Preface: Net Investment Income Tax is an IRC code section applicable to certain passive earnings. Taxpayers should be aware of this tax and its relevancy to their tax attributes.

 

Net Investment Income Tax and Application of IRC 1411

 

IRC 1411 created a new tax code section for taxable years beginning in 2013. This new IRC code section is a tax on net investment income. The net investment tax is a 3.8% Medicare surtax assessed on passive and unearned income, e.g. any income that is not part of an active trade or business. The net investment tax applies to individual taxpayers, estates, and trusts. Earning thresholds apply to the applicability of the tax. Individuals with income in excess of $250,000 and married filing jointly taxpayers are subject to the tax, and say $200,000 for single filers. Three categories of income are subject to the net investment tax 1. gross income from interest, dividends, annuities, royalties, and rents unless, from ordinary business, i.e. bank earnings or active real estate rental enterprises are not passive while interest income on an investment portfolio is subject to the tax. 2. gross income from trade or business that is passive with respect to the individual taxpayer, estate or trust, or trade or business in financial instruments or commodities, e.g. earnings from a passive interest in a partnership is subject to the tax. 3. net gains attributable to the disposition of property other than property held in a trade or business that is not a passive activity or trading business, e.g. gains from the sale of partnership, gain on sale of a second property, or S corporation stock interests. For active traders, the determination of the activity being in financial instruments or commodities is made at the entity level that produced the income. Real estate professionals who participate more than 500 hours per year, for at least 5 of the last 10 years in the real estate rental activities considered passive, e.g. rental of real estate, will not be subject to net investment income tax. A tax grouping election option exists for business owners with new activities that are passive. The grouping feature permits passive activity interests e.g. equity ownership in a business that is passive, to be grouped with nonpassive or active participation interests. Talk with your tax advisor for specific rules relevant to your ownership interests. Examples of the applicable net investment income tax. Kaitlyn and her husband sell their principal residence they have resided in for the previous ten years for $1.3 million. Their cost basis is $700,000. The realized gain is $600,000. With IRC Section 121, $500,000 of the gain is exempt from the net investment income tax. With $125,000 of other passive income, their cumulative net investment income is $225,000. With a modified adjusted gross income of $300,000, they exceed the $250,000 in the amount of $50,000. Therefore, their net investment income tax is $50,000 * 3.8; or $1,900. Amos and his wife earn $850,000 from a passive investment in Jabbe Farms. With a modified adjusted gross income of $2m from additional active participation business activities, the net investment tax on the $850,000 is say $22,000. If Amos’ CPA had grouped the activities of the passive investment with his active business interests the first year, it would result in $22,000 of tax savings. Net investment income tax is a relatively new area of the tax code. For certain taxpayers, trusts, and estates subject to this 3.8% additional tax,  proper tax planning is important to appropriately minimize the additional tax effects. Talk with your tax advisor; and talk before making any tax decisions should you be in a position where your taxable earnings may subject you to the net investment income tax to obtain proactive answers to your important tax questions and appropriate tax advice.