Last Minute Tax Planning for 2016

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My clients often ask me if I can help them reduce their tax bill. The answer is yes… but for most tax saving opportunities, you have to take action before the end of the year.

Here are some things you can do before December 31 that may have a big impact on your tax bill when April 15th comes around.

Itemized Deductions vs Standard Deduction

There is a long list of expenses that are deductible for tax purposes. They include medical expenses, charitable donations, mortgage interest, state and local income taxes, employment expenses, etc. Some of these expenses are subject to limitations, of course.

Most taxpayers are entitled to the Standard Deduction, though, so unless your deductible items add up to more than the Standard Deduction there is no need to keep track of them. A single person, for example, gets an automatic deduction of $6,300, and a married couple filing jointly gets $12,600.

Sometimes, you may find yourself with deductions that are close to exceeding the Standard Deduction, and accelerating payment of some of the deductible expenses could result in claiming additional itemized deductions. This strategy could result in making it difficult or impossible to itemize next year, but you will come out ahead if you can itemize every second year.

Keep this strategy in mind when you read the rest of my comments.

Defer Income / Accelerate Deductions

There are opportunities to defer income items that would be taxable this year, and move them into next year. You may also be able to pay certain deductible expenses this year that you might have waited to pay next year. This strategy only makes sense, of course, if you are not expecting to be in a higher tax bracket next year.

If you have business income – self-employed, partnership, etc. – you can delay billing your customers or clients, so you don’t receive payment until after December 31. Similarly, you can speed up payment of some of your expenses to get a deduction this year.

If you have a rental property, and your income is under $100,000, you may be eligible to deduct up to $25,000 of rental losses against your regular income. The deduction phases out completely when your income goes over $150,000. It is a good incentive to defer income or accelerate expenses if you are in this range.

Talk to your employer about receiving any year-end bonus after December 31, so you don’t pay tax on it until next year.

Pay your January 15 estimated state tax payment before December 31. Make your mortgage payment at the end of December, instead of January 1. If your medical bills for the year are likely to be more than 10% of your income (7.5% if you’re over 65) then pay as many outstanding medical and dental bills as you can before year-end. Same thing for alimony payments and other deductible items due in January.

Property taxes are typically paid twice a year. In Los Angeles, they are due on November 1st and February 1st. Consider paying both installments this year.

An important note… For many taxpayers, particularly those with higher incomes, there is a limit to the benefit you can get from certain deductible expenses. There are phase-outs as your income rises, but another very important consideration is the Alternative Minimum Tax (AMT). The expenses most likely to be affected are state and local income taxes (especially in California and other high-tax states) and office and employment expenses. If you are subject to the AMT, accelerating payment of these expenses will not do you any good. You should speak with your tax advisor about other possible strategies.

Take Losses Before Year-End

If you have losses on taxable investments, think about selling them this year. They will offset any capital gains you may have, but even if your losses are more than your gains, you can use up to $3,000 to reduce other income, and you can carry any excess losses forward to future years.

Retirement Plans

Make the maximum contributions to your retirement plans.

You can deduct contributions of $18,000 (more if you’re over 50) to your 401(k) plan – but at least make sure you contribute enough to get the full amount of your employer’s matching program.

You may be able to deduct up to $5,500 (more if you’re over 50) to a traditional IRA. If you don’t make a contribution before the end of the year, you have until April 15th. Contributions to a ROTH IRA are not deductible, but penalties are much less severe if you have to withdraw funds early.

If you’re self-employed, you can contribute to a SEP IRA or a similar plan. You can deduct approximately 20% of your self-employment income, up to $53,000. The good news is that you can make your contribution all the way up to the filing deadline, including extensions, which gives you plenty of time to calculate your income. If you have an S Corp, you can also take advantage of a SEP IRA.

Don’t take money out of your traditional IRA or 401(k) plan if you are under 59 ½ years old. There is a 10% penalty on top of the regular tax, and some states have an additional penalty. Before you take an early withdrawal, though, remember that you may be able to borrow from your 401(k). There are also penalties for early withdrawal from a ROTH, but your original contributions are not taxed a second time.

You can take a distribution from your IRA without a penalty if you are a first-time home buyer, if you make qualified tuition payments, and several other special situations. Remember that if you have a 401(k), and plan to make tuition payments, roll the 401(k) over into a traditional IRA first.

Consider rolling over your traditional IRA into a ROTH IRA. You will pay tax on the full amount when you roll it over, but if you expect to be in a low tax bracket this year, for any reason, this might be a good time to do it. Also, there is no required minimum distribution from a ROTH IRA after age 70 ½.

Start taking minimum required distributions from your traditional IRA if you turn 70 ½. There is a 50% tax if you don’t.

Charitable Donations

Charitable donations are a nice deduction, assuming your total deductions exceed the Standard Deduction.

If you have shares of stock that have appreciated in value, consider donating the stock to charity. If you have owned the stock for more than one year, you can deduct the entire appreciated value of the stock, and avoid capital gains tax or Net Investment Income Tax (NIIT).

Gifts

You can make tax-free gifts of up to $14,000 ($28,000 for a married couple) per recipient. (Remember that gifts are not taxed to the recipient, but to the giver). Gifts in excess of this amount require filing a gift tax return, but you won’t actually pay tax until you go over your lifetime limit of $5,450,000.

Qualified payments for tuition or medical expenses are not considered a gift, as long as they are paid directly to the educational institution or the medical provider.

Avoid the “Kiddie Tax”

If your dependent children (under 19, or under 24 if they are full time students) have investment income over $2,100, it will be included in your income, and taxed at your full rate, including NIIT. So think carefully before you give them stocks to sell to pay for college.

Depreciation Opportunities

You can deduct 100% of qualifying asset purchases up to $500,000 (with phase-outs if your total purchases exceed $2 million) under Section 179. This is a tremendous incentive to buy capital assets which you would otherwise have to expense over several years. There are exclusions, but many of the excluded items are eligible for a 50% special depreciation allowance in the year of purchase.

These are terrific deductions. If you are planning to buy assets, buy them before year-end, and reduce your taxes for 2016.

Filing Deadline Changes

A number of changes have been made to filing deadlines this year, including:

Form 1065 Partnership (including LLC) Returns are now due on March 15. Previously, the deadline was April 15, which was inconvenient for the partners, who had to wait for their K-1s in order to meet their own April 15 deadlines. This change is logical, but you need to be aware of it. The extension filing date for partnerships has also changed – from October 15 to September 15. Single member LLCs do not file Form 1065, so there is no change.

Form 1099-Misc and Form W-2 must now be issued to employees and contractors, as well as to the IRS or Social Security Administration, by January 31. It’s a good idea to confirm all employee information and W-9 information before the end of the year.

Subchapter S Corporations and LLCs

If you have a Subchapter S Corporation, don’t forget that you are required to pay yourself a reasonable salary. A major benefit of having an S Corp is that not all of your profits need to be subject to employment taxes, but you do need to pay yourself a salary, and issue yourself a W-2 as an employee. Issuing yourself a 1099 is not a substitute. Setting up W-2 payments after year-end is annoying, and there are stiff penalties for late payment of employment taxes, so take care of it before the end of the year. Also, remember that your health insurance premiums should be added to your W-2 wages (exempt from payroll taxes) and deducted on your personal return.

Do you have an LLC or an S Corporation? Are you getting any real benefit from it? If you are in a state that has a minimum LLC or S Corp tax, you may be paying for something you don’t really need. California’s minimum tax is $800, and you’re also paying for a relatively expensive tax return. If limited liability is a big concern, consider buying insurance that offers appropriate protection. Closing the LLC or S Corp before year-end won’t reduce your 2016 tax bill, but it will cut future costs.

I would be pleased to discuss your tax planning issues.

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Buying a House … Residence vs Rental Property

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A common question my clients ask is “Should I buy a house?” A logical extension of the question is “Should I live in the house, or would I be better off renting it out?”

Actually, the question is more often phrased “What are the tax benefits of buying a house?” This can result in a barrage of technical information that doesn’t answer the real question.

THE TAX STUFF

Let’s get the technical tax stuff out of the way:

–  The interest portion of your mortgage payment and your property taxes are tax deductible
–  If you rent out the property, you can also deduct operating expenses like repairs, utilities and management fees
–  If you rent out the property, you can also deduct depreciation. The house itself is depreciated over 27.5 years. Improvements, furnishings and appliances are depreciated at faster rates
–  If you live in the house for more than 2 years, you don’t have to pay tax on the first $250,000 of capital appreciation – the exemption is $500,000 if you’re married and file a joint return
–  If you make under $100,000 you can deduct rental losses on your tax return. But if you make between $100,000 and $150,000, the deduction phases out to zero. The good news is you can deduct the disallowed losses when you sell the house
–  If you rent the property, your gain on sale is taxed at capital gains rates, which are lower than regular rates. Depreciation you deducted is recaptured at regular rates
–  If you pay Alternative Minimum Tax, all bets are off…but if you live in the house, your mortgage interest is a deduction for AMT purposes

There’s the barrage of information. Do you know what you want to do now? I don’t think so.

WHAT YOU”RE TRYING TO ACCOMPLISH

Living in your house accomplishes three main objectives:

– You stop paying rent to somebody else
– Tax deductions for mortgage interest and property taxes make your monthly payments more affordable
– With a relatively small down payment, you get the benefit of the full amount of any gain on sale. It’s not unusual to make a gain as big as your down payment. That’s a 100% return on your investment – and $250,000 or $500,000 of the gain is tax-free

When you rent out your house, the objective is to bring in enough rental income to cover your cash payments for mortgage, property tax and operating expenses. Depreciation doesn’t affect your cash flow, but it can be used to create losses for tax purposes if you are in an income range to benefit from the deduction. I’m sure there are places where you can generate positive cash flow from a rental home, while paying no tax because of the depreciation deduction. A few years ago I worked with a Midwest homebuilder where we marketed houses for exactly that business model, but I now live in Southern California, and positive cash flow is only a dream.

Your income mostly comes from the gain you make when you sell the house. This gain is taxable, but it’s taxed at a lower rate than your regular income.

The downside of renting out your house is that you still have to live somewhere. Any profit you make will be reduced by the rent you pay. If you already own your home, of course, that’s not an issue.

RESIDENCE OR RENTAL – WHICH IS BETTER?

Here’s an example that compares the results of living in your home and renting it out.

I made a number of assumptions as the starting point. I’m sure you can poke holes in some of them, but bear with me.

– You are currently paying rent of $2,500 a month
– You have $150,000 for a down payment
– You buy a house for $600,000 and sell it 5 years later for $700,000
– You take a $450,000 mortgage at 4.0% interest, and pay 2.0% a year for property taxes
– You can rent the house to tenants for $3,600 a month
– Operating costs are $3,600 a year for your residence, and $5,000 for the rental
– Your selling costs are 6% when you sell the house
– Your regular tax rate is 30%

Option 1 – Don’t Buy the House

If you don’t buy the house, you continue to pay $2,500 a month in rent. After 5 years, you have spent $150,000. End of story.

Option 2 – Live in the House

Your mortgage payment is $2,170 a month, and your taxes are another $1,000. You’re now paying for repairs and maintenance, but the tax benefit of the interest and tax deduction means you’re only paying about $200 a month more than when you were renting.

You make $100,000 in profit when you sell the house (less $42,000 in closing costs) but you don’t pay tax on the gain. You also get your down payment back, plus you paid off $43,000 on your mortgage.

Over all, your total cost after 5 years is $63,000. This compares with $150,000 you would have spent on rent. Congratulations – by buying the house you saved $87,000.

Option 3 – Rent the House

You rent the house out for $3,600 a month, which is pretty much exactly the amount you pay out for mortgage payments, property taxes and operating costs. You get a tax deduction of $16,000 a year for depreciation, but if you make more than $150,000 it just adds to your deferred loss.

You make the same $100,000 profit when you sell the house. This is taxable at capital gains rates, but the $42,000 closing costs are deductible. As above, you get back your down payment and the $43,000 you paid down on your mortgage.

Your after-tax income from the rental property is $82,000. Nice, really nice. You’ve made a pretax return on investment of 11% a year. Compare that with the return on other investments.

BUT… not so fast.

You still have to live somewhere while you’re renting out the house. Right? Assuming you continue to pay $2,500 a month in rent, that turns your rental profit into a net cash cost of $68,000. The good news is that you’re still miles ahead of where you would have been if you hadn’t bought the house at all, and only about $5,000 behind using the house as your residence.

Do you think you could increase the rent on the house over 5 years? That would make the results of renting vs living in the house about the same, wouldn’t it?

CONCLUSION

Sorry, I’m not giving you a conclusion. This was just one example, and your situation is almost certainly going to be different. My assumptions are just assumptions, and you would have to do a careful analysis of the facts before you move forward.

There are a lot of subjective issues as well. Do you want the headache of being a landlord? And what about unforeseen problems like bad or unreliable tenants? But what about the upside gain if rents keep climbing the way they are in Los Angeles these days?

I would be happy to discuss your specific situation, and run my model with assumptions that apply to you.