The familiar adage, “It’s not how much you make, but how much you keep” rings truer than ever for real estate investors in 2013. Not only have capital gain taxes increased significantly for high earners, but many investors below the top tax bracket face an additional 3.8% surtax on passive investment income like capital gains. Fortunately, IRC Section 1031, a provision which has been in the tax code since 1921, provides critically needed tax relief.
Under the American Taxpayer Relief Act of 2012, the top capital gain tax rate has been permanently increased to 20% (up from 15%) for single filers with incomes above $400,000 and married couples filing jointly with incomes exceeding $450,000. In addition, the new IRC Section 1411 3.8% Medicare surtax on net investment income, which includes capital gains, results in an overall rate for higher-income taxpayers of 23.8% — a significant 58% increase from 2012 tax rates!
Four Steps Involved in Determining Capital Gain Taxation
Snapshot of 2013 Federal Capital Gain Tax Rates
Single Taxpayer | Married Filing Jointly | Capital Gain Claim up to $26,000 per W2 Employee
| Section 1411 | Combined |
$0 – $36,250 | $0 – $72,500 | 0% | 0% | 0% |
$36,250 – $200,000 | $72,500 – $250,000 | 15% | 0% | 15% |
$200,000 – $400,000 | $250,000 – $450,000 | 15% | 3.8% | 18.8% |
$400,001+ | $450,001+ | 20% | 3.8% | 23.8% |
* The 3.8% Medicare surtax only applies to “net investment income” as defined in IRC Section 1411.
1031 Exchanges Help Investors Defer the New 3.8% Medicare Surtax
Under recently proposed regulations, REG-130507-11, taxpayers have received proposed guidance from the IRS that notes: “to the extent gain from a like-kind exchange is not recognized for income tax purposes under Section 1031, it is not recognized for purposes of determining net investment income under Section 1411.” [§1.1411-5(C)(i)(2)(ii)]. Although these regulations are not yet finalized, taxpayers may rely on the proposed regulations to be in compliance with Section 1411 until the effective date of the final regulations.
Despite these new tax increases, one aspect of the tax code provides real estate investors with a huge tax advantage. Section 1031 allows property owners holding property for investment purposes to defer taxes that would otherwise be recognized upon the sale of investment property. Savvy investors use 1031 exchanges to redeploy their investment capital into better performing investment properties. An exchange provides a fantastic opportunity for investment property owners to defer all capital gain taxes that would otherwise be owed.
This information is not intended to replace qualified legal and/or tax advisors. Every taxpayer should review their specific transaction with their own legal and/or tax counsel.
