The Basics of the 3.8% Surtax on Net Investment Income

Although Congress passed legislation extending many of the Bush tax cuts, the new 3.8% surtax on net investment income and gains imposed by The Patient Protection and Affordable Care Act (“Obamacare”) remains in effect. This Net Investment Income Tax (NIIT) applies to individuals, estates, and trusts that have income above the statutory threshold amounts. The NIIT went into effect on January 1, 2013, and it will affect income tax returns of individuals, estates, and trusts for tax years beginning on or after January 1, 2013.

If an individual taxpayer has net investment income and has a modified adjusted gross income (MAGI) over the thresholds below, they will owe the tax:

Modified adjusted gross income is a taxpayer’s normal adjusted gross income (line 37 from Form 1040) plus any amount excluded as foreign earned income under Code Sec. 911(a)(1). For most taxpayers, this amount will be equivalent to their normal adjusted gross income from line 37. A taxpayer who does not have any net investment income or whose modified adjusted gross income does not exceed the above thresholds will not be subject to the 3.8% NIIT.

Estates and trusts will be subject to the NIIT if they have undistributed net investment income and also have adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins for that year (e.g. for tax year 2012, this threshold amount is $11,650)

To better understand this new surtax, it’s imperative to know what’s included in net investment income. In general, investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from business involved in trading of financial instruments or commodities, and businesses that are considered passive activities to the taxpayer. Any gain on the sale of a personal residence that is excluded from regular tax under Code Sec. 121 is also excluded from the NIIT; but if the gain exceeds the exemption amounts ($250,000 for single, $500,000 for married filing jointly), the excess is also net investment income and thus subject to the 3.8% surtax.

Some common types of income that are not net investment income, and thus not subject to this surtax are: wages, unemployment compensation, operating income from a non-passive business, social security benefits, alimony, tax exempt interest, self-employment income, and distributions from certain qualified retirement plans, such as 401(k)s and IRAs.

To calculate net investment income subject to the 3.8% tax, the income items discussed above are combined to arrive at gross investment income, and that amount is reduced by deductions that are allocable to those investment income items. Examples of properly allocable deductions include investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes properly allocable to items included in net investment income.

The amount of net investment income actually subject to the 3.8% tax is based on the lesser of the amount the taxpayer’s modified adjusted gross income exceeds their threshold amount or their net investment income. So if if a single taxpayer has $50,000 of net investment income and has a modified adjusted gross income of $220,000 only $20,000 of the $50,000 net investment income is subject to the surtax.

If that taxpayer’s MAGI had been $250,001, the entire $50,000 of net investment income would have been subject to the 3.8% surtax.

For additional information, a Q&A issued to address many FAQs regarding the 3.8% surtax (Q&A for Net Investment Income Tax). Should you have any questions related to this topic, feel free to contact your Keiter Opportunity Advisor.