(MONEY Magazine) – You know the line about how you should never watch legislation or sausages being made? Well, add this past summer's messy Taxpayer Relief Act to the list. With Capitol Hill lawyers pulling all-nighters to help write it, the 800-odd-page law included baffling provisions compounded by a dearth of information about how to put the changes into practice. What's more, the clarifications that have been trickling out from Congress and the IRS have revealed surprising ways to cut your taxes that had been obscured by the '97 law's dense legalese. For example, it turns out that if you paid tax on the sale of your home within the past three years, you may have a refund coming--of the entire amount you paid. Or if you have college-bound kids and want to take some courses yourself, you may be able to claim new write-offs for everyone's expenses.

Meantime, the President and lawmakers in Washington have turned their focus to the next round of tax cuts and tax reform. The two likeliest goodies this year: some relief from the marriage penalty (the quirk that can cause working couples to pay more tax than they would owe if each were still single) and reform of the alternative minimum tax--a provision originally designed to hit the superrich but that has increasingly punished middle-class taxpayers. (For more about the future shape of tax reform and IRS reform, see the articles on pages 82 and 86.)

Right now, however, you need to focus on getting the most out of the latest tax law. In this article, you'll learn about 20 little-known ways to benefit, grouped in four broad categories: capital gains, home sales, tuition tax credits and other college savings breaks. Each section begins with an overview of the rules followed by our advice on how to grab the new write-offs and avoid the inevitable tax traps. In the story beginning on page 74, you will find clever strategies for taking maximum advantage of the new Individual Retirement Accounts, and in the article starting on page 88, there's timely advice on cutting the tax on your mutual fund gains.

Now get set to slash your tax bill, just as the people profiled in this story are doing.

CAPITAL GAINS

Under the new law, starting July 29, 1997, the top tax rate on capital gains is 20% for investments you've owned for more than 18 months before selling, or 10% if you're in the 15% bracket (joint filers with taxable income of less than $42,351; singles with taxable income of less than $25,351). The old top rate of 28% (or 15% if you're in the 15% bracket) still applies if you hold an asset for more than a year but not more than 18 months. And if you unload a winner that you've owned for a year or less, look out! You'll pay capital-gains tax at your top income tax rate--as high as 39.6% if your taxable income tops $278,449 in 1998.

Two exceptions: For real estate investors, the top long-term rate is 25% on the portion of a gain attributable to any depreciation you claimed. And the maximum capital-gains rate on the sale of collectibles remains at 28% and applies to assets you hold for more than a year.

Here's how to get the biggest savings from the new capital-gains rules:

Take your investment losses in years when you report short-term gains, which are otherwise taxed at your top income tax rate of up to 39.6%. The new law requires you to group your gains and losses according to the tax rates that apply to their holding periods: For example, the gain on a stock you held for more than 18 months--which would be taxed at a top rate of 20%--gets offset first by losses on assets you held for more than 18 months. Similarly, the gain on the sale of a stock you held for, say, 13 months--which would be taxed at 28%--is offset first by losses on assets that you have held for more than a year and not more than 18 months. But here's the boon: If your losses in any group exceed your gains in that group, the excess can be used to offset your other gains, starting with the gains that are subject to the highest rate of tax.

Consider the differing tax savings from a $10,000 loss you take on a stock held for more than 18 months: If you sell the loser in a year when you also have a $10,000 gain on stock you owned for more than 18 months, you must deduct the loss against that gain, which would otherwise be taxable at 20%. Thus your savings come to $2,000 ($10,000 times 20%). But if you dump the $10,000 loser in a year when you have gains only from assets owned for less than a year--taxable at your highest income tax rate, say, 31%--your tax savings from your loss jump to $3,100 ($10,000 times 31%).

If your losses exceed all your gains, write off the excess against $3,000 in ordinary income. Even if you don't anticipate selling any investments for a gain in 1998, you ought to comb through your portfolio later in the year to turn up dogs you could unload for a loss of up to $3,000. By using a capital loss to shelter $3,000 in ordinary income, you'll save $840, assuming you're in the 28% bracket.

Try to hold your investments for more than five years, especially if your taxable income is around $40,000 if you're married or $25,000 if you're single. In an important but little-noted section of the new law, truly long-term investors reap an even bigger tax boon: Starting in 2001, if you're in the 15% income tax bracket and sell an asset you've owned for more than five years, you'll pay tax on your capital gain at a super-low 8%. That could amount to a tax savings of as much as $1,200 on a $10,000 gain, assuming that you were in the 28% bracket or higher when you bought the asset but had dropped into the 15% bracket by the time you sold the asset at least five years later. Such a bracket drop is not uncommon if, for example, you retire or your spouse leaves the work force. Any asset you bought before 1996 will qualify for the 8% rate, as long as you put off selling until 2001; similarly, stock you buy now will qualify for the 8% rate in 2003.

Your best move: Identify the investments you plan to hold for at least five years and, unless the companies fall apart in a fundamental way, stick with them.

YOUR HOME

For home sales on or after May 7, 1997, married joint filers can now exclude from tax as much as $500,000 in profits; single filers can shield $250,000. Moreover, you can use the exclusion as often as every two years. To qualify, you must have owned and lived in the home as your principal residence for at least two out of the five years before the sale.

A reminder: When you compute the gain on your current home, you must include any profits you previously deferred by trading up. So if you've been pyramiding your profits for many years and the accumulated deferrals plus the gain on your current home exceed the new exclusion, you'll owe tax on the amount above the limit when you sell. The strategies:

See if you have an income tax refund coming if you traded down within the past three years when you were age 55 or older. The new law repeals the once-in-a-lifetime exclusion of as much as $125,000 in profit on the sale of your home if you were 55 or older at the time. So if you qualified for the $125,000 exclusion in the past but didn't use it--say, because you had a smallish gain on your sale and expected a larger profit on a future home sale--you unwittingly forfeited a huge tax-saving opportunity. Thankfully, you may have recourse: If you traded down and paid the tax within the past three years, you can file an amended return using Form 1040X (available by calling the IRS at 800-829-3676 or off the Web at irs.ustreas.gov) to retroactively claim the $125,000 exclusion and get a refund.

The savings could be substantial. Assume you were 55 in 1995 when you sold your home, exposing a $40,000 capital gain to tax. Also assume that you expected your new home to appreciate by more than $40,000 and so chose not to use the one-time exclusion. Rather, you paid the $11,200 tax due on your gain. By filing an amended return, you can get a full refund.

Unfortunately, this ploy won't work if you filed the tax return for the sale more than three years ago, since you get only three years from the return's due date--or, if you filed late, the date you actually filed--to ask for a refund. One exception: If you paid your tax late, you have two years from the time you paid the tax to file an amended return.

Important note: If you traded down in 1994 and paid the tax with your timely filed '94 return, you must submit your refund claim by April 15, 1998.

You're selling but haven't lived in your home for two of the past five years? then see whether you qualify for a partial tax exclusion. The new law lets you claim a pro rata share of the exclusion if you must sell your home because of a job transfer, ill health or another significant unexpected event. For example, if you're single, have lived in your house for just 10 months and accept a new job in another city, you can escape tax on a gain of as much as $104,167 (that's 10 months divided by 24 months, or 42%, times $250,000).

If you're legally separated or divorced, and you've moved out of the house, you can make the split less taxing. Under the old law, if you separated or divorced and stopped living in the family home but retained sole or joint ownership, you could not defer the tax on your share of the gain when the house was sold. Reason: At the time of the sale, the home was no longer your principal residence. But for home sales on or after May 7, 1997, a separated or divorced taxpayer can now exclude from tax his or her share of the gain--as long as the ex-spouse has been living there under a separation or divorce agreement for at least two of the five years before the sale.

The law is unclear, however, on whether the spouse who moved out will be held to an exclusion limit of $250,000 (the max for single filers) or can exclude as much as $500,000, provided he or she has remarried and is filing jointly. Either way, the new exclusion limits are likely to be capacious enough to shield nearly all gains from tax.

Divorced taxpayers who stay in the family home can generally sell as soon as they wish. If your ex owns the house but transfers title to you in the divorce agreement, the new law assumes you've owned the house for the same length of time as your ex did. That means, in most cases, you'll be able to sell and claim the new exclusion as soon as you want, rather than waiting until you have owned the home in your own name for at least two years.

Be sure to keep excellent records even if you think you will qualify for the new exclusion. Because the majority of home sellers will no longer owe tax, you might think you don't have to retain documents proving your home's purchase price and the cost of improvements anymore. Wrong. If you claim the home-sale exclusion on your return and are subsequently audited by the IRS, you'll be asked for records to prove the amount of your gain. You will also need records of your home's purchase price and improvements (such as invoices and canceled checks) to compute any casualty-loss deduction if fire, flood or other calamity damages your home.

TUITION TAX CREDITS

If you, your spouse or your dependents are in college--or soon will be--and your adjusted gross income is less than $80,000 for joint filers ($40,000 for singles), you can cut your tax bill with the new law's Hope tuition credit and lifetime learning credit. (The credits phase out as your AGI rises above the $80,000 and $40,000 thresholds and disappear once the AGI exceeds $100,000 for couples, $50,000 for singles.)

Starting this year, the Hope credit lets you slash your tax by up to $1,500 a year per student for tuition you pay during the first two years of college. (The full credit is 100% of the first $1,000 of tuition you pay; 50% of the next $1,000.) So if you shell out at least $2,000 apiece in tuition for your college freshman and sophomore this year and your income is below the phaseout range, you can claim the maximum Hope credit for each of them--for a 1998 tax cut of $3,000.

In contrast, the full lifetime learning credit is $1,000 a year--20% of as much as $5,000 in tuition payments--but it can be claimed for any year in which you don't also take the Hope credit for the same student's tuition. Assume, for example, that your AGI is $70,000 in 1998 and you pay $4,000 in tuition for your college senior plus $2,000 for your spouse's graduate school tuition. Up to $5,000 of the payments qualifies for the 20% credit, for a $1,000 tax break.

Seven ways to make the most of these credits:

Be certain that you're paying the right type of college expenses. Only payments for tuition and required fees, such as lab costs, qualify for the credits--not other wallet-busters such as room, board, books and athletic fees. Moreover, the law allows only your out-of-pocket outlays. So, for example, if your child has a merit scholarship that fully covers tuition or your employer provides tax-free reimbursement for your tuition, you can't claim these credits.

Make sure you pay the tuition at the right time. To qualify for either credit, the education must occur within the tax year in which the payment is made or within the first three months of the following year. This requirement is trickier than it seems: For most taxpayers, the tax year is the same as the calendar year, but a calendar year rarely tracks an academic year. To ensure your eligibility, bear in mind that you can claim the Hope credit for tuition you pay starting this year as long as the classes start or continue through March 1999. The lifetime credit is available for tuition paid after June 30, 1998 and for instruction that takes place through March 1999.

Claim your child as a dependent on your tax return in order to take either tuition tax credit. Conversely, if your child wants to claim either of the credits on his or her own return, he or she can't be claimed as a dependent on anyone else's return.

This rule means that your son or daughter cannot claim the credit, even if he or she pays the tuition, as long as you're eligible to claim the child as a dependent. Under the law, you're eligible to take the dependency exemption if you provide more than half the support of your child who is under age 24 and attends college at least half time.

One twist: Tuition paid by your dependent child is treated as if you paid it for purposes of taking the credits. Assume that your college senior will pay $1,000 of her tuition this year. As long as she is your dependent, you can claim a lifetime learning credit against her payment for a $200 tax savings.

Feel free to use proceeds from a home-equity loan or credit line to pay the tuition and take these tax credits. You can use the credits against tuition payments made with loan proceeds as long as you claim the credit in the year you pay the tuition, not the year in which you repay the loan.

Part-time students: Grab full credits. To hitch a Hope, a student must take at least half the normal course load in a program that leads to a degree, certificate or other bona fide educational credential for at least one semester during the academic year. If you drop below half time in the other semester, you still qualify.

The requirement is even looser for a lifetime learning credit. You can claim the credit against the cost of any course as long as the schooling is provided by an "eligible educational institution"--generally an accredited two- or four-year college or university or a vocational or proprietary school that qualifies for the federal financial aid program.

Since there is no course-load requirement for the lifetime learning credit, you can use it to write off the cost of even a single course that helps you acquire or improve your job skills. Such classes include continuing-education programs required by your professional association. Before claiming the lifetime learning credit against job-related courses, though, you will need to determine whether you can deduct all or part of the cost of the classes as a miscellaneous itemized employment expense. If so, you can't double-dip.

Let's say you'll spend $3,000 on management classes at a local college in 1998. If you're married with an AGI of $70,000, you can then deduct $1,600 of the $3,000 as a miscellaneous itemized deduction, for a tax savings of $448, assuming you're in the 28% bracket. (You can't write off the entire $3,000 because the deduction is allowed only to the extent that your miscellaneous costs top 2% of your AGI.) After the deduction, you still have $1,400 in unreimbursed expenses against which you can take a 20% lifetime learning credit, giving you an extra $280 in tax savings. If you weren't able to deduct your classes as a miscellaneous expense, you could claim the credit against the entire $3,000, for a $600 tax cut.

OTHER COLLEGE TAX BREAKS

The new law offers three more tasty tax tidbits for college bills. First, starting in 1998 you can deduct student-loan interest in each of the first five years of the loan payback. You can write off as much as $1,000 in interest in 1998; the amount rises every year thereafter, to $2,500 in 2001. Better still, you don't need to itemize deductions to claim this break. The deduction starts phasing out for singles with an AGI above $40,000 and joint filers making more than $60,000, disappearing at $55,000 and $75,000 respectively.

The law also created a small tax-favored education savings account, known as the Education IRA. Couples with an AGI of up to $150,000 (singles making as much as $95,000) can contribute as much as $500 a year, after tax, to an Education IRA at a bank, brokerage or mutual fund for any child to age 18. The earnings grow tax deferred and can be withdrawn tax-free to pay for tuition, room, board, books and other supplies. If you saved $500 a year earning 10% from the time your son was born, you'd accumulate $28,137 by his 18th birthday. You can't claim the tuition credits in the same year that you make tax-free withdrawals from an Education IRA to pay for any one student's college bills, though. So as a general rule, if your child is a few years away from college, you should forgo funding an Education IRA in favor of the credits. Reason: With the low $500 funding limit on the Education IRA, you generally need a decade or more to build up a stash big enough to beat the tax savings you get from claiming one of the new credits.

Finally, the law slightly enhanced the advantages of state prepaid-tuition plans, which let you pay in advance for your child's college tuition in a lump sum or through installments that grow tax deferred. Among the improvements: Starting this year, you can use money from a prepaid plan to pay the college's bill for room and board as well as tuition. Currently, 14 states offer prepaid plans, and seven states--Illinois, Maine, Missouri, Nevada, South Carolina, Washington and West Virginia--propose to launch plans soon.

Some A+ strategies for these new breaks:

Look into the escape hatch in the law that lets you pull money out of an education ira and claim the credits too. If you elect on your tax return to pay tax on withdrawals from an Education IRA to pay for college, rather than taking the money tax-free, you can still use the credits against your tuition outlays. Sure, you give up the Education IRA's tax-free payout, but you'll still have benefited from years of tax-deferred earnings buildup.

Grandparents: Fund an Education IRA for your grandchildren. Anyone whose income is below the contribution limits can fully fund an Education IRA for any child, as long as the total contributions to an account in the child's name don't exceed $500 a year. So grandparents can set up Education IRAs for each grandkid, which would be a great way to help out if the children's parents can't do so, either because their income is too high or they can't afford it.

Remember to contribute to an Education IRA each year by Dec. 31. This deadline is likely to trip up a lot of taxpayers because it differs from the IRA deadline, which hasn't changed under the new law: You still have until the time you file your tax return on April 15 to open and fund an IRA for the previous year.

If you think you'll apply for college financial aid, tread cautiously before opening an Education IRA. Although the law has not yet been clarified, experts assume that money in an Education IRA will be treated as your child's when you apply for aid. That will likely result in less aid than you would receive if you had saved the money in your own name. Reason: The formula for computing aid assumes that students ante up 35% of their assets each year to pay for college, while parents are expected to contribute only 5.65% of assets. So skip funding an Education IRA unless you already know you won't qualify for aid or your children are so young that you prefer the certainty of building up your own savings to speculation about future financial aid.

Consider a state prepaid-tuition plan only if you are confident that your child will attend a participating school. That's because if your kid doesn't go to one of the schools in the program, most plans will return only your principal plus a paltry 3% to 5%. One more point: Chances are you can accumulate more money by investing in stocks on your own, which historically return 10% a year, than you can by saving through a prepaid plan, which currently grows by about 5% a year. And get this: If you contribute to a state prepaid plan for your child, you can't also contribute to an Education IRA for him or her. Fund both types of plans in the same year and you will be slapped with a 6% excise tax on the Education IRA contribution. That would be tantamount to flunking out of Tax Savings 101.

Money tax editor Mary L. Sprouse is a tax lawyer and former audit group manager at the IRS.