Kevin Koval, CPA, ABV, CFP and Roger C. Nagel, CPA, CMA of Nagel, CPAs*

With the completion of the presidential elections there has been much discussion focused on the so-called “fiscal cliff”. Many economic forecasts have stated that President Obama and Congress need to reach some agreement to avoid the fiscal cliff if the nation is to avoid another recession.  As you probably know, the Bush tax cuts are set to expire at the end of 2012 and there are many other tax changes set to take place in 2013, such as the implementation of the taxes from the Obamacare healthcare plan. Given the disagreements between the President and Congress, it is difficult to predict what will happen to all of the tax cuts that are set to expire at year-end and what the outcome will be.  Year-end tax planning is always a challenge, but many long-time tax practitioners have noted that this could be the most challenging environment that they have faced.

Whatever the outcome of the any agreements between Congress and the President, it is likely that at least some taxes will be increasing and it is almost certain that dividend and capital gains tax rates will not be going down in 2013.  Maximum long-term capital gains rates are set to increase, generally, from the current rate of 15% to 20%. Dividends will be taxed at ordinary income rates instead of the current capital gains rate of 15% in most cases.  The top marginal rate will increase from 35% to the “pre Bush rate” of 39.6% and the rates for other income brackets would increase as well. Regardless of the outcome of any agreements reached between the President and Congress regarding the expiring Bush tax rates, taxes on investment income will rise next year by at least 3.8 percent on taxpayers with higher investment income due to the funding provisions in the President’s healthcare plan. Beginning in 2013, an additional Medicare hospital insurance tax will apply to wages or self-employment of married individuals with earnings exceeding $250,000 or single individuals with earnings greater than $200.000.  There will also be a new 3.8% net investment income tax for individuals exceeding these same income thresholds.  If Congress and the President do not make changes, the combined effect could result in an average tax hike of around $3,500 per household for up to 90% of Americans, and much higher rate for upper-income taxpayers.

It is reasonably likely that rates will be going up for investors, small business owners, and high income individuals, traditional tax planning strategies to defer revenue and taxes may not be applicable this year.  Taxpayers should consider an approach that involves addressing many of the possible changes directly while also making use of all options for deductions and credits, or other tax-advantaged opportunities to lower their taxable income. Planning for these changes should begin now, since it may involve significant modifications in your tax strategy.

Since most advisors are confident that capital gains rates and rates on investment income will be higher next year, taxpayers may want to consider some of the following strategies concerning the potential for higher rates in 2013:

If your portfolio includes significant long-term capital gains, taxpayers should take advantage of the lower rates in 2012.  For upper-income taxpayers who will be facing rates of 20% (barring any changes) on capital gains and the additional 3.8% healthcare tax on investment income their top rate will rise to 23.8% versus the current capital gains rate of 15%.  It may pay to take advantage of the lower rates in 2012 by selling investments with potentially big profits.

While advisors often recommend that taxpayers offset their capital gains by selling investments with capital losses, it may be beneficial to hold off incurring losses to offset against potential gains in the following year that will be taxed at higher rates.

Consider various strategies to accelerate ordinary income into 2012. If you have flexibility on when you can receive payments of income before year end, consider that the income may be subject to lower taxes this year than in 2013. Again, this is counter to tax strategies that are often employed to defer taxable income. Similarly, taxpayers would normally look to increase deductions before year end; it could be beneficial to defer expenses such as charitable deductions until the following year when tax rates will likely be higher.

Another option may be to convert a traditional IRA to a Roth IRA this year, if a conversion otherwise makes sense.

You may want to move dividend paying equity investments into tax deferred or federally non-taxable investments like municipal bonds.

Many taxpayers are accelerating gifts under the current $5 million ceiling on lifetime giving. Not only is there a good chance that estate tax rates will rise (the scheduled Sunset provision is for rates to revert to 55%) but the exclusion amount for estates and gifts will revert to $1 million.

Some other acceleration strategies include exercising stock options, taking bonuses, foregoing 1031 elections, and electing out of installment sales.

The alternative minimum tax (AMT) will apply to 2012 income for many more Americans if not indexed for inflation. At the end of 2011, the AMT exemption was $74,450 for married taxpayers and $48,450 for singles. In 2012, the AMT exemption is $45,000 for joint filers and $33,750 for single filers. In making their estimated payments, taxpayers will need to consider that for 2012 they could be exposed to a higher AMT tax if Congress does not revise the exemption amount.  Additional care will need to be taken to help avoid potential AMT taxes.

Business owners will want to look at accelerating taxable income, but they will also need to evaluate the fact that the Section 179 deduction can be significantly reduced in 2013.  Under Section 179 of the tax code, small businesses can deduct the total cost of some qualifying property in the year it is placed in service, within certain limits, rather than depreciating it over time. The limit on the cost of property (including real property) that can be expensed is now $139,000 which will drop to $25,000 if no changes are made. The total value of the equipment purchased cannot be higher than $560,000. In 2010 and 2011, businesses were allowed to expense as much as $500,000 in equipment and property on one year’s tax return. Additionally, bonus depreciation which was 100% in 2010 and 50% in 2012 is set to expire in 2013.

Business owners need to evaluate the potential for immediate write-offs and 50% bonus depreciation for capital purchases made in 2012 versus being stuck with the longer term depreciation MACRS depreciation schedules for purchases made in 2013. It may pay to make planned purchases of equipment in the current year. On the other hand, faced with higher tax rates business may not want to elect Section 179 or bonus depreciation treatment to preserve more deductions for future years when the rates are scheduled to be higher at least for individual owners operating as Schedule C or as pass through entities.

Like so much in life, we can only plan ahead, confidently, based on what we know to be fact.  Today, we know that tax laws will change back to “pre-Bush tax cuts” on January 1, 2013.  Of course, Congress and the President can intervene, before year end, or even afterwards (and make new rules retroactive.)  This unprecedented level of uncertainty makes good decision making difficult. Consequently, seek tax advice about your specific circumstances.  If you have large, pending transactions, the timing of which you can control easily, then this is a good year to engage your advisors soon to harvest sizeable benefits.

*Kevin Koval, CPA, ABV, CFP and Roger C. Nagel, CPA, CMA of Nagel, CPAs. They can be reached at 505-898-2558 or email pchadwick@nagelcpa.us. They are located at 2240 Grande Blvd SE Suite 103, Rio Rancho, NM 87124.

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