Due to a looming new Medicare tax on investment earnings, you may be tempted to unload your principal residence to the first qualified buyer you can find. In a word—don’t.
Despite what you may have heard or read, the 3.8% Medicare tax, which is scheduled to take effect in 2013, won’t erode the amount of gain you can shelter from tax through the home sale exclusion (up to $250,000 for unmarried individuals or $500,000 for married joint-filing couples). The tax consequences for a future home sale, if any, may be relatively small.
But that doesn’t mean you should keep all your real estate property.
Strategy: Consider putting up a vacation home or rental property for sale. Reason: The $250,000/$500,000 home sale gain exclusion doesn’t apply to any real estate except your principal residence. So gains from other sales may be hit with the extra tax if you have a high income.
Conversely, if you sell property before 2013, you’re in the clear (at least as far as the Medicare tax goes).
Here’s the whole story: Under the 2010 health care legislation, you must pay a 3.8% Medicare tax starting in 2013 on the lesser of net investment income or the excess of modified adjusted gross income (MAGI) over a $250,000 threshold ($200,000 for single filers). For this purpose, net investment income includes interest, dividends, royalties, rents, gains from dispositions of property and income from passive activities.
That means a sale of a home you own, whether it’s your principal residence or a vacation home, could trigger the Medicare tax or increase it. But the $250,000/$500,000 home sale gain exclusion provides leeway for a principal residence.
Example: A tale of two home sales
George and Mona York, a married couple, bought their main home 20 years ago for $300,000. It’s currently valued at $750,000. The couple also owns a vacation home in a resort area they bought 20 years ago for $500,000 that’s now worth $900,000.
For simplicity, let’s say the Yorks have annual modified adjusted gross income well in excess of the $250,000 threshold for the 3.8% Medicare tax. Therefore, any extra investment earnings they receive in 2013 will be subject to the 3.8% Medicare tax.
Here’s what happens if the Yorks sell both homes in 2013 at their current values.
Sale of principal residence: The couple realizes a taxable gain of $450,000 ($750,000 sales price – $300,000 basis). But the entire gain is sheltered by the $500,000 joint-filer home sale gain exclusion. (The exclusion is available if you’ve owned and used the home as your principal residence at least two of the previous five years.)
Only the gain in excess of the $500,000 exclusion—in this case, zero—is affected by the Medicare tax.
Sale of vacation home: The couple realizes a taxable gain of $400,000 ($900,000 sales price – $500,000 basis). The entire gain is subject to the 3.8% Medicare tax. Thus, the Yorks owe an extra $15,200 tax (3.8% x $400,000) on top of the regular income tax on their $400,000 gain.
Note that the couple must pay the Medicare tax on the sale of the vacation home even though the taxable gain is smaller than the gain from the sale of their principal residence.
Bottom line: The Yorks might be encouraged tax-wise to sell the vacation home before 2013, but not necessarily their principal residence.
Tip: There’s more to just taxes to weigh in home-selling decisions. Just don’t be misled by erroneous media reports.
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