IRS Adopts Stricter Interpretation of One-Year Waiting Period for IRA Rollovers

An individual can make only one tax-free rollover from one traditional IRA to another in any one-year period.  For at least as far back as 1981, the IRS has interpreted that rule as applying to IRAs on an-IRA-by-IRA basis. However, in the wake of a recent Tax Court case, the IRS announced that it would apply the one-year waiting period on an aggregate basis to all of an individual's IRAs. In Announcement 2014-15, the IRS also stated that it will not apply this more restrictive interpretation to IRA distributions occurring before 2015.

One-Year Waiting Period for IRA Rollovers

Under Code Sec. 408(d)(3)(A), a taxpayer can roll over, tax free, a distribution from a traditional IRA into the same or another traditional IRA. Generally, the individual must make the rollover contribution by the 60th day after the day the individual receives the distribution from the IRA. Code Sec. 408(d)(3)(B) provides that an individual can make only one such rollover in any one-year period. The one-year waiting period begins on the date the individual receives the IRA distribution.

Prop. Reg. Sec. 1.408-4(b)(4)(ii) and IRS Publication 590, Individual Retirement Arrangements (IRAs), provide that the one-year waiting period is applied on an IRA-by-IRA basis. Under this interpretation, an individual who makes a tax-free rollover of any part of a distribution from a traditional IRA cannot, within a one-year period, make a tax-free rollover of any later distribution from that same IRA. The individual also cannot make a tax-free rollover of any amount distributed within the same one-year period from the IRA into which he or she made the tax-free rollover.

For example, applying the one-year waiting period on an IRA-by-IRA basis also means that if an individual maintains more than one IRA say, IRA-1, IRA-2, and IRA-3 - and rolls over the assets of IRA-1 into IRA-3, he or she would not be precluded from making a tax-free rollover from IRA-2 to IRA-3 or any other IRA within one year after the rollover from IRA-1 to IRA-3. However, a recent Tax Court opinion, Bobrow v. Comm'r, T.C. Memo. 2014-21, held that the one-year waiting period applies on an aggregate basis, rather than on an IRA-by-IRA basis. That means an individual cannot make an IRA-to-IRA rollover if he or she has made such a rollover involving any of the individual's IRAs in the preceding one-year period.

IRS Will Follow Bobrow

In Announcement 2014-15, the IRS stated that it anticipates that it will follow the interpretation of Code Sec. 408(d)(3)(B) in Bobrow and, accordingly, intends to withdraw the proposed regulation and revise Publication 590 to the extent needed to follow that interpretation.

The IRS noted that these actions will not affect an IRA owner's ability to transfer funds from one IRA trustee directly to another, because, under Rev. Rul. 78-406, such a "trustee-to-trustee transfer" is not a rollover and, therefore, is not subject to the one-waiting period under Code Sec. 408(d)(3)(B).

Practice Tip: A trustee-to-trustee transfer may be accomplished by any reasonable means of direct payment to the receiving IRA. If the payment is made by wire transfer, the wire transfer must be directed only to the trustee or custodian of the receiving IRA. If payment is made by check, the check must be negotiable only by the trustee or custodian of the receiving IRA.

Proposed Regs Clarify New 3.8% Investment Income Tax

The IRS has issued proposed regulations that provide guidance on the new 3.8% healthcare surtax on investment income and gains (IRC Sec. 1411). This article explains the general operating rules of the tax, and specific rules applicable to estates and trusts.  

The proposed regulations can be found at this link:  Proposed Net Investment Income Tax Rules.  This article does not contain a complete analysis of the regulations.  Please review the regulations before applying them to your own situation.

Although there are still many unresolved issues surrounding 2013's tax rates and the so-called “fiscal cliff,” with this surtax, higher taxes on investment-type income and gains are a relative certainty for higher-income taxpayers who meet the thresholds explained below.

Background. Beginning in 2013, certain “unearned income” of individuals, trusts, and estates is subject to a surtax (i.e., it's payable on top of any other tax payable on that income). The surtax, also called the “unearned income Medicare contribution tax” or the “net investment income tax” (NIIT), is 3.8% of the lesser of:

(1) net investment income (NII); or

(2) the excess of modified adjusted gross income (MAGI) over the threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case). MAGI is adjusted gross income (AGI) plus any amount excluded as foreign earned income under Code Sec. 911(a)(1).

Example:  In 2013, a single taxpayer has net investment income of $100,000 and MAGI of $220,000. He pays the surtax only on $20,000, which is the amount by which his MAGI exceeds the threshold amount of $200,000, and because that is less than his NII of $100,000. Therefore, the surtax is $760 ($20,000 × 3.8%).

For an estate or trust, the surtax is 3.8% of the lesser of undistributed NII, or the excess of AGI (as defined in Code Sec. 67(e)) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.

Net Investment Income (NII) is defined as investment income less deductions properly allocable to such income.  Investment income is (a) gross income from interest, dividends, annuities, royalties, and rents, unless derived in the ordinary course of a trade or business to which the 3.8% surtax doesn't apply; and (b) other gross income derived from a trade or business to which the Medicare contribution tax does apply; and (c) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the Medicare contribution tax doesn't apply.

The 3.8% surtax applies to a trade or business only if it is a passive activity of the taxpayer or a trade or business of trading in financial instruments or commodities.

Investment income does not include amounts subject to self-employment tax, distributions from tax-favored retirement plans (e.g., qualified employer plans and IRAs), or tax-exempt income (e.g. earned on state or local obligations).

The surtax doesn't apply to trades or businesses conducted by a sole proprietor, partnership, or S corporation (but income, gain, or loss on working capital isn't treated as derived from a trade or business and thus is subject to the tax).

Gain or loss from a disposition of an interest in a partnership or S corporation is taken into account by the partner or shareholder as net investment income only to the extent of the net gain or loss that the transferor would take into account if the entity had sold all its property for fair market value immediately before the disposition.

The tax does not apply to: nonresident aliens; trusts all the unexpired interests in which are devoted to charitable purposes; trusts exempt from tax under Code Sec. 501; or charitable remainder trusts exempt from tax under Code Sec. 664.

General operating rules. The IRS has provided definitional rules in the proposed regs designed to both promote the fair administration of Code Sec. 1411 and prevent taxpayers from circumventing its purposes (significantly, to impose a tax on the unearned income or investments of certain individuals, estates, and trusts).  The IRS will closely review transactions that manipulate a taxpayer's NII to reduce or eliminate the amount of the surtax and, when appropriate, challenge such transactions based on applicable statutes and judicial doctrines (e.g., substance over form).

Application to Estates and Trusts. The proposed regs provide rules with regard to these specific trust types:

(a)   Grantor trusts. The income of a grantor trust (i.e., a trust any portion of which is treated as owned by the grantor, with items of income, deduction, and credit attributed accordingly) is taxed to the owner. So, these amounts are taken into account in calculating the owner's NII.

(b)   Electing Small Business Trusts (ESBTs). ESBTs, which are treated as two separate trusts when a portion of the ESBT's holdings is S corporation stock, are subject to special computational rules. The proposed regs treat the ESBT as two separate trusts for computational purposes, but consolidate the ESBT into a single trust for determining the AGI threshold.

(c)   Charitable remainder trusts (CRTs). CRTs are also subject to special computational rules. The trust itself isn't subject to Code Sec. 1411, but the annuity and unitrust distributions may constitute NII to the noncharitable recipient.

(d)   Foreign estates and foreign nongrantor trusts. In general, foreign estates and foreign trusts aren't subject to Code Sec. 1411.  However, IRS and Treasury believe that the NII of a foreign trust or estate should be subject to Code Sec. 1411 to the extent that such income is earned or accumulated for the benefit of, or distributed to, U.S. persons.

(e)   Bankruptcy estates. A bankruptcy estate of a debtor who is an individual is treated as an individual for Code Sec. 1411 purposes.  Therefore, the bankruptcy estate computes its tax in the same manner as an individual, and the rate is the same as that imposed on a married taxpayer filing separately.  

Effective date. The proposed regs are to be effective for tax years beginning after December 31, 2013.  However, taxpayers may rely on the proposed regs for purposes of compliance with Code Sec. 1411 until the effective date of the final regs.

Is the Mortgage Interest Deduction Dead?

As lawmakers continue to debate how to handle the nation's debt and aim to do “something big” rather than simply patch the problem, it seems probable that many broader tax reform issues may resurface during the course of the negotiations. One such issue, which was addressed by President Obama in his 2012 and 2011 budget proposals, is the mortgage interest deduction—one of the largest tax expenditures. According to various estimates, the deduction cost the Treasury Department somewhere between $80 and $103 billion in 2010, and its value over the 10-year budget window is expected to exceed $1 trillion. This article examines the mechanics of the deduction, arguments for and against reforming it, reform proposals, and the projected effect of any changes on both taxpayers and the budget.

Background. Interest paid with respect to a mortgage on real estate is deductible interest on indebtedness under Code Sec. 163(a) . Itemizing taxpayers can deduct their mortgage interest on up to $1 million of qualifying acquisition debt on a qualified principal and, if applicable, secondary residence. A residence includes a house, condominium, cooperative, mobile home, house trailer, or boat. (Reg. § 1.163-10T(p)(t)(ii)) In effect, this deduction reduces the after-tax cost of financing a home. In contrast, taxpayers are not permitted to deduct the costs of renting a home.

Itemizing taxpayers can also deduct interest on up to $100,000 ($50,000 for married individuals filing separately) of home equity debt—i.e., debt secured by a taxpayer's qualified residence up to the fair market value of the residence, as reduced by the amount of acquisition indebtedness on it. (Code Sec. 163(h)(3)(C)(i))

Arguments for and against reforming the deduction. The mortgage interest deduction is often criticized as being an “upside-down” subsidy, in that it tends to provide greater benefit to taxpayers with higher incomes. The amount of interest paid by lower- and moderate-income taxpayers is less likely to be sufficiently high to make it worthwhile to forego the standard deduction, so they are less likely to claim any benefit from it.

Proponents of the deduction argue that it encourages home ownership and makes it affordable to taxpayers who would otherwise not be able to own a home. Critics claim in response that, rather than encouraging home ownership, the deduction actually encourages middle-class and wealthy taxpayers to take on more debt and buy larger homes than they otherwise would. Further, critics argue that the deduction tends to benefit taxpayers with larger incomes who likely would have purchased a home regardless of the deduction.

Illustration: A married couple who takes out a $150,000 mortgage on Jan. 1, 2011, payable over 30 years with 7% interest, pays $9,584.85 in interest in the first year. Unless the couple has other itemized deductions, they may simply opt for the $11,400 standard deduction. If the same couple were to double their mortgage to $300,000, same interest and term, their interest payment in the first year is $19,169.71. If the couple were to again double their mortgage to $600,000, the interest payment would be $38,339.42.

Critics of the deduction also claim that the deduction artificially drives up home prices. However, this same argument is cited by its proponents, who observe that eliminating the deduction could further impact home prices in an already depressed market.

Proposals. A number of different proposals have been advanced regarding the mortgage interest deduction. In light of the popularity of the provision, and the strength of the real estate lobby, it appears unlikely that it would be repealed outright. In general, the proposals tend to focus on converting the deduction to a credit, capping the maximum mortgage amount, and limiting the credit to a primary residence.

The President's Fiscal Commission proposed a 12% nonrefundable credit on up to a $500,000 mortgage, with no credit for a second residence or for home equity. The Debt Reduction Task Force would have a 15% refundable tax credit capped at $25,000. Other proposals suggest a 20% credit, whereas another proposal is to simply have a fixed credit for owning a home as opposed to having a mortgage.

President Obama's 2012 budget proposal, as well as his 2011 proposal, suggested capping itemized deductions, including mortgage interest, for taxpayers in the top two tax brackets (33% and 35%). Under the proposal, these taxpayers would only be able to reduce their tax liability by a maximum of 28%.

Illustration: The current structure of the mortgage interest deduction reduces the after-tax cost for each $100 borrowed by a taxpayer in the 35% bracket to $65. However, the after-tax cost for each $100 borrowed by a taxpayer in the 10% bracket is $90. In other words, the higher a taxpayer's tax bracket, the greater relative benefit he will receive from the deduction. The Administration's proposal would limit the benefit to higher-income taxpayers by five or seven percentage points, such that the after-tax cost for each $100 borrowed would rise to $72.

Economic effect. Given the amount of foregone revenue from the deduction, the effects of reforming or repealing the provision could be significant.

If the deduction was repealed flat out, estimates are that the average tax bill of those who claim the mortgage interest deduction would increase by $710. However, this increase would vary widely among taxpayers—those with $30,000 to $40,000 incomes would face an average increase of $70, whereas taxpayers making over $1 million would face an average increase of $4,000. However, given the popularity of the deduction, its outright repeal seems unlikely.

According to the TPC, replacing the current mortgage interest deduction with a 20% nonrefundable credit, limiting mortgages eligible for the credit to $500,000, and limiting the credit to primary residences would only have a nominal or positive effect on the majority of the tax bills of those who claim the deduction. Again, those who would face the largest increase are taxpayers in the top tax brackets with the largest mortgages.

The economic effect of replacing the deduction with a flat credit for home owners, regardless of whether their home debt-financed, would obviously depend on the amount of the credit. In general, credits are considered more progressive than deductions, and the benefit of a flat credit to higher-income taxpayers would presumably be less than that under the current regime. However, the incentive towards home ownership would remain intact.

The Joint Committee on Taxation estimates that President Obama's proposal to limit upper-income taxpayers' itemized deductions to 28% would yield $293,261 million over the 2011 through 2021 period. (JCX-19-11) This increased revenue would be largely attributable to the limits on mortgage interest and charitable contribution deductions.

Conclusion. While it seems unlikely that the deduction will be repealed outright, it is nonetheless possible that this popular tax expenditure could be somehow reformed or curtailed. The context of the looming debt crisis may well provide the necessary push for lawmakers to take action on this issue. What choices will be made and when remains to be seen—stay tuned.