If you owe the IRS money and don’t file a return, the IRS has an unlimited period of time to collect any tax you owe, plus penalties and interest. But if the IRS owes you money, you have only 3 years from the filing deadline to claim your refund. Time’s almost up for those who didn’t file a 2009 return…
I love being a regular telecommuter. The time and cost savings of not having a standard commute are invaluable, and I love the flexibility that goes with telecommuting. And from an employer’s perspective, this allows companies to find the best talent with fewer geographical limitations, and saves costs by not requiring office space for every employee. It’s no wonder it has become so popular.
But if you’re a telecommuter and a home owner, and you’re looking forward to taking a big home office deduction, chances are you’re in for a disappointment.
The amount of home office deduction is determined by finding what portion of your home is used as your home office, and then multiplying that ratio by your home expenses. For home-owners, your two largest home expenses are probably mortgage interest and real estate taxes…which you already get to deduct as personal expenses. Having a home office allows home-owners to deduct a portion of their utilities and insurance, which they wouldn’t normally deduct at all. Home-owners can also take a deduction for a portion of the depreciation on their home. (That’s just taking a very small percentage of the purchase price and deducting it each year.)
However, in order to benefit from the home office deduction, you have to have enough work-related expenses to exceed 2% of your Adjusted Gross Income (AGI). Only expenses exceeding this amount are actually deductible. There are a few other expenses that go in this 2% category as well (investment expenses and tax preparation expenses being the most common), but usually work-related expenses are the big one in this 2% category. What this means for many people is after subtracting 2% of AGI, they actually have little or no deduction available. In fact, taking the home office deduction can cost you money in the long run, as I’ll show in this example.
Suppose you have a household Adjusted Gross Income of $90,000. You have a home office that takes up 10% of the square footage of your home. You pay $15,000 each year on mortgage interest and real estate taxes. You have $3,000 in insurance and utilities. And your home was bought for approximately $270,000 — I say approximately because we’ll assume the depreciation on the whole home would be $10,000…which means the purchase price was close to $270,000. And finally, we’ll assume you paid $500 in investment expenses and tax preparation fees.
Using 10% of your expenses gets you a home office deduction of $2,800. (10% of $15k plus 10% of $3k plus 10% of $10k) That sounds good at first. But remember we also have to subtract 2% of AGI from the home office deduction and other expenses in this category. The home office deduction ($2800) plus $500 in other expenses gets us to $3300, but we have to subtract 2% of our $90,000 AGI, or $1800. So now you’re left with a deduction of $1,500. A deduction of $1,500 sounds good…but part of your home office deduction is $1,500 for mortgage interest and real estate taxes that you could have deducted anyway!
So you kept all those records and did all that calculating…for no deduction at all! But wait, it gets worse…
Because you took the home office deduction, you were allowed to depreciate a portion of your home. That was worth $1,000 as a deduction. If you later sell your home at a gain, which we all hope to do eventually, you’ll have to “recapture” that $1,000 of depreciation that you were allowed to deduct earlier. “Recapture” just means you now treat that $1,000 as income because you were allowed to deduct it earlier…even though the deduction didn’t actually benefit you!
This may be one of the biggest traps in the tax code. People sometimes deduct depreciation because it offers a small benefit now…but when they later have to recapture the depreciation, they wind up paying tax on more money than they actually deducted earlier. In this example, the true value of the home office deduction was $0! Nevertheless, if the home is sold the next year, this taxpayer will pay tax on $1,000 of “recaptured” depreciation that didn’t actually do any good.
So that’s the home office trap. This isn’t to say it’s never a good idea to take the home office deduction. If you’re self-employed or a renter (or both!), then the home office deduction is much more likely to make sense for you. But this is a great example that just because you CAN deduct something, doesn’t mean it’s always a good idea!
In a surprising turn of events, a federal district court granted an injunction in the case of Loving v. Internal Revenue Service that blocks the IRS from requiring tax return preparers to pass even the most basic standards of competency.
In this day and age where the person who cuts your hair or even walks your dog is probably required to have some sort of license, it seems utterly absurd that the person who prepares and files your tax return — an activity that often represents the largest single financial transaction each year for most people — is not required to be licensed in any way or demonstrate any level of basic competency. The IRS has agreed on this point for some time and began taking action to change this situation a couple years ago.
However, it appears some people believe the very minimal requirements set by the IRS are too much of a burden to ask of people who play such a large role in the financial lives of so many people. To be clear, what the IRS has required is extremely minimal. When fully implemented, the program would require professional preparers to pay an annual registration fee and complete some continuing education hours each year. All in all, the annual cost could be as little as $100 or less, with the burden of staying up to date with continuing education adding about 20 hours of study time. Considering the many complexities of the tax code and the fact it’s constantly changing, this hardly seems an unreasonable burden.
So for the time being, the best advice if you’re going to seek professional assistance with your taxes is to look for an Enrolled Agent or CPA. (There are a very small number of states–I know Oregon and California are among them–that have long required tax preparers to be licensed and demonstrate basic competency…so if you live in a state with such requirements you’re in luck.) And let’s hope the courts come around and see the rationality of requiring basic competency from the people whose work can have such a huge impact on people’s financial lives.
One of the more complicated pieces of the tax code that people commonly encounter is the home office deduction.
But yesterday the IRS announced it will offer a very simplified option for taking the home office deduction. As I’ll explain, this option will be very beneficial for most home-owners, especially in low cost areas. On the other hand, most renters, especially renters in expensive areas, will want to pass on this option. (Fortunately, the simplified option is just that, an option. You can still calculate your home office deduction under the old rules if you prefer.)
First, a quick background. The home office deduction is available to anybody who uses a portion of their home regularly and exclusively for business purposes. This part hasn’t changed.
Under the old method, the amount of the deduction was calculated by finding the ratio of the square footage of the home office to the entire square footage of the home. This ratio was then multiplied by various expenses related to maintaining a home such as utilities, insurance, mortgage interest, rent, etc. In addition, there are various instructions related to which expenses are always deductible, which expenses are only deductible to the extent of business profits, and so forth.
Under the new method, any area that meets the definition of a home office is eligible for a deduction of $5 per square foot, up to a maximum of 300 square feet (or $1500). So, for example, if you use a 200 square foot room as a home office during the tax year, you can deduct $1000 as a home office expense. This rule takes effect for tax year 2013. (So you won’t be able to use it when filling out our return in the next few months, but you will for the following year.)
Homeowners can still deduct the full amount they pay for mortgage interest and real estate taxes on Schedule A. Homeowners no longer deduct depreciation, which means no longer having to track depreciation over time and add that depreciation to income when the home is later sold. For these reasons, many homeowners will likely benefit from using this simplified method. In addition to fewer record-keeping hassles, many homeowners will actually get a larger deduction overall when considering that mortgage interest and real estate taxes will still be fully deductible. This won’t be true in every case, particularly if you pay a lot for utilities, home insurance, or other expenses that aren’t otherwise deductible. But as a general rule, if you own your home, you might want to consider using the simplified method.
For renters, on the other hand, you’ll probably want to continue tracking what you pay in rent and other costs so you can keep using the standard method. The reason for this is simple — you usually can’t deduct rent unless it’s a home office expense. So, let’s say you rent in even a low-cost area where you pay only 50 cents per square foot in monthly rent (this works out to $750 per month for a 1500 square foot home, just to give you an idea). Even at this rate, you’re paying $6 per square foot each year in rent alone. Plus you’re probably paying utilities on top of that, and maybe even insurance and some other costs as well. So being able to deduct $5 per square foot isn’t a particularly good deal for you. And if you’re in a high-rent area, like the SF Bay Area, you’re probably paying at least $1 per square foot each month, or $12 per year, so taking a deduction of only $5 per square foot doesn’t make much sense.
It’s a common trade-off in the tax world. Everybody claims to want simplification. But the downside to simplification is some people pay more and some pay less. And not many people like simplification if it means they pay more in tax. Fortunately in this case, every taxpayer has the choice. If taking the simplified option will mean a much smaller deduction for you, then keep doing things under the old method. But if you can save money, or even come out close to even, then your tax return will be getting a little simpler in 2013.
The IRS announced today that they will begin accepting e-filed returns (and begin processing paper returns), on January 30. This is about two weeks later than the mid-January time frame when the IRS typically begins processing returns. The delay is a result of the uncertainty surrounding the “fiscal cliff” negotiations that weren’t concluded until just after the New Year.
This delay will mean those in a rush to get their refunds may have to wait a few weeks longer than usual. Some filers, most notably those claiming Residential Energy Credits or depreciating property (typically rental or business property), may have to wait until early March before the IRS will begin processing their returns. (Although it could have been much worse, the IRS had previously announced that under certain scenarios, they might not have been ready to start processing any returns until March.)
Once again, this is just one more example of why I advise people to try to minimize their tax refunds as much as possible. While it’s tempting to get excited about a big refund check, the reality is that’s just money you could have been receiving during the previous year, rather than having to wait until the end of the year and file a return to get it.
The IRS provides a withholding calculator that can help you fill out your W-4 with your employer. Most people claim too few exemptions on this form, resulting in too much tax being withheld during the year. By claiming the right amount of exemptions, you’ll fatten every paycheck you receive throughout the year.
Of course, having fewer taxes deducted from each paycheck means a smaller refund (or possibly even owing a little bit) at the end of the year. But that just means not having to worry about rushing out to file your return to get your money as soon as possible. Wouldn’t you rather have your money now?
After much anticipation of a Grand Bargain and big changes to US tax and spending policies, the US public finally got a deal just a couple days after going off the “fiscal cliff”. And for the most part it’s more of the same.
Tax rates and most deductions and credits remain in place. A very small portion of taxpayers — those making more than $250k if filing joint, or $200k if single — will see a slight reduction in the amount of deductions they can take. An even smaller portion — those making more than $450k if joint, $400k if single — will see a small increase in tax rates from 35% to 39.6%. The most common credits and deductions remain in place — for example, the energy credits, the American Opportunity Tax Credit for education costs, and (very important to those who are foreclosed on or go through a short sale) the exclusion of canceled debt income. In general, any credit or deduction you used in 2011 is probably still available for 2012 (and 2013). The 0% tax rate for capital gains by individuals in the 10% and 15% tax brackets remains the same, while the top rate goes up from 15% to 20% for taxpayers at the very top end of the income brackets. The “carried interest” loophole that allows hedge fund managers and certain other privileged members of the financial community to treat their income as capital gains subject to a maximum rate of 20% (instead of ordinary income at 39.6%) remains in place.
Overall, there’s good news and bad news. The good news is that virtually all taxpayers were saved from significant tax hikes (at least in the short term, more on that in a moment). One piece of particularly good news is that the Alternative Minimum Tax has finally been permanently fixed, with inflation adjustments built into the law, so that taxpayers in middle and upper-middle income levels won’t have to worry about how AMT might affect their taxes since the adjustments will no longer be made at the very end of almost every year. Overall, total federal tax revenues in the US will remain near post-WWII lows at about 16% of GDP, with estimates that they may reach 18-19% of GDP in a best-case economic recovery scenario. (Overall tax revenues will generally be a little less than under Reagan, just by way of comparison.) Unfortunately, this is also bad news for a variety of reasons.
First of all, the fact that it takes this much posturing and debate to make such insignificant legislative action does not bode well for the future of our nation. It’s clear that about 1/3 of the nation, and by extension about 1/3 of Congress, will irrationally refuse to support absolutely anything proposed by the current President. (It’s quite possible that if a Republican is elected President, about 1/3 of Congress would act the same way after seeing that irrational opposition can be a winning strategy electorally in much of the nation.) This means that any legislation at this point now needs to be supported by almost 80% of the remaining members of Congress. Getting 80% support for pretty much any idea is nearly impossible, meaning we’re stuck with an almost completely paralyzed legislature for the foreseeable future. (On the bright side of things, the Texas secession movement seems to be picking up steam; so maybe the die-hard obstructionists will join them in leaving and we can dissolve into a couple of peaceful neighbors with different philosophies of democratic governance…or at least a rational person can dream irrational dreams…)
Second, the deal does almost nothing to reduce the deficit. As my favorite quote on the deal put it, “President Obama sought $1.6 trillion [in additional tax revenue] over 10 years. House Speaker John Boehner offered $800 billion. So they compromised … on $620 billion.” (Nicely put, Ruth Marcus.) At less than $100 billion per year in additional revenue, this deal goes less than 10% of the way toward closing the deficit. Now, as Andrew Jackson demonstrated by paying off the national debt just before we entered one of the worst depressions of the 19th century, paying off the national debt is no panacea. In fact, it’s not particularly desirable. (Complicated discussion, skipping it for now.) But a “sustainable” deficit is one that causes the debt to grow no faster than the rate of overall economic growth, keeping the overall debt stable as a percent of GDP. That means a sustainable deficit to shoot for is somewhere in the range of $250 billion. But the increased revenue of this deal does almost nothing toward getting us to even that goal. And the only spending cuts that can make any significant progress toward this goal are MASSIVE cuts to both the military and Medicare/Medicaid, which is a political impossibility. (Although if we simply kept our military spending in line with the global average — ~1.5% of GDP — this would still leave us with far and away the most well-equipped military in the world and save $500 billion in the process…so that’s certainly a rational possibility, just not a political possibility, unfortunately.)
The last bit of bad news, and this one will come as quite a surprise, is that based on the historical evidence, the top tax rate didn’t go high enough to maximize overall economic growth. Now of course, a lot of things go into increasing growth, and it’s impossible to say with absolute certainty how any change will affect the economy. But, the empirical evidence based on history shows that when tax rates on the top earners are quite high, they tend to reinvest more money in their business (which generally means to their employees) in order to avoid those high rates. One good statistical analysis I’ve seen puts the optimal top tax rate for maximizing economic growth at about 65%, and there are a number of other studies (many that are far more wonkish…for example work by Pikkety and Saez) that reach very similar conclusions.
So in the short run, good news for tax filings this year and next. The credits and historically low tax rates remain pretty much in place. In the long run, we’re continuing to run unsustainable deficits and set top tax rates at levels that have historically been associated with slower growth. So enjoy the breaks for 2012 and 2013 while they last.