December represents one last chance to consider certain year-end tax strategies before the door closes on the amount of income, deductions and credits set for the year. Many traditional eleventh-hour techniques are applicable to this year-end 2011, with certain twists that recognize changes on the horizon for 2013. This column examines a handful of considerations especially useful to the individual taxpayer in these final weeks of 2011.
Note: While we will examine in this column how uncertainty for 2013 projects itself onto 2011 year-end tax planning, it should be noted that, as we go to press, no resolution has been found over those "expiring provisions" due to sunset at the end of 2011. They include, among others, 100 percent bonus depreciation, a payroll tax reduction, a higher alternative minimum tax exemption, the higher education expense deduction, the optional itemized deduction for state and local sales tax, non-business energy credits, the classroom expense deduction and the nontaxable charitable contribution of IRA assets by those over age 70 1/2. As explained in our October column, 2011 year-end planning must include keeping a watchful eye over what Congress will do and acting quickly in late December if extensions are not forthcoming.
When accelerating or deferring income or expenses at year-end as part of an overall strategy, certain timing rules become critical. Those more frequently used at year-end -and sometimes more frequently overlooked - include:
Actual payment rule. Cash-basis taxpayers who want to maximize their deductions and credits for 2011 must make a payment of each expense-giving rise to a deduction or credit by December 31. A cash-basis taxpayer generally is entitled to a deduction only when actual payment is made, irrespective of the fact that the expense has already been incurred. "Cash substitutes" under this rule include:
Payment by check. If the check is mailed, the payment is considered made at the time of mailing, even if the check is received in the following year, as long as the check is honored in the routine course of business. If the recipient delays but ultimately cashes the check, and the date of delivery is not disputed, the payment dates back to the time the check is delivered or mailed.
Payment by credit card. The IRS treats a payment by credit card as a cash equivalent. In effect, the taxpayer has borrowed funds from the bank issuing the card and has paid the seller for goods or services. However, in a quirky rule apparently still in effect, if the taxpayer uses a card issued by the seller, there is no payment until the taxpayer pays the bill. The application of this rule would also depend on whether an intermediary bank technically would be considered the issuer. Using a general MasterCard, Visa, etc. in circumstances in which a deduction may be claimed might be the safer course.
Prepayment of an expense before it is incurred, however, generally does not trigger the immediate right to a deduction in the year paid.
Gift by check. To have a gift by check considered made by December 31, the transfer of the check must be a completed gift. Unlike the mailing rule applicable to charitable donations or other deductible payments by checks, this occurs on the date that the recipient deposits the check, cashes it against his or her own funds, or presents it for payment
Trade date. Stock traded in an over-the-counter market or on a regulated national securities exchange is generally treated as sold on the date the taxpayer enters into a binding contract to sell. This is the trade date, in contrast to the settlement date, when delivery of the stock certificate and payment are made. The trade date also marks the end of the selling taxpayer's holding period.
Short sale. In the case of short sales, Rev. Rul. 2002-44 requires that if the stock price falls and a gain results, the gain is considered realized on the trade date, when the seller directed his or her broker to purchase shares. If the price rises and a loss results, the loss is not realized until the stock is delivered on the settlement date.
Wash sale. Under the so-called wash sale rules, a stock (or securities) loss is not allowed to be taken if, within a period beginning 30 days before the date of the disposition and ending 30 days after that date, the individual acquired, or entered into a contract or option to acquire, substantially identical stock or securities. The wash sale rule was designed to prevent taxpayers from selling stock to establish a tax loss and then buying it back the next day. Certain techniques, however, are available to minimize its impact:
Buy more of the same shares, then sell the original shares 31 days later.
Sell the original shares, then buy the same shares 31 days later.
Buy shares in the same industry rather than the same company.
Investors with more than one brokerage account must coordinate loss sales among all accounts. However, no similar "wash sale" restriction is imposed on recognizing gain and then immediately purchasing the same shares. This may be especially relevant at year-end 2012 if the rate for capital gains goes up in 2013.
FIFO stock sales. Investors also should be aware of the automatic first-in, first-out (FIFO) rule for selling securities. Under FIFO, the shares purchased first are considered sold first within the same brokerage account, unless a specified ID method is used by identification of a share's purchase date and cost. Selling higher cost shares mean lower gain and therefore lower tax (unless losses are available to absorb those gains). Identification must be made at the time of sale by the broker.
Charitable pledges. Like unsecured promissory notes, pledges to a charitable organization are treated as unenforceable promises to pay in the future and are not deductible until payment is made to the charity. However, if the pledge is legally binding, a deduction is allowed when the pledge is made.
Certificates of deposit. For certificates of deposit maturing near year-end, some taxpayers are under the misperception that extending the term beyond the upcoming year will defer all the interest income to the end of that term. Under the original issue discount (OID) rules, interest paid on a term of more than one year is considered available as accrued rather than when actually paid out.
BLINDSIDED BY AGI
In shifting income, deductions and credits between tax years as a year-end strategy to even out overall tax liability between one year and another, a taxpayer should not forget adjusted gross income (AGI) and the role it plays in determining qualification for certain deductions and credits. Manipulating AGI to qualify for these benefits in 2011 or setting the stage to have them available in 2012 should be considered. Having the size of AGI negate the tax benefits otherwise so carefully planned at year-end, on the other hand, should also be considered a possibility for those inattentive to the ability of AGI to blindside expectations.
Some adjusted gross income phaseout levels to keep in mind when either accelerating or deferring income include:
Interest exclusion of U.S. savings bonds. Interest exclusion on U.S. savings bonds used to pay qualified higher education expenses begins to be phased out in 2011 at modified adjusted gross income (MAGI) above $71,100 ($106,650 for joint filers); $72,850 and $109,250, respectively, for 2012.
Student loan interest deduction. For 2011 and 2012, the above-the-line deduction for student loan interest starts to phase out at MAGI of $60,000 ($125,000 for joint filers).
Education credits. For 2011 and 2012, the American Opportunity (Hope) Credit starts to be phased out at MAGI in excess of $80,000 ($160,000 for a joint return). For 2011, the Lifetime Learning Credit phaseout begins at MAGI in excess of $51,000 ($102,000 for joint filers); $52,000 and $104,000, respectively, for 2012.
Higher education expense deduction. Ending in 2011 unless extended by Congress, a $4,000 maximum above-the-line education expense deduction is available for taxpayers with MAGI not exceeding $65,000 ($130,000 for joint filer) and $2,000 for taxpayers with MAGI exceeding $65,000 and $130,000, respectively, but less than $80,000 and $160,000, respectively.
Traditional IRA contributions. For 2011, deductible contribution to traditional individual Retirement accounts (IRAs) are phased out starting at $56,000 (rising to $58,000 for 2012).
In addition those taxpayers who took advantage of a Roth conversion in 2010 that deferred income into 2011 and 2012 should not forget about the additional income in 2011 that now must be added back. Certain AGI-dependent deductions and credits may therefore also be foreclosed as a result of what had been considered largely a tax benefit available to 2010 Roth conversions.
LOOKING AHEAD TO 2013
Major changes in the tax law are likely to take place in 2013 due to the sunsetting of the Bush-era tax rates and the mood among many in Congress and on the campaign trail to control the deficit. In addition, three tax increases are already scheduled to go into effect under the health care legislation passed in 2010:
Additional Medicare taxes on earned income (0.9 percent) and investment income (3.8 percent) in 2013 on incomes over $200,000 ($250,000 joint filers)
A higher medical expense itemized deduction limit rising to 10 percent in 2013 (up from the current 7.5 percent); and
A $2,500 limit on health Flexible Spending Accounts.
While each of these increases should be at least noted in 2011 year-end tax planning, the 3.8 percent tax on investment income has the most direct impact. Especially is this the case for investors who are also threatened by a probable increase in the maximum rate on capital gains from its current 15 percent level. Also in play is the fact that any capital asset purchased after Dec. 30, 2011 must be held until Jan. 1, 2013 or beyond to qualify for a long-term capital gain rate (held for at least more than one year). All these factors combine to suggest the some immediate portfolio reallocations to anticipate selling in 2012, before rates rise in 2013, might be in order starting at year-end 2011.
Some practitioners have commented that the growing number of tax opportunities afforded from year-end planning makes this time of year second only to tax filing season in activity. Being aware of all the mistakes that can be made - from misjudging timing rules and overlooking phaseout levels, to missing the importance of pending legislation or legislation with a sunset or delayed effective date - is a necessary part of capitalizing on those opportunities and moving us all more optimistically into the New Year.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
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