More last-minute tax law changes

After several failed attempts throughout the year to pass a bill that extends popular credits and deductions to tax year 2006, Congress finally succeeded with the Tax Relief and Health Care Act of 2006 (signed into law on December 20, 2006). Unfortunately, it was too late to be reflected in the final IRS releases of the most widely used forms, such as Form 1040 and its schedules, so there will surely be a great deal of confusion among taxpayers as the IRS provides supplemental instructions for some forms and major revisions for others. We review here the most anticipated changes and their impact on forms and instructions, including the complex way the IRS has already defined for claiming deductions for educator expenses and higher-education tuition and fees. (The congressional delay caused problems not only for the IRS but also for anyone whose actions are affected by the credits and deductions they can expect to receive. Intelligent tax planning is nearly impossible when tax bills are passed long after their provisions are effective.)

But wait ... there's more! In typical fashion, Congress turned a simple bill into an omnibus bill that satisfies many special interests by adding extensive new benefits for the energy industry, health savings accounts, and even a number of provisions unrelated to taxes, including whistleblower reforms and rules for semi-generic wine names. We review here some of the provisions that have an impact on present and future tax forms.

Changes for tax year 2006

A number of popular credits and deductions expired at the end of 2005, so the IRS spent the year revising forms and instructions to reflect the law without those benefits. Now these benefits have been retroactively renewed as if they had never expired, but the IRS has already released most of the related forms. We'll review below the new law and what we expect the IRS to do about the changes.

• State and local sales tax deduction for itemizers. The option to deduct state and local sales tax instead of state and local income tax has been reinstated retroactively to 2006 and extended to the end of the 2007. The IRS removed the corresponding check boxes in its final release of Schedule A, and line 5 of Schedule A now refers only to income taxes. Nevertheless, the IRS is not changing the form now that it has been printed and mailed to taxpayers. Instead, they are handling the change through instructions in a new IRS Pub. 600, which was released on December 22, 2006 and updated with Excel attachments on December 23. This publication contains special instructions for those who want to use line 5 for sales taxes, including tables for each state for those who don't save receipts. If you want to deduct sales taxes at line 5 instead of income taxes as the form reads, you must enter a code ST on the dotted line for line 5. (Tax Preparer, of course, will do this for you automatically.)
• Tuition and fees deduction. An above-the-line deduction of up to $4,000 of tuition and fees for higher education has been reinstated retroactively to 2006 and extended to the end of the 2007 tax year. The IRS removed the special line for this deduction in its final release of Form 1040; line 34 is now used for jury duty payments instead. In bulletin IR-2006-195, the IRS now instructs you to use line 35 for this deduction, even though the label for that line is Domestic production activities deduction, and enter a code T 'on the dotted line to the left of that line entry' (even though there is no dotted line for line 35 of the IRS-printed Form 1040) if the line is used ONLY for tuition and fees, a code B if used for BOTH tuition and fees and domestic production activities, and attach a statement of the breakdown if code B is used. (The IRS could have made it simple by instructing you to claim the deduction as a write-in deduction at line 36, like they already do for many other deductions, but they opted for a much less intuitive way. Tax Preparer, of course, will do this for you automatically.)
• Educator expense deduction. An above-the-line deduction of up to $500 of elementary and secondary school teachers' out-of-pocket expenses has been reinstated retroactively to 2006 and extended to the end of the 2007 tax year. The IRS removed the special line for this deduction in its final release of Form 1040; line 23 is now used for Archer MSAs instead. In bulletin IR-2006-195, the IRS now instructs you to use line 23 for this deduction, even though the label for that line is Archer MSA deduction, and enter a code E on the dotted line to the left of that line entry if the line is used ONLY for educator expenses, a code B if used for BOTH educator expenses and Archer MSA, and attach a statement of the breakdown if code B is used. (The IRS could have made it simple by instructing you to claim the deduction as a write-in deduction at line 36, like they already do for many other deductions, but they opted for a much less intuitive way. Tax Preparer, of course, will do this for you automatically.)
• Research credit. The credit for increasing research has been not only reinstated retroactively to 2006 and extended to the end of the 2007 tax year, but expanded for 2007 with better rates and a simpler alternative calculation. Because of the expiration of this credit, the IRS did not release even an advance draft for this form for tax year 2006. The IRS is now likely to release a Form 6765 that is similar to the one for 2005 but with Part II omitted. (Part II was used to compute the amount of credit allowed in the current year for those who do not have to otherwise file Form 3800. However, the IRS now requires Form 3800 for all business credits even if you have only one credit to report on that form.) The changes in the credit percentages and simplified methods do not take effect until 2007, so they will not be reflected in the forms for 2006.
• Work opportunity and welfare-to-work credits. These two credits for hiring employees in targeted groups have been not only reinstated retroactively to 2006 and extended to the end of the 2007 tax year, but integrated for 2007 into a single credit. (The credit is generally 40 percent of up to $6,000 of first-year wages.) Even with the expiration of these credits at the end of 2005, the forms would still exist for 2006 because they apply to first-year wages (and second-year wages in the case of welfare-to-work) of employees who started work before January 1, 2006. The IRS was therefore uncharacteristically clever in their design of the forms for 2006 (Forms 5884 and 8861). The IRS advance drafts of these forms merely state that they are for employees who began work for you before the applicable date in the instructions. The forms will therefore not have to be redesigned for 2006 to accomodate their renewal. By contrast, for tax year 2007 the two forms will be combined into a single form and their calculations will be simplified.
• Domestic production activities deduction. Puerto Rico now qualifies as a qualifying location for domestic production in determining this above-the-line deduction. The addition of Puerto Rico applies to tax years 2006 and 2007.
• Archer medical savings accounts. The ability to set up a new Archer Medical Savings Account (MSA) has been extended for two more years, through 2007. The associated form (Form 8853) is not affected because the form still has to be used by those who set up an Archer MSA before 2006.
• D. C. first-time homebuyer credit. This credit for new homeowners in the District of Columbia has been reinstated retroactively to 2006 and extended through 2007. The associated form (Form 8859) was redesigned by the IRS to handle only carryovers from prior years, so their advance draft has no section for credits stemming from home purchases in 2006. The form will have to be redesigned again by the IRS to handle the retroactive renewal of this credit.
• D. C. enterprise zone benefits. Favorable treatment for activities in the designated zone has been reinstated retroactively to 2006 and extended through 2007. Wage credits, sec. 179 expensing, and capital gains rates are all affected.

The complete tax bill is huge, and a number of other benefits were extended, so you may want to review Technical explanations by the Joint Committee on Taxation.

Other changes

The bill also includes a number of extensions and modifications to provisions that were not set to expire before 2007. Here are just a few of the changes that will only affect activities in later years.

• Bonus depreciation in the Gulf Opportunity Zone. The special 50% first-year allowance for new property in the GO Zone was set to expire at the end of 2007. It is now extended through 2010.
• Combat pay election for the earned income credit. The option to use non-taxable combat pay in computing earned income for the earned income credit was set to expire at the end of 2006. It is now extended to the end of 2007.
• Health savings accounts. A number of enhancements to health savings accounts (HSAs) were added, but most do not take effect until tax year 2007. They include a provision to roll over an IRA into an HSA (only once in a lifetime) and the elimination of limits on deductible annual contributions.
• Energy credits and deductions. A number of provisions of the 2005 energy act (actually passed in 2006) were set to expire at the end of 2007. Several of these have been extended through 2008, including the credit for manufacturers of energy-efficient homes, the dedution for energy-efficient commercial buildings, the residential solar and fuel cell credit, the renewable energy production credit, and much, much more.
• Capital gains treatment for musical works. In the tax bill enacted in May, 2006, self-created musical works were added to the list of assets that qualify for favorable treatment as capital assets. However, this treatment was set to expire at the end of 2010. The new bill makes this treatment permanent.

The complete tax bill is huge, and a number of other benefits were enacted, so you may want to review Technical Explanation by the Joint Committee on Taxation.