There are many ways to describe the U.S. Tax Code; however, “simple” is not one of them. There are limits on deductions and tax credits, and certain thresholds and exclusions may have an adverse effect on your total tax liability for 2016.
Individuals with taxable income of more than $415,050 ($466,950 for married, filing jointly) are in the 39.6% tax bracket, and single households making at least $200,000 ($250,000 for married, filing jointly) are subject to a 3.8% surtax on net investment income. These numbers do not include Pennsylvania individual income tax of 3.07% (New Jersey tax rates of 5.525% up to 8.970%) and local earned income taxes of 1% to 4% depending on the municipality and the school district. As you can see, combined federal, state and local income tax rates can easily exceed 50% for 2016. As a result, tax planning is essential to achieving the best possible outcome.
Capital Gains and Losses
If you currently have capital gains, and you’re holding a stock with a paper loss, you should consider selling that stock and realize either a short-term or a long-term loss. This strategy is especially beneficial if the loss offsets a highly-taxed short-term capital gain. Short-term capital gains are taxed at ordinary income rates reaching up to 39.6% plus the 3.8% surtax on net investment income. Conversely, the maximum tax rate on long-term capital gain is only 15%, or 20% plus the 3.8% surtax on net investment income if you are in the top ordinary income tax bracket.
It can be argued that taking capital gains is even more important than taking losses in this current tax landscape. First and foremost, investors can reap tax rewards from the preferential tax rates for long-term gains. Second, with presidential candidates advocating higher taxes for the upper class, these tax breaks might not be around much longer.
Start with the basic tax premise that capital gains and losses from the sale of securities and other capital assets are treated as short-term gains or losses if you’ve held the asset a year or less and long-term if you’ve owned it for more than a year. Gains and losses are “netted” when your tax return is filed to produce the final results. If you have a net loss, you may then offset up to $3,000 of highly taxed ordinary income before carrying over any remaining loss to the next year. The top tax rate on ordinary income in 2015 is 39.6% (plus a 3.8% surtax may apply to the net investment income of certain upper-income taxpayers).
The main attraction is the maximum tax rate on long-term capital gains. Typically, an investor will pay a long-term capital gains tax of 15% on a securities transaction. For someone in the top ordinary income tax bracket of 39.6%, the maximum tax rate on long-term capital gains is 20% — still a good deal at almost half the tax rate of the tax rate you’d owe on any additional ordinary income.
What about short-term capital gains? If you’ve already realized capital losses this year, any capital gains – whether they are short-term or long-term – are effectively tax-free up to the amount of the total capital loss. As a result, you can cherry-pick the short-term gains that will provide the biggest and best tax benefit.
One other issue that is often overlooked is the fact that Pennsylvania does not allow carryover of net capital losses from one year to the next year. For example, if you had net capital losses of $500,000 in 2016 and net capital gains of $500,000 in 2017, you would owe $15,350 to the Commonwealth of Pennsylvania in 2017 ($500,000 x 3.07%), despite the fact that your net capital gains for 2016 and 2017 are zero.
Gains of up to $500,000 on the sale of a principal residence by a couple remains potentially exempt from tax; for singles, $250,000. Surviving spouses have two years following a spouse’s death to sell a primary home and claim the $500,000 exclusion. A taxpayer who owned and used the property as a principal residence for a cumulative two years during the five years preceding the sale can claim this exclusion once in any two-year period, for any number of periods. To qualify for a full exclusion, either spouse can meet the ownership requirement, but both must meet the use requirement. Unmarried co-owners of a house each can exclude $250,000 if they meet the other conditions.
You can deduct mortgage points paid on the purchase of a main residence as long as the cash down payment at least equals the cost of the points. You can deduct points on a refinanced loan evenly over the term of the loan. Refinancing the loan for a second time triggers the deduction of the remaining balance of points from the prior refinancing. If you sell a residence while amortizing the points, any points not yet deducted are written off in full.
Interest on the first $1,000,000 of home acquisition debt (to buy, build, or substantially improve a main or second residence) is deductible. (For mortgages dated before October 13, 1987, all interest is deductible.) Interest on a home equity loan up to $100,000 secured by a residence is also deductible. If you borrow more than $1,000,000 to buy your primary home, the next $100,000 may qualify as home equity debt.
Gifts and Inheritances
For 2016, the Federal annual gift exclusion is $14,000. In addition, the Federal estate and gift tax exemption is $5,450,000 per individual. That means an individual can leave $5,450,000 to heirs and pay no federal estate or gift tax. A married couple will be able to shield $10,900,000 from federal estate and gift taxes.
In addition, the Pennsylvania inheritance tax is imposed as a percentage of the value of a decedent’s estate transferred to beneficiaries by will, heirs by intestacy (where there is no will) and transferees by operation of law (for example, by a trust). There is no bottom threshold – even small estates are subject to PA inheritance tax. The tax rate varies depending on the relationship of the heir to the decedent.
The rates for Pennsylvania inheritance tax are as follows:
- 0% on transfers to a surviving spouse or to a parent from a child aged 21 or younger;
- 4.5% on transfers to direct descendants and lineal heirs (see below for definitions);
- 12% on transfers to siblings; and
- 15% on transfers to other heirs, except charitable organizations, exempt institutions and government entities exempt from tax.
Direct descendants (4.5% rate) include all natural children of parents and their descendants (whether or not they have been adopted by others), adopted descendants and their descendants and step-descendants. Lineal heirs (4.5% rate) include grandfathers, grandmothers, fathers, mothers and their children. Children include natural children (whether or not they have been adopted by others), adopted children and stepchildren.