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Powerball Lottery Tax Planning

Stephen Nelson CPA — Wed, 07 Jan 2026 18:55:08 +0000

A while back I talked about Lottery Tax Planning for a Billion Dollar Drawing. And what I said in the earlier article still stands… But the recent bumps in the Washington state estate tax rate made me think a quick update might be good.

For purposes of this blog post, I’m going to talk in terms of the recent, late December 2025 $1,500,000,000 Powerball. That drawing gave the winner an option. Receive $50,000,000 annually for three decades. Or, alternatively, take a roughly $700,000,000 lump sum.

And that choice—annuity vs lump sum—is the part I want to focus on…

The TLDR Summary: Take the Lump Sum

To cut to the chase, with large Powerball lottery winnings, the safe tax plan is probably to take the lump sum. This advice appears to be the opposite of what I saw reported in the media. Most experts appeared to think $50 million a year for thirty years makes more sense. And just superficially? That advice sounds right.

But seriously you really don’t want to burden heirs with the catastrophic estate tax risks of an annuity. And a quick illustration explains why.

Say you were confronted with the exhilarating choice of either $50 million a year for three decades versus a lump sum $700 million. And then (sorry) say you died the day after you won.

In this situation, your estate owes about $427,000,000 in estate taxes if you domicile in Washington state. (The state’s new 35% estate tax will amount to about $245 million. The federal 40% estate tax would account for the other $182 million.)

And the problem here? Your estate and heirs only “have” enough cash to pay the $427 million of estate taxes due a few months after your death if you took the $700 million lump sum.

Paying the Estate Taxes Off Over Time

In other words, in the tragically absurd scenario where you took the annuity and then died, your heirs will find themselves paying off the $427,000,000 estate tax liablity using the $50,000,000 annual annuity.

That sounds workable. But let me step you though the details so you see it’s a terrible outcome.

First of all, the federal and state income taxes on the $50 million might run about $18 million for a Washingtonian if the state’s new 10% millionaire’s tax has become law. So you don’t have $50 million each to grind down the debt. You have about $32 million after income taxes.

But because you owe the state and the federal government several hundred million dollars in taxes? Your estate accrues, one way or another, interest on the hundreds of millions of dollars of tax debt. Close to $24 million the first year, roughly $23 million in years two and three, and then ever smaller amounts as the “loan balance” shrinks.

Now, yes, your heirs will slowly be able to pay off the estate tax lability loan using the leftover money: $8 million of principal the first year, $9 million the second year, and increasingly large amounts each future year. But the paydown process will take decades. (I did a little Excel spreadsheet that amortizes the pay down and it takes the first 24 annual payments to extinguish the debt if the interest rate is 6%.)

And that’s the surprise here. Taxes not only reduce the net winnings (by more than 80%.) Taxes also delay when heirs receive their inheritances. And worse than that , some heir will find him or herself jungling estate finances over decades to pay off the $400,000,000-ish estate tax bill.

Thus my advice: If you ever do win a big state lottery? Yeah, absolutely take the lump sum.

Closing Comments and Caveats

Let me share three other comments, too, before I close.

First, comment: I was a little rough in my accounting. The federal tax rate for example isn’t exactly 40%. Rather, it’s 37% for the federal income tax and then 3.8% for the net investment income tax so a total of 40.8%. The federal estate tax is a flat 40% but only after any state estate tax is paid and only above $15 million (roughly). The new 35% Washington state tax applies only above $3 million and uses a $9 million phase in range where the rate starts at 10% and then rises to 35%. Finally, I assume that both federal income taxes and state income taxes calculations allow a deduction for the estate taxes paid. Federal rates do work that way. But we don’t know how a new Washington state millionaires tax might work.

Second comment: The fundamental, structural problem here is the estate needs to pay taxes on illiquid assets not easily converted to cash. And note this isn’t only a problem with something like a lottery annuity. Illiquid business and investment interests may create a similar timing problem for families.

Third comment: A change in domicile can fix or address a state estate tax problem as well as reduce a state income tax burden. Moving from Washington state to Nevada, for example, potentially zeros out your Washington state estate and income taxes. (If you really did win a Powerball lottery and you currently reside in Washington state? You’d probably want to seriously look at a domicile change.) You can’t however do something similar with federal estate and income taxes. Thus, moving from Washington state to, say, Luxemburg does not zero out your federal estate and income taxes.

Additional Resources

Washington State Estate Tax Calculator

Planning for the 35% Washington Estate Tax

Changing Your Washington State Residency (or Domicile)

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Trump Savings Accounts – Free Money from the Government

Christian Block CPA — Wed, 01 Oct 2025 17:59:58 +0000

Child focused tax benefits have taken on many forms over the years. We’ve had child tax credits, dependent care credits, education credits, 529 accounts, UTMA & UGMA accounts, and more. But, the recently passed One Big Beautiful Bill (OBBB) introduced something completely new: a federally seeded, tax deferred savings product for children known as Trump Savings Accounts.

This is a big deal that parents, grand parents, legal guardians, and even employers should pay attention to. The federal government is giving $1,000 to eligible new born babies. This isn’t a tax credit, a tax deduction, or anything else. It is actual cash the government deposits into a bank account. And that is just the beginning.

We’ll unpack what these new Trump Savings Accounts are, who qualifies, how to maximize contributions, and what they can be used for. We’ll also compare these to other accounts designed for children and see how they differ from what is already available.

What is a Trump Savings Account?

A Trump Savings Accounts is a tax-deferred custodial account that is structured like a Roth IRA. Qualifying children will receive a seed deposit of $1,000 from the federal government, beginning 1/1/2026.

To be absolutely clear, this is FREE money from the government! To qualify, a child only needs to:

Be a United States Citizen
Be born between 1/1/2025 and 12/31/2028
Have a Social Security number

No income limits for the parents or guardians exist. Every single qualifying child receives the seed deposit. However, parents and guardians can make additional deposits into the account as well. Lets dig into the details.

Contribution Rules and Limits

In addition to the government seed money, parents, relatives, friends, and even employers can make contributions into the savings account until the child reaches age 18.

The annual contribution limit is $5,000/child, indexed for inflation in future years. Employer’s can also contribute up to $2,500 per child, which counts towards the $5,000 contribution cap. Ignoring the inflation adjustments, it’s possible for a child to have $90,000 deposited into their account by the time they reach 18! That is serious money.

Contributions aren’t tax-deductible for the donor and aren’t treated as income to the child. The money grows tax deferred, however, until the child starts withdrawing the funds.

The IRS determines the tax rate on a distribution based on how the recipient uses the funds. The tax rate is the same as long term capital gains tax rates on qualified withdrawals. A qualified withdrawal includes the following:

Education, including tuition, supplies, & room and board.
Expanded definition of education to include certified trade and vocational programs
First time home purchase
Starting a business

If the recipient uses the money for anything else before turning 59½, they must pay ordinary income taxes and a 10% penalty on the amount withdrawn. These are the same consequences as taking a nonqualified distribution from a retirement account.

Account Investment Vehicles

The money must be invested within specific eligible investments as detailed in the OBBB. Eligible investment means any mutual fund or exchange traded fund which:

Tracks the returns of a qualified index
Does not use leverage
Does not have annual fees and expenses of more than 0.1% of the balance of the investment fund

The term “qualified index” means:

The S&P 500 market index, or
Any other index which is
- comprised of equity investments in primarily United States companies, and
- for which regulated futures contracts are traded on a qualified board or exchange

So how do you open an account?

Opening a Trump Savings Account

First, as previously discussed, you must have a qualifying child born between 1/1/2025 – 12/31/2028 to open an account. If qualified, there are two ways to establish an account:

Eligible custodians can manually open accounts after 12/31/2025 with an authorized financial institution.
If no eligible custodian establishes an account on behalf of a qualified child within 12 months of the child’s date of birth, the Secretary of Treasury shall cause an account to be opened in the name of such child and held by a designated institutional custodian.

The treasury hasn’t issued guidance or an approved list of authorized financial institutions at the time of this writing. But most likely, a majority of the major financial institutions (Fidelity, Vanguard, Ascensus, JP Morgan Chase etc.) will support the accounts.

Trump Savings Account Alternatives

Now let’s see how Trump Savings Accounts stack up against more familiar options like 529 plans and custodial accounts, and explore which might be the best fit for your financial goals.

As compared to Trump Savings accounts, Section 529 plans

Are designed to help families save for education-related expenses
Contributions are not federally deductible but are deductible in some states
No contribution limits and considered as gifts to minor
Can change beneficiary
Funds grow inside of the account tax free
Qualified withdrawals are not taxed, if used to pay for
- College tuition and fees
- K-12 tuition
- Room and board
- Books, supplies, and required technology
Non-qualified distributions are taxed at ordinary rates and subject to a 10% penalty

A Section 529 plan has the advantage over a Trump Savings Account IF the funds are used for college expenses. If flexibility is a priority, the advantage goes to the Trump Savings Account.

As compared to Trump Savings accounts, custodial Accounts (UTMA, UGMA)

Are designed to allow an adult custodian to manage assets of a minor child
Contributions are not federally or state deductible
No contribution limits and considered as gifts to minor
Cannot change beneficiary
Funds can be used for anything that benefits the child
No tax shelter treatment, income is subject to kiddie tax annually

A custodial account has the advantage over a Trump Savings Account when spending flexibility is the priority. However, there is little to no tax advantage like a Trump Savings Account provides. Verdict? Max out Trump Savings Account contributions first, fund a custodian account second.

Are Trump Savings Accounts a Good Deal?

For eligible families (those with children born between 2025 and 2028) they present a rare opportunity: a $1,000 head start, tax-deferred investment growth, and potential employer contributions.

While they don’t replace the role of Section 529s for education savings or offer the flexibility of UGMA/UTMA custodial accounts, they fill a new niche by helping families build long-term wealth for their children with minimal upfront cost. Like any financial tool, the value depends on your goals, but for many, opening one is a low-risk, high-upside way to diversify a child’s financial future.

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How EV Credits Work

Christian Block CPA — Mon, 02 Oct 2023 14:59:52 +0000

Do you plan on purchasing a new vehicle within the next ten years? If the answer is yes, and good chance it is, you want to know how EV credits work.

Really, the correct term is “Qualified Plug-In Electric Drive Motor Vehicle Credits,” which is quite a mouthful. For purposes of this blog post, I’m going to call them EV credits.

Admittedly, I have not personally owned an EV or seriously shopped for one. However, electric motor and battery technology is improving rapidly, the charging network is growing, and the incentives are great, if you can make them work.

I’m going to discuss how EV credits work and how they can benefit, and possibly influence, your next vehicle purchase.

What is an EV Credit?

Put simply, the US government gives you money, in the form of a tax credit, for purchasing a qualified electric vehicle. The credit has been around for a while. Maybe you’ve already gotten one.

But, the rules changed in the summer of 2022 with the passing of the Inflation Reduction Act (IRA). And the changes make the credit less accessible to many taxpayers.

So let’s briefly discuss how EV credits worked before the IRA (pre 2023), and how EV credits work starting in 2023.

EV Credits 2022 and earlier:

If you purchased a qualified electric vehicle, you could claim a non-refundable credit of $2,917 for a vehicle with a battery capacity of at least 5 kilowatt hours, plus $417 for each kilowatt over 5 kilowatts, up to a maximum of $7,500. (Note that “non-refundable” means you can’t get a credit for more than the income taxes you otherwise owe.)

Criteria for EV to qualify:

purchased brand new
have an external charging source
used in the United States primarily
have a gross weight rating of less than 14,000 lbs
not purchased to resell
manufacturer can’t sell more than 200,000 EV’s in the U.S.

BTW, GM sold 200,000 EV’s by Q4 2018, with Tesla reaching 200,000 by Q1 2020 and Toyota reaching 200,000 by Q2 2022. These brands were ineligible for any more credits under the old rules.

EV Credits 2023 and later:

The maximum credit is still a non-refundable $7,500, but the EV credits work differently with the passing of the IRA. The IRA broadened the range of vehicles that qualify, but restricted the amount of taxpayers able to take them (more on this later).

First, lets break down the new rules for brand new EV’s.

Criteria for new EV to qualify:

purchased brand new
have an external charging source
used in the United States primarily
have a gross weight rating of less than 14,000 lbs
not purchased to resell
two components; $3,750 credit for critical mineral requirements (critical minerals extracted or processed in the US) and $3,750 for battery component requirements (battery produced or assembled in US)
produced by qualified manufacturer
final assembly in North America

Number of units sold is no longer a limitation, and, in an effort to stimulate US manufacturing, the final assembly of a qualified EV must be completed in North America.

The website fueleconomy.gov has a neat search engine to look up qualified EV’s. You just input year/make/model to check eligibility. You can also find a list of manufacturers and qualified models on the IRS website here. The selling dealer is also required to provide you with a written statement detailing, under penalties of perjury, the maximum allowable EV credit for the vehicle you are buying.

The IRA also opened up the EV credit to used vehicles, and is limited to $4,000.

Criteria for a used EV to qualify:

must be the first sale other than to the original owner
vehicle must be at least two years old
had to be a qualified EV when sold new
must be sold by a dealer
have a gross weight rating of less than 14,000 lbs
purchased in the United States
credit is limited to 30% of purchase price
purchase price must be less than $25,000
can be claimed once every three years

Limitations

Earlier I mentioned EV credits will be more restrictive for a lot of taxpayers. Gone are the days of trading in your top of the line, six figure Tesla Model S every year for the newest latest and greatest, and subsidizing the initial cash outlay with a nice big $7,500 credit at tax time.

There are now MSRP restrictions and adjusted gross income (AGI) restrictions we need to cover. Let’s begin with the MSRP restrictions.

MSRP Limits:

You cannot claim an EV credit if MSRP exceeds the following amounts:

Vans – $80,000
Sport Utility Vehicles – $80,000
Pickup Trucks – $80,000
Other – $55,000

These prices might seem high, but it is easy to cross the threshold when you start adding options to the base price.

For fun, I went to Ford’s website to build a new Lightning truck. The base price of the Lariat model starts at $69,995. Add in the extended range battery option and a tonneau cover, and the MSRP jumps to $81,040, making this EV ineligible for any credits. I guess you’d want to wait on the tonneau cover and buy one with your $7,500 tax credit the following year.

Please note, MSRP does not include tax, title, license, or dealer mark-up fees. So good news there.

Now let’s cover the new AGI limitations:

AGI Limits:

You cannot claim an EV credit if your AGI exceeds the following amounts:

Married Filing Jointly – $300,000
Head of Household – $225,000
All other taxpayers – $150,000

These are respectable income levels, yes. But I don’t think it is a stretch to assume most (or at least many) people purchasing brand new EV’s likely have an AGI above the threshold. And there is no phase out, you either qualify or you don’t.

Final Thoughts:

Hopefully no one purchases a new EV and gets surprised they don’t qualify for EV Credits when they file their tax return the following year. This is especially true for the early EV adopters that have already taken EV credits and are not aware the rules have changed, substantially, for 2023.

If the EV credit is a major deciding factor in your car purchasing process, you want to to know how EV credits work. If you follow the rules and don’t make too much money, you should get a nice big tax credit.

Make sure to read our post “Inflation Reduction Act: Tax Credits for Homeowners” for information on additional clean energy property credits.

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Grouping Activities to Achieve Material Participation

Stephen Nelson CPA — Mon, 07 Aug 2023 16:01:39 +0000

This week, a quick discussion of grouping activities as backdoor way to materially participate.

But first a bit of background about what material participation is and why it matters. And then I’ll talk about how grouping activities sometimes makes a giant difference on your tax return.

Why Material Participation Matters

Okay, so here’s the main thing: You can’t deduct losses from a business venture or hands-on investment except if you materially participate in the activity.

Example 1: Two brothers, Pete and Tom, invest in a new venture. Say a restaurant. The brothers agree to each invest $100,000 and will proportionally share the losses and the profits. Tom will also receive a salary from working in the business. Pete won’t work in the business. He’s keeping his regular job. If the first year, the business loses $100,000, each brother suffers a $50,000 loss. Tom, because he materially participates, can deduct that loss on this tax return. Pete, because he doesn’t participate at all, can’t.

That’s the basic concept.

The Seven Material Participation Recipes

Next question: How does someone materially participate? Well, tax law provides seven recipes:

You spent more than 500 hours on the activity.
You spent more than 100 hours but nobody else spends more time.
In essence? You were the only person who spent any time in the activity.
You spent more than 100 hours in the activity, also spent more than 100 hours in some other activities, somehow fail to materially participate in any of these activities using some other recipe, but in total, your hours spent in all of these “significant participation activities” exceed 500 hours.
For five of the last ten years, you materially participated (for example, using more than 500 hours recipe) .
You materially participated in a personal service activity for any three years. (Again, for example, by spending more than 500 hours those years.)
You’ve been involved in an activity on such a “regular, continuous and substantial basis” that you material participated even if one of the other six material participation recipes doesn’t work. (This is an impractical recipe. Too vague. Please don’t think you can use it.)

And one important wrinkle to this discussion for married people. Spouses combine hours to determine material participation. For example, if two spouses each spend 300 hours, the total material participation hours equals 600 hours.

Grouping Activities: Backdoor Material Participation

If you don’t materially participate using one of those seven recipes just listed, however? You have one other gambit you can maybe use: Grouping activities.

The best way to understand grouping is to copy and paste an example from the relevant Treasury regulations at 1.469-4(c)(3):

Example 2: Taxpayer C has a significant ownership interest in a bakery and a movie theater at a shopping mall in Baltimore and in a bakery and a movie theater in Philadelphia. In this case, after taking into account all the relevant facts and circumstances, there may be more than one reasonable method for grouping C‘s activities. For instance, depending on the relevant facts and circumstances, the following groupings may or may not be permissible: a single activity; a movie theater activity and a bakery activity; a Baltimore activity and a Philadelphia activity; or four separate activities. Moreover, once C groups these activities into appropriate economic units, paragraph (e) of this section requires C to continue using that grouping in subsequent taxable years unless a material change in the facts and circumstances makes it clearly inappropriate.

I boldfaced key part of the copied text above. But let me summarize how I think you read this. A taxpayer invested in and works in four activities. Possibly she or he doesn’t materially participate in an activity at least using one of the usual recipes. But the taxpayer can combine activities in any reasonable method. And once activities get aggregated? Probably, the taxpayer does materially participate.

For example, maybe the taxpayer in Example 2 doesn’t qualify as materially participating in the bakery in Philadelphia. And maybe she doesn’t qualify as materially participating in the bakery in Baltimore either. But if she or he combines the Philadelphia bakery with the Baltimore bakery? Maybe that works.

Rules for Grouping Activities

As noted earlier, you can use “any reasonable method.” The Treasury regulations flesh out what that means. And they provide some logical instructions.

You need to look at all the relevant facts and circumstances. Further, a logical handful of factors should be given the “greatest weight” in determining whether it’s reasonable to treat “more than one activity as a single activity:”

I’m going to again copy and paste the actual language from the regulations. (See the bulleted list below.) But think about how these apply to the fictional business owner with bakeries and movie theaters in Baltimore and Philadelphia.

Similarities and differences in types of trades or businesses
The extent of common control
The extent of common ownership
Geographical location; and
Interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between or among themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records).

Limitations on Grouping Activities

Because grouping activities is so potentially powerful, limitations exist.

You can’t group a rental activity with a non-rental trade or business except in usual situations. (We’ve described those situations in another blog post here: A Dozen Ways to Deduct Passive Losses. But the common exception to this limitation: You can ignore this limitation when one of the activities is insubstantial in relation to the other. Another common exception: Self-rental situations.)

You can’t group real property rentals with personal property rentals.

You can’t group limited partner and limited entrepreneur activities except when the activities are in the same type of business. (This limitation applies to farming; movie and video production, distribution and holding; leasing Section 1245 property (so mostly depreciable personal property); oil and gas exploration; and geothermal exploration.)

But other than these limitations? In many cases, business owners should be able to group activities to achieve material participation. If they need to.

Grouping Activities Paperwork

You or your tax advisor need to add some paperwork to your tax return to group activities. For example, you include a grouping election with the first tax return you combine activities.

If facts and circumstances change and the original grouping no longer makes sense? You regroup and disclose that action on the first affected tax return.

If you haven’t made a grouping election but should have? Yeah, you should talk to your tax advisor about that. Typically, you can make a “backdated” grouping election.

One predictable and fair caveat? The IRS may regroup activities if (1) a group is “not an appropriate economic unit” and (2) a “principal purpose” of the grouping was to “circumvent” Section 469’s passive loss limitation rules.

Crazy Grouping Activities Examples That Work

Let me share three example groupings that probably work.

Example 3: A contractor works full-time in his own construction business. His spouse spends 50 hours a year on a short-term rental business—which tax law doesn’t consider a rental activity. But the short-term rental housekeeper spends 80 hours a year. Thus, without grouping the businesses? The taxpayers can’t deduct short-term rental losses. However, if the couple groups the activities, they achieve material particpation. Note that it should be reasonable to group these activities. In addition to the common ownership and control, the husband maybe does construction and repair work in both activities. And then the wife may do the accounting in both activities.

Example 4: A real estate broker qualifies as a full-time real-estate professional, and also spends 75 hours per property per year managing two rental properties. But if he uses separate landscapers for each property and the two landscapers each spend 100 hours a year? He doesn’t materially participate and won’t be able to deduct rental losses. Unless he groups. And in that case, bingo, he material participates. Because his 150 hours exceeds the 100 hours spent by either of the landscsapers. (As mentioned earlier, you can’t group his real estate sales activity with the rental activity.)

Example 5: A taxpayer rides horses professionally (one activity) and operates an interior design business that specializes in equestrian-themed home interiors (another activity). Very possibly, she can group the horseriding with the interior design. Risk exists here that the IRS might see the horse business as a hobby, something I discussed here: What Ms. Topping Learned. But ignoring the hobby loss issue, if someone owns and operates two businesses that together create synergies? Grouping might be reasonable. (Be sure to consult your tax advisor if you want to try something like this.)

A Final Caution Here

And let me end with a caution. The IRS regularly rejects taxpayers grouping an airplane business with another business. Which maybe doesn’t seem to matter to you if you don’t own an airplane. But the rejected airplane activity groupings highlight a risk.

The pattern that seems to show up when the IRS removes an airplane business from grouping? Common ownership and control isn’t enough. You need more than that. You want interdependencies or similarities in the activities. Probably some synergy. And then you don’t want huge differences in the activities. (Grouping a doctor’s office with an airplane charter, for example? Yeah, that’s stretch.)

Other Related Resources:

Real Estate Professional Audits

Surviving Short-term Rental Audits

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The Qualified Family-Owned Small Business Deduction

Stephen Nelson CPA — Thu, 13 Jul 2023 14:22:39 +0000

If you own or invested in a Washington state small business, you want to know about the qualified family-owned small business deduction.

And here’s why: Washington state now levies a seven-percent capital gains tax on (1) the net long-term capital gains residents realize and (2) the Washington-state-y net long-term capital gains that nonresidents realize.

But if you’re a small business owner or entrepreneur? You can probably avoid the capital gains tax on the sale of a small business. Because the law includes a qualified family-owned small business deduction.

A warning though: Washington state’s new capital gains tax is complicated. And the most complicated bit? The small business loophole you may want to use.

The Washington Capital Gains Tax in a Nutshell

But let me briefly explain how the Washington capital gains tax works. And then I’ll get into the gritty details of the qualified family-owned small business deduction (aka, the “QFOSB” deduction.)

So the big picture on this Washington capital gains tax. The state levies a seven percent tax on the net long-term capital gains an individual taxpayer realizes.

However two wrinkles here: First, the law exempts a bunch of special-case capital gains, including most capital gains on real estate, gains from selling depreciable property, and for specific industry situations. (For a complete list of the exemptions, you can refer to a blog post over at our CPA firm website: Washington State Capital Gains Tax Planning.)

And then the second wrinkle. The law provides three deductions: A standard $250,000 deduction (so the first $250,000 of gain is never taxed). A charitable contribution deduction of up to $350,000, which is an alternative to the $250,000 standard deduction. (You would use the alternative charitable deduction only if it exceeds the standard deduction.) And then a qualified family-owned small business deduction.

Note: Those amounts in the preceding paragraph get adjusted annually for changes in the Seattle-area consumer price index. The actual standard deduction for 2023, for example, should be eight or nine percent higher.

So, that’s the big picture. But you’ll need to understand the gritty details of the QFOSB deduction.

Deduction Detail #1: Gross Revenues $10 Million or Less

A first thing to know about the QFOSB deduction: To be a small business, a firm’s worldwide revenues for the twelve-month period prior to the sale or exchange need to equal $10,000,000 or less. (This value also gets adjusted for inflation. So if you’re looking at a sale in 2023? The value might be closer to $11,000,000.)

But note that the tax doesn’t look at the capital gain, as the following two examples highlight:

Example 1: George developed and patented artificial intelligence software. After several years of development, annual revenues average less than $1,000,000 a year. But a large technology company buys his business for $100,000,000. He should qualify for the full qualified family-owned small business deduction on the $100,000,000.

Example 2: George’s wife Martha starts an ecommerce business and slowly grows the business to $12 million in revenues. After George sells his business, she sells her firm in 2022 for $500,000 based on the firm’s annual profits. (Profits roughly run $200,000 a year.) Probably half of her $500,000 of capital gains, or $250,000, gets taxed. Her business? Too big to use the QFOSB deduction on her tax return.

Deduction Detail #2: Three Families or Fewer Control

The next thing to know. The QFOSB deduction only works for an interest in a family-owned business that meets, and here I use the language of the statute, one of the following characteristics:

An interest as a proprietor in a business carried on as a sole proprietorship
An interest in a business if at least 50 percent of the business is owned, directly or indirectly, by any combination of the taxpayer or members of the taxpayer’s family.
An interest in a business if at least 30 percent of the business is owned, directly or indirectly, by any combination of the taxpayer or members of the taxpayer’s family and at least 70 percent of the business is owned, directly or indirectly, by the members of two families or at least 90 percent of the business is owned, directly or indirectly, by the members of three families.

The Washington capital gains tax law, by the way, says a taxpayer’s family members include ancestors (so parents and grandparents of the taxpayer, for example), spouses and state registered domestic partners, lineal descendants, lineal descendants of a taxpayer’s spouse or state registered domestic partner, and finally, the spouse or state registered domestic partner of a lineal descendant. (These definitions come from Revised Code of Washington Section 83.100.046.)

Example 3: George and his wife Martha along with their good friends John and his state registered domestic partner Abigail start a small business. Initially they each own half. Later on they sell a third of the company to a venture capital fund. If they subsequently sell the business, because their two families together own less than 70 percent, they won’t get to use the QFOSB deduction. Note that had they sold the firm before raising venture capital? Yeah, they would have qualified.

One thing to note here: The new law doesn’t define what a business is. But a reasonable guess is that the definition used for federal income taxes works. For example, the Section 162 standard established in a famous U.S. Supreme Court case, Commissioner v Groetzinger, says a business is an activity conducted in pursuit of profit and carried on with regularity and continuity. (Groetzinger was a professional gambler, by the way.)

One would think that all the common business forms “qualify” for the qualified small business interest deduction: sole proprietorships, partnerships, regular “C” corporations, S corporations, LLCs operating as a proprietorship, partnership or corporation, and so forth.

But an awkward reality: We don’t at this point know for sure how the state defines a “business.” (For example, federal income tax laws say a real estate rental activity may rise to the level of a trade or business. Yet who knows how the state sees this issue.)

Deduction Detail #3: Sell Substantially All of the Business or the Interest

Another detail you need to know to assure the deduction: The business owner needs to sell at least 90 percent of her or his interest or the owners need to sell at least 90 percent of the business’s real property, taxable personal property, and intangible personal property.

Example 4: Washington and Adams, a land surveying partnership with two owners, sells all of the assets of their business for a $1,000,000 capital gain. The two owners share the $1,000,000 equally. Assuming all the other requirements are met, each owner shelters their proportional $500,000 gains with the QFOSB deduction because they’ve sold 100 percent of the consulting business.

Example 5: Jefferson and Burr operate a law firm as equal partners. Burr wants to sell his 50 percent interest in the law firm to a young new partner, Clinton, and then retire. When Burr sells his 50 percent interest to Clinton, he realizes a $500,000 capital gains tax and he also avoids the Washington capital gains tax on the $500,000 gain. The reason? He sells 100% (so more than 90%) of his interest in the business.

Note: The statutory and administrative guidance available from Washington state provide no guidance on whether an existing business might be split into two or more separate businesses. For example, in Example 4, could Washington and Adams split the land survey firm into two businesses—say a Virginia operation and a Massachusetts operation—prior to the sale? And then they could possibly sell substantially all of one of those businesses? I would guess this does work. And here’s why: In the July 2023 administrative rules’ Example 11, the Department of Revenue describes how a real estate gain potentially subject to capital gains tax can be “moved” into another entity and so escape the tax.

Deduction Detail #4: Hold Interest for Five Years

The usual time frame required to receive long-term capital gain treatment on a federal and most other state income tax returns is more than one year. But to enjoy the qualified family-owned small business deduction, a taxpayer needs to have held her or his interest in the business, either directly or beneficially, for at least five years immediately preceding the sale. And while a mere change in the form of the business doesn’t necessarily restart the five year countdown, the change in form needs to not change the proportions of any beneficial ownership interest. (This last requirement comes from page 12 of the July 2023 administrative rules.)

Example 6: James starts a restaurant on January 1, 2020 and operates as a sole proprietor for two years. He then incorporates the restaurant and elects Subchapter S status two years later on January 1, 2022. He sells the restaurant on December 30, 2024 and realizes a $1,000,000 capital gain. Because he sells the business one day short of five years? He will pay the capital gains tax on a portion of the $1,000,000. (Partial days count as full days per the statute. So if he’d sold on December 31, 2024 or later, he could have taken the deduction.) Note that the change in the form of the business ownership—a sole proprietorship for two years and then an S corporation for almost three years—doesn’t matter because James’ ownership percentage doesn’t change when the form of the business changes.

Example 7: John, James’s brother, also started a restaurant on January 1, 2020 and then owned and operated it for a full five years, selling the restaurant on January 1, 2025. John operated the restaurant as a sole proprietorship for the first two years and then as an S corporation the remaining three years. When he elected Subchapter S status, however, he allowed his key employee to acquire a five percent interest in the S corporation. Unfortunately, he fails to qualify for the qualified family-owned small business deduction. Why? Because his changed ownership percentage in the S corporation “form” of the business restarts the five-year holding period.

Deduction Detail #5: Taxpayer or Family Materially Participates

A material participation rule exists for the QFOSB deduction: Either the individual or a family member owning the business needs to materially participate in the business for five of the ten years immediately preceding the sale unless the sale is to another member of your family.

To determine material participation, the Washington statute basically regurgitates Section 469 of the Internal Revenue Code, which says material participation means a taxpayer needs to be involved in the operations of the activity on a regular, continuous and substantial basis. And then the statute says material participation has the roughly same meaning as the Section 469 statute and its regulations. (The actual statute says, “materially participated must be interpreted consistently with the applicable treasury regulations for Title 26 U.S.C. Section 469 of the internal revenue code…” The administrative rules then soften the “consistently” requirement with a rule to “generally” apply the 469 regulations.)

But a note: The Section 469 temporary regulations provide seven methods of achieving material participation. And only the first three methods, which set time-spent thresholds (more than 500 hours a year or more than 100 hours when no one works more or substantially all of hours), appear to work well. The regulations’ other material participation methods appear not to work. Or not to work cleanly. (Two methods, for example, say a taxpayer has materially participated for federal income tax purposes even when she or he hasn’t spent any time working in the preceding five years.)

Deduction Detail #6: Document Material Participation

A related material participation thing. Material participation from any member of the family of the taxpayer apparently counts for the entire family. But surely many family-owned small business owners have not been documenting their participation.

And for a good reason: They haven’t needed to.

Internal Revenue Code Section 469 and the companion Treasury regulations use material participation to determine when individual taxpayers claim passive activity losses and use passive activity tax credits. That’s exactly the opposite of what Washington state wants. The state uses the passive loss material participation regulations to determine if individual taxpayers report taxable income.

The practical problem in this misapplication? Profitable “qualified family-owned small business” businesses probably won’t have been tracking their material participation at least before now. Because they didn’t need to. But now they should. Probably. So they can later prove material participation.

Deduction Detail #7: Consider (Reconsider?) Activity Groupings

One other wrinkle related to Section 469 material participation rules bears mentioning.

Section 469 and its companion regulations provide a way for taxpayers to aggregate their trade or business activities into larger grouped trades or businesses.

As a generalization, trades or businesses (which is what the Washington state statute appears to talk about) might qualify for the family-owned small business deduction if they meet the requirements and follow the rules described here.

But one probably needs to stay alert to the possibility that the state says activity groupings create trades or businesses for purposes of the Washington state capital gains tax.

Example 8: Years ago, for purposes of filing his federal income tax return, Andrew appropriately grouped a warehouse he owns (held in an LLC) with a distribution business he owns (in an S corporation) based on self-rental grouping rules embedded in the Section 469 regulations. Because the IRS sees these two activities as a single activity, one wonders if the Washington Department of Revenue would see them as a single trade or business. That unintended consequence would mean that Andrew would not get a qualified family-owned small-business deduction unless he sells both the warehouse and the distribution business to the same buyer.

A related thought: Even if Andrew sold both the warehouse and distribution business simultaneously, would two sales to different buyers count as a sale or exchange that disposes of substantially all of the assets? The language of the statue talks about the “sale of substantially all of the taxpayer’s interest in a qualified family-owned small business.” Not “sales” plural, then. But a singular “sale.”

And another related thought: If the Washington Department of Revenue would see an activity grouping consisting of a warehouse and a distribution business as a single trade or business, could the business owner first sell the warehouse? (That would presumably not trigger Washington capital gains because real estate gains are exempt from the tax.) Then later, but perhaps even in the same year, the business owner could sell substantially all of the remainder of the previously grouped activities—so just the distribution business. I would guess this works. For what it’s worth.

Deduction Detail #8: Use Smart Purchase Price Allocations

Some small businesses get sold as a collection of assets: the inventory, furniture and fixtures, maybe the real estate and then the intangible personal property like the goodwill. Because some of the assets fall into exempt income categories, a seller might want to sell assets rather than the entity.

Example 9: Martin owns a small business, Van Buren Inc., that he can sell his stock in for a $750,000 gain. However, he worries he will fail to qualify for the QFOSB deduction because he can’t confidently prove his material participation. Thus, by selling this stock, he might pay the seven percent tax on $500,000 of the gain (assuming the 2022 $250,000 standard deduction). Alternatively, in an asset sale, he can sell the inventory for a $100,000 gain (not taxed because inventory is not a capital asset), sell the depreciated furniture and fixtures for a $200,000 gain (statutorily exempt from the Washington capital gains tax), sell the real estate for a $200,000 again (again, statutorily exempt), and thus completely avoid the Washington capital gains tax.

Note: Some practitioners wondered how the Department of Revenue would handle purchase price allocations. And the July 2023 rule proposals provide helpful guidance. The proposed rules say that taxpayers can use full appraisal reports, assessor valuation if the assessment date closely matches the sale or exchange date, or the purchase price allocation the seller and buyer use to comply with IRC Section 1060. Predictably, the Department of Revenue reserves the right to change or modify what it views as an inappropriate allocation.

Deduction Detail #9: Consider Domicile of Owners

A Washington state domiciliary (basically what tax law usually thinks of as a resident) pays taxes on essentially all of her or his net long-term capital gains. (I’m ignoring the credit for taxes paid to another state if some net long-term capital gains get sourced outside Washington.)

For nonresidents, however, only tangible personal property sold or exchanged from a location in the state gets hit with the Washington capital gains tax.

Tangible personal property, per the administrative rules means “personal property that can be seen, weighed, measured, felt or touched”. Tangible personal property, then, does not include an interest in a partnership or shares of a corporation. Thus, an out-of-state small business owner might optimize by selling her or his interest in the partnership or the corporation instead of having the partnership or corporation sell its assets.

Example 10: Martin’s wife Hanna, also owns a small business, Hannah Hoes Corporation. After Martin sells his business, he and his wife move to Nevada. And then, after establishing residency there, Hannah sells her interest in her Washington corporation for a $1,000,000 gain. She avoids Washington capital gains tax.

Deduction Detail #10: Avoid Section 338(h)(10) Treatment

The modest guidance from the Department of Revenue, at least at the time we’re writing this, suggests to us that taxpayers might want to avoid common but more complex transaction structures.

As one example of this, I’d think a taxpayer wants to avoid applying Section 338(h)(10) to a qualified stock purchase transaction. Section 338(h)(10), by the way, treats a sale of stock as a sale of assets. The issue with Section 338(h)(10) is, one might not know how to handle the transaction on a Washington capital gains tax return.

Deduction Detail #11: Reconsider Section 754 Elections

A technical point.

I’m not necessarily a fan of making Section 754 elections. (The work required to make the election and then the resulting annual tax return adjustments often exceeds the tax savings.) However, taxpayers and their tax advisors probably want to reconsider Section 754 elections for appreciated property held inside a partnership at the time when a partner dies and receives a Section 1014 step-up in basis.

The reason? The step-up in basis may eliminate, or at least minimize, a taxpayer’s long-term capital gains. And that will probably eliminate or minimize Washington state’s taxation of long-term capital gains.

Deduction Detail #12: Consider Using Trust or Estate Ownership

A final, weird tangential comment: The list of pass-through entities which confer beneficial ownership for an individual excludes estates as well as trusts other than grantor trusts. That means if a nongrantor trust or estate realizes a long-term capital gain, the individuals who are beneficiaries of the estate or trust don’t pay the seven percent tax.

Thus, some small business owners may want to move an interest in a small business into a trust or sell an interest held in an estate before realizing the gain. (This gambit also works for capital assets other than interests in small businesses.)

Additional Resources for Qualified Family-Owned Small Business Deductions:

As noted earlier, we’ve got a “general” blog post over at the CPA firm website that discusses the mechanics of the Washington state capital gains tax including some common tax planning tactics: Washington State Capital Gains Tax Planning

The actual statute appears here: https://lawfilesext.leg.wa.gov/biennium/2021-22/Pdf/Bills/Senate%20Passed%20Legislature/5096-S.PL.pdf?q=20210426052154

The most recent July 2023 draft of the administrative regulation appears here: https://dor.wa.gov/sites/default/files/2023-06/20-XXXcr1frmdraftjune23.pdf?uid=64aac2f8dc5d9

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Vacation Home Rental Tax Traps

Stephen Nelson CPA — Mon, 03 Jul 2023 17:50:04 +0000

You want to learn the vacation home rental tax rules if you rent, own or are considering renting or owning a second home.

Here’s why: Vacation home rentals present some tax traps for unwary owners. Some big ones.

But learn where the traps are? And how they hurt you? You can limit the damage. In same cases, you can even avoid getting blindsided or beat up. This article reviews the rules.

The General Vacation Home Rental Tax Rule: Proportional Allocations

A chunk of tax law called Section 280A describes the basic rule regarding accounting for vacation homes.

You need to calculate the percent of rental use. And then you can write off that percentage of the expenses but no more than the rental income you earned.

This sounds complicated. But in practice? Pretty easy. An example illustrates.

You personally used a vacation home for 25 days. You rented the home for 75 days.

The rental use equals 75 percent of the overall use. Therefore, you can write off up to 75 percent of the expenses.

If your expenses ran $40,000, for example, you can write off as much as $30,000 of expense.

But the rub: You can’t write off more expense that you earned in rent.

If your rental income equals $40,000, for example, you get to write off the $30,000.

But if your rental income equaled $20,000? You can only write off $20,000. Because the last $10,000 of expenses? Disallowed.

One bright spot here: Disallowed vacation home expenses—like the $10,000 in the previous example–carry over into future years and may be used then to shelter rental income. Potentially. (You’re subject to the same income limitation.)

Anyway, that’s the usual rule. And the main thing to note: You can subsidize the costs of a vacation home by renting. But you can’t generate tax deductible losses.

The De Minimis Vacation Home Rental Tax Rule

A variety of exceptions to the general vacation home rental rule of Section 280A exist.

One is sometimes called the Augusta rule because homeowners in Augusta Georgia, rumor says, make heavy use of it.

Note: The real name of this exclusion is the Section 280A(g) exclusion, which you’ll want to know for a reason I’ll explain in a minute.

If a homeowner rents her or his home for fourteen days or less and uses it as a residence for more than fourteen days? The homeowner can exclude the income.

Note that the homeowner doesn’t get to deduct expenses. But the homeowner enjoys tax free income.

Another example illustrates.

You own a home in Augusta Georgia. During the Masters Tournament, you can rent your home for $25,000 a week. Due the crazy crowds, you leave home during the tournament and rent your home for two weeks for $50,000. That $50,000? Tax-free income because you rent for fourteen days or less and because you use the home the rest of the home (so more than fourteen days.)

Note: You technically shouldn’t have to report the $50,000 of income on your tax return. But because the payor probably will report the income to the Internal Revenue Service? You’ll possibly want to show the income on a Schedule C or Schedule E form. show the Section 280A(g) exclusion as a reduction in that income, and then explicitly calculate the resulting taxable income as “zero.”

Minimal Personal Use Dodges Loss Limitation

Another common scenario with vacation rentals. When your personal use is very minimal.

When personal use is minimal? You also allocate expenses between personal use and business use. But Section 280A doesn’t prevent you from deducting a loss on the rental.

And what level of personal use counts as so minimal it doesn’t trigger the limitation? You need to use property for the lessor of fourteen days or ten percent of the days rented.

Another illustration to show the accounting.

Suppose you used a vacation property for ten days and rented it for one hundred days. In this case, because your personal use days are not more than ten percent of the one hundred rented days? And also not more than fourteen days? You allocate. But you don’t limit.

To be extreme, say you incur $110,000 of expenses. With ten personal use days and one hundred rented days, you treat $10,000 of the expenses as personal expenses and $100,000 of the expenses as business expenses.

And the kicker: Because the personal use was so minimal? You wouldn’t get limited to the income. If the rental income equals $40,000 for example? You would still get to deduct $100,000 of expenses. The loss on the property would the be $60,000 (Because $40,000 minus $100,000 equals minus $60,000.) And you’d get to deduct that $60,000 at some point during your ownership of the property.

Note: When you can deduct the $60,000 of losses would depend on Section 469 of the Internal Revenue Code. In another blog post, we describe how and when you can deduct these sorts of passive losses.

Counting Personal Days Trickier Than You’d Guess

A sidebar: You need to be careful about counting days as personal days. Or as rented days. The Section 280A chunk of law makes it easy to lose vacation home rental tax savings.

A day spent on maintenance, as long as an adult in the family, works fulltime? That day does not count as personal day. Even if the rest of the family is lounging around. This loophole, by the way, specifically applies to days spend on repairs and maintenance. To be safe, don’t assume you can use a property for some other business-y purpose and call the day a non-personal day. You can’t.

Another related wrinkle: Any day you rent a property to someone at below market value? That automatically counts as a personal day. Sorry.

Yet another wrinkle: Any day you rent to a family member counts as a personal except when you rent at a fair market rate to a family member for use as primary residence.

Finally, a last giant wrinkle to know about. Personal use of a principal residence doesn’t count as personal use days when those days fall before or after a qualified rental period.

And what the heck is a “qualified rental period?” Quoting from the law, it’s a “consecutive period of 12 months or more” for which the property is “rented or held for rental at fair market value.” Or it’s a “consecutive period less than 12 months” for which the property is “rented or held for rental” and “at the end of which such dwelling unit is sold or exchanged.”

The takeaway here: If you rent your former principal residence for at least twelve months to someone? Or you rent your former personal residence to someone (like maybe the buyer?) who occupies your home after the point you move and before you sell it? Your occupancy doesn’t count as personal days. Which means you don’t get entangled in Section 280A.

And the big planning point: You want to minimize your personal days. (Ideally, you want to so minimize your personal days that you don’t see your deductions limited to your rental income.) And if you can, you want to jack up the rental use percentage by having lots of rented days. That way you write off more of your expenses.

Other Vacation Home Rental Tax Resources

The Internal Revenue Service provides a very useful publication you want to read if you own and may rent a second home: Renting Residential and Vacation Property Note that you use some special accounting rules to pick which expenses get deducted when you report your vacation home rental income and deductions. The publication describes these.

We’ve got another copy of blog posts that talk about how to work the short-term rental tax planning opportunity: Tax Strategy Tuesday: Vacation Rental Property and Surviving Short-term Rental Audits.

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Filing Washington State Capital Gains Tax Returns

Stephen Nelson CPA — Mon, 27 Mar 2023 15:19:34 +0000

You maybe need to file a Washington state capital gains tax return with your 2022 federal tax return.

Specifically, if you realized long-term capital gains in 2022 of more than $250,000 and you’re a Washington resident. you need to file a Washington state capital gains tax return.

And if you’re not a resident but you realized more than $250,000 of long-term capital gains inside Washington state, you need to file the return.

Unfortunately, the whole process is tricky. And messy. So let’s go over the details. And quickly. You don’t have much time.

When You Need to File

The statute and the Washington State Department of Revenue says you only need to file the income tax return if you have to pay the new capital gains tax.

Thus, if you can wriggle out from under the tax by using one of the exemptions or deductions? (See this blog post at our CPA firm website for more information: Washington State Capital Gains Tax Planning.) Even though your long-term capital gains cross that $250,000 threshold? You can skip this goat rodeo.

Note that this approach differs from the way federal and most other state’s income tax laws work. Usually if your gross income is high enough, you file. Even if in the end you don’t owe tax due to deductions or credits.

Confusingly, this approach also differs from the way Washington state handles state estate tax returns and other excise tax returns like the business and occupation tax. (Washington state requires estates to file a state estate tax return if the gross estate exceeds the $2,193,000 threshold.)

Getting Ready to File Washington State Capital Gains Tax Return

Reflecting the state’s inexperience with administering an income tax, Washington State requires taxpayers to use their poorly designed, cumbersome SAW system for filing capital gains tax returns.

In a nutshell, the process works like this if a taxpayer will delegate the return preparation to a tax accountant:

A taxpayer creates a SAW account (Details here: https://dor.wa.gov/manage-business/my-dor-help/set#saw.)
The taxpayer registers a capital gains account for her or his SAW account (Details here: Capital Gains – My DOR help | Washington Department of Revenue )
The taxpayer adds the tax accountant as a user to the SAW account. The Department of Revenue suggests you add your tax accountant as an “Account Manager” user. That won’t work well for any situation where your accounting firm employs more than one accountant. You want to add your tax accountant as an “Administrator.” (Details here: Information on electronic filing for tax preparers | Washington Department of Revenue )
Engage your tax accountant to prepare the tax return.
When the tax return is complete, sign on to your SAW account, access your capital gains account, review the tax return and then, if it’s correct and complete, you then both file the tax return and pay the capital gains tax.

ABCs of Preparing Capital Gains Tax Return

You can tell the Washington State Department of Revenue doesn’t really understand how the federal income tax return works. And that’ll probably create all sorts of confusion as they process the capital gains tax returns.

In a nutshell, though, you enter the long-term capital gains information that shows up on the summary Schedule D form in the federal 1040 return. Then—and I kid you not—you enter each capital gains transaction that Washington state taxes.

If you invest using a rebalancing strategy (like Betterment), you or your accountant may have hundreds or even thousands of transactions to enter. By hand. The system doesn’t provide a way (yet?) to import transactions.

And then this friction point: The Department of Revenue’s instructions say you enter the detail that shows up on the Form 8949. But as any experienced tax accountant and many taxpayers know, most capital gain transactions don’t actually appear on the 8949 form. I can’t imagine that misunderstanding on the part of the Department of Revenue will produce good results for taxpayers.

What I think you ought to do is use the IRS instructions for preparing the 8949 and then complete the Washington state capital gains tax return as best you can.

If You Have Trouble with the Website

If you have trouble with the website or the process? Don’t call your tax accountant. Sorry. She or he can’t solve the problem.

Rather, call the Washington State Department of Revenue. Here’s the telephone number: 360-705-6655.

Another suggestion? If you do have trouble with the process? Like you can’t easily use the SAW system? Or the capital gains webpages don’t work well? Call or write your state legislators. (Contact information here: Washington State Legislature Member Information. ) Seriously. These men and women probably aren’t ever going to experience the system they decided you need to now use. Any feedback you can give them will encourage them to work to improve the process.

Extending the Due Date of the Return

One final suggestion: The state says if you extend your federal income tax return you automatically extend your Washington state capital gains tax return too. You probably want to do that.

Here’s why: The Supreme Court decided on March 25, 2023 you would need to file this tax return by April 18, 2023. But that late notice doesn’t give you or your accountant time to learn the law. Or if you’ve got a lot of transactions, time to manually enter the data.

But this caution: You need to have really good proof you extended. Probably you want to have your tax accountant electronically extend the federal tax return. If you don’t use a tax accountant, you should probably make an extension payment for your return to get extension documentation you can show state. (You can use this IRS web page to make an extension payment: Make an IRS Payment.)

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How IRS Audits Work

Christian Block CPA — Wed, 01 Feb 2023 16:35:44 +0000

Audit anxiety is something nearly every taxpayer has in common. But, have you ever considered how IRS audits actually work?

The IRS processes millions of tax returns each year that are never subject to additional examination or audit. Obviously, it is in your best interest to report things accurately and hope to stay off the IRS’s radar. Unfortunately, that isn’t always possible. Being selected for an audit does not inherently imply guilt or deception, and can happen to anyone that files a tax return.

I thought this would be a good topic of discussion as we go into the 2023 tax year. The IRS announced they are hiring 5,000 new agents in 2023, so this is especially relevant. Therefore, I will discuss how audits work, how returns are selected for audit, different types of audits, and ways to keep yourself protected if you are audited.

First, let’s go over some interesting statistics found in the 2021 IRS Service Data Book.

Statistics

The chances of being audited are pretty low. The IRS had 78,661 full time employees in 2021, and IRS employees dedicated to enforcement are only around 45%. Contrast this with the 167,915,264 individual 1040 tax returns filed in 2021. Consequently, the IRS has an estimated one IRS enforcement agent for every 4,800 individual 1040 returns filed, an extremely low ratio of agents to returns.

These enforcement agents don’t just look at 1040’s, either. Let’s add the 12,209,623 business entity returns filed in 2021 to our numerator. That equals roughly one IRS enforcement agent for every 5,200 returns. I won’t bother factoring estate, excise, payroll, tax exempt, and trust tax returns into the calculation, you get the idea.

Return Selection

Most tax returns go through an automated, electronic system called the “Discriminant Function,” or “DIF” for short. The IRS calculates the DIF score by weighting and adding together return characteristics. The higher the DIF score, the higher the potential for audit. Every 1040 return gets a DIF score. Additionally, S Corp and C Corp returns with assets less than $10,000,000 get DIF scores. The IRS uses other techniques to select returns for audits as well.

The IRS matches information in their files to information reported on your tax return. For example, a taxpayer receives a 1099-INT after cashing in a savings bond. If the taxpayer fails to report the interest or reports a different amount than what the 1099-INT shows, chances are this return will get selected for an audit.

Confidential informants can tip off the IRS, resulting in return selection. So can related party transactions with a taxpayer already under examination.

Certain schedules are high risk and can trigger scrutiny from the IRS. Form 8283 Non-cash Contributions, Form 8275 Disclosure statement, and Form 8082 Notice of Inconsistent Treatment are a few examples that can trigger a closer look at your return.

Per the 2021 IRS Data Book, here are some current trends the IRS is looking closely into:

Too many round numbers and deductions that offset large income items
FBAR reporting issues related to perceived under-reporting of foreign income
Virtual currency
Passive vs. non-passive flow through income
Real estate professional positions on rental real estate
Worker classification – employee vs. contractor
Matching source documents to returns, as mentioned above

But not all audits are equal. The intensity varies. So lets discuss the different types and cover some details of how IRS audits work.

Correspondence Examination/Audit

Correspondence audits are the most common, and there is a good chance you may have already had one. Have you ever received an IRS notice for your tax return? Maybe you failed to make estimated tax payments and received a notice asking you to pay interest. That is a correspondence audit, and usually not a big deal.

The IRS conducts these audits entirely through the mail. The IRS will make an adjustment or correction to a return, indicate the change, and calculate additional tax or refund due. Then, the taxpayer can either pay the additional tax or collect their additional refund if they agree with the adjustment.

Taxpayers can request more information or disagree with the change or correction and propose their own. The taxpayer should support their position with additional supporting documentation in their IRS response letter.

Sometimes taxpayers avoid these letters and take no action; not a recommended strategy. The IRS will send a second notice of deficiency letter, often referred to as a 30 day letter, requesting payment, when no action is taken by the taxpayer.

If no response is sent within 30 days, the IRS issues a Statutory Notice of Deficiency, and if the taxpayer still disagrees, they can file an appeal with the tax court.

Office Examination/Audit

A Tax Compliance Officer (TCO) conducts this type of audit in person at an IRS office to resolve issues too complex to resolve by mail. Typical issues include large itemized deductions, travel expenses, and misclassified income from rents and royalties.

The TCO will send the taxpayer a letter requesting an appointment and the type of documentation they need to bring to substantiate data reported on the tax return.

At the appointment, the TCO will collect oral testimony and physical documentation and will make one of three determinations; 1.) No change 2.) Deficiency 3.) Over-assessment.

Finally, lets discuss the third type of audit, the Field Audit.

Field Examination/Audit

A TCO conducts this type of audit at the location where the original books, records, and source documents are maintained, generally the taxpayer’s home or place of business. As you can probably guess, they are the least common type of audit. 21% of 2021 audits were field audits, per the 2021 IRS Service Data Book.

Spending the day in an office with an IRS agent is nobody’s idea of fun, however, these audits can produce more favorable results for the taxpayer than the other audit types.

Markedly, here are a few tips if you find yourself in a field audit:

Be polite and friendly
Know your taxpayer rights
Avoid offering more information than needed
Be honest
Have your records organized and easily accessible
Never leave the examiner alone
Negotiate your positions

Appeals

A taxpayer can appeal if no agreement is reached. You must submit a formal written protest if the total amount owed exceeds $25,000, or the appeal is for a partnership, S Corp, or tax exempt organization.

There is no IRS form for a written appeal, but, it needs to include the following information:

Statement the taxpayer wants to appeal the examiner’s findings to the appeals office
Taxpayer’s name, address, and phone number
A copy of the letter showing the proposed changes
Tax periods involved
Schedule of adjustments the taxpayer disagrees with
Statement of fact supporting the taxpayer’s position
Statement outlining the law the taxpayer relies on
Declaration under penalties of perjury attesting the statement of facts as true and accurate

Protection

Now lets discuss some different expenses and how to ensure they are substantiated.

Trade or Business Expenses

Before taking a deduction, you want to ensure your activity rises to the level of a trade or business. 26 U.S. Code § 162 allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. A taxpayer must continuously and regularly be involved in the activity for the primary purpose of making a profit.

The regulations provide a list of relevant factors when considering if the activity rises to the level of a trade or business, including:

Expertise of the taxpayer
Time and effort expended on the activity
History of income and losses with respect to the activity
Whether elements of personal pleasure or recreation are involved in the activity
Manner in which the taxpayer carried on the activity

Example

Lets explore this a bit more and use myself as an example. I like fixing up cars, which inevitably ends up with me having more money in them than I can sell them for. I also have a job as a CPA and know this car hobby is not a money making endeavor. There is no profit motive, no history of success, and is done purely for personal pleasure. It surely does not rise to the level of a trade or business, therefore I cannot report the activity on my 1040 tax return and claim a loss that offsets my CPA income.

The scenario is probably different if I am working on other people’s cars for money on the side. I would need to report the income, and I would certainly have expenses (tools, supplies, etc.) that are legitimate business deductions.

In summary, be careful not to take losses and deductions on an activity the IRS would classify as a hobby and not a business.

Travel Expenses

You need to substantiate business expenses, clearly, but this is especially true with travel expenses. Travel expenses aren’t as straight forward as say, a rent payment to the landlord of a retail store, so extra diligence must be used when deducting travel.

To qualify for a deduction, travel expenses must be:

Reasonable and necessary
Incurred while traveling “away from home”
Directly related to the conduct of the taxpayer’s trade or business

Three factors are used to determine a taxpayer’s “tax home:”

Whether there existed a business connection to the location of the home
Were duplicate living expenses incurred while traveling and while maintaining the tax home?
Whether personal connections exist to the tax home

Commuting to the office is not a qualified travel expense. And if your place of employment is somewhere other than your residence, and you decide not to move your residence to your work location, living and travel expenses getting to your job are not deductible either.

Mixed purpose travel gets murky too. It must be primarily related to the taxpayer’s trade or business to be deductible, with time spent on business being the most relevant factor. If you have business seminars in Hawaii for four days, and you stay for two additional vacation days, that probably counts. Reverse the business and personal time, that probably doesn’t count. And there must be a bona-fide business purpose for a spouse’s travel expenses to be deductible.

Charitable Contributions

If you generally have enough deductions to itemize, chances are you have probably taken a charitable contribution deduction. And you want to have very good records to substantiation the contribution.

For cash contributions of $250 or less, you need to have one of the following:

Canceled check
Bank or credit card statement
Receipt from the organization
Paystub if contributed through a payroll deduction

Cash contributions greater than $250 should, ideally, be substantiated with a receipt from the organization detailing the dollar amount, date, and whether any goods or services were provided to the donor.

Worker Classification Audits

The last topic I want to discuss is worker classification audits. Employers have a financial incentive to misclassify employees as independent contractors because costs and record keeping is lower. Workers have an incentive to be classified as independent contractors because they can deduct expenses not available to employees.

The IRS uses a three-factor test to determine if a person is an employee or a contractor:

Behavior Control – Does the employer provide training to the worker? The more training provided, the more control the employer exerts over the worker.
Financial Control – Key factors include the workers investment in the services they provide, other services they make available to the market, and the opportunity for their own profit with respect to their services.
Relationship of Parties – Relationship factors include the extent to which either party can terminate the relationship, the party’s contractual relationship, and the employer providing, or not providing, benefits typically provided to an employee.

Misclassification of a worker as an independent contractor can have large consequences to the employer. The employer may end up liable for payroll taxes on all open tax years, federal income tax that should have been withheld from the workers paychecks, and any state income taxes that should have been paid on the worker. Consequently, only one or two worker misclassifications could lead to thousands of dollars of tax owed.

Final Thoughts

The goal of this blogpost was to (hopefully) relieve some anxiety by covering how IRS audits work and what you can expect if you ever find yourself in an audit situation. You should not feel bad if it happens to you. But, you want to be smart and methodical on how your respond to and deal with the IRS.

Good record keeping, honesty, and a little bit of knowledge will go along way on keeping yourself protected.

We have some additional posts on IRS audit prevention tips, real estate professional audit troubles, and surviving short term rental audits that contain great information if you want even more detail.

The post How IRS Audits Work appeared first on Evergreen Small Business.

Lottery Tax Planning for a Billion Dollar Drawing

Stephen Nelson CPA — Wed, 11 Jan 2023 16:58:16 +0000

Okay. This is silly. You’re probably not going to win. But just for fun, let’s talk about lottery tax planning for one of those giant Power Ball or Mega Millions lotteries. What should you do, tax-wise, if you win a billion dollars?

Quite a lot, actually. But let me explain.

Share Your Winnings

A first thing you want to do. Maybe. If you plan to share your winnings with heirs, gift an interest in your lottery ticket before the drawing.

A one quarter interest in a $2 Power Ball or Mega Millions ticket is worth $.50. That minimal amount can be given away without any gift tax consequences. An individual can give away up to $17,000 to someone without triggering gift taxes.

But if you win a $1,000,000,000 lottery? And then you give away a big chunk? Like a quarter interest?

You’ll pay roughly 40 percent in gift taxes. Give three heirs $100,000,000 each, for example, and you’ll pay $40 million in gift taxes, roughly, on each of those three gifts.

Note: If you don’t give away the money, it ends up in your estate. And then your estate pays roughly 40 percent in federal estate taxes. In many states, another chunk goes to state estate taxes. Washington state for example levies a 20 percent state estate tax. (More information here: How Washington State Estate Taxes Work )

So anyway: That’s idea one. Share before you win.

Note: I have a standard agreement with my two kids. Every time I buy a lottery ticket, I gift each of them a one quarter share. Something I memorialize with a text message. And sure. It’s all just fun and games right now. But if I win? Yeah. Bingo.

Take the Lump Sum Payout

Here’s another lottery tax planning idea. And this is a bit controversial.

You have a choice to take your winnings as a lump sum or in thirty annual payments. The choice might be, for example, $500,000,000 up front. Or $1,000,000,000 paid out over three decades. (See here for a description of how the Mega Millions payout options work: https://www.megamillions.com/How-to-Play/Difference-Between-Cash-Value-and-Annuity.aspx )

I think you take the $500,000,000 if you live in a no or low income tax state. Or if you live in a state with income taxes but winning the lottery won’t cause you to move to a lower-tax state.

The reasoning behind this suggestion rests on two factors.

First factor? Today tax rates are still pretty low at a federal level. You’ll pay roughly 37 percent.

In 2026, however, the Trump tax cuts expire. And then the top tax rate jumps to 39.6%. A three-percent-ish bump doesn’t sound like a lot. But it adds tens of millions of dollars of taxes.

And then there’s a second reason to take a lump sum payout. Or at least seriously consider the lump-sum payout.

Stack Charitable Contributions in Year You Win

That reason? If you’re going to contribute any of the winnings to charity, you want to get that deduction onto a return when it’s fully deductible.

In 2023? A big charitable deduction works on your return. If you give away $50 million or $100 million? You deduct the $50 million or $100 million.

However, in 2026, tax law changes and essentially prevents or limits high income taxpayers from deducting charitable deductions.

The bottom line? You want to stack your charitable deductions in the year you win. And onto a tax return when you get a full deduction.

One other tip: You don’t want to overwhelm some small charity with a giant contribution. Further, you will want to do a thoughtful job of where and how and when you donate. That’s just good stewardship. Thus this companion idea: Probably you want to contribute your big charitable deduction to a charitable donor advised fund. (For example, Vanguard’s: Donor advised fund.) That gives you the deduction this year. And then you can, over time, smartly parcel out your gift to worthy recipients.

Note: Other tax accountants disagree with my suggestion to take the lump sum payout. And I”ll talk more about this in a minute.

Consider Post-Drawing Gifts

You can in 2023 give $17,000 in any given year to someone without paying gift tax.

If you’re married, your spouse can do the same.

Then over and above these limits, you can give away another $12,600,000 in gifts yourself over your lifetime. And then your spouse if you’re married can do the same.

Thus this idea: If you have other giving you want to do? Think about using the annual exclusion allowed (that $17,000 per person per year) to make gifts to friends and family.

And then think about using up the single $12,600,000 or the married $25,200,000 life-time exclusion.

Let’s say for example that you and your spouse have ten people—family members and friends—who you want to share your winnings with.

I think you give each of them 1/10^th of your lifetime exclusion. So maybe that’s roughly $2.5 million a person.

What this maneuver saves? More estate and gift tax. And then one other thing. Maybe these gifts lessen the distance between you and your brother or dad. The distance created by you receiving a giant windfall, I mean. Just an idea.

Note that this option works when you take a lump sum payout. It probably doesn’t work or work well if you take the annuity.

Be Tax-efficient Investing Your Winnings

I have two final lottery tax planning ideas for you, too. Ideas connected to how you handle the remaining winnings in a tax-smart manner.

But let’s summarize the hypothetical situation. You won a $1,000,000,000 drawing but took the lump sum payment. So your billion-dollar ticket actually resulted in roughly a $500,000,000 payout.

You gifted interests in the ticket prior to the drawing to your kids. (That probably saves about $100,000,000 in federal estate taxes in the case where you win a “billion dollars” drawing.) And it means the $500,000,000 drops to $250,000,000.

On the $250,000,000, say you gave $25,000,000 to a charitable donor fund. That gift drops the balance in your bank account balance to $225,000,000. (But by making the deduction now you save roughly $9 million in federal income taxes. Stretch your giving out, however, and you’ll lose most of this.)

You will have paid maybe $90,000,000 in federal and state income taxes. That payment drops your bank account balance to roughly $135,000,000.

And so then, at that point, I think you invest the remaining funds using the recipe Warren Buffett has reportedly set up for his wife upon his passing. That recipe puts 90 percent of the investment into a US stock index fund and 10 percent into US Treasury bonds.

You and I should do something similar with a $100 million or $135 million portfolio.

The big tax reason for this suggestion? The income generated by such a portfolio would mostly be either untaxed or taxed at low rates. Appreciation in the stocks, for example, wouldn’t be taxed until you sell. And you might never sell.

Further, dividends and capital gains would probably be taxed at a federal rate of roughly 24 percent. (The sum of the top capital gains and qualified dividends tax rate, 20 percent, plus the net investment income tax rate, 3.8 percent.)

Consider Moving to Another State

Let me also throw out another lottery tax planning idea which is maybe a little less workable. But something to consider. You may want to move to a low or no-income-tax sate.

On a passive portfolio of $135,000,000 with a Warren Buffet allocation, your annual income might run roughly $3,000,000. (That’d be roughly $500,000 of interest and roughly $2.500,000 of dividends and long-term capital gains.) A Buffet style allocation would result in a federal tax burden of roughly $800,000. Or about 25 percent.

A handful of states don’t tax or mostly don’t tax investment income, however. Probably you living in one of those (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) will save you several hundred thousand dollars a year.

By the way, if you think you’ll move? The lump sum option possibly doesn’t make as much sense. This article explains why: Smart Tax Strategies for Lottery Winners. But to summarize, the article authors point out that the implicit return someone earns by “investing” the lump sum payout into the annuity represents a decent return. (About 3.7% after taxes, I calculate.) An annuity maybe limits a winner’s ability to spend all the money quickly and foolishly. Finally, and I think this is really key, an annuity may provide for the opportunity to do something like move to another state. (This would make a big difference potentially.)

I agree with those points for small-ish lottery winners. For gigantic winners, my opinion, looking at the lump sum payout option makes sense.

Final Remarks Concerning Lottery Tax Planning

A couple of quick remarks in closing. First, the highest impact idea in the preceding paragraphs? A pre-drawing gift. That’s the lottery tax planning gambit you really want to consider. And that gambit illustrates a key tax planning reality: Up front planning often makes the biggest impact.

A second point: It probably makes sense to get a good tax accountant involved in your decision making once you win. The federal and state income and estate taxes get really big.

The post Lottery Tax Planning for a Billion Dollar Drawing appeared first on Evergreen Small Business.

A Dozen Ways to Deduct Real Estate Losses

Stephen Nelson CPA — Thu, 01 Dec 2022 16:57:55 +0000

Tax law (and especially Section 469 of the Internal Revenue Code) mostly eliminates your ability to save big on taxes using real estate. That said, you do have a bunch of clever tricks available to deduct real estate losses on your tax return.

You just need to to plan ahead. And carefully structure your investing. But with little effort? You’d be surprised at the results.

Quick Review of Why Real Estate Produces Big Deductions

Let’s quickly review, though, how you can use real estate to generate big tax deductions.

Say you own a $1,000,000 property that generates $50,000 in rent. Further, suppose the property expenses, including the interest on the mortgage used to fund a part of the purchase, run $50,000.

You might assume such an investment breaks even for tax return purposes.

However, tax accounting rules will typically show a property like that described as losing money. Why? Because the investor depreciates the property.

Tax laws say investors can depreciate, or write off, the purchase price of a residential building over 27.5 years. And those same laws say a taxpayer can depreciate the purchase price of a commercial building over 39 years. (You only get to depreciate the building, not the land, by the way.)

And then the other wrinkle: Some of the bits and pieces of a residential property or commercial property can be written off much faster. Maybe in the year of your purchase.

A $1,000,000 rental property that breaks even, for example, might result in you putting a $100,000 or $200,000 deduction on the tax return you file the first year of ownership.

Which is why tax law includes the Section 469 passive loss limitation rules. In most situations, these rules say you don’t get to use big real estate deductions to shelter other income.

Exceptions exist for all rules, however. And more than a dozen exceptions allow you to deduct real estate losses or use real estate to shelter your other taxable income.

Real Estate Deduction Trick #1: Active Real Estate Participant

The first and easiest to use exception: The active participant exception (provided by Section 469(i)).

Specifically, if your modified adjusted gross income equals $100,000 or less, you can deduct real estate losses of up to $25,000 each year. The only two rules to make this deduction work are:

You or your spouse need to own at least ten percent of the property.
You or your spouse need to be actively participating in managing the property by doing things like picking the property manager, approving tenants and expenditures, and making rental agreement decisions.

By the way, if your modified adjusted gross income exceeds $100,000 but falls below $150,000, tax law proportionally phases out the $25,000 allowance. Someone with a modified adjusted gross income halfway between $100,000 and $150,000, for example, loses half of the $25,000 allowance.

The active real estate participant exception works for middle class taxpayers and for most upper-class taxpayers.

Note: Modified adjusted gross income equals a taxpayer’s adjusted gross income plus retirement deductions, passive losses such as on real estate, deductions for self-employment taxes, student loan interest, tuition deductions, and some foreign income deductions.

Real Estate Deduction Trick #2: The Section 280A(g) Exception

A weird trick works for property owners who also own a business structured as a corporation or a partnership.

A taxpayer in this situation can sometimes direct the corporation or partnership they own to pay rent to them for the use of a personally-owned real property.

If the rent counts as an ordinary and necessary expense, the rent payments get deducted on the corporation or partnership return. Which makes sense.

But here’s what’s weird. If the property owner rents the property for fourteen days or less, and then the property owner also personally uses the property for more than two weeks, the rent payments the taxpayer receives from their business don’t count as income.

An example shows how this works. You own a condo in Florida. When you attend a two-week industry conference in Orlando, rather than pay some hotel for lodging, your corporation pays you for using the condo for two weeks. (Say the corporation pays you $10,000.)

On the corporation’s tax return, the corporation counts the $10,000 as a valid deduction.

But on your individual tax return, the $10,000 rent received doesn’t count as income. Because of the Section 280A(g) rule.

By the way, the rental rate needs to be the market rate. (Accordingly, if the market rate is high, the rent amount can and must also be high.)

Real Estate Deduction Trick #3: Self-Rental

A related gambit works to deduct real estate losses, too.

If you buy property to rent to another trade or business you own, you can group the rental property trade or business with the operating trade or business on your tax return. That self-rental grouping lets you sidestep the passive loss limitation.

For example, if you run a professional practice (perhaps as an S corporation) and then you personally buy the building you use for the business, you get to deduct the real estate losses from the building on your personal return.

The one key bit of this rule to be alert to: The ownership of the rental property and the ownership of the operating trade or business need to match. Perfectly.

Note: We’ve got a longer and rather detailed discussion of how the self-rental trick works here: The Self-Rental Loophole.

Real Estate Deduction Trick #4: Real Estate Professional

Here’s a really powerful strategy to deduct real estate losses.

A real estate professional gets to deduct real estate losses if she or he materially participates in the rental operation.

To be a real estate professional, someone needs to spend more than 750 hours and more than 50% of their work day in a real estate trade or business they own (Section 469(c)(7)). Real estate trades or businesses include property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, property management, learning, or brokerage.

And then, as noted, either the taxpayer or the spouse needs to materially participate in the rental business by spending enough time. (The standard, clean way to materially participate is to spend more than 500 hours on the investment property or properties in a year. But you can achieve material participation in other ways, too. Like by spending more than 100 hours a year if no one spends more time.)

An example shows the power of this strategy. Say a high income professional or executive earns $400,000 annually. Suppose his or her spouse manages a family real estate portfolio and in that role as a property manager qualifies as a real estate professional. Further suppose that the real estate portfolio produces real estate losses equal to $150,000. This married couple pays taxes on the net $250,000 in this situation. In other words, $150,000 of the household’s $400,000 annual income gets sheltered by the paper real estate losses.

Note: A longer discussion of how the real estate professional strategy appears here: How the Real Estate Professional Tax Strategy Works Also note that California prevents a taxpayer from using the real estate professional strategy for its state income tax returns. (A Californian still can use the real estate professional loophole to shelter federal income taxes.)

Real Estate Deduction Trick #5: Short-term Weekly-or-less Rentals

Here’s another strategy to deduct giant real estate losses.

If your average rental interval equals seven days or less, tax law (specifically Reg. Sec. 1.469-1T(e)(ii)(A)) says you’re not in the real estate rental business. Rather, you’re in a non-real-estate business. That means you get to deduct any of the non-real-estate losses if you materially participate.

Note: A longer discussion of how this real estate deduction exception works appears here: How the Vacation Rental Tax Strategy Works. But know that short-term rentals work really well as long as you carefully follow the rules.

Real Estate Deduction Trick #6: Short-term More-than-a-Week Rentals

Another similar, but less well-known, short-term rental exception applies, too.

If a taxpayer rents property for, on average, thirty days or less but more than a week and she or he provides significant personal services, tax law (in this case, Reg. Sec. 1.469-1T(e)(ii)(B)), says they’re also not in the real estate rental business. Rather, they’re in a non-real-estate business. If a taxpayer materially participates in the non-real-estate business? Bingo. They get to deduct real estate losses.

So for example, if someone operates a hotel and the hotel provides daily maid service, a front desk with bellhops, and then maybe a concierge, that’s not a real estate business. And the taxpayer gets to deduct any of the non-real-estate losses if she or he materially participates.

Sidebar: The IRS Definition of “Significant”

One caution here: The IRS says “significant personal services” means really significant. Here’s the example the Treasury regulations give for when personal services provided by a residential apartment hotel fail to reach the level of “significant:”

Example 4:

The taxpayer is engaged in an activity of owning and operating a residential apartment hotel. For the taxable year, the average period of customer use for apartments exceeds seven days but does not exceed 30 days. In addition to cleaning public entrances, exists (sic), stairways, and lobbies, and collecting and removing trash, the taxpayer provides a daily maid and linen service at no additional charge. All of the services other than maid and linen service are excluded services (within the meaning of paragraph (e)(3)(iv)(B) of this section), because such services are similar to those commonly provided in connection with long-term rentals of high-grade residential real property.

The value of the maid and linen services (measured by the cost to the taxpayer of employees performing such services) is less than 10 percent of the amount charged to tenants for occupancy of apartments. Under these facts, neither significant personal services (within the meaning of paragraph (e)(3)(iv) of this section) nor extraordinary personal services (within the meaning of paragraph (e)(3)(v) of this section) are provided in connection with making apartments available for use by customers. Accordingly, the activity is a rental activity.

So, daily maid service isn’t enough. A taxpayer needs more than that.

Real Estate Deduction Trick #7: Rental Incidental to Extraordinary Personal Services

Sometimes, the owner of a residential property or commercial building lets customers use the residential facilities or commercial property just as part the customer receiving some other service.

For example, a hospital or nursing home may in effect “rent” hospital rooms to patients. But the rental activity pales in comparison to the medical or nursing care the people receive.

Another example: A college or boarding school provides (so in effect “rents”) rooms in on-campus dormitories to students attending classes. But the real activity is education.

In these settings where extraordinary personal services are provided, tax law (specifically Reg. Sec. 1.469-1T(e)(ii)(C)) considers the activity a non-real-estate activity. And the taxpayer may deduct the non-real-estate deductions and losses if they materially participate.

Probably not an idea many people will use. But you never know.

Real Estate Deduction Trick #8: Rental Activity Incidental to Nonrental Activity

Another way exists to deduct real estate losses based on the incidental nature of the real estate, too.

Specifically, if a trade or business owns and rents property, but that rental activity is only incidental relative to the main trade or business? The losses connected to the rental property don’t get limited by the Section 469 passive loss limitation rules.

The current Section 469 regulations (at Reg Sec. 1.469-1T(e)(vi)) provide three examples of this sort of incidental rental activity. One example says that if the taxpayer holds the property for appreciation and the gross rental income is less than the lesser of two percent of either the unadjusted basis or the fair market value of the property, that counts as incidental. Another example says that renting property to an employee counts as incidental. Finally, a third example says that if a property is used in a trade or business the taxpayer owns an interest in and the gross rental income falls less than two percent of the lesser of property’s unadjusted basis or fair market value, that minuscule rental income counts as incidental.

This approach to deducting real estate losses probably won’t result in giant tax savings. But might produce some.

Real Estate Deduction Trick #9: Nonexclusive Rental Activity

Nonexclusive use of property doesn’t count as a real estate rental activity (per Reg. Sec. 1.469-1T(e)(ii)(E)).

Examples of this situation? The Treasury’s regulations talk about a golf course where, in one sense, the property owner rents the use of the course to golfers. But not exclusive use. So that works.

And then a crazy idea which I also think works. Suppose you decide to get into the amusement park business. And you set up a haunted house attraction that charges people an admission fee. Again in this example, the property owner in effect rents the use of the house through an admission fee. But again not exclusive use. So that should work.

In these nonexclusive-use situations, as long as the owner materially participates in the activity, she or he can deduct real-estate-y losses.

Real Estate Deduction Trick #10: Insubstantial Rental Activity

The Regulations for Section 469 describe rules taxpayers can use to group activities. For example, a barber with two barber shops might treat the two shops as two activities. Or he might group the two barber shops into a single activity.

Normally, though, taxpayers can’t group rental activities with a nonrental activity.

But except for that special rule, most grouping rules apply common sense. Stuff a taxpayer would logically think of as one trade or business can be grouped. (The specific rules appear at Reg. Sec 1.469-4 but talk about similarities and differences in the businesses, the extent of common control and ownership, geographical locations, and then interdependencies between the activities.)

However, these grouping rules also flag a couple of other interesting possibilities that effectively allow a taxpayer to deduct real estate losses by clever grouping. For example, a taxpayer might (per Reg. Sec. 1.469-4(d)(1)(i)(A)) group an insubstantial rental activity with another trade or business. And then in effect deduct real estate losses.

The now-expired former Reg. Sec 1.469-4T provided a less than “20 percent of the activity’s income” threshold for determining insubstantial-ness. In an example the regulations provided, a law firm earned 90 percent of its gross income from practicing law and 10 percent from renting out two floors in the ten-story office building it owned and operated out of. That example said the two floors of rental activity counted as insubstantial.

But note what happens in this case: The taxpayer probably does get to deduct real estate losses in situations where an insubstantial rental occurs.

Tip: If you need to explore this possibility in more detail, read the Technical Advice Memorandum 200014010. It describes why the less than 20 percent approach shouldn’t be considered a “bright line” test.

Real Estate Deduction Trick #11: Insubstantial Nonrental Activity

The other example of insubstantial-ness occurs when an insubstantial non-rental activity gets grouped with a rental activity. In that situation, income from the insubstantial non-rental activity might allow a taxpayer to deduct real estate losses equal to the income from the insubstantial non-real-estate activity.

For example, a building owner starts a small coffee shop in the lobby of an apartment house she owns. Those two activities might be group-able based on georgraphy, common ownership and control, and then interdependencies. Further, if they are group-able and the coffee shop activity is insubstantial, it’s income may be netted with the apartment house losses. That means the taxpayer shelters active trade or busienss income using real estate losses.

Tip: Another tip for taxpayers or tax accountants who want to explore in more detail grouping real estate with insubstantial non-real estate activities: look at the Glick v. United States federal district court case.

Real Estate Deduction Trick #12: Other Passive Income

A twelfth way to deduct real estate losses: You get to deduct the passive losses you incur on an investment property to the extent you have passive income. And you may unlock past suspended passive losses.

For example, if your tax return will report a large $1,000,000 passive gain on the sale of one rental property, Section 469(d), so the actual law, essentially says that gain can be sheltered by $1,000,000 of suspended passive losses you’ve incurred in the past. And it can be sheltered by large passive losses you intentionally orchestrate for the current year. So that’s another way to deduct real estate losses on your return.

Real Estate Deduction Trick #13: Disposition of the Activity Generating Passive Losses

A final way to deduct real estate losses exists: You do get to deduct passive losses generated in some activity when you dispose of the activity.

For example, if over the years your tax returns have shown passive losses accumulating on a rental property, selling the property will typically unlock those losses.

Say you bought a property for $1,000,000, for example, wrote off $500,000 of the purchase price through depreciation deductions, and will now sell the property for $500,000. And say the rental income and rental expenses equaled each other. So, the property essentially broke even before considering the depreciation deductions.

A sale in this situation will unlock the previously suspended losses.

Closing Thought

As always, taxpayers want to discuss a strategy like this with their tax advisor.

But this plug for our CPA firm: If you don’t have a tax advisor who can help? Please consider contacting us: Nelson CPA.

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