Champagne, funny hats, and the ball-drop in Times Square might not be the only significant events to mark the New Year in 2013. If you are a real estate investor or a home-seller, you could have a couple of surprises lurking in your federal taxes.
The Medicare Tax
One of those surprises found its way into the Health Care and Reconciliation Act of 2010 at the last minute. If, as the the National Association of Realtors® states, it was added to the legislation at the last minute, then one has to wonder just how carefully our elected officials studied this before passing it.
What It Is Not
There has been a lot of talk and many email blasts, claiming that this is a sales tax on real estate. It is not. It doesn’t apply to every real estate transaction, and it doesn’t get tacked on at the point of sale, the way a sales tax would. That much is clear.
What It Is, Sort Of
The details may seem a bit daunting, but let’s try to summarize:
- It is a 3.8% surtax on “net investment income,” which appears to include rental income, capital gains on the sale of investments (and to a limited extent on the sale of a personal residence), interest, dividends, royalties, and annuities, all net of the expenses to achieve that income.
- It does not apply to withdrawals from IRAs and 401ks, or from veterans benefit, life-insurance proceeds and several other types of income. (For a further discussion, see this article in Forbes.)
- But wait, it can actually get even more complicated. According to an article in SmartMoney, there is an exception for income from sources that come from business activities. Presumably this would mean that if you derive your livelihood solely from operating rental property or from flipping houses then your rental income or capital gain from those activities is business- and not investment-related; hence it doesn’t go into the bucket of items subject to the Medicare surtax. But that same article notes an “exception to the exception” if the income is from a “passive business activity.”
- It will never apply (should we ever say never?) if your adjusted gross income is less than $200,000 as an individual or $250,000 for a married couple filing jointly. Fire up your spreadsheet now, because there is a further test: The tax applies to the lesser of your total net investment income or the excess of your Modified Adjusted Gross Income over the $200,000 (single) or $250,000 (joint return) thresholds. (MAGI is the same as AGI for most taxpayers.) Keep in mind a couple of potential “gotchas” in regard to these thresholds. Even though your conventional (not Roth) IRA or 401k withdrawal is not considered investment income for the purpose of this law, it’s still income and could potentially push you over the threshold. Likewise, the gain from the sale of an investment property could catapult you over the line.
- If you are selling your personal residence, you will continue to get the $250,000 exclusion for individuals, or $500,000 for a married couples filing jointly, so it is only your gain over that amount that is in play. As before you still have to pay the capital gains tax on your profit in excess of those exclusions. More about capital gains in a moment.
- Congress did not learn its lesson from the Alternative Minimum Tax debacle, because there does not appear to be any provision to index the threshold amounts for inflation, so the tax may affect more people as time goes on.
For more information about this tax, you can refer to the articles noted above as well as a PDF summary put out by the National Association of Realtors®. You’ll find a link to that PDF here.
Capital Gains and the Fiscal Cliff
Another sobering New Year’s Day adventure is what is being called the “fiscal cliff.” Part of the wild ride into the abyss is the scheduled expiration of the Bush-era tax cuts on January 1, 2013. Here, in brief, is what it means for those of us in real estate:
- If you sell your real estate investment property for a profit, that profit is taxed at the capital gains rate. Currently that capital gains tax rate is 15%, but if we go over the fiscal cliff on January 1, 2013, the rate will go to 20% with the potential to add the 3.8% Medicare tax to part of the gain.
- If you sell your home for a profit and if you have a gain that exceeds the $250,000 or $500,000 exclusion (not an unrealistic possibility, especially for older homeowners who bought several decades ago – especially in what are now the more costly markets on the coasts like Fairfield County, Connecticut where I live) you may be faced with a similarly higher tax on that gain.
- The cliff notwithstanding, the Senate narrowly passed a Democratic-sponsored bill last summer, which did not achieve Congressional agreement but which did include a 20% capital gain rate.
The Bottom Line
I believe the significance of the Medicare tax may be not so much the money it raises -- probably not very much -- but rather in the anti-investor mindset it reveals. The same would seem to underlie the proposals to raise the capital gains tax. Both taxes suggest to me a policy that puts investing and risk-taking in the crosshairs, that seeks to discourage rather than encourage the activities that are essential to making an economy grow.
This writer shares the opinion of many that higher tax rates on capital gains are a bad idea generally, and a terrible idea during a struggling economy. Existing businesses need capital to grow and startups need capital to launch. If our tax structure is changed to impose a disincentive to invest, then we shouldn’t be surprised to see our economy shrink even further. This WSJ article says it well.
Those who invest and who see investing as vital to our society need to keep careful watch on every new tax proposal and to keep ourselves in the conversation about those proposals. And as this Wall Street Journal article put it: “If you’re planning to sell rental real estate or other investment property, run, don’t walk, to a trusted tax expert.”
About Frank Gallinelli: Frank Gallinelli graduated from of Yale University with a BA is Psychology, and from Southern Connecticut State University with a MS in education. After teaching for nine years in New Haven, he worked in commercial real estate and then moved to Southport in 1979 to manage and computerize the finances of a family retail business. In 1981 he founded a software company, RealData (now realdata.com), to provide financial analysis tools for real estate investors and developers.
Mr. Gallinelli served on the Fairfield RTM as a member and moderator in the ‘90s. Since 2003 he has served as an Adjunct Assistant Professor of Finance in Columbia University's Master of Science in Real Estate Development program, and has recently joined the faculty of Homburg Academy, a startup online school specializing in real estate and finance.
Gallinelli has written several books on real estate investing, including two that were published by McGraw-Hill, and another that was self-published. He has continued to write articles, blogs, and digital books and to produce educational videos for investors.