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Time payments to maximize year-end tax benefits

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When accelerating or deferring income or expenses at year end as part of an overall tax strategy, certain timing rules become critical. So does the ability to prove to the IRS when certain actions take place. The following timing rules, among others, should be considered especially important as year-end approaches:

Actual payment rule. Cash-basis taxpayers who want to maximize their deductions and credits for 2014 must make a payment of each expense giving rise to a deduction or credit by December 31. A cash-basis taxpayer generally is entitled to a deduction only when actual payment is made: irrespective of the fact that the expense has already been incurred. “Cash substitutes” under this rule include:

  • Payment by check. If the check is mailed, the payment is considered made at the time of mailing, even if the check is received in the following year, as long as the check is honored in the routine course of business. If the recipient delays but ultimately cashes the check, and the date of delivery is not disputed, the payment dates back to the time the check is delivered or mailed.
  • Payment by credit card. The IRS generally treats a payment by credit card as a cash equivalent. In effect, the taxpayer has borrowed funds from the bank issuing the card and has paid the seller for goods or services. However, in an adjacent rule apparently still in effect, if the taxpayer uses a card issued by the seller with no involvement by an intermediary bank, there may be no payment until the taxpayer pays the bill.

Prepayment of an expense before it is incurred, however, generally does not trigger the immediate right to a deduction in the year paid.

Paid/gifted by check. The mailing rule applicable for a charitable donation calls for any check dated and mailed via the US Post Office within the tax year to be considered deductible in that year, provided the charity cashes it in due course and sufficient funds are available.

Charitable pledges. Like unsecured promissory notes, pledges to a charitable organization are treated as unenforceable promises to pay in the future and are not deductible until payment is made to the charity. However, if the pledge is legally binding, a deduction is allowed when the pledge is made.

Trade date. Stock traded in an over-the-counter market or on a regulated national securities exchange is generally treated as sold on the date the taxpayer enters into a binding contract to sell. This is the trade date, in contrast to the settlement date, which occurs when delivery of the stock certificate and payment are made. The trade date also marks the end of the selling taxpayer’s holding period, important for separating short- and long-term capital gain.

Short sale. In the case of short sales, if the stock price falls and a gain results, the gain is considered realized for tax purposes on the trade date, when the seller directed his or her broker to purchase shares. If the price rises and a loss results, the loss is not realized until the stock is delivered on the settlement date.

Wash sale. A stock (or securities) loss is not allowed to be taken if, within a period beginning 30 days before the date of the disposition and ending 30 days after that date, the individual acquired, or entered into a contract or option to acquire, substantially identical stock or securities. This wash sale rule was designed to prevent taxpayers from selling stock to establish a tax loss and then buying it back the next day. Certain techniques, however, are available to minimize its impact:

  • Buy shares in the same industry rather than the same company
  • Buy more of the same shares, then sell the original shares 31 days later
  • Sell the original shares, then buy the same shares 31 days later.

No similar “wash sale” restriction is imposed on recognizing gain and then immediately purchasing the same shares.

FIFO stock sales. Under the automatic first-in, first-out (FIFO) rule for selling securities, the shares purchased first are considered sold first within the same brokerage account, unless a specified ID method is used by identification of a share’s purchase date and cost. Identification must be made at the time of sale by the broker.

If you have any questions regarding the application of these or other timing rules to your situation, please call this office.