In my last column I wrote of the added Medicare tax created by the Affordable Care Act. This time its another tax for high income earners, the net investment income tax, or NIIT, also created by the Affordable Care Act.
The NIIT imposes a 3.8 percent tax on a taxpayers net investment income when the taxpayers modified adjusted gross income is above an applicable threshold based on theirfiling status for tax years beginning after Dec. 31, 2012. The threshold for taxpayers who file single is $125,000. For those who are married filing jointly it is $250,000. For all others it is $200,000.
Investment income is similar to what we know as passive income, but the way the law is structured some exclusions allowed for passive income do not apply to investment income. Your calculation of passive income is a good first estimate of investment income, and for most taxpayers investment income will be the same as passive income. In the past, the primary tax concern for passive income was about the limits on passive losses one could deduct. Now you must also be more aware of the positive passive income you earn.
Investment income generally includes interest, dividends, royalties, proceeds from installment sales, annuities, rent, gains on investments, and all gross income from trading in investment instruments or commodities net of losses. There are some exceptions. For example, NIIT does not apply to any item taken into account in determining self-employment income on which tax is imposed, unless the business is trading investments or commodities.
Rules for the inclusion of rent are similar to those for determining if rent is passive income. Income on the investment of working capital is not subject to NIIT.
So where can some of the surprises come from? Well, if you own a condo in Park City and rent it out through the management company and earn a profit above allowed expenses for that rental, thats investment/passive income subject to NIIT. If you sell the condo, a portion of the gain on that sale may be considered the sale of an investment and liable for the NIIT.
With this new tax, the distributions that owners take need to be carefully classified as compensation, repayment of loans the owner made to the company, return of capital or dividends. The dividends a small business owner takes from an S-Corp are subject to the NIIT.
Also, return of capital may have a significant tax implication when the owner sells the company. Any gain on the sale of the owners investment (stock or partnership interest) is subject to the NIIT after deducting the equivalent of the sale of company assets at fair market value. Remember that gain is calculated on the difference between the sale price, less asset equivalent, and the basis the owner has in the stock. Return of capital reduces the owners basis in that stock or partnership share.
The regulations, just published in their final form in December, are complex. If you think you may be liable for the net investment income tax, you should seek competent counsel.