By Tim Reamer & Nicholas A. Perrine, CPA
In the wake of the Supreme Court’s decision to uphold the Patient Protection and Affordable Care Act, also known as “Obamacare”, many real estate investors have been scrambling to interpret exactly how the ruling will affect them. Of specific concern in President Obama’s health care overhaul is a new 3.8% Medicare tax on investment income, which many in the real estate industry are describing as a real estate investment tax.
As the Internal Revenue Service hasn’t yet released guidelines on the new tax, many investors have unanswered questions. There are many misconceptions and rumors floating around out there, including the – false – notion that all real estate transactions will be subject to a 3.8% tax.
First, the Facts
Congress passed the new 3.8% Medicare tax as part of the Health Care and Education Reconciliation Act of 2010. The new tax applies to all tax years beginning after 2012 and will impact some – but not all – real estate transactions, thus its moniker as the real estate investment tax. The tax is imposed on the lesser of: 1) an individual’s net investment income for the tax year, or 2) any excess of modified adjusted gross income (AGI) for the tax year over a threshold amount. The threshold amount is $200,000 ($250,000 in the case of joint filers and surviving spouses, and $125,000 in the case of a married taxpayer filing separately). Do note the marriage penalty as the threshold for joint filers is only 125% of that for single filers. .
What Income Will Be Affected?
The real estate investment tax isn’t a sales tax per se; rather, it’s a levy tax assessed on investment income less any otherwise allowable deductions properly allocable to such income or gain, including: interest, dividends, annuities, royalties, rents, and net capital gains. The tax is not assessed on income generated in the ordinary course of any trade or business. For this purpose, income derived in the ordinary course of a trade or business excludes any trade or business that is either a passive activity of the taxpayer or involves trading in financial instruments and commodities. Therefore, unless the taxpayer is a materially participating real estate professional the tax will apply on rental income and dispositions of real property.
For example, if an individual with an AGI of more than $200,000 who is not a real estate professional sold an investment property for $300,000 with a cost basis of $250,000, they’d have to pay a 3.8% tax on a taxable gain of $50,000, or $1,900. However, if that individual’s AGI was less than $200,000, the real estate investment tax wouldn’t apply unless the gains from the sale caused them to exceed the income threshold, in which case they would pay the tax on the amount above $200,000. (The tax would be on the lesser of one’s investment income or the amount of AGI above the income threshold.)
|Single Filer with AGI||Single Filer with AGI|
|Exceeding $200,000||of $160,000|
|Investment Property Sale||$300,000.00||Investment Property Sale||$300,000.00|
|Cost Basis||$(250,000.00)||Cost Basis||$(250,000.00)|
|Capital Gain||$50,000.00||Capital Gain||$50,000.00|
|Investment Tax Due||$1,900.00||New AGI||$210,000.00|
|Subject to Investment Tax||$10,000.00|
|Investment Tax Due||$380.00|
Why Does This Tax Exist?
The legislation’s intent was to generate approximately $210 billion over a 10-year period in order to provide funding for the Medicare overhaul. The tax is commonly called the Medicare tax, as its proceeds are slated to be directed to the Medicare Trust Fund. Putting political opinions aside, some question this legislation’s efficacy. Given that this tax will affect only about 3% of the U.S. population and that the average home price is hovering somewhere around $182,000, according to the National Association of Realtors, the real estate investment tax may not raise quite as much money as it’s meant to. Moreover, some have suggested that pools of money shift based on incentives and disincentives. This certainly could be a levy that triggers a flow of investment capital elsewhere that may not be subjected to the tax further reducing revenue to the program.
Who Should Worry?
On the whole, the real estate investment tax will affect a very small number of transactions by an even smaller number of investors. Within the investment community, however, the percentage impacted is expected to be larger. At its core, the levy can be viewed as a flat tax on investment income that exceeds the $200,000-per-individual and $250,000-per-couple adjusted gross income threshold.
For some, the investment tax will be a non-issue and even those impacted by the new tax would be best served by maintaining focus on the matters that impact business and income the most on a day-to-day basis – such as cost overruns, debt costs, unpaid rents and property vacancies. Investors don’t have to like the tax, and the majority most certainly won’t, but with some advance planning, those impacted can manage their investment income and their adjusted gross income in order to best handle the implications of the tax.
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