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As we sort through the wreckage of the housing bubble, I see another, similar bubble emerging: a student loan crisis.  Fueled by a combination of low lending standards, unrealistic expectations and the proliferation of for-profit universities, this crisis is likely to cost banks and the federal government significant sums of money.  It will also leave borrowers subject to crippling debt for decades after they receive their degrees.

Americans have come to expect they should own a home and receive a college education (next up, health care).  Actually being able to pay for either has not been part of the decision-making process.  Financial institutions, chasing fees and government guarantees, are following the same path they took on their subprime mortgage adventures.  The economy is producing fewer jobs and its impact on students’ ability to repay their loans is similar to subprime mortgage borrowers.  No job.  No loan repayment.  Worse, because student loan debt is generally not discharged by bankruptcy proceedings, students may labor under this debt for decades after graduation.  

The debt incurred by students attending for-profit institutions and subprime mortgage loans are eerily similar.  Both the subprime mortgage industry and for-profit college universities rely on loans made to low-income borrowers who are less likely to be able to meet their obligations.  (Phoenix University, for example, relied on $1.8 billion in federal student aid last year.)  Repayment of subprime mortgage loans requires a housing market that continuously appreciates.  Repayment of debt to pay for-profit school tuition requires that students obtain good paying jobs upon graduation.  In fact, many students who borrow money for tuition never receive a degree. (By one count Phoenix University has an 86% drop-out rate.) In both situations, taxpayers bear the cost of defaults. 

The bail out of subprime mortgage borrowers is costing hundreds of millions of federal dollars and for-profit tuition debt will cost the taxpayer as well.  Some industry analysts predict that defaults of for-profit university tuition debt could exceed $275 billion in the next ten years. 

In a classic good news/bad news conundrum, the Internal Revenue code provides that for those who leave this vale of tears in 2010 will pass on estates completely free of estate taxes, but leave their heirs with much higher capital gains tax.

The estate tax is scheduled to return with a vengeance on January 1, 2011 with a top rate of 55%.  The bad news for the beneficiaries of assets and property inherited in 2010 is the elimination of the tax provision known as a “step-up in basis“.

The step-up in basis provisions provide the value of property inherited is equal to its fair market value at the date of death, thus generally eliminating taxable gains on a subsquent sale.  For example, the old family homestead that mom and dad bought for around $100,000 or more, may now be worth a million.  With no step-up in basis, taxable gain will be determined using the $100,000 cost basis, as opposed to its step-up basis of $1 million, resulting in a $900,000 gain.

Capital gain tax rates are scheduled to rise from 15% to 20% in 2011, when asset sales will likely occur for many estate assets received in 2010.

This should make for an interesting year for estate planners.  

A client recently asked for advice on her investment of $100,000.  Bank of America had offered her a CD for three months at a rate of .15%.  That equates to $150 of income in exchange for the banks use of her $100,000.  She is retired and her investment income, which is primarily invested in fixed income, has plummeted over the past 18 months.

Investors are doing double takes at the yields generated by their money market funds, CD’s, and overnight deposits.  Over the next six months, however, they may be in for a pleasant surprise.

Our clients in the home building and mortgage banking industry report good sales and revenues.  A casual observation of restaurant traffic in downtown Bethesda on weekends, also points to an economy that is getting back on its feet.

Warren Buffett has described the U.S. 30 year Treasury bill as the next investment bubble of the twenty-first century to burst (after the .com and real estate meltdowns).  In my opinion, one of the safest investments one can make, and can potentially make a lot of money, is shorting the U.S. Treasury bill.  TBT, an exchange-traded fund (ETF), is a vehicle that shorts U.S. Treasuries.  Be patient, and you’ll be rewarded handsomely.  Interest rates are going up.

The New Year brings five significant changes to consider as you prepare your 2009 federal income tax return.  These changes generally provide opportunities to decrease overall tax liability through increased deductions, taxpayer credits and more. 

When preparing your 2009 return consider these five changes:

1. The American Recovery and Reinvestment Act (ARRA) provides significant incentives for taxpayers. These include: 

- Those purchasing a home or improving energy efficiency.

- Those purchasing a car.

- Parents and students paying for college.

2. Expansion of IRA deduction to those covered by a retirement plan with adjusted gross income of less than $65,000 (single) or $109,000 (married filing jointly).

3. Increase in the Standard Deduction to $11,400 for those married and filing jointly, and $5,700 for singles and those who are married and filing separately.

4. Change to the standard mileage rate to $.55 per business mile.

5. Increase of investment income a child may receive ($1,900) without being taxed on their parents’ return.

On December 3, the House of Representatives voted 225-200 on a bill to address issues with the estate tax or “death tax”, as it’s been nicknamed. The estate tax will disappear completely in 2010 under rules put in place under the Bush administration. These rules lapse 2011, returning the laws to those in force in 2001. The higher 2001 rates would affect estates worth $1 million and up, which include many small farms and businesses. The bill to repeal the tax must now pass the Senate and be signed by President Obama in order to become law.  The bill includes a permanent $3.5 million federal estate tax exemption (up from $1 million) and sets the gift tax and estate tax rates at 45%.  This is a reduction from the 55% rate if the current law lapses without new legislation in place.

I encourage you to evaluate your IRA before the new year, as the tax laws regarding Roth IRA conversions are changing effective January 2010.  If your adjusted gross income is above $100,000, you will have the option of converting an existing traditional pretax IRA to a Roth IRA.  In previous years, this option was only available to those making less than $100,000.

When you’re evaluating your IRA and making a decision to invest in a Roth IRA, consider the following:

-         Direct contributions can be withdrawn tax free any time.

-         Earnings may be withdrawn penalty free after five years. 

-         Assets in your Roth can be passed to your heir’s tax free. 

-         No withdrawal requirements when you reach a certain age (70 ½), so your money can continue to accumulate tax free.

Key attributes of a Roth Conversion include: 

- Any investor with a Traditional IRA, Rollover, SEP or 401(k) plan is eligible.

- For the 2009 tax year, your adjusted gross income must be $100,000 or less.

- For 2010 and beyond, the income restriction will be lifted and anyone will be eligible to convert.

- Conversions are a distribution from the Traditional IRA and therefore a taxable event.

- A conversion may cause you to increase your tax bracket.

- For the 2010 tax year, you have the option of applying 50% of the conversion amount to the 2011 tax year and 50% to 2012, or pay 100% in 2010.

- If you convert to a Roth and discover that you were ineligible or that the conversion is not tax advantageous to you, you can reverse the conversion.  This is called a “recharacterization”.

A Roth conversion is best suited for you if you meet all three of the following criteria:

- You will be in the same or higher tax bracket by the time you retire.

- You won’t need to withdraw the money for at least 10 years.

- You have cash on hand to pay the income taxes for the conversion.

Investors need to be aware of all of the tax implications and rules of the conversion to make the right decision for their investments. 

The Home Office Tax Deduction Simplification and Improvement Act of 2009 could make it easier for individuals who own small businesses to take the home office tax deductions.  Currently, in order to take the deduction an area of the business owner’s home must be the principal place of business and must be used regularly and exclusively for business purposes.  According to the U.S. Small Business Administration, 53 percent of small businesses are home-based. However, only a few people take the home office tax deduction due to the complex requirements and the high number of tax audits home office deductions seem to generate. 

The proposed legislation would allow for minimal use of the designated business space for personal activities and would reduce the burden of proof required to claim the deduction. This is a welcome improvement to the home office deduction regulations.

The American Recovery and Reinvestment Act of 2009 amended Section 529 to add a new provision, Section 529(e)(3)(A)(iii), which expands the definition of qualified education expenses, and Section 25A(f) of the Hope and Lifetime Learning Credit legislation.

            Section 529 Plans are education savings plan that allows distributions to be tax free if they are used to pay a beneficiary’s qualified educational expenses. Section 529(e)(3)(A) defines qualified higher education expenses as “tuition, fees, books, supplies and equipment required for enrollment or attendance at an eligible institution.” Section 529(e)(3)(B) adds room and board to the list of qualified expenses for students attending at least part-time. The Recovery Act added Section 529(e)(3)(A)(iii) to expand the list of qualified higher education expenses to include purchases made in 2009 or 2010 of computer technology (equipment), as well as Internet access and related services to be used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is enrolled at an eligible education institution. These expenses include: computers, computer software, computer equipment, and fiber optic cable related to computer use. Equipment and software used for entertainment purposes is not included.

            New Section 25A(f) expands the definition of qualified expenses for purposes of the Hope and Lifetime Learning Credits and the deductions allowed under Section 222. Qualified expenses include tuition and fees at an eligible institution. For example, qualifying fees include course materials such as mandatory equipment fees for a science class. The Recovery Act added new Section 25A(i), which expands the definition of fees to include “books, supplies and equipment needed for a course of study whether or not the materials are purchased from the educational institution as a condition of enrollment or attendance.”  Section 25A(f) also increases the Hope Scholarship credit limit from $1,800 to $2,500. This is equal to 100 percent of the first $2,000 in qualified expenses and 25 percent of the second $2,000, for a possible total of $2,500. Previously, the credit was available for the first two years of college, but now it is available for a student’s first four years of college. This credit is also refundable for the first time up to 40 percent.

The American Recovery and Reinvestment Act of 2009 provides consumers with tax breaks when purchasing a new vehicle. Between February 17, 2009 and December 31, 2009, both itemizers and non-itemizers may deduct state, local, and excise taxes incurred on the purchase of the vehicle.  For both itemizers and non-itemizers, the deduction can be claimed in computing both regular tax and alternative minimum tax liability. The deduction is limited to the state and local sales and excise tax paid on up to $49,500 of the purchase price of the qualified new car, light truck, motor home, or motorcycle.

For example: A DC resident buys a new car for $30,000 and has a trade-in of $10,000. The DC sales tax would be $1,150, as follows:

                                    New car purchase price       $30,000

                                    Trade-in Value                     (10,000)

                                                                                      20,000

                                    Sales tax (DC)                       x   5.75%

                                                                                        $1,150       

This sales tax of $1,150 can be claimed as a deduction on your 2009 tax return. The phase out for taxpayers begins at $125,000 for individuals and $250,000 for married filing jointly.

Last year, Maryland politicians created a “millionaire” tax bracket raising the top income tax rate to 6.25% from 5.5% on taxable income over 1 million dollars.  Maryland legislators were hoping the increase in the tax rate on the states’ highest income and wage earners would help to offset the states’ expanding deficit.  As of April 15th, however, the State Comptroller’s Office reported that a total of 2,000 returns were received from those qualifying for the “millionaire” tax bracket, compared to the 3,000 returns that were received in 2008. Where are the missing high income residents? Have they moved to close-by tax friendlier states like Delaware, Virginia, and Pennsylvania?  According to the Center on Budget and Policy Priorities, state officials become fearful that whenever tax increases are imposed, the change might have a negative impact on the states’ economy or “might lead upper-income families to leave the state.” In Maryland’s case, this fear might just be realized.

An Op- Ed piece in the Wall Street Journal on Tuesday, May 26^th, commented on Maryland’s “millionaire tax” failure. The increase in marginal rates in the Maryland tax code demonstrates the pitfalls of attempting to raise taxes on citizens who are mobile, informed, and motivated.