Get Ready for the Net Investment Income Tax

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By Robert V. Lally, Published in Hartford Business Journal.

Taxes get more complicated. As if they were not hard enough before, starting in 2013 taxpayers, and their diligent accountants, face an entirely new tax.

We have all endured, if not mastered, the hugely complex regular income tax, which had its 100th birthday in 2013. Then since 1969, we have struggled with the infamous Alternative Minimum Tax (AMT).

Now for 2013, taxpayers must integrate the Net Investment Income Tax (NII) into their tax geography.

Basically, there are now three taxes: two compete with each other for top billing — you pay either the higher of the regular tax or the AMT.

The new world of the NII is a stand-alone, add-on tax.

The new tax applies if a taxpayer crosses a threshold income of $250,000 on a joint return and $200,000 for a single taxpayer. The $250,000 is presumably the dividing line between the rich and the not so rich. Once crossed, the new NII is a comprehensive tax with its own rules.

At its most simplistic, it is a tax on investment income. Investment income includes interest, dividends, capital gains and rents. But many taxpayers have been surprised to learn that this tax would also apply to any taxable gain on the sale of their home (after exclusions). As first presented, this new tax seemed simple. But the NII is also a net investment tax. Taxpayers can offset certain expenses against income of this type.

But by defining new sub groups of income items and further permitting certain deductions, Congress heads down the slippery slope of further tax complexity. This new tax has plenty.

Like its 44-year-old father, the AMT, and 100 year-old grandfather, the regular income tax, this new tax may look simple now, but its first steps will be harder than they appear.

Questions abound

Many taxpayers rent buildings to themselves; for example a manufacturer may own its factory in a separate legal entity. Do these rents count as investment income? Recent IRS pronouncements suggest this type of arrangement may be OK.

There is an exception for trade or business rentals. Is owning one property sufficient to be considered a trade or business, or must there be more? Real estate professionals, a special group to whom certain passive activity rules do not apply, are now fractured into two classes. There are pure real estate professionals whose activities include rental properties, and real estate professionals who are involved in other activities such as brokerage or support services to real estate who may not be included. As if the passive activity rules needed further nuance, this complex area just got worse.

Certain expenses can offset the tax. Investment interest expense (a complex topic all on its own) can be allocated against the investment income. But the two types of income are not precisely the same and the expense allocation will be complicated. Similarly, state income taxes can be allocated as an expense, but how?

The tax is not to be trifled with. While the tax is 3.8 percent, and seemingly not a high rate, dividends and capital gains have already been increased from 15 percent to 20 percent and a 3.8 percent add on is yet another 20 percent increase. Not a minor matter. Many taxpayers are going to be surprised at the increase in effective tax rates. Five percent here and 3.8 percent there, and the old 15 percent rate has gone up by 59 percent.

So we begin the new year with a new tax. And since taxes seem to come and never go, we are making a New Year’s resolution for further study and research. The world is just a bit more complicated than it was.

View the original print publication.