Avoiding Taxes When Selling Short

ANSWER: Short sales — when a home is sold for less than its mortgage and the lender agrees to forgive the difference — can be a decent solution to a bad situation. Problem is, the Internal Revenue Service considers that debt forgiveness to be a taxable event, which means the seller would owe income tax on that amount. But in its frenzy to be useful amid the subprime mess, Congress passed the Mortgage Forgiveness Debt Relief Act late last year, eliminating the tax on short sales through 2009. (Exceptions have always applied, including debts discharged through bankruptcy.)

QUESTION: If I convert a rollover IRA to a Roth IRA in 2010, is there any way to minimize the taxes?
— Christopher Hudson, McLean, Va.

ANSWER: A man who likes to plan ahead! Starting in 2010 the income requirement on Roth conversions — currently limited to folks with incomes below $100,000 — will be removed. That's a huge boon, since Roth IRAs make sense for a lot of people who are unable to convert or contribute because of income limitations (earn more than $169,000 between you and your spouse and no Roth for you). Because there are no tax breaks offered on contributions (that includes rollovers), Roths allow investors to take money out tax-free. But that also means conversions can be pricey: You'll have to pay income tax on any amount you transfer from a traditional or rollover IRA into a Roth IRA, though if you've made any nondeductible contributions, you won't owe tax on that amount. There is some good news: Investors who convert all or part of an IRA to a Roth can elect to pay just 50% of the tax owed in 2011 and the other half in 2012. "It's an interest-free loan from the government — you might as well use it," says Randy Frischer, partner at BDO Seidman.

There is one potential downside to that strategy: Today's current income-tax rates — which max out at 35% — are set to expire after 2010, at which point the top rate returns to 39.6%. Congress could vote to extend the lower tax rates, but whether or not that happens is largely tied to who's sitting in the Oval Office next year. That makes tax planning at this early stage difficult, but you can start thinking about deferring potential deductions, like charitable donations, into 2011.

QUESTION: I got married in June 2007. My wife has a son from a previous relationship whom I'd like to claim as a dependent. What filing status do we use?
— Andrew Bodine, Asheboro, N.C.

ANSWER: According to Uncle Sam, even if you married on Dec. 31, 2007, you were married for all of 2007. That means your filing-status options are "married filing jointly" and "married filing separately." For the vast majority of couples, filing jointly is the way to go, since filing separately often means forgoing numerous tax breaks. Claiming your new stepson as a dependent shouldn't be a problem, provided your wife is the custodial parent and the divorce decree doesn't grant her ex the right to claim him on his return, explains New York City-based CPA Michael Goodman. Filing jointly for the first time may be a little tricky — but no one ever said married life is easy.

QUESTION: I have a 401(k) and a Roth IRA. I plan to start a side business. Can I also contribute to a self-employment type of plan, like a SEP?
— Kirt Manecke, Milford, Mich.

You bet. The IRS doesn't prevent you from contributing to multiple retirement accounts, although you may hit a couple of limitations. The maximum contribution limit on defined-contribution plans (which includes 401(k)s and Simplified Employee Pensions, or SEPs) is $46,000 in 2008 or 100% of your compensation, whichever is less. There are a variety of options for savings if you're self-employed, including the SEP, Keogh plans and Solo 401(k)s. For more information on each, see smsmallbiz.com.