Russ Merrick, EA & Associates

The “line” in this term refers to the line drawn when totaling the items that make up the taxpayer’s adjusted gross income (AGI). The term “deduction” is usually associated with itemized deductions, but an above-the-line deduction is one that can be taken in addition to the standard deduction or itemized deductions, whichever is used. This type of deduction is taken before determining the taxpayer’s AGI; hence, the term “above-the-line.”

This is the debt used to acquire, build, or substantially improve a taxpayer’s principal residence or a second home, and it is debt that is secured by the principal residence or second home. The interest on up to $1 million of acquisition indebtedness is deductible as an itemized deduction.

This may be the most important tax term since the tax code uses the AGI to limit a vast number of tax benefits. AGI is basically a taxpayer’s gross taxable income from all sources (gross income) reduced by certain allowable adjustments, sometimes referred to as above-the-line deductions, which are deductible whether or not the taxpayer itemizes their deductions. The more frequently encountered adjustments include deductions for deductible IRA contributions, moving, alimony payments, higher education interest, forfeited interest and deductions for health insurance premiums, pension plan contributions and 50% of SE tax for self-employed individuals.

A different way of computing one’s tax liability; it MUST be used if the resulting tax is higher than the tax computed by the regular method. This alternate way of computing the tax was introduced several years back to prevent higher income taxpayers from reducing or escaping income tax. The AMT is structured to ignore the use of certain tax breaks and deductions and to apply special rates - 26% and 28%. Inflation over the years has slowly increased the number of taxpayers who are subject to the AMT. Although the factors affecting the AMT are too numerous to delineate here, the ones most frequently encountered by the average taxpayer include: • The 7.5% of AGI adjustment for medical itemized deductions is increased to 10%. • Taxes, including property taxes and state income tax, are not allowed as an AMT itemized deduction. • The difference between the current market value and the exercise price of stock acquired through an Incentive Stock Option (ISOs) is added to income even though the stock has not been sold. • Interest on home equity debt is not allowed as an AMT itemized deduction.

Basis is the dollar value from which a taxpayer measures any gain or loss from an asset for income tax purposes. Generally, your basis begins with what you paid for the asset, including purchase costs (cost basis) and then is adjusted up for improvement and sales costs and down for any depreciation or casualty losses claimed on the asset during the period of ownership. As an example, a rental property is purchased for $200,000. $50,000 is made in improvements to the property, $15,000 is deducted in depreciation during the period of ownership and $12,000 is incurred in sales expenses. The basis for that property, referred to as the adjusted basis, is $247,000 ($200,000 + $50,000 - $15,000 + $12,000). Special rules apply in determining a taxpayer’s basis in property that is acquired by gift or inheritance. For gifts, the starting basis is generally the adjusted basis of the giver; for inherited assets, the basis generally begins with the value of the property on the date of the decedent’s death. Please note that the word “generally” is frequently used in this explanation since it cannot be relied upon in all situations. Please contact this office for assistance.

Gifts to customers, business contacts, clients, etc., are deductible if they are otherwise ordinary and necessary business expenses. However, business gifts are subject to a $25 limit to each donee per year.

Gains from the sale of certain assets owned for more than one year and inherited assets such as stocks, bonds and real estate enjoy a special tax treatment referred to as a long-term capital gain. Gains from assets held for a shorter period are called short-term capital gains and do not enjoy that special tax treatment. For 2008 through 2010, long-term gains are generally taxed at 0% to the extent a taxpayer is in the 15% or lower tax bracket and 15% for the balance. Note: Prior to 2008, the capital gains rate was 5% to the extent a taxpayer was in the 15% or lower tax bracket. There are some exceptions; to the extent that gain results from depreciation on real property claimed since May 1997 (such as the example used in basis), the tax rate is 25%, except to the extent the taxpayer is in the 10% or 15% bracket, in which case those rates would then apply. Also, long-term gains from the sale of collectibles such as artwork, coins, stamps, etc., are taxed at 28%.

This is generally a loss from the sale of investment property such as stocks, bonds and land. Losses must first offset other sales in the same year that resulted in capital gains. Then, up to $3,000 ($1,500 for married individuals filing separately) can be deducted against other types of income. Any excess (referred to as capital loss carryover) can be carried over to future years until used up. It should be noted that losses from the sale of personal use property are not allowed for tax purposes; although, gains must be reported. This rule would apply to the taxpayer’s home, second home, cars, etc.

Generally, most individual taxpayers are considered cash basis taxpayers. That means they pay taxes on income in the year they receive it. At the end and beginning of a tax year, questions sometimes arise as to when the income was received. The tax concept of constructive receipt treats the income as taxable in the year the taxpayer could have received it, even if it was not received until a later date. An example would be a check for an income item received in December of Year 1 that was not cashed until January of Year 2. Since the income was available when the check was received, the income would be reportable on Year 1’s return and not on the return for Year 2 when the check was cashed. Another example would be if the taxpayer earned dividends on stocks but chose to reinvest them. Since the taxpayer has a right to the dividends but chooses to reinvest, it becomes income to the taxpayer on the date the dividends are credited to the account.

This term is used to describe debt incurred to purchase consumer products and includes debt such as motor vehicle loans and credit card debt. Interest paid on consumer debt is not deductible as an itemized deduction on a tax return. However, see the section on Home Equity Debt.

Typically, an individual’s minor child is thought of when the word dependent is used, but a dependent could be another relative, or in some cases, even an unrelated person. Generally, a dependent is someone who is reliant upon a taxpayer for support. Five specific qualifications must be met for an individual to be treated as a dependent for tax purposes: the relationship or member of the household test, gross income test, joint return test, citizenship or residence test and support test. For each dependent claimed in 2008, a taxpayer can deduct $3,500 from their income. For higher income taxpayers, 2% of this deduction is disallowed for each $2,500 of AGI in excess of a threshold amount. The 2008 threshold amounts are $159,950 for single taxpayers, $239,950 for married taxpayers filing jointly, $199,950 for taxpayers filing as Head of Household and one half the Joint amount for married taxpayers filing separately. The tax rules related to dependents can be complicated. Please call this office if you need assistance.

This is a tax deduction that is taken to reflect the wear and tear and gradual decline in value of an asset used in business. Although there are some options for depreciation, the tax law requires that the depreciation deduction be taken even if a taxpayer prefers not to (this is sometimes called the “allowed or allowable” rule). If a taxpayer fails to take the deduction, he/she will still be required to account for the depreciation as if it were taken when the property is sold and pay taxes on the depreciation to the extent of any gain. For purposes of the deduction, tax law assigns a life to various types of business assets and the asset is depreciated over that period of time. Generally, business assets placed in service would be depreciated over 3, 5, or 7 years, except for real estate which would be 27.5 or 39 years.

Is a method of moving retirement and IRA funds directly from one account to another without the taxpayer taking possession of the funds and avoiding the potential problems associated with a rollover. Another term for this type of transaction is trustee-to-trustee transfer.

Generally, when a taxpayer withdraws funds from a qualified plan or Traditional IRA before reaching the age of 59-1/2, the withdrawal is considered an early distribution and is subject to a penalty equal to 10% of the taxable amount withdrawn. This penalty is in addition to any income tax due on the distribution. There are a number of exceptions that might avoid the penalty, depending upon if a distribution is from an IRA or a qualified plan. Taxpayers should consult with this office prior to taking a distribution before reaching age 59-1/2.

This refers to income that is earned from providing your personal services as distinguished from unearned income such as interest, dividends, pensions, capital gains and passive income. Examples of earned income would include W-2 wage income, commissions, net self-employment income and tips. Generally, earned income is subject to FICA withholding or self-employment tax and is the type of income that is required to qualify for IRA and self-employment pension plan contributions and the earned income credit.

If a taxpayer does not have sufficient withholding from wages and pensions to cover the tax liability for the year, he/she could be subject to underpayment penalties. Self-employed taxpayers and those with substantial investment or other income frequently find themselves in this position. Quarterly estimated tax payments provide a means of prepaying the anticipated tax liability as a way to avoid the penalties. Generally, penalties can be assessed if a taxpayer’s prepayments (withholding and estimated tax payments) are not within $1,000 or 90% of the tax owed on their return.

An exemption is an amount ($3,500 for 2008) that can be deducted for the taxpayer and spouse (if applicable) and each dependent claimed on the tax return. The exemptions are phased out for higher income taxpayers. See the term “Dependent.” The exemption deduction is disallowed for an individual who files a return and is also claimed, or could be claimed, as a dependent by another taxpayer.

This is the price at which a property would change hands between a willing buyer and a willing seller, neither being compelled to buy or sell, and both having reasonable knowledge of all the necessary facts.

These initials stand for Federal Insurance Contributions Act, which is the law that covers Social Security and Medicare. Amounts are withheld from the wages of employees for their contribution to the Social Security and Medicare programs. The withholding rate for Social Security contributions is 6.2% and for Medicare 1.45%. The maximum wage amount on which Social Security tax is paid for 2008 is $102,000; there is no maximum for the Medicare portion. The employer also pays an amount equal to the employee’s contribution. If an employee works for 2 or more employers and has tax withheld for Social Security contributions on more than the annual wage maximum, the excess withholding is refundable as a tax credit on the employee’s income tax return.

A taxpayer’s filing status (except Head of Household) is based on their marital status as of the last day of the year and in the case of married individuals whether they wish to file jointly or separately. Thus, if not married on the last day of the tax year, the taxpayer would generally file as “single” status. If married on the last day of the year, he/she would file as married filing jointly or as married filing separately. A taxpayer’s filing status determines the amount of their standard deduction for the year and income levels where tax rates change. In addition to the filing statuses discussed above and the Head of Household discussed separately, there is one additional rarely used status called qualified widow(er) with a dependent child. It is for a surviving spouse who is allowed to use the married filing joint rates for the two years after the year of death of a spouse if certain requirements are met.

Many taxpayers believe they can deduct gifts they give to others. That is not true! To prevent people from giving their assets away prior to their death and thereby avoid taxes on their estate, our tax system includes a gift tax, which is paid by the giver and must be reported on a gift tax return if the amount given to any one individual for the year exceeds the annual gift exemption ($12,000 for 2008). Gifts of larger amounts are taxable but each individual giver can offset the gift tax with a tax credit that offsets the first $1 million of lifetime taxable gifts. Caution - credit used to offset gift tax will not be available to offset estate taxes when the giver passes away. Head of Household – Is a special filing status for unmarried and, in certain special situations, married taxpayers who pay more than half the cost of maintaining a home for themselves and a qualifying person, for more than half the tax year. The special filing status affords qualifying taxpayers with a higher standard deduction and more beneficial tax brackets than are available to taxpayers who file using the single status.

This term refers to debt incurred on a principal residence or second home that is not used to buy, build, or substantially improve that residence or home. An example is a home equity loan used to acquire consumer products or pay off consumer debt. The portion of refinanced debt that exceeds the acquisition debt is also considered home equity debt. Interest on the first $100,000 of home equity debt is deductible as an itemized deduction for regular tax purposes but not for alternative minimum tax (AMT).

Generally, the length of time an asset is owned will determine if it qualifies for long-term capital gains rates when it is sold. To qualify for long-term capital gains rates, an asset must be owned more than 12 months or be inherited property. The holding period of an asset usually begins the day after an asset is acquired and ends on the date of sale or other disposition. For stock, the trade dates, not the settlement dates, are the acquisition and disposition dates to use.

Is someone who performs services for others. The recipients of the services do not control the means or methods the independent contractor uses to accomplish the work. Independent contractors are self-employed.

Is interest paid on debt used for investment purposes. Typical examples are interest paid on vacant land held for investment and margin account interest. Investment interest is deductible as an itemized deduction but only to the extent the taxpayer has net investment income and any excess is carried over to future years. Generally, net investment income means investment income less investment expenses. As an example, suppose a taxpayer’s only investment income is $1,000 of taxable interest and dividend income. He also paid property taxes of $400 and interest of $1,300 on some vacant investment land. His net investment income is $600 ($1,000 - $400). Therefore, his investment interest deduction is limited to $600 and the excess $700 is carried over to future years. If the taxpayer had capital gains, he could elect to forgo the special capital gains rates and treat the capital gains as investment income and thereby increase the amount of investment interest he could deduct.

Taxpayers are permitted to deduct either a standard deduction or itemized deductions in determining their taxable income. Itemized deductions are in five basic categories: • Medical expenses that exceed 7.5% of the AGI. • Taxes - state income tax, property taxes, personal property taxes but not sales or excise taxes. • Interest – generally limited to home mortgage interest and investment interest. • Charitable contributions not exceeding an AGI limitation. That limitation is 50% for most contributions but there are contributions limited to 20% and 30% of the AGI. • Miscellaneous expenses – only miscellaneous expenses that exceed 2% of the AGI are generally allowed. However, there is a second category that includes gambling losses (cannot exceed reported gambling winnings) and several other rarely encountered deductions that are allowed without an AGI reduction. In addition, for higher income taxpayers, some of the itemized deductions may be further reduced by 3% of the amount that the AGI exceeds $159,950 ($79,975 for married taxpayers filing separately) but not more than 80% of the total of those deductions affected by this limitation. The phase-out rates are annually adjusted for inflation and those shown are for 2008.

Sole proprietors, partnerships (but not individual partners) and corporations may establish qualified retirement plans. A qualified retirement plan set up by a self-employed individual is frequently called a Keogh plan. The Keogh name comes from the Congressman who sponsored the legislation allowing these types of plans for individuals. They are also sometimes referred to as H.R. 10 plans (H.R. 10 was the number of the House bill enacting these plans). A Keogh plan can cover both the self-employed person who establishes the plan and his or her employees.

To prevent parents from using their children’s tax return to avoid taxes on investment income, Congress established what is now referred to as the kiddie tax on the unearned income of children. This applies to children under the age of 18 and full-time students over age 18 and under the age of 24 for 2008 and future years. Under the kiddie tax rules, a child’s unearned income in excess of $1,800 for 2008 is taxed at the parent’s tax rate. The child’s earned income continues to be taxed at the child’s rate.

Insurance policy dividends that the insurer keeps and uses to pay the taxpayer’s premiums are not taxable. However, interest paid on dividends left to accumulate with the insurer is taxable as interest income. This term shouldn’t be confused with dividends paid on stock owned in an insurance company, which are taxable.

Certain assets such as cars, computers, cell phones, cameras and video equipment, boats and airplanes purchased for business are used for personal purposes. To limit a taxpayer’s ability to deduct the personal use of these items as business use, Congress established a list of these assets (thus the term “listed property”) for the IRS to monitor more closely and apply certain restrictions and recordkeeping requirements.

Section 1031 of the tax code allows a taxpayer to exchange like-kind business and investment assets. This type of transaction is frequently referred to as a tax-free exchange, which is misleading since the tax is not “free” but instead is deferred to a later date when the replacement property is sold. Tax-free exchanges have special timing rules and this office should be consulted before proceeding with one.

Is a partner whose participation in partnership activities is restricted, and whose personal liability for partnership debts is limited to the amount of money or other property that he or she contributed or may have to contribute.

Most think that marginal tax rate is synonymous with tax bracket. This may generally be true but as the tax brackets advance to higher rates so does the taxpayer’s income; as incomes increase, tax breaks begin to be reduced, phased out and in some cases totally eliminated. This effectively increases the marginal tax rate above the tax bracket. Knowing your marginal rate tells how much of each additional dollar will go to taxes or how much each additional dollar of deductions will reduce taxes. Also see “tax bracket.”

Many tax deductions, adjustments and credits are phased out or disallowed once a taxpayer’s adjusted gross income (AGI) reaches a certain level that varies depending on the particular tax benefit. However, the AGI for these purposes is usually not the regular AGI, but is instead AGI without certain other benefits being allowed and is called modified AGI. For example, when testing to see if the income phase-out threshold has been reached for claiming an education credit, the AGI must be figured without claiming the exclusions that are available for certain foreign earned income.

A term used for interest received on an obligation issued by a state or local government. Generally, this type of interest is not taxable (but see Private Activity Bonds) for Federal tax purposes. Most states, on the other hand, will treat municipal bond interest from other states as taxable.

Sometimes bonds are issued (sold) at a discount (thus the term “original issue discount”) and then some years later mature at face value. The difference between the issue price and the face value represents the interest paid by the bond issuer. A portion of that interest, referred to as “OID,” must be reported annually even though the bond owner doesn’t actually receive any of the interest until the bond matures. Information about the amount to report is provided to the bond owner on Form 1099-OID.

In order to limit the tax benefits of tax shelters, the tax code imposes loss limitations on entities that Congress defined as passive activities. Generally, passive activities are investments in which a taxpayer does not materially participate, and losses from such investments can be used only to offset income from other passive investments and cannot be deducted against other kinds of income such as wages, pensions, interest, dividends, capital gains, etc. Most real estate and limited partnership investments are classified as passive activities. There is an exception for rentals that taxpayers actively participate in and manage which allows up to $25,000 of loss to be deducted. However, this special exception phases out for AGIs between $100,000 and $150,000.

In financing lingo, one point is equivalent to 1% of the loan value. Because they constitute prepaid interest, points are usually deducted ratably over the loan term. This rule would apply, for example, when a taxpayer purchases a rental real estate property--the points paid in such a transaction are amortized over the life of the loan. However, tax law provides a break for points paid on a mortgage to buy or improve a taxpayer's principal residence, allowing them to be deducted in full in the year paid.

A taxpayer can exclude up to $250,000 ($500,000 for married taxpayers) of gain from the sale of the taxpayers’ principal residence if they meet the ownership and residence tests. If a taxpayer alternates between two properties, using each as a residence for successive periods of time, the property that the taxpayer uses a majority of the time during the year is ordinarily considered the taxpayer's principal residence.

Generally, interest from municipal bonds issued by a state or local government is federally tax-exempt for both regular and alternative minimum tax (AMT) purposes. However, some municipal bonds whose proceeds are used to support private businesses are classified as private activity bonds and the interest from them – whether paid directly to the bondholder or through a mutual fund – is taxable for AMT purposes. Taxpayers subject to the AMT may wish to utilize alternate investment vehicles.

This term refers to retirement and employment benefit plans that conform to IRS requirements and are designed to protect the interests of employees or retirees.

Is to include as income or as additional tax in the return an amount allowed or allowable as a deduction or a credit in a prior year. In some cases, the tax law requires that a tax benefit taken in an earlier year be paid back if the property on which the benefit was claimed isn’t held for a specific time period. This payback is termed “recapture”.

A rollover is a tax-free withdrawal of cash or other assets from one retirement plan and its reinvestment in another retirement program. The amount rolled over is excluded from gross income in the year of the transfer. Generally, a rollover must be completed within 60 days after a distribution is received in order to ensure non-taxability. The 60-day rule can be waived by the IRS if a delay is caused by a financial institution and certain conditions are met or caused by an event out of the control of the taxpayer and the IRS issues a waiver. Only one rollover is permitted per account per year. However, there is no limit on direct transfers from one financial institution to another. If a distribution is taken from an employee pension plan, the company will withhold 20% of the distribution even if the taxpayer plans a rollover. In that case, the taxpayer would need to make up the difference from other funds to in order to have a fully tax-free rollover. This problem can be avoided by having the funds transferred directly to other retirement programs.

This refers to a section of the Internal Revenue Code that permits taxpayers to expense (write off in one year) up to $125,000 (adjusted for inflation annually) of business equipment expenditures that would normally have to be depreciated over their useful lives. The $125,000 allowance is gradually reduced for businesses that place into service more than $500,000 (adjusted for inflation annually) of business equipment during the year. However, for 2008, only as part of the Economic Stimulus legislation, the limit was raised to $250,000 and the phase-out threshold raised to $800,000.

Qualified Tuition Plans (also known as Section 529 Plans) are plans established to help families save and pay for college in a tax-advantaged way and are available to everyone, regardless of income. These plans, also known as qualified tuition programs, allow taxpayers to gift large sums of money for a family member’s college education, while continuing to maintain control of the funds. The earnings from these accounts grow tax-deferred and distributions are tax-free, if used to pay for qualified higher education expenses. They can be used as an estate planning tool as well, providing a means to transfer large amounts of money without gift tax.

Employees pay Social Security and Medicare taxes (collectively often referred to as FICA tax) through payroll withholding and the employer contributes a like amount for the employee. Since self-employed taxpayers do not have withholding, they pay an equivalent through what is called self-employment tax (SE tax). The tax is based upon the net profits from self-employment. For 2008, the rate is 15.3% of the first $102,000 of earnings and 2.9% on all earnings over that amount. The SE tax is included as “other” tax on Form 1040 and can be paid as part of the estimated tax installments the taxpayer makes.

A shared equity arrangement is a method of financing the purchase of a residence where two or more individuals acquire an ownership interest in a dwelling unit and one or more of the co-owners occupies the property and pays fair rent to the non-occupying co-owner(s). The agreement must be in writing. Before entering into this type of arrangement, be sure to contact this office.

Most taxpayers are permitted to deduct either a standard deduction or itemized deductions in determining their taxable income. The standard deductions are based on filing status. For 2008, the amounts are: Single and Married Taxpayers Filing Separately $5,450 Head of Household $8,000 Married Filing Jointly and Surviving Spouse $10,900 In addition, elderly and blind taxpayers are allowed an “add-on” to the standard deduction for their filing status. The add-on amount in 2008 for single taxpayers is $1,350 and $1,050 for married taxpayers. As an example, a married couple filing jointly and both over age 65 would have a standard deduction of $13,000 ($10,900+ $1,050 + $1,050). For 2008, the standard deduction of an individual who is, or could be, a dependent of someone else is limited to the greater of $900 or the individual’s earned income plus $300 (but not exceeding $5,450). Standard Mileage Rate – This is the per mile rate that can be used in lieu of actual expenses when using a vehicle for a deductible purpose. For 2008, the cents per mile rates are: 50.5 for business use, 19.0 for moving and medical use and 14.0 for charity. Parking expenses can be taken in addition to the standard mileage rate. Self-employed individuals can also add the business portion of the interest expense to acquire the vehicle. The standard rate can be used for up to four vehicles being used simultaneously.

This is the per mile rate that can be used in lieu of actual expenses when using a vehicle for a deductible purpose. For 2004, the cents per mile rates are: 40.5 for business use and 15.0 for moving, charity and medical use. Parking expenses can be taken in addition to the standard mileage rate. Self-employed individuals can also add the business portion of the interest expense to acquire the vehicle. For 2004, the standard rate can be used for up to four vehicles being used simultaneously.

When property is inherited, the basis for the beneficiaries is the value assigned to that property in the estate. Generally, that basis is the value of the property on the date of death of the decedent or on an alternate date selected by the executor of the estate. Thus, any appreciation up to the date of death is forgiven for regular tax purposes and the beneficiary starts with a stepped-up basis. This also applies to property inherited from a spouse. Caution – though infrequent, there is a potential for a step-down in basis as well.

This can mean income that is taxable as opposed to income that is not, such as tax-exempt interest from municipal bonds. Or, it can refer to taxable income on a tax return, which is income less adjustments, deductions and exemptions (the final income upon which tax is computed).

A tax credit is a tax benefit that offsets the tax dollar for dollar. Most credits are nonrefundable and can only be used to reduce the tax to zero. A refundable credit, like the earned income credit, offsets the tax and any balance not used to offset the tax is refundable and included in the year’s refund. Unused credit from some nonrefundable credits can be carried over and some cannot.

For most individuals, their tax identification number is their Social Security number (SSN). It is used when filing tax returns and must be given to financial institutions, employers and other income payers so that appropriate information reporting forms can be completed. Failing to do so can result in a penalty or mandatory back-up withholding. A SSN is also required for a dependent, regardless of age, in order to claim the dependent’s exemption allowance and certain tax credits, such as the earned income credit. Nonresident or resident aliens may apply to the IRS for an “individual taxpayer identification number” (ITIN) if they are not eligible for a SSN. A special “adoption taxpayer identification number” (ATIN) may be obtained when a taxpayer is in the process of adopting a U.S. citizen or resident child and a SSN cannot be obtained; the ATIN cannot be used once the adoption is final – a SSN must be obtained for the child. Individuals who have household employees or who are self-employed with employees are required to obtain and use a Federal employer identification number (FEIN) as well. A self-employed taxpayer who has a Keogh plan must have an FEIN, even if no other person is employed in the business.

This can mean income that is taxable as opposed to income that is not, such as tax-exempt interest from municipal bonds. Or, it can refer to taxable income on a tax return, which is income less adjustments, deductions and exemptions (the final income upon which tax is computed).