RONALD R. WILLIAMSON : Time Is Ripe to Cut Tax Loss : ‘Tis the Season for 401K Plans, Home Equity Loans
It’s no fun to think about income taxes at holiday time. But businesses and individuals alike can often save substantial tax dollars with a little prudent year-end planning. Even though tax returns aren’t filed until April, it’s the calendar year ending Dec. 31 that counts when it comes to determining actual tax liability.
The changes in the tax law this year are relatively minor, but several provisions could make a big difference to some people. And even in the absence of changes in the law, the Internal Revenue Service is continually interpreting the numerous ambiguities, and such interpretations can sometimes be as important as the legislation itself.
The supposed tax simplification of 1986, moreover, made a great many changes which are only beginning to make their impact felt, and many people are not aware of them.
In an effort to weed through the maze of the tax code and figure out what kinds of things should be done before the year ends, Times reporter Jonathan Weber spoke with Ronald R. Williamson, managing partner of the Orange County office of BDO Seidman, one of the nation’s leading accounting firms.
Q. What sorts of things should one be concerned about when thinking about taxes at this time of year?
A. The first thing that every individual should look at is the avenue they have for funding pension requirements. This includes an IRA account, a 401-K plan, or if you are self-employed, a Keogh plan. An individual who is not covered by a pension plan, or who has income under $40,000, can put $2,000 per year into an IRA. You have until April 16 to fund your IRA this year.
Q. Does that also apply to 401-K and Keogh plans?
A. The 401-K has to be funded by Dec. 31, and the maximum limit for 1989 is $7,625. With the Keogh, the critical thing is to have a plan set up before Dec. 31, even though it doesn’t have to be funded until the filing of the 1989 tax return. So for a self-employed person with a fair amount of income who is not sure whether to take a deduction, my advice is to open up a Keogh account and put $100 in it just to have it available. That way, if you’re completing the return and looking for options of how to save some tax dollars, the vehicle is already set up.
Q. So one area to keep an eye on at the year’s end is retirement funds. Any other concerns?
A. One year-end deduction for a business, for example, is that you can write off equipment purchases of up to $10,000. If you have your own business and you buy a computer, instead of having to depreciate it, you can write the whole thing off up to $10,000.
Q. So if you haven’t bought up to $10,000 worth of equipment this year, and you’re going to need some next year, you should buy that now?
A. Exactly. In addition, you have the normal year-end shuffle people go through in deciding whether they should prepay certain expenses to get a deduction this year. The classic thing to prepay is state income tax.
You can also prepay property taxes, and you can prepay your January house payment, because the interest is always in arrears, and the January payment would include the December interest.
Q. Why would someone want to prepay these things?
A. If you are in the same tax bracket or a higher bracket in 1989 than you expect to be in 1990, then you would benefit. If you’re lower in 1989 than in 1990, you would be motivated not to prepay those expenses, and push them off to 1990. And the popular view among professionals is that tax rates will go up next year.
Q. Does the prospect of a tax increase next year affect what people should do now?
A. Yes. The top tax bracket now is 33%, for a certain window of income between $75,000 and $155,000 for a married couple. Over $155,000 it drops back down to 28%. And from $31,000 to $75,000 it’s 28%, so the top tax rate kicks in at $75,000.
The likelihood is that next year the re-entry to the lower 28% bracket will be extended to a higher level, so you would continue at 33% even beyond $155,000. Or they might increase the 28% level as high as 33% or 34%.
You’re dealing with uncertainty, but if you expect an increase of 2% in your bracket, then you’re at a wash between this year or next year in terms of taking a deduction that could be put off because of time value of money. If the tax rate will go up more than 2%, than I would push the deductions off until next year. It’s hard to give blanket advice--it all depends on how the brackets change for your situation. When in doubt, take the deduction now; tax laws could change next year, reducing or eliminating certain deductions.
Q. Any other year-end considerations?
A. There are a couple of critical decisions that need to be made by Dec. 31. For very high net worth individuals, over $5 million, there is a temporary exemption for the “generation-skipping” tax, an additional tax you pay on top of gift tax.
In the past, when gift-giving to your children, you might skip a generation and give it to grandchildren instead. Then there’s no tax when grandparents or parents pass away, and the gifted property is not taxed until the grandchildren pass away. It allowed you to keep the value of the estate in the family much longer.
Several years ago, however, they put in a generation-skipping tax to prevent people from avoiding estate taxes by giving to grandchildren. But an exemption, which was lobbied for by the Gallo wine family and is known as the Gallo exemption, gives people until Dec. 31 of this year to make gifts to grandchildren without paying that tax. If someone gave $2 million in 1989, they would pay something just short of $600,000 in gift tax. If they gave $2 million in 1990, they also have to pay about $1.8 million for the generation-skipping tax.
So for people in that financial position, this is a major thing. They should take advantage of this window of opportunity to gift large sums to grandchildren.
Q. What’s the second critical area that you mentioned?
A. A similar critical window that expires Dec. 31 has to do with what we call estate freezing, in which a family corporation would do some recapitalization or issue some preferred stock to parents in order to freeze the value of the parents’ estate--all future appreciation would go to the children, and estate taxes were thus reduced.
The 1987 tax law prohibited estate freezing, and some questions have been raised about normal sales between family members. Say the father wants to retire, and a son wants to buy him out. If the transaction is not structured correctly, it might not actually transfer the wealth to the son, and when the father dies, the full value of the corporation would still be in the father’s estate.
In August, 1989, the Treasury interpreted the laws broadly, and we have found there are a lot of transactions among family members that will not transfer the value out of the parents’ estate. These include sales, consulting agreements, and in some cases, intra-family loans.
Q. So what is the urgency?
A. They’re going to allow a cleanup, a correction period, for any transactions closed between December, 1987, and Dec. 31. So my advice is that any intra-family transfer of assets other than a personal residence or life insurance should be reviewed now.
Q. Are there any changes in the tax code for this year that people might not be aware of?
A. This year’s revenue reconciliation act, which has been passed by Congress but not yet signed by President Bush--though it will be signed--is very bland. There are no major tax changes, and I think that’s indicative of the standoff between Bush, with his “read my lips” pledge on no new taxes, and Congress, which is scrambling and trying to reduce the budget to meet the Gramm-Rudman deficit requirement.
Next year, they are going to be hard-pressed to meet those requirements without raising taxes. Bush has held to his promise at least the first year in office, but it will be difficult to accomplish that in 1990.
Q. Are there even minor changes which might affect people?
A. They have repealed the Medicaid catastrophic illness surtax and the controversial Section 89 on employee benefit discrimination. But most of the changes are are industry-specific, or procedural changes.
Q. What are some of the industry-specific changes?
A. A new law will hit the chemical industry--an ozone-depleting chemical tax. Producers of certain chemicals, or companies importing products made from those chemicals, will have to pay a tax.
Also, in the real estate industry, like-kind exchanges of property have been limited. Previously, if you wanted to sell a property that had a large gain in it, you could trade that low-basis property for a high-basis property between related partnerships, immediately sell the property and pay little or no tax on that sale. You now must hold the property two years before selling it if it was acquired in a trade from a related party.
Q. So it limits the ability of real estate partners to shuffle assets around for tax purposes?
A. Right. And a lot of people in Orange County will be interested in that, because so many people are involved in real estate here.
Q. Any other changes people should keep in mind?
A. There have been a number of changes pertaining to the penalties for non-filing of tax returns, non-payment of tax, frivolous lawsuits, understated income, undervaluation of property, and other things. They’re putting a lot more teeth in the penalty provisions.
In the past, the negligence penalty was 5% of the underpayment, but that’s now going up to 20%. Let’s say you received some income and didn’t report it, because of some oversight, and it was not substantial enough to be deemed fraud, but was substantial enough to be negligence. They’ve programmed the computer that any underpayment has a penalty, and the burden is on taxpayers to prove they weren’t negligent.
Q. If you have underpaid for some reason, is it worth your while to try and pay by Dec. 31?
A. If you make quarterly estimated payments, and coming to the end of the year you are underpaid, you would get hit with a penalty from the time you underpaid to when you are paid up. However, if you have withholding on a paycheck, the withholding gets spread evenly throughout the year even though you may have excess withholding for the month of December. So people who are under-withheld, may want to ask their employer to withhold more now.
Q. Any previous changes in the law that people might not be aware of?
A. The deductions for personal interest, as for a car loan or credit card charges, are now limited to 20%. But you can still borrow up to $100,000 against a home and fully write off the interest.
Q. So it’s best to take out a home equity loan and use it to pay off personal loans?
A. Exactly. If you have $20,000 in car loans and credit card loans, with an average rate of 16%, and you can get a home equity loan at 12%, you’ll save on the interest rate and on the deductibility of the interest. So you could come up with as much as $100 or $120 a month in net savings.
Another hot issue has to do with passive losses on rental property. People have gone out and bought duplexes, or apartment buildings, and rented them out. In the old days, the entire loss they had could be used to offset salary income. But now, only if someone is actively involved in the management of a property, can they write off a maximum of $25,000 against their other income if their income is below $100,000. For income over $100,000, you lose the benefit of that at 50 cents on a dollar.
But people who find themselves with these loses they cannot write off, if they have a corporation, they can rent property to their corporation and develop passive income that would be fully sheltered by the passive losses.
Q. Any other handy tax tips?
A. If you want to withdraw money from an IRA or SEP account, there is normally a 10% penalty in addition to regular tax. (An SEP account is a simplified employee pension fund, similar to an IRA for a self-employed person.) But the IRS has allowed withdrawal without a penalty if the money is taken out in periodic payments of the person’s life expectancy. So there is a way to withdraw money from an IRA without a penalty.
A trap that some people fall into concerns refinancing of rental property. The deductibility of interest on such refinancing depends on what you did with the money. The law requires a tracking of the proceeds of the loan, and if it is used for personal reasons--for college education or buying a boat--then it’s deemed to be personal interest subject to the 20% maximum deduction. If it is to buy other real estate, it may be passive interest limited to passive income.
Also, the IRS has approved a tax-delayed exchange for buying a property that is not identified at the time you are selling your rental property. You have to set up a specific account, and the proceeds from the sale of the first property go into that account. Then you have 45 days to identify like-kind property and 180 days to close the purchase, and if you have complied with these and a few other requirements, taxes will be deferred until a future sale occurs.
