The Patient Protection and Affordable Care Act and the Health Care and education Reconciliation Act of 2010, otherwise as it has become known as Obamacare imposes a 3.8% Medicare contribution tax on all net investment income of higher-income individuals as of January 1, 2013
Net investment income, for purposes of the new 3.8 percent Medicare tax, includes interest, dividends, annuities, royalties and rents, net of deductions, capital gains, and other gross income attributable to a passive activity.
Gains from the sale of property that is not used in an active business and income from the investment of working capital are treated as investment income for the new tax.
The tax does not apply to nontaxable income, such as tax-exempt interest or veterans’ benefits.
Capital gains income will be subject to the tax. This includes gain from the sale of a principal residence except for that portion of the gain that is excluded from income under Code Sec. 121 where the gain up to $250,000 for a single individual, or $500,000 for a married couple is excluded, but any amounts above the exclusion is subject to the tax.
Gains from the sale of a vacation home are fully subject to the new tax as of January 1, 2013, unless the sale was entered into before 2013. Special rules yet to be released by the IRS will apply, but it will be important to have escrow on such a property opened prior to December 31, 2012.
No guidance has been issued as to IRS Section 1031 Exchanges at this point as to the new tax being applicable, and it is not known if a tax free exchange is exempt from the new tax.
The tax applies to estates and trusts, on the lesser of undistributed net income or the excess of the trust/estate adjusted gross income (AGI) over the threshold amount ($11,200) for the highest tax bracket for trusts and estates, and to investment income they distribute.
Net investment income for purposes of the new 3.8 percent tax is gross income or net gain, reduced by deductions that are “properly allocable” to the income or gain as normally computed under the tax law.
This is a key term that the Treasury Department expects to address at some later date prior to the law going into effect, but at this moment, no such guidance is available.
Passive investments such as real estate rental property, allocable expenses will still include depreciation and operating expenses. Indirect expenses such as tax preparation fees may also qualify.
Capital gain property, stocks, bonds, intellectual properties, etc. are also included in the new tax therefore it will be doubly important to keep accurate and precise records as to the basis of any such asset sold, expenses attributable to such investments that may reduce net gains, interest on loans to purchase investments, investment counsel and advice, and fees to collect income.
It is not currently clear as to how net investment interest that has been carried as nondeductible in prior years will factor into the new tax, and guidance is awaited from Treasury on this point. Other costs, such as brokers’ fees, may increase basis or reduce the amount realized from an investment.
Should you be considering an installment sale this year it maybe important to reconsider any installment sale for payments received after December 31 will be subject to the new tax.
Tax the Millionaires
Despite all the political rhetoric and political promises, the new tax applies to those making much less than a million dollars a year. The tax applies to the lesser of net investment income or modified AGI above $200,000 for individuals and heads of household, $250,000 for joint filers and surviving spouses, and $125,000 for married filing separately – so much for the promise of not taxing anyone below million dollars.
The tax will have a substantial impact above the specified thresholds. In addition to the tax on investment income, there may also be other tax increases that take effect in 2013 with the expiration of the so called Bush Tax Cuts.
The top two marginal income tax rates on individuals are scheduled to rise from 33 and 35 percent to 36 and 39.6 percent, respectively. The maximum tax rate on long-term capital gains will increase from 15 percent to 20 percent. Dividends, which are currently capped at the 15 percent long-term capital gain rate, are scheduled to be taxed as ordinary income.
The cumulative rate on capital gains will increase to 23.8 percent in 2013, and the rate on dividends will increase to as much as 43.4 percent. The thresholds are not indexed for inflation, therefore a greater number of taxpayers will be affected each year.
Congress may step in and change these rate increases, but the possibility of rates going up for upper income taxpayers is sufficiently real that tax planning must take them into account.
A significant exception applies to distributions from qualified plans, 401(k) plans, tax-sheltered annuities, individual retirement accounts (IRAs), and eligible 457 plans. At the present time, however, there is no exception for distributions from nonqualified deferred compensation plans subject to Code Sec. 409A. This last issue appears to be a Congressional oversight that possibly will be rectified by an amendment to the law before 2013, assuming Congress acts on this during an election year, although very doubtful.
This exception relating to distributions from certain types of qualified plans provides for an interesting tax planning opportunity in that potentially taxed investors may want to shift wages and investments to retirement plans such as 401(k) plans, 403(b) annuities, and IRAs, or to 409B Roth accounts thereby avoiding the 3.8% tax in future years when these plans are distributed to the retirees. Increasing contributions will reduce current taxable income, and avoid the 3.8% tax in later years.
This also provides business owners a huge planning tool in that setting up or increasing current retirement plans, especially 401(k) plans will help to avoid current taxation, and the future 3.8% tax on distributions.
Millionaires Under Obamacare
It appears that with inflation millionaires, or due to some misunderstanding of math by the government, those earning more than $200,000.00 annually will incur an additional .09 percent Medicare Tax starting January 1, 2013 in addition to the other tax increases in the legislation. This is in addition to the currently imposed Medicare Tax of 1.45 percent on all earnings.
Under provisions of the Patient Protection and Affordable Care Act and amended by the Health Care and Education Reconciliation Act of 2010, in addition to the 1.45 percent employee portion of the HI (Medicare) tax imposed on wages, a 0.9 percent Medicare tax will be imposed on every taxpayer (other than corporations, estates, and trusts) who receives wages with respect to employment after December 31, 2012, in excess of $200,000 ($250,000 in the case of a joint return, $125,000 in the case of a married taxpayer filing separately).
Peter Muffoletto is with Muffoletto & Company, providing individuals, small businesses, corporations, partnerships, professionals, and other business entities with the necessary guidance and answers for a complex world. Should you have questions relating to any tax or financial matters, or if you know of someone that could benefit from our assistance feel free in calling us at (818) 346-2160, or you can visit us on the web at www.petemcpa.com.