Bulletins

New 3.8% Medicare Tax on Net Investment Income

by Dennis W. Donnelly, CPA, PFS

Dear clients and friends,

The IRS has issued much-needed guidance on the new 3.8% Medicare tax on net investment income. The guidance comes in the form of proposed reliance regulations (which means taxpayers can rely on them until further notice) and some FAQs (which are posted on the IRS website). For purposes of our analysis, we will adopt the IRS terminology and call the new tax the Net Investment Income Tax, or NIIT. The NIIT was established by IRS Sec. 1411, and it is effective for tax years beginning on or after 1/1/13.

Impact on Individual Taxpayers

An individual taxpayer won't be hit with the 3.8% NIIT unless his or her Modified Adjusted Gross Income (MAGI) exceeds:

  • $200,000 for an unmarried taxpayer.
  • $250,000 for a married joint-filing couple or a qualifying widow or widower.
  • $125,000 for those who use married filing separate status
  • These MAGI thresholds will not be adjusted for inflation in post-2013 years.

Impact on Trusts and Estates

Trusts and estates can also be hit with the 3.8% NIIT. For trusts and estates, the NIIT applies to the lesser of: (1) the trust's or estate's undistributed net investment income or (2) the trust's or estate's AGI in excess of the threshold for the top trust federal income tax bracket. (See FAQs 5 and 6.) For 20l3, that threshold is only $11,950. Due to this low threshold, many trusts and estates will no doubt be affected this year. Special rules apply to certain types of trusts such as electing small business trusts.

Gains from Selling Personal Residences

Gain from selling a principal residence is federal income taxfree to the extent of the allowable Section 121 home sale gain exclusion (up to $250,000 for an unmarried taxpayer and up to $500,000 for a married joint-filing couple). Such tax-free principal residence gains are exempt from the NIIT. However, to the extent a principal residence gain exceeds the exclusion, the excess is considered investment income that is potentially subject to the NIIT. Gain from selling a vacation property is also considered investment income that is potentially subject to the NIIT.

Exempt Income Categories

The following categories of income are exempt from the NIIT:

  • Wages and self-employment income.
  • Operating income from non-passive business activities.
  • Distributions from tax-favored retirement accounts such as 401(k) plans, pension plans, traditional IRAs, and Roth IRAs.
  • Social Security benefits.
  • Tax-exempt interest, unemployment compensation, alimony, and Alaska Permanent Fund Dividends.

Also, any gain that is not recognized for income tax purposes for a tax year (e.g., because of the like-kind exchange, installment sale, or involuntary conversion rules) is not recognized for NIIT purposes that year. Instead it is recognized for NIIT purposes in the same year it's recognized for income tax purposes.

Business Gains and Income May or May Not Be Exempt

In general, gains from selling assets used in a business in which the taxpayer materially participates are outside the definition of net investment income and are therefore exempt from the NIIT. As indicated earlier, an unfavorable exception to the preceding general rule applies to gains from the business of trading in financial instruments or commodities. Such gains are included in the definition of net investment income-whether the taxpayer materially participates or not-and therefore are potentially subject to the NIIT. Income from dividends, interest, rents, royalties, and annuities earned in the ordinary course of a business in which the taxpayer materially participates are also outside the definition of net investment income and are therefore exempt from the NIIT. However, gains and income attributable to a passive business activity, such as a partnership or S corporation in which the taxpayer does not materially participate, are potentially subject to the NIIT.

Here are some general examples that illustrate how the NIIT can affect individual taxpayers:

Example 1: In 2013, Bailey files as an unmarried individual. She has $300,000 of MAGI, which includes $90,000 of net investment income. She owes the 3.8% NIIT on all of her net investment income (the lesser of her excess MAGI of $100,000 or her net investment income of $90,000).

Example 2: In 2013, Clyde and Carol file jointly. They have $300,000 of MAGI, which includes $110,000 of net investment income. They only owe the 3.8% NIIT on $50,000 (the lesser of their excess MAGI of $50,000 or their net investment income of $110,000).

Example 3: In 2013, Danny files as an unmarried individual. He has $199,000 of MAGI. He is completely exempt from the 3.8% NIIT because his MAGI is below the $200,000 threshold for unmarried individuals. Therefore, it doesn't matter how much net investment income he has.

Example 4: In 2013, Eunace and Ernie file jointly. They have $249,000 of MAGI. They are completely exempt from the 3.8% NIIT because their MAGI is below the $250,000 threshold for joint filers. Therefore, it doesn't matter how much net investment income they have.

This article has just scratched the surface of the issues to be considered in dealing with this new tax. Stay tuned for more informative articles on this subject in future months. Feel free to give us a call if you would like a more in depth discussion of your unique situation.

Very truly yours,

Dennis W. Donnelly, CPA, PFS
Daniel A. Kosmatka, CPA, PFS, CFF, CGMA
Michael R. Gohde, CPA, PFS