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Tax Planning

Avoid These Tax Headaches

Here's how to steer clear of five big problem areas for taxpayers.

Some of the most common mistakes taxpayers make, the IRS says, are simple ones, such as:

  • Incorrect or missing social security numbers, or identification numbers for child care providers.

  • Incorrect tax entered from the tables.

  • Math errors.

  • Withholding and estimated tax payments entered on the wrong line.

These simple blunders can create enough problems, but throw in complicated forms, tables and instructions and it's no wonder taxpayers get confused. Below are five of the biggest problem areas for taxpayers and tips to help you minimize mistakes.

Going bonkers over basis

In a poll, readers said figuring their investment basis was their biggest tax headache. In general, your basis is what you paid for your shares plus commissions. But things can get a lot more complicated depending on how the shares are acquired or if you only sell a portion of your holdings.

Dividend-reinvestment plans. Your basis is the fair market value of the shares on the day of the distribution. See "Finding a Stock's Cost Basis" for tips on smoothing out a difficult DRIP basis calculation.


Inherited stock. Your basis is the fair market value on the day of your benefactor's death. (See "Taxes on Inherited Stock.")

Gaining custody of stock in divorce. Shares acquired in divorce are considered a transfer between spouses. Your basis doesn't change. It would be the same as your former spouse's.

Stock as a gift. Your basis will depend on whether the shares gained or lost value since you received them. If you sell at a loss, your basis would be either the stock's original purchase price or the shares' value at the time the gift was made, whichever is less. If you sell at a profit, your basis would be the same as the original owner's. (See Sharing Your Gift with Uncle Sam" for more.)

If you've purchased mutual fund shares, you can choose to calculate your basis four ways:

  • Specific identification. This method is applied when you direct the fund to sell specific shares.

  • First in/first out. Used when unspecified shares are sold. It's assumed that the shares you've owned longest (typically those with the lowest basis) are the first ones sold.

  • Average basis single-category. You add up the total investment and divide by the number of shares.

  • Average basis double-category. Similar to the single-category method, but a little more complicated. Here you have to divide your shares up according to how long they've been owned.

For more, see "Manage Mutual Fund Basis to Minimize Taxes."

Taxpayers can run into problems if they haven't kept records of their transactions. If you find gaps in your record keeping go to your stock's investor relations department, your broker or mutual fund firm for help. You can also find historical closing prices on various financial Web sites, such as Yahoo! Finance.

For more on figuring your basis, turn to IRS Publication 551 Basis of Assets (97K PDF).

Cursing the child-care credit

One of the top five mistakes taxpayers make on their returns is miscalculating the child- and dependent-care credit, the IRS says. To receive the credit, taxpayers must fill out the two-page Form 2441. "If you're doing it on your own, read the instructions carefully," says Jackie Perlman, a CPA and senior tax research analyst at HR Block World Headquarters in Kansas City.


The law currently allows taxpayers to claim up to $3,000 in expenses for one individual, $6,000 for two or more. Your adjusted gross income will determine what percentage of the $3,000 or $6,000 in qualified expenses you can actually claim as a credit. For example, if your AGI exceeds $43,000, you're credit is only 20% of the maximum $6,000 -- or 1,200.

The calculation can get really tricky if you receive employer benefits that allow you to set aside pre-tax earnings for dependent care. Expenses covered or reimbursed by your employer's plan can't be claimed. Because the maximum you can set aside in an employer's benefit plan is $5,000 and the most you can claim for the credit is only $6,000, the dependent care benefit usually wipes out most of the credit.

Even if you don't set aside or use the entire $5,000 allowable in a benefit plan and want to claim a portion of the child credit, Perlman says it's better to pick one or the other to avoid future frustration. Figure which option gives you the most tax savings and go with it.

Social in-security

The belief that only half of social security benefits are taxable is one mistake that regularly trips up retired taxpayers, says Connie Kurtz, an enrolled agent and owner of Tax Masters, a tax preparation service in Rockville, Md.


Several years ago, Congress changed the law to increase the portion of benefits that can be taxed to 85% if provisional income -- AGI plus tax-exempt interest plus 50% of your Social Security benefits -- exceeds $34,000 for singles or $44,000 for couples filing jointly. (See "Taxing Your Social Security Benefits.") Nonetheless, many taxpayers fail to follow the social security benefit worksheet in the 1040 form and assume the 50% rule applies to them, Kurtz says.

Plan to increase or decrease your provisional income on alternate years so social security benefits won't be taxed so severely. Some strategies include staggering IRA withdrawals, timing the sale of stock or other assets, and unloading tax-free municipal bonds.

You can minimize the sting in on your return if Medicare Part B premium withdrawals were deducted from your social security benefits. (The SSA-1099 form shows how much was withheld from your benefits.) You can deduct these withholdings along with medical expenses, to the extent that your costs exceed 7.5% of your AGI.

The landlord's conundrum

Taxpayers with rental property find it particularly confusing sorting out whether money they've put into their property qualifies for an expense or capital-improvement deduction. "There are very gray areas in the difference between the two," says enrolled agent Frank Degen, who runs a tax preparation business in Setauket, N.Y.

An expense, paid to keep property in working condition, can be deducted the year it's made.

A capital improvement adds significant value and extends the life of property. The deduction must be spread out over the life of the property and depreciated. For example, patching a hole in the roof is an expense but a new roof is a capital improvement.

If you attempt to write off a capital improvement as an expense to get the immediate deduction, you could risk an audit.

Because there is no dollar amount that differentiates an expense from a capital improvement, Degen says, figuring which to claim can be difficult.

If you're a new landlord facing this question, a seasoned tax professional may be your best medicine for avoiding this headache.

Trapped by the AMT

The alternative minimum tax is a parallel tax system originally created to make sure the rich didn't escape taxation by jumping through loopholes. However, the AMT is ensnaring more and more middle-incomers.

The AMT taxes more income and allows fewer write-offs than the regular system and applies different tax rates. You have to pay the AMT whenever it would cost you more than the regular tax rules.

You are most at risk if you claim high state-income-tax deductions or several exemptions for children. Neither of those tax breaks count when figuring the AMT. Exercising incentive stock options also can push you into the AMT, because the difference between the exercise price and the value of the stock is considered income for AMT purposes but not under the regular tax rules (see "Living in the AMT World").

If you fall victim to the AMT, says Alan Kahn, a CPA in Syosset, N.Y., seek professional help. A qualified tax professional will handle the complicated Form 6251 and might be able to help you avoid the AMT in future years.

See "How to Hire a Tax Pro" for tips on finding the right tax pro for you.

To err is human; file correctly online

A simple mistake rarely triggers an audit. Typically, errors are handled through correspondence with the taxpayer, IRS spokesman Tim Harms says.

If there's a math error, the IRS usually corrects it and sends a letter explaining the change. A wrong social security number can complicate things more, especially if a couple is trying to claim a credit for a child and enters the wrong number (they can lose the credit).

To avoid simple errors, consider e-filing. IRS computers can instantly catch many mistakes. The error rate for paper returns hovers around 20%, while it's only 1% for electronic returns.