Final Net Investment Income Regs Offer Clarity– December 23, 2013

After a year-long wait, final regulations have been released that clarify Code Sec. 1411, better known as the 3.8% Net Investment Income (NII) tax, which went into effect January 1, 2013. While there were no big surprises from the proposed regulations to the final version, there is now more detailed guidance on who this tax will impact and in what ways. We have summarized the main provisions below; as we continue to delve into the detailed regulations we will post more information on specific areas of impact. We also will continue to meet with our clients to identify specific planning opportunities surrounding this tax.

What is Net Investment Income?

NII is the excess of gross income from interest, dividends, annuities, royalties and rents — or “passive” income. NII applies to:

  • Other gross income from a trade or business that includes passive activity with respect to the taxpayer or income by a financial trader.
  • Net gain from the sale, exchange, transfer, conversion, cash settlement, cancellation, termination lapse, expiration or other disposition including a deemed disposition of property. This does not include gain or loss attributable to the trade or business of a non-passive activity.
  • Gain in excess of $250,000 ($500,000 for married couples) realized from the sale of personal residence or like-kind exchanges.

One of the biggest exceptions to NII is income derived in the ordinary course of a trade or business that is not a passive activity. This includes income that professionals earn in the real estate industry. Importantly, the final regulations include a safe harbor for real estate professionals, allowing for a particular grouping that can be made when filing tax returns that would exempt this particular income from the tax.

Who Does NII Apply to?

The 3.8% NII tax is in addition to ordinary income tax and applies to U.S. citizens or residents whose adjusted gross income (AGI) exceeds $250,000 for joint filers, $200,000 for single taxpayers and $125,000 for married filing separately. If AGI is above one of these thresholds, the tax will apply to the lesser of (1) net investment income for the tax year or (2) the excess of AGI for the tax year over the threshold amount. Threshold amounts are not indexed for inflation, meaning as time goes by more taxpayers will become subject to the tax.

In addition to individuals, the tax also applies to estates and trusts, but with lower threshold amounts ($11,950 for 2013 and $12,150 for 2014). Distributions to grantors or beneficiaries will be considered NII when grantors or beneficiaries are calculating their individual NII. Certain trusts and estates are exempt from the NII tax, including religious, charitable and scientific trusts; grantor trusts (the NII is treated as being paid directly to the grantor and will be included in their individual calculation of NII); and foreign trusts and estates.

The 3.8% tax also has specific implications for partnerships and S Corporations and provides exceptions for distributions from qualified plans and self-employment income.

Next Steps

The 3.8% NII is in effect for tax years beginning after December 31, 2012. That means the 2013 tax returns being prepared this spring will be affected. Below are some initial steps to discuss with your service team.

  1. Calculate your income. First determine if you exceed the threshold and therefore are subject to the NII tax. Be mindful of the various ways you can file and what those specific thresholds are. For example, if a U.S. citizen or resident is married to a nonresident alien, the spouses will be considered as married filing separately for purposes of the NII tax.
  2. Take a second look. If you are close to the threshold, calculate your income again. Be sure to take into consideration that some income excluded for income tax purposes may in fact apply to NII, or vice versa.
  3. Identify opportunities. Key planning opportunities exist to minimize the NII tax moving forward. Some of the most fruitful areas to re-evaluate each year include the option of distributing or not distributing trust income, since trusts have a much lower NII threshold, or reviewing any significant change in your investments.

Since the final regulations were just released in December, that does not leave much time to adjust for the coming tax filing season. However, there are still plenty of opportunities to minimize the impact of the tax in future tax years.

We want to hear from you! We encourage you to comment below on this blog post, share it on social media or contact a member of your service team for further discussion.

This communication is for information only, and any action should only be taken after a detailed review of the specific situation and appropriate consultation.

Notwithstanding that these materials do not constitute legal, accounting or other professional advice, as may be required by United States Treasury Regulations and IRS Circular 230, you should be advised that these materials are not intended or written to be used, and cannot be used by you or any other person, for the purpose of avoiding penalties that may be imposed under federal tax laws. No written statement contained in these materials may be used by any person to support the promotion or marketing of or to recommend any federal tax transaction(s) or matter(s) addressed in these materials, and any taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor with respect to any such federal tax transaction matter.