The IRS has acknowledged there’s plenty of pain to go around in the current economic downturn. Financially strapped taxpayers can take advantage of several relief initiatives and provisions that could lessen their tax bite. Those with investments posting a loss may be able to “harvest” it or at least reposition themselves for favorable treatment of gains once the economy turns around. The JofA asked AICPA Tax Section Vice President Tom Ochsenschlager to describe some recessionary tax strategies for clients of CPA tax advisers and traps to avoid when financial market bears rule the day.
JofA: You mentioned that owners of qualified tuition programs, better known as section 529 plans, can recognize an ordinary loss from them. How does that work?
Ochsenschlager: I think it’s particularly interesting that the IRS has published [in Publication 970, Tax Benefits for Education] that if you have a 529 plan and the assets’ fair market value is less than when you put them into the plan, then if you completely liquidate the plan, you can take that loss as an ordinary loss, not a capital loss. It is an opportunity for many people to go in, take the loss and then reinvest the proceeds in a new 529 plan.
If you do reinvest the proceeds, you do need to wait at least 60 days to avoid the transaction being characterized as a qualified rollover, which is tax-free but might not be considered a total distribution.
There’s another big caveat, as well: It is an ordinary loss, but it’s a miscellaneous itemized deduction subject to the 2% of AGI [adjusted gross income] limitation. And even worse, if taxpayers claiming the loss are subject to the AMT [alternative minimum tax], they won’t get the loss at all. So you want to be pretty careful with that. But again, many people might have a relatively low AGI this year compared to other years because of the market’s decline. Therefore, this might be an opportune time to take advantage of this provision. Even if the amount gets a 2% of AGI haircut, it still might be a lot better for the taxpayer than claiming a capital loss. [In Announcement 2008-17 (REG-127127-05), March 3, 2008, the IRS stated it plans to provide formal guidance on how to recognize a loss in a section 529 plan but that in the interim, taxpayers may rely upon the interpretation of Publication 970.]
JofA: Another tax-deferred account strategy that has been getting some attention is converting a traditional IRA to a Roth account. But aren’t there some changes coming up in 2010 that could make it worth waiting until then to do a conversion? How can taxpayers decide whether to act now or wait?
Ochsenschlager: If you think the market is going to recover between now and Jan. 1, 2010, then you might want to consider doing it now. But keep in mind another big difference between 2010 and what we see today is that today there is a $100,000 modified adjusted gross income limit, not including the amount of the conversion. If you exceed that limit, or if you’re married filing separately, you can’t do a conversion. In 2010 that income limit is eliminated, and married but separate filers may also take advantage of the provision. Furthermore, if you’re doing the conversion in 2010, you get to pay the tax over two years, 2011 and 2012. So you get a full year’s deferral, plus another year’s deferral of half the amount. What’s not to like there?
If the market is still down in 2010, I certainly hope it will recover sometime not too long after that. If and when it does, all that additional appreciation attributable to the recovery is not going to be taxed at all in the Roth as it would, of course, upon distribution from a regular IRA.
Another big advantage of a Roth is that if you think you might not need it, you don’t have to make any withdrawals at age 70½. That’s an advantage especially for high-net-worth individuals, because they really don’t want to take distributions but would like to pass it on to their children or grandchildren. The Roth is a perfect vehicle to do that, because the children and grandchildren won’t be taxed, either.
Then again, if you think that appreciation will start occurring sooner rather than later, you’re within the income limit and you can forgo the tax deferral, you might consider a Roth conversion this year. You could hedge your bets. It’s not an all-or-nothing thing. If your income is lower than normal—as it might be for many people right now—or your itemized deductions are high and you can convert just enough to avoid getting up into a higher marginal rate, you might do that. A good crystal ball helps.
JofA: But otherwise, individual taxpayers generally are limited to $3,000 in net capital losses that they can deduct against ordinary income, right?
Ochsenschlager: That’s right. The good news, if there is any good news, is that the $3,000 is carried over for the rest of your life; there’s no limit on the number of years it can be carried over. But if you have $60,000 in losses and then you don’t have a prospect of any long-term capital gains in the future, you’re talking 20 years.
JofA: You hear the warnings about the possibility of taxable capital gain distributions from mutual funds even when their net asset value has gone down by a far greater amount.
Ochsenschlager: That catches people off guard all the time. The market has gone south, and mutual fund investors know the funds didn’t do well. They get the report, and they’re saying, “Well, at least I don’t have any tax effects.” They should be very careful, because it’s not unlikely they’ll have large capital gains. This happens when many investors are hitting the panic button and fund managers need cash to redeem people out. There’s a tendency for them to sell the stocks that they think have peaked out, in many cases stronger stocks. That sometimes generates a capital gain that you’d never expect.
JofA: Another surprise to some is cancellation-of-debt income. Home mortgage debt has been talked about and given relief by Congress, but what about credit cards, where taxpayers may think their settlement isn’t going to be taxable?
Ochsenschlager: And it is. I think if you went to the bus stop and asked people if someone negotiated their debt down and the lender forgave the debt, would they be taxed on it, they’d say, “No, because I didn’t get anything. It’s just something I don’t have to pay.” They got the cash and then they spent it on something apparently, because they didn’t have the cash to pay it back. And so they benefited from it directly or indirectly, and they owe tax on it. That catches a lot of people off guard, and of course there are not many in that position who can pay the tax. It is excluded from income, however, when it occurs within bankruptcy proceedings or to the extent that the taxpayer is insolvent. It can also be excluded if it secures a qualified principal residence and a few other instances found in Internal Revenue Code section 108.
If none of those exclusions apply, you could attempt an offer-in-compromise (OIC) with the Internal Revenue Service. One of the big disadvantages of an offer-in-compromise, however, is that you have to pay 20% of the tax you owe up front before they look at the papers, and it’s not refundable.
JofA: For those reasons, OICs have fallen off pretty drastically, haven’t they? Yet the Service recently highlighted them in a news release, along with reminders of other measures by which it said it can provide assistance to distressed taxpayers. Can taxpayers really expect more enforcement relief?
Ochsenschlager: Given the economic conditions, we can probably believe the IRS is going to work with taxpayers more than they have in the past. I think the Service realizes they’ll have to be a little more open to it, because you can’t get blood out of a turnip.
JofA: There’s a lot of debate in Congress right now about a proposed temporary increase of the business net operating loss carryback period from two to five years. It’s been suggested this kind of relief might not have as much stimulus effect as accelerated depreciation and higher dollar limits on section 179 expensing. What’s your take on that?
Ochsenschlager: It’s debatable. Obviously, a company that can use the five-year carryback is a company with current losses. Accelerated depreciation methods, on the other hand, could help companies that are currently profitable by stimulating their interest in acquiring additional assets in the current year. So it’s a bit of an economic judgment as to where you see the most important part of the stimulus: Stimulate profitable companies and encourage them to acquire assets in the near future, or help companies that are having a difficult time currently in the economy by permitting them to get a refund of taxes they paid in prior years.
My own personal view is that a five-year carryback will provide a stimulus. Keep in mind that if the company has had losses for the whole five years, it can’t get a refund, because it won’t have any taxes to recover. If, on the other hand, it was profitable three, four or five years ago but maybe not profitable in the past two years, that may be the profile of a company that has fallen on hard times just on a temporary basis. And therefore, by recovering some taxes they have paid in prior years, they may able to pull themselves up by their bootstraps and become profitable going forward.