Net Investment Income Tax

After 2012, a 3.8-percent tax is imposed on the lesser of (i) net investment income or (ii) modified gross income that exceeds a threshold amount. Most individuals, estates and trusts are subject to the tax. Although the tax is not limited to net investment income, it is often referred to as the "net investment income tax" (NII tax). It is also known as the "Medicare surtax" or the "Medicare tax on unearned income."

The NII tax is one of the major new taxes imposed by the Patient Protection and Affordable Care, also known as "health care reform" or "Obamacare." Other new taxes include the 0.9-percent additional Medicare tax on wages and self-employment income , the individual shared responsibility payment for failing to carry health insurance, and the employer’s penalty for failing to offer health insurance.

The modified adjusted gross income (MAGI) threshold for the NII tax is

• $200,000, for single or head of household;
• $250,000, for married filing jointly; and
• $125,000, for married filing separately.

MAGI is adjusted gross income, plus otherwise excludable foreign earned income and housing offsets.

Net investment income (NII) is a complex concept that may require assistance from your tax advisor. In general, net investment income is the sum of the following less any allowable deductions that are “properly allocable” to the investment income:

1. most gross income from interest, dividends, annuities, royalties and rents that are not attributable to the taxpayer’s active trade or business;
2. gross income from a “passive activity” or a trade or business of trading commodities or financial instruments; and
3. net gain derived from the disposition of property.

The net investment income tax rules for passive activities are generally the same rules used for passive activity losses. The standard for a passive activity is whether you materially participate in the trade or business on a regular, continuous and substantial basis.

These properly allocable deductions include:

• Deductions allocable to gross income from rents and royalties;
• Trade and business deductions that
• (a) are allocable to a passive business activity or to a business of trading in commodities or financial instruments; and
• (b) are not included in self-employment income;
• The penalty on early withdrawal of savings;
• The portion of the net operating loss deduction related to net investment income;
• Properly allocable investment-related deductions reduced by the two-percent AGI floor for miscellaneous itemized deductions and the overall limit on itemized deductions phased out for high-income taxpayers;
• Capital losses;
• Certain deductions allowed to estates or trusts, or with respect to a decedent;
• Ordinary loss deductions for certain debt instruments; and
• Other deductions identified as properly allocable deductions published in IRS guidance.

Warning Properly allocable deductions may have to be adjusted to account for the refunds and recoveries of amounts that were deducted in prior years.

Reporting and Paying the NII Tax

The NII tax is reported and paid with your federal income tax. The NII is also subject to the estimated tax provisions. Therefore, individuals, estates and trusts that expect to be subject to the tax should adjust their income tax withholding or estimated tax payments to account for the tax increase in order to avoid underpayment penalties.

The NII tax is reported on Form 8960, Net Investment Income Tax, which is filed with your income tax return.

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