Big Tax Mines That Could Blow Up Your Return
Most people don’t have tax returns as complex as Mitt Romney, Newt Gingrich or Barack Obama, but even if you aren’t reporting a Cayman Island account or many millions in S-corp. profits or book sales, there are brand-new pitfalls to watch for as you go to do your 2011 return.
Congress’s relative gridlock last year means there aren’t a slew of complex tax changes to deal with when you file this year — but there are some doozies that may trip up taxpayers.
For instance, thanks to a law passed in 2008, investors now face new rules and a new form for reporting cost basis for stocks sold in 2011. And now that brokers are reporting your cost basis to the IRS, too, it’s all the more crucial that you get it right.
Also, taxpayers with financial assets overseas need to make sure they’re on the right side of new rules, and a new form, for reporting those assets. The penalty for failing to file the new Form 8938 starts at a flat $10,000 and rises to as much as $50,000, and that doesn’t include other potential penalties.
Meanwhile, the tax breaks for homeowners who made energy efficient improvements shrank last year, and those rules are labyrinthine and easy to get wrong. Plus, homeowners who took part in the 2008 first-time home-buyer tax credit — for that year, that tax break was an interest-free loan, not a grant — face their second year of loan repayments.
And taxpayers who converted their individual retirement account (IRA) to a Roth IRA in 2010 and chose to spread the tax payment over 2011 and 2012 (that was an option thanks to a one-time tax break) must pay one-half of the income taxes owed on that conversion on their 2011 return.
“That conversion you did? Now the chickens are coming home to roost,” said Mark Luscombe, principal tax analyst with CCH Inc., a Riverwoods, Ill.-based tax publisher and unit of Wolters Kluwer.
“People seem to have fairly short memories, and something they did in 2010, they’ve forgotten about by 2011 and tend to assume it’s a dead issue,” he said.
While making an honest mistake doesn’t necessarily land you in hot water or steep penalties, why risk a letter or call from the IRS?
The payroll tax cut
One major tax issue going forward is the payroll tax cut and whether Congress will extend this tax break — a two-percentage-point reduction in the Social Security taxes paid by workers — beyond the two-month extension through February that lawmakers enacted in December. The payroll tax cut essentially replaces the Making Work Pay credit — that credit expired, and is no longer reflected on Line 63 of Form 1040.
While there’s no tax-return pitfall here to worry taxpayers, some workers are confused by their changing paycheck amounts. And since employers have until Jan. 31 to implement the two-month extension, workers may see additional paycheck adjustments.
“If I had to pick one thing that we’re hearing grousing about, it’s the payroll changes,” said Cynthia Jeanguenat, an enrolled agent in Virginia Beach, Va. “People want to know, ‘How come my check changed this week? I worked the exact same hours.’”
Be prepared for more changes as Congress revisits this tax break.
New rules to report foreign assets
You’ve heard about the IRS going after money held in offshore accounts? That’s related to taxpayers failing to file the Report of Foreign Bank and Financial Accounts, or FBAR.
But this year, some taxpayers need to steel themselves for a new, broader reporting requirement, thanks to the Foreign Account Tax Compliance Act, or FATCA, passed by Congress in 2010.
This new requirement is in addition to the fact that taxpayers with accounts overseas worth $10,000 or more generally are required to report those funds to the U.S. Treasury on the FBAR form.
Put simply, the new rules require that if you have overseas accounts worth more than $100,000 if you’re married filing jointly, or $50,000 if single, you must report those assets on the new Form 8938 and attach that to your tax return. And the new rules encompass more types of financial assets than the FBAR.
“This was actually passed to, in essence, catch a bigger potential group of taxpayers,” said Ryan Losi, a certified public accountant and partner in charge of the international practice at Piascik & Associates in Richmond, Va. “They want to expand the web of reporting.”
The failure-to-file penalty for this new form starts at $10,000 and can rise to as high as $50,000 for people who fail to come into compliance, Losi said.
The rules are complex and more detailed than described here, so find a tax professional with expertise in this area. Read more about FATCA on this IRS.gov page.Also see "Do I need to file Form 8938?" on IRS.gov.
See this IRS page for more on when and where to file the FBAR.
Investors reporting their capital gains and losses face new reporting requirements this year. And your broker must also report your cost basis to the IRS.
The goal of the new rules is to make sure taxpayers pay their capital-gains taxes, and this way the IRS will be able to compare and contrast your claims to your broker’s.
The new rules phase in over three years, so brokers are required to report cost basis on only a limited number of stock-sale transactions for the 2011 tax year. As part of the changes, the IRS now requires that investors fill out a new form, Form 8949, and Schedule D has been revised.
And that new form is not easy to decipher.
Surprise tax hit on inherited assets
Speaking of capital gains, people who inherited assets from someone who died in 2010 may find themselves with a bigger-than-expected tax bill, Luscombe said.
In 2010, when reporting the cost basis of assets, estates could opt for the usual stepped-up basis; that is, the asset’s value at the time of death. (That date-of-death cost basis is then subtracted from the sale price to calculate a capital gain or loss.)
Or estates could opt out of the estate-tax rules and go with rules that used carryover basis — that is, put simply, the price the decedent paid for the asset. That means a much higher tax bill, potentially, than a date-of-death basis; if, say, the person purchased the asset decades earlier the cost likely was much lower.
Traditionally, if heirs sold the assets soon, Luscombe said, “they’d have limited gain because they have a basis for date-of-death value.
“But because of the way 2010 was handled, with people being able to elect to not be subject to the estate tax and therefore subject to carryover basis,” he said, “the heir could be subject to a very significant gain on the sale of the inherited asset.”
For 2010 deaths, executors soon will send out Form 8939 noting the basis, Luscombe said. Some taxpayers may be surprised how low that basis is — and how much capital-gains tax they owe.
Also, that cost-basis figure noted on Form 8939 might not be enough to satisfy the IRS if you get audited. Heirs “might want to go back to the executor and get any support the executor has for determining that basis so if they get audited they’ll have that to show the IRS,” Luscombe said.
Remember that IRA-to-Roth conversion you did back in 2010? Taxpayers had the option then of spreading out their income-tax hit over 2011 and 2012. Time’s up, at least for the first half of that bill.
It’s a similar story for anyone who took a 2008 home-buyer tax credit, which was really an interest-free loan rather than a credit. Taxpayers had to start paying back that loan in 2010 (15 equal payments over 15 years).
This year, at least, those home buyers don’t have to fill out Form 5405 again, as long as you filled it out last year and your situation hasn’t changed. (Generally, that means you still own the home and it’s your main residence.) There’s a new line on Form 1040 to report your loan payment: Line 59b.
Energy efficient home improvements
Making your home more green with energy efficient windows and appliances used to pay off at tax time — as much as $1,500. But that tax credit shrank considerably in 2011.
In 2011, the maximum credit for eligible projects is $500 — and that’s essentially a lifetime total.
If you tapped the credit in previous years, “you may not have anything left to take in 2011,” Jeanguenat, the enrolled agent, said. “I don’t think people generally are aware that this was a cumulative credit.”
Until 2016, there is still a separate tax credit in effect for bigger-ticket home-improvement projects, such as installing solar panels, wind turbines or geothermal heat pumps. Homeowners can reap up to 30% of their materials and installation costs back at tax time — and there’s no dollar limit on the credit.
Andrea Coombes is MarketWatch's personal finance editor, based in San Francisco.