One rumor circulating over the Internet is that the Health Care and Education Reconciliation Act of 2010, Public Law 111-152 (the “Act”), commonly known as the health care reform bill, imposes a new tax on real estate sales. The reform bill, however, does not directly impose such a tax. Rather, for certain individuals, it imposes a new 3.8 percent Medicare tax on “net investment income,” which might result from a real estate sale. This tax applies to taxable years beginning after December 31, 2012. § 1402(a)(4) of the Act. The Act amends Subtitle A of the Internal Revenue Code of 1986 (the “Code”) by inserting Chapter 2A after Chapter 2, and the changes to the Internal Revenue Code can be found in §1411, as added by the reform bill.
Before the reform bill was enacted, no Medicare tax was assessed on unearned income. Generally, unearned income consists of interest, dividends, annuities, royalties, rents and capital gains. While the reform bill will impose a Medicare tax on individuals, estates and trusts for unearned income, the tax will not apply to any distribution from a plan or arrangement described in IRC §401(a), 403(a), 403(b), 408, 408A or 457(b). IRC §1411(c)(5).
For individuals, the Medicare tax will be equal to 3.8 percent of the lesser of (a) net investment income for the taxable year or (b) the excess (if any) of the modified adjusted gross income (“MAGI”) for the taxable year over the threshold amount. IRC §1411(a)(1). Net investment income is the amount by which gross income from interest, dividends, annuities, royalties, rents (other than such income derived in the ordinary course of a trade or business), other gross income derived from a trade or business described in IRC §1411(c)(2), and net gain attributable to the disposition of property other than property held in a trade or business not described in IRC §1411(c)(2) exceeds deductions properly allocable to the income. IRC § 1411(c)(1). In addition, the Medicare tax applies to a trade or business if it is either (1) a passive activity of the taxpayer (within the meaning of IRC §469), or a trade or business of trading in financial instruments or commodities (as defined in IRC §475(e)(2)). §1411(c)(2).
As used in IRC §1411, “MAGI” means adjusted gross income increased by the excess of (1) the amount excluded from gross income under §911(a)(1), over (2) the amount of any deductions or exclusions disallowed under §911(d)(6) with respect to the amounts described in (1) above. IRC § 1411(d). In addition, the threshold amount is $250,000 for a taxpayer filing a joint return or for a surviving spouse, $125,000 for a married taxpayer filing a separate return and $200,000 in all other cases. IRC §1411(b). If a person has MAGI that does not exceed the threshold amount, he or she will not be subject to the tax.
For example, suppose that in 2013, John, a single taxpayer, has MAGI of $190,000. Suppose further than he sells his principal residence, which results in a profit of $350,000 (after taking into account commissions and fees and the price he paid for the home). Because John is allowed to exclude $250,000 of gain from the sale of his principal residence, his net investment income from the sale of his house is $100,000. If this is the only net investment income John incurs in 2013, he will not be liable for the new tax because his MAGI does not exceed the $200,000 threshold.
If, however, John had MAGI of $250,000, he would be required to pay the Medicare tax on $50,000, because $50,000 is less than his net investment income of $100,000. That is, the Medicare tax would be $1,900 ($50,000 x 3.8 percent).
For estate and trusts, the Medicare tax will be equal to 3.8 percent of the lesser of (a) the undistributed net investment income for the taxable year or (b) the excess (if any) of the adjusted gross income for the taxable year over the dollar amount at which the highest estate and trust income tax bracket begins. IRC §1411(a)(2).
Because this new tax is not scheduled to take effect until January 1, 2013, Congress may make several changes, refinements and “clarifications” to this provision before it actually takes effect, especially in light of the recent elections. ■