Special Report of Future Tax Changes – Individuals and Capital Gains

This is a continuation of  posts to provide information about income taxes for 2012 and beyond.  While what will actually happen is uncertain at this time; however, the potential changes are quite significant to your bank account.

SELECTED CHANGES IF BUSH-ERA TAX CUTS EXPIRE AFTER 2012

Top individual income tax rate: 39.6 percent
Child tax credit: $500
Maximum contribution Coverdell ESA: $500
Top estate tax rate: 55 percent
Top gift tax rate: 55 percent

Child Tax Credit

The $1,000 child tax credit under current law is scheduled to revert after 2012 to $500 per qualifying child (dependents under age 17 at the close of the year). In addition to increasing the amount of the credit, EGTRRA also modified the refundable component, provided that the refundable portion of the child tax credit does not constitute income, provided that the child tax credit is allowable against regular income tax and allowable against AMT, repealed the AMT offset against the additional child tax credit for families with three or more children, and eliminated the supplemental child tax credit. These enhancements to the child tax credit were extended by the 2010 Tax Relief Act through 2012 only.

IMPACT

Taxpayers with qualifying dependent children should consider adjusting withheld income tax (or estimated tax payments) to account for the reduction from $1,000 to $500. Current divorce settlements in which child credits and other EGTRRA-sensitive benefits are allocated may need to be recalibrated to accommodate the lower amounts.

IMPACT

The child tax credit is reduced by $50 for each $1,000, or fraction thereof, of modified adjusted gross income above threshold amounts. Those thresholds are $110,000 for joint filers, $55,000 for married individuals filing separately, and $75,000 for other taxpayers. If the credit is reduced to $500 after 2012, the smaller credit will phase out more quickly.

The 2009 Recovery Act lowered the refundability threshold for the child tax credit from $8,500 to $3,000 (not adjusted for inflation) for 2009 and 2010. The $3,000 threshold (not adjusted for inflation) was extended by the 2010 Tax Relief Act, again, only through 2012.

Comment

President Obama and the GOP have expressed support for extending or making permanent the $1,000 child tax credit after 2012.

Comment

The maximum amount of credit a taxpayer can receive is equal to the number of qualifying children times $1,000. If the value of the taxpayer’s child tax credit is greater than his/her actual tax liability, the taxpayer may be eligible to receive the difference as a refund. In April 2012, the House Ways and Means Committee approved a bill that would require taxpayers claiming the additional child tax credit to provide a Social Security number.

Adoption Credit/Adoption Assistance Programs

EGTRRA increased the dollar limitation for the adoption credit and the income exclusion for employer-paid or reimbursed adoption expenses to $10,000 (indexed for inflation) (both for non-special needs adoptions and special needs adoptions). The 2010 Tax Relief Act extended the enhancements to the adoption credit under EGTRRA through 2012. In addition, the Patient Protection and Affordable Care Act made the adoption credit refundable for 2010 and 2011.

Comment

The adoption credit phases out for taxpayers above specified inflation-adjusted levels of modified adjusted gross income. For 2012, the phase-out level starts at $189,710.

Child and Dependent Care Credit

The child and dependent care credit is intended to help individuals pay child and dependent care expenses so the taxpayer (and spouse if filing jointly) can work or look for work. A child, for purposes of this tax benefit, must be under 13 years of age at the close of the tax year. A qualifying dependent who is disabled, however, may be of any age if he or she is a dependent, or spouse, who lives with the taxpayer for more than half the year. EGTRRA and subsequent legislation increased the maximum amount of eligible employment-related expenses for purposes of the dependent care credit and made other enhancements. The 2010 Tax Relief Act extended these enhancements through 2012.

Comment

Expenses qualifying for the child and dependent care credit must be reduced by the amount of any dependent care benefits provided by the taxpayer’s employer that are excluded from the taxpayer’s gross income. Total expenses qualifying for the dependent credit are capped at $3,000 in cases of one qualifying individual or at $6,000 in cases of two or more qualifying individuals subject to income thresholds. Absent extension, these monetary amounts are scheduled to be reduced to $2,400 in cases of one qualifying individual or $4,800 in cases of two or more qualifying individuals subject to income thresholds. The current 35 percent credit rate is scheduled to fall to 30 percent after 2012.

CAPITAL GAINS/DIVIDENDS SUNSETS

Under current law, reduced tax rates on qualified capital gains and dividends are scheduled to sunset after 2012. The pre-JGTRRA treatment (as extended by the 2010 Tax Relief Act) of qualified capital gains and dividends would apply thereafter.

Capital Gains

The 2010 Tax Relief Act extended the reduced maximum tax rate of 15 percent on adjusted net capital gains through 2012. The 15 percent rate had originally been enacted in JGTRRA and was extended by the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). Additionally, taxpayers in the 10 and 15 percent tax brackets are eligible for a zero percent tax rate on qualified capital gains through 2012.

IMPACT

Absent extension, the maximum tax rate on net capital gain of noncorporate taxpayers will revert to 20 percent (10 percent for taxpayers in the 15 percent bracket) after 2012. Thus, the acceleration of capital gains into 2012 while the tax rates are lower is one strategy for taxpayers to consider. Accelerating the sale of capital assets is the general means by which taxpayers effectuate this strategy. As long as the sale is bona fide, and the proceeds are received in 2012, capital gains can be accelerated. The “wash sale” rules that apply to claiming losses do not apply to gains. Accordingly, capital gains can be recognized at any time and, immediately thereafter, the identical asset can be repurchased, with a new tax basis established in the amount of the purchase price.

Five-Year Holding Period for Capital Assets.

Under the 2010 Tax Relief Act, there is no special capital gain treatment in 2011 or 2012 for property held for more than five years. After 2012, the JGTRRA-based lower capital gain rates for five-year gain of individuals, estates and trusts are scheduled to be revived. Long-term gain on the sale or exchange of property held for more than five years generally will be taxed at 18 percent (eight percent for taxpayers in the 15 percent bracket).

IMPACT

For higher-income taxpayers, the 15 percent rate under the 2010 Tax Relief Act applies if the taxpayer has held the asset for more than one year, but only if the taxpayer sells the asset by no later than December 31, 2012. The 18 percent rate for qualified five-year property applies if the taxpayer acquired the asset in 2001 or later, has held the asset for more than five years, and sells it after December 31, 2012. The 20 percent rate applies if the taxpayer acquired the asset in 2001 or later, sells the asset after December 31, 2012 and has held the asset for more than one but not more than five years; or has held the asset for more than five years but acquired the asset by exercising an option, right or obligation to acquire the property and the taxpayer has held such since before 2001.

Dividends

The 2010 Tax Relief Act extended the reduced net capital gains tax rates for qualified dividends through 2012. These rates had originally been enacted by JGTRRA and were extended by TIPRA. The maximum tax rate for qualified dividends received by an individual is 15 percent for tax years beginning before January 1, 2013. A zero percent rate applies to qualified dividends received by an individual in the 10 or 15 percent income tax rate brackets.

IMPACT

Absent extension, qualified dividends will be taxed at the applicable ordinary income tax rates after 2012 (with the highest rate scheduled to be 39.6 percent after 2012), despite the highest rate for net capital gains rising to 20 percent. Qualified corporations may want to explore declaring a special dividend to shareholders before January 1, 2013. President Obama’s proposed fiscal year (FY) 2013 federal budget recommended increasing the dividends rate to the ordinary income tax rate for higher-income individuals.

Comment

Generally, dividends received from a domestic corporation or a qualified foreign corporation, on which the underlying stock is held for at least 61 days within a specified 121-day period, are qualified dividends for purposes of the reduced tax rate. Certain dividends do not qualify for the reduced tax rates. They include (not an exhaustive list) dividends paid by credit unions, mutual insurance companies, and farmers’ cooperatives.

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