Trimming your sails for tax reform

IT may happen late this year. Maybe next year. Maybe in bits and pieces. But someday tax reform is going to be upon us.

Don't count on its being the sweeping revision introduced in May by President Reagan (officially entitled ``The President's Tax Proposals to the Congress for Fairness, Growth, and Simplicity'' -- sometimes referred to simply as ``Treasury II'').

Even though the President says he intends a ``major fall offensive'' for his tax plan, it is doubtful Congress will simply rubber-stamp it. In the face of huge budget deficits and congressional elections next year, the confusion and hurt feelings brought on by a wholesale revision of tax laws would be politically dangerous. And recent polls have shown the American public underwhelmed by the notion anyway.

Which is not to say that tax reform is dead. It will probably come piecemeal over the next several years. For whatever the means and methods, most personal financial planners agree that change is in the air.

Already, they say, lawmakers are having the Internal Revenue Service stress income and de-stress tax shelters. Democrats and Republicans appear to agree that there should be more incentives to earn money and fewer incentives to pile up debt.

And you should make financial plans accordingly, the financial planners say.

``Do it now, because we don't know about next year,'' says Neil Alexander, head of Alexander Associates Inc., a Los Angeles investment adviser. Although he recognizes that much of ``the financial community is responding as though this law were a fait accompli,'' Mr. Alexander does not expect big tax reform this year.

Congress and the President are likely to have a long tug of war over tax reform, and most changes won't take effect right away, although some may be retroactive to Jan. 1, 1986.

Still, it's a good time to begin getting ready.

``It's important to pay attention,'' says Thomas Ochsenschlager in the Washington office of Alexander Grant, the accounting firm. ``But it is too early for a dramatic move.''

Mr. Oschsenschlager says he thinks it is likely the President and Congress want ``something to sign in the Rose Garden'' and, unlike Alexander, he expects an initial package of tax-law changes out of Congress this year.

The consensus in Washington is that regardless of specifics, two things are likely: (1) Your earnings could be subject to less taxation in future tax years, and (2) many deductions you enjoy will be reduced or eliminated at the same time.

Consequently, personal financial planners are dispensing tried and true advice this year with just a bit more emphasis: Accelerate your deductions; defer any income you can until next year.

``That's always good advice,'' says John Markese, director of research at the American Association of Individual Investors. The part of the President's proposal most likely to pass, he says, will be the cut in income-tax rates. And deductions are going to get curtailed -- starting with the most abused (from the IRS point of view) ones.

This may be the last year you can take the investment tax credit (ITC), for instance. It may be the last year in which you can take charitable deductions without itemizing. It may be the last year you can transfer income to a child to shelter it.

But if you see a bonus, a royalty, or a gift on the way toward the end of this year, you might want to defer these until after Jan. 1. That way, in case income-tax rates are reduced you can benefit.

Ochsenschlager also notes that ``you have nothing to lose prepaying state taxes this year,'' and he thinks it is virtually certain that the ITC will be repealed, so he suggests putting ``equipment into service'' before year's end.

But when it comes to the question of whether or not you can expect to keep the interest deduction for a mortgage on an unrented vacation home (or second home), he suggests caution.

It probably isn't a propitious time to buy a vacation home, he notes, but don't rush to sell one under the concern that you won't get to keep that deduction. Ochsenschlager says there are big questions about whether the IRS will actually be able to differentiate between a home-interest deduction and other types of interest deductions. ``Tracing funds,'' he says, ``is extremely difficult, and it's reasonable to think the IRS won't try.''

Nevertheless, the philosophical shift in Washington appears to be away from that unique -- and often criticized -- provision that allows deductibility of all interest expenses. Treasury II would limit personal-interest deductions, excluding those on your main home mortgage, to $5,000 above net investment income.

In other words, if your investments were earning you, say, $5,000 a year, you would have a $10,000 limit on interest deductions.

With this in mind, investment adviser Neil Alexander notes that in the future real estate should be viewed as an ``income vehicle, not a tax deduction.'' Hence he recommends investments such as property that can be fixed up and sold at a profit rather than property that simply gives you the depreciation and interest deductions.

``The coming tax reform,'' Alexander says, ``will wipe out investments geared mainly to tax benefits rather than economic value.''

He is therefore negative about virtually all tax shelters. But he favors stocks, which he sees as coming in for preferential treatment under most possible tax-reform plans -- especially under more liberal income-tax and capital-gains provisions.

Real estate investment trusts that practice ``buy-and-hold strategies'' in property markets such as Houston or Dallas are good, too, he says.

Most observers agree that the prospect of tax reform has created unique opportunities. For instance, given that many fretful owners of vacation homes have decided to sell, you might actually be able to pick up a dream retirement home at a bargain price.

It also makes sense to take a lump-sum distribution from a retirement program this year if you are in a position to do so. The tax-reform plan would eliminate your ability to use the special 10-year forward-averaging method for this income.

The same with single-premium life insurance and tax-deferred annuities -- after 1985, both would be taxed as they build up value each year.

Tax-free gifts to minors will probably be curtailed, too. Under Treasury II, children under 14 who receive more than $2,000 in income would be taxed at the parents' marginal tax rate. Take advantage of it this year; it may not be around next.

Clifford trusts would also be much less attractive under Treasury II. Don't rush to set one up this year, however, because you have to maintain it in future years, and the tax-reform plans would make that much a less attractive prospect.