IRS Releases Final Regulations Affecting the Net Investment Income Tax
As the Holiday season is in full swing the last thing on most taxpayers’ minds is the upcoming tax filing season. However, we have been busy planning to make sure you are not surprised by the higher tax bill coming courtesy of The Affordable Care Act. The Act contained two new tax provisions which kicked in January 1, 2013, and affect high-income individuals, trusts and estates. The final regulations were issued November 27, 2013, but we are still waiting for the IRS to publish the final version of the related forms and instructions. The two new provisions facing high-income individuals are the 3.8% surtax on net investment income and an additional 0.9% Medicare tax on wages and self-employment income.
Additional Medicare Tax
The Additional Medicare Tax is relatively straight-forward. Listed below are the key highlights.
- Single taxpayers will be subject to an additional 0.9% Medicare Tax on wages and self-employment income over $200,000 ($250,000 if MFJ)
- Employers must withhold using the higher rate if the employee receives wages in excess of $200,000, regardless of the employee’s spouse’s wages. Because withholding begins at $200,000 irrespective of the income of the employee’s spouse, the potential for over-withholding or under-withholding exists for married couples filing jointly
- Taxable fringe benefits are also subject to the Additional Medicare Tax
- Unlike the historical Medicare tax, there is no employer matching portion of this tax
Net Investment Income Tax
The Net Investment Income Tax regulations are much more complex than the regulations for the Additional Medicare Tax. Beginning January 1, 2013 single taxpayers will be subject to a 3.8% tax on the lesser of their net investment income or their modified adjusted gross income (MAGI) in excess of $200,000 ($250,000 if MFJ, $125,000 if MFS). For the average taxpayer, MAGI is the same as adjusted gross income. These threshold amounts are not indexed for inflation.
- The first question taxpayers have to consider is “What is net investment income (NII)”?
- Net Investment Income includes gross income from the following items:
- Taxable interest
- Annuities, other than those from a qualified retirement plan
- Passive business income
- Gains on the sale of property (to the extent taken into taxable income)
The above types of income are grouped into 3 Categories. Traditional investment income is Category 1, while passive business income is included in a category of its own (Category 2) as is gain on the sale of property (Category 3). The computation of net investment income takes into account allowable deductions properly allocated to investment income. Thus, deductible fees, losses and other expenses allocable to net investment income reduce the amount subject to the tax.
Exclusions from Net Investment Income include:
- Income derived in the ordinary course of a trade or business, including certain types of the income above (unless the trade or business is a passive activity or involves trading in financial instruments)
- Tax-exempt income, such as interest from municipal bonds
- Earnings from self-employment
- Distributions from qualified plans, such as IRAs or 401(k)s
- Social Security income
- Income earned by nonresident aliens
The computation of NII is a project all to itself. Once we determine what gross NII is, we have to determine what expenses allocable to the income can be used to reduce the tax. The final regulations have some complexities which provide planning opportunities to minimize the tax impact.
In the past, if a taxpayer owned an interest in several profitable business activities, whether those business interests were classified as an active or a passive activity was generally moot. If a passive business activity produced a loss, that loss could be limited under the passive activity rules. But passive income, in the past, has not been detrimental. Starting in 2013, however, business income from a passive activity is subject to the new 3.8% tax.
To compound this, passive business owners face another hurdle related to gains on the sale of property. A taxpayer who is passive with regard to an interest in an entity that sells property will be required to classify those gains as Category 3 income. The complexity comes from inventory being considered property that generates Category 3 income when sold, resulting in the income from the passive activity being split for purposes of the new tax.
There could be an opportunity to review your passive activities and determine whether a grouping election can be made which will recharacterize a passive activity as active. If the business income can be recharacterized as active business income, it will not be subject to the 3.8% tax. This one-time regrouping election is only available to taxpayers who will be impacted by the new tax.
Taxpayers should be aware that the regrouping election is only allowed for the 2013 tax year; therefore it is important to do the analysis before completing your 2013 filing.
The final regulations reverse a position in the proposed regulations, and now allow rental income from a self-rental arrangement to be excluded from NII. Self-charged interest may also be excluded from NII. A self-rental arrangement is net rental income from property that is rented for use in a trade or business in which the taxpayer materially participates.
If the self-rental activity has been grouped with the active trade or business, such rental income will be deemed to be an active trade or business and will not be subject to the 3.8% tax. Additionally, if the self-rental property is sold in the future, the net gain from the sale of property will be excluded from NII.
If a grouping election has not previously been made, it is important to ensure the election is made in 2013 to ensure the related rental income (and potential gain on the future sale of the property) is excluded from NII.
Real Estate Professionals
The final regulations do not treat every real estate professional as necessarily engaged in the trade or business of rental real estate. A safe harbor rule included in the regulations provides that if a real estate professional participates in rental real estate activities for more than 500 hours per year (or 500 hours per year in five of the last 10 years), the rental income from the rental activity is deemed to be derived in the ordinary course of a trade or business, and gain or loss resulting from the disposition of property used in the rental activity is also deemed to be derived from property used in the ordinary course of a trade or business. If you meet the safe harbor rule, rental real estate income will not be subject to the tax.
However, if a real estate professional does not meet the safe harbor rule; additional analysis will be needed to determine if the level of activity will be considered a trade or business under these new regulations. The trade or business rules for purposes of the NII tax differ from the trade or business rules provided in the passive activity regulations.
Overall, the new regulations include important changes to the proposed regulations and address many concerns taxpayers had raised with the IRS. With careful planning and the right grouping elections, the impact of the new tax can be minimized.