An Overview

The recently enacted Taxpayer Relief Act of 1997 carries a wide variety of important tax changes that affect individuals, families, investors, and businesses. It is also one of the most complex tax laws enacted in recent memory (or at least since last year). Many of you will have to review your tax and financial plans in order to take advantage of the many new tax breaks found in the Act, and to avoid the few crackdowns.

While many of the new provisions aren't effective until next year, it may be prudent to plan now to get the most benefits. For example, some of the new credits and other tax breaks available next year are lost in whole or in part if income exceeds a certain level. That being the case, it may be possible to take steps now to reduce your income next year and thus get a greater benefit from one or more of these credits or other breaks. On the other hand, some provisions are effective retroactively and provide refund opportunities that you may want to take advantage of now.

This overview is intended to give you a very brief summary of the new law's major provisions so that you can begin to consider how your plans and goals may be affected in the coming weeks and months.

The major new tax breaks for individuals and families are as follows:

Starting in 1998, parents will get a new tax credit equal to $400 ($500 in 1999 and future years) for each qualifying dependent child under age 17. This credit phases out for those with adjusted gross income (AGI) exceeding $75,000 for a single person, $110,000 for married persons filing jointly, and $55,000 for married persons filing separately.

Beginning in 1998, more of you will be able to make deductible IRA contributions. The new law increases the adjusted gross income levels at which the IRA deduction begins to phase out for individuals who participate in an employer retirement plan. For single individuals, the AGI limitation range is increased to $30,000 - $40,000, and for married persons filing jointly, the AGI limitation range is $50,000 - $60000. The good news is that these limits will increase each year until 2006. And a spouse who isn't a retirement plan participant will be able to make a deductible IRA contribution even if the other spouse is a retirement plan participant, within certain AGI limitations. The new IRA break for the non-participant spouse phases out for those with adjusted gross income between $150,000 and $160,000.

Effective in 1998, retirement savers will have a new tax-favored alternative called the Roth IRA. The new IRA won't yield deductions when you put money in, but will result in tax-free distributions for withdrawals made after five years if you are at least 59 1/2, or because of death, disability, or the need to pay for certain first time homebuyer expenses. Otherwise allowable contributions to Roth IRAs phase out for single taxpayers with adjusted gross income between $95,000 and $110,000, and for joint filers, between $150,000 and $160,000 of adjusted gross income.

Additionally, in 1998 you will have the option to "rollover" (or simply convert) your current IRA account into a new Roth IRA if your AGI is not more than $100,000 in the year of the rollover. And while you will be required to pay income tax on any amounts rolled over (but NOT the 10% early withdrawal penalty), if you complete the rollover in 1998, you'll be able to spread your tax on the withdrawal over a four-year period.

There are major new tax changes for investors in stocks, bonds, and real estate. In addition, homesellers have also received some terrific news. Read on:

The top tax rate on long-term capital gains is reduced from 28% to 20% (and to 10% for taxpayers in the 15% bracket), and these changes are effective NOW. For example, if you currently sell appreciated stock you bought several years ago, your profit won't be taxed at a rate higher than 20%. However, there are some tricky holding period rules to contend with. Let's say you sold some stock for a profit:

***AFTER May 6, 1997 but BEFORE July 29,1997… you'll benefit from the new, lower rates if you held the asset for more than one year on the date of the sale.

***AFTER July 28, 1997… you'll benefit from the new, lower rates ONLY if you held the stock for more than 18 months on the sale date. If you held it between one year and 18 months, a 28% maximum tax rate applies to your profit.

Even lower capital gains rates are on the way. After the year 2000, the top tax rate for long-term capital gains will be 18% (8% for taxpayers in the 15% bracket) if a 5-year holding period is met. The 18% rate (but not the 8% rate) will apply only if the holding period for the assets begins after the year 2000.

It should be noted that the reduced capital gains rate applies for purposes of BOTH the regular tax and the Alternative Minimum Tax.

Long-term capital gains from the sale of collectibles continues to be taxed at a maximum rate of 28%, and long-term capital gains from the sale of depreciable residential or nonresidential income or business real property will be taxed at a top rate of 25% to the extent it does not exceed depreciation previously taken. The balance of the capital gain will be taxed at a top rate of 20%.

Up to $250,000 of the profit on the sale of your principal residence is tax-free if the sale takes place after May 6, 1997, and other restrictions are met. The exclusion is doubled to $500,000 for married persons filing jointly. The new break replaces the home-sale rollover rules and the "once in a lifetime" $125,000 exclusion rules for homesellers age 55 and over. There are also some tricky holding period rules regarding the sale of the home, so be careful with this provision. Not only that, this exclusion can be used every two years on the sale of your principal residence. It is NOT just a one-time shot.

Certain sales of assets entered into after June 8, 1997 are treated as taxable sales even though you could previously defer reporting gain on those sales as income. As many of you know, "shorting against the box" is one of the most popular methods that has been impacted and is really the target of this law. But the law does not exempt option players and other hedging transactions. So for those of you with sophisticated financial transactions: beware!

A number of new tax incentives for higher education are on the way, including:

#1: There are two new elective tax credits for higher education. The first is a HOPE credit of up to $1,500 a year per student for qualified tuition paid during the first 2 years of a student's post-secondary education. This credit is effective for post-1997 payments for post-1997 education. The second is a Lifetime Learning credit per taxpayer (as opposed to per student) equal to 20% of up to $5,000 ($10,000 after 2002) of qualifying higher education expenses a year, including graduate-level education. The credit for lifetime learning applies to post June 30, 1998 expenses for education beginning after that date. Both credits phase out for those with adjusted gross income between $40,000 and $50,000 (between $80,000 and $100,000 for joint return filers). Qualified tuition for purposes of the Lifetime Learning credit does NOT include tuition of an individual for whom a HOPE credit is allowed for the year. Neither of these credits can be claimed for a year in which a person takes tax-free distributions from an education IRA (see below).

#2: After 1997, individuals will be able to make annual nondeductible contributions of up to $500 per beneficiary (or, in other words, per child) to an education IRA. Distributions from the IRA to pay for college expenses will be tax- and penalty-free as long as you are able to meet a number of conditions. The education IRA contribution limit phases out for those with adjusted gross income between $95,000 and $110,000 (between $150,000 and $160,000 for joint return filers).

#3: After 1997, you can take penalty-free (but NOT tax-free) distributions from non-education IRAs to pay for qualified higher-education expenses.

#4: Part of the qualified education loan interest due and paid after 1997 (i.e., student loans) may be deductible. The maximum deductible amount is $1,000 for 1998 (increasing $500 a year in 1999 through 2001), but it phases out for those with adjusted gross income between $40,000 and $55,000 (between $60,000 and $75,000 for joint return filers). This deduction is available to all taxpayers, regardless of whether or not you itemize deductions.

For those of us unlucky to lose loved ones in the years to come, the new law has affected estate tax issues as follows:

More of a person's assets can be passed on or given to family members (or anyone else, for that matter) free of estate or gift taxes. The amount exempted from estate or gift tax (currently $600,000) rises to $625,000 for persons dying and gifts made in 1998. The increase goes to $650,000 in 1999, jumps to $675,000 in 2000 and 2001, and will continue to increase until the exempt amount tops out at $1 million in 2006 and later years.

If more than 50% of a person's estate consists of qualified family owned business interests or a farm, his or her executor can exclude up to $675,000 of such interests from the gross estate. This exclusion, which is available for decedents dying after 1997, can't exceed (1) $1.3 million minus (2) the amount that can be left or given free of estate or gift taxes. For example, in 1999, the exclusion for qualified family owned business interests can't exceed $650,000 ($1.3 million minus $650,000).

For individuals dying after 1997, executors who choose the installment method of paying estate taxes arising from closely held businesses will qualify for a lower interest rate (2% instead of current law's 4%). And the lower rate will apply to a larger amount of deferred estate tax.

Taxpayers will no longer be penalized for taking large withdrawals from IRAs, qualified plans and tax-sheltered annuities, or leaving large retirement plan accumulations to their heirs. The 15% excise tax on excess distributions, which had been suspended for 1997 through 1999, is repealed (effective in 1997), and so is the additional 15% estate tax on excess retirement accumulations (effective for persons dying after 1996).

And you'll find quite a few business provisions in the new tax law. The major ones include:

For tax years beginning after 1997, the Alternative Minimum Tax (AMT) is repealed for small corporations. Briefly, the exemption from the AMT applies to a corporation that has under $5 million of 3-year-average annual gross receipts, and continues to apply as long as it has under $7.5 million of average gross receipts.

The AMT adjustment requiring use of a generally longer depreciation write-off period than applies for regular tax purposes is repealed, effective for property placed in service after 1998.

Retroactively effective to tax years beginning in 1987, qualified farmers are eligible to use the installment method of accounting for AMT and regular tax purposes.

A self-employed individual's above-the-line deduction for health insurance costs (40% of eligible expenses for 1997) will increase at a quicker pace than it would have under prior law. The deduction will be equal to 45% of eligible costs in 1998 and 1999, and 50% in 2000 and 2001. The deductible percentage will grow in later years until it reaches 100% in 2007 and all future years.

Beginning in 1999, more of you will able to claim home-office deductions. Qualifying home-offices will include those used to conduct administrative or management activities relating to a business if there's no location outside the home where the taxpayer conducts those activities. But this is no slam-dunk. With the new "universal gain" rules applicable to personal residence sales, many of you will chose NOT to claim the office in home deduction, even if you might qualify. Remember that under the "universal gain" rules you are required to recapture any depreciation (and pay tax on that recaptured depreciation) for any depreciation taken after May 6, 1997. This means that, while the depreciation deduction may benefit you in your "office in home" deduction, you may have to turn around and pay tax on that depreciation at some time in the future when the home is sold. Without that depreciation, it is very possible that you could avoid the entire gain on the home sale. But the depreciation deduction could mess things up a bit, which is why the decision to take the home office deduction may be a little more difficult to make.

Some other provisions of general interest include:

The annual exclusion for up to $5,250 of employer-provided educational assistance has been extended and will apply to expenses paid for courses beginning before June 1, 2000 (it had expired for courses beginning after June 30, 1997).

The estimated tax rules are overhauled for individuals with adjusted gross income over $150,000 in the tax year preceding the current year. Under the rules that apply this year, they avoid underpayment penalties for 1997 if they made:

Estimated tax payments at least equal the lesser of:

(1) 110% of the tax shown on their 1996 return, or;

(2) 90% of the tax shown on the 1997 return.

But for tax years beginning in 1998, all taxpayers are subject to the same rules:

Underpayment penalties are avoided if their estimated tax payments are at least EQUAL to the lesser of:

(1) 100% of the tax shown on their 1997 return, or;

(2) 90% of the tax shown on the 1998 return.

The estimated tax penalty safe harbor rules for higher-income taxpayers will change again for tax years beginning in 1999 through 2003.

For tax years beginning after 1997, the estimated tax penalty is not imposed if the shortfall for the year is less than $1,000 (up from $500).

The standard mileage rate deduction for charitable use of a car is increased from 12 cents a mile to 14 cents a mile for tax years beginning after '97.

Charitable givers can continue to deduct the fair market value of qualified appreciated stock (publicly traded stock that is capital gain property) donated to private foundations. This break, which had expired on May 31, 1997, is extended for the period June 1, 1997 through June 30, 1998.

But there are also some crackdowns in the new law. Changes you should watch out for include:

A number of relatively specialized corporate provisions are subject to tougher rules (e.g., gain recognition on certain distributions of controlled corporate stock, tougher holding period rules for the corporate dividends received deduction, registration of certain confidential corporate tax shelters).

There are several changes in the partnership area. For example, contributing partners recognize gain on the property distributed to another partner or on distribution of other property to the contributing partner within seven years of the original contribution (the old law had been five years). This is effective generally for appreciated property contributed to a partnership after June 8, 1997. In addition, effective generally for sales, exchanges, and distributions after August 5, 1997, gain on the sale or exchange of a partnership interest generally is taxed as ordinary income to the extent it is attributable to inventory. This had previously applied only to the extent attributable to substantially appreciated inventory.

Gross proceeds reporting will be required on all post-1997 payments to attorneys made in the course of a trade or business (except those now reported on Form 1099-MISC or Form W-2).

The net operating loss (NOL) carryback period is decreased from three to two years, but the carryforward period is increased from 15 to 20 years, effective for NOLs arising in tax years beginning after August 5, 1997. But the three-year carryback is retained for losses in disaster areas by farmers or a small business, and for an individual's casualty losses.

Keep in mind that you won't be exposed to estimated tax penalties to the extent any underpayment was created or increased by the Taxpayer Relief Act of 1997. This penalty protection applies for any period before 1998 for any payment due before January 16, 1998.

So there you have it. And remember that these are only the MAJOR provisions. A number of other specialized provisions are included in the Taxpayer Relief Act of 1997. If you have any specific questions on any of these provisions, make sure to put Strategies or Inheritance in the subject line of your email. I'll be glad to try to answer 'em.

- Article Tax 32

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