Your liability for filing a tax return and paying income tax is derived primarily from your filing status and the amount of your income for the year. However, not all income is subject to tax, and the various kinds of taxable income are handled differently.
Today's column explains briefly the different kinds of income and tells how to report each kind. For those items where the rules are quite complex or may not be of general interest, the pertinent IRS publication is cited.
The following kinds of income are not subject to federal income tax and should not be reported on your tax return. (State rules vary in some instances, so be sure to riview Sunday's article carefully before beginning your state return.)
Social security benefits.
Veterans Administration payments to veterans and their families or survivors.
Gifts or bequests (but there may be a liability for gift or estate tax).
Lump-sum insurance benefits received by a beneficiary on the death of the insured (but these payments may be subject to estate or inheritance tax).
TAX TIP: Life insurance proceeds received in the form of periodic payments generally include some interest in addition to the insurance portion. The interest component is taxable income to the recipient.
But if you're a surviving spouse receiving installment payments of insurirance proceeds following the death of your husband or wife, up to $1,000 a year of this interest may be excludable (even if you remarry). See IRS Publication 525 for details.
Interest earned on state or municipal bonds, and specified dividends from tax-free mutual funds.
Scholarship grants (with limitations).
Military allowances and certain cost-of-living allowances for U.S. civilians employed overseas.
Workmen's compensation or Federal Employe's Compensation Act payments for injury or illness.
Payments made by certain employers (primarily public school systems) on your behalf to a qualified taxdeferred annuity retirement plan.
The value of parsonage provided to a clergyman, or a rental allowance paid in lieu of a home.
Campaign contributions (unless diverted to personal use).
Payments received by foster parents for care of a child in their home (except any amount in excess of actual expenses).
Reimbursement from your employer for out-of-pocket costs of business travel not in excess of actual expenses, including flat-fee reinbursement of up to $44 a day in per diem or 17 cents a mile for travel (if you accounted for the travel to your employer).
WAGES OR SALARY
By Jan. 31, your employer should have provided you with a Form W-2, in severl copies, on which has been entered the amount of wages, salary, commissiopns or other payments made to you, and the total federal and state income tax and social security contributions withheld from your pay during 1978.
If the information is correct, you need only transfer the figures for wages and income tax withheld to the appropriate lines of Form 1040 or 1040A, and attach Copy B of the Form W-2 to your return.
TAX TIP: The various fringe benefits provided to many employes may or may not be taxable income. Your employer should be familiary with the rules and should include or exclude the value of these benefits on your W-2 as required. If you want to look it up yourself, get a copy of IRS Publication 525, "Taxable Income and Nontaxable Income."
Cash tips received in the course of your employment are subject to income tax, and in addition may be counted towards social security contributions and later benefits. If you regularly receive tips, you should have a copy of Publication 531 for reporting instructions.
If you operated a business or profession, either full or part-time, use Schedule C to report gross income and expenses. As noted earlier, the free IRS book "Tax Guide for Small Business" provides much useful information on record-keeping and taxation.
A legitimate loss from a business may be deducted from income from other sources, thus, reducing your net tax liability.To qualify, the business must have been conducted with the expectation of producing income, rather than as a hobby.
TAX TIP: The IRS generally applies a "two-of-five" rule to determine profit-making intent. That is, the Service expects you to have shown a profit in two of the last five years to qualify as a bona fide business. If you don't meet this test, you may cite special circumstances; and application of the test may be deferred for a new business.
In addition to Schedule C, if your income from self-employment was $400 or more, you must complete Schedule SE to determine any liability for social security tax on those earnings.
If you had a salaried job subject to social security withholding, you need only pay social security tax (identified as "FICA Tax" on the W-2) on the first $17,700-the 1978 ceiling on covered earnings.
But if you had $400 or more in earnings from self-employment, you must file Schedule SE to show the calculations even though the maximum amount of social security tax may already have been withheld.
TAX LIMIT ON EARNED INCOME
The maximum tax on earned income (wages, salary, tips, professinal fees, etc.) for 1978 cannot exceed 50 percent regardless of the amount of the earnings.
TAX TIP: "Earned income" refers to all income from "personal services" -- specifically including retirement pay, employment-related taxable pensions and annuities, and various forms of deferred compensation, as well as current wages or salary.
Income from the investment of capital (rents and royalties, some capital gains, interest and dividents) is not protected by the ceiling and may be subject to the maximum individual tax rate of 70 percent.
If the normal method of computing your tax imposes a rate greater than 50 percent on only portion of your income which is "earned," use form 4726 to calculate the lower maximum tax.
TAX TIP: You should check this provisision if you were single or married filing separately and your taxable earnings for 1978 exceeded $40,200; or was greater than $55,200 if you are married and filing a joint return.
Report as income any interest earned on bank, credit union and savings and loan accounts; on loans, notes, and mortgages; on insurance dividends left on deposit (but not the dividends themselves) and on corporate -- but not state or municipal -- bonds or notes.
Also report interest on U.S. savings bonds cashed during the year, if not previously reported; on Series E bonds still held if you had elected to report the interest annually; on other U.S. obligations such as Series H bonds. Treasury bills, etc.; and the interest on any tax refunds from the IRS or your state received during 1978 for overpayments or errors in previous years.
TAX TIP: if you converted Series E to Series H bonds during the year, you need not report interest on the Series E bonds until the Series H bonds mature or are disposed of (except to the extend of any cash received on the exchange). But the semi-annual interest on the H-bonds is income in the year received.
Interest must be reported as income whether actually received by you in cash or "constructively" received -- that is, credited to your account at a savings institution on Dec. 31 must be reported as income for 1978 even if not entered in the passbook until sometime in 1979.
If you redeem a certificate of deposit from a savings institution before the maturity date, a substantial interest penalty is imposed by law (unless redemption was due to the death or disability of the certificate owner).
However, the savings institution must show the full amount of interest earned by the certificate on the Form 1099-INT issued to you for your tax records. The amount of the penalty is shown separately on the same form.
Do not balance one against the other to get the net amount. Instead, you must include as interest income the gross interest earned, then deduct the amount of forfeited interest by entering it on line 26 of Form 1040. (You may not use 1040A if you are reporting a CD penalty.)
Thus your adjusted gross income includes only the net amount of interest received -- but you get there by entering both the gross interest and the penalty or forfeiture in two different places on your return.
If total interest received during the year is $400 or less, simply show the total on either Form 1040 (line 9) or 1040A (line 8). If it adds up to more than $400, you must use Form 1040 and itemize the amount of interest from each source on Schedule B.
Like interest income, ordinary dividends tends totaling $400 or less need only be entered in sum on either tax form. If the total is more than $400, you must use 1040 and list each source and amount on Schedule B.
In either case, subtract from the full amount any capital gains or nontaxable dividends received, plus up to $100 for qualifying dividends paid by U.S. corporations.
This exclusion increase up to $200 on a joint return if each spouse had independent dividend income of at least $100, or if the securities were held in joint ownership. Only the balance, if any, after subtracting the exclusion is taxable.
A dividend identified as "non-qualifying" by the payer is not eligible for and may not be reduced by this $100 (or $200) exclusion.
A dividend which is a return of capital is normally not taxable as income, but must be used instead to reduce the cost basis of the stock.
Similarly, a stock dividend is usually not taxable; but the original cost must be spread over the total number of shares owned after the dividend.
Capital gains dividends, usually received from mutual funds, are normally reported on Schedule D rather than as dividends. But if schedule D is not otherwise needed, you may simply enter half of the total capital gains dividends on line 15 of Form 1040. (If you have capital gains of any kind you may not use 1040A.)
TAX TIP: "Tax-free" mutual funds may pass through to shareholders nontaxable interest earned by the fund. Watch for such a pass-through on the Form 1099 issued by the fund, and do not report tax-free interest on your federal return. But capital gains from portfolio transactions are taxable even if derived from the sale of municipal bonds.
If you have a share account in a savings and loan association, "dividends" received on your shares are really interest payments and should be reported as such.
A "dividend" on a life insurance policy is not a true dividend, but rather a refund of previously paid premiums. Such a dividend should not be reported as income unless the accumulated total of dividends received exceeds the total net premiums paid (a rare case).
PENSIONS AND ANNUITIES
Taxable income from pensions to which you did not contribute (including military retirement pay) should be reported on line 17 of Form 1040.
Federal civil service retirees and others covered by retirement plans to which both employer and employe contributed, and from which the employe's total contribution is recoverable within three years, may exclude annuity payments from income until an amount equal to that contribution has been received.
If your pension payments qualify for exclusion under this "three-year rule," a statement should have been issued to you when you retired specifying the number of dollars you had contributed during your working years.
Income from qualifying contributory plans from which your total contribution had not yet been recovered is reported in Part I of schedule E. But if you had recovered your entire cost before Jan. 1, 1978, then the full amount received is taxable and should be reported on line 17 of the 1040.
If you received annuity or retirement payments from a contributory plan not covered by the three-year rule, then a portion of each payment is nontaxable, based on total cost and your life expectancy at the time of the first payment.
TAX TIP: Once established at retirement, the ratio of taxable to nontaxable income doesn't change (even though the dollar amounts might) so you don't have to recompute the percentage each year.
Disability retirement pay from the armed forces is nontaxable and should not be reported; normally it is not included on the W-2 issued by the service. Similarly, a disablity pension from the Veterans Administration is not taxable income.
The exclusion of "sick pay" of up to $5,200 of the taxable part of disability pay is not authorized unless you were under 65 on Dec. 31, 1978, and were either 100 percent disabled at retirement or were eligible for disability retirement in any degree and were 100 percent disabled on Jan. 1 of either 1976 or 1977.
If you qualify for the sick pay exclusion under these rules, the amount allowed must be reduced dollar-for-dollar by the excess over $15,000 of adjusted gross income (line 19 of Form 1040). Use Form 2440 for the exclusion.
INCOME FROM RENTAL PROPERTY
Rental income is reported in Part II of Schedule E (unless you're in the realty business). If you need more space for listing expenses or have several pieces of rental property, use the more convenient Form 4831 and carry the totals to the corresponding lines and columns of Schedule E.
If you own property which you rent for part of the time and use yourself at other times, there are restrictions on the deductions allowed for expenses.
If the property was rented for less than 15 days during the year, do not use Schedule E and do not report the rental income at all. But only taxes, interest and casualty losses are deductible, and then only if you itemize.
If the property was rented for 15 days or more, use Schedule E to report the income and expenses. In that case:
If the property was used by you (or any relative) for 15 days or more or for ten percent or more of the total number of days it was rented (whichever is greater), you may deduct all interest, taxes and casualty losses; but you may only claim other expenses up to the amount of income remaining after those three items are subtracted.
But if the amount of personal or family use was less than these ceilings, you may claim all operating expenses (including depreciation) without an income limitation.
SALE OF PROPERTY
Profit or loss from sale of property such as real estate, stocks or bonds (other than property used in a business) is called a capital gain or loss, and is normally accounted for on Schedule D.
If you sold property in 1978 which you had owned for 12 months or less, any gain or loss is considered "short term" and is counted in full as an addition to or a subtraction from other income.
The sale of property owned for more than 12 months may give rise to a "long term" gain. If the sale took place before Nov. 1, 1978, then half of any gain is includable in income for the year.
But if the sale occurred after Oct. 31, then 60 percent of any gain is excluded, and only the remaining 40 percent is taken into account as income.
If you sustained a loss on the sale of property owned for more than 12 months, you can count 50 percent of the loss against other income regardless of the date of sale. The Revenue Act provides and improved tax break on gains while leaving the loss provisions intact.
Because of the mid-year changeover date and the difference between the handling of gains and losses, the capital gains calculations are rather tricky. Schedule D for 1978 is designed to handle the various split-year possibilities -- but it is complicated, so be sure to read the line-by-line instructions carefully.
TAX TIP: If you sold property on the installment plan, the capital gains portion of payments received after Oct. 31, 1978 qualifies for the 60 percent exclusion even if the sale itself took place before Nov. 1.
If you have a net loss after consolidating all capital gains and losses, you may deduct a maximum of $3,000 (up from $2,000) last year) from other income.
Any excess over $3,000 may be carried forward to subsequent years until used up, either by deduction from future income or by offset against future capital gains. Show the calculations for this carryover to next year on page 2 of Schedule D.
A non-business bad debt which became uncollectible during 1978 -- a personal "bad debt" -- is treated as a shortterm capital loss. But it must represent an actual out-of-pocket loss; you may not claim as a bad debt a payment you didn't get which was due you for services.
If you owned securities which became worthless during the year, they are considered to have been sold for "zero" dollars on Dec. 31, 1978, for the purpose of determining whether the loss is shortterm or long-term.
TAX TIP: If you received property as a gift or bequest, the cost basis for determing gain or loss on sale may not be the actual cost. See IRS publication 551 for detailed instructions.
SALE OF YOUR HOME
Profit on the sale of your personal residence is a capital gain; but a loss is never deductible. The amount of gain can be reduced by adding to the original purchase price certain of the closing costs and the cost of any permanent (capital) improvements; and by deducting selling expenses from the sales price.
Normally the tax on any gain must be deferred if you buy another personal residence costing as much as the selling price of the old home, and occupy it within 18 months before or after the sale. The gain on which the tax is deferred is applied to reduce the cost basis of the new residence.
If you build a new home, construction must begin before the sale of the old residence or within 18 months after sale; and you must occupy the new home as your principal residence within 24 months.
TAX TIP: In the event of a divorce or separation and the sale of a jointlyowned residence, either owner may qualify independently for the tax deferral if he or she bought a new residence. The amount of gain on which tax is deferred is based on his or her share of the proceeds from sale of the old home.
If you sell the newly purchase home and in turn replace it before the end of the original 18-month period, only the more recently purchased home qualifies for tax deferral. Any gain on the intervening sale must be reported as income.
TAX TIP: The Revenue Act of 1978 waives this rule for a sale made after July 26, 1978 if the multiple sale/purchase activity resulted from a job relocation which qualifies for deduction of moving expenses.
If you sold your home at any time before July 27, 1978 and you were 65 or older on the date of the sale, part or all of the gain may be excludable from income. To qualify, you must have owned and occupied the home as your principal residence for at least five of the eight years immediately preceding the sale.
If the sale took place after July 26, 1978 there is a much more liberal exclusion. In the first place, the age restriction has been lowered: You must have reached the age of 55 by the date of the sale.
The ownership-residence requirement has been changed to three of the past five years. And if you qualify, you can exclude up to $100.000 of gain realized on the sale.
If you were 65 or older on the date of sale and can't meet the new three-of-five rule, you may elect instead to use the five-of-eight rule for sales made at any time up to July 26, 1981.
In the case of a jointly owned residence, the tax saving is available if either co-owner had reached the required age of 55 (or 65) by the date of sale.
TAX TIP: Keep in mind the precautionary note in Sunday's column.This exclusion may only be used once in a lifetime -- so don't squander it on a small gain if you are likely to sell a new principal residence later for a larger gain, or if tax can be deferred because you have bought a new and higher-priced residence.
Here's a checklist of other types of reportable income, and where each goes on your tax return:
Alimony or separate maintainence payments (but not child support): line 12, Form 1040.
State income tax refunds (but only if you claimed the tax paid as an itemized deduction in a prior year): line 11, form 1040.
Income (or loss) from farming: Schedule F.
Any gambling winnings, lottery or bingo prizes: line 20, Form 1040.
TAX TIP: Gambling losses may be deducted on Schedule A if you itemize, but only up to the amount of winnings reported as income.
Income from a partnership, estate or trust: Part III of Schedule E.
TAX PREFERENCE LOSSES
A minimum tax is imposed on selected forms of income which would otherwise escape taxation. The minimum tax is 15 percent of net tax preference income after the application of specified exclusions.
Tax preference income includes stock options; certain types of accelerated depreciation, depletion and amortization; the excluded portion of net-long-term capital gains; and itemized deductions (excluding medical expenses and casualty losses) in excess of 60 percent, but not over 100 percent, of adjusted gross income.
TAX TIP: The excluded part of recognized capital gain on sale of your residence prior to July 27, 1978 is tax preference income, but not if tax on the gain is deferred because of purchase of a new home. And if you sold your residence after July 26, 1978 the 50 (or 60) percent of recognized but excluded capital gain on the sale is not a preference item.
If you had tax preference income of $10,000 or more ($5,000 if married filing separately), you must complete Form 4625 to determine if there is any tax due. Form 4625 must be attached to your return to show the calculations even if no tax liability results.