Jeremy Wells

The Legal Default Every Tax Pro Gets Backwards About Married Filing Status

Earmark Team · September 8, 2025 ·

Your tax software automatically defaults to “Married Filing Jointly” the moment you indicate a client is married. Your training taught you that joint returns almost always produce better tax outcomes. Your clients assume that filing together is not just preferred, but somehow more “correct” than filing separately.

Here’s what most practitioners miss: the legal hierarchy works in reverse of what we assume.

This insight comes from Jeremy Wells on his Tax in Action: Practical Strategies for Tax Pros podcast, where he walks through one of the most misunderstood areas in tax practice. The reality? Filing separately isn’t the alternative—it’s the legal default under the tax code. Joint filing is an election under Code Section 6013 that requires both spouses’ explicit consent. If either spouse refuses, both must file separately, period.

While tax software defaults to married filing jointly and most practitioners assume it’s always the better choice, understanding the actual legal framework changes how you approach married clients—especially when non-tax factors create situations where paying more in taxes delivers better overall financial outcomes.

Understanding the Legal Framework Behind Filing Decisions

The foundation of smart filing decisions starts with grasping what the law actually says versus what practice assumes. Code Section 6013 doesn’t make joint filing automatic. It allows couples to “jointly elect” to file together if both spouses agree.

“Filing separately is actually the default,” Wells says. ”If it weren’t for code section 6013, we would have all married couples filing separate returns.” Without this specific code section creating the joint filing option, every married person in America would file individually.

Yet tax software creates false defaults that completely reverse this legal structure. The moment you indicate a client is married, the software assumes joint filing “to the point at which we have to backtrack whenever a situation comes up that might lead us to consider filing separate returns instead.”

This backward approach means we assume joint filing is normal and treat separate filing as the exception that needs justification. But legally, it works the other way around. Joint filing is the special election that both spouses must actively choose.

Wells explains, “The joint return, although it tends to produce the better result from a tax perspective, isn’t the default.” The better tax result doesn’t automatically make it the legal starting point.

Understanding this legal framework becomes crucial in situations involving financial disagreement, pending divorce, or simple disagreement between spouses. One spouse cannot force the other into a joint return, and that protection exists precisely because the law treats separate filing as the baseline position.

This legal reality also affects how you approach client conversations. Instead of asking “Why would you want to file separately?” you might ask “Do you both want to elect joint filing?” It’s a subtle shift that acknowledges the actual legal structure while opening space for clients to express concerns they might not otherwise voice.

The Tax Code’s Systematic Push Toward Joint Returns

Understanding why the tax code penalizes separate filers reveals both the logic behind joint filing’s popularity and the threshold where those penalties become acceptable costs for better overall outcomes.

The most immediate impact comes through tax rates and brackets. “Tax rates tend to be lower on a joint return,” Wells explains. Separate return brackets are higher but also smaller, meaning “more income being taxed at lower marginal rates” on joint returns, creating “a relatively lower effective rate across the returns.” For many couples, this difference alone can mean several thousand dollars in additional taxes when filing separately.

But the real penalties come from eliminating or restricting credits and deductions. The earned income credit, American Opportunity credit, and lifetime learning credit simply disappear for separate filers. Other credits have their income limitations cut in half. For example, the child tax credit and retirement savings contributions credit phase out at income levels that are 50% of joint return thresholds.

The Roth IRA contribution restriction is perhaps the most puzzling example. “Contributions to Roth IRAs are phased out for a modified AGI of just $10,000 for separate returns,” Wells notes. “This, honestly, is one of the provisions that really just confuses me… I’m not really sure what the justification for that is.” The practical effect? Most working couples filing separately simply cannot contribute to Roth IRAs at all.

Wells points out other significant restrictions. The state and local tax (SALT) cap drops from $10,000 for joint filers to just $5,000 for separate filers, even though single filers get the full $10,000 cap. The capital loss deduction gets cut in half from $3,000 to $1,500, and the student loan interest deduction disappears entirely for separate filers.

The “itemization trap” creates another layer of complexity. If one spouse itemizes deductions, the other spouse must also itemize—they cannot claim the standard deduction. This creates challenges when his firm prepares a return for one spouse but cannot get information about the other spouse’s filing decisions. “If we just don’t know, then we go with the approach that is most advantageous to the taxpayer we’re working with. But we issue a strong caveat.”

These disadvantages create what Wells calls a “preference” toward joint filing that has become so assumed that practitioners often don’t consider separate filing until specific problems arise. Yet understanding these penalties helps identify situations where accepting them delivers superior overall results.

When Separate Filing Makes Financial Sense

The mark of sophisticated tax practice isn’t finding the lowest tax liability; it’s delivering the best overall financial outcome for clients. Sometimes that means recommending the higher-tax option.

“Our job as tax professionals is not always to prepare the simplest, most tax-efficient return possible… Sometimes, our job is to advise the taxpayer on the options and tradeoffs and help them achieve the best overall result for their personal and financial needs.”

Student loan income-based repayment plans drive most separate filing decisions in modern practice. “Nine out of ten times when we file married filing separate returns in our firm, it’s because of student loan income-based repayment plans,” Wells says. These plans calculate monthly minimums based on the borrower’s tax return income. File jointly with a high-earning spouse, and those monthly payments can become unaffordable.

The financial impact often dwarfs any tax savings from joint filing. When one spouse owes substantial student loans while the other earns significant income, filing separately might increase taxes by $2,000 but reduce annual loan payments by $6,000, creating a net benefit of $4,000 for choosing the “higher tax” option.

Wells addresses practitioner hesitation about this strategy: using filing status as a tool to achieve a financial goal is completely legitimate. It absolutely is proper tax planning, he emphasizes. There’s no ethical concern, no audit risk, no regulatory problem. It’s smart financial planning that considers the complete picture.

Financial protection scenarios create another category where separate filing is advantageous. When couples face “disagreement, mistrust, or even financial abuse,” separate filing is about financial survival and legal protection.

Both spouses on a joint return become “jointly and severally liable for the tax liability,” meaning either spouse can be held responsible for 100% of any tax debt. This remains true even after divorce. IRS collection efforts don’t respect divorce decree assignments of tax liability because the IRS was never a party to that agreement.

Treasury offset protection is another practical application. When one spouse defaults on student loans, the federal government can garnish the entire joint refund to pay that debt. “Filing separately could protect that spouse’s refund… Getting some of that refund with a separate return could be a better result than having the entire refund garnished by the student loan lender,” Wells explains.

Separate filing may also unlock better results for AGI-limited deductions. The 7.5% AGI threshold for medical expenses is much more achievable when calculated against one spouse’s lower individual income rather than the couple’s combined AGI. Wells notes this same principle applies to casualty losses at 10% of AGI.

“Tax filing status is never a reflection of the couple’s marriage or relationship,” Wells explains, countering clients’ concerns that separate filing might signal relationship problems. “There’s nothing wrong about filing separate returns. Nobody looks at separate returns and thinks that’s an indication of something wrong with your marriage.”

Professional Implementation and Practice Management

The realities of implementing separate filing strategies reveal professional challenges beyond tax calculations. Wells shares insights from his firm’s experience that help practitioners navigate these complex decisions effectively.

One fundamental challenge involves timing and irrevocability. Wells explains the common saying, “A couple can make up, but they can’t break up.” Once you file jointly and pass the filing deadline, you generally cannot switch to separate returns. However, the reverse is possible. Separate filers can amend to joint returns within the statute of limitations.

There are limited exceptions to this rule. Couples can file a superseding return before the unextended due date to switch from joint to separate. They can also amend joint returns to separate if the marriage gets annulled, if one spouse can prove the joint return was signed under duress, or if both taxpayers didn’t properly sign the joint return. However, these exceptions require a substantial legal burden of proof.

Technology can streamline the analysis process, as professional tax software includes joint versus separate worksheets. These comparison tools show four columns: the joint return result, each spouse individually as if filing separately, and the combined result of two separate returns. “Usually it’s not an insignificant amount of money. A lot of times we see several thousand dollars” in savings from joint filing, Wells notes.

Wells uses these worksheets for quality control. “That comparison can actually help work through whether or not we’ve made an error.” For example, if all wages show under one spouse and none under the other, it might indicate misallocated W-2s that could incorrectly trigger Social Security overpayment calculations.

Wells describes a specific error his firm caught this way. “I have mislabeled those W-2s and that’s triggered a calculation of that excess Social Security tax paid.” Since Social Security overpayment calculations work on an individual basis, not a joint return basis, misallocating W-2s between spouses can create incorrect refund calculations that later generate IRS notices.

Conflict of interest considerations are crucial when working with couples contemplating separation or divorce. “Working with a married couple that is on the rocks might cause a conflict of interest, especially if the firm started working with one spouse before the couple got married,” Wells explains. Some firms require written waivers, while others simply refuse to work with both spouses during contentious situations.

Different firms handle separate filing preparation differently. Wells notes that some treat separate returns as completely independent engagements with separate fees for each spouse. Others charge for three returns when preparing both joint and separate scenarios. The key is establishing clear policies before these situations arise.

Transforming Client Relationships Through Strategic Tax Planning

The separate filing decision is sophisticated tax practice at its best, where technical knowledge meets strategic thinking to deliver advice that considers clients’ complete financial circumstances rather than just tax calculations.

Wells’ approach demonstrates how understanding these concepts transforms client relationships. Instead of simply optimizing tax calculations, you help clients navigate complex financial decisions that affect their long-term financial health. You become the advisor who understands that sometimes paying more in taxes is the smartest financial move.

Client education is crucial for successful implementation. Wells often encounters clients who resist separate filing because they believe it signals relationship problems or creates complications. Having clear, confident responses to these concerns, backed by a solid understanding of the legal framework, positions you as the expert who can cut through confusion.

“Our job as tax professionals is not always to prepare the simplest, most tax efficient return possible,” Wells says. “Sometimes, our job is to advise the taxpayer on the options and tradeoffs and help them achieve the best overall result for their personal and financial needs.”

This philosophy requires moving beyond traditional tax optimization to consider complete financial circumstances. When you can save a client thousands in student loan payments by recommending separate filing (even while paying extra taxes), you’ve delivered genuine strategic value that differentiates sophisticated tax professionals from basic return preparers.

The separate filing decision crystallizes everything that makes tax planning both challenging and valuable: technical complexity, client relationship management, strategic thinking, and the wisdom to optimize for outcomes rather than just tax calculations. It’s where true tax professionals prove their worth by delivering advice that transforms clients’ financial lives.

Ready to master these strategic filing decisions that could save your clients thousands while protecting them from significant financial risks? Listen to Jeremy Wells walk through the complete framework for navigating married filing status elections, including real-world examples and technical details that will change how you approach these decisions.

Why S Corporation Elections Backfire More Often Than You Think

Earmark Team · September 5, 2025 ·

Early in his accounting career, Jeremy Wells, EA, CPA, landed what seemed like the perfect client: a newly independent contractor drowning in tax debt to both the IRS and his state agency. Within just a couple of years, Wells helped transform this financial disaster into a success story. Through strategic S corporation planning, proper bookkeeping, and careful tax planning, his client went from owing thousands to receiving small but satisfying annual refunds.

The S corporation election was absolutely the right move. But Wells emphasizes that this was the right client at the right time, with the right circumstances.

In a recent episode of Tax in Action, “S-Corporation Reality Check,” Wells examines the oversimplified advice flooding social media feeds and startup marketing campaigns. While countless online voices promise S corporation elections deliver automatic self-employment tax savings for any successful self-employed person, Wells sees this advice creating expensive problems for businesses that never should have made the election in the first place.

“There’s a cottage industry developing around this concept,” Wells explains. We’re in a perfect storm where remote work and the gig economy have created lots of successful self-employed people who need tax help, but there’s a shortage of qualified advisors who can provide proper guidance.

The reality is, while this cottage industry promises easy self-employment tax savings, the one-size-fits-all approach ignores critical deal-breakers that can transform a supposed tax benefit into a costly mistake.

Balance Sheet Red Flags That Kill S Elections

The cottage industry’s relentless focus on self-employment tax savings completely sidesteps fundamental balance sheet realities that can make S elections counterproductive or even trigger unexpected taxable events.

The most dangerous misconception involves debt basis. Unlike partnerships, where partners receive basis credit for their share of entity debt, S corporation shareholders get no such benefit unless they personally loan money to the corporation.

“I can go get a loan and intend to use the funds in my S corporation, but if I personally guarantee that debt, that is not me generating debt basis,” Wells explains. “I am not loaning money to my corporation.”

This distinction catches many business owners—and their advisors—completely off guard. The COVID-era Economic Injury Disaster Loans are a perfect example of this misunderstanding. Thousands of sole proprietorships took personally-guaranteed SBA loans and later elected S corporation status, only to discover that their EIDL debt provided zero debt basis benefit. When these businesses generated losses, shareholders couldn’t deduct them against other income because they lacked sufficient basis.

But there’s another trap buried in the S election process itself. When an LLC elects S corporation status, the tax code requires a two-step transaction that most people don’t understand. First, the LLC becomes an association taxed as a C corporation, then immediately elects S status. During that first step, a Section 351 exchange occurs where the entity’s assets and liabilities transfer to the new corporation in exchange for stock.

Here’s where it gets dangerous: if the business has liabilities exceeding assets—not uncommon for debt-heavy service businesses with minimal fixed assets—this exchange creates taxable gain. “We might be inadvertently generating a taxable event for that owner or those partners when they make that selection,” Wells warns.

The equity structure challenges run even deeper. S corporations demand a single class of stock, pro-rata allocations of everything, and pro-rata distributions with no exceptions. “All items of income, loss, deduction, gain and credits must be allocated to the shareholders pro rata based on their percentages of ownership in the corporation stock, and there are no exceptions to that,” Wells notes.

This inflexibility is particularly problematic for businesses planning future acquisitions. Many small businesses today are built with acquisition in mind—not just Silicon Valley startups, but local businesses designed to be attractive to buyers within three to ten years. S corporations complicate these plans because many acquisition entities aren’t qualified S corporation shareholders. Non-US entities, partnerships, and C corporations can’t own S corporation stock, forcing expensive workarounds.

This is why Wells always asks clients about their long-term goals: “We always have to plan with the end in mind, especially when it comes to equity.”

Operating Agreements: The Hidden S Election Killers

The S corporation promotion industry systematically ignores a fundamental reality: most operating agreements are legal landmines for S elections. Wells’ firm learned this lesson the hard way, which is why they now require operating agreements from all multi-member LLC clients before making any S election recommendations.

“We read through it and try to pick out these terms and concepts and potential red flags,” Wells explains. What they consistently find are documents written exclusively for partnership taxation under Subchapter K—documents that can directly contradict the rigid requirements of Subchapter S.

The most dangerous provisions involve substantial economic effect requirements under Section 704(b). Partnership operating agreements routinely include liquidation provisions requiring distributions based on positive capital accounts. This creates non-pro-rata distribution requirements that are perfectly normal for partnerships but absolutely prohibited for S corporations.

Wells has encountered operating agreements that explicitly prohibit S elections, containing language like “this LLC will always be a partnership for tax purposes” or “the business cannot do any sort of corporate election.” Even more commonly, he’s seen agreements with waterfall distribution clauses that prioritize some members over others—a structure that violates S corporation pro-rata distribution requirements and can trigger inadvertent election termination.

Perhaps most problematic, Wells notes: “I have never seen an operating agreement in an original draft that listed out what happens if an S election takes place.” Most templates simply don’t consider the possibility, leaving businesses with agreements that actively work against their tax election goals.

Even operating agreements that appear silent on these issues often default to state partnership laws that can require non-pro-rata distributions. “If we have an operating agreement that doesn’t really cover these topics, that’s when state law intervenes,” Wells explains.

The solution requires proactive legal work that the quick-and-easy S corporation services don’t provide. Businesses need either revised operating agreements that explicitly allow for S elections or entirely new agreements written with tax flexibility in mind. This legal work might cost a few thousand dollars upfront, but it’s far cheaper than dealing with an inadvertent election termination that requires a private letter ruling or Tax Court intervention.

The Math Doesn’t Add Up: Hidden Costs and Incomplete Calculations

The S corporation promotion machine focuses entirely on self-employment tax savings while conveniently ignoring every other aspect of a client’s tax situation. This creates problems where businesses make expensive elections based on wildly inaccurate financial projections.

The most glaring flaw involves reasonable compensation requirements. “A lot of the estimates of tax savings with an S election just estimate reasonable compensation way too low,” Wells observes. “Those tax savings are not the result of the S election. Those tax savings are unreasonably low salaries being paid through those S corporations.”

It’s a mathematical sleight of hand. Of course, any advisor can eliminate 100% of self-employment tax by simply not running payroll to active S corporation shareholders. But this isn’t tax planning; it’s setting clients up for IRS problems down the road.

The Section 199A qualified business income deduction creates another calculation error that the cottage industry ignores. Higher reasonable compensation reduces the pass-through income that forms the basis for this valuable 20% deduction. As Wells explains: “We save a little bit of self-employment tax at the expense of a pretty significant deduction for a lot of small business owners.”

For many successful small business owners, losing substantial QBI deductions easily outweighs any self-employment tax savings from an S election.

State and local taxes deliver the knockout punch to many S election projections. Tennessee imposes a 6.5% tax on S corporations. New York City hits S corporations with an 8.85% rate. California charges the greater of $800 or 1.5% of net income. As Wells puts it, “Those taxes can wipe out any projected tax savings from an S election.”

A business owner in Tennessee could save $3,000 in federal self-employment tax only to pay $5,000 in additional state tax. The cottage industry’s federal-only analysis turns a supposed tax benefit into a $2,000 annual penalty.

The complications extend to asset transactions. S corporations create taxable gain when distributing appreciated property to shareholders, which is a problem that partnerships avoid. For businesses holding real estate or other appreciating assets, this difference can cost tens of thousands in unexpected taxes. That’s why Wells generally recommends not holding real estate in an S corporation.

Similarly, S corporations lose access to Section 754 elections that allow partnerships to step up the inside basis of assets when ownership changes. This valuable planning tool helps partnerships minimize taxes when partners sell their interests or inherit them. S corporations simply don’t have this option.

The Professional Alternative to Checkbox Solutions

The problems with S corporation election advice reveal a broader issue: complex tax decisions are being oversimplified into marketing soundbites. While the cottage industry profits from reducing professional judgment to self-employment tax calculators, tax professionals face a choice between participating in this race to the bottom or demonstrating why expertise matters.

“We need to seriously look at what that entity election will mean for the business today, in the future, and for the shareholders or partners themselves,” Wells says. This level of analysis requires understanding balance sheet implications, legal document conflicts, comprehensive tax calculations, and long-term business planning—expertise that can’t be packaged into a simple online service.

When clients arrive demanding an S election because “everyone online says it saves taxes,” the professional response isn’t to immediately comply or dismiss the idea. Instead, walk them through the complete analysis: balance sheet structure, operating agreement provisions, reasonable compensation realities, QBI impacts, state tax consequences, and future business goals.

This educational approach protects clients from expensive mistakes while positioning you as genuinely knowledgeable rather than just another order-taker. It creates long-term relationships built on trust and demonstrated expertise.

While the cottage industry promises simplicity, its oversimplified approach consistently creates far more complexity down the road. Inadvertent election terminations, operating agreement conflicts, unexpected state taxes, and acquisition complications all require costly professional intervention to resolve.

For tax professionals willing to master this complexity, the S corporation election presents both a professional responsibility and a market opportunity. Clients need advisors who can navigate the factors that determine whether an S election truly benefits their specific situation.

Good tax advice requires understanding the complete client situation, not just plugging numbers into a self-employment tax calculator.

To hear Wells’ complete analysis and learn how to position yourself as the thoughtful alternative to the S corporation promotion industry, listen to the full Tax in Action podcast episode where he details the specific questions to ask and analyses to perform that separate professional advice from marketing-driven recommendations.

The Hidden Traps in Clean Energy Credits That Could Cost Your Clients Thousands

Earmark Team · August 27, 2025 ·

Picture this scenario: You just finished a call with a client who mentioned installing solar panels on her vacation home. Now it’s tax time, and she’s dropped off her tax documents, including information about the solar installation. Among the paperwork, you find two invoices: one for the solar panels, equipment, and installation labor, and another from a building contractor for roof work. Your client included a note explaining that the solar panel installation required structural retrofitting to make the roof suitable for the panels.

This is your first time dealing with solar tax credits. You know there’s some special tax benefit, but you’re not sure how it works. Which expenses qualify? How do you calculate the credit? And what about those two different invoices? Does the roof work count toward the solar tax credit?

This scenario comes from Jeremy Wells’ Tax in Action podcast, where he walks tax professionals through the residential clean energy credit. Wells, a CPA and Enrolled Agent in Florida, has seen this situation repeatedly as more clients install solar panels and other clean energy property.

While the residential clean energy credit offers substantial savings—at least until it’s eliminated at the end of 2025— tax professionals must navigate complex qualification rules, timing requirements, and cost allocation issues, often with limited regulatory guidance beyond the basic code section.

Understanding the Clean Energy Credit Basics

The residential clean energy credit comes from Internal Revenue Code Section 25D. It provides a nonrefundable credit for up to 30% of qualifying expenses on residential clean energy property. The credit was initially designed to be worth 30% of qualifying expenses through 2032, then drop to 26% in 2033 and 22% in 2034. However, H.R. 1, commonly known as the “One Big Beautiful Bill Act,” eliminated the credit at the end of 2025.

Since this is a nonrefundable credit, it can’t reduce a taxpayer’s liability below zero or create a refund. However, if the credit exceeds the taxpayer’s current tax liability, the excess carries forward to future years.

The qualifying property includes several types of clean energy installations:

Solar panels (most common)
Solar water heaters
Small wind energy systems
Geothermal heat pumps
Fuel cell property
Battery storage property

It’s important not to confuse this with the residential energy efficiency improvements credit under IRC Section 25C, which covers items like new windows, insulation, or HVAC systems. Those fall under a completely separate credit.

What Makes a Residence Qualify

Unlike some residential tax benefits that only apply to primary residences, Section 25D has broader requirements. The property must be installed at a “dwelling unit,” a place the taxpayer actually lives in the United States and uses as a residence. This can include second homes, vacation homes, or summer homes, as long as the taxpayer uses them personally.

However, the credit doesn’t apply to rental properties or investment properties. If a client installs solar panels on a rental property, that falls under entirely different tax provisions.

Business use of the home creates additional considerations. If more than 20% of the property’s square footage is used for business purposes (like a large home office), you’ll need to allocate the expenses. The taxpayer can only claim the credit on the portion allocated to personal use of the home. For business use of 20% or less, no allocation is required.

Qualifying Costs and Technical Requirements

Determining which costs qualify for the credit requires careful analysis of invoices and documentation. Eligible expenditures include:

The cost of the property itself
On-site labor costs to prepare, assemble, and install the property
Costs to connect the property to the home’s electrical or plumbing systems
Sales tax paid on eligible costs

However, not all installation-related costs qualify. Wells explains the critical distinction: “If the panels actually become a structural part of the roof, then we can include that cost. That’s different from saying that we had to do some work to the roof to be able to install those panels.”

In the opening scenario, the solar panel installation costs would likely qualify, but the separate roof retrofitting work probably wouldn’t. The roof work represents preparation rather than panels becoming part of the roof structure.

Different types of property have specific technical requirements:

Solar water heaters must be certified by the Solar Rating Certification Corporation or a comparable state-endorsed entity.
Geothermal heat pumps must meet Energy Star requirements.
Battery storage needs a capacity of at least three kilowatt hours. As Wells notes, “I’m not an electrical expert. I’m a tax professional. I’m going to ask the client for some piece of paper from the installer showing me that it has a capacity of at least three kilowatt hours.”
Fuel cells face cost limitations of $1,667 per half-kilowatt of capacity.

Any property that serves additional functions beyond energy production, like a swimming pool or hot tub heated by solar energy, can’t include those additional components in the credit calculation.

Rebates, Incentives, and Excess Generation

Rebates and incentives can affect the credit calculation. Direct or indirect rebates from manufacturers, distributors, sellers, or installers reduce the eligible costs. However, state government incentives typically don’t reduce the federal credit calculation.

A particularly complex issue arises when solar installations generate more electricity than the home needs. If the taxpayer sells excess electricity back to the grid, only the portion of costs related to the home’s actual electricity needs qualifies for the credit.

Wells acknowledges the challenge this creates: “Do we allocate this based on actual electricity generated and over what period of time? Should we be using data from the home’s electrical usage prior to installation? These are all unanswered questions as far as the guidance we have now.”

Timing Rules That Matter

When a taxpayer can claim the credit depends on the type of installation:

For existing residences, the credit applies when the property is completely installed, when work crews are done, and when the property is ready for use. For new construction or reconstruction, the credit applies when the taxpayer begins using the dwelling unit, which may be later than when the clean energy property is installed.

This distinction can shift credits between tax years and impact tax planning. Wells sees many situations where taxpayers start work in one year but don’t complete installation until the next year, or where installation happens late in the year but certification doesn’t arrive until the following year.

If taxpayers finance the purchase through the seller, they can calculate the credit based on the full cost of their payment obligation, not just the amounts actually paid. However, interest on financing doesn’t count toward eligible costs.

Documentation and Reporting Requirements

Tax professionals often find themselves helping clients gather documentation that the client should have obtained during the purchase process. This includes:

Detailed invoices breaking down eligible and non-eligible costs
Certification documents showing technical specifications
Information about any rebates or incentives received
Details about excess electricity generation and sale back to the grid

Taxpayers report the credit on Form 5695, Residential Energy Credits, with different lines for different types of property. The form calculates the maximum credit amount and applies limitations based on the taxpayer’s tax liability.

Since this is a nonrefundable credit, it can offset the alternative minimum tax but can’t create a refund. Any unused credit carries forward to future years.

Practical Takeaways for Tax Professionals

Wells emphasizes that, unlike most areas of tax law, practitioners have limited guidance beyond the code section itself. “We really don’t have much guidance beyond what’s in the code section itself. We don’t have any Treasury regulations related to this code section, which is not very common.”

This means tax professionals must rely heavily on professional judgment when making determinations about qualification, cost allocation, and timing. The key is asking the right questions:

Is this the taxpayer’s personal residence, and what percentage do they use for business?
What costs did the homeowner pay, and are there any rebates or incentives?
For a solar electric property, is the property owner selling any electricity back to the grid?
When was the property completely installed, or when did the taxpayer move into a new residence?

Wells notes that sometimes by helping clients gather proper documentation, “we actually help them ensure they’ve gathered all the documentation they might need in the future.”

The residential clean energy credit offers significant tax savings for qualifying installations, but success depends on careful analysis of costs, proper documentation, and understanding the technical requirements that vary by property type. While the guidance may be limited, a systematic approach to qualification and documentation helps ensure clients can take advantage of these valuable credits while maintaining compliance with tax requirements.

To hear Wells’ complete analysis and additional examples of how to handle complex scenarios, listen to the full Tax in Action episode.

Why Two Identical 1031 Exchanges Had Opposite Outcomes in Tax Court

Earmark Team · August 13, 2025 ·

Two real estate investors. Two 1031 exchanges. Two family members moving into replacement properties. One investor successfully deferred taxes, while the other faced a costly audit that wiped out their claimed benefits entirely.

The difference wasn’t timing, family relationships, or even rental income. It was something far more subtle: the ability to prove genuine investment intent through documented business behavior that could withstand IRS scrutiny.

In Click v. Commissioner, the taxpayer’s relatives moved into the replacement properties the day after the exchange closed. Seven months later, she gifted both properties to those families. The Tax Court saw through what it called a sham transaction.

But in Adams v. Commissioner, when the taxpayer’s son moved into the replacement property and paid below-market rent, the court sided with the taxpayer. The exchange qualified despite the family connection and reduced rental income.

In a recent episode of the Tax in Action podcast, host Jeremy Wells broke down the 1031 fundamentals to explain why the transaction worked out for one taxpayer and not another. While Section 1031 exchanges offer real estate investors a powerful tool to defer capital gains taxes, success depends on more than following the rules. It requires proving genuine business intent through careful documentation.

Understanding the 1031 Exchange Foundation

Here’s what Section 1031 does: it allows you to exchange property held for productive use in a trade, business, or investment for like-kind property with the same intended use. But there’s a crucial point many miss: Section 1031 defers gain; it doesn’t eliminate it.

Wells explains, “There is a misconception out there among taxpayers who could use or want to use section 1031 exchanges that 1031 just eliminates the gain from a like-kind exchange.”

When you exchange one property for another, you don’t avoid taxes; you postpone them. The deferred gain carries forward, and the replacement property takes the same basis as the original property. Eventually, when you sell the replacement property in a taxable transaction, you’ll pay tax on both the original deferred gain and any subsequent appreciation.

Since the Tax Cuts and Jobs Act took effect in 2018, 1031 exchanges only work for real estate. But within that category, the definition of “like kind” is remarkably broad. You can exchange an apartment building for raw land, a commercial office building for a single-family rental, or developed property for agricultural land.

The key requirement is that both properties must be held for productive use in trade, business, or investment. You can’t use a 1031 exchange for your personal residence or vacation home that you use strictly for personal purposes.

The Intent Test That Trips Up Investors

The biggest challenge with 1031 exchanges isn’t the technical requirements; it’s proving you genuinely intended to hold the replacement property for investment or business use. Wells points out that this has become “a question of facts and circumstances that has to be determined at the time of the exchange itself.”

The courts have seen numerous attempts by taxpayers to use 1031 exchanges to defer gain on what were essentially personal property acquisitions disguised as investments. This leads to intensive scrutiny of taxpayer motivation, regardless of whether they follow all the mechanical rules correctly.

Consider the Moore v. Commissioner case. The taxpayers exchanged one vacation property for another, using both properties personally without any rental activity. When audited, they argued they held the properties for “investment,” meaning they expected the properties to appreciate in value.

The Tax Court disagreed. “Just the mere expectation of an increase in value is not sufficient to establish that investment intent,” Wells notes. Simply hoping property values will rise doesn’t qualify as holding property for investment under Section 1031.

This reveals how enforcement has evolved. Technical compliance with timing rules and intermediary requirements won’t protect you if your behavior contradicts your stated investment intent. The IRS looks at the complete picture surrounding each exchange.

What the Court Cases Reveal About Documentation

The contrast between successful and failed exchanges often comes down to documentation quality, not transaction structure. Let’s examine what separated the winners from the losers.

The Click Failure

The taxpayer exchanged her farm for two residential properties. Her children moved into those houses the day after the exchange closed. Seven months later, she gifted both properties to the families. Her defense crumbled because she couldn’t demonstrate any genuine rental activity during those seven months. The court saw this as a sham transaction designed to defer gain on personal property transfers.

The Adams Success

This taxpayer exchanged a rental property for a fixer-upper. His son moved in and began extensive renovations, living there during a three-month repair period in exchange for renovation work. After that, the father began charging rent. Yes, the rent was below market rate, and the son missed one payment. But the court saw a consistent pattern of business-like behavior: formal rental arrangements, regular cash payments, and documented property improvements.

The Goolsbee Disaster

These taxpayers placed a single advertisement in a neighborhood newsletter and moved into the replacement property within two months. When questioned during the audit, they couldn’t even answer whether rentals were allowed in their community. Their minimal marketing effort and inadequate preparation convinced the court that their investment intent was fabricated.

The Reesink Victory

Even though these taxpayers moved into their replacement property after eight months, they had a compelling record of genuine rental attempts: multiple flyers distributed around town, documented property showings to prospective tenants, and one potential renter who actually testified in court on their behalf.

Wells emphasizes the key insight: “It’s not necessarily a matter of waiting a certain number of months. It’s not a matter of whether you advertised that property for rent or not. It’s the culmination of all of these different facts and circumstances.”

The Technical Requirements You Must Follow

Beyond proving intent, you need to navigate specific compliance requirements that can make or break your exchange.

Timing Rules for Deferred Exchanges

Most 1031 exchanges today are deferred exchanges, where the sale and purchase don’t happen simultaneously. You have two critical deadlines:

45-day identification rule. You must identify replacement property within 45 days after closing on the sale of your original property. This identification must be in writing, signed, and sent to someone involved in the exchange.
180-day completion rule. You must receive the replacement property within 180 days of transferring the original property, or by the due date (including extensions) of your tax return for that year, whichever comes first.

Safe Harbor Requirements

The most common approach uses a qualified intermediary who holds the proceeds from your property sale and facilitates the replacement property purchase. The key is that you never have control of the funds from the original property sale.

Disqualified Persons

You can’t do exchanges with certain people, including your employees, attorneys, accountants, investment brokers, bankers, or real estate agents, if they’ve worked for you within the past two years. You also can’t exchange with close family members or entities where you own more than 10% of the stock or partnership interest.

Geographic Restrictions

You cannot exchange U.S. real estate for foreign real estate, or vice versa. Wells notes he’s “had to advise clients on this before because they want to start dabbling in rental markets outside the U.S.” or dispose of foreign properties to build their U.S. portfolio.

Reporting and Ongoing Obligations

Taxpayers must report successful 1031 exchanges on Form 8824, which has three main parts: property descriptions with key dates, related party disclosures (if applicable), and calculation of deferred gain and basis in the replacement property.

If your exchange involves related parties, you must file Form 8824 for two years after the exchange, and neither party can sell their received property during that two-year period without potentially disqualifying the exchange.

The replacement property continues the depreciation schedule from the original property. “Wherever we’re at in the depreciable life, the number of years of depreciation, the accumulated depreciation of the relinquished asset, we’re going to carry that over generally into the new asset,” Wells explains.

Building Your Defense Strategy

Enforcement of 1031 exchange rules has fundamentally shifted from checking compliance boxes to evaluating business narratives. Every marketing effort, tenant interaction, and business decision becomes part of a story that auditors may scrutinize for evidence of authentic business purpose.

When helping clients with 1031 exchanges, focus on creating documentation that demonstrates genuine investment intent:

Document all rental marketing efforts thoroughly
Maintain records of tenant interactions and property showings
Keep evidence of rental income and expenses
Avoid personal use that could undermine investment intent
Create a paper trail that supports your business purpose

A failed 1031 exchange can trigger penalties and interest that devastate investment returns. But when properly structured and documented, these exchanges provide real estate investors with a powerful tool for building wealth through tax-efficient property portfolios.

Wells’ comprehensive exploration provides the technical foundation every practitioner needs, but your ability to tell a compelling business story through consistent, credible evidence often matters more than perfect technical compliance.

For the complete technical framework and additional insights that can help you guide real estate investor clients through successful exchanges, listen to Wells’ full Tax in Action episode.