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Estate Planning
Business Owner
Education Incentives
Kiddie Credits
Marriage Penalty Relief
Pension Reform
Real Estate Exchanges—A “Capital Gain”?
Some Helpful Information on Income Tax Filing
Sunrise Sunset
Tax Basics: Understanding Tax Basis
The AMT—Affecting More and More
Transfer Taxes
What Should You File—Joint or Separate Returns?
Your Income Taxes—Marginal Rates vs. Effective Rates

Education Incentives


All parents want the best for their children. To help their offspring achieve a bright future, wise parents will start planning early to provide them with the best possible higher education. In support of this effort, the Economic Growth and Tax Relief Reconciliation Act of 2001 (the Tax Relief Act) provides a variety of tax incentives and tax breaks for higher education. As with all aspects of this legislation, these changes are complex, phase-in or out according to varying schedules, and are scheduled to "sunset on December 31, 2010, unless Congress takes action in the interim.

The extensive list of changes includes important modifications to education IRAs, now known as Coverdell Education Savings Accounts (Coverdell ESAs), and qualified tuition programs, as well as to the tax treatment of student loan interest, employer-provided educational assistance, and other higher education-related expenses. A more detailed summary of each follows.

Coverdell ESAs
The annual contribution limit to a Coverdell ESA has been raised from $500 to a more substantial $2,000. Taxpayers no longer face an excise tax on contributions to a Coverdell ESA when made in the same year as contribution to a qualified tuition program on behalf of the same beneficiary. And, taxpayers may claim a Hope Scholarship Credit or Lifetime Learning Credit for any taxable year and still exclude distributions from a Coverdell ESA for the same student from their gross income, as long as they do not apply to the same educational expenses.

The changes affecting Coverdell ESAs are remarkable in that the Tax Relief Act now allows qualified expenditures from such accounts to pay for elementary and secondary school tuition and associated costs. Covered expenses can include room and board, computer equipment, tutoring, uniforms, and extended day program costs. Contributions for any tax year after 2001 are now permissable until April 15th of the following year, instead of December 31st. In addition, contributions to Coverdell ESAs may be received from corporations, tax exempt organizations, and other entities. The new law also allows contributions that benefit a special needs student to continue after the beneficiary reaches 18 years of age. All Coverdell ESA provisions became effective in January, 2002.

Qualified Tuition Programs
Prior to the Tax Relief Act, individuals could only pre-pay higher education tuition costs under state-sponsored qualified tuition programs. Now, eligible private higher education institutions may sponsor certain programs (as long as such funds are held in trust). Distributions from qualified tuition programs are excludable from gross income as long as they are used to pay for qualified expenses (for existing state-sponsored programs and beginning in 2004 for newly established private programs). Additionally, taxpayers may concurrently claim a Hope Scholarship or Lifetime Learning credit under the same rules applying to Coverdell ESAs described above.

The penalty tax on distributions not used for qualified expenses has been modified, and the definition of qualified expenses for special needs beneficiaries has been expanded. The Tax Relief Act also allows rollover treatment for a single transfer per beneficiary between qualified tuition programs in any 12-month period. These new education incentives are generally effective for taxable years beginning in 2002, with the exception of the exclusion from gross income provision for distributions from private programs noted above.

Temporary Deductibility of Higher Education Expenses
An above-the-line deduction is temporarily established for qualified higher education expenses (as defined under the Hope Scholarship credit). For 2002 and 2003, single taxpayers with adjusted gross income (AGI) not exceeding $65,000 are entitled to a maximum deduction of $3,000 each year. For 2004 and 2005, single taxpayers with AGI not exceeding $65,000 may deduct up to $4,000 each year, while those with AGI from $65,000-$80,000 may deduct up to $2,000 each year. Married taxpayers filing jointly face AGI limits twice those of single taxpayers. This deductibility provision expires in 2006.

Student Loan Interest Deduction
As of 2002, the Tax Relief Act completely repealed the limitation that payments be attributable to the first 60 months in which they are required. In addition, eligibility for the deduction phases out between AGI of $50,000-$65,000 for single taxpayers (up from $40,000-$50,000) and between AGI of $100,000-$130,000 for married taxpayers filing jointly (up from $60,000-$75,000).

Employer-Provided Educational Assistance Exclusion
The $5,000 annual exclusion for employer-provided educational assistance has been permanently extended for courses begun after December 31, 2001 and it now applies to both undergraduate and graduate education.

Stay Current
In addition to the major changes noted above, the Tax Relief Act also contains provisions that affect the taxable status of certain scholarship awards and that modify the tax benefits associated with certain bonds issued for public school educational facilities. Thus, staying abreast of tax changes and education incentives can help you best plan for your own, or your child's education.

Kiddie Credits


In today's world, where the cost of living continues to rise, the expense of raising a family is also rising. Now for the good news. . .among the many changes in the Economic Growth and Tax Relief Reconciliation Act of 2001 (the Tax Relief Act), some of the benefits are targeted specifically toward families with children. As with other provisions in the legislation, the relief related to child credits may be phased-in over many years and will "sunset" come 2011.

The Tax Relief Act both increases and expands existing tax breaks aimed at assisting parents: the child tax credit; the adoption credit and exclusion; and the dependent care tax credit. It also establishes a new business tax credit related to employer-provided child care. Below are highlights of the major implications for each.

Child Tax Credit
The Tax Relief Act gradually doubles the existing child tax credit to $1,000 per child over the ten-year life of the legislation.

The existing adjusted gross income (AGI) limits for eligibility are left unchanged at $55,000 for single taxpayers and $110,000 for married taxpayers filing jointly. The new law allows the credit to be refundable up to a specified percentage of the taxpayer's earned income in excess of $10,000 (indexed annually for inflation), initially 10% from 2001-2004 and 15% thereafter.

The Tax Relief Act also repeals the alternative minimum tax (AMT) offset of refundable credits and permanently allows the child tax credit to be claimed against the AMT. The present-law rule, allowing families with three or more children to receive a refundable credit up to the amount by which the taxpayer's Social Security taxes exceed their earned income credit, remains applicable to the extent such amount is greater than their refundable credit under the new law. In addition, the new law clarifies that the refundable portion of a credit shall not constitute income and shall not be considered when determining eligibility or calculating benefits under any federal program or any state or local program receiving federal funds.

Adoption Credit and Exclusion
The Tax Relief Act permanently increases the adoption credit to $10,000 per eligible child and permanently allows the credit against the AMT. In addition, up to $10,000 per eligible child in employer-provided adoption assistance may now be excluded from income. Beginning in 2003, a taxpayer finalizing a special needs adoption need not have qualifying expenses to be eligible for the credit or exclusion. The income phase-out range for both the credit and exclusion is doubled to $150,000 of modified AGI. All provisions became effective in 2002 unless otherwise noted.

Dependent Care Tax Credit
The new law increases to 35% (from 30%) the rate at which qualifying expenses may be eligible for the dependent care tax credit. It also increases the amount of employment-related expenses that are eligible for the credit to $3,000 per qualifying individual (from $2,400) and to $6,000 for two or more qualifying individuals (from $4,800). The beginning of the income phase-out range is increased to $15,000 of AGI. All provisions relating to the dependent care tax credit became effective in 2002.

Credit for Employer-Provided Child Care
The Tax Relief Act allows employers to claim a tax credit for up to 25% of qualifying expenses for employee child care and up to 10% of qualifying expenses for child care resource and referral services, up to a maximum credit of $150,000 per year.

All for the Children

With these targeted changes, the Tax Relief Act aims to direct a portion of its benefits to providing a helping hand to growing families. Therefore, whether you're already a parent of minor children or considering expanding your family in the near future, you may want to consult with a qualified professional to help ensure you are able to take full advantage of these more generous tax breaks.

Marriage Penalty Relief


Over the years, the tax system has often thrown a few "clouds" over the institution of marriage. However, there is now some good news for married couples. The Economic Growth and Tax Relief Reconciliation Act of 2001 (the Tax Relief Act) includes partial relief for married taxpayers from the additional "penalties" that can be imposed upon them. The changes only eliminate the so-called marriage penalty in certain circumstances-such as related to the standard deduction, the lower-income rate brackets, and the earned income credit-while leaving it unchanged in others. The targeted relief is designed to benefit lower-income taxpayers the most, is gradually phased in over the next decade, and will "sunset" on December 31, 2010 along with all other provisions in the legislation.

Among the many worthy reforms, the new legislation: expands the number and types of plans available; increases the amounts that may be contributed to such plans; enhances portability; accelerates vesting; and strengthens participant protections. Below are highlights of the major changes included in the bill.

Standard Deduction Parity
Specifically, the Tax Relief Act will increase the standard deduction for a married couple filing jointly over a five-year phase-in period to twice the standard deduction for a single taxpayer. Beginning in 2005, the standard deduction for joint filers will be set at 174% of the deduction for singles, then 184% in 2006, 187% in 2007, 190% in 2008, and finally 200% in 2009 and thereafter. As most taxpayers with higher incomes tend not to take the standard deduction, they will continue to be subject to the marriage penalty despite this change.

Partial Rate Bracket Adjustments
Lower-income taxpayers will be pleased to note that the new 10% income tax rate bracket created under the new law establishes an upper limit for married taxpayers filing jointly that is twice that for single taxpayers from its inception in 2002 and thereafter. Additionally, the 15% rate bracket for joint filers will be steadily increased over a four-year phase-in period beginning in 2005 to twice that of the corresponding rate bracket for singles. As such, the upper limit of the 15% bracket for joint filers will be set at 180% of the end point of the 15% bracket for singles in 2005, then 187% in 2006, 193% in 2007, and finally 200% in 2008 and thereafter.

For higher-income taxpayers, the remaining four rate brackets will continue to be subject to a marriage penalty built into their structure that is not addressed by the provisions of the bill.

Earned Income Credit
The Tax Relief Act also increases both the lower and upper limits of the earned income credit phase-out range by $1,000 for 2002-2004, by $2,000 for 2005-2007, and by $3,000 for 2008 and adjusted for inflation thereafter. In addition, the definition of a child for purposes of the credit is simplified, the present law tie-breaking rules are modified, and special rules are implemented pertaining to cases involving child support. The definition of earned income for purposes of the credit is also modified to exclude nontaxable employee compensation, and the calculation of the credit is partly simplified.

Saying "I do" Becomes Slightly Less Taxing

While most people do not base marital decisions primarily on issues of taxation, it's nice to see the new law address some of the inequities imposed on married taxpayers built into the Internal Revenue Code (the Code). In particular, lower-income couples (frequently younger couples just starting out) will see the most relief under these new provisions designed to alleviate, at least in part, the marriage penalty.

Pension Reform


When it comes to the subject of taxes, many people may just want to "hit the snooze button." However, when it comes to the subject of taxation and retirement planning, there is some interesting news worth heeding. The Economic Growth and Tax Relief Reconciliation Act of 2001 (the Tax Relief Act) included numerous, substantive changes to the rules governing retirement and pension plans. Much like the rest of the law, these sweeping provisions can be quite complicated, are phased-in or phased-out according to various timetables over the next decade and ultimately face "sunset" in 2011, unless Congress takes action in the interim.

Among the many worthy reforms, the legislation: expanded the number and types of plans available; increases the amounts that may be contributed to such plans; enhanced portability; accelerated vesting; and strengthened participant protections. Below are some highlights of the major changes included in the bill.

Annual contribution limits to Individual Retirement Accounts (IRAs) (both traditional and Roth IRAs) will gradually increase to $5,000 in 2008 (adjusted for inflation thereafter). Annual elective deferral limits for 401(k)-type plans (including 403(b) annuities and salary reduction SEPs) will steadily rise to $15,000 in 2006 and thereafter. The annual elective deferral limit for a SIMPLE plan will rise gradually to $10,000 in 2005 and thereafter. A schedule of these limits follows:

"Catch-Up" Contributions and Elective Deferrals
In recognition that older taxpayers may not have as long to benefit from the increased contribution limits, the new law permits those age 50 and above (who fall within the standard adjusted gross income (AGI) limits for regular contributions) to make additional "catch-up" contributions to their IRAs up to a maximum of $1,000 in 2006 and thereafter. "Catch-up" elective deferrals are also permitted to 401(k)-type plans (up to $5,000 in 2006 and adjusted for inflation thereafter) and to SIMPLE plans (up to $2,500 by 2006 and adjusted for inflation thereafter). In addition to these dollar limits, combined annual elective deferrals and "catch-ups" may not exceed the participant's annual compensation. A schedule of "catch-ups" follows:

Qualified Plan Limits
The compensation limit that may be taken into account under qualified plans in applying nondiscrimination rules and in determining allocations or benefit accruals remains at $200,000 in 2003 (indexed for inflation in $5,000 increments). The annual limit on additions to a defined contribution plan will remain at $40,000 in 2003 (indexed for inflation in $1,000 increments). For 2003, the annual benefit limit under a defined benefit plan increases to $160,000 subject to adjustment for inflation.

Roth 401(k) and 403(b)
Accounts Beginning in 2006, the Tax Relief Act allows 401(k) and 403(b) plans to incorporate a "qualified Roth contribution program" into their plan. Participants in these programs will be able to designate all or a portion of their elective deferrals as after-tax Roth contributions, with qualified distributions not subject to income taxes upon withdrawal (although qualified distributions are not subject to income taxes upon withdrawal, there is a 10% federal income tax penalty on certain withdrawals taken before age 59 ½).

Tax Credit for Contributions
Lower-income workers will now be able to claim a tax credit, instead of merely a tax deduction, for their contributions to qualified retirement savings plans. Married taxpayers filing jointly earning less than $30,000 will be entitled to a maximum 50% credit.

Accelerated Vesting Schedules
The Tax Relief Act established two accelerated vesting schedules that apply to employer matching contributions. Plans will now have to provide participants with either full vesting after three years of service or 20% vesting each year beginning in the second year of service, resulting in full vesting in the sixth year.

Increased Portability
The Tax Relief Act enhanced portability of pension assets by allowing rollover distributions from qualified plans, 403(b) annuities, and 457 plans into any other such plan, including rollovers of after-tax contributions. Additionally, the Internal Revenue Service (IRS) has the authority to grant hardship waivers of the 60-day rollover restriction.

Enhanced Participant Protections In response to the controversy surrounding conversions of traditional defined benefit plans into cash balance plans that can potentially reduce future benefit accruals for certain participants in such plans (particularly older workers), the law expanded the notice requirements applicable to defined benefit plan amendments. While previous law required plan administrators to provide written notice to participants of certain plan amendments, the Tax Relief Act modified both the Internal Revenue Code (the Code) and the Employee Retirement Income Security Act (ERISA) to expand the circumstances requiring notice to participants, while clarifying that "sufficient information" must be provided within a "reasonable time" prior to any amendment's effective date.

By offering something for nearly everyone, the Tax Relief Act provides a much-deserved opportunity to increase your retirement savings and security on a tax-deferred basis. It also presents a significant planning challenge due to its considerable complexity. As such, it may be prudent to seek out the guidance of qualified professionals to assist you in revising and updating your retirement savings program to make the most of these promising reforms.

Real Estate Exchanges—A “Capital Gain”?


With the passage of the Taxpayer Relief Act of 1997, homeowners who own appreciated residential property are given a major capital gains tax break. Those individuals who own investment or corporate real estate are not afforded the same "luxury." Although their options are limited, a like-kind exchange may be an appropriate tax planning mechanism for deferring capital gains taxes.

Exchanging Basics
A "like-kind" exchange is a popular method of deferring taxation upon the disposition of a piece of property. In a like-kind exchange, property held as an investment or for productive use in a trade or business is exchanged for another piece of property of the same nature or character (but not necessarily of an equivalent grade or quality).

The exchange must consist of tangible property, such as real estate. Securities, evidences of indebtedness, and partnership interests are not eligible for like-kind exchange treatment. Exchanging properties that are of a different kind or class do not qualify as a tax-deferred like-kind exchange.

In its simplest form, the transaction might take the form of a simultaneous exchange by "A" of a piece of rental property for a similar piece of rental property owned by "B." Sometimes, however, "B" will be interested in acquiring "A`s" property, but owns no property in which "A" is interested. In this situation, the parties can effect a delayed exchange. For example "A" can transfer property to "B" and direct "B" to purchase another property that "A" would like to own. "B" purchases that property and transfers it to "A" in exchange for the property "A" transferred to "B."

In order to qualify as a like-kind exchange (under Code Sec. 1031), the transaction must meet the following requirements:

  1. The property to be received by "A" in the exchange must be identified within 45 days following the transfer of the property from "A" to "B" in the exchange, and,
  2. The like-kind property must be received by "A" within180 days after the date of transfer or, if earlier, before the due date for filing "A`s" federal income tax return for the tax year (including extensions).

Professional Assistance a Must
For all exchanges, a qualified intermediary (someone who is not deemed to be an agent of one of the parties-- i.e., accountant, attorney, or real estate broker) may be necessary to ensure constructive receipt of funds (which might trigger recognition as a taxable sale) has been avoided.

If only like-kind property is received in an exchange, no taxable gain or loss will be reported for federal income tax purposes as a result of the exchange, regardless of the tax basis in (and value of) the respective properties.However, if in addition to like-kind property, cash or other property is received that is different in kind or class from the property transferred (in other words, nonlike-kind property which is often referred to as "boot"), any gain realized in the exchange will be taxable to the extent of the sum of the amount of cash and the fair market value of the nonlike-kind property received. Any loss realized in such an exchange may not be taken into account in calculating federal income tax.

Like-kind exchanges can provide substantial tax benefits beyond the tax deferral of the immediate transaction. The deferral could become permanent (for income tax purposes) if the property were to be held until death, at which time its basis would be "stepped up" to its fair market value (FMV). However, holding such highly appreciated property in one`s estate could have adverse estate tax implications.

Before You Jump Ahead. . .
The more complex the transaction, the greater the need to ensure it will pass the scrutiny of the Internal Revenue Service. Moreover, Congress occasionally considers proposals to make it more difficult to qualify nonsimultaneous exchanges involving multiple parties. Consequently, prior to considering any exchange, transferors should examine all details of the transaction to see if it can be made according to the current rules for a like-kind exchange.

Some Helpful Information on Income Tax Filing


With April 15th fast approaching, it is time to get down to business and prepare your income tax return. By now you have probably received your W-2 Form(s) from your employer and various 1099 Forms from your bank or investment accounts. You should have also received your 1040 package from the Internal Revenue Service (IRS). If you haven’t, your local post office has all the forms you need. Take a moment to review the following tax filing options and issues, and get one step closer to completing your taxes.

Electronic Filing.
The IRS has implemented several new filing methods and forms for computers. Currently, individuals filing a short form who have access to a computer (and the appropriate software) can file their return electronically using a modem. By the year 2007, the IRS hopes to make electronic filing available for taxpayers with more complex returns.

Using Your Computer.
Numerous tax planning computer software programs that can help take some of the mystery and mathematical headaches out of income tax return preparation are available. These easy-to-use, menu-driven programs prompt you to input tax information directly from your tax forms and records. When you are through, the program will print out Form 1040-C. This printout should be signed and mailed (together with the appropriate tax forms, etc.) for filing with the IRS.

Late Filers.
Individuals with complex tax planning issues may need additional time to compile their data. If you can’t complete your tax return by April 15th, you can probably get an automatic extension of four months for filing a return (but not for payment of tax) provided that Form 4868 is properly filed and accompanied by payment of estimated tax owed for the year. No late payment penalty will be imposed if:

  1. the tax paid with Form 4868 is at least 90% of the total tax due with Form 1040 and,
  2. the remaining unpaid balance is paid with the completed return within the extension period.However, if the amount of tax included with the extension request is insufficient to cover the taxpayer`s liability, interest will be charged on the overdue amount, including other penalties.

If you expect to owe taxes and are concerned that you may be unable to make a full payment to the IRS by April 15th, it is important that you make at least a partial payment when it comes time to file your tax return. Include a letter explaining your situation and then immediately contact your local IRS office. In future years, keep in mind that filing early results in quicker refunds from the IRS and tends to eliminate the frustrations typically experienced by late filers (e.g., obtaining answers to last-minute questions, searching for additional forms, etc.).

Maintaining Your Tax Records.
Generally, the IRS has up to three years to conduct an audit, either randomly or based on a questionable return. However, if income is misstated by 25 percent or more, the IRS has up to six years to enact an audit (there is no limitation if the IRS suspects fraud). Thus, it is generally wise to hold on to tax records (tax returns, W-2s, other forms, etc.,) for six years.

Questions for the IRS.
The IRS has all refund information on computer and you can find out the current status of your refund by calling the IRS Tele-Tax service line. The Tele-Tax service also has recorded answers to frequently asked questions that can help make tax preparation a whole lot easier. In order to find out the toll-free number for your area, dial the national toll-free service directory (800-555-1212). In addition, if you are using the Internet, the IRS Website is filled with helpful information and tips. You can visit them at

Seeking Professional Assistance.
One question commonly asked by many taxpayers is whether to prepare one`s own return or seek out a tax return preparer. Some taxpayers are uncomfortable preparing their own returns because of complex schedules (e.g., Schedule C for the self-employed business expenses), or tax issues (e.g., capital losses carried over from a previous tax year, complicated deductions, etc.). If you fall into this category, you may wish to save yourself needless worry and consult with a qualified tax professional.

Taking the time now to prepare and file your return will certainly help make this tax season less stressful and much more relaxing.

Sunrise Sunset


Passage of the new tax law, the Economic Growth and Tax Relief Reconciliation Act of 2001 (the Tax Relief Act), has created new planning opportunities for many taxpayers. However, each individual and family may be affected quite differently depending on their particular goals, circumstances, and time horizon. In addition, the Tax Relief Act will automatically expire on December 31, 2010 and revert to prior law unless Congress takes action to retain all or specific aspects of its provisions.

Sweeping Scope and Complexity
In total, the legislation is estimated to result in nearly $1.35 trillion in tax cuts over the next ten years, representing the largest tax cut since the 1981 rate reductions under President Reagan. While the scope of the changes included in the final language of the bill is far-reaching, a comparable degree of complexity accompanies this relief, largely due to somewhat arbitrary budgetary constraints. In particular, most of the benefits contained in the bill are phased-in or phased-out to varying degrees over multiple years during the course of the next decade.

Despite the delayed nature of most benefits, and the targeted nature of certain provisions, the new law succeeds in providing meaningful tax relief for nearly all taxpayers, through one or more of the following major categories of changes.

Income Tax Cuts.
The Tax Relief Act carves a new 10% income tax rate bracket out of the existing 15% rate bracket and also provides for marginal cuts in the higher-income rate brackets

Modified Transfer Taxes.
The Tax Relief Act contains substantial changes to the taxation of asset transfers, including a gradual phase-out and repeal of the estate tax and generation-skipping transfer tax, while leaving gift taxes in force and placing new income tax consequences on post-mortem transfers

Significant Pension Reform.
Look for numerous and sweeping changes to pension plans and IRAs, including expanding the number and types of plans available, increasing the amounts that may be contributed to such plans, enhancing portability, accelerating vesting, and strengthening participant protections.

Marriage Penalty Relief.
The Tax Relief Act provides partial relief from the so-called marriage penalty, targeted primarily to lower-income taxpayers.

Enhanced Education Incentives.
There are several provisions designed to enhance education incentives, including important changes to education IRAs, and qualified tuition programs, as well as the tax treatment of higher education expenses, student loan interest, and employer-provided educational assistance.

Expanded Kiddie Credits.
Targeted relief for growing families is also on the way, including a doubling of the child tax credit, as well as increases to the adoption credit and exclusion, the dependent care tax credit, and the credit for employer-provided child care.

Miscellaneous Provisions
In addition to the changes within each of these broad categories, the Tax Relief Act also contains several minor miscellaneous provisions, including: delaying the due date for two specific corporate estimated tax payments (effectively pushing the revenue into the federal government's next fiscal year); temporarily increasing the alternative minimum tax (AMT) exemption amount; granting authority to the Treasury to postpone certain tax-related deadlines for taxpayers affected by a presidentially-declared disaster; and extending favorable tax treatment to certain restitution payments to Holocaust victims.

One "Sunset" We Hope not to See
As part of the final compromise worked out in Congress by the conference committee, the entire legislation is ultimately subject to an obscure, budgetary "sunset" provision mandating that all provisions contained in the bill expire after December 31, 2010 (absent additional action by Congress in the interim). As such, all changes implemented over the next ten years will be automatically repealed after 2010, reverting in 2011 to their status prior to the Tax Relief Act's enactment.

Educate Yourself and Seek Assistance
When carefully scrutinized, the Tax Relief Act reveals a complex structure involving numerous benefits with varying effective dates. Of course, the time-delayed aspects of that relief will ultimately determine how valuable the Tax Relief Act turns out to be for each taxpayer and household.

As such, the challenge now becomes sorting out the various provisions through self-education, which you may begin by examining the remaining sections of this booklet, each of which provides a more detailed explanation of one of the major categories listed above. Then, once you have familiarized yourself sufficiently with the highlights of the new law, you will want to consult with your qualified professional(s) to determine precisely how these numerous, and sometimes conflicting, benefits will affect your individual financial circumstances and future planning decisions.

Tax Basics: Understanding Tax Basis


You probably know that when a capital asset is sold for profit, it is subject to a capital gains tax. But, did you know that how you acquired the property, and what you have done with it since acquisition, will affect the determination of basis and, ultimately, the gain on which the tax is paid?

Basis is used to determine gain upon the disposition of any asset. In simple terms, basis is an owner's out-of-pocket cost for the asset. For purchased property, the starting basis is the original price paid (plus any acquisition costs). An asset's basis can be increased (e.g., by making improvements to real property) or decreased (e.g., after a casualty loss reduces the value of an asset), and can change according to how it was acquired and the nature of the eventual disposition. Adjusted basis refers to changes in basis after an asset was acquired.

Here's a closer look at basis and how it can affect capital gains:

Selling an Asset

Assume Helen Bradley (a hypothetical case) bought an antique dining room set for $25,000. While having the antique appraised, Helen learned its current fair market value (FMV) is $85,000. Helen’s basis is the original cost of $25,000. If she were to sell the antique dining room set at current FMV, her taxable gain would be $60,000 ($85,000 selling price minus $25,000 basis).

"Gifting" an Asset

Now, suppose Helen decides not to sell the antique set, but rather to give it to her daughter Laurie. As a general rule, the donee (Laurie) assumes the basis of the donor (Helen) at the time of the gift (plus a portion of any gift tax incurred by the transfer). However, if Laurie were to sell the antique dining room set, her gain or loss on the sale would depend upon whether the FMV of the antique at the time of the gift was greater, or less, than the adjusted basis at the time of the gift.

If the FMV at the time of the gift is greater than the donor's (Helen) basis, then Helen’s basis is used to determine gain or loss (in this case, $25,000). However, suppose the FMV at the time of the gift is less than Helen’s basis—say $15,000. In that case, the foundation for determining a gain and loss are different. For a loss, the donee's (Laurie's) basis is the lesser of the donor's (Helen's) cost of $25,000 or the FMV at the time of the gift, which is $15,000. For a gain assuming the antique is still valued at $85,000 when Laurie sells it, the basis remains Helen’s basis of $25,000.

Bequeathing an Asset

After reviewing these rules with her accountant, and being apprised of possible gift tax complications for any gift exceeding $11,000 per person per year (for the year 2004), Helen wonders if other techniques exist to transfer the antique dining room set to Laurie with fewer tax complications.

Upon further investigation, Helen learns that the basis of property acquired by inheritance is adjusted to the FMV of the property at the time of the owner's death. Thus, if she were to bequeath the antique to Laurie, Laurie's basis in the antique would be the FMV of the antique on the date of Helen's death.

In summary, the main advantage of acquiring property through inheritance is that it allows the recipient to sell the property shortly after inheriting the property with little or no capital gains tax. Assuming that an immediate sale of an inherited asset would be at the asset's FMV, there would be no recognized gain since the basis (FMV) would also be the same. Even if the asset were held for some time after inheritance, an eventual sale would result in smaller capital gains tax, due to the higher (stepped-up) basis established at inheritance.

Capital gains tax laws can be complex. Understanding how basis is determined can help you make wise choices about disposing of your capital assets. This knowledge can help you minimize the tax burden for yourself, your heirs, and those to whom you make gifts.

The AMT—Affecting More and More


It seems that nowadays, an increasing number of middle class taxpayers are being affected by the Alternative Minimum Tax (AMT). This is rather interesting, considering the AMT was originally intended to prevent taxpayers with substantial incomes from avoiding tax liability through the use of tax shelters.

On its most basic level, the AMT is a minimum amount of income tax that must be paid by each taxpayer. The AMT is calculated under rules that are, in many ways, quite different from those used to calculate your ordinary income tax liability. The AMT can serve to increase your federal income taxes if your federal income tax liability, as calculated under AMT rules, is greater than your ordinary federal income tax liability as calculated without regard to the AMT rules.

Congress implemented the AMT because too many people were using tax shelters, income tax deductions, and tax credits. As a result, some individuals often paid little or no income tax. So, in recent years, Congress has continued to modify the Alternative Minimum Tax. Now, more than just the wealthy are becoming affected. What does that mean if you are in the middle class?

Since significant modifications were made to the AMT in 1986, there have been changes in the economy. For instance, healthcare costs have increased beyond expectations; home equity buildup has allowed homeowners to obtain substantial equity loans; and state and local taxes, in some cases, have remained at significant levels. All these changes relate to the AMT and to your income taxes. Consequently, if you have tax deductions, tax-exempt income, and tax credits, you may discover that you are subject to the AMT.

Here’s a general overview of some of the more common differences between AMT rules and ordinary income tax rules, that can increase a middle class taxpayer’s chances of being subject to the AMT:

  1. Medical and dental expenses that are greater than 10% of your adjusted gross income (AGI) are deductible for purposes of the AMT. However, medical expenses are deductible for ordinary income tax purposes to the extent they exceed 7.5% of AGI. This difference in tax treatment can make you more likely to be subject to AMT if you have high medical expenses for which you are taking a deduction against your regular taxable income.
  2. Taxes you paid to your state and local governments are nondeductible for AMT purposes. However, these items are deductible from your regular taxable income. This includes real estate, personal property, and any other tax. Therefore, if you live in New York, Massachusetts, California, or a state with a significant income tax, your chances of being affected by the AMT are increased.
  3. Mortgage interest you paid and deducted may not be deductible for the AMT even though it is generally deductible from your regular taxable income. If you obtained a home equity loan that was not used to buy, build, renovate, or improve your home, the interest is nondeductible. Once again, the likelihood that you could be subject to AMT is increased.
  4. Employers often use incentive stock options as part of an employee’s compensation. As an employee, you may have been given a qualifying stock option to purchase your company’s stock in the future. Ordinarily, you would pay no income tax at the time you receive the stock option or at the time you convert the option to the stock and receive a profit. For ordinary tax purposes, tax is deferred until the stock is sold. However, for AMT purposes, the difference between the fair market value (FMV) of the stock and the amount paid for the stock due to the option is generally considered taxable income when the option is exercised. This may make a big difference for taxpayers with stock options, and may significantly increase their chances of being subject to AMT when they exercise these options.

Many tax credits and deductions are often not used when calculating the AMT. In addition, the standard deduction is also not considered.

If any of these areas resulted in a substantial reduction of your ordinary income taxes, you should consult with a qualified tax professional to check your AMT status. You may be able to take steps now to reduce your exposure for the coming tax year.

Transfer Taxes


To paraphrase a famous saying, there are two things you can be sure of in life-death and taxes. When it comes to estate planning, taxes will play an important role. The Economic Growth and Tax Relief Reconciliation Act of 2001 (the Tax Relief Act), signed by the president on June 7, 2001, contains several statutory revisions related to transfer taxation. Like most other provisions in the Tax Relief Act, the changes related to transfer taxation are quite complicated, are phased-in or phased-out over various schedules during the ten-year life of the legislation, and are ultimately subject to the obscure, budgetary "sunset" provision.

Transfer taxation broadly addresses all forms of taxation related to the transfer of assets between individuals both during one's lifetime and at death, including gift taxes, estate taxes, generation-skipping transfer taxes, and income tax basis on transferred assets. Below are highlights of the major implications for each.

Estate Taxes
If the Tax Relief Act represents the final word on the subject, it appears the infamous "death tax" is going to die quite a slow death. Specifically, the estate tax has been repealed for precisely one year-2010-only to be revived in 2011 due to the sunset provision that applies to all aspects of the bill. In the interim, the maximum estate tax rate will be gradually reduced, while the exemption amount per person that can avoid any estate taxation will be gradually increased, according to the following schedule:

Generation-Skipping Transfer Taxes
The generation-skipping transfer tax, imposed on assets transferred to heirs two or more generations removed from the grantor, is also scheduled for repeal in 2010. During phase-out, rates will be pegged to the top estate tax rate throughout the 10-year repeal period. The per person lifetime exemption amount that can be transferred without triggering generation-skipping transfer taxes remains unchanged at $1 million.

Gift Taxes
While estate taxes may be headed for repeal, gift taxes on lifetime transfers are here to stay. The lifetime exemption amount for gift tax purposes is increased to $1 million in 2002 and remains constant thereafter. The top gift tax rate mirrors the top estate tax rate during the phase-out period and is pegged to the top marginal income tax rate (35%) beginning in 2010 and thereafter.

Income Tax Basis
No sooner will the estate tax be repealed in 2010, when an arbitrary modified carryover basis rule will take effect that will potentially impose an income tax liability on assets transferred from a decedent at death. Prior to the Tax Relief Act, appreciated assets transferred at death received a "stepped-up" income tax basis to fair market value (FMV) on the date of death (or alternate valuation date) for purposes of determining potential capital gains tax liabilities upon the subsequent sale of such assets. Now, post-death transfers beginning in 2010 will retain, or carry over, the basis from the decedent, with two limited and restricted exemptions: 1) $1.3 million of tax basis will be allowed to be added to certain assets; and 2) $3 million of additional tax basis will be recognized for assets transferred to a surviving spouse.

Begin Planning Now
In addition to the major changes noted above, the Tax Relief Act also contains transfer tax-related provisions affecting state death tax credits, conservation easements, installment payment rules, surtaxes, and certain recapture and refund provisions. As such, whether you're just beginning to establish an estate plan or need to revisit and revise an existing plan in the light of the new law, the assistance of qualified professionals is crucial to avoid pitfalls and ensure your desired goals and objectives are ultimately met.

What Should You File—Joint or Separate Returns?


A common question for married people is whether to file a joint return or to file separately. Most married people tend to file joint returns because the tax rate is lower than that on separate returns. However, here are some things to keep in mind if you are considering filing separately:

If spouses file separate returns and one spouse itemizes deductions, the other spouse must itemize also--even if that spouse has zero itemized deductions.

If separate returns are filed, in most cases, neither spouse may claim a credit for child and dependent care or the earned income credit. In addition, if the spouses lived together at any time during the tax year and file separate returns, they may have to include up to one-half of all Social Security benefits received in their income.

If a taxpayer made contributions to an Individual Retirement Arrangement (IRA), the deduction is subject to a phase-out rule if the taxpayer and his or her spouse lived together during the year and either one was covered by an employee retirement plan. Thus, the IRA limitations cannot be expanded or avoided by filing separate returns.

The $25,000 deduction for passive activity losses resulting from rental real estate ownership is split when married individuals file separately. Each spouse may only deduct up to $12,500 of his or her own passive rental real estate losses for the tax year.

If spouses file separate returns, each reports only his or her own income, deductions, credits, and exemptions. Exemptions may not be split between married taxpayers. For example, the parent who provides the most monetary support for a child (assuming all support for the child comes from the two filing parents), is the one entitled to claim the dependent deduction. When neither has provided more than one-half of the dependent`s support, the parents and other persons furnishing support can, by written agreement attached to their tax returns, allocate the dependency exemption to one specific person.

If a taxpayer files a separate return, an exemption can be taken for the spouse only if the spouse has no gross income and was not a dependent of another taxpayer.

If spouses file separate returns for a tax year, they may amend those returns and change to a joint return at any time within three years of the due date of the separate returns (not counting extensions). If the amount paid on the separate returns is less than the total tax shown on the joint return, the additional tax due on the joint return must be paid when filed. However, once a joint return has been filed, the taxpayers may not choose to file separate returns for that year after the due date for the return.

Your particular circumstances may make filing separately more advantageous, but you will need to "run the numbers" both ways in order to make the proper determination.


Your Income Taxes—Marginal Rates vs. Effective Rates


Whether tax season has already passed or is right around the corner, income taxes are an issue you should remain familiar with throughout the year. Here’s a quick primer on the basics of taxation. There are several definitions that are useful in understanding the tax you actually pay on your income. Gross income is your total income from all sources, unless specifically excluded by tax law (e.g., tax-exempt bond interest). Taxable income is calculated by subtracting all your allowable adjustments, deductions, and exemptions from gross income. The tax rates are then applied to taxable income to determine how much tax is due. There are two tax rates that are important for understanding how your income is taxed. The marginal tax rate is the rate applied on your last dollar of earnings.

For the sake of illustration, let's assume a purely imaginary tax system with two rates: Income up to $10,000 is taxed at 5 percent and income in excess of $10,000 is taxed at 10 percent. If you earned $15,000 in salary and received a $1,000 bonus, your marginal tax rate on the bonus is 10 percent--that is, the rate on the last dollar you received.

The effective tax rate, on the other hand, is the overall rate at which your income is taxed--it is calculated by dividing total tax paid by total income. Assume the same simple two-rate system and an income of $15,000. The tax on the first $10,000 in income is $500 ($10,000 x 5%). Since the rate is 10 percent on income over $10,000, in this example $5,000 is taxed at 10 percent, generating another $500 in tax ($5,000 x 10%). So, the total tax comes to $1,000 ($500 plus $500). Even though the top marginal tax rate is 10 percent in this imaginary system, the effective tax rate is only 6.7 percent ($1,000 total tax divided by $15,000 total income).

What Do the Numbers Mean?
Your marginal tax rate will tell you the rate that is applied to your last dollar of taxable income. Unless you are on a rate "bubble" (i.e., the point where two rates meet), it will also tell you the rate that would be applied to additional taxable income. Furthermore, your marginal rate will tell you the effective tax savings of deductions. For example, a $1,000 deduction for someone with a marginal tax rate of 28 percent gives an effective tax savings of $280 ($1,000 x .28).

Your effective tax rate tells you the percentage of your total income that is paid in taxes. It is possible for a taxpayer to have a high marginal tax rate with a comparatively much lower effective tax rate. Indeed, many income earners in the highest marginal tax bracket are able to substantially reduce their effective tax rate by taking large tax deductions.

In reality, no one has a single "real" tax rate. Both marginal and effective tax rates are important numbers, providing different pieces of tax information. When used together, they can help you achieve a better understanding of how the tax system affects the money you earn. A qualified tax professional can provide you with additional information regarding your particular situation