Know the Facts on the New 3.8% Tax

Tax

Know the facts on the new 3.8% tax (Affordable Care Act, Medicare Tax, aka Obama Care). All we have heard about the 3.8% levy on real estate is not true. This compressed research will get you headed in the right direction, towards knowing the truth.

It is not true that the tax that started January 1, 2013 will affect all home sales, or even most home sales. It won’t cost you $3,800 in taxes to sell a $100,000 home, or $15,200 if you sell your $400,000 home. The tax is designed to raise around $210 billion to fund Medicare and to accomplish health care reform. It is a tax on “unearned” income, including investments, rental income, and home sale profits on exemption amounts of $250,000 for singles and $500,000 for married couples. The unearned income is already subject to ordinary income taxes or capital gains taxes. The new 3.8% tax is added only for some individuals with incomes above $200,000 or some married couples with incomes more than $250,000.

This Medicare Tax (3.8% levy on real estate sales) applies only to the lesser of (a) the unearned income or (b) the excess over the required AGI (Adjusted Gross Income) thresholds.

For example, if you were married filing jointly, and your AGI was $300,000 and your unearned income was $30,000, then you would be taxed only on the unearned income total ($30,000). However, if you were married filing jointly and your AGI was $300,000, and your unearned income was $60,000, the Medicare tax would only be subject to $50,000 (the excess of the AGI threshold of $250,000).

Here is another illustration: Jack and Jill bought a home in Southern California in 1965 for $50,000. Today, the home is worth $650,000. If the couple sold the house, their profit would be $600,000 (costs of selling and home improvements would typically reduce that number, but we’ll ignore that for the sake of example).

The first $500,000 of that profit would be tax-free, thanks to a federal law that went into effect May 6, 1997. The remaining $100,000 would be subject to a capital gains tax rate of up to 20% (the maximum capital gains tax rate is currently 15%, but that’s scheduled to rise in 2013). It might also be subject to the 3.8% tax.

The next step is to add the $100,000 profit (or “net investment income”) to Jack and Jill’s AGI. If the profit pushes their AGI over $250,000, the new tax would apply to either: the net investment income amount, or the profit over the exemption limit of $500,000 ($250,000 for singles). The amount that Jack and Jill’s AGI exceeds $250,000 ($200,000 for singles) in income, Jack and Jill would owe tax on whichever of those two options is less.

If Jack and Jill’s AGI was $50,000 without the home sale and $150,000 with it, they wouldn’t be subject to the 3.8% tax (They’d still have to pay the capital gains tax, however, which would be $20,000 on their $100,000 of profit above the exemption limit.)

If, on the other hand, their AGI was $200,000 and the remaining home sale profit pushed it to $300,000, they would compare the amount more than $250,000 ($50,000) with the amount of investment income ($100,000) and pay the 3.8% tax on the lower of those two amounts. So they would pay an additional $1,900 (3.8% of $50,000).

Are there are circumstances when the tax could affect Jack and Jill, if they were not high-income earners? If their home profit is large enough, it could push them into a bracket where that person might face the tax.

It is not rational to assume that all will face the tax, since some homes might sell at a loss and others might not have enough appreciation to generate the tax. Note, the costs to sell a home, and improvements made to the house over the years, can reduce the potentially taxable profit on a home sale, sometimes considerably.

THE BOTTOM LINE: If you think you may be subject to this new tax, sit down with a tax professional to talk about alternatives and what is best for you.

Until next time,
Cary

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