Frequently Asked Questions
We try to anticipate questions you might have about taxes and CFO/Controller Services and provide the answers here. If you need additional information send email to firstname.lastname@example.org
Am I Having Enough Withheld?
If you fail to estimate your federal income tax withholding properly, it may cost you in a variety of ways. If you receive an income tax refund, it essentially means that you provided the IRS with an interest-free loan during the year. By comparison, if you owe taxes when you file your return, you may have to scramble for cash at tax time--and possibly owe interest and penalties to the IRS as well.
When determining the correct withholding amount for your salary or wages, your objective should be to have just enough taxes withheld to prevent you from incurring penalties when your tax return is due. (You may owe some money at the time you file your return, but it shouldn't be much.) You can accomplish this by reading and understanding IRS Publication 505 and 919, properly completing Form W-4 (and accompanying worksheets), and providing an updated Form W-4 to your employer when your circumstances change significantly.
When determining the correct withholding amount for your salary or wages, your objective should be to have just enough taxes withheld to prevent you from incurring penalties when your tax return is due. (You may owe some money at the time you file your return, but it shouldn't be much.) You can accomplish this by reading and understanding IRS Publication 505 and 919, properly completing Form W-4 (and accompanying worksheets), and providing an updated Form W-4 to your employer when your circumstances change significantly.
Form W-4 helps you determine the proper withholding amount
Two factors determine the amount of income tax that your employer withholds from your regular pay: the amount you earn and the information you provide on Form W-4. This form asks you for three pieces of information:
- The number of withholding allowances you want to claim: You can claim up to the maximum number you're entitled to, claim less than you're entitled to, or claim zero.
- Whether you want taxes to be withheld at the single or married rate: The married status, which is associated with a lower withholding rate, should generally be selected only by those taxpayers who are married and file a joint return. Other people (including those who are married and file separately) should generally have taxes withheld at the higher, single rate.
The additional amount (if any) you want withheld from your paycheck: This is optional; you can specify any additional amount of money you want withheld.
When both spouses work and have taxes withheld at the married rate, they sometimes end up with insufficient taxes withheld. If this happens to you, remember that you can always choose to withhold at the single rate. In addition, you can determine the proper withholding amount by completing Form W-4's two-earner/two-job worksheet.
To understand Form W-4, you must understand allowances. Think of allowances as cash in your pocket at the time that you receive your paycheck. The more allowances you claim, the less taxes are taken from your paycheck (and the more cash ends up in your pocket on payday). For example, you can maximize the amount withheld from your paycheck to ensure that you have enough tax withheld to cover your tax liability by claiming zero allowances. This will reduce the amount of cash you take home in your paycheck. The following factors determine your number of allowances:
- The number of personal and dependency exemptions that you claim on your federal income tax return
- The number of jobs that you work
- The deductions, adjustments to income, and credits that you expect to take during the year
- Your filing status
- Whether your spouse works
To claim the correct number of allowances, you should complete Form W-4's worksheets. These include a personal allowances worksheet, a deductions and adjustments worksheet, and a two-earner/two-job worksheet. IRS Publication 505 (Tax Withholding and Estimated Tax) explains these worksheets.
Check your withholding
To avoid surprises at tax time, it's a good idea to periodically check your withholding. If you accurately complete all Form W-4 worksheets and don't have significant nonwage income (e.g., interest and dividends), it's likely that your employer will withhold an amount close to the tax you'll owe on your return. But in the following cases, accurate completion of the Form W-4 worksheets alone won't guarantee that you'll have the correct amount of tax withheld:
- When you're married and both spouses work, or if either of you start or stop working
- When you or your spouse are working more than one job
- When you have significant nonwage income, such as interest, dividends, alimony, unemployment compensation, or self-employment income, or the amount of your nonwage income changes
- When you'll owe other taxes on your return, such as self-employment tax or household employment tax
- When you have a lifestyle change (e.g., marriage, divorce, birth or adoption of a child, new home, retirement) that affects the tax deductions or credits you may claim
- When there are tax law changes that affect the amount of tax you'll owe
In these cases, IRS Publication 919 (How Do I Adjust My Tax Withholding?) can help you compare the total tax that you'll withhold for the year with the tax that you expect to owe on your return. It can also help you determine any additional amount you may need to withhold from each paycheck to avoid owing taxes when you file your return. Alternatively, it may help you identify if you're having too much tax withheld. If you find that you need to make changes to your withholding, you can do so at any time simply by submitting a new Form W-4 to your employer.
Choosing an Income Tax Filing Status
Selecting a filing status is one of the first decisions you'll make when you fill out your federal income tax return, so it's important to know the rules. And because you may have more than one option, you need to know the advantages and disadvantages of each. Making the right decision about your filing status can save money and prevent problems with the IRS down the road.
The five filing statuses and how they affect your tax liability
Your filing status is especially important because it determines, in part, the tax rate applied to your taxable income, the amount of your standard deduction, and the types of deductions and credits available. By choosing the right filing status, you can minimize your taxes.
The five filing statuses are unmarried, married filing jointly, married filing separately, head of household, and qualifying widow(er) with dependent child. There are six income tax brackets. Your tax rate depends on your filing status and the amount of your taxable income. For example, if you're unmarried and your taxable income is more than $8,700 but not more than $35,350 (in 2012), it's taxed at 15 percent. If you're a head of household filer, though, your taxable income can climb to $47,350 and still be taxed at 15 percent. So, it's clear that some filing statuses are more beneficial than others.
Although you'll generally want to choose whichever filing status minimizes your taxes, other considerations (such as a pending divorce) may also come into play.
You're unmarried if you're unmarried or legally separated from your spouse on the last day of the year
This one's pretty straightforward. And, depending on your circumstances, it may be your only option. Your filing status is determined as of the last day of the tax year (December 31). To use the unmarried status, you must be unmarried or separated from your spouse by either divorce or a written separate maintenance decree on the last day of the year. Unfortunately, you jump into a higher tax bracket more quickly with the unmarried status than with some of the other filing statuses.
Married filing jointly often results in tax savings for married couples
You may file jointly if, on the last day of the tax year, you are:
Married and living together as husband and wife
Married and living apart, but not legally separated under a divorce decree or separate maintenance agreement, or
Separated under an interlocutory (i.e., not final) decree of divorce
Also, you are considered married for the entire tax year for filing status purposes if your spouse died during the tax year.
When filing jointly, you and your spouse combine your income, exemptions, deductions, and credits. Filing jointly generally offers the most tax savings for married couples. For one thing, there are many credits that you can take if you file a joint return that you can't take if you file married filing separately. These include the child and dependent care credit, the adoption expense credit, the Hope credit (renamed the American Opportunity credit for 2009 to 2012), and the Lifetime Learning credit.
Still, this filing status is not always the most advantageous. If your spouse owes certain debts (including defaulted student loans and unpaid child support), the IRS may divert any refund due on your joint tax return to the appropriate agency. To get your share of the refund, you'll have to file an injured spouse claim and probably have to jump through hoops. You can avoid the hassle by filing a separate return.
You don't have to be separated to choose married filing separately
You and your spouse can choose to file separately if you're married as of the last day of the tax year. Here, you'd report only your own income and claim only your own deductions and credits. Filing separately may be wise if you want to be responsible only for your own tax. With a joint return, by comparison, each spouse is jointly and individually liable for the full amount of the tax due. So, if your spouse skips town, you'd be left holding the tax bag unless you qualified as an innocent spouse.
Filing separately might also be the best tax move if one spouse has significant medical expenses or miscellaneous itemized deductions. Your ability to take these deductions is tied in to the level of your adjusted gross income (AGI). For example, medical expenses are deductible only if they exceed 7.5 percent of AGI. By filing separately, the AGI for each spouse is reduced. Keep in mind that if you and your spouse file separately and your spouse itemizes deductions, you'll have to do the same.
Remember, though, that you won't qualify for certain credits (such as the child and dependent care tax credit) and can't take certain deductions if you file separately. For example, you cannot deduct qualified education loan interest if you're married, unless you file a joint return.
Head of household status offers certain income tax advantages
Those who qualify for the head of household filing status get special tax treatment. Not only are the tax rates lower for head of household filers than for unmarried filers and married filing separately filers, but the standard deduction is larger as well. However, you'll have to satisfy the following requirements:
Generally, you should be unmarried at the end of the year (unless you live apart from your spouse and meet certain tests)
You must maintain a household for your child, dependent parent, or other qualifying dependent relative
The household must be your home and generally must also be the main home of a qualifying relative for more than half of the year
You must provide more than half the cost of maintaining the household
You must be a U.S. citizen or resident alien for the entire tax year
Qualifying widow(er) with dependent child offers the advantages of a joint return
You may be able to select the qualifying widow(er) with dependent child filing status if your spouse died recently. This status allows you to use joint tax rates and offers the highest possible standard deduction, the one applicable to joint tax returns. To qualify, you must satisfy all of the following conditions:
Your spouse died either last tax year or the tax year before that
You qualified to file a joint return with your spouse for the year he or she died
You have not remarried before the end of the tax year
You have a qualifying dependent child
You provide over half the cost of keeping up a home for yourself and your qualifying child
As you can see, choosing the correct filing status is not always easy. You might want to speak with a professional tax preparer or consult IRS Publication 17 for more information.
Help! I Can't Pay My Tax Bill
You're almost done with your federal income tax return, and you're already thinking of ways to spend your refund. Then, the unthinkable happens--instead of a refund, you find that you owe $3,000. Or perhaps you've just received an IRS notice in the mail claiming that you owe $9,000 for the retirement plan distribution you took two years ago. You thought it was tax free at the time. Whatever the reason, you're now in the unenviable position of owing money to the IRS--and you don't have the cash. What do you do now?
First, don't panic. You have several options. That said, however, don't put your head in the sand. The IRS won't go away, and the amount you owe will only grow larger if you procrastinate. If you ignore your tax bill entirely, not only will interest and penalties accrue, but the IRS may go after your assets and wages as well. You can avoid all of that unpleasantness by finding a way to pay your taxes. Here are some possibilities.
Pay what you can afford when you file the return, then wait for a bill
Perhaps you're between paychecks right now, or maybe you just paid a substantial car repair bill. For one reason or another, you're suffering from a short-term cash flow problem. You'll eventually have the cash to pay your tax bill--you just don't have it right now. If that's your situation, you may want to consider the following approach. First, pay as much as you can when you file your tax return. This will help reduce the penalties and interest that you'll be charged.
Next, wait for the IRS to send you a bill for the remaining balance. This should take roughly 45 days. Perhaps by then you'll have enough cash to pay the bill in full. If not, call the number or write to the address on the bill you've received, or visit the nearest IRS office to explain your situation. Based on the circumstances, you could qualify for an agreement to full pay within 60 or 120 days. The IRS is willing to offer these short-term agreements to full pay in order to assist in tax debt repayment. You can request an agreement length depending on the specific situation.
One problem with this approach, however, is that interest and penalties continue to accrue on the unpaid balance. So, while you may buy yourself some time, the total amount that you'll end up paying may be much higher than it would have been if you had paid your tax bill in full when due.
There's another thing to keep in mind--filing an extension will do you no good. An extension simply extends the time to file your tax return; it doesn't extend the time to pay your tax. Whatever you do, file your return on time. A timely filed return can reduce your subsequent penalties.
Borrow money from a relative or take out a loan to pay your bill
One of the easiest ways to pay your tax bill may be to borrow the money from a relative or close friend. Borrow whatever you must to pay the bill in full, and draw up a payment plan to reimburse your benefactor. By paying the bill in full, you'll be able to avoid IRS penalties and interest. And you may not have to pay interest to your relative or friend. However, be careful if you borrow more than $10,000; the below-market interest rules may trigger certain tax consequences.
If you can't borrow from a relative or friend, consider taking out an unsecured bank loan or tapping into a home equity line of credit. Although the interest rates may be higher than interest that a relative or friend may charge, the interest will probably be less than the interest and penalties owed on the unpaid tax.
Pay by credit card
Another option is to pay your taxes by credit card. Obviously, you'll want to use the card with the lowest interest rate. If you're approaching your credit limit on a given card, you can split payments between two different credit cards. Contact the IRS to find out which credit cards are accepted.
Paying by credit card allows you to pay your tax bill on time. You'll avoid both penalties and interest for late payment of taxes. However, the interest rate that your credit card company charges may be higher than what the IRS charges on installment payments or late payments.
You can make credit card payments through certain tax software programs or by calling (888) 272-9829 or (888) 729-1040. You can expect to be charged a fee by the company that the IRS has hired to process credit card payments by phone. The fee varies with the amount of taxes that are charged. This fee is in addition to any interest that your credit card company charges.
Pay by installments
An installment agreement is a monthly payment plan with the IRS. It's the most widely used method for paying an IRS tax debt. The IRS is required to accept the payment of your tax liability in installments if your total tax liability (not counting interest, penalties, and other additions) is $10,000 or less, and if you meet a few other requirements.
To enter into an installment agreement, contact the IRS by telephone, mail, or online, and inform it that you're unable to pay your tax bill in full. The IRS will send you Form 9465, Installment Agreement Request, to fill out, and the fee is $105 ($52 for direct debit installment agreements); you may qualify to pay a reduced fee of $43 if your income is below a certain level. Your tax liability may be spread out over three years, and payments can be automatically withdrawn from your bank account or made through payroll deduction. You'll generally be expected to pay the maximum installment amount that you can afford. Although you won't avoid interest and penalties with this payment method, you'll avoid more severe collection action.
Propose an offer in compromise
If you meet certain criteria, such as doubt as to liability or doubt as to collectibility, you may want to propose an offer in compromise to the IRS on Form 656. This is a negotiated settlement between you and the IRS. Here, the IRS may agree to accept a lesser figure from you in full satisfaction of your tax debt. If you owe $20,000 in taxes, you might, for example, be able to settle for $5,000. However, there's no guarantee that the IRS will accept your offer. There's also generally a lot of paperwork to submit, including various IRS forms, financial statements, pay stubs, and bank records. And, there's generally an up-front application fee of $150.
If you feel overwhelmed by the amount of your tax bill, though, and if you meet the criteria, an offer in compromise may be a good solution. It's important to note, however, that the IRS won't accept an offer if the IRS believes that the liability can be paid in full or through an installment agreement.
Bankruptcy: it's no panacea, but it might help
Bankruptcy is a way to resolve your debts when you're unable to pay them. Although many taxes can't be avoided in bankruptcy, declaring bankruptcy will suspend most collection activities by the IRS. In some cases, interest and penalties will also cease to accrue. Finally, reducing your overall debt burden by eliminating unsecured debt (e.g., credit card balances) through bankruptcy can leave more money to pay your IRS tax bill.
Income Tax Planning and 529 Plans
The income tax benefits offered by 529 plans make these plans attractive to parents (and others) interested in saving for college. Qualified withdrawals from a 529 plan are tax free at the federal level, and some states also offer tax breaks to their residents. It's important to evaluate the federal and state tax consequences of plan withdrawals and contributions before you invest in a 529 plan.
Federal income tax treatment of qualified withdrawals
There are two types of 529 plans--college savings plans and prepaid tuition plans. The federal income tax treatment of these plans is identical. Your contributions to college savings plans and prepaid tuition plans are tax deferred. This means that you don't pay income taxes on the plan's earnings each year.
Then, if you take out money and use it to pay for qualified education expenses, the earnings portion of your withdrawal is free from federal income tax. This presents a significant opportunity to help you accumulate funds for college.
Qualified education expenses include tuition, fees, and books for college and graduate school. Room-and-board expenses are also considered qualified if the beneficiary is attending college or graduate school on at least a half-time basis.
State income tax treatment of qualified withdrawals
States differ in the 529 plan tax benefits they offer to their residents. For example, some states may offer no tax benefits, while others may exempt earnings on qualified withdrawals from state income tax and/or offer a deduction for contributions. However, keep in mind that states may limit their tax benefits to individuals who participate in the in-state 529 plan.
You should look to your own state's laws to determine the income tax treatment of withdrawals (and deductions). In general, you won't be required to pay income taxes to another state simply because you opened a 529 account in that state. But you'll probably be taxed in your state of residency on the earnings distributed by your 529 plan (whatever state sponsored it) unless your state grants a specific exemption. Also, make sure you understand your state's definition of "qualified education expenses," since it may differ from the federal definition.
Income tax treatment of nonqualified withdrawals (federal and state)
If you make a nonqualified withdrawal (i.e., one not used for qualified education expenses), the earnings portion of the distribution will usually be taxable on your federal (and probably state) income tax return in the year of the distribution. The earnings are usually taxed at the rate of the person who receives the distribution (known as the distributee). In most cases, the account owner will be the distributee. Some plans specify who the distributee is, while others may allow you (as the account owner) to determine the recipient of a nonqualified withdrawal.
You'll also pay a federal 10 percent penalty on the taxable amount of the nonqualified withdrawal (usually, that means on the earnings). There are a couple of exceptions, though. The penalty is usually not charged if you terminate the 529 account because the beneficiary has died or become disabled, or if you withdraw funds not needed for college because the beneficiary has received a scholarship. A state penalty may also apply.
Deducting your contributions to a 529 plan
Unfortunately, you can't claim a federal income tax deduction for your contributions to a 529 plan. Depending on where you live, though, you may qualify for a deduction on your state income tax return. A number of states now allow a state income tax deduction for contributions to a 529 plan, and several other states are considering such a measure. Again, keep in mind that most states let you claim an income tax deduction on your state tax return only if you contribute to your own state's 529 plan.
Most of the states that provide a deduction for contributions impose a deduction cap, or limitation, on the amount of the deduction. For example, if you contribute $10,000 to your son's 529 plan this year, your state might allow you to deduct only $4,000 on your state income tax return. Check the details of your 529 plan and the tax laws of your state to learn whether your state imposes a deduction cap.
Also, if you're planning to claim a state income tax deduction for your contributions, you should learn whether your state applies income recapture rules to 529 plans. Income recapture means that deductions allowed in one year may be required to be reported as taxable income if you make a nonqualified withdrawal from the 529 plan in a later year. Again, check the laws of your state for details.
Coordination with the Coverdell education savings account and education tax credits
You can fund a Coverdell education savings account and a 529 account in the same year for the same beneficiary without triggering a penalty.
You can also claim an education tax credit in the same year you withdraw funds from a 529 plan to pay for qualified education expenses. But your 529 plan withdrawal will not be completely tax free on your federal income tax return if it's used for the same higher education expenses for which you're claiming a credit. (When calculating the amount of your qualified higher education expenses for purposes of your Section 529 withdrawal, you'll have to reduce your qualified expenses figure by any expenses used to compute the education tax credit.)
Even the most honest of taxpayers can be left trembling at the thought of an IRS audit. Let's face it--it's right up there with public speaking. To survive an audit, you've got to arm yourself with information. You should understand what the audit process is all about, why your return was audited, what your rights and responsibilities are, and how you can appeal the findings.
An audit is not an accusation of wrongdoing
An IRS audit is an impartial review of your tax return to determine its accuracy--it's not an accusation of wrongdoing. However, you must demonstrate to the IRS that you reported all of your income and were entitled to any credits, deductions, and exemptions in question.
The IRS must complete an audit within three years of the time the tax return is filed, unless tax fraud or a substantial underreporting of income is involved.
Certain returns run a greater risk of audit
Several factors can lead the IRS to single out your return for an audit. For instance, taxpayers who are self-employed, receive much of their income in tips, or run cash-intensive businesses face a greater likelihood of audits. The IRS also pays more attention to professionals such as doctors, lawyers, and accountants (who often run their own businesses and do their own bookkeeping). In addition, if your itemized deductions in several major categories--medical and dental expenses, taxes, charitable contributions, and miscellaneous--are greater than average, you'll have an increased chance of being audited. Other red flags may include:
A return that is missing required schedules
A return that is missing a required alternative minimum tax form
A return signed by a preparer associated with problems in the past
A return reporting income of at least $150,000
There are three types of audits
If you are to be audited, the IRS will inform you by letter. There are three types of audits:
A correspondence audit: This is for minor mistakes and requires only that you mail certain information to the IRS. For example, maybe you forgot to attach a Schedule C to your income tax return. The matter will be closed if the IRS is satisfied with your paperwork.
An office audit: Here, you'd typically bring your tax-related records to an IRS office for examination. For example, if you claimed an unusually high deduction for medical expenses, the IRS may want to see your medical bills and canceled checks, among other things.
A field audit: Here, the auditor generally visits your home or business to verify the accuracy of your tax return. It may be possible for the auditor to visit the office of your representative, instead.
Know your rights regarding the audit
You have several rights when you're involved in an audit. These include:
The right to an explanation of the audit process
The right to representation by an attorney, CPA, or enrolled agent
The right to claim additional deductions that you didn't originally claim on your tax return
The right to request an opinion from the IRS's national office on specific technical issues that arise during the audit
Audit survival tips
Consider the following when you are audited:
Request a postponement (whenever you need it) to gather your records and put them in order
Be sure to read IRS Publication 1 (Taxpayers' Bill of Rights) before your audit
Before your initial interview with the IRS agent, meet with your representative (if any) to discuss strategies and expected results
Bring to the audit only the documents that are requested in the IRS notice
Be thoroughly prepared--if your records clearly substantiate the items claimed on your return, the agent won't waste time conducting a more in-depth audit
Be professional and courteous (and expect the same treatment in return)
Do not volunteer information to the IRS agent; if you have a representative, he or she should respond to the agent's questions
Keep detailed records of any materials that you submit to the agent and of any questions asked by the agent
Ask to speak to the auditor's supervisor if you think that the agent is treating you unfairly
When you get the examination report, call the auditor if you don't understand or agree with it
If you don't agree about the tax liability, meet to see if a compromise can be reached
You can appeal if you disagree with the audit result
You can either agree or disagree with the auditor's findings. If you agree, you'll complete some paperwork and pay what's owed. If you disagree with the auditor, the issues in question can be reviewed informally with the auditor's supervisor. Or, you can appeal to the IRS Appeals Office, which is independent of the local office that conducted the audit. You can appeal the auditor's findings by sending a protest letter to the IRS within 30 days of receiving the audit report. If you do not reach an agreement with the appeals officer, you may be able to take your case to the U.S. Tax Court, U.S. Court of Federal Claims, or U.S. District Court where you live.
Tax Benefits of Home Ownership
In tax lingo, your principal residence is the place where you legally reside. It's typically the place where you spend most of your time, but several other factors are also relevant in determining your principal residence. Many of the tax benefits associated with home ownership apply mainly to your principal residence--different rules apply to second homes and investment properties. Here's what you need to know to make owning a home really pay off at tax time.
Deducting mortgage interest
One of the most important tax benefits that comes with owning a home is the fact that you may be able to deduct any mortgage interest that you pay. If you itemize deductions on Schedule A of your federal income tax return, you can generally deduct the interest that you pay on debt resulting from a loan used to buy, build, or improve your home, provided that the loan is secured by your home. In tax terms, this is referred to as "home acquisition debt." You're able to deduct home acquisition debt on a second home as well as your main home (note, however, that when it comes to second homes, special rules apply if you rent the home out for part of the year).
Up to $1 million of home acquisition debt ($500,000 if you're married and file separately) qualifies for the interest deduction. (Different rules apply if you incurred the debt before October 14, 1987.) If your mortgage loan exceeds $1 million, some of the interest that you pay on the loan may not be deductible.
You're also generally able to deduct interest you pay on certain home equity loans or lines of credit secured by your home, but the rules are different. Home equity debt typically involves a loan secured by your main or second home, not used to buy, build, or improve your home. Deductible home equity debt is limited to the lesser of:
The fair market value of the home minus the total home acquisition debt on that home, or
$100,000 (or $50,000 if your filing status is married filing separately) for main and second homes combined
The interest that you pay on a qualifying home equity loan or line of credit is generally deductible regardless of how you use the loan proceeds. For more information, see IRS Publication 936.
For 2011, you can treat qualified mortgage insurance as home mortgage interest, provided that the insurance is associated with home acquisition debt, and is being paid on an insurance contract issued after 2006. Qualified mortgage insurance is mortgage insurance provided by the Department of Veterans Affairs, the Federal Housing Administration, the Rural Housing Service, and qualified private mortgage insurance (PMI) providers. The deduction is phased out, though, if your adjusted gross income is more than $100,000 ($50,000 if you're married and file separately). Unless extended by additional legislation, this deduction is not available in 2012.
Deducting real estate property taxes
If you itemize deductions on Schedule A, you can also generally deduct real estate taxes that you've paid on your property in the year that they're paid to the taxing authority. If you pay your real estate taxes through an escrow account, you can only deduct the real estate taxes actually paid by your lender from the escrow account during the year. Only the legal property owner can deduct real estate taxes. You cannot deduct homeowner association assessments, since they are not imposed by a state or local government.
If you're subject to the alternative minimum tax (AMT) in a given year, your ability to deduct mortgage interest and real estate taxes may be limited. That's because, under the AMT calculation, no deduction is allowed for state and local taxes, including real estate tax. And, under the AMT rules, only interest on mortgage and home equity debt used to buy, build, or improve your home is deductible. So, if you use a home equity loan to purchase a car, the interest on the loan may be deductible for regular income tax purposes, but not for AMT.
Deducting points and closing costs
Buying a home is confusing enough without wondering how to handle the settlement charges at tax time. When you take out a loan to buy a home, or when you refinance an existing loan on your home, you'll probably be charged closing costs. These may include points, as well as attorney's fees, recording fees, title search fees, appraisal fees, and loan or document preparation and processing fees. You'll need to know whether you can deduct these fees (in part or in full) on your federal income tax return, or whether they're simply added to the cost basis of your home.
Before we get to that, let's define one term. Points are certain charges paid when you obtain a home mortgage. They are sometimes called loan origination fees. One point typically equals one percent of the loan amount borrowed. When you buy your main home, you may be able to deduct points in full in the year that you pay them if you itemize deductions and meet certain requirements. You may even be able to deduct points that the seller pays for you. More information about these requirements is available in IRS Publication 936.
Refinanced loans are treated differently. Generally, points that you pay on a refinanced loan are not deductible in full in the year that you pay them. Instead, they're deducted ratably over the life of the loan. In other words, you can deduct a certain portion of the points each year. If the loan is used to make improvements to your principal residence, however, you may be able to deduct the points in full in the year paid.
What about other settlement fees and closing costs? Generally, you cannot deduct these costs on your tax return. Instead, you must adjust your tax basis (the cost, plus or minus certain factors) in your home. For example, you'd increase your basis to reflect certain closing costs, including:
Charges for installing utility services
Transfer or stamp taxes
Owner's title insurance
For more information, see IRS Publication 530.
Tax treatment of home improvements and repairs
Home improvements and repairs are generally nondeductible. Improvements, though, can increase the tax basis of your home (which in turn can lower your tax bite when you sell your home). Improvements add value to your home, prolong its life, or adapt it to a new use. For example, the installation of a deck, a built-in swimming pool, or a second bathroom would be considered an improvement. In contrast, a repair simply keeps your home in good operating condition. Regular repairs and maintenance (e.g., repainting your house and fixing your gutters) are not considered improvements and are not included in the tax basis of your home. However, if repairs are performed as part of an extensive remodeling of your home, the entire job may be considered an improvement.
If you make certain improvements to your home that improve your home's energy efficiency, you may be eligible for a federal income tax credit in 2011.
Energy tax credit
In 2011, but not in 2012, a credit is available to individuals who make energy-efficient improvements to their homes. You may be entitled to a 10% credit for the purchase of qualified energy-efficient improvements including a roof, windows, skylights, exterior doors, and insulation materials. Specific credit amounts may also be available for the purchase of specified energy-efficient property: $50 for an advanced main air circulating fan; $150 for a qualified furnace or hot water boiler; and $300 for other items, including qualified electric heat pump water heaters and central air conditioning units.
There's a lifetime credit cap of $500 ($200 for windows), however. So, if you've claimed the credit in the past--in one or more tax years after 2005--you're only entitled to the difference between the current cap, and the total amount that you've claimed in the past. That includes any credit that you claimed in 2009 and 2010, when the aggregate limit on the credit was $1,500.
Exclusion of capital gain when your house is sold
If you sell your principal residence at a loss, you generally can't deduct the loss on your tax return. If you sell your principal residence at a gain you may be able to exclude some or all of the gain from federal income tax.
Generally speaking, capital gain (or loss) on the sale of your principal residence equals the sale price of your home less your adjusted basis in the property. Your adjusted basis is the cost of the property (i.e., what you paid for it initially), plus amounts paid for capital improvements, less any depreciation and casualty losses claimed for tax purposes.
If you meet all requirements, you can exclude from federal income tax up to $250,000 ($500,000 if you're married and file a joint return) of any capital gain that results from the sale of your principal residence. In general this exclusion can be used only once every two years. To qualify for the exclusion, you must have owned and used the home as your principal residence for a total of two out of the five years before the sale.
For example, you and your spouse bought your home in 1981 for $200,000. You've lived in it ever since and file joint federal income tax returns. You sold the house yesterday for $350,000. Your entire $150,000 gain ($350,000 - $200,000) is excludable. That means that you don't have to report your home sale on your federal income tax return.
What if you fail to meet the two-out-of-five-year rule? Or what if you used the capital gain exclusion within the past two years with respect to a different principal residence? You may still be able to exclude part of your gain if your home sale was due to a change in place of employment, health reasons, or certain other unforeseen circumstances. In such a case, exclusion of the gain may be prorated.
Additionally, special rules may apply in the following cases:
If your principal residence contained a home office or was otherwise used partially for business purposes
If you sell vacant land adjacent to your principal residence
If your principal residence is owned by a trust
If you rented part of your principal residence to tenants, or used it as a vacation or second home
If you owned your principal residence jointly with an unmarried individual
Note: Members of the uniformed services, foreign services, and intelligence community, as well as certain Peace Corps volunteers and employees may elect to suspend the running of the two-out-of-five-year requirement during any period of qualified official extended duty up to a maximum of ten years.
Consult a tax professional for details.
The goal of income tax planning is to minimize your federal income tax liability. You can achieve this in different ways. Typically, though, you'd look at ways to reduce your taxable income, perhaps by deferring your income or shifting income to family members. You should also consider deduction planning, investment tax planning, and year-end planning strategies to lower your overall income tax burden.
Postpone your income to minimize your current income tax liability
By deferring (postponing) income to a later year, you may be able to minimize your current income tax liability and invest the money that you'd otherwise use to pay income taxes. And when you eventually report the income, you may be in a lower income tax bracket.
Certain retirement plans can help you to postpone the payment of taxes on your earned income. With a 401(k) plan, for example, you contribute part of your salary into the plan, paying income tax only when you withdraw money from the plan (withdrawals before age 59½ may be subject to a 10 percent penalty). This allows you to postpone the taxation of part of your salary and take advantage of the tax-deferred growth in your investment earnings.
There are many other ways to postpone your taxable income. For instance, you can contribute to a traditional IRA, buy permanent life insurance (the cash value part grows tax deferred), or invest in certain savings bonds. You may want to speak with a tax professional about your tax planning options.
Shift income to your family members to lower the overall family tax burden
You can also minimize your federal income taxes by shifting income to family members who are in a lower tax bracket. For example, if you own stock that produces a great deal of dividend income, consider gifting the stock to your children. After you've made the gift, the dividends will represent income to them rather than to you. This may lower your tax burden. Keep in mind that you can make a tax-free gift of up to $13,000 per year per recipient without incurring federal gift tax.
However, look out for the kiddie tax rules. Under these rules, for children (1) under age 18, or (2) under age 19 or full-time students under age 24 who don't earn more than one-half of their financial support, any unearned income over $1,900 is taxed at the parent's marginal tax rate. Also, be sure to check the laws of your state before giving securities to minors.
Other ways of shifting income include hiring a family member for the family business and creating a family limited partnership. Investigate all of your options before making a decision.
Deduction planning involves proper timing and control over your income
Lowering your federal income tax liability through deductions is the goal of deduction planning. You should take all deductions to which you are entitled, and time them in the most efficient manner.
As a starting point, you'll have to decide whether to itemize your deductions or take the standard deduction. Generally, you'll choose whichever method lowers your taxes the most. If you itemize, be aware that some deductions (for example, medical and miscellaneous expenses) are allowed only to the extent the deduction exceeds some percentage of your adjusted gross income (AGI). Since the portion allowed may increase as your AGI decreases, you might try to lower your AGI. To lower your AGI for the year, you can defer part of your income to next year, buy investments that generate tax-exempt income, and contribute as much as you can to qualified retirement plans.
Note: Unless Congress acts, in 2013 some of your itemized deductions may be disallowed if your AGI reaches a certain threshold figure. If you expect that your AGI might limit your itemized deductions, try to lower your AGI.
Because you can sometimes control whether a deductible expense falls into the current tax year or the next, you may have some control over the timing of your deduction. If you're in a higher federal income tax bracket this year than you expect to be in next year, you'll want to accelerate your deductions into the current year. You can accelerate deductions by paying deductible expenses and making charitable contributions this year instead of waiting until next.
Investment tax planning uses timing strategies and focuses on your after-tax return
Investment tax planning seeks to minimize your overall income tax burden through tax-conscious investment choices. Several potential strategies may be considered. These include the possible use of tax-exempt securities and intentionally timing the sale of capital assets for maximum tax benefit.
Although income is generally taxable, certain investments generate income that's exempt from tax at the federal or state level. For example, if you meet specific requirements and income limits, the interest on certain Series EE bonds (these may also be called Patriot bonds) used for education may be exempt from federal, state, and local income taxes. Also, you can exclude the interest on certain municipal bonds from your federal income (tax-exempt status applies to income generated from the bond; a capital gain or loss realized on the sale of a municipal bond is treated like gain or loss from any other bond for federal tax purposes). And if you earn interest on tax-exempt bonds issued in your home state, the interest will generally be exempt from state and local tax as well. Keep in mind that although the interest on municipal bonds is generally tax exempt, certain municipal bond income may be subject to the federal alternative minimum tax. When comparing taxable and tax-exempt investment options, you'll want to focus on those choices that maximize your after-tax return.
In most cases, long-term capital gain tax rates are lower than ordinary income tax rates. That means that the amount of time you hold an asset before selling it can make a big tax difference. Since long-term capital gain rates generally apply when an asset has been held for more than a year, you may find it makes good tax-sense to hold off a little longer on selling an asset that you've held for only 11 months. Timing the sale of a capital asset (such as stock) can help in other ways as well. For example, if you expect to be in a lower income tax bracket next year, you might consider waiting until then to sell your stock. You might want to accelerate income into this year by selling assets, though, if you have capital losses this year that you can use to offset the resulting gain.
Note:You should not decide which investment options are appropriate for you based on tax considerations alone. Nor should you decide when (or if) to sell an asset solely based on the tax consequence. A financial or tax professional can help you decide what choices are right for your specific situation.
Year-end planning focuses on your marginal income tax bracket
Year-end tax planning, as you might expect, typically takes place in October, November, and December. At its most basic level, year-end tax planning generally looks at ways to time income and deductions to give you the best possible tax result. This may mean trying to postpone income to the following year (thus postponing the payment of tax on that income) and accelerate deductions into the current year. For example, assume it's December and you know that you're in a higher tax bracket this year than you will be in next year. If you're able to postpone the receipt of income until the following year, you may be able to pay less overall tax on that income. Similarly, if you have major dental work scheduled for the beginning of next year, you might consider trying to reschedule for December to take advantage of the deduction this year. The right year-end tax planning moves for you will depend on your individual circumstances.
Tax Planning for the Self-Employed
Self-employment is the opportunity to be your own boss, to come and go as you please, and oh yes, to establish a lifelong bond with your accountant. If you're self-employed, you'll need to pay your own FICA taxes and take charge of your own retirement plan, among other things. Here are some planning tips.
Understand self-employment tax and how it's calculated
As a starting point, make sure that you understand (and comply with) your federal tax responsibilities. The federal government uses self-employment tax to fund Social Security and Medicare benefits. You must pay this tax if you have more than a minimal amount of self-employment income. If you file a Schedule C as a sole proprietor, independent contractor, or statutory employee, the net profit listed on your Schedule C (or Schedule C-EZ) is self-employment income and must be included on Schedule SE, which is filed with your federal Form 1040. Schedule SE is used both to calculate self-employment tax and to report the amount of tax owed.
Make your estimated tax payments on time to avoid penalties
Employees generally have income tax, Social Security tax, and Medicare tax withheld from their paychecks. But if you're self-employed, it's likely that no one is withholding federal and state taxes from your income. As a result, you'll need to make quarterly estimated tax payments on your own (using IRS Form 1040-ES) to cover your federal income tax and self-employment tax liability. You may have to make state estimated tax payments, as well. If you don't make estimated tax payments, you may be subject to penalties, interest, and a big tax bill at the end of the year. For more information about estimated tax, see IRS Publication 505.
If you have employees, you'll have additional periodic tax responsibilities. You'll have to pay federal employment taxes and report certain information. Stay on top of your responsibilities and see IRS Publication 15 for details.
Employ family members to save taxes
Hiring a family member to work for your business can create tax savings for you; in effect, you shift business income to your relative. Your business can take a deduction for reasonable compensation paid to an employee, which in turn reduces the amount of taxable business income that flows through to you. Be aware, though, that the IRS can question compensation paid to a family member if the amount doesn't seem reasonable, considering the services actually performed. Also, when hiring a family member who's a minor, be sure that your business complies with child labor laws.
As a business owner, you're responsible for paying FICA (Social Security and Medicare) taxes on wages paid to your employees. The payment of these taxes will be a deductible business expense for tax purposes. However, if your business is a sole proprietorship and you hire your child who is under age 18, the wages that you pay your child won't be subject to FICA taxes.
As is the case with wages paid to all employees, wages paid to family members are subject to withholding of federal income and employment taxes, as well as certain taxes in some states.
Establish an employer-sponsored retirement plan for tax (and nontax) reasons
Because you're self-employed, you'll need to take care of your own retirement needs. You can do this by establishing an employer-sponsored retirement plan, which can provide you with a number of tax and nontax benefits. With such a plan, your business may be allowed an immediate federal income tax deduction for funding the plan, and you can generally contribute pretax dollars into a retirement account to grow tax deferred until withdrawal (as a tradeoff, tax-deferred funds withdrawn from these plans prior to age 59½ are generally subject to a 10 percent premature distribution penalty tax--as well as ordinary income tax--unless an exception applies). You can also choose to establish a 401(k) plan that allows Roth contributions; with Roth contributions, there's no immediate tax benefit (after-tax dollars are contributed), but future qualified distributions will be free from federal income tax. You may want to consider evaluating one of the following types of retirement plans:
Simplified employee pension (SEP)
Individual (or "solo") 401(k)
The type of retirement plan that your business should establish depends on your specific circumstances. Explore all of your options and consider the complexity of each plan. And bear in mind that if your business has employees, you may have to provide coverage for them as well (note that you may qualify for a tax credit of up to $500 for the costs associated with establishing and administering such a plan). For more information about your retirement plan options, consult a tax professional or see IRS Publication 560.
Take full advantage of all business deductions to lower taxable income
Because deductions lower your taxable income, you should make sure that your business is taking advantage of any business deductions to which it is entitled. You may be able to deduct a variety of business expenses, including rent or home office expenses, and the costs of office equipment, furniture, supplies, and utilities. To be deductible, business expenses must be both ordinary (common and accepted in your trade or business) and necessary (appropriate and helpful for your trade or business). If your expenses are incurred partly for business purposes and partly for personal purposes, you can deduct only the business-related portion.
If you're concerned about lowering your taxable income this year, consider the following possibilities:
Deduct the business expenses associated with your motor vehicle, using either the standard mileage allowance or your actual business-related vehicle expenses to calculate your deduction
Buy supplies for your business late this year that you would normally order early next year
Purchase depreciable business equipment, furnishings, and vehicles this year
Deduct the appropriate portion of business meals, travel, and entertainment expenses
Write off any bad business debts
Self-employed taxpayers who use the cash method of accounting have the most flexibility to maneuver at year-end. See a tax specialist for more information.
Deduct health-care related expenses
If you qualify, you may be able to benefit from the self-employed health insurance deduction, which would enable you to deduct up to 100 percent of the cost of health insurance that you provide for yourself, your spouse, and your dependents. This deduction is taken on the front of your federal Form 1040 (i.e., "above-the-line") when computing your adjusted gross income, so it's available whether you itemize or not.
Contributions you make to a health savings account (HSA) are also deductible "above-the-line." An HSA is a tax-exempt trust or custodial account you can establish in conjunction with a high-deductible health plan to set aside funds for health-care expenses. If you withdraw funds to pay for the qualified medical expenses of you, your spouse, or your dependents, the funds are not included in your adjusted gross income. Distributions from an HSA that are not used to pay for qualified medical expenses are included in your adjusted gross income, and are subject to an additional 20 percent penalty tax unless an exception applies.
It's nice to own stocks, bonds, and other investments. Nice, that is, until it's time to fill out your federal income tax return. At that point, you may be left scratching your head. Just how do you report your investments and how are they taxed?
Is it ordinary income or a capital gain?
To determine how an investment vehicle is taxed in a given year, first ask yourself what went on with the investment that year. Did it generate income, such as interest? If so, the income is probably considered ordinary. Did you sell the investment? If so, a capital gain or loss is probably involved. (Certain investments can generate both ordinary income and capital gain income, but we won't get into that here.)
If you receive dividend income, it may be taxed either at ordinary income tax rates or at the rates that apply to long-term capital gain income. Currently, dividends paid to an individual shareholder from a domestic corporation or qualified foreign corporation are generally taxed at the same rates that apply to long-term capital gains. These rates are 15 percent for an individual in a marginal tax rate bracket that is greater than 15 percent, or 0 percent for an individual in the 10 or 15 percent marginal tax rate bracket. But special rules and exclusions apply, and some dividends (such as those from money market mutual funds) continue to be treated as ordinary income.
Note: Unless extended by Congress, in 2013, dividends will be taxed at ordinary income tax rates.
The distinction between ordinary income and capital gain income is important because different tax rates may apply and different reporting procedures may be involved. Here are some of the things you need to know.
Categorizing your ordinary income
Investments often produce ordinary income. Examples of ordinary income include interest and rent. Many investments--including savings accounts, certificates of deposit, money market accounts, annuities, bonds, and some preferred stock--can generate ordinary income. Ordinary income is taxed at ordinary (as opposed to capital gains) tax rates.
But not all ordinary income is taxable--and even if it is taxable, it may not be taxed immediately. If you receive ordinary income, the income can be categorized as taxable, tax exempt, or tax deferred.
Taxable income: This is income that's not tax exempt or tax deferred. If you receive ordinary taxable income from your investments, you'll report it on your federal income tax return. In some cases, you may have to detail your investments and income on Schedule B.
Tax-exempt income: This is income that's free from federal and/or state income tax, depending on the type of investment vehicle and the state of issue. Municipal bonds and U.S. securities are typical examples of investments that can generate tax-exempt income.
Tax-deferred income: This is income whose taxation is postponed until some point in the future. For example, with a 401(k) retirement plan, earnings are reinvested and taxed only when you take money out of the plan. The income earned in the 401(k) plan is tax deferred.
A quick word about ordinary losses: It's possible for an investment to generate an ordinary loss, rather than ordinary income. In general, ordinary losses reduce ordinary income.
Understanding what basis means
Let's move on to what happens when you sell an investment vehicle. Before getting into capital gains and losses, though, you need to understand an important term--basis. Generally speaking, basis refers to the amount of your investment in an asset. To calculate the capital gain or loss when you sell or exchange an asset, you must know how to determine both your initial basis and adjusted basis in the asset.
First, initial basis. Usually, your initial basis equals your cost--what you paid for the asset. For example, if you purchased one share of stock for $10,000, your initial basis in the stock is $10,000. However, your initial basis can differ from the cost if you did not purchase an asset but rather received it as a gift or inheritance, or in a tax-free exchange.
Next, adjusted basis. Your initial basis in an asset can increase or decrease over time in certain circumstances. For example, if you buy a house for $100,000, your initial basis in the house will be $100,000. If you later improve your home by installing a $5,000 deck, your adjusted basis in the house may be $105,000. You should be aware of which items increase the basis of your asset, and which items decrease the basis of your asset. See IRS Publication 551 for details.
Calculating your capital gain or loss
If you sell stocks, bonds, or other capital assets, you'll end up with a capital gain or loss. Special capital gains tax rates may apply. These rates may be lower than ordinary income tax rates.
Basically, capital gain (or loss) equals the amount that you realize on the sale of your asset (i.e., the amount of cash and/or the value of any property you receive) less your adjusted basis in the asset. If you sell an asset for more than your adjusted basis in the asset, you'll have a capital gain. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $15,000, your capital gain will be $5,000. If you sell an asset for less than your adjusted basis in the asset, you'll have a capital loss. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $8,000, your capital loss will be $2,000.
Schedule D of your income tax return is where you'll calculate your short-term and long-term capital gains and losses, and figure the tax due, if any. You'll need to know not only your adjusted basis and the amount realized from each sale, but also your holding period, your marginal income tax bracket, and the type of asset(s) involved. See IRS Publication 544 for details.
Holding period: Generally, the holding period refers to how long you owned an asset. A capital gain is classified as short term if the asset was held for a year or less, and long term if the asset was held for more than one year. The tax rates applied to long-term capital gain income are generally lower than those applied to short-term capital gain income. Short-term capital gains are taxed at the same rate as your ordinary income.
Marginal income tax bracket: Marginal income tax brackets are expressed by their marginal tax rate (e.g., 15 percent, 25 percent). Your marginal tax bracket depends on your filing status and the level of your taxable income. When you sell an asset, the capital gains tax rate that applies to the gain will depend on your marginal income tax bracket. Generally, a 0 percent long-term capital gains tax rate applies to individuals in the 10 or 15 percent tax bracket, while the long-term capital gains of individuals in the other tax brackets are currently subject to a maximum rate of 15 percent.
Note: Unless extended by Congress, in 2013, a 10 percent long-term capital gains tax rate will generally apply to individuals in the 15 percent tax bracket, while the long-term capital gains of individuals in the higher tax brackets will generally be subject to a maximum rate of 20 percent.
Type of asset: The type of asset that you sell will dictate the capital gain rate that applies, and possibly the steps that you should take to calculate the capital gain (or loss). For instance, the sale of an antique is taxed at the maximum tax rate of 28 percent even if you held the antique for more than 12 months.
Using capital losses to reduce your tax liability
You can use capital losses from one investment to reduce the capital gains from other investments. You can also use a capital loss against up to $3,000 of ordinary income this year ($1,500 for married persons filing separately). Losses not used this year can offset future capital gains. Schedule D of your federal income tax return can lead you through this process.
Getting help when things get too complicated
The sale of some assets are more difficult to calculate and report than others, so you may need to consult an IRS publication or other tax references to properly calculate your capital gain or loss. Also, remember that you can always seek the assistance of an accountant or other tax professional.
Starting in 2013 -- new Medicare contribution tax on unearned income may apply
Beginning in 2013, high-income individuals may be subject to a new 3.8 percent Medicare contribution tax on unearned income (the new tax is also imposed on estates and trusts, although slightly different rules apply). The tax is equal to 3.8 percent of the lesser of:
Your net investment income (generally, net income from interest, dividends, annuities, royalties and rents, and capital gains, as well as income from a business that is considered a passive activity), or
The amount of your modified adjusted gross income that exceeds $200,000 ($250,000 if married filing a joint federal income tax return, $125,000 if married filing a separate return)
So, effectively, you're subject to the additional 3.8 percent tax only if your adjusted gross income exceeds the dollar thresholds listed above. It's worth noting that interest on tax-exempt bonds is not considered net investment income for purposes of the additional tax. Qualified retirement plan and IRA distributions are also not considered investment income.
As the end of the year approaches, it's time to consider strategies that can help you reduce your tax bill. But most tax tips, suggestions, and strategies are of little practical help without a good understanding of your current tax situation. This is particularly true for year-end planning. You can't know where to go next if you don't know where you are now.
So take a break from the usual fall chores and pull out last year's tax return, along with your current pay stubs and account statements. Doing a few quick projections will help you estimate your present tax situation and identify any glaring issues you'll need to address while there's still time.
When it comes to withholding, don't shortchange yourself
If you project that you'll owe a substantial amount when you file this year's income tax return, ask your employer to increase your federal income tax withholding amounts. If you have both wage and consulting income and are making estimated tax payments, there's an added benefit to doing this: Even though the additional withholding may need to come from your last few paychecks, it's generally treated as having been withheld evenly throughout the year. This may help you avoid paying an estimated tax penalty due to underwithholding.
Of course, if you've significantly overpaid your taxes and estimate you'll be receiving a large refund, you can reduce your withholding accordingly, putting money back in your pocket this year instead of waiting for your refund check to come next year.
Will you suffer the alternative?
Originally intended to prevent the very rich from using "loopholes" to avoid paying taxes, the alternative minimum tax (AMT) snags more and more middle-income taxpayers every year, since (unlike regular income tax) it doesn't keep pace with inflation. The AMT is governed by a separate set of rules that exist in parallel to those for the regular income tax system. These rules disallow certain deductions and personal exemptions that you are allowed to include in computing your regular income tax liability, and treat specific items, such as incentive stock options, differently. As a result, AMT liability may be triggered by such items as:
Large numbers of personal exemptions
Large deductible medical expenses
Large deductions for state, local, personal property, and real estate taxes
Home equity loan interest where the financing isn't used to buy, build, or improve your home
Exercising a large incentive stock option
Large amounts of miscellaneous itemized deductions such as unreimbursed employee business expenses
So when you sit down to project your taxes, calculate your regular income tax on Form 1040, and then consider your potential AMT liability using Form 6251. If it appears you'll be subject to the AMT, you'll need to take a very different planning approach during the last few months of the year. Even some of the most basic year-end tax planning strategies can have unintended consequences under AMT rules. For example, accelerating certain deductions into this year may prove counterproductive since AMT rules may require you to add them back into your income. See a tax professional for information on your specific tax situation.
Timing is everything
The last few months of the year may be the time to consider delaying or accelerating income and deductions, taking into consideration the impact on both this year's taxes and next. If you expect to be in a different tax bracket next year, doing so may help you minimize your tax liability. For instance, if you expect to be in a lower tax bracket next year, you might want to postpone income from this year to next so that you will pay tax on it next year instead. At the same time, you may want to accelerate your deductions in order to pay less tax this year.
To delay income to the following year, you might be able to:
Defer year-end bonuses
Defer the sale of capital gain property (or take installment payments rather than a lump-sum payment)
Postpone receipt of distributions (other than required minimum distributions) from retirement accounts
To accelerate deductions into this year:
Consider paying medical expenses in December rather than January, if doing so will allow you to qualify for the medical expense deduction
Prepay deductible interest
Make alimony payments early
Make next year's charitable contributions this year
The gifts that give back
If you itemize your deductions, consider donating money or property to charity before the end of the current tax year in order to increase the amount you can deduct on your taxes. As an aside, now is also a good time to consider making noncharitable gifts. In 2012, you may give up to $13,000 ($26,000 for a married couple) to as many individuals as you want without incurring any federal gift tax consequences. If you gift an appreciated asset, you won't have to pay tax on the gain; any tax is deferred until the recipient of your gift disposes of the property.
Postpone the inevitable
To reduce your taxable income this year, consider maximizing pretax contributions to an employer-sponsored retirement plan such as a 401(k). You won't be taxed on the contributions you make now, and you may be in a lower tax bracket when you do eventually withdraw the funds and report the income.
If you qualify, you might also consider making either a tax-deductible contribution to a traditional IRA or an after-tax contribution to a Roth IRA. In the first instance, a current income tax deduction effectively defers income--and its taxation--to future years; in the second, while there's no current tax deduction allowed, qualifying distributions you take later will be tax free. You'll generally have until the due date of your federal income tax return to make these contributions.
Tax credits and deductions
It's tax time, and your kitchen table is littered with papers and forms. As if this isn't bad enough, you recently paid your child's college semester bill, and you don't know where you'll find the money to pay the taxes that you expect to owe. Well, you might finally catch a break. Now that your child is in college, you might qualify for one of two education tax credits--the American Opportunity credit (formerly the Hope credit) and the Lifetime Learning credit. And because a tax credit is a dollar-for-dollar reduction against taxes owed, it's more favorable than a tax deduction, which simply reduces the total income on which your tax is based.
These education tax credits depend on the amount of qualified tuition and related expenses that you pay in a given year, as well as your modified adjusted gross income (MAGI). In 2012, to qualify for the maximum American Opportunity credit, your MAGI must be below $80,000 if you're a single filer and $160,000 if you're a joint filer. A partial credit is available for single filers with an MAGI between $80,000 and $90,000 and joint filers with an MAGI between $160,000 and $180,000. To qualify for the maximum Lifetime Learning credit in 2012, your MAGI must be below $52,000 if you're a single filer and $104,000 if you're a joint filer. A partial credit is available for single filers with an MAGI between $52,000 and $62,000 and joint filers with an MAGI between $104,000 and $124,000.
American Opportunity credit can help with college expenses
The American Opportunity credit is a tax credit that covers the first four years of your, your spouse's or your child's undergraduate education. Graduate and professional-level courses aren't eligible. The credit is worth a maximum of $2,500 in 2012. It's calculated as 100 percent of the first $2,000 of tuition and related expenses that you've paid for the year, plus 25 percent of the next $2,000 of such expenses.
To take the credit, both you and your child must clear some hurdles:
Your child must attend an eligible educational institution as defined by the IRS (generally, any post-secondary school that offers a degree program and is eligible to participate in federal aid programs qualifies).
Your child must attend college on at least a half-time basis.
Your child can't have a felony conviction.
You must claim your child as a dependent on your tax return. If your child has paid the tuition expenses, you can still take the credit as long as you claim your child as a dependent on your return. But if your child has paid the tuition expenses and isn't claimed as a dependent on your return, your child can take the credit on his or her own return.
The American Opportunity credit can be taken for more than one student in the same year, provided each student qualifies independently. So, if you have twins who are in their freshman year of college (and you otherwise meet the requirements), your credit would be worth $5,000. However, there are other restrictions. You can't take both the American Opportunity credit and the Lifetime Learning credit in the same year for the same student. And whatever education expenses you cover with a tax-free distribution from your 529 plan or Coverdell education savings account cannot be the same expenses you use to qualify for the American Opportunity credit.
Lifetime Learning credit can help with college, graduate school, and individual course expenses
The Lifetime Learning credit is a tax credit for the qualified education expenses that you, your spouse, or your child incur for courses taken to improve or acquire job skills (even courses related to sports, games, or hobbies qualify if they meet this requirement!). The Lifetime Learning credit is much less restrictive than the American Opportunity credit. In addition to college expenses, the Lifetime Learning credit covers the tuition expenses of graduate students and students enrolled less than half-time.
The Lifetime Learning credit is generally worth a maximum of $2,000. It's calculated as 20 percent of the first $10,000 of tuition and related expenses that you've paid for the year.
One major difference between the American Opportunity credit and the Lifetime Learning credit is that the Lifetime Learning credit is generally limited to a total of $2,000 per tax return, regardless of the number of students in a family who may qualify in a given year. So if you have twins who are in their senior year of college, your Lifetime Learning credit would be worth $2,000, not $4,000.
As with the American Opportunity credit, if you withdraw money from your 529 plan or Coverdell ESA in the same year that you claim the Lifetime Learning credit, your withdrawal cannot cover the same expenses that you use to qualify for the Lifetime Learning credit.
My child is in college--how do I know which credit to take?
The American Opportunity credit and the Lifetime Learning credit cannot be claimed in the same year for the same student, so you'll need to pick one. Because the American Opportunity tax credit is available for all four years of undergraduate education, is worth more, and the income limits to qualify are higher, that credit will probably be your first choice. But if your child is attending school less than half-time, the Lifetime Learning credit will be your only option (assuming you meet the income limits).
How do I claim either credit on my tax return?
You should receive Form 1098-T from the college, showing the tuition expenses you've paid for the year. Then, at tax time, you must file Form 8863 to take either credit. If you are married, you must file a joint return to take either credit. For more information, see IRS Publication 970 or consult a tax professional.
Personal Deduction Planning
Taxes, like death, are inevitable. But why pay more than you have to? The trick to minimizing your federal income tax liability is to understand the rules and make the most of your tax planning opportunities. Personal deduction planning is one aspect of tax planning. Here, your goals are to use your deductions in the most efficient manner and take all deductions to which you're entitled.
Deductions lower your taxable income
Your first step is to understand how deductions work. You subtract certain deductions from your total income to arrive at your adjusted gross income (AGI). Then, you subtract other deductions and exemptions from your AGI to determine your taxable income. Your tax liability is calculated based on your taxable income. Generally speaking, therefore, the higher your deduction level, the lower your tax liability.
You can either take a standard deduction or itemize
After you've computed your AGI, you'll generally want to subtract the greater of either the standard deduction or the total of your itemized deductions. The standard deduction is a fixed dollar amount, indexed for inflation yearly, that is determined according to your filing status (e.g., married filing jointly, single) and certain circumstances. Itemized deductions are various deductions that are reported on Schedule A of your federal tax return (Form 1040). They involve certain personal expenses, such as medical expenses, mortgage interest, state taxes, charitable contributions, theft losses, and miscellaneous itemized deductions. If you have enough of these types of expenses, your itemized deductions may exceed your standard deduction. In that case, it would be to your advantage to itemize.
When filling out your tax return, how do you know whether to take the standard deduction or itemize? You should calculate your taxes (including any alternative minimum tax) using both methods, and go with the one that lowers your tax liability the most. Be aware that there are some limitations regarding who can use the standard deduction and who can itemize. Also, certain itemized deductions are available to you only if your expenses exceed a particular percentage of your AGI. For example, miscellaneous itemized deductions are allowed only to the extent that they (when totaled) exceed 2 percent of your AGI. So, if your AGI is $100,000, your first $2,000 of miscellaneous itemized deductions won't count toward your total itemized deductions. Your medical expense deduction may also be limited by your AGI.
Note: There may be circumstances where it is better to itemize deductions even if the standard deduction is greater than itemized deductions. For example, if you are subject to alternative minimum tax, even a small amount of itemized deductions may be preferable to the standard deduction, which is reduced to zero for alternative minimum tax purposes.
The medical and dental expenses deduction: what it is, and how it involves your income level
The medical and dental expenses deduction is an itemized deduction that you may take (within certain limits) for unreimbursed medical and dental expenses you paid during the year for yourself, your spouse, and your dependents. You may be surprised to learn which medical and dental expenses are deductible and which are not; the line is sometimes blurry. For example, you can't deduct your expenses for nicotine gum, but you can deduct your fee for a smoking cessation program. Many expenses qualify for this deduction, including acupuncture treatments, crutches, eyeglasses, and prescription drugs. You should obtain IRS Publication 502, Medical and Dental Expenses, for an authoritative list of eligible and nondeductible expenses. If you don't review this list, you may miss out on some important tax-saving opportunities.
You can take this deduction only to the extent that your unreimbursed medical expenses exceed 7.5 percent of your AGI. That might sound complicated, but here's how it works. First, add up your eligible medical expenses. You can deduct only part of that total on Schedule A of your federal income tax return. The schedule will actually lead you through this calculation. On that form, you'll multiply your AGI by 7.5 percent (.075). The figure you come up with will represent the amount of your medical expenses that you cannot deduct. Subtract this figure from your total eligible medical expenses. The remaining amount is your medical deduction.
Note: Starting in 2013, the threshold to deduct medical expenses will be raised from 7.5 percent of adjusted gross income to 10 percent. The threshold increase will be delayed until 2017 for those age 65 or older.
Proper timing of your deductions will minimize your taxes
For most people, income is reported in the year that it's received, while deductions are generally taken for the year in which expenses are paid. In many cases, you can control whether you incur an expense this year or next. That means that you can control the timing of your itemized deductions to some extent. If you're in a higher income tax bracket this year than you expect to be in next year, you may want to accelerate your deductions into the current year to minimize your tax liability. You can do this by paying deductible expenses before year-end and making charitable contributions before year-end. For example, if you have major dental work scheduled for January of next year, you can reschedule for December to take advantage of the deduction this year. Here are some tips:
If you pay a deductible expense by check, make sure it's dated and mailed before year-end. It needn't clear the bank by year-end, however.
If you pay by credit card, the expense is deductible in the year the charge is incurred, not when the credit card bill is paid.
A mere pledge or promise to make a charitable contribution is not deductible.
Along with your cash contributions to a charity, remember to deduct noncash contributions like clothes. You can also deduct mileage if you use your car for charitable purposes.
Qualifying for the Home Office Deduction
Working from home can certainly provide you with personal benefits, such as a flexible schedule and more family time. But increasing numbers of people are discovering the tax advantages as well. It's no secret that you generally can't deduct certain personal expenses (e.g., homeowners insurance, utilities, and home repairs) on your federal income tax return. But if you're using part of your home as a home office, you may be able to write off part of these expenses. To qualify for the home office deduction, you must first understand the IRS requirements.
The home office deduction is really a group of deductions
First of all, what is a home office? A home office is a room in your home, a portion of a room in your home, or a separate building next to your home (such as a converted garage or barn) that you use exclusively and regularly to conduct business activities.
This definition is important, because you may be able to deduct part of your housing expenses (such as rent, utilities, and insurance) on your federal income tax return if you have a home office. This deduction (or group of deductions) is known as a home office deduction. To take the deduction, you'll need to file Form 8829 with the IRS. To even consider the home office deduction, though, your at-home business activities must involve a trade or business--a hobby won't do.
Now let's consider the IRS requirements. To qualify for a home office deduction, you must meet two threshold tests--the place of business test, and the regular and exclusive use test.
The place of business test is somewhat flexible
To pass this test, you must show that you use part of your home as:
The principal place of business for your trade or business, or
A place where you regularly meet with clients, customers, or patients
In some cases, you can also meet the principal place of business requirement if you conduct substantial administrative and management tasks for your outside business at home and have no other fixed location where you conduct these activities. These tasks might include billing customers, keeping books and records, ordering supplies, setting up appointments, or writing reports. For example, assume you're a doctor at a local HMO who's been given examination space but no office space. You use a room in your home regularly and exclusively to correspond with insurance companies, bill patients, and read medical journals. You have no other fixed location for conducting these types of activities. In such a case, your space would likely pass the place of business test for a home office deduction.
What if your home office is in a separate structure next to your home, like a shed or garage? In such a case, that needn't be your principal place of business. However, you must use that office regularly and exclusively in connection with your trade or business. Be sure you use this structure only for business purposes--you can't store your car there.
You must also meet the regular and exclusive use test
In general, you must also pass the regular and exclusive use test before you can take a home office deduction (exceptions apply for taxpayers who run day-care facilities from home and for sellers who use part of their homes for storing inventory). As you might expect, this test requires you to show that you exclusively use a portion of your home for business purposes on a regular basis.
For example, assume you set aside one room in your home as your home office. You also use this room as a playroom for your children. Here, you wouldn't meet the exclusive use test. Now assume that you use one room in your home exclusively for your side business of selling insurance. You engage in this business only occasionally. Because you don't use the office on a regular basis, you still won't qualify for the home office deduction.
Telecommuters might also qualify for the home office deduction
If you telecommute or are an employee who works at home, you may also qualify for the home office deduction. You'd have to meet the above requirements. In addition, though, your home office must be for the convenience of the employer. In plain English, this means that your employer must ask you to work out of your home. The arrangement must serve your employer's business needs, not vice versa.
The home office deduction for an employee who works at home is taken as a miscellaneous itemized deduction on Schedule A of Federal Form 1040. This deduction is subject to the 2 percent limit for miscellaneous itemized deductions.
If you qualify for the deduction, you can deduct all direct expenses and part of your indirect expenses
You can deduct both your direct and indirect expenses regarding your home office. Direct expenses are costs that apply only to your home office. You can deduct these costs in full against your business income. Some examples include the cost of a business telephone line and the cost of painting your home office. However, no deduction is allowed for basic local telephone charges on the first line in your home, even if that line is used for the home office.
Indirect expenses are costs that benefit your entire home. You can deduct only the business portion of your indirect expenses. Some examples of indirect costs include rent, deductible mortgage interest, real estate taxes, and homeowners insurance. The business percentage of your home is determined by dividing the area exclusively used for business by the total area of the home. For example, assume your home is 2,000 square feet and your home office is 200 square feet. Your business percentage is 10 percent (200 divided by 2,000). In such a case, if you rent your home, you can deduct 10 percent of your rent as part of your home office deduction.
Even if you don't qualify for the home office deduction and are unable to deduct home-related expenses (e.g., homeowners insurance), you can still take a deduction for your regular business expenses, such as the purchase of file cabinets, business equipment, and supplies.
Some of your home office expenses may be limited
If the gross income from your home office equals or exceeds your regular business expenses (including depreciation), all expenses for the business use of your home can be deducted. But if your gross income is less than your total business expenses, certain expense deductions for the business use of your home are limited. The deduction isn't lost forever, though. It's simply carried forward to the next year.
Can you spell "audit"?
In the past, the IRS has closely scrutinized home office deductions. Although it has eased up a bit--perhaps because legitimate home offices are commonplace today--you can never be too careful. Here are some steps you can take to substantiate the existence of your home office:
Use your home address on your business cards, stationery, and advertisements
Install a separate telephone line for your business
Instruct clients or customers to visit your home office, and keep a log of those visits
Log the dates, hours spent, and type of work performed in your home office
Have business mail sent to your home
Having a home office can be a disadvantage when you sell your home
Unless you're careful, deductions today can cost you money when you sell your home. Homeowners who meet all requirements can generally exclude from federal income tax up to $250,000 of capital gain (up to $500,000 if you're married and file a joint return) when a principal residence is sold. You may end up paying some taxes, though, if you have a home office. That's because when you sell your principal residence, an amount of capital gain equal to certain depreciation deductions you were entitled to (as a result of having your home office) won't qualify for the exclusion. Specifically, the exclusion won't cover an amount equal to depreciation deductions attributable to the business use of your home after May 6, 1997.
Note: In addition, where the business portion of the home is separate from the dwelling unit (e.g., an office in a converted detached garage) any capital gain on the sale of the house has to be apportioned; only the part of the gain allocable to the residential portion is eligible for exclusion.
For example, assume a self-employed accountant bought a home in 1998 and sells the home several years later at a $20,000 gain. Although the house was always used as his principal residence, the accountant used one room within the house as his business office. Over the years, the accountant claimed $2,000 of depreciation deductions for his office. Under IRS regulations, $18,000 of the capital gain will be tax free. Only the $2,000 of the gain equal to the depreciation deductions will be taxable.
If the accountant's office had been located in a converted detached garage on his property, he would have to treat the sale as two separate transactions and pay tax on any gain allocable to the converted garage.
Because this area is complex, you should consult a tax professional. Also, you might want to read IRS Publication 587, Business Use of Your Home.
Understanding Personal Tax Credits
Have you ever thought that you're paying too much income tax? You may be, if you're not claiming all of the tax credits for which you are eligible when you file your federal tax return. These credits may significantly reduce your tax liability.
What is a tax credit?
A tax credit is a dollar-for-dollar reduction of your tax liability. Generally, after you've calculated your federal taxable income and worked out how much tax you owe, you can subtract the amount of any tax credit for which you are eligible from your tax obligation. In some cases, if your tax credits exceed your tax liability, you will be able to claim the difference as a refund.
What is the difference between a tax deduction and a tax credit?
A tax deduction reduces your taxable income, so that when you calculate your tax liability, you're doing so against a lower amount. Essentially, your tax obligation is reduced by the same percentage as your tax rate.
Here's an example. If you're in the 28 percent marginal tax bracket and you have $1,000 in tax deductions, your tax liability will be reduced by $280. That reduction would be greater if you were in a higher tax bracket.
A tax credit, on the other hand, is constant. A tax credit of $100 will reduce your tax liability by $100, regardless of your tax bracket. The following is a summary of the main personal federal tax credits that may be available to you.
Child and dependent care credit
If you're working or looking for work, and you need to pay someone to look after your child or other qualifying individual, you may be eligible for the child and dependent care credit. Depending on your adjusted gross income, you may be able to claim up to 35 percent of the qualifying expenses that you pay to provide care for a dependent child under the age of 13, a disabled spouse, or a disabled dependent. A dollar limit applies to the amount of work-related expenses you can use to figure the credit. This limit is $3,000 for one qualifying person, or $6,000 for two or more qualifying persons.
For more information, see IRS Publication 503.
Child tax credit
The child tax credit provides tax relief for parents and others who have dependent children. If you're eligible, you may be entitled to take a credit of up to $1,000 per child. A qualifying child is typically a child, grandchild, stepchild, or foster child under the age of 17 who lives with you for more than half the year and provides less than half of his or her own support.
The child tax credit begins to phase out if your modified adjusted gross income (MAGI) exceeds a certain level ($110,000 for married persons filing jointly, $55,000 for married persons filing separately, and $75,000 for heads of household, widow(er)s, and single persons).
For more information, see IRS Publication 972.
Earned income credit
The earned income credit benefits working taxpayers who have low income. You can apply for it only if you work, either as an employee or in your own business, and you have earned income during the tax year. The amount of the credit is based on your adjusted gross income, your filing status, and the number of qualifying children you have.
For more information, see IRS Publication 596.
There are two tax credits that you may qualify for if you, your spouse, or your children are attending an eligible educational institution: the American Opportunity tax credit (Hope credit) and the Lifetime Learning credit. Whether you can claim one of these credits (they can't both be claimed in the same year for the same student) depends on your educational status, your modified adjusted gross income (MAGI), and the amount of qualified tuition and related expenses you pay in a given year.
Note: For 2009 through 2012, the Hope credit is renamed the American Opportunity tax credit.
The American Opportunity credit is worth a maximum of $2,500 per year and is available to each student in the household who is in the first four years of undergraduate education (provided the student is attending at least half-time). The Lifetime Learning credit is worth a maximum of $2,000 per year and is more widely available--students who are attending college or graduate school (even less than half-time), taking continuing education courses, or pursuing courses connected to hobbies and other interests may be eligible for this credit. However, the Lifetime Learning credit is limited to $2,000 per tax return per year, regardless of how many students in the family may qualify.
To qualify for the full Lifetime Learning credit, your MAGI must be below $52,000 if you're a single filer and $104,000 if you're a joint filer (2012 thresholds). Single filers with a MAGI between $52,000 and $62,000 and joint filers with a MAGI between $104,000 and $124,000 can claim a partial credit.
To qualify for the full American Opportunity credit, your MAGI must be below $80,000 if you're a single filer and $160,000 if you're a joint filer. Single filers with a MAGI between $80,000 and $90,000 and joint filers with a MAGI between $160,000 and $180,000 can claim a partial credit.
For more information, see IRS Publication 970.
Other tax credits
You may also be eligible for other federal tax credits, including the credits listed below:
Adoption tax credit
Tax credit for the elderly or the disabled
Foreign tax credit
Tax credit for IRA and retirement plan contributions (retirement savings contribution credit)
Tax credit for health insurance costs (for certain qualifying individuals only)
Tax credits for certain energy-efficient vehicles
Tax credit(s) for making energy-efficient improvements to a primary residence, or for purchasing qualified energy-efficient property (unless extended by Congress, these credits are not available in 2012)
If you would like more information on personal tax credits, contact your tax advisor or log on to the IRS website at www.irs.gov.
Income Tax Tips: Business Insurance
Insurance serves many purposes for a business. You'll need insurance to protect your business from property damage, personal injury suits, and other forms of financial loss. In addition, you may want to provide your employees with certain types of insurance (e.g., group health and life insurance) to attract and retain them. One of the issues you'll face as a business owner involves the tax treatment of business-related insurance. Just what can you deduct, and how do you handle insurance reimbursements? Here's an overview of what you should know.
Your business may be able to deduct insurance premiums paid
A business can deduct certain business expenses that it has properly paid. To be deductible, business expenses must be both ordinary (i.e., common and accepted in your field of business) and necessary (i.e., appropriate and helpful for your business). Your company may be able to deduct--as a business expense--insurance premiums paid for a variety of coverages. These include:
Fire, theft, flood, or other casualty insurance
Employee group medical insurance
Life insurance provided for the benefit of employees
Business liability insurance
Professional malpractice insurance
Business interruption insurance (pays for lost profits in certain cases if your business is shut down)
Auto and other vehicle insurance used for business (unless the standard mileage rate is used to figure car expenses)
Credit insurance (covers losses from unpaid debts)
However, if your business is the beneficiary of a life insurance policy (either directly or indirectly), it can't deduct the life insurance premiums it pays on behalf of an owner, employee, or any person who has a financial interest in the business. This also applies to split dollar life insurance coverage on key employees--the business can't deduct the premiums.
What happens if your business property is damaged, destroyed, or stolen?
If your business suffers a property-related loss, you should read your business insurance policy carefully to find out what is and isn't covered. Your policy should explain the types of property coverages, list the specific perils that your business is insured against (e.g., damage caused by fire, theft, and hail), describe the exclusions from coverage (e.g., damage caused by a flood or earthquake), and detail any conditions you must meet for coverage to apply.
In many cases, your business insurance policy will reimburse your business for a given loss. Sometimes, though, you'll be only partially reimbursed or not compensated at all. In such cases, your business may be entitled to some tax relief. In general, a reasonable insurance reimbursement is not taxable. If you receive reimbursements, subtract them from your total loss. The unreimbursed portion of your loss may be deductible. But if the amount of your reimbursement exceeds the loss, you may have to report taxable income (see a tax professional for exceptions to this rule).
If your business property is damaged or destroyed in an accident, by an act of nature (e.g., storm), or through theft or vandalism, and your policy does not completely reimburse your business for the loss, your business may be entitled to claim a casualty loss tax deduction. (A casualty is direct damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual.)
Calculating the amount of your casualty or theft loss deduction
If there's a casualty loss, a company can deduct 100 percent of the loss against business income (assuming there's no insurance reimbursement). To compute a business casualty loss deduction, you've got to know three things:
The decrease in the fair market value (FMV) of the property as a result of the loss
Your adjusted basis in the property before the casualty or theft (adjusted basis is usually the property's original cost, plus the cost of improvements, minus depreciation)
The amount of the insurance reimbursement that you receive (or the salvage value)
If your property was damaged but not destroyed, the casualty loss equals the decrease in the property's FMV as a result of the damage, minus any insurance reimbursements. If your property was completely destroyed, ignore the FMV and compare the adjusted basis of the property before the incident to the insurance reimbursement. You can deduct the amount by which the adjusted basis exceeds the insurance reimbursement.
Remember, if your property is covered by insurance, an insurance claim must be filed; otherwise, the casualty loss deduction is not allowed. Use IRS Form 4684 to calculate and report all casualty losses or gains.
Handling other types of business insurance proceeds
Business interruption insurance pays for lost profits if your business is shut down due to a fire or other covered cause. You should report any insurance proceeds as ordinary income. Any credit insurance proceeds should also be reported as ordinary income.
What if you're self-employed?
If you own your own business, you can also deduct most ordinary and necessary business expenses against business income. However, different rules may apply if you're self-employed and your business provides group insurance benefits to its employees. Although a business can generally deduct the cost of group insurance premiums, you may be unable to deduct those insurance premiums that benefit you personally. Alternatively, your deduction may be limited. This is true even if you provide similar benefits to your employees and are able to deduct the cost of those benefits.
For example, assume you are a sole proprietor and maintain a group health employee benefit plan. Your business deducts the costs associated with the plan. However, any expenditures (e.g., premiums) made for your own benefit are generally not deductible as a business expense. You can get around this, though, if your spouse is an employee of your business, participates in the group health plan, and covers you under a family plan.
If you're self-employed and can't deduct your health insurance premiums and other medical costs as a business expense, you may qualify for the self-employed health insurance deduction. This deduction enables you to deduct 100 percent of the cost of health insurance that you provide for yourself, your spouse, and your dependents. If some of your health insurance premiums do not qualify for the self-employed health insurance deduction, you may still be able to deduct them on Schedule A of your Form 1040, assuming that you itemize and meet all other requirements. (The definition of self-employed for this purpose includes sole proprietors, partners, and owners of more than 2 percent of an S corporation.)
For more information, speak with a tax professional.