Preparing Income Taxes - Why You Need to Know About Capital Assets

The IRS is in the business of collecting revenue to support our government. It collects taxes on various forms of money we "accumulate". We are taxed on income we earn; on interest we receive on savings, on dividends from stock we own, and from gains or losses from the sale of our possessions. The IRS Tax Code often categorizes these possessions using negative definitions. It is very confusing! According to the IRS, "our stuff" might belong to some category of property UNLESS it is listed as an exception to that category! For example, in IRS-speak, capital assets are defined as any property that is not explicitly listed as an exception! Sounds crazy (or deviously clever)? Let's start with that negative definition...

Some stuff is real and some stuff is personal. Real stuff is typically associated with "dirt"; like real estate, buildings, or just land. Personal stuff is anything that is not real! Personal property is "movable". Your car, your refrigerator, and your lawn mower are stuff you can hold, move, or break. This "stuff" or property is tangible; it has "substance" and usually some intrinsic value. You can also have intangible property like pieces of paper called stocks and bonds. The value of the "paper" is in the rights of ownership it conveys; they are examples of intangible personal property.

Thus, almost all the "stuff" you own for personal or investment use is a capital asset. Your car, your refrigerator, your lawn mower are examples of personal-use property. The definition begins to blur though because while your home is real, personal use property, a rental home that is not your residence would be business-use property. That rental is maintained to produce some form of income. It might also be considered investment-use property because it has the potential to increase in value over time.

But there is an even more important classification the IRS relies on to collect revenue: holding period. When "stuff" is owed for periods of time that exceed 12 months and a day, the gain or loss from the sale of that property is classified as long-term rather than short-term. The net capital gain is the difference between more preferably long-term gains (or losses) over short-term gains (or losses). The tangible "stuff" you use for non-business or personal reasons is called a capital asset. When you sell this kind of "stuff", any profit or amount over the "original cost" is considered a capital gain and, most important, is taxable. You are required by law to report a capital gain on your income tax return. Depending upon the size of a capital gain, you might also need to make an estimated tax payment! You calculate the gains or losses on Form 1040, Schedule D, Capital Gains and Losses and transfer the net amount to Line 13 in the income section on the top page of your IRS Form 1040. You can find out more information on the IRS website, IRS.gov.

Recording Income Or Capital Gains

To keep a record of your investments income like interest share and also dividends or capital gains which are issued by mutual companies here are the procedures.

One you should display the investment account register, this is by clicking the accounts and bills link then select the account list then the money will show pick an account to use this window. After that click on investment accounts, then the display comes up for the account register for mutual funds. The second thing to do is to state that you want to record your purchase and additional shares from the mutual fund, after that click the investment transaction link, and then this information is added at the bottom of the account registry, and to record a new transaction click the new button.

The next thing to do is state on which day the income or capital gains were received in the date box. You can either enter the information in the box provided or you can click the date box button to access the program's pop up calendar. Next click the investment box and select the mutual funds from the list of investment funds shown. To identify this particular transaction you will have to enter it as capital gains transaction, click on the activity box and then select the preferred activity from the list. If you are particularly in record interest click on interest, if you are recording a dividend then select dividend. After that select the necessary option that you need.

Report It The Right Way On Your Federal Income Tax Return

It is important to understand capital gains and losses when filling out your federal income tax return. The category of capital asset includes almost everything you have which you use for personal and investment reasons. Your home, household furnishings, stocks, and bonds in personal accounts are considered capital assets. Your capital gains and losses are calculated from the difference between the amount you paid originally for that asset and the amount you received when you sold it.

The IRS publishes important information to help you understand how your investments affect your tax return.

When you are figuring out what is classified as a capital asset, remember that purchases you made for personal, investment, and pleasure purposes are all included. Upon your resale of that asset, you can calculate your capital gain or loss. The original purchase amount is generally your basis from which you will derive your loss or gain.

Make sure to report all of your investment income on your tax return on Schedule D, Capital Gains and Losses, and then transferred to line 13 of Form 1040. Keep in mind that you can only deduct capital losses that come from investment property, not from personal property. They are classified in accordance with how long you actually owned it. They are either short-term or long-term, and that classification is based on one year's time. If you held it for one year or less, it is considered short-term. If you held it any longer than one year, it is long-term.

To have net capital gain, your long-term gains must be greater than your long-term losses. The difference between your loss and you gain in this case equals your net capital gain. Net capital gain is calculated separately from your regular income because the tax rates are lower, typically 15 percent. For individuals with lower incomes, the tax rate may be as low as 0%, but some specific types of net capital gains are taxed at 25% or 28%.

On the flip side, if you lose more than you gain, you can deduct those losses on your income tax return. This could reduce up to $3,000 in taxable wages (or $1,500 if you are married filing separately). If your net capital loss is greater than this amount, then you can treat it on your next year's tax return as if it happened in that year.

More details on reporting these parts of your income are available on the Schedule D instructions, Publication 550, Investment Income and Expenses or on Publication 17, Your Federal Income Tax.

Income Tax - UK Landlords

Introduction

It's only a small word but it looms very large in the thoughts and the nightmares of many of us. It was Disraeli who said that there are only two things in life that are certain...., "death and taxes". The good news is that you don't have to be quite so fatalistic. Like anything in life, you can be a victim, or you can make circumstances work for you. It always helps if you have a good accountant to guide you.

I confess it is only belatedly that I've become acquainted with the intricacies of the taxation system. For years I managed without making a return. Not out of any deliberate plan to defraud. But just because I knew I wasn't making any money. My mortgage payments were barely covered by the rental income and having not sold any property, there were no capital gains. So why trouble the poor overworked civil servants I thought!

Then house prices went through the roof! I sold a few properties and realised some capital gains, investing most of it back into property. It was only when talking to a tennis friend, who turned out to be an accountant that I started to think I might need to explore the matter a bit more carefully. A holiday to Australia in which I took along a copy of the Zurich Tax Handbook as a bit of 'light reading' convinced me that there might be a problem. I think it was the bit on 'tax evasion' being a criminal offence punishable by imprisonment that focused my thoughts. I resolved on my return to come clean. To my amazement, the tax system was not as penal or as complicated as I had feared. Now let's look briefly at what the main taxes that affect a property investor are.

My Tax Liabilities

Tax liabilities for rental properties are assessed on the basis of income and capital gains. Firstly, let's examine how liabilities derived from income are calculated.
All income from land and property in the UK is taxed under Schedule A; that includes residential investments whether they are furnished or not. Income and expenses for tax purposes are assessed as a single letting business. So effectively if you have one or one hundred properties, Her Majesty's Revenue & Customs (HMRC) take the total figure rather than looking at individual properties. Income is assessed by tax years ending on the 5th April. Schedule A income is treated as investment income. As such any losses can only be carried forward and offset against Schedule A income and not personal income such as a salary.

Taxable profit is the income that remains after all allowable expenses have been deducted. It's always helpful to have a quick flick through the 'revenues' booklet IR150 in Taxation of Rents for detailed guidance. Like everything these days a copy is available to download from their website http://www.hmrc.co.uk

In essence, your taxable profit is calculated by taking your annual rent and then deducting expenses. For convenience HMRC separate expenses into 5 categories. These are:

Legal & professional- Legal services for a remortgage, valuation fees, mortgage broker fees, landlord safety certificate costs, tenancy agreement costs, letting agent fees, admin cost to close a mortgage, membership fees to a professional body

Repair, maintenance & renewals-redecoration costs, appliance repair charges, plumbing, electrical repairs, etc

Rent, rates, insurance, ground rents, etc -insurance, council tax charges, grounds rent

Cost of services provided, including wages - cleaning, meals

Other expenses -Telecom charges, utility bill costs, computer software, advertising costs, computer purchase (if used exclusively for the business - could be accounted as a capital allowance (see section on capital allowances below)

What are my allowable expenses?

Repair and renewals
Where a property is furnished or part furnished; rather than to claim as each renewal arises it is possible to make a single claim of 10% of rent as a 'wear and tear' allowance. This is accepted by the Revenue as broadly equivalent to the cost of normal renewals of furniture. Beyond the fittings, such as furniture there will be renewals and repair to the building e.g. repair to the roof, bathroom and windows, etc. This raises a real taxation hornet's nest. When does a renewal become an improvement? The latter is not an allowable expense against income (although it can be offset against capital gains - see later under Capital Gains Tax( CGT)).

There is, as with many tax issues, a grey area of when a renewal becomes an improvement. It is largely a question of fact and degree in each case whether expenditure on a property leads to an improvement and therefore become a capital expense. UPVC windows were considered for many years to be an improvement and therefore the expenditure counted as capital. However, in recent years HMRC have relented and accepted that UPVC is for most people the modern equivalent of wood and therefore is considered a renewal.

Another example of the way the HMRC approach the subject is their approach to the refurbishment of a fitted kitchen. For example, they consider that where a kitchen is refurbished, including work such as stripping out and replacement of base units, wall units, sinks, etc, retiling, work top replacements, repair to floor coverings and associated re-plastering and re-wiring. Provided that the kitchen is replaced with a similar standard kitchen then this is a repair and the expenditure can be off set against income. If at the same time additional cabinets are fitted that increase the storage space, or extra equipment is installed; then this element is a capital addition and not allowable and the additional expense should be apportioned as a capital cost. If the standard units are replaced by expensive customised items using high quality materials, the whole expenditure is then judged to be capital.

Loans and Interest

Most people will have borrowed money to finance their investment. When accounting for these costs it is interest payments alone that are an allowable expense. This means where a loan is a repayment mortgage; only the interest element of the loan can be offset against rental income. It is also possible to offset other loans that have been taken out for the business. For instance, when one has been raised to finance a new kitchen or extension of the rental property. It should be quite clear in these cases that the loan is specifically for the business and where possible documentary evidence should be available (just in case the revenue raises an enquiry on the matter). Therefore, if a loan is arranged, try to separate it off from your personal finances. This could be done by using it to set up a separate business account.

Non - standard lettings

So far I have referred to the tax treatment of a 'standard' buy-to-let property rented on an Assured Shorthold Tenancy. There are two categories of residential rentals that are treated slightly differently by the Revenue. These are where somebody rents a room in their house and a furnished holiday let.

Rent a room

Under this system a person is allowed to rent out a room in their own home without having to pay tax providing the rent is no more than £4250 pa. If it is more than this, the taxpayer has the option to have the excess income (i.e. above £4250) taxed as a Schedule A rental profit. Otherwise the entire rent will be taxed in the usual way on the profit from the gross receipts minus allowable expenses.

Furnished holiday lettings

These are treated slightly differently to the Revenue from a standard residential let. This is because of the amount of management time involved and the relatively short rental periods. They are therefore are therefore classified as a business rather than an investment. Consequently a different tax treatment applies.

To qualify as a holiday let the following criteria must be met. The property must be:

* Available for holiday let at least 140 days a year

* Actually let for 70 days a year

* Not occupied by the same person for over 31 days in 7 months

The main advantage to landlords with a holiday let is that the activity is regarded as a trade and is assessed under Schedule D. Therefore, any losses can be offset against an individual's personal income, which includes their salary.

The Tax Laws Favor Capital Gains Over Regular Income!

The government gives tax advantages to capital gains because investments build businesses that provide jobs.

Also, someone with investments is less likely to need government assistance in old age. As a result, traders and investors do not have to pay Social Security and Medicare taxes on stock profits.

Also, there are no taxes for buying stocks!

Taxes do not become a consideration for traders and investors until they sell a stock or fund. At that point, they either have a capital gain or capital loss.

For every sale, you need to figure out which shares were sold.

This information is called the Cost Basis, and is important for figuring out if the sale results in a gain or loss, as well as whether the gain or loss is long term or short term.

A capital gain or loss is Short Term if the sale happened less than a year and a day after the purchase - otherwise it is a Long Term gain or loss.

Long term capital gains are especially favored. While short term gains are taxed at the same rate as your regular income (currently up to 35%), long term gains are currently capped at a maximum rate of 15% (though this cap rises to 20% in 2011).

For stocks and ETFs, you can choose two options for figuring out the cost basis: "First in, First Out" (FIFO) or Specific Shares.

For mutual funds, you have three options: FIFO, Specific Shares, or Average Cost.

You cannot use the Average Cost method for stocks and ETFs.

The Difference Between Capital Gains and Ordinary Income

Most long-term capital gains are taxed at 15% for 2010. This rate is scheduled to increase to 20% in 2011. Unfortunately, we need to say "most" because there are some exceptions as follows:

Taxpayers in the 10% and 15% ordinary bracket-0%
Certain depreciation recapture on real estate-25%
Collectibles-28%

A long-term gain is from the sale of a capital asset held longer than a year. A capital asset includes stocks, bonds, mutual funds, and real estate (other than residence).

Short-term gains are those that are held one year or less. Short-term gains are taxed at ordinary income tax rates. Ordinary income tax brackets for married couples filing joint for 2010 are projected as follows:

Taxable Income Tax Rate

0€-16,750 - 10%
16,750€-68,000 - 15%
68,000€-137,300 - 25%
137,300€-209,250 - 28%
209,250€-373,650 - 33%
Over 373,650 - 35%

The highest ordinary income tax bracket is also scheduled to increase in 2011 to 39.6%.

Capital gains and losses are netted against each other. If this results in a net loss, this loss is limited to a $3,000 tax deduction for a married couple filing a joint return. Any loss above this is carried into future years.

However, be cautious. Some taxpayers may be subject to an Alternative Minimum Tax ("AMT"). Taxpayers need to calculate their income two ways. First, calculate the income tax under the regular method, and second, under the AMT method. Then pay the higher of the two taxes. For taxpayers subject to the AMT, it may make their effective tax rate on long-term capital gains higher than the stated rate of 15%.

It is important to know the holding period for any capital assets and whether the sale will result in a gain or loss.

Thomas F. Scanlon, CPA, CFP.

Federal Income Taxes - Top 10 Things To Like About The Tax Relief Act Of 2010

President Obama just signed into law the Tax Relief Act of 2010. The full name of this legislation is the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010. But for purposes of this article, let's just call it the Tax Relief Act.

There are plenty of good things in this bill. Here are some of the highlights:

1. Personal income tax rates will remain the same for the next two years. If this bill had not been passed, individual tax rates would have increased on January 1, 2011 to 15, 28, 31, 36 and 39.6 percent. Instead, they will remain at the levels of 10, 15, 25, 28, 33, and 35 percent for 2011 and 2012.

2. Maximum capital gains tax rates will also remain unchanged for 2011 and 2012. The maximum rate of 15 percent (zero percent for folks in the 10 and 15 percent tax brackets) stays in effect instead of increasing to 20 percent (10 percent for those in the 15 percent bracket).

3. Maximum dividend tax rates also stay the same for the next two years - 15 percent rather than ordinary income tax rates.

4. The child tax credit of $1,000 is extended for the next two years, rather than returning to $500 per qualifying child.

5. The American Opportunity Tax Credit (a credit to offset qualified higher education expenses) remains in effect for 2011 and 2012.

6. Employers can continue to provide tax-free educational assistance to their employees up to $5,250 per year in 2011 and 2012.

7. Several tax breaks that had expired on December 31, 2009 have been extended for 2011 and 2012. These include the teacher's classroom expense deduction, the higher education expense deduction, and the state/local sales tax deduction.

8. The deduction for qualified mortgage insurance premiums has been extended for 2011.

9. The dependent care credit remains as is for the next two years.

10. Social Security taxes have been reduced by 2 percent for 2011. This reduction applies to both employees and the self-employed.

Of course, there's at least one thing to dislike about this bill - all these provisions are temporary. A few exist for only one year (2011). Most of them will expire at the end of 2012, and so in two years, we get to watch Congress and the President have yet another debate on what to do about tax rules that change repeatedly because our politicians created them that way. So enjoy these tax breaks while they last.

Convert Income to Capital Gain and Pay Less Tax

Most people distinguish between capital and income. You read about people, especially retired people, whose capital sits in a bank or building society account while the owner lives on the income alone (mustn't touch the capital!). For people with little money and financial knowledge this is not a bad rule, except of course the capital depreciates every year due to inflation.
I learnt many years ago that you should regard your money as a machine that generates cash. At times the machine may grow bigger or smaller, but as long as it continues to generate the cash, that is OK. The cash may be income, interest, dividends or capital gains - it doesn't matter. It's still money in your bank account. And in the short-to-medium term, as long as you don't need to touch your capital, it doesn't matter if it shrinks. (Actually you gain a little bit - investment fund managers take a fee each year that is usually calculated as a percentage (1% - 1.5%) of the fund value, so whenever the fund shrinks, their fee falls).

This all assumes you have a cash reserve of readily accessible 'rainy day' money (in a high interest account, not a high street bank, please!).

In the UK, when you retire, you have to draw your pension (state as well as personal and/or company pension) as taxable income, and this uses up your personal allowance and your low rate tax band: any additional income is then taxed at 22% (and then 40% if you have a very good income!).

However, if the funds that generated this additional income are invested in a way that will produce capital gains instead, these gains are tax-free (up to about £8,000 per tax year, an amount that is usually indexed annually in the Budget). Capital losses can be carried forward for up to six years and offset against subsequent gains.

This rule applies to everybody, but this example (roughly; figures have been rounded for simplicity) applies to people aged 65+ and shows how this can work. In each case, the person is assumed to have an annual income of £20,000.

Case 1. Total income: £20,000, all from pensions, interest and dividends.

Tax on the first £7,500 (personal allowance) 0

Tax on the next £2,500 (lower rate 10%) 250

Tax on the last £10,000 (standard rate 22%) 2,200

Total tax paid: £2,450.

Case 2. Total income: £20,000, of which £15,000 is income from pensions, interest, etc. and the other £5,000 arises from capital gains.

Tax on the first £7,500 (personal allowance) 0

Tax on the next £2,500 (lower rate 10%) 250

Tax on the last £5,000 (standard rate 22%) 1,100

Tax on the £5,000 capital gain 0

Total tax paid: £1,350.

All you have done is exchange £5,000 of income for £5,000 of capital gain, and you've saved about £1,100 in tax.

Case 3. If you can get the income down to £12,000 and the capital gain up to £8,000, you will do even better:

Tax on the first £7,500 (personal allowance) 0

Tax on the next £2,500 (lower rate 10%) 250

Tax on the last £2,000 (standard rate 22%) 440

Tax on the £8,000 capital gain 0

So the tax paid drops again to £690, saving about £1,750 compared to Case 1. And remember, you can do this every tax year!

Is Ordinary Income Different From Capital Gains?

Earned income (typically from employment) is considered ordinary income. In 2009, ordinary income tax rates range from 10 to 35 percent. An individual's marginal tax rate is the percent of the last dollar made during the year that must go towards taxes. It's important to note that a taxpayer's marginal tax rate is not applied to every dollar earned during the year. Examine the following chart, which illustrates the federal tax schedule for married individuals filing jointly in 2009.

o 10% on the income between $0 and $16,700
o 15% on the income between $16,700 and $67,900; plus $1,670
o 25% on the income between $67,900 and $137,050; plus $9,350
o 28% on income between $137,050 and $208,850; plus $26,637.50
o 33% on income between $208,850 and $372,950; plus $46,741.50
o 35% on the income over $372,950; plus $100,894.50

As the chart indicates, all income up to $16,700 will be taxed at 10 percent, and only income between $16,700 and $67,900 will be taxed at 15%. This layering of tax rates creates a distinction between a taxpayer's marginal and effective tax rates. If a couple earned $75,000 in a year, they would be in the 25 percent marginal tax bracket, but their actual federal tax bill would be $11,125 (calculated by subtracting $67,900 from $75,000 and multiplying the result by 25 percent, then adding $9,350). Thus, the couple's effective federal tax rate would be 14.83 percent ($11,125 divided by $75,000).

Marginal rates are used to calculate how much tax can be saved by increasing deductions. A taxpayer in the 25 percent marginal tax bracket will save 25 cents in federal tax for every dollar spent on a tax-deductible expense, such as mortgage interest.

Capital gains tax is applied to most items purchased and sold for investment purposes. For the purposes of this writing, the items most applicable to capital gains taxes are stocks, bonds, money market accounts, and property. When a capital asset is sold, the difference between the selling price and the basis (usually what was paid for the asset plus the costs of any improvements made) is subject to capital gains tax.

Capital gains or losses are further classified as short-term and long-term. An asset that was owned for 12 months or less is considered to be a short-term asset, and any gains from the sale of short-term assets are taxed at ordinary income rates. Long-term assets are owned for more than 12 months, and qualify for taxation at favorable capital gains tax rates.

Capital gains tax rates are lower than ordinary income rates in order to give investors an incentive to invest in the economy. In 2009, taxpayers in the 10 or 15 percent marginal tax brackets qualify for the generous capital gains tax rate of 0 percent, while taxpayers who are in the 25 percent or higher marginal tax brackets pay a capital gains tax of 15 percent.

Your financial planning efforts should always consider tax implications. Recruit an independent fee only financial planner who prefers to work closely with your tax preparer.

Preparing Income Taxes - 2 Ways Capital Assets Save You Money

What is a capital asset? Tax authorities like the Internal Revenue Service and state taxing authorities expect you to report any capital gains or losses on your annual income tax return. This information is reported on IRS Form 1040, Schedule D, Capital Gains and Losses and then transferred as a "cumulative" net amount to Line 13 in the income section on the top page of your IRS Form 1040. You can't file an income tax return that has capital gains or losses using IRS Form 1040A if you are required to file Schedule D to report the income.

Why should you care what is or is not a capital asset? It is important because it could save you money! Tax rates applied to capital gains income are often significantly lower than a person's marginal income tax rates. In other words, you often owe less tax if you sell a capital asset! For 2009 and 2010, a taxpayer in the 15% marginal income tax bracket will pay 0% on any net capital gains! But there is yet another way it can save you money.

The second way you can save money is if your capital loss is greater than your capital gains for the tax year. If gains are less than your losses, you have a cumulative or net loss. This means you can deduct up to $3000 ($1,500 if you are married but filing separately) from your income tax. If the loss is greater than this annual limit, you can "carry forward" the unused loss into future years until it is all used up. There is a catch, though. You can deduct a capital loss only on investment property; you can't deduct a capital loss on personal use property. This distinction is important; you typically don't own investment property, according to IRS code, for personal enjoyment! It is also important to remember that if you anticipate a significantly large taxable capital gain during the year, you are required to make estimate tax payments (even though it will be taxed at a preferentially lower rate).

Your understanding of the definition of a capital asset and how you dispose of it is an important part of managing your personal finances. More information is available in IRS Publication 544, Sales and Other Dispositions of Assets or on the IRS website, IRS.gov. Knowing the "rules" about capital assets could save you lots of cash AND grief.

Preparing Income Taxes - How Do I Report Information on a 1099-A?

The reporting of any cancellation of debt (COD) involves two different information documents; an IRS Form 1099-A, Acquisition or Abandonment of Secured Property and an IRS Form 1099-C, Cancellation of Debt. An IRS Form 1099-A is specifically provided to both tax authority and tax payer when a lender forecloses, repossesses, or has reason to suspect property is abandoned. Whether or not you receive either of these documents in a timely fashion, you must report cancellation of debt you have owed on your personal income tax. Acts of repossession, abandonment, or foreclosure are treated as a sale or exchange of property and the rules of gain or loss apply. Any income arising from the cancellation of a recourse debt is taxable whether or not property is returned or surrendered.

The IRS Form 1099-A is information form that includes the balance of outstanding debt, the fair market value of the property involved, a description of the property, and whether the debt is classified as recourse or non-recourse. Specifically, in Box 5, a "Yes/No" check box indicates whether or not the borrower is personally liable for repayment of the debt. The information in this single box on the form is critical because, if the box is marked "No", the debt is classified as non-recourse; that is, the borrower is not personally liable for the debt. In the case of a recourse debt however, the buyer is not only liable but, under cancellation of that debt, may have a gain, and thus additional taxable income, from the removal of the burden to repay the obligation. Where a recourse loan leads to foreclosure or repossession, the Form 1099-A provides critical information about additional taxes owed on that debt-generated income.

The sale information reported on a Form 1099-A is transferred to the IRS Form 1040 Schedule D, Capital Gains and Losses if the property was categorized as personal - use and there was a reported gain; losses are not reported. If the property was considered an investment, information is entered on Schedule D and ordinary gain/loss rules apply to the transaction. If the Form 1099-A describes business property, an IRS Form 4797, Sales of Business Property is completed and the results are, in turn, transferred to IRS Form 1040 Schedule C (business, sole proprietorship), E (rental), or F(farm).

The proper transfer of information from an IRS Form 1099-A to your income tax return is best left to an experienced tax preparer. You should expect to also include an IRS Form 1040 Schedule D with your tax return. Do NOT overlook COD events when filing your income tax return. For more information, visit the IRS website, IRS.gov.

Need More Income from Your Investment Property?

The goal of every real estate investor is to see their property appreciate in value and to have it generate a positive cash flow. The appreciation normally takes care of itself if the property is of good quality, in a good location, and is held over a long enough period of time. Just like the stock market, real estate has proven to go up way more than it goes down over time.

The positive cash flow component is not always a given though. Ask any seasoned investor, and unless the property is owned free and clear, there have probably been times when he's had to dip into his own pocket to pay for some aspect of his rental. Who hasn't seen a raise in homeowner's fees, property taxes, an outlay of cash for a new roof, plumbing, paint, carpet, appliances, or a length of time supporting it between tenants.

So, what if you're nearing retirement age and see the need for increased and steady income? You may even look forward to taking a permanent break from the "joys" of hands-on property management. We all deserve to reap the rewards of our labors, right?

Basically, to meet these goals, one can do one of two things.

1. Sell the property, pay all the capital gains taxes, recaptured depreciation, etc. and pocket what is left. To receive an income, one would have to either live off whatever interest/gains your proceeds produced, or begin depleting your funds to provide you with the amount of monthly income you deem necessary. Depending on your age and financial needs and whether or not you desire to leave as large a legacy as possible, this approach may or may not work for you.

2. Employ a strategy that will defer the payment of any tax or depreciation. Let all of your gains continue to work for you throughout the course of your retirement and into the next generation. Yet, you will still get a significant and partially tax deductible monthly income.

What strategy is #2? If your property is over a million and you are not a young retiree, you might consider a Private Annuity Trust. You will get monthly income for the rest of your life, but you will be depleting your asset and only spreading out the repayment of capital gains tax over a longer period of time. That is a simplification of a complex agreement, but that is the gist.

A better option may be a 1031 exchange into a tenant in common (TIC), Basically, you exchange your property for a deeded partial interest in a grade A commercial property. You sign a contract with a property management company, and in turn receive a monthly income (typically 6-7% of your total equity). You never have to deplete your asset, and it can pass to your heirs at the stepped up basis.

The 1031/TIC exchange is a fairly new concept, sanctioned by the IRS in 2002. It is projected that the influx of property assets into this type of exchange will be close to 5 Billion dollars in 2005. That's a lot of equity. Why not let your equity continue to work for you instead of parting with a lot of profits that would take you years to replace.

Investing in Real Estate, Flipping Houses, and Income Taxes

Understand the tax consequences of flipping houses, rehabbing houses, and how to defer taxes with the 1031 Exchange before you get into real estate investing. Problems arise when real estate investors don't follow federal and state tax laws. This is why you need professional advice. Although I am not a tax advisor, here are some common mistakes beginning real estate investors make by not understanding tax liabilities:

Flipping Houses

The reason flipping houses is a mistake for some beginners is that they don't know the income tax consequences. One problem with flipping houses, or selling too many properties too quickly, the IRS could say that your real estate business is your trade, subject to ordinary income and self-employment taxes.

Self-employment tax, a social security and Medicare tax primarily for individuals who work for themselves, is similar to the social security and Medicare taxes withheld from the paycheck of most employees. The self-employment tax rate costs you 15.3% of your profits. (However, this may provide retirement benefits.)

Rehabbing Houses

Another common mistake that beginning investors make is selling a property after holding it for almost a year. Some rehabbers work part time on a fixer and take six months to get the house ready. Add on two months to sell with a 60 day closing, and they're up to ten months. To take advantage of the low 15% capital-gains tax rate, you must keep the investment property for at least a year before selling. If you sell before a year, your tax rate, the usual capital gains rate of 35%, could eat up a significant amount of your profits.

If you're rehabbing houses, be patient. You could save thousands in taxes by holding your property just a few more weeks.

1031 Exchange

However, the Internal Revenue Code provides real estate investors away to defer capital gains taxes indefinitely. Section 1031 of the Internal Revenue Code provides a tax-free exchange. Also known as a "like-kind" exchange, this code allows you to sell a business or investment property and defer capital-gains taxes by immediately reinvesting the gains into a similar piece of property. The key, replacing a business or investment with similar property, means that no gain gets paid to the investor. Any profit taken out of escrow gets taxed. This means that beginning investors might take out a portion of the profit after they carefully explore their tax liabilities. In other words, talk to an accountant and find out what your tax would be according to your current usual income. Many business owners take advantage of this because they have many business deductions.

The big mistake beginning real estate investors make doing a 1031 tax-free exchange, taking possession of the profits, voids the tax deferment. You must declare the sale of your property to be a part of a 1031 exchange before you sell the property. Then you have the money placed in a trust account held by an intermediary until you purchase the new investment property. You have 45 days to identify a replacement property and 180 days to close on the new investment. You can't purchase a primary residence or a vacation home with funds from an investment property and defer taxes in a 1031 exchange.

The best advice for beginning real estate investors:
Talk to an accountant.

Would you be better off making extra money, even if you must pay taxes?

© 2005 Jeanette J. Fisher.

Australian Tax - Bamford Decision and the Streaming of Income to Trust Beneficiaries

Due to the decision impact statement on the Bamford High Court decision and recent statements by high ranking Australian Taxation Office ("ATO") officers, there is a great deal of uncertainty concerning the future ability of a trustee of a trust to stream different classes of income to different beneficiaries of the trust.

First some background. The trustee (or trustees) is the legal owner of the assets of the trust. The trustee derives income from the assets of the trust. This can be just about any type of income that you can think of. It can include interest, dividends, distributions from other trusts, capital gains, trading income and so forth. The trustee must apply that income for the benefit of the beneficiaries and in accordance with the powers given to the trustee under the trust deed. In a discretionary trust, the trustee has the absolute ability to decide how much is to be distributed to each beneficiary and how much is not to be distributed.

It is usually the case that the beneficiaries of the trust have different marginal tax rates and different tax rules can apply to them, depending on what type of taxpayer they are. It is prudent for the trustee to direct certain types of income to certain types of beneficiaries in order to lower the overall tax payable by the beneficiaries on the income derived from the trust. Accordingly, the concept of the streaming of income to beneficiaries has been a widely accepted part of trust administration for some years. This concept came particularly to the fore when the dividend imputation and capital gains tax rules were enacted in the mid 1980's.

The ability to stream income to beneficiaries rests on the assumption that income of different types can be separately identified by the trustee. Further, the expenses that relate to that income can also be separately identified. Alternatively, the expenses of the trust may need to be apportioned over the various types of income. So, the underlying assumption is that income can retain its character, and therefore its tax characteristics, as it flows into and then out of the trust.

Streaming was approved (in a sense) by the ATO when it issued a public ruling in 1992 on the distribution by trustees of dividend income under the imputation system. This was TR 92/13. The ruling referred to the dividend imputation legislation as it existed at that time. This legislation has since been repealed and replaced with another set of dividend imputation rules.

The Bamford Decision

What's all this got to do with the Bamford decision? On one view, nothing. The High Court did not refer to the issue of streaming in the Bamford decision. But, due to the statements that the High Court made in relation to the method by which Sub-section 97(1) of the Income Tax Assessment Act 1936 operates when determining the taxable income of a beneficiary, the ATO considers that TR 92/13 must be withdrawn. Nevertheless, the ATO states that tax returns for the 2009/10 income years and earlier years which are/were reasonably prepared on the basis of TR 92/13 "will not be disturbed".

Why does the ATO consider TR 92/13 should be withdrawn? This is because, according to the High Court, under Sub-section 97(1), a beneficiary is assessed in the following manner:

[1] The beneficiary's percentage share of the trust law income for a particular income year is determined.
[2] The taxable income of the trust is determined.
[3] The percentage under [1] is applied to the taxable income in [2] and the resultant amount is the taxable income of the beneficiary.

In the above process, on one view, there is no regard to the classes of income that have been received by the trustee and whether the trustee has decided to allocate certain classes of income to certain beneficiaries. But there are other provisions in the income tax law that refer to the taxation of the beneficiaries of a trust in relation to certain classes of income. Regard must also be had to these provisions.

Is streaming dead after 30 June 2010?

I think that it is a bit early to say that streaming is dead, although perhaps casket measurements should be taken. I have attended two recent seminars. At one seminar, the speaker (non-ATO) said that the ATO would no longer sanction streaming. At another seminar, there was a senior ATO technical officer speaking. There was no indication from him that streaming was definitely not going to be permitted by the ATO. There is to be a review of the area by the ATO and this will include the scheme of the law in the current imputation provisions and relevant capital gains tax provisions.

Unfortunately, nothing can be said about the future of the streaming of income to beneficiaries with any certainty. We will have to wait for future ATO pronouncements and possible changes to the law. Based on past experience, this will also create further uncertainty. But, this is the Australian tax system.

Wishing you easier business.

John M. Jeffreys

About Income Taxes; Tidbits

1812

The first attempt to impose an income tax on America occurred during the War of 1812. After more than two years of war, the federal government owed an unbelievable $100 million of debt. To pay for this, the government doubled the rates of its major source of revenue, customs duties on imports, which obstructed trade and ended up yielding less revenue than the previous lower rates.

And to think that the Revolution was started because of Tea Taxes in Boston?

Excise taxes were imposed on goods and commodities, and housing, slaves and land were taxed during the war. After the war ended in 1816, these taxes were repealed and instead high customs duties were passed to retire the accumulated war debt.

What is Taxable Income?

The amount of income used to arrive at your income tax. Taxable income is your gross income minus all your adjustments, deductions, and exemptions.

Some specific taxes:

Estate Taxes:

One of the oldest and most common forms of taxation is the taxation of property held by an individual at the time of death.

The US still has Estate Taxes, although there are proposals to do away with them.

Such a tax can take the form, among others, of estate tax (a tax levied on the estate before any transfers). An estate tax is a charge upon the deceased's entire estate, regardless of how it is disbursed. An alternative form of death tax is an inheritance tax (a tax levied on beneficiaries receiving property from the estate). Taxes imposed upon death provide incentive to transfer assets before death.

Canada no longer has Estate Taxes.

Most European countries have Estate Taxes, one prime example is Great Britain which has such high Estate Taxes that it has just about ruined the financial well-being of most of Britain's Nobility which has been forced to sell vast Real Estate holdings over time.

. Such a tax can take the form, among others, of estate tax (a tax levied on the estate before any transfers). An estate tax is a charge upon the decedent's entire estate, regardless of how it is disbursed. An alternative form of death tax is an inheritance tax (a tax levied on individuals receiving property from the estate). Taxes imposed upon death provide incentive to transfer assets before death.

Capital Gains Taxes

Capital Gains are the increases in value of anything (including investments or real estate) that makes it worth more than the purchase price. The gain may not be realized or taxed until the asset is sold.

Capital gains are normally taxed at a lower rate than regular income to promote business or entrepreneurship during good and bad economic times.