Prepare for a major tax increase

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Your taxes are going to go up. Not just taxes on the rich, or the mass affluent, or the solidly middle class. Taxes for everyone will increase, since we're going down the road of needing a value added tax (VAT) in the form of a national sales tax to get us out of this massive national debt hole that we've dug ourselves into.

The bill is far too big for only the rich to pick up. There aren't enough of them. America will have to lean on citizens far below the $250,000 income threshold: nurses, electricians, secretaries, and factory workers. Within a decade the average household that pays income tax will owe the equivalent of $155,000 in federal debt, about $90,000 more than last year. What the Obama administration isn't telling Americans is that the only practical solution is a giant tax increase aimed squarely at the middle class. The alternative, big cuts in spending, aren't part of the President's agenda. To keep the debt from wrecking the economy, the U.S. would need to raise annual federal income taxes an average of $11,000 in 2019 for all families that pay them, an increase of about 55%. "The revenues needed are far too big to raise from high earners," says Alan Auerbach, an economist at the University of California at Berkeley. "The government will have to go where the money is, to the middle class." The most likely levy: a European-style value-added tax (VAT) that would substantially raise the price of everything from autos to restaurant meals.

(Added emphasis is mine.)

Anyone who tells you that our national debt won't be a huge problem is bs'ing you. Sure, politicians love to talk about how they'll bring down the national debt by eliminating earmarks, cutting discretionary spending, blah, blah, blah. Budget cuts ain't happening, unless China stops buying all those Treasuries which would negate our ability to do deficit spending. And then there is the required spending on entitlements: Social Security, Medicare and Medicaid. Do a search on 'generational accounting' to see what kind of financial damage entitlements are going to do to our children and grandchildren. Except we're the children and grandchildren and the problems are upon us already. Don't get me wrong, I think entitlements are a great thing and keep people out of poverty. However, we as a nation never figured out how to pay for them.

It can't go on forever, and it won't. What will shock America into action is the prospect of fiscal collapse, which will grow more vivid each year. In 2008 federal borrowing accounted for 41% of GDP, about the postwar average. By 2019 the burden will double to 82% by the CBO's reckoning, reaching $17.3 trillion, nearly triple last year's level. By that point $1 of every six the U.S. spends will go to interest, compared with one in 12 last year. The U.S. trajectory points to the area that medieval maps labeled "Here Lie Dragons." After 2019 the debt rises with no ceiling in sight, according to all major forecasts, driven by the growth of interest and entitlements. The Government Accountability Office estimates that if current policies continue, interest will absorb 30% of all revenues by 2040 and entitlements will consume the rest, leaving nothing for defense, education, or veterans' benefits.

National bankruptcies

The other option is national bankruptcy. It's not an option, obviously, and a national U.S. bankruptcy will never happen. But for kicks, I did some research on what happens when nations go bankrupt.

A couple of examples I found (thanks Wikipedia!) are defaults on debt incurred by previous national governments, such as post-Revolutionary France defaulting on the debts of Bourbon France and Soviet Russia defaulting on debts of Czarist Russia. There's also an example of a default of Danish bonds in 1850, and another Danish bankruptcy in 1813. Germany has gone bankrupt twice after the World Wars. More recent examples are Russia in 1998, Argentina in 2001-2002, and Iceland in 2008. A national bankruptcy may lead to massive inflation, as the country prints money to pay its debts. Gold could be a hedge against this situation.

Looking at the last Argentina bankruptcy:

Once the Argentine businessmen had transferred their dollars abroad, the second phase of the collapse began. The Argentine government froze all bank accounts, capping the maximum amount an accountholder could withdraw at only $250 (€198) a week. Small investors, those who had left their money in the banks, were the hardest hit. Tens of thousands of desperate citizens stormed the banks, and many spent nights sleeping in front of the automated teller machines.

The last phase of the downturn began in the Buenos Aires suburbs. After consumption had dropped by 60 percent, young men began looting supermarkets. In December 2001, 40,000 people gathered on Plaza de Mayo in front of the Casa Rosada, the presidential palace. There, they banged pots and pans together day and night, until an unnerved President Fernando de la Rúa fled by helicopter.

[...]

Nevertheless, the country recovered from the crash with astonishing speed. In recent years, the Argentine economy has grown at impressive rates of 7 to 9 percent.

Again, it's inconceivable that the U.S. will go bankrupt. That's just not going to happen. But, I do see a large tax increase and increased inflation. The hardest thing to swallow about the tax increase is that since it may be a national sales tax, there's no way to avoid the taxes later by using vehicles like a Roth IRA or Roth 401(k).

More simple estate planning

A Fortune article reinforces the basics of estate planning; gifts, life insurance and trusts.

Gifts

Gifts of $13,000 or less a year to an individual aren't taxable.

Life Insurance

Look into using a life-insurance trust as the beneficiary of your life insurance policy. Another (maybe somewhat depressing) suggestion is to gift money to your children to use to take a life insurance policy out on you.

Trusts

Grantor-retained annuity trusts (GRATs) are seeing a surge in popularity due to depressed asset prices.

Taxes originally designed for the wealthy now hit the mass affluent

Money Magazine has a short article on taxes that used to exclusively hit the wealthy, but, because of their not being adjusted for inflation, now hit lower income earners.

• Social Security benefits get taxed if you have more than $25,000 in income, the same as 1984
  

• The Alternative Minimum Tax (AMT) that now affects over 4 million taxpayers, up from less than 20,000 in 1970

• The capital-loss carry-forward amount hasn't been adjusted for inflation since 1978, and still stands at $3,000

I won't do any editorializing.

Estate planning for your home

Most of us won't be hit by the estate tax when we shed this mortal coil. Even adding in the value of a home, the vast majority of Americans won't owe an estate tax, so their homes can be passed on to their heirs and avoid most taxes. Those who would be hit by the estate tax can do some prior planning to pass on a home with as little tax implications as possible. One sophisticated strategy is a qualified personal residence trust.

Here's how a QPRT works. Say a retired doctor in Florida wants to give his $1 million beachfront home to his two daughters. This strategy would require the doctor to put his home into an irrevocable trust for several years, while he continues to live in it. Through a complex IRS calculation based on interest rates, the length of the trust and his age, the IRS values his right to live in the house at, say, $600,000.

For the purposes of his taxable estate, that knocks the value of his house down to just $400,000 -- regardless of how much the house appreciates in the meantime. (That $400,000, though, comes out of the doctor's federal gift- and estate-tax exemptions.) When the trust is up after the stipulated number of years, if he chooses to continue living there, he can pay his daughters rent, further reducing the size of his taxable estate.

Your 1099-B will be late this year

I received a mailing from my broker that my 1099 wouldn't be mailed until February 15 of this year. It said that the IRS reporting deadline has changed from January 31. What the heck?

Well, it turns out I can blame Congress. The reason for the change is brokers now have to include tax basis as well as sales proceeds on all sales you make in the tax year. I have a couple of issues with this as a reason for pushing back the deadline.

First, the 1099 forms are generated by a computer. It's not like people are calculating the tax basis for all my sales transactions by hand. So once the computer program is updated to print the basis on the 1099, there is no other work. The incremental processing time to include this when the 1099 forms should be trivially small, or else the programmers who made the change should be fired. No extra time is needed.

Second, the tax basis isn't required to be put on the 1099 forms for 2008. It's not going to be required until a later date. So the brokers are being given more time to add information to the 1099 form that they aren't even required to add this year.

Third, the change in the law only applied to the 1099-B, but since most brokers send out a combined 1099 with the 1099-DIV and 1099-INT with the 1099-B, the IRS is allowing the later date to apply to the entire combined 1099.

Why am I making a big deal about this? Because I like to get my taxes done early, and this will delay me by at least 2 weeks. The worst part is that my broker usually screws up the dividend classification (qualified vs. non-qualified) and has to send me a corrected 1099. I'm sure that it still won't catch the mistakes it's made in the past even with this deadline extension, and I'll be getting a corrected 1099 even later than usual. OK, rant done.

Convert IRAs that have plummeted in value to Roth IRAs

A Traditional IRA whose value has fallen off of a cliff is a good candidates to convert to a Roth IRA. You'll have to pay taxes when you do the conversion, but they'll be less than when (if?) the value of the IRA.

When you convert traditional IRA assets to a Roth, you have to pay the income taxes upfront on the account's value -- and in some cases, those values may be next to nothing at the moment.

Kent Lawson, a 66-year-old AT&T retiree in Bloomington, Ind., signed the paperwork last month to convert a traditional IRA containing a $40,000 Lehman Brothers principal-protected note to a Roth. "It's gone to a zero price, so hopefully we can convert it at no value," says David Hays, his financial planner. "We expect it to be worth something eventually, and then he won't owe any taxes on it."

This smacks of market timing, but I think it's a good move. Making this move is a bet that asset values won't fall further, so it carries some risk, but the tax savings could make it a smart one, since there should be no further taxes on a Roth.

One big caveat is that your income must be $100,000 or less in the year of the conversion. This will change in 2010, assuming the tax laws don't change, when anyone, regardless of income, will be able to convert a traditional IRA to a Roth IRA.

Real estate driven tax changes

I wasn't really paying attention to this before, but I've seen quite a few stories on the Housing Assistance Tax Act of 2008 over the last week. (The about.com story gives better examples.)

A few things the new law encompasses

• First-time homebuyer credit of up to $7,500
• Property tax deduction even if you don't itemize
• Better tax credits for low-income housing and renovating old buildings
• More relief for 2005 hurricane victims
• Changes in capital gains exclusion for real estate
• Reporting of credit and debit card payments

Being a law written by our Congress, there are of course other provisions in it (why can't our laws ever be simple changes?). I'm interested in the first-time homebuyer credit and the changes in the capital gains exclusion for real estate.

First-time homebuyer credit

The first-time homebuyer credit is a credit up to $7,500. The 'credit' has to be repaid though over 15 years. And there is an income limit of $95,000 for individuals and $170,000 for married couples filing jointly, so those in the mass affluent segment may not qualify due to income.

Changes in capital gain exclusion for real estate

Previously, the tax laws allowed a homeowner to exclude up to $250,000 in gains (or $500,000 for joint filers) as long as the homeowner owned and lived in the house for at least two years out of the five years ending on the date of sale. Now, any gains will need to be allocated based on usage. Only gains allocated to time spent living in the property as a primary residence will qualify for the tax exclusion

OK, an example really helps to understand this.

Here's an example: Suppose a married couple buys a home on Jan. 1 next year for $600,000, says Mr. Olivieri of White & Case. They plan to hold it as an investment. On Jan. 1, 2012 -- three years later -- they begin using it as their principal residence. They live there two years and sell it on Jan. 1, 2014 for $1.1 million, for a profit of $500,000.

Under the old law, they would have been able to exclude the entire $500,000 gain from their taxable income, Mr. Olivieri says. But under the new law, they could exclude only two-fifths of the gain, or $200,000, since the other three-fifths would be considered attributable to the three years the home wasn't their principal residence, he says.

Taxes for the mass affluent to increase

How's that for a headline? This outcome is predicated on the fact that Barack Obama wins the Presidency. The CNN story delves into how Obama's tax plan defines wealthy:

Indeed, under Obama's tax plan, married couples with at least $250,000 in gross income are likely to see their taxes go up if Obama is elected president.

But what about single filers? The line for them would likely be about $200,000, according to an Obama adviser.

The purpose of this post isn't to talk about whom to vote for, but to lay out facts. Are higher taxes on the wealthy good or bad? I have my opinions, but won't go into them here. The mechanism for the increase is simple:

Obama would restore the top two income tax rates to their pre-2001 levels of 36% and 39.6%. Currently they're 33% and 35%.

Impact of the proposed plan on taxes

From what I've read, McCain would keep the rates as is, if not lower them. The latest issue of Fortune has a story with a comparison chart prepared by the Urban-Brookings Tax Policy Center of how taxes would change for the various income levels (unfortunately, the story isn't online. It's the one titled The Evolution of John McCain.) For the $112,000-$161,000 level, McCain's plan decreases taxes by $2,614, and Obama's plan by $2,204. At the $161,000-$227,000 level, McCain's plan decreases taxes by $4,380, and Obama's plan decreases taxes by $2,789. And at the $227,000-$603,000 level, McCain's plan decreases taxes by $7,871 and Obama's plan increases taxes by $12. Obama's plan really starts to increase taxes at the $227,000 and above income levels.

Does Obama's plan really just soak the 'rich'?

The 'not-so-rich' rich that these changes would impact are of course not happy.

Such rhetoric leaves Hammer steaming. "I don't mind paying my fair share, but people act like they're just talking about Bill Gates," he says. "We would definitely feel a hit if our taxes went up." Although a year ago he would not have considered voting Republican in November, now he's not so sure: "Do you vote your heart, or do you vote your wallet?"

[...]

Like Hammer, many facing higher taxes don't consider themselves part of the exalted crowd. They have good incomes, to be sure, particularly compared with the median household income of $48,200. Of the 149 million households filing federal income taxes for 2006, some 3% reported income between $200,000 and $500,000; fewer than 1% claimed income above half a million dollars.

But many also live in high-cost areas with expenses to match—and feel burned by talk of "taxing the rich" that doesn't recognize that $250,000 stretches a lot further in the South or the Midwest than in Manhattan or Silicon Valley. "There is a huge difference between what politicians define as rich and what many Americans would call middle class," says Patrick Anderson, CEO of the Anderson Economic Group and co-editor of The State Economic Handbook.

I understand the point of the family profiled in the story, things are getting tougher for the mass affluent, especially in high cost areas like the coasts. Times are getting tougher for every other American. What isn't seen in the online version of the article, but is in the print version in BusinessWeek, is that the family is posing for a picture in their hot tub, with their pool in the background. If they are looking to get a little sympathy, that isn't the scene they should have painted. I'm sure that the photographic editor had a lot to do with the setup, but still.

Better be paying taxes on foreign accounts

The IRS is cracking down on U.S. taxpayers that conceal assets in foreign accounts, according to BusinessWeek. Countries have been sharing more information about assets with each other, making it easier to catch tax cheats.

It's not just blatant tax cheats who have reason to worry. The IRS has also focused increased attention on the more than 700,000 U.S. taxpayers thought to be concealing assets in overseas accounts. Some may be doing so unintentionally, like expatriates living abroad and banking locally. A law dating back to 1970 requires a U.S. taxpayer with an overseas account of $10,000 or more to disclose it to the IRS. Until 2004, people who failed to file that special form received a maximum fine of $100,000, and the law was rarely enforced. Now they can face penalties that amount to as much as half the balance in the cloaked accounts, along with prison terms of up to 10 years.

Do the right thing and pay your taxes, or face 10 years in the big house. A pretty easy decision.

Gift taxes when transacting with family members

An article in SmartMoney suggests filing a gift tax form (form 709) every time you engage in a transaction with a family member that is over $12,000 (the annual gift tax exemption). The problem is presented as follows:

Did you sell a house, a car or that inherited Chippendale secretary to your children this year? If so, you should consider filing Form 709. Why? Because the IRS can claim transactions between you and family members were actually disguised gifts. This can potentially happen whenever you sell a hard-to-value asset, like real estate or stock in the family business, to a relative.

Say you sell your vacation home to an adult child for $275,000 in 2008. In your opinion, the $275,000 price represented the full market value at the time. The IRS may disagree. After you are dead and gone, the Feds could audit your estate's tax return and claim the home was actually worth $375,000. This would amount to a $100,000 gift to your child ($375,000 - $275,000), which could trigger a bigger estate tax bill for your heirs. Or if you make lots of taxable gifts during your life, you could wind up owing a bigger federal gift tax bill before you die.

The solution is to file the gift tax form, even though the vacation home sale wasn't a gift. The article gives more specifics, such as the fact that the IRS only has 3 years to challenge the valuation of the vacation home.

This article led me to read up on gift taxes in instructions to IRS publication 709. I didn't know before that there are medical and educational exclusions to gift taxes. I'll have to read through the IRS tax tip on gift taxes and this other article from SmartMoney when I have some time.

Kiddie tax

An article in this week's Baron's goes over kiddie tax changes for 2008. The basics from the story:

Under kiddie-tax rules, a child's unearned income of more than $1,800 (up from $1,700) is subject to the parents' tax rates of up to 35% on interest and short-term capital gains, and 15% on long-term capital gains and most dividends. The first $900 of the child's unearned income is tax-free; the second $900 is taxed at the child's rates. Most children are in the 10% or 15% income tax bracket, and they would typically be subject to the lowest capital-gains tax rate, which this year has dropped to 0%, from 5%.

Keep in mind this special tax treatment is for unearned income, not for earned income kids make by working. The real kicker is that the maximum age of children the kiddie tax applies to is rising to 18, or 23 for full-time, dependent students (it wouldn't apply to children not claimed as dependents on someone else's return). This will obviously effect your ability to lower capital gains taxes by gifting investments to children, and the article explains the ramifications.

I want to bring up one uncommon situation that I think makes this tax change really unfair. (Admittedly, it's far fetched). Let's say you are a full time student in college, under 24 years old, and you are a whiz at the stock market. All you do is pick winners. If you have capital gains of over $1800, and your parents have a higher tax bracket than you do, you'll pay taxes at a higher rate and are therefore penalized.

529 plans are not subject to the kiddie tax, and I'm using them to my advantage. Much more information on child tax rules are in IRS publication 929.

Mortgage refinancing tax trap

Business Week ran a column on a mortgage interest deduction rule that piqued my interest. The interesting parts:

In general, the IRS lets you deduct 100% of the interest you pay on one or more home mortgages, up to a total loan value of $1 million. But when you refinance and withdraw cash, the rules change: Only the interest on your original mortgage balance, plus an additional $100,000, qualifies for a deduction. (If you want to take out more cash, use a home-equity loan or line of credit. The law allows a separate deduction for interest on borrowings of up to $100,000.)

[...]

Here's how the refi tax trap works. Let's say you borrowed $500,000 at 8% in 1998 to buy your house. By 2003, the house had appreciated substantially and the mortgage balance had been whittled down to $450,000. Then you refinanced, taking a new loan of $650,000 at 6%. At tax time, Form 1098 would show that you forked over about $39,000 in interest on the $650,000 mortgage in 2003.

[...]

If you use that $39,000 figure to calculate your annual mortgage interest deduction and you're in the 33% marginal tax bracket, you would wind up taking $1,980 more in deductions than you're entitled to, according to William Lazor, a CPA at Kronick Kalada Berdy in Kingston, Pa. That's because you may take a deduction on a mortgage of only $550,000—the $450,000 left on the original loan plus $100,000. On $550,000, the interest paid would be $33,000, says Lazor.

I did some further looking into this by reading IRS Publication 936. It says that any secured debt that's used to refinance home acquisition debt is treated as home acquisition debt. However, the new debt will qualify as home acquisition debt only up to the amount of the balance of the old mortgage principal just before the refinancing. Any additional debt is not home acquisition debt, but may qualify as home equity debt.

My reading of this publication is that in the example from the article, the $450,000 is the home acquisition debt, and the $100,000 is the home equity debt ($100,000 is the maximum home equity debt you can deduct interest on). I'm a little confused on the first paragraph I quoted, where it implies that the $100,000 in the refinance PLUS a separate $100,000 in another home equity loan can both have their interest expenses deducted. I'll try to contact the author for clarification.

Update:
I was able to get in touch with the article author, and she graciously replied to me. She says that the explanation given in the article was confirmed with several tax experts. I'll continue to research this to prove it to myself.