Charting the New 3.8% Investment Tax Waters

As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.

The investment income tax is an additional 3.8 percent tax that is imposed upon the lesser of the following amounts:

(1) Net investment income; or

(2) The excess (if any) of (i) the taxpayer’s adjusted gross income (AGI) for the year over (ii) the applicable threshold amount.

The threshold amount for single taxpayers is $200,000. For married taxpayers filing a joint return, the threshold is increased to $250,000.

Example: Erica and Mickey are a married couple with earnings of $400,000 and net investment income equal to $125,000 for 2013. Their AGI, therefore, exceeds the threshold level for married taxpayers by $150,000. Because $125,000 is less than the $150,000 by which their income exceeds the threshold, the tax applies to all of their net investment income. In 2014, Erica and Mickey have earnings of only $300,000 and net investment income of $125,000. Because their AGI only exceeds the threshold by $50,000 in 2014, the tax applies to the $50,000 excess. Their $125,000 in net investment income is not subject to the tax in 2014.

Q: What is net investment income?

The investment income tax is a 3.8 percent tax on “net investment income” that is added to any tax that certain high income taxpayers would otherwise owe on such income. The tax applies for tax years beginning after December 31, 2012.

The tax is imposed on a taxpayer’s “net investment income” or a portion of the taxpayer’s adjusted gross income (AGI).  In general, net investment income encompasses income that is considered to be “unearned,” and is defined in IRC Section 1411 to include the sum of the following three categories of income:

(a) gross income from interest, dividends, annuities, rents and royalties that is not derived in the ordinary course of the taxpayer’s trade or business;

(b) income derived from a trade or business involving a passive activity of the taxpayer or trading in financial instruments or commodities; and

(c) net gain attributable to the disposition of property other than property held in a trade or business not described in (b), above.

“Substitute income” and “substitute dividends” are also included in net investment income under the proposed regulations, because, as explained in the preamble to the regulations, such income could otherwise be used to facilitate tax avoidance.

Though the IRC exempts income obtained in the ordinary course of a taxpayer’s trade or business, the investment income tax specifically does apply to trade or business income if the trade or business is considered to be a passive activity of the taxpayer or involves trading in financial instruments or commodities.

In some cases, the additional 3.8 percent tax can apply to a sale of the taxpayer’s primary residence; as such a sale would represent a disposition of property that is not held in the taxpayer’s trade or business. Further, income derived from a taxpayer’s passive activities, such as income generated from participation in a partnership, may be subject to the investment income tax.

Net investment income includes a trust beneficiary’s share of the trust’s distributable net income to the extent that the income is properly characterized as net investment income. Amounts received from Social Security, 401(k) plans, IRAs, pensions and similar retirement income sources are not included in net investment income.

Q: Who is liable for paying the investment income tax? 

For tax years beginning after December 31, 2012, a 3.8 percent tax must be added to the tax rates already in effect for certain investment-type income received by higher income taxpayers.

The 3.8 percent tax on net investment income applies for taxpayers with annual adjusted gross income (AGI) of more than $200,000 for single filers, $125,000 for married taxpayers filing separate returns or $250,000 for married couples filing jointly. Unlike many other threshold amounts, these thresholds are not indexed annually for inflation.

This 3.8 percent will be added to the rates currently in effect, increasing the capital gains and dividend tax rates for many taxpayers (the rate will increase from 20 percent to 23.8 percent for taxpayers in the 39.6 percent income tax bracket and from 15 percent to 18.8 percent for taxpayers in lower tax brackets). The tax applies both to individuals and to certain trusts and estates. Nonresident aliens are not subject to the tax. 

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