How to cut your taxes: tax relief starts here - a guide to pruning the bottom line on your 1977 return, plus smart ways to jump-start your savings for 1998

Kiplinger's Personal Finance Magazine, Feb, 1998 by Marc L. Schulhof

In the long, often cold history of paying taxes, many will remember this as the winter of our discontent.

Long gone are the warm and fuzzy days of summer, when the President and congressional leaders practically did cartwheels on the White House lawn to congratulate themselves for a balance-the-budget deal that includes billions of dollars in tax cuts. In their place is the acrid taste of congressional hearings on Capitol Hill, at which congressmen berated the IRS for abusing taxpayers and promised critically needed reforms. The lawmakers struck the set and rushed off for a long vacation, leaving legislation in the wings.

Congress will soon take to the stage again, with more hearings to remind us of how miserable the tax system it created -- and perpetuates -- really is.

Thus the scene's set for your annual ritual of settling up with Uncle Sam. This arduous task has not been made any more bearable by last year's "Taxpayer Relief Act." Since most new breaks didn't arrive until January 1, you won't feel much relief until you work on your return next year.

"A lot of the changes in the legislation don't show up on the 1040 this year," says John Mueller, an analyst at CCH, a tax and legal publisher in Chicago. "People have heard about it, and they might be looking for it, but they won't see it."

The major exception to the delayed-gratification nature of the new law is the tax cut for capital gains. It applies to sales for most of 1997. There's a trade-off, though: an almost villainously complex Schedule D on which to report investment profits and losses (see the box on page 73).

As the curtain rises on 1998, your first priority is to put the 1997 forms behind you as painlessly -- in terms of tax owed and time devoured -- as possible. Once your return is in the mail, or zapped electronically to the IRS, you'll have to do a quick change for your new role behind the scenes: as the stage manager in charge of limiting your 1998 tax liability.

CASH IN ON CAPITAL GAINS

Your first reaction to the revised Schedule D -- where you report capital gains and losses -- might be that the IRS has made a terrible mistake. As in the past, the form asks you to separate short-term and long-term gains and losses, with one year being the demarcation date. But, you may ask, what about the new 18-month holding period to earn that sweet, 20% top rate for long-term gains?

Although never mentioned on the form, the new holding period is the reason for the 36-line addition on the back. That step-by-step procedure determines how much of your gain should be taxed at 10%, 20%, 25%, 28% or in your top bracket.

Working through the form will ensure that your gains are taxed at the appropriate rate, but it's still up to you to report those gains accurately. You'll have 1099-B forms that report how much you received when you sold stock, bonds or mutual fund shares. But it's your records that will show your basis.

Gregory Page, 42, a Commack, N.Y., pharmaceutical consultant and avid investor, will have little trouble with that task this spring. He keeps solid records and knows how to use them to hold down the tax on his gain.

When he unloaded blocks of Novell and Merck stock during market dips last year, he told his broker to sell the shares with the highest basis. That maximized the capital loss he will claim on his Schedule D -- not a bad idea because that loss will offset profits he scored in other transactions during the year.

If you didn't specifically identify the stocks you sold during 1997 -- and you didn't sell your entire position -- use the first-in, first-out method to set the basis of shares sold. Basically, that means assuming you sold the shares you owned for the longest time, which usually means those with the lowest basis and the highest taxable profit.

When it comes to mutual fund redemptions, you have another option: the average-basis method. It's attractive to millions of investors because most funds do the work for you. They keep track of the average basis of shares redeemed and report it, as well as the proceeds of the redemption, to you at tax time. The difference is your gain or loss.

PREVAIL OVER FUND PAPERWORK

Speaking of mutual funds, there's a big change this year when it comes to reporting capital-gains distributions. In the past, shareholders who didn't have other gains or losses to report could disclose these distributions -- which represent their share of long-term capital gains realized on sales inside a fund -- on the face of the Form 1040 and not mess with the Schedule D at all. That's out, starting this year. You must report the capital-gains distribution on Schedule D, which lets you take advantage of the new lower rate for capital gains.

Count on confusion here, too, because capital-gains payouts from funds include income that is to be taxed at different rates, just as your redemptions are treated differently depending on when you sold and how long you had owned the shares.

As explained in the box, you'll be required to report total long-term gains and also to break out the 28% rate" portion of those gains. That's the term the IRS decided to apply to long-term gains taken before May 7, 1997, midterm gains taken after July 28, and long-term collectible gains taken at any time -- all of which are taxed at the top rate of 28%.