No matter your income, your taxes are likely going to increase in 2013. Although the amount depends on what Congress does about the “fiscal cliff” of budget measures due to expire at the end of 2012, chances are that at least one of many scheduled changes will directly impact your finances.
In addition to automatic spending cuts, the fiscal cliff includes an end to Bush-era tax cuts that will take brackets from current rates of 10 percent, 25 percent, 28 percent, 33 percent and 35 percent back to 15 percent, 28 percent, 31 percent, 36 percent and 39.6 percent, respectively.
Other changes include raising the capital gains rate from 15 percent to 20 percent, reducing the child tax credit from $1,000 to $500, reducing the exemption for estate taxes from $5 million to $1 million and an end to temporary relief for the so-called “marriage penalty.”
“Absent action, we know what’s going to happen — all of these things are going to expire,” says Jim A. Forbes, CPA, a principal with Skoda Minotti. “I read an article calling this the legislative equivalent of a slow-motion train wreck. I’m sure they’ll get something done. It’s a matter of how many things get done before the end of the year.”
Smart Business spoke with Forbes about scheduled tax changes and the impact on families and businesses.
How will these changes impact business owners?
If your business is a closely held corporation, like an S Corp or a partnership, its tax flows through to your personal tax return. So your tax rates are going up if you own a small business that is an S Corp or a limited liability company.
For all businesses, regardless of the type, your ability to write off capital goods or fixed asset purchases will likely be severely limited in the future. Since 2001, we’ve had some form of bonus depreciation — accelerated writeoffs of purchases like computers, machinery, equipment and office furniture. In 2011, you were allowed a 100 percent write off. In 2012, it was 50 percent.
In 2013, absent any action, you’re not going to get an immediate writeoff; you’ll have to depreciate it over five years or whatever the life of the asset is. So incurring capital expenditures before the end of 2012 will give you a much better tax deduction than in 2013.
We’ve been telling clients for a long time to accelerate purchases if it makes good business sense because they’ll get a bigger deduction right now.
How are estate and gift taxes changing?
This year is an ideal time, if you’re wealthy, to gift something to your children. Right now, you can gift up to $5 million per individual, or, if you die today, no estate tax is paid on the first $5 million. Beginning Jan. 1, that reverts back to $1 million. If someone who is 55 or 60 years old wants to get their kid involved in their business that’s worth several million dollars, they can start gifting shares to them now because they can gift up to $5 million.
How will the Alternative Minimum Tax (AMT) change?
Your individual tax is computed under two methods. One is under the regular Form 1040. There is also a separate AMT calculation you have to do. It doesn’t allow you certain deductions, like state and local taxes, and it uses a different tax rate. What happens is that you pay the higher of the two, regular tax or AMT. The AMT captures upper middle class people generally with incomes from about $100,000 to a few hundred thousand — people who are wealthy but not in the top 1 percent of earners.
The AMT exemption is not set to index for inflation, so what’s happening is more people are going to be subject to AMT. That happens every year, but historically, they always put a patch on it. The exemption amount has been around $75,000 and it’s going to drop to $45,000 without action by Congress. About 4 million people paid AMT in tax year 2011. Without a patch, it’s projected that 31 million will pay AMT on their 2012
How will the average family be affected?
The one change that everyone will see in their paychecks is the end of a 2 percent reduction in the Social Security taxes they pay. Since 2011, the rate has been 4.2 percent. That was put into place as part of the stimulus plan. The likelihood of that one getting extended is not very high. That change affects anyone who gets wages. Absent anything else, you’re going to see a 2 percent reduction in take-home pay in January.
Another one that will affect an average family is the reduction of the child tax credit. If you have a child, you’ve been getting up to a $1,000 tax credit per child; that number is going to decrease to a maximum of $500 per child.
Also, the marriage penalty is going to come back. Many years ago, the rule was that the standard deduction and graduated tax rates for a married couple were not two times that of a single person, they were about 167 percent. Congress fixed the marriage penalty and, over the last few years, a married couple’s standard deduction and tax rate were exactly double a single person’s. What’s happening now is that the marriage penalty is returning.
The exemptions and tax brackets that were double the single person amount revert back to around 167 percent. So married couples are going to pay a little bit more tax, absent anything else. That applies whether you file jointly or separately.
JIM A. FORBES, CPA, is a principal with Skoda Minotti. Reach him at (440) 449-6800 or firstname.lastname@example.org.
At the end of the year, a couple of tax provisions are expiring that have been a great benefit to those who own real estate. First, the 15 percent capital gains tax rate will return to where it was before 2003, to 20 percent. The historically low capital gains tax rate allowed many to sell their properties with a significantly reduced tax obligation. Second, bonus depreciation has made it possible for property owners to write off as much as 100 percent of the cost of machinery, equipment, vehicles, furniture and other qualifying property. This method of depreciation allows the business owner to record lower incomes, and therefore pay less in taxes.
While these tax features will come to an end, Terry Coyne, SIOR, CCIM, an executive vice president with Newmark Grubb Knight Frank, formerly Grubb & Ellis, says there are still solutions that will allow property owners to defer expenses.
Smart Business spoke with Coyne about the changes and what to do if you can’t take advantage of them before they expire.
What real estate tax strategies should business owners take advantage of in the short term?
The capital gains tax rate is scheduled to go up on Jan. 1 from the current, historically low rate of 15 percent to 20 percent because the Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act that extended the Bush-era tax cuts until the end of this year will expire. In addition, the Patient Protection and Affordable Care Act, in 2013, will impose a new 3.8 percent tax on certain investment income for households that make more than $200,000 for singles and $250,000 for married couples, which includes real estate transactions. So the net effect of these two tax increases could result in a 23.8 percent tax rate for high earners.
When capital gains rates are raised, those still wanting to unload an investment property should consider a 1031 like-kind exchange. These real estate transactions have actually become less popular in the past couple of years because the capital gains rate has been so low, and building owners are trying to sell by year-end to take advantage of the rates.
This tax-deferred exchange involves selling one qualified property for another within a specific time frame. For example, you can sell a property and take up to 45 days to identify three qualified properties for the exchange. You’ll then have 180 days to close. To do a 1031 exchange, you need to work through a qualified entity, so make sure you’re dealing with someone reputable because if they’re wrong and it blows up, you’ll be stuck with the tax.
Next year, many owners will go from paying the capital gains rate to transacting through a 1031 exchange to avoid paying the taxes on those sales altogether. So, if you can, try to close your transactions this year, and if not, expect to pay more next year if you don’t use a 1031 exchange.
What real estate tax strategies exist for those who own and occupy their building?
For those who own their buildings, the biggest impact could be the potential change to bonus depreciation, which has been around for the past couple of years and was extended by the American Recovery and Re-Investment Act.
Typically, in real estate, you spend money and capitalize it. So, if you put a new roof on your building, you look at the cost of the roof and how long it takes to depreciate it, let’s say over the course of 20 years. Recently, bonus depreciation has allowed you to expense as much as 100 percent of an investment in qualified business properties. The bonus depreciation will likely go away, though it’s not clear when. Going back to standard methods of depreciation is a big deal because it ends a program that provided an immediate tax benefit. Bonus depreciation has had a positive impact on the real estate industry because builders will spend more on improvements or spend on speculation because they’re trading dollars — rather than paying taxes, you’re spending that money on real estate.
You’re well advised to pay close attention to depreciation. The question remains whether it will go back to normal right away or if it will be phased out. If it is phased out, take advantage of it soon because it will never be 100 percent again. Bonus depreciation absolutely creates jobs in the short term because it encourages people to spend money.
What if I miss out on bonus depreciation? Are there other strategies a business owner can use to defer expenses?
It’s a good idea to cost segregate your building, using the expertise of a professional such as an accountant and an engineer, so you can depreciate the components of your property over the life of each component’s expected use and not over 39.5 years, which is a typical depreciation cycle for a building. More sophisticated business owners are segregating their costs and depreciating everything they can because it gives great tax benefits for those who are unable to do bonus depreciation.
The Internal Revenue Service allows you to depreciate a building, not the land, over 39.5 years, so that every year you get a benefit on your taxes, which is a noncash loss. But the code also allows you to cost segregate all of your different costs. For example, the roof is segregated from the parking lot, which is segregated from the HVAC, etc., on a schedule that outlines the ‘life,’ or schedule of depreciation, of the different components of your building. It’s a way to reduce your current income tax obligations.
Terry Coyne, SIOR, CCIM, is an executive vice president with Newmark Grubb Knight Frank, formerly Grubb & Ellis. Reach him at (216) 453-3001 or email@example.com.
Tax planning is even more uncertain and complex this year because of the number of tax changes scheduled to take place when the calendar flips to 2013.
“The expiration of the Bush-era tax cuts, the imposition of the Medicare surtax in 2013, whether or not certain tax provisions will be extended and President Obama’s proposed extension of the 36 percent tax bracket to married couples earning more than $250,000 adds a level of uncertainty to year-end tax planning not seen in years,” says Tom Tyler, partner with Crowe Horwath LLP.
Smart Business spoke with Tyler about potential tax changes and what business owners should do in preparation.
What are the Bush-era tax cuts, and what would be the effect of their expiration?
President George W. Bush cut individual tax rates to 10 percent, 15 percent, 28 percent, 33 percent and 35 percent, depending on a taxpayer’s taxable income, and reduced to 15 percent the rates for qualified dividends and capital gains. Taxpayers in the 10 percent and 15 percent brackets pay zero percent on qualified dividends and capital gains.
If Congress does not extend these rates beyond 2012, the new tax rates beginning in 2013 would be 15 percent, 28 percent, 31 percent, 36 percent and 39.6 percent. Dividends would no longer receive preferential tax treatment; instead, they would be taxed at ordinary income rates. Capital gains would be taxed at 20 percent — 10 percent for taxpayers in the 15 percent tax bracket.
In addition, President Obama has proposed extending the 36 percent tax bracket to adjusted gross incomes greater than $200,000 and $250,000 for single filers and joint filers, respectively. Note that adjusted gross income is determined before personal exemptions and itemized deductions; taxable income is determined after personal exemptions and itemized deductions. Absent the Obama changes, the 36 percent bracket would start at taxable income of $183,250 and $223,050, for single and joint filers, respectively.
What other tax changes are on the way in 2013?
The Patient Protection and Affordable Care Act added a 3.8 percent Medicare surtax beginning in 2013 for higher-income taxpayers. The tax applies to the lesser of a taxpayer’s net investment income or the amount by which the taxpayer’s modified adjusted gross income — adjusted gross income with foreign income added back — exceeds $200,000 in the case of a single filer or $250,000 in the case of a joint filer. Net investment income includes interest, dividends, royalties, rents, capital gains and passive income from trade or business activities. Higher income individuals with wages or self-employment income exceeding $200,000 for single filers and $250,000 for joint filers will see an increase in their Medicare tax rate from 1.45 percent to 2.35 percent.
For the past two years, the employee share of Old Age, Survivors, and Disability Insurance (OASDI) has been reduced from 6.2 percent to 4.2 percent. This rate reduction is scheduled to expire at year-end and will return to 6.2 percent. Employers that typically pay bonuses after year-end should consider accelerating the payment of those bonuses into 2012 for those employees below the Social Security wage base of $110,100.
Any other steps people should take before the tax rates change?
With respect to the tax rate increases and Medicare surtax, individuals might want to consider selling in 2012 appreciated capital assets that would generate long-term capital gains to take advantage of the 15 percent tax rate — zero percent for those in the 10 percent or 15 percent bracket. Loss assets could be held and sold in 2013 when the loss could be deducted at higher rates and result in increased savings.
If an individual controls a C corporation, consider distributing dividends from the corporation in 2012 instead of 2013, when the maximum rate on dividends is 15 percent instead of a potential rate of 43.4 percent — 39.6 percent plus 3.8 percent Medicare surtax. An S corporation that was formerly a C corporation and is considering distributing former C corporation earnings and profits could do so in 2012 to take advantage of the 15 percent tax rate on dividends.
Taxpayers also might want to consider repositioning their investment portfolios in light of these changes. Higher tax rates make tax-exempt investments more appealing. A shift away from dividend-paying stocks to nondividend paying stocks makes tax sense given the expiration of the favorable tax rate on dividends and the application of the 3.8 percent Medicare surtax to dividend income in 2013.
These tax saving ideas should be considered just one tenet of an individual’s overall investment plan.
Are deductions and exemptions going to change as well?
Unless extended by Congress, personal exemptions and itemized deductions will be subject to a phase-out beginning in 2013. Personal exemptions will begin to phase out at $267,200 of adjusted gross income for joint filers and $178,150 for single filers. Itemized deductions will be reduced by 3 percent of the amount adjusted gross income exceeds a threshold, projected at $178,150 for 2013.
Another uncertainty is the alternative minimum tax (AMT) exemption. Without congressional action, the exemption for 2012 would be $45,000 for joint filers and $33,750 for single filers. However, we are hopeful that an AMT ‘patch’ will be passed prior to year-end and increase the exemption. Last year’s exemption for joint filers was $74,450.
Tom Tyler is a partner with Crowe Horwath LLP. Reach him at (214) 777-5250 or firstname.lastname@example.org.
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