Tax Law Changes 2007

By:  Eliot M. Bassin and Andrew B. Martin, CPA

We apologize for the delay in writing about the recent tax law updates, however, Congress only recently got the job mostly complete.  Since its most recent reincarnation in 1986, the Internal Revenue Code has been subject to almost constant revision.  This past year was no exception.  While we did not experience sweeping reforms, as in years past, several changes have the potential to seriously impact taxpayers in specific demographic groups.

Thankfully, two important legislatively driven changes for 2007, the Temporary Tax Relief Act of 2007 (TTRA) and the Mortgage Forgiveness Debt Relief Act of 2007, were passed by Congress and signed by the President just prior to the end of the year.  These changes were signed into law during the last week of December 2007, and will provide relief for certain taxpayers from the Alternative Minimum Tax and those faced with the recognition of income as a result of the discharge of mortgage indebtedness. 

As in years past, this article will review the more significant changes to the tax code, as well as the potential impact of those changes, where appropriate.

1. Alternative Minimum Tax (AMT) Relief

We are once again pleased to see that the federal government has seen fit to provide middle-income taxpayers relief from the AMT.  The AMT was originally enacted to ensure all taxpayers, especially high-income taxpayers claiming too many deductions, paid at least a minimum amount of federal taxes.  However, due to a lack of attention and Congress’s abysmal understanding of the tax code, the AMT has deteriorated into a tax affecting many taxpayers it was not originally designed to go after (e.g. the middle class).  In fact, prior to the passage of the TTRA, the AMT standard exemption was set to be reduced; thereby, subjecting approximately 20 million additional taxpayers to the AMT for the year-ended December 31, 2007 alone.

The federal government has implemented the AMT provisions so poorly, that the AMT has had very negative consequences on taxpayers.  There are two reasons for these negative consequences and the increase in the number of taxpayers subject to the AMT.  First, when the AMT was initially implemented, individual income tax rates were much higher (especially the top marginal rate).  Now, with a lowering of the marginal rates, the AMT captures more taxpayers, thus nullifying many of the benefits of the lower rates.  Second, unlike most provisions within the tax code, the AMT is not indexed for inflation.  As a result, as salaries are increased to account for cost of living increases, more and more individuals exceed the AMT standard exemption amount and are subject to the AMT.  As we have said in the past, the AMT needs to be adjusted to keep up with the times.
This year’s Congressional AMT patch amends the tax code to provide individual taxpayers with some temporary relief by providing a slightly higher AMT standard exemption (essentially adjusting the 2006 amount for inflation) and allowing the use of nonrefundable credits to offset the AMT.  Congress has also abated the underpayment of tax and related interest and penalties attributable to the application of special AMT rules for the treatment of incentive stock options.  It is important to note this is a one-year AMT patch.  Absent Congressional action for the 2008 tax year, the AMT will once again threaten to ensnare unsuspecting middle-income taxpayers.

If you are curious about the intricacies of the AMT you can study form 6251, which is a required attachment to every tax return filed, and should be updated by early- to mid-February.

2. Retirement Accounts

We have several changes here, and while some of these changes have been mentioned in previous articles, they are important and worth repeating.  The good news is that starting on January 1, 2008 taxpayers will be able to rollover pension funds directly into a Roth Individual Retirement Account (IRA), replacing the current process which requires us to first rollover the pension funds into a traditional IRA and then roll them over into a Roth IRA. This "one and done" approach is definitely the right idea and will greatly simplify things. A few important items to note here are that the income limitation will still be in effect (a taxpayer with $100,000 of adjusted gross income and above will not be allowed to convert any retirement plan into a Roth IRA), and any amounts rolled into a Roth IRA will be includable in gross income for the year.

While still a few years off, another important change affecting Roth IRAs is on the horizon. Some taxpayers may be interested to learn that beginning January 1, 2010, the income limitation on converting traditional IRAs to Roth IRAs will be eliminated.  This is not quite the “one and done approach,” as amounts from pension plans will still need to be rolled over to a traditional IRA first, but may provide eligible taxpayers a planning tool to avoid future tax rates which will almost inevitably increase. However, until that time the old rules remain in effect and conversions may only be made if a taxpayer’s income does not exceed $100,000.

In an interesting move, Congress provided for the extension of several special rules relating to IRAs which merit separate mention. First, with regard to charitable contributions, individuals age 70 ½ may continue to transfer up to $100,000 directly from an IRA to a charitable organization during 2008, without being taxed on the distribution. This option is available from either a traditional IRA or a Roth IRA; however, we recommend this transfer be done only from a traditional IRA since much of that cash might be eventually taxed whereas Roth IRA distributions are tax free by definition.

Taxpayers who must take required minimum distributions from a traditional IRA, but do not need the money to live on, might find this donation option appealing. By going directly to the charity, the contribution amount is not included in the taxpayer’s income. Of course, the temptation on some taxpayer’s part will be to “double dip” by trying to claim a deduction for the charitable contribution; of course, this is not allowed. Taxpayers who will be especially helped by this rule are people who would not normally itemize.

Second, in an effort to support America’s military families, Congress provided a one year extension of the tax code provision providing for tax-free distributions from retirement plans for individuals called or ordered to active military duty.

Additionally, as a reminder, the limit for IRA contributions will increase to $5,000 ($6,000 if you are age 50 or older) in 2008 versus the current limit of $4,000 ($5,000 if you are age 50 or older).

3. Mortgage Forgiveness Debt Relief

The fall out from the sub-prime mortgage market has managed to make its way to Congress. In an effort to help families caught by rising interest rates (assumption being that there were so called “teaser rates”) and falling home values, the federal government has amended the tax code to exclude from gross income the discharge of up to $2 million of indebtedness incurred to acquire a principal residence.  Prior to this change, if an individual was discharged/released from such debt, the amount of debt discharged was includable in the individual’s income for the year, and was taxable at regular tax rates.

While this change seems rosy on the surface, as one might expect, the government did not completely relinquish its right to the “income” associated with the discharge of such debt.  Instead, the trade-off is a deferral of taxes until such time as the residence is sold, at which point it is assumed the taxpayer will have sufficient cash flow to pay the tax liability associated with the sale. 

The mechanics are fairly simple; the amount of debt discharged is considered a reduction to the amount paid by the homeowner for purposes of calculating the homeowner’s gain on the sale of the residence.  The gain on the sale is then subject to tax.  The goods news is the normal rules for the sale of a principal residence still apply.  Meaning, if the residence was the taxpayer’s principal residence for two years or more of the five year period preceding and ending on the date of the sale, the taxpayer may still exclude up to $250,000 of the gain ($500,000 if married filing a joint return) from their income, and the remaining gain will be taxed at long-term capital gains rates, which could be as low as 0% in 2008 (see below for additional information)!

4. “Kiddie Tax” Rules Tightened Again

For the second straight year, the federal government has changed the rules governing the taxation of children with “unearned” investment income.  Originally, parents, in order to save for college costs, opened accounts in their child’s name so that the investment income could be taxed at the child’s usually lower rate.  Previously, when an account was held in a child’s name, any earnings exceeding an annual threshold amount ($1,700) were taxed at the parent’s highest marginal rate.  When a child turned 14, however, his or her usually lower tax rate applied. Last year, the government raised the cut-off age to 18.  This year, the government further raised the cut-off age to 19 and specifically included children who are full-time students over the age of 18 but under the age of 24.

The changes to the tax code over the past 2 years virtually eliminate a parent’s ability to use traditional investment vehicles to save for their children’s educational needs in a tax preferred manner.  As a result, we continue to stress the tax merits of a section 529 plan which allows for the tax free accumulation of investment earnings specifically earmarked for educational expenses.  Please consult your financial advisor for more details on section 529 plans.

We generally believe that people should be given incentives to save as the savings rate in this country is virtually non-existent.  One has to wonder what Congress was thinking (or not thinking) when they changed this rule that helped so many middle class families save for their children’s college education.

5. Charitable Contributions

In 2006, the Administration and Congress decided that people were taking advantage of the rules governing charitable giving.  The biggest change we are going to see is how the IRS will enforce the donation of clothing and household items.  Beginning on August 18, 2006, any donated clothing or household goods must be in good or better condition.  The change was prompted by the belief that many taxpayers were claiming excessive values for items that were probably more suitable for the garbage dump than a recognized charity.  The IRS is expected to scrutinize these non cash charitable deductions more closely and this continues a pattern of stricter rule enforcement such as we have seen with auto donations.

Additionally, the IRS is getting stricter with cash donations. In the past a taxpayer was expected to maintain documentation for all donations over $250. Now, a donation of any dollar amount must have documentation to support it.  “Documentation” may include a canceled check, a bank copy of a canceled check, or a bank statement containing the name of the charity, the date and the amount -- or a written communication from the charity. The written communication must also include the name of the charity, the date of the contribution and amount of the contribution.

Many of our clients who put money in the Church collection plate weekly are probably wondering what to do now. Our advice is to arrange with the house of worship of your choice to go on a monthly or quarterly giving plan so that they can maintain the records of your giving for you.

One additional change concerning cash contributions relates to taxpayers deducting charitable contributions to “donor advised funds.” Beginning February 14, 2007, taxpayers may no longer deduct contributions to “donor advised funds,” if the sponsoring organization is a war veterans’ organization, a fraternal society, or a nonprofit cemetery company. Generally, a donor advised fund is a fund or account in which a donor can, because of being a donor, advise the fund how to distribute or invest amounts held in the fund.  This seems to be a poor way to thank veterans for their service to our country or to honor the dead.

We can probably look forward to more audits or inquiries on contributions in general. In fact, we have already seen evidence of this in our CPA practice with a number of clients being questioned.  So far we have been successfully arguing our points but we are going to encourage all of you to be aware and to abide by the new rules concerning charitable giving.

6. One Year Extenders

Several very important deductions and credits were set to expire on December 31, 2007 and, fortunately were deemed worthy of extending.  For those of you who live in states with no income taxes, such as Florida and Nevada, we will continue to be able to take the deduction for state and local sales taxes in lieu of the deduction for state and local income taxes.

Additionally, several education related deductions were extended.  We will continue to be able to deduct up to $250 as an adjustment to income for teachers.  Although it hardly captures the out-of-pocket expenses of a teacher, at least it is an acknowledgement of those expenses.  Along the same line of reasoning, we will continue to be able to deduct a portion of qualified tuition and fees (or optimize and claim the tax credit) as we have done in the past.

For DC home buyers, the $5,000 credit that was available in the past was extended until December 31, 2008. The credit will continue to be subject to same rules as in prior years.

7. Minor But Important Changes

a. Inflationary Increases

The vast majority of changes to the tax code during 2007 involved adjustments for inflation including increases to the standard deduction and personal exemption amounts, an increase in the phase-out threshold for allowable itemized deductions, an increase in the phase-out thresholds for the Hope and Lifetime Learning credits, and an increase in the Adoption credit.

b. §179 Expense

In a move to help small businesses, the federal government increased the §179 expense limitation to $125,000 for taxable years beginning in 2007 through 2010. Internal Revenue Code §179 provides self-employed taxpayers and small businesses the opportunity to immediately expense, rather than capitalize and depreciate, the cost of qualifying property placed into service for the taxable year.  This provision enables small businesses to immediately recognize the tax affect of expensing new equipment (e.g. lower net income).  The federal government also increased the phase-out threshold, the starting amount at which the §179 expense limitation is phased-out (based on the cost of qualifying property placed in service during the year), from $400,000 to $450,000.

c. Unincorporated Family Businesses

In an effort to reduce the administrative burden on small family-owned businesses, under legislation enacted during 2007, a joint venture whose only members are a husband and wife filing a joint return are not to be treated as a partnership for federal tax purposes.  This special rule only applies if: (i) the only members of the joint venture are a husband and wife; (ii) both spouses materially participate in the trade or business; and (iii) both spouses elect to have the provision apply.  If such an election is made, each spouse takes into account their distributive share of income, gain, loss, deduction, and credit as a sole proprietor (e.g. reported on Schedule C rather than filing a Partnership tax return).

d. Foreign Earned Income Adjustment

As in the past, U.S. taxpayers will be able to exclude their foreign earned income from taxation here in the United States, subject to certain restrictions.  For tax year 2007, the exclusion limit increases slightly to $85,700. 

e. Mileage Deduction Allowed

The mileage deduction has steadily increased over the years and 2007 is no exception. First, the standard mileage rate for operating your car for business use is $0.485 per mile. Second, if you have driven your car on behalf of a charity, the rate is still $0.14 per mile. Finally medical and moving mileage is calculated at $0.20 per mile.
In 2008, the standard business mileage rate deduction will increase to $0.505 per mile, while the deduction for miles driven for medical or moving will decrease to $0.19 per mile.

8. Tax Holiday on the Horizon

Looking ahead to 2008, there are several changes scheduled concerning the taxation of dividends and capital gains (long-term).  Pandering to big businesses and the wealthy constituents who voted them into office, the tax cuts enacted by the Bush Administration and Congress during 2001 have caused dividends and capital gains (long-term) to be taxed at extraordinarily low rates with no limits on the total amounts qualified.

The dichotomy between the taxation of wage-based earnings, and dividends and capital gains will be further exasperated in 2008, when these rates are scheduled to decrease again. Between 2008 and 2010, the tax rates for dividends and capital gains (long-term) are schedule to decline as low as 0%, up to the income floor of the 25% tax bracket, before they revert to 39% and 20%, respectively in 2011 (for 2008 to 2010 the rate will be 15% after the 0% bracket amount is exceeded).  At least these new provisions have limits and there is some good that will come out of it, especially for our seniors who are attempting to live off their portfolios. Although we support lower taxes in general we should consider practical limits on the amounts of dividends and capital gains that are allowed to be taxed at the lower rates.

We would much rather see real tax relief in the form of a reduced social security tax (aka, “the jobs tax”).  Of course, this would require the Federal government to actually segregate the funds and stop raiding our social security and medicare dollars to mask the real annual deficits (then they turn around and tell us the system is “broke”).  Is it really?  Since 1981 approximately $2,000,000,000,000 (2 Trillion in case you lost sight of all those zeroes) has been taken to cover the current 9 Trillion dollar debt (the real total “owed” but not all of it yet due is closer to $50 Trillion. 

Interestingly, while President Reagan and Sen. Dole were lowering taxes on the wealthy they jammed through a huge tax increase on the working men and women of America in the form of a much higher social security tax.  More Americans pay more in social security and medicare taxes than they do in Federal income taxes.  Obviously, the “tax holiday” should be directed towards this tax and not a 0% percent capital gains and dividends tax rate. 

This “tax holiday” will require extra tax planning given some of the provisions but as it looks right now, a C corporation with a large net operating loss might have its shareholders benefit.  If you feel you are in such a situation please contact us as soon as possible.
Due to the potential for abuse that accompanies these changes, taxpayers can expect additional scrutiny from the IRS in coming years.  Areas of enhanced concern are: “wash sales” of stock; earnings management of closely held corporations; and appropriate compensation of officer/shareholders of closely held corporations.

9. Tax “Stimulus” Plan

Another item causing delay in the publishing of our annual tax law update is the tax “stimulus” plan, which at the time of this writing, has cleared the US House but not the US Senate.  Congress is electing to approve (and this still needs Senate approval and no doubt the provisions of the “stimulus” package will change) rebate checks for some taxpayers at a cost of about $150 Billion (our deficit for the year will move from $250 Billion to about $400 billion after taking into account the surplus from social security covering up the real deficit).  This is a very significant cost. 

Under the US House plan, taxpayers earning less then $75,000 (adjusted gross income) will qualify for a $600 rebate check ($1,200 if jointly filing) as well as $300 per child. 

There are also some other stimulus provisions that are more geared towards the mortgage crisis such as raising the limits on FHA (Federal Housing Administration) loans (the government insures these so the higher the limit the easier it will be for more people to refinance out of the “teaser” loans).  Additionally and equally important is that the stimulus package also raises the cap on loans that Fannie Mae and Freddie Mac can buy from $417,000 up to $729,750 in high cost markets.  Fannie and Freddie act as a secondary market for mortgages thereby lowering the overall mortgage risk (which is why if your mortgage exceeds $417,000 currently you pay a higher rate of interest to compensate for the extra risk).

We will all have to keep our eyes on Congress as it decides what to do.  The House version passed 385-35 so at least the economy and the mortgage crisis have become a top issue with bipartisan support.

Conclusions

Overall, the Internal Revenue Code remained relatively static during 2007.  As detailed above, many of the changes enacted simply provided for inflationary adjustments or the extension of expiring benefits.  Furthermore, since 2008 is an election year, it is not likely that there are sweeping changes on the horizon with the possible exception of some kind of “family tax credit” by the end of year. 

Despite these facts, there are several disturbing trends that have emerged over the last several years.  Perhaps the most troubling of these trends is Congress’s reluctance to provide a long-term solution to the AMT debacle.  Through a series of patches, Congress has slowly raised the AMT standard exemption at a rate disproportional to inflation, trapping more and more taxpayers to become unwittingly ensnared.  As a result, approximately 20 million taxpayers are one failed vote away from paying a tax they were never meant to bear. As noted above in the AMT section, many in Congress, including the people in charge, do not really understand how the tax imposes an unfair burden and does not work as intended.  Our hope is that somehow they will receive the education they need to make sensible decisions regarding this ever growing problem.

As discussed above and expanded upon here, another troubling trend over the years that has emerged is the degree to which the Internal Revenue Code favors the wealthy.  The working women and men of this country who earn less than $102,000 effectively pay a “jobs tax” that the wealthy receiving the majority of their income from dividends and capital gains do not.  Specifically, we are referring to the social security and medicare taxes withheld from your paychecks.  If a taxpayer is in the 25% bracket you would need to add an additional 7.65% for social security and medicare taxes for a total percentage of 32.65% which is more than double the capital gains or dividends tax rates.  Sound fair?

With respect to the “stimulus” package we agree with the mortgage industry adjustments discussed above, however, we are in extreme opposition to the idiocy of tax rebate checks being issued.  The government’s goal is to have you go out and spend on consumer goods (so there will be a lot of new flat panel TVs out there) whereas we believe most people will probably pay off debt (at least that is our hope if this crazy lawmaking gets done).  The old Chinese proverb comes to mind “Give a man a fish you feed him for the day, teach a man to fish you feed him for life”.  The point being that giving people rebate checks is a very short term solution. 

Spending $150 billion (and speaking of the Chinese, where do you think the government that has no money will go to borrow the money needed for this “stimulus”?)  Folks, this is a giant payday loan scheme.  IF we were to agree to stimulate the economy to the tune of $150 billion we would rather see the money invested in infrastructure, job creation, maybe some help for the fledging renewable energy industry.  Imagine if the government said that it was investing in solar technology and everyone would get a solar panel to help reduce their power bill.  Obviously investing into our nation’s future would be the smarter move but 385 Congressman believe that it is better to give a man a fish rather then teach him how to fish.  Our leaders are as guilty as most of the population and the financial markets when they cave in on the short term group think.

There are many ways to create a more equitable tax system in this country; however, to our knowledge, few have even proposed the types of sweeping changes necessary.  If the US economy is to continue to grow, Congress must look beyond one-year patches and debate the types of long-term, sustainable changes necessary for economic prosperity.

As always, if you have questions concerning your specific situation please feel free to contact us.