final staff training part 3 individuals

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Staff Training Part 3: Individuals

[webinar Title] 2©2021, CCH Incorporated. All Rights Reserved.

Staff Training Part 3:

Individuals

Greg White, CPA

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3Staff Training Part 3: Individuals

Speaker Background

Greg White, CPA

• Founder and S‐H ‐‐WGN, PS. (Seattle, WA)

• Adj. Professor, Golden Gate Univ. – Seattle Campus

• Practices in U.S. Tax Court

• Named “Top 50” IRS Practitioner by CPA Magazine


Relearning

It’s unlikely that you’ll remember every detail.

But when you encounter same issue in practice, you’ll be able to recall some, and research shows you can “relearn’ the balance much more quickly.

Relearning

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Staff Training Course Day 2: Overview


Staff Training – Day 2

Income 1. Unincorporated one‐owner business (Schedule C)2. Rental property – Schedule E3. Farming income – Schedule F

Business expenses 1. Meals and entertainment2. Automobile expenses3. Depreciation4. Accounting fees5. Repairs (and de minimis rule)

Capital gains and losses 1. Examples – corporate stock and investment land2. Special tax treatment

a. Gains (long‐term) – special lower tax ratesb. Losses – very limited (offset capital gains + $3,000)

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Staff Training – Day 2 Overview

Home sale exclusion 1. Only for principal residence2. Up to $500,000 MFJ3. Can exclude (never any tax) if meet the “3 two‐year tests”

a. Own for 2 out of last 5 yearsb. Use as principal resident 2 out of last 5 yearsc. No excluded gain on another principal residence ‐ prior 2 years

Vacation homes 1. No loss allowed if personal use > 14 days, rent > 14 days

Passive activities 1. Can’t offset passive losses against nonpassive incomea. Example

1. Can’t offset losses of baseball team where work little2. Against dental income (2,000 hours/year)

2. Rentals usually treated as passive a. Even if lots of workb. Exceptions

1. Real estate professionals2. Short‐term rentals3. “Active participation” if moderate income


Staff Training – Day 2 Overview

Adjustments to income 1. Educator expenses2. Health savings accounts3. Deductible part of self‐employment tax4. Self‐employed person’s contribution → re rement plan5. Self‐employed health insurance deduction6. Alimony paid (agreement final before 1/1/19)7. Individual retirement accounts (IRAs)8. Student loan interest expense9. Tuition expense

QBID 1. Qualifying business income deduction2. 20% of business income

1. $100,000 in business income, $20,000 deduction

3. If higher income (phaseout $321,400 → 421,400 MFJ)1. Need wages and property from business2. No QBID for SSTB income (accounting, law, etc.)

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Course Overview – Part 2

Other taxes 1. Self‐employment taxes

a. 2‐tier (2020)

i. First $137,700 (2020) – 15.3%

ii. > $137,700 – 2.9%

b. Net self‐employment earnings

i. Schedule C income or partnership business income x 92.35%

2. Net investment income tax (3.8%)

3. Medicare surtax (.9% of wages and business income)

a. Excess > $250,000 (MFJ)

b. Excess > $250,000 (single)

Net operating losses 1. Carryback 5 years

2. Only for 2018, 2019, and 2020

Paying tax 1. Withholding

2. Estimated tax payments


Increasing Mechanization

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Evolving Tax World

History of tax preparation (my career):

1. Early 1980s

• Most tax returns were hand prepared ‐‐ you’d hand write in income and expenses

• Manually compute the totals and tax due

2. Mid‐1980s

• You’d manually write in numbers on a computer input sheet

• You’d have computer input sheets delivered → computer processing center

3. Early 1990s

• You had software on your computer

• You’d enter numbers directly into software, could view tax return in real time

4. Late 2010s

• You scan tax documents

• So ware inputs tax documents → to tax return

• You review software’s input


Tightrope

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Tightrope

1. Following

Following last year

• Workpapers and last year’s tax return ‐‐ best starting point.

• Make similar adjustments, tax return should look similar

2. Determining

Determining what’s different

• Example: New K‐1

3. Learning

Learning what’s behind the numbers

• Passive loss limitations, etc.


Checklists and Diagnostics

1. Most firms complete a checklist

To make sure they don’t miss anything

2. Most computer software has diagnostics

Warnings → preparer

• To make sure we don’t make mistakes

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Income


Schedules C and F

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Schedule C

Business Income


Schedule F

Farming Income

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Schedule C – Business Income

1. Schedule C is used report business income.

Accounting firms, auto body shops, hairdressers, restaurants, etc.

Subject to self‐employment tax.

• Like Social Security tax on wages.

• We’ll discuss this later.

2. Only for unincorporated businesses.

Includes single‐member LLCs.

3. Not for multi‐owner businesses.


Schedule C Business Income

Owner Type of Entity Form to File

Jerry (100%) Unincorporated

Form 1040, Schedule C

Jerry and Phil (50/50) Partnership Form 1065

Jerry and Phil (50/50) Corporation 1. Form 1120S – If made S corp electiona. Income passes through to Jerry and Phil –

i. They report on their Forms 1040

2. Form 1120 – If didn’t make S corp electiona. Corporation pays tax (like Boeing)b. Owners report income when dividends paid

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• Schedule C

Report sales

Common expenses cover next:

1. Car and truck expenses

2. Depreciation

3. Repairs

4. Accounting fees

Some expenses reported on Schedule 1 (we’ll cover later):

1. Owner’s contribution to retirement plan for self (we’ll discuss later)

2. Owner’s contribution to health savings account

3. Deductible part of self‐employment taxes (we’ll discuss later)



• Top of Schedule.

Asks if business issued required 1099s.

• And if they were, did they or will they issue 1099s?

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Form 1099‐MISC

Reporting to Payees


Form 1099‐NEC

Reporting to Payees

Nonemployee Comp

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When We Should Issue 1099‐MISC

1. 1099‐Misc Payments by a business – Issued to recipients of:

Rents

Royalties,

Other income

2. 1099‐NEC Payments by a business – Issued to recipients of:

Non‐employee compensation

• Generally, not issued → corporate service providers (exceptions: law and medicine)

• There are other 1099 forms

To report interest income, dividend income, etc.


1099‐MISC and 1099‐NEC

1. Issued → unincorporated businesses

Other sole proprietors

Entities taxed as partnerships (includes most LLCs).

2. Also issued to some corporations:

Incorporated law practices

Incorporated medical practices

3. Commonly issue Form 1099‐NEC for services of nonemployees

If payments > $600

• Landscapers

• Unincorporated accountants

• Plumbers, etc.

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1099‐MISC

• Example

Feliciano is 100% owner of LLC

• Operates a chain of restaurants

2020 –payments for services → several unincorporated nonemployees

• CPA (for tax preparation) operated as partnership ‐‐ $2,210

• Landscaper operated as sole proprietor ‐‐ $2,350

• Janitor operated as sole proprietor ‐‐ $9,000

He issues 1099s to all of the above listed workers

Feliciano should check “yes”

• He was required to issue 1099s

• He issued Forms 1099


Reason for 1099s

• IRS study ‐‐ income is 10 times more likely to be reported by recipient

Ifwe issue a Form 1099

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Bitcoin Disclosure


Background

• IRS has added a Bitcoin disclosure question for Form 1040.

Form 1040, page 1.

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IRS General Guidance on Crypto

• IRS issued guidance on crypto in Notice 2014‐21

Google “virtual currency FAQs irs.gov”


Crypto Currency (IRS FAQs)

• Law

Cryptocurrency is treated as property

• For tax purposes, generally it’s like Microsoft stock

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Example

• You sell crypto held for investment

• Recognize capital gain or loss

• If you held crypto for > one year, the gain will be long term

• If you sell for $40,000 and paid $10,000, gain = $30,000



Example

• You run a bicycle repair business

• A client pays you with crypto, FMV = $450

• $450 as ordinary income, just as if you’d received cash

• If you later convert the crypto (to cash or other property), recognize capital gain or loss (if capital asset). Basis = $450

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Business Expenses


Common Business Expenses

• In this section we’ll be covering common business expenses:

1. Meals and entertainment

2. Automobile expenses

3. Depreciation

4. Accounting fees

5. Repairs

6. Home office expenses

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Common Business Expenses

• These expenses relate to many different areas:

1. Schedule C – Business profits and losses

2. Schedule E – Rental properties

3. Schedule F – Farming income


Meals and Entertainment

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Entertainment

• No deduction allowed for:

• Entertainment, amusement or recreation.

• Athletic tickets, theater, golf & athletic clubs, hunting and fishing, etc.


Business Food and Beverages

• Business meals 50% deductible.

• Even business meals connected → entertainment.

• As long as separately stated. Notice 2018‐76.

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Business Meals

• Xinlu (owns tax preparation firm) goes to lunch with a client.

She spends $50 on lunch.

She can only deduct $25 (other 50% is nondeductible).


Business Meals

• Xinlu takes a client to a Broadway plan.

She spends $200 on tickets.

None of this expense is deductible (entertainment is nondeductible).

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Notice 2018‐76

Broadway show (w/business contact)

Tickets N/D

Food and beverages 50%


Exceptions ‐‐ 100% Food Deduction Allowed

• 100% food and beverages deduction allowed:

1. To extent treated as compensation→ recipient. §274(e)(2)

2. Reimbursement → employee or other person. §274(e)(3)

3. For recreational, social, or similar activities for employees. §274(e)(4)

4. Made available → general public. §274(e)(7)

5. Sold by taxpayer for adequate and full consideration. §274(e)(8)

6. To extent treated as income → a person other than an employee.§274(e)(9)

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Automobiles


Business Use of Automobiles

Automobile expenses:

1. Disclosure on Form 4562, page 2 (next page)

2. Business use does not include commuting

Driving from home → office not business use

3. More rigorous record keeping

4. Cents/mile or actual

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Form 4562

AutomobileDisclosure






Driving from home → office not business expense



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Commuting Is Not a Business Expense

• Commuting from home → work is considered personal.

Not a business expense. Treas. Reg. 1.262‐1(b)(5).

• Example

Paul lives in suburbs.

Drives → work in the city.

This is a personal expense (nondeductible commuting).









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Special substantiation required for automobile use. §274(d)

• Substantiation standard:

1. “Adequate records” or

2. Sufficient evidence corroborating taxpayer’s own statement

• Elements to be proven for use of automobiles. Treas. Reg. 1.274‐5T(b)(5):

1. Date of trip,

2. Amount of each expenditure (e.g., repairs, gas, etc. unless use mileage rate)

3. # miles driven

• Business,

• Total miles


Substantiation

Some judges take a relaxed stance on documentation:

1. Car dealer testified he made 4 trips each week → attend auction

• Provided round trip distance → auc on

─ He satisfied the substantiation rules. Paul Rademacher, TC Memo 2018‐43

2. Attorney didn’t keep auto log to support mileage

• But his personal calendar showed business trips he’d made

─ He satisfied substantiation rules. Marty Martin TC Memo 2016‐189

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Mileage

• Taxpayers can choose to either base expense on:

1. Cents/business mile

• 2020 – 57.5ȼ/mile

• 2021 56ȼ/mile

• Example – if drive 1,000 business miles in 2020, auto expense = $575

2. Actual expenses prorated for business use

• If 60% business use

• Actual expenses (gas, repairs, depreciation) = $10,000

• Business expense = $6,000 (60% x $10,000)

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Parking Provided by Employer

• Employer can’t deduct cost of parking provided to employees.

But employees can exclude value of parking from income.


Form 4562

Depreciation

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Depreciation

• Only need to enter information on depreciable property

In year acquire and place in service.

• Example

If Sasha purchased rental property in prior year

We won’t have to do anything

• Rental house will already be in tax prep software

─ Software will compute depreciation expense automatically

• This will post automatically to Schedule E (rental income)


Bonus Depreciation

Bonus depreciation:

1. Property eligible for bonus depreciation (100%) in year acq’d.

• Unless make election not to take bonus depreciation.

2. New property always eligible for bonus depreciation.

• Used property eligible if acquired and placed in service after 9/27/17.

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Depreciation

ExamplesDepreciable

PeriodBonus

Depreciation?

Personal property Copiers, appliances, carpeting,, etc.

5 Years Yes

Land improvements Fences, driveways, landscaping, etc.

15 Years Yes

Residential building structure Duplex, condo, apt. building 27.5 Years No

Commercial building structure Office building, restaurant building, hotels/motels. etc.

39 Years No

Land Land Nodepreciation

No


Land ImprovementsExample

• Seth acquires rental duplex on Sept. 30, 2020

Originally constructed in 2002

• Bonus depreciation on land improvements (unless elect out)

Even though “used” property

Also bonus for personal property

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Bonus Depreciation %s

Placed in Service* Bonus %**

9/28/17‐2022 100%

2023 80%

2024 60%

2025 40%

2026 20%

2027 None

* Property must also be acquired after 9/27/17.** Special rule applies to longer prdn. period prop. and certain planes.


Bonus and Residential RP ImprovementsExample

• Sasha buys a used duplex in November 2020 for $205,000

Purchase price allocated as follows:

CostDepreciable

Period Method BonusDepreciationExpense

Land $50,000 N/A N/A No $0

Building $120,000 27.5 years Straight‐line, mid‐mo.

No $546*

Land Improvements $20,000 15 years 150 DB Yes $20,000

Personal property $15,000 5 years 200 DB. Yes $15,000

* $120,000 ÷ 27.5 years ÷ 12 mos. X 1.5 months (mid‐mo.) = $546

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Sasha’s Depreciation – Future Years

• Depreciation in 2021 (year after Sasha purchased)

Personal property and land improvements

• No depreciation (took 100% bonus depreciation in 2020)

Building structure = $4,364 ($120,000 ÷ 27.5)


Depreciation – Acquisition Before 9/28/17

• If Sasha had purchased used duplex before 9/28/17

No bonus deprecation on personal property and land improvements

Therefore, he would have depreciated as follows:

• Personal property (appliances, etc.) – 5 years (DDB)

• Land improvements (fencing, landscaping, etc.) – 15 years (150 DB)

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Review Questions 1-5


Rough Hewn Estimates

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Rev. Rul. 92‐29

A portion of our tax preparation fees is deductible

• Including portion related to preparing Sch. E

RE rentals


Rev. Rul. 92‐29

Can deduct the following above the line:

1. Portion of tax preparation fee related → Schedule E, Part 1

a. This covers rental real estate

2. Portion of tax prep fee “allocable” → Schedule C

3. Portion of fee related → Schedule F

Also, professional fees on above if taxpayer audited

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Practical Approaches

• In practice, precise answers are not available.

We’d want a precise alloca on of tax prep fees → Sch. E (rental income).

However, best we can get is sometimes a rough estimate.

─ That works for tax purposes.

• A limited of number of areas requires more precision.

Automobile usage.

Documenting charitable contributions.


Estimates and Allocations

• The “Cohan rule” applies to income taxes.

“Cohan” ‐‐ can make rough estimates of most expenses.

• Example – a client can estimate amount spent on business publications.

─ Or tax preparer can estimate % of fee related to rental property.

• If precise allocations are possible, use those.

• If not, use a rational allocation method.

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Rational Approach

Issue Allocation

Craft v. Comm’r

TC Memo 2005‐197

3 corps shared PO box 1/3 to each company

Catalano v. Comm’r

TC Memo 2000‐82

Legal fees in bankruptcy

‐‐ 94% of liabilitieswere from business

94% of legal fees →business expenses

Pasadena City Lines23 TC 34

Allocate legal costs → asset purchase‐‐ > 50% purchase price for franchise rights

‐‐ More time was spent on franchise rights

75% → franchise rights

Rev. Rul. 73‐565 Allocate office exp. → tax‐free muni int. inc. ‐‐ 20% of gross inc. from municipal interest

20% nondeductible

80% deductible


Might an Auditor Disagree?

• An IRS auditor might disagree with some of preceding examples

• But, in the context of the likelihood of audit, and

• In my experience, most auditors are reasonable

• Rough estimates usually works (if they’re rational)

• Caveat: if $ amounts are large, may wish to do more work

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Tax Prep Fees (David Burleson)

Dave Burleson ‐‐ wood cutter in South Dakota.

• Operated as a sole proprietor.

• Wife had income (appears wages).

• They paid $55 for tax preparation services.

• Issue: Could they deduct entire tax prep on Sch. C?

• Result: Yes! Cost was “predominately” for Sch. C.

• Breaking out de minimis portion not necessary.

• Court clearly irritated with IRS.


Rental Expenses

Common rental expenses include:

1. Interest expense,

2. Real estate taxes,

3. Insurance,

4. Homeowner association dues,

5. Depreciation,

6. Accounting fees (including tax preparation), and

7. Repairs.

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Capital Expenditure or Repair

Work performed on property divided into 2 categories:

I. Capital expenditures ‐‐ Capitalize and depreciate cost if:

1. Materially improve property,

2. Material “betterment” to property, or

3. Adapt property to new use.

II. Repairs.

1. If not “capital expenditure.”

a. Deduct immediately as repair expense.

i. Much easier to do.



Example

• 2021 ‐‐ Sasha spends $1,300 replacing 4 sinks in rental.

1. If capital expenditure, put on depreciation schedule ($1,300).

• Deduct by taking depreciation each year.

• Sinks are depreciated over 27.5 years (real property).

1. If repair.

• Sasha simply takes a “repairs” deduction ($1,300) on 2021 Schedule E.

• Much easier, faster write off.

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Example

• 2022 – Sasha has 32 receipts for work on property.

• He dumps on your desk.

• You’ve got to figure out whether capital expenditure or repair.

• You could review all 32 receipts and ask Sasha questions. . . Or. . .

Use the de minimis rule.


Capital Expenditures vs. Repairs

Use the “De Minimis” Rule Review All 32 Receipts

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Safe Harbors

Two de minimis rules:

1. $2,500 – If don’t have audited financials.

2. $5,000 if have audited financials.


De Minimis Election ‐‐ Purchased Items and Improvements

Taxpayers with Audited Financials (“AFS”):

1. ≤ $5,000 per invoice (or per item, substantiated by invoice).

2. Make election.

3. Must have written policy used for financial accounting.

4. Book conformity requirement– must expense on AFS.

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De Minimis Election for Purchased Items

2. No Audited Financial Statements:

$2,500/invoice (Notice 2015‐82).

or per item, shown on invoice.

Need:

1. Accounting policy for financial purposes (can be unwritten).

2. Make election.

3. Book conformity.



Examples (no AFS)

• Example ‐ No AFS, invoice = $2,495. Deduct.*

• Even if other invoices result in cost of UOP being > $2,500.

* Assumes election made, book conformity met.

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Examples (no AFS)

• Example ‐ Invoice > $2,500, “look through” items.*

Invoice = $24,900.

10 desks listed on invoice (items) @ $2,490/ea., deduct.*

* Assumes election made, book conformity met.


Scope of Election

Potentially applies to 2 types of expenditures:

1. Improvements ‐‐ otherwise capitalizable.

Example‐ AFS w/$2,400 invoice for building insulation.

‐‐Materially improves energy efficiency.

‐‐ Normally capitalizable, but can deduct.

‐‐We’ll discuss this more in the next section.

2. Purchases of property otherwise capitalizable.

Example‐ Taxpayer (AFS) buys truck for $2,000. Deduct.

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Anti‐Abuse Rule. Treas. Reg. 1.263(a)‐1(f)(6)

Can’t artificially get low $ invoices to abuse safe harbor.

Example

─ Taxpayer gets invoices that separately bills for truck components usually acquired as single UOP (e.g., truck costs $6,500, asks for separate invoices for chassis, tires, engine and trailer). Treas. Reg. 1.263(a)‐1(f)(7), example 11.


De MinimisBook Conformity

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Book Conformity

Book conformity required under de minimis rule.

• If you want to deduct for tax, you need to deduct on books.

• But book conformity not required for bonus deprec. or §179.


Book Conformity

Example

• Apartment building – replace all kitchen cabinets

Cabinets separately listed on invoices

Cost = ≤ $2,500

• Capitalized for book purposes

Client wants income higher for bank purposes

• Can’t use de minimis for tax (no book conformity)

• But may still get bonus depreciation

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Improvements and the De Minimis Rules

De Minimis Rule

Improvements


Putting It Together

• De minimis –improvements and remodels qualify.

Ifmeet de minimis requirements.

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Example

• John replaces every window in apt. bldg. (100 windows)

Cost per window shown on invoice ‐‐ $795

Windows are real property

Won’t qualify for bonus or §179

Will qualify for de minimis, if:

• Policy,

• Make election,

• Expense on financials (book conformity)


32 Receipts

• Back to Sasha and 32 receipts

Much easier to use de minimis

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Home Office Expenses


Employee – Home Office Expense Reimbursement

Home office requirements:

1. Regular and exclusive, and

2. Any of the following:

1. Principal place of business (incl. admin. home office if no other admin location),

2. Place to meet patients, clients, or customers in normal course of business ,

3. Separate structure in connection with business, or

4. Storage of inventory or samples (if in business of selling products and no other fixed location‐ not required to be exclusive).

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Reimbursement of Employee Home Office Expenses

• Expenses – Portion of residence used as office:

Utilities,

Maintenance,

Real estate taxes and interest expense,

Insurance,

Rent.

Deprecation.


Home Office Expenses

• Russ runs a commission sales business

His only office is in his home

He uses the office regularly and exclusively for business purposes

He may deduct expenses for the home office

If his office comprises 10% of the square footage of his home

• And total utilities, maintenance, mortgage interest, etc. = $22,000

• He will deduct $2,200 ($22,000 x 10%)

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Schedule E

Rental Income and Expenses


Why Buy Rental Real Estate?

1. No gain on appreciation until sell

a. Even if property triples in value, no tax until sell it

2. Like‐kind exchanges when sell

a. If decide to sell, can put off tax

b. Use like‐kind exchange

i. Sell old property acquire new property, generally no tax

3. Depreciation expense

a. Even though property usually increases in value

i. You get to take a deduction for depreciation

4. Tax‐free step‐up if you hold until death

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Rental Real Estate – Tax Benefits

Real Estate Certificate of Deposit

Avoid tax until sell? Yes – even if triples in value.

N/A – No gain, pay tax as interest income received.

Qualifies for like‐kind exchange? Yes – can sell property tax free,

reinvest in other RE.

No.

Get to write‐off cost of property? Yes – Depreciation. No – but return of principal tax free.

Tax‐free step‐up if hold until death?

Easy to borrow money to acquire? Yes, usually. No.

Easy? No. Yes (advantage of CDs).

Risk free? No. Yes (advantage of CDs).


Rental Income

1. Report rental income when received:

a. Rent for current year.

b. Prepayments for future years.

2. Don’t report security deposits that you plan to return.

a. Report them in the year you retain them.

i. If don’t return.

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Rental Income

Example

• Sasha buys rental house in November 2020.

• Rents it for period beginning December 1.

• Receives:

1. $2,000 rent (December) and

2. $2,000 security deposit.

• He expects to return security deposit.

• Sasha reports $2,000 rental income for 2020.


Rental Income

Example

• In 2021, Sasha’s client moves out

• Sasha doesn’t return the security deposit (damaged wall, etc.)

• $2,000 security deposit (received in 2020) is 2021 rental income

• Since Sasha decides not to return it in 2021

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Rental Expenses

• Common rental expenses include:

1. Interest expense,

2. Real estate taxes,

3. Insurance,

4. Homeowner association dues,

5. Depreciation,

6. Accounting fees, and

7. Repairs.


Form 1098

Interest Expense Paid → Bank

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Interest Expense

• Interest expense paid → bank is shown on Form 1098.

Form 1098 also used to report interest on a principal residence.

Can usually identify whether it’s client’s rental or principal residence.

• By looking at property address on Form 1098.


Interest Expense

• You’re preparing Sasha’s 2020 Form 1040.

• You have two Forms 1098.

• Uncertain which is for rental and which is for his principal residence.

• Sasha’s rental is on Poplar Lane, principal residence is Forgey Ave.

• Check Forms 1098 to get the property address.

• Enter interest expense from Poplar Lane (rental property) on Schedule E.

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Real Estate Taxes

Real estate taxes on rentals obtained in several ways:

1. Form 1098 – Often included in Box 10.

2. County records – many counties provide amount of taxes paid.

a. On county’s website (just input property address) – public information.

3. Client provides (copies of checks, etc.).


Recap

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Business Expenses

Meals and entertainment 1. Meals – 50% deductible2. Entertainment ‐‐ nondeductible

Depreciation 1. Bonus depreciation ‐‐ immediate expense

Automobiles 1. Special disclosure (Form 4562)a. Business and personal useb. Special substantiation rules

a. Adequate records, orb. Sufficient evidence corroborated by taxpayer’s

testimony

Rough hewn estimates 1. Most tax allocations not precisea. Example – accounting fees

Repairs vs. capital expenditures 1. Use de minimis rules to reduce work

Home office expenses 1. Use must be “regular and exclusive”2. Used for principal places of business


Defending Clients

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Defending Clients

• Most people at IRS want to help taxpayers.

• But some lose perspective, overly aggressive against taxpayers.

• We help defend our clients.

• Eventually, you’ll gain skills to work with the IRS.

• Represent clients in IRS audits.

• Navigate the complex system to get client problems solved.

• Installment agreements if clients can’t pay taxes.

• Obtain refunds for clients who become lost in the system.

• Knowing how to navigate the system is a powerful skill.


Defending Clients

• If a client is audited by the IRS, many procedural steps.

1. Meet with auditor.

a. If disagree, meet with auditor’s manager.

2. If can’t agree with auditor, file appeal.

a. Meet with appeals officer.

b. If can’t agree, meet with appeals manager.

3. If can’t agree with appeals office, file petition in Tax Court.

a. 98% of the cases are settled.

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Defending Clients

Example

• I had a married couple in their late 70s as clients

• They’d used retirement funds to invest in a Ponzi scheme

• An IRS auditor mistakenly assessed a large amount of tax

• They had insufficient funds to pay the tax

• We used IRS administrative appeals process to resolve problem

• Our client’s tax liability was eliminated, and they were able to retire

• Without working into their 80s


Capital Gains and Losses

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Form 8949Page 1 ‐ Short‐Term

Capital Gains and

Losses


Schedule D


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Common Capital Assets

• The following are common examples of capital assets.

Corporate stock.

• Example: Microsoft stock.

Land held for investment.


Reporting Capital Gains and Losses

• Two types of reporting for capital gains:

1. Form 8949 reporting

a. Most sales are reported on Form 8949

i. Then transferred → Schedule D

b. Form 8949 used when there’s any difference between selling price and basis

i. Reported by broker vs. reported on tax return

2. Direct report on Schedule D

• If both sales price and adjusted basis are exactly as reported on 1099‐B

─ Report sum of these transactions directly on Schedule D

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• Example

John sold land in 2020

He received Form 1099‐S reporting sales price of land

• But 1099‐S did not include tax basis in land

─ And basis not reported to IRS

John will report on Form 8949

• Then a summary of the transactions will be transferred→ Schedule D



• Example

Dave had 10 stock sales in 2020

• All 10 sales were reported in 1099‐B

─ Amounts reported on 1099‐B (sales price and basis) identical → Dave’s tax reporting

Dave will report combined sales price and tax basis directly on Schedule D

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Capital Gains: What’s the Big Deal?

Why do capital gains matter?

1. Taxpayers get a special tax rate for long‐term capital gains.

2. But capital losses subject to severe restrictions.


Importance of Capital Gains

Importance of capital gains and losses:

1. Good: Tax rate differences:

Top long‐term capital gains rate: 20%.

Top ordinary income rate: 37%.

2. Bad: Capital losses only deductible to extent of:

Capital gains + $3,000/year.

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Proposed Law Change

• Proposed change

For taxpayers with income > $1 million

Top LT capital gains rate = 37%


Importance of Capital Losses

Example

• $1,000,000 wages, and

• $1,000,000 net capital losses

• No other income or loss

• Can only deduct $3,000 in capital losses currently

• $997,000 income ($1 million wages ‐ $3,000 allowed capital loss)

• Even though client had no income, no cash, big tax bill

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Reason for Lower LT Capital Gains Tax Rates

Why do we have special tax rates for capital gain?

1. Relates to purpose of capital gains rates:

• Intended to apply if made investments and gain accrues over time.

• Unfair to recognize years of appreciation in one year, drive up tax bracket.

2. Also intended to encourage taxpayers not to defer sales. Gillette v. Commissioner.

• If tax rates too high, owner of asset will simply choose to hold on to it.

• Lower rates encourage sale and payment of tax.


Calculating Gain or Loss

Big Picture: Focuses is calculation of gain

• This has two components

1. Amount realized – Selling price

2. Adjusted basis – Usually the cost of the property

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Adjusted Basis

• Adjusted basis =

• Amount paid (including liabilities incurred)

• + Any cost incurred to get asset ready for its intended use

• ‐ Accumulated depreciation, if any


Special Rules ‐‐ Adjusted Basis

• Special rules for adjusted basis apply →

1. Inherited property

2. Gifts

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Basis of Property Acquired by Inheritance

Basis of inherited property usually FMV of property on date of death. §1014

• Example

Rongxiu’s great aunt owns apartment building

• Cost $100,000 many years ago

Rongxiu’s great aunt passes away on July 28, 2020

• Rongxiu inherits apartment building

• FMV on July 28, 2020 = $1 million

Rongxiu’s adjusted basis = FMV on date of death ($1 million)

• If she sells the building the next day for $1 million, no income tax liability


Step‐up ‐‐ Inherited Property

Community Property Step‐Up‐

• Spouse’s share of community property is also stepped up. §1014(b)(6)

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Example

• Jerry passes away

• He and wife own 100 shares of Microsoft as community property

• Bought for $1 per share

• FMV = $120 per share when he passes away

• Tax basis of all 100 shares of the Microsoft stock

• Both Jerry’s and wife’s community property shares

• Stepped up to $120 per share


Basis of Property Received by Gift

• Property received by gift is different.

Usually a “carryover” basis.

In other words, the cost to the person making gift.

• Nina’s great aunt gifted her Boeing stock (while still living).

Stock cost great aunt $1 share.

Nina gets “carryover” basis ($1/share).

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Basis of Property Received by Gift

• Proposed change in law.

The increase in basis at date of death would be limited.

• $1 million limit per person.



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Long‐Term Capital GainYear and a Day


Determining Dates

• To compute holding period (if no special rule applies):

• Date of acquisition

• Date of disposition

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Benefits and Burdens

• Property is acquired or disposed of on the date benefits and burdens of ownership transfer.

• For corporate stock, use trade date, not the settlement date. Rev. Rul. 70‐598, Rev. Rul. 93‐84

• Date that the trade is executed on an exchange.


Example

• Steve places an order online through Scottrade.

• Purchases stock at 9:33 am on June 10, 2015.

• June 10 is trade date.

• Receives securities in his account on June 14.

• Pays seller for the stock on June 14.

• Stock is acquired for tax purposes on June 10, the trade date.

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Year and a Day

• Long‐term holding period requires holding stock for a year + 1 day. Rev. Rul. 70‐598 Fogel v. Commissioner and E. T. Weir.

• Holding exactly one year will notmeet long‐term holding period requirement.

• So won’t get special lower long‐term capital gains rate.


Year and a Day

Example

• Fred buys land on January 4, 2019

• He sells the same land on January 4, 2020

• Won’t qualify for L‐T holding period

Held asset for exactly one year, not required period of more than one year

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Year and a Day

Example

• Same facts as above, except Fred sells land on Jan. 5, 2020

─ He will qualify for a long‐term holding period. Rev. Rul. 66‐6


Netting of Capital Gains and Capital Losses

• Netting

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Carrybacks

Individuals

No carry back net capital losses, indefinite carryovers (until death)

Capital loss limits:

• Can offset capital gain income +

• Capital losses can offset $3,000 of taxable income. §1212(b) and §1211(b)(2)


Carrybacks

Example

• Yunhee has ($44,000) capital loss in 2019

• Also has $1,000 capital gain

• She can offset $1,000 capital gain and

• Deduct net ($3,000) loss in 2019

• Carryover remaining balance ($40,000) indefinitely

• But can’t carry back capital loss.

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Recap



Reporting 1. Form 8949 – if differences from reporting → IRS2. Schedule D

a. Report items identical to IRS reportingb. Summarize Form 8949

Examples capital assets 1. Stocks and bonds2. Investment land3. Rental real estate taxed similarly

Characteristics 1. Gains – special lower tax rates (if long‐term)1. Rates range from 0%→ 20%

2. Losses – Very limited (capital gains + $3,000/year)

Long‐term 1. Hold for at least year + 1 day

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Home Sale Exclusion (§121)


Purpose ‐‐ §121

1. Can exclude gain on sale of principal residence

2. Maximum exclusion:

1. Married filing joint return ‐‐ $500,000

2. Other $250,000

3. Need to pass three tests:

The “3 two‐year tests”

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3 Two‐Year Tests

The 3 two‐year tests:

1. Own the residence 2 of 5 years preceding sale.

2. Use as principal residence 2 of 5 years preceding sale.

3. Not excluded gain on another house w/i preceding 2 years.


Tests 1 and 2

Example

• Jim and Yunhee own house 2014‐2019

─ They’ve used house as their principal residence entire time

─ They haven’t sold another house in the preceding 2 years

─ They meet the “3 two‐year tests”

• If they sell house in 2020, can exclude up to $500,000 gain

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“Unforeseen” Rule

“Unforeseen” exception

Can prorate exclusion if move before 2‐years for any of following:

1. Change in place of employment,

2. Health or,

3. Unforeseen circumstances (to extent provided in regs)


“Unforeseen” Rule

Example

• You and spouse buy and move into home on Feb 1, 2019

• Sell previous home (and exclude gain) on Feb 1, 2019

Feb 1, 2020 ‐‐ sell home, move → Houston (change jobs)

• Exclude up to $250,000

[12 mos since prior home sold ÷ 24 mos qualifying period] x $500,000

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Form K‐1

Pass‐through Income


Forms K‐1

• Passthrough entities don’t pay tax themselves

S corporations and partnerships

They issue K‐1s → their owners

• And owners report the income on their tax returns

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Patience and Persistence



• Initially, I was overwhelmed by knowledge of my supervisors.

It was hard to imagine that I’d ever know as much as they did.

• Of course, as my career progressed, I learned just as they had.

• Many times I’ve heard the new generation “just doesn’t have it.”

That’s the same stuff I heard when I entered the profession 38 years ago.

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• Phil Knight, founder of Nike complained to his financier that new employees at Nike didn’t “have what it takes.”

They weren’t nearly as effective as first generation of Nike employees.

• His financier said:

“See those bamboo trees over there? ... Next year . . . when you come . . . they will be one foot higher. I stared. I understood." ‐‐Mr. Hayami, Nissho CEO → Phil Knight.

• The new workers took Nike → the next level.

The Air Jordan, etc.


Form 8582Passive Losses

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Form 8582

Passive Activity

Loss Limits


Purpose – Passive Loss Rules

• Prior to passive activity rules.

Taxpayers would buy interest in tax shelter.

Use tax shelter losses to offset:

• Wages, active business income, interest income, etc.

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PurposeExample

• Year: 1984.

John is a dentist (works 2,000 hours/year).

He has $600,000 income from dental practice (Schedule C business).

• John buys interest in apartment building.

Receives ($600,000) loss on K‐1.

John pays no tax for 1984.

• Congress enacted passive losses to stop this.


PurposeExample

• Year: 1984.

John has $600,000 wages from Wall Street investment bank.

• John buys interest in baseball team.


John pays no tax for 1984.

• Congress enacted passive losses to stop this.

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PurposeExample

• Year: 1986.

John is a dentist.

He has $600,000 wages from Wall Street investment bank.

• John buys interest in baseball team (works just few hours/year).


Can’t deduct.

• Has income = $600,000 (despite baseball loss).

Can’t deduct baseball loss.

Must carryover baseball loss → future years.


General Overall Passive Loss Rule

• Can’t offset net passive losses (like baseball team)

Against nonpassive income (like dental practice inc.), or

Portfolio income (interest, dividends, etc.)

• Also, can’t offset net losses of passive business

Against income of active business (where “materially participate.”)

• 7 ways to materially participate

─ Most common is to work in business > 500 hours/year

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General Overall Passive Loss Rule

• Example

Gary is a dentist

• Has $275,000/year income from dental practice

─ Works 2,000/hrs/year.

─ This is “material participation” – non‐passive

Gary also owns 50% interest in restaurant

• Works 10 hours/year

• Has losses of ($100,000)

─ This is a “passive activity”

─ Can’t offset passive restaurant losses against nonpassive dental practice income

• $100,000 loss is “suspended” and carried over → next year


Passive and NonpassiveSeparate Buckets

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The Right Bucket

• Passive activities ‐‐ special treatment.

Passive losses can’t be used against nonpassive income.

• But can offset other passive income.

Exception: Entirely dispose of activity in fully taxable transaction.

• Basically, you can’t “pour a net loss” out of passive bucket.

Net passive losses are trapped (they stay in the bucket).

1. Passive income goes into same bucket.

2. So passive income allows use of passive losses.


Passive Losses

Example

• Phil’s new rental house has a ($5,000) passive loss in 2020

Phil has another rental house (older) with $6,000 of net income

• Phil can offset passive loss new rental against passive income of older rental

Phil’s net rental income = $1,000 ($6,000 old rental ‐ $5,000 new rental)

• Passive losses can be offset against other sources of passive income

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Passive Losses

Example

• Sasha’s rental house has a ($5,000) loss in 2020

This will be a passive loss

• Can’t be currently deducted

Carried over → 2021

• If Sasha has $1,000 income from rental in 2021

Carryover from 2020 offsets 2021 $1,000 rental income

Remaining 2020 loss ($4,000) is carried over → 2022


Passive Losses

Example

• Sasha’s has ($4,000) passive loss carryover → 2022

Sasha sells rental house January 1, 2022

A taxable disposi on of property → unelated person frees up loss

• Sasha can deduct remaining $4,000 loss in 2022

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Rental Losses

• Usually Trapped in “Passive” Cage


Rentals

• Rental income or loss is usually “per se” passive.

Even if taxpayer materially participates (e.g. spends > 500 hours).

• Still treated as passive loss (or income).

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Per Se PassiveExample

• Michelle is a CPA, also owns a duplex.

Duplex has 2018 loss of ($24,580).

• 2020 – spends 525 hrs. managing/repairing duplex.

She materially participates (> 500 hours).

• Most businesses, could deduct loss.

But rentals are usually per se passive.

Therefore, losses are passive and suspended.


Per Se PassiveExample

• Michelle is a CPA, also owns a hardware store.

Hardware store has 2018 loss of ($24,580).

• 2020 – spends 525 hrs. managing hardware store.

She materially participates (> 500 hours).

• She materially participates in hardware store businesses.

Can offset hardware losses against CPA income.

The “per se passive” rule just applies to property rentals.

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Why?

Congress passed passive loss rules in 1986.

• Purposes of rental “per se” passive rule:

1. Prevent use of losses from businesses w/ little involvement.

• Against wages, interest income, etc.

2. Rentals typically involved little involvement.

• They were, therefore, treated as per se passive.


Exceptions to “Per Se” Passive Rule

• Exceptions→ “per se” passive rule:

1. Real estate professionals – Clear two hurdles:

• > 50% of time “real property business” (rentals, development, RE sales, etc.)

• > 750 hours “real property businesses”

2. Short‐term rentals

• Usually rentals of beach properties, ski resort properties or Airbnb

3. Active participation rule

• For taxpayers with moderate income

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Active Participation Exemption

“Per Se” Passive – Rentals

Additional Exception

1. Moderate Income

and

2. “Actively Participate”


Basics

• Deduct up to $25,000 loss if “actively participate” in a RE rental §469(i)(1)

Active participation much easer to meet than material participation

• Not for higher income taxpayers

$25,000 limit reduced by 50% of amount MAGI* > $100,000. §469(i)(3)

• If MAGI ≤ $100,000, rental loss allowed up to $25,000

• If MAGI > $150,000, no deduction under “active participation” exception

* Adjusted gross income with some adjustments

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Active Participation Requirements

• To be “active participant,” 3 tests must be met:

1. Must own ≥ 10% value of interests in activity

2. You must “actively participate”

3. Can’t be a limited partner



The committee reports provide:

“... active participation ... can be satisfied without regular, continuous, and substantial involvement in operations, so long as the taxpayer participates, e.g., in the making of management decisions or arranging for others to provide services (such as repairs), in a significant and bona fide sense.

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• “Management decisions” include:

Approving new tenants,

Deciding on rental terms,

Approving capital or repair expenditures, and

Other similar decisions.


Active Participation Exception

Example

• 2020 ‐‐ Feliciano has a rental house ($20,000 loss)

House is leased on an annual basis

Feliciano is not a real estate professional

• He actively participates in rental (management decisions)

His MAGI = $180,000

• Feliciano doesn’t qualify for “active participation” exception

Income too high – he will carry over loss → 2021

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Example

• 2020 ‐‐ Harold has a rental house ($20,000 loss)

House is leased on an annual basis

Harold is not real estate professional


His MAGI = $100,000

• Harold qualifies for “active participation” exception

Full $20,000 loss can be used to offset wages, interest income, etc



Example

• 2020 ‐‐ DeShawn has a rental house ($20,000 loss)

House is leased on an annual basis, DeShawn not RE professional


His MAGI = $140,000

• $40,000 excess x 50% = $20,000 reduction in limit

─ Limit reduced → $5,000 ($25,000 allowance ‐ $20,000 income phase out)

• DeShawn qualifies for limited “active participation” exception

$5,000 of total loss can be used to offset wages, interest income, etc

$15,000 remaining loss carried over → following year

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Recap: Per Se Passive Exceptions


Recap: Rental Real Estate ‐‐ Per Se Passive Exceptions

Exceptions → “per se” passive 1. RE professional2. ST rentals3. Active participation

RE Professional 1. > 50% of time real prop businesses2. > 750 hours on real prop businesses3. Need to materially participate in rental

Short‐term rentals 1. Average period occupancy ≤ 7 days2. Usually vacation rentals, Airbnbs3. Need to materially participate in rental

Active participation 1. Own > 10%2. “Actively participate” (mgt decisions)3. Moderate income (fully phased out if MAGI >

$150,000)

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Thank You for Attending Today’s Program

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Final Exam

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final staff training part 3 individuals

Documents