The AZ Real Estate Boom & Bust

(7/11/2014 AZ Republic by Dr. Harold Wong)

This summer, I will be writing about a number of topics about how people view money, manage their money, and the consequences. The same cycle of greed and fear occurs in every market, whether it is real estate, stocks or gold. Of these two emotions, normally greed is dominant and let me prove it. Even the most degenerate gambler knows that when you enter a casino, the odds favor the house in every game. However, that does not prevent millions of Americans from entering casinos.

Among other things, I was in the mortgage industry from 2001 through 2007, and so saw the rise and fall of the AZ real estate market. In 2001 we still had a fairly normal mortgage market, where those applying for a mortgage loan had to prove income with paystubs and also the last 2 years’ tax returns if self-employed. One had to prove sufficient asset reserves with bank and other financial statements. One had to have a sufficiently high credit score, or the loan officer would not even fill out your loan application. Finally, there was the debt-to-income ratio (DTI).

The typical DTI limit in the 1970s was that monthly housing expense should be less than 25 percent of monthly income and there was no codified limit for the back-end ratio (which includes housing and all other debt). The back-end ratio limit was left to the discretion of lenders on a case-by-case basis. The rule of thumb was that one should not spend more than one week’s pay on total housing expense. Over time, this DTI ratio allowed by lenders increased.

On April 13, 2005, HUD (Housing Urban Development, a government agency) increased the allowable DTI for manually underwritten loans to 31/43. The first number, 31, is the front-end ratio and represents the percentage of the borrower’s income that will go to his new housing expense of principal, interest, taxes, insurance, and homeowner association dues. The 43 is the back-end ratio, which is the percentage of total monthly income that goes to total debt, including all housing, credit card, car, student loans and alimony and child support payments. With the use of automated system underwriting approvals, a borrower’s debt-to-income (DTI) ratios can exceed the guidelines and may go as high as 50 percent of more.

Around 2002, innovative products led to totally relaxed mortgage underwriting standards. If one had a very high credit score, one did not have to prove one had a job or a specific amount of income or assets. This was called a NINJA loan (No Income, No Job, and No Assets). There were even popular negative amortization mortgages, where the true rate of interest might be 7 percent, but you only had to pay 2 percent for the first 5 years. The extra 5 percent interest that you owed, but did not pay, was added to your loan balance every month. So, at the end of 5 years, your initial $400,000 mortgage loan would now have a balance of over $500,000.

The relaxed mortgage underwriting standards gave homebuyers this choice: I can buy my $450,000 brand-new dream home in a gated community, with 3,000 square feet, 5 bedrooms, 3 baths, 3 car garage, and swimming pool; OR I can buy the 30-year-old $225,000 home that has 3 bedrooms, 2 baths, and no pool. Investors jumped in and bought houses with hopes of quick and big profits. Greed won out and led to the big housing boom. When the value of homes started dropping in 2006, it led to massive foreclosures and over 500 banks going under. All of this eventually led to the 2008 stock market crash and The Great Recession, where 10 million jobs were lost. Excessive greed always has consequences.

Contact Dr. Harold Wong at (480) 706-0177, haroldwong1@yahoo.com, or www.drharoldwong.com. For his archived articles, click on www.DrWongInvestorGuide.com.

When You Start Social Security Matters!

(6/27/14 corrected version 2 AZ Republic by Dr. Harold Wong)

Let me cover the dramatic difference in taking SS at age 62 instead of 70. Waiting until age 70 really matters if you are married and both have long life expectancy.

Your expected life expectancy is one of your key factors in deciding when to take SS. Let’s compare taking 100% of SS benefits at age 66 versus 132 percent at age 70. Mathematically, it takes you 12.5 years (if you take SS benefits at 70) to make up the difference of not collecting 4 full years of SS from age 66 to 70. Here’s where many Baby Boomers make a mistake: they plan by average life expectancy instead of the life expectancy of the longest-surviving spouse. On average, Baby Boomers will live until 83. However, in year 2000; the Society of Actuaries study showed some startling statistics. If a married couple is 65, there is about a 50 percent chance that at least one will live until age 92 and about a 25 percent chance that at least one will live until 97.

Example 1: You are a single Baby Boomer born in 1950 who earned $50,000. When the Great Recession started in 2008, you looked at your SS monthly benefit choices: $1,070 if took benefits at age 62; $1,489 at 66; or $2,047 at 70. If we ignore any future cost-of-living increases, here’s the total SS benefits would have by age 83: $269,640 if took SS at 62; $303,756 at 66; or $319,332 at 70. One argument for taking SS early is that you can invest the money and so your total income is the same, no matter what age you chose to take SS. That’s a logical argument, but it assumes there is no risk from stock market crashes and being victims of scams. However, you can take the position “I’ll live or die with the consequences if I lose money with my investments”.

Example 2: You are a married Baby Boomer husband and don’t worry about your spouse. Suppose you had consistently earned the higher income and your wife is 6 years younger. Suppose you decide to start SS at age 62 and get $17,000 a year versus $32,000 at age 70. Suppose your wife did not work long and discovers that taking half of your (once she becomes age 66 Full Retirement age) SS benefit is higher than what she would receive on her own earnings history. You live until 88 and she lives until 97.  If you took SS at age 62, you would collect $17,000 each year for 26 years, or a total of $442,000. Starting when his wife became age 66 (Full Retirement Age), she collects half of your SS, or $8,500 each year for 16 years from her age 66 to age 82, or a total of $136,000. Once you die, she can collect your full SS benefit (but not both yours and hers) of $17,000 for 14 years from her age of 83 until she dies at 97, which is a total of $238,000. The total this couple will collect is $816,000.

Example 3: You actually love your spouse and wait until age 70 to collect your SS. Assume the SS benefits are the same as Example 2. You would collect $32,000 for 18 years, a total of $576,000. Your wife would collect $16,000 each year for 16 years, totaling $256,000. After you die, your wife would collect $32,000 each year for 14 years, totaling $448,000. The grand total for the couple would be $1,280,000. This is $464,000 more than if he took SS benefits at age 62.

Conclusion: Waiting until age 70 to take SS benefits really protects a younger spouse who has not earned much during her career. Receiving 85 percent more SS protects against future inflation and unexpected expenses.

Contact Dr. Wong at (480) 706-0177, haroldwong1@yahoo.com, or www.drharoldwong.com. For his previous articles, click on www.DrWongInvestorGuide.com.

Social Security & Baby Boomers’ Retirement Plan

6/13/2014 AZ Republic by Dr. Harold Wong

For Baby Boomers born between 1943-54, Full Retirement Age (FRA) for full Social Security (SS) is age 66. This contrasts to the age 65 that was FRA for decades since the Social Security Act was passed in 1935. For those born in 1955, FRA is 66 plus 2 months. For every year after those born in 1954, FRA increase by 2 months until FRA is 67 for those born 1960 and later. For those whose FRA is 66, you get 25 percent less if you start SS benefits at 62. For every year after 66, you get 8 percent more for every year you wait until age 70. Note: only 1.2 percent of men and 2 percent of women wait until age 70 in order to get 32 percent more than if they took SS benefits at age 66. Example: if you would have received $2,000 monthly with FRA of 66, you receive $1,500 at 62 or $2,640 monthly if you wait until age 70.

There is a major difference in sources of retirement funds for those retirees versus nonretirees. Among those already retired, 49 percent said that a major source of funds was from a work-sponsored retirement plan; 48 percent from Social Security (SS); 38 percent from a 401k, IRA, or other retirement savings account; 32 percent from the equity in their house; 30 percent from individual stock or mutual funds; 25 percent from other savings such as savings accounts or CDs; 19 percent from annuities or insurance plans; 7 percent from part-time work; and 6 percent from inheritance money.

In contrast, for nonretirees, 74 percent said that a major source of funds for retirement was a 401k, IRA, or other retirement savings account; 40 percent from individual stock or mutual funds; 39 percent from a work-sponsored pension plan; 36 percent from home equity; 30 percent from other savings such as a regular savings account or CDs; 28 percent from SS; 17 percent from annuities or insurance plans; 16 percent from part-time work; and 7 percent from inheritance. Source: Wells Fargo Gallup Poll: Investor and Retirement Optimism Index, February 1-8, 2011.

Retirees rank as virtually a dead heat their major sources of retirement funds being from a work-sponsored pension plan and Social Security. In contrast, nonretirees expect their major source of retirement funds to come from what they have saved in a 401k, IRA, or other retirement savings account and their individual stock or mutual fund investments. Nonretirees have seen a drastic drop in workers covered by old-fashioned defined benefit pension plans and understand that their retirement income has to come from savings. Nonretirees rank SS as only their 6th major source of retirement funds, a striking contrast to retirees who rank it as their 2nd major source. Unless one is a government employee, most Baby Boomers, Generation X and Y workers will never enjoy an old-fashioned employer defined benefit pension plan.

Conclusion: When the Social Security Act was passed in 1935, men’s average life expectancy was less than 65. Social Security never envisioned a situation where people would be taking SS for 20-30 or more years in retirement. In 2014, the average monthly SS benefit received by 39 million retired workers was $1,294. Social Security will still be a major source of Baby Boomers’ retirement income because they have not saved enough. Any interest-bearing investment pays very low, whether it is bank instruments, U.S. Treasuries, or bonds. The average dividend yield for the stock market is only about 2 percent. Baby Boomers best strategy is to work until 70 to maximize their SS benefits and to save a big chunk of the extra 8 years of job income from age 62 to 70. Quite a few also plan to work part-time while collecting SS.

Contact Harold Wong at (480) 706-0177, haroldwong1@yahoo.com, or www.drharoldwong.com. Visit www.DrWongInvestorGuide.com for his previous articles.

How Social Security Strategies Affect Your Retirement

(5/23/2014 AZ Republic by Dr. Harold Wong)

The Social Security Press Office has published a Fact Sheet that gives some interesting numbers. In 2014, There 39 million retired workers who receive $1,294 in average monthly benefits; 8.8 million disabled workers who receive $1,146 in average monthly benefits; and 6.2 million Survivors who receive $1,244 in average monthly benefits.

Social Security is the major source of income for most of the elderly. Nearly 90 percent of individuals age 65 and older receive SS benefits. This represents about 38 percent of elderly income. Among elderly SS beneficiaries, 52 percent of married couples and 74 percent of unmarried persons receive 50 percent or more of their income from SS. Among elderly SS beneficiaries, SS is 90 percent or more of the income for 22 percent of married couples and about 47 percent of unmarried persons.

Many workers take SS too early, given their retirement goals. An April 22, 2014 article by Mandi Woodruff found on www.yahoofinance.com, cites new data released by the SS Administration. For 2012, 37.2 percent of men and 42.4 percent of women took SS at age 62, the earliest age that non-disabled individuals can take SS. Only 5.2 percent of men and 11.4 percent of women waited until age 66 (considered your full retirement age for workers who turned 65 after year 2008) to start taking SS benefits. Only 1.2 percent of men and 2 percent of women waited until age 70, when one gets 32 percent more than age 66.

Example: I met Helen about 4 years ago. She was a divorced real estate agent in Oregon, but the market fell apart. Luckily, she was able to move to the Phoenix area and got a job at a hospital where she earned about $50,000 annually until age 70 and then took SS. Her benefits were $2,400 a month, instead of only $1,250 a month had she taken SS at age 62. Note: in virtually all incomes that I have seen, one gets almost double the SS benefits at age 70 compared to age 62.

She owned her home free and clear, but had to pay $600/month to the community park owner for the land rent, given that she owned the manufactured home but not the land. If we add all utilities, including cable TV, high-speed internet, and phone, it was another $250 per month. If she had taken SS at age 62, she would only have $400 per month to cover all other expenses, including food, healthcare, car, and fun. Life would have been very grim. Because she was receiving $2,400 a month SS, she was able to lead a normal life, such as buying the groceries she wanted and going out to lunch with her girlfriends.

Private Pension Plan Offsets Future Inflation: Helen had only $150,000 in her IRA and about $30,000 of cash in the bank. She understood that with only 4 percent annual inflation, what cost $25,000 today will cost $37,006 in 10 years when she is 80. She deposited $100,000 of her IRA in a private pension at age 70 and it will generate $10,256 of annual income, starting at age 77, for the rest of her life. The 10.256 percent of annual cash flow is guaranteed and her principal is not at risk in the stock market. This is substantially more than what her IRA was generating.

Free Seminars: “How You Can Maximize Your Social Security & Other Income” will be given Thursday June 5, 2014 6:30-8:30 P.M. following a light supper 6-6:30 P.M.; and Saturday June 7, 2014, 10-12 seminar followed by a light lunch 12-1 P.M. Both events will be at Keller Williams University, 2077 E. Warner Road, Suite 110, Tempe, AZ 85284. To RSVP, call (800) 955-2490 or email haroldwong1@yahoo.com

Contact Dr. Harold Wong at (480) 706-0177, haroldwong1@yahoo.com, or www.drharoldwong.com. For his previous articles and future seminars, click on www.DrWongInvestorGuide.com.

Multi-Generational IRA Multiplies Your Family Wealth!

(5/9/2014 AZ Republic by Dr. Harold Wong)

This is the 5th article in a row for a series on taxation. My previous article “Converting to Roth IRA can Counter Future Tax Increases” gave the history of federal tax rates and showed that recent tax rates have been some of the lowest in modern history. Tax rates are likely to increase in the future due to large federal deficits. The Roth IRA Conversion allows one to pay your taxes once, and then enjoy unlimited earnings without taxation for up to 3 generations.

The Multi-Generational IRA (MGIRA) is the second advanced IRA strategy that can multiply family wealth. Without using this MGIRA strategy, when both spouses die in a car accident, the IRA funds gush out in a lump-sum. The funds normally get distributed to the kids and/or grandkids who want the money as soon as possible. If there’s $500,000 in an IRA, 401k, 403b, or any other tax-deferred retirement account and there are 2 kids, each gets $250,000 of income added to whatever taxable income their household has. This increases their tax rate substantially.

If the combined federal and state tax rate is 40 percent, there’s a total $200,000 loss in taxation, leaving $150,000 for each child. Even if a revocable living trust is the beneficiary of the IRA, the funds can only remain for up to 5 years before all has to be paid out. With the MGIRA strategy, the IRS will force a Required Minimum Distribution (RMD), but it will be over the life expectancy of the child or grandchild. So, only a small amount has to be distributed each year, allowing the vast majority of the principal to still grow.

Example 1: A 74-year-old grandma wants to leave a legacy to her 4 grandkids, ages 25, 23, 19, and 17. She deposits $173,054 in a MGIRA and we assume it earns 4.50 percent. She will be forced to take out RMDs totaling $156,573 during her lifetime. This would leave $157,770 if the lump-sum was distributed to the 4 grandkids. However, by distributing it over their lives, the total becomes $563,493, or 3.57 times more. Every year for the rest of their life expectancy, each grandchild will receive a check. Hopefully, they will say “What wonderful memories of Grandma. She may be gone, but look how she’s still looking after me”. It will become a permanent birthday gift, Christmas gift, or legacy that you leave.

Example 2: a 65-year-old Grandma only has one grandson, a new born not yet age 1. She combines the Roth IRA Conversion and MGIRA strategies and deposits $360,000 with the assumption of a 4.50 percent annual rate of return. This will multiply to $4,088,451 of tax-free income over the life of the grandson. If she dies at 86, the grandson will start receiving $15,360 at his age 22. Each year the income will increase, rising to: $21,136 at 30; $31,541 at 40; $47,171 at 50; $70,814 at 60; $107,201 at 70; and $168,539 at 80. The income will be tax-free each and every year. Her initial $360,000 deposit will multiply 11.36 times to $4,088,451 of total tax-free income.

Conclusion: The MGIRA multiplies income for future generations and provides a permanent “forget me not” legacy. If one adds the Roth IRA Conversion strategy, the future income will be tax-free for the life of the heirs. This MGIRA is protected from creditors in case of a lawsuit.

Free Seminars: “Secrets of the Roth and Multi-Generational IRA’s will be given Sat. May 17, 2014 from 10 A.M.-1 P.M. and “Protect Your Money” will be given Thurs. May 15, 2014 from 6:30-8:30 P.M. Both will be held at Keller Williams University, 2077 E. Warner Road, #110, Tempe, AZ 85284. To RSVP, call 1 (800) 955-2490.

Contact Dr. Wong at (480) 706-0177, haroldwong1@yahoo.com, or www.drharoldwong.com. For his previous articles or future seminars, click on www.DrWongInvestorGuide.com.

Why Consider a Roth IRA Conversion in 2014?

(4/25/2014 AZ Republic by Dr. Harold Wong)

As a taxpayer, one does not have any control of what future tax rates will be under any new tax law. The highest marginal federal income tax rate was: 94 percent in 1944 and 1945; 91 percent from 1946-1951; 92 percent from 1952-1953; 91 percent from 1954-1963; 77 percent in 1964; 70 percent from 1965-1981. When I passed the CPA national CPA exam in November, 1979, the highest federal tax bracket was 70 percent. Under President Reagan, The Economic Recovery Tax Act of 1981 eventually lowering the maximum 70 percent rate to 50 percent from 1982-86. The maximum rate was 38.5 percent in 1987; 28 percent from 1988-1990; 31 percent from 1991-1992; 39.6 percent from 1993-2000; 39.1 percent in 2001; 38.6 percent in 2002; and 35 percent in 2003-2012. The American Taxpayer Relief Act of 2012, signed by President Obama on January 2, 2013, raised the maximum federal income tax rate to 39.6 percent, starting in 2013. The maximum federal tax rate hit historic lows in 1988-1990 and has been going up ever since.

A Roth IRA conversion means that one pays the tax on one’s traditional IRA, 401(k), 403(b), 457, or any other IRS-approved tax-deferred retirement account now, but can earn unlimited amounts without tax for the rest of your life. I regularly see retired couples with total incomes of $100,000-120,000 who are paying only $10-14,000 of total federal income tax. Before 1981, they would have paid at least twice as much. In essence, taxes are “on sale” right now, compared to the probable future rates.

Why Are Tax Rates Likely to Increase for the Future? The federal government has had a budget deficit totaling about $6.03 trillion from fiscal year 2009-2013, or an average deficit of $1.206 trillion over this 5-year period. The Great Recession, was partly caused by housing prices declining by over half from 2006 to 2011 in states such as AZ, CA, FL, and NV, In many parts of the country, housing prices have still not recovered to their 2005-2006 peak values. Tax revenues were cut, but the federal government increased spending, including the infamous The Emergency Economic Stabilization Act of 2008 (passed and signed into law on October 3, 2008). This was commonly known as the $800 billion bailout of Wall Street, Big Banks, Detroit automakers, and state government union employees.

After the 2008 Stock Market Crash officially started The Great Recession, over 10 million jobs were lost. This decreased many Americans’ incomes and net worth as many raided savings to cover living expenses. Although there has been a slow economic recovery, labor participation rates have been at historic lows. Many millions are either unemployed; working part-time instead of their desired full-time work status; or have given up looking for work (the so-called “discouraged workers” who are no longer counted in the official unemployment rate statistics). Recent statistics show that of the monthly increase in employment, over half is part-time or temporary jobs, instead of the good-paying full-time jobs with benefits that were lost during The Great Recession. Until most Americans have good-paying, full-time jobs, they will not be paying income taxes at the level prior to The Great Recession.

Conclusion: The federal government has shown no shame about bailing out special interest groups. Also, when the 80 million Baby Boomers born from 1946-64 retire (or have already done so), they will be collecting Social Security and Medicare benefits instead of paying income taxes. The federal government will want to ask for higher taxes instead of cutting spending. This is why one should seriously consider a Roth IRA conversion in 2014 and eliminate Uncle Sam from your family income taxes for the rest of your life, your kids’ lives, and even your grandkids’ lives.

Contact Dr. Harold Wong at (480) 706-0177, haroldwong1@yahoo.com, or www.drharoldwong.com. For his previous articles and future seminars, click on www.DrWongInvestorGuide.com.

Solo 401(k) Saves Tax for Small Family Business

(4/11/2014 AZ Republic by Dr. Harold Wong)

People are scrambling to finish their 2013 tax year return and wondering how they can save tax for the 2014 tax year. The Solo 401(k) is a strategy that few utilize. It is designed for small business owners who have only family employees. The limit is two participants, which typically is the business owner and the spouse. The Solo 401(k) is not a new type of 401(k) plan and has the same rules and requirements as any other 401(k) plan. More details can be found on www.irs.gov and search for “Retirement-Plans-One_Participant-401k-Plans”.

How much can one contribute? The business owner wears two hats in a 401(k) plan: employee and employer. Contributions can be made to the plan in both capacities. The owner can elect to defer up to 100 percent of compensation (also known as earned income for the self-employed) up to $17,500 for both 2013 and 2014 tax years. If he is age 50 or over, there can be an extra $5,500 (called the “catch-up” contribution) to make the total $23,000 per year.

The second part is the employer contribution of up to either 25 percent of the compensation defined by the plan, typically wages, or a different calculation for the self-employed individual. One defines one’s compensation as “earned income”, which is net earnings from self-employment after deducting half of one’s self-employment tax (calculated on Schedule SE). Then 20 percent of this number is what the employer contribution is. The total of both the employee salary deferral as well as the employer contribution cannot exceed $51,000 for 2013 and $52,000 for 2014. If the individual is age 50 or over, there can be an extra $5,500 “catch-up” contribution, making the total maximum contribution to the Solo 401(k) plan $56,500 for 2013 and $57,500 for 2014.

Example of a Schedule C, unincorporated small business, where the owner is at least age 50 and the net profit in 2014 is $200,000:

One calculates the Section 1402(a)(12) Deduction, which reduces the figure to $184,700. Next one uses Schedule SE to calculate FICA and Medicare Tax, which totals $19,864.30. Half of this is $9,932,15, and is subtracted from $200,000. The result is $190,067.85 of Self-Employment Income. The maximum Employee Salary Deferral contribution is $17,500 plus $5,500 or $23,000. If one takes 20 percent of $190,067.85, the maximum employer profit sharing contribution is $38,013.57. The total of the two contributions is $61,013.57. However, one cannot exceed the total limit of $57,500. Note: a step-by-step worksheet for this calculation can be found in IRS Publication 560. In contrast, the contribution limit for a SIMPLE IRA plan would be $20,035.96 or $38,013.57 for a SEP IRA plan. One can contribute substantially more to a Solo 401(k) instead of these other two employer IRA plans, and certainly much more than the $6,500 limit for a traditional individual IRA plan.

Deadlines: One must establish your Solo 401(k) plan by December 31, 2014, if you want to make a contribution for tax year 2014 and reduce taxable income. The contributions must be funded by your tax-filing deadline. If one files for the 6-month extension before the April 15, 2015 deadline to file one’s 2014 tax return, one would have until October, 15, 2015, to make the cash contribution.

Free Seminars: On Thursday April 17, 2014, from 6:30-8 P.M., there will be a seminar “How Obamacare Will Increase Your Taxes and Affect Your Retirement Future”. On Saturday April 19, from 10-12 noon, followed by a light lunch from 12-1 P.M., there will be a different seminar “How Women, Widow(ers), and Couples Can Increase Income and Reduce Taxes”. Both seminars will cover various tax-savings strategies and will be held at Keller-Williams Realty East Valley, at 2077 E. Warner Road, Suite 110, Tempe, AZ 85284. To RSVP, call 1 (800) 955-2490.

You can contact Dr. Wong at (480) 706-0177; haroldwong1@yahoo.com; or www.drharoldwong.com. For his articles and future seminars, click on www.DrWongInvestorGuide.com.

Use Section 1031 to Defer Higher Taxes

(3/28/2014 AZ Republic by Dr. Harold Wong)

The American Taxpayer Relief Act of 2012 (ATRA) adds a new higher ordinary income tax bracket of 39.6 percent for these filing statuses and taxable income in 2013: Married filing jointly and surviving spouses ($450,000); Single taxpayers ($400,000); Heads of households ($425,000); and Married filing separately ($225,000). These are inflation adjusted and will increase in future years.

My previous article, “High-income taxpayers must deal with 2013 rate increase” March 14, 2014 The AZ Republic, focused on the increase in long-term capital gains tax from 15 percent to 20 percent and the extra 3.8 percent tax on net investment income (NII) for successful taxpayers. Note: The top tax rate for qualified dividends also is increased from 15 percent to 20 percent for those whose income is at the levels noted above.

There is a new tax commonly referred to as the Obamacare Medicare Tax or Medicare Surtax. It is an extra 0.9 percent and applies to employees or those with self-employment income with Modified Adjusted Gross Income in excess of: $200,000 single or head of household; $250,000 married filing jointly; $125,000 married filing separately. When one adds this extra 0.9 percent tax and the 3.8 percent tax on NII, the total is 4.70 percent. This 4.70 percent increase plus the current 2.90 percent Medicare tax equals 7.60 percent. This is a 262 percent increase for high-income taxpayers and is designed to cover the increased cost of the Affordable Care Act, popularly known as Obamacare.

Here is a major tax strategy you might consider for the 2014 tax year!

Use a Section 1031 tax-deferred exchange for big real estate gains. Suppose that you purchased a rental house 40 years ago in San Francisco and planned to sell it in 2014 with a net $1,000,000 long-term capital gain. If you are a high-income taxpayer, to whom the 39.6 percent new tax applies, you would face a 20 percent long-term capital gains tax plus the 3.8 percent Net Investment Income Tax of a total of 23.8 percent. This would be $238,000 of tax.

If you were either a CA resident OR taxed by CA because your rental house was in S.F., you could pay another 13.3 percent CA tax if your income was $1 million or more. The combined effective Fed and CA tax rate on long-term capital gains would be 33.0 percent (not 33.3 percent due to some offsets).

Instead of selling your rental house, you can use the Section 1031 tax-deferred exchange provision of the tax law. It has been around for about 4 decades and, after a number of court cases, the rules were codified in The Deficit Reduction Act of 1984. Here are the main provisions: This is only for investment and business property and the property must be “like-kind”. You can exchange a rental house for an apartment building, commercial warehouse, office building, land, or retail strip shopping center. You can exchange certain equipment for other equipment. But you can’t exchange a rental house for a Caterpillar bulldozer. You must designate the replacement property in writing within 45 days of the sale of your property and close within 180 days of the sale of the old. The new property must be at least the same price and mortgage balance as the old property. You can’t receive the cash personally and the exchange must be handled by a third party, normally known as a Section 1031 intermediary. Some of the rules are complex and you should consult a specialist. There is no limit how many times you can do a 1031, which allows your investment to continue to grow tax deferred.

Summary: There are higher taxes, starting in 2013 for high-income taxpayers, and it’s especially bad if you also owe CA taxes. Future articles will cover other major tax-savings strategies.

Contact Dr. Wong at (480) 706-0177; haroldwong1@yahoo.com; www.drharoldwong.com. For previous articles or future seminars, click on www.DrWongInvestorGuide.com.

New 2013 Taxes on High-Income Taxpayers

3/14/2013 AZ Republic by Dr. Harold Wong

On January 2, 2013, President Obama signed the American Taxpayer Relief Act (ATRA). ATRA raises the maximum long-term capital gains tax rate from 15 to 20 percent, for: Singles with taxable income above $400,000; Married Filing Jointly above $450,000; and Heads of Households above $425,000. In addition, there is a 3.8 percent tax on Net Investment Income (NII) that is designed to cover part of the expense of the Affordable Care Act (also known as Obamacare). For this article, I looked at several sources, but a particularly helpful one is found at http://www.irs.gov/uad/Newsroom/Net-Investment-Income-Tax-FAQs.

  • What is the Net Investment Income Tax (NIIT)? It is calculated at 3.8 percent of certain net investment income (NII) of individuals, estates and trusts. You may owe NIIT if you have NII and also have Modified Adjusted Gross Income (MAGI) over the following amounts: $250,000 for Married Filing Jointly; $125,000 for Married Filing Separately; $200,000 for Single or Head of Household (with a qualifying person); and $250,000 for qualifying widow(er) with dependent child. NIIT takes effect on January 1, 2013. MAGI is a fairly complex calculation best left to your CPA.
  • What is included in Net Investment Income? In general, investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer (within the meaning of section 469). To calculate your NII, your investment income is reduced by certain expenses properly allocable to the income (see below).
  • What are some common types of income that are not Net Investment Income? Wages, unemployment compensation; operating income from a nonpassive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, and distributions from certain Qualified Plans such as 401(k), 403(b), 457, and others.
  • What kinds of gains are included in Net Investment Income? To the extent that gains are not otherwise offset by capital losses, the following gains are common examples of items taken into account in computing NII: Gains from the sale of stocks, bonds, and mutual funds; Capital gain distributions from mutual funds; Gain from the sale of investment real estate (including gain from the sale of a second home that is not a primary residence); and Gains from the sale of interests in partnerships and S corporations (to the extent the partner or shareholder was a passive owner).
  • What investment expenses are deductible in computing Net Investment Income? In order to arrive at NII, Gross Investment Income is reduced by deductions that are properly allocable to items of Gross Investment Income, such as: investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, tax preparation fees, fiduciary expenses (in the case of an estate or trust) and state and local income taxes.
  • Example: Single taxpayer with income greater than the statutory threshold. Taxpayer, a single filer, has $180,000 of wages. Taxpayer also received $90,000 from a passive partnership interest, which is considered Net Investment Income. Taxpayer’s modified adjusted gross income is $270,000. Taxpayer’s modified adjusted gross income exceeds the threshold of $200,000 for single taxpayers by $70,000. Taxpayer’s Net Investment Income is $90,000.

Note: The Net Investment Income Tax is based on the lesser of $70,000 (the amount that Taxpayer’s MAGI exceeds the $200,000 threshold) or $90,000 (Taxpayer’s Net Investment Income). Taxpayer owes NIIT of $2,660 ($70,000 x 3.8%).

Conclusion: For certain high-income taxpayers, their total tax on long-term capital gains assets has increased from a maximum 15 percent in 2012 to 23.8 percent in 2013. That’s a 59 percent increase in taxes. A future article will discuss ways to avoid paying this 3.8 percent NIIT and perhaps even the 20 percent long-term capital gains tax.

Contact Dr. Wong at: (480) 706-0177; haroldwong1@yahoo.com; or www.drharoldwong.com. For his previous articles or future seminars, click on www.DrWongInvestorGuide.com.

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