Will the new healthcare taxes impact you or your clients? Read on to get informed.
Words from the art of taxation
First, we will review some critical definitions in the existing tax law necessary to the understanding of the new healthcare taxes.
Adjusted gross income (AGI) is a taxpayer’s total annual income, profits and losses from all three income categories. Modified AGI includes tax exempt foreign earned income. AGI is not the same as taxable income remaining from AGI after personal deductions, the income amount on which you are taxed.
The three income categories:
- trade or business income, which includes income, profits and losses from the taxpayer’s trade or his owner-operated business, resale inventory and real estate used in the trade or business.
- passive income, which includes profits and losses, are from operations and sales of rental real estate, and from non-owner-operated businesses; and
- portfolio income, which includes profits and losses, including earnings on stocks, interest earned on bonds, savings and trust deeds notes, earnings on land held for profit and management-free long-term property leases. [See Figure 1]
Earned income is income subject to self-employment tax, and/or wages received with respect to employment, which are subject to Medicare tax.
Internal Revenue Code (IRC) §1031 tax exempt transactions include the sale of §1031 property when sales proceeds are properly reinvested in replacement §1031 property. The profit or loss is not reported, but is implicitly deferred and carried forward as reflected in the cost basis of the replacement property. [26 United States Code§1031]
IRC §121 principal residence exclusions waive the tax on the sale of a principal residence up to a gain of $500,000 for joint filers or $250,000 for a single filer. [26 USC §§121]
No aspects of the aforementioned tax laws were changed. The healthcare law added:
- a 3.8% tax on net investment income and profits when AGI exceeds the $250,000 threshold; and
- an additional 0.9% self-employment Medicare tax on earned income exceeding $250,000.
These additions go into effect for the 2013 taxable year.
The surtax on investment income
Net investment income for real estate investors is income, profits and losses from:
- operations and sales of rental property (passive income category assets); and
- interest income on savings and trust deed notes, earnings on land held for profit and rents received on triple net leased property (portfolio income category assets).
Net investment income is classified as unearned income; it is not earned income defined as income resulting from trade or business operations and subject to self-employment taxes (which includes the 2.9% Medicare tax and a separate additional 0.9% surtax discussed below).
The net investment income healthcare surtax formula is 3.8% on the lesser of:
- net investment income; or
- AGI in excess of the $250,000 threshold amount for joint filers ($200,000 for single filers). [26 USC §1411(a)(1)]
Thus, if AGI exceeds net investment income, net investment income is the only income subject to the 3.8% surtax, and then only to the extent your AGI exceeds the threshold of $250,000 for joint filers ($200,000 for single filers).
Note that if you have net investment income, but your AGI is below the set threshold, you are not subject to the 3.8% investment tax. Likewise, if your AGI is solely from salary or wages, it is not subject to the 3.8% investment income / profit tax. For example, if you had an AGI of $5,000 over the threshold amount, but $0 in net investment income, the lesser of the two amounts ($0) would result in $0 healthcare tax.
This is all in addition to current income tax rates on rental operations [10%, 15%, 25%, 28%, 33%, 35%], and capital/recaptured gains on sales of capital assets [15% and 25%].
However, a second healthcare tax exists. The separate additional 0.9% Medicare tax added by the healthcare law is on earned income, including income from a trade or business subject to self-employment taxes. The additional 0.9% tax is on wages earned in excess of $250,000 for joint filers ($200,000 for single filers). This tax is separate, and may apply in addition to the 3.8% tax.
Consider our short example above. Your AGI consists solely of self-employed income. While you are not subject to the 3.8% tax since you have no net investment income, the $5,000 over the threshold AGI amount is subject to the 0.9% additional Medicare tax.
How many Californians are affected
How many Californians will this new tax law affect? Perhaps less than 3.5% of Californians who file tax returns.
What we do know is that 3.9% of California taxpayers, and 3% of U.S. taxpayers had an AGI over $200,000 in 2010 (the percent of taxpayers with AGIs exceeding $250,000 – the threshold amount above which joint return filers may be subject to the 3.8% tax – is unavailable and thus uncertain), based on the latest IRS statistics. The median household income in California is $54,500, as reported by the U.S. Census. Thus, the vast preponderance of taxpayers are very, very far away from ever reaching income and profit levels to trigger these surtaxes.
Why this tax is necessary
The healthcare tax is an issue of the government of a developed country caring for its people. Some have much, most have little. Those with much do not make money based on their labor (with rare exception), while those with little make their money as the fruit of their labor. The distinction is between the rentiers and the debtors.
So when the management of society (government) decides to improve the standard of living for its extremely low-income or impoverished citizens, such as with healthcare for all, the cost of the program not covered from earnings of the low earners among us must be paid with government revenues.
A government’s sole method for raising revenue is to tax its people who have earnings. Thus, the healthcare increase in operating costs falls on the wealthiest among us, but only those who have huge net investment income AND an AGI over the threshold amounts who will not suffer a drop in their standard of living due to the tax.
Benefits for California
Opponents of the healthcare tax argue that some of the healthcare taxes collected from our wealthy Californians will not come back to California, a transfer to people living in other states, particularly those impoverished areas of the South which benefit most from healthcare.
In fact, the Golden State will benefit from the healthcare law, as 14% of the state’s population lives below the poverty level. (According to the latest census data, Mississippi has the highest poverty level, at 22%, compared to the nation’s lowest poverty level in New Hampshire, at 8.5%). As of 2011, 15% of Americans did not have health insurance.
So, who is to be taxed to pay for this transfer of wealth to those who are very poor and do not pay “income taxes” or cannot afford health insurance? (They do pay their one-half share of the 15.3% employment taxes if they have a job, unless their employer does not withhold taxes, as occurs in California’s grey economy).
Thus, healthcare tax revenue must be set at an amount sufficient to cover the additional cost of the government paying to cover insurance premiums for the poorest among us; those who have insufficient or no access to healthcare outside of the Emergency Room, cost of which is covered by state and federal general tax revenue. As a result of the healthcare tax, the government will not incur a cost that is not already covered by taxes paid in other ways – a pay-as-you-go effort avoiding government deficit financing.
In 2013, a married couple,as real estate licensees, earns $150,000 in net trade or business income subject to self-employment taxes in 2013. They also have $400,000 in net rental operating income and profits on the sale of those properties, part of the net passive income category. Further, they receive interest of $50,000 on trust deed notes, which is portfolio income.
Thus, their total AGI is $600,000, $350,000 of which exceeds the AGI threshold of $250,000.
The couple also has net investment income of $450,000 ($400,000 in the passive income category, and $50,000 in portfolio income). The 3.8% tax applies to the lesser of the net investment income, or the excess of AGI over the $250,000 threshold. Thus, they must pay 3.8% of the $350,000 AGI over the threshold amount, or $13,300.
Their personal income does not trigger payment of the additional 0.9% Medicare tax, since the earned income threshold of $250,000 was not exceeded by their $150,000 net business income.
Further, if an owner-occupant sells their home for a profit, to the extent the profit exceeds the IRC §121 $500,000 principal home profit exclusion, that excess profit is from a capital asset and is part of net investment income. Again, the homeowner’s AGI must exceed $250,000 before the net rents, profit and other investment income begin to be taxed at the surcharge rate of 3.8%.
Lastly, if an investor sells their §1031 property, replacing it with newly acquired §1031 property, the taxable profits realized on the sale are deferred until the next transaction. Thus, the 3.8% surtax does not apply to exempt profit in §1031 transactions. [IRC 1031]
The same is true of tax exempt eminent domain actions, since profits are not taxable so long as the money is re-invested in replacement property. Thus, the profit is not reported and the 3.8% tax does not apply. [IRC §1033]
Installment sales defer taxes, spreading out taxable profits over several years instead of requiring the tax to be fully paid the year of the sale. The 3.8% tax will likewise not apply, until the profits are declared in the years during which principal is paid, and then only to the extent AGI exceeds the $250,000 threshold. [IRC §453]