Prepayments: Tax Rules and Strategies

As the end of the year approaches, there is still time to make last-minute payments, including prepayments for items that might otherwise be due in 2011. How do repayments affect your taxes this year?

Cash Method Taxpayers

Since almost all individuals use the cash method of accounting for their personal finances, they generally can deduct payments when made. Thus, for example, if a taxpayer in December 2010 pays 6 months of health insurance premiums, then the 5 months of 2011 coverage qualifies as a deductible medical expense for the 2010 return.

12-month rule. There is a limit on how much can be prepaid. Under a 12-month rule, you do not have to spread the deduction for the expense over the period to which it relates if prepayment creates a right or benefit that does not extend beyond the earlier of (1) 12 months after the first date of the right or benefit or (2) the end of the tax year following the tax year in which the expense was paid or incurred. Essentially, you can prepay an expense for 12 months without concerns.

For example, since self-insured individuals can reduce their net earnings from self-employment for self-employment tax purposes by their health insurance premiums in 2010 only, some self-employed individuals might want to prepay some or all of their 2011 premiums to obtain the self-employment tax reduction in 2010.

Year-end payments. If you had planned to pay certain expenses in 2011, you might want to accelerate payment into 2010. This will allow you to deduct your payments on your 2010 return. Examples: Charitable contributions and discretionary medical expenses.

Special Rules

Some items are subject to special tax treatments that do not fit neatly within the basic rules already discussed:

Mortgage points. Points are viewed as a prepayment of mortgage interest. If the mortgage is on any property other than a principal residence (such as a vacation home or rental property), the points cannot be deducted up front; they must be deducted ratably over the term of the mortgage.

If the points are paid on a home mortgage, they can be deductible in full in the year of payment if:

1. The loan is secured by the principal residence;

2. The charging of points is an established business practice in your area;

3. The points do not exceed the normal amount charged in your area;

4. The points are computed as a percentage of the loan amount; and

5. You pay the points directly to the lender.

Education credits. There’s a special prepayment rule for the American Opportunity and Lifetime Learning Credits. You can claim a tax credit with respect to 2010 payments of qualified expenses for academic periods beginning in the first three months of 2011. Expenses that are prepaid for academic periods beginning after March 2011 are not eligible for a credit in either 2010 or 2011.

AMT Planning

Prepayments of certain items may not make sense for taxpayers subject to the alternative minimum tax (AMT). While the items may be deductible for regular tax purposes, they are not deductible for AMT purposes, thereby losing any tax benefit from them. Some items that are not deductible for AMT purposes include:

• State and local taxes
• Job-related expenses
• Trade and professional association dues