Your Guide to the Medicare Surtax
By: Stacey Nickens
Upper-income taxpayers should be aware of an additional tax that could increase their bill come April 15. Certain taxpayers are subject to a 3.8% “Medicare” surtax on their net investment income.
Single filers with modified adjusted gross incomes (AGIs) above $200,000 and joint filers with AGIs above $250,000 will be hit with this surtax, as will married filing separately filers with AGIs above $125,000. Modified AGI includes both AGI and tax-free foreign earned interest.
Should your income be above these thresholds, you will be taxed on the smaller of Net Investment Income or the excess of modified AGI over the threshold. For example, a single filer with a modified AGI of $215,000 is earning $15,000 in excess of the threshold. If their Net Investment Income is $13,000, they will be taxed on their Net Investment Income because it is smaller than the $15,000 excess.
Trusts and estates may also face a Medicare surtax if they do not distribute all of their net investment income and if their 2021 AGI exceeds $13,050.
Net Investment Income includes dividends, taxable interest, capital gains, passive rents, annuities, and royalties. Net Investment Income also includes other forms of passive income from activities in which the taxpayer does not participate. This could include income from a business such as an LLC, limited partnership, or S corporation. However, with S corporations, shareholders who participate in the corporation’s operations will likely not face a surtax on their share of income or on distributions. This exception does not cover passive S corporations or S corporations who trade in financials. Essentially, income earned through doing labor would likely not face the Medicare surtax.
Net rental income could fall under Net Investment Income if the taxpayer is a real estate professional. For tax purposes, real estate professionals are taxpayers who spend more than 50% of their working hours and 750 or more hours each year participating in professional real estate activities. Brokers, developers, and similar individuals are included in the definition of real estate professional.
Real estate professionals could be exempt from this surtax if their rental income comes from a trade or business. The professional has to prove that they spent more than 500 hours on rental activities during the tax year, or more than 500 hours on rental activities during 5 of the past 10 tax years. Essentially, a taxpayer must prove that they earned their rental income actively, doing more than just collecting rent and completing routine maintenance. If a real estate professional can prove their income was earned actively, it may not qualify as passive income subject to the Medicare surtax.
Finally, Net Investment Income does not include tax-exempt interest from municipal bonds, nor does it include payouts from 401(k)s, IRAs, and pensions. Taxpayers can deduct certain investment expenses to reduce their taxable Net Investment Income.
