To Save, Use New Rules Carefully
A bundle of new tax breaks and rule changes took effect in the last year--including a few that started Friday--that could benefit you in 1999.
The child tax credit for middle-income taxpayers rose to $500 from $400 in 1998, for example, and income limits to deduct individual retirement account contributions have been raised. The estate tax exemption rose to $650,000, and the self-employed can now deduct 60% of their health insurance premiums, up from 45%.
But accountants and tax officials say many of the other changes to tax law and tax rules are not well understood. You may not be able to take advantage of some of the most attractive tax breaks or rule changes--and using them incorrectly can wind up costing you.
Home office rules have been relaxed, for example, but most people still won’t be able to write off theirs--and some who can may not want to, at least not to the fullest extent allowed. Burden of proof has shifted from the taxpayer to the IRS under certain conditions, but that’s no cause for shredding your tax documents or mouthing off during an audit. Fewer truly innocent spouses will wind up with an ex’s tax bill, but most of us should still carefully scrutinize any joint return we file.
Here are the areas that seem to be causing the most confusion:
* Home office deductions. Congress loosened the requirements for deducting a home office starting in 1999, and accountants estimate about 2 million taxpayers will benefit.
But the requirements are still fairly strict.
For example, a home office must still be used regularly and exclusively for business. If you balance the family checkbook on the business computer or use the office as a guest room during the holidays, you don’t qualify for the deduction. You can claim part of a room as a home office, as long as none of the office equipment or furniture is also for personal use.
In addition to the above requirements, the office must be used regularly to meet with clients or be the principal place of business. The definition of “principal place of business” is what Congress changed, after a 1993 Supreme Court ruling prohibited an anesthesiologist from deducting his home office because he performed only administrative functions there, not his main job, which was performed in a hospital. Now home offices that are used for managerial or administrative functions can be deducted, as long as the bulk of such functions are performed there and not somewhere else.
An employee will still have a tough time claiming the deduction unless the employer is willing to stipulate that the home office is for the company’s convenience--that it is a requirement for the job or that it is necessary for the employer’s business. If you occasionally telecommute for your own convenience, you won’t be able to take the deduction.
There are actually several parts to a home office deduction. Direct costs, such as installing a new phone line or adding soundproofing, are fully deductible. A portion of utilities, mortgage interest or rent, property taxes, maintenance, and homeowner’s insurance can be written off. These deductions usually reflect the proportion of the home that is used for business; if the office is 250 square feet in a 2,500-square foot home, then 10% of the home’s expenses can be deducted.
Another potentially valuable deduction, if you own the home, is depreciation. You can write off the proportional value of your home office, using either the adjusted cost basis of the home or its market value on the day your business started, over 39 years.
But you may not want to take this particular deduction. That’s because Congress decided to “recapture” the break with a 25% tax on the home sale profit that can be attributed to the depreciation. You could also lose out on part of the $250,000 home sale profit exemption that might otherwise apply. Deciding whether the tax benefit now is worth the tax bite later is a complex decision, and depends on several factors, including your current and future tax brackets, how long you’ll use your office and how fast your house appreciates, among others. Run the numbers or ask a tax preparer for help to make sure the benefit outweighs the potential tax cost.
* Burden of proof. Starting with audits that begin after July 22, 1998, the burden of proof has shifted from the taxpayer to the IRS once a case reaches civil tax court. But until then, you have to comply with reasonable IRS requests for documentation and help during audits, including arranging meetings and producing witnesses. In criminal cases, the burden of proof remains with the taxpayer.
Accountants say some of their clients inaccurately believe they are no longer required to keep records to document their deductions. In fact, the burden of proof shifts to the IRS only if you keep good records, document deductions as required by law and cooperate as outlined above.
* Tax-cheating spouses. Until Congress changed the law in July, the IRS could come after a divorced spouse for a tax liability created by their former partner during the marriage, even if the other spouse was entirely responsible for the underpayment, and even if the so-called innocent spouse had no idea that their joint tax return wasn’t correct. Proving innocence to the IRS’ satisfaction was a difficult task, and getting out from under the tax liability was even more difficult.
Under the new law, divorced or separated taxpayers who were duped by a tax-cheating spouse may now find it easier to avoid financial liability, but strict rules apply. This option to separate tax liability has to be taken no more than two years after the IRS starts collection proceedings.
*
The so-called innocent spouse must be divorced, legally separated or living apart from the other spouse for at least 12 months.
To escape liability, those who elect to separate their responsibility must be able to establish that they did not know an item on the joint return was erroneous; the IRS must also determine that it would be inequitable to require the innocent spouse to pay tax for the item.
If the IRS can prove the spouse did know the item was wrong, the spouse can still escape the tax bill if he or she can prove the return was signed under duress.
Although Congress softened the requirements for proving innocence, spouses can’t simply play dumb. If a spouse enjoyed a multimillion dollar lifestyle and glibly signed a tax return that showed income in the 15% bracket, ignorance, let alone innocence, would be hard to prove. And fraudulently transferring funds--such as the “guilty” spouse giving all her money to the “innocent” spouse in order to cry poverty and inability to pay--voids the innocent spouse protection.
The IRS is more responsible for making sure spouses and ex-spouses know that trouble is brewing, however. The IRS can no longer mail a “notice of deficiency”--the document that states there are unpaid taxes owing--to last-known address of the innocent spouse and claim that as sufficient notice. Instead, the IRS must let both spouses know that it plans to dun them jointly for a tax liability. That should give the innocent spouse time to opt for separate liability.
Some other important tax changes have received little publicity:
* Five-year forward averaging is scheduled for extinction Dec. 31, 1999. Five-year forward averaging allows retirees to spread the income from a lump-sum retirement distribution over five years for tax purposes, which can significantly reduce the tax bite.
As of Jan. 1, 2000, retirees taking a lump-sum distribution and who are not able to roll the money over into an IRA will have to pay the tax in a single year. Ten-year forward averaging is still allowed for people who were born before 1936, however.
* Hardship rollovers are no longer allowed. In the past, taxpayers who were able to convince their employers to give them a “hardship” distribution from their retirement plan--a withdrawal to be used for large medical expenses or other catastrophes--could actually roll the money over into an IRA without penalty instead of using it for the hardship. The 1998 technical corrections bill squashed that loophole.
