If you look at your real estate bill or assessment notice you’ll probably see two different assessment amounts.  The first, usually called an “assessment value” or “market assessment” is the value that tax assessors come up with and usually bears at least some resemblance to the market value of your home. In most states market values serve as an upper or maximum assessment limit, but it’s not what your real estate taxes are actually based on.

The second amount, the important one, is the “taxable assessment”.  Most state start with the “market assessment” when a house is first built or purchased, then add an amount each year to establish the “taxable assessment”.  The amount added is often dictated by state law.  I live in Maryland, and in my county the added amount has been 4% a year for a long, long time.  During times of real estate inflation, such as the one which lasted about 30 years until the market crash in 2008, taxable assessments will lag further and further behind market values as time goes by.  In my neighborhood, for instance, a typical house that in 1977 cost $40,000 or so was worth $300,000 or more by 2007.  Yet the taxable assessment, at 4% per year, would’ve been only $130,000.  So even if the market value dropped by 30 or 40 percent in 2008 and 2009, the taxable assessment would keep going up.

State & Counties set real estate tax rates with the taxable assessments in mind, not with market values in mind. It’s good for them because it provides for stable or even increasing tax revenues in times of recession.  It’s also good for long-term homeowners whose real estate taxes can only increase very gradually so long as they don’t move.

New home buyers, of course, get screwed.  They start out paying tax based on current market values even though their neighbors, with similarly valued homes, may be paying only half as much.  Those who bought house at the peak of the real estate boom, between 2003 and 2007, were paying the most real estate tax when the recession hit and 2008 and will be the first to see their taxes go down as market assessments dip below taxable assessments.

In light of the national war on flip-flopping, and now that we’re getting ready to celebrate (if that’s the right word) the centennial of the first Internal Revenue Code, I thought it would be fun to put together a brief history of capital gains legislation.  No issue, it seems to me, has caused more congressmen to change their minds more often than has the capital gains tax.  If you look at my brief history you’ll see that capital gains tax rates have been as low as 0% and as high as 75% (counting the AMT effect) and everywhere in between.  During that time the required holding period for capital assets has ranged from 6 months to 10 years.  Capital loss deductions have come and gone and come and gone and then come again.  The exclusion amount (a portion of gain excluded from tax) moved back and forth between 6 different rates until 1986, when it was eliminated altogether.  The one and only consistent thing about capital gains law during its first hundred years has been the progressively liberal treatment of homeowners.  Steadily, step by step, the amount of tax paid on gains from the sale of personal residences decreased until 1997; that’s when the exclusion hit $500,000 and all but a small handful of homeowners were liable for any tax at all.

Notice my use of the word “brief”.  My short history only lists major legislation affecting most individual taxpayers (1040 filers). I haven’t included legislation concerning the sale of business or rental assets, corporate capital gains, gains on inherited or gifted assets or laws aimed at one type of asset, like timber, movie rights, agricultural land, etc.  Such a history would be 10 times longer.

Back to the Future

 The 2003 capital gains rates, the so-called Bush tax cuts, are set to expire at the end of this year, having already been extended twice.  President Obama has said that, going forward into the next tax century, at a minimum the capital gains tax should increase to 20%, and ideally, that capital gains should be taxed at ordinary income rates.  He’s also suggested that capital gains should be subject to payroll taxes just like earned income if.  As an investor I find his ideas appalling.  To my mind, investment, which involved risking my hard earned money, is an entirely different activity from punching a time clock, and the tax system should recognize the difference and acknowledge the risk.  The president doesn’t agree.  For him, income is income.  He has plenty of company; any number of congressmen and a large part of the American public, perhaps most of it, are on his side.

We’ve been here before.  In 1913, when the IRC was written, and again in 1986, after Reagan’s so-called tax revolution, investment income and earned income were taxed alike.  In both cases, within 3 years, tax law began to evolve towards recognizing capital gains.  But this time around there are two new issues muddying the legislative waters, one of which is “carried interest”, a loophole which allows hedge fund and private equity managers to treat large portions of income as investment income.  It’s a smokescreen.  Hedge funds invest and risk other people’s money, not their own, which mean that their income is earned.  To me it’s that simple.  Unfortunately, half of Congress wants to do away with all capital gains in order to tackle the carried interest problem and the other half defends carried interest in the defense of all capital gains law.

The other issue is “employee benefits”.  Based on BEA numbers, benefits topped 1.5 trillion dollars in 2010.  That’s 20 cents for every dollar of payroll.  The number of 401k and cafeteria plans, not to mention the cost of health insurance, has grown by leaps and bounds since 1986.  These benefits are virtually all tax free (many of them are also payroll tax free), which means that the typical American worker gets a 20% income exclusion on his/her tax return without even realizing it.  Since 1986 the number of tax credits has also grown by leaps and bounds.  Most credits, the most generous ones – the EIC, Child Tax Credit, Making Work Pay Credit and Dependent Care Credit – can be applied only to tax resulting from earned income.  In 2009 (latest IRS figures available) these credits reduced total tax liability by almost 15%; for working people with children the reduction was over 40%.  It’s not hard to see why many investors think it’s actually earned income which gets the preferential treatment.  That’s not far from the truth.

Going forward into the next century it’s hard to see how capital gains legislation could be more sensible than it was in the last.  Our tax law will surely continue as a muddle, a mish-mash of largely politically motivated, re-hashed proposals which come and go and come again.  The situation is probably worse than in 1913, of even 1986, because now any politician who’s ever weighed in on the carried interest or employee benefit questions or on any aspect of capital gains law couldn’t change his mind even if he wanted to.

Believe it or not, this new reporting requirement was a revenue provision in the “Energy Improvement and Extension Act of 2008”, one of five different acts which formed the “Emergency Economic Stabilization Act of 2008”, otherwise known as the “Troubled Asset Relief Program” or TARP.  Revenue provisions are the pieces of a congressional act designed to raise the money to pay for expenditure provisions in the act, the stuff that costs money.  According to Congress, the new stock sale reporting requirements will generate some 6.7 billion dollars over a ten year period.  The money is supposed to come from taxpayers who are underreporting or misreporting capital gains.  But Congress didn’t take into account what the new reporting requirement will cost the IRS to implement, what it will cost the banks and brokerage firms to administer and what it will cost investors in terms of paper, postage, accounting time, tax preparation fees and general hassle.

There are three major problems inherent in the new law.  Firstly, your stock broker doesn’t know what your cost basis is if you didn’t buy the stock from him.  Secondly, tax law provides for three different methods of computing a basis, called “first-in-first out”, “last-in-first-out” and “average cost”.  Your stock broker doesn’t know which method you’re going to use when preparing your tax return, nor should he know — it’s none of his business.  To make things more complicated, you’re allowed under the tax law to use different methods for different assets on the same tax. Which brings us to problem number three, the number of disputes bound to arise between the IRS and taxpayers when gains reported on tax returns don’t jive with gains reported on 1099 forms.  Congress didn’t figure out the cost of resolving these disputes either.

A final word of warning:  if you’re an active investor, you should expect to receive 1099 forms quite late this year.  In 2008, after the IRS significantly changed the reporting rules for reporting dividends, many brokerage firms had to send out two or three sets of “corrected” 1099 forms before getting it right.  That year, some of our clients didn’t get final 1099 forms until April.  This year could be the same.

What is a Health Savings Account (HSA)?  An account set up by the insured (not the insurance company) through a bank or other “trustee” in conjunction with an HDHP.  The insured deposits money into his/her HSA each year and then draws from the account in order to pay deductible medical costs.  Money deposited to an HSA is tax deductible, but money withdrawn to pay medical costs is not taxable income.

What Tax Reporting is Required?  Trustees report contribution amounts each year to the IRS on Form 5498 in much the same way that IRA contributions are reported.  Distributions are reported on Form 1099-SA.  Taxpayers must file Form 8889 with their tax returns to compute tax deductible contributions and to account for reported distributions.

What about Employer-Sponsered HSAs?  An employees may start an HSA in conjunction with an employer-sponsered HDHP. Contributions made to an HSA through payroll deductions are made “pre-tax” and not reported as taxable wages on an employee’s W2 form.  If employee contributions are made as part of a Section 125 plan, sometimes called a “flexible spending plan”, then the contributions also avoid payroll tax.

Average Indexed Monthly Earnings (AIME)

When we compute a worker’s benefit, we first adjust or index his or her earnings to reflect the change in general wage levels that occurred during the worker’s years of employment. Such indexation ensures that a worker’s future benefits reflect the general rise in the standard of living that occurred during his or her working lifetime. Up to 35 years of earnings are needed to compute the average indexed monthly earnings. After we determine the number of years, we choose those years with the highest indexed earnings, sum such indexed earnings, and divide the total amount by the total number of months in those years. We then round the resulting average amount down to the next lower dollar amount. The result is the average indexed monthly earnings.

An insured worker becomes eligible for retirement benefits when he or she reaches age 62. If 2010 were the year of eligibility, we would divide the national average wage index for 2008 (41,334.97) by the national average wage index for each year prior to 2008 in which the worker had earnings and multiply each such ratio by the worker’s earnings. This would give the indexed earnings for each year prior to 2008. We would consider any earnings in or after 2008 at face value, without indexing. Then we would compute the average indexed monthly earnings and use this average amount in computing the worker’s primary insurance amount for 2010.

Primary Insurance Amounts

The PIA is the sum of three separate percentages of portions of the average indexed monthly earnings. The “bend points” of the PIA formula are the dollar amounts that govern the portions of the average indexed monthly earnings. The bend points in the year 2010 PIA formula, $761 and $4,586, apply for workers becoming eligible in 2010. For example, a person who had maximum-taxable earnings in each year since age 22, and who retires at age 62 in 2010, would receive a reduced benefit based on a PIA of $2,413.30. The first COLA this individual could receive is the one effective for December 2010.

PIA formula

For an individual who first becomes eligible for old-age insurance benefits or disability insurance benefits in 2010, or who dies in 2010 before becoming eligible for benefits, his/her PIA will be the sum of:

• (a) 90 percent of the first $761 of his/her average indexed monthly earnings, plus
• (b) 32 percent of his/her average indexed monthly earnings over $761 and through $4,586, plus
• (c) 15 percent of his/her average indexed monthly earnings over $4,586.

We round this amount to the next lower multiple of $.10 if it is not already a multiple of $.10.

Monthly Benefit Amounts

Monthly retirement benefits derived from the PIA may be higher or lower than the PIA. Reduced benefits are paid if one retires before his/her normal retirement age. A person cannot collect retirement benefits before age 62. In the case of a person retiring at exactly age 62 in 2010, the benefit will be 25 percent less than the person’s PIA. Benefits can be higher than the PIA if one retires after the normal retirement age. The credit given for delayed retirement will gradually reach 8 percent per year for those born after 1942. No delayed retirement credit is given after age 69. (See Separate Table.)