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IRS Provides Guidance on Next Year's Medicare Surtax

As Congress continues to argue about how to handle the approaching "fiscal cliff," taxpayers should be aware that there is a new tax taking effect next year that is not part of the tax breaks expiring at the end of this year.

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» Background: The "fiscal cliff" or "Taxmageddon" generally refers to a combination of upcoming spending cuts and tax breaks expiring on December 31, 2012. These tax breaks, which have been in place since 2003, include lower tax rates, lower dividend and capital gains rates, and more. If Congress does not act, these favorable tax rates expire and virtually all taxpayers will be affected.

Apart from those potential increases, a new 3.8 percent "Net Investment Income Tax" (also called the Medicare surtax) is scheduled to kick in on January 1, 2013. It is part of the healthcare law passed in 2010 (the Patient Protection and Affordable Care Act). It will only be imposed on certain high-income taxpayers.

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» Bottom line: Regardless of whether the expiring tax breaks are extended, the 3.8 percent Medicare surtax is likely to remain in place.

To clear up confusion about the details of the new tax, the IRS just released guidance and some answers to frequently asked questions. Here are edited excerpts:

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Q. What is the Medicare surtax or Net Investment Income Tax?A. The Net Investment Income Tax is imposed under the Internal Revenue Code and applies at a rate of 3.8 percent to certain net investment income of individuals, estates, and trusts with income above certain amounts.

Q. When does it take effect?A. The Net Investment Income Tax goes into effect on January 1, 2013. It will affect income tax returns of individuals, estates, and trusts for their first tax year beginning on (or after) January 1, 2013. It will not affect income tax returns for the 2012 taxable year that will be filed in 2013.

Q. Who is subject to the Net Investment Income Tax?A. Individuals will owe the tax if they have net investment income and also have modified adjusted gross income over the following thresholds:

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IncomeThreshold Filing Status

$200,000 Single or head of household

$250,000 Married filing jointly

$125,000 Married filing separately

$200,000 Head of household (with qualifying person)

$250,000 Qualifying widow(er) with dependent child

Notes: These threshold amounts are not indexed for inflation. If you are exempt from Medicare taxes, you still may be subject to the Net Investment Income Tax if you have certain types of income and also have modified adjusted gross income over the applicable thresholds.

Q. What is included in net investment income?A. In general, investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities, and businesses that are passive activities to the taxpayer (under IRC section 469). To calculate your net investment income, your investment income is reduced by certain expenses properly allocable to the income.

Q. What are some common types of income that are not net investment income?A. Wages, unemployment compensation; operating income from a non- passive business, Social Security benefits, alimony, tax exempt interest, self employment income, Alaska Permanent Fund Dividends, and distributions from certain qualified plans.

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Q. What kinds of gains are included in net investment income?A. To the extent that gains are not otherwise offset by capital losses, the following gains are common examples of items taken into account in computing net investment income:

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• Gains from the sale of stocks, bonds, and mutual funds;• Capital gain distributions from mutual funds;• Gain from the sale of investment real estate (including gain from the sale of a second home that is not a primary residence); and• Gains from the sale of interests in partnerships and S corporations (to the extent you were a passive owner).

Q. Can you provide some examples of how the Net Investment Income Tax is calculated?A. Sure. Here are two examples to illustrate how the tax is calculated:

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Example: Tom, a single filer, has wages of $180,000 and $15,000 of dividends and capital gains. His modified adjusted gross income is $195,000, which is less than the $200,000 statutory threshold for singles. Therefore, Tom is not subject to the Net Investment Income Tax.

Example: Laura is a single filer with $180,000 of wages. She also received $90,000 from a passive partnership interest, which is considered net investment income. Laura's modified adjusted gross income is $270,000 ($180,000 plus $90,000. Her modified adjusted gross income exceeds the $200,000 threshold for single taxpayers by $70,000. Laura's net investment income is $90,000.The Net Investment Income Tax is based on the lesser of $70,000 (the amount that Laura's modified adjusted gross income exceeds the $200,000 threshold) or $90,000 (her net investment income). So Laura owes Net Investment Income Tax of $2,660 ($70,000 times 3.8 percent).

Q. Does this tax apply to gain on the sale of a personal residence?A. It depends on the price of the residence, your income and other factors. The Net Investment Income Tax will not apply to any amount of gain that is excluded from gross income for regular income tax purposes. Current tax law exempts the first $250,000 for unmarried taxpayers ($500,000 for married joint filers) of gain recognized on the sale of a principal residence from gross income for regular income tax purposes. Thus, this amount is exempt from the Net Investment Income Tax.

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Example 1: Alan is single and earns $210,000 in wages. He sells his principal residence, which he has owned and resided in for the last 10 years, for $420,000. Alan's cost basis in the home is $200,000 so his realized gain on the sale is $220,000. Under current tax law, he can exclude up to $250,000 of gain on the sale. Because this gain is excluded for regular income tax purposes, it is also excluded for purposes of determining net investment income. In this example, the Net Investment Income Tax does not apply to the gain from the sale of Alan's home.

Example 2: Brad and Connie are a married joint filing couple. They sell their principal residence, which they have owned and resided in for the last 10 years, for $1.3 million. The couple's cost basis in the home is $700,000 so their realized gain on the sale is $600,000. The recognized gain subject to regular income taxes is $100,000 ($600,000 realized gain minus the $500,000 home sale exclusion for married joint filers). Brad and Connie have $125,000 of other net investment income, which brings their total net investment income to $225,000. Their modified adjusted gross income is $300,000 and exceeds the threshold amount of $250,000 by $50,000. Results: The couple is subject to Net Investment Income Tax on the lesser of $225,000 (total net investment income) or $50,000 (the amount the couple's modified adjusted gross income exceeds the $250,000 married threshold). Brad and Connie will owe Net Investment Income Tax of $1,900 ($50,000 times 3.8 percent).

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Example 3: Diane, a single filer, earns $45,000 in wages and sells her principal residence for $1 million. She has owned and resided in the place for the last decade. Diane's cost basis in the home is $600,000 so her realized gain on the sale is $400,000. The recognized gain subject to regular income tax is $150,000 ($400,000 realized gain less the $250,000 home sale exclusion for singles), which is also net investment income. Diane's modified adjusted gross income is $195,000. Since her modified adjusted gross income is below the single threshold amount of $200,000, Diane does not owe any Net Investment Income Tax.

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Q. Does net investment income include interest, dividends, and capital gains of my children that I report on my tax return? A. The amounts that are reported on your Form 1040 (on Form 8814, Parents Election to Report Child's Interest and Dividends) are included in calculating your net investment income. However, the calculation of your net investment income does not include amounts excluded from your Form 1040 due to the threshold amounts on Form 8814 and amounts attributable to Alaska Permanent Fund Dividends.

Q. Will I have to pay both the 3.8 percent Net Investment Income Tax and the additional 0.9 percent Medicare tax?A. You may be subject to both taxes, but not on the same type of income. The 0.9 percent additional Medicare Tax applies to individuals' wages, compensation, and self-employment income over certain thresholds, but it does not apply to income items included in net investment income.

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Q. Is the Net Investment Income Tax subject to the estimated tax provisions?A. Yes. The Net Investment Income Tax is subject to the estimated tax provisions. Individuals, estates, and trusts that expect to be subject to the tax in 2013 or thereafter should adjust their income tax withholding or estimated payments to account for the tax increase in order to avoid underpayment penalties.

Q. Does the tax have to be withheld from wages?A. No, but employees can request that additional income tax be withheld from their wages.

Q. Are there taxpayers who are not subject to the Net Investment Income Tax regardless of income?A. Nonresident aliens are not subject to the tax.

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Q. Will estates and trusts be subject to the Net Investment Income Tax?A. Estates and trusts will be subject to the tax if they have undistributed net investment income and also have adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins for such taxable year (for tax year 2012, this threshold amount is $11,650). There are special computational rules for certain unique types of trusts, such charitable remainder trusts and electing small business trusts.

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These answers provide some clarity to questions that many taxpayers have about the new Net Investment Income Tax (or Medicare surtax). Still have questions about your situation? Consult with your tax adviser.

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