Feature
by Douglas Schultz & Jackie Matsumura
Although many people are probably unaware of it, 2006 was a big year for tax law changes, especially in terms of the number of changes. During 2006, President George W. Bush signed into law the Tax Increase Prevention and Reconciliation Act of 2005, the Pension Protection Act of 2006, and the Tax Relief and Health Care Act of 2006. It was a busy year to say the least.
The last of the three tax acts, the Tax Relief and Health Care Act of 2006, was passed by the 109th Congress as one of its last official acts of 2006. This act is a wide-ranging measure that preserves a variety of popular tax breaks for families and businesses, and includes a few new tax breaks as well. The new law is almost overwhelming “good news” for taxpayers, particularly because it restores and extends key tax breaks that went off the books at the end of 2005. These include the election to deduct state and local general sales tax, the deductions for higher education expenses and for schoolteachers’ books and supplies, and the research credit.
However, the new law also will prove to be a challenge when the time comes to file 2006 returns. That’s because the IRS had to send key forms and schedules for the 2006 year off to the printer before the new law extended these tax breaks. The IRS has said it will not reprint forms and schedules to reflect the new law, but will, instead, issue supplementary instructions. In other words, filing 2006 returns could be a real challenge for the uninformed, and refunds could be delayed because the IRS will have to retool its computers and procedures to reflect the new law’s changes.
Following are highlights from the new tax laws of 2006 that are of interest to property owners, business owners and individuals.
Extended Deductions Affecting Individuals
This section provides a quick rundown of the most widely applicable tax breaks for individuals that have been restored and/or extended, and for how long.
The tax deduction for qualified higher education expenses is restored for 2006 and extended through 2007. It allows individuals to deduct up to $4,000 of higher education expenses instead of claiming the Hope or Lifetime Learning tax credits. The deduction is taken “above the line,” so it may be claimed by all individuals regardless of whether they itemize their deductions. The amount of the deduction, if any, depends on your income.
The tax break allowing individual taxpayers to elect to take an itemized deduction for state and local general sales taxes instead of the itemized deduction permitted for state and local income taxes is restored for 2006 and extended through 2007. You have two options for determining deductible sales tax: actual sales tax paid if receipts are maintained for IRS verification; or approximate sales tax paid as estimated in tables provided by the IRS, plus sales tax on certain additional items (such as a boat or car) that may be added to the table amount. The IRS said it will be issuing a separate publication carrying optional sales tax tables for the 2006 tax year; these tables will not be in the Form 1040 instructions.
The tax break permitting elementary and secondary school teachers, and certain other school professionals to deduct up to $250 of out-of-pocket costs incurred to purchase books, supplies and other classroom equipment is restored for 2006 and extended through 2007. This deduction is claimed “above the line.”
The 30% tax credit for the purchase of residential solar water heating, solar electric equipment and fuel cell property is extended through December 31, 2008. The maximum credit depends on the type of energy-efficient property that you buy.
New contributions to Archer medical savings accounts (MSAs) may be made through 2007. New contributions may be made after 2007 only by or for individuals who previously had Archer MSAs, and employees who are employed by a participating employer. Individuals may make tax-deductible contributions to an Archer MSA to pay for health care expenses. The distributions are tax free if used to pay for eligible medical expenses.
New Deductions Affecting Individuals
In addition to these renewed and extended deductions, there are also several completely new tax breaks for individuals. After 2006, a limited relief provision helps individuals who wound up with alternative minimum tax (AMT) problems because they exercised incentive stock options (ISOs). The relief provision, which is complex, allows individuals to take advantage of a refundable credit with respect to certain long-term unused AMT credits existing before January 1, 2013.
Let’s say you were stung in the dot-com bust because you exercised all of your ISOs and shortly thereafter your newly acquired shares became worthless. You didn’t pay regular income tax gain, but you may have paid AMT to the extent of the value of the shares in excess of what you paid for them. This was devastating for many internet entrepreneurs after the bust. They were hit with a huge AMT tax liability resulting from the exercise of ISOs that later proved worthless. They had a tax liability, but no cash with which to pay the tax. This provision provides some relief by enabling you to take a larger AMT credit to claim a refund for at least part of the AMT you paid on the exercise of your ISOs. This provision also applies to credits generated by other AMT adjustments.
Also, the cost of premiums for certain mortgage insurance paid or accrued during 2007 is now deductible as an itemized deduction. The premiums are treated as qualified residence interest if the mortgage insurance is paid or incurred in connection with your acquisition indebtedness of a principal residence or second residence. The deductible amount is subject to a phaseout, however. For each $1,000 that the taxpayer’s adjusted gross income (AGI) exceeds $100,000, the premiums treated as interest are reduced by 10%. Thus, if your AGI is $110,000 or over you would not be allowed the deduction. Married taxpayers filing separate returns are subject to different phaseout limitations: the reduction is 10% of the amount of qualified mortgage insurance for each $500 that the taxpayer’s AGI exceeds $50,000.
Deductible contributions to a traditional IRA are taxed when distributions are made. On the other hand, contributions to Roth IRAs are not deductible, but distributions are tax-free as long as they are “qualified distributions.” A qualified distribution from a Roth IRA is a distribution that is made after the five-year period beginning with the first tax year in which the individual or the individual’s spouse made a contribution to the Roth IRA, and which is made on or after the individual attains age 59 and one-half; after the death of the individual; on account of the individual becoming disabled; or for a “qualified special purpose distribution.” Distributions from a Roth IRA that are not qualified distributions are includible in gross income to the extent attributable to earnings.
Currently, individuals can convert their traditional IRAs to Roth IRAs as long as their modified AGI (without regard to the Roth IRA conversion amount) is less than $100,000. Though the conversions are taxable, they are attractive to taxpayers who expect their tax rates to increase during their retirement, or expect the value of their accounts to appreciate significantly. The Tax Increase Prevention Act makes this conversion available to taxpayers whose modified AGI exceeds $100,000 starting in 2010. Additionally, instead of a one-time hit, the converted funds will be taxable over two years (2011 and 2012).
Under the 2006 Pension Act, a taxpayer may take a “qualified charitable distribution” from an IRA without tax. This exclusion is limited to $100,000 per year, per taxpayer and the benefit is available for tax years 2006 and 2007. A “qualified charitable distribution” is a distribution made from a traditional or Roth IRA account that would otherwise be taxable, after the taxpayer or other beneficiary of the IRA has reached age 70 and one-half, which is donated directly to a charitable organization by the IRA trustee. If the distribution is made to the taxpayer and then donated to a charitable organization, the distribution would be taxable.
New Law Changes Affecting Businesses
Back in 2004, the cost recovery lives for qualified leasehold improvement property placed in service after October 22, 2004, and before January 1, 2006, were shortened from 39 years to 15 years. This provision is now extended through December 31, 2007. Qualified leasehold improvement property generally includes improvements made pursuant to a lease to the interior of the building when the improvements are placed in service more than three years after the date the building was first placed in service. This provision applies to commercial buildings only and, thus, improvements to residential property do not qualify. There are similar provisions for qualified restaurant properties.
A familiar provision that taxpayers are taking advantage of is the immediate write-off of certain qualifying property. For 2007, the allowable amount is $112,000 on the first $450,000 additions of qualifying property. These amounts were scheduled to be reduced to $25,000 on the first $200,000 after December 31, 2007, but the sunset date has been extended to December 31, 2009, under Section 179 of the Tax Prevention Act of 2005.
Qualifying property includes tangible personal property that is acquired by a purchase and is used in the taxpayer’s business. However, for individual property owners, property acquired for rental activities do not qualify as a 179 deduction. The 179 deduction and the qualifying cost are adjusted for inflation each year.
Sport utility vehicles that weigh less than 14,000 pounds gross vehicle weight do not qualify for the full Section 179 expense. It is instead limited to a write off of $25,000, which is still more beneficial than depreciation under the luxury vehicle rules (limited to depreciation of $2,960 for 2006).
These are a few of the highlights of the tax changes that came through in 2006. There were several changes in regard to very specific business entities that have not been addressed in this article. The new laws are generally favorable to taxpayers and probably reflect the last of the significant tax changes we may see for a while. There is speculation that a Democrat-controlled Congress and a Republican president may produce very little in the way of tax reform.
The opinions expressed in this article are those of the authors and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. Douglas Schultz is a CPA and partner in the tax practice in the San Francisco office of Burr, Pilger & Mayer, LLP. Jackie Matsumura is a CPA and senior tax manager in the Walnut Creek office of Burr, Pilger & Mayer, LLP. Both can be contacted at 415-421-5757. Copyright © 2007 by SF Apartment Magazine. All rights reserved.