by Ken WeissenbergA recent Congressional Research Service (CRS) Report tries to reduce fears that the 3.8% Medicare contributions tax on unearned income (added by the Health Care and Education Reconciliation Act of 2010) effective for tax years beginning in 2013, is a “real estate” or “home sales” tax. As noted below, part or all of the gain on the sale of a residence will be subject to this new tax, along with many other items of passive income.
The Medicare contribution tax is a 3.8% additional tax that is imposed on individuals, estates and trusts on the lesser of (i) unearned income and (ii) Modified Adjusted Gross Income (MAGI) in excess of a threshold amount. The threshold amount for married individuals filing jointly is $250,000 ($125,000 if filing separately) and $200,000 for all others.
The CRS report stresses that the tax is not limited exclusively to real estate transactions and does not apply to the portion of gain which is excluded from tax under Internal Revenue Code section 121. Currently, under code sec 121, when a taxpayer sells his or her principal residence, there is an exclusion from taxable income of up to $250,000 of the capital gain if single or $500,000 if married filing jointly. Certain ownership and use tests must be satisfied to qualify for the exclusion. Gains in excess of the section 121 exclusion will be treated as capital gain for regular tax purposes and investment income for purposes of the 3.8% Medicare tax. However, given the exclusion amount only a limited number of taxpayers would be affected, especially since many home owners have experienced a decline in the value of their homes in recent years. It should be noted that gains on the sale of second homes (i.e., those which are not a principal residence) will not be eligible for the exclusion and may very well be subject to the 3.8% Medicare tax, in addition to the regular income tax.
If you are planning on selling a primary residence with a significant gain in excess of the $250,000/500,000 or a second residence, it may be a better idea to sell before the end of 2012 to avoid this additional 3.8% tax. For sales after 2012, installment sales reporting may be helpful to spread the recognition of gain into more than one year. An installment sale would also spread the regular capital gains tax over more than one year, but you are also delaying the receipt of the cash. An unknown is what would happen if you made an installment sale of a home in 2012 with some of the proceeds payable in 2012. Would the portion of the gain reportable in 2013 for regular tax purposes be subject to the 3.8% Medicare tax?
Finally, for regular tax purposes a loss on the sale of a personal residence is not deductible. Will the same rule apply to the 3.8 % Medicare tax or can that loss be used to reduce the tax on other investment income?
