The 3.8% “Rental Income” Income Tax – More Than Meets the Eye

There’s a lot to know when it comes to the new 3.8% net investment income tax (3.8% NIIT). This new tax is imposed on income from several sources and its impact is far reaching. So, analyzing its impact can get complicated fast.

Originating as a component of 2010 health care legislation and first effective in 2013, the 3.8% NIIT is assessed on the lesser of net investment income (NII) or modified adjusted gross income (MAGI) above specific thresholds.  MAGI is adjusted gross income plus any excluded net foreign earned income. The MAGI thresholds are $200,000 for single individuals, $250,000 for joint filers and surviving spouses, and $125,000 for married taxpayers filing separate returns.  Only individuals with NII and MAGI above the applicable threshold amount will be subject to the 3.8% NIIT.

Example: If a married couple has $200,000 of wage income and $100,000 of interest and dividend income (i.e., MAGI totaling $300,000), the 3.8% NIIT applies to the $50,000 that is over the $250,000 MAGI threshold.

Trusts and estates can also be hit with the 3.8% NIIT. But for them, the tax applies to the lesser of their undistributed net investment income or AGI in excess of the threshold for the top trust federal income tax bracket. For 2013, that threshold is only $11,950. So, many trusts and estates will no doubt be affected this year.

The components of NII generally include gross income from interest, dividends, royalties, and rental income.  Gross income from a trade or business involving passive activities; and net gain from the disposition of property (other than property held in a trade or business in which the owner materially participates). All of these components are reduced by any allocable deductions.

This may sound simple, but as always, the devil is in the details.  Fortunately, distributions from retirement plans are generally not included in NII.  However, if included in MAGI, qualified plan distributions may push the taxpayer over the threshold that would cause other types of investment income to be subject to the 3.8% NIIT.  Another positive aspect of the 3.8% NIIT is that it does not apply to income from trades or businesses conducted by a sole proprietor, partnership, or S corporation; but income, gain, or loss on working capital is not treated as derived from a trade or business and thus is subject to the tax.

Unfortunately, the 3.8% NIIT does apply to income derived from a trade or business if it is a passive activity such as a rental activity.  For this purpose, the term passive activity has the same meaning as under the passive activity loss (PAL) rules.

With regard to property dispositions, a gain from the disposition of property that is considered held in the ordinary course of a trade or business is generally exempt from the 3.8% NIIT.  Despite the preceding exception, gains from dispositions of property held in a passive business activity are included in the definition of NII.  For business owners, a gain or loss from the disposition of an interest in a partnership or S corporation may be subject to the 3.8% NIIT.  However, a complex calculation involving a deemed sale analysis may be required to make this determination.

You may face myriad of challenges in learning about and dealing with the 3.8% NIIT. But, these challenges can lead to a greater opportunity to structure and save income taxes.

Warmest regards,

Doug

© 2013 Douglas Rutherford, CPA, CGMA.  All Rights Reserved.  Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the  Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.

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