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Deducting Interest Paid

Among the itemized deductions on Schedule A of Form 1040, you’ll find “Interest You Paid.” As you get your records together for tax preparation, you should realize that not all interest can be deducted on your return. Interest you paid last year on credit card debt generally isn’t deductible, for example.

Interest deductions on Schedule A fall into two categories. You probably can deduct interest on debt related to your home, and you might be able to deduct interest on debt you incurred as part of your investment activity.

Mortgage interest debt

If you have borrowed money to buy, build or improve your home, you can deduct some or all of the interest you paid during 2015. A “home” can be a house or an apartment you own—even a trailer or a boat, as long as it has cooking, sleeping and toilet facilities. You can deduct the interest on two such homes.

Example 1: Warren Young owns a single-family home as well as a cabin on a nearby lake, which he uses on weekends. If Warren has mortgages on both homes, he typically can deduct all the interest he paid on those loans in 2015.

Going forward, suppose that Warren gets married in 2016, and his wife also owns a home. Assuming the couple files a joint income tax return in 2016, what mortgage interest can this three-home couple deduct?

They’ll be limited to the interest paid on two homes. If one home is debt-free, the couple can deduct the interest paid on the two home loans. If all three homes are mortgaged, the couple can deduct the interest on the two homes with the highest interest payments during the year.

Home Equity Debt

In addition to home acquisition debt, there is a second category of debt, home equity debt, which may give rise to deductible interest. Interest on home equity debt, which includes loans secured by the home but not necessarily used for any specific purpose, is deductible for balances up to $100,000 ($50,000 for married taxpayers filing separately).

Example 2: Assume that Warren Young’s mortgages on his primary home and his vacation home total $900,000, and Warren also has a home equity loan secured by his primary home of $50,000. Warren can deduct all the interest he pays on both the mortgage loan and the home equity loan.

Million dollar limit

The deduction for interest paid on home acquisition debt is limited to interest paid on $1.0 million of debt ($500,000 for married taxpayers filing separately) and, as noted previously, the deduction for home equity debt is limited to interest paid on $100,000 of debt ($50,000 for married taxpayers filing separately). However, the IRS has ruled that it will treat home acquisition debt as home equity debt to the extent it exceeds $1 million or $500,000 for married taxpayers filing separately, effectively increasing the limit on home acquisition debt to interest paid on $1.1 million of debt or $550,000 of debt for married taxpayers filing separately.

Example 3: Assume that Warren Young has an $800,000 balance on his primary home mortgage plus a $400,000 mortgage on his vacation home for a $1.2 million total, and he has no home equity debt. Warren’s deduction on Schedule A would be limited to the interest paid on $1.1 million of this debt. (If you are in such a situation, our office can calculate the allowable deduction.)

Don’t forget the AMT

The alternative minimum tax (AMT) rules for deducting mortgage interest are more restrictive than the regular tax rules. If you expect to be subject to the AMT, our office can determine whether the interest on home acquisition debt or home equity debt is deductible when calculating your AMT.

Investment interest

If you borrow money to make investments, the interest you pay on the loan may be deductible on Schedule A. Often, interest paid on a margin account at a brokerage firm will be classed as investment interest, but that’s not the only possible source. If you borrow to buy a parcel of land that you think will gain value, the interest you pay can be investment interest.

On Schedule A, investment interest can be listed up to the amount of taxable investment income you report.

Example 4: Stan Rogers had $1,200 of taxable investment income from bond interest in 2015 and $1,500 of interest on a margin loan. Stan can deduct $1,200 of margin interest on Schedule A of his tax return for 2015, offsetting his $1,200 in taxable investment income. The unused $300 of investment interest expense can be carried over to a future year in which Stan’s taxable investment income exceeds his investment interest expense.

Note that the situation would be more complicated if all of Stan’s 2015 investment income came from dividends instead of interest. Assuming those dividends qualify for low tax rates of 0% to 20%, which generally is true, the dividends would not count as investment income for this purpose. In this situation, Stan could not deduct any of his investment interest expense.

However, Stan could elect to treat his dividends as nonqualified, which are taxable at higher rates. Then, Stan could deduct his investment interest expense.

Net capital gains (that is, net long-term capital gain less short-term capital losses) from the disposition of investment property are also not included in investment income. Like dividends, a taxpayer may elect to have net capital gains included in investment income, but the gains included in net investment income will be taxed at the higher ordinary tax rates.

There are times when electing to include dividends or net capital gains in income makes sense; if you have that choice, HLB Gross Collins, P.C. can help you make the most tax-effective decision.

Trusted Advice

Naming names

  • For many homeowners, mortgage interest will be reported annually to the IRS by the lender on Form 1098.
  • However, that may not be the case if the seller “takes back” a loan, effectively lending part of the purchase price to the buyer.
  • Assume the buyer makes monthly payments to the seller, on this loan. Payments include interest and some reduction of the principal.
  • Then, the buyer probably will be entitled to deduct the interest paid.
  • The buyer should put the seller’s name, address, and tax identification number on Schedule A of Form 1040.

The IRS May Put You On Hold

During the tax preparation season, business owners, individual taxpayers, and CPAs may have questions for the IRS. If you need to call the agency, be prepared for a long wait. Increased tax code complexity plus budget cuts have resulted in frustrating experiences for many callers.

Advocate’s assessment

In her latest report to Congress, National Taxpayer Advocate Nina E. Olson noted that the number of taxpayer calls routed to “telephone assistors” increased by 41% during last year’s filing season. Yet the number of calls answered by those phone assistors decreased by 26%.

The number of “courtesy disconnects” received by taxpayers calling the IRS skyrocketed from about 544,000 in 2014 to about 8.8 million in 2015. A courtesy disconnect occurs when the IRS essentially hangs up on a taxpayer because its switchboard is overloaded and cannot handle the call. For those callers fortunate enough to get through, hold time averaged 23 minutes last year.

Tax professionals ran into similar problems. The IRS has a Practitioner Priority Service line, to answer questions from CPAs and other tax preparers. In the 2015 filing season, the IRS answered only 45% of such calls, with hold times averaging 45 minutes.

More questions, more time

Why did incoming calls spike by 41% last year? Olson pointed out that the IRS “sharply restricted the availability of paper copies of forms and publications, imposing burden on taxpayers without Internet access or online literacy.” Without paper forms and publications, more people called in.

Olson’s report also mentions that the IRS had to implement large portions of the Affordable Care Act and the Foreign Account Tax Compliance Act. Both laws, passed in 2010, contain provisions that raise questions for taxpayers, and those questions apparently soared last year after delayed provisions went into effect.

Cost cutting

As demands on the IRS have risen, the agency’s budget has fallen. In 2015, the federal General Accountability Office (GAO) reported that IRS total appropriations declined from a high of $12.1 billion in fiscal year 2010 to $11.3 billion in fiscal year 2014, with an additional $346 million decrease from fiscal year 2014 to fiscal year 2015. As of this writing, still more funding cuts appear to be in store for the 2016 fiscal year.

According to the GAO, some IRS business units have responded to the budget reductions by reducing staff by 16% to 30%.

Grim outlook

For the 2016 filing season, neither a decline in complexity nor an increase in IRS funding can be expected. Therefore, callers to the IRS likely will once again face difficulty getting through to the agency. Rather than trying to deal with the IRS, you can call us with your questions and concerns.

Portability in Estate Planning

The federal estate tax exemption for deaths in 2016 is $5.45 million. Married couples may be able to pass twice that amount—$10.9 million—to their heirs without triggering estate tax. Some planning is necessary to reach the higher level, but a relatively new tax code provision, known as portability, can simplify the process.

Traditional tactics

For decades, estate tax planning for married couples with substantial net worth involved asset shifting and trust creation.

Example 1: George Hall owns a small business valued at $4 million. George’s other assets (real estate, retirement plans, investments, etc.) total $3 million. If George dies and leaves everything to his wife, Irene, no estate tax will be due. Bequests to spouses usually avoid estate tax.

In this scenario, Irene would inherit George’s $7 million estate. Including the proceeds from a life insurance policy and her own wealth, Irene might have a net worth of $10 million.

Assuming Irene dies with that $10 million a few years later, when the estate tax exemption has risen to $6 million, her estate would be $4 million over the limit. With the current 40% estate tax rate on nonexempt assets, Irene’s estate would owe $1.6 million in federal estate tax (40% of $4 million), reducing the net payout to the Halls’ children, who are Irene’s heirs.

To avoid this tax, the Halls might set up trusts, to receive some assets at the first spouse’s death, untaxed because of the estate tax exemption. George also might shift some assets to Irene, so that a tax-effective trust could be funded regardless of which spouse is the first to die.

Easier does it

Recently, the concept of estate tax exemption portability has been introduced to the Internal Revenue Code. Under the portability rules, the surviving spouse can use the decedent spouse’s unused estate tax exemption if the executor of the decedent spouse’s estate makes a portability election on the decedent spouse’s estate tax return. Trusts and asset transfers can still be used, but they may not be necessary.

Example 2: George Hall keeps his $7 million in total assets, which he leaves to Irene, as in example 1. At his death in 2016, the executor of George’s estate files a federal estate tax return, IRS Form 706, making the portability election.

In example 2, George has used none of his estate tax exemption, so all $5.45 million is transferred to Irene. If she dies in a year when the exemption amount is $6 million, Irene will have an $11.45 million federal estate tax exemption: her own $6 million plus $5.45 million from George. (These examples all assume that neither spouse made any taxable gifts.) If Irene dies with $10 million in net worth, her $11.45 million exemption will allow it all to go to their children, free of federal estate tax.

HLB Gross Collins, P.C. can help you determine whether using portability makes sense in your overall wealth transfer planning.

HLB International Appoints New Members in Brazil, Jamaica and Paraguay

HLB International, one of the leading global accountancy networks with presence in 130 countries, continues its growth with the recent signing of new members in Brazil, Jamaica and Paraguay.

Brazil

Olimpio Teixeria Auditores Independentes S/S joins the network in Campo Grande City. Established in 1997, the firm provides services across audit, tax and consulting. The firm will be joining the local federation, HLB Brazil, which includes members HLB Onix Auditoria e Consultoria Empresarial Ltda, HLB Spot Contabil and Rokembach + Lahm, Villanova, Gais & Cia Auditores. The new firm is an excellent addition to HLB’s already well-established network in Latin America.  www.olimpioteixeira.com.br

Jamaica

Boldeck Jamaica joins the network, strengthening HLB International’s presence across the Caribbean. Established in 2001, and with partners that are all Big Four-trained, the firm  ranks in the Top 8 nationally and provides audit, accounting, taxation and consulting services and specializes in business valuations, business coaching and strategic and business planning. Jamaica’s close proximity to the North and Latin American markets with strategic sea and air routes, makes it an important logistic hub offering strong investment opportunities. www.boldeck.com

Paraguay

AÑAZCO Contadores & Consultores joins the network in Asuncion, the capital city. Established in 2003, the firm provides audit, accounting, tax, consulting and legal services. Paraguay continues to grow as an investment market and the firm will provide invaluable local knowledge and expertise. Already establishing working relationships with member firms across Latin America, the firm will strengthen HLB International’s presence in the region. www.acc.com.py

Depreciable Assets Under The 2015 End of Year Tax Legislation

The tax update related to Section179 and bonus depreciation is for federal purposes only until adopted by the states. Through 2014 some states have differed in the amount allowed under Section 179 and have totally disallowed the bonus depreciation deduction.

Section 179 – Taxpayers (other than estates, trusts, and certain noncorporate lessors) can elect to treat the cost of qualifying property, called section 179 property, as a deductible expense rather than a capital expenditure. Section 179 property is generally defined as new or used depreciable tangible section 1245 property that is purchased for use in the active conduct of a trade or business.

The Code Sec. 179 dollar and investment limitations of $500,000 and $2 million, respectively, was extended for 2015, have been made permanent and will be adjusted for inflation for tax years beginning after 2015. In addition, the computer software deduction rule has been made permanent, and the qualified real property allowance has been modified and made permanent. For tax years beginning after 2015, the Code Sec. 179 expense deduction will be allowed for air conditioning and heating units.

Off-the-shelf computer software means any program designed to cause a computer to perform a desired function that (i) is readily available for purchase by the general public, (ii) is subject to a nonexclusive license, and (iii) has not been substantially modified. Software does not include any database or similar item, unless it is in the public domain and is incidental to the operation of otherwise qualifying software.

Qualified real property generally consists of qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property as defined under the internal revenue code. The elected amount is counted toward the $500,000 annual dollar limitation applicable to each of those years.  If there is a taxable income limitation on the ability to utilize the Section 179 expensing option of qualifying real property then any unused amount attributable to qualifying real property is not carried forward but is instead depreciated.

Bonus Depreciation –  Through the end of 2014, a 50-percent bonus depreciation deduction is allowed for the first tax year in which qualifying MACRS property is placed in service. The bonus depreciation allowance is only available for new property (i.e., property the original use of which begins with the taxpayer depreciable under MACRS that: (1) has a recovery period of 20 years or less, (2) is MACRS water utility property, (3) is computer software depreciable over three years under Code Sec. 167(f), or (4) is qualified leasehold improvement property.

The bonus depreciation allowance is extended to apply to qualifying property placed in service before January 1, 2020 (or before January 1, 2021 in the case of certain noncommercial aircraft and certain long production period property. In addition to extending bonus depreciation, a number of modification have been made which includes:

  • reducing the bonus rate from 50 percent for 2015 to 2017 to 40 percent for property placed in service in 2018 and to 30 percent for property placed in service in 2019;
  • replacing the bonus allowance for qualified leasehold improvement property with a bonus allowance for additions and improvements to the interior of any nonresidential real property, effective for property placed in service after 2015;
  • allowing farmers to claim a 50 percent deduction in place of bonus depreciation on certain trees, vines, and plants in the year of planting or grafting rather than the placed-in-service year, effective for planting and grafting after 2015;
  • reducing the $8,000 bump-up in the first year luxury car depreciation cap for passenger automobiles on which bonus depreciation is claimed to $6,400 for passenger automobiles placed in service in 2018 and to $4,800 for passenger automobiles placed in service in 2019.

Qualified Improvement Property – Effective for property placed in service after 2015, the provision which allows bonus depreciation on “qualified leasehold improvement property” is replaced with an expanded version which allows bonus depreciation on “qualified improvement property. Qualified improvement property is defined similarly to qualified leasehold improvement property except that qualified improvement property does not need to be placed in service pursuant to the terms of a lease and qualified improvement property does not need to be placed in service more than three years after the improved building was first placed in service. The new law permanently extends the 15-year recovery period for qualified leasehold improvement property, qualified retail improvement property, and qualified restaurant property. “Qualified improvement property” does not qualify for a 15-year recovery period unless it meets the definition of qualified leasehold improvement property, qualified retail improvement property, or qualified restaurant property.

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