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Casualty loss tax deduction and the Lawrence area tornado

Posted by Ben Miller Posted on June 30 2019

Today’s post is about the casualty loss deduction specific to individual taxpayers (not businesses) and how it works.  Typical situations involve an expensive set of golf clubs getting stolen out of the back of a car or damage sustained from an event such as a tornado.  When these things happen and the taxpayer isn’t reimbursed by insurance this is called a casualty loss.

The Internal Revenue Service (IRS) has the following definition for a casualty loss: Damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual.  The key thing to remember here is the event has to be sudden – not gradual.  Termite damage is a common example.  Termite damage can result in a big loss and taxpayers try to deduct it, only to have the IRS challenge the deduction because in the IRS’s eyes, termite damage is not a ‘sudden’ event.  So in that fact pattern, generally taxpayers lose and the deduction gets thrown out.

Starting in 2018, when the new Trump tax law took effect, the casualty loss deduction is restricted to losses sustained in a presidentially declared disaster area.  On May 28th areas around Lawrence, Eudora, Linwood, and Bonner Springs sustained damage due to a massive tornado. 

On June 20th the President approved a Kansas Disaster Declaration.  See the press release here: https://www.fema.gov/news-release/2019/06/21/president-donald-j-trump-approves-major-disaster-declaration-kansas.  The tornado, among other very recent weather events, resulted in personal property damage.  Damage sustained from any of these events is eligible for a casualty loss tax deduction.

Example 1: The taxpayer incurred damage from a tornado in 2018.  The taxpayer’s house was just purchased for $250,000.  The next day, before any personal effects were moved in, a tornado destroyed the house.  The insurance company only reimbursed the taxpayer $220,000.  This resulted in a $30,000 loss.  The area was not declared a federal disaster area.  The taxpayer is not eligible for any tax loss deduction.

Example 2: Assume the same facts except the area was declared a federal disaster area.  In this case the $30k the taxpayer is out would be eligible for a tax deduction because of the declaration.  Here’s the calculation:

$30,000  -  Loss

   ($100)  -  Casualty loss floor per loss occurrence

($7,000)  -  10% AGI limitation (this is 10% of your Adjusted Gross Income, assume AGI is $70,000)

$22,900   -  Casualty loss deduction on 2019 tax return – Schedule A

Additionally, the tax code allows taxpayers the option to deduct the casualty loss in the prior year by amending the prior year return (2017 in the example).  By deducting the loss in the prior year it gets cash in the taxpayer’s hands more quickly than waiting to file the current year’s return.

What about the golf clubs?  Again, all casualty and theft losses are not deductible unless they occur in a presidentially declared disaster area.  So if the clubs were destroyed in the tornado or were stolen in the declared disaster area the loss would then be deductible.

In conclusion, these sorts of events are rare but they do happen.  Although congress has limited casualty losses to presidentially declared disaster areas, they are a last a remedy when the insurance company does not make the taxpayer whole after a catastrophic event.  Message me with any questions.

Three choices when you can't pay the tax

Posted by Ben Miller Posted on May 29 2019

This past spring when 2018 tax returns were due, because of changes from the new Trump tax law, some taxpayers were left with jaw-dropping tax liabilities they were not expecting.  What happens if they can’t pay the tax?  There are options for individual taxpayers and we will take a look at each of them.

The first thing to note is tax returns should always be filed even if the funds to pay the bill are not available.  Why?  There are penalties that can be levied because the returns are not filed, separate from interest and penalties from not having paid the tax due shown.  So the lesson here is to always file the returns regardless of whether the tax can be paid.  Ok, let’s get onto the show.

Taxpayers that have a small balance due that can be paid in full within 120 days, should pay whatever they can when the returns are filed.  The IRS will send the taxpayer a bill for the remaining tax due plus a small amount of interest.  The Internal Revenue Service (IRS) refers to this as a Full Payment Agreement.  This is the easiest and most time efficient of the choices.

The second choice is submitting an Installment Agreement (IA) with the IRS.  If the balance due cannot be paid off over the short period of time mentioned above then an IA is an option.  There are some formalities to an IA: 

     1. During the past 5 years the taxpayer (and spouse if married filing jointly) have timely filed                 their returns and paid any tax due

     2. The taxpayer agrees to pay the full amount owed within 3 years 

     3. The taxpayer is unable to pay the liability in full with the return

     4. Administrative fees under $100 are required to be paid when setting up an IA

The IA option is generally accepted by the IRS if the above requirements are met.

 

The IRS will review the above payment options and if those options have been exhausted they will consider an Offer in Compromise (OIC) as the final option available.  The OIC is just that – an offer to compromise on the tax owed.  By choosing this route, the taxpayer hopes the IRS will take less than the full amount owed to satisfy the tax obligation.  There are 5 requirements necessary for the IRS to consider an OIC:

     1. The taxpayer has not filed for bankruptcy

     2. From 656, the OIC package must be submitted and is 27 pages long!

     3. $186 application payment must be included

     4. If the taxpayer chooses a lump-sum (6 or fewer installment payments) offer to the IRS, that                 offer must include a 20% payment of the offer

     5. If the taxpayer chooses a longer payment period (> 6 installment payments) the taxpayer                   must comply with the taxpayer’s own proposed payment schedule while the OIC is being                 considered

Typically, taxpayers in this position are in a tough spot financially and don’t see any way to pay the full tax due.  The IRS will look at all the facts and circumstances surrounding the OIC application to determine ‘doubt as to collectability’.  When the IRS receives the completed 27 page OIC, they will use it to figure out how able the taxpayer is to pay the tax.  Then the IRS determines whether to accept the OIC for less tax than was due on the returns.  The IRS has accepted roughly 40% of the OIC requests it has received over the last few fiscal years so it’s not a given an OIC will be accepted.

Actually, there is a 4th option.  That involves not paying the tax which leads to having property confiscated, wages garnished, or getting thrown in jail but those are not advisable.  Though the taxpayer may not have the funds to pay the tax due right away, there are options available to them in this situation.  Message me with any questions.

The magic of Health Savings Accounts

Posted by Ben Miller Posted on May 12 2019

As health insurance premiums rise, health savings accounts (HSA) are becoming more prevalent.  Why?  Health insurance premiums for high deductible health insurance plans (HDHP) are generally cheaper than traditional health insurance plans.  In many cases, in tandem with HSAs, HDHPs are becoming the only affordable health insurance option for many individuals.  In this post I provide the nuts and bolts of why HSAs are so beneficial from a tax perspective.

HSAs were established in 2003 with the intent of putting more responsibility into the individual’s hands.  Congress’s thought was, “if individuals have more control over how their health dollars are spent, those dollars would be more wisely spent”.  When individuals participate in a HDHP they have the option of also contributing pre-tax dollars to an HSA.  When distributions, used to pay for medical expenses of the individual, the spouse, and their dependents, are distributed from the HSA account they are 100% tax free.

When an individual signs up for HDHP insurance through work and contributes to their HSA, both amounts are taken out pre-tax.  What does this mean?  This means that the amounts income and payroll taxes are calculated on are reduced first before the taxes are calculated.  In the examples assume Ross is a single, non-married individual and has HDHP coverage the entire year.

Example 1 – Ross works as a bouncer in 2018, removing unruly patrons.  Ross’s gross wages were $52,000.  His total HDHP premium is $1,300 and his total HSA contribution is $2,500.  Instead of calculating the income tax and payroll tax (FICA) withholding on $52,000 it was instead calculated on $48,200 ($52,000 – $3,800).  Say Ross’s total income tax rate was 30% and his FICA tax rate is 7.65%.  Ross saved $1,431 ($3,800 x 37.65%) in overall tax. 

Another positive aspect of HSAs is the ability to make after-tax contributions into the account.

Example 2 – The following spring Ross gives his CPA his tax information.  Ross’s CPA notices he is in the 30% overall income tax bracket.  Before Ross’s CPA finalizes the tax returns the CPA recommends Ross contribute $950 to his HSA to max it out for 2018.  Ross has until April 15th, 2019 to make this contribution for the 2018 tax year.  Ross sees tax savings of $285 ($950 x 30%).

An item to note: In the two examples above do you see a difference?  It is the FICA tax.  Ross making contributions through his employer avoids the FICA tax.  When he writes the $950 check to the HSA he only gets the income tax deduction not the FICA tax deduction.

Flexible Savings Accounts (FSA) are another way to put away pre-tax dollars for medical expenses.  Much like HSA accounts the individual specifies how much they’d like taken out of their paycheck and these amounts avoid income and payroll tax similar to HSA contributions.  FSAs, however, are a “use it or lose it” account.  If the individual has not spent the funds inside the FSA by the end of the tax year those funds are lost forever.  The individual’s employer may allow a grace period of March 15th of the following year, but again the funds have to be spent.  Amounts contributed to an HSA are the individual’s money forever, sort of like a contribution to a 401k retirement account.  The tax law forbids the individual from contributing to both an FSA and HSA in the same tax year i.e. no double-dipping.

Speaking of retirement let’s address that advantage.  Depending on who the custodian (banks for example) is for the HSA account the individual may be able to invest the funds residing inside the HSA.  This allows the individual to earn an investment return on funds sitting inside the account.  This sounds like a 401k doesn’t it?  Everyone reading this will have medical expenses at some point in their life.  If possible, it makes sense tax-wise to fully fund these each year.

HSAs are the rare unicorn found in the tax code.  Nowhere else in the code does the government allow pre-tax contributions, tax-free investment growth, and tax-free withdrawals from the same account.

If medical premiums continue their ascent each year, an increasing amount of individuals will be trying to find ways to reduce their exposure and HDHPs combined with HSAs are a viable option to combat the increases.  Message me with any questions.

Married Filing Joint versus Married Filing Separate.

Posted by Ben Miller Posted on May 07 2019

About once a year, typically during tax season, I get asked if it is better to file jointly or separately.  As my answer is to many things tax – it depends.  There are reasons for filing as married filing separate (MFS) but most taxpayers will see more financial benefit filing as married filing jointly (MFJ).  In this post I will explore some advantages and disadvantages of each filing status.

The tax law is written in a way that penalizes taxpayers who choose to file separately.  Some credits are cut in half, such as the child tax credit and the credit low-income workers receive for making retirement plan contributions.  The earned income credit, American Opportunity tax credit, and Lifetime Learning credit are not available to MFS taxpayers at all.  Taxpayers filing as MFS are only allowed a $1,500 capital loss deduction instead of $3,000, and cannot deduct student loan interest.  These are just some of the limitations placed on taxpayers filing MFS.

An important choice impacting this discussion is the role itemized and standard deductions have.  If Fred, who itemizes, choosing MFS status Wilma must also itemize.  By the same token if Fred uses the standard deduction Wilma must also, but the standard deduction for both is cut in half.  Do you see the game here?  Say together the couple has $30k of itemized deductions.  If Fred itemizes and deducts the $30k you might think Wilma could utilize the $12k standard deduction (remember the standard deduction ($24k) is cut in half for MFS taxpayers).  Congress was keen to this when the law was made which is why both taxpayers must use the same itemized or standard deduction choice i.e. no double dipping. 

There are many reasons for filing as MFS.  If Fred’s income is low and has significant itemized deductions that are phased out by adjusted gross income (AGI) and Wilma has few itemized deductions but high income it can make financial sense to file separately.  In this scenario Fred would get to deduct more of his itemized deductions than he would filing jointly because if Wilma’s income was included with Fred’s return, (MFJ), Fred’s deductions may get phased out.  The term “phased out” means benefits in the tax code that are taken away as the taxpayer’s income climbs.  This is the government’s way of saying, “the more money you made in a given tax year, the fewer deductions you need which results in more tax we think you can afford to pay”. 

Taxpayers may choose to file separately to keep their finances separate.  Some couples prefer to keep their income and the resulting taxation distinct.  Fred may believe in his mind that having Wilma’s income included with his would cause Fred to unjustly pay some of Wilma’s tax bill.  Another reason for the MFS status is one spouse doesn’t trust the other spouse.  If Fred believes Wilma is hiding illegally obtained forms of income Fred might feel more comfortable not signing a MFJ tax return he believes to be inaccurate or fraudulent. 

Sometimes income driven repayment plans on student loans can cause an advantage using MFS.  If Fred has high income and Wilma low income, if they file separately, it may benefit Wilma since the student loan repayment plan would look at her income only since the return only included her income.

When asked which filing status is better there is a report available within the software I use that shows the analysis between both filing statuses for that tax year.  It is very clear and lists both scenarios in a column format that is easy to understand.  This gets reviewed each year with the processing of the returns.

All of this sounds complex and it is.  Sometimes there are reasons outside of pure financial benefit that causes a taxpayer to go down the MFS route.  In rare cases the overall tax might be lower filing as MFS.  For a majority of taxpayers MFJ is the route to go.  Contact me if you have any questions.