Colorado Real Estate Journal - August 6, 2014

2013 tax changes were dramatic

Many individuals, particularly those in higher income brackets, found 2013 to be a year of dramatic change.

Changes included the return to a top marginal tax rate of 39.6 percent (from 35 percent), and the return of limitations to itemized deductions (such as mortgage interest, state taxes, etc.) and personal exemptions.

It has been several years since itemized deductions have been “phased out” for high-income taxpayers. Limitations on tax deductions will come as a surprise to many when filing their 2013 tax returns. Itemized tax deductions will be reduced by 3 percent of the amount a taxpayer’s adjusted gross income exceeds certain thresholds. Of course, the Internal Revenue Service is generous enough to ensure that no more than 80 percent of itemized deductions can be lost.

The Affordable Care Act of 2010 (ACA, referred to as Obamacare) also changed the picture for taxpayers, imposing new taxes including a 3.8 percent Medicare surtax on investment income (such as interest, dividends and income from passive activities). Real estate professionals should consult their tax advisers to determine the impact of these new taxes on income from their real estate activities. Also, anyone who has passive activities should be taking a hard look at the material participation tests to see if there is an opportunity to change this classification. Additionally, taxpayers should consider whether electing to group certain activities would be tax advantageous.

Other changes for 2013 include an increase in capital gains tax rates from 15 percent to 20 percent for high-income taxpayers and the introduction of a 0.9 percent surtax on wages that exceed certain thresholds.

In the absence of legislation extending many provisions, 2014 will prove equally dramatic for taxpayers as several of the Bush-era tax cuts are set to expire. Many of these changes will impact all business owners, regardless of income levels.

Bonus depreciation has become a widely utilized tax strategy for business owners of all types and sizes over the past several years. Bonus depreciation incentivizes business owners to expand the business through the purchase of property and equipment by allowing an immediate tax deduction for 50 percent of those costs (100 percent in some past years), with relatively few limitations. Bonus depreciation is currently set to expire Dec. 31, 2013. Section 179 of the IRS Code also offers an immediate tax deduction for the cost of purchased property and equipment, but imposes limitations based on active business income and an overall deduction cap. The maximum deduction allowed under Section 179 decreases from $500,000 in 2013 to $25,000 in 2014. Another popular tax break for business owners over the past several years has been favorable treatment of qualifying leasehold improvements. Since 2004, these costs have been deductible over a 15-year period rather than 39 years. Beginning in 2014, these costs will revert to a 39-year recovery period. Also expiring in 2014 are the research and development credits as well as certain employment related credits.

Another change worth noting, the IRS has released final “repair” regulations governing when taxpayers must capitalize, rather than deduct, their expenses for acquiring, maintaining, repairing and replacing tangible personal property. The final regulations make significant, taxpayer-friendly changes to the previous 2011 temporary regulations. Compliance with these regulations is mandatory for tax years starting after Jan. 1, 2014, and optional for tax years beginning on or after Jan. 1, 2012. Taxpayers should be working with their tax advisers to determine whether it would be beneficial to amend previously filed tax returns to voluntarily implement these new rules for the 2012 or 2013 tax years.

The long-term focus in Washington is to overhaul a so-called “broken” tax code with comprehensive tax reform. Current proposals include dramatic changes to the basic foundation of the U.S. taxing system. One overall theme is moving to more of a flat tax whereby the tax base is broadened and tax rates are lowered and less graduated. Broadening the tax base likely would entail increased limitations or even repeal of certain popular tax deductions, such as depreciation, home mortgage interest, state and local taxes, and charitable donations.

Other changes could impact contractors directly. Currently, contractors are exempt from reporting revenue earned on home construction contracts on the Percentage of Completion Method as required for other types of contracts (not applicable for small contractors).

This exemption allows for a significant deferral of tax for homebuilders since gross profit on those contracts is potentially deferred until construction is complete. Current tax reform proposals include repeal of this exemption, as well as repeal of the Section 199 Domestic Production Activities Deduction (DPAD).

Profitable contractors have been able to benefit from this deduction for several years.

This deduction is typically 9 percent of a company’s qualifying net income, subject to certain limitations. Even some of the oldest tax strategies, for example like-kind exchanges (which have been around since 1924), may be eliminated in some reform proposals.

It is very unlikely that any type of comprehensive tax reform will be passed in 2014. Because of this, multiple “extender” bills have been introduced in Congress in an effort to prolong the policies temporarily. Some of the provisions that expire in 2012 and 2013 would be reinstated in order to maintain status quo while the reform is negotiated. Current extender bills differ significantly, so it is still unknown what a final bill would include or if it would be passed by year-end. Since it is an election year, there likely will not be any clarity until closer to November.