Beginning with the 2013 tax year, individuals, trusts and estates face a new 3.8% tax on net investment income. This tax was a creation of the Affordable Care Act, and will likely cause some unhappy surprises when 2013 returns are filed.
The tax only applies if 1040 page one income exceeds a $200,000 threshold ($250,000 for joint filers). At that point, the tax is levied on the smaller of net investment income or 1040 income in excess of the threshold. Investment income includes interest, dividends, annuity and royalty income, rental income and most net capital gains. Income and gains from a business in which the taxpayer materially participates (generally over 500 hours per year) are exempt, but passive business income and gains are subject.
Here is a quick rundown on those who will be hit with this new tax:
— Upper income filers. Those with 1040 income under $200,000 single or $250,000 joint are exempt from the tax, but those over will typically have some amount of net investment income. The amount of investment income subject to the 3.8% tax is limited to total income in excess of the $200,000 or $250,000 thresholds. So an obvious strategy is to keep total annual income under the trigger point of this tax.
— Landlords. Higher-income retirees receiving rents, whether cash or crop share, are exposed to this tax on their net rental income and land sale gains. The big hit will occur when land is sold and the gain spikes income over the $200,000/$250,000 threshold. Installment sales that spread the gain out may help avoid the tax.
— Trusts and estates. For trusts and estates, the tax applies at a very low threshold of only $12,000 of undistributed taxable income. At that point, income is subject to both the 39.6% top income tax rate plus the new 3.8% tax. Trust and estate income is generally all in the net investment income categories. The only solution is to distribute the income to the beneficiaries of the trust or estate, but in some cases that is not permitted under the governing documents.
— Active business owners. Those actively farming will not be exposed to the 3.8% tax on business income, nor on any rental income from leasing their land to their business entity. Recent IRS regulations exempt rents if the income arises from leasing to a business in which the taxpayer or spouse materially participates. This exception applies to those leasing land to any entity, whether a C corporation, S corporation or partnership, assuming sufficient annual participation in the entity’s business.
— Multiple business owners. Those who have an interest in several business entities may have trouble achieving material participation in each. Income from passive businesses is subject to the 3.8% tax. Those owners will want to consider a passive activity grouping election. By grouping similar businesses, the taxpayer can measure participation as if a single entity and possibly escape the new tax. This election will require professional tax assistance.