Health-reform-related legislation passed in 2010 instituted a new 3.8 percent Medicare tax on investment gains. This 3.8 percent tax has caused quite a bit of confusion, leading some to believe incorrectly that gains on all home sales will now be taxed at 3.8 percent.
When the new tax kicks in
If you are planning to sell property, how does this tax affect you?
First, let's look at what the provision of this law, the Health Care and Education Reconciliation Act, does. It institutes a 3.8 percent tax on investment gains, which includes taxable capital gains on the sale of property. The tax does not apply specifically to home sales, and it doesn't kick in until tax year 2013.
When it does take effect, relatively few home sellers will be affected by this 3.8 percent tax. Only investment gains beyond a high threshold and for certain individuals will be subject to this tax.
Income test limits affected home sellers
This tax is imposed on net investment income or income in excess of threshold amounts, whichever is lower. In other words, you are off the hook for this tax if you are:
- A single filer with a modified adjusted gross income (MAGI) of $200,000 or less
- Married but filing separately with a MAGI of $125,000 or less
- Married filing jointly with a MAGI of $250,000 or less
Exclusions on gains limits taxable amounts
If you have a MAGI higher than the above thresholds, you could trigger the tax if your net investment gains are high enough. Even so, the 3.8 percent Medicare tax only applies to gains subject to capital gains tax anyway based on IRS rules.
So if your property sale would not be taxed, you won't have to pay this 3.8 percent health care tax, either. Your gain isn't subject to the tax if:
- You lived in the home as your primary residence for at least two of the last five years, and
- Your gain on the sale doesn't exceed $500,000 for a married couple filing jointly or $250,000 for a single filer
Gains on the sale of investment property would be a taxable event that year, unless you replace one property with another with a 1031, or "like-kind," exchange. Disposing of investment property through this mechanism allows you to defer all capital gains tax, including the new health care tax.
Determining your tax liability
If you fail the income test, you'll have to calculate two numbers to determine your tax liability.
First, calculate the taxable gain on your sale. That's your sales price, less the costs of selling, minus what you paid to acquire and improve the property. You may have to make adjustments if you have taken deductions for depreciation on the home in prior years.
Next, take your modified adjusted gross income and subtract the threshold amount. That's your second figure.
You'll be paying the 3.8 percent tax on the lower of these two figures.
Example #1: Taxable sale
Here's an example of a taxable sale. A single man earns wages of $215,000 per year. In addition, he sells a ski condo for $130,000. It was originally purchased for $70,000 and he never treated it as a primary residence. Here are the two calculations:
- His taxable gain on the condo is $130,000 - $70,000 = $60,000
- His above-threshold income is $215,000 + 60,000 - $200,000 = $75,000
The lower of the two numbers is $60,000. His Medicare tax is 3.8 percent of $60,000, or $2,280.
Example #2: Taxable sale with exemption
Here's an example of a sale partially subject to the tax. A married couple filing jointly earns $260,000 a year. They sell their $1 million primary residence that cost them $380,000 when they purchased it 10 years ago. Their selling expenses are $20,000. Here are their two calculations:
- Their gain from sale is $1,000,000 - $380,000 - $20,000 = $600,000. However, they can exclude $500,000 because the home qualifies as a main home, so their taxable gain is $100,000
- Their above-threshold income is $260,000 + $100,000 - $250,000 = $110,000
The lower of the two numbers is $100,000. Their Medicare tax is 3.8 percent of $100,000, or $3,800.
Planning now to avoid the tax later
If you've followed these calculations and exemptions, it's clear that most people will not be paying this tax. Only the top 2 percent of households will be affected at all, according to the Tax Foundation.
However, if your anticipated income and plans for a home sale in 2013 or beyond mean you will likely be subject to this 3.8 percent tax, you may want to consult a tax planner if you are interested in minimizing your liability. He or she may advise you to time prospective sales of investment or vacation property to coincide with years in which your income is lower, help you set up tax-deferred exchanges or tell you to put off selling a home until you have lived in it for a couple of years.