2013 Brings New and Higher Taxes

How 1031 Exchanges Can Help

The end of a year usually brings excitement about a new year as well as a review of our goals and an assessment of where we are.  As 2013 approached, many postponed financial decisions while others rushed to initiate or complete real estate and stock transactions because taxpayers had no idea what would happen to the Bush tax cuts that were set to expire at the end of 2012.  After the November election, it seemed likely taxes would increase but how much and for who was still a question.  We did know for sure that the new 3.8% Medicare Tax, part of the health care reform bill, would kick in on January 1, 2013. 

The Taxpayer Relief Act of 2012 diverted the “Fiscal Cliff” but what does it mean to taxpayers, especially those who utilize 1031 tax-deferred exchanges.  Following is a brief overview of what will affect investors and business owners:

Income Tax

For individual taxpayers with more than $400,000 in taxable income and married couples with $450,000, the top marginal income tax rate will rise to 39.6% in 2013. This is up from 35% in 2012.  For taxpayers earning less, the 2012 income tax rates become permanent.   

Capital Gains and Dividends

Long-term capital gain and dividend tax rates will increase to 20% for individual taxpayers with more than $400,000 in taxable income and married couples with $450,000. The rates will remain 15% for those in the 25%, 28%, 33% and 35% income tax brackets and those in the 10% and 15% income tax brackets will continue to have a zero rate.  Fortunately, regardless of your tax bracket, 1031 exchanges allow you to defer the capital gains on the exchange of assets held for business use or investment. Capital gains on collectibles remain at 28%. 

Estate and Gift Tax

The $5,000,000 exclusion on estate and gift tax remains intact. The estate and gift tax for anything above the $5,000,000 will increase from 35% to 40%.

Alternative Minimum Tax (AMT)

The bill included an annual inflation adjustment to the exemption amounts to help keep middle class taxpayers out of AMT. The 2012 exemption amounts for unmarried individuals are $50,600 and $78,750 for married couples filing jointly. 

Social Security Tax

All taxpayers will say goodbye to our payroll deduction vacation. The Social Security deduction returned to 6.2% after two years at 4.2%.  The vacation was part of a stimulus package. 

Personal Exemption Phase out

The bill eliminates or reduces the personal exemption which was $3,800 for most individual taxpayers in 2012.  Effective 2013, the personal exemption will phase out for single taxpayers with taxable income over $250,000 and married couples over $300,000.

Pease Limitation

The bill would eliminate up to 80% of deductions for single taxpayers with taxable income over $250,000 and married couples over $300,000.  This affects all deductions including mortgage interest and charitable contributions.

Bonus Depreciation

The bill included a one year extension on the current 50% bonus depreciation rules for businesses purchasing new equipment and other depreciable personal property.

Unemployment Benefit

Jobless benefits for the long-term unemployed have been extended for one year.

Miscellaneous

Several deductions have been extended:

    • American Opportunity Tax Credit worth up to $2,500 was extended for five years
    • Child Tax Credit extended for five years
    • Earned Income Tax Credit extended for five years
    • $100,000 – charitable donation of IRA assets by account owners 70½ and older

On a recent webinar, a CPA said the bill took us from indecision to “confusion and complication” and he was right. There is no simple quick calculation to estimate how much tax might be due when you sell. You now have to look at a variety of different thresholds just to get started and some are based on taxable income and others are based on adjusted gross income (AGI). These figures will help you determine which income tax bracket you fall into, at what rate cap gains and dividends will be taxed and whether or not you have to deal with AMT, personal exemption phase outs or the Pease limitations. Your advisor will also let you know if you have to pay the extra 3.8% Medicare Tax.

New 3.85 Medicare Tax

Included in The Health Care and Education Reconciliation Act of 2010, signed into law on March 30, 2010, was an "Unearned Income Medicare Contribution" that imposes a 3.8% tax on all unearned income, including any profit on the sale of real estate.

As part of the health care reform law, the new Medicare Tax went into effect on January 1, 2013 and will require high income households to pay 3.8% on all investment income. Generally, this tax will affect individuals with a gross annual income exceeding $200,000 and married couples exceeding $250,000. Some examples of investment income subject to this new tax include capital gains, interest, annuities, royalties and rents.

So What Does this Mean to Those that Use 1031 Exchanges?

Believe it or not, the benefits of a 1031 tax-deferred exchange just increased significantly.  In addition to benefits we have touted for years, there are a number of new ones:

    • Defer the capital gains (often on both the federal and state side);
    • Defer the 25% depreciation recapture;
    • Defer the 3.8% Medicare Tax;
    • Potentially stay out of AMT;
    • Potentially avoid the personal exemption phase outs and Pease limitations; and
    • Potentially have all gain forgiven at death.

Estate Taxes and 1031 Exchanges

One of the least known benefits of a 1031 exchange is the possibility that the deferred gain may be forgiven.  How does that happen?  When does the deferred gain catch up to you?  When exchanging, the gain is deferred as long as the replacement property is held.  When selling that replacement property, assuming the property is still held for business use or investment, it may be exchanged and the gain (from the old property as well as this replacement property) deferred again.  If the property is sold rather than exchanged, the tax comes due.

So what happens if the replacement property is held for the rest of the taxpayer’s life?  When a taxpayer dies, his/her heirs receive the assets with a stepped up basis (the full value of the asset at the time of death). This means all of the gain deferred during the taxpayer’s life is forgiven and no one has to pay back the deferred gain. 

Of course, we have to think about estate taxes but the first $5,000,000 of one’s estate is exempt of estate taxes. Many expected the $5,000,000 exemption to be reduced but under the new bill, the $5,000,000 exclusion remains. Anything above the $5,000,000 is taxed at 40% which is up from 35%. This $5,000,000 exemption is excellent news for those who take advantage of 1031 exchanges to build their portfolio with pre-tax dollars and want to pass those assets to their heirs. Another benefit is the ability for a surviving spouse to “port” the unused portion of his/her deceased spouse’s exclusion

Conclusion

Always an excellent wealth building strategy, 1031 exchanges just got more powerful.  Anyone considering the sale of an asset held for business use or investment should estimate their tax liability and determine how an exchange would work in their particular situation.  Exchanges can be a great way to not only defer the gain but help you accomplish many other investment and business goals, too.