What Is Tax Basis and Why Is It So Important?
For tax purposes, the term “basis” refers to the monetary value used to measure a gain or loss. For instance, if you purchase shares of a stock for $1,000, your basis in that stock is $1,000; if you then sell those shares for $3,000, the gain is calculated based on the difference between the sales price and the basis: $3,000 – $1,000 = $2,000. This is a simplified example, of course—under actual circumstances, purchase and sale costs are added to the basis of the stock—but it gives an introduction to the concept of tax basis.
The basis of an asset is very important because it is used to calculate deductions for depreciation, casualties, and depletion, as well as gains or losses on the disposition of that asset.
The basis is not always equal to the original purchase cost. It is determined in different ways for purchases, gifts and inheritances. In addition, the basis is not a fixed value, as it can increase as a result of improvements or decrease as a result of credits claimed, business depreciation or casualty losses. This article explores how the basis is determined in various circumstances.
Cost Basis – The cost basis (or unadjusted basis) is the amount originally paid for an item before any improvements and before any credits, business depreciation, expensing or adjustments as a result of a casualty loss.
Adjusted Basis – The adjusted basis starts with the original cost basis (or gift or inherited basis), then incorporates the following adjustments:
increases for any improvements (not including repairs),
reductions for tax credits claimed based on the original cost or the cost of improvements,
reductions for any claimed business depreciation or expensing deductions, and
reductions for any claimed personal or business casualty-loss deductions.
Example: You purchased a home for $250,000, which is the cost basis. You added a room for $50,000 and a solar electric system for $25,000, then replaced the old windows with energy-efficient double-paned windows at a cost of $36,000. You claimed tax credits of $7,500 and $200, respectively, for the solar system and windows. The adjusted basis is thus $250,000 + $50,000 + $25,000 - $7,500 + $36,000 - $200 = $353,300. Your payments for repairs and repainting, however, are maintenance expenses; they are not tax deductible and do not add to the basis.
Example: As the owner of a welding company, you purchased a portable trailer-mounted welder and generator for $6,000. After owning it for 3 years, you then decide to sell it and buy a larger one. During this period, you used it in your business and deducted $3,376 in related deprecation on your tax returns. Thus, the adjusted basis of the welder is $6,000 – $3,376 = $2,624.
Keeping records regarding improvements is extremely important, but this task is sometimes overlooked, especially for home improvements. Generally, you need to keep the records of all improvements for 3 years (and perhaps longer, depending on your state’s rules) after you have filed the return on which you report the disposition of the asset.
Gift Basis – If you receive a gift, you assume the donor’s (giver’s) adjusted basis for that asset; in effect, the donor transfers any taxable gain from the sale of the asset to you.
Example: Your mother gives you stock shares that have a market value of $15,000 at the time of the gift. However, your mother originally purchased the shares for $5,000. You assume your mother’s basis of $5,000; if you then immediately sell the shares, your taxable gain is $15,000 – $5,000 = $10,000.
There is one significant catch: If the fair market value (FMV) of the gift is less than the donor’s adjusted basis and you then sell it for a loss, your basis for determining the loss is the gift’s FMV on the date of the gift.
Example: Again, say that your mother purchased stock shares for $5,000. However, this time, the shares were worth $4,000 when she gave them to you, and you subsequently sold them for $3,000. In this case, your tax-deductible loss is only $1,000 (the sales price of $3,000 minus the $4,000 FMV on the date of the gift), not $2,000 ($3,000 minus your mother’s $5,000 basis).
Inherited Basis – Generally, a beneficiary who inherits an asset uses the asset’s FMV on the date of the owner’s death as the tax basis. This is because the tax on the decedent’s estate is based on the FMV of the decedent’s assets at the time of death. Normally, inherited assets receive a step up (increase) in basis. However, if an asset’s FMV is less than the decedent’s basis, then the beneficiary’s basis is stepped down (reduced). (Congress has been considering a change that would make the inherited basis the amount of the decedent’s adjusted basis, thus eliminating the beneficial step-up in basis rule. Please check with this office for the current status of the legislation.)
Example: You inherited your uncle’s home after he died in 2020. Your uncle’s adjusted basis in the home, which he purchased in 1995, was $50,000, and its FMV was $400,000 when he died. Your basis in the home is equal to its FMV: $400,000.
Example: You inherit your uncle’s car after he died in 2020. Your uncle’s adjusted basis in the car, which he purchased in 2015, was $50,000, and its FMV was $20,000 at his date of death. Your basis in the car is equal to its FMV: $20,000.
An inherited asset’s FMV is very important because it is used to determine the gain or loss after the sale of that asset. If an estate’s executor is unable to provide FMV information, the beneficiary should obtain the necessary appraisals. Generally, if you sell an inherited item in an arm’s-length transaction within a short time, the sales price can be used as the FMV. A simple example of a transaction not at arm’s length is the sale of a home from parents to children. The parents might wish to sell the property to their children at a price below market value, but such a transaction might later be classified by a court as a gift rather than a bona fide sale, which could have tax and other legal consequences.
For vehicles, online valuation tools such as the Kelly Blue Book can be used to determine FMV. The value of publicly traded stocks can similarly be determined using website tools. On the other hand, for real estate and businesses, valuations generally require the use of certified appraisal services.
The foregoing is only a general overview of how basis applies to taxes. If you have any questions, please call your tax preparer today!
4 of the Most Common IRS Tax Problems - That Are Totally Avoidable.
For years, politicians have been talking about simplifying the process of filing federal taxes, but despite the promises, the process continues to be complicated and stressful. But as bad as preparing taxes can be, it pales in comparison to the sinking sensation of receiving an IRS notification telling you that you’ve done something wrong.
The IRS reviews each tax return for accuracy and to ensure that taxpayers have paid the amount that they owe, and when they find something wrong, they immediately send a letter alerting the taxpayer of the problem. Though there are several issues that can arise, the four situations listed below are common reasons for the IRS to contact — and demand action — from you.
But we forbid you from panicking, getting angry, or ignoring the letter. These reactions don’t help. Often letters are simple fixes and don’t warrant getting upset about. Especially now, when the IRS is shooting out letters in error by the millions.
Failure to file a return at all
Every American is supposed to send in a tax return, whether you owe the government money or whether the government owes you. Failure to file can lead to you not getting the refund money you’re owed – you only have three years to get your paperwork in to get money back, and if you’ve shortchanged the government then your failure to file can lead to fines adding an additional 25% of what you owe, charged over five months.
Failure to pay taxes
If you receive a form CP14 from the IRS it means that you have shortchanged the government on your taxes and you owe them the difference. If you both fell short on your payment and didn’t file a return, you’re likely to have to pay penalties and interest too. If your debt is substantial the agency will allow you to negotiate a Partial Payment Installment Agreement (PPIA) to break your payments into monthly installments.
Notification of tax levy
Failure to pay taxes can lead to a seizure of your property known as a tax levy. The IRS does not descend upon your property unannounced: They will notify you using either the LT11, the CP504, the CP90, or the CP91 form.
Notification of tax lien
The IRS also can use a tax lien to collect unpaid tax debts. If you receive a Letter 3172, it means that the government is asserting its rights to your property or assets. This letter also gets sent to your creditors, as a tax lien allows the government to get in line for your assets ahead of all others.
If you receive one of these notifications from the IRS or any other form of correspondence regarding a mistake or monies owed, there’s no reason to panic. Again, we forbid it. The best way to handle it is to speak to your tax pro right away, they will help you respond to it in a timely manner.
What to do When a Loved One is Facing Mental Decline
Dementia, Alzheimer’s disease, and other cognitive decline diagnoses are among the health issues that people fear the most. Cognitive decline is devastating for the patient as well as for their loved ones, who not only bear witness to the deterioration but who are often tasked with ensuring that all financial matters have been addressed in keeping with the individual’s wishes.
Even with a definitive diagnosis, raising the subject can be cause for discomfort, but the earlier you do so the more effective these conversations can be, and the more certain you can be that you’re doing the right thing. Here are our tips for what to do when a loved one is declining mentally.
Don’t delay. It is so easy to put off difficult conversations, but when it comes to financial planning in the face of a dementia diagnosis, the sooner you do it, the better. In most cases, there is enough time between diagnosis and significant deterioration for you to discuss your loved one’s wishes and put them into place without fear that their abilities are compromised. Now is the time to ask what type of care they want, to take them to different facilities and choose where they would like to be, to ask how they want their assets allocated, and more. Just keep in mind that time is not your friend. Act early, and if you meet resistance, keep pushing. Once everything is in place, everybody can take a deep breath and relax a bit.
Don’t ambush the individual. People who are facing cognitive decline are already vulnerable, so you don’t want the conversation to be intimidating. Give careful consideration to who will participate, and where and how you will broach the subject. Have a specific goal in mind so that the conversation can be controlled. This means that if you hope to have papers signed or brochures reviewed, you should bring them with you. Be mindful of your loved one’s condition and how different times of day and setting impact their cognition. You want to choose a time when they are generally attentive, strong, and engaged.
Familiarize yourself with the proper paperwork. Addressing the needs of a person in cognitive decline requires more than agreement. There are legal documents that codify their wishes about their finances and medical directives, and if these are signed while the person is still in control of their mental powers, these documents will be extremely helpful. The most important documents to have in place are a durable power of attorney to indicate who is in charge of financial decisions, a will to indicate both the executor of the estate and its beneficiaries, and a living trust to designate the person who will manage all assets when they are no longer able. An advanced directive for medical decisions is also important.
Get control of the paperwork. We’re all familiar with our own daily transactions and documents – we receive and pay invoices, balance our checkbooks, and make sure that all of our financial obligations are attended to. The same is true for your loved one, but they will not be able to continue much longer. Now is the time to sit down with them and make sure that you know exactly what these duties are and make sure you have all of their obligations and tasks organized so that you can assume responsibility when the time comes.
Find professional help. Taking care of your loved one’s economic well being is overwhelming, especially when you’re also taking care of your own needs. Do not be afraid to turn to financial planners, tax planners, social workers and others who have the experience and resources to help you manage your loved one’s finances, medical needs, expenses, and other tasks. Their expertise will prove to be invaluable as you try to find the right way to address each legal, medical, and financial issue that arises, including government benefits and tax issues.
The needs of the elderly are unique, and an elder law attorney can be one of your most valuable resources. The National Academy of Elder Law Attorneys provides an online directory to help you find a professional in your local area, and the website LawHelp.org is specifically dedicated to supporting those for whom cost is an issue. You can also find help on financial planning from the Alzheimer’s Association website, or by contacting us directly and asking for help with putting a personalized tax plan in place.
Tax Information Reporting Requirement for Cryptocurrency Added by Infrastructure Bill
Over the last 3 years, the Internal Revenue Service has been engaged in a virtual currency compliance campaign to address tax noncompliance related to cryptocurrency use. The IRS’ efforts have included outreach to taxpayers through education, audits of taxpayers’ returns, and even criminal investigations.
Soon the IRS will have another arrow in its quiver. Thanks to a requirement included by Congress in the Infrastructure Investment and Jobs Act (IIJA) of 2021, signed into law November 15, 2021, cryptocurrency exchanges will be subject to information reporting requirements similar to those that stockbrokers have to follow when a taxpayer sells stock or other securities. These new rules generally will apply to digital asset transactions starting in 2023, so the first reporting forms related to cryptocurrency transactions will be issued to the IRS and crypto investors in January 2024.
Form W-9 – As crypto exchanges gear up for the new reporting requirement, and if they don’t have a record of their users’ taxpayer-identification numbers (usually a Social Security number), they will contact their users for the information, likely using IRS Form W-9, Request for Taxpayer Identification Number and Certification. If the taxpayer doesn’t complete and returns the W-9 to the requestor, the taxpayer may be subject to backup withholding, which means the exchange would have to withhold 24% of future transactions and submit the withheld tax to the IRS.
Form 1099-B – At this time it’s not known if the IRS will modify Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, currently most commonly used by brokers to report stock sales, for reporting crypto transactions, or if a new form will be created.
As with the information on the 1099-B that brokers report, the IRS will then use the reported crypto transaction details – sales proceeds, acquisition and sale dates, tax basis for the sale, and character of the gain or loss – to match to the information reported on the taxpayer’s tax return. Those who don’t report, or don’t properly report, their cryptocurrency transactions will be liable for the tax, penalties, and interest. In some cases, taxpayers could be subject to criminal prosecution.
Crypto is Treated as Property – Although cryptocurrency may seem like money, according to the IRS it is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency. So, it is necessary to report the disposition of cryptocurrency when it is sold for cash, used to buy something, or traded for another cryptocurrency. But just transferring the currency from an online wallet to an exchange, or vice versa is not a disposition.
The character of the gain or loss from the transaction generally depends on whether the cryptocurrency is a capital asset in the hands of the taxpayer. Generally, a taxpayer realizes capital gain or loss on the sale or exchange of cryptocurrency that is held as a capital asset. On the other hand, a taxpayer generally realizes ordinary gain or loss on the sale or exchange of cryptocurrency that he or she does not hold as a capital asset. Inventory and other property held mainly for sale to customers in a trade or business are examples of property that is not a capital asset.
Digital Assets – The IIJA defines a digital asset as any digital representation of value that is recorded on a cryptographically secured distributed ledger or any similar technology. Furthermore, the IRS can modify this definition. As it stands, the definition will capture most cryptocurrencies as well as potentially include some non-fungible tokens (NFTs) that are using blockchain technology for one-of-a-kind assets like digital artwork.
Transfer Reporting - Based on the IIJA change, the definition of brokers who will need to furnish Forms 1099-B (or whatever new form the IRS might design) includes businesses, referred to as crypto exchanges, that are responsible for providing any transfer services for the transfer of digital assets on a taxpayer’s behalf. So, any platform on which a taxpayer can buy and sell cryptocurrency will be required to report digital asset transactions, both to the taxpayer and the IRS.
Of course, not every transfer transaction is a sale or exchange. An example would be transferring cryptocurrency from a wallet at Crypto Exchange #1 to the taxpayer’s wallet in Crypto Exchange #2. In this case, Crypto Exchange #1 will be required to provide relevant digital asset information to Crypto Exchange #2. Such a transaction is not a reportable sale or exchange, and similar to when a taxpayer switches stockbrokers, the prior exchange must provide the new exchange with the basis, and purchase dates, just as a stockbroker must when the brokerage firms are changed.
Cash Transaction Reporting for Businesses - Currently when a business receives $10,000 or more in cash in a transaction, the business is required to report the transaction on IRS Form 8300, including the ID of the person from whom the cash was received. Under the IIJA rules, businesses will be required to treat digital assets like cash for purposes of this reporting requirement. The $10,000 may occur in a single transaction or a series of related transactions. Transactions between a buyer, or agent of the buyer, and a seller that occurs within a 24-hour period are related transactions.
1040 Crypto Question – Starting with the 2020 tax return, the IRS asks a question on the return that requires a yes or no answer. The draft of the 2021 Form 1040 shows the following question will be posed: “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” Once the IIJA crypto reporting requirement is effective, the IRS will know if the taxpayer’s response to the question is correct. Taxpayers should consider that when signing their Form 1040, they are attesting under penalties of perjury to filing a true, correct, and complete return. A response contrary to the 1099-B reporting information could lead to unwanted interaction with the IRS.
If you have questions about reporting cryptocurrency transactions, please don’t hesitate to contact your tax preparer.
How Can a Non-working Spouse Qualify to Fund an IRA?
One of the fallouts of the COVID-19 pandemic is that millions of people have dropped out of the workforce, particularly female workers with families. While they remain unemployed, these women will have lost the opportunity to build up their retirement nest egg through their employers’ retirement plans. However, those who are married have an option to accumulate retirement funds that will help make up for some of their lost retirement savings.
This frequently overlooked tax benefit is the spousal IRA. Generally, IRA contributions are only allowed for taxpayers who have compensation (the term “compensation” includes wages, tips, bonuses, professional fees, commissions, taxable alimony received, and net income from self-employment). Spousal IRAs are the exception to that rule and allow a nonworking or low-earning spouse to contribute to his or her own IRA, otherwise known as a spousal IRA, as long as his or her spouse has adequate compensation.
The maximum amount that a nonworking or low-earning spouse can contribute to either a traditional or Roth IRA (or a combination) is the same as the limit for a working spouse, which is $6,000 for 2021. If the non-working spouse is 50 years or older, that spouse can also make “catch-up” contributions (limited to $1,000), raising the overall contribution limit to $7,000. These limits apply provided that the couple together has compensation equal to or greater than their combined IRA contributions.
Example: Tony is employed, and his W-2 for 2021 is $100,000. His wife Rosa, age 45, didn’t work during the year after deciding to care for their children at home due to their difficulty finding childcare providers. Since her own compensation of zero is less than the contribution limit for the year, Rosa can base her contribution on their combined compensation of $100,000. Thus, Rosa can contribute up to $6,000 to an IRA for 2021. Even if Rosa had done some part-time work and earned $2,500, she could still make a $6,000 IRA contribution.
The contributions for both spouses can be made either to a traditional or Roth IRA or split between them as long as the combined contributions don’t exceed the annual contribution limit. Caution: The deductibility of the traditional IRA and the ability to make a Roth IRA contribution are generally based on the taxpayer’s income:
Traditional IRAs – There is no income limit restricting contributions to a traditional IRA. However, if the working spouse is an active participant in any other qualified retirement plan, a tax-deductible contribution can be made to the IRA of the nonparticipant spouse only if the couple’s adjusted gross income (AGI) doesn’t exceed $198,000 in 2021. If the couple’s income is $198,000 to $208,000, only a partial deduction is allowed. Once their AGI reaches $208,000, no amount is deductible.
Roth IRAs – Roth IRA contributions are never tax-deductible. Contributions to Roth IRAs are allowed in full if the couple’s AGI doesn’t exceed $198,000 in 2021. The contribution is ratably phased out for AGIs between $198,000 and $208,000. Thus, no contribution is allowed to a Roth IRA for 2021 once the AGI exceeds $208,000.
Example: Rosa from the previous example can designate her IRA contribution as either a deductible traditional IRA or a nondeductible Roth IRA because the couple’s AGI is under $198,000. Had the couple’s AGI been $203,000, Rosa’s allowable contribution to a deductible traditional or Roth IRA would have been limited to $3,000 because of the phaseout. The other $3,000 could have been contributed to a traditional IRA and designated as nondeductible.
Contributions to IRAs for 2021 can be made no later than April 15, 2022.
Please give your tax preparer or financial advisor a call if you would like to discuss IRAs or need assistance with your retirement planning.
The IRS May be Getting a Massive Budget Increase. Will It Impact the Audit Rate?
In September of 2021, the Congressional Budget Office announced a proposal to increase funding for the Internal Revenue Service by as much as $80 billion over the next ten years. The argument is that doing so would ultimately increase the revenue the organization is able to generate by as much as $200 billion over the next decade.
A significant portion of the new money — to the tune of about $60 billion — is aimed at empowering enforcement actions in particular. All told, that means by 2031, the IRS will double the number of people working for it and will have a 90% higher budget than they do right now.
This, of course, has led people to wonder — does that mean that more people than ever are about to get audited?
Obviously, the situation is a lot more nuanced than people on both sides of the aisle are giving it credit for. Therefore, understanding what this means and what implications it may have requires you to keep a few key things in mind.
The Current Situation With the IRS: What You Need To Know
While it's difficult to say exactly what the future might hold, some Republicans believe that the plan would indeed increase the rate at which people are audited. House Minority Leader Kevin McCarthy, for example, cited research saying that the funding would lead to an increase of 1.2 million additional audits each year compared to those that are taking place right now. More than that, he claimed that roughly 50% of them would target homes making under $75,000 per year.
Others are not quite as pessimistic about the situation. According to a report filed in September from the CBO, it's estimated that the new funding won't necessarily lead to a "major increase" in audits in the strictest sense of the term. It's just that the IRS has been understaffed and underfunded for so long that they haven't been able to operate at their "normal" level of activity.
Therefore, the increase in the budget — and the new employees that it will bring with it — will simply allow audit levels to rise to where they were roughly 10 years ago. It's an increase over recent memory, yes — but historically, that isn't necessarily the case.
Despite all this, the United States Treasury has stated several times that its goal is for audit rates to not increase for households that make under $400,000 per year. Again, it's difficult to know exactly what the future will bring with it — which is why this is one situation that many will be paying attention to moving forward.
If you'd like to find out more information about whether the IRS's new budget increase will impact the audit rate, or if you'd just like to discuss your own needs with someone in a bit more detail, please feel free to contact your own tax preparer today.
Advance Child Tax Credit and EIP Must Be Reconciled on Your 2021 Return
Early in 2021, Congress passed the American Rescue Plan which included a provision that increased the child tax credit amount and upped the age limit of eligible children. Normally, the credit was $2,000 per eligible child under age 17. For the 2021 tax year, the American Rescue Plan increased the credit to $3,000 for each child under age 18 and to $3,600 for children under age 6 at the end of the year.
Even though the benefit of a tax credit traditionally isn’t available until after the tax return for the year has been filed, for 2021 the new tax law included a provision to get the credit benefit into the hands of taxpayers as quickly as possible and charged the Secretary of the Treasury with establishing an advance payment plan. Under this mandate, those qualifying for the credit would receive monthly payments starting in July equal to 1⁄12 of the amount the IRS estimated the taxpayer would be entitled to by using the information on the 2020 return. If the 2020 return had not been filed or processed yet by the IRS, the 2019 information was to be used.
However, since the IRS only estimated the amount of the advance payments, some taxpayers may have received too much and others not enough. Thus, the payments received must be reconciled on the 2021 tax return with the amount that each taxpayer is actually entitled to. Those who received too much may be required to repay some portion of the advance credit while some may be entitled to an additional amount.
To provide taxpayers with the information needed to reconcile the payments, the IRS has begun sending out Letter 6419, an end-of-year statement that outlines the payments received as well as the number of qualifying children used by the IRS to determine the advance payments. For those who filed jointly on their prior-year return, each spouse will receive a Letter 6419 showing the advance amount received.
Do not discard the letter(s) from the IRS as they will be required to properly file 2021 returns.
Having received the advance credit payment, taxpayers will find their refunds will be substantially less than they may have expected, or they might even end up owing money on their tax return unless their AGI is low enough to qualify for the safe harbor repayment protection for lower-income taxpayers, in which case the excess advance repayment is eliminated or reduced.
Example: If a taxpayer received advance child tax credit payments for two children based on the 2020 return, and the taxpayer doesn’t claim both children as dependents in 2021, the taxpayer would need to repay the excess on their return, unless they are protected by the safe harbor provision.
It is also possible that one taxpayer could have received the advance child tax credit payments based on their 2020 return and not have to make repayment under the safe harbor rule, while another taxpayer, who can legitimately claim the child, can get the credit on their 2021 tax return. This is most likely to happen when the parents are divorced. So, there’s the potential for the child tax credit to be received by both parents.
Economic Impact Payment (EIP) Letter - The IRS will begin issuing Letter 6475, regarding the third Economic Impact Payment, to EIP recipients in late January. This letter will determine if EIP recipients are entitled to and should claim the Recovery Rebate Credit on their tax year 2021 tax returns filed in 2022.
Letter 6475 only applies to the third round of Economic Impact Payments that were issued starting in March 2021 and continued through December 2021. The third round of EIPs, including the “plus-up” payments, were advance payments of the 2021 Recovery Rebate Credit that would be claimed on a 2021 tax return. Plus-up payments were additional payments the IRS sent to people who received a third EIP based on a 2019 tax return or information received from the Social Security Administration, Railroad Retirement Board or Dept. of Veterans Affairs; or to people who may be eligible for a larger amount based on their 2020 tax return.
Most eligible people already received the payments. However, those who are missing stimulus payments should review the information to determine their eligibility and whether they need to claim a Recovery Rebate Credit for the tax year 2020 or 2021.
Like the advanced CTC letter, the EIP letter includes important information that can help tax preparers quickly and accurately reconcile the Recovery Rebate Credit when preparing 2021 tax returns.
Please contact your tax preparer if you have questions regarding the Child Tax Credit or the Recovery Rebate Credit and the advance payments of either that you received.
2022 Standard Mileage Rates Announced
As it does every year, the Internal Revenue Service recently announced the inflation-adjusted 2022 optional standard mileage rates used to calculate the deductible costs of operating an automobile for business, charitable, medical, or moving purposes.
Beginning on Jan. 1, 2022, the standard mileage rates for the use of a car (or a van, pickup, or panel truck) are:
58.5 cents per mile for business miles driven (including a 26-cent-per-mile allocation for depreciation). This is up from 56.0 cents in 2021;
18 cents per mile driven for medical care or by an active member of the armed forces for moving purposes. This is up from 16 cents in 2021; and
14 cents per mile driven in service of charitable organizations.
The business standard mileage rate is based on an annual study of the fixed and variable costs of operating an automobile. The rate for medical and moving purposes is based on the variable costs as determined by the same study. The rate for using an automobile while performing services for a charitable organization is statutorily set (it can only be changed by Congressional action) and has been 14 cents per mile for over 15 years.
Important Consideration – The 2022 rates are based on 2021 fuel costs. Given the potential for the continuation of substantially higher gas prices, it may be appropriate to consider switching to the actual expense method for 2022, or at least keeping track of the actual expenses, including fuel costs, repairs, maintenance, etc., so that the option is available for 2022.
Taxpayers always have the option of calculating the actual costs of using their vehicle for business rather than using the standard mileage rates. In addition to the possibility of higher fuel prices, the bonus depreciation and increased depreciation limitations for passenger autos that were part of the 2017 Tax Cuts and Jobs Act may make using the actual expense method worthwhile during the first year a vehicle is placed in business service.
However, the standard mileage rates cannot be used if you have used the actual method (using Sec. 179, bonus depreciation, and/or MACRS depreciation) in previous years. This rule is applied on a vehicle-by-vehicle basis. In addition, the business standard mileage rate cannot be used for any vehicle used for hire or for more than four vehicles simultaneously.
Employer Reimbursement – When employers reimburse employees for business-related car expenses using the standard mileage allowance method for each substantiated employment-connected business mile, the reimbursement is tax-free if the employee substantiates to the employer the time, place, mileage, and purpose of employment-connected business travel.
The Tax Cuts and Jobs Act eliminated employee business expenses as an itemized deduction, effective for 2018 through 2025. Therefore, employees may not take a deduction on their federal returns for those years for unreimbursed employment-related use of their autos, light trucks, or vans. However, those who are self-employed are eligible to claim expenses for their personal vehicles used in their businesses.
Faster Write-Offs for Heavy Sport Utility Vehicles (SUVs) – Many of today’s SUVs weigh more than 6,000 pounds and are therefore not subject to the limit rules on luxury auto depreciation; taxpayers with these vehicles can utilize both the Section 179 expense deduction (up to a maximum of $27,000) and the bonus depreciation (the Section 179 deduction must be applied before the bonus depreciation) to produce a sizable first-year tax deduction. However, the vehicle cannot exceed a gross unloaded vehicle weight of 14,000 pounds. Caution: Business autos are 5-year class life property. If the taxpayer subsequently disposes of the vehicle before the end of the 5-year period, as many do, a portion of the Section 179 expense deduction will be recaptured and must be added back to income (SE income for self-employed individuals). The future ramifications of deducting all or a significant portion of the vehicle’s cost using Section 179 should be considered.
Consider Bonus Depreciation - Consider using bonus depreciation as an alternative to the Section 179 deduction. Under this provision, a taxpayer can elect to claim a deduction of 100% of the cost of a new or used vehicle used for business in the first year it is placed into business service. However, the luxury auto rules impose a maximum annual deduction for depreciation, including the bonus depreciation. For example, in 2021, the maximum depreciation deduction for an auto for which bonus depreciation was claimed was $18,200. This compares to a maximum of $10,200 if bonus depreciation isn’t elected. Of course, if the vehicle is used only partly for business, then only the business-use percentage of the cost is eligible to be deducted.
After 2022, the deductible bonus depreciation percentage drops by 20 percentage points a year, until 2027 when, barring an extension by Congress, no bonus depreciation will be allowed.
Whether to claim bonus depreciation, Section 179, regular depreciation, or a combination of these methods for a business vehicle or to use the standard mileage rate instead, can be a complicated decision to make.
If you have questions related to the best methods of deducting the business use of your vehicle or the documentation required, please give your own tax preparer a call.
Filing as Married Separate? Better Read This.
TLDR: Married Filing Separate has consequences, call your tax pro to see how many are applicable to you.
Married taxpayers have two options when filing their 1040 or 1040-SR tax returns. The first and most frequently used filing status is married filing joint (MFJ), where the incomes and allowable expenses of both spouses are combined and reported on one tax return. The joint status almost always results in the lowest overall tax. Spouses who file together are jointly liable for the tax, meaning either or both can be held responsible for paying the tax from the joint return.
The second option is to file as married filing separately (MFS), with each spouse filing a return. Depending on whether the taxpayers are residents of a separate or community property state, these separate returns may include just the income and eligible expenses of each filer or a percentage of their combined income and expenses. Couples may choose the MFS option for a variety of reasons:
• They want to avoid the joint and several liability for the tax.
• They have children from a prior marriage and want to keep finances separate.
• They only want to keep their taxes separate.
• The marriage is tenuous.
• The taxpayers are separated and don’t want to cooperate in filing a joint return.
• One spouse might get a larger refund by filing separately (the other will pay more).
• They think they can save money by filing separate returns, and a variety of other reasons.
The fact of the matter is that Congress carefully writes the tax laws to eliminate tax breaks for those filing MFS and can make filing very complicated. Here are some of the issues related to separate filings.
Filing Requirements – MFJ taxpayers generally do not need to file a return unless their joint income exceeds the standard deduction, $25,100 for 2021, but those filing MFS must file if they have just $5 of income.
Changing Filing Status – Taxpayers cannot change their filing status from joint to separate after the unextended return due date, usually April 15. However, they can change from a separate to a joint return any time up to 3 years.
Social Security Benefits – For joint filers, the income threshold where Social Security benefits become taxable is $32,000. For those filing separately, 85% of the benefits are taxable from the very first dollar of Social Security income.
Traditional IRA Deductibility – An IRA contribution is not deductible for higher-income taxpayers who are also active participants in qualified requirement plans. For joint filers with employer-sponsored plans, the IRA deductibility for 2021 begins to phase out when their joint income reaches $105,000 and is fully phased out at $125,000. But when filing MFS, the deductibility begins to phase out with the first dollar of income and is fully phased out when the AGI (adjusted gross income) reaches $10,000.
Roth IRA Contribution Restrictions – The ability to contribute to a Roth IRA is limited for higher-income taxpayers, and for joint filers, the 2021 allowable contribution phases out with AGIs between $198,000 and $208,000. However, for separate filers, the ability to contribute to a Roth IRA phases out for AGIs between $0 and $10,000.
Higher Education Interest Deduction – Joint-return filers can deduct $2,500 per year of qualified student loan interest, but separate-return filers are not allowed any deduction.
Itemized Deductions – Where one spouse filing MFS itemizes their deductions, the other spouse must do the same and cannot take the standard deduction.
Medicare Premiums – The premiums for Medicare participants are substantially higher for individuals filing separate returns compared to those filing jointly. In addition, premiums are based on a taxpayer’s filing status 2 years prior. That means you won’t even notice the increase when the separate returns are filed. For example, if a couple filing jointly had an AGI of $180,000 in 2019, their monthly Medicare premiums in 2021 would be $207.90 per month each. On the other hand, if they had filed separate 2019 returns and each had an AGI of $90,000, their Medicare premiums in 2021 would be $475.20 per month each. Thus, each one’s premiums for the year would be $3,208 more in 2021 because they used the MFS status in 2019.
Child & Dependent Care Credit – Separate filers cannot claim this credit unless they are legally separated.
Earned Income Tax Credit (EITC) – Generally, MFS filers cannot claim the EITC unless one or both are qualified to claim the head of household (HH) filing status. That would generally mean they are separated and maintaining separate households. To qualify for HH, a married taxpayer must pay half the cost of maintaining a home for a dependent child for the last 6 months of the year. A married couple cannot reside together and one of them claim HH filing status. Thus, under most martial separation circumstances, one spouse would file MFS and one HH, and only the one filing HH could claim the EITC if otherwise qualified.
Premium Tax Credit (PTC) – Although there are some infrequent exceptions, taxpayers filing as MFS won’t qualify for the PTC, which is the government supplement for the cost of health care insurance purchased through a government health marketplace for lower to middle-income taxpayers.
Tax Rates – The tax rates for MFS are twice what they are for joint-filing taxpayers.
Other Limitations – For MFS filers, most other tax deductions and limitations, such as the standard deduction, allowable capital losses, and rental loss limitations, are half of what they are for joint filers.
If you anticipate filing married separate returns, please contact your tax pro to see how that filing might impact the outcome of your tax liability.
As always folks, this post is educational and informational only. This stuff is complicated. Don’t take advice from the internet. Ask your own tax pro or financial advisor for specific information about your situation.
Avoiding IRS Underpayment Penalties
Congress considers our tax system a “pay-as-you-earn” system. To facilitate that concept, the government has provided several means of assisting taxpayers in meeting the “pay-as-you-earn” requirement. These include:
Payroll withholding for employees;
Pension withholding for retirees; and
Estimated tax payments for self-employed individuals and those with other sources of income not covered by withholding.
When a taxpayer fails to prepay a safe harbor (minimum) amount, they can be subject to the underpayment penalty. This nondeductible interest penalty is higher than what might be earned from a bank. The penalty is applied quarterly, so making a fourth-quarter estimated payment only reduces the fourth-quarter penalty. However, withholding is treated as paid ratably throughout the year, so increasing withholding at the end of the year can reduce the penalties for the earlier quarters. This can be accomplished with cooperative employers or by taking an unqualified distribution from a pension plan, which will be subject to 20% withholding, and then returning the gross amount of the distribution to the plan within the 60-day statutory rollover limit (but check with this office before using the latter strategy).
Federal law and most states have so-called safe harbor rules, meaning if you comply with the rules, you won’t be penalized. There are two Federal safe harbor amounts that apply when the payments are made evenly throughout the year.
The first safe harbor is based on the tax owed in the current year. If your payments equal or exceed 90% of your current year’s tax liability, you can escape a penalty.
The second safe harbor—and the one taxpayers rely on most often—is based on your tax in the immediately preceding tax year. If your current year’s payments are equal to or exceed 100% of the amount of your prior year’s tax, you can escape a penalty, regardless of the amount of tax you may owe when you file your current year’s return. If your prior year’s adjusted gross income was more than $150,000 ($75,000 if you file married separate status), then your payments for the current year must be 110% of the prior year’s tax to meet the safe harbor amount.
Where taxpayers get into trouble is when their income goes up or their withholding goes down for the current year versus the prior year. Examples are having a substantial increase in income, such as when investments are cashed in, thereby increasing income but without any corresponding withholding or estimated payments. Another frequently encountered situation is when a taxpayer retires and their payroll income is replaced with pension and Social Security income without adequate withholding. Taxpayers who don’t recognize these types of situations often find themselves substantially underpaid and subject to the underpayment penalty when tax time comes around.
The bottom line is that 100% (or 110% for upper-income taxpayers) of your prior year’s total tax is the only true safe harbor because it is based on the prior year’s tax (a known amount), whereas 90% of the current year’s tax amount is a variable based on the income for the current year, and often that amount isn’t determined until it is too late to adjust the prepayment amounts.
That being said, there are times when using the 100%/110% safe harbor method doesn’t make a lot of financial sense. For example, let’s say that in the prior year, you had a large one-time payment of income that boosted up your tax to $25,000, which is $10,000 more than you normally pay. You know that you won’t have that extra income in the current year. Rather than rely on the 100%/110% of prior tax safe harbor, where you’d be prepaying $10,000 more than your current year’s tax is likely to be, it may be appropriate to use the 90% current-year tax safe harbor, determined by making a projection of your current year tax, and as the year goes along, monitoring your income and the tax paid in to be sure you are on track to reach the 90% goal.
Please contact your tax pro promptly if you have a substantial increase in income so that withholding or estimated tax payments can be adjusted to avoid a penalty.
As always folks, don’t trust anything from the internet. These posts are meant to inform and educate, not to advocate for any position. Always reach out to your own tax preparer for your own advice.