Taxes are one of the two most certain things that people can expect in life. The two most common taxes individuals are concerned with are income and property taxes. In this piece, we’ll take a look at the basics of both of these taxes, helping you better understand these important filings.
Income Taxes 101
Although some people have low enough incomes that they can escape the tax man, those in the middle and upper classes cannot escape their obligation to render a portion of their earnings to the IRS. Although some parts of our tax code are devilishly complicated, the overall tax formula that is laid out on the 1040 is relatively straightforward, and those who are filing for the first time can now often do so themselves with the aid of one of the many online and computer-based tax programs that are now available.
Filing Your Income Taxes
The basic tax formula that is now used by the IRS can be broken down as follows:
Taxes are reported on Form 1040. There are two shorter forms, form 1040A and 1040 EZ, for those with simple returns. There are also several supporting schedules that are used for certain types of income and expenses. Schedule A is used for itemized deductions, Schedule C is for self-employment income and expenses and Schedule D is for investment income. There are many other schedules for other types of income and expenses as well.
Exclusions represent all forms of tax-free income, such as municipal bond interest and the proceeds from a life insurance policy. (These are not listed anywhere on the 1040 and thus are simply not reported.)
Gross income includes all forms of earned and investment income, such as wages, salaries and self-employed income. Interest, dividends and capital gains are also listed here, as well as Social Security income, pension income, awards and winnings, gambling income, unemployment benefits, alimony received and miscellaneous income. Be sure to read A Brief History of Dividend Tax Rates.
Above-the-line deductions include such items as:
- Moving expenses
- Traditional IRA and retirement plan contributions
- Health insurance premiums
- Self-employed business expenses
- Student loan interest
- Tuition and fees
These items are subtracted from the taxpayer’s gross income to determine Adjusted Gross Income. AGI is important because it is used to determine the taxpayer’s eligibility for a number of different deductions and taxes, such as whether and how much of one’s Social Security income is taxed. AGI is considered the “line” that divides the two main categories of deductions.
There are two types of below-the-line deductions. The most common form is the Standard Deduction, which is what taxpayers take if they cannot itemize. The Standard Deduction is an arbitrary amount of money determined by the IRS that every taxpayer can take to reduce their taxable income. The other type of below-the-line deductions is called itemized deductions. If a taxpayer’s total itemized deductions are more than the Standard Deduction, then these will be taken instead. Taxpayers cannot take both types of deductions on the same return in the same year. Itemized deductions include charitable contributions, mortgage interest paid on a primary residence, real estate and property taxes, property-casualty losses and unreimbursed medical and work expenses that are subject to certain limits. Be sure to check out the IRS’s full list of credits and deductions.
Taxpayers can also subtract a personal exemption for themselves and each of their dependents that they support. This is another amount of money that is set by the IRS ($3,800 in 2012) that taxpayers can subtract from their AGI to lower their taxable income. A married filer with four kids would be able to reduce his or her taxable income by $22,800 ($3,800 X 6).
Taxable Income and Credits
The amount of income that remains after all of these deductions have been taken is taxable income, which is the amount of income on which the taxpayer will actually pay taxes. The amount of tax owed is determined by the tax tables that are listed on the IRS website.
Once the amount of tax that is owed has been determined, all eligible tax credits are subtracted from this amount. Tax credits are much more effective than deductions at reducing the amount of tax that is owed, because they reduce the actual tax bill on a dollar-for-dollar basis, whereas deductions only reduce the amount of income that must be taxed. For example, a $3,000 deduction will reduce a taxpayer’s taxable income from $80,000 to $77,000, but there could still be a tax bill of $4,200. While a $3,000 credit would not reduce the taxable income, it would directly hit the $4,200 tax bill and reduce it to $1,200.
There are two types of tax credits: refundable and nonrefundable. Nonrefundable credits are those where a portion of the credit may go unused if it is larger than the tax bill. For example, if the total tax owed is $2,500 and the taxpayer can take a nonrefundable $3,000 credit, then the tax will be eliminated and the remaining $500 of the credit will go unused. But if the credit is refundable, then the $500 difference will be paid to the taxpayer as a refund. Unused credits cannot be carried forward to the following year; taxpayers must use them or lose them. Nonrefundable credits include education tax credits, the Adoption Credit, The Child Tax Credit and the Child and Dependent Care credit. Refundable credits include the Earned Income Credit and the Additional Child Tax Credit.
The amount of tax that the taxpayer had withheld or sent in as quarterly payments is then applied to the remaining tax balance. If the amount withheld or paid exceeds the remaining tax, then the taxpayer is refunded this amount. If it is less, then the taxpayer must pay the difference.
For additional help, be sure to check out the IRS’ list of online tools.
There are five filing statuses for taxpayers based upon their marital status and the number of dependents that they can claim. The amount of personal exemptions and standard deduction are determined by this status.
Single – The simplest filing status. The taxpayer typically only claims him or herself, although single filers can also claim dependents in some cases.
Married Filing Separately – Taxpayers are married but file separate returns. This is commonly done for one of three reasons:
- If the taxpayers are feuding or divorcing and can’t be together to file.
- If one or both of the taxpayers is pursuing an aggressive or risky tax strategy and the spouse doesn’t want to be involved.
- If one spouse has substantial deductions that will result in a bigger refund than if they filed jointly.
It should be noted that MFS is by far the worst filing status financially, because many of the standard credits and deductions that are available to other filers are disallowed for this status. It is usually used when a taxpayer cannot qualify to file any other way and very seldom results in a larger refund than by filing jointly (#3 being the only exception).
Married Filing Jointly – This is the normal filing status for married couples. The standard deduction is twice the amount for single filers.
Head of Household – This is the status usually claimed by single filers with dependents. Certain criteria regarding the residence, relationship and support of the dependents must be met.
Qualifying Widow/er – Those whose spouses have passed away in the past two years can use this status. It is basically the same as MFJ, except that one spouse is deceased.
If you are not sure which filing status you are eligible for, please use this interactive guide.
Property Taxes 101
The federal and state governments derive their revenue from taxpayers through income, gift and estate taxes. But while local governments and municipalities may assess income or earnings taxes, they usually get the majority of their revenue from taxes that are levied on personal property. The rules and rates for these taxes vary substantially by state and location, and they can have a significant impact on the taxpayer’s bottom line. State governments can also impose certain property taxes such as for vehicle registration or for specific types of business-related property.
What Are Property Taxes?
As stated previously, property taxes are used to generate income for towns and cities, municipalities, counties, school districts, utilities and other local jurisdictions as well as some states. These taxes can be levied on various types of property such as personal property, land, real estate, mineral rights and business property and equipment, and the amount of property tax that is levied upon the owner will vary widely according to several factors such as the tax rate and method of assessment of the taxing jurisdiction as well as the type of property that is taxed. For example, the state of Kansas has a 7.5% severance tax on all oil and gas that is extracted at the wellhead.
From a jurisdictional viewpoint, property taxes are substantially superior to income or sales taxes because the actual revenue that is generated from property taxes is exactly equal to the amount that was levied; although taxpayers can reduce their tax bills through deductions or other incentives such as the homestead exemption, there is no chance of a deficit in the jurisdiction’s budget as the result of a discrepancy between the amount that is levied and what is actually collected. Property taxes are just one of the concerns when you’re bying your first home; find out what else you need to know in How to Invest in Real Estate: A Crash Course.
Assessment and Calculation
Property taxes can be calculated and assessed in several different ways. In most cases, the city or other jurisdiction will assess a tax based on the fair market value (FMV) of the property, which is then multiplied by an assessment ratio that is equal to some percentage of the actual value of the property. This assessed value is then taxed at the appropriate tax rate.
The most common definition of FMV is the price of a sale between an informed and willing buyer and seller who are not related, and where neither party is compelled to engage in the transaction. In some cases, the taxing jurisdiction allows the owner to declare the value of the property via rendition, or the jurisdiction may use a tax assessor to assign a value to the property. If the property to be taxed has not been sold in a qualified arm’s length transaction recently, then recent sales of comparable property (i.e. similar in nature, location, size, purpose and/or other characteristics) can be used. If no comparable sales are available, then the property assessment may be based on its original purchase price, with adjustments for inflation, depreciation and any improvements or repairs that have been made.
Properties that produce income, such as oil and gas wells, may need to be based upon their projected revenues, which may require specialized information such as a qualified reserve report. Other specialized forms of valuation must be used for certain types of property such as forestry and farmland. The tax assessor will determine which method of valuation is most appropriate if the property owner is not allowed to declare its value.
Of course, the value of property changes over time, and most jurisdictions require that most or all of the property that is taxed to be revalued at least every three or four years. A limit on the amount that the property value can be increased from one valuation to the next is also often imposed, either by the taxing jurisdiction itself or by the state. Most states also require all taxing jurisdictions within their borders to tax the same property using identical market values. For example, a city cannot use a different market value for a given piece of property than the county in which it is located.
Can’t Afford to Pay Your Taxes? Here’s What to Do
There are many things that can get in the way of you paying your tax bill. Fortunately, while the IRS can (but rarely does) throw taxpayers in jail for failing to hand over their share, it provides plenty of less-severe options for those who don’t have the cash when Uncle Sam comes calling. Taxes are due on April 15th. Here’s what to do if you can’t pay on time.
1. File Your Return
When you know you can’t pay, it’s easy to just want to bury your head in the sand about it. Don’t. File your return on time or file an extension to file using Form 4868. The IRS charges a penalty for late payment if you do not pay at least 90 percent of your taxes by April 15th, but if you file on time or file for an extension to file, at least you can avoid the IRS’s failure-to-file penalty, which will cost between 5% and 25% of the balance you owe. You’ll still face an interest charge on the amount you owe each month, but if you file your return, it’ll be only 0.5% of the balance up to a maximum of 25%. Find out how compound interest can be your best friend or your worst enemy in The Pros And Cons Of Compound Interest.
2. Try to Find the Money
Suppose you file your taxes on time but you don’t have the money to pay them right them. If you can find it in a few weeks, it may make sense to wait until the IRS sends you a bill. You’ll pay some interest, but it will be relatively low compared to financing the payment from another source. This isn’t a long-term solution though. If you can’t get what you owe together within a few weeks, you’ll have to move on to another option. One way to ensure that you always have money for a situation like this is to have an emergency fund; find out Why You Need An Emergency Fund – And How To Build One.
3. Set Up a Payment Plan
If you can’t pay at least 90% of what you owe to the IRS right away, it’s best to set up a repayment plan by filing Form 9465. This form is simple to fill out and allows you to present the amount you owe to the IRS and the amount you can afford to pay toward the balance each month. Plus, if you’ve filed and paid your taxes on time for the last five years, you owe less than $10,000 (or $25,000 for businesses) and you can prove you’re unable to pay your full bill, the IRS can’t refuse your request. Whatever payment amount you choose, though, you have to pay off your balance within three years (two for businesses).
4. Borrow to Pay
This isn’t the best option, but it can be a good choice for some people, particularly those who are expecting a lump sum of money in the near future. The IRS now accepts plastic in the form of American Express, Discover, MasterCard and Visa. This is certainly a convenient way to pay, but as you’re probably aware, credit card interest is pretty steep. Plus, the companies contracted to provide credit card payment services for the IRS also charge their own fees of about 2% of each transaction. However, even with credit card interest and fees, paying with a credit card on time might be less than the IRS’ penalties and interest on late payments. You’ll have to run the numbers to find out if this is the case for you.
5. Consider an Offer in Compromise
One last-ditch option for taxpayers who can prove they’re really hard up is called an Offer in Compromise (OIC). An OIC is basically an agreement between a taxpayer and the Internal Revenue Service that settles the taxpayer’s tax liabilities for less than the full amount owed. You can apply for this option by filing Form 656. This type of offer will not be accepted if the IRS believes that the liability can be paid in full as a lump sum or through a payment agreement.
There are three circumstances under which the IRS will issue an Offer in Compromise. One is if doubt exists that you could ever pay the full amount of tax liability owed within the remainder of the collection period. The IRS may also accept an OIC if there is doubt that the amount you owe is correct. This is referred to as doubt to liability. Finally, an OIC might be an option if an exceptional circumstance of economic hardship has emerged. If you think you might qualify for an OIC, consult a tax professional for advice before filing an application with the IRS.
6. Keep an Eye Out for Fees
The options provided here offer some respite for late taxpayers, but they do come with fees of their own. Setting up a payment plan will cost you $52 for an automatic debit agreement, and $105 if you will be sending payments in by mail or online each month. Taxpayers who are considered low-income (with incomes at 250% of or lower than the poverty level set by the Department of Health and Human Services), may be able to get off with just a $43 charge. The Offer in Compromise involves a non-refundable application fee of $150. And, as we mentioned above, paying by credit card involves fees and charges from the credit card service provider.
7. Start Working on Next Year
If you had trouble coming up with money to pay your taxes this year, now might be a good time to think about how you can ensure you have the cash you need next tax season. There are very few aspects of personal finance that can be counted on year and year out. Taxes are one of them. That predictability is what makes them feel like such a chore, but it’s also their greatest advantage because they give you the opportunity to set yourself up to reap the benefits of paying on time. Most people feel they pay plenty of taxes as it is. Fees and interest charges only serve to drive up your tax liability – and drag down your take-home pay.
The Bottom Line
Filing income and property taxes every year can sometimes be overwhelming. Be sure to keep on top of your finances throughout the year, and utilize great free resources (such as the IRS website) to make filings easier every year.