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Capital Gains Tax and Health Care Reform Tax Impac

Capital Gains Tax and Health Care Reform Tax Impact
 
I. Introduction

The Taxpayer Relief Act of 1997 (the "1997 Act") and
the IRS Restructuring and Reform Act of 1998 (the "1998 Act") provide for an
exclusion from income for certain amounts of gain from the sale of a principal
residence.  The Mortgage Forgiveness Debt Relief Act of 2007 (the "2007 Act")
provides clarification regarding certain capital gains issues as
well.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (the
"2003 Act") also made important changes to the federal taxation laws including,
among other matters, lower capital gains tax rates, acceleration of a reduction
in tax rates, increased child tax credits and a reduction in the so-called
marriage penalty.  Sunset provisions in the 2003 Act were extended by the Tax
Increase Prevention and Reconciliation Act of 2005 (the "2005 Act").


With passage of H.R. 3221, the Housing and Economic
Recovery Act of 2008, further changes were made to capital gains exclusions for
a principal residence that wasn't used as a principal residence part of the time
of ownership.

This legal article discusses portions of all of these
laws having an impact on capital gains treatment for the sale of real property
and providing an exclusion from income for gain from the sale of a principal
residence. 


In addition, this article discusses the tax
impact of the federal health care reform law and the American Tax Payer Relief
Act of 2013 (HR8).


II. Taxation on Sale of
Principal Residence


Q 1. What happens if I sell
my principal residence?


A Individuals are generally
permitted to exclude from income up to $250,000 ($500,000, in general, for
married couples filing a joint return) realized on the sale or exchange of their
principal residence (26 U.S.C. § 121 also cited as IRC § 121).


Q 2. May I use this
exclusion more than once?


A Yes, but generally not more than
once every two years.  In order to qualify, you must have owned and used the property as your
principal residence for at least two years during the five-year period ending on
the date of the sale or exchange.  In addition, the two-year periods do not have
to be continuous. (IRC § 121.)


Q 3. May I use this
exclusion in connection with Internal Revenue Code ("IRC") section 1034
"rollover" of gain on the sale of my principal residence if I purchase a home of
equal or greater value?


A No.  The IRC § 1034 provision
allowing a delay in the recognition of gain when purchasing a replacement
residence of equal or greater value was repealed by the 1997 Act (IRC § 121).


Q 4. May I still take a
one-time  exclusion of $125,000 of gain from the sale of my principal residence
if I am age 55 years or older?


A No.  This exclusion was also
repealed by the 1997 Act.


Q 5. If I have previously
used the $125,000 exclusion of gain, am I prohibited from using the new $250,000
($500,000 for married couples filing jointly) exclusion of gain?


A  Generally no.   Even if you have
previously taken the one-time $125,000 exclusion, if you are otherwise eligible
for the exclusion you can take advantage of the $250,000 exclusion ($500,000 for
married couples filing jointly) as often as you meet the requirements.  (IRC §
121.)


Q 6. How does the exclusion
apply to married couples?


A The $500,000 exclusion applies to
married couples filing jointly when all of the following conditions are
met:



  • Either spouse meets the ownership requirement;
  • Both spouses meet the use requirement; and
  • Neither spouse has had a sale of their principal residence in the preceding
    two years subject to the exclusion.

    (IRC § 121.)

Q 7. What if I marry someone
who has used the exclusion within two years prior to our marriage?


A Even though your spouse has used
the exclusion within two years prior to your marriage, you would still be
allowed a $250,000 exclusion.  Once both spouses satisfy the eligibility
requirements and two years have passed since the last exclusion was allowed to
either spouse, a full $500,000 exclusion would be allowed for the next sale or
exchange of a principal residence.  (IRC § 121.)

Q 8. If my spouse dies, must
I sell our principal residence within the year of my spouse's death in order to
take advantage of the $500,000 exclusion from gain?


A No.  The 2007 Act amends IRC §
121(b) to allow the exclusion of $500,000 in capital gains tax if the principal
residence is sold within two years of the spouse's death (but this applies only
for sales after December 31, 2007).


Q 9. What
if I move before I have occupied my residence for two years or before two years
have elapsed since the last time I sold or exchanged my principal
residence?


A If you fail to meet either two-year requirement, you will
still be entitled to a pro-rata amount of the exclusion as long as the failure
to meet the requirement is because the sale or exchange is by reason of a change
in place of employment, health or other unforeseen circumstances. 


The 1998 Act provides that this ratio is that portion of the
$250,000/$500,000 exclusion equal to the fraction of the two years that the
ownership and use requirement is met.  Therefore, an unmarried taxpayer who owns
and uses a principle residence for one year and then sells because of a job
transfer may exclude up to $125,000 of gain (one-half of the regular $250,000
exclusion).


Example:  Ms. Seller purchased and occupied her principal
residence in 1998.  One year later, she is transferred by her employer to
another city and sells her house for a $100,000 gain.  Because she occupied her
residence for one-half of the required two years, Ms. Seller is entitled to
exclude up to one-half of the $250,000 otherwise allowed, thereby covering her
entire $100,000 gain.  This is a change from the IRS's previous position
allowing her to exclude only one-half of her gain, or $50,000.


Q 10. Are there
clarifications to the permissible reasons for sale or exchange allowing a
pro-rata exclusion?


A Yes.  Treasury
regulations provide clarifications and safe harbors for the exemptions from the
two-year period.  Treasury Regulation 1.121-3(b) provides that a sale or
exchange is by reason of a change in employment, health, or unforeseen
circumstances only if the primary reason for the sale or exchange is a
change in place of employment, health or unforeseen circumstances. The
regulation provides the following guidelines and safe harbors:



Place
of Employment


Generally, a sale or exchange is deemed to be a change in employment if the
primary reason for the sale or exchange is a change in the location of a
qualified individual's place of employment.  (See Question 11 for a definition
of  qualified individual.)


The regulation provides a distance safe harbor if (i) the change of
employment occurs during the period of the taxpayer's ownership and use of the
property as the taxpayer's principal residence, and (ii) the individual's new
place of employment is at least 50 miles further from the residence sold or
exchanged than was the former place of employment, or, if there was no former
place of employment, the distance between the individual's new place of
employment and the residence sold or exchanged is a least 50 miles.


For purposes of the regulation, employment includes starting a job with a new
employer, continuing employment with the same employer, and starting or
continuing self-employment.


Health


A sale or exchange is by reason of health if the primary reason for the sale
or exchange is to obtain, provide, or facilitate the diagnosis, cure,
mitigation, or treatment of disease, illness, or injury of a qualified
individual
, or to obtain or provide medical or personal care for a
qualified individual suffering from a disease, illness or injury.  A sale or
exchange that is merely beneficial to the general health or well-being of the
individual is not a sale or exchange by reason of health.


The regulations provide a safe harbor if a physician recommends a change of
residence for reasons of health.  (See Question 11 for a definition of
qualified individual.)


Unforeseen
Circumstances


A sale or exchange is by reason of unforeseen circumstances if the primary
reason for the sale or exchange is the occurrence of an event that the
taxpayer does not anticipate before purchasing and occupying the residence.


The regulations provide a safe harbor for any of the following events
occurring during the taxpayer's ownership and use of the residence as the
taxpayer's principal residence:


1.  The involuntary conversion of the residence;

2.  Natural or man-made disasters or acts of war or
terrorism resulting in a casualty to the residence;


3.  In the case of a qualified individual:



a.  Death;

b.  The cessation of employment as a result of
which the individual is eligible for unemployment compensation;

c.  A
change in employment or self-employment that results in the taxpayer's inability
to pay housing costs and reasonable basic living expenses for the taxpayer's
household (including amounts for food, clothing, medical expenses, taxes,
transportation, court-ordered payments, and expenses reasonably necessary to the
production or income, but not for the maintenance of an affluent or luxurious
standard of living);

d.   Divorce or legal separation under a decree of
divorce or separate maintenance;

e.   Multiple births resulting from the
same pregnancy; or

4.   An event determined by the Commissioner
to be an unforeseen circumstance to the extent provided in published guidance of
general applicability or in a ruling directed to a specific
taxpayer.

(See Question 11 for a definition of  qualified
individual
.)

(26 C.F.R. § 1.121-3.)


Q 11. Who is a "qualified
individual" as used in Question 10?


A Qualified individual is
defined in the regulations as the taxpayer, the taxpayer's spouse, a co-owner of
the residence, or a person whose principal place of abode is in the same
household as the taxpayer.  For purposes of the pro-rata exclusion of gain for a
sale or exchange due to health
only, a qualified individual also includes (i) an individual with a relationship
described as a dependent in IRC § 152(a)(1) through (8), without regard to
whether they are actually a dependent, or (ii) a descendent of the taxpayer's
grandparent.  (26 C.F.R. § 1.121-3(f).)


Q 12. What if I do not
qualify for a safe harbor?


A The regulations provide the
following factors, which may be relevant in determining the taxpayer's primary
reason for the sale or exchange:



1.      The sale or exchange and the circumstances giving rise to the sale or
exchange are proximate in time;


2.      The suitability of the property as the taxpayer's principal
residence materially changes;


3.      The taxpayer's financial ability to maintain the property
materially changes;


4.      The taxpayer uses the property as the taxpayer's residence
during the taxpayer's ownership of the property;


5.      The circumstances giving rise to the sale or exchange are not
reasonably foreseeable when the taxpayer begins using the property as the
taxpayer's principal residence; and


6.      The circumstances giving rise to the sale or exchange occur
during the period of the taxpayer's ownership and use of the property as the
taxpayer's principal residence.  

(26 C.F.R. § 1.121-3(b).)          


Q 13. May I deduct a loss on
the sale of my principal residence?


A No.  Although there were
discussions about allowing homeowners to deduct losses on the sale of their
principal residence, this provision did not become law.


Q 14. If I have gains from
the sale of my principal residence above the $250,000/$500,000 exclusion limits,
what tax rate will I pay?


A Depending on the length of time
you owned your principal residence, your gain may be taxed at the more favorable
capital gain rates discussed below.  See Section II, below.


Q 15. Are there more special
rules?


A Yes, including, among others, the
following:



  • A taxpayer can elect not to have the exclusion apply to any sale or
    exchange.
  • Certain periods an individual resides in a nursing home on account of
    physical or mental incapacity are included as part of the two-year use
    requirement if certain other rules apply.
  • An individual whose spouse is deceased on the date of the sale of the
    property can include the period the deceased spouse owned and used the property
    before death.
  • An individual is treated as using the property as his or her principal
    residence during any period of ownership while the individual's spouse or former
    spouse is granted use of the property under a divorce or separation instrument.

Q 16. What happens if I
transfer my principal residence into a revocable living trust?


A IRC § 676 provides that a grantor
(the person who creates and funds the trust) is treated as the owner of the
property when the grantor retains the power to revoke the trust and revest title
in him or herself.  The 2003 Act does not change this provision.  This means
that the $250,000 exclusion ($500,000 if married filing jointly) applies to a
sale or exchange by a revocable living trust so long as the grantor of the trust
and owner of the property before it was conveyed to the trust are the same
person and that person, either as owner or grantor, has owned and used the
property as his or her principal residence for two of the previous five years. 
In other words, because the grantor is still treated as the owner of the
property, the transfer into the trust is not a taxable event.


Q 17. May I utilize an
IRC
1031 ("like kind" tax-deferred exchange) in
connection with an owner-occupied residence?


A No.  However,
individuals sometimes exchange one rental property for another planning to move
into the acquired property and, after living in it for two years, sell it and
take advantage of the capital gains exclusion. This sometimes occurred as soon
as three or four years after the acquisition.  As of October 22, 2004, this was
no longer possible. Pursuant to the American Jobs Creation Act of 2004, a
property acquired in a 1031 exchange and later converted to a principal
residence must by owned for five years from the date of the exchange before the
owner can claim the capital gains exclusion. Therefore, in order to take
advantage of a 1031 exchange and the capital gains exclusion, the owner must
both have used the acquired property as a principal residence for two years and
owned it for five years.


Q 18. Is the exclusion
treated differently for the sale of a principal residence that was used as a
second home or as income property during the ownership
period
?


A Yes.  For any periods
of ownership occurring on or after January 1, 2009, under the Housing and
Economic Recovery Act of 2008 (H.R. 3221), the exclusion from capital gains
recognition will be reduced by the amount of time the property was not used as a
principal residence (“non qualified use”).  The gain from the sale will be
allocated between periods when the property was used as a principal residence
(“qualified use”) and periods of non-qualified use.  The math is as follows: 
The gain is multiplied by a fraction where the top number (the numerator) is the
period that the property was used as a principal residence (qualified use) and
the lower number (the denominator) is the total period of ownership.



Gain x (Time of qualified
use/Total time owned)  =  exclusion from
capital gains (capped at  $250,000 and $500,000).



Example
: A married couple
filing jointly purchased a vacation property on January 2, 2009 which they sell
on January 2, 2017 for a gain of $600,000.  During the last two years of
ownership they occupied the property as their principal residence.  They would
multiply $600,000 gain by 2 years of qualified use divided by 8 total years of
ownership (or $600,000 x ¼ = $150,000). They could exclude $150,000 from capital
gains (which is less than the $500,000 cap for joint filers) and the balance of
the $600,000 gain, $450,000 would be taxed as capital gains.


Q 19. Are there exemptions
from the non qualified use rules
?


A Yes. There are three
exemptions from the non qualified use rules:


1) Any portion of the 5-year ownership and use requirement occurring after
the last date the property was used as a primary residence of the taxpayer or
the taxpayer’s spouse.



Some examples may help. 


Example One:


In January 2009, married taxpayers filing a joint return buy a house and use
it as their principal residence for the first two years. They then convert the
residence to a rental for the next three years, after which they sell the
residence and realize gain of $600,000.  None of the three years of otherwise
non qualified use after the initial use as a principal residence would be used
to reduce the capital gains exclusion.  They would be entitled to the full
$500,000 exclusion and would owe capital gains on $100,000. 


The formula would be the $600,000 gain times the five years of qualified use
(the initial two-year qualifying use period plus the balance of the five-year
qualifying ownership period following the two-year qualifying use period) over
the five year total ownership period.



$600,000 x 5/5 = $600,000
qualifying gain (capped at $500,000 for joint filers).


Example Two:


The same couple buys a house in January 2009 and rents it out for the first
three years. They then convert it to their principal residence for the next two
years.  Following this they once again rent the residence out, this time for
three years, after which they sell the residence for $600,000 gain. They owned
the property for a total of eight years.  They have three years of non qualified
use and five years of qualified use (the two-year qualifying use period plus the
balance of the five-year qualifying ownership following the two-year qualifying
use period).


The formula would be $600,000 gain times five years of qualified use over
eight total years of ownership.



$600,000 x 5/8 = $375,000
excluded from capital gains and capital gains tax would be owed on $225,000.


Example Three:


The same couple buys a house in January 2009 and rents it out for six years. 
They then occupy it as their principal residence for two years and sell it for
$600,000 gain.  Since none of the five-year qualifying ownership period occurs
after the two-year qualifying use period only the last two years of occupancy
count as qualified use.


The formula would be $600,000 times 2 years of qualified use over 8 total
years of ownership.



$600,000 x 2/8 [or 1/4] =
$240,000 excluded from gain and capital gains tax would be owed on $360,000.



The other two exemptions from the
non-qualified use rules are:


2) Any period (not to exceed an aggregate period of 10 years) during which
the taxpayer or taxpayer’s spouse is serving on extended official duty as a
member of the Foreign Service or the uniformed services of the United States,
and


3) Any other period of temporary absence (not to exceed an aggregate of two
years) due to change of employment, health conditions, or other such unforeseen
circumstances.


For more examples of calculating capital gains exclusions visit NAR’s Web
site at http://www.realtor.org/gapublic.nsf/pages/hr_3221_key_provisions.


III. Capital Gains Tax 


Q 20. What are the
basic capital gains tax rates?


A The 2003 Act reduced the maximum
rate on the net capital gains rate of an individual (net long-term capital gains
less net short-term capital losses) from 20 percent to 15 percent.  Net capital
gains previously taxed at 10 percent were reduced to 5 percent.


Q 21. Has the holding period
for long-term capital gains changed?


A In order to qualify for long-term
capital gains treatment, property must be held for more than 12 months.


Q 22. Are there further
capital gains tax rate reductions?


A  In 2008, the capital gains tax
rate for gains taxed in the lowest tax bracket (5 percent) was reduced to zero.


Q 23. When did the
reductions in capital gains take effect?


A  The 2003 Act took effect May 6,
2003 and applies to taxable years ending on or after May 6, 2003. 


Q 24. Do
these capital gains rates expire?


A Under HR8, The American Tax Payer
Relief Act  of 2013, the capital gains rate reductions were extended for most
taxpayers. For tax payer's whose income exceeds $400,000 for single filers,
$450,000 for joint filers, and $425,000 for heads of households, the top for
capital gains and divided will be 20 percent. For all others, the capital gain
will continue to be 15 percent. For those in the lowest tax bracket, the capital
gain rate will continue to be zero. 


Q 25. Are there any changes
to depreciation recapture rules?


A No.  Generally, when selling
investment real property, a tax is imposed on all amounts previously taken as
depreciation.  Under prior law, these amounts were taxed as ordinary income and
not capital gains.


The 1997 Act provides for a 25 percent maximum tax rate on any gain
attributable to depreciation already claimed on the property in the case of real
property for which the maximum tax rate is reduced to 15 and 5 percent. 
Although there was an effort to reduce the recapture rate, no reduction
materialized.


Example:
Ms. Seller purchases a triplex for $200,000
after January 1, 2001, and takes depreciation deductions of $50,000 over the six
years she owns it.  She sells the duplex for $300,000.  Her basis in this
property is reduced to $150,000 because of her deductions for depreciation, and
she would have a $150,000 gain.


Under the 2003 Act, she would be taxed at a 15 percent (or 5 percent) rate on
the $100,000 portion of gain over her original $200,000 basis and at a 25
percent rate on the $50,000 portion of gain attributable to her depreciation
deduction.


Q 26. Can you provide a
summary of the capital gains tax rates?


A  Yes. Sales of assets held more
than 12 months and sold on or after May 6, 2003 qualify for the 15 percent
capital gains rate (5 percent for lowest income taxpayers and zero percent
beginning in 2008).  The capital gains rate reverts to 20 and 10 percent for
assets held for more than 12 months and sold after December 31, 2010.


Q 27. Can I still take
advantage of an IRC 1031 ("like kind" tax-deferred) exchange?


A  Yes.  The tax-free exchange of 
"like-kind" property used in a trade or business is not affected by the 1997,
1998, 2003 or 2007 Acts.


IV. Health Care
Reform Tax Impact



A. New Medicare
Tax on "Unearned" Net Investment Income


There has been great confusion in the REALTOR® world about a provision in the
recently-passed health care reform bill that creates a 3.8% Medicare tax on
unearned income for high-income households.  Recently, one newspaper article
made its way around the internet defining the new tax as a “Tax on Home Sales.” 
Sadly, the information going around the REALTORS® community does not present a
full and detailed explanation of exactly what the new provision entails.


The new Medicare tax is for all unearned net investment income and includes
interest-income, dividends, rents and capital gains.  The new Medicare tax will
not impact the capital gains exclusion for principal residences ($250,000 for
individuals/$500,000 for married couples).  So the 3.8% tax will apply to
taxable gains above this exclusion. 


The tax will take effect on January 1, 2013, and will be applicable for
high-income taxpayers with adjusted gross incomes of $200,000 or more for
individuals or $250,000 or more for married couples. 


More information, reproduced below, is taken from NAR’s Frequently-Asked
Questions (http://www.realtor.org/small_business_health_coverage.nsf/Pages/health_ref_faq_state_of_play?OpenDocument).


Q 28. What
is “unearned” net investment income?


A  Unearned income is the income
that an individual derives from investing his/her capital. It includes capital
gains, rents, dividends and interest income. It also comes from some investments
in active businesses if the investor is not an active participant in the
business.


The portion of unearned income that is subject both to income tax and the new
Medicare tax is the amount of income derived from these sources, reduced by any
expenses associated with earning that income. (Hence the term “net” investment
income.) Thus, in the case of rents, the taxable amount would be gross rents
minus all expenses (including depreciation) incurred in operating the rental
property. So if gross rents were $100,000 with associated expenses of $40,000,
net rents of $60,000 ($100,000 minus $40,000) would be included in Adjusted
Gross Income (AGI).


Q 29. Who will be subject to
the new taxes imposed in the health legislation?


A  A new 3.8% tax will apply to the
“unearned” income of “High Income” taxpayers. Another 0.9% tax will apply to the
“earned” income of many of these same individuals. Both levies are referred to
as “Medicare” taxes. 


Q 30. Who
is a “High Income” Taxpayer?


A  Those whose tax filing status is
“single” will be subject to the new unearned income taxes if they have Adjusted
Gross Income (AGI) of more than $200,000. Married couples filing a joint return
with AGI of more than $250,000 will also be subject to the new tax. (The AGI
threshold for married filing separate returns is $125,000.)


Q 31. Are the $200,000 and
$250,000 thresholds indexed for inflation?


A No. Thus, over time, more
individuals may become subject to this tax.


Q 32. When
does the new 3.8% Medicare tax take effect?


A The new Medicare tax on unearned
income will take effect January 1, 2013.


Q 33. Will the new tax will
apply to rents from investment properties that I own?


A Maybe. Remember that net
investment income includes only net rental income. Thus, gross rents would not
be subject to the tax. Rather, gross rents would be reduced (as they are under
the income tax) by all allowable expenses, including depreciation, cost of
repairs, property taxes and all other expenses related to the property. AGI
includes net income from rent, so if your AGI is above the $200,000/$250,000
thresholds, then the rental income might be subject to the tax. For many
investment real estate owners, the net rents will be the same as or similar to
the amounts reported on their Schedule E, filed with their Form 1040 Income Tax
Return. (For calculations, see Question 35, below. See also Question 36 through
Question 39 related to capital gain from sale of principal residence, losses on
sale and to vacation homes, below.)


Q 34. Does the tax apply to
the yearly appreciation of an asset?


No. Capital gains are subject to this new tax only in the year when the asset
is sold. The amount of the gain will be measured in the same way that it is for
income tax purposes. This rule applies to real estate and all other appreciating
capital assets. Net capital gains are taxable only in the year of sale.


Q 35. How is the new 3.8%
Medicare tax calculated?


A The new 3.8% Medicare tax is
assessed only when Adjusted Gross Income (AGI) is more than $200,000/$250,000.
(See Question 29 above.) AGI includes net income from interest, dividends, rents
and capital gains, as well as earned compensation and several additional forms
of income presented on a Form 1040 Income Tax Return.


The tax is NOT imposed on the total AGI, nor is it imposed solely on the
investment income. Rather, the taxable amount will depend on the operation of a
formula. The taxpayer will determine the LESSER of (1) net investment income OR
(2) the excess of AGI over the $200,000/$250,000 AGI thresholds. Thus, if net
investment income is the smaller amount, then the 3.8% tax is applied only to
the net investment income amount. If the excess over the thresholds is the
smaller amount, then the 3.8% tax would apply only to the excess amount.


For example, if AGI for a single individual is $275,000, then the excess over
$200,000 would be $75,000 ($275,000 minus $200,000). Assume that this
individual’s net investment income is $60,000. The new 3.8% tax applies to the
smaller amount. In this example, $60,000 of net investment income is less than
the $75,000 excess over the threshold. Thus, in this example, the 3.8% tax is
applied to the $60,000.


If this single individual had AGI if $275,000 and net investment income of
$90,000, then the new tax would be imposed on the smaller amount: the $75,000 of
excess over $200,000.


Rules of thumb for predicting the application of this tax year to year are
not readily determinable, largely because the proportion of net investment
income compared to AGI will vary from year to year and from individual to
individual.


Q 36. Will the
$250,000/$500,000 exclusion on the sale of a principal residence continue to
apply?


A Yes. Any gain from the sale of a
principal residence that is less than $250,000 (individual) or $500,000 (joint
return) will continue to be excluded from the income tax. The new 3.8% tax will
NOT apply to this excluded amount of the gain.


Q 37. Will the 3.8% tax
apply to any part of the gain on the sale of a principal residence?


A The new Medicare tax would apply
only to any gain realized that is more than the $250K/$500K existing primary
home exclusion (known as the “taxable gain”), and only if the seller has AGI
above the $200K/$250K AGI thresholds.


So, for example, if the taxable gain was $30,000 and a married couple had AGI
(which would include the taxable gain) of $180,000, the 3.8% tax would not apply
because AGI is less than $250,000. If that same couple had AGI of $290,000, then
the application of the 3.8% tax would be subject to the same formula described
above. The $30,000taxable gain on the sale would be less than the $40,000 excess
above $250,000 AGI, so the $30,000 gain would be subject to the new 3.8% tax.


Q 38. Is rent from a
vacation home subject to the 3.8% tax? And what about the gain on sale of a
vacation or rental property?


A The application of the tax will
depend on whether the vacation home has been rented out, the period for which it
has been rented and whether the property is solely for the enjoyment of the
owner. If the owner has rented the home out to others, then the 14-day rent
exclusion will continue to apply. Thus, if the owner rents the property to
others (including family members) for 14 or fewer days, there would be no net
investment tax. (Note that no deductions for expenses would be available, as
under current law.)


If the home has been rented to others (including family members) for more
than 14 days, then the rents (minus related expenses) would be considered as
part of net investment income and could, depending on AGI and the calculations
described above, be subject to the new tax.


If the vacation home has been used solely for personal enjoyment (i.e., there
is no rental income and no associated expenses), then a gain on sale would be
treated as net investment income and could be subject to the tax, depending on
AGI. Similarly, if the property had generated rents, any net gain on sale could
also be included in net investment income. The amount of the tax (if any) would
depend on the calculation formula, above in Question 34.


Q 39. My rental property
generates a net loss each year. How will those losses be factored into the new
tax? And what if I have net capital losses when I sell?


A Net losses from rents and net
capital losses reduce AGI. Thus, the losses themselves would not be subject to
the tax. If, after losses, AGI still exceeds the High Income thresholds, the
3.8% tax would still apply if there were any interest or dividends income.
(Capital losses reduce capital gains. If losses exceed gains, no more than $3000
of capital losses may reduce other income in any year.)


Note that passive loss limitations will continue to apply to rental income
and loss.


Q 40. All of my income is
derived from real estate investments that I own and operate myself. Will my
rents and gains be subject to the new tax?


A No. If the ownership and operation
of real estate you own is your sole occupation, then those activities are what’s
called your “trade or business.” Income derived from a trade or business is not
subject to the new 3.8% tax, but could be subject to the 0.9% tax on earned
income.


If the owner of rental properties has a “day job,” however, real estate
investments are not considered as a trade or business, but are rather considered
as investments, even if they are a major source of income. Note that many
Realtors engage in business activities are that are the “typical” selling,
leasing and brokerage endeavors usually associated with the term “REALTOR®.” If
they also own real estate assets as part of their own personal investment
portfolio, the rents from that portfolio could become subject to the new 3.8%
tax on net investment income, depending on AGI.


Q 41. Is there a real estate
“sales tax” or a transfer tax in the new health care bill?


A No. There is neither a real estate
“sales tax” nor a real estate transfer tax in the bill.


Q 42. Will “High Income
Filers” lose any portion of the Mortgage Interest they are allowed to deduct?


A No. The mortgage interest
deduction is unchanged. No cap was imposed on any itemized deductions.


Q 43. Why is this new tax
called a “Medicare tax?”


A The revenues generated from this
tax will be allocated to the Medicare Trust Fund that is part of the Social
Security System. That fund is currently on shaky financial footing. The
additional revenues generated from the new earned income and unearned income
taxes are intended to shore up the Medicare Trust Fund.


Q 44. How will this new tax
affect marginal (the highest) tax rates when it is combined with existing law
and with the possible expiration of the Bush tax cuts enacted in 2001?


A Marginal tax rates are the tax
rates assessed on the “last” dollars included in taxable income. If the Bush tax
cuts are allowed to expire, then the marginal rates for upper income individuals
will increase, particularly for capital gains income. Download the chart below
to view the impact of those changes, based on implementation of current law
effective dates.



B.  New Medicare
Tax on Earned Income: Wages, Salaries and Commissions


Q 45. What is “earned”
income?


A The term “earned income” is
essentially the income derived from an individual’s labor. It can take the form
of wages, salaries, commissions or similar compensation arrangements. Employees
of an organization and self-employed individuals are generally compensated for
the work they do in some form of earned income.

Q 46. Who will be subject to the new taxes
imposed in the health legislation?


A A new 0.9% tax will apply to the
“earned” income of “High Income” taxpayers. Another 3.8% tax will apply to the
“unearned” income of many of these same individuals. Both are described as
“Medicare” taxes.


Q 47. Who is a “High Income”
Taxpayer?


A Those whose tax filing status is
“single” will be subject to the new taxes on earned income if the earned income
that is part of Adjusted Gross Income (AGI) is more than $200,000. Married
couples filing a joint return with earned income of more than $250,000 will also
be subject to the new tax. (The earned income threshold for married filing
separate returns is $125,000)


Q 48. Are the $200,000 and
$250,000 thresholds indexed for inflation?


A No. Thus, over time, more
individuals could become subject to this tax.


Q 49. When does this tax go
into effect?


A Implementation will begin January 1, 2013.


Q 50. Does
the new 0.9% tax apply to all of an individual’s earned income?


A No. The 0.9% tax applies only to
the portion of a high income taxpayer’s earnings that exceed the $200,000 or
$250,000 thresholds. Taxpayers with adjusted gross income below those amounts
will experience no change in their Medicare taxes.


Q 51. Does
the new tax apply to gross commissions?


A No. The tax applies only to net
commissions, i.e., gross commissions minus the expenses of earning the
commission. For many Realtors, this will be the amount reflected in the Schedule
C they file as part of their annual Form 1040 income tax filings.


Q 52. So
will a self-employed person pay an additional tax of 1.8% (i.e., both the
“employer” and “employee” portions of the Medicare tax) on the taxable portion
of earnings?


A No. There is no “employer” portion
of this new tax. The rate for all individuals subject to the tax will be 0.9%,
whether they are employees or they are self-employed. Real estate professionals
who have employees would not be required to pay any portion of this tax for any
of their employees who might become subject to it. (Note, however, that real
estate professionals who have employees may have responsibility to withhold the
new tax on behalf of employees who might be subject to it.) Independent
contractor sales agents will always pay the full share of this tax they might
owe on their earned income.


Q 53. How
does the new tax on self-employment income interact with the current rules for
the Self-employment Tax (SECA)?


A Under current law, self-employed
individuals must pay a Medicare tax (also known as Hospital Insurance tax, or
HI) of 2.9 percent (1.45% “employer” and 1.45% on “employee”) on ALL
self-employment income. Generally, self-employment income is comprised of
earnings from self-employment activities minus the expenses associated with
generating those earnings.


For example, a REALTOR® might have gross commissions of $95,000 and expenses
associated with that income of $35,000. That individual’s self-employment income
would be $60,000 ($95,000 minus $35,000). Assuming no other earned income
sources, this Realtor would not be subject to the new tax.


By contrast, a high producer REALTOR® might have net self-employment income
of $280,000. If that Realtor were single, the tax would apply only to the
$80,000 that exceeds the $200,000 AGI threshold. Thus, the additional new tax
would be $720. ($280,000 minus $200,000 = $80,000) ($80,000 x .009 = $585). A
married couple with earned income of $280,000 would pay an additional new tax of
$270 ($280,000 minus $250,000 = $30,000) ($30,000 x .009 = $270).


(Note that these examples are over-simplified. Determination of
self-employment income requires more calculations than are presented here. The
example is intended to illustrate that the new tax applies only to a portion of
an individual’s or couple’s earned income.)


Q 54. Under
current law, a self-employed Realtor deducts one-half of his/her SECA/HI payment
for income tax purposes. Can all or some portion of this new tax be deducted?


A NO AMOUNT of any payment of the
new 0.9 percent HI tax on self-employment income will be deductible for income
tax purposes.


Q 55. Why
is this tax called a “Medicare” tax when it is structured so differently from
SECA?


A The revenues generated from this
tax will be allocated to the Medicare Trust Fund that is part of the Social
Security System. That fund is currently on shaky financial footing. The
additional revenues generated from the new earned income and unearned income
taxes are intended to shore up the Medicare Trust Fund.


Q 56. Is
there a real estate “sales tax” or a transfer tax in the new health care
bill?


A No. There is neither a real estate
“sales tax” nor a real estate transfer tax in the bill.


Q 57. Will
“High Income Filers” also see a reduction in the amount of Mortgage Interest
they are allowed to deduct?


A No. The mortgage interest
deduction is unchanged. No cap was imposed on any itemized deductions.


Q 58. Where
can I obtain additional information?


A This legal article is just one of the many
legal publications and services offered by C.A.R. to its members. For a complete
listing of C.A.R.'s legal products and services, please visit car.org.

Readers who require specific
advice should consult an attorney. C.A.R. members requiring legal assistance may
contact C.A.R.'s Member Legal Hotline at (213) 739-8282, Monday through Friday,
9 a.m. to 6 p.m. and Saturday, 10 a.m. to 2 p.m.  C.A.R. members who are
broker-owners, office managers, or Designated REALTORS® may contact the Member
Legal Hotline at (213) 739-8350 to receive expedited service. Members may
also submit online requests to speak with an attorney on the Member Legal
Hotline by going to http://www.car.org/legal/legal-hotline-access/.  Written
correspondence should be addressed to:

CALIFORNIA ASSOCIATION OF
REALTORS®
Member Legal Services
525 South Virgil Avenue
Los Angeles, CA
90020  





The information contained herein is believed accurate as of February 8, 2013.
It is intended to provide general answers to general questions and is not
intended as a substitute for individual legal advice. Advice in specific
situations may differ depending upon a wide variety of factors. Therefore,
readers with specific legal questions should seek the advice of an attorney.
Revised by Howard Fallman, Esq.


Copyright© 2013 CALIFORNIA ASSOCIATION OF REALTORS® (C.A.R.). Permission is
granted to C.A.R. members only to reprint and use this material for
non-commercial purposes provided credit is given to the C.A.R. Legal Department.
Other reproduction or use is strictly prohibited without the express written
permission of the C.A.R. Legal Department. All rights reserved.



















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