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With the end of the year rapidly approaching, it’s time to consider moves that will lower your 2021 tax bill and hopefully position you for tax savings in future years too. This column is Part One of my two-part list of suggested year-end strategies.
But first, we need to address the big uncertainties about what the future holds for your personal tax situation. Here goes.
What to know about proposed tax increases
In May, the Treasury Department released its General Explanation of the Biden Administration’s Fiscal Year 2022 Revenue Proposals, also known as the “Green Book.” The document contains fairly detailed information about President Joe Biden’s proposed tax changes that would be included in the so-called American Jobs Plan and in the so-called the American Families Plan.
Individuals could see federal income tax increases under these proposals. At this point, it’s too early to tell which proposed changes, if any, will actually become reality. So, this subject is a moving target. What follows below does not include all the proposed changes found in the Green Book, but I briefly summarize the ones that I think are of the most interest to individuals, including those who own small businesses. I’ve also included some changes proposed by House Democrats.
Higher maximum individual rate
Starting in 2022, the Biden plan would raise the top individual federal income tax rate on ordinary income and net short-term capital gains back to 39.6%, the top rate that was in effect before the TCJA. This proposed rate increase would affect singles with taxable income above about $450,000, married joint-filing couples with taxable income above about $510,000, and head of households with taxable income above about $480,000.
Under the separate plan proposed by House Democrats, the maximum federal rate on ordinary income and net short-term capital gains would be increased to 39.6%, with that top bracket starting at $400,000 for individuals and $450,000 for married joint-filing couples. The House Democrats’ proposal would also add a new 3% surtax on individuals and married couples with adjusted gross income (AGI) above $5 million. After tacking on the 3% surtax, the new maximum effective rate on ordinary income and net short-term capital gains would be 42.6% (39.6% + 3%) or 46.4% if the 3.8% net investment income tax (NIIT) applies (39.6% + 3% +3.8%), compared to the current maximum effective rate of “only” 37% or 40.8% if the 3.8% NIIT applies (37% + 3.8%).
Higher maximum rate on long-term gains and dividends
For gains recognized after an as-yet-unspecified date in 2021, high-income individuals would face a 39.6% maximum rate on net long-term capital gains. After tacking on the 3.8% NIIT, the maximum effective rate would be 43.4% (39.6% + 3.8%) compared to the current maximum effective rate of “only” 23.8% (20% + 3.8%). The same maximum rate increase would apply to qualified dividends received after that date. However, this proposed retroactive rate increase would only apply to taxpayers with AGI above $1 million, or above $500,000 if married filing separate status is used. Taxpayers would be subject to the higher maximum rate only to the extent adjusted gross income (AGI) exceeds the applicable threshold.
For example, a married joint-filing couple with AGI of $1.2 million, including a $300,000 net long-term capital gain, would apparently pay the 39.6%/43.4% maximum rate on only the last $200,000 of net long-term capital gain.
Under a separate plan proposed by House Democrats, the maximum federal rate on net long-term capital gains and qualified dividends would be retroactively increased to 25% effective after a date in September of this year. After tacking on the new 3% surtax and the 3.8% NIIT, the new maximum effective rate would be 31.8% (25% + 3% + 3.8%) compared to the current maximum effective rate of “only” 23.8% (20% + 3.8%).
All pass-through income could be hit with NIIT or SE tax
Under current law, singles and heads of households with AGI above $200,000 and married joint-filing couples with AGI above $250,000 are potentially subject to the 3.8% NIIT on all or part of their income from capital gains, interest, dividends, royalties, and passive activities. Self-employment (SE) income is not subject to the NIIT. The proposed changes would target S corporation shareholders, limited partners, and LLC members whose shares of passed-through income are not currently subject to either the NIIT or the SE tax.
Under one proposed change, all income that is not subject to SE tax would be subject to the NIIT, for taxpayers with AGI over $400,000. Under another proposed change, income passed through to S corporation shareholders, limited partners, and LLC members who materially participate in the entity’s business would be subject to SE tax to the extent the passed-through income exceeds certain thresholds. These proposed changes would effectively make affected pass-through income subject to either the NIIT or SE tax, effective for tax years beginning after 2021.
The House Democrats’ separate plan would simply impose an additional 3.8% tax on income from pass-through entities.
Limit real estate Section 1031 like-kind exchanges
The Trump administration’s Tax Cuts and Jobs Act restricted the ability to defer gains using Section 1031 like-kind exchanges to exchanges of real property. The Biden tax plan would limit the amount of gain that can be deferred in Section 1031 exchanges to $500,000 per year or $1 million for married joint-filing couples. This change would be effective for exchanges completed after 2021.
Other proposed changes that have been floated
Beyond the “more-official” proposed changes summarized above, several other proposed changes have been trotted out at various times, including in pre-election information put out by the Biden campaign. These other proposed changes include the following.
Higher social security taxes for upper-income individuals
For 2021, the 12.4% Social Security tax hits the first $142,800 of wages and/or net self-employment income. Employees pay 6.2% via withholding from paychecks, and employers pay the remaining 6.2%. Self-employed individuals pay the entire 12.4% out of their own pockets via the self-employment (SE) tax. For 2021, the 12.4% Social Security tax cuts out once wages and/or net SE income exceed the $142,800 ceiling. For 2021 and beyond, the Social Security tax ceiling will be adjusted annually to account for inflation.
A change that has been floated would restart the 12.4% Social Security tax on wages and net SE income above $400,000. This is the so-called donut-hole approach to increasing the Social Security tax. Over the years, the donut hole would gradually close as the lower edge of the hole is adjusted upward for inflation while the $400,000 upper edge of the hole remains static.
Eliminate investment real estate breaks
Beyond the proposed limits on Section 1031 like-kind exchanges, other changes that have been floated for investment real estate would: (1) eliminate the $25,000 exemption from the passive loss rules for rental real estate losses incurred by middle-income individuals, (2) eliminate rules that allow faster depreciation write-offs for certain real property, and (3) eliminate the qualified business income (QBI) deduction for net income from rental real estate.
Specific year-end tax moves to consider
After contemplating all of the above, here are some year-end tax planning ideas to consider.
Game the standard deduction
The Tax Cuts and Jobs Act (TCJA) almost doubled the standard deduction amounts. For 2021, the basic standard deduction allowances are:
- $12,550 if you are single or use married filing separate status.
- $25,100 if you and your spouse file jointly.
- $18,800 if you are a head of household.
- Slightly higher standard deductions are allowed to those who are 65 or older or blind.
Here’s the plan. If your total itemizable deductions for this year will be close to your standard deduction allowance, consider making enough additional expenditures for itemized deduction items before year-end to exceed the standard deduction. Those expenditures will lower this year’s tax bill. Next year, your standard deduction will be bigger thanks to an inflation adjustment, and you can claim the bigger allowance if you don’t itemize.
- The easiest deductible expense to prepay is included in the house payment due on January 1. Accelerating that payment into this year will give you 13 months’ worth of itemized home mortgage interest deductions in 2021. Although the TCJA put new limits on these deductions, you’re probably unaffected. But ask your tax adviser to be sure.
Next up on the prepayment menu are state and local income and property taxes that are due early next year. Prepaying those bills before year-end can decrease your 2021 federal income tax bill, because your itemized deductions total will be that much higher. However, the TCJA decreased the maximum amount you can deduct for state and local taxes to $10,000 or $5,000 if you use married filing separate status. So, beware of that limitation.
Warning: The state and local tax prepayment drill can be a bad idea if you will owe the dreaded alternative minimum tax (AMT) for this year. That’s because write-offs for state and local income and property taxes are completely disallowed under the AMT rules. Therefore, prepaying those expenses may do little or no tax-saving good if you will be in the AMT zone. Thankfully, changes included in the TCJA took millions of taxpayers out of AMT danger, but not everybody. Ask your tax adviser if you’re in the clear for this year or not.
- Consider making bigger charitable donations this year and smaller donations next year to compensate. That could cause your itemized deductions to exceed your standard deduction this year.
- Finally, consider accelerating elective medical procedures, dental work, and expenditures for vision care. You can deduct medical expenses to the extent they exceed 7.5% of your AGI if you itemize.
Carefully manage gains and losses in taxable investment accounts
If you hold investments in taxable brokerage firm accounts, consider the tax advantage of selling appreciated securities that have been held for over 12 months. Assuming no retroactive change to the contrary, the federal income tax rate on net long-term capital gains recognized this year is “only” 15% for most folks, although it can reach the maximum 20% rate at high income levels. The add-on 3.8% NIIT can also bite at high income levels. So, the true maximum rate for high-income individuals is 23.8%: the advertised 20% top rate plus 3.8% for the unadvertised NIIT.
To the extent you have capital losses this year or capital loss carryovers from earlier years, selling winners by year-end will not result in any tax hit. In particular, sheltering net short-term capital gains with capital losses is a tax-smart move because net short-terms gains will otherwise be taxed at your higher ordinary income rate of up to 37%, plus another 3.8% if the NIIT bites. Ouch.
What if you have some loser investments that you would like to unload? Biting the bullet and taking the resulting capital losses this year would shelter capital gains, including high-taxed short-term gains, from other sales this year.
If selling some losers would cause your 2021 capital losses to exceed your 2021 capital gains, the result would be a net capital loss for the year. No problem. That net capital loss can be used to shelter up to $3,000 of 2021 income from salaries, bonuses, self-employment income, interest income, royalties, and whatever else ($1,500 if you use married filing separate status). Any excess net capital loss is carried forward to next year and beyond.
In fact, having a capital loss carryover could turn out to be a really good deal. The carryover can be used to shelter both short-term gains and long-term gains recognized next year and beyond. This can give you extra investing flexibility in those years, because you won’t have to hold appreciated securities for over a year to get a lower tax rate. You’ll pay 0% to the extent you can shelter gains with your loss carryover. If there are future tax rate increases, capital loss carryovers into future years could turn out to be really valuable.
The bottom line
With all the federal income tax increase proposals floating around out there, nothing about taxes is certain, including year-end tax planning strategies that will turn out to work. But I think that what we say here is good advice, all things considered. Meanwhile, please stay tuned for Part Two of our menu of year-end tax planning strategies for individuals. Coming soon.