Bruce Norris is joined again this week by Susie Leivas. Susie is the CFO of Leivas Associates. She has been doing taxes for Bruce for many years and has gotten a lot of referrals from him and other real estate investors.
Sometimes when they change tax laws, they think something is going to be revenue-positive, and it does not turn out this way. One specific thing was when they changed capital gains to the equivalent of the highest personal rate. This generated way less revenue because these people decided not to sell anything. You have to be careful about this, and this is one of the things you have to consider when discussing the fiscal cliff. They talk about raising taxes and pulling a certain amount of money out of the system at a certain point, it will be revenue negative. You will have more tax per person and less total tax. This is why they have to be careful.
For capital gains, one of the topics that has to be on the chart for them is how we get more revenue. If you are in almost a zero tax bracket and you have a capital gain, it is zero. On the upper end, it is 15%. However, you cannot just say it is 15% because the money ends up on the front of the tax return. This increases adjusted gross income, and everything comes off of adjusted gross income. For some deductions, such as medical, the first 7 ½% of your adjusted gross income does not count. You can’t just say 15% because other things happen on your return when you throw more income on it. It could make your social security become taxable, you could lose some deductions, have alternative minimum tax. When a client asks Susie if they should sell a property or a stock, that requires a consultation. Susie said she is going to run the numbers since an off the top of her head answer is not good enough. This also means extra California tax since there is no capital gain on the state side.
Bruce wondered when social security is taxable and if it varies with age. Susie said it does not vary with age but rather how much money you have. If you are a single person whose total income is under $25,000, that social security is not taxable. However, once you have a pension or a part-time job, this can be taxable. Another thing that really throws it off is gambling. What happens with gambling is you put the winnings on the front of your return, making your income higher. This can then make your social security taxable. You also have to be able to itemize your deductions. Often when someone is not itemizing, they do not receive the deduction for the loss. The moral of the story is if you are going to gamble, gamble little.
Regarding interest deductions, a long time ago we were writing off interest on credit cards. The Holy Grail of interest deductions is the real estate ones, which they keep talking about being changed. It used to be unlimited, then it was changed to $1 million dollars on a residence. It was unlimited on rental properties as long as the money was for the rental property. This will most likely not change, although there has been talk on the residence side. Bruce wondered if second-home deductible interest is still deductible. Susie said this actually goes under the umbrella of $1 million.
Bruce also asked about charity deductions. If you have a basket of deductions that is $25 grand, that could be a very significant thing if it took out charity. Susie said she can’t imagine the lobbyists will allow this to happen. She can see in her practice just with everyone being a little less liquid that where they are making up the difference is they are giving less to charity. This is already a problem, so she can’t imagine this would totally go away. Our economy relies on the nonprofits in a lot of ways, so if the nonprofits really did not have the funds to function and handle a lot of the social things that they do, it would be an expense to the government. Most of this is funded by folks raised by these values. It could be a really low-income family that was raised to tithe 10% and have this value system. There are some folks that make a lot of money and don’t give it away. If you are going to tax people who make all this money, then they are probably not going to have the desire to give the rest of it away.
Bruce and Susie talked off-air about sale of a residence, which Bruce was surprised even existed. He made a phone call to the late Robert Bruss who was the brightest person he knew. Bruce was wondering how many states could ever take advantage of it, so it seemed like lobbyists from five different states tried to sneak it in since it would be helpful to them. It is still in place and will most likely not go away. When you start thinking about it or live in one of the states where it may be possible, it’s not a bad way to go. Susie has some younger folks, some in the construction industry, and she has always shared with them how it would be a lovely way to accumulate wealth tax-free.
The idea is to acquire a home in a decent neighborhood, live in it, fix it up for two years, and sell it. A single person could pocket $250,000, while a married couple could pocket $500,000. In the old days there was a requirement to repurchase, which is not the case now. You can put the money in your pocket tax-free and go repeat the process every two years. In the old days it was a one-time thing, and you had to be 55 or buy a more expensive house. It’s a radical change and why when Bruce looked at it he saw it as a game-changer and a ticket to make a quarter-million dollars a year free. What is interesting is that this is your home and is personal, and not too many people want to move every two years.
One of the things that is facing a fair amount of investors and owner-occupants is they have had short sales. The owner-occupant has been under one set of rules until December 31, and the investor has not been under that same set of rules. Bruce asked Susie if she saw some surprised faces in her tax year when they realized they had a tax bill. Susie said this is usually before the transaction happens that she sees their surprised faces. Susie talks real estate a lot, and was talking about it before a lot of the things happening now even started. She has done some planning before so people can decide if they were going to let something go and what the tax ramifications would be. She would show them what it would require them cash-flow wise to do regards to making payments versus letting it go. There are a couple code sections, although the one for personal residences is too sudden-set. At every seminar she has attended they have talked about this one being extended.
There are two other code sections that can really be used. One is if you can show that you are insolvent to the extent of the debt or filed bankruptcy. These are two options, but unfortunately the investor often is not insolvent when you look at retirement assets recorded in the mix. Typically they don’t want to do bankruptcy, so they are looking at a tax bill. Getting a tax bill you expect is one thing, but getting a tax bill when you are going to go off on your own and do something may require you to have an advisor. Bruce had his first audit when he did not have Susie on his team, and his IRS agent looked at all the things he had done. The agent saw how many properties he had done and thought he must be a dealer. He thought it was a compliment, but later realized this was not a good thing.
Bruce was surprised that a bankruptcy could do away with an IRS lien. Susie said it is not necessarily a lien, but a cancellation of debt. If the debt is included in the bankruptcy, then it does not become taxable. Bruce also wondered if there was any talk about messing with 1031 exchanges, which Susie said she has not heard. This would be nice to be left alone.
Bruce gave an example of you going for a deal to sell your home every two years and exceeding the number. For example, if your house sells for a $400,000 profit, the $250 is free and the $150 is long-term capital gain. We just don’t know right now what long-term capital gain will be. If you are single and over the $200 or married and over the $250, you will have that additional 3.8% on top of your tax rate that looks to be increasing. You really have to make some tax-free income to deal with some of this. This will really be a viable strategy because you know the one bucket that will be taxed to death, so you want to have at least some bucket not get taxed at all. The blended thing is we are back to where we were.
The really important thing about any of the changes is that you usually have to change you game plan, but there at least is usually a game plan to pursue. Bruce wondered if it does not force investments in directions that it would not otherwise go. Susie said the talk in her office is the Roth conversion, which has been talked about for a very long time. Not a lot of people have been taking advantage of this because not too many folks either have the cash flow to pay the tax or are willing and trusting enough to pay the tax. She thinks the IRS really thought they were going to see quite a number of these. She was at a financial conference recently, and the question was raised about how many clients were doing these conversions. Not too many clients are doing these, and then they changed it and asked how many advisors were doing conversions. Not a hand went up, and when they started asking the audience why they weren’t doing it when you can see that it makes sense, there are not too many people who want to give up the money and trust that if they do it will remain non-taxable.
This is a scary sentence since this was the deal, and you really don’t want to think your government can do this to you. Susie said she personally does not feel this way and if you do a ROTH conversion, you will be fined. Every time you hear people talk about Social Security running out of money, this cannot happen. We already know they don’t have any money, so they will just figure it out another way. There is no way to make this fall apart, and Susie said she feels the same way about ROTH. However, Bruce said he has heard these suspicions and sees how this would be a major breach of trust. He would not want to be the person making this decision since this would be basically theft, which you cannot do to too many people without somebody being really unhappy.
Bruce said every year Susie does his taxes there is an odd line that is called alternative minimum tax that sneaks off with some more money for reasons he can’t explain. Susie said the reason for this is it is a lovely little loop. They only want you to get your tax bill so low. Following every deduction legally, if you get too much of a good thing they will still limit you. This is one of the scary things out there on this whole fiscal cliff that needs to be fixed. Every year they have been fixing it to where it has been affecting some people, but not to the extent the law was written. She would imagine they will fix it again, but what is interesting is they have not permanently fixed it. They keep doing this patch work. Everybody thinks they will repair it again, but we will have to see. However, it is not as significant as people think it is. Bruce said in just the last three years he has paid $45,000 to that cause. It really adds up after a while, and there is only so much you can do about it. Bruce does not just pretend to understand the formulas and sit there trying to figure out what he can avoid and why.
Bruce asked if there were any smart year-end tax moves. Susie said it is the opposite of what you have always been told. In all the years, Susie has always told Bruce to put off taking income if he can and pay as many bills now as you can in order to get your taxable income as low as possible. This year is the exception where we are going to do the opposite. She said she would make sure all her clients paid her before December 31, and she will not be aggressive in her spending. One thing business owners might consider if they are in a business that has a lot of equipment, such as a backhoe operator, is that the big piece of equipment still might be a nice idea since we have the bonus depreciation.
The Section 179 is still up in the air, and we don’t know what number it will land on right now for 2012. However, we do know the bonus depreciation is still there. This means you can take 50% of the purchase price and write it off. There is also some bonus depreciation on an automobile, but they would have to do two radio shows just on this topic since it would really depend on how much your vehicle weighs and how much you use it.
Regarding setting aside money when you are trying to retire, Bruce wondered if the rules are going to change. For example, for what he makes right now Bruce could set aside 25%. Susie said the numbers are out and they have all inched up by about $500 as far as the maximum contribution. She does not think they are going to take them away. It would make more sense if they were more aggressive to allow them to fund more. Forget about Social Security and plan for your own retirement. It would make sense for them to put in some additional incentives. For the very low income people, there is a credit to fund their pension plans. She does not know the limit and does not see it too often since it is the lower income client. However, she would think they would incent us to do these things.
When you are working for somebody else, Bruce thought there was a small amount of money, such as a $2500-$7500 maximum. Susie said this applies for a 401k, and this number also changes every year. It is right now in the $15,000 range and has inched up another $500. Bruce has friends who every once in a while talk about setting ¼ million dollars because of their age in a year. It is just like this massive funding of this program late in the game. Once you’re 50 there are catch-up provisions, but it is not that big. This is what they have been telling him, although it does not necessarily mean it’s right. If you are told something wrong by an advisor or even the IRS, you still have liability. If you call the IRS and they tell him to do something wrong, it is still on you. You may be able to get out of the penalty, but you are definitely not getting out of the tax.
Bruce asked how he could set aside money for his grandkids’ education. He wondered how it was not taxable to them and if it was ever deductible to him. There are three easy ways. The most common one right now is the 529 plan. That one is not deductible for Bruce and gets to grow up in their account tax free provided they take the money out for education. The very first one that ever came out was the Covered L IRA. This is another thing that could sunset since when it first came out it was at $500 and was later bumped to $2,000. What some business owners are doing is if you have a child who could actually earn some money from you and do an after school job, it’s earned income and they can open a ROTH. In order to take earnings out without paying a penalty, they have to be 59 ½. However, if you fund a ROTH and don’t get a deduction, you can take your contribution out as long as that ROTH has been opened for five years. Susie said she does have some business owners who are paying their children on a W2, then taking the full amount and putting it into a ROTH.
Bruce wondered about if you come in late in the game when your kids are no longer kids but already in their teens. Susie said you can do this with a 529. The gifting rule is $13,000 a year, which is going to go up with inflation as well. You can take five years of $13,000 and put it into a 529 plan. The beautiful thing about this plan is you stay in control as the owner, but it is off your estate as far as your gross estate.
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