April 3, 2018
The countdown to Tax Day has begun! The deadline for filing your 2017 individual income tax return this year is Tuesday, April 17, 2018.
Drawbacks to a Filing Extension
Before you file for an extension, be aware of three potential pitfalls:
1. Underpayment penalties. You still must pay your estimated tax liability for 2017 by April 17. If you underpay, you will owe an interest charge penalty.
2. Delayed refunds. If you’re due a refund, filing an extension will postpone it. In effect, you’re granting Uncle Sam interest-free use of your refund money.
3. Bad feng shui. Don’t let this dreaded chore hang over your head all summer; you might just be postponing the inevitable. If you have nothing to gain, it’s probably better to get the tax return off your to-do list.
Despite rumors that an extended tax return increases your exposure to an IRS audit, there’s no evidence to support that theory. In fact, an extension could reduce the risk of an audit if you’re using the extra time to fix errors, assemble your records or clear up inconsistencies.
Many taxpayers are currently scrambling to wrap things up. If you’re among the procrastinators, there’s an easy fix: Ask your tax advisor to file Form 4868 by April 17, and you’ll automatically qualify for a six-month extension from the IRS. Doing so gives you until October 15, 2018, to file your 2017 return.
An extension allows you to avoid late filing penalties. But there’s a catch: An extension to file is not an extension to pay your tax bill. By April 17, you must make a good-faith estimate of your 2017 tax liability. In general, to avoid penalties, you also must have paid in at least 90% of the current year’s tax liability or 100% of the prior year’s liability by April 17. The latter threshold increases to 110% of the prior year’s (2016 in this case) liability if your adjusted gross income (AGI) for 2017 was over $150,000.
Here are some scenarios where an extension may provide opportunities to collect data or complete transactions that would reduce your 2017 tax liability.
In-Progress “Like-Kind” Exchanges
An extension can provide extra time if you need to complete a like-kind exchange that you initiated in late 2017. Under Section 1031 of the tax code, you can defer the capital gains tax hit on transfers of certain investment or business property if you exchange it for qualifying “like-kind” property.
For instance, you might swap an apartment building for a warehouse or vacant land in a like-kind exchange. If your transaction qualifies for Sec. 1031 treatment, there’s generally no tax due on a timely exchange, except for any “boot” you receive (such as cash to make up for differences between the properties’ fair market values).
To qualify for a tax-favored like-kind exchange, you must receive the replacement property by the earlier of:
- Midnight of the 180th calendar day following the date you relinquished your property, or
- The due date of your federal income tax return for the tax year in which you relinquished your property, including any extensions of time to file.
Important: The Tax Cuts and Jobs Act (TCJA) generally limits tax-free Sec. 1031 exchanges to only real estate for exchanges that are completed after 2017. However, if you relinquished other business property in 2017, you can still complete the second leg of a Sec. 1031 like-kind exchange in 2018 so long as you meet the deadline for receiving the replacement property.
You may convert a traditional IRA into a Roth IRA to benefit from future tax-free payouts. Qualified distributions from a Roth IRA (for example, those made after age 59½ if you’ve had at least one Roth account open for over five years) are 100% exempt from federal income tax. By comparison, qualified distributions from a traditional IRA are wholly or partially taxable.
A Roth conversion is subject to tax in the year of conversion based on the account balance on the conversion date. You may later second-guess an IRA conversion if, say, the Roth IRA’s investments decreased in value after the conversion date or you need the money you set aside for the conversion tax for another purpose.
Fortunately, you can still undo a 2017 conversion. You just need to “recharacterize” the Roth IRA back into a traditional IRA by the 2017 tax return due date, including extensions, for the year of the conversion. Although you don’t need to extend your 2017 return to recharacterize a Roth conversion, an extension gives you a little extra time to evaluate your options.
Important: Starting in 2018, the TCJA repeals the Roth recharacterization privilege. But the IRS has confirmed that you can still recharacterize a 2017 conversion, so long as you get it done by October 15, 2018.
Medical Expense Deductions
Most TCJA changes don’t go into effect until 2018. But the liberalization for itemized medical expense deductions goes into effect retroactively for 2017. Many people are unaware of this change and could use more time to compile their medical records. If you incurred major medical expenses in 2017, you might benefit from an extension if you need more time to compile all your medical expenses.
Under prior law, if you itemized deductions in 2017, you could deduct unreimbursed medical expenses in excess of 10% of adjusted gross income (AGI). The new tax law lowers the deduction threshold to 7.5% of AGI — but only for 2017 and 2018.
This change might open the door for an additional or increased deduction on your 2017 return. It also might affect your decision to itemize deductions or take the standard deduction for 2017.
Business Auto Expenses
If you use a vehicle for your self-employed business, you can deduct either:
- Actual expenses (including depreciation expense) related to your business use, or
- A simplified flat mileage rate prescribed by the IRS.
For 2017, the flat rate is 53.5 cents for each mile of business travel, plus the actual cost of any tolls and parking fees. (For 2018, the rate increases to 54.5 cents for each mile of business travel.)
Using the flat rate is certainly easier. But, if you take the time to examine your records, you might determine that using the actual expense method produces a significantly bigger deduction. An extension gives you extra time to compile the detailed records needed to support the actual expense method.
Important: You can generally switch to the actual expense method if you’ve used the flat rate to deduct business auto expenses in a prior year. But, if you’ve previously claimed a deduction for accelerated depreciation on the vehicle, you generally can’t switch to using the flat rate on that vehicle in subsequent tax years.
Should You Call a Timeout?
The clock is running out on filing your 2017 tax return. An extension stops the clock and gives you extra time to plan out your final tax strategy. In addition to these examples, your tax advisor might have other last-minute ideas that apply to your personal situation. Contact him or her to coach you through this decision.