Tax Strategies for Individuals

1. Maximize deductions. If you find you're not able to use all of your itemized deductions these days, you're not alone. Several of the deduction categories must meet thresholds before you can take any deductions. For example, you can only deduct medical expenses above 7.5% of adjusted gross income, miscellaneous and job expenses above 2%.

Many taxpayers feel they are “wasting” deductions because they don't meet the threshold levels. One way around this is to bunch deductions, timing your discretionary expenses so you exceed the threshold one year but not the next.

2. Minimize taxable income while saving for retirement. If you're an employee, make sure you are investing as much as you can afford in any 401(k) or similar deferred-income plan provided by your employer. Dollars put into these plans don't even show as taxable income on your W-2.

You can also reduce your current-year taxes by making tax-deductible IRA contributions, if you qualify.

If you're self-employed, use a Keogh plan, a SEP (simplified employee pension), a SIMPLE (Savings Incentive Match Plans for Employees), or a 401(k) plan to shelter income. You can also take advantage of these plans if you're employed, but have outside earnings from a sideline or home business.

3. Review investment strategies. If you are in the higher tax brackets, consider investing in tax-free instruments such as municipal bonds. Compare the return with the after-tax equivalent you could earn from taxable instruments of the same risk.

Remember, however, that tax consequences alone should never drive your investment decisions.

4. Check taxability of social security benefits. Social security recipients may benefit from strategies to reduce or defer taxable income. If your “provisional income” exceeds certain levels, it will trigger taxation on a higher percentage of social security benefits. Be sure to review the options available in your situation.

5. Be charitable. One excellent tax-saving strategy to consider is donating appreciated property. For example, you may own 20 shares of stock worth $50 a share that you bought several years ago for $5 a share. If you sold the shares, the $900 difference between the current value ($1,000) and your cost basis ($100) would be taxed as a long-term capital gain.

However, you can donate the shares to your favorite charity and take a deduction for the full $1,000 without paying any tax on the gain.

6. Shift income to your children. Take advantage of your child's lower tax rates by shifting income from you to your child. This can be done by making tax-free gifts to your children and investing the money in their names. Beware: For children under age 18, the “kiddie tax” can mean that some of your child's investment income is taxed at your highest tax rate.

If you have family-owned real estate or business interests, you might consider more sophisticated income-shifting techniques such as a family limited partnership.

7. Review your interest expense. If you are paying any interest that is not tax deductible (such as interest on auto loans or credit cards), consider paying off the debt, or convert it to debt that will allow for deductible interest (such as a home-equity loan, where available).

8. Pay attention to record keeping. Good record keeping can save taxes, particularly when you're determining gain or loss on the sale of mutual fund shares. Whether you make regular, periodic investments in mutual funds or simply make lump-sum deposits and reinvest all of the dividends, detailed records are imperative for determining your gain or loss. Good records and the right choice of cost-allocation method will minimize your tax bill.

The IRS recognizes three major methods of calculating the basis (cost) of the mutual fund shares you sell: (1) the first-in, first-out (FIFO) method, (2) specific identification of shares, and (3) the average cost method. Choose the right method to minimize your taxes.

9. Maximize your child care credit. If you and your spouse are both employed at full- or part-time jobs, make sure you get the maximum benefit from the child care credit. When calculating the credit, remember that you may be able to include the cost of day care, nursery school, babysitting, and summer day camp.

Tax Strategies for Homeowners

Be aware that important tax consequences are often associated with some fairly common events involving your home.

Home purchase. When purchasing a home, you may pay a portion of the mortgage interest in advance. This loan origination fee, or “points,” is a percentage of the total amount borrowed.

If points are paid for a principal residence, you generally can deduct the full amount in the year paid, even if the points were paid by the seller. One caution: you must reduce your home's tax basis (cost) by the amount of seller-paid points.

Of course, one of the greatest tax benefits of home ownership kicks in during the early years of the mortgage, when most of your payments go toward tax-deductible interest.

IRA withdrawals. The tax law allows penalty-free IRA withdrawals, up to a lifetime limit of $10,000 for the purchase of a first home for you or members of your family. Withdrawals from Roth IRAs for qualifying first-home expenses can be both penalty- and tax-free (after the Roth is five years old).

Refinancing. What happens if you refinance? If you pay points, the general rule requires that you prorate deduction over the life of the loan. But if some of the refinance proceeds go toward home improvements, you may be able to take a current deduction for the portion of the points related to those improvements.

Improvements. If you take out a loan to make substantial improvements to your principal residence, and the loan is secured by that property, the interest is generally deductible. To the extent that remodeling increases the value of your property, the property's basis will increase, potentially reducing capital gains tax if a future sale is partially or fully taxable.

Home office. The home office deduction can be another tax break of home ownership. If you use part of your home regularly and exclusively as a principal place of business, you may be able to deduct costs associated with that part.

Home sale. When you sell a home that you have owned and used as your principal residence for at least two of the five years before the sale, you can generally exclude from taxation up to $250,000 of profit if you're single and up to $500,000 if you're married filing jointly. Profits in excess of those amounts are subject to regular capital gains rates and rules.

The definition of “principal residence” includes not only the conventional single family house, but also such homes as house trailers, mobile homes, houseboats, condominiums, cooperative apartments, and duplexes.

Selling at a loss. Unfortunately, if you sell your home for less than you paid for it, you may not take a tax deduction for your loss.

Should You Invest in Rental Real Estate?

If you want to make a profit by investing in rental real estate, you must be willing to commit more resources to this property than you would to an investment made at your bank, through a broker, or in a mutual fund.

Someone has to collect rents, find good tenants, and maintain the property. If you hire help to do these tasks, your profit shrinks.

Also, if you borrow money to buy the property, you have to pay the mortgage whether or not the property is rented. You should have emergency funds so that you will not lose the property to foreclosure if you lose your tenant.

If you decide to invest in rental property, you may need professional help to match your resources to property that will meet your goals. Some of the questions you should consider before you invest:

What can you afford? Determine the highest price range you can sustain, given your present resources and the projected cash flow from the property.

Is the property fairly priced? Get a list of comparable listings and recent sales from a real estate company. Make any purchase offer contingent on the results of structural and pest inspections. Check local records to verify that additions and major improvements were made in compliance with building codes.

Are there any restrictions on the property? Rent control will lower the price that you can afford to pay for a property.

Who will be your tenants? Evaluate the likelihood of nonpayers, transients, and untidy housekeepers – and adjust your price accordingly. If you are buying a condominium in a building populated with young people, you may find it difficult to interest a retired couple (if that's your market) in living in the unit.

Investing in rental property can be very profitable, but you should be fully informed before you invest, or you could end up with more work and less return than you anticipated.