Delve into details before you buy state tax credits

Question: I know of several colleagues who are purchasing state tax credits to satisfy their 2004 state individual income tax obligation. Is this a good idea? Are there any traps I need to worry about?

Answer: Each state has different tax credit programs with different rules. The concept behind tax credits generally is to provide a financial incentive, through tax credits, to encourage cash investments for certain social or economic activities. If your state allows the tax credits they issue to be transferred without severe penalties, a tax market is created for buying and selling.

The Internal Revenue Service has several tax credit programs, but most of its tax credits cannot be transferred without causing significant financial penalties to the seller. Consequently, you don't hear much about federal tax credits being sold in an open market.

Typically tax credits are purchased from the original holder -- who made the desired expenditure to earn the tax credit -- by a bank, broker or other service organization for cents on the dollar. Then, the broker/purchaser resells these credits, at a profit but below their face value, to someone who is looking for a method to satisfy a state tax obligation for an amount less than was originally owed.

Tax credits can be used for many different types of taxes, such as individual income tax, corporation income tax and franchise tax. Sometimes you may be able to negotiate the price, depending on the supply of tax credits, and when you plan to purchase them. If you purchase them at a popular time such as December or April, you most likely will pay more for them than making your purchase at an off-tax season time, such as in the summer months.

Make sure when you buy tax credits that they are for the correct type of tax, for the correct tax year and for the correct name. If you have income, but your spouse doesn't, and your state separately taxes married individuals' income, the tax credit must be in the name that owes the tax or it will be wasted. If there are errors made, they can be corrected, but it takes time to prepare, file and receive the corrected paperwork from the tax credit seller and your state, and the delay will cause late payment penalties.

Purchasing tax credits for cents on the dollar provides significant benefits, but the savings is not the difference between your purchase price of the credit and their face value. Because tax credits are considered purchased "property" the difference between the purchase price and full value of the tax credits must be reported as short-term capital gain income. So, to evaluate your true savings you must reduce the state tax savings by the income taxes thereon.

Another aspect of the tax credit to evaluate when considering the purchase is the effect on your state income tax deduction for federal tax itemized deductions. Because the tax credit is considered your property until it is assigned to your 2004 tax return, the federal deduction is not available until April 2005. If you were counting on a 2004 tax deduction, you may owe more federal income tax than anticipated. Furthermore, it might cause a bunching of state tax deductions in 2005 if you didn't continue to buy state tax credits for your 2005 tax liability, which creates an alternative minimum tax add-back to your 2005 regular tax liability.

Sometimes it is possible to buy prior years' tax credits, which may be used against a prior year's tax liability. By filing an amended income tax return, you may receive a refund that you didn't expect. Of course, the tax refund is taxable income, but you still come out ahead. Contact a broker in your area and, of course, consult your tax adviser to determine if this is something that might benefit you.

Question: Recently I was approached to purchase long-term care insurance. I am a 47-year-old urologist and am not sure I am old enough to need this type of protection. What are the income tax benefits of paying the premiums, and does it make sense for me?

Answer: To be eligible for long-term insurance you need to be in reasonably good health. Buying insurance, like taking out a bank loan when you don't need the money, is always better when you are healthy.

There are many different products to purchase depending on what type of coverage you are pursuing. Your policy should cover at-home care, community programs, assisted-living services and nursing home care. Also, carefully select how soon you want benefits to start after the need arises.

Long-term care premiums are deductible in part, based on an IRS-released chart. The deductible amount on the chart increases as you age, but does not match with the actual costs. Some states allow a tax deduction for some or all of your premiums paid. The good news is that benefits received would not be taxable income to you.

But do you need this type of coverage? If nursing home care or home care after an injury or condition is needed after you are 65 years old, Medicare may cover the cost for a certain period, such as the first 100 days. After the 100 days are up, you would be responsible for payment, which currently costs in the range of $3,000 to $6,000 per month. That could erode your retirement savings.

After all the savings are gone, Medicaid or help from family members would be your only option to provide necessary care.

If being a burden to your family or the idea of being a Medicaid patient at a nursing home is unsettling, then consider purchasing long-term care insurance. Premiums can be high, but starting at a younger age may help.