We’ve all felt that time crunch as tax deadlines approach. In addition to being complex, tax code is subject to change at any time. Doctors are among the busiest of professionals and have little spare time to learn about the latest developments in tax law. In preparing your own taxes, you run the risk of missing out on potential tax deductions for doctors that could reduce your taxable income or unknowingly exposing yourself to an audit from the IRS.
Income and Material Participation
It’s important to recognize commonly used tax terms due to the nuances unique to physician tax returns. Having a good understanding of how income is defined will help clarify some of the more complicated tax concepts and strategies. Active income (sometimes called earned income) is what is reported on W2 and 1099 documents. This income is derived from your labor and is the most heavily taxed form of income. In addition to Federal and state income taxes, you’re also subject to Social Security and Medicare taxes also known as FICA witholdings. You may also be obligated to pay local income taxes depending on the municipality in which you practice or live.
Passive income (or unearned income) is income derived from your assets instead of your labor. One example of this would be any income from your investment portfolio such as interest, dividends or capital gains. On the federal level, you could be subject to either long-term or short-term capital gains depending on how long you’ve held an investment. You may be responsible for paying taxes at your state’s rate as well. The cost of acquiring and selling an investment will affect your cost basis, so accurately tracking this information may lower your overall tax consequences. For tax purposes, cost basis is defined as the original value of an asset (usually the purchase price) which can be adjusted for stock splits, dividends, commissions and return of capital distributions. (1)
Passive income or losses are defined as activities in which the tax payer does not materially participate. There are several criteria for defining material participation, and you only need to meet one to qualify (2):
- Does the taxpayer and/or spouse work more than 500 hours a year in the business?
- Does the taxpayer do most of the work? Even if 500 hour test is not met, is his or her participation the only activity in the business? (ex. Sole proprietor with no employees)
- Does the taxpayer work more than 100 hours and no one works more hours?
- Does the taxpayer have several passive activities in which he participates between 100-500 hours each and the total time is more than 500 hours? Cannot include rental activities or activities involving portfolio or investment income.
- Did the taxpayer materially participate for any 5 out of the 10 preceding years (need not be consecutive)?
- Did the taxpayer materially participate in a personal service activity for any 3 prior years (need not be consecutive)? Personal service activities include fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting.
- Do the facts and circumstances indicate taxpayer is materially participating? Test does not apply unless taxpayer worked more than 100 hours a year. Furthermore, it does not apply if any person other than the taxpayer received compensation for managing the activity or if any person other than the taxpayer spent more hours managing the activity.
Tax Deductions for Doctors
Did you know that many of the professional expenses that are required of you as a physician are tax deductible? Continuing medical expenses, medical malpractice insurance and membership dues for professional and public service organizations can be deducted. (3) There is also physician tax deductions for practices that have incurred losses or damages due to a natural disaster. You automatically qualify for this deduction if your practice is located in an official federal disaster area. (4)
For self-employed doctors and practice owners, travel related to the operation of your practice is fully deductible. However, typical commuting expenses are non-deductible. Keeping adequate travel records may allow you to qualify for a $0.55 per mile deduction. Most business meals and entertainment expenses are only partially deductible. To account for these, you should keep a log noting the amount spent, date, time, place of expenditure and business purpose.
There are numerous options for structuring your business from a legal and tax entity standpoint such as sole proprietorship, partnership, or limited liability company. Each form has advantages and disadvantages, and your choice will impact how you pay your taxes and the amount that you’ll owe.
Real estate investments and rental properties are a popular source of alternative income. Historically, real estate has been an attractive investment by providing 11.22% annualized returns over the past 15 years, according to the S&P Global REIT Index. However, it should not be assumed that past performance is indicative of future results, and fluctuations do occur up and down. As you can imagine, there are quite a few guidelines in regards to claiming rental properties on your tax return.
With real estate, your basis in a property is not fixed. (5) This also applies to your personal residence as well, but rules regarding taxation of a personal residence differ from rental property. The cost basis of a property can typically be reduced by items that represent a return of your cost, including an insurance payment you receive as a result of a casualty or theft. (6) Remember, it’s important to keep track of any renovations or improvements you’ve made that could affect the value of your property.
One important distinction to be aware of in the context of adjusted cost basis is the difference between property expenses and depreciation. According to IRS.gov, “depreciation is an income tax deduction taken against expenses that allows a taxpayer to recover the cost basis of a property. It is an annual allowance for the wear and tear or obsolescence of the property.” This mainly applies to tangible property like machinery or furniture but there are some intangible properties such as patents or computer software that are depreciable as well. In order to be eligible you must own the property and use it for a business, and it must have a determinable useful life of more than one year. (7) For example, having a new roof put on your practice’s building is depreciable whereas repairing an existing roof is classified as an expense.
When selling business property, you need to be aware of potential recapture situations where you would have to add back the deduction from a previous year to your current income. You can defer paying taxes on any gains under IRC Section 1031, allowing you to reinvest the proceeds in a similar property as part of a qualifying “like-kind” exchange. (8) To qualify for this exchange, you have to identify at least three “like-kind” properties within 45 days of the transaction, and then close on one of these properties within 180 days from the date of sale. This can be tricky due to the complex nature of real estate transactions, so professional assistance is often necessary.
This is just scratching the surface of the tax code as it relates to physicians. There are countless exceptions and minutiae that have to be considered on a case-by-case basis. You shouldn’t make decisions based solely on the recommendations of your colleagues or from articles you have read. Getting assistance from a trusted professional can reduce the uncertainty regarding these decisions.
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Larson Financial Group, Larson Financial Securities, and their representatives do not provide legal or tax advice. Please consult the appropriate professional regarding your legal or tax planning needs.