I’ll sit here and give it some time yet.

In YNAB:
- File -> Export
- CSV

In Excel
- File – Open -> [your file name]-Register.csv
- Delete all rows that don’t apply to your tax year (as I write this, 2010)
- Keep the date, category, payee, outflow, and inflow columns (you can delete the others).
- Highlight all of your columns (five remaining)
- Data -> Pivot Table Report .. -> Finish
- Drag the Category field from the Pivot Table Settings box to the Column section (far left of your pivot table Shell)
- Drag the Outflow field from the Pivot Table Settings box to the Data section (big area of your pivot table).
- Right-click on the Total column -> Field Settings -> Make sure Sum is selected.

That was for those of you that don’t want to watch the short video. If you get stuck, watch the video :)

Sorry the screen’s kind of small at some points. Next time I’ll do it in HD. This was supposed to be a stop-gap :)

• Health Care Reform’s Effect on Your Taxes (Part 1)
• …(Part 2)
• …(Part 2 1/2)
• …(Part 3)
• Business Use of the Home (Part I)
• …(Part 2)
• …(Part 3)
• …(Part 4)
• 81 Days Left for Energy Saving Improvements (there are now fewer days!)
• Great News for the Self-Employed
• Capture Those Investment Gains Tax Free

Typical conversation:

Me: Wow! Things are looking really good! I think we should maybe hire a developer to build YNAB for the [insert your favorite device] platform.

My Accountant: Yeah…about that. Quarterlies are due.

Me: Oh. I’ll go get the checkbook. YNAB on the [insert your favorite device] platform will have to wait.

[Crying begins]

I could cry and whine here for the rest of this post, or we could talk about how you can handle the cash flow ramifications of what is likely your single largest expense.

[Crying ends]

In this little Small Business Tax Crash Course, we’ll cover a few very important topics:

• Quarterly taxes
• Profits vs. Distributions
• The Self-Employment Tax (FICA) (and how to minimize it a bit)

Quarterly Taxes

If you’re familiar with the YNAB Way, then you know that Rule Two calls for us to “Save for a Rainy Day”. Oh what a rainy day it is on January, April, June and September 15th!

If you’re an employee, your employer withholds your taxes from your paycheck. You determine how much is withheld by filling out the W4. At the end of the year, you get your W2 that tells you how much you were paid, how much you had withheld, etc.

If you’re a self-employeed small business owner (ranging from an Avon rep to a Zebra Whisperer), you don’t have an employer to withhold the taxes for you. You’re required to withhold them yourself. You do this with quarterlies. Quarterlies are basically estimated tax payments. You figure out what you’ll owe for the year, divide that by four…and then pay that amount when the quarterlies come due (on the 15th of January, April, June, and September).

YNAB saves the day here, because we know exactly what to do with those larger, less-than-monthly expenses. I don’t want you realizing suddenly that quarterlies are due and you have virtually no funds left in your checking account!

At the beginning of each month, you’ll do your monthly bookkeeping. One of those tasks absolutely must be to make sure you’re squared away with your quarterly filing. Here’s how:

1) Go to Reports -> Net Income/Net Worth and find the month’s Net Income:

2) Multiply the month’s Net Income by your average tax rate (Total Tax / Gross Income from last year…you could also let your CPA figure this out).

3) Budget the answer from #2 into your Quarterlies category.

4) When quarterlies are due, pay the balance of your Quarterlies category.

If you follow this, you’ll be well-equipped to handle the acid tax rain that comes four times per year. Do things this way and your cash flow will be zipping right along without any issues.

Profits vs. Distributions

If you’re a sole proprietor, you are the business. Whatever profits the business makes, those are your profits. Done. A piano teacher is paid $80,000 and has $20,000 in business expenses. The teacher’s profits are $60,000.

If you’re running things as an LLC, you’re not the business. You’re a member/owner. If the LLC makes $80,000 and has $20,000 in business expenses, the LLCs profits are $60,000. What if you decide to live frugally and you only pull $30,000 of the $60,000 out of the business as a “distribution”? You still pay tax on the $60,000 in profits. The business passes through its profits (all of its profits), to you.

You’ll hear people that don’t know, acting like they do know, and they’ll say something like, “Yeah, just don’t take as much of a distribution and you can keep your taxes low.” Wrong. When you’re dealing with a pass-through entity such as an LLC, you’re taxed on profits. The IRS doesn’t care about what you took out of the business.

The Self-Employment (SE) Tax

At the time of this writing, the Social Security tax is 12.4% and the Medicare tax is 4.9% — 15.3% in total. The employer pays half, and the employee pays half.

Remember: this tax is above and beyond the income tax. If your income tax rate is 15%, and you’re self-employed, you’re really looking at 30% (give or take, it’s not quite that exact because you can deduct half of your self-employment tax)!

The profit from your LLC has the SE Tax levied against it. If you’re a sole-proprietor, you pay the SE tax on your profits as well. However, if you’re an S Corp (or an LLC electing to be taxed like an S Corp), your profits are not subject to the SE tax. This is a big deal. Here’s why.

Let’s compare two scenarios where the only difference is on paper:

How’d we suddenly save $7,650 in SE tax? We took 50,000 of the 100,000 in profits from the S Corp (or LLC taxed like an S Corp) and made them a wage–the kind you’d get on a W2–for you, the owner. The other 50,000 we left in there to pass through (from above, remember Profits vs. Distributions…) to your tax return as self-employment income.

This is just a reclass of income when it comes down to it. Your taking $100,000 of general income and classifying $50,000 of it as a wage (subject to the SE tax) and the other $50,000 leaving as profits that simply pass through. This is where the difference between a distribution and profits really matter.

Now imagine that! You save $7,650 because you change things on paper just a little bit! (You actually need to run payroll — that is, pay yourself as an employee of your own business).

What will the IRS look for? Excessively low wages. You can’t have $100,000 in S Corp profits and pay yourself a wage of $10,000 unless that’s considered “reasonable”. Whatever’s reasonable is your call.

What We Covered

Quarterlies. Use YNAB as it’s intended and plan for those large, soul-crushing outflows in advance!

Profits vs. Distributions. They’re likely the same when it comes to taxes…unless you’re operating as an S Corp.

Self-Employment Tax. This is a big cahuna. Minimize it if possible by making yourself an employee of your S Corp and managing your wage (subject to SE tax) there.

If you want to get a better grasp of taxes overall (high-level, fairly entertaining stuff), check out YNAB’s Tax Insight course. (Free & Fun). And if you’re wanting some serious insights on taxes that go into the nitty-gritty, Casey, my tax advisor, writes some great stuff.

Enroll by filling out the form below. It’ll be free. And fun. (If you’ve already filled the form out, you’re enrolled and will be notified on Tuesday of course availability!)

• Begins Tuesday, March 2nd.
• All on demand. No scheduling necessary.

The full course is now available on demand, over at YNAB’s Tax Insight.

On the survey, one of the questions I asked was whether the respondent uses a tax preparer (human, not software) and if they don’t, their reasoning. I want to discuss the main reasons why a human preparer isn’t used. Some of the responses scared me a bit. Others made sense. :)

(Before I dive into this, let me be clear that I am not directly trying to make the case that everyone should use a tax preparer — hardly. I am trying to make the case that everyone needs to be much better informed about the black box we call the tax code.)

I’m worried about the cost. It’s expensive. Benefit doesn’t outweigh the cost.

The first two sentences there don’t make sense. To be worried about the cost isn’t a real reason. I’d have to ask why they’re worrying. My guess is that it’s because they feel it’s too expensive, or that it’s not worth the potential savings.

To “it’s expensive”–that needs to be qualified. Do we say something is expensive based on some fixed number in our head? Is a car expensive, but a tricycle inexpensive? Or do you need to evaluate “expensive” as it compares to the value of what you’re getting? That’s why I like that third related reason, where the respondent is weighing the cost and benefit of a tax preparer and making a decision.

Be careful about this. My hope is that the course will help people see that they would be benefited by help, or that they clearly wouldn’t be. But either way we’ll be making an informed decision and that’s what matters.

My situation is simple (straightforward, easy, etc.)

Simple because you understand it and have managed to file your taxes without ever being audited? How do you know you aren’t leaving money on the table? How do you define simple? Is your understanding of The Code great enough that you’re confident in saying you have a simple situation?

This is a tough one. How do you know what you don’t know? Scary! I imagine there’s someone out there operating a sole-proprietorship where they’re leaving thousands of dollars in tax savings on the table because they’ve had a “simple” situation for 10 years and nothing’s changed.

Again, my hope is that the course will help you understand “simple” a bit better, and motivate you to educate yourself more re: The Code.

I don’t trust my finances to someone else. I like the control.

It may just be a control thing — that’s fine. But the same person that doesn’t trust their finances to a tax preparer will trust their finances to a software package? I see a huge disconnect here. If you have privacy concerns, that’s a different story, but just know that the software was written by “preparers” in a sense.

What’s scarier about this isn’t the software side of the equation. It’s the you side of the equation. I would imagine that the odds of you making an error are much higher! Do you know the implication to your answering question 13c that way?

I tried an advisor and felt like they were simply doing data entry on my behalf.

People that have had this experience definitely need to find a new advisor! I had that same experience for two years and you’re right — it’s awful. You’re paying them to do nothing more than you could do yourself–except you’d be faster at it because you’d know all the answers to the questions.

I’d encourage you to hunt for a new advisor if you feel that the only thing they’re doing is simply plugging and chugging numbers. Your advisor should be informing you frequently about possible tax strategies you can employ that will save you money. If your advisor is in touch multiple times outside of the tax season then you’ve probably found yourself a gem.

I shouldn’t need an advisor. The tax code should be rewritten.

The tax code is absolutely crazy in its complexity. It truly is mind-boggling. But this answer just doesn’t cut it! This upcoming tax course will have nothing to do with policies or politics and everything to do with the situation we’re currently in, and what we can do to keep more of our hard-earned dollars in our own pockets.

You may hold a very strong belief that the tax code needs a rewrite, but that doesn’t change the fact that today, you’re being taxed under that code. You should be aware enough to minimize your taxes, and then continue your fight for tax reform as needed.

I don’t have anyone to prepare my taxes that I trust.

This one’s huge. At YNAB we’ve had the hardest time finding good developers that 1) share our vision and 2) can code to our standard. It’s a time-consuming process to find the “right fit” — trust your gut on this one. If you have any doubts about a preparer that you’re interviewing, walk out! (And yes, you interview them).

These are just a few of the reasons people aren’t looking to a preparer. Some of them are quite valid. Participating in next week’s tax course will certainly arm you with the knowledge you’ll need to knowingly decide if the benefit of a tax preparer will be worth the cost.

To those reading this that haven’t yet signed up for the free tax course, you can do that below. The course starts next Tuesday and will run through the week. It’ll be… easily digestible to fit any schedule :) Signup closes Friday at midnight.

You can now view the tax course on demand, during your lunch hour :) It’s educational and entertaining (and yes, it’s about taxes). Check it out!

Get ready to gain new tax insights beginning next Tuesday :)

Update 2/24/10: You can see my comment below, but based on some feedback I received, my apologies if I came across as condescending or belittling in this post. That was NOT my intention.

Here it is in a nutshell. I just want you to make an informed decision about how you handle your taxes. Remember, it’s likely your single largest expense (if you’re on a wage, it’s 7.65% from every paycheck, forever), so it deserves some attention! If you gather information, educate yourself, and feel comfortable using tax preparation software (personal preference, knowledge of your own situation, etc.) that that is the correct choice. On the flip side: if you gather information and, through learning more, decide you should be going about it a different way, that’s the correct choice.

There are certainly cases where you don’t need a tax preparer. After reading this over again, it sounds like I’m saying that a preparer is the only way to go. Not hardly! I just don’t want people blindly going one direction without having their eyes wide open. Hopefully that makes more sense.

About the Course
This will be on demand. I’ll be presenting a video each day for five days beginning next Tuesday. It will be mainly video and just a little bit of text. My goal is to keep each video to less than ten minutes. Also, my goal is to have these tax videos be not boring :)

The course will be high level. As I looked at the survey responses it was very apparent that we can’t drill down to specific situations because so many people have so many different situations. It just isn’t feasible. At this high level though, my goal is to have you understand the framework and then make decisions from within that framework. I’m hoping you’ll learn some principles that will help you make decisions in a more informed way.

And of course I hope you love the course and that it meets your expectations. I think most everyone will walk away learning something that will help them have their eyes more wide open concerning taxation.

So I don’t legally “know” what I’m talking about, but I can still remember a bit from when I did. And since this is my least-favorite season of the entire year, it’s also going to become a Savings Tip topic (and the focus of a free course launch I’m working on, see below for details).

You’re Trained to be Focused on the Completely Wrong Thing

The impetus of this post actually happened this morning on the treadmill. There was a commercial for Intuit’s TurboTax…how it guides you through your taxes and then they showed this really fancy image with a guarantee seal. On Inuit’s website you’ll see this front and center:

What’s the focus of Intuit’s marketing for TurboTax? It’s about the Refund.

I don’t want to just single out Intuit. Not at all actually. Take a look at TaxACT.com’s front page:

Intuit’s fine print reads as follows:

If you get a larger refund or smaller tax due from another tax preparation method, we’ll refund the applicable TurboTax federal and/or state purchase price paid. TurboTax Federal Free Edition customers are entitled to a payment of $14.95 and a refund of your state purchase price paid.

Fair enough.

TaxACT’s fine print re: their guarantee sheds a bit more light on the problem:

If you get a larger refund or smaller tax due from another tax preparation method with the same data, we will refund the applicable product price you paid for your TaxACT Deluxe federal return.

Emphasis mine.

I won’t even go into H&R Block’s “Instant Refund Anticipation Loans.” Nasty — and a whole other story.

The focus is on that carrot dangling out in front of you. Your own money that you paid to the government in anticipation of your tax liability — your tax refund.

Even Trained Accountants Get it Wrong and Fall For the…Indoctrination :)

Back when I worked for a large accounting firm (don’t get the idea that I have tons of experience doing that — I lasted 10 LONG months), I remember sitting around the table in the cafeteria of our client. It was tax season and I was probably complaining about this very thing. One of my colleagues — a CPA said something along the lines of:

Oh, I didn’t pay any taxes this year. I got a refund.

I about lost my lunch.

If that same concept can happen to someone who passed the Reg section of the CPA exam, it certainly happens to your average Joe the…Piano Tuner.

What was the problem with my colleague’s statement? Even if they had just slipped up and really meant to say that they didn’t need to pay any additional taxes for the year…it was still alarming.

Just to be 100% clear.

1) You earn money.
2) You pay income taxes that are either withheld from your paycheck automatically (so you’re not as aware of the expense, removing you psychologically from it and encouraging just the problem we’re discussing here — a HUGE lack of awareness) or you’re required to file quarterly estimates.
3) By April 15 of each year, you calculate what you actually owe and either pay more (because your estimates weren’t enough) or you’re paid a refund (because you paid too much).

Unless you literally did not have a tax liability that year, you paid taxes. You may not have a tax liability if:

1) You’re dead or,
2) You earned only a small amount of income.
3) You have tons and tons of kids :)

I’m grossly simplifying with the above three points.

So know this: you very likely pay taxes every single year.

And I’m not even talking about the FICA (Social Security & Medicare) taxes that you can’t avoid (re: minimize) much at all if you’re a wage worker. Even if you did fall into #2 or #3 above, you still paid almost 8% of your wage in FICA. (By the way, your employer paid another almost 8% to FICA as well — the money which they just might pay to you if they weren’t paying it to the government, so you can choose to see that as a tax you pay as well).

You pay taxes. Every year of your life. And when you die, you pay again. Don’t let me ever hear you say, “Oh, I didn’t pay taxes this year — I got a refund.” Wrong. Wrong. Wrong.

This is Not About Tax Policy. It’s About Your Life’s Single Biggest Expense

This is not about political leanings, or tax policy. It’s about what will likely be (or already has become, and will only continue to be) the single largest expense of your entire life.

I’m guilty as charged. These Savings Tips that I’ve written have ranged from saving time and money with dinner groups to 29 Ways to Save a Fortune on Your Energy Bill.

If I were doing these tips according to bottom-line affecting expenditures, I’d probably be writing about tax savings two out of every five times. For almost everyone.

Going Back to the Refund Focus. Which Way Are You Facing?

At the beginning here I established that we’re trained to be refund-focused. With tax compliance software we’re trained to drop in data (what we’ve done) and have the computer spit out what we owe or are owed. We’re complying. We’re facing backward.

Over a year ago I wrote about preferring head-on to rear-end collisions (the metaphor breaks down quickly in real life, but you get my point) when it comes to making spending decisions. You want to be proactively looking forward and acting — not looking backward and reacting.

Taxes are the exact. same. way.

Remember TaxACT’s guarantee from above? How they mentioned the same data? They’re basically saying that their software will return the same result as another software because both softwares do an excellent job of looking back, crunching the numbers, considering the rules and spitting out the liability. Hang on to that thought.

If Things Were Simpler, It’d Be Easier. But They’re Not, so Let’s Move On

We can lament and moan (I do my share of it) about how economically costly tax compliance is. How it’s a huge drain (as a whole) on the economy with no value-add. How a client I worked on employed 35 people full-time to make sure their M-1 (that’s a C-Corporation’s return, that has maybe…12 boxes to fill out) was correct…

But we won’t.

Things aren’t simple. Life is complex. In honor of the season premier of Lost tonight, I’m going to say it’s a lot like that black cloud that haunts the island. It’s always there. Nobody knows what it is or how it works. And it kills you.

At the end of Lost this season, perhaps we’ll know how it works. At the end of this tax season, we still won’t know how the tax code works.

So, let’s just get comfortable with the idea that the tax code will always be complex.

Even for those situations where the tax scenario really is simple, we have divergent voices. The New York Times wrote a very interesting article days ago, “Why Can’t the I.R.S. Help Fill in the Blanks?” that cast some of the large tax preparation software backers in a negative light.

The gist: California uses ReadyReturn, where they send eligible Californians a pre-filled return. The data can then be validated by the person, but it “gets the ball rolling”. It costs the state $.34 to process a ReadyReturn, while a paper return filed in the traditional way costs $2.59 (not including the taxpayer’s savings in both time and possibly money).

The tax preparation software lobby pushes against this for obvious reasons. Intuit’s response is here.

Whichever side of that debate you’re on, it’s clear that there are interests hard at work on both sides, furthering their own agenda. What I want you to take away from this Savings Tip is that you need to have your own agenda.

What To Do About Your Single Largest Expense

The agenda is simple. Minimize it. Minimize your tax liability. Educate yourself.

My real awakening to this situation happened last year during preparation of our 2008 personal return. Before I get into that, let me tell you about my brother-in-law, Casey.

Casey is a tax preparation…guru? Yeah, guru’s the right word. He might be partially insane as well — he loves this stuff. Absolutely loves it. I’ve seen him become giddy over some strategy. It’s a sight to behold.

He’s also a straight-arrow. He deals in blacks and whites. Prior to using Casey, I used another CPA to prepare my taxes and heaven only knows how much money I overpaid (he was lousy, and I should have fired him immediately. Plenty of warning signs told me as much). This was all apparent once Casey got a hold of my tax documents for the 2008 return.

It’s the kind of thing where taking an expense here instead of there saved me over $10,000. I’ve been trained in taxes. The Reg section of the CPA exam was my shining moment (a 94 baby! Nothing to show for it now). I had class after class in school. I know enough to know that I need help.

$10,000 (and change)!

We used the money to help us pay down the mortgage.

But that money would have been gone. Forever. There’s literally nothing that you’re given in return for the extra you pay on your taxes. You are flushing money down the toilet. Stop doing that.

Casey’s in the know about this stuff though. He soaks it up. He prepares return after return and sees different situations. He dives into the tax code — discusses strategies and knows the forms inside and out. He’s a phenomenal resource.

I don’t think he’d want me to disclose what it cost me to have him prepare our 2008 taxes, but I will say it was a bargain (and I didn’t get any family discount :). An absolute, no-brainer bargain.

But here’s where the real value comes. Casey now can sit down with me and help me look forward and begin planning. For the 2008 return, he hadn’t seen anything going on prior to having my documents in hand. He was forced to comply and we still did phenomenal.

So the real value comes in being able to plan and structure things in such a way that your tax bill is minimized. Having that ability is, as Michael Scott (The Office) would say, “Incalclacable.”

I led into this talking about tax preparation software. I think, on net, it’s a positive thing. But don’t be deceived. No consumer-facing software is forward-looking. No tax prep software would have told me that I just needed to take my health expense here instead of there. It would have just accepted my answer and moved on. Did you hear that flushing sound? :)

The savings we found had to do with how we were handling health insurance premiums in relation to adjusted gross income (AGI) that was on a threshold of causing phaseouts for roth contributions, child tax credits, and I believe some itemized deductions. Sound like a foreign language to you? Embrace it.

After quite a bit of prodding, cajoling (begging?), I convinced Casey to help me put together something that would help that Piano Tuner I mentioned above get a handle on their tax situation. What we cooked up last year was awesome and we’re re-opening it this year. If you’re interested in taking part in a free course all about tax minimization, drop your first name and email in the box below:

Remember, you need to have your own tax policy: Educate yourself. Pay as little as possible and use the savings to reach your financial goals.

And please, please, please people: Do not turn this into some raging political discussion. I’m not talking about tax policy. I’m talking about taking the tax hand you’ve been dealt and proactively making the most of it.

Giving to Charity — the Normal Deduction
When you give to a charitable organization, the IRS allows you to deduct that contribution from your taxable income. For instance, if I had $60,000 of taxable income and donated $6,000 to a qualified charitable organization, my taxable income would be $54,000 ($60,000-$6,000).

What are the tax savings from this? It depends on my marginal tax rate. For the sake of this example, let’s say it’s 20%.

Without the charitable contribution, my taxes would be $12,000 ($60,000 * .20).

With the charitable contribution, my taxes would be $10,800 ($54,000 * .20).

Total tax savings as a result of the contribution: $1,200.

(The quick way to calculate the savings associated with any deduction is to multiply the deduction by your marginal tax rate. In this case, we would do: $6,000 * .2 and get $1,200.)

But this isn’t the Savings Tip.

Giving to Charity — the Souped-Up Deduction

Let’s suppose that instead of giving $6,000 in cash to a charitable organization, you gave $6,000 of an appreciated asset. For our example, let’s pretend you bought into XYZ stock at $1,000 and it has now appreciated to be worth $6,000. Let’s also assume that you had held the XYZ stock for three years.

First, let’s do an example without the charitable contribution.

You decide to sell the stock, in order to donate the $6,000 to a charity. Because you’ve sold a capital asset, you’re subject to the capital gains tax (remember, governments tax us buying, earning, growing, and dying). In this instance, your capital gain is $5,000 ($6,000 – $1,000). The capital gains tax is either 15% or 5% depending on your situation. For this example, let’s assume it’s 15%. The tax due on this sale of XYZ stock would be $750 ($5,000 * 15%). (Special Note: If the XYZ stock had been held less than a year, it would be classified as a short-term capital gain and would be taxed at our example person’s ordinary tax rate of 20%, so the tax on the realized gain from the sale would be $1,000, not $750).

BUT, you can completely avoid the capital gains tax if you simply donate the stock to the charity. The charity can then sell the stock and have the $6,000 in cash (less a tiny selling fee probably). So, you avoid a $750 capital gains tax because your basis increased from $1,000 to $6,000, but you get the full deduction available to you of the current value of the stock at $6,000.

This is the scary thing about taxes. You can do something one legal way and pay more. Or you can do it another legal way, and pay less.

This is also why you should get great advice. TurboTax is fine and everything, but it would never tell you what you should have done, only what the tax ramifications are from what you have done. I’m actually working with an extremely knowledgeable tax person about putting together some fantastic ways to save on taxes. We’re still in the concept stage, but I’m pretty excited about it.

Takeaway: If you’re going to be selling some stock, and you give to charities, considering giving the appreciated stock (or a portion of it) to the charity to avoid the capital gains tax.

I have lost track of the number of people that have told me that the reason they are not paying off their mortgage is because it is a tax deduction. Another comment closely related to that on is when people buy things for their business that they don’t really need because it is a tax write-off. It has to just be an excuse to spend the money, or a convenient justification in their minds, because it just doesn’t make sense to me.

So Let Me Get This Straight
Here is an example. A client came to me a little while back and he said that he planned to take out a much larger mortgage on his house. When I inquired why he explained to me that his CPA had told him that he needed more deductions to get his tax bill lower. The CPA suggested taking out a much larger loan on his home and showed him how much he would save on his taxes.

“So,” I said, “you are going to pay $10,000 more per year in interest to the bank so that you can pay $3,000 less to the government in taxes? You must really, really hate paying money to the government!” Why on earth would someone put themselves $7,000 more in the hole to avoid taxes? It seems like they are taxing themselves more in the process.

I’m All for Paying Fewer Taxes
Don’t get me wrong. I have no desire to pay more taxes. I try to find every honest way to save my clients tax dollars and help them keep what they earn. But I wouldn’t suggest that they spend more than the tax savings in order to get those savings.

Now, if you have to have a mortgage, then by all means you should take the tax deduction for it. But please don’t get a bigger mortgage so that you get a bigger deduction. And don’t take out a home equity line of credit to pay for your vacation so that you get a deduction for the interest you pay on the cost of that vacation. No matter how big the deduction, you are still paying more for the vacation! You only get a percentage of the interest, not a dollar for dollar reduction of the price you paid.

One More Example
There is a guy I know that owns his own little business. Almost every time I talk to him he tells me about the new tools or equipment that he just bought. Then he smiles and says, “Hey, it’s a tax deduction.” Maybe he is just taunting me. But it is not like the fact that the tool is a tax deduction makes that tool free. Especially if he is not making a lot of profit on this business, which in turn means that his tax bracket is not very high. So, maybe he saved 20% on the tool when you take into account the write-off. He still spent the other 80% on a tool that he didn’t really need. It is the same logic that leads people to by things that are “on sale” that they never would have bought otherwise. I don’t care how much you saved – if you wouldn’t have bought it otherwise you just wasted your money.

* This article is commentary on basic principles. In no way should the things said in the article be construed or interpreted to be advice for your specific situation. Before making any financial decision you should consider all factors and consult with a professional. 

The Way it Normally Works

The IRS looks at all debt that is reduced or forgiven in one way – as taxable income! Why? Because then they can tax it! No, it actually makes sense. If you owe money and the debtor forgives the debt, what that really means is that they paid the debt for you. If they paid the debt for you it is the same as if they paid you and then you paid the debt. So, the debt paid is considered income. (Another way to think about this: If this were not the case then we could all have our employer just by our food, housing, entertainment, etc. and we would never have any income to report and no one would ever need to pay taxes.) Since the debt that is reduced or forgiven is income you may now owe income tax on that portion that was eliminated. So not only did you lose your house because you couldn’t make the payment, but now you have a big tax bill to boot!

Relief for a Short Period of Time

Because the housing crisis is so big, and in an effort to lessen the economical impact of the foreclosures, in December 2007 President Bush signed the Mortgage Debt Forgiveness Act of 2007. The act allows for mortgage debt relief to not be included in income for those whose mortgage debt is forgiven between January 1, 2007 and December 31, 2009. So, if losing your house is inevitable, I guess now is a “good” time to do it.

Some of the “Nitty Gritty” Details

Probably the most important footnote to this is that only the portion of debt that was used for the construction, purchase, or significant improvement of the home qualifies for the benefits of the Act. In other words, if you used part of the money from your mortgage to consolidate debt or pay for a vacation, etc., then that portion is still considered income and is subject to taxes. For example, if the amount of money used for things other than the home is $55,000 and the amount of debt forgiven is $90,000, then only $35,000 of the debt relief is not included in taxable income.

A second important note is that this tax relief only applies to a principal residence. So, if it is a second home or a vacation home then the debt forgiveness will be treated as it always has – taxable income.

There are a few other details to the Act as well, but they don’t apply to most people and/or they aren’t within the scope of this BLOG. My intention is just to give you an idea of the overall tax consequences of debt forgiveness and the effects of this Act.

* This article is commentary on basic principles. In no way should the things said in the article be construed or interpreted to be advice for your specific situation. Before making any financial decision you should consider all factors and consult with a professional.