Landmark legislation signed into law by President Clinton in August 1997 as part of a larger act designed to balance the federal budget. Some of the major provisions of the law:
1. Tax credits for children: Parents or grandparents supporting children under the age of 17 are allowed to claim a Tax Credit of $400 per child in 1998 and $500 per child in 1999 and every year thereafter. The credit can be used in addition to the existing deduction for each dependent. This tax credit is phased out for families reporting an Adjusted Gross Income of $110,000 on a joint return, $55,000 for those married filing separately, and $75,000 for a single filer. The credit is reduced by $50 for each $1,000 of the threshold, and it disappears altogether for couples with incomes of $119,000 or more and singles with incomes of $85,000 or higher. A tax credit of $5,000 was also added for taxpayers who adopt children, with up to $6,000 for adoptions of "special needs" children.
2. Estate tax exclusion raised: The amount of Assets that individuals can exclude from estate taxes was boosted from $600,000 to $1 million, and up to $1.3 million for small businessmen and farmers. The increase in the universal estate tax exclusion is phased in over a 9-year period, with the limit rising to $625,000 in 1998, $650,000 in 1999, $675,000 in 2000 and 2001, $700,000 in 2002 and 2003, $850,000 in 2004, $950,000 in 2005, and topping out at $1 million in 2006 and later years. However, the $1.3 million limit for farms and other small businesses went into effect fully on January 1, 1998. To qualify as a small business, an estate's business assets must represent at least 50% of its total assets. To preserve the tax break, heirs must also "materially participate" in running the business for at least five of the eight years within ten years of the owner's death. If heirs sell the business to nonfamily members within 10 years after the owner's death, they must pay some of the taxes from which they were originally exempt.
In the Tax Act, three other estate tax limits were indexed to inflation, rounded to the next lowest multiple of $10,000:
• the $1 million exemption from the generation-skipping transfer (GST) tax.
• the $750,000 maximum reduction in value on special use valuation of real property used in farming or a closely held business.
• the $1 million maximum value of a closely-held business eligible for a special 4% interest rate on estate tax installment payments.
3. Gift tax limit indexed to inflation: The $10,000 a year Gift Tax limit was tied to the rate of inflation, and is adjustable in $1,000 increments starting on January 1, 1999.
4. Lower capital gains tax rates: The top tax rate on profits from the sale of assets like stocks, bonds, mutual funds and real estate was lowered from 28% to 20%. Before this law, those in the 15% and 28% income tax brackets paid the same tax rate on Capital Gains as on regular income. Only those in higher tax brackets benefited from the 28% capital gains tax rate cap. Under the 1997 law, those in the 28% bracket pay a maximum rate of 20%, while those in the 15% tax bracket pay a maximum of just 10% when they realize capital gains. The new rules apply to anyone selling assets after May 6, 1997, but do not apply to sales of hard assets like art, antiques, stamps, coins, gems and collectibles, for which the top capital gains tax rate remains 28%. These capital gains tax rates apply for Alternative Minimum Tax (AMT) purposes as well as for regular federal taxes.
5. New tax rate for property that received accelerated depreciation: For those selling a business or investment real estate on which they took accelerated depreciation, the portion of the capital gain representing depreciation is eligible for a maximum tax rate of 25% if the asset is sold after May 6, 1997.
6. Longer-term capital gains rates created: For assets like stocks, bonds, and mutual funds purchased after January 1, 2000 and held for at least five years, the top capital gains rate was lowered to 18% for those in the 28% tax bracket or higher. The tax rate for holding assets for five years was lowered to 8% for those in the 15% tax bracket.
7. Changed holding period for capital gains: Previous law stated that assets had to be held for at least 12 months to qualify for long-term Capital Gains rates. Under the 1997 law, assets must be held for at least 18 months to qualify for the advantageous capital gains tax rates. Subsequently, the Internal Revenue Service Restructuring and Reform Act of 1998 enacted into law in the summer of 1998, reduced the holding period back to 12 months.
8. Expanded tax deductibility for individual retirement account contributions: Under previous law, taxpayers could not fully deduct their contributions to Individual Retirement Accounts if their adjusted gross income exceeded $40,000 on a joint tax return or $25,000 for a single tax return. The law raised those income caps to $50,000 for a joint return and $30,000 for a single, starting in 1998. The caps gradually climb over ten years (by 2007) to $80,000 for a couple and $50,000 for a single. Over those limits, the deduction phases out for the next $10,000 in income. For singles, the deduction is phased out completely once income tops $40,000 in 1998, climbing to $60,000 in 2005. For married couples filing jointly, the deduction is phased out once income exceeds $60,000 in 1998, rising to $100,000 in 2007.
9. Introduction of the Roth IRA: A new kind of Individual Retirement Account was created called the Roth Ira, which allows individuals to invest up to $2,000 in earnings a year, even after they reach age 701⁄2. They can withdraw all the principal and earnings totally tax free after age 591⁄2, as long as the assets have remained in the IRA for at least five years. Unlike regular IRAs, participants do not have to take distributions from a Roth IRA starting at age 701⁄2. In fact, they do not have to take distributions at all in their lifetime if they prefer, allowing them to pass the assets in the Roth to their beneficiaries income-tax free. Contributions to Roth IRAs do not generate tax deductions.
Roth IRA rules also permit account holders to withdraw assets without the usual 10% early withdrawal penalty if they use the money for the purchase of a first home (withdrawals are limited to up to $10,000), for college expenses or if they become disabled.
Only married couples with adjusted gross incomes of $150,000 or less and singles with adjusted gross incomes of $95,000 or less can contribute the full amount to Roth IRAs. The amount they can contribute is phased out for incomes between $150,000 and $160,000 for married couples, and between $95,000 and $110,000 for singles. No contributions are allowed over those income limits.
For those with adjusted gross incomes of $100,000 or less, the law allows people to roll over existing deductible and nondeductible IRA balances into a Roth IRA without the normal 10% premature distribution penalty. When they do so, however, they must pay income tax on all previously untaxed contributions and earnings. For rollovers executed before January 1, 1999, the resulting tax bill is spread over four years. Starting in 1999, the rollover is fully taxable in the year it is completed.
10. "Cash-out" threshold for 401(k) plans raised: Under previous law, an employer could "cash out" any departing employee whose 401(k) balance was $3,500 or less. The employee could either take the money and pay taxes on it or roll it over into an Ira Rollover Account. The new tax law raised that limit to $5,000, meaning that more workers will be "cashed out" of their 401(k) plans than before.
11. More investments allowed in IRAs: Starting in 1998, IRA account holders can invest in metals such as gold, silver, platinum and palladium. Previously, such IRA investments were banned.
12. Repeal of the "short-short" rule: Under previous law, mutual funds lost their tax pass-through status if more than 30% of their gross income was generated from short-term investment gains under what was known as the "short-short" rule. As a result, fund managers were afraid to use trading strategies such as the use of options contracts, hedging, and short-selling that would generate short-term profits on holdings, even though the fund manager wanted to do so for investment reasons. The tax bill repealed the "short-short" rule, freeing up managers to trade frequently without fear of losing their tax pass-through status. See also Short-Short Rule.
13. Eliminated "short against the box" as a tax delay technique: A popular way for some investors to delay paying taxes was "Sell Short Against the Box." In this technique, an investor who owns a particular stock would sell borrowed shares of the stock rather than shares already owned. This tactic is similar to selling because the investor no longer owns an economic interest in the stock, but previous tax law did not treat it as a sale. Under the 1997 law, shorting against the box after June 8, 1997 is considered a "constructive sale," and will result in a Capital Gains Tax liability. In effect, this law change means it no longer makes sense to use this technique to delay paying taxes.
14. Simplifies reporting of taxes on foreign investments: Starting with 1998 tax-year returns, investors with holdings in foreign stocks, bonds, or mutual funds no longer need to fill out the complicated IRS Form 116 to claim the foreign tax credit. This applies to single investors who pay up to $300 a year in foreign taxes and for married couples filing jointly up to $600 a year. The amount of foreign earned income that taxpayers can exclude from taxation increases from $72,000 in 1998 to $74,000 in 1999, $76,000 in 2000, $78,000 in 2001 and $80,000 in 2002 and later years.
15. Repeal of excess accumulation and excess distributions tax: In earlier legislation, Congress imposed a 15% "excess accumulation tax" on Lump Sum payouts of more than $800,000 from pension plans and a 15% "excess distributions tax" on payouts from Individual Retirement Accounts of more than $160,000. All of these taxes were repealed for distributions made after December 31, 1996.
16. New capital gains rules for home sales: Under previous law, homeowners could avoid Capital Gains Taxes on the sale of their home only if they bought another home within two years and reinvested the proceeds into a home of the same or greater value. Those over age 55 could escape capital gains tax when selling their homes up to $125,000 once in their lifetime. The 1997 tax law allows people to avoid all capital gains taxes on profits up to $500,000 for married couples filing jointly and up to $250,000 for those filing singly. The rule which benefits anyone selling their home after May 6, 1997, only applies to a person's primary residence, defined as a home occupied for at least two of the five years prior to the sale. Individuals can claim the $500,000 capital gains tax exemption every two years. The old $125,000 exemption for those over 55 was superceded by the new law. In the past, someone with gains of more than $500,000 could avoid taxes by rolling the profits into a larger home. The 1997 law eliminates such a rollover. Capital gains taxes of up to 20% are due upon the sale of a home with profits over $500,000. One other twist affects real-estate investors who depreciate their property over time. When these investors sell the property, they must pay a maximum 25% capital gains tax for the part of their gain due to depreciation.
17. Tax credits for college education: The law created the "Hope Scholarship," a tax credit to help pay for the first two years of tuition and fees for students attending college or vocational school. The tax credit started at $1,500 in 1998 and rises to $2,000 in 2003. Starting on July 1, 1998, a yearly "Lifetime Learning Credit" of up to $1,000 for 20% of tuition and school fees up to $5,000 is available for third- and fourth-year college students, graduate students, and people returning to school to sharpen job skills. This credit rises to 20% of $10,000, or a maximum of $2,000, in 2002. These tax credits are available only to married couples filing jointly with adjusted gross incomes of $80,000 or less, or singles with $40,000 or less. The credit is phased out for couples with incomes of $100,000 and singles earning over $50,000.
18. Deductible education-related interest: Starting in 1998, up to $1,000 in interest on student loans is deductible for taxpayers repaying loans for their own or a dependent's college or vocational school expenses. The interest is deductible only for the first 60 months (5 years) that the loan is outstanding. The $1,000 cap increases by $500 annually until it reaches a maximum of $2,500 in 2001. Taxpayers can get this deduction even if they don't file an itemized return. This deductible interest is fully available to married taxpayers with $60,000 or less in income if filing jointly or $40,000 or less for singles. The deduction phases out for couples with incomes between $60,000 and $75,000 and for singles with incomes between $40,000 and $55,000, and is not available for those with incomes over those thresholds. Income levels will be adjusted for inflation starting in 2003.
19. Tax-free employer-paid education: Employees are entitled to receive up to $5,250 per year from their employers for undergraduate classes without having to declare that money as taxable income. This rule applies to classes not directly related to their job. The tax break remains in effect for courses beginning before June 1, 2000. Reimbursement for schooling that is job-related remains tax-free without limitation.
20. Creation of Education IRA: A new type of account, similar to an Individual Retirement Account, called the Education Ira, was created to allow parents to save up to $500 per year per child under age 18 to help pay educational expenses. The money invested does not generate a deduction when placed in the Education IRA, but the principal, income, and Capital Gains are completely tax-free when withdrawn to pay for college expenses such as tuition, fees, books and room and board. See also Education Ira.
21. Tax relief for children: In the past, children earning more than $650 a year in wages could not use their standard deduction to shelter investment income from taxes. Beginning in 1998, children can use the standard deduction to shelter both their job earnings plus up to $250 in investment income.
22. Bigger deductions for health insurance premiums for the self-employed: Under previous law, only a portion of health insurance premiums paid by the self-employed were deductible, while all premiums paid by larger companies were deductible. This inequity was phased out by the law. In 1997, 40% of the premium paid by the self-employed were deductible. In 1998 and 1999, it rose to 45%. In 2000 and 2001, it rises to 50%. In 2002 it is 60%. From 2003 through 2005, the deduction rises to 80%. In 2006 it is 90%. From 2007 and future years, the deduction is 100%.
23. Creation of the Medical Savings Account (MSA): People with high-deductible health plans may participate in a Medical Savings Account. They can deduct MSA contributions even if they do not itemize deductions. MSAs are generally available for the self-employed and small employers with fewer than 50 workers.
24. Social Security and Medicare taxes: The maximum wages subject to Social Security tax (6.2%) was raised to $65,400. All wages are subject to the Medicare tax of 1.45%.
25. Liberalization of the home office deduction: For many years, the IRS rules and court decisions greatly restricted home office deductions. The 1997 tax law eased the rules and home office deductions are allowed starting in 1999 if the space used is essential to running or administering the business. No longer does the space have to be the only place where the taxpayer meets clients or conducts their work. However, taxpayers must use the home office space exclusively and regularly for business purposes.
26. Higher exemption from filing quarterly estimated taxes: Starting in 1998, the law exempts those expecting to pay less than $1,000 in taxes from having to make quarterly estimated tax payments. This doubles the previous limit of $500. In figuring estimated tax, however, taxpayers must include any expected employment taxes for household workers.
27. Higher deduction for charitable use of your car: The deduction for using an automobile to benefit a charity rose from 12 cents to 14 cents a mile, starting in 1998.
28. Repeal of motorboat gas tax: The 24.3 cent a gallon tax on diesel fuel for recreational motorboats was repealed.
29. Paying taxes by credit card: The bill authorized the Internal Revenue Service to accept payment of taxes by credit or debit card or electronic funds transfer, though the IRS is prohibited from paying fees to card issuers.
30. Higher cigarette taxes: The excise tax on cigarettes rose by 10 cents a pack to 34 cents in 2000 and by an additional 5 cents to 39 cents in 2002.
31. Higher airline ticket taxes: The excise tax on airline tickets rose from $6 to $12 on departures to international destinations, and a $12 per ticket fee was added on international arrivals. A $3 airport-to-airport segment tax was also added on all domestic flights. The airline ticket tax was gradually scaled back from 10% to 7.5%.
See also Economic Growth and Tax Relief Reconciliation Act of 2001; Internal Revenue Service Restructuring and Reform Act of 1998.
