Although no major tax reform legislation was passed in Washington or Raleigh this year, most taxpayers are still trying to figure out the Taxpayer Relief Acts of 1997 and 1998. Most of the provisions of the later law went into effect in 1998, but some are still being phased in. Also, this might be a good year to take another look at your current personal finances and the plans you have made for the future. Let's review:

Of Bulls and Bears

What a difference a year makes. As we rang in 2000, dot-com companies were the darlings of Wall Street. Valuations and stock prices were hitting never-before-seen levels. Stock options were all the rage and new millionaires were being created as fast as SUVs rolling off the assembly line.

But by the time the leaves turned, many of those high-flying dot-coms had gone belly up and investors were rethinking the value of New Economy stocks compared to blue chip winners in Old Economy portfolios.

“With the market plunging in the fall, this is a good year to balance your losses against your gains,” advises Steve Miller, a CPA and tax partner in the Raleigh accounting firm Cherry Bekaert & Holland. “If you have capital gains, get rid of the losing stock. But you don't want to sell off more than $3,000 worth of your gains.”

Becky Wray, a CPA and one of the owners of the Dixon Odom accounting firm, agrees. “If you've already got a lot of capital gains from securities sold in the beginning of the year, now's a good time to sell those that are losing money.”

Wray explains that you can offset capital loses against capital gains “dollar for dollar.” But, she adds, “If your capital losses are more than your capital gains, you can only deduct $3,000 against your ordinary income.”

If you've reached that $3,000 cap, you can carry forward unused capital losses as a deduction in future tax years. But if your portfolio has taken a beating this year you can also sell some securities that have gains in order to offset your losses.

The Taxpayer Relief Act of 1998 provided for lower capital gains tax rates effective in 2001. For those in the 15 percent tax bracket, assets purchased after Dec. 31, 2000, and held for more than five years will be taxed at the new maximum rate of 8 percent — down from the previous 10 percent. The old 20 percent rate is also scheduled to drop to 18 percent on qualifying five-year gains for assets also acquired after Dec. 31, 2000.

But according to Wray, assets purchased earlier can still qualify for the lower rate if you elect on your 2001 tax return to restart your holding period as of Jan. 1, 2001, and include unrealized appreciation in your 2001 income. If you decide to do this, then wait more than five years to sell your assets, any additional gain will be taxed at the 18 percent rate.

However, long-term capital gains from the sale of collectibles such as art, jewelry, stamps or coins will still be taxed at the pre-Taxpayer Relief Act rate of 28 percent. Also, long-term gains realized from the sale of depreciable real estate, such as rental properties, will be taxed at a maximum rate of 25 percent.

The sale of a primary residence may also need to be considered when calculating capital gains. While the Taxpayer Relief Act of 1998 offered a partial exclusion to the two-out-of-five-year residency requirement for those who were forced to sell their home, a typical sale may result in a capital gain — especially the way many houses are appreciating these days. Nonetheless, you will have taxes due, CPAs caution, if you sell your primary home at a profit in excess of the tax-free limits of $250,000 for single people and $500,000 for couples.

Interestingly, consideration of capital gains often pays a role in the timing of a divorce. If neither party wants to keep the house and its sale would produce a gain of more than $250,000, it would be best to sell the house before the divorce.

Selling off assets to achieve a balance between losses and gains is one of the most popular year-end tax strategies, but Wray warns investors to be aware of the “wash-sale” rule under which you cannot deduct a loss if you buy stock or securities “substantially identical” to those you sold within 30 days before or after the sale. This prevents investors from selling a loser, and then buying it right back.

Also, if you sell shares of stock or a mutual fund at a loss and dividends from the stock or fund were automatically reinvested within this wash-sale period, all or part of your loss will not be deductible.

To avoid this trap, most advisers tell their clients to wait at least 31 days before repurchasing a stock or security.

Another strategy that applies to capital gains, according to Wray, is the use of “like-kind exchanges” when the sale of an appreciated business or investment property is involved.

Suppose you have a rental house and a developer wants to buy it and build a shopping center on the land. “Before you sell it, find another property worth the same or more,” she says.

Because the exchange of funds is between agents, none of the money actually goes into your pocket. In essence, you are reinvesting in new property without cashing out your investment in the old. However, you are only deferring taxes on the built-in gain, she notes. “Someday, when you want to sell it, you'll have to pay taxes on the gain.”

Retirement Plans

It's never too early or too late to be thinking about retirement. With most of the savings burden now placed on employees, this is a good time to evaluate your options. And for those whose employers offer a 401(k) plan or a 403(b) tax-sheltered annuity, now is the time to max them out. However, tax advisors point out that if you can exceed the 401(k) IRS limit of $10,500, be sure your contribution allows you to put money in all year to avoid leaving matching money on the table.

Here's an example. An employee earns an annual income of $100,000 and his company offers a 401(k) plan allowing employees to contribute 15 percent of income while matching 50 cents on the dollar up to the first 6 percent. If you contribute the maximum 15 percent, you will reach the limit in about mid-September and your contributions and your company's match will both stop at that point. The company match at that point would be about $2,125. By reducing your contribution to between 6 and 7 percent, you will get to put money in all year and the match will continue all year too, allowing you to get the full $3,000 in for a net gain of $875.

Another popular retirement plan is the IRA. Anyone who opens an IRA can put within it a number of savings vehicles such as mutual funds, bond funds or CDs. Money put into a regular IRA cannot be taken out until the individual reaches the age of 59 1/2. And all money put in over the years is tax-deferred, meaning that when you begin withdrawing funds, you have to pay taxes on those withdrawals.

If, for whatever reason, money is withdrawn before age 59 1/2, not only is that money taxed, but also there is a 10 percent penalty for early withdrawal. In 1998, the Roth IRA was introduced. Often recommended for younger individuals who have many years left to save for their retirement, the Roth IRA guarantees tax-free savings and no age limits for withdrawals. In addition, withdrawals up to $10,000 can be made from a Roth IRA to pay for a college education or to assist in buying your first house.

According to Wray, the differences between a regular and Roth IRA need to be considered before deciding which one to use in your retirement plan. Allowable Roth IRA contributions are phased out as one's adjusted gross income rises from $95,000 to $110,000 (unmarried), $150,000 to $160,000 (married, filing jointly), and $0 to $10,000 (married, filing separately).

You can set aside as much as $2,000 per year in both traditional and/or Roth IRAs. And if you're married, you and your spouse may contribute as much as $4,000 annually even if one of you is not showing any earnings.

However, the total contribution cannot exceed your joint income, she adds. In addition, your entire contribution to a traditional IRA will be tax deductible regardless of your income if you are single and not eligible to participate in an employer-sponsored retirement plan, or you are married and neither you nor your spouse is eligible to participate in such a plan.

But changes to AGI levels that will take effect in 2001 will affect those who are already participating in employer-sponsored plans. As of next year, IRA deductions for plan participants are phased out in the following ranges: $33,000 to $43,000 (single or head of household); $53,000 to $63,000 (married, filing jointly); and $0 to $10,000 (married, filing separately). But the phase-out range for a nonparticipant spouse whose spouse is a participant is being raised from $150,000 to $160,000 of joint AGI.

It is possible to convert a traditional IRA to a Roth IRA, but there are some factors that need to be considered, according to Wray. A traditional IRA may be converted to a Roth IRA if the modified AGI (not counting the converted amount) is $100,000 or less and you file a joint return if you are married.

But, Wray says, “If your compensation is over $100,000 you can't convert your regular IRA to a Roth IRA. If you do, you have to recognize the tax. The amount you convert is income and, therefore, you have to pay taxes on it.”

Another major difference between a traditional IRA and a Roth IRA is that individuals must, by law, begin withdrawing funds from a traditional IRA once they've reached age 70 1/2.

Advises Wray, “If you turn 70 1/2 in 2000, check before Dec. 31 to see if you need to make minimum withdrawals from your retirement plan. If you wait, you'll have to make two withdrawals next year, which means you will double up on your income for next year.”

Individuals have until April 15 to open either a traditional or Roth IRA. But employers who want to adopt a retirement plan, like a 401(k), for their employees, must do so before Dec. 31.

Hunting for Deductions

By April 15, most people are scratching their heads trying to find enough deductions to lower their taxes. But now is the time to start looking at your current and projected income and the items that might be deductible.

One strategy, known as income or deduction shifting, works best if you know what your income is likely to be next year. If you expect your income to be higher next year due to bonuses or raises, you might want to shift deductions into next year to help offset it. However, if it looks as though your income will be higher this year, you might consider accelerating your deductions for this year.

A similar strategy that individuals can use if they are having a problem reaching the 2 percent personal deduction threshold is to use what is referred to as “bunching.” It might be advisable, for example, to “bunch” together your major medical or legal expenses in order to increase the deductions for that year.

Tax specialists also advise business owners to be aware of when they bill their clients and when their clients pay their bills. If you have a client that always pays his bills as soon as he gets them, you might defer some of your billing until late in December so that his payment will show up on your books in the new year.

But when it comes to paying your own bills, most experts agree that you should pay them all by the end of the year in order to accumulate as many deductions as possible.

It is also wise, these same experts say, to reimburse your employees for such items as mileage, medical insurance expenses and other fringe benefits before the end of the year.

Given the high cost of health care, most people try to find as many medical-related deductions as possible. But deductions for medical expenses are limited to those that, over the course of one year, exceed 7.5 percent of your AGI.

Included are unreimbursed amounts paid for health insurance, hospital and nursing care, doctors' and dentists' visits, prescription medications, eyeglasses, hearing aids, and some long-term care insurance premiums and services. In addition, the IRS now allows deductions for admission and transportation to medical conferences relating to a dependent's chronic disease, smoking cessation programs, and prescribed drugs taken to alleviate the effects of nicotine withdrawal. And, if you need to travel in order to obtain medical treatment, you may be able to deduct the cost of your transportation as well as food and lodging while enroute.

Another deduction that people should be aware of involves the interest on mortgages and home equity loans. CPAs point out that you can make your January mortgage payment in December, getting 13 months in this year and increasing your itemized deductions.

And the fact that interest on a home equity loan is also tax deductible can help if you need to make a sizable purchase, says Wray. “If you want to buy something personal that you will have to finance, use a home equity loan,” she advises. “You can buy up to $100,000 secured by your residence and use the money for any purpose and still deduct that interest.”

In addition to the interest on mortgages and home equity loans, real estate taxes also are deductible in the year in which they are paid. So you might consider paying these taxes before the end of the year.

Also, if you pay estimated state and local taxes, you can prepay them by Dec. 31 rather than waiting until Jan. 15. Because state income taxes are deductible for federal income tax in the year in which they are paid, this would give you an added deduction for this year.

Wray points out that you also can deduct investment interest to the extent of your net investment income. And interest that exceeds this limit can be carried over to future years, she says.

Gifts Are for Giving

Increasing your charitable donations is win-win. The Taxpayer Relief Act of 1998 extended, indefinitely, the ability to deduct contributions of appreciated stock to private foundations.

It also is often more advantageous to donate appreciated property rather than cash because the deduction is based on the asset's current fair market value. As a result, its appreciation is not subject to capital gains tax. All contributions to qualified charities, however, cannot exceed 50 percent of your AGI.

Currently, individuals can reduce the taxable worth of their estates by making annual gifts of up to $10,000 per year without having to pay a gift tax. In addition, you also can give away up to $675,000 without incurring a gift or estate tax.

Called the “unified credit shelter amount,” this $675,000 cap will be raised to $1 million in the year 2006, according to Wray. This strategy not only can help your spouse, but also your children at the time of both your and your wife's deaths, Wray says.

Suppose you have assets totaling $1 million. If you die and leave everything to your wife, her estate is now subject to taxes based on that $1 million — plus her own assets. But if you put $675,000 into a special trust for her, that money would not be taxed as part of her estate.

If left in that trust, the money would go directly to the children upon her death. And they would not have to pay an estate tax on it. According to Wray, such taxes currently range from 18 percent to as much as 55 percent.

And for those who are thinking about bequeathing assets to charity only, setting up a “charitable remainder trust” may be the answer. While this trust can produce income for life, once the person dies the remainder of the trust goes to a charity of choice. The only requirements are that the income from this trust not exceed 50 percent of the total investment and that no less than 10 percent of the trust goes to charity.

A gift can also be used to help pay for your child's education. If you have appreciated mutual funds that you need to cash in for your child's college education, making a gift of it to a child allows them to cash them in without subjecting you to capital gains tax.

Building a Business

Because of the complexity of tax laws involving businesses and corporations, most tax advisers suggest that you consult your own tax attorney or accountant to find the best year-end strategies. But Wray offers a few general suggestions.

A “Section 179 deduction” allows many businesses to deduct the cost of property and equipment — up to $20,000 — acquired during that year, instead of depreciating them. However, this deduction covers tangible personal property like computers and heavy machinery but does not apply to real estate and cannot exceed taxable income from any active trades or businesses, Wray says.

Further, all equipment must be set up and ready for use by Dec. 31 in order to qualify, she adds. And while the current deduction is $20,000, it will go up to $24,000 during 2001 and 2002 and to $25,000 in 2003.

Major equipment purchases made this year can result in larger tax deductions. But if your projections indicate that your business will make a lot more money next year, you might want to consider delaying major purchases until next year — when you will need more deductions.

As for the depreciation of equipment, Wray says that businesses are generally entitled to a half-year's worth of depreciation for most non-real estate assets, regardless of the date placed in service. However, when more than 40 percent of such assets are placed in service during the last three months of the year, a “mid-quarter convention” applies, she says.

Those who are self-employed, as well as partners, can now deduct 50 percent of the cost for business-provided individual or family health coverage, Wray says. Next year, that deduction will increase to 60 percent, then to 70 percent in 2002 and 100 percent in 2003.

And, with more and more people using a home office, the IRS allows you to deduct a number of expenses incurred in the running of your business from a specific area of your home. These can include a portion of your mortgage, utilities and even home repairs.

COPYRIGHTED MATERIAL. This article first appeared in the December 2000 issue of the North Carolina magazine

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