November 16, 2007

Watch Out for AMT
No consensus on "Patch" bill in Congress

There is no good news to report regarding the alternative minimum tax, except that legislation has been introduced by House Ways and Means Committee Chairman Charles B. Rangel, D-N.Y. One bill (HR 3970) would eliminate AMT altogether. Passage isn't likely, especially this year.

On the other hand, passage of Rangel's other bill (or similar legislation) which would "patch" the alternative minimum tax for 2007 is extremely important. HR 3996 cleared the House of Representatives a week ago on November 9, but has not gone any further. Objections stem from revenue raising provisions (which affect mainly investment fund managers) included in the bill to keep it "revenue neutral" and President Bush has already warned that he will veto the measure in its current form.

The important thing for you to know is that right now your chances of paying AMT for 2007 are much higher than they were for 2006. Unless a patch bill raising exemption amounts is signed into law soon, approximately 36.2% of taxpayers making $75,000-$100,000 and 70.8% of taxpayers making $100,000-$200,000 can expect to pay thousands in additional tax due to AMT. For 2006, these percentages were only 0.7% and 4.8%. This huge jump in the reach of AMT will affect 21-25 million taxpayers. Many will pay AMT for the first time and others will see their prior year's AMT doubled or tripled.

The politics of the situation make quick passage of the patch bill unlikely. On the other hand, all lawmakers want to avoid the political fallout from doing nothing, so I have to believe that the patch will be made law before the end of the year. Trouble is that until something passes, we are stuck with current law and there's no guarantee it will change. The best outlook seems to be passage of a patch bill in early December

Are you the betting kind? You can either count on Congress and the President to come through or you can hedge your bets and increase your payroll withholding (or estimated tax payments) for the rest of the year. Anyone who owes AMT unexpectedly is also likely to pay penalties for underpayment of tax. Paying more tax now will reduce or eliminate any penalties or AMT owed later. If the patch bill passes and you end up having overpaid, your extra withholding comes back as a tax refund when filing your 2007 tax return.

Kiddie Tax Laws
Expanded Again
2007 change affects kids age 19-23

The idea behind the "kiddie tax" is to prevent well-off families from abusing the strategy of shifting unearned income (dividends, interest and capital gains) to their children, where it would be taxed at a lower tax rate than their own. For this reason, any amount of a child's 2007 unearned income over $1,700 is taxed at the parent's tax rate. Until recently, the kiddie tax applied only to children under the age of 14, but in 2005, the Tax Increase Protection and Reconciliation Act moved the age to 18, and the new legislation passed this year expanded it further. Effective Jan. 1, 2008, the kiddie tax will apply to children age 18 and younger, as well as to college students under the age of 24.

Congress used this tax increase on kids to offset certain business tax breaks back in May. Unfortunately, it misses the mark where its stated purpose is concerned. All children with college savings or other investments in their name are affected, not just those from high income households.

Starting in 2008, kids under the age of 19 should focus on three things: 1) limiting their taxable unearned income until they are older and won't have to pay the kiddie tax, 2) investing in tax-deferred Coverdell Education Savings Accounts and 529 college savings plans, and 3) seeking the maximum after-tax return on their investments.

College students who are currently over the age of 18 can take advantage of the present law by selling appreciated stock and mutual fund holdings before the end of the year and realizing those capital gains on their 2007 tax return. By doing so, they will pay capital gains taxes at their own tax rate (typically 5%) for 2007 instead of paying capital gains taxes at their parents' typically higher tax rate (15%) if they wait to sell in 2008 or later.

Starting in 2008, college students under age 24 can avoid the kiddie tax rules only if they support themselves. Such students must provide over half of their own support from their own earned income (wages and salaries).

Domestic Partner Update
RDPs can no longer file California tax returns
using the "single" status

As of 1/1/07, for California tax purposes, the same long-standing rules applicable to married individuals (relating to income tax filing status, community property income, etc.) also apply to Registered Domestic Partners (RDPs). The rules do not apply to partners registered at the city, county or local level, nor to partners registered in states other than California.

This is a huge change with extensive legal ramifications. Because this is uncharted territory in tax law, it is advisable that all domestic partners seek competent legal counsel before registering their partnership.

The situation is fraught with problems due to the fact that domestic partnerships are not recognized at the federal level. In particular, the implications of re-titling property are unclear. While married persons are allowed unlimited tax-free gifts between spouses, federal law does not extend this treatment to domestic partners. Adding one partner to the title of a home owned by the other partner could result in a taxable gift. The safest thing to do is to keep "separate property" separate for now.

Tax preparation is going to be challenging, to say the least. RDPs must file their California tax returns as married individuals, but continue to file as unmarried for federal tax (IRS) purposes. If filing jointly for state purposes, the first step will be to prepare a "mock" joint federal return using the "Married Filing Jointly" status. If filing separately, things get even more complicated. RDPs must tangle with the community property laws which assign 50% of each partner's wages and other "community income" to the other partner.

"Married Filing Separate" tax returns in community property states like California are very tricky to prepare. Income has to be divided in a fashion acceptable to IRS computers, which match data by social security number. Be sure to get competent professional help if you go this route.

For more information, refer to FTB Publication 737, Tax Information for Registered Domestic Partners, now available in a draft form.

Making Gifts?
Know what gifts are taxable

When an individual receives a gift, whether cash or property, the gift is generally not taxable to that individual. Sometimes, however, the gift giver may incur a gift tax liability. If you make a gift to family members or other individuals, you can give $12,000 or less in value to a single individual during the year and you do not have to report the gift or file a gift tax return. The so-called “annual exclusion” of $12,000 simply means that gifts during the year to an individual that are equal to or below this exclusion amount are not considered reportable gifts.

Certain gifts for medical expenses and educational expenses do not count toward the $12,000 exclusion and allow you to maximize your gifts for the year. For medical expenses, amounts you pay directly to the person or organization providing the medical service or care are excluded from the gift tax. To qualify for the exclusion, the medical expenses must meet the requirements for deductibility and generally include expenses paid for diagnosis, cure, mitigation, treatment, or prevention of disease. It also includes amounts paid for medical insurance.

With regard to educational expenses, similar rules apply. Transfers made to qualifying educational institutions for tuition are not subject to the gift tax and do not count toward the $12,000 annual exclusion. The exclusion applies to tuition for full or part-time students paid directly to the educational institution. Amounts paid for expenses such as books, room, board, or other supplies are not eligible for the exclusion.

Gifts made during the year that exceed the annual exclusion are considered “taxable” gifts and are required to be reported on a gift tax return. You are allowed a lifetime exclusion of $1 million in taxable gifts before any out-of-pocket gift tax is actually due.

Own a Rental Property?
Be sure to send 1099s to your service providers

Landlords, remember to prepare your 1099s by January 31. Give a Form 1099-MISC to each person you paid at least $600 for services (including parts and materials) during 2007. Send copies to the IRS no later than February 29. Remember gardeners, handymen, contractors, house cleaners, etc. (1099s are not required for corporate vendors, other than attorneys.)

Fail to send out a 1099 and you lose that rental deduction if audited by either the IRS or the California Franchise Tax Board. Any doubt about this outcome in an FTB audit was removed this year by SB 1044. This FTB-sponsored bill codified the authority of the FTB to disallow deductions for unreported payments.

Give your vendors a Form W-9 at the time you hire them to obtain their tax id number, whether or not you expect the work to cost $600 or more. Getting a tax id number later can be difficult. Remember that if you choose to hire undocumented workers, you may have to forego any tax deduction.

Obtain Form 1099-MISC, the Form 1096 transmittal form, and instructions via US Mail directly from the IRS (which takes 2-4 weeks) or purchase them at your local business supply store. These special, red, scannable forms cannot be downloaded via the Internet.

[1] If you are a teacher who spent your own money for classroom supplies, this is the last year you can take a deduction for up to $250 of those costs. Unless Congress extends the deduction, expenses you incur next year won’t be deductible.

[2] Remember that you have until April 15, 2008 to make a 2007 contribution to either a traditional or Roth IRA. You can contribute up to $4,000 to your IRA each year. If you are age 50 or older, you are allowed to contribute an additional $1,000.

[3] In 2007, premiums that are paid for “qualified mortgage insurance” in connection with home acquisition debt on your residence are deductible as home mortgage interest.

[4] You are permitted to make a one-time transfer from your IRA to your Health Savings Account from which you can pay future medical expenses. A “qualified HSA funding distribution” is a distribution from your IRA (other than a SEP or a SIMPLE IRA plan) to the extent that the distribution is contributed to your HSA in a direct trustee-to-trustee transfer. Once made, the election is irrevocable.

[5] The optional sales tax deduction has been extended for the 2007 tax year. This means you can elect to deduct sales tax in lieu of your state income tax when you itemize deductions.

[6] If you paid qualifying tuition and related expenses in 2007, you can elect to deduct up to $4,000 of the costs.

529 College Savings Plans
Due to the Kiddie Tax changes, they are more attractive than ever

Now more than ever, 529 college savings plans have advantages as a place to park children's college investments. No income tax is paid on earnings in these accounts. Nor is any tax paid at the time of distribution, as long as the funds are used for qualified educational expenses.

Moreover, new rules for the 2007/2008 academic year have changed the way 529 account assets are factored into a student's financial aid calculation. If the owner of the account is the student's parent (with the student as beneficiary), the Expected Family Contribution (EFC) to the student's school year expenses will include up to 5.64% of the value of the 529 account investments.

A 529 account owned by a grandparent or some other third party has no effect on the EFC and, therefore, has no impact on the financial aid calculation. The same is true when the dependent child/student is the account owner (as well as the beneficiary). This is the case where a parent sets up a custodial 529 account in the child's name under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA).

Probably the only downside to 529 plans is that most give the owner little, if any, control over how the money is invested. Coverdell Education Savings Accounts provide complete control, but contributions to such accounts are much more limited. Since 2001, the annual limit per child has been $2,000 and it is scheduled to revert to $500 in 2008.

Information about various states' plans can be found at the College Savings Plan Network or you can link to California's ScholarShare Plan directly. Columbia Management has a nice Financial Aid Flyer which provides more information about the calculation of a student's Expected Family Contribution. Also refer to IRS Publication 970, Tax Benefits for Education.

FTB Auditors Target
Residence Sales
Maintain good home improvement records

Your chances of being audited continue to be small, but not as small as they used to be. Both the IRS and the California Franchise Tax Board (FTB) are auditing more tax returns. One particular FTB audit program focuses on residence sales.

If you sell a home that you have owned and lived in for 2 out of the last 5 years (as of the date escrow closes), you can exclude up to $250,000 of the gain from your taxable income. This means that up to a quarter million dollars of your gain is tax free and for married couples, that's up to half a million.

Gain is calculated by starting with your home's sale price and then subtracting the original purchase price. Next subtract your selling costs (broker commission mainly) and the cost of any home improvements made over the years. (Note that if you have run a business from your home or rented your home in previous years, there are other factors to consider in calculating your gain, which I am not going to go into here.)

Example: Karen bought her condo in 2000 for $200,000 and sold it in 2006 for $525,000. Her gain on the sale is $250,000, calculated as follows: $525,000 (sales price) minus $200,000 (purchase price), minus $25,000 (sales commission), minus $50,000 (home improvements).

You may be surprised to see that Karen's mortgage balance does not figure into the calculation of her gain. Taxable gains can arise even in situations where homeowners get very little or no cash out of a sale, due to a large mortgage balance. Borrowing against the increased equity in your home is a way of accessing the value of your home without selling, but tax may be owed down the road.

Tax free gains of $250,000-$500,000 sounded incredibly generous when this treatment became law in 1998. It seemed that most ordinary homeowners no longer needed to worry about paying tax when selling their home. Then came several years of significant home price appreciation. Now I commonly see single homeowners with gains over $250,000 and many married homeowners with gains over $500,000.

FTB auditors are also aware that many residence sales now result in some amount of taxable gain. They are auditing a greater number of home sale tax returns and asking to see documentation of any home improvements. Taxpayers with poor records can find themselves owing a substantial amount of additional tax.

Luckily, Karen, from the example above, has good documentation to support the $50,000 she spent on improvements: $20,000 for hardwood floors, $25,000 on a kitchen remodel, $3,000 for window coverings and $2,000 for tile work in her bathroom. Without the improvements, Karen would have had to pay $12,150 in capital gains tax (15% Federal and 9.3% California).

The Bottom Line: Keep good home improvement records, including invoices from contractors and suppliers, canceled checks and credit card statements. In addition, maintain a list of your expenses by date, showing costs and who you paid. Take before and after photographs of work done. Duplicate your records. Keep copies at home AND in your safe deposit box or at another off site location. Preserve this important documentation carefully. It may be years before you need it and the potential money saved is significant.

Tip: If you lack records of improvements done in the past, take steps now to reconstruct them as best possible. Contact contractors and suppliers for duplicate invoices. Go to your bank for canceled checks and your credit card company for past statements.

Another Reason to Keep Good Records: Did you take out a home equity loan to pay for your home improvements? Without good records, you could well lose your equity interest deduction if ever audited. This is because the alternative minimum tax causes many taxpayers to lose their home equity interest deduction. But AMT doesn't apply when loan proceeds are spent on home improvements, so be sure you can prove the connection.

Claiming Dependents
How it works for divorced & separated parents,
even those who never married

If you are a divorced or separated, whether ever married or not, the rules for determining which one of you can claim the children as dependents is confusing at best. Start by identifying the "custodial parent," with whom the child resided for the greater part of the year. If custody is split fairly equally, this can hard to determine. New IRS proposed regulations suggest that the determination be made based on where the child slept for the greater number of nights.

When parents divorce, the decision of who will claim the children is often outlined in the divorce decree. Sometimes the judge will award to the noncustodial parent the dependency exemption for the children because he or she is paying child support while the children reside with the custodial parent. This arrangement tends to even out the tax burden somewhat by allowing the noncustodial parent a deduction for the child’s personal exemption since there is no deduction for child support payments.

This works great when parents abide by the judge’s ruling, but there are cases where they do not. This is when the trouble starts. Why? Because the IRS doesn’t care what the divorce decree states. The IRS makes the assumption that the custodial parent is entitled to the dependency deduction—period. The only exception to this assumption is when the custodial parent releases the claim by signing Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, or a similar statement. Releasing the exemption in this way is only allowed when the parents are divorced or legally separated or when the parents lived apart at all times during the last 6 months of the calendar year.

In the event the custodial parent refuses to sign the waiver and claims the children, the noncustodial parent cannot claim the same children. If both parents claim the same children, the IRS will promptly send a notice stating that there has been an error. Each parent’s refund will be adjusted to reflect the denial of the dependency exemptions until the matter is settled. If the custodial parent still refuses to release the claim to the other parent, the only recourse is to go back to the judge that issued the original divorce decree and have the ruling enforced. Until that is done, the IRS will award the dependency exemptions to the custodial parent provided that parent can prove the children lived in his or her home for more than half of the year.

For more information see IRS Publication 504, Divorced or Separated Individuals.