A tax loophole isn’t illegal. It just seems that the person benefiting from the loophole often is following the letter of the tax law, but not the spirit of the law.
Similarly, there are many tax deductions that appear to provide disproportionate tax benefits to a select few.
Here are five tax breaks that fall into those categories.
Capital gains tax rate
The current 15 percent capital gains tax rate for most investors and zero percent rate for lower income taxpayers are part of the much ballyhooed George W. Bush-era tax cuts. The idea behind the lower capital gains tax is that it encourages investment, which helps create new companies that hire more people — and we’re all fat and happy thanks to this tax-subsidized investment chain. Think again.
This tax loophole is estimated by the Joint Committee on Taxation to cost the U.S. Treasury nearly $457 billion between 2011 and 2015.
And it’s a huge reason why the wealthy, such as financier Warren Buffett, are able to pay substantially lower overall tax rates. Buffett’s oft-repeated confession that his tax rate is lower than his secretary’s sparked the latest political debate on the fairness of low tax rates on investment profits.
Ordinary taxpayers pay tax on their earnings at ordinary income tax rates up to 35 percent. The really rich, however, are different from you and me in that they tend to make most of their money via investments instead of standard paychecks — meaning most of their money is taxed at 15 percent.
But what about the wonderful zero tax rate for investors in the 10 percent and 15 percent income tax brackets? Really? Most folks at those tax levels don’t have a lot, if any, cash left over to invest after paying their bills. But by giving them the option, members of Congress felt better about voting for a tax break that benefits primarily the rich.
Home mortgage interest deduction
If you’ve ever bought a house, one of the first things your real estate agent and mortgage broker probably pointed out was that you get to deduct your home loan’s mortgage interest on your taxes.
What they didn’t tell you was that your deduction is underwritten by the vast majority of homeowners who don’t get this tax break.
The home mortgage interest deduction is the largest individual taxpayer cost to the U.S. Treasury. Uncle Sam will lose an estimated $464 billion between 2011 and 2015. And that amount is racked up by just the third of American taxpayers who itemize.
Even worse, say economists, the tax deduction probably isn’t necessary. Most other industrialized nations worldwide don’t offer their residents a tax break for buying a house, yet those folks buy homes. And the reality is that no one ever bought, or didn’t buy, a house based on the tax law.
What the home mortgage interest deduction really does, say economists, is encourage more financially well-off individuals to buy bigger houses. The July 2011 Reason Foundation study, “Unmasking the Mortgage Interest Deduction,” found that the annual average tax saving of the mortgage deduction for a taxpayer making $50,000 to $75,000 was $179, and that only about one-third in this group claim the deduction. At the upper income level, however, homeowners with incomes exceeding $200,000 get an annual tax benefit of more than $2,200, and almost three-quarters claim the deduction.
The mortgage interest deduction benefits also are geographically disproportionate. Just as high-income taxpayers get more out of it, so do metropolitan areas with high incomes, taxes and housing prices. That historically has tended to be locales in California and the Northeast.
So the next time you visit your cousin at his new house in New Jersey, make sure he thanks you for your help with his purchase.
Second-home mortgage interest deduction
Not to keep picking on homeowners, but there’s yet another residential deduction that needs to go: the deduction for interest on a vacation home loan.
Yes, some owners of second homes are far from wealthy. But those who own a ski chalet in Aspen, Colo., an ocean-view getaway along Miami’s South Beach or a pied-a-terre in New York City in which to rest after a late Broadway opening night usually are rich. And they get to write off the interest on those expensive second homes as an itemized deduction, for mortgage debt as high as $1 million.
Even more amazing, owners of luxury yachts can deduct mortgage interest on loans they took out to buy their mini-Queen Marys. That’s right: The Internal Revenue Code says a boat can be considered a home as long as it has sleeping quarters, a kitchen and a toilet.
The home designation rules also mean that recreational vehicles could qualify as residences, providing owners of those luxury buses an added tax deduction, too.
Sure, some people do live in straightforward houseboats. And because the deduction applies to all types of second-home options, supporters of the tax break argue that it’s fair.
But the tax code would be even fairer if the vast majority of single homeowners didn’t have to subsidize any second homes.
Carried interest special tax treatment
Remember the controversy over the low tax rates that Republican ex-presidential candidate and former Massachusetts Gov. Mitt Romney paid? Part of the reason was because of his capital gains on investments.
But Romney also got some pay for his work at Bain Capital. And a tax loophole allows that compensation to be taxed at a lower rate.
Managers of most private equity funds get a percentage of the net gains as a management fee. This payment is known as carried interest, and here’s the beautiful part for the fund manager: Carried interest is not taxed like the regular interest most taxpayers get on regular savings accounts. It’s taxed as a capital gain.
That means while regular interest received by most taxpayers on their savings accounts is taxed at rates that could go up to 35 percent, folks who get carried interest payments owe a current top rate of 15 percent on that special interest.
A Bloomberg Global Poll in January found that two-thirds of poll respondents worldwide said the carried interest tax break isn’t justified. That’s consistent with the poll’s finding on the topic in the United States, where 67 percent said the lower tax rate isn’t fair.
A bill was introduced in Congress to change the tax treatment of equity fund managers’ earnings. Not surprisingly, it went nowhere.
Tax break for offshoring US jobs
Businesses also get their fair share of tax breaks and tax loopholes. The ability to save on corporate taxes by shipping operations overseas is one of the most vilified corporate tax breaks.
Yes, companies can expense the costs of relocating abroad. True, it’s not a special tax break for moving, say, a factory and its 600 jobs from St. Louis to Singapore. And, says the Tax Foundation, jobs are at least three times more likely to be relocated from one state to another than overseas.
Still, when U.S. unemployment is high, a tax break that rewards the elimination of more U.S. jobs seems like a really bad idea.
Will these and other individual and corporate tax loopholes, deductions or, as the federal government calls them, tax expenditures, be eliminated or even tweaked a bit? It’s not likely. All are quite popular among the groups that receive tax savings from them. And they are the same folks who tend to contribute generously to political campaigns.
But anything can happen on the way to the “fiscal cliff.”