The recently enacted health care reform package imposes a new 3.8% Medicare contribution tax on the net investment income of higher-income individuals. Although the tax does not take effect until 2013, it is not too soon to understand what it means and to examine strategies to lessen the impact of the tax.
Net investment income: Net investment income, for purposes of the new 3.8% 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. Income from trading in financial instruments and commodities is subject to the tax. An individual's capital gains income will be subject to the tax. This would include gain from the sale of a vacation home.
It may be prudent to realize gains in 2012 instead of waiting until 2013.
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 of $11,200 for the highest tax bracket for trusts and estates, and to investment income they distribute. This is a very low threshold so the impact to trusts is significant.
Deductions: Net investment income for purposes of the new 3.8% 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 at a later date. 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 reduce the amount realized from an investment. You may want to consider avoiding installment sales with net capital gains (and interest) running beyond 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 work overseas.
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% 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 current administration that could take effect in 2013. The top two marginal income tax rates on individuals would rise from 33 and 35%t to 36 and 39.6%, respectively. The maximum tax rate on long-term capital gains would increase from 15 to 20%. Moreover, dividends, which are currently capped at the 15% long-term capital gain rate, would be taxed as ordinary income. Thus, the cumulative rate on capital gains would increase to 23.8% in 2013, and the rate on dividends would jump to as much as 43.4%. Because the thresholds are not indexed for inflation, 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 your tax planning must take them into account.
Exceptions: Certain items and taxpayers are not subject to the 3.8% tax. A significant exception applies to distributions from qualified plans, 401(k) plans, tax-sheltered annuities, individual retirement accounts (IRAs), and eligible 457 plans. 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, such as a sole proprietorship.
Investment income from an active trade or business is also excluded.
Self-Employment tax will still apply to proprietors and partners as it has in the past.
The tax does not apply to nontaxable income, such as tax-exempt interest or veterans' benefits.
It also 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.
The first step in any tax plan is to determine if the law applies to you. The second step is to review transactions that you may be considering to determine the timing of them to avoid the increased tax and thirdly to the extent that the tax cannot be avoided, gear up to understand what it means to your cash flow for estimated income tax payment and withholdings.
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