As most people are at least worrying about how much longer they can procrastinate thinking about their 2013 Tax Return (Tuesday April 15th), American taxpayers have just 11 more days to either file or extend. Many of you reading this newsletter also have to deal with many new taxes related to the American Taxpayer Relief Act of 2012 (ATRA). We outlined many of these tips, traps and additional information in our recent 2013 Tax Guide.

Today, we wanted to focus on one particular new tax that many are calling the “Obamacare Tax”. It is actually a 3.8% tax “Medicare Tax” (nothing to do with Medicare, other than helping fund Obamacare) on all “Unearned Income” (see below). This tax will not hit everyone, but it will hit taxpayers with Adjusted Gross Income (“AGI” the income number on the bottom of the first page of your tax return) above $200,000 for individuals or $250,000 for those married filing jointly. Please note that it also applies to trusts and estates at dramatically lower levels that have undistributed income of $11,950 in 2013. For this section, AGI is actually a “modified” or MAGI number, but the modification effects very few.

Now to get into the weeds for a moment to help assure you understand how the tax is calculated before we go into some possible solutions – the tax applies to you only if your income is above the AGI thresholds ($200k/$250k) and to that extent, to the lesser of:

1) Your net investment income, or;

  • Example: If you are single with an AGI of $280k that includes $20k of investment income, since the lesser of $20k and $80k is $20k, you will owe $760 in additional taxes (3.8% on $20k).

2) Excess of AGI over the threshold.

  • Example: If you are single with an AGI of $210k that includes $30k of investment income, since the lesser of $10k and $30k is $10k, you will owe $380 in additional taxes (3.8% on $10k).

So what is considered “investment income” and how does it affect the tax on that income?

If you recall, before 2012 we had several years with much lower income taxes on some types investment income (part the “Bush Tax Cuts” that only helped millionaires and billionaires, but even us mere mortals liked it). Well, for those who wanted to “repeal the Bush Tax Cuts”, their dream has come true.

Prior to 2012, the tax rates on dividends and capital gains were reduced to 15%, well those are now back a maximum 20% and up to 39.6%, respectively (these may be much lower or 0% to lower income tax payers, see “income shifting”, below). In addition to those increases, those higher earning taxpayers above the AGI limits now have to pay an additional Obamacare Tax of 3.8% (so the top tax rates on investment income have now increased to 23.8% and 43.4%). Below are some of the “Unearned (or passive) Income” items that will be affected:

  • Capital Gains (gains that occur when you buy or sell an asset such as a stock, bond or piece of real estate),
  • Dividend Income,
  • Interest Income (but only on taxable bonds, not municipal bonds…at least for now),
  • Real Estate Income/Rents (unless you can prove you were active – such as for a real estate developer…see below),
  • Annuity Distributions,
  • Royalties (such as for oil and gas interests or other intellectual property), and
  • Passive Business Income (really any business income that the IRS would say is a passive activity or “hobby” based on time spent on this or profitability).

Notable Exception: I am asked this question a lot – this tax is NOT incurred on distributions from IRAs, Pensions, 401(k)’s or other qualified retirement plans.

As you can see, this new tax affects a lot of income types and will hit a lot of you reading this letter. So the next “Ask the CPA” question tends to be “how do I avoid it?”.

Bottom line, there is no magic pill. However, there are really two ways to avoid, mitigate and/or reduce the impact, at least in some cases by:

1. Deferring, shifting or adjusting the timing of your income’s receipt (either through deferring the investment income or deferring your income and thus reducing your AGI.

2. Changing the activities from “passive” to “active” – which can be difficult.

Please note that these tax rules are technical can be an audit trap if not executed and documented very well, so anyone trying to attempt these strategies should consult their tax advisor and become very familiar with Internal Revenue Code (IRC) Section 1411 (created by the health care legislation) and the other sections listed below.

One other important point: Don’t let the “tax tails wag the dog”! Don’t hold onto a falling stock (for us Houstonian’s, Enron comes to mind) to avoid the recognition of the gain. Also, don’t get too greedy in terms of tax “creativity,” as my favorite saying goes: “Pigs get fat, but hogs get slaughtered”.

Deferring, Shifting, Mitigating or Adjusting the Timing Income:

1) Defer the investment income where possible:

  • Wait until the next tax year or later sell the stock or real estate asset
    • For real estate: consider an IRC Section 1031 exchange.
    • For real estate: consider increasing rents to “absorb” the tax impact.
  • Buy Municipal Bonds vs. Taxable Bonds
  • For stocks, “cherry pick” losses to offset capital gains (but remember the “Wash Sale Rules”)

2) Transfer the assets to lower tax bracket family members:

  • Transfer any of these income-producing assets (or even just part of them) to lower income family members (you can gift/transfer these assets directly or via certain gifting strategies such as through Family Limited Partnerships).

3) Adjusting the timing of the receipt of your other income (such as wages)

  • For those of you with their own business, look toward business deductions in certain years (or group them) to strategically reduce your income to minimize the impact of these taxes.
    • Example: As a single business owner, if your AGI is $220,000, look into the timing of the purchase of deductible business equipment for $21,000 – such as those available via IRC Section 179.
  • If you are an executive with a company that has a Deferred Compensation Plan (such as those under IRC Section 457(b)), look to defer enough of your income or bonus to keep you under those thresholds. Please note that each year you must make these elections for the next year…so you will be asked later in 2014 to make your elections for 2015 (it is too late to do it for 2014 unless you are looking establishing a new plan this year).
  • If you are in sales and receive commissions, you can consider deferring some new sales that could hit later this year to early 2015 (If you are a business owner, I know you hate to hear us say this…but your best/highest income salespeople will think about this – it is a good reason to consider a deferred compensation plan for them!).
  • Maximize your deferrals into your company 401(k), SIMPLE IRA or 403(b) plans.

For any of these ideas above it is a VERY good idea to meet with your CPA and financial advisor sooner rather than later to discuss them for 2014 (too late for 2013)

Changing Activities for Passive to Active:

This is more difficult to do, but here are two ideas:

1) If you are active in real estate (such as a landlord), see if you can change your real estate business from passive to active (such as by becoming a Real Estate Professional).

2) If you actively trade stocks, you can look into creating a trading business (and you may consider creating a limited liability company/LLC for this activity) and become Trader In Securities.

3) For other passive income, you need to look into seeing if you can “Materially Participate” to make this activity active (to avoid the 3.5% tax); however, this can be tricky if you have another full time job.

OK – so maybe this is more than you wanted to read, but perhaps it got the creative juices flowing as you sit down soon to see your CPA in the near future. One word of caution, made famous by “Hill Street Blues” in the 1980s: “…Be careful out there!”


IMPORTANT DISCLOSURES

Financial Planning and Investment Advice offered through Avidian Wealth Management (STA), a registered investment advisor.

STA does not provide tax or legal advice and the information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters or legal issues, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

As always, a copy of our current written disclosure statement discussing our services and fees continues to be available for your review upon request.

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Financial Planning and Investment Advice offered through Avidian Wealth Solutions (Avidian), a registered investment advisor. Avidian does not provide tax or legal advice and the information presented here is not specific to any individual’s circumstances. To the extent that this material concerns tax matters or legal issues, it is not intended or written to be used, and cannot be used, by a taxpayer to avoid penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

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