Year-end tax planning for upper income taxpayers must include a review of exposure to the new Medicare surtax. The surtax is a new 3.8% tax on the lesser of net investment income or modified adjusted gross income (MAGI) over $250,000 for married taxpayers filing jointly and $200,000 for single taxpayers. The tricky part of this tax is defining what is “net investment income” (NII).
Keep in mind that MAGI is a taxpayer’s income before their itemized deductions. Also note the surtax does not apply to net investment income under the threshold. Nor does it apply to earned income over the threshold. Only net investment income over the threshold will be subject to the new tax.
The definition of NII is found in proposed regulation Section 1.1411-4(a)(1). It separates NII into three categories:
- Interest, dividends, annuities, royalties, rents, substitute interest payments, and substitute dividend payment.
- Income from a trade or business described in Section 1.1411-5.
- Net gain attributable to the disposition of property.
The first category is understandable. Tax-exempt municipal bond interest is excluded, along with distributions from a qualified retirement plan. The second category generally excludes distributions from an S corporation, partnership, or sole proprietorship if it is your ordinary course of trade or business. These distributions are only subject to the tax if the trade or business income is “passive” to the taxpayer. In other words, you must participate in the trade or business to be exempt from the tax.
The final category defines a disposition as a sale, exchange, transfer, conversion, cash settlement, cancellation, termination, lapse, expiration, or other disposition. Section 1031 transfers of like kind property are excluded. The sale of a principal residence is also excluded under Section 121 if the taxpayer claimed the property as their primary residence for 2 of the last 5 years. Capital losses can also be used to reduce other capital gains and $3,000 of other investment income.
The new Medicare surtax can be complex to calculate. You should consult a tax professional familiar with the calculations if you think it affects your situation.