Children Make Poor Tax Shelters
Q. I am in my mid-30s and would like to give two rental properties that my wife and I own, free and clear, to our three preschool children. The properties generate significant rental income that I would like to have my children declare on their tax returns. Does this plan make sense? -- H.G.H .
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A. Your plan may not make as much sense as you might hope. At the very least, you should be aware that it will take years for you to transfer these properties entirely to your children if you rely on the $10,000-a-year, tax-free gift rule. During that time you will still be forced to pro-rate among the various owners the income the properties generate, with you still being the main owner. Even after accomplishing your objective, you stand a good chance of qualifying for what is known as the “kiddie tax.” Unearned income of more than $500 a year generated by investments held by children under 14 is taxed at the highest marginal tax rate that applies to the parents. So, until your children reach age 14, $1,500 is the largest annual income you could shelter under your strategy.
Then there are the costs associated with your strategy. To pass on incremental ownership stakes in your properties, you would have to form what is known as a “family limited partnership” through which you would grant each child an interest in the properties. You can expect to pay an attorney thousands of dollars to establish such a partnership. The California Franchise Tax Board also assesses such partnerships an annual fee.
Finally, our experts warn that your strategy gives your children your tax basis in the homes, meaning that when they sell the properties they could face large tax consequences.
What can you do instead to shelter the income from rental properties? Our experts suggest two alternatives. You could purchase another income property that generates substantial losses to offset your gains. (You would want to be satisfied that the property would appreciate, however, to compensate for its cash-flow handicap.) Or you could enter into a tax-deferred exchange and swap your properties for one that has high growth potential but produces little or no taxable income.
Government Pensions and Social Security
Q. I will soon be retiring from a civil service job that did not include participation in the Social Security program. However, over my career I did contribute to the program through other jobs and I am entitled to some level of benefits. The problem is that I don’t know how much I can expect to receive from Social Security and my retirement planning hinges on this. Can you help? -- L.J.H .
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A. As a recipient of a government pension, your Social Security benefits will be subject to what is known as the windfall elimination provision, a tricky and involved set of mathematics that, in the end, will reduce the amount you get from Social Security because you are already getting benefits from a public agency.
How large will this reduction be? The formula for this calculation is set each year and has only recently been determined for taxpayers turning age 62 this year. (According to your letter, you will be 62 in 2000.) Unfortunately for your retirement planning efforts, the formula covering that year will not be set for several more years. Still, perhaps it would help if you applied the most current formula to your situation. Your Social Security office can help you. According to our research at the Social Security Administration, the most a taxpayer subject to the provision could have Social Security benefits reduced under the latest formula is $213 a month.
Income Averaging and 401(k) Payouts
Q. What Internal Revenue Service Publication explains the five-year and 10-year income averaging available to taxpayers taking lump sum distributions from a 401(k) plan? -- J.A.T .
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A. The publication you refer to is No. 575, “Pension and Annuity Income (Including Simplified General Rule).” It is available free from the IRS; call (800) 829-3676.
U.S. and Municipal Bonds as IRA Deposits
Q. I have a roll-over individual retirement account consisting entirely of 30-year U.S. Treasury bonds that pay interest semi-annually. If this interest is distributed to me is it subject to California state tax or exempt, like Treasury securities’ interest normally is? -- G.S.C .
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A Any money withdrawn from an IRA--except contributions made on an after-tax basis--is subject to both state and federal taxes when withdrawn. This applies as well to municipal bonds, which many taxpayers have mistakenly purchased for IRAs on the assumption that they could avoid taxes when they tapped the IRA.
Jobless Pay Adds to Taxable Income
Q. Do I have to pay taxes on the unemployment insurance benefit I collected for several months last year? Also, am I entitled to deduct any part of the interest I pay on my student loans? -- G.C .
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A. Unemployment insurance benefits are subject to federal income tax, but not state income tax. Student loans are considered personal or consumer debt; interest paid on them is not deductible.
