301-986-2200 301-986-2200

Tax Relief and Health Care Act of 2006

Introduction

H.R. 6111, the Tax Relief and Health Care Act of 2006, Pub. L. No. 109-432, 120 Stat. 2922, (the “Act”) was passed by the House on December 8, 2006, and by
the Senate on December 9, 2006. The Act was signed into law by President Bush on December 20, 2006 and it extends many tax provisions that were scheduled to expire at the end of 2005 and 2006.

PROVISIONS AFFECTING INDVIDUALS

Provisions of the act that affect individuals include sections 101, 103, 106, 108, 117, and 407.

Act Section 101: Deduction for Qualified Tuition and Related Expenses

The Act extends the termination date for section 222 of the Internal Revenue Code (the “Code”) from December 31, 2005 to December 31, 2007. Code section 222
allows an individual to take an “above the line” deduction from gross income for any qualified tuition and related expenses for post-secondary education paid by the individual during the tax year in which the deduction is taken. For purposes of Code section 222, the term “qualified and related expenses” means “tuition and fees required for the enrollment or attendance of (i) the taxpayer, (ii) the taxpayer’s spouse, or (iii) any dependent of the taxpayer with respect to whom the taxpayer is allowed a deduction [or a personal exemption], . . . at an eligible educational institution for courses of instruction of such individual such institution.” Code section 25A(f).

Pursuant to Code section 222(c)(2), the amount of the deduction must be reduced by qualified scholarship and other educational expenses “taken into account in determining any amount excluded under section 135, 529(c)(1), or 530(d)(2). Thus, educational expenses paid from the income of certain United States savings bonds, paid from a Coverdell education savings account, or paid under a qualified tuition program, will reduce the amount of the allowable deduction for higher education expenses under Code section 222.

Code section 222(b)(2) provides an applicable dollar limit for the higher education expenses deduction. For tax years beginning after 2003, the applicable dollar limit is $4,000 for taxpayers whose adjusted gross income does not exceed $65,000 (or $130,000 in the case of a joint return) and $2,000 for taxpayers whose adjusted gross income is between $65,000 and $80,000 (or between $130,000 and $160,000 in the case of a joint return).

The Code section 222 deduction for tuition and related expenses is not without its limits, however. It is important to note that only higher education tuition and qualifying fees are eligible for the deduction. As such, expenses for elementary and secondary schools cannot be deducted.

In addition, a taxpayer may not take the Code section 222 deduction for tuition and related expenses if the taxpayer elects to take a HOPE credit or Lifetime Learning credit under Code section 25A. Pursuant to Code section 25A the maximum HOPE credit is $1,500 per student, whereas the maximum Lifetime Learning credit is $2,000 per return. These credits can be taken in conjunction with one another. For 2006, the phase out for both of these credits is between $45,000 and $55,000 (or $90,000 and $110,000 in the case of a joint return).

Effective Date: Beginning after December 31, 2005. Sunset Date: Taxable years beginning after December 31, 2007.

Code Section Affected: Code section 222.

Act Section 103: Election to Deduct State and Local General Sales Taxes

The Act extends the election allowed under Code section 154(b)(5)(I) for two years. Pursuant to Code section 154(b)(5)(I) as amended, a taxpayer can elect to take an itemized deduction for any state and local general sales taxes paid during taxable years beginning after December 31, 2003 and before January 1, 2008. The taxpayer may elect to take an itemized deduction for state and local sales taxes instead of an itemized deduction for state and local income taxes.

Effective Date: Beginning after December 31, 2005. Sunset Date: Taxable years beginning after December 31, 2007. Code Section Affected: Code section Act

Section 106: Election to Include Combat Pay as Earned Income For Purposes of Earned Income Credit

The Act extends the election to include combat pay as earned income for one year, from December 31, 2007 to December 31, 2008. Pursuant to Code section 112, combat pay is excluded from gross income for any enlisted active service member of the U.S. Armed Forces (below the grade of commissioned officer) who served in a combat zone. The exclusion from gross income is also available for any combat pay received by an active service member while hospitalized due to injuries received while serving in a combat zone (but not for more than two years past service in the combat zone). Combat pay which is excluded from gross income is eligible for the earned income credit under Code section 32.

Effective Date: Beginning after December 31, 2006. Sunset Date: Taxable years beginning after December 3 1, 2007. Code Section Affected: Code section 32.

Act Section 108: Above-The-Line Deduction for Certain Expenses of Elementary And Secondary School Teachers

The Act extends the deduction from gross income for certain expenses paid by elementary and secondary school teachers allowed under Code section 62(a)(2)(D) for two years. As amended, the educator expense deduction is allowed for expenses paid during taxable years 2002 through 2007. Pursuant to Code section 62(a)(2)(D), the deduction is allowed for expenses, up to $250, for “books, supplies (other than non-athletic supplies for courses of instruction in health or physical education), computer equipment (including related software and services) and other equipment, and supplementary materials used by the eligible educator in the class-room.” An eligible educator includes teachers and educators (including counselors, principals, and aides) for kindergarten through grade 12 performing such duties for at least 900 hours during the school year. The educator expense deduction is allowed for “out-of-pocket”(that is, unreimbursed) expenses described by the statute and paid by eligible educators.

Effective Date: Beginning after December 31, 2005. Sunset Date: Taxable years beginning after December 31, 2007. Code Section Affected: Code section 62.

Act Section 117: Availability of Medical Savings Accounts

The Act extends the present Archer medical savings account (“MSA”) provisions under Code section 220 for two years, through December 31, 2007. Pursuant to Code section 220, contributions made by an eligible individual to an Archer MSA are deductible for purposes of determining adjusted gross income. Contributions made by an employer of an eligible individual to an Archer MSA are also excludable from gross income for employment tax purposes. Thus, an employee can make tax-free contributions to an Archer MSA, withdrawals from which may be made to pay for certain types of medical care. Under Code section 220, distributions for medical expenses from an Archer MSA are not includible in gross income. However, distributions from an Archer MSA for purposes other than for medical expenses are includible in the account holder’s gross income.

Effective Date: December 31, 2005. Sunset Date: December 31, 2007. Code Sections: Code section 220.

Act Section 407: Frivolous Tax Submissions

The Act increases the civil penalty imposed for a frivolous tax submission from $500 to $5,000. Code section 6702 provides that a taxpayer is subject to a civil penalty if the taxpayer files an income tax return which includes a frivolous return position or reflects a desire to delay or impede the administration of federal tax laws. The Act also expands the application of Code section 6702 to include the submission of requests for collection due process hearings under Code sections 6320 and 6330, installment agreements under Code section 6159, offers-in-compromise under Code section 7122, and taxpayer assistance orders under Code section 7811 if undertaken to delay or impede administration of federal tax laws.

Pursuant to Code section 6702, the Internal Revenue Service (“IRS”) may either disregard a frivolous tax submission or impose a civil penalty unless
the taxpayer withdraws the tax submission. However, the taxpayer must be given notice that a submission is considered by the IRS to be a frivolous tax submission and must be given the opportunity to withdraw the submission. Further, the IRS must publish a list of any requests or submissions that will be considered frivolous.

Effective Date: Effective after the date on which the Secretary first prescribes a list of frivolous positions. Code Sections Affected: Code sections 6702, 6320,6330,6159,7122, and 7811.

PROVISIONS AFFECTING BUSINESSES

The provisions affecting businesses include 102, 104, 105, 110, 113, 116, 120, and 401.

Act Section 102: Extension and Modification of New Markets Tax Credit

The Act extends the new markets tax credit under Code section 45D for one year, through December 31, 2008, and allows a $3.5 billion maximum annual amount for qualified equity investments in 2008. The Act also modifies Code section 45D(i) by inserting paragraph (6), which requires the IRS to issue regulations to ensure that non-metropolitan counties receive a proportional allocation of qualified equity investments.

Pursuant to Code section 45D a taxpayer may take a new markets tax credit for qualified equity investments in a qualified community development entity. The term “qualified community development entity” means any corporation or partner-ship that is providing investment capital for income communities or persons that has residents of the low-income communities on its governing or advisory board and is certified as such by the Secretary Under Code section 45D, the maximum annual amount of qualified equity investments is limited to $1 billion in 2001, $1.5 billion in 2002 and 2003, $2 billion in 2004 and 2005, and $3.5 billion
in 2006 and 2007.

Effective Date: Date of enactment. Sunset Date: Taxable years beginning after December 31, 2008. Code Sections Affected: Code section 45D.

Act Section 104: Extension and Of Research Credit

The Act extends the availability of the research tax credit under Code section 41 for two years, until December 31, 2007.

Pursuant to Code section 41, a taxpayer may take a research tax credit equal to 20 percent of the amount by which the taxpayer’s qualified research
expenses in a tax year exceed the taxpayer’s base amount. Code section 41(b) defines the term “qualified research expenses” as including any wages paid to an employee for qualified research services performed by the employee, any amount paid for supplies used while conducting qualified research, and any amount paid to another person for the use of computers while conducting qualified research. The term also includes 65 percent of any amount paid by a taxpayer to any person other than an employee for qualified research.

Computation of the Allowable Credit

Code section 41(c)(1) provides that a taxpayer’s base amount is determined by multiplying the fixed-base percentage (determined under Code section 41(c)(3) and the average annual gross receipts of the taxpayer for the four taxable years preceding the taxable year for which the credit is being deter-mined. Code section 41(c)(3)(B) provides that if a taxpayer had both qualified research expenses and gross receipts for the taxable years 1984 through 1988, then the taxpayer’s fixed-base amount was the ratio of the taxpayer’s total qualified research expenses to the taxpayer’s total gross receipts for any five years. For all other taxpayers (referred to as “start-up companies”), a taxpayer’s fixed-base percentage is three percent for each of the taxpayer’s first five taxable years after 1993 during which the taxpayer incurs qualified research expenses. For a taxpayer’s next five taxable years during which the taxpayer incurs qualified research expenses, the taxpayer’s fixed-base percentage phases in until the taxpayer’s tenth taxable year. For any taxable years after the taxpayer’s 10th taxable year, the tax-payer’s fixed base amount will be the actual ratio of the taxpayer’s total qualified research expenses to the taxpayer’s gross receipts for
any five years selected by the taxpayer. Code section 41(c)(3)(B).

Pursuant to Code section 41(c)(2), in no event may a taxpayer’s base amount be less than 50 percent of the taxpayer’s qualified research expenses for the taxable year.

Eligible Research Expenses

Pursuant to Code section 41(d)(1), the term “qualified research” means research that (1) is paid or incurred in connection with a trade or business, (2) is undertaken for the purpose of discovering information which is technical in nature and is intended to be useful in the development of a new or improved business component of the taxpayer, and (3) substantially all the activities of which constitute elements of a process of experimentation. Research is treated as qualified research if it relates to a new or improved function, performance, reliability, or quality. Code section 41(d)(3)(A). Research is not treated as qualified research if it is conducted for purposes of style, taste, cosmetic, or seasonal de-sign considerations. Code section 41(d)(3)(B). Code section
41(d)(4) also provides that qualified research does not include research (1) conducted after the commercial production of the business component, (2) concerning the adaptation of a taxpayer’s existing business component for a particular customer’s needs, (3) related to the reproduction of a taxpayer’s existing business component from a physical examination of the business component, (4) related to surveys or studies, or (5) with respect to computer software developed by the
taxpayer for internal use. Further, Code section 41(d)(4)(F) provides that any research conducted outside the United States, Puerto Rico, or
any possession of the United States does not qualify for the research credit under Code section 41

Alternative Incremental Credit

Pursuant to Code section 41(c)(4)(A), a taxpayer may elect an alternative incremental credit. The Act increases the credit rates applicable under Code section 41(c)(4)(A) for taxable years ending after December 31, 2006. At a taxpayer’s election, the taxpayer’s research credit rate will be equal to the sum of:

  • Three percent of so much of the taxpayer’s current-year research expenses that exceed a base amount computed using a fixed-base percentage of one percent, but not to exceed 1.5 percent of such average;
  • Four percent of so much of the taxpayer’s current-year research expenses that exceed a base amount computed using a fixed-base percentage of 1.5 percent, but not to exceed two percent of such average; and
  • Five percent of so much of the taxpayer’s rent-year research expenses that exceed a base amount computed using a fixed-base percent-age of two percent. Code section 41(c)(4)(A).

Alternative Simplified Credit

Under Code section 41(c), the Act creates a new “alternative simplified credit” for qualified research expenses. At the election of a taxpayer, the alternative simplified credit will be equal to 12 percent of the amount by which the taxpayer’s qualified research expenses for the taxable year exceeds 50 percent of the taxpayer’s average qualified research expenses for the three years preceding the year in which the research credit is being determined. Code section 41(c)(5)(A). For a taxpayer who did not have qualified research expenses in the preceding three years, the alternative simplified credit will be six percent of the qualified research expenses for the taxable year. Code section 41(c)(5)(B).

Effective Date:The extension of the research tax credit applies to amounts paid or incurred after December 3 1, 2005. The modification of the alternative incremental credit and the addition of the alternative simplified credit are effective for taxable years ending after December 3 1, 2006. Transition Rules: For taxpayers electing the alternative incremental credit in the fiscal year 2007, the research credit is calculated using a special formula. Pursuant to section 104(b)(3)(A) of the Act, the research credit is equal to the sum of two components. The first component is the amount of the alternative incremental research credit in effect for tax years ending on December 31, 2006, multiplied by a fraction (the “applicable
2006 percentage”), the numerator of which is the number of days in the fiscal year before January 1, 2007, and the denominator of which is the number of days in the taxable year. The second component is the amount of the alternative incremental research credit in effect for tax years ending on January 1, 2007, multiplied by a fraction (the “applicable 2007 percentage”), the numerator of which is the number of days in the fiscal year before December 3 1, 2006, and the denominator of which is the number of days in the taxable year. The new alternative simplified credit is calculated under the transition rule in much the same manner as the alternative incremental credit. The amount of the credit determined under Code section 41(c) is also the sum of two components. The first component is the amount of the qualified research credit that would be calculated under Code section 41(a)(1) multiplied by the applicable 2006 percentage. The second component is the amount of the alternative simplified credit determined for the tax year multi-plied by the applicable 2007 percentage. Code Section Affected: Code section 41.

Act Section 105: Work Opportunity Tax Credit and Welfare-To-Work Tax Credit

The Act consolidates the work opportunity tax credit (the “WOTC”) and the welfare-to-work credit. Code section 51(e).

Under Code section 51, an employer is given an election for a WOTC of up to $8,500 for wages paid to an employee who is a member of a “targeted group. Code section 51(d)(1) provides a list of individuals who are members of a “targeted group.” Under pre-2006 law, Code section 51A provided a welfare-to-work credit of up to $8,500 for wages paid to an employee who is a long-term family assistance recipient. However, the Act inserts the term “long-term family assistance recipient” in the list of individuals that are considered members of a “targeted group” in Code section 51(d)(1). Thus, the welfare-to-work credit has been
incorporated into the WOTC provisions of Code section 51.

Under Code section 51(d)(1), an individual is a member of a “targeted group” if the individual is a qualified IV-A recipient, a qualified veteran, a qualified ex-felon, a high-risk youth, a vocational rehabilitation referral, a qualified summer youth employee, a qualified food stamp recipient, a qualified SSI recipient, or a long-term family assistance recipient. Code sections 51(d)(1)(A)-(I).

Code section 51(d)(10) defines the term “long-term family assistance recipient” as an individual:

  • Who is a member of a family receiving assistance for at least 18 months ending on the hiring date;
  • Who is a member of a family receiving assistance for at least 18 months after August 5, 1997, and who is hired within two years after the end of the earliest 18-month period; or
  • Who is a member of a family that is no longer eligible to receive assistance because of state or federal time limits and who is hired within two years after the family ceased to be eligible.

Code sections 51(d)(10)(A)-(C). The Act extends the WOTC and the welfare-to-work credit for two years until January 1, 2008. Thus, the WOTC is available for individuals who begin work for an employer after December 31, 2006 and before January 1, 2008. In addition, the Act expands the WOTC by increasing the maximum age for eligibility for food stamp recipients from age 25 to age 40. Code section 51(d)(8)(A)(I). Furthermore, the Act relaxes the filing deadline under Code section 51(d)(13)(A)(ii)(II) from 21 days to 28 days after the individual begins working for the employer. Finally, the Act eliminates the “family
low-income requirement” for being a member of the “targeted group” consisting of “qualified ex-felons” under Code section 51(d)(1)(C).

Sunset Date: Taxable years beginning after December 31, 2008. Code Sections Affected: Code sections 51 and 51A amended.

Act Section 110: Tax Incentives for Investment in the District of Columbia

The Act extends for two years the tax incentives available to businesses and residents of certain economically depressed areas of the District of Columbia, known as the District of Columbia Enterprise Zone (the “D.C. Zone”). These tax incentives to revitalize the District of Columbia terminate on December 31, 2007. The tax incentives include:

  • A first-time home buyer tax credit of up to $5,000; 
  •  A 20 percent wage credit for wages paid by an employer to an employee who is a resident of the D.C. Zone and who works in the D.C. Zone;
  • An additional $35,000 of Code section 179 expensing for qualified zone property;
  • Expanded tax-exempt financing for facilities; and
  • A zero-percent capital gains rate from the sale of certain qualified D.C. Zone assets.

Effective Date: Beginning after December 31, 2005. Sunset Date: Taxable years beginning after December 31, 2007. Code Sections Affected: Code sections 1400, 1400A, 1400B, 1400C, and 1400F.

Act Section 113: 15-Year Straight-Line Cost Recovery for Qualified Leasehold Improvements and Restaurant Property

The Act extends 15-year straight-line cost recovery for qualified leasehold improvements and qualified restaurant property for two years. Generally, nonresidential real property is depreciable over a period of 39 years. However, pursuant to Code sections 168(e)(3)(E)(iv) and (v) as amended, qualified leasehold improvement property and qualified restaurant property placed in service before January 1,2008, has a straight-line cost recovery period of 15 years.

The term “qualified leasehold improvement property” means an improvement made by either the lessor or the lessee to an interior portion of a nonresidential building that is to be occupied exclusively by the lessee. The improvement must be made more than three years after the building was first placed into service. The improvement must not be made to a common area, an elevator or escalator, or the internal structure of the building. The qualified leasehold improvement only applies to the lessor or lessee who makes the improvement and not to any successor lessor or lessee.

The term “qualified restaurant property” means an improvement to a building more than 50 percent of which is used for the preparation and service
of food by the restaurant. The improvement must be made more than three years after the building was first placed into service.

Effective Date: Beginning after December 31, 2005. Sunset Date: Taxable years beginning after December 31, 2007. Code Section Affected: Code section 168.

Act Section 116: Corporate Donations of Scientific Property Used For Research and Of Computer Technology and Equipment

The Act extends the enhanced deduction for computer technology and equipment donations under Code section 170(e)(6) for two years. As amended, Code section 170(e)(6) applies to donations made after December 31, 2005, and on or before December 31, 2007. Generally, a taxpayer’s deduction for charitable contributions of computer technology and equipment is the taxpayer’s basis in the property. Pursuant to Code section donations of computer technology and equipment to elementary and secondary educational organizations or a public library are eligible for an enhanced charitable contribution deduction. The contribution must be made within three years after the taxpayer acquired, constructed, or assembled the property and must not be made in exchange for money or other property. Furthermore, the original use of the property must be by the donor or the donee, and the property must be used by the donee for educational purposes.

The Act also extends for two years the enhanced charitable contribution deduction allowed for scientific property used for research under Code section 170(e)(4). As amended, Code section 170(e)(4) applies to qualified research contributions made after December 31,2005 and on or before December 31, 2007. The contribution must be made by a corporation to an educational organization described under Code section 170(e)(6), must be constructed or assembled by the taxpayer, and must be made within two years after the taxpayer constructed or assembled the property. The contribution must not be in exchange for money or other
property. Furthermore, the original use of the property must be by the donee. Finally, the property must be scientific equipment used by the donee for research or experimentation (or for research training).

Date: Beginning after Decemher 31, 2005. Sunset Date: January 1, 2008. Code Section Affected: Code section 170.

Act Section 120: Extension of Bonus Depreciation for Certain Gulf Zone Property

The Act amends current law by extending the placed-in-service deadline found in Code section for “specified Gulf Opportunity Zone extension property.”

Pursuant to Code section 1400N, a taxpayer is allowed a depreciation deduction bonus for 50 per-cent of the adjusted basis of any Gulf Opportunity Zone (“GO Zone”) property. (A taxpayer may elect out of the bonus depreciation deduction.) The bonus depreciation is subtracted from the adjusted basis of the GO Zone property before the amount, which is otherwise allowed as an annual depreciation deduction, is computed. Under Code section 1400N as amended by the Act, GO Zone property must be acquired by purchase on or after August 28, 2005, and must be placed in service by the Lax-payer on or before December 31, 2010, in order to qualify for the bonus depreciation.

Under Code section 1400N the term “specified Gulf Opportunity Zone extension property” means: “property- (i) substantially all of the use of which is in one or more specified portions of the GO Zone, and (ii) which is- “(I) nonresidential real property or residential rental property which is placed in service by the taxpayer on or before December 31, 2010, or  “(II) in the case of a taxpayer who places a building described in (I) in service on or before December 31, 2010, property described in Section 168(k)(2)(A)(i) if substantially all of the use of such property is in such building and such property is placed in service by the taxpayer not later than 90 days after such building is placed in service.” Code section 168(k)(2)(A)(i) property includes computer software, water utility property, and qualified leasehold improvement property.

Code section 1400N defines the term “specified portions of the GO Zone” as those portions of the GO Zone which are in any county or parish … in which hurricanes occurring during 2005 dam-aged (in the aggregate) more than 60 percent of the housing units in such county or parish which were occupied.”

Effective Date: The provision applies as if included in Code section 101 of the Gulf
Opportunity Zone Act of 2005 (“GOZR”). Code section 101 of GOZA is effective for property placed in service on or after August 28, 2005, in taxable years ending on or after such date. Code Section Affected: Code section 1400N.

Act Section 401: Allowable Deduction with Respect to Income Attributable to Domestic Production Activities in Puerto Rico

The Act amends Code section 199 to allow tax-payers to take a deduction for income attributable to domestic production activities in Puerto Rico. Pursuant to Code section 199, Puerto Rico is treated as part of the United States and a deduction is allowed if all of a taxpayer’s gross receipts within Puerto Rico are taxable for federal income tax purposes. The provision applies to the first two years of a taxpayer beginning after December 1, 2005 and before December 31, 2008.

Under Code section 199 a taxpayer is allowed a deduction from gross income for a percentage of the taxpayer’s domestic production gross receipts.
The percentage deduction is three percent of the taxpayer’s “qualified production activities income” (as defined in Code section 199(c)) for tax years beginning in 2005 and 2006, six percent for tax years beginning in 2007 through 2009, and nine percent for tax years beginning after 2009. However, pursuant to Code section 199(b), a taxpayer’s deduction is limited to 50 percent of the wages paid by the taxpayer for any taxable year. The Act provides that wages paid for services performed in Puerto Rico will not be included when applying the wage limitation.

Effective Date: Beginning after December 31, 2005. Sunset Date: January 1, 2008Code Section Affected: Code section 199.

PERMANENCY OF CERTAIN PROVISIONS ENACTED IN TIPRA

In addition to the extensions discussed above, the Act makes several provisions introduced in the Tax Increase Prevention and Reconciliation Act of 2005 (“TIPRA”) permanent.

Act Section 410: Modification of Active Business Made Permanent under Section 355

The Act makes modification of the active business definition under Code section 355 permanent by deleting the termination date of December 31, 2010, in subparagraphs (A) and (D) of Code section 355(b)(3).

For a corporate division to be tax free under Code section 355, the active business requirement of Code section 355(b) must be met. However, TIPRA
relaxed the active business requirement of Code section 355(b). Under current law, the active business requirement is met if either (1) the distributing corporation and the controlled corporation are engaged in the active conduct of a trade or business immediately after distribution; or (2) the distributing corporation had no assets other than stock or securities in the controlled corporations immediately before the distribution, and the controlled corporations are engaged in the active conduct of a trade or business immediately after the distribution. Code section 355(b)(1).

Effective Date: May 17, 2006. Code Section Affected: Code section 355(b)(3)

Act Section 411: Qualified Veterans’ Mortgage Bonds

The Act makes TIPRA’s changes to the definition of “qualified veteran” and the state volume limits for veterans’ mortgage bonds in Code section 143 permanent by deleting the termination date found in Code section 143(I)(3)(B)(iv).

Qualified veterans’ mortgage bonds are state-issued private activity bonds that may be used to make mortgage loans to qualified veterans. Under the pre-2006 law, a qualified veterans’ mortgage bond could only be issued to a veteran who was a first-time home buyer. Pre-2006 law also required that a veteran had served in the military before 1977 and that the veteran had applied for the mortgage within 30 years after leaving active service. However, TIPRA modified Code section 143(l) to waive the requirement that a qualified veteran be a time home buyer. Further, TIPRA amended the definition of “qualified veteran” by removing the pre-1977 service record requirement and providing that veterans are eligible for the mortgages if they applied for the mortgage within 25 years after leaving active service. The Act makes these changes permanent.

TIPRA also modified the volume limitations of those states eligible to issue veterans’ mortgage bonds. Only five states may issue qualified veterans’ mortgage bonds under Code section 143(l) to finance affordable mortgages for veterans. These states include Alaska, California, Oregon, Texas, and Wisconsin. However, TIPRA modified the volume limitations only for Alaska, Oregon, and Wisconsin. The current volume limits are $10 million in 2007, $15 million in 2009, $20 million in 2009, and $25 million in 2010 and each year thereafter. The Act makes these volume limitations permanent.

Effective Date: Beginning after April 5, 2006. Code Sections Affected: Code section June 2007

Act Section 412: Capital Gains Treatment for Certain Self-created Musical Works Made Permanent

The Act makes capital gains treatment for certain self-created musical works permanent by striking the termination date of January 1, 2011, in Code section 1221(b).

Pursuant to Code section 1221(b), a taxpayer may make an election to treat the sale of musical compositions or copyrights in musical works created and sold by the taxpayer as the sale of capital assets. Thus, the maximum capital gain rate of 15 percent is available for the sale of such musical works (for taxable years beginning in 2006). Before TIPRA, income from the sale or exchange of self-created musical works created by the taxpayer was treated as ordinary income subject to a maximum ordinary income tax rate of 35 percent. The Act makes capital gain treatment permanent.

Effective Date: Beginning after May 17, 2006. Code Section Affected: Code section 122

Act Section 425: Loans to Qualified Continuing Care

The Act makes TIPRA’s modifications to Code section 7872 concerning below-market loans to qualified continuing care facilities permanent by deleting paragraph (4) of Code section 7872(h).

Generally, a below-market loan is one that has an interest rate below the applicable federal rate (determined pursuant to Code section 1274(d)). If a loan has a below-market interest rate, interest must be calculated at the applicable federal rate. The difference between interest calculated at the applicable federal rate and interest calculated at the stated rate is taxable to the lender as imputed interest. However, pursuant to Code section 7872(h), a below-market loan made by a lender to a qualified continuing care facility is not subject to this imputed interest rule if:

  • The lender, or the lender’s spouse, attains age 65 in the calendar year in which the loan is made; and 
  • The loan is subject to a “continuing care contract” Code section 7872(h).

Code section 7872(h)(2)provides that a “continuing care contract” means a contract under which: “(A) the individual or the individual’s spouse may use a qualified continuing care facility for their lives,”(B) the individual or the individual’s spouse will be provided with housing, as appropriate for the health of such individual or individual’s spouse – “(i) in an independent living unit (which has additional available facilities outside such unit for the provision of meals and other personal care), and “(ii) in an assisted living facility or a nursing home facility, as is available in the continuing care facility, and “(C) the individual or the individual’s spouse will be provided assisted living or nursing care as the health of such individual or individual’s spouse requires, and as is available in the continuing care facility.”

Before TIPRA, this exception to the imputed interest rule found in Code section 7872 only applied to loans in amounts less than $163,000. However, TIPRA eliminated this loan ceiling. Now all outstanding loans, regardless of loan amount, made by a lender under Code section 7872 to a qualified continuing care facility are exempt from the imputed interest rule.

Effective Date: Calendar years beginning after December 31, 2005 without regard to when the loan was made. Code Section Affected: Code section 7872(h).

PROVISIONS RELATING TO HEALTH SAVINGS ACCOUNTS

In addition to extending or modifying numerous tax provisions, the Act also modified Code provisions governing health savings accounts.

Act Sections 301 – 307: Provisions Relating To Health Savings Accounts

Health Savings Accounts (“HSAs”) created by the Medicare Prescription Drug, Improvement and Modernization Act of 2003, signed into law by President Bush on December 8, 2003, provide a tax-favored way for eligible individuals to pay for medical expenses and save for future medical expenses. HSAs are tax-favored accounts created to pay for the qualified medical expenses of the account holder and the account holder’s spouse and dependents. An individual is eligible for an HSA if the individual has a high deductible health plan with a deductible of at least $1,100 for individual coverage and $2,200 for family coverage. An individual is not eligible for an HSA if the individual is claimed as a dependent on another individual’s tax return or is older than the age of 65 and enrolled for Medicare benefits.

Contributions to an HSA made by or for the account holder are deductible from gross income by the individual account holder. Further contributions to an HSA
made by an employer are excluded from the account holder’s compensation for income and employment tax purposes. Earnings on the amounts contributed to the HSA are not includible in the account holder’s taxable income. Similarly, distributions from an HSA to pay for qualified medical expenses of the account holder or the account holder’s spouse or dependents are also not includible in gross income. However, any distributions from the HSA that are not used to pay qualified
medical expenses will be included in the account holder’s gross income and will be subject to an additional 10 percent tax.

The term “qualified medical expenses” generally includes amounts paid (1) for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body, (2) for transportation primarily for and essential to medical care, (3) for qualified long-term care services, and (4) for insurance covering such care or long-term care services Code section 213(d)(1)(A)-(D). However, if distributions are made from an HSA for the payment of qualified medical expenses, such distributions will not be treated as “qualified medical expenses” for the purposes of determining the itemized deduction for medical expenses under Code section 213.

Unlike funds held in health flexible spending arrangements (“FSAs”) and health reimbursement arrangements (¿HRAs¿), funds in an HSA are not subject to “use it or lose it” rules, which result in forfeiture of account balances if not used within a limited period of time. In contrast, unused funds in an HSA remain available for use in later years. The Act makes the following changes to Code provisions concerning HSA’s:

  • Subject to certain limitations, employers can transfer amounts in a health FSA or HRA to an HSA for an employee. Amounts rolled over to an HSA are in addition to amounts allowed as annual contributions to the HSA; 
  • The Act increases the limit on the maximum annual HSA contribution. For 2007, the maxi-mum contribution to an HSA for an eligible individual is
    $2,850 for self-only coverage and $5,650 for family coverage;
  • The Act provides that the contribution limitation is not reduced for part-year under an HSA and allows an eligible individual who becomes covered under an HSA mid-year to make the maximum annual HSA contribution for the year based on the individual’s coverage in the last month of the year;
  • The Act provides that an employer is not required to treat a non-highly compensated employee and a highly compensated employee as comparable participating employees. Thus, an employer may make larger HSA contributions for non-highly compensated employees than for highly compensated employees;
  • The Act modifies the cost-of-living adjustment used in determining the monthly dollar limit for deductible HSA contributions;
  • The Act permits a one-time distribution from an IRA to an HSA. The distribution must be contributed to the HSA in a direct trustee transfer.

Effective Date:

The provision allowing rollovers from health FSAs and HRAs into HSAs is effective for distributions and contributions on or after the date of enactment and before January 1, 2012. All other provisions in this section are effective for taxable years beginning after December 31, 2006.

Code Sections Affected: Code sections 223(b), 223(g), 408(d), 4980G.

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