Although there is still well over a year to go before it will be time to file 2014 income tax returns, the time to begin planning your tax strategy is now. Adjustments in withholding or estimated tax payments that may result from the expiration of certain tax deductions or credits will be much less painful if they are spread throughout the year rather than crammed in at the end—or worse yet, revealed at filing time when a large tax bill could also mean penalties and interest for underpayment throughout the year. Many of the changes will affect both domestic and expat taxpayers alike.
As the economy continues to improve (at least by some measures), still more of the tax relief that was implemented during the recession and the aftermath of the financial crisis looks likely to disappear. The beginning of 2013 saw the end of the payroll tax reduction, and many benefits of the American Taxpayer Relief Act of 2012 and other legislation will sunset and expire as of December 31, 2013 assuming no action from Congress—and “action from Congress” has for some time now been less a political reality and more the punch line of some painfully accurate jokes.
Recently the media have made much of 55 such tax breaks that will not be allowed in 2014—unless, of course, Congress acts later in the year to renew some or all of them retroactively. While moving the goalposts after the game has started is pretty much universally seen as unfair, Congress apparently plays by a different set of rules. Needless to say, this sort of uncertainty makes tax planning a challenge, but the wisest course of action is to assume that those deductions are gone for good. After all, should they be reinstated, it will be better to have a pleasant surprise come April 15, 2015 than a nasty one. So cheerfully assuming the worst, let’s look at likely changes for 2014.
As the housing crisis bloomed into an economic mushroom cloud and foreclosures spiked, providing some tax relief for homeowners became a priority. But now private mortgage insurance (PMI) premiums will no longer be deductible. More importantly, 2013 was the last year in which forgiven debt resulting from the foreclosure or short sale of the taxpayer’s primary residence was exempt from federal income tax (up to a $2 million limit). Initiatives designed to encourage renewable energy are also disappearing. The Personal Energy Property Credit, which provided a tax credit (albeit with a lifetime limit of $500) for certain energy efficiency improvements to your primary residence, is also expiring.
A couple of education-related deductions will vanish as well. Previously primary and secondary school teachers and staff could deduct up to $250 spent on classroom and instructional materials (doubling to $500 for two married teachers filing jointly), but no more. For higher education, the formerly permissible above-the-line deduction for post-secondary education tuition and fees is also ending.
Taxpayers had previously been given the option to deduct local and state sales taxes rather than their local and state income taxes; that alternative ended with 2013. A rule that simplified charitable gifts by allowing taxpayers at least 70-1/2 years old and therefore subject to required minimum distribution rules for traditional IRA accounts to make transfers directly from the IRA to the charitable organization tax-free is not slated for renewal.
Not all of the changes are gloomy. For example, the Flexible Spending Account (FSA) for healthcare-related expenses has always been subject to a use-it-or-lose-it rule, but that requirement has been modified beginning in 2014. Now up to $500 in unused funds can be carried over to the next plan year. The change is not automatic, mind you—companies must modify their FSA plans to allow carryovers.
Another good change: the Supreme Court struck down the 1996 Defense of Marriage Act (DOMA) in 2013, leaving the definition of marriage to the individual states. The IRS will consider as legally married all couples who are legally married. Moreover, the IRS will recognize a legally married same sex couple regardless of whether the couple currently lives in a jurisdiction that recognizes same-sex marriage or a jurisdiction that does not recognize same-sex marriage.
Those in higher income brackets will be facing a more painful bite from taxes. In 2012 the top tax bracket had a rate of 35%; in 2013 the top rate bumped up to 39.6%. Income over $406,750 for single filers, $457,600 for those filing jointly, or $432,200 for head of household filers is subject to this highest bracket in 2014.
High-income filers are also the target of multiple surtaxes and FICA changes. The OASDI wage base (the maximum dollar value of wages subject to the Social Security portion of the payroll tax) normally increases annually, and 2014 is no exception: the wage base will rise to $117,000 from the 2013 level of $113,700. The Medicare (HI) portion has never been capped, and moreover those earning more than $200,000 (or $250,000 for married joint filers and $125,000 each for those married and filing separately) will now be subject to a 0.9% Medicare surtax in addition to the standard 1.45%.
Another surtax hitting mostly those with higher incomes is the 3.8% surtax on unearned income (interest, dividends, royalties, rents, annuity payments, net gains on asset disposal, and many forms of passive business income). This began in 2013 and so is nothing new, but it continues to hang over taxpayers in 2014. Determining the basis for this surtax can very quickly become complicated, especially for someone with numerous forms of qualifying income. To offer a couple of quick examples, net business income derived from a master limited partnership or from a closely-held S corporation or LLC when the taxpayer is not involved in the operation of the business is subject to the surtax, but rents that are “derived in the ordinary course of a trade or business” are not. (Rents from a passive business activity are, however.)
The 3.8% is levied on net investment income (any amounts which fit the criteria just discussed) or modified adjusted gross income (MAGI) that exceeds $250,000 (married and filing jointly), $125,000 each (married and filing separately), or $200,000 for all others, whichever is less. Expats need to know that the Foreign Earned Income Exclusion (FEIE) amount must be added back into MAGI when determining MAGI for surtax purposes, and any foreign tax credits are excluded.
Another potential issue for expats is gains on non-U.S. mutual funds—that is, those funds that are not listed on a U.S. exchange. You should be aware that distributions from such funds can be taxed at the maximum 39.6% rate rather than the lower rates for dividends and capital gains on domestic investments. There are ways to avoid this using the Passive Foreign Investment Company rules, but you will need the advice and assistance of a tax professional to do so correctly and legally.
Speaking of investments, expat taxpayers are still eligible to contribute to traditional and Roth IRAs, but only under certain conditions. First, earned income must remain after the FEIE is taken—if none does, you may not contribute. Second, the normal income limits for these deductions apply, so high-income taxpayers who exceed the thresholds will be ineligible.
A final issue for expats is the Report of Foreign Bank Accounts (FBAR). The filing rule remains the same—total balances in foreign accounts exceeding $10,000 at any point during the year—but the FBAR must now be filed online (and, on a side note, has been renamed Form 114). Form 114 filing has a hard deadline of June 30, and extensions are not permitted. The reporting requirements for Form 114 and also Form 8938 (Report of Specified Foreign Financial Assets) can be complicated, and the IRS does not look kindly on omissions. The assistance of a tax professional is strongly advised.