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

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.

You may find that municipals are less attractive than they seem in the advertisements, if you factor in expectations for inflation, the economy and interest rates over the years, or decades, that you may have to hold the bond. To illustrate, stockbroker Earl Fisher, a partner in the Los Angeles firm Stern Fisher Atkinson Inc., calculates the effective rate of return under 1987 and 1988 tax rates on a 1992 California water bond currently yielding 5.25%. The 8.5% taxable equivalent yield for this year would be hard to beat safely in other investments. But once federal tax rates go down to 28%, the municipal’s equivalent yield drops to 7.3% and bears comparison with utility common stock paying a 7.6% dividend. Excluding state tax considerations, the utility stock beats the muni on an after-tax basis in 1988, and it offers some dividend protection against inflation or higher interest rates between now and 1992 that the municipal bond cannot.

The point is not to recommend munis or utilities but to counsel thinking for yourself rather than listening to the crowd. Millions of shareholders became a crowd last December, for example, and swamped brokerage houses with orders to sell stocks that they had held for years. Their impulse was to save on taxes by locking in the old 20% capital gains rate and avoiding this year’s 28%.

Selling stock was the smart thing to do in December. But it didn’t look so smart in January, when the value of many stocks rose far more than the eight-point addition to the capital gains rate. And that leaves aside the fact that at 28%, capital gains remain a bargain compared to the 38.5% top rate on ordinary income in 1987. Somebody wasn’t thinking.

Understandably, perhaps. The new tax law’s changes are so fundamental that they’ve aroused as much fear as hope. Many fear, for example, that eliminating the capital gains differential will discourage people from founding or investing in new businesses.

“Entrepreneurs will only leave the comfort of the big company if they can have an edge,” said Richard Eden, a founder of Gigabit Logic, a software firm in Newbury Park. But Sen. Bradley disagrees. “Capital gains differential was important when marginal tax rates were high,” he said, “but less so when they’re low. And anyway, people found or invest in new businesses because they believe the new idea is going to give them a big payoff.”

Logic favors Bradley. Anybody looking at how the new law eliminates the little comfort deductions of the wage-earning middle class--club dues, magazine subscriptions and the like--will know that, as ever, the tax law makes owning your own business the smartest way to go.

Which brings us to the final big question: Will the terms of the new tax law stay still long enough for you to get used to them? The new law, says Robert Gowring, tax partner in the accounting firm of Touche Ross, is the sixth new tax measure in the last 10 years. He doubts it will go unamended. Most Americans share those doubts, according to a national survey taken for Money magazine, and so do experts in Washington who tell Times reporter Tom Redburn, on Page 00, that the tax law will change all over again two years from now when President Reagan leaves office.

Why this constant fiddling? The blame, says “A History of Taxation and Expenditure in the Western World,” a new book by UC Berkeley professors Carolyn Webber and Aaron Wildavsky, lies with our slow-growing economy. During the 1950s and early 1960s, the scholars report, paying for new government programs or increasing expenditure on old ones was not a problem because rising productivity increased the government’s tax revenues. There was no need to tamper with the tax laws. Then things changed in the late 1960s, although not visibly. Inflation masked declining productivity for a time, so tax revenues appeared adequate. It was the beginning of bracket creep and dissatisfaction with the tax system.

Since the mid-1970s, we have been living without blinders but with a constant struggle between the needs and desires of social and defense programs and the wherewithal to pay for them. The tax system has been hauled this way and that, like a 50-yard tarpaulin trying to cover a 100-yard field.

But take heart. It was impatience, or exhaustion, with the old patch-and-pray tax process that got this bipartisan tax law out of committee one weekend last May and made it law before the leaves fell in October. Last year, the politicians feared the voters’ wrath if they did nothing. Now they may have reason to fear that wrath if they do something, like tampering with the law before it even takes effect. The logic of the situation says we may have a long time to work with the new law, to test the effects of its rules. So put on your thinking cap and plan ahead.

1987 is 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.

HIGHLIGHTS OF THE TAX REFORM ACT OF 1986 Tax rates 1986 (Old tax law): 15 brackets from 11% to 50%. 1987 and later years (New tax law): 1987: 5 brackets from 11% to 38.5%. 1988 and later: 2 brackets: 15% and 28%; effective rate of 33% for certain high-income taxpayers. Personal exemption 1986 (Old tax law): $1,080. 1987 and later years (New tax law): $1,900 in 1987; $1,950 in 1988; $2,000 in 1989; indexed for inflation thereafter. No exemption allowed on children’s returns if their parents claim them as dependents. Standard deduction 1986 (Old tax law): Couples: $3,670 Singles: $2,480 Heads of households: $2,480 1987 and later years (New tax law): Couples: $3,760 in 1987; $5,000 in 1988; indexed for inflation thereafter. Singles: $2,540 in 1987; $3,000 in 1988; indexed for inflation thereafter. Heads of households: $2,540 in 1987; $4,400 in 1988; indexed for inflation thereafter. Medical and dental expense deduction 1986 (Old tax law): Amount in excess of 5% of adjusted gross income is deductible. 1987 and later years (New tax law): Amount in excess of 7.5% of adjusted gross income is deductible. State and local taxes 1986 (Old tax law): Fully deductible. 1987 and later years (New tax law): Income and property taxes still deductible. Sales tax not deductible. Interest expenses 1986 (Old tax law): Fully deductible. 1987 and later years (New tax law): Mortgage interest on first and second homes still deductible. Deduction for consumer interest phased out: 65% deductible in 1987, 40% in 1988, 20% in 1989, 10% in 1990, not deductible thereafter. Charitable contributions 1986 (Old tax law): Deductible for both itemizers and non-itemizers. 1987 and later years (New tax law): Deductible for itemizers. Not deductible for non-itemizers. Casualty and theft losses 1986 (Old tax law): After subtracting $100 per loss, total amount in excess of 10% of adjusted gross income is deductible. 1987 and later years (New tax law): No change. Miscellaneous deductions 1986 (Old tax law): Unreimbursed employee business expenses, such as professional and union dues, tools and work clothes, and certain expenses of producing income are deductible. 1987 and later years (New tax law): In general, the same expenses as in 1986 are deductible, but only to the extent that they exceed 2% of adjusted gross income; some expenses, such as unreimbursed moving costs, are not subject to 2% floor. IRAs 1986 (Old tax law): For all workers, up to $2,000 contribution is deductible; couple with non-working spouse may deduct up to a $2,250 contribution; earnings in account tax-deferred. 1987 and later years (New tax law): Law unchanged for taxpayers not covered by company pension plan, for singles with adjusted gross income up to $25,000 and for couples with adjusted gross income up to $40,000; deduction for contribution phased out between $25,000 and $35,000 for singles, $40,000 and $50,000 for couples; no deduction if covered by company plan and adjusted gross income exceeds $35,000/$50,000 limits; investment earnings of all accounts still tax-deferred. 401(k) plans 1986 (Old tax law): $30,000 annual limit on individual’s contributions to these employer-based plans. 1987 and later years (New tax law): Limit cut to $7,000; rules tightened to reduce benefits to highest-paid employees. Keogh plans 1986 (Old tax law): Limit of $30,000 or 15% of earned income, whichever is less, on annual contributions to these plans for the self-employed. 1987 and later years (New tax law): Same as current law. Tax breaks for elderly and blind 1986 (Old tax law): Additional $1,080 exemption if 65 or older at end of year. Additional $1,080 exemption if blind at end of year. 1987 and later years (New tax law): Additional exemptions repealed;replaced by higher standard deduction. Elderly and blind may take 1988 personal exemption in 1987. In addition, an elderly or blind taxpayer may take an extra personal deduction of $600 for married individuals, $750 for singles ($1,200 or $1,500 if both elderly and blind). Capital gains 1986 (Old tax law): 60% of profits from investments held at least 6 months is excluded from taxes; effective top rate of 20%. 1987 and later years (New tax law): Taxed as ordinary income up to maximum rate of 28% in 1987. Taxed as ordinary income in 1988 and thereafter. Two-earner deduction 1986 (Old tax law): 10% of lower-earning spouse’s income is deductible, up to $3,000. 1987 and later years (New tax law): Deduction is repealed. Dividend income 1986 (Old tax law): First $100 ($200 for couples filing jointly) is excluded from taxable income. 1987 and later years (New tax law): Fully taxable. Unemployment compensation 1986 (Old tax law): Partially taxed if an individual’s total income exceeds $12,000 ($18,000 for couples filing jointly). 1987 and later years (New tax law): Fully taxable. Earned-income credit 1986 (Old tax law): Low-income families eligible for refundable tax credit of up to $550, phased out at income of $11,000. 1987 and later years (New tax law): Maximum credit raised to $800, phased out at income of $14,500. Income averaging 1986 (Old tax law): Permitted. 1987 and later years (New tax law): Repealed. Income shifting to minor children 1986 (Old tax law): Permitted. 1987 and later years (New tax law): For children under 14, up to $1,000 in unearned income is taxed at child’s rate; additional income taxed at parent’s rate. Child-care credit 1986 (Old tax law): Available for up to 2 children when unmarried head of household or both parents work. 1987 and later years (New tax law): Same as current law. Passive income and losses from tax shelters 1986 (Old tax law): Passive losses may be used to offset ordinary income. 1987 and later years (New tax law): Passive losses may be used only to offset passive income; unused passive losses may be carried forward to later years.