How Does the New 3.8% Investment Income Tax Work?

On January 1, 2013 a new tax law takes effect. Section 1411 of the Internal Revenue Code imposes a tax on the net investment income of certain individuals, trusts and estates.

There is a great deal of misinformation circulating about this tax. A frequent assertion is that it is a sales tax. One widely circulated email states that you will incur a tax of $15,200 if you sell your residence for $400,000. This is simply not true.

The tax only applies to a husband and wife with adjusted income in excess of $250,000 or a single person with adjusted gross income in excess of $200,000. It only applies to net investment income. Net investment income includes interest, dividends, rents and capital gains. If a husband and wife have salary and wages of $250,000 and interest income, dividends and capital gains totaling $10,000 they will incur a tax of $380 under the new law.

The new tax applies only to the taxable gain on sale of a home. If a husband and wife sell their principal residence at a gain, they are allowed to exclude $500,000 of gain from income if they have owned the home and lived in it for at least two years. That means, in the case of a husband and wife who sell their residence, the new 3.8 percent tax only applies if they sell their house for $500,000 more than they paid for it. For example, a couple could buy a house for $500,000, live in it for two years and sell it for as much as $1,000,000 without incurring any tax at all. If their other income is $100,000, they can sell the house for $1,150,000 without incurring the new tax.