Limitations on the Mortgage Interest Deduction

Limitations on the Mortgage Interest Deduction

By William Perez,         Jul 30 2009

Dollar Limitations for the Mortgage Interest Deduction

The amount of mortgage interest you can deduct each year is limited. There is one limit for loans used to buy or build a residence — called “home acquisition debt.” And there is another limit for loans not used to buy or to build a residence — called home equity debt. All loans, whether secured by your main home or your second home, are subject to the same overall limitations.

Home Acquisition Debt

You may not deduct interest on more than $1,000,000 of home acquisition debt for your main home and secondary residence. Home acquisition debt means any loan whose purpose is to acquire, to construct, or substantially to improve a qualified home. The limit is reduced to $500,000 if you are married filing separately1.

For example, you borrowed $800,000 against your primary residence and $400,000 against your secondary residence. Both loans were used solely to acquire your residences. The loan amounts add up to $1,200,000. Since your loan amount exceeds the $1 million limit for home acquisition debt, your mortgage deduction is limited. Let’s say both loans have a fixed interest rate of 6% and your total interest paid for the year was $72,000. You would only be able to deduct $60,000, which is the interest on the first $1 million of home acquisition debt. Use the worksheet on page 9 of Publication 9362 to calculate your allowable mortgage deduction.

Home Equity Debt

You may not deduct interest on more than $100,000 of home equity debt for your main home and secondary residence.

Home equity debt means any loan whose purpose is not to acquire, to construct, or substantially to improve a qualified home, or any loan whose purposes was to substantially improve a qualified home but exceeds the home acquisition debt limit. The home equity debt limit is reduced to $50,000 if you are married filing separately3. Your deduction for home equity interest may be reduced even below the $100,000 limit if your indebtedness exceeds the fair market value of your home. See the “home equity debt4” section of IRS Publication 936.

Interest paid on home equity debt is an adjustment for the Alternative Minimum Tax5 (AMT). You should understand whether you will be able to deduct interest on a home equity line of credit before your borrow. You can figure the AMT adjustment for home equity debt using the Home Mortgage Interest Adjustment Worksheet on page 2 of the Instructions for Form 62516 (PDF, 10 pages).

For example, you borrowed $300,000 in a home equity line of credit, and the amount you borrowed did not exceed the fair market value of your house. You used $150,000 to add a new family room to your house. You spent the remaining $150,000 to pay for college tuition. Half of the loan is treated as home acquisition debt (the amount used to substantially improve your home). The other half is treated as home equity debt (the amount not used to improve your home). You would be able to deduct interest only up to the $100,000 limit on home equity debt portion of the loan. Assuming you paid $21,000 interest on the loan, the amounts you can deduct would break down like this:

$10,500 – Fully deductible home acquisition debt (half the loan)
$ 7,000 – Deductible home equity debt (two-thirds of the home equity portion of the loan)
$ 3,500 – Non-deductible home equity debt (the interest paid on the home equity debt exceeding $100,000)

In addition, this taxpayer would have to report $7,000 as an AMT adjustment on Form 6251.

Jointly Held Mortgages

You are entitled to deduct only the interest that you paid, regardless of which person receives Form 1098 for the joint loan. The IRS provides specific instructions for deducting interest not reported to you on Form 1098 and for allocating interest among two or more borrowers. See the “How to Report7” section of IRS Publication 936.

Co-borrowers who make payments to prevent foreclosure can deduct the interest paid, even if the interest was supposed to be paid by someone else. The editors of JK Lasser’s Your Income Tax8 pass along this inside tip:

“The Tax Court has allowed a joint obligor to deduct his or her payment of another obligor’s share of the mortgage interest if the payment is made to avoid the loss of property, and the payment is made with his or her separate funds.” (page 328)

Home Construction Loans

You can deduct interest on mortgages used to pay construction expenses. The proceeds must be used to acquire the land and for construction of the home. Expenses incurred in the 24 months before construction was completed counts toward the $1,000,000 limit on home acquisition debt.

Note that if you deduct interest on a construction loan for two years and then decide to sell the property rather than to use it as a residence, you may have to restate your returns for the years you deducted the interest and recharacterize the interest as investment interest, which may limit its deductibility. In other words, the IRS may want some money back.


Points paid on acquisition debt for primary and secondary residences are fully deductible in the year they are paid. However, points paid on refinancing must be amortized over the life of the loan. See the “Points9” section of Publication 936. Points may not always be reported on Form 1098, Mortgage Interest Statement, from the lender. In some cases you may find points reported on your HUD-1 closing statement.

When to Seek the Help of a Tax Professional

For most taxpayers, figuring out the home mortgage interest deduction is straight-forward. Add up the interest paid as reported to you on Form 1098, and put that total on your Schedule A. However, it is always a good idea to check with a tax professional if you bought or sold property during the year. In fact, it would make sense to seek the advice of a tax pro before you buy or sell real estate, so you can get a handle on the tax consequences of your decision.

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EDUCATION Credits, Deductions and Non-taxable benefits


American Opportunity Credit

Under the American Recovery and Reinvestment Act (ARRA), more parents and students will qualify over the next two years for a tax credit, the American opportunity credit, to pay for college expenses.

The American opportunity credit is not available on the 2008 returns taxpayers are filing during 2009. The new credit modifies the existing Hope credit for tax years 2009 and 2010, making it available to a broader range of taxpayers, including many with higher incomes and those who owe no tax. It also adds required course materials to the list of qualifying expenses and allows the credit to be claimed for four post-secondary education years instead of two. Many of those eligible will qualify for the maximum annual credit of $2,500 per student.

The full credit is available to individuals whose modified adjusted gross income is $80,000 or less, or $160,000 or less for married couples filing a joint return. The credit is phased out for taxpayers with incomes above these levels. These income limits are higher than under the existing Hope and lifetime learning credits.

Special rules apply to a student attending college in a Midwestern disaster area. For tax-year 2009, only, taxpayers can choose to claim either a special expanded Hope credit of up to $3,600 for the student or the regular American opportunity credit.

If you have questions about the American opportunity credit, these questions and answers might help. For more information, see American opportunity credit.

Hope Credit

The Hope credit generally applies to 2008 and earlier tax years. It helps parents and students pay for post-secondary education. The Hope credit is a nonrefundable credit. This means that it can reduce your tax to zero, but if the credit is more than your tax the excess will not be refunded to you. The Hope credit you are allowed may be limited by the amount of your income and the amount of your tax.

The Hope credit is for the payment of the first two years of tuition and related expenses for an eligible student for whom the taxpayer claims an exemption on the tax return. Normally, you can claim tuition and required enrollment fees paid for your own, as well as your dependents’ college education. The Hope credit targets the first two years of post-secondary education, and an eligible student must be enrolled at least half time.

Generally, you can claim the Hope credit if all three of the following requirements are met:

  • You pay qualified education expenses of higher education.
  • You pay the education expenses for an eligible student.
  • The eligible student is either yourself, your spouse or a dependent for whom you claim an exemption on your tax return.

You cannot take both an education credit and a deduction for tuition and fees (see Deductions, below) for the same student in the same year. In some cases, you may do better by claiming the tuition and fees deduction instead of the Hope credit.

Education credits are claimed on Form 8863, Education Credits (Hope and Lifetime Learning Credits). For details on these and other education-related tax breaks, see IRS Publication 970, Tax Benefits of Education.

Lifetime Learning Credit

The lifetime learning credit helps parents and students pay for post-secondary education.

For the tax year, you may be able to claim a lifetime learning credit of up to $2,000 ($4,000 for students in Midwestern disaster areas) for qualified education expenses paid for all students enrolled in eligible educational institutions. There is no limit on the number of years the lifetime learning credit can be claimed for each student. However, a taxpayer cannot claim both the Hope or American opportunity credit and lifetime learning credits for the same student in one year. Thus, the lifetime learning credit may be particularly helpful to graduate students, students who are only taking one course and those who are not pursuing a degree.

Generally, you can claim the lifetime learning credit if all three of the following requirements are met:

  • You pay qualified education expenses of higher education.
  • You pay the education expenses for an eligible student.
  • The eligible student is either yourself, your spouse or a dependent for whom you claim an exemption on your tax return.

If you’re eligible to claim the lifetime learning credit and are also eligible to claim the Hope or American opportunity credit for the same student in the same year, you can choose to claim either credit, but not both.

If you pay qualified education expenses for more than one student in the same year, you can choose to take credits on a per-student, per-year basis. This means that, for example, you can claim the Hope or American opportunity credit for one student and the lifetime learning credit for another student in the same year.


Tuition and Fees Deduction

You may be able to deduct qualified education expenses paid during the year for yourself, your spouse or your dependent. You cannot claim this deduction if your filing status is married filing separately or if another person can claim an exemption for you as a dependent on his or her tax return. The qualified expenses must be for higher education.

The tuition and fees deduction can reduce the amount of your income subject to tax by up to $4,000. This deduction, reported on Form 8917, Tuition and Fees Deduction, is taken as an adjustment to income. This means you can claim this deduction even if you do not itemize deductions on Schedule A (Form 1040). This deduction may be beneficial to you if, for example, you cannot take the lifetime learning credit because your income is too high.

You may be able to take one of the education credits for your education expenses instead of a tuition and fees deduction. You can choose the one that will give you the lower tax.

Generally, you can claim the tuition and fees deduction if all three of the following requirements are met:

  • You pay qualified education expenses of higher education.
  • You pay the education expenses for an eligible student.
  • The eligible student is yourself, your spouse, or your dependent for whom you claim an exemption on your tax return.

You cannot claim the tuition and fees deduction if any of the following apply:

  • Your filing status is married filing separately.
  • Another person can claim an exemption for you as a dependent on his or her tax return. You cannot take the deduction even if the other person does not actually claim that exemption.
  • Your modified adjusted gross income (MAGI) is more than $80,000 ($160,000 if filing a joint return).
  • You were a nonresident alien for any part of the year and did not elect to be treated as a resident alien for tax purposes. More information on nonresident aliens can be found in Publication 519, U.S. Tax Guide for Aliens.
  • You or anyone else claims an education credit for expenses of the student for whom the qualified education expenses were paid.

Student-activity fees and expenses for course-related books, supplies and equipment are included in qualified education expenses only if the fees and expenses must be paid to the institution as a condition of enrollment or attendance.

Student Loan Interest Deduction

Generally, personal interest you pay, other than certain mortgage interest, is not deductible on your tax return. However, if your modified adjusted gross income (MAGI) is less than $70,000 ($145,000 if filing a joint return), there is a special deduction allowed for paying interest on a student loan (also known as an education loan) used for higher education. Student loan interest is interest you paid during the year on a qualified student loan. It includes both required and voluntary interest payments.

For most taxpayers, MAGI is the adjusted gross income as figured on their federal income tax return before subtracting any deduction for student loan interest. This deduction can reduce the amount of your income subject to tax by up to $2,500 in 2008.

The student loan interest deduction is taken as an adjustment to income. This means you can claim this deduction even if you do not itemize deductions on Schedule A (Form 1040).

Qualified Student Loan

This is a loan you took out solely to pay qualified education expenses (defined later) that were:

  • For you, your spouse, or a person who was your dependent when you took out the loan.
  • Paid or incurred within a reasonable period of time before or after you took out the loan.
  • For education provided during an academic period for an eligible student.

Loans from the following sources are not qualified student loans:

  • A related person.
  • A qualified employer plan.

Qualified Education Expenses

For purposes of the student loan interest deduction, these expenses are the total costs of attending an eligible educational institution, including graduate school. They include amounts paid for the following items:

  • Tuition and fees.
  • Room and board.
  • Books, supplies and equipment.
  • Other necessary expenses (such as transportation).

The cost of room and board qualifies only to the extent that it is not more than the greater of:

  • The allowance for room and board, as determined by the eligible educational institution, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student, or
  • The actual amount charged if the student is residing in housing owned or operated by the eligible educational institution.

Business Deduction for Work-Related Education

If you are an employee and can itemize your deductions, you may be able to claim a deduction for the expenses you pay for your work-related education. Your deduction will be the amount by which your qualifying work-related education expenses plus other job and certain miscellaneous expenses is greater than 2% of your adjusted gross income. An itemized deduction may reduce the amount of your income subject to tax.

If you are self-employed, you deduct your expenses for qualifying work-related education directly from your self-employment income. This may reduce the amount of your income subject to both income tax and self-employment tax.

Your work-related education expenses may also qualify you for other tax benefits, such as the tuition and fees deduction and the Hope and lifetime learning credits. You may qualify for these other benefits even if you do not meet the requirements listed above.

To claim a business deduction for work-related education, you must:

  • Be working.
  • Itemize your deductions on Schedule A (Form 1040 or 1040NR) if you are an employee.
  • File Schedule C (Form 1040), Schedule C-EZ (Form 1040), or Schedule F (Form 1040) if you are self-employed.
  • Have expenses for education that meet the requirements discussed under Qualifying Work-Related Education, below.

Qualifying Work-Related Education

You can deduct the costs of qualifying work-related education as business expenses. This is education that meets at least one of the following two tests:

  • The education is required by your employer or the law to keep your present salary, status or job. The required education must serve a bona fide business purpose of your employer.
  • The education maintains or improves skills needed in your present work.

However, even if the education meets one or both of the above tests, it is not qualifying work-related education if it:

  • Is needed to meet the minimum educational requirements of your present trade or business or
  • Is part of a program of study that will qualify you for a new trade or business.

You can deduct the costs of qualifying work-related education as a business expense even if the education could lead to a degree.

Education Required by Employer or by Law

Education you need to meet the minimum educational requirements for your present trade or business is not qualifying work-related education. Once you have met the minimum educational requirements for your job, your employer or the law may require you to get more education. This additional education is qualifying work-related education if all three of the following requirements are met.

  • It is required for you to keep your present salary, status or job.
  • The requirement serves a business purpose of your employer.
  • The education is not part of a program that will qualify you for a new trade or business.

When you get more education than your employer or the law requires, the additional education can be qualifying work-related education only if it maintains or improves skills required in your present work.

Education to Maintain or Improve Skills

If your education is not required by your employer or the law, it can be qualifying work-related education only if it maintains or improves skills needed in your present work. This could include refresher courses, courses on current developments and academic or vocational courses.

Savings Plans

529 Plans Expanded

Tax-free college savings plans and prepaid tuition programs can be used to buy computer equipment and services for an eligible student during 2009 and 2010. These 529 plans — qualified tuition programs authorized under section 529 of the Internal Revenue Code — have, in recent years, become a popular way for parents and other family members to save for a child’s college education. Though contributions to 529 plans are not deductible, there is also no income limit for contributors.

529 plan distributions are tax-free as long as they are used to pay qualified higher education expenses for a designated beneficiary. Qualified expenses include tuition, required fees, books, supplies, equipment and special needs services. For someone who is at least a half-time student, room and board also qualify.

For 2009 and 2010, the ARRA change adds to this list expenses for computer technology and equipment or Internet access and related services to be used by the student while enrolled at an eligible educational institution. Software designed for sports, games or hobbies does not qualify, unless it is predominantly educational in nature. In general, expenses for computer technology are not qualified expenses for the American opportunity credit, Hope credit, lifetime learning credit or tuition and fees deduction.

States sponsor 529 plans that allow taxpayers to either prepay or contribute to an account for paying a student’s qualified higher education expenses. Similarly, colleges and groups of colleges sponsor 529 plans that allow them to prepay a student’s qualified education expenses.

Coverdell Education Savings Account

This account was created as an incentive to help parents and students save for education expenses. Unlike a 529 plan, a Coverdell ESA can be used to pay a student’s eligible k-12 expenses, as well as post-secondary expenses. On the other hand, income limits apply to contributors, and  the total contributions for the beneficiary of this account cannot be more than $2,000 in any year, no matter how many accounts have been established. A beneficiary is someone who is under age 18 or is a special needs beneficiary.

Contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax free until distributed. The beneficiary will not owe tax on the distributions if they are less than a beneficiary’s qualified education expenses at an eligible institution. This benefit applies to qualified higher education expenses as well as to qualified elementary and secondary education expenses.

Here are some things to remember about distributions from Coverdell accounts:

  • Distributions are tax-free as long as they are used for qualified education expenses, such as tuition and fees, required books, supplies and equipment and qualified expenses for room and board.
  • There is no tax on distributions if they are for enrollment or attendance at an eligible educational institution. This includes any public, private or religious school that provides elementary or secondary education as determined under state law. Virtually all accredited public, nonprofit and proprietary (privately owned profit-making) post-secondary institutions are eligible.
  • Education tax credits can be claimed in the same year the beneficiary takes a tax-free distribution from a Coverdell ESA, as long as the same expenses are not used for both benefits.
  • If the distribution exceeds qualified education expenses, a portion will be taxable to the beneficiary and will usually be subject to an additional 10% tax. Exceptions to the additional 10% tax include the death or disability of the beneficiary or if the beneficiary receives a qualified scholarship.

For more information, see Tax Tip 2008-59, Coverdell Education Savings Accounts.

Scholarships and Fellowships

A scholarship is generally an amount paid or allowed to, or for the benefit of, a student at an educational institution to aid in the pursuit of studies. The student may be either an undergraduate or a graduate. A fellowship is generally an amount paid for the benefit of an individual to aid in the pursuit of study or research. Generally, whether the amount is tax free or taxable depends on the expense paid with the amount and whether you are a degree candidate.

A scholarship or fellowship is tax free only if you meet the following conditions:

  • You are a candidate for a degree at an eligible educational institution.
  • You use the scholarship or fellowship to pay qualified education expenses.

Qualified Education Expenses

For purposes of tax-free scholarships and fellowships, these are expenses for:

  • Tuition and fees required to enroll at or attend an eligible educational institution.
  • Course-related expenses, such as fees, books, supplies, and equipment that are required for the courses at the eligible educational institution. These items must be required of all students in your course of instruction.

However, in order for these to be qualified education expenses, the terms of the scholarship or fellowship cannot require that it be used for other purposes, such as room and board, or specify that it cannot be used for tuition or course-related expenses.

Expenses that Don’t Qualify

Qualified education expenses do not include the cost of:

  • Room and board.
  • Travel.
  • Research.
  • Clerical help.
  • Equipment and other expenses that are not required for enrollment in or attendance at an eligible educational institution.

This is true even if the fee must be paid to the institution as a condition of enrollment or attendance. Scholarship or fellowship amounts used to pay these costs are taxable.

For more information, see Pub. 970.

Exclusions from Income

You may exclude certain educational assistance benefits from your income. That means that you won’t have to pay any tax on them. However, it also means that you can’t use any of the tax-free education expenses as the basis for any other deduction or credit, including the Hope credit and the lifetime learning credit.

Employer-Provided Educational Assistance

If you receive educational assistance benefits from your employer under an educational assistance program, you can exclude up to $5,250 of those benefits each year. This means your employer should not include the benefits with your wages, tips, and other compensation shown in box 1 of your Form W-2.

Educational Assistance Program

To qualify as an educational assistance program, the plan must be written and must meet certain other requirements. Your employer can tell you whether there is a qualified program where you work.

Educational Assistance Benefits

Tax-free educational assistance benefits include payments for tuition, fees and similar expenses, books, supplies, and equipment. The payments may be for either undergraduate- or graduate-level courses. The payments do not have to be for work-related courses. Educational assistance benefits do not include payments for the following items.

  • Meals, lodging, or transportation.
  • Tools or supplies (other than textbooks) that you can keep after completing the course of instruction.
  • Courses involving sports, games, or hobbies unless they:
    • Have a reasonable relationship to the business of your employer, or
    • Are required as part of a degree program.

Benefits over $5,250

If your employer pays more than $5,250 for educational benefits for you during the year, you must generally pay tax on the amount over $5,250. Your employer should include in your wages (Form W-2, box 1) the amount that you must include in income.

Working Condition Fringe Benefit

However, if the benefits over $5,250 also qualify as a working condition fringe benefit, your employer does not have to include them in your wages. A working condition fringe benefit is a benefit which, had you paid for it, you could deduct as an employee business expense. For more information on working condition fringe benefits, see Working Condition Benefits in chapter 2 of Publication 15-B, Employer’s Tax Guide to Fringe Benefits.,,id=213044,00.html?portlet=6

Taking Advantage of the 2010 ROTH IRA CONVERSION Rule

Trade-Offs In A Roth IRA Conversion

Donald Jay Korn    Friday July 31, 2009, 6:25 pm EDT

Deciding whether to convert a traditional IRA to a Roth IRA involves trade-offs. If you convert, you pay tax much sooner than you need to. But conversion can cut your overall tax on your retirement account.

People whose modified adjusted gross income (MAGI) in 2009 will be $100,000 or less face a second decision. If you convert, should you do it now or wait until 2010?  In 2010 a unique but temporary tax break will be available: Roth IRA conversions will be available to taxpayers regardless of Modified Adjusted Gross income, and the taxable income can be divided evenly between 2011 and 2012 returns.

Even if your MAGI is over $100,000 this year, you may need to know the choices so you can advise lower-income children or parents.

First, is a Roth IRA conversion desirable?

You’ll owe income tax on all the untaxed money in the traditional IRA you’re converting. After conversion, all Roth IRA withdrawals can be tax-free. (after five years and after you’re age 591/2).

You’ll never have to take required minimum distributions. RMDs are generally required from a traditional IRA once you hit age 701/2.

In the past, Roth IRA conversions were available only to taxpayers with MAGI of $100,000 or less. That cap will be removed in January. In 2010  anyone with a traditional IRA can convert to a Roth IRA — the first chance for many high-income taxpayers to own a Roth. High income taxpayers generally have been barred from starting Roth IRAs from scratch, too. Eligibility for contributions to a Roth in 2009 phases out for a single taxpayer with MAGI of $105,000 to $120,000. For marrieds filing jointly, phaseout is $166,000- $176,000.

To encourage Roth conversions in 2010 and boost tax collections, Congress created a one-year tax break.

Typically, the income tax from a Roth IRA conversion is due for the year of the conversion. For Roth IRA conversions in 2010 the resulting income can be divided evenly between your 2011 and 2012 tax returns.

Tax Tactic

Say a hypothetical Jim Wilson converts a $300,000 traditional IRA to a Roth IRA in 2010.

So Wilson has $300,000 of taxable income from the conversion. He can report that $300,000 on his 2010 tax return.

Or Wilson can report nothing for 2010. If so, he’ll report $150,000 of that income on his 2011 return. Then he’ll report the other $150,000 on his 2012 tax return.

That brings up the second decision, which faces taxpayers with MAGI of $100,000 or less this year. If you’d like to do a Roth conversion, should you do it now or in January 2010?

The case for doing it now.

Despite the recent rally, many IRA balances are still depressed. The less you have in your IRA, the less tax you’ll owe on a conversion.  After a Roth IRA conversion, any subsequent appreciation can be tax-free. But from today’s low levels, it’s likely that a recovering stock market will drive IRA values higher. So the sooner you convert, the less money that’s likely to be hit by tax.

If you don’t convert until 2010, you may owe more tax on a larger IRA. Market rallies can be fast. The S&P 500 was already up 48% off its March 6 low, going into Friday (7/31/09).

And what if Congress hikes tax rates? If you wait until 2010 to convert, planning to defer the taxable income until 2011 and 2012, you might owe tax at higher rates.

What’s more, converting any time in 2009 starts the five-year clock for tax-free withdrawals back at Jan. 1 of this year.

The case for waiting.

By waiting a few months, you’ll lock in years of tax deferral.

If you convert in January 2010, you can start to enjoy tax-free appreciation right away. Yet you’ll get two and three years of tax deferral because you can delay the final tax payment until 2013, when you file your 2012 return.

Given those choices, how should you proceed? “If a Roth IRA conversion seems attractive now, do it,” said attorney Natalie Choate, with Boston’s Nutter McClennen & Fish.

And if a 2009 Roth IRA conversion turns out to be a faulty move, you can change your mind. A conversion this year can be recharacterized — as the IRS calls a reversal — until Oct. 15, 2010.

Suppose Jim Wilson converts his $300,000 IRA to a Roth in 2009. Let’s say that by October 2010 stocks have soared, and the Roth IRA is worth $400,000. Wilson can leave his Roth IRA in place, with $100,000 of tax-free gains.

But suppose stocks plunge, and Wilson’s IRA falls to $200,000. By Oct. 15, 2010, he can tell his IRA custodian he wants to recharacterize.

After filing an amended return, Wilson will get back any tax he paid on the 2009 conversion. He’ll have a $200,000 traditional IRA.

If he wishes, after waiting 31 days Wilson can convert that $200,000 traditional IRA to a Roth IRA in late 2010. He’ll owe less tax than he owed on the 2009 conversion because of the smaller account size and he’ll be able to defer the tax obligation until 2011 and 2012.

2010 Roth IRA Conversions

Back in May of 2006 there was a pretty significant change to the tax laws involving converting a traditional IRA to a Roth IRA.  In the year 2010 everyone can convert their traditional IRAs to a Roth IRA – and that’s an opportunity that not everyone had in the past.

In this article we’re going to talk about the Roth IRA conversion rule change that goes into effect in 2010.  We’re also run through some of the strategies that individuals can use to take advantage of this change, starting today.

Roth IRA Conversion Rules

Under the current tax law for Roth IRA conversions – which was written in 1997 – individuals were permitted to convert a traditional IRA to a Roth IRA.  There were only two stipulations that taxpayers had to worry about – paying taxes on the converted money and an income limit which determined eligibility to convert.

Converting an IRA to a Roth

With a traditional IRA money can be placed into the account on a pre-tax (tax deductible) and after-tax basis.  That investment is allowed to grow on a tax-deferred basis until withdrawn in retirement.

If an individual wanted to convert a traditional IRA to a Roth IRA they had to pay federal income taxes on any pre-tax contributions as well as any growth in the investment’s value.  After all, once converted to a Roth, all of the investment could now be withdrawn on a tax-free basis in retirement.

Income Limits on Conversions

Unfortunately, that same 1997 tax law also contained a provision limiting who could make a conversion.  Upper income taxpayers – those with adjusted gross incomes of more than $100,000 – whether single or married were not eligible to make such a conversion.

In addition, if you earned $110,000 or more ($160,000 for married joint filers) then you also weren’t eligible to contribute to a Roth IRA.  These two tax laws effectively precluded upper income taxpayers from enjoying the benefits of a Roth IRA.  They couldn’t convert their traditional IRA to a Roth, and they could fund one either.

IRA Conversions in 2010

But back in May of 2006 President Bush signed a $70 billion tax cut provision that changed the eligibility rules for Roth IRA conversions.  Starting in 2010, taxpayers with modified adjusted gross income of more than $100,000 will be allowed to convert a traditional IRA to a Roth IRA.  This change applies to all years beyond 2010 – and the income taxes due on the 2010 conversion can be spread over two years.  So the 2010 conversion amount may be included as taxable income in 2011 and 2012 – helping to spread out the tax bite.  Conversions in subsequent years are included in income during the tax year in which the conversion is completed.

Removing the Roth IRA conversion cap however doesn’t mean anyone can fund a Roth IRA, but it does mean that anyone can convert an existing IRA to a Roth IRA.

Taking Advantage of the 2010 Rule

Fortunately there is a way for all taxpayers – regardless of income – to take advantage of this change in the tax code:

Start Funding a Traditional IRA Right Now!

Even if you don’t qualify to make Roth IRA contributions or traditional IRA contributions on a before-tax basis, you can still make after-tax contributions to a traditional IRA.  If you invest in a non-deductible IRA in the tax years 2006 through 2010, then you can convert those IRAs to Roth IRAs in 2010.

Most investors shy away from making non-deductible contributions to an IRA because they are not tax deductible, the investment growth is fully taxable, and because they are subject to minimum distribution rules they offer only a minimal tax shelter.  But by converting these non-deductible IRAs to Roth IRAs in 2010 many of those disadvantages disappear.

Roth IRA Conversion Examples

There is one important rule to keep in mind when it comes to converting a traditional IRA to a Roth IRA – you need to pay federal income taxes on any portion of the conversion that you haven’t already paid taxes on.

Example 1

For example, let’s say you started to fund traditional IRAs in 2006 and by 2010 you’ve got $20,000 in your account.  Furthermore, let’s say this account consisted of four years of $4,000 non-deductible contributions – a total of $16,000 in non-deductible contributions and $4,000 in account growth.

In this example, you’d need to pay income taxes on the $4,000 in fund growth when you convert to a Roth IRA.  But the good news is you’ll never have to pay income taxes on this account again.

Example 2

In this second example, let’s assume that you funded the that same traditional IRA with before-tax dollars – meaning you were able to take a deduction on your tax return for the money placed in the traditional IRA.

In this example, you haven’t paid income taxes on any of the money in the account, so when you convert it to a Roth IRA taxes are owed on the entire account balance.  In this case you’d have to pay income taxes on all $20,000 in your fund.

Example 3

If you have an existing traditional IRA (with tax-deductible contributions) and you start to fund a non-deductible IRA, then you need to be aware that tax rules state that any conversion is done on a pro-rata basis.  Let’s say you had $100,000 in a regular IRA and you had $25,000 in a non-deductible IRA.

If you wanted to convert $25,000 to a Roth, then you’d owe taxes on $20,000 because the pro-rata share of your non-deductible contributions is only $5,000.

Deciding to Fund a Roth IRA

While it might be very exciting for some individuals to learn that they can use this 2010 law to convert an IRA to a Roth IRA, it’s important to mention that Roth IRAs are not for everyone.  Before converting you might want to read our article dedicated to explaining the differences between a Roth IRA and a Traditional IRA.  You might also want to run through some what-if scenarios using our Roth versus Traditional IRA calculator.

It’s always best to make an informed decision and if you ever have a question about what’s right in your particular situation it might be a good idea to consult with a tax professional before deciding if taking advantage of the rule change in 2010 is right for you.

“hobby-loss rule” vs profit-seeking business

IRS Seeking To Tax Your Hobby

William P. Barrett   07/10/09 	 5:30 PM ET

At a time when the federal government is desperate for revenue, the Internal Revenue Service has issued a new manual to help its agents ferret out taxpayers improperly writing off the costs of hobbies.

The latest “audit technique guide” covers the application of what is known informally as the “hobby-loss rule.” This is the Internal Revenue Code provision–Section 183–that prohibits taxpayers from reducing their taxable income through losses generated from activities conducted primarily for personal pleasure, rather than as a profit-seeking business.

The effort to focus on hobby losses is the latest in a series of IRS initiatives scrutinizing taxpayers’ side ventures. The agency has solicited comments on how to implement a new law requiring payment card companies to report sales from taxpayers selling goods over eBay.

The new hobby loss manual, which can be viewed online here (,,id=208400,00.html), contains a long list of hobbies that the IRS deems as red flags. It includes horse and dog breeding, yacht chartering, airplane leasing, gambling, photography, fishing, stamp collecting, bowling, writing and farming.

A 2007 report by the Treasury Inspector General for Tax Administration suggested that improper hobby loss claims cost the feds billions of dollars a year in tax revenues. But the manual itself acknowledged that historically, sorting out hobby losses “has been a difficult issue to pursue.”

While the manual is intended to help IRS agents detect wrongdoing, it also provides taxpayers with a wealth of information and tips on how to pursue a hobby with the best chance of getting Uncle Sam to pick up part of the tab.

The hobby-loss rule comes into play primarily when a taxpayer claims a loss on his tax return’s Schedule C (or, if for farming, on Schedule F) for a questionable activity and that loss is then used to offset other taxable income–like from a day job or investments. What can draw the most IRS scrutiny are claims of big losses for several years in a row.

Tax rules stipulate that there is a presumption the activity is legitimate if it shows a profit, no matter how small, in three of the past five years (two years out of seven for horse breeding). One strategy taxpayers might use to fulfill this requirement is to bunch expenses together to produce three years of small profits and two years of large losses.

Keeping good records and operating in a businesslike manner can go a long way toward convincing agents the pursuit is a vocation rather than an avocation. For instance, the IRS manual tells agents to ask during a face-to-face interview if there is an existing written business plan for the activity, suggesting taxpayers would be well advised to develop one at the outset. Agents also are instructed to ask if the activity has its own bank account–something taxpayers would do well to set up before the IRS begins asking for records.

The manual specifies questions that the IRS agent should ponder: “Are there activities with large expenses and little or no income? Are losses offsetting other income on the return? Does the activity result in a large tax benefit to the taxpayer? Does the history of the activity show that it is generating any profit in any years?”

IRS regulations list nine factors that agents are to weigh in evaluating a hobby-loss situation. Among them: the manner in which the activity is carried out, the expertise of the taxpayer, the time and effort involved and “elements of personal pleasure or recreation.” The manual provides plenty of guidance for taxpayers on how to address these issues.

Under the IRS’s interpretation of the hobby-loss rule, revenue and expenses from separate, unrelated activities cannot be combined unless the undertakings are “sufficiently interconnected.” Stated factors to be considered include the “degree of organizational and economic interrelationships of various undertakings.” The manual says a taxpayer’s characterization of what constitutes a single activity will be accepted unless it is “artificial and cannot be reasonably supported.” Translation: You’re probably not going to be too successful in convincing an IRS agent that a race horse owned Upstate is part of a New York City delivery business.

Besides consulting internal, super-secret IRS databases with cryptic names like IRDS, CFOL and YK-1, the manual counsels examiners to research taxpayers on the Internet using Google and Yahoo. Information found, the manual states, “should be compared with the taxpayer’s return.” So creation of a Web site touting the activity as a business and soliciting customers could work to the taxpayer’s advantage.

The IRS seems particularly obsessed with yacht chartering. One of the few case studies in the manual lists 25 documents that should be requested of taxpayers claiming related deductions, including copies of any promotional materials used to solicit charter business.

If admonitions in the manual are any indication, the IRS has had a problem with indignant agents. “An examiner should not tell a taxpayer that, because he is involved in a particular business activity, it is not possible to make a profit and his/her losses are thereby disallowed” the manual states. “Each taxpayer is entitled to be evaluated by a fair, impartial examiner.”

At one point the manual suggests that agents attempt an end-run around tax advisers that a taxpayer might bring to an audit interview. “Direct the questions to the taxpayer,” it states.

Convincing Uncle Sam To Subsidize Your Hobby

Bunch up expenses

IRS rules presume that a side activity is a legitimate business endeavor, rather than a hobby, if it shows a profit in three of the last five years. Try to incur expenses in a way that shows small profits in three years and large losses in the other two.

Write a business plan

The IRS manual says the existence of a reasonable “formal written business plan” drafted at the outset of an activity can be a favorable factor in regarding deductions as legitimate.

Operate like a business

Maintaining good records, getting a state sales tax identification number and opening a separate bank account can be evidence of intent to run a business and show a profit.

Display personal expertise

It will help your bid to deduct those Vegas gambling losses if you can document your long wagering experience and continuing efforts to improve your knowledge, such as buying books and taking courses on mathematics and risk.

Put in the hours

The more time and effort you devote to the activity, the greater your chance of convincing IRS agents you hope to make a buck from it. Keep a written log of your activities.

Make it one big ball of wax

IRS rules state that revenues and expenses from separate side activities–say bowling and dog breeding–cannot be combined unless they are “sufficiently interconnected.” The manual states that a taxpayer’s declaration should be given some weight, especially if supported with evidence of joint economic purpose or conduct. For instance, a taxpayer might be able cast himself as a lecturer on both topics.

Have an Internet presence

Since IRS agents are advised to research taxpayers on the Internet, creating a Web site promoting your activity as a business can work in your favor.

Let your tax adviser do the talking

The manual slyly suggests that during a face-to-face audit interview with a taxpayer and his tax adviser, IRS agents direct their questions to the taxpayer–who might not know the most tax-appropriate answer and whose answer might hurt the cause. Rather than playing along, politely refer queries to your hired help.

Act in good faith

If what you’re doing is truly just a hobby from which your sole return is personal pleasure, stop right there. It’s probably not worth the effort and potential risks to save what in many cases is pocket change.

Tax Payment Options

IRS tax tips

April 8, 2009

Payment Options

If you cannot pay the full amount of taxes you owe by the April deadline, you should still file your return by the deadline and pay as much as you can to avoid penalties and interest. There are also alternative payment options to consider:

  • Additional Time to Pay Based on your circumstances, you may be granted a short additional time to pay your tax in full. The IRS is sometimes able to allow a brief additional amount of time to pay in order to facilitate tax debt repayment. A brief additional amount of time to pay can be requested through the Online Payment Agreement application at or by calling 800-829-1040. Taxpayers who request and are granted an additional 30 to 120 days to pay the tax in full generally will pay less in penalties and interest than if the debt were repaid through an installment agreement over a greater period of time.
  • Installment Agreement You can apply for an IRS installment agreement using our Web-based OPA application on This Web-based application allows taxpayers who owe $25,000 or less in combined tax, penalties and interest to self-qualify, apply for, and receive immediate notification of approval. You can also request an installment agreement before your current tax liabilities are actually assessed by using OPA. The OPA option provides you with a simple and convenient way to establish an installment agreement and eliminates the need for personal interaction with IRS and reduces paper processing.
  • Pay by Credit Card or Debit Card You can charge your taxes on your American Express, MasterCard, Visa or Discover credit cards. Additionally, you can pay by using your debit card. However, the debit card must be a Visa Consumer Debit Card, or a NYCE, Pulse or Star Debit Card. To pay by credit card or debit card, contact one of the service providers at its telephone number or Web site listed below and follow the instructions. There is no IRS fee for credit or debit card payments, but the processing companies charge a convenience fee or flat fee. If you are paying by credit card, the service providers charge a convenience fee based on the amount you are paying. If you are paying by debit card the service providers charge a flat fee of $3.95, do not add the convenience fee or flat fee to your tax payment.

For more information about filing and paying your taxes, visit the IRS Web site at and choose “1040 Central” or refer to the Form 1040 Instructions or IRS Publication 17, Your Federal Income Tax. You can download forms and publications at or request a free copy by calling toll free 800-TAX-FORM (800-829-3676).


Phyllis Smith and Evelyn Dixon are available to prepare (or amend) your tax return

If you’re not sure your tax return was prepared correctly at your OLD tax preparation firm, or just need to speak to an experienced tax professional – call Phyllis Smith or Evelyn Dixon at 636-240-1511.  If you get an IRS notice – don’t panic and don’t delay – just give us a call.  We can unravel any errors and draft your response to an IRS correction notice.  We can also help estimate next year’s tax based on your projections of income and deductions so that you can more accurately make decisions about your withholding or estimated payments.