Question: In a previous article, you listed some new income taxes that will hit higher income taxpayers especially hard starting this year. One of those taxes is an additional 3.8% surtax on investment income. Most of my income comes from investments, including rental income, dividends, and capital gains. How do I know if I will have to pay the new tax?
Answer: The tax you are referring to is the Net Investment Income Tax, or NIIT. This new federal tax went into effect on January 1, 2013 but most taxpayers won’t feel its impact until they file their tax returns in April 2014. The NIIT is a 3.8% surtax on certain net investment income of individuals, estates, and trusts with income over income limits mandated by Congress. Special rules apply to income from Charitable Remainder Trusts.
For married individuals like yourself, the tax applies if you have NIIT and if your modified adjusted gross income exceeds $250,000. For single filers, the threshold is $200,000. Estates and trusts are subject to the NIIT if they have undistributed net investment income and are in the highest tax bracket (39.6%) and kicks in when the entity’s adjusted gross income exceeds $11,950 in 2013.
Question: What investment income is subject to this new 3.8% tax?
Answer: The NIIT applies to income from interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities, and businesses that are passive activities to you.
Question: What kinds of gains are covered by NIIT?
Answer: The surtax applies to gains from the sale of stocks, bonds, mutual funds and capital gains distributions from mutual funds. You will also pay the surtax on gains from the sale of real estate and gains from the sale of interests in partnerships and S Corporations if you were a passive owner.
Question: Does NIIT apply to the sale of my personal residence?
Answer: Yes, it applies to the amount that you would have to pay tax on after you subtract any excludable amount of gains you may be eligible for. The exclusion amounts for eligible homeowners are $500,000 if you are filing your tax return as married filing jointly and $250,000 if you are filing as single.
Question: Can I deduct my investment expenses?
Answer: Yes, the surtax only applies to the net investment income, which is your gross investment income less any related expenses. Such expenses 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.
Question: What types of income are not subject to NIIT.
Answer: Wages, unemployment compensation, income from operating a non-passive business, Social Security benefits, alimony, tax-exempt interest such as most municipal bond interest, self-employment income, and distributions from most retirement plans are not subject to NIIT.
Question: How do I report and pay the NIIT?
Answer: You must report your net investment income on your IRS Form 1040 annual income tax return and pay the tax along with your other taxes. The IRS has developed a new form, Form 8960, to report your NIIT with your Form 1040.
Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning. Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.