Beginning January 1, 2013, for tax years that end in 2013, the new 3.8% Medicare tax on net investment income goes into effect for single taxpayers with $200,000 or more of adjusted gross income, and married taxpayers filing jointly of $250,000 or more of adjusted gross income.
Tax Applies to ALL Profit on Real Estate Sales. Included in the definition of net investment income is the profit on the sale of real estate, including your home. The key is “profit.” It is not a “sales tax” that applies to the entire purchase price, but instead to the excess of the sales price over your “basis” reduced by costs of sale. But the exclusion from gains does not apply. In other words, most people thing that at least the first $250,000 in profit (for single taxpayers, $500,000 for a married couple) on the sale of a primary residence (assuming it qualifies) is exempt from tax. That is still true as to capital gains tax. But the new 3.8% Medicare tax applies against all profits, including the exemption amount. For example, suppose:
$200,000 sales price for single taxpayer’s home
$120,000 basis
————
$ 80,000 profit
Medicare Tax = 3.8% x $80,000 = $3,040; plus
Capital Gains Tax = $80,000 – $250,000 exclusion = no tax
= $3,040 in taxes on the sale of the home
Planning pointer: If you have been thinking of selling, sell NOW. OR, consider a 1031 tax-deferred exchange. The regulations do not clearly say that there is no 3.8% Medicare tax on the sale of a property in a 1031 tax-deferred exchange, but some commentators believe the tax does not apply. Warning: A 1031 tax-deferred exchange is a technical process that requires expert assistance from a tax lawyer.
Higher Tax Rates: ALL Income Tax on EVERYONE is Going Up
Ordinary Income Tax
The 10% tax bracket is going away, which means that everyone’s income tax on those first dollars are going up. And then all of the other tax brackets jump – 25% goes to 28%; 28% goes to 31%; 33% goes to 36%; and 35% goes to 39.6%.
Capital Gains
The capital gains rate will go from 15% to 20%, plus, if the taxpayer has enough income, the additional 3.8% Medicare tax will be on top of that.
Dividends
For several years, dividends from most domestic corporations have been taxed at only 15% (for lower income taxpayers, the rate has been 0%). Next year, that special rate goes away, and they become part of the ordinary income rates, and are taxed starting at 15% going as high as 39.6%, PLUS if the taxpayer has enough taxable income otherwise, the extra 3.8% Medicare tax will be on top of that.
Practice Pointer: If you have any income that you expect to get in 2013 that somehow you can get in 2012, do the math and consider getting the income accelerated.
Extra Payroll Taxes
Two increases will occur in payroll taxes. First, the employee’s share of FICA (the Social Security tax) has been at 4.2%. That is going back up to 6.2%.
Second, for single taxpayers earning $200,000 or more, and for married taxpayers earning $250,000 or more, there is an increase in the previous 1.45% of 0.9% to 2.35%.
Practice Pointer: Many of you know that I do not like S corporations because of the many potential problems that attend them. But 2013 may see the resurgence of the S corp. Distributions to S corporation shareholders are not subject to employment taxes, assuming you are not trying to game the system and shift what would otherwise be salary into S corporation distributions to avoid the tax. But beware – S coporations have a lot of disadvantages too.
Reduced Deductions for Medical Expenses
Normally, for taxpayers who itemize, medical expenses are deductible only to the extent they exceed 7.5% of adjusted gross income. Two bad things – first, that is going to 10% – and second, the limitations on deductibility of Schedule A deductions are coming back so that the more your earn, the less of your Schedule A deductions you can take.
Practice Pointer: While some may go in the direction of S corporations, others may go in the direction of C corporations to take advantage of the tax advantages of medical expense reimbursement plans (“MERPs”). A MERP is a written plan officially adopted and funded by the corporation (it cannot be adopted or funded by an individual), and it must benefit most employees (it is NOT a flexible spending account, Section 125 plan or a cafeteria plan). Under a MERP, the corporation can reimburse an employee for medical costs and take a deduction. The employee on the other hand is not treated as receiving any income. Having health insurance coverage is not required before a corporation can adopt a MERP.
Estate Tax Strategy to Use NOW
OK, it is no secret that the federal estate tax is about to undergo a massive change. Here is a strategy that you have to consider and use NOW, and you are going to have to get on this ASAP.
A lot of people are talking about using the $5.12 million gift tax exemption before the end of the year. And that should be examined. But significant gifts reduce what the donor will have available for gift or estate tax next year. For example, a donor who gives away $1 million this year will not have any gift or estate tax exemption next year.
But wait, if you have a married couple, and one of the spouses died in 2011 or 2012, the surviving spouse can use the deceased spouse’s unused exemption amount (“DSUEA”) in making gifts. Remember, the surviving spouse gets the DSUEA only if a timely filed federal estate tax return elects portability. If you are within 9 months of the date of death, or if you have extended the tax return for a decedent who died earlier, then you can make the election. So if you are the very end of the 9 month period, extend, and then file.
There are two GREAT things about the proposed regulations that Treasury has issued. First, any taxable gifts made by the surviving spouse are deemed to come out of the DESUEA first. This is absolutely wonderful because the surviving spouse can make gifts
now and not use the surviving spouses own exemption.
For example: Suppose Decedent and Spouse were married, and Decedent died, and a federal estate tax return can be filed and election made in a timely manner. Suppose the Decedent has $3.5 million of DSUEA. Suppose the Spouse wants to gift $1 million to descendants. If it were not for the proposed regulations, that gift would eliminate the Spouse’s exemption in 2013. But the proposed regulations would automatically allocate the DSUEA to the gift, and thus preserve the exemption of the Spouse.
The second great thing about the proposed regulation is that the Spouse can make the gifts before filing the federal estate tax return (as long as one is timely filed).
So in the example above, the Spouse does not have to wait until the estate tax return is filed. Instead, the Spouse can make the gifts now and file later, as long as filing is timely.