How Additional Medicare Taxes Affect Home Sellersby
If your client intends to sell their home soon and has an income that's above the national average, there are some instances in which they'll be affected by the additional Medicare tax the IRS imposes. In his fifth column on the subject of Medicare surtaxes, Julian Block explains this aspect.
I used four previous columns to deal with the basics of the Medicare surtaxes that the IRS exacts from individuals with above-average incomes.
They’re flat taxes of 3.8 percent on certain kinds of investment income and 0.9 percent on earned income. Both were introduced in 2013 by the Affordable Care Act, legislation better known as Obamacare. They help pay for health care reform.
I’m using this column to focus how the 3.8 percent surcharge affects the steadily-growing number of home sellers whose profits exceed Internal Revenue Code Section 121’s exclusions from capital gains taxes.
There’s been no change in the exclusion amounts for home-sale profits since their introduction in 1997, when Bill Clinton was president. They top off at $500,000 for married couples who file joint returns and $250,000 for married couples who file separately or single persons.
The good news: Sellers are liable for taxes only on the portion of their profits that are above $500,000/$250,000.
The bad news: Their exclusions have been steadily eroded by almost a quarter-century of intervening increases in sales prices for homes.
Another requirement for sellers: They must own and use their principal (year-round) residences for at least two years out of the five-year period that ends on the sale date.
Some surtax basics: The 0.9 percent levy for earned income targets high-income individuals who receive salaries, other kinds of employee compensation, such as severance arrangements and golden parachutes, and net earnings from self-employment ventures.
The 3.8 percent levy is imposed on NII, short for net investment income. The tax applies, among other things, to all capital gains from sales of, say, stocks and bonds.
There’s a much-misunderstood exception that benefits sellers of personal residences. The tax applies only to capital gains that exceed Section 121’s exclusions.
Both surtaxes are keyed to MAGI, short for modified adjusted gross income. Sellers need to familiarize themselves with twists and turns in the surtax rules when their MAGIs exceed the thresholds discussed below.
(For most persons, MAGI and AGI are the same. “Modified” applies only to individuals who live outside the United States and qualify under Code Section 911 for the foreign earned income exclusion (2020’s indexed number is as much as $107,600, up from 2019’s $105,900) for wages, salaries and other amounts paid for personal services. Expatriates have to add back excluded amounts when they calculate MAGI.)
As for the threshold amounts, they’re based on filing status. $250,000 for joint filers; $125,000 for married couples filing separate returns; and $200,000 for single persons, heads of household and qualifying widows/widowers (surviving spouses who qualify for the same breaks as married couples for two years after a spouse’s death).
Does the 3.8 percent tax affect someone without investment income? No.
Does it affect someone whose entire income is from investments? No, provided that person’s NII is below the thresholds.
Suppose home sellers and other individuals have MAGIs above their thresholds. Do they become liable for the 3.8 percent tax on all of their NII? No. Congress told the IRS to impose the tax on the lesser of (A) NII or (B) the excess of (1) MAGI over (2) the applicable threshold amount.
The MAGI and NII numbers determine when the tax applies to profits from home sales. It applies only when the profits exceed the $500,000/$250,000 exclusions. And then it kicks in only when the portion of the profit above $500,000/$250,000 causes the seller’s MAGI to exceed the threshold amount.
To illustrate, an affluent couple bought a mansion in an exclusive enclave. Their dwelling perches high on a mountain and comes with an ocean view. Consequently, the canny couple couldn’t care less about, say, flood damage caused by climate change.
The home subsequently appreciated exponentially. Their sales profit is $4,000,000. The $4,000,000 is after offsets from the sales price for the original purchase price and subsequent spending on improvements, as well as selling outlays like realtors’ commissions and legal fees.
They pay regular capital gains taxes on the $3,500,000 of long-term gain above their $500,000 exclusion. As for the surtax, assume their MAGI is $5,000,000 ($1,000,000 from salaries and net earnings from self-employment, $500,000 from dividends and interest, and $3,500,000 of home-sale gain that they couldn’t exclude).
Their MAGI of $5,000,000 puts them $4,750,000 above their threshold of $250,000. Their NII is $4,000,000 ($500,000 dividends and interest and $3,500,000 home-sale gain). As their NII is less than their MAGI, the surtax applies to $4,000,000. The couple pays $152,000—3.8 percent of $4,000,000.
A reminder for wannabe home sellers who anticipate profits that exceed their exclusions. Tax-savvy sellers should assemble documents showing outlays that increase their dwelling’s basis and, thus, lower capital gains. The low-hanging fruit includes settlement or closing costs, such as title insurance and legal fees, as well as later outlays for improvements, such as adding a room or paving a driveway, as opposed to routine repairs or maintenance that adds nothing to the place’s value, such as painting or papering a room or replacing a broken window pane.
Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 350 and counting).