Now that the election is over… let’s talk about that 3.8% Medicare tax

I hesitate to get political here, so now that the nation has decided how it wants to go for the next two to four years, let’s talk about the Patient Protection and Affordable Care Act, also known as “Obamacare” or “Obamatax” depending on your particular side of the aisle.  Starting next year (January 1, 2013), Obamacare (for lack of a better shorthanded term for it) brings America a new three point eight percent (3.8%) Medicare tax imposed on certain investment income.

There’s loads of misinformation out there about this tax in part because the provision is a surtax on a particular kind of income and the application of the tax is not straightforward.  Most landlords and real estate investors (some of them are excluded for various reasons) need to take a look at the law to get a working knowledge of how the tax works and how it will affect their transactions.  The impact of the tax should be considered and analyzed whenever a material financial transaction will be undertaken going forward and I fear that the tax itself and the confusion surrounding its application will make rental properties less attractive to high income investors.

How did we get here?  Well, someone needed to pay for Obamacare and this tax is expected to pay for a good portion of it.  The 3.8% Medicare tax was inserted into the law late in the legislative process.  Luckily, just about no one in congress read the law before the provision was inserted, so it was equally easy for most of the legislators to choose not to read it upon insertion and instead “just pass it”.

A few initial considerations must be understood.  Medicare taxes are usually applied to earned income like “wages”.  Most people are used to a withholding from their paycheck for medicare taxes.  Before this law, however, there was no Medicare tax on “unearned income”.  Unearned income is income that is not derived from someone’s employment.  The tax is not imposed on “all real estate transactions”.  That would actually be easier to understand!  It is not a capital gains tax.  It is not a sales tax.  It is not a tax on everyone.  It is not a transfer tax.

Instead, it is a tax on unearned income.  Unearned income includes most investment income such as interest, dividends, rent, and capital gains.  The tax applies to individuals with an adjusted gross income of $200,000 and couples filing jointly with an adjusted gross income of $250,000.  Income over those limits may be subject to the tax.

With respect to rental income, the amount potentially subject to the tax applies to “net rental income”.  That’s the income amount usually found at the bottom of an individual’s 1040 Schedule E.  That means that the typical rental deductions are not included in the amount of rental income that might be taxed.

There is also a limit to the amount of tax that might be due.  A taxpayer is never subject to a tax amount that would cut into the initial $200,000/$250,000 threshold amount of income that can be made before the tax is imposed.

This is a very new concept to many, so I will stick with it for a bit.  In my next post, I’ll present an example of how the new 3.8% Medicare tax might work in practice.