Will the New 3.8% Tax on Investment Income Apply to You?

Beginning in 2013 the new Unearned Income Medicare Contribution (UIMC) tax takes effect and could affect your tax liability.  Because of the types of income subject to this new tax, it is commonly referred to as the Net Investment Income Tax (NIIT).  The new 3.8% tax is applied to the lesser of:

  1. The taxpayer’s investment income, or
  2. Their Modified Adjusted Gross Income (MAGI) over certain thresholds.  Those thresholds are $250,000 for married filing jointly, $125,000 for married filing separately, and $200,000 for single and head of household filers.

Because this is the “lesser of” rather than the “greater of,” taxpayers with an MAGI under the thresholds, will not be subject to the NIIT.

So, what is Net Investment Income? The IRS has defined net investment income as follows:

  1. Gross income from interest, dividends, annuities, royalties, rents, substitute interest and dividend payments, less allowable deductions.
    • This does NOT include tax exempt interest from state and local bonds, investment income from a qualified retirement plan, nor interest paid to an employee under a non-qualified deferred compensation plan. In addition, rental real estate activities of qualifying “real estate professionals” are NOT subject to the NIIT.
  2. Gross income derived from a “passive” trade or business, less allowable deductions.
    • This includes gross income earned from a partnership or S-corporation, for which the individual does NOT materially participate. (Other amounts earned by individuals for services to the business, for example guaranteed payments or wages, will NOT be subject to NIIT.)
  3. Net gain attributable to the disposition of property.
    • This includes ordinary and capital gains from the sale of stocks, bonds, mutual funds, and investment real estate, as well as, capital gain distributions from mutual funds. Losses on such property may be netted with gains, but may not offset net investment income mentioned in items 1 or 2 above.
    • To the extent the sale of your personal residence generates a taxable gain; it will be considered net investment income for purposes of the 3.8% tax.
    • Ordinary and Capital gains from the sale of assets held in a partnership or S-corporation will be subject to the NIIT if the business is “passive” in nature.

With respect to self-employment income, the 3.8% net investment income tax does not apply to income subject to self employment tax. In other words, the same item of income can’t be subject to both SE tax and NIIT.

Other types of income NOT considered Net Investment Income include wages, unemployment compensation, Social Security Benefits, alimony, gambling and lottery winnings, and operating income from non-passive business.