More CNNfn users' tax questions answered

Your tax queries answered

April 9, 1997: 10:59 a.m. ET

Tax lawyer answers more CNNfn readers' income-tax questions

NEW YORK (CNNfn) - Less than a week before the April 15 deadline for U.S. tax returns, tax lawyer Thomas Kabaker answers another round of your tax questions for CNNfn's Expert Opinion.
     Kabaker is a lawyer and tax analyst with Chicago-based CCH Inc., a provider of tax-law information and software for accounting and small-business professionals.
     Before answering your questions, Kabaker had the following to say regarding filing extensions for your 1996 income-tax return:
     I want to make sure you know that you can get an automatic four-month extension of the time allowed to file your income-tax return.
     This means you can have until August 15 to file, assuming that you report your income using the calendar year.
     This can be a great help to those of you who are having trouble gathering all of the information you need for filing.
     To get this extension, you must file IRS Form 4868, "Application for Automatic Extension of Time To File U.S. Individual Income Tax Return."
     This request for an extension must be filed by the original due date for your 1996 return (normally, April 15).
     There is one catch, however. If you have not paid all the taxes you owe before the April 15 due date, you will be charged interest at the Internal Revenue Service's very high rates from April 15 to the time you pay your taxes.
     Therefore, you must make an accurate estimate of your tax.
     If you find you cannot pay the full amount due when you file your Form 4868, you can still get the extension, but you will owe interest on the unpaid amount.
     By using the extension of time for filing, you have a better chance of straightening out those records you did not know you should have kept. It's also easier to get help from the IRS once the April 15 filing date has passed.
     Now on to your questions.
     1. Is it necessary for my wife and me to file a joint return in order to get credit for child-care expenses? If we file separately, are we eligible to get this credit?
     If you are married, the credit is allowed only if you file a joint return.
     However, you can be treated as unmarried for purposes of claiming the credit if you and your spouse lived apart for the last six months of the tax year, and if you file separate returns.
     Also, you must maintain and reside in a household that is the principal residence of the dependent child for more than one half of the year. Finally, you must furnish over half the cost of maintaining the household for the year.
     2. How do you report the dividend income of children to the IRS?
     This is the dreaded "kiddie tax." A child who:

is not yet 14 years old at the end of the calendar year for which the return is being filed and
has investment income (basically, dividends and interest income) exceeding $1,300

     is taxed at the parents' tax rate if the parents' rate is higher than the child's rate (which is normally the case, because most parents outearn their children).
     The child's investment income is reported on IRS Form 8615, "Tax for Children Under Age 14 Who Have Investment Income of More than $1,300."
     If you don't want to go to the trouble of filing a separate return for the child, you can use IRS Form 8814, "Parents Election To Report Child's Interest and Dividends."
     However, you can only use this form if the child has less than $6,500 gross income for 1996.
     Further, the child must not have made any estimated tax payments for the year, and must not have applied any overpayment of tax from his or her 1995 return to cover 1996 tax liabilities. Finally, the child cannot have had any tax withheld from his or her income.
     3. A friend and I each invested $5,000 in a small business, forming a partnership. Our income for 1996 was only $130. We both are self-employed at other vocations. Can we deduct the entire cost this year?
     I guess I'd need more information to give you a firm answer. First, you must be able to show that you entered into the business with the intention of making a profit.
     Total income of $130 doesn't sound too promising, but that doesn't necessarily rule you out.
     If you can show that you took reasonable steps to make money in this business, you could deduct business expenses in excess of your business income, reporting a net operating loss (which would reduce your taxes due on other sources of income. You can also carry this loss to other tax years.).
     However, if you cannot prove you have a profit motive, you have what is called a "hobby loss."
     In that case, you cannot deduct expenses in excess of the income you earned.
     There is no "bright-line" test to show that you really intended to operate the business at a profit, but here are a few of the items the IRS looks at when making a determination:

whether you carry on the activity in a businesslike manner;
whether the time and effort you put into the activity indicate you intend to make it profitable;
whether you are depending on income from the activity for your livelihood.
Whether your losses from the activity are due to circumstances beyond your control (or are normal in the start-up phase of your type of business);
whether you change your methods of operation in an attempt to improve the profitability of the activity;
whether you, or your advisers, have the knowledge needed to carry on the activity as a successful business;
whether you were successful in making a profit in similar activities in the past;
whether the activity makes a profit in some years, and if so, how much profit it makes;
whether you can expect to make a future profit from the appreciation of the assets used in the activity.

     Even this list isn't all inclusive, but it gives you an idea of the kind of things the IRS looks for.
     4. I put $10,000 in a mutual fund for my grandson. I used the Uniform Transfer to Minors Act, which I am told is irrevocable. Can I get a tax deduction of any kind?
     Sorry, no deduction. You have made a gift, and the best I can do for you is to tell you that you don't have to pay a gift tax. You can give up to $10,000 per year to any individual without being liable for the gift tax, which is probably why your advisers suggested the $10,000 number.
     5. We have two houses on our lot. One is used by our 82-year-old aunt who has a life tenancy in the property, and one by us. Can the house used by the aunt be considered rental property (meaning that we can depreciate the house and deduct expenses related to its upkeep)?
     I assume that the "we" who own the lot is you and your spouse, not the aunt.
     In that case, you have more or less answered your own question. The house can be considered rental property if you, in fact, rent it to your aunt at for a reasonable amount.
     If you don't rent the house, or if you rent it at an unreasonably low price so as to generate tax losses, you cannot take business deductions for the property (depreciation is a type of business deduction).
     Regardless of whether or not you rent the house to you aunt, if you personally pay state and local property taxes on both houses, you can deduct the entire amount paid from your federal taxes.
     That's because the deduction for state and local taxes is not dependent on there being a business purpose for the expense.
     6. In 1996, we sold our home for a gain, and purchased a new, higher-priced home. What issues should we look for while doing our 1996 taxes? Is the issue of selling a residence so complicated that we should have our taxes done by a professional tax preparer?
     I don't know of any particular issues to look for -- it's all pretty cut and dried. You should be able to report the sale of your home without too much difficulty, using IRS Form 2119, "Sale of Your Home."
     You have said nothing about the capital-gains exclusion for taxpayers age 55 or older, so I'll assume you aren't that old.
     The information called for on the one-page Form 2119 is not at all difficult, and if you have kept reasonable records, you should have no trouble.
     However, page 3 of the instruction has a somewhat longer form for computing the tax basis of the home you sold.
     The tax basis is the measuring point for figuring how much gain (or loss) the taxpayer has realized on the sale. Don't panic just because you see a lot of questions.
     I don't see how going to a professional tax preparer would help too much.
     The main problem in this area is collecting the information you need -- receipts for work you had done that resulted in a permanent improvement to the house, canceled checks, and the like.
     If you go to a tax preparer, she or he will just ask you for the same information.
     If you need more time to get your records together, apply for the four-month automatic extension for filing that I talked about at the top of this column.
     One last thing -- be sure to save all documentation on your old home.
     This includes purchase and sale prices, as well as the cost of any improvements, such as new carpeting, new kitchen cabinets, etc.
     All of these things affect the size of the gain you realized when selling your old home.
     Even though you will not have to pay taxes on this gain in 1996, sooner or later you (or your estate) will have to sell your new home. At that time, you or your heirs will need to know the tax basis for the new house.
     With all the rollovers from home to home that can occur in any one person's life, it can be difficult many years later to track all the way back to "House #1" to figure what the basis of the latest house is.
     7. I have been a grad student the past year, during which time I have received no income (other than student loans which I believe are exempt), nor paid any taxes. Historically, I have used a Form 1040, since I itemize deductions. Am I eligible for a refund? Can I carry forward my expenses through to 1997?
     Sorry, since you have paid no taxes, you cannot get a refund.
     As for carrying forward expenses, it doesn't look as if you can.
     Individuals can carry back and carry forward net operating losses. For individuals, a net operating loss is an excess of allowable business deductions over business gross income and non-business net income.
     Nothing you've said indicates that your expenses are business rather than personal expenses. Being a student is not a business.
     8. Last year, together with my mortgage interest and a capital loss (less than $3,000), my deductions exceeded my income, giving me a negative taxable income. I am aware that you may carry forward a capital loss if it exceeds $3,000. Can I carry forward any deductions, such as the amount in my Schedule C, "Profit or Loss from Business," or Schedule E, "Supplemental Income and Loss."
     As noted in the question above, individuals can only carry forward net business-related losses exceeding gross business income and net non-business income.
     Schedule C losses certainly qualify for being put in the loss "pot."
     However, not all Schedule E losses automatically qualify. Schedule E covers rental activities and income derived from trusts or estates, among other things.
     Carrying over a Schedule E loss depends on whether the loss is business related. Renting real estate is a business; being a beneficiary of a trust is probably not.
     Even so, the answer is not in what your Schedule C or Schedule E shows.
     All business-related income and deductions must be pooled, and there is a net operating loss only if the total of all business-related activities over gross business income and net non-business income is negative.
     Therefore, it's the adjusted gross income figure on Form 1040 line 31 that determines whether you have a net operating loss that can you can carry over into another year.
     9. I have two senior citizens living with me, and they receive Social Security benefits. Can I include their income with my return, or do I have to file another return for them?
     There must be a separate return for each of them, unless they are married.
     If they are married, a joint return can be filed for them, but cannot be combined with your return.
     I'm also not sure what you mean by, "Do I have to file another return for them?" While you can help them prepare their returns, they must sign them. You cannot do that for them unless you have some legal authority to do so.
     10. Are child-support payments excludable (non-taxable) income? Do child-support payments even have to be listed on Form 1040?
     Yes, child-support payments are excludable. No, they are not shown on your Form 1040.
     However, be sure that child-support payments are kept separate from alimony. Alimony payments are includable (taxable) for the recipient, and deductible by the payer.
     11. In 1973, I bought 50 mutual fund shares at $10 each. All dividends and capital gains were reinvested. In June 1996, I sold 206 shares at $30 per share. I have paid taxes on capital gains and dividends ever since 1973. How do I figure my taxes on this sale? How do I avoid being taxed twice?
     The best tax advice when investing in mutual funds is to hold on to all of your statements. When you sell any or all of your shares, you will need to know the basis of those shares --typically the price you paid for them and any adjustments, such as non-taxable distributions.
     Reinvestment programs make investing easy, but truly complicate your tax preparation when you sell shares.
     Keep in mind that you already paid tax on distributions, even though you never saw the money. You need to go to your old statements (all the way back to 1973) and determine the number of shares bought and determine the price paid for every reinvestment transaction. The mutual fund itself may have kept track of this adjusted-basis information for you.
     12. I am a full-time MBA student. I previously worked on Wall Street in an information-technology role. After school, I plan to pursue a more finance-related career. Is my tuition deductible? I have read the rules from the IRS, but they seem extremely ambiguous and open to interpretation.
     It doesn't look like your tuition is deductible. From what you tell me, you are going to school to prepare for a new career. Costs of education to prepare for a new career are never deductible. Only education that enhances your value in an existing occupation can give rise to deductions.
     For example, a high school teacher's costs of getting a Ph.D. to become a college-level teacher are not deductible. The IRS says college-level teaching is a different career from high-school teaching. Technology and finance careers are different, even if you end up working for the same company in a different capacity. Sorry.
     13. I trade stocks with my own money. What is the best way for me to deduct my expenses and losses while also minimizing capital-gains taxes? Most of my trading is within days or weeks, and therefore results in short-term capital gains. Are there any benefits to declaring myself self-employed or getting incorporated as a C corporation?
     In the world of investments, there are three types of players -- "dealers," "traders" and "investors."
     The tax treatment of stock sales differs for each type.
     Assuming that you are not a "dealer" (buying and selling for customers in an active trade or business), you would then fall into one of the two remaining categories.
     A "trader" is a person who buys and sells securities in frequent operations for his or her own account (rather than for the accounts of customers) to such extent that the activities might qualify as a trade or business.
     A trader must be actively and continuously occupied in the purchase and sale of securities, with his or her time, energy and organization devoted to such work.
     An "investor" is a person whose activities are limited to occasional transactions for and on his or her own account, and are less than those required in a trade or business.
     Assuming you lack the level of activity and business purpose to qualify as a trader, you are subject to the tax rules as they apply to individual investors.
     Your quick turnaround on trades (stocks held less than one year) means that any gains are short-term capital gains that are taxed as ordinary income.
     Capital losses may offset any capital gains and up to $3,000 of ordinary income per year. Any remaining capital losses may be carried forward indefinitely.
     Investment expenses of an individual investor are deductible as non-business expenses, subject to a floor of 2 percent of adjusted gross income.
     These expenses can include:

subscriptions to investment periodicals;
rent;
rental of safety deposit boxes;
legal fees;
bookkeeping costs.

     If you are self employed, there doesn't seem any point in declaring it. You either are or you aren't. Conducting your activities as a C corporation offers you no advantages.
     14. I am self-employed and I have a SEP-IRA. I have no employees and I had net income of approximately $5,000. What is the minimum and maximum deductible contribution that I may make to my SEP-IRA?
     Despite their name, simplified employee plans (SEPs) can also be used by the self-employed. Under the SEP rules, a self-employed person is treated both as the employee and the employer.
     Your contributions to your SEP-IRA cannot exceed the lesser of:

$30,000, or
15 percent of your net earnings from self-employment.

     In determining your net earnings, the deduction to your own SEP-IRA must be subtracted. However, the maximum SEP-IRA cannot be computed until net earnings are determined.
     In other words, the deduction amount and the net-earnings amount are each dependent on the other.
     Because of these circular calculations, it works out that the maximum percentage of net earnings that you can contribute and deduct to your own SEP-IRA is 13.0435 percent.
     Remember also that in determining net earnings from self-employment, the 50 percent deduction for self-employment tax is also taken into account.
     So while you owe the IRS self-employment taxes which, in effect, make up for the employment taxes that you and your employer would have paid if you worked for someone else, you get to deduct what would have been your employer's half -- the same as your employer would have.
     15. I am self-employed without any employees. I have established a Keogh plan, which I intend to fund to the max for 1996. Can I also make a tax-deductible IRA contribution?
     You probably can't. A Keogh plan is considered a "qualified" plan for income-tax purposes.
     You can make tax-deductible contributions to an IRA, but if you are a participant in a qualified plan, the tax deductibility phases out at fairly low levels.
     Your $2,000 maximum IRA deduction is reduced or eliminated entirely depending on your filing status and modified adjusted gross income.
     If you are filing a joint return, the phase-out range runs from $40,000.01 through $50,000. If you are single, the range is $25,000.01 through $35,000.
     For marrieds filing separate returns, the phaseout begins with dollar one, and no deduction is allowed if the modified adjusted gross income is $10,000 or more.
     For more information, the IRS includes a worksheet on computing your maximum IRA deduction on page 18 of the Form 1040 instructions.