Set to take effect in 2013, a tax increase on capital income – such as capital gain and rents – will affect some real estate investments. According to the National Association of Home Builders, however, it should have a negligible impact on sellers of principal residences.
The new 3.8% Medicare tax on so-called unearned income will affect high-income taxpayers who report taxable income due to capital gains and other non-wage income. It will not affect income that is currently tax-exempt, including most capital gain due to the sale of a principal residence (due to the $250,000/$500,000 gain exclusion rules). Taxpayers with less than $250,000 in income will not see any increase in tax. Another resource for answers to frequently asked questions about this tax increase published by the National Association of Realtors can be downloaded by clicking here.
Under prior law, Social Security and Medicare benefits are financed by payroll taxes on wages. The tax is equal to 12.4% of covered wages up to a maximum amount ($106,800 in 2010), with half paid by the employer and half paid by the employee; and 2.9% of covered wages uncapped, again with half paid by the employer and half paid by the employee. Self-employed individuals – including independent contractors – generally pay both the employee and employer parts of the tax. Unearned income (e.g. rents, dividends, interest and capital gains) were not subject to these taxes.
As a result of the Patient Protection and Affordable Care Act of 2010, this system is changing. Under revised law, the Medicare tax will increase for taxpayers earning more than $250,000 (if married) or $200,000 (if single). In particular, the individual’s Medicare portion of the tax – which was previously 1.45% or half of the 2.9% – increases to 3.8%, but only for certain income amounts. The rate of 3.8% applies to the smaller of: (1) the amount of income above $250,000/$200,000 of modified adjusted gross income; or (2) net investment income. The tax also applies to self-employed individuals.
Net investment income is the sum of income from interest, dividends, annuities, royalties, rents and capital gain – except income derived from active participation in a trade or business, including sole proprietorships, partnerships and S Corporations.
As noted earlier, tax-exempt unearned income (excluded gain from the sale of a principal residence or interest income allocable to a tax-exempt bond) is not subject to this new tax.
Here are two examples:
Suppose a couple has wage income of $260,000 and $9,000 in capital gains. The extra 3.8% tax applies to the smaller of $19,000 (the difference between $269,000 and $250,000) and $9,000. $9,000 is smaller, so the increased tax is equal to $342 ($9,000 times 3.8%).
Suppose a couple has wage income of $50,000 and gains income of $210,000. The extra 3.8% tax applies to the smaller of $10,000 (the difference between $260,000 and $250,000) and $210,000. $10,000 is smaller, so the increased tax is equal to $380 ($10,000 times 3.8%.