Tax Strategies for Individuals

02 Aug 2024

This Financial Guide provides tax saving strategies for deferring income and maximizing deductions and includes some strategies for specific categories of individuals, such as those with high income and those who are self-employed.

Before getting into the specifics, however, we would like to stress the importance of proper documentation. Many taxpayers forgo valuable tax deductions because they haven’t kept receipts or other records. Not only are adequate records required by the IRS, but neglecting to track deductible expenses throughout the year can lead to overlooking them. You also need to maintain records regarding your income. If you receive a large tax-free amount, such as a gift or inheritance, make certain to document the item so that the IRS does not later claim that you had unreported income.

The checklist items listed below are for general information only and should be tailored to your specific situation. If you think one of them fits your tax situation, we’d be happy to discuss it with you.


  • Defer Income Recognition
  • Max Out Your 401(k) or Similar Employer Plan
  • If You Have Your Own Business, Set Up and Contribute to a Retirement Plan
  • Contribute to an IRA
  • Defer Bonuses or Other Earned Income
  • Accelerate Capital Losses and Defer Capital Gains
  • Watch Trading Activity in Your Portfolio
  • Use the Gift Tax Annual Exclusion to Shift Income
  • Invest in Treasury Securities
  • Consider Tax-Exempt Municipal Bonds
  • Give Appreciated Assets to Charity
  • Keep Track of Mileage Driven for Business, Medical or Charitable Purposes
  • Contribute to a Pre-tax Account to Fund Medical Expenses
  • Check Out Separate Filing Status
  • If Self-Employed, Take Advantage of Special Deductions
  • If Self-Employed, Hire Your Child in the Business
Defer Income Recognition

Most individuals are in a higher tax bracket in their working years than they are during retirement, so using tax-advantaged retirement accounts to defer income until retirement can reduce your current-year taxes plus may ultimately result in paying taxes on that income at a lower rate. Additionally, you may be able to invest the money you would have otherwise paid in taxes to increase the amount of your retirement fund. Deferral can also work in the short term if you expect to be in a lower bracket in the following year or if you can take advantage of lower long-term capital gains rates by holding an asset a little longer.

Another way to use timing to reduce your current-year taxes is to accelerate deductions, for example, by paying a state estimated tax installment in December instead of at the following January due date. But be mindful of the $10,000 ($5,000 if you’re married filing separately) annual limit on the deduction for state and local taxes, which through 2025 applies to the combined amount of property taxes and income or sales tax.

Max Out Your 401(k) or Similar Employer Plan

Many employers offer plans where you can elect to defer a portion of your pay by contributing it to a tax-deferred retirement account. For many companies, these are 401(k) plans. For nonprofit employers, such as universities, a similar plan called a 403(b) is available. If your employer offers such a retirement plan, contribute as much as possible to defer income and accumulate retirement assets.

Some employers match a portion of employee contributions to such plans. If this is available, you should structure your contributions to receive the maximum employer matching contribution.

If You Have Your Own Business, Set Up and Contribute to a Retirement Plan

If you have your own business, consider setting up and contributing as much as possible to a retirement plan. These are allowed even for a sideline or moonlighting business. Several types of plans are available which minimize the paperwork involved in establishing and administering such a plan.

Related Guide: For details on retirement plans benefiting self-employed owners, see the Financial Guide: EMPLOYEE BENEFITS: How To Handle Them.

Contribute to an IRA

If you have income from wages or self-employment income, you can build tax-sheltered investments by contributing to a traditional or a Roth IRA. You may also be able to contribute to a spousal IRA even if the spouse has little or no earned income. All IRAs defer the taxation of IRA investment income and in some cases contributions may be deductible or be withdrawn tax-free.

Related Guide: For details on how Roth IRAs work and how they compare in other respects with traditional IRAs, please see the Financial Guide: ROTH IRAs: How They Work and How To Use Them.

To get the most from IRA contributions, fund the IRA as early as possible in the year. Also, pay the IRA trustee out of separate funds, not out of the amount in the IRA. Following these two rules will help ensure that you get the most tax-deferred earnings possible from your money.

Defer Bonuses or Other Earned Income

If you are due a bonus at year-end, you may be able to defer receipt of these funds until January. This can defer the payment of taxes (other than the portion withheld) for another year. If you’re self-employed, defer sending invoices or bills to clients or customers until after the new year begins. Here, too, you can defer some of the tax, subject to estimated tax requirements. This may even permanently save taxes if you are in a lower tax bracket in the following year. Be advised, however, that the amount subject to Social Security or self-employment tax increases each year.

Accelerate Capital Losses and Defer Capital Gains

If you have investments on which you have an accumulated loss, it may be advantageous to sell it prior to year-end. Capital losses are deductible up to the amount of your capital gains plus $3,000. If you are planning on selling an investment on which you have an accumulated gain, it may be best to wait until after the end of the year to defer payment of the taxes for another year (subject to estimated tax requirements). For most capital assets held more than 12 months (long-term capital gains) the maximum capital gains tax is 20 percent. However, make sure to consider the investment potential of the asset. It may be wise to hold the asset to maximize the economic gain or sell it to minimize the economic loss.

Watch Trading Activity in Your Portfolio

When your mutual fund manager sells stock at a gain, these gains pass through to you as realized taxable gains, even though you don’t withdraw them. So you may prefer a fund with low turnover, assuming satisfactory investment management. Turnover isn’t a tax consideration in tax-sheltered funds such as IRAs or 401(k)s. For growth stocks you invest in directly and hold for the long term, you pay no tax on the appreciation until you sell them. No capital gains tax is imposed on appreciation at your death.

Use the Gift Tax Annual Exclusion to Shift Income

You can give away $18,000 ($36,000 if joined by a spouse) per donee in 2024 without owing federal gift tax or using up any of your lifetime gift and estate tax exemption. You can make these annual exclusion gifts to as many donees as you like. While these transfers are not taxable, any income earned on these gifts after the transfer will be taxed at the donee’s tax rate, which in many cases is lower.

Special rules apply to children subject to the “kiddie tax.” Also, if you directly pay the medical or educational expenses of the donee, such gifts will not be subject to gift tax.

Invest in Treasury Securities

For high-income taxpayers who live in high-income-tax states, investing in Treasury bills, bonds, and notes can pay off in tax savings. The interest on Treasuries is exempt from state and local income tax. Also, investing in Treasury bills that mature in the next tax year results in a deferral of the tax until the next year.

Consider Tax-Exempt Municipal Bonds

Interest on state or local municipal bonds is generally exempt from federal income tax and from tax by the issuing state or locality. For that reason, interest paid on such bonds is somewhat less than that paid on commercial bonds of comparable quality. However, for individuals in higher brackets, the after-tax return from municipal bonds will often be greater than that from higher-interest commercial bonds. Gain on sale of municipal bonds is taxable and loss is deductible. Tax-exempt interest is sometimes an element in the computation of other tax items. Interest on loans to buy or carry tax-exempts is non-deductible.

Give Appreciated Assets to Charity

If you’re planning to make a charitable gift, it generally makes more sense to give appreciated long-term capital assets to the charity than to sell the assets and give the charity the after-tax proceeds. Donating the assets instead of the cash prevents your having to pay capital gains tax on the sale, which can result in considerable savings, depending on your tax bracket and the amount of tax that would be due on the sale. Additionally, you can obtain a tax deduction for the fair market value of the donated assets, assuming you itemize deductions.

Many taxpayers also give depreciated assets to charity. The deduction is for fair market value; no loss deduction is allowed for depreciation in value of a personal asset. Depending on the item donated, there may be strict valuation rules and deduction limits.

Keep Track of Mileage Driven for Business, Medical or Charitable Purposes

If you drive your car for business, medical or charitable purposes, you may be entitled to a deduction for miles driven. For 2024, it’s 67 cents per mile for business, 21 cents for medical and moving purposes (members of the armed forces only for tax years 2018-2025), and 14 cents for service for charitable organizations. To substantiate the deduction, you need to keep detailed daily records of the mileage driven for these purposes.

From 2018 through 2025, employees who drive their own cars for business can’t deduct such expenses. This is due to the Tax Cuts and Jobs Act of 2017 (TCJA) suspension of miscellaneous itemized deductions subject to the 2% of adjusted gross income floor. This means that, generally, only businesses and the self-employed can claim a deduction for business miles driven.

Contribute to a Pre-tax Account to Fund Medical Expenses

Medical and dental expenses are generally deductible only if you itemize and only to the extent they exceed 7.5 percent of your adjusted gross income (AGI). For most individuals, particularly those with high incomes, this eliminates the possibility of a deduction. You can get a tax benefit similar to a deduction if your employer offers a Flexible Spending Account, sometimes called a cafeteria plan. You can redirect a portion of your compensation to the account to pay these types of expenses with pretax dollars. Another such arrangement is a Health Savings Account (HSA), though it’s available only if you have a high-deductible health plan (HDHP). Self-employed with an HDHP? You can set up an HSA for yourself and make tax deductible contributions to it.

Check Out Separate Filing Status

Certain married couples may benefit from filing separately instead of jointly. Consider filing separately if you meet the following criteria:

  • One spouse has large medical expenses, and
  • You and your spouse’s incomes are about equal.

Separate filing may benefit such couples because the adjusted gross income “floors” for taking the medical expense deduction will be computed separately. On the other hand, some tax benefits are denied to couples filing separately. In some states, filing separately can also save a significant amount of state income taxes.

If Self-Employed, Take Advantage of Special Deductions

You may be able to expense up to $1,220,000 in 2024 for qualified equipment purchases for use in your business immediately instead of writing it off over many years. Additionally, self-employed individuals can deduct 100 percent of their health insurance premiums as business expenses. You may also be able to establish a SEP or SIMPLE IRA plan, or a Health Savings Account, as mentioned above.

If Self-Employed, Hire Your Child in the Business

If your child is under age 18, he or she is not subject to employment taxes from your unincorporated business (income taxes still apply). This will reduce your income for both income and employment tax purposes and shift income to the child at the same time; however, you cannot hire your child if he or she is under the age of 8 years old.


02 Aug 2024

How are distributions from mutual funds taxed? What happens when they are reinvested? How are capital gains on sales of mutual funds determined? This Financial Guide provides you with tips on reducing the tax on mutual fund activities.

A basic knowledge of mutual fund taxation and careful record-keeping can help you cut the tax bite on your mutual fund investments.

You must generally report as income any mutual fund distributions, whether or not they are reinvested. The tax law generally treats mutual fund shareholders as if they directly owned a proportionate share of the fund’s portfolio of securities. Thus, all dividends and interest from securities in the portfolio, as well as any capital gains from the sales of securities, are taxed to the shareholders.

The fund itself is not taxed on its income if certain tests are met and substantially all of its income is distributed to its shareholders.

Taxable Distributions

There are two types of taxable distributions: (1) ordinary dividends and (2) capital gain distributions:

  1. Ordinary Dividends. Distributions of ordinary dividends, which come from the interest and dividends earned by securities in the fund’s portfolio, represent the net earnings of the fund. They are paid out periodically to shareholders. Like the return on any other investment, mutual fund dividend payments decline or rise from year to year, depending on the income earned by the fund in accordance with its investment policy. These dividend payments are considered ordinary income and must be reported on your tax return.Qualified dividends. Qualified dividends are ordinary dividends that are subject to the same tax rates that apply to net long-term capital gains. Dividends from mutual funds qualify where a mutual fund is receiving qualified dividends and distributing the required proportions thereof. Dividends from foreign corporations are qualified where their stock or ADRs are traded on U.S. exchanges or with IRS approval where the dividends are covered by U.S. tax treaties.
  2. Capital gain distributions. When gains from the fund’s sales of securities exceed losses, they are distributed to shareholders. As with ordinary dividends, these capital gain distributions vary in amount from year to year. They are treated as long-term capital gain, regardless of how long you have owned your fund shares. A mutual fund owner may also have capital gains from selling mutual fund shares.

Capital gains rates

The beneficial long-term capital gains rates on sales of mutual fund shares apply only to profits on shares held more than a year before sale. Profit on shares held a year or less before the sale is ordinary income, but capital gain distributions are long-term regardless of the length of time held before the distribution.

In 2023, tax rates on capital gains and dividends remain the same as 2022 rates (0%, 15%, and a top rate of 20%); however, threshold amounts are different in that they don’t correspond to new tax bracket structure as they did in the past. The maximum zero percent rate amounts are $44,625 for individuals and $89,250 for married filing jointly. For an individual taxpayer whose income is at or above $492,300 ($553,850 married filing jointly), the rate for both capital gains and dividends is capped at 20 percent. All other taxpayers fall into the 15 percent rate amount (i.e., above $44,625 and below $492,300 for single filers).

In 2023, say your taxable income, apart from long-term capital gains and qualified dividends, is $87,000. Even though you’re in a middle-income tax bracket (22 percent on a joint return in 2023) you’ll get the benefit of a lower capital gains tax rate, in this case, 15 percent for long-term gains and qualified dividends.

For tax years 2013-2017 dividend income that fell in the highest tax bracket (39.6%) was taxed at 20 percent. For the middle tax brackets (25-35%) the dividend tax rate was 15 percent, and for the two lower ordinary income tax brackets of 10% and 15%, the dividend tax rate was zero.

At tax time, your mutual fund will send you a Form 1099-DIV, which tells you what earnings to report on your income tax return, and how much of it is qualified dividends. Because tax rates on qualified dividends are the same as for capital gains distributions and long-term gains on sales, Congress wants these items combined in your tax reporting, that is, qualified dividends added to long-term capital gains. Also, capital losses are netted against capital gains before applying favorable capital gains rates. Losses will not be netted against dividends.

Undistributed capital gains. Mutual funds sometimes retain a part of their capital gain and pay tax on them. You must report your share of such gains and can claim a credit for the tax paid. The mutual fund will report these amounts to you on Form 2439. You increase your shares’ “cost basis” (more about this in Tip No. 5, below) by 65 percent of the gain, representing the gain reduced by the credit.

Medicare Tax

Starting with tax year 2013, an additional Medicare tax of 3.8 percent is applied to net investment income for individuals with modified adjusted gross income above $200,000 (single filers) and $250,000 (joint filers). These amounts are not indexed for inflation.

Now that you have a better understanding of how mutual funds are taxed, here are 13 tips for minimizing the tax on your mutual fund activities:

 


  • Tip #1: Keep Track of Reinvested Dividends
  • Tip #2: Be Aware That Exchanges of Shares Are Taxable Events
  • Tip #3: Be Wary of Buying Shares Just Before Ex-Dividend Date
  • Tip #4: Do Not Overlook the Advantages of Tax-Exempt Funds
  • Tip #5: Keep Records of Your Mutual Fund Transactions
  • Tip #6: Reinvesting Dividends & Capital Gain Distributions when Calculating
  • Tip #7: Adjust Cost Basis for Non-Taxable Distributions
  • Tip #8: Use the Best Method of Identifying Sold Shares
  • Tip #9: Avoid Backup Withholding
  • Tip #10 Don’t Forget State Taxation
  • Tip #11: Don’t Overlook Possible Tax Credits For Foreign Income
  • Tip #12: Be Careful About Trying the “Wash Sale“ Rule
  • Tip #13: Choose Tax-Efficient Funds
  • How The Various Identification Methods Compare
  • Government and Non-Profit Agencies
Tip #1: Keep Track of Reinvested Dividends

Most funds offer you the option of having dividend and capital gain distributions automatically reinvested in the fund – a good way to buy new shares and expand your holdings. While most shareholders take advantage of this service, it is not a way to avoid being taxed. Reinvested ordinary dividends are still taxed (at long-term capital gains rates if qualified), just as if you had received them in cash. Similarly, reinvested capital gain distributions are taxed as long-term capital gain.

If you reinvest, add the amount reinvested to the “cost basis” of your account, i.e., the amount you paid for your shares. The cost basis of your new shares purchased through automatic reinvesting is easily seen from your fund account statements. This information is important later on when you sell shares (more about that in Tip No. 5).

Tip #2: Be Aware That Exchanges of Shares Are Taxable Events

The “exchange privilege,” or the ability to exchange shares of one fund for shares of another, is a popular feature of many mutual fund “families,” i.e., fund organizations that offer a variety of funds. For tax purposes, exchanges are treated as if you had sold your shares in one fund and used the cash to purchase shares in another fund. In other words, you must report any capital gain from the exchange on your return. The same tax rules used for calculating gains and losses when you redeem shares apply when you exchange them.

Gains on these redemptions and exchanges are taxable whether the fund invests in taxable or tax-exempt securities.

Tip #3: Be Wary of Buying Shares Just Before Ex-Dividend Date

Tax law requires that mutual funds distribute at least 98 percent of their ordinary and capital gain income annually. Thus, many funds make disproportionately large distributions in December. The date on which a fund’s shareholders become entitled to future payment of a distribution is referred to as the ex-dividend date. On that date, the fund’s net asset value (NAV) is reduced on a per-share basis by the exact amount of the distribution. Buying mutual fund shares just before this date can trigger an unexpected tax.

You buy 1,000 shares of Fund XYZ at $10 a share. A few days later, the fund goes ex-dividend, entitling you to a $1 per share distribution. Because $1 of your $10 NAV is being distributed to you, the value of your 1,000 shares is reduced to $9,000. As with any fund distribution, you may receive the $1,000 in cash or reinvest it and receive additional shares. In either case, you must pay tax on the distribution.

If you reinvest the $1,000, the distribution has the appearance of a wash in your account since the value of your fund investment remains $10,000. The $1,000 reinvestment results in the acquisition of 111.1 new shares with a $9 NAV and increases the cost basis of your total investment to $11,000. If you were to redeem your shares for $10,000 (their current value), you would realize a $1,000 capital loss.

In spite of these tax consequences, in some instances it may be a good idea to buy shares right before the fund goes ex-dividend. For instance, the distribution could be relatively small, with only minor tax consequences. Or the market could be moving up, with share prices expected to be higher after the ex-dividend date.

To find out a fund’s ex-dividend date call the fund directly.

If you regularly check the mutual fund quotes in your daily newspaper and notice a decline in NAV from the previous day, the explanation may be that the fund has just gone ex-dividend. Newspapers generally use a footnote to indicate when a fund goes ex-dividend.

Tip #4: Do Not Overlook the Advantages of Tax-Exempt Funds

If you are in the higher tax brackets and are seeing your investment profits taxed away, then there is a good alternative to consider: tax-exempt mutual funds. Distributions from such funds that are attributable to interest from state and municipal bonds are exempt from federal income tax (although they may be subject to state tax).

The same is true of distributions from tax-exempt money market funds. These funds also invest in municipal bonds, but only in those that are short-term or close to maturity, the aim being to reduce the fluctuation in NAV that occurs in long-term funds.

Many taxpayers can ease their tax bite by investing in municipal bond funds. The catch with municipal bond funds is that they offer lower yields than comparable taxable bonds. For example, if a U.S. Treasury bond yields 2.8 percent, then a quality municipal bond of the same maturity might yield 2.45 percent. If an investor is in a higher tax bracket, the tax advantage makes it worthwhile to invest in the lower-yielding tax-exempt fund. Whether the tax advantage actually benefits a particular investor depends on that investor’s tax bracket.

To figure out how much you would have to earn on a taxable investment to equal the yield on a tax-exempt investment, use this formula: Tax-exempt yield divided by (1 minus your tax bracket) = equivalent yield of a taxable investment.

You are planning for the 32% bracket. The yield of a tax-exempt investment is 2.8 percent. Applying the formula, we get .028 divided by .68 (1 minus .32) = .041. Therefore, 4.1 percent is the yield you would need from a taxable investment to match the tax-exempt yield of 2.8 percent.

In limited cases based on the types of bonds involved, part of the income earned by tax-exempt funds may be subject to the federal alternative minimum tax.

Although income from tax-exempt funds is federally tax-exempt, you must still report on your tax return the amount of tax-exempt income you received during the year. This is an information-reporting requirement only and does not convert tax-exempt earnings into taxable income.

Your tax-exempt mutual fund will send you a statement summarizing its distributions for the past year and explaining how to handle tax-exempt dividends on a state-by-state basis.

Capital gain distributions paid by municipal bond funds (unlike distributions of interest) are not free from federal tax. Most states also tax these capital gain distributions.

Tip #5: Keep Records of Your Mutual Fund Transactions

It is very important to keep the statements from each mutual fund you own, especially the year-end statement.

By law, mutual funds must send you a record of every transaction in your account, including reinvestments and exchanges of shares. The statement shows the date, amount, and number of full and fractional shares bought or sold. These transactions are also contained in the year-end statement.

In addition, you will receive a year-end Form 1099-B, which reports the sale of fund shares, for any non-IRA mutual fund account in which you sold shares during the year.

Why is record keeping so important? When you sell mutual fund shares, you will realize a capital gain or loss in the year the shares are sold. You must pay tax on any capital gain arising from the sale, just as you would from the sale of individual securities. (Losses may be used to offset other gains in the current year and deducted up to an additional $3,000 of ordinary income. Remaining loss may be carried for comparable treatment in later years.)

The amount of the gain or loss is determined by the difference between the cost basis of the shares (generally the original purchase price) and the sale price. Thus, in order to figure the gain or loss on a sale of shares, it is essential to know the cost basis. If you have kept your statements, you will be able to figure this out.

In 2012, you purchased 100 shares of Fund JKL at $10 a share for a total purchase price of $1,000. Your cost basis for each share is $10 (what you paid for the shares). Any fees or commissions paid at the time of purchase are included in the basis, so since you paid an up-front commission of two percent, or $20, on the purchase, your cost basis for each share is $10.20 ($1,020 divided by 100). Let’s say you sell your Fund JKL shares this year for $1,500. Assume there are no adjustments to your $ 1,020 basis, such as basis attributable to shares purchased through reinvestment (for an example of the effect of reinvestment on the cost basis, see Tip #6.). On this year’s income tax return, you report a capital gain of $480 ($1,500 minus $1,020).

Since they are taken into account in your cost basis, commissions or brokerage fees are not deductible separately as investment expenses on your tax return.

One of the advantages of mutual fund investing is that the fund provides you with all of the records that you need to compute gains and losses–a real plus at tax time. Some funds even provide cost basis information or compute gains and losses for shares sold. That is why it is important to save the statements. However, you are not required to use the fund’s gain or loss computations in your tax reporting.

Tip #6: Reinvesting Dividends & Capital Gain Distributions when Calculating

Make sure that you do not pay any unnecessary capital gain taxes on the sale of mutual fund shares because you forgot about reinvested amounts. When you reinvest dividends and capital gain distributions to buy more shares, you should add the cost of those shares (that is, the amount invested) to the cost basis of the shares in that account because you have already paid tax on those shares. Failure to include reinvested dividends and capital gain distributions in your cost basis is a costly mistake.

You bought 500 shares in Fund PQR 15 years ago for $10,000. Over the years, you reinvested dividends and capital gain distributions in the amount of $8,000, for which you received 100 additional shares. This year, you sell all 600 of those shares for $40,000. If you forget to include the price paid for the 100 shares purchased through reinvestment (even though the fund sent you a statement recording the shares you received in each transaction), you will unwittingly report on your tax return a capital gain of $30,000 ($40,000 – $ 10,000) on your redemption of 600 shares, rather than the correct capital gain of 22,000 ($40,000 – [$10,000 + $8,000]).

Tip #7: Adjust Cost Basis for Non-Taxable Distributions

Sometimes mutual funds make distributions to shareholders that are not attributable to the fund’s earnings. These are nontaxable distributions, also known as returns of capital. Because a return of capital is a return of part of your investment, it is not taxable. Your mutual fund will show any return of capital on Form 1099-DIV in the box for nontaxable distributions.

Nontaxable distributions are not the same as the tax-exempt dividends described in Tip No. 4.

If you receive a return-of-capital distribution, your basis in the shares is reduced by the amount of the return.

Fifteen years ago, you purchased 1,000 shares of Fund ABC at $10 a share. The following year you received a $1-per-share return-of-capital distribution, which reduced your basis in those shares by $1, to give you an adjusted basis of $9 per share. This year you sell your 1,000 shares for $15 a share. Assuming no other transactions during this period, you would have a capital gain this year of $6 a share ($15 – $9) for a total reported capital gain of $6,000.

Nontaxable distributions cannot reduce your basis below zero. If you receive returns of capital that, taken together, exceed your original basis, you must report the excess as a long-term capital gain.

Your overall basis will not change if non-taxable distributions are reinvested. However, your per-share basis will be reduced.

Tip #8: Use the Best Method of Identifying Sold Shares

Calculating the capital gain or loss on shares you sell is somewhat more complicated if, as is usually the case, you are selling only some of your shares. You then must use some accounting method to identify which shares were sold to determine your capital gain or loss. The IRS recognizes several methods of identifying the shares sold:

  • First-in, first-out (FIFO),
  • Average cost (single category and double category), and
  • Specific identification.

Reports from your funds may include a computation of gain or loss on your sale of mutual fund shares. Typically, these will use the average cost method, single category rule. This is done as a convenience. You are allowed to adopt one of the other methods.

First-In, First-Out (FIFO)

Under this method, the first shares bought are considered the first shares sold. Unless you specify that you are using one of the other methods, the IRS will assume you are using FIFO.

Average Cost

This approach allows you to calculate an average cost for each share by adding up the total cost of all the shares you own in a particular mutual fund and dividing by the number of shares. If you elect to take an average cost approach, you must then choose whether to use a single-category method or a double-category method.

  • With the single category method, you simply group all shares together, add up the cost, and divide by the number of shares. Under this method, you are deemed to have sold first the shares you have held the longest.
  • The double category method enables you to separate short-term and long-term shares. Shares held for one year or less are considered short-term; shares held for more than one year are considered long-term. You average the cost of shares in each category separately. In this way, you may specify whether you are redeeming long-term or short-term shares.

Keep in mind that once you elect to use either average cost method, you must continue to use it for all transactions in that fund unless you receive IRS approval to change your method.

Specific Identification

Under this method, you specify the individual shares that are sold. If you have kept track of the purchase prices and dates of all your fund shares, including shares purchased with reinvested distributions, you will be able to identify, for example, those shares with the highest purchase prices and indicate that they are the shares you are selling. This strategy gives you the smallest capital gain and could save you a significant amount on your taxes.

To take advantage of this method, you must, at the time of the sale or exchange, indicate to your broker or to the mutual fund itself the particular shares you are selling. The IRS also insists that you receive written confirmation of your instructions.

To see the advantages and disadvantages of these methods of identifying sold shares, see How The Various Identification Methods Compare (below).

Money market funds present a very simple case when you redeem shares. Because most money market funds maintain a stable net asset value of $1 per share, you have no capital gain or loss when you sell shares. Thus, you only pay tax on any earnings distributed.

Tip #9: Avoid Backup Withholding

One way the IRS makes sure it receives taxes owed by taxpayers is through backup withholding. In the mutual fund context, this means that a mutual fund company is required to deduct and withhold a specified percentage (see below) of your dividend and redemption proceeds if one of the following situations has occurred:

  • You have not supplied your taxpayer identification number (Social Security number) to the fund company;
  • You supplied a TIN that the IRS finds to be wrong;
  • The IRS finds you have underreported your interest and dividend payments; or
  • You failed to tell the fund company you are not subject to backup withholding.

The backup withholding percentage is 24 percent for tax years 2018-2025 (28 percent in prior years).

Tip #10 Don’t Forget State Taxation

Many states treat mutual fund distributions the same way the federal government does. There are, however, some differences. For example,:

      • If your mutual fund invests in U.S. government obligations, states generally exempt from state taxation dividends attributable to federal obligation interest.
      • Most states do not tax income from their own obligations, whether held directly or through mutual funds. On the other hand, the majority of states do tax income from the obligations of other states. Thus, in most states, you will not pay state tax to the extent you receive, through the fund, income from obligations issued by your state or its municipalities.
      • Most states don’t grant reduced rates for capital gains or dividends.

Tip #11: Don’t Overlook Possible Tax Credits For Foreign Income

If your fund invests in foreign stocks or bonds, part of the income it distributes may have been subject to foreign tax withholding. If so, you may be entitled to a tax deduction or credit for your pro-rata share of taxes paid. Your fund will provide you with the necessary information.

Because a tax credit provides a dollar-for-dollar offset against your tax bill, while a deduction reduces the amount of income on which you must pay tax, it is generally advantageous to claim the foreign tax credit. If the foreign tax doesn’t exceed $300 ($600 on a joint return), then you may not need to file IRS form 1116 to claim the credit.

Tip #12: Be Careful About Trying the “Wash Sale“ Rule

If you sell fund shares at a loss (so you can take a capital loss on your return) and then repurchase shares in the same fund shortly thereafter, beware of the wash sale rule. This rule bars a loss deduction when a taxpayer buys “substantially identical” shares within 30 days before or after the date of sale.

Be sure to wait more than thirty (30) days before reinvesting.

Tip #13: Choose Tax-Efficient Funds

Many investors who hold mutual funds directly may hold others through tax-sheltered accounts such as 401(k)s, IRAs, and Keoghs. Your aggressive high-turnover funds and high-income funds should be in tax-sheltered accounts. These generate more current income and gains, currently taxable if held directly but tax-deferred in tax-sheltered accounts. Buy-to-hold funds and low activity funds such as index funds should be owned directly (as opposed to a tax-sheltered account). With relatively small currently distributable income, such investments can continue to grow with only a modest reduction for current taxes.

For some investors, the simpler approach may be to hold mutual funds personally and more highly taxed income (such as bond interest) in the tax-sheltered account.

As you can see, there are many tax pitfalls that await the unwary mutual fund investor. Professional guidance should be considered to minimize the tax impact.

How The Various Identification Methods Compare

To illustrate the advantages and disadvantages of the various methods of identifying the shares that you sell, assume that you bought 100 shares of Fund PQR in January 2005 at $20 a share, 100 shares in January 2006 at $30 a share, and 100 shares in November 2010 at $46 a share. You sell 50 shares in June of this year for $50 a share. Here are your alternative ways to determine cost basis.

      1. First-In, First-Out (FIFO).The FIFO method identifies the 50 shares sold as among the first 100 shares purchased. Your cost basis per share is $20. This rate gives you a capital gain of $1,500 ($2,500 – (50 x $20)).
      2. Advantages/Disadvantages. In this example, this method produces the highest amount of capital gain on which you are taxed. FIFO provides the lowest capital gain amount when the fund’s net asset value has declined, and the first shares purchased were the most expensive. It can also sometimes save tax when shares bought later weren’t held long enough to qualify for long-term capital gains treatment.
      3. Average Cost/Single Category. Average cost/single category allows you to calculate the average price paid for all shares in the fund. Here, your cost basis per share is $32 (your 300 shares cost $9,600: $9,600 divided by 300 = $32), giving you a capital gain of $900 ($2,500 – (50 x $32)).
      4. Advantages/Disadvantages.: Compared to FIFO, this method can reduce the amount of your capital gain if the fund’s net asset value has increased over time. You could generate a lower long-term capital gain by using specific identification, but average cost/single category is useful if you did not designate shares at the time of sale or you simply do not want to do the record-keeping required to use the specific identification method.
      5. Average Cost/Double Category. Under this method, you average the cost of the short-term shares (those held for one year or less) and the cost of the long-term shares (those held for more than one year) separately. Thus, in the long-term category, you have 200 shares at $5,000 for an average cost of $25 per share ($5,000 x 200), and in the short-term category, you have 100 shares at $4,600 for an average cost of $46 per share ($4,600 divided by 100). Comparing the two categories, your taxable gain using the long-term shares would be $1,250 ($2,500 – (50 x $25)), to be taxed at up to 20 percent, while your taxable gain using the short-term shares would be $200 ($2,500 – (50 x $46)), to be taxed at up to 37 percent (top rate for 2023).
      6. Advantages/Disadvantages. In this example, using the average cost of short-term shares produces a better result. However, because of the current spread between the top marginal income tax rates and the maximum rate on long-term capital gains, it could make sense in some instances to choose the long-term shares. Furthermore, as with specific identification, you must plan ahead to use this method by specifying to the broker or mutual fund company at the time of sale that you are selling short-term or long-term shares, and you must receive confirmation of your specification in writing. If you have elected to use average cost-double category but do not specify for a particular redemption whether you are redeeming short-term or long-term shares, the IRS will deem you to have redeemed the long-term shares first.
      7. Specific identification. With this method, you designate which shares you are selling. To reduce your capital gains tax bill the most, you would select the shares with the highest purchase price. In this case, you would identify the 50 shares sold as among those purchased in 1999. Your cost basis, therefore, is $46 per share, giving you a capital gain of $200 ($2,500 – (50 x $46)).
      8. Advantages/Disadvantages: This method can produce favorable results in lowering the capital gain, but IRS regulations require you to think ahead by providing instructions before the sale and then receiving confirmation of your specification in writing. The IRS will not let you designate shares after the fact.

Government and Non-Profit Agencies

Securities and Exchange Commission

100 F Street, NE
Washington, D.C. 20549
(202) 942-8088

The SEC has public reference rooms at its headquarters in Washington, D.C., and at its Northeast and Midwest Regional offices. Copies of the text of documents filed in these reference rooms may be obtained by visiting or writing the Public Reference Room (at a standard per page reproduction rate) or through private contractors (who charge for research and/or reproduction).

Other sources of information filed with the SEC include public or law libraries, securities firms, financial service bureaus, computerized on-line services, and the companies themselves.

Most companies whose stock is traded over the counter or on a stock exchange must file “full disclosure” reports on a regular basis with the SEC. The annual report (Form 10-K) is the most comprehensive of these. It contains a narrative description and statistical information on the company’s business, operations, properties, parents, and subsidiaries; its management, including their compensation and ownership of company securities: and significant legal proceedings which involve the company. Form 10-K also contains the audited financial statements of the company (including a balance sheet, an income statement, and a statement of cash flow) and provides management’s discussion of business operations and prospects for the future.

Quarterly financial information on Form 8-K may be required as well.

Anyone may search the SEC’s Company Filings database for information regarding to including quarterly and annual reports, registration statements for IPOs and other offerings, insider trading reports, and proxy materials.

American Association of Individual Investors
(Offers an annual guide to low-load mutual funds):

625 North Michigan Avenue
Chicago, IL 60611
Tel: 312-280-0170 or 800-428-2244

Investment Company Institute
(Publishes an annual directory of mutual funds):

1401 H Street NW, Suite 1200
Washington, DC 20005
Tel: 202-326-5800

Investment Management Education Alliance
(Offers a free Portfolio tool, complete with data from Morningstar, Inc.):

2345 Grand Boulevard
Kansas City, MO 64108
Tel: 816-454-9427


02 Aug 2024

Don’t overpay your income taxes by overlooking expenses that you are entitled to deduct. Use this Financial Guide to ensure you are handling your business travel, meal and auto costs in a tax-wise manner.

This Financial Guide shows you how to take advantage of all of the travel, meal and auto expenses you’re legally entitled to and offers guidance on which expenses are deductible and what percentage of them you can deduct. It also discusses the importance of following IRS rules for keeping records and substantiating your expenses in order to avoid an audit.

From 2018 through 2025, employees who travel or incur meal or auto costs for business can’t deduct such expenses on Form 1040, Schedule A. This is due to the Tax Cuts and Jobs Act of 2017 (TCJA) suspension of miscellaneous itemized deductions subject to the 2% of adjusted gross income floor. Generally only businesses and the self-employed can deduct such costs.


  • Travel Expenses
  • Meal and Entertainment Expenses
  • Recordkeeping and Substantiation Requirements
  • Employees Who Are “Fully Reimbursed“
  • Auto Expenses
Travel Expenses

If you’re eligible, you generally can deduct two types of travel expenses related to your business:

1. Local transportation costs. Commuting expenses aren’t deductible, but costs related to trips from your workplace to other locations, such as to visit a client or vendor, are deductible. Examples of such costs include public transportation, taxi, ride share or your own auto, as well as parking and tolls. For those whose main place of business is their personal residence, business trips from the home office and back are considered deductible transportation and not non-deductible commuting.

Please see the special section below for the most effective ways of deducting auto expenses.

2. Away-from-home travel expenses. You can only deduct one-half of the cost of meals (50 percent) in 2024. Lodging expenses incurred while traveling away from home are fully deductible. You also can deduct 100 percent of your transportation expenses as long as business is the primary reason for your trip.

The 100 percent deduction for the cost of business meals and beverages purchased from restaurants in 2021 and 2022 was not extended.

Here are some additional considerations as you assess the deductibility of your local transportation and away-from-home travel expenses:

To be deductible, travel expenses must be “ordinary and necessary,” although “necessary” is liberally defined as “helpful and appropriate,” not “indispensable.” The deduction is also denied for that part of any travel expense that is “lavish or extravagant,” though this rule does not bar deducting the cost of first-class travel or deluxe accommodations or (subject to percentage limitations below) deluxe meals.

What does “away from home” mean? To deduct the costs of lodging and meals (and incidentals, see below) you must generally stay somewhere overnight. In other words, you must be away from your regular place of business longer than an ordinary day’s work and need to sleep or rest to meet the demands of your work while away from home. Otherwise, your costs are considered local transportation costs and the costs of lodging and meals are not deductible.

Where is your “home” for tax purposes? The general view is that your “home” for travel expense purposes is your place of business or your post of duty. It is not where your family lives (some courts have stated that it’s the general area of your residence). Here is an example:

George’s family lives in Boston and George’s business is in Washington, DC. George spends the weekends in Boston and the weekdays in Washington, where he stays in a hotel and eats out. For tax purposes, George’s “home” is in Washington, not Boston, therefore, he cannot deduct any of the following expenses: cost of traveling back and forth between Washington and Boston, cost of eating out in Washington, cost of staying in a hotel in Washington, or any costs incurred traveling between his hotel in Washington and his job in Washington (the latter are considered non-deductible commuting costs).

There are some rules in the tax law concerning where a taxpayer’s “home” is for purposes of deducting travel expenses that are less clear, such as when a taxpayer works at a temporary site or works in two different places.

We’ll cover these rules briefly in these two examples:

Example #1: Joe, who lives in Connecticut and is self-employed, works eight months out of the year in Connecticut (from which he usually earns about $100,000) and four months out of the year in Florida (from which he usually earns about $50,000). Joe’s “tax home” for travel expense purposes is Connecticut. Therefore, the costs of traveling to and from the “lesser” place of employment (Florida), as well as meals and lodging costs incurred while working in Florida, are deductible.

Example #2: Susan is self-employed and works and lives in New York. Occasionally, she must travel to Maryland on temporary assignments, where she spends up to a week at a time. Assuming Susan’s clients don’t reimburse her for travel expenses, she can deduct the costs of meals and lodging while she’s in Maryland, as well as the costs of traveling to and from Maryland. This holds true because her work assignments in Maryland are considered temporary since they will end within a foreseeable time. If an assignment is considered indefinite, that is, expected to last for more than a year, under the tax law, travel, meal, and lodging costs are not deductible.

Here’s a list of some deductible away-from-home travel expenses:

  • Meals limited to 50 percent in 2024 and lodging while traveling or once you get to your away-from-home business destination.
  • The cost of having your clothes cleaned and pressed away from home.
  • The costs of transportation between job sites or to and from hotels and terminals.
  • Airfare, bus fare, rail fare, and charges related to shipping baggage or taking it with you.
  • The cost of bringing or sending samples or displays, and of renting sample display rooms.
  • The costs of keeping and operating a car, including garaging costs.
  • The cost of keeping and operating an airplane, including hangar costs.
  • Transportation costs between “temporary” job sites and hotels and restaurants.
  • Incidentals, including equipment rentals, stenographers’ fees.
  • Tips related to the above.

However, many away-from-home travel expenses are not deductible or are restricted in some way. These include:

Travel as a form of education. Trips that are educational in a general way, or improve knowledge of a certain field but are not part of a taxpayer’s job, are not deductible.

Seeking a new location. Travel costs (and other costs) incurred while you are looking for a new place for your business (or for a new business) must be capitalized and cannot be deducted currently.

Luxury water travel: If you travel using an ocean liner, a cruise ship, or some other type of “luxury” water transportation, the amount you can deduct is subject to a per-day limit.

Seeking foreign customers: The costs of traveling abroad to find foreign markets for existing products are not deductible.

Meal and Entertainment Expenses

Tax law requires you to keep records that will prove the business purpose and amounts of your business travel and meal expenses. To substantiate business travel and business meal expenses, you must prove:

  • The amount,
  • The time and place of the travel or meal,
  • The business purpose, and
  • The business relationship of the recipient of business meals.

The most frequent reason for IRS’s disallowance of travel and meal expenses is the failure to show the place and business purpose of an item. Therefore, pay special attention to these aspects of your record-keeping.

Keeping a diary or logbook and recording your business-related activities at or close to the time the expense is incurred is one of the best ways to document your business expenses.

Here’s how these rules apply to your record-keeping for travel expenses and business meals:

Away-from-home travel expenses. You must document the following for each trip:

  • The amount of each expense, e.g., the cost of each transportation, lodging and meal. You can group similar types of incidentals together, i.e., “meals, taxis,”
  • The dates of your departure and return and the number of days you spent on business.
  • Your destination, and
  • The business reason for the travel or the business benefit you expect.

Business meal expenses. You must prove the following for each claimed deduction for meal expenses:

  • The amount,
  • The date of the meal, and
  • The name, title, and occupation (showing business relation) of your meal guests.

Recordkeeping and Substantiation Requirements

If you are considering divorce, it is vital to plan for the dissolution of the financial partnership in your marriage. Such dissolution involves dividing financial assets accumulated during the marriage. Further, if children are involved, future financial support for the custodial parent must be planned for. While it may not be at the top of your to-do list, taking time to prepare financially during divorce pays off in the long run.

Take Stock Of Your Situation

Assessing your financial situation helps you in two ways:

  • It will provide you with preliminary information for an eventual division of the property.
  • It will help you to plan how debts incurred during the marriage are to be paid off. Although the best way to deal with joint debt (such as credit card debt) is to pay it off before the divorce, this strategy is often impossible so compiling a list of your debts will help you to come to some agreement as to how they will be paid off.

To take stock of your situation start by preparing an inventory of your financial assets:

    • The current balance in all bank accounts;
    • The value of any brokerage accounts;
    • The value of investments, including any IRAs;
    • Your residence(s);
    • Your autos; and
    • Your valuable antiques, jewelry, luxury items, collections, and furnishings.
  1. Make sure you have copies of the past two or three years’ tax returns. These will come in handy later.
  2. Make sure you know the exact amounts of salary and other income earned by both yourself and your spouse.
  3. Find the papers relating to insurance-life, health, auto, and homeowner’s-and pension or other retirement benefits.
  4. List all debts you both owe, separately or jointly. Include auto loans, mortgage, credit card debt, and any other liabilities.

If you are a spouse who has not worked outside the home lately, be sure to open a separate bank account in your own name and apply for a credit card in your own name. These measures will help you to establish credit after the divorce.

Related Guide: For a system that makes it easy to organize and locate your records, please see the Financial Guide: DOCUMENT LOCATOR SYSTEM: A Handy Aid For Keeping Track Of Your Records

Estimate Your Post-Divorce Living Expenses

Figure out how much it will cost you to live after the divorce. This is especially important for the spouse who is planning to remain in the family home with the children; it may be determined that the estimated living expenses are not manageable.

To estimate these expenses, add up all of your monthly debts and living expenses, including rent or mortgage. Then total your after-tax monthly income from all sources. The amount left over is your disposable income.

Related Guide: Please see the Financial Guide: BUDGETING: How To Prepare A Workable Plan

Cancel All Joint Accounts

It is important to cancel all joint accounts immediately once you know you are going to obtain a divorce because creditors have the right to seek payment from either party on a joint credit card or another credit account, no matter which party actually incurred the bill. If you allow your name to remain on joint accounts with your ex-spouse, you are also responsible for the bills.

Your divorce agreement may specify which one of you pays the bills. However, as far as the creditor is concerned both you and your spouse remain responsible if joint accounts remain open. The creditor will try to collect the bill from whoever it thinks may be able to pay while at the same time reporting the late payments to credit bureaus under both names. Your credit history could be damaged because of the cosigner’s irresponsibility.

Some credit contracts require that you immediately pay the outstanding balance in full if you close an account. If this is the case, then try to get the creditor to have the balance transferred to separate accounts.

If Your Spouse’s Poor Credit Affects You

If your spouse’s poor credit hurts your credit record, you may be able to separate yourself from the spouse’s information on your credit report. The Equal Credit Opportunity Act requires a creditor to take into account any information showing that the credit history being considered does not reflect your own. If for instance, you can show that accounts you shared with your spouse were opened by him or her before your marriage and that he or she paid the bills, you may be able to convince the creditor that the harmful information relates to your spouse’s credit record, not yours.

In practice, it is difficult to prove that the credit history under consideration does not reflect your own, and you may have to be persistent.

For Women: Maintain Your Own Credit Before You Need It

If a woman divorces, and changes her name on an account, lenders may review her application or credit file to see whether her qualifications alone meet their credit standards. They may ask her to reapply even though the account remains open.

Maintaining credit in your own name is the best way to avoid this inconvenience. It also makes it easier to preserve your own, separate, credit history. Further, should you need credit in an emergency it will be available when you need it.

Do not use only your husband’s name (for example, Mrs. John Wilson) for credit purposes.

Check your credit report if you have not done so recently. Make sure the accounts you share are reported in your name as well as your spouse’s name. If not, and you want to use your spouse’s credit history to build your own credit, write to the creditor and request that the account is reported in both names.

Also, carefully review your credit report to determine whether there is any inaccurate or incomplete information. If there is, write to the credit bureau and ask them to correct it. The credit bureau must confirm the data within a reasonable time period, and let you know when they have corrected the mistake.

Related Guide: Please see the Financial Guide: CREDIT REPORTS: What You Should Know-And Do-About Yours.

If you have been sharing your husband’s accounts, building a credit history in your name should be fairly easy. Call a major credit bureau and request a copy of your report. Contact the issuers of the cards you share with your husband and ask them to report the accounts in your name as well.

If you used the accounts, but never co-signed for them, ask to be added on as jointly liable for some of the major credit cards. Once you have several accounts listed as references on your credit record, apply for a department store card, or even a Visa or MasterCard, in your own name.

If you held accounts jointly and they were opened before 1977 (in which case they may have been reported only in your husband’s name), point them out and tell the creditor to consider them as your credit history also. The creditor cannot require your spouse’s or former spouse’s signature to access his credit file if you are using his information to qualify for credit.

If you do not have a credit history, a secured credit card is a fairly quick and easy way to get a major credit card. Secured credit cards look and are used like regular Visa or MasterCard’s, but they require a savings or money market deposit of several hundred dollars that the lender holds in case you default. In most cases, the creditor will report your payment record on these accounts just like a regular bank card, allowing you to build a good credit record if you pay your bills promptly.

Consider the Legal Issues

The best way to plan for the legal issues involved in a divorce including child custody, division of property, and alimony or support payments is to come to an agreement with your spouse. If you can reach an agreement, the time and money you will have to expend in coming up with a legal solution–either one worked out between the two attorneys or one worked out by a court–will be drastically reduced.

Here are some general tips for handling the legal aspects of a divorce:

  • Get your own attorney if there are significant issues to deal with such as child custody, alimony, or significant assets.
  • The best way to find a good matrimonial attorney is to ask for referrals or contact the American Academy of Matrimonial Lawyers (see the last section of this guide for contact information).
  • Make sure the divorce decree or agreement covers all types of insurance coverage including life, health, and auto.
  • Be sure to change the beneficiaries on life insurance policies, IRA accounts, 401(k) plans, other retirement accounts, and pension plans.
  • Don’t forget to update your will.

Those who have trouble arriving at an equitable agreement–and who do not require the services of an attorney–might consider the use of a divorce mediator. Ask friends, relatives, and other professionals for recommendations or contact the Association for Conflict Resolution (see the last section of this guide for contact information). You can also look in the phone book or classifieds under “Divorce Assistance” or “Lawyer Alternatives.”

Division of Property

The laws governing the division of property between ex-spouses vary from state to state. Further, matrimonial judges have a great deal of latitude in applying those laws.

Here is a list of items you should be sure to take care of, regardless of whether you are represented by an attorney.

  1. Understand how your state’s laws on property division work.
  2. If you owned property separately during the marriage, be sure you have the papers to prove that it has been kept separate.
  3. Be ready to document any non-financial contributions to the marriage such as support of a spouse while he or she attended school or non-financial contributions to his or her financial success.
  4. If you need alimony or child support, be ready to document your need for it.
  5. If you have not worked outside the home during the marriage, consider having the divorce decree provide for money for you to be trained or educated.

Employees Who Are “Fully Reimbursed“

Employees who are “fully reimbursed” by their employer for travel or business meal expenses must:

  • Adequately account to their employer by means of an expense account statement, and
  • Return any excess reimbursement.

As long as you are covered by (and follow) an “accountable plan,” and your reimbursements don’t exceed your expenses, you won’t have to report the reimbursements as gross income. Some per diem arrangements (by which you receive a flat amount per day) and mileage allowances can avoid detailed expense accounting to the employer, but proof of time, place, and business purpose is still required.

However, if your employer’s reimbursement plan is not “accountable,” you must report the reimbursements as income. Prior to 2018, you could deduct these expenses on your tax return as miscellaneous itemized deductions on Form 1040 Schedule A, subject to the two percent-of-adjusted-gross-income floor. As noted earlier, however, the TCJA eliminated miscellaneous deductions for tax years 2018 through 2025.

Auto Expenses

If you’re eligible, you have two choices as to how to claim the deduction for business auto expenses:

  1. You can deduct the actual business-related costs of gas, oil, lubrication, repairs, tires, supplies, parking, tolls, chauffeur salaries, and depreciation, or
  2. You can use the standard mileage deduction, which is an inflation-adjusted amount that is multiplied by the number of business miles driven.

Parking fees and tolls may be deducted no matter which method you use.

The standard mileage rate produces a larger deduction for some business owners, while others fare better (tax-wise) by deducting actual expenses. Figuring your deduction using both methods tells you which method is better for you tax-wise. Here are some additional considerations:

Expensing and depreciating vehicle costs. Deduction options and amounts depend on the percentage used for business. Also, if the car is used more than 50 percent for business, it can be included as business property and qualify for Section 179 expensing in the year of purchase. The deduction is reduced proportionately to the extent the car is used for personal purposes. If you take this deduction, you can’t use the actual mileage for that vehicle in any year.

Depreciation. Assuming the car cost more than the Section 179 limit, or Section 179 is not available or is not claimed, depreciation is allowed. Several depreciation options are available, but there are limits to the amount of depreciation that can be claimed per year. Depreciation otherwise allowable is reduced by the proportion of personal use. For example, a car used 20 percent for personal use is depreciated at 80 percent of the amount otherwise allowed.

Accelerated depreciation is defined as depreciation that is at a rate higher than normal that results from dividing the vehicle’s cost by the number of years it will be used. It is not allowed where personal use is 50 percent or more. If you claimed accelerated depreciation in a prior year and your business use then falls to 50 percent or less, you become subject to “recapture” of the excess depreciation (i.e., it’s included in income). Of course, using the standard mileage deduction described below allows you to avoid these limits.

Determining whether to use the standard mileage deduction. If you opt for the standard mileage rate, you simply multiply the applicable cents-per-mile rate by the number of business miles you drove. Be aware, however, that the standard mileage deduction may understate your costs. This is especially true for taxpayers who use the car 100 percent for business, or close to that percentage.

Once you choose the standard mileage rate, you cannot use accelerated depreciation even if you opt for the actual cost method in a later year. You may use only straight line.

The standard mileage method usually benefits taxpayers who have less expensive cars or who travel a large number of business miles. To determine which method is better for you, make the calculations each way during the first year you use the car for business.

You may use the standard mileage for leased cars if you use it for the entire lease period. Or, you can deduct actual expenses instead, including leasing costs.

Recordkeeping. Tax law requires that you keep travel expense records and that you give information on your return showing business versus personal use. Not only is keeping good records essential in case of an audit, but it also allows you to make the most of your auto deductions. For example, you won’t be able to determine which of the two options is better if you don’t know the number of miles driven and the total amount you spent on the car. If you use the actual cost method, you’ll have to keep receipts as well. For many business owners, using a separate credit card for business simplifies your record-keeping.

Don’t forget to deduct the interest you pay to finance a business-use car if you’re self-employed.


02 Aug 2024

There are a number of tax vehicles for turning charitable desires into tax deductions. While these techniques are quite complex, they can with the proper guidance provide substantial tax deductions. This Financial Guide provides an introductory view of the ways to maximize your tax deduction while satisfying your charitable goals.

When an organization claims to be tax-exempt, it does not necessarily mean that contributions are deductible. Tax-exempt means that the organization does not have to pay federal income taxes while tax-deductible means the donor can deduct contributions to the organization. The Internal Revenue Code defines more than 20 different categories of tax-exempt organizations, but only a few of these offer tax-deductibility for donations.

The well-known mainstream charities generally provide deductibility for donations. But, surprisingly, some well-known organizations do not. If deductibility is a factor in your decision to make a contribution to a tax-exempt organization, especially if the amount is substantial, you might want to determine whether the organization qualifies for deductibility. IRS Publication 78, the Cumulative List of Organizations, is an annual list of those charities eligible for deductibility. You can also call the IRS (800-829-1040) about the deductibility of a contribution if you’re in doubt.

You can obtain three documents on a specific charity by sending a written request to the attention of the Disclosure Officer at your nearest IRS District Office. The IRS will charge a per-page copying fee for these items. To speed your request, have the full, official name of the charity, as well as the city and state location. These three publicly available documents are:

  • Form 1023: the application filed by the charity to obtain tax-exempt status.
  • IRS Letter of Determination: the two-page IRS letter that notifies the organization of its tax-exempt status.
  • Form 990: the financial/income tax form filed with the IRS annually by the charity. (Charities with a gross income of less than $25,000 and churches are not required to file this form). Among other things, Form 990 includes information on the charity’s income, expenses, assets, liabilities and net assets in the past fiscal year. Form 990 also identifies the salaries of the charity’s five highest-paid employees. When contacting the IRS for copies, specify the fiscal year.

Tip: If your request for information involves only Forms 990, you can get a faster response by writing directly to the IRS Service Center where the charity files its return. Contact your nearest IRS office for the address of the appropriate Service Center.

Tip: The charity registration office in your state (usually a division of the state attorney general’s office) may also have a copy of the charity’s latest Form 990, along with other publicly available information on charities soliciting in your state.

Related Guide: For a discussion of how to make charitable donations, please see the Financial Guide: CHARITABLE CONTRIBUTIONS: How To Give Wisely.

Related Guide: For a discussion of how to make charitable donations, please see the Financial Guide: FRAUDULENT CHARITIES: How To Protect Yourself.

Even though the charity qualifies for deductibility, taxpayers are often disappointed to learn that their expected deductions are not allowed. Here are some of the common misconceptions about the deductibility of charitable contributions:

  • If you go to a charity affair or buy something to benefit a charity (e.g., a magazine subscription or show tickets), you cannot deduct the full amount you pay. Only the part above the fair market value of the item you purchase is fully deductible. For example, if you pay $500 for a charity luncheon worth $200, only $300 can be deducted. An exception allows you to deduct the full amount if what you get in return is insubstantial in value (e.g., 2 percent of the value of your contribution) and the charity tells you the deductible amount.
  • Since contributions are deductible only for the year in which they are actually paid or delivered, pledges are not deductible until they are paid.
  • It’s a mistake to believe you can deduct estimated cash contributions. This was widely done though IRS required you to make a record of some kind at or around the time of the gift. But cash contributions in 2007 and after aren’t deductible at all unless substantiated by a receipt from the charity, a canceled check, a credit card statement or other supporting documentation from the charity.
  • No donation of $250 or more is deductible unless the taxpayer has a receipt from the charity substantiating the donation.
  • Since contributions must be made to qualified organizations to be tax-deductible, donations made directly to needy individuals are not deductible.

Note: The amount of the deduction you can get for the garden-variety charitable contribution (we’ll talk about more sophisticated techniques in a moment) depends on the type of charity and the type of contribution, as well as on the specific tax situation of the donor (since there are percentage-of-income limitations). For these reasons, tax planning for charitable contributions requires the assistance of your tax advisor.


  • Planned or Deferred Giving
  • Types of Planned and Deferred Gifts
  • Should You Make a Planned or Deferred Gift?
  • Government and Non-Profit Agencies
Planned or Deferred Giving

There are a number of sophisticated techniques for giving money to a charity that differ substantially from the usual method of just writing a check. You’ve probably been approached by a number of charitable organizations suggesting ways you can save tax dollars through the use of planned or deferred giving techniques. Indeed, much of the revenue of many charities comes from the use of such techniques. However, not all charities have the resources to be able to offer sophisticated arrangements. Briefly stated, these various techniques, discussed below, work as follows:

A planned or deferred gift is a present commitment to make a gift in the future, either during your lifetime or pursuant to your will. Aside from assuring your favorite charities of a contribution, planned or deferred giving brings with it certain tax benefits. Charitable gifts made pursuant to your will reduce the amount of your estate that is subject to estate tax. Lifetime gifts have the same estate tax effect (by removing the assets from your estate), but also might offer a current income tax deduction. If you have property that has significantly appreciated in value but does not bring in current income, you may be able to use one of these techniques to convert it into an income-producing asset. Further, you will be able to avoid or defer the capital gains tax that would be due on its sale – all the while helping a charity.

Tip: Many variables affect the type of planned or deferred giving arrangement you choose, such as the amount of your income, the size of your estate and the type of asset transferred (e.g., cash, investments, business interests, real estate, retirement plan) and its appreciated value. Professional guidance is even more important here than in the garden-variety type of contribution program because these of the complexity of these gifts.

Types of Planned and Deferred Gifts

There are several types of planned and deferred gifts: (1) life insurance, (2) charitable remainder annuity trust, (3) charitable remainder unitrust, (4) charitable lead annuity trust, (5) charitable lead unitrust, (6) charitable gift annuity, (7) pooled income fund. These are discussed briefly below:

Life Insurance

You name a charity as a beneficiary of a life insurance policy. With some limitations, both the contribution of the policy itself and the continued payment of premiums may be income-tax deductible.

Charitable Remainder Annuity Trust

You transfer assets to a trust that pays a set amount each year to non-charitable beneficiaries (for example, to yourself or your children) for a fixed term or for the life or lives of the beneficiaries, after which time the remaining assets are distributed to one or more charitable organizations. You get an immediate income tax deduction for the value of the remainder interest that goes to the charity on the trust’s termination, even though you keep a life-income interest. In effect, you or your beneficiaries get current income for a specified period and the remainder goes to the charity.

Charitable Remainder Unitrust

This is the same as the charitable remainder annuity trust, except the trust pays the actual income or a set percentage of the current value (rather than a set amount) of the trust’s assets each year to the non-charitable beneficiaries. Here, too, you or your beneficiaries get current income for a specified period and the remainder goes to the charity.

Charitable Lead Annuity Trust

You transfer assets to a trust that pays a set amount each year to charitable organizations for a fixed term or for the life of a named individual. At the termination of the trust, the remaining assets will be distributed to one or more non-charitable beneficiaries (for example, you or your children).

You get a deduction for the value of the annual payments to the charity. You may still be liable for tax on the income earned by the trust. You keep the ability to pass on most of your assets to your heirs. Unlike the two trusts above, the charity gets the current income for a specified period and your heirs get the remainder.

Charitable Lead Unitrust

This is the same as the lead annuity trust, except the trust pays the actual income or a set percentage of the current value (rather than a set amount) of the trust’s assets each year to the charities.

Here, too, the charity gets the current income for a specified period and your heirs get the remainder.

Charitable Gift Annuity

You and a charity have a contract in which you make a present gift to the charity and the charity pays a fixed amount each year for life to you or any other specified person. Your charitable deduction is the value of your gift minus the present value of your annuity.

Pooled Income Fund

You put funds into a pool that operates like a mutual fund but is controlled by a charity. You, or a designated beneficiary, get a share of the actual net income generated by the entire fund for life, after which your share of the assets is removed from the pooled fund and distributed to the charity. You get an immediate income tax deduction when you contribute the funds to the pool. The deduction is based on the value of the remainder interest.

Should You Make a Planned or Deferred Gift?

When determining whether to make a planned or deferred gift to a charity, ask whether you are ready to make a commitment to invest in a charitable organization. Keep in mind that despite the tax benefits, you will still be out-of-pocket after the deduction.

Some questions you should consider are:

  • Does the gift fit into your estate and family plan?
  • Is the charity viable, reputable, creditable, and reliable?
  • Do you wish to support its programs?

Government and Non-Profit Agencies

  • Most state governments regulate charitable organizations. To obtain information on these regulations, which vary from state to state, contact the appropriate government agency (usually a division of the Attorney General or the Secretary of State).
  • Contact the appropriate state government agency to verify a charity’s registration and to obtain financial information on a soliciting charity.
  • Contact your local Better Business Bureau to find out whether a complaint has been lodged against a charity.


02 Aug 2024

This Financial Guide discusses the rules that apply when you contribute property – as opposed to money – to charity and is meant to provide general information. Contact your tax advisor if you need tax planning assistance.

The rules in this area are extremely complex. We urge you not to act on any transaction without seeking the proper advice.

If you contribute property to a qualified organization, the amount of your charitable contribution is generally the fair market value of the property at the time of the contribution. However, if the property fits into one of the categories discussed here, the amount of your deduction must be decreased.

After discussing how to determine the fair market value of something you donate, we’ll discuss the following categories of charitable gifts of property:

  • Contributions subject to special rules
  • Property that has decreased in value;
  • Property that has increased in value;
  • Food Inventory.
  • Bargain Sales.

Related Guide: See What Records You Should Keep To Substantiate Your Charitable Contributions


  • Determining Fair Market Value
  • Contributions Subject to Special Rules
  • Donating Property That Has Decreased in Value
  • Donating Property That Has Increased in Value
  • Ordinary Income Property
  • Capital Gain Property
  • Food Inventory
  • Bargain Sales
  • Penalty
Determining Fair Market Value

Fair market value is the price at which property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all of the relevant facts.

Used Clothing and Household Items.

The fair market value of used clothing and used household goods, such as furniture and furnishings, electronics, appliances, linens, and other similar items is usually much lower than the price paid when new. These items may have little or no market value because they are in a worn condition, out of style, or no longer useful. Claim as the value of used clothing the price that buyers of used items actually pay clothing stores, such as consignment or thrift shops.

Be prepared to support your valuation of other household items with photographs, canceled checks, receipts from your purchase of the items, or other evidence. Magazine or newspaper articles and photographs that describe the items and statements by the recipients of the items may be useful. This documentation does not get filed with your return; it is kept on hand as proof.

No deduction is allowed after August 17, 2006 for household items in less than “good used condition.” However, deduction is allowed where the amount claimed for the item in less than good condition is more than $500 and a qualified appraisal supporting the valuation is filed with the return.

Cars, Boats, and Aircraft

If you donate a car, a boat, or an aircraft to a charitable organization, you must determine the FMV.

The FMV of a donated car, boat, or airplane is generally the amount listed in a used vehicle pricing guide for a private party sale, not the dealer retail value, of a similar vehicle. The FMV may be less than that, however if the vehicle has engine trouble, body damage, high mileage, or any type of excessive wear.

Similar is defined as the same make, model, and year, sold in the same area, in the same condition, with the same or similar options or accessories, and with the same or similar warranties as the donated vehicle.

Boats. Except for inexpensive small boats, the valuation of boats should be based on an appraisal by a marine surveyor because the physical condition is so critical to the value.

If you donate a qualified vehicle to a qualified organization and you claim a deduction of more than $500, you can deduct the smaller of the gross proceeds from the sale of the vehicle by the organization or the vehicle’s fair market value on the date of the contribution. If the vehicle’s fair market value was more than your cost or other basis, you may have to reduce the fair market value to figure the deductible amount.

Paintings, Antiques, and Other Objects of Art.

Deductions for contributions of paintings, antiques, and other objects of art should be supported by a written appraisal from a qualified and reputable source unless the deduction is $5,000 or less.

  1. Art valued at $20,000 or more. If you claim a deduction of $20,000 or more for donations of art, you must attach a complete copy of the signed appraisal to your return. For individual objects valued at $20,000 or more, a photograph of a size and quality fully showing the object, preferably an 8 x 10-inch color photograph or a color transparency no smaller than 4 x 5 inches, must be provided upon request.
  2. Art valued at $50,000 or more. If you donate an item of art that has been appraised at $50,000 or more, you can request a Statement of Value for that item from the IRS. You must request the statement before filing the tax return that reports the donation.

Large quantities. If you contribute a large number of the same item, fair market value is the price at which comparable numbers of the item are being sold.

Example: You purchase 20 rare books for $1,000. The person who sells them to you says the retail value of these books is $3,000. If you contribute these rare books to a qualified organization, you can claim a deduction only for the price at which similar numbers of the same book are currently being sold. Your charitable contribution is $1,000 unless you can show that similar numbers of that book were selling at a different price at the time of the contribution.

Contributions Subject to Special Rules

Special rules apply if you contribute:

  • Clothing or household items,
  • A car, boat, or airplane,
  • Taxidermy property,
  • Property subject to a debt,
  • A partial interest in property,
  • A fractional interest in tangible personal property,
  • A qualified conservation contribution,
  • A future interest in tangible personal property,
  • Inventory from your business, or
  • A patent or other intellectual property.

These special rules are described here briefly.

Used clothing or household items. You cannot take a deduction for clothing or household items you donate unless the clothing or household items are in good used condition or better. However, there is an exception. You can take a deduction for a contribution of an item of clothing or a household item that is not in good used condition or better if you deduct more than $500 for it and include a qualified appraisal of it with your return.

Car, boat, or airplane. A qualified vehicle is defined as a car or any motor vehicle manufactured mainly for use on public streets, roads, and highways, a boat, or an airplane. If you donate a qualified vehicle to a qualified organization and you claim a deduction of more than $500, you can deduct the smaller of:

  • The gross proceeds from the sale of the vehicle by the organization, or
  • The vehicle’s fair market value on the date of the contribution. If the vehicle’s fair market value was more than your cost or other basis, you may have to reduce the fair market value to figure the deductible amount

Taxidermy property. If you donate taxidermy property to a qualified organization, your deduction is limited to your basis in the property or its fair market value, whichever is less. This applies if you prepared, stuffed, or mounted the property or paid or incurred the cost of preparing, stuffing, or mounting the property.

Your basis for this purpose includes only the cost of preparing, stuffing, and mounting the property. Your basis does not include transportation or travel costs. It also does not include direct or indirect costs for hunting or killing an animal, such as equipment costs. In addition, it does not include the value of your time.

Taxidermy property means any work of art that:

  • Is the reproduction or preservation of an animal, in whole or in part,
  • Is prepared, stuffed, or mounted to recreate one or more characteristics of the animal, and
  • Contains a part of the body of the dead animal.

Property subject to a debt. If you contribute property subject to a debt (such as a mortgage), there are two possible ways your deduction might be reduced. First, special rules require you to reduce your deduction by certain interest payments you make. These rules prevent a double deduction of the same amount as both investment interest and a charitable contribution.

Second, if the debt is assumed by the recipient (or another person), you must reduce the fair market value of the property by the amount of the outstanding debt.

If you sold the property to a qualified organization at a bargain price (discussed later), the amount of the debt is also treated as an amount realized on the sale or exchange of property.

Partial interest in property. Generally, you cannot deduct a charitable contribution (not made by a transfer in trust) of less than your entire interest in property. A contribution of the right to use property is a contribution of less than your entire interest in that property, and is not deductible.

There are important exceptions to this rule. You can deduct a charitable contribution of a partial interest in property if that interest fits one of the following categories:

1. A remainder interest in your personal home or farm. A remainder interest is one that passes to a beneficiary after the end of an earlier interest in the property.

Example: You keep the right to live in your home during your lifetime and give your church a remainder interest that begins upon your death.

2. An undivided part of your entire interest. This must consist of a part of every substantial interest or right you own in the property and must last as long as your interest in the property lasts.

Example: You contribute voting stock to a qualified organization but keep the right to vote the stock. The right to vote is a substantial right in the stock. You have not contributed an undivided part of your entire interest and cannot deduct your contribution.

Where it’s an undivided interest in tangible personal property (defined below) the donee must have possession of the property for a part of the year consistent with its interest in the property. Special rules apply for contributions after August 17, 2006, of further undivided interests in the same property by the same donor. And, for contributions after August 17, 2006, of undivided interests in tangible personal property, the deduction is “recaptured” if the donee doesn’t get all of the donor’s interest in the property by the earlier of 10 years from the first gift or the donor’s death.  “Recapture” means the deduction is added back to the donor’s income (say, in the 11th year), with interest due from the year of contribution and a tax penalty of 10 percent of the recaptured income.

3. A partial interest that would be deductible if transferred in trust.

4. A qualified conservation contribution (as specifically defined in the tax law).

Fractional Interest in Tangible Personal Property. A fractional interest in property is an undivided portion of your entire interest in the property. You cannot deduct a charitable contribution of a fractional interest in tangible personal property unless all interests in the property are held immediately before the contribution by you or you and the qualifying organization receiving the contribution.

Qualified Conservation Contribution. A qualified conservation contribution is a contribution of a qualified real property interest to a qualified organization such as a governmental unit or publicly supported charitable, religious, scientific, literary or educational organization that is to be used only for conservation purposes.

The organization also must have a commitment to protect the conservation purposes of the donation and must have the resources to enforce the restrictions. Conservation purposes are defined as:

  • Preserving land areas for outdoor recreation by, or for the education of, the general public.
  • Protecting a relatively natural habitat of fish, wildlife, or plants, or a similar ecosystem.
  • Preserving open space, including farmland and forest land, if it yields a significant public benefit. It must be either for the scenic enjoyment of the general public or under a clearly defined federal, state, or local governmental conservation policy.
  • Preserving a historically important land area or a certified historic structure.

If a building in a registered historic district is a certified historic structure, a contribution of a qualified real property interest that is an easement or other restriction on the exterior of the building is deductible only if it meets all of the following three conditions:

Future interest in tangible personal property. You can deduct the value of a charitable contribution of a future interest in tangible personal property only after all intervening interests in and rights to the actual possession or enjoyment of the property have either expired or been turned over to someone other than yourself, a related person, or a related organization.

Related persons include your spouse, children, grandchildren, brothers, sisters, and parents. Related organizations may include a partnership or corporation that you have an interest in, or an estate or trust that you have a connection with.

Tangible personal property. This is any property, other than land or buildings, that can be seen or touched. It includes furniture, books, jewelry, paintings, and cars.

Future interest. This is any interest that is to begin at some future time, regardless of whether it is designated as a future interest under state law.

Example: You own an antique car that you contribute to a museum. You give up ownership, but retain the right to keep the car in your garage with your personal collection. Since you keep an interest in the property, you cannot deduct the contribution. If you turn the car over to the museum in a later year, giving up all rights to its use, possession, and enjoyment, you can take a deduction for the contribution in that later year.

Inventory. If you contribute inventory (property that you sell in the course of your business), the amount you can claim as a contribution deduction is the smaller of its fair market value on the day you contributed it or its basis. The basis of donated inventory is any cost incurred for the inventory in an earlier year that you would otherwise include in your opening inventory for the year of the contribution. You must remove the amount of your contribution deduction from your opening inventory. It is not part of the cost of goods sold.

If the cost of donated inventory is not included in your opening inventory, the inventory’s basis is zero and you cannot claim a charitable contribution deduction. Treat the inventory’s cost as you would ordinarily treat it under your method of accounting. For example, include the purchase price of inventory bought and donated in the same year in the cost of goods sold for that year.

A special rule applies to donations of food inventory (see Food Inventory below)

Patents and Other Intellectual Property. If you donate a patent or other intellectual property to a qualified organization, your deduction is limited to the basis of the property or the fair market value of the property, whichever is less. After the legal life of the patent or other intellectual property ends, or after the 10th anniversary of the donation, no additional deduction is allowed. Also, additional deductions cannot be taken for patents or other intellectual property donated to certain private foundations. Intellectual property means any of the following:

  • Patents.
  • Copyrights (other than a copyright described in Internal Revenue Code sections 1221(a)(3) or 1231(b)(1)(C)).
  • Trademarks.
  • Trade names.
  • Trade secrets.
  • Know-how.
  • Software (other than software described in Internal Revenue Code section 197(e)(3)(A)(i)).
  • Other similar property or applications or registrations of such property.

Donating Property That Has Decreased in Value

If you contribute property with a fair market value that is less than your basis in it (generally, less than what you paid for it), your deduction is limited to its fair market value. You cannot claim a deduction for the difference between the property’s basis and its fair market value.

Common examples of property that decreases in value include clothing, furniture, appliances, and cars.

Donating Property That Has Increased in Value

If you contribute property with a fair market value that is more than your basis in it, you may have to reduce the fair market value by the amount of appreciation (increase in value) when you figure your deduction.

Again, your basis in property is generally what you paid for it. Different rules apply to figuring your deduction, depending on whether the property is:

1. Ordinary income property, or

2. Capital gain property.

Ordinary Income Property

Property is ordinary income property if its sale at fair market value on the date it was contributed would have resulted in ordinary income or in short-term capital gain. Examples of ordinary income property are inventory, works of art created by the donor, manuscripts prepared by the donor, and capital assets held 1 year or less.

Equipment or other property used in a trade or business is considered ordinary income property to the extent of any gain that would have been treated as ordinary income under the tax law, had the property been sold at its fair market value at the time of contribution.

Amount of deduction. The amount you can deduct for a contribution of ordinary income property is its fair market value less the amount that would be ordinary income or short-term capital gain if you sold the property for its fair market value. Generally, this rule limits the deduction to your basis in the property.

Example: You donate stock that you held for 5 months to your church. The fair market value of the stock on the day you donate it is $1,000, but you paid only $800 (your basis). Because the $200 of appreciation would be short-term capital gain if you sold the stock, your deduction is limited to $800 (fair market value less the appreciation).

Exception. Do not reduce your charitable contribution if you include the ordinary or capital gain income in your gross income in the same year as the contribution.

Capital Gain Property

Property is capital gain property if its sale at fair market value on the date of the contribution would have resulted in long-term capital gain. Capital gain property includes capital assets held more than 1 year.

Capital assets. Capital assets include most items of property that you own and use for personal purposes or investment. Examples of capital assets are stocks, bonds, jewelry, coin or stamp collections, and cars or furniture used for personal purposes.

For purposes of figuring your charitable contribution, capital assets also include certain real property and depreciable property used in your trade or business and, generally, held more than 1 year.

Real property. Real property is land and generally, anything that is built on, growing on, or attached to land.

Depreciable property. Depreciable property is property used in business or held for the production of income and for which a depreciation deduction is allowed.

Amount of deduction – general rule. When figuring your deduction for a gift of capital gain property, you usually can use the fair market value of the gift.

However, in certain situations, you must reduce the fair market value by any amount that would have been long-term capital gain if you had sold the property for its fair market value. Generally, this means reducing the fair market value to the property’s cost or other basis.

This can happen where the charity’s use of tangible personal property is not in connection with its exempt purpose. For contributions after September 1, 2006, of more than $5,000, the deduction is generally reduced to basis if the charity disposes of the property within 3 years of the donation. If disposition takes place after the donation, the appreciation (fair market value less basis) is recaptured as ordinary income in the year of the disposition (absent certification from the charity that use for its exempt purpose occurred or was intended). The charity must notify IRS and the donor of the disposition ( and the certification, if applicable).

Ordinary or capital gain income included in gross income. You do not reduce your charitable contribution if you include the ordinary or capital gain income in your gross income in the same year as the contribution. This may happen when you transfer installment or discount obligations or when you assign income to a charitable organization.

Example: You donate an installment note to a qualified organization. The note has a fair market value of $10,000 and a basis to you of $7,000. As a result of the donation, you have a short-term capital gain of $3,000 ($10,000 – $7,000), which you include in your income for the year. Your charitable contribution is $10,000.

Food Inventory

Special rules apply to certain donations of food inventory to a qualified organization. These rules apply if all of the following conditions are met.

  1. You made a contribution of apparently wholesome food from your trade or business. Apparently wholesome food is food intended for human consumption that meets all quality and labeling standards imposed by federal, state, and local laws and regulations even though the food may not be readily marketable due to appearance, age, freshness, grade, size, surplus, or other conditions.
  2. The food is to be used only for the care of the ill, the needy, or infants.
  3. The use of the food is related to the organization’s exempt purpose or function.
  4. The organization does not transfer the food for money, other property, or services.
  5. You receive a written statement from the organization stating it will comply with requirements (2), (3), and (4).
  6. The organization is not a private non-operating foundation.
  7. The food satisfies any applicable requirements of the Federal Food, Drug, and Cosmetic Act and regulations on the date of transfer and for the previous 180 days.

Bargain Sales

A bargain sale of property to a qualified organization (a sale or exchange for less than the property’s fair market value) is partly a charitable contribution and partly a sale or exchange.

The part of the bargain sale that is a sale or exchange may result in a taxable gain.

Penalty

The IRS may impose a penalty if you overstate the value or adjusted basis of donated property.


02 Aug 2024

Since charities ask for larger and more frequent donations from the public these days, soliciting by mail, telephone, television, and radio, for example, they should be checked out before you donate money or time. Here are some tips on how to maximize your charity dollar and avoid scams.

Here are some basic, common-sense suggestions for avoiding rip-offs in making charitable contributions:

  • Do not contribute cash. All contributions should be in the form of a check or money order made out to the charity never to the individual soliciting the donation.
  • Do not be misled by a charity that resembles or mimics the name of a well-known organization–all charities should be checked out.
  • Ignore pressure to donate immediately. Wait until you are sure that the charity is legitimate and deserving of a donation.
  • When appropriate, ask for written descriptions of the charity’s programs and/or finances, especially if the intended contribution is substantial.
  • If you have any doubt about the legitimacy of a charity, check it out with the local charity registration office (usually a division of the state attorney’s general office) and with the Better Business Bureau (BBB).

Related Guide: Please see the Financial Guide: FRAUDULENT CHARITIES: How To Protect Yourself.

You should, of course, keep receipts, canceled checks and bank statements so you will have records of your charitable giving at tax time.

Related Guide: Please see the Financial Guide: ADVANCED CHARITY TECHNIQUES: Maximizing Your Deductions.


  • Giving Your Time
  • Mail Solicitations
  • Public Education Solicitations
  • Telephone, Door-To-Door, And Street Solicitations
  • Sweepstakes Appeals
  • Charity Thrift Stores
  • Fund-Raising Dinners, Variety Shows, And Other Events
  • Charity-Affinity Credit Cards
  • Charity/Business Marketing
  • Disaster Appeals
  • Police And Firefighter Appeals
  • Child Sponsorship Groups
  • A Charity’s National Office and Its Affiliates
  • Government and Non-Profit Agencies
Giving Your Time

Volunteering your time can be personally rewarding, but it is important to consider the following factors before committing yourself:

  • Make sure you are familiar with the charity’s activities. Ask for written information about the charity’s programs and finances.
  • Be aware that volunteer work may require special training and the devotion of a scheduled number of hours each week to the charity.
  • If you are considering assisting with door-to-door fund-raising, be sure to find out whether the charity has financial checks and balances in place to help ensure control over collected funds.

Although the value of your time as a volunteer is not deductible, out-of-pocket expenses (including transportation costs) are generally deductible.

Mail Solicitations

Many charities use direct mail to raise funds. While the overwhelming majority of these appeals are accurate and truthful, be aware of the following:

  • The mailing piece should clearly identify the charity and describe its programs in specifics. If a fund-raising appeal brings tears to your eyes but tells you nothing about the charity’s functions, investigate it carefully before responding.
  • It is against the law to demand payment for unsolicited merchandise-e.g., address labels, stamps, bumper stickers, greeting cards, calendars, and pens. If such items are sent to you with an appeal letter, you are under no obligation to pay for or return them.
  • Appeals that include sweepstakes promotions should disclose that you do not have to contribute to be eligible for the prizes offered. To require a contribution would make the sweepstakes illegal as a lottery operated by mail.
  • Appeals that include surveys should not imply that you are obligated to return the survey.
  • Beware of fund-raising appeals that are disguised as bills or invoices. It is illegal to mail a bill, invoice or statement of account that is, in fact, an appeal for funds unless it has a clear and noticeable disclaimer stating that it is an appeal and that you are under no obligation to pay unless you accept the offer.

Deceptive-invoice appeals are most often aimed at businesses, not individuals. If you receive one of these, contact your local Better Business Bureau.

Public Education Solicitations

If you respond to mail appeals, you should be aware that certain charities consider this to be a significant part of their educational budgets. In a recent survey, half of 150 well-known national charities included their direct mail and other fund-raising appeals in their public education programs. This practice makes fund-raising drives look like a smaller part of a charity’s expenses than they are. These 75 charities allocated $160 million of their direct mail and other appeal costs to public education programs.

A charity whose purpose is to combat cruelty to animals uses direct mail to raise funds. The cost of a nationwide direct mail campaign is $1 million much more than the $200,000 the charity has budgeted for its program of research grants. This embarrassingly high allotment for fund-raising costs can be significantly reduced if the direct mail pieces include some information about cruelty to animals. Since the information is considered educational, the charity calls it a program expense and allots half the cost of the mailing to public education, thus reducing fund-raising expenses from $1 million to only $500,000, and bumping up program spending from $200,000 to $700,000.

The line between pure fund-raising and genuine public education activities is not always clear. However, if the charity is confident that the fund-raising appeal truly serves its educational purposes, it should be willing to disclose this fact in the appeal. This disclosure allows donors to make an informed decision about whether to support the activity.

Telephone, Door-To-Door, And Street Solicitations

When you are approached for a contribution of time or money, ask questions – and do not give until you are satisfied with the answers. Charities with nothing to hide will encourage your interest. Be wary of any reluctance to answer reasonable questions.

  • Ask for the charity’s full name and address. Demand identification from the solicitor.
  • Ask if the contribution is tax-deductible.
  • Ask if the charity is licensed by state and local authorities. Registration or licensing is required by most states and some local governments.

Contributions to tax-exempt organizations are not always tax-deductible.

Registration, by itself, does not mean that the state or local government endorses the charity.

  • Do not give in to pressure to make an immediate donation or allow a runner to pick up a contribution.
  • Statements such as “all proceeds will go to charity” may mean money left after expenses, such as the cost of fund-raising efforts, will go to the charity. These expenses can be big ones, so check carefully.
  • When asked to buy candy, magazines, or tickets to benefit a charity, be sure to ask what the charity’s share will be. Sometimes the organization will receive less than 20 percent of the amount you pay.
  • If a fund raiser uses pressure tactics- intimidation, threats, or repeated and harassing calls or visits-call your local Better Business Bureau to report the actions.

Sweepstakes Appeals

Sweepstakes mailings, used by businesses for many years to promote their products, have recently become popular with charities. Here are some points to consider when reviewing a sweepstakes appeal.

    • The sweepstakes mailing should clearly disclose that no contribution is necessary to participate.

* If you wish to participate, read the sweepstakes promotion and direct mail contents carefully. Your entry may be discarded if the rules are not followed to the letter.

  • If the charity sweepstakes promotion says you are a pre-selected winner, you will usually receive a prize only if you respond to the sweepstakes. Most “pre-selected winners” receive just pennies per person.
  • Both donor and non-donor sweepstakes participants must have an equal chance of winning a prize.

For a national campaign, the probability of winning the big prize may be quite low. Some campaigns involve mailings of a half-million to ten million or more letters.

If you are considering a donation, check out the appeal as you would any other request for funds. Does it clearly specify the programs your gift would be supporting? Do not hesitate to ask for more information on the charity’s finances and activities.

Charity Thrift Stores

Since all charity thrift stores do not necessarily operate the same way, it is important to find out if the charity is benefiting from thrift sales. There are three major types of thrift store operations:

  • Conduit-type shops run by volunteer church and civic groups. These thrift stores generally distribute most of their proceeds to various charitable organizations, often community-based.
  • Thrift operations are represented by service organizations such as The Salvation Army and Goodwill Industries. Here, the thrift stores are operated as part of their program activities through the goal of “rehabilitation through employment.”
  • Charities that collect and sell used merchandise to raise funds for their own use. This arrangement is popular for a number of veterans organizations and other charities. Such arrangements generally work one of two ways: (1) the charity owns and operates the store or (2) more commonly, variously charities solicit and collect used items, which are then sold to independently managed stores for an agreed-upon amount.

The fair market value of goods donated to a thrift store is deductible as a charitable donation, as long as the store is operated by a charity. To determine the fair market value, visit a thrift store and check the going rate for comparable items. If you are donating directly to a for-profit thrift store or if your merchandise is sold on a consignment basis whereby you get a percentage of the sale, the thrift contribution is not deductible.

Remember to ask for a receipt that is properly authorized by the charity. It is up to the donor to set a value on the donated item.

If you plan to donate a large or unusual item, check with the charity first to determine if it is acceptable.

If you are approached to donate goods for thrift purposes, ask how the charity will benefit financially. If the goods will be sold by the charity to a third party such as an independently managed thrift store, then ask what the charity’s share will be.

Sometimes the charity receives a small percentage, e.g., 5 to 20 percent of the gross or a flat fee per bag of goods collected.

Fund-Raising Dinners, Variety Shows, And Other Events

Dinners, luncheons, galas, tournaments, circuses, and other events are often put on by charities to raise funds. Here are some points to consider before deciding to participate in such events.

  • Check out the charity. The fact that you are receiving a meal or theater tickets should not justify less scrutiny.
  • Your purchase of tickets to such events is generally not fully deductible. Only the portion of your gift above the fair market value of the benefit received (i.e., the meal, show, etc.) is deductible as a charitable donation. This rule holds true even if you decide to give your tickets away for someone else to use.

If you decide not to use the tickets, give them back to the charity. In order to be able to deduct the full amount paid, you must either refuse to accept the tickets or return them to the charitable organization. In this way, you will not have received value for your payment.

Make donations by check or money order out to the full name of the charity and not to the sponsoring show company or to an individual who may be collecting donations in person.

  • Watch out for statements such as “all proceeds will go to the charity.” This can mean the amount after expenses have been taken out, such as the cost of the production, the fees for the fund-raising company hired to conduct the event, and other related expenses. These expenses can make a big difference and sometimes result in the charity receiving 20 percent or less of the price paid.

Ask the charity what anticipated portion of the purchase price will benefit the organization.

  • Solicitors for some fund-raising events such as circuses, variety shows, and ice skating shows may suggest that if you are not interested in attending the event you can purchase tickets that will be given to handicapped or underprivileged children. If such statements are made, ask the solicitor how many children will attend the event, how they will be chosen, how many tickets have been already distributed to these children, and if transportation to the event will be provided for them.

It has happened that the number of children eligible to receive free tickets has been limited or transportation has not been arranged. So, in effect, free tickets given to the few needy children who attend the event are paid for many times over by businesses and individuals who purchase tickets.

Charity-Affinity Credit Cards

You may receive an offer to apply for an affinity credit card bearing the name and logo of a particular charity. Sometimes offered exclusively to an organization’s donors or members, these cards are issued by banks and credit card companies under agreements worked out with individual charities. These cards are just like other credit cards, but the specified charity gets some kind of financial benefit.

All affinity credit cards are not created equal. Offers vary in terms of how the charity benefits as well as the terms of the credit agreement with consumers. So check the terms carefully!

Consider the specific terms as you would any credit card offer: the amount of the interest rate/finance charges, the amount of the annual fee, if any, the amount of late fees and over-the-limit fees, if any, and the length of the grace period, or amount of time after which finance charges begin to accrue on any unpaid balance.

The charity usually receives a benefit in one or more of the following ways:

  • The charity receives a certain percentage of each purchase or a specified amount every time the consumer makes a purchase with the card,
  • The charity receives a certain dollar amount every time a new customer signs up for a card, or
  • The charity receives a portion of the annual renewal fee for the card.

Make sure the promotional literature states exactly how the charity benefits. For example, one affinity card offer declared that a specified national charity would receive half of one percent of all transactions made with the card (that works out to 5 cents for every $10 worth of purchases). If the financial benefit for the charity is not spelled out, then ask.

Contributions made by a bank and/or credit card company through the use of an affinity credit card are not deductible to consumers as charitable donations for federal income tax purposes.

Remember also to consider your interest in the charity and not to hesitate to seek out more information on the charity’s programs and finances.

If saving money is your bottom line, make a direct donation to the charity and seek a credit card with the best terms and lowest interest rates, regardless of affinity.

Charity/Business Marketing

The following points should be kept in mind when considering promotions that partner charities and businesses:

  1. Charity/business marketing campaigns should clearly disclose the actual or estimated portion of the purchase price that will benefit the specified cause. Without such information, you cannot know how much of your purchase will aid a charity participating in such a campaign.
  2. Read the disclosure carefully. Some charity/business marketing campaigns have an expiration period (for example, ten cents goes to the charity for all purchases made until October 31.) If there is no disclosure, be aware that the amount that goes to the charity is usually between one and ten percent of the retail price.
  3. In schemes during the Gulf War, businesses made no arrangements with the named charity and no contributions were given. Various items and services were sold with the false promise that a donation would be made to the USO or other organizations helping members of the armed services or their families. Similar advertising abuses commonly occur in the wake of hurricanes, floods and other natural disasters.
  4. Some advertisements falsely imply the existence of a direct connection between the consumers’ purchase and the charity when, in fact, the charity was guaranteed a “flat” contribution regardless of the level of the resulting purchases.

Disaster Appeals

The tragedy of a flood, massive fire, hurricane, earthquake, or another disaster always triggers an outpouring of public support and concern. During such crises, watch out for fraudulent appeals by some who see disasters as an opportunity to take advantage of American concern and generosity.

Examine your options instead of giving to the first charity from which you receive an appeal. There will be a variety of relief efforts responding to the diverse needs of disaster victims. Be wary of appeals that are long on emotion and short on what the charity will do to address the specific disaster.

Ask how much of your gift will be used for the crisis and how much will go towards other programs and to administrative and fund-raising costs. And find out what the charity intends to do with any excess contributions remaining after the crisis has ended.

Check with organizations before donating goods for overseas disaster relief. Most groups involved in overseas relief will not accept donated goods since purchasing goods overseas is often less expensive and more efficient. If a charity accepts donated items, ask about their arrangements for shipping and distribution.

Some charities change their program focus during a crisis in order to respond to the changing needs of disaster victims. Do not assume the charity will carry out the same activities throughout a crisis situation.

Police And Firefighter Appeals

In reviewing such appeals, potential donors should be aware of the following points.

  • Many different types of police and firefighter organizations exist. Some are charities that operate educational or youth programs. Others are labor organizations, fraternities, or benevolent associations that provide benefits to members.
  • Your gift may not be deductible. Police and firefighter organizations can be tax exempt under different sections of the Internal Revenue Code. Only some of them are eligible to receive deductible charitable donations.
  • Do not make assumptions based on the name alone. The words “police” and “firefighter” in the organization’s name do not necessarily mean that representatives from your local and/or state police or fire departments are members. In fact, the organization may not have any police or firefighter members.
  • Ask about any affiliations the group might have with other organizations. Some groups operate as a lodge or chapter of a larger organization. Others are independent associations of local, state, and/or federal law enforcement officers.
  • Do not believe promises that your donation will “give you special treatment” from your police or firefighters. If such suggestions of threats are used, contact your state attorney general’s office and your Better Business Bureau.
  • Ask how your contribution will be used and what programs and activities it will support. Do not hesitate to ask for written materials on the police or firefighter group’s programs and finances.
  • Groups offering legitimate help to your police, firefighters, and community will welcome your questions and encourage your interest.

Child Sponsorship Groups

Not all sponsorship programs are alike. Sponsored donations usually benefit a project for an entire community (for example, medical care, education, food) and not the sponsored child exclusively. Some groups believe this is the most effective way to make significant and lasting changes in a child’s living conditions. Other organizations do give a certain amount of the contribution directly to the sponsored child. Before deciding to participate in a sponsorship program, you may want to consider the following:

  • Do you know how children are assisted (i.e., through a community development project operated by the charity or through an affiliated project that the group funds)?
  • Can you commit at least several years to a program in the form of financial assistance and letter-writing?
  • The child will not be your adopted child in any legal sense, and you will not be able to make any demands on him or her.
  • Do you agree with the overall philosophy of the organization (e.g., any religious focus a program might have)?

Contact other child sponsors to get a sense of their overall satisfaction with the organization.

A Charity’s National Office and Its Affiliates

While some organizations are a single entity under one name, others may be a network of local affiliates or chapters. If you give to a local chapter or affiliate, do not assume your donation will be spent locally. Nor should you assume that a chapter’s operations are fully controlled by the national office.

Many different types of relationships can exist between a charity’s national office and its chapters. Here are three possible relationships chapters:

  1. The national office performs certain functions, such as developing educational or fund-raising materials but does not supervise affiliates. In this case, the local chapters are incorporated separately from the national office and each applies for its own tax-exempt status from the IRS. Each local chapter’s programs and fund-raising is under the control of the chapter’s local board of directors. To support the national office, the local affiliates purchase materials produced by it or send it a small percentage of their locally collected funds.
  2. The organization’s national office and affiliates function as one centralized unit under the control of a national board of directors. All income and expenses are channeled through the national office. In this case, the chapters are not separate legal entities and have only limited authority, as stated in their charter agreements with the national office.
  3. Most national/chapter relationships fall somewhere between the two extremes in the preceding two paragraphs. In such a case, both the national office and the local affiliates share some level of authority. Local chapters may or may not be separately incorporated, but all have their own governing boards, some of which share control with the national office. The charity may have statewide affiliates that perform functions at the state level. With this structure, there is usually a fund sharing or dues formula between the local affiliates and the national office.

The bottom line for you is that, depending on the organization’s structure, the local affiliate may carry out different activities from those of the national office. It is important to inquire about this difference. In addition, donors may want to identify how much of a local affiliate’s contributions are spent on local programs.

When considering a donation to a local chapter, it is wise to check out the chapter separately.

Government and Non-Profit Agencies

  • Most state governments regulate charitable organizations. To obtain information on these regulations, which vary from state to state, contact the appropriate government agency (usually a division of the Attorney General or the Secretary of State).
  • Contact the appropriate state government agency to verify a charity’s registration and to obtain financial information on a soliciting charity.
  • Contact your local Better Business Bureau to find out whether a complaint has been lodged against a charity.


02 Aug 2024

Many tax benefits are available to you when you sell your principal residence. However, the rules are complex and personal guidance is necessary to take full advantage of these benefits so that you and your tax advisor can best work together to minimize the tax on the gain. This financial guide discusses the key rules so that you and your tax advisor can best work together to minimize the tax on the gain.

The IRS allows an exclusion of up to $250,000 of the gain on the sale of your main home ($500,000 if you are married and file a joint return. Most taxpayers can take advantage of the exclusion and will not have to pay any tax on the sale of a main home as long as they meet the IRS ownership and use tests (see below).

If you do have a loss from the sale, it is a personal loss. You cannot deduct the loss.

If you don’t qualify for the exclusion, your gain exceeds the exclusion, or you used part of the property in business or for rent, you have a taxable gain and must report the sale of your main home on your tax return on IRS Form 8949, Sales and Other Dispositions of Capital Assets and Schedule D, Capital Gains and Losse.


  • Principal Residence
  • How To Figure Gain Or Loss
  • Non-Traditional Sales
  • Basis
  • Basis Other Than Cost
  • Adjusted Basis
  • Exclusion For Sales After May 6, 1997
  • Recapture Of Federal Subsidy
  • Glossary
Principal Residence

Usually, the home you live in most of the time is your main home. In addition to a standard dwelling unit, your home can also be a houseboat, mobile home, cooperative apartment, or condominium.

Example 1: You own and live in a house in town. You also own beach property, which you use in the summer months. The town property is your main home; the beach property is not.

Example 2: You own a house, but you live in another house that you rent. The rented home is your main home.

Where a second residence has soared in value and you want to sell, some tax advisors have suggested moving to the second residence for the required period to qualify for exclusion on its sale. If this is your situation, please consult with a tax professional.

How To Figure Gain Or Loss

Key information for determining gain or loss is the selling price, the amount realized, and the adjusted basis.

The selling price is the total amount you receive for your home. It includes money, all notes, mortgages, or other debts assumed by the buyer as part of the sale, and the fair market value of any other property or any services you receive. Next, you deduct the selling expenses such as commissions, advertising, legal fees, and loan charges paid by the seller from the selling price.

The difference is the “amount realized.” If the amount realized is more than your home’s “adjusted basis,” discussed later, the difference is your gain. If the amount realized is less than the adjusted basis, the difference is your loss.

However, it does not include amounts you received for personal property sold with your home. Personal property is property that is not a permanent part of the home, such as furniture, draperies, and lawn equipment.

Non-Traditional Sales

The following discussion covers how to determine your gain or loss if you trade one home for another, if your home is foreclosed on or repossessed or if you transfer a jointly owned home.

Jointly owned home. If you and your spouse sell your jointly owned home and file a joint return, you figure and report your gain or loss as one taxpayer. If you file separate returns, each of you must figure and report your own gain or loss according to your ownership interest in the home. Your ownership interest is determined by state law.

If you and a joint owner other than your spouse sell your jointly owned home, each of you must figure and report your own gain or loss according to your ownership interest in the home. Each of you applies the exclusion rules individual basis.

Trading homes. If you trade your old home for another home, treat the trade as a sale and a purchase.

Foreclosure or repossession. If your home was foreclosed on or repossessed, you have what the IRS calls a disposition and will need to determine if you have ordinary income, gain, or loss. The amount of your gain or loss depends on whether you were personally liable for repaying the debt secured by the home and whether the outstanding loan balance is more than the fair market value (FMV) of the property.

If you were not personally liable for repaying the debt secured by the home, the amount you realize includes the full amount of the outstanding debt immediately before the transfer. This is true even if the FMV of the property is less than the outstanding debt immediately before the transfer.

If you were personally liable for repaying the debt secured by the home and the debt is canceled, the amount realized on the foreclosure or repossession includes the smaller of the outstanding debt immediately before the transfer reduced by any amount for which you remain personally liable immediately after the transfer, or the Fair Market Value (FMV) of the transferred property.

In addition to any gain or loss, if you were personally liable for the debt you may have ordinary income. If the canceled debt is more than the home’s fair market value, you have ordinary income equal to the difference. However, the income from the cancellation of debt is not taxed to you if the cancellation is intended as a gift, or if you are insolvent or bankrupt.

You owned and lived in a home with an adjusted basis of $41,000. A real estate dealer accepted your old home as a trade-in and allowed you $50,000 toward a new house priced at $80,000 (its fair market value). You are considered to have sold your old home for $50,000 and to have had a gain of $9,000 ($50,000 minus $41,000). If the dealer had allowed you $27,000 and assumed your unpaid mortgage of $23,000 on your old home, $50,000 would still be considered the sales price of the old home (the trade-in allowed plus the mortgage assumed).

Transfer to spouse. If you transfer your home to your spouse, or to your former spouse incident to your divorce, you generally have no gain or loss, even if you receive cash or other consideration for the home. Therefore, the rules explained in this Guide do not apply.

If you owned your home jointly with your spouse and transfer your interest in the home to your spouse, or to your former spouse incident to your divorce, the same rule applies. You have no gain or loss.

If you buy or build a new home, its basis will not be affected by the transfer of your old home to your spouse, or to your former spouse incident to divorce. The basis of the home you transferred will not affect the basis of your new home.

Basis

You will need to know your basis in your home as a starting point for determining any gain or loss when you sell it. Your basis in your home is determined by how you got the home. Your basis is its cost if you bought it or built it. If you acquired it in some other way, its basis is either its fair market value when you received it or the adjusted basis of the person you received it from.

While you owned your home, you may have made adjustments (increases or decreases) to the basis. This adjusted basis is used to figure gain or loss on the sale of your home.

Cost as Basis

The cost of property is the amount you pay for it in cash or other property.

Purchase. If you buy your home, your basis is its cost to you. This includes the purchase price and certain settlement or closing costs. Your cost includes your down payment and any debt, such as a first or second mortgage or notes you gave the seller in payment for the home.

Seller-paid points. If you bought your home after April 3, 1994, you must reduce the basis of your home by any points the seller paid, whether or not you deducted them. If you bought your home after 1990 but before April 4, 1994, you must reduce your basis by the amount of seller-paid points only if you chose to deduct them as home mortgage interest in the year paid.

Settlement fees or closing costs. When buying your home, you may have to pay settlement fees or closing costs in addition to the contract price of the property. You can include in your basis the settlement fees and closing costs that are for buying the home. You cannot include in your basis the fees and costs that are for getting a mortgage loan. A fee is for buying the home if you would have had to pay it even if you paid cash for the home.

Settlement fees do not include amounts placed in escrow for the future payment of items such as taxes and insurance.

Some of the settlement fees or closing costs that you can include in the basis of your property are:

  • Abstract fees (sometimes called abstract of title fees),
  • Charges for installing utility services,
  • Legal fees (including fees for the title search and preparing the sales contract and deed),
  • Recording fees,
  • Surveys,
  • Transfer taxes,
  • Owner’s title insurance, and
  • Any amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.

Some settlement fees and closing costs not included in your basis are:

  • Fire insurance premiums.
  • Rent for occupancy of the house before closing.
  • Charges for utilities or other services relating to occupancy of the house before closing.
  • Any item that you deducted as a moving expense (settlement fees and closing costs incurred after 1993 cannot be deducted as moving expenses).
  • Fees for refinancing a mortgage.
  • Charges connected with getting a mortgage loan, such as mortgage insurance premiums (including VA funding fees), loan assumption fees, cost of a credit report, and fee for an appraisal required by a lender.

Real estate taxes. Real estate taxes for the year you bought your home may affect your basis, as follows:

If you pay taxes that the seller owed on the home up to the date of sale and the seller does not reimburse you, then the taxes are added to the basis of your home.

If you pay taxes that the seller owed on the home up to the date of sale and the seller does reimburse you, then the taxes do not affect the basis of your home.

If the seller pays taxes for you (taxes owed beginning on the date of sale) and you do not reimburse the seller, then the taxes are subtracted from the basis of your home.

If the seller pays taxes for you (taxes owed beginning on the date of sale) and you reimburse the seller, then the taxes do not affect the basis of your home.

Construction. If you contracted to have your house built on land you own; your basis is the cost of the land plus the amount it cost you to complete the house. This amount includes the cost of labor and materials, or the amounts paid to the contractor, and any architect’s fees, building permit charges, utility meter, and connection charges, and legal fees directly connected with building your home. Your cost includes your down payment and any debt, such as a first or second mortgage or notes you gave the seller or builder. It also includes certain settlement or closing costs. You may have to reduce the basis by points the seller paid for you. If you built all or part of your house yourself, its basis is the total amount it cost you to complete it. Do not include the value of your own labor or any other labor you did not pay for, in the cost of the house.

Cooperative apartment. Your basis in the apartment is usually the cost of your stock in the co-op housing corporation, which may include your share of a mortgage on the apartment building.

Condominium. Your basis is generally its cost to you. The same rules apply as for any other home.

Basis Other Than Cost

If your home was acquired in a transaction other than a traditional purchase (such as gift, inheritance, trade, or from a spouse), you may have to use a basis other than cost, such as fair market value.

Fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither having to buy or sell and both having reasonable knowledge of the relevant facts. Sales of similar property, on or about the same date, may be helpful in figuring the fair market value of the property.

Home received as gift. If your home was a gift, its basis to you is the same as the donor’s adjusted basis when the gift was made. However, if the donor’s adjusted basis was more than the fair market value of the home when it was given to you, you must use that fair market value as your basis for measuring any loss on its sale.

If you use the donor’s adjusted basis to figure a gain and get a loss, and then use the fair market value to figure a loss and get a gain, you have neither a gain nor a loss on the sale or disposition.

If you received your home as a gift and its fair market value was more than the donor’s adjusted basis at the time of the gift, you may be able to add to your basis any federal gift tax paid on the gift. If the gift was before 1977, the basis cannot be increased to more than the fair market value of the home when it was given to you. On the other hand, if you received your home as a gift after 1976, you would add to your basis the part of the federal gift tax paid that is due to the home’s “net increase” in value (value less donor’s adjusted basis).

Home received from spouse. You may have received your home from your spouse or from your former spouse incident to your divorce.

  • If you received the home after July 18, 1984, you had no gain or loss on the transfer. Your basis in this home is generally the same as your spouse’s (or former spouse’s) adjusted basis just before you received it. This rule applies even if you received the home in exchange for cash, the release of marital rights, the assumption of liabilities, or other consideration.
  • If you owned a home jointly with your spouse and your spouse transferred his or her interest in the home to you, your basis in the half interest received from your spouse is generally the same as your spouse’s adjusted basis just before the transfer. This rule also applies if your former spouse transferred his or her interest in the home to you incident to your divorce. Your basis in the half interest you already owned does not change. Your new basis in the home is the total of these two amounts.
  • If you received your home before July 19, 1984, in exchange for your release of marital rights, your basis in the home is generally its fair market value at the time you received it.
  • Home acquired from a decedent who died before or after 2010. If you inherited your home from a decedent who died before or after 2010, your basis is the fair market value of the property on the date of the decedent’s death (or the later alternate valuation date chosen by the personal representative of the estate). If an estate tax return was filed or required to be filed, the value of the property listed on the estate tax return is your basis. If a federal estate tax return did not have to be filed, your basis in the home is the same as its appraised value at the date of death, for purposes of state inheritance or transmission taxes.
  • Surviving spouse. If you are a surviving spouse and you owned your home jointly, your basis in the home will change. The new basis for the interest your spouse owned will be its fair market value on the date of death (or alternate valuation date). The basis of your interest will remain the same. Your new basis in the home is the total of these two amounts.

Your jointly owned home had an adjusted basis of $50,000 on the date of your spouse’s death, and the fair market value on that date was $100,000. Your new basis in the home is $75,000 ($25,000 for one-half of the adjusted basis plus $50,000 for one-half of the fair market value).

In community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), each spouse is usually considered to own half of the community property. When either spouse dies, the fair market value of the community property becomes the basis of the entire property, including the portion belonging to the surviving spouse. For this to apply, at least, half of the community interest must be included in the decedent’s gross estate, whether or not the estate must file a return.

Home received in trade. If you acquired your home in a trade for other property, the basis of your home is generally its fair market value at the time of the trade. If you traded one home for another, you have made a sale and purchase. In that case, you may have realized a capital gain.

Adjusted Basis

Adjusted basis is your cost or other basis increased or decreased by certain amounts.

Increases to basis include:

  • Additions and other improvements that have a useful life of more than 1 year.
  • Special assessments for local improvements.
  • Amounts spent after a casualty to restore damaged property.

Decreases to basis include:

  • Discharge of qualified principal residence indebtedness that was excluded from income (but not below zero).
  • Gain from the sale of your old home before May 7, 1997 on which tax was postponed.
  • Insurance payments for casualty losses.
  • Deductible casualty losses not covered by insurance.
  • Payments received for granting an easement or right-of-way.
  • Depreciation allowed or allowable if you used your home for business or rental purposes.
  • Residential energy credit (generally allowed from 1977 through 1987) claimed for the cost of energy improvements that you added to the basis of your home.
  • Adoption credit you claimed for improvements that you added to the basis of your home.
  • Nontaxable payments from an employer’s adoption assistance program that you used for improvements you added to the basis of your home.
  • Nonbusiness energy property credit (allowed beginning in 2006 but not for 2008) claimed for making certain energy-saving improvements you added to the basis of your home.
  • Residential energy efficient property credit (allowed beginning in 2006) claimed for making certain energy-saving improvements you added to the basis of your home.
  • First-time home buyer’s credit (allowed to certain first-time buyers in the District of Columbia–beginning on August 5, 1997).
  • Energy conservation subsidy excluded from your gross income because you received it (directly or indirectly) from a public utility after December 31, 1992, to buy or install any energy conservation measure. An energy conservation measure includes an installation or modification that is primarily designed either to reduce consumption of electricity or natural gas or to improve the management of energy demand for a home.

Discharges of qualified principal residence indebtedness. You may be able to exclude from gross income a discharge of qualified principal residence indebtedness. This exclusion applies to discharges made after 2006 through the end of 2025 (Consolidated Appropriations Act, 2021) and also applies to debts forgiven as the result of a written agreement entered into before January 1, 2026, even if the actual discharge happens later. If you choose to exclude this income, you must reduce (but not below zero) the basis of your principal residence by the amount excluded from gross income.

Amount eligible for the exclusion. The exclusion applies only to debt discharged after 2006 and before 2025. The maximum amount you can treat as qualified principal residence indebtedness is $750,000 ($375,000 if married and filing separately). Prior to December 31, 2020, this amount was $2 million ($1 million if married filing separately). You cannot exclude from gross income discharge of qualified principal residence indebtedness if the discharge was for services performed for the lender or on account of any other factor not directly related to a decline in the value of your residence or to your financial condition.

Improvements. These add to the value of your home, prolong its useful life, or adapt it to new uses. You add the cost of improvements to the basis of your property.

Putting a recreation room in your unfinished basement, adding another bathroom or bedroom, putting up a fence, putting in new plumbing or wiring, installing a new roof, or paving your driveway are improvements.

Here are some other examples:

  • Additions: Bedroom, bathroom, deck, garage, porch, patio
  • Lawn and grounds: Landscaping, driveway, walkway, fence, retaining wall, sprinkler system, swimming pool
  • Miscellaneous: Storm windows or doors, new roof, central vacuum, wiring upgrades, satellite dish, security system
  • Heating and air conditioning: Heating system, central air, furnace, duct work, central humidifier, filtration system
  • Plumbing: Septic system, water heater, soft water system, filtration system
  • Interior: Built-in appliances, kitchen modernization, flooring, wall-to-wall carpet
  • Insulation: attic, walls, floor, pipes, duct work
  • Improvements no longer part of home. Your home’s adjusted basis does not include the cost of any improvements that are no longer part of the home.

You put wall-to-wall carpeting in your home 15 years ago. Later, you replaced that carpeting with new wall-to-wall carpeting. The cost of the old carpeting you replaced is no longer part of your home’s adjusted basis.

Repairs. These maintain the good condition of your home. They do not add to its value or prolong its life, and you do not add their costs to the basis of your property.

Repainting your house inside or outside, fixing your gutters or floors, repairing leaks or plastering, and replacing broken window panes are examples of repairs.

The entire job is considered an improvement, however, if items that would otherwise be considered repairs are done as part of an extensive remodeling or restoration of your home.

Recordkeeping. You should keep records of your home’s purchase price and purchase expenses. Furthermore, you should also save receipts and other records for all improvements, additions, and other items that affect the basis of your home.

You must keep records for 3 years after the due date for filing your return for the tax year in which you sold, or otherwise disposed of, your home. But if the basis of your old home affects the basis of your new one, such as when you sold your old home before May 7, 1997, and postponed tax on any gain, you should keep those records forever.

The records you should keep include:

  • Proof of the home’s purchase price and purchase expenses;
  • Receipts and other records for all improvements, additions, and other items that affect the home’s adjusted basis;
  • Any worksheets or other computations you used to figure the adjusted basis of the home you sold, the gain or loss on the sale, the exclusion, and the taxable gain;
  • Any Form 982 you filed to exclude any discharge of qualified principal residence indebtedness;
  • Any Form 2119, Sale of Your Home, you filed to postpone gain from the sale of a previous home before May 7, 1997;
  • Any worksheets you used to prepare Form 2119

Exclusion For Sales After May 6, 1997

If you sell your main home after May 6, 1997, you may qualify to exclude up to $250,000 of the gain ($500,000 if married filing jointly) on the sale of your main home; however, to claim the exclusion, you must meet the ownership and use tests. This means that during the 5-year period ending on the date of the sale, you must have:

  • Owned the home for at least 2 years (the ownership test)
  • Lived in the home as your main home for at least 2 years (the use test)
  • During the 2-year period ending on the date of the sale, you did not exclude gain from the sale of another home.

Exception. If you owned and lived in the property as your main home for less than 2 years, you can still claim an exclusion in some cases. However, the maximum amount you may be able to exclude will be reduced.

If you sell the land on which your main home is located, but not the house itself, you cannot exclude any gain you have from the sale of the land.

If you have more than one home, only the sale of your main home qualifies for excluding the gain. If you have two homes and live in both of them, your main home is the one you live in most of the time.

If you owned and used the property as your main home for less than 2 years, you may be able to claim a reduced exclusion.

The two years of ownership and use during the five-year period don’t have to be continuous. You meet the tests if you can show that you owned and lived in the property as your main home for either 24 full months or 730 days during the five-year period. Short temporary absences, e.g., for vacations, are counted as periods of use, even if you rent out the property during that time.

From 1994 through August 2007, Anne lived with her parents in a house that her parents owned. On September 29, 2007, she bought this house from her parents. She continued to live there until December 15 of 2007 when she sold it at a gain. Although Anne lived in the property as her main home for more than 2 years, she did not own it for the required 2 years. Therefore, she cannot exclude any part of her gain on the sale, unless she sold the property due to a change in health or place of employment.

Professor Moore bought and moved into a house on January 4, 2005. He lived in it as his main home continuously until October 1, 2006, when he went abroad for a one-year sabbatical. During part of the leave, the house was unoccupied, and during the rest of the time, he rented it out. On October 1, 2007, he sold the house. Because his leave was not a short temporary absence, he cannot include the period of leave to meet the 2-year use test.

Ownership and Use Tests Met at Different Times. You can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale.

In 1996, Harry was 60 years old and lived in a rental apartment. When the apartment building went co-op, he bought his apartment on December 1, 1999. Harry then went to live with his daughter on April 14, 2001, because he became ill. On July 10, 2003, he sold his co-op while still living with his daughter. Harry can exclude gain on the sale of his co-op because he met the ownership and use tests. His 5-year period runs from July 11, 1998, to July 10, 2003, the date he sold the co-op. Even though he only owned the co-op from December 1, 1999, to July 10, 2003–over two years, he lived in the apartment from July 11, 1997 (the beginning of the five-year period) to April 14, 2001 (over two years).

Special Situations. There are a number of special situations that may result in exceptions to the general rules.

Individuals with Disabilities. There is an exception to the 2-out-of-5-year use test if you become physically or mentally unable to care for yourself at any time during the 5-year period. You qualify for this exception to the use test if, during the 5-year period before the sale of your home:

  • You become physically or mentally unable to care for yourself, and
  • You owned and lived in your home as a main home for a total of at least one year during the 5-year period before the sale of your home.

Under this exception, you are considered to live in your home during any time that you live in a facility (including a nursing home) that is licensed by a state or political subdivision to care for persons in your condition.

If you meet this exception to the use test, you still have to meet the 2-out-of-5-year ownership test to claim the exclusion.

Gain postponed on sale of previous home. For the ownership and use tests, you may be able to add the time you owned and lived in a previous home to the time you lived in the home on which you wish to exclude gain. You can do this if you postponed all or part of the gain on the sale of the previous home because of buying the home on which you wish to exclude gain.

Also, if buying the previous home enabled you to postpone all or part of the gain on the sale of a home you owned earlier, you can also include the time you owned and lived in that earlier home.

Previous home destroyed or condemned. For the ownership and use test, you add the time you owned and lived in a previous home that was destroyed or condemned to the time you owned and lived in the home on which you wish to exclude gain. This rule applies if any part of the basis of the home you sold depended on the basis of the destroyed or condemned home. Otherwise, you must have owned and lived in the same home for 2 of the 5 years before the sale to qualify for the exclusion.

Members of the uniformed services or Foreign Service, employees of the intelligence community, or employees or volunteers of the Peace Corps. You can choose to have the 5-year test period for ownership and use suspended during any period you or your spouse serve on qualified official extended duty (defined later) as a member of the uniformed services or Foreign Service of the United States, or as an employee of the intelligence community.

You can choose to have the 5-year test period for ownership and use suspended during any period you or your spouse serve outside the United States either as an employee of the Peace Corps on qualified official extended duty (defined later) or as an enrolled volunteer or volunteer leader of the Peace Corps. This means that you may be able to meet the 2-year use test even if, because of your service, you did not actually live in your home for at least the required 2 years during the 5-year period ending on the date of sale.

The period of suspension cannot last more than 10 years. Together, the 10-year suspension period and the 5-year test period can be as long as, but no more than, 15 years. You cannot suspend the 5-year period for more than one property at a time. You can revoke your choice to suspend the 5-year period at any time.

Married Persons

If you and your spouse file a joint return for the year of sale, you can exclude gain (up to $500,000) if either spouse meets the ownership and use tests.

Mary sells her home in June of this year and marries John later in the year. She meets the ownership and use tests, but John does not. Emily can exclude up to $250,000 of gain on a separate or joint return for this year.

Now assume that John also sells a home. He meets the ownership and use tests on his home. Mary and John can each exclude $250,000 of gain.

Death of spouse before sale. If your spouse died before the date of sale, you are considered to have owned and used the property as your main home during any period of time when your spouse owned and used it as his or her main home.

Home transferred from spouse. If your home was transferred to you by your spouse (or former spouse if the transfer was incident to divorce), you are considered to have owned it during any period of time when your spouse owned it.

Use of home after divorce. You are considered to have used property as your main home during any period when you owned it and your spouse or former spouse is allowed to use it under a divorce or separation instrument. Such use is added to your own use before or after divorce.

Special Exceptions Affecting Exclusions

Home destroyed or condemned. If your home is destroyed or condemned after May 6, 1997, any gain (e.g., due to insurance proceeds) qualifies for the exclusion.

Expatriates. You cannot claim the exclusion if the expatriate tax applies to you because you have renounced their citizenship and one of the primary purposes was to avoid U.S. taxes.

More Than One Home Sold During the Two-Year Period. You cannot exclude gain on the sale of your home if, during the two-year period ending on the date of the sale, you sold another home at a gain and are excluding all or part of that gain. If you cannot exclude the gain, you must include it in your income.

However, you can claim a reduced exclusion if you sold the home due to a change in health or place of employment or experienced unforeseen circumstances such as natural disasters, death, or unemployment (eligible unemployment compensation). When counting the number of sales during a two-year period, do not count sales before May 7, 1997.

The $250,000 (or $500,000) exclusion is reduced according to a formula whose numerator is the number of days of qualified ownership or use (or between sales of the homes) and the denominator is 730 days (for 2 years). If married filing jointly, duplicate the same calculation for your spouse’s ownership and use (or days between sales).

You owned and used your main home for 400 days before selling it at a $150,000 gain following your move to a new job location. Your exclusion is $136,986, that is, 400/730 x $250,000.

Change in Place of Employment. You may qualify for a reduced exclusion if the primary reason for the sale of your main home is a change in the location of employment of a qualified individual.

Health. You may qualify for a reduced exclusion if the sale of your main home is because of health if your primary reason for the sale is to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a qualified individual, or to obtain or provide medical or personal care for a qualified individual suffering from a disease, illness, or injury.

Unforeseen Circumstances. You may qualify for a reduced exclusion if the sale of your main home is because of an unforeseen circumstance if your primary reason for the sale is the occurrence of an event that you could not reasonably have anticipated before buying and occupying that home. You are not considered to have an unforeseen circumstance if the primary reason you sold your home was that you preferred to get a different home or because your finances improved.

Home used in business. So long as the business use takes place in the same dwelling unit as your main home, the exclusion is not affected by business use, with this exception: You cannot exclude the part of your gain that is equal to any depreciation allowed or allowable for the business use of your home after May 6, 1997. The 2 out of 5-year use-as-the-main-home test is not applied to deny exclusion for gain allocable to business use in the same dwelling unit, except for allowable depreciation.

You bought a home in 1997 and used it throughout 3/4 as your residence and 1/4 as your home office. On December 30, 2002, you sold it. The gain qualifies for exclusion except that you cannot exclude the part of your gain that is equal to any depreciation allowed or allowable for the business use of your home after May 6, 1997.

Recapture Of Federal Subsidy

If you financed your home under a federally subsidized program (loans from tax-exempt qualified mortgage bonds or loans with mortgage credit certificates), you may have to recapture all or part of the benefit you received from that program when you sell or otherwise dispose of your home. You recapture the benefit by increasing your federal income tax for the year of the sale. You may have to pay this recapture tax even if you can exclude your gain from income under the rules discussed earlier; that exclusion does not affect the recapture tax.

Glossary

Adjusted basis: This is your basis in the property increased or decreased by certain amounts. See Adjusted Basis, earlier in this Guide, for a list of items that increase or decrease your basis in the property.

Amount realized: This is the selling price of your old home minus your selling expenses.

Basis: Your basis in the property is determined by how you got it. If you bought or built the property, your basis is what it cost you. If you got the property in some other way, your basis will be determined differently. See Cost as Basis and Basis Other Than Cost earlier in this Guide for more information.

Date of sale: If you received a Form 1099-S, Proceeds From Real Estate Transactions, the date should be shown in box 1. If you did not receive this form, the date of sale is the earlier of (a) the date title transferred or (b) the date the economic burdens and benefits of ownership shifted to the buyer. In most cases, these dates are the same.

Fair market value: Fair market value is the price at which property would change hands between a willing buyer and a willing seller, neither having to buy or sell and both having reasonable knowledge of the relevant facts. Sales of similar property, on or about the same date, may be helpful in figuring the fair market value of the property.

Fixing-up expenses: These are costs you pay for decorating or repairing your home to make it easier to sell. You may be able to deduct fixing-up expenses from the amount realized on the sale of your old home.

Gain: Your gain on the sale of your home is the amount realized minus the adjusted basis of the home you sold.

Improvements: These add to the value of your home, prolong the life of the property or allow the property to be used for new purposes. The cost of improvements increases your basis in the property.

Main home: This is the home you live in most of the time. It can be a house, houseboat, cooperative apartment, condominium, etc.

Repairs: These maintain your property in good condition. They differ from Improvements in that they do not add much to the value or life of the property and their cost does not increase your basis in the property.

Seller-financed mortgage: This is a mortgage from the buyer of your home. The buyer makes mortgage payments to you.

Selling expenses: Selling expenses include items such as sales commissions and advertising and legal fees you pay to sell your home. Selling expenses also usually include loan charges you pay on the buyer’s behalf as an aid in selling your home, such as loan placement fees or “points.”

Settlement fees (or closing costs): These are amounts paid in purchasing your property in addition to the contract price. Some of these amounts are added to the basis of the property and some are deductible as itemized deductions. Certain amounts are neither deductible nor added to the basis of the property. See Settlement fees or closing costs under Basis, earlier in this Guide, for more details.


02 Aug 2024

This Financial Guide explains when and to what extent points paid on the purchase of a home or refinancing are deductible. It explains the rules for deducting points and discusses special circumstances and situations.


  • What Are Points?
  • Tests for Deductibility
  • Non-Deductible Amounts
  • Points Paid By Seller
  • Funds Provided Are Less Than Points
  • Excess Points
  • Points Paid on Second Home
  • Mortgage Ends Early
  • Points Paid on Refinancing
  • Limits on Home Mortgage Interest Affect Points
  • Form 1098
What Are Points?

For an explanation of the deductibility of home mortgage interest, please click here.

The term “points” is used to describe certain charges paid or treated as paid, by a borrower to obtain a home mortgage. Points may also be called loan origination fees, maximum loan charges, loan discount, or discount points.

Points are prepaid interest and may be deductible as home mortgage interest if you itemize deductions on Form 1040, Schedule A. Generally, if you can deduct all of the interest on your mortgage, you may be able to deduct all of the points paid on the mortgage. If your acquisition debt exceeds $750,000 for tax years 2018-2025 or your home equity debt exceeds $100,000, you cannot deduct all the interest on your mortgage, and you cannot deduct all your points.

A borrower is treated as paying any points that a home seller pays for the borrower’s mortgage. See “Points Paid by Seller,” later.

Tests for Deductibility

Generally, you cannot deduct the full amount of points in the year paid. Because they are prepaid interest, you generally must deduct them over the life (term) of the mortgage.

However, you can fully deduct points in the year paid if you meet all of the following tests.

  1. Your loan is secured by your main home (the one you live in most of the time).
  2. Paying points is an established business practice in the area where the loan was made.
  3. The points paid were not more than the points generally charged in that area.
  4. You use the cash method of accounting (the method used by most individual taxpayers).
  5. The points were not paid in place of amounts that ordinarily are stated separately on the settlement statement, such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes.
  6. You use your loan to buy or build your main home.
  7. The points were computed as a percentage of the principal amount of the mortgage.
  8. The amount is clearly shown on the settlement statement (such as the Uniform Settlement Statement, Form HUD-1) as points charged for the mortgage. The points may be shown as paid from either your funds or the seller’s.
  9. The funds you provided at or before closing, plus any points the seller paid, were at least as much as the points charged. The funds you provided do not have to have been applied to the points. They can include a down payment, an escrow deposit, earnest money, and other funds you paid at or before closing for any purpose. You cannot have borrowed these funds from your lender or mortgage broker.

Home improvement loan. You can also fully deduct in the year paid points paid on a loan to improve your main home if statements (1) through (5) above are true.

Non-Deductible Amounts

Amounts charged by the lender for specific services connected to the loan are not considered interest. Examples of these charges are:

  1. Appraisal fees
  2. Notary fees
  3. Preparation costs for the mortgage note or deed of trust
  4. Mortgage insurance premiums
  5. VA funding fees.

You cannot deduct these amounts as points either in the year paid or over the life of the mortgage.

Points Paid By Seller

The term “points” includes loan placement fees that the seller pays to the lender to arrange financing for the buyer. The seller cannot deduct these fees as interest. But they are a selling expense that reduces the seller’s amount realized. The buyer reduces the basis of the home by the amount of the seller-paid points and treats the points as if he or she had paid them. If all the tests explained earlier are met, the buyer can deduct the points in the year paid. If any of those tests are not met, the buyer deducts the points over the life of the loan.

Funds Provided Are Less Than Points

If you meet all the tests referred to earlier; except that the funds you provided were less than the points charged to you (test 9), you can deduct the points in the year paid, up to the amount of funds you provided. You can also deduct any points paid by the seller.

Example 1: When you took out a $100,000 mortgage loan to buy your home in December, you were charged one point ($1,000). You meet all the nine tests for deducting points in the year paid, except the only funds you provided were a $750 down payment. Of the $1,000 charged for points, you can deduct $750 in the year paid. You spread the remaining $250 over the life of the mortgage.

Example 2: The facts are the same as in the example above except that the person who sold you your home also paid one point ($1,000) to help you get your mortgage. In the year paid, you can deduct $1,750 ($750 of the amount you were charged plus the $1,000 paid by the seller). You must reduce the basis of your home by the $1,000 paid by the seller.

Excess Points

If you meet all the tests except that the points paid were more than generally paid in your area (test 3), you deduct in the year paid only the points that are generally charged. You must spread any additional points over the life of the mortgage.

Points Paid on Second Home

The general rule of instant deductibility does not apply to points you pay on loans secured by your second home. You can deduct these points only over the life of the loan.

Mortgage Ends Early

If you spread your deduction for points over the life of the mortgage, you can deduct any remaining balance in the year the mortgage ends. However, if you refinance the mortgage with the same lender, you cannot deduct any remaining balance of spread points. Instead, deduct the remaining balance over the term of the new loan.

A mortgage may end early due to a prepayment, refinancing, foreclosure, or similar event.

Example: Dan paid $3,000 in points in 2008 that he had to spread out over the 15-year life of the mortgage. He deducts $200 points per year. Through 2019, Dan has deducted $2,200 of the points. Dan prepaid his mortgage in full in 2019. He can deduct the remaining $800 of points in 2019.

Points Paid on Refinancing

Generally, points you pay to refinance a mortgage are not deductible in full in the year you pay them. This is true even if the new mortgage is secured by your main home.

However, if you use part of the refinanced mortgage proceeds to improve your main home and you meet the first five tests listed earlier; you can fully deduct the part of the points related to the improvement in the year paid. You can deduct the rest of the points over the life of the loan.

Example 1: In 1999, Bill Fields got a mortgage to buy a home. In 2019, Bill refinanced that mortgage with a 15-year $100,000 mortgage loan. The mortgage is secured by his home. To get the new loan, he had to pay three points ($3,000). Two points ($2,000) were for prepaid interest, and one point ($1,000) was charged for services, in place of amounts that ordinarily are stated separately on the settlement statement. Bill paid the points out of his private funds, rather than out of the proceeds of the new loan. The payment of points is an established practice in the area and the points charged are not more than the amount generally charged there. Bill’s first payment on the new loan was due July 1. He made six payments on the loan in 2019 and is a cash basis taxpayer.

Bill used the funds from the new mortgage to repay his existing mortgage. Although the new mortgage loan was for Bill’s continued ownership of his main home, it was not for the purchase or improvement of that home. For that reason, Bill does not meet all the tests, and he cannot deduct all of the points in 2019. He can deduct two points ($2,000) ratable over the life of the loan. He deducts $67 [($2,000 ÷ 180 months) x 6 payments] of the points in 2019. The other point ($1,000) was a fee for services and is not deductible.

Example 2: The facts are the same as in Example 1, except that Bill used $25,000 of the loan proceeds to improve his home and $75,000 to repay his existing mortgage. Bill deducts 25 percent ($25,000 ÷ $100,000) of the points ($2,000) in 2019. Therefore, his deduction is $500 ($2,000 x 0.25).

Bill also deducts the ratable part of the remaining $1,500 ($2,000 – $500) prepaid interest that must be spread over the life of the loan. This is $50 [($1,500 ÷ 180 months) x 6 payments] in 2018. The total amount Bill deducts in 2019 is $550 ($500 + $50).

Limits on Home Mortgage Interest Affect Points

You cannot fully deduct points paid on a mortgage that exceeds the limits on home mortgages for purposes of the home mortgage interest deduction.

Form 1098

The mortgage interest statement (Form 1098) you receive should show not only the total interest paid during the year but also your deductible points.

The statement will show the total interest you paid during the year. If you purchased a main home during the year, it also will show the deductible points paid during the year, including seller-paid points. However, it should not show any interest that was paid for you by a government agency.

As a general rule, Form 1098 will include only points that you can fully deduct in the year paid. However, certain points not included on Form 1098 also may be deductible, either in the year paid or over the life of the loan. See the earlier discussion of Points to determine whether you can deduct points not shown on Form 1098.


02 Aug 2024

Roth IRAs differ from other tax-favored retirement plans, including other IRAs (called “traditional IRAs”), in that they promise complete tax exemption on distribution. There are other important differences as well, and many qualifications about their use. This Financial Guide shows how they work, how they compare with other retirement devices–and why YOU might want one, or more.

With most tax-favored retirement plans, the contribution to (i.e., investment in) the plan is deductible, the investment compounds tax-free until distributed, and distributions are taxable as received. There are variations from this pattern, as with 401(k)s where the exemption for salary diverted to a 401(k) takes the place of a deduction and for after-tax investments where invested capital is tax-free when distributed.

With a Roth IRA, there’s never an up-front deduction for contributions. Funds contributed compound tax-free until distributed (standard for all tax-favored plans) and distributions are completely exempt from income tax.


  • How Contributions Are Treated
  • How Withdrawals Are Treated
  • Undoing a Conversion to a Roth IRA
  • Withdrawal Requirements
  • Retirement Savings Contributions Credit
  • Use in Estate Planning
How Contributions Are Treated

The 2023 annual contribution limit to a Roth IRA is $6,500. An additional “catch-up” contribution of $1,000 is allowed for people age 50 or over bringing the contribution total to $7,500 for certain taxpayers. To make the full contribution, you must earn at least $6,500 ($7,500 if age 50 or older) from personal services and have income (modified adjusted gross income or MAGI) below $138,000 if single or $218,000 on a joint return in 2023. The $6500 limit in 2023 phases out on incomes between $138,000 and $153,000 (single filers) and $218,000 and $228,000 (joint filers). Also, the $6,500 limit is reduced for contributions to traditional IRAs though not SEP or SIMPLE IRAs.

You can contribute to a Roth IRA for your spouse, subject to the income limits above. So assuming earnings (your own or combined with your spouse) of at least $13,000, up to $13,000 ($6,500 each) can go into the couple’s Roth IRAs. As with traditional IRAs, there’s a six percent penalty on excess contributions. The rule continues that the dollar limits are reduced by contributions to traditional IRAs.

How Withdrawals Are Treated

You may withdraw money from a Roth IRA at any time; however, taxes and penalty could apply depending on the timing of contributions and withdrawals.

Qualified Distributions

Since all your investments in a Roth IRA are after-tax, your withdrawals, whenever you make them, are often tax-free. But the best kind of withdrawal, which allows earnings, as well as contributions and conversion, amounts to come out completely tax-free, are qualified distributions. These are withdrawals meeting the following conditions:

1. At least, five years have elapsed since the first year a Roth IRA contribution was made or, in the case of a conversion since the conversion occurred and

2. At least one of these additional conditions is met:

  • The owner is age 59 1/2.
  • The owner is disabled.
  • The owner has died (distribution is to estate or heir).
  • Withdrawal is for a first-time home that you build, rebuild, or buy (lifetime limit up to $10,000).

A distribution used to buy, build or rebuild a first home must be used to pay qualified costs for the main home of a first-time home buyer who is either yourself, your spouse or you or your spouse’s child, grandchild, parent or another ancestor.

Non-Qualified Distributions

To discourage the use of pension funds for purposes other than normal retirement, the law imposes an additional 10 percent tax on certain early distributions from Roth IRAs unless an exception applies. Generally, early distributions are those you receive from an IRA before reaching age 59 1/2.

Exceptions. You may not have to pay the 10 percent additional tax in the following situations:

  • You are disabled.
  • You are the beneficiary of a deceased IRA owner.
  • You use the distribution to pay certain qualified first-time homebuyer amounts.
  • The distributions are part of a series of substantially equal payments.
  • You have significant unreimbursed medical expenses.
  • You are paying medical insurance premiums after losing your job.
  • The distributions are not more than your qualified higher education expenses.
  • The distribution is due to an IRS levy of the qualified plan.
  • The distribution is a qualified reservist distribution.

Part of any distribution that is not a qualified distribution may be taxable as ordinary income and subject to the additional 10 percent tax on early distributions. Distributions of conversion contributions within a 5-year period following a conversion may be subject to the 10 percent early distribution tax, even if the contributions have been included as income in an earlier year.

Ordering Rules for Distributions

If you receive a distribution from your Roth IRA, that is not a qualified distribution, part of it may be taxable. There is a set order in which contributions (including conversion contributions) and earnings are considered to be distributed from your Roth IRA. Order the distributions as follows.

  1. Regular contributions.
  2. Conversion contributions, on a first-in-first-out basis (generally, total conversions from the earliest year first). See Aggregation (grouping and adding) rules, later. Take these conversion contributions into account as follows:
    • Taxable portion (the amount required to be included in gross income because of conversion) first, and then the
    • Nontaxable portion.
  3. Earnings on contributions.

Disregard rollover contributions from other Roth IRAs for this purpose.

Aggregation (grouping and adding) rules.

Determine the taxable amounts distributed (withdrawn), distributions, and contributions by grouping and adding them together as follows.

  • Add all distributions from all your Roth IRAs during the year together.
  • Add all regular contributions made for the year (including contributions made after the close of the year, but before the due date of your return) together. Add this total to the total undistributed regular contributions made in prior years.
  • Add all conversion and rollover contributions made during the year together.

For years prior to 2018, add any recharacterized contributions that end up in a Roth IRA to the appropriate contribution group for the year that the original contribution would have been taken into account if it had been made directly to the Roth IRA. Disregard any recharacterized contribution that ends up in an IRA other than a Roth IRA for the purpose of grouping (aggregating) both contributions and distributions. Also, disregard any amount withdrawn to correct an excess contribution (including the earnings withdrawn) for this purpose.

On October 15, 2016, Justin converted all $80,000 in his traditional IRA to his Roth IRA. His Forms 8606 from prior years show that $20,000 of the amount converted is his basis. Justin included $60,000 ($80,000 – $20,000) in his gross income. On February 23, 2017, Justin makes a regular contribution of $4,000 to a Roth IRA. On November 7, 2023, at age 65 Justin takes a $7,000 distribution from his Roth IRA.

  • The first $4,000 of the distribution is a return of Justin’s regular contribution and is not includible in his income.
  • The next $3,000 of the distribution is not includible in income because it was included previously.

Distributions after Owner’s Death

Qualified distributions after the owner’s death are tax-free to heirs. Nonqualified distributions after death, which are distributions where the 5-year holding period wasn’t met, are taxable income to heirs as they would be to the owner (the earnings are taxed), except there’s no penalty tax on early withdrawal. However, an owner’s surviving spouse can convert an inherited Roth IRA into his or her own Roth IRA. This way, distribution can be postponed, so that nonqualified amounts can become qualified, and the tax shelter prolonged.

Roth IRA assets left at death are subject to federal estate tax, just as traditional IRA assets are.

Converting from a Traditional IRA or Other Eligible Retirement Plan to a Roth IRA

The conversion of your traditional IRA to a Roth IRA was the feature that caused most excitement about Roth IRAs. Conversion means that what would be a taxable traditional IRA distribution can be made into a tax-exempt Roth IRA distribution. Starting in 2008, further conversion or rollover opportunities from other eligible retirement plans were made available to taxpayers.

Conversion Methods

You can convert a traditional IRA to a Roth IRA. The conversion is treated as a rollover, regardless of the conversion method used.

You can convert amounts from a traditional IRA to a Roth IRA in any of the following three ways.

  • Rollover. You can receive a distribution from a traditional IRA and roll it over (contribute it) to a Roth IRA within 60 days after the distribution.
  • Trustee-to-trustee transfer. You can direct the trustee of the traditional IRA to transfer an amount from the traditional IRA to the trustee of the Roth IRA.
  • Same trustee transfer. If the trustee of the traditional IRA also maintains the Roth IRA, you can direct the trustee to transfer an amount from the traditional IRA to the Roth IRA.

Conversions made with the same trustee can be made by redesignating the traditional IRA as a Roth IRA, rather than opening a new account or issuing a new contract.

Prior to 2008, you could only roll over (convert) amounts from either a traditional, SEP, or SIMPLE IRA into a Roth IRA. You can now roll over amounts from the following plans into a Roth IRA.

  • A qualified pension, profit-sharing or stock bonus plan (including a 401(k) plan),
  • An annuity plan,
  • A tax-sheltered annuity plan (section 403(b) plan),
  • A deferred compensation plan of a state or local government (section 457 plan), or
  • An IRA.

Any amount rolled over is subject to the same rules for converting a traditional IRA to a Roth IRA. Also, the rollover contribution must meet the rollover requirements that apply to the specific type of retirement plan.

There is a cost to the rollover. The amount converted is fully taxable in the year converted, except for the portion of after-tax investment in the traditional IRA. So you must pay tax now (though there’s no early withdrawal penalty) for the opportunity to withdraw tax-free later, an opportunity that can extend to your heirs.

Undoing a Conversion to a Roth IRA

The information in this section only applies to taxable years beginning after December 31, 2017.

Under tax reform (Tax Cuts and Jobs Act of 2017), if a contribution to a regular IRA has been converted into a contribution to a Roth IRA, it can no longer be converted back into a contribution to a regular IRA. This provision prevents a taxpayer from using recharacterization to unwind a Roth conversion.

Since everyone recognizes that conversion is a high-risk exercise, the law, and liberal IRS rules provide an escape hatch: You can undo a Roth IRA conversion by what IRS calls a “recharacterization.” This move, by which you move your conversion assets from a Roth IRA back to a traditional IRA, makes what would have been a taxable conversion into a tax-free rollover between traditional IRAs. Re-characterization can be done any time until the due date for the return for the year of conversion.

If your assets are worth $180,000 at conversion and fall to $140,000 later, you’re taxed on up to $180,000, which is $40,000 more than you now have. Undoing-re-characterization-avoids the tax, and gets you out of the Roth IRA.

One reason to do this, dramatized by a volatile stock market, is where the value of your portfolio drops sharply after the conversion.

Can you undo one Roth IRA conversion and then make another one a reconversion? Yes, but only one time and subject to the following requirements: Reconversion must take place in the tax year following the original conversion to Roth IRA, and the reconversion date must also be more than 30 days after the previous recharacterization transfer from the Roth IRA back to the traditional IRA.

Withdrawal Requirements

You are not required to take distributions from your Roth IRA once you reach a particular age. The minimum distribution rules that apply to traditional IRAs do not apply to Roth IRAs while the owner is alive. However, after the death of a Roth IRA owner, certain of the minimum distribution rules that apply to traditional IRAs also apply to Roth IRAs

Also, unlike traditional IRAs (but like other tax-favored retirement plans), a Roth IRA owner who continues working may continue to contribute to the Roth IRA.

Retirement Savings Contributions Credit

Also known as the saver’s credit, this credit helps low and moderate-income workers save for retirement. Taxpayers age 18 and over who are not full-time students and can’t be claimed as dependents, are allowed a tax credit for their contributions to a workplace retirement plan, traditional or Roth IRA if their modified adjusted gross income (MAGI) in 2023 for a married filer is below $73,000. For heads-of-household MAGI is below $54,750 and for others (single, married filing separately) it is below $36,500.

These amounts are indexed for inflation each year. The credit, up to $1,000, is a percentage from 10 to 50 percent of each dollar placed into a qualified retirement plan up to the first $2,000 ($4,000 married filing jointly). The lower the MAGI is, the higher the credit percentage, resulting in the maximum credit of $1,000 (50 percent of $2,000). Both you and your spouse may be eligible to receive this credit if you both contributed to a qualified retirement plan and meet the adjusted gross income limits.

The saver’s credit is available in addition to any other tax savings that apply. Further, IRA contributions can be made until the April 15 tax return due date of the following year and still be considered in the current tax year.

Use in Estate Planning

Though Roth IRAs enjoy no estate tax relief, they are already figuring in estate plans. The aim is to build a large Roth IRA fund largely through conversion of traditional IRAs-to pass to beneficiaries in later generations. The beneficiaries will be tax exempt on withdrawals (of qualified distributions) and the Roth IRA tax shelter continues by spreading withdrawal over their lifetimes.

Long-term planning with Roth IRAs. If you would be allowed a deduction for a contribution to a traditional IRA, contributing to a Roth IRA means surrendering current tax reduction for future tax reduction (to zero) for qualified distributions. This can be presented as an after-tax return-on-investment calculation involving assumed future tax rates. The higher the projected tax rate at withdrawal, the more tax Roth IRA saves.

Comparable considerations apply to conversions to Roth IRAs. Here the taxpayer incurs substantial current tax cost (directly or indirectly reducing the amount invested) for future tax relief to the taxpayer or an heir. So the return on investment resulting from conversion increases as projected future rates rise.

A key element in making such projections is the possibility that current and future federal deficits will lead to future tax rate increases a factor which would tend to encourage current Roth IRA investment and conversion. On the other hand, there’s the question whether Roth IRA benefits currently promised will survive into future decades.

Highly sophisticated planning is required for Roth IRA conversions. Consultation with a qualified advisor is a must. Please call if you have any questions.


02 Aug 2024

If you are thinking of retiring soon, you are about to make a major financial decision: how to take distributions from your retirement plan. This Financial Guide will discuss your various options. And, since the tax treatment of these distributions will influence your decision, we will also review the tax rules.

You may have a number of options as to HOW you can take retirement plan distributions, i.e., your share of company or Keogh pension or profit-sharing plans (including thrift and savings plans), 401(k)s, IRAs, and stock bonus plans. Your options depend (1) on what type of plan you are in and (2) whether your employer has limited your choices. Essentially, you can:

  • Take everything in a lump sum.
  • Take some kind of annuity.
  • Roll over the distribution.
  • Take a partial withdrawal.
  • Do some combination of the above.

As you will see, the rules on retirement plan distributions are quite complex. They are offered here only for your general understanding. Professional guidance is advised before taking retirement distributions or other major withdrawals from your retirement plan.

Before discussing the specific withdrawal options, let’s consider the general tax rules affecting (1) tax-free withdrawals and (2) early withdrawals.

Related Guide: The tax treatment will be dictated not only by the form of the withdrawal (i.e., how to take it) but also by the timing of the withdrawal (i.e., when to take it). This Financial Guide discusses the “how.” For a discussion of the “when,” please see the Financial Guide RETIREMENT PLAN DISTRIBUTIONS: WHEN to Take Them.

Tax-free Withdrawals. If you paid tax on money that went into the plan, that is if it was made with after-tax funds that money will come back to you tax-free. Typical examples of after-tax investments are:

  • Your non-deductible IRA contributions.
  • Your after-tax contributions to company or Keogh plans (usually, thrift, savings or other profit-sharing plans, but sometimes pension plans).
  • Your after-tax contributions to 401(k)s (in excess of the pre-tax deferral limit).

Early Withdrawals. Tax-favored retirement plans are meant primarily for retirement. If you withdraw funds before reaching what the law considers a reasonable retirement age – age 59 1/2 – you usually will face a 10 percent penalty tax in addition to whatever tax would ordinarily apply.

At age 47, you withdraw $10,000 from your retirement account (and do not roll over the funds). That $10,000 is ordinary income on which you’ll owe regular tax at your applicable rate plus a 10 percent penalty tax ($1,000).

As with any other tax on withdrawal, the 10 percent penalty doesn’t apply to any part of a withdrawal that would be tax-free as a return of after-tax investment

There are several ways to avoid this penalty tax. The most common are:

  • You’re age 59 ½ or older.
  • You’re retired and are age 55 or older (however, this does not apply to IRAs).
  • You’re withdrawing in roughly equal installments over your life expectancy or your joint-and-survivor life expectancy (discussed later).
  • You’re disabled.
  • The withdrawal is required by a divorce or separation settlement (here, too, this does not apply to IRAs).
  • The withdrawal is for certain medical expenses.
  • The withdrawal is for health insurance while unemployed (also available to self-employed).
  • For IRAs only: The withdrawal is for certain higher education expenses and for first-time home purchases (up to $10,000).

Taxpayers affected by the coronavirus are able to withdraw up to $100,000 and will not be subject to the 10 percent penalty for early withdrawals. Distributions can be taken through December 31, 2020. The amount withdrawn is considered income, however, and taxpayers have three years to pay the tax on the additional income and replace the funds in-kind. If you need to withdraw funds from a retirement plan, please call a tax and accounting professional to discuss how it could impact your financial situation.

Eligible taxpayer. Anyone who has been diagnosed with SARS-CoV-2 virus or COVID-19 disease or whose spouse or dependent has been diagnosed with the same. In addition, any taxpayer experiencing financial hardship from any of the following situations:

  • Quarantined
  • Furloughed
  • Laid off
  • Work hours reduced
  • Unable to work due to lack of child care

Now let’s review the basics for each of the options for taking retirement plan distributions and then discuss the tax planning for each option.


  • Take Everything In A Lump Sum
  • Roll Over The Distribution
  • Take A Partial Withdrawal
  • Do Some Combination Of The Above
  • Life Insurance Options
  • Assets Withdrawn In Kind
  • The Economics Of Retirement Annuities
  • Can Creditors Reach Your Retirement Assets
  • State Taxes On Retirement Plan Distributions
Take Everything In A Lump Sum

The Basics

You might want to withdraw all retirement funds in a lump sum, perhaps to spend them on a retirement home or assisted living arrangement, on a second home, or to buy or invest in a business. Or you might want to take everything out of a company account because you mistrust leaving funds with a former employer or to take control of investment decisions, although here a rollover (discussed later) might be preferred. Maybe you have to take a lump sum, as some employers will require, though here, too, a rollover option is probably available.

Lump sum is the standard form of retirement distribution for profit-sharing, 401(k) and stock bonus plans, but may also happen in other plans. Put another way, while plans generally allow lump sum distribution, the employer may have decided to preclude the lump sum form.

While your funds remain in the plan, earnings on the investment assets grow tax-free. The tax shelter ends once the funds are withdrawn. Preserving this tax shelter is one reason to decide not to withdraw the funds at all or to decide against withdrawing everything in a lump sum. The tax shelter continues, in one form or another, for funds withdrawn as annuities and for funds left in the plan when there’s a partial withdrawal of funds. And the shelter continues on rollovers.

Tax Planning

Special tax relief applies, in certain cases, for those who withdraw their pension assets in a lump sum. For most, this relief comes in the form of “forward averaging,” which is also known as the 10-year tax option.

Forward averaging reduces your tax below what it would be if figured at regular progressive rates. You will pay tax in one year (for the year you receive it) as if the lump sum amount was received in equal installments over 10 years. Forward averaging isn’t allowed if any part of the account is or was rolled over to an IRA.

Capital gain treatment for lump sums is available only for those born before 1936 and only with respect to plan participation before 1974. You will need to report the taxable part of the distribution from participation before 1974 as a capital gain (if you qualify) and the taxable part of the distribution from participation after 1973 as ordinary income using the 10-year tax option to figure the tax on the part from participation after 1973 (if you qualify).

It’s a “lump sum” if you take out everything left in your account in a single calendar year. If you took $50,000 last year and $250,000 this year, and nothing is left, $250,000 is the lump sum. If you took $250,000 last year and $50,000 this year and nothing is left, $50,000 is the lump sum. In general, lump sum relief is available only once in a worker’s lifetime.

You may also report the entire taxable part as ordinary income or roll over all or part of the distribution. No tax would be due on the part rolled over and any part of the distribution that is not rolled over is reported as ordinary income.

Because lump sum withdrawal ends the tax shelter, it’s rarely the road to maximizing wealth. Retirees will usually do better with arrangements that preserve the shelter, through rollovers, annuities or partial withdrawals.

Roll Over The Distribution

The Basics

Rollovers are transfers of funds from one plan to another (from one company or Keogh plan to another, from a company or Keogh to an IRA, or from one IRA to another, or from an IRA to a company or Keogh plan.

Rollovers are usually distributions from a company or Keogh plan that are put into an IRA. You might do this (1) to transfer control of the funds from your employer to yourself or (2) because your employer forces the distribution when you leave so as to close its books on your plan participation. In your own Keogh plan, you might make the rollover as part of a decision to terminate your plan or your business.

A rollover to your own IRA can give you flexibility in dealing with the funds (for example, so you can invest in options or create a separate IRA for each beneficiary) that would not be available for funds left in your employer’s plan. Rollovers can be of the entire retirement account or only part of the account.

Rollovers can be made from one IRA to another. Apart from Roth IRA situations, these are usually done to expand investment options or to create several IRA accounts. Rollovers also can be made from one pension, profit-sharing or 401(k) plan to another or between types of plan. This might happen if you change jobs or set up a new Keogh plan because of starting a new business after you retire.

Rollovers from company or Keogh plans preserve the retirement plan tax shelter while postponing retirement distributions, thereby often prolonging the tax-free buildup of retirement funds. They have other consequences, some undesirable:

Federal law grants a person no rights in his or her spouse’s IRA. Thus, a plan participant’s rollover will strip the participant’s spouse of rights the spouse had under the plan from which the assets are being removed. In the case of a pension plan, the spouse has a measure of protection because the spouse must approve the transfer that will forfeit his or her rights. However, no such approval is required in the case of 401(k)s or profit-sharing plans. Thus, a rollover from such plans can eliminate spousal rights. (Employers sometimes provide spousal rights that federal law does not require.)

A rollover will eliminate the chance of lump sum tax relief, unless the IRA was just a conduit for the movement of funds between retirement plans.

In some cases, a rollover from an IRA to a retirement plan can extend the tax shelter period. IRA distributions must begin at age 72, but distributions from a retirement plan can be postponed beyond that until the participant retires, unless he or she is an owner of the business.

A rollover from an IRA to a retirement plan could also get greater creditor protection than if left in an IRA.

Tax Planning

Rollovers are tax-free when properly handled, but consider these qualifications and exceptions:

  • After-tax investments can be rolled over from a company or Keogh plan to an IRA and, in some cases, to defined contribution plans, but not to defined benefit plans.
  • You can’t roll over amounts you’re required to withdraw after reaching age 72 or amounts you’re due to receive under a fixed annuity.

If you do the rollover yourself-personally withdrawing funds from one plan and moving them to another-the plan you’re withdrawing from must withhold tax at a 20 percent rate on the withdrawal. To avoid tax on the 20 percent withheld, you’ll have to come up with that amount from elsewhere and add it to the rollover IRA. (The tax withheld can be taken as a credit against the year’s tax liability.) On the other hand, a direct rollover (having the funds transferred directly from the transferring plan to the receiving plan) avoids withholding.

If you do the rollover yourself, the withdrawn funds are taxable if they don’t reach the rollover destination within the deadline (generally, 60 days). Therefore, the least risky way to roll over funds is a direct rollover.

Where the plan holds specific assets for your account, a rollover may (1) transfer the specific asset or (2) sell it and transfer the cash.

The rollover is not tax-free if cash is withdrawn, used to buy investment assets, and the new assets are then transferred to the new plan.

Take A Partial Withdrawal

The Basics

Partial withdrawals are withdrawals that aren’t rollovers, annuities or lump sums or don’t qualify for lump sum forward averaging or capital gain relief. They include certain withdrawals that you can make while you are still working as well as withdrawals at or after retirement. They may be made for investment or consumption, including education and health care. Because they are partial, the amount not withdrawn continues its tax shelter.

A partial withdrawal will usually leave open the option for other types of withdrawal (annuity, lump sum, rollover) of the balance left in the plan.

Before retirement, partial withdrawals are fairly common with profit-sharing plans, 401(k)s, and stock bonus plans. After retirement, they are fairly common in all types of plans (though least common with defined-benefit pension plans).

Tax Planning

A partial withdrawal is taxable (and can be subject to the penalty tax on early withdrawal) except to the extent it consists of after-tax funds. The withdrawal is generally tax-free in the proportion the after-tax investment bears to the total retirement account.

Your retirement account totals $100,000, which includes an after-tax investment of $10,000. You withdraw $5,000. The withdrawal is tax-free to the extent of $500 ($10,000/$100,000x$5,000).

The tax-free portion is computed differently for plan participants who were in the plan on 5/5/86.

Do Some Combination Of The Above

Combination withdrawals are quite complex and beyond the scope of this Financial Guide.

For an overview of how states tax retirement plan withdrawals, see State Taxes On Retirement Plan Distributions.

Related Guide: For a discussion of Roth IRAs, please see the Financial Guide: ROTH IRAS: How They Work And How To Use Them.

Life Insurance Options

Here are your typical options where whole life insurance is held for you in a retirement plan:

  • Your employer surrenders the policy to the insurance company for its cash surrender value, which it pays over to you.
  • Your employer trades in the policy for an annuity on your life.
  • Your employer distributes the policy to you.
  • Some mix of the above, such as getting some cash proceeds and an annuity.

The tax shelter ends when cash is received. Otherwise, it continues, to some degree.

Assets Withdrawn In Kind

In general, assets withdrawn in kind (i.e., withdrawn in the form held by the retirement plan, rather than withdrawn in cash) are taxed at their fair market value when received, reduced by after-tax investment. Exceptions:

  • Stock distributed by a stock bonus plan. Your after-tax investment in the stock comes back tax-free and you pay no tax on the stock’s appreciation in value until you sell it. But you have the option to pay tax on the value when received.
  • Annuity contract. These aren’t taxed when distributed. You’re taxed under the annuity rules above on annuity payments as received.
  • Insurance policy. If you convert the policy to an annuity contract within 60 days, the distribution is tax-free. However, you’re taxed under the annuity rules as payments are received. If you keep the policy, you’re taxed on the policy’s cash value (less your after-tax investment).

The Economics Of Retirement Annuities

Retirement annuity economics are built around the straight life annuity, where the retiree receives a certain amount for life, however, long or short that might be. This amount stops at the retiree’s death. The cost of such an annuity is computed, and that’s the cost the employer is obligated to provide.

However, you may want, or be obliged to take, something other than a straight life annuity, such as:

  • A fixed-term annuity, whereby the annuity will continue for a fixed term (say, ten years) even though you die before the end of this term. (This additional benefit is called a “refund feature.”)
  • A joint and survivor annuity, where the annuity is payable over two lives instead of one.

These types of annuity are worth more than the straight life annuity. But the employer isn’t obliged to pay for more than the cost of a straight single life annuity. So if you opt for something other than straight life, the amount you collect each period will be correspondingly reduced to the “actuarial equivalent” of straight life.

Can Creditors Reach Your Retirement Assets

Federal law generally protects your retirement assets or accounts against claims of your creditors so long as the assets remain in the retirement plan, except for unpaid federal taxes. Generally, this protection is in federal labor law (ERISA). Protection denied under labor law is provided under bankruptcy law (if the case is begun after October 16, 2005) to:

  • Keogh plans where the Keogh owner (or owner and spouse) are the only ones in the plan and
  • IRA plans, up to the amount rolled over from retirement plans, plus up to $1 million (which the bankruptcy court may increase where appropriate).

State Taxes On Retirement Plan Distributions

With 50 different state tax systems, only an overview is possible on how states tax retirement plan withdrawals. Here are the highlights:

  • A state cannot tax a retirement plan distribution if it imposes no income tax on individuals (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming).
  • A state from which a pension is paid, by an employer or former employer in the state, can’t tax the pension recipient in another state. In other cases, states generally follow the basic federal approach of taxing retirement distributions as ordinary income (and treating return of after-tax investment as tax-free). But some states don’t follow the federal rules for Keogh or IRA investment. Hence, withdrawals from such plans can get state tax relief not allowed under federal law.
  • Some states grant tax relief for a certain dollar amount of retirement income, relief that extends to retirement plan withdrawals. In some states the relief may look something like the federal credit for the elderly.
  • Rarely if ever, would a state impose a penalty tax on early withdrawal or on inadequate withdrawals after age 72.