I had a client who once told me about his friend who would buy junk cars, then donate them to a charity and claim an itemized deduction equal to the Blue Book value of the vehicle. Buy a clunker for $50 or so, and save hundreds of dollars in taxes by claiming a deduction of $500, $1,000, or more. Sounds like an opportunity for easy arbitrage (no-risk financial gain) at the government's expense.
While no CPA would endorse such a strategy, using the Blue Book to determine the value of a donated vehicle was pretty much standard operating procedure - no matter the condition of your car. The IRS was well aware of the potential for exaggerated deductions for donated vehicles, and, last fall, dramatically changed the rules.
For cars donated after December 31, 2004, the deduction you can claim is limited to what the charity gets for selling your car. Within 30 days of your vehicle's sale, the charity is required to provide you with written acknowledgement including the following information:
If you plan to claim a deduction in excess of $500 in connection with the donation of your car, make sure to attach the charity's statement to your tax return. Many charities will choose to incorporate all of this information on new IRS Form 1098-C. Failure to attach the statement or Form 1098-C could result in your deduction being disallowed.
Are there any exceptions to this rule? Of course there are. We're talking about the U.S. income tax rules, right?
If the charity will use the vehicle for its own purposes, make major repairs or improvements to increase its value, or donate or sell it at a discount to a needy individual, the pre-2005 rules apply and you can base your deduction on the car's fair market value.
If any of these three exceptions apply, time to dig up the Blue Book once again so you can determine the car's fair market value. Just make sure that the charity replaces the last two bullets on its acknowledgement with a statement detailing its intentions.
Is It Still Worth It?
Does it still make sense to donate your car to a charitable organization in light of these new rules? You need to compare what you could get by selling your car yourself, with what the charity can sell it for multiplied by your marginal tax rate.
Let's say you could sell your car for $1,000, or the charity, because it's in the business of selling cars, could sell it for $2,000. Assuming you're in the 28% tax bracket and you'll itemize your deduction, you'll pocket a $560 tax savings ($2,000 * 28%) by donating it, leaving you $440 short if you choose the charitable route.
Don't overlook the intangibles, however. By donating your car to a charity, you'll get some personal satisfaction. And what's it worth to avoid the headaches of advertising and selling a used vehicle on your own?
Because of these new rules, deciding between selling your car and donating it to a charity has gotten a lot more difficult.
Some compare it to adding salt to a wound. Others see it as adding insult to injury. And many feel like they're being kicked when they are down.
I am referring to paying IRS penalties. For many people, paying the taxes owed every year is painful enough. But getting hit with IRS penalties can push even the most mild mannered taxpayer over the edge. Let's take a look at some of the more commonly incurred penalties.
Late Filing Penalty:
How does a 5% penalty per month on any outstanding tax balance sound to you? $50 per month on every $1,000 owed is what the IRS charges if you fail to file your tax return, or an extension request, by the tax return's due date. The good news is that the maximum failure to file penalty is capped at 25% of the unpaid balance.
The moral of this story is simple. Even if you can't pay all the taxes you owe by the filing date, make sure to submit the paperwork or extension request on time.
Late Payment Penalty:
The late payment penalty is a lot more reasonable than the late filing penalty. The IRS will assess a penalty of 0.5% per month on any taxes owed, provided you file the paperwork or extension requests on time. The clock starts ticking as of the due date of your tax return (including extensions if the amount you owe is small enough).
It's very important to always file an extension request with the IRS if you can't complete the tax return on time, since filing the one-page extension ensures that you'll avoid the 5% per month late filing penalty. And if you have 90% of your tax liability paid in by the due date of the return, or owe less than $1,000 with your return, expect to avoid the late payment penalty as well.
Like the failure to file penalty, the late payment penalty is limited to 25% of any unpaid taxes. And if you get hit with both penalties, your combined penalty won't exceed 5% per month and 25% of the total taxes owed.
Underpayment of Estimated Taxes:
Being late with your estimated taxes or not having enough taxes withheld is the cheapest money you can borrow from the IRS. Expect to be assessed an underpayment penalty if you owe more than $1,000 with the filing of your tax return and don't meet certain other exceptions. These exceptions include paying in 90% of your current year's tax liability or 100% (110% for high income taxpayers) of your prior year's liability.
Since the rate for this penalty is based on the prevailing market interest rates, it's been running at only 4%-5% in recent years. For many people, the rate charged by the IRS for this penalty is one-third or less of the rate charged on their credit cards.
Accuracy Related Penalty:
If the IRS makes changes to your tax return, either through an audit or through its matching program, and determines that you understated your taxes by the greater of 10% of the corrected tax or $5,000, they will automatically assess a penalty of 20% of the underpaid tax. You might also get hit with this penalty for failing to keep adequate records to substantiate your tax return.
Getting Penalties Waived:
What happens if you get assessed one of these penalties? You have the right to request that the IRS waive the penalties for "reasonable cause". In most cases, it makes sense to draft a letter explaining why you either missed a deadline or owed so much in taxes that you got hit with a penalty - no matter how lame your excuse might be. Chances are pretty good that if it's your first or second offense, the IRS will give you the benefit of the doubt and waive the penalty.
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