A Little Planning Could Lead to Big Tax Benefits in ’91


Most middle-class American families have missed their chance to reduce their 1990 tax bills. But, if they start soon, they could take a big bite out of their 1991 taxes.

Now more than ever, some simple, common-sense ideas such as paying off credit cards and contributing to tax-favored retirement plans can help consumers save on taxes while improving their long-term financial health.

“The focus has changed,” said Robert Solomon, partner in charge of taxes at the accounting firm Levine, Cooper, Spiegel & Co. in Los Angeles. Today’s tax-favored investment opportunities are a lot more stable, he added. “People tend to look more at the economic soundness of the deal than the tax ramifications.”

To illustrate the point, consider two hypothetical examples. One is a single individual earning $50,000, who, we’ll call Joe Doe. The other is a family of four, the Saunders. They earn $100,000 annually and already have a home.


Doe does not have a mortgage, but he does pay about $1,100 in annual interest on his car loan and his revolving credit card accounts. He has $10,000 in the bank that he’s been saving to buy a house. He earns 8%, or $800 annually, on that nest egg.

In 1990, Doe will not itemize deductions because those interest expenses are only 10% deductible, netting him a deduction of only $110. His only other itemized deduction would be his state taxes, which will probably not be high enough to get him a bigger break than the standard deduction of $3,250 for single taxpayers.

Because he does not contribute to a tax-favored retirement plan, Doe’s adjusted gross income is simply $50,800--his wages plus earned interest. After subtracting the standard deduction and one personal exemption, his taxable income is reduced to $45,500. His tax amounts to $10,219.

If he wants to reduce that bill next year, he has a variety of options.

One is to pay off the credit cards and the car loan with his savings. That eliminates his $800 interest income and thus pares his taxable income to $44,700. Doe’s total tax bill subsequently drops to $9,995, for a $224 savings.

Meanwhile, he is also saving $1,100 in interest payments, which will not be deductible at all in 1991. So in the end he is $524 richer. That’s $1,100 in interest expense minus $800 in interest income ($300), plus the tax savings of $224.

This would also simplify his tax return, because he would be able to fill out the nine-line 1040EZ. He had previously been prohibited from using this form because he had more than $400 in taxable interest income.

Another option: Use the $10,000 in savings to buy a rental property.


Let’s assume he bought a $100,000 condominium with $10,000 down. The seller financed another $10,000 at 10% and he secured bank financing at 9% for the remaining $80,000. His mortgage expenses, homeowner fees, maintenance expenses and property taxes amount to roughly $14,040 annually.

He rents the condo for $750 a month, which gives him $9,000 in rental income. The difference of $5,040 is a deductible loss.

Doe’s taxable income drops to $39,660. His tax (assuming the same 28% rate) falls to $8,581, for a $1,638 savings.

Had Doe bought the home for his personal use, he would lose deductions for depreciation, maintenance expenses and homeowners fees (combined $4,840).


All of his interest expense, estimated here at $9,000 annually, would be deductible. But his cash flow would be reduced because he would lose the rental income.

“You end up with a few thousand (dollars) more in tax deductions than you would have had if you bought the house and lived in it,” said Phil Holthouse, partner at the Los Angeles accounting firm Parks, Palmer, Turner & Yemenidjian.

Doe might also decide to move into the house a few years before he sells it, which would give him the ability to defer any gain on the sale if he rolls over that gain into a more expensive property.

Meanwhile, the tax picture for the Saunders family is substantially different.


The Saunders are already supporting a $250,000 mortgage at 10% interest, which gives them $25,000 in annual mortgage interest deductions. They have $4,000 outstanding on a 13% car loan, which costs them about $520 annually in interest but nets them only a $52 itemized deduction.

After accounting for property taxes, annual registration fees on their cars, state taxes and $2,000 in charitable contributions, they have itemized deductions of $34,000.

They subtract an additional $8,200 for personal exemptions ($2,050 times four), and their taxable income falls to $57,800. Their tax would be $11,966.

What could the Saunders do to reduce the 1991 tax bite?


Because they are itemizing deductions, they should take a long look at medical and business expenses that might be deductible and see if they can “bunch” these costs. They want to push as many of these bills as possible into one year, because these deductions can be used only if they exceed certain “floors"--a percentage of the couple’s annual income.

They should also consider contributing to some tax-favored retirement program. If either spouse’s employer offers a 401k plan, for example, this couple could set aside $8,475 in 1991.

If none of the other particulars of their tax return changed, that would cut their taxable income to $49,325. And their total tax (assuming the same tax rate) would drop to $9,593 for a $2,373 savings. Moreover, the interest they earn in this account is tax-deferred until they begin to withdraw the funds at retirement.

They also might want to consider taking out a home equity loan to pay off their car loans. That would convert about $500 in non-deductible expenses into deductible expenses, and it could improve their cash flow by stretching out the loan repayment over a longer period.


TWO MIDDLE-INCOME FAMILIES John Doe earns $50,000 annually and has $10,000 in the bank earning 8% interest. He owes money on his car and credit cards, which costs him about $1,100 annually in interest expense. But because personal interest expense is only 10% deductible in 1990, he’ll forgo itemized deductions and take the standard deduction of $3,250 instead.

Here’s his picture in 1990 and what it could be if he made the minor change of paying off car and credit card debts with his savings.

1990 Plan for 1991* Earned income: $50,000 $50,000 Interest income: 800 0 Standard deduction: 3,250 3,250 Personal exemption: 2,050 2,050 Taxable income: 45,500 $44,700 Tax: 10,219 9,995

The four-member Saunders family earns $100,000 annually. They pay 10% interest on a $250,000 mortgage. And between charitable contributions, state, personal and property taxes, and mortgage interest expenses, they’ve got $34,000 in itemized deductions.


Here’s their tax picture today and how it would change if they simply decided to contribute to a 401(k) plan in 1991.

1990 Plan for 1991* Earned income: $100,000 $100,000 Personal exemptions: 8,200 8,200 Itemized deductions: 34,000 34,000 401(k) contribution: 0 8,475 Taxable income: 57,800 49,325 Tax: 11,966 9,593

*Assumes that all factors--taxable income, personal exemptions and tax rates--remain unchanged.