Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)
Part II. Ordinary Income
Chapter 8. Other Sources of Ordinary Income
Each with Its Own Quirks
In addition to employment income and retirement income, there are almost innumerable other sources of “ordinary” income. The purpose of this chapter is to address some of the more common sources of ordinary income that can catch a taxpayer unaware because of the special rules or misperceptions attached to them. The ordinary income sources covered in this chapter are:
· State tax refunds
· Debt forgiveness
· Gambling winnings
· Awards for legal damages
· Unemployment income
· Bartering (trading)
State Tax Refunds
State tax refunds fall into the “potentially taxed” category of income. The key to whether a refund is taxed is whether you claimed state taxes as an itemized deduction for the tax year that the refund belongs to. If you did not claim state taxes as a deduction, then you are not taxed on the refund. If you did claim the taxes as a deduction then you may have to pay tax on part or all of the refund, but not always.
The idea behind taxing state refunds is that if you used the taxes as a deduction, but overpaid the tax, then you claimed a deduction that was too large to begin with. If you get a refund, then the deduction should have been smaller to accurately reflect the state tax that you truly paid, so you need to add the refund amount (or a portion of it) back into your income for the current year so that you can be properly taxed on it. It would be more accurate if the tax code required that a refund be shown in the previous year through an amended return (so that the deduction is for the correct amount in that year), but because of the deluge of amended returns that this would cause, Congress has instead required it to be recognized in the year that you receive the refund.
This requirement would be simple if all you needed to do were to add the refund into your income for the year, but, since the words “simple” and “tax code” are diametrically opposed to each other, there are some extra steps you must go through to find out the proper amount of the refund to add into your income. Because of how the deduction for state taxes is determined, part or all of the refund could actually be tax-free.
When itemizing deductions you have a choice between claiming the state income tax that you paid during the year and claiming the sales taxes that you paid. Since you have a choice of deductions, the added value of choosing the state income tax deduction is really only the difference between the state income tax and the sales tax that you paid. If you choose to deduct state income taxes because they are $100 higher than the sales taxes were, then the added value that you gain from choosing the income tax deduction is $100.
Example Fritz had the choice of claiming $500 in sales tax or $600 in state income taxes. Choosing to use the state income taxes as his deduction gives Fritz an additional benefit of $100 ($600 state income tax – $500 sales tax = $100 greater deduction by claiming the income tax).
When you receive a refund of your state income tax, it is because you paid more to the state than you really owed, which means that the deduction for state income taxes that you claimed was too high. (It’s like paying $20 for a $15 item at a store and getting $5 back in change. You didn’t really pay $20 for the item; you paid $15.) You must claim that extra amount paid (the refund or “change”) as income, but only to the extent that it brought you a greater benefit on the previous year’s taxes than you would have received if you had not claimed it.
Example In the previous example, Fritz received a refund of $200 from the state after filing his taxes. Fritz will need to claim $100 of that refund as income because that is the additional benefit that he received by claiming state taxes as a deduction. If he had originally only paid the $400 that he truly owed ($600 paid – $200 refund = $400 truly owed) then he would have claimed the $500 sales tax deduction instead of the income tax deduction, because the sales tax deduction would have been larger. So, the tax benefit that he received because of paying $200 more in state income tax than he really owed was $100, the amount that by which it was greater than the other deduction that he could have claimed. Even though he had a $200 refund, the amount deducted on the previous year’s return was only $100 more than it would have been otherwise, so that is all that is included in this year’s income.
There are other factors that go into this calculation as well. One of these is to take into account the standard deduction vs. the itemized deduction, and how much of an additional benefit there was from claiming the state tax deduction as compared to just using the standard deduction. Another factor is whether the taxpayer had taxable income after deductions, and how much it would have changed taking the refund into account.
The end goal in all of the factors that need to be considered is to determine what portion of the refund (or overpayment/over-deduction of state income tax) actually benefited the taxpayer. That portion, if any, is the amount added back into the current year’s tax return as income, to make up for the reduction in taxable income from the previous year.
Alimony is the payment of money by one ex-spouse for the support of the other ex-spouse. This payment is a deductible expense for the spouse who is paying it (as an above-the-line adjustment to income) and is recognized as taxable income for the spouse who is receiving it. For the alimony to be deductible/taxable, the following conditions must exist:
· The payments must be required by law, written in a divorce or separation agreement. If they are not legally required, then any payments made are considered a gift.
· The payments must be made in cash or cash equivalents, or made directly to another person or entity for the benefit of the spouse (such as paying the spouse’s rent or utilities, etc.).
· The payments cannot extend beyond the death of the spouse receiving payments (such as to an heir or beneficiary).
· Payments cannot be made to members of the same household. (You can’t pay a spouse from whom you are separated but still living with. This is to keep people from playing games with the tax system.)
· Payments must not be designated as anything other than alimony (such as child support).
· The spouses may not file a joint tax return (which would be silly anyway, because the income and expense would cancel each other out if they were on the same return).
Alimony and Child Support Tax Rules
Any portion of the alimony payment that is considered child support for minor children (as determined by the divorce decree or separation agreement), or is based upon a child’s status, is not taxable/deductible. In addition, if the paying spouse does not pay the full required amount of alimony and child support during the year, the payments that are made count first toward the child support until the entire obligation to the child is fulfilled; then any additional amount remaining can be considered alimony.
Example Seth and Valery are divorced, and Valery has custody of their two minor children. The divorce decree stipulates that Seth must pay Valery $2,000 per month and designates $1,500 of that amount as child support ($18,000 per year) and $500 as alimony ($6,000 per year). During the year Seth paid the full $2,000 each month to Valery, until he lost his job on November 1. At that point Seth made no more payments to Valery for the remainder of the year. Of the $20,000 that he paid Valery ($2,000 per month × 10 months paid = $20,000), $18,000 will be considered child support and $2,000 will be alimony, even though the division of child support to alimony was really $15,000 and $5,000. This is because all of the child support must be met before any amount can be considered alimony for tax purposes. As a result, Seth can claim only $2,000 for alimony as a tax deduction and Valery needs to claim only $2,000 as income.
In general, if any personal debts are cancelled or forgiven, you must pay income tax on the amounts forgiven. The reasoning behind this is that if you purchase an item using debt, and then later the debt is forgiven, the money used to purchase the item is essentially income, since you don’t have to pay it back but received the benefit of it.
If the item that you purchased with debt is repossessed you will need to pay taxes only on the difference between the debt owed and the market value of the item.
Example Jack bought a new car for $40,000, using a loan to make the purchase. After two years Jack lost his job and stopped making payments on the car. When the car was repossessed he still owed $25,000 on the loan. The bank was able to sell the car for $20,000. Jack will owe taxes on $5,000 of debt cancellation income ($25,000 of debt cancelled – $20,000 value of repossessed car = $5,000 debt cancellation income).
While it is the general rule that cancelled debts lead to taxable “income,” there are many exceptions to that rule. If one of the exceptions applies to you, then it would be good to seek professional guidance so that you do not end up paying more taxes than necessary. Some of the more common types of debt cancellation that have special guidelines include:
· Student loan debt
· Debt on your principal residence
· Debts cancelled in bankruptcy
· Debts cancelled when you are insolvent (insolvent means your liabilities exceed the fair market value of your assets)
· Business real estate debt
· Farm debt
One item from the preceding list merits a more detailed discussion in this book because of the large number of people it affects and because it has special rules affecting it at this time. The exception for non-taxation of debt cancellation income for personal residences is temporary, since it was enacted as part of the economic relief legislation during our last economic downturn. Typically debt relief on a house is considered taxable income. However, this temporary rule makes it non-taxable for any debt (up to $2,000,000) that is cancelled between 2007 and the end of 2013. (At the publishing deadline for this book, it appeared likely that Congress would extend this tax relief through 2014 after the elections. Be sure to check whether this occurred if you are affected by debt cancellation income on your home in 2014.)
In order for the debt cancellation to be tax-free, the debt must have been used solely for the purchase, construction, or improvement of the taxpayer’s principal residence. Any amount of debt that was used for other purposes and merely secured by the house would be taxable.
Example Alisha and Allen purchased a home five years ago for $300,000, making a down payment of $30,000 and securing a loan for the remaining $270,000. Three years after the purchase the home’s appraised value had jumped to $420,000, while the loan principal balance had been paid down to $250,000. Alisha and Allen refinanced the home, securing a loan of $350,000. They used the additional loan funds to pay for a $60,000 remodel of their kitchen and bathrooms and used the remaining $40,000 from the loan to pay off credit card debt and take a vacation. Soon afterward, through tragic circumstances, they were not able to make the payments on the home and it was foreclosed. In a foreclosure sale the bank was able to get $300,000 for the home. This sale resulted in $50,000 of debt cancellation income ($350,000 debt – $300,000 sale price = $50,000 debt cancellation). Of the $50,000 of debt cancellation, $40,000 is taxable to Alisha and Allen ($40,000 of the loan refinancing was used for things other than the purchase, construction, or improvement of the home, which makes that portion of the debt forgiveness ineligible for the special exclusion from taxes).
At times you may be able to use more than one exclusion to reduce your taxes. For instance, in the preceding example, if Alisha and Allen were insolvent at the time of the foreclosure they could use the principal-residence exclusion for part of the debt forgiveness and the “insolvency” exclusion for the portion of the loan that they used for personal expenses.
Note When you have had a debt cancelled for an item that fits into one of the “exception” categories, you may not need to recognize income on that debt forgiveness. However, if you still own the asset, you will have to reduce the cost basis of that item by the amount of debt that was forgiven—meaning the asset didn’t really cost you as much as the original price because some of the debt was forgiven. For example, if you have $50,000 of debt forgiven on your residence that originally cost $250,000, it is now as if the house really only cost you $200,000 ($250,000 original cost – $50,000 non-taxable debt forgiveness = $200,000). The end result of this is that when you sell the asset in the future you may have a larger gain from the sale because of the “lower” original purchase price, increasing the taxable portion of the income from the sale.
Gambling Winnings and Losses
The way in which gambling winnings are taxed is unique. The laws governing gambling taxation are not favorable and actually seem to intentionally penalize those who receive this type of income.
Gambling winnings are fully taxable as ordinary income. In fact, all winnings are included in income, not net winnings (winnings minus losses). If you spend $1,000 at a casino, and from that $1,000 win $200, the full $200 is included in income even though you really lost $800! ($200 won – $1,000 spent = $800 lost.) You may be able to deduct a portion of those losses, but because of the unique tax rules for this kind of income, many people end up being taxed on some or all of their “income,” even when they had a net loss.
The most important rule regarding gambling income is that you can deduct losses only to the extent of your winnings. So, if you had $200 in winnings and $30,000 in losses, you can still deduct only $200 of those losses. Any losses that are greater than your winnings are, well . . . lost.
The next important rule is that the losses that you are allowed to deduct must be taken as an itemized deduction on Schedule A. You cannot simply net the loss against the income and claim no gambling income. You must still claim the winnings as income, and then take the itemized deduction.
This rule has two significant consequences. First, your Adjusted Gross Income (AGI) will be increased, possibly affecting your ability to claim other deductions and credits, and potentially affecting your marginal tax rates. Second, if all of your itemized deductions do not add up to be more than the standard deduction, the itemized gambling losses that you could have claimed are worthless to you because you do not have enough total itemized deductions to claim on your return.
Example Luis loves to gamble, but his gaming isn’t very successful. During the year Luis bet $40,000 on various gambling excursions. From those bets he actually won $10,000. Even so, Luis’ total gambling experience for the year was a net loss of $30,000 ($10,000 in winnings – $40,000 in bets = $30,000 in net losses). Luis must claim $10,000 of income from gambling winnings on his tax return. Even though he had $30,000 in losses, the maximum deduction he could possibly take is $10,000 because the deduction for losses cannot be greater than the income he received. Worse yet, Luis doesn’t have any other expenses that qualify as itemized deductions. Since the $10,000 in losses is less than the standard deduction available to Luis and his wife, he is not able to claim any of the losses. He has to claim $10,000 more income for the year, which is not offset by any of the losses, even though he really lost $30,000 during the year! If Luis were in the 25% tax bracket he would actually have to pay $2,500 in taxes on that “income,” even though there wasn’t any real net income at all.
As you can see, when you choose to gamble you may be risking even more money that you put on the betting table. In essence, when you make a bet you are also gambling with your tax bill—and the tax code has pretty good odds at getting its take.
Note There is actually a way to get around some of these rules. To do so, you must qualify as a professional gambler. To qualify you must devote a significant amount of your time to gambling on a regular basis, depend on gambling winnings as a significant source of your income, and keep records in the same way that you would if you were running a business. If you qualify, you will report all of your winnings as income on Schedule C (for businesses) and all of your losses up to (but not greater than) your winnings. In addition, you could deduct other expenses, such as travel, lodging, and meals.
Caution There is a significant downside to claiming the professional gambler designation. By doing so you are claiming gambling as your business, and as such you are required to pay self-employment taxes on your net income. This additional tax may eliminate the benefits of being able to claim losses (from expenses) in bad years.
The tax code treats royalty income in two different ways, depending on the source of the royalty income. The key distinction is whether you perform work in order to receive the income, or if it is simply coming from an investment.
Royalties received from creative work, such as writing, music, art, or inventions are generally considered self-employment income (which means they are taxed at ordinary income rates and are subject to the self-employment tax). To receive this kind of income, you had to perform some kind of work. This kind of royalty income is reported on Schedule C (for business income), which allows for the deduction of expenses from the income. An example of an exception to this rule is if you are receiving royalties from a creative work that you did not create yourself, such as inherited royalties.
Other royalties, such as those from oil, gas, and mineral rights, are considered passive income and are reported on Schedule E (unless you own and operate a well or mine—then it would be employment income).
Just remember that the important factor is not what the income is called (such as “royalty”) but what you had to do to receive that income. If you had to work to get it, then it is probably self-employment income, subject to self-employment tax and reported on Schedule C. If you did not perform any labor to receive a right to the income, then it is probably passive income and reported on Schedule E.
Awards for Legal Damages
There are three types of legal awards that are taxable as ordinary income. The first is any award for “punitive” damages (except for wrongful death damages in states where the only damages allowed are punitive). The second type of taxable legal damages are those awarded for a loss of personal reputation. Finally, any damages that are intended to replace lost income are taxable also.
Income from unemployment benefits is taxed as ordinary income. It is replacing the income that you would have had if you had remained employed, so it is taxable. However, you do not have to pay the payroll taxes on that income that you would have if you had been employed. Although there are no special rules or issues with this income, I have included this brief explanation because I am often asked whether unemployment income is taxable.
Bartering is making a trade with someone without exchanging money. I have often heard people talk about trading products or services with each other as a way to avoid taxes on the exchange. Though it may be hard for the government to track, the tax code is clear that such exchanges are taxable. If I provide tax preparation services for you in exchange for a weekend stay at your vacation home after the busy season, I should recognize income in my business at the value of the services or products that we have exchanged, as you should for the “rental” of your vacation home.