There’s lots of talk about taxes these days. President Obama is calling for higher taxes on the wealthiest Americans. Republicans have repeatedly vowed to block tax increases. Everyone seems to agree on the need to overhaul the enormously complicated and loophole-filled U.S. tax code. And the pressure is on to cut the country’s more than $14 trillion debt burden.
Even if Congress slashes spending, it seems inevitable that sooner or later millions of upper-income Americans will face a bigger tax bill. That will only increase the attractiveness of legitimate techniques to minimize or eliminate taxes. Here are seven of them to consider now, before Congress changes the law.
1. Home, Sweet Home: Rent your home for 14 days or less each year. All that rental income typically will be free from federal income tax. The Clinton administration tried to kill this break, known as the "14-day rule," but the idea quickly ran into intense opposition in Congress and elsewhere.
Among the opponents were homeowners in Augusta, Ga., site of the annual Masters golf tournament, who each year can charge big bucks to rent their homes to golf fanatics. The 14-day rule also benefits homeowners in popular vacation communities, such as the Hamptons.
Rent your home for 15 days or more, and the entire amount becomes taxable.
2. Home Sweet Home, Part 2: Although millions of Americans own homes worth far less than they paid for them, others, including many who bought a long time ago, are sitting on big gains that can be a valuable source of tax-free income. In most cases, the gain on selling your primary residence is tax-free -- at least under current law.
Married couples filing joint returns who sell their principal residence for a profit typically can exclude as much as $500,000 of the gain. For singles, the maximum exclusion is $250,000. If you live in an expensive area and your gain is bigger than that, you’ll at least be able to exclude that part of it from taxation.
And you may be eligible to exclude part or all of your gain for other reasons. For example, you may qualify for a partial exclusion if you had to sell your home because of such factors as health or a job change.
3. Leave Home: Get a job in some other country with low, or no, income tax, and take advantage of what's known as the "foreign earned income exclusion," which allows you to keep all or a portion of your compensation each year from being taxed by the U.S. You may also be eligible to exclude or deduct an amount for foreign housing.
The foreign earned income exclusion is $92,900 for 2011, up from $91,500 for 2010. (The amount is adjusted each year to reflect inflation.) You’ll do best in a place like Saudi Arabia, which has no income tax, or Hong Kong, which has a very low rate.
The exclusion applies only to "earned" income, such as your salary. You’ll still have to pay tax on investment income. And because of the U.S. tax law's complexity, to take full advantage of this provision, you may need a tax expert to figure out the rules.
4. Bite the bullet: Big losses from the stock market's sharp drop over the past few months, however painful, can save money on your taxes. Consider selling the losers you were thinking of getting rid of anyway, a technique known as "loss harvesting." Capital losses generally can be used to offset capital gains on a dollar-for-dollar basis, with no limit. If your losses are larger than your gains, or if you don't have any gains at all, you can deduct as much as $3,000 a year of that net loss ($1,500 if married and filing separately) from ordinary income. Additional losses are carried over into future years.
5. Gifts: A wealthy and generous parent or friend, under current law, can give you – and as many others as he or she wants -- as much as $13,000 a year each -- without any tax considerations. There is no limit on the total dollar amount that can be given this way.
For example, a husband and wife can each give as much as $13,000 apiece tax-free to each child, grandchild -- and anyone else. Of course, the gift must truly be a gift; it can't be disguised payment for services rendered.
And there’s an easy way to give away even more without any tax considerations: Paying tuition or medical bills doesn’t count toward the $13,000-a-year exclusion. Just make sure your generous benefactor sends those payments directly to the educational or medical institution, rather than giving you the money. There is no limit on how much may be transferred this way.
Some people have pre-paid several years of tuition bills for children or grandchildren.
6. A Job with Fringes: Some lucrative fringe benefits, such as employer-provided housing, may be tax-free under certain circumstances. Employees at some educational institutions, including colleges and universities, get free or reduced tuition for their children. These benefits are worth a lot in areas such as New York City, where the cost of housing can be astronomical and some of the city's private schools now cost $40,000 or more a year. Cutting the cost of sending a kid to college isn’t a bad deal, either.
But this break, too, may require a skilled tax pro to help interpret the rules. The IRS says the value of lodging furnished to an employee may be excluded from wages if it's on the employer's business premises, for the employer's convenience, and if the employee accepts it as a condition of employment.
The exclusion from taxation typically "wouldn't apply if the IRS believes the benefits are effectively a substitute for compensation -- or, in the case of tuition, they are provided mostly to highly paid employees," says Mary B. Hevener, a tax lawyer at Morgan, Lewis & Bockius in Washington. A tax-free tuition reduction program would have to include lower-paid workers at the school, as well.
7. Munis: State and local government bonds, known as municipals, are a time-honored way to save on taxes. They typically pay interest that is exempt from federal income tax -- and, in many cases, state and local income taxes, too. These are especially attractive for investors in the top tax brackets. But they can also be beneficial for many people in lower brackets.
Some so-called tax-exempt bonds aren't tax-free. For example, some munis pay interest that is subject to the alternative minimum tax, or AMT. If you sell a muni for more than you paid for it, the gain typically would be subject to capital gains tax. Many states, such as New York, exclude interest on in-state bonds but tax interest on out-of-state bonds.
According to preliminary Internal Revenue Service data, more than 6.2 million federal income-tax returns reported tax-exempt interest income for 2009, totaling nearly $68.4 billion.
There has been speculation that Congress, in its search for additional revenue, might one day impose significant new limits in this area on upper-income taxpayers. The exclusion for muni-bond interest "is certainly at risk if Congress decides to undertake comprehensive tax reform that lowers tax rates in exchange for eliminating various breaks," says Tim Hanford, a former House Ways and Means Committee staffer and now a consultant in Bethesda, Md.
