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Understanding the Net Investment Income Tax: Calculation and Examples

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In last week’s blog, the first in a two-part series, we discussed the new Net Investment Income Tax (NIIT) which became effective on January 1, 2013 and must be paid by those affected this April. As promised, in this post we look at the specific steps involved in its calculation, and consider a few examples to illustrate how it works. 

Steps to Calculate the NIIT

Here are the steps involved in the calculating this tax. It should be noted that step four can be found in last week’s post. 

Step 1) Determine total Investment Income

Step 2) Determine investment expenses allocable to Investment Income

Step 3) Determine Net Investment Income (Subtract Step 2 from Step 1) 

Step 4) Determine Modified Adjusted Gross Income (MAGI)

Step 5) Select applicable threshold

Step 6) Determine the amount of MAGI which exceeds the applicable threshold (Subtract Step 5 from Step 4) 

Step 7) Determine the lesser of Step 3 and Step 6 

Step 6) Multiply Step 7 by 3.8% 

That’s the basic formula. If you’d like more details, refer to IRS Form 8960 and the corresponding instructions.

Thresholds and Examples

I’ve included the applicable thresholds from last week’s post for your convenience. As mentioned, they are not indexed for inflation.

Click to enlargeConsider a single filer with wages of $150,000 and dividends plus capital gains equal to $35,000. His MAGI is $185,000. Since this is less than the threshold for a single filer ($200,000), he is not subject to the NIIT.Example One

Example Two

Assume a single filer with wages of $180,000 and Net Investment Income of $100,000. His MAGI is $280,000 which exceeds the applicable threshold by $80,000 ($280,000 – $200,000). The lesser of his Net Investment Income ($100,000) and the amount that his MAGI exceeds the applicable threshold ($280,000 – $200,000) is $80,000. Therefore, his NIIT would be $3,040 ($80,000 x 3.8%).

Last week we mentioned that the sale of a personal residence could also trigger this tax. Let’s look at an example where this might occur. 

Example Three (Sale of Personal Residence)

Assume a single filer with wages of $60,000 who sold his personal residence for $750,000 in 2013. His basis in the home was $300,000. Therefore, his total gain from the sale would be $450,000 ($750,000 – $300,000). However, under Section 121, $250,000 of the sale is exempt from capital gains, leaving $200,000 exposed. His MAGI would be $260,000 ($60,000 + $200,000). Since his MAGI exceeds the applicable threshold, and, he has Net Investment Income, he is subject to the NIIT. Again, the NIIT is calculated on the lesser of: 

a) the amount by which his MAGI exceeds the applicable threshold ($60,000); or

b) his Net Investment Income ($200,000). 

Hence, his NIIT would be $2,280 ($60,000 x 3.8%). However, he will also owe capital gains tax on the exposed profit from the sale of his residence ($200,000). Therefore, he will owe an additional $30,000 in capital gains tax ($200,000 x 15%). 

Summary (and an Opinion)

That’s how the NIIT works. A tax which targets a specific activity has the potential to reduce the amount of the activity. In this case, the NIIT targets dividends, interest, capital gains and, in some cases, the profit from the sale of a personal residence. As such, it is another headwind in the fight to achieve economic growth.

For more tax planning advice, see our special report, 21 Days of Tax Planning Advice for 2014.