The new net investment income tax went into effect on Jan 1, 2013. In December 2012 the IRS issued a set of proposed regulations that will govern how this new tax is implemented. The tax places a 3.8% tax on the lower of either the net investment income or the amount of modified adjusted gross income (MAGI) that exceeds certain levels.
The American Institute of CPAs covered these new regulations and some special considerations when assessing a possible tax liability in a recent article. We’ll explain the details in two posts this week. Today’s post will explore what constitutes net investment income and who is affected. The second will examine some special factors involved in calculating tax liability.
Only individual filers with MAGI above certain levels and specific types of trusts and estates will have a tax liability under the new law. Entities not considered natural persons and nonresident aliens are exempt. Individuals who file jointly or have a qualifying surviving spouse can report income up to $250,000 without being subject to the tax. Married filing separately and single tax filers can report income up to $125,000. Those filing as head of household can report up to $200,000. For the majority of tax filers, MAGI and adjusted gross income (AGI) will be identical. Section 911 lists certain deductions and excluded income for citizens living abroad and non-resident aliens as the only allowable modifications to AGI when calculating net investment income.
Certain trusts and estates are also subject to the net investment income tax. Undistributed net investment income and an AGI that exceeds the dollar amount at which a trust or estate began a tax year will cause it to incur a potential tax liability. Exempt trusts include grantor trusts under Secs. 671–679, REITs and common trust funds, tax-exempt trusts under Secs. 501 and 664, and charitable trusts under Sec. 170(c)(2)(B).
The definition of what is considered to be net investment income falls into three categories:
Category I: Gross income from interest, dividends, rents, royalties, and nonqualified annuities, other than such income derived in the ordinary course of a trade or business not described in Category II.
Category II: Other gross income from businesses that trade financial instruments or commodities, and businesses that are passive activities within the meaning of Sec. 469.
Category III: Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property, other than property held in a trade or business that is not described in Category II. Gains and losses from dispositions of trade or business property used in passive activities are included in calculating the net investment income tax.
There are a number of expenses that can be used to reduce the amount of net investment income that needs to be reported. These include early-withdrawal penalties, interest expense, advisor fees, directly-related rental and royalty expenses, and state and local taxes allocable to items included in investment income. When calculating net investment income wages, self-employment income, unemployment compensation, business income from nonpassive sources, Social Security benefits, tax-exempt interest, and qualified pension, annuity, and individual retirement account distributions do not need to be factored into the calculation.
Our second post will explore some special situations to take into account when calculating net investment income.