APPLICATION OF THE 3.8% SURTAX TO INDIVIDUALS


For tax years beginning after 2012, new Internal Revenue Code (IRC) section 1411 imposes a 3.8 percent healthcare surtax on certain passive investment income of individuals and of trusts and estates based on a mathematical formula.

Contrary to numerous email posts circulating, it is not a sales tax on the sale of real estate.  See Example 6 below for how it could apply to the sale of a personal residence.

For individuals, the amount subject to the tax is the lesser of (1) net investment income (NII) or (2) the excess of a taxpayer’s modified adjusted gross income (MAGI) over an applicable threshold amount. Let’s first define each component of the formula.

Net Investment income. This is investment income reduced by any deductions properly allocable to such income. For purposes of the surtax, investment income includes:

  • Dividends
  • Rents
  • Interest
  • Capital gains
  • Annuities
  • Royalties
  • Passive activity income

There are also items of income that are specifically excluded. The surtax does not apply to:

  • Self-employment income
  • Non-resident aliens
  • Active Trade or business income
  • Gain on the sale of an active interest in partnership or S Corporation
  • IRA or qualified plan distributions
  • Trusts for charity (except Charitable Lead Trusts)

The active trade or business exclusion means that dividends, rents, interest, capital gains, annuities and royalties are not treated as NII to the extent they are derived from an active trade or business. Thus, if a taxpayer is not engaged in a passive activity business, NII includes only nonbusiness income from dividends, rents, interest, capital gains, annuities and royalties. No business income is included. If the taxpayer is engaged in a passive activity business, however, NII includes all the items listed above plus income from the passive activity.

Threshold Amounts. The applicable threshold amounts for individuals vary depending on filing status and are shown below.

Married taxpayers filing jointly………………$250,000

Married taxpayers filing separately…………$125,000

All other individual taxpayers………………..$200,000

Here are a few examples to help you better understand how 3.8% healthcare surtax on investment income will work.

Example 1. Jim, a single taxpayer has $110,000 of salary income and $60,000 of NII in 2013. The surtax applies to the lesser of $60,000 (NII) or the excess ofJim’s MAGI over the threshold amount of $200,000 for a single taxpayer. Because Jim’s income is less than $200,000, the excess amount is zero so no surtax is payable. Note that there can never be any surtax unless MAGI exceeds the applicable threshold amount.

Example 2. Herb and Cindy, married taxpayers filing jointly, have $1,000,000 of salary income and no NII. The surtax applies to the lesser of NII ($0) or the excess of $1,000,000 over the threshold amount of $250,000 for married taxpayers filing jointly ($750,000). Thus, no surtax is payable. There can be no surtax without NII regardless of how high MAGI is.

Example3. Bill and Gretchen, married taxpayers filing separately, have $300,000 of salaries and $100,000 of NII. The amount subject to the surtax is the lesser of NII ($100,000) or the excess of their MAGI over the threshold amount. The threshold amount is $250,000, so the excess amount is $150,000 ($400,000 -$250,000). Thus, the amount subject to the tax is $100,000 and the surtax payable is $3,800 (.038 x $100,000).

Example 4. Steve (age 71) and Beth (age 64), married taxpayers filing jointly, have NII of $125,000 and salary income of $125,000 in 2013. Steve receives a $60,000 RMD from his traditional IRA. The distribution is not NII, but it increases MAGI to $310,000. As a result, $60,000 of the NII is subject to the surtax because of the RMD.

Example 5. Assume the same facts as in Example 4 except that Steve converted his traditional IRA to a Roth IRA in 2011 and received a $60,000 distribution from the Roth IRA in 2013 rather than a $60,000 RMD from a traditional IRA. Unlike an RMD, a Roth distribution does not increase MAGI. As a result, MAGI stays at $250,000 and there is no surtax even though Steve and Beth have substantial NII.

Example 6. John and Mary sold their principal residence and realized a gain of $525,000.They have $325,000 Adjusted Gross Income (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 – $500,000*)

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

Excess of AGI over $250,000     $100,000  ($350,000 – $250,000)

Lesser Amount (Taxable)               $25,000  (Taxable gain)

Tax Due                                               $950  ($25,000 x 0.038)

*Note that a married couple, filing a joint return, are only taxed on the gain of a personal residence to the extent it exceeds $500,000.

By Don James CPA/PFS, CFP

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About Don James, CPA/PFS, CFP
Don is the Tax & Financial Planning partner with Kiplinger & Co., CPAs headquartered in sunny Cleveland, Ohio since 1982. He partners with business owners and families and specializes in goal achievement solutions, tax minimization strategies and serves in the role of gatekeeper of sound financial advice.

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