Tax-Free IRA Distributions
The American Taxpayer Relief Act of 2012 (2012 Taxpayer Relief Act) extends through 2013 the provision which allows individuals who are at least 70½ by the end of the year to exclude from gross income qualified charitable distributions up to $100,000 from a traditional or Roth IRA that would otherwise be included in income. Married individuals filing a joint return are allowed to exclude a maximum of $200,000 for these distributions ($100,000 per individual IRA owner).
A review of your tax return indicates that you may be eligible to take advantage of these opportunities. As you may know, IRA owners must either withdraw the entire balance or start receiving periodic distributions from their traditional IRAs by April 1 of the year following the year in which they reach age 70-1/2. The distribution that is required each year is computed by dividing the IRA account balance as of the close of business on December 31 of the preceding year by the applicable life expectancy. An IRA owner who does not make the required withdrawals may be subject to a 50-percent excise tax on the amount not withdrawn.
2012 Resolves Many Uncertainties
2012 Resolves Many Uncertainties, Creates Others; Sets Stage For Future Tax Reform.
Uncertainty during 2012 over what tax laws would govern in 2013 and beyond because of the expiring Bush-era tax cuts clearly was the most significant development of the year. Now that Congress and President Obama — through the American Taxpayer Relief Act of 2012 (ATRA) — have provided a degree of certainty over tax rates into at least the immediate future, taxpayers need to adjust their tax plans accordingly. Individuals and businesses should immediately recalibrate strategies in light of ATRA. 2012 was also a significant year for important tax developments from the Treasury Department, the IRS and the courts. These developments demand the attention of individual and business taxpayers not only to caution what is no longer allowed under the tax laws but also to shape what steps can be taken in 2013 and beyond to maximize tax savings. With that forward-looking perspective, this Tax Briefing reviews key federal tax developments that took place during 2012.
3.8 Percent Medicare Tax on Investment Income
The health care reform package (the Patient Protection and Affordable Care Act and the Health Care and education Reconciliation Act of 2010) imposes a new 3.8 percent Medicare contribution tax on the investment income of higher-income individuals. Although the tax does not take effect until 2013, it is not too soon to examine methods to lessen the impact of the tax. Certain year-end strategies might also be considered to avoid the tax, such as accelerating capital gains and other investment income into 2012 or converting a portion of your investments into tax-exempt interest.
Net investment income. Net investment income, for purposes of the new 3.8 percent Medicare tax, includes interest, dividends, annuities, royalties and rents and other gross income attributable to a passive activity. Gains from the sale of property that is not used in an active business and income from the investment of working capital are treated as investment income as well. However, the tax does not apply to nontaxable income, such as tax-exempt interest or veterans’ benefits. Further, an individual’s capital gains income will be subject to the tax. This includes gain from the sale of a principal residence, unless the gain is excluded from income under Code Sec. 121, and gains from the sale of a vacation home. However, contemplated sales made before 2013 would avoid the tax.
The tax applies to estates and trusts, on the lesser of undistributed net income or the excess of the trust/estate adjusted gross income (AGI) over the threshold amount ($11,200) for the highest tax bracket for trusts and estates, and to investment income they distribute.
Deductions. Net investment income for purposes of the new 3.8 percent tax is gross income or net gain, reduced by deductions that are “properly allocable” to the income or gain. This is a key term that the Treasury Department expects to address in guidance, and which we will update you on developments. For passively-managed real property, allocable expenses will still include depreciation and operating expenses. Indirect expenses such as tax preparation fees may also qualify.
For capital gain property, this formula puts a premium on keeping tabs on amounts that increase your property’s basis. It also puts the focus on investment expenses that may reduce net gains: interest on loans to purchase investments, investment counsel and advice, and fees to collect income. Other costs, such as brokers’ fees, may increase basis or reduce the amount realized from an investment. As such, you may want to consider avoiding installment sales with net capital gains (and interest) running past 2012.
Thresholds and impact. The tax applies to the lesser of net investment income or modified AGI above $200,000 for individuals and heads of household, $250,000 for joint filers and surviving spouses, and $125,000 for married filing separately. MAGI is AGI increased by foreign earned income otherwise excluded under Code Sec. 911; MAGI is the same as AGI for someone who does not work overseas.
The tax can have a substantial impact if you have income above the specified thresholds. Also, don’t forget that, in addition to the tax on investment income, you may also face other tax increases proposed by the Obama administration that could take effect in 2013. The top two marginal income tax rates on individuals would rise from 33 and 35 percent to 36 and 39.6 percent, respectively. The maximum tax rate on long-term capital gains would increase from 15 percent to 20 percent. Moreover, dividends, which are currently capped at the 15 percent long-term capital gain rate, would be taxed as ordinary income. Thus, the cumulative rate on capital gains would increase to 23.8 percent in 2013, and the rate on dividends would jump to as much as 43.4 percent. Moreover, the thresholds are not indexed for inflation, so a greater number of taxpayers may be affected as time elapses. Congress, together with a new administration, may step in and change these rate increases, but the possibility of rates going up for upper income taxpayers is sufficiently real that tax planning must take them into account.
Please contact our office if you would like to discuss the tax consequences to your investments of the new 3.8 percent Medicare tax on investment income.
Taxpayers who did not establish insolvency must recognize COD income
Taxpayers who settled a credit card debt for $4,412 less than they owed in 2008 had to include that amount in income because they did not prove they were insolvent under Sec. 108(a)(1)(B) at the time of the debt discharge (Shepherd, T.C. Memo. 2012-212).
Sec. 108(a)(1)(B) excludes cancellation of debt (COD) income from gross income if the debt discharge occurs while the taxpayer is insolvent. The taxpayers, Bernard and Desiree Shepherd, claimed to be insolvent in 2008 when the credit card company cancelled their debt. At issue in the case was the fair market value (FMV) at the time of the debt discharge of two pieces of real estate the Shepherds owned: their principal residence and their vacation home. In addition, the parties disagreed whether the value of Bernard Shepherd’s state pension should be included in the taxpayers’ assets when calculating the insolvency.
The valuation of these assets would determine whether the value of taxpayers’ liabilities exceeded the total value of their assets, and therefore whether they were insolvent. If the Tax Court accepted the taxpayers’ valuation of their houses and excluded the pension loan from their liabilities (and the corresponding amount of the balance in the pension from their assets), petitioners would be approximately $32,000 insolvent and therefore would not be required to include the COD income in their income for 2008.
Married Taxpayer Filing Separately Not Entitled to Full Deduction
Married Taxpayer Filing Separately Not Entitled to Full Deduction of $1.1 Million for Mortgage Interest.
A taxpayer who elects married filing separately is limited to a deduction for interest paid on $500,000 of home-acquisition indebtedness plus interest paid on $50,000 of home-equity indebtedness, the Tax Court has ruled (Bronstein v. Commissioner, Dec. 59,060, 138 TC No. 21).
The Tax Court found that the statutory language on acquisition indebtedness and home-equity indebtedness is clear on its face. A married individual filing a separate return is limited to a deduction for interest paid on $500,000 of home-acquisition indebtedness. Likewise, a married individual filing a separate return is limited to a deduction for interest paid on $50,000 of home-equity indebtedness. The taxpayer offered no evidence to override this language and have the $1 million and $100,000 limits apply to the returns of married taxpayers filing separately.
Business and Tax News
President Signs Highway/Student Loan Bill (Jul. 9, 2012).
President Obama on July 6 signed the Moving Ahead for Progress in the 21st Century Act (MAP-21) (HR 4348 ), which raises $20.4 billion in revenue and reauthorizes the fuel and ticket excise taxes that support the Highway Trust Fund through the end of fiscal year 2014. The bill raises $9.4 billion by stabilizing interest rates for pension funds and about $9.8 billion from changes to single-employer pension plans.
Obama Plugs Extension of Middle-Class Tax Cuts.
President Obama on July 9 reiterated his call for a one-year extension of the Bush-era tax cuts for those earning under $250,000 per year, but it does not appear likely that Republicans will go along as they continue to insist on a one-year extension for all taxpayers, including the wealthy. No one should see an income tax hike next year—not families, not small businesses and other job creators.
White House Renews Call to Increase Enhanced Small Business Expensing After 2012 (Jul. 12, 2012).
The White House renewed its support for enhanced Code Sec. 179 expensing on July 11. Senior Obama administration officials announced the proposal and related initiatives for small businesses during a conference call with reporters. Under current law, the Code Sec. 179 dollar limit for tax years beginning in 2012 is $139,000 and the investment limitation is $560,000.