Consider applicable rates, breaks and limits as well as possible tax law changes to better time income and expenses
Tax law uncertainty makes planning especially challenging this year. Regular tax rates are scheduled to rise in 2013, but current rates might be extended for some or all taxpayers. And which tax strategies will be best for you will depend in part on whether your rate next year will be higher, lower or the same.
Then there’s the alternative minimum tax (AMT). The top AMT rate is lower than the top regular income tax rate on ordinary income (salary, business income, interest and more). But the AMT rate typically applies to a higher taxable income base. So if you plan only for regular income taxes, it can result in unwelcome tax surprises.
Also, income-based phaseouts and other limits can increase your marginal rate for regular-tax or AMT purposes. You also may be eligible for various tax deductions or credits that could reduce your tax liability — but some breaks expired at the end of 2011 and others are set to expire after 2012.
That’s why it’s important to review your income, expenses and potential tax liability throughout the year, keeping in mind the many rates and limits that can affect income tax liability — and keeping an eye out for possible tax law changes. Only then can you time income and expenses to your advantage.
Before you take action to time income or expenses, determine whether you’re already likely to be subject to the AMT — or whether the actions you’re considering might trigger it. Many deductions used to calculate regular tax aren’t allowed under the AMT and thus can trigger AMT liability. Some income items also might trigger or increase AMT liability:
- Long-term capital gains and dividend income, even though they’re taxed at the same rate for both regular tax and AMT purposes,
- Accelerated depreciation adjustments and related gain or loss differences when assets are sold, and
- Tax-exempt interest on certain private-activity municipal bonds.
Finally, in certain situations incentive stock option (ISO) exercises can trigger significant AMT liability.
Avoiding or reducing AMT
With proper planning, you may be able to avoid the AMT, reduce its impact or even take advantage of its lower maximum rate. But planning for the AMT will be a challenge until Congress passes long-term relief.
Unlike the regular tax system, the AMT system isn’t regularly adjusted for inflation. Instead, Congress must legislate any adjustments. Typically, it has done so in the form of a “patch” — an increase in the AMT exemption. A patch was in effect for 2011, but Congress hasn’t passed one for 2012. If a patch isn’t enacted, there may be a greater chance you could be subject to the AMT this year. (Check back here for the latest information.)
Whether or not the patch is extended, it’s critical to work with your tax advisor to determine whether:
You could be subject to the AMT this year. Consider accelerating income and short-term capital gains into this year, which may allow you to benefit from the lower maximum AMT rate. Also consider deferring expenses you can’t deduct for AMT purposes until next year — you may be able to preserve those deductions.
Additionally, if you defer expenses you can deduct for AMT purposes to next year, the deductions may become more valuable because of the higher maximum regular tax rate. Finally, carefully consider the tax consequences of exercising ISOs.
You could be subject to the AMT next year. Consider taking the opposite approach. For instance, defer income to next year, because you’ll likely pay a relatively lower AMT rate. And prepay expenses that will be deductible this year but that won’t help you next year because they’re not deductible for AMT purposes. Also, before year end consider selling any private activity municipal bonds whose interest could be subject to the AMT.
The AMT credit
If you pay AMT in one year on deferral items, such as depreciation adjustments, passive activity adjustments or the tax preference on ISO exercises, you may be entitled to a credit in a subsequent year.
In effect, this takes into account timing differences that reverse in later years. But the credit might provide only partial relief or take years before it can be fully used. Fortunately, the credit’s refundable feature can reduce the time it takes to recoup AMT paid.
Timing income and expenses
Smart timing of income and expenses can reduce your tax liability, and poor timing can unnecessarily increase it.
When you don’t expect to be subject to the AMT in the current year or the next year, deferring income to the next year and accelerating deductible expenses into the current year typically is a good idea. Why? Because it will defer tax, which is usually beneficial.
But when you expect to be in a higher tax bracket next year — or you expect tax rates to go up — the opposite approach may be beneficial: Accelerating income will allow more income to be taxed at your current year’s lower rate. And deferring expenses will make the deductions more valuable, because deductions save more tax when you’re subject to a higher tax rate. Warning: Tax rates are scheduled to increase in 2013, although Congress may extend current rates or take other action.
Also keep in mind that the adjusted gross income (AGI)-based phaseout limiting the benefit of many deductions is scheduled to return in 2013. Therefore, certain deductions might provide you more tax savings this year — depending on the potential impact of higher rates next year and as long as they don’t trigger the AMT.
Whatever the reason you’d like to time income and expenses, here are some income items whose timing you may be able to control:
- Consulting or other self-employment income,
- U.S. Treasury bill income, and
- Retirement plan distributions, to the extent not required. (See Required minimum distributions.)
And here are some potentially controllable expenses:
- State and local income taxes,
- Property taxes,
- Mortgage interest,
- Margin interest, and
- Charitable contributions.
Warning: Prepaid expenses can be deducted only in the year to which they apply. For example, you can prepay (by Dec. 31) property taxes that relate to this year but that are due next year, and deduct the payment on this year’s return. But you generally can’t prepay property taxes that relate to next year and deduct the payment on this year’s return.
Miscellaneous itemized deductions
Many expenses that may qualify as miscellaneous itemized deductions are deductible for regular tax purposes only to the extent they exceed, in aggregate, 2% of your AGI. Bunching these expenses into a single year may allow you to exceed this “floor.”
Carefully record your potential deductions throughout the year. If as the year progresses they get close to or start to exceed the 2% floor — and you don’t expect to be subject to the AMT this year — consider paying accrued expenses and incurring and paying additional expenses by Dec. 31, such as:
- Deductible investment expenses, including advisory fees, custodial fees and publications,
- Professional fees, such as tax planning and preparation, accounting, and certain legal fees, and
- Unreimbursed employee business expenses, including travel, meals, entertainment and vehicle costs.
Health care breaks
Medical expenses are another deduction you may be able to bunch. If your medical expenses exceed 7.5% of your AGI, you can deduct the excess amount. Eligible expenses can include:
- Health insurance premiums,
- Long-term care insurance premiums (limits apply),
- Medical and dental services, and
- Prescription drugs.
Consider bunching nonurgent medical procedures and other controllable expenses into one year to exceed the AGI floor. Bunching such expenses into 2012 may be especially beneficial because in 2013 the floor is scheduled to increase to 10% under the Patient Protection and Affordable Care Act of 2010. (For taxpayers age 65 and older, the floor isn’t scheduled to increase until 2017.) On the other hand, if tax rates go up in 2013 as scheduled, your deductions might be more powerful then.
If one spouse has high medical expenses and a relatively lower AGI, filing separately may allow that spouse to exceed the AGI floor and deduct some medical expenses that wouldn’t be deductible if the couple filed jointly.
Also remember that expenses that are reimbursed (or reimbursable) by insurance or paid through one of the following accounts aren’t deductible:
HSA. If you’re covered by qualified high-deductible health insurance, a Health Savings Account allows 2012 contributions of pretax income (or deductible after-tax contributions) up to $3,100 (up from $3,050 for 2011) for self-only coverage and $6,250 (up from $6,150 for 2011) for family coverage. Moreover, account holders age 55 and older can contribute an additional $1,000.
HSAs bear interest or are invested and can grow tax-deferred similar to an IRA. Withdrawals for qualified medical expenses are tax-free, and you can carry over a balance from year to year.
FSA. You can redirect pretax income to an employer-sponsored Flexible Spending Account up to an employer-determined limit (not to exceed $2,500 for plan years beginning in 2013). The plan pays or reimburses you for qualified medical expenses. With limited exceptions, you have to make your election before the start of the plan year. What you don’t use by the end of the plan year, you generally lose. If you have an HSA, your FSA is limited to funding certain “permitted” expenses.
Warning: Since 2011, you no longer can use HSA or FSA funds to pay for over-the-counter drugs unless they’re prescribed.
Sales tax deduction
The break allowing you to take an itemized deduction for state and local sales taxes in lieu of state and local income taxes was available for 2011 but hasn’t been extended for 2012. (Check back here for updates.) When available, the deduction can be valuable to taxpayers residing in states with no or low income tax or who purchase major items, such as a car or boat.
In addition to income tax, you must pay Social Security and Medicare taxes on earned income, such as salary and bonuses. The 2011 reduction of the employee portion of the Social Security tax from 6.2% to 4.2% has been extended to 2012. The maximum taxable wage base for Social Security taxes for 2012 is $110,100 (up from $106,800 for 2011). So the maximum tax savings from this break is $2,202 for 2012.
Warning: All earned income is subject to the 2.9% Medicare tax (split equally between the employee and the employer). And Medicare taxes are scheduled to go up for high-income taxpayers next year.
If you’re self-employed, your employment tax liability typically doubles, because you also must pay the employer portion of these taxes. As a result, self-employment income can be taxed at an effective federal rate as high as 48% compared to about 43% for income from wages. Why isn’t the difference greater? Because, generally, half of the self-employment tax paid is deductible above-the-line.
However, for 2012, the self-employed’s rate for the Social Security portion is also reduced by two percentage points, from 12.4% to 10.4%. This doesn’t reduce a self-employed individual’s deduction for the employer’s share of these taxes — you can still deduct the full 6.2% employer portion of Social Security tax, along with one-half of the Medicare tax, for a full 7.65% deduction.
Employment taxes for owner-employees
There are special considerations if you’re a business owner who also works in the business, depending on its structure:
Partnerships and limited liability companies. Generally, all trade or business income that flows through to you for income tax purposes is subject to self-employment taxes — even if the income isn’t actually distributed to you. But such income may not be subject to self-employment taxes if you’re a limited partner or an LLC member whose ownership is equivalent to a limited partnership interest. Check with your tax advisor.
S corporations. Only income you receive as salary is subject to employment taxes. So to reduce these taxes, you may want to keep your salary relatively low and increase your distributions of company income (which generally isn’t taxed at the corporate level).
But you need to take care.
C corporations. Only income you receive as salary is subject to employment taxes. Nevertheless, you may prefer to take more income as salary (which is deductible at the corporate level) as opposed to dividends (which aren’t deductible at the corporate level and are taxed at the shareholder level) because the overall tax paid by both the corporation and you may be less.
Warning: The IRS is cracking down on misclassification of corporate payments to shareholder-employees, so tread carefully.
Estimated payments and withholding
You can be subject to penalties if you don’t pay enough tax during the year through estimated tax payments or withholding. To avoid such penalties, make sure your estimated payments or withholding equals at least 90% of your tax liability for this year or 110% of your tax last year (100% if your AGI last year was $150,000 or less or, if married filing separately, $75,000 or less).
Here are some more strategies that can help you avoid underpayment penalties:
Use the annualized income installment method. This method often benefits taxpayers who have large variability in income by month due to bonuses, investment gains and losses, or seasonal income (especially if it’s skewed toward the end of the year). Annualizing computes the tax due based on income, gains, losses and deductions through each estimated tax period.
Estimate your tax liability and increase withholding. If as year end approaches you determine you’ve underpaid, consider having the tax shortfall withheld from your salary or year end bonus by Dec. 31. Because withholding is considered to have been paid ratably throughout the year, this is often a better strategy than making up the difference with an increased quarterly tax payment, which may still leave you exposed to penalties for earlier quarters. •
Property ownership offers many
benefits — including tax savings
Although the real estate market has its ups and downs, real estate can be a valuable investment — whether it’s your home or vacation home or a rental or investment property. Property ownership also can offer significant tax savings, as long as you take advantage of all the breaks available to you. But watch out for the limitations as well. (For information on some changes to temporary breaks for owners of leasehold, restaurant or retail properties,
Home-related tax breaks
Whether you own one home or several, it’s important to make the most of available tax breaks:
Property tax deduction. If you’re looking to accelerate or defer deductions, property tax is one expense you may be able to time. You can choose to pay your bill for this year that’s due early next year by Dec. 31, and deduct it this year. Or you can wait until the due date and deduct it next year.
Mortgage interest deduction. You generally can deduct (for both regular tax and AMT purposes) interest on up to a combined total of $1 million of mortgage debt incurred to purchase, build or improve your principal residence and a second residence. Points paid related to your principal residence also may be deductible.
Home equity debt interest deduction. Interest on home equity debt used to improve your principal residence — and interest on home equity debt used for any purpose (debt limit of $100,000) — may be deductible. So consider using a home equity loan or line of credit to pay off credit cards or auto loans, for which interest isn’t deductible.
Debt forgiveness exclusion. Homeowners who receive debt forgiveness in a foreclosure or a mortgage workout for a principal residence generally don’t have to pay federal income taxes on that forgiveness. Warning: This break is scheduled to expire after 2012.
Home office deduction
If your use of a home office is for your employer’s benefit and it’s the only use of the space, you generally can deduct a portion of your mortgage interest, property taxes, insurance, utilities and certain other expenses. Further, you can take a deduction for the depreciation allocable to the portion of your home used for the office. You can also deduct direct expenses, such as a business-only phone line and office supplies.
You must claim these expenses as a miscellaneous itemized deduction, which means you’ll enjoy a tax benefit only if your home office expenses plus your other miscellaneous itemized expenses exceed 2% of your AGI. If, however, you’re self-employed, you can use the deduction to offset your self-employment income and the 2% of AGI “floor” won’t apply.
Of course, there are numerous exceptions and caveats. If this break might apply to you, discuss it with your tax advisor in more detail.
Home rental rules
If you rent out all or a portion of your principal residence or second home for less than 15 days, you don’t have to report the income. But expenses associated with the rental won’t be deductible.
If you rent out your principal residence or second home for 15 days or more, you’ll have to report the income. But you also may be entitled to deduct some or all of your rental expenses — such as utilities, repairs, insurance and depreciation. Exactly what you can deduct depends on whether the home is classified as rental property for tax purposes (based on the amount of personal vs. rental use):
Rental property. You can deduct rental expenses, including losses, subject to the real estate activity rules. You can’t deduct any interest that’s attributable to your personal use of the home, but you can take the personal portion of property tax as an itemized deduction.
Nonrental property. You can deduct rental expenses only to the extent of your rental income. Any excess can be carried forward to offset rental income in future years. You also can take an itemized deduction for the personal portion of both mortgage interest and property taxes. In some situations, it may be beneficial to reduce personal use of a residence so it will be classified as a rental property.
When you sell your principal residence, you can exclude up to $250,000 ($500,000 for joint filers) of gain if you meet certain tests. To support an accurate tax basis, maintain thorough records, including information on your original cost and subsequent improvements, reduced by casualty losses and any depreciation that you may have claimed based on business use.
Warning: Gain on the sale of a principal residence generally isn’t excluded from income if the gain is allocable to a period of nonqualified use. Generally, this is any period after 2008 during which the property isn’t used as your principal residence. There’s an exception if the home is first used as a principal residence and then converted to nonqualified use.
Losses on the sale of a principal residence aren’t deductible. But if part of your home is rented or used exclusively for your business, the loss attributable to that portion will be deductible, subject to various limitations.
Because a second home is ineligible for the gain exclusion, consider converting it to rental use before selling. It can be considered a business asset, and you may be able to defer tax on any gains through an installment sale or a Section 1031 exchange.
Or you may be able to deduct a loss, but only to the extent attributable to a decline in value after the conversion.
Real estate activity losses
Losses from investment real estate or rental property are passive by definition — unless you’re a real estate professional. Then you can deduct real estate activity losses in full. To qualify as a real estate professional, you must annually perform:
- More than 50% of your personal services in real property trades or businesses in which you materially participate, and
- More than 750 hours of service in these businesses during the year.
Each year stands on its own, and there are other nuances to be aware of. If you’re concerned you’ll fail either test and be stuck with passive activity losses, consider increasing your hours so you’ll meet the test. Keep in mind that special rules for spouses may help you meet the 750-hour test.
Tax-deferral strategies for investment property
It’s possible to divest yourself of appreciated investment real estate or rental property but defer the tax liability. Such strategies may, however, be risky from a tax perspective until there’s more certainty about future capital gains rates — if rates go up, tax deferral could be costly. (See the Chart “What's the maximum capital gains tax rate?”) So tread carefully if you’re considering a deferral strategy such as the following:
Installment sale. An installment sale allows you to defer gains by spreading them over several years as you receive the proceeds. Warning: Ordinary gain from certain depreciation recapture is recognized in the year of sale, even if no cash is received.
Sec. 1031 exchange. Also known as a “like-kind” exchange, this technique allows you to exchange one real estate investment property for another and defer paying tax on any gain until you sell the replacement property. Warning: Restrictions and significant risks apply. •