Tax loopholes are back - with a vengeance! Tax simplification and fairness are out the
window. In the battle to bestow tax breaks on their constituencies, Republicans and
Democrats both shouted victory - which usually means the public will get the shaft.
President Clinton became Santa Claus to the middle-class, while Speaker Gingrich showered
the wealthy with capital gains cuts.
The Taxpayer Relief Act of 1997 should be renamed "The Tax Attorneys and
Accountants Full-Employment Act to the Year 2000 and Beyond!" It is so complex and
riddled with loopholes and exceptions, it will take months for the tax professionals to
digest its provisions. This much is certain: There will be numerous tax planning
opportunities for those with investments and large estates. In the past, Congress forced
tax complexity on the wealthier taxpayers and corporations. The law's confusion may affect
middle-class and some low income taxpayers who will now need costly professional advice to
figure out whether they qualify for the tax breaks targeted to them.
For instance, there are 5 different phase-out requirements for the schooling and IRA
benefits alone. Each phase-out is based on a taxpayer's adjusted gross income
("AGI") and is dependent on whether the taxpayer is single or married filing
jointly. A "phase-out" gradually reduces the maximum benefit as AGI rises, until
the benefit is eliminated.
Capital gains rates will be 28%, 25%, 20%, 14% or 10%, depending on the type of asset
and holding period. The 20% rate becomes 18% for certain assets held for 5 years after
2001 and the 10% rate drops to 8%. Depreciated real estate will be subject to the 25%
capital gains tax, although taxpayers may not have retained the records necessary to
compute this new tax. There is a big trap for those using a home-office and depreciating
their homes: any depreciation will be subject to a 25% tax, while the sale of the home
would otherwise be tax-free for the first $500,000 in profits for a couple ($250,000 for a
single person). Those using a home-office in rented property, however, will not suffer
this adverse consequence.
The educational benefits are mostly an illusion to two-wage earning families living in
the Bay Area, since they phase out for couples with AGI's between $80,000 and $100,000 ,
and many so-called, blue-collar or middle-class working jobs - teachers, police, bus
drivers, sanitation workers, truck drivers, nurses, administrators, construction workers -
earn more than $50,000 per year. (Note: if each spouse earned $50,000, the couple receives
nothing) Also, overtime work, the sale of assets or the withdrawal from a retirement
account to pay for a child's education all increase AGI.
Investors with large capital gains may claim victory under the accord. Small business
or farm owners, and those with complicated estates, will enjoy unprecedented estate
planning opportunities. Losers include wage-earners without children, the flat-tax and tax
simplification advocates, professional couples with combined incomes over $110,000, and
long-time owners of very expensive residences. In short, most working families in the Bay
Area and other expensive metropolitan areas will not benefit much from this tax bill,
unless they have money to invest.
The one major exception to this general observation is the ability to sell a principal
residence tax-free for the first $500,000 in profits ($250,000 for single taxpayers). This
will allow a California taxpayer with large profits in a residence to sell it, buy a much
cheaper home in another part of the country, and live off the savings. Whether this will
cause a mass exodus of Californians remains unclear, but there is now a tax incentive to
quit the "rat-race" and telecommute from a remote mountain top in Utah. Given
Oregon's and Washington's disdain of the recent Californian exodus, these states also
could be considered losers under this legislation.
The biggest winners, however, may be the tax and estate planning professionals who now
have an enlarged arsenal of weapons to slash taxes. Indeed, not only will the upper 20% of
taxpayers - the traditional clientele using tax professionals - need tax counsel, but for
the first time, middle-class taxpayers with educational credits and IRA issues will need
sophisticated advice. Also, in the estate planning area, there are several new approaches
for wealthy taxpayers to consider - including an expanded Unified Estate and Gift Tax
Credit and special tax breaks for small businesses and farms.
The capital gains tax rate is reduced from 28% to 20% for assets (except collectibles
such as artwork, trading cards, stamp collections, memorabilia) sold after May 6, 1997,
and held longer than 18 months. For sales between May 6 and July 28, the holding period is
12 months. For those in the 15% tax bracket, currently couples with adjusted gross income
("AGI") of $41,200, the tax is reduced from 15% to 10%. In general, rates drop
from 20% to 18% (and from 10% to 8%) for assets held for at least 5 years and sold after
December 31, 2005 (special rules apply to publicly traded stock held on January 1, 2001).
Gain caused by real estate depreciation will be taxed at 25%. These reductions apply to
all taxpayers and are not restricted by AGI.
The capital gains cut is significant for those owning stock and highly appreciated real
property. Those who have depreciated their real property will be subject to a 25% capital
gains tax on that depreciation. This could negatively impact those owning apartment houses
and those who have used a home-office deduction for their residences.
Moreover, if a taxpayer acquired a property through a series of Sec. 1031 exchanges, he might not have the records necessary to compute the depreciation recapture. The adjusted basis in the present property is the value used to compute the gain on sale. This value, however, may have no relation to prior depreciation taken with respect to the properties that were subject to the Sec. 1031 exchange provisions. For instance, if a taxpayer buys a property for 100x, improves it by 50x and then depreciates it by 80x, the adjusted basis would be 70x (100 + 50 = 150 - 80 = 70). If the taxpayer then exchanged the property for another property worth 200x, he'd carryover his 70x basis. If he then depreciated the property 20x and sold it for 250X, would the depreciation recapture be the current 20x or 100x (prior plus the current depreciation)?
With the new 18-month holding requirement for capital gains treatment, many taxpayers
would be tempted to lock-in gains and wait the 18-month period by selling "short
against the box" (selling short the identical securities) to eliminate a risk of loss
during the holding period. Congress, however, has put a stop to this technique.
The new law requires gain recognition (but not loss recognition) upon the constructive
sale of any "appreciated financial position" in stock, a partnership interest or
debt other than on certain straight debt instruments. In general, a taxpayer engages in a
constructive sale when he enters into a short sale, an offsetting notional principal
contract (a complicated hedging transaction of limited interest to most taxpayers), or a
futures or forward contract, with respect to the same or substantially identical property.
The sale occurs when the taxpayer acquires the related long position. Some limited
exceptions apply to transactions that are closed in the 90-day period ending with the 30th
day after the close of the taxable year. The effective date is transactions occurring
after June 8, 1997.
Profits from the sale of a principal residence may be excluded up to $250,000 for
individuals and $500,000 for couples, provided the home was owned and used as a residence
for 2 of 5 years preceding the sale. The exclusion is limited to home sales occurring
every 2 years or longer. Taxpayers with profits exceeding these limitations will pay
capital gains on sale. Current tax-free rollover provisions (IRC Sec. 1034) and the
once-in-a-lifetime exclusion of $125,000 (IRC Sec. 121) have been eliminated. Sales of a
remainder interest may qualify for this exclusion. Also, a married couple who each own
their principal residence may exclude $250,000 on the sale of a residence, provided they
filed separate returns.
Residences which have been depreciated (usually through the home office deduction) must
recapture the depreciation at a 25% capital gain. This amount, however, should not
diminish the $500,000 tax-free portion. Example: If a married couple sells a home with an
adjusted basis of $100,000 for $750,000 and $50,000 is subject to recapture, their taxes
should be determined as follows: Taxable gain: $750,000 - $100,000 = $650,000. Amount
subject to 25% capital gain = $50,000; amount tax-free: $500,000, amount subject to 20%
capital gain = $100,000.
The effective date is for all sales or exchanges of principal residences occurring
after May 6, 1997. Taxpayers may elect to apply present law to sales occurring before
August 5, 1997, after August 5, 1997, pursuant to a binding contract entered into before
that date, or where the replacement property was acquired before the date of enactment and
the rollover provisions would otherwise apply.
The home office deduction has been expanded to include an office used to conduct
administrative and managerial activities of the taxpayer's trade or business, provided
there is no other fixed location where the taxpayer conducts these services. This
provision effectively overrules the Supreme Court decision in Commissioner v. Soliman,
113 S. Ct. 701 (1993) which disallowed a home office deduction to an anesthesiologist who
practiced at several hospitals, but used a room in his home exclusively for administrative
and managerial activities related to his profession.
Taxpayers should exercise caution regarding the home office deduction, given the
adverse treatment of real estate depreciation. Depreciation deductions incurred through a
home office deduction will be taxed at a 25% capital gains rate, whereas, gain from the
sale of a principal residence will be untaxed up to $500,000 for couples ($250,000 for
individuals) under the new rules.
Commencing in 1998, there will be a $400 per child credit (rising to $500 in 1999) for
children under age 17. The credit will phase out for an AGI of $75,000 for individuals and
$100,000 for couples. The phase-out rate is $50 for each $1,000 over these thresholds. In
other words, an individual with one child will lose $250 of the credit if his AGI is
$80,000 ($5,000 over the $75,000 threshold = 5 X 50 = $250). These thresholds are not
indexed for inflation. Low income families earning at least $18,000, but who pay little or
no tax, will receive the benefit of the per-child credit as a refund.
Democrats hail the child care credit as a tax cut for the middle-class. But compare
this tax benefit for an eligible family with 2 dependents with the capital gains reduction
championed by the Republicans: If Bill Gates sold just 10% of his Microsoft stock for a
gain of $3 billion, in 1997, he would have an immediate tax cut of $240,000,000, (capital
gains reduction from 28% to 20%) compared to no relief for the middle-class family,
because the child care credit takes effect next year. In 1998, the tax benefit to Mr.
Gates equates to the tax benefit received by 300,000 middle class families (each receiving
an $800 credit). In 1999, the ratio drops to 240,000 when each family receives a $1,000
While the Bill Gates example dramatically illustrates the absolute advantage of the
capital gains cut compared to the child care credits, a taxpayer who sells stock for
$1,000,000 in profit will save $80,000 in taxes, the equivalent child care credit received
by 1,000 families. Remember, that many two-wage earning couples will not qualify for the
child care credit because of the AGI limitations. The sale of stock, distribution form an
IRA or merely working overtime will increase their AGI for child credit purposes. In
contrast, there are no AGI limitations for capital gains treatment, which means this
provision benefits the low income sellers of stock and billionaires alike! (Note: 74% of
the capital gains reductions go to those earning $100,000 per year or more).
Families get a maximum credit of $1,500 for a student's first two years of college
(100% of the first $1,000 in expenses and 50% of the next $1,000) at an "eligible
educational institution." For the next two years and for graduate students, the
maximum credit will be $1,000 (20% of the first $5,000 in expenses). These credits are
phased out for individuals with AGI of $50,000 to $60,000 and couples with AGI of $80,000
to $100,000 -- which might preclude most full-time working couples in the Bay Area. This
credit is available for tuition and fees required for attendance. Books, meals, lodging,
student activities, athletics, insurance, transportation and similar personal, living or
family expenses are not included.
To illustrate: If a student pays $1,500 in tuition and $400 in books, the credit is
$1,250 ($1,000 + ½ of $500 = $1,250; books are not eligible for the credit).
Students must be enrolled at least half time in school and cannot have a federal or
state felony conviction consisting of possession or distribution of a controlled
substance. In other words, if you have a felony conviction for marijuana, you are
ineligible -- murders, rapists and child molesters are, nevertheless, free to qualify for
these student credits! This rule adversely impacts the Afro-American and Latino
communities, where drug use and the lack of resources to hire attorneys to plea bargain
down drug possession offense could render a large number of potential students ineligible.
Consequently, this restriction discriminates against those segments of society the tax
credit for education is supposed to help.
Eligible educational institutions include accredited post-secondary educational
institutions offering credit towards bachelor's degree, an associate's degree,
graduate-level or professional degree, or other recognized post-secondary credential.
Certain proprietary and post-secondary vocational institutions are also included.
Student loan interest on a "qualified education loan", which is repaid during
the first 60 months after payments are required, will now be partially deductible to
eligible borrowers -- to a maximum of $1,000 in 1998 (rising by $500 annual increments to
$2,500 in 2001) -- whether or not the taxpayer itemizes his deductions. This provision
phases out ratably for individuals with AGIs between $40,000 and $55,000 ($60,000 and
$75,000 for joint filers). The maximum deduction is not adjusted for inflation. The
deduction is allowed to the person who pays the interest, but no deduction is allowed to
an individual if he is claimed as a dependent on another's tax return.
A qualified education loan is generally indebtedness incurred to pay for the
"qualified education expenses" of the taxpayer, the taxpayer's spouse, or any
dependent as of the time the indebtedness was incurred. Qualified indebtedness expenses
means tuition, fees, room and board and related expenses reduced by, in general, tax-free
scholarships or educational benefits or other amounts which are excluded from gross
income. The indebtedness must be incurred to attend post-secondary educational
institutions and certain vocational schools (defined in section 481 of the Higher
Education Act of 1965).
The AGI phase-out limits will be adjusted for inflation, starting in 2003. Strangely,
amounts excluded from gross income under the qualified adoption expense exclusion (IRC
Sec. 137) are added to AGI for purposes of determining the student loan deduction. The
provision is effective for interest payments due and paid after December 31, 1997.
Under current law, student loan forgiveness did not constitute income to the taxpayer,
if he worked for a certain period of time in certain professions for a broad class of
employers (See IRC Sec. 108(f)). The new law expands these provisions to certain
tax-exempt charitable organizations as lenders, such as educational organizations or
private foundations if the loan proceeds are used to pay the costs of education or to
refinance outstanding student loans, provided the borrower is not employed by the lender.
For loans made by charitable organizations, the student's work must fulfill a public
service requirement. This provision is effective for loan forgiveness occurring after the
date of enactment.
There are two new IRA-type accounts and changes to the existing IRA rules.
The new "IRA Plus" account is an IRA with a twist: Investors cannot deduct
the contributions, but earnings accumulate tax-free. However, unlike a traditional IRA
which had distributions that were tax deferred, the IRA Plus distributions will never be
taxed. Withdrawals must commence at age 59½ and the account must be at least 5 years old.
The annual contribution limits are $2,000 for individuals and $4,000 for couples. There is
a phase-out of eligibility starting at AGIs of $95,000 to $110,000 for individuals and
$150,000 to $160,000 for couples. Early withdrawal is permitted for first-time homebuyer
expenses, subject to a $10,000 lifetime cap and educational expenses.
Investors with regular IRAs may convert them to IRA Plus accounts. The conversion will
be taxed as an IRA distribution, but without penalty for early withdrawal. Only taxpayers
with less than $100,000 in AGI (determined prior to the conversion) are eligible to
rollover an IRA into an IRA Plus account.
AGI limitations for contributions to IRAs (currently $25,000 for individuals and
$40,000 for couples) will increase at $5,000 per year for individuals and $10,000/year for
couples in 1998, 2002, 2003 and 2004. After 2004, the AGI limitations will be $50,000 for
individuals and $80,000 for joint filers. Also, penalty-free withdrawals are permitted for
first-time home purchases to a maximum of $10,000 or educational expenses (without
If one spouse is an active participant in an employer-sponsored retirement plan, the
other spouse is now eligible for an IRA deduction to a maximum of $2,000. This benefit
phases out for couples with AGI between $150,000 and $160,000.
Beginning January 1, 1998, the general prohibition against investment in collectibles
has been lifted for permitted certain platinum coins and certain gold, silver, platinum or
Contributions to a maximum of $500 per year per beneficiary may be made to an Education
IRA. The contribution limit is phased out ratably for individuals with AGIs between
$95,000 and $110,000 and joint filers with AGIs between $150,000 and $160,000. These IRA's
are created for post secondary tuition, fees, books, supplies, equipment, and certain room
and board expenses, but not elementary or secondary school expenses. Earnings in the IRA
and distributions to the beneficiary are tax-free, provided the distribution does not
exceed the qualified higher education expenses incurred by the beneficiary. Excess
distributions will be taxed to the beneficiary (who might not have any other taxable
Any balance remaining in the IRA when the beneficiary becomes 30 years old must be
distributed and the earnings portion of the distribution will be subject to ordinary
income tax plus a 10% penalty, however, the IRA may be rolled over tax free to another
Education IRA for the benefit of another member of the family (using the dependency
definition), provided this occurs before the current beneficiary reaches age 30.
The HOPE credit or the Lifetime Learning credit cannot be used in the same year that an
Education IRA is distributed to a beneficiary.
Eligible students must be enrolled at least half time in a degree certificate
undergraduate or graduate program at an eligible educational institution. Also, the
student cannot have a felony conviction for possession or distribution of a controlled
The Education IRA begins after December 31, 1997.
An income exclusion for educational assistance paid by an employer up to $5,250 per calendar year, per employee, has been extended to June 1, 2000. This exclusion is restricted to undergraduate educational assistance.
The 35% excise tax on the gain arising from a transfer by a U.S. to a foreign entity
under Chapter 5 of the Internal Revenue Code (IRC Secs 1491-1494) has been repealed. This
provision is effective after August 5, 1997.
The current $600,000 unified estate and gift tax exemption will increase to $1,000,000
over the next 10 years as follows:
The annual gift tax exclusion will be indexed for inflation for gifts made after
December 31, 1998.
Next year, a new exemption for family-owned businesses goes into effect. In addition to
the unified credit, there will be an exemption for a family owned business (regardless of
the entity), not to exceed $1,300,000 (including the unified credit). The business must
comprise at least 50% of the value of the estate, be an active trade or business in the
U.S. and owned 50% or more by one family, 70% or more by two families or 90% or more by
three families, as long as the decedent's family owned at least 30% of the trade or
The family members must have owned and materially participated in the business 5 out of
the 8 years preceding the decedent's death, and must continue to materially participate in
the business for at least 5 years of any 8-year period within 10 years of the decedent's
death. There are complicated recapture provisions if these requirements are not met.
A new non-deductible interest rate of 2% on the first $1,000,000 in taxable value of
the closely held business (computed after all applicable credits are considered). The
interest rate on amounts over $1,000,000 will be equal to 45% of the rate applicable to
underpayments of tax.
The effective date is for decedents dying after December 31, 1997, but estates electing
to defer taxes under current law may elect to use the 2% instead of the current 4% rate
for all future installments.
The dreaded alternative minimum tax has been eliminated for corporations with average
gross receipts of less than $5 million for the 3-year period commencing January 1, 1994
(called a "small business corporation"). A small business corporation will
continue its status until its average gross receipts reach $7,500,000. This provision is
effective for tax years beginning after December 31, 1997.
Payments to attorneys, including corporations providing legal services, made by a trade
or business must now be reported on Form 1099-B, unless the payment constitutes wages.
This provision will insure the IRS receives notification whenever payments for settlements
or attorney's fees are made to an attorney. The effective date is for payments made after
December 31, 1997.
When a taxpayer owes the IRS money, it uses a variety of collection methods, including
levies on bank accounts. Generally, a levy is limited to the amount a third party holds
for the taxpayer at the time the levy is issued. Unlike wage garnishments, a levy is not
usually continuous in nature.
Social security benefits are now subject to an IRS continuous levy. Also, a continuous
levy could now apply to unemployment benefits and means-tested public assistance. This
levy would attach to as much as 15% of the payment amount.
Under another provision, continuous levies may be applied to worker's compensation
benefits, unemployment benefits and means-tested public assistance, if the Secretary of
the Treasury or his delegate, approves the levy of such property.
These provisions are effective for levies issued after the date of enactment.
The IRS will now accept tax payments by "commercially acceptable means"
including credit card, debit card and charge card payments. This provision is effective
for payments made after May 5, 1998.
The Treasury may extend tax filing deadlines up to 90 days for taxpayers located in a
Presidentially declared disaster ("Disaster") area. In addition, the Treasury
may abate interest charges in connection with an extension to file tax returns due to a
Taxpayers may withdraw funds from an IRA without paying the 10% penalty for early
withdrawal for "qualified disaster-related distributions" which include the
repair or replacement of tangible property which was destroyed or substantially damaged as
a result of a disaster. The damage must have occurred in a Disaster area. Also, the 10% of
AGI floor for deducting casualty losses as an itemized deduction is eliminated for
tangible property substantially damaged or destroyed in a Disaster.
These provisions are effective for Disasters occurring after December 31, 1997.
The reintroduction of a capital gains cut marks a reversal from the Tax Reform Act of
1986 which eliminated loopholes in exchange for flatter and lower overall tax rates. The
philosophy behind the TRA 86 was that Investments should be judged on their economics, not
their tax consequences.
These new tax changes are substantial and will benefit taxpayers with significant
investment assets and estates. Middle-class taxpayers will receive a modest reduction,
provided they can qualify for them.
With these new changes, the tax code may have finally met the breaking point - it has
become too complex for citizens to deal with. There could be a major movement towards a
flat tax or other forms of radical tax reform, as middle class taxpayers discover that
much of the promised tax relief will not apply to their particular situation.
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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**