Personal Income Tax: Filing Status, What is Taxable, Deductions, Exemptions, Tax Shelters Preparing for the Coming Year
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It’s been said that death and taxes are the only certain things in life. Income tax – on all levels – is the government’s chief means of generating revenue. It is also the most complex of all subjects, due to confusing law verbiage and the vastness of the Internal Revenue Service Code which never seems to decrease in volume.
Forty years ago there were calls for simplification of the Code but in fact the opposite has happened. New tax credits, which reduce one’s tax liability dollar-for-dollar, increase every year, and don’t usually go away, while a large number of new credits may be added each year. It’s a complex annual obligation, one that most of us are subject to.
Will it ever get easier? How does the average person wade through the forms and jargon and regulations? The best place to begin to study income tax law is with the filing status. So let’s look at what the government gives us to work with. Refer to Pages 1 and 2 of Form 1040 on the following pages.
Even at this very beginning point, there is much complexity. There are five different filing statuses for which taxpayers are eligible and several are very confusing. The simplest is that of a single taxpayer, but that doesn’t necessarily mean never having been married or not married now. The status of single or married is always determined as of the last day of the tax year: if you were married on December 31 of any year, you are considered married for the entire year; if you are divorced as of December 31 of any year, you are considered single for that whole year.
Another complication pops up in community property states such as Wisconsin, my home state. In the absence of a marital property agreement prepared ahead of the year of divorce, the divorced couple will have to allocate the community income up to the date of divorce if they lived together any days of that year. These couples, including some who were my income tax students, have trouble with this calculation.
Secondly, a person married as of the last day of the year can claim the status of married filing jointly (MFJ) or they can elect to complete their return as married filing separately (MFS). However, in fully 99% of cases, it is almost always bad for the couple to file MFS because they lose many deductions and credits that would otherwise be available to them. It takes some real skill as a counselor to convince the couple that they are better of filing MFJ, regardless of their current marital status.
A fourth filing status is that of qualifying widow/er. For two years after a spouse dies, the taxpayer is eligible to file as a surviving spouse as long as he or she has a dependent child or stepchild living in the home. The qualifying widow/er must have been eligible to file a joint return with the decedent in the year of death and cannot remarry during those two years.
In the third year after a spouse’s death, the surviving spouse may qualify for head of household (HOH).
This is probably the most confusing filing status of all the preceding. First, the taxpayer must be unmarried as the last day of year. However, persons who are legally married may be considered unmarried if they have not lived together for the last six months of that year and if the home was the principal residence of a dependent child, grandchild, stepchild, or foster child. The taxpayer must be responsible for over 50% of the cost of that household, which includes food, mortgage payment, property taxes, rent, maintenance and utilities.
In a divorce situation, there might be an agreement which grants the HOH status to one of the parties, or to each party in alternate years. You must follow this agreement, especially if spelled out in the divorce decree. There is also an exception requiring that the dependent child must reside with the taxpayer for more than six months. The tax code allows a parent to be claimed as a dependent even if he or she lives in their own home or in a retirement/nursing home and you provide over 50% of their upkeep.
What is taxable and what is not?
After you get through complex filing status, the next issue you must deal with is what type of receipt is taxable and which is not. Almost all cash receipts are taxable – income, interest, dividends, net rents, self employment income, etc. The exceptions are actually few: gifts and inheritances are not taxable. Interest income derived from municipal obligations is free from federal income taxation.
Interest income from federal bonds is exempt from federal but is subject to state income taxes. There are some state bonds that are exempt from state income tax. Examples of this are Miller Baseball Park and Lambeau Field bonds issued to help fund the building of these stadiums.
Receipts of property are sometimes not taxable. Fringe benefits such as hospital insurance and medical reimbursement plans are almost always nontaxable. Retirement plans provided by employers are usually not currently taxable but will be later on when withdrawn. Awards for longevity and safety, if received in the form of property, and are relatively small in value, are tax free.
Certain kinds of income are taxed at different rates. Long-term capital gains (LTCG) and qualifying dividends are subject to special tax rates of 0 and 15%, while other income can be taxed as high as 35%. The best principle to follow in determining whether any type of receipt is taxable or not is to check the code and presume it is, if the code doesn’t say it isn’t. Confusing, isn’t it?
Deductions are many and diverse. Individuals are allowed a standard deduction or they can itemize. The standard deductions are dependent on one’s filing status and are as follows for tax year 2012:
You should note that the MFS and the Single standard deduction are identical and that each one is exactly . of the Married Filing Jointly.
|Filing Status||Standard Deduction|
In addition, if a taxpayer is blind and/or 65 years or older, they are entitled to one extra standard deduction for each situation: $1,150 for married and qualifying widow/er and $1,450 for unmarried.
Dependents can be claimed on another person’s tax return, especially in the case of divorced or single parents. They are entitled to a minimum standard deduction of $950 or earned income plus $300, whichever is larger. The basic standard deduction is limited to $5,950 and calculations cannot exceed that figure.
Instead of the standard shown above, if a taxpayer’s itemized deductions are larger, they should itemize. The itemized deductions consist of medical expenses (doctors, other health practitioners, medical supplies, transportation, medical insurance, and nursing home costs) in excess of 7.5% of an individual adjusted gross income; real estate taxes on all non-business real property; state and local income taxes, ad valorem4 non-business personal property taxes; foreign taxes; mortgage and investment interest; charitable contributions; casualty and thefts losses of non-business property in excess of 10% of the adjusted gross income; miscellaneous itemized deductions in excess of 2% of adjusted gross income (tax preparation and advice, employee business expenses, etc); miscellaneous itemized deductions not subject to 2% of adjusted gross income (gambling losses to the extent of gambling winnings).
In addition to the standard and itemized deductions, there are deductions for adjusted gross income. They include alimony, traditional IRA contributions; self-employment tax; self-employment health insurance; moving expenses; penalties imposed by financial institutions for premature withdrawal of certificate of deposits; health savings accounts contributions; student loan interest; tuition for higher education; and domestic production activities. They are sometimes called above-the-line deductions which are listed on the front of the Form 1040.
Taxpayers are allowed a personal exemption of $3,800 for 2012 if they are not claimed as a dependent on another person’s income tax return . In addition, they are allowed one exemption for their spouse if they file a joint return (even if they file MFS and that spouse has zero income) and for each qualifying dependent. There are two types of these dependents: the qualifying child or qualifying relative. A qualifying child must be (1) the taxpayer’s child, step-child, eligible foster child, sibling, stepbrother or stepsister, or descendant of any of them (niece or nephew); (2) younger than age 19 or a full-time student under age 24, or any age if permanently disabled; (3) had not provided more than 50% of their own support; (4) did not file a joint return except to claim a refund; and (5) not claimed as a dependent on another person’s tax return.
To be a qualifying relative,
- the person must not be a qualifying child of another Person;
- be a member of the taxpayer’s household for the entire year or be related to taxpayer (parent, grandparent, child, grandchild, niece, nephew, uncle, aunt but not cousins);
- have gross income less than $3,800 (the dollar amount of the dependent exemption);
- taxpayer must provide more than 50% of their support.
If a person operates an unincorporated business or rents real estate, they are allowed deductions from that gross income on schedules C, E, or F where will report the net income or loss from those activities. In some cases, there is an alternative minimum tax (AMT) imposed on certain taxpayers. If this tax exceeds the regular tax liability, the difference is added to that tax on a person’s 1040. A tax professional is the best resource to find out if AMT applies.
A tax professional is the best resource to find out if AMT applies to any return because the computations are confusing!
There are various credits subtracted from the regular and AMT liability. These include business credits for such actions as increasing your research expenditures, hiring persons who have high unemployment rates as a group, investing in low income housing, etc. These credits are nonrefundable but many have a provision of a one year carryback and a twenty year carryfoward.
That means if a tax liability is found to be zero, the taxpayer can “carry forward” the credit to a year in which they do have to pay. The credits can also “carry back” to prior years, which would mean filing an amended return. The credits can also “carry back” to prior years, which would mean an amended return. Amended returns must be filed by the regular due date (usually April 15) and an amount equal to 100–110%, of last year’s taxes, depending on income level, must be paid by the due date along with a Form 1040X.
They are also many personal credits most of which are nonrefundable and do not have carryback and carryfoward provisions. These include child, education, energy, and dependent care credits. These are nonrefundable. There is a credit for low income persons who have earned income and usually a qualifying child. This is a refundable credit.
Finally the taxpayer subtracts his or her withholding amounts and estimated tax payments from the remaining liability to arrive at the refund or tax due. As a person’s tax situation becomes more complex and they are not as comfortable preparing their own tax return, they should seek out a professional tax preparer. The preparer should also be an advisor on tax matters, suggesting ways to legally minimize one’s taxes but also assisting on issues with the Internal Revenue Service. They can be involved in audit situations and in resolving payment problems.
Tax payers should be aware that one of the best tax shelters available is their primary residence. Not only are the real estate taxes and the mortgage interest currently deductible if you itemize, but when the residence is sold, all or most of gain will not be taxed if the individual used the residence as his or her primary residence for two out of the last five years.
This transaction can be repeated every two years. In addition there is a way to make good money and avoid income taxes on the rent you receive: consider renting your primary residence. You would be able to deduct 100% of the real estate taxes and mortgage interest if you meet the following test: the home is rented for the greater of 14 days or 10% of days rented. For example, say you rent your home for one week to a niece while you attend a seminar.
Ten percent of that would be 7 days, less than 14, so you’re not eligible But if you rented it out for a year while you studied abroad, you would be. Examples of this strategy could include renting your home for large national sporting events, such as major golf tournaments or national-level swimming, diving, or track meets. You could probably charge at least $2,000 a week to the players, maybe $1,000 to $1,500 to the fans.
In addition, if you have a vacation home or a condo in some resort or seasonal area of the country, there is a way to move that location out of your estate if you have lived there for two years. You would pay a small gift tax if its value really exceeds the annual exclusion and $5,000,000 million equivalent credit. It is called a qualified personal residence trust. The calculation is a little strange but not impossible to do following a worksheet.
It is based on actuarial life expectancy when the personal residence trust is created and the age of person at the end of trust. The lower the current applicable interest rate is, the lower the value of the gift. If you outlive the trust, you will have to pay rent to whomever the house was transferred to, which could be your child or grandchild. The house would not be in your estate in either case, and you have effectively used the tax law to reduce the estate taxes.
Preparing for the Coming Year
IRS will mail each taxpayer a booklet of forms for the coming year late in the current year. However it will contain only those forms used in the prior year’s return. If your situation has changed and you find you need different forms, and if you file your own return non-electronically – by snail mail – you can access any forms you might need at IRS.gov.
Also most libraries have both federal and state forms available to the public. But if you find that your situation has changed enough to warrant a new filing status, more deductions, or different exemptions, or if you have moved, opened a business, taken on rental property, or any of the other situations outlined above, the best advice would be for you to consult a tax professional. If you still choose to complete your return on your own, at least have that professional check your work. Rather safe than sorry!