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Unraveling Conflicting Tax Rules for Active vs. Passive Income February 26, 2020

Posted by bradstreetblogger in : 2019 Taxes, Business consulting, General, Tax Rules, Tax Tip, Taxes, Taxes, Uncategorized , add a comment

February 26, 2020

Few topics in the office cause more arguments than the tax definition of active versus passive.  The answer affects your income taxes vastly more than one would ever guess.  And, not in just one area of tax but often involving a multitude of seemingly unrelated areas.  At times, both parties in our office scuffles will have written evidence to support each of their opposing views.  Taxes have many shades of gray.

                            -Mark Bradstreet

It is commonly accepted wisdom that tax rules are complicated. This belief is well supported by the conflicting tax rules that apply to business owners, depending on their participation in the business. Let me try to make some sense of these conflicting rules.

Overview

Business owners may be active in their business. This means they are hands-on and are involved in day-to-day activities. Other business owners may be mere investors, adding their capital but not their labor. The following are various rules that take into account whether owners do or do not work in their businesses.

Qualified business income deduction

The 20% deduction for qualified business income (QBI) applies to owners of pass-through entities. There is no requirement that they do or do not participate in the daily operations of the business in order to claim this personal deduction based on their share of business income. If they participate (e.g., they are an S corporation shareholder who receives a salary), this factors into the QBI determination. For example, salary to an S corporation shareholder is not an item allowed in determining QBI, but the salary does count as wages for purposes of W-2 wages used in the formula for the QBI deduction.

Net investment income deduction

The 3.8% net investment income (NII) tax depends entirely on an owner’s participation in the business. Only income from a business in which the taxpayer does not materially participate is treated as investment income and potentially subject to the NII tax. The determination of material participation is made using the passive activity loss rules (below).

Passive activity loss rules

Under the passive activity loss rules, losses from a business activity in which an owner does not materially participate, and has no passive income, are not currently deductible (sorry for the double negative but it’s the best way to explain this limitation). Suspended losses can be carried forward and used to offset passive activity income in the future.

The determination of whether an owner is passive or active is based on 7 tests. An owner is treated as materially participating (i.e., active) and is exempt from the passive activity loss rules if he or she meets any of these tests:

1.    The owner participated in the activity for more than 500 hours.
2.    The owner’s participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
3.    The owner participated in the activity for more than 100 hours during the tax year, and he or she participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
4.    The activity is a significant participation activity, and the owner participated in all significant participation activities for more than 500 hours (i.e., participation for more than 100 hours during the year and in which the owner didn’t materially participate under any of the material participation tests).
5.    The owner materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
6.    The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
7.    Based on all the facts and circumstances, the owner participated in the activity on a regular, continuous, and substantial basis during the year.

Note: When it comes to rental real estate activities and the passive activity loss rules, an owner’s participation doesn’t entitle him or her to claim losses. Owners of rental real estate activities can escape the passive activity loss rules only by demonstrating that they are real estate professionals (part of the definition of a real estate professional is based on material participation).

Self-employment tax

Sole proprietors pay self-employment tax on their net self-employment income. This is so whether they run their business or are totally in the background, relying on a full-time manager to handle the business.

General partners are subject to self-employment tax on their distributive share of self-employment income, plus any guaranteed payments. In contrast, limited partners are exempt from self-employment tax (other than for any guaranteed payments they receive for personal services rendered for the partnership).

Members in limited liability companies may or may not be subject to self-employment tax. There is no firm IRS guidance on this matter. However, tax professionals have argued that where members are mere investors (i.e., they act like limited partners), they should be treated like limited partners who are exempt from self-employment tax on their distributive shares.

Bottom line

Whether you sweat each day in your endeavors or are an investor who watches the books determines the tax rules that apply to you. Discuss your status with your CPA or other tax advisor.

Credit given to:Barbara Weltman

Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.  

Today’s author – Mark Bradstreet

–until next week.

Energy Tax Credit: Which Home Improvements Qualify? February 19, 2020

Posted by bradstreetblogger in : 2019 Taxes, Taxes, Taxes, Uncategorized , add a comment

Updated for Tax Year 2019

Taxpayers who upgrade their homes to make use of renewable energy may be eligible for a tax credit to offset some of the costs. Through the 2019 tax year, the federal government offers the Non-business Energy Property Credit. The renewable energy tax credits are good through 2019 and then are reduced each year through the end of 2021. Claim the credits by filing Form 5695 with your tax return.

Residential Renewable Energy Tax Credit

Equipment that qualifies for the Residential Renewable Energy Tax Credit includes solar, wind, geothermal and fuel-cell technology:

Renewable energy tax credit details

According to the U.S. Department of Energy, you can claim the Residential Energy Efficiency Property Credit for solar, wind, and geothermal equipment in both your principal residence and a second home. But fuel-cell equipment qualifies only if installed in your principal residence.

Non-business Energy Property Tax Credit
(Extended through December 31, 2019)

Equipment and materials can qualify for the Non-business Energy Property Credit only if they meet the standards set by the Department of Energy. The manufacturer can tell you whether a particular item meets those standards.

For this credit, the IRS distinguishes between two kinds of upgrades.

The first is “qualified energy efficiency improvements,” and it includes:

The second category is “residential energy property costs.” It includes:

Details of the Non-business Energy Property Credit
(Extended through December 31, 2019)

You can claim a tax credit for 10% of the cost of qualified energy efficiency improvements and 100% of residential energy property costs. This credit is worth a maximum of $500 for all years combined, from 2006 to its expiration.  Of that combined $500 limit;

Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.

–until next week.

Tax Tip of the Week | How is Hobby Income Taxed? February 12, 2020

Posted by bradstreetblogger in : 2019 Taxes, General, tax changes, Tax Planning Tips, Tax Preparation, Tax Tip, Taxes, Taxes , add a comment

February 12, 2020

The hobby world has been turned upside down. In the past, hobby expenses were deducted to the extent of hobby income. Starting with 2019 and moving forward, hobby expenses are no longer deductible but your hobby income is fully taxable. Why? I have no idea. Hobbyists should be making whatever efforts necessary to convert their hobby to a business. Unlike hobby expenses, business expenses are deductible.  

                                -Mark Bradstreet

If you earn money from a hobby, you must report it as income on your federal income tax return. But if your hobby turns into a business, you may be eligible to take business deductions as well.

If you’re like most people, you probably have at least one hobby.

Unless your hobby’s mining for cryptocurrencies, you may not profit much from it. But you could still have at least a little hobby income coming in. If you do, you’re probably wondering: How is hobby income taxed?

The answer: You must pay taxes on any money your hobby makes, even if it’s just a few dollars. The good news is, if you incurred hobby expenses, you might be able to deduct them. It’s important to know how to declare hobby income, how to deduct hobby expenses and how to know if your hobby’s a business. You can find out about the rules right here.

Is it a hobby, or is it a business?

First things first — are you pursuing a hobby or running a business? Generally, if you’re doing something with the intention of making a profit, that’s a business, according to the IRS. A hobby is something you do for sport or recreation, and not for the objective of making a profit.

Some additional factors the IRS considers when defining a hobby versus a business include:

•    Do you depend on the income from your hobby?
•    Do you conduct your hobby like a business, maintaining meticulous records?
•    Have you taken steps to make your hobby more profitable?
•    Do you (or anyone who’s advising you) have the knowledge you would need to conduct your hobby as an actual business?
•    Can you expect to turn a profit from appreciation of assets you use in your hobby?

Maybe you answered “no” to all of the questions above. Sometimes, however, your hobby isn’t just for fun and you decide to try to make a living doing what you love. If your hobby becomes a business in the eyes of the IRS, the rules change. Check out the IRS Small Business and Self-Employed Tax Center if you find that your hobby has turned into a business.

You must declare hobby income

The IRS wants you to declare all your hobby income, even if it’s a small amount of money.

“If your hobby or side business has a net profit, you have to pay income taxes on that net profit, even with the new tax law,” says Irene Wachsler, a CPA at Tobolsky & Wachsler CPAs LLC in Canton, Massachusetts.

If you file your taxes using Form 1040, you’ll typically report your hobby income on Line 21, labeled “Other income.” While this is the simplest approach for most situations, there’s an alternative if you’re a collector.

If your hobby income comes from selling collectibles at a profit, you may report income from sales, including stock sales, on Schedule D. Reporting profits on a Schedule D means you could be taxed at capital gains rates instead of ordinary income tax rates.

Hobby expenses

Most hobbies — even those that earn you income — also cost money. Prior to the 2018 tax year, you could deduct hobby expenses equal to your hobby income. For tax years after 2018, this deduction is no longer available.

Since tax reform has significantly increased the standard deduction for 2018, you may be thinking you’ll likely lose the ability to deduct hobby expenses if it no longer makes sense for you to itemize. In fact, it doesn’t matter whether you do or don’t itemize — you’ve lost the deduction for hobby expenses in 2018 anyway because tax reform removed the miscellaneous deduction.

“Under the new tax reform bill, there is no place to deduct the expenses, so income will be recognized but the expense will not, starting in 2018,” says Alan Pinck, an enrolled agent and founder of A. Pinck & Associates, San Jose, California.

When does your hobby become a business, and why does it matter?

If your hobby becomes a business, you’re subject to a whole different set of tax rules.

First, you’ll typically have to declare income on Schedule C and pay both income tax and self-employment taxes (self-employment taxes include taxes for Social Security and Medicare, which an employer normally pays half of when you earn wage income). You can also deduct losses from a business, even if those losses exceed income the business earns, which differs from hobby losses.

It may seem tempting to classify your hobby as a business so you can deduct all your expenses, but proceed with caution — as mentioned earlier, the IRS uses specific criteria to differentiate a hobby from a business.

“If the activity makes a profit during at least three out of the last five years, the IRS will generally consider it a business,” Pinck explains, noting that the rules change if horses are involved.

Still, if you decide you do want to turn your hobby into a business and reap the tax benefits of business deductions, Wachsler recommends you keep a log showing your attempts to participate materially in the business.

Your log could include details on your efforts, including advertising, meetings, trying to obtain income or sell services, mileage logs and work logs. Of course even if you make an effort, the IRS may still decide your “business” isn’t really a business at all if you suffer persistent losses year after year.

Bottom line

Now that you know how hobby income is taxed, it’s up to you to decide if making money doing something for fun is worth the potential tax ramifications. While declaring income earned from your hobby may seem like a hassle — especially since you can’t deduct expenses after 2017 — you don’t want to get in trouble with the IRS for not reporting all your income.

Be sure to follow the rules for paying taxes on any money your hobby earns, and be sure you understand the differences between a hobby and a business. If the IRS decides you incorrectly classified your hobby as a business or vice versa, you could face additional taxes, penalties and interest.

Credit Given to: Christy Rakoczy Bieber

Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.  

Today’s author – Mark Bradstreet

–until next week.

Tax Tip of the Week | How to do 1031 Exchanges to Defer Taxes February 5, 2020

Posted by bradstreetblogger in : 2019 Taxes, General, Tax Planning Tips, Tax Preparation, Tax Tip, Taxes, Taxes , add a comment

Like-kind tax free exchanges aka Internal Revenue Code Section 1031 are one of the most valuable yet underutilized sections of the IRC (the last major tax law change eliminated 1031 exchanges for anything but real estate).  We have prepared thousands of individual income tax returns and only a very small fraction of those with commercial and residential real estate sales use Section 1031.  Why?  I speculate lack of 1031 education is the primary culprit.  Also, the people that are aware simply don’t wish to tackle its complexities.  Its rules are unforgiving and the deadlines are engraved in stone as the accompanying article discusses.  However, it benefits may be significant.

                                    -Mark Bradstreet 

The Definition of Like-Kind Properties Has Changed Over the Years

The time-worn saying “Nothing is certain but death and taxes” is only half true for a savvy American taxpayer who is planning the sale of an investment or business property. Since capital gains tax on your profits could run as high as 15 percent to 30 percent when state and federal taxes are combined, why not take the necessary steps to avoid this loss? A big tax bite could wipe out money you could use for future investments.

Enter the 1031 tax-deferred exchange. To many taxpayers, this is like money dropping from the skies.

1031 Exchanges Defer Taxes

The 1031 Exchange has been cited as the most powerful wealth-building tool still available to taxpayers. It has been a major part of the success strategy of countless financial wizards and real estate gurus. Taking its name from Section 1031 of the Internal Revenue Code, a tax-deferred exchange allows a taxpayer to sell income, investment or business property and replace it with a like-kind property.

Capital gains on the sale of this property are deferred or postponed as long as the IRS rules are meticulously followed. It is a wise tax and investment strategy as well as an estate planning tool. In theory, an investor could continue deferring capital gains on investment property until death, potentially avoiding them all together.

1984 Legislation Changed Some Aspects

In the early days of “like-kind exchanges,” the term was taken quite literally and often posed difficulties. For instance, if you owned a three-story brick apartment building that you wanted to sell through a 1031 exchange, you would have to find another three-story brick apartment building whose owner wanted to swap. Then the two of you would meet, and the exchange would take place.

3 Saving Habits to Steal and 3 to Skip

In the past, there were no time constraints on the exchange. The IRS demanded stricter controls on the process, which resulted in Congress passing in 1984 Section 1031(a). This legislation limited deferred exchanges, further defined “like-kind” property and established a timetable for completing the exchange.

Qualifying

Real estate property held for business use or investment qualifies for a 1031 Exchange. A personal residence does not qualify and, generally, a fix-and-flip property also doesn’t qualify because it fits into the category of property being held for sale. Vacation or second homes, which are not held as rentals do not qualify for 1031 treatment; however, there is a usage test under Paragraph 280 of the tax code that may apply to those properties. A tax expert should be consulted in this case.

Land, which is under development, and property purchased for resale do not qualify for tax-deferred treatment. Stocks, bonds, notes, inventory property, and a beneficial interest in a partnership are not considered “like-kind” property for exchange purposes.

To qualify as a 1031 exchange today, the transaction must take the form of an “exchange” rather than just a sale of one property with the subsequent purchase of another. First, the property being sold and the new replacement property must both be held for investment purposes or for productive use in a trade or a business. They must be “like-kind” properties.

The following types of real estate swaps fit the requirement for a qualified exchange of “like-kind” property:

•    An office in exchange for a shopping center
•    A shopping center in exchange for land
•    Land in exchange for an industrial building
•    An apartment building in exchange for an industrial building
•    A single family rental in exchange for a tenants in common (TIC) property

Today, you could exchange that brick apartment building for raw land, a warehouse, or a small office building. However, there are strict time constraints which must be met, or the 1031 Exchange will not be allowed, and tax consequences will be imposed.

Prior to 1984, virtually all exchanges were done simultaneously with the closing and transfer of the sold property (Relinquished Property), and the purchase of the new real estate (Replacement Property). In addition to the problems encountered when trying to finding a suitable property, there were difficulties with the simultaneous transfer of titles as well as funds. Not so today.

The delayed 1031 Exchange avoids those pre-1984 problems, but stricter deadlines are now imposed. A taxpayer who wants to complete an exchange, lists and markets property in the usual manner. When a buyer steps forward, and the purchase contract is executed, the seller enters into an exchange agreement with a qualified intermediary who, in turn, become the substitute seller. The exchange agreement usually calls for an assignment of the seller’s contract to the Intermediary. The closing takes place and, because the seller cannot touch the money, the Intermediary receives the proceeds due to the seller.

Exchanges Carry Time Restrictions

At that point, the first timing restriction, the 45-day rule for Identification, begins. The taxpayer must either close on or identify in writing a potential Replacement Property within 45 days from the closing and transfer of the original property. The time period is not negotiable, includes weekends and holidays, and the IRS will not make exceptions. If you exceed the time limit, your entire exchange can be disqualified, and taxes are sure to follow.

Types of Replacement Properties to Identify:

1.    Three properties without regard to their fair market value.
2.    Any number of properties as long as their aggregate fair market value at the end of the identification period does not exceed 200 percent of the aggregate fair market value of the relinquished property as of the transfer date.
3.    If the three-property rule and the 200 percent rule is exceeded, the exchange will not fail if the taxpayer purchases 95 percent of the aggregate fair market value of all identified properties.

What Is Boot?

Realistically, most investors follow the three-property rule so they can complete due diligence and select the one that works best for them that will close. Generally, the goal is to trade up to avoid the transfer of “boot” and keep the exchange tax-free.

“Boot” is the money or fair market value of any additional property received by the taxpayer through the exchange. Money includes all cash equivalents, debts, liabilities to which the exchanged property is subject. It is “non-like-kind” property, and the rules governing it during the exchange are complex. Suffice it to say, without expert advice, receiving “boot” can result in taxes.

Subject to the 180-Day Rule

Once a replacement property is selected, the taxpayer has 180 days from the date the Relinquished Property was transferred to the buyer to close on the new Replacement Property. However, if the due date on the investor’s tax return, with any extensions, for the tax year in which the Relinquished Property was sold is earlier than the 180-day period, then the exchange must be completed by that earlier date. Remember, a portion of this period has already been used during the Identification Period. There are no extensions and no exceptions to this rule, so it is advisable to schedule the closing prior to the deadline.

Since the law requires that the taxpayer not touch the proceeds from the first transaction, the Qualified Intermediary acquires the Replacement Property from the seller at closing and after the transaction is completed, then transfers it to the taxpayer.

Are Not for Do-It-Yourself Investors

It is a basic description of how a successful 1031 Exchange works. Depending upon the taxpayer’s situation, the type of property relinquished, and the characteristics of the Replacement Property, other aspects of the Exchange may be involved. Its completion may become complex, and experts should always be consulted. This is no task for a “do it yourself” investor.

Using the power of the 1031 Exchange to build and preserve wealth and assets, generate cash flow from investments, restructure, diversify and consolidate real estate holdings is the right of every owner of investment property in the United States. American taxpayers should never have to pay capital gains taxes on the sale of their investment property if they intend to reinvest those proceeds in more investment property.

Today’s author – Elizabeth Weintraub

Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.  

–until next week.