Did you know that beginning January 1, 2013, a new 3.8% tax will take effect for those individuals with an adjusted gross income (AGI) above $200,000 and couples filing joint returns with more than $250,000 AGI?

President Obama’s Affordable Care Act, which was deemed constitutional by the Supreme Court, includes some major tax changes that will take effect next year. Here’s a refresher course on how sweeping health-care reform will impact individual taxpayers like you.  Please note this article is designed to give you a basic understanding of this law.  South Coast does not offer specific tax/legal advice, please be sure to discuss your specific situation with your tax professional.

Medicare Tax

Currently the Medicare tax on salary and/or self-employment (SE) income is 2.9%  If you work for someone as an employee, 1.45% is withheld from your paycheck, and the other 1.45% is paid by your employer.  If you happen to own your own business you pay the entire 2.9%.

Starting in 2013, an additional 0.9% Medicare tax will be charged on: 1. Salary and/or SE income above $200,000 for individuals, 2. combined salary and /or SE income above $250,000 for married couples filing jointly, and 3. salary and/or SE income above $125,000 for those who use married filing separately.  For the self-employed, the additional 0.9% Medicare tax will come in the form of a higher SE bill.

Medicare Tax on Investment Income

Here is where the new 3.8% tax is going to hurt the most.  Today, the maximum federal income tax rate on long-term capital gains and dividends is only 15%.  Beginning in 2013, the maximum rate jumps to 20% for long-term capital gains and the maximum rate on dividends is scheduled to increase to 39.6% when the Bush tax cuts expire and are not renewed.

Adding to the pain, also beginning in 2013, all or part of the net investment income, including long-term capital gains and dividends, collected by those people with higher incomes will also get hit with an additional 3.8% “Medicare contribution tax.”  This means the maximum federal rate on long-term capital gains in 2013 is actually 23.8% and the maximum rate on dividends will be 43.4% (a 28.4% increase!!!).

Investment income includes interest, dividends, royalties, annuities, rents, income from passive business activities, income from trading financial instruments or commodities, and gains from assets held for investment like stocks and other securities.

$2,500 Cap on Health-Care FSA Contributions

Many people have taken advantage of FSA plans (flexible spending accounts).  Amounts contributed to these plans are subtracted from taxable income.  The funds can then be used to reimburse qualified medical expenses tax free.  Sounds pretty good; however, starting in 2013 the maximum annual FSA contribution for each employee is capped at $2,500.

Itemized Medical Expense Deductions

Currently, tax payers are able to itemize deductions for medical expenses to the extent the expenses exceed 7.5% of AGI.  Next year, the threshold jumps to 10% of AGI.  If you are older than 65, you can rest easy for a few years because spike will not take effect until 2017.

Let’s Take a Look at Some Examples:

The new tax applies to the LESSER of

– Investment income amount

– Excess of AGI over the $200,000 or

$250,000 amount

 

Example 1 – Sale of a Primary Residence

John and Jane sold their principal residence and realized a gain of $550,000.  They have $325,000 Adjustable Gross Income (before adding taxable gain).  The tax applies as follows:

AGI Before Taxable Gain      $325,000

Gain on Sale of Residence    $525,000

Taxable Gain                          $25,000

(Added to AGI $525,000 – $500,000)

New AGI                               $350,000

($325,000 + $50,000 taxable gain)

Excess of AGI over $250k   $100,000

($350,000 – $250,000)             

Lesser Amount                      $25,000

(Taxable gain)    

Tax Due                                   $950

($25,000 x 0.038)

*Note: If John and Jane had a gain of less than $500,000 on the sale of their primary residence, none of that gain would be subject to the 3.8% tax.  Whether they paid the 3.8% tax would depend on the other components of their $325,000 AGI.

Example 2 – Capital Gains, Interest and   

Dividends: Securities

Let’s take a look at Harry and Sally who have substantial income from their securities investments.  Their AGI before including that income is $190,000.  Their investment income is listed below.  The tax applies as follows:

Interest Income                        $60,000

(Bonds, CDs)

Dividend Income                      $75,000

Capital Gains                           $10,000

Total Investment Income       $145,000

New AGI                                $335,000

($190,000 + $145,000)

Excess of AGI over $250k     $85,000

($335,000-$250,000)

Lesser Amount                      $85,000

(AGI excess)

Tax Due                                  $3,230

($85,000 x 0.038)

Example 3 – Rental Income: Income Sources Including Real Estate Investment Income

Mitt has a “day job” from which he earns $85,000 a year.  He owns several small apartment units and receives gross rents of $130,000.  He also has expenses related to that income.  The tax applies as follows:

AGI Before Rents                    $85,000

Gross Rents                           $130,000

Expenses                               $110,000

(Including depreciation and debt service)

Net Rents                                $20,000

New AGI                                $105,000

($85,000 + net rents)

Excess AGI over $200k                $0

Lesser Amount                             $0

(Taxable)

Tax Due                                       $0

*Note: Even though Hank’s combined gross rents and day job earnings exceed $200,000, he will not be subject to the 3.8% tax because investment income includes NET, not gross, rents.

Example 4 – Sale of a Second Home with No Rental Use (or no more than 14 days rental)

The Smiths own a vacation home that they purchased for $275,000.  They have never rented it to others.  They sell it for $335,000.  In the year of sale they also have earned income from other sources of $225,000.  The tax applies as follow:

Gain on Sale of Vacation Home    $60,000

($335,000 – $275,000)

Income from Other Sources        $225,000

New AGI                                       $285,000

($60,000 + $225,000)

Excess AGI over $250k                $35,000

($285,000 – $250,000)

Capital Gain                                  $60,000

Lesser Amount                              $35,000

(Taxable AGI excess)

Tax Due                                         $1,330

($35,000 x 0.038)

*Note: If the Smiths rent the home for 14 or fewer days in the course of a year, the rental is non-taxable and the results in the year of sale will be the same as shown above.  If the rental period exceeds 14 days in any year, then the rental income (less expenses) will be taxable and AGI would include not only the capital gain, but also some amount that is depreciation recapture. (See next example).

**Note: If the second residence is SOLELY a rental property, it is treated as an investment property.

Example 5 – Purchase and Sale of Investment Property (Residential or Commercial)

Robert has purchased an investment property for $900,000.  During his period of ownership, he takes $230,000 in depreciation deductions.  He has also made some improvements to the property.  At the time of sale, his adjusted basis in the property is $750,000.  He subsequently sells the property for $1.2 million.  In the year of sale, he is single and reports self-employment income of $315,000.  The tax applies as follows:

Gain on Sale                             $440,000

($1.2 million less adjusted basis of $760,000)

Depreciation Recapture          $230,000

Total Gain                                 $670,000

(Gain on sale plus depreciation recapture)

Schedule C Income                  $315,000

New AGI                                   $985,000

($315,000 + $670,000)

Excess AGI over $200k           $785,000

($985,000 – $200,000)

Lesser Amount                       $670,000

(Taxable capital gain)

Tax Due                                 $25,460

($670,000 x 0.038)

*Note: The statute provides no guidance as to whether Robert can defer the 3.8% tax by entering into a 1031 like-kind exchange when he sells the property.  This question may be addressed in regulations at a later time, but for the present is not resolved.

Do not forget that this is an additional tax.  Normal taxes people are used to paying will also be due as customary.  This new tax as part of the Affordable Care Act is expected to raise more than $210 billion (over 10 years), representing more than half of the total new expenditures in the health care reform package according to the National Association of Realtors.

The 3.8% tax has been referred to as the “Medicare Tax” because the proceeds from it are to be dedicated to the Medicare Trust Fund.  This Fund is anticipated to run dry soon, so this tax is a means of extending its life.

A second new tax, also dedicated to Medicare funding, is imposed on the so-called “earned” income of higher income individuals.  This earned income tax has a lower rate of 0.9% (0,009).  This additional or alternative tax is also based on AGI thresholds of $200,000 for an individual and $250,000 for couples filing joint returns.

-Posted by Chris