THE TAXES THAT MOST REAL ESTATE INVESTORS THINK DON'T APPLY TO THEM
In this edition of the Real Estate Revolution, we will discuss Self-Employment and Alternative Minimum Taxes.
Sadly, we live in a whole new world of taxes and restriction. In 2005, I attended a conference for CPAs and other tax professionals that was hosted by the IRS. At that conference, the IRS official conducting the meeting was asked specifically about self-employment taxes as it applies to real estate investing. The official was noticeable amused when he said that self-employment taxes have been in the code forever but up to 2005 the IRS didn't actively enforce the tax. Then he went on to say that starting in 2005-2006, the IRS would start actively enforcing the taxability of this tax. He said that the IRS tracks all real estate transactions and that in a year or two they would be auditing and penalizing those investors who failed to file and pay the tax in the year it was due. (OUCH!)
WHAT ARE SELF-EMPLOYMENT TAXES?
Self-employment taxes (SE tax) are a social security and Medicare tax primarily for individuals who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of most wage earners. You figure SE tax using Schedule SE (Form 1040). (See IRS Code Section 1402 and/or IRS Publication 533).
IRS PUBLICATION 533 STATES THAT YOU ARE SELF-EMPLOYED AND MUST PAY SELF-EMPLOYMENT TAXES IF ANY OF THE FOLLOWING APPLY TO YOU:
˜ You Carry On A Trade Or Business: A trade or business is generally an activity carried on for a livelihood or in good faith to make a profit. The regularity of activities and transactions and the production of income are important elements. You do not need to actually make a profit to be in a trade or business as long as you have a demonstratable profit motive. You do need, however, to make ongoing efforts to further the interests of your business.
˜ You Are A Sole Proprietor. You are a sole proprietor if you own an unincorporated business by yourself or owned by a husband and wife.
˜ You Are An Independent Contractor. People who are in an independent trade, business, or profession in which they offer their services are generally independent contractors.
You Are A Partner. If you are self-employed as a managing partner in a partnership or managing member in an LLC.
Husband And Wife Partners. You and your spouse may operate a business as a partnership. If you and your spouse operate a business as partners, you will report business income and expenses on form 1065, U.S. Return of Partnership Income, and attach separate Schedules K-1 showing each partner's share of the earnings. Each spouse must report his or her share of a general partnership earnings on Form 1040 and file a separate Schedule SE (Form 1040) to report SE tax. Worse yet,, if your spouse is your employee, not your partner, you must withhold and pay social security and Medicare taxes for him or her instead.
OTHER NOTEWORTY CONSIDERATIONS CONCERNING SELF EMPLOYMENT TAXES REAL ESTATE RENT:
Rental income from real estate is NOT included in earnings subject to SE tax UNLESS either of the following applies to you.
(a). You provide services for your tenants: You personally manage your properties.
(b). You are a real estate dealer.
AS YOU CAN SEE, SELF-EMPLOYMENT TAXES APPLY TO MOST OF US
WHAT IS THE ALTERNATIVE MINIMUM TAX?
Remember back to when you were young and poor and nothing made you madder than tales of rich people who paid nothing in income taxes? Well, you weren't alone, and that anger led to the creation of something called the alternative minimum tax, which was designed to keep the rich from living tax-free.
Fast-forward a few years. You're a bit older, somewhat better off and paying far more in taxes than you ever thought possible. So what's the last thing you expect to see when you fill out your tax return? That you owe the alternative minimum tax. You can take some solace in the fact that thousands of taxpayers just like you have been snagged by this nasty bit of tax law in recent years. While only 19,000 people owed the AMT in 1970, over 4 million are paying it now.
What happened? Inflation, mostly. While the "regular" tax brackets, exemptions and standard deductions are adjusted annually for inflation, the AMT brackets and exemptions are not, so many people whose income has grown with the economy enter the dreaded AMT zone each year. Especially vulnerable are people with income over $75,000 and some large deductions, but not the exotic ones that were originally targeted by the AMT's creators. Most vulnerable are taxpayers with several children, interest deductions from second mortgages, capital gains, high state and local taxes, and incentive stock options.
How The Tax Works: The best way to understand the AMT is to view it as a separate tax system. It has its own set of rates and its own rules for deductions, which usually are less generous than the regular rules. Because of these confusing rules, the only ways you can tell if you owe the tax are by filling out the forms (essentially doing your taxes a second time) or by being audited by the Internal Revenue Service. If it turns out you should have paid the AMT but didn't, you will owe the back taxes plus any interest or penalty that the IRS decides to dole out.
You should definitely run the numbers if your gross income is above $75,000 and you have write-offs for personal exemptions, taxes and home-equity loan interest. Ditto if you exercised incentive stock options during the year, or if you own rental properties, partnership (or LLC) interests or S corporation stock or If you earn more than $100,000.
That means filling out Form 6251. In effect, you are simply adding back some tax deductions and income exclusions to your regular taxable income to arrive at your alternative minimum taxable income. Here is where the middle class gets soaked. First you have to add back your personal- and dependent-exemption deductions ($3,200 each in 2005, $3,300 each in 2006), then your standard deduction if you don't itemize ($10,000 for joint filers in 2005 and $10,300 for joint filers in 2006; $5,000 for singles in 2005 and $5,150 for singles in 2006). You also lose your state, local and foreign income and property-tax write-offs, as well as your home-equity loan interest, if the loan proceeds are not used for home improvements.
The AMT also ignores some itemized deductions, such as investment expenses and employee business expenses, and some medical and dental expenses. Under the regular rules, you wouldn't pay current taxes on that amount, but under the AMT, it's considered income.
The AMT reporting form has quite a few other pluses and minuses, but you can probably ignore them unless you own a business, rental properties or interests in partnerships (or LLCs) or S corps. If you do, you may need a tax pro to prepare at least the Form 6251 part of your return.
Finally, you get to deduct the AMT exemption - $58,000 for joint filers; $40,250 for unmarried persons; $29,000 for those married filing separately. However, this exemption is reduced by 25 cents for each dollar of AMT taxable income above $150,000 for couples ($112,500 for singles and $75,000 for married filing separate status), and it's not adjusted for inflation, which is one reason why more people owe the AMT every year. (The exemption amounts for 2006 are not yet finalized, but we expect them to remain the same.)
After the exemption (if any) has been deducted, the result is subject to AMT rates - 26% on the first $175,000 ($87,500 for married couples filing separately) and 28% on the excess. Again, the AMT brackets are not adjusted for inflation, which causes much greater exposure to the tax as the years go by. If the AMT exceeds your regular tax, you have to pay the greater amount. Technically, the AMT is just the liability over and above the regular tax, and this figure is entered on line 45 on page 2 of Form 1040.
IMPORTANT NOTE: When you read this brief regarding the AMT, did you notice that you and every entity was listed as being subject to this disastrous tax EXCEPT the "C" corporation? In actuality there is a corporate AMT but it only applies should your C-Corp earn in excess of 7.5 million dollars over a three-year period. In other words for most of us, there is no reason to worry about this tax applying to our C-Corp business.
CONFUSED YET? MOST PEOPLE ARE BY THIS POINT. BUT NOT TO WORRY, OUR ESCROW PROGRAM WILL LEGALLY ELIMINATE BOTH OF THESE TAXES ALL TOGETHER.
