United States: Year-End Tax Guide For 2011 - Part 1

Planning makes perfect

Success isn't easy and it certainly isn't free. As your income increases, so does your tax burden. For successful individuals, tax rules become complicated quickly. Whether you're managing your individual tax rates, the rates on your investments, the taxes on your privately held or pass-through business, or the income of executives and shareholders at your company, managing a tax burden has never been more difficult.

That's where tax planning comes in. With so much at stake, don't bury your head in the sand and wait for a big surprise on April 15. There are now more ways than ever to reduce your tax liability, but all of them take planning. Both the tax code and your economic situation are continually evolving. You need to think farther ahead, employ clearer strategies and use every tax break you can. Don't act first and think about taxes later. A little foresight can go a long way.

To help answer as many of your questions as possible, this Grant Thornton guide discusses recent tax law changes and provides an overview of strategies to deal with your situation.

The guide includes information on the following:

• Tax law changes: We've dedicated a section to cover the most important tax changes for you and your business. Plus, look for our highlighted Tax law change alerts throughout each section of the guide.
• Action opportunities: We've highlighted our top 20 Action opportunities. These are strategies you can put into play right now.
• Business solutions: We know you don't look at your tax situation as an individual taxpayer alone, but also as a shareholder, owner, employee or executive. We've added sections throughout the guide that focus on tax opportunities from the Business perspective.

As always, our guide will help show you how to tax-efficiently invest for education and retirement and transfer your wealth to loved ones in the most tax-efficient manner possible. However, this guide simply can't cover all possible strategies, and there may be legislative tax changes after this guide goes to print. Our Washington National Tax Office tracks tax legislation as it moves through Congress. Be sure to contact us to find out what strategies will work best for you and what is happening on the legislative front.

Tax law changes: What's new this year?

Congress walked back from the edge of a tax precipice in 2010 and agreed to extend the 2001 and 2003 tax cuts for two years. The scheduled expiration of these tax cuts at the end of 2010 had threatened to increase taxes on virtually every taxpayer in 2011. The compromise legislation passed last December extended the individual income tax cuts in their entirety through the end of 2012. This massive December tax bill also extended alternative minimum tax (AMT) relief and a number of popular temporary tax provisions known as "extenders."

Yet lawmakers weren't content with a simple extension of expiring tax laws — they also made some key changes. The December tax cut package made dramatic changes to transfer tax rules and offered taxpayers new tax incentives, such as 100 percent bonus depreciation and an employee payroll tax holiday. Earlier legislation, the Small Business Jobs Act of 2010, also included many tax incentives that could benefit businesses this year.

So far, Congress has been quieter in 2011. Lawmakers did repeal an onerous expansion of Form 1099 reporting rules early in the year, but as this guide went to print, had not yet enacted any major tax bills. Of course, 2011 is not over. Congress could still consider revenue increases or tax reform as part of a deficit reduction effort, and the president was pushing for a job creation tax package as this guide went to print. Check with Grant Thornton's Washington National Tax Office for the latest information.

2001 and 2003 individual income tax cuts

The biggest development by far was the extension of the 2001 and 2003 tax cuts. These tax cuts include rate cuts across the individual income tax brackets, plus scores of other tax benefits:

• The top rate of 15 percent on dividends and capital gains (on most sales and exchanges)
• The zero rate for capital gains and dividends in the bottom Brackets
• The top rate on ordinary income of 35 percent
• The repeal of the phaseouts of the personal exemption and itemized deductions
• Marriage penalty relief
• $1,000 child tax credit and its refundability
• The increased dependent care credit
• $10,000 adoption credit and $10,000 income exclusion for employer assistance
• $2,000 contribution limit for Coverdell education savings Accounts
• The above-the-line deduction for student loan interest
• The exclusion for employer-provided education assistance

When originally enacted in 2001 and 2003, these tax cuts were given sunsets for a variety of policy, political and budget reasons. The sunset dates are now extended through 2012. Without legislation, the tax cuts will now expire in 2013 — at the same time new Medicare taxes enacted in the health care reform legislation are scheduled to take effect. These Medicare taxes will impose an additional 0.9 percent tax on earned income above $200,000 for singles and $250,000 for joint filers, and a 3.8 percent tax on investment income above those thresholds. We're likely to see another legislative battle over the tax cuts in 2012. See Chart 1 for what is scheduled to happen to tax rates under current law.

Extenders and AMT

The popular tax provisions known as "extenders" include over 30 tax provisions that have traditionally been renewed by Congress on a temporary basis. The provisions expired again at the beginning of 2010, but most were retroactively reinstated for all of 2010 and through 2011. They are now scheduled to expire at the end of 2011.

Key individual tax extenders include the following:

• Election to deduct state and local sales taxes
• Above-the-line tuition deduction
• $250 above-the-line teacher expenses deduction
• Standard deduction for property taxes for non-itemizers
• Tax-free charitable distributions from individual retirement Plans
• Withholding exception for interest-related dividends of regulated investment companies (RICs)
• Estate tax look-through for RIC stock held by nonresidents Lawmakers also completed an AMT "patch" for 2010 and 2011. The AMT relief increases the exemptions modestly over 2009 levels (see Chart 2).

Estate and gift taxes

No area of the tax code has shifted more dramatically over the last few years than transfer taxes. Under the 2001 and 2003 tax cuts, the estate tax and generation-skipping transfer (GST) tax were temporarily repealed for 2010. This relief was scheduled to be short-lived. Like the individual income tax cuts, all transfer tax relief was scheduled to expire beginning in 2011, with the rules reverting to those in place in 2000.

Instead, the compromise tax bill enacted in late 2010 puts in place a new transfer tax regime for 2010, 2011 and 2012.

In general, the legislation:

• reunifies the gift and estate tax;
• increases the gift, estate and GST tax exemption amounts to $5 million;
• provides for a top gift, estate and GST tax rate of 35 percent; and
• allows portability between spouses of their estate tax exemption amounts.

Although the estate tax and GST tax were nominally reinstated for 2010 under the legislation, the GST tax rate in 2010 is zero and estates of 2010 decedents can elect out of the estate tax if desired. In 2013, transfer taxes are once again scheduled to revert to the rules in place in 2000 — though legislative intervention is likely. See Chart 3 for the shifting transfer tax rules. The drastic swings in transfer tax rules and rates present challenges and opportunities for estate planning. You will likely need to review your estate plan to make sure it still makes sense given the changes in tax law (and your own circumstances). See Chapter 10 for a full discussion of estate planning issues.

Payroll tax holiday

The December tax cut compromise reduced the employee share of Social Security taxes under the Federal Insurance Contributions Act (FICA) from 6.2 percent to 4.2 percent in 2011. Social Security tax is imposed on wages up to an annually adjusted cap that reached $106,800 in 2011, meaning taxpayers at or above the wage cap received a $2,136 tax cut from this provision.

The reduction in FICA taxes also applies to the selfemployment tax, reducing the combined rate from 15.3 percent to 13.3 percent for self-employment income earned in 2011. Consistent with the concept that this reduction comes from the employee's share of employment taxes, this will not reduce the amount of self-employment taxes allowed as an above-the-line income tax deduction, which will continue to be calculated as one-half of 15.3 percent of self-employment income.

New tax opportunities for business

It was another stormy economic year for many businesses, but on the tax front, it was mostly sunshine. Lawmakers again looked to the tax code to try and add fuel to the slow-burning economic recovery. The legislative efforts included not just extensions of current benefits, but many new tax provisions.

Business extenders

Congress last year gave businesses a two-year extension, through 2011, of the popular business tax provisions known as "extenders." These provisions are now scheduled to expire at the end of the year. These "extender" provisions include the following:

• Research credit
• 15-year cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements
• New markets tax credit
• Subpart F exception for active financing income
• Look-through treatment for payments between related controlled foreign corporations under foreign personal holding company income rules

Form 1099 reporting

Lawmakers gave businesses a break this year by repealing a drastic expansion of information reporting that would have forced businesses to issue millions of additional Form 1099 information reports beginning in 2012.

Trades and businesses are generally required to report (typically on a Form 1099) payments over $600 per year to a vendor for services, and the regulations generally exempt payments made to a corporation. These rules will now remain intact, as lawmakers repealed an expansion that would have also required reporting on payments made for property, payments made to corporations and payments in connection with earning rental income. However, the legislation did not repeal new, higher penalties for information-reporting failures.

Organizing as a QSB

Qualified small business (QSB) stock has become an even more attractive investment. Legislation enacted in September 2010 offers a generous new tax planning opportunity to enterprises that meet qualified small business (QSB) requirements. QSB stock purchased after Sept. 27, 2010, and through the end of 2011, will never be subject to tax on the gains if the stock is held at least five years and all other requirements are met.

QSB stock must be original issue stock in a C corporation with no more than $50 million in assets (and meet several other tests). Investments in QSB stock also come with several other tax benefits and restrictions. See Chapter 4 for a discussion from an individual investor's perspective and Chapter 6 for a QSB tax planning opportunity from the business perspective.

Fully expensing business investments

Legislation enacted in 2010 doubles a bonus depreciation tax benefit for property placed in service after Sept. 8, 2010, and before the end of 2011 — meaning taxpayers can expense the cost of eligible equipment placed in service before the end of the year. To qualify for bonus depreciation, property must generally have a useful life of 20 years or less under the modified accelerated cost recovery system (MACRS). The amount of business investment that can be expensed under Section 179 was also increased to $500,000 for tax years beginning in 2010 and 2011 (with the phaseout increasing to $2 million). See Chapter 6 for a full discussion of these tax benefits.

Getting started: Individual tax rates and rules

Whether you're an executive, partner or owner, your business income eventually gets taxed at the individual level. That's where tax planning needs to start.

Different types of individual income are taxed in different ways, and you want to start by looking at ordinary income. Ordinary income includes things like salary and bonuses, selfemployment and business income, interest, retirement plan distributions and more.

Ordinary income is taxed at different rates depending on how much you earn, with rates increasing as income goes up. These tax brackets, along with many other tax preferences, are adjusted for inflation annually. Persistent low inflation provided another year of relatively shallow adjustments in 2011. Check Chart 4 for a full breakdown of the tax brackets for ordinary income in 2011 and Chart 5 for the 2011 adjustments to a number of other tax items.

The top tax rate that applies to you is usually considered your marginal tax rate. It's the rate you will pay on an additional dollar of income. But unfortunately, the tax brackets for ordinary income don't tell the whole story. Your effective marginal rate may be very different from the stated rate in your tax bracket. Hidden taxes that kick in at higher income levels when you reach the top tax brackets can drive your marginal tax rate higher. These hidden taxes largely include phaseouts of many tax benefits at high income levels.

Fortunately, two of the most costly phaseouts are currently repealed. The personal exemption phaseout (PEP) and "Pease" phaseout of itemized deductions will not affect your 2011 return, and you will be able to enjoy these tax preferences in full this year. However, they are scheduled to return in 2013. You want to avoid early withdrawals from tax-advantaged retirement plans, such as 401(k) accounts and IRAs. Distributions from these plans are treated as ordinary income, and you'll pay an extra 10 percent penalty on any premature withdrawals (generally, withdrawals prior to reaching age 59½).

This can raise your effective federal tax rate to as high as 45 percent on the income. Generally, distributions must be made after reaching the age of 70½ to avoid penalties.

Action opportunity: Maximize above-the-line deductions

Nearly all of the tax benefits that phase out at high income levels are tied to adjusted gross income (AGI). The list includes personal exemptions and itemized deductions (except in 2010–12), education incentives, charitable giving deductions, the alternative minimum tax (AMT) exemption, the ability to contribute to some retirement accounts and the ability to claim real estate loss deductions.

These AGI-based phaseouts are one of the reasons above-the-line deductions are so valuable. They are not subject to the AGI floors that hamper many itemized deductions. They even reduce AGI, which provides a number of tax benefits. Most other deductions and credits only reduce taxable income or tax, itself, without affecting AGI.

Above-the-line deductions that reduce AGI could increase your chances of enjoying other tax preferences. Common above-the-line deductions include traditional Individual Retirement Account (IRA) and Health Savings Account (HSA) contributions, moving expenses, self-employed health insurance costs and alimony payments. Remember that beginning this year, HSA's can no longer be used to pay for over-the-counter drugs unless you have a prescription, and penalties for improper expenditures have increased from 10 percent to 20 percent.

Save on taxes by contributing as much as possible to retirement vehicles that provide above-the-line deductions, such as IRAs and SEP IRAs. Don't skimp on HSA contributions either. When possible, give the maximum amount allowed. Even if you withdraw the full amount that was contributed to pay medical expenses, at least you have effectively moved those medical expenses "above the line." And don't forget that if you're self-employed, the cost of the high deductible health plan tied to your HSA is also an above-the-line deduction.

Tax law change alert: Strict new rules for medical spending in 2011

The health care reform bill enacted in 2010 made many changes to health care-related tax rules that will be phased in over the next several years. Beginning in 2011, you can no longer use an HSA, flexible spending arrangement (FSA) or health reimbursement account (HRA) to pay for over-the counter dugs unless you have a prescription. Employers are also now operating under stricter rules to prevent improper HSA expenditures, and your penalty for misuse has increased from 10 percent to 20 percent.

Tax law change alert: Payroll tax holiday for 2011

The Social Security tax rate is typically 6.2 percent for both employees and employers, while the Medicare rate is 1.45 percent. However, lawmakers provided a partial payroll tax holiday in 2011 that reduces the employee Social Security tax rate from 6.2 percent to 4.2 percent. The employer rate is unaffected.

This Social Security rate cut also applies to the self-employment tax, lowering the combined rate from 15.3 percent to 13.3 percent for self-employment income earned in 2011. Consistent with the concept that this reduction comes from the employee's share of employment taxes, this will not reduce the amount of self-employment taxes allowed as an above-the-line income tax deduction, which will continue to be calculated as one-half of 15.3 percent of self-employment income.

Payroll taxes take a bite

Employment taxes, often called "payroll taxes," are imposed against earned income under the Federal Insurance Contributions Act (FICA). Earned income generally comprises wages, salaries, tips and self-employment income. There are two components to employment taxes: Social Security and Medicare. Generally, FICA requires matching contributions from the employer and the employee for both Social Security and Medicare taxes. Social Security taxes are imposed up to a wage cap that is adjusted for inflation each year and is $106,800 in 2011. Medicare taxes are uncapped and apply to all income.

If you are employed and your earned income consists of salaries and bonus, your employer will withhold your share of employment taxes and pay them directly to the government. If you are self-employed, you must pay both the employee and the employer portions of employment tax, though you can take an above-the-line deduction for the employer's portion of the tax.

Payroll taxes are scheduled to become even more costly in 2013. The health care reform bill enacted in 2010 is scheduled to increase the employee share of Medicare tax in 2013 from 1.45 percent to 2.35 percent on any earned income above $200,000 (single) or $250,000 (joint). What's worse, a Medicare tax on unearned income will be imposed for the first time. Income such as interest, dividends and capital gains above the $200,000 and $250,000 thresholds will be subject to an additional 3.8 percent Medicare tax beginning in 2013. This new employment tax on unearned income will not apply to distributions from IRAs and other qualified plans, which may provide an additional incentive to maximize contributions to those plans. See Chart 6 for the employment tax rates under current law.

Paying your tax

Although you don't file your return until after the end of the year, it's important to remember that you must pay tax throughout the year with estimated tax payments or withholding. You will be penalized if you haven't paid enough. If your adjusted gross income (AGI) will be over $150,000 in 2011, you generally can avoid penalties by paying at least 90 percent of your 2011 tax liability or 110 percent of your 2010 liability through withholding and estimated taxes (taxpayers under $150,000 need only pay 100 percent of 2010 liability). If your income is irregular due to bonuses, investments or seasonal income, consider the annualized income installment method. This method allows you to estimate the tax due based on income, gains, losses and deductions through each estimated tax period.

Leveraging deductions and managing tax burden

Why pay tax now when you can pay tomorrow? Deferring tax is a traditional cornerstone of good tax planning. Generally this means you want to accelerate deductions into the current year and defer income into next year. So it's important to review your income and deductible expenses well before Dec. 31. You need to take action before the new year to affect your 2011 return.

But the current legislative scenario presents a unique challenge. Many tax benefits in place right now are scheduled to disappear in 2013. You may be asking yourself if this is the year to reverse your tax strategy and accelerate income and defer deductions.

Remember to be cautious. Legislative action is likely to make a big difference in this area, as will your personal situation. Tax rates were scheduled to go up in 2011, but in the end no one saw a rate increase. Income acceleration can be a powerful strategy, but it should be employed only if you are comfortable with your own political analysis and are prepared to accept the consequences if you are wrong. Because today's low tax rates are available through 2012, you should wait until next year before thinking of accelerating taxes. Even if some of the tax cuts expire in 2013, the time value of money will still make deferral the best strategy in most cases. Whether it eventually makes more sense for you to defer or accelerate your taxes, there are many items with which you may be able to control timing:

Income

• Consulting income
• Other self-employment income
• Real estate sales
• Other property sales
• Retirement plan distributions

Expenses

• State and local income taxes
• Real estate taxes
• Mortgage interest
• Margin interest
• Charitable contributions

Action opportunity: Make up an estimated tax shortfall with increased withholding

If you're in danger of being penalized for not paying enough tax throughout the year, try to make up the shortfall through increased withholding on your salary or bonuses.

Paying the shortfall through an increase in your last quarterly estimated tax payment can still leave you exposed to penalties for underpayments in previous quarters.

But withholding is considered to have been paid ratably throughout the year. So a big bump in withholding on high year-end wages can save you in penalties when a similar increase in an estimated tax payment might not.

Action opportunity: Bunch itemized deductions to get over AGI floors

Bunching deductible expenses into a single year can help you get over AGI floors for itemized deductions. Miscellaneous expenses that you may be able to accelerate and pay now include:

• deductible investment expenses, such as investment advisory fees, custodial fees, safe deposit box rentals and investment publications;
• professional fees, such as tax planning and preparation, accounting and certain legal fees; and
• unreimbursed employee business expenses, such as travel, meals, entertainment, vehicle costs and publications — all exclusive of personal use.

Bunching medical expenses is often easier than bunching miscellaneous itemized deductions. Consider scheduling your non-urgent medical procedures and other controllable expenses in one year to take advantage of the deductions. Deductible medical expenses include:

• health insurance premiums,
• prescription drugs, and
• medical and dental costs and services.

In extreme cases — and assuming you are not subject to the AMT — it may even be possible to claim a standard deduction in one year, while bunching two years of itemized deductions in another.

Keep in mind that medical expenses aren't deductible if they are reimbursable through insurance or paid through a pretax Health Savings Account or Flexible Spending Account. The AMT can also complicate this strategy. For AMT purposes, only medical expenses in excess of 10 percent of your AGI are deductible.

It's important to remember that prepaid expenses can be deducted only in the year they apply. So you can prepay 2011 state income taxes to receive a 2011 deduction even if the taxes aren't due until 2012. But you can't prepay state taxes on your 2012 income and deduct the payment on your 2011 return. And don't forget the alternative minimum tax (AMT). If you are going to be subject to the AMT in both 2011 and 2012, it won't matter when you pay your state income tax, because it will not reduce your AMT liability in either year.

Maximizing deductions can make a big difference

Timing can often have the biggest impact on your itemized deductions. How and when you take these deductions is important because many itemized deductions have AGI floors. For instance, miscellaneous expenses are deductible only to the extent they exceed 2 percent of your AGI, and medical expenses are only deductible to the extent they exceed 7.5 percent of your AGI. Bunching these deductions into a single year may allow you to exceed these floors and save more. Also keep in mind that the AGI floor for medical expenses is scheduled to increase to 10 percent for taxpayers under 65 beginning in 2013.

Alternative minimum tax

The alternative minimum tax (AMT) is perhaps the most unpleasant surprise lurking in the tax code. It was originally conceived to ensure all taxpayers paid at least some tax, but has long since outgrown its initial purpose. The AMT is essentially a separate tax system with its own set of rules. How do you know if you will be subject to the AMT? Each year you must calculate your tax liability under the regular income tax system and the AMT, and then pay the higher amount.

The AMT is made up of two tax brackets with a top rate of 28 percent. Many deductions and credits are not allowed under the AMT, so taxpayers with substantial deductions that are reduced or not allowed under the AMT are the ones stuck paying. Common AMT triggers include the following:

• State and local income and sales taxes, especially in high tax states
• Real estate or personal property taxes
• Investment advisory fees
• Employee business expenses
• Incentive stock options
• Interest on a home equity loan not used to build or improve your residence
• Tax-exempt interest on certain private activity bonds
• Accelerated depreciation adjustments and related gain or loss differences on disposition

Proper planning can help you mitigate, or even eliminate, the impact of the AMT. The first step is to work with Grant Thornton to determine whether you could be subject to the AMT this year or in the future. In years that you'll be subject to the AMT, you want to defer deductions that are erased by the AMT and possibly accelerate income to take advantage of the lower AMT rate.

Tax law change alert: AMT relief extended through 2011

The AMT includes a large exemption, but this exemption phases out at high-income levels. And unlike the regular tax system, the AMT was never indexed for inflation. Instead, Congress must legislate any adjustments. Congress has been doing this on an approximately year-byyear basis for many years, and lawmakers in 2010 raised the exemption levels through 2011.

But it's important to remember that Congress only increases the exemption amount with each year's "patch," while the phaseout of the exemption and the AMT tax brackets remain unchanged. See Chart 7 for a full breakdown. Without further AMT relief, the exemption will plummet in 2012 and subject millions more taxpayers to the AMT.

Action opportunity: Accelerate income to "zero out" the AMT

You have to pay the AMT when it results in more tax than your regular income tax calculation, typically because the AMT has taken away key deductions. The silver lining is that the top AMT tax rate is only 28 percent. So you can "zero out" the AMT by accelerating income into the AMT year until the tax you calculate for regular tax and AMT are the same.

Although you will have paid tax sooner, you will have paid at an effective tax rate of only 26 percent or 28 percent on the accelerated income, which is less than the top rate of 35 percent that is paid in a year you're not subject to the AMT. If the income you accelerate would otherwise be taxed in a future year with a potential top rate of 39.6 percent, the savings could be even greater. But be careful. If the additional income falls in the AMT exemption phaseout range, the effective rate may be a higher 31.5 percent. The additional income may also affect other tax benefits, so you need to consider the overall tax impact.

Capital gains and qualified dividends deserve special consideration for the AMT. They are taxed at the same 15 percent rate either under the AMT or regular tax structure, but the additional income they generate can reduce your AMT exemption and result in a higher AMT bill. So consider your AMT implications before selling any stock that could generate a large gain.

If you have to pay the AMT, you may be able to take advantage of an AMT credit that has become more generous recently. You can qualify for the AMT credit by paying AMT on timing items such as depreciation adjustments, passive activity adjustments and incentive stock options. Most individuals paying the AMT do not have AMT credits and will not benefit from this new break. However, you may have earned credits if you've had business income from a partnership, S corporation or Schedule C business.

The credit can be taken against regular tax in future years, as it is meant to account for timing differences that reverse in the future. AMT credits at least four years old can be taken in 50 percent increments over a period of two years, even in years when the AMT continues to apply. Under legislation passed in the last several years, there is no AGI phaseout for this benefit. If you haven't kept careful records of your credits because you assumed that you would continue to be subject to the AMT and unable to use them, consider reviewing your prior-year returns to determine if you can benefit from this new provision.

Investment income

Managing your investment tax burden can feel like driving with your eyes closed. The tax treatment of investment income should affect how you organize your portfolio, but it's difficult when the economy is so unpredictable.

The financial crisis and the slow recovery have taken the stock market on several wild turns since 2008. You likely experienced upheaval in your own business enterprises. Although the temptation may be to focus on economic decisions now and worry about taxes later, this is when tax planning becomes even more important. You can't grope in the dark and hope it all works out in the future, especially with so much legislative uncertainty. Taxes on investment income are scheduled to rise in 2013 without congressional intervention. A little upfront consideration may save a lot in the long run.

First, investment income comes in a variety of forms, and it's not all created equal. Income such as dividends and interest arises from holding investments, while capital gains income results from the sale of investments. And while investment income is often treated more favorably than ordinary income, the rules are complex. Long-term capital gains and qualifying dividends can be taxed as low as 15 percent, while nonqualified dividends, interest and short-term capital gains are taxed at ordinary income tax rates as high as 35 percent. Special rates also apply to specific types of capital gains and other investments, such as mutual funds and passive activities.

But more importantly, the top tax rates on investment income are scheduled to change dramatically over the next several years. If the 2001 and 2003 tax cuts expire as scheduled at the end of 2012, the top long-term capital gains rate would increase from 15 percent to 20 percent for property held more than a year and 18 percent for property held more than 5 years.

Dividends would be taxed as ordinary income at a top rate of 39.6 percent. Yet, it gets worse! Those rates don't include a new

Medicare surtax on investment income such as dividends, capital gains and interest. This surtax, enacted in the 2010 health care bill, will add an additional 3.8 percent tax on investment income above $200,000 (single) or $250,000 (joint) beginning in 2013 (see Chart 8).

2011 is probably not the year to begin accelerating your investment income. First, the current low tax rates could very well be extended as they were at the end of 2010. More importantly, you still have next year to think about accelerating your gain, and you'll have more information then on the legislative outlook. Deferral is a cornerstone of good tax planning and may still be the best strategy even if your tax rates do go up in 2013.

Regardless, your investment planning should go well beyond any one-time decision about a prospective tax increase. The various rules and rates on investment income offer many opportunities for you to manage your tax burden. Understanding the tax costs of various types of investment income can also help you make tax-smart decisions. It starts with understanding all the investment income tax rules. But remember that tax planning is just one part of investing. You should also consider your risk tolerance, desired asset allocation and whether an investment makes sense for your financial and personal situation.

Managing capital gains and losses

To benefit from long-term capital gains treatment, you must hold a capital asset for more than one year before it is sold. Selling an asset you've held for a year or less results in less favorable short-term capital gains treatment. (In 2013, assets held more than five years will be subject to a separate capital gains rate unless legislation changes the rules.) Several specific types of assets such as collectibles have special, higher capital gains rates, and taxpayers in the bottom two tax brackets enjoy a zero rate on their capital gains and dividends in 2011 and 2012.

Your total capital gain or loss for tax purposes generally is calculated by netting all the capital gains and losses throughout the year. You can offset both short- and long-term gains with either short- or long-term losses. Taxpayers facing a large capital gains tax bill often find it beneficial to look for unrealized losses in their portfolio so they can sell the assets to offset their gains. But keep the wash sale rule in mind. You can't use the loss if you buy the same — or a substantially identical — security within 30 days before or after you sell the security that creates the loss. There are ways to mitigate the wash sale rule. You may be able to buy securities of a different company in the same industry or shares in a mutual fund that holds securities much like the ones you sold. Alternatively, consider a bond swap.

It may prove unwise to try and offset your capital gains at all. Up to $3,000 in net capital loss can be claimed against ordinary income (with a top rate of 35 percent in 2011, scheduled to increase to 39.6 percent in 2013), and the rest can be carried forward to offset future short-term capital gains or ordinary income.

Regardless of whether you want to mitigate a net capital gain, the tax consequences of a sale can come as a surprise, unless you remember the following rules:

• For tax purposes, the trade date and not the settlement date of publicly traded securities determines the year in which you recognize the gain or loss.
• If you bought the same security at different times and prices, consider specifically identifying which shares are to be sold by the broker before the sale. Selling the shares with the highest basis will reduce your gain or increase your losses.

Action opportunity: Avoid the wash sale rule with a bond swap

Bond swaps are a way to maintain your investment position while recognizing a loss. With a bond swap, you sell a bond, take a capital loss and then immediately buy another bond of similar quality from a different issuer. You'll avoid the wash sale rule because the bonds are not considered substantially identical.

Tax law change alert: New broker reporting rules affect basis on stock sales

Beginning in 2011, brokers for the first time are required to report your basis to the IRS when you sell stock. Brokers must generally report the sales of securities on a first-in, first-out basis within an account unless the customer specifically identifies which securities are to be sold. The sale of any shares with unknown acquisition dates are reported first. Taxpayers have the option of electing an average basis method. Your broker may also use a default basis method, so make sure you check the rules and affirmatively elect the method you want to use.

Deferral strategies

Deferring taxes is normally a large part of good planning. Even with the possibility of capital gains rates going up in 2013, the time value of money will still make deferral the best option for many taxpayers. If you believe your rates will go up, you can also consider adjusting the strategies you're using to defer gain, such as an installment sale or like-kind exchange.

Like-kind exchanges under Section 1031 allow you to exchange real estate without incurring capital gains tax. Under a like-kind exchange, you defer paying tax on the gain until you sell your replacement property.

An installment sale allows you to defer capital gains on most assets other than publicly traded securities by spreading gain over several years as you receive the proceeds. If you're engaging in an installment sale, consider creating a future exit strategy. You may want to build in the ability to pledge the installment obligation. Deferred income on most installment sales made after 1987 can be accelerated by pledging the installment note for a loan. The proceeds of the loan are treated as a payment on the installment note itself. If legislation is enacted that increases the capital gains rate in the future (or makes clear that the scheduled increase will occur), this technique can essentially accelerate the proceeds of the installment sale.

Action opportunity: Use zero capital gains rate to benefit children

Taxpayers in the bottom two tax brackets pay no taxes on long-term capital gains and qualifying dividends in 2011 and 2012. If income from these items would be in the 10 percent or 15 percent bracket based on a taxpayer's income, then the tax rate is zero.

If you have adult children in these tax brackets, consider giving them dividend-producing stock or long-term appreciated stock. They can sell the stock for gains or hold the stock for dividends without owing any taxes.

Keep in mind there could be gift tax and estate planning consequences. Income generated by gifts to children up to the age of 23 can also be subject to the "kiddie tax," which taxes some of their unearned income at the marginal rate of their parents (see Chapter 8 for more information).

Mutual fund pitfalls

Investing in mutual funds is an easy way to diversify your portfolio, but comes with tax pitfalls. Typically, earnings on mutual funds are reinvested. Unless you (or your broker or investment adviser) keep track of these additions to your basis, and you designate which shares you are selling, you may report more gain than required when you sell the fund.

It is often a good idea to avoid buying shares in an equity mutual fund right before it declares a large capital gains distribution, typically at year-end. If you own the shares on the record date of the distribution, you'll be taxed on the full distribution amount even though it may include significant gains realized by the fund before you owned the shares. Worse yet, you'll end up paying taxes on those gains in the current year — even if you reinvest the distribution in the fund and regardless of whether your position in the fund has appreciated.

Small business stock comes with tax rewards

Buying stock in a qualified small business (QSB) comes with several tax benefits, assuming you comply with specific requirements and limitations. QSB stock must be original issue stock in a C corporation with no more than $50 million in assets (and meet several other tests).

There are other tax benefits for small business stock that meet separate eligibility requirements. If you sell small business stock under Section 1244 (generally stock in a domestic corporation with no more than $1 million in capital) for a loss, you can treat up to $50,000 ($100,000, if married filing jointly) as an ordinary loss, regardless of your holding period. This means you can use it to offset ordinary income such as salary and interest taxed at a 35 percent rate (or 39.6 percent rate in future years if tax rates go up as scheduled).

Tax law change alert: No tax on gain from QSB stock purchased in 2011

Thanks to legislation meant to jumpstart the economy, you won't have to pay a dime of tax on gain from QSB stock purchased in 2011, ever, as long as you follow all the rules. You can normally exclude only half of the gain on QSB stock held for five years. The new legislation doubles this exclusion to 100 percent for QSB stock bought after Sept. 27, 2010, and before the end of 2011. So invest in a QSB stock before the year is up, and enjoy any future growth in value totally tax-free.

You can also roll over QSB stock without realizing gain. If you buy QSB stock with the proceeds of a sale of QSB stock within 60 days, you can defer the tax on your gain until you dispose of the new stock. The new stock's holding period for long-term capital gains treatment includes the holding period of the stock you sold.

Rethinking dividend tax treatment

The tax treatment of income-producing assets can affect investment strategy. Qualifying dividends generally are taxed at the reduced rate of 15 percent in 2011, while interest income is taxed at ordinary income rates of up to 35 percent.

As long as dividends remain at a lower rate than ordinary income, dividend-paying stocks may be more attractive from a tax perspective than investments such as CDs and bonds. But there are exceptions. Some dividends are already subject to ordinary income rates. These include certain dividends from:

• money market mutual funds,
• mutual savings banks,
• real estate investment trusts (REITs),
• foreign investments,
• regulated investment companies, and
• stocks — to the extent the dividends are offset by margin debt.

Some bond interest is exempt from income tax. Interest on U.S. government bonds is taxable on your federal return, but generally it is exempt on your state and local returns. Interest on state and local government bonds is excludible on your federal return. If the state or local bonds were issued in your home state, interest also may be excludible on your state return. Although state and municipal bonds usually pay a lower interest rate, their rate of return may be higher than the after-tax rate of return for a taxable investment.

Review portfolio for tax balance

You should consider which investments to hold inside and outside your retirement accounts. If you hold taxable bonds to generate income and diversify your overall portfolio, consider holding them in a retirement account where there won't be a current tax cost.

Bonds with original issue discount (OID) build up "interest" as they rise toward maturity. You're generally considered to earn a portion of that interest annually — even though the bonds don't pay you this interest annually — and you must pay tax on it. They also may be best suited for retirement accounts. Try to own dividend-paying stocks that qualify for a lower qualified dividend tax rate outside of retirement plans so you'll benefit from the lower rate.

It's also important to reallocate your retirement plan assets periodically. Assuming different investments yield different returns, it may not take long for your portfolio to have a very different allocation than you intended originally. And the allocation you set up for your 401(k) plan 10 years ago may not be appropriate now that you're closer to retirement.

Planning for passive losses

There are special rules for income and losses from a passive activity. Investments in a trade or business in which you don't materially participate are passive activities. You can prove your material participation by participating in the trade or business for more than 500 hours during the year or by demonstrating that your involvement represents substantially all of the participation in the activity.

The designation of a passive activity is important, because generally passive activity losses are deductible only against income from other passive activities. You can carry forward disallowed losses to the following year, subject to the same limitations. There are options for turning passive losses into tax-saving opportunities.

For instance, you can increase your activity to more than 500 hours so the losses will not be passive. Alternatively, you can limit your activities in another business to less than 500 hours or invest in another income-producing business that will be passive to you. This will allow the other businesses to give you passive income to offset your passive losses. Finally, consider disposing of the activity to deduct all the losses. The disposition rules can be complex, so consult with a Grant Thornton tax adviser.

Rental activity has its own set of passive loss rules. Losses from real estate activities are passive by definition unless you're a real estate professional. If you're a real estate professional, you can deduct real estate losses in full, but you must perform more than half of your personal services annually in real property trades and businesses and spend more than 750 hours in these services during the year.

If you participate actively in a rental real estate activity but you aren't a real estate professional, you may be able to deduct up to $25,000 of real estate losses each year. This deduction is subject to a phaseout beginning when adjusted gross income (AGI) reaches $100,000 ($50,000 for married taxpayers filing separately).

Leveraging investment expenses

You are allowed to deduct expenses used to generate investment income unless they are related to tax-exempt income. Investment expenses can include investment advisory fees, research costs, security costs (such as a safe deposit box) and most significantly, investment interest. Apart from investment interest, these expenses are considered miscellaneous itemized deductions and are deductible only to the extent they exceed 2 percent of your AGI.

Investment interest is interest on debt used to buy assets held for investment, such as margin debt used to buy securities. Payments a short seller makes to the stock lender in lieu of dividends may be deductible as an investment interest expense. Your investment interest deduction is limited to your net investment income, which generally includes taxable interest, dividends and short-term capital gains. Any disallowed interest is carried forward for a deduction in a later year, which may provide a beneficial opportunity.

If you don't want to carry forward investment interest expense, you can elect to treat net long-term capital gain or qualified dividends as investment income in order to deduct more of your investment interest, but it will be taxed at ordinary-income rates. Remember that interest on debt used to buy securities that pay tax-exempt income, such as municipal bonds, isn't deductible. Also keep in mind that passive interest expense — interest on debt incurred to fund passive activity expenditures — becomes part of your overall passive activity income or loss, subject to limitations.

Action opportunity: Defer investment interest for a bigger deduction

Unused investment interest expense can be carried forward indefinitely and may be usable in later years. Many taxpayers elect to treat qualified dividends and long-term capital gains as investment income in order to deduct unused investment expenses. It could make sense instead for you to carry forward your unused investment interest until after 2013 when tax rates are scheduled to go up and the 15-percent rate on long-term capital gains and dividends is scheduled to disappear. The deduction could save you more at that time if taxes increase as scheduled.

Your home as an investment

There are many home-related tax breaks. Whether you own one home or several, it's important to maximize your deductions and plan for any gains or rental income. Generally, property tax is deductible as an itemized deduction, but isn't deductible for AMT purposes.

Consumer interest isn't deductible, so consider using home equity debt (up to the $100,000 limit) to pay off credit cards or auto loans. But remember, home equity debt is not deductible for the AMT unless it's used for home improvements.

When you sell your home, you generally can exclude up to $250,000 ($500,000 for joint filers) of gain if you've used it as your principal residence for two of the preceding five years, subject to new limitations based on how long the home may not have been used as your primary residence.

Maintain thorough records to support an accurate tax basis, and remember, you can only deduct losses if they are attributable exclusively to business or rental use (subject to various limitations).

The rules for rental income are complicated, but you can rent out all or a portion of your primary residence and second home for up to 14 days without having to report the income. No rental expenses will be deductible. If you rent out your property for 15 days or more, you have to report the income, but you can also deduct all or a portion of your rental expenses — such as utilities, repairs, insurance and depreciation. Any deductible expenses in excess of rental income can be carried forward.

If the home is classified as a rental for tax purposes, you can deduct interest that's attributable to its business use but not any interest attributable to personal use.

Tax law change alert: Deduct interest on a mortgage of up to $1.1 million

You can deduct mortgage interest and points on your principal residence and a second home. For many years, courts and the IRS had interpreted the tax code to limit your deduction to the interest from up to:

• $1 million in total mortgage debt used to purchase, build or improve a home, PLUS
• $100,000 for home equity debt that is NOT used to acquire the home.

This allowed taxpayers to deduct interest on up to $1.1 million in mortgage debt, but only if $100,000 was not used to purchase or build the home. The IRS in 2010 issued a revenue ruling (Rev. Rul. 2010-25) taking a more taxpayer-favorable position. The IRS has now ruled that debt used to buy, construct or improve a home can be treated as both acquisition and equity indebtedness — allowing taxpayers to deduct interest on up to $1.1 million in mortgage interest even if all of it was used to purchase or build the home.

Tax law change alert: Primary residence gain exclusion limited

New rules limit how much gain you can exclude under the general exclusion rules applying to the sale of a principal residence. You will now have to include gain on a pro-rata basis for any years after 2009 that your home was not used as your principal residence. So if you use a home as a rental from 2010 through 2014, and then use it as a primary residence from 2015 through 2019, you will only be able to exclude half of any gain.

To read Part 2 of this article please click next page.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.