It seems that one can do some post year-end tax planning to avoid loss of some state income tax deductions due to AMT. By paying additional state estimated taxes between Jan 1 and Jan 15, one has the potential of shifting a non-deductible tax payment in 2007 to a deductible one in 2008. Example clarifying follows. Does anyone see a problem with this?
Suppose for 2007 one has paid to state $5K, and one's state income tax is $5K (no refund, no payment due). Suppose also that for AMT purposes, $1K is non-deductible - that is, if one had only paid in $4K, then ordinary income tax = AMT tax (so no additional amount would have been owed due to AMT). But the final $1K reduces the ordinary income tax below AMT tax, and is thus useless.
Suppose the person pays an early Jan estimate of $1,250 (toward 2007 taxes). The state will refund $1,250 (excess payment). The IRS will prorate that refund: 4/5 is attributable to 2007 (since 4/5 of the $6250 paid in was paid in 2007), and 1/5 ($250) is attributable to 2008.
Of the $1250 payment in 2008, the IRS will regard $250 as a wash (paid in in
2008, refunded in 2008). It will regard the other $1000 as a true tax refund. Even though the person itemized and tried to deduct that $1000, it had no effect on taxes; that means that the person did not benefit from the deduction, and thus the $1000 refund is not taxable in 2008 (the same reasoning as if one had taken a standard deduction).
Net result - the taxpayer gets to deduct $1000 of taxes on the 2008 return, with no taxable income generated by the refund, and no out-of-pocket expenses (the taxpayer paid in $1250, but got it back from the state a couple of months later).
Of course this could all be an exercise in futility if the 2008 taxes are also in the AMT range, but at least it preserves the possibility of getting the deduction. Any problems with this strategy?
Thanks, Mark Freeland snipped-for-privacy@sbcglobal.net
If I understand you correctly, this is completely wrong. For a cash basis taxpayer, there is no proration.
It is possible that due to AMT, a state tax refund will not be fully taxable as a recovery of a deductible amount in the *previous* year. If the deduction and the recovery are in the *current* year, then the whole thing is a wash. Again, there is no allocation of refunds across tax years.
More likely, the taxpayer gets a $1,250 deduction in 2008 and a $1,250 taxable refund in 2008 -- net result zero.
Yes, if subject to AMT in 2008, it is an exercise in futility.
Why would it be a wash, even if there were no allocation of refunds across tax years?
The hypothesis was that in 2007, one paid in exactly the correct amount, and in Jan 2008, one made an exta payment toward 2007 state taxes. As you note, because of AMT, the refund might not be taxable (at least in part, though I believe it could be fully nontaxable under the right circumstances).
Let's stick with the numbers for clarity. You pay in an extra $1250 in Jan. Suppose only part of the refund is non-taxable, say $250 is non-taxable. So, in 2008 (current year), you get a $1250 deduction, and a recovery of of $1250, including taxable income of $1000. You've effectively generated a net $250 worth of deductions. Is that a wash?
The instruction for 1040 line 10 (1099-G tax refund) says, on p. 20, that if "you made your last payment of 2006 estimated tax in 2007" you cannot use the worksheet, and must go to Pub 525 (Itemized Deduction Reduction section).
Going to Pub 525, p. 21, we have: "If you receive a refund ... that is for amounts you paid in 2 or more separate years [e.g. 2006 and Jan 2007], you must allocate, on a pro rata basis, the recovered amounts between the years in which you paid it."
The example following demonstrates the pro rating, and further points out that the amount allocated to the current year (2007) reduces the deduction you take for that Jan 2007 payment.
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will take you exactly to paragraph quoted and example follows immediately)
So, you're saying, there *IS* an effective allocation of refunds across tax years, if you are subject to AMT in the first year but not the second?
I guess this would be analogous to deferring ordinary taxable income to Year 2 by making very large estimated state tax payments in Year 1, if the taxpayer guessed th3y would be in a lower ordinary tax bracket in Year 2 despite the taxable state tax refund...
The difference is that what I'm suggesting can be done after the fact - there's no guessing (worst case, one is subject to AMT both years, and that would indeed be a wash). Otherwise, I agree that the deduction shifting is somewhat analogous to this income shifting.
A cash basis taxpayer gets to deduct the $1250 he paid in January 2008 as a 2008 payment. The refund is also a 2008 event. Everything works purely by the calendar year in which it takes place.
Now, if he had only $4,000 withheld (or estimated) in 2007 (and owes $5,000), whether he pays the estimated in 2007 (and gets no benefit due to AMT) or 2008 (and maybe gets a benefit) does make a difference. That's because the payments occur in different years.
Why is that? The part of the refund that doesn't affect 2008 taxes is non-taxable; for that to happen, the taxpayer is either paying AMT for
2008, or has low enough deductions to use the Standard Deduction.
"After the fact" equals two weeks max, plus the cost of a free loan to the state government of a month or more. By comparison, a deductible contribution to an IRA can happen up until the normal filing deadline (April 15). So if it is indeed a loophole, I'd argue it's a small one...
Right reasoning, wrong year. What determines whether a refund in 2008, of
2007 state taxes, is taxable (in 2008) or not is 2007's tax situation, not the 2008 tax situation.
Simple case first - forget about AMT. Suppose a taxpayer takes a std deduction in 2007 and gets a state tax refund in 2008. That tax refund is nontaxable, because it didn't affect the 2007 taxes. Doesn't matter what the tax situation is in 2008.
(Pub 525 - "If you did not itemize deductions for the year for which you received the recovery of an expense that was deductible only if you itemized, do not include any of the recovery in your income."
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- example with income tax refunds follows text immediately) If 2007 (not 2008) taxes were subject to AMT, the same logic applies - to the extent that one received no benefit (reduction in fed tax) from the payment of state income taxes in 2007, the refund of those payments is not taxable.
(Pub 525 - "If you were subject to the AMT in the year of the deduction [2007], you will have to recompute your tax for the earlier year [2007] to determine if the recovery [tax refund] must be included in your income. This will require a recomputation of your regular tax [for 2007] as shown in the preceeding example, and a recomputation of your AMT [for 2007]. If inclusion of the recovery [refund amount] does not change your total tax [for 2007], you do not include the recovery in your income [for 2008].)
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- take a look at the referenced example to ensure I inserted years correctly - the example uses 2006/2007 rather than 2007/2008, but the idea is the same. The quoted section goes on to say that if, after adding back the refund to your 2007 income your 2007 tax goes up, then you received a benefit from the deduction, and only part of the refund is non-taxable. Again, this has nothing to do with whether 2008 is subject to AMT.
Using the numbers in my original example, the taxpayer paid in $1250 and recovered a $1000 deduction, worth about $250. That seems like a pretty big benefit for "lending" the state $1250 for a month. (Of course, the one thing speculative is whether the deduction has any value - depends on whether taxpayer will be in AMT in 2008.)
A few posts earlier, you stated the benefit would be a net $250 deduction (approx. $62 tax savings). As you said, you still have taxable income of $1,000 which washes out $1,000 of deduction. Here is your statement:
For me it boils down to two things:
Does it work?
Is it something to get excited about?
As for (1), I can see in principle how it *might* work -- in layman's terms, you have an expense in Year 1 which is partly deductible and partly non-deductible. By artificially "inflating" the expense payment into Year 2, you are "dragging" a portion of the non-deductible Year 1 expense into Year 2, where it might be deductible.
On the other hand, Pub 525 clearly states: "Recovery and expense in same year. If the refund or other recovery and the expense occur in the same year, the recovery reduces the deduction or credit and is not reported as income." So, I still question whether the $1,250 paid and then refunded in Year 2 isn't still just a wash, neither deductible nor taxable. (You are claiming that the $1,250 refunded in Year 2 is only partly due to the Year 2 payment, with the remainder due to Year 1 payments).
As for (2), it sure seems like a lot of work for a very uncertain gain. Also, I have been told anecdotally that this type of "playing around" with large and clearly unnecessary estimated state tax payments may attract unwanted attention from state taxing authorities.
What I said in that later text you are quoting (as I felt the issue of whether the whole refund or only part was non-taxable was a distraction) was: "_Suppose_ only part of the refund is non-taxable." A new/changed hypothesis.
Under the original hypothesis, the refund was fully non-taxable, though only $1000 of it was deductible (the remaining $250 being a 2008 refund allocated to a 2008 payment, thus a wash).
We are going around in circles here. I'll repeat the numbers, and fill in a few more to leave little to the imagination.
2007 AMT total tax (6251, line 31): $15,005
2007 State taxes (Sch A, line 5): $5K No deduction phaseout (Deduction worksheet, p. A-10, line 7 = 0)
2007 Total deductions (1040 line 40): $15K
2007 1040 AGI (1040 line 38): $91,701
2007 exemptions (line 42): $3400 (single filer)
2007 taxable income (line 43) $73,301 (AGI - exemptions - deductions)
2007 tax (excluding AMT): $14,755 (from tax table)
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No capital gains/qualified income, no credits - straight tax table lookup for total tax.
With these numbers, one could have deducted $1,000 less and still owed the same amount (because that would make line 43 $74,301 and the tax $15,505; the same as the AMT tax).
The refund of $1250 is allocated as $250 to 2008 and $1000 to 2007. The Pub
525 cite, again, is
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The $1000 portion allocated to 2007 is non-taxable, because taxpayer did not benefit from its deduction (as demonstrated above). Pub 525 citation for non-taxability of recovery when no benefit received is:
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Under my original hypothesis, I'm dragging _all_ of the non-deductible Year
1 expense into Year 2 - doesn't change affect your agreement that this works, though it amplifies the potential impact. (My original hypothesis was that $1K was non-deductible in year 1, the figures above show how that can happen, and I've demonstrated how to drag $1K into year 2).
I'm not the only one claiming it. So is Pub 525. Read the Pub 525 lines and example immediately following the two lines you quoted. See cite above for link. The example given in the Pub is the same situation as above: you make 4 equal quarterly estimates, the last one in Jan. And it calls that "Recovery for 2 or more years".
Only the work in this post is a lot. Writing a cheque is no work at all. :-)
Frankly, I'd be more inclined to expect IRS scrutiny, since the fed (may) lose taxes. The state won't care - as you noted, it gets a free "loan" of money, and the taxes owed to the state don't change.
The final payment doesn't have to be any larger. Again, just go back to my example. $5K paid in 3 estimated payments ($1666.67/payment). I'm suggesting a fourth payment that is _less_ ($1250).
Well, you started by asking, "anyone see any problems?" -- I haven't been able to shoot this down. Maybe someone else can...(after all, there's always the tax code to explore -- reading the IRS pub, I can't help but wonder if this situation isn't the result of some court case).
Then I step back and look at the "big picture", (as if there is one!):
Q. Why does this work with estimated state tax payments, but not other payments, such as real estate property tax?
A. Unlike most tax payments, deductible state estimated income tax payments are self-determined, not billed by a governmental agency. You decide when and how much to pay. Also, income taxing authorities require quarterly payments but only offer annual refunds, so this is what I'd call an "arbitrage" of the difference.
Q. Is this unique to the situation where there is an AMT liability in Year 1 but not Year 2?
A. No, I can't see why. Any similar "reduction" in overall tax rate from Year 1 to Year 2 would benefit from the same treatment, such as itemized deduction limitations, zero tax liability before all credits are used, loss carryovers, etc.
Sometimes a deduction is worth more in a higher-tax-rate year, sometimes more in a lower-tax-rate year...
it has long been known that one can prepay their second property tax installment before year end to shift that expense into the current year, if that helps with tax planning. It has also long been known that a business operating as a cash basis taxpayer can elect to postpone payment of certain expenses to shift them into the subsequent tax year, it that helps with tax planning. etc., etc. Of course the same could hold true for estimated state income taxes, that has been well known for a long time. The kicker is the AMT, and how you plan with this in mind. It is another layer of complexity, but the concept is the same.
So does the following summarize the net benefit of your scheme? Assuming that in 2008 your income is below the AMT limits, you'll get to deduct $250 in 2008, saving you about 25% or $62.50.
One thing I'm confused about is that you only get your refund check for year N in year N+1, so how can you file your taxes correctly for year N. The last payment of $1,250 was made on 1/15/2008, and the refund of $1,250 would probably arrive on 6/30/2008. Yet this refund is needed for 2007 federal return line 10 (taxable refunds, credits, etc) which is due on 4/15/2008. I see that in this example you are allocating $1,000 of the refund to 2007 but it is also deductible and there is no phaseout of the itemized deduction, so you won't bother reporting the refund on line 10, or the deduction in Schedule A. But what if you are subject to the itemized deduction phaseout? Do you then have to file an amended return?
This got me to thinking about another scenario. Namely Scheule A asks you for the state and local income taxes paid (line 5), not the amount due.
Suppose your income in 2007 is very high and you are in AMT, but in
2008 your income is expected to be lower. This could happen if you receive a large lump-sum payment in 2007 from a lawsuit payment, winnings on a TV show, etc.
If for 2007 your state tax due is $20,000 and you pay it all like a good citizen, you get to deduct all $20,000 on Schedule A saving you about 33% or $6,600, but the AMT causes you to add back 28% or $5,600, and the net deduction is $1,000, although there will be some phase out and the actual deduction will be less. BTW, in 2008 and 2008 the phaseout will be 1/3 of the original phaseout (by the 2000 rules), and in 2010 the phaseout will vanish.
But suppose in 2007 you paid only $10,000. You pay the remaining $10,000 plus penalties (probably around $500) in 2008. And throughout year 2008 you also pay your usual state tax, which suppose is $10,000. Suppose that in 2008 you are not subject to AMT. So you get to deduct $20,500.
The net result: In the scheme where you pay your state tax in full, you reduce your taxes by $1,000 in 2007 (33-28=5% of $20,000), and $2,500 (25% of $10,000) in 2008. In the scheme where you underpay your state tax, you reduce your taxes by $500 in 2007 (5% of $10,000), and $5,125 (25% of $20,500) in 2008, which is $2,125 net.
Rather the opposite. You pay a 4Q estimate of $1250 (Jan 2008). As a result, you get a $1250 refund. Since $250 of that is allocated to 2008, it cancels out $250 of the 4Q estimate. That leaves you with $1000 to deduct on your 2008 taxes for your 4Q estimate. You save 25% of $1000, or $250.
Nothing special here. You always get your refund for last year's taxes this year. See more below - case (a).
See the instructions for line 10 (p. 20). If you received a refund in 2008 for overpayment of your 2007 state taxes, then you declare the refund (assuming it is taxable) on your 2008 tax return.
The taxpayer pays in, toward 2007 state taxes, $5000 in 2007, and $1250 in
2008. The refund is allocated proportionately. So the IRS says that:
a) You paid $5K in 2007 and got a $1K refund of this amount in 2008 b) You paid in $1250 in 2008 and got a $250 refund - this is treated as though you simply paid in $1K in 2008 (same year, the amounts are netted out).
(a) is the usual case - pay taxes in year N, get refund year N+1. The $1000 refund is taxable in year N+1 (here 2008), only if you got some benefit by deducting that amount in year N (2007). For example, if you took a standard deduction in 2007 the refund in 2008 would not be taxable in 2008. Or in the situation I described, because of AMT, the "deduction" of $1000 did not reduce taxes in 2007. So again, the refund is not taxable.
(b) simply says that, net, you paid $1000 in taxes in 2008. So you get to deduct that on your 2008 return.
See above. The point of the exercise is to report the deduction on Schedule A (2008) _without_ reporting the refund as income.
What you get in 2008 (the refund) stays in 2008. The only question is whether that income is taxable - reportable on line 10.
So long as AMT tentative minimum tax (6251) is greater than your "ordinary" income tax, you get no benefit from deductions.
Reduce your deductions until your ordinary income tax rises to the level of the tentative minimum tax. The deductions that you eliminated were worthless. Further deductions are worth 33% (assuming you are in the 33% tax bracket). The AMT tax rate doesn't come into play here.
For example...
Suppose you had only ordinary income (including your lottery winnings) of $250K, and deductions/exemptions of $25K (disallowed for AMT).
Then your ordinary tax would be $60,318.25 (tax rate tables - Sched X - single) Your tentative min tax would be $63,707 (on $250K, as a single).
If you had reduced deductions by $10K, then you'd recompute your ordinary income tax on $235K, and get $63,618.25. In this case, you'd pay the slightly higher tentative minimimum tax. But if you reduced your deductions more, your ordinary tax would be higher than the tentative min tax, so you'd pay your ordinary income tax.
In other words, the value of the second $10K of deductions is (approx.) 0, the value of the first $10K of deductions is $3,333.
The instruction on p. A-2 for deducting state and local income taxes says "Do not include penalties or interest". So I'd guess you could only deduct $20,000.
See above.
If you deduct $10K less in 2007, and $10K more in 2008, then best case, you don't pay any more taxes in 2007 (because you're still paying the tentative minimum tax, and not more), and you get an extra $10K deduction in 2008 (worth $2,500).
This is pretty conventional shifting of deductions. Whenever possible, take deductions in the year where your effective marginal tax rate is highest. In the example above, the effective marginal rate on the first $10K of deductions is 33% in 2007 and 25% in 2008, so you want to pay that first $10K of taxes in 2007. The effective marginal rate on the second $10K of deductions is 0 in 2007 and 25% in 2008, so you want to pay the second $10K of taxes in 2008.
Of course, I've rigged the example (blind luck, I admit :-). Had the income been significantly higher, then you'd have no benefit from any deductions in
2007, and it would be to your advantage to shift all tax payments into 2008 if possible.
Note that states expect you to pay estimates somewhat evenly, but so long as you met your 100%/110% requirement on schedule (even payments), you wouldn't have to pay anything extra until you filed your taxes. No 1/15 deadline. You could pay the taxes on your winnings as late as April 2008. That's still being a good citizen - following the rules.
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