Category Archives: Tax Planning

Cover topics of interest that will help keep you informed on tax issues that might be relevant to you – our clients.

Building Wealth: Your Real Estate Asset

Posted on by
Reply

Real estate is often purchased as a lifestyle asset (to live in) or as a commercial investment (to generate rental income). It’s also quite common for people to think of their home as both lifestyle and an investment. Certainly, the most common near-term goal for families is home ownership – many think it amounts to a “no brainer” investment (meaning they think their home is a great investment) when it actually costs them much more than they realize.

In our examination of annual return rates on residential and commercial real estate we find that real estate is by no means a no brainer investment. Real estate assets can indeed contribute to wealth creation if the purchaser buys for value, carefully manages maintenance/renovation costs, and the sale is handled with an eye to minimizing taxes on gain from the sale.

Your residence has the potential to be a large part of your wealth, particularly in the Bay Area, but it can also be your largest liability.

Lending institutions have different requirements when lending for an owner occupied residence than for commercial real estate. A primary residence can often be purchased with lower down payments and lower mortgage rates than non-owner occupied real estate. In addition, on the sale of the owner occupied residence the gain will often fall under the capital gain exclusion rules which allow couples to exclude $500K from their income, tax free. This is one of the few opportunities to realize gain completely tax free. Couples who want their residence to be an investment rather than a lifestyle asset should consider selling their home once the gain (market value above basis) in their home approaches the $500K cap gain exclusion. This doesn’t mean you have to buy bigger or smaller or move away from your neighborhood but it does mean that you must sell a property to capture this tax free gain.

If a couple bought a home for $600K, made no renovations and 5-10 years later it is worth $1M they could choose to sell their home and retain the $400K gain tax free. They could repeat this process several times in a couple’s lives and each time a sale is completed the gain can be retained tax free. At the end of 3 rounds (there are residence requirements for each exclusion to be allowed) this couple could have managed to clear (net) well over $1M tax free. Despite this unparalleled opportunity to build tax free wealth, most home owners will buy one home and live in it until retirement. A well purchased property will still yield gain but much of it will be taxed. A home purchased at $600K that sells for $1.8M in retirement will have $500K of the gain tax free but $700K will be taxed at capital gain rates federally and at regular income rates by the state.

A residence can turn into a large liability when the debt burden is too high, when the home renovations do not yield increased value for resale, when the home requires a lot of maintenance, and when the location is no longer appealing (loss of home value appreciation).

Unlike residential home purchases, real estate purchased for investment is first valued on its ability to generate sufficient income and not as much on its appreciation. Before buying an investment property the property is thoroughly analyzed from various perspectives. An APOD (Annual Property Operating Data) is the principal tool to understand the cash flow, return rate, and profitability that can be expected from a prospective property. Once a property passes the APOD test (primarily for risk assessment) then the tax shelter provided by such an investment and the impact of the time value can be used to determine if this is an appropriate investment. Not surprisingly, much of the success of these investments stem from proper usage of tax rules. The value of the annual depreciation (using Schedule E) is well known. An equally important tax tool is a 1031 exchange. In a 1031 exchange the value of the investment property you own can be used to buy a second investment property of the same or greater market value while deferring tax payments on the gain.

In short, both residential and non-owner occupied real estate can be part of your investment plan. Unlike market investments it is more difficult to identify and protect against unexpected events and the illiquid nature of ‘real’ assets. Managing real estate to attain investment value requires thoughtful deliberate actions that may not always be aligned with your personal wishes (far from being a “no brainer”). Investing in real estate can reap big rewards, but entails doing a lot of meticulous research, taking only risks that are necessary, covering for contingencies, working with an experienced team, and then allowing time to do the work.

If you need help deciding whether a real estate purchase fits with your long term goals, give Aikapa a call.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Tax Penalty/Bonus? – Single, Married, Domestic Partnerships

Posted on by
Reply

After nearly thirty years of marriage, I would be the last person to suggest that
tax consequences are a reason for making a lifelong personal commitment. On
the other hand, I am often the first to point out that marriage is not always a
tax neutral activity. Some people work on the expectation that a “married
filing jointly” (or MFJ) tax filing will always result in a lower combined tax
liability and a marriage tax bonus (meaning taxes are reduced solely due to
filing as MFJ). They are surprised when this joint filing actually creates a
marriage tax penalty (meaning filing MFJ results in higher taxes).

So when should we expect a penalty or bonus? The literature describes that ‘in
general’ we see a tax bonus when two partners have disparate incomes and a
tax penalty when they have similar or equal income. Based on the literature I
expected that income splitting (as occurs in a domestic partnership tax filing)
could provide an additional tax bonus over MFJ since disparate incomes can
be split evenly between partners.

While exploring the new 2013 tax rules we examined some tax scenarios and
want to share some highlights with you. We found that starting at a combined
AGI (Adjusted Gross Income–the number at the very bottom of the 1040
form) of $230K filing as MFJ resulted in a tax bonus of about $2K IF the two
people had disparate incomes ($200K and $30K respectively) but a penalty of
$2K for those with similar incomes ($115K each). Therefore at this level of
AGI couples with disparate incomes do slightly better under MFJ and those
with similar AGI do slightly better filing as individuals.

With a joint AGI of $330K the single disparate earners ($300K and $30K)
receive a marriage tax bonus of about $3K. If the same joint income was
earned evenly ($165K each) they would pay $4K more filing as MFJ than as
two individuals (a $4K tax marriage penalty). Looking at these scenarios, it
became clear that those with similar incomes would annually save thousands
of dollars if they filed as individuals rather than MFJ (Note: this is not the
same as married filing separately but rather unmarried individuals). As a
corollary, those in a domestic partnership may want to verify that they will not
have a large tax increase if they marry and file as MFJ.

Finally we looked at a couple with a $530K AGI who will pay $143K in taxes if
they file as two individuals with disparate incomes ($500K and $30K) and
taxes will be about the same if they file under MFJ (there is about a $1K tax
bonus). We do see a large tax penalty if this income was earned evenly by two
individual filers ($265K each) and they file MFJ. As two individuals the tax
burden would drop by at least $15K.

Marriage does provide non-income tax related advantages for spouses and
the family which are not discussed here.

Once you consider tax consequences of marriage, domestic partnership or
single tax filings any decision you make will work as long as you make plans to
cover the marriage tax penalty or find ways to spend the marriage bonus.
The above analysis assumed that ‘itemized deductions’ were kept constant and
that there was no AMT. These were modeled tax estimates – please consult
your tax preparers for the specific tax impact in your situation.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Tax Season and the Retiree

Posted on by
Reply

Tax Season and the Retiree

There are a lot to contemplate when considering the state in which to retire. Most want to be close to family and friends, the weather to be suitable for them, and what they hope to do in terms of activities.  A consideration this time of year are taxes — one of life’s two certainties and, one often a large expense in retirement.  It is never a good idea to seek out a retirement state based solely on tax burden but it is good to be aware which states fit your plans best for retiement.

So, find out how each state taxes your income and plan accordingly. Also consider how the state taxes your property and your consumption and you might want to consider how it taxes your estate.  That should give you a state tax burden that you’ll need to cover during retirement.

Older Americans who planned for retirement often generate income from several sources during retirement, including income from wages or self-employment; Social Security; pensions; and personal assets, including taxable and tax-deferred accounts. Taxes on those sources of income, mean less money for your care and enjoyment.  But don’t forget state and local property taxes, state and local sales and use taxes. You might pay plenty in property taxes and sales taxes.

Remember, what you save on income taxes in one state you might pay in property taxes or sales taxes. And vice versa. What you save on property and sales taxes in one state you might pay in income taxes – so calculate for your specific retirement situation.

One more note, for those who itemize deductions, there are five types of deductible non-business taxes, including state, local and foreign income taxes; state, local and foreign real estate taxes; state, and local personal property taxes; state and local sales taxes, and qualified motor vehicle taxes.

Your specific tax burden, will depend on whether you can take advantage of these deductions.

The states are listed in order of tax friendliness from an overall tax burden point of view:

1. Alaska:  Alaska doesn’t tax personal income, including Social Security benefits and pension income. And, there’s no state-imposed sales tax. This is not to say that you won’t pay any taxes in Alaska – You’ll pay other types of taxes, such as property taxes.

2. Nevada: This state doesn’t tax income, Social Security benefits or pension income. And its property taxes are reasonable, too. Its sales tax, however, is higher than the national average.

3. South Dakota: The state doesn’t tax individual income, Social Security benefits or pension income. And the overall tax burden is among the lowest in the nation.

4. Wyoming: There’s no individual income tax on Social Security benefits or pension income in Wyoming but property taxes and sales taxes tend to be higher than the national average.

5. Texas: In Texas, there’s no individual income tax. But property and sales taxes tend to be higher than the rest of the nation.

6. Florida: There are plenty of reasons why people choose to retire to the Sunshine state, the low tax burden being among those reasons. There’s no individual income tax on Social Security benefits or pension income with high property and sales taxes.

7. Washington: There’s no individual income tax on Social Security benefits or pension income. But if you plan on spending lots money while in retirement watch out for the high sales tax.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Estate Planning – Don’t forget to prepare the heirs

Posted on by
Reply

Estate Planning should include Coaching Heirs

Estates fail at a rate of 70 percent following their transition to heirs. Why?  Attorneys and financial planners do a good enough job on the assets and the estate but seldom have the mandate or interest to prepare the heirs for the assets they will receive.  Preparing heirs dramatically increases the ability to retain investmented portfolios through the tramatic transition and beyond.

The failure of estates following transition to heirs For many years, estate planning has routinely focused on the “Big Four” issues of taxation, preservation, control and philanthropy. Estate planners do a great job in these four areas, as fewer than 3 percent of estate failures (post-transition) can be attributed to errors by professional advisors, according to research conducted by The Williams Group.

What is missing from the traditional focus on the “Big Four” planning objectives?

. Research clearly shows that the missing element is preparing the heirs for the assets. In fact, the losses that occur during the estate’s post-transition period are driven by unprepared heirs, the lack of a family agreement on the mission of the estate, and the family’s fundamental inability to trust and communicate internally. It is not the scapegoat of estate taxes or the federal government, or even the litigious mentality of the modern day. It is frequently the result of an unprepared generation whose parents have not committed to preparing their heirs to receive and manage wealth in a responsible and competent manner. Lacking both preparation (skills, practice and team support) and motivation (commitment to a mission greater than that of satisfying self), heirs and their bequeathed estates are failing badly, at an astonishing 70 percent rate.

Family coaches that interact with the complete multigenerational family. Their objective is to ready the entire family to work with the advisory professionals by having the family meet and agree upon a mission for the family’s wealth. This is not only mom’s or dad’s mission, but also a multigenerational mission.

Once a mission is agreed upon, the family can move on to work with the family’s advisors to determine the roles that need to be filled (in the post-transition estate), to agree on the qualifications for those roles, and finally to set the observable and measurable standards that must be met to be allowed to continue operating (on behalf of the family) in those roles.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

=================================

(1) Family Coaches: The “Missing” Link in Estate Planning By Vic Preisser and Roy Williams. Institute for Preparing Heirs.  http://www.cegworldwide.com/expert-team/001-family-coaches-estate-planning

IRS Audit rates for the wealthy

Posted on by
Reply

The Internal Revenue Service in 2011 (2010 tax year filings) overall audit rate stayed constant for individual taxpayers at 1.1%. For those earning between $200-500K it is at 2.66%. Of note since 2009 has been the significant increase in audits for the following groups:

–> an increase in audits of 29.9% for taxpayers with $10 million in income (in 2010 it was 18.3% and 10.6% in 2009).This is a group that consists of 0.01 percent of taxpayers. In addition, the IRS has implemented a more a more intense IRS task force audit that is more time consuming and costly.

–> an increase of 20.75% (from 11.55%) for those with Adjusted Gross Incomes (AGI) of $5-10 million.

Interestingly many tax prepares claim that the IRS is quicker to audit individual returns than in the past, sometimes contacting people within months of their return being filed. In some cases, “correspondence audits” are the norm, where the IRS will send a letter asking a taxpayer to verify a specific item on the return such as charitable deductions.

This change started in 2009 when the IRS created a special unit to examine the tax returns of high-wealth individuals. “We will take a unified look at the entire web of business entities controlled by a high-wealth individual, which will enable us to better assess the risk such arrangements pose to tax compliance and the integrity of our tax system,” IRS Commissioner Douglas Shulman said in a December 2009 speech. “We want to better understand the entire economic picture of the enterprise controlled by the wealthy individual and to assess the tax compliance of that overall enterprise.”

=============== March 23, 2012 – Credit: Bloomberg News online

How insiders can legally profit from insider information

Posted on by
Reply
 Insight on how company insiders can still profit from insider information

Despite efforts by the Senate and president to reduce profiting from inside information there remain loopholds for corporate insiders that may be useful to those who are observant. Corporate insiders whose companies are about to be bought by rivals are forbidden from buying shares ahead of time to profit from the price jumps that takeover announcements often bring. But they accumulate plenty of shares just the same.
That’s because company managers are often paid partly in stock. Many sell these shares at regular intervals, whether to use the cash for other purposes or to keep their personal assets from becoming too concentrated in a single stock.
For this reason, managers who decline to buy their companies’ shares ahead of takeovers may nonetheless accumulate them if they also halt their typical selling.

Anup Agrawal of the University of Alabama and Tareque Nasser of Kansas State University studied 3,700 takeovers announced between 1988 and 2006. They compared trading in the year before takeover announcements (the “informed period”) with the year before that (the “control period”).  They found that insiders tended to reduce their buying during the informed period, but they reduced their selling even more. The result was an increase in net buying. Over the six months prior to deal announcements, the dollar amount of net purchases for officers and directors at target firms rose 50% relative to ordinary net purchase levels.

This “passive insider trading,” as the authors call it, is legal. But it is profitable? Agrawal and Nasser didn’t look at returns, but a study published a year ago in the Journal of Multinational Financial Management offers clues. Researchers from Australia’s Commonwealth Bank and Deakin University looked at U.S. takeovers between 2001 and 2006. They found that shares of target firms tended to outperform by nearly seven percentage points during the 50 trading days preceding deal announcements.

Nothing illegal in these situation just good old fashion financial planning can yield a net gain if properly structured.

*Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

===================================================

*Inspired by “An Insider Trading Loophole Congress Didn’t Close” by Jack Hough | SmartMoney | March 23, 2012

ETNs (as ETFs) are they a good idea in your portfolio?

Posted on by
Reply

ETNs (as ETFs) are they a good idea in your portfolio?

Unlike an exchange-traded fund (ETF), an ETN (exchange-traded note) is your uncollateralized loan to investment banks. The banks promise exposure to an index’s return, minus fees. The draw is that, many (but not all) ETNs are taxed like stocks, regardless of the ETN’s true exposure not as ordinary income. These benefits could be a godsend for a hard-to-implement, tax-unfriendly strategy. You might think that you can have your cake and eat it, too.  Did we learn nothing from the bail out?

In fact, ETNs are dangerous tools in the hands of ‘professionals’ and a disaster for the unsuspecting public. They are one of the easiest ways individual investors and advisors unwittingly enter into contract relationships with vastly more sophisticated investment banks. It is hard to believe that in the midst of ‘financial regulation’ that ETNs (unlike mutual funds and most exchange-traded funds) are not registered under the Investment Company Act of 1940, or the ’40 Act, which obliges funds to have a board of directors with fiduciary responsibility and to standardize their disclosures. ETNs, on the other hand, are weakly standardized contracts. Where an ETN investor should fear what s/he doesn’t know, s/he instead is gulled into thinking s/he understands the risks and costs s/he bears.  If you can’t get yourself to read the prospectus carefully and analyse the fee structure caveat emptor.

The ETN is a fantastic deal for banks. An ETN can’t help but be fabulously profitable to its issuer. Why? They’re dirt-cheap to run. They’re an extremely cheap source of funding. More important, this funding becomes more valuable the bleaker an investment bank’s health – they can have their cake and eat it too! Finally, investors pay hefty fees for the privilege of offering this benefit. Believe it or not this isn’t enough for some issuers. They’ve inserted egregious features in the terms of many ETNs. The worst appear to insert a fee calculation that shifts even more risk to the investor, earning banks fatter margins when their ETNs suddenly drop in value (examples include DJP and GSP but there are many more).

The above fees scratch the surface. Other examples of investor unfriendliness follow:  UBS’s ETRACS (AAVX and BBVX etc) have a 4% levy on top of the 1.35% fee called event risk hedge cost.  Barclays’ iPath (BCM, etc) add 0.1% fee futures execution cost.  Also an additional 0.5% index calculation fee charged for Credit Suisse’s Liquid Beta (CSLS, CSMA, etc).

When many players in the industry behave in ways that signal they can’t be trusted, it raises questions about all ETNs. What a shame. The best ETNs could be useful tools, fulfilling their promise of tax efficiency and perfect tracking but none of these do.

The ETN product creators have gotten away with such investor-unfriendly behavior by free-riding the goodwill conventional ETFs have created as simple, low-cost, transparent, tax-efficient products. Understandably, many investors have taken for granted that the ETNs’ headline fees are calculated just like expense ratios, that “gotcha” fees are not facts of life. Given how publicly accessible ETNs are I recommend that most stay away from them.

*Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

===============================================================

*The above is my opinion based on readings and triggered by an excellent article in Seeking Alpha by By Samuel Lee  “Exchange-Traded Notes Are Worse Products Than You Think” March 23, 2012.

2012 -0213 Obama’s budget today

Posted on by
Reply

Obama’s budget announcement today – not a surprise

Proposed 2013 budget would reduce dividend tax break, impose new rules, and raise top marginal rate to almost 40%

The $3.8 trillion budget that President Barack Obama proposed today for 2013 would generate $1.4 trillion in new taxes for the wealthy.

Perhaps the only surprising element of the proposal puts dividends paid by high-income Americans at ordinary income, boosting the rate paid to 39.6% from a current rate of 15%.

The higher rates would apply to couples making $250,000 or more and individuals making $200,000 or more IF they earn significant income from dividends.

Originally, the president had supported continuing to tax dividends at a favorable rate, but administration officials said Mr. Obama decided the nation couldn’t afford it.

“We don’t need to be providing additional tax cuts for folks who are doing really, really, really well,” Obama said today in a speech at Northern Virginia Community College.

This is not news, in 2003, dividends were taxed as ordinary income.

Not surprisingly, Republicans in Congress immediately criticized the president’s budget and predicted failure for the tax increases wanted by the White House. .

The change in dividend taxation would raise $206.4 billion over a decade, according to the administration, which has said the wealthy need to pay more to help the nation control its deficit and spur economic growth.

The president’s proposal would end the Bush era tax cuts and limit tax deductions to 28% for wealthy Americans, again defined as those couples earning $250,000 and individuals making at least $200,000.  Limits them to 28% but does not eliminate them. These high-income earners already were set to take a hit in next year when a provision of the 2010 health care law kicks in that will tax their unearned income at 3.8%.

The administration’s proposed budget also would boost the top capital gains tax rate to 20% from today’s top rate of 15% and the income tax rate would max out at 39.6% in 2013 (increased from 35%). As expected, the plan also would tax private-equity managers’ profits-based compensation at ordinary income rates (which it is) instead of the 15% current capital gains rate.

The president’s budget also sets a new rule called the “Buffett rule,” that would set a 30% minimum tax for individuals with $1 million or more of annual income, a proposal that’s been discussed since last year after billionaire Warren E. Buffett said the wealthy weren’t paying enough in taxes. That tax would replace the alternative minimum tax (AMT), which the White House contends hits the middle class instead of its goal of keeping the richest Americans from paying too little.  It is great if it replaces AMT.

Republicans do control the House and wield significant influence in the Senate so it’s unlikely that Obama’s budget will make it out of Congress but only time will tell.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Self Employed Individual 401K Plan Loans

Posted on by
Reply

Who said you can’t have your cake and eat it too?

Self employed small business owners have an opportunity to not only save maximally through retirement plans but also build a safety-net through their ability to borrow from their individual 401K accounts.  Properly structured they can borrow from their retirement plan when the need arises without incurring the usual 10% penalty for early withdrawal.

In addition, 401k Loans for the Self employed business owners provides a loan, while allowing them to pay back interest to their own 401K rather than a financial institution.

An Individual 401k loan is permitted using the accumulated balance of the Individual 401k as collateral for the loan. Individual 401k loans are permitted up to 1/2 of the total balance of the 401k (but not exceed $50,000). A loan from an Individual 401k is received tax free and penalty free. There are no penalties or taxes if loan payments are paid on time.

Individual 401K Loans

  1. Can be used for any purpose.
  2. There are no income or credit qualifications to receive the loan.
  3. The monthly loan payments of principal and interest are repaid back into your own Individual 401k – you borrow and grow your retirement at the same time.

In addition, the assets can be from prior employer or IRA accounts that are rolled over to your individual 401K account.

Individual 401k are available to self employed individuals and small business owners with no full time employees other than a spouse. Your business can be a Sole proprietorships, LLC, S and C corporations,

The terms are set by the employer (yourself) but the 401k usually has a 5 year maximum repayment term for most loans, except it can be longer, for home purchase. There are no income or credit qualifications although you must charge yourself a competitive interest rate.

Although simple and fast to execute you  should remember that you are borrowing on your retirement nest egg.  It is only a valid action when you know you will have the ability to pay it back – default results in a withdrawal that can carry a 10% penalty.  The loan facilitates borrowing when it might be too difficult or too expensive to go through banks and lending institutions.

As good as it sounds consider that unlike a mortgage or a home-equity loan, if you use a 401(k) loan to buy or improve your home, you won’t get a tax deduction on the interest you pay. You may have to pay a one-time fee to the plan administrator for the cost of originating a loan; the fee is usually $50-100. Your retirement plan will also miss future targets if you don’t continue making annual contributions while you have this outstanding loan.  Though most self-employed who borrow from their 401K often pay their loans early it is important not to misuse your hard-earned retirement assets.

As can be seen the 401K Loan, like all tools, has advantages in disadvantages.  The advantages for the self employed should  encourage anyone who is or is planning to have their own business to begin saving in a tax deferred manner maximally.  By using an individual 401K account you can have your tax deferred savings and simultaneously build a safety net.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

IRS reports: Payroll Tax Extended into 2012

Posted on by
Reply

Payroll Tax Cut Temporarily Extended into 2012
– reprinted from IRS Newswire IR-2011-124

The Temporary Payroll Tax Cut Continuation Act of 2011 temporarily extends the two percentage point payroll tax cut for employees, continuing the reduction of their Social Security tax withholding rate from 6.2 percent to 4.2 percent of wages paid through Feb. 29, 2012. This reduced Social Security withholding will have no effect on employees’ future Social Security benefits.

Employers should implement the new payroll tax rate as soon as possible in 2012 but not later than Jan. 31, 2012. For any Social Security tax over-withheld during January, employers should make an offsetting adjustment in workers’ pay as soon as possible but not later than March 31, 2012.

Employers and payroll companies will handle the withholding changes, so workers should not need to take any additional action.

Under the terms negotiated by Congress, the law also includes a new “recapture” provision, which applies only to those employees who receive more than $18,350 in wages during the two-month period (the Social Security wage base for 2012 is $110,100, and $18,350 represents two months of the full-year amount). This provision imposes an additional income tax on these higher-income employees in an amount equal to 2 percent of the amount of wages they receive during the two-month period in excess of $18,350 (and not greater than $110,100).

This additional recapture tax is an add-on to income tax liability that the employee would otherwise pay for 2012 and is not subject to reduction by credits or deductions. The recapture tax would be payable in 2013 when the employee files his or her income tax return for the 2012 tax year. With the possibility of a full-year extension of the payroll tax cut being discussed for 2012, the IRS will closely monitor the situation in case future legislation changes the recapture provision.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com