A DISCUSSION ON REFORMING THE TAX CODE

I wrote an article for the Summer 2011 issue of NATP’s quarterly TAXPRO JOURNAL titled “Shred the Tax Code!”.  Actually my original title was “The Tax Code Must Be Destroyed” (a reference to the Hammer horror films I enjoyed in my youth).  You can find the article in the TAXPRO JOURNAL archives at the NATP website.

The JOURNAL does not have a “letters to the editor” section allowing members to comment on articles and editorials.  A member – Enrolled Agent Michael A. Poretsky – sent a commentary on my article to my Editor, who passed it along to me.

Below is Michael’s commentary, in italics, and my responses in blue.

There are some parts of Robert D. Flach’s article, “Shred the Tax Code” with which I, or anyone else, can readily agree:

·   The code should be written in plain (I would say, clear) English. Of course, one has to be careful when writing any legal document since words have even more power in a piece of legislation than in casual conversation. The current code has a history of court cases and interpretation which a careless rewrite could readily overturn leading to more, not less, confusion about how to properly prepare tax returns.

{I would accept “clear” as an alternative to “plain” English, and do realize that the actual verbiage in the Code is important. – rdf}

·   There should be only one system; the Alternate Minimum Tax should be eliminated as part of any overhaul of the Code.

·   Adjustments for inflation should be applied uniformly to all deductions and credits.

Mr. Flach and I part company on other matters:

·   While the original intention of the tax code might have been only to collect revenue to fund governmental operations, that lasted only nanoseconds. Virtually since the beginning of the income tax as we know it, the code has been a tool to frame policy and encourage or discourage various kinds of investments. And, yes, to redistribute income to some extent.

{I do agree that over the years the idiots in Congress have used the Tax Code as “a tool to frame policy” and “to redistribute income to some extent”.  My point is that the Tax Code should not be so used.  I agree that the Tax Code can be used to encourage savings and investment, i.e. via tax-deferred and tax-free retirement savings vehicles and beneficial treatment of long-term capital gains, but it should not be used as a vehicle to distribute social policy benefits. – rdf} 

·   Everything is taxable? Including municipal bond interest (as just one example)? There is bound to be significant push back from State and Local governments who rely on the attractiveness of tax-free income to fund capital projects at reasonable rates of interest.

{I believe Michael is referring to the following statement from the article -“The basic concept would not be much different than that of the current Code—everything is taxable except . . . and nothing is deductible except . . . .It’s the exceptions that would be reformed.

What I am saying is that the “starting point” for the new Tax Code is “everything is taxable” and “nothing is deductible”.  We would then add back only those “excepts” that are appropriate and necessary.  I did not say that everything should be taxed.  One of the “excepts” that could be added back to “everything is taxable, except” is municipal bond interest.  I am not saying we should tax currently exempt municipal bond interest, although it is something that may be considered. – rdf}

·   Mr. Flach writes, “… the Tax Code should be permanent … [with no changes permitted] …for ten years…[with exemptions for] … natural disasters and identifiable national emergencies.” Does he really think that the economy and the world as a whole will be the same ten years after any code is adopted? Five years? One? We can be certain that national emergencies will be declared with some frequency as an excuse to tweak the code.

I would prefer some limitation on the number of times the code could be changed in any one year and a deadline such as, no new tax legislation after September 30^th. That would give IRS time to write instructions and taxpayers time to figure out their tax strategies.

{I do not believe that the Tax Code should be able to be changed at the drop of a hat to provide “stimulus” in times of economic troubles or for any other poorly thought out quick and easy way for the idiots in Congress to make believe they are actually responding to a problem.  Other avenues should be used if a “stimulus” is needed.  Taxpayers, especially small business owners, need consistency to be able to properly plan. 

When I speak of natural disasters I mean that there could be the potential for temporary exemptions from tax or additional deductions for victims of such natural disasters – such as was done in response to Katrina – if appropriate and necessary.  And when I refer to national emergencies I mean true national emergencies, such as times of, God forbid, a real war. – rdf}

·   All of the various tax credits listed in Mr. Flach’s article do, in fact, encourage certain behaviors our legislators and the president have decided are valuable. Yes, there is fraud, but - speaking as a Certified Fraud Examiner (Retired) - taking these items out of the code and distributing the benefits through other means will change the fraud but not reduce it. In addition, there will likely be new bureaus created to track those benefits allocated outside the tax system. There are, I believe, better ways to address these issues.

{While there will always be fraud, I do believe that there would be less fraud if the distributions of the targeted benefits were done via the appropriate departments and not through the Tax Code.  And specifically “tax preparers would no longer need to take on the added responsibility of having to verify if a taxpayer qualified for a government benefit”. 

Under the current system a taxpayer defrauds the government by filing a false tax return, getting a refund up front.  The IRS then has to actually discover and verify the existence of the fraud and try to get the money back.  If a person’s qualifications to receive a government benefit were investigated up front, before any money was paid out, there would be less actual accomplished fraud.

The bureaus to distribute the benefits already exist in most cases.  Student financial aid is already administered via an existing government system.  The Earned Income Credit is basically welfare – specifically Aid to Parents with Dependent Children – and there already exists a system to distribute this type of welfare.

The “Cash for Clunkers” program proved that rebates for specified purchases, such as energy efficient products, can be done easily at the point of purchase outside of the Tax Code.

Recent studies by TIGTA have proven that refundable tax credits are not efficient and are magnets for excessive fraud. – rdf}      

·   Under Mr. Flach’s structure, everyone (especially those receiving government benefits) would “… actually paying federal income tax.” My question is, if an individual must pay $1,000 in federal income tax to be entitled to and receive $5,000 in government benefits, how are we ahead of the game?

{Different individuals receive differing “returns on investment” on the income taxes paid at different times.  This is nothing new.  As I said in the article, by taking social benefit programs out of the Tax Code and placing them where they belong –

“Qualifying individuals would get the money at the point of purchase when it’s really needed. They won’t have to pay out of pocket up front and wait to be reimbursed when they file their tax return.” (taxpayers need money to pay for college tuition when the tuition is due, and not 6 – 12 months later).

And -

“We could measure the true cost of education, housing, health and welfare programs in the federal budget because the various subsidies would be properly allocated to the appropriate departments and not be reported as a part of net income collected via income tax.”

And -

“The Tax Code would be much less complicated, the cost to the public for preparing a tax return would be reduced, and the IRS would have much less to process and to audit.”- rdf}

I was disappointed in Mr. Flach and the editors of Tax Pro Journal, that he wrote and they passed on an erroneous explanation of the depreciation of real property.

He says, “… real estate does not depreciate. A building has a life of much more that 27.5 or 39 years.” Maybe.

Certainly, land does not depreciate. The useful life of any other asset, including buildings, could easily be more or less than the allowable depreciable life. And I challenge his contention that the “… value of real estate as a component of the value of a business does not drop as it ages.” Perhaps he has never had the misfortune to stay at an older motel or consulted on changing the use of a building.

{There was no “erroneous explanation of the depreciation of real property”.  Historically, as a general rule, the value of real estate, both land and improvements, appreciates over time.  Obviously there exist exceptions to everything – such as cheaply built motels losing value with age.  But even in this situation if the motel was properly maintained and upgraded over the years I expect it would retain and increase its value.

Let’s be honest – with the exception of market adjustments as have occurred recently (real estate was grossly overvalued at purchase in many areas of the country and the market eventually corrected to reflect reality) – the value of a residential or commercial building does not go down over time. 

What I am saying is that, historically, the sale price of real estate is generally more than the original purchase price. 

A few years back my parents sold partially rented residential real estate that was 100 years old.  I don’t have to tell you that the sale price was certainly more than the cost of the property when it was built, and more than what my grandparents had paid for it 60+ years ago.  In my 40 tax seasons of preparing 1040s I have rarely, if ever, come across a capital loss on the sale of real estate (even after discounting depreciation).

The depreciation deduction for rental real estate eventually causes problems and agita for the owners, and their tax preparers, when the property is sold.  And this deduction does truly distort the economic reality of the investment.  If a person actually realizes a economic loss on the sale of real estate this will result in a deduction when sold. – rdf}

I agree that the tax code needs to be rewritten.

While the tax code is not the economic engine that runs our nation, it has the potential to either stimulate our economy or drag it down. The code reflects what we value as a nation and a people.

Any changes to the tax code need to be considered very, very carefully.

{I stand by my original article, and my contention that the purpose of the federal income tax is to raise money to run the government. – rdf}

I thank Michael for taking the time to comment on my article.  I also welcome the comments of my readers, especially other tax professionals, either on my original article, Michael’s comments, or my responses to Michael.

TTFN

THE NEW TAX CODE - THE FINAL ITEMS

So what it left to re-write in the new simple, fair, and consistent Tax Code?

Contributions? I would not change the current rules for deducting contributions to church and charity – except to make the standard deduction for charitable miles equal to the standard deduction for all other miles (the amount currently used for medical and moving mileage) and have it indexed for inflation annually. This deduction would be determined annually by the IRS and not the idiots in Congress, who have not increased the amount in years.

Casualty and Theft Losses? I think I would limit this deduction, without any AGI exclusion, to “out of pocket” casualty losses from Presidentially-declared natural disaster areas and “theft” losses from Madoff-like Ponzi schemes.

Moving Expenses? I would keep the current rules, but make it an “employee business expense” deductible on Schedule A.

Medical Expenses? This is the only area where I have considered maintaining a % of AGI exclusion. I would want to limit the deduction to “excessive” medical expenses. As an alternative to the AGI-based exclusion I have thought about allowing a deduction for expenses in excess of a flat exclusion amount of $5000 for a single taxpayer or $10,000 for a married couple. What do you think about this?

I would once again make taxpayers age 65 or older eligible for an additional personal exemption, and not an additional standard deduction amount. And I would do away with the special tax treatment for legally blind taxpayers. I see no reason why blind taxpayers should be treated differently than any other disabled or handicapped taxpayer.

I have decided that I would not have a “dependent credit” - but instead double the personal exemption for dependent children under age 19.

Before I begin to put my proposals for the new Tax Code into summary format – is there anything I forgot?

TTFN

THE NEW TAX CODE – MISCELLANEOUS ITEMIZED EXPENSES

My new fair, simple and consistent Tax Code will continue to allow taxpayers to claim Miscellaneous Deductions on Schedule A for employee business expenses, investment expenses, tax preparation costs, and legal fees for the protection and collection of income. They would all be deductible in full – there would be no 2% of AGI exclusion.

Some employees receive a salary and are reimbursed in full for any and all “employee business expenses” via an “accountable plan”. Others, generally outside salesmen, receive a base salary and/or commissions, and perhaps a flat monthly “expense allowance” which is included in W-2 wages, and any and all employee business expenses are truly “out of pocket”. Allowing a deduction for unreimbursed employee business expenses assures that the true net economic benefit is being taxed.

I would, however, make some changes to the current rules for deducting business use of an automobile – which would apply to both employee business expenses and Schedule C, E and F.

For the most part, taxpayers who use their car for business, other than commuting, would own a car whether or not one was needed for business. The business use, however extensive, is basically secondary to personal use.

I own a car. I have always owned a car, even when I was an employee (many, many, many years ago). Although a large percentage of my current driving is business related (because, as I work out of a home office, I have no “commute”), I own the car primarily for personal and not business reasons, and would own a car whether it was needed for business or not.

If you use your car for business, either as an employee or a self-employed individual, the standard mileage allowance for business miles would not include a factor for depreciation. Basically the standard mileage allowance for business miles would be the same as the standard mileage allowance for medical and moving miles. This standard mileage allowance would also be used for miles related to doing volunteer work for a church or charity – the standard mileage allowance for charitable driving would no longer be determined by Congress.

There would be one standard mileage allowance for all deductible travel, which would be indexed annually for inflation in the same manner as everything else in the Tax Code is indexed for inflation, and not based on a separate calculation.

Taxpayers using their car for business would continue to have the option of using the appropriate business use percentage of actual expenses, but without depreciation. Those who lease a car and use it for business could also use the standard mileage allowance or actual expenses, but this deduction would not include the monthly lease payment.

In the case of motor vehicles used 100% in a business – trucks, vans, limos, cars that are leased out to others (including one’s corporation) or used exclusively by couriers or for deliveries – a deduction will be allowed for 100% of the actual costs of maintaining and operating the vehicle, including depreciation. The standard mileage allowance would not be allowed, and there would be no Section 179 deduction.

Deductible investment expenses would be limited to investment advisory fees charged by brokerages and consultants, subscriptions to investment advisory services, fees to collect dividends and interest (often reported on Form 1099-DIV), including service charges paid as part of a dividend reinvestment plan, investment management software, although there would be no deduction for actual computer usage, and certain pass-through investment expenses from partnership K-1s.

There would be no deduction for minor pedestrian expenses like safe deposit box rental fees, subscriptions to Smart Money or the Wall Street Journal, and basic account maintenance fees.

Losses on IRA investments (if all IRA accounts have been liquidated and the total amount received is less than the “tax basis”) and losses on deposits in an insolvent or bankrupt financial institution would be claimed on Schedule D. A theft loss deduction would be allowed for losses in Madoff-like Ponzi schemes. Repayments of Social Security and other taxable benefits received in prior years would be treated as an adjustment to income.

Gambling losses, to the extent of reported gambling winnings, would also now be deductible “above-the-line” as an adjustment to income. This way individuals would not be paying tax on net gambling activity for the year of 0, or a loss, as is currently possible.

A taxpayer winning a legal settlement in the hundreds of thousands of dollars will usually pay a substantial percentage of the award in legal fees, so that the resulting economic benefit to the “winner” is much less. Taxpayers receiving taxable legal judgments and settlements include the gross settlement in taxable income. While the legal fees relating to awards for claims of unlawful discrimination, and certain other claims, are currently deductible “above-the-line”, in all other cases these fees are claimed as a Miscellaneous deduction on Schedule A. In my new Tax Code all contingent legal fees would be fully deductible “above-the-line” as an adjustment to income.

If the Estate Tax were to remain in the Tax Code in some form I would continue to allow a Miscellaneous deduction for estate taxes paid on income that is taxed on both the Form 706 and the Form 1040 (i.e. retirement plan distributions).

TTFN

THE NEW TAX CODE - INVESTMENT INCOME

Here is how investment interest would be taxed in my new simple, fair and consistent Tax Code.

(1) When it comes to the question of taxing municipal bond interest I am “bi” – I could go either way. I am not against taxing the interest earned on municipal bonds, and the dividends paid by mutual funds that invest in mutual bonds. But I would also be willing to continue to exempt this income from federal taxation. Or I could tax only the earnings of “private activity” bonds, which are currently taxed under the dreaded AMT.

However, I think at this point I would tend toward taxing municipal bond interest the same as any other kind of interest.

(2) My new Tax Code would do away with “qualified” dividends. All dividends would once again be taxed as ordinary income.

The reason certain dividends were allowed “qualified” status and as such taxed at lower rates was to somewhat alleviate the “double-taxation” of corporate dividends. Corporate profits are taxed on the corporate return, and dividends, which are a distribution of corporate profits, are also taxed on the individual tax return of the shareholder. My new Tax Code would do away with the double taxation of corporate dividends by allowing corporations to claim a tax deduction for “dividends paid”.

If a corporation had a net profit of $100,000, and paid $90,000 out to shareholders in dividends, it would pay federal corporate income tax on only $10,000. The shareholders would pay tax on the dividends received at ordinary income rates.

Coupled with this new “dividends paid” deduction for corporations would be the total abolition of all current special interest corporate deductions, credits and loopholes. A corporation would simply report gross income and deduct “ordinary and necessary” business expenses and come up with a net profit or loss. Dividends paid to shareholders would be deducted from any gain to determine taxable income.

There would be no “special deduction” for dividend income, and charitable contributions would be 100% deductible as a business expense on the Form 1120, regardless of the amount of profit or loss.

One side benefit to doing away with the category of “qualified” dividends on the Form 1040 is that brokerage and mutual fund houses will no longer need until the middle of March to properly prepare year-end Consolidated 1099 reports. The 1099 information can be prepared and sent to taxpayers by January 31st, as was done before qualified dividends were created, and there will be no more need for one or more “corrected” copies.

(3) When it comes to the taxation of long-term capital gains, and capital gain distributions, I would return to my early days in “the business”. I would not have a separate, lower tax rate for long term capital gains (as I would not have a separate, lower tax rate for qualified dividends) – instead my new Tax Code would bring back the 50% “capital gain exclusion”.

When I first started preparing 1040s back in the early 1970s the Schedule D allowed for a 50% deduction for net long-term capital gain – only half of such gains were included in taxable income. So if net long-term capital gain was $10,000, only $5,000 was carried over to Form 1040 as income. There was only one set of tax rates for all income – no special lower rates for capital gains. This 50% exclusion was later increased to 60%.

The result would be that capital gains, and capital gain distributions, would be taxed at a rate half that of the rate for “ordinary income”, without having to create a separate set of tax rates and a separate tax calculation. If net long-term capital gain on Schedule D was $10,000, and the taxpayer was in the 25% tax bracket, the effective tax on the net capital gain would be 12.5% - calculated at 25% tax on $5,000 of income.

I would also increase the maximum net capital loss deduction from $3,000 to $5,000 and index it for inflation. And I would allow taxpayers net capital losses to elect to “carryback” losses for three years to apply against capital gains reported in prior years.

I first proposed this idea in a letter to Dubya back in 2002. Here was my thinking at the time (see my post Dear George) –

“During the late 1990s and into 2000, when the stock market was flourishing, many taxpayers realized, and were taxed on, large capital gains, including excessive capital gain distributions from mutual funds. In most cases these capital gains were reinvested in the market and in additional mutual fund shares. In 2001 and 2002 the bear market provided these same investors with substantial capital losses.”

I had clients who had 6-figure gains in one year and 6-figure losses in the next. The net effect of 24 months of investing was basically 0 gains or an actual net loss. However the clients paid tons of tax to Sam on the gains in the first year, but were limited to deducting $3,000 in losses in the next year and a loss carryover that will last for decades and, unless they have a big score in the future, may never be fully deducted.

It seems only fair in such a situation that investors be allowed to carry back the losses to apply against the earlier gains of a bull market and get a refund of the taxes paid on these gains.

FYI, in response to my letter I received a brief form “thank-you for sharing your views and concerns” letter from the “Director of Presidential Correspondence”.

(4) Since the new Tax Code will not allow a deduction for depreciation of real property, I would remove the income and deduction limitations on claiming losses from rental real estate with active participation.

Business, including rental, losses passed through to “limited” partner investors on a Form K-1 would be treated similar to investment interest, with the deduction limited to net K-1 income from all passive activity K-1s. Suspended losses could be deducted in the year the investment is sold or terminates. The “at risk” rules would remain as currently written.

As mentioned above under my discussion of corporations, all current special interest deductions, credits and loopholes for partnerships, limited or otherwise, would be abolished. A partnership would simply report gross income and deduct “ordinary and necessary” business expenses and come up with a net profit or loss to be allocated on the K-1s.

So what do you think about these proposals?

TTFN

THE NEW TAX CODE – SAVING FOR EDUCATION, MEDICAL EXPENSES AND RETIREMENT

In my new fair, simple, and consistent Tax Code I would replace the IRA, ESA, HSA, and MSA with one USA – “Universal Savings Account”.

I would also replace all of the various retirement savings options for self-employed taxpayers (i.e. Keogh, SIMPLE. SEP, etc) with one SERSA – “Self-Employed Retirement Savings Account”.

All taxpayers could contribute up to the lesser of $10,000 or total earned income to a Universal Savings Account. This $10,000 maximum would be indexed for inflation.

There would be a “traditional” USA and a ROTH USA. There would be no restrictions on the ability to contribute to either option. A taxpayer, regardless of his/her level or income or current coverage under an employer plan, could elect to contribute to a “traditional” USA and claim a tax deduction, elect to contribute to a ROTH USA with no current deduction but all withdrawals after age 59½ being totally tax-free (subject to the same current 5-year rule), or elect to split the maximum allowable deduction between the two options.

There would no income tax or premature withdrawal penalty on withdrawals of any amount at any time from a “traditional” USA that are used to pay for qualified post-secondary education (including room and board) or medical expenses (including health insurance premiums). There would be income tax on “unspecified” withdrawals, with a 10% penalty for “unspecified” withdrawals made prior to reaching age 59½, except for death or disability.

In the case where there is a “tax basis” in a traditional USA (resulting from non-deductible contributions to IRAs made prior to the effective date of the new Code) withdrawals would be considered to come from “tax basis” first. If a taxpayer had a “tax basis” of $10,000 in a traditional USA and withdrew $15,000, only $5,000 would be subject to income tax, unless used for qualified education or medical costs. If the taxpayer withdrew $6,000 there may be a 10% premature penalty assessment, depending on the taxpayer’s age and what was done with the money, but there would be no income tax. Withdrawals for qualified education and medical costs would not reduce “tax basis”.

There would be no income tax, or penalties, on any withdrawals of any amount at any time from a ROTH USA to pay for qualified post-secondary education (including room and board) or medical expenses (including health insurance premiums). All other rules that currently exist for ROTH IRA withdrawals would apply to ROTH USA withdrawals.

A self-employed taxpayer could contribute up to the lesser of the current maximum contribution, including “catch-up”, allowed for a 401(k) or 403(b) account or “net earnings from self-employment” to a “Self-Employed Retirement Savings Account”. Employees of the self-employed business could also elect to contribute up to the maximum to their own RSA (established like a current IRA) as part of the business’s SERSA plan, with their contribution reducing taxable federal wages on the W-2.

There would be a “traditional” SERSA and a ROTH SERSA, and all self-employed taxpayers, and their employees, could split their deduction between the two options in any way they so choose regardless of income.

A SERSA plan would have to be established before the end of the calendar year, so that any employees could be notified of its availability and could chose to contribute via payroll deduction. But the owner’s contribution could be determined and deposited up to the due date of the return, including extensions. The owner would not, under any circumstances, be required to make any contribution for himself/herself.

Contributions to a traditional USA or SERSA (by the owner) would continue to be deducted "above-the-line" as an Adjustment to Income.

I admit that the above concepts are not original to me. They do mirror some proposals actually suggested by Dubya during his tenure. Hey, everything that George W did or proposed during his Presidency was not bad, although the list of his good actions and ideas is truly small.

TTFN

THE NEW TAX CODE - INTEREST AND TAXES

Currently a taxpayer can deduct on Schedule A either state and local income taxes, including employee contributions to state unemployment, disability and family leave funds, or state and local sales taxes, real estate taxes on all property held, personal property taxes, foreign taxes, mortgage interest, including points, on acquisition debt and home equity debt on two personal residences, mortgage insurance premiums, and investment interest.

There has been talk of doing away with the deductions for real estate taxes, state income taxes, and mortgage interest. My new Tax Code would allow an itemized deduction for state and local income taxes, real estate taxes paid on the taxpayer’s primary personal residence only, and mortgage interest on acquisition debt only for the primary personal residence only.

So taxpayers who itemize would be able to deduct state and local income taxes paid, including state fund withholdings, and the real estate taxes and acquisition debt interest on the home in which they live.

There would be no current deduction for real estate taxes on any other real estate held by the taxpayer. Real estate taxes on vacation homes would be considered a personal expense and non-deductible. Real estate taxes on rental property would continue to be deductible as currently allowed on Schedule E. Real estate taxes on property held for investment, such as vacant lots or houses purchased to be “flipped”, would be capitalized and added to the cost basis in determining gain or loss. There would be no deduction for personal property taxes. Foreign tax paid would be allowed as a credit only, direct from a Form 1099 or K-1 and without the need for a Form 1116, regardless of the amount of the foreign tax paid.

Only interest on “acquisition debt” – money borrowed to buy, build or substantially improve a taxpayer’s primary personal residence, and secured by the residence - would be deductible. There would be no deduction for mortgage interest on a second personal residence or for interest on home equity debt not used to substantially improve one’s primary personal residence.

Interest on home equity borrowing would be allowed on Schedule C, E or F if the money borrowed was used for business or rental purposes, using the current “follow the money” tracking rules.

This would require special new rules and regulations for banks and mortgage companies for issuing home-secured loans.

A “mortgage” loan would only be permitted for “acquisition debt”. Interest on a “mortgage” for a taxpayer’s primary personal residence would be fully deductible, up to the current acquisition debt limitations. “Home equity debt” would have to be a totally separate loan, and interest on this type of loan would not be deductible. A Form 1098 would only be issued for interest paid on a “mortgage” loan, and the bank or mortgage company would be required to report only interest paid on up to $1 Million of principal, and indicate if the mortgage was secured by a primary personal residence.

One would not be able to refinance a home-secured loan to include both types of debt in one loan. Therefore a homeowner could not refinance a “mortgage” to get additional money in hand unless he/she could prove to the lender that the money is used to “substantially improve” the secured residence. One would have to refinance the “mortgage” for the exact same principal, adding perhaps related closing costs, and take out a separate “home equity” loan to get any money in hand.

By instituting these requirements a taxpayer, or his/her preparer, would truly be able to just take the amount of mortgage interest reported on the Form 1098 for the primary personal residence and transfer it to Schedule A.

Points on acquisition debt for a taxpayer’s primary principal residence would be deductible as mortgage interest – but would have to be “amortized” over the life of the mortgage in all situations. Points paid on the purchase of vacation or investment property would be capitalized and added to cost basis in determining gain or loss when sold.

Why would I allow these deductions in the new simple and fair Tax Code?

The Internal Revenue Code taxes Americans based on income measured in pure dollars. However it is a fact that the “value” of one’s level of income differs, sometimes greatly, based on one’s geographical location. A family living in the northeast (New York, certainly New Jersey, Connecticut) or California that has an income of $150,000 may be just getting by, while a similar family that resides in “middle America” lives like royalty on $150,000. Many components of the Tax Code are indexed for inflation, but nothing is indexed for geography. To be honest I have no idea how one would even begin to index for geography.

It costs an awful lot to live in, for example, New York, certainly New Jersey, Connecticut, and California. State and local income and property taxes are the highest in the country. The cost of real estate is also excessively high. As a result one must earn a lot more money to be able to live in these states – and salaries are arbitrarily increased to reflect the increased cost of living. Yet $150,000 in income is taxed by the federal government at the same rate in New York City as it is in Hope, Arkansas.

Taxes and the cost of a home, and therefore also the amount of “acquisition debt” mortgage interest paid on a residence, are higher in the Northeast, and California. Since we pay taxes on “net income” after deductions, allowing an itemized deduction for these items would help to somewhat geographically “equalize” the tax burden.

No deduction would be allowed for mortgage insurance premiums in any circumstances. This deduction should never have been allowed in the first place.

As of this writing I think I would keep the itemized deduction for investment interest as it is under current law, and continue to limit it to net investment income. Home equity interest could be deductible as investment interest under current tracking rules.

TTFN

THE NEW TAX CODE - WHAT WILL NOT BE IN INCLUDED

Last week my posts in the re-writing the Tax Code series talked about what I would put in the new simple, fair, and consistent federal Tax Code. Today I would like to list some of the current and recent Tax Code provisions that will not be included.

First and foremost – the new Tax Code would not have any kind of “Alternative Minimum Tax”. There would be only one method of determining income tax liability. The dreaded AMT would be dead and buried – for good.

There would be no Adjustments to Income for –

Educator Expenses
Business Expenses of Reservists, Performing Artists, etc
Moving Expenses
Self-Employed Health Insurance
Student Loan Interest
Tuition and Fees
Domestic Production Activities

That is not to say that all of these items would no longer be deductible. Educator expenses, Business Expenses of Reservists, and Moving Expenses would be deductible under the category of Employee Business Expenses. The deduction for health and long-term care insurance premiums for self-employed taxpayers would be claimed directly on Schedule C or F.

Also gone for good are the following credits -

Education Credit
Retirement Savings Credit
Residential Energy Credit
Alternative Motor Vehicle Credit
Making Work Pay Credit (already gone)
Earned Income Credit
Additional Child Tax Credit
First-Time Homebuyer Credit (already gone)
And all other weird and sundry special interest business and personal credits

Now taking these benefits out of the Tax Code does not necessarily mean that the government will no longer provide benefits to encourage higher education, energy-efficient purchases, and to encourage individuals “on the tit” to work. As I have been saying for years, such government benefits should be administered as direct “point of purchase” payments or discounts paid out by the appropriate cabinet agency.

· When you buy a qualifying energy-efficient water heater or hybrid car you would get a “cash-for-clunkers-like” discount directly from the seller, who would be reimbursed directly by the government.

· Additional government grants would be given through the existing Student Financial Aid system, directly reducing tuition payments, again with the institution being reimbursed by the government.

· Incentives to work could be built in to the Aid to Families With Dependent Children program – such as a government reimbursement for certain payroll tax withholdings.

· If the government wants to give those with student loans a break it should just reduce the amount of interest on the loans, providing subsidy payments directly to banks.

In an earlier post in the series I mentioned that, as of this writing I have not decided if the new Code will have a special increased dependent exemption amount or a Dependent Credit. Whichever option I chose will replace the current Child Tax Credit.

There will be itemized deductions that also will not “make the cut”, but I will discuss these items in future posts.

TTFN

THE NEW TAX CODE – TAXATION OF SOCIAL SECURITY AND RAILROAD RETIREMENT BENEFITS

When unemployment benefits first became taxable I remember turning to my mentor and saying, “Next thing you know they will be taxing Social Security”. I was right!

Social Security and Railroad Retirement Benefits were first taxable up to a maximum of 50% of the benefits paid, based on income. The 50% figure was chosen because one-half of the total Social Security contribution is made by the taxpayer and 50% by the employer. This was eventually increased to a maximum of 85% of benefits paid, taking into account the “accrued earnings” on the contributions.

Currently the taxable portion of Social Security and Railroad Retirement benefits is determined using a complicated formula based on taxable and tax-exempt income and filing status. Under this formula it is possible that each additional $1.00 in income could be taxed as $1.85, and 85 cents of each additional $1.00 of tax-exempt municipal interest would be effectively taxed.

And under the current rules, although we say that capital gains and qualified dividends are taxed at a special 0% or 15% tax rate, these items of income can increase the amount of taxable Social Security and Railroad Retirement benefits, so that the effective tax rate is in reality more than 0% and 15%.

In my new Tax Code I would calculate the taxable portion of Social Security and Railroad benefits in the same manner as any other pension or annuity.

I would use the Simplified General Method to allocate the recovery of employee “after tax” contributions to the Social Security system (employee Social Security tax, but not Medicare tax, withholdings) to each monthly check over a period of time based on the age of the recipient when payments began.

If it was determined that the annual recovery of employee Social Security contributions for a retiree was $3,000, and the total Social Security benefits received for the year was $18,000, then $15,000 would be taxed income, regardless of the amount of the taxpayer’s other taxable and tax-exempt income.

The Social Security Administration has a record of employee contributions and can accurately identify the taxable portion on the Form 1099-SSA, as also can be done with the information return for Railroad Retirement benefits. There would no longer be the need for taxpayers to complete a complicated worksheet to determine the taxable amount.

Determining the taxable portion of Social Security benefits for individuals who had paid “self-employment tax” over the years may be a bit more complicated. The taxable portion of benefits paid to minor children will also be more complicated to determine. But I expect the SSA software can be adjusted to determine the amount to report in these situations.

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THE NEW TAX CODE – DEPRECIATION OF REAL PROPERTY

I first discussed this in 2007, and have been touting it ever since as a tax reform proposal.

The new Tax Code, as I would write it, will do away with the deduction for depreciation of real estate, including capital improvements to real estate.

According to the IRS, depreciation is “an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property”. The IRS discusses depreciation in detail in Publication 946 - How To Depreciate Property.

Let’s look at depreciation from the point of view of the Income Statement. Basically, if you purchase an asset (i.e. equipment, a vehicle, or real estate) that will last more than one year you spread the cost of the asset over its “useful life”. You purchase a new computer. You certainly do not purchase a new computer each year – you expect that it will continue to provide service for several years. So you divide the cost of the computer over a period of years to reflect this fact, and to properly report the “economic reality” of the purchase.

If you deducted the full cost of the computer in the year of purchase this would distort the true cost of doing business. Since you generally purchase a new computer every five years, claiming a deduction of 1/5 of the cost each year “more better” represents your cost of operations.

Thus depreciation is used to “recover the cost or other basis of certain property”.

Another way to look at depreciation is from the Balance Sheet perspective. When you purchase an asset that asset has value to you. You trade the asset of cash for a computer. If you sold your business the value of the computer would be included in the value of the business. As an asset ages its value drops. A two-year old computer does not have the same value in the market as a comparable brand new computer. Depreciation is used to reflect the drop in value of the asset.

Thus depreciation is used to reflect the “wear and tear, deterioration, or obsolescence of the property.”

If we look at economic reality, a building has a life of much more than the 27.5 or 39 years over which depreciation is currently allowed. The building I lived in before moving to my current apartment was 100 year old and is still going strong. And, for the most part, the value of real estate does not drop in value over the years. If properly maintained its value will generally increase. My parents purchased their first home for $13,000 and sold it many, many years later for $75,000 (and they were robbed).

Granted real estate values can go down, as we have seen a lot of in the last few years, due to market conditions. But this is the exception and not the rule.

For all intents and purposes, and for the most part, real estate does not “depreciate”. You do not replace a building every few years because it no longer provides the same service or function. And the value of real estate as a component of the value of a business does not drop as it ages. So why should we allow a tax deduction for the depreciation of real estate?

The new Tax Code would not permit a deduction for the depreciation of real property or capital improvements thereto on any income tax return – not on Schedule C, Schedule E, Schedule F, Form 1041, Form 1065, Form 1120, or Form 1120-S.

By doing away with the depreciation of real property a taxpayer would no longer have to “recapture” depreciation when the property is sold, which would greatly simplify the process.

Along the same lines, so as not to distort the economic reality of the situation, I would also do away with Section 179 expensing of personal depreciable property on any income tax return.

TTFN

THE NEW TAX CODE - FILING STATUS

As the Flach Tax Reform Commission, consisting of Robert D Flach, meets to rewrite the US Tax Code we begin with “everything is taxable and nothing is deductible”. In this series of posts I will talk about what items of income I would exclude from taxation and what deductions, and credits (if any), I would allow in our new fair, simple, and consistent Tax Code – the “excepts” – as well as filing status and tax brackets rules.

I will not necessarily be working my way down the Pages of the 1040 in order – dealing with items of income before deductions. I will be skipping all over the place. But when the series is completed I will organize the posts in proper order in a published report.

As I said in the initial post of the series - Your comments on my recommendations are welcomed and encouraged. I especially want to hear from fellow tax professionals.

OK – let’s begin. Just coincidentally we begin with the topic of Filing Status.

Currently there are 5 choices for a return’s filing status, each with its own rules and regulations –

1. Single
2. Married Filing Joint
3. Married Filing Separately
4. Head of Household
5. Qualifying Widow(er)

In the new Tax Code I would reduce this to 3 –

1. Single
2. Married Filing Joint
3. Married Filing Separately

The new Code would create neither a “marriage tax penalty” nor, for the most part, a “marriage tax benefit”.

The Married Filing Separately status would permit a married couple, whether living together or not, to file as if they were filing two individual returns as Single. All of the exclusions from income, deductions and credits that are available to a Single filer would be available to the Married Filing Separate status. The Tax Rate Schedule (and Tax Table) for Married Filing Separately would be exactly the same as that for Single. As per current law this status would be elective, and two-earning families will be able to file a joint return if they so choose.

I would create a special 2-columned 1040 and 1040A form that would allow both spouses to file separately on one return. Married taxpayers would still have the option of filing separately on two separately filed returns.

The Married Filing Joint status would provide for double of everything available to the Single status. For example, if, as under current law, a Single filer can deduct up to $3,000 in net capital losses per year, a married couple filing jointly would be able to deduct up to $6,000. The standard deduction for Married Filing Joint would be twice that for Single, as it currently is under the extended “Bush” tax cuts. It would be as if the separate incomes and deductions allowed on the new 2-column 1040 for separate filers were combined in one column.

The Married Filing Joint status would provide a marriage tax benefit for most couples with only one working spouse, but I would support a benefit for couples where one spouse is a “stay-at-home” parent.

The tax benefits currently provided by the Head of Household and Qualifying Widow(er) status would be replaced by an increased either dependent personal exemption or dependent tax credit (I have not yet decided which) that would combine the current personal exemption for dependents and the Child Tax Credit. If a dependent exemption is used it would be much greater than the personal exemption allowed for taxpayer and spouse. If a dependent credit is allowed then there would be no personal exemptions for dependents.

I like the idea of having only one Tax Rate Schedule (and Tax Table) for all taxpayers, regardless of filing status. In the case of Married Filing Joint perhaps the net taxable income would be divided by two, the tax determined from either table or rate schedule on this half of the combined income, and then multiply that tax amount by two. This method assumes that income earned by and deductions allowed for the couple combined apply equally to each spouse if they had filed separately.

John and Jane Q Taxpayer file a joint return. The net taxable income on the return is $100,000. The tax is taken from the tables is based on $50,000 of income. If the tax on $50,000 is $5,000, then the tax liability on the joint return is $10,000 (the 10% tax rate on this level of income is used only as an example for simplicity).

TTFN

BRING ME THE HEAD OF THE US TAX CODE!

Here it is – 2011 is almost half over and the idiots in Congress have taken absolutely no action on tax reform. They have not even begun a serious, or any kind of, discussion of the issue.

This was a big topic toward the end of last year, with several studies, government and private, recommending a re-writing of the mucking fess that is our current federal Tax Code, and calls for reform by both Parties, both houses of Congress, and the Administration.

I doubt that anyone disagrees that the Tax Code should be reformed, and I expect that most agree that it should be rewritten. However, 2011 is the year that this must be done – and nobody with any power is doing anything.

2012 is an election year. It is a known fact that the main goal, and primary motivation, of every elected official, at the local, state and federal level, is to be re-elected. The elected official’s secondary goal and motivation is to legislate pork for its constituents and supporters, which is really an off-shoot of goal #1. #3 on their list is to unwaveringly support and quote verbatim, without independent thought, whatever script is written for them by their Party. The proper administration of the government, which should be their primary purpose, is at most fourth on the list, if it is even on the politician’s list at all.

There is no way that any kind of substantive legislation on tax reform, or anything else, will be passed in an election year. No one wants to be in the position of having an opponent say “Congressman X is bad – he just voted to take away your deduction for home equity interest”.

The “Bush” tax cuts, that expired on December 31, 2010, and were extended at the very last minute for two years (no surprise - the idiots in Congress took the obvious easy way out rather than doing any thinking), will again expire on December 31, 2012. If nothing is done in 2011, the idiots in Congress will most likely again take the easy and cowardly way out by extending them for another two years, with the possible exception of perhaps bringing back the higher top brackets for high-earners.

Like Frankenstein, the current Tax Code must be destroyed. And re-written from scratch.

When describing how our income tax system works I usually say that “everything is table, except . . . and nothing is deductible, except . . .” The re-writing process must begin with “everything is taxable” and “nothing is deductible” and carefully examine all the current, and possible, “except”s (aka “tax expenditures”) to see which should be added.

In rewriting the Tax Code we must keep in mind that its purpose is to raise money to fund the government. It must not be used to redistribute wealth. While it may be used, sparingly, to reward or discourage certain financial behavior, it must not be once again made an easy back-door entry for social benefit legislation.

Our new Tax Code must be fair, simple, and consistent. There must be no phase-out levels or other income limitations. No “read my lips” back-door taxes. If a deduction is good for one it is good for all. There must be no “alternative” tax system – just one basic tax system that applies to all taxpayers. If we are to index items in the Code for inflation, than all items in the Code should be indexed for inflation. Definitions of terms must be uniform in all possible situations.

This post will serve to launch an ongoing series on what I personally believe should be the “excepts” in the new fair and simple Tax Code. I will talk about what and how income should be taxed and what deductions and credits (if any) should be allowed. Your comments on my recommendations are welcomed and encouraged. I especially want to hear from fellow tax professionals.

If the idiots in Congress are too lazy to keep the discussion of tax reform alive then I will attempt to do so.

TTFN