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The Buffett Rule

On Monday President Obama unveiled his deficit reduction plan.  In addition to reducing the deficit, he outlined his ideas to pay for the American Jobs Act he proposed two weeks ago.   No surprise his plan includes tax increases on more wealthy Americans.  Phrases such as “shared sacrifice” and people paying “their fair share” make for good sound bites.  However with Washington, the challenge is often deciphering what their pithy sayings mean.

He referenced the “Buffett Rule” as one of his proposals.  It’s named after Billionaire Warren Buffett who has been rather outspoken about the need to raise taxes on the super-wealthy.  Cueing off of a New York Times op-ed piece written by Mr. Buffett a few weeks ago, the Buffett Rule is supposed to make sure people who make over $1 million a year will pay a higher percentage of their income in taxes than someone who makes less than the $1 million threshold.

You may agree or disagree with the concept of the Buffett Rule.  Regardless if you think it’s a good idea, I have three primary issues with the proposed Buffett Rule.

  1. Additional Complexity.  As a tax professional, I can attest that the tax code is exceptionally complex and at times unwieldy.  With the myriad of deductions, exemptions and exceptions, it will be virtually impossible to make sure some making over $1 million will pay taxes at a higher rate than someone making less.  Everyone’s tax situation is unique, so it’s near impossible to offer such a guarantee.  It may sound simple, but it’s going to be very difficult to achieve.
  2. Increased Tax Avoidance.  While it may be good for those of us in the tax business, I can assure you that there will be a host of tax professionals looking for ways to minimize the tax liabilities of their clients under whatever new rules are enacted.  It’s simple economics.  The higher the tax rate, the more cost-effective it is to pay someone to find strategies which minimize your taxes.   You may have your opinions about what’s fair and right, but there is nothing illegal or immoral about structuring your affairs to pay less tax.  Tax evasion is illegal, but tax avoidance is not.  As I recently wrote, if you personally feel like you aren’t paying your fair share, then I would encourage you to make a voluntary contribution to the U.S. Treasury.  Trust me… they’ll take your money.  Political discourse and debate are fine, but it’s wrong to castigate someone who is abiding by the law because you don’t think the result is fair.
  3. Unintended Consequences.  Congress has a lousy track record of using the tax code to target certain persons.  The Law of Unintended Consequences often kicks in, and the negative ramifications are often much more detrimental than anyone anticipated.  Two great examples come to mind; one recent and one from decades ago.  The 1099 reporting provision included in the health care reform is the most recent Congressional bumbling.  As soon as it was passed, it became clear the administrative nightmare would far exceed any benefits obtained.  Fortunately, Congress repealed it before it became effective.  The Alternative Minimum Tax (AMT) is the classic example of unintended consequences.  The AMT was enacted in 1969 to tax 155 wealthy families who were viewed as not paying their fair share.  By 2008, 3.9 million taxpayers were subject to AMT, and 27% of them made less than $200,000. This probably isn’t what the 91st Congress had in mind.

The Buffett Rule may cause some wealthy people to pay more in taxes, but if history is a predictor of the future, the long-term results will be much different than expected.  Such targeted tax policy generally hasn’t yielded the desired results.  I’m not sure why they think the Buffett Rule will be any different.

Paying for Stimulus II

President Obama unveiled his latest jobs plan before a joint session of Congress last night.  Click here to read the summary of the proposals included in the American Jobs Act.  Since many of the proposals are essentially the same as the $827 billion Stimulus Bill passed in February 2009, many people consider the recent proposal to be Stimulus II.

The debates and discussions about the effectiveness of such the programs can be tackled later.  In this article, I simply want to explore the way the government is going to pay for any new spending, should it pass Congress.

Although many of the details are still being hammered out, President Obama estimated the cost of his proposals to be $450 billion.  He expects to pay for the additional spending by closing corporate tax “loopholes” and raising taxes on wealthier Americans.  Closing loopholes usually involves minor tweaks to selected tax provisions, and typically don’t raise huge amounts of revenue.  For the past few months, President Obama has been touting the need to close a “loophole” for corporate jets.  The “loophole” is all about depreciation, which is merely a timing issue.  Jet owners will still get to depreciate their aircraft, but it will take a little longer.  The additional tax revenue from closing this “loophole” is estimated to be $3 billion, over ten years, or the equivalent of $300 million a year in additional revenue.

See the graph below of the total government revenues.  You’ll notice total tax revenues are approximately $2 trillion annually.  Thus, total tax collections would have to increase by nearly 25% to raise an additional $450 billion.  Congress will need to close a lot of “loopholes” and increase rates substantially to raise an additional $450 billion, which is extremely doubtful in the current political environment.

Although this may seem like simple arithmetic, but there is a twist.  You need to understand Washington code to decipher what President Obama really means.  Just like the $3 billion in savings from closing the corporate jet depreciation “loophole,”  the $450 billion will come trickling in over the next decade, not next year.

Members of Congress and the President frequently talk about the current budget and the 10-year budget horizon simultaneously and interchangeably.  It most applications, it means spending will be paid in the current year, and any additional revenues or spending cuts take place over the next decade.

Time will tell if I’m correct, but I expect the President wants us to borrow the $450 billion over the next 12 months in an attempt to spur economic growth and pay it back over the next decade.  Given our current economic situation, you may think this is a wise decision and/or necessary.  I’m not convinced.  With a $14.7 trillion debt, which is growing by $100 billion a month, I’m not sure adding another $450 billion is the best for our long-term financial future.

Before you decide if it’s a good idea or not, at least make sure you know what the President and Congress want to do.  Like so many other things in Washington, you may think they mean one thing, only to find out our leaders meant something else.

If anyone says the American Jobs Act will be fully paid for, check to see how and when.

Raising Taxes on the Super-Rich

Billionaire Warren Buffett made headlines last week with an opinion article he wrote for the New York Times.  His statement “My friends and I have been coddled enough by a billionaire-friendly Congress” attracted a lot of media attention and discussion.

In writing, “It’s time for our government to get serious about shared sacrifice” you can deduce his apparent attempt to sway public opinion and encourage Congress to increase the tax burden upon the wealthiest individuals in the country.  He generally described the targets for the additional sacrifice as those making over $1 million each year, but he didn’t offer specific proposals or suggestions of what additional sacrifice they should be required to make.

In the article, Mr. Buffett disclosed his 2010 tax liability of $6,938,744, which he said was 17.4% of his 2010 income.  It’s a hefty sum; not surprising for one of the world’s richest men.  Most of us would be happy to earn $6,938,744 in our lifetime, let alone pay that much in taxes in one year.

I have no qualms with Mr. Buffett sharing his opinion and participating in the debate over U.S. tax policy.  It’s part of his First Amendment rights to free speech.  Hypothetically, I would ask Mr. Buffett one question… if you believe your taxes are too low, what’s stopping you from paying more?

If Mr. Buffett thought $6,938,744 was insufficient or not his fair share, what prevented him from paying more?  I contend the only thing preventing him from paying a greater sum was himself.   If he chose, Mr. Buffett could have voluntarily added to his 2010 tax liability whatever additional amount he thought was fair.  The U.S. Treasury would have gladly accepted his additional contribution.

His tax liability of $6,938,744 is a rather exact number.  While not explicitly stated, it’s implied this was the statutory amount he was required to pay.  Thus, he paid the minimum amount he was legally obligated to pay, which is what everyone does, irrespective of their socio-economic status.

I may be cynical, but I know many wealthy people who advocate for government spending and programs, yet are constantly trying to minimize their personal tax liabilities.  There is nothing wrong with minimizing your tax liability.  It is part of what I do for people on a daily basis.  However, I see a tinge of hypocrisy when you think others should pay more tax, yet look for “loopholes” for yourself.

I think Mr. Buffett’s credibility in advocating for higher personal income taxes would be bolstered if he chose to make a voluntary contribution above and beyond the minimum required tax liability. His convictions would be demonstrated by his actions and not just his words.

That’s my opinion. What’s yours?

Details of the Debt Deal

After weeks of political wrangling, Congress and President Obama enacted the Budget Control Act of 2011.  The legislation provides for an immediate increase the debt ceiling of $400 billion, averting a potential default by the U.S. government.  Avoiding default is probably the one thing most Americans are pleased with in this bill.

The debt deal is long on political rhetoric and short on details.  While many of our political leaders are touting the success of this legislation as a significant step towards dealing with the fiscal challenges of our country, there is little discussion of what is actually going to happen.  Beyond deferring the most significant spending cuts to a Joint Select Committee (JSC) composed of 12 Congressional leaders, evenly divided by house and party, there are few details of how the actual spending cuts are going to be achieved.

The Congressional Budget Office scored the spending cuts to be $2.1 trillion between 2012 through 2021. Of this amount $917 billion is supposed to be guaranteed in exchange for allowing the Treasury to sell another $900 billion in bonds.  The remaining $1.2 trillion is supposed to be determined by the JSC.  At this point, no one knows what is going to be cut to achieve any savings.

From what has been released, the bill calls for $21 billion of spending cuts in Fiscal 2012 and $42 in 2013.  Not surprisingly, the substantial cuts happen far in the future, which means there is always the chance the cuts won’t happen.  For those of us who believe government spending is on an unsustainable path, this is not very encouraging.  Here are a couple of things to consider.

President Obama’s 2012 Budget  proposal calls for $2.6 trillion in revenue and $3.7 trillion of spending; resulting in a $1.1 trillion deficit.  The House passed a budget with $2.5 trillion in revenue and $3.5 trillion of spending; racking up a $1 trillion deficit.  According to the debt deal, spending will be trimmed by a measly $22 billion.  This is about 0.6% of all federal  spending for the coming year.

Talking in trillions and billions can seem rather esoteric, so think in these terms.  Assume you make $50,000 this year.  If you managed your finances like the federal government, you would spend over $70,000, borrowing the difference.  If you cut your spending like Congress and the President have proposed, you would only trim your spending by $420 for the next year.  That’s right… just a mere $8 per week, even though you’re overspending by $20,000.  Given those parameters, would you say you were serious about changing your spending habits by cutting $8 per week?

Many politicians and commentators are calling this a historic piece of legislation.  They refer to it as a down payment on our debt and an important first step.  This may be true, but it’s an indication of how difficult it is for Congress to cut federal spending.   If they can barely manage to trim $22 billion, how are they going to come anywhere near close to $1 trillion?  It would take over $1 trillion of additional cuts and/or revenues to balance the budget, before we can even begin to pay down the debt.

The debt deal further illustrates the Congressional propensity to defer hard decisions.  Effectively, it will be a future Congress and potentially a different President, who will have to make the hard decisions to cut spending and balance the budget.  Given the history and culture of Congress, it’s no wonder the debt deal is long on politics and promises and short on specifics and spending cuts.

Decoding the Debt Debate

If you’re following the current debate on raising the debt ceiling, you’re probably frustrated.  Your angst may be triggered by, the partisan bickering, the lack of great leadership or the uncertainty of what may happen and what it all means.

Politicians from all political persuasions and affiliations have become very adept at obfuscation.  Knowing whatever they say or do can and will be used against them in a future election, politicians have become very proficient in deflecting and dodging direct answers.  They speak in vague terms and try to boil everything down to a 30 second sound bite.

Politicians and political commentators often use terminology that is confusing and often misleading.  You almost need a secret decoder to decipher what they are saying.  I don’t all of the secret codes, but I have a few.

As you listen to the debate, the following are a few terms to keep in mind.

  • The National Debt – The cumulative amount of money owed by the U.S. government. These are actual bonds held by various investors (including the Chinese government and your friendly bank).  The total outstanding debt is approximately $14.5 trillion.
  • The Debt Ceiling – The total amount of bonds the U.S. Treasury is authorized to issue.  The debt ceiling is currently equal to the National Debt.  A law must be passed to increase the debt limit.
  • Deficit – This is the amount of money the government is spending in excess of revenues it collects in one fiscal year (October 1 – September 30).  The deficit for fiscal 2011 is projected to be $1.4 trillion.
  • Credit Rating – Every bond traded on a public market is rated by an independent credit rating agency, which assesses the financial strength of the issuer and the likelihood of default.  The lower the rating, the higher the interest rate required.  For bonds already issued, a change in credit rating will often influence the price at which the bond is traded on the market.

Aside from these terms bantered about, I believe there are a few important factors you need to pay close attention to in any deal that is reached.  These will be the types of issues our  political leaders will attempt to obfuscate.

  • Time Horizon – The time horizon for the spending cuts and additional revenues will be calculated over the next 10 years.   If Congress and the President agree to cut $1 trillion in spending, it won’t all come in fiscal 2012.  They may sound like everything is happening this year, but any plan will be adopted over the next decade.  Raising the debt ceiling is the only thing to take effect immediately.
  •  Timing – Look at the timing for when additional revenue is received and spending cuts are enacted.  If history repeats itself, the revenues will start to be received soon, and the  bulk of the spending cuts will happen in the latter years.  In the world of pork barrel politics, elected officials use government spending to buy votes, and the termination of programs will frequently cost votes.  Thus, politicians have a real incentive to defer spending cuts to another day.
  • Details –It won’t be easy, but do your best to understand the details of the plan.  Congress is trying to make major changes to the tax code, Social Security, Medicare and  Medicaid, and they’re rushing to get it done in the next few days.  I don’t think you want a repeat of Nancy Pelosi’s famous quote, “We have to pass the bill so you can find out what is in it.”

I believe this is a serious issue, and how it is resolved could have far-reaching implications for the future.  No one knows what will happen if the government defaults on its debt, since it has never happened.  As I previously wrote, I think Congress will and should raise the debt ceiling, but it also needs to curtail government spending.  Racking up over $1 trillion of debt each year is just as perilous as defaulting on the current obligations by not raising the debt ceiling.

I also have serious reservations about our leaders’ability and willingness to cut spending.  The 2011 budget compromise is a good illustration of this.  Although they supposedly agreed to $38 billion in spending cuts, most of it was accounting gimmicks and money that wasn’t going to be spent anyway.  One analyst calculated the reduction in spending on specific programs to be less than $1 billion in comparison to fiscal 2010.

As the debate continues forward, follow closely.  Here’s why.  Last week, President Obama was pushing a plan to cut spending by $3.7 trillion and add $1 trillion of new revenue, for a net decrease of $2.7 trillion over the next decade.  Sound like a reasonable compromise?  Before deciding, you may want to consider this.  When the Administration presented their 2012 budget to Congress, they also provided a 10-year budget estimate.  The Administration projected total deficits over the next 10 years to be in excess of $9 trillion.  If the current deal cuts it by $2.7 trillion, that still means we’ll add over $6 trillion to the national debt, pushing out total debt close to $21 trillion by the end of the decade.  Still think it’s a good deal?

To me this is a good example of why we must watch this closely.  Despite the political rancor, everyone in Washington is looking for a deal which will make them look good.  Let’s just make sure the American people get as good of a deal as our politicians.

Do we really want to be European?

Let me start by stating that I’m not anti-European.  I have European roots, European friends, and am fascinated with their rich history and heritage.  I really enjoy the cuisine, cobblestone streets, outdoor cafés and centuries-old buildings.  I also respect their current government and political structures, but I happen to disagree with some of their fundamental economic philosophies.

I often hear politicians and friends say that we should be like____ (insert name of European country).  It was one of the biggest arguments for passing Obamacare (i.e., we were the only major industrialized country without socialized medicine).  People seemed to forget who leads the development of new medical products, procedures and technology, but that is a separate matter.

I’ll admit, that there are days when I would enjoy a 35 hour work week, 4+ weeks of vacation (holiday) and a 13th month pay, but I know that it comes with a cost.

  • Gasoline and diesel prices are nearly double the U.S. pump prices
  • Accommodations are small and vehicles even smaller
  • High taxes
  • Complex and intrusive government regulations
  • High unemployment

Since the recession hit in 2008, the U.S. unemployment rate has been on par with the European Union.  However, the U.S. unemployment rate has historically been considerable lower than France, Germany, Italy and Spain.  The United Kingdom is the notable exception.   We may be contending with a 30-year high rate, but unemployment in France and Spain has barely dipped below 8% in the past five years.

As economic recovery has dragged along, the unemployment rate remains high, which has caused many economists to speculate that we may have reached a new level of “full  employment.” You can read this article for a greater discussion on the rationale for this speculation.

Time will tell if this is true, but there aren’t any indications that unemployment is going to dramatically decrease in the near future.  This may be an unintended consequence of our drive to be more European.  Concerns of higher taxes, more regulation and mandatory health coverage may be causing employers to refrain from expanding their workforce.  You may argue the merits of such structural changes, but it will definitely require a shift in the American psyche for us to accept 7-9% constant unemployment as normal.

I’m not advocating for the Europeans to change their social or economic structures.  It’s great if it works for them, but that doesn’t mean it is right for the U.S.  I also don’t believe that we have all of the good ideas.  We can definitely learn from our international brethren.  However, we must be careful in trying to reshape our economy and society to be like someone else.  Albeit different, every nation has its challenges and struggles.  There is no utopian society.

Consequently, we should ponder whether we really want to be like the Europeans or any other nation for that matter.  Embracing our differences doesn’t mean we have to stop celebrating what makes them or us great.

Do Rich People Pay Taxes?

What do you think… do rich people pay taxes?

Here is a quick answer… Yes!

You may not think that they pay enough, or their fair share, but let me assure you that rich people pay taxes.  Having practiced public accounting for over 20 years and dealing with millionaires and billionaires, I know they pay taxes.  A select few pay more income tax in one year than the average American will make in a lifetime.  When you look at the statistics, it’s actually low-income people who don’t pay income taxes.

Despite the facts, it makes great headlines to claim that rich people don’t pay taxes.  Last week, a CNNMoney article reported that 4,000 millionaires didn’t pay any federal tax in 2010.   The Tax Policy Center was their source of information.  Since I’m always looking to learn and stay abreast of innovative ideas, I read the article hoping to glean something useful.   Not surprising, the details of the article didn’t exactly support the headline.  Here are a few points of contention and contradiction that I noted.

  • Although the article references 2010, it’s unclear how they can make claims about 2010.  The IRS is still processing 2010 returns filed a few weeks ago.  Plus, many high-income taxpayers’ returns are on extension until October 15, 2011.  They don’t cite the source of their statistics, but it certainly isn’t the IRS.
  • The exclusion of municipal interest income from federal income tax was mentioned as a prime example of how millionaires avoid paying taxes.  This is not a tax break for the wealthy.  All interest income from municipal bonds is exempt from federal taxation, irrespective of your wealth or tax bracket.  The contributors failed to mention that this not a tax issue.  It’s a Constitutional issue dealing with the sovereignty of the States.  If Congress could tax municipal interest income, I’m suspect that they would.
  • A capital loss carryover was cited as another possibility.  Capital loss carryovers are generated from the economic loss incurred when you sell something for less than you paid for it.  I don’t think offsetting prior losses with current gains is a great “loophole.”
  • The mortgage interest deduction was another.  This is completely bogus.  You can only deduct interest on $1.1 million of mortgage debt.  Even if you were paying an incredibly high interest rate of 10%, your mortgage interest deduction would be $110,000; far short of being able to shelter $1 million of income each year.
  • Charitable contributions were listed as another possibility.  This is a little better than the mortgage interest deduction, because you can deduct up to 50% of your adjusted gross income to certain qualified charities.  It may get you closer to eliminating your tax liability, but it’s still only 50%.  Furthermore, you have to give the money away. The tax savings might make it more affordable to give, but you’re still out the economic value of what you contributed.
  • Foreign tax credits are also cited.  Generally, you are allowed a credit for taxes paid to another jurisdiction on income that is also taxed in the U.S.  It’s supposed to prevent you from  being taxed twice on the same income.  There are limitations on foreign tax credits which make it extremely difficult to eliminate your U.S. tax liability with foreign tax credits.  Even if it is possible, you’re still paying tax, just not to the U.S.  Furthermore, you would have to pay more to the foreign jurisdiction than the IRS to avoid the imposition of U.S. taxes.

Since tax information is personal and private there no actual examples cited.  These were the possible strategies that the contributors cited.  In reality, this article is a headline searching for a story.  None of the examples given are really “loopholes,” nor do they support the notion that millionaires receive special treatment to avoid paying taxes.

Such articles may seem benign, but I disagree.  Whenever one class of people is able to avoid paying taxes (whether real or perceived), it can provide justification for others to be dishonest in filing their taxes.  Additionally, misinformation can easily lead to tax policy with unintended consequences.  The Alternative Minimum Tax (AMT) is a great example.  The AMT was enacted in 1970 to target 155 high-income families who supposedly paid no federal income tax in 1969, but today, millions of middle-class families are subject to AMT.  A provision originally designed to snare the “rich people” is now being imposed on many middle-class families.

It might make a great headline to suggest that wealthy people don’t pay income taxes, but it’s not really true.  There is no magic to avoid paying taxes.  More often than not, rich people pay income taxes.  If you’re still not convinced, become wealthy and see what you find out.

Tax Tip: Credits v. Deductions

Credits and deductions will reduce your tax liability, but credits provide a bigger bang for the buck.  Tax credits provide a dollar-for-dollar reduction in your tax liability, whereas deductions reduce your taxable income.  Thus, the economic benefit of a particular deduction is determined by your tax rate. 

The following is a simple illustration.  In 2010, each individual is granted a $3,650 personal exemption.  A personal exemption can only be claimed by one taxpayer and requires a valid Social Security Number.  Assuming that your marginal tax rate is 25%, you save $912.50 in taxes as a result of your personal exemption. Thus, your tax rate determines your tax savings.  Contrast this with the $400 making work pay credit, which will reduce your tax liability by $400.  Thus, all else being equal, a credit is more valuable than a deduction.

Although credits are more valuable than deductions, you usually don’t have a choice of which benefit you will take.  With few exceptions, the rules define if you get a credit or a deduction.  One exception relates to higher education expenses.  You may choose to take an education credit or a tuition deduction.  Depending upon your situation, you may find the deduction generates a greater benefit.

How can this be?  Well… in the world of tax credits, not all credits are created equal.  There is a distinction between refundable credits and nonrefundable credit.  A refundable credit (e.g., the earned income credit) can actually pay you money, even if you owe (or paid) no taxes.  A nonrefundable credit (e.g., child and dependent care credit) can only reduce your tax liability to a certain threshold (even zero).  Thus, a nonrefundable credit will only refund money that you previously paid, but a refundable credit can actually put dollars in your pocket that you didn’t pay.  You probably aren’t surprised that most credits are nonrefundable.

To make matters worse, many credits are limited to the dreaded alternative minimum tax (AMT).  When utilizing these credits, you can’t reduce your tax liability below the alternative minimum tax (e.g., education credits).  As a result, you may qualify for an education tax credit, but not be able to realize the full benefit of it, because of your AMT liability.

As you can imagine, there are more potential deductions than credits, and more nonrefundable credits than refundable ones.  It may seem rather obvious, but it’s helpful to understand the distinction.  You might be disappointed if you equate a deduction with a nonrefundable credit that is subject to AMT.   It can be confusing, so if you have questions or are unsure, consult a tax professional for further guidance.

Tax Tip: Deducting Sales Taxes

Sales taxes are generally not deductible, unless paid in connection with a qualified business expense.  Even in a business context, sales taxes paid for the purchase of a capital asset must be added to the cost of the asset and are recaptured through depreciation.

In the 2010 Tax Relief Act, Congress extended a provision that allows individual taxpayers to claim a sales tax deduction in lieu of deducting state income taxes.  This provision is allowable for tax years 2010 and 2011.  Frequently, it is only beneficial to taxpayers who reside in those states that do not have a state income tax. 

The deduction amount is determined by either (1) accumulating actual receipts showing general sales tax paid or (2) using IRS tables.  The tables are published in the instructions to Schedule A (Itemized Deductions).  You can also click here and go to an IRS link that will calculate the deduction for you.  The deduction tables are based upon your state, the number of exemptions claimed on your tax return, and your income.  Carefully review the instructions for calculating your income.  Income for this purpose is your adjusted gross income, plus certain nontaxable income such as tax-exempt interest, nontaxable Social Security benefits, worker’s compensation, etc.

Taxpayers who use the IRS tables can also add the sales taxes paid for certain large purchases, such as vehicles, boats, motorcycles, RV’s, etc.   If you made a substantial purchase of one of these items in 2010, you may receive a larger benefit from claiming the sales tax deduction in lieu of state income taxes, especially if your state income tax liability is not that large. 

You must personally pay the expenses in order for the tax to be deductible. This provision may eliminate a potentially large benefit to taxpayers who engaged in a substantial construction project.  The sales taxes on construction materials are often paid by the contractor, which would prevent you from claiming the deduction.

Some of what Congress gives, they also take away.  Keep in mind that no taxes are deductible for the alternative minimum tax.  Thus, your benefit may be reduced or eliminated as a result of the alternative minimum tax.

Sales taxes paid on personal purchases have generally not been deductible since 1986.  Congress added a benefit in 2005, which was primarily targeted towards those individuals living in states without a state income tax.  Although set to expire in 2009, the provision was extended through 2011. 

No matter where you live, if you made large purchases in 2010 and can document the sales taxes paid, you may benefit from the sales tax deduction.

Tax Tip: Mortgage Interest Deduction

If you have a mortgage on your personal residence, you’re probably well aware of the mortgage interest deduction, but like many tax provisions, a simple rule can be complex.  There are many factors involving the deductibility of mortgage interest. 

Generally, you are able to deduct the interest associated with $1 million of acquisition indebtedness and $100,000 of home equity debt.  The interest can relate to your principal residence (as defined) and one other residence you select. 

Some of the requirements for deducting the interest associated with acquisition indebtedness are as follows.

  • Acquisition debt is associated with acquiring, constructing or substantially improving a qualified residence.
  • The debt must be secured by the residence.  Not a problem if you borrowed money from a financial institution, since they will definitely secure their mortgage.  However, if you borrowed money from a family member, your loan document may not state that the loan is secured by the property.
  • You must own the property on the debt you are paying and must personally make the payments. For example, if parents pay the mortgage for their children, the interest isn’t deductible by either of them.

The following are some of the rules related to deducting interest on a home equity loan.

  • The home equity loan can’t exceed the equity in your house.  You generally can’t borrow more than the value of your home, but this could be problematic given the recent decline in real estate prices.
  • The proceeds from a home equity can be used for any purpose, except to purchase tax-exempt securities. 
  • Interest associated with proceeds used for purposes other than for a residence may be subject to the alternative minimum tax.

Mortgage points are generally deductible when paid for an initial loan to purchase a property.  Points paid upon the refinance of a mortgage must be amortized over the life of the new loan.

The IRS is very strict in apply the $1 million acquisition and $100,000 home equity debt limits.  However, the Service issued a ruling in 2009 in which they stated that acquisition indebtedness in excess of $1 million to acquire, construct or substantially improve a residence could be considered home equity interest.  Thus, taxpayers could deduct interest on $1.1 million of acquisition indebtedness without having to take out a separate home equity loan.

As you can see, a simple deduction has rather complex requirements.  If you have an unusual situation or are unclear about the tax rules, you should consult a tax professional.  A mortgage interest deduction can drastically reduce your tax bill, but it can also be quite costly if your deduction is disallowed.