Tax Consequences of Unemployment

Tax Consequences of Unemployment

In Bell, Calif., the city manager, assistant city manager, and chief of police recently resigned in the government wage scandal of the decade. While they may collect unreasonably generous pensions, they won’t be collecting unemployment insurance (UI) benefits.

In California, as in most states, in order to collect unemployment benefits you must be laid off, or your position must be terminated.

If you are among the 10 percent of the population who is unemployed, you may qualify to apply for benefits. Unemployment insurance benefits provide some money, but rarely enough to cover your rent or mortgage. And there’s a catch. Since the stipend is so small, people don’t realize unemployment insurance benefits are subject to income taxes.

Unemployment income is taxed for IRS purposes—at your highest tax rate, which could be anywhere from 0 percent to 35 percent, depending on your other income during the same year. Be sure to withhold federal taxes for at least 10 to 20 percent, depending on your other income for the year.

The state of California doesn’t tax unemployment income, so it shocked me to learn most other states do assess taxes on unemployment benefits. If your state is one that does, make sure you have enough taxes withheld to cover that liability.

Doing the responsible thing, having your taxes withheld, doesn’t leave much money to pay your bills. You will undoubtedly need to draw money from somewhere else.

But where?

Savings get depleted quickly—and there’s no tax consequence to drawing down your savings account. When you face early withdrawal penalties, you’re entitled to deduct those as adjustments to income on page 1 of your Form 1040.

Another smart tax move is to sell appreciated stocks. In 2010, there is a 0 percent or 15 percent capital gains rate for most stock profits.

What Are the Two Biggest Financial Mistakes Unemployed People Make?

1. People don’t file for state disability benefits when they are entitled to claim them. Did you know that state disability benefits are tax-free? They are usually higher than unemployment insurance benefits.

Often, I hear from people who were hospitalized or ill while unemployed who never switched their benefits to disability insurance—and ended up owing taxes needlessly.

Look at your situation. If you can find a legitimate reason to file for disability insurance benefits, do so immediately. Be sure to get a doctor’s written confirmation for your tax file.

2. You’re broke, so you draw money from your retirement accounts. That money is taxed, possibly subject to 10 percent early withdrawal penalties from the IRS—plus penalties from your state.

You can avoid some of those penalties, but none of the taxes. If you’re going to draw money from a pension plan or 401(k)-type plan, first move the money to an IRA. Only money drawn from an IRA is entitled to the exceptions for payments to cover health insurance or medical expenses. There are some other exceptions to the penalty on page 2 of the instructions to Form 5329.

What Is THE Biggest Mistake Unemployed People Make?

Believing you’re going to find a new job earning what you used to. It’s time to face reality. If you haven’t found a comparable, acceptable job within three months, you won’t. Start looking at more practical alternatives so you can keep your home and your dignity.

Eva Rosenberg, EA is the publisher of TaxMama.com, where your tax questions are answered. Eva is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com.

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Phantom Income from a Short Sale or Foreclosure? TaxMama Gives You Two Ways to Avoid the Tax

Before one of my EA Exam Review classes recently, a student asked the class for guidance. Rosie said that her client had a house that was underwater. Considering the hurricanes, floods, and storms we've been having, I thought she meant it literally.

But no—Rosie's client's home loan was upside down: the mortgage balance was higher than the home's market value. What could Rosie do to help her client with the tax implications of a short sale or foreclosure?

When you think about how well the federal government protected our investments and the housing market, it's no surprise we are facing a foreclosure rate rapidly approaching that of the Great Depression.

According to RealtyTrac, 1 out of every 136 homes received a foreclosure notice in the third quarter of 2009. If you live in one of these homes, you are facing a decision: try to sell your home, deed it to the bank, or let it go to foreclosure. You're hoping, now that you've hit rock bottom, that at least the pain will end and you can start over.

The bad news is that when you don't pay the full amount of a debt, you face an ugly tax consequence: income from cancellation of indebtedness. Sometimes it is called "phantom income" but what it really refers to is income you don't have in your pocket.

Worse, you may owe taxes on it. Look for a 1099-C, Cancellation of Debt, or a 1099-A, Acquisition or Abandonment of Secured Property, in the mail early next year, if you haven't already received one.

Lessening the Pain

All is not lost! Remember, your TaxMama is all about finding ways around the taxes.

1. Avoid taxes altogether. The Mortgage Forgiveness Debt Relief Act of 2007 protects you from taxes on the cancelled or abandoned debt if the defaulted loans were "qualified principal residence indebtedness" -meaning your original mortgage debt or loans were taken to buy, repair, rebuild, or remodel your home.

Here's what the IRS Says: "You can exclude canceled debt from income if it is qualified principal residence indebtedness. Qualified principal residence indebtedness is any mortgage you took out to buy, build, or substantially improve your main home. It also must be secured by your main home. Qualified principal residence indebtedness also includes any debt secured by your main home that you used to refinance a mortgage you took out to buy, build, or substantially improve your main home, but only up to the amount of the old mortgage principal just before the refinancing."

This also works with farm debt and nonrecourse debt-debt where the lender may not go after you for any unpaid balance.

This special deal applies to defaulted debts from 2007 through 2012. Read more about it here.

2. Avoid some or all of the taxes. What if you refinanced and consolidated your debts or your debt cancellation is from credit cards, and you don't qualify for the mortgage amnesty? TaxMama has another way out for you!

Insolvency: The IRS has a special provision to help you exclude all or part of the cancelled debt income. How does it work? For each 1099-C or 1099-A you receive, you have to do a worksheet showing how much your total debt was the day before the loan was cancelled. Subtract your total assets. If your debts were higher, you're insolvent on that day. You can exclude as much of your cancelled debt income as the level of your insolvency.

Example: On August 2, your lender cancelled a $25,000 credit card balance. On August 1, your total debt, including the credit card balance, was $175,000. Your assets were $160,000, and $15,000 is the amount of your insolvency. You still have to pay taxes on $10,000.

Most people who reach this point will be fully insolvent. You will probably qualify to avoid all the tax.

Use IRS Form 982 to exclude the debt in both instances. The Taxpayer Advocate Service website provides tools for you.

Of course, if neither of these two options works, you can always file tax bankruptcy. But that's another story-for another day.

Eva Rosenberg, EA is the publisher of TaxMama.com, where your tax questions are answered. Eva is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com.

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New Tax Increase for Wealthy Americans: Will You Pay More?

New Tax Increase for Wealthy Americans: Will You Pay More?

In March, Congress passed landmark legislation that will affect taxpayers in good ways and bad. It's called the Health Care and Education Affordability Reconciliation Act of 2010. You've heard talk about the benefits for folks with average and lower incomes.

But what about the wealthy? Tax returns for Americans making over $200,000 a year (in adjusted gross income) account for over 3 percent of all tax returns filed in 2007 (the most recent year of IRS statistics).

Will you have a new tax increase?

Perhaps. The following two new taxes take effect in 2013. The law could be changed at least twice by then.

Meet the new Hospital Insurance Tax: a 0.9 percent tax on the wages of individuals whose earned income is over $200,000 ($250,000 for couples filing jointly). "Earned income" means wages or profits from your Schedule C businesses and self-employment income from partnerships.

Lest you feel discouraged from working and instead want to kick back and build up your investments, beware. There's a sister tax, the 3.8 percent Medicare tax. That is imposed on unearned income-investments, passive income, capital gains, etc. This affects modified adjusted gross income of $200,000 for singles, $250,000 for couples filing jointly, and $125,000 for couples filing separately. This tax will be imposed as well on trusts with undistributed income of about $12,000, so trusts aren't a solution.

What's excluded from both these new taxes? Retirement income (taxable draws from IRAs, pension plans, and the like) and tax-exempt trusts, like charitable remainder trusts.

The bad news? If you end up facing these additional taxes, no amount of itemized deductions will help you avoid them.

New Tax Planning Ideas

Reduce earned income by maximizing your participation in flexible spending plans that cover health-care costs, child-care costs, and education expenses. Increase your contributions to your retirement accounts as high as you can. Better yet, if you are in a position to elect Roth IRA treatment for part of your pension contributions, take advantage of that option. In the long run, this will reduce your tax impact.

This strategy will help about 70 percent of people affected by the tax. Everyone else's income will be too high for this to make even a minute difference.

Will it help to convert your retirement accounts to a Roth IRA? It won't make a difference, since income from IRAs and pension plans isn't hit by these two taxes.

Well-planned investments in real estate and oil can generate lots of passive losses through depreciation and depletion while generating substantial cash flow. Your passive loss deductions will be suspended in the early years but will be deductible once the investments generate taxable income. Meanwhile, none of the cash flow will be taxed.

The Wall Street Journal suggests you buy life insurance and borrow against it. That's one way to spend lots of money, give your heirs tax-free income, and still get enough cash back to live on.

It's time to learn to maximize your investment growth in Roth accounts. Learn more about self-directed Roth IRAs and investing in intangibles, like royalties, copyrights, etc., that bring in a solid stream of income instead of traditional stocks and bonds. Ultimately, the more money you can convert to tax-free income when you draw it, the less you will be affected by any income taxes.


Eva Rosenberg, EA is the publisher of TaxMama.com, where your tax questions are answered. Eva is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com.

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Tax Tips for Commercial Real Estate Owners

Tax Tips for Commercial Real Estate Owners

Once upon a time, TaxMama handled taxes and accounting for a small empire of commercial real estate projects around the country. Tax laws and business structures were much simpler then, before the Tax Reform Act of 1986 simplified the Internal Revenue Code.

Today, commercial real estate owners have to contend with passive loss limits, active participation, alternative minimum tax, and limits on practically everything.

Regardless, there are always tax benefits you can use when investing in commercial real estate, if you can find them. Let me give you a few highlights.

Tax Tips for Commercial Real Estate: Get Speedier Depreciation

Increase your depreciation deductions via component depreciation, or cost segregation. If you can establish distinct costs for each of the components of your building, here are some benefits:

Now: Specific parts of the building, like elevators, air-conditioning systems, paving, and roofing, may qualify for fifteen-year depreciation. Others may qualify for five or seven years. For existing buildings, a sophisticated, detailed cost appraisal is needed. They are not cheap. When the increase in deductions is significant, it can be worth it. Switch over to cost-segregation accounting by having your tax professional file Form 3115, Application for Change in Accounting Method.

Future: There are two ways to benefit:

1. When buying or making improvements to the building, establish the specific costs at the outset. It's easier to do with the construction costs in front of you, or by using a new appraisal.
2. Section 179 depreciation may apply to some parts of the building that are considered tangible personal property and to certain qualified leasehold improvements—those built specifically for use by one tenant. Section 179 allows deductions up to $250,000 of the cost all at once, providing all qualifying assets purchased during the year total $800,000 or less.

The Economic Stimulus Act, extended by the American Recovery and Reinvestment Act of 2009, provides even more help for commercial real estate owners. After using up all the available Section 179 depreciation, if the asset still has any basis, you can deduct up to 50 percent of the rest of the cost in the year of purchase.

Tax Tips for Commercial Real Estate: Change Passive Losses to Business Losses

A big area of frustration for commercial real estate owners is that your losses are limited to 25 percent of your adjusted gross income (AGI), which is the number at the bottom of page 1 of your Form 1040. Worse, when your modified AGI (MAGI) reaches $100,000, even this benefit phases out, disappearing entirely when your MAGI reaches $150,000. What can you do?

1. Track your hours working on the properties. See if you can qualify as a real estate professional. If more than half your working hours, and more than 750 hours per year, are devoted to your real estate enterprises, you can avoid the passive loss limits altogether.
2. Determine if your property is exempt. Read the exceptions to the definition of rental activities-especially exceptions 3 and 4. Perhaps your particular property is already exempt from the passive loss rules and you didn't know.

There are also a variety of credits available for rehabilitation, for being in certain enterprise zones, or for being in various disaster areas each year. It is in your best interest to schedule an appointment with your tax professional to explore all the opportunities. You may be overlooking free money from the IRS.


Eva Rosenberg, EA is the publisher of TaxMama.com, where your tax questions are answered. Eva is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com.

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Hiring? Do Your New Hires Qualify You for Tax Credits?

Hired anyone lately? Oh, my! It's a daunting prospect.

Have you read the National Taxpayer Advocate Report to Congress that was released in July? In it, National Taxpayer Advocate Nina E. Olson describes hiring hardships faced by the average small-business owner:

Consider an individual without a college degree who becomes a successful plumber or electrician with a growing customer base. If he hires employees, he will face a host of employment, immigration verification, and state and federal tax requirements, including the need to withhold and pay over payroll taxes . . . and to file employment tax and income tax returns on behalf of his business. For most taxpayers, these requirements would seem daunting or even impenetrable, and some taxpayers inevitably do not comply simply because they have no idea where to begin.

Let's face it-when you are a small-business owner faced with the burden of endless paperwork, you're apt to overlook the tax benefits available to you when you hire new employees.

New Tax Credit: Hiring the Unemployed

The Hiring Incentives to Restore Employment (HIRE) Act, enacted in March 2010, gives employers two benefits:

1. Immediate benefit: You don't have to pay your share of Social Security on the wages of new employees hired since March 18, 2010. Save 6.2 percent on all wages paid through the end of this year. Claim this payment reduction on your quarterly payroll tax returns and payroll tax deposits right now. The 2010 Form 941 has been revised to take this benefit into account.

2. Future benefit: Once your employee has worked for you for a full year (okay, a year and a day), you are entitled to a tax credit of $1,000 per employee.

Which new employees will give you these benefits under HIRE? They must have been unemployed, or underemployed, for at least the last sixty days before you hired them. Underemployed means they have not worked more than forty hours in the last sixty days.

The IRS has developed a new Form W-11 for new hires to fill out to swear that they qualify. Don't worry-as an employer, you won't be responsible for investigating or proving their claim.

There is a whole set of rules about rehiring laid-off workers-and other situations folks have found themselves in. The IRS answers questions about these on its FAQs about Qualified Employees page.

Hiring Special Employees

Often overlooked is the Work Opportunity Credit. It's been around for years. Hire unemployed veterans, young people, poor people, old people, convicts, and other hard-to-place workers. Your credit will range from 25 percent to 50 percent of first- and second-year wages. The wage limits depend on the category of worker. Summer youth wages are limited to $3,000. Discharged military wages are limited to $12,000, and everything else is limited to $6,000. The employees need to be certified by your state's unemployment department or certain government agencies. Read the instructions for Form 5884.

Hiring the right employee is very important. Credits are great, but remember that whoever works for you must fit your business needs and the social environment of your workplace. You, your other employees, and your customers will be "living" with this individual, so make the choice that's right for everyone involved.


Eva Rosenberg, EA is the publisher of TaxMama.com, where your tax questions are answered. Eva is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com.

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Tax Credits: Effortless Energy Tax Credits

Yesterday, I heard Ed Asner in a commercial touting somebody's solar installations. That reminded me of my first trip to Israel, in 1977.

Waaaaaayyy back then, in a country where the residents had fought to reclaim land from marshes and deserts, where trees were planted one by one to create an arable environment, people were using the power of the sun to heat their water.

Practically every rooftop had this thing that looked like a trash barrel. These solar water heaters weren't the most attractive things in the world-they could have used aesthetic improvement-but the concept was sound.

The Fantasy of Alternative Energy

I expected the southern portion of the United States to take advantage of solar technology quickly. Especially since, shortly after it was developed, we faced a crippling oil crisis, with cars lined up to buy rationed fuel on alternate days. I anticipated legislation requiring new construction to incorporate solar power for heating water, if not electricity. If solar had been mandatory, today power units would be mass produced, cheaply. Everyone would afford it. We wouldn't need to cover miles of desert to collect power. We could use the miles of existing rooftops. Alas...

No Coercion-Just Tax Incentives for Hybrid Cars

One way to get a tax credit for being energy responsible is to buy a hybrid car. You can snag a credit worth $900 to $3,400 on the purchase of a new hybrid vehicle, but be forewarned: the credit is limited by the total number of vehicle sales. The IRS publishes a list of qualifying vehicles by model and year with their current credit amounts.

Is all your driving very local? Consider an electric car. The tax credit is worth 10 percent of the cost, up to $2,500, for qualified plug-in electric vehicles. Use Form 8834. There was a tax credit of up to $15,000 for a plug-in electric vehicle on Form 8936. That ended in 2009. Who knows? Perhaps it will return.

The two big problems with plug-in vehicles?

1. You need somewhere to plug them in to recharge them. With a limited range, commuters must plug in at work.
2. They are drawing power off the main grid. What happens if everyone switches from gas to electric cars and recharges them at the same time?

Coming Home to Tax Savings: Tax Incentives for Going Green at Home

Other ways to earn tax credits for going green include insulating your home, getting a new roof, and installing double-paned windows or better doors. The Nonbusiness Energy Property Tax Credit is worth 30 percent of the cost, up to $1,500, reported on Part I of Form 5695. It applies to 2009 and 2010 purchases.

You might also want to install an alternative-energy system. The Residential Energy Efficient Property Tax Credit is worth 30 percent of the full price. Use Part II of Form 5695. This applies to solar power, geothermal power, and wind turbines.

BONUS! Similar tax credits may be available from your state or city. Your local utility companies may subsidize your costs through rebates, or by buying back some of the energy you produce. Perhaps manufacturers' rebates can help defray the costs. See the Energy Star site rebate finder at http://www.energystar.gov/.

Enter these arrangements with open eyes. Even with the tax credits and rebates, you're apt to spend a lot for alternative-energy systems. It may take decades to recoup your costs via savings from reduced monthly utility fees. Don't forget the costs of system maintenance, replacement, and repairs.

Even so, you may just want to do it for the "green" of it, or to become at least partially independent of the grid.

Eva Rosenberg, EA is the publisher of TaxMama.com, where your tax questions are answered. Eva is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com.

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8 Tax Benefits for Savers

When I met Karen, she was earning $17,000 a year. Today, if you account for inflation, that would be about $45,000 a year. (See the nifty inflation calculator at the Bureau of Labor Statistics.)

Karen set aside enough money to buy a rental condominium at Port Hueneme, California, and a vacant lot with a magnificent view at the top of a bluff above Laguna Beach. Her retirement account at work was maxed out, with savings set aside. That was before IRAs were available to people covered by employer retirement plans. Karen's only incentive? Saving for a secure financial future.

Do You Really Need External Incentives to Save?

It isn't that tough to save, once you start. The best thing you can do is to simply develop good saving habits.

Rita Veen, an enrolled agent in Castaic, California, encourages her clients to set aside $25 a week. You can invest those savings by buying a single share of a corporation's stock and reinvesting the dividends. She also recommends subscribing to The Moneypaper. The calculator on its front page shows that investing $100 a month for 50 years would result in nearly $1.75 million by the time you're ready to retire.

OK, You Need Government Incentives to Keep You Saving

If you'll only save because the government gives you an incentive, here's a list of incentives that individuals control, with the annual contribution limit per person. In parentheses is the contribution limit for folks age fifty or over. (Note that employers can offer more options.)

1. Deductible IRA: $5,000 ($6,000). Savings grow tax-free and are taxed at retirement.
2. Nondeductible IRA: $5,000 ($6,000). Savings grow tax-free and are taxed at retirement. Track your contributions-you get them back tax-free.
3. Roth IRA: $5,000 ($6,000). Savings grow tax-free and are not taxed at retirement.
4. Coverdell Education Savings Account (ESA): $2,000. Savings grow tax-free. Draws are not taxed if funds are used for education. Anyone may fund the account (parents, grandparents, employers, friends, etc.).
5. Qualified Tuition Program (or Section 529 Plan): Maximum annual contributions equal to the gift tax exclusion limit ($13,000 in 2010), or a onetime contribution of up to $65,000. Contributions may restart after the fifth year. Earnings grow tax-free. Draws are not taxed if used for education. Investment options are limited.
6. Retirement Savings Contribution Credit: $1,000 credit per saver for contributions to IRAs or qualified employee retirement plans.
7. Homes: Sell a home every two years without paying taxes on up to $250,000 of profit ($500,000 if married filing jointly).
8. Capital Gains Tax Rate: In 2010, you may sell your stocks or assets and pay as little as 0 percent tax on the profit-or no more than 15 percent. Cash in on profits and reinvest in something with a better future.

Savings Incentives are Helpful, But Watch Out

Be aware that all these investment options have limitations based on your income level, or if you're covered by a retirement plan at work. There are penalties for early withdrawal, ranging from 10 percent to 25 percent, plus state penalties. Of course, there are ways to avoid the penalties. And there are special incentives for people in the military and people who live in certain disaster areas.

Before investing in or drawing money from these savings plans, consult with your tax professionals. They can help you work out the best tax advantage for what you're trying to do. Whatever you do, don't count on the government to take care of you in your old age. Taking responsibility for yourself ensures a much happier life-and a better retirement.

Eva Rosenberg, EA is the publisher of TaxMama.com, where your tax questions are answered. Eva is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com.

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