Impending Increases and Tax Breaks - What Real Estate Investors Need to Know

It is difficult to remember a time when there was more uncertainty about taxes than the present.  Although no one knows what the end result will be, it is a good idea to understand what may be on the horizon for next year.  These are the most important issues for most real estate investors:

1)       Expiration of the 15% Long-Term Capital Gains Rate

In 2003, President Bush lowered the maximum long-term capital gains rate from 20% to 15%.  This reduction was originally due to expire at the end of 2008, however it was further extended through 2010.  On January 1, 2011, if Congress does nothing, this rate will automatically return to 20%.  Congress is currently considering a variety of options relating to the future rates.  Whether Congress lets the tax break expire, extends the tax break for everyone, or extends it only for people who are not “high income” taxpayers, has not yet been determined. 

2)       The Return of the Estate Tax

In 2010, there has been no estate tax and no full step-up in basis when property passes on to an heir.  If Congress takes no action, starting in 2011 the estate tax is scheduled to return to 55% with an exemption amount of $1,000,000, and the step up in basis will return.    

3)       Proposed Income Tax Increases

Under current law, nearly all of the 2001 and 2003 tax cuts expire in 2011, returning the individual income tax to its pre-2001 level.  President Obama recently announced a tentative agreement to extend the tax cuts for all taxpayers another two years, but as of the date this article was written, legislation has not been enacted. 

4)       Private Transfer Fees

Also known as capital recovery fees, private transfer fees have been around for a few years.  These fees allow a developer to receive a percentage of the sale proceeds every time a property is sold for up to 99 years.  There are competing bills in Congress which either approve or disapprove this practice.  Proponents argue that allowing a developer to receive a percentage of the sales price for up to 99 years results in a lower original sales price to the consumer, ultimately lowering all costs associated with the purchase of the property.  Opponents say that this fee strips homeowners of their equity when they sell property and that homeowners are often not made aware of the fee.

5)       3.8% Medicare Tax

As part of The Health Care and Education Affordability Reconciliation Act of 2010 (HR 3200), a tax on “unearned income” was implemented, but it won’t take effect until 2013.  This tax applies to both the gain from the sale of property and income from passive investments, including in many cases income from rent.  It is limited to so-called “high-earners,” defined as married couples making over $250,000 per year and individuals making over $200,000 per year.  If you fall within any of these categories and you are selling an investment property, the additional 3.8% tax will apply to the profit on the sale and will be added on to the capital gains tax that would otherwise be due.   

If you are selling your primary residence and are entitled to the exclusion under IRC Section 121 (meaning you have owned and lived in the property for 2 of the last 5 years), you will only need to pay the 3.8% tax to the extent you have gain in excess of $250,000 ($500,000 for married couples filing jointly).  

6)       Carried Interest

What is "carried interest" and how does it affect the real estate industry?  It is common for real estate investors and developers to form partnerships where the general partner is paid an incentive known as carried interest.  Carried interest is currently taxed at the capital gains tax rate.  Congress is attempting to change this so that for two years, 50% of these profits would be taxed at ordinary income rates and 50% at long term capital gains rates.  After the two years, it could increase to 75% at ordinary income tax rates and 25% at long term capital gain rates.   This proposal was dropped due to lack of votes, but many real estate professionals expect the idea to resurface. 

7)       State Capital Gains Taxes and the 1031 Exchange

Forty-one states have a capital gains tax on the state level, but in all states except Pennsylvania, you can defer the state tax in a 1031 exchange.  If you trade into property out of the state in which the relinquished property is located, some states take the position that, when you sell the out-of-state replacement property, you have to go back to the original state where the first sale occurred and pay the deferred tax at that time.  These “clawback” provisions vary by state and it is important to maintain accurate records and consult with your tax advisor regarding whether this applies to you.

8)       Tax Cuts due to Expire

There are many less publicized tax cuts and credits that are due to expire at the end of 2010.  Some of them are:

Child Credit: The current $1000 exemption per child will be reduced back to $500 per child.

Return of the “Marriage Penalty”: The current standard deduction for married couples will decrease.

Making Work Pay Credit:  In tax years 2009 and 2010, the Making Work Pay credit provided a refundable tax credit of up to $400 for individuals and up to $800 for married taxpayers filing joint returns.  For people who receive a paycheck and are subject to withholding, the credit was typically handled by the employer through automated withholding changes which resulted in an increase in take home pay. 

American Opportunity Credit – Under the American Recovery and Reinvestment Act (ARRA), this credit modified the existing Hope Credit for tax years 2009 and 2010, providing this credit to a broader range of taxpayers.  The credit relates to certain qualifying education expenses.  The existing maximum annual credit is $2,500 per student. 

The next few months should provide some clarification on many of these tax issues. Be sure you are signed up to follow First American Exchange on Facebook and Twitter, as we will be sending out new information as it becomes available.