Thursday, June 27, 2013

Increased Taxes Are Here

In addition to the change in estate and gift tax provisions made as a result of the passing of the American Taxpayer Relief Act of 2012 by Congress as mentioned in this post, the Act also increased taxes on certain income tax provisions, including but not limited to federal income tax rates, capital gains tax rates, and dividend tax rates.

Individuals with taxable income of $400,000.00 per year or $450,000.00 per year for a married couple on a joint tax return will experience higher income taxes in several areas:
  1. The top marginal tax rate on income will increase to 39.6% up from 35%.
  2. The top marginal tax rate on long term capital gains will increase to 20% up from 15%.
  3. The top marginal tax rate on on dividends will increase to 20% up from 15%.
Most people reading this will think after looking at these income levels, that this does not concern them and will never affect them. They think the above applies only to the "1%" and they are just one of the regular folks. However, many people come to find it a surprise that the above tax rules, in fact, does affect them without ever realizing it before when they plan to sell their investment property. This is especially true with real estate being as expensive as it is in New York City.

As an example, you have an investment property that you sold for $800,000.00 this year. You have held title to this property for 20 years which was originally purchased for $450,000.00. That means you have a capital gains of $350,000.00. But do not forget that you have held this property for 20 years which means you have depreciated the property for those 20 years. If you depreciated $30,000.00 per year for 20 years, that means you have benefited from $600,000.00 in total depreciation. Depreciation is simply a tax deferral. The IRS will want to do a depreciation recapture so that you now have to pay taxes for that entire time you have benefited from not having to pay those taxes through depreciation. Depreciation recapture will be taxed at ordinary income rates.

So, for a married couple with a household income of $75,000.00 per year, and who sold the above property this year, the married couple will have the following "taxable income" for this tax year:

             $75,000.00 ordinary income
           $600,000.00 depreciation recapture
           $350,000.00 capital gains income
        $1,025,000.00

That means, for this tax year, the married couple will have a taxable income of $1,025,000.00! If the federal and state government takes roughly 40 to 45% of that from you, then you are left with just over half of that total amount. That is a lot of taxes. Many people in a situation like the above, look to a 1031 Exchange, a tax deferral tool made available by the IRS, to avoid or defer having to pay such taxes upon the sale of an investment property.

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