The acceleration of income for tax purposes has not traditionally been a top-shelf strategy because of the simple fact that the delay of taxable income means the postponement of tax into a subsequent year, which is usually a good thing based upon time-value-of-money principles. The same reasoning applies to postponing deductions.
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With the current uncertainties over the tax laws in 2013, however, some taxpayers are trading in the time-value-of-money principle in favor of a bird-in-hand. Rising income tax and capital gains rates, as well as new "Medicare taxes" for 2013, are persuading more advisors to take a closer look at techniques to accelerate income into 2012.
The tax law itself sometimes puts restrictions on the recognition of income. At other times, certain facts and circumstances must be present to have a transaction considered complete and income recognized in the current year. Broadly speaking, however, taxpayers who anticipate a higher income tax rate after 2012 should explore shifting income into 2012 and pushing deductions into 2013 and beyond.
MEASURING TYPES OF INCOME
A taxpayer can have net losses and still have taxable income. This apparent contradiction arises from the fact that not all income is treated equally. Certain types of losses can only be netted against certain income, so delay tactics in moving a deduction into the subsequent year may not increase income at all if the deduction is allowed only against certain income. The most common losses in these categories are capital losses and passive activity losses. A third type, investment income expenses, also becomes relevant in 2013 in figuring the new 3.8 percent Medicare surtax on net investment income.
• Capital gains and losses. Capital gain net income is the excess of all gains from the sale or exchange of capital assets over all losses from the sale or exchange of capital assets arising during the tax year. Net capital losses are only deductible to the extent of $3,000 against ordinary income. The remainder must be carried forward.
Capital assets yield short-term gains or losses if the holding period is one year or less, and long-term gains or losses if the holding period exceeds one year, so that care must be taken in timing a sale. The excess of net long-term gains over net short-term losses is net capital gain. While short-term capital gains are taxed at ordinary rates, net capital gains of noncorporate taxpayers, as adjusted for certain types of long-term gains (adjusted net capital gain), are eligible for lower maximum tax rates than ordinary income.
Depending upon the appreciation locked into a current portfolio, strategies should be considered to either accelerate long-term capital gains, which has the certainty of being taxed at the Bush-era 15 percent maximum, or increase carryover losses into potentially higher-rate years after 2012. In C corporations, declaring special dividends to be distributed before 2013 may prove even more fruitful, if top rates on dividends rise from 15 percent to 43.4 percent (39.6 percent plus the 3.8 percent Medicare surtax).
• Passive income and losses. Individuals, trusts, estates, personal service corporations and closely held C corporations may only deduct passive activity losses from passive activity income. The reciprocal, however, may not always be the case: Net passive activity income is lumped into a taxpayer's gross income and is taxed at regular income tax rates to the extent that it is not reduced by deductions in arriving at adjusted gross income or taxable income. Nevertheless, ordinary losses or capital losses are not deductible from passive activity income. While holding a capital asset for investment may be passive in the sense of requiring no active participation on the investor's part, it is not considered passive income for the passive activity rules and, therefore, net capital losses may not reduce passive activity income (except to the extent of the $3,000 used to offset any other form of ordinary income, $1,500 for marrieds filing separately).
A passive activity is a trade or business activity in which the taxpayer does not materially participate. Rental activity is a passive activity without regard to the taxpayer's material participation, except for real estate professionals, and certain taxpayers primarily providing services and short-term rentals. Remaining passive activity deductions are deductible against nonpassive income only when the taxpayer disposes of the passive activity.
• 3.8 percent net investment income surtax. For tax years beginning after Dec. 31, 2012, a 3.8 percent Medicare contribution tax is imposed on the lesser of an individual's net investment income for the tax year or the excess of modified adjusted gross income for the tax year over $200,000 ($250,000 for joint filers and surviving spouses and $125,000 for married taxpayers filing separately).
"Net investment income" as defined under Code Section 1411(c) means the excess (if any) of the sum of gross income from interest, dividends, annuities, royalties and rents; income derived from passive activities; and net capital gain derived from the disposition of property, over the deductions allowed and properly allocable to such gross income or net gain.
Tax-exempt income is not a component of net investment income. Gain from the sale of a residence is also excluded from net investment income, but only to the extent exempt under the Code Sec. 121 exclusion up to the $250,000/$500,000 maximum, as applicable. Those fortunate homeowners with excess gains may want to accelerate any plans for moving into 2012 if the numbers add up and a closing can be done in time.
Non-investment income such as wages, Social Security payments or IRA and other qualified plan distributions also may have a bearing on payment of the surtax, since they can increase MAGI, which determines when the surtax kicks in. It should also be noted that certain forms of tax-favored income under other provisions are cut no breaks under the 3.8 percent surtax; for example, long-term capital gains are taxed at the same 3.8 percent rate as short-term capital gains.
• Roth Conversion and the 3.8 percent surtax. Net investment income for purposes of the 3.8 percent surtax does not include distributions from qualified plans or IRAs, but taxable distributions count towards the income threshold amount. A Roth conversion now in 2012 will not only ensure being taxed at the Bush-era income tax rates, but will also lower taxable income during the upcoming years in which the 3.8 percent tax is in play. (Contributing the maximum allowed to a qualified retirement plan once 2013 arrives also may prove to be a good retirement strategy two ways, first in reducing MAGI in the year of contribution and then in being exempt from the surtax when eventually distributed.)
Wash sales are sales of stock or securities in which losses are realized, but not recognized, because the seller acquires substantially identical stock or securities 30 days before or after sale. Nonrecognition, however, applies only to losses; gains are recognized in full. As a result, both a higher capital gains rate and the 3.8 percent surtax rate may be avoided by selling before year-end 2012 and then immediately re-investing. To buy back the same or substantially similar securities both in kind and amount, of course, there is the upfront cost of finding the cash elsewhere to pay the immediate tax, or lowering the amount re-invested.
While there is no wash sale rule for gains, a true sale must nevertheless take place to successfully accelerate income. Outside of the context of marketable securities, this rule prevents "basis resetting" without further substance behind it. For example, selling real estate to a straw man who then sells it back to the taxpayer does not accomplish a resetting of basis since there must be an underlying true sale to support it. A leaseback, however, would work ... unless other than a true lease is otherwise apparent. While arguments of sham transaction and economic substance are more likely raised when a loss is involved, courts have nevertheless often looked to determine whether or not the parties intended that the purchaser retain title in the property. The benefits and burdens of ownership must be transferred for a sale to occur.
Further, while a sale must be final or closed to determine gain or loss, determining what is final or closed for tax purposes is not always intuitive. Despite the general rule that a sale occurs when title to property is transferred to a buyer, a sale for tax purposes can occur before or without the transfer of title. For example, once the parties have reached a binding agreement, the transfer of possession of property to a buyer usually closes a sale for tax purposes.
In selling to reset basis, looking ahead to 2014 also requires building in the flexibility of being able to sell at long-term capital gain rates at the end of 2013 to take advantage of any Bush-era extended rates on capital gains that may not last into 2014. Long-term capital gain rates are only available to assets held for more than one year. The holding period starts the day after a capital asset is acquired and ends on the date of its disposition. The holding period of securities generally begins on the trade date if they are publicly traded or upon receipt of title if not publicly traded.