While it may be a little early in the year for tax talk for some, I personally believe that it is never a bad time to plan or even talk about taxes. Today, I happened to see a tweet linking to an article on Kiplinger’s Website for a section called 10 Ways To Lower Your Taxes. I read it and was left wondering, first if the editors fact check this information since the author, Kimberly Lankford does not have anything regarding an accounting or tax background on her mini-bio (and no, I am not taking a shot at her personally) and secondly, why the entire story is not told about such deductions. Articles like these, whether in financial magazines or on blogs geared toward personal financial topics seem to be guilty of stating a deduction, and then summarizing them without going into full detail including the drawbacks and limitations. Below, I will mention just a few of the most common deductions that are mentioned which I feel need to be explained a bit further, and not all simply from a tax standpoint .
Selling off investments that have lost value: This is a very bad idea right from the start. The first reason is that you can only offset $3,000 of income after countering capital gains with the losses. It would make sense if the advice was to sell enough losers to first wipe out any gains you may have had, and then just enough to reach the $3,000 limit. You get no bonus points for carrying a loss forward, and there is no guarantee that you will even have any gains in the following years in order to use up and loss carry-forwards. Simply because you want to save a little bit on your tax bill now is a terrible reason to sell stocks or funds that are down. The second reason why it is a bad ideas is because there was a purpose behind investing in certain fund or individual stocks, and unless that purpose has changed, there is no need to dump it for a small benefit today. If the purpose of the purchase was because of the high dividend yield, then you will be giving up an even higher yield since the price is now lower but the rate is either the same or higher.
Giving to charities: This is another one that confuses me. To begin with, you can only take a deduction if you itemize, and that is a fact that escapes many people. If you are looking to lower your tax bill, especially if it is due to the fact that you need the extra money in the refund, then why would you spend money to save even less on your return? It is counter-intuitive. It is one thing to donate because you want to and can afford to, but if you are in such dire straits that you need to scratch and claw for every penny you can get back on your return then donating to charity is not the way to go about finding those extra pennies. Also, what many advice articles do not mention is that the IRS has established guidelines for what are reasonable amounts of donations based on income levels, and anything above those figures may flag the return for a potential audit. All will be fine if everything you reported is on the up and up (and not just when it comes to the donations), but if not you better be able to come up with a pretty good rationale for why you did report what you did or else face not only paying the tax that would have been due had the correct numbers been used, but also penalties and interest are attached. Worse yet, once you are audited and found to be guilty of falsifying your return or abusing certain privileges, you will then be on the IRS watch list, and no one wants to be in that position.
Prepaying mortgage : This is a simple one to explain. Very plainly, the IRS has established guidelines that state that a deduction can only be claimed for the portion of the expense that was allocated to the current year. In plain English that means if you pay your January mortgage in December, the 1098 will only contain the interest that was paid and applied up until December 31. If you report more and try to justify that you are including it due to the fact that you made the payment in the current year, guess what: you’re wrong. Since the interest portion of your payment was originally allocated to the next year, you are disallowed from claiming it early.
Real estate taxes: Another pretty simple one. You cannot claim any deduction unless it was paid in the current year. Everyone knows that the assessments are sent out in August or September and that the bill goes out in November, but just because you were issued a bill does not allow you the right to claim the deduction. You must have physically paid the taxes by December 31 of the current year in order to get the deduction. There is a bright side, however, and if for some reason you do not have the ability to pay that bill in the current year, you are permitted to claim the deduction in the following year when you do finally pay it.
Buying a home is a great tax write-off: I’m not sure where to even begin. Many people, particularly the frugal will tell you that buying a home simply for the mortgage and real estate tax deduction is a horrible idea. Beside the fact that you will generally take on a great deal of debt, certain other factors come into play. If you happen to buy into an area that has a homeowners association, or if you purchase a condo, you will have to pay association fees which are not deductible. Then you have guidelines by which you must follow in regard to upkeep and appearance such as: lawn maintenance, cleanliness of the sidewalks and roof, replacing damaged portions of the visible domicile (ie: driveway and roof). And, in order to even receive the deduction for the real estate taxes, you must (as was mentioned previously) actually pay them, and this is one of the top areas in which people underestimate or even exclude from their budget when considering a home purchase. If you can afford to do so, then a home certainly does provide many tax breaks, although the breaks alone do not justify making such a large investment.
College/post-secondary expenses: This may be one of the more difficult deduction to figure out, especially since there are multiple deductions to choose from and the rules are about to change. But one thing is very clear: not every expense is allowed in the calculation of qualified expenses. Tuition and associated fees are the only costs that are deductible, or to put it another way, only those costs that you pay to matriculate and sit in a class are deductible. So what does that leave as non-deductible? Well, pretty much everything else: Room and board (including meal plans even though most freshman are required to buy them) or costs of living (if off campus); transportation fees; student life fees (sports and activities fees); books, supplies and lab fees, insurance and medical expenses. Unfortunately, that is the way it is, and equally unfortunate is the fact that this distinction is often left out of the discussion on the topic giving taxpayers false hope for a large deduction.
Again, this is just a list of the more common deductions that are not often fully explained. Almost every deduction has limitations of some sort, but many of the other major ones get full attention when it comes to their discussion. The only thing you can do is to educate yourself to the best of your ability on the ones that apply to you, or pay an experienced professional to prepare your taxes and know that in most instances, they have a much better understanding of the tax code and will get you the deductions that you truly qualify to take and save you the risk of being audited by ignoring the ones that you have no business even going near.