The Tax Reform Act of 1986 will eventually change the spending, savings, borrowing, and investing patterns of almost every taxpayer in the United States. But first, financial planners say, these taxpayers have to be ready to take advantage of current law -- to take whatever actions are needed before the end of the year and get ready for the new era of ``tax simplification'' to follow.
``There is a lot of planning that should be done before now and the end of the year,'' says Marilyn Pitchford, a tax partner in the Boston office of Arthur Young & Co., an accounting firm. ``There are so many provisions and interlocking provisions, it's hard to know where to start.''
The apparently contradictory message from tax experts: Don't be hasty, but don't delay.
This new law represents the most sweeping changes to United States taxes since the Revenue Act of 1942. That law converted the income tax from a ``class tax'' applying to the wealthy few to a tax system that applied to almost all Americans.
While accountants, planners, and newspapers can generalize about how people should deal with the changes, the effects of this bill are so wide ranging, Ms. Pitchford says, that each individual should figure out, perhaps with the help of an accountant, how he or she will fare. Only then should any pre-New Year's adjustments be made.
``If it's a clean situation, with just wage income, state income tax, a mortgage, real estate tax, and some charitable contributions, they can pretty well understand their own situation and have a pretty good idea how they will be affected,'' Pitchford said. ``But for others with capital gains property, a lot of debt, or tax shelter losses, it's just not going to be easy to know what effect the law will have.''
One example of the problem can be seen in the usual advice about which year to take income and deductions. In the past several years, as tax rates have gone down and previous tax-overhaul laws have taken effect, the general rule has been to take as many deductions as possible immediately and shift as much income as possible into the following year.
In general, that's true here, too. But not for everyone.
``Unless people understand how they might be subject to the alternative minimum tax, they could be unpleasantly surprised,'' says William Taylor, a partner at Deloitte, Haskins & Sells, another accounting firm.
The alternative minimum tax is designed to ensure that even upper-income individuals and corporations pay at least some tax. It has been strengthened under the new law. The alternative minimum tax goes into effect after a large number of deductions and tax credits are added up. If too many deductions are taken this year, a taxpayer could be pushed to the alternative-minimum and end up paying more tax.
Under tax reform, it doesn't take as many deductions to set off the alternative-minimum trigger. But since this usually happens only to upper-income taxpayers who have attempted to shelter much of their income, most people won't have to worry about it. Others should check with their accountants.
Many upper-income people -- and even moderate-income taxpayers, if many two-earner couples are included -- are apt to have another surprise when tax reform goes into full effect in 1988. All the ballyhoo over the tax bill has focused on its structure of just two rates, 15 and 28 percent.
But there is a third rate of 33 percent. Income below $71,900 will be taxed at 28 percent. But all income above that will have a 5 percent surcharge added, for a total tax of 33 percent on adjusted gross income over $71,900.
While this is still a tax cut for those at or near the current 50 percent top bracket, it will be a major tax increase for those receiving capital-gains income. Until now, 60 percent of that income has been tax-exempt, leaving only 40 percent to be taxed. For those at the top rate, this has meant a tax of just 20 percent.
Now, with no exclusion for capital gains, most people involved in investments will see their capital-gains taxes jump 40 percent, or the difference between the 20 percent rate and the 28 percent rate. If those gains are taxed at 33 percent, this will represent an increase of 65 percent.
``The whole concept of using tax money to fund investments will change,'' says Michael Leonetti, a financial planner in Arlington Heights, Ill.
An investor may be able to help his or her cause now by selling stocks before year-end and buying them back a day or so later, says Thomas Hakala, director of personal financial planning at the Coopers & Lybrand accounting firm.
If the stock has been held for at least two or three years, Mr. Hakala says, and its price has increased substantially, the profits would be taxed at no more than 20 percent. After waiting at least a day to satisfy the tax laws and then buying it back, the taxpayer will have a higher price basis.
Thus, although the taxes will be higher when the stock is eventually sold again, the gains will start from the higher level. This won't work for all stocks or taxpayers, so check with your broker or tax adviser first.
Even for taxpayers not involved in investments, there are several year-end moves that can be made. This includes funding your individual retirement account as much as possible, to get the full deduction (you can still do this until April 15). After this year, couples with taxable incomes above $50,000 and singles above $35,000 will lose the write-off if they are covered by a pension.
Many deductions, including those for charitable contributions, medical expenses, employee business expenses, and investment guides and newsletters, will also be eliminated or sharply curtailed. Charitable contributions, for instance, won't be deductible at all to non-itemizers. So try to get in any payments for these that you can this year.
If you make estimated state income tax payments, try to send in as much as possible before year-end to get a larger deduction. And since the deduction for state sales tax will be eliminated completely, try to make any large purchases -- like a car, boat, or appliances -- this year.
When considering these acquisitions, try not to charge them. The elimination of the deduction for consumer interest will make car loans, credit cards, and most other debt more expensive. As a result, however, owning a home will become even more valuable. If you have to borrow, you can take out a second mortgage on your home (or your second home) equal to its original purchase price plus improvements.
The money from this home equity loan can be used for any purchase. But since you're putting your home at some risk, be careful and closely examine your ability to repay both the first and second mortgages.
In addition, interest on mortgages that exceed the home's original purchase price plus improvements are still fully deductible if the money is used to pay for education or medical expenses.
The next few months are also likely to be busy ones for those in the tax shelter business. The next several days may be the busiest of all. Investors who buy shelters before President Reagan signs the bill -- as early as next week -- will be included in a ``phase in'' provision allowing them to use all of their shelter write-offs this year and 65 percent of them next year. But if they invest in such shelters after the bill is signed, they won't get any carryover on write-offs next year.
The law also ends the practice of using losses from these ``passive'' investments (where the investor has no voice in management) to offset other income, such as wages and capital gains.
Thus, investors will now have to find ways to generate other passive income, which they can offset with their losses. Or if they can find a way to become a participant in a passive activity, like a real estate limited partnership, any losses can then be used against ordinary income.
As a result of these changes, tax shelters such as real estate will have to be evaluated on their economic merits rather than their ability to cut the tax bill.
``Real estate is still a good investment,'' says Elliot Lesser, a partner in charge of real estate services at the Laventhol & Horwath accounting firm. ``But people are going to have to be a lot more selective and look for very solid economics in what they buy.''