By Scott Molloy, Director of Government Affairs, San Diego Association of REALTORS®
With all the talk about Obama’s new health care plan, there was little mention of new Medicare taxes for the Country’s top earners. Under the bill signed into law by Obama, a new 3.8% Medicare Tax will apply to the “unearned” income of “high income” taxpayers. Individuals making more than $200,000 or married couples making more than $250,000 in Adjusted Gross Income (AGI) a year will be subject to the new tax.
The new 3.8% tax takes effect on January 1, 2013, applying to the 2013 Tax Year and beyond. The tax applies to “unearned income,” income that is derived from investing capital. It impacts capital gains, including from the sale of real estate, rents, dividends, interest income, and investments in active businesses if the investor is not an active participant in the business.
The tax applies to net income above the $200,000 for individuals and $250,000 for married couples. The good news is that the $250,000 (for individuals) and $500,000 (for married couples) tax exclusions for the sale of your primary residence still apply. Any gain from the sale of a primary residence that does not exceed the $250,000/$500,000 thresholds will continue to be excluded from the capital gains tax and the 3.8% Medicare Tax. The tax would apply only to any gain realized that is more than the $250,000/$500,000 existing primary home exclusion, and only if the seller has AGI above the $200,000/$250,000 AGI thresholds.
The one bright spot is that the 3.8% tax applies only to the lesser of net investment income or the amount above the $200,000/$250,000 AGI thresholds. If net investment income is the smaller amount, then the 3.8% tax is applied only to the net investment income. If the amount above the thresholds is the smaller amount, then the 3.8% tax would apply only to the amount above the thresholds.
For example, if the AGI for a single individual is $275,000, then the excess over $200,000 would be $75,000 ($275,000 minus $200,000). Assume that this individual’s net investment income is $60,000. The new 3.8% tax applies to the smaller amount, in this case, the $60,000 of net investment income which is less than the $75,000 over the threshold. If this single individual had an AGI of $275,000 and net investment income of $90,000, then the new 3.8% tax would apply to the smaller amount: the $75,000 over the $200,000.
When it does apply, the 3.8% tax is on top of your income or capital gains tax, effectively serving as a double tax. Consider the following example of how this new tax might affect an individual making more than $200,000. If an individual were to have an Adjusted Gross Income (AGI) of $300,000, $100,000 of which was investment income, the entire $100,000 would be subject to the 3.8% Medicare Tax in addition to the other taxes that apply to that $100,000 of income.
Another bright spot is that the tax does not apply to real estate income if the ownership and operation of real estate you own is your sole occupation. Those activities are known as your “trade or business” and are not subject to the 3.8% tax.
The tax may apply to rental income received from a vacation rental. The application of the tax will depend on whether the vacation home has been rented out, the period for which it has been rented and whether the property is solely for the enjoyment of the owner.
The new law also includes a 0.9% Medicare Tax on any income earned above the $200,000/$250,000 AGI thresholds. This 0.9% tax applies only to the net income above the AGI thresholds but does not include some of the allowances and exemptions that the 3.8% tax includes.
These new taxes could have a dampening effect on real estate investing among other investment activities and the economy in general. The examples in this article are meant for illustrative purposes only and may or may not apply to individual circumstances. High income earners are strongly encouraged to consultant their tax accountant and make preparations for what could be a sizable tax increase come 2013.
Note: The National Association of REALTORS® Health Insurance Reform: Frequently Asked Questions (FAQs) contributed to this article.