Best Bet on Your Tax Hit Next Year

Lawmakers punted on key tax decisions before they returned home to hit the campaign trail. Democrats had thought about holding a vote on extending the Bush tax cuts for all taxpayers except upper incomers -- a way to frame a key campaign issue -- but after a number of defections by moderate Democrats, party leaders decided to hold off until after the voters have had their say at the polls. They left everything for a lame-duck session next month. That leaves taxpayers scratching their heads, trying to figure out how to do their tax planning for this year and next.

Here’s what we think will end up happening:

On income tax rates, a one- or two-year extension of all Bush tax rate cuts is now more likely to prevail. A substantial number of moderate House Democrats and several Senate Democrats have come out in opposition to raising anyone’s taxes while the economy continues to limp along, and Republicans in both houses agree. If Republicans win control of the House on Nov. 2, it will take a lot of chutzpah for lame-duck Democrats to defy the will of the voters.

Plus, the GOP is likely to add a couple of senators who will be seated in November, once the results of their special elections are certified. That will make it even harder for the Senate to pass a rate cut extension in 2010 just for lower and middle incomers (individuals making less than $200,000 a year and couples under $250,000).

Ditto for taxes on capital gains and dividends. A short-term extension of the current 15% maximum tax rate on these income items is almost guaranteed. More House Democrats have come out in favor of retaining the 15% top rate on gains and dividends than have backed keeping the top income tax rate bracket at 35%. Counting those Democrats, a majority of the House support the 15% maximum rate.

The chances of the estate tax being revived for 2010 are fading fast. Lawmakers tarried too long, and a retroactive reinstatement would be challenged in court on constitutional grounds. So it is more and more likely that the estate tax will not return for this year. That comes with a huge headache for heirs of larger estates: They will have to use carryover basis for inherited assets, which isn’t always easy to determine. Executors can raise the basis of estate assets by $1.3 million plus an additional $3 million of basis step-up for assets going to a surviving spouse. That will ease some of the income tax bite when the inherited assets are sold.

For 2011, lawmakers will OK a minimum exemption of $3.5 million with a top rate of no more than 45%. There’s lots of support for raising the exemption in steps to $5 million and concurrently phasing down the maximum rate to 35%. Passage this year is not guaranteed, however. If taxwriters don’t have the appetite for a long lame-duck session, they may wait until next year to tackle the issue, allowing a puny $1-million exemption to go into effect temporarily on Jan. 1. Since the first estate tax returns of people dying in 2011 wouldn’t be due until October, lawmakers figure they’d have plenty of time to pass a bill to boost the exemption.

The many tax breaks that lapsed after 2009 will be restored retroactively. They include deductions for state sales tax in lieu of income tax, teachers’ supplies, college tuition and the extra standard deduction for realty taxes. Plus tax free payouts from IRAs to charity and higher alternative minimum tax exemptions to hold the minimum tax at bay.

Businesses will get an extension of the research and development credit, and faster write-offs for restaurant renovations.