As discussed in our prior client alert, “Reconciliation Bill Codifies ‘Economic Substance’ Doctrine, Expands Medicare Taxes on High Income Earners and Imposes Reporting Requirements on Certain Payments to Corporations,” to pay for health care reform, among other revenue raisers, the Health Care Act introduced a 3.8% Medicare contribution tax (the “Medicare tax”) on unearned income (i.e., income other than from wages) of certain high income earners. There has been some confusion as to the application of this provision on the sale of a taxpayer’s principal residence—specifically, whether the tax is a 3.8% sales tax on a taxpayer’s principal residence (i.e., applies on the gross proceeds of the sale of the taxpayer’s home). The short answer is that it does not act as a sales tax on a taxpayer’s home, but it may apply to net gain on certain sales of a high-income earner’s residence, provided that the amount is not otherwise excluded under the Code.
The Medicare tax imposes on individuals a tax at the rate of 3.8% on the lesser of (i) “net investment income,” or (ii) the excess of “modified adjusted gross income” over the “threshold amount.” The “threshold amount” is $250,000 in the case of a joint return or surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in any other case. “Modified adjusted gross income” is adjusted gross income increased by the amount excluded from income as foreign earned income.
“Net investment income” generally equals the taxpayer’s gross investment income reduced by the deductions that are allocable to such income. Investment income is the sum of (i) gross income from interest, dividends, annuities, royalties, and rents (other than income derived from any trade or business to which the tax does not apply), (ii) other gross income derived from any business to which the tax applies, and (iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply.
Footnote 285 of the accompanying JCT report on the Health Care Act explicitly makes it clear that “[g]ross income does not include items, such as interest on tax-exempt bonds, veterans’ benefits, and excluded gain from the sale of a principal residence, which are excluded from gross income under the income tax.”1
In general, Section 121 of the Code provides that “[g]ross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.” The maximum exclusion is $250,000, and, in the case of a husband and wife filing jointly, $500,000.
It thus appears that the Medicare tax may apply to a sale a residence if three requirements are met: (a) the individual selling the real property is a high-income earner; (b) the high-income earner has “net gain” from the disposition of the real property (i.e., it does not operate as a “sales tax” on the gross proceeds from a sale); and (c) the net gain is not otherwise excluded from gross income under the principal residence exclusion. For example, assuming the taxpayer qualifies for the principal residence exclusion, the excess amount over the excludible amount (i.e., $250,000, or $500,000, in the case of joint filers) of the taxpayer’s net gain on the sale of the taxpayer’s principal residence would get caught by the Medicare tax. If the taxpayer does not qualify for the principal residence exclusion (e.g., if the residence is a second home), the Medicare tax would also apply to the entire net gain. The Medicare tax is effective for taxable years 2013 and thereafter. The tax does not apply to capital gain recognized in 2011 and 2012.