Update for 2007 federal income tax returns

Army Lawyer, Dec, 2007

There are a few changes that legal assistance attorneys should be aware of when completing and filing tax returns for military taxpayers this tax season. Most of these changes relate to recent tax legislation for the Alternative Minimum Tax (AMT), (1) mortgage debt relief, (2) deductions for charitable cash contributions, (3) and a number of credits including the Hope and Lifetime Learning Credit, (4) Adoption Credit, (5) and Earned Income Credit. (6) In addition, to aid legal assistance clients with tax planning for future years, legal assistance attorneys should be aware of a change in the taxation of unearned income of minors (7) which will take effect in 2008.

Key Changes for 2007

Expired Provisions

For the last two years taxpayers affected by Hurricanes Katrina, Rita, and Wilma have been granted certain tax benefits under the Katrina Emergency Tax Relief Act of 2005 (8) and the Gulf Opportunity Zone Act of 2005. (9) These benefits included waiver of penalties and delayed repayment of loans from Individual Retirement Arrangements (IRAs) and qualified employer plans, (10) increased limits on amounts allowed for the Hope and Lifetime Learning Credits, (11) and authorization of additional exemptions for housing individuals displaced by Hurricane Katrina. (12) Those tax benefits expired in 2006 and will not be authorized for 2007 federal income tax returns. (13)

Alternative Minimum Tax

The Tax Increase Prevention Act of 2007, passed on 26 December 2007, amended the AMT. (14) Many taxpayers were concerned about the AMT because it increases the tax liability of the taxpayer. (15) The AMT does this by eliminating many deductions and credits normally allowed to the taxpayer, ultimately increasing the taxpayer's tax liability. (16) A taxpayer would have to pay the AMT if his or her taxable income was more than the AMT exemption amount based on filing status. (17)

The Tax Increase and Prevention Act of 2007, temporarily increases the exemption amount before the taxpayer becomes liable for the AMT. This amount is now $44,350 for single taxpayers and $66,250 for taxpayers married filing jointly. (18) However, due to the late action taken by Congress, filing for certain federal income tax returns will be delayed until 11 February 2007. (19) This will affect federal income tax returns utilizing these forms: (1) Internal Revenue Service (IRS) Form 8863, Education Credits; (2) IRS Form 5695, Residential Energy Credits; (3) Schedule 2, IRS Form 1040A, Child and Dependent Care Expenses for Form 1040A Filers; (4) IRS Form 8396, Mortgage Interest Credit; and (5) IRS Form 8859, District of Columbia First-Time Homebuyer Credit. (20)

Mortgage Interest and Debt Forgiveness

On 20 December 2007, the President signed the Mortgage Forgiveness Debt Relief Act of 2007. (21) This statute amends [section] 108(a) of the Internal Revenue Code (IRC) allowing taxpayers to exclude from gross income the discharge of indebtedness on their principal residence. (22) At this time, the statute only applies to discharges of indebtedness on or after 1 January 2007 to 1 January 2010. (23)

Even though the taxpayer's discharge of indebtedness is not included in gross income, the amount that is excluded from gross income will reduce the taxpayer's basis in his or her principal residence. (24) Even though the basis in the home is reduced, the Mortgage Forgiveness Debt Relief Act of 2007 prevents the basis in the home from being reduced below zero. (25) This can affect taxpayers at a later date when they sell the home and realize capital gains.

A taxpayer realizes capital gains on the amount earned on the sale of the home above the taxpayer's basis in the home. (26) Currently, taxpayers who sell a home that they have lived in for two of the last five years are allowed to exclude the following amounts of capital gains on the sale: $500,000 if married filing jointly; and $250,000 if filing as a single taxpayer. (27) For example, if a taxpayer has a basis of $750,000 in a town home purchased in Alexandria, Virginia and that taxpayer later goes into arrears on his mortgage and has $350,000 of indebtedness discharged, he can exclude that amount from gross income. However, the taxpayer's basis in his town home is now $400,000. If that taxpayer were to sell the town home for $800,000, he could only exclude $250,000 of that total amount from gross income and would have to include a capital gain of $150,000 in gross income. If the basis had not been reduced to $400,000, the taxpayer could have excluded the entire amount earned on the sale because the taxpayer's basis in the home was $750,000 and only realized capital gains on the sale in the amount of $50,000, well below the $250,000 exclusion amount.

Section 2(h)(2) of the Mortgage Forgiveness Debt Relief Act of 2007 increases the amount allowed for acquisition indebtedness from $1,000,000 to $2,000,000. (28) Acquisition indebtedness is debt incurred for the purchase, construction, or significant renovations of a home. (29) Under [section] 163(h)(3)(B) of the IRC, taxpayers are limited to a maximum amount of indebtedness on which they receive a deduction for mortgage interest paid. (30) If the taxpayer incurs acquisition indebtedness over this amount, he will not be allowed to take a deduction for the entire amount of mortgage interest paid. (31) The change in the amount of acquisition indebtedness now means that taxpayers who purchase a home over $1,000,000 but less than $2,000,000 can take the entire amount of mortgage interest paid as a deduction.