It Was Nice While it Lasted…

By Allen G. Yee

What am I talking about you ask?  Mortgage interest deduction!

Quietly at work is a bipartisan group of U.S. Senators (referred to as the Gang of Six) who are closing in on proposals that they hope may be the best solutions for reducing the national deficit crisis.  Among the many topics and remedies they have discussed is the reduction or possible elimination of mortgage interest deduction for homeowners.  This suggestion has thus far has received bipartisan support.

Many believe that mortgage interest deduction is seen as promoting homeownership and drives greater demand for real estate, which has become debatable recently.  During the Tax Reform Act (TRA) of 1986 the tax deductibility of interest was stripped away for all personal items with the exception of mortgage interest.  This was likely because of the effort of lobbyist and industry groups.

Fast forward-  add enormous and mounting debt, polarization of Americans, political emphasis on federal budget reduction and mortgage interest deduction is under scrutiny and a prime target in the race to make some breathing room.

It’s intuitive but worth noting that the benefits of mortgage interest deduction is disproportionate and based on one’s income.  This model means the wealthy accrue a greater benefit than the middle-class and low-income Americans.  Low-income earners rent and do not own, so they receive no benefit from the deduction.  The middle-class homes cost substantially less than wealthy American homes and thus have less interest deductions.  Households earning more than $200,000 a year account for less than 10% of the all Federal income tax returns, but get 30% of all the benefits.  And households earning more than $100,000 a year get 69% of all the benefit*.  The mortgage interest deduction might be billed as a middle-class tax break, but realistically it’s a tax break for the upper-class.

There are arguments on both sides regarding the merits and lack thereof in the motive behind reducing or eliminating mortgage interest deductions.  I expect a hotly contested struggle over the issue as I don’t see Americans giving up one of the last deductions available without a fight.  Nor, do I expect to see special interest groups like the National Association of Realtors accept this lightly.  It will be interesting to see what happens here.  The solution could be to phase out the deduction slowly, say over a 10 or 20 year period which could gain support from both current homeowners and those looking to solve our fiscal woes.

*  http://blogs.reuters.com/felix-salmon/2011/07/12/chart-of-the-day-where-does-the-mortgage-interest-deduction-go/

Mid-Year Tax Considerations

Though it may seem as if the ink has barely dried on your 2010 federal income tax return, the end of 2011 is now visible on the horizon.  Here are some things to consider as you take stock of your current tax situation.

The 2% difference

If you’re an employee, 6.2% of your wages (up to the taxable wage base–$106,800 in 2011) would normally be withheld for your portion of the Social Security retirement component of FICA employment tax.  But legislation passed in December 2010 included a temporary one-year 2% reduction in this tax.  That means for 2011, you’re paying the tax at a rate of 4.2%. If you’re self-employed, the 12.4% you would normally pay for the Social Security portion of your self-employment tax is reduced to 10.4%.

Have you earmarked the resulting extra dollars in your paycheck efficiently by, for example, paying down high-interest debt or saving for retirement?  If you haven’t, consider making up for it by contributing an extra 4% of your income to your 401(k) or an IRA for the remainder of the year.  By applying the extra money toward a long-term goal, the potential benefit of the temporary tax reduction can extend beyond 2011.

Tax rates

The same federal income tax rates that applied in 2010 continue to apply in 2011 and 2012 (depending on your taxable income, you’ll fall into either the 10%, 15%, 25%, 28%, 33%, or 35% rate bracket).  And, as in 2010, long-term capital gains and qualifying dividends in 2011 and 2012 continue to be taxed at a maximum rate of 15%; if you’re in the 10% or 15% marginal income tax brackets, a special 0% rate will generally apply.  So, unlike this time last year, you don’t have to contend with the uncertainty of not knowing what next year’s tax rates will be.

That consistency, however, does not apply to the alternative minimum tax (AMT)–essentially a parallel federal income tax system, with its own rates and rules.  While the December legislation extended regular income tax rates through 2012, it only extended AMT relief (in the form of increased AMT exemption amounts) through 2011.  You can probably expect another AMT fix in legislation later this year, since without it there would be a dramatic increase in the number of individuals subject to AMT in 2012.  But that leaves a fair degree of uncertainty today, however, as you consider your overall tax situation.

Also worth noting

Small business stock: Generally, individuals may exclude 50% of any capital gain from the sale or exchange of qualified small business stock provided they meet certain requirements, including a five-year holding period.  For qualified small business stock issued and acquired after September 27, 2010, and before January 1, 2012, however, 100% of any capital gain may be excluded from income if the stock is held for at least five years and all other requirements are met.

IRA qualified charitable distributions: Absent additional legislation, 2011 will be the last year that you’ll be able to make qualified charitable distributions (QCDs) of up to $100,000 from an IRA directly to a qualified charity if you’re age 70½ or older.  Such distributions may be excluded from income and count toward satisfying any required minimum distributions (RMDs) that you would otherwise have to receive from your IRA in 2011.

Depreciation and IRC Section 179 expensing: If you’re a business owner or self-employed individual, you’re allowed a first-year depreciation deduction of 100% of the cost of qualifying property acquired and placed in service during 2011 (the “bonus” first-year additional depreciation deduction will drop to 50% for property acquired and placed in service during 2012).  For 2011, the maximum amount that can be expensed under IRC Section 179 is $500,000, but in 2012 the limit will drop to $125,000.

Forefield, Inc. Copyright 2011 Forefield, Inc.

“Portability” of the Federal Estate Tax Exemption

By Allen G. Yee

Back in March I wrote an article about Gift Tax in which I describe an exemption opportunity as “a window” that would possibly close in the next 2 years.  This month I would like to discuss another window that can also have significant implications as to how your wealth may be passed on.  New legislation has added an element of portability to the estate planning process in which the estate of a deceased spouse can transfer to the surviving spouse any portion of the federal estate tax exemption that he or she does not use.  The surviving spouse’s estate can then transfer that amount to the exemption it is entitled to.  This act can increase the amount of tax-free dollars that can be passed on to heirs.  This new feature makes it easier for married couples to minimize the potential impact of estate taxes.

On its face, exemption portability is a good thing. However, like many “good” things from Congress, this one may not be all that it is cracked up to be.  Like any tax situation, careful consideration must be given to each individual’s particular situation before attempting to implement strategies.

What is the federal estate tax exemption?

When you pass on, Uncle Sam taxes the value of your property as it passes to your heirs.  Any amount that is passed to a surviving spouse is generally fully deductible.  The estate is also allowed to exclude a certain amount that passes on to non-spouse beneficiaries.  That amount is called the “basic exclusion amount,” which is $5 million in 2011 and 2012.

Exemption works differently between direct transfer to spouses.  Prior to the new tax law, if a spouse died without having planned for his or her exemption, the deceased spouse’s estate would have passed tax free to the surviving spouse under the unlimited marital deduction (assuming all assets passed to the surviving spouse), and the deceased spouse’s exemption was lost or “wasted.”  The surviving spouse’s estate could then only transfer an amount equal to his or her own exemption free from federal estate tax.  To solve this dilemma, married couples typically set up what is commonly referred to as a credit shelter trust (aka “bypass” or family trust) that sheltered or preserved the exemption of the first spouse to die.

The following examples illustrate how portability can achieve a similar result without the use of a credit shelter trust.

Without portability

Assume John and Jane are married, have all of their assets jointly titled, and have a net worth of $10 million. John dies first, when the federal estate tax exemption is $5 million and there is no portability.  John’s estate passes to Jane free from federal estate tax under the unlimited marital deduction and does not use any of his $5 million exemption.  Assume that at the time of Jane’s death, the exemption is still $5 million, the federal estate tax rate is 35%, and Jane’s estate is still worth $10 million.  With John’s exemption completely wasted, Jane can pass on only $5 million free from federal estate tax.  Assuming no other variables, Jane’s estate will owe about $1,750,000 in federal estate tax: $10 million estate – $5 million exemption = $5 million taxable estate x 35% estate tax rate = $1,750,000.

With portability

Assume John and Jane are married, have all of their assets jointly titled, and have a net worth of $10 million.  John dies first, when the federal estate tax exemption is $5 million and there is portability.  As above, John’s estate passes to Jane free from federal estate tax under the unlimited marital deduction and does not use any of his $5 million exemption.  Even though John’s estate owes no tax, John’s executor files a timely return on which he elects to transfer John’s unused exemption to Jane.  Assume that at the time of Jane’s subsequent death, the exemption is still $5 million, the federal estate tax rate is 35%, and Jane’s estate is still worth $10 million.  Since Jane has “inherited” John’s unused exemption, she can pass on the entire $10 million estate free from federal estate tax.  Portability of the estate tax exemption saves John and Jane’s heirs $1,750,000 in estate tax.

Considerations

Despite the possible advantages portability can have, there are still many factors to contemplate.  In the end, using a credit shelter trust may be what best suites your individual situation.  One factor to consider is time.  Effective for only two years, portability will expire after 2012, unless Congress enacts further legislation.  The trust can help protect assets against creditors of the surviving spouse or future beneficiaries (typically children and grandchildren).  Another factor is control.  The trust allows the first spouse to die to control the ultimate distribution of his or her assets.  For example, in a second marriage situation, one spouse may wish to ensure that any assets remaining after his or her spouse’s death pass to his or her children from a previous marriage.  Appreciation of assets placed in the trust will escape estate taxation in the survivor’s estate.  There are also limitations to the portability option.  Portability feature applies only to estate tax; it does not apply to the generation-skipping transfer (GST) tax. Without a trust, any unused GST tax exemption of the first spouse to die is lost.

Information gathered from Forefield, Inc. Copyright 2011 Forefield, Inc.

TWO YEAR GIFT TAX WINDOW – Don’t let this one close on you!

Allen G. Yee

The end of the year is always met with a flurry of activities and changes, making it very difficult to touch on and discuss everything.  However, this past December historic tax legislation was signed into law that can potentially have a significant impact on how you handle the succession of your wealth.  This sweet-heart deal is definitely something you can’t/shouldn’t pass up without at least investigating how it may impact your situation.  It is also something you might not want to wait long to think about.  Because, although opportunity may be knocking, it’s not at the door… It’s knocking on a 2 year window.

For the next two years (ending 12/31/2012), the gift-tax exemption is increased from $1 million to $5 million for individuals and from $2 million to $10 million for couples.  Further, the tax rate above the exemption is 35 percent.  After 2012 the exemption is expected to revert back to $1 million and a tax rate of 55% above the exclusion.  In essence, the government just provided a two-year window to decrease your taxable estate.  Why should you gift hard earned money and/or assets away you ask?  Well, would you rather retain them until mortality and face the possibility that the Federal Tax Exemption has decreased and now faced with paying a potential Federal Estate Tax of say 55%?  The following article by the Wall Street Journal can shed more light on this topic.  Whatever you decide, I believe that further investigation is warranted before you let this window close. 

http://lnk.nu/online.wsj.com/1jkt.html

Who Pays Taxes and Where Does the Money Go?

By Allen G. Yee

Paying taxes…  Arguably is one of the most patriotic, yet financially painful actions we do regularly as Americans.  While we all understand the concept of taxes and appreciate the benefits such as driving on maintained streets (minus the occasional potholes); Is the US Income Tax structure equitable?  Well, it all depends on whose shoes you’re in when answering that question.  However, as with everything in life, nothing is totally equal or fair.  The Internal Revenue Service recently released new data describing our income tax system at work.  As you may have guessed the wealthy pays the most tax, but exactly who is considered wealthy?  Again, whose shoes are you in?

New IRS information shows that the top 1 percent of wage earners pay 38 percent of all income taxes.  The top 10 percent pay 70 percent of all income taxes.  The top 50 percent pay 97.3 percent of all taxes paid (in 2008), that leaves the bottom 50% paying the remaining 2.7 percent of all income tax, most of who pays nothing.  If people don’t pay taxes they often perceive government as being free.  Why would they ever want to change that?

The following articles provide a greater insight into who pays what and where your hard earned dollars go.  I in particular like the “Itemized Taxpayer Receipt” shown below.

Tax Foundation – Fiscal Facts: Summary of Latest Federal Individual Income Tax Data. October 6, 2010

http://www.taxfoundation.org/news/show/250.html

Chicago Sun-Times – Where your tax dollars go.  January 7, 2011

http://www.suntimes.com/business/2828231-418/debt-percent-spending-tax-budget.html

An Itemized Taxpayer Receipt (for above referenced Chicago Sun-Times article)

http://www.suntimes.com/csp/cms/sites/STM/dt.common.streams.StreamServer.cls?STREAMOID=2FVQtAo10QlXS4uTVXVzfIBepVVNbUlus9N$Tns$ZfDhZGQYyHOp235JA2Ffg9624Aw$6wU9GSUcqtd9hs3TFeZCn0vq69IZViKeqDZhqNLziaXiKG0K_ms4C2keQo54&CONTENTTYPE=application/pdf&CONTENTDISPOSITION=TAXRECEIPT-CST-1215.2.pdf

WIBW.com – Taxes Too High?  Actually, They’re At A 60 Year Low. February 7, 2011

http://www.wibw.com/home/headlines/Taxes_Too_High__Actually_Theyre_At_a_60-Year_Low_115536289.html

The Economist – Avoidable Errors. November 22, 2010

http://www.economist.com/node/17492955

Estate Tax Update

By Allen G. Yee

Once again, Congress waited until the eleventh hour to extend, patch, and reinstate old tax laws, and once again, they made most changes temporary (generally, for two years). The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Act), signed into law on December 17, 2010, dramatically changes the federal transfer tax landscape. The biggest news: the estate and generation-skipping transfer (GST) taxes have been reinstated for 2010. And, to the delight of some and great disappointment of others, for 2010 through 2012, the estate tax exemption equivalent amount is increased to $5 million (indexed for inflation in 2012), and the top estate tax rate is set at 35%. Here is a brief summary of all the changes.

For 2010

For 2010, the federal gift tax is unchanged by the 2010 Tax Act. The gift tax remains in force with an exemption equivalent amount (called the “applicable exclusion amount”) of $1 million and a top tax rate of 35% (also, remember that if you file as single, you can exclude gifts of up to $13,000 per recipient, or if you’re married and file jointly, you can exclude gifts of up to $26,000 per recipient).

The estate tax has been reinstated for 2010, with a “basic” exclusion amount (the name has been changed from the “applicable” exclusion amount) of $5 million. That translates into a tax credit of $1,730,800. The top estate tax rate is 35%.

The 2010 Tax Act gives estates of decedents dying after December 31, 2009, and before January 1, 2011, the option to elect to apply (1) the reinstated estate tax with a step-up (or step-down) in basis, or (2) no estate tax with a modified carryover basis. The modified carryover basis allows an increase in basis of $1.3 million, plus an additional $3 million for property that passes to a surviving spouse.

The GST tax (a separate tax on assets transferred to grandchildren and lower generations) has also been reinstated, but at a rate of zero percent.

Note: The 2010 Tax Act provides an extension of sorts to pay estate taxes for decedents dying after December 31, 2009, and before the date of enactment of the 2010 Tax Act. The due date for filing an estate tax return, paying estate taxes, or disclaiming an interest in property passing to a beneficiary from a decedent’s estate is nine months after the date of enactment of the 2010 Tax Act.

Note: IRS Form 8939 is necessary to allocate the $1.3 million basis adjustment allowed for any heirs and the additional $3 million basis adjustment allowed for surviving spouses of decedents who die in 2010. Originally, the form was due on the same date as the decedent’s final income tax return (April 18, 2011). The 2010 Tax Act also extends this deadline to nine months after the Act becomes effective.

For 2011 and 2012

For 2011 and 2012, the gift tax is reunited with the estate tax. There is a lifetime basic exclusion amount of $5 million (which will be indexed for inflation in 2012). The top tax rate is 35% (for taxable gifts/estates in excess of $500,000).

The basic exclusion amount is portable (new in 2011). That means a surviving spouse can use that portion of the exclusion that was left unused by a deceased spouse. This “deceased spousal unused exclusion amount” (DSUEA) is available only from the estate of a spouse who dies in 2011 or 2012. For gift tax purposes, the DSUEA is available for an unlimited number of deceased spouses. But there can be only one DSUEA at a time. For gift tax purposes, the DSUEA is determined on the last day of the year using the DSUEA of the last deceased spouse as of such date. For estate tax purposes, however, the DSUEA is available only from the last deceased spouse as of the date of death of the surviving spouse. Thus, the DSUEA can change if the surviving spouse remarries, and is then widowed for a second time.

Note: An election is required on the estate of the first spouse to die in order to preserve the ability of the surviving spouse’s estate to use the DSUEA.

The GST tax rate for transfers made after 2010 is equal to the highest estate tax rate in effect for the year. The GST exemption for 2011 is $5 million, which will be indexed for inflation for 2012.

Note: The GST tax exemption is not portable.

For 2013 and beyond

If there is no further legislation, the changes described above will sunset after 2012. The transfer tax rules that were in effect in 2000 will apply for 2013 and beyond. That means a gift and estate tax exemption equivalent amount of $1 million and a top tax rate of 55%.

Representative does not provide tax or legal advice. Always consult with a CPA, qualified tax professional or attorney for tax and legal advice.

Estate Tax Uncertainty

By Allen G. Yee

What do Dan Duncan, John Kluge and George Steinbrenner have in common?  Well at the very least they were each listed in the October 19, 2009 issue of Forbes Magazine in an article titled The Richest 400 Americans and all three passed away during 2010, a year of death that is currently legislated to require the payment of zero federal estate taxes.  The respective estates (potentially) saved millions to billions of dollars.

As we progress through the fall of 2010, American citizens have reaped the benefit of almost 10 months of complete repeal of the federal estate tax.  Prior to the current repeal, the federal estate tax (1916) was almost as old as the federal income tax (1913) which required the 16^th Amendment to the United States Constitution to adopt.  But is it gone forever?  I doubt it.  In fact, the Economic Growth Tax Relief Reconciliation Act (EGTRRA) of 2001 which put the current 2010 repeal into motion is due to sunset 12/31/2010.  This means the federal estate exemption and rate will revert to the 2001 thresholds of $1,000,000 exemption and 55% tax rate.  The sunset provision was strategically included in the EGTRRA to avoid the “Byrd Rule.” 

Named for its creator, Sen. Robert Byrd, the Byrd Rule allows just one U.S. Senator to object to the passage of any law that will affect revenue for more than ten years.  Although any such objection may be overridden with the support of 3/5 of the Senate, it was not believed that the EGTRRA would receive the necessary support of the Senate during its proposal.  In order to avoid the Byrd Rule, a sunset provision was included that automatically terminates the law within ten years. By ending within ten years, EGTRRA does not affect revenue for more than ten years and therefore was not susceptible to objection by just one Senator.

Currently, due to the uncertainty and flux, estate planning is particularly challenging from an estate planner’s perspective despite having the federal estate tax technically repealed.  A number of different paths are available for Obama and Congress to take:

1. Do absolutely nothing.  Some believe the Republicans created this mess and the current administration will just let it play out.  The federal estate tax will be back on January 1, 2011, with a $1,000,000 exemption and 55% tax rate.  The generation-skipping transfer tax will also reappear with a $1,000,000 exemption that will be indexed for inflation in 2011 and beyond.  By far this will be the easiest path for Obama and Congress to take and with very few working days left in 2010, it is unlikely that Congress will have time to act before the estate tax comes back, so this option is getting closer and closer to reality.

2.  Another option is to retroactively reinstate the federal estate tax back to January 1, 2010.  While this may have made sense a few months ago, the first federal estate returns were due October 1, 2010.  However, the biggest problem with this option is that it is unclear whether applying a tax retroactively will be constitutional which, in turn, will lead to one or more lawsuits that could take years to unravel.  Therefore, this option is becoming less likely by each day that passes.

3.  The last option I’m going to review is a new and different approach discussed by Rep. Sander Levin (D-MI), acting chairman of the House and Means Committee.  This option takes a middle road between a retroactive law and a new law going forward offering the heirs of the estates of people who died on or after January 1, 2010 a choice: a) The heirs can opt to be subject to the new modified carryover basis regime (See New Cost Basis Rules below), or b) The heirs can opt to receive a stepped up basis but nonetheless be subject to wherever the new estate tax exemption and estate tax rate ends up.  Apparently and theoretically the thought of this approach will head off any constitutional challenges to implementing a full retroactive law.  However, I believe many will still question the constitutionality of this option as well as the feasibility of passing this to law, since this will result in huge tax breaks for certain wealthy heirs, something to which some Democrats are fundamentally opposed.

While there are a host of other possible scenarios, with time winding down in 2010, the “do nothing” approach seems to be leading the race.  So as the saying goes; “Stay tuned for further developments…”

New cost basis rules for 2010

What’s cost basis? The cost basis of an asset is generally its purchase price, and it’s used to calculate taxable gain (or loss) when the asset is sold. For example, if you own a share of stock, your cost basis is generally the purchase price plus any costs incurred in the purchase (e.g., any commissions). With real property, your cost basis is increased if you make capital improvements.

Prior to 2010, the cost basis of any asset you inherited was generally “stepped up” (or “stepped down”) to what the asset was worth (its fair market value) on the day that the person who left you the property passed away. So, for example, if you inherited a piece of property worth $100,000, that property would generally have a basis of $100,000, even if the person who passed away had purchased the property for $10,000. If you sold the property years later for $115,000, any taxes due would be based on $15,000 gain ($115,000 minus $100,000).

If you inherit property as a result of a death in 2010, however, this step-up rule doesn’t apply. Instead, your basis in the inherited property is the lower of the property’s fair market value as of the date of death or the deceased owner’s cost basis. In the example above, that means that your basis in the property would be $10,000, resulting in a $105,000 gain if you sold it for $115,000.

There are two very important exceptions. First, every estate gets a $1.3 million increase in basis that can be allocated among assets (up to fair market value) by the executor of the estate, increased by unused built-in losses and loss carryovers. Second, there is generally an additional $3 million increase in basis available for assets (also up to fair market value) passing to a surviving spouse, either outright or through a qualified terminable interest property (QTIP) trust (but only $60,000 basis increase for nonresident alien decedents). This means the basis of assets in an estate with a surviving spouse as a beneficiary can potentially be increased up to $4.3 million.

So, if the appreciation of assets in the estate is $1.3 million or less (or $4.3 million for a surviving spouse), then the basis of those assets can be increased to fair market value as of the date of death. This means if you inherit an asset in 2010 with its basis stepped up to fair market value, and you sell that asset for no more than its date-of-death fair market value, you’d realize no tax on the sale.

Year-End Investment Planning Is More Challenging in 2010

Prepared by Forefield, Inc. Copyright 2010 Forefield, Inc.

Allen G. Yee

1499 Huntington Dr. South Pasadena, CA 91030

(626) 396-1650

Allen Yee is a registered representative with, and offers securities through

First Allied Securities, Inc., a registered broker dealer, Member FINRA/SIPC

The opinions expressed are for general information

only and are not intended to provide specific advice or recommendations for any individual.

To determine which investment(s) may be appropriate for you,

consult with your financial or tax advisor before investing.