A 3.8% “Sales Tax” On Your Home?

Buried deep in the new health care law is a new and little known tax of 3.8% on the sale of your home. It is actually a tax on “unearned” net investment income, but I’ll get to that in a minute. Unfortunately, there is not much information out there about this new tax and, consequently, most of it is misinformation or outright misrepresentation.

You may have already seen an e-mail alluding to this new tax. The e-mail states that if you sell your $400,000 home you will have to pay $15,200, or 3.8%, in tax on that sale. I’m not sure whether this is an example of misinformation or misrepresentation, but this post will clear up the confusion once and for all. The truth is that only a tiny percentage of home sellers will pay the tax, but it doesn’t change the fact that this is a new tax above and beyond the existing capital gains tax.

The “Medicare Tax,” as it is called, takes effect January 1, 2013. The revenues generated from this tax will be allocated to the Medicare Trust Fund, which is part of the Social Security System, and is designed to decrease the shortage that currently exists.

As I already mentioned, the tax will apply to what is referred to as “unearned” income. Unearned income is income that an individual derives from investing his/her capital. It includes capital gains, rents, dividends and interest income. Income derived from the sale of a home is considered capital gains. Under current tax law, any gain from the sale of a principal residence that is less than $250,000 for individuals or $500,000 for married couples may be excluded from the capital gains tax. According to the IRS, to qualify for the $250k/$500k exclusion, a seller must have owned the home for at least two years, with few exceptions, and lived in the home as a primary residence for at least two years out of the last five years prior to the sale. The capital gains tax and the new “Medicare Tax” would apply only to any gain realized that is more than the $250,000/$500,000.

While the law imposes a 3.8% tax on the capital gains over the $250k/$500k exclusions in an effort to make the “wealthy” pay, the exclusion only applies to primary residences. There are a lot of “not so wealthy” individuals who own rental property, vacation property (second home) or vacant land. These properties are not shielded from this 3.8% tax increase.

Let’s look at two examples:

1) Take an “empty nester” couple with combined income of over $250,000 a year who sell their $1 million primary residence to move to smaller quarters. If they cleared $600,000 on the sale, they would be taxed on the $100,000 of profit (the amount over the $500,000 exclusion). Their “Medicare Tax” on the sale would amount to $3,800 ($100,000 x 3.8%) over and above the usual capital gains tax.

2) Take a single executive making $210,000 a year who sells his $300,000 ski condo for a $50,000 profit. His/her tax on the sale of that vacation home would amount to $1,900 ($50,000 x 3.8%), in addition to the usual capital gains tax.

The situation is similar in the case where someone owns a rental property. The rents received and the profit from a sale are taxed. However, the income from these sources are reduced by any expenses associated with earning that income. Thus, in the case of rents, the taxable amount would be the gross rents minus all expenses (including depreciation) incurred in operating the rental property.

Who will be subject to the new tax? “High Income” taxpayers. In this law a high income earner is defined as a “single” person with an Adjusted Gross Income (AGI) of $200,000, a married couple filing a joint return with an AGI of $250,000, or a married couple filing separately with AGI of $125,000. These income levels are even more important when you consider that they are not indexed for inflation. That means that over time more and more people may become subject to this tax, just like happened with the Alternative Minimum Tax. Over time a person’s income typically increases. Someone making $75,000 today may be making $125,000 in ten years or less. If the spouse also works they could see themselves making more than $250,000 and now be subject to a tax that was supposedly not designed to apply to them.

Hopefully, this explanation of the “Medicare Tax” is clear and easy to understand. If you have any questions please feel free to call me or comment below.