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Taxes in December - The Year-End Strategies

For most investors, income tax is not a "hot topic" during the Holiday season. This is a BIG mistake! December is actually the most important month to reduce your income tax for this year.

How come? Before I explain, I need to review four basic principles.

Rule A - "Calendar rules"

Your 2007 tax return will only reflect events that happened between January 1st and December 31st of 2007. Whatever happens in January 2008 will not matter. Examples: rent check received on January 1st of 2008 does not count. But neither does school district or HOA bill that you plan to pay next January - even if it is a payment "for 2007." In other words, if you need to reduce your 2007 income taxes, do it in December!

Rule B - "More is not always better"

A good illustration for this idea is Holiday over-eating. Another example is chasing business write-offs. Before you spend all this money in December to maximize 2007 deductions, make sure that you will actually benefit from extra deductions. This is not automatically the case! And even if it is, sometimes you may still be better off by waiting. Also keep in mind that, as you income increases, many of your tax benefits disappear due to various limits and phase-outs.

Rule C - "Taxes are only the tail"

Never let taxes "wag the dog." While I will be the first to exploit any tax loophole, I will also be the first to point out if you make a stupid business decision just to "save on taxes." Getting into a lousy deal is far worse than paying taxes on a great deal.

Rule D - "Change is the only constant"

Especially when we deal with the Government. They keep changing the laws, and 2007 was no exception. Make sure you are aware of all the new tax laws. Some of the recent changes directly affect investors.

Now, let's talk business. What should you do today? If I were a "staff writer" or a "syndicated columnist" for a national consumer magazine, I would've given you a straight answer. Unfortunately, being a responsible advisor, I cannot do it. Why? Because every investor has a different tax situation. The exact same move can be very smart for Jenny, but prove a total disaster for Jimmy.

The good news: while I cannot tell you the correct answers (because - you guessed it - they depend), I certainly can tell you the correct questions to discuss in December. By the way, when I say "discuss", I do not refer to your equally confused business partner. I hope that you will talk to somebody who understands taxes.

Paying property taxes

This can be a "biggie." If you pay your 2007 assessments in December, your payments will count for 2007. If you wait until January, the money will not count until a year later. For most landlords, it's better to pre-pay property taxes in December. However, if we are talking about your own residence, the answer becomes more difficult.

Paying other business-related bills

Remember Rule A - any bill you pay after December 31st will not help your 2007 taxes. This is true for any kind of payments - utility bills, vendor and contractor invoices, insurance, and even RICH renewal fee. On the other hand, do not forget Rule B. Most importantly, check whether you generated enough taxable income in 2007 to need more deductible "offsets." Keep in mind that certain expenses, particularly those related to rehabbing, may not be deductible until the property is rented or sold. In that case, paying the bills in December will not reduce your taxes.

Paying personal bills

Rule B is essential here. Increasing your personal "deductible" expenses may or may not result in tax savings. For instance, charitable donations are only deductible when you "itemize." Unfortunately, a lot of people cannot itemize: among them are renters and high-income folks. When you want to deduct expenses such as medical bills and job search costs, you will discover additional limits that may kill all the expected benefits. The same is true for various other tax breaks, such as the credits for higher education and child care. Bottom line: your mileage may vary.

Buying "big ticket" items for business

Yes, I am talking about autos too. There is no question that a big portion of (if not all) the cost can potentially be written off your taxes. There is, however, a question whether it can really be written off. For starters, make sure you have enough taxable income to offset.

Closing on a new property

Before I say another word, let me refer you back to Rule C. Never ever make a business decision strictly based on tax considerations. Taxes should, of course, be considered - but only after business fundamentals are taken care of. That said, I should also mention that accelerating closing date into December for tax deductions does not always work. The starting date for all rental-related deductions (including depreciation!) is not the closing date, like many investors think. It is the date when the property is "placed into business use." Translation from the IRS-speak: if you bought a pre-foreclosure dump in December and will need another 2 months to bring this "dwelling" back into rentable condition - you will still have almost nothing to write off in 2007.

Selling a property

While Rule C is 100% valid, this is one case where tax considerations should be given more weight. The reason: the moment you closed the sale, you have to declare the income - unless, of course, you use IRAs or 1031 exchanges. With the income come capital gain taxes and depreciation recapture. If you are classified as a "dealer", it's even worse - you'll be liable for much higher "regular" income tax plus possibly "self-employment" tax (which is, by the way, another frequent sign of poor tax planning). Further, "dealers" may be stuck with full taxes even when owner financing. Therefore, everything else being equal, delaying a sale into January may be wise. Always? By now, you should anticipate my answer: of course, not! At a minimum, you should compare your 2007 income with your projected 2008 income. And then refer to Rule C one more time.

Selling traditional investments

In today's world, investments are typically sold at a loss. Deduction for capital loss is limited to $3,000 per year. From tax point of view, the best time to take a loss is in the same year when you need to "offset" some capital gain - such as from selling a property. Therefore, if you already sold a rental this year, and you are thinking about dumping a losing mutual fund - consider selling it in December rather than in January. (At this point, if you expect me to mention Rule C again - you are right! Thanks for paying attention!)

Contributing to a retirement fund

Surprisingly, this may not be urgent. In most cases (but not all), you can still put money in after New Year. One notable exception is your employer's 401k plan. For that, you need to talk to your payroll department today - tomorrow can be too late.

Converting to a Roth IRA

With the growing popularity of self-directed IRAs, many investors choose to convert their retirement savings into Roths. Unlike most other business decisions, this one is primarily dictated by taxes. And it is far from easy. If you still need another reason to hire a tax advisor - deciding on Roth conversion is not a "kitchen table" project.

Defeating the "estimated tax penalty"

Everyone who does not receive "regular" paychecks with automatically withheld taxes must pay "estimated taxes" four times a year. Very few people actually do pay these quarterly taxes. Many of those who don't pre-pay are rewarded with the IRS penalties. If you (or your spouse) have a traditional "W-2" employer, you may be able to eliminate the penalty by making a larger-than-usual withholding from your December paychecks. Again, acting on this is extremely urgent: payroll departments are not known for their speed.

Any other major personal and financial decision

There is a tax aspect to almost anything: getting married, moving, changing jobs, starting businesses, taking classes, not to mention buying and selling! As Rule A says, tomorrow can be too late. The time to reduce taxes is now.

Accountants (at least the honest ones) cannot "rewrite the history" after the fact. You get ahead by planning ahead. As you know, the most successful Real Estate investors work smarter, not harder. Sitting down with your tax advisor in December is smart. Very smart.