Income Averaging and Transitions in Tax Law

Over the years tax law has been quite fluid based on changes and incentives Congress intends to provide to taxpayers in each session. This amoeba-like quality is what makes comparisons between different generations of the tax code difficult. It's more than tax rates and deductions. Also, as the tax law takes different shapes benefits come and go some benefits just take on a different form. Following is one example.

Income Averaging

I have a little tax book that I pick up and read on occasion, How to Legally Avoid Paying Taxes by Sidney Walton. This book came out after the tax reform act of 1964. That year, the individual capital loss carryover was $1000 and carried over for unlimited years. Moving expense deduction was new. There was a deduction for political contributions. Capital gain rates were cut to as little as 7%. While some of the benefits of that era are not so impressive considering today's standards, one benefit had a lot of potential, income averaging.

For most types of income, taxpayers could have the ability to average their income over a five-year period. The benefit was only beneficial for taxpayers with fluctuations in income or those with windfall profits in a single year. The law did not apply to gambling, capital gains, and certain other income. Today that law doesn't exist except for specific industries. Instead, taxpayers have to effectively average their income by doing such things as taking losses in years they have gains, keeping funds invested, using IRA rollovers or recharacterizations, or grouping deductions in prosperous years.

The most discouraging part of this law were the complicated calculations. Remember this was before the introduction of the Personal Computer in the early 1980's. For the knowledgeable, it was a blessing. You could earn $40,000 is one year and average it with the $8,000 for each of the previous four years and you would pay tax based on the rate for less than $15,000 each year.

Home Sales

Years after the 1964 reform permitting income averaging, I remember reading a feature article (hard copy) about how one couple took advantage of the income averaging law. They would buy an old house, live in it and fix it up over several years. When they sold it, they income averaged the profits. Of course, there were issues relating to whether the gain was capital gain or ordinary income that had to be settled.

As mentioned, income averaging no longer exists, but those taxpayers may have an even better incentive for that. With the exclusion of captial gain on a home in the current law, that same couple could buy and fix up a house, sell it for a $500,000 gain and pay no taxes on it all. They have to have lived in it for 2 of last 5 years and meet some other requirements, but with proper planning it could be profitable venture.
Incidentally, home sales also had a exclusion in the 1964 law as well. That exclusion was a one-time event, and required the owner to live in it five of the last eight years, and be age 65 or older. The limit was based on a modified sales price of $20,000.

Aside: On Loopholes

When Congress writes tax laws that provide a benefit, they generally are providing a reward for some action or activity, or a benefit for someone with a need. Inadvertently, some of those laws are used by others for whom the law was not intended. That's might be referred to as a loophole. The current fixer-upper business is something that some would call a loophole. However, the law was specifically written to permit this type of activity. The exclusion is available every two to five years. It could have been written like the 1964 law for home sales with an age requirement and a one-time limitation. It wasn't. In the end, a subsequent Congress will determine if it was a loophole and then attempt to close it.

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