On March 23, 2010, President Obama signed into law the Patient Protection and Affordable Care Act (the “PPACA”). The PPACA had originated, and was first passed, by the Senate less than two months after a rival health care reform bill had been passed by the House of Representatives. With the death of Senator Edward Kennedy of Massachusetts and the election of his replacement, Republican Scott Brown, the ability of the Senate to pass the House-originated bill seemed bleak, and many House Democrats refused to vote for the Senate bill without modification. In order to rescue health care reform, the House passed the PPACA, with assurances that amendments would soon be added via an arcane legislative process known as reconciliation.
One week later, on March 30, 2010, the PPACA was amended to the satisfaction of the House, and President signed into law the Health Care and Education Reconciliation Act of 2010 (the “Reconciliation Act”). Together, the PPACA and the Reconciliation Act are known colloquially as “Obamacare.”
Primarily designed to reform health care in the United States and bring universal health care coverage to most citizens, Obamacare also contains several penalties and taxes designed to generate revenue to pay for the costs created by health care reform. The biggest source of revenue for Obamacare will come from a new Medicare tax on investment income earned by wealthy taxpayers, as well as an increase in the existing Medicare payroll tax for those same individuals. To date, most taxpayers seem to be unaware of these changes to the Medicare tax law, which were enacted at the eleventh hour as part of the Reconciliation Act.
Currently, employers and employees each pay a 1.45 percent Medicare payroll tax on all wages earned – a total of 2.9 percent. Under Obamacare, beginning on January 1, 2013, taxpayers will pay an additional 0.9 percent on wages earned in excess of $200,000 ($250,000 for married individuals filing jointly).
Additionally, in accordance with Section 1402 of the Reconciliation Act, starting in 2013, individuals with adjusted gross income (“AGI”) greater than $200,000, or married individuals filing jointly with AGI greater than $250,000, will be subject to a new Medicare tax on investment (or unearned) income at a rate of 3.8 percent. Dividends, interest, annuities, royalties, capital gains, net rental income and passive income from a trade or business will all be subject to the tax. In contrast, income of an active participant in a business and distributions from a qualified retirement plan are not investment income, and thus not subject to the tax. The new Medicare tax is also imposed on estates and trusts to the extent that the AGI of the estate or trust exceeds the dollar amount necessary to place it in the highest tax bracket. It is estimated by the Joint Committee on Taxation that these tax increases will generate $210 billion between 2013 and 2019.
The new Medicare tax will not be levied on total investment income. Rather, it will be imposed on the lesser of the taxpayer’s: a) net investment income; and b) the excess of the taxpayer’s AGI over the $200,000 threshold ($250,000 for married couples filing jointly).
For example, if an individual has investment income (e.g., capital gains from the sale of stock) of $100,000 and earns salary of $300,000 for a total AGI of $400,000, the Medicare tax would be paid on the lesser of the taxpayer’s net investment income ($100,000) or the excess of his AGI over the $200,000 threshold ($200,000). The taxpayer would pay Medicare tax of $3,800 (3.8 percent * $100,000), and additional Medicare payroll tax – detailed above – of $900 ($100,000 * 0.9 percent). Conversely, if the individual has investment income of $300,000 and earns salary of $100,000 for a total AGI of $400,000, the Medicare tax would be paid on the lesser of the taxpayer’s net investment income ($300,000) or the excess of his AGI over the $200,000 threshold ($200,000). Here, the taxpayer would pay Medicare tax of $7,600 (3.8 percent * $200,000), but no additional Medicare payroll tax would be due.
The 3.8 percent Medicare tax on investment income will be paid in addition to the usual capital gains tax. Assuming the “Bush” tax cuts are not extended, and capital gains tax rates are once again 20 percent, the combined 23.8 percent tax rate would be the highest for long term capital gains since 1997.
This new tax applies to the taxable portion of all home sales and other real estate transactions. But under Section 121(d) the Internal Revenue Code individual taxpayers are permitted to exclude the first $250,000 on the sale of a primary residence ($500,000 for married couples filing jointly). Thus, the excluded portion of the gain will not be subject to the Medicare tax. But for those taxpayers who sell a vacation home or investment property, the taxable gain from the sale may be subject to the 3.8 percent tax, assuming the investment income/AGI threshold has been exceeded.