As 2016 draws to a close, add year-end tax planning to your “to-do” list. Many overlook end-of-the year tax planning and the money savings benefits it can provide. There is very little that can be done after December 31st to reduce taxes, so it is important to look at your tax situation before the end of the year.
Know your tax rate, and plan income and expenditures to best utilize the lower brackets. This can mean accelerating deductions such as charitable contributions, paying your fourth quarter state estimated tax payment in December and making your January mortgage payment in December. Alternative minimum tax (AMT) should be considered with any strategy, especially with accelerating state tax payments and/or real estate taxes, neither of which are allowed for AMT purposes.
In addition to the regular tax and alternative minimum tax systems, the Net Investment Income Tax (NIIT) is another consideration. The NIIT is an additional 3.8% tax on the lesser of net investment income (such as interest, dividends, capital gains and pass-through income that you do not materially participate in the business) or the excess of modified adjusted income over a threshold dependent on your filing stats ($250,000 for joint filers; $125,000 for married filing separate filers and $200,000 for all others). Equalizing income between years and avoiding large spikes in a given year can be an effective strategy to keep income under the threshold amounts for the imposition of the NIIT.
Large spikes between years in income can also cause higher rates to be imposed on capital gains. The tax rate on long-term capital gains is dependent upon the individual’s income tax rate. Capital gains are taxed at 0% for those in the 10 and 15% marginal income tax brackets, 15% for the 25-35% marginal income tax brackets, and 20% for those in the 39.6% highest marginal income tax bracket. A large capital gain could result in as much as 23.8% federal tax to be paid on the gain subject to NIIT. Therefore, spreading capital gains between years can be an effective way to decrease overall tax. Also, if your portfolio contains loss stocks, selling those positions before year-end will help offset other large capital gains and decrease overall tax liability. If losses exceed gains, up to $3,000 of capital losses can offset ordinary income in a given year.
In years prior to 2016, much year-end planning revolved around the nuances of expiring tax provisions. For 2016 however, the Protecting Americans from Tax Hikes Act (PATH Act) passed in December 2015, provided many multi-year tax incentives – some temporary and some permanent extensions. Among the popular permanently extended provisions for businesses and individuals include:
- Increased Section 179 Limits of $500,000 with phase-outs starting at $2M of qualifying purchases, including off-the-shelf software and air conditioning and heating units eligible for Section 179 immediate expensing
- 15-year straight-line cost recovery for qualified leasehold improvements; qualified retail improvement property; and qualified restaurant property
- Charitable contributions of up to $100,000 of IRA proceeds for those over 70 1/2 annually
- State and local sales tax deduction in lieu of state income tax deduction
- American Opportunity Tax Credit (AOTC) up to $2500 annually for the first four years of post-secondary education for a maximum of $10,000 credit over a four-year period.
- Teacher classroom expense deductions – up to $250 annually, now indexed for inflation
Some temporary extensions include:
- Bonus depreciation (50% for tax years 2016 and 2017; reduced to 40% for 2018 and 30% for 2019; eliminated thereafter).
- Tuition and related expense above the line deduction of up to $4,000 for 2016
- Principal mortgage debt forgiveness relief up to $2M is excluded from income through 2016
- Deduction for mortgage insurance premiums through 2016
- Residential energy credit for up to $500 maximum lifetime credit
- Section 179D deduction for energy efficient commercial building improvement/construction
With the extended depreciation provisions, those with businesses have many options related to the amounts of deductions to take in a given year with equipment purchases. The Section 179 deduction allows you to expense (i.e. currently deduct) up to $500,000 of otherwise depreciable business equipment in the current year. Subject to business income limits, the maximum deduction of$500,000 is limited if total eligible property purchased is under $2,010,000. If purchases are over the investment threshold, the Section 179 deduction is reduced dollar for dollar for amounts in excess of the $2,010,000 phase out limit. In additional to tangible business property, qualified real property (no longer subject to a $250,000 limit), off-the-shelf software and air conditioning and heating units are all eligible for Section 179 expensing.
Bonus depreciation is also an option for accelerated deductions in the year eligible property is acquired – if you do not want to take bonus depreciation, an election out is necessary on your annual tax return. Unlike Section 179 deductions, bonus depreciation is not limited by business income. This means that net operating losses (NOL) can be generated from additional bonus depreciation deductions in a given year. NOLs can generally be taken against taxable income going back two tax years. Any excess NOL after the carryback is carried forward to offset future taxable income for up to 20 years.
Besides depreciation options, the Tangible Property Regulations, effective for tax years starting in 2014, provided for a de minimis safe harbor expensing election for materials and supplies and other property produced/acquired subject to a per-item dollar limit based on the taxpayer’s capitalization policy. Starting in 2016, the limit for taxpayers without audited financial statements is $2,500 per item. Those with applicable financial statements can expense up to $5,000 pursuant to a written capitalization policy.
Be mindful of proposed tax reform proposals and what “could” happen to tax rates and deductions. President-elect Trump wants to lower taxes rates and decrease deductions. Given this, there may be opportunities to defer income to 2017 and accelerate deductions into 2016. For example, to accelerate deductions you could increase charitable contributions before year-end, pay property taxes and/or state and local income taxes early (but watch out for the AMT discussed above), and pay upcoming business expenses such as rent in December. To defer income to 2017, you could request that if you are getting a company bonus to have it paid in January rather than December, if you have a cash-based business you could ask that your customers pay you In January rather than December, or if you turned 70 ½ in 2016, you could defer the first year Required Minimum Distribution from your IRA or profit sharing plan until 2017.
If you want an idea of how this might affect you, we can prepare a personalized analysis. We have a worksheet you can use to help project your income and deductions for 2016 and 2017. If you would like to receive a copy of our worksheet, please call us at (816) 561-1400 or e-mail us at firstname.lastname@example.org.