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Just before adjournment, Congress has handed out some Christmas presents for taxpayers affected by the alternative minimum tax (AMT) and forgiveness on their mortgage debt. Congress left a number of tax issues, including extension of expiring provisions, for another day.
"Congress ended up doing the minimum that was expected, but what they did will spare many taxpayers some grief," said Mark Luscombe, JD, CPA, CCH principal federal tax analyst.
A One-year Patch for the AMT
The AMT can apply to almost anyone, but tends to affect mainly middle-class taxpayers with substantial itemized deductions, such as those who live in high-tax states. Like the standard deduction for regular taxes, there is an "exemption" based on filing status used in calculating possible AMT liability. But unlike the standard deduction, exemption amounts for the AMT were never indexed for inflation and each year threaten to revert to levels that will ensnare millions of additional taxpayers in the alternative tax system. The Tax Increase Prevention Act of 2007 offers relief in the form of a one-year "patch" that will help taxpayers in 2007 but leaves the future of the AMT in doubt.
The law sets 2007 AMT exemption amounts at $44,350 for single taxpayers, $66,250 for married couples filing jointly and $33,125 for married filing separately. These amounts are $2,000 higher than 2006 for single filers and married taxpayers filing separately; $4,000 higher for joint filers. More important, they are about $11,000 higher for single and married filing separately and about $22,000 higher for joint filers than the 2007 exemptions they would have had to use if no "patch" had been enacted.
The new law also extends for the 2007 tax year the ability of taxpayers to use most nonrefundable personal credits to offset their AMT liability. These include the dependent care credit, credit for interest on certain home mortgages, credit for the elderly and disabled, the Hope credit for certain college expenses, the Lifetime Learning credit and the credit for certain non-business energy property.
Altogether, the "patches" for 2007 will keep about 20 million taxpayers out of the clutches of the AMT. But only for 2007. What happens in 2008 is anyone's guess.
Help for Those with Mortgage Troubles
The Mortgage Forgiveness Debt Relief Act of 2007 will help people who have lost their homes through foreclosure or whose lenders have forgiven some of their mortgage debt so they can keep their homes.
Ordinarily, when someone is relieved of a debt, the amount forgiven is considered taxable income.
"People who didn't have the money to meet their mortgage payments have found that they owe income taxes on tens of thousands of dollars," Luscombe observed. For example, if a bank forecloses when the borrower owes $400,000 on a home and then sells the property for $310,000 in full satisfaction of the debt, the borrower will usually owe tax on $90,000.
"It seems like the tax system is kicking them when they're down," Luscombe said.
The new law excludes discharges of up to $2 million of indebtedness from taxation if the debt is secured by a principal residence and if it was incurred in the acquisition, construction or substantial improvement of the principal residence. This special relief is temporary and is available for three years, retroactively applied for discharges from January 1, 2007, through December 31, 2009.
Forgiveness of debt on vacation or other second homes or on home equity debt will still count as income. In addition, homeowners who took advantage of the run up in real estate prices to refinance their mortgages can only take advantage of the new law for higher mortgage debt that was used to improve the home. "Cash out" refinancings that went for other purchases or to pay off credit-card debt don't qualify for the exclusion if they are forgiven.
Taxpayers who take advantage of this new provision will have to reduce their "basis" in their homes by the amount excluded. For example, someone who paid $300,000 for their home and had $20,000 in mortgage debt forgiven will figure that their "basis" in their home is now $280,000. If they later sell their home for $350,000, their gain will be $70,000 rather than $50,000.
"Since single people can exclude as much as $250,000 in gain on the sale of a home, and joint filers as much as $500,000, in many cases there is no tax due anyway," Luscombe noted. "Even if there is, most people would be willing to trade a capital gains tax in the future for tax relief at ordinary income rates today."
Mortgage Insurance Deduction Extended, Help for Surviving Spouses
The Mortgage Forgiveness Debt Relief Act of 2007 also temporarily extends the deduction for qualified mortgage insurance premiums for three years, through January 1, 2011. This allows taxpayers to deduct mortgage insurance premiums for debt accrued after December 31, 2007, but only for contracts entered into after December 31, 2006 and prior to January 1, 2011.
"This provision is a popular one among home buyers and realtors, since it effectively reduces the after-tax cost of buying a home," Luscombe noted.
Luscombe predicts that there will be some moves in Congress to make both mortgage-related provisions permanent parts of the tax code, but the potential cost of doing that may keep lawmakers from acting anytime soon.
One new provision that will become effective January 1, 2008, gives a surviving spouse two years in which to sell a home that was jointly owned and occupied with a spouse and still take advantage of the $500,000 gain exclusion for joint filers. Currently, a surviving spouse is entitled to the $500,000 exclusion only to the extent he or she can file a joint return with the deceased spouse's estate, which only occurs for the tax year in which the spouse dies.
"This is a significant new benefit, and the surviving spouse continues to be allowed a step up in basis in a jointly owned residence for the deceased spouse's one-half share. The $500,000 exclusion is in addition to that," Luscombe said.
Other Changes for 2008
The effects of inflation will raise various tax brackets and phase-out levels for many tax provisions. These types of changes happen every year. But there are a handful of tax changes for 2008 that are scheduled to be enacted.
One significant change will be the amount of reduction for personal exemptions and itemized deductions when income exceeds phase-out levels. For these taxpayers, the amount by which these deductions are reduced in 2008 will be only half of the amount of the reduction that otherwise would have applied in 2007.
For taxpayers in the 10- or 15-percent tax bracket, the capital gains tax rate of 5 percent has been temporarily reduced to zero percent for 2008-2010. Also, in 2008, children with investment income over $1,800 will be subject to their parent's tax rates if they are under 19 years old or are full-time students under the age of 24. Finally, the following tax credits have expired for 2008 (but be warned: Congress may choose to renew them anytime in 2008):
- Deduction for educator expenses in figuring adjusted gross income
- Tuition and fees deduction
- The exclusion from income of qualified charitable distributions
- Credit for nonbusiness energy property
- District of Columbia first-time homebuyer credit (for homes purchased after 2007)
- The election to include nontaxable combat pay in earned income for the EIC
Looking Ahead
Congress has left a number of tax measures for action in 2008. In the days before Christmas adjournment, the House and Senate came close, but not close enough, to agreement on a package of tax breaks for members of the military. It will be revisited next year. There is also widespread sentiment that some tax breaks expiring at the end of 2007 should be extended for at least one more year.
If no other solution to the AMT is found, another "patch" will have to be enacted for 2008. Congressman Charles Rangel, chairman of the House Ways and Means Committee, has put forward a plan that would abolish the alternative tax, but it has yet to garner bipartisan support.
"Given the close party divisions in Congress and the fact that 2008 is an election year, it's unlikely that we'll see major legislation that will radically alter the tax landscape any time soon," Luscombe said. "It looks like the tax code will resemble an old car, that keeps getting repaired and refurbished here and there until we can afford a new model."
- Related items:
- Congress Agrees To AMT Tax Relief at Last-Minute, Before Its Recess
- Clean Patch for AMT Clears Senate
- Delayed Start to 2008 Filing Season Could Mean Numerous Problems for IRS, Taxpayers
- No Changes Anticipated in Tax Extenders Package
- House Approves One-Year AMT Patch Legislation
- Congress Begins Work on Temporary AMT Patch, Extenders Bill
- Year-End Tax Planning Must Deal with Uncertainty
- Tax Rate Projections for 2008
- Senate Finance Panel Hears Solutions for AMT Problem
- IRS Begins Tax Season With Important Issues Unresolved
- Permanent AMT Fix Poses Difficult Choices
Posted January 3, 2008.
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