Question

1. A tax client wants to know the difference between getting a tax deduction and a tax credit. Compare and contrast the two concepts.

2. Please inform your tax client why they are now paying an Alternative Minimum Tax. They have not had to pay this tax in prior years. Explain to them how they might legally avoid this tax in the future.

3. Your tax client has a large capital loss carry forward from prior years. Explain to them the difference between the taxation of capital assets versus ordinary income. Also, please explain to them the erosion of the value of the capital loss carry forward based upon the time value of money

Answer 1

1. A tax client wants to know the difference between getting a tax deduction and a tax credit. Compare and contrast the two concepts.

tax credits and tax deductions can help reduce your overall income tax liability. Every year, millions of taxpayers search for credits and deductions that can help them save money. While you should take advantage of as many of these as possible, don’t overlook the fact that tax credits and deductions are not the same things.

There are a few basic differences between tax credits and tax deductions. Tax credits provide a dollar-for-dollar reduction of your income tax liability. This means that a $1,000 tax credit saves you $1,000 in taxes. On the other hand, tax deductions lower your taxable income and they are equal to the percentage of your marginal tax bracket. For instance, if you are in the 25% tax bracket, a $1,000 deduction saves you $250 in tax (0.25 x $1,000 = $250).

A tax credit is always worth more than a dollar-equivalent tax deduction because deductions are calculated using percentages. Referring to the numbers above, you can see that a $1,000 credit offers $750 more in savings than a $1,000 deduction

Tax Credits

Tax credits can help reduce your liability dollar-for-dollar. However, they cannot reduce your income tax liability to less than zero. In other words, your gross income tax liability is the amount you are responsible for paying before any credits are applied.

The majority of tax credits are non-refundable. With non-refundable tax credits, any excess amount expires in the year in which it was used, meaning that the additional amount is not refunded to you. There are some refundable tax credits, though, and these can be used to help grow your tax refund.

To get a better idea of how tax credits work and whether or not you qualify, you need to know what is available to taxpayers in your situation — such as your filing status, age, employment, and education. It is important to remember that just because you qualify for one type of tax credit does not mean that you qualify for the rest.

How much are tax credits worth? That depends on the particular tax credit you’re talking about. And just as the amount of each tax credit is different, so are the qualification guidelines. Since a credit helps reduce the amount of money that you pay in income tax, it is essential that you are 100% accurate with this information. If you are unsure of whether or not you qualify for a tax credit, it’s recommended that you check with a tax professional before claiming the credit on your income tax return.

While tax credits are less common than tax deductions, they are available for things such as adopting a child, buying a first home, child care expenses, home office expenses and caring for an elderly parent. Additionally, there are various business tax credits that you may be able to consider.

Tax Deductions

As we learned earlier, tax deductions lower your taxable income, and they are calculated using the percentage of your marginal tax bracket. For example, if you are in the 25% tax bracket, a $1,000 tax deduction saves you $250 in tax (0.25 x $1,000 = $250).

There are 2 main types of tax deductions: the standard deduction and itemized deductions. A taxpayer must use one or the other, but not both. It is generally recommended that you itemize deductions if their total is greater than the standard deduction.

The Standard Deduction

The standard deduction is a dollar amount that reduces your taxable income. It is typically adjusted up for inflation each year. Your standard deduction amount is based on your filing status and is subtracted from your AGI (adjusted gross income).

Itemized Deductions

If you do not qualify for the standard deduction, you may choose to itemize your deductions. A taxpayer will usually itemize deductions if it offers them more benefits than the standard deduction (i.e., when the amount of qualified deductible expenses totals more than the standard deduction).

Note that some itemized deductions are based on a minimum (or “floor”) amount. This means that you can only deduct amounts that exceed the specified floor. There is also an income limit for taxpayers who itemize their deductions. If your AGI (adjusted gross income) exceeds a certain level, then a portion of itemized deductions is not permitted.

If you decide to itemize your tax deductions, it is important to keep detailed records of those itemized deductions including documentation for medical expenses, property taxes, charitable donations, mortgage interest, and non-business state income taxes.

2. Please inform your tax client why they are now paying an Alternative Minimum Tax. They have not had to pay this tax in prior years. Explain to them how they might legally avoid this tax in the future.

To avoid the AMT, you need to understand how the AMT differs from the regular tax system.

We'll walk through Form 6251, line by line, looking at how the AMT handles different deductions and expenses. Wherever we see a tax-planning opportunity, we will suggest how to lessen the impact of the AMT.

Line 1: Adjusted Gross Income after itemized deductions: If you itemize, this line is the amount shown on line 41 of your 1040, which is your Adjusted Gross Income (AGI) minus your itemized deductions (some of which are added back in on the following lines). If you take the standard deduction instead, this line is solely your AGI from line 38 of your 1040, because you can't take any part of the standard deduction when calculating the AMT. So if you took the standard deduction on your regular return, it is effectively added back into your income here. If you itemized your deductions then the next few lines add back some of those itemized deductions.

Line 2: Medical expenses: If you itemize deductions, medical deductions have to exceed an additional 2.5 percent of your AGI with the AMT.

Suggestion: If your employer has a pre-tax medical deduction plan, sign up for it. You can reduce your salary to pay your medical expenses on a pre-tax basis, which will help you reduce both the AMT and your regular tax.

Line 3: Taxes: In calculating the AMT, you cannot take itemized deductions for state and local income tax, real estate taxes and personal property taxes, even though these are deductible on your regular return.

Suggestion 1: In a year that you have to pay the AMT, don't bother prepaying real estate or fourth-quarter state estimated tax payments in December. You get no benefit from paying these taxes in a year that you are subject to the AMT.

Suggestion 2: Real estate and personal property taxes are not deductible for AMT if they are part of itemized deductions. Taxes deductible on a business schedule (Schedule C), rental schedule (Schedule E), or farm schedule (Schedule F or Form 4835) are allowed for the AMT.

• Perhaps you can qualify for a home office, which would allow you to deduct part of your home real estate tax on Schedule C.
• If you have a farm operation and use your car in your work, you might be able to deduct the personal property tax on the car on Schedule F.
• If you have vacant land on which you are paying real estate taxes, you could turn it into a farm rental and deduct the taxes on Form 4835.

Line 4: Home equity interest: Home mortgage interest claimed as an itemized deduction is only deductible for the AMT if the loan was used to buy, build or improve your home. For regular tax purposes, interest on home equity mortgages up to $100,000 is deductible, even if you used the proceeds for personal purposes, such as buying a car or paying off credit card debt. So unless the home equity loan proceeds were used to improve your home, the interest is added back for AMT purposes.

Suggestion: If you are subject to the AMT, there is no advantage to using your home equity line of credit to buy a car, because the interest will not be deductible. You may be able to get a lower interest rate from a regular car loan. If the car is used in your business, you may be able to write off some of your auto loan interest as a business expense on Schedule C.

Line 5: Miscellaneous itemized deductions (for tax years prior to 2018): Miscellaneous itemized deductions are not deductible for AMT purposes. Often generated by employee business expenses, these itemized deductions can save you a lot of money on your regular return. If so, when the AMT puts them back into your taxable income, you could face a big problem.

Suggestion 1: Employee business expenses (Form 2106) are incurred by employees, not self-employed individuals. These are work-related expenses not reimbursed in full by your employer. They become miscellaneous deductions on Schedule A, Itemized Deductions, and can only be deducted to the extent that all miscellaneous deductions exceed 2% of your adjusted gross income. Only the excess amount can be deducted. If you are in this situation, ask your employer to start reimbursing you for your business expenses.

If your employer has a non-accountable business expense plan (explained below), encourage him or her to adopt an accountable plan.

• In a non-accountable plan, your employer gives you an expense advance check and you are not required to keep records of your purchases.
• The advance is included in your income, and you take your expenses as miscellaneous itemized deductions.
• In the AMT system, you are taxed on the expense advance, but can't take a deduction for the expenses.

To avoid this situation, encourage your employer to change to an accountable plan. With this plan, you turn in your receipts to your employer and you must refund any expense advance not used. Because you are not taxed on the advance and you do not take a deduction for the expenses, you avoid being hit by AMT rules.

Suggestion 2: If you have employee business expenses that your employer refuses to reimburse, and you know that these expenses are causing you to pay the AMT, consider negotiating with your employer. You may be better off by having the employer pay some of these expenses in exchange for a lower salary. Your employer will save on payroll taxes, workers' compensation insurance, and in some cases liability insurance premiums, and you will reduce your taxable income and possibly avoid the AMT altogether.

Line 6: This line is reserved for future use.

Line 7: State tax refund: If you have a taxable state tax refund on your regular tax return, you get to remove it from your income for AMT purposes because you do not receive a corresponding deduction for state taxes.

Line 8: Investment interest: The investment interest deduction may be different for AMT purposes because it depends on whether you have taxable private activity bond interest (see line 12). If you do, you may have an additional deduction for investment interest.

Line 9: Depletion: You can calculate depletion from mining, oil, gas, timber or other similar activities for regular tax purposes using either the cost or percentage depletion method. For AMT, only the cost method is allowed.

Suggestion: If this line is generating AMT on your tax return, consider electing the cost method of depletion.

Line 10: Net operating loss: If you claimed a net operating loss deduction on Form 1040, you have to add it back to your income.

Line 11: Alternative Tax Net Operating Loss deduction: This is the sum of the alternative tax net operating loss (ATNOL) carryovers and carrybacks to the tax year.

Line 12: Private activity and tax-exempt bond interest: Normally, tax-exempt interest from private activity bonds is not tax-exempt for AMT purposes. A private activity bond is a state or local bond issued to provide funds for private, nongovernmental activities such as building a sports stadium, industrial development, student loan financing, or low-income housing. These bonds are often issued by states, counties or cities and are tax-exempt for regular federal tax, but not for the AMT. If you invest in mutual funds, 1099 you get will list how much interest you received from private activity bonds. This amount is entered on Line 12 to show the income as taxable for AMT purposes.

Suggestion: If you are subject to the AMT, invest in tax-exempt bonds issued before 2009 that are not private activity bonds. Many mutual fund companies have two listings of state bond funds, one that contains private activity bonds, and one that doesn't. Read the literature carefully.

Line 13: Section 1202 exclusion: You can exclude from your income some portion of the gain on the sale of qualified small business stock held more than five years. The gain on the sale of this stock is 50 percent excludable for regular tax purposes, but 7 percent of the excluded gain is added back for AMT purposes.

Suggestion: In the year that you sell qualified small business stock, try to eliminate or reduce as many other AMT adjustments as possible to get the maximum gain exclusion on the sale of the stock.

Line 14: Incentive stock options: This line is another common problem for people affected by the AMT. If you exercise an Incentive Stock Option (ISO) but do not sell the stock in the year of exercise, the transaction is not taxable that year for regular tax purposes.

However, the difference between the exercise price and the fair market value of the stock on the day of the exercise is an adjustment for AMT purposes and appears on Line 15. For many people, this adjustment can be a very large number. Essentially, you are going to be taxed on a hypothetical profit (what you might have made if you sold the stock on the day you bought it.)

Example:

You exercise Incentive Stock Options (ISOs) to purchase 100 shares of stock at $3 per share and you decide to hold the stock as a long-term investment. The stock is trading at $33 per share on the day of the exercise. Line 15 on your Form 6251 is $3000 (100 shares x ($33-$3 per share).

Your basis in this stock is now $300 ($3 x 100) for regular tax purposes, but $3300 ($33 x 100) for AMT purposes. When you later sell the stock, you will have an entry on Line 18, Disposition of Property Difference, to account for the difference in your tax basis for regular and AMT purposes.

Suggestion 1: If you exercise ISOs as in the previous example at $33 and the stock falls before the end of the current year, you can sell the stock and avoid the AMT. If the stock fell to $25 during the year of the exercise, you would be subject to regular tax on only $22 per share ($25-$3) and not be subject to the AMT adjustment at all.

Suggestion 2: When you exercise ISOs, always use tax planning software to forecast the tax consequences. You may need to sell some of the stock in the year of the exercise to pay the tax due.

Line 15: Estates or trusts: This line contains differences between AMT and regular tax deductions from estates or trusts. Unfortunately, decisions by the administrators of the estate or trust may be beyond your control.

Line 16: Electing large partnerships: An entry on this line comes from a partnership in which you are a partner. Other than disposing of the investment, which would have other tax ramifications, there is probably nothing you can do about an entry on this line.

Line 17: Disposition of property difference: The tax basis in assets that you sold may be different for regular and AMT purposes depending on the depreciation method you chose (see Line 19), or on your incentive stock options (see Line 15).

Line 18: Post-1986 depreciation: On this line, you enter the depreciation difference for regular and AMT purposes. For AMT purposes, you generally must depreciate (deduct) business assets over a longer period of time than you can for regular tax purposes. This creates a difference between regular tax depreciation and AMT depreciation. This is an entry that does self-correct. By the time the asset is completely written off, you have received the same deduction for both regular and AMT purposes.

Suggestion: If you have an entry on this line, consider electing a slower depreciation method for your business assets, which could eliminate the AMT adjustment.

Line 19: Passive activities: This line contains the differences between AMT and regular tax deductions for passive activities. This line usually relates to a difference in depreciation methods for rentals, partnerships or S Corporations.

Suggestion: If the adjustment is from a rental property, consider using slower depreciation methods for regular tax purposes to eliminate an entry on this line. If the adjustment is from a partnership or S Corporation, the depreciation methods are selected at the entity level and there is probably nothing you can do.

Line 20: Loss limitations: You may have AMT or regular tax differences due to passive investments in partnerships or S Corporations. Depending on your percentage of ownership, you may discuss with the management of these investments any items that are generating AMT on your tax return to see if the AMT impact can be lessened in future years.

Line 21: Circulation expenditures: This line relates to the difference between how newspaper or magazine circulation expenditures are deducted under both tax systems.

Suggestion: If you have an entry on this line, consider making an election under Internal Revenue Code (IRC) section 59(e) to amortize these expenses over three years for regular tax purposes. This will eliminate the entry on this line for AMT purposes.

Line 22: Long-term contracts: Long-term construction contractors are generally required to use the percentage of completion method of accounting for long-term contract revenue, rather than the completed-contract method. This is a timing difference that will reverse in later years.

Line 23: Mining costs: Mining exploration and development costs may also generate an AMT adjustment unless you make an IRC section 59(e) election to write-off the costs over 10 years. Making the election eliminates an entry on this line.

Line 24: Research and experimental expenditures: This adjustment is related to a timing difference between deducting Research and Experimental Expenditures for regular and AMT purposes. You can eliminate this line entry if you make the IRC section 59(e) election to deduct the costs over 10 years.

Line 25: Installment sales: Installment sales of inventory items are not allowed for AMT purposes for sales entered into between August 16, 1986, and January 1, 1987. (Almost no one uses this line.)

Line 26: Intangible drilling costs: This line relates to the difference in timing of the deductions for intangible drilling costs. You can make an election under IRC section 59(e) to write off intangible drilling costs over 60 months for regular tax purposes, and eliminate an entry on this line.

Line 27: Other adjustments: This line relates to any other income or deduction items that are affected by AMT differences, such as taxable IRA distributions, self-employed health insurance, IRA deductions, and other income-based calculations.

Having thrown so many items back into your income, you now get a small break. Your taxable income for AMT purposes is reduced by the exemption amount shown above at the beginning of this article. This exemption amount phases out as income increases.

Now you calculate the Tentative Minimum Tax (Line 34). You compare this figure to the tax you calculated under the regular tax system on Form 1040.

The difference, if positive, is the Alternative Minimum Tax.

You add the positive difference, if any, to your regular tax.

3. Your tax client has a large capital loss carry forward from prior years. Explain to them the difference between the taxation of capital assets versus ordinary income. Also, please explain to them the erosion of the value of the capital loss carry forward based upon the time value of money

ORDINARY INCOME TAXATION

Ordinary income can be simply defined as the income earned from providing services or the sale of goods (inventory). This category includes income earned from interest, wages, rents, royalties, and similar income streams. Ordinary income is taxed at different rates depending on the amount of income received by a taxpayer in a given tax year. In 2012, there are currently six tax brackets for taxing ordinary income: 10%, 15%, 25%, 28%, 33%, and 35%. These ordinary income marginal tax brackets are scheduled to expire at the end of 2012. In 2013, the 10% through 28% tax rates will remain the same and the top two rates of 33% and 35% will be replaced with higher rates, 36%, and 39.6% respectively.

CAPITAL GAIN TAXATION

Capital gains are usually associated with the sale or exchange of property characterized as capital assets. The amount of gain is measured as the difference between the amount received by the taxpayer on the sale less the original purchase price, adjusted through the date of the sale (purchase price plus any improvements less depreciation taken). For more information on the formula to calculate capital gain on the sale of a property, see Calculating Capital Gain Tax Calculator.

The category of capital gain taxation is further broken down into long and short-term capital gains. If a property is sold within one year of its purchase, the gain is characterized as short-term and taxed at the same marginal rate as the taxpayer’s other ordinary income. Thus, at least for short-term gains, the tax rates are the same as the taxpayer’s ordinary income. On the other hand, if the taxpayer holds the property for more than one year before selling, the gain is characterized as long-term capital gain and is taxed at a favorable long-term rate.

In 2012, the long-term capital gain tax rate is 15% and this reverts on January 1, 2013, to the previous long-term rate of 20%. Long-term capital gains, on assets held for over one year, are subject to a lesser tax rate than short-term capital gains from investments held for less than one year. For more details on capital gain taxes and investment income, see Internal Revenue Service publications 17 and 550, at irs.gov.

What is 'Capital Loss Carryover'

Capital loss carryover is the net amount of capital losses eligible to be carried forward into future tax years. Net capital losses (total capital losses minus total capital gains) can only be deducted up to a maximum of $3,000 in a tax year. Net capital losses exceeding this threshold may be carried forward to future years

Tax-Loss Harvesting

Tax-loss harvesting provides a mean of improving the after-tax return on taxable investments. It is the practice of selling securities at a loss and using those losses to offset taxes from gains from other investments and income. Depending on how much loss is harvested, losses can be carried over to offset gains in future years. Tax-loss harvesting often occurs in December, with December 31 being the last day to realize a capital loss. Taxable investment accounts identify realized gains incurred for the year and find losses to offset those gains. Doing so allows the investor to avoid paying capital gains tax. If the investor wants to repurchase the same investment, he must wait 30 days to avoid a wash sale. For example, suppose a taxable account currently has $10,000 of realized gains that were incurred during the calendar year, yet, within its portfolio is Apple stock with an unrealized loss of $9,000. If the Apple stock was sold on or prior to December 31, the investor would realize $1,000 ($10,000 gains - $9,000 Apple loss) in capital gains. Abiding by the wash-sale rule, if the stock was sold on December 31, the investor would need to wait until January 30 to repurchase it

Capital Losses Can Be Carried Over Indefinitely

Let's assume the stock market has a bad year. You sell a stock or mutual fund and realize a $20,000 loss. You have no capital gains that year. First, you use $3,000 of the loss to offset ordinary income. The remaining $17,000 will carry over to the next year. Next year, if you have $5,000 of capital gain, you can use $5,000 of your remaining loss carryover to offset this gain, $3,000 to deduct against ordinary income, and the remaining $9,000 will then carry forward to the next tax year. If you had no realized capital gains for the following three years, the remaining $9,000 tax loss would be used up, $3,000 at a time, over those three years.

Should I Realize Losses Now?

Sometimes it makes sense to realize a capital loss on purpose so you can use it to offset capital gains and ordinary income in future years. This concept is referred as tax loss harvesting and is used by savvy investors.

Here's an overview of how it works. Ordinary income is taxed at a higher tax rate than capital gains. It means realizing a loss and carrying your capital loss forward where $3,000 of it can offset ordinary income each year may mean a lower tax bill for you. If retired, having less ordinary income can also mean less of your Social Security benefits are taxable for the year. Of course, the actual benefit of a capital loss all depends on your individual tax situation. When it comes to taxes, it is always wise to seek a qualified tax adviser to determine what applies to your specific situation.

Keeping Track of Capital Loss Carryover Amounts

Capital gains and losses, and tax loss carryforwards are reported on IRS forms Schedule D, and for real estate or business investments, on Form 8949. When reported correctly these forms will help you keep track of any capital loss carryover.

The gain and loss rules discussed in this article apply primarily to publicly traded investments such as stocks, bonds, and mutual funds, and in some cases, to real estate holdings. There are additional rules that apply when you dig into short-term gains vs. long-term gains, whether deductions can be used to offset state income, how real estate gains are treated when you must recapture depreciation, and how you account for passive losses and gains.