Preparing for the New Surtax

As part of the Affordable Care Act (the new health care legislation), a new tax kicks in this year. The official name of this tax is the Unearned Income Medicare Contribution Tax, and even though the name implies it is a contribution, don’t get the idea that it is voluntary or that you can deduct it as a charitable contribution. It is actually a surtax levied on the net investment income of taxpayers in the higher income brackets. And although it is perceived as an additional tax on higher-income taxpayers, it can affect even those who normally don’t have higher income if they have a large income from the sale of real estate, stocks, or other investments.

The surtax is 3.8% on whichever is less: your net investment income or the excess of your modified adjusted gross income (MAGI) over a threshold based on your filing status. Net investment income is your investment income reduced by investment expenses; MAGI is your regular AGI increased by income excluded for working out of the country.

The filing status threshold amounts are:   

• $250,000 for married taxpayers filing jointly and surviving spouses.
• $125,000 for married taxpayers filing separately.
• $200,000 for single and head-of-household filers.

Example: A single taxpayer has net investment income of $100,000 and MAGI of $220,000. The taxpayer would pay a Medicare contribution tax only on the $20,000 amount by which his MAGI exceeds his threshold amount of $200,000, because that is less than his net investment income of $100,000. Thus, the taxpayer’s Medicare contribution tax would be $760 ($20,000 × 3.8%).

Investment income includes: 

• Interest, dividends, annuities (but not distributions from IRAs or qualified retirement plans), and royalties,
• Rents (other than derived from a trade or business), 
• Capital gains (other than derived from a trade or business),
• Home-sale gain in excess of the allowable home-gain exclusion,
• A child’s investment income in excess of the excludable threshold if, when eligible, the parent elects to include the child’s investment income on the parent’s return, 
• Trade or business income that is a passive activity with respect to the taxpayer, and
• Trade or business income with respect to trading financial instruments or commodities.

Planning Note: For surtax purposes, gross income doesn’t include interest on tax-exempt bonds. Thus, one can avoid or reduce the net investment income surtax by investing in tax-exempt bonds.  

Investment expenses include:

• Investment interest expense, 
• Investment advisory and brokerage fees,
• Expenses related to rental and royalty income, and
• State and local income taxes properly allocable to items included in Net Investment Income.

Do you think you will never get hit with this tax because your income is way under the threshold amounts? Don’t be so sure. When you sell your home, the gain is a capital gain, and to the extent that the gain is not excludable using the home-gain exclusion, it will add to your income and possibly push you above the taxation thresholds. And, since capital gains are investment income, you might be in for a surprise. The same holds true for gains from selling stock, a second home, or a rental. So when planning to sell a capital asset, be sure to consider the impact of this new surtax.

The surtax also applies to the undistributed net investment income of trusts and estates, and there are special rules applying to the sale of partnership and Sub-S Corporation interests.

Example: A taxpayer has owned a residential rental property for a number of years, planning to use the rental’s increased value to help fund his retirement. The taxpayer normally has income well below the threshold for this new tax. The taxpayer sells the rental and has a substantial gain. The gain from the rental sale gives the taxpayer a one-time windfall that pushes his income above the threshold for the new tax, and he ends up having to pay the regular capital gains tax plus an additional 3.8% tax on the appreciation that is attributable to the increase in value that occurred over several years.     

If this surtax will apply to you in 2013, you may need to increase your income tax withholding or estimated tax payments to cover the additional tax so you can avoid or minimize an underpayment of estimated tax penalty when you file your 2013 return.

Example: A taxpayer has owned a residential rental property for a number of years, planning to use the rental’s increased value to help fund his retirement. The taxpayer normally has income well below the threshold for this new tax. The taxpayer sells the rental and has a substantial gain. The gain from the rental sale gives the taxpayer a one-time windfall that pushes his income above the threshold for the new tax, and he ends up having to pay the regular capital gains tax plus an additional 3.8% tax on the appreciation that is attributable to the increase in value that occurred over several years.     

If your income normally exceeds the threshold for this new tax, or you have or are contemplating a large capital gain and would like to explore options to mitigate the impact of the tax, please give our office a call.

(601) 649-5207