Will newly proposed tax changes whack the wealthy?

With the Bush tax cuts extended for another two years, the status remains quo on major — and imminent — potential changes in tax law, right?

Wrong. The budget released by the Obama administration this week has a number of tax proposals that could hit wealthy Americans and investors hard at the beginning of next year, according to Robert Gordon, president of Twenty-First Securities Corp.

The most significant of these changes is another proposal by the administration to limit the benefits that wealthy taxpayers can get from itemizing tax deductions. The biggest such deductions include mortgage interest payments and charitable contributions.

Under the proposal, single taxpayers making more than $171,850 and married people making more than $209,250 would be allowed to reduce their tax liability from deductions only at a rate of 28%. That’s the same rate at which a single taxpayer making between $82,400 and $171,850 can claim.

The Congressional Budget Office has estimated that such a change would bring in about $300 billion over the next 10 years.

The president has argued for the proposal in his previous two budgets. After all, Mr. Obama himself has asked why rich people — including the president — get to write off more of a charitable contribution or an interest payment than a middle-class family. “I don’t think that’s fair,” Mr. Obama said in early 2009 when he introduced his first budget proposal.

Mr. Gordon, however, points out that the government effectively would be saddling higher-income taxpayers with a new tax. “The administration is saying that a dollar coming in the door is taxable at one rate and a dollar going out is deductible at a lower rate. It’s technically not a tax increase, but it amounts to that.”

For example, a dollar of legitimately deductible expense no longer would offset a dollar of income earned for wealthier taxpayers. Instead, those in the 35% tax bracket would lose 7 cents on the dollar after tax — a $1 deduction would cost them 72 cents rather than 65 cents.

The proposal could make things a lot tougher for investors using margin accounts, as well. If an investor earned $100,000 in interest and/or short-term capital gains and spent $100,000 in deductible interest to earn it, he or she would be on the hook for $7,000 in taxes.
“They would have to earn more on their portfolios to break even,” Mr. Gordon said.

In the last two budgets, charitable groups were particularly critical of the proposal, fearing that wealthy taxpayers would cut back on their giving. This time around, however, the $300 billion in extra revenue may look a lot more attractive to Congress given the increasingly dire deficit situation.

“I’m not sure people realize this would kick in next January,” Mr. Gordon said.