Potential tax changes await investors in 2013.

• Author: Hattox, Bill

Depending on political developments, taxpayers could face higher taxes on investment income in 2013, including a new Medicare tax on net investment income and the sunset of lower rates for capital gains and qualified dividends.

Medicare Tax on Net Investment Income

To generate revenue for various health care reform items in the Patient Protection and Affordable Care Act, P.L. 111-148, the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, included a 3.8% Medicare tax on net investment income that is slated to go into effect for the 2013 tax year. For taxpayers with modified adjusted gross income (MAGI--AGI increased by the foreign earned income exclusion) over a threshold amount, the tax is imposed on the lesser of (1) net investment income or (2) MAGI over the threshold amount. The threshold amounts are:

* $250,000 for married taxpayers filing jointly and qualifying widows or widowers;

* $200,000 for single and head-of-household filers; and

* $125,000 for married taxpayers filing separately.

Items classified as investment income include interest, dividends, royalties, rents, annuities, and capital gains from investment property, as well as passthrough income from a passive business such as a partnership or an S corporation. Distributions from qualified retirement plans and IRAs would not count as investment income. It should be noted that the portion of any gain excluded from the sale of a principal residence under Sec. 121 will not be subject to the tax. The amount that exceeds the exclusion, however, will be included in net investment income and MAGI for purposes of the tax.

There was a chance the U.S. Supreme Court would invalidate the Medicare tax on investment income as part of its decision on the individual health insurance mandate (Sec. 5000A). However, the Supreme Court, in a 5-4 vote, declared the mandate to be a constitutional exercise of Congress's power to tax under the Constitution and allowed the health care reform legislation, including the Medicare tax on investment income, to stand (National Federation of Independent Business v.Sebelius, Sup. Ct. Dkt. No. 11-393 (U.S. 6/28/12)).

Health care reform has also generated considerable political controversy, and outcomes of the November 2012 presidential and congressional elections also could affect the law's future.

Now that the Supreme Court has upheld the law, those who could be affected by the 3.8% Medicare tax on investment income need to be aware of the...