Off to the Mine


March/April 1985


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One spoof of income tax is a form with three lines. The first says, "How much money did you make last year?" The second says, "How much did it cost to earn it?" The last says, "Send in the difference." This, of course, is inaccurate from the word go, because you already sent much of it in—in the form of withholding from your paycheck. But actually, the satirical form describes pretty accurately the process of filing taxes. You need to know [1] how much you earned (gross income) . . . [2] how much you spent getting there: your income adjustments and deductions (either itemized or according to Uncle Sam's standard deduction, whichever is greater) . . . [3] the amount of tax imposed on the remainder when [2] is subtracted from [1] . . . and [4] the amount of any credits that can be taken from that tax.

Working for one employer doesn't give you a wide range of tax options, but a review of the basic process involved in filing in this situation will give you the groundwork you need to move on to the more involved tax situations we'll be discussing later. If you choose to itemize your deductions (by filing Schedule A), you'll be allowed to include a broad range of business-related expenses as deductions, in addition to non business itemized deductions. Unless you own a home and are paying interest on a mortgage, however, you probably won't have enough expenses to justify itemizing. The standard deduction, now called the zero bracket amount, may prove to be more to your advantage. Thus you'll be filing the standard 1040—perhaps with a couple of other explanatory forms.

HOW MUCH YOU EARNED

For tax purposes, you have two lives: your personal and business ones. And when you work at a regular job for a salary, from which your employer withholds income tax prepayments throughout the year, the majority of your income is likely to be from that job (your business life) as reflected in one form: the W-2. But receiving a W-2 certainly doesn't mean that employment is your sole source of income. Beyond the standard supplementary types of income, such as interest and dividends, some examples of other sorts of revenue, and the locations on Form 1040 where they must be reported, include the following:

* Alimony (as opposed to child support) received must be reported on line 11 of Form 1040.
* Barter income: The exchange of goods or services for other goods or services must be reported on line 22 of Form 1040 if they aren't related to your trade or business. If you are self-employed and barter for your wages, the fair market value of the income must be reported on Schedule C.
* Canceled debts you owed must be reported as income on line 22, Form 1040. (If you don't believe it, just ask Geraldine Ferraro.)
* Cooperative benefits: If you receive a discount on goods for services rendered at a cooperative, this is taxable income. If you receive dividends on your membership fee from a cooperative, this amount is taxable, and you should receive Form 1099-PATR in the mail from the cooperative.
* Damages you are awarded for lost wages or profits, but not those that compensate for personal injury or sickness (unless those awards are punitive), must be reported on line 22, Form 1040.
* Foreign income of U.S. citizens is fully taxable and must be reported on line 7, Form 1040.
* Free tours, even those for which you serve as an organizer, must be reported as income on line 22, Form 1040. Expenses of voluntary leaders may not be deducted.
* Gain from sale of your home: The amount you receive when you sell your home (minus expenses of sale), less the price you paid for your house added to the cost of improvements you've made (the total of which is called your basis), is taxable as a capital gain and must be reported on Schedule D. Thus, keeping good records of improvements you make to your house is quite important. An excess of improvements isn't helpful, though: If you sell your house for less than your basis, the loss isn't deductible (unless you turn your home into a rental house before selling it—see Publications 523 and 527 for rules).

Fortunately, even if you have a substantial gain, you can postpone taxes on that amount by reinvesting the basis and gain in a new principal residence. It's important to understand that you'll only be postponing the inevitable, however. The basis of your new home will be reduced by the amount of gain you reinvest (and defer taxes on), so that when you sell that home, the "new" taxable gain will include the amount you postponed earlier. You may not postpone the gain on any part of your home used for business during the year of sale. But you can choose to exclude up to $125,000 in gain from the sale of your principal residence if you are 55 or older, have used the home as your principal residence for three of the last five years, and have not excluded gain on a sale or exchange of a home after July 26, 1978.

* Gambling winnings must be reported on line 22 of Form 1040. Losses may be deducted on Schedule A up to the extent of winnings.
* Hobby income should be reported on line 22 of 1040. Expenses may be deducted, but only to the extent of income.
* Refunds you have received on state or local taxes that were deducted in previous years should be reported on line 10, Form 1040.
* In some cases, per diem expenses from your employer in excess of $44 per day must be reported as income on line 7, Form 1040. Attach an explanation.
* Sales of personal items, as well as investment property, at a profit should be reported as capital gains on Schedule D. If the items are not considered investments, losses may not be deducted; items such as gold, coins, and gems are generally considered investments, and a sale at a value greater or less than the purchase price is treated as either a capital gain or loss.
*
Solar energy grants received from your state under the Solar Hot Water Initiative Program must be reported on line 22 (you may also qualify for a renewable energy tax credit, however).

SPECIAL ITEMS FOR WHICH YOU SHOULD RECEIVE
(AND MUST SUBMIT) 1099 OR W-2 EARNINGS STATEMENTS

* Annuities or pensions: Payments received from an employer pension plan must be reported on line 16 or 17a and b, Form 1040. Distributions from Individual Retirement Accounts must be reported on line 17a of 1040, unless certain penalties apply. See Publication 590.
* Awards: All prizes and awards—except certain ones that are made in recognition of achievement, that were not applied for, and that imply no future services-should be reported on line 22, Form 1040.
* Group life insurance premiums paid by your employer on a policy that exceeds $50,000 are reported on line 7 of Form 1040.
* Stock options: Some stock options must be reported on line 7, Form 1040. See IRS Publication 525.
* All unemployment benefits must be reported on line 20a, and they may be taxable. Receiving such benefits may also force you to make estimated tax payments during the year. See IRS Publication 505.

Further elaboration on what is and isn't taxable income can be found in IRS Publications 17 and 525.

DEDUCTIONS AVAILABLE TO ALL

The following items are some of the expenses that can be deducted from gross income whether or not you itemize deductions.

* Alimony paid: Report this amount on line 29, Form 1040.
* Business travel: Necessary expenses incurred while traveling away from home on your employer's behalf (but not paid by the employer) for a period long enough to require sleep or rest are deductible. You may claim these amounts by filing Form 2106. You may claim mileage for which your car was put to business use (except for commuting) at a rate of 20.5¢ per mile for the first 15,000 miles and 11¢ per mile thereafter, or you may calculate actual expenses. Actual expenses may include depreciation (see the glossary and IRS Publication 572). You may also deduct travel expenses for traveling to and attending school required by your employer or necessary to improve or maintain skills used in your present work. When figuring travel expenses, don't forget auto club dues, garage rent, parking fees, tolls, etc. See Publication 463 for record-keeping requirements.
* Contributions to qualifying charitable organizations may be deducted up to a limit of 25% of the first $300 if you don't itemize. Report this amount on line 34b of Form 1040.
* Convention expenses incurred to further your employer's business, and for which you weren't compensated, may be deducted as travel expenses on Form 2106. If your spouse or other family members attended with you, their portion of the expense may not be deducted unless they actually had specific business duties at the function.
* Married couple with both working: If you are married, you and your spouse both work, and you file a joint return, you can exclude 10% of $30,000 or 10% of the lesser of the spouses' earned incomes—whichever is smaller—from your taxable income. Figure your exclusion on Schedule W and report the amount on line 30 of Form 1040.
* Moving expenses: If you moved your home to accommodate your employer in a different job location or to take a new job, and if the new job location is at least 35 miles farther from your former home than the old one was, and if you work at least 39 weeks of the 12 months after the move, you may deduct the reasonable expenses of moving your household goods and personal effects, of traveling to your new home, of house-hunting trips before you move, of temporary living in the new area, and of disposing of your former home and acquiring a new one—within certain dollar limits. Fill out Form 3903 to determine the moving expense deduction you can report on line 24 of Form 1040.
* Penalty on early withdrawal of savings: If you are assessed a penalty for prematurely withdrawing funds from a time savings account, you may deduct this penalty on line 28, Form 1040. (Interest payments you receive must be reported as income on line 8, Form 1040.)
* Retirement plan payments: You may deduct up to $2,000 ($2,250 if married and filing jointly, for joint accounts with a nonworking spouse) of earned income for contributions to an Individual Retirement Account (IRA) if you are younger than 70-1/2. Trustee fees may be added. This deduction is reported on lines 26a and 26b of Form 1040.

The Morass of Depreciation

If you itemize as an employee, are self-employed, or have rental income, and if you buy property for your trade or business or for investment that has a useful (and calculable) life expectancy of greater than one year and that can be expected to wear out, lose value, or become obsolete, you may deduct a portion of the cost of that property each year by filing Form 4562. Report the deduction on line 22 of Schedule A (if the property is for the convenience of your employers on Schedule C (if you're self-employed), or on Schedule E (for rental income). This property may be tangible (vehicles, equipment, tools, etc.), intangible (patent rights, copyrights, etc.), or real estate. Land itself, in spite of what we know about the rates of soil loss, can never be depreciated.

Reporting all the nuances of depreciation is an involved enough matter to merit a major article in itself, but here are a few of the basics. Most property is now depreciated by the Accelerated Cost Recovery System (ACRS) as either 3 year property (cars and light trucks), 5-year property (most tools and equipment) 10 year property (mobile homes and certain light-duty structures), or 18-year property (buildings). The specific percentages of the cost that may be recovered each year for each type of property
are specified in the instructions for Form 4562. The full first year percentage may be taken for all but 18 year property, no matter when the item was put into service during the tax year. However, property depreciated under ACRS may not be claimed for a deduction in the year it's disposed of, no matter when during the year it's sold. ACRS is figured against your cost in the item, less 50% of any investment tax credit that you claim on the item.

Cars, computers, and (possibly) some other business items as yet unspecified by the IRS that are put into service after June 18, 1984, must be held at least 50% for business use in order to qualify for ACRS. Accurate, itemized daily logs of use are required! In addition, these items must be required for the convenience of the employer, " and the IRS has decided that a letter from the employer isn't sufficient evidence. (Just what proof is sufficient hasn't been specified by the IRS yet . . . leaving taxpayers wondering just how to handle this matter.) In addition, for cars put into service after June 18, 1984, a $16,000 limit has been placed on the total amount that may be depreciated by ACRS The amount in excess of $16,000 must be depreciated by one of several other methods. See IRS Publication 534 for more information.

Certain property may be "expensed" rather than depreciated under IRS Code Section 179. You may directly deduct up to $5,000 (the amount was frozen this year) for tangible business equipment put in service in 1984. The item must remain in business service for at least two years following the tax year; if the property is sold, the deduction must be recaptured as ordinary income. Selecting the expensing option prevents you from taking the investment tax credit or depreciation, so it generally doesn't result in as great tax benefits over the life of property, but it may be advantageous for those seeking an immediate large deduction.

DEDUCTIONS AVAILABLE TO ITEMIZERS ONLY

By filing Schedule A, you may be able to deduct greater expenses than the standard income exclusion for non itemizers. The viability of this approach usually depends on a substantial mortgage interest deduction. The following deductions are in addition to those listed in the previous section.

* Adoption expenses up to $1,500 may be deducted for children adopted under the Social Security adoption program for children with special needs. This is reported on line 22, Schedule A.
* Bad non-business loans—in other words, loans that you can't collect on—may be deducted as short-term capital losses on Schedule D in the year in which the loans are proved to be worthless. You must have written evidence that the debt existed and is uncollectible. Bad business loans to your employer are fully deductible from gross income on line 22 of Form 1040. Loans to family members are a tricky matter-for example, if the IRS judges that the loan was made in an attempt to transfer income from a person in a high tax bracket to a person in a lower one, the deduction probably won't be allowed.
* Books: Professional libraries maintained for use in your employment may be depreciated, as explained in the sidebar on depreciation.
* Business gifts: Gifts less than $25 in value given to those you do business with (or their spouses or children) are deductible on line 22 of Schedule A. See Publication 463 for record-keeping requirements.
* Casualty and theft losses: If your property is stolen, or if it is damaged, destroyed, or lost because of a "sudden, unexpected, and unusual" identifiable event, you may deduct the amount for which you were not compensated by insurance or some other means-after subtracting $100 per loss and 10% of your adjusted gross income from the resulting total. The amount of the deduction is based on fair market value, not replacement cost.
* Club dues may be deducted, with certain restrictions, when the club is used primarily for business purposes. See Publication 463 for clarification of requirements and record keeping.
* Contributions to qualifying charitable organizations may be deducted on Schedule A up to a maximum of 50% of your adjusted gross income. You may deduct gifts of property (they must be fully described if valued at greater than $200; contributions made after 1984 and valued at greater than $5,000 must be appraised) or cash, and you may deduct reasonable expenses incurred in service to a charitable organization (implied compensation for services is not an allowable deduction). Car expenses in this case are figured for oil and gas only, or at a standard rate of 9¢ per mile.
* Depreciation of property held for use in your employment: Please see the sidebar on depreciation.
* Dues paid to professional organizations may be deducted on line 20 of Schedule A.
* Educational expenses: You may deduct expenses for tuition, books, supplies, laboratory fees, tutoring, research, typing, etc., if the education maintains your present job skills or improves them, as required by your employer. These expenses are listed on line 22 of Schedule A, but Form 2106 must also be prepared to show how the education relates to your business. If you're self-employed, see the discussion on filing Schedule C in the section "Digging Your Own Mine: Self-Employment."
* Entertainment: You may deduct ordinary (not lavish) entertainment costs directly related to or associated with conducting business, as long as they were primarily for the furtherance of business, not for personal or social purposes. These deductions are taken on line 22 of Schedule A. Outside salespersons may deduct entertainment on Form 1040, line 25, and should report such expenses on Form 2106. Expenses for entertaining an out-of-town customer's spouse may be deductible, as may the entertainment of your spouse if his or her purpose is to entertain the customer's spouse. See Publication 463 for record-keeping requirements.
* Gambling income losses, only to the extent of gains reported, may be claimed on line 22, Schedule A.
* Hobby losses, only to the extent of income reported, may be claimed on line 22, Schedule A.
* Income tax return preparation costs, books, counseling, and legal representation in income tax matters, etc., can be deducted in the year the expense is incurred. These items are listed on line 21 of Schedule A.
* Interest expense: Up to certain limits, you may deduct the interest you pay on borrowed money—such as personal loans, mortgages, credit cards, charge accounts, etc.—on Schedule A. Don't forget to deduct also any prepayment penalties you may have incurred. Interest on money used to purchase tax-exempt securities may not be deducted.
* Investment expenses-such as accounting fees, custodial fees, counseling fees, IRA setup and administration costs, legal costs, safe deposit box rental, salary for secretary, bookkeeper, etc., subscriptions to investment services, and travel costs to look after investments-may be deducted if the expense is directly related to maintenance of your investments. Fees for the purchase or sale of securities, however, are subtracted from the selling price. Report these expenses on line 22 of Schedule A.
* Legal fees related to your production of income are deductible on Schedule A, line 22.
* Looking for a new job in your same profession is a deductible expense on line 22 of Schedule A. Likewise, fees paid to an employment agency may also be deducted on line 22, Schedule A.
* Medical and dental expenses that are greater than 5% of your adjusted gross income (see the glossary) may be deducted on Schedule A. Only prescription drugs and insulin may be included as medicines. See Publication 17 for a rather lengthy list of deductible and nondeductible expenses, but don't forget that for 1984 you are allowed up to $50 per day for lodging when you travel to obtain medical care. Car expenses are figured at 9¢ per mile. Deduct medical examination expenses that are required to get or keep a job on line 22 of Schedule A; there is no percentage limit.
* Office-in-home: Please see sidebar.
* Phone expenses incurred at your home for your employer's use, along with an allocation of monthly service charges, may be deducted on line 22, Schedule A.
* Tools and supplies (small items generally valued at less than $100) that you use in your work may be deducted as expenses on line 22 of Schedule A. A briefcase, mechanic's hand tools, and pencils are just a few examples. More expensive items must be depreciated; please see the sidebar on that subject.
* Taxes: State, local, or foreign income tax; state and local real property tax and personal property tax; and general sales tax may be deducted on Schedule A. You may either take a standard sales tax deduction from IRS tables or deduct actual taxes paid if you can document them. A major purchase during the tax year probably means that you will benefit by figuring the actual tax paid. Taxes you directly paid on the purchase of a vehicle (yes, boats are included) or on materials for building a house (mobile homes too) may be added to the standard amount of deductible sales tax. Taxes are deducted on Schedule A.
* Trade and professional magazine subscriptions may be deducted on line 22 of Schedule A.
* Union dues and expenses are deductible on line 20 of Schedule A.
* Work clothes and uniforms: The cost of clothing and safety items necessary for your employment that aren't suitable for everyday wear—as well as laundering of same may be deducted on line 22, Schedule A. A union clothing requirement does not make the clothing deductible.

Using Your Home as an Office

The office-in-home deduction is generally not provided for people working for an employer, unless the office is for the convenience of your employer" and "not just appropriate and helpful." In any event, to claim an office-in-home deduction, you must use the area "regularly and exclusively, " and it must be either (a) your principal place of business or trade, (b) a place to meet clients, customers, or patients, or (c) a separate building for trade or business. No personal activities may take place in this office; rather, the activities must be a trade or business—not personal investment.

Note the inequity that allows an employee of a company to use the company's work space to reconcile his or her personal checkbook, or to keep various personal records, while the self-employed person can't put the office-in-home to any personal use. Exclusive use is 100%, not 99.99%: People have lost their entire deductions because they reconciled their personal checkbooks in their offices-in-home.

The exclusive-use rule does not apply to registered day-care centers.

If you can qualify according to the restrictions listed above, you may deduct that portion of your household expenses that relates to the area used for the office. This is calculated by figuring the percentage of a house's square feet in use for business and apportioning that percentage of taxes, mortgage interest, maintenance, operating expenses, and depreciation. These deductions must be reported on Schedule A, C, E (partnership), F (farm income), or 2106—as is appropriate.

If you use a computer in a qualified office-in-home, you don't have to keep a detailed usage log-as is the usual requirement-in order to depreciate it using ACRS. Bear in mind, however, that if your office-in-home is denied, that log will be required retroactively-so you may want to keep a log anyway.

Another important consideration, if you claim an office-in-home , is that you may not defer capital gains on the portion of the house that is your office-in-home, if you claim that deduction in the year in which you sell your home. When you sell, depreciation must be recaptured, as described in the sidebar on depreciation. For more information, see Publication 587.

TAX CREDITS AVAILABLE TO ALL

Credits are allowed for certain expenditures whether or not you itemize deductions. These items reduce your tax liability on a dollar-for-dollar basis.

* Campaign contributions may be subtracted from your tax at a rate of 50%o, up to $50 for individual filers or $100 on joint returns. Report these amounts on line 44 of Form 1040.
*
Child and dependent care: Between 20 and 30% of child care expenses, up to $2,400 per dependent, that you incurred in order to earn income are credited on line 41 of Form 1040. Prepare and file Form 2441 to claim this credit. The total is limited to $4,800.
* Earned income credit: If you supply more than half of the cost of maintaining a household in which you have children or are a surviving spouse, you may take a credit equal to 10% of the first $5,000 in earned income—minus 12.5% of your adjusted gross income exceeding $6,000. (This is a typically confusing-sounding IRS formula, but if you work with it awhile, plugging in the appropriate figures, it begins to make sense. Figuring taxes is often easier than reading about them!) You may receive a credit even if no taxes were withheld from your income during the year. This credit is taken on line 59 of Form 1040.
* Elderly: See the sidebar "Tax Considerations for Those Over 65."
* Foreign taxes: All or part of the amount paid in tax to foreign countries may be deducted by filing Form 1116 and entering the amount of the credit on line 47 of Form 1040.
* Investment tax credit: A credit of up to 10% of the cost of tangible property put into service for your business or trade (limited to $1,000 on cars and light trucks) may be taken by filing Form 3468 and listing the amount on line 48, Form 1040. See the sidebar on depreciation.
* Residential energy credit: A credit of 15% of the first $2,000 spent on energy conservation equipment on existing houses substantially completed before April 20, 1977, is allowed. Forty percent of the first $10,000 spent on renewable energy equipment for your principal residence may be taken as a credit. Both of these credits are claimed by filing Form 5695 and reporting the total on line 43 of Form 1040. Conservation items include insulation for house or water heater, storm windows, caulk, setback thermostats, energy-efficient parts for furnaces, and energy monitoring devices. Heat pumps, woodstoves, and hydrogen-burning equipment are not included. Renewable energy sources include active solar heating equipment and portions of some passive features, photovoltaic panels, wind-powered generators, and high-temperature geothermal equipment. Unfortunately, hydropower and groundwater heat pumps aren't included.

These are the basic building blocks for preparing your income tax return. Now that you've read through them quickly, go back and place a small check mark next to each area you need to investigate further. Then move on either to a sidebar covering that tax matter or to request the appropriate paperwork from your regional IRS form center (the addresses are listed in an accompanying sidebar).

Tax Considerations for Those Over 65

Many requirements, deductions, and credits are different for those who are over 65. First of all, you need not file a return at all if you're single and your income is less than $4,300; if you're married, one of you is over 65, and your income is less than $6,400; or if your income is less than $7,400 and you're both over 65. Unless, that is:

* You had self-employment income exceeding $400.
* You can benefit by filing as a qualifying widow or widower (see Publication 17), in which case the limit is $5,400.
* You could be claimed as a dependent by another taxpayer and had unearned income (say, from investments) of $1,000 or more.
* You receive distributions from an Individual Retirement Account.

Gruesome as it may seem, dying doesn't exempt you from filing. The surviving spouse or the legal executor, administrator, etc., must file in the year of a taxpayer's death if that person would have been required to file. On the other hand, joint returns maybe filed by the surviving spouse with dependent children for two years after the year of death. Additionally, the estate will probably file a return for the year of death on any earnings during probate.

On lines 6a and b of Form 1040, you may take an additional personal exemption for yourself and/or your spouse if you are over 65. The additional exemption may not be claimed by someone reporting you as a dependent.

If your gross income is less than $17,500 (unmarried, filing single), $20,000 (filing joint with one spouse under 65), of $25,000 (if you're both 65 or older), you may qualify for the Credit for the Elderly. (Note: This credit is also available to some people under 65. See general instructions for Form 1040 or Publication 17.) To determine what your credit is, file Schedule R.

A FEW TAX TIPS

If, when you retire, you receive a lump sum distribution or a large retirement bonus, consider prepaying charitable and political contributions, medical expenses, and other Schedule A items, so that you can take large deductions in the year in which you receive the lump sum. For example, you might arrange to pay your doctor in advance for medical expenses you expect to have in the next year. Take note, however, that there are limitations on how far in advance you can prepay many items . . . you may want to consult a tax pro for this.

In addition, if you receive a lump sum distribution upon retirement, consider ten-year income averaging, a special provision for this situation. Get a copy of Form 4972 to look into ten-year averaging's possibilities. Other options to consider for this situation are capital gains treatment (see the glossary) and tax-free rollover into an IRA. Now that you're retired, perhaps you'll have time to work out these options to your best advantage.

Remember to add social security and other nontaxable income to your available income, line 33—Form 1040—when figuring your sales tax deduction on Schedule A.

Income Averaging

If your income increases significantly from one year to the next-particularly if the good year follows three lean ones-you may benefit from income averaging, which, in effect, allows you to spread out your taxable income over the years involved. Here's how you qualify.

First, you must be a citizen or resident alien. Second, you may not average if you or your spouse provided less than 50% of your support during 1981, 1982, and 1983, unless (a) you were 25 or older at the close of 1984 and weren't a full-time student during four of the taxable years after you reached 21; (b) more than 50% of your 1984 income came from work performed in 1981, 1982, and/or 1983; (c) your spouse's earnings were less than 25% of your joint 1984 income and you were self-supporting in 1981, 1982, and 1983. Owner-employees and key employees may not average premature distributions from retirement plans. Publication 506 outlines other requirements and adjustments for income averaging.

Once you've determined that you qualify to attempt to income average, you'll need to figure out if it's actually to your advantage to average. Follow the instructions on Schedule G very carefully, bearing in mind that this is one of the most mistake-ridden forms submitted to the IRS. If you do it correctly, buy yourself a treat!


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