Talk to a tax expert long enough and you’re likely to hear some variant on this phrase: Don’t let the tail wag the dog.
It makes sense. Focus too much on the details, and you may lose sight of the big picture. When it comes to taxes — the tail in this case — a short-term tax benefit may not be the best investment or lifestyle decision.
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The tax overhaul that was rushed through the Republican-controlled Congress and enacted last year gave taxpayers little time to grasp its implications. As the new law now becomes understood, accountants and tax advisers say the tail is wagging like an excited Labrador hovering over a T-bone steak. And advisers say their job is to calm the dog before he does something he will regret.
“You have to be careful making permanent decisions based on a temporary law,” said Mitchell Drossman, national director of wealth planning strategies at U.S. Trust. “This tax law is a temporary provision because most of the individual tax provisions sunset at the end of 2025.”
In many cases, once these tax-driven decisions are made, they either cannot be undone or they will cost people more than they saved to undo them. And it is not limited to the very wealthy; middle- and upper-middle-class earners could fall into this trap.
Short-term benefits may look desirable, but here are three tax breaks that may be better in the long run.
For the very wealthy, a key question is whether to make substantial gifts to heirs now or to leave it to them later in a will. It has become a big issue because the estate and gift tax exemption is now $11 million per person or $22 million for a couple — more than double what it was last year.
The advantage of giving it away now is that the gift can grow in an heir’s estate, with only capital gains tax to worry about.
But there is a downside. Gifts made through an estate receive what is called a step-up in basis, which values the securities on the date of the giver’s death. When the giver is alive, however, gifts are transferred with what is called the original basis, or purchase price; when sold, the recipient will have to pay tax on the capital gains tax stretching back to whenever the investment was originally made.
However, the math for making a large gift now is compelling, said Amanda DiChello, a partner at Cozen O’Connor’s private client services group, who ran a comparison for The New York Times.
A person worth $25 million who made a $10 million gift today and lived another 10 years would save $4 million in taxes, assuming a 5 percent growth rate. If those assets were then sold, and capital gains were paid, the person would still save about $3 million. If that person lived another 20 years, the tax savings would only increase.
But basing such a large choice on taxes alone is not always easy to stomach. After all, $10 million is a large gift for anyone.
Reasons to amend your tax return
Adding to the uncertainty is the fear that such a high estate-tax exemption — which is indexed to inflation, so it will keep growing — will not be renewed in 2025, or will be repealed sooner by the next administration.
“Clients with $20 million to $30 million are asking, ‘What do we do? We can’t afford to give it all away,’” Ms. DiChello said. “But there could be a backlash. Would a new administration come and take the exemption down?”
That’s the big unknown. And the cost could be millions of dollars that goes to pay taxes, not to heirs.
Robert M. Finkel, a co-chairman of the tax practice group at the law firm Moritt Hock & Hamroff and a former senior trial lawyer at the Internal Revenue Service, said he had found himself increasingly popular at cocktail parties. People want to divine what he thinks is likely to happen with the tax law, but they also want to know how to handle situations with heirs when they no longer can hide behind a lower gift exemption.
“For many years the low gift-tax exemption was the reason parents said they couldn’t give any more,” Mr. Finkel said. “Now, the talk around the dinner table from children is, ‘Geez, why don’t you make the gift now?’”
One answer is for parents to have an in-depth conversation with their children. Another, though, is to structure a transfer that allows parents to retain control of the asset during their life but still secure the deduction.
One way to achieve this is to put property worth $11 million, like a house, into a sophisticated arrangement called a qualified personal residence trust. Mr. Drossman said the parents could continue living in the home with provisions that the gift would be made to their heirs on their death.
If structured properly, the donor is considered to have made the gift at the higher amount, even if the exemption drops back to $5 million.
It’s complicated, but it’s also an example of uncertain tax policy driving people to make decisions they may not otherwise make.
Capital gains tax
The Trump administration has floated the idea of indexing the basis of an investment to inflation, which could greatly lower the taxable capital gains on an investment when it is sold. And the administration has hinted at doing it by executive order, which has raised a lot of concern. Previous administrations have entertained the same idea but decided it would need congressional approval.
Politics aside, there is a practical implication to this. In the long term, indexing an investment’s purchase price to inflation could also reduce the amount of a loss a taxpayer could claim as a deduction. Not all investments rise. And the ones that lose money can be carried forward on tax returns until future gains soak them up.
Focus on your finances
In the short term, with the stock market continuing to rise, the idea of increasing that basis could be an inducement to not sell highly appreciated stock now.
“I’m a bit concerned that the administration floated this idea to create a kind of uncertainty,” Mr. Finkel said. “We have a market at near-record level. Why not create uncertainty so people don’t take profits off the table?”
Such thinking is likely to apply to investors in stocks with outsize gains — like someone who bought Apple years ago. The standard recommendation from any financial adviser is to rebalance your portfolio, selling winners to maintain the weight in your financial plan.
The increase in the standard deduction to $12,000 for individuals has saved most American taxpayers from having to itemize their deductions.
Swept up in this, though, are affluent taxpayers who are charitably inclined. A $5,000 contribution to charity may no longer count beyond the deduction that anyone gets, for being charitable or not.
Alexander L. Reid, partner at the law firm Morgan Lewis, where he focuses on nonprofit organizations, said one strategy for the person who regularly gives $5,000 a year would be to front-load five years of donations into a donor-advised fund.
There are two advantages to this. The $25,000 total donation would get the taxpayer over the $12,000 hurdle, allowing the person to claim a deduction while still parceling out the donations over five years.
Additionally, if the person made the gift by transferring $25,000 of highly appreciated stock, there would be no tax on the capital gains. “It may be a good time to lock in the gains and bunch your charitable giving,” Mr. Reid said.
These tax changes seem to be affecting the most taxpayers, but confusion abounds throughout the new tax code. And the government is still trying to clear things up.
On Wednesday, the I.R.S. issued a 184-page explanation of how companies structured as “pass-through” entities — ones in which the income passes through to the owners, who pay the taxes on their individual returns — might take advantage of a 20 percent income tax deduction.
“The fact is, no one knows what is going to happen,” Mr. Finkel said. “In fact, no one thought this would happen.”
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