The Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010, contains a provision that may have taken many taxpayers by surprise several years ago. The provision is known as the new Net Investment Income Tax. Internal Revenue Code Section 1411 was enacted to help fund health care through a tax on certain sources of unearned income of individuals, estates and trusts. This new law took effect for tax years ending after December 31, 2012, and taxpayers have been dealing with the new tax for several years. While many tax changes were enacted as part of the 2018 Tax Cuts & Jobs Act, repeal or lessening of the Net Investment Income Tax was not part of it. Thus, the Net Investment Income Tax is still a burden for taxpayers to whom the Act applies, and a proper understanding of the law is important.
Net investment income falls into one of three categories and is generally made up of passive investment income. This includes interest, dividend, annuity, royalty, and rental income, unless those items were derived in the ordinary course of an active trade or business such as income from real estate professionals. Capital gains from dispositions of property, other than property held in an active trade or business, are also subject to the tax. In addition, any income from a trade or business that is classified as passive activity is subject to tax. This would include income reported to you on a Schedule K-1 from the business activity unless you are an active participant in the business.
Internal Revenue Service Code Section 1411 imposes a 3.8% tax on a taxpayer’s net investment income. The net investment income tax will apply to a taxpayer only if their modified adjusted gross income exceeds $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately, and $200,000 for unmarried taxpayers and heads of household. The amount subject to the tax is the lesser of a taxpayer’s net investment income or the amount by which modified adjusted gross income exceeds the threshold amount that applies. Thus, a taxpayer will not be subject to the additional tax on net investment income unless their modified adjusted gross income exceeds the respective threshold amount that applies to them.
Take, for example, a married couple with a modified adjusted gross income of $270,000 for 2018, of which $100,000 is net investment income. They would pay the additional tax on only the $20,000 amount by which their modified adjusted gross income exceeds their threshold amount of $250,000. That is because the $20,000 excess is less than their net investment income of $100,000. Thus, the couple’s net investment income tax would be $760 ($20,000 × 3.8%).
There are several types of income that are exempt from the net investment income tax. Items excluded from income for regular income tax purposes are generally also excluded from net investment income. This would include such items as tax-exempt interest, gains subject to the like-kind exchange rules and the excluded gain from the sale of your principal residence. Additional items of income not included in the definition of net investment income are distributions from qualified retirement plans such as individual retirement accounts and Roth IRAs, and wages and self-employment income.
The next logical question is what can a taxpayer do to minimize the potential net investment income tax burden?
Several strategies do exist that can help minimize the overall effect of the tax. Investments in tax-exempt bonds or securities that are more capital appreciating versus dividend-paying can help reduce the exposure to the tax. Capital loss harvesting has always been a strategy to help reduce capital gains tax on any net capital gains a taxpayer may have but can be even more valuable now as it may also help reduce net investment income tax. Since income from passive activities is subject to the tax, an effort should be made to increase participation in an activity in order to make a passive investment non-passive in nature.
There are several strategies that can help reduce a taxpayer’s modified adjusted gross income, such as installment sales, Roth IRA conversions and Above-the-Line deductions and exclusions. Installment sales allow the taxpayer to spread the gain on the sale of an asset over a period of years rather than receive a lump sum. Since the gain is distributed over multiple years, income is lowered. Unlike other qualified retirement plans, Roth IRAs have no minimum required distributions. This makes a Roth conversion an effective strategy for reducing a taxpayer’s modified adjusted gross income. Another way to decrease the modified adjusted gross income is to increase above-the-line deductions. These include items such as contributions to qualified retirement plans and IRA deductions, Health Savings Account deductions, and student loan interest deductions. Any additional strategies that will help to reduce modified adjusted gross income will also generally reduce a taxpayer’s exposure to the net investment income tax.
The enactment of the Patient Protection and Affordable Care Act will create additional tax burdens for taxpayers. Certain types of passive investment income will be subject to the 3.8% tax on net investment income. Taxpayers should consider the various strategies available to reduce both net investment income and modified adjusted gross income. Keep in mind that the net investment income tax will not apply unless a taxpayer’s modified adjusted gross income exceeds the applicable threshold amount. The net investment income tax is a reality for taxpayers, but proper planning may help to reduce or eliminate the potential tax burden it may create.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.