Whatever your politics or position on the new health insurance law, you may wish to take note of a provision that has received relatively little publicity: the new 3.8% tax on unearned income, which will take effect in 2013. Revenue collected by this so-called “Medicare Tax” will be dedicated to the Medicare Hospital Insurance Program.

The Medicare Tax applies to the lesser of the taxpayer's net investment income or the excess of the taxpayer's modified adjusted gross income over the threshold amount. The threshold amount is $250,000 for married couples filing joint returns, $125,000 for married individuals filing separate returns, and $200,000 for all other individuals.

"Net Investment"

The definition of “net investment income” is very broad and includes (a) gross income from interest, dividends, royalties, annuities and rents (other than rent from a trade or business); (b) other gross income from a passive activity or a trade or business of trading in financial instruments or commodities; and (c) net gain attributable to property other than property used in an active trade or business.

Net investment income would also include the capital gain on the sale of a principal residence in excess of the current $500,000 joint return/$250,000 individual return exclusion. Under the current tax law, the sale of a principal residence is treated as a capital gain transaction. Many people seem to think that the "old" law, allowing a one-time exemption for people over the age of 55, is still in effect. Unfortunately, it is not.

Let's use a hypothetical. You may have an income tax basis (generally, the cost of your house plus improvements) of $500,000. When the Arizona residential market comes back, perhaps you can sell it for $2 million, giving you a capital gain (forgetting for a moment the transaction costs and commissions) of $1.5 million. That gain would be subject to capital gains tax, although there currently is an exclusion of the first $250,000 of capital gain for individuals or $500,000 for a married couple. In our hypothetical, a married couple would have a capital gain, subject to the tax, of $1 million. There is no break for "reinvestment" and, as was noted previously, no exemption for taxpayers over the age of 55 (i.e., the old law).

Continuing our hypothetical, the Medicare Tax on the gain from the sale of the principal residence would be at least $28,500 and as much as $38,000. The exact amount of the Medicare Tax will depend on other income that may further increase one’s modified adjusted gross income above the threshold amount. In any event, the Medicare Tax on the gain is in addition to the capital gains tax that is due.

I am neither an accountant nor a tax lawyer, and you should consult one or the other if you have any questions about how this tax will work. Incidentally, I have seen this tax misreported in the blogosphere as an overall 4% tax on home sales, which is obviously not accurate.

These materials are designed to provide general information prepared by professionals in regard to the subject matter covered. It is provided with the understanding that the author is not engaged in rendering legal, accounting, or other professional service. Although prepared by professionals, these materials should not be utilized as a substitute for professional service in specific situations. If legal advice or other expert assistance is required, the service of a professional should be sought.