DO NOT PROVIDE THIS ARTICLE TO ANY POTENTIAL AND ACTUAL CLIENT. THIS ARTICLE IS FOR YOUR INFORMATION ONLY. NO EXCEPTIONS. THE CLIENT MUST SEEK THEIR OWN TAX ADVICE FROM THEIR PERSONAL TAX PROFESSIONAL. NO EXCEPTIONS.
Words from the art of taxation
First, we will review some critical definitions in the existing tax law necessary to the understanding of the new healthcare taxes.
Adjusted gross income (AGI) is a taxpayer’s total annual income, profits and losses from all three income categories. Modified AGI includes tax exempt foreign earned income. AGI is not the same as taxable income remaining from AGI after personal deductions, the income amount on which you are taxed.
The three income categories:
■trade or business income, which includes income, profits and losses from the taxpayer’s trade or his owner-operated business, resale inventory and real estate used in the trade or business.
■passive income, which includes profits and losses are from operations and sales of rental real estate, and from non-owner-operated businesses; and
■portfolio income, which includes profits and losses including earnings on stocks,interest earned on bonds, savings and trust deeds notes, earnings on land held for profit and management-free long-term property leases.[See Figure 1]
Earned income is income subject to self-employment tax, and/or wages received with respect to employment, which are subject to Medicare tax.
Internal Revenue Code (IRC) §1031 tax exempt transactions include the sale of §1031 property when sales proceeds are properly reinvested in replacement §1031 property. The profit or loss is not reported, but is implicitly deferred and carried forward as reflected in the cost basis of the replacement property. [26 United States Code§1031]
IRC §121 principal residence exclusions waive the tax on the sale of a principal residence up to a gain of $500,000 for joint filers or $250,000 for a single filer. [26 USC §§121]
No aspects of the aforementioned tax laws were changed. The healthcare law added:
■a 3.8% tax on net investment income and profits when AGI exceeds the $250,000 threshold; and
■an additional 0.9% self-employment Medicare tax on earned income exceeding $250,000.
These additions go into effect for the 2013 taxable year.
The surtax on investment income
Net investment income for real estate investors is income, profits and losses from:
■operations and sales of rental property (passive income category assets); and
■interest income on savings and trust deed notes, earnings on land held for profit and rents received on triple net leased property (portfolio income category assets).
Net investment income is classified as unearned income; it is not earned income defined as income resulting from trade or business operations and subject to self-employment taxes (which includes the 2.9% Medicare tax and a separate additional 0.9% surtax discussed below).
The net investment income healthcare surtax formula is 3.8% on the lesser of:
■net investment income; or
■AGI in excess of the $250,000 threshold amount for joint filers ($200,000 for single filers). [26 USC §1411(a)(1)]
Thus, if AGI exceeds net investment income,net investment income is the only income subject to the 3.8% surtax, and then only to the extent your AGI exceeds the threshold of $250,000 for joint filers ($200,000 for single filers).
Note that if you have net investment income, but your AGI is below the set threshold, you are not subject to the 3.8% investment tax. Likewise, if your AGI is solely from salary or wages, it is not subject to the 3.8% investment income / profit tax. For example, if you had an AGI of $5,000 over the threshold amount, but $0 in net investment income, the lesser of the two amounts ($0) would result in $0 healthcare tax.
This is all in addition to current income tax rates on rental operations [10%, 15%, 25%, 28%, 33%, 35%], and capital/recaptured gains on sales of capital assets [15% and 25%].
However, a second healthcare tax exists. The separate additional 0.9% Medicare tax added by the healthcare law is on earned income, including income from a trade or business subject to self-employment taxes. The additional 0.9% tax is on wages earned in excess of $250,000 for joint filers ($200,000 for single filers). This tax is separate, and may apply in addition to the 3.8% tax.
Consider our short example above. Your AGI consists solely of self-employed income. While you are not subject to the 3.8% tax since you have no net investment income, the $5,000 over the threshold AGI amount is subject to the 0.9% additional Medicare tax.
How many Californians are affected
How many Californians will this new tax law affect? Perhaps less than 3.5% of Californians who file tax returns.
What we do know is that 3.9% of California taxpayers, and 3% of U.S. taxpayers had an AGI over $200,000 in 2010 (the percent of taxpayers with AGIs exceeding $250,000 – the threshold amount above which joint return filers may be subject to the 3.8% tax – is unavailable and thus uncertain), based on the latest IRS statistics. The median household income in California is $54,500, as reported by the U.S. Census. Thus, the vast preponderance of taxpayers are very, very far away from ever reaching income and profit levels to trigger these surtaxes.
Why this tax is necessary
The healthcare tax is an issue of the government of a developed country caring for its people. Some have much, most have little. Those with much do not make money based on their labor (with rare exception), while those with little make their money as the fruit of their labor. The distinction is between the rentiers and the debtors
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