Higher Taxes May Await Investors and Businesses in 2013
This final article in our three-part look at Taxmageddon explores changes that could affect investments and business asset purchases and suggests strategies to reduce the impact. For a look at the factors pushing us toward the fiscal cliff, see "Forget the Zombie Apocalypse: Taxmageddon Is Far Scarier (and Likelier)". Part 2, "Individual Tax Planning Tips for Those on the Edge of the Fiscal Cliff," offered insight into changes that will affect nearly all individuals.
Capital Gains Rate Slated to Jump to 20 Percent
Beginning in 2013, the tax advantage granted to long-term capital gains will be significantly eroded. In 2012, most capital gains are taxed at either zero percent or 15 percent, depending upon the taxpayer's tax bracket. Taxpayers in the 10- and 15-percent brackets have a zero percent tax on gains from the sale of property held for more than one year. Taxpayers in the higher tax brackets face a 15 percent tax rate.
In 2013, the long-term capital gaisn rate for most types of property will be 20 percent, regardless of the taxpayer's tax bracket. (Property held more than five years will be taxed at 18 percent, rather than at 20 percent.)
While this rate increase applies to the gain from the sales of most property, the following special rates continue to apply:
Gain from the sale of collectibles will stay at 28 percent
Recaptured depreciation on real estate (section 1250 property) will stay at 25 percent
Gain from sales of property held less than one year (short-term gain) will continue to be taxed at ordinary income rates (the taxpayer's tax bracket)
The special tax break provided for qualified dividends, which was designed to spur equity investment, will also vanish in 2013.
After 2012, qualified dividends will be taxed at the individual's applicable income tax rate (with 39.6 percent the highest), rather than at 15 percent, regardless of the individuals tax bracket. (For those in the top tax bracket, this translates to an additional $24.60 in tax for every $100 of dividends received.)
Medicare Tax on Investments Will Add to Tax Bill
Beginning in 2013, there will be a new 3.8 percent Medicare tax imposed on net investment income of higher-income taxpayers. This Medicare tax is in addition to the income tax that is owed on net investment income.
The new Medicare tax is imposed on the lesser of:
- net investment income for the year, or
- modified adjusted gross income (MAGI) over threshold amount
Tax return filing status determines the MAGI threshold that applies. These thresholds are:
- $200,000 for single
- $250,000 for married filing jointly
- $125,000 for married filing separately
Investment income is broadly defined. It includes all gross income from interest, dividends, annuities, royalties and rents. Income from any passive trade or business income or income from a business engaged in trading financial instruments or commodities is also considered net investment income. It also includes gain from disposing of non-business property—including non-excludable gain from the sale of a home.
There is some good news for small business owners. Income that is generated in the ordinary course of a non-passive business activity (including gain from disposing of business assets) is not subject to this new tax.
For more information and examples illustrating this new tax, see the BizFilings Business Owner's Toolkit article "Plan Now to Reduce New Tax on Investment Income."
Strategies to Lessen the Pain of Capital Gain
In order to minimize your exposure to this new tax on investment income, you should engage the enemy on two fronts:
- reduce your taxable investment income, and
- reduce your modified adjustable gross income
Many of these strategies are very complex. Many have significant downsides. All of them must be tailored to your exact circumstances. It is absolutely essential that you work with your tax professional to achieve the best results!
One way to reduce the amount of taxable investment income is to "harvest" your capital gains.
Gain harvesting is selling assets that have increased in value, then reinvesting in same or similar assets. The new assets are held indefinitely.
By harvesting gains in 2012, you may save yourself from the tax increase triple-whammy: the 3.8 percent Medicare tax, the 5 percent capital gains increase and the increased marginal tax rates. Like most tax strategies, whether this makes sense depends upon your circumstances.
Gain harvesting can be a good choice if you plan to hold the new assets for only a brief period of time and expect to be in a higher tax bracket in the future. On the other hand, you are if you plan to hold the new assets for a long time or if you have loss carryovers, then harvesting gains in 2012 might not be prudent. Work with a tax professional who can run the numbers and develop the best plan for you.
You can reduce taxes over the long-haul by shifting your investment portfolio to avoid generating taxable income. Some tax-advantaged investments include: municipal bonds, tax-deferred annuities and whole-life life insurance. Once again, you need to work with a tax advisor because each of these investments come with tricky tax rules
Reduce Your Income and Lower Your Taxes
The other prong of attack is to reduce your taxable income. If you can afford to divert current income, then look into these strategies:
- Fund your retirement plans
- Convert to Roth IRA
- Shift income to children
- Establish charitable trusts
A tax advisor or financial planner can help you understand the risks and leverage all of the short- and long-term benefits of each of these options.
Bonus Depreciation Ends in 2013 and Expensing Is Dramatically Curtailed
If you own a small business, then you need to be aware that the tax incentives to invest in business property will decrease substantially in 2013. Generally, you can not deduct the cost of capital asset in the year in which you purchase it. Instead, you recover the cost by claiming a depreciation deduction over a prescribed number of years. The expensing election and bonus depreciation are two exceptions to this rule.
The expensing election allows you to do exactly what the name suggests: deduct all or a portion of an asset's cost as if it was a business expense. For the past few years, the amount allowed as a deduction has been quite generous. However, in 2013, the amount is scheduled to drop from $139,000 to only $25,000. In addition, the investment limit, which reduces maximum amount dollar-for-dollar for each dollar over the limit, drops from $560,000 to $200,000. This limitation will render the election useless for most businesses.
Bonus depreciation is the other exception that allowed an accelerated deduction of the cost of a capital asset. After having been at 100 percent for several years, the allowable amount of bonus depreciation dropped to 50 percent in 2012. It will be eliminated completely in 2013.
Julio needs a new $100,000 oven for his restaurant. His business income is $300,000. If Julio purchases the oven in 2012, he can expense the full amount-giving him an additional $100,000 deduction against his business income.
However, if he waits and makes the purchase in 2013, he will not be able to expense any of the cost. The $25,000 maximum amount is reduced dollar-for-dollar for each dollar of income over $200,000. Because Julio's income is more than $225,000, he cannot make the expensing election. (He can, of course, claim the normal, allowable depreciation)
Given the possible loss of these tax incentives, if you will need to replace assets or purchase new assets within the next six to twelve months, accelerating the purchase could make sense. However, don't let the tax tail wag the business dog. And--as with everything in tax law--there are pros and cons to every strategy. In uncertain economic times, depleting cash reserves just to obtain a tax break may not make sense for your business. Deferring a purchase to next year, could lower your income and convert cash to a business investment (beyond the reach of the 3.8% surcharge). A tax professional should be able to crunch the numbers for all the various scenarios
Consider Your Options
Hopefully, this three-part series has helped you understand the pending tax law changes and has given you some ideas to work through with your tax adviser. If you'd like to hear more about these strategies, please register now to attend our upcoming webinar: "Taxmageddon or How to Survive a Fall Off the Fiscal Cliff." This free webinar is scheduled for November 1, 2012.