The Net Investment Income Tax (Explained)
The Net Investment Income Tax (“NIIT”) is an additional tax that is paid by those with high income. This can include those who regularly have high income and those whose tax is high in one or more years due to a significant transaction, such as the sale of a business or real estate.
We are a tax law firm in Houston, Texas, and we help clients avoid or minimize their net investment income tax liabilities.
How is Net Investment Income Tax Calculated?
The NIIT was enacted in 2012 by the Obama administration to fund the Affordable Care Act. It is codified in Section 1411 of the tax code.
Individuals, estates, and trusts with income over the statutory threshold amounts are subject to the NIIT. The NIIT is 3.8 percent on certain net investment income. More precisely, the NIIT is the lesser of (1) net investment income or (2) the amount by which Modified Adjusted Gross Income (“MAGI”) exceeds the threshold amounts.
The thresholds amounts are $250,000 MAGI for married couples filing jointly and $200,000 for single individuals. MAGI is generally gross income less certain allowable deductions.
What is Net Investment Income?
Individuals who have net investment income and modified adjusted gross income above certain dollar thresholds owe the tax.
What Counts as Investment Income?
The “investment income” in NIIT includes those items of investment income one would expect.
Investment income includes interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses that trade financial instruments or commodities, and businesses that are passive activities to the taxpayer (within the meaning of Section 469).
As noted above, investment income also includes capital gains. The capital gains that are subject to the NIIT include:
- Gains from the sale of stocks, bonds, and mutual funds.
- Capital gain distributions from mutual funds.
- Gain from the sale of investment real estate (including gain from the sale of a second home that is not a primary residence).
- Gains from the sale of interests in partnerships and S corporations (to the extent the partner or shareholder was a passive owner).
Are dividends from C corporations subject to net investment income tax?
Dividends received by a C corporation shareholder are net investment income. They are subject to NIIT. The IRS reached this conclusion in CCM 202118009 for a shareholder who was an employee of a C corporation. The IRS concluded that the dividends that the shareholder received were investment income.
Is rental income subject to net investment income tax?
The reference to passive activities pulls in the difficulties in determining whether an activity is passive or nonpassive. This difficulty is most prevalent with rental activities.
Whether a rental activity is passive or nonpassive has been subject to a number of court disputes. The case law on point is difficult to square. To prevent taxpayers from having to address whether a rental activity is conducted with the continuity, regularity, and profit motive necessary to qualify it as a trade or business when there is so little judicial precedent on the issue, the final regulations for the NIIT provide a safe harbor whereby if a real estate professional participates in an activity for over 500 hours during the year — or has participated in that real estate activity for over 500 hours in any five tax years of the preceding 10 years — the rental income from the activity will be treated as having been derived from the ordinary course of a trade or business. Even better, if a real estate professional elects under Treas Reg. 1.469-9(g) to aggregate all rental activities for purposes of measuring material participation, the NIIT regulations provide that as long as the taxpayer spends 500 hours in the aggregated activities, the safe harbor will be satisfied.
The following income is not subject to the net investment income tax: wages, unemployment compensation; operating income from a nonpassive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent Fund Dividends (see Rev. Rul. 90-56, 1990-2 CB 102), and distributions from certain Qualified Plans.
What Expenses Reduce Investment Income?
The “net” in NIIT refers to these income amounts being lowered by specific expenses that are properly allocated to the income. These expenses can include investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, tax preparation fees, fiduciary expenses (in the case of an estate or trust) and state and local income taxes.
What Tax Credits Offset the NIIT?
Tax credits that can offset estate and gift taxes, employment taxes, or excise taxes can offset the NIIT. Tax credits that only offset income taxes cannot.
For example, the foreign tax credit only offsets income taxes. The taxpayer can elect to deduct foreign taxes rather than tax credit for them. This election can reduce net income and therefore offset the NIIT. Those who opt to take a foreign tax credit cannot offset NIIT.
Tax treaties could lead to a different result. In Toulouse v. Commissioner, 157 T.C. No. 4 (2021), the court held that the U.S. Tax Treaty with France did not change the general rule that the foreign tax credit cannot offset the NIIT.
How is the NIIT Reported?
The net investment income tax is reported on Form 8960. This form is to be included with the Form 1040 and Form 1041.
How Do You Avoid Net Investment Income Tax?
Traditional tax planning techniques can help reduce or avoid the net investment income tax.
This includes tax planning to reduce income and defer recognition of income.
Examples include taking advantage of charitable contribution deductions, investing in tax-free vehicles (such as municipal bonds), and taking advantage of bonus depreciation in real estate investments. Deferral techniques include installment sales, Section 1031 exchanges, and opportunity zone funds. These strategies can reduce the net investment income and thereby decrease the net investment income tax.
Taxpayers may also be able to actively participate in their business or rental activity to avoid the net investment income tax.
These are just a few examples.
Experienced Tax Advice Attorneys
We are tax lawyers in Houston, Texas. We help clients structure their affairs to avoid taxes. This includes avoiding and reducting the NIIT.
If you have a question about the NIIT, we want to hear from you. Please call us at (713) 909-4906.