Year-end tax strategies in a down year
Year-end tax planning this year will be different from years past, largely because of the recession. For many taxpayers, the year has meant a job loss, a job with less income or perhaps a home foreclosure. If you own a small business, chances are you have seen revenue drop by 10 to 25 percent.
Many of the financial indicators are worse than they have been during my entire career. Not every business is declining. And the recession offers some opportunities. The point is, the old rules of tax planning cannot be blindly followed this year.
Conventional wisdom says to defer income and accelerate deductions to reduce your federal income tax. The theory is that in this way you will delay taxes and hopefully you will be in a lower tax bracket next year. Things are different this year for a lot of people in situations they’ve never been in before because of the economic times.
For many people who have seen their family incomes slashed, this may be the year to go against conventional wisdom. Here are the possible tax implications of scenarios created by the ailing economy:
Home foreclosure:
Generally, if you owe a debt to someone and they cancel or forgive that debt, the canceled amount may be taxable. However, the government offers a tax break to help homeowners who lost their home to foreclosure. Under the law, a taxpayer whose principal residence was foreclosed on does not have to claim the amount of debt canceled as income. Debt reduced through a loan modification also is exempt. A loan modification makes mortgage payments more affordable by reducing the interest rate or lengthening the term of a mortgage. Up to $2 million of forgiven debt is eligible for this exclusion; the limit is $1 million for married couples filing separate tax returns. The provision applies to debt forgiven in 2007 through 2012.
Job loss
If you’ve been laid off, your taxable income could well be significantly lower when you start taking into account exclusions and dependency deductions. That could leave you in a situation where your tax deductions exceed your income.
If your deductions exceed your income and you need money, you could tap your retirement plan if you’re over age 59 ½. In those cases, the tax paid on the withdrawals will be largely offset by your deductions.
If you’re younger than 59 ½ and make withdrawals from your retirement plan, you’d have to pay a 10 percent penalty on top of the tax owed. That’s why you should tap your retirement funds only as a last resort. If you’ve been collecting unemployment, know that for 2009, the first $2,400 of unemployment compensation is excluded from tax. All unemployment compensation beyond the first $2,400 is taxable.
If you’re hunting for a job, keep track of the miles you drive, fees you pay for parking or tolls, employment agency fees, résumé preparation fees, long-distance calls and other costs associated with your search. You may be able to claim these expenses as a miscellaneous deduction on your tax return.
If you are one of the lucky ones who did not feel the bite of the recession, here are some ways to save on your taxes.
Sales tax
If you buy a new vehicle by Dec. 31, you can deduct state and local sales taxes paid on up to $49,500 of the purchase price, whether you itemize or not. The tax break starts to phase out if your modified adjusted gross income is $125,000 or more for single taxpayers and $250,000 or more for joint filers.
Homebuyer’s credit
New legislation, the Worker, Homeownership and Business Assistance Act of 2009, which was signed into law on Nov. 6, 2009, extends and expands the first-time homebuyer credit allowed by previous Acts. The new law:
• Extends deadlines for purchasing and closing on a home.
• Authorizes the credit for long-time homeowners buying a replacement principal residence.
• Raises the income limitations for homeowners claiming the credit.
Under the new law, an eligible taxpayer must buy, or enter into a binding contract to buy, a principal residence on or before April 30, 2010 and close on the home by June 30, 2010. For qualifying purchases in 2010, taxpayers have the option of claiming the credit on either their 2009 or 2010 return.
For the first time, long-time homeowners who buy a replacement principal residence may also claim a homebuyer credit of up to $6,500 (up to $3,250 for a married individual filing separately). They must have lived in the same principal residence for any five-consecutive year period during the eight-year period that ended on the date the replacement home is purchased.
People with higher incomes can now qualify for the credit. The new law raises the income limits for homes purchased after Nov. 6, 2009. The credit phases out for individual taxpayers with modified adjusted gross income (MAGI) between $125,000 and $145,000 or between $225,000 and $245,000 for joint filers. The existing MAGI phase-outs of $75,000 to $95,000 or $150,000 to $170,000 for joint filers still apply to purchases on or before Nov. 6, 2009.
Several new restrictions apply to homes purchased after Nov. 6, 2009. Purchasers must attach a properly executed settlement statement to their return. Imagine the government’s surprise that some people claimed the $8,000 tax credit without actually buying a new house. No credit is available if the purchase price of the home exceeds $800,000.
The purchaser must be at least 18 years old on the date of purchase. For a married couple, only one spouse must meet this age requirement. You would not believe how many five-year-old children bought their first house last year and let their parents live with them. A dependent is not eligible for the credit.
The new law gives the IRS broader authority to deny first-time homebuyer credit claims, without having to first audit a taxpayer’s return. Known as math error authority, this authority applies, retroactively, to credits claimed on original and amended 2008 returns, as well as to claims yet to be filed.
Additionally, there are new benefits for members of the military and certain other federal employees:
Members of the uniformed services, members of the Foreign Service and employees of the intelligence community serving outside the U.S. have an extra year to buy a principal residence in the U.S. and qualify for the credit.
In many cases, the credit repayment (recapture) requirement is waived for members of the uniformed services, members of the Foreign Service and employees of the intelligence community.
More information on these new benefits for the military, Foreign Service and intelligence community serving outside the U.S. is available at irs.gov.
General information
Homebuyers who purchased a home in 2008, 2009 or 2010 may be able to take advantage of the first-time homebuyer credit. The credit:
• Applies only to homes used as a taxpayer’s principal residence.
• Reduces a taxpayer’s tax bill or increases his or her refund, dollar for dollar.
• Is fully refundable, meaning the credit will be paid out to eligible taxpayers, even if they owe no tax or the credit is more than the tax owed. The credit is claimed using Form 5405, which you file with your original or amended tax return.
For 2008 home purchases
The Housing and Economic Recovery Act of 2008 established a tax credit for first-time homebuyers that can be worth up to $7,500. For homes purchased in 2008, the credit is similar to a no-interest loan and must be repaid in 15 equal, annual installments beginning with the 2010 income tax year.
For 2009 home purchases
The American Recovery and Reinvestment Act of 2009 expanded the first-time homebuyer credit by increasing the credit amount to $8,000 for purchases made in 2009 before Dec. 1. However, the new Worker, Homeownership and Business Assistance Act of 2009 has extended the deadline. Now, taxpayers who have a binding contract to purchase a home before May 1, 2010, are eligible for the credit. Buyers must close on the home before July 1, 2010. (Added Nov. 12, 2009.) For home purchased in 2009, the credit does not have to be paid back unless the home ceases to be the taxpayer’s main residence within a three-year period following the purchase.
First-time homebuyers who purchase a home in 2009 can claim the credit on either a 2008 tax return, due April 15, 2009, or a 2009 tax return, due April 15, 2010. The credit may not be claimed before the closing date. But, if the closing occurs after April 15, 2009, a taxpayer can still claim it on a 2008 tax return by requesting an extension of time to file or by filing an amended return. News release 2009-27 has more information on these options.
Retirement contributions
You can make tax deductible retirement contributions that will lower your taxable income.
• Maximize 401k contributions. Calculate how much you have left under your 2009 401k contribution limits and determine if you can increase your contribution through work. This can be a great move if you can work it into your budget.
• Traditional IRA contributions. You can deduct up to $5,000 if you qualify. Here is more information about 2009 IRA contribution limits.
Self employed retirement plan contributions
Several self-employed retirement plans are tax deductible, including SEP IRA, Solo 401k, SIMPLE Plan, and Keogh Plan.
Of these plans, you can contribute to the Traditional IRA, SEP IRA, SIMPLE Plan or Solo 401k after January 1. So you should focus your contributions toward maxing out your retirement plans that must be funded by the end of the year, such as your 401k, 403b, Thrift Savings Plan (TSP), or similar retirement plans. Then focus your retirement contributions on any retirement plans that allow you to max out your retirement contributions in the following calendar year. Here are more year-end planning tips.
Buy an energy star appliance.
This year there are special rebates for Energy Star rated appliances. These programs are federally funded, but the money and rebates are being handled by the states, so the details may vary. Eligible appliances include heat pumps, furnaces, central and window air conditioners, refrigerators, freezers, dishwashers, washing machines and water heaters.
The amount of the rebates varies between $50 to $200 per item, and you do not have to turn in an old appliance like one had to turn in an old car with the Cash for Clunkers program.
Business deductions
If you own a business, you may be able to deduct eligible expenses. If you haven’t been categorizing your expenses, now is a good time to go through your receipts and categorize them based on type of expenditure. You can also look at your expense forecast to see if there are any purchases you can make before the year end to increase the amount of deductions you can take. You should also look at depreciation schedules, some of which have changed for this tax year. This is an area where hiring an accountant can really pay off.
Other year end tax deductions and tips
Harvest tax losses. You can write off investment losses.
Donations. You can make tax-deductible donations to eligible charities and non-profit organizations. Be sure to avoid charity scams and determine which charities are legitimate before giving your hard earned money.
Avoid capital gains taxes. Wait until after the New Year to sell investments for gains — postponing your taxes for a full calendar year. Remember, however, that capital gains tax rates will increase from 15 to 20 percent as of January 1, 2011. So don’t delay harvesting gains too long.
Every tax situation is unique
The focus of this article is to share a few ways you can prepare for your taxes before December 31 rolls around. This article isn’t designed to be a full blueprint for tax planning as it only covers a small percentage of the available tax deductions. You may also consider meeting with a tax professional for more advanced tax planning.
Year-end tax planning always makes sense, but this year it’s especially vital.
I offer a “mini consultation” for employers and provide them with some free handouts they can share with their employees in order to help them with their tax planning in a cost and time effective manner. The consultation includes offering a deep discount on tax preparation for both employer and employees, who often spend far more on tax preparation with companies such as H&R Block than I charge.
Because tax laws have become so complex, using a CPA can save employers and their employees a great deal of expense, avoid costly mistakes and prevent IRS audits. For more information on the mini consultation service, contact my office at (423)648-6240.
