Not really.
There’s much noise about this new 3.8% Medicare tax, but most of this noise is just that – noise. Indeed, buried deep in the Obamacare, was an extra 3.8% Medicare tax, starting from January 2013. It probably will not affect you, the real estate investor. This is why.
Step 1 – Your need high income
If your total income for this year is less than $200,000 for singles or $250,000 for couples – this new tax will not touch you. Skip the rest of this article and go back to TV.
If you’re into technicalities, the income we’re talking about is your adjusted gross income (AGI) from your tax return, which is basically everything combined: salary plus business income plus investment income plus capital gain or loss, etc.
Step 2 – Your need investment income
If your income is over this threshold, accept my congratulations first. You’re doing better than most Americans. Your next calculation is your investment income. It combines:
- interest and dividends from banks, mutual funds, and owner financing
- net income from rental properties – meaning rent minus all expenses, including depreciation
- capital gains from stocks and from the sale of rental properties, including depreciation recapture
The income or losses I just listed are added up into one total figure of investment income.
Step 3 – They tax the “overflow”
Finally, you take the smaller of the two numbers:
- Investment income figured above
- How much you total income is over the $200,000 or $250,000 threshold
The smaller of these two numbers will be subject to the 3.8% tax.
Why is this not a major concern for most investors?
- Your income may be lower than the $200,000/$250,000 trigger point.
- Most rentals with mortgages show a loss on tax return, even if they cash flow, thanks to depreciation deduction.
- Capital gains on sale of your residence is usually tax-free, up to $250,000 of gain for singles and $500,000 for couples. It is not included in the 3.8% tax calculation.
- Sales of flip properties do not count here, either.
Which investors are at risk?
I can see 3 scenarios where this tax can affect real estate investors with high overall income.
- Interest from owner-financed properties, especially with wraps. In a wrap situation, you will not be able to offset the interest you receive from the outside loan with the interest you pay on the inside loan. This will hurt.
- High cash flow properties without mortgage debt, where expenses and depreciation do not offset rental income.
- Sales of rentals that either appreciated substantially or were heavily depreciated. You have to keep in mind the depreciation recapture trap.
One comment before we discuss defenses against the extra tax: even if you are hit with the tax, keep it in perspective. After all, we’re talking about less than 4% of your actual profit. There’re worse things to worry about in our business.
Example of a 3.8% tax victim.
Herb and Margo are (gasp) engineers, making $150k in salary each. They sold a rental house for $200,000 that they purchased a few years ago for $180,000. They have taken $25,000 worth of depreciation since purchase, and they paid $15,000 in closing costs at sale.
Their capital gain is: $200,000 – $180,000 + $25,000 – $15,000 = $30,000. If this calculation is confusing, please read my article on calculating gain on a sold house.
Herb’s and Margo’s total income, consisting of their two salaries and capital gain, is $330,000. It is $80,000 over the $250,000 threshold, but only investment income of $30,000 is subject to the extra 3.8% tax. Result? They pay $1,140 more towards Obamacare.
Let’s alter this example slightly: assume that both salaries are only $120,000. The capital gain remains $30,000. Together with the two salaries, total income is now ($120,000 x 2) + $30,000 = $270,000. It’s just $20,000 over $250,000, and only $20,000 will be hit with the 3.8% tax. Result? The tax is $760. I would not be happy, but I could live with it.
If you want to see more examples, you can find them in this whitepaper from National Association of Realtors.
What can we do about it?
What do you mean? Pay, of course!
As far as preventing this tax, yes, you can restructure your real estate transactions to minimize the impact of this new tax. Just do not get carried away, please. Remember that, in the end, taxes is simply cost of doing business. Do not sacrifice your business profits by being overly concerned about taxes. That said,
- Minimizing capital gains at sale will also minimize 3.8% tax. 1031 exchanges in particular let you sidestep the new tax.
- Timing of sales can make a big difference, especially if you’re selling some properties at a loss or losing them to foreclosures. Gains can be offset by losses in the same year.
- Investors who use self-directed retirement accounts cannot care less about this tax.
- Investors who qualify as Real Estate Professionals avoid a lot of tax problems, including this 3.8% tax. But be careful: qualifying for RE Professional status is tricky, and the IRS specifically targets investors who choose this option. Be prepared for an IRS audit!
- If you sell rentals with owner-financing, you may need an expert real estate accountant on your team.