Tax Guide: Individual Tax Planning
Universal Advisor, 2007 Issue No. 3

Edward Teach, better known as Blackbeard, is perhaps the most familiar pirate to most of us today. His legendary status was built from his tendency for wild fighting and antics such as lighting his large black beard on fire while attacking unfortunate merchant ships. Legend has it that Blackbeard began the tradition of burying treasure to protect it from his enemies as much as hiding it from his crew — an early example of deferred compensation!

Deferring Income

Taxpayers may wish to defer income to a future year to delay tax payments or to permanently decrease their tax payments if they anticipate being taxed in lower tax brackets in the future. Strategies to defer income include:

• Requesting that bonuses or salaries be paid after year end. (If the employee has a choice, any election to postpone the payment must generally be made before the beginning of the earnings period as the result of the new Section 409A rules for deferred compensation arrangements.)
• Requesting stock options or deferred compensation arrangements in lieu of salary. (All of the new Section 409A requirements for deferred compensation plans must be satisfied to avoid current taxation of the benefit as well as penalties and interest charges.)
• Using installment sale reporting to delay the gain on sale of property until future years.
• Electing to receive a pension plan benefit as an annuity rather than as a lump-sum distribution.
• Delaying the sale of assets with gains until the following year.
• Adjusting the taxpayer’s investment strategy to focus on long-term investment rather than current income.

Maximizing Deductions

Taxpayers may also accelerate deductions such as mortgage interest, state income and property taxes, charitable contributions, and medical costs. When maximizing deductions taxpayers need to be aware of limitations on certain deductions (medical, investment interest, and miscellaneous deductions). Taxpayers should also consider the impact of the alternative minimum tax, which does not allow the deduction of certain deductions (state income and property taxes). A taxable income projection in November or December will help taxpayers in identifying opportunities to accelerate (or defer) expenses for the best tax result.

Donations of Property

Individuals generally receive a deduction for the fair market value of property donated to charitable organizations. Deductions for autos and boats are generally limited to the proceeds received by the charity when they are sold. If the auto or boat is retained and used by the charity, the taxpayer may be able to deduct the fair market value. Donations of clothing and household items may be deducted only if the items are in good condition. For record-keeping purposes, you should prepare a detailed list of the donated items and their value to support your tax deduction.

Individuals should also consider donating appreciated stock that has been held more than one year. A deduction equal to the stock’s fair market value may be claimed, and no capital gain is recognized. If the taxpayer wishes to maintain the investment position in an appreciated stock, they should still donate the stock but repurchase additional shares in the stock with cash that would have otherwise been used for the donation. The donation followed by the repurchase increases the basis in the stock without incurring capital gains tax.

Alternatively, stock that has declined in value should not be contributed since it is more tax-efficient to sell the stock to receive a tax benefit from the loss. The proceeds from the sale can then be contributed to the charitable organization.

Remember that out-of-pocket cash donations may no longer be deducted unless you obtain a receipt from the charity.

Interest Expense Maximization

Taxpayers with nondeductible personal interest should consider the following strategies to convert nondeductible interest into a deductible expense:

• Mortgage Interest — Interest incurred to purchase or improve your home or a second residence (which can be a boat or motor home that has bathroom, cooking, and sleeping amenities) is generally deductible. The loans must be secured by a mortgage on the residence to qualify.
• Home Equity Interest — Taxpayers with equity in their homes should consider home equity loans to pay off personal debt or to fund purchases associated with personal debt (autos or furniture, for example). Interest on up to $100,000 of home equity indebtedness is deductible regardless of how the proceeds are used.
• Margin Interest — Taxpayers with equity in investments should consider margin loans. Proceeds from margin loans must be traced to the purchase of investment property to be deductible as investment interest. Original investments can then be liquidated to pay off personal debt. Proper care should be taken when identifying assets to liquidate, as the sale of investments may result in taxable gains. Investment interest expense deductibility is limited to the amount of investment income (not including qualified dividends or capital gains unless an election is made).
• Business Interest — Interest is deductible against business income when the proceeds are traceable to business expenses. Taxpayers that own interest in a flow-through business entity (such as a partnership, limited liability company, or S Corporation) may have that entity borrow money to pay business expenses and facilitate cash distributions to the taxpayer that may not have been possible without the borrowing. The distributions can be used to pay down personal debt.
• Business Acquisition Interest — Interest on amounts borrowed to fund an investment in a flow-through entity is deductible against the entity’s business income (subject to the passive loss and “at-risk” deduction limitations).

Teacher’s Expenses

A deduction for work-related expenses can normally only be taken to the extent that employee expenses and other miscellaneous deductions exceed 2 percent of adjusted gross income. For 2007, elementary and secondary teachers are allowed to deduct up to $250 for unreimbursed expenses for classroom materials. Eligible expenses include books, supplies, computer hardware or software, and other materials used in the classroom. The deduction is scheduled to expire after 2007.

Education Expenses

A summary of tax-advantaged deductions, credits, and other incentives that are targeted at reducing the cost of post-secondary education is provided below:

• Hope Credit — A credit of up to $1,650 is available for tuition and related expenses (based on 100 percent of the first $1,100 and 50 percent of the second $1,100) incurred during the first two years of a postsecondary program in which a degree is sought.
• Lifetime Learning Credit — A credit of up to $2,000 is available for tuition and related expenses (based on 20 percent of expenses up to $10,000) for any postsecondary classes.
• Student Interest Expense — Interest expense on qualified student loans is deductible in computing adjusted gross income (not as an itemized deduction).
• Section 529 Plans — “Section 529” Plans are offered by most states to fund future higher education costs. Earnings on investments within the plans are tax-free, and donations to such plans are eligible for favorable gift tax treatment.

The Hope and Lifetime Learning credits are phased out for taxpayers with adjusted gross incomes between $94,000 and $114,000 for married couples ($47,000 and $57,000 for single taxpayers). Dependents may claim the benefit on their return if the parents do not claim an exemption for the child.

Vacation Homes

Interest expense and property taxes associated with a second home are deductible as itemized deductions. A second home may include a boat or motor home if the boat or motor home has bathroom, cooking, and sleeping amenities. The loan must be collateralized with the second home to be deductible as mortgage interest.

If a second home is rented during the year, but for less than 14 days, the rental income is not required to be reported.

Child Care Expenses

Taxpayers paying child care expenses may be eligible for a child care credit of up to $2,100. Eligible expenses are limited to the greater of $3,000 per child (or $6,000 for multiple children) and the earned income of the spouse with the lowest earned income. The credit is based on a declining percentage that starts at 35 percent for adjusted gross incomes lower than $15,000 and reaches 20 percent for taxpayers with adjusted gross incomes greater than $43,000.