Washington Watch
Casualty Losses
Reducing Debt

Washington Watch

If there is any justice in the world, at least one tax reduction bill will be introduced and passed in 1999. That would be the bill to overhaul the alternative minimum tax (AMT). Although many of you have heard of the alternative minimum tax, few really understand how it works. In a nutshell it works like this: First calculate your tax the normal way, using the depreciation lives prescribed by law, taking the deductions allowed by law, and performing the numerous fun calculations such as phase-outs of exemptions, itemized deductions, passive losses, and the infamous capital gains tax rate calculation. After spending the 29.85 hours the IRS estimates it takes to do the above (assuming you file 1040, itemize your deductions, have interest and dividends, capital gains and rental property), you should be done, right? Wrong! Second, you have to completely recalculate your income taxes for the alternative minimum tax. For this tax, completely different depreciation rules apply for many assets, you aren’t allowed a deduction for any state tax payments such as income tax, real estate taxes or personal property taxes, and you also don’t get to deduct your personal exemptions for yourself or your dependents. While there is a $40,000 exemption amount involved in the calculation, it phases out as income increases. There are numerous additional add backs such as some interest on tax free bonds which are subject to alternative minimum taxes. So is the value of stock options exercised, but not sold in the same year. Finally, you pay the higher of the two taxes.

There are several problems with this tax. First is the unnecessary complicated calculation involved. Second is the unfairness of targeting such items for taxation. If Congress doesn’t like a deduction or exclusion, why not just remove it rather than legislate around it (sort of a reverse loophole so to speak). Finally, the tax is in no way indexed. Therefore, as more taxpayers see their income rise, and their investments become more sophisticated, more of them get hit with the tax. We have seen an almost exponential number of clients get hit with this tax over the past several years. A perfect example is a recent case involving a married couple who had 10 children. They didn’t claim any special tax deductions, just 12 personal exemptions. Bingo, they got hit with the AMT.

In today’s Wall Street Journal there is an article indicating that both the Democrats and Republicans are investigating how to undo this dilemma. Indexing the exemption amount would be a start, but the problems caused by AMT go farther than just that quick fix. I hope that Congress has better luck getting a consensus on this problem than they have so far on eliminating the marriage penalty. All talk, but no action so far on that either!

In other areas, the IRS has been pretty busy. That call at dinnertime may be the IRS. They are increasing the number of calls they make from 4 PM to 8 PM since they have had more luck catching taxpayers at home during that time period. Talk about indigestion at dinnertime! The Service also will start withholding up to 15% of Social Security benefits from those who owe back taxes. This should start in July 2000. It’s nice to know Uncle Sam is thinking of us.

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Casualty Losses

Taxpayers who experience certain types of major personal casualties may be able to recoup some of their losses through tax savings. An itemized deduction may be available for personal losses from fires, storms, car accidents, and similar "sudden, unexpected, or unusual" events. Losses from theft are included as well. The deduction is only available for physical damage or loss to your property. Thus, if you are in an automobile accident and pay for the damage done to the other driver's car, the cost does not qualify. Similarly, if you're injured in the accident, your medical bills do not qualify as part of your casualty loss (although, of course, they may result in a medical expense deduction). The loss is not always the decline in economic value you suffer. It's measured as the lesser of:

(a) the drop in value or;

(b)your basis in the property (usually, your cost).

Example: Dan bought an antique vase for $500, which rose in value to $3,000. It was damaged in a fire after which it was worth only $1,000. For casualty loss purposes, the loss is only $500 even though the economic loss was $2,000 ($3,000 - $1,000). The lesser of cost ($500) and drop in value ($2,000) is used. It may be difficult to establish these elements. If you have your original receipt, you can show your cost. In some cases, appraisals will be needed to establish pre- and post-loss values. Sometimes, repair costs can be used as a measure of drop in value.

Next, the loss figure is reduced by three amounts. In many cases, these reductions result in no deduction being available. First, to the extent you are insured, you must reduce your loss by your reimbursement. You shouldn't fail to file an insurance claim in the hope of increasing your deduction. In this event, the IRS will reduce your loss by the insurance reimbursement you could have received. Next, for each casualty, you must reduce your loss amount by $100. Note that this reduction is per "event," and not per item damaged. Thus, if a storm knocks over a tree, which damages your car and home, you have three property losses (tree, car, house) and only one $100 reduction. Third, after combining all your losses under the above guidelines, you must reduce them by 10% of adjusted gross income (AGI). Only the loss amount above this "floor" can be deducted. This final limitation is often the one that wipes out the deduction. For example, if your AGI is $75,000, your losses (determined as described above) are only deductible to the extent they exceed $7,500 (10% of $75,000). Except for "disaster losses" (below), the deduction is taken in the year the loss is incurred (or, for a theft, the year it's discovered).

Disaster losses. If your loss is from a disaster in an area designated by the President as a disaster area, you can elect to take your loss in the year before it was incurred. This may increase the tax savings from the loss and may entitle you to a refund earlier than if you waited to file the loss year's return. For additional information on these issues, please call.

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Reducing Your Debt

If you carry a balance on your credit cards from month to month, you are not alone. It is estimated that almost 75% of credit card users do the same. The average unpaid monthly balance is approximately $2,500, and at a 20 % interest rate, that adds up to an extra outlay of $500 a year. Breaking the cycle isn’t easy, but here are some tips if you are serious about getting out of debt.

First, stop using your cards and don’t open any new accounts. Charging more at this point is self-defeating. Resolve not to buy unless you can pay cash.

Second, come up with a plan to pay off your card balances. List all debts, with names, addresses, account numbers, amounts owed, and monthly payments. Begin with the highest interest debt or the lowest balance. You might consider consolidating your debts with a lower rate home equity loan – the interest is usually tax deductible.

Third, design a budget for fixed and variable monthly expenses, and a "sinking fund" for expenses that you owe annually or semiannually. For example, if you will owe $2,000 in property taxes on January 31 and it is now the end of March, set aside $200 every month to have the funds on hand by the due date.

Let your creditors know if an emergency forces you to temporarily stop payments. If the problem persists, you may want to write to creditors and ask for special payment arrangements.

Finally, stick with your plans. As you pay off your debts, put money into savings. Once you have established a new pattern, the old pattern of carrying credit card debt is less likely to reemerge.

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Loaning Money to Relatives & Friends

Your grown daughter needs $50,000 and you agree to loan it to her, interest free, for 10 years. Your grandson asks you to lend him $200,000. You say "yes" but warn that if you need the money yourself, he’ll have to take a bank loan and pay you back immediately. You decide to charge him a very low interest rate because you know he can’t afford to pay you more. In both situations, your loans could have tax consequences you weren’t expecting.

The first possibility is gift taxes. Every month, the IRS publishes a series of interest rates (called applicable federal rates or AFRs) that generally reflect prevailing market conditions. If you charge a rate lower than the AFR required for your loan – or no interest at all – the interest you didn’t charge may be considered a taxable gift. Once your taxable gifts to any one person exceed $10,000 in 1999, you’ll need to file a federal gift-tax return.

The second possibility is income taxes. The lender (you, in our example) will be viewed as having received cash for the missing interest. And that interest may be considered taxable income to you.

As with most tax rules, there are exceptions. For example, you may loan up to $100,000 per person interest free or at a rate less than the AFR without worrying about taxes. For more details regarding these rules, see us.

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A Tax Tip for Property Owners

When is a repair not a repair? And why does it matter?

A repair isn’t a repair when it’s part of a general plan of improvement. And it can matter a great deal when you’ve spent money fixing up a rental property or your business premises. Naturally, you’ll want to recoup some of your cost by deducting the expense as soon as possible. But the IRS will insist that the deduction be claimed over a period of years (depreciated) rather than all in one year if the "repair" was really an "improvement."

You can’t always get around this tax rule. But do try to avoid having routine repair work done while you are in the midst of major renovations. As always, be sure to keep detailed records of how much you are paying for what.

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A Graduation Gift to Last a Lifetime

If you are looking for a unique gift for your child, grandchild, or other graduate, here is one you may not have considered: A Roth Individual Retirement Account.

Why fund a retirement account for an 18 year old? If you put $2,000 into a Roth IRA when a child is 18—assuming a 10% annual return and no withdrawals—that account could be worth $176,395 at age 65, $284,086 at age 70, and $457,523 at age 75, even if no further contributions are made. An added bonus: The earnings are tax free.

A Roth IRA offers other benefits as well. While earnings generally cannot be withdrawn before age 59 ½ without incurring taxes and a penalty, contributions may be withdrawn free of tax at any time. If the money is used to pay college expenses, even earnings may be withdrawn penalty free, although taxes will be due. And, after five years, up to $10,000 may be withdrawn from earnings—tax and penalty free—to pay first-time homebuying expenses.

What are the requirements for opening a Roth IRA? Only that the child has earned income equal to the amount contributed to the Roth, or $2,000, whichever is lower. Salaried jobs or odd jobs—as long as the child has appropriate records—qualify. Keep in mind that net self-employment earnings of $400 or more will trigger self-employment taxes.

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