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Net Investment Tax in 2013

Starting in 2013 high income taxpayers [whose income is at or above $200,000] may be subject to two new Medicare taxes which consist of a 0.9% tax on earned income and self-employment income, and a 3.8% tax on net investment income.

The additional .9% tax applies to wage and self-employment income when income from these sources exceeds the threshold amount in table 1.

The additional 3.8% tax applies to the lesser of net investment income or the Modified Adjusted Gross income over the threshold amount in Table 1, below:

Table 1 – High Income Thresholds
Single $ 200,000 Not adjusted for inflation
Married Filing Joint $ 250,000 Not adjusted for inflation
Married Filing Separate $ 125,000 Not adjusted for inflation
Estates and Trust $ 11,950 Adjusted for inflation

Modified adjusted gross income is defined as adjusted gross income as shown on IRS Form 1040 line 37 plus net foreign earned income excluded plus or minus certain foreign income from Controlled Foreign Corporation’s and Qualified Electing Funds.

Investment income must be broken out into one of three categories listed below. Losses in one category do not offset gains in another category.

3.8% Net Investment Income tax
IRS CategoryType of IncomeSubject to NOL carryover/carryback
1 Interest, dividends, annuity distributions (income portion), rents, royalties (unless trade or business) NO, could be negative as NII is reduced by expenses
2 Passive Activity Income from a trade or business (generally a limited partner cannot be a material participant unless meeting the 500 hour material participation test, then income will avoid NII tax) NO, could be negative if disposing of activity with suspended loss
3 Net Capital Gain from Disposition of Property not used in trade or business  (not material participant) Yes
Not subject to 3.8% Net Investment Income tax
  Salary, wages, bonuses, Self-employment income, Distributions from IRA’s or qualified plans, Gains on the sale of an active interest in Partnerships or S Corps, Tax exempt income (i.e. muni bond interest, capital gains under 121), social security benefits, personal services on a non-recurring basis (i.e. executor of family estate)  

Income from a trade or business that is from passive activities under IRC § 469 will be subject to net investment tax as category 2 income.  In general, IRC § 469 defines passive activity as an activity in which the taxpayer does not materially participate. Material participation means the taxpayer is regularly, continuously, and substantially involved in the business operations.  Once passive activities have been grouped together they cannot be regrouped in later years. A special one-time “fresh start” rule applies after 12/31/12 to regroup passive activities for the purpose of net investment tax.

  • Rental real estate activities are treated as passive activities unless the taxpayer is deemed a real estate professional, and even if the taxpayer is a real estate professional those activities must constitute an actual trade or business under IRC §162.  If the taxpayer meets these requirements they would avoid the net investment tax.
  • Income from the use of tangible personal property  will generally be deemed rental property and treated as passive unless those activities constitute an actual trade or business under IRC §162.  If the taxpayer meets these requirements they would avoid the net investment tax.
  • Any income or net gain from the investment of working capital will not be subject to the net investment tax.

Disposing of Partnership or S Corp Interest may not be taxable for net investment tax if you meet certain exceptions:

  • The trade or business must not be in the business of trading in financial instruments or commodities under § 475(e) (2).
  • The taxpayer must be engaged in at least one trade or business of the Partnership or S-Corporation under IRC §162.

Trust and Estates may also be subject to the net investment tax, if income is accumulated in the trust or estate then it is taxed to the trust or estate. If the income is distributed to the beneficiaries then trust or estate gets an income distribution deduction and the beneficiaries have taxable income.

  • Net investment tax applies to the lesser of Undistributed net investment income or the excess adjusted gross income over the threshold in table 1
  • Charitable remainder trust are not subject to net investment tax
  • Grantor trust are not subject to net investment tax but income distributed may be
  • Foreign estates are not subject to net investment tax

CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by the United States Treasury Department, you are hereby informed that any tax advice contained in this written or electronic communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code or any governmental taxing authority or agency. This advice may not be forwarded without our express written consent.  Securities and Advisory Services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. Fixed insurance products and services, as well as tax services, offered by Summit Financial Strategies, Inc. are separate and unrelated to Commonwealth.