3.8% Medicare/Real Estate Tax

I had a call this week from a neighbor who had just learned of the new tax that MAY be applied to the proceeds of his selling his house.  He was pretty upset, thinking that once again, the administration will be stimulating others using his proceeds from the sale of his house. 

So I thought this would be a good time to explain this new tax and how it will be applied. As a long-time Realtor, I try to be aware of these laws, but if you suspect the law applies to you, be sure to call your CPA or tax professional to discuss just how it will apply to you—or not.  This so called Medicare tax is a part of Obama Care, and was added to the healthcare package hours before the final vote—as Nancy Pelosi said, “we have to pass it to find out what’s in it.”  It was added without Congressional review.  Realtors strongly oppose this tax and our trade association NAR remains hopeful that it will not go into effect—BUT—if it does, here’s what you need to know.

The tax is neither a real estate “sales tax” nor a real estate transfer tax under any federal law. The new 3.8% tax is a tax on unearned income (see below) gains, and will take effect January 1, 2013.  In truth, it will not apply to most of us, but it is a method of taxing interest and dividends and a “taxable event” like selling a house.

All Americans who qualify will be subject to this tax. Including “singles” who have Adjusted Gross Income (AGI) of more than $200,000. Or “married” couples filing a joint return with AGI of more than $250,000. (The AGI threshold for married filing separate returns is $125,000.)

This tax is on unearned income.  This is the income that an individual derives from investing his/her capital. It includes capital gains, rents, 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. (Hence the term “net” investment income.)

The amount of the gain will be measured in the same way that it is for income tax purposes. This rule applies to real estate and all other appreciating capital assets. Net capital gains are taxable only in the year of sale. 

In an effort to make this simple, the tax is NOT imposed on the total AGI, nor is it imposed solely on the investment income. Rather, the taxable amount will depend on the operation of 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 were the smaller amount, then the 3.8% tax would apply only to the excess amount.

Any gain from the sale of a principal residence that is less than $250,000 (individual) or $500,000 (joint return) will continue to be excluded from your income tax. The new tax will NOT apply to this excluded amount of the gain.

Landlords need to be aware that net investment income includes only net rental income. Thus, gross rents would not be subject to the tax. Rather, gross rents would be reduced (as they are under the income tax) by all allowable expenses, including depreciation, cost of repairs, property taxes and interest expense associated with debt service. AGI includes net income from rent, so if your AGI is above the $200,000/$250,000 thresholds, then your rental income might be subject to the tax. 

Rent from a second home may be subject to the 3.8% tax, the application of the tax will depend on whether the vacation home has been rented out, the period for which it has been rented or whether the property is solely for the enjoyment of the owner. If the owner has rented the home out to others, then the 14-day rent exclusion will continue to apply.
If the home has been rented to others (including family members) for more than 14 days, then the rents (minus related expenses) would be considered as part of net investment income and could, depending on AGI and the calculations described above, be subject to the new tax.

Even if the vacation home has been used solely for personal enjoyment (i.e., there is no rental income and no associated expenses), then a gain on sale would be treated as net investment income and could be subject to the tax. Net losses from rents and net capital losses reduce AGI. Thus, the losses themselves would not be subject to the tax. If, after losses, AGI still exceeds the High Income thresholds, the 3.8% tax would still apply to any net rental, interest or dividends income.

Dane Hahn is a real estate professional practicing in Englewood Florida.  You can reach him at dane.hahn@gmail.com or by phone at 941-681-0312.  See him on the web at www.danesellsflorida.com