3.8% Medicare Tax - The Impact To Real Estate Owners

Many people are wondering if the federal capital gain tax rate will be raised.  The truth is it already has been under certain circumstances.  The new 3.8% Medicare tax on unearned income will take effect January 1, 2013.

The revenues generated from this tax will be utilized to help fund the Medicare Trust Fund.  The income subject to this tax will include net rental income, as well as the capital gains upon the sale of real property.

This additional tax will apply to those taxpayers with an Adjusted Gross Income (AGI) exceeding $200,000 (single)/ $250,000 (married).  Net losses from rents and net capital losses will reduce AGI. However, if, after losses, AGI still exceeds the AGI thresholds, the 3.8% tax would still apply to any net unearned income.

Unearned income is the income that a taxpayer derives from investing their capital, including capital gains, net rental income (net of allowable expenses including depreciation, cost of repairs, property taxes and interest expense associated with debt service), dividends and interest income. It also comes from some investments in active businesses if the investor is not an active participant in the business. The portion of unearned income that is subject both to income tax and the new Medicare tax is the amount of income derived from these sources, reduced by any expenses associated with earning that income.

The actual tax is not imposed on the AGI or solely on the investment income, but rather calculated based on a formula. The taxpayer will determine the lesser of (1) net investment income or (2) the excess of AGI over the $200,000/$250,000 AGI thresholds. Thus, if net investment income is the smaller amount, then the 3.8% tax is applied only to the net investment income amount. If the excess over the thresholds is the smaller amount, then the 3.8% tax would apply only to the excess amount.

For example. if 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 example, $60,000 of net investment income is less than the $75,000 excess over the threshold. Thus, in this example, the 3.8% tax is applied to the $60,000.

If this single individual had AGI of $275,000 and net investment income of $90,000, then the new tax would be imposed on the smaller amount: the $75,000 of excess over $200,000.

The Medicare tax will apply to a primary residence, however, only to the extent the gain realized is in excess of the $250,000/ $500,000 primary residence exclusion (and to the extent their AGI exceeds the referenced thresholds. Furthermore, net rental income from a vacation home, to the extent it has been rented out for more than 14 days, would be considered net investment income and could be subject to the new tax.

The new Medicare tax, coupled with the possible expiration of the Bush-era tax cuts (which would increase the Federal capital gain tax rate to 20%) will significantly increase the tax burden placed upon taxpayers selling real property. The opportunities to defer the capital gain tax through a 1031 tax deferred exchange or a Deferred Sales Trust will become that much more important.

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