By: Mathew Sorensen, Partner KKOS Lawyers
The Affordable Care Act, also known as Obamacare, includes a new tax on net investment income of 3.8%. While the application of this new tax was slated for 2013, many lawyers, investors, and politicians believed that this law would never come into effect. That was before the Supreme Court upheld the law by one vote and before President Obama won re-election by less than 2% of the popular vote. Given the laws narrow survival in the courts and in the political process we now need to prepare for how the new 3.8% medicare tax will apply to us.
The tax is 3.8% on net investment income which includes; rental real estate, real estate capital gains, dividend income, royalty income, interest income, and passive business activity income. Essentially, think of income that is not taxed as ordinary income and subject to self employment tax. The new tax will apply to taxpayers whose adjusted gross income is $200,000 or more single or $250,000 or more married. It will apply whether the investment income comes from an s-corporation, LLC, or other entity that does not pay a corporate level tax. Keep in mind, the new tax only applies to net investment income so expenses and losses will offset income.
There are situations where the investment income tax will not apply. For example, the new tax will not apply to retirement plans such as 401(k)s or IRAs even if those plans are receiving these classifications of income outlined in the law (e.g self directed IRAs with rental income, capital gains, interest, etc.). Also, taxpayers whose business or trade is real estate are also exempt from the new 3.8% tax since their income is classified as income from a business or trade and not as investment income. In order to qualify for this classification a taxpayer must be deemed to have materially participated in the real estate investments, which participation requires a certain level of hours committed to real estate for the year. Many real estate investors will qualify as having materially participated but you need to be coordinating with your CPA so you understand how this law will apply to you and your investments as the hour requirement can differ from short term real estate deals versus long term rental properties. IRS Publication 925 provides additional guidance on this issue and exception. Unfortunately, the new law recognized this exception but included a new tax of 0.9% for tax on earned income so those who are in the business or trade of real estate don’t completely avoid the new Obamacare taxes.
If an exemption to the law doesn’t apply and an investor will be subject to the tax on the sale of real estate, an investor may want to consider a 1031 exchange whereby the real estate is sold and the proceeds of the sale are re-invested into a new property. A 1031 exchange is a strategy used by many real estate investors to defer the capital gains into a new replacement property purchased with the proceeds from the sale of a property. This 1031 exchange strategy will also have the effect of also deferring the application of the new net investment income tax from the capital gain on the sale of a property.