The 3.8% tax – The Real Story

The 3.8% Tax

Beginning January 1, 2013, a new 3.8 percent tax on some investment income will take eect. Since this new tax will aect some real estate transactions, it is important for you to clearly understand the tax and how it could impact you or your clients and friends. It’s a complicated tax, so you won’t be able to predict how it will aect every buyer or seller.

This new tax — passed by Congress in 2010 with the intent of generating an estimated $210 billion to help fund President Barack Obama’s health care and Medicare overhaul plans — MAY be relevant to you. Understand that this tax WILL NOT be imposed on all real estate transactions, a common misconception. Rather, when the legislation becomes eective in 2013, it may impose a 3.8% tax on some (but not all) income from interest, dividends, rents (less expenses) and capital gains (less capital losses). The tax will fall only on individuals with an adjusted gross income (AGI) above $200,000 and couples filing a joint return with more than $250,000 AGI.

 

APPLIES TO:

 

· Individuals with adjusted gross income (AGI) above $200,000

 

· Couples filing a joint return with more than $250,000 AGI

 

 

TYPES OF INCOME

 

·  Interest, dividends, rents (less expenses), capital gains

 

SOME EXAMPLES

 

SALE OF PRINCIPAL RESIDENCE

 

John and Mary sold their principal residence and realized a gain of $525,000.

They have $325,000 Adjusted Gross Income (before adding taxable gain).

 

The tax applies as follows:

AGI Before Taxable Gain $325,000

Gain on Sale of Residence $525,000

Taxable Gain (Added to AGI) $25,000 ($525,000 – $500,000) ( First $500,000 is exempt)

New AGI $350,000 ($325,000 + $25,000 taxable gain)

Excess of AGI over $250,000 $100,000 ($350,000 – $250,000)

Lesser Amount (Taxable) $25,000 (Taxable gain)

Tax Due $950 ($25,000 x 0.038)

In this example, only $10,000 of their capital gain is subject to the 3.8% tax.

If their gain had been smaller (less than $110,000), they would not pay the 3.8%

tax because their AGI would be less than $250,000.

 

CAPITAL GAIN: SALE OF A NON REAL ESTATE ASSET

 

Barry and Michelle inherited stocks and bonds that they have decided to liquidate. The sale

of these assets generates a capital gain of $120,000. Their AGI before the gain is $140,000.

 

The tax applies as follows:

AGI Before Capital Gain $140,000

Gain on Sale of Stocks and Bonds $120,000

New AGI $260,000

Excess of AGI over $250,000 $10,000 ($260,000 – $250,000)

Lesser Amount (Taxable) $10,000 (AGI excess)

Tax Due $380 ($10,000 x 0.038)

 

RENTAL INCOME: INCOME SOURCES INCLULDING REAL ESTATE INVESTMENT INCOME

 

Hank has a “day job” from which he earns $85,000 a year. He owns several small apartment units and receives gross rents of $130,000. He also has expenses related to that income.

 

The tax applies as follows:

AGI Before Rents $85,000

Gross Rents $130,000

Expenses (Including depreciation and debt service) $110,000

Net Rents $20,000

New AGI $105,000 ($85,000 + net rents)

Excess of AGI over $200,000 $0

Lesser Amount (Taxable) $0

Tax Due $0

Even though Hank’s combined gross rents and day job earnings exceed $200,000,

he will not be subject to the 3.8% tax because investment income includes NET,

not gross, rents.

 

CAPITAL GAINS, INTEREST AND DIVIDENDS: SECURITIES

 

Harry and Sally have substantial income from their securities investments. Their AGI before including that income is $190,000. Their investment income is listed below.

 

The tax applies as follows:

Interest Income (Bonds, CDs) $60,000

Dividend Income $75,000

Capital Gains $10,000

Total Investment Income $145,000

New AGI $335,000 ($190,000 + $145,000)

Excess of AGI over $250,000 $85,000 ($335,000 – $250,000)

Lesser Amount (Taxable) $85,000 (AGI excess)

Tax Due $3,230 ($85,000 x 0.038)

 

RENTAL INCOME: RENTAL INCOME AS A SOLE SOURCE OF EARNINGS – REAL ESTATE TRADE OR BUSINESS

 

Henrietta’s sole livelihood is derived from owning and operating commercial buildings. _ us, these assets are treated as business property and not as investment property. Her income stream is outlined below.

 

The tax applies as follows:

 

Gross Rents $750,000

Expenses (Including depreciation and debt service) $520,000

Net Rents $230,000

New AGI (Net rental income) $230,000

Excess of AGI over $200,000 $30,000

Lesser Amount (Taxable) $0 (No investment income)

Tax Due $0

 

Henrietta’s rental income is from a trade or business so it is NOT treated as investment income. Thus, she is NOT subject to the 3.8% investment income tax. BUT:

 

The health care bill created a separate tax for high wage and self-employment

business income. Thus, Henrietta IS subject to the new 0.9% (0.009) tax on earned

income, because some portion of the net rents represents her compensation for

operating the commercial buildings. See additional background below.

 

For this example, assume that the total net rents are her sole compensation. The tax

on this earned income would be as follows:

 

AGI $230,000

Excess of AGI over $200,000 = $30,000

Tax Due $270 ($30,000 x .009)

 

NOTE:

Depending on how Henrietta has organized her business (S Corp, LLC or sole proprietor),

she might be able, for example, to pay herself $175,000, leaving the remaining

$55,000 in the business in anticipation of making improvements the following year.

In that case, because her AGI of $175,000 is less than $200,000, she will owe neither

the unearned income tax (3.8%) nor the earned income tax (0.9%).

 

SALE OF A SECOND HOME WITH NO RENTAL USE (NO MORE THAN14 DAYS RENTAL)

 

The Bridgers own a vacation home that they purchased for $275,000. Theyhave never rented it to others. The sell it for $335,000. In the year of sale they also have earned income from other sources of $225,000.

 

The tax applies as follows:

Gain on Sale of Vacation Home $60,000 ($335,000 – $275,000)

Income from Other Sources $225,000

New AGI $285,000 ($60,000 + $225,000)

Excess of AGI over $250,000 $35,000 ($285,000 – $250,000)

Capital Gain $60,000

Lesser Amount (Taxable) $35,000 (AGI excess)

Tax Due $1,330 ($35,000 x 0.038)

 

NOTE: If the Bridgers rent the home for 14 or fewer days in the course of a year, the rental

income is non-taxable and the results in the year of sale will be the same as shown

above. If the rental period exceeds 14 days in any year, then the rental income

(less expenses) will be taxable and AGI would include not only the capital gain,

but also some amount that is depreciation recapture. (See next example.)

If the second residence is SOLELY a rental property, it is treated as an investment

property. See previous examples.

 

PURCHASE AND SALE OF INVESTMENT PROPERTY ( RESIDENTIAL OR COMMERICAL)

 

Ethan has purchased an investment property for $900,000. During his period of ownership, he takes $230,000 in depreciation deductions. He has also made some improvements to the property. At the time of sale, his adjusted basis in the property is $760,000. He subsequently sells the property for $1.2 million. In the year of sale, he is single and reports self-employment income of $315,000.

 

The tax applies as follows:

Gain on Sale $440,000 ($1.2 million less adjusted basis of $760,000)

Depreciation Recapture $230,000

Total Gain $670,000 (Gain on sale plus depreciation recapture)

Schedule C Income $315,000

New AGI $985,000 ($315,000 + $670,000)

Excess AGI over $200,000 $785,000 ($985,000 – $200,000)

Lesser Amount (Taxable) $670,000 (Capital gain)

Tax Due $25,460 ($670,000 x 0.038)

 

NOTE: The statute provides no guidance as to whether Ethan can defer the 3.8% tax by

entering into a like-kind exchange when he sells the property. This question may be

addressed in regulations at a later time, but for the present is not resolved.

 

The previous information was published by Realtor.org. There are online FAQs at www.realtor.org/healthreform

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