alimony and separation support payments for the spouse making them. And the alimony payments aren’t included in the gross income of the spouse receiving them. (The rules are different for divorce or separation agreements executed before 2019.)

Issue 2: Child support. No matter when a divorce or separation instrument is executed, child support payments aren’t deductible by the paying spouse (or taxable to the recipient).

Issue 3: Your residence. Generally, if a married couple sells their home in connection with a divorce or legal separation, they should be able to avoid tax on up to $500,000 of gain (as long as they’ve owned and used the residence as their principal residence for two of the previous five years). If one spouse continues to live in the home and the other moves out (but they both remain owners of the home), they may still be able to avoid gain on the future sale of the home (up to $250,000 each), but special language may have to be included in the divorce decree or separation agreement to protect the exclusion for the spouse who moves out.

If the couple doesn’t meet the two-year ownership and use tests, any gain from the sale may qualify for a reduced exclusion due to unforeseen circumstances.

Issue 4: Pension benefits. A spouse’s pension benefits are often part of a divorce property settlement. In these cases, the commonly preferred method to handle the benefits is to get a “qualified domestic relations order” (QDRO). This gives one spouse the right to share in the pension benefits of the other and taxes the spouse who receives the benefits. Without a QDRO the spouse who earned the benefits will still be taxed on them even though they’re paid out to the other spouse.

More to consider

These are just some of the issues you may have to deal with if you’re getting a divorce. In addition, you must decide how to file your tax return (single, married filing jointly, married filing separately or head of household). You may need to adjust your income tax withholding and you should notify the IRS of any new address or name change. If you own a business, you may have to pay your spouse a share. There are also estate planning considerations. Contact us to help you work through the financial issues involved in a divorce.

© 2020

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Buying and selling mutual funds shares: Avoid these tax pitfalls

If you invest in mutual funds, be aware of some potential pitfalls involved in buying and selling shares.

Surprise sales 

You may already have made taxable “sales” of part of your mutual fund investment without knowing it.

One way this can happen is if your mutual fund allows you to write checks against your fund investment. Every time you write a check against your mutual fund account, you’ve made a partial sale of your interest in the fund. Thus, except for funds such as money market funds, for which share value remains constant, you may have a taxable gain (or a deductible loss) when you write a check. And each such sale is a separate transaction that must be reported on your tax return.

Here’s another way you may unexpectedly make a taxable sale. If your mutual fund sponsor allows you to make changes in the way your money is invested — for instance, lets you switch from one fund to another fund — making that switch is treated as a taxable sale of your shares in the first fund.

Recordkeeping 

Carefully save all the statements that the fund sends you — not only official tax statements, such as Forms 1099-DIV but the confirmations the fund sends you when you buy or sell shares or when dividends are reinvested in new shares. Unless you keep these records, it may be difficult to prove how much you paid for the shares, and thus, you won’t be able to establish the amount of gain that’s subject to tax (or the amount of loss you can deduct) when you sell.

You also need to keep these records to prove how long you’ve held your shares if you want to take advantage of favorable long-term capital gain tax rates. (If you get a year-end statement that lists all your transactions for the year, you can just keep that and discard quarterly or other interim statements. But save anything that specifically says it contains tax information.)

Recordkeeping is simplified by rules that require funds to report the customer’s basis in shares sold and whether any gain or loss is short-term or long-term. This is mandatory for mutual fund shares acquired after 2011, and some funds will provide this to shareholders for shares they acquired earlier if the fund has the information.

Timing purchases and sales

If you’re planning to invest in a mutual fund, there are some important tax consequences to take into account in timing the investment. For instance, an investment shortly before the payment of a dividend is something you should generally try to avoid. Your receipt of the dividend (even if reinvested in additional shares) will be treated as income and increase your tax liability. If you’re planning a sale of any of your mutual fund shares near year-end, you should weigh the tax and the non-tax consequences in the current year versus a sale in the next year.

Identify shares you sell 

If you sell fewer than all of the shares that you hold in the same mutual fund, there are complicated rules for identifying which shares you’ve sold. The proper application of these rules can reduce the amount of your taxable gain or qualify the gain for favorable long-term capital gain treatment.

Contact us if you’d like to find out more about tax planning for buying and selling mutual fund shares.

© 2020

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Business website costs: How to handle them for tax purposes

The business use of websites is widespread. But surprisingly, the IRS hasn’t yet issued formal guidance on when Internet website costs can be deducted.

Fortunately, established rules that generally apply to the deductibility of business costs, and IRS guidance that applies to software costs, provide business taxpayers launching a website with some guidance as to the proper treatment of the costs.

Hardware or software?

Let’s start with the hardware you may need to operate a website. The costs involved fall under the standard rules for depreciable equipment. Specifically, once these assets are up and running, you can deduct 100% of the cost in the first year they’re placed in service (before 2023). This favorable treatment is allowed under the 100% first-year bonus depreciation break.

In later years, you can probably deduct 100% of these costs in the year the assets are placed in service under the Section 179 first-year depreciation deduction privilege. However, Sec. 179 deductions are subject to several limitations.

For tax years beginning in 2020, the maximum Sec. 179 deduction is $1.04 million, subject to a phaseout rule. Under the rule, the deduction is phased out if more than a specified amount of qualified property is placed in service during the year. The threshold amount for 2020 is $2.59 million.

There’s also a taxable income limit. Under it, your Sec. 179 deduction can’t exceed your business taxable income. In other words, Sec. 179 deductions can’t create or increase an overall tax loss. However, any Sec. 179 deduction amount that you can’t immediately deduct is carried forward and can be deducted in later years (to the extent permitted by the applicable limits).

Similar rules apply to purchased off-the-shelf software. However, software license fees are treated differently from purchased software costs for tax purposes. Payments for leased or licensed software used for your website are currently deductible as ordinary and necessary business expenses.

Was the software developed internally?

An alternative position is that your software development costs represent currently deductible research and development costs under the tax code. To qualify for this treatment, the costs must be paid or incurred by December 31, 2022.

A more conservative approach would be to capitalize the costs of the internally developed software. Then you would depreciate them over 36 months.

If your website is primarily for advertising, you can also currently deduct internal website software development costs as ordinary and necessary business expenses.

Are you paying a third party?

Some companies hire third parties to set up and run their websites. In general, payments to third parties are currently deductible as ordinary and necessary business expenses.

What about before business begins?

Start-up expenses can include website development costs. Up to $5,000 of otherwise deductible expenses that are incurred before your business commences can generally be deducted in the year business commences. However, if your start-up expenses exceed $50,000, the $5,000 current deduction limit starts to be chipped away. Above this amount, you must capitalize some, or all, of your start-up expenses and amortize them over 60 months, starting with the month that business commences.

Need Help?

We can determine the appropriate treatment of website costs for federal income tax purposes. Contact us if you have questions or want more information.

© 2020

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Tax implications of working from home and collecting unemployment

COVID-19 has changed our lives in many ways, and some of the changes have tax implications. Here is basic information about two common situations.

1. Working from home

Many employees have been told not to come into their workplaces due to the pandemic. If you’re an employee who “telecommutes” — that is, you work at home, and communicate with your employer mainly by telephone, videoconferencing, email, etc. — you should know about the strict rules that govern whether you can deduct your home office expenses.

Unfortunately, employee home office expenses aren’t currently deductible, even if your employer requires you to work from home. Employee business expense deductions (including the expenses an employee incurs to maintain a home office) are miscellaneous itemized deductions and are disallowed from 2018 through 2025 under the Tax Cuts and Jobs Act.

However, if you’re self-employed and work out of an office in your home, you can be eligible to claim home office deductions for your related expenses if you satisfy the strict rules.

2. Collecting unemployment

Millions of Americans have lost their jobs due to COVID-19 and are collecting unemployment benefits. Some of these people don’t know that these benefits are taxable and must be reported on their federal income tax returns for the tax year they were received. Taxable benefits include the special unemployment compensation authorized under the Coronavirus Aid, Relief, and Economic Security (CARES) Act.

In order to avoid a surprise tax bill when filing a 2020 income tax return next year, unemployment recipients can have taxes withheld from their benefits now. Under federal law, recipients can opt to have 10% withheld from their benefits to cover part or all their tax liability. To do this, complete Form W4-V, Voluntary Withholding Request, and give it to the agency paying benefits. (Don’t send it to the IRS.)

We can help

We can assist you with advice about whether you qualify for home office deductions, and how much of these expenses you can deduct. We can also answer any questions you have about the taxation of unemployment benefits as well as any other tax issues that you encounter as a result of COVID-19.

© 2020