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Lower Your Salary and Make More Money???

November 6, 2012

If your incorporated business pays you rent for real estate that you own personally, the tax laws can have a significant impact on your personal income tax planning.

Here is an example of a client (names have changed) named Bobby that owns “Bobby Luxury Cars, Inc,” a very successful automobile dealership that Bobby built from the ground up. Luxury cars had been a way of life for Bobby since the day his father showed up in a gleaming new ’68 Cadillac. Bobby cared for that car as if it were a member of the family and the high point of each Saturday was the half-hour neighborhood drive that was Bobby’s reward for washing and buffing that treasured automobile. Years later, Bobby founded “Bobby Luxury Cars.” Thanks to Bobby’s driving ambition, the business got off to a fast start. One after another, Bobby delivers Mercedes, Jaguars, and BMW’s to satisfied customers. As he steered the business toward even greater success, Bobby bought some land, built a new showroom, and rented the property to his now incorporated business.

Like many taxpayers in his situation, Bobby reasoned that if the business paid him a low enough rent, he could report a loss on his rental property, deduct the loss on his personal income tax return, and lower his income taxes accordingly.

By 2011 “Bobby Luxury Cars, Inc.” was humming along like a well-tuned engine and was paying Bobby a salary of $170,000 a year. Because of the low rent he receives from the corporation, Bobby will show a $40,000 loss on his property and he planned to write it off on his 2011 personal income tax return. But Bobby’s tax plan suddenly ran out of gas when he filed his federal income tax return. Based on his $170,000 salary, the $40,000 net loss on his rental property, 2011 joint return rates, personal exemptions of $7,400, and ignoring all other deductions, Bobby’s federal income taxes totaled $30,350, far more than he had expected.

Bobby’s tax plans came to a screeching halt when he discovered that he could not deduct his $40,000 rental loss. Under tax laws, rental losses from property in which the taxpayer is an active management participant are considered passive losses. Passive losses can be deducted only to the extent that they offset passive income. in addition, passive losses cannot be deducted from active income, such as wages. However, a special exception applies fo passive losses from rental property. This exception permits a deduction of up to $25,000 in rental losses in excess of passive income for taxpayers whose adjusted gross income is $100,000 or less. The $25,000 is phased out for taxpayers whose adjusted gross income exceeds $100,000. If, as in Bobby’s case, a tax payer’s adjusted gross income is more than $150,000, no deduction is allowed.

Although passive losses which are not deducible in a current year may be carried forward to future ears, the tax bite that Bobby faces for 2011 could have been greatly reduced. If “Bobby Luxury Cars, Inc.” had paid Bobby a salary of $130,000 instead of $170,000, he could have received the $40,000 difference in the form of additional rent. His total income will still be $170,000, but his federal income taxes will then be $20,000 instead of $30,350.

This is such a great example of why it is important to have strategic tax planning…and that is what we can do for you here at Gunwel Associates Inc. This is a great time of year to take a look at your tax liabilities as we head into the last few months of the year. Give us a call at 615-730-9444 to review any financial matters that have you concerned. Visit our website at www.gunwel.com. Remember, you work hard for your money, let Gunwel work smart to help you keep it! See you soon!

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