This is the second article in a multi-part series to address the impact of significant life transitions on tax planning. Click here for Part I.
Earlier this year, Councilor, Buchanan & Mitchell (CBM) kicked off an article series about the impact of significant life transitions on tax planning. In Part I of the series, we covered getting married, divorce, having children and buying a home. In this second part of the series, we will address selling your home, starting a business and retirement. This article is not intended to be comprehensive, and we may link to other articles where we go more in-depth on these topics. However, we provide this overview of several different areas of tax planning and strategy to share CBM’s expertise helping clients work through an array of life transitions.
Selling Your Home and Tax Considerations
Capital gains tax, exclusions and possible deductions are important considerations when selling your home. The capital gains tax is a tax on the profit made from selling your home at a higher price than the one at which it was purchased. The rate at which you are taxed on this gain (assuming you’ve owned the home for at least a year) is calculated based on your taxable income. Rates may be 15% or 20% though lower-income tax payers may not have to pay any capital gains tax.
The Section 121 exclusion, however, lets homeowners exclude a certain amount of capital gains if the home was used as a primary residence for at least two of the past five years including $250,000 of capital gains for single homeowners and $500,000 for married couples filing jointly. Partial exclusions are available for homeowners who don’t meet that two-year requirement such as in the case of work relocation, health reasons or other circumstances.
Additional relief on capital gains tax results from home improvements by increasing your cost basis (i.e. the original amount you paid for the home). Other deductions to your capital gains tax include costs related to the sale of your home such as real estate agent commissions, legal fees and closing costs.
Assuming the capital gain from the sale of your home doesn’t fall below the exclusion limit, the sale of your home should be reported on IRS Form 8949 and Schedule D.
A note about second homes or investment properties. Unfortunately, they do not benefit from the same deductions as a primary residence. The full capital gain on such a property is taxable and there is no primary residence exclusion. Additionally, any depreciation deductions claimed while renting the property may be recaptured and taxed at a higher rate during the sale.
Starting a Business
Another dedicated article will be developed to cover this topic in greater detail. However, as starting a business represents a significant life transition, we wish to quickly address these high-level considerations.
Your business entity type will impact how and where you are taxed. A sole proprietorship, for example, is the simplest business structure where business income and expenses are reported on the owner’s personal tax return (Form 1040, Schedule C). Income tax and self-employment tax are reported on net earnings. By contrast, partnerships must file an annual Form 1065 information return with income and deductions; income passes through to the partners who report in on a personal tax return. Limited liability companies, S corporations and C corporations have varying tax reporting requirements. An experienced tax professional can work with business owners to determine which entity makes the most sense from a tax perspective.
Individuals starting a new business are also responsible for paying self-employment taxes including Social Security and Medicare, employment taxes if they hire employees, and state and local taxes. Depending on the nature of the business, a business owner may also need to collect sales tax from customers and remit it to state and local authorities. Business owners who owe more than $1,000 annually in taxes for the year must make quarterly estimated tax payments to avoid penalties.
While starting a business leads to several tax liabilities, new business owners also benefit from many deductible expenses including rent, supplies, travel, marketing and insurance, which can lower your taxable income. If part of you home is used exclusively for business, you may also qualify for a home office deduction. Finally, business owners may deduct the cost of business assets (e.g. equipment or property) over time through depreciation.
Finally, business owners can benefit from tax credits including a research and development credit for investments in innovative products or processes (the credit may be up to 10% of qualified expenses), a work opportunity credit for hiring workers recognized as facing barriers to employment and a small business health care credit for businesses that provide employees with insurance.
Retirement and Tax Planning
CBM has written and presented on retirement planning and tax considerations. However, in this series on life transitions, we wish to list a few high-level areas to consider.
- Taxation of Social Security benefits
- Taxation of required minimum distributions from IRAs, 401(k)s, other tax-deferred retirement accounts
- Taxes on capital gains and dividends (and opportunities for tax-loss harvesting)
- Tax differences in different states
- Medicare premium surcharges if your income exceeds a certain threshold (including income from retirement accounts)
- Taxation of annuities
- Charitable contributions – which can satisfy RMD requirements and reduce taxable income when donations from your IRA are made through a qualified charitable distribution
- Estate and inheritance taxes
- Deductibility of healthcare costs beyond a certain threshold
Several strategies should be considered to minimize your taxes in retirement such as keeping tax-efficient investments in taxable accounts and higher-yield investments in tax-deferred or tax-free accounts. Also consider strategic withdrawals from different accounts in a tax-efficient order, as well as balancing taxable and non-taxable sources of income.
We hope Part II of this series on life transitions and tax planning has been helpful. We’ll be back with Part III to discuss tax considerations for inheritances, significant medical events and job changes.
Contact Richard Morris via our online contact form with any questions.
Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.
