Tax Connections Newsletter – Summer 2012
Frank L. Washelesky

Renting Out a Vacation Home? Do Some Planning

Renting out a second home can help defray the cost of owning and maintaining the property. And there may be valuable tax benefits from the rental arrangement as well. Here are some things to think about if you are going to rent out a vacation property.

Two Week Rule

Your rental income won’t be taxable as long as you limit the number of rental days to 14 or fewer each year. In this situation, you won’t be able to deduct your rental expenses (other than property taxes and qualifying mortgage interest).

More Than 14 Rental Days

Once you exceed 14 rental days, all rental income becomes taxable to you. But you may deduct various rental expenses. There are different limits on rental deductions depending on your personal use of the home.

  • All expenses associated with renting out the property, such as utilities and maintenance, are potentially deductible if you limit personal use of the home to no more than the greater of (1) 10% of the total number of days the home is rented or (2) 14 days. However, if there’s a rental loss, the tax law’s passive activity rules may limit your loss deduction.

Where personal use exceeds the 10% or 14-day threshold, your tax deductions for rental expenses generally will be limited to the amount of rental income you collect. No loss is allowed.

Roth IRA Strategy for High Earners

Have you been locked out of contributing to a Roth individual retirement account (IRA) by the tax law’s income limits? There may be a way you can get around those limits and invest in a Roth IRA.

Why Consider a Roth IRA?

Unlike a traditional IRA, a Roth IRA offers the potential for tax-free earnings. You’re not taxed on investment earnings while they remain in the account, and qualified Roth distributions are not included in taxable income. If you want, you can leave your Roth IRA intact for your beneficiaries since you won’t have to take required minimum distributions (RMDs) after age 70½.

The Problem

Their potential for tax-free growth makes Roth IRAs a powerful planning tool. However, high earners face contribution restrictions. No Roth IRA contribution is allowed for 2012 if modified adjusted gross income (AGI) is more than $125,000 (unmarried filers) or $183,000 (married joint filers).

A Potential Solution

Even if you aren’t allowed to contribute to a Roth IRA directly, you still may convert a traditional IRA to a Roth IRA. No income limits apply to conversions. This opens up a planning possibility: Make nondeductible contributions to a traditional IRA and later convert it to a Roth IRA. Repeating this process over several years would allow you to build up the amount in your Roth IRA. You’d be taxed on the account earnings you convert, but the taxable amount may be small if you haven’t held the traditional IRA for long.

Caution: This strategy could backfire if you already have a large traditional IRA (from a plan rollover or regular contributions). Under complex rules, much more of each conversion amount would be subject to tax.  See us for details.

COBRA Compliance Checkup

Does your company sponsor a group health plan? If it does, you are probably at least somewhat familiar with COBRA,* the federal law that gives individuals covered by an employer’s group health plan the right to continue their coverage for a period of time, at their own expense, in certain situations. COBRA generally applies to employers with 20 or more employees. However, many states extend certain COBRA rights to workers at companies with fewer than 20 employees.

IRS Audit Guide

The IRS recently released updated COBRA audit procedures, a development that may indicate stepped-up enforcement of the tax law’s COBRA provisions. Since penalties for non-compliance can be steep, it’s smart to make sure your company’s COBRA practices are in order.

COBRA Triggers

An employee’s, spouse’s, or dependent’s right to temporarily continue group health plan benefits under COBRA is triggered by a qualifying event, and the coverage must last a minimum period. The most common qualifying events and the generally required coverage periods are:

  • Employee is voluntarily or involuntarily laid off or terminated (unless the reason is gross misconduct) — 18 months
  • Employee’s work hours are reduced below plan eligibility requirements — 18 months
  • Employee dies — 36 months
  • Employee becomes eligible for Medicare — 36 months
  • Spouse is no longer eligible for plan coverage because of a divorce or legal separation — 36 months
  •  Dependent is no longer eligible for coverage — 36 months

The availability of COBRA coverage generally begins on the date of the qualifying event that causes the loss of coverage. The coverage period can end early if premium payments aren’t made on time (generally within 30 days of the due date) or in certain other limited circumstances. Coverage periods vary under state programs.

COBRA Compliance Checkup

Premium Payments

Employees who elect COBRA coverage are responsible for paying the full cost of their health insurance premiums. You can add 2% to the premium charge to cover administrative costs.

Potential Penalties

The tax law imposes a penalty of $100 per person (maximum penalty of $200 per family) for each day the COBRA requirements are violated, referred to as the “noncompliance period.” This period can start on the date coverage is denied, a required notice is not sent out, or on some other required date and extend until the compliance failure is corrected. The noncompliance period for a particular person ends on the date six months after the last date on which continuation coverage would have been required, regardless of whether the failure is corrected.

Example: Terminated employee X wasn’t notified of her COBRA election rights until 20 days after the notification should have been given. The penalty for failure to timely notify X would be $2,000 (i.e., 20 days × $100). Generally, the employer is liable for the noncompliance penalty. Certain penalty limits may be applicable where a COBRA failure is unintentional and due to reasonable cause and not willful neglect. In certain circumstances, a minimum penalty can apply.

Update Your Procedures

You’ll want to be sure you have good procedures in place to ensure that your health insurer(s) or plan administrator is informed of qualifying events in a timely manner and that employees and beneficiaries receive the proper COBRA notices when they should. The updated IRS audit manual suggests that examiners ask employers for a copy of their health care continuation coverage procedures manual — if you don’t have a manual, you should put one together. Having standard form letters that you can send out to COBRA-eligible individuals also can help streamline compliance.

* COBRA is an acronym for the Consolidated Omnibus Budget Reconciliation Act of 1985.

Dependent Care Credit or FSA — Which Is Best?

Parents who pay for child care so they can work may be eligible for a federal income tax credit. However, the tax credit is not available for dependent care expenses paid through an employer’s flexible spending account (FSA). If your employer offers a dependent care FSA, should you take advantage of it? Or would the tax credit provide a greater benefit?

The FSA Route

With a dependent care FSA, you can set aside as much as $5,000 of your earnings annually on a pretax basis to pay qualifying child care expenses. To estimate how much tax your employer’s dependent care FSA arrangement might save you, you can multiply your marginal tax rate (plus your FICA tax rate) by your planned FSA contribution amount.

The Tax Credit Alternative

The dependent care credit is equal to a percentage of your employment-related expenses — as much as $3,000 of expenses for the care of one child ($2,400 after 2012) or $6,000 ($4,800 after 2012) for the care of two or more children in 2012. The minimum credit rate is 20% (increasing to as much as 35% for lower-income families). Married individuals must file jointly to claim the credit, and children must be under age 13. To estimate your tax savings from the credit, multiply the applicable credit rate by the amount of qualifying dependent care expenses you expect to have. The credit reduces your tax liability dollar for dollar.

Planning Tips

If you decide to use the FSA option, it’s smart to plan your election carefully since you’ll forfeit any surplus remaining in your account at the end of the plan year (or at the end of the plan’s grace period, if available). With two or more eligible dependents in 2012, you may find you can claim a dependent care credit for expenses that fall between $5,000 (the FSA limit) and the $6,000 maximum under the tax credit rules.

The general information in this publication is not intended to be nor should it be treated as tax, legal or accounting advice. Additional issues could exist that would affect the tax treatment of a specific transaction and, therefore, taxpayers should seek advice from an independent tax advisor based on their particular circumstances before acting on any information presented. This information is not intended to be nor can it be used by any taxpayer for the purpose of avoiding tax penalties.

Forward Thinking