An IRA may invest into a real estate investment trust. Real estate investment trusts (“REIT”) are trusts whereby the company undertakes certain real estate activities (e.g. own or lend on real estate) and returns profits to its owners. An IRA may invest and be an owner in a REIT. As many self directed IRA investors know, a form of unrelated business income tax (“UBIT” tax) known as unrelated debt financed income tax (“UDFI” tax) can arise from real estate leveraged by debt.
Many REITs engage in real estate development activities and/or use debt to leverage their cash purchasing power and as a result may cause a form of UBIT tax known as UDFI tax to IRA owners. Most REITS will not pay corporate taxes and as a result will not be considered exempt from UBIT tax as a result of having paid corporate tax. However, income from REITs is still typically exempt from UBIT and UDFI tax because the definition of a “qualified dividend” in a REIT has been defined to include dividends paid by a REIT to its owners. IRS Revenue Ruling 66-106. Qualified dividends from a REIT are exempt from UBIT and UDFI tax. REITs can be publically traded or private trusts but are not easy to establish. They require at least 100 owners and must distribute at least 90% of their taxable earnings to their owners each year. Despite the general application of exception to UBIT/UDFI tax for REITs, a REIT may be operated in a manner that will not allow for qualified dividends to be paid and therefore income from the REIT would not be exempt from UBIT/UDFI tax. If you’re investing into a REIT with an IRA, make sure you know whether the REIT intends to be exempt from UBIT/UDFI tax or not. As discussed, most will be exempt from UBIT/UDFI tax but some REITs may choose to operate in ways that will not qualify for the exception. Because UBIT/UDFI tax is about 39% at $10,000 of annual income this is something every IRA should understand before investing into a REIT.
Before the new 2013 capital gains rates went into effect taxpayers had a relatively simple way of understanding their capital gains taxes as there was only two rates for long term capital gains: zero percent for low income earners and 15% for middle and upper income earners. The fiscal cliff tax bill, the affordable care act, and numerous expiring tax cuts have all created a new and confusing system for long-term capital gains. The bottom line is that everyone will be paying more under the rules so careful planning is only that much more important as you have much more to lose by failing to plan.
Here’s a breakdown of the changes for 2013 forward.
1. CAPITAL GAINS TAXES. There are now three rates for long-term capital gains taxes. The applicable rate depends on your taxable income. Taxable income, not to be confused with adjusted gross income, is your taxable income after retirement plans and HSA deductions as well as your itemized deductions of mortgage interest, charitable deductions, etc. The rates and income brackets break down as follows.
I. 0% Rate- Single filers with taxable income of $36,250 or below and joint filers at $72,500 or under.
II. 15% Rate- Single filers with taxable income of $36,251 to $400,000, or joint filers with $72,500 or $450,000 of income.
III. 20% Rate- Single filers with taxable income of $400,001 and above and joint filers with $450,001 and above.
2. 3.8% NET INVESTMENT INCOME TAX. This tax was a result of the affordable care act and adds an additional tax to capital gains of 3.8%. The rate applies after a taxpayer reaches $200,000 of adjusted gross income for single tax filers or $250,000 adjusted gross income for those filing joint. Keep in mind that these income limits are based on adjusted gross income, which takes into account retirement plan contribution deductions but does not take into account itemized deductions such as mortgage interest or charitable deductions.
Because the new tax rules and the new higher rates are based on income levels it provides for a number of planning opportunities for families and others wishing to minimize taxes. Here are a few things to keep in mind when planning for these new rates.
Older High Income Earners- They may want to hold onto assets until death rather than sell. Now that the rates are significantly higher older high-income earners not in need of the capital from the sales of stocks, real estate, or other assets that would generate a capital gain may want to hold onto their assets and allow their heirs to inherit them. One of the key benefits to inheriting property is that the heir inherits the property at the value of the decedent’s death and all of the gains in the asset are wiped out so that if the heir sold the property then the heir would avoid capital gains taxes entirely.
Real Estate Investors Looking to Re-Invest. Real estate investors looking to re-invest in another property should strongly consider selling their property and repurchasing a replacement property using a 1031 exchange. A 1031 exchange can be used to defer capital gains taxes by effectively rolling them into a new property such that when you sell the new replacement property you would pay the taxes due. The idea here is that delaying and deferring payment of taxes is always better than paying taxes now. There are some procedures and timelines that need to be followed here to properly complete a 1031 exchange but this is a great strategy for real estate investors who plan to buy more real estate when selling a property.
The Sale Of Home Exemption Is Still Alive. The sale of home exemption is still in place and joint filers who have owned and lived in their home for 2 out of the last 5 years can sell their home and avoid paying taxes on up to $500,000 of capital gains ($250,000 if single filer).
Gift Appreciated Assets for Your Charitable Contributions. High income earners facing the higher capital gains rate and the new net investment income tax may want to consider gifting their appreciated assets to charity as opposed to selling the asset, paying the capital gains and net investment income tax and then gifting the proceeds from the sale of the asset. This could result in as much as a 35% tax savings depending on the taxpayer’s income and state of residence (20% federal capital gains rate, 3.8% net investment income tax, plus state taxes from 5% to 10% on average, depending on your state). Under current law, a taxpayer may gift a certain level of assets to charity and can take the fair market value of the asset as a charitable deduction and then the charity sells the asset and avoids paying any taxes too. The net result is the asset transfers to the church or charity you intend and the capital gain (and net investment income tax) ends up disappearing. Many large charities, universities, and churches have departments set up to receive these assets and to assist and encourage contributors.
The bottom line is that rates have gone up so planning for the sale of an asset has only become that much more important in order to minimize your tax burden. Please contact us at the office at 435-586-9366 to speak with one of the attorneys or CPAs about your specific tax situation and planning needs.
By: Mathew Sorensen, Partner KKOS Lawyers
The Affordable Care Act, also known as Obamacare, includes a new tax on net investment income of 3.8%. While the application of this new tax was slated for 2013, many lawyers, investors, and politicians believed that this law would never come into effect. That was before the Supreme Court upheld the law by one vote and before President Obama won re-election by less than 2% of the popular vote. Given the laws narrow survival in the courts and in the political process we now need to prepare for how the new 3.8% medicare tax will apply to us.
The tax is 3.8% on net investment income which includes; rental real estate, real estate capital gains, dividend income, royalty income, interest income, and passive business activity income. Essentially, think of income that is not taxed as ordinary income and subject to self employment tax. The new tax will apply to taxpayers whose adjusted gross income is $200,000 or more single or $250,000 or more married. It will apply whether the investment income comes from an s-corporation, LLC, or other entity that does not pay a corporate level tax. Keep in mind, the new tax only applies to net investment income so expenses and losses will offset income.
There are situations where the investment income tax will not apply. For example, the new tax will not apply to retirement plans such as 401(k)s or IRAs even if those plans are receiving these classifications of income outlined in the law (e.g self directed IRAs with rental income, capital gains, interest, etc.). Also, taxpayers whose business or trade is real estate are also exempt from the new 3.8% tax since their income is classified as income from a business or trade and not as investment income. In order to qualify for this classification a taxpayer must be deemed to have materially participated in the real estate investments, which participation requires a certain level of hours committed to real estate for the year. Many real estate investors will qualify as having materially participated but you need to be coordinating with your CPA so you understand how this law will apply to you and your investments as the hour requirement can differ from short term real estate deals versus long term rental properties. IRS Publication 925 provides additional guidance on this issue and exception. Unfortunately, the new law recognized this exception but included a new tax of 0.9% for tax on earned income so those who are in the business or trade of real estate don’t completely avoid the new Obamacare taxes.
If an exemption to the law doesn’t apply and an investor will be subject to the tax on the sale of real estate, an investor may want to consider a 1031 exchange whereby the real estate is sold and the proceeds of the sale are re-invested into a new property. A 1031 exchange is a strategy used by many real estate investors to defer the capital gains into a new replacement property purchased with the proceeds from the sale of a property. This 1031 exchange strategy will also have the effect of also deferring the application of the new net investment income tax from the capital gain on the sale of a property.