Renting to yourself

A common source of investment income is owning rental properties.  Rental properties can be tax advantageous in that, after considering depreciation, the property can have positive cash flow with little to no taxable profit.  Rental activities can also be tax beneficial because they are by definition "passive", and their losses in most cases can be used to offset other passive income.  This can be very helpful for taxpayers subject to the Net Investment Income Tax (NIIT), also known as the 3.8% Medicare surtax because passive income is considered Net Investment Income (NII).  

But, there is a situation where this is not applicable which involves "self-rental" activities.  A taxpayer is engaged in self-rental when a property is rented for use in a trade or business activity in which the taxpayer materially participates.  For example, a taxpayer owns a building personally.  The taxpayer rents that building to their business, a corporation, in which they are a majority stockholder and work full time.  This would be characterized as a self-rental activity because the taxpayer is renting the building to a business in which they materially participate.  

Self-rental activities are treated differently than normal rental activities when it comes to passive activity losses.  By rule, income generated from self-rental activities is treated as nonpassive, but losses are treated as passive.  The treatment of income or loss from the self-rental activities can have a significant impact on the taxpayer's tax situation as a whole.  If the taxpayer has a $1,000 income from a self-rental activity, and a $1,000 loss from a normal rental activity, those two activities do not "offset" under the passive income rules as they would if both activities were normal rentals.  The impact is instead of having a net $0 rental income on their tax return, the taxpayer ends up with a $1,000 net rental income and a $1,000 passive activity loss, which will most likely be suspended until future years when the taxpayer has other passive income.  

This is a big point of contention for taxpayers engaged in rental activities, because tax law defines all rental activities as passive no matter what, then in the fine print excepts self-rental activities.  The rule also unjustly penalizes taxpayers that, for tax or estate planning purposes, want to keep real estate assets from their businesses.  The business can be sold, merged, or closed but the taxpayer will always own the building.  

This has been a rule for many years, however has resurfaced under new scrutiny in 2013 in conjunction with the NIIT.  By treating income from self-rental activities as passive instead of nonpassive, a taxpayer can mistakenly reduce their NII subject to the NIIT and also their taxable income as a whole.  When a taxpayer reduces their NII by passive losses, they should be prepared to justify how they are treating their rental activities in the event that the IRS inquires as to whether the activity is self-rental or normal rental.  Taxpayers should also reevaluate their rental arrangements between themselves, businesses they work in, or other partnerships where they have ownership interest to ensure they are in compliance with the self-rental rules.  

Op Ed: A Millenial's View of Social Security

Social security is a pyramid scheme.  Bigger than Enron and Madoff and the calling cards Michael Scott was selling on The Office.  

I preface this by saying everyone that pays into the Social Security system (SS) deserves to benefit from those contributions at some point.  Receiving a SS check each month is evidence that you spent a long career working hard and you are benefiting from a system you paid into.  You can Google "social security benefits" and find hundreds of articles on when to start drawing SS, how spousal benefits work, and how much more you can get if you don't start drawing until 68 instead of 65.  These people are at the  "top of the pyramid".  But what about those of us at the bottom of the pyramid, looking up and wondering what will be left if we ever get to the top?  

SS was passed by Congress and signed into law by President Roosevelt in August 1935.  This was a part of a nationwide recovery after the Great Crash and depression in the late 20's and early 30's.  A complete history of SS can be found at the SSA website (in case you forgot it all from high school history like I did).  

In general, the program was designed to help older Americans that had lost all of their savings.  Almost 80 years later, the program is still in existence.  The program is funded through FICA taxes, which are withheld from an employee's paycheck at a rate of 6.2% and then matched by the employer.  Once an employee's wages reach a certain threshold ($117,000 for 2014) they are no longer subject to the FICA tax (Medicare never phases out, and is a whole other debate for another time).  

The problem is, every dollar a 30 year old worker puts into the system is paying benefits for someone in their 60s and 70s, hence the "pyramid".  The result is my kids will be paying the benefits for my parents, leaving my grandkids to pay for my benefits.  Furthermore, the SS system is heavily underfunded, meaning that it projects to have greater liabilities in the future than expected assets/income.  This is why you will hear some politicians suggest raising the minimum age when Americans can begin to draw SS benefits - so as to delay the number of new people signing up for benefits a little bit further down the road.  

In a perfect world, I would like the option to not contribute to the SS system, and also bypass the future benefits.  I have been educated on retirement accounts and insurance and understand my responsibility for myself and family in retirement.  Unfortunately that is not feasible for a variety of reasons, mainly being that if I quit contributing to the system, they will not be able to meet their current liabilities.  You can't do away with the program, because It would be impossible to draw a line in time and say "everyone from this age and older gets it, and everyone younger doesn't get it".  You also can't apply income limits, because the higher wage earning Americans pay more into the system through the FICA taxes.  

Absent any major overhauls, the greatest looming problem in my opinion, especially for Millenials, is that eventually the government will have to find a way to rectify the deficit in the SS program.  According to the 2014 Trustees Report, SS and Medicare payments accounted for 41% of all Federal expenditures in fiscal year 2013.  Since these benefits are set in stone and will increase as more baby boomers hit retirement, the only way to fix the deficit is to raise revenue i.e. some form of taxation.  It could be in the form of higher FICA rates which would affect take-home pay, or it could be in the form of a special "other tax" like the net investment income tax that is designed to siphon tax revenue from a specific group of taxpayers.  

If you are currently drawing SS or will be drawing it in the next 10 years - thank you for your years of hard work contributing to our economy.  You deserve the benefits from the system you paid into, and I will gladly pay in so that you can reap the rewards of your long career.  But I'm not counting on anything for me because in the next 35 years someone will figure out that the system is broken and unsustainable.  And I'm not sure my grandkids will be as willing to foot the bill as I am.

Savings bonds

When my wife and I got married, we opened a joint checking account at our local bank.  It was a basic checking account which is all we needed, but it came with the use of a safe deposit box free for a year.  Me, believing I was now a "grown up" because I was married, owned a house and had a salary job, jumped at the chance to protect our most precious belongings in said safe deposit box.  I immediately went through our home and gathered up everything I thought, at the time, that we could not live without were our house to burn to the ground.  I took these items back to the bank and stored them in our new safe deposit box.  

Last year when our first child was born, as most parents do we began looking at our budget to find ways to make buying diapers, wipes and baby clothes less painful by cutting other expenses.  That's when we saw the $40 annual charge for the safe deposit box on our bank statement.  

Tax tip: fees paid for safe deposit boxes are subject to the miscellaneous itemized deductions in excess of 2% of AGI on Schedule A of Federal Form 1040.  If you pay a fee for having a safe deposit box, remember to give that information to your tax preparer.

Since I could not recall exactly what was in the safe deposit box, we set a reminder for one year later to clean the box out so as to save the $40 a year.  Last week, the reminder popped up and I rushed back to the bank, excited to see what was in the box before closing it out.  The contents of the box: our original signed marriage license, a copy of the title insurance to our first house, and a stack of savings bonds.  As I looked over the savings bonds, some which we had received more than 25 years ago, I started to wonder what they were worth now.  

Beginning the year I was born and for most years until I turned 18, my grandmother would give me a $50 Series EE savings bond on my birthday.  This type of savings bond is purchased with a fixed interest rate, and it earns interest for 30 years.  For example, the first bond I received was a $50 bond with a fixed interest rate of 4%.  Using the savings bond calculator at the Treasury Direct website, I discovered that this bond will mature in January, and is currently worth approximately $113.  That is a 126% return!  I used the calculator to build the entire inventory of our savings bonds and discovered that we owned $850 of bonds that had been originally purchased for $450 and are now worth $925.  This results in a total return on our savings bond portfolio of 105.75%.  

Savings bonds can be cashed in at most financial institutions.  When the bond is cashed in, you will receive a 1099-INT for the interest portion of the bond.  In the example above, I would receive a 1099-INT for $63, because that is the amount of interest the bond accrued over 30 years.  This interest is paid on government obligations and is subject to Federal tax, but in some cases might be exempt from state taxes.  

The Treasury Direct website has several resources for savings bonds and other types of US Government obligations.  However, the key to successful investing in savings bonds is to hold them as close to maturity as possible.  In January I fully intend to take my first savings bond down to the bank, cash it in, and then take my family out to a nice dinner.  If my grandmother was still with us I know that's what she would have wanted.  

Bitcoin

If you have been keeping up with new fads, you have probably noticed the growing popularity of the Bitcoin.  But, what exactly is a Bitcoin and how does it work?  

Bitcoin is a digital currency.  Bitcoin can be used to pay for goods or services (if the vendor accepts that type of payment).  But, there is no physical currency.  Bitcoin is completely electronic, and payments are made and received over the internet using computers, tablets and smartphones.

To get Bitcoin, you visit an exchange on the internet and buy them with real money (US dollars, Euros, etc.).  Then you can use your Bitcoin to pay for goods and services from vendors that accept Bitcoin.  You can also transfer your Bitcoin to another user.  For example, if you and your buddy split a cab and he pays for the ride, you can transfer him Bitcoin to reimburse him for your share.   

Sounds pretty neat right?  It's like going to the arcade and cashing in dollar bills for game tokens, except the tokens do not physically exist and they can be used all over the world.  But, there are a few other considerations that make the concept not so simple.  

First, Bitcoin has a market value, similar to an exchange rate.  As of the writing of this article, according to bitcoinexchangerate.org, 1 Bitcoin is valued at $653.42.  This value will fluctuate according to the demand for Bitcoin, similar to a stock in the S&P 500.  This creates an environment where some use Bitcoin to pay for goods and services, while others are holding them as an investment.  According to this chart from CoinDesk, the value of a Bitcoin has fluctuated between $67 and $640 in the last year.  

Second, the IRS has issued a notice and FAQ's regarding the tax treatment of Bitcoin.  In the notice, the IRS states that virtual currency is treated as property similar to other property in the hands of the taxpayer.  This means that the exchange of virtual currency for goods and services could result in a gain or loss to the buyer.  For example, if I use one Bitcoin I paid $600 for to buy a set of golf clubs for $700, the seller must report the receipt of the Bitcoin as a sale at fair market value on the day of receipt ($700).  Also, I must report a $100 gain on the exchange of the currency because I used an asset that cost me $600 to buy something worth $700.  Using virtual currency is also subject to the tax reporting rules i.e. 1099's.  If I pay a contractor $1,000 in the form of two Bitcoin, I must issue that contractor a 1099 at the end of the year since the value of the services were more than the $600 1099 reporting limit.  

In closing, I am a big fan of modern technology and moving into a "greener" world.  The use of virtual currency makes it easier for buyers and sellers to transact business across borders without the worry of currency translation.  However, users of virtual currency should make themselves familiar with the ins and outs of their transactions and any related tax consequences prior to buying or selling.  To find more information about Bitcoin, I found their website very helpful.  

Idea$ 2014 - June: Tax-efficient investments

Taxpayers are always looking for ways to accomplish the wealth trifecta - preserve principal, generate income, and minimize taxes.  Yet accomplishing this feat is very challenging due to a number of external factors.  In order to preserve principal, investors must often sacrifice higher returns for less risky investments, which reduces income.  Riskier investments have the potential to generate higher returns (income), but they also present the risk of loss of capital.  Furthermore, investments that generate income subject the investor to a higher tax rate.  As you can see, it's easy to find investments that meet 2 out of 3 of these criteria, but winning the trifecta is much more difficult.  Following are some alternatives for taxpayers looking for tax-efficient investments.  

Municipal bonds

Municipal bonds (muni's) are tax-efficient in that the income they generate is typically not taxable at the Federal level and, if planned correctly, at the state level.  Muni's are bond issues for municipalities such as cities, counties or school districts.  Muni's, like all bonds, are sold at a premium or a discount depending on the bond's yield at the time of sale.  

Interest on municipal bonds is always tax-exempt at the Federal level.  Each state is different, but in Arkansas, all interest earned on Arkansas municipal bonds is tax-exempt to Arkansas.  For example, an Arkansas taxpayer with municipal bond interest from school districts in Arkansas and Texas will only pay Arkansas tax on the interest from the Texas school districts.  

Beware that tax-exempt income is a preference item for the alternative minimum tax.  Investors considering substantial investments in tax-exempt bonds should consult their tax adviser to verify that the interest will not subject them to the AMT.  

Master limited partnerships

Master limited partnerships (MLPs) have gained popularity in recent years for their favorable tax treatment.  Investors enter into MLPs as a partner.  During the year, they receive distributions from the partnership that are not taxable.  Then, at the end of the year, the investor receives a Form K-1 reporting their share of income and losses.  

Although it is possible for the K-1 to report income to the partner, due to non-cash expense items the distributions typically exceed the amount of income on the K-1.  The downside to owning units in an MLP is that, upon sale, a portion of the gain (if any) is reported as ordinary income.  See additional information regarding investing in MLPs in a previous article regarding owning MLPs in a retirement account.  

Practical considerations

Tax-efficient investing is best suited for investors that desire to preserve principal in their investments and also do not have many deductions to offset their taxable income.  A young taxpayer with children at home, dependent care expenses and a mortgage can afford to generate more investment income because their effective tax rate will be lower as a result of their deductions.  However, a taxpayer with no children and few deductions will benefit more from tax-efficient investing.