It’s not how much you make, but how much you keep.
This familiar adage rings truer than ever for Real Estate Investors in 2013. Not only have capital gains taxes increased significantly for high earners, but many investors below the top tax bracket face an additional 3.8% surtax on passive investment income like capital gains. Fortunately, IRC Section 1031, a provision in the tax code since 1921, provides critically needed tax relief.
Under the American Tax Payer Relief Act of 2012, the top capital gain tax rate has been permanently increased to 20% (up from 15%) for single filers with an income above $400,000 and married couples filing jointly with incomes exceeding $450,000. In addition, the new IRC Section 1411 3.8% Medicare surtax on net investment income, which includes capital gains, results in an overall rate for higher income taxpayers of 23.8% – a staggering 58% increase from 2012 tax rates.
4 Steps to Determine Capital Gains Taxation
A summary of the four ways investors will be taxed on the sale of investment property without the tax deferral benefits of a 1031 exchange:
1. Depreciation Recapture: Taxpayers will be taxed at a rate of 25% on all depreciation recapture.
2. Federal Capital Gain Taxes: Investors owe capital gains taxes on the remaining economic gain depending upon their taxable income. With a new higher capital gain tax rate of 20% added to the tax code, investors exceeding $400,000 in taxable income for single filers and $450,000 for married couples filing jointly, will be subject to the new, higher rate. The previous tax rate remains at 15% for those below these income thresholds.
3. New Medicare Surtax pursuant to IRC Section 1411: The Healthcare and Education Reconciliation Act of 2010 added a new 3.8% Medicare surtax on “net investment income”. This applies to taxpayers with “net investment income” who exceed threshold income amounts of $200,000 for single filers and $250,000 for married couples filing jointly. Pursuant to IRC Section 1411, “net investment income” includes interest, dividends, capital gains, retirement income and income from partnerships, as well as other forms of “unearned income”.
4. State Taxes: Taxpayers must also take into account the applicable state tax, if any, to determine their total tax owed. Some states have no state tax at all while others, like California, have a 13.3% top tax rate.
1031 Exchanges help Investors defer the New Medicare Surtax
Under recently proposed regulations, REG-130507-11, taxpayers have received proposed guidance from the IRS that notes: “to the extent gain from a like-kind exchange is not recognized for income tax purposes under Section 1031, it is not recognized for purposes of determining net investment income under Section 1411.” [1411-5(C)(i)(2)(ii)]. Although these regulations are not yet finalized, taxpayers may rely on the proposed regulations to be in compliance with Section 1411 until the effective date of the final regulations.
1031 Tax Deferred Exchanges
Despite these tax increases, one aspect of the tax code provides real estate investors with a huge tax advantage. Section 1031 allows property owners holding property for investment purposes to defer taxes that would otherwise be recognized upon the sale of the property. Savvy investors use 1031 exchanges to deploy their investment capital into better performing investment properties. An exchange provides a fantastic opportunity for investment property owners to defer all capital gain taxes that would otherwise be owed.
Republished with permission from Asset Preservation, Inc.
Don Ellwanger
DRE# 01008217
Senior Vice President
Sperry Van Ness
Office: 916-456-8389
Mobile: 916-789.6545