The Investment Tax, which has been referred to as the “Medicare surtax” because it falls under a provision entitled, “Unearned Income Medicare Contribution,” was added to Obamacare to serve as a revenue generator. It applies not only to individuals but to businesses treated like individuals by the tax code such as partnerships, limited liability companies, or S corporations. It is calculated as follows:
3.8% is taken out of the lesser of:
- An individual’s “net investment income” (“NII”); or
- The excess of “modified adjusted gross income” (“MAGI”) over $200,000 for an individual or $250,000 for married joint filers.
NII means the excess of the sum of the below listed items less allowable deductions:
- Income derived from interest, dividends, royalties, annuities, and rents unless such income derived is in the ordinary course of any trade or business;
- Income from passive trade or business activities;
- Income from the trading of financial instruments and commodities; and
- Net gains derived from the disposition of property other than property held in any trade or business that is not a passive trade or business.
Given this broad definition of NII and the relatively low MAGI threshold, the Investment Tax could have significant tax ramifications for investors with large portfolios and individuals seeking to transfer their interest in a small business or sell certain real property after 2012. Whether property is held in a passive trade or business is determined by technical definitions set forth in the tax code.
As identified above, the capital gains rate may very well increase by 5% in 2013. If this Administration and Congress, infamous for their brinkmanship which has led to stunningly low 178 laws passed to date, fails to reach a compromise regarding the extension of the Bush tax cuts before year end, the long-term capital gains rate will increase from 15% to 20%. There are also other political obstacles to maintaining the current rate as the Democratic controlled Senate passed a bill in July staking ground on a 20% rate. Simply put, if the Senate position wins out or Congress does nothing, all investors will pay 5% more in capital gains taxes, translating into a total increase of 8.8% for individuals subject to the Investment Tax.
Given the partisan climate in Washington combined with the uncertainty surrounding the outcomes of the upcoming elections, these individuals have a larger than normal incentive to accelerate gains before year end. If the fear of indecision in Washington and the threat of higher taxation manifest into a glut of early capital gains harvesting, the market could suffer as a consequence. With the economy already fragile and the other significant political issues at play, i.e. the extension of the Bush income tax rates and other key tax provisions, the government spending cuts called for by the sequestration, and threat of another debt ceiling default battle (also known as the “fiscal cliff”), the market could be looking at a turbulent fourth quarter.
Another factor contributing to this swirling volatility is that comprehensive tax reform on the scale of the Simpson-Bowles Plan is receiving serious attention. Many are predicting that a temporary patch during lame duck Congress will punt the fiscal cliff into 2013 under the auspices of providing a framework for such reform. In that scenario, everything will be on the table and even less will be predictable. It is important to note, however, that the last time the United States achieved comprehensive reform in 1986, the tax rate on capital gains was increased to the rate of ordinary income at that time, 28%.
With all the impending political fanfare, investors with large portfolios and individuals seeking to transfer their interest in a small business or sell certain high end real property should be mindful of the potential for an 8.8% tax increase in 2013 and be prepared to take action to harvest gains before year end when appropriate. If they hold on to their investments into 2013, they should, at a minimum, anticipate the 3.8% Investment Tax, and explore methods to curtail their NII such as investing in tax exempt municipal bonds or engaging in installment sales. They should also maintain a watchful eye on the lame duck negotiation process in November and December to see what will happen with the capital gains tax rate in 2013 as well as to anticipate the deeper market impact of the fight over the Bush tax cut extensions and the fiscal cliff.