by MITCH DIETZ
Recently a client sent me an email that has been circulating around cyberspace. Chances are you have seen it too. The email was purporting to explain that there is a new federal tax on home sales. The email goes on to say that 3.8% of the sales price of the home will be taxed by the federal government. For example, a $300,000 home would generate a whopping $11,400 tax bill to the seller. While this is great shock and awe conversation — it is also totally untrue.
For those not fond of new taxes, there is a new 3.8% federal tax. And it does, in fact, have application in housing sales, but the impact is not anywhere nearly as broad as these email chains would have us believe. The reality is that this tax will apply to very, very few home sellers. Still, it is a new tax and not fun for anyone to whom it may impact.
This new tax is part of the funding mechanism for the new national health care law (officially known as the Affordable Care Act or affectionately known as ObamaCare) that also goes into effect in 2013. The tax applies to certain types of income, essentially passive forms such as interest, dividends, rents (less expenses), and capital gains – including certain non-exempt gains on the sale of real estate.
There are three questions to ask when determining the tax: (1) to whom does the tax apply; (2) what type of income is taxable; and (3) how much of the qualifying income will be subjected to the tax.
First: To whom does the tax apply?
This tax only applies to top income earners. An individual has to make $200,000 or more for the tax to apply. For married couples (or joint tax return filers) the threshold is $250,000 or more. Keep in mind that more than just salary factors into the “income” equation — capital gains, interest, dividends, net rents all factor into these threshold amounts.
When a sale of a primary residence is involved, the amount of gains applied to this income threshold is limited to the amount of gains over the exclusion amount, which is $250,000 for an individual and $500,000 for a married couple. So, for instance, if a couple had $400,000 in gain from the sale of the home, none of that gain would apply to the $250,000 income threshold because the $400,000 gain is $100,000 less than the half million dollar exclusion. Remember, the exclusion from gains on real estate only comes for a person’s home that has been the primary residence for two of the past five years.
If a person has gains in excess of the exclusion amounts, that excess will be applied to the threshold calculation. For instance, an individual, Jill, sold her house for $550,000. That sale resulted in a gain of $350,000. As this was her primary residence for two of the past five years $100,000 of that gain ($350,000 minus the $250,000 individual gain exclusion) would be applied to the threshold calculation. If Jill had a salary of $110,000, she would be over the $200,000 income threshold ($110,000 salary plus $100,000 excess gain on the sale of her home). Therefore, the 3.8% tax would apply to a portion of the gain on the sale of the home. For the tax calculation, see the third point below.
Second: What type of income is taxable?
Besides the limitation on who the tax applies to there is also on limitation on what type of income is taxed. This is a tax only on investment or passive forms of income such as interest, dividends, net rents, and capital gains. If a person/couple is above the income threshold, then the income derived from these other investment income sources (basically income from something other than salary) would be taxed. For example, if John and Sarah, a married couple, had a joint salary of $150,000 and $120,000 of income from dividends, rent, and capital gains from the sale of a rental house, their total income of $270,000 would put them over the income threshold ($250,000). As a result, aportion of the $120,000 in investment income would be subject to the tax, just as a portion of Jill’s gain from the sale of her home will be subjected to the tax.
Third: How much of the qualifying income is subjected to the tax?
The amount of the income subjected to the tax is the final question to ask. The tax applies to the LESSER of (1) the taxpayer’s adjusted gross income that is over the income threshold ($200,000 for singles, and $250,000 for married couples or joint return filers), or (2) the investment income amount. Therefore, in the example of John and Sarah above, the lesser amount would be $20,000 ($270,000 total income minus the $250,000 threshold amount). So even though they had qualifying investment income of $120,000, only $20,000 of that will be subjected to the 3.8% tax. The resulting tax would be $760.
Back to Jill’s situation. As an individual, the $200,000 threshold will apply in her case. Her $210,000 in total adjusted gross income means she is over the income threshold, so tax will apply. In her case, the lesser amount is $10,000 ($210,000 total income minus $200,000 threshold amount). Therefore, only $10,000 of the $100,000 excess gain will be subjected to the 3.8% tax. Her tax on that is $380.
Based on the questions we’ve received from clients, many people believe that Jill’s tax would be an eye-popping $20,900, because the 3.8% tax would be applied to the full $550,000 sales price. As you can see, that is not the case.
It is important to remember that they would still pay other income taxes on their salary and investment income, but you can see from the analysis above that the new 3.8% tax is not nearly as severe or far reaching as is being reported on many blogospheres. The vast majority of people will not be subjected to this tax at all because the income threshold.
To learn more about this new tax, read the following information provided by the National Association of Realtors:http://www.realtor.org/small_business_health_coverage.nsf/docfiles/government_affairs_invest_inc_tax_broch.pdf/$FILE/government_affairs_invest_inc_tax_broch.pdf
NOTE: This article is not tax or legal advice. Consult with your attorney and tax advisors to determine how your own set of facts may or may not be impacted by this new tax.
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