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IRS Guidance for New 3.8% Tax on Net Investment Income


Recently, the IRS issued proposed regulations regarding the new 3.8% net investment income tax (NIIT, also known as the Medicare contribution tax) that was created by the Health Care and Education Reconciliation Act of 2010 and takes effect Jan. 1, 2013. The IRS also released answers to frequently asked questions (FAQs) concerning the new tax. Taxpayers may rely on the proposed regulations until final regulations are published.


Background


Beginning in 2013, higher-income taxpayers generally will be subject to the 3.8% NIIT on some or all of their net investment income. This is in addition to — and calculated separately from — the taxpayers’ regular income tax or alternative minimum tax liability.


NIIT will be applied to net investment income to the extent that modified adjusted gross income (MAGI) exceeds the following thresholds: $250,000 for joint filers; $125,000 for married taxpayers filing separately; and $200,000 for individuals, heads of household and other filers. Individuals who are exempt from Medicare taxes may nonetheless be subject to the NIIT if they have net investment income and they have MAGI above the applicable thresholds.


The new tax also applies to estates and trusts that have undistributed net investment income and adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins for the taxable year. (This amount is $11,650 for 2012; as of this writing, the 2013 amount hasn’t been released.) Grantor trusts, exempt trusts (for example, charitable trusts) and trusts that aren’t classified as trusts for tax purposes (for example, real estate investment trusts) aren’t subject to the NIIT.


Individuals may also be subject to a new 0.9% additional Medicare tax on FICA wages and self-employment income over certain thresholds. (Information regarding this additional tax was covered in our recently published article titled “IRS provides guidance on additional 0.9% Medicare tax.”) It is important to note that the 0.9% tax doesn’t apply to income items included in net investment income.


Income subject to the NIIT


According to the proposed regulations, investment income includes (but isn’t limited to):
• Interest,
• Dividends,
• Capital gains,
• Rental and royalty income,
• Nonqualified annuities (including payments under life insurance contracts),
• Income from businesses involved in the trading of financial instruments or commodities, and
• Income from businesses that are passive activities to the taxpayer (meaning the taxpayer doesn’t “materially participate” in the business).


Common examples of investment income include gains from the sale of stocks, bonds and mutual funds; capital gain distributions from mutual funds; gains from the sale of partnership or S corporation interests; and gains from the sale of a second home.


Net investment income is calculated by deducting from investment income certain expenses that can be allocated to that income. Expenses that can be deducted include interest expense, advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes. Deductions aren’t allowed for net operating losses.


Income exclusions


Income from interest, dividends, annuities, rents and royalties is excluded from investment income if the income is derived in the ordinary course of a trade or business that’s not a passive activity with respect to the taxpayer or trading in financial instruments or commodities. Investment income also doesn’t include wages, unemployment compensation, operating income from an active (or nonpassive) business, Social Security benefits, alimony, self-employment income, interest on tax-exempt bonds and Alaska Permanent Fund Dividends.


The proposed regulations also exclude from net investment income distributions from the following retirement or similar plans:


• Qualified pension, stock bonus or profit-sharing plans,
• Qualified annuity plans,
• Tax-sheltered annuities,
• Traditional IRAs,
• Roth IRAs, and
• Deferred compensation plans of a state and local government or a tax-exempt
organization.


Distributions from these plans are, however, taken into account when determining a taxpayer’s MAGI — so they could trigger NIIT on net investment income.


Notably, the NIIT also doesn’t apply to any amount of gain that’s excluded from gross income for regular income tax purposes. This means the first $250,000 ($500,000 for a married couple filing jointly) of gain recognized on the sale of a principal residence is excluded from the NIIT, provided the taxpayer meets the requirements for the exclusion.


For example, Jill, who is single, earns $210,000 in wages, which exceeds the applicable MAGI threshold of $200,000. Jill sells the house she’s owned and lived in for 10 years for $420,000. Her cost basis in the home is $200,000; thus, she realizes a gain of $220,000. Jill may exclude the gain from the NIIT because it’s $30,000 under the gain exclusion limit for regular income tax purposes.


Calculating the tax


Individuals are required to report and pay the NIIT on their income tax returns. If a taxpayer meets the applicable MAGI threshold and has net investment income, the NIIT equals 3.8% of the lesser of the amount by which the taxpayer’s MAGI exceeds the threshold or the taxpayer’s net investment income.


Consider, for example, Jack, a single taxpayer who earned $180,000 in wages. He also received $90,000 from a passive partnership interest, making his MAGI $270,000. Jack’s net investment income is $90,000. His tax is based on the lower of $70,000 ($270,000 less the $200,000 threshold) or $90,000 (the net investment income). Jack therefore owes NIIT of $2,660 ($70,000 × 3.8%).


Here’s another example, involving the sale of a home: Gary and Maria are married and file jointly. They sell the home they’ve owned and lived in for 10 years for a gain of $600,000, which exceeds the $500,000 exclusion. The gain that’s subject to regular income taxes, and therefore includible in net investment income, is $100,000. With their additional investment income, their total net investment income comes to $225,000. Their MAGI is $300,000, which exceeds the applicable threshold by $50,000. Gary and Maria owe NIIT of $1,900 ($50,000 × 3.8%).


Act now


The NIIT is lurking right around the corner, and higher-income taxpayers need to plan accordingly. If you might be affected, you should evaluate your potential liability and, if you expect to be subject to the NIIT in 2013, adjust either your income tax withholding with your employer or your estimated payments to account for the tax increase and avoid underpayment penalties. Also consider selling highly appreciated securities before 2012 ends. We’d be pleased to help assess the potential impact of the NIIT on your particular situation and provide additional ideas on how you can minimize it.