By Dave Owens, CPA
Republished with Permission
As someone that has been in the tax business for over twenty years, I cannot ever remember seeing any predicament like the tax code is in now. Most people do not realize but I believe there will be major tax legislation sometime in 2010. There has to be. Because of the current stalemate in Congress, there are several problems in the tax code that need to be extended, corrected, or repealed. I don’t want to debate or argue fairness on any proposals. My experience has taught me there is no right answer but there is an opinion.
Back in the early 2000s, then President Bush passed a massive tax bill that was phased in over the decade. What most people don’t realize is that most of the tax changes expire on December 31, 2010. While fundamentally the tax system does not changes, many tax rates, credits and deduction will phase out unless extended. You can look at the glass half full or half empty but there many in Congress that are glad these tax provisions will go away, if for no other reason than to start reducing our federal deficit.
For example, The estate tax is a major controversy because the parties could not agree on a solution. Effective January 1, 2010 there is no estate tax but on January 1, 2011 it comes back with a vengeance. The estate tax provision of the tax code is one of the largest. Interesting how it is allowed to go away and then come back with reduced exemptions and higher rates. Only in America I guess? Many in Congress said for years that they would fix the estate tax, but January 1 came and went with no correction.
Capital Gains tax is interesting and will definitely be one of the most hotly debated taxes. The current capital gain law will expire on December 31, 2010. Short term laws will not change and long term capital gains will go up to 28% if there are no new law changes in Congress. Let me tell you the current law and what is being proposed. The short term capital gain rates are based on your current income tax rates. Long term capital gains rates are taxed at 15%. This means any investments sold that are held less than one year will be taxed according to your ordinary income rates. If you are in the 20% bracket and you sell some gains on short term real estate, the gain would be taxed at 20%.
Capital Losses have restrictions on them. I have seen no proposals to change how capital losses are treated after December 31, 2010. Currently capital losses are limited to a $3,000 write off per year until the losses are used up. For example if you lost $18,000 on General Motor Stock and assuming you had no other gains, you would only be allowed to write off $3,000 for 6 years until the losses are used up.
You can net capital gains against capital losses. So going back to my previous example, if I also had long term gains on say Google of $20,000, I could apply the gains against the GM loss and I would pay tax on the $2,000 net gain.
There is one caveat with netting gains and losses. Short term gains must be netted against short term losses first and long term gains must be netted against long term losses. For the best tax result, it is not advised to net short term losses against long term gains because the short term is taxed at ordinary income rates which are higher. So don’t waste a higher deduction (ST Loss) against a lower tax rate (LT Gain). It is best to sell short term gains and net with short term losses. While mathematically this works out fine, don’t ask for the logic behind it. The one thing I have learned there is no logic in many parts of the tax code.
The big question at year end is what is going to happen to long term capital gains. Currently, if you hold an asset more than one year, it is taxed at 15% on the appreciation. Remember at year end the rate is going to go to 28% if the law is not amended.
I have heard many proposals being tossed around on long term capital gains. During the campaign candidate Obama pledged to raise all capital gains, now that he is President he is taking a softer approach. His current proposal will leave capital gains at 15 or 20% on taxpayers that have gross income under $200,000. Taxpayers with gross income greater than $200,000 will have their rate go up to either 25% or 28%, which will be phased up from $200,000 to $250,000. No one said this would be uncomplicated.
There is a thorn on this bush that must be addressed with capital gains. Currently, ordinary dividends from corporate stocks are taxed at the capital gain rates of 15%. The reason dividends get lower tax rates is because income from Corporations is taxed at very high rates with no deduction for dividend pay outs. So when dividends are paid it is technically double taxation. So President Bush and Congress enacted these special rates to lessen the blow. Before the law change, if you were a high income taxpayer, and received corporate dividends, the corporation probably paid 35% tax and then you as a taxpayer paid another 35% on the corporation gains. That is 70% tax on corporate earnings so the rate was lowered to 15% so now the max a corporation and the shareholder would pay is 50%. Congress is hesitant to change this rate because the majority of dividends go to retirees. So the rate on Dividends should stay at 15%
The final unknown is depreciation recapture tax or Section 1250 tax. Most taxpayers are totally unaware of depreciation recapture tax. Capital Gains tax is on appreciation, so if you buy a rental house and sell it for a $10,000 gain from the purchase price, the appreciation is taxed at 15% today in 2010. What many taxpayers do not realize is that any depreciation I wrote off when I owned the house is taxed at 25% when I sell. For example, let’s assume I bought the rental house for $100,000 about 10 years ago. During the last 10 years I wrote of approximately $20,000 of depreciation. Now that it is time to sell, the depreciation is taxed at 25%(20,000 * 25%) and appreciation is taxed at 15% (10,000 gain * 15%) so my effective tax rate is blended and not a flat 15%. Real estate investors should calculate all gains before selling. I have seen no proposal eliminating depreciation recapture tax.
Sometime this year Congress will have to address these upcoming tax laws that are expiring. The deficit will be a burden and will have to be confronted; the tax code is the first place to go. What will happen to capital gains taxes? As always, the truth lies somewhere in the middle.
Dave Owens, CPA, CES is the Managing Member of Entrust Freedom, LLC a company that specializes in Self-Directed IRAs and 1031 Exchanges. Dave can be reached at 239-333-1031 or firstname.lastname@example.org