Copyright © 1998 Robert L. Sommers, all rights reserved.
Note: Portions of the December 1998 Hot Topics have been taken from other writings appearing on this Website throughout the year.
Year-end tax planning actually involves the provisions of the Taxpayer’s Relief Act of 1997 ("Act") which took effect in 1998. Although Congress passed the IRS Reform and Restructuring Act of 1998 this year, few of its provisions will affect your income taxes. The major change in this year's legislation was the shortening of the long-term capital gains period from 18 to 12 months, effective for sales after January 1, 1998.
The 1998 Reform rules leveled the playing field between IRS and taxpayers, but did not provide any significant income tax changes. Taxpayers were given protections regarding tax collections and controversies, including expanded innocent spouse relief, liberalized Offer in Compromise rules for reduction of delinquent tax bills, a shift in the burden of proof from the taxpayer to the IRS, and procedural "due process" safeguards regarding IRS collection efforts.
For 1999, the Congressional Republicans plan to push for more capital gains cuts, from the present 20% to 15% for all investment property, including real estate depreciation recapture which is now taxed at 25%. However, don't count on these proposals becoming law soon. President Clinton has announced social security reform as his top priority which must be addressed before any tax-cutting measures will be considered. Also, Republican enthusiasm for tax cuts stems from 10-year projections of mammoth budget surpluses, an assumption that can quickly change if the economy slows. Nevertheless, if you are planning to sell real estate with substantial depreciation recapture, it might be prudent to wait and see whether the promised capital gains cuts materialize in 1999.
As discussed in last year's article on year-end tax planning, the simple rule -- defer income to next year and accelerate deductions in 1998 -- no longer automatically applies. Such a strategy could backfire, causing taxpayers to lose benefits in ‘99. Under the Act, many of the tax breaks which began January 1, 1998, will be phased out (reduced ratably over a range of income) when a taxpayer's adjusted gross income ("AGI") reaches certain levels. Therefore, it is critical to determine which tax breaks you are eligible for and then take the appropriate steps to keep your AGI within the limits. The accompanying chart illustrates the impact of AGI on various tax incentives.
| Tax Break | Description |
AGI Limitations |
| Dependency Credits | $400 per child; $500 per child in 1999, for children under age 17 | Single: $75,000 Joint: $100,000 |
| Hope Scholarship | $1,500 credit for first two year of post-secondary education | Single: $40,000 -$50,000 Joint: $80,000 to 100,000 |
| Lifetime Learning Credit | 20% of first $5,000 ($10,000 in 2003). $1,000 in total ($2,000 in total in 2003) | Single: $40,000 -$50,000 Joint: $80,000 - $100,000 |
| Education IRA | $500 per student until age 18 | Single: $95,000 - $110,000 Joint: $150,000 - $160,000 |
| IRA Contributions | Eligibility increases in stages | Single: Increase from $25,000 to $40,000 in 2005. Joint: Increase from $40,000 to $80,000 in 2007. |
| Educational Loan Deductions | Interest deduction of $500 in 1998; increasing $500 per year to $2,500 | Single: $40,000 to $55,000 Joint: $60,000 to $75,000 |
| Roth IRA | Non-deductible $2,000/ yr. Distributions are tax-free | Single: $95,000 to $110,000 Joint: $150,000 to $160,000 |
| IRA Rollover to Roth | Rollover of IRA account to Roth IRA (transaction could be taxable) | Single: $100,000 Joint: $100,000 (ineligible if married filing separately) |
| IRA for Non- Participant Spouse | Up to $2,000 per year | Joint: $150,000 |
When calculating your 1999 tax bite, start with your total income. From total income, there are certain "above-the-line" deductions (IRA, SEP and Keogh contributions, moving expenses, self-employed health insurance and alimony payments) which may be taken to arrive at AGI. These deductions are permitted whether or not you itemize deductions. Your AGI becomes your focal point for potential tax benefits.
[See the December, 1997 Hot Topics for more on this strategy. Note: The techniques discussed in the December, 1997 Hot Topics apply for 1998 tax planning as well.]
Roth Rollover: The most important investment decision most taxpayers will make this year is whether to take advantage of the Roth IRA by rolling over some or all of their investments held in traditional IRAs. Thus far, only 1% of the funds held in traditional IRAs has been rolled over into Roths.
If your adjusted gross income ("AGI") is less than $100,000, seriously consider converting all or a part of your IRA to a Roth IRA by year's end. Reams of advice have been written about the Roth IRA. Basically, when you rollover a traditional IRA to a Roth, you'll pay ordinary income tax (but no penalties) on the full amount of the rollover, but there are no additional taxes paid on any "after-tax" IRA contributions. The tax is due in the year of the rollover, however, if you complete the rollover by midnight, 1998, then any taxes owing are spread equally over four years. Those who converted prior to the market's decline, may switch back to an IRA and then reconvert to a Roth (at the lower value) by the year's end.
For example: If you transferred your original IRA to a Roth when the IRA was worth $20,000 but now is worth only $12,000, you may switch back to the old IRA, then attempt to time the market to fund your Roth at $12,000 or a lower valuation.
To Marry or Not to Marry?
The impact of getting married on one's taxes cannot be under-estimated. Usually, marriage will have a negative impact if both parties are earning significant amounts of income, but that is not always the case.
Couples who "tie-the-knot" on or before December 31, 1998 are considered married throughout the entire year, and this may significantly impact your taxes.
Note: Congress is considering the elimination of the so-called "marriage tax penalty" by increasing the standard deduction for married couples, but this change will have little impact on those who itemize their deductions (usually those who own a home or pay substantial state income taxes).
Roth Limitation: An individual with AGI of $100,000 or less may engage in a Roth rollover, but the same AGI limitation applies to the combined incomes of a married couple. Postpone marriage until next year if you and your fiancé's combined AGI will exceed $100,000. Although it is patently unfair to limit a married couple's AGI to the same amount ($100,000) that applies to single filers for the Roth rollover, there is little movement in Congress to change this rule.
Avoid the 10% Surcharge: The 10% surcharge (36% tax bracket becomes 39.6%) applies to individuals or couples with taxable incomes exceeding $250,000. Therefore, if two individuals with taxable income of $225,000 each ($450,000 total) get married, $200,000 of their income will be taxed at 39.6% ($450,000 taxable income - $250,000). In contrast, if they do not marry (each files as a single person), neither will pay tax at 39.6%.
Sale of a Principal Residence: Individuals who have owned and lived in their home for two of the past five years prior to sale ("residence"), may exclude up to $250,000 in profits ($500,000 for joint filers). Assume a single woman, who has lived in her residence with her fiancée for at least two years, sells her residence during the year for a $500,000 profit. If the couple marries before year's end and files a joint return, the full $500,000 will be excludable, even though the residence was sold prior to their marriage.
Those searching for last minute deductions should consider the following "standard" techniques:
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 as part of your records), then donate them to Goodwill or your favorite charity to claim a charitable deduction. Items over $250.00, require a receipt. Also, if you have a used car, consider donating it to charity for a full blue book deduction.
Contribute appreciated property to public charities and receive a deduction for the full fair market value on the date of the donation. Congress restored the provision allowing a full charitable deduction for gifts of publicly traded stock (held more than 12 months) to a private foundation for the full fair market value of the stock.
Taxes and Mortgage Interest: Pay your fourth quarter state income tax estimate and prepay your January mortgage payment this year. Pay your second property tax installment due in 1999, by the end of 1998. The same holds true for deductible alimony payments and student loan interest (provided you meet the stringent rules for the deduction).
The mortgage and property tax prepayment techniques work when you make direct payments to the property tax authorities, rather than include them ratably with your mortgage payment. Also, it is prudent to pay your January mortgage several weeks in advance so that your mortgage company will properly record the payment as made in 1998 when it issues you a Form 1096.
Note: Although an inaccurate Form 1096 does not prevent you from deducting the January payment, it could require you to prove to IRS that you actually made the January payment in December, if you are audited.
Medical Expenses: Schedule medical and dental work prior to the end of this year and pay all medical expenses prior to the end of ‘98. These expenses are deductible to the extent they exceed 7.5% of 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 (these have strict requirements), certain education expenses for maintaining skills, union and professional dues and expenditures for equipment (up to $18,500) placed in service in 1998, 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 1999 count as 1998 deductions, even though the credit card charges are paid in 1999. If you are considering several large expenditures, obtain a less-expensive (less than interest charged on credit cards) home-equity line of credit (or use one you already have) to pay the expenses in 1998. Generally, interest on the first $100,000 borrowed against a home-equity line is deductible.
Note: It is possible to earn bonus mileage or rebates by paying your property taxes with a credit card. Also, starting in 1999, you will be permitted to pay your federal income tax liability with a credit card. Determine which credit cards are available for these payments and the services charges. Earn bonus points on your credit card without incurring the high interest rates by paying for taxes with your credit card, then using your home-equity loan to pay off the credit card balance.
Capital Gains: Reduce your tax bite by netting your long-term capital gains and losses. Remember, you may sell stock at a loss for tax purposes and reacquire the same stock, provided you wait at least 31 days after the sale. Note: You can sell your stock in one company and purchase stock in a similar company (or mutual fund) without running afoul of the wash sales rules.
Annual Gift Tax Exclusion: Maximize your annual gift tax exclusion by gifting up to $10,000 (couples may gift $20,000), per beneficiary, in money or property, by year's end. Since this annual benefit expires on December 31 of each year, for those facing large estate taxes, it is prudent to maximize your gift giving privilege each year.
Note: Gift giving reduces your estate for estate tax purposes, but does not reduce your income tax burden. There is no income tax deduction for gifts.
Use the "minority discount" technique to gift a much larger percentage of property than the equivalent amount of cash. For example, a couple owns real estate worth $200,000 and gifts a 10% interest to their daughter. If the gift is subject to a 30% minority discount, the interest is not valued at $20,000 ($200,000 x 10%), but is worth only $14,000. Thus, a 14.25% interest initially worth $28,500 but then discounted by 30%, receives a value of $19,950, which is under the $20,000 annual gift tax limit.
By forming a family limited partnership then gifting limited partnership interests at a discount, taxpayers hope to substantially reduce their estates. But beware of using family limited partnerships to create minority discounts when the partnership merely holds appreciated securities or other passive investments. This no longer works (if it ever did) and IRS is aggressively challenging these arrangements as lacking economic substance.
Incentive Stock Options: If you have Incentive Stock Options, 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 Alternative Minimum Tax (AMT). For example, if you exercise 1,000 options at $5.00 each (total option price $5,000) and the stock is worth $50 a share (total value $50,000), the spread will be $45,000 for AMT purposes. Calculate the maximum amount you can exercise without triggering tax consequences under the AMT. Use a tax software program or contact your tax preparer regarding this calculation.
California Businesses and Self-Employed Workers: Annual Minimum Franchise Tax: California charges corporations, limited partnerships and limited liability companies an annual minimum franchise tax of $800 a year. If you have an inactive company, liquidate it prior to the end of the year. You need to file for dissolution with the Secretary of State prior to the end of the year. Likewise, wait until 1999 to form a new entity and save the annual minimum tax otherwise payable in 1998.
Self-employed individuals should open a Keogh Retirement Plan prior to December 31st, although once opened, contributions may be made until the due date of your return (including extensions).
Whether to reduce your income in 1998 or 1999 depends on the income restrictions for those tax breaks you desire and your AGI estimate in 1999. You lower your income in 1999 by deferring AGI adjustments to 1999 or by accelerating income into 1998. You lower your income in 1998 by doing the opposite.
Remember: Itemized deductions reduce your taxable income but not your AGI.
The Roth rollover is the most important investment decision facing taxpayers in many years. The Roth holds the promise of a tremendous tax break in the future, although you'll likely pay an up-front tax, payable at the time of conversion. That tax bite, however, is spread over 4 years if it is accomplished by midnight, 1998. Juggling the incentive stock options within the AMT exclusions is another important tax decision that should be made annually. Also, maximizing your gift giving on an annual basis will reduce your estate for estate tax purposes.
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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**