Historically, Medicare taxes have been imposed only on "earned" income—wages earned by employees and net income from self-employment. Medicare taxes were never paid on "unearned" income—investment or rental income. However, this is scheduled to change. Starting in 2013, a 3.8% Medicare tax will be imposed on investment and rental income earned by higher income taxpayers. The funds from the tax will be used to help pay for the nation's financially troubled Medicare program. This is a major change in the tax law that will affect many landlords. For higher income taxpayers, it will make rental property a less attractive investment than it used to be. Here are the basics about the new tax you should understand now.
The additional 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.
The new Medicare tax is imposed only on a taxpayer's net investment income. Investment income consists of interest, dividends, royalties, annuities, and rents not derived from an active trade or business, any other gain from a passive trade or business, and taxable gains from the sale or other disposition of investment property.
You need not include tax-exempt interest (for example, interest from tax-exempt bonds), tax-free withdrawals from Roth IRAs, income earned by tax qualified retirement plans such as 401(k) plans, income earned from renting a home less than 15 days during the year or the amount of profit excluded from tax when you sell your principal residence ($250,000 for individuals and $500,000 for married joint filers).
To determine your net investment income, you deduct your allowable expenses for the activity from your gross income for the activity.
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 in one year 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 for that year. 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.
Landlords who qualify for the real estate professional exemption are specifically exempted from the new Medicare tax. (IRC §1141(c).) This includes full-time landlords, and many part-time landlords who engage in other real estate businesses such as real estate brokerage or development. This makes the real estate professional exemption more valuable than it has ever been.
In addition, real estate dealers will not be subject to this tax on rental income they earn from property they hold for sale as a dealer. However, they will have to pay 3.8% Medicare tax on their net self-employment income above the same thresholds. For details, see "The New Medicare Payroll Tax."
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.