Inflation

Inflation – The Tax Code’s Secret Weapon

Author’s note:  I had  anticipated writing about the tax changes that were included as part of the  final bill addressing the Debt Ceiling crisis.  Alas, as of July 31st,  Congress had not yet agreed on what to do.  So instead I’ve updated this  popular article that was first posted inFebruary, 2007, and will wait  until next month to write about any changes to the tax laws brought on as part  of the solution to the Debt Ceiling crisis.

A dollar today is worth more than a dollar tomorrow.  Known as the time value of money, that’s one of the first concepts taught at any business school program.

If that statement doesn’t makes sense to you, don’t overlook the impact of inflation.  Even at a low rate of 3%, a dollar today only buys 97 cents worth of goods and services after one year.  Wait ten years and the buying power of a dollar falls to just 77 cents.

So what does this have to do with taxes? Unless the amount of a tax break is indexed for inflation, that tax break becomes less valuable over time.  And less valuable tax breaks equate to your paying higher taxes.

During 1986, President Reagan signed the massive Tax Reform Act of 1986 into law.  Even though 25 years have since passed, some of the tax breaks haven’t increased at all over the years.  But how has the dollar fared since then?  According to the calculator available at the website of The Department of Labor, Bureau of Labor Statistics, a basket of goods and services that would have cost $1,000 in 1986 now costs $2,060 today.

Let’s look at some of the tax breaks which haven’t changed over the years:

Mortgage Interest Deduction:  The Tax Reform Act of 1986 capped the mortgage interest you can deduct to $1.1 million of mortgage debt on your primary residence and a second home, including $100k for equity loans.  Since this threshold hasn’t increased in 25 years, the maximum allowable inflation-adjusted mortgage interest deduction continues to fall.  To keep pace with inflation, the mortgage debt ceiling would have to be increased to $2,266,000 in 2011.

Rental Losses: The Tax Reform Act of 1986 also introduced limits to the annual rental losses that could be claimed each year.  Under the existing rules that haven’t changed since first being introduced twenty-five years ago, deductible rental losses are capped at $25,000.  Factor in 25 years of inflation, and the maximum rental loss of $25,000 falls to an inflation-adjusted $12,150.   Another part of the 1986 Tax Act limits the rental losses you can claim once your income exceeds $100,000, and then disallows any current year losses once your income exceeds $150,000.  Since these thresholds haven’t been increased for inflation since 1986, the phase-out range of $100,000 to $150,000 is now equivalent to just $48,500 to $72,800.  For this tax break to have remained equivalent to rental losses allowed in 1986, the maximum annual rental losses would need to increase to $51,500, and the phase-out would need to be adjusted to $206k – $309k.

Student Loan Interest:  While the Tax Reform Act of 1986 eliminated the student loan interest deduction, Congress re-instated this deduction back in 1997.  Since 2001, the maximum student loan interest deduction has been stuck at $2,500.  Based on 11 years with no increases, the $2,500 student loan interest deduction has eroded to be worth only $1,960 this year.

Capital Losses:  Each year, you’re allowed to claim your capital losses against your capital gains, and then can claim up to $3,000 in additional capital losses to offset you wages and other income.  Any excess losses will be carried forward to your next year’s return.  Sounds like a pretty good deal, right?  Unfortunately, the $3,000 capital loss limit hasn’t changed for at least 25 years.  Due to inflation, the maximum capital losses you can claim is now worth just $1,450 in inflation-adjusted dollars.  For this tax break to have remained equivalent to the $3,000 allowed in 1986, the allowable capital losses would need to jump to $6,180.

Roth Contributions: Yes, the amount you can contribute to a Roth IRA each year has increased since these tax-free investment opportunities were first introduced in 1998.  The problem is that the income limitations haven’t kept up with inflation during these 14 years.  To qualify to contribute to a Roth IRA in  2011, your income can’t exceed $120,000 if single or $179,000 if married.  Over these 14 years, the thresholds have actually decreased to an inflation-adjusted $86,600 for single taxpayers and $129,200 for married couples, down from $110,000 for single individuals and $150,000 for married couples as originally set in 1998.

No Increases = Big Decreases

Since many of your tax breaks are indexed for inflation, it doesn’t make sense that the items listed above haven’t increased at all over the years.  But until such time that Congress decides to bump up these tax breaks, inflation will continue to make a fibber of anyone serving in the executive or legislative branches who brags about no new taxes.

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