A Sales Tax on Real Estate Sales? Yes, Well Sort of…
The internet can be great for providing information on any number of subjects. And real estate is among the most popular, with “experts” weighing in on any issues raised by (confused) consumers. Recently, there has been a flurry of activity offering “guidance” on the new 3.8% sales tax on real estate. Much of the “analysis” out there is, frankly, just wrong, calling it a “hidden” tax in the recently passed national healthcare bill without bothering to explain that, on a closer look, the tax will actually have a very narrow impact on transactions, as the exceptions largely swallow the rule.
Here are the basics of the new added sales tax.
Rule 1: The tax only applies to income from interest, dividends, rents (less expenses) and taxable capital gains (less capital losses).
Rule 2: The tax only applies to individuals with an adjusted gross income (AGI) above $200,000 in the tax year, and for couples filing jointly with more than $250,000 AGI, before adding the taxable gain.
Rule 3: The formula for calculating the tax applies if Rules 1 and 2 are met, and is the lesser of the (a) investment income amount, or (b) the excess of the AGI over the $200K/$250K threshold.
A few examples might help.
Example 1: A married couple sells their home in 2013 for $1,200,000, and realizes a gain of $575,000. In tax year 2013, the couple (who file jointly) have an AGI of $350,000 before adding the gain.
Analysis: Rule 1 applies, as this is income from a capital gain. Assuming no capital losses, the gain of $575,000 is subject to the remaining rules. Rule 2 applies because the couple has AGI exceeding $250K (they file jointly). But their total gain of $575,000 on the home is still subject to the exclusion of gains on the sale of a principal residence, so the couple is exempt from the first $500,000 of gain, and thus must deal with $75,000 of gain after the $500K exemption. That taxable gain is added to the AGI ($350,000) to get $425,000. Now, the couple pays tax on the lesser of the investment income amount and the excess (see Rule 3 above). The investment income amount is $75,000 (total gain of $575,000, less the $500,000 principal residence exclusion). The excess over the threshold is $175,000 ($425,000 less $250,000). So the sales tax must be paid on the lesser investment income amount, or $75,000. The rate of 0.038 on $75,000 is $2,850, which is the additional tax to be paid.
Example 2: John, a single person, sells his home in 2013 for $1,000,000, and realizes a total gain of $375,000. It was his principal residence for the last 7 years, and his AGI is $125,000.
Analysis: Rule 1 applies (this is income from a capital gain) but Rule 2 does not, his AGI is below the threshold. You can stop there, the sale tax will not apply.
Example 3: Pam, a single person, sells her home in 2013 for $3,500,000, and realizes a gain of $700,000. It was her principal residence for the last 5 years, and her AGI is $425,000 before the gain.
Analysis: Rule 1 applies, this is a capital gain. Rule 2 applies, as the individual has an AGI before the gain of $425,000, which is higher than the $200,000 individual threshold. Rule 3 requires that that the tax applies to the lesser of (a) and (b) above in Rule 3. Since it was a principal residence, the taxable gain is reduced by $250,000, to make it $450,000. That number is added to the AGI, to get a new AGI of $875,000. The excess of AGI over threshold is $675,000. So the tax is paid on the lesser number, which is $450,000. The additional tax owed is 3.8% of this amount, or $17,100.
Most transactions will simply not be covered by this additional tax. The principal residence exclusion handles many gains, and the adjusted gross income thresholds will exclude many sellers. Those who are not excluded will in fact have to pay the 3.8% tax, but only on the lesser amount of the investment income or the excess over the threshold.