With advance planning, you may still be able to make smart financial moves and take advantage of legal loopholes that minimize the tax cost.
Smart financial moves pay off best if you tie them to futuretax breaks. Here are some you should consider.
The Internal Revenue Code is the law of the land, but you shouldn't alwaystake it literally. Who says so? The IRS, that's who.
For example, the tax agency's Publication 936 states that you can deductyour home mortgage interest only if the loan is secured by your home. Butit adds that, "You can choose to treat any debt secured by your . .. home as not secured by the home." This, the IRS says, may allow youmore of a deduction.
No, the IRS hasn't lost its marbles. It's just conceding that the rulesof the game include tax-saving options and exceptions for players who knowwhere to look. Some of our suggestions for year-end tax moves illustrate this point. But more extensive planning can lead to evenjuicier tax reductions in the years ahead.
Here are some of the best examples we've found. One or more of them maywell apply to your situation, but even if they don't, consider them evidenceof an undeniable truth: All sorts of quirks are hidden in the tax code,and by planning well beyond the current year, you're bound to find new waysto save.
The IRS currently allows you to deduct all interest on home equity loansof up to $100,000. But what happens when you need to borrow much more thanthat? Can you do something to enable you to write off your interest on theentire amount?
Depending on your circumstances, the answer may be Yes. For instance,let's examine Dr. Lang's situation. He's borrowing $80,000 of his $150,000home equity to enlarge his medical office. He expects to borrow $40,000more during the next couple of years to cover his daughter's wedding andother personal expenses. While his home equity loans would total $120,000,he could deduct only the interest on $100,000the IRS' limit. The restwould be classified as nondeductible personal interest.
However, Lang can treat the $80,000 mortgage debt as a business loanfor his unincorporated practice and deduct the interest along with otherexpenses on Schedule C, instead of claiming it as an itemized deductionon Schedule A. Then it won't count toward the $100,000 limit.
Lang should consider doing this even if he's unlikely to tap his equityfurther. Deducting the current interest as a business expense will probablytrim $6,000 to $7,000 off the practice net he'll declare on his return ineach of the first several years of the loan, lowering his adjusted grossincome by an equal amount. That could mean annual tax savings of severalthousand dollars, since a high AGI cuts allowances for personal exemptionsand deductions. Claiming home mortgage interest as a personal deductiondoesn't lower AGI.
Putting one child through collegeespecially a private schoolis costlyenough. Multiply that expense by two or three kids, and you could wind upin a pickle.
To pay the tabs, you'll likely cash out several investments, but thatwill result in a whopping long-term capital gains bill. Is there a way aroundhaving to pay so much in taxes? Yes. By depositing stock instead of cashin custodial accounts each year, you can cut the tax to half or less.
Here's how Dr. Carroll, the father of 14-year-old twin boys, is managingit. He and his wife plan to set up a custodial account for each of theirsons and contribute the maximum gift-tax-free amount annuallycurrently$20,000 per childfor the next six years. That would add up to at least$240,000.
Since the children are 14, their investment income is no longer taxableto their parents under the "kiddie tax" rules. Assuming that eachchild earns $25,750 or less for 1999, which puts him in the lowest tax bracket,a capital gains rate of 10 percent will apply if the stock is sold thisyear or next. Beginning in 2001, an even lower rate8 percentwill applyto profits on shares held for more than five years.
Suppose the Carrolls contribute stock purchased in 1995 to one son'saccount in 2000, and the custodian sells it that year. If the Carrolls originallypaid $5,000 for shares that brought $10,000 when sold, the tax due wouldbe 10 percent of $5,000, or $500. But say the sale is delayed until 2001and brings $11,000. Then the tax will be only 8 percent of the $6,000 gain,or $480.
Converting a traditional IRA to a Roth IRA makes good sense for manypeople. After all, you won't owe a penny of tax on your principal and earningswhen you're eligible to begin withdrawing them. But to get that benefit,you'll have to pay taxes on the full amount you convert, assuming you'vemade only tax-deductible contributions. You used to be able to spread thetax on Roth conversions over four years, but this isn't permitted anymore.
In addition, you can't convert a traditional IRA to a Roth if your AGItops $100,000. That presents a dilemma for Dr. Golden, whose AGI could exceedthat amount beginning in 2000.
In January, when she starts her own incorporated practice, Golden willreceive a $90,000 payout from her former employer's pension plan. She canmake an immediate tax-free rollover to her new corporation's qualified profit-sharingplan, but she'd rather put the payout into a Roth. To do so, Golden mustfirst transfer the funds to a traditional IRA. She can then convert thisIRA to a Rothagain, provided her AGI doesn't top $100,000.
Golden can keep her options open by setting up a "conduit IRA"atraditional IRA consisting entirely of her pension payout plus earningson the principal. She can roll that fund into her corporate plan any timeshe chooses.
Meanwhile, Golden can stay alert for opportunities to reduce her AGIbelow the Roth conversion ceiling. She can sell some of the losers in herinvestment portfolio, register a capital loss, and buy them again laterif she or her adviser thinks they're due to rebound. If she waits more than30 days to buy the securities again, she can deduct her losses from thecurrent year's income. Even if the rebought shares rise, she won't havean offsetting taxable gainas long she doesn't sell them before Dec. 31.
Golden can also lower her AGI by increasing her deductible business expenses.For example, she can claim an immediate write-off for up to $20,000 of officeequipment and furnishings purchased in 2000, plus regular depreciation onthe balance. And she can supplement her profit-sharing plan with a money-purchasepension plan, another type of defined-contribution plan. This could raisethe deductible contribution limit from 15 percent of salary (the maximumfor profit-sharing plans) to 25 percent.
Golden needs to keep in mind that she'll owe tax on the amount convertedto a Roth. In her 36 percent bracket, that would add $32,400 to her billfor 2000, if she converted the entire $90,000. With proper planning, however,Golden might be able to meet the AGI requirement for Roth conversions inboth 2000 and 2001. Then she could convert only part of the fund each year,which would allow her to spread the tax over two years, though it wouldn'treduce the total tax unless it put her in a lower bracket.
If you hanker to parlay real estate into profits, play the tax rulesright and you can wheel and deal to your heart's content. Take Dr. Morton.He has received a handsome cash offer for some land he bought a while back.He'd like to put the money down on a luxury one-family house that he couldrent out and eventually sell at a profit. But the $50,000 capital gainstax on the land sale would reduce the amount he'd have for the down payment.
Morton and the buyer, however, have agreed on a maneuver that will letthe doctor postpone the tax. Instead of giving Morton the cash, the buyerwill make the down payment on the house, become the nominal owner, thenswap it for the land. Morton's cost basis for the new property will reflectthe price he originally paid for the land, not the land's current value,so his taxable gain when he sells the house will include his profit on theland deal.
But Morton has another ploy up his sleeve. Once the home's value hasappreciated enough to generate a significant capital gain when it's sold,he'll make it his main residence. Afterward, if he waits at least two yearsto sell, he and his wife will be able to exclude up to $500,000 of thatgain from taxes. The fact that the house once was a rental won't bar theexclusion, although Morton will owe a 25 percent capital gains tax on anydepreciation claimed while he rented it out.
Why should you settle for less when negotiating a practice sale? Afterall, you spent years earning your patients' trust and respect. You deservea fair price for goodwill. But such a payment would be taxable at the 20percent capital gains rate.
In Dr. Mason's case, a buyer has agreed to pay $75,000 for goodwill,which would leave $60,000 after taxes. But the buyer has offered Mason,who'll be 65 shortly, a choice: $75,000 upfront, or $100,000, payable overfour years, if he performs consulting work during that period. The consultingfees would be taxed in the years received, as ordinary income. The effectiverate, including self-employment taxes, would be roughly 50 percent, leavingMason just $50,000.
At first glance, the lump-sum payment seems a better deal. But Masonshould consider other tax angles. As a consultant, he could lower his taxableincome by taking advantage of newly liberalized rules on home-office andother business deductions. He could also write off an increasing portionof his and his spouse's health insurance costs50 percent in 2000, risingin steps to 100 percent by 2007. Moreover, even though he'll terminate hispresent pension plan when he sells his practice, the doctor could open ahassle-free SIMPLE IRA. That would let him contribute at least $6,000 ofhis net income each year. Taking all this into account, Mason stands todo better as a consultant.
One drawback to earning money after retirement is the possible loss ofSocial Security benefits. Next year, for example, every $3 of earned incomeabove $17,000 would cost Mason $1 of benefits. But in 2001 and 2002, hecould earn up to $25,000 and $30,000, respectively, without penalty. Topreserve his full Social Security entitlement, Mason could tailor his consultingfees to the annual earnings limits.
As these examples demonstrate, with careful planning you can save moneyandnot only the IRS' way. By sifting through conflicting and interacting tax-lawprovisions, you can do things your way and enjoy some pretty goodtax breaks, too.
Lawrence Farber. Play by the rules--for all they're worth.