STATE TAXES ATTRIBUTABLE TO IRC SECTION 68 PHASE-OUT

By John Thompson and Mitchell Eichen, CPA, Perelson Weiner

IRC section 68 reduces certain itemized deductions by the lesser of three percent of the excess of adjusted gross income over the threshold amount for that year or 80% of the amount of the itemized deductions otherwise allowable for that year. NYS Tax Law section 115.2(g) assumes that the Federal IRC section 68 limitation applies first to those itemized deductions not subject to the subtraction modification under Tax Law section 615(c). The effect of this regulation, as indicated in the following example, is the potential double add-back with regard to the state and local income tax itemized deduction.

A recent decision by the NYS Tax Appeals Tribunal allows taxpayers to subtract only the prorated amount of state and local taxes deducted on their Federal tax return when determining their
subtraction modification for state and
local taxes.

The July 31, 1997 decision, In the Matter of James R. Shorter, Jr.­DTA No. 813571, invalidates NYS Tax Law section 115.2(g). In determining his 1991 NYS taxable income, Mr. Shorter reduced his Federal itemized deductions by only the pro rata amount of state and local taxes deducted on his Federal tax return. The NYS Division of Taxation and Finance adjusted his return by reducing Federal itemized deductions for 100% of the state and local taxes deducted pursuant to NYS Tax Law section 615(c)(1) which requires, in part, taxpayers to reduce their Federal itemized deductions by state and local taxes. The NYS Division of Taxation and Finance under NYS Tax Law section 115.2(g), assumed that the Federal limitation applies first to those itemized deductions not subject to the subtraction modification. Thus the state required Mr. Shorter to add-back his NYS taxes once, in part, based on IRC section 68 and a second time, due to the add-back for state and local taxes pursuant to section 615(c)(1). Mr. Shorter filed suit in NYS tax court where the administrative law judge decided in his favor.

Upon appeal by the division, the NYS tax appeals tribunal affirmed the ALJ's decision and also invalidated regulation section 115.2(g). The tribunal believed that this regulation was unfair and was "not in harmony" with NYS Tax Law section 615(c). The tribunal held that no assumption exists in regulation section 615(c) to apply the Federal section 68 limitation first to those deductions not subject to the subtraction modification. The tribunal further found that "the pro-rata basis of allocation results in a reasonable, simple, and easily applied method for determining the amount of the
Tax Law section 615(c)(1) subtraction modification..."

The tribunal's decision to invalidate section 115.2(g) is final and effective immediately. Taxpayers affected by this decision should consider filing amended returns for all open years. *

NEW JERSEY TREATMENT DIFFERS FROM FEDERAL TREATMENT ON SALE OF PRINCIPAL RESIDENCE

By Neil Becourtney, CPA, J.H. Cohn LLP

The Taxpayer Relief Act of 1997 (1997 Tax Act) made significant changes to the treatment of gain from the sale of a principal residence. The new law applies to sales of principal residences on or after May 7, 1997, with certain transition rules. The new rules have eliminated the prior law "rollover" provision and have replaced the prior law "once in a lifetime" exclusion, which provided an exclusion of up to $125,000 of gain for taxpayers age 55 and older.

The new rules provide a blanket exclusion of up to $250,000 of gain ($500,000 if married filing jointly) for each sale of a principal residence as long as the residence was used for at least two out of the prior five years. The elimination of the rollover provision will result in taxable gains being realized by those individuals selling principal residences at the high end of the real estate market, while the average middle class taxpayer will never realize a taxable gain in the future on the sale of their principal residence.

The New Jersey gross income tax (GIT) law does not piggyback the Internal Revenue Code. Specifically, regulations section 18:35-1.13 follows former IRC sections 121 and 1034 literally in providing the rollover provision as well as the over-age-55-gain exclusion of $125,000. Absent any change in this regulation, a taxpayer may have a taxable gain for Federal purposes upon the sale of a principal residence yet have no New Jersey taxable gain or vice versa.

For example, assume a married couple filing jointly sell their principal residence that they had lived in for 30 years in November of 1997 for $1,500,000 with a cost basis of $300,000 for a gain of $1,200,000. The taxpayer simultaneously reinvests the entire sales proceeds in a new home. Under the 1997 Tax Act, there would be a taxable gain of $700,000 (after the $500,000 exclusion) for Federal purposes yet no gain for NJGIT purposes. On the other hand, any individual realizing a gain below $250,000 on the sale of a principal residence on or after May 7, 1997, which would be nontaxable for Federal purposes will have a taxable gain for NJGIT purposes if the proceeds of the sale are not reinvested within two years. *

State and Local Editor:
Marshall L. Fineman, CPA
David Berdon & Co. LLP

Interstate Editor:
Stuart A. Rosenblatt, CPA
Wiss & Company LLP

Contributing Editors:
Henry Goldwasser, CPA
M.R. Weiser & Co. LLP

Leonard DiMeglio, CPA
Coopers & Lybrand L.L.P.

Steven M. Kaplan, CPA
Konigsberg Wolf & Co., PC

John J. Fielding, CPA
Price Waterhouse LLP

Warren Weinstock, CPA
Paneth Haber & Zimmerman LLP