For months now, one of the major ongoing focuses has been on deficit spending and the risk of the US economy falling off the Fiscal Cliff. The issue is simple, the solution, not so much. We can’t keep spending as a nation. The US can’t keep spending money it doesn’t have without creating a future financial disaster. At some point, irresponsible spending will require a much higher interest payment on US debt. That alone could lead to financial ruin as it has in European nations such as Greece, Spain, Italy, Ireland, and Portugal.
The solution will require two difficult decisions:
- Spending must be reduced significantly.
- Revenue must be increased by higher taxes, limiting deductions, or doing both.
The re-election of Barack Obama affirms the population’s approval of placing a much heavier financial burden on people that are successful. It is inevitable that taxes paid on active and passive income will increase significantly, even for people earning less than $250,000. Keep in mind that the proposed tax rate for the wealthy would only cover the cost of running the government for 8 days. A lot more revenue is needed to offset the over $1 trillion annual deficit expected over the next several years. It’s also an absolute given that many deductions will either disappear or be severely limited.
Let’s consider a worst case scenario by looking at the following case study:
Michael Moneybags purchased a large estate 30 years ago for $100,000. He wants to sell the home for $2.6 million. He has an offer for just $2 million, but the buyers are willing to close before the end of the year. Michael has another home and wants to give the majority of the money to his children and to charity.
Let’s look at the difference for Mr. Moneybags if he were to accept the lowball offer now instead of waiting for a better offer next year.
1. Capital Gains Tax – Michael is realizing a profit of $2.5 million. The Capital Gains Tax Rate is expected to increase 5%, from the current 15% to at least 20% next year. If Michael waits until next year to close, he will pay an extra 5% x $2.5 million profit = $125,000 in additional taxes.
2. Health Care Surcharge – Michael will also have to pay an extra 3.8% fee to help offset the costs of the new healthcare reform. $2.5 Million x 3.8% = $95,000.00 in additional taxes.
3. Gift Tax – Michael is giving his kids $2 million of the profit from the sale of his home. Right now, there is a $5.12 million exemption for money transferred by gift tax. Michael pays nothing this year. Next year, the exemption is likely to drop to $1 million. The remaining $1 million will be taxed at 55%. $1 million x 55% = $550,000 in additional taxes next year.
4. Michael plans on giving $300,000.00 to charity. This year, he gets a full deduction for this donation. Next year, under tax reform, he could be taxed on this amount if the charitable deductions are eliminated, or total deductions are capped. This could cost Michael more.
Conclusion – Based on Michael Moneybags’ situation above, he could easily end up paying an additional $770,00. This means Michael could sell for hundreds of thousands less this year and still be way ahead of the ball game. For those of you thinking Michael’s situation is unique, consider that mortgage interest deductions and even total deductions could be capped at a very low rate. This would lead to much higher taxes for anyone that doesn’t live in an average American home.