3.8% and Beyond

Dollar bills background

As of 1/1/2013, all taxpayers will have to pay the additional 3.8% Medicare Surtax if their Modified Adjusted Gross Income exceeds a threshold of $200,000 filing single, or $250,000 married filing jointly on their Unearned Investment Income. What is Unearned Investment Income?

Under Section 1411 of the Internal Revenue Code, the Service will levy a 3.8% tax on the lesser of an individual’s net investment income for the tax year or the excess of the individual’s modified adjusted gross income for the tax year over a specified threshold amount. The tax also pertains to trusts with undistributed net investment income in excess of $11,950 for 2013. In both cases, individuals and trusts, the surtax is subject to estimated tax requirements and penalties for underpaying estimated taxes.

Section 1411 defines investment income to be: interest, dividends, annuities, royalties, rents other than income derived in the ordinary course of a trade or business that is not a passive activity, and a trade or business of trading financial instruments or commodities. It also includes any net gain from the sale of those passive entities held as well as any net stock gains. Net investment income does not include income subject to the self-employment tax or municipal bond interest or qualified annuities, those funded by retirement monies such as an IRA or a 401k or 403b plan. Non-qualified annuities, such as those funded by after-tax dollars are fully taxable for the net investment tax.

What is not included in Net Investment Income? Wages, unemployment income, operating income from non-passive businesses, social security benefits, tax-exempt income, self-employment income, distributions from retirement plans, and Alaskan Permanent Fund Dividends are excluded.

Did you notice that gambling income is not on either list? That is because the IRS has not made up its mind on the issue, many tax professional believe it will be excluded, however!

Also note the importance of passive versus non-passive income. Passive activities, covered under §469, are those in which you do not actively participate, those activities which have under 750 hours of active participation, and specifically rental activities even if you actively participate. The only exception is for those individuals who are real estate professionals, and the IRS will be paying very close attention to those individuals this year and going forward.

It will include the gain from the sale of a second home and gain from the sale of a principal residence, to the extent the gain is not excluded under §121 of the code.

If you have invested in passive activities and get a K-1 and sold the activity during the year, your gain from the sale will be three fold: One, the regular gain taxed on Schedule D, Two, the gain from the disposition of the assets of the activity reported on Form 8960 for Net Investment Income Tax purposes, and Three, for Alternative Income Tax Purposes.

What expenses can be deducted from Net Investment Income? Investment interest expense, investment advisory and brokerage fees, expenses related to the royalty and rental income, and state and local income tax. State and local income can be very important, particularly if you live in New Hampshire and sold rental property in Massachusetts. Your only state income tax in Massachusetts is what you paid to the state before December 31, 2013 on the gain from the sale, so it is important that you go to your accountant and make a determination of the state quarterly estimate and get it paid before December 31, 2013 to minimize the Net Investment Income Tax.


For more information, call or email us at 603-882-1677 or email at: Bill@KulchandWilson.com