Demystifying the New 3.8% “Medicare” Tax

On January 1, 2013, a new 3.8% federal tax on some, but not all, investment income will go into effect. The tax is sometimes called a “Medicare Tax” because the proceeds of the tax are earmarked for the Medicare Trust Fund. This tax has the potential to increase taxes for owners who sell their primary residence and investors who sell investment property, so it is important for all owners of real estate and their advisors to have a basic understanding of how the tax will work.

The new tax is an additional 3.8% tax on “unearned income” which is generally defined as interest, dividends, rents and capital gains. The tax is only imposed to the extent the taxpayer’s adjusted gross income (AGI) is higher than $200,000 for an individual or $250,000 for a married couple.

For example, assume that in 2013 you sell investment real estate for $1.2 million and you have a gain (including depreciation recapture and appreciation) of $670,000. Your wages are $315,000 and your AGI (in this case, your wages plus the gain from the sale of the real estate asset) is $985,000.

The tax is computed on the lesser of:

The total gain from the investment or
The excess of your AGI over $200,000 (assuming you are filing as a single person).

Please note that for purposes of this article, this example is simplified and your situation may be more complicated.

A. Total gain from the sale of real estate: $670,000

B. AGI:

Wage income	$315,000
Gain from investments	$670,000
AGI	$985,000

C. Excess of AGI over $200,000: $785,000

D. Taxable amount is lesser of (A) $670,000 or (C) $785,000.

E. Tax is $25,460, which is computed by multiplying $670,000 by 3.8%.

Please also note that:

The 3.8% tax is in addition to capital gains tax that may be imposed;
Taxpayers with an adjusted gross income lower than the threshold of $200,000 ($250,000 for married couples) will not have to pay the additional tax; and
Although no regulations have been issued yet, you should be able to defer paying this tax by doing a 1031 exchange. The tax is imposed on “net investment income” which the statute says includes net gain, to the extent taken into account in computing taxable income. Since gain deferred in an exchange is not included in taxable income, such gain should not be subject to the 3.8% tax.

The example used in this article was taken from a recent publication by the National Association of REALTORS® (in slightly modified form). The full publication including other examples can be found on NAR’s website at www.realtor.org/healthreform.

Investors and owners of real estate should consult with their advisors to determine whether this tax may affect them. This article does not cover every instance where the tax may be due and First American Exchange cannot give tax or legal advice.

If you are selling your property and would like to set up a tax-deferred exchange, please contact First American Exchange Company.