The new Medicare tax passed as part of Obamacare could pose a significant tax burden to affluent individuals already straining under other tax increases enacted last year.
Single taxpayers who earn more than $200,000 and married couples earning $250,000 ore more will feel an extra .9-percent bite above the 2.9 percent Medicare tax when they file this year. Additionally, the 3.8-percent Medicare surtax, also called the Net Investment Income Tax (NIIT), applies to the lesser of net investment income or the amount by which adjusted gross income exceeds $200,000 for single taxpayers and $250,000 for married couples.
Taxpayers and their advisors should focus on the Medicare surtax’s impact on various holdings, as well as strategies for avoiding the 3.8-percent sting, including changing investment portfolios, regrouping rental activities on real estate holdings and having wealthy taxpayers more actively participate in their investments.
The Medicare surtax can reach estates and certain trusts that have undistributed net investment income and adjusted gross income exceeding the dollar amount at which the highest tax bracket begins for a given tax year, which for 2013 is $11,950.
Net investment income includes interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in the trading of financial instruments or commodities and businesses that are passive activities to the taxpayer, as defined by the tax code. Gains from the sale of stocks, bonds and mutual funds, capital gains distributions from mutual funds, gains from the sale of partnership and S corporation interests and real estate investments, including the sale of a second home that is not a primary residence, count as net investment income.
Reducing investment income and decreasing adjusted gross income are key to avoiding the Medicare surtax. Attaining that goal could entail measures such as adjusting investment portfolios to focus on tax-exempt bonds and growth stocks rather than dividend-paying securities that would be susceptible to NIIT, and maximizing income-reducing deductions such as depreciation and investment costs. Roth IRAs yield tax-free qualified distributions that are not subject to the surtax. Likewise, life insurance is tax-free.
The IRS has an incentive to characterize investment income derived from business and rental activities as passive to generate Medicare surtax revenues. Therefore, wealthy taxpayers should boost their participation and become more actively involved in their S corporation or LLC investments.
Most rental income is considered passive and subject to the NIIT. However, taxpayers can escape the 3.8-percent Medicare surtax if they meet the criteria to be characterized as “real estate professionals.” This can be achieved by materially participating in a real property trade or business in which they hold a minimum 5-percent interest, spending at least half their professional time during the tax year performing services for real property trades or businesses and devoting more than 750 hours during the tax year to performing services for real property trades or businesses. Beyond taking a more active role in managing real estate investments, a taxpayer may meet the 750-hour prerequisite by grouping multiple rental interests as a single real estate activity, provided the grouping creates an appropriate economic unit.
Harvesting capital losses, unloading low-yielding rental properties or stocks at a loss and holding income-sheltering annuities may help to reduce potential surtax liability.
Scott B. Kaplowitch, CPA, is a partner with Edelstein & Company LLP in Boston.