Year End Tax Planning

This column, in slightly different format, was written for, but did not appear in, The San Francisco Chronicle Newspaper, December 10, 2000.

Copyright 2000  Robert L. Sommers, all rights reserved.

 Year End Tax Planning

Predictions for the new year

 The new president, whomever he may be, will face an almost evenly divided Congress, making major tax changes difficult.  Even if the Republican estate tax elimination proposal passes, it does not take effect for 10 years.   Income-tax reductions are problematic because proposals were based on unrealistic budget-surplus projections that did not reflect the economy's recent slowdown.

 If you believe that tax reductions will occur in 2001, then defer income until next year and maximize deductions this year.  Remember, there are three goals for income tax planning: (1) recognize income and pay taxes when in a low tax bracket; (2) use deductions to offset income when your tax bracket is high; and (3) when possible, delay the recognition of income, thus delaying the payment of tax.

 Net Capital Gains and Losses

 In 2000, if you purchased investment assets eligible for long-term capital gains (LTCG) and hold them for at least 5 years, you'll pay a maximum federal LTCG rate of 18%, down from the current 20%.  Assets held between 1 and 5 years will continue at the 20% LTCG rate.

 Capital gains and losses during each year are netted: If you have a net capital gain, you pay tax on the gain; if you have a net capital loss, you may apply up to $3,000 against ordinary income, but you must carry forward any additional loss to future years.

 Because of these rules, those with a large capital gain in one year and a loss the next could face disaster – the loss does not offset the previous gain.

 Note: Many "day-traders," those who use the internet to execute stock trades on a daily basis for their own personal gain, are in for a rude tax surprise.  Not only are their short-term capital gains (STCG) taxed at ordinary income rates (as high as 45% for federal and California combined), but short-term capital losses (STCL) incurred in the subsequent year do not offset gains for the prior year.

 Suppose you own a stock that has lost value, but you want to keep it. Can you sell it, recognize the loss, then repurchase it? Yes, if you wait at least 31 days before repurchasing it. This is called a "wash transaction" and the rules state that you cannot acquire "substantially identical securities" within a 61 day period which begins 30 days before the sale and ends 30 days after it.

 Alternative Minimum Tax

 If you expect to owe AMT, because of the exercise of incentive stock options (ISOs) or otherwise, consider accelerating income into 2000 -- by exercising non-qualified stock options, receiving bonuses, collecting on accounts receivable, collecting on installment notes, increasing retirement plan or IRA distributions, or exercising your ISO and disposing of the stock -- by year’s end. Concurrently, wait until 2001 to pay state income taxes, interest payments on home-equity loans or other expenses which are not deductible in calculating the AMT for 2000.

 Note:   If you have LTCG, the AMT might eliminate the deduction for state taxes paid in 2000.  Run the numbers: you might be better off paying state income taxes on those gains in 2001.   The same holds true for real estate taxes and other deductions that do not count for AMT purposes, such as home-equity-loan interest and itemized miscellaneous deductions.

 ISOs and the AMT

 If you have ISOs, exercising them is not a taxable event; however, the spread between the option price and the stock price is an item of tax preference under the AMT. For example, if you exercise 10,000 options at $5 each (total option price $50,000) and the stock is worth $50/share (total value $500,000), the spread will be $450,000 for AMT purposes.  If the stock price drops to $10/share, your stock could be worth less than the amount of AMT payable on that stock.  In this case, consider selling your stock by year's end to avoid the AMT.

 Note: Watch out for stock options that increase your income when exercised, when the underlying stock is "locked-out" of the market (may not be sold, usually for six months).   If you exercise stock options in December, you’ll be taxed on the income in 2000, but because of the lock-out, you may not sell your stock in time to pay your tax liability on April 16, 2001.

 There is an annual AMT exemption ($33,750 for single and $45,000 for married filers - although the actual exemption amount is usually less) available for those who’ve exercised ISOs.  Calculate the maximum amount you can exercise without triggering tax consequences under the AMT with a tax software program or tax preparer. 

 Last Minute Deductions

 For those who itemize deductions, consider the following:

 Charitable Deductions: Empty your house of old clothes, furniture, computer and sports equipment and other "garage sale" items, estimate their fair market value (make an inventory and take pictures for your records).  Then donate them to your favorite charity to claim a charitable deduction. Items over $250 require a receipt. Also, if you have a used car, consider donating it to charity for a full blue-book deduction. Note: IRS is investigating abuses involving charitable donations of automobiles so be prepared to substantiate the value of your donated automobile.

 Contribute appreciated property to public charities and receive a deduction for the full fair market value on the date of donation. Remember, donations of appreciated property, such as stock, include the appreciation as part of the charitable donation, but you will not pay any capital gains tax.

 Taxes and Mortgage Interest: Pre-pay your fourth-quarter state income tax estimate and prepay your January mortgage payment this year. Pre-pay your second property-tax installment due in 2001, by the end of 2000. The same holds true for deductible alimony payments and deductible student-loan interest.

 Medical Expenses: Schedule medical and dental work prior to the end of this year and pay all medical expenses before December 31; these expenses are deductible to the extent they exceed 7.5% of your adjusted gross income (AGI).

 Itemized Miscellaneous Deductions: Itemized miscellaneous deductions must exceed 2% of AGI. Employee expenses not part of an employer’s accountable plan are considered itemized miscellaneous deductions. These include uniforms, travel expenses, automobile expenses, job-related moving expenses, meals and entertainment expenses (with strict requirements), certain education expenses for maintaining skills, union and professional dues, equipment (up to $20,000) placed in service in 2000, supplies and publications. Note: Special rules might apply to computers, automobiles and other mixed-use equipment.

 Paying Deductible Expenses: Payments by check and credit card made in 2000 count as 2000 deductions, even though the charges are actually paid in 2001.

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All contents copyright 1995-2003 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.