Dictionary of Tax Deductions

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Edward A. Lyon, JD
TaxTuneup.com, Inc.
3416 Shaw Ave #5
Cincinnati OH 45208
513.321.2821
elyon@taxtuneup.com

Radial Keratotomy

Deductible Medical Expense subject to the 7.5% floor.

Radiation

Deductible Medical Expense subject to the 7.5% floor.

Raffle Tickets

Deductible Charitable Gift. (Keep losing tickets to prove your deduction.)

Reading Classes

Deductible Medical Expense, subject to the 7.5% floor, for child suffering from dyslexia.

Real Estate

Real estate is still considered the most tax-advantaged investment, even after passage of the 1986 tax reform. There are several reasons for this:

• You can deduct Mortgage Interest, Property Taxes, Maintenance and Repairs, utilities, and other operating expenses against income you earn from the property.
   

• You can Depreciate a portion of your purchase price each year. This cuts your tax without cutting your cash flow. There's no depreciation for raw land or the land portion of any real estate investment. Depreciate residential real estate over 27.5 years and nonresidential real estate over 39 years. Depreciation reduces your Basis for figuring Capital Gain or loss on sale or exchange.

Example: You buy a four-family apartment for $180,000. $110,000 of the price is attributable to the building and $70,000 is attributable to the land. The building nets $4,000 after mortgage interest, utilities, and maintenance. However, you can depreciate $4,000 per year ($110,000 divided by 27.5). Your taxable income from the property is zero, and you pocket the $4,000 tax-free.

(Be sure to see Cost Segregation for more information on maximizing real estate depreciation deductions.)

• You'll owe a special 25% "recapture" tax on whatever amount you've depreciated when you sell the property.

Example: In the situation above, you depreciate the property for four years, then sell the building for $200,000. Your gain on the sale is $32,000. $12,000 is taxed as depreciation recapture at 25%. The rest is taxed as long-term capital gain at your regular long-term gain rate.

• IRS tables tell you what percentage of your purchase price to depreciate the year you buy a property, depending on what month you place it in service:

• Rental real estate is considered a Passive Activity. That generally means you can't write off real estate losses against ordinary income. However, the Rental Real Estate Loss Allowance may let you write off up to $25,000 in losses. And if you claim Real Estate Professional status, you can treat your real estate activities as nonpassive activities.
   

• You can use a Tax-Deferred Exchange to swap one investment property for another, tax-free.
   

• You can defer tax you pay on a sale with an Installment Sale.

Report real estate income and expenses on Schedule E. For more information, see IRS Publication 527, "Residential Rental Property."

Real Estate Investment Trusts

Real estate investment trusts, or REITs, are publicly-traded companies that buy and manage property and mortgages. Equity REITs buy actual properties; mortgage REITs buy mortgages; and hybrid REITs buy both. There are even golf course and trailer-park REITs. Investors who want to buy commercial property--office parks, industrial parks, shopping centers, and large apartment complexes--often can't invest enough to buy it directly themselves. These properties also require a tremendous amount of specialized management expertise. REITs let you buy invest in these properties with many of the same advantages of mutual funds: professional management, instant liquidity, and better diversification than you could achieve on your own.

REITs pay income dividends, capital gains dividends, and tax-free "return of capital" dividends. Here's how they work:

• REITs have to "pass through" at least 95% of their earnings to shareholders in order to avoid corporate income tax. This lets them pay more to investors, but generally means high taxable distributions.
   

• Income dividends are taxed as ordinary income.
   

• Capital gains dividends are taxable at long-term capital gains regardless of how long you've held the REIT shares.
   

• "Return of capital" dividends are tax-free income. However, each return of capital dividend reduces your basis for figuring gain or loss on sale.

The National Association of Real Estate Investment Trusts maintains a web page listing which REITs pay these dividends and how much of their total distributions are tax free. 

REITs that pay high current income may be the real estate best suited for tax-deferred accounts such as Individual Retirement Accounts. Many variable Life Insurance and Annuity providers have also added REIT funds to their investment options.

Recreational Vehicle (See Vacation Home)

Rehabilitation Tax Credit

The rehabilitation credit is a credit against your tax for costs of rehabilitating certified historic structures and nonresidential pre-1936 buildings:

• The minimum rehabilitation expense is $5,000 or your adjusted basis in the building, whichever is greater.
   

• The credit itself is equal to 10% of the cost of rehabilitating industrial and commercial buildings placed in service before 1936 and 20% for certified historic structures.
   

• You can use the credit to offset up to $25,000 of nonpassive income
   

• The credit phases out by one dollar for every two dollars of adjusted gross income above $200,000.
   

• Your basis in the property is reduced dollar-for-dollar by the full amount of the credit you claim.

Report rehabilitation expenses on Form 3468.

Rent

Rental income you receive from Real Estate you own as an individual, a partner, or a shareholder is taxable as rental income on Schedule E or your partnership or corporate return.

Rent you pay for office space, manufacturing or storage space, or tools and equipment you use in your business is deductible as a Business Expense on Schedule C, Form 1065, or your corporate return.

Rent you pay for an apartment or other living quarters is generally a nondeductible personal expense. However, you can deduct part of any residential rent you pay if you claim Home Office expenses for part of that space.

Rental Real Estate Loss Allowance

The rental real estate loss allowance is a special deduction that lets you use passive losses from rental real estate to offset ordinary income.

Rental real estate is a Passive Activity, and you can't use passive losses to offset ordinary income. However, if your adjusted gross income is $150,000 or less, you can deduct up to $25,000 in losses from property you help actively manage. (The loss allowance phases out by 50 cents for each dollar of adjusted gross income between $100,000 and $150,000. For purposes of this allowance, adjusted gross income does not include Social Security benefits, and is not reduced by Individual Retirement Account contributions or the exclusion for U.S. Savings Bonds used to pay higher education expenses.) Here are the rules:

• You have to "actively participate" in managing the property. This is a low threshold that means you're helping make management decisions, even if you're hiring a property manager for day-to-day tasks.
   

• You have to net out losses first against other real estate in which you materially participate, then any other passive income, before using the allowance.
   

• The allowance isn't available to married couples filing separately.
   

• You can carry forward a loss disallowed by the allowance phaseout.

The allowance isn't available for six specific uses treated as businesses rather than rental real estate:

1. "incidental" rentals of property, where the main reason for holding the property is to profit from the gain and the rental income is less than 2% of the property"s value
    

2. short-term rentals averaging seven days or less
    

3. rentals averaging between seven and 30 days where you provide significant personal service
    

4. rentals involving extraordinary personal service (nursing home facilities, etc.)
    

5. rentals to a partnership or S corporation not engaged in the business of renting property (such as renting an office building to your S corporation or medical partnership)
    

6. property opened for use of customers during regular business hours (i.e., golf course or swimming pool).

Retirement Plan (See Qualified Plan)

Reverse Mortgage

A reverse mortgage is a special loan against your home's equity that lets you draw an income without making repayments until your death. The lender advances you money, in a lump sum, series of payments, or line of credit for a term of years or a lifetime. At your death, the lender collects the house and returns any equity not needed to repay the loan. Since the money comes in the form of a loan, you pay no tax on what you receive from the arrangement.

Early reverse mortgage lenders have been criticized for inadequate disclosures and unconscionably high fees. But the FHA and Fannie Mae have become involved, and the American Association of Retired People (AARP) has forced better disclosure for its constituents, who make up the majority of borrowers.

Rollover IRA

A rollover Individual Retirement Account is one you set up to accept a "rollover" from an employer retirement plan once you leave your job. If you roll your account balance into an IRA, you can manage your account just like any other IRA (see below). You'll enjoy the full range of investment options your IRA sponsor provides. There are two ways to transfer money from your employer plan into an IRA:

• Your old employer can transfer the money directly to your IRA. This is called a trustee-to-trustee transfer. There will be no tax on the amount you transfer.
   

• You can take the money directly, then deposit the payment into an IRA. If you take the money yourself, your employer will withhold 20% of the balance for tax. You can replace that 20% with funds from other sources within 60 days of taking the money, then claim a refund for the 20% withheld. If, for any reason, you don't replace that 20% within the 60-day period, you'll owe tax on the amount withheld. You'll also lose your tax-deferral on the lost part of your account.

Example: You switch jobs with $40,000 in your employer plan account. You can choose to roll the $40,000 directly into an IRA. You can also take the money directly. You'll get $32,000, and your employer will withhold $8,000. You can deposit the $32,000 into an IRA yourself. But if you don't add $8,000 more, you'll owe tax on that amount because it didn't make it into the IRA. If you're in the 28% tax bracket, that failure will cost you $2,240.

Net Unrealized Appreciation

If your qualified plan balance includes employer stock, it may not make sense to roll that stock into an IRA. Employer stock gets special treatment that lets you take advantage of lower rates for long-term Capital Gains. This can be valuable whether you choose to hold your employer stock or sell some to diversify your portfolio.

Presumably, your stock has gained value since it was contributed to the plan and will continue to gain value in the future. If you roll the stock into an IRA, you'll avoid tax now, but you'll pay ordinary income rates on the entire value when you withdraw the funds.

However, you can choose to take your employer stock outright. You'll pay tax at ordinary rates now on the value of the stock at the time it was contributed to the plan. When you eventually sell the stock, you'll pay lower capital gains tax on the appreciation since the date of contribution. It may make sense to take a small tax hit now in exchange for capital gains rate savings down the road:

• If you plan to keep some stock and sell the rest to diversify, it makes sense to roll the portion you plan to sell into an IRA. This avoids immediate tax on the portion you sell to diversify your portfolio.
   

• If you plan to sell stock to raise cash, take the stock outright. You'll benefit from lower capital gains rates on the portion of stock you sell. Also, you can take stock outright and use it to secure a loan to raise cash without selling at all. For more information, see Capital Gains.
   

• If you've acquired stock at different values over the course of your employment, you can pick and choose which shares to take now and which to roll into the IRA. That way, you can take advantage of capital gains rates on older shares with a lower cost basis, while rolling the rest into your IRA. (If your stock's value now is lower than when it was contributed to the plan, you'll pay ordinary income rates on the full value at the time you take the distribution.)

Roth IRA

A Roth IRA is a new form of Individual Retirement Account with a "back-end" tax advantage: contributions aren't deductible; but withdrawals are tax free if earnings are held in the account for at least five years and you have reached age 599½. Here's how they work:

• You can contribute to a Roth IRA, regardless of whether you participate in an employer plan, if your adjusted gross income is less than $116,000 ($169,000 for joint filers). Contributions are phased out between $101,000 and $116,000 ($159,000 and $169,000 for joint filers).
   

• You can contribute up to $5,000 annually to a Roth IRA (2008).
   

• You have to contribute cash; you can't transfer securities from another account.
   

• You can put almost any investment in an IRA: bank deposits, stocks, bonds, mutual funds, real estate, mortgages and other loans, private placements, even limited partnerships. About the only things you can't buy are most collectibles (rugs, wine, stamps, etc.), and certain options and futures investments.
   

• It pays to contribute early. You can contribute as early as January 1 or as late as April 15 of the following year. Let's say you plan to contribute $5,000 for tax year 2008. If you contribute $5,000 on January 1, 2008 and earn a steady 10.5% return, your contribution will already be worth $5,690 by the April 15 2009 deadline.
   

• You can withdraw funds without taxes or penalties once you've reached age 59½ and held the funds in the Roth IRA for five tax years after the year in which you make your initial contribution.

Example: On April 15, 2003, you open a Roth IRA for the 2002 tax year. The five-year period expires January 1, 2007, even though five calendar years haven't passed.

• Withdrawals within the five-year period are treated first as original deposits, then earnings. That means you can withdraw your original deposits without paying any tax. Once you start withdrawing earnings, you'll owe ordinary income tax plus the usual 10% penalty if you're under age 59½.

Example: You contribute $2,000 per year for 3 years and your account grows to $7,000. You can withdraw $6,000 (your original contribution) tax and penalty-free. If you withdraw the $1,000 growth, you'll owe ordinary tax on that amount (because the account is less than five years old), plus the 10% penalty if you're under 59?.

• There are no required distributions from a Roth IRA as there are for a regular Individual Retirement Account. You can continue contributing to a Roth IRA even after reaching age 70½.

• At death, your Roth IRA passes to your designated beneficiaries without passing through probate. Your beneficiaries can withdraw the entire balance, tax-free. Or they can leave the balance in the account up to five years or withdraw the money, tax-free, over their own life expectancies.

Figuring which IRA is best for you, the ordinary IRA or the Roth IRA, depends on two main issues:

1. What would you do with the tax savings from an ordinary IRA?
    

2. What will your tax rate be tomorrow, compared to where it is today?

 If your tax rate in retirement will be lower than your tax rate today, choose a deductible IRA for immediate tax savings. If your rate in retirement will be the same as your rate today, choose a deductible IRA if you can afford to invest your tax savings in a side fund. Finally, if your tax rate in retirement will be higher than it is today, choose the Roth IRA for tax-free income when the tax break is worth more.

You can convert your existing IRA into a Roth IRA if your adjusted gross income (not including the conversion amount) is under $100,000. If you convert, you'll have to report the value of your account on the date of conversion (minus any nondeductible contributions) as taxable income the year you convert. The answer here turns on similar issues as the choice between IRAs for new money. First, where will your tax bracket be when you take out the money, compared to where it is now? And second, where will you find the money to pay the tax?

Consider converting your IRA if: 1) the tax you would pay on the conversion is less than the tax you would pay on an ordinary IRA withdrawal when you retire; 2) the income you report by converting doesn't significantly increase the tax you pay today; and 3) you can pay the tax with funds from outside the IRA itself. Also consider converting if you're rich enough that you'll never spend the money. Converting saves more for your heirs. 

There's no shortage of web resources for Roth IRA planning. For the IRS take, see IRS Publication 590, "Individual Retirement Arrangements." You'll find the most complete coverage, including worksheets and calculators, at www.rothira.com. But be careful before you rely on these tools. None of them can guarantee the right choice--and all of them are based on assumptions that are bound to change over time.