Tax & Business Strategies Monthly Newsletter - March 2008

Tax Planning Strategies
Will You Get a Cash Rebate?
Avoiding the IRS Audit Net

Business & Management Practices
New Law Allows Faster Write-Off of Business Assets
Heavy SUVs Get Big Deduction As Result of New Bonus Depreciation.
Better Hurry - Pending Legislation Could Close Loophole!
Employers Beware – Misclassifying Workers

General Information
How to Get a Copy of Your Tax Return Information
2007 Non–Profit Filing Requirements
The Earned Income Tax Credit
Life After the Real Estate Bubble Burst

Briefs
Deducting Prepaid Business Expenses
Are You Required to File a Gift Tax Return?
Charitable Contributions in a Self-Employed Business
IRS Touts Higher Audit Levels

TAX PLANNING STRATEGIES

Will You Get a Cash Rebate?

As part of the economic plan to stimulate the economy, the government will be sending rebate checks to most taxpayers. As with most tax issues, it is not simple and, in fact, somewhat complicated. There are many factors to consider, such as who qualifies for the rebate, how is it calculated, what does a taxpayer need to do, if anything, to get the rebate, and how does the rebate affect a taxpayer’s return for 2008.

These rebates are actually advance payments for a new refundable tax credit called the Recovery Rebate Credit (RRC). This credit will be claimed on a taxpayer’s 2008 tax return. The rebates are, in fact, an advance payment of the new RRC and must be accounted for when a taxpayer files for his or her 2008 tax return in 2009.

So the government can get the money into people’s hands quickly and not wait for the 2008 returns to be filed in 2009, the IRS will compute and mail out advance payments of this 2008 credit based upon the information included on a taxpayer’s 2007 tax return. (IRS will make a direct deposit of the advance payment into a taxpayer’s account if direct deposit was requested for the 2007 return refund.) Then, when the taxpayer files their 2008 return, the RRC will be reduced by the amount of the advance payment. Should the advance payment exceed the amount of the RRC, the taxpayer will not be required to make up the difference!

Who does not qualify for a rebate? Specifically, only individuals who meet certain requirements will be receiving rebates. Businesses, estates and trusts do not qualify. Neither do individuals that are or can be claimed as a dependent on someone else’s tax return. Also excluded are non-resident aliens and illegal immigrants.

Do all qualified individuals get rebates? No, each individual must qualify for the rebates in one of two ways, and the rebates and the credit in 2008 is phased out for higher-income taxpayers. To qualify, a taxpayer must (1) owe tax, as computed in a special way, or (2) have at least $3,000 of qualifying income. Qualifying income generally includes earned income, social security benefits, and veterans' disability payments (including payments to survivors of disabled veterans).

How much will your rebate be? The rebates are broken into two categories, the basic credit rebate and the qualifying child rebate credit. For the basic credit rebate, a single person with no qualifying children gets a maximum rebate of $600 or a minimum rebate of $300. A married couple filing jointly with no qualifying children gets a maximum rebate of $1,200 or a minimum rebate of $600. To get the maximum, your 2007 tax (figured in a special way) must be $600 or more for a single person and $1,200 or more for a married couple filing jointly. To get the minimum, you must have at least $3,000 of qualifying income (explained above) or owe tax (figured in a special way) of at least $1. Your rebate amount will fall in between the minimum and maximum if your tax is more than $300 but less than the maximum rebate for your filing status. In that case, your rebate will be equal to your tax. Let’s say that you are single, and your tax is $500. In this scenario, your rebate will be $500.

An eligible individual who is entitled to any amount of the basic credit is also allowed a credit equal to $300 for each qualifying child of the individual, in addition to the basic credit. “Qualifying child” has the same meaning for this purpose as it has for purposes of the child tax credit. Thus, for each child that qualifies for the child tax credit, a taxpayer qualifies for an additional $300 rebate.

For example, a married couple filing jointly with one qualifying child could be eligible for a maximum rebate of $1,500 ($1,200 + $300).

Phase out for higher-income taxpayers - The amount of the rebate (both the basic and the child amount) is reduced by 5% of a taxpayer's adjusted gross income (AGI) above $75,000 ($150,000 for joint returns). For example, a married couple filing jointly with one child has an AGI of $170,000, and net tax liability of over $1,200. Their rebate is $500: [$1,200 basic rebate plus $300 qualifying child rebate - $1,000 phase out (i.e., 5% × ($170,000 - $150,000)].

When will the rebates be issued? If you file a 2007 federal income tax return, the IRS will automatically figure your rebate based on your 2007 tax return (due April 15, 2008). Rebate checks will be sent out in May for those who file before that date.

Since these advance payments (cash rebates) are computed based on the data from the 2007 return, a 2007 return must be filed to obtain a cash rebate. Thus, some taxpayers, such as those receiving SS income and who are not otherwise required to file a return, must file one to qualify for the advanced payment. However, if a taxpayer does not file a 2007 return, he or she would still qualify for the RRC when a 2008 return is filed. This also applies to taxpayers who file late. They don’t lose the RRC – they just don’t receive it in advance and will have to wait for the benefit when their 2008 return is filed. The IRS is prohibited from issuing advance payments after December 31, 2008.

We hope this information is helpful. If you would like more details about the tax rebates, please do not hesitate to call.


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Avoiding the IRS Audit Net

The IRS recently announced they will be stepping up their tax return audits after several years of heavy reliance on correspondence audits. Their mission is to help fill the tax gap. The areas of increased audits include Schedule Cs (sole proprietor businesses) where the Treasury Department estimates income is underreported by an estimated $68 billion.

An IRS tax audit can come in a number of forms. The most demanding are the face-to-face audits, which require sitting down with an auditor and reconciling income and deductions.

Others are the less demanding correspondence audits where the IRS has reason to believe that the taxpayer failed to include reported income or has overstated deductions.

Face-to-Face Audits – Self-employed, high-income taxpayers, those who have omitted substantial income, or those who repeatedly fail to show income to support their lifestyle are more likely to be subject to these types of audits. Some are simply random to provide the IRS with statistics for targeting the most fruitful audit results.

You can appear for the audit yourself, but that is probably a bad idea since you are not trained in the rules and regulations regarding audit procedures and what limits the IRS’s incursion into your private life. You can authorize your tax professional to handle it without you. Often, this is the best way to prevent the audit from escalating beyond the original areas that attracted the IRS's interest in the first place. Practitioners experienced with IRS audits are less likely to become emotional or to make statements that would lead to additional IRS questioning.

Correspondence Audits – Employers, banks, lending institutions, schools, brokerage firms, escrow companies and others all feed data to the IRS, which the IRS, in turn, matches by computer to the information reported on your tax return. If there is a significant discrepancy, the IRS will correspond with the taxpayer. Sometimes these discrepancies will result in additional tax liability, while other times a simple explanation will satisfy the IRS and make the problem go away. Here are some examples of typically-encountered discrepancies:

• Unreported Retirement Income – Whenever a taxpayer takes money out of one IRA account and rolls it over within the 60-day statutory limit into another IRA or qualified plan, the income is not taxable. The IRS will know about the withdrawal but not the subsequent rollover, and unless the rollover is reported on the tax return, the IRS will believe it to be a taxable distribution. So what would have been a simple entry on the tax return results in a correspondence audit. When moving an IRA from one institution to another, making arrangements for a direct transfer will generally avoid these types of audits.

• Gross Proceeds of Sale – Generally, when real estate, stock or marketable securities are sold, the IRS knows what you sold and for what price. Thus, you must account for the sale on the tax return and compute the gain or loss. If you omit reporting the transaction, the IRS will treat the entire sales price as profit, adjust your tax, and notify you via a correspondence audit.

• Alimony Paid or Received – A taxpayer who pays alimony is able to deduct the amount he or she paid. On the other hand, the recipient of that alimony must report that amount as taxable income. The IRS checks to make sure the amounts match. If they don’t, expect a notice in the mail.

• Home Mortgage Interest – Each of your mortgage lenders will report to the IRS the interest paid on your mortgage for the year and issue you a Form 1098 for the same amount. If these amounts don’t reconcile, expect a notice or a request for an explanation. This is frequently an issue when the loan is from a private party not reporting the interest to the IRS, or when more than one individual is on the loan but the 1099 only has space for one Social Security Number (SSN). In both cases, the IRS provides a procedure for dealing with these issues on your tax return. However, if the procedure is not followed, the IRS will be unable to verify interest paid under your SSN and will issue a notice or request an explanation.

• Tuition Paid – Because of the education tax credits that can be claimed for paying tuition to a qualified higher education institution, the IRS requires those institutions to report the tuition received to the IRS and issue Form 1098-T to the student. Thus, the IRS has the ability to verify the tuition paid during the year, and any mismatch could result in a correspondence audit.

• Interest and Dividends – The IRS allows many financial institutions to issue substitute 1099s, i.e. forms that are not in the standard 1099 format. These substitute forms—with various types of interest and dividends reported separately and spread throughout lengthy annual account statements—can often be misinterpreted by an untrained eye. To make matters worse, many brokerage firms have issued amended 1099 statements late in the tax filing season because of errors in allocating the investment income by the proper type. Incorrectly reported, erroneously reported, or omitted investment earnings can trigger correspondence from the IRS.

• Non-Taxable Interest – Interest from municipal obligations are tax-free for purposes of computing federal tax. However, tax-free municipal interest income is added to income for purposes of computing taxable social security income and determining whether a taxpayer qualifies for earned income credit (EIC). Thus, all tax-free municipal interest must be reported on the tax return or risk a subsequent inquiry from the IRS.

• Cash Contributions Beginning in 2007 – Beginning for the 2007 tax year, regardless of the amount of cash contributed, the contribution must be backed up with either a bank record or written communication from the donee organization showing the: (1) name of the donee organization, (2) date of the contribution, and (3) amount of the contribution. The recordkeeping requirements may not be satisfied by maintaining other written records.

What this means is that unless the charitable organization provides written communication, cash donations put into a “Christmas kettle,” church collection plate, and pass-the-hat collections at youth sporting events will not be deductible. Donations by debit or credit card can be substantiated by bank records. These new rules will give the IRS the ability to audit taxpayer’s charitable contributions via correspondence audits since all contributions must be backed by a written receipt or bank record.

Don’t assume that just because you received a notice that the IRS is correct. They are frequently wrong. Please call this office before responding to any IRS notice. Tax laws are complicated, and the notices are not always easily understood.

Caution: It is strongly recommended that you contact this office immediately upon receipt of any inquiry from the IRS or state tax agency. Don’t procrastinate, because that only leads to further action on the part of the IRS or state agency.

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BUSINESS & MANAGEMENT PRACTICES

New Law Allows Faster Write-Off of Business Assets

The new 2008 Economic Stimulus Act includes several provisions that will benefit businesses by providing enhanced expensing and depreciation provisions for equipment purchased and placed into service in 2008. This tax relief will encourage businesses to make investments that will enable them to keep growing, and the requirement for investment in 2008 will achieve the stimulus bill's goal of injecting money into the economy right away.

Section 179 Expensing – Code Section 179 allows taxpayers to elect to treat the cost of Section 179 property as an expense deduction for the tax year in which the Section 179 property is placed in service, instead of having to capitalize the expense and recover the cost over several years. Generally, Section 179 property is acquired by purchase for use in the active conduct of a trade or business, and is generally either (i) tangible property to which accelerated cost recovery applies or (ii) computer software (to which depreciation applies) placed in service in tax years beginning after 2002 and before 2011. The property must be used more than 50% for business.

The 2008 Economic Stimulus Act made no changes to the general rules for the types of qualifying property but did increase the 2008 Sec. 179 expensing limits from $128,000 to $250,000, and increased the 2008 phase-out threshold from $510,000 to $800,000. The new law does not alter the Sec. 179 limitation imposed on sport utility vehicles, which have an expense limit of $25,000.

Bonus Depreciation is Back – For assets purchased and placed in service during 2008, the Economic Stimulus Act allows trades or businesses to depreciate an additional 50% of the cost of the assets. The types of property eligible for this 50% bonus depreciation will be the same as those included in previous bonus depreciation packages: (1) tangible property that had a recovery period not exceeding 20 years; (2) purchased computer software; (3) water utility property; and (4) qualified leasehold improvement property. The original use of the property must begin with the taxpayer. The bonus depreciation will be allowed under the alternative minimum tax (AMT).

Note: When using both the Sec. 179 expensing and the 50% bonus depreciation on the same asset, the Sec. 179 amount is applied first. Any amount not expensed under Sec. 179 or depreciated under the 50% bonus depreciation is depreciated in the normal manner.

Vehicle Depreciation Limits Increased - For vehicles, the luxury auto limits still apply. However, the limits for 2008 have been adjusted to account for the new 50% bonus depreciation by adding $8,000 to the luxury auto first-year depreciation limit, allowing a taxpayer to deduct up to $11,060 for a passenger vehicle (which is the normal $3,060 cap plus the additional $8,000). For qualifying trucks and vans, the cap increased by $200 (to $11,260). When a vehicle is used partially for business and personal use, some prorations may apply.

Caution – The new 50% bonus depreciation automatically applies unless a taxpayer elects not to take it.

Please call if you would like to discuss how these new tax benefits may apply to your business situation.



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Heavy SUVs Get Big Deduction As Result of New Bonus Depreciation.
Better Hurry - Pending Legislation Could Close Loophole!

The new 50% bonus depreciation for 2008 will provide big tax write-offs for taxpayers who purchase heavy sport utility vehicles (SUVs) and use them for business. However, pending energy legislation could end this tax windfall.

The tax law generally limits the depreciation allowed on passenger vehicles and light trucks weighing 6,000 pounds or less. For passenger cars, the maximum for 2008 (assuming 100% business use) is $11,060; for light trucks and vans, the limit is 11,260. Both of those limits include $8,000 of the new 50% bonus depreciation allowance.

SUVs weighing more than 6,000 pounds are exempt from those limitations, except that the Sec. 179 first-year expense is limited to $25,000. However, combining the $25,000 Sec. 179 deduction with the new 50% bonus depreciation and the regular depreciation on the balance can provide a huge first-year write-off in 2008. The following is a representative example (assuming 100% business use):

On Feb. 12, the Democratic House leadership introduced H.R. 5351, the “Renewable Energy and Energy Conservation Tax Act of 2008.” Effective for property placed in service after its enactment date, this bill as introduced would erase the current tax preference for heavy SUVs by subjecting all SUVs with a GVW of over 6,000 pounds to 14,000 pounds to the annual Code Sec. 280F luxury auto depreciation and expensing limits. The bill also would repeal the special $25,000 heavy SUV expensing limit in Code Sec. 179(b)(6). Thus, if the bill becomes law, the first-year write-off for heavy SUVs, bought and placed in service in 2008 after its enactment date, would be capped at $11,260 (and at $3,260 in 2009, assuming there's no adjustment in the first-year allowance for trucks or vans placed in service in 2008 or 2009).

If you are planning to buy an SUV based on this big write-off, be sure to call first to see the status of the legislation. Congress tried last year to limit the write-off for SUVs, but the legislation did not pass partly because Congress was sensitive to the negative effect it would have on U.S. car makers. So, it is wait and see!

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Employers Beware – Misclassifying Workers

The Internal Revenue Service has developed a new form for employees who have been misclassified as independent contractors by their employers. Form 8919, Uncollected Social Security and Medicare Tax on Wages, will now be used to figure and report the employee’s share of uncollected social security and Medicare taxes due on their compensation.

Generally, a worker who receives a Form 1099 for services provided as an independent contractor must report the income on Schedule C and pay self-employment tax on the net profit, using Schedule SE. However, sometimes the worker is incorrectly treated as an independent contractor by their employer when they are actually an employee. When this happens, beginning for tax year 2007, Form 8919 will be used by workers who performed services for an employer but the employer did not withhold the worker’s share of Social Security and Medicare taxes.

In addition, the worker must meet one of several criteria indicating they were an employee while performing the services. The criteria include:

• The worker was previously treated as an employee by the firm and they are performing services in a similar capacity and under similar direction and control.

• The worker’s co-workers are performing similar services under similar direction and control and are treated as employees.

• The worker’s co-workers are performing similar services under similar direction and control and filed Form SS-8 for the firm and received a determination that they were employees.

• The worker has been designated as a Section 530 employee by their employer or by the IRS prior to January 1, 1997.

• The worker has filed Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, and received a determination letter from the IRS stating they are an employee of the firm.

• The worker has received other correspondence from the IRS that states they are an employee.

• The worker has filed Form SS-8 with the IRS and has not yet received a reply.

By using Form 8919, the worker’s Social Security and Medicare taxes will be credited to their social security record. To facilitate this process, the IRS will electronically share Form 8919 data with the Social Security Administration.

A completed Form SS-8 may be filed with the IRS by either the employer or an employee – with or without the knowledge or consent of the other party – to request a determination of the worker’s status as an employee. The IRS will only rule with regard to prior employment status, not on the individual’s prospective employment status as an employee or independent contractor. During the review of the information provided with Form SS-8, enough questions may be raised to result in an employment tax audit of the employer.

If it is determined in audit that the worker should have been treated as an employee and not an independent contractor, the employer may face some serious, and potentially expensive, consequences. In addition to having to pay the payroll taxes that should have been withheld, the employer must issue the employee a W-2 and revised Form 1099 for the years that are reclassified. The employer will also need to review any of its benefit plans to determine the consequences of the reclassification. For example, the employer’s qualified retirement plan could be disqualified because not all employees were covered.

While it may be tempting to classify a worker as an independent contractor to avoid paying the employer’s share of employment taxes or having to deal with the extra tax filings and paperwork that comes with employees, the consequences of having that person reclassified as an employee can be severe. Now that the IRS has provided employees with a convenient method to pay their share of the Social Security and Medicare taxes, and thus raise the “red flag” as to the classification, it is likely that the IRS will be more aggressive in following through with audits of the employers.

If you have any questions, please give this office a call.

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GENERAL INFORMATION

How to Get a Copy of Your Tax Return Information

We can generally provide you with copies of tax returns prepared by the office for current and three prior calendar years. There may be a nominal reproduction charge. Please keep in mind, that due to privacy laws, we can only provide the copy to you and not to a third party. If you would like copies of returns that were not prepared by this firm, you can easily obtain tax return or tax account transcripts by phone or mail directly from the IRS.

A tax return transcript shows most line items from the tax return (Form 1040, 1040A or 1040EZ) as it was originally filed, including any accompanying forms and schedules. It does not reflect any changes you, your representative, or the IRS made after the return was filed. In many cases, a return transcript will meet the requirements of lending institutions such as those offering mortgages and student loans. You should receive your tax return transcript within 10 working days from the time the IRS receives your request.

A tax account transcript shows any later adjustments either you or the IRS made after the tax return was filed. This transcript shows basic data, including marital status, type of return filed, adjusted gross income and taxable income. The IRS does not charge a fee for transcripts, which are available for the current and three prior calendar years. Allow 30 calendar days for delivery of a tax account transcript.

To request either transcript:

• By phone: Call 800-829-1040 and follow the prompts in the recorded message.

• By mail: Complete IRS Form 4506-T, Request for Transcript of Tax Return. If you need a photocopy of a previously processed tax return and attachments, complete Form 4506, Request for Copy of Tax Form, and mail it to the IRS address listed on the form for your area. There is a fee of $39.00 for each tax period requested. Copies are generally available for the current and past six years.

Forms 4506-T and 4506 can be found on the IRS Web site at IRS.gov or by calling the IRS forms and publications order line at 800-829-3676.

If you need assistance in obtaining past returns, please give our office a call.

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2007 Non–Profit Filing Requirements

Organizations exempt from income tax under Internal Revenue Code Section 501(a), which includes Sections 501(c), 501(e), 501(f), 501(k), 501(n) and 4947(a)(1) must generally file Form 990 or Form 990-EZ based on their gross receipts for the tax year. The following is a general overview of the filing requirements. Please consult the instructions for Form 990 and 990-EZ for additional details.

Gross Receipts $25,000 - If the organization does not meet any of the exceptions listed in General Instruction B, and its annual gross receipts are normally more than $25,000, it must file Form 990 or Form 990-EZ. If the organization is a sponsoring organization, or a controlling organization within the meaning of Section 512(b)(13), it must file Form 990. However, if the organization is a supporting organization described in Section 509(a)(3), it generally must file Form 990 (Form 990-EZ if applicable) even if its gross receipts are normally $25,000 or less. Supporting organizations of religious organizations need not file Form 990 (or Form 990-EZ) if their gross receipts are normally $5,000 or less.

Generally, all religious organizations (see Exceptions to file 990 below) must file Form 990 or Form 990-EZ unless their annual gross receipts do not normally exceed $25,000.

$25,000 Gross Receipts Test - To determine if an organization’s gross receipts are normally $25,000 or less, apply the following test. An organization’s gross receipts normally are considered to be $25,000 or less if the organization is:

1. Up to a year old and has received, or donors have pledged to give, $37,500 or less during its first tax year;

2. Between one and three years old and averaged $30,000 or less in gross receipts during each of its first two tax years; or

3. Three years old or more and averaged $25,000 or less in gross receipts for the immediately preceding 3 tax years (including the year in which the return would be filed).

Gross Receipts $100,000 - If the organization’s gross receipts during the year are less than $100,000 and its total assets at the end of the year are less than $250,000, it may file Form 990-EZ instead of Form 990. Even if the organization meets this test, it can still file Form 990.

Exceptions to file 990
The following is a list of some of the organizations that are not required to file Form 990.
• Churches (as opposed to “religious organizations,” defined earlier)
• Inter-church organizations of local units of a church
• Mission societies sponsored by or affiliated with one or more churches or church denominations, if more than half of the activities are conducted in, or directed at, persons in foreign countries
• An exclusively religious activity of any religious order

For a list of other organizations that are not required to file Form 990, see the instructions for Form 990 and Form 990-EZ.

Please call this office for additional details.

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The Earned Income Tax Credit

The EITC is for people who work, but have lower incomes. If you qualify, it could be worth up to $4,700 this year. So, you could pay less federal tax or even get a refund. The credit is a refundable credit, so you can receive the benefits of the credit even if you may not owe any taxes. That’s money you can use to make a difference in your life.

In Tax Year 2006, over 22.4 million taxpayers received $43.7 billion dollars in EITC – making the credit a great investment in the lives of those who claim it. However, the IRS estimates 20 to 25 percent of people who qualify for the credit do not claim it. At the same time, there are millions of Americans who have claimed the credit in error, many of whom simply don’t understand the criteria.

The EITC is based on the amount of your earned income and whether or not there are qualifying children in your household. If you have children, they must meet the relationship, age and residency requirements. Additionally, you must file a tax return to claim the credit.

If you were employed for at least part of 2007, you may be eligible for the EITC based on these general requirements:

• You earned less than $12,590 ($14,590 if married filing jointly) and did not have any qualifying children.

• You earned less than $33,241 ($35,241 if married filing jointly) and have one qualifying child.

• You earned less than $37,783 ($39,783 if married filing jointly) and have more than one qualifying child.

In addition, you must meet a few basic rules:

• You must have a valid Social Security Number.

• You must have earned income from employment or from self-employment.

• Your filing status cannot be married, filing separately.

• You must be a U.S. citizen or resident alien all year, or a nonresident alien married to a U.S. citizen or resident alien, and filing a joint return.

• You cannot be a qualifying child of another person.

• If you do not have a qualifying child, you must:
o be age 25 but under 65 at the end of the year,
o live in the United States for more than half the year, and
o not be a qualifying child of another person.

• You cannot file Form 2555 or 2555-EZ (related to foreign earned income).

Members of the military can elect to include their nontaxable combat pay in earned income for the earned income credit. If you make the election, you must include in earned income all nontaxable combat pay received. If you are filing a joint return and both you and your spouse received nontaxable combat pay, then each of you can make your own election. The amount of your nontaxable combat pay should be shown on your Form W-2 in box 12 with code Q.

If you have any questions, please give this office a call.

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Life After the Real Estate Bubble Burst

With lenders becoming more conservative, money tightening up, and the real estate market in decline, many homeowners and speculators find themselves faced with some unpleasant choices. One strategy is to wait until home prices rebound, but that could be some time and probably too far off for the owner with a variable rate or short-term introductory rate loan and increasing mortgage payments.

There are other reasons—such as job relocation, divorce, declining income or poor health—that can force a property owner to sell in a down market and possibly take a financial loss. This article explores the tax ramifications of selling a home or rental property at a loss. But first, here are some terminology and tax rules associated with selling property:

• Personal-Use Property - The general rule that applies to personal-use property is that gains are taxable as capital gains but losses are not deductible. Examples of personal-use property are the family car (no business use) and the family home or second home. So, if you sell your personal residence or second residence at a loss, that loss is not deductible.

• Investment Property – For investment property, generally, gains are taxable and losses are deductible as capital gains/losses. However, the amount of capital loss that can be deducted annually is limited. If, after combining all investment capital gains and losses, the result is a loss, the loss is generally limited to $3,000 per year. Examples of investment property include vacant land or improved real estate that is not a business property, home or second home.

• Business Property – The general rule for business property is that gains are taxable as capital gains and losses are deductible as ordinary income. Examples of business property include residential rentals, commercial rentals and an office-in-the-home.

• Primary Home Sale Gain Exclusion – Generally, an individual who owns and lives in a home for two of the prior five years can exclude $250,000 of home sale gain. This applies to each individual so a couple could exclude $500,000. In addition, an individual who does not meet the two-out-of-five requirements may still be able to exclude a lesser amount if the home was sold due to certain unforeseen circumstances.

Now let’s apply these general rules to some representative situations that are likely to occur in a down real estate market.

Example #1 – You sell your primary (or second) home for a loss when taking into consideration what you originally paid for the home, improvements and the sales costs. Bad news - your home is personal use property and losses from “personal-use property” are not deductible. Thus, there is no tax relief from having a loss on the sale of your primary or secondary home.

Example #2 – You purchased a residential or commercial property as a rental. Now the value has declined below your basis and a sale will result in a loss. Since it is business property, the entire loss will be deductible as ordinary income in the year of sale. Thus, you will achieve tax relief based on your tax bracket(s) in the year of sale. Caution: The depreciation of the real property that you claimed as a rental expense decreases your cost basis. This means that you could actually end up with a tax gain on the sale when you thought you would have a loss.

Example #3 – You purchased vacant land for an investment and need to sell it. Unfortunately, the sale will result in a loss. The good news is the loss is tax-deductible, but lacking any capital gains to offset the loss, you will only be able to deduct $3,000 ($1,500 if filing as married separate) of the loss in the sale year; the excess loss carries over to future years.

Example #4 – Your home that you are selling for a loss includes an office from which you conduct your business. The home office is deductible under the income tax rules, and represents 10% of the home. In this case, 10% of the loss would be deductible as an ordinary loss in the sale year. None of the remaining 90% of the loss is deductible due to the personal- use property rules.

Example #5 – Yes, we read your mind. You are planning to move out of your home that will sell for a loss and convert it to a rental thinking you could then deduct the loss. Problem with this strategy is that tax law requires you to use the fair market value (FMV) of the home at the time of conversion as the business basis if the FMV is less than your adjusted cost basis. Thus, the loss in value that occurred prior to the conversion will not be included in your loss when you sell the rental. However, if the market continues to decline, you will be able to take advantage of any future losses.

Example #6 – The property will sell for a loss, so you decide to just let it go into foreclosure. By doing this, you avoid the sales costs but destroy your credit rating for years to come. In addition, if the property sells at auction for less than the mortgage balance, you may, depending on some complicated rules, have to include in your income the difference between the loan amount and the sales price (referred to as debt relief income).

Example #7 – Let’s say you originally purchased your home for $200,000; it increased in value to $300,000, so you refinanced it for $240,000 and used the money to buy a car, go on vacation, pay off credit card balances, etc. Now your mortgage is higher than both your basis (cost) in the home and its current value. Your home sells for $225,000, and assuming you have $10,000 in sales costs, you end up with a tax gain of $15,000 rather than a loss, which may come as a surprise. The gain may or may not be taxable depending upon whether you qualify for the home sale gain exclusion. Bad news is you need to make up the $15,000 mortgage shortage and the $10,000 sales costs.

We strongly suggest you carefully weigh your options before selecting a course of action. A consultation appointment may be appropriate to see what option is the best for your particular tax situation. Please give us a call.


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BRIEFS

Deducting Prepaid Business Expenses

A question that often arises is whether prepaid business expenses can be deducted in the year it is paid. Unfortunately, they cannot. Generally, where an expense relates to a period covering more than 12 months, the IRS and most courts agree that the deduction must be spread over the period to which the expense applies.

For example, you purchase a three-year maintenance plan for your office photocopy machines. The service company offers you a discount to prepay the contract, which you end up doing. In this case, the expense must be amortized (ratably deducted) over the three-year period and not all at once in the year paid. If you had only prepaid three months of the contract, that amount would have been deductible in the year paid. This rule precludes business owners from prepaying expenses as a means to reducing their profits for a particular year.

If you have questions regarding prepaid expenses, please give us a call.



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Are You Required to File a Gift Tax Return?

If you gave any one person gifts in 2007 that are valued at more than $12,000, you must report the total gifts to the Internal Revenue Service even if you have not exceeded the $1 million gift tax exemption. The gift tax return is used to track the nontaxable gifts and determine when gifts from all years exceed the gift exemption and become taxable. The person who receives your gift does not have to report the gift to the IRS or pay gift or income tax on its value.

Gifts include money and property, including the use of property without expecting to receive something of equal value in return. If you sell something at less than its value or make an interest-free or reduced-interest loan, you may be making a gift.

There are some exceptions to the tax rules on gifts. The following gifts generally are not taxable and do not count against the annual limit:

• Tuition or Medical Expenses that you pay directly to an educational or medical institution for someone's benefit
• Gifts to your Spouse
• Gifts to a Political Organization for its use
• Gifts to Charities

If you are married, both you and your spouse can give separate gifts of up to the annual limit of $12,000 to the same person without making a taxable gift.

Alternatively, with consent from your spouse, you can make a gift of up to $24,000 ($12,000 x 2) to the same person without making a taxable gift. This is commonly known as splitting gifts between spouses. Essentially, it means a gift by you or your spouse to a third person can be considered as made one-half by each of you provided there is consent by both spouses.

If you need assistance determining if you are liable for a gift tax return, please give us a call.


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Charitable Contributions in a Self-Employed Business

Generally, for self-employed individuals, charitable contributions are not deductible on Schedule C as a business expense and can only be deducted as an itemized deduction on Schedule A. However, tax regulations state that transfers to a charity that are directly related to a taxpayer's business and are made with a “reasonable expectation of financial return commensurate with” the amount transferred may be deductible as a business expense. For example, if you pay a charitable organization to run an ad in their newsletter that is intended to generate new customers for your business, the cost of the ad would be an advertising expense, but not a charitable contribution expense.

You should contact this office if you have questionable contributions.

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IRS Touts Higher Audit Levels

As reported in a statement issued by IRS, it has continued to make strong progress in a number of key enforcement areas. IRS enforcement efforts increased in fiscal year 2007; overall, enforcement revenue reached $59.2 billion, up from $48.7 billion in 2006.

Individual enforcement - Overall, the total individual return audits were up 7% in 2007. The table below is a summary of IRS audit activity for fiscal year 2007:

(1)One out of 11 individuals with incomes of $1 million or more faced an audit in 2007.

Business enforcement – Overall, the total business return audits were up 14% in 2007. The table below is a summary of IRS audit activity for fiscal year 2007:

(2)Assets between $10 million and $50 million dollars

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