2012 December Year-End Tax Planning

Transcription

1 PC Kevin E. Branson, CPA John A. Letourneau, CPA Debra K. Mason, CPA/CFE, CFE Erich R. Lamirand, CPA Cindy L. Hulquist, CPA Ronald E. Greisen, CPA/ABWCFF 2012 December Year-End Tax Planning Dear Clients & Friends: Year-end tax planning is always complicated by the uncertainty that the following year may bring and 2012 is no exception. Indeed, 2012 is one of the most challenging in recent memory for year-end tax planning. A combination of events - including possible expiration of some or all of the "Bush-era" tax cuts after 2012, the imposition of new so-called Medicare taxes on net investment income and wages / earned income, doubts about renewal of tax extenders, and the threat of massive across-the-board federal spending cuts - have many taxpayers asking how can they prepare for 2013 and beyond, and what to do before then. The short answer is to quickly become familiar with expiring tax incentives and what may replace them after 2012 and to plan accordingly. "Bush-era" tax cuts - The phrase "Bush-era" tax cuts is the collective term for the tax measures enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). EGTRRA and JGTRRA made over 30 major changes to the Tax Code that are scheduled to sunset at the end of Nothing adds complexity to year-end 2012 tax planning as much as uncertainty over the Bushera reductions to individual tax rates. The 2010 Tax Relief Act extended the reduced individual income tax rates from the Bush-era tax cuts. Unless extended further, the reduced individual income tax rates will disappear after 2012 to be replaced by higher rates. The current 10, 15, 25, 28, 33 and 35 percent rate structures would be replaced by the higher pre-bush 15, 28, 31, 36 and 39.6 percent rates. Unless Congress takes action, the tax rates on long-term capital gains and qualified dividends are also scheduled to increase significantly after 2012~ The current favorable rates of zero percent for taxpayers in the 10 and 15 percent brackets and 15 percent for all other taxpayers will be replaced by pre-2003 rates of 10 percent for taxpayers in the 15 percent bracket and a maximum 20 percent rate for all others. In addition, dividends will be subject to the ordinary income tax rates. The maximum rate on five-year property will be 18 percent (8 percent for those in the 15 percent bracket). 3.8 Percent Medicare Contribution Tax - Taking effect immediately on January 1, 2013, the Medicare surtax will be imposed on a taxpayer s "net investment income" (Nil) and will generally apply to passive income. The Medicare surtax also will apply to capital gains from the disposition of property. However, the Medicare surtax will not apply to income derived from a trade or business, or from the sale of property used in a trade or business. For individuals, the Medicare surtax is based on the lesser of the taxpayer s Nil or the amount of "modified" adjusted gross income (MAGI) (AGI with foreign income added back) above a specified threshold. The MAGI thresholds are: $250,000 for married taxpayers filing jointly or a surviving spouse; T.(907) F.(907) I 1400 West Benson Blvd. Suite 400, Anchorage, Alaska I

2 $125,000 for married taxpayers filing separately; and $200,000 for single and head of household taxpayers. Nil includes: Gross income from interest, dividends, annuities, royalties, and rents, provided this income is not derived in the ordinary course of an active trade or business; Gross income from a trade or business that is a passive activity; Gross income from a trade or business that trades in financial instruments or commodities; and Net gain from the disposition of property, other than property held in an active trade or business. Additional 0.9 Percent Medicare Tax - Also effective January 1, 2013, higher income individuals will be subject to an additional 0.9 percent HI (Medicare) tax. This additional Medicare tax should not be confused with the 3.8 percent Medicare surtax. The additional Medicare tax means that the portion of wages received in connection with employment in excess of $200,000 ($250,000 for married couples filing jointly and $125,000 for married couples filing separately) will be subject to a 2.35 percent Medicare tax rate. The additional Medicare tax is also applicable for the selfemployed. End of Payroll Tax Holiday - For the past two years, the employee s share of Social Security Taxes has been reduced from 6.2 percent to 4.2 percent (with comparable relief for the selfemployed). Under current law, that reduction is scheduled to expire after December 31, On January 1, 2013, the employee s share of Social Security taxes will revert to 6.2 percent; effectively increasing payroll taxes across the board. Alternative Minimum Tax - The alternative minimum tax (AMT) rates (26 and 28 percent on the excess of alternative minimum taxable Members of Western Association of Accounting Firms income over the applicable exemption amount) are not scheduled to change in However, exposure to the AMT may change as a result of the scheduled sunset of the regular tax rates. Because the determination of AMT liability requires a comparison between regular tax and AMT computations, the higher regular tax rates post-2012 may help lower AMT exposure by the same amount. However, taxpayers should not ignore the possibility of being subject to the AMT, as this may negate certain year-end tax strategies. For example, if income and deductions are manipulated to reduce regular tax liability, AMT for 2012 may increase because of differences in the income and deductions allowed for AMT purposes. As in past years, taxpayers are waiting to see if Congress will enact an AMT "patch" for The last patch, which provided for increased exemption amounts and use of the nonrefundable personal credits against AMT liability, expired after Personal Exemptio~lltemized Deduction Phase-outs - Higher income taxpayers may also be subject to the return of the personal exemption phase-out and these so-called Pease limitation on itemized deductions. Both of these provisions were repealed through However, they are scheduled to return after 2012 unless the repeal is extended. Revival of the personal exemption phase-out rules would reduce or eliminate the deduction for personal exemptions for higher income taxpayers starting at "phase-out" amounts that, adjusted for inflation, would start at $267,200 AGI for joint fliers and $178,150 for single fliers. In addition, return of the Pease limitation on itemized deductions (named for the member of Congress who sponsored the legislation) would reduce itemized deductions by the lesser of: Three percent of the amount of the taxpayer s AGI in excess of a threshold inflation- Associate Offices in: (]ellevue, Chico, Colusa, Eugene, Fresno, Laguna Hil~s, Palo Alto, Pasadena, Phoenix, Pteasanton, Portland, Rancho Cucamonga, Redding, Reno, San Francisco, and Westlake

3 adjusted amount projected for 2013 to be $178,150 ($89,075)for a married individual filing separately, or 80 percent of the itemized deductions otherwise allowable for the tax year. Education - American Opportunity Tax Credit. In 2009, Congress enhanced the Hope Education Credit and renamed it the American Opportunity Tax Credit (AOTC). The temporary enhancements, including a maximum credit of $2,500, availability of the credit for the first four years of post-secondary education, and partial refundability for qualified taxpayers, are scheduled to expire after Under current law, less generous amounts will be available with the revived Hope Education Credit. Coverdell Education Savings Accounts. Similar to IRAs, Coverdell Education Savings Accounts (Coverdell ESAs) are accounts established to pay for qualified education expenses. Under current law, the maximum annual contribution to a Coverdell ESA is $2,000, and qualified education expenses include elementary and secondary school expenses. Unless extended, the maximum annual contribution for a Coverdell ESA is scheduled to decrease to $500 after Employer-Provided Education Assistance. Under current law, qualified employer-provided education assistance of up to $5,250 may be excluded from income and employment taxes. However, the 2010 Tax Relief Act only made the exclusion available through Student Loan Interest. Individual taxpayers with MAGI below $75,000 ($150,000 for married couples filing a joint return) may be eligible to deduct interest paid on qualified education loans up to a maximum deduction of $2,500, subject to income phase-out rules. The enhanced treatment for the student loan interest deduction is scheduled to expire after Higher Education Tuition Deduction. The above-the-line higher education tuition deduction expired after The maximum $4,000 deduction was available for qualified tuition and fees at post-secondary institutions, subject to income phase outs. Other Tax Extenders for Individuals Taxpayers who claim the child tax credit need to plan for its scheduled reduction after Absent Congressional action, the child tax credit, at $1,000 per eligible child for 2012, will be $500 per eligible child, effective January 1,2013. Before 2012, qualified taxpayers could deduct state and local general sales taxes in lieu of deducting state and local income taxes. The 2010 Tax Relief Act last extended the optional itemized deduction for state and local general sales taxes, which had been available since 2004, to tax years 2010 and Unless extended again, the deduction for state and local general sales taxes will not be available for tax year 2012 and beyond. For the period 2007 through 2011, premiums paid for qualified mortgage insurance could be treated as qualified residence interest and deducted as an itemized deduction, subject to certain restrictions. Renewal of this tax break into 2012 is uncertain at this time. Two incentives, the residential energy property credit, and the residential energy efficiency credit, are designed to reward taxpayers who, on the consumer level, make qualified energy improvements. The residential energy property credit expired after The residential energy efficiency is scheduled to expire after Individual Tax Planning - Year-end planning for 2012 requires a combination of multi-layered strategies, taking into account a variety of possible scenarios and outcomes. Traditional year-end planning techniques nevertheless remain important. Particularly as applied to the special 2012 year-end circumstances discussed in this letter, the following income acceleration and reciprocal deduction / credit deferral techniques should be considered: Members of Western Association of Accounting Firms Associate Offices in: Bellevue, Ch{co, Colusa, Eugene, Fresno, Laguna Hills, Palo Alto, Pasadena, Phoenix, Pleasanton, Portland, Rancho Cucamonga, Redding, Reno, San Francisco, and Westlake T.(907) F.(907) I 1400West Benson Blvd. Suite 400, Anchorage, Alaska I

4 Income Acceleration: Sell outstanding installment contracts Receive bonuses before January Sell appreciated assets Redeem U.S. Savings Bonds Declare special dividend Complete Roth conversions Accelerate debt forgiveness income Maximize retirement distributions Accelerate billing and collections Avoid mandatory like-kind exchange treatment Take corporate liquidation distributions in 2012 Deductions/Credit Deferral: ~unch itemized deductions into 2013 / Standard deduction into 2012 Postpone bill payments until 2013 Pay last state estimated tax installment in 2013 Postpone economic performance Watch AGI limitation on deductions/credits Watch net investment interest restrictions Match passive activity income and losses In recent years, end-of-the-year tax planning for businesses has been complicated by uncertainty over the future availability of many tax incentives. This year is no different. In 2010, Congress extended many business tax incentives for one or two years. Now, those incentives have expired or are scheduled to expire. Whether they will be extended beyond 2012 is unclear as Congress debates the fate the Bush-era tax cuts and across-the-board spending cuts scheduled to take effect in In the meantime, you need to be aware of the expiring provisions and explore developing a multiyear tax strategy that takes into account various scenarios for the future of these incentives. Code Sec. 179 expensing - Code Sec. 179 gives businesses the option of claiming a deduction for the cost of qualified property all in its first year of use rather than claiming depreciation over a period of years. For 2010 and 2011, the Code Sec. 179 dollar limitation was $500,000 with a $2 million investment ceiling. The dollar limitation for 2012 is $139,000 with a $560,000 investment ceiling. Under current law, the Code Sec. 179 dollar limit is scheduled to drop to $25,000 for 2013 with a $200,000 investment ceiling. Businesses should consider accelerating purchases into 2012 to take advantage of the still generous Cod Sec. 179 expensing. Qualified property must be tangible personal property, which you actively use in your business, and for which a depreciation deduction would be allowed. Qualified property must be newly purchased new or used property, rather than property you previously owned but recently converted to business use. Examples of types of property that would qualify for Code Sec. 1"79 expensing are office equipment or equipment used in the manufacturing process. Additionally, Cod Sec. 179 expensing is allowed for off-theshelf computer software placed in service in tax years beginning before If your equipment purchases for the year exceed the expensing dollar limit, you can decide to split your expensing election among the new assets anyway you choose, if you have a choice, it may be more valuable to expense assets with the longest depreciation periods. As long as you start using your newly purchased business equipment before the end of the tax year, you get the entire expensing deduction for that year. The amount that can be expensed depends upon the date the qualified property is placed in service; not when the qualified property is purchased or paid for. Congress could raise the Code Sec.179 dollar limit and investment ceiling for In July 2012, the Senate voted to increase the Code Sec.179 dollar amount to $250,000 with an Members of Western Association of Accounting Firms Associate O~ces in: 8el(evue, Chico, Colusa, Eugene, Fresno, Laguna Hills, Palo A(to, Pasadena, Phoenix, Pleasanton, Portland, Rancho Cucamonga, Redding, Reno, San Francisco, and Westlake

5 $800,000 investment limitation for tax years beginning after December 31, The House voted to increase the Code Sec. 179 dollar amount to $100,000 with a $400,000 investment limitation for tax years beginning after December 31, Bonus depreciation - The first-year 50 percent bonus depreciation deduction is scheduled to expire after 2012 (2013 in the case of certain longer-production period property and certain transportation property). Unlike the Section 179 expense deduction, the bonus depreciation deduction is not limited to smaller companies or capped at a certain dollar level. To be eligible for bonus depreciation, qualified property must be depreciable under Modified Accelerated Cost Recovery System (MACRS) and have a recovery period of 20 years or less. The property must be new and placed in service before January 1, 2013 (January 1, 2014 for certain longer-production period property and certain transportation property). Businesses also need to keep in mind the relationship of bonus depreciation and the vehicle depreciation dollar limits. Code Sec. 280F(a) imposes dollar limitations on the depreciation deduction for the year a taxpayer places a passenger automobile in service within a business, and for each succeeding year. Code Sec. 168(k)(2)(F)(i) increases the firstyear depreciation allowed for vehicles subject to the Code Sec. 280F luxury-vehicle limits, unless the taxpayer elects out, by $8,000, to which the additional first-year depreciation deduction applies. The maximum depreciation limits under Code Sec. 280F for passenger automobiles placed in service by the taxpayer during the 2012 calendar years are: $11,160 for the first tax year ($3,160 if bonus depreciation is not taken); $5,100 for the second tax year; $3,050 for the third tax year; and $1,875 for each tax year thereafter. The maximum depreciation limits under Code Sec. 280F for trucks and vans first placed in service during the 2012 calendar year are $11,360 for the first tax year ($3,360 if bonus depreciation is not taken); $5,300 for the second tax year; $3,150 for the third tax year; and $1,875 for each tax year thereafter. Sport utility vehicles and pickup trucks with a gross vehicle weight rating in excess of 6,000 pounds are exempt from the luxury vehicle depreciation caps. New de minimis rule in repair regulations - Comprehensive repair and capitalization regulations issued by the IRS in late 2011 may open up a new planningopportunity. A new de minimis expensing rule allows a taxpayer to deduct certain amounts paid or incurred to acquire or produce a unit of tangible property if the taxpayer has an Applicable Financial Statement (AFS), written accounting procedures for expensing amounts paid or incurred for such property under certain dollar amounts, and treats the amounts as expenses on its AFS in accordance with its written accounting procedures. An overall ceiling limits the total expenses that a taxpayer may deduct under the de minimis rule. The de minimis expensing rule applies to amounts paid or incurred (to acquire or produce property) in tax years beginning on or after January 1, Let s look at an example. A taxpayer purchases 10 VolP phones for its business at $200 each for a total cost of $2,000. Each phone is a unit of property and is not a material or supply. The taxpayer has an AFS and a written policy at the beginning of the tax year to expense amounts paid for property costing less than $500. The taxpayer treats the amounts paid for the phones as an AFS. Assume further that the total aggregate amount treated as de minimis and not capitalized, including the amounts paid for the phones, are less than or equal to the greater of 0.1 percent of total gross receipts or 2 percent of the taxpayer s total financial statement depreciation. The result: the de minimis rule applies and the taxpayer is not required to capitalize any portion of the $2,000 paid for the 10 phones. Dividends - Under current law, favorable tax rates on qualified dividends are scheduled to expire after Qualified dividends currently are eligible for a maximum 15 percent tax rate for taxpayers in the 25 percent and higher brackets; Members of Western Association of Accounting Firms Associate Offices in: Bellevue, Chico, Corusa, Eugene, Fresno, Laguna Hills, Palo Alto, Pasadena, Phoenix, Pleasanton, Portland, Rancho Cucamonga, Redding, Reno, San Francisco, and Westlake T.(907) F.(907) I 1400West Benson Blvd. Suite 400, Anchorage, Alaska I

6 zero percent for taxpayers in the 10 and 15 percent brackets. In July, the House voted to extend the current dividend tax treatment though The Senate, however, voted to extend the current tax rates only for individuals with incomes below $200,000 (families with incomes below $250,000). For income in excess of $200,000 / $250,000 the tax rate on qualified dividends would be 20 percent. If Congress takes no action, qualified dividends will be taxed at the ordinary income tax rates after 2012 (with the highest rate scheduled to be 39.6 percent not taking into account the 3.8 percent Medicare contribution tax for higher income individuals). Qualified corporations may want to explore declaring a special dividend to shareholders before January 1, Expiring business tax incentives - Many temporary business tax incentives expired at the end of In past years, Congress has routinely extended these incentives, often retroactively, but this year may be different. Confronted with the federal budget deficit and across-the-board spending cuts scheduled to take effect in 2013, lawmakers allow some of the business tax extenders to expire permanently. Certain extenders, however, have bipartisan support, and are likely to be extended. They include the Code Sec. 41 research tax credit, the Work Opportunity Tax Credit (WOTC), and 15-year recovery period for leasehold, restaurant and retail improvement property. Small Employer Health Insurance Credit - A potentially valuable tax incentive has often been overlooked by small businesses, according to reports. Employers with 10 or fewer full-time employees (FTEs) paying average annual wages of not more than $25,000 may be eligible for a maximum tax credit of 35 percent on health insurance premiums paid for tax years beginning in 2010 through Taxexempt employers may be eligible for a maximum tax credit of 25 percent for tax years beginning in 2010 through The credit is subject to phase-out rules. The credit is reduced by percent for each FTE in excess of 10 employees. The credit is also reduced by four percent for each $1,000 that average annual compensation paid to the employees exceeds $25,000. This means that the credit completely phases out if an employer has 25 or more FTEs and pays $50,000 or more in average annual wages. Let s look at an example. A for-profit employer has 10 FTEs and pays average annual wages of $25,000 in tax year The employer s qualified employee health care costs for tax year 2012 are $70,000. The employer s credit is $24,500 ($70,000 x 35 percent). The credit is scheduled to climb to 50 percent of qualified premium costs paid by for-profit employers (35 percent for tax-exempt employers) for tax years beginning in 2014 and However, an employer may claim the tax credit after 2013 only if it offers one or more qualified health plans through a state insurance exchange. Planning - Today s uncertainty makes doing nothing or adopting a wait and see attitude very tempting. Instead, multi-year tax planning, which takes into account a variety of possible scenarios and outcomes, should be built into your approach. Please contact our office for more details on developing a tax strategy in uncertain times that includes consideration of certain tax-advantaged steps that may be taken before year-end Members of Western Association of Accounting Firms Associate Offices in: Bellevue, Chico, Colusa, Eugene, Fresno, Laguna Hills, Palo Alto, Pasadena, Phoenix, Pleasanton, Portland, Rancho Cucamonga, Redding, Reno, San Francisco, and Westlake

7 THOMAS, HEAD & GREISEN. c December 2012 Although we can t escape death or taxes, we may be able to minimize the federal income taxes due on our final Form Filing a tax return after we die (we are then known as the "decedent") is probably not something most of us think much about. But, a final Form 1040 generally must be filed for the year of our death and, just as in life, is typically due by April 15th of the following year. Normal tax accounting rules regarding the recognition of income and deductions generally apply for this final return. And, as is the case during life, tax planning opportunities are available both when death is imminent and after death. For instance, several decisions can affect the income or deductions reported on that final return. However, as we will discuss below, a major decision for married individuals concerns whether to file a joint return for the year of death. Filing Options for Your Final Form 1040 spouse remarries before the close of the tax year that includes the date of death, the spouse may not file jointly with the decedent. Instead, a separate return must be prepared for the decedent. Listed below are some of the advantages and disadvantages for joint tilers to consider when filing that final return. Advantages of Filing a Joint Return. Since the surviving spouse s tax )/ear does not end upon the death of the decedent, it may be possible to reduce their combined income tax liability by accelerating or postponing indome or de- When a married taxpayer dies and the surviving spouse does not remarry during the year, the spouse may file a joint return with the dece- ductions to maximize use of the joint tax rates. Some other benefits include, but are not limited dent for the year of death, but is not required toto: (a) use of one spouse s excess deductions do so. The joint return will include income andagainst the income of the other spouse (e.g., deductions for the decedent prior to the date of excess charitable contributions); (b) an increase death and the surviving spouse s income and in the IRA contribution limit (because of the deductions for the entire year. If the surviving (Continued on Page 2.) The information contained in this newsletter was not intended or written to be used and cannot be used for the purpose of (1) avoiding tax-related penalties prescribed by the lnternal Revenue Code or (2) promoting or marketing any tax-related matter addressed herein.

8 Maximizing the Deduction for Start-up Expenses... ndividuals starting a new business or ~,. acquiring the assets of an existing business often incur start-up expenses, which can be considerable, in the investigation and acquisition phase before actual business operations begin. Most start-up expenditures can be segregated into two broad categories: (a) investigatory expenses and (b) business preopening costs. Taxpayers can immediately deduct up to $5,000 of start-up expenses in the year when active conduct of a business begins. However, the $5,000 instant deduction allowance is reduced dollar for dollar by cumulative start-up expenses in excess of $50,000 for the business in question. Start-up expenses that cannot be immediately deducted in the year a business begins must be capitalized and amortized over 180 months on a straight-line basis. In many cases, start-up expenses for small businesses will be modest enough to qualify for immediate deduction under the $5,000 instant deduction allowance in the year when active conduct of business commences. Example: Claiming the deduction for startup expenses. Suzie (a calendar-year taxpayer) incurs $4,200 of start-up expenses in 2012 before opening her new car wash in November of Suzie s 2012 deduction is $4,200. Since her start-up expenses did not exceed $50,000, she can deduct the entire $4,200 in Note: A taxpayer is not considered to be engaged in carrying on a trade or business until the business has begun to function as a going concern and has performed the activities for which it was organized. Filing Options for Your Final Form 1040 (Conffnued from Page 1.) liabilities (e.g., tax on the surviving spouse s spousal IRA rules); and (c) the ability of the decedent s net operating loss (NOL), capital loss, unreported income). Potentially, this exposure and passive activity loss (subject to the limita- may be avoided because of the innocent spouse tion) carryovers to offset income of the surviving spouse. Note that any NOL or capital loss carryover of the decedent that is not used on the final return (whether separate or joint) will expire unuse& Disadvantages of Filing a Joint Return. Filing a joint return with the surviving spouse is not always the best option. One disadvantage of filing a joint return for the decedent s final tax is not the sole beneficiary of the estate, the decedent s personal representative may not be willing to expose the estate to potential unknown rules. Also, filing a joint return can negatively impact the amount of the decedent s deductions that are subject to adjusted gross income (AGI) limitations (e.g., medical, casualty, miscellaneous itemized) since AGI is based on joint income rather than separate income. Finally, the surviving spouse must cooperate with the decedent s personal representative by sharing the information necessary to prepare the return and by signing the return once it is prepared. year is that the decedent s estate and the surviving spouse are jointly and severally liable for Planning for that final 1040 is something we any tax, interest, and penalties due on the jointmay not think much about, but it is a good idea return. In addition, when the surviving spouseall the same.

9 Many taxpayers bought a second home, such as a vacation home, with the intention of later converting the second home into their principal residence. Under pre-2008 Housing Act law, those taxpayers could have excluded up to $250,000 ($500,000 for certain joint fliers) upon a later sale of that former vacation home as long as the ownership and use tests for the exclusion were satisfied. However, the Housing Act changed the method for recognizing post-2008 gain on the sale of a principal residence formerly used as a vacation or second home. Specifically, the revised rule makes a portion of the gain from selling the residence--the nonqualified use period--ineligible for the gain exclusion privilege. A property s nonqualified use period equals the amount of time after 2008 during which the property is not used as the taxpayer s principal residence. However, periods of nonqualified use don t include temporary absences that aggregate to two years or less due to changes of employment, health conditions, or certain other unforeseen circumstances; certain time periods after use as a principal residence; or certain time periods while on qualified official extended duty. Example 1: Nonqualified use leads to additional taxes. Floyd bought a vacation home in an exclusive area on January 1, On January 1, 2011, he converts the property into his principal residence, and he and his wife live there for all of 2011 and On January 1, 2013, he sells the home for a $450,000 gain. Floyd s total ownership period is eight years ( ). However, the two years of post-2008 use as a vacation home ( ) count against him and result in a nonexciudable gain of $112,500 (2/8 x $450,000). Floyd must report the $112,500 as capital gain income on his 2013 federal tax return and pay the resulting income tax. If Floyd files jointly, he won t owe any federal income tax on the remaining $337,500 of gain ($450,000 - $112,500) because it s completely sheltered by the $500,000 exclusion. Home Sale Gain Exclusion Restrictions for Second Homes Example 2: Nonqualified use has no impact. Sandy, a single person, bought a vacation home on January 1, On January 1, 2011, she converts the property into her principal residence and lives there for all of 2011 and On January 1, 2013, she sells the home for a $360,000 gain. Sandy s total ownership period is 12 years ( ), but the two years of post-2008 use as a vacation home ( ) result in a nonexcludable gain of $60,000 (2/12 x $360,000). Sandy can claim the $250,000 home sale gain exclusion against the remaining $300,000 ($360,000 - $60,000) gain, leaving a $50,000 taxable gain. The end result is that Sandy must report a total gain of $110,000 (the nonexcludable gain of $60,000, plus the $50,000 gain in excess of the home sale g~dn exclusion). Even before the new nonexcludable gain rule, Sandy would have had to report taxable gain of $110,000 ($360,000 - $250,000). Since the $110,000 gain that she would have had to report anyway exceeds the $60,000 nonexcludable gain, the new nonexcludable gain rule has no impact on Sandy. To minimize the amount of taxable gain from the sale of one of these homes, it is essential that taxpayers keep accurate records of all the money invested in home improvements (before and after it became the taxpayer s principal residence).

10 Save Taxes Using a Partial Annuity Exchange Variable annuity contract distributions generally contain two components, taxable income and nontaxable return of basis (investment). However, distributions received before the annuity starting date (nonannuity distributions) are likely to be less taxpayerfriendly. Initially, these nonannuity payments generally consist entirely of taxable income until all of the armuity contract s earnings have been distributed. Subsequent payments are considered to be a nontaxable return of basis. Because of this issue, when an annuity owner must take a nonannuity distribution, the tax impact can be onerous. Internal Revenue Code Section 1035 has traditionally provided a federal tax-free mechanism to exchange one annuity contract for another annuity contract. This Section 1035 exchm~ge, without recognition of gain or loss, is limited to cases where the person who is the insured or annuitant is the same in both contracts. Recent regulatory guidance offers a way to lessen the tax impact on nonannuity distributions using the Section 1035 exchange mechanism. A person holding a highly appreciated annuity (one containing a large amount of built-up earnings) can lessen the tax bite using a twostep process. First, he or she makes a partial withdrawal from the original annuity by completing a partial exchange into another annuity. Next, he or she surrenders eitlier am~uity contract more than 180 days later to minimize the tax impact. Example: Partial annuity exchange. Pat originally invested $50,000 in an annuity, which has now grown to a fair market value of $200,000. If she withdraws $100,000 from this annuity, the funds will come first from her gain and will be taxed as ordinary income. So, instead, Pat makes a Section 1035 (tax-free) exchange with half of the original annuity into a second annuity worth $100,000. Her basis in each annuity is split proportionally. Accordingly, she has a $25,000 tax cost (basis) in each $100,000 annuity after the partial Section 1035 exchange. If Pat surrenders one of the annuities in full more than 180 days after the date of the Section 1035 exchange, she receives a $100,000 distribution that is considered to be $25,000 return of basis and $75,000 of ordinary income. This is a better result than receiving $100,000 of ordinary income without the partial Section 1035 exchange. Observation: The new annuity contract(s) received in the partial exchange typically will have a fresh surrender charge period. For this reason, Pat should surrender the old annuity first rather than the new contract subject to the penalty. ~ The Tax attd Business Alert is designed to provide regarding the subject ing any significant the information c~ntaincd herein, please contact us l~r advice on how the information applies in your specific situation, Copyright 2012.