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Year-end tax tips
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December 12, 1997: 6:05 p.m. ET
As 1997 draws to a close, capital gains cuts could save many a bundle
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NEW YORK (CNNfn) - Changes in federal law will make it easier for certain people to hang onto their hard-earned dollars at the close of 1997.
Among the lucky taxpayers are investors with stellar returns on Wall Street who can take advantage of capital gains cuts. Middle-income people can also plan ahead for a new IRA that takes effect next year.
"I don't think this will mean a major tax break for anybody," said John Gardner, senior manager in personal financial planning at KPMG Peat Marwick in Washington, D.C. "But it provides moderate relief to certain people."
Capital gains
Among the brightest parts of the new tax law are the capital gains rates, which will drop from a maximum of 28 percent to 20 percent on assets you've owned for longer than 18 months. The new rates take effect on assets sold after July 28.
While the change may deliver big savings, it could give you a throbbing migraine because it's so complicated, said John Chapoton, a tax expert at law firm Vinson & Elkins in Washington, D.C.
Depending on your income level, you'll pay different rates on assets you've owned less than a year, up to 18 months, and more than 18 months. Two other rates don't take effect until 2000.
And that isn't all. Because of a blunder by lawmakers, you can take advantage of the 20 percent rate on assets you've owned longer than a year that you sold between May 7 and July 28, Levy said.
That means it will take a lot more planning to offset year-end gains against losses, Chapoton said.
"The capital gains reductions are wise, but they're unnecessarily complex," Chapoton said. "I think there's a chance [lawmakers] are going to straighten them out."
Another benefit is a new capital gains exclusion on home sales of up to $500,000 for a couple and $250,000 for an individual, Gardner said.
"A lot of our clients are older and have been trading up in homes, but as their kids move out they're reluctant to 'buy down' because of capital gains," Gardner said. "This [provision] is getting a lot of interest."
Taxes and your investments
The capital gains changes make it a good time to reorganize your portfolio if most of your holdings are in stocks, Gardner said.
"As the market has risen, a lot of people are probably over-invested in stocks," Gardner said. "You can sell some stocks and buy bonds, mutual funds or CDs that are less risky."
Investors in the process of building their mutual fund holding should be careful about which funds they buy at this time of the year, said Victor Levinson, a personal finance expert at investment firm Weiss, Peck and Greer.
When a mutual fund sells a stock and makes a profit, it passes along the tax on the gain to fund holders - usually at the end of the year. You'll want to avoid buying shares of a fund just before that date. Otherwise, said Levinson, "you will have the tax consequences without the economic benefit."
A new IRA
Another change in tax law that has people scrambling is the new Roth IRA. When you draw money out of a Roth IRA after 59-1/2, all the gains you earned after the first five years will go to you free of taxes. By contrast, current IRA holders are taxed on all their gains.
If you're within certain income levels in 1998, you can transfer existing IRAs into Roth IRAs next year, said Michael Levy, a tax partner at Friedman, Alpren & Green in New York.
The limit is $150,000 for a couple and $95,000 for a single person. You'll pay taxes on the full amount you've transferred, but most people can spread it out over four years (couples must earn under $100,000 to take advantage of this).
"There's tremendous growth opportunity," Levy said.
One way to reduce your 1998 income is to take capital gains this year instead of next year, said Elda Di Re, a partner at Ernst & Young. If you're self-employed, you could bill clients now and collect the money in 1997. You might also want to ask your boss for your bonus this year rather than in 1998.
Deductions
Another way you can save money on your 1997 return is by grouping together medical deductions you might normally spread over more than one year, said Gail Winawer, tax partner at Goldstein, Golub Kessler & Co.
For example, you can only write off medical costs if they exceed 7.5 percent of your income, Winawer said. That's a pretty high threshhold -- but if you have dental work planned for 1998, you might want to pay for it before the end of the year. (75K WAV) or (75K AIFF)
Most people don't realize you can deduct premiums and other costs to get to the doctor's office, such as mileage, Di Re said.
You can also bundle expenses that fall under the "miscellaneous" category if they total more than 2 percent of your adjusted income, Di Re said. These include unreimbursed employee business expenses, investment expenses, and tax preparation fees.
But be warned that deductions for home offices and travel and entertainment could put you at a greater risk of an audit by the Internal Revenue Service, said David Kahn, another tax expert at Goldstein, Golub, Kessler & Co. He said it's crucial to keep careful documentation of all of your expenses.
You can also donate stocks to your favorite charity and deduct the full amount of the stock. The advantage is that you won't pay any taxes on your gains.
While some changes in the tax law won't take effect until next year, it doesn't mean you can't start planning now. For example, parents putting kids through college can write off up to $1,500 of the cost next year -- which means you should wait until after Dec. 31 to pay spring tuition bills.
Other tax-saving tips
You can pre-pay state income taxes and real estate taxes so you can write them off on your federal return. Paying real estate taxes earlier can also benefit you with certain state tax bills, Di Re said.
You should plan on keeping records for at least three years. Some records, such as documents relating to home improvements or purchases of any securities, you should hang onto forever.
The IRS can go back six years if it thinks you've underestimated your income by 25 percent or more - but there's no limit for fraud.
Hanging onto records becomes even more important because of capital gains changes. Starting in 2000, the government will tax assets you've owned longer than 5 years at 18 percent.
Lastly, don't expect any breaks because the IRS has taken heat this year for its practices.
Levy said IRS agents might be more sensitive with people -- but it won't reduce anybody's tax bill. The burden of proof is shifting to the IRS only in tax court - not at the level of a routine audit, he said.
Kahn said people who have been treated unfairly by the IRS might see a difference. The agency might not want another public relations nightmare to surface in the news, he said.
"But for the average person, I wouldn't use [the IRS controversy] as my leverage in terms of dealing with Uncle Sam," Kahn said.
-- By staff writer Martine Costello
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