In an 1939 BBC broadcast, Winston Churchill called Russia “a riddle wrapped in mystery inside an enigma.” This would also be an apt description of our tax code.
Our tax laws are written piecemeal year after year by lawmakers unfamiliar with our existing body of tax laws and with little thought toward coherence or consistency. It is therefore easy to understand how myths and misunderstandings of our tax laws grow each year.
Many people feel they don’t have to report income if they don’t receive a W-2, 1099 or other reporting document. Taxable income always must be reported whether you receive a document or not.
The Internal Reveuse Service curbs the temptation of the self-employed and independent contractors to underreport income. Auditing them five times as often as others is a strong discouragment.
Bank deposits help ascertain “real income.” Also, expenditures and lifestyles often tip them off to unreported income. Willfully underreporting income can lead to negligence or fraud penalties.
Some taxpayers think they don’t have to report income from transactions or investments if they don’t receive any money. This common sense misconception is refuted by our complex tax code.
Limited Partnerships can report “phantom income” to the taxpayer that accrues to one’s interest in the partnership but is not distributed. Cancellation of debt income reported on 1099-C results when you are forgiven a debt for which you are personally responsible. Certain installment sales involving recapture of excess depreciation can result in immediate recognition of recapture income although little or no principal is received in the year of sale.
Taxpayers often think they can receive a current deduction for home improvements. Unless done per the instructions of a doctor for medical reasons, home improvements simply increase your cost basis in your home. With a high exclusion on principal residence gains when the home is sold, seldom is any tax benefit received.
When taxpayers are refinancing their homes they are sometimes told they can deduct the points paid. This is only true in regard to acquisition debt, i.e. buying a home or pulling out money to be spent on improving your home.
Points on refinances are amortized over the term of the loan, commonly 30 years.
After the real estate market crash, many taxpayers thought that when they sold their homes at a loss at least they could deduct the loss on their taxes. Although this sounds logical it is not true.
Homes and all “personal use property” sold at a loss do not create a deductible tax loss for you. However, gains may be taxable (the heads I win-tails you lose rule).
It’s often thought that getting an extension and filing by Oct. 15 will increase your chance of audit. Since you are required to send in the estimated amount you owe, the IRS doesn’t mind if you extend. If you are due a refund the IRS is perfectly happy to sit on it till you file your return.
Filing after April 15 may actually decrease your chance of audit since your information reaches their audit data base later.
Many people who have foreign investment accounts think they are in compliance as long as they report the income on their tax return. It may be necessary to file Form 8939 with your return. It could also be necessary to file an information return Form TD F 902-22.1 by June 30. To fail to do so when required can result in a penalty of $10,000 or more.
Unfortunately logic, fairness and consistency are only occasionally used in devising our tax code. It’s a good idea to rely on your tax professional throughout the year to ensure you understand the tax implications of proposed actions ahead of time.
