articles


August 5, 2022

By Paul Bonner

July 28, 2022

A path toward a long-sought congressional vote on a federal budget reconciliation bill appeared to open Wednesday as Sen. Joe Manchin, D-W.Va., endorsed fast-track legislation that would contain a variety of tax provisions.

Manchin’s buy-in, which surprised observers and even some members of his own party, came with his agreement on the package’s contents with Senate Majority Leader Chuck Schumer, D-N.Y. Provisions intended to reduce the federal deficit, along with measures aimed at lowering energy and health care costs, were prominent in Manchin’s statement issued Wednesday.

The bill, titled the Inflation Reduction Act of 2022, also includes some of the proposed measures to combat climate change that were originally in President Joe Biden’s signature Build Back Better legislation, which had been mired in debate for much of Biden’s administration. Some of these provisions feature new or expanded tax credits.

The Inflation Reduction Act’s centerpiece tax provision, however, is a 15% corporate minimum tax, which also has been controversial but that Manchin endorsed in his statement.

“It is wrong that some of America’s largest companies pay nothing in taxes while freely enjoying the benefits of our nation’s military security, infrastructure, and rule of law,” Manchin said.

The provision would apply the tax generally on the excess of 15% of C corporations’ adjusted financial statement income over any corporate alternative minimum tax foreign tax credit for the tax year, for corporations with average annual adjusted financial statement income for the three consecutive tax years ending with the tax year exceeding $1 billion. A $100 million threshold would apply to certain “foreign-parented” corporations. The provision, which would apply to an estimated 200 companies, would be effective for tax years beginning after 2022.

Individuals and organizations including the AICPA have criticized a corporate minimum tax based on financial statement, or “book,” income. The AICPA wrote congressional tax-writing committee leaders in October 2021 and again in June 2022, counseling against including such a tax in a reconciliation bill.

Among its concerns with the provision, the AICPA stated that it introduces new complexities in calculating taxes for affected corporations. More fundamentally, by basing it on book income, the tax “takes the definition of taxable income out of Congress’s hands and puts it into the hands of industry regulators and others,” both letters stated.

Under provisions intended to increase clean and reliable energy supplies, the bill contains production tax credits intended to spur $30 billion in investments for domestic manufacturing of solar panels, wind turbines, batteries, and “critical minerals” processing. An investment tax credit would aid facilities manufacturing electric vehicles, wind turbines, and solar panels, worth another $10 billion.

Provisions to reduce carbon emissions would include tax credits for clean sources of electricity, energy storage, clean fuels, and efficient commercial vehicles. Other tax credits would encourage development of biofuels, help reduce industrial manufacturing emissions, and support consumer expenditures on energy-efficient residential property and vehicles.

In all, the energy and environmental provisions are estimated to cost $369 billion and reduce carbon emissions by 40% by 2030, according to a summary by Schumer’s office. In an accompanying statement, Schumer thanked Manchin for helping reach an agreement “that can earn the support of all 50 Senate Democrats.”

Biden said in a statement Wednesday that he had spoken with Manchin and Schumer, thanked them, and offered his support for the bill. He stated that, besides the energy provisions, the legislation would reduce the federal deficit, thereby combating inflation, and allow Medicare to negotiate prescription drug prices, reducing health care costs.

“And we will pay for all of this by requiring big corporations to pay their fair share of taxes, with no tax increases at all for families making under $400,000 a year,” Biden said.

Despite an air of assurance in the senators’ and president’s statements, however, the deal still faces hurdles that include vetting by the Senate parliamentarian for budgetary rule compliance and a vote by the chamber, which Schumer said he expects will occur next week.

The apparent freeing of the logjam on reconciliation comes a day after the Senate passed another bill that had been long in reaching consensus, one that would support domestic semiconductor manufacturing and research, in part with a new investment tax credit.



May 20, 2022
EXECUTIVE
SUMMARY
 
  • Besides providing a tax-favorable option for taxpayers to pay out-of-pocket medical expenses, HSAs can be used as a flexible tax-favored investment vehicle.
  • Annual contributions to an HSA are limited in 2022 to $3,650 for an individual self-only plan or $7,300 for a family plan ($3,600 and $7,200, respectively, in 2021). An additional $1,000 is allowed for taxpayers who reach age 55 by the end of the tax year. HSA contributions within these limits are tax-deductible.
  • Withdrawals from HSAs are tax-free to the extent that they are used to pay qualified medical expenses, including expenses for over-the-counter drugs and menstrual care products. There is no time limit on a taxpayer requesting reimbursement from an HSA for a medical expense he or she paid with funds outside the HSA.
  • Because there is no reimbursement time limit, a taxpayer can defer reimbursement from the HSA for medical expenses paid until the time he or she chooses. By deferring reimbursement of medical expenses, contributions to an HSA can grow tax-free, similar to contributions to an IRA or Roth IRA.
  • Withdrawals of the amounts a taxpayer contributes to the HSA plus investment earnings, up to the amount of accumulated reimbursable medical expenses, can be taken tax-free when the taxpayer chooses to request reimbursement.

This article shows how clients can benefit from viewing a health savings account (HSA) as a flexible tax-favored investment strategy. HSAs allow taxpayers of any income level to deduct contributions immediately and withdraw the contributions, with accumulated investment earnings, free of tax at any age. That is, the “health” moniker can be a misnomer by disguising a key benefit of an HSA: An HSA can be a flexible tax-favored investment vehicle.

Compared with more aptly named individual retirement accounts (IRAs), an HSA savings strategy (1) allows tax-deductible contributions like a traditional IRA but without its limitations on working alongside a Sec. 401(k); (2) allows tax-free withdrawals like a Roth IRA and without its income-based contribution limits; and (3) avoids waiting until retirement age for penalty-free withdrawals of earnings, as required by both traditional and Roth IRAs. This short article explains that U.S. tax law currently permits this tax-favored investment strategy by effectively combining the tax benefits of an HSA with an investment strategy.1

Sec. 223 allows a taxpayer covered by a qualified family high-deductible health plan (HDHP) to make deductible contributions to an HSA trust account of up to $7,300 in 2022 or $7,200 in 2021 (for taxpayers with a qualified self-only HDHP, $3,650 in 2022 and $3,600 in 2021). An additional $1,000 deduction is allowed for taxpayers who are at least 55 years old at any time during the tax year. Employer contributions made to an HSA are excludable from the employee’s gross income (Secs. 106(d) and 125). The employer contributions to the HSA also reduce the annual limits on the employee’s deductible contributions. An HSA remains with a taxpayer after he or she leaves an employer or the workforce entirely, which adds portability to the benefits of an HSA.

Withdrawals from an HSA to cover the costs of qualified medical expenses as defined in Sec. 223(d)(2) are tax-free, including withdrawals of investment earnings on the HSA funds. Employees can direct the HSA administrator to pay for qualified medical expenses directly from the account. Indeed, some plans provide HSA participants with debit cards to pay these expenses directly, which can help the taxpayer meet the substantiation requirements. Regardless of how medical costs are withdrawn, the taxpayer is responsible for documenting that the funds are used exclusively to pay for qualified medical expenses, that the expense has not previously been reimbursed or paid for by another source, and that the medical expense is not also included among itemized deductions.

An alternate approach — the strategy recommended here — is for the taxpayer to pay the medical bills personally and request reimbursement of these costs from the HSA only when he or she needs the funds. Of course, a taxpayer should carefully document each medical expenditure and carefully preserve this documentation. However, there is no time requirement for requesting reimbursement from the HSA. Therefore, a valid tax strategy is to pay medical costs from non-HSA funds, retain the reimbursement documentation, and wait until the funds are needed to obtain reimbursement for the costs. Note, however, this strategy is only useful to the extent that the taxpayer can afford to pay the medical expenses from sources outside the HSA. This approach is valid because no time limit prescribes when a qualified medical expense claim must be filed.

The ability to use an HSA as a tax-favored investment vehicle depends on two things. First, when a medical bill falls due, the taxpayer must be capable of paying it with funds outside the HSA. The investment benefit decreases as the taxpayer draws on the HSA funds. Second, taking tax-free withdrawals depends in part on the taxpayer’s incurring medical costs that can be reimbursed from the HSA upon submission of receipts. Since some taxpayers and their families are relatively healthy, their health decreases the flexibility of the HSA as a tax-favored investment vehicle from which funds can be drawn upon quickly and without penalty. However, even healthy taxpayers face regular health and dental expenses, which include unprescribed over-the-counter medicine and menstrual care products, that qualify for reimbursement. To the extent that a taxpayer pays these costs out of pocket and can substantiate they were paid, these paid but unreimbursed costs allow the taxpayer to later draw on his or her tax-favored investment as needed. One way to view paying qualified medical expenses with non-HSA funds is that these payments become highly flexible, heavily tax-favored investments. Of course, if non-HSA savings or after-tax investments are not available to pay medical costs, HSA funds can be used. But using HSA funds to pay qualified medical expenses should be a last resort, not the default strategy.

Examples of applying the strategy

Example 1: M (age 25) and J (age 24) married in 2021. M works for a large public accounting firm, and J freelances as a graphic design artist. Starting in 2021, each year, M’s employer pays the cost of family HDHP coverage and contributes $2,000 to M’s HSA. In addition, M and J annually contribute $1,000 to the HSA and claim a deduction for this amount on their joint tax return; this $1,000 pretax contribution is considerably smaller than would be required for traditional full-coverage health insurance. The net annual cost is $700 after considering their 30% marginal tax rate. M and J are in good physical condition, but annual vision, dental, and menstrual care; wellness checks; and over-the-counter medicine costs total $2,500 per year, which M and J carefully document and pay out of pocket without requesting reimbursement from the HSA. The HSA funds are invested and earn 8% annually.

The couple buy a house in 2027 after having a baby in 2025.The couple planned and paid for the $6,000 cost of having the baby out of pocket, including prenatal care and two hospital nights.2 By 2027, the balance in the HSA has grown to $27,839, which includes $6,839 of tax-free income. In 2027, the couple submit reimbursable receipts that total $23,500, the proceeds of which finance a portion of the down payment on the house. 3

Example 2: B (age 51) and G (age 47) are empty nesters at the beginning of their high-income years and begin considering the heavier medical costs that are likely to come with getting older. B is a successful self-employed consultant who earns approximately $300,000 annually, an amount that trends upward a bit each year. Starting in 2021, they switch to an HDHP and begin contributing (and deducting) the maximum per year, which is $7,200 and is assumed to increase $100 per year; they add $1,000 per year to their contributions when B turns 55 in 2025. Annual reimbursable medical costs from 2021 to 2035 begin at $3,500 and increase by $200 per year; these costs are paid out of pocket, but the receipts are carefully maintained. The HSA funds are invested and earn 8% annually.

Just before B retires, shortly after reaching age 65, they buy a second home in an active retirement community. Part of the down payment for the home is the $73,500 supported by medical receipts that they withdraw tax-free from their HSA. After the withdrawal, $162,924 remains in the HSA earning 8% annually. These funds can be withdrawn tax-free to pay premiums for Medicare Part A, B, C, or D coverage and long-term health care costs.4

Quantified benefits of the strategy

Let us assume that in December 2021 a taxpayer receives a $1,000 medical bill for a recent outpatient procedure. She maintains an HDHP and possesses both a $5,000 balance in her HSA and sufficient after-tax investment funds with which to pay the bill. She expects the same risk and return from the HSA investment that she would obtain from the non-HSA investment. Let us compare the 10-year after-tax effects of two ways of using the HSA: (1) paying the $1,000 medical bill personally, requesting reimbursement of the $1,000 from her HSA, and investing the $1,000 reimbursement check outside the HSA, and (2) paying the $1,000 medical bill using existing after-tax investment funds that do not require gain recognition to access, and leaving $1,000 invested within the HSA with annual earnings realizations.

Table 1 (below) shows the results of this comparison across three possible pretax rates of return (2%, 6%, and 12%). In the table, the investments (either inside or outside the HSA) are assumed to produce interest or short-term capital gain income that is reinvested annually and, if invested outside the HSA, are subject to two possible marginal tax rates (20% and 40%).

Table 1, Panel A, shows that, facing a 20% marginal tax rate, after 10 years, the investment outside the HSA increases in value by 17.2%, 59.8%, and 150.1% with respective annual pretax returns of 2%, 6%, and 12%. However, if the funds are invested within the HSA, the 20% annual tax does not apply. Thus, the annual pretax returns of 2%, 6%, and 12% are the after-tax returns. At 2%, 6%, and 12%, the 10-year cumulative after-tax returns are 21.9%, 79.1%, and 210.6%, respectively. If the only difference between investing outside the HSA and inside the HSA is the 20% annual tax on investment earnings, a $1,000 investment within the HSA will produce cumulative 10-year returns that are 4.7, 19.3, and 60.5 percentage points greater than an investment outside the HSA, given pretax returns of 2%, 6%, and 12%, respectively. In Panel B, the marginal tax rate is 40%, and the additional after-tax benefit of investing within the HSA nearly doubles to 9.2, 36.7, and 110.2 percentage points across the respective 2%, 6%, and 12% pretax returns.

Table 2 (below) shows comparable figures to Table 1, except that the underlying investment produces taxable gain only at the end of the 10-year period. The capital gains tax rate for the investment outside the HSA is assumed to be 15% in Panel A and 30% in Panel B. For example, in the first column of Panel A, the $1,000 investment that earns 2% compounded annually produces a pretax investment value of $1,218.99 (i.e., $1,000 × (1 + 0.02)10). The increase in investment value, $218.99, is subject to 15% capital gains tax ($32.85), which leaves an after-tax investment of $1,186.15 and an after-tax 10-year cumulative return of 18.6%.

If the $1,000 had remained invested inside the HSA at the same 2% compounded annually, it would have produced an after-tax investment valued at $1,218.99 and a 10-year after-tax return of 21.9%, 3.3 percentage points higher than if invested outside the HSA. Assuming pretax rates of return of 6% and 12%, respectively, an investment inside the HSA produces cumulative 10-year investment returns that are 11.9 and 31.6 percentage points higher than an investment outside the HSA. In Panel B, we see that increasing the 15% long-term capital gains tax to 30% doubles the additional 10-year after-tax return from delaying HSA reimbursement to 6.6, 23.7, and 63.2 percentage points across the 2%, 6%, and 12% respective annual pretax rates of return.

Tables 1 and 2 show that funds allowed to remain in an HSA produce greater after-tax returns than funds withdrawn from an HSA and then invested. The differential is widest when the underlying investment produces higher pretax rates of returns and when the taxpayer’s marginal tax rate is greater. Also note that keeping the funds inside the HSA has greater relative tax benefits when the underlying investment produces annual earnings realizations (Table 1) than when it produces end-of-the-investment-period capital gains (Table 2).

Comparing the HSA with a traditional IRA and a Roth IRA

A variety of investments provide tax benefits, including (1) purchasing a security that produces tax-exempt municipal bond interest; (2) acquiring real estate and property that produces tax-sheltering depreciation; and (3) investing in nondividend growth securities that defer gain realizations, among many other possibilities. But for many taxpayers, IRAs are comparable with the HSA. If a taxpayer is familiar with an HSA, she also likely is somewhat familiar with a traditional IRA or a Roth IRA. So, next we compare the features of these tax-favored vehicles, although it is important to note that it is quite possible, and likely advisable, for a taxpayer to utilize both an HSA and an IRA simultaneously.

Some pertinent HSA details: An HSA is available to any taxpayer who maintains an HDHP, who has no other health insurance (including Medicare), and who cannot be claimed as a dependent on someone else’s tax return. For this purpose, an HDHP must meet the requirements of Sec. 223(c)(2), including 2022 maximum annual out-of-pocket expenditures of $7,050 for a self-only plan or $14,100 for a family plan ($7,000 and $14,000, respectively, in 2021). In accord with its high-deductible name, an HDHP must also have 2022 (and 2021) minimum deductible amounts of $1,400 for a self-only plan and $2,800 for a family plan.

Contributions to an HSA are deductible if contributed by a taxpayer or excludable from gross income if contributed by a taxpayer’s employer. However, once a taxpayer begins Medicare coverage, no contributions to an HSA are allowed. For taxpayers who will begin Medicare in the month they turn 65, contributions to the HSA must cease and the taxpayer can only deduct a month-based pro rata portion of the annual HSA contribution limit for that year. Taxpayers should be aware that they can become accidentally enrolled in Medicare when they turn 65 because the Social Security Administration automatically enrolls them or because they work for a smaller employer who automatically shifts medical insurance to Medicare upon reaching their 65th birthday. However, a taxpayer can reject these automatic enrollments, allowing the taxpayer to continue making tax-deductible contributions to an HSA as long as he or she maintains coverage under a qualified HDHP.5

Some employers allow employees to receive some (or all) of their health insurance benefit in the form of contributions to an HSA, which are deductible to the employer and excludable to the employee. Taxpayers without this form of compensation can make their own contributions. Regardless of source, the annual contributions to an HSA are limited in 2022 to $3,650 for an individual self-only plan or $7,300 for a family plan ($3,600 and $7,200, respectively, in 2021), and an additional $1,000 for taxpayers who are age 55 by the end of the tax year.

Withdrawals from an HSA are tax-free if they are used for qualified medical expenses, as defined in Sec. 223(d)(2), that, for expenditures incurred after Dec. 31, 2019, include menstrual care products and over-the-counter medicine.6 A taxpayer must be able to substantiate that the withdrawals were used for qualified medical expenses. Withdrawals from an HSA greater than amounts used for qualified medical expense are taxable, and an additional 20% penalty is applied to withdrawals before the taxpayer reaches age 65 that are not used for qualified medical expenses. The 20% penalty is waived upon the death or disability of the beneficiary. The HSA has no minimum required distributions.

Comparable aspects of traditional IRAs and Roth IRAs: Neither the traditional nor Roth IRA requires health insurance coverage of any kind, and certainly not HDHP coverage. On the other hand, both IRA types require service-related income (“compensation”), while an HSA can be used to reduce any type of taxable income. Contributions to either the traditional IRA or Roth IRA (or both) are limited to the lesser of $6,000 (in both 2021 and 2022) or taxable service-related compensation. An additional $1,000 is allowed for contributions to the IRA account(s) by taxpayers who are age 50 by the end of the tax year, five years younger than the 55 required for the $1,000 addition for an HSA.

Like contributions to an HSA, contributions to a traditional IRA generally are deductible by taxpayers. It is also possible to structure excludable employer contributions on behalf of employees under separate rules for a Sec. 408(k) SEP IRA or a Sec. 408(p) SIMPLE IRA. However, taxpayers with an employer-provided retirement plan (e.g., Sec. 401(k)) can only deduct their IRA contribution if they have modest amounts of income. Specifically, for these taxpayers, the traditional IRA contribution deduction completely phases out in 2022 when modified adjusted gross income (MAGI) reaches $78,000 for single or head-of-household taxpayers, $129,000 for married-filing-jointly taxpayers, or $10,000 for married-filing-separately taxpayers.

Contributions to a Roth IRA are not deductible, in contrast with contributions to both an HSA and a traditional IRA. Also, for Roth IRAs, contributions are generally disallowed for higher-income taxpayers. In 2022, the amount a taxpayer can contribute to a Roth IRA is completely phased out when MAGI reaches $214,000 for a married-filing-jointly filer, $144,000 for a single or head-of-household filer, or $10,000 for a married-filing-separately filer.7

Withdrawals from a traditional IRA are taxable. Furthermore, a 10% additional tax on early distributions applies to amounts withdrawn before the taxpayer reaches age 59½. Withdrawals from a Roth IRA are not taxable and not subject to the 10% additional tax on early distributions if they are made after the taxpayer reaches age 59½ and the taxpayer has had a Roth IRA for at least five years. Withdrawals of contributions to a Roth IRA at any age are not taxable or subject to the 10% additional tax on early distributions. However, withdrawals of earnings from a Roth IRA generally are taxable and may be subject to the 10% additional tax on early distributions unless one of several exceptions applies.

Table 3 (below) compares basic features of traditional IRAs, Roth IRAs, and HSAs as investment vehicles.


Flexibility and tax benefits

Taxpayers with HSAs receive tax and flexibility benefits when they pay medical costs using non-HSA funds. The tax benefit arises because HSA withdrawals are tax-exempt income to the extent that they are supported by receipts for qualified medical expenses. The flexibility arises because the taxpayer can choose when to submit the receipts, accumulating them over time until the taxpayer chooses to make a tax-free withdrawal. Compared with either a traditional IRA or a Roth IRA, an HSA has the advantage that it accumulates tax-exempt income that can be withdrawn at any age, subject only to the requirement that the taxpayer can submit receipts for qualified medical expenses.

1This article only summarizes, compares, and analyzes some of the key features of the HSA, traditional IRA, and Roth IRA tax-favored health and retirement savings vehicles. Other sources should be consulted for complete details, which could include related articles in The Tax Adviser and Tax Insider: Zonneveld, “Health Savings Accounts Can Save Taxpayers Money,” Tax Insider (Oct. 10, 2019); Mindy, “How to Make Sure an HSA Avoids ERISA,” Tax Insider (Sept. 28, 2017); Doerrer and Trotta, “Developing a Solid Approach to Advising Clients on Roth IRAs,” 51 The Tax Adviser 604 (September 2020); and Lott “Roth IRA Planning,” 47 The Tax Adviser 202 (March 2016).

2See Cautero, One Mom Shares How Much It Cost to Have a Baby With an HDHP,” Northwestern Mutual website (Oct. 21, 2020).

3Details of the M and J computations can be viewed here.

4Details of the B and G computations can be viewed here.

5Practitioners should discuss with the clients the possible downsides of not enrolling in Medicare Part A, which are beyond the scope of this article.

6Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, Sec. 3702, Sec. 223(d)(2).

7It is possible to circumvent Roth income limitations using a so-called backdoor Roth conversion strategy where the taxpayer contributes to a traditional IRA and, by the end of the tax year, the traditional IRA is rolled into a Roth IRA so that no balance remains in any traditional SEP or SIMPLE IRA account at year end. Details of this strategy are beyond the scope of this article.

Contributor

Jeffrey Gramlich, Ph.D., is a professor of accounting at Washington State University in Pullman, Wash. He is also the director of the Hoops Institute of Taxation Research and Policy. For more information about this article, contact thetaxadviser@aicpa.org.

 


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January 13, 2022

Importance of purchase price allocation in real estate transactions

By Jennifer M. Ray, CPA, Frazier & Deeter LLC, Tampa, Fla.

December 1, 2021

The bright pink house for sale was an eye-catcher. Built in the 1960s, this not-really-updated two-bedroom, one-bath house was purchased in 2001 for $100,000. In 2019, the asking price was $300,000, but it did not sell. Fast forward to 2021, and during a pandemic, the same house sold for $400,000. Could this little gem of construction really have increased so much in value in a couple of years? Or possibly was it the fact that it was on an extra-wide waterfront lot?

Suppose that this pink house was an income-producing property for the seller. When the property was originally acquired, the purchase price would have been allocated between the land and the building so that the building could be depreciated. Typically, in this situation the owner wants to be able to allocate as much purchase price as possible to the building so that the cost can be recouped (albeit ever so slowly) by depreciation. Often, this allocation is an afterthought and is done using the 20/80 rule of thumb (20% of the purchase price to the land and 80% of the purchase price to the building).

To calculate the gain on a sale, the same principle applies — the sales price needs to be allocated between the land and the building. Again, this allocation is typically done as an afterthought and, quite frankly, at the time the return is being prepared, potentially more than 1½ years after the sale. Here is where tax practitioners have a responsibility to advise their clients as to the significance of the land/building value allocation and what it means to the client’s tax bill.

Depreciable real estate, whether residential or commercial, that is used in a trade or business is Sec. 1231 property. The sale of Sec. 1231 property results in taxation at capital gain rates if there is a gain and ordinary income rates if there is a loss. Property owners are typically aware of the favorable tax rates they are allowed upon sale, but just like the rules of grammar, there is usually an exception to the rule. For depreciable real estate, the exception is in Sec. 1250, which provides that to the extent of depreciation taken (or allowed), the gain on the real estate sale is taxed at ordinary rates up to 25%. Depreciable real property is taxed at 25% up to the amount of depreciation taken and then taxed at capital gain rates. On the other hand, land is also Sec. 1231 property, but because it is not eligible for depreciation, it is not Sec. 1250 property.

To return to the little pink house on the extra-wide waterfront lot, which this analysis supposes is rental property: This more-than-50-year-old house was sold for four times its purchase price 20 years after acquisition. The tax practitioner likely did an easy 20/80 allocation to establish the house value for depreciation purposes. It would be easy enough to do the same for the sale and call it a day. The firm has other returns to get done, and this is just one more it can check off its list.

Under this approach, gain would be calculated on the sale first by allocating $320,000 of sale proceeds to the house and $80,000 to the land. Remember that the initial purchase price of $100,000 was allocated $80,000 to the house and $20,000 to the land. Assuming no closing costs and $60,000 of accumulated depreciation (for ease of calculation), the Sec. 1250 gain is $60,000 and the Sec. 1231 gain is $300,000 ($240,000 for the house and $60,000 for the land). Using the maximum capital gain rate, the tax on the sale is $75,000 (Sec. 1250 gain of $15,000 ($60,000 × 25%) and Sec. 1231 gain of $60,000 ($300,000 × 20%)). But is this really in the client’s best interest? Remember, it is the tax practitioner’s responsibility to advocate for the client.

In reality, the purchaser of this property has little to no interest in the ’60s-style pink house. The real value of this property lies in the large waterfront lot (sunsets included). With this in mind, a tax practitioner can rethink the purchase price allocation of the $400,000 sale proceeds and potentially allocate $20,000 to the house and $380,000 to the land. Using this method, the gain on the house is $0, and the entire $360,000 gain ($380,000 — $20,000) is on the land at capital gain rates. The resulting tax is $72,000 ($360,000 × 20%), a $3,000 cash-in-pocket savings over the 20/80 allocation method. Not only has the tax practitioner saved the client $3,000 (possibly more than the cost of the invoice), but he or she is also a tax hero, bound to receive numerous referrals from a happy client.

Note that it is important to properly document the allocation of value between the building and the land. Ideally, an appraisal would separately state the land and building values. Often, the tax practitioner finds out about a sale after the fact, and such an appraisal is not practical. In this case, the practitioner may look to the county tax assessor’s allocation, the advice of a knowledgeable real estate professional, or even an estimated replacement cost for the building (see Meiers, T.C. Memo. 1982-51).

In a year when real estate prices are soaring in many areas of the country, these easily overlooked allocations can have a significant tax impact. The above example is a relatively small dollar amount for real estate, and the tax savings could easily be multiplied for larger, more valuable properties. By using the proper land/building value allocation, tax practitioners can continue to do their best for clients.

EditorNotes

Todd Miller, CPA, is a tax partner at Maxwell Locke & Ritter in Austin, Texas.

For additional information about these items, contact Todd Miller at 352-727-4155 or taxclinic@cpamerica.org.

Contributors are members of or associated with CPAmerica Inc.


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January 11, 2022

Minimizing a hobby loss issue by electing S status

Editor: John Baer, CPA

December 1, 2021

If an activity is not engaged in for profit, the “hobby loss” rules of Sec. 183(a) provide that deductions in excess of gross income are not allowable. This statute specifically applies to activities engaged in by both individuals and S corporations. Accordingly, the mere form of conducting business is not the determinative factor in the hobby loss issue.

Due to the suspension of miscellaneous itemized deductions in the years 2018 through 2025, deductions for hobby expenses under Sec. 183 are not allowed in those years (Sec. 67(g), as added by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97). The inability of a taxpayer to deduct even a portion of the hobby expenses while recognizing all the hobby income in adjusted gross income makes establishing a profit motive for a hobby activity even more desirable.

The question of whether an activity is engaged in for profit involves a series of subjective interpretations regarding the business. The regulations list nine relevant factors to consider when determining whether an activity is engaged in for profit (Regs. Sec. 1.183-2(b)):

  • The manner in which the taxpayer carries on the activity, including such formalities as maintaining books and records;
  • The expertise of the taxpayer or his or her advisers;
  • The time and effort expended by the taxpayer in carrying on the activity;
  • An expectation that assets used in the activity may appreciate in value;
  • The taxpayer’s success in carrying on other similar activities;
  • The taxpayer’s history of income or losses with respect to the activity;
  • The amount of occasional profits that are earned;
  • The financial status of the taxpayer; and
  • The elements of personal pleasure or recreation involved with the activity.

Planning tip: Although an activity must be engaged in for profit to avoid the hobby loss rules, a predictable or highly probable expectation of profit is not required. For example, a taxpayer may well have a profit motive for investing in a very risky venture (e.g., wildcat oil and gas drilling or providing capital to startup businesses). The circumstances should indicate that the taxpayer entered into or continued the activity with the honest objective of making a profit, but even risky investments can be considered made for a profit motive.

The following example illustrates planning devices that can be used to reduce the chances that a hobby loss issue will arise.

Example. Planning to avoid the hobby loss issue: G owns a highly successful auto repair business that he operates in partnership with brothers N and J, who are unrelated to G. As a separate activity, G maintains several racing cars he enters in competitions on evenings and weekends. G’s auto racing activities have been increasingly successful, and last year he won prize money of about $10,000. He reports this activity on a Schedule C, Profit or Loss From Business, within his Form 1040, U.S. Individual Income Tax Return. Despite the increasing gross receipts of this proprietorship, the operating expenses, travel costs, and depreciation on several racing vehicles have resulted in large losses for the venture.

G expects his auto racing winnings to continue to increase, but he also recognizes that the deductions will continue to exceed the income for the next several years. He visits his tax practitioner and inquires whether he can minimize the risk of a hobby loss attack in case of an IRS audit. Will an S election assist in preventing a hobby loss determination?

If G’s car racing proprietorship was determined by the IRS not to have a sufficient profit motive, he would only be allowed to claim deductions to offset the gross income and would not be allowed to claim a loss within his personal tax return. In making this determination, the subjective factors listed above must be considered.

The first of these factors is clearly enhanced when a taxpayer conducts the activity in a business-like fashion, maintaining a separate checking account, accurate business records, and the other formalities normally associated with a for-profit trade or business. If G incorporates, he would be required to use a separate corporate checking account for the car racing activity and file a separate S corporation tax return. He would probably also become involved in the payroll tax system by issuing a Form W-2, Wage and Tax Statement, for the labor he provides to the corporate activity.

At a minimum, the existence of the S corporation would enhance the business-like appearance of the activity. In fact, by using the additional procedures associated with the formation of a corporation and expanding his recordkeeping requirements, G would likely improve his ability to meet the various subjective tests that go into the determination of a hobby loss issue. However, G must clearly understand that the mere formation of an S corporation provides no direct statutory assurance of overcoming the hobby loss question; the courts have held that losses incurred by an S corporation are deductible by the shareholders only if the corporation is in fact engaged in a for-profit trade or business (DuPont, 234 F. Supp. 681 (D. Del. 1964); Demler, T.C. Memo. 1966-117).

The tax practitioner would also advise G of the other advantages and disadvantages associated with S corporation status. For example, any salary G draws from the corporation for his labor would present additional Federal Insurance Contributions Act and Federal Unemployment Tax Act costs that would not exist in a proprietorship.

This case study has been adapted from the Checkpoint Tax Planning and Advisory Guide‘s S Corporations topic. Published by Thomson Reuters, Carrollton, Texas, 2021 (800-431-9025; tax.thomsonreuters.com).

Contributor
John Baer, CPA, is a specialist editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org

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January 7, 2022

IRS issues information letters to Advance Child Tax Credit recipients taxpayers should hold onto letters to help the 2022 Filing Season experience

IR-2021-255, December 22, 2021

WASHINGTON — The Internal Revenue Service announced today that it will issue information letters to Advance Child Tax Credit recipients starting in December and to recipients of the third round of the Economic Impact Payments at the end of January. Using this information when preparing a tax return can reduce errors and delays in processing.

The IRS urged people receiving these letters to make sure they hold onto them to assist them in preparing their 2021 federal tax returns in 2022.

Watch for advance Child Tax Credit letter

To help taxpayers reconcile and receive all of the Child Tax Credits to which they are entitled, the IRS will send Letter 6419, 2021 advance CTC, starting late December 2021 and continuing into January. The letter will include the total amount of advance Child Tax Credit payments taxpayers received in 2021 and the number of qualifying children used to calculate the advance payments. People should keep this and any other IRS letters about advance Child Tax Credit payments with their tax records.

Families who received advance payments will need to file a 2021 tax return and compare the advance Child Tax Credit payments they received in 2021 with the amount of the Child Tax Credit they can properly claim on their 2021 tax return.

The letter contains important information that can make preparing their tax returns easier. People who received the advance CTC payments can also check the amount of their payments by using the CTC Update Portal available on IRS.gov.

Eligible families who did not receive any advance Child Tax Credit payments can claim the full amount of the Child Tax Credit on their 2021 federal tax return, filed in 2022. This includes families who don’t normally need to file a tax return.

 


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January 5, 2022

After decreasing two years in a row, the rate by which taxpayers may compute their deductions for costs of using an automobile for business purposes will go up to 58.5 cents per mile for the 2022 tax year, an increase of 2.5 cents per mile over the 2021 rate.

Notice 2022-03, in which the IRS announced the update on Friday, also provides the standard mileage rate for use of an automobile for purposes of obtaining medical care under Sec. 213, which will be 18 cents per mile, up 2 cents from 2021. The rate for providing services to a charitable organization remains the same, set by statute at 14 cents per mile (Sec. 170(i)).

The same rate as for medical care, 18 cents per mile, also applies to the deduction for moving and storage expenses under Sec. 217(g) by members of the armed forces on active duty who move pursuant to a military order and incident to a permanent change of station.

Taxpayers may use the business standard mileage rate for their use of an automobile as an ordinary and necessary business expense. Or they may claim actual allowable expense amounts if they substantiate the expenses, including by maintaining adequate records or other sufficient evidence.

The Tax Cuts and Jobs Act (TCJA), P.L. 115-97, suspended for tax years 2018 through 2025 the miscellaneous itemized deduction under Sec. 67 for unreimbursed employee business expenses, including those incurred in the use of an automobile. However, the business standard mileage rate can still be used during this period as the maximum amount an employer can reimburse an employee for operating an automobile for business purposes without substantiating the actual expense incurred.

The portion of the business standard mileage rate that is treated as depreciation for purposes of calculating reductions to basis will be 26 cents per mile for 2022, the same as for 2021.

Notice 2022-03 also provides the maximum standard automobile cost under a fixed-and-variable-rate (FAVR) plan of $56,100 for automobiles (including trucks and vans), up $5,000 from 2021. Under a FAVR plan, a standard amount is deemed substantiated for an employer’s reimbursement to employees for expenses they incur in driving their vehicle in performing services as an employee for the employer. The same amount also applies as the maximum fair market value of automobiles (including trucks and vans) first made available in calendar year 2022 for purposes of the fleet-average valuation rule in Regs. Sec. 1.61-21(d)(5)(v) and the vehicle cents-per-mile rule under Regs. Sec. 1.61-21(e).

The rates (other than for charitable mileage) are determined as the result of an annual study by an independent contractor that analyzes fixed and variable costs of operating an automobile, the notice stated.

— To comment on this article or to suggest an idea for another article, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.