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Investment Property News: New Medicare Tax on “Unearned” Net Investment Income
The 3.8% Tax- Effective January 1, 2013
Effective January 1, 2013, investment income will start being taxed 3.8% due to the new Medicare Tax on “unearned” income. It is very important for REALTORS and mortgage clients to clearly understand the new tax on net investment income since it will involve many real estate transactions. Because it is a complex tax, it is difficult to forecast how it will affect every buyer and seller. To help you better understand the new tax legislation, The Leaman Team has developed a list of answers to Frequently Asked Questions regarding the new 3.8% tax on net investment income.
1.) What is the new “Medicare tax” for?
Because the fund is currently on unstable financial ground, the revenues generated from this new “Medicare tax” and all revenues generated from the new earned and unearned income taxes will be allocated to the Medicare Trust Fund that is part of the Social Security System.
2.) Which individuals will be affected by new taxes imposed in the health legislation?
“High Income” taxpayers will have to apply the new 3.8% tax to their “unearned” income. In addition to the new 3.8% tax, a 0.9% tax will affect several of those same individuals but will apply to their “earned” income. These two levies are referred to as “Medicare” taxes.
3.) Which individuals are considered “High Income” Taxpayers?
Anyone whose tax filing status is “single” with an Adjusted Gross Income (AGI) of more than $200,000 is considered as a “High Income” taxpayer and will be required to pay the new unearned income taxes. Also, married couples who file a joint return with an AGI of over $250,000 will also fall into the “High Income” taxpayer category and will be subject to the tax. For married couples filing separate returns, the AGI is set to anything above $125,000.
4.) What all is considered “unearned” net investment income?
Basically, unearned income is the earnings an individual receives from investing his/her capital. Capital gains, rents, dividends and interest income are all considered unearned net investment income. Also, investments made in an active business by an investor who is not an active participant of that business can become subject to the new tax.
To calculate the share of unearned income that is subject to the new Medicare tax and income tax you take the total income gained from the sources previously listed and subtract all expenses related to that earned income.
5.) Are the set thresholds of $200,000 and $250,000 indexed for inflation?
The $200,000 and $250,000 thresholds are not indexed for inflation. Consequently, there is a possibility more individuals may become subject to the new tax.
6.) Will the new tax apply to the amount gained from rents on the investment properties I currently own?
It is possible. Your Adjusted Gross Income (AGI) includes the amount of net income gained from investment property rents. Therefore, if your AGI falls above the $200,000 or $250,000 thresholds, there is a chance your rental income would fall subject to the new tax. Keep in mind gross rents will not be subject to the new tax, only net rental income. Therefore, all allowable expenses related to the investment property would reduce to gross rent, leaving you with a “net” rental income that is subject to the new tax.
7.) Is the yearly appreciation of an asset subject to the new tax?
No, the tax will not apply to the yearly appreciation of an asset. Only in the year the asset is sold are the net capital gains taxable.
8.) Is the new 3.8% Medicare tax based on my total AGI or is it solely based on my investment income?
The new 3.8% Medicare tax does not apply to either scenario. Rather, the operation of a formula will determine the taxable amount. As a taxpayer, you will determine the lesser of (1) your net investment income or (2) the amount that falls over the $200,000 or $250,000 set thresholds. The smaller of the two will become subject to the 3.8% tax. Thus, you will only pay a 3.8% tax on either the excess amount over the threshold OR the amount of net investment income. Again, whichever is smaller amount will be taxed.
9.) Will the exclusion on gains from the sale of a principal residence continue to apply?
Yes, all gains 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 the income tax and will not be subject to the new 3.8% tax.
However, if the seller has an AGI above the set thresholds and the gains from the sale of a principal residence fall above their set threshold, then the new 3.8% Medicare tax would apply to the “taxable gain.” The amount that would fall subject to the tax would follow the same formula as stated above. If the gain from the sale was less than the excess over the AGI threshold then the “taxable gain” would be taxed the 3.8%.
10.) Is either rent from a vacation home or the gain on the sale of a vacation or rental property subject to the 3.8% tax?
Three items are evaluated before rendering the answer to this question. First, the application depends on whether the vacation property has been rented out. If the vacation home has been rented out, then the period of time in which the property was rented is verified. If the owner of the property rented it out for more than 14 days, then the net investment income could fall subject to the new tax, depending on the owner’s AGI.
The last piece of the puzzle is determining if the home was used solely for the enjoyment of the owner. If the property was solely used for personal enjoyment and the owner decides to sell the property, then any gain on the sale could be subject to the new tax. Again, that all depends on the owner’s AGI. Likewise, if the property did generate income from rents, then any net gain on the sale of the property would be included in the net investment income and become subject to the tax.
11.) What if my rental property generates a net loss every year?
Because net losses reduce your AGI, they will not be subject to the new tax. However, if after the losses are deducted, your AGI still surpasses the ìhigh incomeî threshold, then any interest or dividends income will be taxed the 3.8%.
12.) If owning and operating my real estate investments is my sole occupation, will my rents and gains from it be subject to the new tax?
Your rents and gains will not be subject to the new 3.8 % “unearned net investment income” tax if your sole occupation is the ownership and operation of those properties. However, they could still be subject to the 0.9% tax on “earned income.” If you have a “day job” and operate those properties at night or on the weekends, they are still considered investments and not your “trade or business” even if they bring in the majority of your income.
13.) Does the new health bill contain a transfer tax or real estate “sales tax”?
No, the new health care bill contains neither a real estate transfer tax nor a “sales tax.”
14.) Will any portion be lost of the Mortgage Interest that “High Income Filers” are allowed to deduct?
No portion will be lost and no cap was imposed on any itemized deductions.
15.) How will the new tax influence marginal tax rates when united with the existing law and the potential expiration of the Bush tax cuts?
The marginal rates, best defined as the tax rates assessed with the “last” dollars included in taxable income, for those upper income individuals will increase, mainly for capital gains income.
This article is brought to you by the Leaman Team, a recognized leader in Investment Property Mortgage lending, serving clients in the greater Austin area and nationwide.
New American Funding is not authorized to give tax advice. Please consult your tax professional for tax advice for your specific situation.
Read more about this tax in an FAQ report from the National Association of REALTORS (NAR).
Read more about this tax in a brochure from the National Association of REALTORS (NAR).