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Archive for Tax Planning

Personal Property or Rental Property: How to Get the Most Savings from Your Vacation Home

By Kim M. Larsen EA CTFS
Saturday, February 28th, 2015

Your vacation home provides you with the benefits of relaxation and time away from the busy day-to-day responsibilities. But, if you play your cards right, it can also be a source of income and tax savings. After all, there’s no real reason to leave your vacation property sitting vacant when you’re not using it. And, this allows you to take advantage of the repair-day tax benefit.

IRS Rules Regarding Rental Property

You won’t be surprised to know that the IRS has a few rules about treating your vacation home as rental property. You see, just because you rent out the property doesn’t necessarily mean that it qualifies as a rental. It’s all about how the numbers play out. When your vacation home is used for both personal use and as a rental property, tax law still classifies your home as personal property if you use the home for personal purposes more than 1) 14 days, or 2) 10 percent of the number of days it was rented out (at a fair market price) to someone unrelated to you, whichever is greater.[1]

Here’s an example of how such a situation may play out:

Non-family members rent your vacation home for 180 days of the year. You personally stay in the home for 17 days out of the year. This gives you 90.6 percent rental use and 9.4 percent personal use. Regarding taxes, you’ll simply treat 90.6 percent of the property as rental property and the remaining percentage as a personal home.[2]

Figuring in Repairs

So, you’ve counted the rental days and the days of personal use. But, are any days used for something else? Certainly! If you’re renting out your property, you’re more than likely taking some days to make repairs. For tax purposes, the repair day counts in neither the personal nor the rental days. It’s a non-use day.[3]

In fact, as long as you spend the majority of any particular day making repairs, it counts as a repair day regardless of anything else that you or anyone else is doing on the property that day.[4]

To this IRS, this means:

  • Any day for which your primary purpose lies in making repairs or providing maintenance to your vacation home, you are not considered to be using the home for personal purposes;[5] and
  • Any time that you make repairs or provide maintenance to your vacation home on a substantially full-time basis for any given day, it is not a personal day. (Now, the IRS does not state this, but according to the law, your repair day counts no matter what the rest of your family is doing during the time you are working on repairs.[6])

Those regulations sound pretty good, so how do they play out in actual situations? Well, before we explain that, let’s just make clear that IRS regulations are not the law. Lawmakers have already passed legislation regarding repair days, and the IRS regulations are partly based on those laws. Here are a couple of examples of what the IRS regulations would mean for your repair activities:

  1. Let’s say that you and your spouse drive out to your vacation home and arrive on a Thursday evening in order to spend Friday and Saturday making repairs for the upcoming rental season. You eat dinner at the vacation property, but don’t start on any work Thursday night. On Friday and Saturday, you spend 8 hours each day working on property repairs. Your spouse helps out with a few tasks, but does not spend the majority of the time working. You both leave a little before noon on Sunday.

Which days count as repair days? All of the days do—Thursday through Sunday.[7]

  1. As another example, you own a mountain in the cabins and rent it out throughout most of the year. For one week, you and your family stay at the cabin, and you spend 3 to 4 hours each day performing maintenance. The rest of the time is spent relaxing, hiking, and fishing. Per the above regulations, you spent substantially full-time working on the cabin, so your entire week is a repair week, not personal use. The relaxation and leisure activities make no difference.[8]

Note that in each of the examples based on IRS regulations, all the family members (you included) worked at least a little bit in both examples. Under the actual laws regarding these situations, that is not required. According to the law, your family does not have to participate in any repairs to your vacation home in order for you to claim those days as repair days.[9] The IRS may try to make these rules sound vague, but the law is clear—you are entitled to use your repair days when counting personal versus rental use.

  1. IRC Section 280A(d) ↑
  2. IRC Section 280A(e)(1) ↑
  3. Prop. Reg. Section 1.280A-1(c)(1) ↑
  4. IRC Section 280A(d)(2) ↑
  5. Prop. Reg. Section 1.280A-1(e)(6) ↑
  6. Robert J. Twohey, TC Memo 1993-547; IRC Section 280A(d)(2) ↑
  7. Prop. Reg. Section 1.280A-1(e)(7), Example 3 ↑
  8. Prop. Reg. Section 1.280A-1(e)(7), Example 4 ↑
  9. IRC Section 280A(d) ↑
Categories : Real Estate, Rental Properties, Tax Planning, Vacation Homes

Subdividing Your Land? Consider an S Corporation for Lower Taxes

By Kim M. Larsen EA CTFS
Saturday, February 28th, 2015

Did you know that Section 1237 allows individuals selling lots on subdivided land to get out of ordinary income taxes and pay at the lower capital gains rate? Well, if you’re classified as a real estate dealer (as are many who sell real estate on a regular basis), you can forget about it. You have $1 million in appreciation on your land? Yup, you’re paying taxes of up to 35 percent.

Capital gains rates, on the other hand, are capped at 15 percent. We’re talking possible tax savings of hundreds of thousands of dollars. Wouldn’t it be nice if you too could benefit from those reduced tax rates? With the right strategy, you can!

The Developer Entity

All you have to do is set up a developer entity to sell your land to. That entity then develops the land. And, how does this change your tax status? Well, it divides your income into two categories: 1) profits on subdividing, developing, and advertising the lots are ordinary income, and 2) the land sale is a capital gain.

Again assuming that the total appreciation for your land is $1 million, let’s say developing it makes you $500,000 in profit. With a separate developer entity, you pay $325,000 in taxes (15 percent times $1 million plus 35 percent times $500,000). But, if you did not set up the separate developer entity to purchase your land, you pay $525,000 in taxes (35 percent on the entire $1.5 million).

Tip: You only get the long-term capital gains tax rates if you were holding the land as an investment and owned it for more than a year.

Here’s what to do:

  1. Create an S Corporation—This is the developer. If you own the land, you can simply set up a single-owner S corporation. In the case of a partnership (including some LLCs), you and your partners will also create an S corporation, but you’ll divide the stock according to your ownership interests.
  2. Sell the Land to Your S Corporation—You’ll make this sale at fair market value. Use the installment payment method in order to pay the capital gains rate on your profits and the ordinary income rate on the interest paid to you by the S corporation. How you set up the loan terms is up to you. You may or may not want a down payment, or the interest may only apply to a certain period of the loan, for instance. Of course, you will be required to charge some interest.
  3. Develop the Property and Sell—Finally, your developer entity will prepare the lots for sale. All of the money it makes for subdividing, developing, and advertising is corporate income that passes to you and any other shareholders. Although you still have to pay your ordinary income tax rate on this money, you saved with the capital gains rates on the sale to your S corporation. Basically, the profits have been divided between you and your corporation. Notice the advantage here: you end up paying at the lower tax rate for your biggest profit and at the higher tax rate only for your smaller profit.

Why an S Corporation?

Technically, you could set up either an S or a C corporation as the developer entity for these purposes. However, you’re likely to face double taxation as a C corporation, and you won’t get the lower capital gains tax rates. So, usually that option doesn’t make a whole lot of sense.

What you definitely do not want to do is set up a controlled partnership (including controlled LLCs) as your developer entity. Per tax law, a partnership must treat the gains as ordinary income if the property it purchases will not be used as a capital asset.[1] For your purposes (selling the lots at a profit), the property is certainly not a capital asset for the developer entity. With a corporation, on the other hand, you avoid such rules because you are not selling the property for stock.[2]

How Does This Method Stand Up against Audits?

Whenever your business dealings involve transactions between two entities you have an interest in, the IRS will be watching you closely. If you do not take care of all the details, the IRS could ignore your little corporate developer entity structure and just go ahead and tax everything at your ordinary income rates.

What do you need to document?

  • The sale of your land to the S corporation
  • When using the installment method (promissory notes), evidence that the corporation pays on the principal and interest when its due and follows all loan terms[3]
  • That the formation of the corporation was separate from its purchase of the appreciated land (otherwise, the IRS could argue that the land was capital used in exchange for stocks—see Section 351[4])
  • A professional appraisal of the land and evidence that this is the price you charged the S corporation

In a nutshell, keep your business and personal finances separate—always. Do not confuse your S corporation with yourself as an individual. It is a separate entity, and as long as you treat it as such, you and the IRS will get along just fine.

  1. IRC Section 707(b)(2) ↑
  2. IRC 351(b) ↑
  3. See Jolana S. Bradshaw v. U.S., 50 AFTR 2d 82-5238, 82-2 USTC ↑
  4. IRC Section 351 ↑
Categories : Corporations, Land, Tax Planning

Rent Your Home to Your S Corporation and Get Double the Tax Benefits

By Kim M. Larsen EA CTFS
Saturday, February 28th, 2015

S corporations are one of those funny structures that make you wonder if you’re living in another dimension. The corporation is a separate entity from you, but tax benefits pass through the corporation to your advantage. For a sole owner of an S corporation, the lines between individual and company can sometimes become blurred, even in terms of tax law.

Generally, the IRS is very strict about your making sure you keep your personal finances separate from those of your S corporation. That’s why it seems unbelievable that you could rent your home to your own S corporation and receive a tax advantage from this situation. Doesn’t that cross the lines of personal and business interests? Unbelievable or not, if you play your hand right, you may very well be able to pull off this rental deduction situation.

14-Day Rule for Free-Rent

According to the free-rent rule, you cannot take personal residence deductions against rental income when you rent your home for less than 15 days, and the income for that 14-day or less period is not taxable.[1] Furthermore, in Roy, the court ruled that for tax-free rental cases using the 14-day rule, it is not necessary for the rent to be at fair market value (although you probably should document that it is anyway for your S corporation).[2] The free-rent rule is in IRC Section 280A(g), and it provides you with two distinct tax advantages:

  1. On the personal side, you don’t have to report the rent as taxable income, and
  2. On the corporate side, your company gets to deduct the amount it spent on rent.

According to Section 280A, the tax-free residence-rental rule takes precedence over the other provisions in Section 280A. That means this particular tax code is the key to defending the rental of your personal home tax strategy. However, you are going to come up on several obstacles to getting these benefits. Let’s see what they are and how you can get around them.

You can’t get a deduction for renting to your employer.[3] Section 280A(c)(6) states that an employee cannot take a deduction when renting to the employer. For your S corporation, you are the employee; you are the employer. Therefore, you cannot rent to yourself without breaking this rule, right?

Not so fast. When using the 14-day rule, you as an employee are not entitled to any deductions anyway. So, this problem isn’t really a problem at all! Whether you can get personal deductions or not, you still get rental income tax-free. Additionally, as stated above, the 14-day tax-free rent rule overrides this because it is also a provision in Section 280A.

You can’t take deductions for entertainment facilities.[4] All this really means is you need to be careful about how you have your S corporation rent your home. What will it be using the space for? If your company will be entertaining prospects or customers (including patients), then this puts the brakes on your plan. Although there are exceptions, you’re better off just not renting your home to your business for purposes of entertaining. If you absolutely must use your home for entertainment, limit to those situations that are exempt from the entertainment facility rules.[5][6]

You can’t deduct rental to a related-party.[7][8] It turns out this is another one that’s actually not an issue at all. It seems like renting from yourself would count, but that’s not exactly what’s happening here. Your corporation is renting from you, and as a separate entity, your corporation is not you, and it is not related to you (as in the way your family is related to you).[9] Additionally, the related-party rule prohibits deductions when the recipient does not have to include income “by reason of the method of accounting.”[10] But, that’s not the case here. The reason you don’t have to include the income is because tax law says you don’t have to.

You can’t deduct personal, family, or living expenses.[11] Every business owner should be aware that you cannot deduct these kinds of expenses. However, renting out your home to a third-party is not a personal or family use. Tax law already recognizes that some uses of the home, such as a home office, are not included in these categories.[12]

You have to prove an ordinary and necessary business expense.[13] Renting space for business meetings and/or the annual holiday party is unarguably an ordinary and necessary business expense. Every year, businesses deduct these expenses with no problems. On your corporation’s side, the business purpose of this rental expense is clear. Tip: Document your business use of the space, perhaps even taking photos of the activities.

The IRS could consider this a bogus rental with the substance-over-form doctrine.[14] If you follow the advice of avoiding entertainment facility rules, charging fair market value rent, ensuring that business activities actually take place, and documenting all of this, there’s really no reason for suspicion of fraud. After all, tax law itself allows you to take the rent tax-free, and it’s not an issue of substance-over-form for your corporation to deduct rent for business meetings or a space for holiday parties.

There you have it—all of the information you need to justify your personal tax-free rent income and a business expense deduction for your S corporation. As long as you know the rules and document properly, you can come out ahead with your taxes. Remember, paying taxes is about paying what you owe—no more and no less. So, if tax law allows you to avoid taxes or take deductions, it’s your right to do so.

  1. IRC Section 280A(g) ↑
  2. Leslie A. Roy v Commr., TC Memo 1998-125 ↑
  3. IRC Section 280A(c)(6) ↑
  4. IRC Section 274(a)(1)(B) ↑
  5. IRC Section 274(e)(4) ↑
  6. IRC Section 274(n)(2)(A) ↑
  7. IRC Section 280A(d)(2) ↑
  8. IRC Section 267(a)(2) ↑
  9. IRC Section 280A(d)(2)(A) ↑
  10. IRC Section 267(a)(2)(A) ↑
  11. IRC Section 262 ↑
  12. IRC Section 280A; Rev. Rul. 76-287 ↑
  13. IRC Section 162 ↑
  14. Gregory v Helvering, 293 U.S. 465, 14 AFTR 1191 (1935); Frank Lyon Co. v United States, 435 U.S. 561, 573, 41 AFTR 2d 78-1142 (1978) ↑
Categories : Corporations, Home, Real Estate, Rental Properties, Tax Planning

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

By Kim M. Larsen EA CTFS
Saturday, February 28th, 2015

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).

Advantages

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 ↑
Categories : Capital Gains, Installment Sales, Investments, Real Estate, Rental Properties, Tax Planning

Increase Your Tax Deductions—Switching from the IRS Mileage Rate to Actual Expenses

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

Do you feel like you’re not getting as much as you should from your business vehicle mileage deductions? For some business owners, gas and maintenance for a vehicle can be significant business expenses. If you’re not already using the actual expense method to calculate your mileage deduction, that may be your ticket to getting more from your vehicle expenses.

Usually, you’ll make a decision once regarding whether to use the IRS mileage rate for your deductions or to use the actual-expense method. If you choose the IRS mileage rate, you also lose out on MACRS depreciation.[1] However, you’re not locked into your choice forever. You have two different options for switching to claiming actual expenses.

Option 1: Amending Your Tax Return

If you realize fairly quickly that you’ve made the wrong decision in choosing to use the IRS mileage rate, you can act quickly and change your decision. That means you’ll have to file an amendment to your tax return before its original due date (if you filed extensions, the deadline includes the extensions).[2]

This option is fairly easy to enact. You’ll file the amendment, electing actual mileage expenses, Section 179 deductions, and MACRS depreciation. But, you have to act fast. This method essentially replaces the election on your original tax return.

Option 2: Straight-Line Depreciation

If you’ve already missed out on your chance to amend your return, you do have other options. You could still switch to the actual-expense method with MACRS depreciation, but you’ll have to get permission from the IRS commissioner . . . if you enjoy wasting time and money with the possibility of rejection.[3] Let’s be smart here; the commissioner is not a good option.

Instead, you can opt for straight-line depreciation for the remainder of your vehicle’s useful life.[4] This allows you to make the actual expense deductions. For calculating the straight-line depreciation, you’ll need the following information on your vehicle:[5]

  • Its Adjusted Basis—This is typically the original cost of the vehicle minus depreciation. When you use the IRS mileage rate, depreciation is included in it (22 cents per mile in 2014 and 24 cents per mile in 2015).[6] If you pay $30,000 for your car and drive it 5,000 miles for business (with no personal miles), you would calculate your depreciation at 5,000 miles x $0.22, which equals $1,100. Your adjusted basis is $28,900 ($30,000 – $1,100).
  • Its Estimated Remaining Useful Life—You don’t need to think too hard about this. It’s simply how long you expect to keep the vehicle.[7] We’ll call it 5 years for our example.
  • An Estimate of Its Salvage Value when the Useful Life Ends—To get a salvage value, you should use a respected pricing source, such as Kelly Blue Book. In our example, the value is what you estimate you could sell the vehicle for in 5 years (the remaining useful life). Let’s say this number is $4,000. Don’t forget to document where you get this number from!

Now, when you switch to actual mileage expenses, the IRS gives you a bonus on the salvage value if you plan to keep the vehicle for more than three years. Our example vehicle meets that requirement, which means you can reduce the salvage value by $3,000 (10 percent of the basis). If 10 percent of the basis exceeds the salvage value, that’s no problem. You’ll simply claim a salvage value of zero.

An Additional Consideration

When claiming actual expenses, you’ll have to pay attention to the luxury vehicle depreciation limits. These apply to passenger vehicles, and the limits differ between cars, vans, and trucks. You’ll need to find the amounts for the year you placed your vehicle in service.

For 2014 the limits for cars placed in service that year are:

The limits for vans and trucks are:

Note: These are amounts for used vehicles only. If your leased or purchased a new vehicle, use the tables in Rev. Proc. 2014-21 . Regardless of the type of vehicle or whether it is new or used, you must reduce the limit by your personal use. So, if you use your car for 80 percent business and 20 percent personal purposes, your first year limit is $2,528. If these limits affect your depreciation, you can simply claim the rest of the depreciation in a later year—you do not lose it.

Some vehicles are exempt from the luxury limits. Your truck, van, crossover, or SUV may be exempt if it 1) is classified as a truck by the Department of Transportation, and 2) has a gross vehicle weight rating over 6,000 pounds. Note that some passenger trucks are not classified as a “truck” by this definition.

If you don’t like the choice you made for your mileage deductions, you can fix it. If you catch it early, you’ll still get all the additional benefits that come with the actual-expense method (Section 179 expensing and bonus depreciation). However, if you make the switch later, you can still get some benefit from actual expense deductions with straight-line depreciation. What you need to know is that the choice to switch is available to you.

  1. Rev. Proc. 2010-51; IRC Section 168(f)(1) ↑
  2. Reg. Section 301.9100-2(d) ↑
  3. Rev. Proc. 2011-14, Appendix 6.02 ↑
  4. Rev. Proc. 2010-51 ↑
  5. IRS Pub. 534, Depreciating Property Placed in Service Before 1987, (Rev. Nov. 1995), p. 7 ↑
  6. Notice 2014-79; http://www.irs.gov/2014-Standard-Mileage-Rates-for-Business,-Medical-and-Moving-Announced ↑
  7. IRS Pub. 534, Depreciating Property Placed in Service Before 1987, (Rev. Nov. 1995), p. 7 ↑
Categories : Audits, Business Expenses, Cars, Trucks & SUVs, Depreciation, Listed Property, Tax Planning

How to Know if the S Corporation is Your Best Choice in Entity Structure

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

You have a lot of details to consider when it comes to choosing the entity structure for your business. You can run it as a sole proprietorship, a single-member LLC, an S corporation, or a C corporation. How do you know which is the best choice? One of the biggest considerations is how your choice in entity structure affects your tax bill, and that’s exactly what this article looks at—specifically focusing on the pros and cons of the S corporation.

What an S Corporation Is

An S corporation is basically a federal tax election status. Your company can be formed as either an LLC or a corporation and still make the S corporation election.[1] That means your business name could end with (and legally be) “LLC”, but for tax purposes, you file as an S corporation. This tax status allows your company’s tax credits, deductions, and income to pass through to you as shareholder. For the right kind of business, this could grant liability protection with the benefits of personal taxation.

Knowing the Rules

In order to qualify for S corporation status, you only need to meet a few rules that are fairly easy for singly-owned businesses (or even husband-wife ownership teams):[2]

  • You must be a domestic corporation (LLC’s are included in this designation).
  • You must have no more than 100 shareholders.
  • Each individual shareholder must be either a US citizen, resident alien, or estate. Certain types of trusts and tax-exempt entities may also be shareholders.
  • Your business must carry one class of stock only.

So, the real question is: does an S corporation election make sense for your business?

Pros and Cons

No matter which entity structure you choose, you’ll come across both advantages and disadvantages. There is no one choice that works for every business and consistently generates the most tax advantages. You will need to do your research and make the best determination for you and your company. That being said, weighing the tax savings is an important part of the decision-making process.

Here are the positive tax implications for electing S corporation status:

  • You Pay Less in Payroll Taxes—Operating as an S corporation makes the owner both a shareholder and an employee. This means you 1) receive distributions for your investment in the business, and 2) receive a salary for the work you do. The salary is paid to you by your corporation (because it acts as a separate entity from you as an individual), and thus is subject to payroll taxes. However, because you also receive income as an investor, you have the opportunity to pay yourself a lower wage (reducing your payroll taxes) and still make good money on the dividends. Of course, you should research what a reasonable wage would be—the IRS can ding you for paying yourself too little in salary.
  • You Can Split Taxable Income—This can be a tax advantage if you want to provide money to someone, such as a parent. You basically have two options. You can give the money directly to your mom or dad as a gift, but this comes out of your after-tax dollars because you’ve already earned the money and must pay income tax on it. Alternately, you can give the parent a share in your company’s stock, so that the gift money comes in the form of dividends. The second option is probably the better one if your parent is in a lower tax bracket than you are because you’ll be able to provide the same amount of cash with less going to taxes.

For example, your parent is in the 10 percent tax bracket and you’re taxed at 35 percent. You have to make $15,385 at your tax rate in order to give an after-tax gift of $10,000. But, if you give stock that earns $11,111, your parent still gets $10,000 after their 10 percent taxes. Of course, the second method also means your parent is now part owner in the company, so you’ll have to weigh the consequences. Note that this strategy is not a good choice for splitting income with your children because they will be subject to the kiddie tax for investment income over $1,900 if they are younger than 19 or in college and younger than 24.[3]

  • You Avoid Double Taxation—In general C corporation dividends are taxed at 15 percent. In addition, a C corporation is in the 15 percent income tax bracket for the first $50,000 it earns; however, the income tax percentage jumps up to 35 percent if your business is a personal service corporation, and you still have to pay taxes on dividends on top of that. If your corporation’s income exceeds $50,000, it has moved into the 25 percent income tax bracket. You can see that the numbers keep creeping up, since the amount you’ll earn (and pay taxes on) in dividends depends upon what’s left after income taxes. With an S corporation, you are likely to avoid this frustrating situation.

With these advantages, you may already be considering taking the S corporation election, but remember that no entity is a perfect choice all around.

Here are some reasons you may decide not to go with an S corporation for tax purposes:

  • You’ll Have Corporate Paperwork (and Extra Fees)—If your business currently operates as a sole proprietorship, you’re in the easy situation of paying your taxes on Schedule C of Form 1040. However, if you switch to an S corporation, you will take on all the corporate tax paperwork that comes along with it. Remember, your corporation will be a separate entity from you as an individual, so you will have paperwork for each. Pretty much any time money goes anywhere between you and your corporation, you’ll have more required paperwork to fill out. Because you probably have neither the time nor the expertise to handle all of these tax, accounting, and legal documents, you’ll likely need to pay for a tax preparer (and/or accountant) and lawyer. When you operate as a sole proprietor or single-member LLC, in contrast, you and your business share assets, and money can flow more easily between the business and yourself (but you should still keep the finances separate!).
  • Your Assets are Not Yours—As mentioned above, a sole proprietorship or single-member LLC has one set of assets, and they belong to the business owner. But, when you create an S corporation and designate business assets, you no longer own those items—the corporation does. This means you’ll be watched much more closely regarding how assets are used, and taking company assets for personal use can trigger a taxable event. Of course, even sole proprietors must watch out for Section 179 recapture rules.
  • You May Have to Pay Extra State Taxes—Some states require S corporations to pay state income taxes or franchise taxes. And, here’s the bigger kick in the teeth, it’s not offset by any additional personal tax deductions for you.
  • Your Heirs May Have Higher Taxes—Upon your death, a sole proprietorship or single-member LLC’s assets are valued individually at fair market value, which usually means lower taxes for your heirs.[4] For a corporation, on the other hand, the company’s stock is marked up to fair market value, and this could be much different from the value of the individual assets.
  • You Get No Break on Medical Costs—If you’re a more than 2 percent owner in your corporation, you won’t be getting much in tax benefits for your health insurance, and neither will your spouse. You see, attribution rules dictate that your spouse has the same ownership interest as you. So, if you’re a 100 percent owner, your spouse also has 100 percent interest in the company. This also means you cannot provide your employee-spouse with a Section 105 medical reimbursement plan, unlike the owner of a sole proprietorship or LLC. The Section 105 benefits are not counted as W-2 income.
  • You Have to Pay Payroll Taxes for Your Employed Children—A proprietorship and single-member LLC both get the benefit of no payroll taxes for wages earned by their own underage children. They also don’t pay Medicare, FICA, or employment taxes for the owner’s kids. Unfortunately for S corporation owners, both the corporation and the child will be subject to payroll taxes.
  • You May Lose Out on 401(k) Contributions—Because your S corporation income is divided between salary and distributions, you’ll have less money available to contribute to your retirement plan. Contributions are based on your salary, and you’ll probably have kept this amount low in order to save on self-employment taxes.

If none of these disadvantages deters you, then an S corporation may be a good fit for your company. The main reason to opt for an entity structure other than sole proprietorship is to attain liability protection. So, ask yourself how much liability protection you need for the type of business you’re in, and then hire a tax professional to help you figure out which entity structure generates the biggest tax savings for you. You’ll more than make back the money spent on professional advice in the years of tax-savings from choosing the appropriate entity structure.

  1. IRC Section 1361(a)(1) ↑
  2. IRC Section 1361(b); Reg. Section 301.7701-3(c)(1)(v)(C) ↑
  3. IRC Section 1(g)(2); Rev. Proc. 2011-52 ↑
  4. IRC Section 1014(a) ↑
Categories : Corporations, Section 105 Medical Plan, Self-employment Tax, Tax Planning

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

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

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. ↑
Categories : College, Employ Your Kids, Investments, Tax Planning

Do You Own Multiple Businesses? Consider this Tax Advice for Passive Losses

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

Any time one of your businesses experiences a loss, you want to be able to claim those losses on your tax return. Unfortunately, the passive loss rules can stand in the way of these deductions, unless you plan ahead. In case you don’t already know the passive loss rules, here’s a breakdown of the requirements for deducting passive losses:

  1. You must participate materially in the business that has losses in order to deduct those losses (or if you group the business with another, you must actually participate in the group); or
  2. If you do not participate materially in the business, you must have other sources of passive income that you can deduct the losses against.

Grouping to Claim Passive Losses

Here’s a likely scenario. A medical doctor owns a medical practice, and she would like to open a physical therapy business, but she does not plan to actually work at the new business. Someone else will handle management of this business, and employees will provide the services. The doctor understands that the business will likely lose money for the first couple of years.

However, the doctor does not have any other source of passive income; her only other business is the medical practice in which she actively participates. Therefore, she has to figure out some other way to avoid passive loss rules and claim her deductions. Aside from deducting the losses from other passive income, she could also wait to deduct the losses in total when she gets rid of her entire interest in this passive business.[1] But, she doesn’t want to do that—she wants the deductions now because she doesn’t plan on selling this business for quite some time.

As you can see from the above points, one option for getting around passive loss rules is to form a group from the multiple businesses you own. So, in order to deduct those losses, she groups her new physical therapy business with her medical practice. “Wait a minute,” you may say. Even if she groups these two businesses together, doesn’t the physical therapy business still have only passive income?

It turns out that in order to meet the material participation requirements, you can group your business together to form suitable economic units.[2] That means the businesses and business activities within the grouping must make sense together based on these factors (quoted from IRS Publication 925):[3]

  1. The similarities and differences in the types of trades or businesses,
  2. The extent of common control,
  3. The extent of common ownership,
  4. The geographical location, and
  5. The interdependencies between or among activities.

Note that each business may conduct multiple sets of activities, and any entity structure may group its businesses or activities into one.[4] Even if you are the sole owner of three business that conduct four separate business activities, you can group all of these into one. Your material participation in the grouping then allows passive loss deductions for any of the business activities.

If you want to take advantage of such a common ownership grouping, you’ll need to make the election on your tax return and attach a disclosure statement.[5] Additionally, you’ll need to attach a statement with your tax return for any year that you add another activity to an existing group or regroup a grouping that was inappropriate. If you group inappropriately and don’t follow the requirements, you could end up losing your deductions because the activities will be treated separately.

Your disclosure statements should include the names, addresses, and employer identification numbers for each of the businesses being grouped together. Once you’ve made the election to group, you’re good to go with claiming deductions on an activity’s passive losses, so long as you meet the material participation requirements for the group. What that typically means is you have to participate in the combined businesses for at least 500 hours per year. Going back to our doctor, if she works at the medical practice for 1,968 hours in the course of a year and never does any work at the physical therapy business, she has met the 500-hour test for the entire group.

Not everyone has two business interests that make sense together as an economic unit. If you, like the doctor, are considering opening a second business, but your second business operates in a completely different way from the first, you may not be able to take advantage of grouping. When that’s the case, you should ask yourself, “Is it even worth it to start a business I cannot deduct losses for?” Remember, your tax deductions can make a big difference in your yearly profit.

Basically, you want to make sure the plans you make for your business ventures are the best choices for your bottom-line. Grouping elections are easy to make for the single-owner business, and the rules apply to real estate rentals, as well. So, if you have taxable income you’d like to offset, grouping may be a solution for your business.

  1. IRC Section 469 ↑
  2. Reg. Sections 1.469-4(a); 1.469-5T(a)(1) ↑
  3. Reg. Section 1.469-4(c)(2). ↑
  4. Passive Activity Loss Audit Technique Guide (ATG), Training 3149-115 (02-2005), Catalog Number 83479V, p. 4-2. ↑
  5. Rev. Proc. 2010-13 ↑
Categories : Audits, Business Expenses, Passive Income & Losses, Receipts, Records, Tax Planning

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

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

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?

Prevention

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 ↑
  10. http://www.irs.gov/pub/irs-pdf/p547.pdf ↑
  11. Rev. Rul. 2009-9 ↑
Categories : Audits, Casualty Losses, Investments, Records, Tax Planning

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

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

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). ↑
Categories : Investments, Leases, Real Estate, Rental Properties, Shared Equity, Tax Planning
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