As you can see from the length of this topic, this has been another banner year for tax law changes. Not only has there been a lot of action from Washington during 2006, with more on the way, but we're also experiencing the impact of changes made in prior years with delayed effective dates. Fortunately, most of these changes are good news for taxpayers, and we've built the appropriate changes into TaxCut. The rules Congress created or altered in 2006 and earlier years that affect your 2006 return are all here.
Some changes enacted in 2006 don't go into effect until 2007 or later. Even though they have no affect on the return you're working on now, you need to know about them now. Why? Because the way the changes will affect your tax bill in the future might affect your financial behavior in the months ahead.
In recent years Congress has tended to dole out tax relief in short-lived doses. As each relief provision threatens to expire, lawmakers go to work on extension legislation that becomes a patchwork of other tax provisions along for the ride. 2006 was no exception, with two major bills and counting.
The first major tax bill to pass in 2006, the Tax Increase Prevention and Reconciliation Act of 2005, was the product of months of wrangling, and combines extensions of expiring relief provisions with a stew of new tax relief and revenue raising provisions.
AMT relief. The alternative minimum tax (AMT) began life as a defense against wealthy taxpayers who deducted their way out of paying income tax. Thanks to lower tax rates and inflation, the AMT has insinuated itself into the pocketbooks of millions. To turn back the clock on this process, Congress bumped up the AMT exemption to $62,550 ($42,500 for single taxpayers). The exemption is like a standard deduction for the AMT, and protects the not-so-wealthy from the AMT's sting. True to form, Congress limited the relief to one year, assuring that the AMT will continue to be a legislative battlefield.
Taxing teenagers. For parents of means, one of the milestones in their child's lives has been the magic age of 14, at which the vexing "kiddie tax" no longer applies to the child's investment income. The kiddie tax stacks kids' investment income on top of the parents' income, applies the parents' tax rate to the total, and hands the child the tax bill for his or her share. Looking for some revenue to offset the cost of the taxpayer-friendly provisions in the Reconciliation Act, Congress raised the age of tax independence to 18 effective for 2006 returns.
Extension of lower capital gain and dividend tax rates. The capital gain and dividend rate cuts beloved by the Republicans and lamented by the Democrats were due to expire in 2008. The Reconciliation Act extended the rate cuts two years — they will expire in 2010 along with the lower regular tax rates enacted in 2001.
Roths for everyone. Wealthy taxpayers have been on the sidelines for the popular Roth IRA, unable to either convert an existing IRA or contribute funds to a Roth due to income cutoffs. This will change in 2010, when the income cap on conversions will be lifted. Sound strange? It's all part of a budget gimmick — Congress anticipates a surge of conversions in 2010, with an accompanying surge in tax revenues from the taxes due on the conversions. The extra revenue goes on the plus side of the ledger for the Reconciliation bill, whereas the tax savings the Roths' owners will enjoy farther off in the future aren't in the picture due to the time frame.
Last year's major energy bill included several new tax breaks to encourage energy conservation.
Hybrid vehicles. In 2005, those who bought new gasoline/electric hybrid-vehicles — such as the Toyota Prius, Honda Insight, Honda Civic Hybrid and Ford Escape Hybrid — earned a $2,000 tax deduction. In the 25% bracket, that deduction was worth $500. For 2006, the hybrid deduction morphed into a much more powerful tax credit. There's no one-size fits all credit. The value depends on the fuel efficiency of the hybrid. Unfortunately, all hybrid buyers aren't guaranteed a full-strength credit. Once a manufacturer sells 60,000 hybrids (starting with the first one sold in 2006), a convoluted phase-out system gradually reduces the value by 50%, then 75% and then wipes it out all together. Your car dealer should be able to help you figure out your credit.
Home improvements. Also starting in 2006, homeowners can earn small tax credits for undertaking energy-saving home improvements. The credit is 10% of the cost of skylights and energy-efficient doors and windows. Also earning the 10% credit: energy-efficient furnaces, water heaters and central air conditioners. The maximum credit you can earn is $500, with no more than $200 attributable to windows.
Homeowners can also take a credit for 30% of the cost of solar energy systems to heat air or water, but not pools or hot tubs. This credit is capped at $2,000 each for home furnaces and water heaters. It's available for solar systems installed in second homes as well as principal residences.
New homes. Builders get a credit for energy-efficient homes built after 2005 that are sold in 2006 or 2007. The maximum credit is $2,000 per house. . .and maybe builders will pass part of the tax savings on to the buyers of qualifying homes.
While mostly focused on pension reform to avert fiscal disaster, the Pension Protection Act of 2006 also qualified as a major tax bill with tax provisions affecting retirement savings and charitable contributions, among other things.
Donations of used clothing and household goods. Concerned that America was giving "rags to riches" a new meaning, Congress has cut back on the popular deduction for donations of used clothing and household goods. Effective for donations on or after August 18, 2006, no donation is allowed unless the item is in "good" used condition. The IRS will be issuing guidelines to help us interpret the new standard — meanwhile, we have clues from the legislative history, which tells us not to write off donations of used undergarments or other items of limited monetary value. There's an exception for items for which you have an appraisal of more than $500, and for art, jewelry, gems and collectibles.
Cash donation records. Beginning with donations in 2007, you'll need to have a bank record or receipt to back up any cash donation you claim on your return. This is a major change from the old recordkeeping rules, which only kicked in at the $250 donation level.
Direct donation from an IRA. For 2006 and 2007, Congress cut retirees a break with a new way to meet their IRA minimum distribution requirements: Donate directly from an IRA to a charitable organization. Only those age 70-1/2 or over are eligible. This new rule opens up a new strategy for eligible IRA owners who intend to make a charitable gift. By sending the donation directly to the charity out of an IRA, the IRA owner is assured that there will be no tax on the withdrawal.
Other retirement plan provisions. The Pension bill has these other provisions to help with retirement savings:
In the aftermath of Hurricanes Katrina, Rita, and Wilma, Congress enacted several tax breaks to aid victims. Some of these continue to apply for 2006.
Retirement plan breaks. The government will not add insult to injury to victims of Katrina, Rita or Wilma who have to crack their retirement nest eggs early to get needed cash. The normal 10% penalty for early withdrawals from IRAs, 401(k)s and other retirement plans does not apply to distribution of up to $100,000 made on or after August 25, 2005, and before Jan.1, 2007. In addition to the withdrawal's being penalty free, the tax bill on the withdrawals can be spread over three years. And, if you can afford to return the cash to your IRA or other retirement plan within three years, you can file an amended tax return and retrieve the tax you paid on the payout. (To qualify for penalty-free withdrawals, your principal residence must have been in one of the areas hit by the storms and you must have suffered an economic loss.)
Redevelopment help. To encourage rebuilding in the devastated areas, Congress enacted several breaks for businesses, including bonus depreciation, a doubling of the amount of new investment that can be "expensed" — written off right away rather than being depreciated over several years — and creation of a new tax credit to encourage employers to keep employees on the payroll. If you're doing business in one of the Gulf Opportunity (GO) Zones, be sure you get up to speed on all the new breaks.
College credits. Students who attend colleges in New Orleans and other areas of the Gulf Coast hit by Hurricanes Katrina are eligible for Hope and Lifetime Learning credits double the normal size — $3,300 for Hope credits and $4,000 for Lifetime Learning credits.
Housing exemption. To encourage assistance to those made homeless by Hurricane Katrina, Congress granted people who house Katrina victims a tax deduction in the form of an additional $500 personal exemption for each person housed, up to a total of $2,000 over the 2005-2006 time period. To qualify, the housing must be provided rent-free for 60 days or more.
Sometimes tax relief comes through the judicial process — that was the case in May, when the U.S. Treasury, after losing several court cases, decided it would no longer collect an excise tax on long distance telephone service that had been put in place to help fund the Spanish-American War over 100 years ago. What's more, Treasury will refund $10 billion in tax collected in 2003 - 2006. To simplify the process, you can claim your refund on your 2006 income tax return and don't even need to dig up old phone bills to do so. The IRS is allowing all long-distance customers to claim between $30 - $60 as a tax credit on their return, depending on family size. Of course if you have your old phone bills and want to go to the trouble, you can claim the actual amount you paid if that puts you ahead.
If you have a high income, you may have noticed that each year you have to give back some of your itemized deductions and personal exemptions. This is the other stealth tax — in addition to the AMT — that high-income individuals contend with. It's called a phaseout, and the way it works is the higher your income, the less you can claim of your itemized deductions and personal exemptions.
Back in 2001, Congress decided that the stealth tax wasn't a good way to raise revenue, and repealed it in slow motion. Between 2006 - 2009, the itemized deductions and personal exemption phaseouts are reduced by 1/3 each year, until they disappear altogether.
The volatile price of oil has kept the IRS on its toes. For business use of a car, the standard mileage rate for driving in 2006 is 44.5 cents a mile, down from the emergency level of 48.5 cents a mile put in place after Hurricane Katrina. For qualified medical use — such as driving to see your doctor — and for driving in connection with a move to take a new job, the rate for 2006 is 18 cents a mile, and the rate for charitable volunteers is 14 cents per mile. However, if your mileage was for a charity serving Hurricane Katrina victims you can deduct it at 32 cents a mile.
Congress may adjourn for 2006 with many tax matters still pending. The new itemized deduction for state and local sales taxes — of particular importance to those who live in states that do not impose a state income tax — expired in 2005. We expect it will be extended at least through 2006. We also believe you can count on the continuation of the $250 deduction for teachers and teachers' aides, the $5,000 Washington, D.C., first-time homebuyers credit and the $4,000 college tuition deduction, all of which expired in 2005.
Stay alert for developments that affect you and your tax bill and check for updates at taxcut.com.