Itemize or Standard Deduction? It’s a Complicated Decision for 2009.

Most taxpayers have annually had the option to itemize their deductions or take a standard deduction, and the rationale for making the choice has always been rather simple: take the higher of the two amounts. However, for 2009, the choice can be complicated, and, in some cases, requires advanced planning to maximize the tax benefits of that choice.

The complications have been brought about by the ability, in 2009, to add real property taxes, new vehicle sales and excise taxes, and disaster casualty losses to the standard deduction, creating a hybrid deduction that is part standard and part itemized. Consequently, the decision becomes more difficult, especially when deciding whether to buy a new car this year or not; pay all the property taxes or only the first installment this year; and exercise the option to take a 2009 disaster loss in the current year or the preceding year.

Some taxpayers who only marginally itemize each year have adopted the strategy of “bunching” deductions in one year and then claiming the standard deduction in the alternate year. This technique is applied to tax payments, charitable contributions, some medical expenses and to certain business expenses. Those employing this technique may need to reevaluate their strategy for 2009, take the hybrid standard deduction, and defer the other deductible payments into 2010.

When making the analysis, keep in mind: (1) the property tax add-on to the standard deduction is limited to $500 for single taxpayers and $1,000 for married taxpayers filing jointly, and (2) the vehicle tax is only allowed for the sales or excise tax paid on the first $49,500 of the purchase price for each new vehicle bought after February 16, 2009 and through the end of the year, and it begins to phase-out for single taxpayers with an AGI above $125,000 ($250,000 for married taxpayers).

If you marginally itemize your deductions, it may be appropriate for you to schedule a consultation with this office prior to the holidays, and defer tax-deductible payments and buying a car until after a strategy has been determined for your particular circumstances.

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Homebuyer Credit Extended

To stimulate home sales, Congress first established the first-time homebuyer credit in 2008, then modified it for 2009 (through November 30, 2009), and then extended it again through the middle of 2010 (2011 for certain service members) resulting in some complicated rules.

There are basically two credits, with significantly different sets of rules for each.  In addition, the extension legislation passed in November of 2009 added a new category of home buyer referred to as “long-time residents” and special provisions for U.S. Service Members.  The following is only an overview of these credits and you are encouraged to call this office in advance of a purchase to insure you will qualify for the credit.

2009 -2010 CREDIT HIGHLIGHTS:

• Credit Amount – The credit amount is based upon whether the buyer is a “first-time homebuyer” or a “long-time resident.”  See definition for both below.  The credit is 10% of the purchase price with a maximum credit of $8,000 ($4,000 for those filing married separate) for “first-time homebuyers” or $6,500 ($3,250 if married filing separate) for “long-time residents.” 

• Repayment Required: If the home is sold or ceases to be the taxpayer’s principal residence within 36 months of its purchase.

• Purchased: Between January 1, 2009 and before May 1, 2010 (July 1, 2010 if the taxpayer had entered into a binding contract before May 1, 2010.  Note: Credit provisions are extended for one additional year for members of the uniformed services, U.S. Foreign Service, or an employee of the intelligence community (and, if married, the individual's spouse) who serves on qualified official extended duty service outside of the U.S. for at least 90 days during the period beginning after Dec. 31, 2008, and ending before May 1, 2010.

• Home Location: Within the U.S.

• Home Price: For homes purchased after November 6, 2009, no credit is allowed if the home’s purchase price exceeds $800,000.

• Seller: Cannot be purchased from a close relative.

• When Claimed: Credit can be claimed on the taxpayer’s return for the year of purchase or the preceding year.

• Financing: Credit can be claimed even if financing is from tax-exempt mortgage revenue bonds.

The following are some additional details that relate to the credit for both 2008 and 2009:

Definition of a First-Time Homebuyer - A taxpayer is considered a first-time homebuyer if he (or spouse, if married) had no present ownership interest in a principal residence in the U.S. during the three-year period before the purchase of the home to which the credit applies. If the individual is married, neither the individual nor his spouse may have had a present ownership interest in a principal residence during that three-year period, even if they file as married taxpayers filing separately. Ownership of a home outside the U.S. during the three-year period will not disqualify the taxpayer.

Definition of a Long-Time Resident - Any individual (and spouse, if married, i.e., both must meet qualifications) who have owned the same principal residence for any 5 consecutive years during the 8-year period ending on the date of purchase of a subsequent principal residence.

Service Members Special Extension and Recapture Waiver - Credit provisions are extended for one additional year for members of the uniformed services, U.S. Foreign Service, or an employee of the intelligence community (and, if married, the individual's spouse) who serves on qualified official extended duty service outside of the U.S. for at least 90 days during the period beginning after Dec. 31, 2008, and ending before May 1, 2010:

• Qualifying Period Extension - Extends the credit provisions one year, through April 30, 2011 (June 30, 2011, in the case of an individual who enters into a written binding contract before May 1, 2010, to close on the purchase of a principal residence before July 1, 2011) for any of the following on qualified official extended duty.

• Recapture Waiver – In the case of a disposition of a principal residence by an individual (or a cessation of use of the residence that otherwise would cause recapture) after Dec. 31, 2008, in connection with Government orders received by the individual (or the individual's spouse) for qualified official extended duty service, no recapture applies by reason of the disposition of the residence, and any 15-year recapture with respect to a home acquired before Jan. 1, 2009, ceases to apply in the tax year of the disposition.

Homes That Qualify - Only the purchase of a main home located in the United States qualifies.  Vacation homes and rental property are not eligible.

Income Limits – The credit is reduced or eliminated for higher-income taxpayers.  The credit is phased out based on the modified adjusted gross income (MAGI).  MAGI is the adjusted gross income plus various amounts excluded from income - for example, certain foreign income.  The MAGI limits are different depending upon the purchase date of the home.

• For homes purchased before November 7, 2009 - The phase-out range is $150,000 to $170,000 for married taxpayers filing a joint return.  For other taxpayers, the phase-out range is $75,000 to $95,000.  This means that the full credit is available for married couples filing a joint return whose MAGI is $150,000 or less and for other taxpayers whose MAGI is $75,000 or less.

• For homes purchased after November 6, 2009 - The phase-out range is $225,000 to $245,000 for married taxpayers filing a joint return.  For other taxpayers, the phase-out range is $125,000 to $145,000.  This means that the full credit is available for married couples filing a joint return whose MAGI is $225,000 or less and for other taxpayers whose MAGI is $125,000 or less.

Who Cannot Take the Credit – In addition to the other qualifications and limitations discussed above, a taxpayer cannot take the credit if the following apply:

• Home is purchased from a close relative. This includes a spouse, parent, grandparent, child or grandchild.

• Home is no longer used as the main home.

• Home is sold before the end of the year in which it was purchased.

• If taxpayer is under the age of 18 (if married, both under the age of 18) on the date of purchase and the home is purchased after November 6, 2009.

• If the taxpayer can be claimed as a dependent of another.

• Taxpayer is a nonresident alien.

• Home financing comes from tax-exempt mortgage revenue bonds.

If you or a family member is contemplating on utilizing this credit, it may be appropriate to consult with this office in advance of a home purchase to discuss additional details not included in the above summary and your particular situation as related to the potential credit.

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Tips for Year-End Donations

Individuals and businesses making contributions to charity should keep in mind several important tax law provisions that have taken effect in recent years.

One provision offers older owners of individual retirement arrangements (IRAs) a different way to give to charity. There are also rules designed to provide both taxpayers and the government greater certainty in determining what may be deducted as a charitable contribution. Some of these changes include the following.

Special Charitable Contributions for Certain IRA Owners - An IRA owner, age 70 ½ or over, can directly transfer tax-free up to $100,000 per year to an eligible charitable organization. This option, only available through 2009, applies to eligible IRA owners, regardless of whether they itemize their deductions. Distributions from employer-sponsored retirement plans, including SIMPLE IRAs and simplified employee pension (SEP) plans, are not eligible.

To qualify, the funds must be contributed directly by the IRA trustee to the eligible charity. Amounts so transferred are not taxable and no deduction is available for the amount given to the charity.

Not all charities are eligible. For example, donor-advised funds and supporting organizations are not eligible recipients.

Transferred amounts are counted in determining whether the owner has met the IRA’s required minimum distribution rules. Where individuals have made nondeductible contributions to their traditional IRAs, a special rule treats transferred amounts as coming first from taxable funds, instead of proportionately from taxable and nontaxable funds, as would be the case with regular distributions.

Rules for Clothing and Household Items - To be deductible, clothing and household items donated to charity must be in good used condition or better. A clothing or household item for which a taxpayer claims a deduction of over $500 does not have to be in good used condition or better if the taxpayer includes a qualified appraisal of the item with the return. Household items include furniture, furnishings, electronics, appliances, and linens.

Guidelines for Monetary Donations - To deduct any charitable donation of money, regardless of amount, a taxpayer must have a bank record or a written communication from the charity showing the name of the charity and the date and amount of the contribution. Bank records include canceled checks, bank or credit union statements, and credit card statements. Bank or credit union statements should show the name of the charity, the date, and the amount paid. Credit card statements should show the name of the charity, the date, and the transaction posting date.

Donations of money include those made in cash or by check, electronic funds transfer, credit card, and payroll deduction. For payroll deductions, the taxpayer should retain a pay stub, a Form W-2 wage statement or other document furnished by the employer showing the total amount withheld for charity, along with the pledge card showing the name of the charity.

The following additional reminders are offered to help taxpayers plan their holiday-season and year-end giving:

• Contributions are deductible in the year made. Thus, donations charged to a credit card before the end of the year count for 2009. This is true even if the credit card bill isn’t paid until next year. Also, checks count for 2009 as long as they are mailed this year.

• Only donations to qualified organizations are tax-deductible. IRS Publication 78, available online and at many public libraries, lists most organizations that are qualified to receive deductible contributions.

• For individuals, only taxpayers who itemize their deductions can claim deductions for charitable contributions. This deduction is not available to people who choose the standard deduction. A taxpayer will have a tax savings only if the total itemized deductions (mortgage interest, charitable contributions, state and local taxes, etc.) exceeds the standard deduction.

• For all donations of property, including clothing and household items, a receipt is required that includes the name of the charity, date of the contribution, and a reasonably-detailed description of the donated property.  A receipt from the charity is not required if a donation valued at less than $250 is left at a charity’s unattended drop site.  However, the taxpayer must keep a written record of the donation that includes the foregoing information, as well as the fair market value of the property at the time of the donation and the method used to determine that value. Additional rules apply for a contribution of $250 or more.

• The deduction for a motor vehicle, boat or airplane donated to charity is usually limited to the gross proceeds from its sale. This rule applies if the claimed value of the vehicle is more than $500. Form 1098-C, or a similar statement, must be provided to the donor by the organization and attached to the donor’s tax return.

• If the amount of a taxpayer’s deduction for all non-cash contributions is over $500, a properly-completed Form 8283 must be submitted with the tax return.

If you have questions regarding your specific situation and planned year-end contributions, please call the office for additional information.

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Bunching Your Deductions Can Provide Big Tax Benefits

If your tax deductions normally fall short of itemizing your deductions or even if you are able to itemize, but only marginally, you may benefit from using the “bunching” strategy.

The tax code allows taxpayers to utilize the standard deduction or itemize their deductions if that provides to be a greater benefit.  As a rule, most taxpayers just wait until tax time to add everything up and then use the higher of the standard deduction or their itemized deductions.

If you want to be more proactive, you can time the payments of tax-deductible items to maximize your itemized deductions in one year and take the standard deduction in the next.

For the most part, itemized deductions include medical expenses, property taxes, state and local income taxes, home mortgage and investment interest, charitable deductions, unreimbursed job-related expenses and casualty losses.  The “bunching strategy” is more commonly associated with medical expenses, tax payments and charitable deductions; although, there are circumstances where the other deductions might be come into play.  There are many opportunities to bunch deductions, and the following are examples of the most commonly used with the “bunching” strategy:

• Medical Expenses – You contract with a dentist for your child’s braces. He may offer you an up-front lump sum payment or a payment plan.  By making the lump sum payment, the entire cost is credited in the year paid, thereby dramatically increasing your medical expenses for that year.  If you do not have the cash available for the up-front payment, then you can pay by credit card, which is treated as a lump-sum payment for tax purposes.  If you use a credit card, you must realize that the credit card interest is not deductible and you need to determine if incurring the interest is worth the increased tax deduction.  Another important issue with medical deductions is that only the amount of the total medical expenses that exceeds 7.5% of your income is actually deductible.  If you are caught by the Alternative Minimum Tax (AMT), then only the amount that exceeds 10% of your AGI is actually deductible.  So, there is no tax benefit of bunching medical deductions if the total is less than 7.5% (10% if taxed by the AMT).

If the current year is an abnormally high-income year, you may, where possible, wish to put off making medical expense payments until the subsequent year when the 7.5% (10%) threshold is less.

• Taxes – Property taxes are generally billed annually at mid-year and most locales allow the tax bill to be paid in semi-annual or quarterly installments.  Thus, you have the option of paying it all at once or paying in installments.  This provides the opportunity to bunch the tax payments by paying one semi-annual (or 2 quarterly) installment and a full year’s tax liability in one year and only paying one semi-annual (or 2 quarterly) in the other year.  In doing so, you are able to deduct 1-½ year’s taxes in one year and ½ a year’s taxes in the other. If you are thinking of being late on the property tax payments as means of bunching, you should be cautious.  The late payment penalty will probably wipe out any potential tax savings.

If you reside in a state that has state income tax, the state income tax paid or withheld during the year is deductible as a federal itemized deduction.  So, for instance, if you are making state quarterly estimates, the fourth quarter estimate is generally due in January of the subsequent year.  This gives you the opportunity to either make that payment before December 31st, and be able to deduct the payment on the current year’s return, or pay it in January before the January due date and use it as a deduction in the subsequent year.

A word of caution about the itemized deduction for taxes!  Taxes are only deductible for regular tax purposes.  So, to the extent you are taxed by the AMT, you derive no benefits from the itemized deduction for taxes.

• Charitable Contributions – Charitable contributions are a nice fit for “bunching” because they are entirely payable at the taxpayer’s discretion.  For example, if you normally tithe at your church, you could make your normal contributions during the year and then prepay the entire subsequent years’ tithing in a lump sum in December of the current year, thereby doubling up on the church contribution one year and having no deduction for charity in the other year.  Normally, charities are very active with their solicitations during the holiday season, giving you the opportunity to make the contributions at the end of the current year or simply wait a short time and make them after the end of the year.

If you think a “bunching” strategy might benefit you, please call this office to discuss the issue and set up an appointment for some in-depth strategizing. 

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Fine-Tuning Capital Gains and Losses

Year-end has historically been a good time to plan tax savings by carefully structuring capital gains and losses.  Conventional wisdom has always been to minimize gains by selling “losers” to offset gains from “winners,” and, where possible, generating the maximum allowable $3,000 capital loss for the year.

Long-term capital losses offset long-term capital gains before they offset short-term capital gains. Similarly, short-term capital losses offset short-term capital gains before they offset long-term capital gains. (“Long-term” means that the stock or property has been held over one year.) Keep in mind that taxpayers may use up to $3,000 of total capital losses in excess of total capital gains as a deduction against ordinary income in computing adjusted gross income or AGI.  Individuals are subject to federal income tax at a rate as high as 35% on short-term capital gains and ordinary income. Long-term capital gains are generally taxed at a maximum rate of 15%.

All of this means that having long-term capital losses offset long-term capital gains should be avoided where possible, since those losses will be more valuable if they are used to offset short-term capital gains or ordinary income. Avoiding this requires making sure that the long-term capital losses are not taken in the same year as the long-term capital gains. However, this is not just a tax issue; investment factors also need to be considered. It would not be wise to defer recognizing gain until the following year if there is too much risk that the property’s value will decline before it can be sold. Similarly, one wouldn't want to risk increasing a loss on property that is expected to continue declining in value by deferring its sale until the following year.

To the extent that taking long-term capital losses in a different year than long-term capital gains is consistent with good investment planning, a taxpayer should take steps to prevent those losses from offsetting those gains.

However, historical tax-planning logic may not apply this year for the following reasons:

• Increasing Capital Gains Rates - The special long-term capital gains rates that have been in effect since 2003 sunset (end) at the end of 2010 and return to the pre-2003 levels of 10% and 20%! These federal rates are currently 0% for taxpayers in the 15% and lower tax brackets, and 15% for those in higher tax brackets. Although only talk up to this point, proposals have been floated to raise the rate to 20% as early as 2010, plus tack on a 4.5% surtax for the wealthiest taxpayers.  Individuals with large, long-term capital gains in their investment portfolios might consider selling those holdings to take their gains now at the lower tax rates.  The good news here is that the wash sale rules do not apply to assets sold at a gain. So if you like a stock, you are free to buy it back right away. If your state doesn’t have a lower tax rate on capital gains, then the additional state tax you’d pay from selling profitable capital assets will need to be weighed against the federal tax you’d potentially save when deciding whether to make tax sales before year-end.

• Raising Marginal Tax Rates –With record deficits, taxes have to go up—campaign promises notwithstanding—and we can expect that to happen in the near future.  The only questions are when, how much, and for whom?  Conventional wisdom has always been to defer income, but with a potential for increased taxes, it may be appropriate to consider accelerating income to take advantage of the current lower tax rates.

It may be in your best interest to review your current year tax strategy with an eye to the future to maximize your benefits from gains or losses associated with capital assets.  Please call this office for assistance. 

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Don’t Cut Corners with Your Retirement Savings

This has been a tough year for many small business owners, and many are looking for corners to cut to conserve cash.  One corner that you should not cut unless you are desperate is contributing to your retirement plan.  Not only do these contributions help you fund your future retirement, but they can also provide you with a current tax deduction when you contribute to a self-employed retirement plan or to most traditional IRAs.

The benefit derived from the deductions for pension contributions is based upon your tax bracket.  The higher your tax bracket is, the larger the tax savings; thus, higher-income taxpayers benefit the most.  For example, John and George both wish to contribute $5,000 to their retirement plans.  John is in the 15% tax bracket, and George is in the 35% bracket.  Assuming both contribute to a deductible plan, George will save $1,750 on his tax bill by making the contribution while John only saves $750.

Here is where some tax-planning strategies come into play.  Distributions from deductible plans are taxable when withdrawn at retirement, while distributions from Roth IRA accounts are tax-free at retirement (provided a five-year holding period is met and withdrawals are made after age 59½).  Thus, John may find it more beneficial to make a Roth contribution and forego a current tax deduction while having tax-free retirement income.  George, on the other hand, would benefit from a nice deduction now but still may wish to consider the Roth options.  However, he will be barred from making Roth IRA contributions because his income exceeds the AGI phase-out limitations.  Instead, George might consider making a nondeductible traditional IRA contribution and then converting it to a Roth IRA in 2010 when the Roth IRA AGI limitations for conversions are removed.

There are a number of retirement account options available to a self-employed individual.  The 2009 limits for the most commonly encountered plans are:

• Traditional IRA - Contributions are limited to $5,000 ($6,000 if age 50 or over) and are deductible, but the taxpayer can elect to treat the contribution as nondeductible.  If the taxpayer participates in another pension plan, the deductibility may be limited depending on income.

• Roth IRA - Contributions are limited to $5,000 ($6,000 if age 50 or over), and the contributions are nondeductible.  Contributions are limited for higher-income taxpayers.  The yearly contribution limit for traditional and Roth IRAs is a combined limit.

• Self-Employed Retirement Plan (SEP) – The contribution limit is 25% of the net profits from self-employment (20% of the net profits before deducting the contribution itself) but not more than $49,000.  If you have employees, you generally must contribute the same percentage amount of their wages for the year to their SEP accounts (but not more than $49,000).

• Spousal IRA – Frequently overlooked is the fact that the spouse of a self-employed individual may also be able to make a contribution to either a traditional or Roth IRA based on the self-employed spouse’s self-employment income.

There are additional requirements that must be met for these plans as well as other options.  Please call this office for further details and/or assistance with selecting the pension option that best suits your current situation and your long-term needs.

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When is a Home Modification Deductible?

Generally, home improvements are not deductible except to offset home gain when the home is sold.  But a medical expense deduction may be claimed when it is a medically-necessary home modification.  The modification expense is deductible as a medical expense to the extent it exceeds any resulting increase in the value of the property.

The full cost of certain improvements can be included as medical expenses, because they are considered not to increase the home’s value.  Examples of these types of modifications include constructing entrance or exit ramps for the home; widening entrance/exit doorways, hallways and interior doorways; installing railings and support bars; and lowering or modifying kitchen cabinets.  Note, however, that medical expenses can be claimed only to the extent that they exceed 7.5% of the taxpayer’s adjusted gross income (AGI) (10% if taxed by the AMT).

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Earmarked Charitable Contributions

The IRS recently responded to a Senator’s inquiry related to contributions to a church that were made to help the church’s minister pay previous health expenses. The issue of the inquiry was whether members could take a contribution deduction and whether the minister has to include such donations in income.

IRS said that for a contribution to a church to be deductible under the tax code, the church must have full control of the donated funds and discretion as to its use. This ensures that the organization will use the funds to carry out its functions and purposes.  Additionally, the donor must intend to benefit the charitable organization and not an individual recipient.  Thus, contributions earmarked for a specific individual aren't deductible as charitable contributions.  As a result, an individual member's contribution to the church that is designated for the benefit of the minister is not deductible as a charitable contribution.

With regard to the taxability to the minister, the IRS noted that generally a taxpayer’s gross income includes all income from whatever source derived.  However, the value of property acquired by gift is excluded if it: comes from a detached and disinterested generosity; is made out of affection, respect, admiration, charity or like impulses; is not made from any moral or legal duty, nor from the incentive of anticipated benefit of an economic nature; and is not in return for services rendered.  Thus, if meeting the criteria of a gift, the amounts would not be taxable to the minister.

If you have further questions regarding earmarked contributions, please give this office a call.

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Luxury Car Rules May Limit Vehicle Write-Offs

Unfortunately, if you deduct actual expenses for the business use of your car, you will probably find your write-offs for depreciation restricted due to so-called luxury car limitations. And most cars (including trucks or vans) fit the IRS definition of a "luxury vehicle," regardless of their cost. If a vehicle is four-wheeled, used mostly on public roads, and has an unloaded gross weight of no more than 6,000 pounds, the car is considered a "luxury vehicle."

To see how this works, let's hypothetically say you and an associate each bought a car in 2009. Your car costs $50,000 while your associate's costs $25,000. You both use your vehicles 75% for business. Cars are in the 5-year life depreciation category and generally the first-year depreciation rate for 5-year life items is 20%.  However, the depreciation deduction for the year (including any choice to expense part of the car's cost) will be subject to the first-year "luxury vehicle" limitation, which for 2009 is $2,960 or $10,960 if a special 2009 50% bonus allowance is claimed. 
                             

As you can see, both you and your associate’s depreciation for the first year is the same amount because of the luxury auto limits.  Thus, your associate will be able to deduct the same amount as you, even though his car had a much lower cost than yours.

This may seem unfair, but there is an alternative that can help. Certain sports utility vehicles (a Suburban for example) exceed 6,000 pounds unloaded gross weight and have special rules and can provide a much higher first year write off.  For more information on how to maximize your business vehicle deductions, please give us a call.

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Lodging Expense Requires Substantiation

Self-employed individuals who pay for lodging expenses while away from home on business can deduct these lodging expenses only if they are substantiated in full (record of time, place, amount, and business purpose, plus paid bills or receipts). The expenses can't be substantiated using the lodging component of the federal per-diem rate.

IRS Office of Chief Counsel points out that Revenue Procedures don't allow self-employed individuals to use the federal lodging per diem rate to substantiate deductions for lodging expenses. For example, a self-employed individual who is away from home overnight on business for three days cannot deduct $150 for lodging (assuming a federal lodging rate of $50 x 3) on the strength of simplified substantiation (written record of time, place, and business purpose). The lodging deduction can only be claimed as a deduction if the expense is documented. Examples of documentary evidence includes receipts, paid bills, or similar evidence.

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