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By Douglas Schultz and Craig Schmitt

While 2007 was not a year where we expected significant federal tax reform (in light of the upcoming presidential election), there were a flurry of significant tax bills that made it through Congress and on to the president for signature in the last weeks of the year. Notable among these are the “Tax Increase Prevention Act of 2007” and the “Mortgage Debt Relief Act of 2007.” Other tax law changes came with the “Small Business and Work Opportunity Tax Act of 2007” and the “Energy Independence and Security Act of 2007,” as well as numerous technical corrections to the tax code.

This article will explore some of the more significant changes to the tax laws that are most likely to affect you and your family.

Alternative Minimum Tax Relief
The Tax Increase Prevention Act provides a stopgap measure to provide limited relief from the alternative minimum tax for the year 2007. Earlier temporary measures to deal with the AMT expired at the end of 2006, which would have forced more than 20 million additional taxpayers to pay the AMT on their 2007 returns. This short-term measure is in the law only for the year 2007, which means we will have to wait and see what Congress will do for the year 2008.

If you are not familiar with the AMT, here is a brief overview. The AMT is a parallel tax system that does not permit several of the deductions that we take for granted in computing our “regular tax”: the tax calculated on page 2 of Form 1040. The deductions not allowed for purposes of the AMT include, among others, state and local income taxes and the property taxes on your personal residence. For California taxpayers, these are often large deductions.

Individuals who may be subject to the AMT must calculate their tax liability under the regular tax system and under the AMT system, taking into account certain “preferences” and “adjustments,” such as the state income taxes and property taxes mentioned above. Other adjustments include certain depreciation deductions in excess of allowable AMT depreciation amounts. If your liability is greater under the AMT system, that’s what you owe to the federal government.

In recent years, Congress has provided a measure of relief from the AMT by raising the AMT “exemption amounts”: allowances that reduce the amount of AMT income, thereby reducing or eliminating the AMT. These exemption amounts are phased out for taxpayers whose income exceeds specified amounts.

For 2006, the AMT exemption amounts were $62,550 for married couples filing jointly and surviving spouses; $42,500 for single taxpayers; and $31,275 for married couples filing separately. However, for 2007, those amounts were scheduled to fall back to the amounts that applied in 2000—$45,000, $33,750 and $22,500, respectively. This would have brought millions of additional middle-income Americans under the AMT system, resulting in higher tax bills for many of them, along with higher compliance costs associated with filling out the complicated AMT form.

Congress has once again relied on a temporary “patch” to the problem, this time a one-year extension of the 2006 AMT exemption amounts, increased slightly for inflation. The new exemption amounts are $66,250, $44,350 and $33,125. We will have to wait and see what relief, if any, is provided at the end of 2008.

Mortgage Debt Forgiveness Relief
In response to the subprime lending crisis, Congress passed a bill that was quickly signed into law by the president, which gives tax breaks to homeowners who have mortgage debt forgiven. Prior to this new change, the debt forgiven by a lender, such as for short sales and refinances, was taxable to the borrower as cancellation of indebtedness income (CODI). Under this new law, a taxpayer does not have to pay federal income tax on up to $2 million of CODI for a loan secured on a qualified principal residence. This change applies to debts discharged from January 1, 2007, to December 31, 2009. It does not apply to debt forgiven on a second home, apartment rentals or other investment property. (See the “Debits and Credits” column in the January 2008 issue of SF Apartment Magazine for an in-depth look at the implications of foreclosures, debt restructuring and cancellation of debt income on investment property, including apartment buildings).

Here’s how it works: the 2007 Mortgage Relief Act excludes from an individual’s income any cancellation of indebtedness income by reason of a discharge of qualified principal residence debt prior to 2010. The exclusion applies where homeowners restructure their acquisition debt on their residence or lose their residence in a foreclosure.

For example, Tony, who isn’t in bankruptcy or insolvent, owns a principal residence in San Francisco and is subject to a $600,000 mortgage debt, for which Tony has personal liability. Tony’s interest rate was reset under the terms of his adjustable rate mortgage in July and Tony’s monthly mortgage payments nearly triple. Meanwhile, Tony sees the fair market value of his home start to drop. Tony gets behind on his payments and cannot catch up. Tony’s bank forecloses, and the home is sold for $500,000 in satisfaction of the debt. Prior to the new law, Tony would have had $100,000 of CODI. The result would be the same if Tony’s bank had agreed to restructure the loan and reduce the principal amount by $100,000. The $100,000 gain would be ordinary income subject to a combined federal and California tax rate of up to 44%. Tony did not get a penny of cash from the transaction. Tony loses his house and has a huge tax bill to boot.

Under the new law, Tony has no CODI to report on his tax return whether the bank forecloses the home or if the loan is restructured and the principal amount of the loan reduced. Tony may still have lost his house, but now he does not have to scramble to come up with a pile of cash to pay off a tax bill for income on the discharge of debt.

The tax relief applies to the original purchase price, plus improvements, of the taxpayer’s principal residence. It does not apply to discharges of second mortgages or home equity loans, unless the loan proceeds were used to acquire, construct or substantially improve the taxpayer’s principal residence. Refinanced debt qualifies, provided it does not exceed the amount of the debt being refinanced; cash out from a refinancing doesn’t qualify for the exclusion.

One final note: if the debt is restructured such that the home is not foreclosed upon, the basis in the individual’s residence must be reduced by the amount excluded from income under this new exclusion provision.

Another provision of the 2007 Mortgage Relief Act provides relief to widows and widowers. It essentially gives them more time to sell the home and still qualify for the maximum exclusion amount of $500,000. Here’s how it works: if you sell your principal residence, you typically can exclude as much as $500,000 of the gain if you are filing jointly in the year of sale, and $250,000 if you’re single. To be eligible for the full exclusion, you must have owned the home—and lived in it as your primary residence—for at least two of the five years prior to the sale.

Under the new law, a surviving spouse may still qualify for the $500,000 joint-filer exclusion if the sale occurs not later than two years after the spouse’s death, as long as the requirements for the $500,000 exclusion were met immediately before the spouse’s death and the survivor has not remarried as of the date of sale.

Mortgage insurance premiums will continue to be deductible after 2007, thanks to another provision of the 2007 Mortgage Relief Act. Under the deduction that was originated in 2007 and has now been extended for three years (through 2010), taxpayers can treat amounts paid during the year for qualified home mortgage insurance as mortgage interest and thus deductible. The insurance must be in connection with home acquisition debt, the insurance contract must have been issued after 2006, and the taxpayer must have paid premiums for coverage in effect in the year.

Kiddie Tax Expands
Under the so-called “kiddie tax” rules, the unearned income (such as investment income) of children that exceeds $1,700 (for 2007) is taxed to the children, but at the rates that would apply if that income were included in the parent’s return, if that rate is higher than what the child would otherwise pay. The 2007 Small Business Act expands the kiddie tax rules to apply to children up to age 18, and children over age 18 but under age 24 who are full-time students, if their earned income doesn’t exceed one-half of the amount of their support.

So, for the year 2007, the kiddie tax applies where a child under the age of 18 or who turned age 18, or if a full-time student turned age 19-23, before the close of the year; the child’s earned income for the year does not exceed one-half of his or her support; the child has more than $1,700 of unearned income in 2007; the child has at least one parent living at the end of 2007; and the child does not file a joint tax return for the year.

Under the kiddie tax rules, a parent can elect to include in the parent’s gross income for the year the child’s gross income in excess of $1,700, if certain provisions are met.

Final Thoughts
These are some of the highlights of the 2007 tax law changes. There were numerous other changes that have less direct impact on the readers of this magazine. At the time this article went to press, top lawmakers (Democrats and Republicans) had unveiled a $150-billion-dollar economic stimulus package. President George Bush described the deal as a robust set of incentives that will boost the economy. The package would give most tax filers refunds of $600 to $1,200. It would also increase the limits on Fannie May- and Freddie Mac-conforming loans beyond the current $417,000 in high-cost areas.

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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. Craig Schmitt is a CPA and senior tax manager in the San Francisco office of Burr, Pilger & Mayer, LLP. Both can be contacted at 415-421-5757. Copyright © 2008 by SF Apartment Magazine. All rights reserved.