Planning for the New 3.8 Percent Tax on Investment Income

Nov. 21, 2013

Individuals, trusts, and estates are subject to a new 3.8 percent tax on net investment income earned on or after Jan. 1, 2013. The new tax applies when adjusted income exceeds $250,000 for joint filers, $200,000 for individual filers, $125,000 for married filing separate filers, and $11,950 for estates and trusts.

The 3.8 percent tax applies to investment income including interest, dividends, capital gains, annuities, and royalties. The tax also applies to three other categories of income Congress included as investments:

  • Rental income
  • Income from passive activities
  • Income from the business of trading in financial instruments or commodities

 

The IRS issued proposed regulations on the 3.8 percent tax in December 2012, which, based on recent public comments, are expected to be finalized before the end of the year. Some changes are expected in the final regulations, but it is unlikely these changes will significantly alter most of the guidance already provided. Although the final regulations might affect some tax planning strategies, taxpayers subject to the tax need to begin preparing now for year-end.

  • Taxpayers should review their level of activity in any partnerships or S corporations to determine if the activity is a passive activity subject to the 3.8 percent tax. If an individual can demonstrate material participation in a business activity through contemporaneous documentation such as time logs or calendars, that activity generally will not be subject to the 3.8 percent tax. In addition, taxpayers are eligible for a one-time regrouping election for their passive activities in either 2013 or 2014, which could minimize the effect of the tax.
  • Taxpayers with rental activities, especially those who rent property to related businesses, should review their leases to determine if they can meet any of the exceptions for the 3.8 percent tax. Although IRS rules permit treating a self-rental activity as nonpassive, most self-rental activities are structured as net leases. The proposed regulations make it clear that the IRS generally will view income from net leases as investment income subject to the 3.8 percent tax. Taxpayers may be able to exempt a self-rental activity from the tax if the lease is not a net lease and the lessor provides services (such as landscaping, repairs, or snow removal) to the lessee.
  • Taxpayers should track and document expenses incurred for their investment activities. These expenses can be used to offset investment income to the extent they are deductible for regular tax purposes.

 

For More Information
Howard Wagner
502.420.4567
howard.wagner@crowehorwath.com
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David Holets
317.706.2683
david.holets@crowehorwath.com
  LinkedIn Profile

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Howard M. Wagner
Partner, National Tax Services