Anyone who owns, develops, or invests in real estate should note that dramatic changes in the tax landscape are likely, effective January 1, 2013. We cannot yet know the precise tax code changes, but we can predict that important windows of opportunity may close at the end of this year. The time to start planning is now! Although we will probably know more about the 2013 tax landscape after the November 6, 2012 election, the few weeks remaining at that point may not be sufficient to arrange important transactions. A few days delay in closing acquisitions, dispositions, and improvements of real estate assets could affect, very keenly, their associated tax cost.
Anticipated changes in the tax code will likely affect four key areas of special interest to real estate owners, developers and investors:
Capital gains rates are likely to increase for at least some taxpayers; this will impact directly the net after-tax proceeds of most real estate sales.
The alternative minimum tax may be increased, reduced or eliminated, which will directly affect the tax bills of many high- and middle-income taxpayers.
Bonus depreciation, which is available for certain equipment and leasehold improvements, as well as, furniture and fixtures may or may not be expanded, or extended past 2012.
The 3.8% Medicare surtax on investment income comes into effect in 2013 and will increase tax rates on investment income for high income taxpayers.
CAPITAL GAINS RATES
In 2001 and again in 2003, the “Bush tax cuts” decreased dramatically the federal income tax rates on long term capital gains, which are the rates that usually apply to the sale of real estate. Although intended to be temporary, the Bush tax cuts were extended in 2010, and now are set to expire at the end of 2012.
If the Bush tax cuts are allowed to expire, the maximum tax rate on long-term capital gains will jump from 15% to 20%. Also beginning in 2013, the Affordable Care Act, which was signed into law on March 23, 2010, will impose an additional 3.8% tax on capital gains (and other investment income) of “high income” taxpayers.
Democrats and Republicans in Congress have introduced competing legislation in response to the impending expiration of the Bush tax cuts.
The Democrats’ Proposal
Democrats in Congress have proposed legislation to extend the Bush tax cuts for one year for all income under $250,000 for couples filing jointly and all income under $200,000 for individuals. Capital gains would be taxed at 20% for any income above that threshold. President Obama has expressed support for this plan, stating that anyone making over $250,000 a year should be taxed at the rates in place during the Clinton presidency. This means that the top marginal tax rate would increase from the current 35% to 39.6%, in addition to the increase in the capital gains tax rate.
There has been some opposition from Democratic Senators from California and New York, who propose that the threshold should be $1 million instead of $250,000 due to the high cost of living in their states. They have also argued that the higher threshold could be a compromise for Republicans, but no significant support from either party for this proposition has been seen as yet.
Some Democrats have also stated that they are prepared to let all Bush tax cuts lapse on December 31 of this year if Republicans do not agree to an income cap on the tax cut extension. In that case, Democrats would likely call for a vote on tax cuts for the middle class early in 2013.
The Republicans’ Proposal
Republicans in Congress have introduced legislation calling for an extension of the Bush tax cuts for one year for all income levels. Republican presidential nominee Mitt Romney supports the extension of the Bush tax cuts for all income levels. He has stated that there should be no increase in taxes in the current economy.
The proposed Republican bill also instructs the Finance Committee to develop tax reform legislation in 2013. The bill would direct the Finance Committee to produce a plan that results in the highest individual rate being significantly below the current rate of 35%.
Planning for Possible Outcomes
On July 25, the Senate voted to extend the Bush tax cuts to all income under $250,000 for couples filing jointly and $200,000 for individuals. On August 1, the House voted to extend the Bush tax cuts for all income levels. These competing bills demonstrate that both parties are unwilling to compromise on their proposals at this time.
Both parties recognize that there will likely be no viable tax bill until after the election in November. Currently, the House is controlled by Republicans pushing for an extension of the tax cuts for all income levels and the Senate is controlled by Democrats looking to limit the tax cuts to income below $250,000 for couples and $200,000 for individuals. This impasse is not likely to resolve until the results of the election are known.
If President Obama wins re-election in November and the Democrats take control of both houses of Congress, it is likely that the Bush tax cuts will be extended only for persons with income less than $250,000. Tax rates on capital gains for persons with income over $250,000 would increase from 15% to 20%, in addition to the 3.8% tax on capital gains for high income taxpayers.
Conversely, if Mitt Romney is elected President in November and if the Republicans take control of both houses of Congress, it is likely that the Bush tax cuts will be temporarily extended for all income levels. In that case, capital gains will be taxed at the same rate in 2013 as in 2012. However, this extension might only last one year.
If no compromise can be reached and the Bush tax cuts are allowed to expire, tax rates will increase across the board.
THE ALTERNATIVE MINIMUM TAX
The Alternative Minimum Tax (AMT) is also under debate in Congress. Historically, the AMT has most keenly impacted taxpayers with incomes in the $150,000 to $400,000 range; an artifact of the Bush tax cuts in 2001-2003 was that the number of taxpayers affected by the AMT was greatly increased.
Because the AMT is not indexed for inflation, for the last several years Congress has provided a “patch” to the AMT each year, increasing the amount of the exemption allowed. The proposed Democratic legislation would again “patch” the tax, minimizing its impact by increasing the current AMT exemption temporarily. In contrast, the proposed Republican legislation would require the permanent repeal of the Alternative Minimum Tax in 2013. If no action is taken, the current exemption “patch” would expire and the AMT would increase the effective tax rate for many taxpayers.
Under the current law, companies may expense 50% of the cost of certain types of equipment, and leasehold improvements. This accelerated depreciation expires at the end of 2012.
Democrat-sponsored legislation, the Small Business Jobs and Tax Relief Act, proposes to increase bonus depreciation to 100% for all of 2012. The Act would also provide businesses with a tax credit equal to 10% of all new wages and compensation added in 2012, capped at $500,000.
Although the Small Business Jobs and Tax Relief Act were blocked in the Senate, there has been bilateral support for the extension of bonus depreciation for 2012 and 2013. Proposed legislation in both the House of Representatives and the Senate call for either the extension of 100% bonus depreciation through 2012, or of 50% bonus depreciation through 2013.
THE 3.8 PERCENT MEDICARE SURTAX
Beginning in 2013, a 3.8% Medicare surtax will apply to modified adjusted gross income over $200,000 for single individuals and $250,000 for married couples filing jointly. The surtax will apply to the lesser of net investment income or the amount of modified adjusted gross income over the applicable threshold.
Modified adjusted gross income refers to adjusted gross income plus certain tax-free income from foreign sources. In most cases, modified adjusted gross income will be equal to adjusted gross income. Net investment income includes capital gains, interest, dividends, royalties, annuities, rents, income from passive business activities, and taxable gains from personal residence sales.
Despite common perception, the 3.8% tax is not a national sales tax. However, it does apply to the taxable proceeds of capital transactions, including sales of real estate. For any income affected by the Medicare surtax, the tax rate on capital gains will be 23.8% in 2013.
There have been no major efforts to repeal the Medicare surtax by either party. However, depending on the outcome of the elections in November, there is a possibility that Republicans will try to repeal the surtax in 2013. If this were to happen, the tax would likely be repealed retroactively back to the beginning of 2013 and would have no effect on taxpayers.
Although there is uncertainty about 2013 tax rates at this point in time, a proactive strategy can position real estate owners, developers and investors to take full advantage of the current tax landscape and opportunities that may arise over the next several months. It may behoove investors to close deals that will yield significant capital gains prior to year end. Similarly, planned capital expenditures that qualify for bonus depreciation should be made by year-end.
Source: Hinckley, Allen & Snyder LLP