Edward A. Lyon, JD
TaxTuneup.com, Inc.
3416 Shaw Ave #5
Cincinnati OH 45208
513.321.2821
elyon@taxtuneup.com
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Tax Credits
Tax credits are like turbocharged tax deductions. Tax
deductions cut your taxable income. Every dollar of deduction cuts your tax
by whatever percentage of that deduction equals your tax bracket. Tax
credits cut your actual tax. So every
dollar of credit cuts your tax by a full dollar. Some credits, like the
Earned Income Tax Credit,
are even refundable, which means that if your credit is more than your tax,
the IRS send money to you.
Tax deductions grow more
valuable as your taxable income rises. If you're in
the 15% bracket, every dollar you deduct cuts your tax by 15 cents. If
you're in the 35% bracket, that same dollar deduction cuts your tax by
35 cents. But tax credits are more valuable for taxpayers in lower
brackets. In the 35% bracket, you need $2,857 in deductions to get the
same break as a $1,000 credit. In the 15% bracket, you'd need a whopping
$6,666.66 in deductions to equal that $1,000 credit.
There's no shortage of tax
credits you can use to cut that final bill:
Tax Deferral
Tax deferred investments, including most
Individual
Retirement Accounts,
Qualified Plans, Annuities,
and Life Insurance, let
you defer tax on your gains until you withdraw your money from the account.
This boosts your return by letting you earn income on the money you would
have paid in tax. Tax-deferred investments also preserve the value of
deductions, credits, and other breaks by holding down your adjusted gross
income. Over time, this extra income can make a real difference.
Example: You have $2,000 per year to
invest for 20 years at 10%. If you invest the money in a tax-deferred
account, you'll end up with $126,005. If you pay income tax of 28% on your
annual earnings, your account will be worth just $89,838, or nearly 29%
less.
Tax-deferred accounts have one significant
disadvantage: plan withdrawals are taxed as ordinary income. There's no
chance to take advantage of lower rates on capital gains, and there's no
stepped-up basis for assets you hold until your death. In some cases, the
advantages of capital gains outweighs the advantage of tax-deferred
compounding. So, if your portfolio is large enough to include investments
outside your tax-deferred accounts, you need to plan which investments to
hold in tax-deferred accounts (to take advantage of tax-deferred
compounding) and which to hold in taxable accounts (to take advantage of
capital gains).
Tax-Deferred Exchange
Tax-deferred exchanges let you exchange one
business or investment asset for another and defer tax on your gain until
you dispose of the replacement asset. These are available for several
types of property, including real estate ("Section 1031 exchange") and
insurance and annuities ("Section 1035 exchange"). Tax-free exchanges let
you exchange one property for another and defer tax until you dispose of the
replacement property. In some cases, you can defer tax indefinitely through
a series of exchanges.
Section 1031 Exchange
You can exchange one investment property
for another "like-kind" investment property, tax-free. Like-kind property
is liberally defined according to how you use the property--investment
property, property held for business use, or residential property--and not
character. You can exchange raw land for developed acreage, a city
apartment for a suburban strip center, and even fee-simple property
(outright ownership) for a leasehold of 30 years or longer. (You can't
trade American property for foreign property.) Postponing the tax gives
you the same advantage as an interest-free loan in the amount of tax you
save. Here are the rules:
- You have to hold both the old and new
properties for investment. For example, you can't trade investment
property for a primary residence.
- Both transfers have to happen within a
180-day period. If you don't specifically identify one of the properties
to be traded, you must do so within 45 days of the first transfer.
- If you receive extra property in the
exchange--cash or nonlike-kind property--called "boot," you'll owe tax on
the value of the boot.
- If you trade mortgaged property, the value
of the mortgage released is boot. If both parties transfer mortgaged
property, the one giving up the larger mortgage reports the difference in
mortgage amounts as taxable boot.
- Ordinarily you can't declare a loss on a
like-kind exchange. However, if you give up "boot" in the trade, you can
declare the amount you give up as a loss.
- You have to carry over your basis in the
old property to the new property. This can limit your depreciable basis in
the new property, plus increase your taxable gain if you eventually sell.
Report exchanges of like-kind property,
along with boot, on
Form
8824. If you report a loss on the trade, carry the loss to
Schedule D as well.
Section 1035 Exchange
You can exchange a life insurance policy
for another life insurance policy, an annuity for another annuity, or a
life insurance policy for an annuity. (You can't exchange an annuity for a
life insurance policy, and you can't exchange an individual policy for a
survivorship policy.)
Tax-Engineered Products
Tax-engineered products are a group of
sophisticated strategies to avoid tax on stock sales. These may be limited
to investors with at least $1 million in a single stock-- which sure isn't
as much as it sounds anymore. Some of these strategies turn on separating
ownership of a stock from the risk of ownership. Other strategies involve
creating "derivative" securities based on underlying equities.
"Equity swaps" let you lock in
profit on a stock without selling. For example, you may have $5 million
worth of stock in your former company. The stock yields 2%, and pays just
$100,000 a year. You'd rather buy some Treasury bonds and make three times
that amount. You'd sell the stock to buy the bonds, but you'd owe tax of
$1 million on the sale. Instead, go to a Wall Street investment bank. The
bank creates a derivative security giving them the risk of ownership and
paying you the income from the Treasuries. You keep legal title to the
stock. There's no tax because you don't actually sell.
"Swap funds" are a similar device
for diversifying low-basis stock or other assets without selling. A swap
fund lets you contribute your low-basis stock or other assets into a
partnership made up of other wealthy investors. There's no tax due on the
exchange, and you wind up owning shares in a more diversified portfolio
consisting of all the investors? various assets. Alternatively, the fund
itself sells the assets and invests in a diversified portfolio.
"Zero-cost collars" are
one more technique to diversify without selling. This strategy uses put
and call options to hedge your stock position so that you can borrow more
against it. First, sell a call on the stock--an option requiring you to
sell the stock at a certain price. Then, buy a put on the same shares--an
option that lets you sell at a predetermined price and protects you from a
fall in the price. The money you make from selling the call pays for the
cost of the put--hence the name "zero cost" collar. Then, simply borrow
against the stock, safely knowing the put protects your position. Most
lenders will only give you 50% of the stock's value. This is to protect
them against a drop in price. The collar gives your lender confidence to
lend you up to 90%.
"Variable prepaid forwards"
are agreements to sell shares at a future date in exchange
for a specified payment today. The investment bank writing the contract
specifies a minimum “floor price” and maximum “cap price,” writes options to
hedge its risk, then prepays you the purchase price on the trade date. When
the position expires, you’ll deliver as much stock as it takes to fulfill
your obligation, depending on its price at that time. If the price doubles,
for example, you’ll deliver just half of the shares you based your price on
to satisfy your obligation. Or you can renew the arrangement to defer the
tax even further.
Variable prepaid forwards may be the most
popular "tax-engineered product." However, they have also attracted the most
IRS scrutiny. The IRS has recently instructed auditors to pay close
attention to them. that doesn't mean avoid the strategy -- it just means pay
attention to dotting your "i"s and crossing your "t"s.
Tax-Managed Mutual Funds
Tax-managed mutual funds are a category of
mutual funds that focus on avoiding taxes. They do this by avoiding
turnover, matching gains with losses, selling specific shares within
holdings to minimize taxable gain, and avoiding stocks that pay large
dividends. Some tax-managed funds also hit sellers with an early-redemption
penalty to discourage withdrawals that might force the manager to sell
shares and realize gains. These funds may be appropriate for college savings
and retirement planning outside tax-deferred accounts. They can also help
avoid Kiddie Tax on funds in your
children's names. Few of them have long-term track records. But the
category bears watching. See also Index Funds and
Exchange-Traded Funds.
Tax Preparation
Fees,
- Personal tax preparation fees, including
legal and accounting fees for IRS audits, IRS rulings, or Tax Court cases, are a
Miscellaneous
Itemized Deduction subject to the 2% floor.
- Tax preparation fees for your trade or
business are a deductible
Business Expense on
Schedule C,
Form 1065, or
your corporate return.
- Tax preparation fees for rental real
estate income are a deductible
Real Estate
expense on
Schedule E
or your partnership or corporate return
If you have self-employment income, rent
and royalty income, or farm income, you can allocate a portion of your tax
preparation fee to specific schedules to avoid the 2% floor on
miscellaneous itemized deductions. However, be aware that the IRS is on
the lookout for taxpayers who improperly shift personal expenses onto
business schedules.
Tax Refunds
Tax refunds are generally nontaxable income.
State and local tax refunds are nontaxable income if you did not itemize the
previous year. However, your refund is taxable if you deducted your state
taxes the previous year. Report taxable refunds on Form 1040.
Example: In 2007, your employer
withholds $2,000 in state taxes that you deduct on your 2007 return. In
2008, the state refunds $400. That $400 is taxable in 2008.
Tax Shelters
Tax shelters, broadly defined, include any investment or business arrangement designed to
avoid tax. (A more cynical definition would be any investment or business
arrangement with no business purpose other than tax
avoidance.) These may involve deferring income, accelerating deductions, or
converting ordinary income into capital gains. Historically, investors could
use these investments to shelter unrelated income.
Congress killed most of these opportunities
with the 1986 tax reform and passage of the passive activity rules. However,
there are still opportunities to earn tax-advantaged income:
-
Equipment Leasing programs use
accelerated Depreciation to pay tax-advantaged income today and defer
taxes into the future.
-
Low-income Housing
Credit programs generate low-income housing credits that you can
use to shelter a limited amount of unrelated income.
- Oil
and Gas programs give you deductions for depletion, depreciation,
and intangible drilling & development costs.
- Real
Estate investments take advantage of
depreciation to pay tax-advantaged income.
Many of these programs are organized as
Limited
Partnerships, subject to the
Passive Activity rules. The general
partner will report income and deductions on Schedule K-1 for you to report
on Schedule E and other parts of your Form 1040.
Tax Swaps
Tax swaps
are when you sell an asset at a loss and replace it with a similar, but not
identical, investment. The tax swap leaves your portfolio looking the
same--but lets you claim a deduction for the loss on your original asset.
You can use tax swaps with individual securities, mutual funds, and even
real estate. For example, you can swap one computer company for another, one
growth fund for another, or one apartment for another. If you buy back your
original investment within 31 days before or after the original sale, your
loss (but not any gain) will be disallowed as a "wash sale." Buying back
shares in the same security counts as buying your original asset.
To keep your same investment and still
realize a loss, consider "doubling up," buying an identical lot more than
31 days before selling your old lot. You can also use your IRA to avoid
the wash sale rule. Sell an investment from a taxable account, and buy it
back in your IRA. The taxable account lets you take the loss, but buying
it back in an IRA is not treated the same as buying it back yourself. Of
course, if the asset's value continues to fall, you can't take extra loss
from the IRA.
Teeth
Cleaning/Filling/Straightening/Extracting
Deductible Medical Expense
subject to the 7.5% floor.
Telephone
Telephone
costs may be deductible if you use the phone for a deductible purpose. The
cost of installing and maintaining your primary telephone line and any extra
personal lines, such as for your children or your computer, is a
nondeductible personal expense.
Television
Television
costs for watching Monday Night Football and The Simpsons are
nondeductible personal costs. (You might argue that watching Who Wants to
be a Millionaire? is deductible. But you'd lose.) However, television
costs for these purposes are deductible:
Television Close Captioning
Deductible Medical
Expense subject to the 7.5% floor.
Theft Losses
(see Casualty Losses)
Travel
Travel costs, including transportation, lodging, and 50% of meals and
entertainment, are deductible if you travel for a deductible purpose under
these rules:
- Travel for your trade or business is a
deductible Business Expense
on
Schedule C,
Form 1065 or
your corporate return.
- Travel on behalf of your employer is a
deductible
Employee Business Expense subject to the 2% floor on
Miscellaneous
Itemized Deductions. This includes living costs for temporary
assignments lasting less than a year.
- Travel to and from medical facilities is a
deductible Medical Expense
subject to the 7.5% floor. This includes meals and lodging for out-of-town
travel to medical providers such as the Mayo Clinic or Betty Ford. You can
deduct 19 cents per mile for auto expenses, plus parking and tolls.
- Travel for investments is a deductible
Investment Expense,
up to your investment income and subject to the 2% floor on
Miscellaneous
Itemized Deductions (for example, if you travel out-of-state to
acquire investment property). You can deduct 50.5 cents per mile for auto
expenses (2008), plus parking and tolls. (There's no deduction for travel
to investment seminars or shareholder meetings.)
- Travel on behalf of a volunteer or
charitable organization is a deductible
Charitable Gift. Deduct
19 cents per mile for auto expenses, plus parking and tolls.
- If you bring a spouse or dependent, their
costs are deductible only if there's a business purpose for bringing them.
If there's no business purpose, you can still deduct the full cost that
you could deduct if you had traveled alone. For example, if your hotel
costs $140 a night for you, but $160 for you and your spouse, you can
deduct the full $140 that you would pay if you had traveled alone. Don't
just divide the $160 by two and claim $80.
- If you add
Vacation days to a
business trip, the cost of personal travel isn't deductible. For example,
you spend a week in Boston for business, then a weekend visiting family on
the Cape. Your airfare is still deductible, along with the costs of your
week in Boston. But there's no deduction for the cost of your stay on the
Cape.
Travel outside the United States is
deductible if the primary purpose of the trip is for business and you
don't have control of the trip. However, if you're in charge of the
business--you're a managing executive, self-employed, related to your
employer, or own more than 10% of the business--travel abroad is
deductible only if the trip lasts a week or less, or you spend less than
25% of the trip vacationing. If you spend more than 25% of the trip
vacationing, allocate your travel expenses to deductible business travel
and nondeductible vacation travel.
Treasury Securities,
U.S. Treasury securities, including bills
(maturities up to one year), notes (maturities between one and ten years),
and bonds (maturities between 10 and thirty years) pay tax-advantaged income
because Treasury interest isn't subject to state taxes. Your "taxable
equivalent yield" for comparing your true yield is figured much like with a
municipal bond.
Treasury bills, with maturities up to one
year, pay no actual interest. Instead, the Treasury sells the bill at a
discount and redeems it at face value at maturity. There's no interest due
until the bond matures or you sell it at a gain. This lets you push tax on
your "interest" until the following year.
Example: On February 1, 2008, you
buy a T-bill maturing on February 1, 2009. You pay just $950 for the bill,
hold it for a year, then redeem it at maturity for $1,000. No tax is due
on interest you earn in 2008.
Treasury Inflation Protection
Securities
Treasury inflation protection securities, or TIPs, are a new category of
Treasury securities "indexed" to inflation. Each year, your interest and
your face value rise with the consumer price index. The rising interest,
naturally, is taxable as you receive it. The principal "resets" each year to
reflect the rise in the consumer price index. This principal gain is also
taxable each year. If inflation spikes like it did in the 1970s, you could
wind up paying considerable tax on inflationary, paper gains.
Example: In 2008, you pay $1,000 for
a ten-year TIP paying a stated interest rate of 3%. The 2008 inflation
rate is 4%. At the end of 2008, your bond's value will rise by $40, or 4%
of $1,000, and your annual interest will increase by $1.20, or 4% of $30.
TIPs pay a lower stated interest in
exchange for the inflation protection. But since both the interest and
principal gain are taxed each year as paid, they're best suited for
tax-advantaged accounts.
Trusts
Tuition Reduction Programs
Tuition reduction programs that give you tuition
discounts as a school employee or employee's spouse or dependent are nontaxable so long as the program doesn't
discriminate in favor of officers, owners, or highly-compensated employees
of the school.
Tummy Tuck
(See Cosmetic Surgery)
Telephone Teletype Device
Deductible Medical
Expense subject to the 7.5% floor.
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