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Author: Red Spot Design2

How the New Tax Law Affects Rental Real Estate Owners

Posted on by Red Spot Design2

Do you own residential or commercial rental real estate? The New Tax Law – Tax Cuts and Jobs Act (TCJA) brings several important changes that owners of rental properties should understand.

In general, rental property owners will enjoy lower ordinary income tax rates and other favorable changes to the tax brackets for 2018 through 2025. In addition, the new tax law retains the existing tax rates for long-term capital gains. (See “Close-Up on Tax Rates” in the right-hand box.)

Close-Up on Tax Rates

If you own property as an individual or via a pass-through entity — meaning a sole proprietorship, a limited liability company (LLC) treated as a sole proprietorship for tax purposes, a partnership, an LLC treated as a partnership for tax purposes, or an S corporation — net income from rental properties is taxed at your personal federal income tax rates.

For 2018 through 2025, the TCJA retains seven tax rate brackets, but six of the rates are lower than before. The 2018 ordinary income rates and tax brackets are as follows:

Bracket Single Married, Filing Jointly Head of Household
10% tax bracket $0 – $9,525 $0 – $19,050 $0 – $13,600
Beginning of 12% bracket $9,526 $19,051 $13,601
Beginning of 22% bracket $38,701 $77,401 $51,801
Beginning of 24% bracket $82,501 $165,001 $82,501
Beginning of 32% bracket $157,501 $315,001 $157,501
Beginning of 35% bracket $200,001 $400,001 $200,001
Beginning of 37% bracket $500,001 $600,001 $500,001

In 2026, the rates and brackets that were in place for 2017 are scheduled to return.

In addition, the new law retains the current tax rates on long-term capital gains and qualified dividends. For 2018, the rate brackets are:

Bracket Single Married, Filing Jointly Head of Household
0% tax bracket $ 0 – $38,600 $0 – $77,200 $0 – $51,700
Beginning of 15% bracket $38,601 $77,201 $51,701
Beginning of 20% bracket $425,801 $479,001 $452,401

These brackets are almost the same as what they would have been under prior law. The only change is the way the 2018 inflation adjustments are calculated.

Additionally, as under prior law, you still face a 25% maximum federal income tax rate (instead of the standard 20% maximum rate) on long-term real estate gains attributable to depreciation deductions.

Unchanged Write-Offs

Consistent with prior law, you can still deduct mortgage interest and state and local real estate taxes on rental properties. While the TCJA imposes new limitations on deducting personal residence mortgage interest and state and local taxes (including property taxes on personal residences), those limitations do not apply to rental properties, unless you also use the property for personal purposes. In that case, the new limitations could apply to mortgage interest and real estate taxes that are allocable to your personal use.

In addition, you can still write off all the other standard operating expenses for rental properties. Examples include depreciation, utilities, insurance, repairs and maintenance, yard care and association fees.

Possible Deduction for Pass-Through Entities

For 2018 and beyond, the TCJA establishes a new deduction based on a noncorporate owner’s qualified business income (QBI) from a pass-through business entity — meaning a sole proprietorship, a limited liability company (LLC) treated as a sole proprietorship for tax purposes, a partnership, an LLC treated as a partnership for tax purposes, or an S corporation. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels.

While it isn’t entirely clear at this point, the new QBI deduction is apparently available to offset net income from a profitable rental real estate activity that you own through a pass-through entity. The unanswered question is: Does rental real estate activity count as a business for purposes of the QBI deduction? According to one definition, a real property business includes any real property rental, development, redevelopment, construction, reconstruction, acquisition, conversion, operation, management, leasing or brokerage business.

Liberalized Section 179 Deduction Rules

For qualifying property placed in service in tax years beginning after December 31, 2017, the TCJA increases the maximum Section 179 deduction to $1 million (up from $510,000 for tax years beginning in 2017). Sec. 179 allows you to deduct the entire cost of eligible property in the first year it is placed into service.

For real estate owners, eligible property includes improvements to an interior portion of a nonresidential building if the improvements are placed in service after the date the building was placed in service. The TCJA also expands the definition of eligible property to include the expenditures for nonresidential buildings:

  • Roofs,
  • HVAC equipment,
  • Fire protection and alarm systems, and Security systems.

Finally, the new law expands the definition of eligible property to include depreciable tangible personal property used predominantly to furnish lodging. Examples of such property include:

  • Beds and other furniture,
  • Appliances, and
  • Other equipment used in the living quarters of a lodging facility, such as an apartment house, dormitory, or other facility where sleeping accommodations are provided and rented out.

Important: Sec. 179 deductions can’t create or increase an overall tax loss from business activities. So, you need plenty of positive business taxable income to take full advantage of this break.

Expanded Bonus Depreciation Deductions

For qualified property placed in service between September 28, 2017, and December 31, 2022, the TCJA increases the first-year bonus depreciation percentage to 100% (up from 50%). The 100% deduction is allowed for both new and used qualified property.

For this purpose, qualified property includes qualified improvement property, meaning:

  • Qualified leasehold improvement property,
  • Qualified restaurant property, and
  • Qualified retail improvement property.

These types of property are eligible for 15-year straight-line depreciation and are, therefore, also eligible for the alternative of 100% first-year bonus depreciation.

New Loss Disallowance Rule

If your rental property generates a tax loss — and most properties do, at least during the early years — things get complicated. The passive activity loss (PAL) rules will usually apply.

In general, the PAL rules only allow you to deduct passive losses to the extent you have passive income from other sources, such as positive income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you 1) have sufficient passive income or gains, or 2) sell the property or properties that produced the losses.

To complicate matters further, the TCJA establishes another hurdle for you to pass beyond the PAL rules: For tax years beginning in 2018 through 2025, you can’t deduct an excess business loss in the current year. An excess business loss is the excess of your aggregate business deductions for the tax year over the sum of:

  1. Your aggregate business income and gains for the tax year, plus
  2. $250,000 or $500,000 if you are a married joint-filer.

The excess business loss is carried over to the following tax year and can be deducted under the rules for net operating loss (NOL) carryforwards.

Important: This new loss deduction rule applies after applying the PAL rules. So, if the PAL rules disallow your rental real estate loss, you don’t get to the new loss limitation rule.

The idea behind this new loss limitation rule is to further restrict the ability of individual taxpayers to use current-year business losses (including losses from rental real estate) to offset income from other sources (such as salary, self-employment income, interest, dividends and capital gains). The practical result is that the taxpayer’s allowable current-year business losses (after considering the PAL rules) can’t offset more than $250,000 of income from such other sources or more than $500,000 for a married joint-filing couple.

Loss Limitation Rules in the Real World

Dave is an unmarried individual who owns two strip malls. In 2018, he has $500,000 of allowable deductions and losses from the rental properties (after considering the PAL rules) and only $200,000 of gross income. So he has a $300,000 loss. He has no other business or rental activities.

Dave’s excess business loss for the year is $50,000 ($300,000 – the $250,000 excess business loss threshold for an unmarried taxpayer). The $50,000 excess business loss must be carried forward to Dave’s 2019 tax year and treated as part of an NOL carryfoward to that year. Under the TCJA’s revised NOL rules for 2018 and beyond, Dave can use the NOL carryforward to shelter up to 80% of his taxable income in the carryforward year.

Important: If Dave’s real estate loss is $250,000 or less, he won’t have an excess business loss, and he would be unaffected by the new loss limitation rule.

Like-Kind Exchanges

The TCJA still allows real estate owners to sell appreciated properties while deferring the federal income hit indefinitely by making like-kind exchanges under Section 1031. With a like-kind exchange, you swap the property you want to unload for another property (the replacement property). You’re allowed to put off paying taxes until you sell the replacement property — or you can arrange yet another like-kind exchange and continue deferring taxes.

Important: For 2018 and beyond, the TCJA eliminates tax-deferred like-kind exchange treatment for exchanges of personal property. However, prior-law rules that allow like-kind exchanges of personal property still apply if one leg of a personal property exchange was completed as of December 31, 2017, but one leg remained open on that date.

Need Help?

The new tax law includes several expanded breaks for real estate owners and one important negative change (the new loss limitation rule). At this point, how to apply the TCJA changes to real-world situations isn’t always clear, based solely on the language of the new law.

In the coming months, the IRS is expected to publish additional guidance on the details and uncertainties. Your tax advisor can keep you up to date on developments.

Capital Gains Rates Before and After the New Tax Law

Posted on by Red Spot Design2

Are you confused about the federal income tax rates on capital gains and dividends under  the Tax Cuts and Jobs Act (TCJA)? If so, you’re not alone. Here’s what you should know if you plan to sell long-term investments or expect to receive dividend payments from your investments.

Old Rules

Prior to the TCJA, individual taxpayers faced three federal income tax rates on long-term capital gains and qualified dividends: 0%, 15% and 20%. The rate brackets were tied to the ordinary-income rate brackets.

Specifically, if the long-term capital gains and/or dividends fell within the 10% or 15% ordinary-income brackets, no federal income tax was owed. If they fell within the 25%, 28%, 33% or 35% ordinary-income brackets, they were taxed at 15%. And, if they fell within the maximum 39.6% ordinary-income bracket, they were taxed at the maximum 20% rate.

In addition, higher-income individuals with long-term capital gains and dividends were also hit with the 3.8% net investment income tax (NIIT). So, many people actually paid 18.8% (15% + 3.8% for the NIIT) or 23.8% (20% + 3.8% for the NIIT) on their long-term capital gains and dividends.

New Rules

The TCJA retains the 0%, 15% and 20% rates on long-term capital gains and qualified dividends for individual taxpayers. However, for 2018 through 2025, these rates have their own brackets that are not tied to the ordinary-income brackets. Here are the 2018 brackets for long-term capital gains and qualified dividends:

Tax Rates Single Married Joint Filers Head of Household
0% $0 – $38,600 $0 – $77,200 $0 – $51,700
15% $38,601 – $425,800 $77,201 – $479,000 $51,701 – $452,400
20% $425,801 and up $479,001 and up $452,401 and up

After 2018, these brackets will be indexed for inflation.

The new tax law also retains the 3.8% NIIT. So, for 2018 through 2025, the tax rates for higher-income people who recognize long-term capital gains and dividends will actually be 18.8% (15% + 3.8% for the NIIT) or 23.8% (20% + 3.8% for the NIIT).

Rates for Trusts and Estates

For 2018, the brackets for trusts and estates that collect long-term capital gains and qualified dividends are as follows:

Tax Rate Long-term capital gains and qualified dividends
0% $0 – $2,600
15% $2,601 – $12,700
20% $12,701 and up

For 2018 through 2025, the TCJA stipulates that these trust and estate rates and brackets are also used to calculate the so-called “kiddie tax” when it applies to long-term capital gains and qualified dividends collected by dependent children and young adults. The kiddie tax can potentially apply until the year that a dependent young adult turns age 24. (Under prior law, the kiddie tax was calculated using the marginal rates paid by the parents of affected children and young adults.)

Got Questions?

In a nutshell, the new law keeps the same tax rates for long-term capital gains and qualified dividends, but the rate brackets are no longer tied to the ordinary-income tax brackets for individuals. If you have questions or want more information about how long-term capital gains and qualified dividends are taxed under the TCJA, contact your tax advisor.

Paying Taxes on Short-Term Capital Gains

As under prior law, the Tax Cuts and Jobs Act (TCJA) taxes short-term capital gains recognized by individual taxpayers at the regular ordinary-income rates. For 2018, the ordinary-income rates and brackets are as follows:

Tax Rates Single Married Joint Filers Head of Household
10% $0 – $9,525 $0 – $19,050 $0 – $13,600
12% $9,526 – $38,700 $19,051 – $77,400 $13,601 – $51,800
22% $38,701 – $82,500 $77,401 – $165,000 $51,801 – $82,500
24% $82,501 – $157,500 $165,001 – $315,000 $82,501 – $157,500
32% $157,501 – $200,000 $315,001 – $400,000 $157,501– $200,000
35% $200,001 – $500,000 $400,001 – $600,000 $200,001 – $500,000
37% $500,001 and up $600,001 and up $500,001 and up

Protect Your Restaurant from Employee Embezzlement

Posted on by Red Spot Design2

restaurant employee embezzlementMitigating the risk of loss in restaurants through theft is an ongoing challenge. Automation has improved security in transactions as well as back-office functions. But with top concerns in the restaurant industry being wholesale food costs and building and maintaining sales volume, the reduction of theft can improve those concerns for restaurateurs. We review the key areas for employee embezzlement and provide guidance on limiting loss with proper checks and balances.

In 2015, Texas reported a 4.8 percent growth rate in restaurant sales, one of the highest in the nation. Restaurant employment grew by 22 percent.

Texas is experiencing one of the highest growth rates in the country for restaurant sales, according to a 2016 survey by the National Restaurant Association. However, members cited the cost of food and the ability to build and maintain sales volumes among their top concerns.

Employee embezzlement could be a hidden contributor.

Restaurant owners and managers are always looking for ways to reduce overhead costs while keeping their prices competitive for the market. A hidden contributor to overhead costs and lost margins is embezzlement. If food or money walks out the door consistently because of employee theft, it needs immediate attention.

Anyone who has worked in a restaurant has probably witnessed questionable behavior — not just from the patrons. History has shown that some employees — from the line cooks to servers and management — can demonstrate unethical and even criminal behavior when presented with an opportunity to put a little extra in their pockets. It is up to management to put safeguards in place to reduce those employee embezzlement opportunities.

Common types of theft in restaurants include:

  • Food theft from deliveries or freezersRestaurant Embezzlement WP Download
  • Prepared food and beverages given to patrons (unticketed)
  • Theft of equipment and supplies
  • Pocketed cash for undocumented orders
  • Patrons overcharged and the difference pocketed
  • Misuse of discounts, reward programs or coupons
  • Fake accounts payables
  • Underreporting daily receipts
  • Underreporting of earnings to franchisor and investors
  • Theft of recipes, processes or intellectual property

As an owner or franchisor expands to more than one location and relies on management, the risks of theft can increase. The impact of theft over time can be exponential, including a lower return on profits, an inability to reinvest in the business or provide employee benefits as well as difficulty recruiting and retaining staff. Restaurant communities tend to be small, close-knit groups who can quickly identify red flags with regard to a restaurant’s ownership or management. Reputation is critical to keep top talent and attract patrons.

In the next restaurant blog article, we will address each of these risks with solutions that incorporate a combination of automation and sound operational controls.

Continue Reading: The Most Common Types of Restaurant Theft

Cornwell Jackson has worked with retail businesses, including restaurants for decades, and provides direction on compliance as well as business advisory services. We help restaurant owners and franchisors determine policies and procedures, investments in technology and the viability and timing of additional locations. If you have questions around employee theft and how our team can support your accounting processes and daily POS or reconciliation methods, contact us for a consultation.

Scott Bates, CPA, is a partner in Cornwell Jackson’s audit practice and leads the business services practice, including outsourced accounting, bookkeeping, and payroll services. He is an expert for clients in restaurants, healthcare, real estate, auto and transportation, technology, service, construction, retail, and manufacturing and distribution industries.

Originally published on March 1, 2016. Updated in 2018. 

 

How the New Limit on SALT Deductions Affects Homeowners

Posted on by Red Spot Design2

The ability to deduct state and local taxes (SALT) has historically been a valuable tax break for taxpayers who itemize deductions on their federal income tax returns. Unfortunately, the Tax Cuts and Jobs Act (TCJA) limits SALT deductions for 2018 through 2025. Here’s important information that homeowners should know about the new limitation.

Old Law, New Law

Under prior law, in addition to being allowed to deduct 100% of state and local income (or sales) taxes, homeowners could deduct 100% of their state and local personal property taxes.

In other words, there was previously no limit on the amount of personal (nonbusiness) SALT deductions you could take, if you itemized. You also had the option of deducting personal state and local general sales taxes, instead of state and local income taxes (if you owed little or nothing for state and local income taxes).

Under the TCJA, for 2018 through 2025, itemized deductions for personal SALT amounts are limited to a combined total of only $10,000 ($5,000 if you use married filing separately status). The limitation applies to state and local 1) income (or sales) taxes, and 2) property taxes.

Moreover, personal foreign real property taxes can no longer be deducted at all. So, if  you’re lucky enough to own a vacation villa in Italy, a cottage in Canada or a beach condo in Cancun, you’re out of luck when it comes to deducting the property taxes.

Thinking about Selling Your Home?

There’s good news if you’re planning to sell a personal residence: The Tax Cuts and Jobs Act retains the home sale gain exclusion.

If you meet certain conditions, this valuable tax break allows you to exclude from federal income tax up to $250,000 of gain from a qualified home sale (or $500,000 if you’re a married joint-filer). The home sale gain exclusion rules remain unchanged under the final version of the new tax law — even though both the House and Senate proposed restrictions on this tax break during tax reform negotiations.

Who’s Hit Hardest?

These changes unfavorably affect individuals who pay high property taxes because:

  • They live in high-property-tax jurisdictions,
  • They own expensive homes (resulting in a hefty property tax bill), or
  • They own both a primary residence and one or more vacation homes (resulting in bigger property tax bills due to owning several properties).

People in these categories can now deduct a maximum $10,000 of personal state and local property taxes — even if they deduct nothing for personal state and local income taxes or general sales taxes.

Tax Planning Considerations

Is there any way to deduct more than $10,000 of property taxes? The only potential way around this limitation is if you own a home that’s used partially for business. For example, you might have a deductible office space in your home, lease your basement to a full-time tenant or rent your house on Airbnb during the winter months.

In those situations, you could deduct property taxes allocable to those business or rental uses, on top of the $10,000 itemized deduction limit for taxes allocable to your personal use. The incremental deductions would be subject to the rules that apply to deductions for those uses.

For example, home office deductions can’t exceed the income from the related business activity. And deductions for the rental use of a property that’s also used as a personal residence generally can’t exceed the rental income.

Important: If you pay both state and local 1) property taxes, and 2) income (or sales) taxes, trying to maximize your property tax deduction may reduce what you can deduct for state and local income (or sales) taxes.

For example, suppose you have $8,000 of state and local property taxes and $10,000 of state and local income taxes. You can deduct the full $8,000 of property taxes but only $2,000 of income taxes. If you want to deduct more state and local property taxes, your deduction for state and local income taxes goes down dollar-for-dollar.

AMT Warning

Years ago, Congress enacted the alternative minimum tax (AMT) rules to ensure that high-income individuals pay their fair share of taxes. When calculating the AMT, some regular tax breaks are disallowed to prevent taxpayers from taking advantage of multiple tax breaks.

If you’re liable for the AMT, SALT deductions — including itemized deductions for personal income (or sales) and property taxes — are completely disallowed under the AMT rules. This AMT disallowance rule was in effect under prior law, and it still applies under the TCJA.

More Limits on Homeowners

The new limits on property tax deductions will affect many homeowners. But that’s just the tip of the iceberg. If you have a large mortgage or home equity debt, your interest expense deductions also may be limited under the new law. For more information about how the TCJA affects homeowners, contact your tax advisor.

Close-Up on Mortgage Interest Deduction Rules

Posted on by Red Spot Design2

The Tax Cuts and Jobs Act (TCJA) imposes new limits on home mortgage interest deductions. Here’s how the changes could affect your tax situation.

The Basics

For the 2018 through 2025 tax years, the new law generally allows you to deduct interest on only up to $750,000 of mortgage debt incurred to buy or improve a first or second residence. This type of debt is called “home acquisition indebtedness” in tax lingo. (For married individuals who file separately, the home acquisition indebtedness limit is $375,000 for 2018 through 2025.) Under prior law, you could deduct interest on up to $1 million of home acquisition indebtedness (or $500,000 for those who use married filing separate status).

In addition, for 2018 through 2025, the TCJA generally eliminates deductions for interest paid on home equity debt. Under prior law, individuals were allowed to deduct interest on up to $100,000 of home equity indebtedness. (Married individuals who filed separately could deduct interest on up to $50,000 of home equity indebtedness.)

Under prior law, you could also treat another $100,000 of mortgage debt as home acquisition indebtedness ($50,000 for married people who file separately) if the loan proceeds were used to buy or improve a first or second residence. The additional debt could be in the form of a bigger first mortgage or a home equity loan. So, technically, the limit on home acquisition indebtedness under prior law was $1.1 million (or $550,000 for those who use married filing separate status).

What Is Home Acquisition Indebtedness?

Under the tax law, home acquisition debt is a mortgage taken out “to buy, build, or substantially improve a qualified home (your main or second home). It also must be secured by that home.”

An improvement is “substantial” if it:

  • Adds to the value of your home
  • Prolongs your home’s useful life, or
  • Adapts your home to new uses.

Repairs that maintain your home in good condition, such as repainting your home, aren’t substantial improvements. However, if you paint your home as part of a renovation that substantially improves your qualified home, you can include the painting costs in the cost of the improvements.

Exceptions for Grandfathered Debts

The TCJA “grandfathers” in existing home mortgage debt under the old rules. That is, the new law doesn’t affect home acquisition indebtedness of up to $1 million (or $500,000 for married-separate filers) that was taken out 1) before December 16, 2017, or 2) under a binding contract that was in effect before December 16, 2017, so long as the home purchase closes before April 1, 2018.

Under another grandfather provision, the previous home acquisition indebtedness limits of $1 million (or $500,000 for married-separate filers) continue to apply to home acquisition indebtedness that was taken out before December 16, 2017, and then refinanced during the period extending from December 16, 2017, through 2025. But the grandfather provision applies only to the extent that the initial principal balance of the new loan doesn’t exceed the principal balance of the old loan at the time of the refinancing.

Real-World Examples

Are you confused yet? Here are some examples of how the new mortgage interest deduction limits work.

The Andersons. This married joint-filing couple has a $1.5 million mortgage that was taken out to buy their principal residence in 2016. In 2017, the Andersons paid $60,000 of mortgage interest, and they could deduct $44,000 [($1.1 million ÷ $1.5 million) x $60,000].

For 2018 through 2025, they can treat no more than $1 million as acquisition indebtedness. (Their mortgage is exempt from the new limit, because it’s grandfathered in and the old limit applies.) So, if they pay $55,000 of mortgage interest in 2018, they can deduct only $36,667 [($1 million ÷ $1.5 million) x $55,000].

Now, let’s assume that the Andersons decide to refinance their mortgage on July 1, 2018, when the existing loan’s outstanding balance is $1.35 million.

Under the grandfather provision, the couple can continue to deduct the interest on up to $1 million of the new mortgage for 2018 through 2025.

Bob. This unmarried individual has an $800,000 first mortgage that he took out to buy his principal residence in 2012. In 2016, he opened up a home equity line of credit (HELOC) and borrowed $80,000 to pay off his car loan, credit card balances and various other personal debts.

On his 2017 return, which he will file in 2018, Bob can deduct all the interest on the first mortgage under the rules for home acquisition indebtedness. For regular tax purposes, he can also deduct all the HELOC interest under the rules for home equity debt. (However, the interest deduction is disallowed under the alternative minimum tax (AMT) rules, because the HELOC proceeds weren’t used to buy or improve a first or second residence. Contact your tax advisor for more information on the AMT rules.)

On his 2018 through 2025 tax returns, Bob can continue to deduct all the interest on the first mortgage under the grandfather provision, because the loan balance is below the $1 million limit on home acquisition indebtedness. But he can’t treat any of the HELOC interest as deductible home mortgage interest. The HELOC is characterized as home equity debt and interest on home equity debt is nondeductible under the new law.

Connie. She’s an unmarried taxpayer in the same situation as Bob, except her $80,000 HELOC was used entirely to remodel her principal residence. So, her home acquisition indebtedness included her first mortgage of $800,000 plus $80,000 of home equity debt used to remodel the home.

On her 2017 return, Connie can deduct the interest on the first mortgage and the HELOC because she can treat the combined balance of the loans as home acquisition indebtedness that doesn’t exceed $1.1 million.

For 2018 through 2025, Connie can continue to deduct the interest on both loans under the grandfather rule for up to $1 million of home acquisition indebtedness.

Diana. She’s an unmarried individual with an $800,000 first mortgage that was taken out on December 1, 2017, to buy her principal residence. In 2018, she opens up a HELOC and borrows $80,000 to remodel her kitchen and bathrooms.

For 2018 through 2025, Diana can deduct all the interest on the first mortgage under the grandfather provision for up to $1 million of home acquisition indebtedness. However, because the $80,000 HELOC was taken out in 2018, the $750,000 limit on home acquisition indebtedness under the new law precludes any deductions for the HELOC interest.

The entire $750,000 limit on home acquisition indebtedness was absorbed (and then some) by the grandfathered $800,000 first mortgage. So, the HELOC balance can’t be treated as home acquisition debt, even though the proceeds were used to improve Diana’s principal residence. Instead, the HELOC balance must be treated as home equity debt and interest on home equity debt is disallowed for the 2018 through 2025 tax years under the new law.

Eddie. He’s an unmarried taxpayer with a $650,000 first mortgage that was taken out on December 1, 2017, to buy his principal residence. In 2018, he opens up a HELOC and borrows $80,000 to remodel his basement.

For 2018 through 2025, he can deduct all the interest on the first mortgage under the grandfather provision for up to $1 million of home acquisition indebtedness. In addition, the $80,000 HELOC balance can be treated as home acquisition indebtedness, because the combined balance of the first mortgage and the HELOC is only $730,000, which is under the new limit of $750,000 for home acquisition indebtedness. So, Eddie can deduct all the interest on both loans under the rules for home acquisition indebtedness.

Important: If Eddie had used the HELOC to purchase a new car or pay off his credit card debt, it would not qualify as home acquisition indebtedness. To be eligible for this deduction, the HELOC proceeds must be used to substantially improve the taxpayer’s qualified residence. (See “What Is Home Acquisition Indebtedness?” at right.)

Got Questions?

The new limits on deducting home mortgage interest won’t affect all taxpayers. But homeowners with larger mortgages and home equity loans must take heed. Also, please understand that what you see here is based purely on our analysis of the applicable provisions in the Internal Revenue Code. Subsequent IRS guidance could differ. If you have questions or want more information about how the new home mortgage interest deduction rules affects homeowners, contact your Cornwell Jackson tax advisor.

Stretch Out Real Estate Tax Benefits

Posted on by Red Spot Design2

Let’s say you own a C corporation that needs to raise some cash and you’re considering the sale of a warehouse that has been depreciated to zero. But the company still uses the warehouse and doesn’t want to lose control of it.

Think about entering into a sale-lease transaction. You buy the warehouse personally and then lease it back to the company.

Advantages:

Your company raises the cash it needs and retains control of the warehouse. In addition, the lease payments are deductible by your company so they generate tax benefits from a property that was no longer providing depreciation deductions. Meanwhile, you get a source of income and can start a new depreciation schedule based on what you paid for the warehouse.The deductions provide a tax shelter for some of your lease income.

This plan may hold particular appeal to you if you are close to retirement because you can get a regular income without giving up equity in the company. When you’re no longer active in the business, the payments will become “passive” income, which could be offset by passive losses from tax-shelter investments. If you eventually sell the property, you’ll probably owe tax of 25% on depreciation you’ve taken and a maximum of 15% on long-term capital gains from appreciation.

But if your corporation continued to own the warehouse, subsequent appreciation probably would have been taxed at 34%. What’s more, any future gains go to you, not to the company, so you can collect cash without having to take a nondeductible dividend from the company.

In order for this deal to work, the property’s useful life must exceed the lease term. All the terms of the transaction — sale price, lease rates, renewal rates, repurchase option — must be at fair market value.

The Bottom Line:

You must assume the risk of losing money and have a real chance of making money, in order for the tax benefits to be sustained. As with all complex transactions, consult with your tax adviser to help you structure the deal.

New QBI Deduction Gives Eligible Pass-Through Businesses a Special Tax Break

Posted on by Red Spot Design2

Federal income tax rates for C corporations have been reduced to a flat 21%, starting in 2018 under the Tax Cuts and Jobs Act (TCJA). But what about pass-through businesses?

But not every pass-through entity is eligible for the break — and it isn’t always 20%. Here’s an overview of how much this deduction can amount to and which types of income count as qualified business income (QBI) under the new tax law.Congress devised a special tax break for pass-through businesses to help achieve parity between the reduced corporate income tax rate and the tax rates for business income that pass through to owners of sole proprietorships, partnerships, S corporations and limited liability companies (LLCs), which are treated as sole proprietorships or partnerships for tax purposes.

Calculating the QBI Deduction: It’s All Relative

To illustrate how the qualified business income (QBI) deduction works, let’s suppose you and your spouse file a joint tax return for 2018, reporting taxable income of $300,000 (before considering any QBI deduction or any long-term capital gains (LTCGs) or qualified dividends). Your spouse has $150,000 of net income from a qualified pass-through business that isn’t a specified service business.

Your preliminary QBI deduction is $30,000 (20% x $150,000). Since your joint taxable  income is below the $315,000 threshold for the phase-in of the W-2 wage limitation, you’re unaffected by the limitation. So, your QBI deduction is the full $30,000.

Alternatively, let’s suppose your brother and his wife file a joint tax return for 2018, reporting taxable income of $355,000 (before considering any QBI deduction or any LTCGs or qualified dividends). Your brother is an architect with $150,000 of net income from a qualified pass-through business.

His preliminary QBI deduction is $30,000 (20% x $150,000). Your brother’s share of W-2 wages paid by the business is $40,000. So, his W-2 wage limitation is $20,000 (50% x $40,000). The $10,000 difference between the $30,000 preliminary QBI deduction and the $20,000 W-2 wage limitation is 40% phased in [($355,000 – $315,000) ÷ $100,000]. Therefore, your brother’s QBI deduction is limited to $26,000 [$30,000 – (40% x $10,000)].

Now let’s turn to your sister, who works as an investment broker. She files as a single taxpayer for 2018, reporting taxable income of $187,500 (before considering any QBI deduction or any LTCGs or qualified dividends). Her income includes $125,000 of net income from selling investments, a specified service business.

Her tentative QBI deduction is $25,000 (20% x $125,000). For simplicity, let’s assume she’s unaffected by the W-2 wage limitation. However, under the service business limitation, she can take into account only 40% of her service business income, or $50,000 (40% x $125,000). That’s because the service business limitation is 60% phased in at your sister’s taxable income level [($187,500 – $157,500) ÷ $50,000 = 60%]. Therefore, her QBI deduction is limited to $10,000 (20% x $50,000).

Important: If your sister’s taxable income (before considering any QBI deduction or any LTCGs or qualified dividends) was below the $157,500 threshold for the phase-in of the service business limitation, she would qualify for the full QBI deduction of $25,000.

How Much Is the Deduction?

Under prior law, net taxable income from pass-through business entities was simply passed through to owners and taxed at the owners’ level at the standard rates.

For tax years beginning after December 31, 2017, the TCJA establishes a new deduction based on a non-corporate owner’s QBI. This break is available to individuals, estates and trusts. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels and another restriction based on taxable income.

A non-corporate owner’s deduction generally equals:

  1. 20% of QBI from a partnership (including an LLC treated as a partnership for tax purposes), S corporation, or sole proprietorship (including a single-member LLC that is treated as a sole proprietorship for tax purposes), plus,
  2. 20% of aggregate qualified dividends from REITs, cooperatives and qualified publicly traded partnerships (special rules apply to specified agricultural and horticultural cooperatives).

The QBI deduction isn’t subtracted in calculating the non-corporate owner’s adjusted gross income (AGI), but it reduces taxable income. In effect, it’s treated the same as an allowable itemized deduction. However, you don’t need to itemize to claim the QBI deduction.

Which Types of Income Count as QBI?

QBI is defined as the non-corporate owner’s share of items of taxable income, gain, deductions and loss from a qualified business. It includes interest income that’s properly allocable to a business, along with the aforementioned qualified dividends from REITs, cooperatives and publicly traded partnerships.

Investment-related items — such as capital gains and losses, dividends and interest income — don’t count as QBI. In addition, employee compensation and guaranteed payments from a partnership to a partner (including an LLC member who’s treated as a partner for tax purposes) don’t count as QBI.

Qualified items of income, gain, deductions and loss must be effectively connected with the conduct of a business within the United States or Puerto Rico.

Finally, QBI is calculated without considering any adjustments under the alternative minimum tax (AMT) rules.

Important: The QBI deduction and the applicable limitations are determined at the owner level. Each owner takes into account his or her share of qualified items of income, gain, deductions and loss from the pass-through entity and his or her share of W-2 wages paid by the entity.

Are There Any Restrictions?

In addition to being limited to 20% of your taxable income — calculated before the QBI deduction and before any net long-term capital gains (LTCGs) and qualified dividends that are eligible for preferential federal income tax rates — the QBI deduction is subject to two other limitations.

1. W-2 wage limitation. The QBI deduction generally can’t exceed the greater of the non-corporate owner’s share of:

  • 50% of amount of W-2 wages paid to employees by the qualified business during the tax year, or
  • The sum of 25% of W-2 wages plus 2.5% of the cost of qualified property.

Qualified property means depreciable tangible property (including real estate) owned by a qualified business as of the tax year end and used by the business at any point during the tax year for the production of QBI.

Under an exception, the W-2 wage limitation doesn’t apply until an individual owner’s taxable income exceeds $157,500 or $315,000 for a married-joint filer. Above those income levels, the W-2 wage limitation is phased in over a $50,000 taxable income range or over a $100,000 taxable income range for married joint-filers.

2. Service business limitation. Income from specified service businesses generally doesn’t count as QBI if the owner’s taxable income (not counting any potential QBI deduction) exceeds the applicable level. This limitation potentially affects income from such professions as:

  • Health care,
  • Law,
  • Accounting,
  • Actuarial science,
  • Performance art,
  • Consulting,
  • Athletics,
  • Financial and brokerage service,
  • Investing and investment management,
  • Trading or dealing in securities, partnership interests or commodities, and
  • Any business where the principal asset of the business is the reputation or skill of one or more of its employees.

Engineering and architectural service business are specifically excluded from this limitation.

The service business limitation doesn’t apply until an individual owner’s taxable income exceeds $157,500 or $315,000 for a married-joint filer. Above those income levels, the service business limitation is phased in over a $50,000 taxable income range or over a $100,000 taxable income range for married joint-filers.

Need Help?

Calculating the QBI deduction can be complicated. This article explains the basics, but additional factors may come into play, such as how business losses affect the QBI deduction calculation and how the deduction is calculated if you have income from several pass-through entities.

While the QBI deduction is beneficial, in some circumstances, it could make more sense to operate your business as a C corporation, which would be taxed at the flat 21% corporate income tax rate. Your tax advisor can help you sort through the complexities and find the best tax-smart strategies for your specific personal and business circumstances.

AMT Calculations: It’s Showtime

Posted on by Red Spot Design2

The alternative minimum tax (AMT) was enacted back in 1969 to ensure that high-income individuals don’t take advantage of multiple tax breaks and avoid paying federal tax. However, in recent years, the AMT has been imposed on many middle-income taxpayers. Unfortunately, the Tax Cuts and Jobs Act (TCJA) retains the individual AMT. But AMT exemptions and phaseout thresholds have been increased for 2018 through 2025.

How it works: The AMT calculation runs side-by-side with your regular income tax calculation. The starting point for the AMT is your taxable income calculated under the regular tax rules. Next, you add in “tax preference items” and make other adjustments that disallow some regular tax breaks or change the timing of when they’re taken into account. Then you subtract an AMT exemption amount that’s based on your tax return filing status. The result is your AMT income.

Finally, you apply the AMT tax rates of 26% and 28% to your AMT income and compare the result to your regular tax liability. In effect, you’re required to pay the higher of the two amounts.

Many people are unsure how the changes in the TCJA will affect their specific tax situations. Here are some examples to help you better understand the effects of how the AMT works under the new law. (For simplicity, we’ve assumed all of these imaginary taxpayers are empty nesters who don’t qualify for education-related tax credits or child tax credits.)

The Adams

It’s scary to think that taxpayers with less than $100,000 of taxable income could be hit with the AMT, but that’s just what happened to the Adams family in 2017. Fortunately, the TCJA brings good news: The Adams won’t owe AMT (assuming the same facts) for 2018 under the new law. Here’s why.

In 2017, this married joint-filing couple exercised an “in-the-money” incentive stock option (ISO) granted by the husband’s employer. The difference between the exercise price of the ISO shares and the trading price on the exercise date (the bargain element) was $50,000. The bargain element doesn’t count as income under the regular tax rules, but it does count as income under the AMT rules.

The calculation of the couple’s 2017 regular tax and AMT liabilities are as follows:

2017 Regular Tax Calculation

Salary

$75,000
Other ordinary income

$2,000
Adjusted gross income

$77,000
Standard deduction

($12,700)
Personal exemptions

($8,100)
Taxable income

$56,200
Regular tax liability

$7,498

2017 AMT calculation

Regular taxable income

$56,200
ISO bargain element

$50,000
Standard deduction

$12,700
Personal exemptions

$8,100
AMT income before exemption

$127,000
AMT exemption (no phase-out)

($84,500)
AMT taxable income

$42,500
AMT liability

$11,050

So, for 2017, the Adams family owes $11,050 for the AMT.

Important note: This calculation would have been more complicated if the couple itemized deductions. But, for simplicity, we’ve assumed that they took the standard deduction instead.

Now, let’s assume the same facts for 2018. The calculation of the couple’s 2018 regular tax and AMT amounts under the TCJA are as follows:

2018 Regular tax calculation

Salary

$75,000
Other ordinary income

$2,000
Adjusted gross income

$77,000
Standard deduction

($24,000)
Taxable income

$53,000
Regular tax liability

$5,979

2018 AMT calculation

Regular taxable income

$53,000
ISO bargain element

$50,000
Standard deduction

$24,000
AMT income before exemption

$127,000
AMT exemption (no phase-out)

($109,400)
AMT taxable income

$17,600
AMT liability

$4,576

Thanks to the TCJA, the Adams will not owe AMT in 2018. They’ll owe the regular tax amount of $5,979. So, the new law benefits this couple.

The Bradys

Like the Adams, the Bradys experience a bunch of good luck under the TCJA. That is, they’ll owe AMT under the old rules but not new rules. Here’s how their tax situation will improve from 2017 to 2018.

In 2017, this married joint-filing couple had itemized deductions totaling $50,000, including $25,000 for state and local taxes. The calculation of the couple’s 2017 regular tax and AMT liabilities are as follows:

2017 Regular tax calculation

Salary

$310,000
Other ordinary income

$2,000
Adjusted gross income

$312,000
Itemized deductions

($50,000)
Personal exemptions

($8,100)
Taxable income

$253,900
Regular tax liability

$59,004

AMT calculation

Regular taxable income

$253,900
Itemized deduction for state and local taxes

$25,000
Personal exemptions

$8,100
AMT income before exemption

$287,000
AMT exemption (after partial phase-out)

($52,975)
AMT taxable income

$234,025
AMT liability

$61,771

For 2017, the Bradys owe the AMT amount of $61,771.

Now assume the same facts for 2018. The calculation of the couple’s 2018 regular tax and AMT amounts under the TCJA are as follows:

2018 Regular tax calculation

Salary

$310,000
Other ordinary income

$2,000
Adjusted gross income

$312,000
Itemized deductions*

($35,000)
Taxable income

$277,000
Regular tax liability

$55,059

*For 2018 through 2025, itemized deductions for state and local income and property taxes are limited to $10,000 (combined).

2018 AMT calculation

Regular taxable income

$277,000
Itemized deduction for state and local taxes

$10,000
AMT income before exemption

$287,000
AMT exemption (no phase-out)

($109,400)
AMT taxable income

$177,600
AMT liability

$46,176

Thanks to the TCJA, the Bradys won’t be hit with the AMT for 2018. They’ll just owe the regular tax amount of $55,059. So the new tax law benefits this couple.

The Cunninghams

Tax Day is never a happy day in the Cunningham house. This is the wealthiest hypothetical couple in our examples. So, it’s not surprising that they’ll owe AMT under both the old and new rules.

In 2017, this married joint-filing couple exercised an in-the-money ISO granted by the wife’s employer. The difference between the exercise price of the ISO shares and the trading price on the exercise date (the bargain element) was $50,000. The calculation of the couple’s 2017 regular tax and AMT liabilities are as follows:

2017 Regular tax calculation

Salary

$400,000
Other ordinary income

$12,550
Adjusted gross income

$412,550
Standard deduction

($12,700)
Personal exemptions

($8,100)
Personal exemption phaseout

$6,480
Taxable income

$398,230
Regular tax liability

$106,633

2017 AMT calculation

Regular taxable income

$398,230
ISO bargain element

$50,000
Standard deduction

$12,700
Partially phased-out personal exemptions*

$1,620
AMT income before exemption

$462,550
AMT exemption (after partial phase-out)

($9,088)
AMT taxable income

$453,462
AMT liability

$123,213

* The personal exemption less the phaseout ($8,100 – $6,480).

So, the Cunninghams owe $123,213 in AMT for 2017.

Assuming the same facts for 2018, the calculation of 2018 regular tax and AMT amounts under the TCJA are as follows:

2018 Regular tax calculation

Salary

$400,000
Other ordinary income

$12,550
Adjusted gross income

$412,550
Standard deduction

($24,000)
Taxable income

$388,550
Regular tax liability

$87,715

2018 AMT calculation

Regular taxable income

$388,550
ISO bargain element

$50,000
Standard deduction

$24,000
AMT income before exemption

$462,550
AMT exemption (no phase-out)

($109,400)
AMT taxable income

$353,150
AMT liability

$95,052

In 2018, this couple is still in the AMT zone and owes $95,052 under the AMT rules. However, there is something for the Cunninghams to be happy about: Their 2018 AMT bill is much lower than their 2017 AMT bill, because the increased AMT exemption for 2018 is fully deductible. Therefore, the new law greatly benefits them, even though they still owe the AMT.

Applying Fiction in the Real World

These fictitious examples showcase how the AMT rules have changed for 2018 through 2025 under the TCJA. Although fewer taxpayers will be hit by this dreaded tax under the new law, it still will create headaches for some taxpayers. Consult your tax advisor to discuss customized strategies for minimizing the AMT.

Meeting the ERISA Plan Audit Requirement

Posted on by Red Spot Design2

When filing the Form 5500 annual report for employee benefit plans that is required under the Employee Retirement Income Security Act (ERISA), employer-sponsors must also be sure to include a financial statement audit for certain types of plans.

Small Plan Waivers

Small plans were once automatically exempt from audits. But the Labor Department amended the regulations and now small plans must meet certain conditions for an audit waiver.

By and large, small plans don’t require an audit, but they must disclose that they are waiving the audit on Form 5500 Schedule I. To claim the waiver, at least 95% of the plan’s assets must be “qualifying assets” such as employer securities, assets held by regulated financial institutions or shares of a registered investment company.

If that is not the case, any person handling non-qualifying assets must be bonded in an amount at least equal to the value of those assets. Additional disclosure requirements also apply.

 

The audit, which must be made by an independent qualified public accountant, is aimed at ensuring that a plan’s financial statements are presented fairly in all material respects and that they conform to U.S. generally accepted accounting principles (GAAP).

Pension and 401(k)-type plans typically fall under the audit requirement. While both large and small plans must file Form 5500 annually, typically only large plans need an audit. “Large” generally means plans with more than 100 eligible participants at the beginning of the plan year. (See right-hand box for discussion of audit waivers for small plans.)

Because the focus is on eligible participants, former employees who remain in the plan with balances or benefits, and active employees who are eligible but choose not to participate, count toward the 100-participant threshold. This is an important distinction in 401(k) plans.

Plans that fluctuate in size between 80 and 120 participants may be able to use the “80-120 rule.” This rule allows plans that have participants within the numerical range use the same small or large category they used the previous year when they file their annual reports. This can affect the audit requirement, so consult with your benefits professional to be sure the rule is being applied correctly.

A “limited-scope audit” is available in cases where a bank, trust company or insurance company, acting as a plan trustee or custodian, certifies that the investment information on the plan is complete and accurate. In these circumstances, the independent accountant doesn’t have to audit the certified financial information.

However, this is not an exemption from the audit requirement. It is simply a reduction in the scope of the auditor’s responsibilities. That can streamline the audit and cut costs. The accountant still must audit non-investment information, such as contributions and participant data, as well as assets that aren’t held by a certifying institution.

Auditors must be licensed or certified as public accountants by the state regulatory authority and cannot have a financial interest in the plan or the sponsoring employer.

Note: Welfare benefits plans — medical, dental, disability and the like — require an audit only if they are funded. If your company’s plan pays those benefits through some other means, check with your benefits professional to determine whether the plan requires an audit.

Inventory Accuracy Counts

Posted on by Red Spot Design2

Using sophisticated inventory management software is supposed to solve the problem of inaccurate counts, but that’s not always the case. Delays in order fulfillment and angry customers are inevitable if your warehouse is plagued by erroneous inventory counts.

If your inventory data doesn’t match what you physically have in your warehouse, it’s time to take corrective action.

Achieving Inventory Accuracy

Unfortunately, there’s rarely a quick fix to inaccurate inventory counts. Most likely you’ll need to employ a multipronged solution. First, turn your attention to defining and mapping your work processes. Work with your staff to gain a comprehensive understanding of all steps that affect inventory.

Also chart the actual workflow and document how the processes should work down to the individual task level for each position involved in the process — from purchasing, receiving and stocking to order processing, fulfillment and shipping. This includes completing and processing paperwork, entering data through automated scanning techniques or manually at workstations, and performing any required monitoring checks for inventory.

Next, ensure your employees are properly trained. Set up training sessions for all of your staff to review inventory processes and individual responsibilities. This will help them gain a solid understanding of workflow and how one process affects another.

Consider customizing your training so new employees receive more extensive training while more experienced employees receive periodic refresher courses as processes change. Test your employees on their knowledge of, and ability to perform expected tasks, and provide constructive guidance for correcting errors.

The next step is to set realistic goals for minimum inventory accuracy. On a regular basis, such as monthly, identify and report inventory inaccuracies — for example, improper counting, data entry errors or goods lost to theft, damage or disorganization. Translate what these inaccuracies mean in terms of lost profit.

Finally, continuous improvement is a must. Regularly review your operations with your staff to pinpoint broken process areas and identify solutions for reducing errors. This will allow you to incorporate enhancements or new processes as business needs change.

Try to batch together several process improvements at one time to avoid confusing employees with multiple process iterations. Then roll out the changes through formal training sessions to ensure everyone is on the same page.

Implement Cycle Counting to Improve Inventory Accuracy

To help you reach your inventory accuracy goal, be sure to include cycle counting. Cycle counting involves taking a physical count of part of your inventory in the warehouse each day.

These physical counts are then compared against the levels shown on your inventory management system. By pinpointing inventory discrepancies, cycle counting helps you identify the source of accuracy problems, so you can implement the right solutions.

To this end, there are two types of cycle counting that distributors need to employ in combination:

  1. Control group cycle counting.This type of counting involves selecting a control group made up of a cross-section sample of inventory, including parts and materials, and then counting the control group and comparing it against your inventory management system data. Control groups are rotated according to an established set schedule to ensure that all inventory in the warehouse is counted at least annually. Because control group cycle counting should be performed at least weekly, it can help you timely identify the source of errors.
  2. Random cycle counting.After you’ve implemented control group cycle counting, identified any sources of inventory accuracy problems and put the necessary solutions in place, begin implementing random cycle counting. With this type of counting, take a random mathematical sampling of your inventory to assess conformance against inventory accuracy expectations. An inference of the accuracy is then made relative to the entire inventory.

Cycle counting shouldn’t be a one-time event. Conducted frequently, it will ensure continuing improvement in the accuracy of inventory.

Does it Add Up?

If inaccurate inventory counts are a problem at your company, you need to take corrective steps as soon as possible. Not taking proactive measures may result in a loss of customers and reduced profits. If you need help remedying inventory inaccuracy, contact your CJ business advisor. We can help you ensure your numbers add up.

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