Foreign earned income filers, here’s an interesting approach

I work with a number of clients who claim the foreign earned income exclusion, allowing them to exclude up to $91,500 of income earned while living and working overseas (plus part of housing costs in some situations). If you don’t claim this (or know anybody who does), you can safely assume you’ll have no interest in the rest of this post.

I recently came across a blogger who lives overseas and made an interesting argument that he believed the IRS was wrong to disallow the Making Work Pay Credit to individuals whose entire “earned income” was excluded by the foreign earned income exclusion. I find his argument interesting, but ultimately disagreed with his position because it seems to hinge on the idea that income can be simultaneously included and excluded from gross income. (There’s far more to it than that, and tax nerds can read pretty much the entire lengthy exchange here.)

But that got me thinking, and I did realize another possible approach ex-pats might take in order to claim the $400 ($800 if married filing jointly) credit. So taxpayers living abroad can choose to qualify for the Foreign Earned Income Exclusion under either the Bona Fide Resident test or the Physical Presence test. Under the Physical Presence test, if you’re physically present in a foreign country for 330 full days out of a 12 month period, you can exclude the foreign income earned during that period up to the limit (currently $91,500).  You can choose any 12 month period you want; it doesn’t have to be the tax year. And it doesn’t matter if the 12-month periods overlap–the 12 month period could extend into another tax year and have no effect on what’s excluded in any other year. In Publication 54, the IRS advises taxpayers to choose the 12 month period that gives them the most benefit.

So, if a taxpayer is living abroad and doesn’t get back to the US very often or for very long, they could choose any 12 month period they want as long as there is at least some overlap with the tax year. Choosing a period other than the tax year would have the effect of reducing the amount of income that’s excluded under the foreign earned income exclusion. So a taxpayer could choose a 12 month period that doesn’t exclude ALL foreign earned income, but only leaves enough income “included” in gross income to maximize the Making Work Pay Credit, but not enough that it exceeds the standard deduction and exemption. In other words, they wouldn’t have enough income recognized that they would owe any federal tax…but they would have enough income to get the Making Work Pay Credit.

Here’s an example: Taxpayer lives overseas and earns $54000. Normally, the taxpayer would just exclude the whole amount. But, the taxpayer could choose a 12 month period that only covers half the tax year, limiting their exclusion to $45,750. That leaves $8,250 in taxable earned income. Based on this, the taxpayer would get the full $400 Making Work Pay Credit. And a taxpayer using the standard deduction, and claiming an exemption for himself, would get a deduction for over $9,000, leaving no taxable income. No tax owed. $400 credit received.

Let me just say I’m not advising anybody to do this. All of my foreign clients are either excluded from Making Work Pay due to high AGI, or they already qualify because they lived in the US part of the year and have eligible earnings. I would want to do a little more research before actually advising anybody to take this position. But I can’t think of any reason it wouldn’t work and be perfectly legal.

Nearly 100 things your tax software can not do…

Tax software has come a long way in less than two decades of existence. Most of the time, people who use tax software to do their returns won’t have any serious mistakes and will be able to handle their entire tax situation without help.

BUT, even the best tax software has many limitations. TurboTax, by far the most popular personal tax software and widely recognized as the most capable for non-professional users, has posted its annual list of limitations and unsupported tax situations. The list includes nearly 100 situations. Less capable tax software packages would probably have a much longer list.

Now, most of the unsupported situations are extremely rare situations. But some situations do affect significant numbers of people…and they can be extremely costly.

Had a foreclosure or other debt cancellation? In nearly all cases, your tax software can’t handle it. Are you self-employed with a net loss for the year? Did you have mortgages in excess of $1 million? Have a vehicle w/ varying business use over the years? Did you work abroad? Or just receive a large state tax refund? These situations and many more frequently trip up taxpayers.

And how much could it cost you if you don’t handle one of these situations correctly? Well, several of the examples above could easily cost tens of thousands of dollars if not handled correctly.

So what do you do if you’re in one of these situations…or you think you might be affected but aren’t sure? Well, traditionally you’ve had only two options: Roll the dice and hope that taking your best guess with the tax software isn’t going to turn out to be a costly mistake…or take your whole return into a professional even though you could do the other 95% all by yourself.

It’s situations like these that are the reason Class 5 offers tax reviews for people who do their own taxes. Go ahead and do your own return. If you get stuck or have questions, just hand it off to us and we’ll complete the hard part. Save money without sacrificing peace of mind. In these economic times, you can’t afford costly tax mistakes, and that’s why Class 5 is here.

The (tax) year in review

This post is primarily to rehash several earlier posts that are of particular relevance as we come to the end of the year. In chronological order, here are this year’s posts that should be revisited for year-end tax planning purposes.

• IRS offers new guidance for same-sex spouses & registered domestic partners in community property states. This one doesn’t have to be addressed by year-end, but most same-sex partners who benefit from this ruling will run out of time to claim a refund for 2007 if they don’t file an amendment by April 15, 2011.
• Several valuable tax benefits may be ending at the end of this year…or maybe not. The following benefits are among those slated to end, but they may be extended as part of the latest tax bill being negotiated right now in Congress: The American Opportunity Credit, certain energy credits, and favorable tax rates for long-term capital gains. (See UPDATE at the end.)
• Individuals considering a Roth conversion for 2010 are running out of time to make the conversion this year. But before you act, make sure you’re not acting based on one of these common myths.
• And finally here’s some basic tips from the IRS.

If you’ve got year-end tax questions, now’s the chance to ask. If you have general questions, please put them in the comments and I’ll address them here.

UPDATE: The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 was passed the week after this article was originally published. It appears the American Opportunity Tax Credit and favorable treatment of Capital Gains & Qualified Dividends has been extended for two more years. Most of the Energy Credits have also been extended.

Direct Democracy. FAIL. Prop 26 makes a mess of California tax law.

This one escaped my attention until recently.

On November 2, California voters narrowly approved Proposition 26. Skip to the next paragraph if you just want the take-away and not the lengthy explanation. This proposition amended the state Constitution to require a 2/3 vote to authorize ANY legislation that raises the tax liability of ANY taxpayer. So revenue-neutral bills–bills that increase funds from one source but reduce funds from another source–now require a 2/3 vote to pass. In addition, any bills that were passed after Jan 1, 2010 will become void on November 2, 2011 unless they are re-authorized by a 2/3 vote. One such bill is SB 401, which is very important to taxpayers because it brought California into conformity with Federal law for 2009 and forward. Conformity simply means California uses the same rules as the Federal government. Conformity means you don’t have to keep track of separate income and deductions on your state and federal tax returns. Keeping track of items that don’t conform is a huge burden on taxpayers (and tax preparers), and SB401 reduced the items that don’t conform to Federal law. Most importantly, SB401 allowed California taxpayers who had a foreclosure on a home with a mortgage balance higher than the value of the home to not recognize income from the value of the home. As an example, individuals with a $500k mortgage on a home that was foreclosed on and sold for $200k would have to recognize $300k of income without SB401. As a result of SB401, people who just went through foreclosure won’t have to pay tax on all that “income” that was not actually received. But without a 2/3 vote to reauthorize SB401–and frankly, no fiscal policy bill gets a 2/3 vote in the California legislature–the law will be nullified on November 2, 2011.

So, thanks to Prop 26,  many California taxpayers might have to amend their 2010 (and maybe 2009 as well) tax returns in November, 2011. Individuals who had a foreclosure in 2009 or 2010 may be facing tax bills of tens of thousands of dollars as a result. At this point, nobody knows if this will be the way the law is actually enforced, but that does seem to be what it says. It will certainly put the legislature in the awkward position of having to choose between enforcing a law that voters approved…even though it will be wildly unpopular once the effects are known…or doing the paternal thing of simply ignoring a law that voters approved because it’s “what’s best for them”.

One thing’s for sure: Unless by some miracle the legislature manages to re-authorize a fiscal policy bill by a 2/3 majority, the California public will be irate with Sacramento over a proposition passed directly by the California public.

I love the idea of democracy. But unfortunately, once again, when it comes to practical results…

Direct democracy. FAIL.

When you should absolutely sell stock before year-end (UPDATE)

UPDATE: It sounds like the compromise reached this week on extending tax cuts will also extend the very favorable treatment of long-term capital gains. So, assuming the legislation actually gets passed by year-end, you can put the advice in this article on hold for another year or two…although if you’re in a much lower tax bracket this year than you expect to be in the next few years, you still may want to consider the moves suggested below. And increasing your basis in stocks at no cost is never a bad idea.

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As we approach the end of 2010, a possibly-once-in-a-lifetime opportunity may be coming to an end.* Taxpayers who fall in the 10% or 15% tax brackets are able to recognize gains on the sale of capital assets (generally stocks, bonds, real estate, etc.) and pay 0% tax on the gain as long as you’ve held the assets long-term (i.e. more than a year). Yeah, 0, as in nothing. Generally if you’re single with taxable income of $34k or less or married filing jointly with taxable income of $68k or less, then you’re in the 10% or 15% bracket. (NOTE: Taxable income means after subtracting deductions, so your actual income may be much higher.) And for those with significantly higher incomes, you currently enjoy 15% capital gains rates which is near an historic low. After 2010, these rates are scheduled to go back up unless the government acts to change the laws enacted by previous administrations.

So here’s one great strategy, especially for those who can recognize gains at the 0% rate: sell stocks that have gone up in value, then immediately buy them back. Why would you do this? To save several thousand dollars potentially. Here’s how: by selling the stock now (and immediately re-buying the stock), you increase the basis at no actual cost to you. Basis is how you determine how much gain you have from a stock, and therefore how much tax you have to pay, and the more basis you have, the better off you are. Here’s an example:

Let’s say a couple has $40k in taxable income. (To give a fuller picture, we’ll say they actually have a household income of $70k, but between their deductions and exemptions for themselves and dependents, their taxable income is only $40k.) Suppose that couple has invested $25k in stocks over the last couple decades, and those stocks are now worth $50k. But if they sell the stocks at the current value of $50k, recognize the gain of $25k, then re-buy the stock at $50k, they’ve increased their basis (or investment) in the stock from $25k to $50k. The additional $25k of income gets $0 tax because their taxable income (even after adding the gain from stock sale) is still in the 15% bracket. To see the real value in this strategy, let’s see what happens in 2011…

…Imagine in 2011 the higher-earning spouse is laid off, and to cover expenses the couple decides to sell the stock. If the stock is still worth $50k, and they sold-and-repurchased the stock in 2010, they will recognize no gain (i.e. no income) from the sale and have no tax to pay. BUT, if they did NOT sell-and-repurchase the stock in 2010, then when they sell the stock in 2011 they will recognize a long-term gain of $25,000. Based on the law as currently written, they will have to pay a 10% tax on the $25k gain, or $2,500. So in this simple example, the couple saves $2,500 from this very simple strategy.

It’s also possible that this couple will hold the stock for many years, during which time their income and personal tax bracket may rise, or tax rates in general may rise, or both. Regardless of what happens, the $25k in increased basis represents $25k that will never be taxed in the future (barring a complete legal overhaul of the nature of income tax in this country…which would be an event nobody can plan for anyways).

In general, if you’re in the 10% or 15% tax bracket, and have appreciated assets that can easily be sold and replaced (e.g. stocks and bonds), then you should strongly consider selling these assets and repurchasing them by year-end. This strategy may also make sense for upper income taxpayers as well, if they expect to sell assets in the next few years anyway, and do not anticipate their income going down substantially.

Of course, it’s always a good idea to review your specific situation with a tax professional before taking action. This advice cannot possibly take into account every variable that could affect your tax situation. I will point out one useful tool you can use, if you’re reasonably familiar with your own tax situation, is TaxCaster from TurboTax. Here you can enter all of your current information (income, deductions, marital status, dependents, etc.) and get a very good estimate of what your tax liability will be. Then go to the “Other Income” category of the app and in the “Gains/Losses (long-term)” category you can enter the gain you would recognize by selling appreciated stock you own. TaxCaster will immediately recalculate your tax liability with this new information. If your “Total Income” changes, but not “Your Refund”, this means you will likely not pay any additional tax by selling that stock. You can effectively increase your basis in the stock at no cost, potentially saving you thousands of dollars in taxes down the road.

A couple final NOTES: If your stocks pay large dividends, and the gain relative to the total value of the stocks is small, then this strategy also might not make as much sense. The reason is that by repurchasing the stock, you’ll lose preferential “qualified dividend” treatment on the stock for a year. In most cases, this effect will be very small relative to the basis increase that you gain. But in rare cases–with large dividends and relatively small built-in gains–the effect of losing qualified dividend status for a year might offset the gains from increasing your basis. ALSO, this analysis does not consider the impact of state taxes. States generally offer no special benefit for long-term capital gains, so you’ll likely recognize income at your regular state rates.

*Of course, the political process is unpredictable and I make no claims on psychic powers.

End of year tax tips from the IRS

I’ve posted several items recently about year end moves to make before 2010 comes to an end. (Did you know most students should pay their spring tuition before year-end? Do you know when selling stocks before year-end will save you thousands? Are you aware of the advantages of a Roth IRA conversion AND the myths surrounding conversions in 2010?) And I’ll soon be adding a post of a few more year-end tips. But for now, here’s some useful year-end information straight from the IRS:

Make taxes easier – Start planning today

Don’t wait until the last minute to start tax planning. Mid-April will be here soon enough and there are many things you can do to ensure a stress-free tax filing season.

The first thing you should do is consider any changes in your life that happened in 2010 and that might affect your taxes. Ask yourself a few questions:

• Did my marital status change due to marriage or divorce?
• Did my kids move out?
• Did I buy or sell a home?
• Did my employment situation change? Did I lose my job? Did I retire?
• Did a disaster – like a hurricane, tornado or flooding – cause a hardship for me and my family?
• Do I qualify for tax credits?

Here are a few more things to think about before you sit down to fill out your tax return:

Determine the amount of tax withheld

Use the IRS Withholding Calculator to determine whether you’ve had the correct amount of Federal income tax withheld from your pay. If you find that you need to change your withholding, give your employer a new Form W-4, Employee’s Withholding Allowance Certificate, to avoid having too much or too little tax withheld from your pay. Don’t be surprised come April!

Organize your records

In addition to the Forms W-2, Forms 1099 or other statements you need to support deductions or credits you claim on your tax return, you might also need bills, credit card and other receipts, invoices, mileage logs, canceled, imaged or substitute checks, proofs of payment and other records.  Refer to Publication 552, Recordkeeping for Individuals, Table 1, Proof of Income and Expense, for more information.

Did you move, have a new name or address?

Use Form 8822, Change of Address Form, to notify the IRS if you changed your name, home or business mailing address or the location of your business. If this change also affects the mailing address for your children who filed income tax returns, complete and file a separate Form 8822 for each child.

Have you taken advantage of all available 2010 credits?
It’s not too late to take advantage of the benefits from the American Recovery and Reinvestment Act of 2009.

Are you a student or do you have students in your household?
You may qualify for the American Opportunity Credit. It is worth up to $2,500 toward the cost of qualified tuition and expenses, and a portion of the credit may be refundable. The term, qualified tuition and related expenses, has been expanded to include expenditures for course materials. For this purpose, the term, course materials, means books, supplies and equipment needed for a course of study whether or not the materials are purchased from the educational institution as a condition of enrollment or attendance.

Did you buy a new computer for college use in 2010?
ARRA added computer technology to the list of college expenses that can be paid for by a Qualified Tuition Plan, also called a 529 Plan. Qualified higher education expenses include expenses paid or incurred for the purchase of computer technology equipment and Internet access used by the student and their family while enrolled at an eligible education institution.

Considering home improvements?
You may qualify for the credit offered for making energy efficient improvements to your home. The credit applies to improvements such as adding insulation, replacing exterior windows or replacing an old furnace or air conditioning unit with new energy efficient systems. Be sure the products you buy qualify for a tax credit. For detailed information about qualifying improvements, visit the U.S. Department of Energy’s and the Environmental Protection Agency’s joint Energy Star website and the Energy Star Frequently Asked Questions page.

Did you go green with a new vehicle this year?
A new plug-in electric drive vehicle qualifies for various credits based on its battery capacity. Certain low-speed vehicles and two or three-wheeled vehicles that draw electricity from a battery may also qualify for a credit based on their battery capacity.

Don’t forget the Making Work Pay Credit.
The Making Work Pay Credit provides a refund of up to $400 for working individuals and up to $800 for married taxpayers filing joint returns. The credit is based on earned income and is taken on your 2010 tax return when you file your taxes in 2011.

Check out the American Recovery and Reinvestment Act Information Center on IRS.gov — for provisions that are still available for 2010.

Do you qualify for other tax credits?

There are temporary increases in the Earned Income Tax Credit, a credit for individuals and families. You may be able to take the credit if you earned less than $43,352 ($48,362 for married couples filing their taxes jointly).  Working families with three or more qualifying children may be entitled to a maximum credit of $5,666. Visit the EITC Home page and use the EITC Assistant to find out if you qualify for EITC.

If you have children, you can also benefit from the increase in the Additional Child Tax Credit that changed in 2009 and 2010 to allow more people to get the benefit. ARRA reduces the minimum earned income amount used to calculate the additional child tax credit to $3,000. This is a refundable credit, which means you may receive refunds even if you don’t owe any tax.

Remember, a little planning now can save you a lot of frustration and surprises later.