©2003 south-western college publishing, cincinnati, ohio chapter 3 business expenses &...

©2003 South-Western College Publishing, Cincinnati, Ohio©2003 South-Western College Publishing, Cincinnati, Ohio©2003 South-Western College Publishing, Cincinnati, Ohio©2003 South-Western College Publishing, Cincinnati, Ohio

CHAPTER 3

Business Expenses & Retirement PlansBusiness Expenses & Retirement Plans

© 2003 South-Western College Publishing Transparency 3-2

Objective

Be familiar with the tax rules for rental property and vacation homes


Rental Income/Expenses Net Rental Income or Loss is part of Gross Income

Report on Schedule E

Vacation Homes - must allocate expenses, if both personal and rental use of residence

Residence defined as anything providing shelter and accommodations for eating/sleeping (therefore ‘residence’ can be houseboat, mobile home, etc.)

Personal use is:

1. Use by taxpayer or taxpayer’s family

2. Any use by party who doesn’t pay FMV rent

3. Reciprocal agreement use


Homes With Dual Use as Rental and PersonalThree Categories

Primarily Personal useRented for < 15 days

Primarily Rental useRented > 15 days and personal use does not exceed

greater of 14 days or 10% of total vacation days

Dual uses of property

Rented > 15 days and personal use does exceed greater of 14 days or 10% of rental days


Primarily Personal UseTreated as a personal residenceRent income is not taxable

Mortgage interest/taxes reported on Form 1040, Schedule A

Other expenses are nondeductible


Primarily Rental PropertyMust allocate expenses between rental and

personal use, based on Rental days / Total days used = Rental % Expenses x % = Deductions

If rental loss, can deduct against other income, subject to passive loss rules

Personal % of mortgage interest and real estate taxes always included on Schedule A


Dual Use PropertyAllocate expenses between rental and personal based

on # of rental days / total days used = Rental %

Deduct rental expenses up to amount of rental income only, as follows Taxes and interest (can calculate % as Rental days/365 -

thereby taking more to Schedule A) Utilities/maintenance (only allowed up to amount of rental

income) Depreciation (only up to remaining rental income)

Any loss can be carried forward


Example of Rental/Personal Use

Facts: Ski cabin Personal use = 25 daysRental use = 50 days

Income = $10,000Taxes = $ 1,500 Interest = $ 3,000 Utilities = $ 2,000Insurance = $ 1,500Snow removal =$ 2,500Depreciation = $12,000

Step 2: taxes/interest = $4,500 x 50/75 = $3,000 deduction on E

Step 3: other expenses = $6,000 x 50/75 = $4,000 deduction on E

Step 4: depreciation = $12,000 x 50/75 = $8,000 but limited to $3,000 ($10,000 - 3,000 - 4,000 = $3,000) because dual use property can’t create a loss situation

Step 5 = What amount goes to Schedule A? (4,500 – 3,000 = $1,500)

Step 6 = What is the loss carry-forward? (8,000 – 3,000 =$5,000)

Step 1: personal use is > 14 days or 10% of rental (5 days); therefore, does exceed the greater number and this is dual use property


Objective

Understand the general treatment of passive income

and losses


Passive Loss LimitationsRule: When taxpayer is not actively involved

in an activity – losses are “passive” and may not be deducted in excess of passive gains, but

Loss can be carried forward and deducted in future years, or

Can deduct when property is sold

Report on Form 8582


Rental property, by nature, is passive Special Rule: If taxpayer rents real estate as a

profession, he/she is not subject to passive loss limitations

Passive Loss Limitations


When taxpayer is actively involved in rental activity (screens tenants, repairs and maintains property, etc.)

May take up to $25,000 of rental loss against ordinary income

The $25,000 loss capability is reduced by 50 cents for each $1 AGI exceeds $100,000

Doesn’t apply to Real Estate Limited Partnerships

Passive Loss Limitations -Rental Real Estate Exception


Rental Loss Exception ExampleTaxpayer actively participates in rental activity that has a rental loss of $20,000. AGI before the loss is $118,000. What amount of the rental loss can be claimed?

$118,000 - $100,000 = $18,000 excess, thus $25,000 allowable loss is reduced:

$25,000 - ($18,000 x 50%) = $16,000

Only $16,000 of the rental loss can be deducted.


Objective

Know the tax treatment of various deductions for AGI


Bad Debts If income was included in past -

worthlessness of a debt is deductible up to basis

Q: Can a cash basis taxpayer deduct a bad debt?

A: No, because revenue was never included in income


Two types of bad debts Business bad debts are fully deductible (for partial

or full worthlessness) - reported on Schedule C Non-business bad debts are short term capital

losses, which are netted against other capital gains and losses - reported on Schedule Dneed to show bona fide debtor/creditor relationship and

have proof (for example, bankruptcy proceedings)

can use specific write-off only (no estimates) and any future recovery would be income

Bad Debts


InventoriesLIFO, FIFO, and Specific Identification are all

acceptable for calculating cost of inventory

Choose one method and apply consistently

If LIFO is used for tax, LIFO must also be used for financial statement purposes

Form 970 used to elect LIFO

Why do most companies choose LIFO?


Net Operating Losses (NOL)NOLs result from business and casualty losses

only Taxpayer may carry loss back 2 years and file

amendments for prior years (1040X) or 1045 (for quick refund), or may elect to carry forward 20 yearsMay make an irrevocable election to forgo carry back, but

must elect this in year of loss

NOLs from 2001 or 2002 carry-back 5 yearsPre 8/97 NOLs are carried back 3 years and forward 15

Enter NOLs on line 21 of the Form 1040 as a negative number


Objective

Know the current treatment of Individual Retirement Accounts

(IRAs)


Kinds of IRAs

Regular IRAs (deduction for AGI)Nondeductible IRAs (regular IRAs, but

taxpayers cannot deduct because AGI exceeds requirements)

Roth IRAs

Educational “IRAs” (covered in Chapter 5)


Regular IRAs Contributions may be deducted for AGI

Earnings are not taxed until distribution

Must begin taking distributions by age 70.5 and can’t begin before age 59.5

10% penalty plus income tax for early withdrawal

May take distribution before age 59.5 penalty free up to $10,000 for first time home purchase, higher education expenses or medical expenses > 7.5% of AGI

Can make contributions up to tax return due date (through April 15, 2003 for 2002 deduction)


Deductibility of ContributionsIf neither spouse is in a qualified plan at work

(e.g., 401(k)), may deduct up to $3,000 per year per person

A spouse with no earned income will be able to contribute up to $3,000 annually to an IRA

Taxpayers age 50 and over may add an additional $500

If both spouses are in qualified plans, the phase out for deductibility is based on filing status (see tables in text)


If one spouse is in a qualified plan:

That spouse’s deduction is phased out based on AGI (see tables in book)

Other spouse (one not in a plan) doesn’t hit phase out until AGI > $150,000 MFJ

Even if deductibility is phased out, can still make a nondeductible IRA contribution

Important to track, because some distributions may be tax free return of capital (if taxpayers had nondeductible contributions due to phase outs above)

Deductibility of Contributions


Roth IRAContributions, lesser of $3,000 or earned

income for year, are nondeductible Taxpayers 50 or older may add $500 Phase outs for AGI from $95,000 to $110,000 for

single and $150,000 to $160,000 for MFJ

Qualified distributions are tax free as long as Roth IRA was open for 5 years and if: Distribution is made after age 59.5 or due to a

disability Distribution is used for a first time home buyer


Catch-Up Contributions

Contribution limits will gradually increase each year through 2008

Taxpayers over age 50 will be able to make catch-up contributions of $500 per year


Objective

Understand the general rules for qualified retirement plan

contributions


Keogh PlanFor self employed individuals

Tax free contributions are limited to lesser of 20% of earned income or $40,000

Cannot take distributions prior to age 59.5

Must begin distributions by age 70.5


Qualified Retirement Plan Qualified retirement plan - primarily deferred

compensation not to exceed $11,000/year for all salary reduction plans (includes Section 401(k) plans) Taxpayers 50 and older may defer $12,000 maximum Employee isn’t taxed on earnings in account or amount

contributed by employer

To achieve qualified plan status, the plan must: Be for the exclusive benefit of employees Be nondiscriminatory Have certain participation and coverage requirements Have uniform distribution rules Have minimum vesting requirements


Qualified Retirement Plan Funding a deferred compensation plan

Employee can contribute

Employer may match and will be allowed a deduction for the amount contributed

Maximum contribution is $11,000 ($12,000 if 50 or older) or 15% of gross wages

reduce max $ for $ for any other salary reduction plan for employee

maximum will increase by $1,000 each year from 2003 to 2006

10% excise tax is charged on excess contributions

When pensions are distributed, taxpayer gets 1099R


Plan 1 Plan 2

Direct Transfer Rollovers

No backup withholding necessary because $ goes right from one plan to another

Unlimited number of direct transfers per year

Taxpayer


Plan 1 Taxpayer Plan 2

Distribution Rollovers

Taxpayer has 60 days to get 100% of the $ from one plan to another

20% backup withholding is mandatory, so taxpayer must make up the 20% withholding and then wait until year end to get refund on 1040

Unlimited number of rollovers allowed per year


Savings Incentive Match Plan for Employees (SIMPLE Plans) Designed for use by employers with less than 100

employees

Can be SIMPLE-IRAs or part of 401(k)

Great plan for employers to maximize retirement contributions

Employee may elect % of gross wages to contribute (up to $7,000 per year; $7,500 if age 50 or older)

Employer must either: match employees’ contributions $ for $ up to 3% of gross wages, or contribute 2% of gross wages of all employees who make over

$5,000 per year (even if they don’t elect salary deferral)


Examples of SIMPLEExample 1

Sue makes $70,000 and chooses 8% of her salary; therefore, she makes a $5,600 SIMPLE contribution through salary reduction. Her employer matching = $2,100 ($70,000 x 3% maximum match)

Example 2

John has a small computer consulting business and has a salary of $5,000. He can contribute 100% of this to his SIMPLE. The employer matching is $5,000 x 3% = $150; for a combined SIMPLE contribution = $6,150


The End

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