Archive for Investments

Advice for Real Estate Investors—Maximize Your Tax Savings with Installment Sales

If you’ve been looking at tax strategies regarding your real estate investments, one of the first lessons you probably learned is that it’s good to defer your taxes. Why? Because even if you eventually have to pay those deferred taxes, you get a chance to invest more money early on and take advantage of that growth, rather than losing it right away to taxes.

How the Installment Sale Works

If you’re a real estate investor (sorry dealers—this one’s not for you), you can take advantage of installment sales in order to defer part of the taxes you owe on the sale of your real estate property (or personal property). Doing it this way, you as the seller don’t have to report all the gains on the sale before you actually receive all the sale proceeds. The only catch is that at least one payment in the installment must be received after the year that’s taxable regarding the sale. If the payments are so large that the entire amount is paid within the same taxable year, you lose out on this advantage.

Here’s the easy formula for how much you’ll report each year in taxable gains on the installment payments:

Total Annual Principal Payments x (Gross Profit / Total Contract Price)

Those principal payments include any of your existing loan indebtedness that the buyer is subject to, to the extent that it exceeds your adjusted tax basis. In the case that you do have an existing loan, the buyer is not personally liable to your lender (in contrast to when a buyer assumes a loan). This is called a wraparound mortgage because the buyer is taking a loan on a property on which you already have a mortgage loan, and instead of you receiving the full amount of the sale proceeds to pay off your existing mortgage, your lender continues to receive payments.

To get the gross profit amount for the equation above, you take the selling price minus the property’s basis and selling expenses. This number is the total gain you will report of the course of the installment period.

Total contract price is the sum of all principal payments you will receive throughout the entire course of the installment period. It is calculated by taking the selling price minus liabilities assumed by the buyer that do not exceed your basis (including selling expenses).


There are two primary advantages to using the installment method for a wraparound mortgage:

  1. You may be able to reduce the amount of the payments you receive in the year of the sale (during which time your existing mortgage may exceed your basis).
  2. The contract price may include the face amount of the wraparound mortgage (increasing the contract price in the equation above decreases the percentage of gains you pay taxes on).

You may notice that these advantages do not reduce the amount of gains you will pay taxes on in total. However, they do help you to defer a larger amount of your taxes. You will only incur tax as each installment payment is actually made on the principal (including any down payment). If you get the buyer to agree to pay the closing costs, you can get even bigger tax savings. How? It’s because the closing costs come out of the down payment paid by the buyer.

For example, if the buyer was paying you $35,000 as a down payment, and you pay the closing costs, then the entire $35,000 is taxable. However, if you get the buyer to agree to pay closing costs (and reduce you reduce the sales price and down payment accordingly), they could still pay $35,000, but you will only pay taxes on that amount less the closing costs.

In order for this to work, you cannot be liable for the brokerage commissions. If you are, then having the buyer pay those costs means they are assuming your liability. And, the tax court has ruled that if a buyer assumes your obligation to pay brokerage commissions, that money counts as a payment received by you in the year of the sale. Pay attention here: that negates any tax benefit you would receive from having the buyer pay closing costs.

So, how do you fix this? It’s actually quite easy. When your broker lists the property for sale, make it clear that they should look to the buyer for payment of the brokerage commission rather than making these costs part of the bargaining between you and the buyer. When you plan ahead and state this up-front, you don’t have any obligation for the buyer to assume (i.e. you were never obligated to pay this in the first place). It shouldn’t be too hard for you to get a buyer to agree to such a situation. They will still be in pretty much the same financial scenario either way. But, the second strategy gives you a tax break in the year of sale.

Seller Beware

The main benefit of this whole strategy is your tax-deferral ability. While you are deferring these taxes, you are also earning interest on the installment payments. But, the IRS knows that you are earning interest on its deferred tax dollars. So, you should be aware that for large transactions, you can be charged interest on that deferred tax under installment reporting law (for situations where the sales price is more than $150,000 and the total installment obligations are more than $5 million).[1]

Several court cases have attempted to disallow this strategy; however, the sticking point in these cases has been the documentation. When you’re considering the installment method with a wraparound mortgage, make sure you hire a legal professional to help you draft all the documentation. The buyer’s obligation to pay closing costs should be clearly stated in the purchase agreement, so that you can keep the additional tax savings. Above all, make sure the installment method is the right method for your situation by checking the numbers and seeing what kind of tax savings you’re looking at.

  1. IRS Publication 537

Did You Know Employing Your Kids Means More College Savings Options? How Your Children can Use an IRA

You probably already know about, or have at least heard of, 529 plans as an investment option for paying for your child’s college education. But, did you know that if you employ your kids in your business, you actually have an option that other people don’t? Children who are employed by their parent’s company have the ability to use an IRA account to pay for college without penalties. That’s a huge advantage!

How It Works

Depending upon how much your children make working for your business, they may benefit more from either the Roth IRA or the traditional IRA—either one is available for their college savings.

Here are the primary reasons that it’s a good choice:

  • For qualified higher education expenses, such as tuition, books, fees, room and board, and even supplies, a child can withdraw the money penalty-free.[1] As long as the child only withdraws the amount needed for qualified expenses, the ten percent early-withdrawal tax does not apply.[2] Of course, for the traditional IRA, regular federal income taxes will apply. Keep in mind that for some costs, the student must be enrolled at least half time in order to qualify.
  • It’s possible that the IRA won’t be factored in when determining student and parent resources for financial aid decisions. The Free Application for Federal Student Aid (FAFSA) is the financial aid form used by most public higher education institutions. This form does not include a section asking about IRAs because it is not typically an asset that is considered available as an educational resource.[3] However, private institutions are more likely to consider the IRA an educational asset and factor that in.[4] If your student is able to exclude the IRA from FAFSA calculations the first year of college, be aware that any IRA distributions will be counted as income on the FAFSA the next year. That is, money in the child’s IRA is not calculated, but money taken out of the IRA is.[5]
  • The money grows tax deferred. Because this provides your child with a great head-start on compounding interest, you should start your child’s savings early and continue it until age 18. Child labor laws do not apply to children who work for their parent’s business (unless the business is particularly dangerous—check the guidelines if you’re unsure), so your child can start earning as early as they can provide a valuable service to your business. This could be as early as seven years old. Of course, this only works if the chosen investments provide a good return.
  • Here’s an example of 12-year growth for a child who contributes $5,000 annually. A 0 percent annual return gives them $60,000. A 2 percent return equals $68,402. But, a 15 percent return garners a total of $166,760 after 12 years.
  • The account could help to reduce or eliminate the kiddie tax imposed on children’s investment income. The kiddie tax imposes the parents’ tax rates on the child’s income. Let’s say your child earns $6,200 at your business for the year (that is the standard deduction for 2014), and they also received $5,000 in investment dividends ($11,200 total). They would have to pay taxes at your tax rate for the additional $5,000. But, if your child contributes their dividend income into a traditional IRA, then they are left with zero taxable income.
  • Even if the child’s income is too low to be taxable, they can use a Roth IRA to continue growing the money and deferring taxes. Usually taxes are paid up-front for the Roth, but in this case, there are no taxes to pay up-front! That means when your child withdraws money from their basis, they do not have to pay taxes when the money goes in nor when it’s withdrawn. If the child contributes $6,000 every year for 12 years, they’ll have $72,000, none of which they ever have to pay any taxes for (because the yearly contribution is less than the standard deduction)! Of course, any interest earned on that amount will be subject to taxation upon withdrawal. A traditional IRA, by contrast, does not have a tax-free basis because the contributions are tax-deductible.
  • If the child earns more than the standard deduction, they get double benefits. Your child will want to get the tax deduction from contributing to a traditional IRA if they earn more than the standard deduction in combined work income and investment income. This means they get the tax deduction, and the money then grows tax-deferred.

It really does pay to employ your children, and the advantage is certainly not all on your side. You can give them a helpful step towards a financially secure future, including making college more affordable and teaching them valuable lessons about how to grow their money. When choosing an IRA for your child, the Roth IRA is best for those earning less than the standard deduction. Otherwise, you’ll want to defer a larger sum of the taxes by choosing a traditional IRA and reducing (or eliminating) their tax bill.

  1. IRC Sections 72(t)(2)(E); 72(t)(7)(A); 529(e)(3).
  2. Notice 97-60, Section 4.
  3. “ASK THE BIZ BRAIN,” Business p. 007, The Star-Ledger (Newark, New Jersey), August 10, 2009
  4. “ASK THE BIZ BRAIN,” Business p. 005, The Star-Ledger (Newark, New Jersey), October 11, 2009.
  5. “Roth Can Be Expensive Gift for 16-Year-Old” by Gail MarksJarvis, (Business; Zone C; p. 5), Chicago Tribune, July 8, 2007.

When Investments Go Wrong: IRS Safe Harbors for Ponzi Scheme Losses

It’s been several years since Bernie Madoff confessed to taking billions of dollars from investors in his fake asset management division. But, Ponzi schemes existed well before Madoff pulled off his extravagant plot, and you will always come across people who think they can skirt the law (and ethics in general). Sometimes, these “opportunities” seem like legitimate investments until you start looking at the statements. So, what do you do if you’ve been caught in a Ponzi scheme?

First, know that you do have some protection. You “invested” your money, so you can’t just get it all back unfortunately. You live and you learn. However, you are eligible to claim tax-deductible losses on that money. The problem is that you’ll have a heck of a time proving your Ponzi scheme losses in the year of the loss, which could really hurt your finances.[1] Luckily, the safe harbor laws grant additional protection. Legislation passed in 2009 allows losses from a Ponzi scheme to be carried back 5 years on your taxes, as long as you are eligible[2].

So, what do you do when you find yourself victim to investment fraud?

Using Tax Law Safe Harbors

First, you should know that you are not required to use the Ponzi scheme tax relief safe harbor. But, you’d be silly not to. If you don’t invoke the safe harbor rules, your losses will be deducted using the general rules for theft loss, which means jumping through more hoops and possibly being audited. Yes, you read that correctly. Regarding taxpayers who choose not to use the safe harbor, the IRS has stated:

Returns claiming theft-loss deductions from fraudulent investment arrangements are subject to examination by the [IRS].[3]

That means being audited.

When the IRS actually threatens you with an audit, you should probably take it seriously. And, what about those general theft rules? If you forego the safe harbors, you’ll be required to prove:[4]

  • The loss actually was theft;
  • You claimed this loss on your taxes the year you found out about it (which can be difficult to prove);
  • You have the exact dollar amounts lost, with documentation; and
  • You cannot reasonably expect to recover the loss through reimbursements in the year you found out about the theft and claimed the deductions.

All in all, it’s just easier to follow the safe harbor rules. In fact, you’ll have a much nicer time of it with the IRS if you do.[5] Here’s how it will work when you use the Ponzi scheme tax relief safe harbor laws:

  • You will be able to deduct the fraudulent scheme as a theft loss.
  • You will be able to deduct the loss the year the scheme was found out (i.e. when the perpetrator was indicted, or when the perpetrator either admits guilt or has their assets frozen following a federal or state criminal complaint).
  • Your losses will be calculated with the safe-harbor formula.

Using the safe harbor rules, you have less evidence to provide, and the deduction process is simpler for you to complete. You should know that the IRS often disagrees with deductions for theft loss. Safe harbor rules prevent that.

How Safe Harbor Amounts are Calculated

Before you can take advantage of the safe harbor, you’ll need to show that you are in compliance with its requirements by providing statements of the following (under penalty of perjury):[6]

  • The name of the Ponzi scheme perpetrator;
  • Confirmation that you have written documentation to back up your deduction amounts;
  • Your declaration of status as a Ponzi scheme victim and qualified defrauded investor; and
  • Confirmation that you will abide by all terms of declaration.

This information will need to be attached to your tax return.[7] Also, in this statement, you will show your loss deduction calculations for the discovery year, as follows:[8]

  1. The starting number is your original investment.
  2. Add all of your subsequent investment amounts.
  3. Add any money that was supposedly reinvested on your behalf and that you claimed on your tax returns as income (but for which you received no cash payments from the perpetrator).
  4. Subtract any withdrawals you made from the investment fund. The resultant number is your qualified investment.
  5. Next, determine whether you are a Ponzi victim with possible third-party recovery.
  6. Determine your net qualified investment. If you do have possible third-party recovery, you will multiple the qualified investment amount from step 4 by 75 percent. If you do not have possible third-party recovery, multiply the qualified investment amount by 95 percent.
  7. List any money you actually recovered from the Ponzi scheme (through any source) in the year you are making a deduction.
  8. List the totals for any agreements that protect you from the loss, including insurance policies, contracts, and amounts you are entitled to by the Securities Investor Protection Corporation (SIPC).
  9. Add together your total recoveries from step 7 and step 8.
  10. Finally, you will subtract the answer in step 9 from the answer in step 6 in order to get your gross theft-loss deduction.

It’s all pretty straightforward. As long as you kept all of your statements, and financial and insurance documents, you’ll have everything you need. In subsequent years, you’ll make adjustments for an additional recovery income or for increased losses in the case that your reasonably estimated recovery claims were too low.[9]

Typically, personal theft is subject to certain reductions before it can be claimed as a tax deduction.[10] First, the amount is reduced by a flat $100. Then, you reduce the remaining amount by 10 percent of your AGI. Fortunately, Ponzi scheme victims are not subject to these reductions; individuals can claim the full deductible amount, and businesses can claim the full business casualty loss amount.

Why the IRS Wants You to Follow Safe Harbor Rules

Do you really benefit from using the safe harbor calculations for your deductions? Let’s look at what you agree to give the IRS:

  • You will only deduct the amounts calculated in their formula (in the year the scheme was discovered);
  • For taxable years that precede the year of discovery, you will not amend or file tax returns that re-characterize or exclude income;
  • You will not claim Section 1341 benefits for your Ponzi scheme loss (restoration of an amount under the claim of right doctrine); and
  • You will not use the mitigation provisions of Sections 1311–1314 or the doctrine of equitable recoupment.

The IRS has made a strong statement against claiming the rights and provisions in that last bullet point.[11] It’s always a gamble going against the IRS in a situation that will likely end up in court. You could win the case, but will it be worth the time, money, and effort to challenge it?


By being educated in financial matters and paying attention to your personal and business finances, you can avoid Ponzi schemes. For one thing, you should never, ever give someone else complete control of your money. The best advice is to always know exactly what you are investing in and not making financial decisions that you don’t understand—even if everyone else is doing it. The government also has some guarantees set up to help people avoid losses: Federal Deposit Insurance Corporation (FDIC) and the Securities Investor Protection Corporation (SIPC).

Aside from avoiding fraudulent investments and being aware of government protections, you have a couple of other options for reducing your risk. One way is to have insurance on your investments. Making the investments yourself (rather than having someone else handle it) is the another way to avoid investment fraud losses. If you feel nervous about making these decisions on your own, know that you have resources from the Internet, news publications, financial magazines, and television, and just because someone says they are a financial expert doesn’t necessarily mean they know more than you do.

Even if you do hire an investment advisor to help you make decisions, you should always maintain control of your funds yourself. Never let an advisor have direct access to your money. You can reduce your chances of needing these safe harbor rules in the future if you ask questions about your portfolio and always know what is happening with your money.

  1. Rev. Proc. 2009-20, Section 2.03
  2. IRC Section 172(b)(1)(H)
  3. Rev. Proc. 2009-20, Section 8.03
  4. Rev. Proc. 2009-20, Section 8.01
  5. Rev. Proc. 2009-20, Section 5.01
  6. Rev. Proc. 2009-20, Appendix A, Part III
  7. Rev. Proc. 2009-20, Section 6.01
  8. Rev. Proc. 2009-20, Appendix A, Part II
  9. Rev. Proc. 2009-20, Section 5.03; Rev. Rul. 2009-9, Law and Analysis, Issue 3, Year of Deduction
  11. Rev. Rul. 2009-9

Thinking of Renting Out a Property? Make It Easier with Shared Equity

Renting your real estate can be a wonderful way to increase your cash flow. However, rental properties can also cause you headaches and add a lot of responsibilities onto you, as landlord. After all, in order to rent your property, you have to deal with tenants and handle their needs. However, it turns out there is a way to share some of that ownership responsibility with your tenants. It’s called shared equity, or a rent-to-own agreement.

The Benefits of Rent-to-Own

Typically, as landlord you are 100 percent responsible for the upkeep of the property. You also take on all of the risk, such as being responsible for a mortgage when you have a vacancy. But, when your tenant shares in the ownership of the property,[1] you keep many of the advantages of owning a rental property and also gain additional benefits.

The benefits aren’t one sided, either. Your tenant shares in equity on the home, as well as putting a down payment on it. And, they get a wonderful opportunity to carefully inspect a home before committing to the purchase (and build equity while making their decision!). The tenants also receive tax deductions that they would not be entitled to as typical renters.

If your agreement gives you 65 percent ownership and the tenant 35 percent ownership, then the tenant pays you rent for your 65 percent. You can treat your share just as you would any other rental property. This arrangement is approved by tax law.

Here are some reasons to consider a rent-to-own situation:

  • The tenant shares responsibility for property upkeep. Normally, as a landlord, you would be responsible for any necessary repairs, including scenarios like an unexpected breakdown of the refrigerator that needs urgent attention. With shared equity, however, tenants have their own interest in keeping the property in shape, whether they exercise their purchasing option or agree to sell the property with you. The tenant has become tenant-owner, and they should be expected to provide most of the day-to-day repair work, like lawn care. So, you won’t be getting calls in the middle of the night about urgent repairs! In addition, they are less likely to cause damage to floors, walls, or other parts of the property because increasing the property’s value is now their goal as well as yours.
  • You don’t have to worry about vacancies, which cost you money. Aside from the lost influx of money, you’re also out the money and time spent finding a new tenant and preparing the property for them. If vacancy goes on for several months or more, it’s going to cost you a lot, but a rent-to-own situation ensures that your tenant is in for the long-haul. They’re not likely to just give up their share of the equity in a home they live in.
  • You have no management fees. Management fees are an optional expense, but for many landlords it becomes necessary, especially if you have another job or business. Typically, management companies are hired to take care of things like property inspection, advertising for tenants, and providing or scheduling repairs. With your tenant-owner, none of this is necessary. You have a long-term renter who will more than likely take good care of the property themselves.
  • You tenant has more reason to make their payments on time every month. In a shared equity situation, your tenant is paying towards an end-goal, whether it’s to own the property in entirety or to own their share of the equity at the time of sale. This means that for the duration of the agreement, you know how much rent you will receive and for how long. You also know the possible scenarios for when the rental term comes to an end. Basically, you have a much better idea of your financial outcome than most landlords do.

Your Tax Situation

But, what about the taxes? Here’s something you don’t hear very often. Tax law regarding shared equity is very straightforward. In fact, for the more than 30 years it’s been on the books, there’s only one private letter ruling to use as an example (PLR 8410038). In this ruling, the landlord made a 20 percent down payment and took half the mortgage; the tenant took the other half. At the end of five years, their agreement allowed for the tenant to buy out the landlord by 1) reimbursing the down payment and 2) paying 50 percent of what the equity increased by since the beginning of the agreement to the landlord. During those five years, the tenant paid the landlord both a rental fee and 50 percent of the mortgage.

The sharing of expenses is, likewise, straightforward and laid out in tax law. Any tax benefits must be divided according to ownership interest. In the above case, both the landlord and the tenant-owner would receive 50 percent of the tax benefits.[2] In addition, for most shared equity situations, the relationship between parties is considered tenants-in-common. That means you’ll have to follow state tax laws, which typically require expenses such as repairs, taxes, and interest to also be divided according to ownership interest. Since your tenant will likely be completing repairs, they do have the right to request reimbursement from you for half the cost. Regardless of whether they pay 50 percent or 100 percent, the tenant only gets tax benefits for their vested interest (as do you).[3] Of course, you’ll want to check your particular state’s tax laws in this area.

Pay attention to how you agree to divide expenses in your equity-share agreement. In one court case, the landlord owned 50 percent of the equity but paid 100 percent of mortgage interest and property taxes on two properties.[4] It didn’t matter how much he paid; he could only deduct 50 percent from his taxes. Just because each party pays 50 percent of the mortgage doesn’t necessarily mean your ownership percentage is 50 percent each. Other factors, such as down payment, can come into play. Always check with an attorney when signing an equity-share agreement.

Calculating the Rent

Tax law also specifies that you and your tenant will need to come to a rental agreement based upon “fair market rent”.[5] All of this planning in advance should make you one happy landlord. You’re getting a written guarantee of how much cash you’ll be receiving for years to come.

As you know, any situation that deals with tax law requires proper documentation. So, be sure to keep a file with all the necessary information. One thing you will need to provide is evidence that your rent price is fair. Some ways to do this are to clip ads for other rentals in the area, print online ads for your area, get a written opinion from a consultant or rental management company, or get information from nearby tenants on what they pay for rent (including their names).

You’ll probably do some of this research anyway in order to come to your determination. The key is to hang on to your research documents. Research you performed but didn’t document don’t count for anything with the IRS, and as landlord, you bear the burden of evidence.

Following the Rules

Once you’ve found the perfect tenant-partner, you’ll want to follow three rules in order to comply with tax law.

  1. The equity-share arrangement must be detailed in a written agreement.[6] This document must include details regarding ownership of the residence by two or more people; agreement that one of the parties must occupy the dwelling as their primary residence; and, agreement to rent payment.
  2. The relationship must be one of joint ownership. According to tax law, both parties will own the property even after the rental period ends. The tax law technically stipulates a period of 50 years of ownership, but what you really need to know is that you both must, in fact, own the property.[7]
  3. Tax benefits are earned according to ownership. As stated above, you can only claim benefits for your share of ownership in the property.

Before entering a shared equity situation, plan accordingly. You’ll want to choose someone trustworthy to enter into a long-term ownership with. Hire a real estate attorney to help make sure you consider all the possible scenarios, and get everything in writing. And, always, always keep your records. If you do rent-to-own right, you can make renting your property both easier and more profitable.

  1. IRC Section 280A(d)(3)(C)(ii)(I).
  2. Prop. Reg. Sections 1.280A-1(e)(5)(iii)(B)(3); 1.280A-1(e)(5)(iii)(C) Example.
  3. Estate of Boyd v. Commr., 28 T.C. 564 (1957).
  4. Joseph J. James v Commr., TC Memo 1995-562.
  5. IRC Section 280A(d)(3)(B)(ii).
  6. IRC Section 280A(d)(3)(C).
  7. IRC Section 280A(d)(3)(D).

Why You May Want to Consider Antiques as Business Assets

It’s already well-known that antiques can make a wonderful personal asset for collectors. If you know how to choose the right pieces, you can see a nice return on investment from quality antiques. But, have you ever thought of doing the same with your business? Let’s put it this way, if you could choose between two desks for your office, both for the same price, do you go with the regular desk or the antique?

In many cases, the antique could be a better choice. Thanks to newer tax laws, antiques are now assets under Section 179, just like any other standard business equipment. That means you’ll get the same business tax deductions regardless of which desk you choose. So, why opt for the antique? For the same reason you might buy an antique for a personal collection. A regular desk will likely depreciate over the years, but the antique is a money-maker, likely to increase in value. The final difference could be thousands of extra dollars for your business.

Antiques as Smart Choices

Let’s put together an example so you can see just how the numbers work. Both desks cost $5,000 to purchase. In 10 years, the antique desk would be worth $15,000 and the regular desk would be worth $500. For the sake of this example, we’ll say you’re in the 35% income tax bracket and 15% capital gain bracket when you sell the piece of furniture. Here’s what your federal taxes would be on the antique:

  • 15% of the $10,000 in capital gain equals $1,500
  • 35% of the $5,000 in depreciation recapture equals $1,750

That means you’ll keep $11,750 after taxes from the sale of your antique desk. Compare that to only $325 from the sale of the regular desk ($500 from the sale minus 35% in recapture taxes). You can see how choosing antiques for multiple items in your office can quickly increase your business’s gains!

What kind of items could be purchased as antiques?

  • Conference tables
  • Desks
  • Rugs
  • Business car
  • Cabinets
  • Clocks
  • Paperweights
  • Bookcases
  • Coatracks
  • Umbrella stands
  • Chairs

Think of the possibilities! Any antique that functions just as well as a new purchase is a great investment. It could increase in value, and thus increase your net worth. Just don’t try to buy an antique computer!

Many business owners don’t even consider antiques when purchasing equipment. But, why not? When you choose antiques, you usually get a quality piece of furniture that looks beautiful in your office. They still count as depreciable Section 179 assets. And, they could increase in value. Even if a particular antique choice doesn’t increase its value significantly, you’ve lost nothing (as long as you pay reasonable prices).

Cases Regarding Antiques as Business Assets

Several previous court cases have held up the ability to count antiques as business assets. In particular, Liddle[1] and Simon[2] allowed these two professional musicians to depreciate antique and collector violins as business assets. These musicians used the violins in their role with the Philadelphia Orchestra.

The instruments involved in the case were already 300 years old when purchased. They were bought for $30,000 and had increased in value to $60,000 in less than 10 years when the musicians had depreciated them to zero. Regarding this case, the court noted that the Economic Recovery Tax Act of 1981 (ERTA) had changed the rules for depreciation. Prior to ERTA, antiques could not be depreciated in a business, no matter how often they were used for business purposes.

The cases went through the Tax Court, the Second Circuit Court of Appeals, and the Third Circuit Court of Appeals. Thanks to the decisions made in these courts, the musicians (and you) may now depreciate antiques and count them as a Section 179 expense. ERTA set the path for this by changing the useful-life rules to statutory depreciation periods. So, what does all this mean for you? It means you qualify for tax-favored expensing and depreciation when:

  • During the normal course of business, you actually use the antiques (they are not decorative).
  • The antiques are subject to the same wear and tear that any other business asset would be.

Interestingly, the IRS did not agree with the decisions of the courts in the cases of Liddle and Simon. In 1996, they formally issued a non-acquiescence and stated that in the seven other circuits they would go after taxpayers who tried to depreciated antiques.[3] However, to date they have never done this.

The circuit for the above cases covers the areas of Vermont, Connecticut, New York, New Jersey, Pennsylvania, Delaware, and the Virgin Islands. This means that if you work in one of those areas, the IRS cannot attack your antique depreciation because the courts have already made their decisions regarding that circuit.

Further, it is unlikely that the IRS will actually go after you for business antique depreciation no matter where you live. That’s because courts can order the IRS to pay attorney’s fees for bringing a case that is “not substantially justified.” Per IRS Publication 556, that means:[4]

  • The IRS didn’t follow its own published guidance, such as announcements, private letter rulings, revenue rulings, and regulations.
  • The IRS has taken on substantially similar cases in another circuit’s courts of appeal and lost.

Therefore, even if you live outside the Second and Third Circuits, you are unlikely to be hassled by the IRS about depreciation of antiques. Bringing a similar case in other circuits could obligate the IRS to pay attorney fees, and the IRS has not tried since the time of these cases.

When Preparing Your Taxes

Just remember to follow certain rules established during Liddle and Simon. Artwork does not count as a depreciable business asset, as found in the Noyce case.[5] Any antique furniture or equipment you plan to depreciate on your taxes must be physically used as a part of your business and subjected to the wear and tear of ordinary office equipment.

It turns out you actually get a better deal on taxes than the antique dealer who sells you the piece. A dealer gets to deduct the antique’s cost as a cost of sale, but he pays both self-employment taxes and regular income taxes on the profit. A business owner, on the other hand, deducts the cost at the time of purchase with Section 179 expensing rather than having to wait for the sale. Also, because the item is counted as a business asset, when you do sell it the amount of profit that exceeds the purchase price is a Section 1231 gain, which is a tax-favored capital gain as long as you used the antique in your business for more than one year (assuming you have no offset from Section 1231 losses).

All of this sounds pretty good so far, right? Well, here’s some even better news. If you’re kicking yourself for having antiques that you have not deducted in your business because you weren’t aware of the rules, you can claim those benefits on this year’s tax return. You just claim the depreciation retroactively with a Form 3115.

For business antiques you buy this year, you can expense up to $125,000 of qualifying purchases. You get immediate deductions for this. Down the road, when you sell the items, you’ll get tax-favored capital gains benefits on the amount of appreciation. All in all, you come out way ahead, even with the price of recapture taxes on the depreciation. After all, a regular piece of office equipment is worth much less when you’re ready to sell it. It’s clear that antiques are a good financial choice when you need to select furniture or equipment for practical use in your business.

  1. Brian P. Liddle v Commr., No. 94 7733, 76 AFTR2d &95 5327, 3d Cir, September 8, 1995, aff’g 103 T.C. 285, 94 TNT 165 8 (1994).
  2. Richard L. Simon v Commr., No. 94 4237; 76 AFTR2d &95 5496; 95 2, 2nd Cir., October 13, 1995, aff’g 103 T.C. 247, 94 TNT 165 7(1994).
  3. AOD 1996 009, July 15, 1996.
  4. IRS Pub. 556, Examination of Returns, Appeal Rights, and Claims for Refund (Rev. August 2005), p. 10.
  5. Noyce v Commr, 97 T.C. 689.

Increase Deductions on Your Vacation Home with a Hidden Tax Technique

Usually, when you want to research which tax deductions are available to you, you go to the IRS’s publications and tax regulations documents. The IRS can even be pretty helpful at times by letting you know exactly what you need to do in order to get your deductions. However, the technique in this article won’t be found in any of the typical tax literature. In fact, you’d only find it if you’ve been reading up on old court cases or tax treatises.

The Precedent

So, how does this tax tactic help you if it’s not approved in IRS documents? Aside from the typical sources for supporting your deduction strategies, you can also use tax court precedents. In 1981, Dorance and Helen Bolton found their money trapped behind vacation home deduction limits, but they decided to get creative and find a way around those limits.

Because they set this precedent, you can legally use the same technique today, even though the IRS doesn’t publicize it for everyone’s use. In fact, the IRS’s calculation methods for vacation homes are much more stringent. Nevertheless, the IRS is required to allow the method used by the Boltons because the tax court has ruled it a legal tax strategy.

How this Money-Saving Strategy Works

Do you have a second home, a ski cabin or beach house for example, that you both rent out and use for your personal use? If so, you’ve probably found that the vacation home rules cap the deductions allowed for rental expenses.[1] Additionally, for properties that qualify as a “residence” those rules are at their most stringent. Your property is considered a residence for tax purposes if you take advantage of its personal use for the greater of the following two time periods:[2]

  • More than 14 days in a year, or
  • More than 10 percent of the days you rent it at fair rental price during the year.

You see, when your home qualifies as a residence, you have to split your deductions between residence and rental property, and that creates two primary disadvantages for you: 1) your rental expenses are limited to your rental income, and 2) part of your mortgage interest and property tax deductions are considered rental expenses, which—because of the limit in #1—reduces the amount of other rental expenses you are able to deduct.

Now, here’s what the Boltons did to mitigate these disadvantages. They were able to come up with a way to decrease the amount of mortgage interest and property taxes that counted as rental expenses. Let’s take a look at how their method differs from that of the IRS:

  • IRS MethodCount the property’s total use. That means of your tenants rent the property for 75 days and you personally use it for 25, you divide the rental use days by the total number of days, 100. The use percentages divide up as 75 percent rental and 25 percent personal. Assuming your mortgage interest and property taxes come to $10,000, you must count $7,500 (i.e. 75 percent of $10,000) towards the rental expense limit.
  • Bolton MethodDetermine percentages for the entire year, not just for days of use. With this calculation, you take that same 75 days of rental use and divide it by 365 days, giving you only 21 percent rental use for the year. Again, given $10,000 in mortgage interest and property taxes, you now take 21 percent of that, getting a rental expense total of only $2,100. The Bolton method leaves you with an additional $5,400 of rental expenses that can be deducted.

To see how the numbers work out after deductions, here’s the Boltons’ case:[3]

  • 91 days of rental use
  • 30 days of personal use
  • 244 unoccupied days
  • $2,700 in gross rental income
  • $3,475 in expenses for mortgage interest and property taxes
  • $2,693 in expenses for rental property maintenance

The Boltons were able to claim an additional $1,738 in deductions. Adjusting for today’s dollars, you can save substantially more than that. This case has been on the books for more than 30 years and remains seldom-used, but the IRS is required by precedent tax law to allow it.[4] Now you know the secret, so start claiming your full rental deductions on your vacation home this year.

  1. IRC Section 280A(e).
  2. IRC Section 280A(c)(5) and (d)(1).
  3. Bolton v Commr., 77 TC 104, aff’d 694 F.2d 556 (9th Cir.).
  4. McKinney v Commr., 732 F.2d 414.

Getting the Most from Your Real Estate Options

Plenty of people will tell you that real estate options are a great way to make money. And, that can be true . . . if you have the right knowledge. By learning how to get the most from options on your real estate investments and rentals, you can increase your profits.

Stand-Alone Purchase Option

One category that can generate profit is the stand-alone purchase option. If you own a property, and someone would like the right to buy that property at a specific price and over a specific time period, this option allows you to receive cash from someone the day you authorize the option. Two things then may happen: 1) the buyer lets the option lapse, and you keep the cash and the property, or 2) the option is exercised, which means you sold your property (and often receive a selling-price bonus).

Here are some of the primary financial reasons people have for leasing their property with the option to buy:

  • Increase profits by fixing a higher rent price (typically applying some of this to the option amount).
  • Increase profits by requiring up-front cash for the option.
  • Protect your real estate by having a tenant who takes better care of the property (because it may eventually be theirs if they use the option).
  • Reduce costs by requiring the tenant to maintain the property and take responsibility for repair work.

Of course, if you are on the other side of the transaction and are buying the option, then you’ll want to arrange some kind of reward for yourself should you use the option. Often, people like to structure these options so that they get a better price on the property because they exercised the option (this is the most desirable outcome for the buyer).

Whether you’re buying or selling, options look pretty straightforward, but circumstances can complicate matters. Some options are structured to require that they be exercised. However, if you enter into such an option, it is viewed as a sales contract under tax law. If, for example, the rent for an option is so high that it forces a tenant to buy, tax law ignores the option, and your contract ends up as a sales contract as far as tax purposes are concerned. It turns out options are not as simple as they appear; varying scenarios can butt up against tax and legal obstacles.

In fact, even a lease without the option to buy can end up being viewed as a sale under tax law. How does this happen? If the tenant takes on the majority of rights, responsibilities, and enjoyment to the extent that they act as the owner of the property, the IRS ignores the lease.

Needless to say, it can come as quite a surprise when the IRS decides your lease is to be considered a sale. So, this article aims to provide some practical advice for securing your after-tax profits and navigating the additional rules associated with leases.

Keeping Control of Your Finances

Your after-tax financial results will depend upon how well you understand the rules regarding when a lease with an option to buy turns into a sale. The rules fall into three categories: 1) commercial real property, 2) personal property, and 3) a house or apartment used as the primary residence by the tenant.

By structuring your rent-to-own agreements so that they comply with tax law, you can avoid unpleasant legalities. These legal situations can result in additional consequences, such as negative articles on the front page of national newspapers, an attorney general investigation if you’re under Florida jurisdiction, or corrective legislation in a Texas jurisdiction.

Now that you have an idea of why you need to handle your options correctly, let’s look at a hypothetical scenario. You have a tenant who buys an option from you for $10,000 that allows her to buy your rental property for $300,000 at any point within the next 15 months. The tenant can do one of two things. She could exercise her option, in which case you treat the $10,000 as sales proceeds on the day the purchase option is used.[1] Or, she could choose not to use the purchase option, and you receive normal income from the $10,000 on the day the option lapses.[2]

Regardless of what your tenant decides, you get a good deal for several reasons:

  • You receive up-front payment for the option.
  • You can use the cash from purchase of the option on the day you receive it because it’s yours no matter which decision the tenant eventually makes.
  • You have no income taxes to pay for this money until the option lapses or is used.

As for your tenant, if she decides to exercise the option, the $10,000 acts as additional basis in the property for her. The lapse of the option depends on the nature of the property. If she intends to use it as a rental unit, the same rules apply that would apply to a loss on the sale of rental property.[3]

Given our hypothetical 15-month holding period, your tenant’s loss would be under Section 1231 (which applies only to long-term gains and losses). This is great for her because Section 1231 allows for:

  • Net section 1231 gains are tax-favored long-term capital gains, and
  • Net Section 1231 losses to be deducted as tax-favored ordinary losses.

However, if the tenant wanted to purchase the rental unit as a personal residence, she would not get the deduction for the option’s lapsing. That’s because a lapsed option for personal property generates a personal loss, which is not deductible.[4] So, options aren’t too difficult to figure out, but they can produce vastly different results under different circumstances.

Options that are Actually Conditional Sales

An option gives the purchaser the right to exercise a property purchase at terms and price that are determined at the start.[5] Some options, however, are actually masked sales. Obviously, any option that is exercised becomes a sale. But, if the option turns into a sale before it is exercised, then it is a sales contract rather than an option.

Here are a few examples that are not options:

  • Nonrefundable deposits—these do not specify terms for a continuing offer for a particular time period
  • High option prices that force the use of the option—the force makes it a sale from its beginning
  • Incidents of ownership and actions that convey possession imply a sale

You may have noticed that some of these are judged by the particular circumstances. For instance, what is considered a price that’s high enough to force a sale is somewhat subjective and depends upon the property and the parties involved. Because of this, issues of what is a sale or what is an option can be complicated. To add to the matter, an option that includes a lease gets even trickier.

In fact, sometimes the lease itself is considered a sale rather than a lease. That means you can really end up with results far different from what you intended when you combine a lease with an option, and either or both of them could end up actually being sales.

When it comes to taxes, a whole system of rules is in place to determine whether a lease is a lease or a sale. Here’s an example. Some public companies will use synthetic leases in order to make their profits look better to investors. These synthetic leases are reported as leases in their financial statements, but reported as purchases in their tax return. Because this strategy makes their profits look better, it increases the performance of the company’s stock. Because the tax return shows a purchase, the company can also depreciate the deductions.

Another example of a lease that’s considered a sale on taxes is a dealer’s rent-to-own program. One such contract’s status as a sale was determined in IRS private letter ruling 9338002. The IRS’s reasoning is that the lease-with-option-to-buy compels customers to make each of the monthly payments so they can own the item. Additionally, payments in such cases are usually high enough that customers pay market value for the item early on, at which point it makes no sense for them not to continue paying until they own the item. In fact, the IRS ruling states that such contracts produce substantially more revenue than if customers bought the item outright.

According to the IRS, the dealer does not have a true lease for tax purposes because:

  • The customer is effectively required to make a purchase by agreeing to the contract,
  • The rental payments end up far exceeding the amount necessary to transfer the title, and
  • The option price is zero, which contributes nothing towards the item’s fair value when the option is exercised (completion of payments).

The same set of criteria are used when judging real property leases.[6] First of all, the IRS defines three parties in a leveraged lease—the lessor, the lessee, and the lender to the lessor. The IRS will look at the following criteria to determine whether a lease is really a lease:[7]

  • The landlord (lessor) is at least 20 percent invested in the property;
  • The renter (lessee) cannot purchase the property for less than fair market value when the option is used; and
  • The lessee cannot have paid for property modifications, improvements, or additions.

Sometimes these criteria are out of your control. For example, it’s possible that after agreeing to an option, your property dramatically increases in value. That means that when the option is exercised, it will no longer reflect the fair market value, and does not meet the second criterion above. You should also watch out for vacation home tax rules, which you can run into when renting out a property, and are quite different from the tax laws for options.[8]

The purpose of setting up a lease with the option to buy is for you, as the current property owner, to make more money and ensure that your real estate is well care for by the tenant. In order to gain the financial benefits, you’ll need to understand the tax laws surrounding options. So, for your convenience, here’s a bit of advice for meeting the six standards in Revenue Ruling 55-540 and those in Revenue Procedure 2001-28:

  • Don’t apply the tenant’s rent to lessee equity.
  • Don’t give the property title to the lessee in exchange for a certain amount of rents or payments made.
  • If the option is relatively short, don’t make the payments a large portion of the total price to be paid.
  • Don’t allow rent prices to exceed fair market value substantially.
  • Don’t put add an interest equivalent to the rent due.
  • Have at least 20 percent invested in the property.
  • Require the option exercise price to be at least fair market value.
  • Don’t allow the lessee to make property modifications, improvements, or additions.

Take the right precautions, and you’re more likely for an IRS judgment to go the way you planned.

  1. IRC Section 1234(a)(1).
  2. Reg. Section 1.1234-1(b).
  3. Reg. Section 1.1234-1(a)(1).
  4. Reg. Sections 1.1234-1(f); 1.1234-1(g) Example (2).
  5. Black’s Law Dictionary, sixth edition, p. 1094.
  6. Revenue Ruling 55-540
  7. Revenue procedure 2001-28
  8. IRC Section 280A(d)(2).

Considering a Historic Building for Your Business? These Tax Credits are Good News

Historic buildings make a beautiful location for doing business. Unfortunately, many of them may seem out of the price range of small business owners. But, that’s not necessarily the case. The state and federal governments have an interest in preserving these properties, and they are willing to give you tax credits for buying and restoring a historic building. The credits reimburse a large proportion of your restoration costs.

This really is a great incentive to go for a building that will give your company a unique and professional feel. You see, unlike deductions, tax credits reduce your taxes dollar-for-dollar. For example, when you spend $20,000 and get a 50 percent tax credit, you save $10,000 on your tax bill. It’s that simple. It depends which state you live in, but tax credits could save you up to 70 percent on the restoration costs, making a historic building a much more reasonable option.

Federal and State Credits

You have two separate tax credit options available to you from the federal government.[1] The first is a 20 percent credit for rehabilitating an income-producing building that has been deemed a certified historic structure by the Secretary of Interior, through the National Park Service. The other is for rehabilitating non-historic buildings that were put into service prior to 1936, and the credit is for 10 percent of the rehab cost.

You can also get an additional credit from most states, and it’s perfectly legal to take advantage of both the state and federal credits. Tax credits at the state level can be anywhere from 0 to 50 percent. You can check the laws for your state at the National Trust for Historic Preservation . If you’re fortunate enough to live in a state that provides a 50 percent credit, you’ll get up to 70 percent off the rehab costs when combined with the federal credit.

Other Credits

A few other credits also exist that may help you with the purchase of a building. Here a few you might consider:

  • If you’re buying in a low-income area, you could qualify for the new markets tax credit for loans and investments in such locales.[2]
  • The low-income housing tax credit is available for real estate investments in affordable housing.[3]
  • Another option is available that is not a credit but is still a good option to keep in mind regarding your business property. You can donate your historic building to a qualified 501(c)(3) organization.

Making Sure You Qualify

In order to get the tax credits for your historic building, you must use it for the purpose of producing income. Some qualifying examples include:

  • Apartments
  • Single-family rentals
  • Industrial buildings
  • Commercial buildings
  • Agricultural buildings

Although some forms of residential real estate are included in the list, you may not claim the historic tax credit for your personal home. However, if you own a property that you use for both your home and an office space or rental unit, it’s possible for you to qualify on just the part of the building you don’t use for your residence.

Important tip: If you don’t plan on keeping the property for more than five years, you will have to repay some of the federal tax credit at the time of sale. This is because the federal government has a five year recapture period for this purpose. On the other hand, if you do keep the property for more than five years, you don’t pay any recapture and benefit from 100 percent of the building’s increased value.[4]

You’ll also need to check the recapture rules for your state, which are separate from the federal recapture period.

Additional Guidance

Now know just how substantial the available historic tax credits are, but you’ll also need some advice on how to get the whole process started:

  1. Use the National Park Service website to search for historic places.
  2. Find contact information for the historic preservation office in your state. They’ll be able to help you with state-specific information throughout the process.
  3. Look for an architect with experience in historic preservation. This is not only important to maintaining your building, but also to your taxes. That’s because the Secretary of Interior has to certify your historic restoration as authentic.[5] Here are some of the regulations:[6]
  • Justification for window removal
  • Justification for alterations to the storefront
  • Ensuring that replacement sash matches with the original size, color, trim details, pane configuration, and reflective qualities (you can see that the requirements are pretty specific)
  1. Make sure you know the specifics for the tax credits available to you in your area. Before you make a purchase, you should consult your tax advisor and the state preservation office.
  2. This should go without saying, but just so we’re clear, be certain that you will make a profit. Calculate the numbers with the after-tax adjusted rate-of-return formula. This is also called the managed internal rate of return (MIRR).

What Do the Credits Cover?

Basically, any costs that are part of renovation, restoration, rehab, or reconstruction of a historic building qualify for tax credits, and a variety of business structures are eligible, including S corporations, partnerships, personal service corporations, closely held corporations, and individuals. The lessee of a historic building also qualifies for credits on the expenses for renovating or rehabilitating a qualifying building. Expenses that do not qualify include:

  • Costs for acquiring the building[7]
  • The price of the land or other features like sidewalks, landscaping, or parking lots[8]
  • New construction[9]
  • Personal property[10]
  • Expanding the volume of the building[11]

There is a caveat that could prevent you from gaining the full benefit of these tax credits if you’re a high income earner—the AMT (alternative minimum tax). The AMT is calculated separately from your regular taxes and works to eliminate some of the deductions you would normally be entitled to. At tax return time, you’ll pay either the AMT or regular taxes, whichever is higher.

Because the highest earners often have the most deductions, the AMT was created as a way to cap that lost tax revenue. You can’t use the historic renovation credit if you’re paying the AMT in a particular year, but you may carry the denied credits back one year and forward 20 years.[12] Just keep track of your credits and rehab expenses, and don’t forget to claim the benefit in a year when you don’t pay the AMT.

It’s important to make sure you check all the details with your tax advisor and document your strategy. If you’re going to go to the work and expense of renovating a historic building for your business, you want to make sure you get the tax advantage you’re expecting. Otherwise, you can find your business with a heavy and unexpected financial burden. With the right plan in place, a renovated building can establish your business as being committed to the local community, its culture, and its history.

  1. IRC Section 47.
  2. IRC Section 45B.
  3. IRC Section 42.
  4. IRC Section 50(a).
  5. IRC Section 47(c)(2)(C).
  6. Federal Taxes Affecting Real Estate (6th Edition), Thom V. Glynn, Esq., Release No. 33, May 2005, Section 5.03[4][b].
  7. Reg. Section 1.48-12(c)(9).
  8. Reg. Section 1.48-12(c)(5).
  9. Reg. Section 1.48-12(b)(2)(iv).
  10. IRC Section 47(c)(2).
  11. Reg. Section 1.48-12(c)(10).
  12. Tax Aspects of Historic Preservation, Mark Primoli, IRS, October 2000, p. 11.

How to Reduce Your Taxes with a Win-Win IRA Strategy

You know the deal with a traditional IRA. You put your tax-deferred money in and breathe a sigh that you didn’t pay taxes on that income. However, looming over your shoulder is the knowledge that eventually, you will pay big for the withdrawal of those funds. Is there anything you can do to minimize the impact?

Yes. The best thing to do is not to put off planning your IRA tax strategy and do something now to reduce your future tax burden. Instead, start paying something now. Why? You should do this because certain years are better than others for paying extra tax. You see, certain circumstances allow you to have additional taxable income but not actually pay any more in taxes. Here are some scenarios:

  • You can offset your income with losses;
  • You fall into a lower tax bracket than usual this year because of less income from other sources;
  • The current year’s tax rates are lower overall; or
  • Some of your investments lose value, such as in a downturn in the stock market.

You may think it would be hard to know when these scenarios will pop up. Fortunately, tax law itself gives you some assistance in making the most of these opportunities.

Switching between Traditional and Roth IRAs

As mentioned above, both your contributions and earnings are taxed when you withdraw cash from your IRA. Make those withdrawals when you’re in a high tax bracket, and you could be eating up your retirement savings pretty quickly. This is especially applicable if you choose to continue working after you reach retirement age. Your work income makes it more likely that you’ll be in a higher bracket. Additionally, once you reach 70 ½ you’re required to take mandatory distributions from your traditional IRA.

Unlike a traditional IRA, you pay taxes up-front with a Roth IRA. Because of this, you can convert from traditional to Roth in order to pay taxes at the most opportune time for you. Here’s the basic information you need:

  • When you convert to the Roth IRA, you will pay taxes, so make the conversion in a year when you plan to have a lower tax bill.
  • After converting, your earnings will continue to accrue and compound tax-free within the Roth IRA.
  • You can undo the conversion (or just a part of the conversion) up until October 15 of the next year, allowing you to make a strategy for how much tax to pay in that year.
  • Since you’ve already paid taxes upon conversion to the Roth IRA, you can withdraw money from it without paying any taxes again, as long as you’re at least 59 ½. This includes on the earnings you make. You will have to wait five years from your first Roth IRA contribution (for any Roth IRA in your name) to take advantage of this.[1]

So, let’s say you expect to claim a $20,000 loss on your federal income tax return this year. From your traditional IRA, you transfer $20,000 to a Roth IRA. What happens next? First, you get a tax deduction for the amount you put into the traditional IRA. Then, you pay no taxes on the transfer to a Roth IRA. Finally, once you’re 59 ½ you pay no taxes when you withdraw the money from the Roth account (again, as long as it’s been at least five years since your first ever Roth contribution).

Now, here’s the part that really reduces your risk from this strategy. You are allowed to undo the Roth conversion![2] For instance, you may have transferred funds from a traditional IRA to a Roth account because your business had been slow and you expected a low tax year (the perfect time to pay IRA taxes). However, after the conversion, it’s possible that your business takes off and your income increases.

In this case, the increased income could put you in a higher tax bracket and make it less beneficial to pay those taxes now. No problem. The IRS will allow you to undo the conversion. They also call this “recharacterizing” the conversion. Simply put, it’s like you never transferred funds to a Roth IRA in the first place. If you find yourself in this situation, just make sure you keep an eye on deadlines—you have until your next tax return is due to undo the change.

Hint: You can give yourself some time to decide whether you need to recharacterize the conversion by applying for a filing extension on your tax return. You’ll then have until October 15. Just as you can undo a conversion, you can also redo it when the time is right, but you’ll have to wait until the later of 1) 30 days after the initial recharacterization or 2) the start of the next year after conversion.[3]

Other Factors to Consider

There is another reason, aside from increased income, why you may want to undo an IRA conversion. You could experience a decline in value for your investments after you make the transfer. If you convert $50,000 from your traditional IRA to a Roth IRA, and the investments drop in value to $30,000, you’ll end up paying higher taxes than if you’d converted after the drop in value. You pay $16,500 for the larger transfer, whereas you would have only paid $9,900 for transferring the smaller amount.[4]

If your investment value drops, why would you want to be stuck with thousands of dollars more in taxes? Instead, you just recharacterize the conversion and save that extra $6,600, waiting to convert the $30,000 back to a Roth IRA once the wait period is up.

As if this strategy isn’t advantageous enough, there’s actually something else you can do to maximize your tax benefit. Do you have multiple investments in your traditional IRA? If so, it would be a smart move to convert those investments separately into their own Roth IRA.

Keeping in mind the example above about declining investments, consider the following scenario. You have a Roth IRA in which you converted two different investments. The value of one increases at the same time that the other’s value decreases. Now, you have to decide whether to undo the conversion, but both investments are tied together (i.e. you cannot undo only one). Don’t get yourself into that frustrating situation!

Instead, transfer each investment into its own separate Roth IRA. Now, when the investments perform differently, you can choose which conversion to recharacterize, giving you more control over your tax strategy.[5] Once the conversions are complete and taxes are paid, you can later consolidate the two accounts, making them easier to maintain.

Although it takes a little more careful observation on your part, you can really maximize your retirement savings by planning the best years to pay taxes on your IRA. Many people debate whether the traditional or Roth account is better (although if you only stick with one, the results are a gamble). The truth is you don’t have to gamble with how much you pay in taxes. You can, and should, decide when you are ready to pay the taxes on your retirement account.

  1. IRC 408A(d)(2).
  2. IRC Section 408A(d)(6) and (7); Reg. Section 1.408A-5(Q&A-1).
  3. IRS FAQ Regarding IRA Recharacterizations.
  4. Given a 33 percent tax rate.
  5. Reg. Section 1.408A-5(Q&A-2).

Selling and Repurchasing Stock the Right Way

There’s a big difference between the interest you earn on your bank account and that earned from your stock investments. Specifically, you have to pay taxes every year on the interest from your bank account, but tax law allows you to wait until a “taxable event” (like when you sell it, for instance) to pay taxes on your stock gains. This is a huge advantage, and may allow you to save a ton on capital gains taxes if you use your advantage right.

How Low Can You Go?

It’s up to you to determine when you’ll pay taxes on your stock gains, so make the most of it! When is the best time to pay taxes? The best time is when they’re the lowest, of course. And, capital gains taxes can go all the way down to zero percent.

You can be one of those people who qualifies for the zero percent tax bracket on capital gains. This advice will guide you through the process. Would you like to know something even better? You won’t even have to permanently dispose of your stock to do this; you can keep right on earning from it.

Understanding the Rules for Stock Sold at a Gain

All right, so you want to avoid high capital gains taxes, and you’re thinking about selling and repurchasing your stock to accomplish that goal. But wait, won’t that be a wash sales transaction that’s disallowed by tax law?

It’s not! For any stock that you sell at a gain, the wash sales tax rules don’t apply.[1] It is perfectly legal (and smart) for you to sell stock that has appreciated and repurchase it right away.

Let’s take a look at how that works. For our example, you purchased $1,000 worth of stock several years ago that is now worth $10,000. You also notice that you are currently in the zero percent tax bracket for capital gains. You sell the stock for its current value ($10,000) and turn around and re-purchase it for the same price. Under tax law, this is a taxable event. You may now pay taxes at the zero percent rate (i.e. you pay no taxes).

Had you been in a higher tax bracket, you would have paid taxes on $9,000 (the gains you made from selling a $10,000 stock bought at $1,000). By doing this, you not only pay no taxes, but you have also re-established your stock’s basis as $10,000, meaning if you have to pay taxes in the future, it will be on subsequent gains. You have permanently banished taxes on that $9,000 in gains! (And, if your stock value decreases in the future, you can sell for a tax loss.)

Which Bracket Do You Fit In?

Okay, so you’d probably like to know whether you fit into this magical zero percent tax bracket. The brackets for capital gains (long-term) range from 0 to 20 percent.[2] In 2014, the zero percent bracket applies to these levels:

  • Single filers with taxable income from $0 to $36,900 and
  • Joint filers with taxable income from $0 to $73,800.

Taxable income is the dollar number you get after taking certain deductions that are available to all. You can also figure the numbers using adjusted gross income (AGI):

  • Single filers with AGI from $0 to $47,050[3] and
  • Joint filers with AGI from $0 to $94,100.[4]

Important note: To qualify for capital gains rates, you must hold the stock for a minimum of one year before selling it. If you don’t, you’ll be paying taxes at the much higher ordinary income rates. It’s a good idea to play it safe. If you buy stock on July 31 of this year, hold onto it at least until August 1 next year. Don’t get in a rush. Make sure you’ve owned that stock for a year before selling—remember, investments are long-term.

By planning your stock sales correctly, you can save thousands of dollars in taxes over the years. You don’t have to sell all of your stock shares at once, by the way. Just calculate the amount of gain you can safely recognize without paying taxes, and only sell that amount. Tax law allows you this benefit, so take advantage of it by selling intelligently.

  1. IRC Section 1091.
  2. Rev. Proc. 2013-35.
  3. $36,900 + $3,950 (exemption) + $6,200 (standard deduction) = $47,050.
  4. $73,800 + $7,900 (exemption) + $12,400 (standard deduction) = $94,100.