Starting in 2013, some taxpayers will be dealing with a new tax on net investment income. This new tax is a surtax that is calculated separately from income tax, much like alternative minimum tax.
The surtax applies only to individual taxpayers with net investment income and modified adjusted gross income over the thresholds listed below.
Married Filing Jointly: $250,000
Married Filing Separately: $125,000
Modified adjusted gross income will be the same as adjusted gross income except for taxpayers who are living overseas and excluding foreign income. Expatriates and individuals using the foreign earned income exclusion will need to increase their adjusted gross income by the excluded amounts in order to calculate their modified adjusted gross income. Taxpayers can locate their adjusted gross income on form 1040 line 38.
The surtax only applies to net investment income, so taxpayers without net investment income will not be subjected to the surtax regardless of their adjusted gross income. Therefore, a single taxpayer who has income only from wages of $1,500,000 will not be subject to the surtax since they have no net investment income.
Net investment income is the sum of three different categories of income and deductions. Each category of income is isolated so taxpayers are unable to offset gains in one category with losses in another category.
This category includes all interest, dividends, annuities, royalties, and rents (rents that are not from a trade or business). This also includes interest, dividends, and royalties that are passed through to a taxpayer on their K-1s from a trade or business. Interest, dividends, and royalties from investment partnerships and hedge funds are also included in the category. Currently, all interest, dividends, and royalties from investment partnerships and hedge funds will be included regardless of whether they are classified as conducting a trade or business.
Common deductions for Category 1 income are investment interest expense, investment expense, and allocated state income tax. These expenses can be deducted from the category 1 income but only to the extent they are allowable as a deduction in the current year. This is where the process gets complicated, but in summary these deductions will be limited by factors such as the investment interest expense limitation, the 2 % floor on miscellaneous itemized deductions, and the resurrected Pease limitation that limits a number of itemized deductions. Apportioning the allowable deductions to net investment income is complex and beyond the scope of this article, but taxpayers and preparers should not blindly rely on their tax software to calculate it since this is a brand new tax, and software bugs should be expected.
The second category is for passive income that is not already included in the first and last category. This category would include income from a trade or business that the taxpayer does not materially participate in. Income that a limited partner is allocated from a partnership that runs restaurants would be included in this category. Similarly, income allocated to a member of a member-managed limited liability company who does not materially participate would be included in this category.
Taxpayers can deduct current and prior year disallowed passive losses when calculating category 2 income, but passive losses that are converted into ordinary losses when a taxpayer terminates their interest in the passive activity cannot be used to offset passive income.
The third category includes gains from dispositions of property such as gains from stocks, options, commodities, real estate, and other property not used in a trade or business.
Deductions for current and prior year capital losses, investment interest expenses, investment expenses, and allocated state income tax can be deducted, but just like deductions in category 1, the deductions must be allowed as an income tax deduction plus properly apportioned.
A taxpayer’s net investment income would be the sum of all three categories if they have positive income. Therefore, if a taxpayer had $100,000 in interest income, ($100,000) in passive losses, and $50,000 in capital gains and no deductions, their net investment income would be $150,000. The passive losses cannot be used to offset the interest income or capital gains.
Calculating the Tax
Once a taxpayer has determined their net investment income, they can calculate their 3.8% surtax. The 3.8% surtax only applies to the lessor of net investment income or the amount that the taxpayer’s adjusted gross income exceeds the limit. If a single taxpayer had $300,000 of interest income with no deductions, their net investment income would be $300,000, but their adjusted gross income would only exceed the limit by $100,000 ($300,000-$200,000), so the 3.8% surtax would be applied only to the lessor of the two, $100,000.
Tom is single and has the following income for 2013: wages of $195,000, interest income of $15,000, passive income of $8,000, and capital losses of ($25,000). Tom also incurred interest expenses and investment expenses of $3,000 and $4,000.
Tom’s adjusted gross income would be $215,000 (195k+15k+8k-3k for allowed capital loss). His net investment income for the year would be $20,000 (15k+8k-3k interest expense). The surtax of 3.8% is applied on the lessor of net investment income or the amount that the taxpayer’s adjusted gross income exceeds the limit, and in this case that limit would be $200,000 for a single taxpayer. Tom’s adjusted gross income exceeds the limit by $15,000 (215k-200k limit), and his net investment income is $20,000, therefore Tom would pay the 3.8% surtax on $15,000 for a net investment tax of $570.
Many taxpayers will be surprised by this new tax in April, and those taxpayers affected by the new surtax should reevaluate their estimated tax payments and see if increases might be necessary. Also, the complexities in apportioning the allowable deduction for net investment income may deter many taxpayers and preparers from taking deductions against net investment income.