Tax planning strategy: "Bunching" itemized deductions

Each year individuals have the choice of itemizing their deductions or taking a specified amount (called the "standard deduction") when they file their income tax returns. At first glance, this decision seems pretty simple and straightforward. Just add up your taxes, mortgage interest, charitable contributions and other itemized deductions. If the total is more than the standard deduction, then itemize; if less, then don’t.

However, some taxpayers end up with itemized deductions nearly equal to the standard deduction year after year. Consider the following example of married taxpayers filing a joint return. They have adjusted gross income of $80,000 and no dependents. Their deductions and income tax are calculated as follows:

		2006		2007
State and local taxes		$ 3,650		$ 3,750
Real estate taxes		1,800		1,850
Mortgage interest		4,450		4,400
Charitable contributions		500		500
Total itemized		10,400		10,500
Standard deduction		10,300		10,700
Adjusted gross income		80,000		80,000
Greater of itemized or standard		(10,400)		(10,700)
Personal exemptions		(6,600)		(6,800)
Taxable income		63,000		62,500
Income tax per tax tables		8,871		8,593

As this illustration shows, their itemized deductions in 2006 were $100 more than the standard deduction. In 2007, their itemized deductions didn't help them at all because they were $200 less than the standard deduction. Their total tax for the two-year period was $17,464.

With a little tax planning, their situation could have turned out much better. Since itemized deductions are claimed when they are paid, taxpayers can "bunch" their itemized deductions in a year when they know the total will exceed the standard deduction. The next year, they can delay payment of itemized deductions if they know the total will be less than the standard deduction.

Assume the same facts, except in November 2006 the taxpayers meet their CPA for some tax planning. As a result, in December 2006 they do the following:

1.       Prepay their 2nd half 2006 property taxes of $925 (due January 2007).

2.       Make their mortgage payment (due January 1st) on December 31st. Assume the interest portion of this payment is $350.

3.       Make a charitable contribution of $125 in December 2006 rather than January 2007.

Their deductions and income tax are now calculated as follows:

		2006		2007
State and local taxes		$ 3,650		$ 3,750
Real estate taxes		2,725		925
Mortgage interest		4,800		4,050
Charitable contributions		625		375
Total itemized		11,800		9,100
Standard deduction		10,300		10,700
Adjusted gross income		80,000		80,000
Greater of itemized or standard		(11,800)		(10,700)
Personal exemptions		(6,600)		(6,800)
Taxable income		61,600		62,500
Income tax per tax tables		8,521		8,593

Please note that their itemized deductions in total over the two year period have not changed. The taxpayers are simply "bunching" their deductions in the year they itemize. They paid $1,400 of deductions in 2006 that were not actually due until 2007. For the two years, their total tax is now $17,114 - a savings of $350!

This strategy allows taxpayers to "bunch" their itemized deductions in every other year. The taxpayers in our example would plan on itemizing again in 2008. With this in mind, the charitable contributions they made in December 2007 (when they took the standard deduction) could have been paid in January 2008 (when they are itemizing again). By prepaying (or delaying) the payment of property taxes, mortgage interest and charitable contributions, taxpayers can maximize the tax savings of their itemized deductions.