This past November, residents of Massachusetts voted in favor of amending the state constitution to impose an additional 4% tax on taxable income over $1M, with proceeds going towards education and transportation infrastructure. The new law narrowly passed with 52% of the vote and it marks the first time since 1915 that Massachusetts will implement a graduated tax scheme. Starting in 2023, Massachusetts will move from what was a 5% flat tax on income and long-term capital gains to this new, graduated tax structure where the state will now tax income and capital gains above $1M at 9%.
From a financial planning perspective, what is important to understand about the new tax law is that it doesn’t just apply to wages, but could also ensnare many people who have large, one-time earnings/income. This applies to any form of taxable income, including the sale of a home or business, retirement distributions, taxable portfolio dividends and interest, exercise of non-qualified stock options, vesting of RSUs, and golden parachute packages.
The new law means new planning opportunities for many individuals who find themselves in the otherwise enviable situation of recognizing a large, one-time income event. Undoubtedly, people in Massachusetts will be looking for ways to mitigate this new tax, especially if they have flexibility around when they can recognize the income. Here are a few ideas of how you can shift income around and/or defer its recognition for some of the income events listed above.
- Installment sale
This applies primarily for large business transactions, such as the sale of a long-held family business. In fact, two of the biggest groups opposing the passage of the new law were small businesses and family farmers. For these groups, an installment sale could be a good solution to minimize the impact of this new tax.
Installment sales are quite flexible, as there are no requirements as to the number of payments, size of payments, or the start or end date of payments. Even though the buyer may not make all payments for quite some time, they receive immediate title to the property upon commencement of the installment sale contract. Aside from decreasing the capital gains tax liability each year, installment sales have several advantages:
- Sellers can tailor installment sale payments to meet their needs—such as by filling an income gap between retirement and collecting Social Security.
- Sellers can also potentially increase the value of their sale by enticing would-be buyers to bid up the price by, for example, allowing for smaller payments over a longer timeframe.
- Sellers can “freeze” their estate value and thereby remove the future appreciation of the property from their estate. This can be an advantage to the seller who may be worried about having a federally taxable estate.
The primary disadvantage to an installment sale, aside from not getting all the money upfront, is the risk that the buyer defaults on payment. Although the seller can reclaim title to the property in the event of the buyer’s default, the buyer may have mismanaged the business/property and destroyed some of its value.
- Look into filing taxes “married filing separately” instead of the more typical “married filing jointly”
This planning strategy could apply to just about any married couple and would work especially well when selling jointly owned property, such as a family home. The way this new tax law is written, the $1M threshold for jumping from a 5% to a 9% tax rate applies equally whether you file taxes as single or married. You’ll need to be careful with this, as you could end up paying more in federal taxes since the brackets cut in half when you go from married filing jointly to married filing separately. However, you may be able to keep your federal filing status as married filing jointly and still file separately for state purposes.
- Utilize a Section 1031 like-kind exchange
A 1031 exchange allows you to defer recognition of the gain on real property. The two key requirements are that you must exchange the property for one of a similar nature and you must use the property for business or investment purposes. Notice that this technique does not reduce your capital gain (and associated tax), it merely defers it. But in doing so, you open other options such as potentially offsetting the future sale of the property with capital losses.
Continue reading Part 2 of this blog post in which I will offer up four more ideas for how to potentially reduce this new surtax.