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Virginia Cooperative Extension -
 Knowledge for the CommonWealth

Tax Payer Relief Act of 1997and Its Effects on Farmers

Farm Business Management Update, February 1998

By Frank Smith of the Department of Agricultural and Applied Economics, Virginia Tech

The Taxpayer Relief Act of 1997 (along with the Balanced Budget Act of 1997) is the first major tax cut legislation in more than 16 years. Congress passed it on July 31, 1997 and sent it to the President who made minimal changes with his line item veto and signed it. The legislation has large tax cuts and is expected to have a widespread impact. The tax cut is not broad-based and is selective which makes big winners out of some taxpayers but causes others to be losers.

Estate and Gift Taxes

The effective unified estate and gift tax exemption is increased from the present $600,000 to $1 million in a series of steps between 1998 and 2006. In 1998, the credit will be the equivalent of a $625,000 exemption. After December 31, 1997 family-owned farms will have an exclusion up to $1.3 million for assets if the farm is at least 50 percent of the estate and the heirs materially participate in the business for at least 10 years after the decedent's death. In 1998, the exclusion will be the equivalent of a $675,000 exemption (see Table below).

Beginning in 1998 closely-held businesses (farms) with the value exceeding 35 percent of the adjusted gross estate will have the interest rate lowered from 4 percent to 2 percent during the installment payment period for estate tax.

Retroactive to December 31, 1976, the cash leasing of specially valued (use-value) real property by a lineal descendant of the decedent to a member of the lineal descendant's family, who continues to operate the farm or closely held business, does not cause the qualified use of such property to cease for the purposes of imposing the additional estate tax.

Beginning in 1999 indexing (connecting values to inflation) of the $10,000 gift exclusion, the $750,00 maximum reduction in value on special use valuation of real property, the $1million exemption from generation-skipping transfer tax, and the $1 million maximum value for estate tax installment payments will become effective. Gifts made to charity in excess of $10,000 are not subject to the gift tax filing requirements.

Estate Taxes Estate Tax Exemption Amounts

YearExemption AmountFamily-Owned Business Exclusion Amount
1997$600,000-0-
1998$625,000$675,000
1999$650,000$650,000
2000$675,000$625,000
2001$675,000$625,000
2002$700,000$600,000
2003$700,000$600,000
2004$850,000$450,000
2005$950,000$350,000
2006 and thereafter$1 million$300,000

Capital Gains

Sound tax management requires maximization of capital gains. Assets used in the farm business are entitled to special capital gain and ordinary loss treatment. After May 6, 1997 the top capital gains tax rate for individual taxpayers in higher tax brackets (28 and 39.6 percent) is lowered to 20 percent from the present 28 percent maximum rate, for investments held for more than 18 months (12 months if the investment was sold after May 6, but before July 29, 1997). Assets purchased after December 31, 2000 and held for more than five years at the time of the sale will be taxed at an 18 percent rate. Assets sold after December 31, 2000 for those in the 15 percent tax bracket will be taxed at an 8 percent rate. For taxpayers in the 15 percent regular tax bracket, the maximum net capital gains tax rate is 10 percent. The current 28 percent maximum capital gain rate will continue to apply to sales of collectibles before May 7, 1997 and after July 28, 1997 of property which were held for more than one year but less than 19 months. Many exceptions to these rates are based on date the asset was sold, length of time the asset was owned, and the type of asset owned. Financial planning and retirement planning are all affected significantly by these rate reductions.

CAPITAL ASSETS (28 PERCENT TAX BRACKET OR ABOVE)

Holding Period Maximum Rate (%)
   Assets held less than one year39.6
   Assets held more than one year but less than 18 months and sold after July 28, 199728
   Assets held more than one year but less than 18 months and sold after May 6, 1997 but before July 28, 199720
   Assets held longer than 18 months20
   Assets purchased after 2000 and held more than five years18

CAPITAL ASSETS (15 PERCENT TAX BRACKET)

Holding Period Maximum Rate (%)
   Assets held less than one year15
   Assets held more than one year but less than 18 months and sold after July 28, 199715
   Assets held more than one year but less than 18 months and sold after May 6, 1997 but before July 28, 199710
   Assets held longer than 18 months10
   Assets purchased after 2000 and held more than five years8

Gain on Principal Residence

Retroactive to May 7, 1997, no tax is due on a gain up to $500,000 for married couples from the sale of a principle residence ($250,000 for single homeowners). The taxpayer must have owned the home at least five years and used it as his principal residence at various times totaling at least two out of five years. For those who have sales or contracts signed after May 6, 1997, but before the date of enactment, have the option of using the old rollover deferral and "age 55 or over exemption of $125,000" instead. The taxpayer must recognize gain to the extent of any depreciation allowable with respect to the rental or business use after May 6, 1997. Other complicated rules apply.

Miscellaneous

Self-employed health insurance: A deduction for health insurance for self employed individuals (farmers) will increase to 45 percent in 1998 and 1999; 50 percent in 2000-2001; 60 percent in 2002; 80 percent in 2003 through 2005; 90 percent in 2006; and 100 percent in 2007.

Three-year income averaging (not as we have known it!): For tax years after 1997 and before 2001, farmers may elect to average all or a portion of farm income over the three prior taxable years (1/3 each year). Income includes gain from the sale of farm business property other than land. The income averaged amount does not apply for employment tax purposes.

Disaster areas: The IRS is permitted to postpone more tax deadlines.

Involuntary conversion treatment: Beginning in 1997, the sale of livestock due to drought is extended to other weather-related problems such as floods, etc.

Environmental remediation costs: Certain environmental remediation costs can be expensed immediately.

Carryback and Carryover of Unused Business Credits: Beginning in 1998, unused business credits can be carried back only one year but can be carried forward for the next 20 years.

Home Office Deduction: Effective in 1999, the taxpayer is allowed to conduct administrative or management activities of the business in the home provided no other fixed location where administrative and management activities are conducted exists.

Estimated Tax-Safe Harbor Tests: In 1997, a tax penalty for underpayment of estimated tax is not enacted if 100 percent of the tax shown on the return of the individual for the preceding year or 90 percent of the tax shown on the return for the current year is paid in timely estimated tax payments. In 1998 the following apply: 110 percent of the tax shown on the return of an individual with Adjusted Gross Income of more than $150,000 for the preceding tax year; 105 percent in 1999-2001; 112 percent in 2002; and 110 percent in taxable years after 2003.

Work Opportunity Tax Credit (Welfare to Work Tax Credit): A tax credit of 25 percent to 40 percent of qualified wages up to $6,000 (25 percent for less than 400 hours and 40 percent for 400 hours or more) is given. Maximum credit per individual is $2,100 and for summer youth employees, $1,050. Employees must have been employed for at least 180 days; 20 days in the case of a qualified summer youth employee or 120 hours. Qualified employees include families receiving Aid to Families with Dependent Children, qualified ex-felons, high-risk youth, vocational rehabilitation referral, qualified summer youth employee, qualified veteran, families receiving food stamps, Social Security Insurance beneficiaries.

Child Tax Credit

A tax credit of $400 per child will be available in 1998. The tax credit will increase to $500 per child per year after 1998. This credit is available for families with children under age 17. They are required to provide name and identification number of child. It is phased out at higher income levels: in excess of $110,000 of Adjusted Gross Income for joint filers and $75,000 for single filers. The credit is not fully refundable and limited to the tax liability net of credits other than Earned Income Credit. It will not benefit low-income taxpayers. It is partially refundable against payroll taxes.

Education Tax Credits

For each qualifying student, taxpayers must choose between the Hope Scholarship, Lifetime Learning Credit, or education IRA. They cannot claim more than one of these benefits for a student for any year. Taxpayers are required to provide name and taxpayer ID number of the student on the return. Educational institutions are required to report information about higher education tuition and related expenses, including refunds of such expenses, paid during the taxable year.

The Hope Scholarship Credit is $1,500 (100 percent of the first $1,000 of qualified tuition and 50 percent of the next $1,000) and is allowed only for the first two years of post-secondary education for qualified tuition and related expenses includes registration fees, but not room and board or books. It applies to expenses paid after December 31, 1997 and is indexed to inflation. It can be used for any filer or dependent under age 24. It is reduced when your Adjusted Gross Income exceeds $80,000 filing jointly and eliminated after $100,000 Adjusted Gross Income. The credit cannot reduce a tax liability below zero.

The Lifetime Learning Credit can be used for filers and dependents who are college juniors, seniors, graduate students or filers in the pursuit of improved job skills. The number of years of use is unlimited. It is a 20 percent credit that would be applied to the first $5,000 of qualified tuition and fees with a maximum credit $1,000 through 2002 and to the first $10,000 thereafter with a maximum credit of $2,000. It applies to expenses paid after June 30, 1998.

Other Education Incentives

Deduction for Student Loan Interest: On qualified educational loans, a deduction up to $2,500 can be made for interest costs. This deduction can be used only for interest paid during the first 60 months in which interest payments are required. The deduction schedule gradually increase until 2001: $1,000 in 1998; $1,500 in 1999; $2,000 in 2000; and $2,500 in 2001. It is phased out for taxpayers with modified Adjusted Gross Income of $60,000 to 75,000 for joint returns and is indexed for inflation after 2002. Married taxpayers must file jointly to use the deduction, and the credit may not be claimed on the return of anyone who is claimed as a dependent on another person's return.

State Qualified Tuition Programs: When saving for education, after-tax cash contributions to a state qualified tuition program of $5,000 per year per student until the student turns 18 can be made. Total contributions cannot exceed $50,000. "Qualified higher education expenses" are defined as tuition, fees, books, supplies, equipment, and room and board required for enrollment or attendance at a college or university (or certain vocational schools). At the time of distribution, the earnings portion of the distribution is includable in the gross income of the person who receives the distribution. Any unused balance must be distributed when student turns 30, dies, or completes the first four years of post-secondary education. Unused balances can be transferred to other qualified family members.

Withdrawals from regular IRAs: Beginning January 1, 1998, withdrawals from IRAs can be made without penalty to pay for eligible higher education expenses for the filer and dependents or grandchildren. Withdrawn amounts must be included in income to the extent that they were not taxed when contributed.

Employer-provided assistance: Employer-provided educational assistance for tuition, fees, books, and supplies for courses not related to the current job can continue to be excluded up to $5,250 per year as long as the course begins before June 1, 2000.

Individual Retirement Accounts

Regular IRA
Increased income phase-out ranges. In recent years, if an individual (or, if married, the individual's spouse) is an "active participant" in an employer-sponsored retirement plan, the $2,000 IRA deduction has been phased out (for those filing joint returns) between $40,000 and $50,000 of adjusted gross income. The deductible IRA income phase-out limits increased as follows for those filing joint returns.

IRA income phase-out

Year Single AGI Joint AGI
1998$30,000-40,000$50,000-60,000
1999$31,000-41,000$51,000-61,000
2000$32,000-42,000$52,000-62,000
2001$33,000-43,000$53,000-63,000
2002$34,000-44,000$54,000-64,000
2003$40,000-50,000$60,000-70,000
2004$45,000-55,000$65,000-75,000
2005$50,000-60,000$70,000-80,000
2006$50,000-60,000$75,000-85,000
2007 and after$50,000-60,00$80,000-100,000

Non-wage earner spouse. Deductible contributions of up to $2,000 can be made for the non-wage earner spouse of a wage-earning spouse who is an active participant in an employer-sponsored retirement plan. The minimum deductible contribution is phased out for those with adjusted gross income between $150,000 and $160,000.

Exceptions to the 10 percent early withdrawal penalty. Higher education expenses and first home purchase with distribution limited to $10,000 are exceptions to the 10 percent early withdrawal penalty.

Roth IRA. This is an opportunity for tax-free buildup and withdrawal. These non-deductible contributions are subject to maximum $2,000 per individual limit less the taxpayer's deductible IRA contributions. These contributions may continue after age 70. Qualified distributions are not includable in gross income or subject to the additional 10 percent tax on early withdrawals. Qualified distributions are those in which five years have elapsed since the initial contribution, and the distribution is due to the attainment of age 59 , death or disability, first home purchase (withdrawal limited to $10,000). Distributions that are not qualified are includable in income to the extent they exceed total contributions and subject to the early withdrawal penalty. Individuals and couples with Adjusted Gross Income under $100,000 can roll regular IRAs into Roth IRAs. Note: The amount rolled over will not be subject to the 10 percent early withdrawal penalty, but will be taxed as ordinary income. If the transfer occurs in 1998, income from the transfer is spread out over four years (i.e. one-fourth of the transferred amount is includible in 1998, 1999, 2000, and 2001).

Education IRA. Beginning in 1998, these IRAs can only be created for paying for qualified higher education expenses (post-secondary tuition, fees, books, supplies, equipment, and certain room and board expenses). They are non-deductible annual contributions up to $500 per designated beneficiary, usually children until age 18. Withdrawals and earnings buildup are tax-free and penalty free if used to pay for higher education expenses of the designated beneficiary. Distributions not used for qualified higher education expenses are subject to a 10 percent addition to tax. Income phase-outs begin at $150,000 for joint filers. Distributions must be made before beneficiaries reach age 30. Tax-free and penalty-free rollovers can be made to another education IRA whose beneficiary is a member of the family of the original beneficiary. Any balance after age 30 must be distributed. The earnings portion of the distribution must be included in gross income and is subject to the 10 percent penalty tax. Contributions cannot be made to an education IRA in any year that contributions are made to a state tuition program. The Hope Tax Credit and a Lifetime Learning Credit cannot be utilized in any year distributions are claimed as exclusions from gross income.

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