Will You Be Subject to the New Medicare Surtax? - Rodgers & Associates
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Will You Be Subject to the New Medicare Surtax?

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:

  1. Interest, dividends, annuities, royalties, rents, substitute interest payments, and substitute dividend payment.
  2. Income from a trade or business described in Section 1.1411–5.
  3. 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.