I’ve been looking at my taxes for 2009 to see if I needed to make any last minute moves to lower my tax bill. One strategy that I use for this is called “bunching tax deductions” or just “bunching”. But this year deserves a little extra consideration because of a new deduction for real estate taxes.
Standard Deduction vs. Itemized Deductions
Every year the IRS gives you an option. You can either itemize your deductions, or you can take the standard deduction. If you itemize, then you add up all of your tax deductible expenses for the year like real estate taxes, mortgage interest, sales taxes, donations, and medical expenses, and that amount is subtracted from your income.
So if you made $50k for the year, and you had $11k in mortgage interest, real estate taxes, sales taxes, and donations, then you would pay taxes on ($50k – $11k) $39k instead of on $50k. That’s a simplified example, but that’s the gist.
If you use the standard deduction, then you just take whatever number the IRS says is the standard deduction for that year, and you subtract that from your annual earnings. For 2009 the standard deduction is $11,400. So if you made $50k for the year, and you take the standard deduction, then you would pay taxes on ($50k – $11,400) $38,600.
You always want to pay less in taxes, so in the above situation, you’d take the standard deduction, and pay taxes on $38,600 instead of paying taxes on $39,000. That’s a difference of ($39,000 – $38,600) $400, which at a tax rate of 15% would save you $60.
This is pretty much the standard procedure that everyone takes every year. The IRS forms even walk you through this decision and all the tax software out there does the same thing, so you always end up taking the better deal, itemized deductions or standard deduction.
But it always bugs me to see that $11k in deductions basically just get wasted. Enter bunching.
Taxes are figured on an annual basis. So for a deductible expense to be counted on your taxes, you have to have paid the expense in the given tax year. This combined with the option to take a standard deduction gives us some room to maneuver and squeeze a little more money out of our tax deductions. We could for example, pay our real estate taxes in January 2010 instead of December 2009, and then pay our 2010 real estate taxes on December 2010. That would mean we bunched our real estate tax deductions and got a double deduction of real estate taxes for 2010.
So from the example above, if your real estate taxes were $3k per year, and you paid them in January 2010, then you would only have ($11k – $3k) $8k in itemized deductions for 2009. But you were already going to take the standard deduction for 2009, so that doesn’t matter. However, you’ve now pushed that real estate tax deduction into 2010, so if you pay your 2010 real estate taxes in December 2010, you’ll have ($11k + $3k) $14k in itemized deductions.
It’s important to note here that the standard deduction is adjusted up for inflation each year. So 2007 was $10,700, 2008 was $10,900, and 2009 will be $11,400. So 2010 will likely be higher than $11,400, like maybe $11,900. But $14k is still higher than $11,900. So you would take the itemized deductions instead of the standard deduction, which would mean paying taxes on $2,100 less, which would save you $315 in taxes.
Some mortgage holders will allow you to tell them when to pay your real estate taxes, but I self-escrow so I can make sure the taxes are paid when I want them paid. I don’t want to miss out on $315 just because of a procedural mess up at my bank.
Note that my example revolves around bunching real estate taxes, but you could bunch any deductible expenses. You could pay your last mortgage payment of the year in the next year to bunch the mortgage interest. You could postpone a medical expense into the next year. You could bunch your charitable donations into the same year. And so on.
So that’s bunching. You choose to “bunch” deductible expenses you would make anyway by paying them all in the same calendar year and attempt to get your itemized deductions above the standard deduction for the next year, or rather for every other year. So you would use the standard deduction for 2009, then bunch in 2010, then standard in 2011, then bunch in 2012. And then according to the Incan calendar the world ends, so it doesn’t matter after that.
Real Estate Tax Deduction
The catch for 2009 is that there was a change to the tax law for 2008 and 2009 that now allows up to $1000 (for married couples, $500 for singles) to be deducted for real estate taxes even if you take the standard deduction. So if you pay at least $1000 in real estate taxes in 2009, then your standard deduction would actually be ($11,400 + $1,000) $12,400.
But if we “bunch” our real estate taxes into 2010, our standard deduction would still only be $11,400. The best would be if we could take advantage of this new deduction in 2009 and still do bunching for 2010. The way to do this is to only pay $1000 of your 2009 real estate tax bill in December 2009 and pay the remaining amount in January 2010. I’m guessing your mortgage holder would definitely not be open to this, so you would probably need to be self-escrowing to do this.
So from the example above, your 2009 taxes would be on ($50k – $12,400) $37,600, which would save you $150 over the $38,600 from before. And now your 2010 taxes would have ($14k – $1k) $13k in tax deductions. If the 2010 standard deduction is $11,900, then you would be paying taxes on $1,100 less than the standard deduction. Which would save you $165 over the standard deduction.
So in the bunching only situation, you saved $315 in taxes, and in this situation you save ($150 + $165) $315. So you pretty much just get the $150 a year earlier. That may seem trivial, but I prefer to keep my money as long as possible.
For some tax situations, moving $1000 in real estate tax deductions to 2009 may not leave enough bunched deductions in 2010 to get over the standard deduction. So in those cases, it may make sense to pay the 2010 real estate taxes in January 2011, and so bunch in 2011 instead of 2010.