"Your Tax Guide," published in Washington Business last Monday, incorrectly stated that the first $1,000 of a child's unearned income is free of tax. The first $500 is free of tax; the second $500 is taxed at the child's rate. Any unearned income over $1,000 is taxed at the child's or parent's rate, whichever is higher. (Published 3/7/88)
When you have completed all the necessary preliminary information, it's time to get started on the business end of the tax return. You start with the "Income" section -- but not all income is taxable. Nontaxable Income
The first step, therefore, is to go through the income information you have collected and pull out those items that are not subject to federal income tax. But don't discard them; some nontaxable items must still be reported to the IRS or may be required at some point in your calculations. Also, state tax requirements may differ from federal.
Here is a checklist of the major types of nontaxable income: Interest on state and local bonds, and municipal unit trusts and specified dividends from tax-free mutual funds. (But a small amount of these dividends may be taxable; and capital gain dividends -- even from tax-free funds -- are taxable and must be reported.)
Worker's compensation payments for injury or illness.
Disability retirement pay from the armed forces.
Veterans Administration payments.
Military allowances and certain cost-of-living allowances for U.S. civilian employees overseas.
Amounts awarded in a civil suit for damages.
A part of the pay received by U.S. citizens living and working in a foreign country, if they meet certain time and place requirements.
Amounts paid to an employee by an employer for dependent care.
A housing allowance received by a cleric, to the extent used to pay for housing or related expenses.
Gifts and bequests.
Child support payments, but not alimony.
Dividends on a life insurance policy, unless the accumulated total exceeds total premiums paid.
Amounts received for living expenses under a casualty insurance policy after a fire or other disaster, except to the extent such payments exceed normal living expenses.
Lump-sum proceeds from a life insurance policy received because of the death of the insured. Periodic payments generally include an interest component, which may be taxable. The annual $1,000 exclusion of installment interest on payments to a surviving spouse was eliminated by the 1986 tax law.
Some scholarship payments; see IRS Publication 520.
Tax may be deferred until a later date on certain types of income. The principal kinds of tax-deferred income are: Earnings accumulating in most retirement plans, such as an IRA or Keogh account, a 401(k) plan, a tax-sheltered annuity (TSA) or a simplified employee pension (SEP) plan.
Earnings accumulating in an insurance annuity or single payment life
Interest on Series EE savings bonds, if you have elected to defer the tax liability. Taxable Income
Most other types of income must be included on your tax return. But different categories of income are reported in different ways and different places, sometimes on a special form or schedule.
The accompanying table, "Reporting Your Income," lists the principal types of taxable income, tells you where each type is to be reported, and lists the applicable IRS publication. If Form 1040EZ or 1040A is not shown for any entry, you may not use that form but must use the long Form 1040.
Here are special considerations relating to some of the income items listed in Table 2:
Interest income. If you received a Form 1099 showing tax-exempt interest, report the interest on line 2 of Schedule B. A few lines above line 3, print "tax-exempt interest" and show the total of that interest in brackets or circled in the "Amount" column. When you add all the figures in that column, subtract the bracketed or circled amount.
If you purchased a corporate bond during 1987, the broker's confirmation slip probably included a charge for "accrued interest," representing interest for the period between the last interest date and the date of your purchase. This interest belongs to the seller, not the buyer; but on the next interest date you should have received interest for the full six-month period -- and your 1099-INT will reflect that amount.
You are not required to pay tax on that part of the interest that wasn't yours. You eliminate it by the same technique used for tax-free interest: On line 2 include the full amount of interest on the 1099. Then on a lower line print "accrued interest" and show the amount charged to you (on the confirmation slip) in brackets, then subtract the bracketed amount when adding the column.
If you sold your home and took back a mortgage, list the interest component of your installment payments on line 1 of Schedule B, and give the name of the payer. If you hold a zero-interest or low-interest mortgage, a part of each installment payment may be considered "imputed interest" rather than a return of principal. See IRS Publications 545 and 550 for the rules.
Dividends. The annual exclusion of $100 or $200 of dividend income was eliminated by the 1986 tax law.
Mutual funds. Under the 1986 tax law, it was expected that the Form 1099-DIV you received from your mutual fund would include a new income item. The 1986 tax law directed fund sponsors to pass through to each shareholder as a part of total income a proportionate share of certain fees charged, even though those dollars were never distributed.
The shareholder, in turn, was authorized to deduct those fees as investment expense as a part of miscellaneous deductions on Schedule A. Problem: If you don't itemize, you would have been required to report this "phantom" income without a corresponding deduction.
However, the Revenue Act of 1987, enacted near the end of the year, delayed implementation of this provision until 1988, perhaps to give Congress an opportunity to take another look at this controversial issue.
Another change: If the rule does go into effect for 1988 as scheduled, the itemized deduction for shareholders to offset this "phantom" income will be allowed in full, without regard to the 2 percent floor for other miscellaneous expenses.
A 1986 tax law rule that remained effective for 1987 required that a fund distribute virtually all income on a calendar year rather than on a fiscal year basis. As a result, many funds made two capital gain distributions in 1987: the first in the spring, at the end of the fund's normal fiscal year, and the second in late December to close out the calendar year.
Foreign accounts. If you had a foreign account or an interest in a foreign trust during 1987, complete Part III of Schedule B, even if you don't otherwise need Schedule B to report interest or dividends.
Business income. If you used Schedule C and reported $400 or more of net income from self-employment, you must complete and file Schedule SE to determine any liability for Social Security tax, even if tax had already been withheld on the maximum earnings of $43,800 by your employer on another job.
Capital gains and losses. The 1986 tax law eliminated the distinction between long-term and short-term gains and losses. After balancing one against the other, 100 percent of a net loss is deductible against other income, up to a maximum of $3,000 a year. Any net loss over that ceiling may be carried forward to future years.
A net capital gain is reportable in full as income.
However, for 1987 there is a 28 percent tax ceiling on a net gain on assets owned for more than six months. Schedule D, therefore, still splits transactions into short-term and long-term. If your calculations end in a net long-term gain and your income is taxed at a rate greater than 28 percent, complete the alternative computation in Part IV of Schedule D to see if you can reduce your tax.
Remember to enter, on line 1 of Schedule D, the total amounts received on sales of securities, as reported by your broker on Form 1099-B. Then in Parts I and II, show any sales not reported by your broker in separate sections, and attach an explanation of any difference in total sales of securities.
In prior years, if you didn't otherwise need Schedule D, you could report capital gain dividends on a single line on Form 1040. If your marginal tax rate is 28 percent or less, you may still do this, using line 14 of Form 1040 and reporting 100 percent of such gains (not 40 percent as in previous years). But because of the 1987 tax ceiling on long-term gains, if your tax rate is greater than 28 percent you should report capital gain distributions on line 13 of Schedule D, then use Part IV to compute the tax even if you have no other entries for Schedule D.
If you sold securities in the last few days of December, intending to defer reporting until 1988 -- forget it. The "installment sale" method that permitted you to select the tax year in which you reported gains on sales made in the last week of the calendar year has been eliminated. The "trade date" is now the date on which you recognize either a gain or a loss on a securities transaction. Retirement income. If your retirement was effective after July 1, 1986, you are not eligible to use the old "three-year rule." Instead, calculate the ratio between your total contributions to the plan and total annuity payments expected, then apply that ratio to each payment to determine the part that may be excluded from income. The expected payout is based on gender-neutral life expectancy tables in IRS Publication 575, "Pension and Annuity Income."
Prior to this year, once that exclusion ratio was established it remained in effect for life. Under the 1986 tax law, however, if you retired after Dec. 31, 1986, you must keep track of the tax-free accumulation of returned contributions. After you have recovered an amount equal to your total contributions, your entire benefit is taxable. IRA distributions. The 1987 distributions from an IRA are fully taxable. If you don't qualify for a tax-deductible IRA contribution and make an after-tax payment for 1987, future distributions will be partly taxable, partly tax-exempt. Keep a cumulative record of your contributions to avoid paying tax twice on the same dollars. Lump-sum distribution. If you receive a lump-sum payment from your employer's pension or retirement plan (including your own self-employed Keogh plan), you may roll over all or part of the proceeds into an IRA within 60 days and continue to defer tax liability until funds are withdrawn from the IRA. Any part of the distribution that is retained must be reported as income in the year received.
If you do not choose a rollover, you may be able to reduce the tax bite by five-year averaging, using IRS Form 4872, if you had been a participant in the plan for at least five years. If you were at least 50 years old on Jan. 1, 1986, you may instead use the old 10-year-averaging method; but if you go that route, you must compute the tax using the 1986 tax rates instead of the lower current rates. Tax shelters. Under the 1986 tax law, new restrictions are placed on losses (including losses resulting from interest expense and depreciation), deductions and credits generated by passive business activities (activities in which the taxpayer does not materially participate). The new rule limits such losses to the extent of income from other passive activities, so they may not be used to offset income from other sources, such as wages, pensions or interest.
This new rule is phased in over a four-year period for investments already owned on Oct. 22, 1986. For the 1987 tax year, you may claim 65 percent of the previously allowable deductions for tax shelters purchased by that date. The allowable rate drops to 40 percent in 1988, 20 percent in 1989 and 10 percent for 1990, and is fully effective for all passive investments beginning in 1991. But the offset limitation is applicable in full this year for investments bought after the Oct. 26, 1986, cutoff.
Gas and oil partnerships were hit somewhat less severely than other tax shelter investments. Pass-through deductions in working interests may be used to offset unrelated income by an investor whose form of ownership doesn't limit liability. And intangible drilling costs continue to be deductible in full in the year incurred.
Losses, deductions and credits not used in the current tax year may be carried forward without a time limit to future years, where they may continue to be applied until used up -- but still only against passive income in those years. Calculate your allowable deduction from passive activities on new IRS Form 8582.
If you include on your tax return any income, loss, deduction or credit from a registered tax shelter, you must report the shelter registration number -- which should have been provided to you by the sponsor -- on Form 8271, which is then attached to your return. Real estate investments. Investments in real estate fall into two categories. If you buy into a limited partnership that invests in any type of real estate operation, you are governed by the passive income rules above.
But if you actively participate in management of the property, up to $25,000 of net loss (including interest expense and depreciation) may be taken each year against nonpassive income. Generally, you are considered an "active participant" if you have responsibility for such things as selecting prospective tenants, establishing rents, approving major repairs, etc., even if you use a real estate agent for overall management.
But this $25,000 writeoff is income-limited. It begins to phase out when your adjusted gross income hits $100,000, and is completely gone -- at the rate of $1 for each $2 of your adjusted gross income -- at the $150,000 level. Form 8582 is also used for these computations.
Another provision enacted in the 1986 tax law reduced the rate of depreciation you may claim against investment real estate. Instead of the prereform 19-year basis allowed for rental real estate, you must use a depreciation period of 27.5 years for residential property or 31.5 years for commercial property placed in service after 1986. Bartering income. If you engaged in bartering transactions, either on your own or as a member of an organized barter exchange, you must report as income the fair market value of goods and services received from others in exchange for your own. Use Part VII of Schedule D to show the distribution to the various schedules of bartering income reported on Forms 1099-B you received. Scholarships and fellowships. If you received funds under a grant made after Aug. 16, 1986, you may exclude from taxable income only that part that was spent on tuition, books and course-related supplies and equipment. The old, more liberal rules continue to apply to grants made before that date.
In addition, any amounts received in 1987 that represent payment for teaching, research or other services required from you as a condition of receiving the scholarship or fellowship grant should be included as income. See IRS Publication 520. State tax refund. If in 1987 you received a refund of state or local income tax that you had claimed as a Schedule A deduction on a prior year's return, you must report the refund as income to the extent that it reduced your adjusted gross income in that earlier year.
In addition to any cash refund you received, report as income any overpayment of state tax from last year that you asked to have applied to your 1987 tax liability. But in that case, if you itemize this year, be sure to include that amount as a part of your Schedule A deduction, in addition to state tax withheld or paid as estimated tax in 1987. Alimony. Taxable alimony payments received qualify as "earned income" for determining eligibility for IRA contributions. Gambling. Gambling winnings must be reported in full; losses may be claimed as a miscellaneous deduction (not subject to the 2 percent floor) only if you itemize on Schedule A, and only to the extent of total winnings reported. Foreign earned income. The ceiling on the annual exclusion of income earned abroad (by other than government workers) has been reduced by the Tax Reform Act of 1986 to $70,000 from last year's $80,000. Social Security benefits. You may be required to include as taxable income up to half of Social Security and Tier 1 Railroad Retirement benefits received in 1987. Liability is tied to a specially defined gross income figure, beginning at $25,000 for a single taxpayer and $32,000 on a joint return.
But if you're married, lived together at any time during the year and decide to file separate returns, the floor drops to zero for you and your spouse. (If you have not lived together in 1987, you may file separately and use the $25,000 trigger of a single taxpayer.)
Because the principal extra element in computing the special gross income figure for determining this liability is the amount of tax-exempt interest received, you must enter the amount of such interest in the offset box on line 9 of Form 1040. (This figure should also include the 1987 allocation of interest earned on any zero-coupon municipal bonds you own.) But be sure not to include the amount on line 9 in your total income on line 22.
If your calculations on Social Security Form 703 or the worksheet in the IRS 1040 booklet show that you have no tax liability for Social Security or Railroad Retirement benefits, you may use Form 1040A or 1040EZ (if you otherwise qualify). But if any part of these benefits is taxable, you must use the long Form 1040. Unemployment compensation. Beginning this year, the entire amount of unemployment compensation received must be included in taxable income.
The Tax Reform Act of 1986 eliminated the opportunity for a double personal exemption; that is, anyone who may be claimed as a dependent on another's tax return may not also claim a personal exemption on his or her own tax return.
Under the new rules, the first $500 of investment income of a child under 14 is exempt from tax. In addition, such a child may claim only those itemized deductions related to the production of the investment income or a special standard deduction of $500 (whichever is greater).
The practical result is that the first $1,000 of investment income is free of tax, but anything over that amount is now taxable at the highest level possible, either the child's own rate or the parent's top or marginal tax rate. The source of the property generating the income doesn't matter. The income may come from gifts, from accounts established under the Uniform Gifts to Minors Act, from trusts -- or even from assets purchased by the child from his or her own earlier earned income.
There is no "grandfather" clause. Income above the $1,000 floor is subject to the new law even if derived from assets owned prior to enactment. The cutoff date for trusts, discussed in the next section, will not protect the child from this new "kiddie tax."
If the parents file a joint return, the total taxable income on the joint return is used for these calculations. In the case of divorced parents, the child is taxed at the top rate of the parent having custody. The joint return of a custodial parent is used even if the other spouse is not the child's parent. If you're married but file separate returns, the child's tax is based on the rate of whichever parent has the greater taxable income.
If your child is subject to this rule and is required to file a return, the tax is computed on new Form 8615, which must then be attached to the child's return. If the child is too young to sign the return, the parent should sign and write "parent" after his or her signature.
In the event you have more than one child subject to these rules, you figure the "total tentative tax" on the net investment income of all the children taken together. This total tentative tax is then allocated to each child based on the ratio of each child's investment income to the total.
Income from trusts established after March 1, 1986, (and from property transferred into existing trusts after that date) is taxable to the grantor (the person who established the trust) if the trust principal will revert at any time to the grantor or the grantor's spouse.
This new restriction, imposed by the 1986 tax reforms, is aimed primarily at Clifford trusts and spousal remainder trusts, both of which had been favored devices for shifting income -- and thus tax liability -- from a high-rate taxpayer to a family member in a lower tax bracket.
These trust techniques were frequently used to reduce tax liability on funds being accumulated for a child's later college expenses. Although the new trust rules have an effective date in 1986, the date of establishing the trust has no effect at all on the tax liability of a child under 14; as explained above, the kiddie tax rule applies to the child's income from any trust, regardless of date.
SOURCE OF INCOME: ---------- WHERE TO REPORT: ---IRS Publication
Wages or salary ................. 1040 line 7 .............. 525
.................................. 1040 line 6 ..................
.................................. 1040EZ line 1 ................
Business or profession .......... 1040 Schedule C .......... 334
Taxable interest up to $400 ..... 1040 line 8 .............. 550
.................................. 1040A line 7a ................
.................................. 1040EZ line 2................
......... If more than $400, add: 1040 Schedule B ..............
.................................. 1040A Schedule 1 Part II......
Tax-exempt interest ............. 1040 line 9 .............. 550
.................................. 1040A line 7b ................
Dividends up to $400 ............ 1040 line 10 ............. 550
.................................. 1040A line 8 .................
.......... If more than $400, add: 1040 Schedule B...............
.................................. 1040 Schedule 1 Part III .....
Investment income of ............ 1040 Form 8615 ........... 929
.........child under age 14 ....................................
Pension or annuity .............. 1040 line 16 ............. 575
Nontaxable IRA distribution ..... 1040 Form 8606 ........... 590
Lump sum pension distribution.... 1040 Form 4972 ........... 575
Social Security benefits ........ 1040 line 21 ..............915
Rental property ................. 1040 Schedule E and ...... 527
.................................. Form 8582.....................
Partnership ..................... 1040 Schedule E .......... 541
Estate or trust ................. 1040 Schedule E .......... 559
Farm ............................ 1040 Schedule F .......... 225
Installment sale ................ 1040 Form 6252 ........... 537
Taxable state tax refund ........ 1040 line 11 ............. 525
Unemployment compensation ....... 1040 line 19 ............. 525
.................................. 1040A line 9 .................
Alimony ......................... 1040 line 12 ............. 504
Bartering ....................... 1040 line 21 ............. 525
Advance earned income credit .... 1040 line 53 ............. 596
................................. 1040A line 20 ................
Gambling, lottery, contest ...... 1040 line 21 ............. 525
Capital gain (loss) ............. 1040 Schedule D .......... 544
Capital gain distribution ....... 1040 Schedule D line 13 .. 544
Sale of residence ............... 1040 Form 2119 ........... 523
Commodity futures gain (loss) ... 1040 Form 6781 ........... 550