Did you pay the new 0.9% Medicare Surtax and 3.8% Net Investment – How did that go?

Well as you know now, 2013 was the first year the new 0.9% Medicare surtax and the new 3.8% tax on net investment income.

OK, let’s get in to detail.

The  income that is subject to tax under these new provisions is different, but  there is an overlap in the definition of taxpayers subject to these new taxes. The 3.8% tax on net investment income applies to unincorporated taxpayers (basically individuals, estates, and certain trusts) who have modified adjusted gross income (“MAGI”) in excess of certain threshold amounts: $250,000 in the case of married taxpayers filing a joint return or a surviving spouse; $125,000 in the case of a married taxpayer filing separately; and $200,000 for everyone else except estates and trusts, where the threshold is equal to the highest amount at which the maximum tax rate begins (projected to be $12,150 in 2014). The 0.9% Additional Medicare Tax applies to individuals at the same threshold amounts, but does not apply to estates or trusts. Neither of these new taxes applies to individuals who are treated as non-resident aliens for U.S. income tax purposes. Let’s review each of these new taxes separately.

3.8% Tax on Net Investment Income

Tax planning is the key to understanding your liability to this tax on net investment income. This tax applies  to net investment income of taxpayers to the extent their net investment income and their MAGI, including their net investment income, is in excess of the threshold amounts mentioned earlier.  “Net investment income;” basically includes most dividends, interest, annuities, royalties, rents and the taxable portion of gains from the sale of property. Gains or losses from the disposition of partnership or S Corp interests are generally not subject to this tax, except to the extent the pass-thru entity would have generated gain or loss if it had sold all of its assets immediately before the sale of the pass-thru interest (the deemed sale rule). To the extent that rents and other income are treated as non-passive investment income, they are not treated as net investment income subject to the 3.8% surtax. Qualified plan distributions and any income items subject to self-employment tax are not treated as net investment income subject to this surtax.

Effective tax planning relating to this tax focuses on: 1) changing investment portfolios so that income generated will not be subject to tax (e.g., tax exempt bond interest, growth stocks instead of dividend paying stocks, annuities which will defer income until later years when the taxpayer will in a lower tax bracket), 2) maximizing deductions (e.g., depreciation, investment expenses, and other properly allocable deductions) that will reduce income otherwise subject to the tax, and/or 3) reorganizing or regrouping rental activities.

Additional 0.9% Medicare Tax

The additional 0.9% Medicare tax on wages and self-employment income is applicable only to income in excess of the threshold amounts discussed above. The threshold and the amount of income subject to tax is based on the combined income of a husband and wife on a joint return. So, even if each is under the threshold amount individually, the couple will be subject to the tax to the extent their combined incomes exceed the threshold. In addition, in the case of wages paid to an employee, the surtax applies only to the employee’s share of the employment tax. Therefore, a single taxpayer with a salary of $300,000 would pay Medicare tax at a rate of 1.45% on the first $200,000 of salary received, but 2.35% on the $100,000 of salary received in excess of the $200,000.

Employers are required to withhold additional Medicare tax on wages in excess of $200,000 in a calendar year, without regard to the employee’s filing status or income from other sources. If an employer withholds the Additional Medicare Tax and no Additional Medicare Tax is due – for example, in the case of a married taxpayer who is under the $250,000 married filing jointly threshold but has wages in excess of $200,000 – the employer must withhold the tax and the employee will claim a credit for the withheld taxes on his or her income tax return for the year. If no tax is withheld – for example, if a husband and wife are each paid under $200,000 for the year, but their combined income exceeds the threshold amount – they should either request additional withholding or cover their additional liability for this tax by paying estimated tax.

A self-employed person will pay self-employment tax at a rate of 2.9% on self-employment income up to the threshold amount and 3.8% on income in excess of the threshold. These amounts are reduced, but not below zero, by the amount of FICA wages taken into account in determining the Additional Medicare Tax.

Self-employed individuals, as well as salaried employees, need to take both of these new taxes into account when determining estimated taxes.

Hope this helped.  Contact us if you need more information.

So your wondering if you should make that gift!

The gift tax only kicks in after lifetime gifts exceed $5.34 million in 2014

The first thing to know about the federal gift tax is that gift givers—not gift recipients—have to pay it. Thankfully, you won’t owe the tax until you’ve given away more than $1 million in cash or other assets during your lifetime. The lifetime exclusion will be raised to $5.34 million starting in 2014. If you’re married, your spouse is entitled to a separate $5.34 million in 2014. So actually owing the gift tax is not a concern for most folks. But you may still have to file gift tax returns even though you don’t owe any tax. So please keep reading.

The annual gift tax exclusion provides additional shelter

The annual federal gift tax exclusion allows you to give away up to $14,000 in 2014 to as many people as you wish without those gifts counting against your $5 million lifetime exemption. 

Say you give two favored relatives $20,000 each in 2014 and give another relative $10,000. The $20,000 gifts are called taxable gifts because they exceed the $14,000 annual exclusion. But you won’t actually owe any gift tax unless you’ve exhausted your lifetime exemption amount. Assuming you haven’t, the two taxable gifts simply reduce your lifetime exemption by $12,000 [($20,000 - $14,000) x 2 = $12,000]. The $10,000 gift is ignored, because it’s below the $14,000 annual exclusion.

If you give three individuals $14,000 each in 2014, these gifts are ignored because they don’t exceed the annual exclusion.

Gift taxes and estate taxes are connected

You have a $5.34 million federal estate tax exemption for 2014, thanks to the 2010 Tax Relief Act signed into law recently by President Obama. You can leave up to that amount to relatives or friends free of any federal estate tax. If you’re married, your spouse is entitled to a separate $5.25 million exemption. Beginning in 2011, the gift tax and the estate tax was reunified with an exclusion amount of $5.34 million for 2014.

Gifts made during your lifetime will reduce your taxable estate. However, gifts in excess of the annual exclusion also reduce your estate tax exemption. In the earlier example, the two $20,000 taxable gifts made in 2014 would reduce your estate tax exemption by $12,000 to $5,328,000 ($5,340,000- $12,000), based on the recently enacted changes in estate law. The $10,000 gift in 2014 and the three $14,000 gifts in 2014 would not reduce your estate tax exemption.

Some gifts are tax-exempt

Among others, the following types of gifts are exempt from the federal gift tax so you can make unlimited gifts in these categories without any gift tax or estate tax consequences and without having to file gift tax returns:

·         Gifts to IRS-approved charities

·         Gifts to your spouse (assuming he or she is a U.S. citizen)

·         Gifts covering another person’s medical expenses, as long as you make the payments directly to medical service providers

·         Gifts covering another person’s tuition expenses, as long as you make payments directly to the educational institution. (Payments for room and board, books, and supplies don’t qualify for this exception, but you can cover those costs by making a direct gift to the student under the annual exclusion.)

You many need to file a gift tax return

If you make a taxable gift (one in excess of the annual exclusion), you must file Form 709: U.S. Gift (and Generation-Skipping Transfer) Tax Return. The return is required even if you don’t actually owe any gift tax because of the $5.34 million lifetime exemption. The return is due by April 15 of the year after you make the gift—the same deadline as Form 1040. If you extend your 1040 to October 15, the extended due date applies to your gift tax return too.

If you’re married, you can’t file a joint gift tax return. Each spouse must file a separate return if he or she makes any taxable gifts. You can, however, choose to “split” gifts with your spouse. Making a split gift allows you to take advantage of your annual gift tax exclusion plus your spouse’s exclusion for a gift that is made entirely by you.

For example, say you gave $28,000 to your child in 2014. By treating it as a split gift, you can completely shelter the gift with your $14,000 exclusion plus your spouse’s $14,000 exclusion. That way no gift tax is due, and the gift doesn't reduce the $5.34 million lifetime gift tax exemption in effect for 2014 or the estate tax exemption for you or your spouse. If you choose to make a split gift, you must file Form 709, and your spouse must consent to the arrangement.

A bigger story

This article only covers the basics of federal gift taxes. For more information, see IRS Publication 950: Introduction to Estate and Gift Taxes. See also the instructions for Form 709. You can find these documents on the IRS website at www.irs.gov.

What taxes will I pay if I sell my rental property that I also used as my principal residence?

If you have a rental unit that has a substantial amount of equity you may be able to take advantage of the Home Sale Exclusion if you lived in the house at any time before it is sold.

However, before you move ahead there are a number of tax consequences that you need to be aware of.

Limits on Home Sale Exclusion

You have heard of the tax law that allows owners a $250,000/$500,000 home sale exclusion on any gain that is made. This rule permits single homeowners to exclude from their taxable income up to $250,000 in profit realized from the sale of a personal residence. The exclusion is $500,000 for married couples filing jointly. There is no limitation on how many times the exclusion may be used during your lifetime. Generally, you can use the exclusion every two years.

To qualify for the home sale exclusion, you must own and occupy the home as your principal residence for at least two years before you sell it. Your two years of ownership and use can occur anytime during the five years before you sell—and you don’t have to be living in the home when you sell it.

However, a special rule enacted in 2009 limits the $250,000/$500,000 exclusion for homeowners who initially use their home for purposes other than their principal residence, such as a rental or vacation home. The rule requires you to reduce pro rata the amount of profit you exclude from your income based on the number of years (the IRS worksheet calculation actually uses the number of days) after 2008 you used the home as a rental, vacation home, or other “nonqualifying use.”

Example: John buys a home on January 1, 2009 for $400,000, and uses it as rental property for two years. On January 1, 2011, he evicts his tenants and moves into the house, thereby converting it to her principal residence. On January 1, 2013, he moves out and rents it again. He then sells the property for $700,000 on January 1, 2014. He has a $300,000 gain (profit) on the sale. John owned the house for a total of five years and used it as a rental property for two years before he converted it to her residence. Thus, two of the five years (40%) before the sale were a nonqualifying use, so 40% of his $300,000 gain ($120,000) does not qualify for the exclusion. This means that he must add $120,000 to her gross income for the year. His remaining gain of $180,000 is less than the $250,000 exclusion, so it is excluded from his gross income.

A nonqualified use can occur only before the home was used as the taxpayer’s principal residence. Time periods after the home was used as the principal residence do not constitute a nonqualified use. This is why John’s nonqualifying use during 2013 does not reduce her exclusion.

Recapture of Depreciation Deductions

Converting a rental into your residence will not eliminate all taxes when you sell it. While the home was a rental, you should have claimed a depreciation deduction for it each year. The total amount of depreciation you claimed during the rental period is not eligible for the exclusion. Instead, you must "recapture" all your depreciation deductions--that is report them on Form 1040 Schedule D and pay a flat 25% tax on these deductions. This can have a significant tax impact. In the example above, if John had taken $10,000 in depreciation deductions during the time he rented out the home, he would have to pay a deprecation recapture tax of $2,500 (25% x $10,000 = $2,500).

Ownership Taxes and Deductions

Once you occupy the home as your personal residence, you will no longer be able to take any of the deductions you took when the property was a rental. This means you will get no depreciation deduction and you can't deduct the cost of repairs. However, you will be entitled to the deductions provided to homeowners--that is, you may deduct a personal itemized deduction on Form 1040 Schedule A  the amount of your mortgage interest, mortgage insurance premiums, and even property taxes. The expenses must be prorated for the time the home was not considered a rental property.