IRS Issues Guidance For New 3.8% Medicare Tax On Net Investment Income

Posted by Michael Kitces on Wednesday, December 19th, 12:01 pm, 2012 in Taxes

In early December, the IRS and Treasury issued a series of Proposed Regulations for the two new Medicare taxes scheduled to begin on January 1, 2013 - the 3.8% Medicare tax on unearned income (generally, a 3.8% surtax on net investment income), and the 0.9% Medicare tax on earned income (i.e., wages and self-employment income), applied to "high income" individuals above certain thresholds. Although the new rules are still proposed and may ultimately be amended or changed, the Treasury and IRS nonetheless indicated that they can be relied upon by taxpayers. However, given the limited time to cultivate these regulations - including addressing potential loopholes - the rules did indicate that taxpayers should not try to read between the lines to find loopholes in the proposed regulations, and that the IRS will closely review transactions that manipulate net investment income to eliminate Medicare tax exposure.

While there were no huge surprises in the guidance, it does provide important clarification on a wide range of issues that planners and their clients must contend with heading into 2013, including how the Medicare tax rules interact with other parts of the tax code, and serves as a reminder to complete any last minute capital gains harvesting that high-income clients may wish to engage in before 2013 begins (including a special opportunity for Charitable Remainder Trusts!)!

New 3.8% Medicare Tax On Net Investment Income

Although the new IRC Section 1411, which defines and applies the new 3.8% Medicare tax on net investment income, is relatively short, the IRS has now issued more than 100 pages of regulations simply trying to define its implementation and key terms and definitions. In particular, a major focus of the regulations appears to have been to clarify and ensure the accurate characterization of "net investment income" which is defined in the tax code as:

1411(c)(1) In general.— 

   The term “net investment income” means the excess (if any) of— 

 - 1411(c)(1)(A) the sum of—

  - 1411(c)(1)(A)(i) gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in paragraph (2), 

  - 1411(c)(1)(A)(ii) other gross income derived from a trade or business described in paragraph (2), and

  - 1411(c)(1)(A)(iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in paragraph (2), over

 - 1411(c)(1)(B) the deductions allowed by this subtitle which are properly allocable to such gross income or net gain.

1411(c)(2) Trades and businesses to which tax applies.— 

   A trade or business is described in this paragraph if such trade or business is—

 - 1411(c)(2)(A) a passive activity (within the meaning of section 469) with respect to the taxpayer, or 

 - 1411(c)(2)(B) a trade or business of trading in financial instruments or commodities (as defined in section 475(e)(2).

Under IRC Section 1411, any "net investment income" that falls above the specified thresholds - $200,000 of AGI for individuals, and $250,000 for married couples (filing jointly) - will be subject to the tax, which will reach widely across most types of portfolio income (e.g., interest and dividends), annuities, passive businesses (from rental real estate to oil and gas partnerships and more), and also capital gains.

Nonetheless, the new IRS guidance does provide some important clarifying points.

Interaction With Other Tax Code Limitations

In one of the most important clarifications regarding the new Medicare tax rules, the new guidance indicated that regular provisions that apply to limit income and deductions in other parts of the tax code will apply for the purposes of the new IRC Section 1411 Medicare tax as well. 

Accordingly, tax code provisions that would prevent income from being recognized for regular tax purposes will also apply for the purposes of the Medicare tax. For instance, if capital gains are stretched out over multiple years through an installment sale, then the Medicare tax on the capital gain will apply each year as the gain is recognized for regular tax purposes. Similarly, if gains are not recognized due to deferral provisions - such as the tax-deferred IRC Section 1031 real estate exchange or Section 1035 annuity exchange - the gains will not be included as net investment income for the Medicare tax, either. Further, gains that are outright excluded under the tax code - such as the first $250,000 / $500,000 (for individuals and married couples, respectively) of capital gains on the sale of a personal residence under IRC Section 121 - will be excluded from net investment income for the Medicare tax.

On the other hand, the crossover of other tax code rules will also serve to limit deductions and other ways to offset net investment income. For instance, the guidance indicates that limits on investment interest expenses will apply for purposes of the Medicare tax too, along with limitations on passive activity losses and other business losses. Capital losses are also restricted, and can only apply to the extent of capital gains. The additional $3,000 ordinary loss permitted for ordinary income tax purposes is not allowed for the Medicare tax, though, unless there are other noncapital gains (e.g., related to the disposition of a business or business assets) against which they can be applied.

On the plus side, to the extent that disallowed losses are carried forward under the regular tax code, they can be carried forward for the Medicare tax (with the notable exception of business Net Operating Losses carryforwards, which won't apply unless the underlying income/loss category can be determined and applied separately). Capital loss carryforwards are permitted as well. In addition, existing capital or other loss carryforwards (e.g., from 2012 or prior) can be applied against 2013 gains (and reduce 2013 net investment income and potential Medicare taxes due), even though the loss itself didn't originate in 2013 when the Medicare tax was established.

Other New Rules And Clarifications

In addition to the rules discussed above, the proposed regulations provided several other important clarifications on specific aspects of the new Medicare taxes, including:

- Income from "annuities" includes all types of income from (non-qualified) annuities, whether a withdrawal from a deferred annuity (under IRC Section 72(e)) or a payment from an annuitized contract (under IRC Section 72(a)). Notably, though, only payments from annuities that are actually includable in income for tax purposes in the first place (i.e., "gains" and not return of principal payments) are net investment income for Medicare tax purposes.

- Income from all types of traditional tax-qualified retirement accounts remain excluded from the definition of net investment income under IRC Section 1411(c)(5), including distributions from pensions, profit-sharing plans, a 403(b) tax-sheltered annuity, any other kind of qualified annuity (held inside a retirement account), IRAs, Roth IRAs, and 457(b) plans (including corrective or deemed distributions).

- Although not expressly stated in the guidance, S corporation dividends appear to still escape both the 3.8% Medicare tax on unearned income and the 0.9% Medicare tax on earned income, assuming the taxpayer is an active participant in the S corporation business (if ownership is passive, it appears that all S corporation income would be classified as passive investment income). As long as there is active participation, though, the S corporation income would escape the 3.8% tax, and as long as it is not paid out as wages, escapes FICA taxes (and therefore the 0.9% Medicare tax on earned income). Notably, though, there is increasing risk that Congress may close this perceived "loophole" for S corporation FICA taxes (including the new 0.9% Medicare tax) by changing the tax treatment for S corporation income to be similar to partnership and LLC income (where active participants must report all of their share of income as earned income for self-employment tax purposes).

- For the purposes of the new 0.9% Medicare tax on earned income, employees whose wage income is projected to be above the $200,000 individual threshold for the tax year will not have increased tax withholding for the entire year. Instead, withholding for the new 0.9% tax will apply once that employee's wages actually cross the $200,000 threshold for that year, and continue at the new higher level for the remainder of that year.

- Withholding for the new 0.9% tax will only be done on the basis of an individual's own income, not a couple's income (as employers do not have the right to request income about a current spouse's year-to-date earnings). Employees who anticipate the Medicare tax as a married couple may request additional withholding to prepare for the tax, but may not request additional FICA/Medicare tax withholding; instead, employees can merely ask for an increase in overall withholding, that can/would apply for both income and employment tax purposes.

Planning Through The End Of 2012 And Into 2013

Although the new rules do not necessarily create a lot of new planning issues and opportunities heading into the final weeks of the year, it is notable that 2012 is the last year to which these taxes will not apply. Accordingly, high-income clients who will be subject to the tax in 2013 may look to strategies like capital gains harvesting to capture and recognize gains now, in 2013, before the new tax applies (a strategy which will only turn out better if capital gains rates themselves rise as well).

One notable planning opportunity that did emerge from the new regulations, though, regards Charitable Remainder Trust (CRT) planning in particular. The issue is that while CRTs are not subject to the 3.8% Medicare surtax on net investment income, distributions from the CRT to non-charitable beneficiaries will be potentially subject to the tax as the income is distributed. To avoid "unfairly" causing Medicare taxes to beneficiaries that receive income in 2013 or beyond that was actually created prior to the Medicare tax (and just not yet distributed), the new rules stipulate that only income in the trust that was created in 2013 or later will be treated as net investment income. As a result, CRTs may wish to harvest capital gains as well between now and the end of the year, to ensure that any current unrealized losses beyond pre-2013 gains not treated as net investment income.

For most planners and clients, though, the onset of 2013 in coming weeks will simply mark the start of a series of new taxes that must become part of the planning discussion for high income clients. Although unfortunately, given that the income threshold for both new Medicare taxes are not indexed for inflation, planning for the 3.8% Medicare tax on unearned income and the 0.9% Medicare tax on earned income may become increasingly common in the decade to come!

(This article was featured in the Final Carnival of Financial Planning for 2012 on Cult of Money, Carnival of Retirement on Young Cheap Living, the Carnival of Money Pros on Good Financial Cents, the Nerdy Finance Carnival #20 on NerdWallet, and also the Carnival of Wealth on Control Your Cash.) 

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  • Ed Horan

    Ed Horan
    As so many have pointed out, including yourself, while a taxpayer would normally not have income over the 3.8% Medicare tax thresholds of $200,000 for individuals, and $250,000 for couples filing jointly, the gain from the sale of an investment property will most likely make them liable for the tax. Most strategies promoted to avoid the 3.8% tax fail to mention the use of the 1031 exchange of the sold/relinquished property.
    While a close look at tax rules will show you a 1031 exchange tax deferral will escape the tax, in the summary to the draft regulations implementing IRC section 1411 it is clear that deferred gain from a 1031 exchange will not be counted as part of your net investment gain. It states ‘for example, to the extent gain from a like-kind exchange is not recognized for income tax purposes under section 1031, it is not recognized for purposes of determining net investment income under section 1411”.
    When advisors talk of strategies to lessen the impact of the 3.8% Medicare tax, they should be sure to include the use of the 1031 exchange.
    For more information on a 1031 exchange contact Bill Horan, CES® of Realty Exchange Corporation, at toll free 1-800-795-0769, cell 703-606-2761, or

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  • Michael Kitces

    A 1031 exchange will indeed defer the recognition of a capital gain, and therefore potential exposure to the 3.8% Medicare surtax.

    But ultimately it is only deferral of gain, not permanent avoidance. Deferring the gain, allowing further growth, and depreciating the property further can potentially expose some investors to a larger gain and even more 3.8% Medicare tax in the future. Of course, if future income declines, exposure to the surtax can be lessened as well.

    Ultimately, whether a 1031 exchange actually results in more or less of the 3.8% Medicare tax will depend on the specifics of the individual’s situation, although in general extended periods of deferral can significantly INCREASE exposure to the tax if/when/as it is ever ultimately liquidated in the future the lump sum gain grows even larger.

    – Michael

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Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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