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A UNIQUE TAX REFORM PROPOSAL
Here is a unique tax reform/simplification proposal I first suggested back in 2007. I hadn’t, and still haven’t, heard it discussed or proposed anywhere else. I submit it is something to think about – and would be truly interested in hearing the thoughts of fellow tax professionals.
What if we did away with the depreciation deduction for real estate?
Because my practice, at this point in time, is limited to 1040 preparation I will discuss this proposal in the context of the 1040 filer.
According to the IRS, depreciation is “an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property”. The IRS discusses depreciation in detail in Publication 946 - How To Depreciate Property.
Let’s look at depreciation from the point of view of the Income Statement. Basically, if you purchase an asset (i.e. equipment, a vehicle, or real estate) that will last more than one year you spread the cost of the asset over its “useful life”. You purchase a new computer. You certainly do not purchase a new computer eVERY year – you expect that it will continue to provide service for several years. So you divide the cost of the computer over a period of years to reflect this fact, and to properly report the “economic reality” of the purchase.
If you deducted the full cost of the computer in the year of purchase this would distort the true cost of doing business. Since you generally purchase a new computer every five years, claiming a deduction of 1/5 of the cost each year “more better” represents your cost of operations.
Thus depreciation is used to “recover the cost or other basis of certain property”.
Another way to look at depreciation is from the Balance Sheet perspective. When you purchase an asset that asset has value to you. You trade the asset of cash for a computer. If you sold your business the value of the computer would be included in the value of the business. As an asset ages its value drops. A two-year old computer does not have the same value in the market as a comparable brand new computer. Depreciation is used to reflect the drop in value of the asset.
Thus depreciation is used to reflect the “wear and tear, deterioration, or obsolescence of the property.”
If we look at economic reality, a building has a life of much more than 27.5 or 39 years, the current depreciable “life” of residential and commercial real estate. A building I lived in in Jersey City was 100 years old and still going strong. And, for the most part, the value of real estate does not drop in value over the years. If properly maintained its value will generally increase. My parents purchased their first home for $13,000 and sold it many, many years later for $75,000 (and they were robbed).
For all intents and purposes, again for the most part, real estate does not “depreciate”. You do not replace a building every few years because it no longer provides the same service or function. And the value of real estate as a component of the value of a business does not drop as it ages. So why do we allow a tax deduction for the depreciation of real estate?
Where depreciation of real estate comes into play most often in the world of 1040s, at least in my 40+ years of experience, is with the rental of a 2-family building. One floor of the building is used as the personal residence of the owner and the other is rented out. Depreciation is claimed as a deduction against rental income on Schedule E and, in most cases, either creates or increases a tax loss. It is possible for the rental activity to provide positive cash flow, but because of the depreciation deduction result in a deductible loss. The depreciation deduction can increase the return’s refund by up to $1,000 or more!
The problem arises when the taxpayer(s) sell the property.
With a two-family house as described above, if the required conditions are met one half of the gain on the sale, up to $250,000 or $500,000 depending on filing status, is eligible for exclusion under Section 121. The other half is taxable as a capital gain. Any depreciation “allowed or allowable” over the years must be “recaptured”, or added back, to the taxable gain from the rental half of the property.
If the total net gain on the sale of the property is $100,000, generally (but not necessarily if, for example, capital improvements were made directly to the rental half) $50,000 will be allocated to the personal residence and $50,000 to the rental activity. If the taxpayer claimed $25,000 in depreciation on Schedule E over the years, or was entitled to claim $25,000 in depreciation (the “allowable” portion of “allowed or allowable”), the taxable capital gain is $75,000.
While long-term capital gain is taxed at 0%, 15%, or 20%, gain resulting from depreciation recapture can be taxed at up to a maximum of 25%. In the above example, if the taxpayer was in the 25% bracket before adding the capital gain, $50,000 is fully taxed at 15%, for $7,500 in tax, and the $25,000 depreciation recapture would be taxed at 25%, for $6,250 in tax, resulting in total federal tax of $13,750 (effective 18 1/3% tax) – plus the appropriate state income tax on $75,000.
The above is the tax reality. But here is what our clients will probably be thinking:
“I sold my personal residence and my gain was only $100,000 – so I do not have to pay any federal or state income taxes!” – or
“Since it was a two family house I only have to pay tax on half the profit - $50,000!” – or, worst of all
“Hey, I just bought a new house that cost more than what I sold the old one for, so there is no tax!”
What is “more bad” is if the sale, after claiming all closing costs from the purchase and sale and capital improvements made over the years but before factoring in the depreciation recapture, results in a net loss! If we assume $25,000 in depreciation recapture against a $5,000 loss (50%) that is $20,000 taxed at up to 25%, or $5,000 in federal tax, plus state tax on the $20,000. You have to answer your client when he screams, “but I lost money – why am I paying tax?”
It is possible that recaptured depreciation can add $12,000+ to the overall federal and state tax bill – which more often than not comes as a complete shock to the taxpayer. And of course I was not told about the sale, which happened in May, until I get the client’s “stuff” in March of the following year. And again of course, the taxpayer did not increase withholding or make any estimated tax payments to cover the gain.
You try to explain to the client that he/she/they was/were saving $500-$1,000 each year by deducting the depreciation in the past, and now they are just paying “Sam” back – but clients cannot always understand or accept this. That $500-$1,000 per year was spent a long time ago!
In the “good old days”, when ordinary income rates were higher and there was a 50% or 60% capital gain exclusion (I am dating myself) instead of reduced capital gain rates, it was easier to show a client that he actually made money in the long run by claiming depreciation – but not so today when the possible 25% rate on depreciation recapture could be the same as the rate for ordinary income.
And, as we know, you can’t avoid the problem simply by not deducting depreciation when it is “allowable” – back to the “allowed or allowable” rule.
So we can see that in the long run depreciating real estate on the 1040 only results in increased “agita” for both taxpayer and tax professional.
Doing away with this deduction would provide Uncle Sam, and corresponding state uncles or aunts, with additional tax money up front, instead of having to wait years or decades to finally collect it. And bottom line - doing away with the depreciation deduction would more correctly tax the actual economic activity.
Recent court cases and IRS regulations have more clearly defined the difference between a capital improvement that is depreciated and a repair that is currently deducted, moving away from the dollar amount as the criteria and towards the nature of the expense as the determining factor. Under my suggestion there would also be no depreciation of true capital improvements – they would simply be added to cost basis.
No longer “allowing” the depreciation of real estate would not only affect the tax on the sale of rental property, but also remove the need for a taxpayer to recapture depreciation claimed on a home office when the residence is sold.
So, what do you think - should we do away with the depreciation deduction for real estate, at least on the 1040? As I said at the beginning, I am truly interested in hearing the opinions of my fellow tax professionals.
WHAT IS OUR LEGAL RESPONSIBILITY?
Here is another topic for discussion –
At the NATP Tax Symposium in Atlantic City last winter the instructor gave us a sneak preview of the calculation of the “Obamacare” penalty for not being properly covered by health insurance that is supposed to be reported on the taxpayer’s Form 1040 or 1040A. In keeping with the theme of our current Tax Code it is a convoluted mess. And it could be very expensive. My first reaction was “I ain’t doing that!”.
Happily I doubt that this penalty will apply to any of my existing 1040 clients, and I no longer accept new clients, so I expect I will not have to deal with this issue.
But it does raise the question –
What is our legal responsibility as tax preparers when it comes to calculating the new convoluted and potentially expensive Obamacare penalty for clients who are not covered by health insurance?
Or perhaps a more inclusive question –
Are we as tax preparers legally required to assess a client an IRS penalty “up front” when preparing a tax return?
I never calculate an underpayment of estimated tax penalty “up front” when preparing a Form 1040 or 1040A, or state tax return, for a client. If the IRS, or the state tax authority, wants to assess a penalty it is up to them to do so. If a client receives a penalty notice for underpayment of estimated tax I will verify the calculation and see if I can reduce it via “annualizing”, applying any other exception, or by arguing “reasonable cause” – but I will never “self-assess” the penalty. I expect I will institute the same policy for the Obamacare penalty.
If a tax professional calculates an IRS penalty for a client “up front” that requires more work and obviously an increased fee. Why should a taxpayer have to pay someone to charge them a penalty?
And then there is the question of “self-incrimination”. The taxpayer is the one who is filing the return – the tax professional is merely preparing it for the taxpayer. Does the taxpayer have the right not to “incriminate” himself/herself and refuse to “self-assess” a penalty?
The only penalty I will include when preparing a client’s tax return is the 10% premature withdrawal penalty, as its application is clearly identified and the calculation is simple. I will, of course, try to reduce the penalty using an exception. I do not charge the client if I merely apply the 10% penalty to the premature withdrawal amount on Line 58 of the Form 1040. But in most cases I do charge an additional fee if I use Form 5329 to reduce or eliminate the penalty claiming one or more of the exceptions. Just as I would charge for using Form 2210 for “annualizing” income or claiming another exception when a taxpayer is assessed an estimated tax penalty by the IRS.
So my fellow tax professionals, what do you think?
NEW YORK STATE TAX PREPARER REGULATION UPDATE
I recently received the following email from the New York State Department of Taxation and Finance -
“All commercial preparers who will prepare New York State personal income tax returns MUST complete continuing education requirements. Your status as a personal income tax preparer will be reflected on your registration certificate.
ARE YOU A COMMERCIAL PREPARER?
You are a commercial tax return preparer if you were:
- Paid to prepare ten or more New York State tax returns during 2014 AND expect to be paid to prepare at least one return in 2015, or
- Paid to prepare fewer than ten NYS tax returns during 2014 AND expect to be paid to prepare ten or more returns in 2015.
If you are not a commercial preparer, but you wish to have your registration certificate reflect that you prepare personal income tax returns; you may voluntarily complete these continuing education requirements.
HOW MANY HOURS OF CONTINUING EDUCATION COURSEWORK ARE YOU REQUIRED TO TAKE?
- If you are a commercial preparer who prepared TEN OR MORE New York State personal income tax returns during each of the past three years, you must take FOUR HOURS of continuing education coursework by the end of December 2015.
- If you are a commercial preparer who prepared FEWER THAN TEN New York State personal income tax returns during each of the past three years, you must take:
- 16 HOURS of continuing education coursework by the end of December 2015, and
- FOUR HOURS of continuing education coursework each year after that.
You will receive further information in the fall about how you can sign up for the required courses.
The Tax Department will never send you an email asking you to validate personal information such as your username, password, or account numbers.”
I was aware of this new requirement, and the, thankfully, reduced requirement for “experienced” preparers. What was unknown was when this requirement would kick in.
The new requirements also included
an initial testing requirement, although there was no indication at the time of
the announcement of a “grandfathering” exemption. The email did not mention the test.
INTRODUCING TAX PRACTICE PRO
Speaking of professional education, I recently became aware of a new CPE provider, whose faculty includes my long-time twitter and internet “buddy” (although we have never met in person) Enrolled Agent John Sheeley.
Proving that the business of preparing taxes does not have to be taxes, NY State based TAX PRACTICE PRO, an IRS-approved continuing education provider, offers quality CPE in Taxation and Practice Management for the small practitioner.
TPP has two upcoming opportunities -
On September 25th Kimberly Manrow, EA will present a full day of classes for tax pros at Rick’s Prime Rib House, located at 898 Buffalo Road in Rochester, New York. You can come for the whole day or select individual classes and earn up to 7 CE credits.
The day will include:
* 9:00am - 10:50am = Representing Clients: Best Practices for responding to Notices - 2 CE credits available.
* 11:00am - 12:15pm = Protecting Your Practice: Client Communications & Engagement Letters - 1 CE credits available.
* 1:40pm - 3:30pm = 990 Preparation and Not-for-Profit Compliance: How to assess the records and best practices for Preparation and filing - 2 CE credits available.
* 3:40pm - 5:30pm = Ethics: Role Plays on Best Practices for dealing with difficult clients - 2 CE credits available.
Individual classes are $49.00 per each. Register for the whole day for only $139.00. A buffet style lunch will be provided. Registration starts at 8:30am.
On October 29th John Sheeley, EA will present two classes for tax pros at the NYC Seminar and Conference Center, located at 71 W 23rd Street in New York City.
* Protecting Your Practice: 19 things your engagement letters need - 8:30am - 10:10am – no CE credits - class fee = $99.00
* Basics of International Tax Preparation - 10:20am - 5:00pm – 6 CE credits - class fee (including lunch) = $150.00
You can register for the entire day, with lunch, for $199.00. Registration starts at 8:00am.
Register Online or call (800) 943-1750 to register or if you have any questions.
CPE providers are not waiting for the outcome of the AICPA lawsuit to end the IRS voluntary Annual Filing Season Program, and are coming out of the woodwork with offerings to satisfy the AFSP 6-hour “Annual Federal Tax Refresher Course” and test requirement.
Click here for the IRS-issued course outline.
For my money, if you want to “volunteer” for a Record of Completion certificate under this program you should stick to the traditional tax CPE providers for the annual refresher course and the rest of the required continuing education. I am talking about the education offered by the membership organizations – NATP, NSTP, NSA – and established companies like Gear-Up.
NATP, NSTP, and Gear-Up have been offering excellent year-end tax update seminars for many years now. The NATP version, which I have been taking annually for decades, is currently known as THE ESSENTIAL 1040 and, unfortunately for me, also includes the 2 hours of ethics preaching. It is offered, coupled with a day-long BEYOND THE 1040 workshop, at several locations throughout each of the 50 states, and is part of the 3-day TAXPRO SYMPOSIUM offered this winter in Scottsdale AZ, Lakewood CO, Orlando FL, Bloomington MN, - October 20 - 22, Las Vegas NV, and Atlantic City NJ. I will be attending the Atlantic City offering on November 17–19.
Even if you are not “volunteering” I would recommend taking THE ESSENTIAL 1040 to prepare for the 2015 filing season.
NATP will provide members, as a free member benefit, an Annual Federal Tax Refresher self-study course based on general filing season concepts, tax updates and typical trouble areas identified by the IRS. This self-study course includes an e-Learning module and online exam.
NSTP offers “The All-New Annual Federal Tax Refresher Course” as a live workshop at six different locations this fall. The cost is $179 for members and $279 for non-members.
The new Latino Tax Professionals Association (LTRA) is offering a comprehensive 18-hr eBook course that includes the refresher course and test for $159.00. Professional members of the association can receive a free 2015 Annual Federal Tax Refresher e-book course.
Gear-Up, while releasing its annual 2014 year-end update schedule, has not yet announced an AFTR course and test.
The publishers of THE TAX BOOK, a Quickfinder Handbook clone, also offers a 2015 Annual Federal Tax Refresher Course and Test. The course is available online through the website’s Education Center.
There are other established tax CPE providers who are or will be offering the Annual Federal Tax Refresher Course and test, but the only provider I have had personal experience with is Gear-Up, so it is the only one that I mention above. I would be interested to hear from fellow tax professionals on their experiences with other tax CPE providers.
I popular feature of my THE WANDERING TAX PRO blog is the twice weekly BUZZ. Here is some BUZZ for tax professionals -
+ I admit it. I have been preparing taxes for over 40 years, and I had never heard of the term “tax inversions” until the recent debate arose. Thanks to Kyle Pomerleau for telling me “Everything You Need to Know About Corporate Inversions” at the Tax Foundation’s TAX POLICY BLOG.
+ Fellow tax blogger Jason Dinesen EA begins a possible post series of “Solo Practitioner Blues” with a discussion of whether it’s better for an accountant to work with a business client once a year at tax time, or throughout the year in “Bridging the Gap Between What Clients Want … And What They’ll Pay For” and “More Commentary About Year-Round Proactive Services to Clients”.
I do agree with, and admit to, the root cause of the problems Jason identifies. Because taxes and tax preparation come so easy to me I do not properly acknowledge the true value of my services. In my case this results in undercharging.
I invite my fellow tax professionals to read Jason’s two posts and to join in the conversation.
+ TAXPRO TODAY tells us “Thomson Reuters Offers Tax Research Certificates for Tax Pros” –
“Candidates who successfully complete the course work and final exam will earn a tax research competency certificate as well as up to 20 hours of continuing education credit. The certificate can be renewed annually by completing eight hours of specially identified CPE credit.”
+ Kelly Phillips Erb, FORBES.COM’s TaxGirl, discusses a truly confusing issue in her post “Credit Cards, The IRS, Form 1099-K And The $19,399 Reporting Hole”.
I would suggest the change of a word in one of her observations to make it more correct. Kelly says –
“Of course, Congress never met a bill that couldn’t be bulked up with other bits and that’s exactly what happened with HERA.”
I would say –
Of course, Congress never met a bill that couldn’t be fucked up with other bits, and that’s exactly what happened with HERA.
TAX PRO PRACTICE TIPS
Each issue I will provide a special tax practice tip or idea. Here is one to help cover your arse:
Place a personalized stamp or mark on all original documents you have viewed, and returned to the client, in the course of preparing an income tax return. This way a client can’t say he gave you information that you failed to include on the return if he is audited and tries to claim “I told my tax preparer, but he forgot to report it”.
For example - enter your initials followed by a sequential number and an arbitrarily chosen non-sequential capital letter (1C, 2T, 3W, 4M, 5F) with a colored pen on each item. The letter “F”, or whatever other letter you chose, indicates the last document viewed in the sequence. So even the most devious client cannot sneak in a 6th item.
If you have a tax practice tip you would like to share with your fellow tax professionals email me at firstname.lastname@example.org with “Tax Pro Practice Tip” in the “subject line”.
TALK TO YOU NEXT MONTH!