NOTE: I wrote this post in 2012, so be aware of its age. However, the point of this post is still valid.
One piece of advice I always give clients is: never spend money on something just because you might get a tax deduction or tax credit for doing it.
For example, I am not one of those accountants who tells business clients to buy massive amounts of equipment or other assets at the end of the year so they can get a big Section 179 or bonus depreciation deduction. If they need the equipment, then the extra deduction may be useful. Otherwise, it’s a waste of money.
Same thing for individuals who clamor to install energy efficient windows and doors to take advantage of a (smaller-than-the-taxpayer-expects) tax credit. If you need new windows or doors, then the tax credit is a nice bonus. Otherwise, you’re spending money on something you don’t need.
One time I helped a client who owed $1,500 on their tax return. This was the result of not having enough tax withheld from their paycheck during the year. If they made no changes, they would owe about the same amount the next year. But instead of changing their withholding, the client wanted to “start a business” that would generate losses to off-set the $1,500.
The client quickly gave up on that idea when I explained to them that business deductions don’t cause a dollar-for-dollar reduction in tax owed. The client was in the 25% tax bracket, so to off-set a $1,500 tax liability, they would have to have a $6,000 business loss. The client agreed with me that spending $6,000 to save $1,500 makes no sense.
Same thing with the residential energy credits. Back when the credit was 30% of the purchase price, that could result in a decent-sized credit. If you spent $3,000 on energy efficient windows or doors, you’d get a $900 tax credit on your tax return.
But you still had to come up with $3,000 to buy the windows or doors, and wouldn’t recover the $900 until you filed your tax return.
If you didn’t need the windows or doors, you were spending $2,100 (net) out of pocket for something you didn’t need, just so you could get $900 on your tax return!
For further reading, check out this article by Robert Flach, which talks about the same topic from the perspective of foregoing reimbursement from your employer to take a deduction on your tax return.
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