Deferral of taxes refers to the practice of postponing tax payments from the current year to a later year. This strategy can be highly beneficial for taxpayers as it allows them to manage their cash flow more effectively and potentially reduce their overall tax burden.
Mechanisms of Tax Deferral
Income Postponement
One common method of tax deferral involves delaying the receipt of income to a subsequent year. By postponing income, taxpayers can defer the associated tax liability to a future period.
Example: A freelancer might delay invoicing for services performed in December until January of the following year, thereby pushing the income, and the tax liability, into the next tax year.
Like-Kind Exchanges (Section 1031 Exchanges)
Another prominent mechanism is through like-kind exchanges, specifically under Section 1031 of the Internal Revenue Code. This allows taxpayers to defer capital gains taxes on the exchange of certain types of property, usually real estate, until the new property is sold.
Example: An investor sells a rental property and uses the proceeds to purchase a new rental property. Under Section 1031, the capital gains tax on the sale can be deferred until the new property is sold.
Benefits of Tax Deferral
Earning Interest
When taxes are deferred, the taxpayer retains the funds that would have been paid in taxes, and these can be invested to earn interest. This allows the taxpayer to benefit from the time value of money.
Timing with Lower Tax Brackets
Deferring taxes can be particularly advantageous if the taxpayer expects to be in a lower tax bracket in subsequent years. By shifting income or gains to a year with a lower tax rate, the overall tax burden can be reduced.
Offset by Losses
Deferred taxes can often be offset by subsequent losses, effectively reducing the future tax liability.
Special Considerations
Tax Code Compliance
Taxpayers must comply with all applicable tax code provisions when deferring taxes. For example, like-kind exchanges have specific requirements and deadlines that must be met to qualify for tax deferral.
Timing and Tax Planning
Deferral strategies should be part of a comprehensive tax planning approach. It’s essential to consider the timing of income, deductions, and potential changes in tax law.
Examples of Tax Deferral
Retirement Accounts
Contributions to certain retirement accounts, such as traditional IRAs and 401(k) plans, are tax-deferred. Taxes on the contributions and any investment gains are deferred until funds are withdrawn, typically at retirement.
Depreciation
Businesses can use various depreciation methods to defer taxes on the expense of capital assets. Accelerated depreciation methods allow for larger deductions in the earlier years of the asset’s life, effectively deferring tax liability.
Historical Context
The concept of tax deferral has been a part of tax planning for many years. The Tax Reform Act of 1986 and subsequent amendments have shaped the current landscape, introducing provisions like Section 1031 and various retirement account regulations.
Comparisons and Related Terms
Tax Evasion vs. Tax Avoidance
- Tax Evasion: Illegally avoiding taxes through deception or fraud.
- Tax Avoidance: Legally minimizing tax liability through strategies like deferral.
Deferred Tax Liability
- Deferred Tax Liability: A tax obligation that has been incurred but will not be paid until a future date, often due to timing differences between financial accounting and tax reporting.
FAQs
What are the risks of deferring taxes?
Can all taxpayers benefit from tax deferral?
How can one ensure compliance with tax deferral strategies?
References
- Internal Revenue Service (IRS). (n.d.). “Tax Code, Regulations and Official Guidance.”
- Tax Reform Act of 1986.
- Section 1031 of the Internal Revenue Code.
Summary
Tax deferral is a strategic approach allowing taxpayers to postpone tax payments to a future period, potentially benefiting from the time value of money and favorable tax rates. Common methods include income postponement, like-kind exchanges, and contributions to retirement accounts. While beneficial, it requires careful planning and compliance with tax laws to mitigate risks.
