This tax filing season brings a whole new tax to the mix: the Medicare surcharge tax. Since 2013 was the first year that this tax became applicable, taxpayers should pay close attention to its complex and untested rules. This article will highlight 10 areas of the new tax.
1. When does the Medicare surcharge tax apply and who does it affect? The new tax is effective for tax years beginning after Dec. 31, 2012. It affects all individuals that have modified adjusted gross income (MAGI) of more than $250,000 for joint filers and $200,000 for those filing single. For trusts, the new tax kicks in at the highest tax bracket (only $11,960 for 2013 and $12,150 for 2014).
2. Earned income surcharge tax — the Medicare surcharge tax is actually two separate taxes. The first tax is a tax on earned income. The rate is 0.9 percent and is in addition to the 1.45 percent paid by wage earners or 2.9 percent paid by the self-employed. Earned income includes wages and self-employment income.
3. Net investment income (NII) tax — the second tax is a 3.8 percent tax on net investment income (or unearned income). Investment income is generally income such as interest, dividends, annuities, rent, and other income that is not derived in the ordinary course of a trade or business. It also includes gains from the disposition of property not in the ordinary course of a trade or business, such as gains from the sales of stocks, securities, and mutual funds. These amounts can be reduced by properly allocable deductions such as investment interest, investment expenses, and state and local taxes.
4. How is the Medicare surcharge tax calculated? Even though a taxpayer may be subject to the tax because his or her MAGI is over the threshold amount, it does not necessarily mean that all net investment income will be subject to the tax. The NII surtax is the lesser of: 1) net investment income, or 2) the excess of MAGI over the threshold amount ($200,000 for single taxpayers and $250,000 for married taxpayers). Similarly, the earned income tax (0.9 percent) applies only to earned income over the threshold amounts.
5. How does it affect those involved in renting real estate? For people renting real estate, the rules become very complex. In general, a taxpayer passively renting properties will be subject to the tax. However, for those in the real-estate business, it is possible that the NII tax will not apply. It is highly recommended that you speak to a tax adviser if your involvement in real estate is more than passive.
6. How does the Medicare surcharge tax affect trusts that accumulate income? Trusts that accumulate income and pay tax at the trust level are also subject to the tax. As mentioned earlier, because of the condensed tax brackets for trusts, they are subject to the tax at a much lower level ($11,960 in 2013).
7. What if you sell a pass-through entity? Owners of pass-through entities such as S corporations and partnerships will generally not be subject to the NII tax when they sell their interests in the business. The rules intend to exclude NII taxes from any gain on non-passive trade or business activities.
8. What if you sell your home? For income-tax purposes, there is a gain exclusion from income ($250,000 for single taxpayers and $500,000 for married taxpayers) on the sale of a primary residence in which a taxpayer owned and occupied it for two of the last five years prior to sale. This same exclusion applies to the NII tax. However, any gain above the exclusion is considered NII for this tax.
9. How does it affect your retirement income? There is an exclusion from the NII tax for distributions from retirement accounts. The exclusion applies to qualified retirement plans and annuity plans, tax-sheltered annuities, IRAs and Roth IRAs, and deferred-compensation plans under Code Sec. 457(b).
10. What if you have children subject to the “Kiddie Tax”? If a taxpayer elects to include a child’s unearned income on his or her return, this will expose that individual to the NII tax since the investment income would be treated as income of the parent.
The Medicare surcharge tax is a completely new tax in the Internal Revenue code, which is in addition to the income tax, the alternative minimum tax, and the self-employment tax. Since the rules are new, complex, and untried, complying with them can be difficult. Consulting a tax adviser is highly recommended.
Heather J. Leggiero, CPA, JD, is a partner and tax director of the Albany office of The Bonadio Group, where she oversees the firm’s tax department. Contact her at firstname.lastname@example.org