Capital Gains Impact on Marginal Tax Rate

[JDARNELL]

Couple is in the 22% marginal tax rate based off retirement income, SS, and normal dividends. They are looking at cashing out of a couple of rentals that will produce a long term capital gain of ~$400K to ~$900K depending on what they sell. 1031 is not considered so the gain will be realized.

I know the 3.8% investment tax will kick in as well as IRMAA increase in two years for the one year til their income goes back down to the first increment and they return to the 22% marginal bracket.

I am struggling to understand how the overall income lines up with the marginal tax rate. Can someone explain to me the impact of a large capital gain may have on overall marginal tax rate?

JDARNELL

 

[LateToFIRE]

Inquiring minds also would like a refresher. I'm gonna have this problem when start selling off wildly appreciated r.e.

 

[SevenUp]

One way to see this is to use the case study spreadsheet and change the x-axis from the default of tIRA withdrawals to LTCG.

A similar article, Roth Conversion with Social Security and Medicare IRMAA, may also be helpful.

 

[RunningBum]

I would just use one of the tax calculators like https://www.irscalculators.com/tax-calculator and estimate their income first, then add this as cap gains. What about depreciation and recapture on the rentals? That's more complicated, but maybe you've figured that in on the gain already. If you use a tax program, use the "what if" function or just make a copy of your tax program and add potential sales to it.

 

[SecondCor521]

Couple is in the 22% marginal tax rate based off retirement income, SS, and normal dividends. They are looking at cashing out of a couple of rentals that will produce a long term capital gain of ~$400K to ~$900K depending on what they sell. 1031 is not considered so the gain will be realized.

I know the 3.8% investment tax will kick in as well as IRMAA increase in two years for the one year til their income goes back down to the first increment and they return to the 22% marginal bracket.

I am struggling to understand how the overall income lines up with the marginal tax rate. Can someone explain to me the impact of a large capital gain may have on overall marginal tax rate?

JDARNELL

Roughly:

1. Take their ordinary income (SS, W-2, Schedule C, interest, ordinary dividends) and stack that up.

2. Take their capital gains and stack that on top of the ordinary income.

3. Take their standard or itemized deduction from the bottom of the pile (so it eats up ordinary income first then may eat up capital gains second).

4. Apply the ordinary income tax brackets to any remaining ordinary income.

5. Apply the capital gains tax brackets to any remaining capital gain income, taking into account that the ordinary income takes up room in the capital gains brackets (So even though the first ~$94K is 0% LTCG bracket, if they have $94K in ordinary income, their first LTCG dollar starts in the 15% bracket).

6. Apply NIIT to any NII above the cutoff amount ($200K single, $250K married).

It does get more complicated if there is depreciation recapture or other stuff going on.

There is also an additional Medicare tax (separate from NIIT). I don't know much about it but it may hit the couple you're talking about with that level of capital gain.

With that much capital gain and any reasonable amount of ordinary income, you can probably count on most of the RE LTCG getting taxed at 15%, some at 18.8% (15% LTCG plus 3.8% NIIT), and maybe even some at 23.8% (20% LTCG plus 3.8% NIIT).

They probably should consider selling the properties off one at a time across multiple tax years if that works for them. $400K LTCG in two tax years each maybe saves 5% compared to $800K in one tax year (because you can shift anything that was in the 20% LTCG bracket down into the 15% LTCG bracket).

The CSS spreadsheet would do a good job modeling all this too.

 

[LateToFIRE]

Roughly:

1. Take their ordinary income (SS, W-2, Schedule C, interest, ordinary dividends) and stack that up.

2. Take their capital gains and stack that on top of the ordinary income.

3. Take their standard or itemized deduction from the bottom of the pile (so it eats up ordinary income first then may eat up capital gains second).

4. Apply the ordinary income tax brackets to any remaining ordinary income.

5. Apply the capital gains tax brackets to any remaining capital gain income, taking into account that the ordinary income takes up room in the capital gains brackets (So even though the first ~$94K is 0% LTCG bracket, if they have $94K in ordinary income, their first LTCG dollar starts in the 15% bracket).

6. Apply NIIT to any NII above the cutoff amount ($200K single, $250K married).

It does get more complicated if there is depreciation recapture or other stuff going on.

There is also an additional Medicare tax (separate from NIIT). I don't know much about it but it may hit the couple you're talking about with that level of capital gain.

With that much capital gain and any reasonable amount of ordinary income, you can probably count on most of the RE LTCG getting taxed at 15%, some at 18.8% (15% LTCG plus 3.8% NIIT), and maybe even some at 23.8% (20% LTCG plus 3.8% NIIT).

They probably should consider selling the properties off one at a time across multiple tax years if that works for them. $400K LTCG in two tax years each maybe saves 5% compared to $800K in one tax year (because you can shift anything that was in the 20% LTCG bracket down into the 15% LTCG bracket).

The CSS spreadsheet would do a good job modeling all this too.

Thanks! This is really helpful. I'm going to eventually have a +$1M gain on one property (so can't break it up over multiple years). Of course, I'll be consulting my accountant but have been trying to estimate how much will receive in net after-tax proceeds for retirement planning.

The irscalculators app also provides a detailed worksheet so I can see exactly how they calc'd the Fed tax.

P.S. The MMM spreadsheet also really helpful, but wow that thing is a beast!

 

[pb4uski]

I would just use one of the tax calculators like https://www.irscalculators.com/tax-calculator and estimate their income first, then add this as cap gains. What about depreciation and recapture on the rentals? That's more complicated, but maybe you've figured that in on the gain already. If you use a tax program, use the "what if" function or just make a copy of your tax program and add potential sales to it.

+1 and I did that with a hypothetical couple MFJ both over 65 that had $200k of unearned income... federal tax was $27,022; 22% marginal rate and 13.51% effective tax rate.

Then I added $500k of LTCG... this added $79,202.50 of capital gains tax, looks like mostly 15% but some at 20% and some NITT at 3.8% on $450k.

With the added LTCG the federal income tax didn't change, just added $96,302.50 of capital gains and NIIT... so 19.2% of the $500k LTCG.

Another way to model it would be with TurboTax What -If worksheet.

And of couurse IRMAA impact is additional.

 

[pb4uski]

Thanks! This is really helpful. I'm going to eventually have a +$1M gain on one property (so can't break it up over multiple years). ...

You could use an installment sale to break up the gain over multiple years. My dad did an installment sale, providing owner financing on a land sale, and that was the impact, in addition to interest on the finncing the gain was spread over several years.

 

[JDARNELL]

+1 and I did that with a hypothetical couple MFJ both over 65 that had $200k of unearned income... federal tax was $27,022; 22% marginal rate and 13.51% effective tax rate.

Then I added $500k of LTCG... this added $79,202.50 of capital gains tax, looks like mostly 15% but some at 20% and some NITT at 3.8% on $450k.

With the added LTCG the federal income tax didn't change, just added $96,302.50 of capital gains and NIIT... so 19.2% of the $500k LTCG.

Another way to model it would be with TurboTax What -If worksheet.

And of couurse IRMAA impact is additional.

Right and the IRMAA impact is just for one year two years later correct?

Also is the LTCG tax rates of 15% and 20% progressive or is it straight to the 20% if over the limit?

Seems like it might be best to bite the bullet in one year vs 2 due to the IRMAA increase?

 

[SecondCor521]

Right and the IRMAA impact is just for one year two years later correct?

Also is the LTCG tax rates of 15% and 20% progressive or is it straight to the 20% if over the limit?

Seems like it might be best to bite the bullet in one year vs 2 due to the IRMAA increase?

Yes, IRMAA is two years later and is based on your MAGI for each year, so if your income drops back down, then IRMAA adjusts back down as well on a two year lag.

The 15% and 20% LTCG work similarly to ordinary income brackets - any amount falling in the 15% bracket is taxed at that rate, and any amount above that is taxed at 20%.

Regarding the "bite the bullet", it would depend on the exact numbers. The general rule is that spreading things out is best, but there are exceptions. You'd have to do the math.

 

[ERD50]

...

It does get more complicated if there is depreciation recapture or other stuff going on.
...

Isn't there almost always depreciation recapture going on? As I understand it, you are 'forced' to depreciate the asset, and this is recaptured at sale time.

I find that some pro real estate people love to talk about their depreciation 'expense' write-off, but don't talk too much about the effect it has at sale time. You can do a 1031 exchange, but that still keeps you in real estate, whereas you might want/need to liquidate.

I wonder if the govt will ever put limits on the 1031 exchange, similar to the limits they've placed on liquidating an inherited IRA, or RMDs on your own IRA?

-ERD50

 

[JDARNELL]

Yes, IRMAA is two years later and is based on your MAGI for each year, so if your income drops back down, then IRMAA adjusts back down as well on a two year lag.

The 15% and 20% LTCG work similarly to ordinary income brackets - any amount falling in the 15% bracket is taxed at that rate, and any amount above that is taxed at 20%.

Regarding the "bite the bullet", it would depend on the exact numbers. The general rule is that spreading things out is best, but there are exceptions. You'd have to do the math.

I think the comparison would be on the amount in the 20% LTCG bracket compared to the additional year of increased IRMAA Fees before they revert to the baseline level?

 

[gauss]

You could use an installment sale to break up the gain over multiple years. My dad did an installment sale, providing owner financing on a land sale, and that was the impact, in addition to interest on the finncing the gain was spread over several years.

How about if the house was sold late in the year and the deal structured so that that 50% came in December and the remaining 50% came in January?

Maybe this would be an example of a very simple installment sale.

Just creatively "thinking out loud here" on the fly. No real experience with this or prior thought on it.

-gauss

 

[SecondCor521]

Isn't there almost always depreciation recapture going on? As I understand it, you are 'forced' to depreciate the asset, and this is recaptured at sale time.

My post was intended to be generally about how income taxation works. You're right in that investment real estate is generally depreciated, but there are other ways to get capital gains (including on a primary residence and investments) and end up subject to capital gains and NII taxes without involving depreciation.

 

[SecondCor521]

I think the comparison would be on the amount in the 20% LTCG bracket compared to the additional year of increased IRMAA Fees before they revert to the baseline level?

Sure, that would be the most obvious and simplest analysis.

One might also consider time value of money (getting the money sooner and also paying taxes now vs. paying later), the fact that there are multiple IRMAA levels, any other complications like how much NII or the additional Medicare tax might apply, whether someone wants to deal with an installment sale, whether the rental sales affect other parts of the tax plan like Roth conversions or when SS starts, the likely direction of real estate prices over the relevant time frame, and maybe more I'm not thinking of at the moment.