March arrives with many of us stressing over “bracketology.” Sure, you handed in the sheet with your college basketball tournament picks a while back, but the brackets a lot of people are concerned and confused about are the new income tax brackets. For owners contemplating the sale of real estate in 2013, a short course in bracketology might be in order.
Depending upon your tax bracket, the long-held notion that all long-term capital gains are taxed at 15 percent and short-term capital gains are taxed at the same rate as ordinary income might no longer be correct. Some property owners might find themselves taxed at a 25 percent rate plus a surtax of 3.8 percent.
Those Pesky Tax Brackets
“I have to watch what I earn this year. A good year could push me into a higher tax bracket.” Whether it is a friend, relative, or the person sitting next to you on the commuter train into work, tax brackets are on people’s minds. Unfortunately, few of us truly understand the topic of tax brackets, but for anyone owning or thinking about owning real estate, a little knowledge could save you big money.
The purpose of tax brackets—whether on the local, state, or federal levels—is to impose a higher tax on those earning higher incomes. After all, who would oppose a program that taxes people earning more money than we do at a higher rate?
How Brackets Work
The misunderstanding about brackets usually comes from the popular misconception that earning an extra dollar will push you and all of your earnings and capital gains for the year into a higher tax bracket. That is not how the system works.
A tax bracket tells you the rate at which the next dollar you earn will be taxed. For example, the following are the tax brackets for a single person including the taxable income amounts:
- 10 percent bracket: Income from $0 to $8,925
- 15 percent bracket: Income $8,926 to $36,250
- 25 percent bracket: Income $36,251 to $87,850
- 28 percent bracket: Income $87,851 to $183,250
- 33 percent bracket: Income $183,251 to $398,350
- 35 percent bracket: Income $398,351 to $400,000
- 39.6 percent bracket: Income over $400,000
A person with $190,000 in income is not taxed at 33 percent on the entire $190,000. The first $183,250 is taxed at various rates; only the remaining $6,750 is taxed at 33 percent.
Real Estate Capital Gains: The Basis
Now that we all understand how brackets work with ordinary income, what happens when real estate is sold? The Internal Revenue Service (IRS) says that whatever you own for personal use or as an investment is a capital asset. This includes your home and other real estate you own. When you sell the property, the difference between the cost of the asset and the amount you sell it for is either a capital gain or a capital loss. You have a capital loss when you sell the property for less than the basis, and you have a capital gain when you sell it for more.
Capital Gains in 2013
Fifteen percent was the tax rate for most long-term capital gains for property held for more than one year. The New Year’s celebration for 2013 ushered in changes in the long-term capital gains rates and a new 3.8 percent Medicare surtax for some taxpayers.
Following are the changes in the capital gains taxes for 2013:
- A single taxpayer in the 10 or 15 percent tax brackets is subject to a zero percent capital gains tax.
- A single taxpayer in the 25 to 33 percent tax brackets is subject to a 15 percent capital gains tax as long as the person’s income does not exceed $200,000.
- A single taxpayer in the 33 to 35 percent tax brackets with income between $200,001 to $400,000 is subject to a 15 percent capital gains tax and the 3.8 percent Medicare surtax.
- A single taxpayer in the 39.6 percent tax bracket is subject to a 20 percent capital gains tax and the 3.8 percent Medicare surtax.
How Depreciation Deductions Can Change Things
An investor in the 25 percent tax bracket who deducts depreciation on real estate might fall under a different rule when it comes to capital gains. The depreciation acts as a reduction of the investor’s basis in the property. When the real estate is sold, the amount of the depreciation is taxed at 25 percent, but the remaining gain on the sale is taxed at a maximum rate of 15 percent.
Get Professional Advice
If tax brackets and capital gains have your head spinning, you’re not alone. Anyone contemplating the sale of real estate or investing in it should seek professional advice.
Image Source: Flickr User 401(K) 2013
