Treatment of Closing Costs and Other Fees

The most frequently asked question when people buy and sell property is "Which closing costs are deductible?". If you look at a closing statement, commonly called a HUD-1, you will see plenty of itemized costs. Unfortunately the only items that are currently deductible
are property taxes (but only those actually paid/credited, escrow doesn't
count), mortgage interest, and in the case of a rental or business property
association dues or other fees that would normally be deductible if invoiced and
paid apart from closing.

The remaining costs are split into three groups: land,
building and loan costs. The building is depreciated (27.5 years for residential
rental, 39 years for other commercial property) and the loan costs are amortized
over the expected life of the loan (we usually use five years). You get no deduction for the land on the theory that it does not deteriorate in value so it's cost should not be recovered as a tax deduction. Here are some areas you should be aware of when trying to optimize tax deductions.

1. The allocation between building and land. If the property is a rental or commercial real estate you will get a depreciation deduction on the building. However, your allocation of the purchase price must be reasonable. If you buy a beach front property with a 50 year old bungalow on it allocating 80% of the cost to the house is a stretch. Property tax records, appraisals and insured values can all point you in the direction of a sound allocation.



2. Classification of loan costs as closing costs. There are many costs required by the lender apart from doc stamps and title fees. If these are not classified as loan costs they will be allocated to the building with a much longer depreciation period or land with no depreciation deduction at all.



3. Identification of intangible taxes paid on the mortgage. These are deductible when paid (at closing). Failure to pull them out most often results in their classification as loan or closing costs.



4. Failure to treat property tax credits properly. A seller in a county that taxes in arrears will often be charged an amount for property tax through the date of sale. This is a tax deductible expense. The buyer will receive a property tax credit at closing and must deduct this from the amount of taxes actually paid during the year to arrive at the proper tax deduction.



5. Failure to seperately account for included goods and furnishings. There are several reasons to write furnishings up as a seperate bill of sale, but one of the biggest it quicker write-offs for furnishings vs. the building itself.



6. Failure to properly amortize or deduct points. Depending on the type of loan and the use of the property you may be able to immediately deduct an points paid. Alternatively they should be amortized over the actual life of the loan. If you refinance make sure any unamortized points are deducted in the same way loan interest is accounted for.

Closing statements can get confusing when it comes to segregating tax deductible items from those that should be capitalized. If you have questions don't be afraid to ask someone who has experience optimizing these transactions to bring the greatest tax benefit.

Joey Brannon is the founder of Axiom Professional Group, a tax, consulting and accounting firm in Bradenton, Florida. Mr. Brannon is both a CPA and an EA. You can find out more about Axiom by visiting www.axiomcpa.com.

Payroll: How to pay yourself, legally.

May has been a busy month as we catch our breath from tax season while also trying to get out of the office and spend a little more time with our families. That hasn't left much time for blogging, but we're back in the swing of things now. Recently we've taken on some new clients who have used some pretty creative accounting techniques for payroll in the past. One of our goals is to help small businesses become big businesses and toward that end we try to bring some sophistication to their accounting practices as well as bring them into compliance with the tax laws.

The simplest type of business entity is a sole proprietorship. However, most people don't understand that these business profits are taxed twice: once for ordinary income tax and once for self employment tax. Self employment tax is nothing more than social security and medicare taxes. When you work for someone else 7.65% of your pay is withheld for social security and medicare in addition to the amounts withheld for income tax (commonly called federal withholding).The employer is also taxed 7.65% on your wages. When you go into business for yourself you get to pay both sides and the tax rate is 15.3%. Owner's of sole proprietorships don't cut themselves a paycheck. Instead they take draws from excess cash. No matter how much or how little they take out they are charged both self employment tax and income tax on the profits...even if they leave all the money in the business and take nothing for themselves.

Corporations are somewhat different. Where a sole proprietorship is not legally distinct from its owner a corporation is. Therefor a corporation must decide how much to pay those working for it and it must go through the formality of cutting a payroll check, filing payroll tax returns and depositing the corresponding payroll tax liability. If a corporation chooses to pay its employees relatively little then it will pay less payroll tax. If it pays them a lot it will expect to have a bigger payroll tax bill. IRS is wise to this and they realized a long time ago that if given the opportunity many small corporation owners wouldn't pay themselves a salary at all; they would just take dividend distributions. That is why IRS requires corporations to pay officers and owners a reasonable amount of salary. They don't give us many guidelines to determine what is reasonable, but generally we can look at the market and determine what we would need to pay an unrelated party to perform the same services and base our compensation on that.

What we have been seeing lately are corporations (specifically S corporations) where the owners are not taking any salary at all. Instead they are continuing to take draws as if they were a sole proprietor. From a federal standpoint their tax rate will be about the same if they claim these draws as self employment income on their tax return. However, because there has been no payroll they have not paid any associated state unemployment taxes. Nor have they paid any federal unemployment taxes. As quickly as possible we try to transition these owners from a 'draw' mentality to a 'payroll' mentality.

The danger in not treating your compensation properly is two fold. First, you are not adhering to the IRS rules regarding fair compensation and you are not paying the proper amount of federal or state payroll tax. Second, by treating your corporation as a sole proprietorship you may be giving up certain liability protections that are often important reasons for incorporating to begin with.

Joey Brannon is the founder of Axiom Professional Group, a tax, consulting and accounting firm in Bradenton, Florida. Mr. Brannon is both a CPA and an EA. You can find out more about Axiom by visiting www.axiomcpa.com.

New Tax Legislation Moving Forward

I'm back from vacation and while I was out Congress passed a new tax bill that the President is expected to sign on Wednesday of this week. Highlights of the new bill include...

1. An extension of the reduced capital gains and dividend tax rates. The rates were set to increase after 2008. The new bill extends the reduced rates through 2010.



2. There's a small provision allowing musical artists to treat the sale of compositions or copyrights as sales of capital assets (subject to reduced tax rates).



3. The AMT exemption is increased to 62,550 for married couples for 2006 (42,500 for others).



4. An extension of the increased section 179 deduction amount through the end of 2009.

In addition to the above cuts the bill also adds several 'revenue raisers' to keep the bill's cost below $70 billion. These include requiring taxpayers to make up-front payments when submitting offers in compromise to IRS and allowing taxpayers with higher incomes to convert their traditional IRA's to Roth's.

The most controversial aspect of the bill (besides the extension of the reduced capital gains and dividend rates) is the requirement for withholding on federal contracts. Beginning in 2011 contractors will have 3% of their contract proceeds withheld. Several lawmakers have vowed to repeal this provision before it has a chance to take effect, but it is an interesting approach to closing the $345 billion tax gap that results from non-compliance. Some estimate that two thirds of the tax gap results from under reporting income associated with 1099 earnings. Withholding at the source of payment of this type of income is seen as a logical enforcement step. It will be interesting to see how it plays out over the next several years.

Will Apple Buy Adobe?

For those of you like me with one foot on either side of the Windows/Mac fence check out this blog post for some interesting supposition.

Tax Treatment of Incentive Stock Options

In 2000 I was working with several dot-com companies and incentive stock options (ISO's) were a hot topic. ISO's were used to lure in new recruits, poach executives from other companies and make up for the mediocre compensation most tech start-ups offered. With the internet bust ISO's fell out of favor, or at least out of the news. That is, unless you follow tax law. Over the last several years there have been a steady stream of tax court cases and news reports about taxpayers racking up huge tax liabilities as the result of option exercises. These cases play well in the press because the tax liability can come due when the taxpayer has no cash to pay it and only a pile of worthless stock certificates to show for their efforts.

Recently ISO's seem to be making a come back. Well established companies have started offering ISO's to offer as additional compensation in today's tight labor market. The resurgence of tech companies and pure internet plays is also driving the ISO rebound. Here's what you need to know to understand how these little gems cause so much trouble for taxpayers.

A stock option is the ability to buy a stock at a predetermined price (the strike price). If the market value of the stock is above the strike price then the option has a value equal to the difference. If the fair market value is below the strike price the option is said to be 'under water' and is worthless.

Normally when you exercise an option the difference between the strike price and the option price is deemed compensation and subject to ordinary income taxation (as well as payroll tax in some cases). If the company sets up the plan in a certain way it becomes a qualified incentive stock option plan (ISO) and the tax treatment is deferred until the underlying stock is sold. Not only is the tax deferred, but it gets capital gains treatment if the buyer holds the stock for one year after the option is exercised.

But here's the rub. The alternative minimum tax (AMT) does not recognize ISO's. As far as the AMT is concerned you have realized income equal to the difference between the strike price and the stock's fair market value on the date of exercise. This can create a huge AMT tax liability. If the story ended there it might not be such a problem. After all, you have stock worth millions so you ought to pay the tax on it, right? And you should be able to eventually get a credit for the AMT tax you pay.

Here's the problem. Since you exercised ISO's you can't sell them for a year. If the stock tanks during that year you are left with worthless securities, and a huge tax bill. Further, limitations on the AMT credit mean it can take a lifetime to recoup the AMT paid in the year of exercise. This all adds up to a tax situation that seems ill conceived at best and horribly inequitable at worst. The problem is that the AMT was enacted before ISO's became common place and it has not evolved to address them. Different groups continue to lobby congress but there is still no substantive AMT reform forthcoming.

So what should you do if you end up with a load of ISO's? In some ways you are rolling the dice. If you exercise the options and wait the year to get favorable capital gains treatment you run the risk of generating an AMT bill you will have no way to repay if the stock collapses. The alternative is to ignore the ISO's favorable tax treatment, sell the stock, pay ordinary income tax and use the remaining proceeds as you wish.

Unfortunately, the options are not always clear cut to the employees who receive ISO's. Many believe the stock is restricted or are misinformed by unknowing managers who hold a different class of shares or who participate in a non-qualified stock option plan. If you have access to an ISO make sure you get a complete copy of the plan document and your option vesting schedule. Then review both with your CPA or tax attorney to determine the best course of action.

Joey Brannon is the founder of Axiom Professional Group, a tax, consulting and accounting firm in Bradenton, Florida. Mr. Brannon is both a CPA and an EA. You can find out more about Axiom by visiting www.axiomcpa.com.