Basics of the Net Investment Income Tax (NIIT)
The Net Investment Income Tax is imposed by section 1411 of the Internal Revenue Code. The NIIT applies at a rate of 3.8% to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts.
The Net Investment Income Tax went into effect on Jan. 1, 2013. The NIIT affects income tax returns of individuals, estates and trusts, beginning with their first tax year beginning on (or after) Jan. 1, 2013. It does not affect income tax returns for the 2012 taxable year filed in 2013.
Individuals who are subject to the Net Investment Income Tax
Individuals will owe the tax if they have Net Investment Income and also have modified adjusted gross income over the following thresholds:
|Married filing jointly
|Married filing separately
|Head of household (with qualifying person)
|Qualifying widow(er) with dependent child
Taxpayers should be aware that these threshold amounts are not indexed for inflation.
If you are an individual who is exempt from Medicare taxes, you still may be subject to the Net Investment Income Tax if you have Net Investment Income and also have modified adjusted gross income over the applicable thresholds.
For the purpose of the Net Investment Income Tax, the modified adjusted gross income is the adjusted gross income (Form 1040, Line 37), increased by the difference between amounts excluded from gross income under section 911(a)(1) and the amount of any deductions (taken into account in computing adjusted gross income) or exclusions disallowed under section 911(d)(6) for amounts described in section 911(a)(1). In the case of taxpayers with income from controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs), they may have additional adjustments to their AGI. See section 1.1411-10(e) of the final regulations.
Individuals who are not subject to the Net Investment Income Tax
Nonresident Aliens (NRAs) are not subject to the Net Investment Income Tax. If an NRA is married to a U.S. citizen or resident and has made, or is planning to make, an election under section 6013(g) or 6013(h) to be treated as a resident alien for purposes of filing as Married Filing Jointly, the final regulations provide these couples special rules and a corresponding section 6013(g)/(h) election for the NIIT.
A dual-resident individual, within the meaning of regulation §301.7701(b)-7(a)(1), who determines that he or she is a resident of a foreign country for tax purposes pursuant to an income tax treaty between the United States and that foreign country and claims benefits of the treaty as a nonresident of the United States is considered a NRA for purposes of the NIIT.
A dual-status individual, who is a resident of the United States for part of the year and a NRA for the other part of the year, is subject to the NIIT only with respect to the portion of the year during which the individual is a United States resident. The threshold amount (described in # 3 above) is not reduced or prorated for a dual-status resident.
Estates and trusts might also be subject to the Net Investment Income Tax
Estates and trusts are subject to the Net Investment Income Tax 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 such taxable year under section 1(e) (for tax year 2013, this threshold amount is $11,950). Generally, the threshold amount for the upcoming year is updated by IRS each fall in a revenue procedure. For 2014, the threshold amount is $12,150 (See Rev. Proc. 2013-35).
There are special computational rules for certain unique types of trusts, such as Qualified Funeral Trusts, Charitable Remainder Trusts and Electing Small Business Trusts, which can be found in the final regulations (see # 20 below).
Estates and trusts that are not subject to the Net Investment Income Tax
The following trusts are not subject to the Net Investment Income Tax:
- Trusts that are exempt from income taxes imposed by Subtitle A of the Internal Revenue Code (e.g., charitable trusts and qualified retirement plan trusts exempt from tax under section 501, and Charitable Remainder Trusts exempt from tax under section 664).
- A trust or decedent’s estate in which all of the unexpired interests are devoted to one or more of the purposes described in section 170(c)(2)(B).
- Trusts that are classified as “grantor trusts” under sections 671-679.
- Trusts that are not classified as “trusts” for federal income tax purposes (e.g., Real Estate Investment Trusts and Common Trust Funds).
- Electing Alaska Native Settlement Trusts.
- Perpetual Care (Cemetery) Trusts.
Net Investment Income includes the following:
In general, investment income includes, but is not limited to: 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 the taxpayer (within the meaning of section 469). To calculate your Net Investment Income, your investment income is reduced by certain expenses properly allocable to the income (see #13 below).
Types of income that are not Net Investment Income
Wages, unemployment compensation; operating income from a nonpassive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent Fund Dividends (see Rev. Rul. 90-56, 1990-2 CB 102) and distributions from certain Qualified Plans (those described in sections 401(a), 403(a), 403(b), 408, 408A or 457(b)).
Gains that are included in Net Investment Income
To the extent that gains are not otherwise offset by capital losses, the following gains are common examples of items taken into account in computing Net Investment Income:
- Gains from the sale of stocks, bonds, and mutual funds.
- Capital gain distributions from mutual funds.
- Gain from the sale of investment real estate (including gain from the sale of a second home that is not a primary residence).
- Gains from the sale of interests in partnerships and S corporations (to the extent the partner or shareholder was a passive owner). See section 1.1411-7 of the 2013 proposed regulations.
The Net Investment Income Tax does not apply to any amount of gain that is excluded from gross income for regular income tax purposes.
The pre-existing statutory exclusion in section 121 exempts the first $250,000 ($500,000 in the case of a married couple) of gain recognized on the sale of a principal residence from gross income for regular income tax purposes and, thus, from the NIIT.
Example 1: A, a single filer, earns $210,000 in wages and sells his principal residence that he has owned and resided in for the last 10 years for $420,000. A’s cost basis in the home is $200,000. A’s realized gain on the sale is $220,000. Under section 121, A may exclude up to $250,000 of gain on the sale. Because this gain is excluded for regular income tax purposes, it is also excluded for purposes of determining Net Investment Income. In this example, the Net Investment Income Tax does not apply to the gain from the sale of A’s home.
Example 2: B and C, a married couple filing jointly, sell their principal residence that they have owned and resided in for the last 10 years for $1.3 million. B and C’s cost basis in the home is $700,000. B and C’s realized gain on the sale is $600,000. The recognized gain subject to regular income taxes is $100,000 ($600,000 realized gain less the $500,000 section 121 exclusion). B and C have $125,000 of other Net Investment Income, which brings B and C’s total Net Investment Income to $225,000. B and C’s modified adjusted gross income is $300,000 and exceeds the threshold amount of $250,000 by $50,000. B and C are subject to NIIT on the lesser of $225,000 (B’s Net Investment Income) or $50,000 (the amount B and C’s modified adjusted gross income exceeds the $250,000 married filing jointly threshold). B and C owe Net Investment Income Tax of $1,900 ($50,000 X 3.8%).
Example 3: D, a single filer, earns $45,000 in wages and sells her principal residence that she has owned and resided in for the last 10 years for $1 million. D’s cost basis in the home is $600,000. D’s realized gain on the sale is $400,000. The recognized gain subject to regular income taxes is $150,000 ($400,000 realized gain less the $250,000 section 121 exclusion), which is also Net Investment Income. D’s modified adjusted gross income is $195,000. Since D’s modified adjusted gross income is below the threshold amount of $200,000, D does not owe any Net Investment Income Tax.
Net Investment Income includes interest, dividends and capital gains of children that are reported on the parents Form 1040 (Form 8814)
The amounts of Net Investment Income that are included on your Form 1040 by reason of Form 8814 are included in calculating your Net Investment Income. However, the calculation of your Net Investment Income does not include (a) amounts excluded from your Form 1040 due to the threshold amounts on Form 8814 and (b) amounts attributable to Alaska Permanent Fund Dividends.
Deductible investment expenses in computing NII
In order to arrive at Net Investment Income, Gross Investment Income (items described in items 7-11 above) is reduced by deductions that are properly allocable to items of Gross Investment Income. Examples of deductions, a portion of which may be properly allocable to Gross Investment Income, include investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, tax preparation fees, fiduciary expenses (in the case of an estate or trust) and state and local income taxes.
You may be subject to both the 3.8% Net Investment Income Tax and the additional .9% Medicare taxes, but not on the same type of income.
The 0.9% Additional Medicare Tax applies to individuals’ wages, compensation and self-employment income over certain thresholds, but it does not apply to income items included in Net Investment Income. See more information on the Additional Medicare Tax.
How the Net Investment Income Tax is Reported and Paid
Individuals, estates, and trusts will use Form 8960 to compute their Net Investment Income Tax.
For individuals, the tax will be reported on, and paid with, the Form 1040. For estates and trusts, the tax will be reported on, and paid with, the Form 1041.
The Net Investment Income Tax is subject to the estimated tax provisions
Individuals, estates and trusts that expect to be subject to the tax in 2013 or thereafter should adjust their income tax withholding or estimated payments to account for the tax increase in order to avoid underpayment penalties. For more information on tax withholding and estimated tax, see Publication 505, Tax withholding and Estimated Tax.
Tax credits may reduce the NIIT liability
Any federal income tax credit that may be used to offset a tax liability imposed by subtitle A of the Code may be used to offset the NII. However, if the tax credit is allowed only against the tax imposed by chapter 1 of the Code (regular income tax), those credits may not reduce the NIIT. For example, foreign income tax credits (sections 27(a) and 901(a)) and the general business credit (section 38) are allowed as credits only against the tax imposed by chapter 1 of the Code, and therefore may not be used to reduce your NIIT liability. If you take foreign income taxes as an income tax deduction (versus a tax credit), some (or all) of the deduction amount may deducted against NII.
The NIIT tax does not have to be withheld from wages, but you may request that additional income tax be withheld from your wages.
Examples of the Calculation of the Net Investment Income Tax
a. Single taxpayer with income less than the statutory threshold.
Taxpayer, a single filer, has wages of $180,000 and $15,000 of dividends and capital gains. Taxpayer’s modified adjusted gross income is $195,000, which is less than the $200,000 statutory threshold. Taxpayer is not subject to the Net Investment Income Tax.
b. Single taxpayer with income greater than the statutory threshold.
Taxpayer, a single filer, has $180,000 of wages. Taxpayer also received $90,000 from a passive partnership interest, which is considered Net Investment Income. Taxpayer’s modified adjusted gross income is $270,000.
Taxpayer’s modified adjusted gross income exceeds the threshold of $200,000 for single taxpayers by $70,000. Taxpayer’s Net Investment Income is $90,000.
The Net Investment Income Tax is based on the lesser of $70,000 (the amount that Taxpayer’s modified adjusted gross income exceeds the $200,000 threshold) or $90,000 (Taxpayer’s Net Investment Income). Taxpayer owes NIIT of $2,660 ($70,000 x 3.8%).
Additional information about the Net Investment Income Tax
You can find additional information about the NIIT in the 2013 final regulations and in a new 2013 proposed regulation published on Dec. 2, 2013.
For taxable years beginning before Jan. 1, 2014 (e.g., calendar year 2013), taxpayers may rely on the 2012 proposed regulations (published on Dec. 5, 2012), the 2013 proposed regulations (published on Dec. 2, 2013), or the 2013 final regulations (published on Dec. 2, 2013) for purposes of completing Form 8960. However, to the extent that taxpayers take a position in a taxable year beginning before Jan. 1, 2014 that is inconsistent with the final regulations, and such position affects the treatment of one or more items in a taxable year beginning after Dec. 31, 2013, then such taxpayer must make reasonable adjustments to ensure that their Net Investment Income Tax liability in the taxable years beginning after Dec. 31, 2013 is not inappropriately distorted. For example, reasonable adjustments may be required to ensure that no item of income or deduction is taken into account in computing net investment income more than once, and that carryforwards, basis adjustments and other similar items are adjusted appropriately.