"People need to be proactive," says Janet Hagy, a certified public accountant in Austin, Texas. "By December, it may be too late."
Income and estate taxes underwent seismic shifts in January, rearranging the landscape for many taxpayers. Wealthy Americans in particular are facing higher tax rates on ordinary and investment income.
That makes it all the more important to review Uncle Sam's highest-impact tax breaks, such as donations of appreciated assets, tax-free exchanges and capital-loss harvesting.
Unlike obvious moves, such as contributing to an individual retirement account or a 401(k) plan, these strategies require a higher degree of awareness and active planning. "It's easy to write a check to charity," says Jeffrey Porter, a CPA in Huntington, W.Va., "but often it's a better idea to give stock that has risen in value."
Some investors already have begun to take advantage of these moves. Scott Saunders, an investment real estate specialist at Asset Preservation in Palmer Lake, Colo., says he has seen a spike in tax-deferred "like-kind" exchanges of residential rental and commercial real estate in the past six months.
In one case, an investor with a $1 million property in Brooklyn, N.Y., exchanged it for two in upstate New York and a third in Queens, N.Y., instead of selling outright. The move deferred federal tax of about $225,000, plus state taxes, Mr. Saunders says.
"People are surprised at how much the new taxes will take, so they're looking for alternatives," he adds (see the Family Value column on page B8 for a tax strategy using trusts).
Not all high-impact breaks are for the wealthy. Any homeowner can benefit from a provision allowing taxpayers to pocket tax-free income from renting a residence for as long as two weeks, and low-bracket taxpayers can pay zero tax on long-term capital gains.
Other important moves can help minimize estate, gift and inheritance taxes. This might seem like a less-urgent task now, since Congress approved in January a generous gift-and-estate tax exemption of $5.25 million per individual that is indexed to inflation. But there already is a proposal to scale back the exemption to $3.5 million.
What's more, 20 states and the District of Columbia have their own estate or inheritance taxes, according to tax publisher CCH, a unit of Wolters Kluwer WTKWY +0.33% . Many of them have exemptions far below the federal level: $1 million in Minnesota, Massachusetts, Maryland and New York, for example, and $675,000 in New Jersey.
Here are some tax strategies that could deliver big benefits.
Capital-loss harvesting. This break—beloved by the superrich, including Mitt Romney and Michael Bloomberg—can be helpful for all investors with taxable accounts. Losses from one investment can be used to offset gains on another. A loss on the sale of stock can be applied against gains on the sale of real estate, for example. Up to $3,000 a year can also be deducted against ordinary income such as wages.
After a sale, capital losses "carry forward" until the investor has gains to offset. Smart taxpayers sold losing assets during the 2008 financial crisis and then bought them back, capturing the losses for use against future gains.
Be careful, though, to avoid a "wash sale," which occurs when you buy shares 30 days before or after selling losing shares of the same investment. It diminishes the strategy's benefits.
Capital-gains harvesting. Although the total tax rate on long-term investment gains rose sharply this year for top-bracket taxpayers—to nearly 25% from 15% in 2012—the rate on gains for low-bracket investors is still zero.
The rate is available to married couples with taxable income below $72,500 this year ($36,200 for singles), which doesn't include tax-free municipal-bond income. Taxpayers who qualify can sell appreciated assets (such as shares) to "scrub" gains and lower future tax bills.
For example, a couple with $50,000 of taxable income could take up to $22,500 of profits on stock tax-free and then buy back the shares immediately. (Sales at a gain aren't subject to wash-sale rules.)
The couple still owns the stock, but future gains will be measured from a higher starting point, or "cost basis," so future taxes will be lower.
Like-kind exchanges. In this strategy, investors trade one investment for another without owing federal tax. Instead, tax is deferred until the replacement asset is sold. If the taxpayer holds the asset until death, no tax might ever be due (see "Step-up at death" below).
The rules are more restrictive than those on capital losses, however, and getting expert help is a good idea.
According to Mr. Saunders, most types of investment real estate can be traded for other real estate (other than a residence), but they can't be traded for personal property—as in a building for art. Still, certain investment collectibles can be traded for one another, he says.
Two-week home rentals. The income from renting a residence for less than 15 days is tax-free, and it doesn't have to be reported on your tax return. This is a boon for people living near the site of the Super Bowl or another major sports event, and it also works for owners of second homes who want to rent short-term.
The tax-free perk is often called the "Masters' provision," because homeowners use it during the famed golf tournament in Augusta, Ga.
"Even people with modest homes get a boost," often earning between 15% and 25% of a year's mortgage payments, says Bill Woodward, a CPA at the Elliott Davis firm in Augusta. Many homeowners pocket from $6,000 to $30,000, he adds.
Home-sale benefit. As often as every two years, taxpayers can sell a principal residence (not a second home) and the profit will be tax-free—up to $500,000 for married couples or $250,000 for singles. A surviving spouse gets the full $500,000 break for up to two years after a spouse's death.
Because the profit doesn't include the purchase price or improvements, most home sales in most areas will be tax-free. For more information, see IRS Publication 523.
Charitable donations of appreciated assets. The tax code offers a great boon to philanthropic Americans. Within certain limits, taxpayers who donate appreciated assets to charities can deduct the fair-market value of the gift and skip paying capital-gains tax on the appreciation.
For example, say a taxpayer wants to give $1,000 to her college. If instead of cash she gives $1,000 of stock that she bought for $500, she won't owe tax on $500 of profit but can take a deduction for the full $1,000.
Charitable IRA rollover. Individual retirement account owners who are at least 70½ years old are allowed to donate as much as $100,000 of account assets directly to one or more qualified charities and count the gift as part of their required annual withdrawal.
While the taxpayer doesn't get a deduction for the gift, neither does it count as income. This popular move also can help reduce a taxpayer's adjusted gross income, which in turn can help minimize Medicare premiums or taxes on Social Security benefits.
Solo defined-benefit pension plan. With this strategy, taxpayers can deduct contributions of tens of thousands of dollars or more to a tax-sheltered retirement plan—as long as they are in the fortunate position of having their own consulting firms or other solo business, plus a steady stream of income they don't need to tap immediately.
The rules are especially generous to older workers, who often can set aside large sums to reach a goal quickly. But the plans, which must be custom-designed, aren't simple. Lisa Germano, president of Actuarial Benefits & Design in Midlothian, Va., estimates the setup cost of a solo plan at about $3,000.
529 plans. These popular college-savings accounts can help save on both income and estate taxes. There isn't a federal tax deduction for money going in, but asset growth and withdrawals are tax-free if used for qualified education costs.
Plans are sponsored by U.S. states, some of which give a state tax deduction for contributions. Some have lower fees and better investment options than others, so choose carefully.
Three features make 529 plans especially attractive. First, owners can change beneficiaries, so if one child doesn't need all the money, a relative can use it. In addition, owners can bunch up to five years' worth of $14,000 tax-free gifts to the plans. President Barack Obama and his wife Michelle used this break several years ago.
Finally, owners such as grandparents who don't want to owe estate taxes but also worry they might have unexpected costs, such as for health care, have a useful option. Although 529 contributions remove assets from an estate, the giver can take back account assets if the money is needed.
Annual gifts of $14,000. The law allows any taxpayer to give anyone else—a neighbor, friend or relative, say—up to $14,000 a year without owing federal gift tax. Above that, the gift is subtracted from an individual's lifetime gift-and-estate tax exemption, now $5.25 million.
The gifts remove assets from the giver's estate, and the total can add up over time. A husband and wife with three married children and six grandchildren, for example, could shift $336,000 a year to family members using this benefit.
This provision can be used to move assets other than cash, such as fractional shares of a business, but expert help is recommended in such cases.
Gifts of tuition or medical care. Taxpayers don't owe federal gift tax on amounts paid for tuition or medical care for another person. Given the growth in medical and education costs, such gifts can also remove large amounts from a taxable estate. Remember, however, that payment must be made directly to the provider.
"Step-up" at death. Under current law, taxpayers don't owe capital-gains tax on assets held at death. Instead, the assets are stepped up to their current value and become part of the taxpayer's estate, with no income tax due on the profits.
The upshot is that people planning estates should look carefully at their gains in various assets.
The taxable profit on a $100 share of stock that was bought for $10 will be $90 if it is sold shortly before death, but zero if it is held till death. There might be no estate tax either, given the current exemption of $5.25 million per individual.
As noted earlier, this benefit can be combined with techniques such as the like-kind exchange to eliminate tax altogether.
Estate-tax exemption portability. This provision, made permanent in January, allows a spouse's estate to transfer to the survivor the unused portion of the lifetime gift-and-estate tax exemption.
So if a wife dies leaving an estate of $500,000, her husband could receive her unused $4.75 million exemption and add it to his own $5.25 million one, for a total $10 million future exemption. But to take advantage of this provision, the executor must file an estate-tax return.
What if the survivor has assets far below the total exemption? File a return to preserve it anyway, says Mr. Porter, the West Virginia CPA. "Who knows?" he says. "You might win the lottery or receive an inheritance."
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