On January 1, 2013, the Net Investment tax went into effect. Despite numerous articles and columns reminding consumers that this tax does not apply to every real estate sale, rumors continue to keep flying all over the country, claiming that the Health Reform legislation Congress enacted includes a sales tax on all real estate sales. While there is a tax, it does not apply to everyone.
The Health Care and Education Reconciliation Act of 2010 was signed into law by President Obama on March 30, 2010. It is a comprehensive and extremely complex piece of legislation. One section (1402) is entitled "Unearned Income Medicare Contribution" and does impose a 3.8 percent tax on any profit on the sale of real estate – residential or investment.
But it is aimed at high-income consumers, who comprise a small majority of American citizens.
Let's look at the true facts of this new law.
First, it is not a sales tax, nor does it impose any transfer or recordation tax. It is often called a "medicare" tax because the moneys received will be allocated to the Medicare Trust Fund, which is part of the Social Security System.
Next, if your income (technically called "adjusted gross income) is less than $200,000, you are home free. The income thresholds are clearly spelled out in the law. If you are married and file a joint tax return with your spouse, the law will apply only if your income is over $250,000. (If you and your spouse opt to file a separate tax return, the threshold is reduced to $125,000. For all other taxpayers, you have to earn more than $200,000 in order to be under the new law.
The up-to-$500,000 exclusion of gain for married couples filing a joint tax return (or up-to-$250,000 for single taxpayers) has not been repealed. Nor has the right to deduct mortgage interest and real estate tax payment been eliminated.
How is the tax calculated? It is a complex formula that could be called "the accountant's protection act". As a taxpayer, you (or your financial advisor) must determine which is less: the gain you have made on the sale of your house or the amount that your income exceeds the appropriate threshold.
Complicated? Yes. Let's look at these examples. Your adjusted gross income is $150,000. You sell your house and made a profit of $400,000. There is no change in the way you determine your gain: you take your purchase price, add any major improvements you have made over the years, and subtract that number from the net sales price. Based on this formula, you and your spouse have owned and lived in the property for at least two out of the five years before it was sold. Accordingly, you are eligible to exclude all of your profit; you are not subject to the new 3.8 tax. Keep the money and enjoy.
Change the example so that your adjusted gross income is $300,000. Since you are eligible to take the profit exclusion of up-to-$500,000, once again you do not have to pay the Medicare tax; your entire gain is excluded, and thus there is no profit to tax.
But let's assume you strike it rich and have made a profit of $600,000. Your income is $300,000. You can only exclude $500,000 under current law, so you will have to pay capital gains tax on the remaining balance. The rate currently is 20 percent, so you will owe Uncle Sam $20,000 ($100,000 x 20%).
But since your income is over the threshold, you now have to pay the 3.8 percent tax. But on what amount?
As indicated earlier, the tax is based on lesser of your profit or the difference between the threshold and your income. Your profit is $100,000. The difference between your income and the threshold is $50,000 ($300,000 - $250,000). In our example, the lower number is $50,000, and you will have to pay an additional $1900 to the IRS (3.8% x $50,000).
According to statistics provided by the National Association of Realtors, the median average sales price for homes in the United States (as of July, 2014) was $213.400. Clearly, none of these homes could make a profit of even $250,000, so if you qualify for the exclusion of gain requirements, you will not be impacted by this new law. Those requirements are: you have to have owned and used the property as your principal residence for two out of the five years before it is sold.
Of course, in homes where a large profit will be made, some home owners may be hit with this tax. But the large profit that you make should offset the nominal tax that has to be paid.
Since the law applies to all forms of real estate, including vacation homes, you should consider consulting with your tax and financial advisors as to your exposure.