CARL WATTS & ASSOCIATES

February 03, 2014

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The Net Investment
Income Tax
As mentioned in our previous newsletter, beginning with years after December 31 2012, certain investment income will be subject to an additional 3.8% surtax.

The Net Investment Income Tax (NIIT) is also known as the “Medicare” surtax because the legislation enacting this tax created a new chapter of the tax code entitled: “Chapter 2A – Unearned Income Medicare Contribution.” However, this was simply a revenue-raiser enacted to offset the cost of health care legislation; there is no requirement that this surtax be used for Medicare.

With the new regulations set in order as of late 2013, the IRS names this surtax only as the Net Investment Income Tax. Nevertheless, the 3.8 percentage of the NIIT tax seems to be quite correlated with the Medicare tax and the Additional Medicare tax.

As you surely remember, the Medicare tax and the Additional Medicare tax apply to all Medicare wages, railroad retirement compensation, and self-employment income. The current Medicare tax rate is 2.9%, with employers and employees each paying 1.45%. The additional tax rate is 0.9% for incomes over the set threshold amounts. Together, they make a tax rate of 3.8%.


The NIIT applies at a rate of 3.8% to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts. This surtax is in addition to the regular income tax, and it is in addition to the alternative minimum tax.

Although not yet complete and still subject to revisions, NIIT regulations are very complicated and complex, therefore the purpose of this newsletter is to offer a summary of these regulations, with an accent on the net investment income of individuals.

First of all, who is affected by this surtax?

NIIT affects U.S. Individuals, U.S. Trusts, and U.S. Estates, but does NOT apply to non-resident aliens. The Surtax is imposed at 3.8% and is assessed on the lesser of:

  1. Net investment income (NII), or

  2. The excess of Modified Adjusted Gross Income (MAGI) over the threshold amounts.

As an individual, you will owe the tax if you have Net Investment Income and also have modified adjusted gross income over the following thresholds:

Filing Status Medicare Wages in Excess of

Married filing jointly $250,000

Single/Head of Household $200,000

Married filing separately $125,000


You should be aware that these threshold amounts are not indexed for inflation.

If you are an individual who is exempt from Medicare taxes, you still may be subject to the Net Investment Income Tax if you have Net Investment Income and also have modified adjusted gross income over the applicable thresholds.

Estates and trusts are subject to the Net Investment Income Tax if they have undistributed Net Investment Income and also have adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins for such taxable year. For tax year 2013, this threshold amount is $11,950; for 2014, the threshold amount is $12,150.

Generally, investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer. To calculate your Net Investment Income, your investment income is reduced by certain expenses properly allocable to the income.
As far as gains are concerned, to the extent that gains are not otherwise offset by capital losses, the following gains are common examples of items taken into account in computing Net Investment Income:

  • Gains from the sale of stocks, bonds, and mutual funds;
  • Capital gain distributions from mutual funds;
  • Gain from the sale of investment real estate (including gain from the sale of a second home that is not a primary residence);
  • Gains from the sale of interests in partnerships and S corporations (to the extent the partner or shareholder was a passive owner).

NIIT does not apply to any amount of gain that is excluded from gross income for regular income tax purposes. The pre-existing statutory exclusion exempts the first $250,000 ($500,000 in the case of a married couple) of gain recognized on the sale of a principal residence from gross income for regular income tax purposes and, thus, from the NIIT.

In order to arrive at Net Investment Income, Gross Investment Income is reduced by deductions that are properly allocable to items of Gross Investment Income. Examples of deductions, a portion of which may be properly allocable to Gross Investment Income, include investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, tax preparation fees, fiduciary expenses (in the case of an estate or trust) and state and local income taxes.

Modified adjusted gross income (MAGI), for purposes of the NIIT is generally defined as adjusted gross income (AGI) for regular income tax purposes increased by the foreign earned income exclusion (but also adjusted for certain deductions related to the foreign earned income). For individual taxpayers who have not excluded any foreign earned income, their regular AGI will also be their MAGI.

So, to make it easier for you to understand how income computation works for purposes of the Net Investment Income Tax, here is an example gracefully offered by the IRS:

“Taxpayer, a single filer, has $180,000 of wages. Taxpayer also received $90,000 from a passive partnership interest, which is considered Net Investment Income. Taxpayer’s modified adjusted gross income is $270,000.

Taxpayer’s modified adjusted gross income exceeds the threshold of $200,000 for single taxpayers by $70,000. Taxpayer’s Net Investment Income is $90,000.

The Net Investment Income Tax is based on the lesser of $70,000 (the amount that Taxpayer’s modified adjusted gross income exceeds the $200,000 threshold) or $90,000 (Taxpayer’s Net Investment Income). Taxpayer owes NIIT of $2,660 ($70,000 x 3.8%).”


Individuals, estates, and trusts will have to use Form 8960 to compute their Net Investment Income Tax. 

For individuals, the tax will be reported on, and paid with, the Form 1040. For estates and trusts, the tax will be reported on, and paid with, the Form 1041.

The Net Investment Income Tax is subject to the estimated tax provisions. Individuals, estates and trusts that expect to be subject to the tax in 2013 or thereafter should adjust their income tax withholding or estimated payments to account for the tax increase in order to avoid underpayment penalties.

For you, as an individual, and even more so for estates and trusts, professional expertise is indispensable in navigating through the complexity of the IRS rules and regulations regarding the NIIT, as well as other tax issues that may apply to your particular situation.
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