Generally, real estate appreciates in value over the years, so the depreciation deduction distorts the economic reality of a rental or business activity. And, as depreciation must be recaptured on the sale of the property, at a potentially much higher capital gain tax rate, the taxpayer really does not get much overall tax benefit from the deduction. The recapture of depreciation, a legitimate practice under the current tax law, only causes confusion and aggravation for many taxpayers and increased “agita” for tax preparers.
I would like to offer up for discussion some other suggestions for changes to the current Tax Code to make it simpler, fairer, and more representative of economic reality.
* The double-taxation of corporate dividends has been an inequity in the Tax Code that has been around it seems forever.
As you know, corporations are taxed by the federal and state governments on their net earnings before any dividend distributions. When the corporation distributes its earnings to shareholders in the form of dividends, the shareholders must pay tax on these dividends to their "uncles" (Sam and Jon, for example).
Corporate earnings distributed as dividends are taxed by Sam at up to 50% (35% top corporate tax rate plus 15% maximum individual tax rate on “qualified” dividends) or more (if the dividends do not qualify for the lower rate due to the shareholder’s holding period). Plus corporate income and dividends received are also taxed at the applicable state tax rate. In New Jersey the corporate tax rate is 9.36% (with the 4% “surcharge”) and individual dividend recipients could be taxed at up to 8.97% - so we are talking a total of 68.33% or more of dividend income going to your “uncles”! NJ has a special problem - even if the corporate net taxable income is "0" NJ corporations must pay a "minimum tax" of from $500 to $2,000.
I would propose that corporations be allowed a “dividend distribution” deduction of up to the amount of net taxable income. So if a corporation distributed all of its net income for the year to its shareholders as dividends it would pay no federal income tax.
This move would not only do away with the unfair double taxation of dividends, but would also help to do away with most corporate tax fraud, offshore shelters, and special interest tax loopholes. To avoid paying federal income tax a corporation would no longer have to resort to Enron-like scams or pay Congress-persons, or lobbyists to pressure Congress-persons, to pass special corporate tax loopholes. All they would have to do is distribute their earnings to their shareholders as dividends.
Not having to pay federal income tax could lead to increased corporate dividend distributions. Without the double-taxation of dividends, Congress could repeal the special capital gain rates on qualified dividends, unless they wanted to continue to encourage investment by taxing dividends at preferential tax rates.
* The “marriage penalty tax” was a popular topic a few years ago. While the Bush tax cuts did away with this penalty to a degree for those in the lower brackets, this penalty is still alive and well in the federal Tax Code.
To truly do away with the marriage penalty I would suggest changing the “Married Filing Separately” filing status to be totally equivalent to that of “Single”. By filing separately, a married couple, regardless of level or income or individual situation, would pay the absolute same federal income tax that they would if they were both single.
If memory serves me, early in my career New York State allowed its married taxpayers to file as if they were two single individuals on the same state tax return. I would rewrite the federal Form 1040, and 1040A, to allow this as well.
To do this the Tax Code would need to be rewritten to remove all the disadvantages of filing separately and make the Tax Rate Schedule for Married Filing Separately the same as that for Single. Currently if you file a separate tax return –
· You cannot claim the Credit for Adoption Expenses, the Credit for Child and Dependent Care Expenses, the Earned Income Credit, the Credit for the Elderly or Disabled, or the HOPE or Lifetime Learning Education Credit.
· You cannot claim an Adjustment to Income for tuition and fees, student loan interest, or a spousal IRA.
· You will probably be ineligible for a ROTH IRA or a deductible IRA if an active participant in an employer pension plan.
· You will not be able to exclude from income savings bond interest used for qualified educational expenses.
· A greater amount of your Social Security benefits may be taxed.
· The maximum net loss deduction is limited to $1,500 for each spouse.
· You will not be able to deduct a loss on rental property.
· One spouse’s passive loss cannot be used to reduce or wipe out the other spouse’s passive income.
· You will not be able to convert a traditional IRA to a ROTH IRA.
I would also look at ways of reducing the “marriage tax benefit” for families with only one earner. Taxpayers should not be penalized, or excessively rewarded, for being married.
* The above two proposals are the most controversial. I would also favor making all legal and contingency fees relating to court and legal awards and settlements deductible “above-the-line” as an “adjustment to income” – not just those relating to discrimination suits. Recipients should only be taxed on the amount they actually receive “in hand”. Having to deduct the related legal fees as a miscellaneous itemized deduction subject to the 2% of AMT exclusion is definitely unfair.
And I would like to see gambling losses allowed as an “above-the-line” deduction, to the extent of winnings as is currently permitted. This would fix the current inequity that has individuals who actually lost money from gambling activities for the year paying tax on their gross earnings. It is true that losses are deductible, to the extent of winnings, as a miscellaneous itemized deduction not subject to the 2% of AGI exclusion, but one needs to be able to itemize without counting the gambling losses to be able to fully benefit, plus the current method increases AGI and as a result unfairly penalizes taxpayers elsewhere on the return
So Kay, Kelly, Gina, Trish, Dan, Joe, Jim, Kerry, Paul, Ryan, and everyone else out there – what do you think? BTW, I am still waiting for your comments on my real estate depreciation idea!