Capital Gains and Recapture Taxes
Tax law changes in 2013-Can a 1031 Exchange help?
You earn capital gains through buying and selling capital assets. The difference between what you paid for an investment and what you received when you sold that investment is the gain. Capital gains are taxed differently depending on what kind of capital asset you invested in and depending on how long you held the asset.
Real property is taxed as a short-term capital gain, long-term capital gain, or ordinary gain, depending on property use. Profits on real estate used as your primary residence may qualify for a capital gains exclusion of $250,000 or $500,000. If the real estate is not your primary residence, the real estate is treated as a short-term or long-term capital gain, depending on how long you have held it.
Long-term Capital Gains
Long-term capital gains, which apply to assets held for more than one year (so 366 days or more), are taxed at a lower rate than short-term gains. The reduced 15% tax rate on qualified dividends and long term capital gains, previously scheduled to expire in 2008, was extended through 2010 as a result of the Tax Reconciliation Act signed in 2006, and then further extended through 2012 on Dec 17, 2010. As a result:
· Since 2003, the rate for long-term capital gains has been 15% (lowered from 20%) for taxpayers in the 25% income tax bracket or higher.
· For taxpayers in the 10% and 15% tax brackets, the tax rate is 5% on profits earned from qualified dividends and long-term capital gains (down from 10% pre-2003). However, in 2008-2012, the 5% rate has been reduced to zero for investment purchases by individuals in the 10% and 15% income tax bracket.
· From 2008-2012, there is a long-term capital gains tax rate of 15% for taxpayers with total income in the 25% tax bracket or higher.
· After 2012, dividends will be taxed at the taxpayer's ordinary income tax rate, regardless of his or her tax bracket.
· After 2012, the long-term capital gains tax rate will be 20% (10% for taxpayers in the 15% tax bracket).
State Capital Gains
In addition to the Federal capital gains tax, capital gains will also be subject to state tax. In some states, there are no capital gains taxes (tax rate is determined by the state in which the real estate is sold). Many states do not have separate capital gains tax rates, but consider it as ordinary income subject to the state income taxes rates. It is advisable to check with one’s own tax advisor to determine the appropriate rate.
Tax on Recaptured Depreciation
If you have taken depreciation on your real estate, you may find that you have a very low tax cost basis, meaning that there are big capital gains built into your holdings. There is a special 25% tax rate associated with the Depreciation Recapture. This rate applies only to the portion of real estate that has been depreciated, and the remainder of the gain will be ordinary or long-term gains, depending on how long the property was held.
Planning Ahead for 2013
The special tax rates on long-term gains and qualified dividends will expire on December 31, 2012. Starting 2013, the tax rate on long-term gains will be 20% (or 10% if a taxpayer is in the fifteen percent tax bracket). Also starting in 2013, the distinction between ordinary and qualified dividends will disappear, and all dividends will be subject to the ordinary tax rates. Also beginning in 2013, capital gain income will be subject to an additional 3.8% Medicare tax.
Consider a 1031 Tax-Deferred Exchange, especially when coupled with the estate tax rate and depreciation recapture.