Renting Vs. Buying a Home

Should you buy or rent your home? This decision can include financial as well as nonfinancial factors. Even if the nonfinancial aspects are extremely important, you should not overlook the financial side.

Crucial ratio

One key to choosing between buying or renting is to determine the annual rent-to-purchase price ratio in the housing market you’re considering. The higher this ratio, the greater the advantage of buying a home.

            

Example 1: Art Smith is considering buying a home that is priced at $200,000. He can rent a comparable home in the same neighborhood for $800 a month, which is $9,600 a year. The rent-to-purchase ratio is $9,600 to $200,000, or 4.8%.

            

Example 2: In a different area of the U.S., Beth Jones also is eyeing a $200,000 home. A comparable home would rent for $1,200 a month. Thus, the rent-to-price ratio for Beth is $14,400 to $200,000, or 7.2% a month.

            

A recent study from Morningstar’s HelloWallet unit indicates that renting might be a better choice when the rent-to-price ratio is below 5%, while buying may be preferable if that ratio is over 7%. That is, the more you’ll have to pay to rent a desirable home, relative to home prices, the greater the chance that the numbers will favor a purchase. 

Assuming the rent-to-purchase price ratio is favorable, young taxpayers with relatively low early career incomes might do well to rent rather than buy a home. The same may be true for relocating retirees who have modest incomes after they stop working.

Conversely, high-income taxpayers might enjoy considerable tax savings from home ownership, assuming they are comfortable with the purchase price. Today’s low interest rates make financing a home purchase appealing, and the leverage can add to any profits from home price appreciation.

Thinking about taxes

Homeowners may enjoy multiple tax benefits that are not available to renters. Mortgage interest and property tax payments generally are tax-deductible. Moreover, profits on a sale of a home often enjoy an exemption from capital gains tax. Assuming the home was owned and occupied at least two of the preceding five years, up to $250,000 of gains are untaxed ($500,000 for married couples filing a joint tax return).

Of course, there is no way for a home buyer to know if a home eventually will be sold at a profit. What’s more, the deductions for mortgage interest may not generate any actual tax savings. That’s because those savings are available only to taxpayers who itemize deductions. Homeowners who take the standard deduction get no tax benefit from their mortgage interest or property tax deductions.

            

Example 3: Craig and Diane Emerson bought a house for $200,000, taking out a $160,000 mortgage. At a 4% mortgage rate, their interest payments this year are $6,400 (4% of $160,000). The Emersons also pay $4,000 in state and local taxes and make $2,000 in charitable donations, for a total of $12,400 in possible itemized deductions.

            

In 2015, the standard deduction is $6,300 for single filers and $12,600 for married couples filing jointly. (Taxpayers who are blind or at least age 65 have higher standard deductions.) Thus, the Emersons will choose the standard deduction and get no tax benefit from paying mortgage interest or property taxes.

Tax bracket truths

Now, what happens if the Emersons had $14,200 in itemized deductions instead of $12,400? If so, they would itemize and deduct their mortgage interest and property tax payments. In this scenario, $14,200 of itemized deductions is $1,600 greater than the standard deduction for couples, so the Emersons’ net tax deduction from home ownership would be $1,600. Assuming an effective marginal income tax rate of 20%, that $1,600 in net deductions would save them $320 in tax this year.

            

Example 4: Assume the same financial information as in example 3, but assume the Emersons have a higher income and, thus, have an effective marginal tax rate of 40%. Then that same $1,600 in net tax deductions from home ownership would save the Emersons $640 in tax. With a higher income, owning a home saves more tax.

           

             

Other issues

The decision about whether to rent or buy a home involves more than the purchase price, rental rates, and tax savings. Buying a house means saving up a great deal of cash for a down payment and putting that cash into an illiquid asset. Renting may leave you with more easily accessible cash, but will that cash be invested wisely or spent imprudently? It’s also important to decide if the responsibility of home ownership is for you.

           

Nevertheless, financial concerns are vital to residential decisions.

When Workers Are Independent Contractors

As business owners know all too well, hiring an employee costs more than just paying a salary. 

Employers generally provide benefits to employees, which can be expensive. Moreover, employers must pay a share of Medicare, Social Security, and state unemployment taxes.

            

None of the above applies when your company hires an independent contractor—a publicist to get your company’s name in the news, for example, or a freelance website designer. You pay these people the agreed-upon amount and let them worry about funding their retirement or handling payroll tax. If that’s the case, why not just use a group of independent contractors to work for your company and do with few or even no employees?

Defining the difference

The answer is that the IRS is well aware of the advantages of using contractors. Therefore, the IRS has established rules governing how independent contractors are classified, as opposed to employees. Drilling down, the major difference is a matter of control.

            

Hiring an independent contractor to do a specific task is fine. You tell the contractor what you want done, and you pay for results. However, if you tell the worker how and when and where the work is to be done, you risk having that worker re-cast as an employee by the IRS.

           

In some cases, common sense will apply. If that freelancer works on your website while doing other paying jobs for other companies, chances are the IRS will go along with independent contractor classification. On the other hand, if you have a person who works from home as a freelancer but works only on your website, does it more or less full time, and takes direction from your IT people, you may have a difficult time treating him or her as a contractor.

If you have been misclassifying employees as contractors, the penalties can be steep. Our office can discuss your workers with you, letting you know how to proceed in order to legitimately treat them as independent contractors.

Accumulated Assets in C-Corps

Owners of regular C corporations face double taxation. The company’s profits are subject to the corporate income tax. 

If some of those profits are paid to the owner and other shareholders, as nondeductible dividends, the same dollars will be taxed again, on the recipients’ personal tax returns.

    

Double taxation might not have been a major concern when the highest tax rate on qualified dividends was only 15%, as it had been for most of this century. However, recent legislation boosted the dividend tax rate to 20% for some taxpayers; high-income taxpayers also may owe the 3.8% Medicare surtax as well as some indirect taxes on dividends they receive. Therefore, business owners may prefer to retain earnings in the company, rather than pay out double taxed dividends.

     

Example 1:

Craig Taylor owns 100% of CT Corp. The company’s profits this year are $400,000, on which CT Corp. pays income tax. Rather than pay himself a dividend, which would be taxed at an effective rate of 25% in this scenario, counting all the various taxes that would be triggered, Craig decides to keep the money inside CT Corp.

Cash crunch

However, CT Corp. might run into a tax problem: the accumulated earnings tax (AET).

Retained earnings over $250,000 are subject to this tax ($150,000 for personal service corporations, such as professional practices). Thus, if CT Corp. had $200,000 in retained earnings from prior years, this year’s $400,000 makes the total $600,000, which is $350,000 over the $250,000 limit. CT Corp. would owe tax on the $350,000 overage: $70,000, at the current 20% AET rate.

     

In practice, the AET is not a certainty. The IRS might investigate when CT Corp. reports retained earnings over $250,000 on its corporate income tax return, but it’s possible that it won’t owe the AET, if the company has a good reason for the large accumulation.

Forward thinking

Earnings in excess of $250,000 will be permitted if the company can show that it had a reasonable need for holding onto cash and other liquid assets. That need could be to provide funding for a specific plan related to the company’s business, such as buying expensive equipment or expanding into a new territory.

Solid proof

In order to retain earnings over $250,000, yet avoid the AET, a corporation must be able to show that there really was a plan in place to use the money, and that the reasons for the retention go beyond tax avoidance. Ideally, corporate minutes or other documentation, such as emails, will include a discussion of, for example, the company’s intent to upgrade its information technology with an expensive new system.

    

No matter how well you can show that a plan was in place as a reason for accumulating excess assets, you’ll also need to show that the plan has since been executed, or is in some stage of progress.

 What’s more, court decisions have approved the concept that C corporations can cite working capital as a reason for accumulating earnings over $250,000. Our office can help you determine an acceptable level of working capital for your company, which might raise its permissible level of accumulated earnings.

Simple solution

Regardless of your needs for working capital, there are basic steps you can take to avoid or limit the AET. For instance, you can pay some dividends to shareholders each year, even if that generates double taxation. A company that retains excess earnings while never paying out dividends may be especially vulnerable to IRS scrutiny and assessment of the AET.

    

Longevity Annuities

Deferred income annuities (DIAs) recently have become popular. New regulations from the U.S. Treasury Department may increase their appeal, opening the way for so-called “longevity” annuities inside IRAs and employer retirement plans.

Later rather than sooner

With a DIA, you pay an insurance company now in return for a predetermined amount of cash flow in the future.

            

Example 1:

Grace Palmer is age 55, planning to retire at 65. She buys an income annuity now for $100,000. Depending on the specific features Grace requests, if she starts to receive payments immediately, she might get around $400 a month ($4,800 a year) as long as she lives.

           

Instead, Grace agrees to wait until she retires at 65 to start payments. In return for giving up her money for 10 years, with no return, Grace might get lifelong annual payouts of $800 a month. (Exact amounts will depend on the contract terms and the annuity issuer.)

Even later

Certain DIAs are known as longevity annuities. They begin paying out late in life, so they appeal to people who are concerned about running short of money if they live into their late 80s or 90s or beyond.

            

Example 2: 

Instead of starting her DIA payouts at 65, Grace asks for them to begin at 75 or later. Such a delay could increase her payouts to $2,000 a month or more, as her remaining life expectancy would be limited. Grace enters into this arrangement to assure herself that she’ll have substantial cash flow if she lives until an advanced age.

Solving the distribution dilemma

Until recently, such longevity annuities were impractical for retirement accounts because required minimum distributions (RMDs) typically start after age 70½. Seniors would have to take RMDs on the annuity value even though no cash would be coming from the annuity.

            

Example 3: 

Suppose Henry Adams had bought a longevity annuity inside his IRA to begin payments at age 80. At age 70½, when Henry has $500,000 in his IRA, the annuity issuer values the contract at $100,000. Under prior rules, Henry would have had to take RMDs based on a $500,000 value even though he had only $400,000 currently available. Henry would have been required to withdraw (and pay tax on) a relatively large amount, even if he doesn’t need all the money he’ll withdraw.

This unfavorable tax treatment would continue, year after year, as long as Henry waited for his longevity annuity. Thus, longevity annuities were not attractive for retirement accounts and few people bought them in their IRA.

This situation is about to change. In July 2014, the Treasury Department issued final regulations on qualified longevity annuity contracts (QLACs). If annuities meet certain conditions, they will be considered QLACs. That way, the account value won’t count for RMD calculations.

Pros and cons

Some insurance companies are working on QLACs that are expected to appear in 2015. QLACs might appeal to seniors who are likely to live well beyond normal life expectancy and who are concerned about running short of money. In addition, individuals who would like to trim their RMDs and, thus, leave more to heirs, may consider buying QLACs. The regulations permit QLACs to have a return of premium feature, which would pay beneficiaries the amount invested yet not paid out in annuity payments by the time the annuity purchaser dies.

            

On the downside, QLACs will not be permitted to have any liquidity features for the buyer. If a taxpayer invests $100,000 in a QLAC, all she can get in return will be her annuity payments.

Rules for QLACs

·         No more than 25% of an individual’s total IRA money can be invested in qualified longevity contracts (QLACs).

·         For this purpose, SEP IRAs and SIMPLE IRAs are included. Roth IRAs don’t count because there is no reason to hold a QLAC in a Roth IRA, where the owner never has required minimum distributions. 

·         The 25% limit also applies to each employer plan.

·         Counting all QLACs in all plans, an investor cannot invest more than $125,000. That ceiling will increase with inflation.

·         QLAC payouts must begin no later than age 85, although they can begin earlier.

ACA & You: 3 Things To Know When Filing

1. Did you have health insurance through your employer, Medicare, Medicaid, or a plan you bought outside of the Marketplace?

 If you answer "yes", stop right here.
 We will check the required box on your federal income tax return and be done.

https://www.healthcare.gov/taxes/other-health-coverage/

2. Did you have health insurance through the Health Insurance Marketplace?

If you answer "yes", you will be receiving a Form 1095-A in the mail by early February. This will be needed in order to complete & file your federal income tax return. 

Some of those who bought health insurance under the ACA received advance tax credits. These were tied to their income to help with the monthly premiums.  

https://www.healthcare.gov/taxes/marketplace-health-plan/

The information from 1095-A will be needed in order to complete Form 8962, which will be a new form on your tax return.

Federal officials will check the taxpayer's actual income against their original estimated income when they applied for the subsidies. 

• If you TOOK LESS advance payments of the premium tax credit than the actual credit you’re eligible for: You’ll get the difference as a credit on your tax return.
• If you TOOK MORE advance payments of the premium tax credit than the actual credit you’re eligible for: You may need to pay the difference with your tax return.
• If you DIDN’T TAKE ANY advance payments of the premium tax credit during 2014: When you complete Form 8962 you may find out that you qualify for a credit. If you do, you can claim it when you file your taxes.

3. If you didn't have any health insurance coverage for 3 months or more in 2014, one of the following will apply to you:

• You will qualify for a health coverage exemption
• OR you will pay a fee when you file your 2014 federal income tax return

The penalty for being uninsured in 2014 is either:

•  $95 per adult (with a family maximum of $285)
• OR 1% of household income, whichever is greater.

The penalty for being uninsured in 2015 will be:

• $325 per person
• OR 2% of household income

https://www.healthcare.gov/taxes/no-health-coverage/

Planning for Retirement

Save substantially. Invest your savings wisely. The conventional wisdom holds that this is the way to accumulate a nest egg for your retirement, and the conventional wisdom is right on the money.

            

However, you probably won’t always have earnings to invest. At some point, your work income is likely to cease or drop sharply in retirement, and you’ll need to draw down prior savings. Yet, studies have found that very few people have considered how they’ll go from investing earned income to generating retirement income. 

The sooner you give this issue serious thought, the more likely you’ll be prepared with a realistic spending plan when the paychecks stop. Here are a few options to consider.

Spend income, not principal

Most people can rely upon Social Security benefits for some retirement income. Beyond Social Security, you probably will have to tap your own savings. The question, then, is how to go about drawing down the money you’ll spend. One method is to use only dividends and investment interest income for cash flow.

     

Example 1: Suppose Ed and Nancy Parker will each receive $20,000 a year from Social Security, so their joint annual benefits will be $40,000 per year, indexed for inflation. The Parkers have a $600,000 portfolio, in this example, invested in high-quality stocks and bonds. If their interest income and dividends average 2.5%, the Parkers will receive another $15,000 a year (2.5% of $600,000). By spending that $15,000 but leaving their stocks and bonds intact, the Parkers’ retirement income will be $55,000 a year, including $40,000 from Social Security.

Cracking your nest egg

Dividends and investment interest yields are low today, and may remain low in the future. The Parkers, in our previous example, may wish for greater retirement income than $55,000 a year. One alternate strategy is to follow the so-called 4% rule, which has been developed by financial advisors and academic researchers.

      

Example 2: The Parkers withdraw 4% of their $600,000 investment portfolio ($24,000) in the first year after they stop working. Now they have $64,000 ($40,000 from Social Security plus $24,000 from their portfolio) to spend rather than $55,000.

      The 4% rule assumes that the Parkers increase their withdrawals each year to keep up with inflation. Going by historic investment results, research indicates a high probability that the Parkers’ portfolio will last at least 30 years, with this method.

      To get that $24,000 in the first year of retirement, the Parkers might spend their $15,000 of investment income, as explained, and sell $9,000 of their investments to raise the rest of their cash. Over time, they would gradually deplete their portfolio in this manner.

      The 4% rule likely will provide more retirement income than just spending interest and dividends. However, active management will be involved—deciding which assets will be sold each year to provide the cash flow. In addition, the Parkers run the risk that poor results in the stock or bond market will accelerate portfolio depletion.

Assessing annuities

Yet another approach is to put retirement funds in an immediate annuity, sometimes called an income or a payout annuity. You can give a lump sum to an insurance company and receive monthly income for the rest of your life. Joint annuities are available, so a married couple might get this payout as long as either spouse is alive.

      

Example 3: The Parkers, both age 65,  weigh putting all of their $600,000 into a joint annuity. By using an online annuity calculator, they learn that such an annuity might pay them $3,000 a month, or $36,000 a year. If one spouse dies, the survivor will continue to get that $36,000 a year.

      Now the Parkers will start retirement with $76,000 of income in the first year, with $36,000 from the annuity plus $40,000 from Social Security. The annuity will protect them from running short of money over a long retirement. They won’t have to make decisions about selling securities, and they’ll enjoy some tax benefits because most of their annuity payments will be treated as a tax-free return of principal for many years, if held in a taxable account.

      On the other hand, annuities typically provide a fixed payment. The $36,000 the Parkers receive in 2015 won’t buy as much in 2025 or 2035, assuming inflation drives prices higher. Depending on the terms of the contract, a joint annuity may not leave anything to their children, even if the Parkers both die in a few years. Buying an annuity today, while interest rates are at historic lows, also will lock in a relatively low return, which might be surpassed by stocks and bonds over the coming decades.

Mix and match

The bottom line is that no method is absolutely better than the others. Some advisors suggest putting some retirement funds into an immediate annuity, for dependable lifetime income, while continuing to manage other assets under a withdrawal plan, such as the 4% rule. Other sources of income also might be considered: an inheritance, selling your home, using a reverse mortgage, even doing some part-time work.

     By planning ahead you will have a better idea of how much cash you reasonably can expect to receive and where it will come from, so you can set your retirement expectations realistically.

---

As Collectibles Boom, Selling Can Be Taxing

In the past two years, five paintings have been sold at auction for more than $100 million apiece, while another (by Cezanne) reportedly brought more than $250 million in a private sale. In the same time frame, a pink diamond was auctioned for a record $83 million.

            As you can see, the collectibles market has been booming. You might not own a multimillion dollar item, but the chances are that the coins, stamps, or paperweights that you collect have grown in value. If you decide to cash in by selling one or more pieces from your collection, you may have to deal with unpleasant tax surprises.

Raising the rates

The tax code has special treatment for collectibles, which can include artwork, rugs, antiques, gems, stamps, metals, coins, and alcoholic beverages, according to the IRS. When you sell collectibles, the special 0%, 15%, and 20% tax rates on long-term capital gains don’t apply. Instead, you’ll owe tax at your ordinary tax rate, with a cap of 28%.

            As is the case with all assets, short-term capital gains on the sale of collectibles are taxed at ordinary rates.

            Example 1: Dan King bought a rare U.S. coin for $1,000 and sold it 11 months later for $1,300. Dan’s $300 gain was short-term, so he owes tax at his ordinary rate, 15% in this example.

            Dan bought another coin at the same price at the same time; he sold that coin for a $300 gain as well. This coin, though, was sold 13 months after Dan’s purchase. Because the holding period was over one year, Dan reports the $300 as a long-term capital gain.

            Normally, a long-term capital gain is taxed at a 0% rate by taxpayers in the 15% tax bracket, such as Dan. That would be the case, for example, if Dan had a $300 long-term gain on a stock sale. A long-term collectibles gain, though, doesn’t qualify for the 0% rate. Thus, Dan will owe 15% in tax on this $300 gain ($45) from the second coin sale, just as he does on the first (short-term) coin sale.

            Similarly, taxpayers in the next higher tax brackets (25% and 28%) also owe tax at their ordinary rate on long-term gains from collectibles. Taxpayers in higher brackets (33%, 35% and 39.6%) do get some tax break from long-term gains on collectibles because the rate does not exceed 28%.

            Example 2: Emily Larsen has taxable income over $500,000, so she is in the top 39.6% tax bracket this year. She sells a painting for a $20,000 gain after holding the artwork for several years. On long-term gains from a stock, Emily would owe tax at the special 20% rate. However, Emily doesn’t qualify for the 20% tax rate on the sale of the painting because it is a collectible. Emily’s tax rate is higher than 28%, so she will owe the maximum 28% rate on her $20,000 long-term collectibles gain: $5,600 in tax.

Personal use

                                                                             

If you plan to sell collectibles at a loss, be aware that the tax code still works against you. If you sell collectibles for which you had “personal use,” you can’t claim a capital loss, and selling collectibles for which you had personal use at a profit will still result in a taxable capital gain.

      Personal use will depend upon specific circumstances. Hanging a painting on the wall of your home might be considered personal use, depriving you of any tax benefit from a loss on a subsequent sale. However, if you regularly buy a specific type of painting, keep some in careful storage when not on display, and maintain careful records of your collection, you might be able to make the case that the artworks were held for investment purposes. Such efforts could result in a capital loss that provides tax benefits. Our office can help you determine if your collectibles may be treated as investment property.

Collecting Net Investment Income Tax

·       Some taxpayers owe a 3.8% surtax, commonly called the net investment income tax, to help finance Medicare.

·       This net investment income tax may be imposed if you report modified adjusted gross income (MAGI) over $200,000, or over $250,000 on a joint tax return.

·       Your net investment income tax amount will depend on your MAGI and your net investment income.

·       If you owe the net investment income tax, that may effectively increase the tax you owe on sales of collectibles: the maximum tax on a long-term gain could rise from 28% to 31.8%.