I recently received the following email from a client upon receipt and review of her 2006 return (a GD extension) – with “ERROR?” in the subject line:
“I'm just comparing the taxes to 2005. In 2005 [my husband’s] SS benefits came to 16,166. and the taxable amount of that was 1,875. On the 2006 taxes his SS benefits came to 18,476. and the taxable amount of that was listed as 9,951. How can he have been taxed 53% on his SS benefits for 2006. That is really outrageous!!”
I replied - “No error! While I agree it is outrageous, you can be taxed on up to 85% of your Social Security benefits! The amount that is taxed is based on the amount of your other income. Because of the depreciation recapture from the sale of your Summit home your income is higher, so more of the Social Security is taxed. There is a special worksheet in the back of your 2006 copy that shows the calculation.”
FYI, because of the way Social Security and Railroad Retirement benefits are taxed it is possible that for every additional $1.00 of income you must pay tax on $1.50 or $1.85.
In this case the taxpayers sold their personal residence in 2006, part of which was used for an income-producing activity. The part of the property “used for business or to produce rental income” was within the home. So, while they could exclude up to $500,000 in gain under Section 121, they had to “recapture” (claim as income) the depreciation “allowed or allowable” after May 6, 1997 (i.e. the home office rule).
This question brings up two very important tax issues.
(1) The maximum tax on long-term capital gain property is not 5%, 15%, or 25% (on recaptured depreciation) as advertised. While long-term capital gains reported on Schedule D are taxed separately from other income on a special worksheet, these gains are included in your Adjusted Gross Income (AGI), so they can increase your net “regular” taxable income in a number of ways - increased taxable Social Security (as in this case) or Railroad Retirement benefits, decreased deductions for medical expenses (as also happened in this case), miscellaneous expenses, tuition and fees, student loan interest, and deductible IRA contributions - and reduce credits such as the Child Tax Credit and the education tax credit. Plus it can cause you to become victim of the dreaded Alternative Minimum Tax (AMT). See my posting on “The Most Important Number on Your Tax Return”. So the effective tax cost of a long-term capital gain is more often than not more than 5%, 15% or 25%.
(2) If you use a property for an income-producing activity and claim depreciation deductions you must “recapture” these deductions when you sell the property. As I explained in my email response to the client – “You claimed a tax deduction over the years for depreciation on a portion of the Summit home, and received additional refunds because of this deduction. When you sell the property you have to "pay back" some of the refunds you had received in the past. In truth, it was only a loan from the government.” When you sell a qualified personal residence you can exclude up to $250,000 or $500,000 of the gain from federal and state taxes. However if you have a home office or rent rooms within your one-family home, you cannot exclude – and must report as a taxable capital gain – any depreciation you claimed after May 6, 1997. And – very, very important to remember - if you have a two-family home and rent out half you can exclude one half of the gain as your personal residence, but you must pay tax on the rental half of the gain and you must recapture (add-back) all the depreciation you claimed over the years.
While I am on the subject there are some other important points I want to make:
· Your gain on the sale of a property has absolutely nothing to do with the amount of cash you walk away with from the sale. When a client sells a home I am often told “The check we received from the lawyer was $XX,XXX”. That is nice, but so what? The gain is the sale price less the original cost, the cost of any capital improvements made over the years, and applicable closing costs such as legal fees, title insurance and transfer fees at both purchase and sale, plus any depreciation “allowed or allowable” over the years. In most cases, the actual capital gain will be much more than the check received at closing, usually because of having to pay off existing mortgages. If you have frequently refinanced or “over-financed” you may actually get next to nothing at closing, but still have a substantial capital gain.
· You may actually have lost money on a property, but you still could have a taxable capital gain. “I bought the property for $100,000 and I sold it for $90,000 – how come I owe tax?” As I mentioned above, and I cannot mention often enough, if all or part of the property was rented you have to add back all or some of the depreciation deductions claimed over the years.
On a final personal note – it is a “pet peeve” of mine when a client who does not understand an item on a tax return I have prepared tells me in a phone message or email “You made an error on my return”!
Obviously I am not perfect, and even I make mistakes. Hey, look at the number of tax returns I prepare – all manually - during a tax season. I am surprised I do not make more mistakes than I actually do. But just because you do not understand an item on your return or you think something does not make sense (who ever said that the Tax Code had to make sense) don’t automatically assume that I FU-ed! You certainly should ask a question – but be honest and say “I don’t understand an item on my return.” If you do discover an obvious error, i.e. I entered the wrong Social Security number for a dependent or I transposed a number, say so – “You have the wrong SS number for my son”.
The above email from my client really doesn’t apply – by putting a ? after ERROR it is more wishful thinking than an accusation – and this doesn’t happen often, but when it does it really “burns my toast”.
So a word to the wise – if you do not understand something on your tax return do not call or email your tax preparer and say “You goofed!”.