The 3.8% Tax on Net Investment Income

Greta Hicks
May 27, 2014 — 5,024 views  
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The Health Care and Education Reconciliation Act of 2010, P.L. 111-152, includes Internal Revenue Code (IRC) Sec. 1411, Unearned Income Medicare Contribution, which places an additional 3.8 percent tax on individuals, estates and trusts net investment income. Nonresident aliens are not subject to this new tax.

The new “Medicare” tax is equal to 3.8 percent applied to the lesser of net investment income or the amount by which modified adjusted gross income (MAGI) exceeds the threshold.

The MAGI thresholds are:    
Filing Status    MAGI in Excess of
Single Taxpayers    $200,000
Married Filing Jointly    $250,000
Married Filing Separately    $125,000

MAGI is adjusted gross income (AGI) with the foreign earned income exclusion or foreign housing exclusion added back in.

Net investment income includes:

  • Interest, dividends, annuities, royalties and rents, other than such income that is derived in the ordinary course of a trade or business, less allocable deductions.
  • Interest earned from idle cash-producing investment income.
  • Net income from a passive activity, whether it be rental or passive trade or business income. (A passive investor in
  • a trade or business housed within a sole proprietorship, limited liability company (LLC), partnership or S corporation would be subject to this tax.)
  • Pass-through income from a passive business such as S corporations and partnerships.

In addition, rents, after related deductions, are subject to the tax unless the rent is derived in the ordinary course of a trade or business. Net gain attributable to the disposition of property not held in an active trade or business is subject to the tax as is the net gain indirectly derived from disposition of S corporation stock or a partnership interest. Gains on the sale of a second home, vacation home and similar assets are taxed at 3.8 percent, as well as the taxable gain on the sale of a personal residence in excess of the Sec. 121 exclusion, currently $250K/$500K. Other examples include:

  • Income from nonqualified annuities. (See annuities below.)
  • Gains from trading in financial instruments or commodities.
  • Net income from a trade or business of trading in financial instruments or commodities. (Reg 1.1275-6(b)

(3), defining financial instruments as “a spot, forward, or future contract, an option, a notional principal contract, a debt instrument, or a similar instrument, or combination or series of financial instruments.” Code Section 731(c)(2)

(C) defines the term more broadly as including stocks and other equity investments and evidences of indebtedness.)

  • Any income, gain or loss attributable to an investment of working capital will be treated as not derived in the ordinary course of a trade or business.
  • All the above items that flow through a pass-through active trade or business.

Net investment income does not include distributions from qualified pensions; profit-sharing and stock bonus plans; qualified annuity plans; annuities purchased by Sec. 501(c)(3) organizations or public schools; individual retirement accounts; or Roth individual retirement accounts. In addition, net investment income does not apply to:

  • Eligible deferred compensation plans;
  • Tax-exempt interest;
  • Inside buildup of life insurance cash surrender value;
  • Life insurance proceeds;
  • Nontaxable veteran’s benefits;
  • Nontaxable portion of Section 1031 exchanges; or
  • Active business ownership within a sole proprietorship, LLC, partnership or S corporation.

The “Medicare” tax is not deductible and the MAGI is not adjusted for inflation. This tax is subject to the individual estimated tax provisions. An individual, estate or trust with active business ownership within a sole proprietorship, LLC, partnership or S corporation would not be subject to this tax. A passive investor in a trade or business housed within one of these flow-through entities is subject to Section 1411. The 3.8 percent Unearned Income Medicare Contribution Tax is effective for the 2013 tax year. There is little time left to make effective 2013 tax planning decisions, but investment changes made in 2013 could generate a tax reduction for 2014 and subsequent years. Use the examples above, such as tax exempt interests, as a jumping off place for discussions with clients. Also re-think past passive activity decisions and determine if actively participating would produce a lower overall effective tax rate.

Greta Hicks