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I sometimes play a little game with people to prove most tax returns are prepared wrong. Before any tax professionals reading this start writing nasty comments I confess I also make errors on tax returns. I get it. Tax season is more triage than solid tax planning. However, once tax season slows down it is time to put your tax preparer to work saving you money, building your net worth, helping you with early retirement and making your life easier from a financial and investing point of view.
Certain errors on a tax return are understandable. Maybe you did not know the tax law or you forgot to tell your accountant about a certain income or expense. Other errors are unacceptable. These include transposed numbers or forgotten elections. This is sloppy tax work and it drives me insane. Anyone plugging numbers on a tax return must review their own work and reduce the number of issues on the return to zero before sending it to the final reviewer.
The game I mentioned at the beginning of today’s lesson involves people bringing me their tax return without any receipts or other tax documents and by glancing at the return tell them if their tax return is correct or wrong. Over half are wrong. Then I ask a few short questions. The answers confirm my suspicions and provide a solution. With the new information in hand I send the client back to their regular tax preparer to amend the tax return.
How accurate am I in my little game? I can tell you if your tax return is wrong with over 85% accuracy and without seeing any supporting documents. So how do I do it?
What You Know
People have tried to understand my thought process when I review tax returns and until now have had only modest success in transferring this skill to themselves. To begin, when I say most tax returns are wrong I mean they are mechanically correct, but not optimized. Certain things jump out as absolutely wrong. For example, if I see gambling winnings on the front of Form 1040 and see no gambling expense on Schedule A I know the taxpayer was either gifted the lottery ticket or they spent at least $1 to pull the lever on the one-armed bandit at the casino. If I see the gambling error I start talking about gambling sessions, but I leave that conversation for another day.
What I am specifically looking for are things that jump out from the tax return. A comparison page of the last few years really helps, but is not always necessary. (I’ll want to see the previous return no matter what if I am going to feel confident in my assessment.) Any number that changes significantly grabs my attention. Assuming all W-2s and other documents were entered correctly I turn to the schedules and the depreciation table if applicable.
If all you have is a W-2 and rent you cannot play my game; there is not much to do wrong on such a tax return if the W-2 and rent are inputted correctly. You can sit and watch the rest of us play because you will get ideas.
A tax return reviewer always looks at numbers that look out of place. A properly prepared tax return has an elegant feel to it. Just by looking at it you can tell if it is right or wrong. The wrong feeling comes from the jaggedness. Massive depreciation schedules are almost always wrong with the new repair regulations and tangible property rules and is a great place to go after checking the comparison page. Rental property owners and small business owners are all overpaying their taxes. You are better off applying proper tax law than cheating when it comes to business and investment properties and the audit risk is eliminated since an audit will result in no change over a penalty for cheating.
Many accountants get this one wrong because the rule changed so late in the year their training books contained the old rule. The new de minimis rules issued by the IRS changed the safe harbor amount from $500 to $2,500 for depreciable assets. This means that under the new repair regulations assets purchased for $500 or less (lasting longer than one year) can be deducted rather than depreciated. But wait (sound like one of those old commercials, doesn’t it), accountants bitched when large corporations could write off up $5,000 per asset if they audited their books. The IRS took pity on the crybabies (thank goodness) and changed the $500 used by most of us to $2,500. Better yet, we can clean our depreciation schedules, but it is not required. All you need to do is make a simple election on the originally and timely filed tax return.
Reviewing tax returns turns up all kinds of fun ways to save money. There are times a landlord can deduct a roof replacement over depreciating over forever. The repair regulations allow most stoves and refrigerators as deductions for additional tax savings. Another election allows remodeling, including certain improvements, as a repair expense rather than depreciation if the amount is under $10,000. Wow! You can call a kitchen or bathroom remodel in a rental property a repair expense and write the whole thing off? Yes! Sometimes. Have a qualified tax professional help you with this. Again, you must make an election to enjoy the grab bag of goodies.
I consider the repair regulations one of the best changes the IRS has made in my career. It allows a simplification of the tax return and brings sanity back to business and investment property owner’s tax returns.
There are more ways to optimize a tax return. Depending on your income you may qualify for a Saver’s Credit. I will need to see a W-2 sometimes to know if this goodie was missed on your return. Another area often missed is mileage. Mileage applies to businesses of course, but did you know medical miles count, too. People exceeding the threshold need to add miles to their medical expense. Charitable miles also count if you itemize. Driving to church for Sunday service does not count even if you teach Sunday school. Helping Habitat for Humanity build a home are charitable mile that count; so do miles driven to church to help on a project.
To finish our review of tax returns I will share an example from this tax season. A small business brought in their paperwork, including the financials prepared by a CPA. I plugged the numbers into the return except for the depreciation. Something was wrong here. There was $20,000 of depreciation on the profit and loss statement. I knew my client. The number did not feel right. To have $20,000 of depreciation would require $100,000 or more in asset purchases to make sense. It had to be wrong. I went back to the CPA and discovered he entered the full year depreciation as monthly depreciation. Now it made sense.
When something does not feel right on a tax return it is probably wrong. A big refund or balance due out of line from previous years and not supported by an accompanying change in your financial situation is a dead giveaway something is off. Don’t take a surprise refund from the accountant without questioning the gift from above. It will come back and bite you later. Remember, the IRS will send you a letter, not your tax preparer. Same applies if you prepare your own tax return. You know approximately where you will end up. If it differs you need to check why. Sometimes it is a real gift from above; sometimes you missed something and thank the gods you caught it before you hit send.
Reviewing your tax return, even if a professional prepared it, can put serious money in your pocket. Your tax bracket can be a major motivator in planning for early retirement. If you are not maxing out your retirement plans you are overpaying your taxes.
A solid tax plan can pay off in unexpected ways. There are a few instances where putting additional money into a retirement plan through your employer can cut your taxes nearly as much as invested in the retirement plan! A solid review of your tax options outside tax season can pay massive dividends every day.
At the very minimum you will save your tax rate by increasing your 401(k) or similar retirement plan contributions to the maximum. A $10,000 increase in retirement savings (a traditional, not Roth) in the 35% tax bracket, federal and state, reduces your cash flow by $6,500, not $10,000. And you still keep all the money!
Some ideas I share here are not errors. Having a mechanically correct tax return is okay; an optimized tax return will make early retirement easier to attain. Not everyone has a goal of early retirement. I get it. The reduced tax burden can be used to send your children to college or make your community a better place. You can change the world, or at least a small piece of it. By optimizing your taxes most of you will make the life of your family better and that is what it is all about.