We define most of the basic terms; so, you can be “in the know” during your discussions, readings, and negotiations. As tax structure complexities steadily increase, it is imperative to understand the multiplicity of abbreviations, acronyms, and definitions – starting with the basics.
In this case, “line” refers to the line drawn when totaling the items that make up your adjusted gross income (AGI). The term “deduction” usually refers to itemized deductions, but an above-the-line deduction is one that can be taken in addition to the standard or itemized deductions. This type of deduction is taken before determining your AGI; hence, “above-the-line.”
This is the debt used to acquire, build, or improve your principal residence or second home, and is secured by the principal residence or second home. The interest on up to $1 million of acquisition indebtedness is deductible as an itemized deduction.
Adjusted Gross Income (AGI)
AGI is essentially your gross taxable income from all sources reduced by certain allowable adjustments (which are deductible whether or not you itemize them) such as moving, higher education interest, deductions for health insurance premiums, and pension plan contributions.
Alternative Minimum Tax (AMT)
An alternate method of calculating your taxes; the AMT must be used if the resulting tax is higher than the tax calculated by the regular method. This method was introduced to ensure that wealthier taxpayers paid at least a minimum amount by ignoring certain tax breaks and deductions. However, the AMT does not account for inflation which has, over the years, slowly increased the number of taxpayers who are subject to this method.
Basis is the dollar value from which you measure any gain or loss on an asset for income tax purposes. Generally, your basis begins with what you paid for the asset, including purchase costs (cost basis) and then is adjusted up for improvement and sales costs or down for any depreciation or casualty losses claimed on the asset during the period of ownership. Special rules apply when determining your basis on property that is acquired by gift or inheritance.
Gifts to business contacts, clients, or customers are deductible if they are otherwise necessary and ordinary business expenses. Keep in mind that gifts are limited to $25 to each recipient per year.
Gains from the sale of some assets owned for more than a year (along with inherited assets like bonds, real estate, and stocks) fall under a special tax treatment called long-term capital gain. Gains from assets held for a shorter time are called short-term capital gains and do not enjoy that special tax treatment.
Losses from the sale of investment property such as bonds, land or stocks. Capital losses must offset other sales in the same year that resulted in capital gains. Up to $3,000 ($1,500 for married individuals filing separately) can be deducted against other kinds of income. Any excess can be carried into later years until completely used. Taxpayers may not report losses from the sale of personal use property (such as cars, primary home, or second home) for tax purposes. However, taxpayers must report gains.
The majority of taxpayers are considered cash basis taxpayers, meaning they pay taxes on income in the year they receive it. Questions sometimes arise regarding when income was received. Constructive receipt treats the income as taxable in the current year, even if the taxpayer didn’t receive it until a later date. For example, suppose you receive a check for income received in December of Year 1, but you didn’t cash the check until January of Year 2. Because the income was available in Year 1 it would be reportable on that tax return, not the return for Year 2.
Consumer Debt describes debt incurred in purchasing consumer products including credit card debt and car loans. The interest paid on this debt is not deductible as an itemized deduction.
When you hear the term “dependent”, your minor child is the first thing that comes to mind. However, a dependent can be another relative or even an individual not related to you. A dependent is a person who relies upon you for support. Five specific tests must be passed for an individual to be qualified as a dependent for tax purposes: the relationship or member of the household test, citizenship or residence test, gross income test, joint return test, and support test.
This Tax deduction is taken to reflect the gradual decline in value (wear and tear) of an asset used in business. There are some options for depreciation, but the tax law requires that this deduction be taken even if you’d prefer not to. Taxpayers who fail to take the depreciation deduction will still be required to account for the depreciation if/when the property is sold and will be required to pay taxes on that depreciation.
This is simply a way to move retirement and IRA funds directly from one account to another without having to take possession of the funds. It allows the taxpayer to avoid potential problems commonly encountered with rollovers. This transaction is also known as a trustee-to-trustee transfer.
When you withdraw funds from a Traditional IRA or other qualified plan before the age of 59-1/2, the withdrawal is considered an early distribution and is subject to a penalty equal to 10% of the taxable amount withdrawn on top of the regular income tax due on the distribution. There are a few ways to avoid the penalty, depending on the kind of plan you withdraw from. Consider seeking the advice of a professional before taking a distribution prior to age 59-1/2.
This is income earned from providing your personal services. Earned income is different than unearned income like capital gains, dividends, interest, and pensions. Earned income includes W-2 wage income, commissions, tips, and self-employment income. This type of income is typically subject to FICA withholding or self-employment tax and is required to qualify for the earned income credit as well as IRA and self-employment pension plan contributions.
If a taxpayer lacks sufficient withholding from wages and pensions to cover their tax liability, he/she could incur underpayment penalties, as is common for the self-employed and those with substantial investment. Quarterly estimated tax payments are an ideal way to pre-pay the anticipated tax liability and may help these taxpayers avoid underpayment penalties.
This is an amount that can be deducted for the taxpayer, spouse, and each dependent claimed. Exemption deductions are disallowed for a taxpayer who files a return and is also claimed, or could be claimed, as a dependent by another taxpayer. Exemptions are phased out for wealthier taxpayers.
Fair Market Value
This is the price at which a property would change hands between a willing buyer and a willing seller, neither being compelled to buy or sell, and both having reasonable understanding of all the facts.
The Federal Insurance Contributions Act is the law that covers Social Security and Medicare. Funds are withheld from the wages of employees for their contribution to these programs. The employer pays a matching amount. If an employee works for 2 or more employers and has Social Security withholdings in excess of the annual wage maximum, those funds will be refundable as a tax credit for the employee.
Your filing status is based on your marital status as of the last day of the year (married individuals may choose to file jointly or separately). Your filing status determines your income level for tax rates and the amount of your standard deduction. Other filing statuses include Head of Household and Qualified Widow(er) with a dependent child.
You may have heard that you can deduct gifts you give to others, but it is unfortunately not true. The gift tax, paid by the giver, is required if the amount given to any one individual for the year exceeds the annual gift exemption. Larger gifts are taxable, but taxpayers may offset the gift tax with a tax credit that offsets the first $1 million of lifetime taxable gifts.
Head of Household
This filing status is complex and difficult to qualify for. It is commonly used for unmarried taxpayers or married taxpayers who pay more than half the cost of maintaining a home for themselves and a qualifying person, for more than half the tax year. The filing status offers a higher standard deduction and more beneficial tax brackets.
Home Equity Debt
This is debt incurred on a principal residence or second home that is not used to buy, build, or substantially improve that residence. For example, a home equity loan used to acquire consumer products or pay off consumer debt would not qualify as Home Equity Debt.
The length of time an asset is owned typically determines if it qualifies for long-term capital gains rates when it is sold. To qualify, the asset must be inherited property or be owned more than 12 months. The holding period begins the day after it is acquired and ends on the date of sale or other disposition. Stock assets are counted from the trade dates, not the settlement dates.
This is someone who performs services for others and whose recipients do not control the means or methods the used to accomplish the work. Independent contractors are considered self-employed.
This is interest paid on debt incurred for investment purposes, such as interest paid on vacant land held for investment. It is deductible as an itemized deduction, but only to the extent of the taxpayer’s net investment income. All excess is carried over to the next year.
Taxpayers are permitted to use either a standard deduction or itemized deductions when calculating their taxable income. There are five basic categories of itemized deductions:
• Medical expenses that exceed 7.5% of the AGI.
• Taxes – state income tax, property taxes, and personal property taxes (not including sales or excise taxes).
• Interest – limited to mortgage and investment interest.
• Charitable contributions not exceeding an AGI limitation. (50% for most contributions)
• Miscellaneous expenses – only miscellaneous expenses that exceed 2% of the AGI are generally allowed.
There is an additional category that includes gambling losses and several other rarely encountered deductions that are allowed without an AGI reduction.
A qualified retirement plan set up by a self-employed individual is often referred to as a Keogh plan. Congressman Keogh sponsored the legislation allowing individuals to establish these plans. They may also be called H.R. 10 plans, after the number of the House bill which enacted them. A Keogh plan may cover both the self-employed person who establishes the plan and his or her employees.
Congress established what is now referred to as the kiddie tax to prevent parents from using their children’s tax return to avoid taxes on investment income. This applies to unearned income of children under the age of 18 and full-time students between the ages of 18 and 24. Under the kiddie tax, a child’s unearned income is taxed at the parent’s tax rate, while their earned income continues to be taxed at the child’s rate.
Life Insurance Dividends
Insurance policy dividends that the insurer keeps and uses to pay their premiums are not taxable. Interest paid on dividends and left to accumulate with the insurer is taxable.
Listed property includes assets like cameras, cell phones, computers, video equipment, and cars, boats, and airplanes purchased for business purposes which are used for personal purposes. Congress established a list of these assets to limit a taxpayer’s ability to deduct the personal use of these items as business use. The IRS monitors these assets more closely and applies to them certain restrictions and recordkeeping requirements.
The tax code allows a taxpayer to exchange like-kind business and investment assets and is frequently referred to as a tax-free exchange. This is a bit of a misnomer because these transactions aren’t tax-free, but instead defers the tax to a later date when the replacement property is sold. Special timing rules apply to this transaction and we recommend you consult us before enacting one.
This is a partner whose participation in partnership activities is limited. Their personal liability for partnership debts is restricted to the amount of money or other property that he or she contributed or may contribute in the future.
Marginal Tax Rate
Many taxpayers assume their marginal tax rate is synonymous with their tax bracket. This is often true, however as the tax brackets go up, so does the taxpayer’s income; as incomes increase, tax breaks begin to be reduced, phased out, and in some cases, completely eliminated. This process raises the taxpayer’s marginal tax rate above their tax bracket. If you know your marginal rate, you can determine much of each additional dollar will go to taxes or reduce taxes through deductions.
Modified Adjusted Gross Income
Once a taxpayer’s adjusted gross income (AGI) reaches a certain level, many tax deductions, adjustments, and credits are phased out or disallowed. For these purposes the AGI is a modified AGI. When testing to see if a taxpayer has reached the income phase-out threshold for claiming a certain credit, the AGI will be calculated without claiming certain exclusions that accompany that credit.
Municipal Bond Interest
This term refers to interest received on an obligation issued by a state or local government. This type of interest is typically not taxable for Federal tax purposes. Most states treat municipal bond interest from other states as taxable.
Original Issue Discount (OID)
Bonds are sometimes issued at a discounted rate and, some years later, mature at face value. The difference between the issue price and the face value is the interest paid by the bond issuer, a portion of which (the OID) must be reported annually, although the owner of the bond doesn’t receive any interest until the bond had matured.
Passive Activity Loss
In order to limit the benefits of tax shelters, the tax code imposes loss limitations on “passive activities”. Passive activities typically include investments in which a taxpayer does not materially participate. Losses from these investments can be used to offset income from other passive investments, but can’t be deducted against other types of income (like wages, pensions, dividends, and capital gains). Real estate and limited partnership investments are often classified as passive activities.
Points constitute prepaid interest and are usually deducted ratably over the loan term. One point is equivalent to 1% of a loan value. When a taxpayer purchases a rental real estate property, the points would be spread over the life of the loan. The tax code offers a break for points paid on a mortgage to buy or improve a taxpayer’s principal residence which allows them to be deducted in full in the year paid.
Taxpayers may exclude up to $250,000 ($500,000 for married taxpayers) of gain from the sale of a principal residence if they meet the ownership and residence qualifications. If a taxpayer alternates between two main residences, the property used for the majority of the year would probably be considered their principal residence.
Private Activity Bond
Interest from municipal bonds issued by a state or local government is typically federally tax-exempt for both regular and alternative minimum tax (AMT) purposes. Taxpayers subject to the AMT may wish to utilize alternate investment vehicles if they use the proceeds from municipal bonds to support private businesses, since those funds are taxable for AMT purposes.
This is a retirement and employment benefit plan that meets IRS requirements and is designed to protect the interests of employees or retirees.
Refers to a tax benefit taken in an earlier year being paid back if the property on which the benefit was claimed isn’t held for a certain time period.
This is a tax-free withdrawal of assets from a retirement plan and its reinvestment in another plan. This amount is excluded from gross income in the year of the transfer and, in order to ensure non-taxability, must be completed within 60 days after a distribution is received. This rule may be waived if a delay is caused by a financial institution or certain conditions are caused by an event out of the control of the taxpayer. One rollover is permitted per account per year, but there is no limit on direct transfers from one financial institution to another.
Section 179 Deduction
This refers to a section of the IRS code that allows taxpayers to write off (in one year) up to $125,000 of business equipment spending that would normally need to be depreciated over their useful lives. This allowance is gradually reduced for businesses that place more than $500,000 of business equipment over the course of the year.
Section 529 Plan
Qualified Tuition Plans (also known as Section 529 Plans) established to help families save and pay for college in a tax-advantaged way. They’re available to everyone, regardless of income. Qualified Tuition Plans enable taxpayers to gift large amounts of money for a family member’s college education while maintaining control of the money. Earnings on these types of accounts are tax-deferred, and distributions are tax-free only if they are used to pay for education expenses.
Because self-employed taxpayers do not have FICA and Social Security withholding through an employer, they pay the equivalent through the self-employment tax (SE tax). The SE tax is based on the taxpayer’s net profits from self-employment.
Shared Equity Arrangement
This is a method of financing the purchase of a residence where two or more individuals acquire an ownership interest in the residence and one or more of the co-owners occupies the property and pays fair rent to the non-occupying co-owner(s). This arrangement required a written agreement.
Most taxpayers are allowed to use either a standard deduction or itemized deductions when calculating their taxable income. Standard deductions are based on filing status (filing jointly, single, etc.).
Standard Mileage Rate
This is the per mile rate (including parking expenses) that can be used in lieu of actual expenses when using a vehicle for a deductible purpose.
Typically, the basis used for inherited property by the beneficiaries is the value of the property on the date of death of the decedent, or on an alternate date selected by the executor of the estate. Any appreciation up to the date of death is forgiven for regular tax purposes, allowing the beneficiary to start with a stepped-up basis.
This typically refers to income that is taxable, rather than income that is not taxable (such as tax-exempt interest from municipal bonds). It can also refer to taxable income on a tax return, which is income less adjustments, deductions, and exemptions.
This is a tax benefit that offsets a taxpayer’s tax liability. Most credits are nonrefundable and may only be used to reduce the tax to zero. Refundable credits (like the earned income credit) offset the tax and any remaining balance is included in the taxpayer’s refund. Some unused credits can be carried over to following years.
Tax Identification (ID) Number
Most taxpayer’s will use their Social Security number (SSN) as their tax ID. A SSN is also required for each dependent, regardless of age, if the taxpayer wishes to claim certain exemption allowances and tax credits. A special “adoption taxpayer identification number” (ATIN) may be obtained from the IRS when a SSN cannot be obtained for a U.S. citizen or resident child being adopted; once the adoption is final a SSN must be obtained for the child. Nonresident or resident aliens may apply to the IRS for an “individual taxpayer identification number” (ITIN) if they are not eligible for a SSN. Individuals who have household employees or who are self-employed with employees must obtain a federal employer identification number (FEIN). A self-employed taxpayer who has a Keogh plan must have an FEIN, even if they do not have any employees.
This refers to income that is taxable (as opposed to income that is not taxable like tax-exempt interest from municipal bonds). It can also refer to taxable income on a tax return, which is income less adjustments, deductions, and exemptions.
Picture your income as blocks of income stacked on top of each other. The first block is your standard or itemized deductions, on which there is no tax. The second block is the total of your personal exemptions, which is also tax-free. The third block of income is any income subject to a 10% rate. Each subsequent block of income is taxed at progressively higher rates. The rates are currently 10%, 15%, 25%, 28%, 33%, and 35%. The tax rate on the last block of your income represents your tax bracket. Typically, any increase or decrease in income would be affected at your top tax rate.
This refers to income not earned from personal services, such as income on capital gains, investments, passive activities, and pensions.
A wash sale is any sale that results in a loss when the majority of the same security is purchased within 30 days before or after the date of the sale. When a loss is limited by the wash sale rule, the basis of the acquired shares is increased by the loss that wasn’t allowed. This rule prevent taxpayers from realizing a loss from the sale of a security and then in a short period of time reacquiring that security. This Wash Sale rule applies only to sales resulting in a loss.
Withholding refers to amounts that are held back from income by the employer to pay Federal and State, Social Security, and Medicare taxes. Most commonly associated with wages, withholding may also occur on gambling income, pension income, social security income, unemployment payments, and in some cases, backup withholding on interest and dividend income where the taxpayer has failed to provide a Tax ID number to the payer.