by Harris W. Willner, C.E.O.
Enrolled Agent, Investment Adivsor Representative
Higher Medicare Taxes
In order to pay for President Obama’s universal health care coverage most of the revenue will come from higher Medicare taxes on about 1 million individuals earning more than $200,000 and about 4 million couples filing jointly who make more than $250,000.
The legislation will for the first time apply Medicare taxes to investment income received by these households, beginning in 2013. An additional 3.8 percent tax rate will apply to unearned income such as realized capital gains, dividends, interest, rents and royalties. It will not apply to other income subject to income taxes, including interest from municipal bonds and retirement accounts such as 401(k) plans until funds are withdrawn. The new tax effectively layers a 3.8 percent Medicare tax on top of the current capital gains rate of 15.0 percent. The tax increases the highest ordinary income tax rate of 35.0% that applies to rental real estate and interest income to 38.8%.
The bill also increases the individual’s share of Medicare tax currently imposed on salaries starting at $200,000 for individuals and $250,000 for couples to 2.35 percent, from 1.45 percent currently. The combination of the new Medicare taxes and Obama’s budget proposals, if they were in place this year, would cost a married couple with a household income of $400,000 an extra $7,050 in taxes.
Bush Tax Cuts Extended Two Years
In December of 2010 President Obama’s willingness to extend present tax rates for two years stunned many democrats.
After weeks of heated Congressional negotiations on Capitol Hill, a tax bill was signed by President Obama that temporarily extended the 2001 and 2003 federal income tax rate cuts, provided new payroll tax breaks, reinstated the estate tax, and more.
The good news: The new law gave taxpayers a bit of clarity—and an opportunity to plan with relative confidence knowing that the playing field won’t change dramatically, at least through 2012. But beyond that, an increase in the Medicare tax for upper-income Americans is slated for 2013. And more changes are likely in the future, given the pressure to raise revenues to reduce the deficit, and talk of sweeping tax reform.
Estate Tax Update
NEW—Estate tax rate and exclusion: The new law reinstated the estate tax in 2011 and 2012 at a maximum rate of 35% with a $5 million exemption per person. This compares to a 45% maximum rate and $3.5 million exclusion in 2009. The new rules will sunset after 2012. Beginning in 2013, there will be a $1 million per person exclusion with a 55% estate and gift tax rate unless further legislation is enacted.
Here are some additional estate tax changes you should know about:
- Portability. New portability rules allow any unused exemption to be passed to a surviving spouse, so a married couple can exempt up to $10 million.
- Estates of decedents who died in 2010. The new law gives executors of these estates a choice: distribute assets to heirs estate-tax-free but with a carryover basis (generally the original purchase price), or step up the basis to the market value (generally at time of death) and pay the 35% rate on anything above the $5 million exemption. A step-up in basis means the value of an appreciated asset is readjusted at a higher market value for tax purposes upon inheritance versus what the value of the asset was when it was originally purchased.
- Gift Tax exemption. The new law reunifies the federal estate tax exemption and the federal gift tax exemption. This means that the new lifetime gift tax exemption is $5 million per person ($10 million per couple) beginning in 2011. Taxable gifts made in 2011 and 2012 will be taxed at the rate of 35%.
- Generation Skipping Transfer Tax (GSTT). Beginning in 2011, the generation skipping transfer tax exemption will also be $5 million per person ($10 million per couple) with a 35% tax rate. Note: The GSTT is not portable.
- Extension of time for certain filings. The new law extends the time to file certain estate and gift tax returns to nine months after the enactment of the new law.
What to consider now:
- Weigh the tax elections for 2010 estates. Executors of 2010 estates over $5 million with highly appreciated assets should consider whether it may be better to subject the estate to the new law or choose the zero estate tax law of 2010. If you choose the former, the first $5 million of estate assets will be exempt from federal estate taxes, but any amount above $5 million may be subject to estate tax. However, the entire estate will receive a full step up in basis. If the latter is chosen, no federal estate tax will be assessed on the estate, but all of the estate assets may not receive a step-up in basis. In this case, the executor can allocate $3 million in basis adjustments for assets passing to a surviving spouse, and another $1.3 million in basis adjustments to property passing to a non-spouse.
Exclusion of Gain on Sale of Principal Residence Not to Apply to Nonqualified Use.
- An individual taxpayer may exclude up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. To be eligible for the exclusion, the taxpayer must have owned and used the residence as a principal residence for at least two of the five years ending on the date of the sale or exchange.
- Under legislation passed in July, 2008, gain from the sale or exchange of a principal residence allocated to periods of nonqualified use is not excluded from gross income. The amount of gain allocated to periods of nonqualified use is the amount of gain multiplied by a fraction the numerator of which is the aggregate periods of nonqualified use during the period the property was owned by the taxpayer and the denominator of which is the period the taxpayer owned the property.
- A period of nonqualified use means any period (not including any period before January 1, 2009) during which the property is not used by the taxpayer or the taxpayer’s spouse or former spouse as a principal residence. For purposes of determining periods of nonqualified use, (i) any period after the last date the property is used as the principal residence of the taxpayer or spouse (regardless of use during that period), and (ii) any period (not to exceed two years) that the taxpayer is temporarily absent by reason of a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances, are not taken into account. The present-law election for the uniformed services, Foreign Service and employees of the intelligence community is unchanged.
- EXAMPLE 1:
Married taxpayers buy a house for use as a vacation home on January 1, 2009 for $400,000. On January 1, 2011 they convert it to their principal residence. On January 1, 2013 they move out, selling the house on January 1, 2014 for $700,000. Fred and Sue meet the requirement of having used the house as their principal residence for 2 of the last 5 years, but they have 2 years of nonqualified use, from the purchase date of January 1, 2009 to the conversion date of January 1, 2011. Since the total holding period was 5 years and 2 of those years represent nonqualified use, 2/5 or 40% of the $300,000 gain ($120,000) does not qualify for the $250,000 ($500,000 if married filing joint) exclusion and is taxable as a long-term capital gain. The remaining $180,000 of gain is less than the maximum exclusion amount, so none of it is included in their income.
- EXAMPLE 2:
Married taxpayers buy a principal residence on January 1, 2009 for $400,000. They move out of the house on January 1, 2019 and sell the property on December 1, 2021 for $600,000. The entire $200,000 gain is excluded from gross income, as under present law, because periods after the last qualified use do not constitute nonqualified use.
- EXAMPLE 1:
On a positive note, use before January 1, 2009 does not count as nonqualified use. Thus, if you were planning using this approach to exclude gain on your vacation home, it may still work, depending on your timing.
Note that the nonqualified use period could also result from the property being used as a rental or for business.
If any gain is attributable to post-May 6, 1997, depreciation, the exclusion does not apply to that amount of gain, as under prior law, and that gain is not taken into account in determining the amount of gain allocated to nonqualified use.
Zero Capital Gains Tax Rate.
Taxpayers age 24 and older with low incomes qualify for a zero capital gains tax through 2012. The exemption applies to total taxable income below $34,000. To reduce your tax exposure, evaluate gifting highly appreciated assets to adult children with taxable incomes under the qualifying sum.
2010 Health Savings Accounts.
If you are healthy and make few trips to the doctor’s office, consider funding a tax deductible Health Savings Account or HSA. Account earnings and distributions for high-deductible health plans are tax free. Unused balances may accumulate without limit for future years. Maximum tax deductible contributions this year are $3,050 for single taxpayer health plans and $6,150 for family plans. An additional $1,000 contribution is allowed for taxpayers age 55 or older. The maximum out-of-pocket expense-including deductibles that employees with single coverage can be required to pay is $5,950, up from $5,800 in 2008. For those with family coverage, the maximum is $11,900 up from $11,600. The minimum deductible allowed is $1,200 for employees with single coverage; the minimum deductible for those with family coverage is $2,400.
Registered Domestic Partners Same Filing Status as Married Couples.
California registered domestic partners are given the option to file their state tax returns using either “married filing jointly” or “married filing separate” status. The tax code gives registered domestic partners (RDPs are not necessarily of the same sex) tax treatment equal to that of married couples. Beginning in 2013, same-sex married couples must file “married joint” or “married separate” when filing their federal tax returns.
Disaster loss election carryback.
If you suffer a casualty loss in a presidentially declared disaster area, you can either deduct the loss in the year it occurs, or carry the loss back to the prior year. Deducting the loss in the prior year can make sense if you were in a higher bracket (often the case). The deadline for making the election is the due date of your return, without extensions, for the year the loss occurs. For example, you had a $26,000 loss in 2012 from a fire or natural disaster. You can take the loss on your 2012 return or on your 2011 return by filing an amended return. You must make the decision by the due date of your 2012 return, April 17, 2013.
Rent with option to buy . . . While not a standard clause in real estate rental agreements, it’s not unusual. The owner receives a stream of payments for the option, avoids selling commissions and reduces risk of vacancy. For the renter it establishes a sense of certainty— that at some point they’ll be able to acquire the home at a fixed price. After deciding on the purchase price and the option’s value, its cost can be spread over the life of the lease in the monthly rent or an amount paid up front. To protect your interests, be sure to obtain competent legal, tax, and real estate advice
Capital Gain Distributions.
If you hold mutual fund shares for less than six months and sell at a loss, the loss is treated as a long-term loss up to the amount of capital gain distributions received on those shares. Losses in excess of distributions are treated as short term capital losses. This rule does not apply to losses on shares redeemed under a periodic liquidation plan.
Tax balance due?
If you are unable to pay a delinquent tax liability consider applying for an installment agreement with the taxing agency. Government financing will often result in lower monthly payments than debt financing through commercial lenders. Federal loan charges or assessments total 6.0% per year including late payment penalties. Annual charges for commercial unsecured debt can run between 18% and 24%.
Estate tax on income in respect of a decedent.
Did you receive income on account of an inheritance such as IRA or pension funds. If so, you’re required to include distributions in your taxable income. Keep in mind however, if the decedent’s estate was large enough to trigger estate tax, you’re entitled to a deduction for the tax attributable to your distribution. The estate’s executor should provide reporting details for the deduction.