By: BMC Tax Department (Posted: 10/26/2012)
The health care reform package (the Patient Protection and Affordable Care Act
and the Health Care and education Reconciliation Act of 2010) imposes a new
3.8 Medicare contribution tax on the investment income of higher-income
individuals. Although the tax does not take effect until 2013, it is not too
soon to examine methods to lessen the impact of the tax.
Net investment income. Net investment income, for purposes of the new 3.8
percent Medicare tax, includes interest, dividends, annuities, royalties and
rents and other gross income attributable to a passive activity. Gains from
the sale of property that is not used in an active business and income from
the investment of working capital are treated as investment income as well.
However, the tax does not apply to nontaxable income, such as tax-exempt
interest or veterans' benefits. Further, an individual's capital gains income
will be subject to the 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. However, contemplated sales made
before 2013 would avoid the tax.
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 for purposes of the new 3.8 percent tax 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 in guidance, and which we will update you on developments. 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. It also puts the focus on
investment expenses that may reduce net gains: interest on loans to purchase
investments, investment counsel and advice, and fees to collect income. Other
costs, such as brokers' fees, may increase basis or reduce the amount realized
from an investment. As such, you may want to consider avoiding installment
sales with net capital gains (and interest) running past 2012.
Thresholds and impact. The tax applies to the lesser of net investment income
or 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 AGI increased by foreign earned income otherwise
excluded under Code Sec. 911; MAGI is the same as AGI for someone who does not
Example. Jim, a single individual, has modified AGI of $220,000 and net
investment income of $40,000. The tax applies to the lesser of (i) net
investment income ($40,000) or (ii) modified AGI ($220,000) over the
threshold amount for an individual ($200,000), or $20,000. The tax is 3.8
percent of $20,000, or $760. In this case, the tax is not applied to the
entire $40,000 of investment income.
The tax can have a substantial impact if you have income above the specified
thresholds. Also, don't forget that, in addition to the tax on investment
income, you may also face other tax increases proposed by the Obama
administration that could 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. Moreover, dividends, which are currently capped
at the 15 percent long-term capital gain rate, would be taxed as ordinary
income. Thus, 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 a greater
number of taxpayers may be affected as time elapses. Congress may step in and
change these rate increases, but the possibility of rates going up for upper
income taxpayers is sufficiently real that tax planning must take them into
Exceptions. Certain items and taxpayers are not subject to the 3.8 percent
tax. A significant exception applies to distributions from qualified plans,
401(k) plans, tax-sheltered annuities, individual retirement accounts (IRAs),
and eligible 457 plans. At the present time, however, there is no exception
for distributions from nonqualified deferred compensation plans subject to
Code Sec. 409A, although some experts claim that not carving out such an
exception was a Congressional oversight that should be rectified by an
amendment to the law before 2013.
The exception for distributions from retirement plans suggests that
potentially taxed investors may want to shift wages and investments to
retirement plans such as 401(k) plans, 403(b) annuities, and IRAs, or to 409B
Roth accounts. 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.
Another exception covers 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. However, SECA (Self-Employment Contributions Act) tax will still
apply to proprietors and partners. Income from trading in financial
instruments and commodities is also subject to the tax. The 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. 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.
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.