Disaster Scenario

First of all, I want to send my prayers, condolences and best wishes to those in the Deep South who have been ravaged by an unprecedented series of natural disasters from tornadoes to massive flooding.  Have courage and rely on your faith and each other to get through this.

It’s probably not surprising that as a tax guy, this morning I found myself thinking about the Casualty, Disaster, & Theft Loss tax deduction that is available to taxpayers on Schedule A of the federal Form 1040.  Can it help in this situation?  Sort of.

As I often tell my clients, the Casualty, Disaster &Theft tax deduction is something I hope they will never need.  Qualifying for the deduction isn’t easy because the IRS doesn’t allow the deduction for comparatively minor losses, so qualifying means that you’ve taken a serious and really significant financial hit during the course of the year.

For openers, any loss that you might experience – such as damage from a tornado or a flood – must be an uninsured loss.  You can’t claim the deduction for losses to the extent that you are being compensated by somebody else because, at least in the financial sense of the word, you haven’t really experienced a loss.  So if replacing the hail-damaged roof of your house is going to cost $15,000 and your insurance will pay the whole thing, you don’t have a deductible loss.

On the other hand, if you experienced $20,000 in flood damage and your insurance specifically excludes flooding (and many policies do – check yours today) then you have a $20,000 loss that is potentially deductible. If your insurance only paid a portion of the damages, then the portion not covered by insurance is also a potentially deductible loss.

Potentially.

Potentially.  Because here’s the catch – you’re not going to be able to claim the whole amount.  Let’s say that your car was stolen and subsequently wrecked.  To calculate your deductible loss, you would take the Fair Market Value of your car on the date it was stolen and then subtract from that amount whatever you received from the insurance company in addition to any amount that you received from the salvage company that towed your wrecked car to the junk yard.

After you deduct the amount of any insurance compensation and salvage value, you then deduct $100 from the remaining balance (don’t ask me how or why the IRS settled on this figure) and then you deduct 10% of your Adjusted Gross Income that appears on from Line 37 of your Form 1040.

And that’s what makes qualifying for the Casualty, Disaster, & Theft tax deduction so difficult.  It’s the reduction by 10% of your AGI that will most likely take “routine” losses off the table for the purpose of receiving a tax deduction.  If your Adjusted Gross Income is $75,000, it would take an uninsured loss of more than $7,600 (10% of your AGI plus $100) before you could even start counting your losses against your income. 

All of which is not to say that people don’t sometimes suffer catastrophic losses like what we’ve seen in Mississippi and Alabama this week.  What happens then?  Let’s use this scenario:

Your home and its contents are insured for $150,000.  A tornado basically destroys everything, and the claims adjuster places the total loss at $300,000.  You receive a check for $150,000 from the insurance company and are able to salvage $5,000 worth of property from the wreckage, so you have a total casualty loss of $145,000. 

Your Adjusted Gross Income for the year was $80,000 and so that reduces your deductible loss by $8,000.  Combine that with the $100 IRS-designated reduction, the amount you can claim on your Schedule A for a Casualty, Disaster & Theft loss is $136,900.  

Now with only $80,000 in Adjusted Gross Income and $136,900 in deductible losses (that’s not including the usual itemized deductions for income taxes paid and so forth), clearly you’re not going to owe any taxes this year because your deductions are greater than your income.  What’s more, the IRS will allow you to carry back these losses up to five years.

What does that mean?  Let’s say that your modified Adjusted Gross Income – this is your AGI minus other itemized deductions and exemptions – comes to $60,000 for the year and you have a $136,900 casualty deduction.  Subtract the $60,000 from the $136,900 and you have zero taxable income for the year, along with $76,900 left over.  This is what’s called a Net Operating Loss or NOL.

You can then carry that Net Operating Loss back to the previous year and amend your tax return to claim this as a loss for the previous year.  All things being equal, you’re probably not going to owe any taxes for the previous year and will get back whatever you had originally paid.  If there’s still a remaining Net Operating Loss, you can carry it back to the next preceding year until you’ve used up the entire amount.  

In the scenario I’ve described, you would realize a savings on your taxes of a less than $20,000 when all is said and done – the actual amount will depend on a host of other factors that would effect your final tax liability.  That’s a good thing, of course, and after a disaster you need whatever help you can get.  But it hardly makes up for the loss of your house and all your belongings.

So as I said earlier, I’m glad that the Casualty, Disaster & Theft tax deduction is out here, but I pray that you’ll never need it.

Thanks for reading.

Filing an Extension? Here's What To Do!

It’s that time of year.  The snow has melted and the flowers are starting to bloom.  And now the tax deadline is looming and you’re just not ready to file.

Maybe this is the year that you file an extension, so let’s talk about that today.

The first thing you have to understand is that filing for an extension on IRS Form 4868 does not give you an extension of time to pay your tax liability.  If you need more time because you owe the IRS big bucks and you just don’t have the money, an extension isn’t going to help you, but more on that later.

People typically file an extension when they have business or investment interests that require more time to calculate gains and losses for the year.  Another common reason to file an extension is because you’re living outside the United States or serving in combat as a member of the armed forces (but those have special rules that we’ll talk about in a future blog).  

In order to file an extension, you have to complete your annual tax return to the extent that you have actual data available, and then use your best estimate for everything else.  The safest thing to do with regard to those best estimates is to use last year’s data, unless you know for certain that there are going to be significant changes.  In any case, filing an estimate really does require you to complete a “draft” version of your tax return and pay what you owe.

So you file the Form 4868 and send in your estimated tax payment, and then you file a complete tax return sometime before October 15^th.  But that’s for when you owe money to the IRS.  Can you use the Form 4868 to claim a refund?

Three Words: Not Bloody Likely.

Actually, it’s really just one word: No.

The IRS and most states expect you to file a return by the April 15^th deadline regardless of whether you owe a tax liability or you expect a refund. However, there are no penalties for filing late when you have a refund coming, and although the IRS will never say this out loud, if you have a refund coming, they don’t care if you never file your tax return.  They’re happy to keep your refund, thank you very much.

OK.  So that’s what you do when you need more time to file your return.  But what about when you owe the IRS thousands in tax liability but just don’t have that kind of money?  The most common response from taxpayers is to not file a return, under the mistaken impression that the IRS can’t collect the balance due until you actually file.

Wrong, wrong, and wrong!

Not only can the IRS collect from you, they’re going to collect a heck of a lot more because of the penalties-and-interest smack down you’re about to experience.  Failing to file a tax return (when there’s a balance due) results in a penalty of 5% of the balance due each month, up to 25% of the total.  So if you owe the IRS $5,000 and wait until December 31 to fess up, your Tax Liability + Penalty = $6,250.  But that’s not the end of it.

There is a monthly penalty for Failure to Pay a tax return that is separate from the Failure to File penalty.  Failure to Pay is .5% each month for as long as it takes you to file a return.  In the example above, you’d be paying an additional $25 per month, so by New Year’s Eve you’d be on the hook for an additional $200.  Now we’re up to $6,450.

Ah, but that’s not the end of it.  In addition to the penalties, the IRS also charges you interest of 4% on your balance due.  In this case, if you didn’t file and pay your return until the end of the year, the interest would be an additional $175, so your grand total would be $6,625 on a $5,000 tax liability.

The lesson?  File your tax return even if you can’t pay.  

As you can see from the example above, the biggest hit one takes is from Failure to File penalty.  The Failure to Pay penalty and the interest are small potatoes by comparison.  What’s more, the IRS will allow you to work out a payment plan that will avoid the Failure to Pay penalty altogether.  

So if you file on time and request a payment plan, all you pay is the interest, which at 4% is really pretty reasonable.  Try getting that deal from your credit card company.

Tax Filing Day is April 18^th – Don’t Forget!

After the 18th, I’m out of here for some well-deserved time off, but I’ll be back with new tax and finance topics in May.  If you have any tax questions or need assistance, you can e-mail me at jeffrey.ritchie@yahoo.com.

Thanks for reading!

Another Day Older and Deeper In Debt?

There’s no denying that it’s been a rough couple of years.  In my practice I’ve assisted more clients with bankruptcies and foreclosures since the downturn started about three years ago than I have in my entire career.  I’ve worked with people who’ve been hit with everything except the proverbial kitchen sink, and they’ve got the lumps to prove it.

So let’s talk about debt and how to deal with it, because even though the economy is showing some signs of life, I think we’re far from out of the woods, and many people are still struggling from the loss of income.

Financial burdens can suck the joy out of life.  Massive debt is emotionally oppressive and casts a shadow over just about everything else in your life.  So it’s not surprising that many people deal with debt issues by ignoring the mound of unpaid bills and hoping that somehow it will all just go away.

But that’s just about the worst thing you can do. 

Looking at all the financial horror stories I’ve witnessed over the past three years, they all have one common element, and that’s time.  The fact is that when you’re investing your money, time and compound interest can work wonders.  But when you owe money, time and compound interest can wreak havoc.  So that’s my first bit of advice for dealing with your debt burden:  Don’t procrastinate.  Start doing something to get your debt under control, and start doing it today.

The next thing you should do is understand the types of debt that you have, because not all debts are equal.  Secured Debt is any debt that is backed by collateral, something of value the creditor can seize if you default on your debt.  We’re talking mostly about mortgages and car loans.  Unsecured Debt is any debt that is not backed by collateral, so your creditor is taking a much bigger risk when loaning you money.  Bigger risk means higher interest rates.  That would be your credit card or the line of credit so generously offered by your bank.

So all other things being equal, the debts that you want to pay off first are your unsecured debts, starting with the one with the highest interest rates – and don’t forget to factor in the late fees that creditor may charge when you get behind.  Whichever one is costing you the most is the one you want to attack first.  Save your mortgage or other secured debts for later.

To deal with unsecured debt, the best place to start is by negotiating with your creditors. Banks don’t want you to declare bankruptcy and they don’t want you taking your balance to somebody else (especially if it means closing your old account). To prevent losing business, creditors are sometimes willing to offer lower rates or even settle debts for a lump sum payment less than what you currently owe.

Creditors know perfectly well that a host of competitors offer cards with low introductory rates and that their customers are not going to pay 20% (or more) indefinitely. Call the customer service desk of your current high-interest credit card and simply inform them that you’d like a lower rate – and it doesn’t hurt to tell them about the great offer you just received in the mail from the other guys.

If they’re not willing to bring the rate down, fill out the paperwork and transfer your balance. But be warned, these low rates can get pretty steep once the introductory period expires, so be disciplined in making payments on the balance regularly to eliminate the debt as quickly as possible.  This is a “grace period” where you can eliminate one of your debts, so use the opportunity wisely.

Lump sum settlements are a little harder to find, but it’s not impossible. In this case, you contact the credit card company offer to pay $5,000 cash to settle your $10,000 debt. Now it’s highly unlikely that the creditor will accept an offer like that, but just as with any other negotiation, you start low and meet somewhere in the middle. If the creditor is willing to play ball, you could take thousands off the balance and thousands more off the interest you’d be paying over time.

But now the question becomes, where can you scratch together the money to pay the lump sum?

Now if you have a large, high-interest credit card balance and some semi-liquid assets like an IRA, it might actually make good financial sense to take the tax hit for cashing out a portion of the IRA in order to pay off the debt. Now this is not something I recommend lightly, so make sure you run the numbers to make sure it’s to your advantage.

To make this determination, figure the tax consequences of taking money out of your IRA – and don’t forget the 10% penalty in addition to the tax liability based on your tax bracket. Then compare the tax consequences to the interest that will be paid on the credit card debt – the website bankrate.com has a handy calculator that can help make this calculation.

If you’re just making the minimum payment required by the credit card company, you’ll likely find that the interest you’re paying on the debt could be two or three times what you actually owed in the first place – and far less that the tax liability you’ll incur from the one-time raid on your retirement savings.

But here’s the thing. Don’t do this until you’re certain that your cash-flow situation is under control. If every month shows you sinking deeper into debt, don’t resort to tapping a retirement account because the result could be that six months from now, you’re back in debt but with a smaller retirement nest egg.  Make sure your current income can cover your current liabilities.

Now you might be thinking that you can’t just do this by yourself.  Negotiate with a multi-billion dollar credit card company?!  Sure you can, but if you want help, there are a couple of things to consider.  The first is that you can find any number of for-profit entities who say they specialize in debt reduction and have some vague but miraculous way of eliminating your debt.  At best, this is an exaggeration and at worst, it could be an invitation to fraud.

There are non-profit organizations out there who assist consumers with getting their debt under control.  But let’s be clear in understanding that just because an organization is non-profit doesn’t mean that their services are free.  You will have to pay for their assistance.   To find an approved consumer credit counselor in your state, go to this website. 

Only twelve days until the tax filing deadline!  Many happy returns!