Couple Reading Newspaper and Tablet Outside

New IRS regulations on the 3.8 percent tax present opportunities for high-net worth and higher income individuals with net investment income.

Tax strategies

Good News on 3.8 Percent Net Investment Income Tax

  • Chris Hesse
  • 12/6/2013

Beginning in 2013, higher income individuals with net investment income are subject to a new 3.8 percent tax. The tax generally applies to individual returns with income over $200,000, but also reaches trust and estate income tax returns with as little as $12,000 of taxable income. In late November, the IRS issued long-awaited final regulations on this new tax.

“The recent IRS regulations generally contain good news,” notes Chris Hesse, a CliftonLarsonAllen tax principal. “And there are some strategies that individuals and trusts can consider to minimize this new tax.”

Overview of the net investment income tax

The net investment income tax or NIIT was enacted by the Affordable Care Act in 2010, but first has application to individual, trust, and estate income tax returns for tax years beginning in 2013. The tax is 3.8 percent of the lesser of two amounts:

  • Net investment income, or
  • the excess of the taxpayer’s modified adjusted gross income (MAGI) above $200,000 (single filer) or $250,000 (joint filer).

Modified adjusted gross income is essentially the income on page one of Form 1040, but increased by any foreign earned income exclusion. If the taxpayer’s MAGI exceeds the $200,000/$250,000 threshold, the excess becomes a limitation on the amount of net investment income exposed to the tax. For example, if a joint return has MAGI of $260,000, the $10,000 excess over the $250,000 threshold is the most that can be exposed to the NIIT, even if actual net investment income exceeds this amount.

Net investment income includes three broad categories:

  • Interest, dividend, annuity, royalty, and rental income
  • Net income from a business in which the taxpayer does not materially participate and business income from trading in financial instruments or commodities
  • Capital gains and other net gains from the sale of investment or passive property

The sum of these three categories of income is reduced by allowable deductions properly allocable to the gross income or net gain. Examples of allocable expenses include investment advisory fees, investment interest expense, and state income taxes allocable to net investment income.

Several categories of income are specifically exempt from net investment income:

  • Income from a business in which the taxpayer materially participates, as well as gain from the disposition of an interest in a partnership or S corporation in which the taxpayer materially participates
  • Qualified retirement plan and IRA distributions
  • Any income subject to the self-employed social security tax
  • Tax exempt interest income, tax-free gains from a principal residence, and other items excluded for regular income tax purposes

The final regulations

The IRS regulations issued in late November consist of almost 200 pages of explanation and technical guidance. In general, they are taxpayer friendly and eliminate many of the concerns raised in the proposed regulations. Much of the guidance is technical and primarily of interest to tax professionals. But there are several items that may present an opportunity for taxpayers.

Grouping of active and passive business activities

In the past, if a taxpayer owned an interest in several profitable business activities, whether those business interests were classified as material participation businesses or passive activities was generally moot. If a passive business activity produced a loss, that loss could be deferred under the passive activity rules. But passive business income, in the past, was not detrimental. Starting in 2013, however, business income flowing into a Form 1040 from a passive activity is subject to the new 3.8 percent tax.

IRS regulations allow a taxpayer a one-time opportunity to regroup multiple business activities on Form 1040, if that election helps to minimize passive business income exposed to this new tax. By grouping multiple business activities as a single “appropriate economic unit,” a taxpayer’s hours of participation in one entity can extend to another business. This causes the combined income to be considered active business income not subject to the NIIT.

“Business owners with interests in multiple activities will want to discuss with the possibility of a revised grouping election with their tax advisor,” observes Hesse.

Self-rental income

The final regulations reverse a position in the proposed regulations, and now allow rental income from a self-rental arrangement to be excluded from NII. A self-rental is net rental income from property that is rented for use in a trade or business in which the taxpayer materially participates. A similar and often overlapping exclusion from NII applies if the taxpayer has electively grouped a rental activity with its trade or business activity. In that case, the rental activity is also deemed to be a material participation business activity and exempt from the NIIT.

“This exemption for self-rental arrangements is very important,” says Hesse. “Most small business owners separate the real estate and active business operations for liability reasons. The regulations recognize that the rental property and active business are effectively a single enterprise. This allows us to prevent exposure to the 3.8 percent tax if the individual or spouse materially participates in the business activity.”

Allowance of losses against NII

Another improvement over the proposed regulations is the final rule allowing taxpayers to claim a loss on NII property when computing overall net investment income subject to the 3.8 percent tax. For example, an individual claiming the $3,000 net capital loss allowance on security sales can use that loss against other net investment income such as interest, dividend and annuity income.

“In some cases, this rule will allow tax planning opportunities,” notes Hesse. “For example, a large business gain, which itself is exempt from the NIIT, can push income to upper levels so as to impose the 3.8 percent tax on investment income such as apartment rental net income. A carefully timed stock loss could now be used to offset that rental income and eliminate the net investment income exposed to the tax.”

Trusts and estates

Estates and trusts have a much lower threshold at which the 3.8 percent tax applies. In general, any undistributed net investment income of a trust or estate in excess of approximately $12,000 is subject to the 3.8 percent tax, as well as the new top 39.6 percent regular income tax rate. The income of trusts and estates typically consists of investment income categories that will be exposed to this tax. It is important for these entities to consider distributions of their income before year-end, or post-year-end under the 65-day rule, in order to minimize their undistributed income subject to a combined top rate of 43.4 percent. By distributing the investment income to individual beneficiaries, there is a possibility that the income will be taxed at lower ordinary rates and also escape the 3.8 percent net investment income tax.

Tax strategies

For individuals with income at or near the $200,000 single or $250,000 joint threshold for the NIIT, the focus should be on maintaining consistency from year to year to keep from encountering the 3.8 percent tax. Spikes in income from any source (bonuses, IRA withdrawals, large capital gains, etc.) can push up income and trigger the 3.8 percent tax on interest, dividends, rent, and other investment income.

For those who might recognize a large capital gain, an installment sale strategy could be beneficial in keeping overall income beneath the threshold of the NIIT. For retirees who hold real estate leased to their former business activity, the retiree could retain a small ownership and continue to qualify as materially participating in that business through any of the material participation standards. This could be a solution to reducing or eliminating the NIIT on both the rental income and the eventual gain from the sale.

How we can help

Consult your tax advisor to help interpret the application of the 3.8 percent tax to your situation, and to discuss possible strategies to minimize its cost. Business owners should review this tax as part of their year-end strategy and know the key tax information for the 2014 and 2015 tax years.