By Benny L. Kass
Special to The Washington Post
Saturday, July 17, 2010; E01
Rumors are flying that the health-care legislation Congress passed this year will impose a sales tax on all real estate sales. But the rumors are based only partly on fact. Although there is a new tax, it will not apply to everyone, and existing tax breaks for home sales will remain in place.
The Health Care and Education Reconciliation Act of 2010, which President Obama signed into law March 30, is comprehensive and complex. Section 1402, "Unearned Income Medicare Contribution," imposes a 3.8 percent tax on profits from the sale of real estate -- residential or investment.
But the levy is aimed at high-income taxpayers, leaving most people untouched. And it will not take effect until Jan. 1, 2013.
Let's look at the facts of this new law.
First, it is not a sales tax, nor does it impose any transfer or recordation tax. It is called a Medicare tax because the money received will be allocated to the Medicare Trust Fund, which is part of the Social Security system.
Next, if your adjusted gross income is less than $200,000, you are home free. The income thresholds are clearly spelled out in the law. If you are married and file a joint tax return with your spouse, the law will apply only if your income is more than $250,000. (If you and your spouse opt to file a separate tax return, the threshold is reduced to $125,000 each.) For all other taxpayers, you have to make more than $200,000 to be covered under the new law.
The up-to-$500,000 tax-free exclusion of gain for married couples filing a joint tax return (or up-to-$250,000 for single taxpayers) has not been repealed, and the right to deduct mortgage interest and real estate tax payments has not been eliminated.
How is the tax calculated? Through a complex formula that could be called "the accountants' protection act." As a taxpayer, you (or your financial adviser) must determine which is less: the gain you have made on the sale of your house, or the amount by which your income exceeds the appropriate threshold.
Complicated? Yes. Let's look at these examples. Your adjusted gross income is $150,000. You sell your house and make a profit of $400,000. There is no change in the way you determine your gain: You take your purchase price, add the cost of any major improvements you have made over the years and subtract that number from the net sales price. This assumes you and your spouse have owned and lived in the property for at least two out of the five years before it was sold. Accordingly, you are eligible to exclude all of your profit; you will not be subject to the new 3.8 percent Medicare tax.
Now let's change the example so your adjusted gross income is $300,000. Since you are eligible to take the profit exclusion of up to $500,000, once again you do not have to pay the Medicare tax. Your entire capital gain is excluded, so there is no profit subject to the Medicare tax.
But let's assume you strike it rich and have made a profit of $600,000 on that home sale. Your income is $300,000. You can exclude only $500,000 under current law, so you will have to pay capital gains tax on the remaining $100,000. The applicable capital gains tax rate is 15 percent, so you will owe Uncle Sam $15,000.
And since your income is over the Medicare tax threshold, you now have to pay the 3.8 percent tax. But on what amount?
As indicated earlier, the tax is based on the lesser of your profit or the difference between the threshold and your income. In this example, your taxable profit is $100,000. The difference between your $300,000 income and the $250,000 threshold is $50,000. You pay the 3.8 percent tax on the lower number, $50,000, so you will owe the IRS an additional $1,900.
According to the National Association of Realtors, half of all existing homes sold nationwide in May cost $179,600 or less. Clearly, none of those homes could make a profit of even $250,000, and if their sellers qualify for the exclusion of capital gain, they will not be affected by the new law.
Of course, the Washington area has experienced dramatic appreciation in real estate (at least in recent years), so some homeowners may be hit with this new tax. But the large profit that has been made should offset the nominal tax that has to be paid.
The new law has not been widely analyzed or interpreted, and it won't go into effect for about 2 1/2 years. However, since the law applies to all forms of real estate, including vacation homes, you should consider consulting with your tax and financial advisers regarding your exposure.
In the meantime, don't believe the rumors.
Benny L. Kass is a Washington lawyer. This column is not legal advice and should not be acted upon without obtaining your own legal counsel. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036.