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    Tax Implications of Renting out a Vacation or Second Home

    Last updated 1 year ago

    The rules surrounding the rental of a vacation home or a second home can be quite complicated.  For that reason, many taxpayers avoid dealing with it altogether, and instead just gather the necessary tax documents and allow a tax professional to take over.  That’s not a bad idea, but it’s also important to have a general understanding of the issue to allow for strategic planning, which can make all the difference when trying to minimize your tax liability.  The bottom line is you want to be proactive, rather than reactive. 

    Fortunately, if the property is rented out for 14 days or less, you are not required to report any rental income.  But, this also means you aren’t able to deduct any expenses associated with the property other than mortgage interest and real estate taxes, which are both reported in full on your Schedule A.   Otherwise, you must count the rental days and divide that by the total numbers of days the property was used throughout the year.  Keep in mind that you are not dividing the rental days by 365, but rather the sum of the rental days and the personal use days.  There very well may be a large portion of the year during which the property remains vacant, particularly if it is located in a region that experiences seasonal tourism or colder temperatures during the fall and winter months. 

    Once the total days of use are allocated between rental and personal, the rental use allocation percentage is multiplied by the total repairs and maintenance, insurance, utilities, property management fees, depreciation, real estate taxes, and mortgage interest for the year.  Those expenses are deductible against the rental income earned and reported on Schedule E.  To account for the remaining time representing personal use, the personal use allocation percentage is multiplied by total real estate taxes and mortgage interest, which will be reported on Schedule A.  So, regardless of whether rental income and expenses are reportable, and regardless of how the total days of use are allocated between rental and personal, the mortgage interest and taxes will always be deducted in full, either on Schedule A, Schedule E, or both (unless rental losses are limited, which will be discussed later). 

    Keep in mind that days used to repair or maintain the property do not count when determining total days of use, but the primary purpose of the occupancy must be to perform the repair and maintenance work.  More importantly, days used by immediate family members are considered personal use days, even if they pay fair market rent.  When swapping vacation homes, whether it is with strangers, friends or immediate family, those days are also considered personal.  It’s essential that rent charged to tenants be considered fair market value, because otherwise, the use is deemed personal, regardless of their connection to you.  In that case, you are required to report the income, but are unable to deduct expenses such as repairs and maintenance, utilities and depreciation. 

    After you allocate the various expenses between rental and personal use, you may find that the rental expenses exceed the rental income received, creating a loss.  The deductibility of that loss depends on multiple factors.  If the personal use of the property is more than 14 days or 10% of the total days rented (whichever is greater), it is considered to be a “hobby rental,” and losses are disallowed.  For example, if you rent the property for a total of 180 days throughout the year, and you and your family occupy it for a total of 20 days, the rental loss is disallowed and expenses are only deductible up to the amount of rental income, because the personal use (20 days) exceeds 14 days and 10% of the rental use (18 days). 

     

     

    With that being said, if it is deemed a “hobby rental,” you may want to consider calculating allocation percentages by dividing by 365 instead of total days of use. This is advantageous because it will reduce the percentage allocated to rental use and increase the percentage allocated to personal use, which allows for a greater real estate tax and mortgage interest deduction on Schedule A. For example, using the same scenario from above, dividing the rental days by the total days of use results in an allocation of percentage of 90% (180/200). But, if you divide the rental days by the total days in a year, the allocation percentage is 49% (180/365). So, as a result, 51% of the taxes and interest are deductible on Schedule A as opposed to 10%.

    On the other hand, if the personal use does not exceed 14 days or 10% of rental use, you will want to use the IRS proscribed allocation method as discussed in the second paragraph. In this situation, if a rental loss is calculated, you are able to deduct up to $25,000 ($12,500 for single taxpayers) of that loss if your Adjusted Gross Income (AGI) is under $100,000 ($50,000 for single taxpayers). If your AGI exceeds $100,000 the $25,000 deduction is gradually phased out, $1 phased out for every $2 increase in AGI, until your AGI reaches $150,000 at which point it is eliminated completely. Keep in mind that in order to claim any portion of the $25,000 rental loss, you must actively participate in the rental activity, meaning you own at least 10% of the property, and participate in approving new tenants, deciding on rental terms, approving expenses for improvements or repairs and maintenance, etc.

    It is important to understand that rental losses are subject to passive activity loss limitations, which means any losses that you are unable to take in the current year can be carried over and used to offset rental income from the same property in future tax years. Moreover, when the property is eventually sold, all of those suspended losses are recognized in the year of sale.

    It is suggested that you consult a tax professional for further guidance on the rules of renting a vacation or second home. Please contact Restivo Monacelli, LLP to setup a consultation.

    Utilizing the R&D Credit as a Small Business

    Last updated 1 year ago

    The research and development (R&D) tax credit was initially introduced in the early 1980s to encourage innovation in a rather stagnant economy by rewarding companies who continue to increase their investment in the development of new or improved products, processes or formulas.  Unfortunately, the credit remains underutilized by small to mid-sized companies, primarily because the complexity involved in calculating the credit can be discouraging.  But, a simplified calculation method has been introduced that will make the task much less daunting for companies with limited resources.  Another factor in the underutilization is the lack of eligibility awareness.  The R&D credit continues to evolve and the range of activities that qualify continues to expand.  The use of engineers, outsourcing of product testing and filing for patents are basic rules of thumb, but it no longer has to be on that scale.  A company simply must prove that it is partaking in the process of experimentation to eliminate uncertainty or the design, development, or improvement of products, processes, techniques, formulas or software.

    As previously mentioned, the Alternative Simplified Calculation (ASC) method was introduced in 2007, and it uses the company’s average R&D expenditures over the prior three years as a threshold.  Any qualified expenses in the current year that exceed the threshold serve as a base, and is then multiplied by 14% to arrive at the credit, which can be used to reduce the company’s tax liability dollar-for-dollar.  Because a company may not have incurred R&D expenditures in the three years prior, the credit can be calculated using the current year qualified expenses only and multiplying that total by 6%.  More importantly, the credit can be taken retroactively and can be carried forward for up to twenty years, the latter of which is essential for startups that may not have income in the years the research and development takes place.

    Another obstacle faced by small to mid-sized companies is the documentation required to support the R&D credit.  Claiming the credit often increases audit risk for larger companies, but smaller companies face a greater risk of credit disallowance.  This is because most have not developed or implemented the proper policies and procedures  necessary to prepare and collect documentation of qualified expenses.  Understanding what the IRS considers acceptable and adequate documentation is an essential first step.  Oral testimony of individuals involved in qualified activities and projects is a good starting point, but it won’t suffice if its stands alone.  Instead, build on the testimony with time sheets for hourly employees (if they are salaried, note what the individual is working on and when) and diagrams or blueprints.  If possible, use project-based accounting to quantify costs associated with eligible projects.  Its helpful to gather documentation during the earliest stages, even if its uncertain whether the expenses will later qualify, and once a project is determined to be eligible, be sure to take note of how that was determined. 

    For more information on calculating the credit, your company’s eligibility, and policies and procedures for documenting expenses, contact Restivo Monacelli, LLP at (401) 273-7600.

    The Challenges of Running a Family-Owned Business

    Last updated 1 year ago

    In addition to the challenges faced by all businesses—remaining innovative and continuing to reinvent, building and maintaining strong relationships with suppliers and customers, understanding the wants and needs of your target audience, and responding to changes in the market—family businesses face unique challenges that are dictated by the family dynamic.  Finding a balance between family and business interests and building a business for the good of the customers, employees and shareholders can be achieved with the help of a group of outside advisors such as lawyers, accountants, internal auditors and financial professionals

    These outside advisors can act as an unbiased third party and are able to make objective decisions that are not influenced by emotion.  With the trust of the members of the family and perspective on the inner dynamics, they can assist in creating a solid organizational structure  and establishing guidelines that set forth proper policies and procedures.  For example, there may need to be guidelines outlined for the hiring, promoting and terminating of family members that ensures they are treated the same as all other employees, or an organizational chart may need to be developed to ensure that all family members are overseen by a non-family member.  Typically, advisors will have a broader range of experience having held a variety of positions overtime, and will bring to the table ideas and knowledge on what will work best for each unique situation. 

    Succession planning is also an important step in this process, and it is essential that this be done many years in advance to facilitate a smooth transition when the current leaders step down from their positions.  With only 30% of family businesses surviving the second generation and only 12% surviving the third, longevity may depend on finding the candidate who possesses those qualities you have determined are necessary to successfully run the company in the future, whether that individual be part of the family or not.  It’s important to take note of how closely tied the company and estate plan are, and may want to work with an estate planner to determine whether your spouse and dependents will still be taken care of if the business goes under, because upon retirement, the livelihood of the company may no longer be in your hands. 

    Retirement Savings Plan Options for Young Investors

    Last updated 1 year ago

    Many young adults are hesitant to invest money into a retirement savings plan because of the perceived risk associated with it. The younger generation saw firsthand what the unpredictability of the stock market did to their parents' nest egg when the recession hit in 2008. Most retirement savings plans offered to young adults just starting out involve a more aggressive investment approach, meaning riskier retirement funds that start out heavy on stocks and grow more conservative over time. Its assumed that with 40-50 years until the target retirement date, if your funds are effected by any future downturns in the market, there would be plenty of time for them to bounce back. But, some are beginning to argue that this is not the smartest approach after all, because by putting new investors into conservative funds that grow more aggressive over time, the investor is taking on risk when he or she is better able to handle it. Not only is there greater diversification, but as an investor matures, he or she may become more knowledgeable and involved in investment decisions, and by taking on risks when the pot of money is larger, the returns prove more worthwhile. So in conclusion, if you are interested in contributing to a retirement savings plan, but are concerned about the risk involved, its important to realize that funding a plan with fewer stocks early in your career can still successfully grow a nest egg of your own.

    Its not just the risk factor that keeps young adults from investing, its the perception that there is more than enough time to save for retirement in the future without beginning that journey now. Most college students have racked up some sort of debt, whether it be with credit cards or student loans, so it seems more logical for graduates to put money toward the debt and wait for a higher paying job and better job security to begin saving. Though paying off debt is important in maintaining good credit, its also important to build an emergency fund that can be used in the event of unemployment, a major illness or even to cover unexpected costs like car repairs. If you are currently looking for work, keep in mind that a new job typically means increased expenses. For example, you may need to relocate for the position, purchase new clothes and could incur additional costs for daily transportation. If you have been deferring student loan payments, those will become due each month after the start of the new position, though the payments can be further deferred if you are attending graduate school at least part time. You will also need to take into account the effects of payroll taxes and benefit premiums taken out of each paycheck when calculating your net pay. Its important to gain a general understanding of taxes to avoid unpleasant surprises upon filing each year. If you are set to receive a refund, use that to boost your savings and resist the temptation to splurge on material goods. Generally speaking, remain frugal while you can get away with it, because its much more challenging to do so when you have a family to worry about.

    Once you have decided you would like to participate in a retirement savings plan, whether it be through your employer or independent of your job, be sure to explore all of your options. This will probably require some research because there are so many alternatives, especially for young adults. If you do contribute to an employer- sponsored plan, be sure to contribute enough to take advantage of employer matching, otherwise you are losing out on free money. With every increase in pay, re-evaluate your contribution amounts, and eventually you may want to consider opening additional accounts, such as a Roth IRA or a brokerage account. Its also important to periodically increase your emergency fund. It has been suggested that an emergency fund should cover at least six months of pay, so as your pay increases, the amount needed to cover those six months will also. As you get married and have children, the frequency and financial impact of those unexpected events will increase significantly. The fact that the younger generation will receive much less help from employers and the government is often ignored, but it should be addressed when planning for retirement because it means the amount of money needed to support oneself in retirement will be much greater than it is for the baby boomers. Though it may be difficult to accurately determine what your financial needs will be in 40 or 50 years, contributing more now will allow for flexibility later in life so that you can live comfortably and afford your children's tuition, instead of having to choose just one. Above all, be honest with yourself and realistic about what kin

    d of lifestyle you want for yourself and your family now and down the line.

    For assistance in retirement planning, contact Restivo Monacelli, LLP at (401) 273-7600.

    The Potential for Revival of Rhode Island's Historic Tax Credit Program

    Last updated 1 year ago

    Ever since Rhode Island’s Historic Tax Credit was eliminated in 2008 amid a growing state budget deficit, it has remained a trending topic, and a variety of individuals and organizations have been voicing their strong support of its reinstatement.  The program was frozen four years ago because the state was not seeing an adequate return in state investment and with developers able to claim up to 30% of qualified construction expenses, it was costing the State Treasury quite a bit in lost tax revenue.  Since 2008, many projects have been abandoned as a result of the recession, and the construction industry as a whole is suffering. 

    Supporters believe the reinstatement of the Historic Tax Credit program will breathe new life into the ailing construction industry and create jobs for the people of Rhode Island.  More specifically, it could encourage property owners and developers to complete construction on stalled projects sooner than later, and could provide incentive to rehabilitate the abandoned mills and empty warehouses throughout the state.  Because both Connecticut and Massachusetts offer similar tax credits already, many believe the approval of the credit here will attract businesses to Rhode Island to invest in projects that would preserve the state’s historic character and produce assets that would remain long after the tax credit is cashed in. 

    To the contrary, those who object to the reinstatement of the Historic Tax Credit cite the past pitfalls, namely the high cost, and question whether the limited economic development dollars available could be put to better use, such as education of the unemployed workforce and repair of the current infrastructure. 

    There are currently two proposals pending before the Rhode Island General Assembly.  The first, which was introduced by Pawtucket Democrat Patrick O’Neill, would offer a Historic Tax Credit of up to 20% of qualified construction costs, while offering a more lucrative credit of up to 25% to projects with at least a quarter of the space or the entire first floor allocated for commercial use.  Under this proposal, social clubs, single family homes, and residences of less than three units would not be eligible for the credit, and projects approved for more than $5 million in credits could only claim up to $5 million in each of the first three tax years, with the balance available in the fourth tax year. 

    The second proposal, which was introduced by Pawtucket Democrat James Doyle, II, would offer a Historic Tax Credit of 30% of qualified construction costs to projects focused on distressed areas throughout Rhode Island, specifically the communities of Burrillville, Central Falls, East and North Providence, Pawtucket, Providence, West Warwick and Woonsocket.  This proposal has garnered support from Governor Lincoln Chafee, who points to the fact that it prioritizes projects in areas most in need of help, and such recovery efforts have a positive impact on the neighborhoods surrounding the project site. 

    With that being said, doubts continue to arise about the whether the returns will be lucrative enough, as not to add the current deficit.  Some wonder whether the timing of the reinstatement is right, and ask whether the state would be investing in a potentially great economic incentive at the wrong time.  The House has schedule a hearing for the first proposal on June 7th, 2012, while the Senate already held a hearing for the second proposal.   

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