2013 Tax Rules Mean Surprises, Especially at High End

As the tax-filing season revs into high gear, most taxpayers will find the rules for filing 2013 taxes are a lot like the requirements of a year earlier. But high-wage earners, who were facing a significant tax increase, may be in for a nasty surprise.

While Congress made most of the Bush-era tax cuts permanent last year, affluent taxpayers were singled out for special treatment. In many cases, it means owing Uncle Sam this year instead of getting a refund.

“What is happening is that those clients used to getting refunds aren’t getting them,” said Bradford Hall, a CPA in Irvine, Calif. “Their reaction is disbelief – like, what changed?”

The changes affect a variety of personal exemptions and itemized deductions that many taxpayers got used to after Congress extended the Bush tax cuts during the recession.

In addition to reducing longtime breaks, Congress increased the tax rates on the highest earners, with the impact generally kicking in at $250,000 in adjusted gross income for couples filing jointly and at $200,000 for singles.

But some changes affect a large number of taxpayers of all incomes. Among them was an increase in the threshold to claim medical expenses, making it more difficult to write off doctor and drug bills.

One new federal tax provision, intended to protect against identity theft, is also proving to be an annoyance for some taxpayers. The law now requires taxpayers who file electronically to include their previous year’s adjusted gross income on the 2013 IRS tax filing.

“It’s not a problem if you have the same person doing your tax return this year as last year, but I have clients I’m seeing for the first time, and they can’t find their 2012 income tax filing to find their adjusted gross income,” said Bill Geideman, an enrolled agent in Santa Ana, Calif.

While generally conforming to federal tax rules, the state of California has some bad news for struggling homeowners who thought they dodged a bullet last year after their lender wrote down their mortgage.

The state legislature failed to extend an exemption that protected homeowners from having to pay California income taxes on the reduction in their mortgage. As it currently stands, homeowners no longer will be eligible for the cancellation-of-debt provision and will owe state income tax on that difference. (Federal law continues to exempt principal reductions.)

Not all the 2013 tax news was bad.

Congress made interest deductions for qualifying student loans and employer-provided education assistance permanent. Coverdell Education Savings Account provisions are also now permanent.

Low-income workers will be able to take advantage of an increase in the earned income tax credit. Eligibility is based on filing status and number of children. Single workers are eligible if they earned less than $14,340 last year, while married couples with three children who file jointly can get the credit if they made less than $51,567.

Taxpayers with a home office will find a simpler alternative calculation that allows them to deduct a flat $5 per square foot, up to $1,500.

For those taxpayers getting refunds, there is also good news. IRS refunds are averaging $3,317, up from last year.

Here are some of the areas most affected by 2013 tax changes:

• Health care law: The Affordable Care Act made two tax changes for affluent taxpayers. A new 3.8 percent surcharge is being imposed on net investment income (dividends, interest, rent and passive activities in LLCs and partnerships) for couples with a taxable income over $250,000, or $200,000 for singles. There is also an additional 0.9 percent Medicare tax on wages and self-employment income for those top earners.
• New top tax rates: The tax rate for couples with ordinary income over $450,000 and singles earning over $400,000 rises to 39.6 percent. The tax rate on dividends for these high earners goes up from 15 percent to 20 percent.
• Phase-out of exemptions and deductions: Itemized deductions are cut up to 80 percent for joint filers making more than $300,000 and individuals at $250,000. Personal exemptions also are phased out at those income thresholds and eliminated entirely at $425,000 for joint returns and $375,000 for singles.
• Medical deductions: For taxpayers 65 or younger, the threshold for medical deductions increases from 7 percent of income to 10 percent.