February 28, 2020
Roughly 15 million individual taxpayers filed for an automatic six-month extension for the 2018 tax year, according to the IRS, compared with about 10 million people in previous years. Why did the number of extensions surge last year? Most changes under the Tax Cuts and Jobs Act went into effect in 2018. So, many people who filed an extension weren’t just procrastinating — they were taking extra time to digest the 2017 tax law.
A year later, there’s generally a better understanding of recent tax law changes. As a result, fewer people are expected to file an extension for 2019 compared to last year. But there are still valid reasons to extend your deadline from April 15 to October 15, as well as some potential pitfalls to watch for.
Filing an Extension
Perhaps you haven’t gathered all the information or completed all the necessary transactions to complete your 2019 federal tax returns. Filing for an automatic six-month extension can give you extra breathing room.
The process is simple: Ask your tax advisor to file Form 4868 by April 15, and you’ll automatically qualify for a six-month extension from the IRS. Doing so gives you until October 15, 2020, to file your 2019 return — and avoid late filing penalties.
But there’s a catch: An extension to file isn’t an extension to pay your tax bill. By April 15, you must make a good-faith estimate of your 2019 tax liability. To avoid penalties, by April 15, you generally must have paid at least:
- 90% of the current year’s tax liability, or
- 100% of the prior year’s liability.
The latter threshold increases to 110% of the prior year’s (2018 in this case) liability if your adjusted gross income (AGI) for 2019 was over $150,000.
Reasons to Extend Your Deadline
Examples of situations where an extension may provide opportunities to collect data or complete transactions that would reduce your 2019 tax liability include:
Medical expense deductions. Under current tax law, if you itemize deductions in 2019, you can deduct unreimbursed medical expenses in excess of 7.5% of adjusted gross income (AGI). The threshold will increase to 10% of AGI starting in 2021, unless Congress passes legislation to extend the current 7.5%-of-AGI deal.
For itemized deduction purposes, medical care is defined as “procedures and care for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body.” IRS regulations further stipulate that medical care includes medical, laboratory, surgical, dental, and other diagnostic and healing services. Care that’s merely beneficial to your general health isn’t medical care.
Important: A portion of the fees paid to enter and reside in a continuing care retirement community can qualify as medical expenses for medical expense itemized deduction purposes. Such fees often are substantial — so they can push you over the AGI threshold.
Compiling all the documentation to support a medical expense deduction can take time and effort. Remember that health care providers need time to work through invoices with your insurance company (or Medicare) and there may be a delay between when you receive services and when you receive the final bill. A tax professional can help you understand which costs are deductible.
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 2019, the flat rate is 58 cents for each mile of business travel, plus the actual cost of any tolls and parking fees. (For 2020, the rate decreases to 57.5 cents for each mile of business travel.)
Using the flat rate is easier. But, if you take the time to examine your records, you might determine that using the actual expense method produces a 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.
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 2019. Under Section 1031 of the tax code, you can defer the capital gains tax hit on transfers of real estate if you exchange it for qualifying “like-kind” property.
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.
For instance, an investor might swap an apartment building for a warehouse or vacant land in a like-kind exchange. If the transaction qualifies for Sec. 1031 treatment, there’s generally no tax due on a timely exchange, except for any “boot” received (such as cash to make up for differences between the properties’ fair market values).
Before you file for an extension, be aware of the potential pitfalls. First and foremost, you must pay your estimated tax liability for 2019 by April 15. If you underpay, you’ll owe an interest charge penalty. In addition, if it turns out that you’re due a refund for 2019, filing an extension will postpone it. In effect, you’re granting Uncle Sam interest-free use of your refund money.
Plus, filing an extension just postpones the inevitable. Rather than allow this dreaded chore to hang over your head all summer, it might be easier to check it off your to-do list this spring — and then move forward with tax planning for the 2020 tax year.
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.
What’s Right for You?
The clock is running out on filing your 2019 tax return. An extension stops the clock and gives you extra time to plan out your final tax strategy. Contact your tax advisor to discuss these and other possible solutions specific to your situation.