Tax Free Income From Renting Your Home

From Canton, Ohio, where the Pro Football Hall of Fame Weekend takes place in August, to Los Angeles, which has Haunted Hayrides to celebrate Halloween throughout October, cities small and large host special events throughout the year. 

Moreover, oceanfront communities attract millions of tourists in the summer while mountain regions offer winter sports each winter.

            

What is the common denominator? If you live in an area popular with tourists, for a season or a month or even a day, you can rent your home for a sizable amount. According to some reports, homes in the Augusta, Georgia area rent for as much as $20,000 for the week of the Masters Golf Tournament in April.

Income from such rental activity is legitimately tax-free: you don’t have to report it on your tax return. You can’t deduct any expenses incurred for the rental, but you still can take applicable mortgage interest and property tax deductions for your home with no reduction for the profitable rental period.

Fortune’s fortnight

As you might expect, you have to clear some hurdles to qualify for this tax-free income. Perhaps most important, you must rent the home for no more than 14 days during the year. If you go over by even one day, tax-free taxation will vanish. In that case, you will have to report your rental income, and you may take appropriate deductions, but the process can become very complicated.

In addition to the 14-day limit, the IRS says that you must use the “dwelling unit as a home.” This means that you must use the property for personal purposes more than (a) 14 days or (b) 10% of the days it is rented to others at a fair price, whichever is greater.

Example 1: Jan Harrison lives in Charlotte, North Carolina, throughout the year but rents her home for a week when the Bank of America 500 race is in town. She moves in with her sister and then goes home after the weeklong rental ends. Jan lives in her home well over 300 days in the year, so claiming the tax-free rental income won’t be a problem.

You also can claim this tax break for a vacation home as long as there are at least 15 days of personal use and you keep rentals under 15 days a year. With either a primary residence or a second home, keep careful records to show that you observed the 14-day rental limit.

Proceed prudently

Tax-free income is certainly welcome, but it shouldn’t be your only concern. Keep in mind that you are letting other people occupy your home, perhaps during a time when parties may occur. Make sure you have a formal rental agreement in place and that you collect the rent upfront, along with a deposit for possible property damage. Check with your homeowners insurance agent to see if you need special coverage, and check with local officials to find out if you need a permit for a short-term rental.

            If you decide to use a service to handle the rental and save you some aggravation, ask what fees you’ll owe. In addition, ask if the rental income will be reported to the IRS. Such reports may complicate what can be a straightforward tax benefit; our office can explain the possible problems and solutions.

SC Rental Home?  Check this out.

Prime Points for Your Buy-Sell

Businesses with more than one substantial co-owner should have a buy-sell agreement. This agreement can help all parties when the inevitable happens, and one of the owners no longer can or will participate in the company as they had been. For the best result, your buy-sell should include a plan for what will happen when the following so-called “trigger events” occur.

Owner’s death

Assume a company is owned equally by Lynn Jones and Greg Harris. They both work full time, contributing to the company’s growth, until Greg dies unexpectedly.
A buy-sell can set the stage for Lynn to buy the company shares that Greg’s wife will inherit. A predetermined formula can set the buyout price, which Lynn will pay, and some life insurance can provide the funds she’ll need. Alternatively, the company might receive the insurance proceeds and buy in Greg’s shares, leaving Lynn as the sole owner.

Dealing with disability

In another scenario, Lynn suffers a serious illness and cannot work. The buy-sell can spell out how disability will be determined, whether Lynn will receive a salary, how long such a salary will continue, and how an ultimate buyout will be structured. Disability insurance may help to provide the necessary funds.

Defending against divorce

Considering the U.S. divorce rate and the demands of running a small business, it’s not surprising when a company co-owner has marital problems. However, if Greg is in a divorce negotiation, his wife may want a share of the company as part of the settlement—and Lynn might not welcome this additional partner.
Such a situation can be avoided if share transfers are restricted in some manner by the buy-sell agreement; the divorcing co-owner, the non-divorcing owners, or the company might be given the right of first refusal, so the divorcing spouse receives cash instead of shares. (Careful drafting is needed to avoid tax traps.) The buy-sell agreement should cover valuation, and the owners should have a plan to generate enough cash.

Ready for retirement

In yet another scenario, Lynn decides that she wants to retire while she is still young and healthy enough to enjoy her favorite pastimes. Greg intends to stay active in the business. A buy-sell can set up a plan in which Lynn steps down and is compensated for her interest in the company, perhaps over an extended time period. Some life insurance policies can be structured to fund such a contingency.

Changing directions

What if Lynn wants to leave the company at, say, age 55 in order to try another career? A buy-sell agreement may distinguish between retirement and “withdrawal” or “departure,” perhaps based on age. A buy-sell could discount the purchase price if an owner leaves after relatively few years and could delay the payout until a certain time, if that’s what the co-owners agree upon.

Personal bankruptcy

Suppose that Greg incurs a tremendous amount of debt, either from extravagant living or from poor financial decisions not directly related to the company. He might file for personal bankruptcy to get relief. Again, the buy-sell can set a procedure for Lynn or the company to buy Greg’s shares so that his creditors get cash instead of interests in the business.

Time and money

Business owners commonly work long hours and need ample cash flow for company growth. Thus, owners of a small firm might not look forward to crafting a detailed buy-sell agreement, paying attorney fees, and committing to premium outlays for life insurance as well as disability insurance. That reluctance should be weighed against the outcome if one or more of the previously mentioned trigger events should arise without a buy-sell in place. A deceased partner’s heirs may inherit shares without a procedure in place for an equitable buyout; an owner’s divorce negotiations might spill over and affect company operations.

Be Sure About Rental Car Insurance

This summer, whether you’re driving for business or pleasure, you may want to rent a car. If so, you’ll likely be driving an unfamiliar vehicle on unknown roads. What’s more, you’ll encounter other (perhaps many other) motorists in similar circumstances. You can’t overlook the chance you’ll be involved in an accident. 

Obviously, your first priority is to avoid injuring yourself, your passengers, and any others. Still, you’ll also want to minimize your financial exposure, so it will pay to have the right insurance in place.

Protection begins at home

Your first line of defense lies in the coverage you already have. Check your auto insurance policy and your excess liability (umbrella) policy to see what—if anything—they say about rental cars.

            Call your insurance agent to double check. If there is coverage, see if there are exclusions for rental cars. Does the coverage apply to long-term rentals or to rentals in a foreign country you may be visiting? If traveling for business, ask how that affects your coverage.

            If you feel your coverage is inadequate, your agent might be able to offer you additional insurance for car rentals. Weigh the added cost versus the extra protection you’ll get. Remember, your greatest exposure might be liability, if you injure someone while driving the rental car.

            After discussing your plans, send an email to the agent, summarizing the conversation, and have the agent respond, so you’ll have a record of what you were told.

Credit check

Besides your existing policies, you also may have coverage from your credit card issuer.

            Example 1: Howard Green rents a car and puts the charge on his Visa card. He skids off the road in a rain storm and causes extensive damage to the vehicle. Some or all of the repair costs may be covered by Visa. Indeed, if Howard has to pay a deductible amount under his personal auto insurance policy, his credit card coverage may reimburse him for the outlay. In some cases, credit card insurance can provide secondary coverage, paying claims beyond the limits of your primary auto insurance policy.

            Again, it pays to read the fine print. To determine what a given credit card will pay, enter the full name of the card and “rental car insurance” into an Internet search engine, such as Google. Be sure to be precise in designating the type of card you have (gold, platinum, etc.) because different cards from the same company may have different levels of protection. With Visa or MasterCard, there can be variations in coverage from one issuing bank to another.

            Credit card coverage can be valuable, especially if it’s included in the basic card member services at no extra charge, but it probably is not absolute. Often, this insurance applies to vehicle damage or theft, but not liability for injuries. In such cases, be sure you have other protection for any liability incurred while driving a rental car.

            Be wary of any exclusions in the coverage you receive from your credit card company. Coverage might not be available, for instance, for rentals of recreational vehicles, rentals of very expensive vehicles, rentals by students, or rentals much longer than 15 days.

            The bottom line is that you almost certainly will use a credit card when you rent a car. You might as well see which of your cards has the best suite of free car-rental benefits, in sync with your auto insurance, and use that card when you rent a car.

Counter moves

When you rent a car, the person behind the counter will ask you if you want the optional insurance offered by the company. The stated cost—often X dollars per day—may seem modest but in fact the annualized costs generally are much greater than you’d pay for standard auto insurance.

            Why would you pay for this expensive coverage? If you haven’t fully researched your insurance options, you might want to buy some coverage from the car rental company, for peace of mind. Alternatively, if you are informed about your present coverage, you might choose some of the optional choices to fill in any gaps.

            Example 2: Mindy Carter lives in New York City without a car, so she has no auto insurance. When she goes away on weekends, she rents a car. Mindy knows that her credit card covers damage and theft but not liability for injury to others. Therefore, she buys liability insurance at the car rental counter.

            Similarly, drivers with little or no collision damage coverage on their personal cars might buy this insurance from the rental company.

Even More on Rental Car Insurance

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Mixing Annuites and IRAs

According to the Investment Company Institute, 68% of households with IRAs have mutual funds in those accounts. That’s followed by individual stocks (41%), annuities (35%), and bank deposits (25%). Therefore, annuities are among the most common IRA holdings; they are also among the most controversial because many observers assert that annuities don’t belong in an IRA.

Defining the terms

To understand this seeming contradiction, you should know some terminology. Generally, the most heated debate does not involve immediate annuities, which also may be known as income or payout annuities. Here, you give a sum of money to an insurance company in return for a specified flow of cash over a specified time period, perhaps the rest of your life.

            Deferred annuities are a different story. With these investments, the money you contribute can grow inside the annuity contract. Different types of deferred annuities offer various ways that the amounts invested can grow over the years. Regardless of the method or the amount of accumulation, earnings inside the annuity aren’t taxed until money is withdrawn.

            Critics of holding deferred annuities inside an IRA say that they are redundant. Any investment inside an IRA is tax deferred or tax-free (with a Roth IRA), so you don’t get any tax benefit by investing IRA money in a deferred annuity. Why pay the costs that come with a deferred annuity when you get the same tax deferral with mutual funds or individual securities or bank accounts held inside your IRA?

            Because there might be advantages as well as drawbacks. Deferred annuities offer various guarantees, which might include certain death benefits and certain amounts of cash flow during the investor’s life, regardless of investment performance. These guarantees may be a valid reason to include a deferred annuity in an IRA, some annuity issuers and sellers contend.

            Among different deferred annuities, death benefits and so-called “living benefits” vary widely. Some can be extremely complicated. If you are interested in a deferred annuity, our office can explain the guarantees in the contract, so you can make an informed decision.

Verifying value

Another thing to consider when deciding whether to hold a deferred annuity in your IRA, is that these annuities must be valued for purposes such as Roth IRA conversions and required minimum distributions (RMDs). This also will arise if you already have such an annuity in your IRA. The reported value of the annuity contract may not be the appropriate number.

            Example: Sarah Thomson invests $50,000 of her IRA money in a deferred annuity that offers several investment options. After this outlay, Sarah’s investments decline, so her annuity account is now reported at $40,000. Sarah decides this reduced value would generate a lower tax cost on a conversion to a Roth IRA.

            However, Sarah’s deferred annuity also contains a rider guaranteeing to pay her a certain amount per year for the rest of her life. Such a rider has some value, which Sarah must include in valuing the annuity inside the IRA if she does a Roth conversion. The same problem will arise when Sarah must take RMDs. Sarah’s best course of action may be to ask the annuity issuer for help with the valuation because insurers typically have actuaries and software designed to perform these intricate calculations.

            Holding an annuity in an IRA raises many issues that don’t arise with other choices. There may be advantages, but you should proceed cautiously.

Annuity Payback Time

Variations of immediate annuities include the following:

·       Fixed ­period annuities. Here, you receive definite amounts at regular intervals for a specified length of time.

·       Annuities for a single life. These contracts provide you with definite amounts at regular intervals for life. The payments end at your death.

·       Joint and survivor annuities. Usually acquired by a married couple, the first annuitant receives a definite amount at regular intervals for life. After he or she dies, a second annuitant receives a definite amount at regular intervals for life. The amount paid to the second annuitant may or may not differ from the amount paid to the first annuitant.

Making Expense Accounts... Accountable

Business owners who work for their company typically have expense accounts; the same usually is true for many employees. If your company has what the IRS calls an accountable plan, everyone can benefit from the tax treatment. The company gets a full deduction for its outlays (a 50% deduction for most dining and entertainment expenses), while the employee reports no taxable compensation.

            A company expense plan judged to be nonaccountable, on the other hand, won’t be as welcome. It’s true that the company can deduct 100% of the payments it makes for meals and entertainment, but it also will have to pay the employer’s share of payroll taxes (FICA and FUTA) on the expense money paid to employees. The employees, meanwhile, will report those payments as wages, subject to income and payroll taxes.

In that situation, the employee can include employee business expenses (minus 50% of those for meals and entertainment) with other miscellaneous itemized deductions, but only miscellaneous deductions that exceed 2% of adjusted gross income can be subtracted on a tax return. Taxpayers who owe the alternative minimum tax can’t get any benefit from their miscellaneous deductions.

                       

Key factors

In order for expense accounts to get favorable tax treatment, they should pass the following tests:

·       Business purpose. There should be an apparent reason why the company stands to gain from this outlay. An employee might be going out of town to see a customer or a prospect, for example.

·       Verification. Employees should submit a record of their expenses, in order to be reimbursed. Lodging expenses require a receipt, as do other items over $75.

            In order to reduce the effort of dealing with multiple receipts, employers are allowed to give employees predetermined mileage and per diem travel allowances. Substantiation of other elements besides amounts spent (time, place, business purpose) is still required. If the amounts of those allowances don’t exceed the amounts provided to federal employees, the process can be considered an accountable plan. (Excess allowance amounts are taxable wages.) Per diem rates can be found at www.gsa.gov/portal/category/104711.

            Example: XYZ Corp. asks a marketing manager, Jill Matthews, to take a two-day business trip to Atlanta to demonstrate new products. The federal rate for Atlanta (lodging, meals and incidentals) on the federal per diem website is $189 per day. As required by the XYZ accountable plan, Jill accounts for the dates, place, and business purpose of the trip. XYZ reimburses Jill $189 a day ($378 total) for living expenses; her expenses in Atlanta are not more than $189 a day. In this situation, XYZ does not include any of the reimbursement on her Form W-2, and Jill does not deduct the expenses on her tax return.

·       Refunds. Employees must return any amounts that were advanced or reimbursed if they were not spent on substantiated business activities.

·       Timeliness. Substantiation and any required refunds should be made within a reasonable amount of time after the expense was incurred. Those times vary, but IRS publications indicate that substantiation should be made within 60 days, and any employee refunds should be made within 120 days.

            For a plan to be accountable, reimbursements and allowances should be clearly identified. They can be paid to employees in separate checks. Alternatively, expense payments can be combined with wages if the distinction is noted on the check stub. Our office can help you check to see that your company’s employee expense plan is accountable, and, thus, qualifies for the resulting tax treatment.

Supreme Court Bolsters Beneficiary Rights

A 2013 decision by the U.S. Supreme Court illustrates the importance of updating beneficiary forms regularly. If you don’t, your desired heirs can lose a valuable asset.

            This case, Hillman vs. Maretta, had its genesis in 1996, when Warren Hillman married Judy Maretta. Warren was a federal employee, so he named Judy as the beneficiary of his group term life insurance policy. The couple was divorced after two years, and Warren subsequently married Jacqueline. Warren and Jacqueline were still married in 2008 when Warren died; that life insurance policy’s death benefit was nearly $125,000.

            As it turned out, Warren had never changed the beneficiary designation on the policy. Thus, Judy received the death benefit, and Jacqueline went to court to get the money from Judy.

State versus federal

The case took place in the state of Virginia, which has passed a state law saying that a divorce or annulment revokes a beneficiary designation relating to death benefits. That sounds like it should have settled the matter, but Warren’s life insurance policy was created under the Federal Employees’ Government Life Insurance Act (FEGLIA), a federal law, and the U.S. Constitution states that federal law will trump state law when there’s a conflict.

            Nevertheless, Jacqueline still had a card to play. Virginia has another law saying, in essence, that if death benefits are turned over to a former spouse because of such a conflict, that former spouse is liable for the amount in question, payable to the person who otherwise would have collected. Thus, Jacqueline (Warren’s widow) sued Judy for the amount of the insurance proceeds.

Court conflicts

Did federal law override state law, giving the life insurance benefits to Judy? All parties agreed that was the case. But did the second Virginia law prevail, allowing Jacqueline to ultimately collect the death benefits from Judy? That was the question dividing the Virginia courts and bringing the matter to the U.S. Supreme Court.

            In 2013, the Supreme Court decided Hillman vs. Maretta in favor of Judy, the former spouse and the designated beneficiary. “FEGLIA establishes a clear and predictable procedure for an employee to indicate who the intended beneficiary shall be,” the Supreme Court noted, so federal employees have an “unfettered freedom of choice in selecting a beneficiary and to ensure the proceeds actually belong to that beneficiary.” State law can’t overturn that federal law’s intent, the Court ruled.

            Not every case will come down in favor of a former spouse. ERISA, a federal law covering retirement plans, gives a current spouse certain rights to death benefits from an employer’s retirement plan, unless that right has been formally waived. Nevertheless, beneficiary conflicts can be time consuming, expensive, and stressful, especially if large amounts are at stake. Regularly updating all beneficiary forms can spare your loved ones from fighting what might wind up being a losing battle.

Paired Plans

• ·       In most 401(k) and similar plans, an amount left by a participant who has not received benefits will automatically go to the surviving spouse.
• ·       If a participant wishes to select a different beneficiary, the spouse must consent by signing a waiver.
• ·       This waiver must be witnessed by a notary or a plan representative.

Time to Trim Stocks?

In 2013, the benchmark Standard & Poor’s 500 Index returned more than 32%, and the average domestic stock fund was up more than 31%, according to Morningstar. Major domestic stock market indexes are at or near record levels, as of this writing. Since the nadir of the financial crisis in early 2009, stocks have enjoyed a powerful five-year run.

 Is it time to move out of stocks, or at least trim your holdings?  Most commentators advise against trying to time the market. There’s no way of knowing if we’re at the top of the market, as we were in 2000 and 2007, or if we’re just beginning an 18-year bull run like the one we enjoyed from 1982 to the 2000 peak.

Rebalancing act

Market timing may not be recommended, but many financial advisers favor the concept of rebalancing your portfolio. Here, you determine an asset allocation to suit your investment goals and your risk tolerance. If your actual allocation departs from the plan, you’ll act to get your investment mix back on the chosen path.

            Example 1: Megan Harris has a basic asset allocation of 65% stocks and 35% bonds. After a few years of a bull market, Megan’s $400,000 portfolio is $300,000 in stocks (75%) and $100,000 (25%) in bonds. To rebalance, Megan would sell $40,000 of stocks and buy $40,000 of bonds. This would bring her to $260,000 in stocks (65%) and $140,000 in bonds (35%).

            Note that Megan will still have a substantial amount invested in stocks, so she will continue to profit if stocks perform well. At the same time, she will have less exposure to a possible stock market reversal.

            The Megan Harris example is extremely simplified. Today, many financial advisers advocate a portfolio that’s diversified among multiple asset classes. Megan might hold international and domestic equities, large company and small company stocks, high grade and lower quality bonds, real estate securities, commodities and so on. Each asset class will have an allocation, and periodic rebalancing can keep the mix on track.

Tax tactics

One advantage of continual rebalancing is that it encourages investors to sell after assets have appreciated and buy other assets that are currently out of favor. Long term, that can be a formula for successful investing. It’s also a formula for realizing taxable gains. Some astute planning can reduce the tax bill, though.

            One approach is to rebalance by executing your asset sales in a tax-favored retirement plan such as a 401(k) or an IRA. Then, any gains on the sale won’t be taxed right away. By building up a substantial amount in such an account and holding a blend of asset classes in there, you’ll increase your ability to rebalance without triggering taxes.

            Another tax reduction method is to sell assets from a large holding within your portfolio, acquired at different times. Specify the shares you’d like to sell, choosing those with the least tax impact.

            Example 2: As in our previous example, Megan Harris wants to rebalance her portfolio by selling $40,000 of stocks. She sells $15,000 of stock funds held inside her 401(k), avoiding a current tax bill, but Megan would like to sell another $25,000 of stocks in her taxable account.

            Megan holds a large position in mutual fund ABC, which she has amassed over several years. She wants to reduce her exposure to this fund, so she sells $25,000 worth of fund ABC in her taxable account. When instructing her broker to make this sale, Megan specifies which shares to sell, choosing those that (a) have declined since her purchase or (b) have relatively small paper profits. Among the gainers, Megan focuses on the shares that have been held more than one year and, thus, qualify for the favorable tax rate on long-term capital gains.

             Yet another way to reduce the tax on rebalancing gains is to build up a bank of capital losses by periodically selling assets that lose value after you buy them. Such capital losses can offset taxable capital gains.

          

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