If Uncle Sam allows the so-called Bush tax cuts to automatically expire at the end of this year, your tax situation next year could be dramatically different. Here's a quick primer on what could happen from the Stambaugh Ness Business Systems firm, headquartered in York, Pa.
Before getting into that, remember that a new 3.8% Medicare surtax on investment income earned by higher-income individuals is scheduled to take effect next year. That surtax is part of the 2010 healthcare legislation recently upheld by the Supreme Court.
The combined impact of the Bush tax cut expiration and the 3.8% Medicare surtax has been dubbed "Taxmageddon" for higher-income investors. Here's what you need to know to be prepared.
Impact of expiring investment tax cuts
* For 2013 and beyond, the maximum federal income tax rate on most long-term capital gains is scheduled to rise to 20% from the current 15%. However, an 18% maximum rate will apply to most long-term gains from selling investments acquired after December 31, 2000 and held for more than five years. Yes, that includes land.
* Starting next year, dividends will once again be treated as ordinary income and taxed at regular rates, as was the case before the Bush tax cuts. This is really bad news because the maximum federal rate on ordinary income, including dividends, for 2013 and beyond is scheduled to be 39.6%. For 2012, qualified dividends are taxed at a maximum rate of 15%.
* For 2013 and beyond, the top federal rate on short-term capital gains, taxable interest income, rental income, royalties, and income from annuities will increase to 39.6%. This year, the maximum rate on ordinary income is 35%.
* Starting next year, phase-out rules for personal and dependent exemption deductions and itemized deductions are scheduled to return with full force. These disguised tax increases can reduce or even eliminate exemption deductions and wipe out up to 80% of certain itemized deductions -- including home mortgage interest, state and local income and property taxes and charitable donations.
Impact of the Medicare Surtax
The surtax will be far-reaching on net investment income.
To the extent a principal residence gain exceeds the exclusion, the excess is potentially subject to the surtax. Gain from selling a vacation property is potentially subject to the surtax.
Gains and income attributable to a passive business activity such as rental real estate or a partnership or S corporation in which you don't actively participate are potentially subject to the surtax.
You won't be hit with that 3.8% surtax on net investment income unless your modified adjusted gross income exceeds:
* $200,000 if you're unmarried
* $250,000 if you're a married joint filer
* $125,000 if you're married, and filing separately
Trusts can also be hit with the surtax. The surtax will apply to the lesser of undistributed net investment income or adjust gross income exceeding the top trust federal income tax bracket. For 2013, that threshold is expected be around $12,000.
Tax planning considerations
If you think you'll be affected by the tax rate increases on investment income for 2013 and beyond, take some steps this year to decrease your exposure. However, realize that triggering gains this year will generally result in an accelerated tax bill.
If you have 2012 capital losses or a capital loss carryover from before this year, things get more complicated (these losses can potentially be used to shelter capital gains recognized this year or capital gains recognized in future years when tax rates are scheduled to be higher).
Depending on how the November 6 election turns out, it's possible that none of the aforementioned tax increases will take effect. But the most prudent approach is to plan for the worst and hope for the best. Start now.
Disclaimer: There are many unanswered questions about exactly how the Medicare surtax on net investment income will work. Some of what's said here could be contradicted by future IRS guidance.