Say Goodbye to EZ Street

If you thought filing last year’s tax return was bad, you might as well gather up your tax information and head to the nearest accountant now, because this tax season contains even more challenges.

Although the bulk of the complex changes passed last year won’t go into effect until you file your 1998 return, the few that did kick in for the ’97 tax year are dizzyingly complex.

Consider capital gains. Congress generously slashed capital gains rates last summer--retroactively, even--which is good news for investors. But before you get giddy, take a look at the new Schedule D.

The new, lower rates have spawned a 54-line form that all investors--even buy-and-hold mutual fund investors--must grapple with. It is so complicated that even the most seasoned tax experts say they can’t quite follow the logic.

“Investors need to make sure that they understand all the directions, so they put their figures in the right boxes on the front of the form,” said Mark Luscombe, a tax attorney and principal tax analyst for CCH Inc., a Riverwoods, Ill.-based firm that writes tax books for tax accountants. “Because once you get to the back of the form, they’re going to ask you to plug in numbers from specific lines, and you just have to kind of trust that it will all come out right. I can’t say that I completely follow what’s going on here.”

It’s tricky, Luscombe noted, because your federal income tax on capital gains could amount to 10%, 20%, 25%, 28% or whatever your ordinary income tax rate is, up to 39.6%. In the past, there were only two rates: a 28% long-term rate that was applied to gains on assets held more than a year and a short-term rate--equivalent to your ordinary income tax rate--that applied to assets held less than a year.

Now the long-term rate applies only to assets held more than 18 months or those that were sold during a brief window--between May 7 and July 28--when the new capital gains rates had been heralded but not yet explained. (Congress “grandfathered” sales during that period because many investors sold assets under the mistaken assumption that they would get the lower 20% rate as long as they had held the assets for a year or more.)

To further complicate matters, different kinds of assets are taxed at different pcapital gains rates. Collectibles such as art and baseball cards, for instance, are subject to a minimum 28% capital gains rate, regardless of how long you owned them before selling.

If you sell a rental property, your gain is likely to be taxed at a 25% rate because that’s the rate that applies when your asset is affected by accelerated depreciation, said Harvey Gettleson, partner in the personal financial planning group at Ernst & Young in Los Angeles.

About 20 million Americans are expected to file a Schedule D this year. That’s up by 4 million because buy-and-hold mutual fund investors, who previously could report gains on the 1040, must use the official capital gains form this year.

Ugly ‘Alternative’

Upper- and middle-income Americans in high-tax states such as California and New York are more likely than ever to get hit with the Byzantine and backward “alternative minimum tax,” or AMT, said Philip J. Holthouse, partner at the Los Angeles accounting firm of Holthouse Carlin & Van Trigt.

The alternative minimum tax was instituted in the 1970s when the nation’s top marginal tax rate was 70% and tax shelters proliferated. It was aimed at ensuring that people with ample income paid at least a minimum amount of federal income tax.

The system requires taxpayers over certain levels to compute their liability in two ways: first, by using the traditional method of filling out a 1040 and claiming itemized deductions, then by using an AMT form, which takes away most itemized deductions but assesses tax at a somewhat lower marginal rate. After calculating their tax under both methods, they pay whichever amount is higher.

Most tax shelters were eliminated in 1986, but the AMT survived. Over the last several years, it has begun to catch increasing numbers of Americans. For tax year 1990, for instance, only 132,103 individuals were subject to AMT taxes. For 1995--the most recent year for which statistics are available--the number had more than tripled to 414,106. And for 1998, it’s likely to grow even more.

Why? There are many reasons, including the fact that key AMT figures have never been indexed for inflation, which means the AMT hits comparatively poorer Americans each year. In addition, top income tax brackets have declined, which also makes it easier for the AMT to be triggered.

As a practical matter, it means that more taxpayers than ever will have to go through the onerous job of computing their tax twice. And computing it via the AMT is no easy task.

“It’s like stepping through the looking glass--entering a parallel universe where everything is reversed left to right,” Luscombe said. “Things that you deducted on your regular return you now add on your AMT form. Things that you added you now subtract.”

The other big tax breaks that took effect for 1997 involve real estate sales and adoptions. Although these are among the most straightforward of the new tax laws, they can still generate plenty of confusion.

Selling Your Home

The 1997 tax law instituted a new rule related to gains on the sale of your personal residence. As of May 7, single taxpayers can exclude up to $250,000 in profit and married taxpayers can exclude up to $500,000 in profit from the sale of their personal residence. If you sold your home in 1997 and plan to take advantage of the law, you need to fill out a 23-line form, Schedule 2119.

Beware: If you claim home office deductions, a portion of the home sale proceeds are taxable. Trying to determine how much of the proceeds are taxable is difficult. To do it, you have to compute the amount of your profit affected by recaptured depreciation. That requires filling out yet another form, the 4797, with its 35 complicated lines, Luscombe said. You then transfer the total to line 25 of Schedule D and hope for the best.

In fact, the home office deduction requirements are so onerous that Holthouse advises home sellers not to claim that deduction in 1997--and to think hard before ever claiming it.

That’s because there’s a short-lived loophole that eliminated the need to recapture depreciation claimed on a home office prior to May 7--as long as you didn’t claim depreciation deductions after that point.

But if you did, there’s no getting out of depreciation recapture, which could more than wipe out the benefits homeowners get from claiming home office deductions in the long run.

Adoption Credits

Also new for 1997 are adoption tax credits. If you adopted a child, you may qualify for federal income tax breaks that reduce the tax you owe by $1 for each dollar you spent on qualifying adoption expenses, up to $6,000.

Qualifying adoption expenses can include everything from attorney fees to medical expenses paid on behalf of the birth mother (when allowed by state law). In addition, adoptive parents can claim the cost of necessary travel, fees paid to both domestic and foreign adoption agencies, and the cost of any necessary psychological counseling for the parents or child. The credit even allows adoptive parents to recoup the cost of home improvements needed to accommodate the new family member.

Additional tax breaks are available to families whose employers offer adoption assistance.

But, as always seems to be the case with the Byzantine U.S. tax code, there are caveats, tips and traps. Among other things, the breaks can’t be claimed on your ’97 return unless all of the adoption paperwork was completed last year.

If you took custody of the child in 1997 but the court didn’t declare the adoption final until 1998, you have to wait until you file your 1998 return to claim the credits.

If you attempted to adopt a child but were unsuccessful, the costs you incurred can be added to the cost of a subsequent successful attempt and then claimed for the year that adoption is final, or for the year after the year in which you incurred the expenses.

Still, these complexities pale in comparison to what taxpayers are likely to face for the 1998 filing season, when a host of income-contingent tax benefits will require middle-class families to wade through a variety of calculations to determine whether they can claim everything from child tax credits to education credits.

“Doing your own tax return this year is like changing the oil in your car,” said Kathy Burlison, an enrolled agent and tax research and training specialist at H&R; Block. “You can do it yourself, but it’s messy, and you’re probably not going to enjoy it.”

As for next year, Burlison said, “I think people should remember that there’s no shame in having someone prepare a return for you.”

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Kathy M. Kristof is a syndicated columnist and author of “Kathy Kristof’s Complete Book of Dollars and Sense.” Write to her in care of Personal Finance, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or e-mail kathy.kristof@latimes.com

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What’s My Bracket?

Here are the federal income tax brackets used by the Internal Revenue Service:

Single

15%: 0-$24,650

28%: $24,651-$59,750

31%: $59,751-$124,650

36%: $124,651-$271,050

39.6%: $271,051 and up

Married, filing jointly

15%: 0-$41,200

28%: $41,201-$99,600

31%: $99,601-$151,750

36%: $151,751-$271,050

39.6%: $271,051 and up

Source: Internal Revenue Service