Tax Reform Act of 1986

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Tax Reform Act of 1986

The Tax Reform Act of 1986 (100 Stat. 2085, 26 U.S.C.A. §§ 47, 1042) made major changes in how income was taxed. The act either altered or eliminated many deductions, changed the tax rates, and eliminated several special calculations that had been permitted on the basis of marriage or fluctuating income. Though the act was the most massive overhaul of the tax system in decades, some of its key provisions were changed in the Revenue Reconciliation Act of 1993 (107 Stat. 416). The 1986 act reduced the number of Income Tax rates to two rates of 15 percent and 28 percent for most taxpayers, although a third rate of 33 percent was imposed on income within a certain upper-middle income bracket. Congress and the administration of President ronald reagan believed a policy of low rates on a broad tax base would stimulate the economy and end an era of complex tax laws and regulations that mainly benefited those who knew how to manipulate the system.

The 1986 act also sought to eliminate special incentives that made tax shelters attractive and the tax law more complicated. Income derived from real estate became distinguishable on the basis of whether it was "active" or "passive." Passive income is income derived from a situation in which the taxpayer does not have an active management role, but it does not include capital gains on stocks, interest income on bonds, or interest on money market accounts. Before 1986 wealthy individuals could use passive income losses from a real estate tax shelter to offset active income. The 1986 act limited the deduction of passive losses to the amount of passive income but allowed taxpayers to carry forward any excess passive losses to the next year.

The act also eliminated the deductibility of nonmortgage consumer interest payments such as interest on credit card balances, automobile loans, and life insurance loans. It also established the floor for miscellaneous expenses at two percent of adjusted gross income for taxpayers who itemized deductions.

Individual Retirement Accounts (IRAs) once allowed a taxpayer to invest before-tax dollars and enjoy tax-free compounding of interest. The 1986 statute ended full deductibility of IRAs for single employees covered by qualified retirement plans and earning more than $35,000 annually. For married employees the cutoff for full deductibility was set at $50,000. In addition, the law imposed a penalty on withdrawals of IRA contributions before the age of fifty-nine and a half years.

Another retirement plan, the Keogh Plan, permitted under section 401(k), once allowed a taxpayer to invest up to $30,000 a year without paying taxes on this income. The ceiling dropped to $7,000 in 1987.

The act also eliminated a provision that had enabled two-income married couples to reduce their taxes. A couple can no longer take a deduction based on the lower salary of the two; the deduction had allowed them to pay the same tax on the lower salary as a single person would pay on that amount. The act also abolished "income averaging." Formerly, individuals whose incomes varied considerably from year to year could average their income over several years, a calculation that resulted in lower taxes owed in the years of highest income.

The ballooning Federal Budget deficits of the late 1980s and early 1990s led Congress to make changes in the 1986 act. The 1993 Revenue Reconciliation Act revamped the rate structure, imposing rates of 15, 28, 31, 36, and 39.6 percent. The act also limited itemized deductions for upper-income taxpayers and removed the limit on earned income subject to Medicare tax. The 1993 act also established tax incentives for selected groups and reduced the amount that can be deducted for moving expenses and meals and entertainment.