In the middle of watching the Sunday morning talking heads not long ago, I saw a commercial touting the benefits of proper planning for a successful retirement.  It showed a series of images of a happy couple retiring out of the rat race to run a cozy bed-and-breakfast, which looks very enjoyable and satisfying.

Boomers’ burning desire to remain engaged and vital means that retirement is starting to look a lot different than it did a generation ago.  Even before the economy took a bite out of everyone’s 401(k) accounts, the idea of working after retirement had started to take hold.  For many, this translated to embarking on an adventure in small business – especially if it meant you could deduct all your expenses for doing the things you like to do anyway.

To no one’s surprise the IRS is all over this trend as well.  For many years now there has been a business classification called “Hobby.”  If a business is judged to be a hobby, the deductions you can take are limited to the amount of income that the business generates.

So what’s the difference between a legitimate business and a hobby?  Or to put it another way, what’s the difference between an operating farm and a nice house on several acres of good topsoil?  Turns out the answer isn’t so easy.

There’s no bright line rule for determining what’s a hobby and what isn’t.  The IRS has identified several factors that it uses when presented with this question.  The most clear-cut is whether the business has made a profit in three out of the last five years.  (Clearly, this isn’t the only factor, or Amazon.com would have been a decade-long hobby.)

Broadly, what the IRS is looking for is that the endeavor is really run like a business.  This would include having a written business plan (that is not only followed but updated as needed); keeping accurate books and records; and having advisors who can supplement the owner’s knowledge or expertise if necessary.  Having a down year (especially for a startup) doesn’t turn a legitimate business into a hobby, as long as the owner acts in ways that indicate making a profit is the eventual goal.

Back in the day when real estate prices went in only one direction (up), selling your home could result in a whopping tax bill.  So Congress took pity on taxpayers, and allowed the exclusion of up to $500,000 of gain ($250,000 if filing singly) from income.  To qualify, the home had to be the taxpayer’s principal residence for two out of the last five years.

But what about those folks who also had a vacation home or rental property in some tropical location?  Those properties wouldn’t qualify for the exclusion, so those taxpayers would still get hit with a huge tax liability.  Or would they?

It turned out with a little planning, it was possible to sell the primary home, move into the rental home for a couple years (thus transforming it into the primary residence), sell the second home – et voilá: a cool million dollars in gain, tax-free.

Now that loophole has been all but eliminated, as the amount of gain recognized on home sales must be allocated between the time the house was used as a personal residence and the time (beginning in 2009) it was used otherwise. In addition, you still have to meet the two years out of five test.

Let’s say you purchased that vacation/rental home in 2002, with the plan that it would become your primary residence in 2010.  Under the old rules, you could live there for two years, sell it in 2012, and exclude all of the gain from taxable income, up to the $500,000 limit.

Under the new rules, however, you would have one year of non personal residence  use (2009) out of a total of 10 years of ownership.  As a result, 10 percent of the gain would not be excludable under the personal residence exemption.

Taxpayers who have made planning decisions based on the old gain exclusion rules should contact their tax advisor to determine what, if any, changes should be made to their plan.

If you’re like many small business owners, you probably have some equipment – whether it’s computers or heavy machinery – you’d like to add or replace, but you’re also worried about whether this is a good time to make such a major outlay.  Should you buy the equipment this year, or put it off until next year?  The answer is, it depends: on your cash flow, balance sheet, and numerous other variables.

All other things being equal, there are two items in the plus column for making that purchase in 2009: section 179 expensing and a special depreciation allowance.  The special allowance was originally supposed to expire in 2008, but to help stimulate the economy Congress extended it in the 2009 American Reinvestment and Recovery Act.  (Depending on how the economy is doing at the end of this year, there is always the possibility that these incentives will be extended again, but currently they are set to expire at the end of 2009.)

The first is an extension of the increased section 179 accelerated depreciation.  Instead of depreciating equipment over five to seven years, section 179 allows you to depreciate the first $250,000 of qualifying capital expenditures all in the year those items were first put into service.

If you have more than $250,000 in capital expenditures, you may be able to deduct half of the excess amount under the 50 percent special depreciation allowance.  The remaining expenditures are depreciated over the usual five- or seven-year recovery period.

What this means is that on a capital investment of $100,000 you could recoup tax savings of $35,000 for 2009 instead of spreading it out over five to seven years.  (Keep in mind, however, that you won’t actually see that saving until next year, after you’ve filed your 2009 tax return.)  For capital expenditures totaling $500,000 you’d be able to depreciate $375,000 this year, for a tax saving of $131,250.

Clearly, 35 percent is a much higher return than you would get if you left those funds in the bank.  You may potentially have some other uses for the money, so you’d need to evaluate the opportunity costs.  If you’d have to borrow money to make the purchase, you possibly still come out ahead, but the calculation is more complicated, taking into account the time value of money and the fact that the interest you pay on the loan is also tax-deductible.

In future posts we’ll examine those calculations in more detail, and give you some other tools you can use to gauge the health of your business.

So what should individuals be saving for?

• Retirement.  This should be your first goal.  If you can’t afford the down payment on a house, you can still rent.  If you haven’t saved enough for your kids’ college tuition, make them work and chip in.  But at some point, you will retire, and you can’t count on Social Security to keep you living in the style to which you’d like to become accustomed.
• Emergencies.  There are any number of unexpected things that come up that can be very expensive – from uninsured medical costs to home repairs.  These days, the prospect of loss of income also looms large.  Don’t count on your retirement nest egg for this purpose.  Emergency funds should be in cash, or easily converted to cash at a moment’s notice without penalties.
• College.  On the day little Janie is born you may not know whether she’s destined for voc-tech or med school; either way, it won’t hurt to have something set aside even if it doesn’t cover the entire cost.  The current cost of four years of college tuition (not counting room and board, books, and other expenses) ranges from $25,000 for an in-state public institution to $100,000 for a private university.  Tuition has been rising about 6 to 7 percent a year nationally – and will jump twice that in Washington state for the next couple years – and in this case, compound interest is working against you.  In a future post we’ll explore some of the college savings plans that are available.  In the meantime, tell grandparents and other relatives that you’ve opened a college savings account, and suggest that they give money instead of expensive gifts for birthdays and holidays.
• Home purchase.  The days of zero-down mortgages are over (for a while, at least).  A generation ago, a 10- or 20-percent down payment was the norm – as we see now, with good reason.  Having the discipline to save up for a down payment is a good indicator of the ability to manage regular mortgage payments and home maintenance.