Tax

You need to think about the sale of your rental property when you claim depreciation on your qualified improvement property (QIP).

Gains may be subject to higher-than-expected tax rates due to Sections 1245 and 1250 ordinary income recapture and other factors. Planning your depreciation methods can significantly impact your current tax liabilities and long-term taxable gains when you sell.

Do you own or are you thinking of owning an office building, a store, a warehouse, or a factory building?

Are you thinking of making improvements to the interior of this building?

If you make improvements to the interior that the tax law classifies as QIP, your commercial property now has three property components:

1. Land (non-depreciable)
2. Building (depreciated over 39 years using the straight-line method)
3. QIP (depreciated over 15 years using the straight-line method, but alternatively eligible for Section 179 expensing and bonus depreciation)

Technically, QIP means any improvement to an interior portion of a non-residential building (think offices, stores, factories, etc.) that is placed in service after the date the building is placed in service.

The exceptions are costs attributable to the enlargement of the building, any elevator or escalator, or the building’s internal structural framework.

QIP Deduction Choices

QIP is 15-year property eligible for deduction in three ways:

1. Straight-line depreciation using the IRS 15-year depreciation table
2. Section 179 expensing
3. Bonus depreciation (technically called “additional first-year depreciation” in the tax code)

You can use a combination of the above to deduct your QIP—except when bonus depreciation is 100 percent, because that uses 100 percent of your basis in the QIP.

Bonus Depreciation

Lawmakers are in the process of reinstating 100 percent bonus depreciation for 2022 and 2023.

Regardless of the bonus deduction percentage—60 percent, 80 percent, or 100 percent—the rules for taxing that deduction when you sell are the same.

The reason to claim the deduction is that it’s immediate. For example, let’s say you spend $120,000 on QIP. With 100 percent bonus depreciation, you deduct $120,000 the year you place the QIP in service.

Caution. Make sure the passive loss rules don’t limit the QIP bonus depreciation deduction.

When you sell the building that contained the QIP for which first-year bonus depreciation was claimed, gain—up to the excess of the bonus depreciation deduction over the depreciation calculated using the straight-line method—is considered additional depreciation for purposes of Section 1250 and is high-taxed ordinary income recapture.

Section 179 Expensing

When you sell QIP for which first-year Section 179 deductions were claimed, gain up to the amount of the Section 179 deductions is high-taxed Section 1245 ordinary income recapture.

Straight-Line Depreciation

If you opt for straight-line depreciation for real property, including QIP (that is, no first-year Section 179 deductions and no bonus depreciation), there won’t be any Section 1245 or Section 1250 ordinary income recapture.

Instead, you will have only unrecaptured Section 1250 gain from the depreciation, and that gain will be taxed at a federal rate of no more than 25 percent.

Planning for the QIP Deductions

As you see above, your QIP deduction is not what it appears on the surface. Regardless of how you deduct your QIP, immediately or over time, you have a deduction that turns into taxable income at the time of sale.

So, what to do? If you want the big deduction in the first year, go for it, but

• make sure you will realize that deduction—in other words, make sure the passive-loss rules don’t deny or defer that deduction; and
• make sure you consider what is going to happen in the year you plan to sell the property.

If you want to discuss QIP, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• March 1, 2024

You can accumulate federal income-tax-free earnings with a Section 529 college savings plan account.

Then, you can take federal-income-tax-free withdrawals to cover qualified education expenses, usually for college.

Great! But what if your designated account beneficiary decides not to attend college?

What are your options, and what are the federal income tax consequences for those options?

Exercise Patience

Your wavering account beneficiary may still decide to go to college after spending some time doing something else.

Unless the 529 plan restricts how long the account can remain open, you can leave the funds invested for years. The money will be there if your beneficiary decides to go to college later.

Change the Account Beneficiary

If you funded the 529 account with your own money, you are the account owner and can designate the account beneficiary.

As the account owner, you can also change the beneficiary.

You can change the beneficiary on a tax-free basis as long as the new beneficiary has one of the following family relationships with the original beneficiary:

• spouse,
• sibling,
• step-sibling,
• first cousin, or
• spouse of first cousin.

Less likely individuals include the original beneficiary’s brother-in-law or sister-in-law.

Much less likely individuals include the original beneficiary’s

• child,
• stepchild,
• foster child,
• adopted child,
• other descendent,
• son-in-law,
• daughter-in-law,
• parent,
• step-parent,
• father-in-law,
• mother-in-law,
• niece or nephew or their spouse, or
• aunt or uncle or their spouse.

Depending on the 529 plan, you can fill out a beneficiary change form online or print and mail it in.

You can also do a tax-free rollover of a 529 account balance into a new account set up for a new beneficiary with one of the above-listed family relationships to the original account beneficiary.

Warning. If the 529 account was funded with money from a custodial account that was set up for the person who is the account beneficiary, that person is the account owner as well as the account beneficiary. So, the funds in the 529 account belong to that person.

If you are the custodian of the 529 account, you are legally obligated to manage the account for the account beneficiary’s benefit, and you don’t have the power to change the beneficiary.

Once the beneficiary becomes an adult under applicable state law, that person assumes legal control over the 529 account. That person could then change the beneficiary to one of the aforementioned family members on a tax-free basis or arrange for a tax-free rollover to one of those family members.

Take Advantage of the Broad Definition of Qualified Education Expenses

You can take tax-free 529 account withdrawals to pay for technical and professional schools as long as the educational institution participates in financial aid programs sponsored by the U.S. Department of Education. Almost all postsecondary educational institutions will pass that test.

You can also take tax-free 529 account withdrawals to cover expenses to attend a registered apprenticeship program.

You can take tax-free 529 account withdrawals to pay up to $10,000 of annual K-12 tuition expenses.

You might do the K-12 withdrawal for a new account beneficiary with one of the family relationships to the original beneficiary. Or you might set up a new account for someone with one of those relationships and fund it with a rollover from the original beneficiary’s 529 account.

Finally, you can take tax-free 529 account withdrawals to cover principal or interest payments on qualified education loans owed by the account beneficiary or a sibling of the beneficiary, subject to a lifetime limit of $10,000.

Take Tax-Free Withdrawals for Your Education Expenses

Suppose you funded the 529 account with your own money (as opposed to funding the account with money from a custodial account set up for the Section 529 account beneficiary). In that case, you can change the account beneficiary to yourself, return to school, and take tax-free withdrawals to cover your qualified education expenses.

Drain the Account

If you choose this option, you pay taxes on the earnings included in your withdrawals that you use for other than qualified education expenses. And you likely have to pay the 10 percent penalty tax on those earnings.

Warning. You may not take money out of a 529 account if it was initially put there from a custodial account that was created for the person who is supposed to benefit from the 529 account.

Any money taken from the 529 account legally belongs to the custodial account beneficiary and can only be used to benefit that person—such as buying your 20-year-old non-student a car.

Once the beneficiary becomes an adult under applicable state law, that person assumes legal control over the 529 account and can do whatever he or she wants with the money, subject to the tax considerations explained here.

If you would like to discuss your 529 account, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• February 27, 2024

The United States has a “pay as you go” tax system in which payments for income tax (and, where applicable, Social Security and Medicare taxes) must be made to the IRS throughout the year as income is earned, whether through withholding, by making estimated tax payments, or both.

You suffer an estimated tax penalty if you don’t pay enough to the IRS during the year.

The IRS levies this non-deductible interest penalty on the amount you underpaid each quarter. The penalty rate equals the short-term interest rate plus three percentage points.

Due to the rise in interest rates, the current penalty rate is 8 percent—the highest in 17 years. And since it’s not deductible, the net cost likely far exceeds 8 percent.

If you’re an employee and have all the tax you owe withheld by your employer, you don’t have to worry about this penalty.

But you must worry about it if you’re self-employed because no one withholds taxes from your business income. Likewise, you must worry if you receive income from which no, or not enough, tax is withheld—for example, retirement distributions, dividends, interest, capital gains, rents, and royalties.

C corporations are also subject to the underpayment of estimated tax penalty.

Fortunately, it’s easy to avoid this penalty!

• All individual taxpayers have to do is pay (1) 90 percent of the total tax due for the current year or (2) 100 percent of the total tax paid the previous year (110 percent for higher-income taxpayers with adjusted gross incomes of more than $150,000 ($75,000 for married couples filing separately).
• Corporations must pay 100 percent of the tax shown on their return for the current or preceding year (but large corporations can’t use the prior year).

Most individuals and corporations make equal quarterly estimated tax payments to the IRS. The IRS applies the penalty separately for each payment period. Thus, you can’t reduce the penalty for one period by increasing your estimated tax payments for a later period. This is true even if you’re due a refund when you file your tax return.

Some individuals and corporations can use alternate methods for computing estimated taxes, such as the annualized income method. But the alternate methods can be complicated.

If you want to discuss your estimated taxes, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• February 20, 2024