BLOGROLL

Many tax code problems exist solely because tax brackets, limits and deductions haven't kept pace with inflation. One of those areas is the limit for the deduction of capital losses.

Senator Hatch and Senator Blanche Lincoln introduced a bill Tuesday to fix this problem with the tax code, The Desert News reports:

Amid the recession's body-slam on stock-market prices, Sen. Orrin Hatch has introduced a bill to increase significantly the amount of capital losses that individual taxpayers may deduct in a year.

The bill, which Hatch is pushing with Sen. Blanche Lincoln, D-Ark., would allow deducting $10,000 in such losses against ordinary income, up from the current $3,000 limit. The new $10,000 limit would then also be increased each year automatically to match inflation.

To understand the bill, it helps to remember that investors may receive ordinary income on assets, such as dividends and interest. They also may have capital gains if they sell their stocks or bonds for more than they paid for them. A capitol loss occurs when people sell their investments for less than they paid originally.

Capital losses now can be offset against capital gains without limit. However, current law limits the amount of capital loss that can be deducted against ordinary income to $3,000 a year.

Unused capital losses can be carried over to future years indefinitely, where they can be used against future capital gains or to offset, again, up to $3,000 in ordinary income a year in the future.

"This is a question of fairness," Hatch said. "Allowing individual investors to deduct only $3,000 per year when their total losses may come to many times that much is simply not fair. The tax code taxes gains without limit, so it should not place such a restrictive limitation on losses."

With the 39.3% loss in the S&P 500 last year, many individuals have been limited in their ability to deduct their losses when they sold his or her investment (stocks, bonds for example) for less than what was paid for it.

To illustrate this problem, let's say you invested $10,000 in a S&P 500 index fund on Jan. 2, 2008, and sold your investment on Dec. 31, 2008. Your $10,000 investment was only worth $6,070 when you sold it -- meaning you had a capital loss of $3,930. Because of the current limit, you would only be able to deduct $3,000 in 2008.

Those familiar with creeping effect of the Alternative Minimum Tax (AMT), know all well what happens when the tax code is not indexed for inflation:

REMEMBER BACK when you were young and poor and nothing made you madder than tales of rich people who paid nothing in income taxes? Well, you weren't alone, and that anger led to the creation of something called the alternative minimum tax, which was designed to keep the rich from living tax-free.

Fast-forward a few years. You're a bit older, somewhat better off and paying far more in taxes than you ever thought possible. So what's the last thing you expect to see when you fill out your tax return? That you owe the alternative minimum tax. You can take some solace in the fact that thousands of taxpayers just like you have been snagged by this nasty bit of tax law in recent years. While only 19,000 people owed the AMT in 1970, millions are paying it now.

What happened? Inflation, mostly. While the "regular" tax brackets, exemptions and standard deductions are adjusted annually for inflation, the AMT brackets and exemptions are not, so many people whose income has grown with the economy enter the dreaded AMT zone each year.