It’s been coming for three years, but now the day of tax reckoning for higher-income investors has finally arrived.
Alert: For the first time, you may have to pay the 3.8% Medicare surtax on “net investment income” (NII) on your 2013 tax return. The tax is computed on Form 8960, Net Investment Income Tax—Individuals, Estates, and Trusts.
The IRS recently issued new regulations clarifying the rules concerning the imposition of this new and long-dreaded tax.
Here’s the whole story: Beginning in 2013, the 3.8% Medicare surtax applies to the lesser of NII or the excess of modified adjusted gross income (MAGI) over an annual threshold.
The threshold is $200,000 for single filers and $250,000 for married joint-filing couples.
For this purpose, NII includes the following:
- Interest and dividends
- Distributions from annuities
- Rent and royalties
- Income and gains from passive business activities
- Income and gains from the business of trading in financial instruments and commodities
- Net capital gain from the sale of investments and property (other than property held in a nonpassive business activity.)
On the other hand, the following items are excluded from the definition of NII:
- Distributions from IRAs and qualified retirement plans
- Social Security benefits
- Income and gains from nonpassive business activities
- Self-employment income
- Gain on the sale of nonpassive interests in a partnership, S corporation or limited liability company
- Income from tax-exempt municipal bonds
- Tax-deferred income from nonqualified annuities
- The portion of capital gain excluded from tax on the sale of a principal residence.
What is the tax impact on 2013 returns? It can be substantial. The following is excerpted from a Frequently Asked Questions (FAQs) section of the IRS website.
Example 1: A single taxpayer has wages of $180,000 and $15,000 of dividends and capital gains. The taxpayer’s MAGI is $195,000, which is less than the $200,000 statutory threshold. Result: The taxpayer is not subject to the NII tax.
Example 2: A single taxpayer has $180,000 of wages. The taxpayer also received $90,000 from a passive partnership interest, which is considered to be NII. The taxpayer’s MAGI is $270,000.
The taxpayer’s MAGI exceeds the $200,000 threshold for single taxpayers by $70,000. The NII tax is based on the lesser of $70,000 (the amount by which the taxpayer’s MAGI exceeds the $200,000 threshold) or $90,000 (the NII). Result: The taxpayer owes NII tax of $2,660 ($70,000 × 3.8%).
The new regulations include several technical changes and clarifications. For instance, the regs make it clear that rental income received by a real estate professional is included in NII, but adopts a safe-harbor exception if the taxpayer participates in rental real estate activities for more than 500 hours per year. In that case, the rental income associated is treated as being derived in the ordinary course of a trade or business and is therefore exempt from the NII tax.
Tip: The IRS hasn’t released the final draft of Form 8960, but it’s expected for February filings.
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