Shedding Light on the Mechanics of the Net Investment Income Tax
For accountants who have clients with investments, one of the best ways to create value is to alert them to their most probable tax bill following a sale.
If a client sells a capital asset, this will trigger the capital gains tax on any recognized gains. But this isn’t the only layer of taxation which that investor may face. Depending on the situation, that investor may also face taxation at the state level, and may also face additional excise or income taxes.
One additional tax an investor may face is called the Net Investment Income Tax (NIIT). This tax is shrouded in uncertainty as many people don’t fully understand what it is and how it is computed. Counseling clients on the structure and computation of the NIIT can go a long way toward building a more loyal client base.
In plenty of instances, investors learn about the NIIT at the last minute, or worse not at all until they receive a notice from the IRS. Let’s go over the basic structure and calculation of the NIIT so you can instruct your clients and create more value for them.
Exemption Schedule for the NIIT
One of the first things to know is that the NIIT is only triggered when a person’s modified adjusted gross income (MAGI) exceeds a certain threshold. The threshold or exemption differs depending on a person’s specific tax status. The exemption schedule as of the current year (2019) is as follows: married filing jointly ($250,000), married filing separately ($125,000), single ($200,000), head of household ($200,000), and qualifying widow or widower with dependent child ($250,000).
If a person doesn’t have modified adjusted gross income above its applicable exemption, then the NIIT will not apply. This is because the exemption will cancel out the income, regardless of how much investment income that person may have.
For instance, if a taxpayer has investment income from the sale of stock of $100,000, but has MAGI of $190,000 and files as an individual, no NIIT would be due. This is true even though the individual has the $100,000 of investment income. The NIIT only kicks in after the MAGI exemption is exceeded.
NIIT Rate Applies to the Lesser of Investment Income or MAGI Above Exemption
If an individual has both investment income and MAGI which exceeds his or her applicable exemption, then the NIIT will apply. However, in computing NIIT, the tax of 3.8 percent is taken from the lesser of these two amounts. Once the exemption is exceeded, the NIIT will be extracted from either the lesser of the investment income or the MAGI in excess of the exemption.
Let’s look at an example: Suppose a taxpayer has a MAGI of $275,000, investment income of $100,000 and files as an individual. In this example, the MAGI would be $75,000 over the applicable threshold. And since $75,000 is less than $100,000, the 3.8% tax would be taken from $75,000.
Let’s assume that, instead of investment income of $100,000, this same person had investment income of only $50,000. But assume that his or her MAGI remains $275,000. If this were the case, then the NIIT would be taken from the $50,000 investment income.
The calculation of a person’s MAGI is fairly involved. For the purposes of NIIT computation, MAGI is adjusted gross income increased by the difference between amounts excluded under Section 911(a)(1) and the amount of any deductions or exclusions disallowed under Section 911(d)(6). What qualifies as “investment income” is also a fairly complex determination.
The IRS provides specific guidelines to aid accountants make this determination in any individual case. In most cases, the determination is intuitive. Investment income generally includes gains derived from stocks, bonds, investment real estate, dividends, royalty income, and so forth. Again, as with calculating MAGI, accountants can add value to their client’s experience by computing their total investment income subject to NIIT.
Excluded Gain Under Section 121 is Excluded in NIIT Computation
Clients often raise the issue of the NIIT when they sell their personal residence. The most common will be: will gains derived from this sale be included in total investment income? The answer is that gains will be included as long as they are not specifically excluded by Section 121, which allows homeowners to exclude up to $250,000 of gain ($500,000 for married couples filing jointly) from the sale of their primary residence.
If a taxpayer utilizes this Section 121 and excludes a certain portion of their gain, then that excluded portion will not be counted in the investment income calculation. Let’s consider an example: Suppose a taxpayer sells his primary residence for $750,000, and assume his basis was $250,000. After he excludes $250,000 of the $500,000 gain, he will have a recognized gain of $250,000.
The recognized gain of $250,000 will be included for purposes of NIIT, but not the excluded gain. This is very significant, because the taxpayer would otherwise incur a substantially larger liability were the excluded to be included in the calculation.
As we can see, the NIIT is quite involved. Accountants will need to consult multiple sources in order to make the correct computation in any given instance. For instance, accountants will need to compute MAGI, and also determine the total investment income which may be subject to the tax.
Counseling clients on topics such as the NIIT is an excellent way to improve client satisfaction. If you can shed light on arcane topics such as this, you have a great chance of building a loyal following.
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Jorgen Rex Olson is a graduate of Washington State (B.A., cum laude, 2008) and the Indiana University (McKinney) School of Law (J.D., 2012). He writes for Mackay, Caswell & Callahan, P.C., one of the leading tax law firms in New York State.