Making the incomprehensible more incomprehensible

Property Owners Face a New Surtax

The housing market may indeed be recovering, as many experts suggest, but investors are still struggling to understand what, if any, taxes they'll owe upon selling their homes.

At issue is how the new "Medicare tax" will apply to real-estate transactions.

Passed in 2010 to help fund the health-care overhaul, this 3.8% surtax kicks in next year on many forms of investment income—including some interest, dividends, rents and capital gains.

While its effect on home sales won't be as far-reaching as many fear, the Medicare tax could pack a punch for certain investors. It is not a sales tax. And it won't apply to home-sale gains excluded from income under current law. But it could affect investors with outsize gains or gains from the sale of a vacation home or investment property.

Determining whether you will be subject to the tax is no easy matter.

"The confusion lies in the fact that it's not a yes or a no," says Melissa Labant, director of tax for the American Institute of Certified Public Accountants. "It's a sometimes or a maybe."

"We're waiting for guidance from the IRS on a lot of specific issues," she adds. "We don't have all of the answers yet."

Here's what we do know:

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Sean Kelly

The new tax will hit individuals with more than $200,000 in adjusted gross income, and married couples with adjusted gross income above $250,000 ($125,000 for married taxpayers filing separately). These thresholds are not indexed for inflation, so more people may be affected over time.

Specifically, the tax will apply to either your net investment income or the amount that your adjusted gross income exceeds the threshold—whichever is less.

Moreover, any gain from the sale of a principal residence that is less than $250,000 (for individuals) or $500,000 (for married taxpayers filing jointly) will continue to be excluded from income, and anything that's excluded for income-tax purposes also is excluded for Medicare-tax purposes.

So, the Medicare tax will apply primarily to higher-income earners who realize gains that aren't sheltered by the exclusion amounts.

The National Association of Realtors provides these examples:

Primary residence

Say a married couple gets lucky and sells their principal residence for a $530,000 profit. Their taxable gain would be $30,000 ($530,000 minus $500,000). If their adjusted gross income, including the gain, is $180,000, they won't owe any surtax because their income falls under the $250,000 threshold.

If their adjusted gross income is $290,000, however, the surtax will be assessed on the $30,000 gain, because that is less than the $40,000 that their income exceeds the threshold ($290,000 minus $250,000).

What if their taxable gain on the sale of the house is $50,000? The surtax will be assessed on the $40,000 excess above the threshold, because $40,000 is less than $50,000.

Vacation home

Now say a couple has adjusted gross income of $225,000, before a $60,000 gain from the sale of a vacation home. Since the gain does not qualify for the income-tax exclusion (because it isn't from the sale of their principal residence), it pushes their adjusted gross income to $285,000, or $35,000 above the threshold.

"That's going to be a big one," says Ms. Labant of the impact of the Medicare tax on sales of vacation homes.

In this case, the surtax will apply to the couple's $35,000 "excess" income, since $35,000 is less than $60,000.

If the couple rents out the house for 14 or fewer days in a year, the rental income isn't taxable and, therefore, should not be subject to the surtax. But any gain from a sale could be.

If they rent it for more than 14 days, the rental income (minus expenses) is generally taxable and could be subject to the surtax, as could any sale profit.

Investment property

If the vacation home is solely a rental property, it is treated as an investment property for tax purposes. Here the rules for applying the Medicare tax are even more complex and somewhat unsettled.

In general, someone with a day job who collects rents on the side must include that income (net of expenses) in investment income, potentially subjecting it to the surtax, while someone whose sole occupation involves owning and operating real estate typically would not be subject to the tax. In either case, any profits from a sale could get hit with the surtax.

If you're planning to sell rental real estate or other investment property, run, don't walk, to a trusted tax expert.