Insight Archives

When do valuable gifts to charity require an appraisal?

Tax Prep, Planning & Strategy|June 27, 2024

If you donate valuable items to charity and you want to deduct them on your tax return, you may be required to get an appraisal. The IRS requires donors and charitable organizations to supply certain information to prove their right to deduct charitable contributions.

How can you protect your deduction?

First, be aware that in order to deduct charitable donations, you must itemize deductions. Due to today’s relatively high standard deduction amounts, fewer taxpayers are itemizing deductions on their federal returns than before the Tax Cuts and Jobs Act became effective in 2018.

If you clear the itemizing hurdle and donate an item of property (or a group of similar items) worth more than $5,000, certain appraisal requirements apply. You must:

Get a “qualified appraisal,”
Receive the qualified appraisal before your tax return is due,
Attach an “appraisal summary” to the first tax return on which the deduction is claimed,
Include other information with the return, and
Maintain certain records.

Keep these definitions in mind. A “qualified appraisal” is a complex and detailed document. It must be prepared and signed by a qualified appraiser. An “appraisal summary” is a summary of a qualified appraisal made on Form 8283 and attached to the donor’s return.

While courts have allowed taxpayers some latitude in following these rules, you should aim for exact compliance.

The qualified appraisal isn’t submitted to the IRS in most cases. Instead, the appraisal summary, which is a separate statement prepared on an IRS form, is attached to the donor’s tax return. However, a copy of the appraisal must be attached for gifts of art valued at $20,000 or more and for all gifts of property valued at more than $500,000, other than inventory, publicly traded stock and intellectual property. If an item of art has been appraised at $50,000 or more, you can ask the IRS to issue a “Statement of Value” that can be used to substantiate the value.

What if you don’t comply with the requirements?

The penalty for failing to get a qualified appraisal and attach an appraisal summary to the return is denial of the charitable deduction. The deduction may be lost even if the property was valued correctly. There may be relief if the failure was due to reasonable cause.

Are there exceptions to the requirements?

A qualified appraisal isn’t required for contributions of:

A car, boat or airplane for which the deduction is limited to the charity’s gross sales proceeds,
Stock in trade, inventory or property held primarily for sale to customers in the ordinary course of business,
Publicly traded securities for which market quotations are “readily available,” and
Qualified intellectual property, such as a patent.

Also, only a partially completed appraisal summary must be attached to the tax return for contributions of:

Nonpublicly traded stock for which the claimed deduction is greater than $5,000 and doesn’t exceed $10,000, and
Publicly traded securities for which market quotations aren’t “readily available.”

What if you have more than one gift?

If you make gifts of two or more items during a tax year, even to multiple charitable organizations, the claimed values of all property of the same category or type (such as stamps, paintings, books, stock that isn’t publicly traded, land, jewelry, furniture or toys) are added together in determining whether the $5,000 or $10,000 limits are exceeded.

The bottom line is you must be careful to comply with the appraisal requirements or risk disallowance of your charitable deduction. Contact us if you have any further questions or want to discuss your charitable giving plans.

Should you convert your business from a C to an S corporation?

Management Advisory Services & Business Consulting|June 25, 2024

Choosing the right business entity has many implications, including the amount of your tax bill. The most common business structures are sole proprietorships, partnerships, limited liability companies, C corporations and S corporations.

In some cases, a business may decide to switch from one entity type to another. Although S corporations can provide substantial tax benefits over C corporations in some circumstances, there are potentially costly tax issues that you should assess before making the decision to convert from a C corporation to an S corporation.

Here are four considerations:

1. LIFO inventories. C corporations that use last-in, first-out (LIFO) inventories must pay tax on the benefits they derived by using LIFO if they convert to S corporations. The tax can be spread over four years. This cost must be weighed against the potential tax gains from converting to S status.

2. Built-in gains tax. Although S corporations generally aren’t subject to tax, those that were formerly C corporations are taxed on built-in gains (such as appreciated property) that the C corporation has when the S election becomes effective, if those gains are recognized within five years after the conversion. This is generally unfavorable, although there are situations where the S election still can produce a better tax result despite the built-in gains tax.

3. Passive income. S corporations that were formerly C corporations are subject to a special tax. It kicks in if their passive investment income (including dividends, interest, rents, royalties, and stock sale gains) exceeds 25% of their gross receipts, and the S corporation has accumulated earnings and profits carried over from its C corporation years. If that tax is owed for three consecutive years, the corporation’s election to be an S corporation terminates. You can avoid the tax by distributing the accumulated earnings and profits, which would be taxable to shareholders. Or you might want to avoid the tax by limiting the amount of passive income.

4. Unused losses. If your C corporation has unused net operating losses, they can’t be used to offset its income as an S corporation and can’t be passed through to shareholders. If the losses can’t be carried back to an earlier C corporation year, it will be necessary to weigh the cost of giving up the losses against the tax savings expected to be generated by the switch to S status.

Other issues to explore

These are only some of the factors to consider when switching a business from C to S status. For example, shareholder-employees of S corporations can’t get all the tax-free fringe benefits that are available as a C corporation. And there may be issues for shareholders who have outstanding loans from their qualified plans. These factors must be taken into account in order to understand the implications of converting from C to S status.

If you’re interested in an entity conversion, contact us. We can explain what your options are, how they’ll affect your tax bill and some possible strategies you can use to minimize taxes.

Nonprofits: Act thoroughly on audit findings

Non-Profits|June 20, 2024

External audits can help assure your not-for-profit’s stakeholders that your financial statements are fairly presented according to U.S. Generally Accepted Accounting Principles. They can also help prevent occupational fraud. Often, audit reports contain recommendations for organizations to act on. And if you fail to make changes that respond to risks or concerns discovered in an audit, it could threaten your nonprofit’s future.

Discuss the report

When auditors complete an engagement, they typically present a draft report to their subject’s audit committee, executive director and senior financial staff. Those individuals need to review the draft before it’s presented to their full board of directors.

Your audit committee and management should meet with auditors before their board presentation. Often auditors provide a management letter highlighting operational areas and controls that need improvement. Your team should explain how your organization plans to improve operations and controls, and this explanation can be included in the report’s final management letter.

Your audit committee also can use the meeting to ensure the audit is properly comprehensive. Auditors will provide a governance letter, which should confirm cooperation from your nonprofit’s staff and whether the auditors received all requested documentation. The letter also will disclose any difficulties or limitations encountered during the process, accounting adjustments required, and significant audit plan changes (and the reasons for such changes).

Finally, the auditors will list any unresolved matters. Your audit committee should determine whether there were any conflicts of interest between the auditors and your team and how they might have affected the audit’s scope.

Taking next steps

The final audit report will state whether your organization’s financial statements are fairly presented in accordance with U.S. Generally Accepted Accounting Principles. The statements must be presented without any material — meaning significant — inaccuracies or misrepresentation.

As noted above, the auditors also may identify, in a separate management letter, specific concerns about material internal control issues. Adequate internal controls are critical for preventing, catching and remedying misstatements that could compromise the integrity of financial statements, whether due to error or fraud.

If the auditors find your internal controls weak, your organization must promptly shore them up. You could, for instance, set up new controls, such as segregating financial duties or implementing new accounting practices or software. These measures can reduce the odds of fraud, improve the accuracy of your financial statements and help reduce future audit costs.

Make your audit effective

Audit reports are only as effective as their reception — and the action subject organizations take in response to their findings. Contact us for help implementing new internal controls and addressing other issues.

Pay attention to the tax rules if you turn a hobby into a business

Tax Prep, Planning & Strategy|June 18, 2024

Many people dream of turning a hobby into a regular business. Perhaps you enjoy boating and would like to open a charter fishing business. Or maybe you’d like to turn your sewing or photography skills into an income-producing business.

You probably won’t have any tax headaches if your new business is profitable over a certain period of time. But what if the new enterprise consistently generates losses (your deductions exceed income) and you claim them on your tax return? You can generally deduct losses for expenses incurred in a bona fide business. However, the IRS may step in and say the venture is a hobby — an activity not engaged in for profit — rather than a business. Then you’ll be unable to deduct losses.

By contrast, if the new enterprise isn’t affected by the hobby loss rules, all otherwise allowable expenses are deductible, generally on Schedule C, even if they exceed income from the enterprise.

Important: Before 2018, deductible hobby expenses could be claimed as miscellaneous itemized deductions subject to a 2%-of-AGI “floor.” However, because miscellaneous deductions aren’t allowed from 2018 through 2025, deductible hobby expenses are effectively wiped out from 2018 through 2025.

How to NOT be deemed a hobby

There are two ways to avoid the hobby loss rules:

Show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing or racing horses).
Run the venture in such a way as to show that you intend to turn it into a profit maker rather than a mere hobby. The IRS regs themselves say that the hobby loss rules won’t apply if the facts and circumstances show that you have a profit-making objective.

How can you prove you have a profit-making objective? You should operate the venture in a businesslike manner. The IRS and the courts will look at the following factors:

How you run the activity,
Your expertise in the area (and your advisors’ expertise),
The time and effort you expend in the enterprise,
Whether there’s an expectation that the assets used in the activity will rise in value,
Your success in carrying on other activities,
Your history of income or loss in the activity,
The amount of any occasional profits earned,
Your financial status, and
Whether the activity involves elements of personal pleasure or recreation.

Case illustrates the issues

In one court case, partners operated a farm that bought, sold, bred and raced Standardbred horses. It didn’t qualify as an activity engaged in for profit, according to a U.S. Appeals Court. The court noted that the partnership had a substantial loss history and paid for personal expenses. Also, the taxpayers kept inaccurate records, had no business plan, earned significant income from other sources and derived personal pleasure from the activity. (Skolnick, CA 3, 3/8/23)

Contact us for more details on whether a venture of yours may be affected by the hobby loss rules, and what you should do to avoid tax problems.

Federal regulators expand overtime pay requirements, ban most noncompete agreements

Management Advisory Services & Business Consulting|June 13, 2024

The U.S. Department of Labor (DOL) has issued a new final rule regarding the salary threshold for determining whether employees are exempt from federal overtime pay requirements. The threshold is slated to jump 65% from its current level by 2025 and is expected to make four million additional workers eligible for overtime pay.

On the same day the overtime rule was announced, the Federal Trade Commission (FTC) approved a final rule prohibiting most noncompete agreements with employees, with similarly far-reaching implications for many employers. Both regulations could be changed by court challenges, but here’s what you need to know for now.

The overtime rule

Under the Fair Labor Standards Act (FLSA), so-called nonexempt workers are entitled to overtime pay at a rate of 1.5 times their regular pay rate for hours worked per week that exceed 40. Employees are exempt from the overtime requirements if they satisfy three tests:

Salary basis test. The employee is paid a predetermined and fixed salary that isn’t subject to reduction due to variations in the quality or quantity of his or her work.
Salary level test. The salary isn’t less than a specific amount, or threshold (currently, $684 per week or $35,568 per year).
Duties test. The employee primarily performs executive, administrative or professional duties.

The new rule focuses on the salary level test and will increase the threshold in two steps. Starting on July 1, 2024, most salaried workers who earn less than $844 per week will be eligible for overtime. On January 1, 2025, the threshold will climb further, to $1,128 per week.

The rule also will increase the total compensation requirement for highly compensated employees (HCEs). HCEs are subject to a more relaxed duties test than employees earning less. They need only “customarily and regularly” perform at least one of the duties of an exempt executive, administrative or professional employee, as opposed to primarily performing such duties.

This looser test currently applies to HCEs who perform office or nonmanual work and earn total compensation (including bonuses, commissions and certain benefits) of at least $107,432 per year. The compensation threshold will move up to $132,964 per year on July 1, and to $151,164 on January 1, 2025.

The final rule also includes a mechanism to update the salary thresholds every three years. Updates will reflect current earnings data from the most recent available four quarters from the U.S. Bureau of Labor Statistics. The rule also permits the DOL to temporarily delay a scheduled update when warranted by unforeseen economic or other conditions. Updated thresholds will be published at least 150 days before they take effect.

Plan your approach

With the first effective date right around the corner, employers should review their employees’ salaries to identify those affected — that is, those whose salaries meet or exceed the current level but fall below the new thresholds. For employees who are on the bubble under the new thresholds, employers might want to increase their salaries to retain their exempt status. Alternatively, employers may want to reduce or eliminate overtime hours or simply pay the proper amount of overtime to these employees. Or they can reduce an employee’s salary to offset new overtime pay.

Remember, too, that exempt employees also must satisfy the applicable duties test (which varies depending on whether the exemption is for an executive, professional or administrative role). An employee whose salary exceeds the threshold but doesn’t primarily engage in the applicable duties isn’t exempt.

Obviously, depending on the selected approach, budgets may require adjustments. If some employees will be reclassified as nonexempt, employers may need to provide training to employees and supervisors on new timekeeping requirements and place restrictions on off-the-clock work.

Be aware that business groups have promised to file lawsuits to block the new rule, as they succeeded in doing with a similar rule promulgated in 2016. Also, the U.S. Supreme Court has taken a skeptical eye to administrative rulemaking in recent years. So it makes sense to proceed with caution. Bear in mind, too, that some employers also are subject to state and local wage and hour laws with more stringent standards for exempt status.

The noncompete ban

The new rule from the FTC bans most noncompete agreements nationwide (which will conflict with some state laws). In addition, existing noncompetes for most workers will no longer be enforceable after the rule becomes effective, 120 days after it’s published in the Federal Register. The rule is projected to affect 30 million workers. However, it doesn’t apply to certain noncompete agreements and those entered into as part of the sale of a business.

The rule includes an exception for existing noncompetes with “senior executives,” defined as workers earning more than $151,164 annually who are in policy-making positions. Policy-making positions include:

A business’s president,
A chief executive officer or equivalent,
Any other officer who has policy making authority, and
Any other natural person who has policy making authority similar to an officer with such authority.

Note that employers can’t enter new noncompetes with senior executives.

Unlike the proposed rule issued for public comment in January 2023, the final rule doesn’t require employers to legally modify existing noncompetes by formally rescinding them. Instead, they must only provide notice to workers bound by existing agreements — other than senior executives — that they won’t enforce such agreements against the workers. The rule includes model language that employers can use to provide notice.

A lawsuit was filed in a Texas federal court shortly after the FTC voted on the final rule, arguing the FTC doesn’t have the statutory authority to issue the rule. The U.S. Chamber of Commerce also subsequently filed a court challenge to block the noncompete ban.

More to come

Whether either of these rules will eventually become effective as written remains to be seen. Judicial intervention or a potential swing in federal political power could mean they land in the dustbin of history before taking effect — or shortly thereafter. We’ll keep you up to date on the latest news regarding these two rules.

Don’t have a tax-favored retirement plan? Set one up now

Tax Prep, Planning & Strategy|June 11, 2024

If your business doesn’t already have a retirement plan, it might be a good time to take the plunge. Current retirement plan rules allow for significant tax-deductible contributions.

For example, if you’re self-employed and set up a SEP-IRA, you can contribute up to 20% of your self-employment earnings, with a maximum contribution of $69,000 for 2024 (up from $66,000 for 2023). If you’re employed by your own corporation, up to 25% of your salary can be contributed to your account, with a maximum contribution of $69,000. If you’re in the 32% federal income tax bracket, making a maximum contribution could cut what you owe Uncle Sam for 2024 by a whopping $22,080 (32% × $69,000).

Other possibilities

There are more small business retirement plan options, including:

401(k) plans, which can even be set up for just one person (also called solo 401(k)s),
Defined benefit pension plans, and
SIMPLE-IRAs.

Depending on your situation, these plans may allow bigger or smaller deductible contributions than a SEP-IRA. For example, for 2024, a participant can contribute $23,000 to a 401(k) plan, plus a $7,500 “catch-up” contribution for those age 50 or older.

Watch the calendar

Thanks to a change made by the 2019 SECURE Act, tax-favored qualified employee retirement plans, except for SIMPLE-IRA plans, can now be adopted by the due date (including any extension) of the employer’s federal income tax return for the adoption year. The plan can then receive deductible employer contributions that are made by the due date (including any extension), and the employer can deduct those contributions on the return for the adoption year.

Important: This provision didn’t change the deadline to establish a SIMPLE-IRA plan. It remains October 1 of the year for which the plan is to take effect. Also, the SECURE Act change doesn’t override rules that require certain plan provisions to be in effect during the plan year, such as the provisions that cover employee elective deferral contributions (salary-reduction contributions) under a 401(k) plan. The plan must be in existence before such employee elective deferral contributions can be made.

For example, the deadline for the 2023 tax year for setting up a SEP-IRA for a sole proprietorship business that uses the calendar year for tax purposes is October 15, 2024, if you extend your 2023 tax return. The deadline for making a contribution for the 2023 tax year is also October 15, 2024. For the 2024 tax year, the deadline for setting up a SEP and making a contribution is October 15, 2025, if you extend your 2024 tax return. However, to make a SIMPLE-IRA contribution for the 2023 tax year, you must have set up the plan by October 1, 2023. So, it’s too late to set up a plan for last year.

While you can delay until next year establishing a tax-favored retirement plan for this year (except for a SIMPLE-IRA plan), why wait? Get it done this year as part of your tax planning and start saving for retirement. We can provide more information on small business retirement plan options. Be aware that, if your business has employees, you may have to make contributions for them, too.

When partners pay expenses related to the business

Management Advisory Services & Business Consulting|June 6, 2024

It’s not unusual for a partner to incur expenses related to the partnership’s business. This is especially likely to occur in service partnerships such as an architecture or law firm. For example, partners in service partnerships may incur entertainment expenses in developing new client relationships. They may also incur expenses for: transportation to get to and from client meetings, professional publications, continuing education and home office. What’s the tax treatment of such expenses? Here are the answers.

Reimbursable or not

As long as the expenses are the type a partner is expected to pay without reimbursement under the partnership agreement or firm policy (written or unwritten), the partner can deduct the expenses on Schedule E of Form 1040. Conversely, a partner can’t deduct expenses if the partnership would have honored a request for reimbursement.

A partner’s unreimbursed partnership business expenses should also generally be included as deductions in arriving at the partner’s net income from self-employment on Schedule SE.

For example, let’s say you’re a partner in a local architecture firm. Under the firm’s partnership agreement, partners are expected to bear the costs of soliciting potential new business except in unusual cases where attracting a large potential new client is deemed to be a firm-wide goal. In attempting to attract new clients this year, you spend $4,500 of your own money on meal expenses. You receive no reimbursement from the firm. On your Schedule E, you should report a deductible item of $2,250 (50% of $4,500). You should also include the $2,250 as a deduction in calculating your net self-employment income on Schedule SE.

So far, so good, but here’s the issue: a partner can’t deduct expenses if they could have been reimbursed by the firm. In other words, no deduction is allowed for “voluntary” out-of-pocket expenses. The best way to eliminate any doubt about the proper tax treatment of unreimbursed partnership expenses is to install a written firm policy that clearly states what will and won’t be reimbursed. That way, the partners can deduct their unreimbursed firm-related business expenses without any problems from the IRS.

Office in a partner’s home

Subject to the normal deduction limits under the home office rules, a partner can deduct expenses allocable to the regular and exclusive use of a home office for partnership business. The partner’s deductible home office expenses should be reported on Schedule E in the same fashion as other unreimbursed partnership expenses.

If a partner has a deductible home office, the Schedule E home office deduction can deliver multiple tax-saving benefits because it’s effectively deducted for both federal income tax and self-employment tax purposes.

In addition, if the partner’s deductible home office qualifies as a principal place of business, commuting mileage from the home office to partnership business temporary work locations (such as client sites) and partnership permanent work locations (such as the partnership’s official office) count as business mileage.

The principal place of business test can be passed in two ways. First, the partner can conduct most of partnership income-earning activities in the home office. Second, the partner can pass the principal place of business test if he or she:

Uses the home office to conduct partnership administrative and management tasks and
Doesn’t make substantial use of any other fixed location (such as the partnership’s official office) for such administrative and management tasks.

To sum up

When a partner can be reimbursed for business expenses under a partnership agreement or standard operating procedures, the partner should turn them in. Otherwise, the partner can’t deduct the expenses. On the partnership side of the deal, the business should set forth a written firm policy that clearly states what will and won’t be reimbursed, including home office expenses if applicable. This applies equally to members of LLCs that are treated as partnerships for federal tax purposes because those members count as partners under tax law.

Disaster relief charities: Know the rules before providing aid

Non-Profits|June 4, 2024

The United States is entering the most natural-disaster-prone time of the year. Tornadoes are most likely to occur in May, and the Atlantic hurricane season starts on June 1. Not-for-profits that provide aid to disaster victims — whether it’s medical care, food, clothing, shelter, cash or rebuilding assistance — are gearing up for potential emergencies. But if your organization operates in this space, know that when dispensing aid you must observe certain IRS rules.

Defining charitable activities

Disaster relief organizations are allowed to provide short-term emergency assistance and long-term aid to help ensure victims have necessities. Relief may also come in the form of cash grants or vouchers. Providing such relief to individuals qualifies as a charitable activity because it aims to relieve human suffering.

However, your nonprofit must assist a “charitable class.” A charitable class should be either large enough that the potential beneficiaries can’t be individually identified or sufficiently indefinite that the community as a whole, rather than a pre-selected group of people, benefits. In addition, you must apply needs-based tests, meaning you can’t distribute aid to individuals just because they’re disaster victims. Decisions about how funds will be distributed must be based on an objective evaluation of needs at the time grants are made.

But practicality and sympathy for victims’ immediate plight can be considered. For example, take a charity that distributes blankets and hot meals to natural disaster victims. In the immediate aftermath of a storm, the charity doesn’t ask victims for proof of financial need. However, as time goes on and victims and their community begin to recover, it may be appropriate to conduct individual financial needs assessments.

Aiding businesses

In addition to helping individuals, your charity generally can provide disaster aid to businesses, so long as two conditions are met:

1. Assistance must be reasonably related to the accomplishment of a tax-exempt purpose. Businesses aren’t members of a charitable class and can’t, therefore, be appropriate charitable objects. However, distributing aid to them can achieve charitable purposes, such as preventing community deterioration or reducing the burden on local government.

2. Any private benefit to businesses must be incidental. An eligible business might not have adequate resources, conventional financing or insurance coverage that would enable it to recover from a disaster. Disaster aid organizations also need to determine that businesses they assist wouldn’t be able to remain in the community without their intervention.

Maintaining records

To prove your organization’s compliance with IRS rules, maintain good records. Document amounts paid, the purpose of payments and evidence that payments were made to meet charitable purposes and victims’ needs. In addition, document:

Your organization’s objective criteria for disbursing assistance,
How specific recipients were selected,
Names and addresses of recipients and the amounts supplied to them,
Any relationship between recipients and your charity’s officers, directors, key employees or substantial donors, and
The composition of the selection committee approving assistance.

Note an exception: Organizations distributing short-term emergency assistance aren’t expected to record the names, addresses and amounts provided. Instead, document the date, place and estimated number of victims assisted.

Other rules may apply

There are other IRS rules that might apply to your nonprofit’s situation. Contact us if you have questions about complying with rules for tax-exempt organizations.

The pros and cons of turning your home into a rental

Tax Prep, Planning & Strategy|May 30, 2024

If you’re buying a new home, you may have thought about keeping your current home and renting it out. In March, average rents for one- and two-bedroom residences were $1,487 and $1,847, respectively, according to the latest Zumper National Rent Report.

In some parts of the country, rents are much higher or lower than the averages. The most expensive locations to rent a one-bedroom place were New York City ($4,200); Jersey City, New Jersey ($3,260); San Francisco ($2,900); Boston ($2,850) and Miami ($2,710). The least expensive one-bedroom locations were Wichita, Kansas ($690); Akron, Ohio ($760); Shreveport, Louisiana ($770); Lincoln, Nebraska ($840) and Oklahoma City ($860).

Becoming a landlord and renting out a residence comes with financial risks and rewards. However, you also should know that it carries potential tax benefits and pitfalls.

You’re generally treated as a real estate landlord once you begin renting your home. That means you must report rental income on your tax return, but also are entitled to offsetting landlord deductions for the money you spend on utilities, operating expenses, incidental repairs and maintenance (for example, fixing a leaky roof). Additionally, you can claim depreciation deductions for the home. And you can fully offset rental income with otherwise allowable landlord deductions.

Passive activity rules

However, under the passive activity loss (PAL) rules, you may not be able to currently claim the rent-related deductions that exceed your rental income unless an exception applies. Under the most widely applicable exception, the PAL rules won’t affect your converted property for a tax year in which your adjusted gross income doesn’t exceed $100,000, you actively participate in running the home-rental business, and your losses from all rental real estate activities in which you actively participate don’t exceed $25,000.

You should also be aware that potential tax pitfalls may arise from renting your residence. Unless your rentals are strictly temporary and are made necessary by adverse market conditions, you could forfeit an important tax break for home sellers if you finally sell the home at a profit. In general, you can escape tax on up to $250,000 ($500,000 for married couples filing jointly) of gain on the sale of your principal home. However, this tax-free treatment is conditioned on your having used the residence as your principal residence for at least two of the five years preceding the sale. So renting your home out for an extended time could jeopardize a big tax break.

Even if you don’t rent out your home long enough to jeopardize the principal residence exclusion, the tax break you would get on the sale (the $250,000/$500,000 exclusion) won’t apply to:

The extent of any depreciation allowable with respect to the rental or business use of the home for periods after May 6, 1997, or
Any gain allocable to a period of nonqualified use (any period during which the property isn’t used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse) after December 31, 2008.

A maximum tax rate of 25% will apply to this gain (attributable to depreciation deductions).

Selling at a loss

What if you bought at the height of a market and ultimately sell at a loss? In such situations, the loss is available for tax purposes only if you can establish that the home was in fact converted permanently into income-producing property. Here, a longer lease period helps. However, if you’re in this situation, be aware that you may not wind up with much of a loss for tax purposes. That’s because basis (the cost for tax purposes) is equal to the lesser of actual cost or the property’s fair market value when it’s converted to rental property. So if a home was purchased for $300,000, converted to a rental when it’s worth $250,000, and ultimately sold for $225,000, the loss would be only $25,000.

The question of whether to turn a home into rental property is complicated. We can help you make a decision.

Watch out for “income in respect of a decedent” issues when receiving an inheritance

Estate & Wealth Transfer Planning|May 28, 2024

Most people are genuinely appreciative of inheritances, and who wouldn’t enjoy some unexpected money? But in some cases, it may turn out to be too good to be true. While most inherited property is tax-free to the recipient, this isn’t always the case with property that’s considered income in respect of a decedent (IRD). If you have large balances in an IRA or other retirement account — or inherit such assets — IRD may be a significant estate planning issue.

How it works

IRD is income that the deceased was entitled to, but hadn’t yet received, at the time of his or her death. It’s included in the deceased’s estate for estate tax purposes, but not reported on his or her final income tax return, which includes only income received before death.

To ensure that this income doesn’t escape taxation, the tax code provides for it to be taxed when it’s distributed to the deceased’s beneficiaries. Also, IRD retains the character it would have had in the deceased’s hands. For example, if the income would have been a long-term capital gain to the deceased, such as uncollected payments on an installment note, it’s taxed as such to the beneficiary.

IRD can come from various sources, including unpaid salary, fees, commissions or bonuses, and distributions from traditional IRAs and employer-provided retirement plans. In addition, IRD results from deferred compensation benefits and accrued but unpaid interest, dividends and rent.

The lethal combination of estate and income taxes (and, in some cases, generation-skipping transfer tax) can quickly shrink an inheritance down to a fraction of its original value.

What recipients can do

Although IRD must be included in the income of the recipient, a deduction may come along with it. The deduction is allowed (as an itemized deduction) to lessen the “double tax” impact that’s caused by having the IRD items subject to the decedent’s estate tax as well as the recipient’s income tax.

To calculate the IRD deduction, the decedent’s executor may have to be contacted for information. The deduction is determined as follows:

First, you must take the “net value” of all IRD items included in the decedent’s estate. The net value is the total value of the IRD items in the estate, reduced by any deductions in respect of the decedent. These are items which are the converse of IRD: items the decedent would have deducted on the final income tax return, but for death’s intervening.
Next you determine how much of the federal estate tax was due to this net IRD by calculating what the estate tax bill would have been without it. Your deduction is then the percentage of the tax that your portion of the IRD items represents.

Calculating the deduction can be complex, especially when there are multiple IRD assets and beneficiaries.

Be prepared

As you can see, IRD assets can result in an unpleasant tax surprise. Because these assets are treated differently from other assets for estate planning purposes, contact us. Together we can identify IRD assets and determine their tax implications.

When do valuable gifts to charity require an appraisal?

Should you convert your business from a C to an S corporation?

Nonprofits: Act thoroughly on audit findings

Pay attention to the tax rules if you turn a hobby into a business

Federal regulators expand overtime pay requirements, ban most noncompete agreements

Don’t have a tax-favored retirement plan? Set one up now

When partners pay expenses related to the business

Disaster relief charities: Know the rules before providing aid

The pros and cons of turning your home into a rental

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