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Smoothing the tax road.

Editor's Note--As the file drawer rolls shut this month on another year's worth of taxable assets, many Americans who don't even have dandruff are still scratching their heads over certain tax-related problems. For some answers, the Post has turned to Howard Ruff, the well-known financial adviser and economics strategist who handles thousands of taxpayers' problems yearly over the "hotline" at his Financial War Room in California. Queries about inheritance as well as income taxes have run heavy in recent months, so Mr. Ruff has identified the 12 most frequent questions. We hope his advise will lead to many happy returns. 1. I understand my husband and I may have to pay federal income tax on our Social Security benefits. Could you tell me if this is so?

A. As a result of the Social Security rescue plan signed by President Reagan in April 1983, about 10 percent of Social Security recipients are now liable for federal income tax on up to half their benefits. Your benefits will be taxed if the sum of your adjusted gross income, "tax-exempt" municipal-bond interest and half your Social Security benefits exceeds the following limits:

(A) $25,000 for a single individual;

(B) $32,000 for a married couple filing jointly;

(C) zero for a married couple who lived together during any part of 1984 and who file separate returns. In this case each would pay income tax on his or her benefits; or

(D) $25,000 for married persons who lived apart for the entire year and who file separately.

2. My income has been very erratic over the last few years. Would it be a good idea to income-tax average?

A. If your income is considerably higher this year than it has been in the past few years, you may be able to compute your tax under the income-averaging method. To determine if income averaging can help you in 1984, do the following:

(A) Add your taxable income for 1983, 198i and 1981;

(B) multiply the total in (A) by 46.7 percent;

(C) subtract (B) from your 1984 taxable income.

(D) If the answer in (C) is more than $3,000, you can probably reduce your taxes using income averaging.

3. I have an office in my home and have never been clear on just how much I can deduct for it.

A. You can take a deduction for the business use of your home if a specific part of your home is set aside and: (a) used exclusively and regularly for the principal place of any business; (b) used to meet with patients, clients or customers; or (c) as an employee, you provide space for the convenience of your employer or facilities to perform your duties. However, there are specific limitations to the amount you may deduct. The deduction limit is the gross income from the business in your home reduced by otherwise allowable expenses such as taxes, insurance, etc. In other words, if gross income minus other allowable expenses is zero or less, there can be no deduction for an office in the home.

4. Is there any way I can deduct the expenses incurred in my hobby?

A. A hobby is a purely personal expense, but if you convert your hobby to a trade or a business, and if all the expenses directly connected with that business are both "ordinary and necessary," you can deduct them. I would suggest you consult Chapter 11 of the book How to Save 50% or More on Your Income Tax--Legally (MacMillan) by B. Ray Anderson or call Anderson's "Taxflation Strategies" newsletter, (415) 463-2215, for a free copy of his Janauary 1985 issue on the subject. Both sources describe and discuss the relevant rules for converting your hobby to a business.

5. I have a vacation home at a lake in the mountains. Are there any tax deductions I can take other than the deduction for interest on my mortgage?

A. Some vacation-home-related expenditures are deductible without regard to how the taxpayer uses the property. As with any other residence, the tax code expressly gives you a deduction for interest payments and local property taxes.

The real question is whether the vacation home is merely another personal residence or whether the taxpayer is holding it for the "production of income." If the vacation home is rented out to others, the taxpayer is entitled to deduct a host of other expenditures: depreciation, maintenance, utilities, advertising, management fees and even some of the costs of travel to and from the "investment property." The trick is to qualify such expenditures as being "ordinary and necessary" for the management, conservation or maintenance of the property.

But qualifying these expenditures as "deductible" and deducting their full amount are separate issues. Even if your vacation property is held for the production of income, your personal use of it will diminish or destroy the possible deduction.

First--no matter how many other parties rent the property--if you use the property too many days of the year, it will be deemed a residence and the extra deductions will be lost. How much is too much? First, the tax code allows you 14 days' personal use without loss of deduction. Beyond that, deductions diminish if you use the property more than 10 percent of the number of days during the year in which property is rented at fair market value.

For example, if you rent your vacation home to non-family members for 100 days, you can use it for 14 days. But if you rent it out for more than 140 days (say 160), then you want to limit your use to the 10 percent level (16 or fewer days here).

Second, even if the taxpayer's personal use of the vacation home is permissible, any personal use will reduce your total deductions. Here's the formula: Days Rented at Fair Market Value divided by Total Days of Use equals Deductible Percentage.

So if you rent your vacation home for 100 days and use it yourself for an additional 14, you can take about 87.7 percent (100/114) of the amount otherwise deductible. (Interest and local property taxes are excluded from this formula--they are always fully deductible.)

6. What changes from the Tax Reform Act of 1984 will affect my IRA account?

A. Prior to the Tax Reform Act of 1984, contributions to an IRA could be made at any time within the period for filing your tax return (normally April 15), but including any periods for an approved extension. The Tax Reform Act of 1984, however has changed the law and now requires that contributions to be deducted for the current year must be made on or before April 15, period. Also beginning in 1985, you can make an IRA contribution out of alimony (not just "earned income").

7. I have children who will be starting college in the next ten years. Is there any way I can start saving for their education and avoid taxes on the earnings?

A. Yes, there are several methods for shifting income from the high-bracket Form 1040 of the parents to the lower or perhaps zero brackets of the children; the children can then save it for their future, tax free. These methods are sometimes referred to as "income shifting." Included are: Clifford trusts, spousal-remainder trusts, investment-grade life insurance, tax-exempt municipal bonds, equipment trust utilizing equipment used in a related family trade or business, some family partnership strategies and S corporations. It's complex, so you should consult your tax attorney for details.

8. I am trying to sell my house, and the realtor has suggested an installment sale. What are the tax advantages of an installment sale?

A. If you sell property under an installment-sale agreement calling for deferred payments, you can report the gain from the sale on the installment method. You only report the gain from the sale in the year(s) you receive the payments. For instance, if you receive 10 percent down and the balance in three equal annual payments, you would report 10 percent of your gain in the first year and 30 percent in each of the following three years. Installment reporting may not always be your best choice; it may depend on your present and future tax brackets and whether you may be subject to the alternative minimum tax.

9. If at the end of the year I am faced with the prospect of paying very high taxes, is there something I can do to reduce my tax bill?

A. Setting up your tax plan early in the year is your best tax shelter--and it's free. The best time to beat the IRS is in May or June.

However, if you realize as the tax year rolls on that you will be facing a high tax rate, you can explore the possibility of investing in tax-advantaged investments that produce significant paper or tax losses. With the passage of the Tax Reform Act of 1984, however, large tax write-offs in an economically sound investment diminish rapidly as fall turns into winter. In 1984, the best year-end tax-advantaged investments were found in oil- and gas-drilling programs and equipment leasing for certain kinds of equipment. Other choices include the acceleration of deductible-expenses payments, well-timed sales of loss assets (those that have declined in value during the tax year) to produce short-term capital losses and the deferral of income into the next tax year.

Once the tax year ends, your tax-planning opportunities, with some very minor exceptions such as an IRA or a Keogh plan, come to an end as well. Anyone who suggests that an investment made in 1985 can retroactively reduce your 1984 tax bill is either a promoter of a fraudulent tax shelter or an undercover IRS agent--in either case, you could be in real trouble.

10. I'm worried about my children having to pay the bulk of my estate to Uncle Sam in estate taxes. How can I leave the majority of my property to my heirs and not to the tax man?

A. Effective estate planning is best done on a family-oriented, forward-looking basis. A married couple can use revocable estate-planning documents (wills, revocable trusts, etc.) to shelter up to $1.2 million from estate taxes by the year 1987. If your estate will be significantly larger than the exemption amounts, then more complicated and irrevocable strategies are called for. These would include intrafamily installment sales, private lead trusts, charitable giving, life insurance owned by an irrevocable life-insurance trust, sales of a "remainder interest," private annuities and multiclass-ownership family-business structures. For this you need a tax attorney or a certified financial planner. The planner we recommend for our clients is Newcastle Financial Group, 1815 S. State St., Orem, UT 84057.

11. What is probate? Is there any way I can avoid it?

A. Probate is the court-supervised process under which the state laws of intestacy (dying without a will) or last will and testament become the "road map" for a court-supervised estate settlement. The process ensures that your wishes will be carried out, that the right people get your assets according to your will (or the intestacy laws of your state, if you die without a will) and that the people receiving your assets get them with clear, marketable title.

Depending on the laws of your state, this process can be very long and very costly--both economically and emotionally. Sometimes the protections provided by the process are overshadowed by the costs, technicalities and frustrations. If you want to avoid this process, use joint tenancy or a revocable living trust.

A revocable living trust is a contractual arrangement between living individuals. The grantor transfers legal title to his property to the trustee, who holds and manages is according to the terms of the trust agreement. Because the trust is revocable, the grantor can change the trust agreement, remove and replace the trustee or even eliminate the trust and take the property back. Revocable living trusts have no income-tax advantages, but if properly drafted, they can avoid a significant amount of estate taxes and otherwise serve as a valid substitute for your will. The primary advantage of a revocable living trust is that its assets need not go through probate. The successor or the surviving cotrustee can do all the right things, including the transfer of marketable title to the right people, without most of the hassles, delays and possible publicity of probate. But remember, the title of your asset must be changed to avoid probate. It's not sufficient to merely set up a revocable trust while keeping the title in your name as an individual. You must transfer the title to a trustee--anyone you choose to trust.

Joint tenancy is sometimes a viable way to avoid probate, but its uses are limited and it has too many tax and legal problems to make it as flexible and as attractive as revocable living trusts. 12. Is it true that having a living trust can save my heirs some money?

A. Yes, in many instances, that is true. Using a living trust as the principal method of settling an estate could reduce estate taxes. It will also save some of the time, expense and complications of the estate-settlement process.

As long as your living trust does no more than serve as a will substitute and a probate-avoidance device, you have no problem. Steer clear of any trust that is supposed to split your income from employment to other family members. These trusts, and their promoters, are fraudulent scams. Many unhappy taxpayers have tested these skunks in court, and the IRS has won every single case.
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Author:Ruff, Howard
Publication:Saturday Evening Post
Date:Apr 1, 1985
Words:2272
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