Why You Should Take Another Look at Your Client’s 1040
Did issues come up during this busy season? Check back on them now to improve quality, efficiency and better tax planning strategies.
June 9, 2011
During the course of reviewing 1040s, reviewers are most likely finding common errors in the 1040 preparation. These issues should be noted for purposes of future training sessions. In addition, there are numerous areas in which tax planning comes into play. A few of these 1040 issues are briefly described below.
Interest limitations apply to 1040s, for both qualified residence interest and investment interest expense. The determination of whether interest is business, personal or investment is based on how the loan proceeds were used, using the interest tracing rules.
Qualified Residence Interest
Tax preparers should be aware of the limitations on home mortgage interest, and pro-rate interest paid on the debt accordingly if the debt exceeds the limitation. Although there is an exception for debt incurred on or before October 13, 1987, generally home acquisition indebtedness is limited to $1 million ($500,000 if married filing separately) and home equity indebtedness is limited to $100,000 ($50,000 for married filing separately). There is also a fair value limitation to take into consideration, in cases where the home acquisition indebtedness and home equity indebtedness exceed the fair value of the home. Home mortgage interest is limited to the principal residence plus one additional residence.
Investment Interest Expense
An investment interest expense deduction is limited to net investment income. Any carryover may be carried forward indefinitely, and is reported on Form 4952. While net-investment income does not generally include qualified dividends and net capital gains, taxpayers may elect to include these items as investment income for the purpose of deducting investment interest. The portion of the qualified dividends and net capital gains that is classified as investment income will no longer be taxed at the qualified dividend or capital gains rate, but will allow the investment expense deduction. Although this deduction may seem like a good idea, proper planning should be done to determine whether the taxpayer expects net investment income in the future which will offset the investment interest carryover.
Estimated Tax Payments
Tax preparers should make sure they get the correct estimated federal and state tax payments on the returns, including overpayments from prior year that were applied to current year, any extension payments made and estimated tax payments. Common errors in this area include confusion between amounts deducted for state taxes as an itemized deduction on Schedule A with amounts actually paid in estimated tax payments for the year.
Basis in S Corporations
When preparing a 1040 for a shareholder in an S corporation, before deducting any losses, one question is whether there is any basis to deduct the loss. This determination comes before any passive loss issue limitations that may apply. Shareholders should maintain basis worksheets to keep track of this basis. While these calculations may be made at the corporate level, it is ultimately the responsibility of the shareholder to determine whether there is stock or debt basis in the Corporation. Information from the K1 is used to determine increases and decreases in basis. Any losses limited for basis may be carried over to future years.
Distributions From S Corporations
An S corporation shareholder may receive a non-taxable distribution if there is stock basis. In instances where distributions exceed basis the taxpayer needs to report the gain on schedule D as gain from the sale or exchange of property. It is treated as long or short term depending on how long the stock was held.
Repayment of Reduced Basis Loan
Shareholders of S Corporations are allowed to use debt owed directly from the corporation to themselves as debt basis for purposes of deducting losses. If the shareholder receives repayment on this debt before the stock basis has been fully restored, there is taxable income for a portion or the entire amount of this debt repayment, depending on the proportion of the debt that has a reduced basis.
Passive Activity Losses
Once a tax preparer has gotten by the basis and at-risk limitations regarding a loss from a K1 or sole proprietor, there is the passive loss issue. While rental activities are normally passive by their nature, this is not the case with ordinary losses, where the exercise of determining whether the taxpayer materially participates becomes important. This test should be done each year as circumstances may change. If the taxpayer does not pass the material participation test, the activity is passive. Passive losses are generally offset by passive income or carried forward until the activity is entirely disposed of, at which time the losses may be recognized. There are special rules for recognizing losses related to rental real estate with active participation. Practitioners also need to be aware of the rules related to self-rented property, when rental income from property used in a trade or business that the taxpayer materially participates in, must be re-characterized as non-passive.
The recent changes in allowable deductions for section 179 depreciation and bonus depreciation has provided practitioners with tax planning opportunities and challenges. Bonus depreciation is now available at 100% on new qualified property placed in service after September 8, 2010. The Section 179 limitation is now at $500,000 with phase-outs after $2 million of qualified property placed in service. These limits leave plenty of choices, keeping in mind that the States are not necessarily following the Federal regulations. In addition, section 179 is limited to active trade or business income. Also keep in mind the basis limitations may apply which may be important where the practitioner is preparing an S Corporation return for the taxpayer.
1040 preparation brings forth a variety of different issues that preparers should be aware of, some that are more complicated than others. Some have bigger tax impacts than others. The goal is for the tax preparer to recognize a potential issue when they encounter it, in order to come up with results that are beneficial to the taxpayer.
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Debbie Mitchell, CPA, MBA, MST, is a principal with Braver PC Accountants and Advisors.