INVESTMENT AND TAX PLANNING STRATEGIES

FOR UNCERTAIN ECONOMIC TIMES

Fenn, Chris . Practical Tax Strategies 83.3 (Sep 2009): 154-168.






Current economic projections suggest that a shortlived recovery may occur in the near future,
followed by a prolonged period of high inflation, economic stagnation, and higher taxes.
Therefore, careful investment and tax planning is essential to protect individuals from these
adverse economic conditions.
Unprecedented deficit and debt levels
The U.S. faces unprecedented annual federal deficit levels of S 1 .8 trillion in 2009 and $ 1 .2
trillion in 20 1 0.1 The Government Accountability Office (GAO) projects that the gross national
debt will reach a staggering $12.8 trillion by the end of 201 0.2 This amount is more than 90% of
the $14.0 trillion U.S. Gross Domestic Product (GDP) projected by the International Monetary
Fund for 20 10.3 The GAO projection is particularly disturbing, given that the gross debt-toGDP
percentages for 1990 and 2000 were only 56% and 58%, respectively4 Equally disturbing,
unfunded liabilities are expected to climb to $79.3 trillion by the end of 201 05 (see Exhibit 1).
These debt levels are being exacerbated by increased government intervention in the struggling
private sector (e.g., banks, insurance companies, automobile manufacturers, as well as small
businesses, unemployed workers, senior citizens, homeowners, etc.). In order to pay for the level
of social welfare benefits the federal government has promised, the Federal Reserve will:
* Issue new Treasury securities to investors.
* Monetize new Treasury securities (i.e., issue and buy back its own securities) and retire
maturing Treasury securities, by printing cash to meet the Treasury debt obligations.
Recent federal bailouts. The Emergency Economic Stabilization Act, enacted on 10/3/08, and the
American Recovery and Reinvestment Act, enacted on 2/17/09, committed $1.5 trillion of
federal funds to stimulate a flagging economy. These Acts followed a $30 billion loan guarantee
in March 2008 that enabled JP Morgan Chase to acquire Bear Stearns and a $200 billion
takeover of Fannie Mae and Freddie Mac in September 2008. Loans to AIG totaling $182.5
billion were made during the period November 2008 to March 2009, and more recently, the
government has committed loans to GM and Chrysler totaling $22.9 billion.8
Federal budget deficit. Despite the staggering level of proposed 2009 and 2010 federal budget
deficits, the federal spending budget provides little room for spending cuts- the greater portion of
the spending budget is earmarked for nondiscretionary commitments such as Medicare and
Social Security entitlements, military spending, and interest payments7 (see Exhibit 2). Without
major spending cuts, the U.S. will be required to raise substantially more tax revenue in order to
service the mounting debt.
Threat of individual tax hikes
Individuals currently represent the largest source of Treasury revenues. Individual income taxes
combined with employment taxes, account for more than 80% of all Treasury revenues, and five
times the Treasury revenues exacted from corporations and estates combined8 (see Exhibit 3).
Therefore, individuals are likely to bear the brunt of future tax increases through some
combination of income and employment taxes. This view is supported by the relatively low
individual rates from both a global and historical perspective.
The top U.S. corporate rate is higher than every western European country, Russia, Japan, China,
and Australia. The top U.S. individual rate is lower than nearly every western European country,
Canada, India, Japan, China, and Australia. In order to remain competitive in global markets,
the U.S. is not likely to increase significantly corporate tax rates. Given the relatively low U.S.
individual tax rates in comparison to other countries, individuals, not corporations, are likely to
be the primary target for future tax increases (see Exhibit 4).
Top individual tax rates have been in the 50% to 94% range for nearly two-thirds of the history
of the current tax system.10 (Under the Jobs and Growth Tax Relief Reconciliation Act of 2003,
the top ordinary rate of 35% will remain in effect through 2010. Without congressional
intervention, after 2010 the top ordinary rate reverts to the pre-2001 rate of 39.6%.) In
developing a solution to the mounting federal debt, lawmakers might view the current top
individual rate of 35% as low from a historical perspective and future tax hikes as a return to the
norm (see Exhibit 5).
Threat of stagflation
Throughout history, governments have tried to solve financial problems by simply printing more
money. This can drive the value of money drastically downward, especially in modern markets
where money is not backed by gold. For example, doubling the number of dollars in an economy
makes those dollars worth half as much in comparison to stable foreign currencies. Absent
countermeasures by the government, a weakened currency can lead to inflation.
Under normal circumstances, a rise in the inflation rate follows a strengthening economy as the
velocity of money in circulation increases (velocity is the speed at which money changes hands).
A common governmental response to inflation is to raise interest rates. Higher interest rates help
to "cool" the economy by tightening the credit markets- fewer business and consumer loans
mean less spending and consumption, which help prevent inflation from spiraling out of control.
A case of hyperinflation. Following World War I, Germany had to make war reparations of
about $33 billion. Its GDP had plummeted to the point where it was unable to produce sufficient
output to cover its commitments. Consequently, the government's only choice was to print more
and more money, none of which was backed by gold. This resulted in unprecedented
hyperinflation. By late 1923, 42 billion German marks were needed to buy one U.S. cent.
Something that had previously cost just one mark in 1919 cost 726 billion marks to buy in
1923.11
A case of stagflation. U.S. economic conditions in the 1970s were far from normal as inflation
and a recession occurred at the same time. The unusual economic condition was coined,
"stagflation" (a stagnant economy coupled with inflation). During this time, the supply and
velocity of money in circulation were substantial. Consumers were encouraged to spend because
prices were increasing quickly (price inflation). The rapid rise in the price of oil, however,
caused many businesses to become unprofitable and forced them to lay off workers.
Unemployment grew in spite of an increase in the money supply. The end result was stagflation
(i.e., price inflation, high unemployment, and a weak economy). By 1980, inflation spiked to
13.5%.12 In its wake, unemployment rose to nearly 10% in 1982 and 1983, the highest level
since the Great Depression.13
In times of stagflation, the common governmental response to inflation, raising interest rates,
serves only to slow down an already stagnant economy by slowing the velocity of money. Also
the common governmental response to a weak economy, lowering interest rates, serves only to
fuel inflation. In the late 1970s, rising prices defied all remedies since it is impossible to
stimulate a "stagflationary" economy by lowering rates while simultaneously fighting inflation
by raising rates. Pressure on industry leaders by Democratic and Republican presidents alike
eventually led to government controls on what companies could charge for their products.
However, the price controls did not fix the problem.
A second attempt to solve 1970s stagflation was more successful. In the early 1980s, Federal
Reserve Chairman Paul Volcker significantly lowered the money supply as oil prices began to
moderate. These actions eventually led to lower inflation, 3.6% in 1987, and lower
unemployment, 5.3% by the end of 1989.14
Current policy. Federal Reserve Chairman Ben Bernanke announced in March 2009 that more
than $1.5 trillion is being printed to allow the Fed buy up to $300 billion of longer-term Treasury
securities for its own portfolio and $ 1 .25 trillion of distressed mortgage-backed bonds.15
Current federal spending policy is expected to provide short-term benefits by increasing
consumption and ending the current economic contraction. However, some leading economists
predict that the long-term impact of this spend-and-print policy will be to accelerate supply
destruction (i.e., depletion of oil, gas, and other natural resources), fuel inflation, and raise
unemployment.
For instance, Milton Friedman, a Nobel Prize winning economist who once backed the
Keynesian approach, was one of the first to break away from commonly accepted principles. In
his work, A Monetary History of the United States, 1867-1960 (1971), a collaborative effort with
fellow economist Anna Schwartz, Friedman argued that the poor monetary policy of the Federal
Reserve was the primary cause of the Great Depression in the U.S., not problems within the
savings and banking system. He argued that markets naturally move toward a stable center, and
that it was an incorrectly set money supply that fueled inflation and accelerated supply
destruction.
Due to a timing lag between federal spending and market stabilization, the money supply has
decreased, not increased, in the first half of 2009. The money supply reduction has been due
primarily to collapsing markets and failing banks. Huge financial entities have been undergoing
massive de-leveraging (i.e., selling off stocks, commodities, and other investments) in order to
accumulate cash and stave off bankruptcy. The drop in the money supply may have given the
impression that the current economic environment has been "deflationary' In the near future,
however, the massive federal bailouts are expected to begin loosening the credit markets by
flooding trillions of new dollars into the economy. This may cause the stock market and some
economic indicators to rise and give the appearance that the U.S. economy is showing signs of a
recovery18
The Governments efforts to stimulate consumption and create jobs will increase the money
supply by an order of magnitude never seen before in the U.S." Many experts feel that, once the
credit markets stabilize, inflation and unemployment may return to, or even exceed, the levels of
the 1 970s. As the government grows, partly as a "solution" to economic difficulties, the
increased burdens of government, such as taxes, controls, and spending, may adversely affect
both consumers and businesses. Continued government spending on unemployment benefits and
"make work" projects may not effectively compensate for the large job losses in the private
sector. The adverse impact from a possible return to stagflation may be compounded by
increased social unrest and heightened global conflicts.
During 1995-2008, many state and local governments over-extended themselves. Because they
thought that good times (and housing booms) would last indefinitely, they took on more
spending and more borrowing. Many of these jurisdictions will be forced into either spending
cuts, higher taxes, or both. Some municipalities may be forced into bankruptcy. California and
New York State are already seeking federal bailouts, and more states will follow. Because of
these events, some areas may experience heightened social unrest due to major cutbacks in social
services (e.g., police and firefighter furloughs, cuts in education, and reduced welfare and
medical assistance) fueled by mounting frustration over higher unemployment and rising prices.
International conflicts over scarce natural resources also may become a pressing issue over the
next several years. As China, India, Middle Eastern countries, and other developing nations seek
to address the wants and needs of their growing populations, there will be aggressive competition
for the worlds limited resources. Natural resources will be seen as strategic as well as economic.
Planning for possible stagflation
By evaluating key economic data and anticipating future economic events, some of which may
be unavoidable, tax planners can better help their clients take appropriate measures to ensure
longterm financial security. Given, the strong possibility of inflationary times ahead coupled
with a stagnant economy, tax planners might consider exploring reallocation strategies more
suitable to these economic conditions. Here are some investments to consider for a new portfolio
or a reallocation plan:
Treasury I-bonds. I-bonds are designed to offer protection from inflation. The I-bond interest rate
has two components:
1. A fixed interest rate that is set when the bond is purchased.
2. A variable-rate portion that changes twice a year based on inflation, as measured by the
Consumer Price Index (CPI).
The portion that adjusts for inflation gives investors essential protection against erosion in the
purchasing power of the dollar in times of high inflation.
Tax advantages. I-bond interest is subject to federal income tax, but exempt from state and local
income taxes. Tax reporting of interest can be deferred until redemption, final maturity, or other
taxable disposition, whichever occurs first. Alternatively, with a proper election, interest can be
reported annually. This election may be advisable if the "bunching" of interest income in the year
of maturity would raise a taxpayers federal income tax bracket to a higher rate. For taxpayers not
above an income phase-out range (in 2009, $104,950 to $134,900 for married filers; $64,950 to
$84,950 for single filers), federal income tax on the interest income can also be avoided by
properly registering the I -bonds for education at the time of purchase and redeeming the bonds
in the same year that college tuition is incurred.18
Other features. I-bonds cannot be bought or sold in the secondary securities market. They are,
however, redeemable after 12 months, with three months interest penalty and after five years
with no penalty. The minimum purchase price is $25; the maximum is $5,000. Interest is paid
only at maturity. Maturities for all I-bonds are 30 years from the issue date. Ibonds can be
acquired directly at anytime online from TreasuryDirect or through banks, credit unions, or
savings institutions. Several mutual funds and exchange traded funds (ETFs) are indexed to this
asset class. Investors often prefer ETFs over mutual funds because:
1. ETFs typically have a lower expense ratio than comparable mutual funds.
2. ETFs generate capital gains only when actually sold by the investor- investors in mutual funds
have no control over capital gains during the holding period.
3. ETFs can be traded during the day like stock, while mutual funds can be traded only at the end
of the day at the mutual fund's closing price.
Treasury Inflation-Protected Securities (TIPS). In contrast to I-bond interest, TIPS interest is
paid semiannually and the interest rate is fixed. However, the underlying principal of TIPS rises
and falls with changes in the inflation rate, as measured by the CPI. As principal changes, the
interest also changes. Thus, like I-bonds, TIPS can provide an important hedge against high
inflation.
Tax advantage. Semiannual interest payments and inflation adjustments that increase the
principal are exempt from state and local income taxes but are subject to federal tax in the year
that they occur. The education-related federal income tax exclusion available for I-bonds
(discussed above) is not available for TIPS. The annual federal reporting requirement can be
avoided by holding TIPS in a tax-advantaged account such as an IRA. However, TIPS purchased
through TreasuryDirect have to be maintained in a taxable account. Other ways to purchase TIPS
are identified below.
Other features. TIPS can be obtained at auction through TreasuryDirect, Legacy Treasury Direct,
or through banks, brokers, and dealers. The minimum purchase price is $100; the maximum is $5
million. Maturities are five, ten, or 20 years. TIPS can also be acquired indirectly through mutual
funds and ETFs. Unlike I-bonds, TIPS can be bought and sold prior to maturity in the secondary
securities market.
Investment-grade rental real estate. Over time, investment-grade rental real estate may provide
an effective inflation hedge. A wide selection of ETFs (explained above) and Real Estate
Investment Trusts (REITs) invest in investment-grade property such as Class "A" office rentals,
hotels, "super-store" shopping centers, and high-rise apartment buildings. These investments
offer the benefits of real estate ownership without the issues typically faced by landlords. Unlike
bonds with predetermined rates of interest, which lose relative value in times of high inflation,
these investments tend to increase as lease terms expire and new lease rates, adjusted for cost of
living changes, replace old rates.
REITS. EITs are nontaxable "pass-through" entities. Equity REITs own and most often manage
their own commercial real estate; they derive most of their revenue and income from rents.
Mortgage REITs make loans secured by real estate, but generally do not own or operate real
estate. Hybrid REITS provide both functions. REITs must distribute at least 90% of their taxable
income (primarily from rent) to their shareholders. Most pay out 1 00%. Because these
distributions bypass corporate taxation, they are not eligible for the 15% dividend tax rate.
REITs, however, provide the important advantages of liquidity and diversity. Unlike ownership
in individual real estate, REIT shares can be quickly and easily sold in a stock market. Because
REITs comprise a portfolio of properties, rather than a single property, they are subject to less
financial risk than individual properties.
Other hedges against inflation or economic contraction. Various other investment vehicles can be
used to hedge the risks of inflation or economic contraction.
Carefully selected commodities. Precious metals, such as gold and silver bullion, tend to retain
their value during a period of economic uncertainty and rising inflation. They can be acquired
directly through most major coin and precious metals dealers, as well as brokerage houses and
participating banks. Precious metals can also be acquired through mutual funds or ETFs.
American Eagle gold bullion coins are minted in four weights- 1Ao, 1A, 1A, and 1 ounce- to fit
a variety of budgets. Other commodities to consider as a possible inflation hedge might include
industrial metals (e.g., copper, lead, zinc, aluminum, and nickel), energy (e.g., oil, coal, and
uranium), grains (e.g., corn, wheat, rice, soybean, cotton, and sugar), livestock (e.g., hogs, pork
bellies, and cattle), and foreign currencies. Risks associated with pricing, supplies, costs, and
political climate should be carefully weighed before investing in commodities.
Currency ETFs. Another possible way to hedge against inflation (i.e., a weakening U.S. dollar) is
to buy foreign currency ETFs through hedge funds, investment management firms, or retail
foreign exchange brokers. However, in a global economic crisis, this hedge may not protect
against inflation if foreign currencies are also being devalued against hard assets.
ETFs tied to "human need." In a stagnant economy, sectors tied to human need (e.g., food, water,
energy, and discount merchandisers) may fare better than sectors tied to discretionary
consumption (e.g., brand name retailers, financial services, autos, airlines, hotels, vacation
resorts, and other "big ticket" items). The large selection of available ETFs enables investors
quickly and easily to build a diversified portfolio that meets any asset allocation model.
Cash reserves. Investors should consider having some money set aside in a safe venue, such as a
highly liquid Treasury money market fund. This is not for long-term investment purposes
because inflation will erode the intrinsic value of currency; rather, it should be held as an
emergency fund for day-to-day needs.
Planning fortax rate hikes
Whether Uncle Sam continues to exact his revenue under the traditional tax system or some
other system (e.g., the alternative minimum tax, the "fair tax," or the "flat tax"), tax revenues
collected in the long run are going to have to increase substantially. Therefore, careful current
and longrange tax planning has never been more important to highly compensated taxpayers or
owners of substantia] assets.
Roth IRA planning. Since its inception in 1997, the Roth IRA has remained out of reach for
high-income earners due to the income limits imposed on both direct contributors (in 2009, $ 1
76,000 for married filers and $ 1 20,000 for single filers) and rollover contributors ($100,000 for
married and single filers).19 Recent tax law changes, however, will enable high-income earners
to participate in the Roth IRA through careful tax planning. This opportunity may prove to be
especially beneficial if future tax hikes are substantial.
The $ 100,000 income ceiling for converting traditional IRAs to Roth IRAs is permanently
eliminated for tax years after 2009.20 Taxpayers who convert in 2010 will have the option of
recognizing the conversion income in 2010 or averaging it over the two subsequent years (201 1
and 2012).21 Although this provision does not extend to 401(k) plans, nothing would prevent
Roth IRA conversions of traditional IRAs that have received proceeds of 401 (k) balances when
an individual leaves employment. Nor does the new law prevent highincome taxpayers from
contributing to nondeductible traditional IRAs now in anticipation of converting to Roth IRAs in
2010. Individuals may want to consider consolidating 401(k) accounts from prior employers and
other plans into a conduit traditional IRA to facilitate a later conversion to a Roth IRA.
Key advantages of Roth IRAs over other retirement plans (e.g., 40 1 (k) plans and traditional
IRAs) include:
1. The tax-free, not merely tax-deferred, accumulation of income.
2. The tax-free treatment for the distribution, at any age, for any reason, of amounts previously
contributed.
If the distribution represents amounts previously contributed by check or by nontaxable rollover,
they will also be penalty-free regardless of age or the reason for which the distribution was
taken. Because Roth IRAs are intended by Congress to be tax-free, their owners are not required
to begin taking minimum distributions at age 701Zz. If a Roth IRA owner dies, and the owners
spouse becomes the sole beneficiary ofthat Roth I RA while also owning a separate Roth IRA,
the spouse is permitted to combine the two Roth IRAs into a single account without penalty.
Roth distributions. In order to determine the character of a distribution, the actual order of items
entering the Roth IRA account is not considered. Instead, amounts withdrawn are deemed to
have previously entered the Roth IRA account in the following order:
1 . Direct contributions (e.g., payments by check) are deemed to be withdrawn first.
2. After amounts equal to direct contributions are fully withdrawn, rollover contributions
previously taxed are deemed to be withdrawn on a first-infirst-out basis.
3. Next, rollover contributions previously tax-free, on a first-in-first-out basis.
4. Finally, earnings from the Roth IRA are treated as withdrawn.
As indicated above, a distribution of items 1 and 3 above can be withdrawn tax-free, penalty free
under any circumstance. Therefore, the remainder of this tax discussion centers on items 2 and 4.
Item 2, the distribution of an amount previously contributed in the form of a taxable rollover, is
taxfree under any circumstance. To avoid a 10% penalty on the distribution, however, the
previously-taxed rollover must have been held for at least five years. The five-year holding
period is deemed to begin on January 1 of the rollover year.
Item 4, the distribution of Roth earnings is tax free and penalty free only if both a five-year test
and a qualifying-events test are met.
The five-year test is applied differently for earnings attributable to direct contributions than for
earnings attributable to previously taxed rollovers. For earnings attributable to direct
contributions, the five-year holding period requirement is met once the initial contribution has
been held for five years. The five-year holding period is deemed to begin on January I of the
initial-contribution year. Direct contributions can be applied to a current year as late as that year's
filing due date (i.e., April 15 of the following year). The amount does not matter (several internet
companies will accept an initial contribution with no minimum requirement). Once the five-year
holding period has been satisfied for that initial amount, it is deemed to be satisfied for all
subsequent direct contributions, for the lifetime of the taxpayer, even if made into different Roth
IRAs.22 For earnings attributable to previously taxed rollovers, a separate five-year test must be
applied to each rollover year. The beginning date for each rollover year is deemed to be January
1 of the rollover year.
Section 408A(d)(A) identifies a qualifying event as a distribution made:
1. On or after the date on which the individual attains age 59 12.
2. To a beneficiary (or to the individual's estate) on or after the individual's death.
3. Because the individual is disabled (an individual is considered to be disabled if he or she is
unable to engage in any substantial gainful activity by reason of any medically determinable
physical or mental impairment that can be expected to result in death or to be of long-continued
and indefinite duration).
4. For a "first home" purchase, not to exceed $ 1 0,000 (lifetime aggregate limit).
Thus, "earnings" represents the only component of a Roth IRA balance that must satisfy both
teststhe five-year holding period test and the qualifying events test- to get tax-free, penalty-free
treatment.
Vacation home as a retirement fund. Qualified plans, such as 401 (k) plans and Roth IRAs, may
not be sufficient to meet the retirement objectives for taxpayers in the 35% ordinary rate bracket
(taxable income above $372,950 in 2009). The maximum earnings subject to deferral
calculations is limited to $245,000, and the limit on employee contributions to the plan is capped
at $ 1 6,500 in 2009 ($22,000 for employees age 50 and above).23 A popular tax planning
strategy, particularly for taxpayers with children, has been to own a vacation home. While the
children are living at home, the family enjoys the "retirement fund" on weekends. Once the
parents become "empty nesters," they make the vacation home their principal residence.
Up to $500,000 of the gain on sale of the former principal residence is tax free, while any excess
gain is taxed at 15%. Once the parents own and occupy the second principal residence for at
least two years, they become eligible for another exclusion of up to $500,000 on the later sale of
the second principal residence. Recent tax law changes affecting the portion of the gain eligible
for the exclusion now require increased due diligence by tax planners in considering the viability
of vacation homes as retirement funds.
With the recent enactment of the Housing and Economic Recovery Act (HERA), taxpayers can
no longer convert a vacation or rental home into a main home after 2008 and have their entire
gain qualify for the home-sale exclusion. Starting in 2009, the portion of gain allocated to a
period of "nonqualified use" is taxable at the capital gain rate. A period of nonqualified use is
any period (other than any period before 2009) during which the property is not used as the
principal residence of the taxpayer, the taxpayer's spouse, or the taxpayers former spouse.25 A
period of absence generally counts as qualifying use if it occurs after the home was used as the
principal residence.
The apportionment of gain attributable to nonqualified use is determined by dividing (1) the
aggregate periods of nonqualified use during the period the property was owned by the taxpayer
by (2) the total period the property was owned by the taxpayer. Because any of the taxpayers
gain attributable to depreciation allowed or allowable after 5/6/97 is not excluded from income,
it is not included when calculating the gain allocated to nonqualified use.
In applying the gain required to be included on the sale of the principal residence by this
provision, the new law is applied after the rules of Section 1 2 1 (d)(6), which reduces the gain
excluded by any depreciation allowed or allowable under Section 1 250(b)(3) for periods after
5/6/97.27
Example. Ceci purchased property on 1/1/01 for $600,000 and rents it for ten years, claiming
$200,000 of depreciation. On 1/1/11, Ceci begins to use the property as her principal residence.
Ceci moves out of the house on 1 2/3 1 / 1 2, and sells it on 1 2/3 1 / 1 5 at a $500,000 gain. The
income tax consequences of the sale are as follows:
* The $200,000 gain attributable to depreciation is taxable as unrecaptured Section 1250 gain as
required under current law.28
* The remaining gain, $300,000, is subject to the allocation rules for nonqualified and qualified
use. The years 2009-2010 represent a "non-qualifying use" period. The years 2013-2015, after
Ceci moves out, are treated as a "qualifying use" period. Thus, of the $300,000 remaining gain,
2/15 (two years out of 1 5 years owned), or $40,000, is not eligible for the exclusion. The
balance of the $300,000 gain, $260,000, may be excluded.
A taxpayer who has converted a vacation or rental home into a principal residence before 2009 is
eligible to use the home-sale exclusion potentially to shelter the full gain. For conversions
occurring after 2008, several exceptions apply to the general definition of "nonqualified use"
period:
* Any period after a home ceases to be a principal residence (and within five years before the
sale) is not considered a nonqualified-use period under the new rules.29 This exception gives the
taxpayer time to sell the principal residence after moving out of it, without having to count this
time as nonqualified use, which would increase the portion of the gain the taxpayer would be
required to recognize on the sale.
* Another exception applies to periods of temporary absence from the taxpayers principal
residence, not exceeding two years in total, attributable to a change of employment, health
conditions, or other unforeseen circumstances that are specified by the IRS.30
* Also, if the taxpayer elects to claim less than "allowable" depreciation (or claims no
depreciation), while the property is held for nonqualified use, unrecaptured Section 1 250 gain is
limited to the actual amount of depreciation claimed.31 The benefits associated with electing out
of depreciation should be weighed against the tax benefits foregone by not claiming the
depreciation.
If the parents decide not to sell the second principal residence and instead allow it to transfer to
the children after death, the entire appreciation on the home would escape income tax since it
would be treated as an inheritance. Any depreciation claimed by the parents would not carry over
to the children as "unrecaptured Sec. 1250 gain!'32 In comparison, the testamentary transfer of
amounts in a taxable plan, such as a Section 401(k) account, would be subject to ordinary income
tax on the eventual distribution to the heirs.
Finally, any gain attributable to nonqualified use under HERA would be subject to the favorable
capital gain rate. In comparison, withdrawals from a taxable retirement plan would be subject to
the higher ordinary rate (currently up to 35%). The viability of a vacation home as a retirement
fund has been enhanced by the current real estate slump in which opportunities abound for
quality properties at attractive prices.
Planning for the alternative minimum tax (AMT).
AMT is calculated in the following manner:
1. First, an individual adds back various tax preference items to the taxable income under the
regular income tax.33 This grossed up amount then becomes the tax base for the AMT.
2. Next, the amount of the basic exemption is calculated and subtracted from the AMT tax
base.34
3. A two-tiered tax rate structure of 26% and 28% is then assessed against the remaining AMT
tax base to determine AMT tax liability.33
4. The taxpayer then pays whichever is greater, the regular income tax liability or the AMT tax
liability.
5. Finally, the AMT tax credit is calculated as an item to be carried forward to offset regular
income tax liabilities in future years.36
For 2009 only, Congress approved a one-year patch for the AMT, increasing the basic AMT
exemption from $45,000 to $70,950 for married couples filing jointly and from $35,750 to
$46,700 for unmarried taxpayers.37 This means that about five million married and single filers
will likely pay ??? in 2009.
Congress is currently reviewing several proposals to modify or eliminate AMT. If nothing is
done, more than 25 million Americans will be subject to AMT in 2010. By comparison, back in
1970, just 20,000 taxpayers were affected. If former President Bush's tax cuts implemented since
200 1 expire as scheduled, 53 million taxpayers- or about half of all taxpayerswill pay the AMT
by 2017.38
AMT planning strategies. Taxpayers can reduce the impact of the AMT by implementing certain
strategies.
* Taxpayers who expect to be subject to only the regular tax in this year but to the AMT next
year, should follow traditional tax planning strategies in 2009, namely delaying income and
accelerating deductions. In order to achieve the right objective, taxpayers should carefully plan
the timing of such items as:
1. Commissions and bonuses.
2. Redemption of Treasury securities.
3. Sale of capital assets.
4. Exercising of nonqualified stock options.
5. Withdrawals from qualified plans.
6. Mortgage payments due in early January.
7. State income tax or alternative sales tax deduction.
8. Charitable contributions.
They should also evaluate whether to depreciate or immediately expense office furniture and
equipment purchases. Care should be taken to accelerate receipt of income or to delay payment
of expenses up to the point when the regular tax equals the amount of taxes due under the
tentative minimum tax. An overly aggressive plan may trigger AMT.
* If AMT is likely to be imposed this year, the traditional tax planning strategies are reversed.
The new game plan should be to accelerate income and delay deductions, particularly if the
timing places the taxpayer below the AMT income limit for 2010. For high-income earners,
income recognized in an AMT year will generally be taxed at 26% or 28% rather than at the
regular rate of up to 35%. Expenses paid in a "non- AMT" year shield income from the 35%
regular rate rather than the 28% AMT rate. If the expense is not allowed for AMT purposes (e.g.,
property taxes, unreimbursed employee business expenses, investment counseling fees, tax
planning and tax preparation fees, and a portion of medical expenses), it will produce no tax
savings, since reducing the regular tax merely increases the AMT by an equal amount.
Conclusion
Factors that may contribute to a heightened economic crisis in the U.S. after 2009 include
unprecedented federal debt levels and the printing of trillions of dollars to stimulate a flagging
economy. The economic fallout from this federal intervention may include significant inflation
and tax hikes over the next several years. The possibility of social unrest as state and local
governments reduce spending while unemployment worsens, and the ripening climate for global
conflicts due to scarce natural resources, may add fuel to the economic crisis. The time for
careful investment and tax planning is now. Tax planners should reevaluate their clients'
portfolios to ensure that some combination of inflation hedges such as 1-bonds, TIPS, REITs,
carefully selected commodities, and currency ETFs is included. ETFs tied to "human needs"
stocks and highly liquid cash reserves should also be considered. The tax-exempt Roth IRA,
available to high-income earners beginning in 2010, along with a vacation home for retirement,
and careful AMT planning, can serve as effective deterrents to possible tax hikes looming in the
future.
Sidebar
Given the current state of the economy, taxpayers should re-evaluate their investment and tax
pians to reflect the impact of projected future changes in tax rates and investment returns.
Sidebar
Top individual tax rates have been in the 50% to 94% range for nearly two-thirds of the history
of the current tax system.
Sidebar
l-bond interest is subject to federal income tax, but exempt from state and local income taxes.
Sidebar
TIPS purchased through TreasuryDirect have to be maintained in a taxable account.
Sidebar
AMT PLANNING TIP
Care should be taken not to accelerate too much Income into an AMT year or to defer too many
expenses into a regular tax year. The receipt of income should be accelerated or expenses
deferred up to the point where the tax due under the tentative minimum tax equals the regular
tax. Here are some items warranting special consideration:
* Passive investments. Taxpayers may be able to improve their AMT position by finding
investments that produce passive income to offset passive tax-shelter losses (Section 469).
Because tax-shelter losses are not deductible for AMT purposes, the alternative minimum tax
will not be increased to the extent that the passive income offsets passive losses. Income-
producing limited partnerships and rental properties generating passive Income may be
appropriate investments.
* Private-activity bonds. Interest on private-activity municipal bonds is a tax preference for the
AMT. Thus, taxpayers holding private-activity municipal bonds in AMT years will find this
income taxable. These taxpayers may be better off trading these bonds for regular municipal
bonds or higher-paying taxable bonds.
* Long-term investments. For AMT purposes, any gain on the sale of investments held long-term
are subject to the same low capital gain rate of 15%. Vet, because of the workings of the AMT, a
large long-term capital gain could trigger some AMT liability. Thus, taxpayers looking to
liquidate investments that have performed well, at the very least, should review the AMT
consequences and determine what (if any) impact such a sale would have. Weighing the
consequences carefully might enable the taxpayer to make decisions that will minimize AMT
exposure (such as selling only part of the investment in each of two or three tax years).
* Incentive stock options (ISOs). Taxpayers who have received ISOs from an employer should
exercise caution before exercising the ISOs. The bargain element (the difference between the
exercise price and the fair market value of the stock on the exercise date) is considered a tax
preference for AMT purposes. While the taxpayer will owe no regular tax on this bargain
element, the AMT could certainly kick In. For many corporate executives, this could be a very
large trigger for the AMT. Worse, if the stock value subsequently drops below the value on the
exercise date, it could really hurt having to pay AMT on the "bargain'' element when the
investment actually lost money.
* Interest on a home equity loan. Interest on a home equity loan is deductible under the AMT
system only if the proceeds are used to buy, build, or improve the home. If all or a portion of the
home equity funds are used to pay for such things as a car, consumer goods, or school tuition, the
interest apportioned to the nonimprovements is not deductible for AMT purposes.
Footnote
1 Office of Management and Budget, "Budget Message of the President" (2/26/09).
2 Government Accountability Office (GAO), Report to the Secretary of the Treasury, Financial
Audit, Bureau of the Public Debt's Fiscal Years 2008 and 2007 Schedules of Federal Debt
(November 2008).
3 International Monetary Fund, World Economic Outlook Database, April 2009.
4 Historical Tables, Budget of the United States Government, Fiscal Year 2009, Table 7.1-
Federal Debt at the End of Year: 1 9402013.
5 2008 Financial Report of the United States Government; Shadowstats.com (John Williams,
publisher).
6 Nankin, Umansky, Kjellman, and Klein, "History of U.S. Government Bailouts"
propublica.org (4/15/09).
7 Note 1 supra.
8 Compiled from Internal Revenue Service Data Books for 2007 (the most recent data available
when this article went to press).
9 Compiled from Worldwide-Tax.com (last partial update, 3/28/09).
10 Tax Foundation, "U.S. Federal Individual Income Tax Rates History, 1913-2009,"
http://www.taxfoundation.org/taxdata/show/ 151.html#federalindividualratehistory-
20090102(l/2,/09).
11 Grabianowski, "What exactly is Inflation?" howstuffworks.com (5/19/05).
12 Compiled from U.S. Department of Labor, Bureau of Labor Statistics,
ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt (5/15/09).
13 U.S. Bureau of Labor Statistics, News USDL 99-53, Productivity and Costs, page 443.
14 Notes 1 1 and 12 supra.
15 CBS 60 Minutes, Scott Pelley, Interview with Federal Reserve Chairman Ben Bernanke (3/1
5/09); Petruno, "Bernanke's Economic Strategy: Trillions Now, Worry Later," Los Angeles
Times (3/18/09).
16 For example, In May 2009, the Conference Board (a private research group) reported that its
index of leading economic indicators rose slightly in April 2009 after seven straight monthly
declines. The Wall Street Journal interpreted this report as "a sign that economic recovery may
be near." "Economy Shows Signs of Recovery," Wall St. J., 5/22/09, page A-2.
17 Id.
Footnote
18 Section 135; Rev. Proc. 2008-66, 2008-45 IRB 1107.
Footnote
19 Section 408A(c)3).
20 Section 408A(c)(3)(B).
21 Section 408A(d)(3)(A)(iii).
22 Section 408A(d)(2)(B).
23 IR-2008-118, 10/16/08.
Footnote
25 Section 121(b)(4)[sic5)l(C)(i).
26 Section 121 (b)(4)[slc (5)](B).
27 Section 121(b)(4)[sic (5)](D)(i).
28 Sections 1(h)(6)(A) and 1250(b)(3).
29 Section 121(b)(4)[sic (5)](C)(ii)(I).
30 Section 121(b)(4)[sic (5)](C)(ii)(III).
31 Section 1250(b)(3).
32 Section 1250(d)(2); Reg. 1,1250-3(b)(2).
33 Sections 56 and 57.
34 Section 55(d).
35 Section 55(b)(1)(A).
35 Section 53.
37 Sections 55(d)(1)(A) and (B).
38 Joint Committee on Taxation Description of Revenue Provisions Contained in the President's
Fiscal Year 2008 Budget Proposal, Part 4 of 4 (3/27/07).
AuthorAffiliation
CHRIS FENN, CPA, M.B.A., M.Tx., is the CEO of American Capital Corporation, which
provides financial and tax planning services to corporations, LLCs, and highly compensated
individuals. He is also a full-time faculty member at Georgia State University in Atlanta.
Copyright Thomson Professional and Regulatory Services, Inc. Sep 2009