Does a Cash Overdraft Kill Tax Deductions at the End of The Year?

Cash Overdraft Treatment For Tax Purposes

Here’s a recent story of a taxpayer that I think you will find of interest.

I have a cash-basis calendar-year client who on December 31, 2018, wrote and mailed $5,000 in checks for 2018 expenses. With this activity, his books showed a $9,000 negative cash book balance.

His December 31, 2018, bank statement shows a positive balance of $15,000.

Outstanding checks totaling $24,000 make up the difference.

The client has $50,000 available in a line of credit that he could have borrowed, but did not. His bank account does not have automatic overdraft protection. 

What answers would you give to the following questions:

1. Can he claim the deduction for the $5,000 of checks he wrote on December 31 and the others that were written when his books showed negative cash?

2. What are the deciding factors such as the line of credit and overdraft protection?

3. If overdraft-paid expenses are deductible, how do I show the result on the balance sheet in the S corporation tax return? Negative cash as asset, overdraft as liability, or increase the line of credit?

4. If he can’t deduct $5,000 or, say, even $9,000, do I increase the book cash to show a zero balance and reduce expenses by $5,000?

Here’s how this works:

1. If the checks are honored, the monies are deductible.

2. If the checks are not paid because of insufficient funds, the courts have disallowed the expenses.

In the S corporation balance sheet, use zero for cash and report the overdraft in the current liabilities section and title it “cash overdraft” or “checks written in excess of cash balance.”

There’s no room for this title on the 1120S tax return balance sheet, so label it in a statement attached to the return.

I found this interesting and thought you would, too.

Get a Free Tax Savings Consultation

Pinewood Consulting’s CPAs will help you assess your tax savings potential through a free consultation. Book yours today with Chad Pavel, CPA.

Converting Your Home Into a Rental Property: Tax Issues

Converting Your Home Into a Rental Property

The simple maneuver of converting your personal residence to a rental property brings with it many tax rules, mostly good when you know how they work.

The first question that arises when you convert a personal residence into a rental is how to determine the property’s tax basis for depreciation purposes during the rental period and for gain/loss purposes when you eventually sell.

Oddly enough, two different basis rules apply: 

1. If, after conversion to a rental, you sell at a gain, your basis on the conversion date is the usual computed amount (cost of home plus improvements, minus depreciation—such as from a home office).

2. If, after conversion to a rental, you sell at a loss, your basis on the conversion date is the lesser of the computed basis or the fair market value.

Once you’ve converted a former personal residence into a rental, you must follow the tax rules for landlords. Here is a quick summary of the most important things to know:

• You can deduct mortgage interest and real estate taxes on a rental property.

• You can also write off all the standard operating expenses that go along with owning a rental property: utilities, insurance, repairs and maintenance, yard care, association fees, and so forth.

• Finally, you can also depreciate the cost of a residential building over 27.5 years, even while it is (you hope) increasing in value.

Rental Real Estate Losses

If your rental property throws off a tax loss, things can get complicated.

The so-called passive activity loss (PAL) rules will usually apply. In general, the PAL rules allow you to deduct passive losses only to the extent you have passive income from other sources, such as positive income from other rental properties or gains from selling them.

Eventually your rental property should start throwing off positive taxable income instead of losses, because escalating rents will surpass your deductible expenses. Of course, you must pay income taxes on those profits. But if you piled up suspended passive losses in earlier years, you now get to use them to offset your passive profits.

Prior Losses Can Offset Future Positive Income

Another nice thing: positive taxable income from rental real estate is not hit with the dreaded self-employment (SE) tax, which applies to most other unincorporated profit-making ventures. The SE tax rate can be up to 15.3 percent, so it’s a wonderful thing when you don’t have to pay it.

One other good thing is that your net rental profits may qualify for the Section 199A deduction.

Another good thing is that if your rental property rises to the level of a trade or business, your rental profits avoid getting socked with the 3.8 percent net investment income tax (NIIT).

Taxes When Selling Rental Real Estate

When you sell a rental property that you’ve owned for more than one year, the profit (the difference between the net sales proceeds and the tax basis of the property after subtracting depreciation deductions during the rental period) is generally treated as a long-term capital gain.

Always keep in mind the good news here. You don’t pay the taxes on the property appreciation until you sell.

Remember those suspended passive losses we mentioned above? The suspended losses are ordinary losses. When you sell a rental, you can find two great benefits: 

1. Gains are tax-favored capital gains.

2. And then, to the extent of your gains, you release suspected passive losses that offset ordinary income.

Avoid Paying Taxes on Real Estate Capital Gains

And always keep this in mind: rental real estate owners can avoid taxes indefinitely using Section 1031 exchanges (named after the applicable section of our beloved Internal Revenue Code).

The tax code totally mislabeled the 1031 exchange. It’s absolutely not an exchange or a swap. It works like this:

1. You sell your property.

2. You buy a new, more expensive property.

3. Your Section 1031 exchange intermediary (such as a bank) handles the paperwork, and that makes the taxes go away.

If you are considering converting your home into a rental property and would like my advice on the conversion, please contact me below.

Get a Free Tax Savings Consultation

Pinewood Consulting’s CPAs will help you assess your tax savings potential through a free consultation. Book yours today with Chad Pavel, CPA.