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Jeremy Wells

The Hidden Tax Trap That Turns Disaster Relief Into Taxable Income

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When Hurricane Ida slammed into Jessica’s print shop in northern Florida, it destroyed equipment worth tens of thousands and left her building damaged. But when she claimed a casualty loss deduction, she discovered that receiving $250,000 in insurance actually created a taxable gain instead of the tax break she expected. Her (fictional) story shows how complex disaster relief provisions have become for tax professionals and their clients.

In this episode of Tax in Action, Jeremy Wells, EA, CPA, begins a three-part series on disaster-related tax provisions. This first installment focuses on casualty losses and how the rules have changed since the Tax Cuts and Jobs Act (TCJA). As Wells notes, “the world’s changing in multiple ways, and one of those ways is that we see more and more frequent big storms, earthquakes, catastrophic events, and those can have serious financial implications.”

The TCJA limited personal casualty loss deductions to federally declared disasters starting in 2018. The documentation requirements are strict. Taxpayers must file insurance claims even when they seem unnecessary. And the calculations, based on the lesser of basis or fair market value changes, can produce unexpected results when insurance enters the picture.

Understanding What Qualifies as a Casualty Loss After 2018

The Tax Cuts and Jobs Act created a two-tier system that treats personal and business casualty losses differently. Starting with the 2018 tax year, personal casualty losses are only deductible if they result from federally declared disasters. This means a house fire, a tree falling on your car, or flood damage from a broken pipe no longer qualify unless FEMA declares your area a disaster zone.

A deductible casualty loss still requires three specific criteria. First, there must be actual damage, destruction, or loss of property. As Wells explains, “theoretical losses or potential losses don’t qualify.” Second, the damage must result from an identifiable event that can be isolated from other occurrences. Third, that event must be sudden, unexpected, and unusual in nature.

The “identifiable event” requirement plays out in interesting ways. Wells shares a Tax Court case where a taxpayer successfully claimed a casualty loss for his home in a Vietnamese village that was destroyed during the war. The court ruled in the taxpayer’s favor because the North Vietnamese invasion of that specific village was an identifiable event, distinct from the broader, years-long conflict.

But not all disasters qualify. When property values drop due to fear of potential mudslides without any actual damage, no casualty loss exists. Wells notes that “even though there’s going to be a significant economic and financial impact on the taxpayer, that doesn’t actually qualify as a deductible casualty loss because there’s been no damage, destruction or loss of property directly to the taxpayer yet.”

Between personal and business losses lies a tricky middle category: activities engaged in for profit but not rising to the level of a trade or business. These might include passive real estate investments or limited partnership interests. Courts consider whether the taxpayer’s main goal was economic profit independent of tax benefits. They also consider factors like the taxpayer’s expertise, reliance on qualified advisors, and success in similar ventures.

The insurance claim requirement often surprises taxpayers. Congress stated that choosing not to file an insurance claim doesn’t create a casualty loss. Instead, it represents “the taxpayer’s personal decision to forgo making a claim against the insurance company.” This means you must file a timely insurance claim to qualify for any casualty loss deduction, even for minor damage where you’d rather not involve your insurance company.

Calculating Losses When Insurance Changes Everything

The basic formula seems simple: take the lesser of your adjusted basis or the change in fair market value, then subtract any insurance or reimbursement received. But each part carries hidden complexities that can dramatically change the outcome.

Jessica’s case shows how insurance can create unexpected results. Her building had a $200,000 adjusted basis, but insurance paid her $250,000. That created a $50,000 gain. Her equipment, with a $50,000 basis but only $30,000 fair market value when destroyed, generated a $30,000 loss. The net result? A $20,000 taxable gain reported on Form 4797, despite her business suffering major damage.

Revenue Procedure 2018-08 provides safe harbors for establishing fair market value when formal appraisals aren’t possible. Wells explains you can use repair costs as evidence if the repairs meet four criteria:

  1. they’re necessary to restore pre-casualty condition,
  2. not excessive,
  3. only fix casualty damage, and
  4. don’t increase value beyond pre-casualty levels.

Getting two qualified repair estimates and using the lower figure offers another safe harbor. But Wells acknowledges the challenge: “It might be difficult to get two different companies or crews to come by and give you estimates” when entire regions need repairs after a disaster.

For personal casualties, the calculation gets even tougher. After determining the basic loss, you reduce it by $100 per event, then reduce the net amount by 10% of adjusted gross income. Wells shares his experience with Florida clients: “It’s entirely possible after the netting of gains and losses, then the reduction by $100, then the reduction by 10% of adjusted gross income, they don’t really see much of any tax effect. And that can be frustrating and disappointing.”

The increased standard deduction under the Tax Cuts and Jobs Act adds another hurdle. Since personal casualty losses become itemized deductions, many taxpayers see no benefit even after suffering significant losses. A couple with $100,000 AGI suffering $20,000 in casualty losses might receive no tax benefit at all after the reductions and standard deduction comparison.

Business casualties avoid these personal loss limitations but face their own issues. Form 4797 captures these transactions and might trigger depreciation recapture, converting expected capital treatment into ordinary income. Mixed-use property requires careful allocation between personal and business portions.

Documentation and Timing: Making the Right Moves

The essential documentation includes several key items. First, you need the cost or adjusted basis for every damaged property. Next, you need fair market value immediately before and after the casualty, although Wells notes “people don’t usually see, for example, a hurricane is about to strike and then go hire an appraiser.” Insurance policies and filed claims are mandatory. For personal losses, you also need the FEMA declaration number.

A valuable option allows taxpayers to claim casualty losses from federally declared disasters on the prior year’s return. For example, if disaster strikes in 2023, you have until October 15, 2024, to elect to claim that loss on your 2022 return, potentially getting a refund much sooner. Wells explains this involves filing an amended return with Form 4684, marking the special election box.

Form 4684 splits casualty losses into two sections. Section A handles personal property with its various reductions and thresholds. The FEMA declaration number goes above line one as proof of deductibility. Section B streamlines business and income-producing property calculations.

Wells emphasizes the importance of cloud storage, especially for firms in disaster-prone areas. “A lot of firms in these disaster prone areas have had to deal with storms hitting and losing their clients’ records.” He strongly recommends digitizing records and backing them up to the cloud.

The timing rules mean casualties are deductible in the year they occur, regardless of when repairs happen. But this creates challenges. How do you prove repair costs for work not yet done? Deadline postponements in disaster areas offer some relief, but you might need to file extensions to gather proper documentation.

Key Takeaways for Tax Professionals

The casualty loss rules have become more restrictive and complex since 2018. Personal losses rarely generate meaningful deductions outside federally declared disasters. Insurance payments can turn apparent losses into taxable gains. And the requirement to file insurance claims even when you don’t plan to pursue them catches many taxpayers off guard.

Preparation is essential for taxpayers and their advisors in disaster-prone areas. Maintain cloud-based records of all property basis and insurance coverage. Document property condition periodically with photos. Understand which events typically qualify for federal disaster declarations in your region. And prepare clients for the possibility that insurance proceeds might create tax liabilities.

Wells, speaking from experience in Florida, observes that hurricanes “don’t happen all the time, but they happen every now and then and they’re becoming more frequent and more powerful.” This reality makes understanding these provisions essential for tax professionals who serve clients in vulnerable regions.

Listen to the full episode to hear Wells explain all the calculations and share details that could save thousands in unexpected tax liabilities. Over the next two episodes, Wells will cover theft losses (including Ponzi schemes and cryptocurrency disasters) and involuntary conversions (which could have helped Jessica defer her unexpected gain entirely). With natural disasters increasing in frequency and severity, this series provides critical knowledge every tax professional needs before the next storm hits.

When Life Happens During the Wrong Tax Years—A $500,000 Lesson in Timing

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Steven and Catherine Webert’s story began like countless American dreams: newlyweds purchasing their first home in 2005, ready to build their life together. Within months, their dream became a nightmare when Catherine received a cancer diagnosis. The couple took out a line of credit against their home to pay mounting medical bills, determined to fight both the disease and the financial strain.

Then 2008 arrived with the Great Recession, making their home impossible to sell when they desperately needed funds. Forced to convert their residence to rental property from 2010 to 2015, they watched helplessly as a decade of homeownership ultimately cost them their entire $500,000 capital gains exclusion—not through poor planning or tax avoidance schemes, but through a series of life events that collided with Section 121’s unforgiving technical requirements.

In a recent episode of the Tax in Action podcast, host Jeremy Wells, EA, CPA, explained a troubling reality about one of the tax code’s most valuable benefits. The Webert v. Commissioner case (Tax Court Memorandum 2022-32) shows how easily clients can lose hundreds of thousands of dollars in tax benefits when life circumstances like health crises, economic downturns, or rental conversions collide with the rigid five-year lookback period and three-part qualification test.

For tax professionals serving clients in a housing market where median home prices hover around $400,000 and three to four million existing homes are sold nationwide each month, understanding these nuances is essential to client protection.

The Deceptively Simple Three-Part Test That Controls Massive Tax Savings

The $250,000 capital gains exclusion from Section 121 seems like a generous gift from Congress until you examine the fine print. What appears to be straightforward tax relief is really a complex web of interconnected requirements that operate within an inflexible timeframe. Missing any single element can cost clients hundreds of thousands of dollars.

Success hinges on passing three distinct but related tests:

  1. The ownership test requires taxpayers own their principal residence for at least two of the five years immediately preceding the sale.
  2. The use test requires they actually live in that property as their primary residence for two of those same five years—specifically, an aggregate of 24 months or 730 days within that five-year window.
  3. The once-every-two-years rule prohibits taxpayers from claiming the exclusion if they’ve used it on another property sale within the previous 24 months.

Understanding how this time counts is crucial for practitioners. As Wells explains, the law provides flexibility in measuring these periods. “We can either measure that in terms of 24 months, or we can measure that in terms of 730 days.” This approach can make the difference in borderline cases because “short periods of absence, such as vacations or even seasonal absences, still count as periods of use of that primary residence.”

For married couples filing jointly, the rules are more nuanced but potentially more generous. While both spouses must satisfy the use test—each living in the property as their principal residence for two of the preceding five years—only one spouse needs to meet the ownership requirement. This recognition of real-world marriage dynamics, where one spouse’s name often appears on the deed while both live in the home, doubles the maximum exclusion to $500,000 for qualifying joint filers.

Proactive planning is crucial, as Wells demonstrates with an example of a retiring client. The client owned both a primary residence near their workplace and a vacation home where they planned to spend retirement. Their natural instinct was to sell the primary residence immediately upon retirement, then move into the vacation home. But when that one-bedroom third-floor condo proved unsuitable for their mobility needs, they wanted to sell it quickly.

“Luckily, they told me about their plans before they got too far into it,” Wells explains, “so I could explain to them that they would probably have an issue with the once-every-two-years rule.” The couple ultimately decided to delay their plans, holding the vacation property until they could claim the exclusion. The decision saved them a significant tax liability on substantial capital gains.

However, failing any one of the three tests destroys the entire benefit.

How Real-World Circumstances Destroy Tax Benefits

The Webert case illustrates how health crises and economic downturns can obliterate even the most well-intentioned tax planning. Catherine and Steven Webert seemed to do everything right. They owned their home for a full decade and used it as their principal residence for four years. Yet when they filed their 2015 tax return claiming the $500,000 exclusion, the IRS issued a notice of deficiency that ultimately cost them hundreds of thousands of dollars.

The couple’s problems began with circumstances beyond their control. Catherine’s cancer diagnosis forced them to tap their home’s equity for medical expenses. The 2008 housing market collapse made selling impossible when they desperately needed cash. Converting their residence to a rental property from 2010 to 2015 seemed like the only viable option, but the couple unknowingly triggered Section 121’s most unforgiving provision.

Wells explains the arithmetic: “We have to look back five years from when they sold it. So that takes us to 2010. That entire five-year period, it was a rental. They never used it as their principal residence during that five-year window.” The law’s rigid five-year lookback period means that regardless of how long they owned the property or how legitimate their reasons for renting it, the final five years before the sale determined their eligibility.

This introduces the concept of “non-qualified use”—periods when the property wasn’t used as the taxpayer’s principal residence. However, the definition contains a crucial distinction: non-qualified use “does not include any portion of the five-year period after the last date, the taxpayer or spouse used the property as the principal residence.”

This timing distinction proves critical. As Wells explains, “If the property was a principal residence and then converted to a rental and then sold, and the taxpayer never moved back into it as a principal residence, then that period of rental is not non-qualified use.” The Weberts fell into this exact scenario. They converted to rental and never returned to personal use before selling.

Had they moved back into their home for two years before selling, converting it from rental back to personal residence, they might have qualified for the exclusion. But life doesn’t always accommodate tax planning timelines. Their health situation and subsequent living arrangements made returning to the property impossible, and the result was an unexpected tax liability.

As this case demonstrates, while Section 121 provides generous benefits for qualifying taxpayers, it offers no relief for those whose life circumstances don’t align with its technical requirements. Health crises, economic downturns, and forced rental conversions often trigger the conditions that eliminate taxpayers’ eligibility for that relief.

Why Partial Exclusions Rarely Save the Day

When tax professionals first encounter the partial exclusion provisions in Section 121, they often see them as the safety net clients need when life disrupts their tax planning. The reality is far more limited and frustrating than the language suggests.

The law establishes three safe harbors:

  1. The distance safe harbor for employment changes applies when taxpayers move at least 50 miles farther from their former residence. Importantly, “self-employment also counts as employment.”
  2. The physician’s recommendation safe harbor covers moves recommended by a doctor “to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of disease, illness or injury.”
  3. The specific event safe harbor addresses unforeseen circumstances including “involuntary conversion,” “natural disaster,” “acts of war or terrorism,” “death,” job loss “that results in an inability to pay housing or living costs,” “divorce or legal separation,” and even “multiple births from the same pregnancy.”

These exceptions allow qualifying taxpayers to claim a partial exclusion calculated by multiplying their maximum exclusion amount by the ratio of their qualifying period. A taxpayer who qualifies for only 18 months could claim 75% of their maximum exclusion—potentially $375,000 for a married couple filing jointly.

But these partial exclusions only address violations of the ownership test, use test, or once-every-two-years rule. They don’t extend the five-year lookback period that proved fatal to the Weberts’ case. As Wells explains, “There is no exception to that five-year time period. Even if you qualify under one of these other exceptions, that’s only for the ownership use or once every two-year rule.”

The health exception can be particularly misleading for practitioners and clients facing medical crises. While Catherine Webert’s cancer diagnosis seems exactly like the type of health issue the exception was designed to address, the law has strict requirements. Wells notes that “a sale that’s merely beneficial to the general health or well-being of an individual does not qualify.” This distinction is important when “older taxpayers want to move to a warmer, drier climate such as the southwest, just because they might expect to have a little bit easier time. that change in climate will not qualify for the partial exclusion.”

The specific events safe harbor creates equally frustrating limitations. While multiple births qualify as an unforeseen circumstance, “just moving because you think you can get a better, higher paying job, or you think the cost of living will be less moving somewhere else doesn’t qualify. And just deciding you don’t like where you live and want to live somewhere different, that also doesn’t qualify.”

Steven Webert attempted to argue before the Tax Court that his wife’s health crisis should qualify them for partial relief. But the court disagreed. The partial exclusions apply “only if you fail to meet the ownership use and once every two-year rule, it does not extend the five-year period. The only way you get an extension there is to work in the armed forces, foreign service, or intelligence community.”

The very circumstances that most desperately require tax relief often create exactly the conditions that eliminate eligibility for that relief. The Weberts received no exclusion—partial or otherwise—from the sale of their principal residence despite compelling reasons for every choice they made.

The case underscores why proactive planning is essential, making the difference between preserving hundreds of thousands of dollars in tax benefits and watching them disappear into the government’s coffers.

Protecting Your Clients from the Section 121 Minefield

Section 121’s technical requirements apply regardless of human circumstances. Understanding these nuances is essential for client protection, particularly when dealing with the complex scenarios that increasingly define modern family finances.

Wells emphasizes the importance of timing conversations with clients before they make irreversible decisions. His retirement planning example illustrates this perfectly. Catching the client’s plans early enough to restructure their approach saved them from losing substantial tax benefits. 

Determining which property qualifies as the principal residence requires analyzing multiple factors when clients own multiple homes. Wells explains that Treas. Reg. § 1.121-2(b)(2) provides guidance including “the taxpayer’s place of employment,” “where immediate family members live,” “mailing addresses for bills and correspondence,” “where is the taxpayer’s religious organizations, recreational clubs, social events,” and “what’s the address that the taxpayer uses on federal and state documents such as tax returns, driver’s licenses, automobile registrations, voter registrations.”

The ownership rules create additional planning opportunities and traps. While married couples need only one spouse to satisfy the ownership test, both must meet the use requirement, and importantly, “the usage does not have to be concurrent.” As Wells explains, “it’s entirely possible that each spouse uses it for a different two-year period out of the last five years before the sale.”

For aging clients, special provisions offer some relief. Wells notes that “taxpayers who move into assisted living might qualify as well. So a taxpayer incapable of self-care that moves into a licensed facility, such as a nursing home, may still qualify for the exclusion if they owned and used that property as a principal residence for periods aggregating at least one year during the five-year period preceding the sale.”

The depreciation recapture rules surprises many clients. Wells explains: “The exclusion does not apply to depreciation recapture. If that property is converted to a rental and then sold, even if there is some period of use there as a principal residence, we cannot use that exclusion against the depreciation recapture.” For homes with business use, “the taxpayer has to allocate the gain to the residential and the nonresidential portions of the property.” They can only exclude  the gain from the residential portion.”

These provisions interact in ways that can catch even experienced practitioners off guard. Successful Section 121 planning requires understanding the rules and how they interact with clients’ broader financial and personal circumstances.

In a highly appreciated housing market, the difference between qualifying for the full exclusion and losing it entirely can determine whether clients retire comfortably or face unexpected six-figure tax bills. As Wells concludes: “It’s incredibly important that we fully understand all of the nuances of the rules when it comes to excluding the gain and sale of the home. In their life, this could be one of the most significant, if not the most significant, financial transactions that a taxpayer is involved in.”

Your Clients’ Financial Future Hangs in the Balance

The Webert case offers a sobering reminder that in tax law, good intentions and compelling circumstances can be powerless against rigid technical requirements. Catherine and Steven Webert’s decade of responsible homeownership, their legitimate health crisis, and their reasonable responses to economic hardship meant nothing when measured against Section 121’s five-year lookback period. 

Tax professionals aren’t just managing technical compliance. They’re protecting what is likely the clients’ largest financial asset and most significant transaction. Listen to the full Tax in Action podcast to learn more about Section 121’s nuances. Missing its critical timing requirements can literally determine whether your clients retire comfortably or face devastating six-figure tax bills.

Three Safe Harbor Elections Could Save Thousands on Your Next Big Repair Project

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When a rental property owner faces a $27,000 repair bill, can they deduct these costs immediately as repairs, or must they capitalize them as improvements and depreciate them over decades?

This exact situation confronted Jeremy Wells, CPA, EA, in his tax practice when a client’s simple plumbing leak turned into a complex restoration project. What started as a ceiling drip in a two-story rental property led to $4,000 in plumbing repairs, a $16,000 bathroom renovation, a $4,000 water heater replacement, and $3,000 in ceiling and floor repairs.

In this episode of Tax in Action, Wells walks through this real case to show how the IRS determines when expenditures qualify as immediately deductible repairs versus when they must capitalize them as improvements. The difference can mean thousands in tax savings if you understand the rules and make the right elections before filing your return.

The Framework That Changed Everything

For years, tax professionals struggled with the gap between two key code sections. Section 162 allows businesses to deduct ordinary and necessary expenses, including repairs. Section 263A requires businesses to capitalize amounts paid to improve tangible property. But the law didn’t clearly define when you’re repairing property versus when you’re improving it.

“If we want to know if a certain type of expense is ordinary or necessary, and if it’s therefore deductible by a business, we look to Section 162,” Wells explains. “We also have Section 263A,  which tells us we have to capitalize amounts paid to acquire, produce, or improve tangible property.”

Treasury Decision 9636 finally bridged this gap. Released in the early 2010s, this collection of regulations established a clear framework for making repair versus improvement decisions. The document includes about 60 pages of explanation in its preamble, showing how the Treasury Department arrived at these rules and addressed public comments.

The framework centers on a two-part test. First, you must determine the “unit of property”—the actual asset you’re repairing or improving. Second, you must assess whether your expenditures constitute improvements to that unit of property.

Understanding Units of Property

Determining the unit of property isn’t always straightforward. Wells uses a car engine replacement to illustrate the concept.

“Think about a vehicle. I have to replace the engine. Is the unit of property the engine? Is it the entire vehicle?” The answer depends on what appears on your balance sheet or depreciation schedule. Since you typically depreciate the entire vehicle rather than individual components, the whole vehicle is the unit of property.

For buildings, the analysis is more complex. The regulations distinguish between building structure and building systems. The structure includes the building itself: walls, doors, windows, floors, ceilings, and permanent coverings like tile or brick. The systems include HVAC, plumbing, electrical, elevators, fire protection, gas distribution, and security systems.

“We have to distinguish between what is happening with the structure of this building versus what’s happening with the specific systems,” Wells notes. This distinction matters because repairs to different units of property receive independent analysis under the improvement rules.

In Wells’ rental property case, this meant treating the ceiling and floor repairs (building structure) separately from the plumbing work (plumbing system). Each unit of property required its own improvement analysis.

The Three Types of Improvements

Once you identify the unit of property, you must determine if your expenditures constitute improvements. The regulations define improvements as expenditures that produce one of three results: betterments, restorations, or adaptations.

Betterments

Betterments include three scenarios. First, fixing conditions or defects that existed before you acquired the property or arose during its use. Using the car engine example, Wells explains, “There is something in that engine that’s not quite working right, and that’s causing a problem for the operation of that vehicle.” Replacing that faulty engine improves the vehicle.

Second, betterments include additions like enlargements, expansions, or capacity increases. Wells draws from Florida real estate: “A lot of people have paved patios right outside the back door. They’ll want to turn that into some usable space that doesn’t have the heat and the direct sunlight and the bugs. So they wall that in and create a sunroom.” This transformation adds value and functionality.

Third, betterments cover changes that increase productivity, efficiency, strength, quality, or output. Replacing an old engine with a high-performance version that delivers better speed and efficiency would qualify.

Restorations

Restorations focus on returning property to proper working condition after damage or deterioration. “Think of some piece of property that has either been damaged or it’s just worn out over time to the point where it’s become either nonfunctional or just unusable,” Wells explains.

This concept applies especially to properties affected by natural disasters. If a tornado rips off your roof or a tree damages a wall, restoring the property to its pre-damage condition qualifies as an improvement under tax law, even though you’re not making it better than before.

Adaptations

Adaptations involve converting property to entirely different uses. Wells points to pandemic-era commercial real estate: “There were attempts to convert some of that office space into apartments.” This conversion requires extensive investment to add kitchens, appropriate bathrooms, and residential layouts, adapting the property for a new use.

When Related Costs Get Bundled Together

The regulations include a rule that often catches taxpayers off guard. When multiple expenditures stem from the same project, taxpayers must capitalize together costs that directly benefit and result from improvements.

In Wells’ case, this meant the $3,000 in ceiling and floor repairs couldn’t be treated separately from the bathroom renovation and plumbing restoration, despite appearing on different invoices from different contractors.

“When these kinds of expenses are all based around the same event, those costs that directly benefit and result from the improvement have to be capitalized as all part of that improvement as well,” Wells explains. “We can’t differentiate between the expenditures that went into fixing the plumbing versus fixing the floor and the ceiling versus improving the bathroom. This is all one project.”

The water heater replacement stood apart only because it was an independent decision. “All of the work done on the bathroom and the ceiling and the floor would have still happened exactly the same way, regardless of whether or not the taxpayer actually replaced that water heater.”

Three Safe Harbors Can Help

The IRS provides three safe harbors that can transform required capitalizations into immediate deductions. But all three are elective—you must actively choose to use them and document that election on your tax return.

The De Minimis Safe Harbor

The de minimis safe harbor election allows taxpayers to expense invoices or items below certain dollar thresholds. For businesses with applicable financial statements (SEC filings, audited financials, or non-tax statements required by government agencies), the threshold is $5,000 per invoice or item.

Most small businesses and rental property owners don’t have applicable financial statements. For these taxpayers, the threshold started at just $500 when the regulations were finalized. That amount proved so restrictive that business owners and tax advisors immediately complained.

“Even ten years ago, the cost of normal business equipment like computers, tablets, and cell phones were easily over $500,” Wells recalls. The IRS eventually increased the threshold to $2,500 through Notice 2015-82, providing more meaningful relief for routine business purchases.

The Safe Harbor for Small Taxpayers

The safe harbor election for small taxpayers specifically targets rental property owners. To qualify, you must have average annual gross receipts of $10 million or less over three years and own eligible building property with an unadjusted basis of $1 million or less.

This safe harbor works building by building. You can expense all repairs, maintenance, and improvements on a qualifying building if total annual costs don’t exceed $10,000 or 2% of the building’s unadjusted basis, whichever is less.

The Routine Maintenance Safe Harbor

The routine maintenance safe harbor election applies to activities you reasonably expect to perform at least once every ten years to keep building structures or systems operating efficiently. However, it explicitly excludes betterments, adaptations, and restorations.

Water heater replacements are a classic example. “Water heaters seem to last like every 6 to 8, maybe ten years,” Wells observes. “Every ten years or so, you need to plan on replacing a water heater.” In his practice, Wells regularly applies this safe harbor to water heater replacements.

Applying the Rules to Real Situations

In Wells’ $27,000 rental property case, applying the improvement framework reveals how the rules work in practice:

  • The $4,000 plumbing repairs constitute restoration, replacing worn, corroded components to return the system to working order
  • The $16,000 bathroom renovation represents betterment, improving the appearance and quality of fixtures that weren’t actually broken
  • The $3,000 ceiling and floor repairs must be capitalized with the other improvements as incidental costs
  • The $4,000 water heater replacement stands apart as an independent decision eligible for the routine maintenance safe harbor

None of the individual expenditures qualified for the de minimis safe harbor since all exceeded $2,500. The total project costs far surpassed the small taxpayer safe harbor limits as well.

But the water heater replacement offered a strategic opportunity. As an independent maintenance decision that falls within the routine ten-year replacement cycle, the taxpayer could immediately deduct it under the routine maintenance safe harbor if they make the proper election.

Making Elections Before It’s Too Late

All safe harbor elections require specific statements attached to timely filed returns, including extensions. Miss the election deadline, and the opportunity disappears permanently for that tax year. Make the election, and it applies to all qualifying expenditures—there’s no cherry-picking individual items.

“You need to attach a statement to the return saying the taxpayer makes the election,” Wells emphasizes. Renew these statements annually for continued use, because there’s flexibility to use safe harbors in some years but not others.

The Bottom Line for Tax Professionals

Wells’ case study demonstrates how identical expenditures can receive dramatically different tax treatment based on understanding available options and making proactive elections. The $4,000 water heater could provide immediate relief through the routine maintenance safe harbor, while the taxpayer had to capitalize the remaining $23,000 and depreciate it over decades.

“When it comes to the decision of whether to repair versus improve, it’s important to look at these regulations, to read through them, to ask yourself, are we bettering this property?” Wells concludes.

The framework offers practical guidance that can save thousands in immediate tax relief or cost clients decades of unnecessary capitalization. But it only helps those who understand the rules, recognize when safe harbors apply, and make the required elections before filing deadlines pass.

For tax professionals, this is the difference between reactive compliance and proactive planning. Your clients need advisors who anticipate these situations and structure approaches to maximize immediate deductions within regulatory boundaries. Understanding these repair versus improvement rules before you need them could save thousands when that next unexpected repair bill arrives.

Tax Law Rewards Professional Stagnation While Punishing Growth

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A Tennessee accountant diligently studies for and passes the CPA exam. His day-to-day work remains virtually identical: same clients, same responsibilities, same desk. Yet when tax season arrives, those CPA exam costs aren’t deductible. Why? Because becoming a CPA qualified him for a “new trade or business,” even though he had no intention of changing careers, and his actual work didn’t change at all.

This real case from Glenn v. Commissioner perfectly captures the absurd reality facing today’s professionals: the very credentials and education that make you more valuable in your current role often become non-deductible under tax law. Jeremy Wells dissects this paradox in his latest Tax in Action podcast episode, where he reveals how our tax system has created a knowledge economy trap that punishes professional advancement.

While tax law theoretically supports professional development through education deductions, it systematically penalizes advanced degrees, professional certifications, and career-expanding skills by classifying them as “personal investments” rather than business necessities. This leaves tax professionals and their clients caught in a regulatory maze where maintaining your current skill level is rewarded, while pursuing excellence faces potential penalties.

The Knowledge Economy Reality Check

“For quite a while now, most of the U.S. economy has been based on not the ability of people to produce things or do things with their hands, but rather the value of what they’re able to accomplish with their minds,” Wells explains.

The financial sector, insurance industry, and professional services all depend on knowledge work. Yet our tax system treats developing those valuable mental capabilities as personal indulgence rather than business necessity.

The existing education tax breaks demonstrate this disconnect clearly. The 529 plans that parents use to save for college offer no federal tax deduction for contributions, though some states do allow deductions. Student loan interest deductions under IRC Section 221 phase out based on income, effectively penalizing successful professionals. Education credits like the American Opportunity Credit and Lifetime Learning Credit focus on traditional college expenses, not the specialized training that drives value in today’s economy.

As Wells notes, these benefits can be rather limited. The problem isn’t that tax law ignores education entirely. It’s that the benefits don’t match the reality of professional development needs.

This brings us to the question Wells hears constantly from business owners: “Can I pay for my own education and use my business to do that?” The answer reveals just how complex this landscape has become.

Educational Assistance Programs: Promise and Pitfalls

The IRC Section 127 educational assistance programs initially appear to offer hope. These programs allow employers to provide up to $5,250 annually in tax-free educational benefits, and the definition of qualifying education is surprisingly broad.

Wells explains that under these programs, “education includes any form of instruction or training that improves or develops the capabilities of an individual.” Even better, “education is not limited to courses that are job-related or part of a degree program.” This could potentially cover everything from technical training to wellness courses that make employees “better people, more productive, happier.”

The program can cover tuition and fees, books, supplies, and equipment, and even student loan repayments. The definition of “employee” is also broad, including “self-employed individuals or what we might refer to as independent contractors.”

But here’s where the system reveals its bias against small business owners.

The fatal flaw lies in the anti-discrimination rules. Any business owner with more than a 5% stake in their company cannot claim more than 5% of the total benefits paid out by the program. As Wells explains, “If you are self-employed, and you want to use this program for yourself, and you have other employees, you, as a more than 5% owner of that business, cannot claim more than 5% of the benefits paid out by that program.”

The math is brutal. If you want to claim the full $5,250 benefit for your own education, your business would need to pay out at least $105,000 in total educational benefits to all participants. For most small businesses, this makes the program impractical.

The discrimination rules add another layer of complexity. Programs cannot favor highly compensated employees: those earning over $160,000 in 2025, those with 5% or greater ownership stakes, or those in the top 20% of employees ranked by compensation.

Wells notes that for many small business owners, this means they either “don’t do this program at all” or “just exclude themselves from the program.” And there’s another catch. Unlike cafeteria plans under IRC Section 125, you can’t offer employees a choice between the education benefit and additional cash compensation.

The program also has strict substantiation requirements. Employees must provide documented proof that expenses qualify, and they can’t double-dip by receiving reimbursement and then claiming education credits on their personal returns. Wells warns this is particularly important because “it’s entirely possible that that employee would then turn around and report those educational costs on their tax return and claim an education credit.”

When Business Owners Go Direct: The Section 162 Minefield

When educational assistance programs fail small business owners, they turn to direct business deductions under IRC Section 162. This is where things get really tricky.

Treasury Regulation 1.162-5 allows education deductions if the education “maintains or improves required skills” or “meets legal or employment requirements to maintain his or her present salary, status or job.” This generally includes professional continuing education and refresher courses.

The regulation also covers education to meet an employer’s minimum requirements “if the requirements are imposed for a bona fide business purpose.” Wells gives the example of requiring employees to take spreadsheet training because “we use a lot of spreadsheets in my business, and my employees need to be able to effectively use those spreadsheets.”

Even travel for education can be deductible if “the travel is directly related to the duties of the individual in employment” and “the major portion of that business needs to include activities directly maintaining or improving required skills.” However, taxpayers must allocate personal activities during the trip separately.

But here’s where the Tax Court draws its line in the sand.

The Tax Court’s War on Professional Growth

Treasury Regulation 1.162-5(b) establishes two types of education that are explicitly non-deductible, and the Tax Court has interpreted these restrictions aggressively.

First, taxpayers cannot deduct education that meets “necessary minimum educational requirements.”  Second, and far more damaging, education that “will lead to qualifying an individual for a new trade or business” is automatically disqualified.

The logic, Wells explains, is that these expenses are “essentially personal or perhaps capital expenditures” where “you’re investing in yourself.” The Tax Court views this as an “inseparable aggregate of personal and capital expenditures” rather than ordinary business expenses.

The cases reveal a pattern of hostility toward professional advancement that spans decades. In the Glenn case, the accountant couldn’t deduct CPA exam costs even though his work remained identical. The Tax Court ruled that becoming a CPA granted “certain rights, responsibilities, privileges that weren’t there before.”

The pattern repeats across professions. In Robinson v. Commissioner (1982), a licensed practical nurse completed an RN program while maintaining virtually identical duties. The Tax Court ruled against her because registered nurses have different capabilities than LPNs.

Even IRS employees get caught in this trap. In Weiler v. Commissioner (1970) and Taubman v. Commissioner (1973), IRS revenue agents couldn’t deduct law school costs despite arguing that legal training enhanced their current tax research abilities.

Law degrees face particularly harsh treatment. Wells notes that “law degrees generally qualify for a new trade or business” regardless of the taxpayer’s current profession or intentions.

The MBA Split Decision

The MBA cases show just how arbitrary these determinations can become. In 2016’s Gora v. Commissioner, the Tax Court allowed a financial controller’s executive MBA costs because his continued work in “management and finance” didn’t represent new qualifications.

Just one year later, in Kray v. Commissioner (2017), a computer design consultant’s identical executive MBA was ruled non-deductible because it qualified her for “new tasks” like “financial analysis, managing a business, managing and overseeing a staff.”

Wells warns that “an MBA may or may not qualify” as deductible, making this area particularly risky for taxpayers.

The Practical Reality for Tax Professionals

This creates impossible situations for tax professionals advising clients. The Tax Court’s standard isn’t whether you actually change careers or even want different opportunities. As Wells emphasizes, the keyword is “potentially”—education that could potentially qualify you for different work is probably non-deductible.

The system forces taxpayers to choose between pursuing valuable education that enhances their business capabilities but facing potential audit challenges, or limiting themselves to narrow, maintenance-level training that clearly fits within existing job requirements.

Wells notes that taxpayers must be “established in a trade or business” before education expenses become deductible, and the Tax Court has ruled that “a relatively short or temporary tenure in a job before starting the education doesn’t establish the taxpayer in the trade or business.”

Even holding a position doesn’t guarantee you’ve met minimum educational requirements. University teaching assistants, for example, haven’t met the minimum requirements for permanent faculty positions until they actually have their PhD.

Navigating the Knowledge Economy Trap

Our tax system rewards professional stagnation while punishing the learning that drives economic value. Tax professionals’ continuing education to maintain existing credentials? Fully deductible. Are the same professionals pursuing advanced degrees to better serve clients? Potentially non-deductible because it might qualify them for “new” responsibilities.

For tax professionals, this creates compliance challenges and ethical questions. Do we advise clients toward valuable education that faces potential tax challenges, or recommend they limit learning to “safe” options that maintain the status quo?

Wells warns that employers and self-employed individuals “really need to be careful when they’re trying to deduct those work-related education costs.” The Tax Court “can be pretty strict about education either meeting those minimum requirements for a profession or even more often than that, qualifying the recipient of that education for a new trade or business.”

Understanding these limitations is about recognizing how tax policy shapes professional development decisions across the entire economy. The knowledge economy demands continuous adaptation and skill development, but our tax code remains anchored to an industrial mindset that views capability expansion as personal indulgence rather than business necessity.

Listen to the full episode of the Tax in Action podcast for Wells’ complete analysis and detailed guidance to help clients make informed decisions about their professional development investments. Don’t let the knowledge economy trap catch you or your clients unprepared.

The Lookback Period Mistake That Turns Valid Refunds Into Permanent Losses

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Lenora Hamilton thought she had everything figured out. She filed her 2017 tax return in November 2021—late, but still claiming a $2,070 refund she believed was rightfully hers. The IRS immediately rejected her claim. She appealed, lost, and spent nearly a year fighting in federal court.

The final verdict in early 2025 delivered a crushing blow: the court ruled her claim was “timely filed,” but she couldn’t recover a single dollar. Not because the refund was wrong, but because she missed something called the “lookback period.” A technical timing rule had permanently erased her entire refund.

In a recent episode of the Tax in Action podcast, host Jeremy Wells used Hamilton’s story to explain the refund statute of limitations—a subject most tax professionals think they understand but actually don’t. The stakes are enormous: once these deadlines pass, Wells warns, “there’s virtually no going back.”

The Two-Step Framework That Trips Up Even Experienced Practitioners

Most tax professionals think the refund statute of limitations is straightforward. File within three years, get your refund. But Wells explains it’s a complex two-step process where each step has different rules and different consequences.

Step One: Can You File at All?

The first step determines whether you can file a refund claim. This “limitation period” is the later of either three years after the return was filed or two years after the tax was paid if no return was filed. Wells calls this the “refund statute end date,” and it’s your final deadline to file any claim.

Here’s the key detail that trips up practitioners: “The filing of an original return, not an amended return, begins the period of limitation,” Wells explains. This means if you amend a return filed years ago, you’re still working within the timeline set by that original filing date.

Step Two: How Much Can You Actually Get?

Even if you file a timely claim, step two determines how much you can recover through the “lookback period.” The rules change dramatically based on when you file:

  • File within three years: You can look back at the full three years
  • File after three years: Your lookback period shrinks to just two years

This is where Hamilton got trapped. The court found she filed a timely claim, satisfying step one. But because she filed her 2017 return so late—November 2021—her lookback period couldn’t reach back to her 2017 tax payments, which were deemed made on April 15, 2018.

As Wells puts it, “The court said she filed a timely claim for refund. However, for that timely claim, there was no refund available. What does that mean? How can that be?” To understand the answer, you have to know when the IRS considers payments “made” under tax law.

The Payment Timing Trap That Caught COVID-Era Taxpayers

The lookback period depends on when payments are “deemed made,” not when they actually happened. This creates counterintuitive situations that can permanently cost taxpayers money.

The Withholding Rule

Under IRC section 6513, all tax withheld from your paychecks during the year is deemed paid on April 15th of the following year. It doesn’t matter if the money was withheld in January or December—it’s all considered paid on April 15th.

For Hamilton, “Her 2018 withholding is deemed paid on April 15th, 2019, which is the 15th day of the fourth month following the close of that tax year.”

The COVID-19 Disaster

These timing rules created a perfect storm during the pandemic. The IRS postponed filing deadlines—2019 returns were due on July 15, 2020, and 2020 returns were due on May 17, 2021. But payments were still deemed made on April 15th of each year.

This trapped taxpayers who filed during the postponement periods. Someone who filed their 2019 return on July 15, 2020 (perfectly timely) might wait until July 15, 2023, to file a refund claim. Their three-year lookback would run from July 15, 202,3 back to July 15, 2020. But their 2019 payments were deemed made on April 15, 2020, which falls outside their lookback window.

Wells explains: “This left taxpayers who didn’t file extensions for those tax years stuck with potentially valid refund claims, yet they didn’t have any periods within the lookback period because those payments were still deemed filed as of April 15th.”

The IRS eventually provided relief through Notice 2021-21, but only after recognizing that its own timing rules created harsh consequences for taxpayers who did nothing wrong.

The Dangerous “Due Date” Myth Costing Taxpayers Money

A destructive misconception in refund statute law sounds perfectly reasonable: “You have three years from the due date to claim a refund.” 

But Wells makes it crystal clear that this perception isn’t accurate. “The end date is actually three years from the filing date or possibly two years from the payment date.” The due date might coincide with these periods for taxpayers who file on time, but it’s not what controls the deadline.

Why the Due Date Myth Fails

The due date myth crumbles in the exact situations where practitioners need precision most:

  • Late-filed returns: A taxpayer who files their 2020 return in September 2023 doesn’t have until April 15, 2024 to claim refunds. Their three-year period starts from September 2023.
  • Amended returns with post-deadline payments: Wells explains these create situations where “a valid refund claim made more than three years after the due date, could look back into those payments made after the deadline.”

The Hamilton case perfectly illustrates this. If you applied the due date myth, you’d think she was too late filing in November 2021 for a 2017 return. But the court found her claim was timely because the real rules don’t work that way.

The Professional Liability Risk

For tax professionals, relying on the due date myth creates serious liability exposure. When practitioners give advice based on this oversimplified rule, they risk costing clients money they can never recover.

Wells emphasizes the finality built into these rules: “Once that statute of limitations is up, once you have passed that refund statute end date, there is no going back with some very, very limited exceptions.”

Why These Rules Are So Unforgiving

The refund statute of limitations operates with mechanical precision, regardless of hardship or apparent unfairness. Courts consistently rule that these deadlines are clear and unambiguous, so there’s no room for equitable exceptions or reasonable cause relief.

The Finality Principle

Congress built finality into the tax code intentionally. As Wells explains: “There’s an implicit concept in the tax code that Congress has written into it. I tend to call it finality.” At some point, taxpayers should feel confident that old tax years are truly closed.

But this finality only works if practitioners understand the real rules. The Hamilton case, with its modest $2,070 refund that became a years-long legal battle, shows how even small amounts trigger the same unforgiving rules that govern million-dollar refunds.

The Stakes for Tax Professionals

These rules affect every practitioner who works with amended returns, late filers, or clients with potential refund claims. Understanding when the IRS deems payments made, how postponements interact with lookback periods, and when the due date myth doesn’t apply isn’t just technical knowledge—it’s client protection. And it can be the difference between recovering thousands of dollars and losing them forever.

When Time Runs Out, Money Disappears Forever

The refund statute of limitations represents tax law at its most technically demanding and unforgiving. The two-step framework of limitation periods and lookback periods creates a system where understanding timing rules can mean the difference between financial recovery and permanent loss.

For tax professionals, these rules represent the intersection of expertise and fiduciary responsibility. Relying on oversimplified rules or misunderstand the distinction between filing dates and due dates means risking giving advice that permanently costs clients money.

This finality places enormous responsibility on practitioners to understand and navigate these rules correctly.

Don’t let technical complexity cost your clients money they can never recover. Listen to Wells’ complete Tax in Action episode to master these critical timing rules and protect your clients’ interests and your professional reputation.