Three facts about the upcoming 3.8% tax

Today is the “Day of the Dead” in Mexico where people honor their dead.   And Benjamin Franklin once said: “…in this world nothing can be said to be certain, except death and taxes.”  And speaking of taxes, several clients have asked me recently about how the new 3.8% tax will affect them when they sell their home.

Day of the Dead

“…nothing is said to be certain, except death and taxes.” – Ben Franklin

First, let’s see where this 3.8% tax is coming from

The 3.8% tax is part of the Health Care Reform Act, which passed in 2010.   According to the National Association of Realtors (NAR), this tax isn’t very well known because it was added at the last minute onto the law and it wasn’t considered in hearings.

However, this tax is now starting to be a concern to some people because it will go into effect in 2013.

Now, let’s see what this tax is and what it is not:

Fact #1: The 3.8% tax is not sales tax. It is income tax.

So let’s get this out of the way first: just because you’re selling a home, it doesn’t mean that you will have to pay the tax. This tax is not a sales tax (or transfer tax).

The 3.8% tax is income tax.

Having to pay income tax means that if you have a certain level of income, you may have to pay this tax.

For example, if you are married filing jointly, and the income from your job(s) plus your investments add up to more than $250k, then you MAY have to pay this tax.

Notice that I wrote “you MAY have to pay this tax”.   This means that you don’t always have to pay the tax.   You won’t always pay the 3.8% tax, especially because this tax is not just “Income Tax”, but specifically Investment Income tax.

To pay Investment Income Tax, you need to have profitable investments in order to pay the tax.

Fact #2: You only pay the 3.8% tax on the gain of certain investments

In order to pay this tax on your investment income, first you must have investments.  Then, they must be profitable, and third, they must not be excluded.   The income from these profitable, non-excluded investments is your “investment income”.

Most of us have some sort of investment income.  A few examples of investment income are: interest from your bank account, dividends from stocks you own, or the gain on selling a home.

Speaking of selling a home, this is where some homeowners selling a home *may* have to pay the 3.8% tax.

Fact #3: You *may not* have to pay 3.8% tax when selling your primary residence

So when exactly will you have to pay 3.8% on the sale of your primary residence?  Let’s review what we mentioned above.

When selling a home, in order to pay the 3.8% tax:

  • You must make more than $250k (if filing jointly) in total income the year that you sell the home,
  • You must have profitable investments (i.e. In the case of selling a home, you must have a gain), and
  • The investment must not be exempt (The $250k/$500k gain exclusion on primary residences still applies).

Let’s illustrate who pays the 3.8% with an example:

In the case above, we assumed a married couple who filed jointly.  Let’s call them Beth and Jimmy.

Beth and Jimmy make over $250k in total income.

Several years ago, Beth and Jimmy bought a home for $150,000, and next year (2013), they are planning on selling this home.   Beth and Jimmy have lived in this home (it’s their primary home) for 2 out of the last 5 years.  And they expect to sell it for about $700,000.

To keep it simple, let’s assume that Beth and Jimmy get to sell their home for $700,000 and that their gain is $550k ($700k-$150k).

Because Beth and Jimmy’s primary home qualifies for the primary home exclusion, they get to keep $500,000 of their sale gain without paying taxes on that gain.  But, because $50k is over the limit for the exclusion, and because they have over $250k in total income, they will most likely have to pay $1,900 in taxes (that’s 3.8% of $50k).

And what if Beth and Jimmy were selling a second home?

Since second homes are not considered in the primary home exclusion, all the gain from the sale of the second home (and any other investment) would be subject to the 3.8% tax.  In the example above, if Beth and Jimmy hadn’t used the home they sold as their primary residence, they would have had to pay $20,900 (that’s 3.8% in taxes on their entire $550k gain).

In summary,

If you are planning on selling a primary home starting in 2013, you may have to pay the 3.8% tax that is part of the Healthcare Reform Act of 2010 only if:

  • You have total income of $200k (or $250k – if married filing jointly)
  • You have a gain on the sale of your primary home of more than $250k (or $500k if married)

*** If you are planning on selling a home, consult with your tax professional.***

And speaking of death and taxes… Happy Day of the Dead!

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Image by Tomascastelazo on Wikipedia

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