One of the advantages of the complexity brought on by social engineering in the Tax Code is that, when personal circumstances change and times get rough, there are usually some provisions in the code that come into play to provide a bit of tax relief. Tax practitioners can do a real service for their clients by alerting them to new or existing tax provisions that might be applicable to a particular taxpayer for the first time. Some of them may require the taxpayer to maintain records or be aware of requirements during the course of the year, so alerting them only at tax return preparation time may be too late for some of the tax benefits.
REAL ESTATE
Congress was fairly quick to provide relief from taxation of forgiveness-of-debt income in connection with foreclosures on a principal residence. Taxpayers should be carefully advised, however, as to how best to negotiate with the lender to take maximum advantage of the forgiveness-of-debt exception. The new law can apply both to mortgage foreclosures and mortgage workouts, but only within certain parameters. A reduction in interest rates, rather than a reduction in principal due, is not a forgiveness of debt and will not engage the new exclusion. Some lenders may be reluctant to immediately forgive debt in excess of the proceeds from a foreclosure sale unless required to do so by state law. Under some foreclosure sales or short sales (sales for less than the mortgage indebtedness with the permission of the lender), it may be difficult to determine the amount of basis reduction.
The IRS has released a new publication, Pub. 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments, to try to gather in one place the rules applicable to mortgage foreclosures and workouts. The publication also specifically addresses mortgage loan modifications, foreclosures, and foreclosures with debt exceeding the $2 million limit on the new exclusion. Many of these issues were addressed in more detail in this column in the Feb. 11-24, 2008, issue.
HIGH COST OF ENERGY
Gas prices are causing many taxpayers to give up the SUV or even, for the first time, to take public transportation to work as a matter of course. Shifting to a hybrid vehicle, or even a natural gas vehicle, can engage some tax credits under the Tax Code. Taxpayers must be careful here as well, however. The tax credits for some successful hybrid vehicles, such as the Toyota models, have already expired, and others are in the process of phasing out. The amount of the credit also varies with the particular energy-saving characteristics of a particular hybrid model and year.
Employees shifting to public transportation for the first time should be alerted to look into transportation reimbursement programs that may be offered by their employers. If employers do not offer those programs, they might be persuaded by enough employee demand in the current economic climate to implement them. For 2008, the monthly limitation on the transportation fringe benefit exclusion for transportation in a commuter highway vehicle or for a transit pass is $115 per month. For employees still driving who have to pay for parking, the transportation fringe benefit exclusion for qualified parking is $220 per month.
If the high cost of energy is hitting at home as well, tax credits are available for home solar and fuel cell installations, and the credit for installations of energy-saving exterior materials and interior systems may be renewed by Congress this year as well.
A SECOND JOB
While this economic downturn has so far been characterized by relatively modest job losses -- perhaps reflecting the fact that the prior recovery was characterized by only modest job increases -- even taxpayers holding on to their jobs may be feeling the pressure to add a second income. A new second job can create new tax issues for a taxpayer, such as excess Social Security withholding. An employee going into business for themselves in the second job, such as taking on consulting work, will also have to deal with keeping good records of income and expenses to complete Schedule C of Form 1040, and also to follow all of the rules necessary to qualify for a home office deduction, if applicable.
If the taxpayer uses a car for business purposes, either as a sole proprietor or as an employee for whom the expenses are not reimbursed by the employer, good records are also required for the business use of the car. While the Internal Revenue Service recently raised the standard business mileage rate allowed for tax purposes to 58.5 cents per mile for the last six months of 2008, up from 50.5 cents per mile for the first half, a lot of tax practitioners are of the opinion that the IRS adjustments are not keeping up with actual expense increases. Taxpayers should be encouraged to keep track of their actual expenses so that deduction can be used as an alternative to the standard rate, if it is greater.
GETTING ACCESS TO CASH
If a second job is not a possibility but access to a little extra cash is needed, there are tax considerations that should also come into play in determining the best source of that cash. Home equity lines of credit are tax-favored for allowing interest deductions for up to $100,000 of principal, but banks are being pretty tight with their equity lending right now as housing prices decline.
A loan or hardship withdrawal from a 401(k) plan may also be a possibility, but the taxpayer may not qualify for a hardship withdrawal and the employer may not offer plan loans. Also, the taxpayer should be advised that, if the employment relationship is terminated and any plan loans are not repaid, the unrepaid amount is considered a taxable distribution that may also involve early-withdrawal penalties.
IRAs can also be tapped for penalty-free funds if for a specific purpose, such as health insurance while unemployed, education expenses or first-time home purchases. These distributions, like 401(k) hardship withdrawals, can be penalty-free, but they are not tax-free. Distributions from Roth IRAs may present a better option since, if the conditions are satisfied, distributions can be tax-free up to the amount contributed to the Roth IRA.
Even if the taxpayer does not have a specific qualified reason for a withdrawal but still needs the cash, it may be possible to structure penalty-free withdrawals that are part of a program of regular periodic distributions from an IRA for five years or until the taxpayer reaches 59-1/2, whichever is later. All of these options, of course, should be considered as a last resort, since even tax-free or penalty-free withdrawals come with a significant cost -- loss of further tax-deferred or tax-free earnings on those funds and loss of a source of retirement income.
If there are any appreciated stocks remaining in the investment portfolio, another source of cash might be to sell some of those investments and realize a tax of only 15 percent for the top brackets and no tax if in the bottom two tax brackets (i.e., a 2008 taxable income of up to $32,550 for single filers and $65,100 for joint filers). Even if the taxpayer is not the one in need but has a family member, other than a dependent child, whom they would like to help out, it might be possible to gift appreciated property to the family member and have the family member sell the assets and qualify for the zero percent tax rate.
Many tax commentators are worried that these low capital gain rates might not be around for too much longer. They are already set to expire after 2010, and if the Democrats get control of the White House and increase their control in the Senate, it is possible that capital gain rates could go up even sooner, perhaps in 2009. Selling appreciated capital assets in 2008 might make sense, therefore, even aside from the need for the cash.
SUMMARY
Tax practitioners can build relationships with clients by helping them prepare for the best possible tax situation well before it's time to prepare the tax return. Practitioners can help clients dealing with troubled economic times by advising them of tax-favored strategies that might help them through the crisis. Consulting with those clients as early in the year as possible will help them take maximum advantage of many of these strategies.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
