STAFF NEWS

• Rob Carmines was a featured presenter at the Summer Seminar for Tax Practitioners. The seminar was sponsored by the South Carolina Tax Council and held in Savannah in June.
• Tom Smith made a series of presentations to the incoming freshman class during orientation at Christopher Newport University in Newport News.  His presentation topics included responsible use of credit cards and financial responsibility.

Washington Watch

• Let’s get ready to rumble!  The fun in Washington is really getting ready to start.  New projections for future budget surpluses are coming in almost every day.  All of them project bigger surpluses than anyone was expecting.  Now the battle over what to do with the money is heating up.  Here are some of the proposals being floated around:
• Republicans – Big tax cuts are being offered.  About $800 billion (with a B) is being offered in tax savings over a 10 year period.  Some of the items on their wish list are a reduction of the capital gains tax rate to 15% from 20% currently.  Elimination of the marriage tax penalty by doubling the standard deductions for married couples and doubling the income limits for the tax rate schedules compared to single taxpayers.  Cutting all tax rates by 10% over the next 10 years. But, don’t get too excited, the reduction would be 10% of the tax rate, not 10 percentage points, i.e. 28% would be 25.2% (28% less 2.8%). Letting self-employed taxpayers deduct 100% of their health insurance now, instead of phasing it in by 2002.  Allowing full deductions for long-term care insurance plans, even for those taxpayers that do not itemize.  Expanding education IRAs to cover elementary and secondary schools.  Increasing the $100,000 limit for those wishing to convert to Roth IRAs.  Finally, eliminating the estate tax entirely. 
• Democrats – Favor modified versions of most of the above, except for the big capital gains tax cut.  Additionally, they are generally against including elementary and secondary schools in the Education IRA plan.  Similarly, they generally oppose abolishing the estate tax entirely.  They favor using most of the surplus to shore-up Medicare and Social Security and to further fund education and other programs.  One very popular provision is prescription coverage for Medicaid recipients.  Even some GOP leaders feel that they may have to get behind that provision. Democrats feel that dropping the capital gain tax rate to 15% from 28% in 1997 is almost a 50% reduction in that tax, and only benefits high income individuals.  Similarly, eliminating estate taxes is viewed as primarily benefiting high income individuals. 
• As you can see, given that we are gearing up for an election, things will get interesting.  It should be noted that several of the Republican items have been vetoed in previous bills and did not ultimately pass muster.  Additionally, Clinton seems willing to accept a modest $250 billion package of cuts, but only if Republicans sign on to some of his agenda in return.  He also favors cuts aimed mainly at low and middle income families.
•  Analysts predict slim chances of any major tax bills this year, but even modest tax relief may yield big savings.   We’ll keep you posted as things progress.

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Mortgage Points

• Points—up-front fees charged by a mortgage lender, expressed as a percentage of the loan principal—are normally the buyer's obligation. But sellers will sometimes sweeten a deal by agreeing to pay the points on the buyer's mortgage loan. We are frequently asked whether the buyer of a home can deduct the mortgage points paid by the seller of the home. Yes, you can, subject to some important limitations described below. In most cases, points the buyer pays are a deductible interest expense. But until a few years ago, IRS had refused to allow buyers to claim an interest deduction for points that the seller paid. But IRS reversed itself, and now says that seller-paid points are deductible.
• Suppose, for example, that you bought a home for $600,000. In connection with a $500,000 mortgage loan, your bank charged two points, or $10,000. The seller agreed to pay the points in order to close the sale.  Under the old rule, you couldn't deduct the $10,000. And, your tax basis in the home was $600,000. That's the figure used to compute gain or loss when you sell the home. Under the present rule, you deduct the $10,000 in the year of sale. The only disadvantage is that your tax basis is reduced to $590,000, which will mean more gain if and when you sell the home for more than that amount. But that may not happen until many years later, and the gain probably will not be taxable anyway. You may qualify for the exclusion for gain on the sale of a principal residence. Or, if you die owning the home, its basis becomes its fair market value and the gain is eliminated.
• There are some important limitations on the rule allowing a deduction for seller-paid points. The rule doesn't apply:
  • to points that are allocated to the part of a mortgage above $1 million;
  • to points on a loan used to improve (rather than buy) a home;
  • to points on a loan used to buy a vacation or second home, investment property, or business property;
  • to points paid on a refinancing, home equity loan, or line of credit.
• We would be happy to review with you in more detail the particular point payment situation involved in your purchase, or any other tax aspects of your home transaction. Please call if you would like to discuss this further.

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Qualifying for Education Tax Credits

     The Hope Scholarship and Lifetime Learning federal tax credits can help make the cost of obtaining a higher education more affordable.  With average bills for tuition and fees at four-year colleges and universities now ranging from $3243 a year (for in-state students at public institutions) to $14508 (at private institutions), that is good news.

     The bad news is that figuring out how to take advantage of the credits can be tricky.  Following are some highlights of new IRS guidance on the law’s finer points.

Third Party Payments:

• If someone other than you, your spouse, or a claimed dependent pays qualifying expenses for a student, these are treated as paid by the student.  However, if the student is your dependent, you can take the credit, if eligible, not the student.  This means that eligible expenses paid by a grandparent for your dependent child are treated as paid by you.
• Suppose you pay tuition for your child who, because or a divorce situation, is not your dependent.   The child’s other parent who does claim him/her as a dependent can take the credit for your payments, if eligible.

Qualifying Expenses:

• Generally, only payments of tuition and fees required for enrollment or attendance at the school can qualify for the credit.  Therefore, a required student activity fee used solely to fund on-campus organizations and student-run activities would qualify.  An optional athletic fee entitling students to discounted tickets at sports events would not qualify for the credit. 

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The Use of Exchange Funds to Diversify Your Investment Portfolio

     Modern investment asset allocation models generally provide that diversification of your portfolio is the safest method to protect long-term investments from the shifting sands of the stock market. These theories have recently further proven that a stable portfolio yielding a steady total return on an annual basis will out-perform portfolios that have higher average yields but very volatile earnings records.

     Many investors would like to diversify their risk, but with the recent run-ups in the stock market, this would require the sale of  substantially appreciated securities and the consequent recognition of taxable gains.

     An alternative to selling securities, but achieving diversification without immediate tax consequences, is the use of Exchange Funds.

     An exchange fund is a limited partnership or a corporation to which a group of individual investors contribute their respective appreciated securities. The investors receive in exchange for their securities ownership interests in the resulting corporation or partnership. As long as the transaction is a "qualified" transaction the exchange of appreciated securities for ownership interests in the investment entity is tax-free and the investors cost basis in the exchange fund is carried over from their cost basis in the contributed securities. The owners of the exchange fund receive proportionate ownership interests based on the fair market value of their contributions so there is no immediate loss of untaxed equity.

     The investor ends up with diversification of their holdings and the investment entity generally is structured to pay to the investors proportionate shares of the co-mingled annual earnings of the investments.

     In exchange for deferring the immediate recognition of capital gains there are some drawbacks. First, in order for the exchange to be tax-free only a maximum of 80% of the assets of the exchange fund can be readily marketable stocks, securities, mutual funds or real estate investments trusts. This restriction is generally met by requiring investors to contribute 20% of value in qualifying illiquid assets such as cash or real estate, which in turn may create a "cash crunch".  The stricture is maintained by the investment company following a policy of  keeping at least 20% of their combined holdings in qualifying illiquid assets which could tend to drag down the average earnings of the aggregate portfolio.    

     The second major criticism is that  the investment is illiquid. In order for the exchange to remain tax-free the appreciated shares need to stay in the entity for a period of seven years before you can begin to withdraw a pro rata share of the diversified investments. If earlier withdrawals are needed some agreements provide that the original contributed investments come back to the owner.

     In spite of these drawbacks exchange funds do have their attractions. Perhaps one of the best is in estate planning. A retired individual needing income, but not needing to dip in to their lifetime savings, can diversify and stabilize their earnings stream and pass the exchange fund to their heirs by annual gifting and testamentary bequests. The bequests ultimately get a step-up in basis just like any other investment and the heirs then have the opportunity to pull out of the exchange funds if further diversification seems warranted.

     If you think you may be a candidate for an exchange fund transaction, give us a call and  discuss your options.        

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Switching to a Leased

Business Car?

• You may owe tax on part of any trade-in allowance you negotiate because you aren’t buying a replacement vehicle.  Also, expect a whole new set of rules at tax time.
• With a lease, you can deduct the part of each lease payment that covers business use (not commuting or other personal use).  But you may have to reduce your deduction by an “inclusion amount” if the fair market value of the car when the lease begins is more than an IRS-specified amount ($25,800 for 1998).  Alternatively, you can generally claim the standard mileage – 31 cents a mile starting April 1, 1999 – for your business driving.
• In contrast, trading one purchased business car for another is a tax-free exchange.  The original basis of the new car for depreciation purposes is generally the adjusted basis of the old car, plus whatever additional amount you may pay for the new car.  Your tax deduction for business use is based on actual expenses (including depreciation) or the standard mileage rate.

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Payroll Tips

     For the first time in more than 15 years, the IRA plans to reduce the amount of “imputed income” it requires employers to include in the W-2s of employees receiving more than $50,000 of group-term life insurance coverage as a benefit.  The proposed rates would be effective for insurance provided after June 30, 1999.

       Do you need help with your payroll?  Call us today and let us take the worry off your hands.   We prepare payroll checks, including cafeteria plan and retirement withholding, tip withholding and preparation of all payroll reports.  We take the headaches out of payroll and let you concentrate on maximizing your business profits. CALL TODAY!

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