New Tax on Investment Income to Support Medicare

The recent Supreme Court ruling on the healthcare law upheld the Patient Protection and Affordable Care Act of 2010. While some elements of the bill have already gone into effect, higher income taxpayers need to be mindful of the 3.8% tax on net investment income effective January 1, 2013. Luckily, there are some beneficial strategies to incorporate over the next few months to offset the additional tax liability.

The Background
This bill, the Unearned Income Medicare Contribution, aims to recover the suffering Medicare branch of the Social Security Administration by taking the form of a surtax of 3.8% on various types of unearned income of individuals, trusts and estates with income above certain thresholds. In effect, the new tax will apply to single taxpayers with a modified adjusted gross income (MAGI) in excess of $200,000 and married taxpayers with a MAGI in excess of $250,000 on a joint return or $125,000 if filing a separate return. For those individuals who are within these brackets, the 3.8% Medicare tax will be applied to the lesser of net investment income or the amount by which one’s MAGI exceeds the implemented thresholds.

The bill specifically targets “unearned” net investment income, which is classified as income that is gained when an individual invests his or her capital. For example, net capital gains resulting from the disposition of property, rents, annuities, dividends and interest income are all subject to the Medicare surtax. Investments in active business and trades are also included in net investment income if the individual is not an active participant in that business or trade. In this case, real estate investments may become more costly for individuals who use real estate as a side business for earning extra income.

Secondly, the Medicare surtax will also apply to trusts and estates of high income individuals defined with the same MAGI thresholds. The surtax will be imposed on the lesser of: 1) the trust or estate’s undistributed net investment income for the year or 2) the excess adjusted gross income over the highest tax bracket (which is $11,650 in 2012).

While the Medicare surtax can prove costly to high income individuals, there are management strategies that can help mitigate or reduce the upcoming tax on investment income.

Tax Planning Strategies to Implement Now
One strategy for reducing or mitigating the Medicare surtax is by classifying real estate investments as active. Real estate investors should research the Active Real Estate Investors’ Rules to determine if they might be able to avoid the Medicare surtax by classifying their real estate investments as active.

Real estate investors are classified as active when they spend more than one half of their time practicing in real estate trades or businesses. When active, rental real estate is not subject to the Medicare surtax because the investor is using such trade as his or her main source of income. In contrast, passive activity—renting rental property to friends, families, etc. for longer than fourteen days—is subject to the surtax, as the property serves as an investment even if it is a major source of income. It is also advised that such investors compile their rental real estate interests into one activity which thereby aggregates all property interests into one trade or business. Those with a significant amount of investment income from real estate transactions should take this time to implement mitigation strategies before the January 2013 commencement date for the Medicare surtax.

Other Tax Planning Strategies to Consider
Another strategy for reducing the Medicare surtax is to make deductible contributions to a traditional IRA which will lower one’s MAGI. Individuals aged 50 and younger are able to contribute $5,000 maximum and those aged 50 or older are able to contribute $6,000 maximum.

Wealth transfer planning will help mitigate the cost of the surtax to wealthy individuals, as the gift of primary income or net income producing property will remove the asset from the donor and thereby reduce the overall net income. A similar strategy can be used to give to charity—gifting income or property to a charity will reduce net income from the donor.

Lastly, installment sales will help high income individuals limit their annual net investment income and thereby manage their MAGI. An installment sale is a type of sale in which an asset is sold in exchange for a promissory note that is paid in increments over an allotted period of time. For example, selling a piece of rental property (that is not used in an active trade or business) for a gain would contribute to one’s net investment income and also raise one’s MAGI. However, if that piece of rental property was sold using an installment sale, the gain would be collected in increments over time and would thereby lessen the effect to the seller’s MAGI.

Defining the Surtax
The new surtax is applicable only when Adjusted Gross Income (AGI) is more than $200,000 for single taxpayers or $250,000 for married taxpayers. It is calculated by a formula, determined by the lesser of net investment income or the excess of AGI over the $200,000/$250,000 parameters. For instance, if a single individual’s AGI is $290,000 (excess is $90,000) and his individual investment income is $60,000, the 3.8% tax would apply to his investment income because it is the lesser value of the two.

Any gain from the sale of a principal residence less than $250,000 for individual returns or $500,000 for joint returns will continue to be excluded from income tax and the Medicare surtax will not apply. However, the Medicare surtax will apply to the sale of a principal residence if the capital gain is more than the $250,000 (individual) and $500,000 (joint) thresholds and the individual(s) has/have AGI above $200,000/$250,000 perimeters. For example, if the gain was $40,000 and a married couple had AGI of $300,000, then the $40,000—the lesser of the two amounts—would be subject to the 3.8% tax. In contrast, if the gain was $40,000 and the couple had AGI of $175,000, they would not be subject to the tax on their AGI or investment income because they are below the $250,000 AGI threshold.

Start Planning Now
Because this legislation does not account for inflation, more individuals will be subject to the Medicare surtax over time. The legislation goes into effect on January 1, 2013, which gives taxpayers enough time to plan changes to their investment portfolios. As always, Bartlett, Pringle & Wolf is ready to assist you with your tax planning needs and is well-versed in the complexities of the Medicare surtax.

Please contact me with any questions at (805) 963-7811 or jsheffield@bpw.com.

For more details about the components of the Medicare surtax, visit www.irs.gov and www.realtor.org.