2. A SUPER SIMPLE INTRODUCTION TO TAXES, Part 2 of 2

2. A SUPER SIMPLE INTRODUCTION TO TAXES, Part 2 of 2

Article posted in General on 28 July 2015| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 28 July 2015
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Summary

We wrap up Dr. James' simple introduction to taxes in this continuation of his book.

VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

2. A SUPER SIMPLE INTRODUCTION TO TAXES, Part 2 of 2

Links to previous sections of book are found at the end of each section.

An additional limitation for itemized deductions, such as the charitable income tax deduction, is referred to as the Pease limitations.  High income earners must reduce their itemized deductions either by 3% of the excess of their adjusted gross income (AGI) less the applicable threshold amount or by 80% of all itemized deductions except medical expenses.

For example, a single itemizing taxpayer with $300,000 of income (AGI) and $15,000 of itemized deductions ($5,000 of which were medical expenses) in 2015 would have to reduce these deductions by the lesser of

  1. ($300,000-258,250)x3%= $1,252.50 or
  2. $10,000x80%=$8,000

For the remainder of this text, all examples will assume that this limitation does not affect additional charitable deductions either because the donor is below the income thresholds or because the donor’s other itemized deductions exceed the 3% floor.

As mentioned previously, the value of a tax deduction depends upon the tax rate of the taxpayer.  For example, a single taxpayer with $8,000 of taxable income in 2015 would pay $800 in taxes.  If the taxpayer were to have received an additional $1,000 deduction, his or her taxable income would have fallen to $7,000 and he or she would have owed $700 in taxes.  Thus, the $1,000 deduction would have caused the taxpayer’s tax bill to drop by $100.

The same tax deduction is worth more to a higher income taxpayer.  For example, a single taxpayer with $500,000 of taxable income in 2015 would pay $154,369.10 in taxes.  If the taxpayer were to have received an additional $1,000 deduction, his or her taxable income would have fallen to $499,000 and he or she would have owed $153,973.10 in taxes.  Thus, the $1,000 deduction would have caused the taxpayer’s tax bill to drop by $396.

In the prior two cases, the quick way to calculate the value of the deduction would have been to simply multiply the deduction by the taxpayer’s marginal tax rate (e.g., $1,000 x 10% marginal tax rate = $100 in the first example and $1,000 x 39.6% marginal tax rate = $396 in the second example).  However, this simple approach does not work if the deduction causes the taxpayer’s marginal tax rate to change.  If the deduction causes the taxpayer to change tax brackets, then part of the deduction will be valued at the higher tax rate and part will be valued at the lower tax rate.

As an example, consider the value of a $1,000 deduction to a single taxpayer with $10,000 of taxable income in 2015.  The taxpayer begins at the 15% marginal tax rate.  However, after applying the first $225 of the deduction, the taxpayer now has $9,225 of taxable income and drops into the lower tax bracket.  Thus, any further deductions will reduce taxation not at the original 15% rate, but at the lower 10% rate.  The first $775 of the deduction reduces taxes at a 15% rate, and the final $225 of the deduction reduces taxes at a 10% rate.  The value of the deduction is thus, ($775x15%) + ($225x10%) = $138.75. 

Put another way, a single taxpayer with $10,000 of taxable income in 2015 would pay $1,038.75 in taxes.  If the taxpayer were to have received an additional $1,000 deduction, his or her taxable income would have fallen to $9,000 and he or she would have owed $900 in taxes.  Thus, the $1,000 deduction would have caused the taxpayer’s tax bill to drop by $138.75.

A separate set of tax rates applies to capital gains.  A capital gain occurs when a taxpayer sells an investment for more than he or she paid for it (including the cost of improvements).  This profit – the difference between the sale price and purchase price – is the amount of the capital gain.

Capital gain is calculated as the sales price less the taxpayer’s “basis” (or “adjusted basis”) in the property.  In most circumstances, the basis is simply the amount that the taxpayer paid for the investment.  However, basis is not always identical with the original price.

Basis always starts as the amount paid for the investment, but it can be adjusted later.  For example, if an investor purchases an apartment building for $1,000,000 and then spends $250,000 making capital improvements and additions to the building, the investor’s basis would increase to $1,250,000 (the $100,000,000 original purchase price plus the $250,000 of improvements).  This makes sense intuitively because in order to get the new, improved building the investor had to spend a total of $1,250,000.

Less intuitive is the effect of depreciation tax deductions.  The investor who purchased the apartment building is allowed to assume for tax purposes that the building is slowly wearing out (i.e., depreciating).  Each year, the taxpayer is allowed to claim this wearing out process (depreciation) as a loss, offsetting gains or income from certain other sources.  These depreciation deductions reduce the taxpayer’s basis in the property.  (If this were not the case, the taxpayer would be able to deduct the same dollar twice, first as a depreciation deduction and later as a reduction of the capital gain.)  Depreciation deductions do not apply to financial instruments such as stocks or bonds or to raw land.  Consequently, this text will not address depreciation unless the transaction specifically involves a gift of developed real estate.

If the taxpayer owns the investment for more than one year, any gain is taxed as a long-term capital gain.  Long-term capital gains tax rates are lower than those for ordinary income or short-term capital gains.  The capital gains tax rates are 0%, 15%, and 20%.  However, the Affordable Care Act imposes an additional 3.8% tax on net investment income of taxpayers over certain income thresholds (e.g., $200,000 of modified AGI for a single individual, $250,000 for a married couple filing jointly, not indexed for inflation).  Net investment income includes capital gains as well as other types of investment income such as interest, dividends, rent, and royalty income.  Consequently, depending upon the taxpayer’s taxable income and modified adjusted gross income, capital gains are taxed at 0%, 15%, 18.3%, or 23.8%.  These rates do not depend upon the amount of capital gain income, but rather depend upon the amount of overall taxable income and modified AGI.  Consequently, all of the taxpayer’s capital gains for a particular year will be taxed at the same rate.  (I.e., there is no run up the rate schedule where some gains are taxed at 15%, then some at 20%, and so forth.)

As described previously, the federal government charges taxes on the gratuitous transfer of money from one person to another, either at death (estate taxes) or during life (gift taxes).  Transfers to charitable organizations are not taxable.  Thus, any part of the estate that is transferred to a charity will not generate estate taxes.  Similarly, any gifts made during life to charity will not generate gift taxes.  This simple reality can be leveraged to create substantial estate tax planning opportunities through the use of trusts such as a non-grantor Charitable Lead Trust or Charitable Remainder Trust.

Most people are not affected by estate and gift taxes because the exemption levels are quite high.  For example, in 2015 there is no tax on estate and gift transfers that, when combined, do not exceed $5,430,000 for a single taxpayer or $10,860,000 for a married couple.  Thus, estate tax and gift tax planning is now limited to the realm of the wealthy.  However, estate planning can also affect other taxes, such as capital gains and income taxes, which are not limited to the wealthy.  Thus, tax planning in estates can still be quite important even where estate taxes are not relevant.

An additional tax, referred to as the generation skipping transfer tax, can arise if the taxpayer makes transfers that “skip” a generation.  For example, if a grandparent makes a gift (either during life or at death) to the child of his or her living child, this transfer skips a generation.  The amount of these generation skipping transfers that, when combined, exceeds the exemption equivalent amount ($5,430,000 in 2015), will generate an additional 40% tax.  This 40% generation skipping transfer tax is applied to the amount remaining after application of the 40% estate and gift tax.  As with the estate tax, because of the high exemption amounts, these generation skipping transfer tax issues are a concern only for those taxpayers transferring substantial wealth.  However, when they apply, the combined impact of these taxes can be dramatic.

As an extreme example of how burdensome the various types of taxation can become, consider the case of a taxpayer who wishes to earn an additional $100,000 to leave as an inheritance to his or her grandchildren.  If this person were living in the state of California and at all of the top marginal tax rates (e.g., in 2015 having income over $1,000,000 and having previously made over $5,430,000 of generation-skipping gifts), the tax consequences would be severe.  The additional $100,000 of income would first be subject to California’s 13.3% state income tax, costing $13,300.  Assuming the taxpayer could successfully claim all of the 13.3% tax as a deduction against his or her federal taxes (e.g., no Pease limitations), the 39.6% federal tax would be applied only to the remaining amount of $86,700, generating a tax bill of $34,333.20.  After paying the federal income tax, the remaining $52,366.80 could then be available to be inherited by the grandchildren.  This transfer at death would generate a 40% estate tax costing $20,946.72 and leaving $31,420.08.  However, if the grandchildren’s parents were still alive, this estate transfer would skip a generation and thus be subject to the generation skipping transfer tax.  This generation skipping transfer tax would generate an additional 40% tax on the remaining $31,420.08 costing $12,568.03 and leaving $18,852.05 for the grandchildren.  Although certainly not commonplace, this extreme example shows just how important tax planning can be in the face of such potentially extreme tax consequences.  As taxation increases, the value of tax planning – including charitable tax planning – also increases.  Consequently, charitably inclined individuals facing significant tax burdens are often excellent candidates for sophisticated charitable planning.

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