Working Abroad Can Yield Tax-Free Income

Article Highlights:

• Tax-Free Income from Working Abroad
• Foreign Earned Income & Housing Exclusions 
• Foreign Self-Employment Income 
• Claiming or Revoking the Exclusion 

U.S. citizens and resident aliens are taxed on their worldwide income, whether the person lives inside or outside of the U.S. However, qualifying U.S. citizens and resident aliens who live and work abroad may be able to exclude from their income all or part of their foreign salary or wages, or amounts received as compensation for their personal services. In addition, they may also qualify to exclude or deduct certain foreign housing costs. 

To qualify for the foreign earned income exclusion, a U.S. citizen or resident alien must: o Have foreign earned income (income received for working in a foreign country); 

• Have a tax home in a foreign country; and 
• Meet either the bona fide residence test or the physical presence test. 

The foreign earned income exclusion amount is adjusted annually for inflation. For 2015, the maximum foreign earned income exclusion is up to $100,800 per qualifying person. If taxpayers are married and both spouses (1) work abroad and (2) meet either the bona fide residence test or the physical presence test, each one can choose the foreign earned income exclusion. Together, they can exclude as much as $201,600 for the 2015 tax year, but if one spouse uses less than 100% of his or her exclusion, the unused amount cannot be transferred to the other spouse. 

In addition to the foreign earned income exclusion, qualifying individuals may also choose to exclude or deduct from their foreign earned income a foreign housing amount. The amount of qualified housing expenses eligible for the housing exclusion and housing deduction is limited, generally, to 30% of the maximum foreign earned income exclusion. For 2015, the housing amount limitation is $30,240 for the tax year. However, the limit will vary depending on where the qualifying individual's foreign tax home is located and the number of qualifying days in the tax year. The foreign earned income exclusion is limited to the actual foreign earned income minus the foreign housing exclusion. Therefore, to exclude a foreign housing amount, the qualifying individual must first figure the foreign housing exclusion before determining the amount for the foreign earned income exclusion. 

Before you become overly excited, foreign earned income does not include the following amounts: 

• Pay received as a military or civilian employee of the U.S. Government or any of its agencies. 
• Pay for services conducted in international waters (not a foreign country). 
• Pay in specific combat zones, as designated by a Presidential Executive Order, that is excludable from income. 
• Payments received after the end of the tax year following the year in which the services that earned the income were performed. 
• The value of meals and lodging that are excluded from income because it was furnished for the convenience of the employer. 
• Pension or annuity payments, including social security benefits. 

A qualifying individual may also claim the foreign earned income exclusion on foreign earned self-employment income. The excluded amount will reduce his regular income tax, but will not reduce his self-employment tax. Also, the foreign housing deduction - instead of a foreign housing exclusion - may be claimed. 

A qualifying individual claiming the foreign earned income exclusion, the housing exclusion, or both, must figure the tax on the remaining non-excluded income using the tax rates that would have applied had the individual not claimed the exclusions. In other words, the exclusion is off-the-bottom, not off-the-top. 

Once the foreign earned income exclusion is chosen, a foreign tax credit, or deduction for taxes, cannot be claimed on the income that can be excluded. If a foreign tax credit or tax deduction is claimed for any of the foreign taxes on the excluded income, the foreign earned income exclusion may be considered revoked. 

Other issues: 

Earned income credit - Once the foreign earned income exclusion is claimed, the earned income credit cannot be claimed for that year. 

Timing of election - Generally, a qualifying individual's initial choice of the foreign earned income exclusion must be made with one of the following income tax returns: 

• A return filed by the due date (including any extensions); 
• A return amending a timely-filed return; 
• Amended returns generally must be filed by the later of 3 years after the filing date of the original return or 2 years after the tax is paid; or 
• A return filed within 1 year from the original due date of the return (determined without regard to any extensions). 

A qualifying individual can revoke an election to claim the foreign earned income exclusion for any year. This is done by attaching a statement to the tax return revoking one or more previously made choices. The statement must specify which choice(s) are being revoked, as the election to exclude foreign earned income and the election to exclude foreign housing amounts must be revoked separately. If an election is revoked, and within 5 years the qualifying individual wishes to again choose the same exclusion, he must apply for approval by requesting a ruling from the IRS. 

Are you looking for foreign employment or has an opportunity already presented itself to you? Before you make your final decision, please call our office to learn more about the foreign earned income and housing allowance exclusions, or how to meet the bona fide residence or physical presence tests.

www.paulandersoncpa.com

Take Advantage of Education Tax Benefits!

Article Highlights:

• Student loans  
• Gifting low basis assets 
• Education credits 
• Education savings programs 
• Educational savings bond interest 

The tax code includes a number of incentives that, with proper planning, can provide tax benefits while you, your spouse, or children are being educated. Which of these options will provide the greatest tax benefit depends on each individual’s particular circumstances. The following is an overview of the various possibilities. 

Student Loans - A major planning issue is how to finance your children’s education. Those with substantial savings simply pay the expenses as they go while others begin setting aside money far in advance of the education need, perhaps utilizing a Coverdell account or Sec. 529 plan. Others will need to borrow the funds, obtain financial aid, or be lucky enough to qualify for a scholarship. Although student loans provide one ready source of financing, the interest rates are generally higher than a home equity debt loan, which can also provide a longer repayment term and lower payments. 

When choosing between a home equity loan or student loan, keep in mind the following limitations: (1) Interest on home equity debt is deductible only if you itemize, and then only on the first $100,000 of debt, and not at all to the extent that you are taxed by the alternative minimum tax; and (2) student loans must be single-purpose loans—the interest deduction is available even if you do not itemize but is limited to $2,500 per year, and the deduction phases out for joint filers with income (AGI) between $130,000 and $160,000 ($65,000 to $80,000 for unmarried taxpayers). 

Gifting Low Basis Assets - Another frequently used tax strategy to finance education is to gift appreciated assets (typically stock) to a child and then allow the child to sell the stock to pay for the education. This results in transferring any gain on the stock to the child at a time when the child has little or no other income; tax on the gain is avoided or is at the child’s low rate. With the lowest of the long-term capital gains rates currently being zero, Congress curtailed income shifting to children by making most full-time students under the age of 24 subject to the “kiddie tax.” This effectively taxes their unearned income at their parents’ tax rates and makes the gifting of appreciated assets to a child less appealing as a way to finance college expenses. 

Education Credits - The tax code provides tax credits for post-secondary education tuition paid during the year for the taxpayer and dependents. Currently, there are two types of credits: the American Opportunity Credit, which is limited to any four tax years for the first four years of post-secondary education and provides up to $2,500 of credit for each student (some of which may be refundable), and the Lifetime Learning Credit, which provides up to $2,000 of credit for each family each year. The American Opportunity Credit is phased out for joint filers with incomes between $160,000 and $180,000 ($80,000 to $90,000 for single filers). The 2015 phaseout ranges for the Lifetime Learning Credit are $110,000–$130,000 for married joint and $55,000–$65,000 for others. Neither credit is allowed for married individuals who file separately. Careful planning for the timing of tuition payments can provide substantial tax benefits. 

Education Savings Programs - For those who wish to establish a formalized long-term savings program to educate their children, the tax code provides two plans. The first is a Coverdell Education Savings Account, which allows the taxpayer to make $2,000 annual nondeductible contributions to the plan. The second plan is the Qualified Tuition Plan, more frequently referred to as a Sec. 529 plan, with annual nondeductible contributions generally limited to the gift tax exemption for the year ($14,000 in 2015). Both plans provide tax-free earnings if used for qualified education expenses. When choosing between a Coverdell or Sec. 529 plan, keep the following in mind: (1) Coverdell accounts can be used for kindergarten through post-secondary education and become the property of the child at age of majority, and contributions are phased out for joint filers between $190,000 and $220,000 ($95,000 and $110,000 for others) of income (AGI); and (2) Sec. 529 plans are only for post-secondary education, but the contributor retains control of the funds and there is no phase out of the contribution based on income. 

Educational Savings Bond Interest - There is also an exclusion of savings bond interest for Series EE or I Bonds that were issued after 1989 and purchased by an individual over the age of 24. All or part of the interest on these bonds is exempt from tax if qualified higher education expenses are paid in the same year that the bonds are redeemed. As with other benefits, this one also has a phase-out limitation for joint filers with income between $115,750 and $145,750 ($77,200 and $92,200 for unmarried taxpayers, but those using the married filing separately status do not qualify for the exclusion). The exclusion is computed on IRS Form 8815,Exclusion of Interest from Series EE and I U.S. Savings Bonds Issued After 1989. 

If you would like to learn more about these benefits, or to work out a comprehensive plan to take advantage of them, please give this office a call. 

Don't Forget Those Nominee 1099s

Don't Forget Those Nominee 1099s!

Article Highlights: 

Who is a nominee?

What a nominee must do

Allocating reported income

Series 1099 forms

For tax purposes, if you receive, in your name, income that actually belongs to someone else, you are also a nominee. Being a nominee means you must file with the IRS a 1099 form appropriate to the type of income you received that reports the other individual’s share of the income and give a copy of the 1099 to the actual owner of the income. However, if the other person is your spouse, no 1099 filing is required. 

The most commonly encountered nominee situations include when you have a joint bank account or brokerage account with someone other than your spouse and all the income from those accounts is reported under your Social Security number (SSN). You will need to issue the IRS and your joint account owner a 1099 reporting the co-owner’s share of the income under his or her SSN. Then, when you file your return, you show all of the income but back out the co-owner’s share as “nominee amount.” Thus only your portion of the income is included in your taxable income. 

The type of 1099 depends upon the type of income: 1099-INT for interest, 1099-DIV for dividends and 1099-B for the proceeds from selling stocks and bonds. 

Forms 1099-INT and 1099-DIV that you issue as a nominee are supposed to be given to the recipients by January 31, while the deadline for giving Forms 1099-B to the other owner(s) is February 15. In order to avoid a penalty, copies of the 1099s need to be sent to the IRS by February 28. (When these due dates are a Saturday, Sunday or legal holiday, as they are in 2015, the forms become due on the next business day.) The 1099s must be submitted on magnetic media or on optically scannable forms (OCR forms). This firm prepares 1099s in OCR format for submission to the IRS along with the required 1096 transmittal form. This service provides recipient and file copies for your records. 

If you have questions about filing 1099s, please call this office.

www.paulandersoncpa.com

Creating Item Records in QuickBooks

Accurate, thorough item records inform your customers and help you track inventory levels correctly. 

Whether you’re selling one-of-a-kind items or stocking dozens of the same kinds of products, you need to create records for each. When it comes time to create invoices or sales receipts, your careful work defining each type of item will: 

• Ensure that your customers receive correct descriptions and pricing,
• Provide the information you must know about your inventory levels, and,
• Help you make smart decisions about reordering.

You’ll start this process by making sure that your QuickBooks file is set up to track inventory. Open the Editmenu and select Preferences, then Items & Inventory. Click the Company Preferences tab and click in the box in front of Inventory and purchase orders are activated if there isn’t a check in the box already. Here, too, you can ask that QuickBooks warn you when there isn’t enough inventory to sell. Click OK when you’re finished.

Figure 1: You need to be sure that QuickBooks knows you’ll be tracking inventory before you start making sales.

To create your first item, open theLists menu and select Item List. Click the down arrow next to Item in the lower left corner of the window that opens and select New. TheNew Item window opens.

Warning: You must be very precise when you’re creating item records in order to avoid confusing your customers and creating problems with your accounting down the road. Please call us if you want us to walk you through the first few items.

QuickBooks should display the list of options below TYPE. Since you’re going to be tracking inventory that you buy and sell, select Inventory Part. Enter a name and/or item number in the next field. This is not the text that will appear on transactions; it’s simply for you to be able to recognize each item in your own bookkeeping.

Figure 2: Let us work with you if you have any doubts about the data that needs to be entered in the New Item window. It must be 100 percent accurate.

In the example above, the box next to Subitem of has a check mark in it because “Light Pine” is only one of the cabinet types you sell (you can check this box and select <Add New> if you want to create a new “parent” item on the fly). Leave the next field blank if your item doesn’t have a Part Number, and disregardUNIT OF MEASURE unless you’re using QuickBooks Premier or above.

Fill in the PURCHASE INFORMATION and SALES INFORMATION fields (or select from the lists of options). Keep in mind that the descriptive text you enter here will appear on transaction forms, though customers will never see what you’ve actually paid for items, of course (your Cost, as opposed to the Sales Price).

QuickBooks should have automatically selected the COGS Account (Cost of Goods Sold), but you’ll need to specify an Income Account. Please ask us if you’re not sure, as this is a critical designation. The Preferred Vendor and Tax Code fields will display lists if you’ve already set these up.

QuickBooks should have pre-selected your Asset Account. If you want to be alerted when your inventory level for this item has fallen to a specific number (Min) so you can reorder up to the point you specify in the Maxfield, enter those numbers there (the Inventory to Reorder option must be turned on in Edit | Preferences | Reminders).

If you already have this item in stock, enter the number under On Hand. QuickBooks will automatically calculateAverage Cost and On P.O. (Purchase Order).

Click OK when you’ve completed all of the fields. This item will now appear in your Item List, and will be available to use in transactions. When you want to create, edit, delete, etc. any of your items, simply open the same menu you opened in the first step here (Lists | Item List | Item).

Figure 3: The Item menu, found in the lower left corner of theItem List.

Precisely created Inventory Part records are critical to accurate sales and purchase transactions. So use exceptional care in building them.

www.paulandersoncpa.com

Is a 1031 Exchange Right for You?

Is a 1031 Exchange Right for You?

Article Summary: 

Basic rules of 1031 exchanges

Advantages of exchanges 

o Tax deferral 

o Leveraging the tax savings 

o Asset accumulation 

o Potential management relief 

Disadvantages of exchanges 

o Added complexity and expense 

o Low tax basis o No property flipping 

o Unknown future law changes 

If you own real property that you could sell for a substantial profit, you may have wondered whether there’s a way to avoid or minimize the taxes that would result from such a sale. The answer is yes, if the property is business or investment related. Normally, the gain from a sale of a capital asset is taxable income, but Section 1031 of the Internal Revenue Code provides a way to postpone the tax on the gain if the property is exchanged for a like-kind property that is also used in business or held for investment. These transactions are often referred to as 1031 exchanges and may apply to other types of property besides real estate, but the information in this article is geared toward real property. 

It is important to note that these exchanges are not “tax-free” but are “tax deferred.” The gain that would otherwise be currently taxable will eventually be paid when the replacement property is sold in the future in a regular sale. As with all things tax, there are rules and regulations to be followed to ensure that the transaction qualifies, such as: 

The property must be given up and its replacement must be actively used in a trade or business or held for investment, so a personal residence or a vacation home won’t qualify. However, under some circumstances a vacation home that has been rented out may qualify. 

 

The properties must be of like kind. For instance, this means you can’t exchange real estate for an airplane. But the definition is quite broad for real property – for example, it is OK to exchange raw land for an office building, a single-family residential rental for an apartment building, or land in the city for farmland. Typically, the owner of a residential rental who participates in an exchange will trade for another residential rental. Both real estate properties must be located in the United States. Caution: Stocks, bonds, inventory, partnership interests and business goodwill are excluded from Sec 1031 exchanges. 

 

It is unusual for two taxpayers to each have a property that the other wants where they can enter into a simultaneous exchange. Most likely, if you wanted to exchange your property, you may need to do a “deferred exchange,” which means you effectively sell your property and then find a suitable replacement property. In this case, the law is very strict. You must identify, in writing, the replacement property within 45 days of the date your property was transferred and complete the acquisition of the replacement property within 180 days of the transfer or, if earlier, by the due date, including extensions, of your tax return for the tax year in which your property was transferred. During this period you aren’t allowed to receive the proceeds from the sale of your property. 

 

The property acquired in an exchange must be of equal or greater value to the one you gave up, and all of the net proceeds from the disposition of the relinquished property must be used to acquire the replacement property. Otherwise, any unused proceeds are taxable. 

With this basic information about 1031 exchanges, you may still be wondering whether an exchange is right in your situation. So let’s consider some of the advantages and disadvantages of exchanges. 

ADVANTAGES:

Tax deferral - The main reason most people choose to do a 1031 exchange is so taxes don’t have to be paid currently on the gain that would result from selling the property. The maximum federal tax rate paid on capital gains for most taxpayers is 15% (20% if you would otherwise be in the highest tax bracket of 39.6%). However, the part of the gain that is equal to the depreciation deduction you’ve claimed while you’ve owned the property is taxable at a maximum of 25%. 

Leveraging the tax savings - When an exchange is used, the money that doesn’t have to be spent to pay the taxes that would have been owed on the gain from a sale can be used to acquire other property or higher-value property. 

Asset accumulation - The money saved from not paying tax on the sale gain can be retained as part of your estate to be passed to your heirs, who would also get a new basis on the replacement property that is equal to its fair market value at your date of death. In this case, none of the postponed gain from the original property is ever subject to income tax. However, depending on the overall size of your estate, there could be estate tax considerations. 

Potential management relief - Taxpayers sometimes decide to sell their property to get out from under the burden of managing and maintaining the property. An exchange may still accomplish this without an outright sale by allowing the taxpayer to acquire replacement property that has fewer maintenance requirements and associated costs or has on-site management. 

DISADVANTAGES: 

Added complexity and expense - An exchange transaction involves more complexity than a straight sale. The timing requirements noted above must be strictly met or the transaction will be taxable. To avoid tainting the transaction when there’s a deferred exchange, the proceeds from the original property must not be received by the seller, and a qualified intermediary, also called an accommodator, must be hired to handle the money and acquire the replacement property. The intermediary’s fees will be in addition to the usual selling and purchase expenses incurred. 

Low tax basis - The tax basis on the property acquired reflects the deferred gain, so the basis for depreciation will be low. Thus, the annual depreciation deduction will often be much less than it would be if the property were purchased outright. Upon sale of the property, the accumulated tax deferrals will catch up, and the result will then be a large tax bill. 

No property flipping - The intent of the law permitting exchanges is for the taxpayer to continue to use the replacement property in his trade or business or as an investment. An immediate sale of the replacement property would not satisfy that requirement. How long must the replacement property be held? In most situations there is no specific guideline, but generally 2 years would probably suffice. “Intent” at the time of the exchange plays a major role according to the IRS. 

Unknown future law changes - When weighing whether to do a 1031 exchange, consider the known tax liability if you sold your property versus the unknown tax that will be owed on the deferred gain when you eventually sell the replacement property in the future. If you think tax rates may be higher in the future, you may decide to pay the tax when you sell your original property and be done with it. Recent proposals by various members of Congress and President Obama would severely curtail or even eliminate 1031 exchanges and increase the depreciation period of real property from 27.5 years for residential property and 39 years for commercial property to 43 years for both. These proposals may never pass, but they are an indicator of how 1031 exchanges are currently viewed in Washington, D.C. 

1031 exchanges are very complex transactions, and the information provided is very basic. Before you commit to an exchange, please call this office so that we can review your particular situation with you.

Getting the Most Out of Employee Business Expense Deductions 

Article Highlights: 

• 2% of income deduction floor 
• Alternative minimum tax 
• Employer accountable plan 
• Bunch deductions 
• Educational assistance plan 
• Sec 179 Expensing 

Individuals can deduct as miscellaneous itemized deductions certain expenses that they incur in the course of their employment. Generally, qualified business expenses are un-reimbursed expenses that are both ordinary (common and accepted in your industry) and necessary and do not include personal expenses.

There are two major barriers to deducting employee business expenses. The most commonly encountered is the 2%-of-income (AGI) deduction floor that applies to most (Tier II) miscellaneous deductions, which besides employee business expenses also includes investment expenses, certain legal expenses, home office and other expenses. The amount deductible as miscellaneous expenses is the total of those expenses reduced by 2% of the taxpayer’s adjusted gross income for the year. Depending upon the taxpayer’s income, this reduction can substantially lessen or eliminate the deductible amount. The second major barrier is the alternative minimum tax (AMT), in which the Tier II miscellaneous expenses are not deductible at all. Thus, to the extent that the taxpayer is affected by the AMT, there is no benefit derived from these deductions. There are, however, some planning strategies that can be applied to overcome these barriers, such as the following:

• Employer Accountable Plan – This is a plan under which your employer reimburses you for your employment-related expenses, but requires you to “adequately account” for the expenses. Expenses reimbursed by the employer under an “accountable plan” are excluded from income, thus essentially allowing 100% of the expenses to be deducted, while avoiding the 2%-of-income and AMT limitations. If the employer does not wish to add a reimbursement plan on top of the employee’s existing income, a salary reduction replaced with an accountable plan might be negotiated.
   
• Bunch Deductions – With proper planning, employee business expenses for more than one year can be deferred or accelerated into one year, thus producing a larger deduction in that one year to overcome the 2% floor for miscellaneous deductions.
   
• Education Expenses – Although certain employment-related education expenses can be taken as an employee business expense, there are other ways to gain a tax benefit and avoid the 2%-of-AGI and AMT limitations. These include income-limited education tax credits, and if your employer has an educational assistance plan, your employer can reimburse you up to $5,250 for most education expenses other than those associated with education travel.
   
• Utilize the Section 179 Deduction – Generally, business assets with a useful life of more than one year must be deducted (depreciated) over several years. However, most business assets, other than real estate, qualify for the Code Section 179 expense deduction that allows the entire cost (up to $25,000 for 2015) to be deducted in one year. While vehicles used for business are eligible for Section 179 expensing, other limitations cap the deduction at lower amounts. The depreciation or Section 179 deduction of an employee’s business assets is part of employee business expenses subject to the 2%-of-AGI floor. However, by claiming the Section 179 deduction in the year the asset is purchased rather than deducting a lower depreciation amount over several years, there is a greater chance that the total miscellaneous deductions will be more than the 2%-of-AGI floor, thus allowing part of the expense to be deducted. 

If you would like to explore any of these techniques, please give this office a call.

Refinanced Mortgage Interest May Not All Be Deductible

Refinanced Mortgage Interest May Not All Be Deductible

Mortgage interest rates continue to be low, and home values are on the uptick. If you are considering a refinance, there are some important home mortgage interest rules you should be aware of. 

Generally, the mortgage interest that you may deduct on your home includes the interest paid on the acquisition debt and on up to $100,000 of equity debt, provided the combined debt does not exceed the lesser of the value of the home or $1,100,000. Acquisition debt is the debt incurred to buy the home or substantially improve it, while equity debt is funds borrowed against the home for other uses. 

A big problem arises when taxpayers fail to consider that acquisition debt steadily declines over the life of the loan. So, for example, if the original acquisition debt was $400,000 and you refinance 15 years later, the acquisition debt has probably been paid down to somewhere around $300,000. In this case, if the loan was refinanced for $475,000, the refinanced debt would be allocated $300,000 to acquisition debt, $100,000 to equity debt and $75,000 to debt for which the interest would not be deductible as home mortgage interest. In this case, the interest paid on the $300,000 acquisition debt and the $100,000 equity debt would be deductible as home mortgage interest. If the use of the $75,000 can be traced to another deductible use (e.g., purchase of taxable investments or expenses related to operating a business), then the interest on the $75,000 loan would be deductible per the limitations of the other deductible use. If the use of the $75,000 cannot be traced to an interest-deductible use, then the interest would not be deductible. 

In the example above, the interest would be allocated as follows: 63.15% as acquisition debt interest, 21.05% as equity debt interest and 15.79% as interest not deductible as home mortgage interest. The result would be different if some or all of the new loan in excess of the $300,000 acquisition debt was used to make improvements to the home. For example, say that $125,000 of the new loan was used to add a bedroom and bathroom to the home. This increases the home acquisition debt to $425,000, leaving $50,000 as equity debt, and the interest would all be deductible because the equity debt amount would then be under $100,000. 

If you have already refinanced or are thinking of doing so, it is imperative that you retain a record of the terms of the original acquisition debt in case you exceed the debt limitation and need to prorate your interest deduction. 

When refinancing, you also need to watch out for the alternative minimum tax (AMT). The AMT is another way of computing tax liability that is used if it is greater than the regular method. Congress originally conceived the AMT as a means of extracting a minimum tax from high-income taxpayers who have significant items of tax shelter and/or tax-favored deductions. Since the AMT was created, inflation has driven up income and deductions so that more individuals are becoming subject to the AMT. 

When computing the AMT, only the acquisition debt interest is allowed as a deduction; home equity debt interest is not. Neither is the interest on debt for unconventional homes such as boats and motor homes, even if they are the primary residence of the taxpayer. 

Before you refinance a home mortgage, it may be appropriate to contact this office to determine the tax implication of your planned refinance and see if there are any other suitable alternatives.

www.paulandersoncpa.com