Category: Tax - PFwise.com

Roth IRA Conversion Strategies - Part D Disadvantages of Roth IRA Conversion

1/26/2021

In last blogpost, we discussed two issues to pay attention to related to Roth IRA conversion.

Roth Conversion Disadvantages
As with any financial strategy, a Roth IRA conversion is not the right answer for everyone. Here are some situations where a Roth conversion may not make sense, or at least where a careful analysis is required. Most of these types of decisions involve the merits of paying taxes now in exchange for the benefits of a Roth IRA at some point in the future.

When considering a Roth conversion, it’s important to look at the potential payback — specifically, the amount of taxes that will be due on the conversion upfront compared to your life expectancy. This is especially crucial for someone who is 60 or older. An analysis needs to be run to analyze a potential break-even point where the benefits of doing the conversion, such as tax-free withdrawals and not taking RMDs, outweigh the current taxes due on the conversion.

You may want to do a Roth IRA conversion as part of your estate planning strategy. This is a prime example of where all of the pros and cons of the Roth conversion need to be weighed. The estate planning benefits of the Roth conversion need to be weighed against the current-year taxes on the conversion.

Even for people who are 59 ½ or older, the five-year requirement for qualified distributions remains in effect. In the case of Roth IRA conversions, there is a separate 5-year rule for each conversion that starts on Jan. 1 the year the conversion occurs. If you will need to take a distribution from the converted funds prior to the completion of the 5-year window, any earnings will be subject to taxes, and if you are younger than 59 ½ penalties as well.

The extra income generated from the Roth conversion could bump you who are on Medicare into a higher cost bracket for your Medicare Part B benefits. For those receiving Social Security, the extra income may cause a higher percentage of their benefit to be subject to taxes in the year of the conversion.

In next blogpost, we will discuss Roth IRA conversion strategy.

Roth IRA Conversion Strategies - Part C Areas to Pay Attention To

1/25/2021

In last blogpost, we discussed the benefits of Roth IRA conversion.

Generally, all assets converted from a traditional IRA account to a Roth IRA will be subject to taxes at ordinary income tax rates. The exception to this are any contributions made on an after-tax basis. Any gains on the investments in the account, regardless of whether the contributions were made on a pretax or after-tax basis, are also subject to taxes in a Roth conversion.

Where you have traditional IRA money from after-tax contributions, pretax contributions and investment gains, calculating the amount of the conversion that is subject to taxes can become complex. This situation sometimes arises in the case of a backdoor Roth conversion to be discussed later.

It’s important to be sure that you have sufficient cash outside of the traditional IRA to cover the taxes on the Roth conversion. If you need to tap your traditional IRA to cover the tax bill, these withdrawals will be subject to taxes and potentially to a 10% penalty if you are younger than 59 ½. This could make the conversion quite expensive for you.

In next blogpost, we will discuss the disadvantages of Roth IRA conversion.

Roth IRA Conversion Strategies - Part B Its Benefits

1/24/2021

In last blogpost, we discussed what is Roth IRA conversion.

How Can You Benefit From Roth IRA Conversion?
A Roth IRA conversion can have several potential benefits.

a. Roth IRAs are not subject to RMDs.
For people who don’t need the RMD income in retirement, this can result in tax savings each year. Additionally, this allows the value of the account to remain intact and potentially continue to grow over time. A Roth IRA can be a powerful estate planning vehicle for leaving money to a spouse or heirs.

b. A Roth IRA can provide you with tax diversification in retirement.
This can be beneficial as we don’t know what direction tax rates will take in the future. At the time of this writing, we are on the cusp of a new presidential administration. Many speculate that President Joe Biden will look to raise taxes over the next few years. A Roth IRA conversion can act as a hedge against future tax rate hikes. Having retirement savings in both Roth and traditional retirement accounts can provide flexibility for you to formulate a retirement withdrawal strategy.

In general, the decision regarding a Roth IRA conversion is often about your current tax situation versus your anticipated future tax situation. With multiple income sources like pensions, withdrawals from retirement accounts and Social Security, it’s not uncommon for you to end up in a higher tax bracket in retirement than you were while you were working.

In next blogpost, we will discuss a few issues to note in Roth IRA conversion.

Roth IRA Conversion Strategies - Part A What It Is?

1/23/2021

Roth IRA Conversion is a retirement savings strategy that might be beneficial for the right people. Here’s a detailed look at Roth IRA conversions to help you decide if this strategy is a good fit for you.

What Is a Roth IRA Conversion?
In a Roth IRA conversion, the account holder takes some or all of the balance in their traditional individual retirement account and converts that money to a Roth IRA. The money converted to a Roth IRA is taxable as ordinary income in the year the conversion is made. The exception is the value of any after-tax contributions made to the traditional IRA that are part of the amount converted.

Another possible type of a Roth IRA conversion might occur if you are leaving your employer. A traditional 401(k) account can be rolled over and converted to a Roth IRA. The tax rules described above will still apply. Depending upon the rules of both your 401(k) plan and those of the IRA custodian, an interim transfer to a traditional IRA may be required.

Once a Roth IRA conversion is completed, distributions from the account are tax-free as long as certain requirements are met.

In next blogpost, we will discuss in details how a Roth IRA conversion benefits you.

2021 Tax Rates and Tax Planning Quick Reference Guide

1/22/2021

As we lean into tax planning for tax year 2021 and tax preparation for the 2020 tax year, the quick reference summary below from Intuit may be helpful!

Possible Income Tax Policy Changes in Biden Administration - Part C

1/20/2021

In last blogpost, we discussed possible capital gain tax increases and some techniques to deal with them. Now we will discuss if you should sell assets before tax rates increase.

It may prove advantageous to sell some of those appreciated assets in 2021 if the law change increasing capital gains to ordinary income tax rates only takes effect in 2022. When evaluating the guesstimated cost/benefits of selling now versus waiting also consider possible state income tax costs and planning.

It may be advantageous to shift assets into an intentionally non-grantor (“ING”) trust in a trust friendly (i.e., no tax) jurisdiction so that state income tax can be deferred or avoided. You might for example, provide in such a non-grantor trust that distributions can only be made to a spouse with the consent of an adverse party. That mechanism may permit a spouse to benefit from trust assets, not undermine characterization as a non-grantor trust, and still permit avoiding state income tax on a large sale to avoid an increase in the capital gains tax.

Note that in Rev Proc. 2021-3 the IRS will no longer rule on ING trusts so caution is in order. A non-grantor trust can be structured as a completed gift or incomplete gift. You can transfer assets to an incomplete gift trust if you have used all exemption, and still create a structure to avoid the state income tax on the sale. If you have exemption remaining that you want to try to use you can structure the non-grantor trust as a completed gift. Lots of options, but keep in mind the uncertainty, risk of retractive change, etc.

Possible Income Tax Policy Changes in Biden Administration - Part B

1/19/2021

In last blogpost, we discussed possible retroactive income tax changes. Now we will discuss possible capital gain tax changes.

Capital gains could be raised substantially. They have discussed doubling the tax on capital gains by taxing capital gains as ordinary income. It could even be worse as those gains could be subject to the 3.8% net investment income tax. Add to that state income tax if you live in a high tax state. The effective tax on capital gains over $1 million could exceed 50%. If this is enacted prospectively expect a tremendous amount of sales of assets before the effective date of that change.

Some commentators have speculated that a capital gains tax could also be made retroactive to January 1, 2021, but many think that is unlikely. Others suggest that such a change might be made effective January 1, 2022. Or there could be an effective date based on the date of enactment of the tax legislation. This will affect planning dramatically. It might prove to be advantageous to sell appreciated assets now and lock in the current capital gains tax rate.

If you sell assets on the installment basis you would pay tax when the proceeds received. You might instead prefer to elect out of the installment sale treatment for income tax purposes so that you have a gain recognized at the current and perhaps lower capital gains rate.

A common income (and estate) tax planning technique is the use of a charitable remainder trust or “CRT.” With a CRT you can donate appreciated stock to a CRT. The CRT can sell the stock without realizing gain since CRTs are tax exempt. As you receive your periodic payments from the CRT (e.g., a unitrust payment) the payments to you will flow out income from the CRT to you. In other words, the cash flow distributed by the CRT to you as part of your periodic payments will be characterized based on the income earned by the CRT. So, if your CRT sold appreciated stock and realized a capital gain, that gain would flow out to you over many future years. If the capital gains tax rate is increased in those future years, using a CRT today might effectively defer your realization of capital gains income to later years when the tax rate is higher.

In next blogpost, we will discuss should you sell assets before capital gain tax rates increase.

Possible Income Tax Policy Changes in Biden Administration - Part A

1/18/2021

With the Democrats Control the House, the Senate and the White House, the potential for harsh tax legislation increasing taxation of the wealthy, along the lines of prior Democratic proposals, might be likely to happen. What might those changes be? We will discuss a few possible changes income tax related changes.

Retroactive Income Tax Changes
Retroactive tax changes could affect income tax changes. Income taxes are paid in quarterly through estimates. A retroactive change could adversely affect the amounts taxpayers paid in through withholding taxes and estimated taxes all based on prior law. In contrast, estate taxes are due nine months following death so that a retroactive change might be a tad cleaner.

Example:
You own commercial real estate and are considering a Code Section 1031 so-called “like-kind” exchange. This is where you swap or exchange an investment property for another real estate investment property and do not trigger gain recognized currently for income tax purposes. Under current law you can exchange real estate instead of selling it and avoid any current income tax costs. A repeal of section 1031 may be on the tax agenda. It has been talked about before.

So, if you plan a 1031 like kind exchange you might be careful as Congress might enact a repeal (or restriction) and might make the change retroactive to January 1, 2021. You might wish to discuss with your real estate attorney whether it is feasible to incorporate into the contract documents that the transaction will be automatically void if the law changes before the transaction is consummated.

In next blogpost, we will discuss possible Capital Gain tax changes.

Legacy Planning Strategies Using Fixed Annuities for Families

12/29/2020

Legacy planning takes on greater importance in unexpected times such as these. To plan ahead and put ambitions into action with protected strategies, you could explore the many purposeful, proven distribution planning options available with fixed annuities.

Non-Qualified
Pre-death

Multigenerational Income (IncomeSource®): Provide income payments for multiple generations.
Period Certain and Lifetime Annuitization
Beneficiary Restriction (all fixed products): Choose how each beneficiary will receive their payments. Add or modify as desired any time.

Post-death

Annuitization
Lump Sum
5-Year Deferral
Non-qualified Stretch with Exclusion Ratio (Indextra®, SPDA II, IncomeSource)

Qualified / IRA
Pre-death

Roth Conversions (Indextra, New Momentum)
Qualified Charitable Distributions (all fixed products)
IRA Max: Fund life insurance for wealth transfer with an IRA SPIA (IncomeSource)
Period Certain and Lifetime Annuitization

Post-death
Spouse beneficiary or beneficiary not more than 10 years younger
■ Inherited IRA: (All fixed products less Indextra)
■ Lump Sum
■ Annuitization
■ 10-Year Deferral
■ Spousal continuation for spouses (all fixed products)

All other designated beneficiaries
■ 10-Year Deferral
- (SPIA 10-year certain or less) last payment due by 12-31 of 10th anniversary
- For annuity claims: Holding account for up to 10 years with an annual renewal rate
■ Lump Sum

How to Maximize After-tax Profits on the Sale of a Rental Property

12/22/2020

When you sell a rental property, you will owe federal and state capital gains and depreciation recapture taxes, according to this article in The Washington Post.

Property investors may also face the net investment income tax and will not qualify for capital gains exclusion, according to the article. Investors who want to boost their after-tax profit are advised to use a 1031 exchange, which will enable them to reinvest the sales proceeds to a like-kind property and defer capital gains taxes.

-----------------------------------------------------

Q: I am selling a house in the District of Columbia that I bought 10 years ago, renovated and have rented out as an investment ever since. I paid $400,000 and can now sell for $800,000. I immediately renovated the kitchen and baths, which cost $100,000. At settlement, I plan on paying $48,000 in real estate commissions, $11,600 in D.C. transfer tax and an additional $10,400 in closing costs and seller credits to buyer. My pretax cash profit should be about $330,000. What are the tax implications, and what can I do to maximize my after-tax profits? — Savvy Seller

A: Congratulations on successfully investing in a rental property. When you sell your rental property, you will incur federal and state long-term capital gains and depreciation recapture taxes. You may also incur the Net Investment Income Tax, which imposes an additional 3.8 percent tax on your net investment income above certain thresholds.

Capital gain is the difference between your selling price and your adjusted tax basis. The Internal Revenue Service classifies capital gains as either short or long term. Gain on the property sales held for one year or less is considered short term and is taxed at your ordinary income tax rate. Gain on property sales held for more than one year is classified as a long-term capital gain and is taxed at rates ranging from 0 percent to 20 percent. Most homeowners will pay at the 15 percent rate.

Although you state that your pretax cash profit is $330,000, your taxable long-term capital gain is only $230,000. Taxable capital gain is calculated by taking your sales price ($800,000), minus commissions and closing costs ($70,000), minus your adjusted tax basis ($500,000). Your adjusted tax basis is your original cost plus your capital improvements. “Assuming you are in the 15 percent capital gains tax bracket, your federal capital gains tax liability would be $34,500,” said Eric J. Wexler, a Rockville, Md., tax attorney and CPA.

IRS regulations generally require that you depreciate residential rental property over 27.5 years (3.636 percent per year). Because land does not wear out, the IRS does not permit you to depreciate the purchase price attributable to the land. To calculate your depreciation deductions, we assume: your $400,000 purchase price was allocated equally between the land and the original improvements; and that the additional capital improvements were made before the home was placed into service as a rental property. As such, your property’s “depreciable base” is $300,000. Accordingly, you were able to take $10,908 annually for the 10 years it was rented, for $109,080 in total cumulative depreciation.

“This non-cash tax deduction may have reduced your annual taxes,” Wexler said. “But now that you are selling, this non-cash tax deduction must be paid back, in part, as depreciation recapture tax. So, in addition to your $34,500 in capital gains tax, you will incur $27,270 in federal depreciation recapture tax, for $61,770 in total federal tax liability.” Your pretax cash profit minus your federal tax liability results in $268,230 in after-tax profits, which will be further reduced by state capital gains and depreciation recapture taxes. “Any taxable gain may be offset by any suspended losses that you were not able to use during the life of the property,” Wexler said.

Because this is investment-only property, you are not eligible to use the $250,000 ($500,000 for a married couple) capital gains exclusion available when you sell your primary residence. IRS Pub. 544, available online at irs.gov, contains detailed instructions for calculating capital gains and depreciation recapture for residential rental property.

Because your current plan to sell investment property results in significant tax liabilities with no real tax advantages, one way to dramatically increase your after-tax profit is to consider using a 1031 exchange. This IRS code section allows you to exchange your D.C. property and reinvest your cash in another like-kind replacement investment, such as other rental real estate or a Delaware Statutory Trust.

A 1031 exchange requires you to identify your replacement property within 45 days and to close on your replacement property within 180 days of settling your D.C. property. A 1031 exchange allows you to defer liability for all federal capital gains and depreciation recapture taxes. You can sell your D.C. property and pay no federal income taxes on that gain so long as you use a qualified exchange intermediary to hold your funds and you reinvest your entire sales proceeds in a new investment property having a value equal to or greater than your D.C. property.

2021 Contribution and Benefits Limits

12/19/2020

The Internal Revenue Service has issued the new benefit and contribution limits for qualified retirement plans for plan years beginning in 2021. Below are some of the key limitation amounts for the upcoming year.

What Is the IRS 5-Year Rule on Withdrawal from IRA Accounts?

11/28/2020

Withdrawals of IRA converted balances are subject to the IRS rule that requires a waiting period of 5 years, or you may pay a 10% penalty. The clock starts on January 1 of the year you do the conversion—no matter when during the year it actually happened.

Withdrawals of earnings are subject to a different 5-year rule. It must have been 5 years since your first Roth contribution or conversion, plus you must be age 59½ or otherwise eligible to make penalty-free withdrawals.

Can I Convert a Specific Stock in IRA to Roth IRA?

11/27/2020

Q. If I want to keep a specific stock or asset in my IRA in my portfolio for the long-term, can I keep that asset and convert it to a Roth IRA?

A. Yes. If you are holding investments in a traditional IRA—ones you want to keep for a number of years— and you think you may be in a lower tax bracket this year than you might be in the future, then a "focused conversion" may be a strategy to consider.

With this strategy you move specific assets from a traditional IRA to a Roth IRA, rather than selling the assets first and then moving the resulting cash. In terms of the taxes, there is no difference between the two techniques.

How To Estimate Tax Liability On IRA Conversions

11/26/2020

When you convert an IRA to Roth IRA, you need to note that all the IRAs you own are considered 1 IRA, no matter how many accounts you have. Your tax liability is based on 2 things: the taxable income generated by the conversion and your applicable tax rate.

To figure out how much of a conversion from a traditional IRA to a Roth IRA may be taxable, you need to note there are 2 types of contributions.

Deductible contributions. These are contributions that are deducted from your taxable income for the tax year in which the contributions were made.
Nondeductible contributions. Any contribution for which you do not take a tax deduction is known as a nondeductible contribution. Such contributions create what is sometimes called "basis" in your traditional IRA.

Estimating the taxable income from a conversion is straightforward if you've never made nondeductible contributions to any traditional IRA. If that is the case, whatever amount you convert will all be taxable income.

Note that earnings are always taxable when converted, whether they come from deductible or nondeductible contributions, so for purposes of figuring out taxes on a conversion, you can think of your balances as falling into just 2 categories: (1) nondeductible contributions, and (2) everything else. According to IRS rules, you cannot cherry-pick and convert just nondeductible contributions, leaving deductible contributions and earnings in the account, in order to avoid taxes. Instead, you must figure out the proportion of your total traditional IRA balances that is composed of nondeductible contributions, then use that percentage to find out how much of your conversion will not be taxable. Note that inherited IRAs are excluded in this calculation.

Keep state taxes in mind too. A Roth IRA conversion is a taxable event. If your state has an income tax, the conversion will generally be treated as taxable income by your state as well as by the federal government.

Below is an example that helps you understand how to estimate the taxable portion of the conversion.

IRA to HSA: The only time it makes sense to move funds

11/25/2020

There is a little-known rule buried deep on the IRS website presents a once-in-a-lifetime opportunity for people with a health savings account — the ability to make a contribution directly from an IRA.

Who would benefit from this move?
People who suffer from large medical expenses in a single year without enough cash on hand or funds in their HSA to cover such costs typically benefit most from this transfer because it saves them incurring penalties or income tax.

If you are interested in knowing more details, here is a link to an article at Financial-Planning magazine that explains it well.

How Financial Advisors Address 3 International Clients' Concerns

11/15/2020

Advisors must be prepared to address specific concerns at each stage and work with clients as they transition through these phases. Expatriate clients may consult with an advisor at any stage of their transition, whether it be before their international move, as they first arrive, or well after moving.

Inbound planning — Inbound planning applies when clients and/or their assets move into a country (e.g., an individual moving from abroad to the U.S.). This category of global planning includes strategy and guidance before and after arrival in a foreign country. For instance, in the case of a non-citizen moving to the U.S., inbound planning involves helping clients to still take care of their financial concerns in their home country while also acclimating to the U.S.’s financial system (i.e., its tax, retirement, investment, insurance and related areas of concern, may be substantively different from what the client is familiar with within their home country).
Outbound planning — This type of planning caters to clients and/or their assets moving out of a country. An American planning to move abroad exemplifies a client in need of outbound international planning. It involves pre-departure preparations, such as helping an American client understand their financial obligations as a US taxpayer abroad and tying up their loose financial ends in the US. For these clients, advice is typically tax-focused (e.g., retirement account transfers, taxation of US assets, and tax-residency planning). US citizens will also require advice regarding their ongoing financial reporting and investment constraints, especially given recent financial and tax reporting requirements implemented by the IRS and Treasury for US citizens living abroad.
Cross-border planning — Cross-border planning describes a comprehensive financial planning approach that accounts for a client and/or their assets from the perspectives of both countries involved in an international move, or with clients who have dual citizenship or residency statuses in another country who need both inbound/outbound and ongoing advice support. Arguably the most specialized type of financial planning advising for cross-border clients requires more intimate knowledge of each country’s financial system, and how the rules of each system interact.

Addressing the 10-year hitch in pretax retirement plans

11/14/2020

Good news for non-spouse beneficiaries of tax-deferred retirement accounts: thanks to the 10-year rule in the Secure Act passed into law in 2019, most will avoid annual required minimum distributions for deaths occurring after 2019.

But there’s a hitch: This RMD hall pass for surviving beneficiaries requires these inherited accounts to be emptied by Dec. 31 of the 10th year following the year of death. Failure to comply could trigger a 50% penalty; a full withdrawal after 10 years of compounding could produce a huge lump-sum of taxable income.

Financial Planning magazine has an article discusses various deft maneuvering to deal with such long term concerns, worth a read for someone face such a situation.

IRS Boosts 2021 Income Limits for Deductible IRA Contributions

11/13/2020

The Internal Revenue Service announced income range increases in 2021 for determining eligibility to make deductible contributions to traditional Individual Retirement Arrangements, to contribute to Roth IRAs and to claim the Saver’s Credit. However, 401(k) contribution limits for 2021 are unchanged at $19,500.

Catch-up contribution limits for employees age 50 and over remain unchanged at $6,500.
The limitation regarding SIMPLE retirement accounts remains unchanged at $13,500.
The limit on annual contributions to an IRA remains unchanged at $6,000.

As the IRS explains in Notice 2020-79, taxpayers can deduct contributions to a traditional IRA if they meet certain conditions. If during the year either the taxpayer or his or her spouse was covered by a retirement plan at work, the deduction may be reduced, or phased out, until it is eliminated, depending on filing status and income. (If neither the taxpayer nor his or her spouse is covered by a retirement plan at work, the phase-outs of the deduction do not apply.)

Here are the phase-out ranges for 2021:

For single taxpayers covered by a workplace retirement plan, the phase-out range is $66,000 to $76,000, up from $65,000 to $75,000.
For married couples filing jointly, where the spouse making the IRA contribution is covered by a workplace retirement plan, the phase-out range is $105,000 to $125,000, up from $104,000 to $124,000.
For an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the deduction is phased out if the couple’s income is between $198,000 and $208,000, up from $196,000 and $206,000.
For a married individual filing a separate return who is covered by a workplace retirement plan, the phase-out range is not subject to an annual cost-of-living adjustment and remains $0 to $10,000. The income limit for the Saver’s Credit (also known as the Retirement Savings Contributions Credit) for low- and moderate-income workers is $66,000 for married couples filing jointly, up from $65,000; $49,500 for heads of household, up from $48,750; and $33,000 for singles and married individuals filing separately, up from $32,500.
The income phase-out range for taxpayers making contributions to a Roth IRA is $125,000 to $140,000 for singles and heads of household, up from $124,000 to $139,000. For married couples filing jointly, the income phase-out range is $198,000 to $208,000, up from $196,000 to $206,000. The phase-out range for a married individual filing a separate return who makes contributions to a Roth IRA is not subject to an annual cost-of-living adjustment and remains $0 to $10,000.

Should You Change Residency to Another State?

11/10/2020

Each state has its own estate and income tax laws, and it is important to plan appropriately. Furthermore, some states are common law property states and others are community property states. There are significant differences between them when it comes to transferring assets, and a document drafted in a common law property state might not be appropriate in a community property state.

Are You Subject to State Estate Taxes?
As of 2020, 17 states and the District of Columbia* also impose some form of estate or inheritance tax. Additionally, each state has different exemption amounts, so it is vital to evaluate your current wealth and estate planning needs with your attorney, keeping both the federal and your state's exemption amounts in mind.

In addition, for many married couples in a state that imposes a state estate tax, this may have the effect of requiring payment of state estate tax after the first death, when none had been anticipated. Prior to 2001, because the "pick-up tax" was imposed only on estates that had to pay federal estate tax, estates below a certain threshold did not have to worry about such a tax. The threshold was the amount of the federal applicable exclusion amount. That is no longer the case.

The practical effect of the difference between a state's exemption amount and the federal applicable exclusion amount is that certain estates will now be subject to a state estate tax, despite the fact that the estate is exempt from federal estate tax. In some situations, establishing a trust as part of an estate plan can help counter state estate tax implications.

Review your estate plan with your attorney and tax professional, with an eye toward reducing federal and state estate taxes, and make sure to reevaluate and potentially update your plan to establish residency in another state.

How to Calculate Capital Gains Sale of Investment Property on Which Mortgage Is Owed?

10/23/2020

Below is an article from Zacks that answers the question.

When you sell investment property, all of your profits are subject to either capital gains tax or depreciation recapture tax, which is a special type of capital gains tax. Your tax gets calculated on the difference between your cost basis and your selling price. Any debt that you owe, such as the balance on your mortgage, will not affect your capital gains liability.

Your Cost Basis
Your cost basis isn't just the purchase price of your investment property. The initial cost is what you actually paid at the closing, including your closing costs.

For example, if you bought a small apartment building for $1 million and paid $1,500 in title fees, $5,000 in attorney's fees, $2,000 in miscellaneous fees and $8,000 in inspection fees, your actual cost would be $1.0165 million.

To that cost, add the cost of any improvements you made to the property. Improvements are anything that changes your property's use, increases its value or extends its useful life. Taking the apartment building as an example, a $50,000 roof and $115,000 in kitchen and bathroom renovations would count as improvements and increase your cost basis to $1.1815 million.

Depreciation and Basis
While you own your investment property, the tax code lets you claim a small portion of its cost basis every year as a depreciation write-off. Depreciation is an accounting tool that simulates the decline in value that accompanies the gradual deterioration of buildings (although in recent years, almost all property has actually gained value over time).

When you sell it for more than the depreciated value, the IRS will want you to return a portion of the money that you saved by claiming depreciation. To properly calculate your capital gains liability, you will need to total all of the depreciation that you were legally entitled to claim, whether or not you actually claimed it.

Calculating Tax Liability
You owe capital gains taxes on the difference between your adjusted cost basis and your net selling price. If you, for example, sell your apartment building for $1.95 million and pay $105,000 in commission and $8,700 in closing costs, your net selling price is $1.8363 million. Subtracting your $1.1815 million cost basis gives you a taxable capital gain of $654,800.

In addition, if you sell for a profit, you will have to pay depreciation recapture taxes on all of your accumulated depreciation. If you claimed $320,000 in depreciation while you owned your building, you need to pay depreciation recapture tax on the all of the $320,000.

If you sell for a loss, you will pay recapture tax on the difference between your net selling price and your depreciated basis. For example, if you sold the building for $925,000, you would have a capital loss, but since your depreciated basis would be $861,500 ($1.1815 million minus $320,000), you would pay recapture tax on the $63,500 difference.

Federal Tax Rates
Capital gains on assets that you hold for at least one year are considered long-term gains. For tax year 2019:

Taxpayers filing single pay 0 percent capital gains tax (income up to $39,375), 15 percent capital gains tax (income $39,376 to $434,550) and 20 percent capital gains tax (income more than $434,550).
Taxpayers filing married filing jointly pay 0 percent capital gains tax (income up to $78,750), 15 percent capital gains tax (income $78,751 to $488,850) and 20 percent capital gains tax (income more than $488,850).
Taxpayers filing head of household pay 0 percent capital gains tax (income up to $52,750), 15 percent capital gains tax (income $52,751 to $461,700) and 20 percent capital gains tax (income more than $461,700).
Taxpayers filing married filing separately pay 0 percent capital gains tax (income up to $39,375), 15 percent capital gains tax (income $39,376 to $244,425) and 20 percent capital gains tax (income more than $244,425).

Short-term gains are taxed at your marginal income tax rate. In addition, depreciation recapture is taxed at 25 percent.

You may also be subject to a 3.8 percent Medicare surtax if your income exceeds $200,000 if you are single or $250,000 if you are married. These rates went into effect for the 2013 tax year and will not change without new laws being passed. It's always a good idea to verify these rates with the IRS or your accountant.

Loans and Gains
What you pay off on your loan isn't tax deductible. However, you can amortize many of the costs of getting your loan over its life.

For example, if you pay $12,000 to take out a mortgage with a 10-year term, you can write off $1,200 per year. If you were to sell your property after only three years, you'd have $8,400 in remaining loan fees that you hadn't claimed. You would be able to add those remaining fees to your cost basis, reducing your gain when you sold your property.

3 Less Known Tax Planning Tips Before 2020 Year End

10/22/2020

1. Use above-the-line charitable deduction

Everyone is entitled to a charitable deduction this year. The Tax Cuts and Jobs Act doubled the standard deduction while repealing or limiting many itemized deductions, leaving millions fewer taxpayers claiming actual itemized deductions. Typically, there is no tax benefit for giving to charity unless you itemize deductions. However, the CARES Act created an above-the-line deduction of up to $300 for cash contributions from taxpayers who don’t itemize. To take advantage of this provision, taxpayers should make sure to donate before the end of the year.

2. Supercharge investment with opportunity zones

Opportunity zones are one of the most powerful incentives ever offered by Congress for investing in specific geographic areas. In certain scenarios, not only can an investor potentially defer paying tax on gains invested in an opportunity zone until as late as 2026, but they only recognize 90 percent of the gain if they hold the investment for five years. Additionally, if they hold the investment for 10 years and satisfy the rules, they pay no tax on the appreciation of the opportunity zone investment itself. If they’re worried about capital gains rates going up under a new administration, this may provide an excellent tax-free investment. There are more than 8,000 opportunity zones throughout the United States, and many types of investment, development and business activities can qualify.

3. Make up a tax shortfall with increased withholding

COVID-19 created cash-flow problems for many individuals. Taxpayers should make sure their withholding and estimated taxes align with what they actually expect to pay while they have time to fix a problem. If they find themselves in danger of being penalized for underpaying taxes, they can make up the shortfall through increased withholding on their salary or bonuses. A larger estimated tax payment at the end of the year can still expose them to penalties for underpayments in previous quarters, but withholding is considered to have been paid ratably throughout the year, so increasing it for year-end wages can save them in penalties.

Can You Claim a Home Office Tax Deduction If You Work From Home

10/15/2020

In the past, employees who were required to work remotely could deduct the cost of their home office. However, that is no longer the case. The new tax law eliminated a provision in the tax code that allowed workers to deduct unreimbursed business expenses, including the cost of a home office, as long as the expense exceeds 2% of their adjusted gross income.

In order to claim a home office tax deduction, you have to meet stringent conditions, see below -

It is part of your home that is used in connection with a trade or business
You are not using it as an employee
The use is regular and exclusive
It is your principal place of business
Or if it is not your principal place of business, you use it to meet clients, or it is a separate structure

6 options for passing down your home - Part C

10/6/2020

In previous blogpost, we discussed 4 options to pass down your home to your children. Now final 2 options.

5. A beneficiary designation—a transfer on death (TOD) deed
Some states offer a TOD designation on a deed which essentially names a beneficiary for that property. With a TOD designation, assets pass outside probate, so it's quick and private, and the heirs still get a step-up in basis for tax purposes, which means the value of the house is adjusted to current market value. It may also be less expensive than setting up a trust.

There are some drawbacks to a TOD designation. It only allows individuals or charities as beneficiaries, not a trustee under a trust. That means that if a child is still young at the time of the transfer, they would directly own the home, which may not be practical. There is also no contingency, so if the child named as beneficiary dies before the original owner, there is no provision to skip a generation and pass the asset to their children—the TOD deed would have to be updated by the owner. Additionally, if the home is passed to an adult receiving government benefits, it could affect their eligibility.

Tip: TOD deed options are limited by state law, and many states do not offer this option at all. Check with your attorney or tax advisor to determine whether this option is available and would be appropriate for your circumstances.

6. Through selling
If it's unlikely that children will want the home, consider selling it and renting a home later in life. Issues like maintenance, health, and lifestyle may be more important than the financial considerations here, but be sure to consider the tax impact of this decision.

Current federal tax law allows a capital gains exclusion of either $250,000 (for an individual) or $500,000 (for a married couple filing jointly) on the sale of a house, provided that they have lived in that house for 2 of the previous 5 years, and that the home meets the residency requirements. Gains above that amount are taxed. Inheriting a property comes with a step-up in basis (which means it's reassessed at current market value) potentially eliminating capital gains tax.

The bottom line
A home can be the most valuable asset in an estate. If you don't take any action and die without a will or having made any other arrangements, your assets will pass according to your state intestacy laws, which may or may not reflect your wishes. This may include going through probate—a process that is potentially expensive, public, slow, and complicated.

The transfer of real estate assets can pose unique legal, tax, and emotional issues for a family, so it may be beneficial to work with a professional to help protect yourself and your loved ones. It's important to come up with a plan that makes sense for you, and your heirs, and to create an efficient strategy to execute it.

6 options for passing down your home - Part B

10/5/2020

In last blogpost, we shared 2 options to pass down your home to your children. Now we will discuss the next 2 options.

3. A revocable trust
A revocable trust is a legal structure that allows the "grantor" or "trustee" to retain control over their assets during their lifetime, as well as specify exactly how and when their assets pass to their beneficiaries. After the trustee's death, the trust acts as a will substitute and enables the assets to be privately and quickly distributed without going through the time and expense of the probate process. This will allow the trustee full control and use of their home during their lifetime while providing for efficient distribution at their death.

Due to the complexity of trusts and the variation in state-level rules, it is important to work with a professional to set up a trust, which costs money, but may be the only way to help ensure that the trust works effectively. It is also important to remember that it may be necessary to change the titling of your assets for the trust to function as intended.

Finally, a trust may be particularly beneficial for families that own properties in more than one state. Without a trust, an estate may pass through probate in multiple states.

4. A qualified personal residence trust (QPRT)
A QPRT is a way to move a primary or vacation residence out of your estate at a reduced gift tax cost. With a QPRT, the home is transferred to the trust right away, but it allows the original owner to retain the right to live in the home for the duration of the QPRT term. During that time, they are responsible for rent, maintenance, taxes, and other aspects of ownership. The trust has an end date after which ownership of the house is transferred to the beneficiary (generally children or a trust for their benefit) and the original owner no longer has the right to occupy the house (although a lease may be negotiated with the beneficiary).

In order for this strategy to be effective for tax purposes, the original owner must outlive the term of the trust. Otherwise, if they die before the trust terminates, the value of the home is included as part of their taxable estate and could be pulled back into the estate. While a QPRT may be used for a primary residence, it can be challenging for a person to lose the right to occupy their home, or pay rent to do so, and thus QPRTs may often be used for vacation homes.

Two big benefits of a QPRT include the reduced gift tax cost of the transfer (because the owner retains the right to live in the home for a period of time and keeps some of the value of the house), and that the value of the home is frozen for estate tax purposes at the time the trust is created. This means that for estate tax purposes, the value of the home is established at the time it enters the trust—and future price appreciation won't affect the estate's tax bill. For a family facing estate tax issues, this strategy may help to limit taxes in the event that the property value increases over time.

Tip: A property that is subject to a mortgage can be difficult to handle from a gift tax perspective, and therefore it is often suggested that any debt be paid off prior to the transfer to a QPRT.

In next blogpost, we will discuss 2 more options to pass down your home to your children.

6 options for passing down your home - Part A

10/4/2020

We will discuss 6 different ways to pass down your home to your children.

1. Co-ownership
One common idea that people have about passing the home to kids is seemingly simple: Just add the heirs as co-owners on the current deed. If the deed lists someone else as a joint tenant, they will become co-owners at the time the deed is changed, and they will automatically take ownership of the home at the time of the original owner's death.

There are some downsides to this approach, however. First of all, if a child is added as a co-owner, there are gift tax considerations. There is a limit to how much someone can gift another person without paying a gift tax, both yearly and in a lifetime. When a house is given as a gift through co-ownership, the portion transferred is considered a taxable gift and counts toward the lifetime exemption, so it has to be reported for gift tax purposes. Say a single parent adds a child to the deed, the parent would need to report 50% of the value of the home as a taxable gift (based on the fair market value of the home at the time of the transfer).

Secondly, gifts made during a lifetime are subject to carryover cost basis (the value of the house for tax purposes). Thus, the cost basis used for capital gains tax purposes doesn't get a step-up at the time of death—instead, the child may get a larger tax bill on the portion of the house that was given to them if they eventually sell the house after the co-owner's death.

Finally, as co-owners, the home becomes an asset of the child, creating several potential issues. First, if the child runs into financial trouble, gets divorced, or has other issues, your home may be put under a lien or become subject to other action. Second, the co-owner would need the child's permission to sell the home, take out a new mortgage, or refinance an existing one. And finally, the child may decide they would like to sell the home, which can create challenges.

2. A will
A will can be used to pass on a home. This process helps ensure that the owner decides who inherits the property. However, assets that transfer through a will still pass through the probate process, which can be time-consuming and expensive. In addition, a will is a public document, so anyone can review the decedent's assets and see who inherited them, so this can create a privacy concern.

We will discuss the next 2 methods in tomorrow's blogpost.

Copyright © 2013 - 2018 PFWise.com, All Rights Reserved.
IMPORTANT DISCLOSURES
PFwise.com does not provide investment, tax, or legal advice. The information presented here is not specific to any individual's personal circumstances.

To the extent that any material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

About Us | Contact Us
中文