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YOUR TAXES : PART ONE: INTRODUCTION : Tax reform: Time for logical deductions : Best strategy to cope with new law is to think clearly, plan carefully

March 15, 1987|JAMES FLANIGAN | Times Staff Writer

If you're making out your 1986 tax return now and wondering where you're going to find deductions for your 1987 return next year, it may be that you just don't understand the situation.

The Tax Reform Act of 1986, the most extensive overhaul of the Internal Revenue Code since 1954, has altered all the equations. It has changed the old deductions-oriented system, where you made your taxable income as small as possible, to one that is earnings-based, meaning you want to earn as much as you can because you get to keep more of it.

You don't respond intelligently to such fundamental change by shifting a few investments--selling a limited partnership in apartments, say, and buying corporate bonds. No, the only way to cope in the new environment is to change your thinking. As Sen. Bill Bradley (D-N.J.), one of the authors of the new tax law, puts it, from now on you should think about "investing money to make money, not losing money for tax purposes."

Creative investing replaces creative borrowing. The most important feature of the new law is not that it phases out consumer interest deductions or renders tax shelters obsolete. It is that the law lowers individual tax rates. And because of that, even the tax breaks that remain, such as home mortgage interest and income from municipal bonds, demand a closer look.

Let's put that in dollars and cents. Under the old law, with more than a dozen tax brackets culminating in a top rate of 50%, it was economically rational to go for the largest mortgage you could afford because Uncle Sam was "paying" more of your interest burden. If each mortgage interest dollar would otherwise be taxed at rates of up to 50%, you were, as business people say, "playing with 50-cent dollars" when you took a larger mortgage, either to get a bigger deduction or to afford a larger house. But under the new law, when it is fully effective starting in 1988, the dollar deducted would otherwise be taxed at either 28% or 33%--the new effective top rate for many high-income individuals--so you will be playing with up to 72 cents of your own money.

The new tax rates by themselves don't make a large mortgage, or buying a larger house, economically irrational. But they do lower the tax-saving value of mortgage interest, and that should make you think about other things you might do with your discretionary dollars. You could, as Sen. Bradley suggests, invest them, because soon you will get to keep 72 cents of each dollar earned--very likely more than you can keep today.

The main thing is that you think through your economic behavior in light of the new law and don't get carried away by the current din of tax advice, telling you to hock your home to buy a car, for instance, or to load up on dividend-paying investments.

This special section of The Times is designed to help you think. Its two dozen articles offer the individual taxpayer analysis and perspective on subjects ranging from second mortgages to college tuition, from self-employment to the new types of investment tax shelters. The section is not a manual for filling out Form 1040, because an abundance of guidebooks on that subject already exist. And it does not address changes in corporate taxes, because business can hire lawyers and accountants to handle tax problems. But as an individual, whether you use a tax preparer or not, you must often think for yourself. This section aims to help you do that.

So, to begin with, don't forget that 1987 is different, a phase-in year when 65% of consumer interest is still deductible and the top tax rate is 38.5%. That means, among other things, that capital gains are still taxed at a lower rate--28% this year--than ordinary income. It's a bridge year, resembling the past while preparing for the future. Not a bad year, in other words, to practice for the new law's full effects by conducting a few experiments.

On municipal bonds, for example. Demand for the bonds of states, cities and public authorities, which offer tax-exempt interest payments, has been tremendous. So many have rushed to buy what bond houses advertise as the last tax shelter of the middle class that customary price differentials between tax-exempt and taxable bonds have narrowed. Crowd psychology rather than economics is at work.

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