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The recently enacted Tax Increase Prevention and Reconciliation Act of 2005 contains investor tax breaks, alternative minimum tax (AMT) relief and several other provisions with immediate and long term consequences. 

AMT relief. Originally enacted to make sure that wealthy Americans did not escape paying taxes, the AMT has started to ensnare more middle-income taxpayers. This is in part due to the fact that the AMT is not indexed for inflation. To prevent the unintended result of having millions of middle-income taxpayers fall prey to the AMT, Congress has once again relied on a temporary fix to the problem, this time a one-year extension of the 2005 AMT exemption amounts, increased slightly. Under the new law, for tax years beginning in 2006, the AMT exemption amounts are increased to: (1) $62,550 in the case of married individuals filing a joint return and surviving spouses; (2) $42,500 in the case of unmarried individuals other than surviving spouses; and (3) $31,275 in the case of married individuals filing a separate return. 

Another provision in the new law extends the 2005 temporary provisions that allow certain nonrefundable personal credits (including dependent care, elderly and disabled, Hope Scholarship and Lifetime Learning, and the D.C. homebuyer) to offset the entire regular and AMT liability through 2006. 

Investor tax breaks extended. In 2003, Congress passed a measure to lower the tax rate on most dividends to 15 percent from as high as 38.6 percent and to lower rates on most capital gains from 20 percent to 15 percent. That measure was set to expire at the end of 2008, but the new law extends the favorable rates through 2010. 

Income limitations on Roth IRA conversions eliminated, beginning in 2010. Under current law, only taxpayers with $100,000 or less in modified adjusted gross income can convert a regular IRA into a Roth IRA. A taxpayer making the conversion generally must pay tax on money he takes out of his regular IRA, but once it's in his Roth IRA, he won't pay tax on that money or the money it earns. Under the new law, beginning in 2010, taxpayers with more than $100,000 of modified adjusted gross income also will be able to convert a regular IRA into a Roth IRA. To make such conversions more attractive in 2010, the new law permits taxpayers who convert in 2010 to spread the income and resulting tax payments on the converted funds over two years-2011 and 2012. 

Kiddie tax age limit raised from under 14 to under 18. At one time, wealthy parents could significantly lower their family's tax bill by transferring investment assets to minor children to be taxed at the children's lower rates. To curtail the use of this technique, Congress enacted the "kiddie tax" rules, which said that children under 14 who had more than a small amount of unearned (investment) income had to pay tax at their parents' marginal tax rate (the rate of tax on the last dollar earned). The threshold amount at which the kiddie tax kicks in is two times the amount allowed as a standard deduction for a dependent who has only investment income. For 2006, that amount is $850, so the kiddie tax begins to apply when the child has more than $1,700 in unearned income. Under the new law, the age limit below which a child's income from investments is taxed at the parents' rates is raised from 14 to 18. This change will apply to the 2006 tax year. 

Capital gain treatment for self-created musical works. Under pre-Act law, capital assets do not include copyrights, literary, musical, or artistic compositions, letters or memoranda, or similar property held by a taxpayer whose personal efforts created the property. As a result, when a taxpayer sells copyrights he owns in, for example, books, songs, or paintings that he created, gain from the sale is treated as ordinary income, not capital gain, which is generally taxed at a lower rate. Under the new law, at the election of a taxpayer, the sale or exchange before Jan. 1, 2011 of musical compositions or copyrights in musical works created by the taxpayer's personal efforts is treated as the sale or exchange of a capital asset. 

Changes to the foreign earned income exclusion and housing allowance for U.S. citizens working abroad. The new law makes three changes to the foreign earned income exclusion and housing allowance. First, the income exclusion is indexed for inflation starting in 2006 (rather than 2008 under current law). Second, the base housing amount used in calculating the foreign housing cost exclusion in a taxable year is 16 percent of the amount of the foreign earned income exclusion limitation (instead of the present law 16 percent of the grade GS-14, step 1 amount). Reasonable foreign housing expenses in excess of the base housing amount remain excluded from gross income, but the amount of the exclusion is limited to 30 percent of the taxpayer's foreign earned income exclusion. Third, income excluded as either foreign earned income or as a housing allowance is included for purposes of determining the marginal tax rates applicable to non-excluded income. 

Please keep in mind that this message only covers the highlights of the new law. If you would like more details on any aspect of this legislation, please call your LBMC tax advisor at your earliest convenience.

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