Individual Tax briefs

A three-step strategy to save tax when selling appreciated vacant land

Let’s say you own one or more vacant lots. The property has appreciated greatly and you’re ready to sell. Or maybe you have a parcel of appreciated land that you want to subdivide into lots, develop them and sell them off for a big profit. Either way, you’ll incur a tax bill.

For purposes of these examples, let’s assume that you own the vacant land directly as an individual or indirectly through a single-member LLC (SMLLC), a partnership or a multimember LLC that’s treated as a partnership for federal income tax purposes.

Here are a couple of scenarios and a strategy to consider.

Scenario 1: You simply sell vacant land that you’ve held for investment

If you’ve owned the land for more than one year and you’re not classified as a real estate dealer, any gain on sale will be a long-term capital gain (LTCG) eligible for lower federal income tax rates. The current maximum federal rate for LTCGs is 20%. You may also owe the 3.8% net investment income tax (NIIT) on all or part of your gain and maybe state income tax, too.

Scenario 2: You develop a parcel and sell improved lots

In this case, the federal income tax rules generally treat a land developer as a real estate dealer. If you’re classified as a dealer, the profit from developing and selling land is considered profit from selling inventory. That means the entire profit — including the portion from any pre-development appreciation in the value of the land — will be high-taxed ordinary income rather than lower-taxed LTCG. The maximum federal rate on ordinary income recognized by individual taxpayers is currently 37%. The 3.8% NIIT may also be owed and maybe state income tax, too. So, the total tax hit might approach 50% of the gain.

S corporation entity strategy to the rescue

Thankfully, there’s a strategy that allows favorable LTCG tax treatment for all the pre-development appreciation in the value of your land. However, any profit attributable to later subdividing, development and marketing activities will be high-taxed ordinary income because you’ll be treated as a dealer for that part of the process. But if you can manage to pay “only” the 23.8% maximum effective federal rate (20% + 3.8%), or maybe less, on the bulk of a large profit, that’s a win. Here’s a three-step plan to accomplish that tax-saving goal.

1. Establish an S corporation

If you’re the sole owner of the appreciated land, establish a new S corporation owned solely by you to function as the developer entity. If you own the land via a partnership, or via an LLC treated as a partnership for tax purposes, you and the other partners can form the S corporation and be issued stock in proportion to your partnership/LLC ownership percentages.

2. Sell the land to the S corporation

Next, sell the appreciated land to the S corporation for a price equal to the land’s pre-development fair market value. As long as the land has been held for investment and has been owned for more than one year, the sale will trigger a LTCG — equal to the pre-development appreciation — that won’t be taxed at more than the 23.8% maximum federal rate.

3. S corporation develops the land and sells it off

Next, the S corporation will subdivide and develop the property, market it and sell it off. The profit from these activities will be higher-taxed ordinary income passed through to the shareholder(s), including you. If the profit from development is big, you might pay the maximum 40.8% effective federal rate (37% + 3.8%) on that income. However, the part of your total profit that’s attributable to pre-development appreciation in the value of the land will be taxed at no more than the 23.8% maximum federal rate.

Seek professional help

The bottom line is if you’re simply selling appreciated vacant land that you’ve held for investment, the federal income tax results are straightforward. But if you’ll develop the land before selling, the S corporation developer entity strategy could be a big tax-saver in the right circumstances. However, it’s not a DIY project. Consult with us to avoid pitfalls.



Pay attention to the tax rules if you turn a hobby into a business

Many people dream of turning a hobby into a regular business. Perhaps you enjoy boating and would like to open a charter fishing business. Or maybe you’d like to turn your sewing or photography skills into an income-producing business.

You probably won’t have any tax headaches if your new business is profitable over a certain period of time. But what if the new enterprise consistently generates losses (your deductions exceed income) and you claim them on your tax return? You can generally deduct losses for expenses incurred in a bona fide business. However, the IRS may step in and say the venture is a hobby — an activity not engaged in for profit — rather than a business. Then you’ll be unable to deduct losses.

By contrast, if the new enterprise isn’t affected by the hobby loss rules, all otherwise allowable expenses are deductible, generally on Schedule C, even if they exceed income from the enterprise.

Important: Before 2018, deductible hobby expenses could be claimed as miscellaneous itemized deductions subject to a 2%-of-AGI “floor.” However, because miscellaneous deductions aren’t allowed from 2018 through 2025, deductible hobby expenses are effectively wiped out from 2018 through 2025.

How to NOT be deemed a hobby 

There are two ways to avoid the hobby loss rules:

  1. Show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing or racing horses).
  2. Run the venture in such a way as to show that you intend to turn it into a profit maker rather than a mere hobby. The IRS regs themselves say that the hobby loss rules won’t apply if the facts and circumstances show that you have a profit-making objective.

How can you prove you have a profit-making objective? You should operate the venture in a businesslike manner. The IRS and the courts will look at the following factors:

  • How you run the activity,
  • Your expertise in the area (and your advisors’ expertise),
  • The time and effort you expend in the enterprise,
  • Whether there’s an expectation that the assets used in the activity will rise in value,
  • Your success in carrying on other activities,
  • Your history of income or loss in the activity,
  • The amount of any occasional profits earned,
  • Your financial status, and
  • Whether the activity involves elements of personal pleasure or recreation.

Case illustrates the issues

In one court case, partners operated a farm that bought, sold, bred and raced Standardbred horses. It didn’t qualify as an activity engaged in for profit, according to a U.S. Appeals Court. The court noted that the partnership had a substantial loss history and paid for personal expenses. Also, the taxpayers kept inaccurate records, had no business plan, earned significant income from other sources and derived personal pleasure from the activity. (Skolnick, CA 3, 3/8/23)

Contact us for more details on whether a venture of yours may be affected by the hobby loss rules, and what you should do to avoid tax problems.



Taxes when you sell an appreciated vacation home

Vacation homes in upscale areas may be worth way more than owners paid for them. That’s great, but what about taxes? Here are three scenarios to illustrate the federal income tax issues you face when selling an appreciated vacation home.

Scenario 1: You’ve never used the home as your primary residence

In this case, the home sale gain exclusion tax break (up to $250,000 or $500,000 for a married couple) is unavailable. Your vacation home sale profit will be treated as a capital gain.

If you’ve owned the property for more than one year, the gain will be taxed at no more than the 20% maximum federal rate on long-term capital gains (LTCGs), plus the net investment income tax (NIIT), if applicable. However, the 20% rate only applies to the lesser of:

  • Your net LTCG for the year, or
  • The excess of your taxable income, including any net LTCG, over the applicable threshold.

For 2024, the thresholds are $518,900 for single filers, $583,750 for married joint filers and $551,350 for heads of households. If your taxable income is below the applicable threshold, the maximum federal rate on net LTCGs is 15%.

If you also owe the 3.8% NIIT, the effective federal rate on some or all of your net LTCG will be 18.8% (15% + 3.8%) or 23.8% (20% + 3.8%).

You may owe state income tax, too.

Scenario 2: You’ve rented out the vacation home

In this situation, you probably deducted depreciation for rental periods. If so, the federal rate on gain attributable to depreciation (so-called unrecaptured Section 1250 gain) can be up to 25%, assuming you’ve held the property for over one year. You may also owe the 3.8% NIIT on the unrecaptured Section 1250 gain. Any remaining gain will be taxed at the federal rates explained earlier.

Plus, if you rented out the vacation home but used it only a little for personal purposes, it has probably been classified as a rental property for federal tax purposes. If so, you may have had rental losses that couldn’t be deducted currently due to the passive activity loss (PAL) rules. You can deduct these suspended PALs when the property is sold.

Scenario 3: You used the vacation home as a principal residence for a time

In this case, you might be able to claim the tax-saving principal residence gain exclusion break. Specifically, if you owned and used the property as your principal residence for at least two years during the five-year period ending on the sale date, you probably qualify for the exclusion.

There’s another major qualification rule for the home sale gain exclusion tax break. The exclusion is generally available only when you’ve not excluded an earlier gain within the two-year period ending on the date of the later sale. In other words, you generally cannot claim the gain exclusion until two years have passed since you last used it.

Of course, if you have a really big gain from selling your vacation home, it may be too big to fully shelter with the gain exclusion — even if you qualify for the maximum $250,000/$500,000 break. Assuming you’ve owned the property for more than one year, the part of the gain that can’t be excluded will be an LTCG taxed under the rules explained earlier.

Conclusion

Taxes on vacation home sales can get complicated, and we haven’t covered all the potential issues here. However, the tax results are simple if you’ve never rented out the property and never used it as a principal residence. We can fill in the blanks in your situation and answer any questions that you may have.



Watch out for “income in respect of a decedent” issues when receiving an inheritance

Most people are genuinely appreciative of inheritances, and who wouldn’t enjoy some unexpected money? But in some cases, it may turn out to be too good to be true. While most inherited property is tax-free to the recipient, this isn’t always the case with property that’s considered income in respect of a decedent (IRD). If you have large balances in an IRA or other retirement account — or inherit such assets — IRD may be a significant estate planning issue.

How it works

IRD is income that the deceased was entitled to, but hadn’t yet received, at the time of his or her death. It’s included in the deceased’s estate for estate tax purposes, but not reported on his or her final income tax return, which includes only income received before death.

To ensure that this income doesn’t escape taxation, the tax code provides for it to be taxed when it’s distributed to the deceased’s beneficiaries. Also, IRD retains the character it would have had in the deceased’s hands. For example, if the income would have been a long-term capital gain to the deceased, such as uncollected payments on an installment note, it’s taxed as such to the beneficiary.

IRD can come from various sources, including unpaid salary, fees, commissions or bonuses, and distributions from traditional IRAs and employer-provided retirement plans. In addition, IRD results from deferred compensation benefits and accrued but unpaid interest, dividends and rent.

The lethal combination of estate and income taxes (and, in some cases, generation-skipping transfer tax) can quickly shrink an inheritance down to a fraction of its original value.

What recipients can do

Although IRD must be included in the income of the recipient, a deduction may come along with it. The deduction is allowed (as an itemized deduction) to lessen the “double tax” impact that’s caused by having the IRD items subject to the decedent’s estate tax as well as the recipient’s income tax.

To calculate the IRD deduction, the decedent’s executor may have to be contacted for information. The deduction is determined as follows:

  • First, you must take the “net value” of all IRD items included in the decedent’s estate. The net value is the total value of the IRD items in the estate, reduced by any deductions in respect of the decedent. These are items which are the converse of IRD: items the decedent would have deducted on the final income tax return, but for death’s intervening.
  • Next you determine how much of the federal estate tax was due to this net IRD by calculating what the estate tax bill would have been without it. Your deduction is then the percentage of the tax that your portion of the IRD items represents.

Calculating the deduction can be complex, especially when there are multiple IRD assets and beneficiaries.

Be prepared

As you can see, IRD assets can result in an unpleasant tax surprise. Because these assets are treated differently from other assets for estate planning purposes, contact us. Together we can identify IRD assets and determine their tax implications.



Keep these 3 issues in mind after you file your return

The tax filing deadline for 2023 tax returns is April 15 this year. If you need more time, you can file for an extension until October 15. In either case, once your 2023 tax return has been successfully filed with the IRS, there may still be some issues to bear in mind. Here are three considerations.

1. Waiting for your refund? You can check on it

The IRS has an online tool that can tell you the status of your refund. Go to irs.gov and click on “Get your refund status” to find out about yours. You’ll need your Social Security number or Individual Taxpayer Identification Number, filing status, and the exact refund amount.

2. Throwing away tax records

You should hold on to tax records related to your return for as long as the IRS can audit your return or assess additional taxes. The statute of limitations is generally three years after you file your return.

However, the statute of limitations extends to six years for taxpayers who understate their gross income by more than 25%.

You should keep certain tax-related records longer. For example, keep your actual tax returns indefinitely, so you can prove to the IRS that you filed a legitimate return. (There’s no statute of limitations for an audit if you didn’t file a return or you filed a fraudulent one.)

What about your retirement account paperwork? Keep records associated with a retirement account until you’ve depleted the account and reported the last withdrawal on your tax return, plus three (or six) years. And retain records related to real estate or investments for as long as you own the asset, plus at least three years after you sell it and report the sale on your tax return. (You can keep these records for six years if you want to be extra safe.)

3. Filing an amended return if you failed to report something

In general, you can file an amended tax return on Form 1040-X and claim a refund within three years after the date you filed your original return or within two years of the date you paid the tax, whichever is later. So for a 2023 tax return that you file on April 15, 2024, you can generally file an amended return until April 15, 2027.

However, there are a few opportunities when you have longer to file an amended return. For example, the statute of limitations for bad debts is longer than the usual three-year time limit for most items on your tax return. In general, you can amend your tax return to claim a bad debt for seven years from the due date of the tax return for the year that the debt became worthless.

We’re here all year

Contact us if you have questions about tax record retention, your refund or filing an amended return. We’re not just available at tax filing time. You can reach us year-round.



The tax deadline is almost here: File for an extension if you’re not ready

The April 15 tax filing deadline is right around the corner. However, you might not be ready to file. Sometimes, it’s not possible to gather your tax information by the due date. If you need more time, you should file for an extension on Form 4868.

An extension will give you until October 15 to file and allows you to avoid “failure-to-file” penalties. However, it only provides extra time to file, not to pay. Whatever tax you estimate is owed must still be sent by April 15, or you’ll incur penalties — and as you’ll see below, they can be steep.

Two different penalties

Separate penalties apply for failing to pay and failing to file. The failure-to-pay penalty runs at 0.5% for each month (or part of a month) the payment is late. For example, if payment is due April 15 and is made May 25, the penalty is 1% (0.5% times 2 months or partial months). The maximum penalty is 25%.

The failure-to-pay penalty is based on the amount shown as due on the return (less amounts paid through withholding or estimated payments), even if the actual tax bill turns out to be higher. On the other hand, if the actual tax bill turns out to be less, the penalty is based on the lower amount.

The failure-to-file penalty runs at the more severe rate of 5% per month (or partial month) of lateness to a maximum 25%. If you file for an extension on Form 4868, you’re not filing late unless you miss the extended due date. However, as mentioned earlier, a filing extension doesn’t apply to your responsibility for payment.

If the 0.5% failure-to-pay penalty and the failure-to-file penalty both apply, the failure-to-file penalty drops to 4.5% per month (or part) so the combined penalty is 5%. The maximum combined penalty for the first five months is 25%. Thereafter, the failure-to-pay penalty can continue at 0.5% per month for 45 more months (an additional 22.5%). Thus, the combined penalties can reach a total of 47.5% over time.

The failure-to-file penalty is also more severe because it’s based on the amount required to be shown on the return, and not just the amount shown as due. (Credit is given for amounts paid through withholding or estimated payments. If no amount is owed, there’s no penalty for late filing.) For example, if a return is filed three months late showing $5,000 owed (after payment credits), the combined penalties would be 15%, which equals $750. If the actual liability is later determined to be an additional $1,000, the failure-to-file penalty (4.5% × 3 = 13.5%) would also apply to this amount for an additional $135 in penalties.

A minimum failure-to-file penalty also applies if a return is filed more than 60 days late. This minimum penalty is the lesser of $485 (for returns due after December 31, 2023) or the amount of tax required to be shown on the return.

Exemption in certain cases 

Both penalties may be excused by the IRS if lateness is due to “reasonable cause” such as death or serious illness in the immediate family.

Interest is assessed at a fluctuating rate announced by the government apart from and in addition to the above penalties. Furthermore, in particularly abusive situations involving a fraudulent failure to file, the late filing penalty can jump to 15% per month, with a 75% maximum.

If you have questions about filing Form 4868 or IRS penalties, contact us.



Update on retirement account required minimum distributions

If you have a tax-favored retirement account, including a traditional IRA, you’ll become exposed to the federal income tax required minimum distribution (RMD) rules after reaching a certain age. If you inherit a tax-favored retirement account, including a traditional or Roth IRA, you’ll also have to deal with these rules.

Specifically, you’ll have to: 1) take annual withdrawals from the accounts and pay the resulting income tax and/or 2) reduce the balance in your inherited Roth IRA sooner than you might like.

Let’s take a look at the current rules after some recent tax-law changes.

RMD basics 

The RMD rules require affected individuals to take annual withdrawals from tax-favored accounts. Except for RMDs that meet the definition of tax-free Roth IRA distributions, RMDs will generally trigger a federal income tax bill (and maybe a state tax bill).

Under a favorable exception, when you’re the original account owner of a Roth IRA, you’re exempt from the RMD rules during your lifetime. But if you inherit a Roth IRA, the RMD rules for inherited IRAs come into play.

A later starting age

The SECURE 2.0 law was enacted in 2022. Previously, you generally had to start taking RMDs for the calendar year during which you turned age 72. However, you could decide to take your initial RMD until April 1 of the year after the year you turned 72.

SECURE 2.0 raised the starting age for RMDs to 73 for account owners who turn age 72 in 2023 to 2032. So, if you attained age 72 in 2023, you’ll reach age 73 in 2024, and your initial RMD will be for calendar 2024. You must take that initial RMD by April 1, 2025, or face a penalty for failure to follow the RMD rules. The tax-smart strategy is to take your initial RMD, which will be for calendar year 2024, before the end of 2024 instead of in 2025 (by the April 1, 2025, absolute deadline). Then, take your second RMD, which will be for calendar year 2025, by Dec. 31, 2025. That way, you avoid having to take two RMDs in 2025 with the resulting double tax hit in that year.

A reduced penalty

If you don’t withdraw at least the RMD amount for the year, the IRS can assess an expensive penalty on the shortfall. Before SECURE 2.0, if you failed to take your RMD for the calendar year in question, the IRS could impose a 50% penalty on the shortfall. SECURE 2.0 reduced the penalty from 50% to 25%, or 10% if you withdraw the shortfall within a “correction window.”

Controversial 10-year liquidation rule 

A change included in the original SECURE Act (which became law in 2019) requires most non-spouse IRA and retirement plan account beneficiaries to empty inherited accounts within 10 years after the account owner’s death. If they don’t, they face the penalty for failure to comply with the RMD rules.

According to IRS proposed regulations issued in 2022, beneficiaries who are subject to the original SECURE Act’s 10-year account liquidation rule must take annual RMDs, calculated in the usual fashion — with the resulting income tax. Then, the inherited account must be emptied at the end of the 10-year period. According to this interpretation, you can’t simply wait 10 years and then drain the inherited account.

The IRS position on having to take annual RMDs during the 10-year period is debatable. Therefore, in Notice 2023-54, the IRS stated that the penalty for failure to follow the RMD rules wouldn’t be assessed against beneficiaries who are subject to the 10-year rule who didn’t take RMDs in 2023. It also stated that IRS intends to issue new final RMD regulations that won’t take effect until sometime in 2024 at the earliest.

Contact us about your situation

SECURE 2.0 includes some good RMD news. The original SECURE Act contained some bad RMD news for certain account beneficiaries in the form of the 10-year account liquidation rule. However, exactly how that rule is supposed to work is still TBD. Stay tuned for developments.



Beware of a stealth tax on Social Security benefits

Some people mistakenly believe that Social Security benefits are always free from federal income tax. Unfortunately, that’s often not the case. In fact, depending on how much overall income you have, up to 85% of your benefits could be hit with federal income tax.

While the truth about the federal income tax bite on Social Security benefits may be painful, it’s better to understand it. Here are the rules.

Calculate provisional income

The amount of Social Security benefits that must be reported as taxable income on your tax return depends on your “provisional income.” To arrive at provisional income, start with your adjusted gross income (AGI), which is the number that appears on Page 1, Line 11 of Form 1040. Then, subtract your Social Security benefits to arrive at your adjusted AGI for this purpose.

Next, take that adjusted AGI number and add the following:

  1. 50% of Social Security benefits,
  2. Any tax-free municipal bond interest income,
  3. Any tax-free interest on U.S. Savings Bonds used to pay college expenses,
  4. Any tax-free adoption assistance payments from your employer,
  5. Any deduction for student loan interest, and
  6. Any tax-free foreign earned income and housing allowances, and certain tax-free income from Puerto Rico or U.S. possessions.

The result is your provisional income.

Find your tax scenario

Once you know your provisional income, you can determine which of the following three scenarios you fall under.

Scenario 1: All benefits are tax-free

If your provisional income is $32,000 or less, and you file a joint return with your spouse, your Social Security benefits will be federal-income-tax-free. But you might owe state income tax.

If your provisional income is $25,000 or less, and you don’t file jointly, the general rule is that Social Security benefits are totally federal-income-tax-free. However, if you’re married and file separately from your spouse who lived with you at any time during the year, you must report up to 85% of your Social Security benefits as income unless your provisional income is zero or a negative number, which is unlikely.

Having federal-income-tax-free benefits is nice, but, as you can see, this favorable outcome is only allowed when provisional income is quite low.

Scenario 2: Up to 50% of your benefits are taxed

If your provisional income is between $32,001 and $44,000, and you file jointly with your spouse, up to 50% of your Social Security benefits must be reported as income on Form 1040.

If your provisional income is between $25,001 and $34,000, and you don’t file a joint return, up to 50% of your benefits must be reported as income.

Scenario 3: Up to 85% of your benefits are taxed

If your provisional income is above $44,000, and you file jointly with your spouse, you must report up to 85% of your Social Security benefits as income on Form 1040.

If your provisional income is above $34,000, and you don’t file a joint return, the general rule is that you must report up to 85% of your Social Security benefits as income.

As mentioned earlier, you also must report up to 85% of your benefits if you’re married and file separately from your spouse who lived with you at any time during the year — unless your provisional income is zero or a negative number.

Turn to us

This is only a very simplified explanation of how Social Security benefits are taxed. With the necessary information, we can precisely calculate the federal income tax, if any, on your Social Security benefits.



A job loss is bad but the tax implications could make it worse

Unemployment has been holding steady recently at 3.7%. But there are still some people losing their jobs — particularly in certain industries including technology and media. If you’re laid off or terminated from employment, taxes are likely the last thing on your mind. However, there are tax implications due to your altered employment circumstances.

Depending on your situation, the tax aspects can be complex and require you to make decisions that may affect your tax bill for this year and for years to come. Be aware of these three areas.

1.Unemployment and payments from your former employer

Many people are surprised to find out that federal unemployment compensation is taxable. (Some states exempt unemployment comp from state tax.) In addition, payments from a former employer for any accumulated vacation or sick time are taxable. Although severance pay is also taxable and subject to federal income tax withholding, some elements of a severance package may get special treatment. For example:

  • If you sell stock acquired by way of an incentive stock option (ISO), part or all of your gain may be taxed at lower long-term capital gain rates rather than at ordinary income tax rates, depending on whether you meet a special dual holding period.
  • If you received — or will receive — what’s commonly referred to as a “golden parachute payment,” you may be subject to an excise tax equal to 20% of the portion of the payment that’s treated as an “excess parachute payment” under very complex rules, along with the excess parachute payment also being subject to ordinary income tax.
  • The value of job placement assistance you receive from your former employer usually is tax-free. However, the assistance is taxable if you had a choice between receiving cash or outplacement help.

2.Health insurance costs

Under the COBRA rules, employers that offer group health coverage generally must provide continuation coverage to most terminated employees and their families. While the cost of COBRA coverage is usually expensive, the amount of any premium you pay for insurance that covers medical care is an eligible medical expense for tax purposes. That means it’s deductible if you itemize deductions and if your total medical expenses exceed 7.5% of your adjusted gross income.

If your former employer pays some of your medical coverage for a period of time after termination, you won’t be taxed on the value of the benefit.

3.Retirement plan balance

Employees whose employment is terminated may need tax planning help to determine the best option for amounts they’ve accumulated in retirement plans sponsored by former employers, such as a 401(k) plan. In many cases, a direct, tax-free rollover to an IRA is the best move. You may also choose to leave the account in your previous employer’s 401(k) plan (although the employer may elect to distribute the funds to you). Or, if you get a new job, you may want to transfer the money in the account with your former employer to your new employer’s 401(k) plan.

If you’re under age 59½, and make withdrawals from your former company’s plan or IRA to supplement missing income, you may owe an additional 10% penalty tax unless you qualify for an exception.

If a distribution from the retirement plan includes employer securities in a lump sum, the distribution is taxed under the lump-sum rules, except that “net unrealized appreciation” in the value of the stock isn’t taxed until the securities are sold or otherwise disposed of in a later transaction.

Further, any loans you’ve taken out from your former employer’s retirement plan, such as a 401(k)-plan loan, may be required to be repaid immediately, or within a specified period. If they aren’t, they may be treated as if the loan is in default. If the balance of the loan isn’t repaid within the required period, it will typically be treated as a taxable deemed distribution.

If you need assistance, contact us. We can help you navigate the best path forward during this transition period.