New 3.8% Medicare Tax on Net Investment Income: How Will this Affect YOU?

Posted by: Barbara Theofilos, CPA

The 3.8% Medicare tax on net investment income, or NIIT took effect for individuals, trusts and estates for tax years beginning on or after January 1, 2013.

Individual taxpayers will be affected by this new tax if their modified adjusted gross income (MAGI) exceeds one of the following thresholds:

• $200,000 for an unmarried taxpayer
• $250,000 for a married couple filing jointly or a qualifying widow or widower
• $125,000 for those  married individuals filing separately

MAGI is regular adjusted gross income adjusted for certain excluded foreign-source income of U.S. citizens as well as residents living abroad. This particular add-back is very narrowly targeted and will not affect many taxpayers. Unfortunately, the above MAGI thresholds are not slated to increase with inflation after the 2013 tax year, so this additional tax will begin to affect even more taxpayers in future years.

If this isn’t complicated enough, the amount of income actually subject to NIIT is a bit convoluted; it is the lesser of (1) net investment income or (2) the amount by which MAGI exceeds the thresholds listed above.

Individuals aren’t the only taxpayers affected by this new tax.  Trusts and estates will also be subject to it on the lesser of the following:

• The trust’s or estate’s undistributed net investment income, or
• The portion of its adjusted gross income (AGI) that exceeds the threshold for the top trust federal income tax bracket.  (This threshold is only $11,950 for tax year 2013.)

The following trust types are exempt from NIIT:

• Charitable trusts
• Retirement plan trusts
• Grantor trusts that are disregarded for federal income tax purposes
• Real estate investment trusts

Those taxpayers and trustees planning for their 2013 tax obligations need to be aware that this tax will have an effect on their estimated taxes, because it needs to be considered when calculating quarterly estimated tax payments.  Failure to do so could result in interest and penalty charges on underpayments of tax.

Examples of income that are considered net investment income include the following:

• Gross income from interest (excludes tax-free interest)
• Gross income from dividends
• Capital gains from the sale of stocks, bonds and mutual funds
• Capital gain distributions from mutual funds
• Gains from selling investment real estate
• Gains from selling personal residences to the extent that the gain is taxable
• Gains from selling interests in partnerships and S corporations if the taxpayer is a passive owner
• Gross income from rents
• Gross income from royalties
• Gross income from annuities
• Gross income and gains from passive business activities
• Gross income and gains from the business of trading in financial institutions or commodities

The above items may be reduced by appropriately allocated deductions including investment interest expense, brokerage fees, investment advisory fees, and expenses related to rent and royalty income.

Capital gains may be offset by capital losses within the guidelines for regular federal income tax purposes. Net capital losses are only permitted to offset other income to a maximum of $3,000. Any remaining capital loss for regular tax purposes is permitted to be carried forward to offset gains in future years.

Examples of items exempt from NIIT include the following:

• Wages and self-employment income
• Operating income from nonpassive business activities
• Distributions from retirement accounts (401(k) plans, pension plans, stock bonus plans,  traditional and Roth IRAs)
• Social security benefits
• Tax-exempt interest, unemployment compensation and alimony

The NIIT has the potential to affect many individuals as well as trusts and estates, especially since the 2013 reporting threshold for trusts and estates is so low. The rules and exceptions can be complicated but it is important to be knowledgeable about this tax and the rules associated with it. Please contact a Zinner professional if you have any questions and to find out how this new tax may affect you.