Year-End Tax Planning
Posted December 22, 2017
The holidays are coming and people start thinking about year-end moves to minimize their taxes. Every week between Christmas and New Year’s Day we field a zillion questions on year-end tax planning. There are several pitfalls and traps to some of the ideas. We’ll talk about deductions in general. We’ll talk about last-minute tax moves. And Yes, we’ll talk about automobiles. They always seems to top the list of good ideas (or at least most business owners think so). First, let’s chat about the recent 2017 Tax Cuts & Jobs Act reform and how it applies to 2017.
Tax Cuts & Jobs Act 2017
Here are three takeaways that you need to be aware of for 2017. Most of the tax reform changes apply to 2018 tax returns which are due in April of 2019. Yeah, a ways away… but there some little devils in the details for 2017.
The deduction for what you pay in state and local income, sales and property taxes is also getting squeezed. This is commonly referred to as SALT deductions (State And Local Tax). People commonly say SALT deductions and property taxes. Property taxes are inclusive of state and local tax… it is like saying drugs and alcohol. Alcohol is a drug. SALT deductions include all taxes imposed by your state or local jurisdiction. This was defined as such by the Revenue Act of 1913 and later clarified in 1964. Riveting. But somehow we’ve managed to say SALT deductions and property taxes as separate items. At least it is not as bad as saying ATM Machine or ABS Brakes. Who says that? We digress…
Starting in 2018, the new law sets a $10,000 limit on how much you can deduct of the state and local taxes you pay. Can you prepay your property taxes in 2017? No, but you can pay early.
Please pay attention on this one- this was generally the rule anyway. If your property taxes were accruing throughout the 2017 year and are due in 2018, you may still pay them by December 31, 2017 for the deduction in 2017. If you sold your house on 12/31/17 the title company would have withheld your property tax obligation from the proceeds. Same thing here.
Let’s close the loop on this… if your property taxes are paid in arrears (such as Colorado, Illinois, Wisconsin, among several) and your tax bill has been building up over 2017, you can pay in 2017 since the expense is truly a 2017 expense. This is in contrast to property taxes that are assessed in the current year such as California, Georgia, Nevada, among others. To pay property taxes in 2017 for these states would be considered a pre-payment which is not allowed as we understand the law. Pay early versus pre-pay. Subtle difference.
Before you pay your 2017 property taxes early, ensure you are not being hit with AMT which will essentially nullify this deduction. Additionally, if your property taxes are paid out of escrow this might be a challenge- talk to your mortgage lender. And… to pay early the taxing jurisdiction must be able “accept” or “generate a tax due notice” to satisfy the IRS. States and counties are doing all kinds of things to assist.
Another thing states are doing is taxing business owners for income tax and then giving them a credit on their individual tax returns to avoid the SALT limit. Huh? A business owner would pay an income tax on his or her business tax return for the state and get a deduction on the same tax return, and then get this as a credit on his or her federal income tax return. Therefore, income tax is being deducted on the business income tax return for the state and only property taxes are deducted on the federal income tax return.
If you commonly donate to charities your deduction might be limited in 2018. How? The standard deduction for married taxpayers is $24,000 in 2018. If your state, local and property taxes are limited to $10,000 that leaves $14,000 in “room” before you can itemize your deductions. If your mortgage interest is below this amount, then that portion of your charitable donations is “lost” or non-deductible. Therefore, whatever you’ve budgeted as your donation in 2018 should be made in 2017. Example-
|Amount Deduction on 2018 Tax Return||24,000 (standard deduction)|
|Amount of Charitable Donation “lost”||5,000|
Ergo, pay your 2018 contributions in 2017 if the situation above applies to you.
To deduct qualified medical expenses, you must be able to itemize your deductions and exceed 7.5% of your adjusted gross income (AGI). This 7.5% was 10% under the old tax law, but the Tax Cuts & Jobs Act of 2017 retro’d the 7.5% back to Jan 1 of 2017. So… if you have medical expenses you might be able to deduct more of them in 2017 than you would have prior to the tax reform.
Now that those three things are out of the way, you can read our summary of the Tax Cuts & Jobs Act of 2017 changes by clicking on the button below-
If you are a small business owner and need to know how the tax reform and specific Section 199A deductions affect you, you can read our summary of that portion as well-
Stay awake? Here we go on the remainder of our end of year tax moves.
Quick lesson on tax deductions. When you write a check and it has a tax savings element (401k, IRA, charity, etc.) it is not a dollar for dollar savings. For example, if you are in the 25% marginal tax bracket, you must write a check for $4,000 just to save $1,000 in taxes. Keep this in mind as you read this information on year-end tax savings. Also keep in mind that cash is king, and that perhaps paying a few more taxes today with the added flexibility of cash in the bank can be comforting.
Another way to look at this is this- most people say “I want to save taxes” but really what they are saying is “I want to save cash.” In other words, most people are in the cash-saving business not the tax-saving business. If we can do both, great. However, most tax-savings moves take cash, and cash is what you want to keep. So keep this concept in mind as review some of the year end tax moves listed below.
At the end of your life, you’ll measure your financial success on the wealth you built not the tax you saved. We agree that a part of wealth building includes tax savings, but be careful not to sacrifice wealth for the thrill of a tax deduction (or deferral). Here is an example- let’s say you stuff all your available cash into a tax-advantaged retirement account such a 401k. A few years go by and a great rental comes on the market but your cash is all tied up in a 401k. So, you sacrificed potential building of wealth by not having an intermediate investment strategy for the sake of tax deferrals.
Here’s the trick. The Holy Grail if you will. You need to find a way to deduct money you are already spending. Read that again. For example, if you have a travel budget then you are already comfortable with a certain amount of money leaving your person, let’s find a way to deduct it.
Automobile depreciation? Same thing. You are already comfortable with automobiles losing thousands of dollars in value especially in the early years, so let’s a find a way to make this degradation in value a tax windfall.
These examples are more aimed at small business owners, but there might be some things you can do on your individual tax return. Remember that the greatest trick the devil ever pulled was convincing the world he didn’t exist. The second greatest trick was finding a way to deduct the expense. You gotta love The Usual Suspects. Classic!
Another consideration is your income in 2017 versus 2018. If you are going to have a better year in 2018, then delay your tax deduction until January 1. Why pile on tax deductions in a low income year? Silly. Conversely, if 2017 is unusually high, then Yes, pile on those tax deductions. Either way, have a plan! Don’t be shortsighted. Don’t save taxes just because you can- make sure it is the right move.
Some taxpayers have their refunds kept by the IRS because of back taxes, or other obligations such as student loans. In these situations, you can put yourself in a “tax due” position by decreasing your withholdings on your pay checks and putting more money in your pocket today. Yes, you will still owe whatever it is you owe, but at least the extra cash you pay in the form of excess income taxes withheld won’t be used to accelerate your debt payoff.
401k / IRA
The simplest way to save taxes is to contribute to your 401k plan or traditional IRA. You saves taxes and pay yourself in the meantime. Remember this as well- this is an IOU to the IRS. When you retire and are forced to withdraw this money, you will be taxed on it. IRA and Roth IRA contributions are due Tuesday, April 17 2018 (the typical filing deadline for individual tax returns Form 1040), no exceptions.
Business owners- SEP IRAs are old school. Lousy contribution limits. No Roth options. A 401k plan is much better. Ask how we can help.
Roth conversions- perhaps you should have us review the conversion of your traditional IRA into a Roth IRA. Yes, pay more taxes today, but perhaps your 2017 income is lower and it makes sense. Or your income is on a rocket trajectory, and this year is the only year it makes sense. Remember that it is usually easier to pay for taxes during your wage-earning years than when you are 80 years old and only have savings to “dip into.”
Writing a check to your church is good. Don’t forget the theater, educational organizations, and others. Also, what is not just good, but actually great, is donating to Goodwill, Salvation Army, Arc Thrift, etc. Donating items from the hollows of your closet doesn’t require cash since that money is already spent.
Keep in mind that some states, such as Arizona, offer huge tax credits (much better than tax deductions) for donations to schools and charities.
Need some cash? Sell some of your profitable stocks along with your dogs. Not literally your dogs, but your under-performing stocks. Sell enough stock to create a $3,000 gain and sell some more to add a $6,000 loss, and presto! You’ve pulled out some cash and create a $3,000 loss and tax deduction.
Pay Bills Earlier
You can pay some bills early such as property taxes, child care, tuition (possibly) and other deductions. Even for business owners, you can pre-pay rent up to 12 months, insurance, stock up on some office supplies, etc. As mention earlier, there are some rules on this. For SALT deductions, the liability must have been accruing throughout 2017.
What a beautiful color! 2017 Porsche 911 in Carmine Red. Someday. Ok. Here we are on everyone’s favorite topic. Buckle up…
A question we entertain almost daily is “I want to save taxes. Should I have the company buy me a car?” Our auto-attendant replies with, “Do you need a car?” If you answer with “Yes” the auto-attendant replies with, “Hold please.” If your “Yes” is not quick or mumbled, or if there is any recognition of hesitation, the auto-attendant is unhappy and will send you to our call center in Hawaii.
We digress. There are only a few questions you need to ask yourself when considering a car purchase. Are you the type of person who buys new? How long do you typically keep your cars? Is the car 100% business use? How many miles do you plan to drive? There is a decision tree you can review on our website (see below).
Back up for a bit. Remember our previous discussions about tax deductions, and how only a fraction of the money you spend is returned to you? So, back to our auto-attendant, “Do you need a car?” If the answer is “Yes” because your bucket of bolts is getting exceedingly dangerous, then Yes, buy a much-needed car out of a sense of safety. If the answer is “Not really, but I want to save taxes,” then don’t. Two rules to live by-
- Cash is King (keep it!)
- Depreciation is a tax deferral not a tax avoidance system (typically)
There might be some other external forces at play. For example, if you need a car next year but your income is ridiculously and unusually high in the current tax year, then reducing your income now makes sense. Again, tax modeling and planning is critical. Here is some more information-
Tax Planning with Depreciation Recapture
Please understand that depreciation is a tax deferral system rather than a tax avoidance system. Huh? When you sell or dispose of an asset, you might have to pay tax on the portion that was depreciated.
For example, you buy a $200,000 piece of machinery and use Section 179 depreciation to deduct the entire $200,000 in the first year. Five years later you sell the equipment for $150,000 because you slapped some new paint on it and you are a shrewd negotiator with your buyer. You will now have to recognize $150,000 of taxable ordinary income. Yuck. But there is a silver lining- depreciation recapture is taxed at your marginal tax rate up to a maximum of 25% tax rate. So, you could have depreciated your asset during 39.6% marginal tax rate years just to pay it all back at 25%. Bonus. Tax planning is a must! How many times have we mentioned that?
You can kick this depreciation recapture can down the road with a Section 1031 exchange (also referred to as a like-kind exchange). Perform your favorite internet search on this topic- way too involved to explain here except that a Section 1031 exchange in most situations allows the deferral of depreciation recapture and capital gains. And if you think you know what a 1031 exchange is, try learning about a reverse 1031 exchange- where you buy the replacement property first. Yup. It exists.
This one gets a little tricky. Let’s say you are a commercial real estate agent, and you sell a lease and collect a $10,000 commission. But there are provisions that if the tenant breaks the lease within three years, you have to pay some of the $10,000 back. Accountants would call this “Unearned Revenue” and we can kick this revenue into the subsequent years. So if you collect money today and there is a bona fide chance you might lose it, then perhaps you should consider accrual based accounting and defer some of this income. Again, this gets tricky.
If you’re Ebenezer Scroog then you’re done reading. If you are paying out year-end bonuses, then keep reading. This might be a no-brainer, but make sure paychecks that are for bonuses are dated for 2017.