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Tax Breaks

Now Or Never Tax Breaks

Take advantage of write-offs set to expire for kids, retirees and homeowners.

Sure, you're busy drawing up holiday gift lists for family and friends. But don't forget to give yourself a present: a lower tax bill next spring.

Now's the time to make last-minute moves to trim your 2007 taxes. Beyond heeding the standard year-end advice of maxing out tax-deductible retirement savings, donating to your favorite charity and selling losing investments to offset taxable gains, you may benefit from taking advantage of several other tax breaks scheduled to expire this year.

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For instance, retirees 70½ and older get one last chance to avoid paying taxes on up to $100,000 in IRA distributions donated directly to a charity. Homeowners who install energy-efficient improvements by December 31 can claim a tax credit of up to $500. And consumers who deduct state sales tax on their federal return have until New Year's Eve to purchase big-ticket items, such as a car or boat, to add to their sales-tax tally.

But the trickiest year-end maneuver is reserved for parents looking to trim taxes on their investment earnings by giving assets to their children. If you're in that situation, act fast. Next year, an expanded "kiddie tax" -- which taxes a child's investment income above a certain level at the parent's higher rate -- will affect older offspring.

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Dodge the kiddie tax
In 2007, the kiddie tax applies to children younger than 18 whose investment income exceeds $1,700 (the first $850 of a child's unearned income is tax-free, and the next $850 is taxed at the child's lower rate). Starting in 2008, children under 19 and full-time students under 24 will also be subject to the kiddie tax (children who provide more than half of their own support are not affected by the change). The first $900 of a child's unearned income will be tax-free, and the child's lower rate applies to the next $900.

What does this change mean to you? If you have children between the ages of 18 and 23, they aren't affected by the kiddie tax this year, but they will be in 2008. In 2007, they can still take advantage of the 5% rate on long-term capital gains that's available to taxpayers in the two lowest tax brackets, says Anne-Marie Fisher, director of tax services for CBIZ Accounting, in Chicago. Higher-income taxpayers pay a maximum capital-gains tax of 15% on qualified dividends and profits on investments held for one year or longer.

Megan Hakala, 19, falls into the kiddie-tax sweet spot. Earlier this year, Megan's parents, Jack and Maggie, gave the college sophomore shares of Marriott stock with a market value of $24,000 -- the maximum married couples can give to an individual without filing a federal gift-tax form. Jack had acquired the stock at a discount when he worked for Marriott, and when you transfer a stock or other property, the recipient of the gift assumes your original cost basis and holding period. Megan will sell the stock this year and use the cash to pay her tuition at Michigan State University.

The income-shifting strategy will save the Hakalas at least $1,600 in capital-gains taxes in 2007. That assumes $16,000 in profit from the sale and a ten-percentage-point spread between Megan's 5% capital-gains rate and her parents' 15% rate. "We certainly want to minimize our taxes," says Jack, a controller with Sodexho USA, near Detroit. "That's why we decided to go full speed ahead and take advantage of these tax breaks while we can."

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The Hakalas also plan to transfer stock to their daughter Jillian, 16, who will be headed to college in two years. They'll have her sell just enough stock this year to keep her profit below $1,700 and hold the maximum tax to her 5% capital-gains rate. They also intend to fully fund a Michigan 529 college-savings plan -- an increasingly attractive vehicle given the latest change in the kiddie-tax rules. That will qualify them for a state-tax deduction of up to $10,000 for 2007.

Give to charity
This year,IRA owners who are 70½ or older can make direct, tax-free donations of up to $100,000 from their IRAs to qualified charitable organizations. The donation can satisfy the requirement that retirees take minimum distributions from their retirement accounts each year.

You can't claim a charitable deduction for your IRA contribution, but the tax break (which applies whether you itemize or not) may be even more valuable because you don't have to include the IRA distribution in your adjusted gross income. By lowering your AGI, you could benefit from other tax breaks, such as reducing taxes on your Social Security benefits or boosting your deductible medical expenses.

Note that this tax break applies only to IRAs, not workplace-based retirement accounts such as 401(k)s. And not all charities are eligible recipients. For example, you can't make tax-free IRA donations to donor-advised funds or use the money to fund charitable remainder trusts or charitable gift annuities.

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Also be aware of new rules that apply to other types of charitable contributions. For example, all cash contributions -- including those bills and coins you toss into a sidewalk Santa's kettle or the Sunday collection plate -- require a written receipt or bank record, credit-card slip or payroll deduction documenting the name of the charity, the date and the amount of the contribution. Remember, you must itemize to claim a charitable deduction, and you must make your contribution by December 31.

Another way to fund a favorite charity is to donate stock or other appreciated assets. Not only do you get to deduct the full market value of the property at the time of donation (not just what you paid for it), but you also avoid the hassle of selling it and the expense of paying capital-gains taxes on the profit.

When you're cleaning out your closets in search of year-end donations, keep in mind that used clothing and household items must be in good condition (according to IRS standards) to qualify for a deduction. Deductible donations of either money or property valued at $250 or more require a written acknowledgement from the charity, and single items valued at $500 or more must be appraised. In most cases, deductions for motor vehicles, boats and airplanes are limited to the amount the charity receives from the sale of the vehicle and require proof of the sale price from the charity.

Energize your home
Installing energy-efficient storm windows and doors is a great way to cut your heating bills. Do it by December 31, and you'll also trim your 2007 tax bill. You can claim a tax credit for 10% of the cost up to a maximum credit of $500, of which no more than $200 can be allocated to replacement windows.

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Installing, say, a high-efficiency air-conditioning system or water heater qualifies for a $300 tax credit, also subject to the $500 credit cap. "It's a win-win situation for homeowners who were planning to make these improvements anyway," says Mark Steber, vice-president of tax matters for Jackson Hewitt Tax Service.

"You do the right thing, and the government subsidizes you for it." In addition, taxpayers who install solar panels, solar water-heating equipment or a fuel-cell power system in their home by the end of the year are eligible for a 30% tax credit, up to $2,000. But no part of the system can be used to heat a pool or hot tub.

If you bought or refinanced a home this year, you may be able to deduct payments for the private mortgage insurance that's required when you finance more than 80% of the home's value. The PMI deduction applies only to mortgage-insurance contracts issued in 2007 and begins to phase out when your AGI exceeds $100,000.

Go on a spree
Unless congress acts to extend this break, it's the last time that taxpayers can choose to deduct either state income taxes or state sales taxes from their federal return. For most taxpayers, the state income tax provides a larger deduction. But for residents of states that don't have an income tax, such as Texas and Florida, the sales-tax deduction is an easy choice. You can save your receipts or use the IRS's state-specific tables to estimate your sales tax based on your family's size and income. In either case, you can boost your sales-tax deduction by purchasing big-ticket items, such as a car, a boat or a motor home, by the end of the year. If you buy an energy-efficient hybrid vehicle, you'll also qualify for an energy tax credit of up to $3,000, depending on the make and model.

This is also the last year in which some taxpayers whose income is too high to qualify for the Hope credit or Lifetime Learning credit can deduct up to $4,000 in college tuition. No college costs this year? You can pay next semester's bill by December 31 and claim the deduction in 2007 before it disappears.

Maximize deductions
For most people, the best way to cut taxes is to maximize their tax-deferred retirement savings. In 2007, you can contribute up to $15,500 to your 401(k) or similar workplace-based retirement plan, plus an extra $5,000 if you're 50 or older. You still have time to boost your salary deferral in your last paycheck or two, or to earmark some of your year-end bonus for your retirement account. Despite the stock market's wild ride this year, 2007 is expected to be a record year for mutual fund distributions, according to Tim Roseen, of Lipper, a mutual-fund analysis firm. Now is a good time to scour your portfolio in search of losses you can use to offset taxable gains. If your investment losses exceed your profits, you can use them to offset up to $3,000 of ordinary income and carry over any unused losses into future years.

Normal year-end tax planning calls for paying next year's deductible expenses, such as January's mortgage interest, property taxes and state income taxes, in the current year. But you don't want to do that if you are subject to the alternative minimum tax. The AMT, a parallel tax system with its own set of rules, does not permit deductions for state and local taxes, home-equity loan interest (unless the borrowed money was used to finance home improvements) or personal exemptions -- worth $3,400 this year -- for yourself, your spouse and your children. Consequently, taxpayers who live in high-tax states or who have large families are increasingly being bitten by the AMT, which was originally designed to make sure the wealthy paid their fair share. It's safe to assume that if you paid the AMT last year, you'll owe it again in 2007.