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Aarp free tax preparation 5. Aarp free tax preparation   Soil and Water Conservation Expenses Table of Contents Introduction Topics - This chapter discusses: Business of Farming Plan Certification Conservation ExpensesWater well. Aarp free tax preparation Assessment by Conservation DistrictAssessment for Depreciable Property 25% Limit on DeductionNet operating loss. Aarp free tax preparation When to Deduct or Capitalize Sale of a Farm Introduction If you are in the business of farming, you can choose to deduct certain expenses for: Soil or water conservation, Prevention of erosion of land used in farming, or Endangered species recovery. Aarp free tax preparation Otherwise, these are capital expenses that must be added to the basis of the land. Aarp free tax preparation (See chapter 6 for information on determining basis. Aarp free tax preparation ) Conservation expenses for land in a foreign country do not qualify for this special treatment. Aarp free tax preparation The deduction for conservation expenses cannot be more than 25% of your gross income from farming. Aarp free tax preparation See 25% Limit on Deduction , later. Aarp free tax preparation Although some expenses are not deductible as soil and water conservation expenses, they may be deductible as ordinary and necessary farm expenses. Aarp free tax preparation These include interest and taxes, the cost of periodically clearing brush from productive land, the regular removal of sediment from a drainage ditch, and expenses paid or incurred primarily to produce an agricultural crop that may also conserve soil. Aarp free tax preparation You must include in income most government payments for approved conservation practices. Aarp free tax preparation However, you can exclude some payments you receive under certain cost-sharing conservation programs. Aarp free tax preparation For more information, see Agricultural Program Payments in chapter 3. Aarp free tax preparation To get the full deduction to which you are entitled, you should maintain your records to clearly distinguish between your ordinary and necessary farm business expenses and your soil and water conservation expenses. Aarp free tax preparation Topics - This chapter discusses: Business of farming Plan certification Conservation expenses Assessment by conservation district 25% limit on deduction When to deduct or capitalize Sale of a farm Business of Farming For purposes of soil and water conservation expenses, you are in the business of farming if you cultivate, operate, or manage a farm for profit, either as an owner or a tenant. Aarp free tax preparation You are not in the business of farming if you cultivate or operate a farm for recreation or pleasure, rather than for profit. Aarp free tax preparation You are not farming if you are engaged only in forestry or the growing of timber. Aarp free tax preparation Farm defined. Aarp free tax preparation   A farm includes livestock, dairy, poultry, fish, fruit, and truck farms. Aarp free tax preparation It also includes plantations, ranches, ranges, and orchards. Aarp free tax preparation A fish farm is an area where fish and other marine animals are grown or raised and artificially fed, protected, etc. Aarp free tax preparation It does not include an area where they are merely caught or harvested. Aarp free tax preparation A plant nursery is a farm for purposes of deducting soil and water conservation expenses. Aarp free tax preparation Farm rental. Aarp free tax preparation   If you own a farm and receive farm rental payments based on farm production, either in cash or crop shares, you are in the business of farming. Aarp free tax preparation If you get cash rental for a farm you own that is not used in farm production, you cannot deduct soil and water conservation expenses for that farm. Aarp free tax preparation   If you receive a fixed rental payment that is not based on farm production, you are in the business of farming only if you materially participate in operating or managing the farm. Aarp free tax preparation Example. Aarp free tax preparation You own a farm in Iowa and live in California. Aarp free tax preparation You rent the farm for $175 in cash per acre and do not materially participate in producing or managing production of the crops grown on the farm. Aarp free tax preparation You cannot deduct your soil conservation expenses for this farm. Aarp free tax preparation You must capitalize the expenses and add them to the basis of the land. Aarp free tax preparation     For more information, see Material participation for landlords under Landlord Participation in Farming in chapter 12. Aarp free tax preparation Plan Certification You can deduct soil and water conservation expenses only if they are consistent with a plan approved by the Natural Resources Conservation Service (NRCS) of the Department of Agriculture. Aarp free tax preparation If no such plan exists, the expenses must be consistent with a soil conservation plan of a comparable state agency. Aarp free tax preparation Keep a copy of the plan with your books and records to support your deductions. Aarp free tax preparation Conservation plan. Aarp free tax preparation   A conservation plan includes the farming conservation practices approved for the area where your farmland is located. Aarp free tax preparation There are three types of approved plans. Aarp free tax preparation NRCS individual site plans. Aarp free tax preparation These plans are issued individually to farmers who request assistance from NRCS to develop a conservation plan designed specifically for their farmland. Aarp free tax preparation NRCS county plans. Aarp free tax preparation These plans include a listing of farm conservation practices approved for the county where the farmland is located. Aarp free tax preparation You can deduct expenses for conservation practices not included on the NRCS county plans only if the practice is a part of an individual site plan. Aarp free tax preparation Comparable state agency plans. Aarp free tax preparation These plans are approved by state agencies and can be approved individual site plans or county plans. Aarp free tax preparation   A list of NRCS conservation programs is available at www. Aarp free tax preparation nrcs. Aarp free tax preparation usda. Aarp free tax preparation gov/programs. Aarp free tax preparation Individual site plans can be obtained from NRCS offices and the comparable state agencies. Aarp free tax preparation Conservation Expenses You can deduct conservation expenses only for land you or your tenant are using, or have used in the past, for farming. Aarp free tax preparation These expenses include, but are not limited to, the following. Aarp free tax preparation The treatment or movement of earth, such as: Leveling, Conditioning, Grading, Terracing, Contour furrowing, and Restoration of soil fertility. Aarp free tax preparation The construction, control, and protection of: Diversion channels, Drainage ditches, Irrigation ditches, Earthen dams, and Watercourses, outlets, and ponds. Aarp free tax preparation The eradication of brush. Aarp free tax preparation The planting of windbreaks. Aarp free tax preparation You cannot deduct expenses to drain or fill wetlands, or to prepare land for center pivot irrigation systems, as soil and water conservation expenses. Aarp free tax preparation These expenses are added to the basis of the land. Aarp free tax preparation If you choose to deduct soil and water conservation expenses, you cannot exclude from gross income any cost-sharing payments you receive for those expenses. Aarp free tax preparation See chapter 3 for information about payments eligible for the cost-sharing exclusion. Aarp free tax preparation New farm or farmland. Aarp free tax preparation   If you acquire a new farm or new farmland from someone who was using it in farming immediately before you acquired the land, soil and water conservation expenses you incur on it will be treated as made on land used in farming at the time the expenses were paid or incurred. Aarp free tax preparation You can deduct soil and water conservation expenses for this land if your use of it is substantially a continuation of its use in farming. Aarp free tax preparation The new farming activity does not have to be the same as the old farming activity. Aarp free tax preparation For example, if you buy land that was used for grazing cattle and then prepare it for use as an apple orchard, you can deduct your conservation expenses. Aarp free tax preparation Land not used for farming. Aarp free tax preparation   If your conservation expenses benefit both land that does not qualify as land used for farming and land that does qualify, you must allocate the expenses between the two types of land. Aarp free tax preparation For example, if the expenses benefit 200 acres of your land, but only 120 acres of this land are used for farming, then you can deduct 60% (120 ÷ 200) of the expenses. Aarp free tax preparation You can use another method to allocate these expenses if you can clearly show that your method is more reasonable. Aarp free tax preparation Depreciable conservation assets. Aarp free tax preparation   You generally cannot deduct your expenses for depreciable conservation assets. Aarp free tax preparation However, you can deduct certain amounts you pay or incur for an assessment for depreciable property that a soil and water conservation or drainage district levies against your farm. Aarp free tax preparation See Assessment for Depreciable Property , later. Aarp free tax preparation   You must capitalize expenses to buy, build, install, or improve depreciable structures or facilities. Aarp free tax preparation These expenses include those for materials, supplies, wages, fuel, hauling, and moving dirt when making structures such as tanks, reservoirs, pipes, culverts, canals, dams, wells, or pumps composed of masonry, concrete, tile, metal, or wood. Aarp free tax preparation You recover your capital investment through annual allowances for depreciation. Aarp free tax preparation   You can deduct soil and water conservation expenses for nondepreciable earthen items. Aarp free tax preparation Nondepreciable earthen items include certain dams, ponds, and terraces described under Property Having a Determinable Useful Life in chapter 7. Aarp free tax preparation Water well. Aarp free tax preparation   You cannot deduct the cost of drilling a water well for irrigation and other agricultural purposes as a soil and water conservation expense. Aarp free tax preparation It is a capital expense. Aarp free tax preparation You recover your cost through depreciation. Aarp free tax preparation You also must capitalize your cost for drilling a test hole. Aarp free tax preparation If the test hole produces no water and you continue drilling, the cost of the test hole is added to the cost of the producing well. Aarp free tax preparation You can recover the total cost through depreciation deductions. Aarp free tax preparation   If a test hole, dry hole, or dried-up well (resulting from prolonged lack of rain, for instance) is abandoned, you can deduct your unrecovered cost in the year of abandonment. Aarp free tax preparation Abandonment means that all economic benefits from the well are terminated. Aarp free tax preparation For example, filling or sealing a well excavation or casing so that all economic benefits from the well are terminated constitutes an abandonment. Aarp free tax preparation Endangered species recovery expenses. Aarp free tax preparation   If you are in the business of farming and meet other specific requirements, you can choose to deduct the conservation expenses discussed earlier as endangered species recovery expenses. Aarp free tax preparation Otherwise, these are capital expenses that must be added to the basis of the land. Aarp free tax preparation   The expenses must be paid or incurred for the purpose of achieving site-specific management actions recommended in a recovery plan approved under section 4(f) of the Endangered Species Act of 1973. Aarp free tax preparation See Internal Revenue Code section 175 for more information. Aarp free tax preparation Assessment by Conservation District In some localities, a soil or water conservation or drainage district incurs expenses for soil or water conservation and levies an assessment against the farmers who benefit from the expenses. Aarp free tax preparation You can deduct as a conservation expense amounts you pay or incur for the part of an assessment that: Covers expenses you could deduct if you had paid them directly, or Covers expenses for depreciable property used in the district's business. Aarp free tax preparation Assessment for Depreciable Property You generally can deduct as a conservation expense amounts you pay or incur for the part of a conservation or drainage district assessment that covers expenses for depreciable property. Aarp free tax preparation This includes items such as pumps, locks, concrete structures (including dams and weir gates), draglines, and similar equipment. Aarp free tax preparation The depreciable property must be used in the district's soil and water conservation activities. Aarp free tax preparation However, the following limits apply to these assessments. Aarp free tax preparation The total assessment limit. Aarp free tax preparation The yearly assessment limit. Aarp free tax preparation After you apply these limits, the amount you can deduct is added to your other conservation expenses for the year. Aarp free tax preparation The total for these expenses is then subject to the 25% of gross income from farming limit on the deduction, discussed later. Aarp free tax preparation See Table 5-1 for a brief summary of these limits. Aarp free tax preparation Table 5-1. Aarp free tax preparation Limits on Deducting an Assessment by a Conservation District for Depreciable Property Total Limit on Deduction for Assessment for Depreciable Property Yearly Limit on Deduction for Assessment for Depreciable Property Yearly Limit for All Conservation Expenses 10% of: $500 + 10% of: 25% of: Total assessment against all members of the district for the property. Aarp free tax preparation Your deductible share of the cost to the district for the property. Aarp free tax preparation Your gross income from farming. Aarp free tax preparation No one taxpayer can deduct more than 10% of the total assessment. Aarp free tax preparation Any amount over 10% is a capital expense and is added to the basis of your land. Aarp free tax preparation If an assessment is paid in installments, each payment must be prorated between the conservation expense and the capital expense. Aarp free tax preparation If the amount you pay or incur for any year is more than the limit, you can deduct for that year only 10% of your deductible share of the cost. Aarp free tax preparation You can deduct the remainder in equal amounts over the next 9 tax years. Aarp free tax preparation Limit for all conservation expenses, including assessments for depreciable property. Aarp free tax preparation Amounts greater than 25% can be carried to the following year and added to that year's expenses. Aarp free tax preparation The total is then subject to the 25% of gross income from farming limit in that year. Aarp free tax preparation To ensure your deduction is within the deduction limits, keep records to show the following. Aarp free tax preparation The total assessment against all members of the district for the depreciable property. Aarp free tax preparation Your deductible share of the cost to the district for the depreciable property. Aarp free tax preparation Your gross income from farming. Aarp free tax preparation Total assessment limit. Aarp free tax preparation   You cannot deduct more than 10% of the total amount assessed to all members of the conservation or drainage district for the depreciable property. Aarp free tax preparation This applies whether you pay the assessment in one payment or in installments. Aarp free tax preparation If your assessment is more than 10% of the total amount assessed, both the following rules apply. Aarp free tax preparation The amount over 10% is a capital expense and is added to the basis of your land. Aarp free tax preparation If the assessment is paid in installments, each payment must be prorated between the conservation expense and the capital expense. Aarp free tax preparation Yearly assessment limit. Aarp free tax preparation   The maximum amount you can deduct in any one year is the total of 10% of your deductible share of the cost as explained earlier, plus $500. Aarp free tax preparation If the amount you pay or incur is equal to or less than the maximum amount, you can deduct it in the year it is paid or incurred. Aarp free tax preparation If the amount you pay or incur is more, you can deduct in that year only 10% of your deductible share of the cost. Aarp free tax preparation You can deduct the remainder in equal amounts over the next 9 tax years. Aarp free tax preparation Your total conservation expense deduction for each year is also subject to the 25% of gross income from farming limit on the deduction, discussed later. Aarp free tax preparation Example 1. Aarp free tax preparation This year, the soil conservation district levies and you pay an assessment of $2,400 against your farm. Aarp free tax preparation Of the assessment, $1,500 is for digging drainage ditches. Aarp free tax preparation You can deduct this part as a soil or conservation expense as if you had paid it directly. Aarp free tax preparation The remaining $900 is for depreciable equipment to be used in the district's irrigation activities. Aarp free tax preparation The total amount assessed by the district against all its members for the depreciable equipment is $7,000. Aarp free tax preparation The total amount you can deduct for the depreciable equipment is limited to 10% of the total amount assessed by the district against all its members for depreciable equipment, or $700. Aarp free tax preparation The $200 excess ($900 − $700) is a capital expense you must add to the basis of your farm. Aarp free tax preparation To figure the maximum amount you can deduct for the depreciable equipment this year, multiply your deductible share of the total assessment ($700) by 10%. Aarp free tax preparation Add $500 to the result for a total of $570. Aarp free tax preparation Your deductible share, $700, is greater than the maximum amount deductible in one year, so you can deduct only $70 of the amount you paid or incurred for depreciable property this year (10% of $700). Aarp free tax preparation You can deduct the balance at the rate of $70 a year over the next 9 years. Aarp free tax preparation You add $70 to the $1,500 portion of the assessment for drainage ditches. Aarp free tax preparation You can deduct $1,570 of the $2,400 assessment as a soil and water conservation expense this year, subject to the 25% of gross income from farming limit on the deduction, discussed later. Aarp free tax preparation Example 2. Aarp free tax preparation Assume the same facts in Example 1 except that $1,850 of the $2,400 assessment is for digging drainage ditches and $550 is for depreciable equipment. Aarp free tax preparation The total amount assessed by the district against all its members for depreciable equipment is $5,500. Aarp free tax preparation The total amount you can deduct for the depreciable equipment is limited to 10% of this amount, or $550. Aarp free tax preparation The maximum amount you can deduct this year for the depreciable equipment is $555 (10% of your deductible share of the total assessment, $55, plus $500). Aarp free tax preparation Since your deductible share is less than the maximum amount deductible in one year, you can deduct the entire $550 this year. Aarp free tax preparation You can deduct the entire assessment, $2,400, as a soil and water conservation expense this year, subject to the 25% of gross income from farming limit on the deduction, discussed below. Aarp free tax preparation Sale or other disposal of land during 9-year period. Aarp free tax preparation   If you dispose of the land during the 9-year period for deducting conservation expenses subject to the yearly limit, any amounts you have not yet deducted because of this limit are added to the basis of the property. Aarp free tax preparation Death of farmer during 9-year period. Aarp free tax preparation   If a farmer dies during the 9-year period, any remaining amounts not yet deducted are deducted in the year of death. Aarp free tax preparation 25% Limit on Deduction The total deduction for conservation expenses in any tax year is limited to 25% of your gross income from farming for the year. Aarp free tax preparation Gross income from farming. Aarp free tax preparation   Gross income from farming is the income you derive in the business of farming from the production of crops, fish, fruits, other agricultural products, or livestock. Aarp free tax preparation Gains from sales of draft, breeding, or dairy livestock are included. Aarp free tax preparation Gains from sales of assets such as farm machinery, or from the disposition of land, are not included. Aarp free tax preparation Carryover of deduction. Aarp free tax preparation   If your deductible conservation expenses in any year are more than 25% of your gross income from farming for that year, you can carry the unused deduction over to later years. Aarp free tax preparation However, the deduction in any later year is limited to 25% of the gross income from farming for that year as well. Aarp free tax preparation Example. Aarp free tax preparation In 2012, you have gross income of $32,000 from two farms. Aarp free tax preparation During the year, you incurred $10,000 of deductible soil and water conservation expenses for one of the farms. Aarp free tax preparation However, your deduction is limited to 25% of $32,000, or $8,000. Aarp free tax preparation The $2,000 excess ($10,000 − $8,000) is carried over to 2013 and added to deductible soil and water conservation expenses made in that year. Aarp free tax preparation The total of the 2012 carryover plus 2013 expenses is deductible in 2013, subject to the limit of 25% of your gross income from farming in 2013. Aarp free tax preparation Any expenses over the limit in that year are carried to 2014 and later years. Aarp free tax preparation Net operating loss. Aarp free tax preparation   The deduction for soil and water conservation expenses, after applying the 25% limit, is included when figuring a net operating loss (NOL) for the year. Aarp free tax preparation If the NOL is carried to another year, the soil and water conservation deduction included in the NOL is not subject to the 25% limit in the year to which it is carried. Aarp free tax preparation When to Deduct or Capitalize If you choose to deduct soil and water conservation expenses, you must deduct the total allowable amount on your tax return for the first year you pay or incur these expenses. Aarp free tax preparation If you do not choose to deduct the expenses, you must capitalize them. Aarp free tax preparation Change of method. Aarp free tax preparation   If you want to change your method for the treatment of soil and water conservation expenses, or you want to treat the expenses for a particular project or a single farm in a different manner, you must get the approval of the IRS. Aarp free tax preparation To get this approval, submit a written request by the due date of your return for the first tax year you want the new method to apply. Aarp free tax preparation You or your authorized representative must sign the request. Aarp free tax preparation   The request must include the following information. Aarp free tax preparation Your name and address. Aarp free tax preparation The first tax year the method or change of method is to apply. Aarp free tax preparation Whether the method or change of method applies to all your soil and water conservation expenses or only to those for a particular project or farm. Aarp free tax preparation If the method or change of method does not apply to all your expenses, identify the project or farm to which the expenses apply. Aarp free tax preparation The total expenses you paid or incurred in the first tax year the method or change of method is to apply. Aarp free tax preparation A statement that you will account separately in your books for the expenses to which this method or change of method relates. Aarp free tax preparation Send your request to the following  address. Aarp free tax preparation  Department of the Treasury Internal Revenue Service Center Cincinnati, OH 45999  For more information, see Change in  Accounting Method in chapter 2. Aarp free tax preparation Sale of a Farm If you sell your farm, you cannot adjust the basis of the land at the time of the sale for any unused carryover of soil and water conservation expenses (except for deductions of assessments for depreciable property, discussed earlier). Aarp free tax preparation However, if you acquire another farm and return to the business of farming, you can start taking deductions again for the unused carryovers. Aarp free tax preparation Gain on sale of farmland. Aarp free tax preparation   If you held the land 5 years or less before you sold it, gain on the sale of the land is treated as ordinary income up to the amount you previously deducted for soil and water conservation expenses. Aarp free tax preparation If you held the land less than 10 but more than 5 years, the gain is treated as ordinary income up to a specified percentage of the previous deductions. Aarp free tax preparation See Section 1252 property under Other Gains in chapter 9. 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Aarp free tax preparation 1. Aarp free tax preparation   Deducting Business Expenses Table of Contents What's New Introduction Topics - This chapter discusses: Useful Items - You may want to see: What Can I Deduct?Cost of Goods Sold Capital Expenses Capital versus Deductible Expenses Personal versus Business Expenses How Much Can I Deduct?Not-for-profit limits. Aarp free tax preparation At-risk limits. Aarp free tax preparation Passive activities. Aarp free tax preparation Net operating loss. Aarp free tax preparation When Can I Deduct an Expense?Economic performance. Aarp free tax preparation Not-for-Profit ActivitiesGross Income Limit on Deductions What's New Optional safe harbor method to determine the business use of a home deduction. Aarp free tax preparation  Beginning in 2013, you can use the optional safe harbor method to determine the deduction for the business use of your home. Aarp free tax preparation See Optional safe harbor method under Business use of your home , later. Aarp free tax preparation Introduction This chapter covers the general rules for deducting business expenses. Aarp free tax preparation Business expenses are the costs of carrying on a trade or business, and they are usually deductible if the business is operated to make a profit. Aarp free tax preparation Topics - This chapter discusses: What you can deduct How much you can deduct When you can deduct Not-for-profit activities Useful Items - You may want to see: Publication 334 Tax Guide for Small Business 463 Travel, Entertainment, Gift, and Car Expenses 525 Taxable and Nontaxable Income 529 Miscellaneous Deductions 536 Net Operating Losses (NOLs) for Individuals, Estates, and Trusts 538 Accounting Periods and Methods 542 Corporations 547 Casualties, Disasters, and Thefts 587 Business Use of Your Home 925 Passive Activity and At-Risk Rules 936 Home Mortgage Interest Deduction 946 How To Depreciate Property Form (and Instructions) Sch A (Form 1040) Itemized Deductions 5213 Election To Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit See chapter 12 for information about getting publications and forms. Aarp free tax preparation What Can I Deduct? To be deductible, a business expense must be both ordinary and necessary. Aarp free tax preparation An ordinary expense is one that is common and accepted in your industry. Aarp free tax preparation A necessary expense is one that is helpful and appropriate for your trade or business. Aarp free tax preparation An expense does not have to be indispensable to be considered necessary. Aarp free tax preparation Even though an expense may be ordinary and necessary, you may not be allowed to deduct the expense in the year you paid or incurred it. Aarp free tax preparation In some cases you may not be allowed to deduct the expense at all. Aarp free tax preparation Therefore, it is important to distinguish usual business expenses from expenses that include the following. Aarp free tax preparation The expenses used to figure cost of goods sold, Capital expenses, and Personal expenses. Aarp free tax preparation Cost of Goods Sold If your business manufactures products or purchases them for resale, you generally must value inventory at the beginning and end of each tax year to determine your cost of goods sold. Aarp free tax preparation Some of your business expenses may be included in figuring cost of goods sold. Aarp free tax preparation Cost of goods sold is deducted from your gross receipts to figure your gross profit for the year. Aarp free tax preparation If you include an expense in the cost of goods sold, you cannot deduct it again as a business expense. Aarp free tax preparation The following are types of expenses that go into figuring cost of goods sold. Aarp free tax preparation The cost of products or raw materials, including freight. Aarp free tax preparation Storage. Aarp free tax preparation Direct labor (including contributions to pension or annuity plans) for workers who produce the products. Aarp free tax preparation Factory overhead. Aarp free tax preparation Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. Aarp free tax preparation Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs. Aarp free tax preparation This rule does not apply to personal property you acquire for resale if your average annual gross receipts (or those of your predecessor) for the preceding 3 tax years are not more than $10 million. Aarp free tax preparation For more information, see the following sources. Aarp free tax preparation Cost of goods sold—chapter 6 of Publication 334. Aarp free tax preparation Inventories—Publication 538. Aarp free tax preparation Uniform capitalization rules—Publication 538 and section 263A of the Internal Revenue Code and the related regulations. Aarp free tax preparation Capital Expenses You must capitalize, rather than deduct, some costs. Aarp free tax preparation These costs are a part of your investment in your business and are called “capital expenses. Aarp free tax preparation ” Capital expenses are considered assets in your business. Aarp free tax preparation In general, you capitalize three types of costs. Aarp free tax preparation Business start-up costs (See Tip below). Aarp free tax preparation Business assets. Aarp free tax preparation Improvements. Aarp free tax preparation You can elect to deduct or amortize certain business start-up costs. Aarp free tax preparation See chapters 7 and 8. Aarp free tax preparation Cost recovery. Aarp free tax preparation   Although you generally cannot take a current deduction for a capital expense, you may be able to recover the amount you spend through depreciation, amortization, or depletion. Aarp free tax preparation These recovery methods allow you to deduct part of your cost each year. Aarp free tax preparation In this way, you are able to recover your capital expense. Aarp free tax preparation See Amortization (chapter 8) and Depletion (chapter 9) in this publication. Aarp free tax preparation A taxpayer can elect to deduct a portion of the costs of certain depreciable property as a section 179 deduction. Aarp free tax preparation A greater portion of these costs can be deducted if the property is qualified disaster assistance property. Aarp free tax preparation See Publication 946 for details. Aarp free tax preparation Going Into Business The costs of getting started in business, before you actually begin business operations, are capital expenses. Aarp free tax preparation These costs may include expenses for advertising, travel, or wages for training employees. Aarp free tax preparation If you go into business. Aarp free tax preparation   When you go into business, treat all costs you had to get your business started as capital expenses. Aarp free tax preparation   Usually you recover costs for a particular asset through depreciation. Aarp free tax preparation Generally, you cannot recover other costs until you sell the business or otherwise go out of business. Aarp free tax preparation However, you can choose to amortize certain costs for setting up your business. Aarp free tax preparation See Starting a Business in chapter 8 for more information on business start-up costs. Aarp free tax preparation If your attempt to go into business is unsuccessful. Aarp free tax preparation   If you are an individual and your attempt to go into business is not successful, the expenses you had in trying to establish yourself in business fall into two categories. Aarp free tax preparation The costs you had before making a decision to acquire or begin a specific business. Aarp free tax preparation These costs are personal and nondeductible. Aarp free tax preparation They include any costs incurred during a general search for, or preliminary investigation of, a business or investment possibility. Aarp free tax preparation The costs you had in your attempt to acquire or begin a specific business. Aarp free tax preparation These costs are capital expenses and you can deduct them as a capital loss. Aarp free tax preparation   If you are a corporation and your attempt to go into a new trade or business is not successful, you may be able to deduct all investigatory costs as a loss. Aarp free tax preparation   The costs of any assets acquired during your unsuccessful attempt to go into business are a part of your basis in the assets. Aarp free tax preparation You cannot take a deduction for these costs. Aarp free tax preparation You will recover the costs of these assets when you dispose of them. Aarp free tax preparation Business Assets There are many different kinds of business assets; for example, land, buildings, machinery, furniture, trucks, patents, and franchise rights. Aarp free tax preparation You must fully capitalize the cost of these assets, including freight and installation charges. Aarp free tax preparation Certain property you produce for use in your trade or business must be capitalized under the uniform capitalization rules. Aarp free tax preparation See Regulations section 1. Aarp free tax preparation 263A-2 for information on these rules. Aarp free tax preparation Improvements Improvements are generally major expenditures. Aarp free tax preparation Some examples are: new electric wiring, a new roof, a new floor, new plumbing, bricking up windows to strengthen a wall, and lighting improvements. Aarp free tax preparation The costs of making improvements to a business asset are capital expenses if the improvements add to the value of the asset, appreciably lengthen the time you can use it, or adapt it to a different use. Aarp free tax preparation Beginning in 2014, you must capitalize as improvements costs that are for the betterment of a unit of property, restore the unit of property, or adapt the unit of property to a new or different use. Aarp free tax preparation Temporary regulations allow you to capitalize costs meeting the above criteria for tax years beginning after 2011. Aarp free tax preparation However, you can currently deduct repairs that keep your property in a normal efficient operating condition as a business expense. Aarp free tax preparation Treat as repairs amounts paid to replace parts of a machine that only keep it in a normal operating condition. Aarp free tax preparation Restoration plan. Aarp free tax preparation   Capitalize the cost of reconditioning, improving, or altering your property as part of a general restoration plan to make it suitable for your business. Aarp free tax preparation This applies even if some of the work would by itself be classified as repairs. Aarp free tax preparation Capital versus Deductible Expenses To help you distinguish between capital and deductible expenses, different examples are given below. Aarp free tax preparation Motor vehicles. Aarp free tax preparation   You usually capitalize the cost of a motor vehicle you use in your business. Aarp free tax preparation You can recover its cost through annual deductions for depreciation. Aarp free tax preparation   There are dollar limits on the depreciation you can claim each year on passenger automobiles used in your business. Aarp free tax preparation See Publication 463. Aarp free tax preparation   Generally, repairs you make to your business vehicle are currently deductible. Aarp free tax preparation However, amounts you pay to recondition and overhaul a business vehicle are capital expenses and are recovered through depreciation. Aarp free tax preparation Roads and driveways. Aarp free tax preparation    The cost of building a private road on your business property and the cost of replacing a gravel driveway with a concrete one are capital expenses you may be able to depreciate. Aarp free tax preparation The cost of maintaining a private road on your business property is a deductible expense. Aarp free tax preparation Tools. Aarp free tax preparation   Unless the uniform capitalization rules apply, amounts spent for tools used in your business are deductible expenses if the tools have a life expectancy of less than 1 year or their cost is minor. Aarp free tax preparation Machinery parts. Aarp free tax preparation   Unless the uniform capitalization rules apply, the cost of replacing short-lived parts of a machine to keep it in good working condition, but not add to its life, is a deductible expense. Aarp free tax preparation Heating equipment. Aarp free tax preparation   The cost of changing from one heating system to another is a capital expense. Aarp free tax preparation Personal versus Business Expenses Generally, you cannot deduct personal, living, or family expenses. Aarp free tax preparation However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. Aarp free tax preparation You can deduct the business part. Aarp free tax preparation For example, if you borrow money and use 70% of it for business and the other 30% for a family vacation, you generally can deduct 70% of the interest as a business expense. Aarp free tax preparation The remaining 30% is personal interest and generally is not deductible. Aarp free tax preparation See chapter 4 for information on deducting interest and the allocation rules. Aarp free tax preparation Business use of your home. Aarp free tax preparation   If you use part of your home for business, you may be able to deduct expenses for the business use of your home. Aarp free tax preparation These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation. Aarp free tax preparation   To qualify to claim expenses for the business use of your home, you must meet both of the following tests. Aarp free tax preparation The business part of your home must be used exclusively and regularly for your trade or business. Aarp free tax preparation The business part of your home must be: Your principal place of business, or A place where you meet or deal with patients, clients, or customers in the normal course of your trade or business, or A separate structure (not attached to your home) used in connection with your trade or business. Aarp free tax preparation   You generally do not have to meet the exclusive use test for the part of your home that you regularly use either for the storage of inventory or product samples, or as a daycare facility. Aarp free tax preparation   Your home office qualifies as your principal place of business if you meet the following requirements. Aarp free tax preparation You use the office exclusively and regularly for administrative or management activities of your trade or business. Aarp free tax preparation You have no other fixed location where you conduct substantial administrative or management activities of your trade or business. Aarp free tax preparation   If you have more than one business location, determine your principal place of business based on the following factors. Aarp free tax preparation The relative importance of the activities performed at each location. Aarp free tax preparation If the relative importance factor does not determine your principal place of business, consider the time spent at each location. Aarp free tax preparation Optional safe harbor method. Aarp free tax preparation   Beginning in 2013, individual taxpayers can use the optional safe harbor method to determine the amount of deductible expenses attributable to certain business use of a residence during the tax year. Aarp free tax preparation This method is an alternative to the calculation, allocation, and substantiation of actual expenses. Aarp free tax preparation   The deduction under the optional method is limited to $1,500 per year based on $5 a square foot for up to 300 square feet. Aarp free tax preparation Under this method, you claim your allowable mortgage interest, real estate taxes, and casualty losses on the home as itemized deductions on Schedule A (Form 1040). Aarp free tax preparation You are not required to allocate these deductions between personal and business use, as is required under the regular method. Aarp free tax preparation If you use the optional method, you cannot depreciate the portion of your home used in a trade or business. Aarp free tax preparation   Business expenses unrelated to the home, such as advertising, supplies, and wages paid to employees, are still fully deductible. Aarp free tax preparation All of the requirements discussed earlier under Business use of your home still apply. Aarp free tax preparation   For more information on the deduction for business use of your home, including the optional safe harbor method, see Publication 587. Aarp free tax preparation    If you were entitled to deduct depreciation on the part of your home used for business, you cannot exclude the part of the gain from the sale of your home that equals any depreciation you deducted (or could have deducted) for periods after May 6, 1997. Aarp free tax preparation Business use of your car. Aarp free tax preparation   If you use your car exclusively in your business, you can deduct car expenses. Aarp free tax preparation If you use your car for both business and personal purposes, you must divide your expenses based on actual mileage. Aarp free tax preparation Generally, commuting expenses between your home and your business location, within the area of your tax home, are not deductible. Aarp free tax preparation   You can deduct actual car expenses, which include depreciation (or lease payments), gas and oil, tires, repairs, tune-ups, insurance, and registration fees. Aarp free tax preparation Or, instead of figuring the business part of these actual expenses, you may be able to use the standard mileage rate to figure your deduction. Aarp free tax preparation Beginning in 2013, the standard mileage rate is 56. Aarp free tax preparation 5 cents per mile. Aarp free tax preparation   If you are self-employed, you can also deduct the business part of interest on your car loan, state and local personal property tax on the car, parking fees, and tolls, whether or not you claim the standard mileage rate. Aarp free tax preparation   For more information on car expenses and the rules for using the standard mileage rate, see Publication 463. Aarp free tax preparation How Much Can I Deduct? Generally, you can deduct the full amount of a business expense if it meets the criteria of ordinary and necessary and it is not a capital expense. Aarp free tax preparation Recovery of amount deducted (tax benefit rule). Aarp free tax preparation   If you recover part of an expense in the same tax year in which you would have claimed a deduction, reduce your current year expense by the amount of the recovery. Aarp free tax preparation If you have a recovery in a later year, include the recovered amount in income in that year. Aarp free tax preparation However, if part of the deduction for the expense did not reduce your tax, you do not have to include that part of the recovered amount in income. Aarp free tax preparation   For more information on recoveries and the tax benefit rule, see Publication 525. Aarp free tax preparation Payments in kind. Aarp free tax preparation   If you provide services to pay a business expense, the amount you can deduct is limited to your out-of-pocket costs. Aarp free tax preparation You cannot deduct the cost of your own labor. Aarp free tax preparation   Similarly, if you pay a business expense in goods or other property, you can deduct only what the property costs you. Aarp free tax preparation If these costs are included in the cost of goods sold, do not deduct them again as a business expense. Aarp free tax preparation Limits on losses. Aarp free tax preparation   If your deductions for an investment or business activity are more than the income it brings in, you have a loss. Aarp free tax preparation There may be limits on how much of the loss you can deduct. Aarp free tax preparation Not-for-profit limits. Aarp free tax preparation   If you carry on your business activity without the intention of making a profit, you cannot use a loss from it to offset other income. Aarp free tax preparation See Not-for-Profit Activities , later. Aarp free tax preparation At-risk limits. Aarp free tax preparation   Generally, a deductible loss from a trade or business or other income-producing activity is limited to the investment you have “at risk” in the activity. Aarp free tax preparation You are at risk in any activity for the following. Aarp free tax preparation The money and adjusted basis of property you contribute to the activity. Aarp free tax preparation Amounts you borrow for use in the activity if: You are personally liable for repayment, or You pledge property (other than property used in the activity) as security for the loan. Aarp free tax preparation For more information, see Publication 925. Aarp free tax preparation Passive activities. Aarp free tax preparation   Generally, you are in a passive activity if you have a trade or business activity in which you do not materially participate, or a rental activity. Aarp free tax preparation In general, deductions for losses from passive activities only offset income from passive activities. Aarp free tax preparation You cannot use any excess deductions to offset other income. Aarp free tax preparation In addition, passive activity credits can only offset the tax on net passive income. Aarp free tax preparation Any excess loss or credits are carried over to later years. Aarp free tax preparation Suspended passive losses are fully deductible in the year you completely dispose of the activity. Aarp free tax preparation For more information, see Publication 925. Aarp free tax preparation Net operating loss. Aarp free tax preparation   If your deductions are more than your income for the year, you may have a “net operating loss. Aarp free tax preparation ” You can use a net operating loss to lower your taxes in other years. Aarp free tax preparation See Publication 536 for more information. Aarp free tax preparation   See Publication 542 for information about net operating losses of corporations. Aarp free tax preparation When Can I Deduct an Expense? When you can deduct an expense depends on your accounting method. Aarp free tax preparation An accounting method is a set of rules used to determine when and how income and expenses are reported. Aarp free tax preparation The two basic methods are the cash method and the accrual method. Aarp free tax preparation Whichever method you choose must clearly reflect income. Aarp free tax preparation For more information on accounting methods, see Publication 538. Aarp free tax preparation Cash method. Aarp free tax preparation   Under the cash method of accounting, you generally deduct business expenses in the tax year you pay them. Aarp free tax preparation Accrual method. Aarp free tax preparation   Under an accrual method of accounting, you generally deduct business expenses when both of the following apply. Aarp free tax preparation The all-events test has been met. Aarp free tax preparation The test is met when: All events have occurred that fix the fact of liability, and The liability can be determined with reasonable accuracy. Aarp free tax preparation Economic performance has occurred. Aarp free tax preparation Economic performance. Aarp free tax preparation   You generally cannot deduct or capitalize a business expense until economic performance occurs. Aarp free tax preparation If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided, or the property is used. Aarp free tax preparation If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services. Aarp free tax preparation Example. Aarp free tax preparation Your tax year is the calendar year. Aarp free tax preparation In December 2013, the Field Plumbing Company did some repair work at your place of business and sent you a bill for $600. Aarp free tax preparation You paid it by check in January 2014. Aarp free tax preparation If you use the accrual method of accounting, deduct the $600 on your tax return for 2013 because all events have occurred to “fix” the fact of liability (in this case the work was completed), the liability can be determined, and economic performance occurred in that year. Aarp free tax preparation If you use the cash method of accounting, deduct the expense on your 2014 return. Aarp free tax preparation Prepayment. Aarp free tax preparation   You generally cannot deduct expenses in advance, even if you pay them in advance. Aarp free tax preparation This rule applies to both the cash and accrual methods. Aarp free tax preparation It applies to prepaid interest, prepaid insurance premiums, and any other expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year. Aarp free tax preparation Example. Aarp free tax preparation In 2013, you sign a 10-year lease and immediately pay your rent for the first 3 years. Aarp free tax preparation Even though you paid the rent for 2013, 2014, and 2015, you can only deduct the rent for 2013 on your 2013 tax return. Aarp free tax preparation You can deduct the rent for 2014 and 2015 on your tax returns for those years. Aarp free tax preparation Contested liability. Aarp free tax preparation   Under the cash method, you can deduct a contested liability only in the year you pay the liability. Aarp free tax preparation Under the accrual method, you can deduct contested liabilities such as taxes (except foreign or U. Aarp free tax preparation S. Aarp free tax preparation possession income, war profits, and excess profits taxes) either in the tax year you pay the liability (or transfer money or other property to satisfy the obligation) or in the tax year you settle the contest. Aarp free tax preparation However, to take the deduction in the year of payment or transfer, you must meet certain conditions. Aarp free tax preparation See Regulations section 1. Aarp free tax preparation 461-2. Aarp free tax preparation Related person. Aarp free tax preparation   Under an accrual method of accounting, you generally deduct expenses when you incur them, even if you have not yet paid them. Aarp free tax preparation However, if you and the person you owe are related and that person uses the cash method of accounting, you must pay the expense before you can deduct it. Aarp free tax preparation Your deduction is allowed when the amount is includible in income by the related cash method payee. Aarp free tax preparation See Related Persons in Publication 538. Aarp free tax preparation Not-for-Profit Activities If you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset other income. Aarp free tax preparation Activities you do as a hobby, or mainly for sport or recreation, are often not entered into for profit. Aarp free tax preparation The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. Aarp free tax preparation It does not apply to corporations other than S corporations. Aarp free tax preparation In determining whether you are carrying on an activity for profit, several factors are taken into account. Aarp free tax preparation No one factor alone is decisive. Aarp free tax preparation Among the factors to consider are whether: You carry on the activity in a businesslike manner, The time and effort you put into the activity indicate you intend to make it profitable, You depend on the income for your livelihood, Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business), You change your methods of operation in an attempt to improve profitability, You (or your advisors) have the knowledge needed to carry on the activity as a successful business, You were successful in making a profit in similar activities in the past, The activity makes a profit in some years, and You can expect to make a future profit from the appreciation of the assets used in the activity. Aarp free tax preparation Presumption of profit. Aarp free tax preparation   An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. Aarp free tax preparation Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least 2 of the last 7 tax years, including the current year. Aarp free tax preparation The activity must be substantially the same for each year within this period. Aarp free tax preparation You have a profit when the gross income from an activity exceeds the deductions. Aarp free tax preparation   If a taxpayer dies before the end of the 5-year (or 7-year) period, the “test” period ends on the date of the taxpayer's death. Aarp free tax preparation   If your business or investment activity passes this 3- (or 2-) years-of-profit test, the IRS will presume it is carried on for profit. Aarp free tax preparation This means the limits discussed here will not apply. Aarp free tax preparation You can take all your business deductions from the activity, even for the years that you have a loss. Aarp free tax preparation You can rely on this presumption unless the IRS later shows it to be invalid. Aarp free tax preparation Using the presumption later. Aarp free tax preparation   If you are starting an activity and do not have 3 (or 2) years showing a profit, you can elect to have the presumption made after you have the 5 (or 7) years of experience allowed by the test. Aarp free tax preparation   You can elect to do this by filing Form 5213. Aarp free tax preparation Filing this form postpones any determination that your activity is not carried on for profit until 5 (or 7) years have passed since you started the activity. Aarp free tax preparation   The benefit gained by making this election is that the IRS will not immediately question whether your activity is engaged in for profit. Aarp free tax preparation Accordingly, it will not restrict your deductions. Aarp free tax preparation Rather, you will gain time to earn a profit in the required number of years. Aarp free tax preparation If you show 3 (or 2) years of profit at the end of this period, your deductions are not limited under these rules. Aarp free tax preparation If you do not have 3 (or 2) years of profit, the limit can be applied retroactively to any year with a loss in the 5-year (or 7-year) period. Aarp free tax preparation   Filing Form 5213 automatically extends the period of limitations on any year in the 5-year (or 7-year) period to 2 years after the due date of the return for the last year of the period. Aarp free tax preparation The period is extended only for deductions of the activity and any related deductions that might be affected. Aarp free tax preparation    You must file Form 5213 within 3 years after the due date of your return (determined without extensions) for the year in which you first carried on the activity, or, if earlier, within 60 days after receiving written notice from the Internal Revenue Service proposing to disallow deductions attributable to the activity. Aarp free tax preparation Gross Income Gross income from a not-for-profit activity includes the total of all gains from the sale, exchange, or other disposition of property, and all other gross receipts derived from the activity. Aarp free tax preparation Gross income from the activity also includes capital gains and rents received for the use of property which is held in connection with the activity. Aarp free tax preparation You can determine gross income from any not-for-profit activity by subtracting the cost of goods sold from your gross receipts. Aarp free tax preparation However, if you determine gross income by subtracting cost of goods sold from gross receipts, you must do so consistently, and in a manner that follows generally accepted methods of accounting. Aarp free tax preparation Limit on Deductions If your activity is not carried on for profit, take deductions in the following order and only to the extent stated in the three categories. Aarp free tax preparation If you are an individual, these deductions may be taken only if you itemize. Aarp free tax preparation These deductions may be taken on Schedule A (Form 1040). Aarp free tax preparation Category 1. Aarp free tax preparation   Deductions you can take for personal as well as for business activities are allowed in full. Aarp free tax preparation For individuals, all nonbusiness deductions, such as those for home mortgage interest, taxes, and casualty losses, belong in this category. Aarp free tax preparation Deduct them on the appropriate lines of Schedule A (Form 1040). Aarp free tax preparation For tax years beginning after December 31, 2008, you can deduct a casualty loss on property you own for personal use only to the extent it is more than $500 and exceeds 10% of your adjusted gross income (AGI). Aarp free tax preparation The 10% AGI limitation does not apply to net disaster losses resulting from federally declared disasters in 2008 and 2009, and individuals are allowed to claim the net disaster losses even if they do not itemize their deductions. Aarp free tax preparation The reduction amount returns to $100 for tax years beginning after December 31, 2009. Aarp free tax preparation See Publication 547 for more information on casualty losses. Aarp free tax preparation For the limits that apply to home mortgage interest, see Publication 936. Aarp free tax preparation Category 2. Aarp free tax preparation   Deductions that do not result in an adjustment to the basis of property are allowed next, but only to the extent your gross income from the activity is more than your deductions under the first category. Aarp free tax preparation Most business deductions, such as those for advertising, insurance premiums, interest, utilities, and wages, belong in this category. Aarp free tax preparation Category 3. Aarp free tax preparation   Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income from the activity exceeds the deductions you take under the first two categories. Aarp free tax preparation Deductions for depreciation, amortization, and the part of a casualty loss an individual could not deduct in category (1) belong in this category. Aarp free tax preparation Where more than one asset is involved, allocate depreciation and these other deductions proportionally. Aarp free tax preparation    Individuals must claim the amounts in categories (2) and (3) as miscellaneous deductions on Schedule A (Form 1040). Aarp free tax preparation They are subject to the 2%-of-adjusted-gross-income limit. Aarp free tax preparation See Publication 529 for information on this limit. Aarp free tax preparation Example. Aarp free tax preparation Adriana is engaged in a not-for-profit activity. Aarp free tax preparation The income and expenses of the activity are as follows. Aarp free tax preparation Gross income $3,200 Subtract:     Real estate taxes $700   Home mortgage interest 900   Insurance 400   Utilities 700   Maintenance 200   Depreciation on an automobile 600   Depreciation on a machine 200 3,700 Loss $(500)   Adriana must limit her deductions to $3,200, the gross income she earned from the activity. Aarp free tax preparation The limit is reached in category (3), as follows. Aarp free tax preparation Limit on deduction $3,200 Category 1: Taxes and interest $1,600   Category 2: Insurance, utilities, and maintenance 1,300 2,900 Available for Category 3 $ 300   The $800 of depreciation is allocated between the automobile and machine as follows. Aarp free tax preparation $600 $800 x $300 = $225 depreciation for the automobile             $200 $800 x $300 = $75 depreciation for the machine The basis of each asset is reduced accordingly. Aarp free tax preparation Adriana includes the $3,200 of gross income on line 21 (other income) of Form 1040. Aarp free tax preparation The $1,600 for category (1) is deductible in full on the appropriate lines for taxes and interest on Schedule A (Form 1040). Aarp free tax preparation Adriana deducts the remaining $1,600 ($1,300 for category (2) and $300 for category (3)) as other miscellaneous deductions on Schedule A (Form 1040) subject to the 2%-of-adjusted-gross-income limit. Aarp free tax preparation Partnerships and S corporations. Aarp free tax preparation   If a partnership or S corporation carries on a not-for-profit activity, these limits apply at the partnership or S corporation level. Aarp free tax preparation They are reflected in the individual shareholder's or partner's distributive shares. Aarp free tax preparation More than one activity. Aarp free tax preparation   If you have several undertakings, each may be a separate activity or several undertakings may be combined. Aarp free tax preparation The following are the most significant facts and circumstances in making this determination. Aarp free tax preparation The degree of organizational and economic interrelationship of various undertakings. Aarp free tax preparation The business purpose that is (or might be) served by carrying on the various undertakings separately or together in a business or investment setting. Aarp free tax preparation The similarity of the undertakings. Aarp free tax preparation   The IRS will generally accept your characterization if it is supported by facts and circumstances. Aarp free tax preparation    If you are carrying on two or more different activities, keep the deductions and income from each one separate. Aarp free tax preparation Figure separately whether each is a not-for-profit activity. Aarp free tax preparation Then figure the limit on deductions and losses separately for each activity that is not for profit. Aarp free tax preparation Prev  Up  Next   Home   More Online Publications