Satisfying the gross income test

Unlike claiming a child as a dependent, it is not necessary that your elderly parent live with you. However, if your parent has gross income that is not exempt from tax of $3,650 or more, you cannot take their exemption on your return. When evaluating your parent’s gross income, do not include their social security payments and other tax-exempt pensions. Their gross income does include, however, dividends, capital gains from the sale of stock, interest earned in a bank account and other passive investments such as income from rental properties they own.

Satisfying the support test

Not only must your parent have minimal gross income, but you must also provide more than half their financial support during the tax year. Satisfying the requirements of the support test requires a comprehensive evaluation of your parent’s expenses. The fact that your parent receives sufficient income during the year does not necessarily mean the funds are used for their support. The support test looks to who actually pays rather than the parent’s ability to pay. For example, if your elderly parent only uses their Social Security benefits to pay $300 in monthly rent and you provide all other expenses that total more than $300 each month, then you will satisfy the requirements of the support test even if your parent puts thousands of dollars of tax-exempt income into a savings account each month.

Sharing your parent’s exemption

Oftentimes an elderly parent receives financial support from multiple children during the tax year. In total, the children may satisfy the support test; however, as individuals they may not. The IRS permits these siblings to take turns claiming the parent as a dependent if in the aggregate they can satisfy the support test. However, only a child who contributes at least 10 percent of the parent’s total support during the tax year is able to claim the dependency exemption. If you and your siblings agree to alternate claiming the exemption, the siblings who do not claim the exemption each tax year must sign a document stating that they will refrain from doing so in the current year.

Exemption limitations

If your Adjusted Gross Income (AGI) is more than the threshold amount for your filing status, you must reduce your total exemptions by 2 percent for each $2,500 or part of $2,500 that your AGI exceeds the limitation. However, the exemption will never be reduced to zero, regardless of your AGI. For example, in 2010, a single taxpayer with AGI of $166,800 or more must reduce the $3,650 exemption accordingly. Therefore, if your AGI is $169,400, you must reduce the exemption by 4 percent to $3,504 since the excess equals $2,600.

1. Add space. Converting a storage attic into a bedroom, building an entertainment deck, or finishing a musty basement is a smart way to add usable square footage to a home, which will increase its livability as well as its resale value. You can even add a second story, enlarge the garage or create an extra bathroom for a busy household. With many families sharing space with other family members or roommates, having more bedrooms and living space is a definite plus.

2. Increase curb appeal. Install a new front door with pizazz, redo an entry, landscape the front yard, paint the house or replace worn siding. All these projects spruce up your home and give the exterior a fresh appeal.

3. Remodel kitchen and baths. Up-to-date kitchens are always in demand, so replacing counter tops and appliances can add a great deal to the saleability of your home. Likewise, bathrooms can sparkle with new fixtures, flooring, paint and mirrors, at relatively little cost.

4. Save energy. Replacing windows and doors that leak and adding insulation will save heating and cooling costs. These improvements may also save tax dollars. For 2011, you can garner an income tax credit of up to $200 for Energy Star-qualified windows and skylights and up to $500 for Energy Star-qualified doors. Replace your water heater with a new efficient one, and you can receive up to $300 in credits. Furnace improvements and central air conditioning may yield tax credits of as much as $300. In most cases, the tax credit is 10% of the amount you spend, and the overall credit is limited to $500. To claim the energy tax credit, file Form 5695 with your 2011 tax return.

5. Go solar. Because they are so efficient, the government is offering a 30% tax credit for solar energy systems and geothermal heat pumps, as well as small wind turbines with no limit on the credit you can claim. This credit is available through 2016.

Allocating between rental and personal use

The IRS does allow a certain amount of personal use of a secondary home without requiring you to do an allocation. However, if you use the home for the greater of 15 days, or more than 10 percent of the days the home is rented, you cannot claim a deduction for all expenses. You then must allocate the expenses between the two types of uses, based on the ratio of personal-use days to days you collect rent. For example, if you spend 25 days in the home for vacation, and rent it out to tenants for 75 days during the rest of the year, then only 75 percent of your expenses for the home are deductible. However, if you limit your use of the home to five days out of the year, then no allocation is necessary and you can deduct all of the expenses.

Deductible rental house expenses

Common deductible expenses of maintaining a rental property include the cost of advertising the home to prospective tenants, cleaning the home after each tenant vacates, commissions and fees you pay to a management company, state and local property taxes and utility service and insurance premiums. Additionally, you can claim annual depreciation deductions to recover a portion of the home’s tax basis each year. Generally, the tax basis of the property is equal to its purchase price, settlement costs and the cost of making permanent improvements to the property that increase its value.

Rental house mortgage interest

Just like the interest you pay on a mortgage to finance the purchase of a personal residence, the interest payments on a loan to acquire a rental property are also deductible. However, the amount of interest you may deduct in a year cannot exceed your net investment income. Net investment income is the total profit you earn on all rental properties you own before reducing it by interest payments. At the end of the year, if you incur a loss or have minimal net investment income, it is unlikely you can fully deduct interest payments. You can, however, carry the nondeductible interest payments forward to any future tax year that you have sufficient net investment income.

Reporting rental house deductions

Taxpayers must report all rental income and deductible expenses on the Schedule E attachment to a personal income tax return. However, if renting houses is your primary occupation, and you actively participate in daily operations, you may need to file the Schedule C attachment instead. Sole proprietors use Schedule C to report the earnings and deductions of a business they actively engage in. Regardless of which schedule you prepare, IRS Form 4562 may also be necessary if you claim depreciation deductions. Entering income from a rental property on your tax return is easy with TurboTax.

Flexible Spending Accounts

If you have a flexible spending account (FSA) through your employer, you can set aside as much as $5,000 from your salary to pay for dependent care. That’s a big benefit, because the funds you contribute to your FSA aren’t subject to income taxes or payroll taxes such as social security and medicare taxes.

There are a few caveats:

1. The person receiving the care must be your dependent, and if a child, must be under the age of 13 or incapacitated.

2. If you are married, both spouses must earn income of $5,000 or more unless your spouse is disabled, a full-time student, or looking for work.

3. The funds you set aside must be used by the end of the year, or else they may be lost.

4. And here’s the kicker: You must sign up for the payroll deduction during your employer’s enrollment period at the beginning of the year.

Now, assuming that you have your FSA in place, what kind of expenses qualify?

Child care providers. In order to be reimbursed for your child care through your FSA, your child care provider must provide you with a taxpayer identification number (employer ID number or social security number). That means they must report the income on their tax return.

Summer camps. Summer day camps qualify for reimbursement, but overnight camps do not. That’s good news for parents who enroll their kids in a variety of day camps, such as soccer camp, tennis camp, computer camp and the like. But if your child needs remedial schooling during the summer, forget it: tutoring and summer school are not eligible.

Payments to Grandma. If you hire grandma or another relative to take care of the kids this summer, you can be reimbursed from your FSA plan as long as grandma has a social security number and reports the income on her tax return. Other relatives qualify as well, unless they are your dependents. So you can’t pay your 16-year old to take care of the younger kids if you claim her as a dependent.

Dependent Care Credits

If you don’t have an FSA, you are still entitled to claim the child care expenses we have been discussing. If your income is $15,000 or less you can claim a federal tax credit of as much as 35% of the costs you pay, up to $3,000 per child ($6,000 total). As your income increases, the credit goes down, settling at 20% if your income is $43,000 or more.

That’s still a goodly amount: if you have two children and pay $3,000 of qualifying child care expenses for each, you’ll get a federal tax credit for $600 for each child. That will reduce the taxes you owe and increase your refund accordingly.

Since you can’t claim a tax credit for expenses that are reimbursed to you through your FSA, which would benefit you the most, the FSA or the tax credit?

Let’s say that you are in a 25% federal tax bracket and contribute $5,000 to your FSA. That will save you $1,250 in federal income tax, and may save you state taxes as well. In addition, you’ll save 1.45% in Medicare tax and up to 6.2% in social security tax.

Now let’s say that you claim the expenses as a dependent care credit instead of contributing to an FSA. Assuming your credit is 20%, that $5,000 in child care expenses will save you $1,000 in federal income taxes. If your income is low, you’ll qualify for the higher 35% tax credit, but most people at that income level wouldn’t pay federal tax anyway, and the credit is not refundable.

So for most parents, the FSA income exclusion is best. But whichever you choose, be sure to reap the tax-savings benefits of child care and day camp expenses this summer.