Since we have started writing our articles, we have replied directly to the individual with questions. We decided to write our article using some of the questions we have received. If you have questions or need assistance based on these questions please contact us.

This question comes from PT, a client in Holstein . . .

My husband and I own two houses. We live in one and rent one to our son and his wife. We want to know, what is the maximum amount you can give a child as a gift in a lifetime? We'd like to give the house to our son, but we don't know if we can do that in one lump sum in one year, or in smaller amounts over a period of years.

Each of you can give up to $11,000 per year ($22,000 for a married couple) to any number of individuals with no tax consequences. Accordingly, you and your husband could give up to $44,000 per year to a combination of your son and his spouse ($22,000 multiplied by 2) as non-taxable gifts.

To qualify, the gift must constitute a “present interest” which means the recipient must have the right to enjoy the gift now. Being able to live in the home now will qualify as a present interest.

An individual can gift up to $1 million in taxable gifts during his/her lifetime before incurring any gift tax liability. Gifts in excess of the $11,000 annual exclusion require that a gift tax return be filed for the year. If you don't want to use up any of the $1 million lifetime exclusion, real estate can be gifted in increments, in the amounts mention above.

Rent should be adjusted annually to account for any partial gift you make. You should have the property appraised to determine the gift value. It is a good idea to seek professional help to properly record the transfer.

This question came from a seminar at St. Luke's Hospital . . .

If I had four separate IRAs , and I've reached the point where I have to start drawing at age 70 ½. Am I allowed to take all of my required withdrawals from one of the plans and leave the other three intact, or must I take the particular percentage from each of them?

The U.S. Treasury published new regulations last year. Following is a brief summary of what they have to say on this issue:

For each non-Roth IRA you own, you're required to calculate how much to withdraw under the rules. But when it comes time to make the actual required withdrawal, you don't have to make it from each of your IRAs; you may add up all the amounts you're supposed to withdraw and take that sum out of just one account (or out of however many accounts you choose).

Here are some of the facts:

You must start withdrawing at least a minimum amount each year from a non-Roth IRA once you reach a certain age (generally 70½). You can use government-published tables to figure out how much to withdraw, or you can have your financial institution or adviser do it for you. These withdrawals are technically known as required minimum distributions. Here's what the new regulations say:

“The required minimum distribution must be calculated separately for each IRA. The separately calculated amounts may then be totaled and the total distribution taken from any one or more of the individual's IRAs that an individual holds as the IRA owner may be aggregated.”

I heard there is a new tax incentive on money put into a retirement account. What is this?

Recent changes to the tax code make it financially easier for low- and middle-income families to defer part of their paycheck into a traditional individual retirement account or an employer-sponsored plan.

Depending on income, taxpayers may now be eligible to receive the Saver's Tax Credit, which can provide as much as a 50 percent tax credit on money saved in most retirement plans. In order to be eligible for the tax credit, filers must: Be an adult and not be claimed as a dependent, and have an adjusted gross income that does not exceed $50,000 if married and filing jointly, $37,500 if filing as head of household or $25,000 if single or married filing separately.

This question comes from N.G., Sioux City . . .

My question concerns an article you had in the paper some time ago about making contributions directly to your grandchild's college for her college education. My tax preparer tells me this is not deductible. I understood it was. Please clarify this for me.

If you asked your tax preparer about a federal income tax break, your tax preparer was correct, you can not claim a federal income tax deduction by paying for your grandchild's college education. (You could claim such a deduction under the circumstances you described IF the student is your dependent for whom you claim an exemption on your tax return. I'm assuming your grandchild is not your dependent for tax purposes.)

The article you are referring to focused not on federal income tax deductions but instead on the federal estate tax. If your estate is big enough (generally $1 million this year, $1.5 million next year), it could, under certain conditions, trigger a federal estate tax.

If however, you pay someone's college tuition directly to the school (the person need not be related to you), you may reduce the size of your estate by that amount and possibly reduce or eliminate the impact of the federal estate tax (and avoid federal gift tax, too).

You recently printed an article on education tax breaks. I had inquired about a specific tax break with my accountant and he was not aware of it. And I inquired about this tax break with my bank in relationship to savings bonds and they are not aware of it. Would you provide some additional information on how the tax break works regarding children attending private schools from grades K through 12?

The article you are referring to talked about a Coverdell Education Savings Account (ESA).  You can cash in your savings bonds and deposit the proceeds into an ESA. There are two good reasons to do this:

• Usually when you cash a savings bond, you must pay federal income tax on all the accumulated interest. But if you put all the proceeds into an ESA, you won't have to pay tax on that interest (assuming you qualify).
• There is normally no income tax break for sending your children to private school, but this is one exception.  When you save money in an ESA and use the proceeds to pay your child's education expenses, the money your account earns is not subject to federal income tax.  This is true no matter if you child attends a private, public or religious school at the elementary, middle school, high school or college level.

So, if you have savings bonds and you're also sending your children to private schools, you may want to consider cashing in part or all of those bonds to avoid tax on the accumulated interest by dumping the proceeds into an ESA.  You can then use the money in the ESA to help pay your child's education expenses tax-free.

A question from B.V., Sioux City …

I contribute to my church regularly. At various times during the year, I wish to make a contribution that is specifically for missions throughout the world instead of general church-related expenditures. Would my mission contributions be deductible?

While contributions to individuals are not deductible, you should be able to deduct mission contributions if they are made to a qualified charitable organization. The IRS allows charitable contributions that are intended for the benefit of an organization and not for a specified individual based on a two-part test:

1. The organization must be in full control of the contribution, and
2. The donor must intend that the donation be for the benefit of the organization.

Generally the church has an annual budgeting process to determine how to spend money such as mission donations. If you have not earmarked the donation for a specific individual, the church remains in control of the funds.

The 5 th Circuit Court allowed a charitable contribution on a case where a taxpayer donated money to his church as part of a fund-raising campaign for mission work of the taxpayer's first cousin.  The court said deductions are allowed for gifts “for the use of” a qualified charity and that the church sponsorship of the missionary's work implied that the contribution was for the use of the church.

This question came from J.S. in Sioux City …

Last year I had Lasik surgery to correct severe near-sightedness, and also because I don't like to wear glasses or bother with contact lenses, and I don't like the way I look in glasses.  Is this surgery a deductible medical expense or is it non-deductible cosmetic surgery?

Since the surgery falls under the category of the “purpose of affecting any structure or function of the body”, it is considered to be deductible medical care. Non-deductible cosmetic surgery is defined as “a procedure directed at improving the patient's appearance and does not meaningfully promote the proper function of the body or prevent or treat illness or disease.” 

Even though you believe the surgery improves your appearance, it also affects the function of your eyes and corrects a physical defect (myopia), so it is deductible.  Of course, you must itemize your deductions and the total of your medical expenses must exceed 7.5 percent of your adjusted gross income before you will realize a deduction.

This is a question from B.J. in Sioux City …

My son lives out of town.  In 2001 he was offered a great job, but he needed a car to be sure he could get to work on time.  I loaned him $8,000 to buy a used car, with the understanding that he would pay me back over the next four years.  He made only a few payments, none on time, then lost his job and still owes me $7,200. In addition to learning a valuable lesson, can I get a tax deduction for the bad loan?

Although a non-business bad debt is a short-term capital loss in the year that it is not collectible, several issues could deny this deduction:

1. You must show that you had a real expectation of repayment, and that you intended to enforce collection of the debt.  The IRS and courts closely scrutinize family loans to see if the lender really intended to enforce repayment. A signed note and written collection activities help this.  If you continue to help your son with living expenses, you may be questioned about your expectation of repayment of the car loan.
2. A loss is allowed only when the loan is worthless.  You must provide evidence that your son can't pay.  Is he insolvent?  Has he refused persistent demands by you for repayment?  You must demonstrate that the loan was uncollectible in the year that you deduct it.  You may also go back three years and amend your returns, if necessary, to deduct an uncollectible debt.

Many people have asked questions about capital gains or losses for mutual funds…

I bought 300 shares of the Vanguard Total Market Index fund in November, 2002.  I purchased $500 worth of the fund each month.  I have heard about the negative capital gains exposure for this and other index funds.  However, I am confused about the implications of negative capital gains.  Can you say more about what the negative capital gains exposure for this fund means to me?

Capital gains (or losses) is one of the most difficult things about mutual funds to understand.  When you buy mutual funds, there is an underlying portfolio containing a variety of investments purchased at various times.  Some of these investments will have been bought at lower prices, and some at higher prices.  Altogether the cost basis for the entire portfolio may be a good deal lower or higher than what you pay for the shares.  What you pay reflects the value of the shares in the portfolio only on the day you buy the shares.   Let's look at two examples:

1. You buy shares in a fund for $10, but the cost basis of the shares in the underlying fund is actually $8.  20% of your investment would be unrealized capital gains.  If the portfolio manager sells all those stocks and builds a new portfolio, he would realize all those capital gains and you would get a $2 capital gain distribution.  That distribution would be taxable income to you.  Financial planners call this “buying a tax liability”.  Your investment may be worth the same amount in total, but you would have to pay taxes even though you didn't have a real gain.  This is how it is, most of the time, in mutual funds – you buy some amount of tax liability because the underlying portfolio has unrealized capital gains. 
2. Currently most equity funds are in the opposite position.  You buy shares in a fund for $10, but the cost basis of the shares in the underlying fund is $12.  The fund may have unrealized or undistributed (but realized) capital losses.  When this happens, you aren't “buying a tax liability.”  In effect, you are buying a tax subsidy.  Losses that already exist will prevent the fund from distributing capital gains until the gains outweigh the losses.

At the end of January, 2003, Vanguard Total Stock Market fund had capital losses equal to 25% of fund assets.  This means the portfolio can increase substantially in the future without distributing any capital gains.

But here's the hard part.  What a fund distributes in capital gains is quite separate from sales that you do as a shareholder.  If you purchased shares at $10 and sold them at $12.50, you would realize a capital gain of $2.50 a share (long-term if you owned them for more than one year).  The capital gains and losses in the underlying portfolio have an impact only on taxable distributions by the fund.

And another question along the same lines…

I invested $50,000 into Enron.  If I sell now for $10, can I deduct this loss on my tax return?

If you sell your $50,000 investment for $10, you will realize a capital loss in the amount of $49,990. This capital loss may be used to offset any capital gains that you may have during the year of sale. If your capital losses exceed your capital gains, you can also offset up to $3,000 of ordinary income. If your capital losses exceed this figure, the remaining balance is carried forward until your capital losses are used up.

Note:  Worthless Enron stock is deductible on 2004 tax returns.  Few investors know that the stock offically became worthless as of December 31, 2004, making their losses deductible as capital losses.  If you already filed your 2004 return, claim the loss on an amended return.

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