1031 Exchanges Offer Full Deferral of the New 3.8 percent Medicare Surtax and 20 percent Capital Gain Tax
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 federal tax bracket face an additional 3.8 percent surtax on passive investment income like capital gains, interest and dividends. 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 long term capital gain tax rate has been increased to 20 percent (up from 15 percent) for single filers with incomes above $400,000, and for married couples filing jointly with taxable incomes exceeding $450,000. In addition, the new IRC Section 1411 3.8 percent Medicare surtax on net investment income, which includes capital gains, interest and dividends results in an overall rate for higher-income taxpayers of 23.8 percent – up nearly 58 percent from 2012 tax rates!
Four Steps Involved in Determining Capital Gain Taxation
Absent the tax deferral benefits of a 1031 exchange, here are the four ways investors can be taxed on the sale of an investment property:
- Depreciation Recapture: Investors will be taxed at a rate of 25 percent on all depreciation recapture.
- Federal Capital Gain Taxes: Investors owe federal capital gain taxes on the remaining economic gain, depending upon their taxable income. Since a new higher capital gain tax rate of 20 percent for higher-income individuals has been added to the tax code, investors exceeding the $400,000 taxable income threshold for single filers and married couples filing jointly with over $450,000 in taxable income will be subject to the new higher tax rate. The previous federal capital gain tax rate of 15 percent remains for investors below these threshold income amounts.
- New Medicare Surtax Pursuant to IRC Section 1411: The Health Care and Education Reconciliation Act of 2010 added a new 3.8 percent Medicare Surtax on “net investment income.” This 3.8 percent Medicare Surtax applies to investors with “net investment income” who exceed threshold taxable income of $200,000 for single filers and $250,000 for married couples filing jointly. Pursuant to IRC Section 1411, “net investment income” includes interest, dividends, capital gains, retirement income and income from partnerships (as well as other forms of “unearned income”).
- State Taxes: Investors must also take into account the applicable state tax, if any, to determine their total tax owed. Some states have no state taxes at all, while other states, like California, have a 13.3 percent top tax rate.
Snapshot of 2013 Federal Long Term Capital Gain Tax Rates
|Single Taxpayer||Married Filing Jointly||Capital Gain Tax Rate||Section 1411 Medicare Surtax*||Combined Tax Rate|
|$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%|
* 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 Percent 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 tax increases, one aspect of the tax code provides real estate investors with a significant and material 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.