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- Written by: Julie Welch, CPA/PFS, CFP
Julie Welch (Runtz), CPA, CFP, and Randy Gardner, LLM, CPA, CFP, are the authors of 101 Tax-Saving Ideas, 10th edition.
- Details
- Written by: Julie Welch, CPA/PFS, CFP
The interest expense and real estate taxes can deduct on both a primary home and a second home. To qualify as a home, the property must have sleeping accommodations, cooking facilities, and a toilet. The second home for many people is a vacation home, such as a cabin at the lake, a condo in a ski resort, a beach house, a recreational vehicle, or a boat with living quarters.
The costs of owning a second home can be significantly reduced if the home is rented out. This allows your clients to also deduct part of the cost of utilities, insurance, maintenance and repairs, as well as depreciation expense for the part of the year they rent out the home. The disadvantage of renting out a vacation home is tenants do not take care of the home the way your clients would.
There are two sets of rules that apply to homes your clients use personally. First, if your client rents out their primary home or second home for less than 15 days, they do not pay tax on the rental income and they cannot claim deductions.
| When the city’s hotels were full for the Super Bowl, your client rented their home to a family who came to see the game. They charged $2,000 for 8 nights. The $2,000 is tax-free. Your client is not required to report the income on his/her return and cannot deduct any rental expenses. |
The second set of rules applies if your clients rent out their home or second home for more than 14 days. The emphasis switches from how much they rent the home to their personal use of the home. If your clients use their home personally for more than 14 days or 10% of the rental days, whichever is greater, then they cannot claim expenses greater than their income. In other words, your clients cannot claim a loss from renting their primary home or second home if they personally use the home a lot.
If your clients use the home less than 15 days or 10% of the rental days, whichever is greater, they can deduct expenses in excess of their rental income. The home is treated as a rental home and, subject to the passive loss rules, your clients can claim a loss.
In calculating your clients’ rental deductions, they cannot deduct expenses related to their personal use. They also must take the deductions in a certain order. The first deductions your clients can take are the ones they can take anyway, such as mortgage interest and taxes. The second deductions they can take are operating expenses, such as utilities, insurance, and repairs and maintenance. Finally, depreciation can be deducted.
To calculate income or loss from renting out a home, one of two methods can be used — the Court Method or the IRS Method. The only difference between the two methods is the way they treat the deduction for interest and taxes. Under the Court Method, you determine the rental portion of interest and taxes by dividing the number of rental days by the 365 days in a year. Under the IRS Method, you determine the rental portion of interest and taxes by dividing rental days by the total of rental and personal-use days. The example below shows both methods.
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Your client uses his/her vacation home for 54 days during the year and rent it out for 146 days. Their rental income is $14,600 ($100 x 146 days). Their expenses are interest of $12,000, taxes of $2,000, utilities of $2,400, and insurance of $800. He/she bought the home for $150,000 ($130,000 for the home and $20,000 for the land). Court IRS Rental income $14,600 $14,600 Utilities and insurance Income before deduction Depreciation expense Rental income 3,213 0 Deductions for interest Total reduction in income $(5,187) $(3,780) Difference $(1,407) In this example, you can deduct $1,407 more depreciation under the Court Method than under the IRS Method. At a 28% tax rate, you will save $394 ($1,407 x 28%). The Court Method is advantageous here because the personal use is more than 14 days and 10% of the rental days. Consequently, the rental deductions cannot exceed the rental income. Because the Court Method allows you to prorate the deduction for interest and taxes over 365 days instead of the 200 (146 + 54) days of rental and personal use, the rental income is more than the rental deductions, including all of your depreciation expense. The interest and taxes that are not deductible as rental expenses are still deductible as itemized deductions on Schedule A. Under the IRS Method, you allocate more of the interest and taxes to the rental property. As a result, the rental deductions are more than the income and $1,407 of the depreciation deduction is disallowed. In this example, you are better off using the Court Method because the deductions are limited if you use the IRS Method. In many cases, however, you are better off using the IRS Method. The IRS Method shifts interest and taxes to deductions in arriving at adjusted gross income (AGI). If the rental deductions are not limited to the rental income because your client did not personally use the home too much or have more rental income than deductions, they save more tax by deducting interest and taxes as deductions in arriving at AGI. When AGI is lowered, more medical and miscellaneous deductions can be deducted. You may also reduce your client’s state income tax since many states use AGI as the starting point for their tax calculations. |
Decide which method is best for your clients in the first year they deduct rental expenses. You cannot switch methods from year to year. Most people use the Court Method because they want to use the home themselves.
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How much does it cost to own a vacation home? Referring again to the example above, cash flows are as follows: Inflows: Outflows: Interest $12,000 Net cash outflow $2,348 Ignoring the costs of acquiring the vacation home and using the rental assumptions above, it costs you $2,348 per year to own a vacation home you use personally for 54 days. If you did not rent out the vacation home, you would pay $14,480 ($18,400 - ((12,000 + 2,000) x 28%)) per year. |
There are additional advantages of renting out vacation homes. Trip expenses, such as transportation, can be deducted to maintain the home. Furthermore, days spent maintaining the home do not count as personal-use days.
There are also some things to watch if your client owns a vacation home. Use of the vacation home by any family member counts as a personal-use day. Also, rental to anyone for less than a fair rental amount counts as a personal-use day.
Some people are very concerned about deducting losses from a vacation home. They keep the personal use of their vacation home under 15 days or 10% of the rental days, whichever is greater. Others use the vacation home as much as they want and view any rents they receive as reducing their costs of owning the home.
Julie Welch (Runtz), CPA, CFP, and Randy Gardner, LLM, CPA, CFP, are the authors of 101 Tax-Saving Ideas, 10th edition.
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- Written by: Julie Welch, CPA/PFS, CFP
If your client has chores their children can do in their business, they should consider hiring them. Generally, children will be in a lower tax rate bracket than your client. Thus, income can be shifted from the client’s higher tax rate bracket to the children’s lower tax rate brackets.
Also, if the children are under 18, your client as the employer, does not need to withhold or pay either Social Security tax or Federal unemployment tax on the children’s wages. The tax treatment under the different Federal employment taxes for family members is:
| Income Tax Withholding | Social Security & Medicare | Federal Unemployment | |
| Son or daughter employed by parent | Taxable | Exempt until age 18 | Exempt until age 21 |
There are four tests a person must meet to deduct the pay to children as a business expense. These are:
1. Ordinary and necessary
The salary must be shown that it, like any other business expense, is an ordinary and necessary expense directly connected with the business.
2. Reasonable
The pay must prove to be reasonable at the time the services were contracted. Reasonable pay is the amount that would normally be paid for similar services under similar circumstances.
3. Services provided
It must be proved that services were actually provided. Also, benefits from the services performed must be reasonably expected.
4. Paid or incurred
The compensation must be paid or the expense incurred during the tax year.
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Example: You are in the 28% tax rate bracket and you are subject to self-employment tax. If you have business filing, typing, cleaning, and other chores for which you hire your child, you can deduct your child’s wages against your business income. The total you pay your 16-year-old child in 2014 is $11,200. Your approximate savings would be:
Your tax savings since you can deduct the wages:
Federal tax ($11,200 x 28%) $3,136
Your tax savings $4,850
Your child’s tax assuming no other income:
Taxable income $5,000 Federal tax $503 Social Security tax 0
Your child’s total tax (503)
Total Federal tax savings to the family $4,347
Additionally, your child is eligible to contribute to an individual retirement account (IRA). In the above example, if your child contributes $5,000 to a deductible IRA, your child pays no tax. The total tax savings to your family is $4,850 ($4,347 + 503). Thus, in 2014, your child can earn $11,200 ($6,200 amount of standard deduction plus $5,000 put into an IRA) without paying any Federal income tax.
Alternatively, your child could contribute to a Roth IRA. In this case, your child would pay $503 of Federal tax but all qualified distributions from the Roth IRA would be completely tax-free.
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Julie Welch (Runtz), CPA, CFP, and Randy Gardner, LLM, CPA, CFP, are the authors of 101 Tax-Saving Ideas, 10th edition.
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- Written by: Julie Welch
Education expenses can reduce taxes in one of three ways. First, job-related education expenses can be deducted, along with other miscellaneous itemized deductions, to the extent they exceed 2% of the adjusted gross income. Education expenses are deductible if they are: job related, do not qualify a person for a new business, and are not taken to meet the minimum educational standards for qualification in a person’s business. The costs of obtaining an undergraduate degree do not qualify because they are usually meeting the minimum educational standards. The costs of obtaining a graduate degree, especially in business, generally qualify if a job is in the same subject area as the classes unless the degree qualifies that person for a new business, such as law or medicine. Examples of some of the costs that can be deducted include tuition, books, supplies, car expenses, and travel costs.
Second, job-related education expenses can be excluded as a working condition fringe benefit. Many employers used this approach when the educational assistance provisions temporarily expired in prior years.
Third, education expenses under an employer’s educational assistance program can be excluded. This is generally the best approach. Check to see if the employer offers an educational assistance plan. If the employer does, up to $5,250 from income can be excluded. Although meals, lodging, and transportation costs cannot be reimbursed, the costs that can be reimbursed tax-free include: tuition, books, supplies and equipment.
An employer can either pay the expenses directly to the school or reimburse the taxpayer after they are paid. Proof of the expenses will need to be provided, such as receipts for tuition and books.
Unlike the deduction for education expenses, the subjects being studied do not have to be business or job related. Thus, a college degree can be completed or non-business courses can be taken. However, subjects considered a sport, game, or hobby are ineligible unless required as part of a degree program or related to an employer’s business. Graduate courses are also included in this exclusion.
Savings include both income tax and Social Security tax. Additionally, many states do not tax educational assistance reimbursements, thus saving even more.
A person has $45,000 in income, is in the 25% tax rate bracket, and has $5,500 of educational expenses. If that person claims the expenses as a deduction, they will save:
Education expenses $5,500
2% floor ($45,000 x 2%) ($900)
Deductible education expenses 4,600
Income tax rate 25%
Tax savings $1,150
If a person’s employer reimburses $5,250 of their educational expenses under an educational assistance plan, the following will be saved:
Federal income tax savings
at 25% tax bracket $1,313
Social Security taxes at 7.65% for 2013 402
Total savings $1,715
The unreimbursed education expenses of $250 ($5,500 - 5,250) are considered a miscellaneous itemized deduction subject to the 2% floor. The person receives no additional tax savings since 2% of the adjusted gross income of $900 ($45,000 x 2%) exceeds the $250.
The person saves $565 ($1,715 - 1,150) in tax by using their employer’s educational assistance plan.
Julie Welch (Runtz), CPA, CFP, and Randy Gardner, LLM, CPA, CFP, are the authors of 101 Tax-Saving Ideas, 10th edition.
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- Written by: Julie Welch, CPA/PFS, CFP
Donating appreciated property to charity can produce substantial tax savings. Appreciated property might include art, antiques, real estate, and stock. It does not include ordinary income property, such as inventory or a work of art you created. Generally, to take full advantage of this tax benefit, you must have owned the property more than one year before you give it away.
Giving appreciated property to charity is better than selling the property and donating the sales proceeds.
| You own art worth $2,000. You bought the art five years ago for $500. If you sell the art and donate the proceeds from the sale, you get these results:
Contribution of cash after the sale $2,000
Taxable gain ($2,000 - $500) $1,500
Tax cost $(420)
Net tax savings $140
By selling the property and contributing the proceeds to charity, you receive a $2,000 tax deduction for the cash contribution. However, you are taxed on the $1,500 gain from the sale. Thus, your net tax savings is only $140. |
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If, instead, you donate the art directly to the charity, you will receive a tax deduction for the full fair market value of the art.
Contribution $2,000
Taxable gain $0
Net tax savings $560
The tax savings are significantly better when you contribute the art directly to the charity because you avoid the tax on the gain from the sale. |
Do not give depreciated property to charity
Giving property that has gone down in value to charity is a bad idea. You cannot deduct the loss. You are better off selling the property and donating the proceeds from the sale to the charity. This allows you to donate the same amount to the charity, deduct the charitable contribution, and also recognize a loss on your tax return, as long as the item is either business or investment property such as stock.
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You bought stock two years ago for $10,000. It is now worth $7,000. You are in the 28% tax rate bracket. If you give the stock to charity, you can only deduct $7,000. Your tax savings is $1,960 ($7,000 x 28%).
However, if you sell the stock for $7,000, you can deduct the $7,000 proceeds you give the charity and you can recognize a loss of $3,000 ($7,000 sales price less $10,000 cost). Your tax savings from the donation is still $1,960 ($7,000 x 28%). However, you also have the tax savings of $840 ($3,000 x 28%) from deducting the loss. |
Julie Welch (Runtz), CPA, CFP, and Randy Gardner, LLM, CPA, CFP, are the authors of 101 Tax-Saving Ideas, 10th edition.