1998 Tax Guide: Timing Income and Deductions

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Chapter 2
Timing Income
and Deductions
Year-end Tax Moves

1998 Tax Guide

Income is generally taxable to individual taxpayers in the year in which it is

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received. In general, a taxpayer may defer payment of tax by deferring receipt of the income. However, you cannot defer taxation by merely delaying receipt of the income if the funds are available to you and the time of payment is subject to your unrestricted discretion. Chapter 6 discusses the deferral of compensation through the use of various retirement plans and deferred compensation arrangements. If you operate a business or collect rental income and report that income on the cash receipts and disbursements method, you have the opportunity to delay or accelerate the billing to your customers or tenants and determine the timing of the related income.

Timing Your Deductions

Opportunities for reducing taxable income may be available by controlling the payment of deductible expenses. You may deduct certain expenses that are due for payment next year on your 1998 return if you pay them by December 31. This strategy helps you the most when you expect your marginal tax rate to be higher in the current year than in the next, because the rate differential makes the deduction worth more in the current year.

However, even if you expect your tax rate to be the same in 1998 and 1999, it may still be worth paying some expenses a few months early in order to gain the tax benefit a full year sooner. There may also be an advantage to reducing your 1998 tax because, if you pay 1999 estimated taxes based on your 1998 tax liability, this amount will also be reduced.

For example, if you pay a deductible expense in December 1998, instead of April 1999 when it is due, you will reduce your 1998 tax instead of your 1999 tax, but you will also lose the use of your money for three or four months. Generally, this will be to your advantage, unless you have an alternative use for the funds that will produce a very high return in that three- or four-month period. You need to decide whether the cash used to pay the expense early is needed for anything more urgent or more valuable than the accelerated tax benefit.

State Taxes. If accelerating deductions makes sense for you, you may consider prepaying and deducting 1998 state income and property taxes that would otherwise be due in the first three or four months of 1999. Paying the balance of your estimated state tax liability in December 1998 secures that deduction on your 1998 tax return, even though the payment might not be required by the state until January 15, 1999, or April 15, 1999.

AMT -- Caution. If you’re likely to have to pay alternative minimum tax, you may not want to accelerate your deductions for state and local income and property taxes. State and local taxes are not deductible in computing alternative minimum taxable income and, therefore, these deductions yield no benefit for you if you’re subject to AMT.

Prepaid Interest. Although a cash-basis taxpayer generally may deduct expenses only in the year they are actually paid, there is an exception for prepaid interest expense. A cash-basis taxpayer may not deduct prepaid interest before the tax year to which the interest relates. However, there is a small amount of flexibility in the ability to prepay year-end interest that is due early in the following year. For example, if a mortgage payment is due on January 10, a taxpayer can accelerate the deduction of the portion of the interest relating to the period up to January 1 by mailing the check by December 31.

The most significant interest deductions currently available are for home mortgage interest, including interest on up to $100,000 of home equity loans, and investment interest expense to the extent of current year investment income. (Note that interest paid in relation to investments that earn a tax-free return is not deductible.)
Medical Expenses. If the timing of certain of your medical and dental expenditures is flexible and if your overall medical expenses are high in the current year, you may want to accelerate payments of these expenses. Because medical expenses are only deductible to the extent that they exceed seven and one-half percent of adjusted gross income, it is best from a tax standpoint to incur expenses, such as replacement eyeglasses or contact lenses, elective surgery, dental work, and routine physical examinations, in a year in which you have already gone over (or the added expenses would take you over) the seven and one-half percent threshold.

Miscellaneous Itemized Deductions. Miscellaneous itemized deductions are a defined group of deductions that you can deduct only to the extent that they exceed two percent of your adjusted gross income. The potential advantage of accelerating miscellaneous deductions is the possibility that you’ll be able to go over the two-percent threshold. Therefore, you may want to bunch as many of these deductions as you can into one year, if as a result your deductions exceed the two-percent threshold.

AMT -- Caution. As with state and local taxes, miscellaneous itemized deductions are not deductible in computing alternative minimum taxable income. Thus, the acceleration of itemized deductions must be planned with alternative minimum tax consequences in mind.

Tax Credits. Tax credits provide another means to reduce your overall tax liability. As you consider the strategies discussed above, you should take into account the effect, if any, that the strategies may have on any credits available to you.

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