Net Investment Income Tax for 1040 Filers: First Year Thoughts

Since the Affordable Care Act was passed in 2010, there have been plenty of articles discussing one of its new taxes, the Net Investment Income Tax (NIIT), which assesses an additional 3.8% tax on the investment income of individuals and trusts. (For instance, we posted a planning article, Minimizing “Net Investment Income”  in May of 2013.) Although the tax was passed in 2010, it only affected tax years starting on or after January 1, 2013… which means we have only just completed our first filing cycle in which this tax was reported. We thought we’d take this opportunity to ponder some of the common questions and issues that came to light as the “rubber hit the road” on the NIIT.

1. Did I pay it?  Wondering if you were subject to this tax in 2013? Grab your Form 1040 and take a look at line 60. If there’s an amount reported there and box b (form 8960) is checked, then it’s a “yes:” at least some of your investment income was assessed additional tax at 3.8%.

2. Did I pay it on the right income? Some types of income are always net investment income (interest, dividends), but some types of income are only net investment income if the circumstances require it. For instance, if you own stock in an S corporation, your pass-through income from the S corporation is net investment income if you don’t work for the company, but might not be net investment income if you do work for it (provided you work enough hours for the company during the year). The same distinction matters if you sold the S corporation stock at a gain: that capital gain may not be investment income if you worked full-time for the business before selling. Since tax preparation software won’t easily make these distinctions, you might want to make sure that you only paid NIIT on income that really is considered “investment income” under these specific rules.

3. Pre-paying state taxes can reduce NIIT. One of the tax accountant’s top year-end planning tools has long been to suggest pre-prepayment of state income taxes before December 31st, so that you reap the benefit of that deduction in the earlier year. However, since 2001, when individual tax rates were lowered significantly, the benefit of pre-paying state taxes eroded due to alternative minimum tax (AMT) effects. State taxes are one of several items not deductible for AMT purposes; when more taxpayers fell into the group of those subject to AMT, the benefit for prepaying state taxes disappeared for many.

However, the NIIT is changing the landscape. For taxpayers who are subject to AMT and have significant investment earnings, prepaying state taxes will reduce net investment income (NII) and therefore also reduce NIIT paid. Since you can only take deductions from NII in the year the deductible items are actually paid, it may again be worthwhile to prepay your states taxes, even if you are subject to AMT. In addition, you will certainly want to prepay state taxes before December 31st in any year in which you have an unusual investment income event: a large capital gain, or an unusual level of dividends or interest, or perhaps the sale of a piece of real property you had held for investment. Failing to pay the state tax in the same year as the unusual investment income item could result in a loss of the benefit of the deduction altogether.

4. In Certain Circumstances, Married Filing Separately Might Be More Beneficial. It takes an unusual fact pattern for married taxpayers to see lower overall taxes from filing separate income tax returns. In years before 2013, the most common instance in which separate returns were beneficial was if one spouse had lower separate income, and a deduction type that was reduced based on higher adjusted gross income (AGI). For instance, if one spouse had high medical expenses (allowed only to the extent they exceed 10% of AGI), and lower income, more of the medical expenses might be deductible if the married couple file separate returns.

With the NIIT, we found another circumstance in which married couples might benefit from filing separately. Here’s the fact patter with the most potential benefit: 

  • • Spouse 1 (the “earnings” spouse) has at least $250,000 in earnings from wages or flow-through income from his/her business, but no investment income.
  • • Spouse 2 (the “investing” spouse) has at least $125,000 in investment earnings from separately-titled accounts or investment pass-through entities, but no earned income.

In this fact pattern, the couple would pay $4,750 in NIIT if they file jointly, but $0 NIIT if they file separate returns.

That’s not an insignificant savings! But keep a few warnings in mind before deciding to separate your tax fate from your spouse. Filing separately requires each spouse to identify his or her individual deductible expenses, such as mortgage interest and charitable contributions. This can be complicated or simply cumbersome, and it would add cost to tax preparation.

Also, we found two instances in which the benefit of this tactic would be completely eliminated: (a) if you are resident in a community property state such as California or Washington: these states legally require you to split all earned income 50/50 to each spouse; and (b) if your investment assets are titled jointly. In which case, only half of the investment income could be sheltered from NIIT with separate filing. That might erode the benefit to a point where it would not be worth the additional hassle and cost of identifying income and expenses separately, and of preparing two tax returns.

This blog post is a summary and is not intended as tax or legal advice. You should consult with your tax advisor to obtain specific advice with respect to your fact pattern.