2011 Tax Law Changes
It's that time of year again where every other billboard and commercial reminds you that the April 15th tax deadline is quickly approaching, and the task of filing your taxes hangs over your head. With the economy slowly trying to rebuild itself and the uncertainty of future tax rates, it is imperative that taxpayers stay informed with regards to tax law changes that may affect them when filing their 2011 tax return.
Some of the 2011 changes were enacted to encourage economic growth while others were aimed at requiring taxpayers to disclose additional information such as foreign investments. In either case, it is important that you stay informed. Below is a laundry list of 2011 tax law changes and tax facts that are worth becoming familiar with.
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Tax Rate Changes
Individual Income Tax Rates
2011 federal income tax rates carry over from 2010, but the brackets are slightly higher than last year due to inflation adjustments. These favorable tax rates are set to expire at the end of 2012.
Investment Tax Rates
Capital gains rates continue to be at historic lows for both long-term capital gains and qualified dividends. For taxpayers in the 15% income tax bracket and below, the tax rate is zero. For those in the 25% bracket and above, the tax rate is 15%. Enjoy these rates through the end of 2012 because starting in 2013 capital gains rates are scheduled to increase and a 3.8% "surtax" will be applicable to certain individuals. The 3.8% surtax will be assessed when individuals and trusts have income above $200,000 for single taxpayers and $250,000 for taxpayers filing jointly.
This Medicare surtax is courtesy of the Health Reform Act of 2010. The surtax will be imposed on the lesser of "net investment income" or the excess of an individual's income over the $200,000/$250,000 threshold amount. Net investment income is defined as interest, dividends, rental income, royalty income, capital gains, and certain income from passive activities such as investments in hedge funds and real estate partnerships
Payroll Tax Rates
Social security taxes for 2011 were lowered by 2% for both employees and employers, saving a maximum of $2,136 per worker. There is no phase-out, and each spouse filing a joint return is eligible for this tax reduction. For most workers, this cut will come as an automatic adjustment to withholding; for self-employed individuals, the self-employment tax rate falls from 12.4% to 10.4%. Although this temporary tax cut was set to expire at the end of 2011, it has been extended though February 29, 2012.
In 2013, taxpayers with wages greater than $200,000 for single taxpayers and $250,000 for married filing joint taxpayers will pay an additional 0.9% Medicare tax on top of the 1.45% that they already pay as employees. This additional Medicare tax will only apply to employees and not employers. The tax is based on the total wages reported on an individual's tax return. Therefore if a joint return is filed, the tax applies to the combined wages rather than each spouse individually.
Estate and Gift Taxes
Big changes were made to the estate and gift tax laws for 2011. The lifetime exemption amount increased to $5 million per individual for estate, gift, and generation-skipping taxes alike; any amount over the $5 million exemption is taxed at 35%. This change is set to expire at the end of 2012 so this is the year to focus on your estate and gift tax planning, if applicable. In addition, the annual exclusion for tax-free gifts remains $13,000 per donor. A donor may make an unlimited number of $13,000 gifts, as long as they are to different individuals. Gifts of tuition and payments for medical care are also exempt from gift tax as long as the payments are made directly to the donee's school or the medical bills are paid directly to the service provider.
Additional Reporting Requirements, Taxpayer Due Diiligence, and Increased IRS Scrutiny
Cost-Basis Reporting by Brokers and Changes to Schedule D
Beginning in 2011, brokers must track their clients' purchases of stock, real estate investment trusts, and foreign securities, then report the original cost to the IRS when the asset is sold on Form 1099-B: Proceeds from Broker and Barter Exchange Transactions. This is an effort to improve tax compliance by investors. The new disclosure rules for investments in mutual funds, bonds, options, and many exchange-traded funds do not take effect until after 2011.
Form Schedule D: Capital Gains and Losses has been revamped for the 2011 tax year to take into account the basis of tracking by brokers previously mentioned. Schedule D will now be a "summary form," with all details reported on the new Form 8949: Sales and Other Dispositions of Capital Assets. Form 8949 will require an individual to provide more detail to the IRS regarding their short-term and long-term stock gains and losses. This will force taxpayers to categorize their gain/loss transactions into various buckets that fit IRS descriptions on the form. One of the categories on Form 8949 specifically entails those transactions reported by brokers on Form 1099-B.
For this filing season, expect your tax preparer to ask you many additional questions related to your stock sales as a result of the more complex reporting requirement for 2011.
Charitable Contributions of $250 or More
Remember that in order to properly claim a charitable contribution deduction of $250 or more to a single organization, a taxpayer must substantiate the contribution with a "contemporaneous written acknowledgment" from the charity. This is a letter or receipt that includes the name of the charity, the date and amount donated, description of the item donated (i.e. cash, stock, etc.), and the estimate of the value of goods provided by the charity, if any.
The IRS is scrutinizing charitable donations more and more and has increased their analysis of charitable donations under audit. It is important to know these tax rules and obtain your receipts so you will be prepared at tax time. Keep those receipts for at least 5-7 years in case the IRS questions your deduction. Also, please remember that only donations to domestic charitable organizations are deductible.
Real Estate Professionals and Time Records
The IRS requires appropriate time records for individual taxpayers claiming to be real estate professionals in order to substantiate the treatment of their rental real estate activities as "non-passive." When real estate activities are considered non-passive, losses from rental real estate may offset other income of the taxpayer, whereas non-real estate professional losses are limited to $25,000. The $25,000 real estate loss deduction for non real estate professionals is allowed as long as the taxpayer's income does not exceed a certain threshold.
Real estate professionals must pass two tests in order to treat their losses as "real estate professional" losses: 1) more than 50% of the personal services performed by the taxpayer in all their trades or businesses during the tax year must be performed in real property trades or businesses and 2) the taxpayer must spend more than 750 hours of service during the tax year in their real property trades or businesses and materially participate.
If you are a taxpayer investing in rental real estate and are claiming to be a real estate professional, keep track of the hours you spend on each activity in case the IRS asks for that information in the future. Time tracking is much easier at the time the activity is performed than years afterwards when the IRS is knocking on your door. In addition, if you are a real estate investor and think you may qualify as a real estate professional, contact your tax advisor to see if you meet the criteria mentioned above.
Election to Combine Rental Real Estate Activities
In order to meet the real estate professional requirements described above, a taxpayer may elect to treat all interests in rental real estate activities as a single activity. Rental properties owned by the taxpayer are considered separate activities unless the "single activity" election is made. This election can be made in any year the special real estate professional rules apply, but the election is irrevocable once it is made. If the election was not made and should have been, IRS relief is available by filing under Revenue Procedure 2011-34. It is important to note that California does not recognize the real estate professional status and therefore all rental real estate activities are considered passive for California tax purposes.
Changes to Rental Real Estate Disclosure Requirements
For 2011, Form Schedule E: Supplemental Income and Loss (from rental real estate, royalties, partnerships, s-corporations, trusts, REMICS, etc.) has been revised. Schedule E now requires taxpayers to provide additional information directly on the form in an effort by the IRS to make taxpayers' real estate activities more transparent.
For example, Schedule E now contains a new question and check box asking taxpayers if they made any payments that would require the filing of Form 1099, requires more detailed disclosure of personal and fair rental days for each property, and requires disclosure by the taxpayer of the type of property being rented (single family resident, commercial, vacation home, etc.).
Again, your tax preparer will be asking you additional questions related to your real estate investments this year. The questions will apply to you even if you have owned your properties for many years.
Foreign Financial Asset Reporting
A new provision effective for the 2011 tax year imposes reporting requirements on individuals that own certain foreign financial assets of $50,000 or more in 2011. Form 8938, Statement of Specified Foreign Assets, is the information reporting form that taxpayers will use to report "specified" foreign financial assets for the 2011 tax year. Assets that qualify as "specified assets" are assets such as foreign bank and brokerage accounts, stock issued by a person other than a US person, any interest in a foreign entity, and more.
Businesses with foreign investments are also required to file this form; however, IRS regulations covering business entities have not yet been finalized. Until the regulations are final, only individuals are required to file the new Form 8938. Additionally, the Form 8938 filing requirement does not replace or otherwise affect a taxpayer's obligation to file an FBAR, Report of Foreign Bank and Financial Accounts.
Additional Information Reporting by Financial Institutions
The IRS uses information returns to make sure that taxpayers are reporting their income, rather than relying on the honor system. For the first time in 2011, banks and other financial institutions have to report merchant transactions on a new Form 1099-K. The transactions include amounts processed on credit cards, debit cards, PayPal, and other electronic transactions.
Increase in IRS Tax Audits
As part of the government's fiscal year 2011, the IRS requested an approximate 5% increase in enforcement activities which include investigations, examinations, and collections. Between 2010 and 2011 the IRS reported a 34% increase in audits for taxpayers reporting income of more than $200,000. Additionally, approximately 12.5% of all taxpayers earning one million dollars or more were issued audit notices during fiscal 2011, which was the highest enforcement rate since 2004, according to IRS enforcement statistics.
Changes to Credits, Deductions, and Elections for Individual Taxpayers
Residential Energy Credits
Certain energy efficient home improvements made through December 31, 2011 to an individual's primary residence may qualify for a tax credit of up to $500. Improvements include insulation, metal and asphalt roofs, water heaters, and exterior windows and doors. The $500 allowable credit is reduced by any previously claimed residential energy credit taken after 2005. If a taxpayer qualifies for a residential energy credit, the credit amount may offset both regular and AMT taxes.
Ability to Make a Charitable Contribution from a Retirement Account
For 2011, a tax-free distribution of up to $100,000 can be made from an individual retirement plan by a person age 70.5 years or older, as long as the distribution is made to an eligible charitable organization. By excluding this income from the taxpayers 2011 adjusted gross income (AGI), the individual may be able to deduct additional items which are normally limited by a taxpayer's AGI.
Roth IRA Conversions
The income limit for Roth IRA conversions has been permanently removed. Therefore, all taxpayers, regardless of income level, may convert ordinary IRAs into Roth IRAs. Taxpayers who convert from traditional to Roth IRAs in 2011 no longer have the option of deferring conversion income into later years as was true for 2010 conversions. In 2010, an individual could elect to report Roth IRA conversion income in 2010 or defer the income reporting for two years and report the income equally in 2011 and 2012. Those who chose to defer the income to 2011/2012 must report half of the conversion income on their 2011 tax return.
Flexible Spending Accounts Used for Medical Expenses
Workers with Flexible Spending Accounts (FSAs) may no longer use pretax funds to pay for many over-the-counter medicines (aside from insulin) without a prescription. FSA funds may, however, still be used for other non-prescription medical items such as crutches, contact lens solution, or post-chemotherapy wigs, if the individual plan allows it. For a list of what is allowed by law, see IRS Publication 502.
Changes to Credits, Deductions, and Elections for Small Businesses
Section 179 Depreciation Deduction
For 2011, small businesses can expense up to $500,000 of the first $two million of business expenditures placed in service in 2011 as long as the property qualifies as "Section 179 Property." Most assets including off-the-shelf computer software, most machinery and equipment, and SUV's (limited to $25k) qualify. Real Property does not qualify for the Section 179 deduction unless it's "Qualified Real Property," in which case the deduction is limited to $250,000. It is important to discuss your businesses' Section 179 eligibility with your tax preparers to ensure you are taking full advantage of this tax incentive. For 2012, the maximum Section 179 deduction decreases to $125,000.
Start-Up and Organization Expense Deduction
For 2011, new businesses can deduct up to $5,000 in start-up and organization expenses on their first tax return. Start-up expenditures are amounts paid or incurred in connection with investigation, creation, acquisition, or establishment of an active trade or business. If the start up or organization expenses are greater than $50,000, the $5,000 deduction is unavailable and the expenses must be amortized over 15 years.
The items explained above are highlights of tax law changes that will affect many individuals and small businesses for 2011 tax year. With the passing of each filing season, tax laws become more complex and it is crucial to always be informed as a taxpayer. Remember that California and other states do not always conform to the federal tax laws, which adds another level of complexity when filing your tax returns. The IRS and California Franchise Tax Board websites are great resources for taxpayers to find information and summaries of tax law changes.
If you have questions about how 2011 tax law changes may affect you or your business, speak with your BPM tax advisor or email email@example.com.
This publication contains information in summary form and is intended for general guidance only. It is not intended to be a substitute for detailed research nor the exercise of professional judgment. Neither BPM nor any member of the BPM firm can accept any responsibility for loss brought to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.