5 tricky tax challenges

@Money March 3, 2012: 7:04 AM ET
Tax prep never gets any easier. To save the most you can this April - and in years to come - you need to master these key challenges.

Tax prep never gets any easier. To save the most you can this April - and in years to come - you need to master these key challenges.

(MONEY Magazine) -- With the Bush tax cuts slated to expire at the end of this election year, consider this filing season the calm before the tax storm: You'll face few new rules, tax rates are the same as last year, and popular deductions are still in place.

But preparing your income taxes remains as tricky as ever.

Here's how to make sure you don't get tripped up by five common filing challenges -- and how to set yourself up for tax savings on next year's return and beyond.

New capital gains rules

Filing challenge: When it comes to paying taxes on investment gains, what's new this year is a key reporting rule: For any stocks you bought on or after Jan. 1, 2011, you no longer get to set your cost basis (that's the cost of your investment for tax purposes).

Your broker will do it for you, based on the accounting method you chose -- your broker should have sent you a notice -- or the firm's default, what's called first-in, first-out, or FIFO, which assumes you sold your oldest shares.

Check 1099s against your records and have your broker fix any errors. "We'll see a lot of revisions on the 1099s," says Roman Ciosek, a partner at HighTower's Strata Wealth Management, who's advising clients not to rush to file. You can't, however, change your cost-basis method once you've sold -- no matter whether it was your choice or your broker's.

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Otherwise, the rules are the same. You can offset your capital gains with capital losses (new and lingering). First match long-term gains (on assets held more than one year and taxed at 15%) with long-term losses, and short-term gains (held one year or less and taxed as ordinary income) with short-term losses. Then match long-term against short-term. If you have extra losses, you can deduct up to $3,000 from your income, and roll over the rest to trim your taxes next year.

How to plan: Going forward, you can switch methods any time, and options include last-in, first-out and specific-share identification. What's best depends on many factors.

If you've invested in a stock over time and have your biggest gains on the first batch you got, for instance, you might want to identify specific shares to sell rather than use FIFO. But if you have ample capital losses to offset gains, this might be a good year to reap big profits. Frequent traders (or anyone who has bought a lot of a stock over time) can run the numbers using NetBasis software (netbasis.com; $20 and up).

The rules extend to mutual funds, most exchange-traded funds, and dividend-reinvestment plans in 2012, then bonds in 2013. Chances are your fund companies have already written to ask what method you want to use (the typical default is average cost). Don't ignore this paperwork.

Retirement plans

Filing challenge: You have until tax day to fund a traditional or Roth IRA for 2011 (April 17, this year), assuming you can. With a traditional deductible IRA, your contributions are in pretax dollars, and your withdrawals are taxable. With a Roth, you pay the taxes upfront, but neither you nor your heirs will owe income taxes on withdrawals. For most, the Roth has the edge over the long term.

Since 2010, everyone has been able to convert a traditional IRA to a Roth, regardless of income. That's great news -- unless it means an unexpectedly high tax bill. This year you owe taxes on 2011 conversions.

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Plus, if you converted in 2010 and spread your tax payments over two years -- a special break for 2010 only -- you owe half those taxes now. In a real pinch? You have until filing day to undo a 2011 conversion.

How to plan: You can open an IRA for 2012 now too, as well as move an old IRA into a Roth. Converting is especially advantageous if you'll face a higher tax rate in retirement than you do now, which is hard to predict. But for anyone considering it, this is a good year to pull the trigger. You know you'll pay no more than 35% on the rollover, while the expiration of the Bush tax cuts could usher in higher rates.

Selling your home -- at a loss

Filing challenge: When you hit the jackpot with your home, you owe capital gains taxes on any profits above $500,000 for marrieds ($250,000 for singles).

What if, like many homeowners today, you sell at a loss? You're out of luck. You can't take a deduction for the hit you took on your primary residence.

You may be entitled, though, to a tax break if your mortgage was reduced through a restructuring, the bank agreed to a short sale, or you lost your home to foreclosure. Typically this kind of relief is considered income since you no longer have to repay the debt. Under a tax break put in place during the real estate crisis, you can exclude up to $2 million in forgiven debt from your income.

How to plan: This exclusion expires at the end of the year. If you need a break, don't wait to act.

Education write-offs

Filing challenge: Sorting through education tax perks isn't easy. Valuable options include the tuition and fees deduction ($4,000 max), the lifetime learning credit ($2,000 per return), and the American opportunity credit ($2,500 per student, for undergraduate work only), but you can take only one per student in a single tax year.

In general, a credit is more valuable than a deduction since it directly cuts your taxes, while a deduction merely trims how much income is taxed. In the 28% tax bracket, a $2,000 credit trumps a $4,000 deduction, which lowers your federal tax bill by just $1,120.

Send The Help Desk your tax questions

"If you qualify for the American opportunity credit, that's the biggest bang for your buck," says Justin Ransome, a partner in Grant Thornton's national tax office. Income limits apply to all, but the AOC's is the highest (adjusted gross income of $180,000 for married couples, $90,000 for singles).

How to plan: Your choice may be simpler next year: The tuition deduction expired at the end of 2011. The American opportunity credit is due to run out this year.

Health care spending

Filing challenge: The bar for deducting health care costs is high -- you can write off only those expenses that exceed 7.5% of your AGI. But rising health care costs may bring it within reach. "If your medical expenses went up significantly or your income was reduced dramatically, pull out the shoebox of receipts," says Allison Shipley, a principal at PricewaterhouseCoopers' personal financial services practice.

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The definition of allowable expenses is broad: doctors' and dentists' bills, prescriptions, glasses, hearing aids, wheelchairs, transportation to doctors' appointments, nursing-home fees, and certain insurance costs (Medicare B and D, but not Part A, for example).

How to plan: The threshold jumps to 10% of your AGI in 2013, so consider moving up some medical expenses this year if you think you'll be close to qualifying in 2012.

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