By Harvey S. Jacobs February 27, 2014
A new controversial tax embedded in the Affordable Care Act affects homeowners who sell their homes for a substantial profit.
Homeowners need to be aware of the new 3.8 percent net investment income tax. While this provision became effective Jan. 1, 2013, its effect is just now being felt by upper-bracket homeowners who have profitably sold their home in 2013. Homeowners planning to sell their home in 2014 are advised to factor this new tax into their sales contract pricing decisions.
Part of the controversy is that though intended to tax investment income, its broad reach may now tax the profit from the sale of a taxpayer’s personal residence. Personal residences historically have not been treated as investments nor subjected to investment-type tax treatment.
IRS Code section 121 still allows homeowners to exempt the first $250,000 ($500,000 for married couples) of capital gains when they sell their principal residence. However, now, capital gains above those amounts are factored into the modified adjusted gross income figure to which the new tax applies. The calculation of this new tax is fairly complex. To minimize the impact of these new taxes, homeowners who have substantial investment income, such as from stock dividends, and who anticipate selling their home at a large profit should consult their CPA or tax attorney in advance to see whether their anticipated sale of their home will trigger this additional tax.
Investment income includes interest, dividends, rental income and capital gains. Capital gains occur when you sell stocks, bonds and mutual funds at a profit; when there are capital-gain distributions from mutual funds; and when you profitably sell investment real estate (including gain when you sell a second home that is not your primary residence).
Net investment income (NII) is calculated by subtracting from income expenses properly allocable to that income. Deductible expenses include investment interest expense, investment advisory, legal and brokerage fees, expenses related to rental and royalty income, tax preparation fees, estate or trust fiduciary expenses and state and local income taxes.
Many taxpayers (individuals, estates and trusts) will now have to pay this extra tax when they have NII and their modified adjusted gross income (from Form 1040) exceeds $200,000 for an individual and $250,000 for a married couple.
An example may illustrate how this new tax works: Harvey and Wendy, a married couple filing jointly, bought their home in 2003 for $500,000. A year later, they added an addition costing $110,000. Documented capital improvements get added to their adjusted tax basis. Consequently, their basis for tax purposes is now $610,000.
In 2013, they sold it for $1.5 million. They paid $90,000 in real estate commissions, which get subtracted from the gross sales price to arrive at their net sale proceeds of $1.410 million. When their tax basis ($610,000) is subtracted from their net sales proceeds, Harvey and Wendy’s sales profit is $800,000.
After excluding the full $500,000 capital-gain exclusion, Harvey and Wendy have a taxable capital gain from the sale of their home of $300,000. The couple have other net investment income of $125,000, which brings their total net investment income to $425,000. Their modified adjusted gross income is $350,000, which exceeds the $250,000 NII tax threshold amount by $100,000. Harvey and Wendy are subject to net investment tax on the lesser of $425,000 (their total NII) or $100,000 (the amount their modified adjusted gross income exceeds the $250,000 married filing jointly threshold). The couple owe an additional $3,800 ($100,000 x 3.8 percent) due to the net investment income tax.
The forms to be used to calculate this tax are in draft stage. Individuals, estates and trusts will use Form 8960 to compute the tax. Copies are available at www.irs.gov/draftforms. Individuals will report and pay the tax with their Form 1040. For estates and trusts, the tax will be reported on, and paid with, Form 1041.
Harvey S. Jacobs is a real estate lawyer with Jacobs & Associates Attorneys at Law in Rockville. He is an active real estate investor, developer, landlord, settlement attorney, lender and Realtor. This column is not legal advice and should not be acted upon without obtaining your own legal counsel. Contact Jacobs at (301) 417-4144, jacobs@jacobs-associates.com or ask@thehouselawyer.com.