As we come to the end of another year, the thoughts of families, business executives and entrepreneurs drift to tax preparation. The usual approach is to maximize deductions and postpone revenue recognition if possible. That extends to personal taxes as well, maximizing itemized deductions because that's the way to lower what you owe the I.R.S.
Roger Pine of Briaud Financial Advisors points out that some people could actually pay thousands more in taxes this way than they would if they deferred significant itemized deductions from this year to next. A simple example is that of a couple in a high tax bracket who itemize $5,000 in property taxes and $10,000 in charitable contributions. The current standard deduction for them would be $11,500. The couple does not have other itemized deductions, such as medical expenses or school tuition. Now let’s look at two scenarios played out over two years each. Obviously this is just one set of hypothetical circumstances; individual numbers will vary depending on a family's location, personal choices and other particulars.
In the first scenario, the couple opts to itemize deductions of the property taxes ($5,000) and charitable contributions ($10,000). The total deduction is thus $15,000 a year, or $30,000 for the two years.
In the other scenario, the couple is able to pay the property taxes for both years at once – perhaps by delaying the first year's taxes until the first week in January of the second year. (Be sure to check whether a delayed property tax payment means incurring a penalty; in some communities, it would do so.) And, of course, they can donate to charity at any time they wish, so they delay their normal contributions from the first year until January as well.
When reporting taxes, the couple can now take the standard deduction of $11,500 in the first year. In the second year, they take their total itemized deductions of $30,000. Their total deductions for the two years are now $41,500, rather than $30,000. According to Pine, at the 35 percent marginal tax rate, the difference would be $4,165 in savings. If the top tax rates go up as part of a deal to avoid the fiscal cliff – or if we go over the cliff – then the savings would be even higher.
On the other hand, if a cliff deal includes a cap on deductions, that could limit the benefits of such a strategy, or negate it altogether. If, for example, deductions are capped at $25,000 a year, the couple above would lose part of the benefit of deferring their deductions, but the strategy would still leave them ahead. Taxpayers with more than $18,250 in deductions in each year would lose out. It all depends on the final cap that Congress sets.
This may seem complicated or confusing, but a minute of thought explains why it works, at least for now. You can only either itemize deductions or take the standard one. By splitting their itemized deductions between two years, the couple effectively frittered away part of the effect of their deductions. By shifting all of the itemized deductions to the second year, they were able to reclaim the itemized deductions in the first year that they would have otherwise lost.
For this to work, you need flexibility in shifting deductible items into another year. That may not be possible with some items. For example, if you need medical attention in the first half of the year, the providers might not be willing to wait until the next year for payment.
This is a scenario that will typically require advanced planning, so you may not be able to implement it this year. Still, it is worth examining whether such an approach could work for you in the future – and it’s worth tracking how any fiscal cliff deal affects deductions.