Understanding the new 3.8%
tax on investment income
With potential tax increases looming on the horizon, the value of tax deferral mechanisms, such as Section 1031 exchanges, have never been greater. One example of a new tax increase scheduled to take effect is the new Medicare tax, which Congress passed as part of the Health Care and Education Affordability Reconciliation Act of 2010. The Medicare tax, which goes into effect on January 1st, 2013, will impose a 3.8% tax on the net investment income of single filers with adjusted gross income (AGI) over $200,000 and joint filers with AGI over $250,000.
The new 3.8% Medicare tax applies to investment income, which includes interest, dividends, rents (less expense), and capital gains (less capital losses). It includes gain from the sale of a principal residence above the $250,000/$500,000 exclusion, gain from the sale of an investment property or a second home, and passive income from real estate and investments in which the taxpayer does not materially participate. The Medicare tax applies to the lesser of (i) investment income amount, and (ii) excess of AGI over the $200,000 or $250,000 amount.
Other Potential Tax
Increases in 2013:
In addition to the new Medicare tax discussed above, the "Bush-era Tax Cuts," which went into effect in 2001, are scheduled to expire at the end of this year. If the Bush-era Tax Cuts are allowed to expire due to inaction by Congress, the Federal capital gains tax rate will increase to 20%, and the highest marginal tax rate for ordinary income will increase from 35% to 39.6%.
The Combined Effect
of the Tax Increases
on Real Estate Investors
Future tax rates remain uncertain. But taking into account the imposition of the new 3.8% Medicare tax, and the uncertainty regarding the Bush-era Tax Cuts, on January 1, 2013 taxpayers could face one of three scenarios:
1) If Congress extends the Bush-era Tax Cuts, the top Federal tax rate on long-term capital gains will increase from 15% to 18.8%.
2) If Congress lets the Bush-era Tax Cuts expire, the top Federal tax rate on long-term capital gains will increase from 15% to 23.8%. This is a 59% increase!
3) If Congress extends the Bush-era Tax Cuts, but not for all tax brackets, this will result in a combination of the above two scenarios, and the top Federal tax rate on long-term capital gains will likely rise for higher earners, but not for all tax brackets.
The Tax Code Taketh, The Tax Code Deferreth - The Increasing Value of 1031 Exchanges
Despite these potential tax increases, one aspect of the tax code provides real estate investors with a huge tax advantage. A Section 1031 exchange, part of the tax code since 1921, allows real estate property owners holding property for investment purposes to defer taxes that would otherwise be incurred upon the sale of investment property. Savvy investors use 1031 exchanges to redeploy their investment capital into better performing investment properties.
An exchange provides a fantastic opportunity for investment property owners to defer capital gain taxes.
Call the 1031 exchange experts at Asset Preservation today and to learn more about this powerful investment strategy.
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Matthew Cholewa is 1031 exchange divisional manager at Asset Preservation, Inc., Fairfield, Conn.