Aug, 2012

printable pdf

About a year ago, I wrote this: "Remember right about this time two years ago when Congress was fighting about whether to extend the Bush tax rates? Well... it's déjà-vu all over again!" Well guess what--it's déjà-vu all over again again (with a few variations).

As things currently stand, there is a myriad of tax rate changes that are on the horizon unless Congress takes some action. This article will deal primarily with only one change, commonly referred to as the "Medicare tax," that may h
av e an impact on taxpayer s involved in Section 1031 exchanges. (If you are interested in details about the Medicare tax, please read to the end. There is a link to a great brochure that the National Association of REALTORS® has made available.)3.8 Medicare tax.jpg

The impending sunset of the Bush tax rates at the end of 2012 will result in an increase in the federal capital gain tax rate from its present 15% to 20%. Congress is currently grappling with whether to extend the present rates, including the capital gain rate, for all taxpayers (as the Republican-controlled House of Representatives has voted) or to extend the rates only for those whose income is $250,000 or less (as the Senate's version puts forth).  I will spare you my editorial comment on the issue, but I will give you this opinion-it is unlikely that this impasse will be resolved prior to the November 6 election because of two things. First, at the end of this week, Congress will take their normal five-week recess. Second, when they return there will be only three weeks before the election. Chances are strong that Congress will be occupied with passing a stop-gap funding measure to avoid a government shutdown after the September 30 end of the fiscal year, since they haven't passed a budget for over three years. (Subtle editorial comment contained in that last phrase-did you pick up on it?)

What I really want you to consider is the new tax commonly called the Medicare tax. This is a 3.8 percent tax that will be imposed on some investment income, ostensibly to help fund President Obama's health care plan and Medicare overhaul. While it will not be imposed on all real estate transactions, it will apply to individuals with an adjusted gross income (AGI) above $200,000 and couples with greater than $250,000 AGI. The key here is that AGI includes income from capital gains.

Here's an example of a situation that is fairly common among our clients. Joe is single. He inherited a farm in 2002 from his parents. At the time of the inheritance, the farm's value was $325,000, which is Joe's basis in the property. Joe's other income will have an effect on these calculations, but for simplicity we will assume that he has no other income. Joe sells the farm for $1.2 million and the closing is set for after January 1, 2013. 

The new "Medicare tax" applies as follows:

Gain on Sale                                         $875,000     ($1.2 million - $325,000)
Adjusted Gross Income (AGI)       $875,000     (Gain + no other

Excess AGI over $200,000                $675,000     (Subject to 3.8% tax)
Medicare Tax Due                              $  25,650     ($675,000 x 0.038%)

Capital Gain Tax Due                        $175,000     ($875,000 x 20%)
Total Tax Due on Sale                       $200,650     ($175,000 + $25,650)

Compare to Current Tax Rate       $131,250     ($875,000 x 15%; no
                                                                                            Medicare tax)

Additional Tax Under New            $   69,400     ($200,650 - $131,250)

Compared to selling in 2012, Joe's tax is 52.9% higher because he sells in 2013.

One interesting thing about this new 3.8% tax is that it is unresolved whether it can be deferred through the use of a like-kind exchange. In general, most of us who work in the exchange industry believe the tax should be able to be deferred, but the question has not been addressed in regulations to date.

As of today (8/1/2012), there are three primary possible tax outcomes to real property sales beginning January 1, 2013:

  1. If Congress extends the Bush-era tax rates , the top federal tax rate on long-term capital gains will increase from 15% to 18.8% (15% capital gain tax plus the new 3.8% Medicare tax).
  2. If Congress lets the Bush-era tax rates expire , the top federal tax rate on long-term capital gains will increase from 15% to 23.8% (20% capital gain tax plus the new 3.8% Medicare tax). By the way, the top tax rate on dividends will nearly triple to 43.4%.
  3. If Congress extends the Bush-era tax rates, but not for all tax brackets , we will face a combination of the above two scenarios. The top federal tax rate on long-term capital gains will likely rise for higher income taxpayers, but remain at current levels for lower earners. In either case, though, the new 3.8% Medicare tax will come into play if it is applicable due to the taxpayer's adjusted gross income.

Remember, the 3.8% Medicare tax increase is a done deal and will apply regardless of whether current tax rates are extended or not. For a more detailed overview of this new tax, including several examples, please see this brochure produced by the National Association of REALTORS®.

Owners of real estate, particularly those who own farmland or investment property, should consult with their advisors to determine whether this tax may affect them. This article does not cover every instance where the tax may be due and Iowa Equity Exchange cannot give tax or legal advice. 

If you are selling your property and would like to discuss the pros and cons of a Section 1031 tax-deferred exchange, please contact Iowa Equity Exchange.