Understanding Net Investment Income Tax

As part of the controversial Affordable Care Act, known by most as Obamacare, several new taxes were enacted to help fund the program.

Among these new taxes is one that became effective on Jan. 1, 2013, the Net Investment Income Tax. This regulation imposes a 3.8 percent surtax on the net investment income of certain individuals, estates and trusts that have income above the statutory threshold amounts. The key consideration, however, is what constitutes net investment income and which taxpayers are affected.

The threshold amount for individuals is based on filing status and is not indexed for inflation.

The threshold amount is $125,000 for taxpayers filing married filing separately; $200,000 for taxpayers filing as single or head of household; and $250,000 for those with a filing status of married filing jointly or qualifying widow(er) with a dependent child.

Individuals will owe the additional net investment income tax if their modified adjusted gross income exceeds these figures. Modified adjusted gross is defined as adjusted gross income plus foreign earned income less deductions and exclusions related that foreign earned income.  

In general, investment income includes, but is not limited to the following: interest income, dividend income, capital gains income, rental and royalty income, income from non-qualified annuities, and income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the tax payer. Gains from the sale of stocks, bonds and mutual funds are subject to this tax.

In addition, capital gain distributions from mutual funds as well as gains from the sale of investment real estate including gains from the sale of a second home that is not a primary residence are also subject to this tax. Gains from the sales of interests in partnerships and S corporations in which the owner is not materially participation are also subject to this tax.

To determine net investment income, investment income from these categories is reduced by investment expenses such as early-withdrawal penalties, interest expense, adviser fees, directly related rental and royalty expenses, and state and local taxes allocable to items included in investment income.

Items such as wages, unemployment, social security benefits, alimony, tax-exempt interest income, self-employment income and retirement income are all examples of income exempted from this net investment income tax.  

In addition to these exemptions for income which are not investment related, the Code Section 1411 excludes non-passive trade or business income from this net investment tax.

As a result, there are renewed discussions on the definition of material participation.

In other words, dividends received from a business where you are actively involved and meet the IRS definition of material participation would be exempted from this net investment income tax. Dividends received from a company where you are an investor and do not meet the definition of material participation will be subject to the tax.

Form 8960 is used to report the net investment income tax. This form is a separate schedule that ultimately flows up into the individual income tax return, the estate return, or the trust return as applicable. The corresponding tax is paid for individuals as part of their 1040 Form, while estates and trusts include this Form 8960 as part of their 1041 return.

Many taxpayers may not be impacted by these new taxes on net investment income.

However, all taxpayers should be aware of the continuing complexity that is placed in our tax code and the tax preparation process.

Despite the ongoing rhetoric from Congress on the need for tax simplification, virtually all legislation in the area of taxes continues to be in the opposite direction.