October through December is an excellent time to consider year-end tax planning moves to save taxes for 2017. Once tax season gets underway in Q1 2018, it’s too late for these smart ideas.
As tax reform advances through Congress, it’s safe to assume your tax rates may be lower in 2018 and some of your expenses will likely be repealed to pay for tax rate cuts. It’s probably wise to use the time-honored strategy of deferring income and accelerating payments to deduct them while you can. Even if Congress fails to pass tax reform, you’ll benefit from the time value of money.
Repealing most itemized deductions
In exchange for lowering corporate tax rates, the tax reform framework repeals most itemized deductions for individuals starting in 2018. The two notable exceptions are deductions for mortgage interest expenses and charitable contributions. Tax reform compensates for middle-income folks by doubling the standard deduction. You should try to pay all 2017 expenditures before year-end to get the deduction while you can and reduce 2017 income.
The tax reform framework repeals “miscellaneous itemized deductions,” which include investment expenses, tax compliance fees and unreimbursed employee business expenses deducted on Form 2106. You should try to pay service providers for 2017 services by year-end. Traders who are eligible for trader tax status (TTS) have business expense treatment, bypassing miscellaneous itemized deductions.
Investment advisory fees, including management fees and incentive fees, are investment expenses, which face repeal in 2018. Brokerage commissions are not investment expenses. Transaction costs are adjustments to proceeds and cost basis, reflected in capital gains and losses. The current framework was silent about earlier blueprints to repeal carried-interest tax breaks for hedge fund managers. I expect these changes would impact the investment management industry, which may consider changes to business models to achieve better tax efficiency.
Employees should submit expenses to employers for reimbursement before year-end since accountable plans have “use it or lose it” rules. Under current law, miscellaneous itemized deductions are deductible above a 2% AGI threshold, and they are not deductible for AMT. If your employer doesn’t have an accountable plan, encourage them to consider one for 2017 and 2018.
Accelerate state and local tax deductions
The current tax reform framework repeals itemized deductions for state and local taxes including income, real estate, property and sales and use taxes. States without an individual income tax, including Texas, Florida, and Washington, have real estate and sales and use taxes. For 2017, you can elect to claim sales and use taxes as an itemized deduction instead of state income taxes. If you are thinking about buying an expensive item that is subject to sales and use tax, consider purchasing it before year-end. Accountants are looking into ways for a business to treat some state and local taxes as a business expense.
The tax reform framework repeals state and local tax deductions and AMT starting in 2018, so your best chance at a deduction might be to pay state and local taxes due by Dec. 31, 2017. This is a change from previous tax years when individuals may have postponed state and local taxes to avoid AMT. Be sure to check the latest developments on tax reform before you make this decision close to Dec. 31 since there is blowback on the repeal of state and local taxes, and I expect there could be changes.
Casualty loss deductions
The tax reform framework repeals the casualty loss itemized deduction for 2018, so try to complete your claims to support a 2017 tax deduction. The 2017 disaster tax relief bill for Hurricanes Harvey, Irma and Maria victims exempts qualified disaster-related personal casualty losses from the 10% AGI threshold. Victims don’t have to itemize; they can add this casualty loss to their standard deduction, and that part is deductible for AMT. (Hopefully, Congress applies this same relief to victims of the California wildfires.)
Maximize charitable contributions
You should make tax-deductible donations before year-end by check and credit card. Property donations of clothing, household goods, and appreciated securities can also be deducted. The itemized deduction is calculated based on fair market value (FMV), or another acceptable method. The FMV of clothing and household goods is usually a small fraction of the purchase price. When you deduct the FMV of appreciated securities, you avoid capital gains taxes. For charitable donations over $250, the IRS requires a written acknowledgment letter. Expect a reduction of the contribution amount based on the value of goods and services you receive, for example at a charity dinner.
The IRS permits individuals age 70½ or older to make charitable gifts up to $100,000 per person, per year, directly from their IRAs, and this generates several tax benefits. The strategy is more tax efficient than taking an income distribution and potentially losing some of the deduction with the Pease itemized deduction limitation for upper-income taxpayers or using the standard deduction. Avoiding an IRA withdrawal lowers AGI, which may unlock middle-income deductions and credits and avert net investment tax (NIT). The charitable donation amount also counts toward meeting the required minimum distribution (RMD) rule. You may not receive goods and services in connection with this donation from the IRA, other than an intangible religious benefit.
Other itemized-deduction limitations
Upper-income individuals should be aware of the 2017 Pease itemized deduction limitation, indexed for inflation: $261,500 single and $313,800 married filing joint for 2017. It wipes away many of your itemized deductions.
The AGI percentage threshold for medical expenses is 10%, and for miscellaneous itemized deductions it’s 2%. Investment interest expenses are limited to investment income, and an investment interest carryover likely won’t be beneficial in 2018 since tax reform repeals it.
Capital gains and net investment tax
The tax reform framework omitted capital gains tax cuts. Previous blueprints applied lower long-term capital gains rates to all capital gains, dividends and interest income, but I expect the current law to continue.
Many investors hoped Republicans would repeal the Obamacare 3.8% net investment tax (NIT) on unearned income, but they retained NIT in the healthcare bills and tax reform framework. Consider reducing income under the thresholds for triggering NIT (modified AGI of $200,000 single, $250,000 married, and not indexed for inflation), or defer net investment income to 2018. The repeal of investment expenses in 2018 will likely also repeal them as a deduction from net investment income (NII), used to calculate NIT.
Tax loss selling
A taxpayer with capital gains can reduce taxes by selling losing securities positions, realizing capital losses, before year-end. This continues to be a smart strategy in 2017, however, if you already have a $3,000 capital loss limitation, tax loss selling won’t help.
Wash sale loss adjustments
Be careful not to trigger a wash sale loss adjustment at year-end by buying back a substantially identical position 30 days before or after realizing a tax loss on a security. In a taxable account, a wash sale loss adjustment from December is deferred to January, adding the tax loss to the replacement position’s cost basis. It accelerates income, when your plan may be to delay income. Congress doesn’t want taxpayers to realize “tax losses” that are not “economic losses.”
If you realize a tax loss in an individual taxable account and buy back a substantially identical position in a traditional IRA or Roth IRA, you will never get the benefit of that tax loss. Avoid this catastrophic problem with “Do Not Trade Lists” between your IRA and taxable accounts.
In taxable accounts, avoid wash-sale loss adjustments at year-end by “breaking the chain.” Sell open positions and don’t get back into substantially identical positions for 30 days before and after selling them. For example, sell the entire position on Dec. 15 and don’t repurchase it until Jan. 16. In December, use trade accounting software to identify potential wash sale loss adjustments so you can break the chain before year-end.
Don’t solely look at a broker’s tax report or 1099-B for identifying potential wash sale losses. The IRS requires taxpayers to assess wash sales across all brokerage accounts, whereas, brokers only look at a single brokerage account. Brokers calculate wash sales based on an exact symbol (identical position), whereas, taxpayers must base wash sales on “substantially identical positions,” an equity and its equity options, at different expiration dates. Many active securities traders are surprised with big tax bills on April 15 because they mishandled wash sale losses at year-end.
Section 1256 contracts, which include futures and broad-based indexes, and Section 475 trades for traders with trader tax status (TTS), are both mark-to-market (MTM) code sections. MTM imputes sales of open positions at year-end, so you are reporting realized and unrealized gains and losses. That negates the need to do tax loss selling. MTM comes with Section 1256 by default, and Section 1256 is capital gain and loss treatment.
Individual TTS traders had to elect Section 475 ordinary gain or loss treatment for 2017 by April 18, 2017, or have elected it in a prior year. Existing partnerships and S-Corps had to elect it by March 15, 2017. The next opportunity to file a Section 475 election is for 2018, or within 75 days of inception for a new entity. I call Section 475 “tax loss insurance” because it exempts traders from the capital loss limitation and wash sale loss adjustments.
Try to be eligible for middle-income tax benefits
Each of these tax breaks has different AGI phase-out ranges. Try to reduce your 2017 AGI to maximize deductions for education, and student loan interest, increase child care credits and the personal exemptions and lower AMT and NIT taxes. You may need to prepare a draft tax return to see where you stand on all these moving parts.
Avoid the highest individual ordinary tax rate
Upper-income individuals should try to avoid the top tax bracket of 39.6%, which starts at taxable income of $418,400 for single filers and $470,700 for married filers. The second bracket is 35%, which the tax reform framework uses as its top bracket for 2018. The tax reform framework empowered Congress to add back a higher top bracket for 2018 to ensure tax reform is progressive. Tax writers have not yet committed to the bracket income ranges, which could make all the difference.
Maximize use of the 0% long-term capital gains brackets
Long-term capital gain rate brackets correlate with ordinary rates for 2017. The 20% capital gains rate applies in the 39.6% ordinary-income tax bracket. The 15% capital gains rate applies to ordinary rates over 15% and under 39.6%. The 0% capital gains rate applies for the 10% and 15% ordinary brackets. If you are in the 10% and 15% ordinary tax brackets, try to sell long-term capital gains before year-end to take advantage of zero capital gains taxes. (State taxes may apply.)
There’s a long-term capital gains rate component in Section 1256 contracts: 60% long-term capital gains and 40% short-term capital gains. The blended 60/40 capital gains rate for the 10% bracket is 4%, and for the 15% bracket, it’s 6%. There is no sense in postponing income if you can pay such a low tax rate.
Arrange required minimum distributions
Take RMDs from traditional IRA, Solo 401(k) plan, and employer retirement plans. Commence RMDs by April 1 of the year following the calendar year in which you reach age 70½. Per IRS.gov, “If you do not take any distributions, or if the distributions are not large enough, you may have to pay a 50% excise tax on the amount not distributed as required.”
Avoid estimated tax underpayment penalties
Many traders and small business owners don’t pay quarterly estimated taxes in Q1, Q2, and Q3 since they might lose significant money in Q4, so strategies to avoid underpayment penalties are helpful. Consider increasing federal and state tax withholding on paychecks before year-end as the IRS and states treat W-2 tax withholding as being made throughout the year.
Fully fund health plans
If you have a health savings account, be sure to pay the maximum allowed contribution for 2017 before year-end. (Self-only is $3,400, family coverage is $6,750, and $1,000 catch-up contributions are allowed for age 55 or older.) Increase your employer’s health flexible spending account for 2018 if you had too little funding in 2017.
Income acceleration strategy
If you’re in a low tax bracket for 2017 and expect to be in a higher tax bracket for subsequent years, including retirement years, consider a Roth IRA conversion before year-end 2017.
This is often a wise move since Roth IRAs are permanently tax-free, whereas traditional IRAs are only temporarily tax-free. Be careful not to take early withdrawals from any of your Roth IRAs for at least five years, and before you reach age 59½, otherwise you may trigger taxation on nonqualified distributions. Roth IRAs are not subject to RMD rules, which apply to traditional IRAs and qualified plans. If the Roth IRA account substantially drops in value after the conversion date, you can reverse the conversion by Oct. 15, 2018.
In my next post, I cover year-end tax planning for businesses, including traders with trader tax status: How Businesses Can Save Taxes For 2017 Before Year-End.
If you have any questions on tax planning, contact your tax advisor for help. I’m encouraging our clients to sign up for our tax compliance service soon to begin year-end tax planning before Dec. 5, 2017.
Darren Neuschwander CPA contributed to this blog post.
Attend our Webinar or watch the recording after: How To Save Taxes For 2017 Before Year-End.