The impending fiscal cliff has garnered a lot of attention, and rightfully so. With taxpayers at all income levels facing the potential for much higher taxes if the expiration of lower tax rates under current law is allowed to happen, the loss of disposable income to higher income taxes could destroy the fragile economic recovery.
But among all the reasonable concerns that policymakers have raised about the fiscal cliff, one particular issue seems patently ridiculous: how the Medicare surtax applies to sales of residential property. Although some have made it sound as though the surtax represents an unprecedented federal property tax, the sad fact is that very few people will be fortunate enough ever to have to pay it.
Understanding the Medicare surtax
As part of the Affordable Care Act, a new surtax is scheduled to take effect at the beginning of 2013. Single taxpayers with salaries or self-employment income of $200,000 will potentially face two different additional taxes; the corresponding income limit for joint filers is $250,000. First, for all earned income over the respective limit, you'll have to pay an extra 0.9% of the amount over the limit in additional Medicare taxes. That takes the current combined employer and employee contribution for Medicare taxes up from 2.9% to 3.8% for that high-income portion.
The second tax, though, could have much bigger implications. For all investment income, which includes interest, dividends, capital gains, and some additional income categories, a 3.8% surtax will apply to the extent that your gross income exceeds the respective limits. So if you were above the limit excluding your investment income, all of that investment income will be subject to the additional tax.
Combined with the increases to high-income tax brackets, which the president has proposed to leave standing despite plans to restore tax cuts for lower- and middle-income tax brackets, taxpayers earning more than those limits stand to face substantial tax hikes.
Reasonable people can disagree about whether those tax hikes are wise at this point. What's silly, though, is focusing on homeowners as potential victims of the surtax.
To be clear, it's definitely possible that some homeowners will end up having to pay the surtax. To the extent that homeowners have a gain that they're required to recognize under the tax code, it will constitute investment income under the surtax rules. It will therefore be subject to the 3.8% surtax to the extent that it pushes homeowners over the respective income limits.
But consider the confluence of factors that has to take place in order for the surtax to apply:
- The homeowner needs to have an actual gain on the property, which is less likely now than at nearly any point in the past. Given how much real estate Bank of America (NYSE: BAC ) , Citigroup (NYSE: C ) , Wells Fargo (NYSE: WFC ) , and their banking peers have had to foreclose upon recently due to underwater mortgages, it's clear that plenty of homeowners are sitting on massive losses.
- The amount of the gain has to exceed the special exclusions for capital gains on principal residences. Single taxpayers get up to $250,000 tax-free, while joint filers enjoy a $500,000 exclusion. Those amounts don't just benefit from low long-term capital gains rates; taxpayers pay absolutely no tax on them.
- Either taxpayers need to already have substantial income outside of the property sale, or the sale has to generate so much gain that it triggers the surtax income limits.
Admittedly, vacation homes don't get the benefit of an exclusion on capital gains. But unfavorable tax treatment is nothing new for those fortunate enough to own two homes.
What's the big deal?
Whenever any tax provision gets proposed that has even a glancing impact on housing, concerns arise that the housing market's fragile recovery will fade away. As the story goes, homebuilders Toll Brothers (NYSE: TOL ) and Standard Pacific (NYSE: SPF ) will suffer from an exodus of buyers who don't want to pay extra taxes on their eventual gains.
But this time, that story is out of touch with the times. Despite the uproar, very few homeowners need to fear what will come down the road when they sell the homes they live in.
Like it or not, Bank of America still makes money on mortgages, and it's done a reasonable job working through the underwater loans on its books. But it still has further to go. Find out how the bank is doing in the Fool's premium report on Bank of America. With a year's worth of updates included free, you've got no excuse not to click here and get started today.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.