Tax Planning Guide 2020 2021 - Year-round strategies to make the tax laws work for you
←
→
Page content transcription
If your browser does not render page correctly, please read the page content below
2020 – 2021
Tax Planning Guide
Year-round strategies to make the tax laws work for you
4783 E. Camp Lowell Drive • Tucson, AZ 85712 • P: 520-545-0500 • F: 520-545-0555
Tax planning in
unprecedented times
t has become a cliché in 2020, but what word other than “unprecedented” can be used to
I describe the events we’ve experienced this year? During such times, tax planning is far from
top of mind. But it’s still important. Smart tax planning can soften the impact of an uncertain
economy and provide much-needed relief to owners of struggling businesses.
To take advantage of all available breaks, you need to be aware of some major changes under this year’s
Coronavirus Aid, Relief and Economic Security (CARES) Act and last year’s Setting Every Community
Up for Retirement Enhancement (SECURE) Act. You also can’t forget about the massive Tax Cuts and
Jobs Act (TCJA) that generally went into effect two years ago but still impacts tax planning. Plus, it’s
possible that there could be more tax law changes before year end — or that the potential for changes
next year could affect 2020 planning.
This guide provides an overview of some of the most significant tax law changes going into effect this
year and other key tax provisions you need to be aware of. It offers a variety of strategies for minimizing
your taxes in the current tax environment. Use it to work closely with your tax advisor to identify the
best strategies for your particular situation. He or she also can keep you apprised of any new tax law
developments that might affect you.
Contents
Income & Deductions................................................2 Click here
Executive Compensation...........................................6 Click here
Investing....................................................................8 Click here
Real Estate...............................................................12 Click here
Business Ownership.................................................14 Click here
Charitable Giving....................................................16 Click here
Family & Education.................................................18 Click here
Retirement...............................................................20 Click here
Estate Planning........................................................22 Click here
Tax Rates..................................................................24 Click here
2 Income & Deductions
Control the timing of income and
deductions to your tax advantage
ax rates on “ordinary income” y U.S. Treasury bill income, and Suspension of miscellaneous itemized
T are higher than those that
apply to much of your
y Retirement plan distributions, to
deductions subject to the 2% floor.
This deduction for expenses such as
the extent they won’t be subject
investment income. Ordinary income certain professional fees, investment
to early-withdrawal penalties and
generally includes salary, income from expenses and unreimbursed employee
aren’t required. (See page 20.)
self-employment or business activities, business expenses is suspended through
interest, and distributions from tax- 2025. While this eliminates the home
deferred retirement accounts. Some of Some expenses with potentially
office deduction for employees who
it may also be subject to payroll tax, controllable timing are mortgage
work from home (even if your employer
or you may have to pay the alternative interest, investment interest expense
has required it during the pandemic),
minimum tax (AMT), under which and charitable contributions.
if you’re self-employed, you may still be
different tax rates apply. This is why able to deduct home office expenses.
careful planning for ordinary income Impact of the TCJA (See page 12.)
and deductible expenses continues to on timing strategies
be important. The TCJA has made timing income More-restricted personal casualty and
and deductions more challenging theft loss deduction. Through 2025, this
Timing income and expenses because some strategies that tax- itemized deduction is suspended except
Smart timing of income and expenses payers used to implement no longer if the loss was due to an event officially
can reduce your tax liability, and poor are making sense. Here’s a look and declared a disaster by the President.
timing can unnecessarily increase it. some significant changes that have
When you don’t expect to be subject affected deductions: Increased standard deduction. The
to the AMT (see page 3) in the current TCJA nearly doubled the standard
year or the next year, deferring income to Reduced deduction for state and deduction. While many higher-income
the next year and accelerating deductible local tax. Property tax used to be a taxpayers will still benefit from itemiz-
expenses into the current year may be popular expense to time. But with the ing, some — such as those in low-tax
a good idea. Why? Because it will defer TCJA’s limit on the state and local states, who don’t have mortgages or
tax, which usually is beneficial. tax deduction, property tax timing who aren’t charitably inclined — may
will likely provide little, if any, benefit now save more tax by claiming the
But when you expect to be in a higher for higher-income taxpayers. (See standard deduction. (See Chart 1 for
tax bracket next year — or you expect Case Study 1 at right.) If you reside the 2020 standard deduction amounts.)
tax rates to rise — the opposite approach in a state with no, or low, income tax,
may be beneficial: Accelerating income this change might be less relevant. Tax-advantaged
will allow more income to be taxed at But keep in mind that deducting sales saving for health care
your current year’s lower rate. And defer- tax instead of income tax may be
If medical expenses not paid via
ring expenses will make the deductions beneficial, especially if you purchased
tax-advantaged accounts or reimburs-
more valuable, because deductions save a major item, such as a car or boat.
able by insurance exceed a certain
more tax when you’re subject to a higher
tax rate. CHART 1
2020 standard deduction
Whatever the reason behind your
desire to time income and expenses, Filing status Standard deduction1
you may be able to control the timing Singles and separate filers $12,400
of these income items:
Heads of households $18,650
y Bonuses, Joint filers $24,800
1
Taxpayers age 65 or older or blind can claim an additional standard deduction: $1,300 if married,
y Consulting or other self-employment $1,650 if unmarried.
income,
Income & Deductions 3
FSA. You can redirect pretax income
CASE Factor state and local tax to an employer-sponsored Flexible
STUDY 1 deduction limits into timing strategies Spending Account up to an employer-
determined limit — not to exceed $2,750
Last year, Justin earned a promotion along with a significant salary increase and
in 2020. The plan pays or reimburses you
bonus, and his state income tax liability increased accordingly. When he filed
his 2019 tax return, he was surprised to find that he could no longer deduct all
for qualified medical expenses. What
of his state and local income and property taxes. This meant that prepaying his you don’t use by the plan year’s end, you
2019 property tax bill due in early 2020 hadn’t helped him. He’d always done his generally lose — though your plan might
income taxes himself, but he decided it was time to consult a tax professional. allow you to roll over up to $550 to 2021.
Or it might give you a 2½-month grace
She told Justin that, through 2025, under the TCJA, his entire itemized deduction period to incur expenses to use up the
for state and local taxes — including property tax and either income or sales previous year’s contribution. In response
tax — is limited to $10,000 ($5,000 for married taxpayers filing separately). The to the COVID-19 crisis, the IRS has
downside of Justin’s raise and bonus was temporarily made FSAs a little more flex-
that his 2019 state and local tax liability ible. Contact your employer for details.
exceeded $10,000, so a portion of this If you have an HSA, your FSA is limited
liability was no longer deductible. to funding certain permitted expenses.
The tax advisor went on to explain that the
limit significantly impacts higher-income
Smaller AMT threat
taxpayers with large state and local income The top AMT rate is 28%, compared
tax and/or large property tax bills. She to the top regular ordinary-income tax
advised that Justin take this into account in rate of 37%. But the AMT rate typically
his income and deduction timing strategies applies to a higher taxable income base.
going forward. You must pay the AMT if your AMT
liability exceeds your regular tax liability.
percentage of your adjusted gross If one spouse has high medical The TCJA substantially increases the
income (AGI), you can claim an expenses and a relatively lower AMT exemptions through 2025. (See
itemized deduction for the amount AGI, filing separately may allow Chart 8 on page 24.) This means fewer
exceeding that “floor.” This floor that spouse to exceed the AGI floor taxpayers will have to pay the AMT. In
can be difficult for higher-income and deduct some medical expenses addition, deductions used to calculate
taxpayers to exceed. that wouldn’t be deductible if the regular tax that aren’t allowed under the
couple filed jointly. Warning: Because AMT can trigger AMT liability, and
The TCJA had reduced the floor from the AMT exemption for separate there aren’t as many differences between
10% to 7.5% for 2017 and 2018, and returns is considerably lower than what’s deductible for AMT purposes
last year the 7.5% floor was extended the exemption for joint returns, filing and regular tax purposes. (See Chart 2
to 2019 and 2020. But it will return to separately to exceed the floor could on page 4.) This also reduces AMT risk.
10% for 2021 unless Congress extends trigger the AMT. However, AMT will remain a threat for
the lower floor again. (Check with your some higher-income taxpayers.
tax advisor for the latest information.) You may be able to save taxes without
having to worry about the medical So before timing your income and
Eligible expenses may include expense deduction floor by contributing expenses, determine whether you’re
health insurance premiums, to one of these accounts: already likely to be subject to the
long-term-care insurance premiums AMT — or whether the actions
(limits apply), medical and dental HSA. If you’re covered by a qualified you’re considering might trigger it.
services, and prescription drugs. high deductible health plan, you In addition to deduction differences,
Mileage driven for health care pur- can contribute pretax income to an some income items might trigger or
poses also can be deducted — at 17 employer-sponsored Health Savings increase AMT liability:
cents per mile for 2020. Account — or make deductible
contributions to an HSA you set up y Long-term capital gains and qualified
Consider bunching elective medical yourself — up to $3,550 for self-only dividend income,
procedures (and any other services and coverage and $7,100 for family
y Accelerated depreciation adjustments
purchases whose timing you can control coverage for 2020 (plus $1,000 if
and related gain or loss differences
without negatively affecting your or you’re age 55 or older). HSAs can
when assets are sold, and
your family’s health) into alternating bear interest or be invested, growing
years if it would help you exceed the tax-deferred similar to an IRA. y Tax-exempt interest on certain
applicable floor and you’d have enough Withdrawals for qualified medical private-activity municipal bonds.
total itemized deductions to benefit expenses are tax-free, and you can (For an exception, see the warning
from itemizing. carry over a balance from year to year. on page 11.)
4 Income & Deductions
Finally, in certain situations exercising
incentive stock options (ISOs) can CHART 2 What itemized deductions are
trigger significant AMT liability. (See also deductible for AMT purposes?
the warning at the top of page 7.)
Expense Regular tax AMT For more information
Avoiding or reducing AMT See “Impact of the TCJA on
State and local income tax n
With proper planning, you may be timing strategies” on page 2.
able to avoid the AMT, reduce its Property tax
See “Home-related
n deductions” on page 12.
impact or even take advantage of its
lower maximum rate: See “Home-related
Mortgage interest n n deductions” on page 12.
If you could be subject to the AMT Interest on home equity debt
this year … consider accelerating See “Home-related
used to improve your principal n n deductions” on page 12.
income into this year, which may residence or second residence
allow you to benefit from the lower See Case Study 5 on
maximum AMT rate. And deferring Investment interest n n page 11.
expenses you can’t deduct for AMT
See “Tax-advantaged saving
purposes may allow you to preserve Medical expenses n n for health care” on page 2.
those deductions (but watch out for
the annual limit on the state and Charitable contributions n n See page 16.
local tax deduction). If you also
defer expenses you can deduct for more per biweekly pay period aren’t Additional 0.9% Medicare tax
AMT purposes, the deductions may eligible. As of this writing, there Another payroll tax that higher-
become more valuable because of are many open questions about the income taxpayers must be aware of
the higher maximum regular tax deferral. Contact your tax advisor is the additional 0.9% Medicare tax.
rate. Finally, carefully consider the for the latest information. It applies to FICA wages and net
tax consequences of exercising ISOs.
self-employment income exceeding
Self-employment taxes $200,000 per year ($250,000 if married
If you could be subject to the AMT If you’re self-employed, you pay filing jointly and $125,000 if married
next year … consider taking the both the employee and employer filing separately).
opposite approach. For instance, defer portions of payroll taxes on your
income to next year, because you’ll self-employment income. The If your wages or self-employment
likely pay a relatively lower AMT employer portion (6.2% for Social income varies significantly from year
rate. Also, before year end consider Security tax and 1.45% for Medicare to year or you’re nearing the threshold
selling any private-activity municipal tax) is deductible above the line. for triggering the additional Medicare
bonds whose interest could be subject You also may be eligible for some tax, income timing strategies may help
to the AMT. COVID-19 payroll tax relief. (See you avoid or minimize it. For example,
“What’s new!” at right.) if you’re an employee, perhaps you
Also be aware that, in certain circum- can time when you receive a bonus
stances, you may be entitled to an As a self-employed taxpayer, you may or exercise stock options. If you’re
AMT credit. benefit from other above-the-line self-employed, you may have flexibility
deductions as well. You can deduct on when you purchase new equipment
Payroll taxes 100% of health insurance costs or invoice customers. If you’re an
In addition to income tax, you must for yourself, your spouse and your S corporation shareholder-employee,
pay Social Security and Medicare dependents, up to your net self- you might save tax by adjusting how
taxes on earned income, such as employment income. You also can much you receive as salary vs. distribu-
salary and bonuses. The 12.4% Social deduct contributions to a retirement tions. (See “Owner-employees” at right.)
Security tax applies only up to the plan and, if you’re eligible, an HSA
Social Security wage base of $137,700 for yourself. And you might be able Also consider the withholding rules.
for 2020. All earned income is subject to deduct home office expenses. (See Employers must withhold the addi-
to the 2.9% Medicare tax. Both page 12.) Above-the-line deductions tional tax beginning in the pay period
taxes are split equally between the are particularly valuable because when wages exceed $200,000 for the
employee and the employer. they reduce your AGI and, depend- calendar year — without regard to an
ing on the specific deduction, your employee’s filing status or income from
Also, an Aug. 8 presidential mem- modified AGI (MAGI), which are other sources. So your employer might
orandum offers a deferral of the the triggers for certain additional withhold the tax even if you aren’t liable
employee share of Social Security taxes and the phaseouts of many for it — or it might not withhold the tax
taxes, but those earning $4,000 or tax breaks. even though you are liable for it.
Income & Deductions 5
If you don’t owe the tax but your the income isn’t distributed to you. C corporations. Only income you
employer is withholding it, you can But such income may not be subject receive as salary is subject to payroll
claim a credit on your 2020 income tax to self-employment taxes if you’re a taxes and, if applicable, the 0.9%
return. If you do owe the tax but your limited partner or the LLC member Medicare tax. Nonetheless, you may
employer isn’t withholding it, consider equivalent. Check with your tax prefer to take more income as salary
filing a W-4 form to request additional advisor on whether the additional 0.9% (which is deductible at the corporate
income tax withholding, which can be Medicare tax on earned income or the level) as opposed to dividends (which
used to cover the shortfall and avoid 3.8% NIIT (see page 11) will apply. aren’t deductible at the corporate level
interest and penalties. Or you can yet are still taxed at the shareholder
make estimated tax payments. S corporations. Only income you level and could be subject to the 3.8%
receive as salary is subject to payroll NIIT) if the overall tax paid by both
Owner-employees taxes and, if applicable, the 0.9% the corporation and you would be less.
There are special considerations if Medicare tax. To reduce these taxes,
you’re a business owner who also you may want to keep your salary Warning: The IRS scrutinizes corporate
works in the business, depending on relatively — but not unreasonably — payments to shareholder-employees
its structure: low and increase the income that is for possible misclassification, so tread
taxed to you through your Schedule K-1 carefully.
Partnerships and limited liability by virtue of your share of the earnings
companies. Generally, all trade or from the business. That income isn’t Estimated payments
business income that flows through to subject to the corporate level tax or and withholding
you for income tax purposes is subject the 0.9% Medicare tax and, typically, You can be subject to penalties if you
to self-employment taxes — even if is not subject to the 3.8% NIIT. don’t pay enough tax during the year
through estimated tax payments and
withholding. Here are some strategies
WHAT’S
COVID-19 payroll tax relief for the self-employed to help avoid underpayment penalties:
NEW!
Know the minimum payment rules.
To help the self-employed — and employers — during
For you to avoid penalties, your
the COVID-19 crisis, the CARES Act allows the pay-
estimated payments and withholding
ment of the employer share (6.2% of wages) of the
must equal at least 90% of your tax
Social Security payroll tax to be deferred. Taxpayers
liability for 2020 or 110% of your
can pay the tax over the next two years, with the first
2019 tax (100% if your 2019 AGI
half due by Dec. 31, 2021, and the second half due
was $150,000 or less or, if married
by Dec. 31, 2022. Be aware that, as of this writing,
filing separately, $75,000 or less).
it appears that the deferral of the employee share of
Social Security taxes noted under “Payroll taxes” at
left isn’t available to the self-employed. Check with
Use the annualized income installment
your tax advisor for the latest information.
method. This method often benefits
taxpayers who have large variability in
If you have employees, additional payroll tax breaks may be available to you: income from month to month due to
bonuses, investment gains and losses, or
Payroll tax credit. Under the CARES Act, this credit is generally available to seasonal income (at least if it’s skewed
employers whose operations have been fully or partially suspended because of a toward the end of the year). Annualizing
COVID-19-related governmental shutdown order or whose gross receipts have computes the tax due based on income,
dropped more than 50% compared to the same quarter in the previous year. The gains, losses and deductions through
credit equals 50% of up to $10,000 in compensation, including health care bene- each estimated tax period.
fits, paid to an eligible employee after March 12, 2020, through Dec. 31, 2020.
Estimate your tax liability and increase
Paid leave credit. The Families First Coronavirus Response Act generally withholding. If you determine you’ve
requires employers with fewer than 500 employees to provide paid leave in underpaid, consider having the tax
certain COVID-19-related situations. Covered employers generally can take a shortfall withheld from your salary or
federal payroll tax credit for 100% of the qualified sick and family leave wages year end bonus by Dec. 31. Because
they pay each quarter, up to $511 per day for leave taken for the employee’s withholding is considered to have been
own illness or quarantine and $200 for leaves taken to care for others. paid ratably throughout the year, this
is often a better strategy than making
Additional rules and limits apply to these breaks, and it’s possible they could
up the difference with an increased
be expanded or extended by the time you’re reading this or that additional
quarterly tax payment, which may
relief for employers could become available. Check with your tax advisor for
still leave you exposed to penalties for
the latest information.
earlier quarters.
6 Executive Compensation
Smart tax planning for your
exec comp package is critical
ompensation may take several There are some potential disad- Such a delay will defer income tax
C forms, including salary, fringe
benefits and bonuses. If you’re
vantages of a Sec. 83(b) election,
however. First, prepaying tax in the
and may allow you to reduce or avoid
exposure to the additional 0.9%
an executive or other key employee, you current year could push you into a Medicare tax (because the RSUs are
might receive stock-based compensa- higher income tax bracket and trigger treated as FICA income). However,
tion, such as restricted stock, restricted or increase your exposure to the any income deferral must satisfy
stock units (RSUs) or stock options additional 0.9% Medicare tax. But the strict requirements of Internal
(either incentive or nonqualified). if your company is in the earlier Revenue Code Section 409A. Also
Nonqualified deferred compensation stages of development, the income keep in mind that it might be better
(NQDC) may also be included in your recognized may be relatively small. to recognize income now because of
exec comp package. The tax conse- the currently low tax rates.
quences of these types of compensation Second, any taxes you pay because of
can be complex — subject to ordinary the election can’t be refunded if you Incentive stock options
income, capital gains, payroll and other eventually forfeit the stock or sell it ISOs allow you to buy company
taxes. So smart tax planning is critical. at a decreased value. However, you’d stock in the future (but before a set
have a capital loss in those situations. expiration date) at a fixed price equal
Restricted stock to or greater than the stock’s FMV
Restricted stock is stock your employer Third, when you sell the shares, any at the date of the grant. Thus, ISOs
grants to you subject to a substantial risk gain will be included in net investment don’t provide a benefit until the stock
of forfeiture. Income recognition is nor- income and could trigger or increase appreciates in value. If it does, you
mally deferred until the stock is no longer your liability for the 3.8% NIIT. (See can buy shares at a price below what
subject to that risk (that is, it’s vested) or page 11.) they’re then trading for, provided
you sell it. When the restriction lapses, you’re eligible to exercise the options.
you pay taxes on the stock’s fair market See Case Study 2 for additional
value (FMV) at your ordinary-income information, and work with your ISOs receive tax-favored treatment
rate. (The FMV will be considered FICA tax advisor to map out whether the but must comply with many rules.
income, so it could trigger or increase Sec. 83(b) election is appropriate Here are the key tax consequences:
your exposure to the additional 0.9% for your situation.
Medicare tax. See page 4.) y You owe no tax when ISOs are
RSUs granted.
But you can instead make a RSUs are contractual rights to
y You owe no regular income tax
Section 83(b) election to recognize receive stock, or its cash value,
when you exercise the ISOs.
ordinary income when you receive the after the award has vested. Unlike
stock. This election, which you must restricted stock, RSUs aren’t eligible y If you sell the stock after holding
make within 30 days after receiving the for the Sec. 83(b) election. So the shares at least one year from the
stock, allows you to convert potential there’s no opportunity to convert exercise date and two years from
future appreciation from ordinary income ordinary income into capital gains. the grant date, you pay tax on the
to long-term capital gains income and sale at your long-term capital gains
defer it until the stock is sold. But they do offer a limited ability rate. You also may owe the NIIT.
to defer income taxes: Unlike
y If you sell the stock before long-term
The election can be beneficial if the restricted stock, which becomes
capital gains treatment applies, a
income at the grant date is negligible taxable immediately upon vesting,
“disqualifying disposition” occurs and
or the stock is likely to appreciate RSUs aren’t taxable until the
any gain is taxed as compensation at
significantly before income would employee actually receives the
ordinary-income rates. (Disqualified
otherwise be recognized. And with stock. So rather than having the
dispositions aren’t, however, subject
ordinary-income rates now especially stock delivered immediately upon
to FICA and Medicare tax, including
low under the TCJA, it might be a vesting, you may be able to arrange
the additional 0.9% Medicare tax.)
good time to recognize income. with your employer to delay delivery.
Executive Compensation 7
Warning: If you don’t sell the stock gains rate and the NIIT. See Case favor highly compensated employees,
in the year of exercise, a tax “prefer- Study 2 for additional information but plan funding isn’t protected from
ence” item is created for the difference and, with your tax advisor, evaluate the employer’s creditors. (For more on
between the stock’s FMV and the the risks and crunch the numbers to 401(k)s, see page 20.)
exercise price (the “bargain element”) determine the best strategy for you.
that can trigger the AMT. A future One important NQDC tax issue is
AMT credit, however, should mitigate Nonqualified stock options that payroll taxes (see page 4) are
this AMT hit. Plus, you may now be at The tax treatment of NQSOs is different generally due once services have been
lower AMT risk because of the higher from the tax treatment of ISOs: NQSOs performed and there’s no longer a
AMT exemption and exemption create compensation income (taxed at substantial risk of forfeiture — even
phaseout range under the TCJA. (See ordinary-income rates) on the bargain though compensation may not be paid
Chart 8 on page 24.) Consult your tax element when exercised (regardless of or recognized for income tax purposes
advisor because the rules are complex. whether the stock is held or sold imme- until much later. So your employer
diately), but they don’t create an AMT may withhold your portion of the
If you’ve received ISOs, plan carefully preference item. payroll taxes from your salary or ask
when to exercise them and whether to you to write a check for the liability.
immediately sell shares received from You may need to make estimated tax Or it may pay your portion, in which
an exercise or hold them. Waiting payments or increase withholding to case you’ll have additional taxable
to exercise ISOs until just before the fully cover the tax on the exercise. income. Warning: The additional
expiration date (when the stock value Keep in mind that an exercise could 0.9% Medicare tax could also apply.
may be the highest, assuming the stock trigger or increase exposure to top tax
is appreciating) and holding on to the rates, the additional 0.9% Medicare Keep in mind that the rules for NQDC
stock long enough to garner long- tax and the NIIT. plans are tighter than they once were,
term capital gains treatment often is and the penalties for noncompliance
beneficial. But there’s also market risk can be severe: You could be taxed on
NQDC plans
to consider. Plus, acting earlier can be plan benefits at the time of vesting, and
advantageous in several situations: These plans pay executives in the future a 20% penalty and potential interest
for services to be currently performed. charges also could apply. So check
y Exercise early to start the holding They differ from qualified plans, such as with your employer to make sure it’s
period so you can sell and receive 401(k)s, in several ways. For example, addressing any compliance issues.
long-term capital gains treatment unlike 401(k) plans, NQDC plans can
sooner.
y Exercise when the bargain element CASE Some stock-based compensation
is small or when the market price is STUDY 2 may qualify for TCJA tax deferral
close to bottoming out to reduce or
Mario was about to receive some
eliminate AMT liability.
stock-based compensation from
y Exercise annually so you can buy his employer, so he contacted
only the number of shares that will his tax advisor to find out what
achieve a breakeven point between the tax consequences would be.
the AMT and regular tax and His advisor explained that the tax
thereby incur no additional tax. treatment would depend on the
type of stock-based compensa-
y Sell in a disqualifying disposition and tion. For example, Mario might
pay the higher ordinary-income rate be able to take advantage of
to avoid the AMT on potentially the Section 83(b) election. (See
disappearing appreciation. “Restricted stock” at left.) Or he
might be eligible for a tax break
On the negative side, exercising early under the TCJA.
accelerates the need for funds to buy
the stock, exposes you to a loss if the The TCJA break allows for the
shares’ value drops below your exercise deferral of tax on stock-based
compensation in certain circumstances. Generally, it gives taxpayers the oppor-
cost, and may create a tax cost if the
tunity to match the taxation of restricted stock and stock options with the timing
preference item from the exercise
of the sale of the stock. It’s intended for situations in which there is no ready
generates an AMT liability.
market for the sale of the stock.
The timing of ISO exercises also could The availability of the deferral opportunity is limited, however. It generally will
positively or negatively affect your lia- apply only if at least 80% of full-time employees are covered by the stock-based
bility for the higher ordinary-income compensation plan.
tax rates, the 20% long-term capital
8 Investing
Uncertainty further complicates
tax planning for investments
ax treatment of investments Being tax-smart with losses against ordinary income (such as wages,
T varies dramatically based
on factors such as type of
Losses aren’t truly losses until they’re
realized — that is, generally until you
self-employment and business income,
interest, dividends, and taxable retire-
investment, type of income it produces, sell the investment for less than what ment plan distributions). But you can
how long you’ve held it and whether you paid for it. So while it’s distressing carry forward excess losses until death.
any special limitations or breaks apply. to see an account statement that shows
On top of that, economic uncertainty a large loss, the loss won’t affect your If you don’t have enough gains to absorb
has made tax planning for investments current tax situation as long as you still losses, you could be left with losses in
especially challenging this year. own the investment. excess of the annual ordinary-income
deduction limit. So think twice before
And there are many additional factors to Realized capital losses are netted against selling an investment at a loss. After
evaluate before deciding whether to sell realized capital gains to determine all, if you hold on to the investment,
or hold an investment, such as invest- capital gains tax liability. If net losses it may recover the lost value. In fact,
ment goals, time horizon, risk tolerance, exceed net gains, you can deduct only a buy-and-hold strategy works well for
factors related to the investment itself, $3,000 ($1,500 for married taxpayers many long-term investors because it can
fees and charges that apply to buying and filing separately) of losses per year minimize the effects of market volatility.
selling securities, and your need for cash.
But taxes are still important to consider.
CHART 3
What’s the maximum 2020 capital gains tax rate?
Capital gains tax and timing
Although time, not timing, is gener- Type of gain Rate1
ally the key to long-term investment Taxpayer’s ordinary-
success, timing can have a dramatic Short-term (assets held 12 months or less)
income tax rate
impact on the tax consequences of
Long-term (assets held more than 12 months) 15%
investment activities. Your marginal
long-term capital gains rate can be as Some key exceptions
much as 20 percentage points lower Long-term gain of certain higher-income taxpayers 20%2
than your ordinary-income tax rate.
Most long-term gain that would be taxed at 10% or
0%
12% based on the taxpayer’s ordinary-income rate
The long-term capital gains rate applies
to investments held for more than 12 Long-term gain on collectibles, such as artwork
28%
and antiques
months. The applicable rate depends
on your income level and the type of Long-term gain attributable to certain recapture of
25%
asset you’ve sold. (See Chart 3.) prior depreciation on real property
Gain on qualified small business (QSB) stock held
Because of TCJA-related changes to more than 5 years
the brackets, through 2025, the top n Acquired before Feb. 18, 2009 14%3
long-term gains rate of 20% kicks
n Acquired on or after Feb. 18, 2009, and before
in before the top ordinary-income 7%4
Sept. 28, 2010
rate does. (See Chart 8 on page 24.)
Higher rates still apply to certain n Acquired on or after Sept. 28, 2010 0%
types of assets. (See Chart 3.) In addition, the 3.8% net investment income tax (NIIT) applies to net investment income to the
1
extent that modified adjusted gross income (MAGI) exceeds $200,000 (singles and heads of
households), $250,000 (married filing jointly) or $125,000 (married filing separately).
Holding on to an investment until
The 20% rate applies only to those with taxable income exceeding $441,450 (singles), $469,050
2
you’ve owned it more than one year (heads of households), $496,600 (joint filers), or $248,300 (separate filers).
may help substantially cut tax on any Effective rate based on a 50% exclusion from a 28% rate.
3
gain. Keeping it even longer can also Effective rate based on a 75% exclusion from a 28% rate.
4
make tax sense.
Investing 9
Mutual funds
CASE
STUDY 3 Use capital losses to absorb unrecognized gains Investing in mutual funds is an easy
way to diversify your portfolio. But
Marisa’s year-to-date net beware of the tax pitfalls.
realized losses are $53,000.
Her portfolio includes First, mutual funds with high turnover
$100,000 of stock that rates can create income that’s taxed
she paid only $50,000 for. at ordinary-income rates. Choosing
Marisa has been thinking funds that provide primarily long-term
about selling it to diversify gains can save you more tax dollars
her portfolio and because because of the lower long-term rates.
year-to-date the stock had
dropped from $130,000 to Second, earnings on mutual funds
$100,000 in value and she’s are typically reinvested. Unless you
not confident it will recover.
or your investment advisor increases
But she’s been concerned your basis accordingly, you may report
about the capital gains tax. more gain than required when you sell
the fund. Brokerage firms are required
Her tax advisor suggests to track (and report to the IRS) your
that now might be a good cost basis in mutual funds acquired
time to sell the stock because her $50,000 gain would essentially be tax-free: during the tax year.
The gain would absorb $50,000 of losses, leaving Marisa with a $3,000 net
loss, the maximum that she could use to offset ordinary income. Third, buying equity mutual fund
shares late in the year can be costly
Of course, an investment might con- Fortunately, there are ways to avoid taxwise. Such funds often declare
tinue to lose value. That’s one reason triggering the wash sale rule and a large capital gains distribution at
why tax considerations shouldn’t still achieve your goals. For example, year end, which is a taxable event.
be the primary driver of investment you can: If you own the shares on the distri-
decisions. If you’re ready to divest bution’s record date, you’ll receive
yourself of a poorly performing stock y Sell the security and immediately and be taxed on the full distribution
because, for example, you don’t think buy securities of a different company amount even if it includes significant
its performance will improve or your in the same industry or shares in a gains realized by the fund before you
investment objective or risk tolerance mutual fund that holds securities owned the shares. And you’ll pay tax
has changed, don’t hesitate solely for much like the ones you sold, on those gains in the current year —
tax reasons. even if you reinvest the distribution.
y Sell the security and wait 31 days
to repurchase the same security, or Small business stock
Plus, building up losses for future
use could be beneficial. This may y Before selling the security, purchase By purchasing stock in certain small
be especially true if you have a large additional shares of that security businesses, you can diversify your
investment portfolio, real estate equal to the number you want to portfolio. You also may enjoy prefer-
holdings or a closely held business sell at a loss, and then wait 31 days ential tax treatment:
that might generate substantial to sell the original portion.
future gains, or if tax rates increase. Conversion of capital loss to
Alternatively, you can do a bond swap, ordinary loss. If you sell qualifying
Finally, remember that capital gains where you sell a bond, take a loss and Section 1244 small business stock at
distributions from mutual funds can then immediately buy another bond a loss, you can treat up to $50,000
also absorb capital losses. of similar quality and duration from a ($100,000, if married filing jointly)
different issuer. Generally, the wash as an ordinary, rather than a capital,
Wash sale rule sale rule doesn’t apply because the loss — regardless of your holding
If you want to achieve a tax loss with bonds aren’t considered substantially period. This means you can use it to
minimal change in your portfolio’s identical. Thus, you can achieve a offset ordinary income, reducing your
asset allocation, consider the wash sale tax loss with virtually no change in tax by as much as 37% of this portion
rule. It prevents you from taking a loss economic position. of the loss. Sec. 1244 applies only if
on a security if you buy a substantially total capital invested isn’t more than
identical security (or an option to buy Warning: You can’t avoid the wash $1 million.
such a security) within 30 days before sale rule by selling stock at a loss in
or after you sell the security that created a taxable account and purchasing Tax-free gain rollovers. If within 60
the loss. You can recognize the loss only the same stock within 30 days in a days of selling qualified small business
when you sell the replacement security. tax-advantaged retirement account. (QSB) stock you buy other QSB stock10 Investing
claim will be able to withstand IRS
CASE scrutiny, carefully track and document
STUDY 4 How to qualify for the 0% capital gains rate
your time. Contemporaneous record-
keeping is better than records that are
Faced with a long-term capital gains
created after the fact.
tax rate of 23.8% (20% for the top tax
bracket, plus the 3.8% NIIT), Michael
and Jennifer decide to give some If you don’t pass the material partici-
appreciated stock to their adult son, pation test, consider:
Ian. Just out of college and making only
enough from his entry-level job to leave Increasing your involvement. If you
him with $25,000 in taxable income, can exceed 500 hours, the activity
Ian falls into the 12% ordinary-income no longer will be subject to passive
tax bracket and the 0% long-term activity rules.
capital gains bracket.
Grouping activities. You may be able
However, the 0% rate applies only to the extent that capital gains “fill up” the gap to group certain activities together
between Ian’s taxable income and the top end of the 0% bracket. For 2020, the to be treated as one activity for tax
0% bracket for singles tops out at $40,000 (just $125 less than the top of the
purposes and exceed the 500-hour
12% ordinary-income bracket). So if Ian sells the stock his parents transferred
threshold. But the rules are complex,
to him and his gains are $15,000, the entire amount will qualify for the 0% rate.
and there are potential downsides
The sale will be tax-free vs. the $3,570 Michael and Jennifer would have owed
had they sold the stock themselves.
to consider.
Warning: If Ian had been subject to the “kiddie tax” (see page 18), the results Looking at other activities. If you
would have been quite different. It’s also important to consider any gift tax con- have passive losses, one option is to
sequences before transferring stock. (See page 22.) limit your participation in another
activity that’s generating income, so
that you don’t meet the 500-hour test.
with the proceeds, you can defer the Keep in mind that all three of these Another is to invest in an additional
tax on your gain until you dispose of tax benefits are subject to additional income-producing trade or business
the new stock. The rolled-over gain requirements and limits. Consult your that will be passive to you. Under
reduces your basis in the new stock. For tax and financial advisors to be sure both strategies, you’ll have passive
determining long-term capital gains an investment in small business stock income that can absorb some or all
treatment, the new stock’s holding is right for you. of your passive losses.
period includes the holding period
of the stock you sold. To be a QSB, a Passive activities Disposing of the activity. This
business must be engaged in an active If you’ve invested in a trade or business generally allows you to deduct all
trade or business and must not have in which you don’t materially partic- passive losses — including any loss
assets that exceed $50 million, among ipate and where income or loss flows on disposition (subject to basis and
other requirements. through to your tax return, remember capital loss limitations). But, again,
the passive activity rules. Why? Passive the rules are complex.
Exclusion of gain. Generally, tax- activity income may be subject to the
payers selling QSB stock are allowed 3.8% NIIT (see page 11), and passive Even if you do pass the material
to exclude up to 100% of their gain if activity losses generally are deductible participation test, be aware that your
they’ve held the stock for more than only against income from other passive loss deduction might be affected by
five years. But, depending on the activities. You can carry forward the TCJA’s rules for deducting business
acquisition date, the exclusion may be disallowed losses to the following year, losses. (See “What’s new!” on page 14.)
less: The exclusion is 75% for stock subject to the same limits.
acquired on or after Feb. 18, 2009, and Income investments
before Sept. 28, 2010, and 50% for To avoid passive activity treatment, Qualified dividends are taxed at the
stock acquired before Feb. 18, 2009. you must “materially participate” in favorable long-term capital gains
the activity, which typically means you tax rate rather than at your higher
When the exclusion is less than 100%, must participate in the trade or business ordinary-income tax rate. Interest
the taxable portion of any QSB gain more than 500 hours during the year income, however, generally is taxed at
will be subject to the lesser of your or demonstrate that your involvement ordinary-income rates.
ordinary-income rate or 28%, rather constitutes substantially all of the
than the normal long-term gains rate. participation in the activity. But there So stocks that pay qualified dividends
(See Chart 3 on page 8.) Thus, if the are other ways to meet the material may be more attractive taxwise than
28% rate and the 50% exclusion apply, participation test. Plus, there are special other income investments, such as
the effective rate on the QSB gain will rules that apply to real estate. (See CDs and taxable bonds. But there are
be 14% (28% × 50%). page 13.) To help ensure your hours exceptions.Investing 11
Some dividends, for example, are sub- y Bonds (except U.S. savings bonds) The fact that a bond is exempt from
ject to ordinary-income rates. These with original issue discount (OID) federal tax doesn’t necessarily make it a
include certain dividends from: build up “interest” as they rise toward better choice than a comparable taxable
maturity. You’re generally considered bond. Municipal bonds, for example,
y Real estate investment trusts to earn a portion of that interest typically offer lower yields than compa-
(REITs), annually — even though the bonds rable corporate bonds. To make a fair
don’t pay this interest annually — comparison, you need to calculate the
y Regulated investment companies
and you must pay tax on it. tax-equivalent yield — which incor-
(RICs),
porates tax savings into the municipal
y Interest on U.S. government bonds
y Money market mutual funds, and bond’s yield — using this formula:
is taxable on federal returns but
y Certain foreign investments. exempt by federal law on state and
Tax-equivalent yield = actual yield /
local returns.
(1 – your marginal tax rate).
The tax treatment of bond income
y Interest on state and local govern-
varies. For example:
ment bonds is excludable on federal But you also need to consider factors
returns. If the bonds were issued in such as risk and how well each bond
y Corporate bond interest is fully your home state, interest also may will help achieve your overall invest-
taxable for federal and state be excludable on your state return, ment goals.
purposes. depending on the state.
Warning: Tax-exempt interest from
CASE private-activity municipal bonds can
STUDY 5 Can you deduct investment interest expense? trigger or increase AMT liability.
However, any income from tax-exempt
Frank borrowed to make some bonds issued in 2009 and 2010 (along
investments this year, and he was with 2009 and 2010 re-fundings of
wondering if the interest would be bonds issued after Dec. 31, 2003, and
deductible. So he consulted his before Jan. 1, 2009) is excluded from
tax advisor.
the AMT. And AMT is less of a risk
She told him that investment for most taxpayers now. (See page 3.)
interest expense — interest on
debt used to buy assets held for 3.8% NIIT
investment, such as margin debt Taxpayers with modified adjusted
used to buy securities — generally gross income (MAGI) over $200,000
is deductible for both regular tax ($250,000 if married filing jointly and
and alternative minimum tax (see $125,000 if married filing separately)
page 3) purposes. But special may owe the net investment income
rules apply. tax (NIIT) on top of whatever other
First, Frank’s investment interest
tax they owe on their investment
expense deduction would be income. The NIIT equals 3.8% of the
limited to his net investment lesser of net investment income or the
income, which, for the purposes amount by which MAGI exceeds the
of this deduction, generally applicable threshold.
includes taxable interest, nonqualified dividends and net short-term capital gains
(but not long-term capital gains), reduced by other investment expenses. Any Net investment income can include
disallowed interest expense is carried forward, and Frank can deduct it in a later capital gains, dividends, interest, passive
year against net investment income. business income, rental income and
other investment-related income. But
If his interest expense exceeds his net investment income, Frank may elect to it doesn’t include business or self-rental
treat all or a portion of his net long-term capital gains or qualified dividends as income from an active trade or business.
investment income in order to deduct more of his investment interest expense.
But if he does, that portion of the long-term capital gain or dividend will be taxed
Many of the strategies that can help
at ordinary-income rates.
you save or defer income tax on your
Frank’s advisor also explained that payments a short seller makes to the stock investments can also help you avoid
lender in lieu of dividends may be deductible as investment interest expense. or defer NIIT liability. And because
But interest on debt used to buy securities that pay tax-exempt income, such the threshold for the NIIT is based
as municipal bonds, isn’t deductible. Finally, she told Frank to keep in mind on MAGI, strategies that reduce your
that passive interest expense — interest on debt incurred to fund a passive MAGI — such as making retirement
activity — becomes part of his overall passive activity income or loss, subject plan contributions (see page 20) —
to limitations. (See page 10.) could also help you avoid or reduce
NIIT liability.12 Real Estate
Make the most of tax breaks for
your home and other real estate
here are many ways you can Home office deduction. Under the depreciate the portion of their home
T maximize the tax benefits
associated with owning a
TCJA, employees can no longer deduct
home office expenses, because of the
that’s used as an office, they can claim
mortgage interest, property taxes and
principal residence, vacation home or suspension of miscellaneous deductions casualty losses as itemized deductions to
rental property. The TCJA has limited subject to the 2% of adjusted gross the extent otherwise allowable, without
certain breaks, but the CARES Act income (AGI) floor. (See page 2.) But needing to apportion them between
provides some relief. Tax planning is the self-employed can still claim the personal and business use of the home.
also important if you’d like to sell your deduction, as long as their home office
home or other real estate this year. is their principal place of business (or Home rental rules
used substantially and regularly to If you rent out all or a portion of your
Home-related deductions conduct business) and that’s the only principal residence or second home
Consider these itemized deductions in use of the space. for less than 15 days, you don’t have to
your tax planning: report the income. But expenses directly
They can deduct from their self- associated with the rental, such as adver-
Property tax deduction. Under the employment income a portion of their tising and cleaning, won’t be deductible.
TCJA, through 2025, the property mortgage interest, property taxes,
tax deduction is subject to a $10,000 insurance, utilities and certain other If you rent out your principal residence
limit ($5,000 if you’re married filing expenses, and the depreciation allocable or second home for 15 days or more,
separately) on combined deductions to the space. Or they can use the you’ll have to report the income. But you
for state and local taxes (SALT). simplified method for calculating the may be entitled to deduct some or all of
(See page 2 for more details.) deduction — $5 per square foot for up your rental expenses — such as utilities,
Higher-income taxpayers owning to 300 square feet. Although taxpayers repairs, insurance and depreciation.
valuable homes in high-property-tax using this method won’t be able to Exactly what you can deduct depends on
locations have seen a huge drop in
the federal tax benefit they receive
from their property tax payments. WHAT’S CARES Act QIP correction
NEW!
increases deductions — retroactively
Mortgage interest deduction. You
Prior to the TCJA, qualified retail improvement property, restaurant property
generally can deduct interest on mort-
and leasehold improvement property were depreciated over 15 years under the
gage debt incurred to purchase, build
modified accelerated cost recovery system (MACRS). The TCJA classifies all of
or improve your principal residence
these property types as qualified improvement property (QIP).
and a second residence. Points paid
related to your principal residence also Congress intended QIP placed in service after 2017 to have a 15-year MACRS
may be deductible. Through 2025, the recovery period and, in turn, qualify for 100% bonus depreciation. Bonus depre-
TCJA reduces the mortgage debt limit ciation is additional first-year depreciation of 100% for qualified property placed
from $1 million to $750,000 for debt in service through Dec. 31, 2022. For 2023 through 2026, bonus depreciation
incurred after Dec. 15, 2017 ($500,000 is scheduled to be gradually reduced.
and $375,000, respectively, for separate
filers), with some limited exceptions. But the statutory language didn’t define QIP as 15-year property. So QIP defaulted
to a 39-year recovery period, making it ineligible for bonus depreciation.
Home equity debt interest deduction.
Through 2025, the TCJA effectively The CARES Act corrected this drafting error. Taxpayers that have made qualified
limits the home equity interest deduction improvements during the past two years can claim an immediate tax refund for the
to debt that would qualify for the home bonus depreciation they missed. Taxpayers investing in QIP in 2020 and beyond also
mortgage interest deduction. (Under can claim bonus depreciation going forward, according to the phaseout schedule. In
pre-TCJA law, interest was deductible some cases, however, it might be more beneficial to claim depreciation over 15 years.
on up to $100,000 of home equity debt
Warning: Under the TCJA, real estate businesses that elect to deduct 100% of
used for any purpose, such as to pay off
their business interest are ineligible for bonus depreciation.
credit card debt or to buy a car.)Real Estate 13
whether the home is classified as a rental
property for tax purposes (based on the WHAT’S CARES Act temporarily eases
NEW!
amount of personal vs. rental use): TCJA interest deduction rules
Generally, under the TCJA, interest paid or accrued by a business is deductible
Rental property. You can deduct rental
only up to 30% of adjusted taxable income (ATI). Taxpayers with average annual
expenses, including losses, subject to
gross receipts of $25 million or less for the three previous tax years generally
the real estate activity rules discussed
are exempt from the limitation. Larger real property businesses can elect to con-
at right. Property tax attributable to
tinue to fully deduct their interest, but then they’re required to use the alternative
the rental use of the home isn’t subject
depreciation system for real property used in the business.
to the SALT limit. You can’t deduct
any interest that’s attributable to your The CARES Act increases the interest expense deduction limit to 50% of ATI
personal use of the home. However, for the 2019 and 2020 tax years. (Special partnership rules apply for 2019.) It
you can take the personal portion of also permits businesses to elect to use 2019 ATI, rather than 2020 ATI, for the
property tax as an itemized deduction 2020 calculation, which may increase the amount of the deduction.
(subject to the SALT limit).
If these changes reduce your tax liability for 2019, you may be able to file an
Nonrental property. You can deduct amended return to receive a refund now.
rental expenses only to the extent of
your rental or other passive income.
Any excess can be carried forward to Real estate activity rules for the following improvements to
offset rental income in future years. You Income and losses from investment real nonresidential real property: roofs,
also can take an itemized deduction for estate or rental property are passive by HVAC equipment, fire protection and
the personal portion of both mortgage definition — unless you’re a real estate alarm systems, and security systems.
interest and property taxes, subject to professional. Why is this important?
the applicable limits. In some instances, Passive activity income and losses have For qualifying property placed in
it may be beneficial to reduce personal some negative tax consequences. (See service in 2020, the expensing limit
use of a residence so it will be classified “Passive activities” on page 10.) is $1.04 million. The break begins
as a rental property. to phase out dollar-for-dollar when
To qualify as a real estate professional, asset acquisitions for the year exceed
Home sales you must annually perform: $2.59 million. (These amounts are
When you sell your principal residence, adjusted annually for inflation.)
you can exclude up to $250,000 of gain y More than 50% of your personal
($500,000 for married couples filing services in real property trades or Other valuable breaks include bonus
jointly) if you meet certain tests. Gain businesses in which you materially depreciation and accelerated deprecia-
that qualifies for exclusion will also be participate, and tion. (See “What’s new!” at left.)
excluded from the 3.8% NIIT. (See
y More than 750 hours of service in Tax-deferral strategies
page 11.) To support an accurate tax
these businesses during the year.
basis, maintain thorough records, includ- It’s possible to divest yourself of appreci-
ing information on your original cost ated investment real estate but defer the
Keep in mind that special rules for
and subsequent improvements, reduced tax liability. Such strategies may even
spouses may help you meet the material
by any casualty losses and depreciation help you keep your income low enough
participation test. Warning: To help
claimed based on business use. Warning: to avoid triggering the 3.8% NIIT and
withstand IRS scrutiny, be sure to keep
Gain that’s allocable to a period of “non- the 20% long-term capital gains rate.
adequate records of time spent.
qualified” use generally isn’t excludable. Consider these deferral strategies:
Losses on the sale of any personal Depreciation-related breaks Installment sale. An installment sale
residence aren’t deductible. But if part Valuable depreciation-related allows you to defer gains by spreading
of your home is rented out or used breaks may be available to real them over several years as you receive
exclusively for your business, the loss estate investors. One such break is the proceeds. Warning: Ordinary gain
attributable to that portion may be the Sec. 179 expensing election. It from certain depreciation recapture is
deductible. allows you to deduct (rather than recognized in the year of sale, even if
depreciate over a number of years) no cash is received.
Because a second home is ineligible for qualified improvement property —
the gain exclusion, consider converting a definition expanded by the TCJA Sec. 1031 exchange. Also known as
it to rental use before selling. It can be from leasehold-improvement, restau- a “like-kind” exchange, this technique
considered a business asset, and you may rant and retail-improvement property. allows you to exchange one real estate
be able to defer tax on any gains through investment property for another and
an installment sale or a Section 1031 The TCJA also allows Sec. 179 defer paying tax on any gain until
exchange. Or you may be able to deduct expensing for certain depreciable you sell the replacement property.
a loss, but only to the extent attributable tangible personal property used pre- Discuss the limits and risks with your
to a decline in value after the conversion. dominantly to furnish lodging and tax advisor.You can also read
