Beginning in 2013, a new tax, the “net investment income tax,” or NIIT, applies at a rate of 3.8% of the “net investment income” of individuals, estates, and trusts with income above certain statutory amounts. For individuals, the threshold amounts are:
• $200,000 for single taxpayers and heads of household;
• $250,000 for married individuals filing joint returns and certain widows and widowers; and
• $125,000 for married individuals filing separate returns.
The threshold amounts include all income, even income not subject to the tax; however, investment income is only subject to the tax if the taxpayer’s total income exceeds the threshold. The NIIT applies to estates and most trusts with income above the point at which the highest tax rate begins (the 2013 threshold is $11,950).
The NIIT applies only to “net investment income.” In general, investment income includes interest, dividends, capital gains, rental and royalty income, nonqualified annuities, income from businesses involved in trading of financial instruments or commodities, and income from businesses that are passive activities for the taxpayer. Net investment income is calculated by reducing investment income by certain expenses properly allocable to the income. The NIIT does not apply to wages, unemployment compensation, operating income from a nonpassive business, social security benefits, tax exempt interest, self-employment income, and distributions from qualified retirement plans, 401(k) plans, and IRAs.
Gains included in net investment income include gain from the sale of stocks, bonds, and mutual funds; capital gain distributions from mutual funds; gains from investment real estate (including gain from the sale of a second home); and gains from the sales of certain partnership and S corporation interests. The tax also applies to the gain on the sale of a personal residence, but only after the $250,000 exemption from such gain ($500,000 for married couples).
The NIIT is based on the lesser of the amount by which the taxpayer’s modified adjusted gross income exceeds the threshold, or the taxpayer’s net investment income. For example, if a single taxpayer has $180,000 in wages and $90,000 in net investment income, the tax is computed on $70,000, the amount by which the taxpayer’s income exceeds the $200,000 threshold amount. The taxpayer would owe net investment income tax of $2,660 ($70,000 ? 3.8%).
This tax is intertwined with the concept of “passive activity,” as income from passive business activities (including any capital gain from the sale of those activities) is generally subject to the NIIT, whereas income from nonpassive business activities generally is not. The concept of passive activity is derived from the IRS’s passive activity loss rules, which prohibit taxpayers from deducting losses from so-called passive activities, or activities in which the taxpayer does not materially participate. These rules generally apply to the actions of the owner of the business interest, not the business itself, although special rules apply to real estate activities. In order for your interest in a business not to be a passive activity, you must materially participate in the operations of the business. Material participation generally means that your involvement in the business operations is regular, continuous and substantial. The IRS regulations provide quantitative tests for meeting this requirement. For example, you will be materially participating if you work more than 500 hours during the year in the business.
Because the IRS passive activity rules apply to restrictions on deducting losses, taxpayers with positive income from passive activities may have had little reason to differentiate those activities from nonpassive activities. Beginning in 2013, however, the distinction may become significant. For example, the IRS has rules that have allowed taxpayers to “group” related activities in order to determine whether the overall group represents a passive or nonpassive activity. With the advent of the NIIT, the IRS is allowing taxpayers to “re-group” their activities in light of potential liability for the tax. Taxpayers with multiple business or real estate investments might be able to eliminate or reduce their exposure to the NIIT with appropriate decisions in this area. The IRS has issued proposed rules on this and other aspects of the NIIT that you might want to apply to your investments. For more information about how this could affect you, please contact me to discuss your particular situation.
Another aspect of the NIIT that appropriate planning might ameliorate involves trusts that have the option of either passing their income to beneficiaries (who would then pay tax on the income) or retaining the income and paying any resulting tax themselves. Because the NIIT applies to trusts at a much lower income threshold than it does for individuals, appropriate planning might help reduce the impact of the new tax. If you have an interest in a trust, or act as a trustee, please contact me to discuss your individual situation.