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Health Care Overhaul & Real Estate Taxes

June 28, 2012

I originally posted this in November 2010. Considering the Supreme Court upheld the ACA today, I believe a re-post is appropriate. As I hope to explain in this post, the new healthcare law does not directly impose a tax on sales of residential real estate, but instead imposes a tax on certain investment income, which in real estate parlance is the capital gain, if any, from the sale of real property. For the purposes of this post, we will focus on a taxpayer’s principal residence.Laying the Groundwork The Health Care and Reconciliation Act of 2010 amended the Internal Revenue Code (“IRC”) by adding Code Section (“§”) 1411, which is currently scheduled to become effective on January 1^st, 2013.¹ Currently, Medicare tax only applies to wages, but beginning in 2013, a Medicare tax will extend to investment income for single taxpayers with an adjusted gross income (“AGI”) above $200,000 and joint filers (i.e., husband and wife) over $250,000. The tax is 3.8% of the lesser of (1) net investment income or (2) the excess of modified AGI (“MAGI”) over the threshold amount. I realize this is quickly becoming complicated, but do not worry because I have provided some examples that help in explaining how the new tax works. As mentioned earlier, investment income includes capital gains, and a capital gain in simplified real estate terms is the selling price of the home subtracted by the acquisition price of the home plus any capital additions to the home. Here is an example: Capital Gain Calculation Example: In 2013, Mr. S sells his home in Missouri for $300,000. Mr. S acquired the home ten years earlier for $150,000. Five years ago, Mr. S built a capital addition onto the home at a cost of $50,000. After the sale of his home, Mr. S has a $100,000 capital gain, which is the sales price minus the purchase price plus any capital additions ($300,000 – ($150,000 + $50,000)). Now, if we were discussing a capital gain other than from the sale of a principal residence, then our analysis would almost be complete. We would simply take Mr. S’s total income, and if it exceeded the threshold amount of $200,000 for single taxpayers and $250,000 for joint filers, then Mr. S would be subject to the new 3.8% tax. Here are some examples: Medicare Tax Calculation Example 1: In 2013, Mr. S, a single taxpayer, earns $100,000 in wages and another $75,000 in dividends and royalties (both considered investment income). Mr. S’s MAGI is $175,000 which is below the MAGI threshold amount. As noted earlier, the 3.8% tax is imposed on the lesser of (1) net investment income or (2) the excess of MAGI over the threshold amount. Since there is no excess MAGI over the threshold amount, there is no tax ($0 x 3.8% = $0). Medicare Tax Calculation Example 2: In 2013, Mr. S, a single taxpayer, earns $150,000 in wages and another $75,000 in dividends and royalties (both considered investment income). Mr. S has exceeded the $200,000 MAGI threshold by $25,000 (($150,000 + $75,000) – $200,000). This excess $25,000 is subject to the new 3.8% Medicare tax. As a result, Mr. S will pay an additional $950 in Medicare taxes ($25,000 x 3.8%) in 2013. Medicare Tax Calculation Example 3: In 2013, Mr. S, a single taxpayer, earns $200,000 in wages and another $175,000 in dividends and royalties (both considered investment income). Mr. S has exceeded the $200,000 AGI threshold by $175,000 (($200,000 + $175,000) – $200,000). Thus, the entire $175,000 in investment income is subject to the new 3.8% Medicare tax. As a result, Mr. S will pay an additional $6,650 in Medicare taxes ($175,000 x 3.8%) in 2013. Remember, the examples above are for capital gains other than from the sale of a principal residence. When dealing with capital gains resulting from the sale of a principal residence, there is another step involved. The Capital Gains Exclusion IRC §121 allows qualifying taxpayers to exclude from gross income the capital gains from selling a principal residence.² For purposes of this post, there is no need to discuss the requirements for qualifying for a §121 exclusion, just know that it exists. The exclusion amount is $250,000 for single taxpayers and $500,000 for joint filers. Thus, in the case of a capital gain resulting from the sale of a principal residence, we need to take the additional step of determining whether or not the §121 capital gains exclusion applies as well. Here are some examples that include the §121 capital gains exclusion: Medicare Tax & §121 Exclusion Example 1: In 2013, Mr. S, a single taxpayer, earns $150,000 in wages and has a $75,000 capital gain from the sale of his principal residence, which qualifies for the §121 exclusion. Mr. S has not exceeded the $200,000 MAGI threshold because the capital gain, by virtue of qualifying for the §121 exclusion, is not included in gross income. Mr. S’s MAGI is $150,000, well below the $200,000 threshold amount. Therefore, Mr. S is not subject to the new 3.8% Medicare tax. Medicare Tax & §121 Exclusion Example 2: In 2013, Mr. S, a single taxpayer, earns $150,000 in wages and has a $75,000 capital gain from the sale of his residential home, which for this example does not qualify for the §121 exclusion. Mr. S hasexceeded the $200,000 MAGI threshold because the capital gain is included in gross income. Mr. S’s MAGI is $225,000, which is now above the $200,000 threshold amount, and therefore subject to the new 3.8% Medicare tax. As a result, Mr. S will pay an additional $950 in Medicare tax ($25,000 x 3.8%) in 2013. Medicare Tax & §121 Exclusion Example 3: In 2013, Mr. S, a single taxpayer, earns $150,000 in wages and has a $350,000 capital gain from the sale of his residential home, which qualifies for the §121 exclusion. Although the capital gain qualifies for the §121 exclusion, Mr. S exceeds the $200,000 MAGI threshold because the allowable §121 capital gain exclusion is limited to $250,000 for single taxpayers. Mr. S. will include $100,000 of the $350,000 capital gain in gross income ($350,000 – $250,000 maximum allowable exclusion). Mr. S’s MAGI is $250,000, which is above the $200,000 threshold amount, and therefore subject to the new 3.8% Medicare tax. As a result, Mr. S will pay an additional $1,900 in Medicare tax ($50,000 x 3.8%) in 2013. Before I finish, I just want to point out that the Medicare tax will rarely apply to capital gains from the sale of a taxpayer’s principal residence. The median price of existing homes sold in the second quarter of 2010 was $176,900.³ This means two things – (1) few sellers are experiencing significant capital gains from the same of their principal residence, and (2) those home-owning taxpayers with gains that qualify for the §121 exclusion still have a long way to go in maxing out their allowable §121 exclusion. I realize this post is not exactly an easy read, but I tried to make it as free of legalese as possible. If you would like me to clarify anything in this post, feel free to leave a comment. Until next time, Alex

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