Income and Deductions

Income and Deductions

Timing income and deductions to your tax advantage for 2016/2017

This is the first post in Joel’s series 2016 / 2017 Tax Planning Guide: Year-Round Strategies to Make the Tax Laws Work For You.

Image of person considering the timing of income and deductionsUsually it makes tax sense to accelerate as many deductible expenses into the current tax year as you can and defer income to the next year to the extent possible. This can reduce current-year tax, deferring tax to future years. In some cases it may even permanently
lock in tax savings. But there are also situations where this strategy could be costly. To time income and deductions to your tax advantage, you must consider the potential impact on your particular situation.

Alternative minimum tax

When timing income and deductions, first consider the AMT — a separate tax system that limits some deductions and disallows others, such as:

  • State and local income tax deductions,
  • Property tax deductions, and
  • Miscellaneous itemized deductions subject to the 2% of adjusted gross income (AGI) floor, including investment advisory fees and unreimbursed employee business expenses.

It also treats certain income items differently, such as incentive stock option exercises. You must pay the AMT if your AMT liability exceeds your regular tax liability. Note the AMT rates and exemptions, and work with your tax advisor to project whether you could be subject to the AMT this year or next. You may be able to time income and deductions to avoid the AMT, or at least reduce its impact.

Home-related breaks

Consider both deductions and exclusions:

Property tax deduction. Before paying your bill early to accelerate this itemized deduction into 2016, review your AMT situation. If you’re subject to the AMT this year, you’ll lose the benefit of the deduction for the prepayment.

Mortgage interest deduction. You generally can deduct interest on up to a combined total of $1 million of mortgage debt incurred to purchase, build or improve your principal residence and a second residence. Points paid related to your principal residence also may be deductible.

Home equity debt interest deduction. Interest on home equity debt used for any purpose (debt limit of $100,000) may be deductible. So consider using a home equity loan or line of credit to pay off credit cards or auto loans, for which interest isn’t deductible and rates may be higher. Warning: If home equity debt isn’t used for home improvements, the interest isn’t deductible for AMT purposes.

Mortgage insurance premium deduction. This has been extended through Dec. 31, 2016. If you can afford to make additional principal payments this year so you won’t have to maintain mortgage insurance next year, you may want to do so.

Home office deduction. If your use of a home office is for your employer’s benefit and it’s the only use of the space, you generally can deduct a portion of your mortgage interest, property taxes, insurance, utilities and certain other expenses, and the depreciation allocable to the space. Or you may be able to use the simplified option for claiming the deduction. (Contact your tax advisor for details.) For employees, home office expenses are a miscellaneous itemized deduction, and you’ll enjoy a tax benefit only if these expenses plus your other miscellaneous itemized expenses exceed 2% of your AGI. (If you’re self-employed, see our post on Business.)

Rental income exclusion. If you rent out all or a portion of your principal residence or second home for less than 15 days, you don’t have to report the income. But expenses directly associated with the rental, such as advertising and cleaning, won’t be deductible.

Home sale gain exclusion. When you sell your principal residence, you can exclude up to $250,000 ($500,000 for married couples filing jointly) of gain if you meet certain tests. Warning: Gain that’s allocable to a period of “nonqualified” use generally isn’t excludable.

Home sale loss deduction. Losses on the sale of any personal residence aren’t deductible. But if part of your home is rented out or used exclusively for your business, the loss attributable to that portion may be deductible.

Debt forgiveness exclusion. This break for homeowners who received debt forgiveness in a foreclosure, short sale or mortgage workout for a principal residence is scheduled to expire Dec. 31, 2016.

Energy-related breaks. A wide variety of breaks designed to encourage energy efficiency and conservation have been extended through Dec. 31, 2016. Consult your tax advisor for details.

Charitable donations

Donations to qualified charities are generally fully deductible for both regular tax and AMT purposes, and they may be the easiest deductible expense to time to your tax advantage. For large donations, discuss with your tax advisor which assets to give and the best ways to give them. For example:

Appreciated stock. Appreciated publicly traded stock you’ve held more than one year can make one of the best charitable gifts. Why? Because you can deduct the current fair market value and avoid the capital gains tax you’d pay if you sold the property. Warning: Donations of such property are subject to tighter deduction limits. Excess contributions can be carried forward for up to five years.

CRTs. For a given term, a charitable remainder trust pays an amount to you annually (some of which generally is taxable). At the term’s end, the CRT’s remaining assets pass to one or more charities. When you fund the CRT, you receive an income tax deduction. If you contribute appreciated assets, you also can minimize and defer capital gains tax. You can name someone other than yourself as income beneficiary or fund the CRT at your death, but the tax consequences will be different.

Tax-advantaged saving for health care

You may be able to save taxes by contributing to one of these accounts:

HSA. If you’re covered by qualified high-deductible health insurance, you can contribute pretax income to an employer-sponsored Health Savings Account — or make deductible contributions to an HSA you set up yourself — up to $3,350 for self-only coverage and $6,750 for family coverage for 2016. Plus, if you’re age 55 or older, you may contribute an additional $1,000. HSAs can bear interest or be invested, growing tax-deferred similar to an IRA. Withdrawals for qualified medical expenses are tax-free, and you can carry over a balance from year to year.

FSA. You can redirect pretax income to an employer-sponsored Flexible Spending Account up to an employer-determined limit — not to exceed $2,550 in 2016. The plan pays or reimburses you for qualified medical expenses. What you don’t use by the plan year’s end, you generally lose — though your plan might allow you to roll over up to $500 to the next year. Or it might give you a 21/2-month grace period to incur expenses to use up the previous year’s contribution. If you have an HSA, your FSA is limited to funding certain “permitted” expenses.

Medical expense deduction

If your medical expenses exceed 10% of your AGI, you can deduct the excess amount. Eligible expenses may include:

  • Health insurance premiums,
  • Long-term-care insurance premiums (limits apply),
  • Medical and dental services, and
  • Prescription drugs.

Mileage driven for health care purposes — at 19 cents per mile for 2016 — also can be deducted.

Consider bunching nonurgent medical procedures (and any other services and purchases whose timing you can control without negatively affecting your or your family’s health) into one year to exceed the 10% floor. Taxpayers age 65 and older enjoy a 7.5% floor through 2016 for regular tax purposes but are subject to the 10% floor for AMT purposes. These taxpayers might particularly benefit from bunching expenses into 2016 to take advantage of the lower floor before it expires.

If one spouse has high medical expenses and a relatively lower AGI, filing separately may allow that spouse to exceed the AGI floor and deduct some medical expenses that wouldn’t be deductible if the couple filed jointly.

Limit on itemized deductions

If your AGI exceeds the applicable threshold, certain deductions are reduced by 3% of the AGI amount that exceeds the threshold (not to exceed 80% of otherwise allowable deductions). For 2016, the thresh- olds are $259,400 (single), $285,350 (head of household), $311,300 (married filing jointly) and $155,650 (married filing separately).

If your AGI is close to the threshold, AGI-reduction strategies (such as contributing to a retirement plan or HSA) may allow you to stay under it. If that’s not possible, consider the reduced tax benefit of the affected deductions before implementing strategies to accelerate or defer deductible expenses. The limitation doesn’t apply, however, to deductions for medical expenses, investment interest, or casualty, theft or wagering losses.

Case Study 1

Benefiting from the sales tax deduction

Luke tells his tax advisor that he’s thinking about buying a new car. He asks if there’s any tax advantage to doing so this year. His tax advisor explains that the PATH Act permanently extended the break, allowing taxpayers to take an itemized deduction for state and local sales taxes in lieu of state and local income taxes. The deduction is always valuable to those who reside in states with no or low income tax, and it can also benefit taxpayers in other states who purchase a major item, such as a car or boat. But because the break is now permanent, there’s no urgency to make a large purchase this year to take advantage of it.

Luke’s advisor estimates that Luke’s state and local income tax liability for 2016 will be $3,000 and that, based on what he expects to spend on his car, the sales tax would also be $3,000. That may sound like a wash, but the advisor reminds Luke that, if he elects to deduct sales tax, he can deduct all of the sales tax he pays during the year, not just the tax on the car purchase. His deduction, other than the amount for the car, can be determined by using an IRS sales tax calculator.

This is the first post in Joel’s series 2016 / 2017 Tax Planning Guide: Year-Round Strategies to Make the Tax Laws Work For You.

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