About the 3.8%

By now you’ve probably heard about the new tax that will go into effect soon on all real estate transactions as part of the new federal health care legislation, right? Well, that’s not really accurate. Yes, a new 3.8% tax will go into effect on January 1, 2013 that may affect certain high income individuals who are engaged in certain kinds of real estate transactions (and other non-real estate transactions such as the sale of stock). However, it is somewhat narrow in scope and should have a fairly minimal impact, if any, in most residential real estate transactions. Here’s a brief summary of how it will work.



First, it only applies to (a) individuals with an annual adjusted gross income (“AGI”) over $200,000, or (b) couples filing a joint return with annual AGI over $250,000 (the “AGI Thresholds”). Second, for those people who meet the AGI Thresholds, this tax will not be imposed on all real estate transactions. Instead, it will be imposed on some income from net capital gains (i.e., after deducting capital losses), interest, dividends, and net rental income (i.e., after deducting expenses). The formula for determining whether and how it applies is complicated and clients should always be directed to consult with their own accountant and/or attorney to determine what tax impact, if any, a transaction may have on them in any given situation. In simplest terms, the new tax applies to the lesser of (i) the amount of AGI that exceeds the applicable AGI Threshold or (ii) the amount of investment income.



To illustrate the complexities, below are some examples provided by NAR (with a few modifications):

ILLUSTRATION 1 - Capital Gain: Sale of Principal Residence: John and Mary sold their principal residence and realized a gain of $525,000. They file jointly and have $325,000 AGI (before adding taxable gain).



The tax applies as follows:

AGI before Taxable Gain

$325,000

Gain on Sale of Residence

$525,000

Taxable Gain (Added to AGI)

$25,000 ($525,000 gain - $500,000 existing capital gains exclusion)

New AGI

$350,000 ($325,000 AGI + $25,000 taxable gain)

Excess of AGI over $250,000

$100,000 ($350,000 New AGI - $250,000 AGI Threshold)

Lesser Amount (Taxable)

$25,000 (Taxable gain – i.e., lesser of Taxable Gain or AGI over $250,000)

Amount of New Tax Due

$950 ($25,000 x 0.038 tax)



NOTE: If John and Mary had a gain of less than $500,000 on the sale of their residence, none of that gain would be subject to the 3.8% tax under the existing capital gains exclusion. Whether they paid the 3.8% tax would depend on the other components of their $325,000 AGI.



ILLUSTRATION 2 - Rental Income: Income Sources Including Real Estate Investment Income: Hank, who files individually, has a “day job” from which he earns $85,000 a year. He owns several small apartment units and receives gross rents of $130,000. He also has expenses related to that rental income.



The tax applies as follows:

AGI before Rents

$ 85,000

Gross Rents

$130,000

Expenses

$110,000 (Including depreciation & debt service)

Net Rents

$ 20,000

New AGI

$105,000 ($85,000 AGI + $20,000 in Net Rents)

Excess AGI over $200,000 threshold

$ 0

Lesser Amount (Taxable)

$ 0

Amount of New Tax Due

$ 0



NOTE: Even though Hank’s combined gross rents and day job earnings exceed $200,000, he will not be subject to the 3.8% tax because investment income includes NET, not gross, rents. The lower $200,000 AGI Threshold is used because Hank files individually.

ILLUSTRATION 3 - Purchase and Sale of Investment Property (Residential or Commercial):

Ethan purchased an investment property for $900,000. During his period of ownership, he takes $230,000 in depreciation deductions. He has also made some improvements to the property. At the time of sale, his adjusted basis in the property is $760,000. He subsequently sells the property for $1.2 million. In the year of sale, he is single and reports self-employment income of $315,000.



The tax applies as follows:

Gain on Sale

$440,000 ($1.2 million - adjusted basis of $760,000)

Depreciation Recapture

$230,000

Total Gain

$670,000 (Gain on sale + depreciation recapture)

Schedule C Self Employment Income

$315,000

New AGI

$985,000 ($315,000 + $670,000 Gain)

Excess AGI over $200,000 threshold

$785,000 ($985,000 New AGI - $200,000 AGI Threshold)

Lesser Amount (Taxable)

$670,000 (Capital Gain - i.e., lesser of Taxable Gain or AGI over $200,000)

Amount of New Tax Due

$ 25,460 ($670,000 Taxable Gain x 0.038)



NOTE: The new law does not address whether Ethan can defer the 3.8% tax by entering into a like-kind exchange (1031) when he sells the property. This question may be addressed in regulations at a later time, but for now is not resolved.



The new legislation also creates a separate tax of 0.9% that will be imposed on earned income (wages and self-employment income) that exceeds the AGI Thresholds. While it is an oversimplification, this new 3.8% tax can be viewed as a tax on certain “investment income” (including capital gains on the sale of a residence) and the separate 0.9% tax can be viewed as a tax on income earned as wages, commissions, and other job related income. There are other examples posted on NAR’s website (www.realtor.org) illustrating the effect of these taxes in other scenarios (an example of how the 0.9% separate tax may apply can be found in Example 5). As you can see, every situation is different and only a lawyer, accountant or other financial advisor is qualified to offer advice. Any sales associate who attempts to provide advice about how this tax works or how it may affect a certain individual could be held liable for damages, as well as face disciplinary action from FREC. Coldwell Banker buyers and sellers all sign agreements (i.e., Buyer’s Acknowledgment, Listing Agreement, and sales contract) acknowledging that as real estate professionals you are not qualified to provide tax and legal advice and they agree to consult with the proper professionals. If you have any questions,