Many people fear that the recently unemployed will be the first targets of the IRS’s more focused investigations. This is because the IRS would likely target individuals who are paying more annually for their mortgages than their reported income would make appear reasonable. However, there may be another group of people whose deductions are questioned in the year to come.

IRS Publication 936 states:

You can deduct home mortgage interest if all the following conditions are met:

• You file Form 1040 and itemize deductions on Schedule A (Form 1040)
• You are legally liable for the loan
• There is a true debtor-creditor relationship between you and the lender
• The mortgage is a secured debt on a qualified home in which you have an ownership interest.

You cannot deduct interest you pay for someone else if you are not legally liable to pay it. Both you and the lender must intend that the loan be repaid.

If the IRS starts taking a closer look at mortgage interest, two things may happen:

• Elderly people whose only income is from social security, but who are listed on the mortgage for a home that their children live in (and pay the mortgage for), may be audited due to speculation that they may have unreported income even if they do not deduct mortgage interest

• Taxpayers who claim the mortgage interest deduction for a home but are not listed on the mortgage may be investigated by the IRS

United States Tax Court Opinion 2008-84
While IRS Publication 936 states that you cannot deduct mortgage interest unless you are legally liable for the loan, a recent US Tax Court case ruled in the favor of two taxpayers (in this example I will refer to them as petitioners) who were not on the title or the mortgage for their house.

The petitioners needed the help of their son to acquire their home and secure a mortgage because they had filed for Chapter 7 bankruptcy just two years prior. The petitioners lived in the home continuously, and they made all mortgage and real estate tax payments. The respondent (the IRS) pled that since the petitioners were not legally obligated to pay the mortgage and did not hold legal title on the property, they were not entitled to deduct the interest.

The key to validating the deduction was proving that the petitioners were equitable and beneficial owners of the property, exclusively enjoying the benefit and burden of the property.

Although the example above yielded a favorable outcome for taxpayer, it is very important to note that past positive results in tax court do not guarantee future success (nor can past negative results guarantee future failure). As stated in the initial lines of the ruling opinion, “the decision to be entered is not reviewable by any other court, and this opinion shall not be treated as precedent for any other case.” Every case is different, just as every court is different. So what works for one taxpayer may not work for another. Still, it may be reassuring to taxpayers who get caught up in future IRS investigations that there may be some hope.

For more information on home mortgage interest deductions, please see the resources below:
IRS Publication 936
US Tax Court Summary Opinion 2008-84
Government Accountability Office report on home interest deductions
Wall Street Journal article about the potential crackdown on taxpayers who “inaccurately” deduct their home mortgage interest

The government has already issued $96 million of its $1 billion budget for the program in just one week, as a result of nearly 23,000 auto sales. That is not including the vast number of sales still waiting for approval. In fact, more than 250,000 sales may be waiting for approval if early estimates are correct, which alone could cost the government more than $1 billion.

If you would like to read the full AP article on the potential halt to CARS, click here. If you would like to learn more about CARS and other auto rebates, you can read our previous post here.

UPDATE: It looks like CARS may be safe for now. Learn more by reading this article from the NY Times.

The business meal and entertainment tax deduction may soon change from an appetizer to a main course. U.S. Representative Neil Abercrombie (HI) has reintroduced a bill to the 111th Congress that aims to increase the business meal and entertainment tax deduction from 50% to 80%. Cosponsored by three U.S. Representatives, House Bill 3333 has been floating throughout congress in some capacity for several years. Most recently, Representative Abercrombie’s 2007 version of the bill (H.R 2648) died in the 110th Congress after being referred to the House Committee on Ways and Means. The bill has also been presented to the Senate during previous sessions, always suffering the same fate.

New Recipe
While H.R. 2648 and H.B. 3333 are virtually identical, the 2009 bill may be more palatable for the House Committee on Ways and Means than in previous sessions. For one, the bill has more support from the house than in previous years with the presence of two additional cosponsors (although, the Senate variation on the bill released in 2003 had seven cosponsors). Also, the economy is in a very different place than it was last time the bill was introduced.

The National Restaurant Association (NRA) has taken a strong position advocating for H.B. 3333. According to research conducted by the NRA, an increase in the business meal tax deduction to 80% would lead to $6 billion in additional restaurant sales and create an $18 billion increase to the overall economy (based on the estimate that every $1 million in restaurant sales creates 33 jobs).

Will Congress Send it Back?
The business meal and entertainment tax deduction was not always set at 50%. In fact, prior to 1983 taxpayers could deduct 100% of their meals. Faced with a growing national debt, congress lowered the deduction to 80%. In 1993, President Clinton proposed to make additional cuts to the deduction, lowering it to 50%. At the time, the belief was that such a cut in the deduction would pay about $5.78 billion more in taxes.

In 1998, the Joint Committee on Taxation estimated that the five-year cost of raising the deduction from 50% to 100% would be $43.8 billion. And while the economy is in a considerably different condition than ten years ago, it is uncertain how drastically the five-year cost estimate might change.

If you would like to learn more about H.B. 3333, you can visit these web pages:
H.B. 3333: Business Meal and Entertainment Tax Deduction
National Restaurant Association Press Release

As consolation, the IRS allows taxpayers to deduct various health care expenditures. However, in order to qualify, taxpayers must have amassed qualifying health care expenditures exceeding 7.5% of their adjusted gross income (AGI), after which all remaining expenditures may be added to their itemized deduction.

Change is on the Horizon?
While health care expenditures are one of the most frequently asked about deductions, rarely do any of our clients qualify. This may all change soon if Representative Clifford Stearns from Florida’s sixth district has anything to say about it.

In January Representative Stearns sponsored H.R. 198, which is designed to allow insurance and prescription drug expenses to be deducted entirely (thus no longer making them subject to 7.5% of the taxpayer’s AGI). H.R. 198 raises some question marks with regard to the treatment of additional medical expenditures, including hospital stays and dental expenses. It often takes the combined affect of health insurance premiums and additional medical expenditures to help a taxpayer utilize the health care expense itemized deduction. With premiums out of the picture, the 7.5% of AGI qualification may need to be adjusted to benefit taxpayers who accumulate a large amount of medical expenses.

It is still uncertain whether the resolution will see the light of day or face rejection like the majority of bills and resolutions referred to committee. Previous versions of this resolution died with the committee during the past five sessions of Congress, and there are no signs that H.R. 198 will break that trend. At the time this post was written, H.R. 198 was still in the hands of the House Committee on Ways and Means.

Flexibility is Needed
Without any significant change to the American health care system, one thing is certain – health care expenditures per capita will continue to rise for years to come. In fact, a recent report from the Urban Institute highlights that consumer health care expenditures may be on a sharp rise in the years to come. Their research indicated that individual and family spending on health care will increase by 45.9% in a best case scenario, and 68% in a worst case scenario.

We are not advocating for or against reform in the American health care system, but we do believe that the IRS code surrounding the health care expenditure deduction will eventually have to address the growing strain placed on taxpayers from rising medical expenses.

Relief for 2009
As described in our recent post “2009 Tax Code Changes Affecting the Unemployed,” the IRS is addressing the costs of COBRA for taxpayers. There have also been significant adjustments to the Health Coverage Tax Credit, which will now pay 80% of the health insurance premiums for taxpayer who lost their jobs due to increased imports or shifts in production outside of the United States. To receive for this credit, taxpayers must qualify for Trade Adjustment Assistance. You can learn more about this program here.

If you would like more information about health care resolutions and tax credits, you can visit these websites:
H.R. 198: Health Care Tax Deduction Act of 2009
Health Coverage Tax Credit

Unemployment Compensation

With unemployment nearing 10%, there are millions of American’s who will rely on unemployment checks this year to keep food on their table and a roof over their heads. What some people collecting unemployment don’t realize (and what many often ignore) is that unemployment compensation is considered taxable income. And while they can elect to withhold taxes from their unemployment checks, this is often unrealistic because it places additional financial stress on the taxpayer. As a result, many people collecting unemployment face quite a painful situation the following tax year when they owe taxes on their unemployment compensation.

There will be some relief for unemployed taxpayers in 2009, when the first $2,400 in unemployment compensation will be excluded from their income (and therefore not taxed). This provision will only affect unemployment compensation earned in ’09.

If you only plan to incur $2,400 or less in unemployment compensation this year, you would benefit from not withholding taxes from this income to maximize your available funds.

COBRA Premium Assistance

One of the most difficult decisions facing Americans after losing their jobs is whether to maintain their healthcare benefits by enrolling in COBRA. While COBRA does help prevent individuals from forfeiting their group health coverage benefits, the cost of these benefits often increase substantially without their previous employer’s assistance. As a result, many Americans make the difficult decision to forgo health coverage altogether (especially if their only source of income is unemployment compensation, and if individual health coverage costs exceed those of COBRA).

There is, however, some relief to recently retired and unemployed American’s on COBRA. Qualifying individuals may elect to retain COBRA for as low as 35% of their plan’s monthly premiums, while the remaining 65% will be paid by their former employer (and subsequently credited against the employers employment taxes). This subsidy will last for a period of up to 9 months and is terminated upon the individual’s enrollment in another health plan (employer sponsored or individual). The subsidy is also terminated if the individual elects to receive Medicare.

Who Qualifies?
Individuals Eligible for this credit must meet the following requirements:

• Must have elected to receive COBRA coverage. If coverage was initially declined, the individual will get an additional 60 days to elect to receive coverage after they receive notice of the special election period.
• Must have had their employment involuntarily terminated
• Is eligible for COBRA between September 1, 2008 and December 31, 2009
• Earn less than $125,000 ($250,000 for those filing married filing jointly) to obtain full benefit. The subsidy gets phased out if you earn $125,000 - $145,000 ($250,000 - $290,000 for those filing married filing jointly)

If you would like more information about the tax code updates discussed above, you can visit these websites:
Unemployment Compensation Tax Exemption
Employers Tax Guide (see page 8 for COBRA information)
COBRA Premium Assistance Credit

Motor Vehicle Sales Tax Deduction

The American Recovery and Reinvestment Act of 2009 includes a state and local sales and excise tax deduction paid on the purchase of new vehicles during 2009. Taxpayers residing in states without a sales or excise tax (Alaska, Delaware, Hawaii, Montana, New Hampshire and Oregon) will be able to deduct other fees or taxes imposed by the state or local government, granted that they are assessed on the purchase of the vehicle and are based on the vehicle’s sales price or as a per unit fee.

Who qualifies?
In order to be eligible for the Sales Tax Deduction, you must fit all of the following criteria:

• Purchase the right type of vehicle: The vehicles that qualify must be new, and include cars, motorcycles, light trucks and motor homes
• Do not exceed the income requirements: If your modified adjusted gross income is less than $125,000 if you file taxes as an individual, or $250,000 if you file jointly, you may qualify for the full tax benefit of this deduction. If your modified adjusted gross income is between $125,000 and $135,000 if you file taxes as an individual, or $250,000 and $260,000 if you file jointly, you may still be able to receive partial benefit of this deduction. If your modified adjusted gross income exceeds $135,000 if you file taxes as an individual, or $260,000 if you file jointly, you will not qualify for the deduction
• Purchase during the right time frame: Only vehicles purchased between February 17, 2009 and December 31, 2009 qualify for the deduction

How beneficial is this deduction?
The sales tax deduction can be very beneficial to taxpayers who qualify. The one caveat, however, is that you may only deduct the sales or excise tax imposed on the first $49,500 of a car. Also, it is very important to note that this deduction is available even if you do not itemize deductions, allowing you to get the full tax benefit even if you just take your standard deduction.

Here’s an example: Let’s say you live in Los Angeles, California, and would like to purchase a brand new Acura TL. For this example, we will say it costs $42,235 (I opted for the all wheel drive and navigation). The sales and use tax rate in Los Angeles is 9.25%, so the sales tax on your Acura will cost $3,906.74. If you qualify for this tax deduction, you will be able to reduce your adjusted gross income for the 2009 tax year by $3,906.74 on top of your standard or itemized deduction.

Car Allowance Rebate System (also known as Cash for Clunkers)

The Car Allowance Rebate System (CARS) was recently enacted to provide new car buyers with incentive for “thinking green” when they explore their new car options. New car buyers who choose to trade in their current vehicle to use toward the purchase of a more environmentally friendly alternative may qualify.

Unlike the motor vehicle sales tax deduction, CARS is a tax-free credit provided by the dealer to reduce the purchase price of their new vehicle, as opposed to a deduction that would lower the taxpayer’s adjusted gross income. The credit will vary between $3,500 and $4,500, depending on the trade-in and purchased vehicles.

What Vehicles Qualify?
In order for a vehicle to qualify, the following criteria must be met:

• The vehicle must be purchased between July 1, 2009 and November 1, 2009
• The trade-in vehicle must be less than 25 years old at the time of trade-in
• The vehicle purchased/leased must be new. If the vehicle is leased, the period must be for at least five years
• Generally, the trade-in vehicle must get combined city/highway fuel economy of 18 or less MPG (very large pickup trucks and cargo vans have a different requirement). Visit http://www.fueleconomy.gov/feg/sbs.htm to view your vehicles estimated fuel economy
• The trade-in vehicle must be registered and insured by the buyer throughout the full year preceding the trade-in date
• The suggested retail price of the new vehicle cannot exceed $45,000
• The vehicle must be sold by a dealership registered with CARS program. Visit http://www.cars.gov/ for a complete list of participating dealerships as soon as the program is under way

So what’s the catch?
Before you trade in your cherished ’99 Mercedes SL500 for a brand new Toyota Prius, be aware that you are not going to receive the Kelley Blue Book value for your car. Rather, you will receive the scrap value of your car, since the law requires that your trade-in vehicle is destroyed. So if your SL’s trade in value is listed around $14,000, it may be in your best interest to forgo this credit. On the other hand, you may want to consider trading in your ’91 Isuzu Trooper in fair condition with 150,000 miles, since its trade in value will likely settle under $500.

Another thing that is yet to be seen will be how participating dealerships work CARS into their current rebate and discount offerings. While the dealerships are reimbursed by the Fed, it will be interesting to see how participating dealerships advertise the program. There is always the possibility that some dealers will cut back on price bargaining, citing the credit as ample incentive to buy with them. However, it is possible that to become a program participant, dealers may have to adhere to certain criteria governing advertising and sales tactics. This is still unknown, as registration details have yet to be released.

Last, it is important to note that CARS will only benefit the owner of the trade-in vehicle if they have owned, registered and insured the vehicle for more than a year. So you cannot go out and acquire the aforementioned Isuzu next week in an effort to save $4,000 on your Prius purchase. You also cannot transfer the title for your mother’s ’85 Cadillac Eldorado into your name to secure the benefit.

If you would like more information about the new vehicle tax and rebate benefits discussed above, you can visit these websites:
Motor Vehicle Sales Tax Deduction IRS description
Cash for Clunkers consumer website
Car Allowance Rebate System government website