A new tax created under the 2010 Affordable Care Act became effective Jan. 1 and may impact your next real estate sale. Outside the professional tax community, little attention has been paid to the implementation of the new tax law, but it is one you should know because it might increase the tax you pay on your next real estate transaction.
To help pay for healthcare reform, Congress and the President created a 3.8 percent surtax on “net investment income” for taxpayers with annual income greater than $200,000 ($250,000 for married couples). While only a small percentage of Americans have that much yearly income on a recurring basis, many will have one-time events (such as a sale of real estate) that push their income above $200,000 for a one-year period. To further compound the problem, Congress did not index these income thresholds to inflation. That means, over time, more and more Americans will be subject to the tax as their salaries and other income increase.
Included in the definition of “net investment income” is any gain included in taxable income other than gain on the sale of property used in a trade or business. This means that you may end up paying additional taxes following the sale of an investment house, a second home or even a primary residence in certain circumstances.
Since 1997, you have been able to exclude the gain on the sale of your principal residence from taxation. However, certain criteria have to be met to exclude the gain and there is a cap on the excludable amount. The exclusion only applies to a house that you use as a principal residence for two or more years during the last five years. The excludable gain is limited to $250,000 ($500,000 for a married couple).
Also, you can only exclude the gain from one house sale every two years. While this law has allowed most Americans to avoid paying taxes on the sale of their homes, it does not protect everyone. In particular, if you have held your home for a long period and have a substantial gain or move frequently, you may still have to pay income tax on the sale of your house. Now, in addition to the capital gains tax, you may have to pay an additional 3.8 percent surtax on the same gain.
Also, the gain exclusion is limited to your principal residence. Gain on the sale of vacation homes and rental properties are not excludable from taxable income or the surtax.
The law does exclude gain from the sale of property used in a “trade or business” from the net investment income tax. However, the law does not define what constitutes a trade or business. Instead, you must look to numerous court cases to decide if your rental real estate activities constitute a trade or business. You must also actively participate in the rental real estate business for a significant amount of time each year. Unfortunately, it may be very difficult for the average American to determine if his or her real estate sale is subject to the tax.
There are a handful of planning techniques that can be used to defer or avoid the net investment income tax in the right circumstances. Given the complexity of the law and the potentially burdensome taxes, you should consult with a professional tax advisor before your next real estate transaction.
