Tax

Maybe the least popular change brought about by the Tax Cuts and Jobs Act (TCJA) was a first-ever cap on the federal personal income tax deduction for state and local taxes. From 2018 through 2025, the TCJA caps itemized deductions for state income taxes (or general sales taxes if elected instead of income taxes), state real property taxes, and personal property taxes at $10,000 (known as the SALT cap).

Thus, for example, if you live in a high-tax state such as California or New York and owe $10,000 or more in property tax, that tax alone uses your $10,000 deduction. You’ll get no federal deduction for the substantial state income taxes you doubtlessly pay.

But suppose you’re an owner of a pass-through entity such as a partnership, multi-member LLC, or S corporation. In that case, there could be a way for you to get around the $10,000 SALT cap by electing to have your pass-through business pay federal income tax on its profits at the entity level.

A majority of states have enacted pass-through entity taxes (PTE taxes).

In these states, pass-through owners can elect to have their entity pay the state income tax due on the entity’s business income that its owners would otherwise pay. The entity then claims a federal business expense deduction for the state income tax payments. The $10,000 SALT cap does not apply to taxes imposed at the business-entity level, such as income taxes imposed on pass-throughs.

Depending on the state where the owners live, they either

• get a state tax credit for the state tax paid by the entity, or
• exclude from their income for state personal income tax purposes their distributive share of the pass-through’s taxable income.

Either way, the owners benefit from a federal deduction for all the state income tax due on their pass-through income, even if it is far more than the $10,000 SALT limit.

You can do this. The IRS gave its seal of approval to PTE taxes in a Notice issued in November 2020.

Unfortunately, not all business owners can benefit from the PTE. As mentioned above, it’s only for business entities that are subject to pass-through taxation. These include multi-member LLCs, partnerships, and S corporations. You’re out of luck if you’re a sole proprietor or an owner of a single-member LLC.

PTE taxes are elective in all states except Connecticut, where they are mandatory. The rules vary from state to state. Your entity must make a PTE election and pay estimated state income taxes. It must meet specific deadlines.

If you have any questions on the PTE or need my help, don’t hesitate to call me on my direct line at 408-778-9651.

• By Leon Clinton
• September 7, 2022

Is the mileage rate sticking it to you?

Could you increase your tax deductions by switching from the IRS mileage rate to the actual-expense method? If so, you will be happy to learn you can make that switch.

When you choose the mileage rate, you elect out of the actual-expense method and also elect out of MACRS depreciation.

This does not mean that you are locked out forever. The IRS grants you two ways to escape from your original mileage-rate decision and switch to the actual-expense method.

Escape 1: The Early Escape

You can make an early escape out of your choice regarding the IRS mileage rate and totally undo that original decision. But you generally have to hurry to do that.

The “hurry” part means that you must amend your tax return before the original due date, including extensions.

Example. You bought a new vehicle in 2021, and when you filed your tax return on April 15, 2022, you chose the IRS mileage-rate method. Now, you realize that was a mistake. You have until 11:59 p.m. on October 17, 2022, to file an amended return and elect actual expenses, including the Section 179 deduction, bonus depreciation, and MACRS depreciation.

In other words, when you amend your return before the final extended filing date, you undo your original tax return position and replace it with the one in the amended return.

Once the final extended filing date passes (September 15 for calendar-year corporations and October 17 for individuals), your ability to undo the original return is gone.

But you can still come out ahead with the later escape.

Escape 2: The Later Escape

In the later escape, you simply switch from the IRS mileage-rate to the actual-expense method, using straight-line depreciation over the vehicle’s remaining useful life.

It’s possible to switch from the IRS mileage-rate to the actual-expense method with MACRS depreciation, but you need the consent of the IRS commissioner. Forget that. Getting consent is too expensive, too time-consuming, and too likely to face rejection.

And besides, the switch to straight-line depreciation works very well, as you’ll see.

To make the switch to the straight-line depreciation method, you need to know your vehicle’s

• adjusted basis,
• remaining useful life, and
• estimated salvage value at the end of its useful life.

Your adjusted basis is the original cost (or other basis) reduced by depreciation. Inside the IRS mileage rate is depreciation at so much a mile. For 2022, the depreciation that’s inside each 58.5- and 62.5-cent mile is 26 cents.

Example. You paid $45,000 for the business portion of your vehicle and drove it 5,000 business miles. Depreciation on the 5,000 miles is $1,300 (5,000 times 26 cents). Your adjusted business basis is $43,700 ($45,000 minus $1,300).

Your official “estimated useful life” is how long you expect to keep the vehicle. That’s easy. Say you estimate that you will keep the vehicle for three more years. So, three years is the estimated useful life at the time of your switch.

Next, you estimate your salvage value by using the Kelly Blue Book or other respected valuation guide. Here, you establish what you think you can reasonably sell the vehicle for at the end of its estimated useful life. Make sure to print or otherwise capture the valuation evidence for your tax file.

IRS grants a bonus reduction in salvage value. If you estimate your vehicle’s useful life at three years or more, you can reduce your salvage value estimate by an amount equal to 10 percent of your basis in the property.

Example. Say you estimate a salvage value of $15,000 on a vehicle with an adjusted basis of $43,700. By using the 10 percent bonus reduction in salvage value, you can reduce your estimated salvage value by $4,370, giving you a salvage value of $10,630 ($15,000 – $4,370).

Straight-line depreciation. With an adjusted basis of $43,700, and salvage value of $10,630, you are going to depreciate $33,070 ($43,700 – $10,630) over three years. Assuming there’s no change in your business mileage, your depreciation deduction for each of the three years is $11,023.

If your estimated salvage value is less than 10 percent of your adjusted basis at the time of the switch from the IRS mileage rate to actual expenses, you use the IRS salvage-value bonus to simply make your salvage value zero.

If you would like to discuss switching to or from the actual-expense method, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• September 4, 2022

Do you own investment property? What about a small business? Sooner or later, you will probably want to sell.

One of the downsides of selling a business or investment property is the huge tax bill at the end. Profits are likely subject to the capital gains tax—perhaps at a much higher rate than you expect.

A seller-financed installment sale enables you to defer taxes to one or more later years, which is almost always a good idea.

And the installment sale could cut your tax bill if spreading out your profits over multiple years puts you in a lower tax bracket.

But as with most programs that can lower your taxes, your lawmakers and the IRS impose a number of limitations.

What Is an Installment Sale?

An installment sale is a sale of eligible property where you receive at least one payment after the close of the taxable year in which the sale occurs. If you make a profit on an installment sale, you report part of your profit when you receive each payment.

You document the buyer’s obligation to make future payments to you, with a deed of trust, note, land contract, mortgage, or other evidence of the buyer’s debt to you. You should also secure the debt.

Although you can’t use the installment method to report a loss, you can choose to report all of your gain in the year of sale.

Installment Sale Advantages

An installment sale offers a number of advantages for you as a seller, as well as for your buyer:

1. You can negotiate the sale without the need for the buyer to pay the full sale price when you finalize the sale.
2. You and the buyer can finalize the sale agreement without waiting for the buyer to qualify for third-party financing.
3. You and the buyer can tailor the terms of the sale to meet your needs without having to get approval from a third-party lender.
4. You can defer taxes on your gain, and potentially pay a lower tax rate in a later year.
5. The buyer receives full basis in the property.

How Is an Installment Sale Reported?

Payments that you receive from an installment sale consist of three parts:

1. Interest
2. Taxable part (gain or profit)
3. Non-taxable part (return of basis)

Each year you receive a payment, you pay taxes on the interest and taxable part. The part of the payment allocated to your basis is not taxable. Basis is the amount of your investment in the property for installment sale purposes.

After you’ve determined how much of each payment to treat as interest, you next determine the taxable portion of the remaining payment.

No Installment Sale in These Instances

There are certain types of property and transactions for which the installment method cannot be used, such as:

• The sale of inventory consisting of personal property. But this rule does not apply to property used or produced in farming.
• The sale of real property held for sale to customers in the ordinary course of a trade or business. But dealers of timeshares and residential lots can treat certain sales as installment sales and report under the installment method if they elect to pay a special interest charge.
• The sale of stock or securities traded on an established securities market.
• The sale of depreciable property to a related buyer, unless you can show to the satisfaction of the IRS that the sale was not made for tax avoidance.

If you are thinking of an installment sale and would like to discuss it, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• August 30, 2022