Don’t Forget About the 3.8% Tax on Net Investment Income

January 8, 2013

In all of the discussion about the fiscal cliff and the change in income tax rates beginning in 2013, it is important not to lose sight of the additional 3.8% tax on net investment income, which was passed as part of the Affordable Care Act and which is likely to affect more taxpayers than the rate change.

Over the last several years, there has been some misinformation circulating, especially on the internet, about the 3.8% tax, including claims that it is a sales tax on real estate and the like. The IRS itself posted an article on its website explaining that these claims were false. It is, in fact, an income tax provision, and any additional tax will be reported and collected on individual and trust income tax returns starting in the year 2013.

The tax has a threshold measured by modified adjusted gross income of $250,000 for a joint return and $200,000 for a single return. The modifications are minor so this is almost always income on a tax return prior to any deductions or personal exemptions. Contrast this to the new income tax rate which applies to $450,000 of taxable income for a joint return and $400,000 of taxable income for a single taxpayer (income after deductions and exemptions), and the reduction of itemized deductions and personal exemptions for adjusted gross income of $300,000 on a joint return and $250,000 for a single taxpayer.

The 3.8% tax applies only to “net investment income,” not to wages, IRA distributions or business income. Wages, IRA distributions and business income count for purposes of determining whether the $250,000/$200,000 threshold is passed, but not for calculating the tax. A taxpayer with no net investment income will never owe the 3.8% tax, no matter what their income.

Included in net investment income are interest and dividends, although exempt municipal interest is excluded, and rents, royalties and capital gains unless derived from an active trade or business. Retirement plan and IRA distributions are not included as net investment income for purposes of the tax. Gains from the sale of a vacation home and gain from the sale of a personal residence in excess of the $500,000/$250,000 (joint/individual returns) exclusion are subject to the tax. There will be no withholding for the tax, but it will be included for calculating penalties for inadequate withholding or estimated tax payments, so taxpayers expecting to be subject to the tax may want to adjust their withholding or estimated payments.

The IRS issued proposed regulations on November 30, 2012 which will not be effective until January 1, 2014, although taxpayers can rely on them in 2013. How to plan for this additional tax will be a function of the level of income, whether that income is passive or not passive and whether a taxpayer has reached the social security earnings limit. Small business owners with pass-through entities such as LLCs or subchapter S corporations need to review how their businesses are organized and operated before we get too far into 2013.