Avoid Taxmageddon: Year-End Planning for Real Estate Owners Real estate sellers and investors may be facing higher taxes next year as a result of a new surtax and a bunch of tax breaks that are scheduled to expire. The “Bush tax cuts” are scheduled to expire at the end of this year (see right-hand box). If that happens, tax rates will go up for everyone next year.
Real estate sellers and investors may be facing higher taxes next year as a result of a new surtax and a bunch of tax breaks that are scheduled to expire. The “Bush tax cuts” are scheduled to expire at the end of this year (see right-hand box). If that happens, tax rates will go up for everyone next year.
Plus, a new 3.8% Medicare surtax on investment income collected by higher-income individuals is scheduled to kick in next year. The combined impact of those changes has been called “Taxmageddon.” Having big real estate profits next year could push you into a higher tax zone. Thankfully, there are some year-end moves that could reduce or eliminate your exposure. Here’s what real estate owners and investors need to know.
Thankfully, there are some year-end moves that could reduce or eliminate your exposure. Here’s what real estate owners and investors need to know.
|New Medicare Surtax
In 2013, higher-income individuals, including real property owners and investors, may get hit with the new 3.8% Medicare surtax on all or part of their net investment income. For purposes of the new surtax, investment income includes:
You won’t be hit with the 3.8% Medicare surtax unless you have positive net investment income and your modified adjusted gross income (MAGI) exceeds these applicable thresholds:
For purposes of the surtax, MAGI equals regular adjusted gross income plus certain tax-free income from foreign sources that most taxpayers don’t have.
The amount subject to the 3.8% Medicare surtax is thelesser of:
1. Net investment income; or
2. The amount by which MAGI exceeds the applicable threshold.
Potential Impact on Homeowners
The following examples illustrate how some people could find themselves in the Taxmageddon zone solely due to large estate gains.
Example 1: Big Principal Residence Gain. You are unmarried and in 2013, you sell a highly appreciated principal residence you’ve owned for 25 years at a $550,000 gain. Thanks to the $250,000 principal residence gain exclusion, your taxable gain for federal income tax purposes is only $300,000 ($550,000 minus $250,000 exclusion for singles).
Unfortunately, that $300,000 taxable gain counts as investment income for purposes of the new 3.8% Medicare surtax. Let’s assume you have no other investment income or capital losses, but you have $125,000 of MAGI from other sources (salary, self-employment income, taxable Social Security benefits, etc.). Due to the big home sale gain, your net investment income is $300,000, and your MAGI is $425,000 ($300,000 from the home sale plus $125,000 from other sources).
Unless Congress changes the rules, you will owe 20% federal capital gains tax on the $300,000 home sale gain, which would amount to $60,000 in taxes (20% of $300,000). Plus, you’ll owe the 3.8% Medicare surtax on $225,000, which is your excess MAGI minus the threshold amount ($425,000 minus $200,000 for singles). The Medicare surtax amounts to $8,550 (3.8% times $225,000). So the total federal tax hit on your 2013 home sale gain is $68,550 ($60,000 plus $8,550). In contrast, if you sell the home this year for the same gain, federal taxes would only be $45,000 (15% times $300,000).
In this example, the federal tax from selling your home next year would be 52% higher than if you sell this year.
It could be even worse. If you have additional 2013 investment income from other sources, your net investment income will go up accordingly, and so will the 3.8% Medicare surtax. You will probably pay a higher federal income tax rate, too. For instance, the maximum federal rate on 2013 dividends is scheduled to be 39.6% (up from 15% this year). Finally, if you live in a state with a personal income tax, you’ll probably owe state income tax on at least some home sale profit.
Example 2: Big Vacation Home Gain. You and your spouse file jointly. In 2013, you sell a greatly appreciated vacation home, which you’ve owned for 35 years, for a $600,000 gain. That profit is fully taxable and treated as investment income for purposes of the 3.8% Medicare surtax.
To keep things simple, let’s say you have no other investment income or capital losses, but you have $125,000 of MAGI from other sources (such as pension income, Social Security benefits, and retirement account withdrawals). Due to the vacation home profit, your net investment income is $600,000, and your MAGI is $725,000 ($600,000 from the vacation home plus $125,000 from other sources).
Unless Congress changes the rules, you will owe 20% federal capital gains tax on the $600,000 vacation home gain. That amounts to a $120,000 tax hit (20% times $600,000). Plus, you’ll owe the 3.8% Medicare surtax on $475,000 (which is $725,000 minus the $250,000 threshold for joint-filing couples). The 3.8% Medicare surtax amounts to another $18,050 (3.8% of $475,000). So the total federal tax on your 2013 vacation home gain is $138,050 ($120,000 plus $18,050). In contrast, if you sell the home this year for the same gain, the federal income tax would be only $90,000 (15% times $600,000).
In this example, the federal tax bill from selling your vacation home next year would be about 53% higher than if you sell this year. It could be even worse for the reasons explained at the end of Example 1.
Potential Impact on Real Estate Investors
Net investment income for purposes of the new 3.8% Medicare surtax includes:
- Gains from selling rental properties;
- Positive operating income from rentals (when rents exceed your deductible expenses, including depreciation); and
- Gains from flipping properties.
These types of gains and income are included in net investment income unless you materially participate in the activity.
It’s pretty hard for most investors to meet the material participation standard for rental activities (either you or your spouse must individually spend at least 750 hours during the year on certain real estate activities, and the time must comprise more than 50% of the total hours spent on personal service activities). However, it might be fairly easy to meet the material participation standard for flipping activities (spending 100 hours might be enough, depending on your circumstances).
The following example illustrates how real estate investors could find themselves in the Taxmageddon zone.
Example 3: Profits from Rentals and Flips. You and your spouse file jointly, and your MAGI is $525,000 in 2013. This includes $200,000 of gains from selling two rental properties you’ve owned for 15 years and a $50,000 gain from flipping a property you bought for a bargain price at a foreclosure sale. Your MAGI also includes $20,000 of positive operating income from rental properties and $255,000 of salary income. To keep things simpler, let’s assume you have no other investment income or capital losses, and 2013 taxable income of $420,000. Here are the tax consequences for your 2013 real estate profits.
- You will owe 25% federal capital gains tax on the part of your rental property gains that is attributable to depreciation write-offs. Assume that portion is $80,000. The tax hit is $20,000 (25% times $80,000).
- You will owe 20% federal capital gains tax on the remaining $120,000 of gains from the rental property sales. The tax is $24,000 (20% times $120,000).
- You will owe 31% federal income tax on the $50,000 gain from the flip and the $20,000 of positive rental property operating income. The tax is $21,700 (31% times $70,000).
- Assuming you don’t meet the material participation for your real estate activities, the $200,000 of gains from rental property sales, the $50,000 profit from the flip, and the $20,000 of positive rental property operating income all count as investment income for purposes of the new 3.8% Medicare surtax. You will owe the surtax on $270,000, which is your net investment income. The Medicare surtax amounts to another $10,260 (3.8% times $270,000).
The federal tax on your $270,000 of 2013 real estate profits would be $75,960 ($20,000 plus $24,000 plus $21,700 plus $10,260). But if you had the same numbers this year, the tax on your real estate profits would be only $57,730 — because the tax rates on most of the profits would be lower, and the 3.8% Medicare surtax wouldn’t be in effect yet.
The federal tax on your real estate profits could be about 32% higher under the rules that are scheduled to apply next year ($75,960 versus $57,730). As explained in Example 1, other factors could make it even worse.
Year-End Tax Planning Considerations
To reduce Taxmageddon exposure in 2013, consider accelerating real estate gains and income into this year, if possible. Amounts you can accelerate into 2012 (for example, by selling appreciated properties in 2012 rather than 2013) will be taxed at today’s favorable rates.
For the same reason, consider selling selected appreciated securities that you hold in taxable brokerage firm accounts this year.
On the other hand, consider hanging onto selected depreciated investment assets (for example a rental property you bought at the top of the market or underperforming stocks). Losses from unloading depreciated assets in 2013 and beyond could provide shelter from higher tax rates on your post-2012 investment income.
Finally, consider accelerating other types of income into 2012, if possible. Examples include income triggered by Roth IRA conversions and income from retirement account withdrawals. If Taxmageddon strikes, taking income this year instead of next would result in lower tax rates on that income. In addition, this strategy would make your 2013 MAGI that much lower, and that could reduce or eliminate your exposure to 3.8% Medicare surtax on net investment income.
Caveat: It’s possible that Taxmageddon will not happen. The Bush tax cuts could be extended and the Medicare surtax could be repealed. If those things happen, accelerating income and gains into 2012 might simply cause you to owe taxes sooner rather than later. So the prudent strategy is to be poised to make appropriate year-end planning moves after you know the results of the November election. Making a move before then could turn out to be bad timing. Consult with your tax adviser to determine the best year-end strategies for your situation.
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– content reprinted with permission from BKR International.
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