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New Medicare Tax on Unearned Income

One of the most important new areas of concern for year-end tax planning in 2012 is the 3.8 percent unearned income Medicare contribution tax on higher-income individuals, estates and trusts.

This tax takes effect January 1, 2013.  It will be imposed on “net investment income” (NII) and will apply to passive income.  The tax will not apply to income from a trade or business or from the sale of property used in a trade or business.

The tax will apply to the lesser of the taxpayers NII or the amount of modified adjusted gross income (AGI with foreign income added back) above $250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately and $200,000 for single and head of household taxpayers.  These amounts are not indexed for inflation.

If the taxpayer will be subjected to the new tax rates that are currently in place, short term gains could be taxed at a rate of 39.6 percent and 3.8 percent for a combined rate of 43.4 percent.  If the taxpayer is a Massachusetts residence, there would be the 12 percent short term capital gain rate as well.

Net investment income includes the following:

  • Gross income from interest, dividends, annuities, royalties and rents provided this income is not derived in the ordinary course of an active trade or business.
  • Gross income from a trade or business that is a passive activity.
  • Gross income from a trade or business of trading in financial instruments or commodities.
  • Net gain from the disposition of property not held in an active trade or business.

Additional guidance is needed from the IRS on these categories of income.
The 3.8 percent Medicare surtax does not apply to non resident aliens, corporations and charitable trusts.  It does not apply to businesses conducted as a sole proprietor, partnership or S Corp.  It also does not include income from qualified plans and IRA’s but these types of income are included in determining the threshold amounts.

Non taxable amounts such as Roth distributions, gain excluded from the sale of a principal residence, interest on tax exempt bonds and veteran’s benefits are excluded from both NII and from modified AGI.

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