2012 Year End Tax Planning

Should Taxpayers Sell in 2012 Before Rates Rise?

In 2012, many taxpayers will have additional considerations when analyzing whether to sell investments before the end of the year or retain them in 2013.

First, the Bush-era tax cuts are scheduled to expire at the end of 2012. This affects ordinary income rates, as well as rates on capital gains and dividends.

Second, under the health care law, a new 3.8 percent Medicare tax on unearned income, including interest, dividends and capital gains, will take effect in 2013.

Third, various tax provisions expired in 2011 and have not been extended to 2012. Here are some of those tax provisions:

• The option to deduct state and local sales taxes instead of state and local income taxes. For states where there in no income taxes, such as Florida, this tax break is of great importance.
• Taking the tax deduction for mortgage insurance premiums
• Making tax-free IRA distributions to qualified charities
• Various energy efficiency tax credits
• Most importantly, the alternative minimum tax (AMT) correction for 2012. If there is no correction the exemption drops to the 2000 level of $45,000 from last year’s level of $74,450 for married couples filing jointly. If nothing is done, then 31 million taxpayers are impacted compared with 4 million taxpayers in 2011.

Together, these real and potential changes may add up to hefty new taxes in 2013, if Congress fails to make changes to the current tax rules for 2013. The problem here is that no one knows for sure what will happen between now and the end of the year, so year end tax planning is made more difficult and uncertain.

Here are more of the details:

Income Tax Rates

Current income tax rates continue through the end of 2012. These so-called Bush era individual income tax rates are currently 10, 15, 25, 28, 33 and 35 percent. These are very favorable tax rates.

If Congress does not take any action, in 2013 these rates revert to the higher rates that used to apply: 15, 28, 31, 36, and 39.6 percent.

Republicans favor retaining all of the Bush-era rates. President Obama and many Democrats support retaining the 10, 15, 25, and 28 percent rates for lower- and middle-income taxpayers, while reinstating the 36 and 39.6 percent rates for taxpayers with income over $200,000 (single taxpayers) or $250,000 for joint filers.

Additionally, there are calls for tax reform and for an overall lowering of income tax rates, in exchange for ending unspecified tax deductions and benefits. For example, House Republicans have called for replacing current income tax rates with two brackets, of 10 and 25 percent in exchange for eliminating many popular tax deductions.

Capital Gains and Dividends

Current income tax rates that extend through the end of 2012 also include the 15 percent rate on capital gains and qualified dividends for qualified taxpayers.

If Congress does not act, these rates revert to much higher ordinary income rates, in the case of dividends, and to the 20 percent rate that formerly applied to capital gains.

Again, the President and the Republicans would both extend the current rates, but disagree on whether to apply the extensions to all taxpayers (the Republicans) or only to lower- and middle-income taxpayers under the $200,000/$250,000 thresholds (the President).

3.8 Percent Tax: Medicare Surcharge

Adding to the mix is the impending 3.8 percent tax on unearned income. Under the health care law, this tax will apply to 2013 income (and beyond) of single taxpayers with income exceeding $200,000 and joint filers with income exceeding $250,000.

The tax is imposed on the lesser of net investment income or the excess of adjusted gross income about the $200,000/$250,000 thresholds.

Net investment income also includes rents, royalties, gain from disposing of property used in a passive activity, and income from a trade or business that is a passive activity.

The tax does not apply to distributions from retirement plans and IRAs.

Taxpayers cannot necessarily avoid the tax by moving assets to a trust, because the tax will apply if trust income exceeds a threshold currently set at only $11,200.

For more on this tax read 2013 Sneaky New Tax: Medicare 3.8% Tax.

The Big Question: Sell or Hold

Generally, taxpayers should make investment decisions based on economics; namely, holding on to a “good” investment and selling a “bad” investment. If the taxpayer expects an asset to continue to decline in value during 2012, he or she should sell the asset soon and not wait until 2013.

The problem here is that making financial decisions based only on financial and economic analysis alone may be unwise. Current and future tax rates and the uncertainty of future tax laws must be taken into account to determine the best result for each individual taxpayer. Even though Congressional gridlock and inaction have put taxpayers in a position of uncertainty, there are still financial and tax decisions that must be made to minimize taxes and to set the stage for overall tax planning over the coming years.

Here are some of the basic income tax planning considerations and strategies:

Appreciated Assets:

Taxpayers that are debating whether to sell appreciated assets or assets that pay qualified dividends may want to act in 2012, when income tax rates are lower and before the 3.8 percent tax takes effect.

Declining Assets:

Taxpayers considering the sale of declining assets may want to consider holding off until 2013, when losses can offset more highly-taxed gains and reduce the income potentially subject to the 3.8 percent tax.

Shifting Assets To Avoid the New 3.8% Medicare Tax:

Because the 3.8 percent tax does not apply to tax-free income, such as municipal bonds, taxpayers may want to shift some of their investments to yield such nontaxable income. Taxpayers who have investments that generate dividend income or capital gain income may want to sell these in 2012 when capital gain rates are lower and reinvest in tax-free investments.

Bunching of Income Strategy:

Another consideration is the bunching of income. Taxpayers that sell substantial capital gains assets in 2013 may push their income up to the $200,000/$250,000 thresholds that trigger higher taxes. If the taxpayer is considering a sell-off of assets, it may make more sense to sell assets before 2013, especially if it turns out that the capital gain tax rate is lower in 2012.

Conservative Minded Investors:

With the uncertainty of the financial markets, our current unsteady geo-political environment, some investors may choose to limit risk. If a taxpayer wants to shift to more conservative investments, income yields may decline, but so will the incidence of the dividend, capital gains, and unearned income taxes described above.

Speculative Investors:

On the other hand, taxpayers looking at more speculative investments should understand that a successful investment may generate income taxed at higher rates in 2013.

Conclusion:

Taxpayer need to look at their particular financial and tax picture to determine what is best for them. The above are merely general guidelines that should trigger further discussion with your tax advisor. Getting with your tax adviser to facilitate tax projections across multiple tax years may be a prudent and worthwhile course of action in light of the current tax uncertainties, your projected taxable income and your particular financial goals.

Please do not hesitate to contact our office if you have any questions or want to do some year end tax planning.