Net Investment Income Tax – What You Don’t Know Will Cost You

Overview – Patient Protection and Affordable Care Act

Many individuals, estates and trusts will be facing new taxes this year.

Beginning January 1, 2013, a 3.8 percent surtax will apply to reported excess net investment income.  Called the Net Investment Income Tax (“NIIT”) and enacted under the 2010-year Patient Protection and Affordable Care Act (“Act”), this new tax has a simple foundation, but complicated rules.  Proposed regulations issued late last year address many areas, but leave a lot to be desired; several concerns remain unaddressed and others are answered in a manner more complex than necessary.

This first article is an overview only.  The beginning point is to understand that only individuals, estates and trusts will be subject to the NIIT.  While business entities and most exempt entities will not be taxed, some will have additional reporting requirements.  Those subject to tax, will only owe the additional surtax if they report a that there is net investment income in an amount equal to the lesser of:  (1) the actual total net investment income or (2) the excess of taxpayer’s modified adjusted gross income (modified AGI) over a statutory threshold amount.[1]  For individuals, the threshold amount depends on their filing status and is as follows:


Filing StatusThreshold Amount
Married filing jointly (both spouses)$250,000
Married filing separately$125,000
Head of household (with qualifying person)$200,000
Qualifying widow(er) with dependent child$250,000


For estates and trusts, the threshold amount is the beginning dollar bracket amount for highest estate/trust income tax rate.  For example, in 2013, that number is $11,950 (the highest bracket beginning dollar amount).

A simple example may help to illustrate this point about AGI for an individual.

Example 1.  For the 2013-year, assume Husband and Wife, filing jointly, report on their personal income tax return:

  • Ÿ$100,000 of net investment income ($105,000 gross investment income minus the $5,000 portion of investor advisor fees excess of 2% itemized deduction limit) and
  • $280,000 of AGI, consisting of $105,000 of gross investment income and $145,000 in wages.

Based on the foregoing facts, the calculation of the 3.8% NIIT will be $1,140, based on 3.8% times the lesser of (i) $100,000 (net investment income (NII)) or (ii) the $30,000 (the result of subtracting from $280,000 AGI the applicable $250,000 statutory threshold amount.)

For planners, it is worth pointing out that while estates/trusts will have a threshold amount that will likely increase annually to reflect a rising dollar amount for the highest tax brackets due to CPI adjustments, for individuals, the threshold amount will not change; as inflation occurs more and more taxpayers will annually become subject to the net investment income tax.

This leads us to the next question of what is “Net Investment Income?”

Net Investment Income

As a brief overview only, net investment income consists of any income that fits within one of the following four categories:

  1. Portfolio Income. Interest, dividends, annuities, royalties and rents (same as part of Section 163(d))
  2. Passive Activity Income. Trade or business which is a passive activity;
  3. Trading Income. All income from financial instruments/commodities trading;
  4. Disposition Income. All net gains (if included in taxable income), from the disposition of property not part of a trade or business.

Portfolio Income.  Category (1), Portfolio Income, is the simplest to describe.  Most already understand that portfolio income, includes under Section 163(d) of the Code and IRS publications interest, dividends, annuities and rents/royalties not subject to Section 469.  For example, portfolio income includes tax-exempt interest income from state and local bonds; but proposed regulations exempt that income from NIIT, if that income is also exempt for regular tax purposes.  Less expected, however, is that some rental income, as described below, will be included in net investment income as portfolio income.

Passive Trade or Business Income.  The second category, (2) a Trade or Business Which is a Passive Activity, is not so simple to describe.  Proposed regulations describe that Section 469 will not be followed if the regulations under Section 1411 differ in approach.

For example, it is the position of the Treasury is that the language of the statute adopted for net investment income tax does not expressly incorporate Code Section 469.  Therefore, while Section 469 deems a rental activity as a trade or business, for net investment income tax purposes this will not be presumed.  Rental activities must proven under Code Section 162 as to whether or not it is a “trade or business.”  If the rental activity involves merely an investment (and not a trade or business) then the rental activity will be treated as portfolio income, reportable under the first category, as (1) portfolio income.  Conversely, if the rental activity is proven to be a trade or business, then it will be presumed to be reported under Category (2), unless the taxpayer can demonstrate that he or she is both engaged in a real estate trade or business and the real estate business producing rental income is not passive.   In addition, there are several other instances where the Treasury will not follow Section 469.

Business Trading Income.  The third category, (3) Business Trading Income is very narrow.  Persons whose business it is to trade financial instruments and commodities – who are exempt from self-employment tax on their career income are to report their earnings based on the profit margins as net investment income.  The regulations make it clear that income by day traders are not covered – this separation is usually easy identified because of the special licensing requirements for professional traders.

Net Gains From Dispositions.  The fourth category, (4) Net Gains From Dispositions, is intended to capture tax net profits/gains on sales and other similar dispositions.  However, “net loss”, it is not reported and cannot be used to reduce other categories (1) through (3) of net investment income.

This fourth category has some fairly simple to understand items, and some more complicated ones.  “Dispositions” resulting in gain or loss are netted to determine if there is a “net gain”.  Dispositions include: “a [taxable] sale, exchange, transfer, conversion, cash settlement, cancellation, termination, lapse, expiration, or other disposition.”  Accordingly, many ordinary income items such as income from receipt of an option payment, upon the option’s expiration, is treated as investment income.  “Dispositions” also include losses under section 165, such as losses attributable to casualty, theft, and abandonment or other worthlessness.  Dispositions include also certain deemed dispositions, such as gain to a partner recognized due to an actual and or deemed distributions of cash from a partnership to a partner, if the distribution amount exceeds the partner’s tax basis.  On the other hand, the regulation recognize that exclusions and exemptions from regular tax, such as the $250,000/$500,000 home sale exclusion or Section 1031 exchange rules will exempt/exclude income from being included in net investment income.

While an intimate discussion of each of these rules is beyond the scope of this article, it is important to understand that the rules are complicated.  Some issues such as the treatment of “self-rental” income for taxpayers who rent property to a related (wholly owned) legal entity and how the IRS will treat cancellation of indebtedness income – i.e., whether it may represent (i) portfolio income or (ii) disposition income, remain unknown.  While in the next article, we will cover more, if there are any questions; our office is prepared to answer.

[1] As for most, AGI, as reported on line 31 will not be modified, we will simply say AGI.  (Only US citizens/permanent residents working abroad have modifications.)


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