So You Are Going Over a Fiscal Cliff?
This is a particularly unusual time in our tax history. Long term tax policies are coming to an end in favor of increasing tax rates and reduced deductions and other "wiggle room." The tools which we will have available in the future are uncertain to some extent. Long term investment by family groups does not appear to be in regulatory favor.
Forest industries have had a sustained profits drought. We have looked for a resurgence of the housing industry to lead favorable price change for some time. Home Depot reports that it is beginning to see the rise in the market. However, the election results have encouraged the administration to push for 1.6 trillion dollars of revenue increases when they were asking for less than half of that a year ago in the "grand bargain." This has led a number of businesses to downgrade the anticipated uptick and put hiring on hold and plans for staff reductions in place.
There appears to be significant economic uncertainty for the remainder of this administration's tenure.
The Fiscal Cliff occurs when the confluence of new laws and regulations relating to health care, the environment, energy policy and tax policy occurs in January 2013. From the tax side, all tax rates will automatically increase to what they were before the so-called "Bush Tax Cuts" (yes, ALL of the rates were reduced). Working couples will see the marriage penalty return. All workers will notice an additional 2% deducted from their paychecks for social security. New responsibilities with respect to the Affordable Care Act will appear. Some will pay penalties for not having insurance only to discover that they are still not covered. Federal long-term capital gain rates will increase to a maximum of 20% for property held over one and less than five years and 18% for property held longer than five years. A new medicare tax at 3.8% will appear on investment income (including capital gains) for thresholds over $200K (single) and $250K (joint filers). While this is not an inclusive list, it is instructive as a background for us to consider.
Income Tax Indications
Particularly for individuals with timber and timberland businesses, it will be important to prove that you are indeed in business. Sales of timber occur infrequently for many and in significant amounts. If a long-term capital gain is incurred from the sale of a business asset, the additional medicare tax does not apply. Additionally, it is important to maintain the deduction of business activity costs in arriving at adjusted gross income. While each of these is not required to prove that you are in a business, it would behoove every timber owner to maintain a written management plan, separate business bank account and separate and continuous records for your business activity. Many of these records may be assimilated annually as you summarize your activities for tax purposes and make plans for the next year. Additionally, you should maintain a calendar showing the activities relating to your business and the time investment which you have made at various times and for what purposes during the year.
In preparing for January 1, 2013, many businesses have elected to realize gains inherent in their assets. Having performed a number of simulations over the last three years, it is a general conclusion that selling assets that are available for sale before 2013 is beneficial for both tax and economic objectives.
Consider as soon as possible in 2012 whether to market and sell timber and/or timberland. The strength of the market recovery going forward is less certain and makes this a primary time to consider asset disposition and replanting.
A Word on Capital Gains Rates
There are many who are convinced that long-term capital gains rates will not just increase to the pre-2001 levels. They believe there is a strong likelihood that these rates will tend to increase to equal ordinary income tax rates (as ordinary rates generally decrease and as itemized deductions are reduced or eliminated).
The 1986 tax code set up a regimen of passive losses. The result is that “passive” losses are disallowed until “passive” gains appear. Many timber owners incur “passive losses” in operating partnerships, LLC’s or proprietorships. These losses are allowed when the businesses generate income, generally from the sale of timber. Most IRS examinations are concentrating on this issue at present. Planning for the deduction of these losses and for circumstances resulting in “nonpassive” deductions is important.
The presence of a $5.1 million lifetime exemption per person from estate tax has eased the consideration of this particularly onerous tax. The older an asset, the more likely that a componenent of “gain” is inflation. Assets held over a lifetime can have substantial inflation values. When that value is taxed, for sale or estate tax, it is an unfair addition.
The Estate and Gift taxes are "unified" for the present, meaning that if a person can pass $5.1 million away at death without tax, the same result occurs for a lifetime gift. The overall exemption will be reduced to $1 million as of January 1, 2013. There is a brief window of opportunity to pass family assets without the incidence of estate tax, up to a lifetime total of $5.1 million per donor. If you believe that this type of planning could benefit you or your family, you should consult a knowledgeable professional. There is already significant pressure for congressional action to eliminate many of the effective planning tools which allow families to maintain businesses and business interests, including forestry.
Points to Consider NOW
As soon as you have opportunity, consider with your financial and tax counsel (1) whether you should enter into any sales of property before the end of the year, (2) whether your timber business needs additional documentation to sustain that it is a business activity, (3) how passive activity rules affect you and how you are making them work in your favor and, (4) whether you should consider additional estate and gift planning before the end of the year. In other words, in a period of uncertainty, take steps to make solid plans where you can.
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