For tax years starting on or after January 1, 2013, section 1411 of the Internal Revenue Code, imposed a new tax on net investment income, in addition to regular income tax. This net investment income tax (NIIT) may apply to investment income of individuals, estates and trusts.
The (NIIT) surtax is 3.8% of the lesser of (1) net investment income (NII), or (2) the excess of modified adjusted gross income over the threshold amounts. Individual taxpayers will owe this additional tax if they have modified gross income over $250,000 (married filing jointly), $125,000 (married filing separately), or $200,000 (single).
Net Investment Income
Your net investment income, subject to NIIT, includes interest, dividends, annuities, rental and royalty income, unless those items were derived from an active trade or business. Taxable net gain from dispositions of property, other than property held in an active trade or business, is also subject to the additional tax. Other gross income from a trade or business that is classified as passive activity is subject to the NIIT.
Net investment income does not include salaries, wages, operating income for a non-passive business, Social Security benefits, tax-exempt interest, self-employment income and distributions from certain qualified plans.
As mentioned above, income from passive activities is generally included in net investment income and is subject to the NIIT.
Passive activities are trade or businesses, or income producing activities, in which you do not “materially participate”. To materially participate you must be involved in the operations of the activity on a regular, continuous, and substantial basis. The IRS will consider you materially participating in an activity if you participate more than 500 hours in the tax year.
Rental activities are automatically treated as passive, regardless of how much you participate. This means, even if you materially participate in these activities, this income may be subject to NIIT unless you are a “real estate professional”. A taxpayer is a real estate professional for a particular tax year if: (1) more than half of the personal services the taxpayer performs during that year are performed in real property trades or businesses in which the taxpayer materially participates and (2) the taxpayer performs more than 750 hours of services during that year in real property trades or businesses in which he materially participates.
Electing to treat all of a taxpayer’s rental real estate activities as a single activity may make it easier to meet the material participation requirement, resulting in treatment of the rental real estate as non-passive and not subject to NIIT. This election may be made by filing a statement with the taxpayer’s original income tax return for the tax year. Please consider, however, that this can have a negative effect, since transforming passive income to non-passive means this income is no longer available to offset with passive losses, and thus these passive losses could be suspended.
The NIIT is subject to the individual estimated tax provisions. Therefore, the division of passive and non-passive income will need to be considered when calculating quarterly estimated tax payments in order to avoid underpayment penalties.
The NIIT may have a significant effect on your tax liability going forward. Our staff is happy to discuss your specific situation and provide tax-planning strategies so the impact of this new tax can be minimized.