Taxing times ahead

Here are some things to keep in mind as you prepare your 2005 tax returns:

Real estate tax traps

Tax time provides an opportunity to cash in many of the rewards of dabbling in last year’s red-hot real estate market — but there are numerous tax traps if you sold a home, refinanced your mortgage or bought an investment property in 2005.

Here are three common real estate transactions that could leave you vulnerable in an audit:

If you sold your home: Couples can sell their home for a $500,000 profit without paying a cent of income tax. Single taxpayers can pocket $250,000. To qualify, the house must be your principal home for two of the past five years. If your gain is over the exclusion amount, hunt for expenses such as the cost of home improvements, real estate commissions and title insurance that can pad your “tax basis.”

Tax trap: The rules changed dramatically in mid-1997. Until then, homeowners could defer tax on their gain by rolling it into the purchase of a more expensive house. If you traded up before the rules changed, you must count that deferred gain against your $250,000 to $500,000 exclusion.

You can pluck the deferred gain from Form 2119, attached to your tax return for the year you sold the previous home. But it will be difficult to remember — let alone prove — what costs you incurred in your current home if you don’t save receipts and records.

In that case, “go back down memory lane and look at old photos,” said Daniel D. Morris, a tax partner with Morris + D’Angelo in San Jose, Calif. The goal is to find evidence of kitchen remodeling, landscaping and other improvements — and hope you draw a forgiving auditor.

If you used your home as a piggy bank: As interest rates crept higher last year, many homeowners refinanced their mortgages to lower their payments and siphon out cash. Others took out home-equity loans to tap the growing value of their real estate.

Refinancing can unleash some tax savings. For example, the charge for “points” — each point equals 1 percent of the loan — usually must be deducted incrementally over the life of the loan.

What if this wasn’t the first time you refinanced? You can deduct the remaining points from the previous loan now. The points from the current loan still must be deducted over time.

Tax trap: Tax pros increasingly are warning that home-equity loans are ripe for audit because few homeowners understand when they can’t deduct all the interest they pay. Sometimes, even interest on refinanced loans can be limited.

Generally, you can borrow up to $100,000 of home equity and deduct the interest, regardless of whether you used the money to remodel your home, buy a Prius, pay college bills or take a vacation. But that can change depending upon whether you borrowed more than $100,000, how you spent the cash, whether you owe the alternative minimum tax and other factors.

If you owe the AMT, for example, you usually can deduct the interest on up to $100,000 if you spent it to remodel your kitchen, but you get no write-off if you spent it on a car or other personal expenses.

If you became a landlord: Investors scooped up rental properties amid the housing boom, looking to profit from appreciation, rental income and a raft of tax breaks. For example, it’s possible to pocket thousands of dollars in rent tax-free and defer taxes years into the future and potentially pay lower tax rates.

Tax trap: The rules of rental real estate are complex and often subject to dispute. It’s highly recommended that you hire a pro to help you cut through the tangled rules of depreciation, passive activity income, capital gains and more.

Capital gains surprise

Investors beware: Last year, stock mutual funds made the largest payouts of capital gains and dividends since the markets were peaking in 2000 — meaning you could face unexpected tax bills this April.

That news could come as a surprise given that the Dow seemed to be in a perpetual dance with the 10,500-point marker. But the average stock fund handed out capital gains that were nearly double what they were in 2004 — and nearly four times higher than in 2003, according to Morningstar.

Against that backdrop, here are two bits of advice at tax time:

•Size up your capital gains soon to give yourself time to scrape up the tax by April 17. Most long-term investors will owe 15 percent to Uncle Sam, but there was no automatic withholding to cover the tab.

•Hunt for ways to whittle down your gains.

For instance, don’t pay tax on gains you didn’t pocket. Properly calculate the taxable “basis” of each investment, especially for shares you bought by automatically reinvesting gains and dividends. Use losses to erase gains; too many investors overlook opportunities to let Uncle Sam eat some of their investment losses.

What is a child?

A taxpayer must meet all four of these tests to claim a qualifying child:

•Relationship: The child must be your child (including an adopted child, stepchild or eligible foster child), brother, sister, stepbrother, stepsister or a descendant of one of these relatives.

•Residency test: A child must live with you for more than half the year. Temporary absences for circumstances such as school, medical care, military service or detention in a juvenile facility count as time lived at home.

•Age: Depending on the tax benefit, a child must be under a certain age.

•Support: A child cannot have provided more than half of his or her own support during the year.

Claim the earned-income credit if you can

One out of five eligible taxpayers fails to claim the federal earned-income tax credit — missing out on tax refunds worth as much as $4,400. The credit is designed to lift low-income families out of poverty, but many workers miss out because they earn so little income that they aren’t required to file tax returns.

You must file a tax return to claim the credit, however. “We know that’s a barrier for some, but it’s worth their while if they can get a big tax refund,” said David R. Williams, director of the Internal Revenue Service’s earned-income tax program.

Here are several ways to get help:

•The “EITC Assistant.” This online tool on the IRS’s Web site ( www.irs.gov) sorts out whether you’re eligible for the credit and estimates how much money you’re entitled to. It’s also available in Spanish.

•Volunteer tax centers: Scores of community centers, churches, charities and other organizations recruit volunteers to help low-income taxpayers prepare tax returns and claim the earned-income tax credit.

Alternative minimum tax is maximum headache

Here’s what politicians don’t say when they boast about cutting income taxes: Every trim forces more Americans to pay the dreaded alternative minimum tax instead.

This parallel tax system was created two generations ago to take away tax breaks from about 150 wealthy taxpayers who had piled up write-offs to erase their tax bills. These days, you don’t have to be rich for the AMT to wipe out your write-offs.

Though most of them are unaware of it, 21 million Americans are on the hook to pay the AMT next tax season barring intervention from Congress. Some experts predict lawmakers will restore an expired tax provision that had slowed the AMT’s spread through 2005. If they don’t, however, it will unleash a fivefold increase in the number of taxpayers who will owe what one prominent U.S. senator calls the “Darth Vader of the tax code.”

The AMT’s dark side is that its burden increasingly will be borne by middle-class taxpayers by intensifying the “marriage penalty,” biting big families harder, erasing itemized deductions and shrinking breaks related to kids.

In 2006, a family of four will step into the AMT quicksand once its adjusted gross income exceeds $67,500 — just for claiming the standard deduction and four personal exemptions, the Congressional Budget Office says.

•The AMT will strike 35 percent of all taxpayers with $50,000 to $100,000 of adjusted gross income in 2006. Two out of three will owe it in 2010.

•The AMT will hit 81 percent of taxpayers with $100,000 to $200,000 of adjusted income in 2006, nearly five times the 17 percent share in 2005. It will net more than 95 percent in 2010.

The long-term flaw in the AMT, however, is that it’s not indexed for inflation. If it were, the exemption thresholds would be about twice as high.

Time to pay up

You can pay with American Express, Discover, Mastercard or Visa. You’ll generally be charged a fee of about 2.49 percent, but rebates, airline miles, tax-preparation discounts or other special offers can offset or defray the cost.

What to do if you can’t pay tax bill by April 17?

Form 9465: The IRS generally rubber-stamps any installment plan you propose up to $10,000 within three years. You’ll face a $43 setup fee, interest charges and late-payment penalties on the unpaid balance. If you fail to make the payments, you’ll face an additional $24 fee to reinstate the plan.