Little-known tax breaks could cut bill

By Sandra Block
USA Today

You keep a copy of Stephen Hawking's "A Brief History of Time" on your bed stand. You think game theory is cool. You met your spouse at a Mensa volleyball tournament. Yet you're still baffled by taxes and haunted by the suspicion you're paying more than necessary.

• Open a spousal individual retirement account: You have until April 15 to open an IRA for 2001. Many taxpayers who have a retirement plan at work don't qualify for a deductible IRA. But if your spouse isn't covered by an employer plan, he or she may be able to invest up to $2,000 in an IRA that's deductible on your joint return, says Theresa Fry, retirement planning specialist for A.G. Edwards. To qualify for a deductible spousal IRA, you must file a joint return and the adjusted gross income on your joint return must be below $160,000.

Douglas Stives, a personal financial specialist in Red Bank, N.J., says Congress slipped this benefit into tax law several years ago, "but probably fewer than 1 percent of the people know it's in there." That's too bad, because deducting your spouse's contribution can reduce your tax bill. A deductible IRA also will reduce your combined AGI, which may make you eligible for tax credits that phase out at specific income levels.

• Decide whether to use a "deemed sale" to take advantage of lower capital gains rates: A new capital gains rate became effective in 2001, reducing taxes on assets held five years or longer. Taxpayers in the 27.5 percent bracket or higher who hold their assets for at least five years will see their rate drop to 18 percent from 20 percent. The catch: The lower rate applies only to investments purchased in 2001 or later. Sales of stocks or funds purchased before 2001 will be taxed at 20 percent, even if you hold them for five years or longer.

Congress gave you a way around this problem. You can pretend you sold your stocks or funds, then repurchased them, on Jan. 2, 2001 — the first trading day of that year. This strategy, known as a "deemed sale," will reset the clock on your holdings, so if you sell in 2006 or later, your gains will be taxed at the 18 percent rate. This offer is limited: If you don't report it on your 2001 tax returns, you can't do it at all.

While the sale is imaginary, the taxes on it are not. You'll owe taxes on any gains you earned on the investment between the time you purchased it and Jan. 2, 2001, the date of your deemed sale. For that reason, most tax experts don't recommend the strategy for investments with big gains. Unless you have other real losses to offset those gains, you'll end up paying a big tax bill now to get a small tax break later.

However, suppose you own a stock or mutual fund that had realized no gains as of Jan. 2, 2001. You could report a deemed sale on your tax returns and reset the clock at no cost, says Mark Luscombe, analyst for tax publisher CCH. If your investment was trading for less than the purchase price on Jan. 2, 2001, you can also report a deemed sale without any tax hit. But you can't use those losses to offset other investment gains or reduce your taxes, as is the case with "real" investment losses.

Report a deemed sale on Schedule D of your tax returns and attach an explanation telling the IRS what you're doing, Luscombe says. Once you report a deemed sale, you can't undo it.

If your investment account is with a brokerage firm, the firm should be able to tell you the price of your securities on Jan. 2, 2001. Twenty-First Securities offers a calculator, www.twenty-first.com/calculator.htm, that will help you research stock prices.

• File your back taxes: About 1.7 million taxpayers who failed to file their tax returns in 1998 are owed more than $2.3 billion in refunds, the Internal Revenue Service says. If you're among them, you have until April 15 to claim your money. After that, your refund will go back to Uncle Sam.

The IRS gives non-filers three years to claim a refund, which is why the clock is ticking for taxpayers who skipped 1998.

There's no penalty for filing a late return if you're owed a refund. However, if you owe the IRS money for other years or have failed to pay child support or student loans, the IRS may use your refund to pay those obligations.

You can find previous year's tax returns at www.irs.gov, or by calling (800) 829-3676. Many tax software programs also will help you fill out previous year's returns. The IRS won't send you your 1998 refund if you failed to file returns in 1999 or 2000.