INDIVIDUAL TAX PROVISIONS

James F. Ivers III

The 1997 tax legislation contains a number of important provisions affecting individual taxpayers. They include reduction of capital gains tax rates, child and higher education tax credits, a new exclusion for the sale of a principal residence, and liberalization of the home office deduction rules. Although Congressional emphasis on fairness and family values is reflected in the legislation, the goal of income tax simplicity is not. The new rules are full of exceptions, qualification, calculation ratios and formulas, and other complications. Taxpayers must also be mindful of the many different effective dates for the new rules.

Capital Gains Tax Rates

Prior Law: Noncorporate taxpayers were generally subject to a maximum tax rate of 28 percent on long-term capital gains. The taxpayer’s required holding period for long-term capital gains treatment was more than 12 months.

New Law: In general, noncorporate taxpayers will be subject to a maximum tax rate of 20 percent on long-term capital gains. However, this beneficial provision also includes additional layers of rules and complexities.

First, the 20 percent capital gains rate will be 10 percent for taxpayers in the 15 percent marginal income rate bracket.

Second, the new lower capital gains rates apply only if the long-term holding period requirements in the new law are met. Sales of assets before May 7, 1997 are taxed under the old rules (28 percent maximum rate). Sales of assets taking place between May 7 and July 28, 1997 are eligible for the lower rates, based on the "more than one year" holding period. Sales of capital assets after July 28, 1997 are taxed at the new lower maximum rates only if the taxpayer has held the asset for more than 18 months. For sales after July 28, 1997, if the taxpayer has held the asset for more than 12 months but not more than 18 months, the 28 percent maximum rate applies as under prior law.

Third, sales of collectibles—such as stamps, antiques, and precious stones—will still be taxed at a maximum rate of 28 percent, not the new lower rates.

Fourth, the portion of long-term capital gain from the sale of real estate that represents "unrecaptured" depreciation will be taxed at a maximum rate of 25 percent, rather than 20 percent or 10 percent under the new law.

Fifth, there are additional rules for sales of capital assets after December 31, 2000. For such sales, the 10 percent rate is lowered to 8 percent and the 20 percent rate is lowered to 18 percent if the taxpayer’s holding period with respect to the asset is more than 5 years. However, with respect to the 18 percent rate (but not the 8 percent rate), the 5 year holding period generally applies only to assets acquired after December 31, 2000. Therefore, the 18 percent rate would not actually be in effect until at least 2006.

Commentary: Although this tax relief for long-term capital gains of individual taxpayers is welcome, it is riddled with hair-pulling complexity that will send many confused clients to their tax advisers for clarification. Of course, the tax incentive for capital gains will tend to favor investments with capital appreciation potential over investments with current ordinary income. On the other hand, fixed-return deferred annuities may become more popular as compared to variable deferred annuities, because the tax-deferred feature of the annuity as applied to long-term capital gains has become relatively less valuable.

Child Tax Credit

Prior Law: No provision.

New Law: The act provides a tax credit against an individual’s tax liability for the year for each qualifying child. For 1998, the amount of the credit is $400 per qualifying child. For tax years after 1998, the credit is $500.

A "qualifying child" for purposes of the credit is one for whom the taxpayer is entitled to claim a dependency exemption under IRC Sec. 151. The child must be a son, daughter, stepson, stepdaughter, or eligible foster child of the taxpayer. In addition, the child must be under the age of 17 at the close of the tax year to be eligible. Finally, the child must be a citizen, national, or resident of the United States.

The taxpayer must include the name and social security number of the child on the tax return in order to claim the credit. If the amount of the credit exceeds the tax liability shown on the return, all or a part of the excess may be refundable under a complex formula that involves the earned income credit computation, the taxpayer’s social security taxes, and the number of children of the taxpayer.

The credit is phased out for upper-income taxpayers. The phaseout occurs based upon the taxpayer’s adjusted gross income with certain minor modifications ("modified adjusted gross income [AGI]"). The phaseout begins at the following levels of modified AGI:

Unmarried taxpayers $  75,000

Married filing joint return $110,000

Married filing separately $ 55,000

The otherwise allowable credit is phased out by $50 for each $1,000 (or fraction thereof) by which modified AGI exceeds the threshold amount. For example, in 1998 when the amount of the credit is $400, a married couple filing jointly with one child would have no child credit if their modified AGI was more than $117,000. This is because their AGI exceeds $110,000 by $7,000 plus a fraction of $1,000. Therefore, the credit is phased out by 8 x $50, or $400, the total amount of the credit.

Under the verbiage of the statute, the credit is apparently phased out sequentially (rather than simultaneously) per child for taxpayers with more than one child. Therefore, taxpayers with more than one child will have a larger "phaseout range" for the child credit. This is different from the phaseout of dependency exemptions for upper-income taxpayers. Such exemptions phase out simultaneously regardless of the number of children.

Commentary: Remember that the taxpayer who claims the dependency exemption for the child is the taxpayer who is entitled to the credit. This rule is important in cases involving divorced, separated, or unmarried parents. Also, the credit may result in many more taxpayers becoming subject to the AMT. The credit cannot be claimed in calculating the AMT.

"HOPE" and "Lifetime" Education Tax Credits

Prior Law: No provision.

New Law: Individual taxpayers are now permitted to claim tax credits for certain expenses for higher education. There are two credits for higher education provided by the 1997 act: the "HOPE scholarship credit" and the "Lifetime learning credit."

Relationship of One Credit to the Other. Before describing the special rules in these credits, it is important to know how they interact. The credits cannot be claimed together with respect to the education expenses of the same student. The HOPE credit applies on a per-student basis, while the Lifetime credit applies on a per-taxpayer basis. This means that the HOPE credit applies separately with respect to each student for whom the taxpayer pays education expenses, while the Lifetime credit applies on an overall basis to all qualifying expenses (for one or more students) paid by a given taxpayer.

Both credits must be elected by the taxpayer with respect to qualifying expenses. The elections must be separate. For example, if a taxpayer elects the HOPE credit for the college expenses of one child, he or she may still elect the Lifetime credit for the qualifying education expenses of one or more other children. Alternatively, the HOPE credit can be elected separately for each child in college. However, the Lifetime credit cannot be elected with respect to the expenses of any child whose expenses have been treated under the HOPE credit.

Expenses Qualifying for the Credits. Both credits are available with respect to "qualified tuition and related expenses." Such expenses include those paid for the attendance by the taxpayer, the taxpayer’s spouse, or the taxpayer’s dependents at a postsecondary educational institution offering credit toward a degree or other recognized postsecondary educational credential. Qualified expenses do not include those for courses involving sports, games, or hobbies unless the course is part of the student’s degree program. Room and board, transportation, and living expenses are also not qualified expenses.

The HOPE credit is allowed only for expenses for the first 2 years of the student’s postsecondary education. The student must be at least a "half-time" student; that is, he or she must carry at least one-half the normal full-time work load for the course of study being pursued. The HOPE credit will not be allowed if the student has been convicted of a felony drug offense during the year.

Coordination with Other Income Tax Provisions. The credits are not applicable with respect to a student whose expenses are paid from an education individual retirement account under IRC Sec. 530(d)(2)(c). Expenses covered by a scholarship that are excludible from gross income under IRC Sec. 117 also do not qualify for the credits. Also, expenses that are qualified for the credits will reduce the amount of the exclusion available under IRC Sec. 135 for certain U.S. savings bond interest used to pay expenses for higher education. Finally, expenses excluded from gross income under IRC 127 (employer educational assistance) do not qualify for the credits.

Rules for Calculating the HOPE Credit. The HOPE credit can be claimed in amounts up to $1,500 per student per year. It is calculated based upon 100 percent of the first $1,000 of qualifying expenses and 50 percent of the next $1,000 of expenses. Therefore, the maximum credit is $1,500 for the first $2,000 of expenses. The expense limits will be indexed for inflation beginning in 2002.

Phaseout of the HOPE Credit. The allowable credit is phased out proportionately for taxpayers with modified AGI (computed in essentially the same way as for purposes of the child credit) in excess of certain levels. For married taxpayers filing jointly, the phaseout range is between $80,000 and $100,000. For single taxpayers, the phaseout range is between $40,000 and $50,000. Married taxpayers filing separately cannot claim the credit.

Rules for Calculating the Lifetime Credit. The Lifetime credit is equal to 20 percent of the first $5,000 of qualifying expenses paid by the taxpayer during the tax year. For 2003 and thereafter, the $5,000 figure is increased to $10,000 (these amounts are not currently scheduled for inflation adjustments). Therefore, the maximum annual Lifetime credit is $1,000 through 2002 and $2,000 thereafter. Note also that the Lifetime credit is available beginning with expenses paid after June 30, 1998, whereas the HOPE credit applies to expenses paid beginning in January 1998.

Unlike the HOPE credit, the Lifetime credit may be claimed for all 4 years of under-graduate education expenses, and for graduate and professional school expenses as well. Also, the Lifetime credit is available with respect to expenses of a student who is taking courses to acquire or improve job skills, even if that student is not a "half-time" student as previously explained under the HOPE credit rules.

Phaseout of the Lifetime Credit. The Lifetime credit is phased out proportionately in the same way and in the same range of income as the HOPE credit, as previously discussed.

Commentary: If the student is not a dependent of another taxpayer, he or she may claim the credit on his or her own return.

Exclusion of Gain from Sale of Personal Residence

Prior Law: There were two major income tax provisions providing tax benefits associated with the sale of a residence. These included the rollover of gain provision under IRC Sec. 1034, and the one-time exclusion of up to $125,000 of gain for taxpayers aged 55 or over under IRC Sec. 121. There were separate rules for qualification under each section, even though the two provisions could be combined and used in one transaction in certain cases.

New Law: Both provisions under prior law have been replaced by a new exclusion for gain on the sale of a principal residence. Effective May 7, 1997, taxpayers of any age who sell their homes can exclude up to $250,000 of their gain ($500,000 for married taxpayers filing jointly).

Ownership and Use Requirement. To qualify for the new exclusion, the property must have been owned and used by the taxpayer as a principal residence for an aggregate of at least 2 years out of the 5 years ending on the date of sale.

For married taxpayers, if only one spouse meets the ownership and use requirements, the available exclusion is $250,000 rather than $500,000. Also, in certain situations taxpayers may "tack on" periods of ownership and use for purposes of the exclusion. For example, a taxpayer whose spouse has died before the sale date can "tack on" the deceased spouse’s period of ownership and use prior to the taxpayer’s ownership and use. Also, if a taxpayer receives a home pursuant to a divorce under IRC Sec. 1041, the taxpayer can "tack on" the transferor’s period of ownership and use.

If prior law’s rollover provision under IRC Sec. 1034 has been used by the taxpayer within the last 5 years, the ownership and use of the home sold under the Sec. 1034 rules may also be "tacked on" for purposes of applying the new exclusion to the current sale.

Also, taxpayers who reside in nursing homes or similar institutions because they are incapable of self-care may treat their stay in such institutions as "use" of their principal residence for up to one year of the 2-year use requirement.

Involuntary conversions under IRC Sec. 1033 are also eligible for treatment under the new home sale exclusion, in conjunction with their treatment under Sec. 1033.

"Once Every 2 Years" Rule. The new exclusion may generally only be used once every 2 years. This 2-year requirement is applied without regard to any sales before May 7, 1997. If a single taxpayer married someone who has used the exclusion within the past 2 years, that taxpayer is allowed a maximum exclusion of $250,000 (rather than $500,000) until 2 years have passed since the exclusion was used by either spouse. This "once every 2 years" rule is obviously related to the "2 out of 5 years" ownership and use requirement.

Reduced Exclusion in Certain Situations. If the taxpayer fails to meet the ownership and use rules or the "once every 2 years" rule and the sale of the home is due to a change of employment, change of health, or other "unforeseen" circumstance (to be defined in forthcoming Treasury regulations), a reduced exclusion may still be available. The reduced exclusion is based on the ratio of the amount which the period of ownership and use (or the period between the last sale and the current sale) bears to 2 years. That ratio is then applied to the amount of the gain from the sale that would be excludible if the requirements for the exclusion were fully met to determine the maximum available reduced exclusion. The reduced exclusion also applies to any sale within the 2-year period beginning August 5, 1997 (date of enactment), that does not satisfy the ownership and use test as long as the individual owned the residence on the date of enactment.

Effective Date and Transition Rules. The new exclusion is generally effective for sales after May 6, 1997. However, the taxpayer may elect to treat sales occurring between May 7 and August 4, 1997, under the old rules. The old rules may also be used for sales that are under a binding contract as of August 4, 1997, but have not yet gone to settlement. This transitional rule will be beneficial for taxpayers who have gain in excess of the new statutory limits and want to use the old rollover rules to defer recognition of all of their gain.

Any depreciation claimed by the taxpayer for periods after May 6, 1997, will reduce the excludible portion of the gain upon sale. This applies in cases where the taxpayer has used the property for rental or business purposes at any time after May 6, 1997, and before the sale of the property.

The exclusion applies automatically unless the taxpayer elects out of it. Generally, information reporting will not be required for sales of homes that result in no taxable gain under the exclusion rules.

Commentary: The new provision will, in the long run, simplify the tax benefits associated with a home sale. The two provisions under prior law (one rollover and one exclusion) have been combined into one exclusion. The only taxpayers who may be hurt by this provision are those who have untaxed gain on their homes in excess of the new $250,000 or $500,000 limits.

Prior Law: The tax law requirement that a qualified home office must constitute the "principal place of business" of the business conducted in the home office (unless one of two other requirements is met; see Commentary below) has given rise to a voluminous amount of litigation. There were many "tests" that various courts applied to interpret this requirement. Regardless of the interpretation, the term "principal place of business" is essentially subjective. The Supreme Court provided some answers (but also more questions) in the Soliman case when it presented its own interpretation of the "principal place of business" requirement. Soliman held that there were two primary considerations in applying the "principal place of business" requirement: the relative importance of the activities performed at each business location, and the relative amount of time spent at each business location. Under this case, some taxpayers were deemed to have no principal place of business, such as those spending most of their time at clients’ business locations. Only Congress or the Supreme Court itself can invalidate a Supreme Court decision.

New Law: Congress has provided some measure of clarification to the "principal place of business" requirement (and has, in part, overturned Soliman) in the 1997 act. Beginning in 1999, the "principal place of business" requirement will be satisfied if the home office is used by the taxpayer for "administrative or management activities," and there is no other fixed location in which the taxpayer performs a substantial portion of such activities for the business conducted in the home office.

Commentary: Several points related to this new provision should be kept in mind. First, it doesn’t take effect until 1999. Until that time, the Soliman case still applies in full for purposes of the "principal place of business" rule. Second, remember that a home office must still always be used exclusively for business purposes to qualify for home office deductions. Third, the "administrative or management activities" rule is just one way, and not the only way, to establish that the home office is the "principal place of business." The new rule is an additional way to qualify. Fourth, under existing law not affected by the 1997 act, if the home office is used on a regular basis to meet with patients, clients, or customers, or is a separate structure not attached to the dwelling unit, the "principal place of business" rule does not apply in the first place. However, as previously stated, the home office must always be used exclusively for business purposes in order to claim home office deductions.

Modification of Rules Regarding "Above-the-Line" Deduction for Health Insurance Costs of Self-Employed Individuals

Prior Law: Under 1996 tax legislation, the percentage of a self-employed person’s health insurance premiums that is deductible "above the line" was increased (see chapter 1 of The American College’s Financial Planning 2000). The deductible percentages were scheduled to increase over time from 40 percent in 1997 to 80 percent in 2006 and thereafter.

New Law: The applicable percentages for the self-employed health insurance deduction have been further increased by the 1997 act. These percentages are now as follows:

Beginning in	Applicable
Tax Year	Percentage
1997	40%
1998 and 1999	45%
2000 and 2001	50%
2002	60%
2003	80%
2004	80%
2005	80%
2006	90%
2007 and thereafter	100%

      Coordination with Rules for Long-term Care Insurance Premiums. The 1997 act also contains an important clarification regarding the relationship of long-term care insurance to the self-employed health insurance deduction. Under the prior IRC Sec. 162(l)(2)(B), taxpayers who are eligible to participate in any "subsidized health plan" maintained by an employer of the taxpayer or the taxpayer’s spouse could not claim the above-the-line deduction. This raised the question of whether a taxpayer who had medical insurance subsidized by an employer could still deduct long-term care premiums above the line if the taxpayer was also self-employed. (See discussion on page 1.4 of Financial Planning 2000.) The 1997 act specifically answers this question by providing that self-employed persons may deduct long-term care premiums using the above-the-line deduction even if they are covered by an employer-provided health plan, so long as that plan does not include long-term care coverage.

Commentary: The clarification of the relationship of long-term care premiums to the self-employed health insurance deduction means that taxpayers who are employed (or who have employed spouses), who have subsidized medical insurance, and who also have self-employment income can deduct the applicable percentage of their personally paid long-term care insurance premiums above the line. Since the applicable percentage is now scheduled to be 100 percent beginning in 2007, this provision will be even more beneficial then.

Deduction for Interest Paid on Loans for Higher Education