Debits & Credits
by Douglas Schultz
On May 17, 2006, President Bush signed the Tax Increase Prevention and Reconciliation Act of 2005. The title of this tax act would suggest a rather positive set of tax law changes. But as usual, when it comes to matters of taxes, the devil is in the details. Many of the tax-savings provisions are temporary and will expire either at the end of this year or in the next few years. In this article, I will discuss a few of the highlights of the new law that may be of interest to apartment building owners and other real-estate professionals.
First of all, the 15% tax rate on qualified dividends and long-term capital gains is extended for two more years. It now expires on December 31, 2010. “Long-term” in this sense means an investment held for more than one year. The good news is that if you are thinking about selling your apartment building, you now know that you can enjoy the benefit of the 15% rate for at least four more years. However, the bill doesn’t change the 25% tax rate that applies to gain resulting from depreciation deductions.
Some individual taxpayers will receive relief from the dreaded alternative minimum tax (AMT)—but only for one more year. For the year 2006, the exemption will increase to $62,550 for those who are married and filing jointly, and $42,500 for single taxpayers. These amounts were slated to drop to $45,000 and $33,750, respectively. The exemptions are phased out at the rate of 25 cents on the dollar for every dollar of AMT income in excess of $150,000 for married, filing joint taxpayers and $112,500 for single taxpayers. This relief is a one-year patch and falls short of the real AMT reform that many were hoping for. What happens to the exemption amounts after 2006 remains to be seen. If Congress had done nothing, the number of people hit by the AMT would have soared to more than 22 million for 2006, compared to about 4 million last year, according to U.S. Treasury Department estimates cited in the Wall Street Journal.
Additional relief from the AMT will come from certain nonrefundable credits that are allowed to offset the AMT for only one more year. These credits include the dependent care credit, credit for the disabled and elderly, and the tuition credits. As with the higher exemption amounts, these credits against the AMT expire at the end of 2006.
Although AMT credits expire this year, the ability to expense business assets purchased during the year has been extended through December 31, 2009. Under the expensing election, a business owner can deduct costs immediately, rather than depreciating them over several years. In 2006, a business taxpayer may expense $108,000 of qualifying property purchased during the year, provided that the total cost of assets acquired during the year does not exceed $430,000. This provision was set to expire at the end of this year. Unless this provision is extended further, the expensing ceiling for years after 2009 will revert back to $25,000. Unfortunately for apartment owners, the expensing election does not apply to property used with respect to lodging, including apartment buildings. However, it does apply to assets purchased in connection with property management, real-estate brokerage activities, hotels and motels, and most other real-estate-related businesses. Also, eligibility of off-the-shelf computer software (such as QuickBooks and Tenant Pro 7) for the expensing election is extended for two more years as well.
Beginning in 2010, the $100,000 adjusted gross income threshold for conversion of traditional IRAs to Roth IRAs is eliminated. (With a Roth IRA, taxpayers can’t deduct contributions, but the money grows tax-free and withdrawals may be tax-free depending upon certain requirements). Under current law, only those with income of $100,000 or less are allowed to convert part or all of their regular IRA into a Roth IRA. This is very good news for taxpayers that have higher incomes and wish to convert their traditional IRAs into Roth IRAs. Those who have an interest in a qualified retirement plan and can receive an eligible rollover distribution of their interests and roll it over into an IRA in 2010 can then convert the amount to Roth IRAs. Although they would have to include in their income the taxable portion of the distribution on conversion to the Roth IRA, they would avoid tax on the earnings permanently. This new change in the law is several years away, but is well worth planning for now since the potential tax savings resulting from the conversion may be huge—particularly for younger taxpayers including children who may already have set up traditional IRAs. Further, high-income taxpayers might consider making nondeductible contributions to regular IRAs between now and 2010, and then converting to a Roth IRA in 2010. For this year, you can contribute as much as $4,000 to an IRA if you’re under age 50, or up to $5,000 if 50 or older by the end of the year.
While this change to the tax law is welcome, there are several detrimental changes as well. The biggest zinger is that the “kiddie tax” imposed on the unearned income of dependent children will apply to children under age 18 beginning in 2006. Previously, the kiddie tax only applied to children under age 14. The kiddie tax was imposed to close up a loophole in the tax law that allowed wealthy parents to transfer investment assets to their minor children who, in many cases, were in a lower tax bracket than their parents. The kiddie tax causes the investment income of the child to be taxed at their parents’ marginal tax rate (the rate of tax on the last dollar earned). Under the new law, the age limit below which a child’s income from investments is taxed at the parents’ rate is raised from 14 to 18. As a result, parents with children who may be affected should consider investments that generate little or no current taxable income, such as U.S. savings bonds.
Another negative change is that the production activities deduction (IRC Sec. 199), which applies to real-estate developers, is scaled back for years beginning after May 17, 2006, by modification of the wage limitation to 50% of wages that are deducted in arriving at qualified production activities income. Before this change, all wages were taken into account.
The overall cost of this new tax law is estimated to be approximately $70 billion. It falls far short of making permanent many of the provisions that would reduce the taxes of apartment owners and other real-estate professionals—especially with regard to the alternative minimum tax. Finally, it doesn’t extend the life of several popular tax breaks that expired at the end of last year. Among them is a provision that allowed millions of people to deduct state and local sales taxes instead of state and local income taxes.
Other expired tax breaks include deductions for millions of teachers and for many people with college and graduate-school tax bills. There is speculation in Washington that there will be another tax bill enacted before the end of the year to extend these expired tax breaks. Finally, bear in mind that these are federal tax law changes only. California has not conformed to these changes.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or the San Francisco Apartment Magazine. Douglas Schultz is a CPA and partner in the tax practice in the San Francisco office of Burr, Pilger & Mayer, LLP. He can be contacted at 415-421-5757. Copyright © 2006 by the San Francisco Apartment Magazine. All rights reserved.