Will it be Jan. 1, 1995? Or Oct. 13, 1995? Or Jan. 1, 1996? For months, the effective date gf the capital-gains tax cut proposed by Congress has been a big guessing game. If you're in the midst of a huge business transaction, reducing the top rate from 28% to 19.8% would cut your federal tax on a $1 million profit by $82,000--as long as the deal is completed after the effective date. Add another several thousand dollars for state tax savings. But wait too long, and your buyer might just walk.
Over the next few weeks, as you flit between parties and rush to do all your holiday shopping, another end-of-year ritual should take some of your time: tax planning. In 1995, the traditional strategies of accelerating deductions into the current year and deferring income into the new year still hold. But thanks to the sizzling stock market rally and the pending federal capital gains rate cut, the sharpest focus is on capital gains.
BIG-TICKET BREAKS. The timing of that rate change is most important if you're selling real estate, a family business, or any other big-ticket item. You can keep your deal going as a straight sale in the hopes that the reduction is retroactive as originally promised. Or you can set it up as an installment-sale arrangement in which the deal gets done but the money isn't collected--and therefore taxed--until 1996 and beyond. That can be risky, though, because it makes you a creditor, a position in which you may not feel comfortable.
But if you have mostly appreciated stocks, mutual funds, and other liquid investments, there'sreally nothingto sweat, even though the effective date is still uncertain. Why rush to sell in 1995 when you could put off gains until 1996--witha lower rate to boot? Indeed, if you're a middle-class taxpayer in the 31% regular tax bracket, then your capital-gains rate willbejust 15.5%--if and when the cut is enacted. Plus, the tax isn't due for another 12 months. "My general advice is that you should plan for the law as it is today," says Clint Stretch, director of tax legislative affairs at Deloitte & Touche.
If you just have to unload that stock right now, however, you could sell it "short against the box," says Tom Ochsenschlager, a partner with accountants Grant Thornton in Washington. Under such a strategy, you lock in the current price by selling borrowed shares. For tax purposes, the sale doesn't occur until next year, when you deliver your shares to the lender. "That's what the big boys are doing," says Janice Johnson, director of financial services for Coopers & Lybrand in New York. But there's an added cost: interest for the time that you have borrowed the shares.
Chances are you've already got a bunch of capital gains to report in 1995. First, you have your actual stock sales during the year. Some will generate huge gains--usually the ones held the longest have the lowest cost basis. Second, don't forget capital gains distributions from your mutual funds (the fund companies have probably notified you by now). Plus, if you have redeemed any mutual-fund shares or switched between funds during the year, then you probably have more gains. Compare your selling price on these shares with your average cost basis--your capital gain is the difference. Make sure to include any reinvested dividends and past distributions in your average cost. That would increase your basis and lower your capital gains.
Your yearend tax-planning time should be spent scouring your portfolio for actual and potential capital losses to offset whatever capital gains you may have already realized during the year. Did any stocks actually go down in 1995? You bet. For instance, Kmart fell to 8 from 20 during the last two years. Check your portfolio for other dogs. "You don't want to sell just to get a tax loss," says Suzanne McGrath, a managing director at Piper Jaffray. "But if you're tired of the stock, or you think it has lost its potential, sell it now and get the government to share a third of the loss. You can always buy it back in 31 days" without incurring the wash-sale rule that would otherwise nullify your initial sale's tax loss.
LEFTOVER LOSSES. Capital losses can be used to offset capital gains, and any excess losses can be used dollar for dollar to offset $3,000 in regular income. Any leftover losses beyond that can be carried over to next year. Consider taking some capital losses now because the market might not be so hot next year--and you might not have gains to match against losses. In addition, under the tax proposal, it would take $2 of long-term capital loss to offset every $1 of ordinary income starting in 1996.
It also might not be a bad idea to walk through Schedule D of Form 1040 in December, listing your actual and proposed capital transactions and netting them against one another. The schedule further organizes gains and losses according to whether they are short- or long-term. A short-term gain--one in which the security is held for less than one year--is taxed at regular rates that max out at 39.6%. A long-term gain is currently taxed at 28%.
Once you determine your yearend capital-gains position together with your other income, make sure that you have paid enough in estimated taxes. That's particularly important in 1995, when you probably have a lot of capital gains. If you have underpaid, you could owe a nondeductible penalty of 9% on the shortfall.
There are two basic ways to avoid the penalty. The first is to pay 90% of your actual 1995 tax due. That's tricky, because the year isn't over yet so you don't know your target. The second way is to make sure you have paid 100% of your 1994 tax due--or 110% of your 1994 tax due if your adjusted gross income in 1994 was above $150,000.
You can accomplish this through a combination of quarterly estimated payments and employer withholding on your paycheck. One problem: If you've underpaid because of capital gains early in the year--and you haven't been making quarterly estimated payments--then there's only one way to catch up: Boost your withholding in December. The Internal Revenue Service regards lump-sum withholdings as if they were distributed smoothly throughout the year. "We see situations where people wind up with a zero net check on Dec. 31 because they want everything to go into tax payments," says Jim Vonachen, a tax partner in Denver with Clifton, Gunderson.
Even though you have satisfied the estimated tax-payment rules without a penalty, you still might have a huge tax bill in April on your capital gains. In that case, revert to some of the classic ways to reduce taxes that apply to everyone. If you haven't already done so, make sure you fund your 401(k) plan to the maximum amount. These contributions reduce gross income dollar for dollar. If you or your spouse is self-employed, plan on funding your individual retirement account or Keogh plan to the highest limit.
Next, pay your state income taxes and property taxes in December to get the write-off in 1995. Give some of your appreciated stock to charity and take a deduction for current market value without having to realize a gain. It's better to bunch medical expenses into one tax year instead of spreading them over two because you can only deduct the excess over 7.5% of adjusted gross income. Then take a look at Schedule A of Form 1040 to see if there are other itemized deductions that you can accelerate into 1995. And if you're planning to get married, could it possibly wait until January? Two single people filing separate returns pay less in combined tax than a married couple pays on a joint return.
Unfortunately, the pending legislation doesn't fix the marriage penalty, but it has some other goodies in it besides capital-gains tax cuts. Most, such as expanded IRAs, the new $500-per-child tax credit, and reduced estate taxes, won't factor into your 1995 yearend tax plan. But if you make too much money next year--right now, the income limit isn't available--you might not qualify for the child-care credit.
With so much uncertainty, the best thing you can do over the next few weeks may be the same actions as in most other years: Delay income into 1996 while moving up write-offs into 1995. And ignore the bickering between the President and Congress.
Ten Ways to Reduce Your 1995 Taxes
-- Take capital losses in 1995 first to offset capital gains and then up to $3,000 in regular income.
-- Sell appreciated stock short against the box. That means you lock in the current price by selling borrowed shares, but put off the gain until next year when you repay the lender.
-- Pay your state income taxes and property taxes in December so you can get the write-off this year.
-- Make charitable gifts of appreciated stock or real estate in 1995 and take a deduction for the current market value without having to realize the gains.
-- Fund your 401(k) plan to the maximum limit to reduce your gross income dollar for dollar.
-- Make the maximum contribution to your tax-deductible individual retirement account or Keogh if you are eligible.
-- Accelerate medical and dental expenses into 1995 so you can exceed the deduction threshold of 7.5% of adjusted gross income.
-- Shift other Schedule A itemized deductions into 1995, such as unreimbursed job-related expenses.
-- Defer consulting income or large bonuses into 1996.
-- If you've waited this long to tie the knot, hold off a bit longer, until after Dec. 31, so you are not subject to the "marriage penalty."