LAST-MINUTE TAX LAW EXTENDS DEDUCTIONS

With only three weeks left in the tax year, Congress overwhelmingly passed, and the President signed, a tax bill called the Tax Relief and Health Care Act of 2006. The stated primary purpose of the bill was to extend to the beginning of 2006 popular tax breaks that would have otherwise expired on January 1, 2006.

Congress appears incapable of passing a simple tax bill, or one that simplifies taxes. Details of the entire law are too voluminous to report here, but we do cover the major portions. Many of the tax breaks are for lower and middle-income taxpayers, thus accounting for the broad bipartisan support. However, a few items benefit the more affluent.

Health Savings Accounts Improved

Health Saving Accounts (HSA) allow taxpayers to save money tax-free toward future health-care expenses. They require enrollment in a catastrophic health care plan, which saves on premiums that have a much larger deductible and co-pay amount. These larger deductibles and co-pays are paid from the HSA.

HSAs are now permanent, and are enhanced. The health savings account changes generally are effective the beginning of 2007. Here are the changes:

1. IRA holders are allowed a once-in-a-lifetime tax-free transfer of moneys in an IRA to their HSA. This allows one to get more rapid access to money for healthcare.
   
2. Changes the annual deduction limits. The limits, now $2,700 for singles and $5,450 for couples filing jointly, increase to $2,850 and $5,650 respectively in 2007.

Health Savings Accounts have not been as popular as most predicted. For this reason, the expected 10-year cost of this tax-break extension is only $1.0 billion.

Business Deductions  

1. At an estimated cost of $16.3 billion, the biggest ticket item by far in the new law is the research and development credit. In addition to extending the credit for two years, the amount of the credit is increased starting in 2007. The research credit is complicated, but is generally equal to 20 percent of the taxpayer’s “qualified research expenses” that exceed a base amount. Alternatively, the taxpayer can take an alternative incremental credit that uses a percentage of qualified expenses that exceed the taxpayer’s average research expenditures over four years.
   
2. In 1997, Congress allowed clean-up cost of environmental contamination to be expensed (written off immediately), instead of capitalized and written off over a longer period. This provision is extended through 2007.
   
3. The Work Opportunity and Welfare-to-Work credits were renewed for 2006 and 2007, and combined into a single calculation. The law generally does not change the amount of the credit, which remains at 40 percent of first year wages not exceeding $6,000 that is paid to targeted groups. The expected cost of this tax-break extension is $1.0 billion.
   
4. A variety of energy incentives initially part of the 2005 Energy Act were extended. These incentives include deduction of costs for energy-efficient improvements, a credit for constructing new energy efficient homes, a maximum $2,000 credit for installing solar equipment, and a credit for building alternative renewable energy sources.      

Personal Deductions

1. The above-the-line deduction for higher education is continued for 2006 and 2007. The deduction of up to $4,000 is phased out for joint tax returns with adjusted gross income (AGI) of more the $130,000, or single tax returns with AGI over $65,000. The maximum deduction amounts and income phase-out amounts are unchanged from what existed in 2004 and 2005. The expected cost of this tax-break extension is $3.3 billion.
   
2. Teachers can deduct up to $250 of certain expenses. The deduction is an income adjustment (i.e., above-the AGI line), so that the teacher need not itemize deductions or accept the limitations for a miscellaneous itemized deduction. This provision is continued for 2006 and 2007. Although 3 million taxpayers claimed this deduction in 2005, the expected cost of this tax-break extension is $0.4 billion, due to the small individual amount for each of these taxpayers.
   
3. In 2004, Congress allowed individual taxpayers to deduct either state income taxes, or state sales taxes. This allowed residents of a handful of states with no income tax to receive a deduction for local taxes. This provision is continued for 2006 and 2007. The expected cost of this tax-break extension is $5.5 billion.  

Last-Minute 2006 Tax Plans 

1. If you make quarterly tax installments and are not already paying the Alternative Minimum Tax, you can accelerate your January 15 tax installment to the end of December to get the deduction a year earlier. The time value of the early tax installment is more than offset by lowering your federal income taxes an entire year in advance.
   
2. If you are not already paying the Alternative Minimum Tax, you can similarly accelerate other deductions, such as the mortgage payment that is due on January 1.
   
3. Make sure you are maximizing contributions to 401(k) or similar accounts, even if you have to take the money from other long-term savings. The tax savings from these accounts are well worth the long-term commitment to savings.
   
4. If you want to save for college education for children, grandchildren or other relatives, establish a Section 529 account. Although this will not reduce your 2006 taxes, there is substantial long-term benefit in tax savings. By gifting before year-end, you and your spouse can each contribute up to $12,000 per recipient for 2006 without any gift tax impact.
   
5. If you otherwise have taxable capital gains in 2006, consider whether you should sell some of your losers to offset the realized profits. Although selling an investment that still looks promising for solely tax reasons is generally a poor idea, sometimes obtaining the certainty of a certain tax loss is a better idea than holding onto an investment that no longer has great promise. Plan your investment sales to get rid of these losers before year-end.

Fulcrum Inquiry is a licensed CPA firm that performs forensic accounting, fraud investigations, and business appraisals.