What You Need to Know About the 3.8% Tax and Real Estate

There seems to be a lot of misinformation about the 3.8% tax coming in January 2013. The following is what you need to know about the tax:

1. It is not a tax on all properties. It is a tax on SOME investment income from interest, dividends, rents and capital gains.
2. It is not a tax on all people. Only individuals with an Adjusted Gross Income of $200,000 and couples with AGI over $250,000 will be included.
3. It is part of Health Care reform.
4. It is not a transfer tax, it is an income tax on investment income.
5. It does not affect the capital gain exclusions on the sale of a principal residence. Currently the first $250,000 of gain for a single person and $500,000 on a married couple is exempt from capital gains. The tax does, however, apply on amounts over the exemption.
6. What real estate does it apply to? For those taxpayers whose AGI is above the limits , the sale of a principal residence when the gain is over and above the exempt amounts, the sale of second homes and invest property and the income derived from investment property.
7. There is a separate tax for high wage and self employment business income. When investment property income qualifies as business income and not property earnings, the 3.8% does not apply, however a new tax of .9% is due.

1. Capital Gain: Sale of a Principal Residence
John and Mary sold their principal residence and realized a gain of $525,000. They have $325,000 Adjusted Gross Income (before adding taxable gain).

If John and Mary had a gain of less than $500,000 on the sale of their residence, none of that gain would be subject to the 3.8% tax. Whether they paid the 3.8% tax would depend on the other components of their $325,000 AGI.

2. Rental Income: Income Sources Including Real Estate Investment Income
Hank has a “day job” from which he earns $85,000 a year. He owns several small apartment units and receives gross rents of $130,000. He also has expenses related to that income.

Note: Even though Hank’s combined gross rents and day job earnings exceed $200,000, he will not be subject to the 3.8% tax because investment income includes NET, not gross, rents.

3. Rental Income: Rental Income as Sole Source of Earnings – Real Estate Trade or Business
Henrietta’s sole livelihood is derived from owning and operating commercial buildings. Thus, these assets are treated as business property and not as investment property. Her income stream is outlined below.
The tax applies as follows:

(No investment income)
Henrietta’s rental income is from a trade or business so it is NOT treated as investment income. Thus, she is NOT subject to the 3.8% investment income tax.

4. Sale of a Second Home with No Rental Use (or no more than 14 days rental)
The Bridgers own a vacation home that they purchased for $275,000. They have never rented it to others. They sell it for $335,000. In the year of sale they also have earned income from other sources of $225,000.
The tax applies as follows:

If the Bridgers rent the home for 14 or fewer days in the course of a year, the rental income is non-taxable and the results in the year of sale will be the same as shown above. If the rental period exceeds 14 days in any year, then the rental income (less expenses) will be taxable and AGI would include not only the capital gain, but also some amount that is depreciation recapture. (See next example.)
If the second residence is SOLELY a rental property, it is treated as an investment.

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