Relatively small changes from the 2003 tax cut–the Jobs and Growth Tax Relief Reconciliation Act, or JGTRRA–will have far-reaching impact on this year’s tax return. Moreover, those changes encourage small business ownership and investment in a way we haven’t seen for years. As an advisor, you can help your clients understand the changes and help them all keep–and in some cases, make–more money. First, let’s review JGTRRA and some of the complications this law has created.
Here is a quick summary of the main changes brought about by the law:
Effective January 1, 2003, there are new income tax rates in place:
Old RateNew Rate
Effective January 1, 2003, here are the new tax rates for dividend income:
Old RateNew Rate
15%5% (0% in 2008)
10%5% (0% in 2008)
The new capital gains rate becomes effective for sales (and payments) received after May 5, 2003:
Old RateNew Rate
10%5% (0% in 2008)
8%5% (0% in 2008)
Marriage Penalty, AMT, Small Business Owners
The marital tax penalty (the very real penalty that couples face when they file jointly, as opposed to two single taxpayers) is going away, sort of. The IRS has increased the size of the 15% tax bracket for married taxpayers so it is now double that of single taxpayers. So, as long as you are in the 15% marginal tax rate, there won’t be a tax penalty. Of course, at the higher rates, it still exists.
The second part of the plan to eliminate the marital tax penalty is doubling the standard deduction. This works as long as the couple uses the standard deduction. If the married couple itemizes, there is no relief.
There’s been some movement on the alternative minimum tax, or AMT. Congress has finally recognized the need to increase the AMT exemption amount. This increased exemption amount means that a higher income tax return can take advantage of the new tax provisions. In the past, tax cuts were always greeted with cheers, but that vanished when the taxpayer realized that the alternative minimum tax would wipe out any benefits. The alternative minimum tax relief lasts through tax years 2003 and 2004.
There’s also some notable changes for small businesses. The Section 179 deduction, the expensing provision for personal property purchased by businesses, has been increased from $25,000 to $100,000. This is effective for property purchased after January 1, 2003.
The bonus depreciation for new personal property put into service has been increased from 30% to 50% for items bought after May 5, 2003.
Potential Traps for 2003 Returns
This year’s tax return preparation will require a higher degree of detail than in previous years due to the phase-in of various tax rate changes. Plus, some of the automatic choices are no longer automatic. Here are some of the traps that we’re watching in our practice.
Dividend versus Interest. It will be important to accurately report dividends (as reported on a Form 1099-DIV) separate from interest (as reported on a Form 1099-INT). Some taxpayers have gotten into the habit of lumping interest and dividends together when it comes to reporting this income. And it’s not always immediately certain whether the return from an investment is interest or dividend income.
Now might be a good time for advisors to review the types of income that all of their clients receive on their investments. It’s amazing how many people don’t understand the tax law change that now taxes dividends at less than half the tax rate for interest income for taxpayers at the highest tax bracket.
Capital Gains, and More
The capital gains calculation is even more complicated. The problem is that the lower capital gains rate goes into effect on May 6, 2003. The tax is 5% more on a property sold on or before May 5, 2003 than it is on May 6, 2003. This will be true for capital gains dividends reported by mutual fund companies as well. Make sure that reporting is correct to take advantage of the lowest possible tax rate.
This change also applies for payments received on installment sales, which are sales in which the taxpayer receives payments over time. This type of sale is most frequently used in the sale of a business or a real estate property.
We also saw some significant tax changes for taxpayers outside of JGTRRA. Here are a few of the most notable ones:
Principal Residence. The IRS provides for a tax-free gain exclusion for a home in which a taxpayer has lived for two of the previous five years. The tax-free gain exclusion is $500,000 for a couple that is married, filing jointly, and $250,000 for the single taxpayer. But if the provision for two full years of ownership wasn’t met, there was no exclusion allowed.
Then, in December 2002, the IRS issued a Treasury Regulation that added some great loopholes for the principal residence for someone who hasn’t lived in the property for the full two years. Prior to this Treasury Regulation, the only guidance that existed was in the IRS Code itself, which said “if the sale or exchange of the residence is due to a change in the taxpayer’s place of employment, health, or, to the extent provided in regulations, unforeseen circumstances, a taxpayer who does not otherwise qualify for the exclusion is entitled to a reduced exclusion amount.” But when the IRS issued its initial regulations, at Prop. Reg. Section 1.121-3(a), it didn’t explain what “unforeseen circumstances” meant.
Fearing audits and penalties, most tax practitioners used the “unforeseen circumstance” loophole very cautiously. We were therefore astonished to see what a liberal view the IRS took when the new regulations came out. In this new regulation, the IRS defines “unforeseen circumstances” to include: involuntary conversion of the home (for example, the government takes your property for a freeway on-ramp); natural or man-made disasters or acts of war; death; cessation of employment; change in employment or self-employment; divorce or legal separation; or multiple births resulting from the same pregnancy.
Notice the “change in employment or self-employment.” This could mean a raise, or a demotion, at your job. It could also mean that the taxpayer starts, changes, or shutters a small part-time business. In fact, for someone who wants to move from an appreciated property in which she has lived for less than two years, perhaps the best strategy is to start a small home-based business. All that is needed is a “change” in self-employment.
The “reduced exclusion amount” from the IRS Code quoted in the first paragraph means that you can then exempt an amount equal to the pro-rata portion of time lived in the house times the total possible gain exclusion, but no more than the total gain. In other words, let’s say that John and Corrine had only lived in their home for one year and had reason under this clause to qualify for the special circumstances. The fraction allowable would be 50% (1 year/2 years). They could then take an exemption for half of the possible gain (50% times $500,000 = $250,000). If they had a gain of $100,000, they could exclude all of it. If they had gain of $300,000, they could only exclude $250,000.
In this same Treasury Regulation, the IRS also made the home office even more attractive for business owners.
In order to take the home office deduction, a portion of your home must be used exclusively for business purposes. It can’t be a corner of the dining room table or the kitchen counter. It needs to be a spot that is only used for business. And it needs to be a place in which business is regularly conducted.
Once the legitimate home office expense is established, a pro-rata portion of the home-related expenses–such as mortgage interest, property tax, insurance, utilities, maintenance, and the like–is deducted against the business income. This pro-ration is determined by dividing the square footage of the business use by the total square footage. A pro-rata portion of the home can also be depreciated.
Contrary to public opinion–or misinformation–the home office deduction will not put the $500,000–for a married couple filing jointly–capital gain exclusion in jeopardy.
The IRS tells us that if the home office is part of the same “dwelling unit” as the home, then there is no need to attribute part of the gain to the sale of the principal residence.
If the home office is in a separate dwelling unit (such as a separate building that is not connected or a “basement apartment” that could be rented out) then the gain must be apportioned for the home office.
Planning for 2004 and Beyond
In 2008, there will be a huge opportunity for lower-income, high-wealth individuals. That’s the year when there will be 0% capital gains tax for individuals in the lowest two tax brackets. That’s also the year when dividends will also be taxed at 0% for individuals in the lowest two brackets. In fact, my CPA firm is already looking for ways to take advantage of these changes by setting up new business structures and structuring income to reduce taxes in 2008.