Medicare Contribution Tax

Renting Out Property? Avoid the 3.8% Medicare Tax.

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Beginning January 1, 2013 there is a 3.8% Medicare tax on net investment income.  The tax applies to the lesser of (1) net investment income or (2) the excess of modified adjusted gross income over a threshold amount ($250,000 for joint files, $125,000 for married filing separately, and $200,000 for other filers).   Net investment income includes gross income from interest, dividends, annuities, royalties, and rents unless derived in a trade or business to which the 3.8% Medicare tax does not apply.

The 3.8% Medicare tax applies to income from a trade or business if:

  • The trade or business is a passive activity or
  • The trade or business deals in financial instruments or commodities

The language is pretty awkward, but what this means is that rental income will be subject to the 3.8% Medicate tax unless:

  • The rental activity is not a passive activity AND
  • The rental activity qualifies as a trade or business

A passive activity is one in which the taxpayer does not materially participate.  A taxpayer may establish that she materially participates by working more than 500 hours per year in the activity.  There are also other ways of establishing material participation, but the 500 hour method is the most used.

However, rental activities are still treated as passive activities even if the taxpayer establishes that she materially participates in the rental.  There are certain exceptions that allow rental activities to avoid being treated as passive activities.  These exceptions include:

  • The taxpayer qualifies as a real estate professional
    • The taxpayer must meet the following three requirements to be classified as a real estate professional:
      • She must spend more than 750 hours per year in real property trades or businesses in which she materially participates (e.g., spends more than 500 hours in the activity) AND
      • She spends more than 50% of her time in real property trades or businesses in which she materially participates
      • The taxpayer must materially participate in the rental activity for which she is trying to claim a loss
    • The property is rented by each customer for 7 days or less
    • The property is rented by each customer for 30 days or less and significant personal services are provided to the tenant

Additional exceptions apply.  If the taxpayer can meet one of these exceptions, the rental activity will not be treated as a passive activity.

Next, the taxpayer must establish that the rental activity is a trade or business.  This requirement generally means that the taxpayer must have a profit motive and operate the activity in a business-like manner.  The taxpayer should adopt some or all of the following actions to establish a trade or business:

  • Conduct the Activity in a Businesslike Manner. Keep accurate books and records. Open a separate checking account for the activity. Complete a formal, written business plan and follow it
  • Eliminate Personal Pleasure and Recreation as a Major Factor for Conducting the Activity. The mere fact that some pleasure or recreation is derived does not cause the activity to be classified as not-for-profit if other factors point to profit status. However, the potential for personal pleasure and recreation should be minimal
  • Devote More Time to the Activity.
  • Consider Hiring a Competent, Qualified Person to Operate the Activity. Employing someone else to operate the activity accomplishes several goals: (a) it shows that the taxpayer is relying on others for their expertise; (b) it gives the taxpayer an opportunity to expand the activity and earn more income; and (c) it reduces the amount of personal pleasure and recreation derived from the activity.

In summation, the 3.8% Medicare tax will apply unless the taxpayer establishes both:

  • The rental activity is not a passive activity and
  • The rental activity is a trade or business

 

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

 

The New Medicare Tax on Investment Income

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Under the 2010 Health Care Act, Medicare taxes will be going up for certain people on January 1, 2013.  There are two separate Medicare tax increases.  One will be a 3.8% Medicare tax on unearned income.  The other is a 0.9% Medicare tax on wages and self-employment income.  This post describes the 3.8% Medicare Contribution Tax on unearned income.

The Medicare Contribution Tax (3.8%) on Unearned Income

This tax is levied on unearned income such as interest, dividends, annuities, royalties, rents, and capital gains.  It also includes flow through income from an LLC or S corporation in which the owners are not active (e.g., investors ).

The tax is 3.8% of the lesser of:

  • Net investment income OR
  • The excess of modified adjusted gross income over the applicable threshold amount

Some definitions:

Net Investment Income is investment income reduced by investment expenses (e.g., research expenses, advisory fees, etc.)

Modified Adjusted Gross Income is adjusted gross income increased by excluded foreign earned income (there is an exemption from U.S. tax for certain income earned overseas-but this is a topic for a separate blog post).

The Applicable Threshold Amount is $250,000 for joint filers or surviving spouses, $200,000 for single filers, and $125,000 for married filing separate filers.

Net Investment Income Does NOT Include:

  • Distributions from regular or Roth IRAs
  • Distributions from 401(k) or other qualified plans
  • Social Security Income
  • Life insurance proceeds
  • Municipal bond interest
  • Veterans’ benefits
  • Gain from the sale of a personal residence if the gain doesn’t exceed the exclusion amounts of $500,000 for a joint return and $250,000 for a single filer
  • Income from businesses where the owners materially participate

Example:  John files a joint return and has $150,000 in wages, $30,000 in interest income, $70,000 in rental income, and a $30,000 gain on the sale of a rental property.  John’s modified adjusted gross income is $280,000.  John’s net investment income is $130,000 (the $30,000 in interest, $70,000 in rental income, and $30,000 gain from the rental property).  John’s Medicare Contribution tax equals 3.8% times the lesser of:

  • Net investment income of $130,000 OR
  • The excess of modified adjusted gross income over the applicable threshold amount.  This amount is $30,000 ($280,000 modified adjusted gross income less $250,000 threshold amount).

John’s Medicare Contribution tax is therefore $1,140 (3.8% times $30,000).

Example 2: Jill has $200,000 in wages.  She is a passive investor in an S corporation, ABC Corp (i.e., outside of her investment in ABC Corp, she has no involvement in the business).  She has $100,000 in flow through income from ABC Corp.  She also sold some of her ABC Corp stock for a $50,000 gain.  Jill’s modified adjusted gross income is $350,000.  Since Jill is not active in ABC Corp, her flow through profit of $100,000 and her gain on sale of stock of ABC Corp of $50,000 are considered investment income.  Jill’s Medicare Contribution tax is calculated as 3.8% times the lesser of:

  • Net investment income of $150,000 OR
  • The excess of modified adjusted gross income over the applicable threshold amount.  This amount is $100,000 ($350,000 modified adjusted gross income less $250,000 threshold amount).

Jill’s Medicare Contribution tax is $3,800.

Example 3: Joan works full time in her S corporation, ABC Corp.  She has $200,000 in wages and $100,000 in flow-through profit from ABC Corp.  She also sold some of her ABC Corp stock for a $50,000 gain.  Based on Joan’s full time employment in ABC Corp, she materially participates in the business.  Since she materially participates, her flow through profit of $100,000 and gain on sale of stock of ABC Corp of $50,000 are NOT included in net investment income.  Therefore, Joan is not subject to the 3.8% Medicare Contribution tax.

Some tips on avoiding the Medicare Contribution Tax:

  • Try to accelerate income into 2012 so that modified adjusted gross income in 2013 will be under the threshold
  • People owning rental property should try to qualify as a real estate professional
    • This requires more than 50% of time spent in real estate activity and 750 hours per year in real estate activity
    • Consider investing in municipal bonds
      • Municipal bond interest is not subject to the 3.8% tax
      • It also does not increase modified adjusted gross income so it may reduce the tax on other investment income
      • Business owners should try to qualify as active owners in their businesses so that flow through income and gain on sale of ownership interests are not subject to the tax.

For more information on how this applies in your situation, please give us a call.

 

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

 

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