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The Bailout Plan and Your Income Tax - PART II

 In Part I of this story we took a glimpse at what the existing banking and economic crises means to us today, what brought us to such an extreme situation and what it could mean to us in the future. Now let’s take a look at how government uses the tax system to influence our economy as well as what this means to you and I today.


 During my 35+ years as an income tax professional I have had to deal with more revisions in the U.S. Tax Code than I can count on my fingers. I have seen the top personal income tax rates range between 70% and 31%. During that time, often what were considered to be major tax reformation legislation (Tax Acts of 1969, 1976 and 1986) was so poorly planned that they required one or more subsequent tax legislation corrections or amendments. Two of the biggest examples of smoke and mirrors (in my opinion) was the Tax Reform Act of 1986 and the Tax Relief Reconciliation Act of 2001. Although the 1986 tax act was touted as an economic savior because it lowered the tax rates (as did the 1981 tax act), it limited or eliminated many deductions. In some cases deductions which once were allowed directly from gross income, from which a standard deduction could be further subtracted by those without home mortgage interest and real estate tax deductions, were now only permitted as an itemized deduction (subject to limitations). As a result, the tax act often had the effect of either neutralizing the effective tax rate (what you actually pay as compared to your gross income) and in some cases actually resulted in a tax increase for certain lower middle class taxpayers. As with the 1986 tax act, the 1981 tax act eliminated the benefit enjoyed by many lower middle income families who had a significant increase in their income (often because they needed an emergency lump sum distribution from their retirement savings account) and could no longer have the additional income taxed at the average effective rate paid over the prior ten years. To add insult to injury, as our social security fund was being used up to offset other government expenses and putting our FICA benefits in jeopardy, a 10% penalty was enacted against anyone who needed to take money from their retirement savings except in very limited exceptions which included a down payment on their first house and medical expenses that were in EXCESS of the amount that was permitted as an itemized deduction. So if you did not have enough itemized deductions, you pay a 10% penalty. Many people who borrowed against their retirement accounts and missed a loan payment, or paid late, have the full amount of the loan included as income subject to a 10% early withdrawal penalty.


 I find it ironic that in many of these tax acts the words fairness and equitable are used. If you listen to candidates who debate about tax reform (I say bottle all the hot air and solve the energy crises), not one speaks about capital gain legislation. First of all, capital gain distributions within a mutual fund account which are usually (and encouraged by brokers and registered securities representatives) reinvested into the fund account are taxed, even though you do not receive the cash. Second, individual taxpayers are not permitted to carry back real cash capital losses to prior years; however corporations are permitted to do so. Finally, for as long as I can remember, capital losses that are carried to future years can only be used to offset future capital gains with the exception of an annual deduction against ordinary income in the amount of $3,000. So here is a real life example which I have seen numerous times, especially when the market tanked in 2000 and which many will experience in 2008! Say you invested $25,000 in a non-retirement mutual fund on which you pay tax every year on dividends and internal capital gain distributions that are reinvested into the fund. Now assume that fund sold stocks  purchased at a low price with your invested money and sells them at a large gain in 2008 (which you don’t learn about until you prepare your 2008 income tax return as you did not read your quarterly statements carefully) thus generating a taxable capital gain distribution to you which you elected to have reinvested in the fund. Now the market crashes in the fourth quarter of 2008 and your fund value is next to nothing, with little hope of recovering within your lifetime. You still must pay the income tax on the gain recognized when the fund manager sold the stock it held, so you cash in your remaining fund in order to pay the income tax. So not only do you lose all your savings, you have to pay tax on a phantom gain you never received in cash. Now it gets worst because although you may have had capital gains in prior years, you can’t amend those back year tax returns to use the capital loss and get a tax refund (but a corporation can) and because you have no money left to invest, you get to deduct that big loss in the amount of only $3,000 each year (the same limited amount that was allowed 30+ years ago). I saw the same thing happen back in 1999 when people sold their tech stocks at a gain and invested it in other companies before the market tanked. They lost their money but still had to pay income tax and could only deduct $3,000 in each of the following years.


 Before I list the income tax changes associated with the Bailout Plan, let me again point out that these are short term, some retroactive to January 1, 2007 and most ending by December 31,2009, so it is important to keep up with these legislative tax provisions and determine if and how they will affect you, and to plan your finances accordingly. It is also important that I remind you that virtually all of the tax law changes that went into effect following the attack of September 11, 2001, were also emergency tax relief “sunset” provisions which expire at the end of 2010 unless they are extended or made permanent by an act of Congress before then. If nothing is done, the tax laws in effect as of 2000 will be reinstated. The final decisions will be made by who is seated as our representatives in the House and Senate during the next two years and who is elected as President. Regardless, however, always remember that it is the responsibility of each of us to communicate and maintain dialogue with our Congress and be equally active (if not more so) as regards or local government and elected officials.

 Although it will be a while before the new tax legislation is codified, here are some (but not all) of the legislative provisions which will affect us now:

 n                   Foreclosure and Refinancing Relief-Most people are not aware that there is a tax provision that requires a finance company, bank, mortgagor (or anyone) who forgives all or a portion of a debt owed to them to report the amount of forgiven indebtedness to the IRS. By the same token, even if this information is not reported, anyone who has a debt forgiven (except under certain bankruptcies and other situations) must report the amount of forgiven indebtedness on their tax return and pay tax on that amount. Unfortunately there are times when the amount of the debt is in honest dispute and the amount for which a demand for payment is made is not legally owed, however the lender reports it to the IRS. Then the IRS computer identifies the difference and sends a bill to the taxpayer, who is left in still another dispute except this time it is for unpaid taxes plus penalties and interest on the debt they never legally owed.

o        As regards the new bailout plan, the new tax relief (which is retroactive to January 1, 2007 and ends December 31, 2009 affects both mortgage workouts and foreclosures, however it only applies to your qualified principal residence and is limited in amount to the cost of the residence plus any substantial improvements made since the purchase or $2 million, whichever is less.

§         Foreclosures-If the mortgagor forecloses on a home with an upside down mortgage loan (that is the value of the home is less than the amount of the debt) and forgives the unpaid balance, the difference is considered taxable “forgiveness of indebtedness” income. Under the new law, if this occurs between 1/1/2007 and 12/31/2009, the difference (subject to limitations mentioned) is exempted from tax.

§         Mortgage workouts- Let’s assume you have an adjustable interest rate mortgage that increases under the terms of the mortgage loan and you fall behind in your payments. If the lender considers that it is in their best interest not to foreclose but instead to forego the additional interest which they are legally entitled to, that is considered also to be a forgiveness of indebtedness. Under the new law, the amount of debt forgiveness income would not be taxable.

·         In this case, the amount of forgiven indebtedness reduces your basis in the residence for purposes of determining any taxable gain when the house is sold.


n                   Refundable Child Care Credit­ – The earned income threshold for determining this credit.

n                   Property Tax Deduction for those who do not itemize-For 2008 and 2009, those who own homes but do not itemize deductions can add to the standard deduction an additional $500 ($1,000 if married filing a joint income tax return)

n                   Tuition and Fees Deduction­, now extended through 2009.

n                   Alternative Minimum Tax (AMT)-A backbreaking tax for many struggling taxpayers, especially in high cost of living areas such as New York, is reduced lightly for 2008 in addition to the ability to use certain personal tax credits to offset the AMT for 2008 as well.

n                   The energy efficient property credit is extended and modified through 2016 and this credit can be used to offset AMT liabilities. The credit limit on solar electric property is removed and new types of equipment added are those that generate wind energy and geothermal heat pumps.

n                   Other energy property credits are extended through 2009 which provide a credit for up to $500 for purchasing energy saving products such as windows ($200), insulation, HVAC systems, biomass fuel stoves with a thermal efficiency rating of 75% or more ($300) and also asphalt roofs with cooling granules. In order to qualify for the credit water heaters must have either an energy factor of at least 0.80 or a thermal efficiency rating of at least 90%.

n                   The $250 deduction for educators’ supplies is extended to 2009.

n                   Nationally Declared Disaster Relief areas will significantly benefit from this new tax legislation as well.


To offset the cost of the personal tax reductions, certain business taxes have been increase, such as extending the 6.2% FUTA rate through 2009 plus a new failure to file penalty for partnerships and Subchapter S corporations of $85 per partner, per month for up to 12 months that the return is filed late.

 Read Part I                                   Return to Home Page


About the author. Andrew J. Powers (Andy) has pursued a full time career as an international tax professional and tax executive since graduating the Iona College School of Business in 1973. His family owned tax practice, Powers & Company has provided income tax solutions to individuals and businesses since 1965. Andy also provides small businesses with consultation services concerning business start up, operations planning, marketing strategies and general business management practices.

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