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| The Basics | What happens if my tax cheat gets caught?
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A worried mother asks whether her son is cheating on his taxes by taking in thousands in under-the-table rental income each year. Plus: How to improve a credit score.
By Liz Pulliam Weston
Dear Liz:
My son has owned his home for 25 years. He rents out three of his rooms, charging $300 to $500 a month. He doesn't take checks, only cash, which he does not report on his tax form. I told him that he's wrong and could face a heavy fine. Isn't that right?
Answer: We'll assume you tried to teach your boy right from wrong, so that particular ship has sailed. What often motivates people with, shall we say, "challenged" ethical systems is fear of getting caught.
Your son is probably counting on the Internal Revenue Service's low audit rate to prevent his little scheme from being uncovered. But all it takes is one disgruntled renter willing to call the feds, and his money-making scheme could be exposed. Then he would have to pay taxes and penalties on the undeclared income.
If he has underreported his income by 25% or more, he could be in twice as much trouble. Normally, the risk of an IRS audit essentially ends three years after a tax return is due. But if you've underreported your income by more than 25%, the IRS can reach back six years.
If the IRS is successful in arguing that your son intended to commit fraud by filing a false tax return, there is no statute of limitations at all, said tax analyst Mark Luscome of CCH Inc., a tax research firm. The IRS could audit and assess taxes for the entire 25-year period he's been collecting rents under the table.
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In any case, your son might discover that declaring the income is a better deal than he thought. Once the rent is on the books, he can start deducting plenty of expenses that otherwise wouldn't be write-offs, such as a portion of the utilities, insurance and home-maintenance costs. Combine that with the depreciation he could take on the rented portion of a house, and he may find himself ahead financially.
He would have a tax issue when he sells the house, though. Typically, he would be able to exclude up to $250,000 of home-sale profit from his income when he sells. But he would have to pay a 25% "recapture" tax on the depreciation he took after May 6, 1997. That's still no reason not to declare the income, though, because the recapture tax is just a return of some of the deduction he took in earlier years.
Dear Liz:
Please tell me how I can improve my credit score, which is in the marginal range around 640. I've never had any judgments or defaults. My late payments usually are because of carelessness, not outright delinquency. I have adequate income, and I always pay my mortgage and car loans on time. I'd like to take charge of all of this so that I am not treated like a pariah when I apply for a lower-rate credit card. Can you help?
Answer: To get the best rates and terms on credit cards, you'll need a credit score of 720 or above. You won't get there if you continue to make late payments, because the credit-scoring formulas treat overdue or missing payments as a sign that you're about to default on your debts.
You need to set up some kind of automatic payment system so that your bills are covered, no matter what. Fortunately, you have a couple of good options.
Many utilities, lenders and credit card companies will happily set up automatic debit arrangements so that your payments are taken automatically from your checking account each month. (If you don't want to pay your entire balance on a credit card, you can arrange for the minimum payment or some other set amount to be taken out each month.) You'd be smart to sign up for overdraft protection for your checking account, just in case one of your payments goes through when you don't have sufficient cash to cover it.
You also could set up recurring payments using an online bill-payment system. This works well when your payment is the same amount each month; if the amounts vary, you'll need to set up some kind of reminder system so you don't blow the deadlines. Many online bill-pay systems have such reminders, or you can use one of the many free e-mail reminder services available on the Web.
You'll also help your score if you pay off those credit card balances and use less than 30% of your credit limit on any card. This can be tough if you have a high balance, but it's the smartest approach to take -- for your credit score and your overall financial situation.
Combine these steps with on-time payments, and you should notice a positive change in your score within a few months.
Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money. She also answers reader questions in the Your Money message board.
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MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.
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