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A Few Things You Need to Know about Debt Discharge Income…And A Few Things You Don’t Want to Know

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Generally speaking, the tax code taxes all income.  If you find a $20 bill on the street, it is taxable (seriously).  When you borrow money, you may have better cashflow, but you do not have taxable income because you are legally obligated to pay the money back. 

Example:  Joe borrows $100,000.  Joe has no taxable income because he is obligated to pay the money back.  Joe has no increase in income.

When a lender discharges (forgives) a borrower’s debt, the borrower has taxable income because the borrower received money but did not pay it back.

Example:  Joe borrows $100,000 and is unable to pay it back.  The lender discharges the debt.  Joe has debt discharge income because Joe is made better off by the $100,000 loan that he does not have to pay back.

Of course in tax law there are always exceptions.  I want to discuss three important exceptions that allow taxpayers to defer (notice I didn’t say exclude) debt discharge income.

Debt Discharge When Taxpayer is Insolvent

Insolvency occurs when the market value of your assets is worth less than your debts.  To the extent that you are insolvent, any debt discharge income is not currently taxable.

Example:  Joe borrows $100,000.  A year later, all of Joe’s assets are worth $150,000 and his debts are $210,000.  Joe still owes $100,000 on the debt, he defaults on the loan, and the lender discharges the debt.  Joe is insolvent to the tune of $60,000 ($210,000 debt less $150,000 assets).  Thus, he can defer $60,000 of the debt discharge income.  He is currently taxed on the remaining $40,000 debt discharge income.

Debt Discharge in Bankruptcy

When debt is discharged under Title 11 (bankruptcy), all of the debt discharge income is deferred, even if the taxpayer is not insolvent.  This is a much more favorable rule than the insolvency rule because the deferred debt discharge income is not dependent on the taxpayer being insolvent.

Example:  Same as above except that Joe declares bankruptcy and the $100,000 debt is discharged.  Here, the entire $100,000 is deferred from tax.

Foreclosure & Discharge of Mortgage Debt

There is a special rule for acquisition debt on a principal residence.  Acquisition debt is borrowed to finance the acquisition, construction, or substantial improvement of a home—it may include refinance loans, but only to the extent that it refinances acquisition debt.  Under this rule, up to $2 million of debt forgiveness can be deferred even if the borrower is not insolvent and not in bankruptcy.  Forgiveness can include restructuring the debt or losing the principal residence in foreclosure. 

Example:  Joe takes out a $100,000 mortgage and buys a $150,000 house.  The entire $100,000 mortgage is acquisition debt because it is used to acquire a principal residence.  If Joe takes out a home equity loan for $20,000 to fund a vacation and pay off credit cards, the $20,000 home equity loan is not acquisition debt because it is not used to acquire a principal residence. 

Say, What’s All This Talk About Deferral?

The policy reason behind the tax relief for debt discharge is that if the taxpayer is insolvent, bankrupt, or has lost his principal residence, the taxpayer is suffering financially and it would be unjust to hit him with taxes on the discharged debt. Especially since he probably doesn’t have the cashflow to pay it.

The tax law defers debt discharge income until the taxpayer is better off financially.  This occurs through attribute reduction.  This means you have to take the amount of deferred debt discharge income and reduce certain items such as:

  • Net Operating Losses (NOLs)
    • When your business losses exceed your business income for a year, you have an NOL that can be carried back or forward to offset income in other years
    • Your NOLs are reduced by deferred debt discharge income so more of your income will eventually be taxed.
    • Thus, you pay the tax when you receive income (and have better cashflow) rather than when your debt was discharged.
  • Basis of property
    • “Basis” basically means the cost of an asset.  If you buy a $10,000 piece of equipment, its basis is $10,000.  Basis can be adjusted for items such as depreciation.  If you deduct $1,000 of depreciation on the piece of equipment, its basis is now $9,000.
    • The higher the basis of an asset, the lower the gain when you sell it.  The higher the basis of an asset, the more depreciation you can deduct against it.
    • The basis of assets is reduced by deferred debt discharge income so that more of the gain is taxed when you sell the asset, and less depreciation can be claimed against the asset when its basis is reduced.
    • Thus, the debt discharge income is eventually recognized when you sell the asset, or through lower depreciation deductions

There are other tax attributes, but I just mentioned the two fun ones.  A special note—when you have debt discharge income on your principal residence under the new rule, ONLY the basis of your principal residence is reduced by the deferred discharge income—no other attribute reductions are required.  This will be relevant when home acquisition debt is restructured. 

One Final Complication

Most mortgage debt is recourse debt, meaning that the lender can come after you for any deficiency after a foreclosure sale.  When a foreclosure or short sale occur, there is a debt discharge component and a gain or loss component.

DEBT DISCHARGE = AMOUNT OF DEBT LESS MARKET VALUE OF PROPERTY

GAIN/LOSS = MARKET VALUE OF PROPERTY LESS BASIS

Only the debt discharge component can be deferred under one of the above exceptions.  Gain/loss is not affected by the debt discharge rules.  On a personal residence, the gain may be excluded under the special $500,000 principal residence gain exclusion, and loss is disallowed as a personal loss.

Example:  Jane buys a home for $200,000 with a $150,000 mortgage.  Jane loses the home when its market value is $120,000 (and the mortgage is still $150,000).

Debt discharge = amount of debt ($150,000) less market value of property ($120,000) = $30,000.  This may be deferred under the special rule for debt discharge on a principal residence.

Gain/loss = market value of property ($120,000) less basis ($200,000).  Here, Jane has a loss of $80,000 but it is not deductible because it is a personal loss.  If Jane had a gain, it could be excluded under the special $500,000 principal residence gain exclusion (assuming she meets the requirements).

If the foreclosed asset was a business asset, the loss component would be deductible and could offset the debt discharge income.

Fine Print: This posting contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

EPISODE IV: A NEW HOPE (CREDIT)

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The Hope Credit has been greatly expanded for 2009 and 2010 under the American Recovery Act of 2009. The Hope Credit is increased to the sum of:

  1. 100% of the first $2,000 of qualified tuition and related expenses
  2. 25% of the next $2,000 of qualified tuition and related expenses

The maximum amount of the credit is therefore $2,500.

Prior to 2009, the credit was only available for the first two years of college. For 2009 and 2010, the credit is now available for the first four years of college.

The definition of “related expenses” is now expanded to include the cost of books and other course materials (which were not allowed as qualifying expenses prior to 2009).

Forty percent of the Hope Credit is now refundable—meaning you can get a refund even if you have no tax liability.

Example: John and Joan pay for their son Jim’s college tuition. His tuition, fees, and books for the year cost $5,000. The credit is equal to:

  1. 100% of the first $2,000 of expenses = $2,000
  2. 25% of the next $2,000 of expenses = $500
  3. Total Hope Credit = $2,500

Let’s say John and Joan’s tax liability for the year is $1,300. Prior to 2009, the Hope Credit was not refundable, so the maximum Hope Credit they could take was limited to their tax liability ($1,300). They lost the extra $1,200 Hope Credit. Now that 40% of the Hope Credit is refundable, they are able to take more of the credit:

Refundable Portion: 40% times $2,500 = $1,000

Nonrefundable Portion: 60% times $2,500 = $1,500

The nonrefundable portion of the Hope Credit is still limited to their $1,300 tax liability (they lose $200 of the Hope Credit here), but they can now take a $1,000 refundable Hope Credit so their total Hope Credit is $2,300.

The Adjusted Gross Income (AGI) phaseouts have also been increased for 2009 and 2010. The phaseout range for a Single filer is $80,000 to $90,000, and the phaseout range for a Joint filer is $160,000 to $180,000.

A final note—the tuition and related expenses must be PAID in 2009 or 2010 for an academic period BEGINNING in 2009 or 2010. For example, if your child registers for a Winter 2009 course (which begins January 2009), but you pay the tuition bill in 2008, the tuition was not paid in 2009 and therefore will not qualify for the enhanced Hope Credit.

A final, final note—the Hope Credit will be known as the American Opportunity Credit for 2009 and 2010.

Fine Print: This posting contains general tax information that may or may not apply in your specific tax situation. Please consulteth a tax professional before thou relyest on any information contained in this post.

Important Tax Law Changes for 2009: If you like paying taxes, DO NOT read this.

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Here is an overview of some of the more relevant tax law changes taking effect in 2009.

The Make Work Pay Credit
This credit equals 6.2% of your earned income (e.g., wages, self-employment income). The maximum credit amount is $400 and $800 if married filing jointly. The credit is phased out if your Adjusted Gross Income is more than $95,000 ($190,000 if married filing jointly). You may have noticed an increase in your take home pay a few months ago. This is because the withholding tables were adjusted to reflect this credit.

Economic Recovery Credit
A $250 credit is available if you collect Social Security. If you are married, you and your spouse may each receive $250 if both are on Social Security. The purpose of this credit was to provide relief for people who are on Social Security but do not work. If you work and collect Social Security, the government feels you are double dipping by claiming both credits. Therefore, your Make Work Pay Credit is reduced by the $250 Economic Recovery Credit to prevent double dipping.

Hope Credit Greatly Expanded
The biggest change with this credit is that it is now allowed for the first four years of college. Prior to the law change, it could only be claimed for the first two years of college. The credit has been increased to $2,500 (100% of the first $2,000 of qualified expenses plus 25% of the next $2,000 of qualified expenses). Qualified expenses include tuition, fees, and course materials. Another change is that 40% of the credit is now refundable—which means you can receive up to $1,000 even if you owe no taxes. To add confusion, the Hope Credit is now being referred to as the American Opportunity Tax Credit.

Unemployment Compensation Tax Break
Unemployment compensation is taxable. Beginning in 2009, you can exclude up to $2,400 of unemployment compensation from your income.

Deduction for Sales Tax on Purchase of New Vehicle
If you buy a passenger automobile, light truck, or motorcycle between February 16, 2009 and December 31, 2009 you can deduct the sales tax you paid on the purchase. The deduction is limited to the sales tax on the first $49,500 of the purchase price. The deduction can be used to increase your standard deduction amount or you can take it as an itemized deduction (if you are not electing to take the state and local general sales tax deduction).

Residential Energy Credits

Nonbusiness Energy Property Credit
You may be able to claim a credit of 30% of the cost of certain energy efficient property or improvements you placed in service during 2009. This credit expired after 2007, but it has been reinstated and expanded. The total amount of credit you can claim in 2009 and 2010 is $1,500 (for both years combined, NOT for each year).

Residential Energy Efficient Property Credit
This credit is equal to 30% of the costs for qualified solar electric property, qualified solar water heating property, qualified small wind energy property, and qualified geothermal heat pump property. There is no dollar limitation on the amount of this credit.

Adoption Benefits Increased
For 2009, the maximum adoption credit and the exclusion from income under your employer’s adoption assistance program has increased to $12,150.

Social Security and Medicare Taxes
The maximum amount of wages subject to the social security tax for 2009 is $106,800. There is no limit on the amount of wages subject to Medicare.
This posting contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

This posting contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Cash for Clunkers: If your car is worth less than $4,500 and gets under 18 MPG, read on. If you just want to read about another ineffective government program, read on.

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As you may have heard, Congress recently passed the “cash for clunkers” program. The program covers new vehicle purchases between July 1, 2009 and November 1, 2009. The basic idea is: you trade in your old, gas-guzzling car for a more fuel efficient car and get an allowance of $3,500 or $4,500 depending on how much more fuel efficient the new car is.

How does it work, you ask. Well…

The government issues electronic vouchers to auto dealers that sign up for the program. Dealers can use these vouchers to reduce the purchase price of a new vehicle by $3,500 or $4,500 for customers who trade in an old, gas-guzzler. When customers buy cars, the dealers will submit these vouchers to the Feds and receive payment within 10 days.

Rules for New Passenger Autos

A new passenger auto must have an MSRP of no more than $45,000 and have a Combined Fuel Economy (CFE) rating of at least 22 mpg. The old clunker must have a CFE of 18 MPG or lower. Leased cars can qualify, but the lease has to be for at least 5 years…good luck finding a 5 year lease.

The dealer gets the $3,500 allowance if the new auto’s CFE is at least 4 MPG higher than the trade-in’s CFE. If the new auto’s CFE is at least 10 MPG higher, the dealer gets the $4,500 allowance.

Rules for New Trucks and Vans

There are three sets of rules for various size trucks and vans.

 

Category 1
SUVs and Small to Medium Sized Pickups and Vans

Category 2
Larger Pickups and Vans

Category 3
Trucks between 8,500 and 10,000 pounds

New Vehicle CFE Requirement

At least 18 MPG

At least 15 MPG

NONE

$3,500 Allowance

At least 2 MPG increase over old vehicle

At least 1 MPG increase over old vehicle

Allowed for model year 2001 or earlier trucks traded in for a Category 2 or 3 truck

$4,500
Allowance

At least 5 MPG increase over old vehicle

At least 2 MPG increase over old vehicle

NOT AVAILABLE FOR WORK TRUCKS

The trade-in vehicle:

  • must be in drivable condition
  • must have been insured and registered to the same owner for at least one year prior to the trade-in
    • this prevents people from buying clunkers at junk yards and immediately trading them in for the allowance.
  • must have been manufactured less than 25 years before the trade-in date
It is pointless to trade in a car whose value is higher than the cash-for-clunker’s allowance amount because the dealer has to destroy the car and won’t offer any trade in allowance over the cash-for-clunkers voucher.

This posting contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

High Taxes are No Laffer-ing Matter (Time for a Rant)

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The above graph is the Laffer Curve, named after economist Arthur Laffer. This graph demonstrates that when tax rates are increased past a certain rate, tax revenues will actually decline.  This is because as tax rates increase, people become more and more upset with more and more of their income being taken by government and spent inefficiently.  As they become more and more upset, they take more and more action to decrease their tax liabilities.  The important aspects of the Laffer Curve are:

  • At the 0% tax rate extreme, tax revenues are obviously $0
  • At the 100% tax rate extreme, tax revenues are also $0
    • Why bother working when the government takes 100% of your income?
    • Businesses close operations and move offshore to lower taxing countries (Ireland, Hong Kong, etc.)
      • "Taxes don’t redistribute income, they redistribute people"–George Gilder
    • People may work enough for basic sustenance, but they will likely report no income to the IRS
  • The revenue maximizing rate is represented by the green dot at the peak of the curve
    • The exact revenue maximizing rate is subject to strong debate
  • When the tax rate increases above the maximum point, tax revenues will actually start to decrease
    • By having more and more of their money taken away from them, people will take action:  They will
      • become much more aggressive in their legitimate tax planning
      • become involved in tax evasion (getting paid under the table)
      • cut back on work (why bother working when most of your income is taken by the government)
      • start asking, “Who is John Galt?”
  • The horizontal line running through the two blue dots shows that an equal amount of revenue can be raised at two different tax rates–a low rate and a high rate
  • Between the high rate and the low rate, Congress should set taxes at the low rate because the higher rate will constrain economic growth

People who favor tax increases (interesting how it’s always tax increases on OTHER people) somehow believe that an X% increase in tax rates will lead to an X% increase in tax revenues.  This is economically similar to a business raising its prices 10% and expecting revenues to also increase 10%.  By increasing its prices, the business is lowering demand for its product, and people buy less (either forgoing the product all together or buying from a competitor). 

People have choices in life—they can work or they can enjoy leisure time.  It requires a certain wage for people to forgo leisure time and work.  So, let’s say that you’ve worked 40 hours this week.  To entice you to work an extra hour, your boss offers you $20.  You say “no way, I’ve worked enough this week”.  You turn down working the extra hour because your leisure time is worth more than $20.  Your boss then offers you $30.  You agree because the $30 wage is worth more than an hour of your leisure time.  Now let’s say the government imposes a 35% income tax.  The $30 wage that enticed you to work that extra hour is now worth only $19.50 ($30 wage less tax of 35%).  Since this after-tax wage is worth less than an hour of your leisure time, you choose leisure over work.  Just a quick example of how a high tax on income can shift productive activity to leisure.  By the way, this harms economic growth :( 

Let’s take a look at CURRENT business and personal tax rates:

Top federal tax rate:                    35%

Michigan personal tax rate:       4.35%

Michigan Business Tax Rates:

    Business Income Tax:            4.95%

    Gross Receipts Portion*:           0.8%

Total Tax Rate                         45.10%

These figures don’t include self-employment taxes of 12.4% on the first $106,800 of self employment income plus 2.9% of all self-employment income. 

* The gross receipts portion is based on gross receipts, not profit.  As a percent of net income, it is greater than 0.8%.

Renters Can Claim the Michigan Homestead Property Tax Credit, Too.

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The State of Michigan offers a refundable Homestead Property Tax Credit of up to $1,200 per year for property taxes you pay on your homestead (principal residence). 

Many people who rent their homes or apartments often do not claim the credit since they are paying rent, and not property taxes.  However, a portion of the rent paid actually is used to pay property taxes on the home. 

The State of Michigan assumes that 20% of rent paid is for property taxes.  Therefore, if you pay $900 rent per month ($10,800 per year), 20% of the rent paid is considered payment of property taxes eligible for the property tax credit.  In this example, the 20% of rent that is deemed payment of property taxes amounts to $2,160.

Two more complexities:

  1. you have to reduce the property taxes you paid by 3.5% of your household income.  So, let’s say you make $40,000 per year.  The $2,160 property taxes you paid is reduced by $1,400 ($40,000 * 3.5%) and this leaves $760 of property taxes eligible for the credit. 
  2. to compute the credit,  you multiply the $760 by 60% and the amount of your refundable credit is $456.

To recap:

  1. Compute your deemed property taxes by multiplying your rent by 20%
  2. Reduce your property taxes paid by 3.5% of your household income
  3. Reduce the product computed in Step 2 by 60%
  4. Deposit your refund check

This posting contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

MBT Tax Savings for Service Businesses with Out of State Clients

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Hey, are you excited about the new Michigan Business Tax?

Neither am I.

But there is a bit of good news for services businesses with out-of-state clients.

Service businesses can reduce their MBT tax by “sourcing” their revenues out of state if the benefit of their service is received outside of Michigan. Under the old SBT, service revenues were generally sourced to the state where the services were performed.

Example: A management consultant in Michigan with $700,000 in revenues has a client in Ohio. The Ohio client provides $400,000 of the management consultant’s revenues. Normally, the management consultant would be subject to MBT because her revenues exceed the filing threshold of $350,000.

However, since the benefit of the consultant’s services are enjoyed in Ohio, the revenues can be sourced outside of Michigan. The consultant’s Michigan revenues are now $300,000 and the consultant is now under the MBT filing threshold and will have no MBT tax liability.

Under the SBT, the revenues would be sourced to Michigan, since this is where the services were performed.

While this strategy may not get you under the filing threshold, it may qualify you for more tax credits and lower your overall tax.

Taxpayers must have “nexus” with the outside state(s) to source revenues outside of Michigan. Nexus exists where:
1) the taxpayer has physical presence in the outside state for more than one day

OR

2) the taxpayer actively solicits in the outside state and has more than $350,000 in revenues sourced to that outside state

The MBT statute defines “state” to include foreign countries. So if you perform services for a Canadian client (or a client in any other country), these revenues can be sourced to an outside “state.”

This posting contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

2009 Mileage Rates

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The mileage rates for 2009 for calculating your mileage deductions are as follows:

Business use of your car: 55 cents per mile
Use of your car for medical care or as part of a deductible move: 24 cents per mile
Use of your car for charitable purposes: 14 cents per mile

Expecting Capital Losses? Use Them to Shelter Capital Gains.

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The rules on deducting capital losses are pretty strict. You can deduct capital losses against capital gains. Capital losses can also be deducted against $3,000 of your ordinary income per year. So if you have only ordinary income, no capital gains, and a $30,000 capital loss, it would take you 10 years to fully deduct the capital loss.

If you have such large capital losses, you should review your stocks to see if any have appreciated in value. You can then sell the appreciated stock and generate capital gains. These capital gains will be sheltered by the capital losses. You can then repurchase the stock and obtain a a higher tax basis that reflects its current price.

Our Friend, the Laffer Curve

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The above graph is the Laffer Curve, named after economist Arthur Laffer. This graph demonstrates that when tax rates are increased past a certain rate, tax revenues will decline.

The important aspects of the Laffer Curve are:

  • At a 0% tax rate, tax revenues are $0
  • At a 100% tax rate, tax revenues are also $0
    • No one works when the government takes 100% of his/her earnings
    • Businesses will close operations and move offshore
      • “Taxes don’t redistribute income, they redistribute people”–George Gilder
    • People may work enough for basic sustenance, but they will likely report no income to the IRS
  • The revenue maximizing rate is represented by the green dot at the peak of the curve
    • The exact revenue maximizing rate is subject to strong debate
  • When the tax rate rises above the maximum point, tax revenues will decrease
    • By having more and more of their money taken away from them, people will become discouraged and will not work as long or as productively
  • The horizontal line running through the two blue dots shows that an equal amount of revenue can be raised at two different tax rates–a low rate and a high rate
    • Between the high rate and the low rate, Congress should set taxes at the low rate because the higher rate will constrain economic growth

Arthur Laffer and Stephen Moore (from the Wall Street Journal) have a new book called “The End of Prosperity–How Higher Taxes Will Doom the Economy, If We Let it Happen.” It is an excellent read and explains how lower taxes and other supply side principles fuel economic growth. It is available through the Recommended Books link above.

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