Internal Revenue Code Sec. 1411, passed by Congress in 2012, introduced a new tax on passive income that went into effect on Jan. 1, 2013, the tax on “net investment income” (NII).
The new tax was created to help pay for health care reforms that were enacted in 2010. The rate is 3.8% of the lower of net investment income or the amount of modified adjusted gross income (MAGI) over specific thresholds. Modified adjusted gross income is adjusted gross income increased by the foreign earned income exclusion (but also adjusted for certain deductions related to the foreign earned income). For taxpayers without foreign income, MAGI is generally their adjusted gross income.
Individuals with MAGI above the thresholds and estates and trusts with undistributed net investment income and AGI above the dollar amount at which the highest tax bracket for an estate or trust begins are subject to the net investment income tax. Nonresident aliens and entities other than natural persons are not subject to the tax. The MAGI thresholds for individuals are: married filing jointly and qualifying surviving spouse, $250,000; married filing separately, $125,000; single and head of household, $200,000.
Three defined categories of income are subject to the tax on NII:
(i) Gross income from interest, dividends, rents, royalties, and nonqualified annuities, other than such income derived in the ordinary course of a trade or business not described in (ii);
(ii) Other gross income from businesses that trade financial instruments or commodities, and businesses that are passive activities within the meaning of Sec. 469
(iii) Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property, other than property held in a trade or business that is not described in (ii).
Gains and losses from dispositions of trade or business property used in passive activities are included in calculating the net investment income tax. Obvious examples of income subject to the tax on NII are gains from the sale of investment real property (including a second home), and gains from the sale of stocks and bonds.
The tax on NII increases the attractiveness of tax-deferred transactions such as like-kind exchanges under Section 1031; other useful strategies include selling loss securities to offset any same-year gains and structuring certain charitable gifts of appreciated property.