2007 Year-End Tax Planning for Individuals

With 2007 gradually drawing to a close, now is the time to review your tax situation and evaluate some strategies that may help minimize your tax liability. 

Year-end tax planning tips typically fall into two basic categories: (1) traditional strategies that have proven themselves useful year after year, and (2) new opportunities that have arisen from recent changes to the tax laws. 

TRADITIONAL STRATEGIES

Traditional tax planning techniques can help almost every taxpayer save money.  The amount you can save depends on your individual circumstances, but examination of the following general areas is worth a look.  Also, you should consider the tax impact of any special circumstances in which you might find yourself this year. 

Income Shifting  

One of the most fundamental year-end tax planning techniques involves accelerating deductible expenses in 2007 and deferring income (if possible) into 2008.  By delaying taxable income, you defer taxes.  Delaying taxable income may also prevent you from losing lucrative tax breaks that could be reduced or eliminated if your income level rises and moves you into a higher tax bracket. 

As the end of the year approaches, you can probably anticipate with reasonable certainty what income and deductions you will be reporting on your 2007 tax return.  You may also be able to predict, with relative accuracy, your income and expenses for the first few months of 2008.  The ability to gauge your income and expenses for 2007 and early 2008 provides a great opportunity to shift income or expenses into one year or the other, depending on what will provide you with the greatest overall benefit. 

However, shifting income is not always a simple matter of delaying the receipt of funds.  Tax rules may require you to recognize certain types of income when you have earned the right to receive it, even if you arrange for its delayed payment.  We can help you recognize and work through these situations so that you are fully aware of the tax consequences. 

Many sole proprietors operate on a cash basis.  Cash-basis taxpayers recognize and report income when they actually or constructively receive cash or its equivalent (such as checks, notes, letters of credit, or forgiveness of debt) and take deductions when expenses are actually paid or transferred, regardless of when the cost was incurred.  For accrual-basis taxpayers, the right to receive income (rather than actual receipt) determines the year of inclusion in income.  For accrual-basis taxpayers, expenses are deductible in the year in which all events have occurred to establish the liability and the amount of the item can be determined with reasonable certainty. 

Cash-basis businesses that anticipate being in the same or higher tax bracket in 2007 as compared to 2008 can smooth out their taxable income by deferring income to 2008 and accelerating deductions this year.  To push income into 2008, cash-basis businesses can delay billing their clients or customers (for example, wait until mid-January) for services and products so that payment is not received until 2008.  Alternatively, if you anticipate taxable income will be higher in 2008, you may want to accelerate income in 2007 and defer deductions until next year.  Accrual-basis businesses can defer income by delaying the shipment of products or provision of services until the beginning of the 2008 tax year. 

Deduction Management  

Essential year-end planning requires determining whether you will take the standard deduction or itemize your deductions.  Consider “bunching” deductible expenses into one year or the other, depending upon whether the standard deduction may be taken in one year or whether the AGI limits for medical (7.5%) or miscellaneous itemized deductions (2%) may be more easily met. 

Even if you know you will itemize deductions, accelerating or deferring them is often a question of determining your probable tax bracket for this year and the next year to maximize their after-tax value. Sometimes planning is as simple as making charitable contributions or paying your state estimated tax or real estate taxes in one year or the other.  However, do not forget about the impact of the alternative minimum tax (discussed later in this letter) when deciding when to pay certain expenses.  At other times, it is a question of making certain you gather the right proof and follow the proper steps in time to be entitled to a deduction in one year or the other.  Proof is also important if you make various charitable contributions in cash.  Cash contributions must be supported by proper documentation (a bank record or a written confirmation from the charitable organization showing their name, the date, and the amount).

Investment Portfolio Timing  

Planning can help you minimize your capital gains income and maximize the benefit of any capital losses.  Capital losses can be used to fully offset capital gains.  Losses taken in excess of gains can also be used to offset up to $3,000 in ordinary income (or $1,500 each for a married couple filing separate returns).   

Starting in 2008, traditional strategies in connection with capital gains and losses also need to accommodate a special, non-traditional opportunity: the 0% net capital gain rate for tax years 2008 through 2010.  While this zero rate is only available for individuals in the 10% or 15% income tax brackets, it is well worth families, retirees, and others to manage their income tax brackets starting in 2008.  That management starts at year-end 2007, as does deciding whether or not to postpone a sale of a capital asset until 2008 to take advantage of this favorable rate. 

Retirement Planning  

Year-end planning for 2007 also involves maximizing annual contributions to your retirement plan accounts, since one year’s limit cannot be added to the next year’s if not taken in time.  While contributions to IRAs may be applied retroactively if made before the filing deadline, contributions to qualified plans must be made before the end of the calendar year.  However, an exception to the rule applies for SEP plans, which can be set up and funded after year-end. 

Maximizing contributions to your retirement plan (or plans) before year-end also allows you to reduce your adjusted gross income in direct proportion to those contributions.  This, in turn, can give you the benefit of increasing the deductibility of medical and other deductions subject to adjusted gross income floors. 

It is also not too early to think about a Roth IRA conversion plan if your present adjusted gross income is too high under the usual conversion rules.  Although the adjusted gross income limit is not lifted until 2010 for a one-year-only conversion opportunity, certain year-end maneuvers now can better set you up for maximizing conversion benefits in 2010.  For example, if you are leaving employment, you may want to consider rolling over 401(k) balances to an IRA rather than leaving it in the 401(k) plan. 

Gifts  

For 2007 and 2008, you can transfer $12,000 per person, per year, without paying gift tax on the amounts transferred.  Married couples can gift $24,000 per person, per year, without tax liability on the amounts transferred. 

NEW OPPORTUNITIES AND DEVELOPMENTS

Tax law changes occur each year, and 2007 is no exception.  While fundamental planning techniques should not be overlooked, attention to new developments and recent tax legislation is equally important for most taxpayers.  Here are some of the more important changes, and potential changes, directly impacting 2007 year-end tax planning. 

Kiddie Tax Changes  

The 2007 Small Business Tax Act introduced a number of tax incentives for small businesses, but it included a few pitfalls for individuals.  For 2007, a child under the age of 18 is subject to the “kiddie tax” (and thus pays tax at his or her parents’ highest marginal tax rate on unearned income in excess of $1,700).  However, in 2008, the applicable age rises and the kiddie tax will apply to a child under the age of 19 and to full-time students under age 24.  In light of this development, parents should consider selling appreciated stock and other assets belonging to their children now, especially if they will be in the 19- to 24-year-old category next year. 

Expiring Provisions for Individuals

A variety of popular tax credits are set to expire at the end of 2007, unless Congress extends them.  However, taxpayers who wish to be proactive planners should not simply take a “wait and see” approach.  Assess your tax situation as if Congress will not extend the tax breaks that apply to you.  If the legislative landscape changes, then fine-tuning in December is always possible.  Tax breaks set to expire at the end of 2007 include the following: 

• State and local sales tax deduction.   Despite being one of the more popular tax breaks, the deduction for state and local sales taxes is not permanent and is set to expire at the end of 2007.  The American Jobs Creation Act of 2004 gave taxpayers who itemize deductions the option of claiming either state and local income taxes or state and local general sales taxes.  Therefore, if you have been considering the purchase of a big-ticket item such as a car or boat, you should consider making it sooner rather than later because the deduction for state and local general sales taxes expires at the end of 2007.  However, you first need to compute what any potential state and local income tax deductions will amount to, and then compare it to your potential sales tax deduction. 
• Mortgage insurance premiums.  Premiums paid or accrued in 2007 for qualified mortgage insurance are deductible as qualified residence interest.  The insurance must be carried on acquisition indebtedness for a qualified residence.  A “qualified residence” is the principal residence and one other residence that is not treated as business property. 
• Tuition and fees deduction.  Taxpayers may deduct qualifying tuition and fees paid in 2007 that are required for the student’s enrollment or attendance at a post-secondary school.  The tuition and fees deduction is an above-the-line item that, depending on adjusted gross income, can reduce taxable income by as much as $4,000.  This is frequently more valuable than taking a Hope or Lifetime Learning education credit.  If a taxpayer is over the phase-out limit, then the deduction is not allowed, but they may be able to take a Hope or Lifetime Learning credit.     
• Classroom deduction.  Full-time teachers, instructors, counselors, and other educators can deduct up to $250 worth of books, supplies, software, and other qualifying materials that they provide out-of-pocket.  The deduction is set to expire at the end of 2007. 
• Qualified conservation contributions.  Also set to expire is the enhanced deduction for contributions of real property interests dedicated exclusively for conservation purposes.  Easements in facades may also qualify.  A 50% contribution base limit applies, rather than the 30% limit for capital gain property.

 

ALTERNATIVE MINIMUM TAX

Dealing with the alternative minimum tax (AMT) may require both traditional year-end planning techniques and new strategies to avoid or at least minimize its impact on a growing number of taxpayers.  A planning technique that may save you a significant amount under the “regular tax” may be worthless if you unexpectedly fall into the AMT. 

You can start planning around the AMT by projecting your income for the rest of 2007 and, to the extent possible, for 2008 and even 2009.  Without eleventh-hour legislation from Congress, the risk of paying AMT in 2007 rises significantly over what had been the situation in 2006. 

For 2007, the AMT exemption amounts have been slashed to only $33,750 for single individuals and $45,000 for married couples filing jointly.  While Congress may well raise the exemption amounts at the last minute, planning for the worst is the safest course at this point. 

Planning for the AMT typically focuses on carefully examining normal income tax deductions that become “tax preference” items no longer deductible under the AMT.  These include: 

Personal exemptions;

1. Personal exemptions;

1. Deductions for state and local taxes;

2. Home equity loans and other mortgage interest not incurred in buying, building, or improving your principal residence;

3. Incentive stock options (which may generate AMT income even when sold at a loss);

4. Interest from some tax-exempt bonds;

5. Deductions for unreimbursed employee business expenses; and

6. Other miscellaneous itemized deductions.

Sincerely,

SMITH & GESTELAND, LLP

 

IRS Circular 230 Disclosure: To comply with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained herein (including any attachments), unless specifically stated otherwise, is not intended or written to be used, and cannot be used, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter herein.