THE AVOIDANCE OF THE FISCAL CLIFF: INCOME AND CAPITAL GAINS TAXES IN 2013

by: Kevin G. Harvey January 2013

In this article, the results of Congress and President Obama enacting law on January 1, 2013, to avoid the dreaded "fiscal cliff" will be discussed, in particular as the new law pertains to income taxes, capital gains taxes, and the "Medicare surtax". A separate article will summarize less publicized provisions of the new law (estate taxes, payroll taxes, etc.) which, while not receiving near as much media attention, will actually have a negative impact on the take-home pay of many American taxpayers.

Income Tax Rates

Leading up to January 1, 2013, most attention regarding "fiscal cliff" issues focused on income tax rates. Tax rate cuts enacted while George W. Bush was President (the "Bush tax cuts") were set to expire at the end of 2012. President Obama wished to extend those lower rates for all single tax payers earning less than $200,000 per year and married couples earning less than $250,000 per year.

The compromise reached on January 1, 2013, extended the Bush tax cuts for all individuals earning less than $400,000 per year and all married couples earning less than $450,000. For taxpayers whose earned income exceeds those thresholds, the rate of taxation will increase from 35% to 39.6%. For taxpayers below those thresholds, the rates applicable in 2012 will also apply in 2013.

Capital Gains Tax

The capital gains tax is a tax on the "gain", or increase the in value of an asset (other than inventory assets) that occurs between the time the asset was acquired and the time that it is sold. The tax is payable when the asset is sold. In 2012, the long-term [1] capital gains tax rate was 15% for all taxpayers. Effective January 1, 2013, the capital gains tax rate increased from 15% to 20% for individual taxpayers with income above $400,000 and married couples with income in excess of $450,000.

Medicare Surtax

The health care reform law passed in 2010 ("Obamacare") include a "Medicare surtax" of 3.8% which was unaffected by the law passed on January 1, 2013. Thus, the Medicare surtax went into effect on January 1, 2013. This new tax applies to certain types of investment income for single taxpayers with annual earned income above $200,000 and married couples with annual earned income above $250,000.

The Medicare surtax is likely to show up and be applicable most often when a taxpayer incurs long-term capital gains tax as the result of the sale of an asset that has appreciated in value and been held for at least a year. Thus, the combined effect of the capital gains tax rate changes and the Medicare surtax will be a gross tax impact of 18.8% on the sale of long-term capital assets for taxpayers above the $200,000/$250,000 threshold, and a gross tax impact of 23.8% for taxpayers above the $400,000/$450,000 threshold.

The impact of all the tax rate increases that went into effect under the new law (see "Little Discussed Provisions of the 'American Tax Payer Relief Act of 2012'" for a summary of additional tax increases) means that many American taxpayers will experience decreased net income in 2013 as a result of taxation - and not just those persons whom our lawmakers define as "wealthy". While lawmakers have tried to characterize the changes as affecting only high wage earners, closer analysis reveals that most taxpayers in America will be affected. The overall impact on the American economy, of course, remains to be seen.

If you have any questions about these tax changes, please contact the attorneys of Allen Wellman McNew Harvey, LLP, for further discussion.


[1] The "long-term" capital gains tax rate is applicable to assets that were owned by a taxpayer for more than one year. The long-term capital gains tax thus applies to most taxpayers who experience an increase in the value of assets they own.