Article: TRHCA - Federal Tax Legislation Offers Significant Tax Benefits


	Jeff Bither

March 2007

Federal tax legislation offers significant tax benefits

TRHCA extends many favorable provisions, provides new ones

In early December 2006, Congress passed the Tax Relief and Health Care Act (TRHCA). The new legislation includes mainly favorable provisions, some of which are retroactive to the beginning of 2006. This article briefly explains the most important changes.

Extended Provisions. For individuals, TRHCA extended a number of popular federal income tax breaks that had expired at the end of 2005, including the following:

Tuition deduction. TRHCA extends for two years, through 2007, the deduction of up to $4,000 (depending on your income) of tuition and fees paid for higher education. You don’t have to itemize to get this deduction, but no deduction is allowed if your adjusted gross income (AGI) is over $80,000 ($160,000 for joint filers).

State and local sales tax deduction. For 2004 and 2005, taxpayers could elect to claim an itemized deduction for sales taxes in lieu of state and local income taxes. TRHCA extends this election for two years through 2007. You can base this deduction on actual sales taxes paid, but only if you have the receipts to back it up. Otherwise, determine the amount of deductible sales taxes for 2006 by using tables provided by the IRS. However, if during 2006 you purchased a motor vehicle, boat, aircraft, home (including mobile and prefabricated homes), and/or materials to build a home, sales taxes paid on such purchases can be added to the IRS table amount.

Deduction for teacher classroom expenses. Before 2006, teachers were allowed to deduct up to $250 of classroom expenses paid during the tax year. Eligible expenses included books, supplies (other than non-athletic supplies for courses of instruction in health or physical education), computer equipment (including related software and services) and other equipment and supplementary materials used in the classroom. TRHCA extends this deduction for two years through 2007.

Archer MSAs. An Archer medical savings account (MSA) offers tax benefits to qualifying individuals who combine high deductible insurance coverage with tax-deductible contributions to an MSA to pay for health care expenses. Distributions from the MSA are tax-free if used to pay for eligible medical expenses. The MSA program expired at the end of 2005, meaning no new MSAs could be set up after 2005. (However, eligible individuals who made or received MSA contributions before 2006, or who are employed by employers whose employees used MSAs before 2006, could continue to make or receive MSA contributions after 2005. They could also continue to receive distributions from MSAs after 2005.) TRHCA extends the program for two years, meaning that new MSAs can be established through 2007.

Credits. TRHCA also extended a number of business income tax breaks that expired at the end of 2005, including the following:

Research and Development Tax Credit. TRHCA extends the R&D credit for two years through 2007, for amounts paid or incurred after 2005 and before 2008. It also increases the value of the alternative incremental credit and adds a new alternative simplified credit, effective for tax years ending after 2006 (see related article on page 5).
Work Opportunity Tax and Welfare-to-Work Credits. The WOT credit applies to employers who hire individuals from groups that are considered to face barriers to employment, while the WTW applies to employers who hire individuals who have received public assistance for an extended period of time. Both credits expired at the end of 2005. TRHCA extends the credits without modification through 2006, then combines them for 2007 and relaxes some of the rules for qualification.
Fifteen-Year Depreciation for Qualified Leasehold and Restaurant Improvements. The cost of leasehold and restaurant improvements is generally depreciated over 39 years. However, qualified leasehold and restaurant improvements placed in service before 2006 could be recovered using the straight-line method over 15 years. TRHCA extends this method through 2007.

Energy tax savings. Finally, TRHCA extends through 2008 several energy tax provisions that would have expired at the end of 2007, including:

Credit for Residential Energy-Efficient Property. This credit equals 30% of expenditures for your personal residence for (a) qualified solar water heating equipment, limited to a maximum credit of $2,000; (b) qualified electricity generating solar photovoltaic property (maximum credit of $2,000); and (c) qualified fuel cell property (maximum credit of $500 for each 0.5 kilowatt of capacity). Before TRHCA, the credit applied only to equipment placed in service during 2006 or 2007. TRHCA extends this credit for one year, for property placed in service in 2008.
Credit for New Energy-Efficient Homes. Homebuilders qualify for a $2,000 credit for each new home sold for use as a residence in 2006 and 2007 if the home (a) is located in the U.S., (b) is substantially completed after August 25, 2005, (c) has an annual heating and cooling energy consumption that is at least 50% below the annual heating and cooling energy consumption of a comparable dwelling, and (d) has building envelope component improvements that account for at least one-fifth of the 50% reduction in heating and cooling energy consumption. TRHCA extends this credit for one year, for property sold in 2008.
Deduction for Energy-Efficient Commercial Buildings. Up to $1.80 per square foot can be deducted for the cost of energy-efficient property placed in service during 2006 or 2007. The $1.80 is cumulative and must be reduced by any deductions claimed in prior years. TRHCA extends this credit for one year, for property placed in service during 2008.

Health Savings Accounts

Eligible individuals (basically, persons covered solely by high deductible health insurance) can make deductible contributions to HSAs, or their employer can make excludable contributions on their behalf. No tax is paid on the earnings in the HSA or on distributions as long as they’re used to pay qualified medical expenses. Distributions not used to pay qualified medical expenses are taxable and are subject to a 10% penalty if received before the taxpayer reaches age 65.

TRHCA contains a number of changes starting in 2007, designed to make it easier for taxpayers (and their employers) to take advantage of these HSAs, including the following.

To help fund an HSA, individuals can make one tax-free transfer from each of their health flexible spending accounts (FSAs) and health reimbursement accounts (HRAs). The transfer can be made any time before 2012. Individuals can also make a one-time-only tax-free rollover, via direct trustee-to-trustee-transfer, from an IRA (but not a SEP or SIMPLE IRA) to an HSA. Only one such rollover can be made during a taxpayer’s lifetime.

Generally, employees who are covered by their employer’s health FSA plan in a given year are ineligible for an HSA in that year. To make it easier for such employees to switch to an HSA, TRHCA provides that, under certain circumstances, employees will not be ineligible for an HSA during any year solely because an FSA in which they participated in the previous year has a grace period that extends into that year. This will allow individuals who no longer participate in an FSA to be eligible for HSAs as of the beginning of the year following the year they no longer participate in the FSA.

The maximum deductible HSA contribution is no longer limited to the insurance’s deductible amount for the year (this limit applied before 2007). That means that, for 2007, the maximum amount that can be contributed to an HSA is $2,850 for self-only coverage and $5,650 for family coverage.

Mortgage Insurance Premiums

TRHCA establishes, under very limited circumstances, an itemized deduction for mortgage insurance premiums paid on acquisition indebtedness for a qualified personal residence. Basically, the deduction is available only for amounts paid or accrued during 2007 for mortgage insurance contracts issued during 2007 for the taxpayer’s personal residence. Furthermore, the deduction is phased-out by 10% for each $1,000 (or fraction thereof) by which the taxpayer’s adjusted gross income (AGI) exceeds $100,000. Thus, the deduction is unavailable for taxpayers with an AGI exceeding $109,000 ($54,500 for married filing separately).

Minimum Tax Credit Relief

Finally, TRHCA provides a limited amount of relief aimed at taxpayers who incurred large alternative minimum tax (AMT) liabilities in previous years because of exercising incentive stock options (ISOs).

To summarize very briefly, taxpayers who pay AMT caused by a deferral AMT preference (such as from the exercise of an ISO where the appreciation is taxable immediately for AMT purposes, but is deferred for regular tax purposes) create a minimum tax credit (MTC) carryover that can be used to offset regular tax in future years, but only to the extent that regular tax exceeds AMT in those years. The excess MTC can be carried over indefinitely.

Unfortunately, the spread between AMT and regular tax is generally so small that it can take many years for a taxpayer to use up an MTC carryover generated by a large deferral preference item, such as that generated by the exercise of a highly appreciated ISO. This is especially true when the phantom AMT gain from exercising the ISO never actually materializes (or creates a large regular tax bill that would be offset by the MTC) because the stock tanks before being sold.

To help alleviate this problem, TRHCA generally allows taxpayers to take advantage of a refundable MTC with respect to certain long-term unused MTCs (i.e., MTCs over three years old). The refundable MTC can offset regular and AMT taxes and is refundable to the extent it exceeds the taxpayer’s tax liability for the year. It is available for six years from 2007 through 2012 but is subject to phase-out for high-income taxpayers.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.