Prepared for Year-End? Here's What You Need to Know
by Lillian Chen, Partner, Real Estate & Hospitality Practice, Moss Adams LLP
With 2012 coming to an end, real estate professionals and investors are making important year-end tax decisions. And while there’s still uncertainty regarding what the tax code will look like next year, taxpayers should carefully consider the following important changes as they prepare.
Tangible Property Regulations
After years of delay, the IRS has finally issued regulations to address the treatment of capital expenditures for tangible property. These “repair” regulations, which are effective for taxable years beginning January 1, 2012, have broad application and affect taxpayers in all industries. For the real estate industry, the new regulations are particularly significant: They have changed the definition of a unit of property. They have also established criteria designed to help taxpayers determine whether to capitalize or expense certain costs associated with their tangible property. If they have not already begun the process, real estate owners need to review their capitalization policy now and assess whether an expense incurred represents a betterment to the property, an adaptation of the property to a new use, or a restoration of the property to its normal function.
Expiration of Bush Tax Cuts
If no congressional action is taken before the end of the year, all higher income earners will face significant tax rate increases as the Bush tax cuts expire. Income tax rates will increase for the top two tax brackets, going from 33 and 35 percent to 36 and 39.6 percent, respectively. The top long-term capital gains tax rate will increase from 15 to 20 percent, and qualified dividends will no longer be taxed at the preferential 15 percent rate; instead, they will be taxed as ordinary income.
Itemized deductions will once again be phased out by the lesser of either 3 percent of AGI over a prescribed amount or 80 percent of the amount of the itemized deductions otherwise allowable for the taxable year. And finally, estate, gift, and generation-skipping transfer tax exemptions will be reduced from $5.12 million to $1 million, and the maximum transfer tax rates will increase from 35 to 55 percent.
It’s important to carefully evaluate the implications of these changes and take action if it makes sense to do so. Unlike in prior years, the standard practice of deferring income and accelerating deductions may not be the best solution given the likelihood of increased tax rates in 2013. For certain taxpayers it may be advantageous to trigger a taxable event before year-end, such as converting to a Roth IRA, exercising nonqualified stock options, electing out of the installment sale method, or selling capital gain assets.
When it comes to transferring wealth to others, the current tax laws provide an opportunity for taxpayers to transfer up to $5.12 million of their estate, during their lifetime or at death, without incurring federal transfer taxes ($10.24 million for married couples). These lifetime exemption amounts are scheduled to drop to $1 million for individuals and $2 million for married couples on January 1. For real estate owners, the decline in real estate values and the availability of valuation discounts could lower their future estate tax burden through the end of the year.
Beginning in 2013, additional Medicare taxes—an increased hospital insurance tax and a new Medicare contribution tax—are set to take effect. The increased hospital insurance payroll tax of 0.9 percent will apply to wages and self-employment income in excess of the following thresholds:
$250,000 for married couples filing jointly
$125,000 for married individuals filing separately
$200,000 for single individuals and the heads of households
The Medicare contribution tax applies to certain investment income of higher income earners. Those affected will incur an additional 3.8 percent on the lesser of:
Net investment income for the year
Modified adjusted gross income exceeding the payroll thresholds above
High income earning taxpayers can lower their family’s taxes by reducing their net investment income through gifting investment income–generating property to other taxpayers not subject to the Medicare tax mentioned above. This transaction can be structured in a flexible manner to fit the owner’s desired level of control and cash flow as it relates to the property.
In an effort to spur economic activity, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extended the first-year bonus depreciation deduction for qualified property. While the 100 percent deduction has expired, taxpayers can still take a 50 percent deduction for certain property acquired after January 1, 2012, and placed in service before December 31, 2012.
The Bottom Line
The current tax laws and impending changes have created a unique window of opportunity for individuals and real estate owners. Careful consideration and action must take place now to ensure that the impact of the tangible property regulations are fully evaluated and the detrimental effects of higher taxes are mitigated.
Lillian Chen works exclusively with clients in the real estate industry, including REITs, funds, homebuilders, developers, investment managers and advisors, and high net worth individuals.
A version of this article previously appeared on GlobeSt.com.
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