NEW TAXES STARTING IN 2013 COULD AFFECT YOUR DECISIONS
A question was raised at a recent meeting in Colorado Springs by an individual who experienced the fire this past summer. The individual raised concerns about the consequences of the upcoming increases in taxes presently scheduled for 2013, particularly those affecting Capital Gains.
“Is there anything people who lose their homes in these fires can do to prepare for changes in 2013?” Can they claim any income this year (2012) instead of next year (2013)? Presumably, this is asking “can the taxable income be in advanced the taxable income regardless of the actual receipt of the proceeds?
There are a number of possible combinations of income tax consequences that may arise as a result of a catastrophic loss and a subsequent insurance reimbursement for the loss. Let’s set the stage for the limits of this post: A number of posts and pages on this blog discuss the computation of a realized gain or loss that results from the receipt of insurance proceeds and similar receipts. Here, I will assume that the reader has a basic understanding of that analysis.
When taxpayers take advantage of the reinvestment rules provided in the tax code, these transactions give rise to deferrals of tax that will possibly be paid at some time in the future when the property is sold in a normal transaction. They are deferrals, not exclusions or exemptions from tax.
2013 will bring new taxes that could affect your after-tax result from collecting insurance proceeds for a casualty loss. There are a number of changes that are scheduled to affect income taxes for 2013 and thereafter. This article is intended only to discuss the new taxes that are scheduled to come into play in 2013 that may affect a catastrophic loss insurance reimbursement.
Here are two changes presently anticipated:
- Repeal of the so-called “Bush Era Tax Rate Cuts,” specifically the basic long-term capital gains tax rate from 15% to 20%.
- New Medicare Taxes.
New Medicare Tax
In 2013, two new Medicare taxes kick-in. The Patient Protection and Affordable Care Act impose:
- An additional 0.9% Medicare tax on wages and self-employment income (this tax is not discussed in this article), and
- A new 3.8% Medicare tax that will apply to single individuals with a “modified adjusted gross income” (MAGI) in excess of $200,000 and married taxpayers with MAGI in excess of $250,000.
MAGI is defined as wages, salaries, tips, and other compensation, dividend and interest income, business and farm income, realized capital gains, and income from a variety of other passive activities and certain foreign earned income. In other words it will include essentially all income reported on page one of your Form 1040 except pensions and taxable Social Security income.
For individuals liable for the new Medicare tax, the amount of tax owed will be equal to 3.8% multiplied by the lesser of -
(1) Net investment income (generally interest, dividends and capital gains) or
(2) The amount by which MAGI exceeds the $200,000/$250,000 thresholds.
Taxpayers with MAGIs below the $200,000/$250,000 thresholds will not be subject to the 3.8% tax. But taxpayers who receive significant proceeds from a casualty loss and do not take advantage of the tax deferral benefits of the law and/or do not reinvest the proceeds to defer the tax liability could exceed the applicable threshold.
Getting Into the Details
People Who Experience a Catastrophic Loss and Receive Large Insurance Proceeds
First, let me emphasize an important point.
Insurance proceeds for a casualty loss claim are not currently taxed if they are reinvested in “qualified replacement property” (QRP) and the transaction is properly reported on the appropriate income tax return.
The costs incurred to replace the destroyed property will be reduced by the amount of the “gain” not currently taxed to arrive at the ongoing cost basis of the replacement property.
(For a loss of personal use real estate, a QRP is any personal use real estate.)
If insurance proceeds are received in excess of the pre-loss event cost basis of the asset, there is a “gain.” If the asset is a primary personal residence taxpayers may be able to reduce the gain by up to $250,000 ($500,000 maximum for married couples) – Referred to as the “Section 121 Exclusion.”
A gain realized is not necessarily a gain that will be taxed currently.
Gains that are recognized currently (taxed) are ones that taxpayers elect not to invoke the tax deferral benefits available in the tax code either, by choice or by failing to reinvest the proceeds. But to avoid the current tax the net proceeds (gross proceeds less cost of collection and the Section 121 Exclusion) must be used to repair / rebuild / replace the property destroyed if those net proceeds exceed the cost basis of the destroyed asset.
When All Required Proceeds Are Reinvested
If the net proceeds required to be reinvested in order that the tax is not currently payable on the realized gain are reinvested in “Qualified Replace Property” there is no tax effect of the new law at this time. Additionally, if the asset is a primary personal residence, and taxpayers use the repaired / rebuilt / replaced residence for at least two years as their prime abode, the Section 121 exclusion may be applied to the gain on the subsequent sale.
Part or All of the Proceeds Are Not Reinvested
Modified Adjusted Gross Income (MAGI) and Taxable Disaster Proceeds Exceed $200,000 ($250,000 for married taxpayers) Threshold:
If the MAGI including the taxable portion of the proceeds exceed the limits noted above, the 3.8% tax will apply to the computed gain.
Modified Adjusted Gross Income (MAGI) and Taxable Disaster Proceeds Are Less Than $200,000 ($250,000 for married taxpayers)
The new tax does not apply.
A taxpayer may elect a partial recognition and include in income “just enough” of the proceeds to stay below the MAGI threshold. Assuming that the proceeds are reinvest, the cost basis of the new asset will be higher by the amount of the reported income for purposes of a later sale.
Other Planning Questions:
Can I accelerate the tax return recognition of the gain into to 2012 for a 2013 collection to avoid the new 3.8% tax?
Most individual taxpayers are what we call “cash-basis” taxpayers. Cash basis taxpayers, generally, report income based on actual receipt of cash or other compensation for the income to be taxable.
An accrual basis taxpayer is one who records income based on completing all the steps necessary for realization, but does not necessarily receive the cash. An example of a common accrual transaction is when a car dealer sells a car and finances the purchase by taking a note from the buyer as part of the purchase. The dealer has not received all the cash, but has realized a sale for the full purchase price of the car for tax purposes.
Therefore, attempting to accelerate income into 2012 without the actual cash receipt for a cash basis taxpayer (most of us) is not possible.
Do you have a question on this subject? Write a comment and if it is generally applicable, this post will be modified to include a response.
How to best resolve a specific situation is best done in consultation with a knowledgeable tax professional who understands your overall tax situation and the complexities of the disaster tax code provisions.
All rights to reproduce or quote any part of the chapter in any other publication are reserved by the author. Republication rights limited by the publisher of the book in which this chapter appears also apply.
Certified Public Accountant
2975 E. Hillcrest Drive #403
Thousand Oaks, CA 91362
(805) 497-4411 E-mail John@TrapaniCPA.com
It All Adds Up For You
This material was contributed by John Trapani. A Certified Public Accountant who has assisted taxpayers since 1976, in analyzing and reporting transactions of the type covered in this material.
Internal Revenue Service Circular 230 Disclosure
This is a general discussion of tax law. The application of the law to specific facts may involve aspects that are not identical to the situations presented in this material. Relying on this material does not qualify as tax advice for purpose of mounting a defense of a tax position with the taxing authorities
The analysis of the tax consequences of any event is based on tax laws in effect at the time of the event.
This material was completed on the date of the posting
© 2012, John Trapani, CPA,