The Patient Protection And Affordable Care Act ("Obamacare") will affect everyone in the United States one way or another. But some people will be affected more than others. Among these are high income taxpayers. Starting in 2013, they will be subject to a brand new Medicare tax on their "unearned income."
The New Tax Only Affects High Income Taxpayers
The new tax applies only to people with relatively high incomes. If you’re single, you must pay the tax only if your adjusted gross income (AGI) is over $200,000. Married taxpayers filing jointly must have an AGI over $250,000 to be subject to the tax. Your adjusted gross income is the number on the bottom of your IRS Form 1040. It consists of your income from almost all sources, including wages, interest income, dividend income, income from certain retirement accounts, capital gains, alimony received, rental income, royalty income, and unemployment compensation, reduced by certain “above the line” deductions such as IRA contributions and one-half of self-employment taxes.
What Income Is Taxed?
The tax applies only to investment income. This includes:
- gross income from interest, dividends, annuities, royalties, and rents other than those derived from an active business
- the net gain earned from the sale or other disposition of investment and other non-business property, and
- any other gain from a passive trade or business.
This includes just about any income not derived from an active business or from employee compensation.
The Tax Is Imposed Only On a Portion of Investment Income
The Medicare tax is a 3.8% tax, but it is imposed only on a portion of a taxpayer’s income. The tax is paid on the lesser of (1) the taxpayer’s net investment income, or (2) the amount the taxpayer’s AGI exceeds the applicable AGI threshold ($200,000 or $250,000).
Example: Phil and Penny are a married couple who file a joint return. Together they earn $200,000 in wages. They also earn $200,000 in net rental income and $150,000 in other investment income. Their AGI is $550,000, including $350,000 in net investment income. They must pay the 3.8% Medicare tax on the lesser of (1) their $350,000 of net investment income, or (2) the amount their AGI exceeds the $250,000 threshold for married taxpayers—$300,000. Since $300,000 is less than $350,000, they’ll have to pay the 3.8% tax on $300,000. Their Medicare contribution tax for the year will be $11,400 (3.8% × $300,000 = $11,400).
At most, you’ll have to pay the tax on the portion of your AGI that exceeds the $200,000 or $250,000 thresholds.
Can the Tax Apply to the Profit Earned Home Sales?
Yes. But, in the case of the sale of a principal residence that qualifies for the special tax exclusion on such income, it would apply only if the net gain from the sale exceeds the $500,000 exclusion for joint filers or $250,000 for singles, and then only to the extent that taxpayer's income exceeds the $200,000/$250,000 MAGI threshold.
Example: Lucy purchased a home in San Francisco in 1995 for 250,000. She sells it in 2013 for $750,000. She also earned $100,000 in employee wages in 2013. She earned a $500,000 profit on the sale of her home ($750,000 - $250,000 = $500,000). She qualifies for the $250,000 home sale exclusion, so she is left with $250,000 of net investment income from the sale. This, added to her wages, gives her a MAGI of $350,000--$100,000 over the Medicare tax threshold. Therefore, she must pay $3,800 in extra Medicare taxes (3.8% x $100,000 = $3,800).
The Tax Applies to Rental Income
Your net rental income is subject to the tax unless you qualify for the real estate professional exemption discussed below. Your net rental income consists of your gross (total) rents minus all deductible expenses you incur in operating your rental property. Your deductible expenses for these purposes will generally be the same as shown on your Schedule E.
For example, if you earn $200,000 in gross rents during 2013 and have $100,000 in expenses, you’ll end up with $100,000 in net rental income that must be included in your adjusted gross income. If you have a net loss from your rental activities, you can use it to reduce your AGI subject to the passive loss rules. This makes the rental property deductions available to landlords more valuable than ever.