Here are several important changes that the IRS wants you to keep in mind when you file your 2010 federal income tax return in 2011.

Health Insurance Deduction Reduces Self Employment Tax  In 2010, eligible self-employed individuals can use the self-employed health insurance deduction to reduce their social security self-employment tax liability in addition to their income tax liability. As in the past, eligible taxpayers claim this deduction on Form 1040 Line 29. But in 2010, eligible taxpayers can also enter this amount on Schedule SE Line 3, thus reducing net earnings from self-employment subject to the 15.3 percent social security self-employment tax.

Premiums paid for health insurance covering the taxpayer, spouse and dependents generally qualify for this deduction. Premiums paid for coverage of an adult child under age 27 at the end of the year, for the time period beginning on or after March 30, 2010, also qualify for this deduction, even if the child is not the taxpayer’s dependent.

As before, the insurance plan must be set up under the taxpayer’s business, and the taxpayer cannot be eligible to participate in an employer-sponsored health plan. Details, including a worksheet, are in the instructions to Form 1040.

First-time homebuyer credit You must meet the required deadlines to be eligible to claim the credit.  You must have bought — or entered into a binding contract to buy — a principal residence on or before April 30, 2010. If you entered into a binding contract by April 30, 2010, you must have closed or gone to settlement on the home on or before Sept. 30, 2010.   Because of the documentation requirements for claiming the credit, taxpayers who claim the credit on their 2010 tax return must file a paper — not electronic — return and attach Form 5405, First-Time Homebuyer Credit and Repayment of the Credit, and a properly executed copy of a settlement statement used to complete the purchase.

Taxpayers who claimed the first-time homebuyer credit for a home bought in 2008 must generally begin repaying it on the 2010 return. In most cases, the credit must be repaid over a 15-year period. Many of those affected by this requirement received reminder letters from the IRS.

A repayment requirement also applies to a taxpayer who claimed the credit on either their 2008 or 2009 return and then sold it or stopped using the home as their main home in 2010. Use Form 5405 to report the repayment.

In addition, certain members of the armed forces and some other taxpayers still have time to buy a home and take the credit. See Form 5405 and its instructions for details.

Standard Mileage Rates for 2010 The standard mileage rate for business use of a car, van, pick-up or panel truck is 50 cents for each mile driven. The rate for the cost of operating a vehicle for medical reasons or as part of a deductible move is 16.5 cents per mile. The rate for using a car to provide services to charitable organizations is set by law and remains at 14 cents a mile.

Tax Breaks Extended Several tax breaks that expired at the end of 2009 were renewed and can be claimed on 2010 returns. They include:
• State and local general sales tax deduction, primarily benefiting people living in areas without state and local income taxes. Claim on Schedule A, Line 5.
• Higher education tuition and fees deduction benefiting parents and students. Claim on Form 8917.
• Educator expense deduction for kindergarten through grade 12 educators with out-of-pocket classroom expenses of up to $250, Claim on Form 1040, Line 23 or Form 1040A Line 16.
• District of Columbia first-time homebuyer credit. Claim on Form 8859

 

Here’s an overview of the provisions included in the law.

Individual income tax rates

A tax law passed in 2001 created what has become known as the “Bush-era tax cuts.” Those tax cuts, including the tax rates in effect for 2010, were set to expire December 31, 2010, and, had that occurred, everyone’s taxes would have gone up in 2011. The Tax Relief Act of 2010 extends the Bush tax rates for all taxpayers for another two years. Therefore, the federal income tax rates for 2011 and 2012 will be 10%, 15%, 25%, 28%, 33%, and 35%.

Tax rates on capital gains and dividends

The new law continues the 2010 tax rates on capital gains and dividends through 2011 and 2012. The maximum rate remains at 15% for taxpayers in the top four regular tax brackets and at 0% for those in the 10% and 15% tax brackets. Without this extension, the maximum capital gains rate would have risen in 2011 to 20%, and dividends would have been taxed at ordinary income rates as high as 39.6%.

Itemized deductions and personal exemptions

Higher-income taxpayers are entitled to full deduction of their personal exemptions and itemized deductions for 2010. The new law continues this full deduction for 2011 and 2012. Without this extension, those whose incomes exceeded certain threshold amounts would have had their itemized deductions limited and their personal exemptions phased out.

Marriage penalty relief

The new law extends the current marriage penalty relief for two years. The standard deduction for married couples filing a joint return will be twice the amount for a single taxpayer, and the size of the 10% and 15% tax rate brackets for couples will be twice that of single taxpayers.

Child tax credit and earned income credit

The $1,000 tax credit for each child under age 17 was set to revert to $500 in 2011. The new law extends the credit at $1,000 for two years and continues the increase in the refundable portion of the credit.

The law also extends the enhanced earned income tax credit through December 31, 2012.

American Opportunity Tax Credit

A 2009 tax law expanded the Hope education credit and renamed it the American Opportunity Tax Credit. The 2010 law extends the credit through 2012, providing a $2,500 maximum credit for qualified higher education expenses. The law also extends the higher income limitations through 2012. Phase out of the credit will begin at $80,000 of income for individuals and at $160,000 for married couples.

Other education breaks

The new law keeps the income exclusion for up to $5,250 of employer-provided education assistance for an additional two years. The student loan interest deduction as structured for 2010 will be extended through 2012.

Coverdell Education Savings Accounts (ESAs) were enhanced by the 2001 tax law, and those enhancements will continue for another two years. The maximum ESA contribution will remain at $2,000, and qualified expenses will continue to include elementary and secondary education costs as well as higher education expenses.

Alternative minimum tax (AMT)

Without Congressional action, the AMT would have applied to more than 20 million taxpayers in 2010. The AMT is a separate tax calculation originally designed to keep the wealthy from escaping all income tax through the use of various tax breaks. Because the exemption from the tax did not include inflation adjustments, the tax has begun to hit more and more middle-income taxpayers each year.

The new law provides a two-year “patch” to the AMT by raising the exemption amounts. For 2010, the exemption is $47,450 for individuals and $72,450 for married couples filing jointly. For 2011, the exemption is $48,450 for singles and $74,450 for couples.

Without this patch, the exemption amounts for 2010 and 2011 would have been $33,750 for singles and $45,000 for couples.

Payroll tax cut

The law creates a new tax break for working taxpayers who pay social security taxes. For 2011, the social security portion of payroll tax paid by employees will be reduced from 6.2% to 4.2% on wages up to $106,800. This new tax break replaces the Making Work Pay credit which expires after 2010.

Self-employed individuals will pay 10.4% on self-employment income up to $106,800.

The employer share of social security tax paid on employee wages up to $106,800 will continue to be 6.2%. The payroll tax rate cut does not affect the Medicare portion of the tax.

“Extenders” for individuals

Certain tax breaks known collectively as “extenders” are typically allowed to expire and then extended retroactively for a year or two. The new law extends a number of these breaks that had expired at the end of 2009, making them effective for 2010 and 2011 tax returns.

The items extended include the following:

• the option for deducting state and local sales taxes in lieu of deducting state and local income taxes.
• the above-the-line deduction for up to $4,000 for higher education expenses.
• the above-the-line deduction of up to $250 for classroom supplies purchased by teachers.
• allowing taxpayers 70½ or older to make tax-free contributions of up to $100,000 from an IRA to a charity.

Estate and gift taxes

The 2001 tax law eliminated the estate tax for 2010. The tax was scheduled to return in 2011 with a 55% top rate and an exclusion amount of $1 million.

Under the new law, the estate tax is retroactively reinstated for 2010 with a maximum estate tax rate of 35% and an exclusion amount of $5 million ($10 million for married couples). The new rate and exclusion amount will apply through December 31, 2012. Along with these changes, the new law reinstates the step-up in basis for inherited property.

For deaths occurring in 2010, estates have a choice between applying the estate tax with a step-up in basis to fair market value for estate property or no estate tax with a modified carryover of the decedent’s basis.

The new law allows a surviving spouse to utilize the unused portion of the deceased spouse’s estate tax exclusion amount, providing the surviving spouse with a larger exemption from the estate tax.

Under the new law, the gift tax maximum rate is set at 35%, with an exclusion amount of $5 million, effective through 2012.

Business provisions

• 100% bonus depreciation. The new law increases the current 50% bonus depreciation to 100% for qualified business equipment purchases made from September 9, 2010, through December 31, 2011. 50% bonus depreciation would be available for purchases made in 2012.
• Section 179 expensing. The first-year expensing option was increased to $500,000 for 2010 and 2011 by the Small Business Jobs act of 2010. The investment limit was set at $2 million.The new law provides a $125,000 expensing limit for tax years beginning in 2012. The investment limit for 2012 is set at $500,000; both limits will be adjusted for inflation.
• Research tax credit. The research tax credit had expired at the end of 2009. The new law extends the credit retroactively through 2010 and 2011.
• Work Opportunity Tax Credit. The new law extends the Work Opportunity Tax Credit through 2011. It had been scheduled to expire after August 31, 2011.

The Tax Relief Act of 2010 gives taxpayers some certainty, if only for the next two years. Had the law not passed, all taxpayers would have seen their taxes increase in 2011.

The new law will have a significant impact on individuals: cutting payroll taxes for workers, preventing the AMT from hitting millions more taxpayers, continuing tax breaks for education expenses, and cutting estate taxes. For more information and planning guidance under this latest tax law, contact our office.