For most investors, income tax is not a hot topic during the Holiday season. This is a BIG mistake! December is actually the most important month to reduce your income tax for this year.
How come? Before I explain, let’s review four basic principles.
Rule A: Calendar rules
Your 2017 tax return will only reflect events that happened between January 1st and December 31st of 2017. Whatever happens in January 2018 will not matter. Examples: rent check received on January 1st of 2018 does not count. But neither does school district or HOA bill that you plan to pay next January – even if it is a payment “for 2017.” In other words, if you need to reduce your 2017 income taxes, do it in December!
Rule B: More is not always better
Because of that, every year I resolve to not over-eat at the holiday table. (Never works for me, though.) In business, over-indulgence is shown by chasing business write-offs. Let’s spend the money in December, so we can write it off on taxes. Smart? Not necessarily.
First, make sure that you will actually benefit from extra deductions. This is not automatically the case! And even if it is, sometimes you may still be better off by waiting.
Rule C: Taxes are only the tail
Minimizing taxes is a great objective, except when it leads to stupid business decisions. Never let taxes “wag the dog.” Getting into a lousy tax-free deal is far worse than paying taxes on a great deal.
Rule D: Change is the only constant
Especially when we deal with the Government. They keep changing the laws, so make sure you are aware of all the updates. Some of the recent changes directly affect investors, and more changes are on their way.
Now, let’s discuss this December business. What should you do today?
If I were writing for a national consumer magazine, I would’ve given you some simple (and wrong) “one-fits-all” answer. Unfortunately, being a responsible professional, I cannot do it. Why? Because every investor has a different tax situation. The exact same move can be very smart for Jenny, but a total disaster for Jimmy.
The good news: while I cannot give you specific answers, I can give you specific questions to discuss in December. By the way, when I say “discuss”, I do not refer to your equally confused business buddies. I hope that you will talk to somebody who understands taxes.
Paying property taxes
This can be a biggie. If you pay your 2017 assessments in December, your payments will count for 2017. If you wait until January, the money will not count until 2018. For most landlords, it’s better to pre-pay property taxes on your rentals in December. However, if we are talking about your own residence, the answer becomes more difficult. And even for investment properties, many complications exist. I wrote a separate post on this topic.
Warning for 2018: Trump’s tax reform includes fundamental changes to itemized deductions and doubling the standard deduction. Deferring deduction for property taxes on your own home into 2018 may backfire on you. If in doubt – pay now!
Paying other business-related bills
Remember Rule A: any bill you pay after December 31st will not help your 2017 taxes. This is true for any kind of payments – utility bills, vendor and contractor invoices, insurance, etc. On the other hand, do not forget Rule B: you do not always benefit from extra business deductions. Most importantly, check whether you generated enough taxable income in 2017 to need more deductible “offsets.” Keep in mind that certain expenses, particularly those related to rehabbing, may not be deductible until the property is rented or sold. In that case, paying the bills in December will not reduce your taxes anyway.
Paying personal bills
Rule B is essential here. Increasing your personal deductible expenses may or may not result in tax savings. For instance, charitable donations are only deductible when you’re able to itemize. Unfortunately, a lot of people cannot itemize: among them are renters and some high-income earners. When you want to deduct expenses such as medical bills and job search costs, you will discover additional limits that may kill all the expected benefits. The same is true for various other tax breaks, such as the credits for higher education and child care. Bottom line: your mileage may vary.
Buying “big ticket” items for business
Yes, I am talking about automobiles, too. There is no question that a big portion of (if not all) the cost can potentially be written off your taxes. There is, however, a question whether it can really be written off, under your specific circumstances. For starters, make sure you have enough taxable income to offset.
Closing on a new property
Before I say another word, let me refer you back to Rule C: Never ever make a business decision strictly based on tax considerations. Taxes should, of course, be considered – but only after business fundamentals are taken care of. That said, I should also mention that accelerating closing date into December for tax deductions does not always work. The starting date for all rental-related deductions (including depreciation!) is not the closing date. It is the date when the property is placed in service. Translation from the IRS-speak: if you bought a pre-foreclosure dump in December and will need another 2 months to bring this “dwelling” back into a rentable condition – you will still have almost nothing to write off in 2017.
Selling a property
While Rule C is 100% valid, selling is one case where tax considerations should be given more weight. The reason: the moment you closed the sale, you have to declare the income – unless, of course, you use self-directed IRAs or a 1031 exchange. With the income come capital gain taxes and depreciation recapture. If you are classified as a dealer, it’s even worse: you’ll be liable for much higher regular income tax plus possibly self-employment tax (which is, by the way, another frequent sign of poor tax planning). Further, “dealers” may be stuck with full taxes even when owner financing. Therefore, everything else being equal, delaying a sale into January may be wise. Always? By now, you should anticipate my answer: of course, not! At a minimum, you should compare your 2017 income with your projected 2018 income. And then refer to Rule C one more time.
Selling traditional investments
In today’s world, investments are typically sold at a loss. Deduction for capital loss is limited to $3,000 per year. From tax point of view, the best time to take a capital loss is in the same year when you need to offset some capital gain – such as from selling a property. Therefore, if you already sold a rental this year at a profit, and you are thinking about dumping a losing mutual fund – consider selling it in December rather than in January. (At this point, if you expect me to mention Rule C again – you are right! Thanks for paying attention!)
Contributing to a retirement fund
Surprisingly, this may not be urgent. In most cases (but not all), you can still put money in after New Year. One notable exception is your employer’s 401k plan. For that, you need to talk to your payroll department today. Tomorrow can be too late.
Converting to a Roth IRA
With the growing popularity of self-directed IRAs, many investors choose to convert their retirement savings into Roths. Unlike most other business decisions, this one is primarily dictated by taxes. And it is far from easy. If you still need another reason to hire a tax advisor – deciding on Roth conversion is not a “kitchen table project.”
Defeating the estimated tax penalty
Everyone who does not receive regular paychecks with automatically withheld taxes must pay estimated taxes four times a year. Very few people actually do pay these quarterly taxes. Many of those who don’t pre-pay are rewarded with the IRS penalties. If you (or your spouse) have a traditional W2 employer, you may be able to eliminate the penalty by making a larger-than-usual withholding from your December paychecks. Again, acting on this is extremely urgent: payroll departments are not known for their speed.
Any other major personal and financial decision
There is a tax aspect to almost anything: getting married, moving, changing jobs, starting businesses, taking classes, not to mention buying and selling! As Rule A says, tomorrow can be too late. The time to reduce taxes is now.
Accountants (at least the honest ones) cannot “rewrite the history” after the fact. You get ahead by planning ahead. As you know, the most successful Real Estate investors work smarter, not harder. Sitting down with your tax advisor in December is smart. Very smart.