Traditional year-end tax planning incorporates a typically standard set of considerations, but remains far from a one-size-fits-all process. However, year-end tax planning requires accounting for the particular needs and circumstances of each individual or business.

Income shifting. Individuals and businesses alike can benefit from the classic strategy of shifting taxable income and accelerating or deferring deductions between 2008 and 2009 by controlling the receipt of income and payment of expenses. Taxpayers expecting to be in the same or lower tax bracket in 2009 should consider deferring income until next year and accelerating deductible expenses in 2008. Alternatively, if a substantial increase in income is anticipated in 2009 (propelling the taxpayer into a higher tax bracket), income should be accelerated in 2008 and deductions deferred until next year.

Accounting methods. The accounting method used by a business determines when income must be recognized and expenses may be deducted for tax purposes. Cash-based businesses can shift income to next year by delaying billing notices for services or products so that payment is not received until 2009. Accrual based businesses can defer income by delaying the shipment of products or provision of services until the 2009 tax year. Sudden changes from one accounting method to another to gain a year-end tax advantage are not permitted unless it is happenstance with a legitimate business reason for which the IRS gives its consent.

Business losses. Business loss deductions can be taken for bad debts; losses on the sale of business assets and net operating losses. If a business will have a bad year in 2008 but had profitable years in 2006 or 2007, a carryback of net operating losses when the 2008 tax return is filed will allow the business to apply for an immediate refund based on use of those losses. A carryforward of up to 20 years is also permitted.

Casualty losses.  Both individuals and businesses are also allowed deductions for casualty and theft losses; and capital losses. Deductions by individual taxpayers for those losses, however, are limited. Casualty losses are deductible only if deductions are itemized and then subject to both a $100 deductible per occurrence and a 10 percent adjusted gross income limitation.

Capital losses. Long-term capital losses can be used to fully offset long-term capital gains. Losses taken in excess of gains can also be used to offset up to $3,000 in ordinary income (or $1,500 for a married couple filing separately) for the 2008 tax year. Short-term losses can be used to offset short-term gains that are otherwise taxable at your ordinary individual income tax rate (which can reach as high as 35 percent). Unlike carrybacks for businesses, excess capital losses incurred by individuals may only be carried forward.

Temporary provisions ending in 2008:

Several tax incentives are set to expire at the end of 2008. These expiring tax breaks include:

50-percent bonus depreciation. The Economic Stimulus Act of 2008 provided businesses with 50 percent bonus depreciation of the adjusted basis of qualifying property. The property generally must be purchased and placed in service during 2008.

Enhanced expensing. The Economic Stimulus Act also increased the amount of deductible Code Sec. 179 expensing for 2008, and increased the threshold for reducing the deduction. For property purchased and placed in service in tax years beginning in 2008, businesses can expense up to $250,000 of Code Sec. 179 property, reduced by the value of the property over $800,000. However, these levels are set to decrease beginning in 2009 to $133,000 (with $530,000 phase-out limit).

Businesses not on a calendar year, should note that the higher expensing limits apply to tax years beginning in 2008. Their higher expensing under the new law does not start until their new fiscal tax year starts. For example, a small business on a June 1 - May 31 year would be limited for purchases for the year ending May 31, 2008 to a $125,000 deduction and a $500,000 threshold. The new $250,000/$800,000 amounts would kick in starting June 1, 2008 and continue through May 31, 2009.

Reduced homesale exclusion.  Gain from the sale of a principal residence will no longer be excluded from gross income under Code Sec. 121 for periods that the home was not used as a principal residence (i.e. "nonqualified use"). This new income inclusion rule applies to home sales after December 31, 2008 and, under a generous transition rule, is based only on nonqualified use periods that begin on or after January 1, 2009. Essentially, the new rule prevents use of Code Sec 121's exclusion of gain from the sale of a principal residence of up to $250,000 ($500,000 for joint filers) for appreciation attributable to periods after 2008 during which a residence was used as a vacation home or as a rental property before its use as the principal residence. Thus, this provision makes 2008 the last year for vacation-property conversions to avoid the new rule entirely.

Property tax deduction for non-itemizer. Also made available by the Housing and Economic Recovery Act of 2008 is an above-the-line deduction, for 2008 only, of up to $500 of real property taxes paid during the year. This gives non-itemizers a limited deduction for state and local real property taxes by increasing the amount of their standard deduction. This temporary deduction expires for individual homeowners on December 31, 2008.

New Provisions

Certain tax provisions appeared for the first time in 2008 and now need to be incorporated for the first time into year end planning. They include

Discharge of principal residence mortgage debt. The Mortgage Forgiveness Debt Relief Act of 2007 excludes from taxation under Code Sec. 108 discharges of up to $2 million of indebtedness that is secured by a principal residence and is incurred in the acquisition, construction or substantial improvement of the principal residence. While this special relief is available for three years beginning January 1, 2007, and ending December 31, 2009, its basis reduction provision works on a calendar year basis. Taxpayers who exclude indebtedness income under the principal residence exclusion under Code Sec. 108 are required to reduce the basis of their principal residence by the amount excluded from gross income.

First-time homebuyer credit. The Housing and Economic Recovery Act of 2008 gives first-time homebuyers a temporary refundable tax credit equal to 10 percent of the purchase price of a home, up to $7,500 ($3,750 for married individuals filing separately). The credit begins to phase out for taxpayers with adjusted gross income in excess of $75,000 ($150,000 in the case of a joint return). The credit is effective for homes purchased on or after April 9, 2008, and before July 1, 2009.  

"Extenders"

Congress is currently debating a package of extenders - temporary but popular tax breaks for individuals and businesses - that have expired, or will expire. The list of extenders is long. Among expired extenders likely to be renewed are:

• State and local sales tax deduction;
• Higher education tuition deduction;
• Teacher's classroom expense deduction; and the
• Research tax credit.

Nonbusiness creditors may deduct bad debts when they become totally worthless (i.e. there is no chance of its repayment). The proper year for the deduction can generally be established by showing that an insolvent debtor has not timely serviced a debt and has either refused to pay any part of the debt in the future, gone through bankruptcy, or disappeared. Thus, if you have loaned money to a friend or family member that you are unable to collect, you may have a bad debt that is deductible on your personal income tax return.

The fact that the debtor is a family member or other related interest does not preclude you from taking a bad debt deduction, provided that the debt was bona fide and that worthlessness has been established. A direct or indirect transfer of money between family members may create a bona fide debt eligible for the bad debt deduction. However, these transactions are closely scrutinized to determine whether the transfer is a bona fide debt or a gift.

Bona-fide debt and other requirements for deductibility

You may only take a bad debt deduction for bona-fide debts. A bona-fide debt is a debt arising from a debtor-creditor relationship based on a valid and enforceable obligation to repay a fixed or determinable sum of money. You must also have the present intention to seek repayment of the debt. Additionally, for a bad debt you must also show that you had the intent to make a loan, and not a gift, at the time the money was transferred. Thus, there must be a true creditor-debtor relationship.

Moreover, nonbusiness bad debts are only deductible in the year they become totally worthless (partially worthless nonbusiness bad debts are not deductible).

To deduct a bad debt, you must also have a basis in it, which means that you must have already included the amount in your income or loaned out your cash (for example, if your spouse has not paid court-ordered child support, you can not claim a bad debt deduction for the amount owed as this amount was not previously included in your gross income).

Reporting bad debts

You can deduct nonbusiness bad debts as short-term capital losses on Schedule D of your Form 1040. On Schedule D, Part I, Line 1, enter the debtor's name and "statement attached" in column (a). Enter the amount of the bad debt in parentheses in column (f). If you are reporting multiple bad debts, use a separate line for each bad debt. For each bad debt, attach a statement to your return containing the following:

•  A description of the debt, including the amount and date it became due;
• The name of the debtor, and any business or family relationship between you and the debtor:
• The efforts you made to collect the debt; and
• An explanation of why you decided the debt was worthless (for example, you can show the debtor has declared bankruptcy or is insolvent, or that collection efforts such as through legal action will not likely result in the debt being paid).

If you did not deduct a bad debt on your original income tax return for the year it became worthless, you can file a refund claim or a claim for a credit due to the bad debt. You must use Form 1040X to amend your return for the year the debt became worthless. It must be filed with 7 years from the date your original return for that year had to be filed, or 2 years from the date you paid the tax, whichever is later.