By Steven Harless, CPA
A lot of confusing, conflicting and sometimes erroneous information has been circulating about the new 3.8 percent Medicare tax that goes into effect on January 1, 2013, and its effects on real estate transactions. This tax is a part of The Patient Protection and Affordable Care Act, which imposes an additional 0.9 percent Medicare tax on wages and self employment income and a 3.8 percent Medicare contribution tax. The idea behind the tax is that money raised by it will help fund Medicare, and it’s touted as a means to supplement the cost of that program. What has people in a tizzy is that the tax may subject real estate transactions to the 3.8 percent tax for anyone who is single with a modified adjusted gross income (MAGI) exceeding $200,000 (or $250,000 if married).
When computing MAGI, remember that it includes more than just capital gains on real estate transactions and also includes wages, salaries, tips and other compensation, dividend and interest income, business and farm income, realized capital gains on investments and securities and income from a host of other passive activities and certain foreign earned income. What’s more concerning for those with MAGI above the thresholds is that the 3.8 percent tax is slated to hit around the same time that the Bush tax cuts expire. Unless Congress acts to restore expiring tax cuts (which may not be addressed until sometime after the election or next year), the new Medicare tax will produce a double whammy for those taxpayers whose income exceeds the aboce benchmarks.
Since the Medicare tax bill is aimed at anyone whose MAGI is more than $200,000 (filing single) or $250,000 (married filing jointly), to be accountable for the 3.8% tax on the sale of a primary residence, the capital gain on the sale of the home would have to push your MAGI above the $250,000 exclusion for a single taxpayer or the $500,000 exclusion for married taxpayers. To be eligible for the exclusion, the taxpayer(s) must have lived in the home as their primary residence for two out of the last five years. On the sale of a second home or real estate investments, there are no exclusions, and the 3.8 percent tax kicks in once the $200,000 (filing single) or $250,000 (married filing jointly) threshold is met.
Many Americans will find themselves virtually unaffected by this new tax because the capital gain on the sale of a primary residence is less than the allowed exclusion and/or because their MAGI is less than the thresholds. However, those with investment portfolios that create significant dividend and interest income and/or capital gains, and those that have rental property income and/or gains from the sale of real estate investments, could find themselves above the MAGI thresholds unknowingly and thus be subject to not only the 3.8 percent Medicare tax, but even higher tax rates due to the expiration of the Bush tax cuts. Fortunately, the 3.8 percent tax does not apply to certain types of income, including qualified plan distributions or income from the disposition of “active” LLCs, partnerships and S corporations.
As a strategy, taxpayers contemplating the sale of real estate, or the sale of securities with significant capital gains may want to consider doing so before the end of the year. Taxpayers owning businesses may also want to consider postponing certain deductions into 2013.
In this time of uncertainty, the best plan is to discuss the new tax and the expiring tax cuts with your tax accountant and financial advisor. Sound multi-year planning before the end of 2012 can help minimize tax surprises in both years.