Late last year, Congress and the president had Americans hurtling towards a fiscal cliff that was going to force tax increases on most taxpayers and impose across-the-board government spending cuts at the start of this year. Just as we were about to fall off that cliff, President Barack Obama signed the American Taxpayer Relief Act of 2012 on January 3, 2013. This averted increasing taxes. However, negotiations on the spending cuts have been deferred and we are now starting to feel the effects of sequestration.
The impact of this legislation is that unmarried individuals with incomes above $400,000 and married couples with incomes above $450,000 move into a 39.6% tax bracket (up from 35%). Although painful to those affected by the tax rate increase, it did avoid the dra- conian automatic sunset provisions that were scheduled to take effect as of January 1, 2013. It also permanently patches the alternative minimum tax (AMT) by maintaining increased exemption amounts that are indexed for inflation going forward.
Without this legislation, individual tax rates on all income groups would have increased, taxpayer-friendly treatment of capital gains and dividends would have completely gone, and other favorable tax benefits would have been reduced or eliminated. In addition, the federal estate tax would have reverted to a maximum rate of 55% for estates greater than $1 million.
The American Taxpayer Relief Act raises the top rate for capital gains and dividends to 20%, up from the Bush-era maximum rate of 15%. That top rate will apply to the extent a taxpayer's income exceeds the thresholds set for the 39.6% rate ($400,000 for single filers; $450,000 for joint filers). Note that capital gains are also subject to the 3.8% net investment income tax.
In addition, the American Taxpayer Relief Act permanently provides for a maximum federal estate tax rate of 40%, with an annual inflation-adjusted $5 million exclusion for estates of decedents dying after December 31, 2012.
Additional Tax on Rental Income
While the president and Congress are working through budget negotiations, as discussed below, there are certain tax changes that definitely apply in 2013. The most significant is the 3.8% tax on net investment income.
The new net investment income tax was created to help pay for healthcare reforms that were enacted in 2010. The rate is 3.8% of the lower of net investment income or the amount of modified adjusted gross income (MAGI) over specific thresholds.
Beginning January 1, 2013, individuals with MAGI above the thresholds are subject to the net investment income tax. The threshold for unmarried taxpayers is $200,000, and for married couples $250,000. For most taxpayers, the MAGI is the same as their adjusted gross income.
The net investment income tax is imposed on three types of investment income: gross income from rents, interest, dividend, royalties and nonqualified annuities; other gross income from businesses with respect to which the taxpayer is passive; and net capital gain income including gain attributable to dispositions of business property used in passive activities.
Most apartment owners will have to pay the 3.8% net investment income tax on their net rental income from their apartment units. This is in addition to the regular tax that they would pay on that income.
There is an exception for real estate professionals that materially participate in their apartment rental activities. To qualify as a real estate professional: more than one-half of the personal services performed by the taxpayer during the year must involve real estate trades or businesses where the taxpayer materially participates, and the individual must perform at least 750 hours of service during the year in real estate trades or businesses.
Real estate trades or businesses are defined as any real estate development, construction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business. Be sure to discuss the "real estate professional" status with your tax advisor before filing your 2013 tax returns.
No Grand Bargain
In spite of the fact that the American Taxpayer Relief Act did not raise taxes for the majority of Americans, it is nowhere close to the "grand bargain" on taxes and spending as envisioned by the president and many lawmakers after the November elections.
In an effort to move the ball forward, on April 10, 2013, President Obama released a $3.77 billion fiscal year 2014 budget with a mix of individual and business tax proposals intended to raise revenue, reduce spending and encourage negotiations between the White House and the GOP on comprehensive tax reform. The president's proposal would achieve $1.8 trillion in additional deficit reduction over the next 10 years, bringing total deficit reduction to $4.3 trillion.
Below are a few of the most significant provisions of the proposals in the president's fiscal year 2014 budget affecting individuals and businesses.
President Obama proposes to reduce the value of specified itemized deductions to 28%, reducing the taxable income in the 33%, 35% and 39.6% tax rate brackets. This limit would apply to all itemized deductions, foreign excluded income, tax-exempt interest, employer sponsored health insurance, retirement contributions and selected above the line deductions. The proposed 28% cap on itemized deductions and exclusions stands out as the most significant single revenue raiser within the resident's budget.
"Fair Share" Tax
The budget would also require millionaires to pay no less than 30% of income (after charitable contributions) in taxes. This would be referred to as the "fair share" tax. The fair share tax would be phased in starting at $1 million and would be fully applicable at $2 million.
This tax would also affect capital gains tax, which would be taxed at a maximum rate of 20%, plus the 3.8% Medicare tax, or 23.8%, causing capital gains to be subject to an increased rate of 30% to the extent the overall income exceeds $1 million.
President Obama also proposes to limit contributions and accruals on tax-favored retirement benefits, including IRAs, qualified plans, tax-sheltered annuities and deferred compensation plans. The limit would apply when a taxpayer accumulates total retirement amounts that exceed the amount needed to fund reasonable consumption and that justify tax-favored treatments. Generally, this provision would prohibit individuals from accumulating more than $3 million in tax-preferred retirement accounts.
Estate and Gift Tax
President Obama's budget calls for the reinstatement of the 2009 estate and gift tax structure which had a 45% rate, a $3.5-million estate tax exclusion and a $1-million lifetime gift exclusion (both indexed for inflation). This would not take effect until 2018. The portability of unused estate and gift tax exclusions between spouses would be allowed.
For businesses, a carried interest in an investment partnership would be designated a services partnership interest under the president's proposals. A partner's share of a services partnership interest that is not attributable to invested capital would be taxed as ordinary income. This income would also be subject to self-employment tax. Essentially, this provision would tax certain carried interest income as ordinary income instead of the 20% capital gains rate.
Also, the Code Section 179 dollar limit for 2012 and 2013 is $500,000 with a $2 million investment limit. President Obama proposes to make this permanent and adjust for inflation the $500,000/$2 million thresholds for qualified property placed in service in tax years beginning after December 31, 2013.
The president's budget proposes a temporary 10% tax credit for qualified employers who create new jobs, increase wages or both. The maximum credit would be $500,000 and would be effective for wages paid during the 12-month period beginning on the date of enactment. The tax credit would be available to firms with annual wages below $20 million in 2012. The proposal would also provide a similar credit to tax-exempt employers.
The budget proposal would also make permanent the temporary 100% exclusion for qualified small business stock acquired after December 31, 2013. The AMT preference for gain excluded under the small business stock provision would be repealed for all excluded small business stock gain.
House and Senate Budget Proposals
The House Republican proposals were unveiled in "The Path to Prosperity: A Responsible, Balanced Budget, The house Republican Fiscal Year 2014 Budget Resolution." The House GOP budget proposes three tax reform goals: simplify the tax code, make the tax laws fairer to families and businesses, and reduce the amount of time and resources necessary to comply with tax laws. The GOP budget proposal would reform the Tax code, but would be revenue-neutral and would not raise any new revenues. The GOP budget would achieve $4.6 trillion in spending cuts over 10 years, with no new tax revenues. The House GOP proposal would also repeal the AMT.
The House GOP proposal would consolidate the seven current individual income tax rates into two rates. The lower rate would be 10% and the budget supports lowering the higher tax rates for individuals, with the goal being a top rate of 25%.
The Senate Democrat proposals are included in their fiscal year 2014 budget resolution entitled, "Foundation for Growth: Restoring the Promise of American Opportunity." Similar to the House Republicans, the Senate Democrats have outlined their own tax reform goals: maintain progressiveness in tax rates; aggressively address the tax gap and off-shore tax abuse; eliminate unfair and inefficient business tax loopholes; increase certainty and simplify the tax code; reform business taxes to help U.S. enterprises compete; and reduce tax rates responsibly, but only if revenue and progressivity goals are achieved or maintained.
The Democratic budget would: impose across-the board limits on itemized deductions claimed by the top 2% of income earners by capping the rate so that itemized deductions and other tax preferences reduce tax liability, a percentage of income cap, or a specific dollar cap; impose a higher tax rate on carried interests; and eliminate offshore tax shelters and remove incentives for companies to move assets offshore.
It is clear that the Senate Democrat proposals have many similarities to the President's budget. The differences between the Democrats and Republicans are more drastic and will require careful negotiations to reach any kind of "grand bargain" in 2013. Some Washington insiders have indicated that the passage of any significant tax reform in 2013 is unlikely, and that the earliest would be 2014.
As the saying goes, nothing is certain but death and taxes. Whether we will see tax reform in 2013 or 2014 is unclear. What is clear is that our tax code continues to become more complicated—as evidenced by the 3.8% net-investment tax taking effect in 2013. The president and house Republicans have a lot of work in store to reform the tax code. Time will tell whether both parties can agree to anything. Being aware of what might change in the tax code provides an opportunity for planning ahead.
Douglas Schultz is a shareholder in the tax practice of BPM He can be reached at 415-677-4504 or email@example.com