By LAUREN BAIER KIM

This article originally ran on March. 14, 2006

RealEstateJournal.com spoke with Tom Ochsenschlager, vice president of taxation at the American Institute of Certified Public Accountants, about income taxes and tax deductions for second-home owners. The AICPA is a New York-based professional organization for certified public accountants. How a second home is used -- for personal use, as a rental property, or both -- affects how you will be taxed for income on that property and the way in which you can take deductions for that home, Mr. Ochsenschlager says.

I rent out my vacation house only a few days a year. Do I have to pay tax on my rental income?

There is a provision where you can rent your house, which a lot of people did for the 1996 Olympics in Atlanta, for two weeks or less a year and not have to pay any tax on the rental income. That's what is sometimes referred to as the Masters provision. People along the Augusta National Golf Club, where the Masters Tournament takes place, rent their homes for fabulous amounts, but the tournament takes less than two weeks. People in this category can't take any deductions against the income from their property for things like utilities and maintenance, but they don't have to report any rental income. Some people make a lot of tax-free money each year renting their house for recurring events like the Masters.

How does one figure out if Uncle Sam considers a property a personal home or a rental property for tax purposes?

There are three different kinds of rental vacation homes. One, discussed above, falls under the so-called Masters provision -- if you rent it for 14 days or less, then you don't pay tax on the rental income.

The second category applies if you rent the home for more than 14 days but also have significant personal use. For this purpose, significant personal use is defined as the greater of 14 days or 10% of the number of days that it is rented.

If the house falls into this category, then it is considered a secondary home and not a rental property. For example, if the house is rented at fair market value for 200 days and is used either by the vacation-home owner, or rented for less than fair market value -- for instance, to friends or family -- for 21 days, it is a secondary home. If it falls in this category, you have to pay taxes on the rental income but can take deductions against the rental income. Generally, your deductions can't exceed your rental income.

The exception to this general rule is that you can claim what are called statutory deductions: interest and property taxes. In some cases, these two deductions might add up to more than the rental income. This would be a situation where you would be able to claim an operating loss for a secondary home. Generally, a secondary-home owner does not get a tax benefit from a loss, nor can he or she carry it forward or back to apply to another tax year.

The third type of house is one that you don't use yourself  -- or let someone else, such as a family member, use it for less than fair-market rental value -- for more than the greater of 14 days or 10% of the days that it is rented. A house in this category is considered a rental property. You have to pay taxes on the rental income but generally can take deductions in excess of the income.

Still, there are the catches. First, the deductions have to be apportioned between personal use and rental use. So, say you used the property for 10 days and rented it for 200 days. Then, every deduction would be apportioned between personal use and rental use. Generally, you would be able to take 200/210 (days rented over total days used) times each deduction to determine what you can claim as a deduction related to the rental activity. In this case, the mortgage interest and real-estate taxes that are allocated to personal use would be claimed as itemized deductions on your Schedule A with the remainder claimed as a deduction against the rental income on Schedule E for Form 1040.

A second limitation on your ability to take advantage of a current loss on this category of house is the so-called "passive loss rule." The details of this rule are beyond the scope of this article, but suffice it to say that most individuals cannot claim a loss from a rental property on their personal return. Rather, the loss is carried forward to future returns to use in a year in which the property does generate positive income. Sometimes, this is not until the property is sold or otherwise disposed of. 

What sort of deductions can owners of rental properties take?

There is an ordering to the deductions. The order you have to take them is the mortgage interest and real-estate taxes first, and then you get to take out-of-pocket deductions that are related to the rental property: things like repairs, maintenance, utilities, homeowner's association dues -- that is, fees paid toward the management of the community's common areas -- and dues to a swim or racquet club that is available to you and the people who rent the property, and finally, the appropriate depreciation for the structure. Generally, that is whatever you paid for the house, plus any capital improvements, such as an addition on the house, divided by the life of the structure, which is assumed to be 27 ½ years. Note the depreciation is only on the cost of the house, not the land. Remember, however, the ability to claim deductions in excess of the income is likely to be subject to the passive loss rules. 

If your vacation home is considered a secondary home, and not a rental residence, what deductions can you take?

Generally, the deductions are the same as those for owners of rental properties. The difference is that, if the deductions create a loss, an owner of a rental property gets to carry a loss forward  -- or, in some situations, carry it back -- whereas the owner of a secondary home that generates a loss  -- other than a loss created by mortgage interest and real-estate taxes -- does not get a tax benefit from that loss.

In both cases, to determine what is deductible, you first have to take the rental portion of expenditures -- such as real-estate taxes and mortgage interest -- that is statutorily deductible. After that, you would take expenses directly related to the rental, such as advertising and commissions. Then, you would take the rental portion of out-of-pocket expenditures discussed above, such as repairs, maintenance costs, utilities, property management fees, association dues and the like.

For instance, if you personally used the residence half the time and rented it half the time, half of your real-estate taxes and mortgage interest would be reported as an itemized deduction on your individual tax return. The other half of the mortgage interest and real-estate taxes would be reported as a deduction from your rental income.

The last deduction you take is depreciation, which is also apportioned between personal and rental use. Remember, you only take these deductions to the extent that you have net rental income after taking all the deductions described in the order above.

Additional Resources

Publication 527, Residential Rental Property

Topic 415 -- Renting Residential and Vacation Property

Publication 925, Passive Activity and At-Risk Rules

Vacation-Home Category	Rental Income	Deductions	Losses
Masters	not taxed	not available besides mortgage interest and property taxes	no tax benefit
Secondary	taxed	available	may possibly report a loss if mortgage interest and property taxes exceed rental income; but can't carry the loss forward or backward to apply to another tax year.
Rental	taxed	available	can carry losses forward, or back

-- Ms. Baier Kim is a senior editor with RealEstateJournal.com.

Are you planning on renting your house, apartment, flat on Airbnb over the holidays? You might need to report the income.

The Internal Revenue Service, not exactly known as a bastion of compassion, had these words for gay and lesbian couples this week: we’re sorry.

The public apology was in response to inquiries from The Bay Citizen about problems faced by same-sex couples, most in California, who are filing returns in compliance with new rules that recognized their relationships for the first time.

The change to the tax code, put into effect for 2010, was supposed to be a step toward equal treatment by the I.R.S.

Instead, couples have faced a litany of conflicts. The latest involves at least 300 taxpayers who have had their returns rejected with terse letters signed by an enigmatic I.R.S. employee named J. Bell from Fresno.

“Your return includes income or tax liability for more than one taxpayer, other than husband and wife,” the letters read. Note: husband and wife. Not two husbands, or two wives.

Couples who received the letters had to produce additional paperwork and faced delays in receiving refunds; most were forced to hire tax professionals.

In a statement this week, the I.R.S. said that the letters had been “incorrectly sent” because of a processing error and that it “apologizes for this mistake and sincerely regrets any inconvenience to taxpayers.”

The agency explained that J. Bell was a manager whose stamped signature was “system-generated.”

Toni Broaddus and Janice Wells of Richmond, who wed while same-sex marriage was legal in California in 2008, received a J. Bell letter in April.

“We were upset and we were angry when we got the letter,” Ms. Broaddus said. “I felt like we were being harassed by someone in the government who works for the I.R.S.” The couple’s case remains unresolved.

How the errant letters started is unclear. Tax experts who brought the letters to the attention of the I.R.S. weeks ago had wondered if anti-gay I.R.S. employees were acting out of malice.

“It’s either intentional or ignorance,” said Pan Haskins, an Oakland tax consultant who had been tracking the letters.

J. Bell is just the latest headache for same-sex couples — 60,000 in California — trying to comply with a tax system that has become increasingly complicated because of inconsistencies between state and federal laws regarding their relationships.

The 1996 Defense of Marriage Act effectively bans federal recognition of gay couples, yet more than a third of states recognize some form of legal partnerships.

To deal with one of these conflicts, the I.R.S. said last year that same-sex couples in states with community property laws (California, Nevada and Washington) should combine and then split their incomes for their federal returns. The motivation behind the change was fairness: heterosexual married couples can combine incomes, which can lower tax brackets and overall taxes paid if one spouse earns more.

But the change has had mixed results.

Interviews with more than a dozen Bay Area tax preparers and same-sex couples have revealed that the new rule has proved to be cumbersome and expensive. It is too complex for do-it-yourself tax filing computer software, and many couples were forced to hire tax professionals.

That help came at a hefty price: accounting fees ranged from double past rates to as high as $4,000 for some returns.

The returns have been so problematic that some tax preparers are specializing in them. Jeff Johnston, a tax accountant with expertise in same-sex returns, took out an advertisement in The Bay Area Reporter, a newspaper that covers the gay community.

“It takes 5 or 10 times as long to do some of these returns,” Mr. Johnston said.

It is not known how many couples have complied with the new rule, although experts say a significant number did not because of the expense and hassle.

Still, for some affluent couples with disparate incomes, the extra paperwork has paid off.

Shannon Schwartz, a stay-at-home father in Mountain View, and his husband, Calvin Kuan, a physician, have saved tens of thousands of dollars by applying the new rule to returns dating to 2007, which is legal, although after 10 months of working with the I.R.S., their case is still not completely resolved. “We’re thrilled about the money,” Mr. Schwartz said, “but the complexity of it seems unnecessary.”

And that was before J. Bell tolled.

“The rules were a mess anyway,” Ms. Broaddus said, “but then you do everything you can and you get this letter. It was a reminder that we’re second-class citizens.”

Scott James is an Emmy-winning television journalist and novelist who lives in San Francisco. sjames@baycitizen.org

It's a step in the right direction, but this year, preparing tax returns for RDPs did take almost 5 times as long.

(Editor’s note: Petra Loer and Kurtis Handa are Managing Directors in WTAS’ Valuation Services practice. They submitted this story to VentureBeat.)

Some entrepreneurs consider 409A valuations a necessary evil.  But too many aren’t particularly familiar with this particular section of the corporate tax code. And while we realize tax law might not be red-hot cocktail party conversation, it’s something that should be top of mind for start-up owners.

409A valuations are most commonly performed to assist companies with setting the strike price for their employee stock options, which needs to be at or above fair market value.  The most common questions surrounding those are: “Do I really need a valuation?,” “How do I select an appraiser and why does it cost so much?” and our personal favorite “Why is my common stock worth so much?”

Let’s explore each one.

Do I really need a valuation? – Internal Revenue Code Section 409A regulates the treatment of “nonqualified deferred compensation” paid by a “service recipient” to a “service provider” for federal income tax purposes.  Nonqualified deferred compensation can take the form of stock options, stock appreciation rights, or similar instruments.  Here’s what you’ll need to consider when you’re determining the need for a valuation:

• The fair market value must be determined using “reasonable application of a reasonable valuation method.”
• A valuation needs to be performed by someone who is qualified (based on their knowledge, training, experience, etc.).  In most cases, companies choose to hire outside appraisal firms to meet this requirement.
• The valuation needs to be updated at least every 12 months, or more frequently if significant changes occur in the business between grant dates (such as new rounds of financing).

If your company fails to comply with 409A, your employees will be personally liable for immediate taxation – plus a 20 percent penalty tax, and potential interest payments.

How do I select an appraiser and why does it cost so much? – You’ll need the appraiser in order to comply with the first two points above. As for the expense, keep in mind that properly performing an appraisal and considering all of the relevant factors can take a considerable amount of time.

As you look for the right person, here are a few questions you should ask:

• What methods would you use to value the common stock? If there is a recent arms-length round of financing, the appraiser may be able to rely on the round to deduce common stock value.  The appraiser should consider using an option-pricing model (i.e., Black-Scholes, lattice, or Monte Carlo – depending on the complexity of your capital structure), the Probability Weighted Expected Return Model (or “PWERM”), or the current value method (which is only appropriate in limited circumstances).  In terms of fees, relying on a round generally costs less, and fees for companies with complex capital structures are generally more.
• How do you support your concluded marketability discount? The IRS will look for evidence that your appraiser considered factors specific to the company and data such as restricted stock studies, not just quantitative models.
• Have you been successfully reviewed by auditors?
• Can your valuation be used for both tax and financial reporting purposes?

Why is my common stock worth so much? – Our clients often want to understand what types of factors influence the value of their common stock.  As one would expect, any factor that increases the value of the overall company increases the value of the common stock.  However, there are other influential factors as well:

• Preferred stock participation feature and dividends:  Most preferred shares contain a conversion option that allows the owner to convert his/her preferred shares into common shares.  Some preferred shares, however, have a participation feature allowing them to share in any upside with the common shares without the exercise of the embedded conversion rights. In other words, they get their cake and eat it too.  The presence of this type of participation feature ultimately increases the value of the preferred shares and reduces the value of the common shares.  The presence of preferred cumulative dividends would also reduce common stock value.
• Sale/transfer restrictions: The presence of certain sale/transfer restrictions associated with the company’s common stock will reduce the stock’s attractiveness and, therefore, reduce its value.
• Transactions in the company’s stock:  Increasingly, private company shares are being traded in the secondary market.  If a recent transaction exists, the appraiser may need to consider this value in determining the fair market value of the stock, depending on the circumstances of the transaction (like block size, buyer/seller motivation, availability of information, etc.).

Private company common stock virtually always has value; therefore, obtaining a defensible appraisal is an important step in potentially saving you from unnecessary IRS challenges and saving your employees from unexpected tax and penalties.

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Tags: IRS, tax code

This is a great overview by Petra Loer at WTAS on 409A Valuations. 409A Valuations have traditionally not gotten a lot of scrutiny by the IRS, but I could see that changing.

A husband and wife with an Upper East Side co-op who were facing over $270,000 in income tax penalties presented affidavits from managers at their regular hardware and wine shops in Connecticut, hoping to prove that they did not live in the city.

Yet another couple noted the devotion, time and money — $470,000 — that the wife had lavished on her garden in East Hampton, “which provided her with a great deal of solace”; it was evidence, they said, that they spent most of their time outside the city and that therefore they did not owe it $25,500.

The well-to-do with more than one home should be warned: it is the equivalent of sending a come-hither look to the tax man. And, as each of these unfortunates learned, pledging allegiance to the East End or the Constitution State will not save you from a very large bill.

Under longstanding rules, a person who spends more than half the year and maintains a home in New York City is taxed as a city resident. But this year, the state tax department, which collects both state and city income taxes, is adding a new line to 2010 tax forms, asking state residents who own second, or perhaps third and fourth, homes to specify how many days they spent in New York City. A number nearing 183 will be a red flag.

Thus, accountants and tax lawyers have been reminding their multi-homed clients to keep paper trails, as recent cases have shown the extent to which tax auditors and those being audited will go to try to prove — or disprove — permanent residence in the city.

In the event of an audit, the onus is on the taxpayers to prove that they were not in New York City, or in some cases, the state, for more than 183 days. Auditors and tax tribunals in these cases are often buried in blizzards of diaries, credit card slips, E-ZPass statements, e-mail and phone records.

For the New York State Department of Taxation and Finance, and the law, a New York minute counts as a day. Popping into Barneys counts as a New York City day. Same for lunching at Le Bernadin.

In one case that reached the state’s tax tribunal last fall, the hedge fund billionaire Julian H. Robertson Jr. presented evidence that he had had his assistant painstakingly collect to account for his whereabouts each day, and said that on some late nights he had frantically searched for a car to take him back to Locust Valley, on Long Island, so that he would be outside the city limits before midnight. He convinced the tribunal that he had spent less than half of 2000, the year in question, in the city, and thus did not owe back taxes of $27 million.

Yet not everyone has the means, or the assistants, to so meticulously record their comings and goings. One tax lawyer, Timothy Noonan, is creating an iPhone app for clients to monitor their “New York days,” using GPS. “I have many clients who track days,” Mr. Noonan wrote in an e-mail, “and yes, many of these clients are very close to the line.”

While the question is new on the 2010 tax form, state officials said they had long been on the lookout for residency discrepancies.

About 230 of the tax department’s 1,800 auditors focus on residency cases, and the number of such audits has been inching up, to 2,508 for the 2010 fiscal year, which ended March 31, from 2,000 in fiscal year 2008 (though down from 2,900 six years ago).

“It’s not more aggressively auditing people,” Brad Maione, a spokesman from the tax department, said. “Our goal is for people to get it right on their tax return when they file it. Our audit program is to identify where people could be doing it wrong and to get them to correct it.”

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If you maintain an "abode" (rent or own) in New York, and are in New York for more than 180 days (and partial days count), you are a New York State resident for the year for tax purposes. This rule also applies for NYC. If you keep a house or apartment in New York or New York City - it might be worth getting the iPhone app for tracking your "New York days".

This is an interesting article on The City applying the 1.5% payroll tax to Incentive Stock Options (non qualified stock options are already included in payroll and taxed) This is an employer payroll tax issue - the company would pay the tax, not the employee. I personally hope The City does not pursue this, but we'll have to wait and see.

Tax cuts enacted under former president George W. Bush are set to expire at year's end, and lawmakers are battling over whether to extend them before the November elections. Most Republicans want to extend all of the cuts, saying that any increase in taxes will hold back the economic recovery. President Obama and Democratic leaders would extend many of the cuts but say tax breaks for top earners should expire to pare down deficits. Each plan would affect average tax rates for income groups differently.

Click on an option to compare:

 

NOTE: Income levels represent cash income. The 20% income percentile groups contain an equal number of people, not tax units. The tax cuts that President Obama is proposing to extend for families earning less than $250,000 also apply to individuals earning less than $200,000.

SOURCE: Tax Policy Center, Joint Committee on Taxation, Office of Management and Budget | GRAPHIC: Wilson Andrews and Alicia Parlapiano / The Washington Post - August 18, 2010

 

This is a great interactive graphic by the Washington Post. The tax cuts are set to expire by the end of this year. Something has to happen. I am bothered that nothing has been done yet. People have to continue to make long-term financial decisions, and Congress has made it difficult by leaving so much uncertainty.

This is a continuing debate with my financially-savvy friends. My objective advice is to prioritize your debt by interest rate from highest to lowest. Next, consider the terms (is the rate fixed or variable?, how long is the loan period?). Finally, does the interest expense have a tax benefit (mortgage interest, student loan interest, investment interest, etc.), and if so, how much?
My subjective advice is that I doubt we'll see interest rates this low again in my lifetime. Home mortgage loans have been subsidized by the government - no private lender would lend money at 5% for 30 years - if you purchased or refinanced your home recently, this is your piece of the stimulus package. I also think there might be inflation on the horizon. If either of those points is correct, then people with fixed-rate debt will be financially well-positioned.

n preparers can cause trouble for taxpayers who fall victim to their ploys. Such preparers derive financial gain by skimming a portion of their clients’ refunds, charging inflated fees for return preparation services and attracting new clients by promising refunds that are too good to be true. Taxpayers s

The IRS released it's annual Dirty Dozen Tax Scams this week. Top of the list - Return Preparer Fraud. The sad truth is that there are a lot of unqualified (and some dishonest) preparers out there. Unfortunately, most taxpayers don't realize that for most instances, having a bad tax preparer is not a defense. When you sign your return, you are declaring that your return is accurate. Hire someone you trust. And if it sounds too good to be true, it probably is.

A little real-life comedy during tax season. Please email me if you receive Ottoman Turkish Empire Settlements - I want to do your taxes just for the story.