Every December, the question I hear the most is, “How much tax am I going to have to pay?” And, my response always is, “What do your financial statements show for income and expenses?”
Your tax is determined by the amount of taxable income you have multiplied by your tax rate. The taxable income is determined by your income and your deductions.
The tax rate is a little trickier. There is an earned income tax rate, an ordinary income tax rate and a capital gains tax rate. Then there are other things like depreciation recapture, surtaxes, and more. But for now, let’s talk about the most common types: ordinary income tax rate and the capital gains tax rate. For years, we’ve always strived to have income subject to the long term capital gains tax rate and not the ordinary tax rate. That’s because capital gains tax was so much lower than ordinary tax.
But after the Trump Tax Plan, things have changed. Is it still better? Maybe. And in some cases, maybe not.
In this case, we’re looking at the sale of a property. In one case, it’s going to be subject to the long-term capital gains treatment. And in the other case, the property will be held as if you were a real estate dealer, in the business of buying and selling property.
Let’s say you are at the tax bracket that is just under $327K and you’re married, filing jointly. (That way you easily qualify for the 20% income deduction. Remember that $326.6K is the income threshold amount. If your taxable income is over that, the amount of deduction phases out or has more complicated restrictions.)
Your capital gains tax rate would be 15%. Your ordinary income tax rate is 24%.
However, with the 20% income deduction, your ordinary tax rate ends up being 19.2%. (24% x 80%). Instead of 24%, the ordinary income tax rate is 19.2%. Not nearly as bad as you might have thought.
**NOTE: The reason why the 20% income deduction works here on a sale of a property is because the property sale is the same as pass-through income from an entity. This, of course, will determine on how you hold that property.
Now let’s look at the capital gains tax. You likely will have the 3.8% Medicare surtax on the capital gains. That means your capital gains rate is actually 18.8% (15% + 3.8%).
The difference ends up being 19.2% (ordinary income) versus 18.8% (capital gains). It really isn’t as big of a difference as it has been in the past.
Let’s look at that one more time. It used to be 24% versus 15%. Now it’s 19.2% versus 18.8%. Capital gains tax really isn’t that much better, at least under the current law in 2020.
These are important points to consider as you’re putting your year-end tax strategy in place. Are you still putting your tax plan together? There is still time to help! Join our next coaching class and catch up on the recorded sessions from November with specific strategies for real estate investors and business owners.
You can learn more at Wednesday Coaching.