Now that tax season is officially underway, you might have seen some recent news coverage that some taxpayers from around the country are surprised that they owe tax. This is generally stemming from taxpayers’ awareness of tax reform (Tax Cuts & Jobs Act) that took effect last year and thus the anticipation of a (larger) refund this year.
So what’s going on? The first important thing to understand is to not confuse a refund (or lack of one) with the actual amount you paid in taxes during the year—either through withholding or quarterly payments. With that said, there’s a couple of common reasons some people are seeing lower refunds or a balance due this year.
Insufficient Tax Withheld
When the TCJA changes were enacted last year (see our earlier newsletter articles here and here), so were changes in what has been withheld from paychecks. In fact, in general, beginning in early 2018 when tax reform took effect, many employers starting taking less money out of their employees' paychecks. As a result, it’s estimated that millions of taxpayers had lower withholding once the new tax law took effect in 2018. While some taxpayers falling into this group might end up with a lower refund (or no refund), they received more money in each paycheck. However, that extra money might not be noticed because of other factors, such as increased health insurance premiums or other paycheck deductions.
If you didn’t adjust your withholding last year, you might want to consider doing a quick checkup to ensure you’re on track for 2019. The simplest method is to review the Form W-4 worksheet, which has a simple worksheet to help you figure out how much to withhold: https://www.irs.gov/pub/irs-pdf/fw4.pdf If you decide to make changes, follow your employer’s procedure to adjust your withholding.
Tip: With the new tax reform changes, claiming just one or even zero allowances on your W-4 may not have created enough tax withholding! So keep in mind that you can freely have more withheld than the amount you compute on the W-4 worksheet. Just add the extra amount to line 6 of the form W-4. The IRS allows you to change your withholding amount anytime during the year, as often as you want.
Taxpayers Living in States High State and Local Taxes
Some taxpayers with higher incomes in states with high state and local taxes are being impacted by the tax reform changes. Many residents in these states will probably be paying more in income taxes starting with the 2018 tax year. This is due mostly to the new limitations on deducting state, local and real estate taxes.
Other Common Reasons
While Tax Reform will certainly create unexpected results for some taxpayers, there's a few common events every year that can result in being underpaid (i.e., owe tax) on your tax return. If you and/or your spouse didn't make estimated tax payments last year and had any of the following events, you might be underpaid for the year:
Keep in mind that if you are self-employed (sole proprietor, independent contractor, freelancer, consulting, etc.) you are also responsible to pay self-employment tax. Unlike an employee who shares the cost of FICA tax with their employer, self-employed persons are responsible for the full burden of paying for their Social Security and Medicare!
You can read more tax articles on our blog:
By Scott Wolkens
The IRS recently issued guidance on the new deduction for up to 20% of qualified business income (QBI) under the Tax Cuts and Jobs Act (TCJA). If you own rental real estate, this article contains important information you need to consider for your rental properties starting this year!
If all the general requirements (which vary based on your level of taxable income) are met, the deduction can be claimed for a rental real estate activity--but only if the activity rises to the level of being a trade or business. An activity is generally considered to be a trade or business if that activity is regular, continuous, and considerable. To illustrate, if the property owner merely collects the rent without really doing much else, the rental is more passive in nature and thus won't qualify for the QBI deduction.
Because determining whether a rental real estate enterprise meets those criteria can be difficult, the IRS has provided a safe harbor under which such an enterprise will be treated as a trade or business for purposes of the QBI deduction if certain conditions are met. For this purpose, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties. Commercial and residential real estate may not be part of the same enterprise.
Under the safe harbor, a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the tax year with respect to the rental real estate enterprise:
(1) Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise.
(2) 250 or more hours of rental services are performed per year with respect to the rental enterprise. Note that these hours of service do not have to be performed by you personally. This means that services can also be performed by employees, agents and independent contractors or businesses you hire. So, for example, if you have hired a service contractor to perform service at your rental property, that service would count toward the total hours (provided they meet rule #3 below).
(3) The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services. Such records are to be made available for inspection at the request of the IRS. The contemporaneous records requirement is effective beginning the 2019 tax year.
For purposes of meeting the hours-of-service test, rental services include:
Rental services do NOT include financial or investment management activities, such as:
Ineligible Property Types
Some types of rental real estate are not eligible for the safe harbor. Real estate used as a residence by the taxpayer (including an owner or beneficiary of a pass-through entity) for any part of a tax year isn’t eligible for the safe-harbor rule. Real estate rented or leased under a triple net lease also isn’t eligible. With a triple net lease, the tenant or lessee, in addition to paying rent and utilities, agrees to pay taxes, fees and insurance, and to be responsible for property maintenance.
Taking the Deduction on your 2018 Tax Return
When we prepare your return and notice that you have either income or expenses for rental real estate, we'll contact you to consult with you and provide you the qualification requirements (which are listed above). If you advise us that your rental real estate meets the eligibility requirements, we'll claim the deduction and safe harbor for you on your tax return. The IRS also requires that all taxpayers include a statement attached to their tax return that claims that the requirements in Section 3.03 (above) have been satisfied. To make it easy for you, we'll provide you a form with the required statement that you must sign. And we'll include it in your return for you. As always, our goal is to make it easy for you!
QBI Loss & Anti-Abuse Rules
The rental real estate QBI deduction is only computed on net profit of your rental(s). If you have a net loss on your rental property, there's no deduction to take. However, if your property qualifies for the QBI deduction safe harbor rules, the amount of your loss is tracked for QBI purposes for subsequent tax returns. For example, if you had a net $5,000 loss on your rental property in 2018, and then had a net profit of $12,000 on your rental property in 2019, your QBI deduction on your 2019 return will be 20% of $7,000 ($12,000 minus $5,000). For this reason, to avoid abuse, taxpayers also aren’t allowed to vary their treatment of properties from year to year, unless there’s a significant change in facts and circumstances.
Taking the Deduction in Future Tax Years
IRS Notice 2019-7 guidance on the eligibility of rental real estate enterprises for the QBI deduction isn’t final. But it can be relied upon until final rules are issued by the IRS. Meanwhile, if you qualify for QBI under the minimum hours provision, you should be aware that you need to start complying with the recordkeeping requirements as of January 1, 2019. No specific format is required. So Excel, Word or a journal log will suffice, as long as all the pertinent details are recorded.
By Scott Wolkens
A popular option to save for college is a 529 tuition savings plan. However, most parents (and grandparents!) are not aware that you may use a 529 for federal tax-free withdraws to pay for private K-12 education. You can take a federal tax-free distribution from a 529 plan of up to $10,000 per calendar year per beneficiary to help pay for tuition at a K-12 private school.
When you fund a 529, the money you contribute doesn't go in tax-free. But you can earn interest on the money in the account. As that money is invested and generates returns, you're not liable for gains on your account's earnings year after year. Rather, you get to reinvest those earnings to accumulate an even higher savings balance. Then, when the time comes to withdraw from your 529, that money is not taxable—provided, of course, it was used for a qualified education expense at a qualified school.
Your child tells you that they want to study abroad in Paris
The good news is that distributions from 529 college savings plans can also be used tax-free to study abroad, but is subject to certain restrictions. In particular, the distribution must be used to pay for qualified higher education expenses at an eligible educational institution. Eligible educational institutions include colleges and universities that are eligible for Title IV federal student aid. There are two different ways to study abroad:
If post-secondary education isn't in the cards
Even if your child's path doesn't include any type of post-secondary education, you still have options. You opened the 529 for the benefit of your child, but the account belongs to you and you have the right to change the beneficiary. Most 529 plans allow you to change the beneficiary once a year, so that leaves the door wide open for future use. You could even convert it back to your original child's benefit should his plans change.
As long as the new beneficiary is a family member—a sibling, first cousin, grandparent, aunt, uncle or even yourself—the money can be used for qualified education expenses without incurring income taxes or penalties. Qualified expenses include tuition, required fees, books, supplies, computer-related expenses, even room and board for someone who is at least a half-time student.
This flexibility gives you a lot of options. Let's say you decide to go back to school. You make yourself the beneficiary and use 50% of the 529 assets for your studies. What do you do with the balance? You could simply change the beneficiary to another member of your family who could use it for their own qualified education expenses
Taking the cash is always a possibility, but it will cost you. If assets in a 529 are used for something other than qualified education expenses, you'll have to pay both federal income taxes and a 10% penalty on the earnings. (An interesting side note is that if the beneficiary gets a full scholarship to college, the penalty for taking the cash is waived.)
Since one of the main benefits of a 529 account is the federally tax-free earnings, think carefully before cashing it out. And really, it might be wise to sit tight before making any decisions. Your child may surprise you again by going in a whole new direction and you'll be glad you've kept those 529 assets in reserve.
by Scott Wolkens
Late last year and early this year, we sent newsletter articles about the 2018 Tax Reform and Jobs Act (TCJA) that was hurriedly passed into law in December 2017. Throughout this year the IRS has been slowly and incrementally releasing information pertaining to the changes.
Recently, some significant guidance that the tax professional community has been anxiously awaiting has finally been distributed. In this post, we’ll summarize the major revisions so that you’re aware of what’s changing. Keep in mind that the individual tax cuts and changes are temporary. Therefore, unless the changes in the TCJA are made permanent, the previous rates and structure would be restored in 2026. As your professional tax preparers, we don't require you to understand the technicalities of these changes because… that’s our job! Instead, the tax questionnaire that you fill out is your assurance that we’re aware of tax related events we’ll need to know. As always, our mission is to simplify the tax filing process for you. So please consider this optional reading!
Individual Tax Rates — The TCJA contains hundreds of changes that affect taxable income, including new tax brackets. The legislation created lower individual income tax brackets as follows: 10%, 12%, 22%, 24%, 32%, 35% and 37%. See the chart for a comparison.
While applicable tax rates at any given level of income have generally gone down by two to three points, some individuals will see an increase in taxes due to the tax brackets at which the rates apply. For example, the tax rate for single payers with taxable income between $200,000 and $400,000 goes from 33 percent to 35 percent. Also, high-income taxpayers are also subject to a 3.8 percent net investment income tax (if applicable) and/or the .9 percent Medicare surtax.
Keep in mind that U.S. taxes are still based on a “progressive” system, which means your tax rate increases as your taxable income amount increases. A common misconception is that all income is taxed at the rate in the bracket a person’s income falls. For example, if you’re single and got a pay raise that resulted in a taxable gross income of, say, $83,000, only $500 is taxed at the 24% tax bracket. The other amounts are taxed at each of the lower corresponding tax rates. Therefore, in general, pay raises and taking in more income is always going to put more money in your pocket! Also, taxable income is the basis for the values in the tables above. It is calculated as gross income, less any adjustments, less either the sum of itemized deductions or the standard deduction, whichever is larger.
Employment Tax Withholding — If you’re an employee, you should have completed a W-4 form when your employment began that showed your employer how much tax to withhold from your paycheck based on a withholding table. Due to tax reform changes, the tables used to determine withholding needed to be revised. Your employer should have used the revised tables beginning February 15, 2018. Accordingly, some tax changes may result in either a lower tax refund or larger balance due because your tax savings may be reflected as increased take-home pay. Also, keep in mind that while the tables provide an approximate amount to properly withhold for basic returns, the tables are generally less reliable for taxpayers with multiple sources of income and more complex returns ; e.g., Schedule A, C, D, E, etc.
Alternative Minimum Tax (AMT) - The legislation increases the exemption amount and phaseout thresholds, which means that fewer people will be subject to AMT. From 2018 through 2025, a higher AMT exemption will apply to income, beginning with $109,400 for joint filers and $70,300 for other taxpayers in 2018. The exemption will phase out at $1 million for joint filers and $500,000 for other taxpayers. The thresholds will be adjusted for inflation.
Standard Deduction — The standard deduction increases significantly from $12,700 to $24,000 for joint filers, from $9,350 to $18,000 for heads of households, and from $6,350 to $12,000 for single filers. Additional amounts apply for upper age brackets and blind persons. However, to ensure that we claim the maximum deduction for you, we’ll still be requesting clients to provide us with all their tax-deductible expenses. These include mortgage interest, property taxes, charity donations, medical, sales tax paid on specific purchases (e.g., a vehicle purchase), etc. After we calculate those deductions, we will closely compare the results and determine which reporting method provides you the most advantageous benefit.
Personal Exemptions — Before the TCJA, taxpayers could claim an exemption for themselves, their spouse, and their dependents (if eligible). Each exemption lowered taxable income by $4,050 under pre-TCJA (2017) law. The TCJA has suspended all personal and dependent exemptions. New tax provisions, including a higher standard deduction, may or may not make up for the removal of personal and dependent exemptions, as taxpayers’ situations vary.
Affordable Care Act (commonly referred to as “Obamacare”) — You may have heard that tax reform eliminated the Affordable Care Act (ACA) individual penalty. However, it’s important to note that the removal of the healthcare tax penalty is not effective until the 2019 tax year! This means that you must still have had Healthcare this year (2018) or be subject to a penalty when your return is prepared in 2019. Accordingly, we will be required to ask you about Healthcare coverage and have you send us Form(s) 1095 that you receive for the 2018 tax year.
Child and Dependent Credits — From 2018 through 2025, the reform legislation increases the value of the child tax credit from $1,000 to $2,000 per child under 17 years-old at the end of the tax year. As much as $1,400 of the credit will be refundable, thus allowing you to claim the benefit even if you don’t have a tax liability. In addition, a $500 nonrefundable tax credit for dependent children over age 16 and all other dependents for whom you provide at least half their support. As before, you will need to provide us your child's full name, Social Security Number (SSN), date of birth, relationship to you, and they must pass an IRS dependency “test” to claim the refundable portion (don’t worry - we’ll guide you on the “test” qualifications). The legislation also expands eligibility for the credit by increasing the phaseout threshold to $400,000 of adjusted gross income for joint filers (up from $110,000 under prior law), with a threshold for all other filers set at $200,000. A $500 nonrefundable credit for dependents other than children will be available.
$10,000 Cap on State and Local Tax Deduction — In a significant departure from prior law, the legislation will allow individuals to deduct no more than $10,000 of any combination of the following taxes: state and local income taxes, state and local property taxes, and sales taxes. This overall limitation may result in the enhanced standard deduction yielding a larger deduction against your adjusted gross income and thus a lower tax bill. Again, we’ll determine what’s most advantageous for you and report that amount.
Mortgage Interest Deduction — The mortgage interest deduction on acquisition indebtedness (e.g., mortgages) of more than $750,000 obtained after December 14, 2017 is limited to the portion of the interest allocable to $750,000. The $1 million limitation remains for mortgages incurred before December 15, 2017. Interest paid on your principal residence and a second home are deductible. Under a grandfather rule, the TCJA changes do not affect up to $1 million of home acquisition debt that was taken out before December 16, 2017 and then refinanced later--to the extent the initial principal balance of the new (refinanced) loan does not exceed the principal balance of the old loan at the time of the refinancing. In other words, under the $1M grandfather rule, if you refinance for an amount that exceeds the current principal balance (including refinance costs built into the loan) the grandfather rule will no longer apply. Based on these new rules, anytime you are planning to refinance, we recommend you send us a quick email for guidance. Also, keep in mind that only the interest on home equity line of credit (HELOC) indebtedness used to purchase or make capital improvements to the home is deductible. For example, if you took out a HELOC to buy a new car, that would not qualify for a tax deduction.
Qualified Medical Expense Deduction — All individuals may deduct medical expenses for 2017 and 2018 if the expenses exceed 7.5% of adjusted gross income, regardless of age. However, the AGI threshold returns to 10% of adjusted gross income in 2019 for all taxpayers, regardless of age. Again, we will need to review whether claiming such expenses, when combined with other allowable itemized deductions, yields a higher deduction than the standard deduction.
Elimination of Deduction for Certain Miscellaneous Expenses — The reform act eliminates the deduction for certain miscellaneous deductions. Thus, deductions (subject to the 2% floor of adjusted gross income) for costs related to the production or collection of income, such as investment fees and a safety deposit box are now non-deductible. Also, expenses related to employment, such as uniforms, professional society dues, computer used for work, and job-hunting expenses also are non-deductible. Employees who incur significant unreimbursed business expenses may want to ask their employer about adjusting their compensation. Don’t confuse the repeal of miscellaneous deductions listed above with self-employed deductions or rental properties, which are still fully deductible on Schedule C and E, respectively.
Alimony Deduction — The tax legislation repeals the above-the-line deduction for alimony paid for divorces or separations executed after December 31, 2018. After that date, alimony payments will not be included in the recipient's income and the payments no longer will be deductible by the payor. If you are currently contemplating divorce or separation, a careful review of the effects of the new law should be undertaken to determine the economic effects on your tax situation and timing of any agreements.
Section 179 Expensing — The expensing limitation is increased to $1 million and the phase out amount to $2.5 million. The new limitations are to be adjusted for inflation. The act further expands the definition of §179 property and the definition of qualified real property for improvements made to nonresidential real property.
Entertainment Expenses Deductions — No deduction is allowed generally for entertainment, amusement, or recreation; membership dues for a club organized for business, pleasure, recreation, or other social purposes; or a facility used in connection with any of the above. Examples include tickets to not-for-profit high school or college sporting events, leased skyboxes for sporting events, transportation to/from sporting events, cover charge, taxes, tips and parking for entertainment events.
NOL Deduction —The limit on the NOL (Net Operating Loss) deduction is 80% of the taxpayer's taxable income and provides that amounts carried to other years be adjusted to account for the limitation. Amounts are to be carried forward indefinitely.
Corporate Tax Rate — Beginning in 2018, there is a 21% flat corporate tax rate; there is no longer a special tax rate for personal service corporations.
Alternative Minimum Tax — Beginning in 2018, the alternative minimum tax (AMT) is repealed for business returns. In 2018, 2019 and 2020, if the entity has AMT credit carryforward, the entity is able to claim a refund of 50% of remaining credits (to extent credits exceed regular tax for year). For 2021, the entity is able to claim a refund of all remaining credits.
Qualified Business Income (QBI) — The biggest—and most complex—change introduced by the tax reform law provides certain individual owners of sole proprietorships, rental properties (and other entities such as S corps, partnerships, etc.) to deduct up to 20% of their income earned from those entities. The regulations to claim and report this deduction are exceptionally complex to summarize in this article. But don’t fret! Our tax questionnaire will have a section pertaining to QBI that we'll ask you to complete so that we can determine your overall qualifications to take this deduction.
Again, we don’t expect you to be tax experts—that’s our job! Instead, we simply need to be aware of what occurred for you during the year. We’ll be asking you to complete the simplified tax questionnaire. Completing this questionnaire is your assurance that we’re aware of qualifying events that provide deductions and credits. The form takes about 5-10 minutes to fill out. It’s that simple!
With so many changes to the tax law and how the tax is determined and calculated on a return, most taxpayers should expect a change in their overall tax liability compared to the prior year. As a result, you might see a significant change in the amount you are over/under paid compared to the prior year(s). It just comes down to how much you paid into the system, through estimated tax payments and/or withholding from your paycheck.
As always, contact our office if you have questions.
Ter Claeys, CPA
The Tax Reform and Jobs Act (see our November blog for an in-depth overview) means that some individuals who itemized in the past won’t itemize if their total qualifying deductions are below $12,000 ($24,000 for married ). Many clients have expressed concern that they might lose out on some tax deductions.
In this article, we'll provide some strategies to maximize your write-offs, including charitable contributions, improvements to your house, tax incentive credits, and how to limit (or eliminate entirely) capital gains if you sell your home.
Due to the increase in the standard deduction, you might think you would seemingly lose some of the tax benefits of your charitable deductions. To explain, assume a married couple has $6,000 of mortgage interest and is capped at $10,000 of deductions for their property taxes and state and local taxes. With the new standard deduction level at $24,000, this couple would receive no tax savings from the first $8,000 of charitable contributions. But there's a way around this limitation! If this couple instead bunches their donations in alternate years, they could itemize their deductions every other year and get the benefit. Over the two-year period, the couple generates an additional $8,000 in tax deductions. If the couple falls in the 32 percent tax bracket (with taxable income over $157,500), bunching would provide a permanent tax savings of $2,560. Another option is a donor advised fund (DAF). A DAF allows you to give in one year, but spread the actual grants made to charities over several years. This option allows your favorite charities to receive a donation from you every year, while you take the full deduction in the year you fund the DAF.
If you own a house, the day may come when you will eventually sell your home. Many individuals are aware that there’s a capital gains exclusion of $250,000 ($500,000 if married) on the sale of a home if they resided in that home as their primary residence for two out of the last five years. However, many individuals who have owned their home for a moderately long time may have experienced a significant increase in the market value of their home. Many homeowners can escape or significantly reduce capital gains tax by accounting for every improvement made to their home. A new roof, siding, windows, kitchen/bath remodel and even landscaping improvements are all capital improvements and can easily add up to $50-100K plus. My advice is to dig up old invoices, receipts, county permits, etc. to capture the total cost for your records. Save this information so that we can report it when we prepare your return for the year in which you sell your home.
Where the total cost of improvements to your house can help you reduce or eliminate capital gains tax, the sales tax you paid for materials and items for the house are deductible. For any improvements or repairs to your home, keep the sales receipt and tally up the sales tax paid for all materials purchases. If you hired a contractor, have them break out the cost of the materials vs. labor on the invoice(s) and then request the sales tax amount paid for the materials. Many contractors won’t automatically do this, so make this specific request when they create the final invoice. Our tax questionnaire will have a question about this topic to help you remember to gather this information.
In general, registration fees paid for vehicles are not deductible if the fee isn't based on the value of the vehicle. However, residents who are taxed for regional transit on their vehicle registration can deduct that particular tax. For example, some county residents in Washington State are charged a regional transit authority (RTA) tax that is based on the value of their vehicle. If you paid this tax (or similar tax in your county or state), dig up your registration documents and provide the information to us.
If you’re in the market for an all-electric car and home battery charger, planning is key. Many of these purchases qualify for a prized tax credit up to $7,500. A credit is prized because it’s a dollar-for-dollar tax reduction. However, many buyers get caught off guard when claiming the credit because they were unaware that there is a maximum tax credit allowed on a given tax return. A simple solution is to straddle your electric car and home battery charger between two tax years; e.g., December and January, respectively.
For example, if you are planning to purchase a new electric car, make the purchase in December and then purchase the home battery charger the following January. The two items in themselves are oftentimes below the maximum allowable credit, meaning you can claim the maximum credit for the car on your 2018 return and the battery on your 2019 return. Bonus tip: If you’re not in the market for an electric car, keep in mind that you may still deduct the sales tax you paid for a traditional new or used vehicle purchase.
The biggest change introduced by the tax reform law provides individual owners of sole proprietorships, rental properties (and certain other entities such as S corps, partnerships, etc.) to deduct up to 20% of their income earned from those entities. If you’re not a business owner, don’t overlook this deduction if you own rental property and have tenants. The regulations to claim and report this deduction are exceptionally complex to summarize in this article. But don’t fret! Our Tax Questionnaire will have a section that ensure we obtain the necessary information to take the deduction for you.
Most individuals don't think about taxes until tax season, and thus seek out a tax professional during the most hectic time of year—tax season. This particular time of year is when most tax preparation firms reach their maximum capacity and are no longer able to take on new clients for April filings. If you have friends or family planning to engage a professional tax preparation firm, my biggest piece of advice is to consult with them now. In fact, meeting now is an opportunity to make strategic tax decisions during the tax year (you can’t change history if you wait till tax season!). So make some calls now and get acquainted in a relaxed setting when the CPA or EA has time. Many firms (including us) offer complimentary consultations to discuss needs and can offer a pre-engagement.
Finally, and most notable is that despite early on claims that tax returns would be simplified, and most taxpayers would file on a postcard, the actual outcome resulted in even greater complexity. Tax law is exceptionally complicated and can’t be fully explained in this post.
Again, we don’t expect you to be tax experts—that’s our job! Instead, we simply need to be aware of what occurred for you during the year. We’ll be asking you to complete the simplified tax questionnaire. Completing this questionnaire is your assurance that we’re aware of qualifying events that provide deductions and credits. The form takes about 10 minutes to fill out. It’s that simple!
Last year's sweeping tax overhaul, the Tax Cuts and Jobs Act of 2017 (TCJA), introduced a new tax break for owners of many pass-through businesses.
Individuals who are sole proprietors, partners in partnerships, own rental real estate, members in LLCs taxed as partnerships (hereafter, "partners"), or shareholders in S corporations, may be able eligible to claim a deduction for qualified business income (QBI) under new Code Section 199A, beginning with the 2018 tax year. Trusts and estates are also eligible for the deduction.
The amount of the deduction (QBI deduction) is generally 20 percent of the taxpayer's qualifying business income from a qualified trade or business.
Example: In 2018, Joe receives $100,000 in salary from his job at XYZ Corporation and $50,000 of qualified business income from a side business that he runs as a sole proprietorship. Joe's QBI deduction for 2018 is $10,000 (20% of $50,000).
The QBI deduction is claimed by individual taxpayers on their personal tax returns. The deduction reduces taxable income, and is not used in computing adjusted gross income. Thus, it does not affect limitations based on adjusted gross income.
An explanation of the main rules for the QBI deduction follows.
Different Rules Apply at Different Levels of Taxable Income
One of the most important things to understand about the QBI deduction is that the rules that apply to individuals with taxable income below certain thresholds in a given tax year are simpler and more permissive than the ones that apply to income above those thresholds. For 2018, the threshold amount is $315,000 for married taxpayers filing a joint return, and $157,000 for all others.
There are actually only two rules that are waived for taxpayers with income below the threshold, but the impact can be profound. These are: (1) a rule that disqualifies income from a broad range of service businesses (referred to as "specified service trades or businesses") from the QBI deduction; and (2) a rule that limits the QBI deduction to a percentage of W-2 wages paid by a business. Both are discussed below.
Other rules, such as one preventing individuals from claiming the QBI deduction for employment income, apply to all taxpayers, regardless of their level of taxable income.
Qualified Trades or Businesses
The QBI deduction can only be claimed for income from a qualified trade or business.
A qualified trade or business means any trade or business other than:
(1) a specified service trade or business; or
(2) the trade or business of being an employee.
Specified service trade or business. A "specified service trade or business" is defined as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. Engineering and architecture services are specifically excluded from the definition of a specified service trade or business.
Some of the categories and fields listed in the previous paragraph are fairly clear in their meaning. Others - such as "consulting" and "any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees" - are vague, and will be difficult to apply until the IRS provides guidance.
Special rule where taxpayer's income is below a specified threshold. The rule disqualifying specified service trades or businesses from being considered a qualified trade or business does not apply to individuals with taxable income of less than $157,500 ($315,000 for joint filers). After an individual reaches the threshold amount, the restriction is phased in over a range of $50,000 in taxable income ($100,000 for joint filers). If an individual's income falls within the range, he or she is allowed a partial deduction. Once the end of the range is reached, the deduction is completely disallowed.
Employees vs. independent contractors. The rule that taxpayers cannot claim a QBI deduction on their employment income is clear. But it isn't always clear when an individual is an employee versus being an independent contractor - and unlike employees, independent contractors are eligible for the QBI deduction. The more favorable treatment of independent contractors for purposes of the new deduction creates new opportunities, but also new pitfalls. If you're currently an employee and find yourself considering a switch to becoming an independent contractor, we should discuss the implications for both employment taxes and any potential QBI deduction.
Qualified Business Income
Qualified business income (QBI) means the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer.
Compensation paid to partners and S corporation shareholders. QBI does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer, or any guaranteed payment (or other payment) to a partner for services rendered with respect to the trade or business.
Example: Monica is a shareholder in, and sales manager for ABC, an S corporation that is a qualified trade or business. During the tax year, she receives reasonable compensation of $250,000 from ABC for her services as its sales manager. In addition, her pro rata share of ABC's net income, its only item of income or loss, is $175,000. Monica's qualified business income from ABC is $175,000. This is the amount eligible for the 20% QBI deduction.
'Domestic' requirement. Items are treated as qualified items of income, gain, deduction, and loss only to the extent they are effectively connected with the conduct of a trade or business within the United States.
Investment income. Qualified items do not include specified investment-related income, deductions, or losses, such as capital gains and losses, dividends and dividend equivalents, interest income other than that which is properly allocable to a trade or business, and similar items.
REIT dividends, cooperative dividends, and publicly traded partnership income. Qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income are not included in the definition of QBI, but these items are eligible for a separately calculated 20 percent deduction.
Calculating the QBI Deduction for Each Trade or Business
The QBI deduction for a qualified trade or business is the lesser of:
(1) 20 percent of qualified business income; or
(2) the greater of: (a) 50 percent of the business's W-2 wages (applies to most businesses), or (b) an amount based on a more complex formula involving the business's W-2 wages and its depreciable property (see "Alternative limitation for rental real estate activities", below).
The amount in (2), above, is referred to as the "W-2 wage limitation".
Example: Susan, a single taxpayer, owns and operates a sole proprietorship that sells cupcakes. The cupcake business pays $100,000 in W-2 wages and has $350,000 in qualified business income. For the sake of simplicity, assume the business has no depreciable property, so the W-2 wage limitation is based on 50 percent of the business's W-2 wages (not the more complex formula involving wages and property). Susan's QBI deduction is $50,000, which is the lesser of (a) 20 percent of $350,000 in qualified business income ($70,000), or (b) 50 percent of $100,000 of W-2 wages ($50,000).
Alternative limitation for rental real estate activities. The more complex formula referred to in (2), above, which typically applies mainly to rental real estate activities, calculates the W-2 wage limitation by adding 25 percent of the business's W-2 wages to 2.5 percent of the original tax basis of the business's depreciable property that's still within its depreciable period at the end of the tax year.
Phase-in of W-2 wage limitation. The W-2 wage limitation does not apply to individuals with taxable income of less than $157,500 ($315,000 for joint filers). After an individual reaches the threshold amount, the W-2 limitation is phased in over a range of $50,000 in taxable income ($100,000 for joint filers).
Calculating the QBI deduction for multiple business. If you own more than one qualifying trade or business, the QBI deduction must be calculated separately for each business. This requirement can sometimes reduce the overall deduction by preventing W-2 wages or qualified property from one business from being used to increase the deductible amount from another business.
Loss carryovers. If the net amount of qualified business income from all qualified trades or businesses during the tax year is a loss, it is carried forward as a loss from a qualified trade or business in the next tax year (and reduces the qualified business income for that year).
Special Rules for Partnerships and S Corporations
In the case of a partnership or S corporation, the business income deduction applies at the partner or shareholder level. Each partner in a partnership takes into account the partner's allocable share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages for the taxable year equal to the partner's allocable share of W-2 wages of the partnership. Similarly, each shareholder in an S corporation takes into account the shareholder's pro rata share of each qualified item and W-2 wages.
Taxable Income Limitation on the QBI Deduction
If your taxable income (reduced by any income taxed at capital gain rates and before applying any QBI deduction) is less than your qualified business income, the QBI deduction is limited to 20 percent your taxable income (reduced by any income taxed at capital gain rates).
Example: Cynthia owns and operates LittleCo, a sole proprietorship that is a qualified trade or business. Cynthia has $100,000 in qualified business income from LittleCo, and no other items of income or loss. She has a total of $25,000 in above-the-line and itemized deductions. Her taxable income, prior to applying any QBI deduction, is $75,000. Cynthia's QBI deduction is $15,000, which is the lesser of her QBI deduction for LittleCo ($20,000 = 20% x $100,000 QBI) or 20 percent of her taxable income taxed at regular tax rates ($15,000 = 20% x $75,000 taxable income).
The effect of this limitation is to ensure that the 20 percent QBI deduction rate isn't applied to more income than the amount taxed at regular tax rates. The limitation mainly applies in situations where most or all of a taxpayer's income is qualified business income. Taxpayers with a significant amount of non-QBI income taxed at regular rates (e.g., salary or wage income, spousal salary or wage income, taxable interest income, etc.) will generally not see their QBI deduction reduced by the taxable income limitation.
Requirement to Carry-Forward Losses
The QBI deduction is based on the computed net profit on your federal tax return. If you have a net tax loss (i.e., your expenses exceeded your rental income) on your qualified trade or business activity, there won't be a deduction to take. However, the amount of your loss will be tracked for QBI purposes on your future tax return(s). For example, if your trade or business had a $5,000 net loss on in 2018, and then had a net profit of $12,000 in 2019, your QBI deduction on your 2019 return will be 20% of $7,000 ($12,000 minus $5,000). To ensure that the safe harbor is not selectively used (e.g., claim the safe harbor only when there's a net profitable tax year), taxpayers cannot vary their safe harbor election, unless there’s a significant change in facts and circumstances.
By Scott Wolkens and Ter Claeys, CPA
The recently passed Tax Reform law (officially known as the Tax Cuts and Jobs Act) made significant changes to the tax law, including increasing the standard deduction, removing personal exemptions, increasing the child tax credit, limiting or discontinuing certain deductions and changing the tax rates and brackets. In this article, we'll delve into highlights of the new tax law for personal returns that takes effect for the 2018 tax year.
Filing a tax return on a postcard isn't in the cards. Despite the goal to simplify the tax code, there will be no true postcard tax form. In the rush to present the bill for signature by year-end, simplification efforts went to the wayside. Instead, the law introduces additional worksheets and schedules, many of which will get more complex. For example, for clients with children, we'll file Schedule 8812 that will allow you to take the expanded Child Tax Credit. For owners of pass-through businesses, for instance, we'll need to do myriad complex calculations to deduct 20 percent of the business income (we'll cover this topic in a future edition). But don’t fret about extra forms and complexity--that’s our job!
The law keeps seven tax brackets, but with different rates and break points. For example, not only is the top individual rate lowered from 39.6% to 37%, but that rate kicks in at a higher income level. However, note that whatever new bracket you fall into, more of your taxable income will be hit with lower rates than before.
There’s a secret hitch to the tax cut. Inflation indexing of income tax brackets and various tax breaks is altered. Tax brackets, standard deductions and many other items will be adjusted annually using a chained consumer price index, resulting in lower inflation adjustments and thus smaller annual increases than with the current index. According to critics, this is a hidden tax hike that over time will nail nearly all individual filers.
Standard deductions become larger. $24,000 for couples, $12,000 for singles and $18,000 for head of household. Folks age 65 or up get $1,250 more per person ($1,550 if unmarried). Given these higher amounts, we expect that more clients will take the standard deduction in lieu of itemizing. However, we’ll continue to ask most clients for qualifying deductions, such as mortgage interest, real estate taxes, charity, medical costs, etc. You may ask why we'd do this. The reason is because we'll still need to prepare Schedule A and do the math to figure out which method is most advantageous! Our objective is always to maximize the deductions for which youi qualify.
The new law pares back or axes many deductions claimed by individuals. Personal exemptions for individual filers and their dependents are repealed. These will partially offset the increase in the standard deduction.
Home mortgage deductions are nicked. Interest can be deducted on up to $750,000 of new acquisition debt on a primary or second residence, which is down from $1 million. The new limit generally applies to mortgage debt incurred after Dec. 14, 2017. Older loans and refinancings up to the old loan amount still get the $1-million cap. No write-off is allowed beginning in 2018 for interest on existing or new home equity loans (HELOCs).
The popular deduction for state and local taxes is squeezed. You can deduct any combination of residential property taxes and income or sales taxes up to a $10,000 cap. Property taxes remain fully deductible for taxpayers in a business or for-profit activity, and taxes paid on rental realty can be taken in full on Schedule E, as before.
The medical expense deduction is enhanced. Not only have lawmakers opted to keep this popular write-off, but they've also temporarily lowered the AGI threshold for deducting 2017 and 2018 medical expenses on Schedule A from 10% to 7.5% (as noted in our tax questionnaire). If you provide(d) us medical expenses, we always automatically prepare your return with the expenses and will file the deduction if your qualified expenses exceed the 7.5% threshold.
Several other write-offs are eliminated: Itemized Schedule A deductions for job-related moves, and miscellaneous personal write-offs subject to the 2% of Adjusted Gross Income (AGI) threshold, including unreimbursed employee business expenses, brokerage investment fees, hobby expenses, and theft losses. (Small business owners: these are not to be confused with Schedule C deductions and Home Office deductions, which continue as-is with no threshold.)
Tax rates on Long-Term Capital Gains and Qualified Dividends do not change. Currently, your capital gains (e.g., stock and security sales) and dividends rate depends on your tax bracket. But with the bracket changes, Congress decided to set income thresholds instead. The 0% rate will continue to apply for taxpayers with taxable income under $38,600 on single-filed returns and $77,200 on joint returns. The 20% rate starts at $425,800 for singles and $479,000 for joint filers. The 15% rate applies for filers with incomes between those break points. The 3.8% surtax on net investment income remains, kicking in for single people with modified AGI over $200,000 , and $250,000 for married.
The law keeps the individual Alternative Minimum Tax (AMT) with higher exemptions: $109,400 for joint return filers and $70,300 for singles and household heads. Additionally, the exemption phase-out zones start at much higher income levels ... above $1 million for couples and $500,000 for single people and heads of household.
The Affordable Health Care (AKA Obamacare) individual mandate isn't gone--yet. The requirement that folks have health insurance, qualify for an exemption, or pay a fine is repealed for post-2018 years. Keep in mind the mandate continues to apply for 2018, and will be a filing requirement for your taxes next year, too.
The Child Tax Credit is doubled to $2,000 for each dependent under age 17. The income phase-out thresholds are much higher ... AGIs over $400,000 for couples and $200,000 for all other filers.
There's a new $500 credit for each dependent who is not a qualifying child, including, for example, an elderly parent you take care of or a disabled adult child. It's nonrefundable and phases out under the same thresholds as the child credit.
The new tax law makes it riskier to convert a traditional IRA to a Roth IRA. In the past, you had until Oct. 15 of the following year to undo the switch and eliminate the tax bill by transferring the funds back to a traditional IRA. This is called a recharacterization and could make sense if the Roth lost money. Conversions done after 2017 are irreversible. You'll still have the ability to convert your traditional IRA to a Roth, but you won't be able to undo the switch. However, you still have time to reverse a 2017 conversion. According to the IRS, Roth conversions for the 2017 tax year can be properly recharacterized up until Oct. 15, 2018.
New Withholding tables. New withholding tables reflect the new tax rates and tax brackets, higher standard deductions and repeal of personal exemptions. The Revenue Service will issue a revised W-4 form that takes into account the changes in the new tax law. You should consider reviewing your withholding to ensure that you have the desired amount withheld from each paycheck.
The new tax law is still being evaluated by the IRS. As we've said before, the IRS has a big job ahead to administer all the changes in the legislation. It will have to issue mounds of guidance, revise many of its forms and publications, reprogram its massive computer systems, and do outreach and education. All of this will take time. So while we shared what we know, keep in mind that projecting many scenarios for these changes right now can't be done with certainty until the IRS provides final guidance.
Keep in mind that, after 2025, all individual tax cuts will expire, while corporate rate cuts were made permanent. As a result, in nine years the Joint Committee on Taxation (JCT) estimates that a majority of Americans will either see little change in their tax bill or a tax increase relative to what they pay today.
Married couples have an option to either choose Married Filing Jointly (MFJ) or Married Filing Separately (MFS). One common question that often comes up for newly married couples and married couples moving to Washington state is “Which one is best for us?”
First and foremost, the State of Washington is community property state. This means that income is paid into the marital community and all expenses are paid out of the marital community. Income variations amongst spouses is not relevant because all income is pooled into the marital community.
Married couples residing in a community property state who file separate federal tax returns must fully understand the community property tax laws for their state, and the IRS requirements for filing separately. The couple needs to identify their community income and community deductions. Generally, the majority of deductions must be split evenly, with each spouse reporting half of the total deductions. Some deductions, however, must be allocated separately. And still other deductions may have a mixed allocation.
If you choose MFS as your filing status, many tax credits are disallowed if you file separate returns. If one spouse itemizes deductions, the other must too, even if he or she has none to itemize–in which case, the deduction is a $0. Following are some disadvantages of Married Filing Separately:
"Our tax liability comes out lower on our returns using the Married Filing Separately type, so there must be something else!"
Even if none of the forfeited credits listed above are applicable, the preparer must ensure that all standard deductions, exemptions, itemized deductions and credits are being allocated properly and precisely across the two returns. Additionally, married couples filing separately must either both itemize or both take the standard deduction--and in doing so, properly allocate the itemized deductions or standard deductions amongst the two individuals. In other words, the preparer must ensure that they didn't "double-dip" any credits or deductions.
Identifying and tracking these credits, deductions and exemptions across two returns can be incredibly complex to identify because myriad calculations are conducted on supporting tax worksheets in the background. Consumer tax software isn't necessarily programmed to cross-check the returns for these calculations. In our experience, these are common errors we've immediately discovered upon evaluating self-prepared returns with a married filing separately status.
There are literally thousands of computations for every tax profile scenario, and if you're not versed in tax law, you risk filing an inaccurate return (that may subject you to hefty penalties, interest owned on underpayment, plus paying the tax due).
If you do choose to file separately, the IRS will probably really wonder why a couple in a community property state is filing separate returns. When the IRS begins to question, that's generally a recipe in the making for an audit. Therefore, unless there is a specific, clear purpose that substantiates a need (i.e., you're attempting to bring forth information vs. hiding information), Married Filing Separately in a community property state is generally disadvantageous and provides heightened exposure for an audit.