New 3.8% Medicare Tax on Investment Income

• Interest
• Dividends
• Annuities
• Royalties and rents and other gross income attributable to a passive activity.
• Gains from the sale of property not used in an active business and income from the investment of working capital are also treated as investment income.
• Capital gains income (other than property held in an active trade or business) will be subject to this tax. This includes gain from the sale of a principal residence, unless the gain is excluded from income under Code Sec. 121, and gains from the sale of a vacation home.
• Special Note For Primary Residence Sales: Sec. 121 provides that taxpayers may exclude up to $250,000 ($500,000 for joint returns) from the gain on the sale or exchange of a principal residence provided they meet certain ownership and use requirements. As a result, only taxpayers with MAGI over $200,000 (or $250,000 if married filing jointly) who sell their principal residence and realize more than $250,000 in gain ($500,000 if married filing jointly) will be subject to the 3.8% tax and only on the amount of gain they realize over the Sec. 121 threshold (and on their other net investment income).
  • Example 1: A married couple with MAGI of $325,000 purchased a home in Pennsylvania many years ago for $300,000 and sold it this year for $900,000, realizing a gain of $600,000. After excluding $500,000 gain under Sec. 121, they are left with $100,000 investment income (assume they have no other investment income). Since their AGI is $75,000 over the tax’s threshold amount for married taxpayers filing jointly, the lesser amount of $75,000 would be subject to taxation. At 3.8% they would owe $1,900.

Items that are not investment income include:

• Sales or capital gains made before 2013
• Nontaxable income, such as tax-exempt interest or veterans’ benefits.

Estates and Trusts

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.

Deductions

Net investment income is gross income or net gain, reduced by deductions that are “properly allocable” to the income or gain. This is a key term that the Treasury Department expects to address with detailed guidance in the future. We will update our clients as developments and pronouncements become available.

For passively-managed real property, allocable expenses will still include depreciation and operating expenses. Indirect expenses such as tax preparation fees may also qualify.

For capital gain property, this formula puts a premium on keeping tabs on amounts that increase your property’s basis.

Certain investment expenses that may reduce net gains include the following:

• Interest on loans to purchase investments
• Investment counsel and advice.
• Fees to collect income.
• Other costs, such as brokers’ fees, may increase basis or reduce the amount realized from an investment.

As such, taxpayers may want to consider avoiding installment sales with net capital gains (and interest) running past 2012.

Thresholds Of Net Investment Income

The tax applies to the lesser of:

1. Net investment income or
2. 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.

MAGI is your AGI increased by any foreign earned income otherwise excluded under Code Sec. 911; MAGI is the same as AGI for someone who does not work overseas.

Example 2. Joe, a single taxpayer, has modified AGI of $230,000 and net investment income of $40,000. The tax applies to the lesser of (i) net investment income ($40,000) or (ii) modified AGI ($230,000) over the threshold amount for an individual ($200,000), or $30,000. The tax is 3.8 percent of $30,000, or $1,140.

In this case, the tax is not applied to the entire $40,000 of investment income.

Example 3. John and Jane, married and filing jointly, has modified AGI of $310,000 and net investment income of $40,000. The tax applies to the lesser of (i) net investment income ($40,000) or (ii) modified AGI ($310,000) over the threshold amount for an individual ($250,000), or $60,000. The tax is 3.8 percent of $40,000, or $1,520.

In this case, the tax is in fact applied on the entire $40,000 of investment income.

Exceptions to the Tax

Certain items and taxpayers are not subject to the 3.8 percent Medicare tax.

Retirement Plan Exceptions: The following are distributions that are not subject to this tax:

• Qualified plans
• 401(k) plans
• Tax-sheltered annuities
• Individual retirement accounts (IRAs)
• Eligible 457 plans.

Special Note For Deferred Compensation Plans: There is no exception for distributions from non-qualified deferred compensation plans subject to Code Sec. 409A. Be aware, that distributions from these plans (including amounts deemed as interest) are generally treated as compensation, not as investment income.

Planning Point: The exception for distributions from retirement plans suggests that potentially taxable investors may want to shift wages and investments to retirement plans such as 401(k) plans, 403(b) annuities, and IRAs, or to 409A deferred compensation plans. Increasing contributions will reduce income and may help you stay below the applicable thresholds. Small business owners may want to set up retirement plans, especially 401(k) plans, if they have not yet established a plan, and should consider increasing their contributions to existing plans.

Trade or Business Exception: Another exception is provided for income ordinarily derived from a trade or business that is not a passive activity under Code Sec. 469, such as a sole proprietorship.

Investment income from an active trade or business is also excluded.

Sale of An Business Ownership Interest: The additional 3.8 percent Medicare tax does not apply to income from the sale of an interest in a partnership or S corporation, to the extent that gain of the entity’s property would be from an active trade or business.

Other Exceptions: The tax also does not apply to:

• Business entities (such as corporations and limited liability companies),
• Nonresident aliens (NRAs),
• Charitable trusts that are tax-exempt, and
• Charitable remainder trusts that are nontaxable under Code Sec. 664.

Other Tax Rate Changes To Worry About and That Compound the Problem

In addition to the tax on investment income, the following are certain other tax increases may take effect in 2013.

• The top two marginal income tax rates on individuals would rise from 33 and 35 percent to 36 and 39.6 percent, respectively.
• The maximum tax rate on long-term capital gains would increase from 15 percent to 20 percent.
• Dividends, which are currently capped at the 15 percent long-term capital gain rate, would be taxed as ordinary income.

The possible impact here is that the cumulative rate on capital gains would increase to 23.8 percent in 2013, and the rate on dividends would jump to as much as 43.4 percent. Moreover, the thresholds are not indexed for inflation, so more taxpayers may be affected as time elapses.

Please contact our office if you would like to discuss the tax consequences to your investments of the new 3.8 percent Medicare tax on investment income.