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The New 3.8% Net Investment Income Tax Continues to Challenge

May 17, 2013

Crystal A. Germanese, CPA
Tax Manager

The 3.8% Medicare tax on net investment income (the NII Tax) is a new tax calculated on a new tax base, on top of the income tax, alternative minimum tax, self-employment tax and payroll tax. Proposed regulations were issued at the end of 2012 for taxpayers to rely on to determine the application of net investment income (NII) to certain categories of income.

A public hearing on the existing Code Section 1411 regulations, held at IRS headquarters in Washington, D.C. in early April 2013 only confirmed how the application of the NII Tax, particularly income arising from passive activities, is challenging even for the experts. The NII Tax became effective January 1, 2013. Current confusion over exactly how the 3.8% operates can impact tax strategies that should be put into motion in 2013. Any misinterpretation can also bear on 2013 estimated tax that may be due to cover any 3.8% NII Tax liability.

NII Tax Thresholds

For tax years beginning after December 31, 2012, the NII surtax on individuals equals 3.8% of the lesser of net investment income for the tax year, or the excess, if any, of:

  • the individual's modified adjusted gross income (MAGI) for the tax year, over
  • the threshold amount.

The threshold amount, in turn, is equal to:

  • $250,000 in the case of a taxpayer making a joint return or a surviving spouse,
  • $125,000 in the case of a married taxpayer filing a separate return, and
  • $200,000 in any other case.

Trusts and estates are also subject to the NII surtax, to the extent of the lesser of:
(i) undistributed net investment income, or (ii) the excess of adjusted gross income over the dollar amount at which the highest tax bracket begins which, for 2013, is $11,950.

Net Investment Income

The primary confusion over application of the 3.8% NII Tax revolves around finding a precise definition of "net investment income" as enacted by Congress. To appreciate the complexity of the task, just look at the applicable Internal Revenue Code provision. Code Sec. 1411(c)(1) defines net investment income as the sum of:

  • Category (i) income: Gross income from interest, dividends, annuities, royalties and rents, other than such income which is derived in the ordinary course of a trade or business;
  • Category (ii) income: Other gross income derived from a trade or business; and
  • Category (iii) income: Net gain attributable to the disposition of property, other than property held in a trade or business; over

deductions properly allocable to such gross income or net gain.

Category (ii) income, other gross income derived from a trade or business, is trade or business income that is a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities.


Application of the 3.8% NII Tax to capital gains and dividends from a personal stock portfolio is clear. But clarity breaks down when a "trade or business" is thrown into the mix and the concept of "passive activity" is added to it. If gain or other income is the result of an active business activity, it generally escapes NII Tax. However, when the "active" business is a passive activity, such as a rental business, it may be deemed to generate income that is subject to the NII Tax.

Code Sec. 1411doesn't define the term “trade or business;” the proposed regulations provide that the definition of a trade or business for NIIT purposes is limited to a trade or business within the meaning of Code Sec. 162. The Service does not say that a rental activity is a trade or business. The determination is based on the facts and circumstances, which generally include profit motivation and scope of activities.

A trade or business has to be carried on with a good faith intention to make a profit or the belief that a profit can be made from the activity; this is generally not a problem for most activities, including rental real estate. But when we turn to the scope of the activities, rental real estate may fall short of the trade or business level.

One aspect of the scope of activities amounting to a trade or business is that there is a participation that is regular, continuous and substantial. Mere ownership of real property rented under a net lease doesn’t constitute a trade or business because mere collection of net rent does not involve sufficient management activity. On the other hand, the proposed regulations offer an equipment rental activity that is a trade or business. The question still remains for the activities that fall in the middle.

If a taxpayer meets the requirements to be a real estate professional, the taxpayer’s interests in rental real estate are not passive; however, the taxpayer is not necessarily engaged in a trade or business within the meaning of Code Sec. 162. If the rental real estate activities of the real estate professional are not Code Sec. 162 trades or businesses, the gross income from rents derived from such activity will not be excluded under the ordinary course of a trade or business exception.

Self-Rental Activities and Grouping

There are also still questions relating to the application of the NII Tax and self-rental activities and grouping.

The self-rental recharacterization rule under Code Sec. 469 affects taxpayers who rent property to a trade or business in which they materially participate. Concern is expressed over the possibility of interpreting net investment income under Code Sec. 1411 to include rental income from a self-rental activity. The hope is that the material participation and trade or business requirements will be tested on the whole so the rent would not be considered as separate from the overall business activity and therefore would not be subject to the net investment tax simply because properties are held in a separate LLC.

A rental activity may not be grouped with a trade or business activity unless it is insubstantial in relation to the trade or business activity or each owner of the trade of business activity has the same proportionate ownership interest in the rental activity. The meaning of the word “insubstantial” is based on the fact and circumstances of each case.

The proposed regulations permit businesses subject to the NII Tax to elect to regroup their activities for passive loss purposes in 2013 or 2014. This regrouping election allows taxpayers with a fresh start to accommodate the new NII surtax. A taxpayer may only regroup activities once, and any regrouping will apply to the tax year for which the regrouping is done and all later years so it is important for the taxpayers to have a clear understanding of the application of the NII Tax to make these determinations.

Application of the net investment income tax is particularly difficult to get a handle on in a variety of situations.  Unfortunately, however, at 3.8%, it is costly enough not to be ignored. 

Crystal A. Germanese is a manager at BlumShapiro, the largest regional accounting, tax and business consulting firm based in New England, with offices in Connecticut, Massachusetts and Rhode Island.  The firm, with 340 professionals and staff, offers a diversity of services which includes auditing, accounting, tax and business advisory services.  In addition, BlumShapiro provides a variety of specialized consulting services such as succession and estate planning, business technology services, employee benefit plan audits, litigation support and valuation, and financial staffing.  The firm serves a wide range of privately held companies, government and non-profit organizations and provides non-audit services for publicly traded companies.

Disclaimer: Under U.S. Treasury Department guidelines, we hereby inform you that (1) any tax advice contained in this communication is not intended or written to be used, and cannot be used by you, for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service (or state and local or other tax authorities), and (2) no part of any tax advice contained in this communication is intended to be used, and cannot be used, by any party to promote, market or recommend any transaction or tax-related matter(s) addressed herein without the express and written consent of Blum, Shapiro & Company, P.C.


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