Potential Tax Changes Await Investors in 2013

By Bill Hattox, CPA, Weaver LLP, Fort Worth, Texas

Editor: Anthony S. Bakale, CPA, M. Tax.


Individuals

Depending on political developments, taxpayers could face higher taxes on investment income in 2013, including a new Medicare tax on net investment income and the sunset of lower rates for capital gains and qualified dividends.

Medicare Tax on Net Investment Income

To generate revenue for various health care reform items in the Patient Protection and Affordable Care Act, P.L. 111-148, the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, included a 3.8% Medicare tax on net investment income that is slated to go into effect for the 2013 tax year. For taxpayers with modified adjusted gross income (MAGI—AGI increased by the foreign earned income exclusion) over a threshold amount, the tax is imposed on the lesser of (1) net investment income or (2) MAGI over the threshold amount. The threshold amounts are:

  • $250,000 for married taxpayers filing jointly and qualifying widows or widowers;
  • $200,000 for single and head-of-household filers; and
  • $125,000 for married taxpayers filing separately.

Items classified as investment income include interest, dividends, royalties, rents, annuities, and capital gains from investment property, as well as passthrough income from a passive business such as a partnership or an S corporation. Distributions from qualified retirement plans and IRAs would not count as investment income. It should be noted that the portion of any gain excluded from the sale of a principal residence under Sec. 121 will not be subject to the tax. The amount that exceeds the exclusion, however, will be included in net investment income and MAGI for purposes of the tax.

There was a chance the U.S. Supreme Court would invalidate the Medicare tax on investment income as part of its decision on the individual health insurance mandate (Sec. 5000A). However, the Supreme Court, in a 5–4 vote, declared the mandate to be a constitutional exercise of Congress’s power to tax under the Constitution and allowed the health care reform legislation, including the Medicare tax on investment income, to stand ( National Federation of Independent Business v. Sebelius , Sup. Ct. Dkt. No. 11-393 (U.S. 6/28/12)).

Health care reform has also generated considerable political controversy, and outcomes of the November 2012 presidential and congressional elections also could affect the law’s future.

Now that the Supreme Court has upheld the law, those who could be affected by the 3.8% Medicare tax on investment income need to be aware of the political events that could determine whether the tax takes effect for the upcoming tax year.

Sunset of Reduced Capital Gains Tax

The current 15% rate on adjusted net capital gains for individuals in the 25% to 35% ordinary income tax brackets first went into effect in 2003 when President George W. Bush signed the Jobs and Growth Tax Relief Reconciliation Act, P.L. 108-27. The Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222, extended the 15% rate through 2010, and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312, extended the rate through 2012. Without another extension, the capital gains rate for individuals in the current 25% to 35% ordinary income tax brackets (which will also increase) will increase to 20%, with a qualified rate of 18% for capital gains on assets held more than five years.

Sunset of Qualified Dividends Rate

Qualified dividends are defined by Sec. 1(h)(11)(B) as dividends from domestic and qualified foreign corporations that meet certain criteria, including a specified holding period. From 2003 through the 2012 tax year, the tax rate on qualified dividends has been the 15% rate assessed for net adjusted capital gains.

For the 2013 tax year, the qualified dividends provision is scheduled to sunset, and dividends would be taxed at individuals’ ordinary income rates, which would range from 15% to 39.6%.

Actions to Consider

Investors considering the sale of any long-term investments need to monitor developments and be prepared to execute those sales before the end of the year rather than possibly subjecting themselves to a higher tax rate in 2013. Considerable uncertainty remains. The outcome of the November elections could alter current health care reform provisions, including the 3.8% Medicare tax on net investment income. If the Medicare tax remains, investors may wish to make larger contributions to an IRA or qualified retirement plans because future distributions from those plans would not be subject to that tax.

As in 2010, late-year congressional negotiations could lead to extensions of current capital gains and qualified dividend tax rates. In the absence of such negotiations, though, investors may wish to divest themselves before Jan. 1, 2013, of holdings that have gains. Investors may also wish to consider carrying over capital losses into 2013 if the new tax and sunset go into effect as scheduled. Prior-year losses may become more valuable because they would offset capital gains taxed at a higher rate than the rate in effect when the investors incurred the losses.

Taxpayers and tax professionals need to stay abreast of developments that could influence tax planning and be prepared to address different scenarios and the various items that contribute to overall tax obligations.

EditorNotes

Anthony Bakale is with Cohen & Co., Ltd., Baker Tilly International, Cleveland.

For additional information about these items, contact Mr. Bakale at 216-579-1040 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly International.

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