Untangling the Most Complex Tax Forms

SAN FRANCISCO – How has the IRS kept Form 1040 as short as it is — just one two-sided page — even as the tax code becomes ever more complex?

By pushing most of the grunt work required to do one's taxes onto the numerous other forms, schedules and worksheets that emanate from that one piece of paper.

Form 1040 "is almost like a summary schedule," said Bernie Kent, a personal financial services partner in PricewaterhouseCoopers' private companies services group.

"The lines in and of themselves are fairly straightforward. It's more the schedules they refer to that create the greater complexity," he said. Once you get past the wages line on Form 1040, "all those things have separate schedules elsewhere." See Weekend Edition for a look at the 1040 lines that are most likely to trip you up.

The following are the most complex forms and schedules, and thus the ones that require the most careful tax handling, according to tax experts interviewed by MarketWatch.

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Form 8801: Don't forget your credit

Everyone knows the alternative minimum tax is confusing, but what about the process for carrying forward AMT credits from previous years? That takes place on Form 8801.

"When you pay AMT, sometimes but not always you can get a credit" for that in the following year, Kent said. "Form 8801 calculates the amount of credit carry-forward which might be available to you," he said.

In general, this credit is available for those people who got caught in the AMT due to a temporary tax situation, such as exercising incentive stock options, but not to those who paid the AMT because of an ongoing tax situation, such as a state income-tax deduction.

"To the extent [your AMT payment] was due to items that will reverse in a subsequent year, then you can get a credit carry-forward for that tax. Incentive stock options are the perfect example, and depreciation is another example," Kent said. By contrast, "income-tax deductions or miscellaneous itemized deductions, they don't reverse in a subsequent year. They are permanent differences ... you don't get a credit for those."

This is a tax rule that's not for the faint of heart. "You have to go through the regular AMT and then go beyond that," Kent said. In the past, "even some of the computer software didn't get the right answer because it made certain assumptions that it shouldn't make."

Click here for IRS instructions for this form.

Form 6251: Our old friend, the AMT

It's easy to skip right over Line 45 on Form 1040, but you shouldn't: That's where you enter your alternative minimum tax. Given that an increasing number of taxpayers are subject to this tax, and that it's difficult to gauge whether you owe it unless you go through the calculations, taxpayers should visit Form 6251.

"In theory, you always have to see if your subject to the alternative minimum tax," said Irene Lawrence, an enrolled agent in Palo Alto, Calif. Lawrence is also first vice president of the California Society of Enrolled Agents.

"In the old days, ordinary people didn't need to bother to go and fill it out because they wouldn't get caught by it. That's why it's just off the radar of most ordinary people," she said.

While many tax professionals advise hiring a tax professional to figure out this tax, others say that taxpayers who feel confident doing their own Form 1040 might be OK with Form 6251.

"It's pretty complex. It's basically like having a second 1040," said Mark Luscombe, principal analyst with CCH, a tax software and publishing firm in Riverwoods, Ill. But "if you can do the 1040 on your own, probably you can do the 6251 on your own. One advantage of using the tax software programs is most of them automatically check as you're going along."

Click here for IRS instructions on this form.

Schedule D

Schedule D, for reporting capital gains and losses, is familiar to many taxpayers, but that doesn't make the calculations any easier.

One problem: There are a variety of different capital-gains tax rates to consider, including a 28% rate on certain types of collectibles, a 5% rate for lower-income taxpayers on gains from stock stales and the 15% rate that higher-income taxpayers pay on long-term gains. Plus, the ordinary income-tax rate applies to short-term capital gains.

There's even another rate of 25% that may apply if you sold real estate on which you claimed depreciation.

"It's not very intuitive when you get to the second page of Schedule D," Kent said. "To figure out what is the right rate of each type of capital gain, you have to go through a complex series" of calculations.

Another Schedule D roadblock for taxpayers: Knowing their investment's cost basis. "When you sell something, you've got to know how much you paid for it," Lawrence said. "We've gotten so used to having all our transactions reported" to us on 1099s, she said. Often, "that only reports how much it was sold for," not necessarily how much the taxpayer paid for the investment. "It's a whole lot of work that is unexpected for many people," Lawrence said.

<a href="http://www.irs.gov/pub/irs-pdf/i1040sd.pdf">See the IRS instructions for Schedule D (PDF).</a>

Form 8903: Domestic ... huh?

There's a new line on Form 1040 that's likely to stump plenty of taxpayers: Line 35 is now for claiming a "domestic production activities" deduction — if you can figure out what that is. You're going to need Form 8903 to do so.

Essentially, this rule allows you to deduct up to 3% of your income from certain business activities (that 3% rises to 9% by 2009).

"I'd be willing to bet this is going to be the No. 1 line on the whole 1040 that gets messed up," said Cindy Hockenberry, a tax information analyst with the National Association of Tax Professionals, a trade group. "There are a lot of partnerships and pass-through entities that qualify ... there are more people affected by this line than you might think."

It's a business deduction, but it appears on the 1040 because "for partners in a partnership or shareholders in an S corporation, the deduction is determined at the individual level rather than the business level," Luscombe said.

Many types of business activity are eligible, he said, including farmers and craft makers. "If you've got a little side business where you're making things," that might qualify.

What's so hard about it? "What's really complex about it is you're going to have to do allocations you've never had to do before," Luscombe said, to capture domestic production but ignore foreign-produced items.

An example: "You import shoes and make the shoelaces domestically. The shoes don't qualify because they're imported, but the shoelaces do," Luscombe said. "So you have to allocate costs to [and income from] the shoelaces separate from the shoes."

To figure this deduction, taxpayers must use Form 8903.

Click here for IRS instructions for this form.

Form 8582: Reporting passive activity losses

Another head-cracker: The form for reporting passive activity losses. "If you invest in a flow-through entity such as a partnership or S corporation in which you are not actively working 500 hours or more per year, then that is a passive activity," Kent said.

If you own real estate that you rent out, that also might qualify as a passive activity. "It's certainly not an uncommon form for people who are investors, particularly investors in real estate," he said.

"It's complicated because of the calculations you have to go through, and you have to do it for regular tax and for AMT," Kent said, plus it can be difficult to determine what is and isn't passive activity. "It gets very complex." For instance, he said, with some real estate deals, the loss could be an active loss against other income.

Click here for IRS instructions on this form.