Like it or not, Obamacare is here to stay, so it’s time to get proactive and start planning for its tax provisions. And since its enactment, no one element of the president’s signature legislation has created more confusion than the additional 3.8 percent Medicare tax to be imposed upon a taxpayer’s “net investment income” beginning in 2013.
As a quick primer, net investment income includes:
1. Income from interest, dividends, annuities, royalties, and rents, net of applicable deductions;
2. Income from a “passive activity” (i.e., activity in which you don’t contribute significant time or effort), and;
3. Gain from the sale of property other than property held in a trade or business in which you materially participate (i.e., contribute significant time or effort).
As the following discussion indicates, determining when the surtax applies is rarely a simple task. Over my next two columns, I will examine several planning opportunities designed to minimize your exposure to the new tax and hopefully, clear up any confusion surrounding this oft-misunderstood provision.
Up this week, we examine those changes you can make prior to year-end to prepare for 2013.
Manage your 2012 and 2013 income. If the Bush tax cuts expire at year-end, the top marginal tax rate will increase from 35 percent to 39.6 percent. As a result, tax advisors have been urging wealthy taxpayers to accelerate year-end compensation and bonus income from 2013 into 2012.
But there’s a secondary motivation for keeping income out of 2013. The 3.8 percent Medicare tax applies only when your modified adjusted gross income, or MAGI (unless you have foreign earned income, this will be the same as your adjusted gross income) exceeds certain thresholds: $200,000 for a single taxpayer, $250,000 for a married couple filing jointly, and $125,000 for a married couple filing separately. Thus, the lower your 2013 MAGI, the less likely you are to incur the additional tax.
Example: Ted Striker, a single taxpayer, earns $195,000 in compensation and $30,000 of dividend and interest income during 2013. These are his only items of income or loss.
A taxpayer with both net investment income and MAGI in excess of the applicable threshold, like our friend Ted here, is subject to the 3.8 percent Medicare tax on the lesser of:
1. MAGI ($225,000) less the applicable threshold ($200,000) or $25,000, or
2. Net investment income, or $30,000.
Thus, Ted would pay a 3.8 percent tax — in addition to the regular income tax — on $25,000 of investment income in 2013.
Assume further that $25,000 of Ted’s 2013 income was a 2012 year-end bonus received on January 3, 2013. If Ted accelerates the receipt of the bonus to December 2012, he will owe the 3.8 percent tax in 2013 on the lesser of:
1. MAGI ($200,000) less the applicable threshold ($200,000) or $0, or
2. Net investment income of $30,000.
Despite the fact that there has been no change to Ted’s investment income, by accelerating his bonus into 2012 and reducing his 2013 MAGI, he has avoided the 3.8 percent surtax on $25,000 of investment income.
Harvest stock gains, rather than losses, prior to year-end. Taxpayers have long been trained to sell loss-generating stock prior to year-end in an effort to offset otherwise taxable capital gains. In the waning days of 2012, however, you should consider selling appreciated stock, not only to lock in the soon-to-expire 15 percent preferential rate currently afforded long-term capital gains, but to avoid the impending 3.8 percent Medicare tax as well.
If you’re worried about losing your investment position in the stock, fear not. The “wash-sale” rules of Section 1091 — which prevent a taxpayer from deducting a capital loss when they purchase the same stock 30 days before or after the sale — do not apply to gains. Thus, you can sell the stock for a gain and repurchase the same amount of shares the next day if you wish.
Example: Marcellus and Mia earn $600,000 per year in wages and hold appreciated publicly-held stock that would generate a $30,000 gain if sold. If the stock is sold during 2013, the entire $30,000 gain would be subject to both the tax rate in place at the time (20 percent if the Bush tax cuts expire) and the additional 3.8 percent Medicare tax.
If instead, Marcellus and Mia sell the stock in December 2012, the $30,000 gain will be taxed at only the 15 percent long-term capital gains rate. Because the wash sale rules don’t apply to capital gains, Marcellus and Mia can purchase the same stock immediately after the sale.
Close on the sale of your home in the next three weeks. Similarly, if the sale of your home is pending, you should consider pushing up the closing date into 2012 because beginning in 2013, any gain recognized from the sale of your home will be subject to not only the potentially higher capital gains tax rate, but also the 3.8 percent surtax. As a reminder, however, if you’ve owned and used your home as your primary residence for two of the previous five years, you may exclude up to $500,000 of gain (if married filing jointly, $250,000 for single taxpayers). Contrary to what some chain emails would have you believe, it is only the gain in excess of the applicable exception that is subject to the investment tax.
Take a hard look at tax-exempt bonds. Assuming the Bush tax cuts expire at year-end, wealthy taxpayers will pay tax on interest income at a maximum rate of 39.6 percent plus the 3.8 percent Medicare tax in 2013 and beyond. Net investment income, however, does not include tax-exempt income. As a result, if you reside in the highest tax bracket, a 3 percent tax-exempt bond will now earn you the equivalent after-tax return of a 5.3 percent taxable bond (3 percent/(1-.434)).
In Part 2, we’ll take a look at steps a taxpayer can take during 2013 to minimize their exposure to the additional 3.8 percent tax on net investment income.
Tony J. Nitti, CPA, MST, is a partner with WithumSmith+Brown, PC in Aspen. Read more of his columns about tax policy at blogs.forbes.com/anthonynitti.