Starting in 2013, the maximum federal income-tax rate on most long-term gains from real property sales is scheduled to be 20% (up from the current 15%). However, a lower 18% maximum rate will apply to long-term gains from properties acquired after Dec. 31, 2000, and held for more than five years (up from 15%).
If you sell a rental property for a gain, a higher 25% maximum rate will apply to the amount of gain attributable to your cumulative depreciation write-offs (same as the current rate). Remember: Those depreciation write-offs can actually cause a taxable gain when a rental is sold for less than the amount you invested (because your basis in the property for gain/loss purposes is reduced by depreciation deductions).
Short-term gains from real property sales and positive operating income from rental properties (when rental income exceeds your tax write-offs, including depreciation) will be taxed at a maximum rate of 39.6% (up from 35%).
3.8% Medicare surtax
Starting in 2013, higher-income individuals may also get hit with a new 3.8% Medicare surtax on all or part of their net investment income. For purposes of this new surtax, net investment income includes gains from flipping properties, gains from selling rental properties and positive operating income from rentals -- unless you materially participate in the flipping or rental activity (more on the material participation issue later).
The good news: You won’t be hit with the surtax unless your modified adjusted gross income (MAGI) exceeds the applicable threshold, which depends on your filing status. The thresholds are as follows.
$200,000 if you use single or head-of-household filing status.
$250,000 if you are a married joint filer.
$125,000 if you use married, filing-separately status.
The amount subject to the 3.8% Medicare surtax is the lesser of (1) your net investment income or (2) the amount by which your MAGI exceeds the applicable threshold. MAGI equals regular AGI from the bottom of page 1 of Form 1040, plus certain tax-free income from foreign sources that only a few taxpayers have.
A tour through Taxmageddon territory
The following example illustrates how real-estate investors could find themselves in Taxmageddon land next year. Please bear with me on the length of the example, because you really need to understand this stuff.Meeting the material participation standard for real estate
Here’s a shred of good news: You won’t owe the 3.8% Medicare surtax on profits from selling or operating rental properties or flipping properties if you are considered to materially participate in those activities. However, it’s hard for most folks to meet the material participation standard for rentals (either you or your spouse must individually spend at least 750 hours during the year on real estate activities). It could be fairly easy to meet the standard for flips (spending 100 hours might be enough). For full details on meeting the material participation standard, see IRS Publication 925 at 47 IRS.gov.The last word
It’s possible that Taxmageddon will never happen. The Bush tax cuts could be extended and the Medicare surtax could be repealed. If so, the 2013 tax hit on real-estate investors won’t be any worse than the 2012 tax hit. The outcome probably depends on how the Nov. 6 election turns out. Stay tuned!This article was originally published By Bill Bischoff with Market Watch and the Wall Street Journal.
